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Pepco Holdings 10-K 2008
phi10k2007.htm
.
UNITED STATES
 
SECURITIES AND EXCHANGE COMMISSION
 
Washington, D.C.  20549
 
FORM 10-K
 
ANNUAL REPORT PURSUANT TO SECTION 13 or 15(d) OF
 
THE SECURITIES EXCHANGE ACT OF 1934
 
For the fiscal year ended December 31, 2007
 
Commission
File Number
Name of Registrant, State of Incorporation,
Address of Principal Executive Offices,
and Telephone Number
I.R.S. Employer
Identification Number
 
001-31403
PEPCO HOLDINGS, INC.
(Pepco Holdings or PHI), a
  Delaware corporation
701 Ninth Street, N.W.
Washington, D.C.  20068
Telephone: (202)872-2000
52-2297449
 
001-01072
POTOMAC ELECTRIC POWER
COMPANY
(Pepco), a District of
  Columbia and Virginia
  corporation
701 Ninth Street, N.W.
Washington, D.C.  20068
Telephone: (202)872-2000
53-0127880
 
001-01405
DELMARVA POWER & LIGHT
COMPANY
(DPL), a Delaware and
  Virginia corporation
800 King Street, P.O. Box 231
Wilmington, Delaware  19899
Telephone: (202)872-2000
51-0084283
 
001-03559
ATLANTIC CITY ELECTRIC
COMPANY
(ACE), a New Jersey
  corporation
800 King Street, P.O. Box 231
Wilmington, Delaware  19899
Telephone: (202)872-2000
21-0398280

Continued

 
 

 

Securities registered pursuant to Section 12(b) of the Act:
 
Registrant
Title of Each Class
Name of Each Exchange
on Which Registered       
Pepco Holdings
Common Stock, $.01 par value
New York Stock Exchange
 
Securities registered pursuant to Section 12(g) of the Act:
 
Registrant
Title of Each Class
Pepco
Common Stock, $.01 par value
DPL
Common Stock, $2.25 par value
ACE
Common Stock, $3.00 par value
 
      Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

   
Pepco Holdings
Yes   X  
No       
 
Pepco
Yes      
No   X  
  
DPL
Yes       
No   X  
 
ACE
Yes      
No   X  

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

   
Pepco Holdings
Yes       
No   X  
 
Pepco
Yes      
No   X  
  
DPL
Yes       
No   X  
 
ACE
Yes      
No   X  

    Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months and (2) has been subject to such filing requirements for the past 90 days.

   
Pepco Holdings
Yes   X  
No       
 
Pepco
Yes   X  
No       
  
DPL
Yes   X  
No       
 
ACE
Yes   X  
No       

    Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in the definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K (applicable to Pepco Holdings only).         .
 
      Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer.  See definition of “accelerated filer and larger accelerated filer” in Rule 12b-2 of the Exchange Act.

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

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

   
Pepco Holdings
Yes      
No   X  
 
Pepco
Yes      
No   X  
 
DPL
Yes      
No   X  
 
ACE
Yes      
No   X  


 
 

 


    Pepco, DPL, and ACE> meet the conditions set forth in General Instruction I(1)(a) and (b) of Form 10-K and are therefore filing this Form 10-K with the reduced disclosure format specified in General Instruction I(2) of Form 10-K.

Registrant
Aggregate Market Value of Voting and Non-Voting Common Equity Held by Non-Affiliates of the Registrant at June 29, 2007
Number of Shares of Common Stock of the Registrant Outstanding at February 1, 2008
Pepco Holdings
$5.5 billion
201,110,282
($.01 par value)
Pepco
None (a)
100
($.01 par value)
DPL
None (b)
1,000
($2.25 par value)
ACE
None (b)
8,546,017
($3.00 par value)

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

THIS COMBINED FORM 10-K IS SEPARATELY FILED BY PEPCO HOLDINGS, PEPCO, DPL AND ACE.  INFORMATION CONTAINED HEREIN RELATING TO ANY INDIVIDUAL REGISTRANT IS FILED BY SUCH REGISTRANT ON ITS OWN BEHALF.  EACH REGISTRANT MAKES NO REPRESENTATION AS TO INFORMATION RELATING TO THE OTHER REGISTRANTS.
 
DOCUMENTS INCORPORATED BY REFERENCE
 
Portions of the Pepco Holdings, Inc. definitive proxy statement for the 2008 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission on or about March 27, 2008 are incorporated by reference into Part III of this report.



 
 

 


TABLE OF CONTENTS
     
Page
 
-
Glossary of Terms
i
PART I
     
  Item 1.
-
Business
1
  Item 1A.
-
Risk Factors
20
  Item 1B.
-
Unresolved Staff Comments
29
  Item 2.
-
Properties
30
  Item 3.
-
Legal Proceedings
31
  Item 4.
-
Submission of Matters to a Vote of Security Holders
32
PART II
     
  Item 5.
-
Market for Registrant’s Common Equity, Related
   Stockholder Matters and Issuer Purchases of
   Equity Securities
32
  Item 6.
-
Selected Financial Data
36
  Item 7.
-
Management’s Discussion and Analysis of
   Financial Condition and Results of Operations
38
  Item 7A.
-
Quantitative and Qualitative Disclosures
   About Market Risk
135
  Item 8.
-
Financial Statements and Supplementary Data
140
  Item 9.
-
Changes in and Disagreements With Accountants
   on Accounting and Financial Disclosure
334
  Item 9A.
-
Controls and Procedures
334
  Item 9A(T).
-
Controls and Procedures
334
  Item 9B.
-
Other Information
336
PART III
     
  Item 10.
-
Directors, Executive Officers and Corporate Governance
336
  Item 11.
-
Executive Compensation
338
  Item 12.
-
Security Ownership of Certain Beneficial Owners and
   Management and Related Stockholder Matters
339
  Item 13.
-
Certain Relationships and Related Transactions, and
   Director Independence
340
  Item 14.
-
Principal Accounting Fees and Services
340
PART IV
     
  Item 15.
-
Exhibits, Financial Statement Schedules
341
 Financial Statements
 -
 Included in Part II, Item 8 341
   Schedule I  
 -
 Condensed Financial Information of Parent Company
    342
   Schedule II 
 -
 Valuation and Qualifying Accounts 345 
   Exhibit 12 
 -
 Statements Re: Computation of Ratios  360
   Exhibit 21 
 -
 Subsidiaries of the Registrant  364
   Exhibit 23 
 -
 Consents of Independent Registered Public Accounting Firm  366
 Exhibits 31.1 - 31.8    Rule 13a-14a/15d-14(a) Certifications  370
 Exhibits 32.1 - 32.4    Section 1350 Certifications  378
   Signatures      382
 

 
 

 


GLOSSARY OF TERMS
 

Term
Definition
A&N
A&N Electric Cooperative, purchaser of DPL’s retail electric distribution business in Virginia
ABO
Accumulated benefit obligation
Accounting Hedges
Derivatives designated as cash flow and fair value hedges
ACE
Atlantic City Electric Company
ACE Funding
Atlantic City Electric Transition Funding LLC
ACO
Administrative Consent Order
ADFIT
Accumulated deferred federal income taxes
ADITC
Accumulated deferred investment tax credits
AFUDC
Allowance for Funds Used During Construction
Ancillary services
Generally, electricity generation reserves and reliability services
APB
Accounting Principles Board
Appellate Division
Appellate Division of the Superior Court of New Jersey
Bankruptcy Settlement
The bankruptcy settlement among the parties concerning the environmental proceedings at the Metal Bank/Cottman Avenue site
Bcf
Billion cubic feet
BGS
Basic Generation Service (the supply of electricity by ACE to retail customers in New Jersey who have not elected to purchase electricity from a competitive supplier)
BGS-FP
BGS-Fixed Price service
BGS-CIEP
BGS-Commercial and Industrial Energy Price service
Bondable Transition   Property
Right to collect a non-bypassable transition bond charge from ACE customers pursuant to bondable stranded costs rate orders issued by the NJBPU
BSA
Bill Stabilization Adjustment
CAA
Federal Clean Air Act
CAIR
EPA’s Clean Air Interstate rule
CAMR
EPA’s Clean Air Mercury rule
CERCLA
Comprehensive Environmental Response, Compensation, and Liability Act of 1980
Citgo
Citgo Asphalt Refining Company
CO2
Carbon dioxide
Conectiv
A wholly owned subsidiary of PHI which is a holding company under PUHCA 2005 and the parent of DPL and ACE
Conectiv Energy
Conectiv Energy Holding Company and its subsidiaries
Conectiv Group
Conectiv and certain of its subsidiaries that were involved in a like-kind exchange transaction under examination by the IRS
Cooling Degree Days
Daily difference in degrees by which the mean (high and low divided by 2) dry bulb temperature is above a base of 65 degrees Fahrenheit
CRMC
PHI’s Corporate Risk Management Committee
CWA
Federal Clean Water Act
DCPSC
District of Columbia Public Service Commission


 
i

 


Term
Definition
Default Electricity
  Supply
The supply of electricity by PHI’s electric utility subsidiaries at regulated rates to retail customers who do not elect to purchase electricity from a competitive supplier, and which, depending on the jurisdiction and period, is also known as SOS, BGS, or POLR service
Default Supply Revenue
Revenue received for Default Electricity Supply
Delaware District Court
United States District Court for the District of Delaware
Directors Compensation
  Plan
PHI Non-Management Directors Compensation Plan
DNREC
Delaware Department of Natural Resources and Environmental Control
DPL
Delmarva Power & Light Company
DPSC
Delaware Public Service Commission
DRP
PHI’s Shareholder Dividend Reinvestment Plan
EDECA
New Jersey Electric Discount and Energy Competition Act
EDIT
Excess Deferred Income Taxes
EITF
Emerging Issues Task Force
EPA
U.S. Environmental Protection Agency
ERISA
Employment Retirement Income Security Act of 1974
Exchange Act
Securities Exchange Act of 1934, as amended
FAS
Financial Accounting Standards
FASB
Financial Accounting Standards Board
FERC
Federal Energy Regulatory Commission
FHACA
Flood Hazard Area Control Act
FIN
FASB Interpretation Number
Financing Order
Financing Order of the SEC under PUHCA 1935 dated June 30, 2005, with respect to PHI and its subsidiaries
FRP
Facility Response Plan required by EPA
FSP
FASB Staff Position
FSP AUG AIR-1
FSP American Institute of Certified Public Accountants Industry Audit Guide, Audits of Airlines--”Accounting for Planned Major Maintenance Activities”
FTB
FASB Technical Bulletin
Full Requirements
  Load Service
The supply of energy by Conectiv Energy to utilities to fulfill their default electricity supply obligations
FWPA
Freshwater Wetlands Protection Act
GAAP
Accounting principles generally accepted in the United States of America
GCR
Gas Cost Recovery
GWh
Gigawatt hour
Heating Degree Days
Daily difference in degrees by which the mean (high and low divided by 2) dry bulb temperature is below a base of 65 degrees Fahrenheit.
HPS
Hourly Priced Service DPL is obligated to provide to its largest customers
IRC
Internal Revenue Code
IRS
Internal Revenue Service
ISONE
Independent System Operator - New England


 
ii

 


Term
Definition
ITC
Investment Tax Credit
LEAC Liability
ACE’s $59.3 million deferred energy cost liability existing as of July 31, 1999 related to ACE’s Levelized Energy Adjustment Clause and ACE’s Demand Side Management Programs
LDA
Locational Deliverability Area within the PJM RTO region that has limited transmission capability to import capacity which, together with internal resources, may not be able to maintain reliability in that area
LTIP
Pepco Holdings’ Long-Term Incentive Plan
Mcf
One thousand cubic feet
MDE
Maryland Department of the Environment
Medicare Act
Medicare Prescription Drug, Improvement and Modernization Act of 2003
MGP
Manufactured gas plant
Mirant
Mirant Corporation
MPSC
Maryland Public Service Commission
NFA
No Further Action letter issued by the NJDEP
NJBPU
New Jersey Board of Public Utilities
NJDEP
New Jersey Department of Environmental Protection
NJPDES
New Jersey Pollutant Discharge Elimination System
NOPR
Notice of Proposed Rulemaking
Normalization
  provisions
Sections of the IRC and related regulations that dictate how excess deferred income taxes resulting from the corporate income tax rate reduction enacted by the Tax Reform Act of 1986 and accumulated deferred investment tax credits should be treated for ratemaking purposes
Notice
Notice 2005-13 issued by the Treasury Department and IRS on February 11, 2005
NOx
Nitrogen oxide
NPDES
National Pollutant Discharge Elimination System
NUGs
Non-utility generators
NYDEC
New York Department of Environmental Conservation
OCI
Other Comprehensive Income
ODEC
Old Dominion Electric Cooperative, purchaser of DPL’s wholesale transmission business in Virginia
Panda
Panda-Brandywine, L.P.
Panda PPA
PPA between Pepco and Panda
PARS
Performance Accelerated Restricted Stock
PBO
Projected benefit obligation
PCI
Potomac Capital Investment Corporation and its subsidiaries
Pepco
Potomac Electric Power Company
Pepco Energy Services
Pepco Energy Services, Inc. and its subsidiaries
Pepco Holdings or PHI
Pepco Holdings, Inc.
PHI Parties
The PHI Retirement Plan, PHI and Conectiv, parties to cash balance plan litigation brought by three management employees of PHI Service Company
PHI Retirement Plan
PHI’s noncontributory retirement plan


 
iii

 


Term
Definition
PJM
PJM Interconnection, LLC
PLR
Private letter ruling from the IRS
POLR
Provider of Last Resort service (the supply of electricity by DPL before May 1, 2006 to retail customers in Delaware who did not elect to purchase electricity from a competitive supplier)
POM
Pepco Holdings’ NYSE trading symbol
Power Delivery
PHI’s Power Delivery Business
PPA
Power Purchase Agreement
PRP
Potentially responsible party
PUHCA 1935
Public Utility Holding Company Act of 1935, which was repealed effective February 8, 2006
PUHCA 2005
Public Utility Holding Company Act of 2005, which became effective February 8, 2006
RAR
IRS revenue agent’s report
RARM
Reasonable Allowance for Retail Margin
RC Cape May
RC Cape May Holdings, LLC, an affiliate of Rockland Capital Energy Investments, LLC, and the purchaser of the B.L. England generating facility
Recoverable stranded
  costs
The portion of stranded costs that is recoverable from ratepayers as approved by regulatory authorities
Regulated T&D Electric
  Revenue
Revenue from the transmission and the delivery of electricity to PHI’s customers within its service territories at regulated rates
RGGI
Regional Greenhouse Gas Initiative
RI/FS
Remedial Investigation/Feasibility Study
ROE
Return on equity
SEC
Securities and Exchange Commission
SFAS
Statement of Financial Accounting Standards
SO2
Sulfur dioxide
SOS
Standard Offer Service (the supply of electricity by Pepco in the District of Columbia, by Pepco and DPL in Maryland and by DPL in Delaware on and after May 1, 2006, to retail customers who have not elected to purchase electricity from a competitive supplier)
Spark spread
The market price for electricity less the product of the cost of fuel times the unit heat rate.  It is used to estimate the relative profitability of a generation unit.
SPCC
Spill Prevention, Control, and Countermeasure plan required by EPA
Spot
Commodities market in which goods are sold for cash and delivered immediately
Standard Offer Service
  revenue or SOS revenue
Revenue Pepco and DPL, respectively, receive for the procurement of energy for its SOS customers
Starpower
Starpower Communications, LLC
Stranded costs
Costs incurred by a utility in connection with providing service which would be unrecoverable in a competitive or restructured market.  Such costs may include costs for generation assets, purchased power costs, and regulatory assets and liabilities, such as accumulated deferred income taxes.


 
iv

 


Term
Definition
Tolling agreement
A physical or financial contract where one party delivers fuel to a specific generating station in exchange for the power output
TPAs
Transition power agreements between Pepco and Mirant pursuant to which Mirant agreed to supply all of the energy and capacity needed by Pepco to fulfill its SOS obligations in Maryland and in the District of Columbia
TPA Claim
An allowed, pre-petition general unsecured claim by Pepco in the Mirant bankruptcy in the amount of $105 million
Transition Bonds
Transition bonds issued by ACE Funding
Treasury lock
A hedging transaction that allows a company to “lock-in” a specific interest rate corresponding to the rate of a designated Treasury bond for a determined period of time
VaR
Value at Risk



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

 
·
electricity and natural gas delivery (Power Delivery), conducted through the following regulated public utility companies, each of which is a reporting company under the Securities Exchange Act of 1934, as amended (the Exchange Act):

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

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

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

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

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


 
1

 


Conectiv is solely a holding company with no business operations.  The activities of Potomac Capital Investment Corporation (PCI) are described below under the heading “Other Business Operations.”
 
PHI Service Company provides a variety of support services, including legal, accounting, treasury, tax, purchasing and information technology services to PHI and its operating subsidiaries.  These services are provided pursuant to a service agreement among PHI, PHI Service Company, and the participating operating subsidiaries.  The expenses of the service company are charged to PHI and the participating operating subsidiaries in accordance with costing methodologies set forth in the service agreement.
 
For financial information relating to PHI’s segments, see Note (3), “Segment Information,” to the consolidated financial statements of PHI set forth in Item 8 of this Form 10-K.  Each of Pepco, DPL and ACE has one operating segment.
 
Investor Information
 
Each of PHI, Pepco, DPL and ACE files reports under the Exchange Act.  The Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and all amendments to those reports, of each of the companies are made available free of charge on PHI’s internet Web site as soon as reasonably practicable after such documents are electronically filed with or furnished to the Securities and Exchange Commission (SEC).  These reports may be found at http://www.pepcoholdings.com/investors.
 
Description of Business
 
The following is a description of each of PHI’s two principal business operations.
 
Power Delivery
 
The largest component of PHI’s business is Power Delivery, which consists of the transmission, distribution and default supply of electricity.  A minor portion of the Power Delivery business consists of the supply and distribution of natural gas.  In 2007, 2006 and 2005, respectively, PHI’s Power Delivery operations produced 56%, 61%, and 58% of PHI’s consolidated operating revenues (including revenue from intercompany transactions) and 66%, 67%, and 74% of PHI’s consolidated operating income (including income from intercompany transactions).
 
Each of Pepco, DPL and ACE is a regulated public utility in the jurisdictions that comprise its service territory.  Each company owns and operates a network of wires, substations and other equipment that is classified either as transmission or distribution facilities.  Transmission facilities are high-voltage systems that carry wholesale electricity into, or across, the utility’s service territory.  Distribution facilities are low-voltage systems that carry electricity to end-use customers in the utility’s service territory.
 
Delivery of Electricity and Natural Gas and Default Electricity Supply
 
Each company is responsible for the delivery of electricity and, in the case of DPL, natural gas in its service territory, for which it is paid tariff rates established by the local regulatory agency.  Each company also supplies electricity at regulated rates to retail customers

 
2

 

in its service territory who do not elect to purchase electricity from a competitive energy supplier.  The regulatory term for this supply service varies by jurisdiction as follows:

 
Delaware
Provider of Last Resort service - before May 1, 2006
 
Standard Offer Service (SOS) - on and after May 1, 2006
 
   District of Columbia  SOS
 
 
Maryland
SOS

 
New Jersey
Basic Generation Service (BGS)

 
Virginia
Default Service

In this Form 10-K, these supply service obligations are referred to generally as Default Electricity Supply.
 
In the aggregate, the Power Delivery business delivers electricity to more than 1.8 million customers in the mid-Atlantic region and distributes natural gas to approximately 122,000 customers in Delaware.
 
Transmission of Electricity and Relationship with PJM
 
The transmission facilities owned by Pepco, DPL and ACE are interconnected with the transmission facilities of contiguous utilities and are part of an interstate power transmission grid over which electricity is transmitted throughout the Mid-Atlantic portion of the United States and parts of the Midwest.  The Federal Energy Regulatory Commission (FERC) has designated a number of regional transmission organizations to coordinate the operation and planning of portions of the interstate transmission grid.  Pepco, DPL and ACE are members of the PJM Regional Transmission Organization (PJM RTO).  In 1997, FERC approved PJM Interconnection, LLC (PJM) as the sole provider of transmission service in the PJM RTO region, which today consists of all or parts of Delaware, Illinois, Indiana, Kentucky, Maryland, Michigan, New Jersey, North Carolina, Ohio, Pennsylvania, Tennessee, Virginia, West Virginia and the District of Columbia.  As the independent grid operator, PJM coordinates the electric power market and the movement of electricity within the PJM RTO region.  Any entity that wishes to have electricity delivered at any point in the PJM RTO region must obtain transmission services from PJM at rates approved by FERC.  In accordance with FERC rules, Pepco, DPL, ACE and the other transmission-owning utilities in the region make their transmission facilities available to the PJM RTO and PJM directs and controls the operation of these transmission facilities.  Transmission rates are proposed by the transmission owner and approved by FERC.  PJM, as the tariff administrator, collects transmission service revenue from transmission service customers and distributes the revenue to the transmission owners.  PJM also oversees the planning process for the enhancement and expansion of transmission capability on a regional basis within the PJM RTO region.  PJM approval is required for transmission upgrades and enhancements undertaken by member utilities.
 

 
3

 


Distribution of Electricity and Deregulation
 
Historically, electric utilities, including Pepco, DPL and ACE, were vertically integrated businesses that generated all or a substantial portion of the electric power supply that they delivered to customers in their service territories over their own distribution facilities.  Customers were charged a bundled rate approved by the applicable regulatory authority that covered both the supply and delivery components of the retail electric service.  However, legislative and regulatory actions in each of the service territories in which Pepco, DPL and ACE operate have resulted in the “unbundling” of the supply and delivery components of retail electric service and in the opening of the supply component to competition from non-regulated providers.  Accordingly, while Pepco, DPL and ACE continue to be responsible for the distribution of electricity in their respective service territories, as the result of deregulation, customers in those service territories now are permitted to choose their electricity supplier from among a number of non-regulated, competitive suppliers.  Customers who do not choose a competitive supplier receive Default Electricity Supply on terms that vary depending on the service territory, as described more fully below.
 
In connection with the deregulation of electric power supply, Pepco, DPL and ACE have divested all of their respective generation assets, by either selling them to third parties or transferring them to the non-regulated affiliates of PHI that comprise PHI’s Competitive Energy businesses.  Accordingly, Pepco, DPL and ACE are no longer engaged in generation operations.
 
Seasonality
 
The Power Delivery business is seasonal and weather patterns can have a material impact on operating performance.  In the region served by PHI, demand for electricity is generally higher in the summer months associated with cooling and demand for electricity and natural gas is generally higher in the winter months associated with heating, as compared to other times of the year.  Historically, the Power Delivery operations of each of PHI’s utility subsidiaries have generated higher revenues and income when temperatures are colder than normal in the winter and warmer than normal in the summer, and conversely revenues and income typically are lower when the temperature is warmer than normal in the winter and cooler than normal in the summer.  In Maryland, however, the decoupling of distribution revenue for a given reporting period from the amount of power delivered during the period as the result of the adoption by the Maryland Public Service Commission (MPSC) of a bill stabilization adjustment mechanism for retail customers has had the effect of eliminating changes in customer usage due to weather conditions or for other reasons as a factor having an impact on reported revenue and income.
 
Regulation
 
The retail operations of PHI’s utility subsidiaries, including the rates they are permitted to charge customers for the delivery of electricity and, in the case of DPL, natural gas, are subject to regulation by governmental agencies in the jurisdictions in which they provide utility service as follows:
 
o  
Pepco’s electricity delivery operations are regulated in Maryland by the MPSC and in Washington, D.C. by the District of Columbia Public Service Commission (DCPSC).
 
o  
DPL’s electricity delivery operations are regulated in Maryland by the MPSC and in Delaware by the Delaware Public Service Commission (DPSC) and, until the sale of its
 

 
4

 
 
   Virginia operations on January 2, 2008, were regulated in Virginia by the Virginia State Corporation Commission.
 
o  
DPL’s natural gas distribution operations in Delaware are regulated by the DPSC.
 
o  
ACE’s electricity delivery operations are regulated by the New Jersey Board of Public Utilities (NJBPU).
 
o  
The transmission and wholesale sale of electricity by each of PHI’s utility subsidiaries are regulated by FERC.
 
o  
The interstate transportation and wholesale sale of natural gas by DPL are regulated by FERC.
 
Pepco
 
Pepco is engaged in the transmission, distribution and default supply of electricity in Washington, D.C. and major portions of Prince George’s and Montgomery Counties in suburban Maryland.  Pepco’s service territory covers approximately 640 square miles and has a population of approximately 2.1 million.  As of December 31, 2007, Pepco delivered electricity to 760,000 customers (of which 241,800 were located in the District of Columbia and 518,200 were located in Maryland), as compared to 753,000 customers as of December 31, 2006 (of which 240,960 were located in the District of Columbia and 512,040 were located in Maryland).
 
In 2007, Pepco delivered a total of 27,451,000 megawatt hours of electricity, of which 30% was delivered to residential customers, 50% to commercial customers, and 20% to United States and District of Columbia government customers.  In 2006, Pepco delivered a total of 26,488,000 megawatt hours of electricity, of which 29% was delivered to residential customers, 51% to commercial customers, and 20% to United States and District of Columbia government customers.
 
Pepco has been providing SOS in Maryland since July 2004.  Pursuant to an order issued by the MPSC in November 2006, Pepco will continue to be obligated to provide SOS to residential and small commercial customers indefinitely until further action of the Maryland General Assembly, and to medium-sized commercial customers through May 2009.  Pepco also has an ongoing obligation to provide SOS service at hourly priced rates to the largest customers.  Pepco purchases the power supply required to satisfy its SOS obligation from wholesale suppliers under contracts entered into pursuant to competitive bid procedures approved and supervised by the MPSC.  Pepco is entitled to recover from its SOS customers the cost of the SOS supply plus an average margin of $.001667 per kilowatt-hour.  Because margins vary by customer class, the actual average margin over any given time period depends on the number of Maryland SOS customers from each customer class and the load taken by such customers over the time period.  Pepco is paid tariff delivery rates for the delivery of electricity over its transmission and distribution facilities to all electricity customers in its Maryland service territory regardless of whether the customer receives SOS or purchases electricity from another energy supplier.
 
Pepco has been providing SOS in the District of Columbia since February 2005.  Pursuant to orders issued by the DCPSC, Pepco will continue to be obligated to provide SOS for small commercial and residential customers through May 2011 and for large commercial
 

 
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customers through May 2009.  Pepco purchases the power supply required to satisfy its SOS obligation from wholesale suppliers under contracts entered into pursuant to a competitive bid procedure approved by the DCPSC.  Pepco is entitled to recover from its SOS customers the costs associated with the acquisition of the SOS supply plus administrative charges that are intended to allow Pepco to recover the administrative costs incurred to provide the SOS.  These administrative charges include an average margin for Pepco of $.00241 per kilowatt-hour.  Because margins vary by customer class, the actual average margin over any given time period depends on the number of District of Columbia SOS customers from each customer class and the load taken by such customers over the time period.  Pepco is paid tariff delivery rates for the delivery of electricity over its transmission and distribution facilities to all electricity customers in its District of Columbia service territory regardless of whether the customer receives SOS or purchases electricity from another energy supplier.
 
For the year ended December 31, 2007, 51% of Pepco’s Maryland sales (measured by megawatt hours) were to SOS customers, as compared to 60% in 2006, and 35% of its District of Columbia sales were to SOS customers in 2007, as compared to 57% in 2006.
 
DPL
 
DPL is engaged in the transmission, distribution and default supply of electricity in Delaware and portions of Maryland and Virginia (until the sale of its Virginia operations on January 2, 2008).  In northern Delaware, DPL also supplies and distributes natural gas to retail customers and provides transportation-only services to retail customers that purchase natural gas from other suppliers.

Transmission and Distribution of Electricity

In Delaware, electricity service is provided in the counties of Kent, New Castle, and Sussex and in Maryland in the counties of Caroline, Cecil, Dorchester, Harford, Kent, Queen Anne’s, Somerset, Talbot, Wicomico and Worchester.  Prior to January 2, 2008, DPL also provided transmission and distribution of electricity in Accomack and Northampton counties in Virginia.  As discussed below, under the heading “Sale of Virginia Service Territory,” DPL, on January 2, 2008, completed the sale of substantially all of its Virginia electric service operations.
 
DPL’s electricity distribution service territory covers approximately 6,000 square miles and has a population of approximately 1.3 million.  As of December 31, 2007, DPL delivered electricity to 519,000 customers (of which 298,000 were located in Delaware, 198,000 were located in Maryland, and 23,000 were located in Virginia), as compared to 513,000 electricity customers as of December 31, 2006 (of which 295,000 were located in Delaware, 196,000 were located in Maryland, and 22,000 were located in Virginia).
 
In 2007, DPL delivered a total of 13,680,000 megawatt hours of electricity to its customers, of which 39% was delivered to residential customers, 40% to commercial customers and 21% to industrial customers.  In 2006, DPL delivered a total of 13,477,000 megawatt hours of electricity, of which 38% was delivered to residential customers, 40% to commercial customers and 22% to industrial customers.
 
DPL has been providing SOS in Delaware since May 2006.  Pursuant to orders issued by the DPSC, DPL will continue to be obligated to provide fixed-price SOS to residential, small
 

 
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commercial and industrial customers through May 2009 and to medium, large and general service customers through May 2008.  DPL purchases the power supply required to satisfy its fixed-price SOS obligation from wholesale suppliers under contracts entered into pursuant to competitive bid procedures approved by the DPSC.  DPL also has an obligation to provide Hourly Priced Service (HPS) for the largest customers.  Power to supply the HPS customers is acquired on next-day and other short-term PJM RTO markets.  DPL’s rates for supplying fixed-price SOS and HPS reflect the associated capacity, energy, transmission, and ancillary services costs and a Reasonable Allowance for Retail Margin (RARM).  Components of the RARM include a fixed annual margin of $2.75 million, plus estimated incremental expenses, a cash working capital allowance, and recovery with a return over five years of the capitalized costs of the billing system used for billing HPS customers.  DPL is paid tariff delivery rates for the delivery of electricity over its transmission and distribution facilities to all electricity customers in its Delaware service territory regardless of whether the customer receives SOS or purchases electricity from another energy supplier.
 
In Delaware, DPL sales to SOS customers represented 54% of total sales (measured by megawatt hours) for the year ended December 31, 2007, as compared to 69% in 2006.
 
     DPL has been providing SOS in Maryland since June 2004.  Pursuant to an order issued by the MPSC in November 2006, DPL will continue to be obligated to provide SOS to residential and small commercial customers indefinitely until further action of the Maryland General Assembly, and to medium-sized commercial customers through May 2009.  DPL purchases the power supply required to satisfy its market rate SOS obligation from wholesale suppliers under contracts entered into pursuant to competitive bid procedures approved and supervised by the MPSC.  DPL is entitled to recover from its SOS customers the costs of the SOS supply plus an average margin of $.001667 kilowatt-hour.  Because margins vary by customer class, the actual average margin over any given time period depends on the number of Maryland SOS customers from each customer class and the load taken by such customers over the time period.  DPL is paid tariff delivery rates for the delivery of electricity over its transmission and distribution facilities to all electricity customers in its Maryland service territory regardless of whether the customer receives SOS or purchases electricity from another energy supplier.
 
In Maryland, DPL sales to SOS customers represented 67% of total sales (measured by megawatt hours) for the year ended December 31, 2007, as compared to 75% in 2006.
 
DPL provided Default Service in Virginia from March 2004 until the sale of its Virginia retail electric business on January 2, 2008.  DPL was paid tariff delivery rates for the delivery of electricity over its transmission and distribution facilities to all electricity customers in its Virginia service territory regardless of whether the customer received Default Service or purchased electricity from another energy supplier.
 
In Virginia, DPL sales to Default Service customers represented 94% of total sales (measured by megawatt hours) for the years ended December 31, 2007 and 2006.
 
           Sale of Virginia Service Territory

On January 2, 2008, DPL completed (i) the sale of its retail electric distribution business on the Eastern Shore of Virginia to A&N Electric Cooperative (A&N) for a purchase price of
 

 
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approximately $45.2 million, after closing adjustments, and (ii) the sale of its wholesale electric transmission business located on the Eastern Shore of Virginia to Old Dominion Electric Cooperative (ODEC) for a purchase price of approximately $5.4 million, after closing adjustments.  Each of A&N and ODEC assumed certain post-closing liabilities and unknown pre-closing liabilities related to the respective assets they are purchasing (including, in the A&N transaction, most environmental liabilities), except that DPL remained liable for unknown pre-closing liabilities if they become known within six months after the January 2, 2008 closing date.  These sales resulted in an immaterial financial gain to DPL that will be recorded during the first quarter of 2008.
 
           Natural Gas Distribution
 
DPL provides regulated natural gas supply and distribution service to customers in a service territory consisting of a major portion of New Castle County in Delaware.  This service territory covers approximately 275 square miles and has a population of approximately 500,000. Large volume commercial, institutional, or industrial natural gas customers may purchase natural gas either from DPL or from other suppliers.  DPL uses its natural gas distribution facilities to transport natural gas for customers that choose to purchase natural gas from other suppliers.  Transportation customers pay DPL distribution service rates approved by the DPSC.  DPL purchases natural gas supplies for resale to its retail service customers from marketers and producers through a combination of long-term agreements and next-day delivery arrangements.  For the twelve months ended December 31, 2007, DPL supplied 67% of the natural gas that it delivered, compared to 66% in 2006.
 
As of December 31, 2007, DPL distributed natural gas to 122,000 customers, as compared to 121,000 customers as of December 31, 2006.  In 2007, DPL distributed 20,700,000 Mcf (thousand cubic feet) of natural gas to customers in its Delaware service territory, of which 38% were sales to residential customers, 25% to commercial customers, 4% to industrial customers, and 33% to customers receiving a transportation-only service.  In 2006, DPL delivered 18,300,000 Mcf of natural gas, of which 36% were sales to residential customers, 25% were sales to commercial customers, 4% were to industrial customers, and 35% were sales to customers receiving a transportation-only service.
 
ACE
 
ACE is primarily engaged in the transmission, distribution and default supply of electricity in a service territory consisting of Gloucester, Camden, Burlington, Ocean, Atlantic, Cape May, Cumberland and Salem counties in southern New Jersey.  ACE’s service territory covers approximately 2,700 square miles and has a population of approximately 1.0 million.  As of December 31, 2007, ACE delivered electricity to 544,000 customers in its service territory, as compared to 539,000 customers as of December 31, 2006.  In 2007, ACE delivered a total of 10,187,000 megawatt hours of electricity to its customers, of which 44% was delivered to residential customers, 44% to commercial customers and 12% to industrial customers.  In 2006, ACE delivered a total of 9,931,000 megawatt hours of electricity to its customers, of which 43% was delivered to residential customers, 44% to commercial customers, and 13% to industrial customers.
 
Electric customers in New Jersey who do not choose another supplier receive BGS from their electric distribution company.  New Jersey’s electric distribution companies, including
 

 
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ACE, jointly procure the supply to meet their BGS obligations from competitive suppliers selected through auctions authorized by the NJBPU for New Jersey’s total BGS requirements.  The winning bidders in the auction are required to supply a specified portion of the BGS customer load with full requirements service, consisting of power supply and transmission service.
 
ACE provides two types of BGS:

 
·
BGS-Fixed Price (BGS-FP), which is supplied to smaller commercial and residential customers at seasonally-adjusted fixed prices.  BGS-FP rates change annually on June 1 and are based on the average BGS price obtained at auction in the current year and the two prior years.  ACE’s BGS-FP load is approximately 2,270 megawatts, which represents approximately 99% of ACE’s total BGS load.  Approximately one-third of this total load is auctioned off each year for a three-year term.

 
·
BGS-Commercial and Industrial Energy Price (BGS-CIEP), which is supplied to larger customers at hourly PJM RTO real-time market prices for a term of 12 months. ACE’s BGS-CIEP load is approximately 16 megawatts, which represents approximately 1% of ACE’s BGS load.  This total load is auctioned off each year for a one-year term.

ACE is paid tariff rates established by the NJBPU that compensate it for the cost of obtaining the BGS supply.  ACE does not make any profit or incur any loss on the supply component of the BGS it provides to customers.
 
ACE is paid tariff delivery rates for the delivery of electricity over its transmission and distribution facilities to all electricity customers in its New Jersey service territory regardless of whether the customer receives BGS or purchases electricity from another energy supplier.
 
ACE sales to BGS customers represented 80% of total sales (measured by megawatt hours) for the year ended December 31, 2007 and 78% of total sales (measured by megawatt hours) for the year ended December 31, 2006.
 
On February 8, 2007, ACE completed the sale of its B.L. England generating facility.  B.L. England comprised a significant component of ACE’s generation operations and its sale required discontinued operations presentation under Statement of Financial Accounting Standards (SFAS) No. 144, “Accounting for the Impairment or Disposal of Long Lived Assets,” on ACE’s consolidated statements of earnings for the years ended December 31, 2007, 2006 and 2005.  ACE’s sale of its interests in the Keystone and Conemaugh generating facilities in September 2006 is also reflected as discontinued operations on ACE’s consolidated statements of earnings for the years ended December 31, 2006 and 2005.
 
ACE has several contracts with non-utility generators (NUGs) under which ACE purchased 3.8 million megawatt hours of power in 2007.  ACE sells the electricity purchased under the contracts with NUGs into the wholesale market administered by PJM.
 
In 2001, ACE established Atlantic City Electric Transition Funding LLC (ACE Funding) solely for the purpose of securitizing authorized portions of ACE’s recoverable stranded costs through the issuance and sale of bonds (Transition Bonds).  The proceeds of the sale of each
 

 
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series of Transition Bonds have been transferred to ACE in exchange for the transfer by ACE to ACE Funding of the right to collect a non-bypassable transition bond charge from ACE customers pursuant to bondable stranded costs rate orders issued by the NJBPU in an amount sufficient to fund the principal and interest payments on the Transition Bonds and related taxes, expenses and fees (Bondable Transition Property).  The assets of ACE Funding, including the Bondable Transition Property, and the Transition Bond charges collected from ACE’s customers, are not available to creditors of ACE.  The holders of Transition Bonds have recourse only to the assets of ACE Funding.
 
Competitive Energy
 
PHI’s Competitive Energy business is engaged in the generation of electricity and the non-regulated marketing and supply of electricity and natural gas, and related energy management services, primarily in the mid-Atlantic region.  In 2007, 2006 and 2005 PHI’s Competitive Energy operations produced 48%, 43%, and 48%, respectively, of PHI’s consolidated operating revenues.  In 2007, 2006 and 2005 PHI’s Competitive Energy operations produced 26%, 20%, and 16%, respectively, of PHI’s consolidated operating income.  PHI’s Competitive Energy operations are conducted by Conectiv Energy and Pepco Energy Services which are separate operating segments for financial reporting purposes.
 
Conectiv Energy
 
Conectiv Energy provides wholesale electric power, capacity, and ancillary services in the wholesale markets and also supplies electricity to other wholesale market participants under long- and short-term bilateral contracts.  Conectiv Energy also supplies electric power to Pepco, DPL and ACE to satisfy a portion of their Default Electricity Supply load, as well as default electricity supply load shares of other utilities within PJM RTO and the ISONE wholesale markets.  PHI refers to these activities as Merchant Generation & Load Service.  Other than its default electricity supply sales, Conectiv Energy does not participate in the retail competitive power supply market.  Conectiv Energy obtains the electricity required to meet its power supply obligations from its own generating plants, under bilateral contracts entered into with other wholesale market participants and through purchases in the wholesale market.
 
Conectiv Energy’s generation capacity is concentrated in mid-merit plants, which due to their operating flexibility and multi-fuel capability can quickly change their output level on an economic basis.  Like “peak-load” plants, mid-merit plants generally operate during times when demand for electricity rises and prices are higher.  However, mid-merit plants usually operate more frequently and for longer periods of time than peak-load plants because of better heat rates.  As of December 31, 2007, Conectiv Energy owned and operated mid-merit plants with a combined 2,725 megawatts of capacity, peak-load plants with a combined 639 megawatts of capacity and base-load generating plants with a combined 340 megawatts of capacity.  See Item 2 “Properties.”  In addition to the generation plants it owns, Conectiv Energy controls another nominal 480 megawatts of capacity through tolling agreements.
 
On December 14, 2007, Conectiv Energy announced a decision to construct a 545 MW natural gas and oil-fired combined-cycle electricity generation plant to be located in Peach Bottom Township, Pennsylvania.  The plant will be owned and operated as part of Conectiv Energy and is expected to go into commercial operation in 2011.  Conectiv Energy has entered into a six-year tolling agreement with an unaffiliated energy company under which Conectiv
 

 
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Energy will sell the energy, capacity and most of the ancillary services from the plant for the period June 1, 2011 through May 31, 2017 to the other party.  Under the terms of the tolling agreement, Conectiv Energy will be responsible for the operation and maintenance of the plant, subject to the other party’s control over the dispatch of the plant’s output.  The other party will be responsible for the purchase and scheduling of the fuel to operate the plant and all required emissions allowances.
 
Conectiv Energy also sells natural gas and fuel oil to very large end-users and to wholesale market participants under bilateral agreements and operates a short-term power desk, which generates margin by identifying and capturing price differences between power pools and locational and timing differences within a power pool.  Conectiv Energy obtains the natural gas and fuel oil required to meet its supply obligations through market purchases for next day delivery and under long- and short-term bilateral contracts with other market participants.
 
PHI’s Competitive Energy businesses use derivative instruments primarily to reduce their financial exposure to changes in the value of their assets and obligations due to commodity price fluctuations. The derivative instruments used by the Competitive Energy businesses include forward contracts, futures, swaps, and exchange-traded and over-the-counter options. In addition, the Competitive Energy businesses also manage commodity risk with contracts that are not classified as derivatives.  The two primary risk management objectives are (1) to manage the spread between the cost of fuel used to operate electric generation plants and the revenue received from the sale of the power produced by those plants, and (2) to manage the spread between retail sales commitments and the cost of supply used to service those commitments to ensure stable and known minimum cash flows, and lock in favorable prices and margins when they become available.  To a lesser extent, Conectiv Energy also engages in energy marketing activities.  Energy marketing activities consist primarily of wholesale natural gas and fuel oil marketing; the activities of the short-term power desk, which generates margin by capturing price differences between power pools, and locational and timing differences within a power pool; and prior to October 31, 2006, provided operating services under an agreement with an unaffiliated generating plant.  PHI collectively refers to these energy marketing activities, including its commodity risk management activities, as “other energy commodity” activities and identifies this activity separately from the proprietary trading activity that was discontinued in 2003.
 
Conectiv Energy’s goal is to manage the risk associated with the expected power output of its generation facilities and their fuel requirements.  The risk management goals are approved by the CRMC and may change from time to time based on market conditions.  The actual level of coverage may vary depending on the extent to which Conectiv Energy is successful in implementing its risk management strategies.  For additional discussion of Conectiv Energy’s risk management activities, see Item 7A “Quantitative and Qualitative Disclosures About Market Risk.”
 
Pepco Energy Services
 
Pepco Energy Services provides retail energy supply and energy services primarily to commercial, industrial, and government customers.  Pepco Energy Services sells electricity, including electricity from renewable resources, to customers located primarily in the mid-Atlantic and northeastern regions of the U.S. and the Chicago, Illinois area.  As of December 31, 2007, Pepco Energy Services’ estimated retail electricity backlog was 31.8 million MWh for
 

 
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delivery through 2013, an increase of 2% over December 31, 2006.  Pepco Energy Services also sells natural gas to customers primarily located in the mid-Atlantic region.
 
Pepco Energy Services also provides energy savings performance contracting services principally to federal, state and local government customers, and owns and operates district energy systems in Atlantic City, New Jersey and Wilmington, Delaware and sells steam and chilled water to customers in those cities.  Pepco Energy Services also designs, constructs, and operates combined heat and power and central energy plants.
 
In addition, Pepco Energy Services provides high voltage construction and maintenance services to utilities throughout the United States and low voltage electric and telecommunication construction and maintenance services to utilities and other commercial customers and streetlight asset management services to municipalities in the Washington, D.C. area.
 
During 2006, Pepco Energy Services sold five businesses that served primarily commercial and industrial customers by providing heating, ventilation, air conditioning, electrical testing and maintenance, and building automation services.  Net assets sold were approximately $20.7 million.
 
Pepco Energy Services also owns and operates two oil-fired power plants.  The power plants are located in Washington, D.C. and have a generating capacity rating of approximately 790 MW.  See Item 2 “Properties.”  Pepco Energy Services sells the output of these plants into the wholesale market administered by PJM.  In February 2007, Pepco Energy Services provided notice to PJM of its intention to deactivate these plants.  In May 2007, Pepco Energy Services deactivated one combustion turbine at its Buzzard Point facility with a generating capacity of approximately 16 MW.  Pepco Energy Services currently plans to deactivate the balance of both plants by May 2012.  PJM has informed Pepco Energy Services that these facilities are not expected to be needed for reliability after that time, but that its evaluation is dependent on the completion of transmission upgrades.  Pepco Energy Services’ timing for deactivation of these units, in whole or in part, may be accelerated or delayed based on the operating condition of the units, economic conditions, and reliability considerations.  Deactivation will not have a material impact on PHI’s financial condition, results of operations or cash flows.
 
PJM Capacity Markets
 
One of the sources of revenue of the Competitive Energy Business is the sale of capacity by Conectiv Energy and Pepco Energy Services associated with their respective generating facilities. The wholesale market for capacity is administered by PJM which is responsible for ensuring that within the transmission control area there is sufficient generating capability available to meet the load requirements plus a reserve margin. In accordance with PJM requirements, retail sellers of electricity in the PJM market are required to maintain capacity from generating facilities within the control area or generating facilities outside the control area which have firm transmission rights into the control area that correspond to their load service obligation. This capacity can be obtained through the ownership of generation facilities, the entry into bilateral contracts or the purchase of capacity credits in the auctions administered by PJM. All of the generating facilities owned by PHI’s Competitive Energy businesses are located in the transmission control area administered by PJM. The capacity of a generating unit is determined based on the demonstrated generating capacity of the unit and its forced outage rate.
 

 
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Beginning on June 1, 2007, PJM replaced its former capacity market rules with a forward capacity auction procedure known as the Reliability Pricing Model (RPM), which provides for differentiation in capacity prices between Locational Deliverability Areas. One of the primary objectives of RPM is to encourage the development of new generation sources, particularly in constrained areas.
 
Under RPM, PJM has held four auctions, each covering capacity to be supplied over consecutive 12-month periods beginning June 1, 2007. Each of these auctions has yielded higher prices for capacity than in the period preceding implementation of RPM.  Auctions of capacity for each subsequent 12-month delivery period will be held 36 months ahead of the scheduled delivery year. The next auction, for the period June 1, 2011 through May 31, 2012, will take place in May 2008.
 
In addition to participating in the PJM auctions, PHI’s Competitive Energy businesses participate in the forward capacity market as both sellers and buyers in accordance with PHI’s risk management policy, and accordingly, prices realized in the PJM capacity auctions may not be indicative of gross margin that PHI earns in respect to its capacity purchases and sales during a given period.
 
Competition
 
The unregulated energy generation, supply and marketing businesses primarily located in the mid-Atlantic region are characterized by intense competition at both the wholesale and retail levels.  At the wholesale level, Conectiv Energy and Pepco Energy Services compete with numerous non-utility generators, independent power producers, wholesale power marketers and brokers, and traditional utilities that continue to operate generation assets.  In the retail energy supply market and in providing energy management services, Pepco Energy Services competes with numerous competitive energy marketers and other service providers.  Competition in both the wholesale and retail markets for energy and energy management services is based primarily on price and, to a lesser extent, the range of services offered to customers and quality of service.
 
Seasonality
 
Like the Power Delivery business, the power generation, supply and marketing businesses are seasonal and weather patterns can have a material impact on operating performance.  Demand for electricity generally is higher in the summer months associated with cooling and demand for electricity and natural gas generally is higher in the winter months associated with heating, as compared to other times of the year.  Historically, the competitive energy operations of Conectiv Energy and Pepco Energy Services have generated less revenue when temperatures are milder than normal in the winter and cooler than normal in the summer.  Milder weather can also negatively impact income from these operations.  Energy management services generally are not seasonal.
 
Other Business Operations
 
Through its subsidiary, Potomac Capital Investment Corporation (PCI), PHI maintains a portfolio of cross-border energy sale-leaseback transactions, with a book value at December 31, 2007 of approximately $1.4 billion.  For additional information concerning these cross-border lease transactions, see Note (12), “Commitments and Contingencies,” to the consolidated financial statements of PHI included in Item 8 “Financial Statements and Supplementary Data”
 

 
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and Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”  This activity constitutes a separate operating segment for financial reporting purposes, which is designated “Other Non-Regulated.”
 
EMPLOYEES
 
At December 31, 2007, PHI had 5,131 employees, including 1,365 employed by Pepco, 916 employed by DPL, 507 employed by ACE and 1,805 employed by PHI Service Company.  The balance were employed by PHI’s Competitive Energy and other non-regulated businesses.  Approximately 2,666 employees (including 1,060 employed by Pepco, 741 employed by DPL, 363 employed by ACE, 344 employed by PHI Service Company, and 158 employed by Conectiv Energy) are covered by collective bargaining agreements with various locals of the International Brotherhood of Electrical Workers.
 
ENVIRONMENTAL MATTERS
 
PHI, through its subsidiaries, is subject to regulation by various federal, regional, state, and local authorities with respect to the environmental effects of its operations, including air and water quality control, solid and hazardous waste disposal, and limitations on land use.  In addition, federal and state statutes authorize governmental agencies to compel responsible parties to clean up certain abandoned or unremediated hazardous waste sites.  PHI’s subsidiaries may incur costs to clean up currently or formerly owned facilities or sites found to be contaminated, as well as other facilities or sites that may have been contaminated due to past disposal practices.
 
PHI’s subsidiaries’ currently projected capital expenditures plan for the replacement of existing or installation of new environmental control facilities that are necessary for compliance with environmental laws, rules or agency orders by its subsidiaries are $51.3 million in 2008 and $43.9 million in 2009.  The actual costs of environmental compliance may be materially different from this capital expenditures plan depending on the outcome of the matters addressed below or as a result of the imposition of additional environmental requirements or new or different interpretations of existing environmental laws and regulations.
 
The projected capital expenditures for 2008 and 2009 include $38 million and $19.2 million, respectively, of expenditures to comply with multipollutant regulations adopted by the Delaware Department of Natural Resources and Environmental Control (DNREC).  Conectiv Energy has appealed these regulations, as described below.  See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations -- Capital Resources and Liquidity -- Capital Requirements -- Compliance with Delaware Multipollutant Regulations”.  The $57.2 million in expected expenditures in 2008 and 2009 for compliance with the multipollutant regulations is only a portion of the total capital expenditures of $79 million, which PHI currently estimates will be necessary for multipollutant regulation compliance over the long term.
 
Air Quality Regulation
 
The generating facilities and operations of PHI’s subsidiaries are subject to federal, state and local laws and regulations, including the Federal Clean Air Act (CAA), which limit emissions of air pollutants, require permits for operation of facilities and impose recordkeeping and reporting requirements.
 

 
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Sulfur Dioxide, Nitrogen Oxide, Mercury and Nickel Emissions
 
Among other things, the acid rain provisions of the CAA regulate total sulfur dioxide (SO2) emissions from affected generating units and allocate “allowances” to each affected unit that permit the unit to emit a specified amount of SO2.  The generating facilities of PHI’s subsidiaries that require SO2 allowances use allocated allowances or allowances acquired, as necessary, in the open market to satisfy applicable regulatory requirements.  Also under current regulations implementing CAA standards, each of the states in which PHI subsidiaries own and operate generating units regulate nitrogen oxide (NOx) emissions from generating units and allocate NOx allowances.  Most of the generating units operated by PHI subsidiaries are subject to NOx emission limits.  These units use allocated allowances or allowances purchased in the open market as necessary to achieve compliance with these regulations.
 
In 2005, the U.S. Environmental Protection Agency (EPA) issued its Clean Air Interstate Rule (CAIR), which imposes additional reductions of SO2 and NOx emissions from electric generating units in 28 eastern states and the District of Columbia, including each of the states in which PHI subsidiaries own and operate generating units.  CAIR uses an allowance system to cap state-wide emissions of SO2 and NOx in two stages beginning in 2009 for NOx and 2010 for SO2.  States may implement CAIR by adopting EPA’s trading program or through regulations that at a minimum achieve the reductions that would be achieved through implementation of EPA’s program.  Each state covered by CAIR may determine independently which emission sources to control and which control measures to adopt.  CAIR includes model rules for multi-state cap and trade programs for power plants that states may choose to adopt to meet the required emissions reductions.  These regulations may require installation of pollution control devices and/or fuel modifications for generating units owned by Conectiv Energy and Pepco Energy Services.
 
The states in which PHI subsidiaries own and operate generating units have adopted, or are in the process of adopting, regulations to implement CAIR which will require, beginning in 2009, the surrender of a NOx annual allowance for each ton of NOx emitted during the year and, beginning in 2010, will require the surrender of more than one SO2 allowance for each ton of SO2 emitted.  To implement CAIR, the New Jersey Department of Environmental Protection (NJDEP) in June 2007 adopted a new NOx trading program that will replace the existing NOx trading program in 2009.  This new trading program will allocate NOx annual and NOx ozone season allowances to Conectiv Energy’s Carll’s Corner, Cedar, Middle, Mickleton, Cumberland and Sherman generating units, and will operate in a manner similar to NJDEP’s existing NOx trading program.  Conectiv Energy’s Edge Moor, Christiana and Hay Road generating units in Delaware will be subject to federal CAIR for NOx and SO2.  Pennsylvania is expected to promulgate CAIR regulations in 2008 that will be applicable to Conectiv Energy’s Bethlehem generating units and the generating units being constructed in Peach Bottom Township, Pennsylvania, known as the Delta Project.  Virginia will implement CAIR by participating in EPA’s cap and trade program and Conectiv Energy’s Tasley peaking unit will be subject to CAIR requirements.  Conectiv Energy’s Maryland generating units are smaller than CAIR’s applicability threshold and therefore are not subject to CAIR.
 
Pepco Energy Services’ Benning Road generating units located in the District of Columbia will be subject to CAIR requirements.  However, it is not yet certain whether the District will adopt a state implementation plan or whether the District will rely on the federal
 

 
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program.  Pepco Energy Services’ Buzzard Point generating units and its landfill gas generating units will not be subject to CAIR.
 
Conectiv Energy and Pepco Energy Services units will use NOx annual, NOx ozone season and SO2 allowances allocated or purchased in the open market as necessary to comply with CAIR.  Although implementation of CAIR will increase costs for Conectiv Energy and Pepco Energy Services units, PHI currently does not anticipate that CAIR will have a significant impact on the operation of the affected generating units.
 
In 2005, EPA finalized its Clean Air Mercury Rule (CAMR), which established mercury emissions standards for new or modified sources and capped state-wide emissions of mercury beginning in 2010.  The regulations, which permitted states to implement CAMR by adopting EPA’s market-based cap-and trade allowance program for coal-fired utility boilers or through regulations that at a minimum achieve the reductions that would be achieved through EPA’s program, were vacated by the United States Court of Appeals for the District of Columbia Circuit in February 2008.
 
In December 2004, NJDEP published final rules regulating mercury emissions from power plants and industrial facilities in New Jersey that impose standards, effective December 15, 2007, that are significantly stricter than EPA’s now vacated federal CAMR for coal-fired plants.  Conectiv Energy has initiated a monitoring program at the Deepwater generating facility, its only coal-fired generating plant in New Jersey, in order to show compliance with NJDEP’s mercury regulations.
 
On November 15, 2006, DNREC adopted regulations to require large coal-fired and residual oil-fired electric generating units to develop control strategies to address air quality in Delaware.  These control strategies are intended to assure attainment of ambient air quality standards for ozone and fine particulate matter, address local scale fine particulate emission problems, reduce mercury emissions, satisfy the now vacated federal CAMR rule, improve visibility and help satisfy Delaware’s regional haze obligations.  For Conectiv Energy’s Edge Moor coal-fired units, these multipollutant regulations establish stringent short-term emission limits for emissions of NOx, SO2 and mercury, and for Edge Moor’s residual oil-fired generating unit, impose more stringent sulfur in fuel limits and establish stringent short-term emission limits for NOx emissions.  The regulations also cap annual emissions of NOx and SO2 from Edge Moor’s coal-fired and residual oil-fired units, and mercury from Edge Moor’s coal-fired units.  Compliance with the regulations will require the installation of new pollution control equipment and/or the enhancement of existing equipment, and may require the imposition of restrictions on the operation of those units.  Conectiv Energy submitted a compliance plan for its facilities to DNREC in June 2007.  Conectiv Energy estimates that it will cost up to $80 million to install the control equipment necessary to comply with the regulations.  These estimated costs do not include increased costs associated with operating control equipment.   In December 2006, Conectiv Energy filed a complaint with the Delaware Superior Court seeking review of DNREC’s adoption of the regulations.  The appeal is pending.
 
In a March 2005 rulemaking, EPA removed coal- and oil-fired units from the list of source categories requiring Maximum Achievable Control Technology for hazardous air pollutants such as mercury and nickel under CAA Section 112, thus, for the time being, eliminating the possibility that control devices would be required under this section of the CAA to reduce nickel emissions from the oil-fired unit at Conectiv Energy’s Edge Moor generating
 

 
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facility.  In the decision issued on February 8, 2008, the U.S. Court of Appeals for the District of Columbia Circuit determined that the delisting of coal- and oil-fired units from regulation under CAA Section 112 was unlawful.
 
Carbon Dioxide Emissions
 
Delaware, Maryland and New Jersey (along with Connecticut, Maine, Massachusetts, New Hampshire, Rhode Island, Vermont and New York) are signatories to the Regional Greenhouse Gas Initiative (RGGI).  Under RGGI, each of the participating states has committed to the adoption of legislation or regulations designed to stabilize and eventually reduce emissions of carbon dioxide CO2 emissions, including the implementation of a regional CO2 budget and allowance trading program to regulate emissions from fossil fuel-fired power plants.  The regulations implementing this program are expected to require fossil fuel-fired electric generating units commencing in 2009 to hold CO2 allowances equivalent to their historic baseline CO2 emissions and to reduce CO2 emissions incrementally beginning in 2015 to achieve an overall 10% reduction from baseline by 2019.  Each state is permitted to adopt its own regulations and can develop its own allowance allocation/auction mechanisms.  Until Delaware, Maryland and New Jersey adopt regulations, PHI will not be in a position to determine whether the allowances allocated to the generating facilities operated by its subsidiaries will be sufficient to cover the CO2 emissions from those facilities, the financial impact of acquiring allowances through auction, or the potential financial and operational consequences of the regulations.
 
In February 2007, the New Jersey Governor signed an Executive Order which requires New Jersey to reduce its greenhouse gas emissions to 1990 levels by 2020, and to 80% below 2006 levels by 2050.  The Executive Order requires NJDEP to coordinate with NJBPU, New Jersey’s Department of Transportation, New Jersey’s Department of Community Affairs and other interested parties to evaluate policies and measures that will enable New Jersey to achieve the greenhouse gas emissions reduction levels set forth in the Executive Order.  In July 2007, New Jersey enacted legislation requiring NJDEP to promulgate regulations by July 1, 2009 that establish a greenhouse gas emissions monitoring and reporting program to evaluate progress toward the 2020 and 2050 greenhouse gas limits.  In January 2008, New Jersey enacted legislation requiring the NJDEP to develop regulations for a trading program for CO2 allowances to be created under RGGI.  Regulatory actions in Delaware and Maryland implementing CO2 regulations are expected in 2008.
 
Water Quality Regulation
 
Provisions of the federal Water Pollution Control Act, also known as the Clean Water Act (CWA), establish the basic legal structure for regulating the discharge of pollutants from point sources to surface waters of the United States.  Among other things, the CWA requires that any person wishing to discharge pollutants from a point source (generally a confined, discrete conveyance such as a pipe) obtain a National Pollutant Discharge Elimination System (NPDES) permit issued by EPA or by a state agency under a federally authorized state program.  All of the steam generating facilities operated by PHI’s subsidiaries have NPDES permits authorizing their pollutant discharges which are subject to periodic renewal.
 
In July 2004, EPA issued final regulations under Section 316(b) of the CWA that are intended to minimize potential adverse environmental impacts from power plant cooling water intake structures on aquatic resources by establishing performance-based standards for the
 
 
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operation of these structures at large existing electric generating plants, including Conectiv Energy’s Deepwater and Edge Moor generating facilities.  These regulations may require changes to cooling water intake structures as part of the NPDES permit renewal process.  In January 2007, the U.S. Court of Appeals for the Second Circuit issued a decision in Riverkeeper, Inc. v. United States Environmental Protection Agency (commonly known as the Riverkeeper II decision), that remanded to EPA for additional rulemaking substantial portions of these regulations for large existing electric generating plants.  EPA has not yet initiated the additional rulemaking.  Petitions for review of the Riverkeeper II decision have been filed with the U.S. Supreme Court by various interested parties.  The Supreme Court has not yet determined whether it will hear the appeal.  The capital expenditures, if any, that may be needed as a consequence of these regulations will not be known until these proceedings are concluded and until each affected facility completes additional studies and addresses related permit requirements.
 
EPA has delegated authority to administer the NPDES program to a number of state agencies including DNREC.  The NPDES permit for Conectiv Energy’s Edge Moor generating facility expired on October 30, 2003, but has been administratively extended until DNREC issues a renewal permit.  Conectiv Energy submitted a renewal application to the DNREC in April 2003.  Studies required under the existing permit to determine the impact on aquatic organisms of the plant’s cooling water intake structures were completed in 2002.  Site-specific alternative technologies and operational measures have been evaluated and discussed with DNREC.  DNREC, however, has not announced how it intends to address Section 316(b) requirements in the renewal NPDES permit in light of Riverkeeper II and the remand of substantial portions of the federal regulations
 
Under the New Jersey Water Pollution Control Act, NJDEP implements regulations, administers the New Jersey Pollutant Discharge Elimination System (NJPDES) program with EPA oversight, and issues and enforces NJPDES permits.  In June 2007, Conectiv Energy filed a timely application for renewal of the NJPDES permit for the Deepwater generating facility.  Timely filing of the application for renewal administratively extended the existing permit.  The previous NJPDES permit for Deepwater required that Conectiv Energy perform several studies to determine whether or not Deepwater’s cooling water intake structures satisfy applicable requirements for protection of the environment.  While those study requirements were consistent with requirements under EPA’s regulations implementing CWA Section 316(b), the result of the Riverkeeper II decision may require reevaluation of the design and operational measures that Conectiv Energy anticipated using for future compliance with Section 316(b) at Deepwater.  In view of the uncertainty associated with Riverkeeper II, Conectiv Energy asked NJDEP to modify or stay a cooling water intake structure design upgrade requirement in Deepwater’s NJPDES permit, and NJDEP agreed to stay that permit requirement.
 
Pepco and a subsidiary of Pepco Energy Services discharge water from a steam generating plant and service center located in the District of Columbia under a NPDES permit issued by EPA in November 2000.  Pepco filed a petition with EPA’s Environmental Appeals Board seeking review and reconsideration of certain provisions of EPA’s permit determination.  In May 2001, Pepco and EPA reached a settlement on Pepco’s petition, under which EPA withdrew certain contested provisions and agreed to issue a revised draft permit for public comment.  EPA has not yet issued the revised draft permit.  A timely renewal application was filed in May 2005 and the companies are operating under the November 2000 permit, excluding the withdrawn conditions, in accordance with the settlement agreement.
 

 
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On November 5, 2007, NJDEP adopted amendments to its regulations under the Flood Hazard Area Control Act (FHACA) to minimize damage to life and property from flooding caused by development in flood plains.  The amended regulations impose a new regulatory program to mitigate flooding and related environmental impacts from a broad range of construction and development activities, including electric utility transmission and distribution construction that was previously unregulated under the FHACA and that is otherwise regulated under a number of other state and federal programs.  ACE is evaluating whether to appeal the adoption of these regulations to the Appellate Division of the Superior Court of New Jersey.  PHI cannot predict at this time the costs of complying with the FHACA regulations due, among other things, to the possibility that NJDEP will issue exemptions from the new regulations.
 
In September 2007, NJDEP proposed amendments to the agency’s regulations under the Freshwater Wetlands Protection Act (FWPA).  PHI believes that these proposed amendments may hinder development of electric transmission and distribution systems by increasing the regulatory obstacles necessary to site public service infrastructure.  On December 31, 2007, ACE filed comments concerning the proposed amendments, urging NJDEP not to change the manner in which the FWPA regulations presently apply to utility lines, poles, and other utility property.  An accurate estimate of PHI’s compliance costs is not feasible until the regulations are adopted.
 
In 2002, EPA amended its oil pollution prevention regulations to require facilities, that because of their location could reasonably be expected to discharge oil in quantities that may be harmful to the environment, to amend and implement Spill Prevention, Control, and Countermeasure (SPCC) Plans and Facility Response Plans (FRPs) by February 2003.  Since 2002, EPA has provided a number of extensions to the compliance deadline.  As a result of those extensions, PHI facilities subject to the regulations must now comply with these regulatory requirements by July 1, 2009.  PHI has undertaken an analysis of its facilities to identify equipment/sites for which physical modifications are necessary to reduce the risk of a release of oil and comply with EPA’s SPCC and FRP regulations.  Physical modification of facilities through the construction of containment structures or replacement of oil-filled equipment with non-oil-filled equipment is scheduled from 2008 through 2010 with an anticipated cost of approximately $56 million.
 
Hazardous Substance Regulation
 
The Comprehensive Environmental Response, Compensation, and Liability Act of 1980 (CERCLA), authorizes EPA, and comparable state laws authorize state environmental authorities, to issue orders and bring enforcement actions to compel responsible parties to investigate and take remedial actions at any site that is determined to present an actual or potential threat to human health or the environment because of an actual or threatened release of one or more hazardous substances.  Parties that generated or transported hazardous substances to such sites, as well as the owners and operators of such sites, may be deemed liable under CERCLA or comparable state laws.  Pepco, DPL and ACE each has been named by EPA or a state environmental agency as a potentially responsible party at certain contaminated sites.  See Note (12), Commitments and Contingencies -- Legal Proceedings -- Environmental Litigation” to the consolidated financial statements of PHI included in Item 8.   In addition, DPL and ACE have undertaken efforts to remediate currently or formerly owned facilities found to be contaminated, including two former manufactured gas plant sites and other owned property.  See Note (12), Commitments and Contingencies -- Legal Proceedings -- Environmental Litigation” to the consolidated financial statements of PHI included in Item 8 and Item 7 “Management’s
 

 
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Discussion and Analysis of Financial Condition and Results of Operations -- Capital Resources and Liquidity -- Capital Requirements -- Environmental Remediation Obligations.”
 
Item 1A.   RISK FACTORS
 
The businesses of PHI, Pepco, DPL and ACE are subject to numerous risks and uncertainties, including the events or conditions identified below.  The occurrence of one or more of these events or conditions could have an adverse effect on the business of any one or more of the companies, including, depending on the circumstances, its financial condition, results of operations and cash flows.  Unless otherwise noted, each risk factor set forth below applies to each of PHI, Pepco, DPL and ACE.
 
PHI and its subsidiaries are subject to substantial governmental regulation, and unfavorable regulatory treatment could have a negative effect.
 
PHI’s Power Delivery businesses are subject to regulation by various federal, state and local regulatory agencies that significantly affects their operations.  Each of Pepco, DPL and ACE is regulated by state regulatory agencies in its service territories, with respect to, among other things, the rates it can charge retail customers for the supply and distribution of electricity (and additionally for DPL the supply and distribution of natural gas).  In addition, the rates that the companies can charge for electricity transmission are regulated by FERC, and DPL’s natural gas transportation is regulated by FERC.  The companies cannot change supply, distribution, or transmission rates without approval by the applicable regulatory authority.  While the approved distribution and transmission rates are intended to permit the companies to recover their costs of service and earn a reasonable rate of return, the profitability of the companies is affected by the rates they are able to charge.  In addition, if the costs incurred by any of the companies in operating its transmission and distribution facilities exceed the allowed amounts for costs included in the approved rates, the financial results of that company, and correspondingly, PHI, will be adversely affected.
 
PHI’s subsidiaries also are required to have numerous permits, approvals and certificates from governmental agencies that regulate their businesses. PHI believes that each of its subsidiaries has, and each of Pepco, DPL and ACE believes it has, obtained or sought renewal of the material permits, approvals and certificates necessary for its existing operations and that its business is conducted in accordance with applicable laws; however, none of the companies is able to predict the impact of future regulatory activities of any of these agencies on its business.  Changes in or reinterpretations of existing laws or regulations, or the imposition of new laws or regulations, may require any one or more of PHI’s subsidiaries to incur additional expenses or significant capital expenditures or to change the way it conducts its operations.
 
Pepco may be required to make additional divestiture proceeds gain-sharing payments to customers in the District of Columbia and Maryland.  (PHI and Pepco only)
 
Pepco currently is involved in regulatory proceedings in Maryland and the District of Columbia related to the sharing of the net proceeds from the sale of its generation-related assets.  The principal issue in the proceedings is whether Pepco should be required to share with customers the excess deferred income taxes and accumulated deferred investment tax credits associated with the sold assets and, if so, whether such sharing would violate the normalization provisions of the Internal Revenue Code and its implementing regulations.  Depending on the
 

 
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outcome of the proceedings, Pepco could be required to make additional gain-sharing payments to customers and payments to the Internal Revenue Service (IRS) in the amount of the associated accumulated deferred investment tax credits, and Pepco might be unable to use accelerated depreciation on District of Columbia and Maryland allocated or assigned property.  See Item 7 “PHI -- Management’s Discussion and Analysis of Financial Condition and Results of Operations -- Regulatory and Other Matters -- Divestiture Cases” for additional information.
 
The operating results of the Power Delivery business and the Competitive Energy businesses fluctuate on a seasonal basis and can be adversely affected by changes in weather.
 
The Power Delivery business is seasonal and weather patterns can have a material impact on their operating performance.  Demand for electricity is generally higher in the summer months associated with cooling and demand for electricity and natural gas is generally higher in the winter months associated with heating as compared to other times of the year.  Accordingly, each of PHI, Pepco, DPL and ACE has generated less revenue and income when temperatures are warmer than normal in the winter and cooler than normal in the summer.  In Maryland, however, the decoupling of distribution revenue for a given reporting period, from the amount of power delivered during the period as the result of the adoption by the MPSC of a bill stabilization adjustment mechanism for retail customers, has had the effect of eliminating changes in customer usage due to weather conditions or for other reasons as a factor having an impact on reported revenue and income.
 
Historically, the competitive energy operations of Conectiv Energy and Pepco Energy Services also have produced less revenue when weather conditions are milder than normal, which can negatively impact PHI’s income from these operations.  The Competitive Energy businesses’ energy management services generally are not seasonal.
 
Facilities may not operate as planned or may require significant maintenance expenditures, which could decrease revenues or increase expenses.
 
Operation of the Pepco, DPL and ACE transmission and distribution facilities and the Competitive Energy businesses’ generation facilities involves many risks, including the breakdown or failure of equipment, accidents, labor disputes and performance below expected levels.  Older facilities and equipment, even if maintained in accordance with sound engineering practices, may require significant capital expenditures for additions or upgrades to keep them operating at peak efficiency, to comply with changing environmental requirements, or to provide reliable operations.  Natural disasters and weather-related incidents, including tornadoes, hurricanes and snow and ice storms, also can disrupt generation, transmission and distribution delivery systems.  Operation of generation, transmission and distribution facilities below expected capacity levels can reduce revenues and result in the incurrence of additional expenses that may not be recoverable from customers or through insurance, including deficiency charges imposed by PJM on generation facilities at a rate up to two times the capacity payment price which the generation facility receives.  Furthermore, if the company owning the facilities is unable to perform its contractual obligations for any of these reasons, that company, and correspondingly PHI, may incur penalties or damages.
 

 
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The transmission facilities of the Power Delivery business are interconnected with the facilities of other transmission facility owners whose actions could have a negative impact on operations.
 
The electricity transmission facilities of Pepco, DPL and ACE are directly interconnected with the transmission facilities of contiguous utilities and, as such, are part of an interstate power transmission grid.  FERC has designated a number of regional transmission organizations to coordinate the operation of portions of the interstate transmission grid.  Pepco, DPL and ACE are members of the PJM RTO.  In 1997, FERC approved PJM as the sole provider of transmission service in the PJM RTO region, which today consists of all or parts of Delaware, Illinois, Indiana, Kentucky, Maryland, Michigan, New Jersey, North Carolina, Ohio, Pennsylvania, Tennessee, Virginia, West Virginia and the District of Columbia.  Pepco, DPL and ACE operate their transmission facilities under the direction and control of PJM.  PJM RTO and the other regional transmission organizations have established sophisticated systems that are designed to ensure the reliability of the operation of transmission facilities and prevent the operations of one utility from having an adverse impact on the operations of the other utilities.  However, the systems put in place by PJM RTO and the other regional transmission organizations may not always be adequate to prevent problems at other utilities from causing service interruptions in the transmission facilities of Pepco, DPL or ACE.  If any of Pepco, DPL or ACE were to suffer such a service interruption, it could have a negative impact on it and on PHI.
 
The cost of compliance with environmental laws, including laws relating to emissions of greenhouse gases, is significant and new environmental laws may increase expenses.
 
The operations of PHI’s subsidiaries, including Pepco, DPL and ACE, are subject to extensive federal, state and local environmental statutes, rules and regulations relating to air quality, water quality, spill prevention, waste management, natural resources, site remediation, and health and safety.  These laws and regulations can require significant capital and other expenditures to, among other things, meet emissions standards, conduct site remediation and perform environmental monitoring.  If a company fails to comply with applicable environmental laws and regulations, even if caused by factors beyond its control, such failure could result in the assessment of civil or criminal penalties and liabilities and the need to expend significant sums to come into compliance.
 
In addition, PHI’s subsidiaries are required to obtain and comply with a variety of environmental permits, licenses, inspections and other approvals.  If there is a delay in obtaining any required environmental regulatory approval, or if there is a failure to obtain, maintain or comply with any such approval, operations at affected facilities could be halted or subjected to additional costs.
 
There is growing concern at the federal and state levels about CO2 and other greenhouse gas emissions.  As a result, it is possible that state and federal regulations will be developed that will impose more stringent limitations on emissions than are currently in effect. Any of these factors could result in increased capital expenditures and/or operating costs for one or more generating plants operated by PHI’s Conectiv Energy and Pepco Energy Services businesses.  Until specific regulations are promulgated, the impact that any new environmental regulations, voluntary compliance guidelines, enforcement initiatives, or legislation may have on the results of operations, financial position or liquidity of PHI and its subsidiaries is not determinable.
 

 
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PHI, Pepco, DPL and ACE each continues to monitor federal and state activity related to environmental matters in order to analyze their potential operational and cost implications.
 
New environmental laws and regulations, or new interpretations of existing laws and regulations, could impose more stringent limitations on the operations of PHI’s subsidiaries or require them to incur significant additional costs.  Current compliance strategies may not successfully address the relevant standards and interpretations of the future.
 
Failure to retain and attract key skilled professional and technical employees could have an adverse effect on the operations.
 
The ability of each of PHI and its subsidiaries, including Pepco, DPL and ACE, to implement its business strategy is dependent on its ability to recruit, retain and motivate employees.  Competition for skilled employees in some areas is high and the inability to retain and attract these employees could adversely affect the company’s business, operations and financial condition.
 
PHI’s Competitive Energy businesses are highly competitive.  (PHI only)
 
The unregulated energy generation, supply and marketing businesses primarily in the mid-Atlantic region are characterized by intense competition at both the wholesale and retail levels.  PHI’s Competitive Energy businesses compete with numerous non-utility generators, independent power producers, wholesale and retail energy marketers, and traditional utilities.  This competition generally has the effect of reducing margins and requires a continual focus on controlling costs.
 
PHI’s Competitive Energy businesses rely on some generation, transmission, storage, and distribution assets that they do not own or control to deliver wholesale and retail electricity and natural gas and to obtain fuel for their generation facilities.  (PHI only)
 
PHI’s Competitive Energy businesses depend upon electric generation and transmission facilities, natural gas pipelines, and natural gas storage facilities owned and operated by others.  The operation of their generation facilities also depends upon coal, natural gas or diesel fuel supplied by others.  If electric generation or transmission, natural gas pipelines, or natural gas storage are disrupted or capacity is inadequate or unavailable, the Competitive Energy businesses’ ability to buy and receive and/or sell and deliver wholesale and retail power and natural gas, and therefore to fulfill their contractual obligations, could be adversely affected.  Similarly, if the fuel supply to one or more of their generation plants is disrupted and storage or other alternative sources of supply are not available, the Competitive Energy businesses’ ability to operate their generating facilities could be adversely affected.
 
Changes in technology may adversely affect the Power Delivery business and PHI’s Competitive Energy businesses.
 
Research and development activities are ongoing to improve alternative technologies to produce electricity, including fuel cells, micro turbines and photovoltaic (solar) cells.  It is possible that advances in these or other alternative technologies will reduce the costs of electricity production from these technologies, thereby making the generating facilities of PHI’s Competitive Energy businesses less competitive.  In addition, increased conservation efforts and advances in technology could reduce demand for electricity supply and distribution, which could
 

 
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adversely affect the Power Delivery businesses of Pepco, DPL and ACE and PHI’s Competitive Energy businesses. Changes in technology also could alter the channels through which retail electric customers buy electricity, which could adversely affect the Power Delivery businesses of Pepco, DPL and ACE.
 
PHI’s risk management procedures may not prevent losses in the operation of its Competitive Energy businesses.  (PHI only)
 
The operations of PHI’s Competitive Energy businesses are conducted in accordance with sophisticated risk management systems that are designed to quantify risk.  However, actual results sometimes deviate from modeled expectations.  In particular, risks in PHI’s energy activities are measured and monitored utilizing value-at-risk models to determine the effects of potential one-day favorable or unfavorable price movements.  These estimates are based on historical price volatility and assume a normal distribution of price changes and a 95% probability of occurrence.  Consequently, if prices significantly deviate from historical prices, PHI’s risk management systems, including assumptions supporting risk limits, may not protect PHI from significant losses.  In addition, adverse changes in energy prices may result in economic losses in PHI’s earnings and cash flows and reductions in the value of assets on its balance sheet under applicable accounting rules.
 
The commodity hedging procedures used by PHI’s Competitive Energy businesses may not protect them from significant losses caused by volatile commodity prices.  (PHI only)
 
To lower the financial exposure related to commodity price fluctuations, PHI’s Competitive Energy businesses routinely enter into contracts to hedge the value of their assets and operations. As part of this strategy, PHI’s Competitive Energy businesses utilize fixed-price, forward, physical purchase and sales contracts, tolling agreements, futures, financial swaps and option contracts traded in the over-the-counter markets or on exchanges.  Each of these various hedge instruments can present a unique set of risks in its application to PHI’s energy assets.  PHI must apply judgment in determining the application and effectiveness of each hedge instrument.  Changes in accounting rules, or revised interpretations to existing rules, may cause hedges to be deemed ineffective as an accounting matter.  This could have material earnings implications for the period or periods in question.  Conectiv Energy’s objective is to hedge a portion of the expected power output of its generation facilities and the costs of fuel used to operate those facilities so it is not completely exposed to energy price movements.  Hedge targets are approved by PHI’s Corporate Risk Management Committee and may change from time to time based on market conditions.  Conectiv Energy generally establishes hedge targets annually for the next three succeeding 12-month periods.  Within a given 12-month horizon, the actual hedged positioning in any month may be outside of the targeted range, even if the average for a 12-month period falls within the stated range.  Management exercises judgment in determining which months present the most significant risk, or opportunity, and hedge levels are adjusted accordingly.  Since energy markets can move significantly in a short period of time, hedge levels may also be adjusted to reflect revised assumptions.  Such factors may include, but are not limited to, changes in projected plant output, revisions to fuel requirements, transmission constraints, prices of alternate fuels, and improving or deteriorating supply and demand conditions.  In addition, short-term occurrences, such as abnormal weather, operational events, or intra-month commodity price volatility may also cause the actual level of hedging coverage to vary from the established hedge targets.  These events can cause fluctuations in PHI’s earnings from period to period.  Due to the high heat rate of the Pepco Energy Services generating
 

 
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facilities, Pepco Energy Services generally does not enter into wholesale contracts to lock in the forward value of its plants.  To the extent that PHI’s Competitive Energy businesses have unhedged positions or their hedging procedures do not work as planned, fluctuating commodity prices could result in significant losses.  Conversely, by engaging in hedging activities, PHI may not realize gains that otherwise could result from fluctuating commodity prices.
 
Business operations could be adversely affected by terrorism.
 
The threat of, or actual acts of, terrorism may affect the operations of PHI or any of its subsidiaries in unpredictable ways and may cause changes in the insurance markets, force an increase in security measures and cause disruptions of fuel supplies and markets.  If any of its infrastructure facilities, such as its electric generation, fuel storage, transmission or distribution facilities, were to be a direct target, or an indirect casualty, of an act of terrorism, the operations of PHI, Pepco, DPL or ACE could be adversely affected.  Corresponding instability in the financial markets as a result of terrorism also could adversely affect the ability to raise needed capital.
 
Insurance coverage may not be sufficient to cover all casualty losses that the companies might incur.
 
PHI and its subsidiaries, including Pepco, DPL and ACE, currently have insurance coverage for their facilities and operations in amounts and with deductibles that they consider appropriate.  However, there is no assurance that such insurance coverage will be available in the future on commercially reasonable terms.  In addition, some risks, such as weather related casualties, may not be insurable.  In the case of loss or damage to property, plant or equipment, there is no assurance that the insurance proceeds, if any, received will be sufficient to cover the entire cost of replacement or repair.
 
Revenues, profits and cash flows may be adversely affected by economic conditions.
 
Periods of slowed economic activity generally result in decreased demand for power, particularly by industrial and large commercial customers.  As a consequence, recessions or other downturns in the economy may result in decreased revenues and cash flows for the Power Delivery businesses of Pepco, DPL and ACE and PHI’s Competitive Energy businesses.
 
The IRS challenge to cross-border energy sale and lease-back transactions entered into by a PHI subsidiary could result in loss of prior and future tax benefits.  (PHI only)
 
PCI maintains a portfolio of cross-border energy sale-leaseback transactions, which as of December 31, 2007, had a book value of approximately $1.4 billion and from which PHI currently derives approximately $60 million per year in tax benefits in the form of interest and depreciation deductions.  On February 11, 2005, the Treasury Department and IRS issued a notice informing taxpayers that the IRS intends to challenge the tax benefits claimed by taxpayers with respect to certain of these transactions.
 
As part of the normal PHI tax audit for 2001 and 2002, the IRS disallowed the tax benefits claimed by PHI with respect to these leases for those years.  The tax benefits claimed by PHI with respect to these leases from 2001 through December 31, 2007 were approximately $347 million. PHI has filed a protest against the IRS adjustments and the unresolved audit has been forwarded to the IRS Appeals Office.  If the IRS prevails, PHI would be subject to
 

 
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additional taxes, along with interest and possibly penalties on the additional taxes, which could have a material adverse effect on PHI’s results of operations and cash flows.  See Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations -- Regulatory and Other Matters -- Federal Tax Treatment of Cross-Border Leases” for additional information.
 
Changes in tax law could have a material adverse effect on the tax benefits that PHI realizes from the portfolio of cross-border energy sale-leaseback transactions entered into by one of its subsidiaries.
 
In recent years, efforts have been made by members of the U.S. Senate to pass legislation that would have the effect of deferring the deduction of losses associated with leveraged lease transactions involving tax-indifferent parties for taxable years beginning after the year of enactment regardless of when the transaction was entered into.  These proposals, which would affect transactions such as those included in PCI’s portfolio of cross-border energy leases, would effectively defer the deduction of losses associated with such leveraged lease transactions until the taxable year in which the taxpayer recognized taxable income from the lease, which is typically toward the end of the lease term.  To date, no such legislation has been enacted; however, there are continuing efforts by members of the U.S. Senate to add legislation to various Senate bills directed to the deferral or other curtailment of the tax benefits realized from such transactions.  Enactment of legislation of this nature could result in a material delay of the income tax benefits that PHI would receive in connection with PCI’s portfolio of cross-border energy leases. Furthermore, if legislation of this type were enacted, under the Financial Accounting Standards Board Staff Position on Financial Accounting Standard 13-2, PHI would be required to adjust the book value of the leases and record a charge to earnings equal to the repricing impact of the deferred deductions which could result in a material adverse effect on PHI’s financial condition, results of operations and cash flows.
 
IRS Revenue Ruling 2005-53 on Mixed Service Costs could require PHI to incur additional tax and interest payments in connection with the IRS audit of this issue for the tax years 2001 through 2004 (IRS Revenue Ruling 2005-53).
 
During 2001, Pepco, DPL and ACE changed their methods of accounting with respect to capitalizable construction costs for income tax purposes.  The change allowed the companies to accelerate the deduction of certain expenses that were previously capitalized and depreciated.  Through December 31, 2005, these accelerated deductions generated incremental tax cash flow benefits of approximately $205 million (consisting of $94 million for Pepco, $62 million for DPL and $49 million for ACE) for the companies, primarily attributable to their 2001 tax returns.
 
In 2005, the Treasury Department issued proposed regulations that, if adopted in their current form, would require Pepco, DPL and ACE to change their method of accounting with respect to capitalizable construction costs for income tax purposes for future tax periods beginning in 2005.  Based on the proposed regulations, PHI in its 2005 federal tax return adopted an alternative method of accounting for capitalizable construction costs that management believes will be acceptable to the IRS.
 
At the same time as the proposed regulations were released, the IRS issued Revenue Ruling 2005-53, which is intended to limit the ability of certain taxpayers to utilize the method of accounting for income tax purposes they utilized on their tax returns for 2004 and prior years
 

 
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with respect to capitalizable construction costs.  In line with this Revenue Ruling, the IRS revenue agent’s report for the 2001 and 2002 tax returns disallowed substantially all of the incremental tax benefits that Pepco, DPL and ACE had claimed on those returns by requiring the companies to capitalize and depreciate certain expenses rather than treat such expenses as current deductions.  PHI has filed a protest against the IRS adjustments and the issue is among the unresolved audit matters relating to the 2001 and 2002 audits pending before the Appeals Office.
 
In February 2006, PHI paid approximately $121 million of taxes to cover the amount of additional taxes and interest that management estimated to be payable for the years 2001 through 2004 based on the method of tax accounting that PHI, pursuant to the proposed regulations, adopted on its 2005 tax return.  However, if the IRS is successful in requiring Pepco, DPL and ACE to capitalize and depreciate construction costs that result in a tax and interest assessment greater than management’s estimate of $121 million, PHI will be required to pay additional taxes and interest only to the extent these adjustments exceed the $121 million payment made in February 2006.
 
PHI and its subsidiaries are dependent on their ability to successfully access capital markets.  An inability to access capital may adversely affect their businesses.
 
PHI, Pepco, DPL and ACE each rely on access to both short-term money markets and longer-term capital markets as a source of liquidity and to satisfy their capital requirements not satisfied by the cash flow from their operations. Capital market disruptions, or a downgrade in credit ratings, would increase the cost of borrowing or could adversely affect the ability to access one or more financial markets.  In addition, a reduction in PHI’s credit ratings could require PHI or its subsidiaries to post additional collateral in connection with some of the Competitive Energy businesses’ wholesale marketing and financing activities.  Disruptions to the capital markets could include, but are not limited to:

 
·
recession or an economic slowdown;

 
·
the bankruptcy of one or more energy companies;

 
·
significant increases in the prices for oil or other fuel;

 
·
a terrorist attack or threatened attacks; or

 
·
a significant transmission failure.

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

 
27

 
 
Future defined benefit plan funding obligations are affected by assumptions regarding the valuation of PHI’s benefit obligations and the performance of plan assets; actual experience which varies from the assumptions could result in an obligation of PHI, Pepco, DPL or ACE to make significant unplanned cash contributions to the Retirement Plan.
 
PHI follows the guidance of SFAS No. 87, “Employers’ Accounting for Pensions” in accounting for pension benefits under its non-contributory defined benefit plan (the PHI Retirement Plan).  In addition, on December 31, 2006, PHI implemented SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106 and 132(R)” (SFAS No. 158) which requires that companies recognize a net liability or asset to report the funded status of their defined benefit pension and other postretirement benefit plans on the balance sheet.  In accordance with these accounting standards, PHI makes assumptions regarding the valuation of benefit obligations and the performance of plan assets.  Changes in assumptions, such as the use of a different discount rate or expected return on plan assets, affect the calculation of projected benefit obligations (PBO), accumulated benefit obligation (ABO), reported pension liability, regulated assets, or accumulated other comprehensive income on PHI’s consolidated balance sheet and on the balance sheets of Pepco, DPL and ACE, and reported annual net periodic pension benefit cost on PHI’s consolidated statement of earnings and on the statements of earnings of Pepco, DPL and ACE.
 
Use of alternative assumptions could also impact the expected future cash funding requirements of PHI, Pepco, DPL and ACE for the PHI Retirement Plan if the plan did not meet the minimum funding requirements of the Employment Retirement Income Security Act of 1974 (ERISA).
 
PHI’s cash flow, ability to pay dividends and ability to satisfy debt obligations depend on the performance of its operating subsidiaries.  PHI’s unsecured obligations are effectively subordinated to the liabilities and the outstanding preferred stock of its subsidiaries.  (PHI only)
 
PHI is a holding company that conducts its operations entirely through its subsidiaries, and all of PHI’s consolidated operating assets are held by its subsidiaries.  Accordingly, PHI’s cash flow, its ability to satisfy its obligations to creditors and its ability to pay dividends on its common stock are dependent upon the earnings of the subsidiaries and the distribution of such earnings to PHI in the form of dividends.  The subsidiaries are separate and distinct legal entities and have no obligation to pay any amounts due on any debt or equity securities issued by PHI or to make any funds available for such payment.  Because the claims of the creditors of PHI’s subsidiaries and the preferred stockholders of ACE are superior to PHI’s entitlement to dividends, the unsecured debt and obligations of PHI are effectively subordinated to all existing and future liabilities of its subsidiaries and to the rights of the holders of ACE’s preferred stock to receive dividend payments.
 
Energy companies are subject to adverse publicity which makes them vulnerable to negative regulatory and litigation outcomes.
 
The energy sector has been among the sectors of the economy that have been the subject of highly publicized allegations of misconduct in recent years.  In addition, many utility companies have been publicly criticized for their performance during natural disasters and
 

 
28

 

weather related incidents.  Adverse publicity of this nature may render legislatures, regulatory authorities, and other government officials less likely to view energy companies such as PHI and its subsidiaries in a favorable light, and may cause PHI and its subsidiaries to be susceptible to adverse outcomes with respect to decisions by such bodies.
 
Provisions of the Delaware General Corporation Law may discourage an acquisition of PHI.  (PHI only)
 
As a Delaware corporation, PHI is subject to the business combination law set forth in Section 203 of the Delaware General Corporation Law, which could have the effect of delaying, discouraging or preventing an acquisition of PHI.
 
Because Pepco is a wholly owned subsidiary of PHI, and each of DPL and ACE are indirect wholly owned subsidiaries of PHI, PHI can exercise substantial control over their dividend policies and businesses and operations.  (Pepco, DPL and ACE only)
 
All of the members of each of Pepco’s, DPL’s and ACE’s board of directors, as well as many of Pepco’s, DPL’s and ACE’s executive officers, are officers of PHI or an affiliate of PHI.  Among other decisions, each of Pepco’s, DPL’s and ACE’s board is responsible for decisions regarding payment of dividends, financing and capital raising activities, and acquisition and disposition of assets.  Within the limitations of applicable law, and subject to the financial covenants under each company’s respective outstanding debt instruments, each of Pepco’s, DPL’s and ACE’s board of directors will base its decisions concerning the amount and timing of dividends, and other business decisions, on the company’s respective earnings, cash flow and capital structure, but may also take into account the business plans and financial requirements of PHI and its other subsidiaries.
 
Item 1B.   UNRESOLVED STAFF COMMENTS
 
Pepco Holdings
 
None.
 
Pepco
 
None.
 
DPL
 
None.
 
ACE
 
None.

 
29

 
 
Item 2.     PROPERTIES
 
Generation Facilities
 
The following table identifies the electric generating facilities owned by PHI’s subsidiaries at December 31, 2007.

Electric Generating Facilities
Location
Owner
Generating Capacity 
Coal-Fired Units
   
(kilowatts)
 
Edge Moor Units 3 and 4
Wilmington, DE
Conectiv Energya
260,000 
 
Deepwater Unit 6
Pennsville, NJ
Conectiv Energya
    80,000 
       
  340,000 
Oil Fired Units
     
 
Benning Road
Washington, DC
Pepco Energy Servicesb
550,000 
 
Edge Moor Unit 5
Wilmington, DE
Conectiv Energya
450,000 
 
Deepwater Unit 1
Pennsville, NJ
Conectiv Energya
     86,000 
   
1,086,000 
Combustion Turbines/Combined Cycle Units
   
 
Hay Road Units 1-4
Wilmington, DE
Conectiv Energya
552,000 
 
Hay Road Units 5-8
Wilmington, DE
Conectiv Energya
545,000 
 
Bethlehem Units 1-8
Bethlehem, PA
Conectiv Energya
1,092,000 
 
Buzzard Point
Washington, DC
Pepco Energy Servicesb
240,000 
 
Cumberland
Millville, NJ
Conectiv Energya
84,000 
 
Sherman Avenue
Vineland, NJ
Conectiv Energya
81,000 
 
Middle
Rio Grande, NJ
Conectiv Energya
77,000 
 
Carll’s Corner
Upper Deerfield Twp., NJ
Conectiv Energya
73,000 
 
Cedar
Cedar Run, NJ
Conectiv Energya
68,000 
 
Missouri Avenue
Atlantic City, NJ
Conectiv Energya
60,000 
 
Mickleton
Mickleton, NJ
Conectiv Energya
59,000 
 
Christiana
Wilmington, DE
Conectiv Energya
45,000 
 
Edge Moor Unit 10
Wilmington, DE
Conectiv Energya
13,000 
 
West
Marshallton, DE
Conectiv Energya
15,000 
 
Delaware City
Delaware City, DE
Conectiv Energya
16,000 
 
Tasley
Tasley, VA
Conectiv Energya
     26,000 
       
3,046,000 
Landfill Gas-Fired Units
     
 
Fauquier Landfill Project
Fauquier County, VA
Pepco Energy Servicesc
2,000 
 
Eastern Landfill Project
Baltimore County, MD
Pepco Energy Servicesd
       3,000 
       
       5,000 
Diesel Units
     
 
Crisfield
Crisfield, MD
Conectiv Energya
10,000 
 
Bayview
Bayview, VA
Conectiv Energya
      12,000 
       
     22,000 
Total Electric Generating Capacity
4,499,000 
   

a
All holdings of Conectiv Energy are owned by its various subsidiaries.
 
b
These facilities are owned by a subsidiary of Pepco Energy Services.  In 2007, a 16 MW combustion turbine at Buzzard Point was deactivated.
 
c
This facility is owned by Fauquier Landfill Gas, LLC, of which Pepco Energy Services holds a 75% membership interest.
 
d
This facility is owned by Eastern Landfill Gas, LLC, of which Pepco Energy Services holds a 75% membership interest.
 

The preceding table sets forth the summer electric generating capacity of the electric generating plants owned by Pepco Holdings’ subsidiaries.  Although the generating capacity of these facilities may be higher during the winter months, the plants operated by PHI’s subsidiaries are used to meet summer peak loads that are generally higher than winter peak loads.  Accordingly, the summer generating capacity more accurately reflects the operational capability of the plants.
 

 
30

 


 
Transmission and Distribution Systems
 
On a combined basis, the electric transmission and distribution systems owned by Pepco, DPL and ACE at December 31, 2007 consisted of approximately 3,600 transmission circuit miles of overhead lines, 160 transmission circuit miles of underground cables, 22,740 distribution circuit miles of overhead lines, and 19,030 distribution circuit miles of underground cables, primarily in their respective service territories.  On January 2, 2008, DPL completed the sale of substantially all of its electric business in Virginia, which included approximately 94.5 transmission circuit miles of overhead lines, .3 transmission circuit miles of underground cables, 534 distribution circuit miles of overhead lines and 291 distribution circuit miles of underground cables.  See “Business - Power Delivery - DPL” in Item 1 of this Form 10-K.  DPL and ACE own and operate distribution system control centers in New Castle, Delaware and Mays Landing, New Jersey, respectively.  Pepco also operates a distribution system control center in Maryland.  The computer equipment and systems contained in Pepco’s control center are financed through a sale and leaseback transaction.
 
DPL has a liquefied natural gas plant located in Wilmington, Delaware, with a storage capacity of 3.045 million gallons and an emergency sendout capability of 48,210 Mcf per day.  DPL owns eight natural gas city gate stations at various locations in New Castle County, Delaware.  These stations have a total sendout capacity of 225,000 Mcf per day.  DPL also owns approximately 111 pipeline miles of natural gas transmission mains, 1,777 pipeline miles of natural gas distribution mains, and 1,292 natural gas pipeline miles of service lines.  The natural gas transmission mains include 7.2 miles of pipeline of which DPL owns 10%, which is used for natural gas operations, and of which Conectiv Energy owns 90%, which is used for delivery of natural gas to electric generation facilities.
 
Substantially all of the transmission and distribution property, plant and equipment owned by each of Pepco, DPL and ACE is subject to the liens of the respective mortgages under which the companies issue First Mortgage Bonds.  See Note (7) “Debt” to the consolidated financial statements of PHI included in Item 8.
 
Item 3.    LEGAL PROCEEDINGS
 
Pepco Holdings
 
Other than ordinary routine litigation incidental to its and its subsidiaries’ business, PHI is not a party to, and its and its subsidiaries’ property is not subject to, any material pending legal proceedings except as described in  Note (12), “Commitments and Contingencies--Legal Proceedings,” to the consolidated financial statements of PHI included in Item 8.
 
Pepco
 
Other than ordinary routine litigation incidental to its business, Pepco is not a party to, and its property is not subject to, any material pending legal proceedings except as described in Note (10), “Commitments and Contingencies--Legal Proceedings,” to the financial statements of Pepco included in Item 8.
 
DPL
 
Other than ordinary routine litigation incidental to its business, DPL is not a party to, and its property is not subject to, any material pending legal proceedings except as described in Note
 

 
31

 

(11), “Commitments and Contingencies--Legal Proceedings,” to the financial statements of DPL included in Item 8.
 
ACE
 
Other than ordinary routine litigation incidental to its business, ACE is not a party to, and its property is not subject to, any material pending legal proceedings except as described in Note (11), “Commitments and Contingencies--Legal Proceedings,” to the financial statements of ACE included in Item 8.
 
Item 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
Pepco Holdings
 
None.
 
           INFORMATION FOR THIS ITEM IS NOT REQUIRED FOR PEPCO, DPL, AND ACE AS THEY MEET THE CONDITIONS SET FORTH IN GENERAL INSTRUCTIONS I(1)(a) AND (b) OF FORM 10-K AND THEREFORE ARE FILING THIS FORM WITH THE REDUCED FILING FORMAT.
 
Part II
 
Item 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
 
The New York Stock Exchange is the principal market on which Pepco Holdings common stock is traded.  The following table presents the dividends declared per share on the Pepco Holdings common stock and the high and low sales prices for the common stock based on composite trading as reported by the New York Stock Exchange during each quarter in the last two fiscal years.

        Period           
 
Dividends
Per Share
   
 Price Range
 
         
High 
   
Low
 
2007:
                 
First Quarter
  $ .26     $ 29.28     $ 24.89  
Second Quarter
    .26       30.71       26.89  
Third Quarter
    .26       29.28       24.20  
Fourth Quarter
    .26       30.10       25.73  
    $ 1.04                  
2006:
                       
First Quarter
  $ .26     $ 24.28     $ 22.15  
Second Quarter
    .26       23.92       21.79  
Third Quarter
    .26       25.50       22.64  
Fourth Quarter
    .26       26.99       24.25  
    $ 1.04                  
                         


 
32

 

See Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations -- Capital Resources and Liquidity -- Capital Requirements -- Dividends” for information regarding restrictions on the ability of PHI and its subsidiaries to pay dividends.
 
At December 31, 2007, there were approximately 64,126 holders of record of Pepco Holdings common stock.
 
Dividends
 
On January 24, 2008, the Board of Directors declared a dividend on common stock of 27 cents per share payable March 31, 2008, to shareholders of record March 10, 2008.
 
PHI Subsidiaries>
 
All of the common equity of Pepco, DPL and ACE is owned directly or indirectly by PHI.  Pepco, DPL and ACE each customarily pays dividends on its common stock on a quarterly basis based on its earnings, cash flow and capital structure, and after taking into account the business plans and financial requirements of PHI and its other subsidiaries.
 
Pepco
 
All of Pepco’s common stock is held by Pepco Holdings.  The table below presents the aggregate amount of common stock dividends paid by Pepco to PHI during each quarter in the last two fiscal years.

            Period           
 
Aggregate
Dividends
2007:
   
First Quarter
$
15,000,000
Second Quarter
 
14,000,000
Third Quarter
 
45,000,000
Fourth Quarter
 
12,000,000
 
$
86,000,000
2006:
   
First Quarter
$
15,000,000
Second Quarter
 
49,000,000
Third Quarter
 
-
Fourth Quarter
 
35,000,000
 
$
99,000,000
     


 
33

 


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

        Period           
 
Aggregate
Dividends
2007:
   
First Quarter
$
8,000,000
Second Quarter
 
19,000,000
Third Quarter
 
-
Fourth Quarter
 
12,000,000
 
$
39,000,000
2006:
   
First Quarter
$
15,000,000
Second Quarter
 
-
Third Quarter
 
-
Fourth Quarter
 
-
 
$
15,000,000
     

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

        Period           
 
Aggregate
Dividends
2007:
   
First Quarter
$
20,000,000
Second Quarter
 
10,000,000
Third Quarter
 
20,000,000
Fourth Quarter
 
-
 
$
50,000,000
2006:
   
First Quarter
$
19,000,000
Second Quarter
 
-
Third Quarter
 
75,000,000
Fourth Quarter
 
15,000,000
 
$
109,000,000
     


 
34

 


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

 
35

 


Item 6.    SELECTED FINANCIAL DATA
 
PEPCO HOLDINGS CONSOLIDATED FINANCIAL HIGHLIGHTS

   
2007
     
2006
     
2005
     
2004
     
2003
   
   
(in millions, except per share data)
Consolidated Operating Results
                                       
Total Operating Revenue
  $ 9,366.4       $ 8,362.9       $ 8,065.5       $ 7,223.1       $ 7,268.7    
Total Operating Expenses
    8,559.8  
(a)
    7,669.6  
(c)
    7,160.1  
(e) (f) (g)
    6,451.0         6,658.0  
(j) (k)
Operating Income
    806.6         693.3         905.4         772.1         610.7    
Other Expenses
    284.2         282.4  
(d)
    285.5         341.4         433.3  
(l)
Preferred Stock Dividend
  Requirements of   Subsidiaries
    .3         1.2         2.5         2.8         13.9    
Income Before Income    
Tax Expense and
Extraordinary Item
    522.1         409.7         617.4         427.9         163.5    
Income Tax Expense
    187.9  
(b)
    161.4         255.2  
(h)
    167.3  
(i)
    62.1    
Income Before
  Extraordinary Item
    334.2         248.3         362.2         260.6         101.4    
Extraordinary Item
    -         -         9.0         -         5.9    
Net Income
    334.2         248.3         371.2         260.6         107.3    
Redemption Premium on Preferred Stock
    (.6 )       (.8 )       (.1 )       .5         -    
Earnings Available for
  Common Stock
    333.6         247.5         371.1         261.1         107.3    
                                                   
Common Stock Information
                                                 
Basic Earnings Per Share of Common
  Stock Before Extraordinary Item
  $ 1.72       $ 1.30       $ 1.91       $ 1.48       $ .60    
Basic - Extraordinary Item Per
  Share of Common Stock
    -         -         .05         -         .03    
Basic Earnings Per Share of 
   Common Stock
    1.72         1.30         1.96         1.48         .63    
Diluted Earnings Per Share of
  Common Stock  
Before 
  Extraordinary Item
    1.72         1.30         1.91         1.48         .60    
Diluted - Extraordinary Item Per
  Share of Common Stock
    -         -         .05         -         .03    
Diluted Earnings Per Share
  of Common Stock
    1.72         1.30         1.96         1.48         .63    
Cash Dividends Per Share
  of Common Stock
    1.04         1.04         1.00         1.00         1.00    
Year-End Stock Price
    29.33         26.01         22.37         21.32         19.54    
Net Book Value per Common Share
    20.04         18.82         18.88         17.74         17.31    
                                                   
Weighted Average Shares Outstanding
    194.1         190.7         189.0         176.8         170.7    
                                                   
Other Information
                                                 
Investment in Property, Plant
  and Equipment
  $ 12,306.5       $ 11,819.7       $ 11,441.0       $ 11,109.4       $ 10,815.2    
Net Investment in Property, Plant 
  
and Equipment
    7,876.7         7,576.6         7,368.8         7,152.2         7,032.9    
Total Assets
    15,111.0         14,243.5         14,038.9         13,374.6         13,390.2    
                                                   
Capitalization
                                                 
Short-term Debt
  $ 288.8       $ 349.6       $ 156.4       $ 319.7       $ 518.4    
Long-term Debt
    4,174.8         3,768.6         4,202.9         4,362.1         4,588.9    
Current Maturities of Long-Term
  Debt and Project Funding
    332.2         857.5         469.5         516.3         384.9    
Transition Bonds issued by ACE
  Funding
    433.5         464.4         494.3         523.3         551.3    
Capital Lease Obligations due
  within 
one year
    6.0         5.5         5.3         4.9         4.4    
Capital Lease Obligations
    105.4         111.1         116.6         122.1         126.8    
Long-Term Project Funding
    20.9         23.3         25.5         65.3         68.6    
Debentures issued to Financing Trust
    -         -         -         -         98.0    
Minority Interest
    6.2         24.4         45.9         54.9         108.2    
Common Shareholders’ Equity
    4,018.4         3,612.2         3,584.1         3,339.0         2,974.1    
   Total Capitalization
  $ 9,386.2       $ 9,216.6       $ 9,100.5       $ 9,307.6       $ 9,423.6    


 
36

 


(a)
Includes $33.4 million ($20.0 million after-tax) from settlement of Mirant bankruptcy claims.  See “Management’s Discussion and Analysis -- Financial Condition and Results of Operations -- Capital Resources and Liquidity -- Cash Flow Activity -- Proceeds from Settlement of Mirant Bankruptcy Claims.”
(b)
Includes $19.5 million ($17.7 million net of fees) benefit related to Maryland income tax settlement.
(c)
Includes $18.9 million of impairment losses ($13.7 million after-tax) related to certain energy services business assets.
(d)
Includes $12.3 million gain ($7.9 million after-tax) on the sale of Conectiv Energy’s equity interest in a joint venture which owns a wood burning cogeneration facility.
(e)
Includes $68.1 million ($40.7 million after-tax) gain from sale of non-utility land owned by Pepco at Buzzard Point.
(f)
Includes $70.5 million ($42.2 million after-tax) gain (net of customer sharing) from settlement of Mirant bankruptcy claims.  See “Management’s Discussion and Analysis -- Financial Condition and Results of Operations -- Capital Resources and Liquidity -- Cash Flow Activity -- Proceeds from Settlement of Mirant Bankruptcy Claims.”
(g)
Includes $13.3 million ($8.9 million after-tax) related to PCI’s liquidation of a financial investment that was written off in 2001.
(h)
Includes $10.9 million in income tax expense related to the mixed service cost issue under IRS Revenue Ruling 2005-53.
(i)
Includes a $19.7 million charge related to an IRS settlement.  Also includes $13.2 million tax benefit related to issuance of a local jurisdiction’s final consolidated tax return regulations.
(j)
Includes a charge of $50.1 million ($29.5 million after-tax) related to a CT contract cancellation.  Also includes a gain of $68.8 million ($44.7 million after-tax) on the sale of the Edison Place office building.
(k)
Includes the unfavorable impact of $44.3 million ($26.6 million after-tax) resulting from trading losses prior to the cessation of proprietary trading.
(l)
Includes an impairment charge of $102.6 million ($66.7 million after-tax) related to prior investment in Starpower Communications, L.L.C.


 
37

 


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