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Pepco Holdings 10-Q 2007
Quarterly Report on Form 10-Q

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934

For the quarter ended June 30, 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

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

   

Pepco Holdings

Yes  X  

No        

 

Pepco

Yes      

No   X  

 

DPL

Yes      

No   X  

 

ACE

Yes      

No   X  

     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of "accelerated filer and large 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 Exchange Act).

   

Pepco Holdings

Yes      

No   X  

 

Pepco

Yes      

No   X  

 

DPL

Yes      

No   X  

 

ACE

Yes      

No   X  

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

          Registrant

Number of Shares of Common Stock of the Registrant Outstanding at June 30, 2007

          Pepco Holdings

193,517,986 ($.01 par value)

          Pepco

100 ($.01 par value) (a)

          DPL

1,000 ($2.25 par value) (b)

          ACE

8,546,017 ($3 par value) (b)

(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-Q 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.

TABLE OF CONTENTS

   

Page

 

Glossary of Terms

i

PART I

FINANCIAL INFORMATION

1

  Item 1.

-

Financial Statements

1

  Item 2.

-

Management's Discussion and Analysis of
   Financial Condition and Results of Operations

110

  Item 3.

-

Quantitative and Qualitative Disclosures
   About Market Risk

186

  Item 4.

-

Controls and Procedures

189

  Item 4T.

-

Controls and Procedures

189

PART II

OTHER INFORMATION

191

  Item 1.

-

Legal Proceedings

191

  Item 1A.

-

Risk Factors

191

  Item 2.

-

Unregistered Sales of Equity Securities and Use of Proceeds

192

  Item 3.

-

Defaults Upon Senior Securities

192

  Item 4.

-

Submission of Matters to a Vote of Security Holders

193

  Item 5.

-

Other Information

194

  Item 6.

-

Exhibits

194

  Signatures

212

 

TABLE OF CONTENTS - EXHIBITS

Exh. No.

Registrant(s)

Description of Exhibit

Page

12.1

PHI

Statements Re: Computation of Ratios

196

12.2

Pepco

Statements Re: Computation of Ratios

197

12.3

DPL

Statements Re: Computation of Ratios

198

12.4

ACE

Statements Re: Computation of Ratios

199

31.1

PHI

Rule 13a-14(a)/15d-14(a) Certificate of Chief Executive Officer

200

31.2

PHI

Rule 13a-14(a)/15d-14(a) Certificate of Chief Financial Officer

201

31.3

Pepco

Rule 13a-14(a)/15d-14(a) Certificate of Chief Executive Officer

202

31.4

Pepco

Rule 13a-14(a)/15d-14(a) Certificate of Chief Financial Officer

203

31.5

DPL

Rule 13a-14(a)/15d-14(a) Certificate of Chief Executive Officer

204

31.6

DPL

Rule 13a-14(a)/15d-14(a) Certificate of Chief Financial Officer

205

31.7

ACE

Rule 13a-14(a)/15d-14(a) Certificate of Chief Executive Officer

206

31.8

ACE

Rule 13a-14(a)/15d-14(a) Certificate of Chief Financial Officer

207

32.1

PHI

Certificate of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350

208

32.2

Pepco

Certificate of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350

209

32.3

DPL

Certificate of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350

210

32.4

ACE

Certificate of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350

211

 

 

 

 

 

 

 

 

           GLOSSARY OF TERMS

Term

Definition

A&N

A&N Electric Cooperative, which has entered into an agreement with DPL to purchase DPL's business of distributing retail electric services to customers located on the Eastern Shore of Virginia

ABO

Accumulated benefit obligation

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

Ancillary services

Generally, electricity generation reserves and reliability services

APB

Accounting Principles Board of the American Institute of Certified Public Accountants

APCA

New Jersey Air Pollution Control Act

APIC

Additional paid-in capital

Appellate Division

Appellate Division of the Superior Court of New Jersey

Asset Purchase and
  Sale Agreement

Asset Purchase and Sale Agreement, dated as of June 7, 2000 and subsequently amended, between Pepco and Mirant (formerly Southern Energy, Inc.) relating to the sale of Pepco's generation assets

Bankruptcy Court

Bankruptcy Court for the Northern District of Texas

Bankruptcy Funds

$13.25 million in funds from the Bankruptcy Settlement

Bankruptcy Settlement

The bankruptcy settlement among the parties concerning the environmental proceedings at the Metal Bank/Cottman Avenue environmental remediation 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)

BSA

Bill stabilization adjustment mechanism, which "decouples" revenue from unit sales consumption and ties the growth in revenues to the growth in the number of customers

CEP

New Jersey Clean Energy Program

Competitive Energy
  business

Consists of the business operations of Conectiv Energy and Pepco Energy Services

Conectiv

A wholly owned subsidiary of PHI, which is a PUHCA 2005 holding company. Conectiv also is the parent of DPL and ACE

Conectiv Energy

Conectiv Energy Holding Company and its subsidiaries

Conectiv Group

Conectiv and certain of its subsidiaries, involved in a like-kind exchange transaction

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.

DCPSC

District of Columbia Public Service Commission

Default Electricity
  Supply

The supply of electricity within PHI's service territories at regulated rates to retail customers who do not elect to purchase electricity from a competitive supplier, and which, depending on the jurisdiction, is also known as Default Service, SOS, BGS, or formerly POLR service

Default Supply Revenue

Revenue received for Default Electricity Supply

Delaware District Court

U.S. District Court for the District of Delaware

District Court

U.S. District Court for the Northern District of Texas

i

 

Term

Definition

DPL

Delmarva Power & Light Company

DPSC

Delaware Public Service Commission

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

EPS

Earnings per share

ERISA

Employment Retirement Income Security Act of 1974

Exchange Act

Securities Exchange Act of 1934, as amended

FASB

Financial Accounting Standards Board

FERC

Federal Energy Regulatory Commission

Fifth Circuit

U.S. Court of Appeals for the Fifth Circuit

FIN

FASB Interpretation Number

First Order

Administrative Order and Notice of Civil Administrative Penalty Assessment issued by NJDEP on April 3, 2007

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

GAAP

Accounting principles generally accepted in the United States of America

GCR

Gas Cost Rate

GPC

Generation Procurement Credit

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.

IRC

Internal Revenue Code

IRS

Internal Revenue Service

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

MAPP

Mid-Atlantic Power Pathway Project

MDE

Maryland Department of the Environment

MGP

Manufactured gas plant

Mirant

Mirant Corporation and its predecessors and its subsidiaries

MOA

Memorandum of Agreement

MPSC

Maryland Public Service Commission

NFA

No Further Action Letter issued by NJDEP

NGC

Non Utility Generation Charge in New Jersey

NJBPU

New Jersey Board of Public Utilities

NJDEP

New Jersey Department of Environmental Protection

NOPR

Notice of Proposed Rulemaking by the IRS

Normalization provisions

Sections of the Internal Revenue Code 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

ii

Term

Definition

Notice

Notice 2005-13 issued by the Treasury Department and IRS on February 11, 2005

NUGs

Non-utility generation contracts between ACE and unaffiliated third parties

NYDEC

New York Department of Environmental Conservation

OCI

Other Comprehensive Income

ODEC

Old Dominion Electric Cooperative, which has entered into an agreement with DPL to purchase certain assets principally related to DPL's provision of electric transmission services located on the Eastern Shore of Virginia

OPEB

Other post-employment pension liabilities

Panda

Panda-Brandywine, L.P.

Panda PPA

PPA between Pepco and Panda

PBO

Projected benefit obligation

PCI

Potomac Capital Investment Corporation and its subsidiaries

Pepco

Potomac Electric Power Company

Pepco Distribution

The total aggregate distribution to Pepco pursuant to the Settlement Agreement

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

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 have not elected to purchase electricity from a competitive supplier)

Power Delivery

PHI's Power Delivery Business

PPA

Power Purchase Agreement

PPA-Related
  Obligations

Mirant's obligations to purchase from Pepco the capacity and energy that Pepco is obligated to purchase under the FirstEnergy and the Panda PPAs

PRP

Potentially responsible party

PUHCA 1935

Public Utility Holding Company 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

RC Cape May

RC Cape May Holdings, LLC, an affiliate of Rockland Capital Energy Investments, and the buyer 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

Reorganization Plan

Mirant's Plan of Reorganization

RI/FS

Remedial Investigation/Feasibility Study

ROE

Return on equity

RTEP

PJM's Regional Transmission Expansion Plan

SBC

Societal Benefits Charge in New Jersey

SEC

Securities and Exchange Commission

Second Order

Administrative Order and Notice of Civil Administrative Penalty Assessment issued by NJDEP on May 23, 2007

Settlement Agreement

Amended Settlement Agreement and Release, dated as of May 30, 2006 between Pepco and the Mirant Parties

iii

Term

Definition

SFAS

Statement of Financial Accounting Standards

SMECO

Southern Maryland Electric Cooperative, Inc.

SMECO Agreement

Capacity purchase agreement between Pepco and SMECO

SMECO Settlement
  Agreement

Settlement Agreement and Release entered into between Mirant and SMECO

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)

Standard Offer Service
  revenue or SOS revenue

Revenue Pepco receives for the procurement of energy by Pepco for its SOS customers

Stranded costs

Costs incurred by a utility in connection with providing service which would otherwise be unrecoverable in a competitive or restructured market. Such costs may include costs for generation assets, purchased power costs, and regulatory assets and liabilities, such as accumulated deferred income taxes.

T&D

Transmission and distribution

Third Circuit

U.S. Court of Appeals for the Third Circuit

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

Utility PRPs

A group of utility PRPs including Pepco, parties to a settlement involving the environmental proceedings at the Metal Bank/Cottman Avenue site

VaR

Value at Risk

Virginia District Court

U.S. District Court for the Eastern District of Virginia

VSCC

Virginia State Corporation Commission

 

 

 

iv

 

 

 

 

 

 

 

 

 

 

 

 

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PART I    FINANCIAL INFORMATION

Item 1.   FINANCIAL STATEMENTS

          Listed below is a table that sets forth, for each registrant, the page number where the information is contained herein.

 

                               Registrants                           

Item

Pepco
Holdings

Pepco*

DPL*

ACE

Consolidated Statements of Earnings

3

52

74

92

Consolidated Statements of Comprehensive Earnings

4

N/A

N/A

N/A

Consolidated Balance Sheets

5

53

75

93

Consolidated Statements of Cash Flows

7

55

77

95

Notes to Consolidated Financial Statements

8

56

78

96

         

*  Pepco and DPL have no subsidiaries and therefore their financial statements are not consolidated.

 

 

 

 

 

 

 

 

 

 

1

 

 

 

 

 

 

 

 

 

 

 

 

THIS PAGE INTENTIONALLY LEFT BLANK.

 

 

 

 

 

 

 

 

 

2

PEPCO HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF EARNINGS
(Unaudited)

 

Three Months Ended
June 30,

Six Months Ended
June 30,

 
   

2007

   

2006

   

2007

   

2006

   
   

(Millions of dollars, except share data)

 
                           

Operating Revenue

                         

  Power Delivery

$

1,162.3 

 

$

1,179.4 

 

$

2,437.4 

 

$

2,354.2 

   

  Competitive Energy

 

904.1 

   

711.0 

   

1,791.2 

   

1,467.7 

   

  Other

 

17.9 

   

26.2 

   

34.5 

   

46.6 

   

     Total Operating Revenue

 

2,084.3 

   

1,916.6 

   

4,263.1 

   

3,868.5 

   
                           

Operating Expenses

                         

  Fuel and purchased energy

 

1,412.4 

   

1,218.9 

   

2,889.4 

   

2,445.6 

   

  Other services cost of sales

 

134.6 

   

168.2 

   

272.7 

   

325.1 

   

  Other operation and maintenance

 

210.8 

   

209.5 

   

417.9 

   

413.9 

   

  Depreciation and amortization

92.7 

104.1 

185.8 

208.3 

  Other taxes

86.2 

82.6 

171.5 

164.0 

  Deferred electric service costs

(10.0)

(29.6)

18.1 

(10.2)

  Impairment loss

1.6 

.2 

1.6 

6.5 

  Gain on sale of assets

(.5)

(2.5)

(1.8)

     Total Operating Expenses

1,928.3 

1,753.4 

3,954.5 

3,551.4 

                           

Operating Income

 

156.0 

   

163.2 

   

308.6 

   

317.1 

   

Other Income (Expenses)

                         

  Interest and dividend income

 

3.5 

   

4.2 

   

6.8 

   

7.7 

   

  Interest expense

 

(83.8)

   

(85.2)

   

(168.4)

   

(166.8)

   

  Income (loss) from equity investments

 

3.7 

   

(.2)

   

7.1 

   

.5 

   

  Other income

 

6.8 

   

11.6 

   

15.4 

   

32.5 

   

  Other expenses

 

(.2)

   

(2.9)

   

(.4)

   

(7.9)

   

     Total Other Expenses

(70.0)

(72.5)

(139.5)

(134.0)

Preferred Stock Dividend Requirements of Subsidiaries

 

.1 

   

.3 

   

.2 

   

.7 

   

Income Before Income Tax Expense

85.9 

90.4 

168.9 

182.4 

Income Tax Expense

 

28.7 

   

39.2 

   

60.1 

   

74.4 

   
                           

Net Income

57.2 

51.2 

108.8 

108.0 

Retained Earnings at Beginning of Period

1,071.4 

1,026.1 

1,068.7 

1,018.7 

Cumulative Effect Adjustment Related to
  the Implementation of FIN 48

1.4 

LTIP Dividend

(.2)

Dividends Paid on Common Stock (Note 4)

(50.2)

(49.4)

(100.3)

(98.8)

Retained Earnings at End of Period

$

1,078.4 

$

1,027.9 

$

1,078.4 

$

1,027.9 

Basic and Diluted Share Information

                         

  Weighted average shares outstanding

 

193.2 

   

190.4 

   

192.8 

   

190.2 

   

  Earnings per share of common stock

$

.30 

 

$

.27 

 

$

.56 

 

$

.56 

   
                           

The accompanying Notes are an integral part of these Consolidated Financial Statements.

3

 

PEPCO HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE EARNINGS
(Unaudited)

 

Three Months Ended
June 30,

Six Months Ended
June 30,

 
   

2007

   

2006

   

2007

   

2006

   
   

(Millions of dollars)

 
                           

Net income

$

57.2 

 

$

51.2 

 

$

108.8 

 

$

108.0 

   
                           

Other comprehensive earnings (losses)

                         
                           

  Unrealized gains (losses) on commodity
    derivatives designated as cash flow hedges:

                         

      Unrealized holding gains (losses) arising during period

1.6 

(27.6)

20.3 

(117.2)

      Less: reclassification adjustment for
                (losses) gains included in net earnings

(.7)

(8.5)

(12.5)

27.3 

      Net unrealized gains (losses) on commodity derivatives

2.3 

(19.1)

32.8 

(144.5)

  Realized gains on Treasury lock transactions

3.3 

3.0 

6.2 

5.9 

                           

  Other comprehensive earnings (losses), before taxes

5.6 

(16.1)

39.0 

(138.6)

  Income tax expense (benefit)

3.2 

(6.8)

15.0 

(55.7)

                           

Other comprehensive earnings (losses), net of income taxes

 

2.4 

   

(9.3)

   

24.0 

   

(82.9)

   

Comprehensive earnings

$

59.6 

$

41.9 

$

132.8 

$

25.1 

                           

The accompanying Notes are an integral part of these Consolidated Financial Statements.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

4

PEPCO HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Unaudited)

ASSETS

June 30,
2007

December 31,
2006

     

(Millions of dollars)

 

CURRENT ASSETS

                         

  Cash and cash equivalents

           

$

23.0 

 

$

48.8 

   

  Restricted cash

             

12.9 

   

12.0 

   

  Accounts receivable, less allowance for
    uncollectible accounts of $37.0 million
    and $35.8 million, respectively

             

1,270.7 

   

1,253.5 

   

  Fuel, materials and supplies-at average cost

             

282.4 

   

288.8 

   

  Unrealized gains - derivative contracts

             

29.2 

   

72.7 

   

  Prepayments of income taxes

             

267.2 

   

228.4 

   

  Prepaid expenses and other

             

119.6 

   

77.2 

   

    Total Current Assets

             

2,005.0 

   

1,981.4 

   
                           

INVESTMENTS AND OTHER ASSETS

                         

  Goodwill

             

1,407.3 

   

1,409.2 

   

  Regulatory assets

             

1,540.6 

   

1,570.8 

   

  Investment in finance leases held in trust

             

1,349.9 

   

1,321.8 

   

  Income taxes receivable

             

204.1 

   

   

  Other

             

371.9 

   

383.7 

   

    Total Investments and Other Assets

             

4,873.8 

   

4,685.5 

   
                           

PROPERTY, PLANT AND EQUIPMENT

                         

  Property, plant and equipment

             

11,992.0 

   

11,819.7 

   

  Accumulated depreciation

             

(4,340.4)

   

(4,243.1)

   

    Net Property, Plant and Equipment

             

7,651.6 

   

7,576.6 

   
                           

    TOTAL ASSETS

           

$

14,530.4 

 

$

14,243.5 

   
                           

The accompanying Notes are an integral part of these Consolidated Financial Statements.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

5

PEPCO HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Unaudited)

LIABILITIES AND SHAREHOLDERS' EQUITY

June 30,
2007

December 31,
2006

     

(Millions of dollars, except shares)

 
                           

CURRENT LIABILITIES

                         

  Short-term debt

           

$

286.0 

 

$

349.6 

   

  Current maturities of long-term debt

             

640.5 

   

857.5 

   

  Accounts payable and accrued liabilities

             

803.5 

   

700.7 

   

  Capital lease obligations due within one year

             

5.7 

   

5.5 

   

  Taxes accrued

             

93.5 

   

99.9 

   

  Interest accrued

             

79.1 

   

80.1 

   

  Interest and tax liability on uncertain tax positions

             

124.3 

   

   

  Other

             

377.4 

   

433.6 

   

    Total Current Liabilities

             

2,410.0 

   

2,526.9 

   
                           

DEFERRED CREDITS

                         

  Regulatory liabilities

             

776.7 

   

842.7 

   

  Deferred income taxes

             

2,000.8 

   

2,084.0 

   

  Investment tax credits

             

38.0 

   

46.1 

   

  Pension benefit obligation

             

86.6 

   

78.3 

   

  Other postretirement benefit obligations

413.3 

405.0 

  Income taxes payable

159.5 

  Other

             

294.3 

   

256.5 

   

    Total Deferred Credits

             

3,769.2 

   

3,712.6 

   
                           

LONG-TERM LIABILITIES

                         

  Long-term debt

             

4,087.8 

   

3,768.6 

   

  Transition Bonds issued by ACE Funding

             

449.6 

   

464.4 

   

  Long-term project funding

             

21.9 

   

23.3 

   

  Capital lease obligations

             

108.3 

   

111.1 

   

    Total Long-Term Liabilities

             

4,667.6 

   

4,367.4 

   
                           

COMMITMENTS AND CONTINGENCIES (NOTE 4)

                         
                           

MINORITY INTEREST

             

6.2 

   

24.4 

   
                           

SHAREHOLDERS' EQUITY

                         

  Common stock, $.01 par value, authorized
    400,000,000 shares, 193,517,986 shares and
    191,932,445 shares outstanding, respectively

             

1.9 

   

1.9 

   

  Premium on stock and other capital contributions

             

2,676.5 

   

2,645.0 

   

  Accumulated other comprehensive loss

             

(79.4)

   

(103.4)

   

  Retained earnings

             

1,078.4 

   

1,068.7 

   

    Total Shareholders' Equity

             

3,677.4 

   

3,612.2 

   
                           

    TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY

           

$

14,530.4 

 

$

14,243.5 

   
                           

The accompanying Notes are an integral part of these Consolidated Financial Statements.

6

PEPCO HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

   

Six Months Ended
June 30,

 
               

2007

   

2006

   
     

   (Millions of dollars)

 

OPERATING ACTIVITIES

                         

Net income

           

$

108.8 

 

$

108.0 

   

Adjustments to reconcile net income to net cash from operating activities:

                         

  Depreciation and amortization

             

185.8 

   

208.3 

   

  Gain on sale of assets

             

(2.5)

   

(1.8)

   

  Gain on sale of other investment

             

(.7)

   

(12.3)

   

  Impairment loss

             

1.6 

   

6.5 

   

  Rents received from leveraged leases under income earned

             

(38.1)

   

(46.3)

   

  Deferred income taxes

             

58.0 

   

46.4 

   

  Changes in:

                         

    Accounts receivable

             

(21.9)

   

248.9 

   

    Regulatory assets and liabilities

             

(24.2)

   

(12.3)

   

    Accounts payable and accrued liabilities

             

79.3 

   

(297.6)

   

    Interest and taxes accrued

             

(21.6)

   

(300.9)

   

    Other changes in working capital

             

(46.2)

   

(42.6)

   

Net other operating

             

36.5 

   

(22.7)

   

Net Cash From (Used By) Operating Activities

             

314.8 

   

(118.4)

   
                           

INVESTING ACTIVITIES

                         

Net investment in property, plant and equipment

             

(285.0)

   

(248.3)

   

Proceeds from sale of assets

             

10.6 

   

3.2 

   

Proceeds from the sale of other investments

             

   

13.1 

   

Changes in restricted cash

             

(.9)

   

10.0 

   

Net other investing activities

             

2.7 

   

7.6 

   

Net Cash Used By Investing Activities

             

(272.6)

   

(214.4)

   
                           

FINANCING ACTIVITIES

                         

Dividends paid on common stock

             

(100.3)

   

(98.8)

   

Dividends paid on preferred stock

             

(.2)

   

(.7)

   

Common stock issued for the Dividend Reinvestment Plan

             

14.1 

   

15.0 

   

Issuance of common stock

             

23.9 

   

2.6 

   

Preferred stock redeemed

             

(18.2)

   

(21.5)

   

Issuances of long-term debt

             

451.4 

   

217.0 

   

Reacquisition of long-term debt

             

(364.2)

   

(491.2)

   

(Repayments) issuances of short-term debt, net

             

(63.6)

   

619.7 

   

Cost of issuances

             

(2.5)

   

(2.9)

   

Net other financing activities

             

(8.4)

   

5.0 

   

Net Cash (Used By) From Financing Activities

             

(68.0)

   

244.2 

   
                           

Net Decrease in Cash and Cash Equivalents

             

(25.8)

   

(88.6)

   

Cash and Cash Equivalents at Beginning of Period

             

48.8 

   

121.5 

   
                           

CASH AND CASH EQUIVALENTS AT END OF PERIOD

           

$

23.0 

 

$

32.9 

   
                           

NONCASH ACTIVITIES

                         

Asset retirement obligations associated with removal
  costs transferred to regulatory liabilities

           

$

7.3 

 

$

(3.7)

   
                           

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION

                         

Cash (received) paid for income taxes

           

$

(6.3)

 

$

172.8 

   

The accompanying Notes are an integral part of these Consolidated Financial Statements.

7

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

PEPCO HOLDINGS, INC.

(1)  ORGANIZATION

     Pepco Holdings, Inc. (Pepco Holdings or PHI) is a diversified energy company that, through its operating subsidiaries, is engaged in two principal business operations:

·

electricity and natural gas delivery (Power Delivery), and

·

competitive energy generation, marketing and supply (Competitive Energy).

     PHI was incorporated in Delaware in February 2001, for the purpose of effecting the acquisition of Conectiv by Potomac Electric Power Company (Pepco). The acquisition was completed on August 1, 2002, at which time Pepco and Conectiv became wholly owned subsidiaries of PHI. Conectiv was formed in 1998 to be the holding company for Delmarva Power & Light Company (DPL) and Atlantic City Electric Company (ACE) in connection with a merger between DPL and ACE. As a result, DPL and ACE are wholly owned subsidiaries of Conectiv.

     On February 8, 2006, the Public Utility Holding Company Act of 1935 (PUHCA 1935) was repealed and the Public Utility Holding Company Act of 2005 (PUHCA 2005) went into effect. As a result, PHI has ceased to be regulated by the Securities and Exchange Commission (SEC) as a public utility holding company and is now subject to the regulatory oversight of the Federal Energy Regulatory Commission (FERC). As permitted under FERC regulations promulgated under PUHCA 2005, PHI has given notice to FERC that it will continue, until further notice, to operate pursuant to the authority granted in the financing order issued by the SEC under PUHCA 1935, which has an authorization period ending June 30, 2008, relating to the issuance of securities and guarantees, other financing transactions and the operation of PHI's money pool.

     PHI Service Company, a subsidiary service company of PHI, provides a variety of support services, including legal, accounting, tax, financial reporting, treasury, 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.

     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 and distribution of electricity and the distribution of natural gas.

     PHI's Power Delivery business is conducted by its three regulated utility subsidiaries: Pepco, DPL and ACE. Each subsidiary is a regulated public utility in the jurisdictions that comprise its service territory. Pepco, DPL and ACE each owns and operates a network of wires, substations and other equipment that are classified either as transmission or distribution facilities.

8

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. Together the three companies constitute a single segment for financial reporting purposes.

     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 public service commission. Each company also supplies electricity at regulated rates to retail customers in its service territory who do not elect to purchase electricity from a competitive supplier. The regulatory term for this supply service varies by jurisdiction as follows:

 

Delaware

Provider of Last Resort service (POLR) -- 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-Q, these supply services are referred to generally as Default Electricity Supply.

Competitive Energy

     The Competitive Energy business provides competitive generation, marketing and supply of electricity and gas, and related energy management services, primarily in the mid-Atlantic region. PHI's Competitive Energy operations are conducted through subsidiaries of Conectiv Energy Holding Company (collectively, Conectiv Energy) and Pepco Energy Services, Inc. and its subsidiaries (collectively, Pepco Energy Services). Conectiv Energy and Pepco Energy Services are separate operating segments for financial reporting purposes.

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 June 30, 2007 of approximately $1.3 billion. This activity constitutes a fourth operating segment, which is designated as "Other Non-Regulated" for financial reporting purposes. For a discussion of PHI's cross-border leasing transactions, see "Regulatory and Other Matters -- Federal Tax Treatment of Cross Border Leases."

(2)  ACCOUNTING POLICY, PRONOUNCEMENTS, AND OTHER DISCLOSURES

Financial Statement Presentation

     Pepco Holdings' unaudited consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States of America (GAAP). Pursuant to the rules and regulations of the SEC, certain information and footnote disclosures normally included in annual financial statements prepared in accordance with GAAP have been omitted. Therefore, these financial statements should be read along with the annual financial statements

9

included in PHI's Annual Report on Form 10-K for the year ended December 31, 2006. In the opinion of PHI's management, the consolidated financial statements contain all adjustments (which all are of a normal recurring nature) necessary to present fairly Pepco Holdings' financial condition as of June 30, 2007, in accordance with GAAP. The year-end balance sheet data was derived from audited financial statements, but does not include all disclosures required by GAAP. Interim results for the three and six months ended June 30, 2007 may not be indicative of PHI's results that will be realized for the full year ending December 31, 2007, since its Power Delivery and Competitive Energy businesses are seasonal.

FIN 46R, "Consolidation of Variable Interest Entities"

     Subsidiaries of Pepco Holdings have power purchase agreements (PPAs) with a number of entities, including three contracts between unaffiliated non-utility generators (NUGs) and ACE and an agreement between Pepco and Panda-Brandywine, L.P. (Panda) entered into in 1991, pursuant to which Pepco is obligated to purchase from Panda 230 megawatts of capacity and energy annually through 2021 (Panda PPA). Due to a variable element in the pricing structure of the NUGs and the Panda PPA, the Pepco Holdings' subsidiaries potentially assume the variability in the operations of the plants related to these PPAs and therefore have a variable interest in the counterparties to these PPAs. In accordance with the provisions of Financial Accounting Standards Board (FASB) Interpretation No. (FIN) 46R (revised December 2003), entitled "Consolidation of Variable Interest Entities" (FIN 46R), Pepco Holdings continued, during the second quarter of 2007, to conduct exhaustive efforts to obtain information from these four entities, but was unable to obtain sufficient information to conduct the analysis required under FIN 46R to determine whether these four entities were variable interest entities or if Pepco Holdings' subsidiaries were the primary beneficiary. As a result, Pepco Holdings has applied the scope exemption from the application of FIN 46R for enterprises that have conducted exhaustive efforts to obtain the necessary information, but have not been able to obtain such information.

     Net purchase activities with the counterparties to the NUGs and the Panda PPA for the three months ended June 30, 2007 and 2006 were approximately $97 million and $98 million, respectively, of which approximately $90 million and $89 million, respectively, were related to power purchases under the NUGs and the Panda PPA.  Net purchase activities with the counterparties to the NUGs and the Panda PPA for the six months ended June 30, 2007 and 2006 were approximately $203 million and $201 million, respectively, of which approximately $186 million and $182 million, respectively, were related to power purchases under the NUGs and the Panda PPA. Pepco Holdings' exposure to loss under the Panda PPA is discussed in Note (4), Commitments and Contingencies, under "Relationship with Mirant Corporation." Pepco Holdings does not have loss exposure under the NUGs because cost recovery will be achieved from ACE's customers through regulated rates.

     In April 2006, the FASB issued FASB Staff Position (FSP) 46(R)-6, "Determining the Variability to Be Considered in Applying FASB Interpretation No. 46(R)" (FSP FIN 46(R)-6), which provides guidance on how to determine the variability to be considered in applying FIN 46(R). Pepco Holdings started applying the guidance in FSP FIN 46(R)-6 to new and modified arrangements effective July 1, 2006.

10

FIN 48, "Accounting for Uncertainty in Income Taxes"

     On July 13, 2006, the FASB issued FIN 48, "Accounting for Uncertainty in Income Taxes" (FIN 48). FIN 48 clarifies the criteria for recognition of tax benefits in accordance with Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes," and prescribes a financial statement recognition threshold and measurement attribute for a tax position taken or expected to be taken in a tax return. Specifically, it clarifies that an entity's tax benefits must be "more likely than not" of being sustained prior to recording the related tax benefit in the financial statements. If the position drops below the "more likely than not" standard, the benefit can no longer be recognized. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition.

     PHI adopted the provisions of FIN 48 on January 1, 2007. As a result of the implementation of FIN 48, PHI recorded a $1.4 million increase in beginning retained earnings, representing the cumulative effect of the change in accounting principle. Unrecognized tax benefits represent those tax benefits related to tax positions that have been taken or are expected to be taken in tax returns, including refund claims, that are not recognized in the financial statements because, in accordance with FIN 48, management has either measured the tax benefit at an amount less than the benefit claimed or expected to be claimed or concluded that it is not more likely than not that the tax position will be ultimately sustained. As of January 1, 2007, unrecognized tax benefits totaled $186.9 million. For the majority of these tax positions, the ultimate deductibility is highly certain, but there is uncertainty about the timing of such deductibility. Unrecognized tax benefits at January 1, 2007, included $35.3 million that, if recognized, would lower the effective tax rate.

     PHI recognizes interest on under/over payments of income taxes and penalties in income tax expense. As of January 1, 2007, PHI had accrued approximately $25.0 million of interest expense and penalties.

     PHI and the majority of its subsidiaries file a consolidated federal income tax return. PHI's federal income tax liabilities for Pepco legacy companies for all years through 2000, and for Conectiv legacy companies for all years through 1997, have been determined, subject to adjustment to the extent of any net operating loss or other loss or credit carrybacks from subsequent years. The open tax years for the significant states where PHI files state income tax returns (District of Columbia, Maryland, Delaware, New Jersey, Pennsylvania and Virginia), are the same as noted above.

     Total unrecognized tax benefits that may change over the next twelve months include the matter described in Note (4) Commitments and Contingencies under the heading "IRS Mixed Service Cost Issue."

     Included in the amount of unrecognized tax benefits at January 1, 2007 that, if recognized, would lower the effective tax rate is a state of Maryland claim for refund in the amount of $31.8 million. Pepco filed an amended 2000 Maryland tax return on November 14, 2005 claiming the refund. The amended return claimed additional tax basis for purposes of computing the Maryland tax gain on the sale of Pepco's generating plants based on the tax benefit rule. This claim for refund was rejected by the state. Pepco filed an appeal by letter dated June 28, 2006. The Hearing Officer denied the appeal by a Notice of Final Determination dated February 22, 2007. Pepco petitioned Maryland Tax Court on March 22, 2007 for the refund. The outcome of this

11

case was uncertain at June 30, 2007. Based on the FIN 48 criteria, management did not believe at June 30, 2007 that this refund claim met the financial statement recognition threshold and measurement attribute for recording the tax benefits of this transaction. On August 1, 2007, Pepco entered into a settlement agreement related to this refund claim. For a further discussion, see "Maryland Income Tax Refund" in Note (6), Subsequent Events, herein.

     On May 2, 2007, the FASB issued FSP FIN 48-1, "Definition of Settlement in FASB Interpretation No. 48" (FIN 48-1), which provides guidance on how an enterprise should determine whether a tax position is effectively settled for the purpose of recognizing previously unrecognized tax benefits. PHI applied the guidance of FIN 48-1 with its adoption of FIN 48 on January 1, 2007.

Components of Net Periodic Benefit Cost

     The following Pepco Holdings' information is for the three months ended June 30, 2007 and 2006.

   

Pension Benefits

   

Other
Postretirement
Benefits

   
   

2007

   

2006

   

2007

   

2006

   
 

(Millions of dollars)

 

Service cost

$

7.4 

 

$

10.1 

 

$

.9 

 

$

1.7 

   

Interest cost

 

26.3 

   

24.2 

   

8.4 

   

8.3 

   

Expected return on plan assets

 

(31.9)

   

(32.5)

   

(2.7)

   

(2.7)

   

Amortization of prior service cost

 

.2 

   

.2 

   

(1.2)

   

(1.1)

   

Amortization of net loss

 

1.0 

   

4.8 

   

2.4 

   

4.2 

   

Net periodic benefit cost

$

3.0 

 

$

6.8 

 

$

7.8 

 

$

10.4 

   
                           

     The following Pepco Holdings' information is for the six months ended June 30, 2007 and 2006.

   

Pension Benefits

   

Other
Postretirement
Benefits

   
   

2007

   

2006

   

2007

   

2006

   
 

(Millions of dollars)

 

Service cost

$

18.1 

 

$

20.3 

 

$

3.6 

 

$

4.2 

   

Interest cost

 

50.9 

   

48.4 

   

18.3 

   

17.3 

   

Expected return on plan assets

 

(65.1)

   

(65.0)

   

(6.7)

   

(5.8)

   

Amortization of prior service cost

 

.4 

   

.4 

   

(2.1)

   

(2.0)

   

Amortization of net loss

 

4.7 

   

8.7 

   

5.7 

   

7.2 

   

Net periodic benefit cost

$

9.0 

 

$

12.8 

 

$

18.8 

 

$

20.9 

   
                           

     Pension

     The pension net periodic benefit cost for the three months ended June 30, 2007 of $3.0 million includes $1.4 million for Pepco, $.3 million for ACE, and $(1.3) million for DPL. The pension net periodic benefit cost for the six months ended June 30, 2007 of $9.0 million includes $4.5

12

million for Pepco, $1.3 million for ACE, and $(2.8) million for DPL. The remaining pension net periodic benefit cost is for other PHI subsidiaries. The pension net periodic benefit cost for the three months ended June 30, 2006 of $6.8 million includes $3.6 million for Pepco, $.2 million for ACE, and $(1.2) million for DPL. The pension net periodic benefit cost for the six months ended June 30, 2006 of $12.8 million includes $6.6 million for Pepco, $2.5 million for ACE, and $(3.0) million for DPL. The remaining pension net periodic benefit cost is for other PHI subsidiaries.

     Pension Contributions

     Pepco Holdings' current funding policy with regard to its defined benefit pension plan is to maintain a funding level in excess of 100% of its accumulated benefit obligation (ABO). PHI's pension plan currently meets the minimum funding requirements of the Employment Retirement Income Security Act of 1974 (ERISA) without any additional funding. PHI may elect, however, to make a discretionary tax-deductible contribution to maintain the pension plan's assets in excess of its ABO. In 2006 and 2005, PHI made discretionary tax-deductible cash contributions to the plan of zero and $60 million, respectively. As of June 30, 2007, no contributions have been made. The potential discretionary funding of the pension plan in 2007 will depend on many factors, including the actual investment return earned on plan assets over the remainder of the year.

     Other Postretirement Benefits

     The other postretirement net periodic benefit cost for the three months ended June 30, 2007 of $7.8 million includes $1.8 million for Pepco, $2.0 million for ACE, and $2.2 million for DPL. The other postretirement net periodic benefit cost for the six months ended June 30, 2007 of $18.8 million includes $6.7 million for Pepco, $4.4 million for ACE, and $4.0 million for DPL. The remaining other postretirement net periodic benefit cost is for other PHI subsidiaries. The other postretirement net periodic benefit cost for the three months ended June 30, 2006 of $10.4 million includes $4.6 million for Pepco, $2.3 million for ACE, and $1.8 million for DPL. The other postretirement net periodic benefit cost for the six months ended June 30, 2006 of $20.9 million includes $9.4 million for Pepco, $4.6 million for ACE, and $3.4 million for DPL. The remaining other postretirement net periodic benefit cost is for other PHI subsidiaries.

Stock-Based Compensation

     No stock options were granted in the second quarter of 2007.

     Cash received from options exercised under all share-based payment arrangements for the quarter ended June 30, 2007, was $3.9 million and the actual tax benefit realized for the tax deductions resulting from these options exercised totaled $.7 million. Cash received from options exercised under all share-based payment arrangements for the six months ended June 30, 2007, was $13.2 million and the actual tax benefit realized for the tax deductions resulting from these options exercised totaled $1.2 million.

 

 

 

13

Calculations of Earnings Per Share of Common Stock

     Reconciliations of the numerator and denominator for basic and diluted earnings per share of common stock calculations are shown below.

For the Three Months Ended June 30,

2007

2006

(In millions, except per share data)

Income (Numerator):

 

 

 

 

 

 

   

Net Income

 

$

57.2 

   

$

51.2 

 

Add: Loss on redemption of subsidiary's preferred stock

   

     

 

Earnings Applicable to Common Stock

 

$

57.2 

 

 

$

51.2 

 

Shares (Denominator) (a):

 

 

 

 

 

 

   

Weighted average shares outstanding for basic computation:

 

 

           

    Average shares outstanding

   

193.2 

     

190.4 

 

    Adjustment to shares outstanding

   

(.2)

     

(.2)

 

Weighted Average Shares Outstanding for Computation of
  Basic Earnings Per Share of Common Stock

   

193.0 

   

 

190.2 

 
                 

Weighted average shares outstanding for diluted computation:

 

 

 

 

 

 

   

    Average shares outstanding

 

 

193.2 

 

 

 

190.4 

 

    Adjustment to shares outstanding

 

 

.3 

 

 

 

.5 

 

Weighted Average Shares Outstanding for Computation of
  Diluted Earnings Per Share of Common Stock

 

 

193.5 

 

 

 

190.9 

 

Basic earnings per share of common stock

 

$

.30 

 

 

$

.27 

 

Diluted earnings per share of common stock

 

$

.30 

 

 

$

.27 

 
                 

(a)

 

The number of options to purchase shares of common stock that were excluded from the calculation of diluted EPS as they are considered to be anti-dilutive were approximately zero and .6 million for the three months ended June 30, 2007 and 2006, respectively.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

14

 

For the Six Months Ended June 30,  

     

2007

     

2006

 

(In millions, except per share data)

Income (Numerator):

 

 

 

 

 

 

   

Net Income

 

$

108.8 

 

 

$

108.0 

 

Add: Loss on redemption of subsidiary's preferred stock

 

 

(.6)

   

 

(.8)

 

Earnings Applicable to Common Stock

 

$

108.2 

 

 

$

107.2 

 

Shares (Denominator) (a):

 

 

 

 

 

 

   

Weighted average shares outstanding for basic computation:

 

 

           

    Average shares outstanding

   

192.8 

     

190.2 

 

    Adjustment to shares outstanding

   

(.2)

     

(.2)

 

Weighted Average Shares Outstanding for Computation of
  Basic Earnings Per Share of Common Stock

   

192.6 

   

 

190.0 

 
                 

Weighted average shares outstanding for diluted computation:

 

 

 

 

 

 

   

    Average shares outstanding

 

 

192.8 

 

 

 

190.2 

 

    Adjustment to shares outstanding

 

 

.3 

 

 

 

.4 

 

Weighted Average Shares Outstanding for Computation of
  Diluted Earnings Per Share of Common Stock

 

 

193.1 

 

 

 

190.6 

 

Basic earnings per share of common stock

 

$

.56 

 

 

$

.56 

 

Diluted earnings per share of common stock

 

$

.56 

 

 

$

.56 

 
                 

(a)

 

Options to purchase shares of common stock that were excluded from the calculation of diluted EPS as they are considered to be anti-dilutive were approximately zero and .6 million for the six months ended June 30, 2007 and 2006, respectively.

Impairment Loss

     During the second quarter of 2007, PHI recorded a pre-tax impairment loss of $1.6 million ($1 million, after-tax) on certain energy services business assets owned by Pepco Energy Services. Also, pre-tax impairment losses of $6.5 million ($4.2 million, after-tax) were recorded on other energy services business assets during the six months ended June 30, 2006.

Sale of Interest in Cogeneration Joint Venture

     During the first quarter of 2006, Conectiv Energy recognized a $12.3 million pre-tax gain ($7.9 million after-tax) on the sale of its equity interest in a joint venture which owns a wood burning cogeneration facility in California. The pre-tax gain is included in the line item entitled "Other Income" in the accompanying consolidated statement of earnings.

Goodwill

     A roll forward of PHI's goodwill balance follows (millions of dollars):

Balance,  December 31, 2006

$  1,409.2    

     Less:  Adjustment due to resolution of pre-merger tax contingencies

         (1.9)   

Balance,  June 30, 2007

$  1,407.3    

15

Reconciliation of Consolidated Income Tax Expense

     A reconciliation of PHI's consolidated income tax expense is as follows:

 

For the Three Months Ended June 30,

For the Six Months Ended June 30,

 
 

2007

2006

2007

2006

 
 

Amount

Rate

Amount

Rate

Amount

Rate

Amount

Rate

 
 

(Millions of dollars)

 

Income Before Income Tax Expense

$85.9   

$90.4   

$168.9  

$182.4  

Add: Preferred stock dividend
          requirements of subsidiaries

.1   

.3   

.2  

.7  

Income Before Income Tax Expense
      and Preferred Dividends

$86.0   

 

$90.7   

 

$169.1  

 

$183.1  

   
                   

Income tax at federal statutory rate

$30.1   

.35  

$31.8   

.35  

$ 59.2  

.35  

$  64.1  

.35  

 

  Increases (decreases) resulting from:

                 

    Depreciation

2.3   

.03  

2.0   

.02  

4.3  

.03  

4.0  

.02  

 

    Asset removal costs

(.5)  

(.01) 

(.5)  

(.01) 

(1.1) 

(.01) 

(2.0) 

(.01) 

 

    State income taxes, net of
       federal effect

2.6   

.03  

8.0   

.09  

6.5  

.04  

12.6  

.07  

 

    Tax credits

(1.2)  

(.01) 

(1.2)  

(.01) 

(2.3) 

(.01) 

(2.4) 

(.01) 

 

    Company dividends reinvested
      in 401(k) Plan

(.5)  

(.01) 

-   

-  

(1.1) 

(.01) 

(1.0) 

-  

 

    Leveraged leases

(1.9)  

(.02) 

(3.0)  

(.03) 

(3.7) 

(.02) 

(4.8) 

(.03) 

 

    Change in estimates related to
       prior year tax liabilities

(2.3)  

(.03) 

2.9   

.03  

(2.3) 

(.01) 

2.5  

.01  

    Software amortization

.7   

.01  

.1   

-  

1.5  

.01  

1.4  

.01  

    Other

(.6)  

(.01) 

(.9)  

(.01) 

(.9) 

(.01) 

-  

-  

 
                   

Total Consolidated Income Tax Expense

$28.7   

.33  

$39.2   

.43  

$ 60.1  

.36  

$  74.4  

.41  

 
                   

Resolution of Uncertain Tax Positions

     In June 2007, DPL agreed to a settlement with the State of Delaware related to the allocation of a gain on the sale of real property that occurred in 2001, pursuant to which DPL has made a cash payment of approximately $12 million, consisting of $7.4 million in tax and $4.6 million in interest. DPL's FIN 48 tax reserves for this issue were in excess of the amount finally settled with the State. As a result, excess reserves of $2.8 million were credited to DPL's income tax expense in the second quarter. Because the matter involved a Conectiv heritage tax contingency that existed at the time of the acquisition of Conectiv in August 2002, an additional adjustment of $1.9 million has been recorded in Corporate and Other to eliminate a portion of the tax benefit recorded by DPL.

Resolution of Certain Internal Revenue Service Audit Matters

     In the second quarter of 2006, PHI resolved certain, but not all, tax matters that were raised in Internal Revenue Service audits related to the 2001 and 2002 tax years. Adjustments recorded during the second quarter of 2006 related to these resolved tax matters resulted in an increase in net income of $6.3 million ($2.5 million for Power Delivery and $5.4 million for Other Non-Regulated, partially offset by an unfavorable $1.6 million impact in Corporate and Other). To the extent that the matters resolved related to tax contingencies from the Conectiv heritage companies that existed at the August, 2002 merger date, in accordance with accounting rules, an additional adjustment of $9.1 million ($3.1 million related to Power Delivery and $6.0 million related to Other Non-Regulated) has been recorded in Corporate and Other to eliminate the tax

16

benefits recorded by the lines of business against the goodwill balance that resulted from the merger.

Amended and Restated Credit Facility

     On May 2, 2007, PHI, Pepco, DPL and ACE entered into an amendment and restatement of their principal credit facility.

     The aggregate borrowing limit under the facility is $1.5 billion, all or any portion of which may be used to obtain loans or to issue letters of credit. PHI's credit limit under the facility is $875 million. The credit limit of each of Pepco, DPL and ACE is the lesser of $500 million and the maximum amount of debt the company is permitted to have outstanding by its regulatory authorities, except that the aggregate amount of credit used by Pepco, DPL and ACE at any given time collectively may not exceed $625 million. The interest rate payable by each company on utilized funds is based on the prevailing prime rate or Eurodollar rate, plus a margin that varies according to the credit rating of the borrower. The facility also includes a "swingline loan sub-facility," pursuant to which each company may make same day borrowings in an aggregate amount not to exceed $150 million. Any swingline loan must be repaid by the borrower within seven days of receipt thereof. All indebtedness incurred under the facility is unsecured.

     The facility commitment expiration date is May 5, 2012, with each company having the right to elect to have 100% of the principal balance of the loans outstanding on the expiration date continued as non-revolving term loans for a period of one year from such expiration date.

     The facility is intended to serve primarily as a source of liquidity to support the commercial paper programs of the respective companies. The companies also are permitted to use the facility to borrow funds for general corporate purposes and issue letters of credit. In order for a borrower to use the facility, certain representations and warranties made by the borrower at the time the amended and restated credit agreement was entered into also must be true at the time the facility is utilized, and the borrower must be in compliance with specified covenants, including the financial covenant described below. However, a material adverse change in the borrower's business, property, and results of operations or financial condition subsequent to the entry into the amended and restated credit agreement is not a condition to the availability of credit under the facility. Among the covenants to which each of the companies is subject are (i) the requirement that each borrowing company maintain a ratio of total indebtedness to total capitalization of 65% or less, computed in accordance with the terms of the amended and restated credit agreement, which calculation excludes certain trust preferred securities and deferrable interest subordinated debt from the definition of total indebtedness (not to exceed 15% of total capitalization), (ii) a restriction on sales or other dispositions of assets, other than sales and dispositions permitted by the amended and restated credit agreement, and (iii) a restriction on the incurrence of liens on the assets of a borrower or any of its significant subsidiaries other than liens permitted by the amended and restated credit agreement. The agreement does not include any rating triggers.

17

Debt

     In April 2007, PHI issued $200 million of 6.0% notes due 2019 in private placement. Proceeds were used to redeem, on May 31, 2007, $200 million of 5.5% notes due August 15, 2007 at a price of 100.0377% of par.

     In April 2007, ACE retired at maturity $15 million of 7.52% medium-term notes.

     In April 2007, Atlantic City Electric Transition Funding LLC (ACE Funding) made principal payments of $4.9 million on Series 2002-1 Transition Bonds, Class A-1 and $2.0 million on Series 2003-1 Transition Bonds, Class A-1 with a weighted average interest rate of 2.89%.

     In May 2007, ACE retired at maturity $1 million of 7.15% medium-term notes.

     In May 2007, DPL retired at maturity $50 million of 8.125% medium-term notes.

     In June 2007, PHI issued $250 million of 6.125% notes due 2017 in a public offering. Net proceeds along with cash on hand or short-term debt will be used to repay $300 million of 5.5% notes due August 15, 2007.

     In June 2007, DPL retired at maturity $3.2 million of 6.95% first mortgage bonds.

Reclassifications

     Certain prior period amounts have been reclassified in order to conform to current period presentations.

New Accounting Standards

     FSP FTB 85-4-1, "Accounting for Life Settlement Contracts by Third-Party Investors"

     In March 2006, the FASB issued FSP FASB Technical Bulletin (FTB) 85-4-1, "Accounting for Life Settlement Contracts by Third-Party Investors" (FSP FTB 85-4-1). This FSP provides initial and subsequent measurement guidance and financial statement presentation and disclosure guidance for investments by third-party investors in life settlement contracts. FSP FTB 85-4-1 also amends certain provisions of FASB Technical Bulletin No. 85-4, "Accounting for Purchases of Life Insurance," and SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." The guidance in FSP FTB 85-4-1 applies prospectively for all new life settlement contracts and is effective for fiscal years beginning after June 15, 2006 (year ending December 31, 2007 for Pepco Holdings). Pepco Holdings has evaluated the impact of FSP FTB 85-4-1 and it does not have a material impact on its overall financial condition, results of operations, or cash flows.

     SFAS No. 155, "Accounting for Certain Hybrid Financial Instruments - an amendment of FASB Statements No. 133 and 140"

     In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain Hybrid Financial Instruments - an amendment of FASB Statements No. 133 and 140" (SFAS No. 155). SFAS No. 155 amends FASB Statements No. 133, "Accounting for Derivative Instruments and Hedging Activities," and SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities." SFAS No. 155 resolves issues addressed in

18

Statement 133 Implementation Issue No. D1, "Application of Statement 133 to Beneficial Interests in Securitized Financial Assets." SFAS No. 155 is effective for all financial instruments acquired or issued after the beginning of an entity's first fiscal year that begins after September 15, 2006 (year ending December 31, 2007 for Pepco Holdings). Pepco Holdings has evaluated the impact of SFAS No. 155 and it does not have a material impact on its overall financial condition, results of operations, or cash flows.

     SFAS No. 156, "Accounting for Servicing of Financial Assets, an amendment of FASB Statement No. 140"

     In March 2006, the FASB issued SFAS No. 156, "Accounting for Servicing of Financial Assets" (SFAS No. 156), an amendment of SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities," with respect to the accounting for separately recognized servicing assets and servicing liabilities. SFAS No. 156 requires an entity to recognize a servicing asset or servicing liability upon undertaking an obligation to service a financial asset via certain servicing contracts, and for all separately recognized servicing assets and servicing liabilities to be initially measured at fair value, if practicable. Subsequent measurement is permitted using either the amortization method or the fair value measurement method for each class of separately recognized servicing assets and servicing liabilities.

     SFAS No. 156 is effective as of the beginning of an entity's first fiscal year that begins after September 15, 2006 (year ending December 31, 2007 for Pepco Holdings). Application is to be applied prospectively to all transactions following adoption of SFAS No. 156. Pepco Holdings has evaluated the impact of SFAS No. 156 and it does not have a material impact on its overall financial condition, results of operations, or cash flows.

     EITF Issue No. 06-3, "Disclosure Requirements for Taxes Assessed by a Governmental Authority on Revenue-producing Transactions"

     On June 28, 2006, the FASB ratified Emerging Issues Task Force (EITF) Issue No. 06-3, "Disclosure Requirements for Taxes Assessed by a Governmental Authority on Revenue-producing Transactions" (EITF 06-3). EITF 06-3 provides guidance on an entity's disclosure of its accounting policy regarding the gross or net presentation of certain taxes and provides that if taxes included in gross revenues are significant, a company should disclose the amount of such taxes for each period for which an income statement is presented (i.e., both interim and annual periods). Taxes within the scope of EITF 06-3 are those that are imposed on and concurrent with a specific revenue-producing transaction. Taxes assessed on an entity's activities over a period of time are not within the scope of EITF 06-3. Pepco Holdings implemented EITF 06-3 during the first quarter of 2007. Taxes included in Pepco Holdings gross revenues were $76.9 million and $63.8 million for the three months ended June 30, 2007 and 2006, respectively, and $150.1 million and $125.4 million for the six months ended June 30, 2007 and 2006, respectively.

     FSP FAS 13-2, "Accounting for a Change or Projected Change in the Timing of Cash Flows Relating to Income Taxes Generated by a Leveraged Lease Transaction"

     On July 13, 2006, the FASB issued FSP FAS 13-2, "Accounting for a Change or Projected Change in the Timing of Cash Flows Relating to Income Taxes Generated by a Leveraged Lease Transaction" (FSP FAS 13-2). FSP FAS 13-2, which amends SFAS No. 13, "Accounting for

19

Leases," addresses how a change or projected change in the timing of cash flows relating to income taxes generated by a leveraged lease transaction affects the accounting by a lessor for that lease.

     FSP FAS 13-2 is effective for the first fiscal year beginning after December 15, 2006 (year ending December 31, 2007 for Pepco Holdings). A material change in the timing of cash flows under Pepco Holdings' cross-border leases as the result of a settlement with the Internal Revenue Service or a change in tax law would require an adjustment to the book value of the leases and a charge to earnings equal to the repricing impact of the disallowed deductions which could result in a material adverse effect on its overall financial condition, results of operations, and cash flows. For a further discussion, see "Federal Tax Treatment of Cross-border Leases" in Note (4), "Commitments and Contingencies."

     SFAS No. 157, "Fair Value Measurements"

     In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements" (SFAS No. 157) which defines fair value, establishes a framework for measuring fair value in GAAP, and expands disclosures about fair value measurements. SFAS No. 157 applies under other accounting pronouncements that require or permit fair value measurements and does not require any new fair value measurements. However, it is possible that the application of this Statement will change current practice with respect to the definition of fair value, the methods used to measure fair value, and the expanded disclosures about fair value measurements.

     SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years (year ending December 31, 2008 for Pepco Holdings). Pepco Holdings is currently in the process of evaluating the impact that SFAS No. 157 will have on its overall financial condition, results of operations, and cash flows.

     FSP AUG AIR-1, "Accounting for Planned Major Maintenance Activities"

     On September 8, 2006, the FASB issued FSP American Institute of Certified Public Accountants Industry Audit Guide, Audits of Airlines--"Accounting for Planned Major Maintenance Activities" (FSP AUG AIR-1), which prohibits the use of the accrue-in-advance method of accounting for planned major maintenance activities in annual and interim financial reporting periods for all industries. FSP AUG AIR-1 is effective the first fiscal year beginning after December 15, 2006 (year ending December 31, 2007 for Pepco Holdings). Pepco Holdings has evaluated the impact of FSP AUG AIR-1 and it does not have a material impact on its overall financial condition, results of operations, or cash flows.

     EITF Issue No. 06-5, "Accounting for Purchases of Life Insurance -- Determining the Amount That Could Be Realized in Accordance with FASB Technical Bulletin No. 85-4, Accounting for Purchases of Life Insurance"

     On September 20, 2006, the FASB ratified EITF Issue No. 06-5, "Accounting for Purchases of Life Insurance -- Determining the Amount That Could Be Realized in Accordance with FASB Technical Bulletin No. 85-4, Accounting for Purchases of Life Insurance" (EITF 06-5) which provides guidance on whether an entity should consider the contractual ability to surrender all of the individual-life policies (or certificates under a group life policy) together when determining the amount that could be realized in accordance with FTB 85-4, and whether a guarantee of the

20

additional value associated with the group life policy affects that determination. EITF 06-5 provides that a policyholder should (i) determine the amount that could be realized under the insurance contract assuming the surrender of an individual-life by individual-life policy (or certificate by certificate in a group policy) and (ii) not discount the cash surrender value component of the amount that could be realized when contractual restrictions on the ability to surrender a policy exist unless contractual limitations prescribe that the cash surrender value component of the amount that could be realized is a fixed amount, in which case the amount that could be realized should be discounted in accordance with Accounting Principles Board of the American Institute of Certified Public Accountants Opinion 21. EITF 06-5 is effective for fiscal years beginning after December 15, 2006 (year ending December 31, 2007 for Pepco Holdings). Pepco Holdings has evaluated the impact of EITF 06-5 and has determined that it does not have a material impact on its overall financial condition, results of operations, cash flows, or disclosure requirements.

     FASB Staff Position No. EITF 00-19-2, "Accounting for Registration Payment Arrangements"

     On December 21, 2006, the FASB issued FSP No. EITF 00-19-2, "Accounting for Registration Payment Arrangements" (FSP EITF 00-19-2), which addresses an issuer's accounting for registration payment arrangements and specifies that the contingent obligation to make future payments or otherwise transfer consideration under a registration payment arrangement, whether issued as a separate agreement or included as a provision of a financial instrument or other agreement, should be separately recognized and measured in accordance with FASB SFAS No. 5, "Accounting for Contingencies." FSP EITF 00-19-2 is effective immediately for registration payment arrangements and the financial instruments subject to those arrangements that are entered into or modified subsequent to the date of its issuance. For registration payment arrangements and financial instruments subject to those arrangements that were entered into prior to the issuance of FSP EITF 00-19-2, this guidance is effective for financial statements issued for fiscal years beginning after December 15, 2006, and interim periods within those fiscal years (year ending December 31, 2007 for Pepco Holdings). Pepco Holdings implemented FSP EITF 00-19-2 during the first quarter of 2007. The implementation did not have a material impact on its overall financial condition, results of operations, or cash flows.

     SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities - Including an amendment of FASB Statement No. 115"

     On February 15, 2007, the FASB issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities - Including an amendment of FASB Statement No. 115" (SFAS No. 159) which permits entities to elect to measure eligible financial instruments at fair value. The objective of SFAS No. 159 is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. SFAS No. 159 applies under other accounting pronouncements that require or permit fair value measurements and does not require any new fair value measurements. However, it is possible that the application of SFAS No. 159 will change current practice with respect to the definition of fair value, the methods used to measure fair value, and the expanded disclosures about fair value measurements.

21

   SFAS No. 159 establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. SFAS No. 159 requires companies to provide additional information that will help investors and other users of financial statements to more easily understand the effect of the company's choice to use fair value on its earnings. It also requires entities to display the fair value of those assets and liabilities for which the company has chosen to use fair value on the face of the balance sheet. SFAS No. 159 does not eliminate disclosure requirements included in other accounting standards.

     SFAS No. 159 applies to fiscal years beginning after November 15, 2007 (year ending December 31, 2008 for Pepco Holdings), with early adoption permitted for an entity that has also elected to apply the provisions of SFAS No. 157, Fair Value Measurements. An entity is prohibited from retrospectively applying SFAS No. 159, unless it chooses early adoption. SFAS No. 159 also applies to eligible items existing at November 15, 2007 (or early adoption date). Pepco Holdings is currently in the process of evaluating the impact that SFAS No. 159 will have on its overall financial condition, results of operations, and cash flows.

FSP FIN 39-1, "Amendment of FASB Interpretation No. 39"

     On April 30, 2007, the FASB issued FSP FIN 39-1, "Amendment of FASB Interpretation No. 39" to amend certain portions of Interpretation 39. The FSP replaces the terms "conditional contracts" and "exchange contracts" in Interpretation 39 with the term "derivative instruments" as defined in Statement 133. The FSP also amends Interpretation 39 to allow for the offsetting of fair value amounts for the right to reclaim cash collateral or receivable, or the obligation to return cash collateral or payable, arising from the same master netting arrangement as the derivative instruments. FSP FIN 39-1 applies to fiscal years beginning after November 15, 2007 (year ending December 31, 2008 for Pepco Holdings), with early adoption permitted. Pepco Holdings is currently in the process of evaluating the impact that FSP FIN 39-1 will have on its overall financial condition, results of operations, cash flows and disclosure requirements.

EITF Issue No. 06-11, "Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards"

     On June 27, 2007, the FASB ratified EITF Issue No. 06-11, "Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards" (EITF 06-11) which provides that a realized income tax benefit from dividends or dividend equivalents that are charged to retained earnings and paid to employees for equity classified nonvested equity shares, nonvested equity share units, and outstanding equity share options should be recognized as an increase to additional paid-in capital (APIC). The amount recognized in additional paid-in capital for the realized income tax benefit from dividends on those awards should be included in the pool of excess tax benefits available to absorb tax deficiencies on share-based payment awards (i.e. the "APIC pool").

     EITF Issue No. 06-11 also provides that when the estimated amount of forfeitures increases or actual forfeitures exceed estimates, the amount of tax benefits previously recognized in APIC should be reclassified into the income statement; however, the amount reclassified is limited to the APIC pool balance on the reclassification date.

22

     EITF Issue No. 06-11 applies prospectively to the income tax benefits of dividends on equity-classified employee share-based payment awards that are declared in fiscal years beginning after December 15, 2007, and interim periods within those fiscal years (year ending December 31, 2008 for Pepco Holdings). Early application is permitted as of the beginning of a fiscal year for which interim or annual financial statements have not yet been issued. Retrospective application to previously issued financial statements is prohibited. Entities must disclose the nature of any change in their accounting policy for income tax benefits of dividends on share-based payment awards resulting from the adoption of this guidance. Pepco Holdings is currently in the process of evaluating the impact that EITF Issue No. 06-11 will have on its overall financial condition, results of operations, cash flows and disclosure requirements.

 

 

 

 

 

 

 

23

(3)  SEGMENT INFORMATION

     Based on the provisions of SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," Pepco Holdings' management has identified its operating segments at June 30, 2007 as Power Delivery, Conectiv Energy, Pepco Energy Services, and Other Non-Regulated. Prior to 2007, intrasegment revenues and expenses were not eliminated at the segment level for purposes of presenting segment financial results but rather were eliminated for PHI's consolidated results through the "Corp. & Other" column. Beginning in 2007, intrasegment revenues and expenses are eliminated at the segment level. Segment results for the three months and six months ended June 30, 2006, have been reclassified to conform to the current presentation. Segment financial information for the three and six months ended June 30, 2007 and 2006, is as follows.

 

                                            Three Months Ended June 30, 2007                                           
(Millions of dollars)

 
   

Competitive
Energy Segments

       
 

Power
Delivery

Conectiv
Energy

Pepco
Energy
Services

Other   
Non-   
Regulated

Corp. 
& Other (a)

PHI    
Cons.  

 

Operating Revenue

$1,162.3     

$  478.2 (b)

$522.6   

$     19.1   

$   (97.9)  

$   2,084.3 

 

Operating Expense (c)

1,049.2 (b)

468.1     

505.9   

1.1   

(96.0)  

1,928.3 

 

Operating Income

113.1     

10.1     

16.7   

18.0   

(1.9)  

156.0 

 

Interest Income

1.2     

1.7     

.6   

2.7   

(2.7)  

3.5 

 

Interest Expense

45.0     

8.0     

.4   

8.8   

21.6   

83.8 

 

Other Income

5.0     

-     

.5   

4.2   

.6   

10.3 

 

Preferred Stock
   Dividends

-     

-     

-   

.6   

(.5)  

.1 

 

Income Taxes

27.9     

2.0     

6.7   

.1   

(8.0)  

28.7 

 

Net Income (Loss)

46.4     

1.8     

10.7   

15.4   

(17.1)  

57.2 

 

Total Assets

9,282.1     

1,806.0     

602.7   

1,635.5   

1,204.1   

14,530.4 

 

Construction
   Expenditures

$   137.1     

$    14.1     

$   5.3   

$          -   

$      1.5   

$     158.0 

               

Note:

 

(a)

Includes unallocated Pepco Holdings' (parent company) capital costs, such as acquisition financing costs, and the depreciation and amortization related to purchase accounting adjustments for the fair value of Conectiv assets and liabilities as of the August 1, 2002 acquisition date. Additionally, the Total Assets line item in this column includes Pepco Holdings' goodwill balance. Included in Corp. & Other are intercompany amounts of $(97.8) million for Operating Revenue, $(96.8) million for Operating Expense, $(23.3) million for Interest Income, $(22.7) million for Interest Expense, and $(.6) million for Preferred Stock Dividends.

(b)

Power Delivery purchased electric energy and capacity and natural gas from Conectiv Energy in the amount of $95.2 million for the three months ended June 30, 2007.

(c)

Includes depreciation and amortization of $92.7 million, consisting of $77.6 million for Power Delivery, $9.3 million for Conectiv Energy, $3.2 million for Pepco Energy Services, $.4 million for Other Non-Regulated and $2.2 million for Corp. & Other.

 

24

 

 

                                        Three Months Ended June 30, 2006                                          
(Millions of dollars)

 
   

Competitive
Energy Segments

       
 

Power
Delivery

Conectiv
Energy

Pepco
Energy
Services

Other    
Non-    
Regulated

Corp. 
& Other (a)

PHI  
Cons.

 

Operating Revenue

$1,179.4     

$  468.5 (b) (e)

$347.5    

$    28.3     

$(107.1) (e)     

$ 1,916.6 

 

Operating Expense (c)

1,065.7 (b)

458.5 (e)     

333.8    

1.7     

(106.3) (e)     

1,753.4 

 

Operating Income

113.7     

10.0          

13.7    

26.6     

(.8)          

163.2 

 

Interest Income

2.5     

2.3          

.6    

1.7 (f) 

(2.9) (e) (f)

4.2 

 

Interest Expense

45.3     

9.1          

.9    

9.5 (f) 

20.4  (e) (f)

85.2 

 

Other Income

6.8     

(.3)         

.4    

1.3     

.3           

8.5 

 

Preferred Stock
   Dividends

.2     

-          

-    

.6     

(.5)         

.3 

 

Income Taxes

29.5 (d)

1.3          

5.6    

.9 (d)

1.9 (d)     

39.2 

 

Net Income (Loss)

48.0     

1.6          

8.2    

18.6     

(25.2)         

51.2 

 

Total Assets

8,747.4     

1,886.7          

502.2    

1,500.6     

1,058.7          

13,695.6 

 

Construction
   Expenditures

$  120.6     

$     2.6          

$   1.2    

$         -     

$      3.7          

$    128.1 

               

Note:

 

(a)

Includes unallocated Pepco Holdings' (parent company) capital costs, such as acquisition financing costs, and the depreciation and amortization related to purchase accounting adjustments for the fair value of Conectiv assets and liabilities as of the August 1, 2002 acquisition date. Additionally, the Total Assets line item in this column includes Pepco Holdings' goodwill balance. Included in Corp. & Other are intercompany amounts of $(107.1) million for Operating Revenue, $(105.8) million for Operating Expense, $(20.8) million for Interest Income, $(20.2) million for Interest Expense, and $(.6) million for Preferred Stock Dividends.

(b)

Power Delivery purchased electric energy and capacity and natural gas from Conectiv Energy in the amount of $103.6 million for the three months ended June 30, 2006.

(c)

Includes depreciation and amortization of $104.1 million, consisting of $89.6 million for Power Delivery, $9.1 million for Conectiv Energy, $2.9 million for Pepco Energy Services, $.5 million for Other Non-Regulated and $2.0 million for Corp. & Other.

(d)

Includes the total favorable impact of $6.3 million related to tax matters that were resolved during the second quarter of 2006 ($2.5 million for Power Delivery and $5.4 million for Other Non-Regulated, partially offset by an unfavorable $1.6 million in Corp. & Other). Additionally Corp. & Other includes the elimination (against the goodwill generated by the merger) of the tax benefits recorded by the lines of business in the amount of $9.1 million ($3.1 million related to Power Delivery and $6.0 million related to Other Non-Regulated).

(e)

Due to the reclassification referred to in the introductory paragraph, the Conectiv Energy segment does not include $45.7 million of intrasegment operating revenue and operating expense and $6.7 million of intrasegment interest income and interest expense. Accordingly, the Corp. & Other column does not include an elimination for these amounts.

(f)

Due to the reclassification referred to in the introductory paragraph, the Other Non-Regulated segment does not include $47.8 million of intrasegment interest income and interest expense. Accordingly, the Corp. & Other column does not include an elimination for these amounts.

 

 

25

 

 

                                             Six Months Ended June 30, 2007                                             
(Millions of dollars)

 
   

Competitive
Energy Segments

       
 

Power
Delivery

Conectiv
Energy

Pepco
Energy
Services

Other   
Non-   
Regulated

Corp. 
& Other (a)

PHI    
Cons.  

 

Operating Revenue

$2,437.4     

$    974.3 (b)

$1,032.5   

$     38.4   

$(219.5)  

$  4,263.1   

 

Operating Expense (c)

2,230.1 (b)

925.0     

1,014.7   

2.1   

(217.4)  

3,954.5   

 

Operating Income

207.3     

49.3     

17.8   

36.3   

(2.1)  

308.6   

 

Interest Income

3.0     

2.9     

1.5   

5.4   

(6.0)  

6.8   

 

Interest Expense

90.5     

16.4     

1.7   

18.0   

41.8   

168.4   

 

Other Income

9.8     

.1     

3.8   

7.5   

.9   

22.1   

 

Preferred Stock
   Dividends

.1     

-     

-   

1.2   

(1.1)  

.2   

 

Income Taxes

49.9     

15.1     

8.1   

3.8   

(16.8)  

60.1   

 

Net Income (Loss)

79.6     

20.8     

13.3   

26.2   

(31.1)  

108.8   

 

Total Assets

9,282.1     

1,806.0     

602.7   

1,635.5   

1,204.1   

14,530.4   

 

Construction
   Expenditures

$  255.4     

$    20.0     

$   7.0   

$         -   

$      2.6   

$    285.0   

               

Note:

 

(a)

Includes unallocated Pepco Holdings' (parent company) capital costs, such as acquisition financing costs, and the depreciation and amortization related to purchase accounting adjustments for the fair value of Conectiv assets and liabilities as of the August 1, 2002 acquisition date. Additionally, the Total Assets line item in this column includes Pepco Holdings' goodwill balance. Included in Corp. & Other are intercompany amounts of $(219.5) million for Operating Revenue, $(217.2) million for Operating Expense, $(44.2) million for Interest Income, $(43.0) million for Interest Expense, and $(1.2) million for Preferred Stock Dividends.

(b)

Power Delivery purchased electric energy and capacity and natural gas from Conectiv Energy in the amount of $206.1 million for the six months ended June 30, 2007.

(c)

Includes depreciation and amortization of $185.8 million, consisting of $155.7 million for Power Delivery, $18.6 million for Conectiv Energy, $6.1 million for Pepco Energy Services, $.9 million for Other Non-Regulated and $4.5 million for Corp. & Other.

 

 

 

 

 

 

 

 

 

 

 

26

 

 

                                            Six Months Ended June 30, 2006                                               
(Millions of dollars)

 
   

Competitive
Energy Segments

       
 

Power
Delivery

Conectiv
Energy

Pepco
Energy
Services

Other    
Non-    
Regulated

Corp. 
& Other (a)

PHI    
Cons.  

 

Operating Revenue

$2,354.2     

$984.5 (b) (g)

$717.2     

$   49.2     

$(236.6) (g)     

$3,868.5 

 

Operating Expense (c)

2,136.6 (b)

951.3 (g)      

694.2 (e)

3.3     

(234.0) (g)     

3,551.4 

 

Operating Income

217.6     

33.2           

23.0     

45.9     

(2.6)           

317.1 

 

Interest Income

4.8     

4.1           

1.0     

3.1 (h)

(5.3) (g) (h)

7.7 

 

Interest Expense

88.7     

17.4           

1.7     

18.9 (h)

40.1  (g) (h)

166.8 

 

Other Income

9.3     

11.7 (d)      

.6     

2.6     

.9            

25.1 

 

Preferred Stock
   Dividends

1.5     

-           

-     

1.2     

(2.0)           

.7 

 

Income Taxes

55.9     

12.9           

9.2     

3.3     

(6.9)           

74.4 

 

Net Income (Loss)

85.6  (f)

18.7           

13.7     

28.2  (f)

(38.2) (f)      

108.0 

 

Total Assets

8,747.4     

1,886.7           

502.2     

1,500.6     

1,058.7           

13,695.6 

 

Construction
   Expenditures

$   233.5     

$     5.0           

$   3.9     

$         -     

$      5.9           

$    248.3 

               

Note:

 

(a)

Includes unallocated Pepco Holdings' (parent company) capital costs, such as acquisition financing costs, and the depreciation and amortization related to purchase accounting adjustments for the fair value of Conectiv assets and liabilities as of the August 1, 2002 acquisition date. Additionally, the Total Assets line item in this column includes Pepco Holdings' goodwill balance. Included in Corp. & Other are intercompany amounts of $(238.1) million for Operating Revenue, $(235.4) million for Operating Expense, $(42.2) million for Interest Income, $(41.0) million for Interest Expense, and $(1.2) million for Preferred Stock Dividends.

(b)

Power Delivery purchased electric energy and capacity and natural gas from Conectiv Energy in the amount of $226.3 million for the six months ended June 30, 2006.

(c)

Includes depreciation and amortization of $208.3 million, consisting of $179.6 million for Power Delivery, $18.2 million for Conectiv Energy, $5.8 million for Pepco Energy Services, $.9 million for Other Non-Regulated and $3.8 million for Corp. & Other.

(d)

Includes $12.3 million gain ($7.9 million after tax) related to the gain on disposition of an interest in a cogeneration joint venture.

(e)

Includes $6.5 million impairment loss ($4.2 million after tax) on certain energy services business assets.

(f)

Includes the total favorable impact of $6.3 million related to tax matters that were resolved during the second quarter of 2006 ($2.5 million for Power Delivery and $5.4 million for Other Non-Regulated, partially offset by an unfavorable $1.6 million in Corp. & Other). Additionally Corp. & Other includes the elimination (against the goodwill generated by the merger) of the tax benefits recorded by the lines of business in the amount of $9.1 million ($3.1 million related to Power Delivery and $6.0 million related to Other Non-Regulated).

(g)

Due to the reclassification referred to in the introductory paragraph, the Conectiv Energy segment does not include $81.0 million of intrasegment operating revenue and operating expense and $13.5 million of intrasegment interest income and interest expense. Accordingly, the Corp. & Other column does not include an elimination for these amounts.

(h)

Due to the reclassification referred to in the introductory paragraph, the Other Non-Regulated segment does not include $81.2 million of intrasegment interest income and interest expense. Accordingly, the Corp. & Other column does not include an elimination for these amounts.

 

 

27

 

(4)  COMMITMENTS AND CONTINGENCIES

REGULATORY AND OTHER MATTERS

Relationship with Mirant Corporation

     In 2000, Pepco sold substantially all of its electricity generating assets to Mirant Corporation (formerly Southern Energy, Inc.) and certain of its subsidiaries. In July 2003, Mirant and certain of its subsidiaries filed a voluntary petition for reorganization under Chapter 11 of the U.S. Bankruptcy Code in the U.S. Bankruptcy Court for the Northern District of Texas (the Bankruptcy Court). On December 9, 2005, the Bankruptcy Court approved the Plan of Reorganization (the Reorganization Plan) of Mirant and the Mirant business emerged from bankruptcy on January 3, 2006, as a new corporation of the same name (together with its predecessors, Mirant).

     As part of the bankruptcy proceeding, Mirant had been seeking to reject certain ongoing contractual arrangements under the Asset Purchase and Sale Agreement entered into by Pepco and Mirant for the sale of the generating assets that are described below. The Reorganization Plan did not resolve the issues relating to Mirant's efforts to reject these obligations nor did it resolve certain Pepco damage claims against the Mirant bankruptcy estate.

     Power Purchase Agreement

     The Panda PPA obligates Pepco to purchase from Panda 230 megawatts of energy and capacity annually through 2021. At the time of the sale of Pepco's generating assets to Mirant, the purchase price of the energy and capacity under the Panda PPA was, and since that time has continued to be, substantially in excess of the market price. As a part of the Asset Purchase and Sale Agreement, Pepco entered into a "back-to-back" arrangement with Mirant. Under this arrangement, Mirant is obligated through 2021 to purchase from Pepco the capacity and energy that Pepco is obligated to purchase under the Panda PPA at a price equal to Pepco's purchase price from Panda (the PPA-Related Obligations).

     The SMECO Agreement

     Under the Asset Purchase and Sale Agreement, Pepco assigned to Mirant a Facility and Capacity Agreement entered into by Pepco with Southern Maryland Electric Cooperative, Inc. (SMECO), under which Pepco was obligated to purchase from SMECO the capacity of an 84-megawatt combustion turbine installed and owned by SMECO at a former Pepco generating facility at a cost of approximately $500,000 per month until 2015 (the SMECO Agreement). Pepco is responsible to SMECO for the performance of the SMECO Agreement if Mirant fails to perform its obligations thereunder.

     Settlement Agreements with Mirant

     On May 30, 2006, Pepco, PHI, and certain affiliated companies entered into a Settlement Agreement and Release (the Settlement Agreement) with Mirant, which, subject to court approval, settles all outstanding issues between the parties arising from or related to the Mirant bankruptcy. Under the terms of the Settlement Agreement:

28

·

Mirant will assume the Asset Purchase and Sale Agreement, except for the PPA-Related Obligations, which Mirant will be permitted to reject.

·

Pepco will receive an allowed claim under the Reorganization Plan in an amount that will result in a total aggregate distribution to Pepco, net of certain transaction expenses, of $520 million, consisting of (i) $450 million in damages resulting from the rejection of the PPA-Related Obligations and (ii) $70 million in settlement of other Pepco damage claims against the Mirant bankruptcy estate, which, as described below, was paid by Mirant to Pepco in August 2006 (collectively, the Pepco Distribution).

·

Except as described below, the $520 million Pepco Distribution will be effected by means of the issuance to Pepco of shares of Mirant common stock, which Pepco will be obligated to resell promptly in one or more block sale transactions. If the net proceeds that Pepco receives from the resale of the shares of Mirant common stock are less than $520 million, Pepco will receive a cash payment from Mirant equal to the difference, and if the net proceeds that Pepco receives from the resale of the shares of Mirant common stock are more than $520 million, Pepco will make a cash payment to Mirant equal to the difference.

·

If the closing price of shares of Mirant common stock is less than $16.00 per share for four business days in a twenty consecutive business day period, and Mirant has not made a distribution of shares of Mirant common stock to Pepco under the Settlement Agreement, Mirant has the one-time option to elect to assume, rather than reject, the PPA-Related Obligations. If Mirant elects to assume the PPA-Related Obligations, the Pepco Distribution will be reduced to $70 million.

·

All pending appeals, adversary actions or other contested matters between Pepco and Mirant will be dismissed with prejudice, and each will release the other from any and all claims relating to the Mirant bankruptcy.

     Separately, Mirant and SMECO have entered into a Settlement Agreement and Release (the SMECO Settlement Agreement). The SMECO Settlement Agreement provides that Mirant will assume, rather than reject, the SMECO Agreement. This assumption ensures that Pepco will not incur liability to SMECO as the guarantor of the SMECO Agreement due to the rejection of the SMECO Agreement, although Pepco will continue to guarantee to SMECO the future performance of Mirant under the SMECO Agreement.

     According to their terms, the Settlement Agreement and the SMECO Settlement Agreement will become effective when the Bankruptcy Court or the U.S. District Court for the Northern District of Texas (the District Court), as applicable, has entered a final order, not subject to appeal or rehearing, approving both the Settlement Agreement and the SMECO Settlement Agreement.

     On August 9, 2006, the Bankruptcy Court issued an order approving the Settlement Agreement and the SMECO Settlement Agreement. On August 18, 2006, certain holders of Mirant bankruptcy claims, who had objected to approval of the Settlement Agreement and the SMECO Settlement Agreement before the Bankruptcy Court, appealed the approval order to the District Court. On December 26, 2006, the District Court issued an order affirming the Bankruptcy Court's order approving the Settlement Agreement. On January 25, 2007, the parties

29

that appealed the Bankruptcy Court's order filed a notice of appeal of the District Court's order with the United States Court of Appeals for the Fifth Circuit (the Fifth Circuit). The brief of the appealing creditors was filed on April 25, 2007, while Mirant's and Pepco's briefs were filed on May 31, 2007.

     In August 2006, Mirant made a cash payment to Pepco of $70 million, which became due in accordance with the terms of the Settlement Agreement as a result of the approval of the Settlement Agreement by the Bankruptcy Court. If the Bankruptcy Court order approving the Settlement Agreement becomes a final order after the exhaustion of all appeals, the payment will be taken into account as if it were proceeds from the resale by Pepco of shares of the Mirant common stock, as described above, and treated as a portion of the $520 million payment due Pepco. If the Bankruptcy Court approval of the Settlement Agreement is not upheld on appeal, Pepco must repay this cash payment to Mirant. Therefore, no income statement impact has been recognized in relation to the $70 million payment.

     Until the approval of the Settlement Agreement and the SMECO Settlement Agreement becomes final, Mirant is required to continue to perform all of its contractual obligations to Pepco and SMECO. Pepco intends to use the $450 million portion of the Pepco Distribution related to the rejection of the PPA-Related Obligations to pay for future capacity and energy purchases under the Panda PPA.

Rate Proceedings

     In electric service distribution base rate cases filed by Pepco in the District of Columbia and Maryland and by DPL in Maryland and in a natural gas distribution base rate case filed by DPL in Delaware, the utility proposed the adoption of a bill stabilization adjustment mechanism (BSA) for retail customers. The BSA would increase rates if revenues from distribution deliveries fall below the level approved by the applicable regulatory commission and will decrease rates if revenues from distribution deliveries are above the commission-approved level. The end result would be that the utility would collect its authorized revenues for distribution deliveries. As a consequence, a BSA "decouples" revenue from unit sales consumption and ties the growth in revenues to the growth in the number of customers. Some advantages of the BSA are that it (i) eliminates revenue fluctuations due to weather and changes in customer usage patterns and, therefore, provides for more predictable utility distribution revenues that are better aligned with costs, (ii) provides for more reliable fixed-cost recovery, (iii) tends to stabilize customers' delivery bills, and (iv) removes any disincentives for the regulated utilities to promote energy efficiency programs for their customers, because it breaks the link between overall sales volumes and delivery revenues. The status of the BSA proposals in each of the jurisdictions is described below in discussion of the respective base rate proceedings.

     Delaware

     On August 31, 2006, DPL submitted its 2006 Gas Cost Rate (GCR) filing to the Delaware Public Service Commission (DPSC), which permits DPL to recover gas procurement costs through customer rates. On October 3, 2006, the DPSC issued an initial order approving the proposed rates, which became effective November 1, 2006, subject to refund pending final DPSC approval after evidentiary hearings. On February 23, 2007, DPL submitted an additional filing to the DPSC that proposed an additional 4.3% decrease in the GCR effective April 1, 2007, in compliance with its gas service tariff and to ensure collections are more aligned with

30

expenses. On March 20, 2007, the DPSC approved the rate decrease, subject to refund pending final DPSC approval after evidentiary hearings. On July 17, 2007, the DPSC granted final approval for the GCR, as filed.

     On August 31, 2006, DPL submitted an application to the DPSC for an increase in gas distribution base rates, including a proposed BSA. On March 20, 2007, the DPSC approved a settlement agreement filed by all of the parties in this proceeding (DPL, the DPSC staff and the Delaware Division of Public Advocate). The settlement provisions include a $9.0 million increase in distribution rates, including certain miscellaneous tariff fees (of which $2.5 million was put into effect on November 1, 2006), reflecting a return on equity (ROE) of 10.25%, and a change in depreciation rates that will result in a $2.1 million reduction in pre-tax annual depreciation expense. Under the settlement agreement, rates became effective on April 1, 2007. Although the settlement agreement does not include a BSA, it provides for all of the parties to the case to participate in any generic statewide proceeding for the purpose of investigating BSA mechanisms for electric and gas distribution utilities. On March 20, 2007, the DPSC issued an order initiating a docket for the purpose of investigating a bill stabilization adjustment mechanism, or other rate decoupling mechanisms.

     District of Columbia

     In February 2006, Pepco filed an update to the District of Columbia Generation Procurement Credit (GPC) for the periods February 8, 2002 through February 7, 2004 and February 8, 2004 through February 7, 2005. The GPC provides for sharing of the profit from SOS sales. The updated GPC filing, which was amended in March 2006, in the District of Columbia takes into account the $112.4 million in proceeds received by Pepco from the December 2005 sale of an allowed bankruptcy claim against Mirant arising from a settlement agreement entered into with Mirant relating to Mirant's obligation to supply energy and capacity to fulfill Pepco's SOS obligations in the District of Columbia. The filing also incorporates true-ups to previous disbursements in the GPC for the District of Columbia. In the filing, Pepco requested that $24.3 million be credited to District of Columbia customers during the twelve-month period beginning April 2006. On June 15, 2006, the District of Columbia Public Service Commission (DCPSC) granted conditional approval of the GPC update as filed, effective July 1, 2006, and on May 24, 2007, the DCPSC issued a final approval.

     On December 12, 2006, Pepco submitted an application to the DCPSC to increase electric distribution base rates, including a proposed BSA. The application requested an annual increase of approximately $46.2 million or an overall increase of 13.5%, reflecting a proposed ROE of 10.75%. If the BSA is not approved, the proposed annual increase is $50.5 million or an overall increase of 14.8%, reflecting an ROE of 11.00%. Hearings were held in the case in June 2007. A DCPSC decision is expected in September 2007.

     Maryland

     On July 19, 2007, the Maryland Public Service Commission (MPSC) issued orders in the electric service distribution rate cases filed by DPL and Pepco. The DPL order approved a temporary annual increase in distribution rates of approximately $14.9 million (including a decrease in annual depreciation expense of approximately $0.9 million). The Pepco order approved a temporary annual increase in distribution rates of approximately $10.6 million (including a decrease in annual depreciation expense of approximately $30.7 million). In each

31

case, the approved distribution rate reflects an ROE of 10.0%. The orders each provided that the rate increases are effective as of June 16, 2007, and will remain in effect for an initial period of nine months from the date of the order (or until April 19, 2008). The temporary rates are subject to a Phase II proceeding in which the MPSC will consider the results of audits of each company's cost allocation manual, as filed with the MPSC, to determine whether a further adjustment to the rates is required. For each of the utilities, the MPSC approved the proposed BSA, under which customer delivery rates are subject to adjustment quarterly (through a surcharge or credit mechanism), depending on whether actual revenue per customer exceeds or falls short of, the approved revenue per customer amount.

     New Jersey

     On June 1, 2007, ACE filed with the New Jersey Board of Public Utilities (NJBPU) an application for permission to decrease the Non Utility Generation Charge (NGC) and increase components of its Societal Benefits Charge (SBC) to be collected from customers for the period October 1, 2007 through September 30, 2008. The proposed changes are designed to effect a true-up of the actual and estimated costs and revenues collected through the current NGC and SBC rates through September 30, 2007 and, in the case of the SBC, forecasted costs and revenues for the period October 1, 2007 through September 30, 2008.

     ACE projects that, as of September 30, 2007, the NGC, which is intended primarily to recover the above-market component of payments made by ACE under non-utility generation contracts and stranded costs associated with those commitments, will have an over-recovery balance of $234.6 million. The filing proposes that the NGC balance, including interest, be amortized and returned to ACE customers over a four-year period, beginning October 1, 2007.

     ACE also projects that, as of September 30, 2007, the SBC, which is intended to allow ACE to recover certain costs involved with various NJBPU-mandated social programs, will have an under-recovery of approximately $21.8 million, primarily due to increased costs associated with funding the New Jersey Clean Energy Program (CEP). In addition, ACE has requested an increase to the SBC to reflect the increased funding levels approved by the NJBPU to $18.9 million for calendar year 2007 and $20.4 million for calendar year 2008, which will require a $42.3 million increase in the SBC for the period of October 1, 2007 to September 30, 2008.

     The net impact of the proposed adjustments to the NGC and the SBC, including associated changes in sales and use tax, is an overall rate decrease of approximately $131.8 million for the period October 1, 2007, through September 30, 2008. The proposed adjustments and the corresponding changes in customer rates are subject to the approval of the NJBPU. If approved and implemented, ACE anticipates that the revised rates will remain in effect until September 30, 2008, subject to an annual true-up and change each year thereafter.

     Federal Energy Regulatory Commission

     On May 15, 2007, Pepco, ACE and DPL each updated its FERC-approved formula transmission rates based on its 2006 FERC Form 1. These rates became effective on June 1, 2007, and will provide the following approximate additional annual revenues: for Pepco, $9.5 million; for DPL, $17.2 million; and for ACE, $20 million. These updated rates reflect the end of a settlement adjustment that reduced the prior rate year's (from June 2006 through May 2007) revenues by an annual amount of $25.3 million for the three utilities.

32

ACE Restructuring Deferral Proceeding

     Pursuant to orders issued by the NJBPU under the New Jersey Electric Discount and Energy Competition Act (EDECA), beginning August 1, 1999, ACE was obligated to provide BGS to retail electricity customers in its service territory who did not elect to purchase electricity from a competitive supplier. For the period August 1, 1999 through July 31, 2003, ACE's aggregate costs that it was allowed to recover from customers exceeded its aggregate revenues from supplying BGS. These under-recovered costs were partially offset by a $59.3 million deferred energy cost liability existing as of July 31, 1999 (LEAC Liability) related to ACE's Levelized Energy Adjustment Clause and ACE's Demand Side Management Programs. ACE established a regulatory asset in an amount equal to the balance of under-recovered costs.

     In August 2002, ACE filed a petition with the NJBPU for the recovery of approximately $176.4 million in actual and projected deferred costs relating to the provision of BGS and other restructuring related costs incurred by ACE over the four-year period August 1, 1999 through July 31, 2003, net of the $59.3 million offset for the LEAC Liability. The petition also requested that ACE's rates be reset as of August 1, 2003 so that there would be no under-recovery of costs embedded in the rates on or after that date. The increase sought represented an overall 8.4% annual increase in electric rates.

     In July 2004, the NJBPU issued a final order in the restructuring deferral proceeding confirming a July 2003 summary order, which (i) permitted ACE to begin collecting a portion of the deferred costs and reset rates to recover on-going costs incurred as a result of EDECA, (ii) approved the recovery of $125 million of the deferred balance over a ten-year amortization period beginning August 1, 2003, (iii) transferred to ACE's then pending base rate case for further consideration approximately $25.4 million of the deferred balance (the base rate case ended in a settlement approved by the NJBPU in May 2005, the result of which is that any net rate impact from the deferral account recoveries and credits in future years will depend in part on whether rates associated with other deferred accounts considered in the case continue to generate over-collections relative to costs), and (iv) estimated the overall deferral balance as of July 31, 2003 at $195 million, of which $44.6 million was disallowed recovery by ACE. Although ACE believes the record does not justify the level of disallowance imposed by the NJBPU in the final order, the $44.6 million of disallowed incurred costs were reserved during the years 1999 through 2003 (primarily 2003) through charges to earnings, primarily in the operating expense line item "deferred electric service costs," with a corresponding reduction in the regulatory asset balance sheet account. In 2005, an additional $1.2 million in interest on the disallowed amount was identified and reserved by ACE. In August 2004, ACE filed a notice of appeal with respect to the July 2004 final order with the Appellate Division of the Superior Court of New Jersey (the Appellate Division), which hears appeals of the decisions of New Jersey administrative agencies, including the NJBPU. Briefs in the appeal were also filed by the New Jersey Division of Rate Counsel (then known as the Division of the New Jersey Ratepayer Advocate) and by Cogentrix Energy Inc., the co-owner of two cogeneration power plants with contracts to sell ACE approximately 397 megawatts of electricity, as cross-appellants between August 2005 and January 2006. The Appellate Division has not yet set the schedule for oral argument.

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Divestiture Cases

     District of Columbia

     Final briefs on Pepco's District of Columbia divestiture proceeds sharing application were filed with the DCPSC in July 2002 following an evidentiary hearing in June 2002. That application was filed to implement a provision of Pepco's DCPSC-approved divestiture settlement that provided for a sharing of any net proceeds from the sale of Pepco's generation-related assets. One of the principal issues in the case is whether Pepco should be required to share with customers the excess deferred income taxes (EDIT) and accumulated deferred investment tax credits (ADITC) associated with the sold assets and, if so, whether such sharing would violate the normalization provisions of the Internal Revenue Code (IRC) and its implementing regulations. As of June 30, 2007, the District of Columbia allocated portions of EDIT and ADITC associated with the divested generating assets were approximately $6.5 million and $5.8 million, respectively.

     Pepco believes that a sharing of EDIT and ADITC would violate the Internal Revenue Service (IRS) normalization rules. Under these rules, Pepco could not transfer the EDIT and the ADITC benefit to customers more quickly than on a straight line basis over the book life of the related assets. Since the assets are no longer owned there is no book life over which the EDIT and ADITC can be returned. If Pepco were required to share EDIT and ADITC and, as a result, the normalization rules were violated, Pepco would be unable to use accelerated depreciation on District of Columbia allocated or assigned property. In addition to sharing with customers the generation-related EDIT and ADITC balances, Pepco would have to pay to the IRS an amount equal to Pepco's District of Columbia jurisdictional generation-related ADITC balance ($5.8 million as of June 30, 2007), as well as its District of Columbia jurisdictional transmission and distribution-related ADITC balance ($4.4 million as of June 30, 2007) in each case as those balances exist as of the later of the date a DCPSC order is issued and all rights to appeal have been exhausted or lapsed, or the date the DCPSC order becomes operative.

     In March 2003, the IRS issued a notice of proposed rulemaking (NOPR), which would allow for the sharing of EDIT and ADITC related to divested assets with utility customers on a prospective basis and at the election of the taxpayer on a retroactive basis. In December 2005 a revised NOPR was issued which, among other things, withdrew the March 2003 NOPR and eliminated the taxpayer's ability to elect to apply the regulation retroactively. Comments on the revised NOPR were filed in March 2006, and a public hearing was held in April 2006. Pepco filed a letter with the DCPSC in January 2006, in which it has reiterated that the DCPSC should continue to defer any decision on the ADITC and EDIT issues until the IRS issues final regulations or states that its regulations project related to this issue will be terminated without the issuance of any regulations. Other issues in the divestiture proceeding deal with the treatment of internal costs and cost allocations as deductions from the gross proceeds of the divestiture.

     Pepco believes that its calculation of the District of Columbia customers' share of divestiture proceeds is correct. However, depending on the ultimate outcome of this proceeding, Pepco could be required to make additional gain-sharing payments to District of Columbia customers, including the payments described above related to EDIT and ADITC. Such additional payments (which, other than the EDIT and ADITC related payments, cannot be estimated) would be charged to expense in the quarter and year in which a final decision is rendered and could have a

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material adverse effect on Pepco's and PHI's results of operations for those periods. However, neither PHI nor Pepco believes that additional gain-sharing payments, if any, or the ADITC-related payments to the IRS, if required, would have a material adverse impact on its financial position or cash flows.

     Maryland

    Pepco filed its divestiture proceeds plan application with the MPSC in April 2001. The principal issue in the Maryland case is the same EDIT and ADITC sharing issue that has been raised in the District of Columbia case. See the discussion above under "Divestiture Cases -- District of Columbia." As of June 30, 2007, the Maryland allocated portions of EDIT and ADITC associated with the divested generating assets were approximately $9.1 million and $10.4 million, respectively. Other issues deal with the treatment of certain costs as deductions from the gross proceeds of the divestiture. In November 2003, the Hearing Examiner in the Maryland proceeding issued a proposed order with respect to the application that concluded that Pepco's Maryland divestiture settlement agreement provided for a sharing between Pepco and customers of the EDIT and ADITC associated with the sold assets. Pepco believes that such a sharing would violate the normalization rules (discussed above) and would result in Pepco's inability to use accelerated depreciation on Maryland allocated or assigned property. If the proposed order is affirmed, Pepco would have to share with its Maryland customers, on an approximately 50/50 basis, the Maryland allocated portion of the generation-related EDIT ($9.1 million as of June 30, 2007), and the Maryland-allocated portion of generation-related ADITC. Furthermore, Pepco would have to pay to the IRS an amount equal to Pepco's Maryland jurisdictional generation-related ADITC balance ($10.4 million as of June 30, 2007), as well as its Maryland retail jurisdictional ADITC transmission and distribution-related balance ($7.8 million as of June 30, 2007), in each case as those balances exist as of the later of the date a MPSC order is issued and all rights to appeal have been exhausted or lapsed, or the date the MPSC order becomes operative. The Hearing Examiner decided all other issues in favor of Pepco, except for the determination that only one-half of the severance payments that Pepco included in its calculation of corporate reorganization costs should be deducted from the sales proceeds before sharing of the net gain between Pepco and customers. Pepco filed a letter with the MPSC in January 2006, in which it has reiterated that the MPSC should continue to defer any decision on the ADITC and EDIT issues until the IRS issues final regulations or states that its regulations project related to this issue will be terminated without the issuance of any regulations.

     In December 2003, Pepco appealed the Hearing Examiner's decision to the MPSC as it relates to the treatment of EDIT and ADITC and corporate reorganization costs. The MPSC has not issued any ruling on the appeal and Pepco does not believe that it will do so until action is taken by the IRS as described above. However, depending on the ultimate outcome of this proceeding, Pepco could be required to share with its customers approximately 50 percent of the EDIT and ADITC balances described above in addition to the additional gain-sharing payments relating to the disallowed severance payments (which Pepco is not contesting). Such additional payments would be charged to expense in the quarter and year in which a final decision is rendered and could have a material adverse effect on results of operations for those periods. However, neither PHI nor Pepco believes that additional gain-sharing payments, if any, or the ADITC-related payments to the IRS, if required, would have a material adverse impact on its financial position or cash flows.

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     New Jersey

     In connection with the divestiture by ACE of its nuclear generating assets, the NJBPU in July 2000 preliminarily determined that the amount of stranded costs associated with the divested assets that ACE could recover from ratepayers should be reduced by approximately $94.8 million, consisting of $54.1 million of accumulated deferred federal income taxes (ADFIT) associated with accelerated depreciation on the divested nuclear assets, and $40.7 million of current tax loss from selling the assets at a price below the tax basis.

     The $54.1 million in deferred taxes associated with the divested assets' accelerated depreciation; however, is subject to the normalization rules. Due to uncertainty under federal tax law regarding whether the sharing of federal income tax benefits associated with the divested assets, including ADFIT related to accelerated depreciation, with ACE's customers would violate the normalization rules, ACE submitted a request to the IRS for a Private Letter Ruling (PLR) to clarify the applicable law. The NJBPU delayed its final determination of the amount of recoverable stranded costs until after the receipt of the PLR.

     On May 25, 2006, the IRS issued the PLR in which it stated that returning to ratepayers any of the unamortized ADFIT attributable to accelerated depreciation on the divested assets after the sale of the assets by means of a reduction of the amount of recoverable stranded costs would violate the normalization rules.

     On June 9, 2006, ACE submitted a letter to the NJBPU, requesting that the NJBPU conduct proceedings to finalize the determination of the stranded costs associated with the sale of ACE's nuclear assets in accordance with the PLR. In the absence of an NJBPU action regarding ACE's request, on June 22, 2007, ACE filed a motion requesting that the NJBPU issue an order finalizing the determination of such stranded costs in accordance with the PLR. The NJBPU and the other parties in interest have agreed to an expedited schedule for resolution of the motion.

Default Electricity Supply Proceedings

     Delaware

     Effective May 1, 2006, SOS replaced fixed-rate POLR service for customers who do not elect to purchase electricity from a competitive supplier. In October 2005, the DPSC approved DPL as the SOS provider to its Delaware delivery customers. DPL obtains the electricity to fulfill its SOS supply obligation under contracts entered pursuant to a competitive bid procedure approved by the DPSC.

     In response to bids received for the May 1, 2006, through May 31, 2007, period, which had the effect of increasing rates significantly for all customer classes, including an average residential customer increase of 59%, as compared to the fixed rates previously in effect, Delaware in April 2006 enacted legislation that provides for a deferral of the financial impact on customers. This legislation provided for a three-step phase-in of the rate increases, with 15% of the increase taking effect on May 1, 2006, 25% of the increase taking effect on January 1, 2007, and any remaining balance taking effect on June 1, 2007, subject to the right of customers to elect not to participate in the deferral program. Customers who do not "opt-out" of the rate deferral program are required to pay the amounts deferred, without any interest charge, over a 17-month period beginning January 1, 2008. As of June 30, 2007, approximately 53% of the eligible Delaware customers have opted not to participate in the deferral of the SOS rates offered

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by DPL. With approximately 47% of the eligible customers participating in the phase-in program, DPL anticipates a maximum deferral balance of $51.4 million.

     Maryland

     Pursuant to orders issued by the MPSC in November 2006, Pepco and DPL each provides SOS to its delivery customers who do not elect to purchase electricity from a competitive supplier. Each company purchases the power supply required to satisfy its SOS obligations from wholesale suppliers under contracts entered into pursuant to a competitive bid procedure approved and supervised by the MPSC. In March 2006, Pepco and DPL each announced the results of competitive bids to supply electricity to its Maryland SOS customers for one year beginning June 1, 2006. Due to significant increases in the cost of fuels used to generate electricity, the auction results had the effect of increasing the average monthly electric bill by about 38.5% and 35% for Pepco's and DPL's Maryland residential customers, respectively.

     On April 21, 2006, the MPSC approved a settlement agreement among Pepco, DPL, the staff of the MPSC and the Office of People's Counsel, which provides for a rate mitigation plan for the residential customers of each company. Under the plan, the full increase for each company's residential customers who affirmatively elect to participate are being phased-in in increments of 15% on June 1, 2006, 15.7% on March 1, 2007 and the remainder on June 1, 2007. Customers electing to participate in the rate deferral plan will be required to pay the deferred amounts over an 18-month period beginning June 1, 2007. As of June 30, 2007, approximately 2% of Pepco's residential customers and approximately 1% of DPL's residential customers had elected to participate in the phase-in program.

     On June 23, 2006, Maryland enacted legislation that extended the period for customers to elect to participate in the phase-in of higher rates and revised the obligation to provide SOS to residential and small commercial customers until further action of the General Assembly. The legislation also provides for a customer refund reflecting the difference between the interest expense on an initially projected deferred balance at a 25% customer participation level and the interest expense on a deferred balance based on actual participation levels referred to above. The total amount of the refund is approximately $1.1 million for Pepco customers and approximately $.3 million for DPL customers. At Pepco's 2% level of participation, Pepco estimates that the deferral balance, net of taxes, will be approximately $1.4 million. At DPL's 1% level of participation, DPL estimates that the deferral balance, net of taxes, will be approximately $.2 million. In July 2006, the MPSC approved revised tariff riders filed in June 2006 by Pepco and DPL to implement the legislation.

     Virginia

     As discussed below under the heading "DPL Sale of Virginia Operations," DPL has entered into an agreement to sell substantially all of its Virginia electric service operations.

     On April 2, 2007, DPL filed an application with Virginia State Corporation Commission (VSCC) to adjust its Default Service rates covering the period June 1, 2007, to May 31, 2008. The proposed rates for this service during the first month of this period (June 2007) are based on the fuel proxy rate calculation described below. The proposed rates for the remaining 11 months of the period (July 1, 2007 to May 31, 2008) reflect the fuel cost of Default Service supply based upon the results of the competitive bidding wholesale procurement process. The calculations in

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the application result in a rate decrease of approximately $1.7 million for the period, June 1 to June 30, 2007, and an increase of approximately $4.2 million for the period, July 1, 2007 to May 31, 2008, resulting in an overall annual rate increase of approximately $2.5 million.

     The "fuel proxy rate calculation" was established under a Memorandum of Agreement (MOA) that DPL entered into with the staff of the VSCC in connection with the approval of DPL's divestiture of its generation assets in 2000, and provides for the calculation of the fuel rate portion of Default Service rates that reflect an approximation of the fuel costs that DPL would have incurred had it retained its generating assets. Since June 1, 2006, use of the proxy rate calculation has resulted in DPL being unable to recover fully its cost of providing Default Service. The new rate application reflects DPL's position that the use of the fuel proxy rate calculation to establish Default Service rates terminated on July 1, 2007, and effective that date, it should be permitted to charge customers market based fuel costs. However, pursuant to an order dated June 8, 2007, the VSCC denied the July 1, 2007 rate increase, based on its conclusion that the MOA's provisions relating to fuel costs did not end effective June 30, 2007. As a result of this decision, DPL estimates that it will under-recover its cost of providing Default Service by approximately $1.7 million between June 1, 2007 and the September 30, 2007 expiration of the current SOS supply contract. Thereafter, any ongoing under-recovery will be determined by market rates for the fuel portion of SOS supply and the timing of completion of the sale of DPL's Virginia electric operations as described below under the heading "DPL Sale of Virginia Operations."

     DPL filed a complaint for a declaratory order and preliminary injunctive relief with the U.S. District Court for the Eastern District of Virginia (the Virginia District Court). On July 23, 2007, the Virginia District Court dismissed the complaint and denied injunctive relief, finding that the court lacked subject matter jurisdiction and stating that even if it had subject matter jurisdiction, it would abstain from exercising that jurisdiction to allow the Supreme Court of Virginia to consider the issues upon which the complaint was based. On July 31, 2007, DPL filed a notice of appeal of the VSCC's orders with the Supreme Court of Virginia. The sale of DPL's Virginia electric operations as described below under the heading "DPL Sale of Virginia Operations" is not contingent upon resolution of any of the matters that are at issue in these proceedings. If the sale of the Virginia electric operations is completed, the effect, if any, on these proceedings is not determinable at this time.

ACE Sale of B.L. England Generating Facility

     On February 8, 2007, ACE completed the sale of the B.L. England generating facility to RC Cape May Holdings, LLC (RC Cape May), an affiliate of Rockland Capital Energy Investments, LLC, for which it received proceeds of approximately $9 million, after giving effect to certain post-closing adjustments. In addition, RC Cape May and ACE have agreed to submit to arbitration whether RC Cape May must pay to ACE, as part of the purchase price, an additional $3.1 million remaining in dispute. RC Cape May also assumed certain liabilities associated with the B.L. England generating station, including substantially all environmental liabilities.

     The sale of B.L. England will not affect the stranded costs associated with the plant that already have been securitized. ACE anticipates that approximately $9 million to $10 million of additional regulatory assets related to B.L. England may, subject to NJBPU approval, be eligible for recovery as stranded costs. The emission allowance credits associated with B. L. England will be monetized for the benefit of ACE's ratepayers pursuant to the NJBPU order approving

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the sale. Net proceeds from the sale of the plant and monetization of the emission allowance credits, will be credited to ACE's ratepayers in accordance with the requirements of EDECA and NJBPU orders. The appropriate mechanism for monetizing the value of the emission allowances for the benefit of ratepayers is being determined in a Phase II proceeding which is currently pending before the NJBPU.

DPL Sale of Virginia Operations

     On June 13, 2007, DPL entered into separate agreements to sell, respectively, all of its distribution assets and a significant portion of its transmission assets in Virginia for an aggregate sales price of approximately $45 million. DPL currently expects the transactions to close during the fourth quarter of 2007, contingent upon the receipt of required regulatory approvals. These sales, if completed, will not result in a significant financial gain or loss to DPL.

     Distribution Purchase and Sale Agreement

     DPL has entered into an agreement to sell to A&N Electric Cooperative (A&N) all of its assets principally related to DPL's business of distributing retail electric services to customers located on the Eastern Shore of Virginia for a purchase price of approximately $39.8 million, subject to closing adjustments. The assets to be sold include real and personal property, accounts receivable and customer deposits. A&N will assume certain post-closing liabilities and unknown pre-closing liabilities related to the distribution assets including most environmental liabilities, except that DPL will remain liable for unknown pre-closing liabilities if they become known within six months after the closing date. The completion of the sale is contingent upon approval by the VSCC.

     Transmission Purchase and Sale Agreement

     DPL has entered into an agreement to sell to Old Dominion Electric Cooperative (ODEC) certain assets principally related to DPL's provision of electric transmission services located on the Eastern Shore of Virginia for a purchase price of approximately $4.8 million, subject to certain closing adjustments. ODEC will assume certain post-closing liabilities and unknown pre-closing liabilities related to the transmission assets, except that DPL will remain liable for unknown pre-closing liabilities that become known within six months after the closing date. The completion of the sale is contingent upon approval of the transfer by the VSCC and approval of two related agreements by FERC.

General Litigation

     During 1993, Pepco was served with Amended Complaints filed in the state Circuit Courts of Prince George's County, Baltimore City and Baltimore County, Maryland in separate ongoing, consolidated proceedings known as "In re: Personal Injury Asbestos Case." Pepco and other corporate entities were brought into these cases on a theory of premises liability. Under this theory, the plaintiffs argued that Pepco was negligent in not providing a safe work environment for employees or its contractors, who allegedly were exposed to asbestos while working on Pepco's property. Initially, a total of approximately 448 individual plaintiffs added Pepco to their complaints. While the pleadings are not entirely clear, it appears that each plaintiff sought $2 million in compensatory damages and $4 million in punitive damages from each defendant.

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     Since the initial filings in 1993, additional individual suits have been filed against Pepco, and significant numbers of cases have been dismissed. As a result of two motions to dismiss, numerous hearings and meetings and one motion for summary judgment, Pepco has had approximately 400 of these cases successfully dismissed with prejudice, either voluntarily by the plaintiff or by the court. As of June 30, 2007, there are approximately 180 cases still pending against Pepco in the State Courts of Maryland, of which approximately 90 cases were filed after December 19, 2000, and have been tendered to Mirant for defense and indemnification pursuant to the terms of the Asset Purchase and Sale Agreement. Under the terms of the Settlement Agreement, Mirant has agreed to assume this contractual obligation. For a description of the Settlement Agreement, see the discussion of the relationship with Mirant above.

     While the aggregate amount of monetary damages sought in the remaining suits (excluding those tendered to Mirant) exceeds $360 million, PHI and Pepco believe the amounts claimed by current plaintiffs are greatly exaggerated. The amount of total liability, if any, and any related insurance recovery cannot be determined at this time; however, based on information and relevant circumstances known at this time, neither PHI nor Pepco believes these suits will have a material adverse effect on its financial position, results of operations or cash flows. However, if an unfavorable decision were rendered against Pepco, it could have a material adverse effect on Pepco's and PHI's financial position, results of operations or cash flows.

Cash Balance Plan Litigation

     In 1999, Conectiv established a cash balance retirement plan to replace defined benefit retirement plans then maintained by ACE and DPL. Following the acquisition by Pepco of Conectiv, this plan became the Conectiv Cash Balance Sub-Plan within the PHI Retirement Plan. In September 2005, three management employees of PHI Service Company filed suit in the U.S. District Court for the District of Delaware (the Delaware District Court) against the PHI Retirement Plan, PHI and Conectiv (the PHI Parties), alleging violations of ERISA, on behalf of a class of management employees who did not have enough age and service when the Cash Balance Sub-Plan was implemented in 1999 to assure that their accrued benefits would be calculated pursuant to the terms of the predecessor plans sponsored by ACE and DPL. A fourth plaintiff was added to the case to represent DPL-heritage "grandfathered" employees who will not be eligible for early retirement at the end of the grandfathered period.

     The plaintiffs have challenged the design of the Cash Balance Sub-Plan and are seeking a declaratory judgment that the Cash Balance Sub-Plan is invalid and that the accrued benefits of each member of the class should be calculated pursuant to the terms of the predecessor plans. Specifically, the complaint alleges that the use of a variable rate to compute the plaintiffs' accrued benefit under the Cash Balance Sub-Plan results in reductions in the accrued benefits that violate ERISA. The complaint also alleges that the benefit accrual rates and the minimal accrual requirements of the Cash Balance Sub-Plan violate ERISA as did the notice that was given to plan participants upon implementation of the Cash Balance Sub-Plan.

     The PHI Parties filed a motion to dismiss the suit, which was denied by the court in July 2006. The Delaware District Court stayed one count of the complaint regarding alleged age discrimination pending a decision in another case before the U.S. Court of Appeals for the Third Circuit (the Third Circuit). In January 2007, the Third Circuit issued a ruling in the other case that PHI believes should result in the favorable disposition of all of the claims (other than the claim of inadequate notice) against the PHI Parties in the Delaware District Court. The PHI

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Parties filed pleadings apprising the Delaware District Court of the Third Circuit's decision in February 2007. In March 2007, the plaintiffs filed pleadings apprising the Delaware District Court that the Third Circuit had denied a request for a rehearing in the other case. Also in January 2007, the plaintiffs filed a Motion for Class Certification and the PHI Parties filed their opposition in February 2007. In May 2007, the PHI Parties filed a motion for summary judgment at the close of discovery. Plaintiffs filed their opposition and cross-motion for summary judgment on June 19, 2007.

     While PHI believes it has a strong legal position in the case and that it is therefore unlikely that the plaintiffs will prevail, PHI estimates that, if the plaintiffs were to prevail, the ABO and projected benefit obligation (PBO), calculated in accordance with SFAS No. 87, each would increase by approximately $12 million, assuming no change in benefits for persons who have already retired or whose employment has been terminated and using actuarial valuation data as of the time the suit was filed. The ABO represents the present value that participants have earned as of the date of calculation. This means that only service already worked and compensation already earned and paid is considered. The PBO is similar to the ABO, except that the PBO includes recognition of the effect that estimated future pay increases would have on the pension plan obligation.

Environmental Litigation

     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. Although penalties assessed for violations of environmental laws and regulations are not recoverable from customers of the operating utilities, environmental clean-up costs incurred by Pepco, DPL and ACE would be included by each company in its respective cost of service for ratemaking purposes.

     Cambridge, Maryland Site. In July 2004, DPL entered into an administrative consent order (ACO) with the Maryland Department of the Environment (MDE) to perform a Remedial Investigation/Feasibility Study (RI/FS) to further identify the extent of soil, sediment and ground and surface water contamination related to former manufactured gas plant (MGP) operations at a Cambridge, Maryland site on DPL-owned property and to investigate the extent of MGP contamination on adjacent property. The MDE has approved the RI and DPL submitted a final FS to MDE on February 15, 2007. The costs of cleanup (as determined by the RI/FS and subsequent negotiations with MDE) are anticipated to be approximately $2.7 million. The remedial action will include dredging activities within Cambridge Creek, which are expected to take place as early as October 2007, and soil excavation on DPL's and adjacent property as early as January 2008.

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     Metal Bank/Cottman Avenue Site. In the early 1970s, both Pepco and DPL sold scrap transformers, some of which may have contained some level of PCBs, to a metal reclaimer operating at the Metal Bank/Cottman Avenue site in Philadelphia, Pennsylvania, owned by a nonaffiliated company. In December 1987, Pepco and DPL were notified by the United States Environmental Protection Agency (EPA) that they, along with a number of other utilities and non-utilities, were potentially responsible parties (PRPs) in connection with the PCB contamination at the site.

     In 1994, an RI/FS including a number of possible remedies was submitted to the EPA. In 1997, the EPA issued a Record of Decision that set forth a selected remedial action plan with estimated implementation costs of approximately $17 million. In 1998, the EPA issued a unilateral administrative order to Pepco and 12 other PRPs directing them to conduct the design and actions called for in its decision. In May 2003, two of the potentially liable owner/operator entities filed for reorganization under Chapter 11 of the U.S. Bankruptcy Code. In October 2003, the bankruptcy court confirmed a reorganization plan that incorporates the terms of a settlement among the two debtor owner/operator entities, the United States and a group of utility PRPs including Pepco (the Utility PRPs). Under the bankruptcy settlement, the reorganized entity/site owner will pay a total of $13.25 million to remediate the site (the Bankruptcy Settlement).

     In March 2006, the U.S. District Court for the Eastern District of Pennsylvania approved global consent decrees for the Metal Bank/Cottman Avenue site, entered into on August 23, 2005, involving the Utility PRPs, the U.S. Department of Justice, EPA, The City of Philadelphia and two owner/operators of the site. Under the terms of the settlement, the two owner/operators will make payments totaling $5.55 million to the U.S. Department of Justice and totaling $4.05 million to the Utility PRPs. The Utility PRPs will perform the remedy at the site and will be able to draw on the $13.25 million from the Bankruptcy Settlement to accomplish the remediation (the Bankruptcy Funds). The Utility PRPs will contribute funds to the extent remediation costs exceed the Bankruptcy Funds available. The Utility PRPs also will be liable for EPA costs associated with overseeing the monitoring and operation of the site remedy after the remedy construction is certified to be complete and also the cost of performing the "5 year" review of site conditions required by the Comprehensive Environmental Response, Compensation, and Liability Act of 1980. Any Bankruptcy Funds not spent on the remedy may be used to cover the Utility PRPs' liabilities for future costs. No parties are released from potential liability for damages to natural resources.

     As of June 30, 2007, Pepco had accrued $1.7 million to meet its liability for a remedy at the Metal Bank/Cottman Avenue site. While final costs to Pepco of the settlement have not been determined, Pepco believes that its liability at this site will not have a material adverse effect on its financial position, results of operations or cash flows.

     In 1999, DPL entered into a de minimis settlement with EPA and paid approximately $107,000 to resolve its liability for cleanup costs at the Metal Bank/Cottman Avenue site. The de minimis settlement did not resolve DPL's responsibility for natural resource damages, if any, at the site. DPL believes that any liability for natural resource damages at this site will not have a material adverse effect on its financial position, results of operations or cash flows.

     Delilah Road Landfill Site. In November 1991, the New Jersey Department of Environmental Protection (NJDEP) identified ACE as a PRP at the Delilah Road Landfill site in Egg Harbor Township, New Jersey. In 1993, ACE, along with other PRPs, signed an ACO with

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NJDEP to remediate the site. The soil cap remedy for the site has been completed and the NJDEP conditionally approved the report submitted by the parties on the implementation of the remedy in January 2003. In March 2004, NJDEP approved a Ground Water Sampling and Analysis Plan. Positive results of groundwater monitoring events have resulted in a reduced level of groundwater monitoring. In August 2006, NJDEP issued a No Further Action Letter (NFA) and Covenant Not to Sue for the site. Among other things, the NFA requires the PRPs to monitor the effectiveness of institutional (deed restriction) and engineering (cap) controls at the site every two years and to continue groundwater monitoring. In December 2006, the PRP group filed a petition with NJDEP seeking approval of semi-annual rather than quarterly ground water monitoring for two years and annual groundwater monitoring thereafter if ground water monitoring results remain consistent or improve relative to prior monitoring data. NJDEP has not acted on the PRP group's petition. In March 2003, EPA demanded from the PRP group reimbursement for EPA's past costs at the site, totaling $168,789. The PRP group objected to the demand for certain costs, but agreed to reimburse EPA approximately $19,000. In a March 19, 2007 letter, EPA demanded from the PRP group reimbursement for EPA's costs at the site between 1985 and 2007 totaling $233,563. The PRP group objected to the demand for these costs for a variety of reasons, including the fact that approximately $97,000 in costs was billed after construction of the remedy by the PRP group was completed. In a June 19, 2007 letter, EPA requested that the PRP group pay $62,623 in response costs and enter into a tolling agreement. In a July 10, 2007 response to EPA, the PRP group indicated a willingness to pay approximately $62,600 (ACE's share of which is one-third) in full satisfaction of EPA's claims for all past and future response costs relating to the site, provided that EPA provides a satisfactory settlement agreement with a covenant not sue and release as to such costs. The PRP group response of July 10, 2007 also questioned the need for a tolling agreement for a site that is the subject of an NFA and accordingly warrants little, if any, activity by EPA. The PRP group is evaluating EPA's July 26, 2007 counteroffer of settlement under which the PRP group would resolve its liability for EPA's past and future costs at the site by paying the offered $62,600 plus a 30% premium to cover the risk associated with EPA's unknown future costs for a total of approximately $81,400. A settlement incorporating these terms also would permit EPA to reopen the settlement in the event of new information or unknown conditions at the site. Based on information currently available, ACE anticipates that its share of additional cost associated with this site for post-remedy operation and maintenance will be approximately $555,000 to $600,000. ACE believes that its liability for post-remedy operation and maintenance costs will not have a material adverse effect on its financial position, results of operations or cash flows.

     Frontier Chemical Site. On June 29, 2007, ACE received a letter from the New York Department of Environmental Conservation (NYDEC) indicating that ACE is a PRP at the Frontier Chemical Waste Processing Company site in Niagara Falls, N.Y. The letter states that NYDEC has hazardous waste manifests indicating that ACE sent in excess of 7,500 gallons of manifested hazardous waste to the site. The letter asks ACE, within 30 days, to express its willingness to enter into an ACO. If ACE is unwilling to enter into the ACO, ACE must respond to NYDEC's request for information within 45 days. ACE informed NYDEC that it has entered into good faith negotiations with a coalescing PRP group to address ACE's responsibility at the site. ACE believes that its responsibility at the site will not have a material adverse effect on its financial position, results of operations or cash flows.

     Deepwater Generating Station. On December 27, 2005, NJDEP issued a Title V Operating Permit for Conectiv Energy's Deepwater Generating Station. The permit includes new limits on unit heat input. In order to comply with these new operational limits, Conectiv Energy restricted

43

the output of the Deepwater Generating Station's Unit 1 and Unit 6/8. In 2006 and the first half of 2007, these restrictions resulted in operating losses of approximately $10,000 per operating day on Unit 6/8, primarily because of lost revenues due to reduced output, and to a lesser degree because of lost revenues related to capacity requirements of the PJM Interconnection, LLC (PJM). Since June 1, 2007, Deepwater Unit 6/8 can operate within the heat input limits set forth in the Title V Operating Permit without restricting output, because of technical improvements that partially corrected the inherent bias in the continuous emissions monitoring system that had caused recorded heat input to be higher than actual heat input. In order to comply with the heat input limit at Deepwater Unit 1, Conectiv Energy continues to restrict Unit 1 output. Beginning with the third quarter 2007, this Unit 1 restriction will result in semi-annual operating losses of approximately $500,000 in 2007 and 2008 due to penalties and lost revenues related to PJM capacity requirements. Beyond 2008, while penalties due to PJM capacity requirements are not expected, further operating losses due to lost revenues related to PJM capacity requirements may continue to be incurred. The operating losses due to reduced output on Unit 1 have been, and will continue to be, insignificant. Conectiv Energy is challenging these heat input restrictions and other provisions of the Title V Operating Permit for Deepwater Generating Station in the New Jersey Office of Administrative Law.

     On April 3, 2007, NJDEP issued an Administrative Order and Notice of Civil Administrative Penalty Assessment (the First Order) alleging that at Conectiv Energy's Deepwater Generating Station, the maximum gross heat input to Unit 1 exceeded the maximum allowable heat input in calendar year 2005 and the maximum gross heat input to Unit 6/8 exceeded the maximum allowable heat input in calendar years 2005 and 2006. The order required the cessation of operation of Units 1 and 6/8 above the alleged permitted heat input levels, assessed a penalty of $1,091,000 and requested that Conectiv Energy provide additional information about heat input to Units 1 and 6/8. Conectiv Energy provided NJDEP Units 1 and 6/8 calendar year 2004 heat input data on May 9, 2005, and calendar years 1995 to 2003 heat input data on July 10, 2007. On May 23, 2007, NJDEP issued a second Administrative Order and Notice of Civil Administrative Penalty Assessment (the Second Order) alleging that the maximum gross heat input to Units 1 and 6/8 exceeded the maximum allowable heat input in calendar year 2004. The Second Order required the cessation of operation of Units 1 and 6/8 above the alleged permitted heat input levels and assessed a penalty of $811,600. Conectiv Energy has requested a contested case hearing challenging the issuance of the First and Second Orders and moved for a stay of the orders pending resolution of the Title V Operating Permit contested case described above.

     Carll's Corner Generating Station. On March 9, 2007, NJDEP issued an Administrative Order of Revocation and Notice of Civil Administrative Penalty Assessment alleging that emissions from Unit 1 at Conectiv Energy's Carll's Corner Generating Station exceeded permitted particulate emissions levels during stack testing performed in June and November 2006. The order revoked Conectiv Energy's authority to operate Unit 1 effective April 21, 2007 and assessed a penalty of $110,000 for the alleged permit violations. Conectiv Energy is continuing to investigate the cause of the stack test results. Conectiv Energy requested a contested case hearing challenging the issuance of the order and moved for a stay of the order of revocation. NJDEP issued stays of the order of revocation until August 31, 2007, to provide time for NJDEP review of June 2007 stack test data and preparation of a settlement agreement rescinding the order of revocation.

 

 

44

IRS Examination of Like-Kind Exchange Transaction

     In 2001, Conectiv and certain of its subsidiaries (the Conectiv Group) were engaged in the implementation of a strategy to divest nonstrategic electric generating facilities and replace these facilities with mid-merit electric generating capacity. As part of this strategy, the Conectiv Group exchanged its interests in two older coal-fired plants for the more efficient gas-fired Hay Road II generating facility, which was owned by an unaffiliated third party. For tax purposes, Conectiv treated the transaction as a "like-kind exchange" under IRC Section 1031. As a result, approximately $88 million of taxable gain was deferred for federal income tax purposes.

     The transaction was examined by the IRS as part of the normal Conectiv tax audit. In May 2006, the IRS issued a revenue agent's report (RAR) for the audit of Conectiv's 2000, 2001 and 2002 income tax returns, in which the IRS exam team disallowed the qualification of the exchange under IRC Section 1031. In July 2006, Conectiv filed a protest of this disallowance to the IRS Office of Appeals.

     PHI believes that its tax position related to this transaction is proper based on applicable statutes, regulations and case law and intends to contest the disallowance. However, there is no absolute assurance that Conectiv's position will prevail. If the IRS prevails, Conectiv would be subject to additional income taxes, interest and possible penalties. However, a portion of the denied benefit would be offset by additional tax depreciation.

     As of June 30, 2007, if the IRS fully prevails, the potential cash impact on PHI would be current income tax and interest payments of approximately $29.8 million and the earnings impact would be approximately $8.5 million in after-tax interest.

Federal Tax Treatment of Cross-border Leases

     PCI maintains a portfolio of cross-border energy sale-leaseback transactions, which, as of June 30, 2007, had a book value of approximately $1.3 billion.

     On February 11, 2005, the Treasury Department and IRS issued Notice 2005-13 informing taxpayers that the IRS intends to challenge on various grounds the purported tax benefits claimed by taxpayers entering into certain sale-leaseback transactions with tax-indifferent parties (i.e., municipalities, tax-exempt and governmental entities) (the Notice). In addition, on June 29, 2005 the IRS published a Coordinated Issue Paper concerning the resolution of audit issues related to such transactions. PCI's cross-border energy leases are similar to those sale-leaseback transactions described in the Notice and the Coordinated Issue Paper.

     PCI's leases have been under examination by the IRS as part of the normal PHI tax audit. On June 9, 2006, the IRS issued its final RAR for its audit of PHI's 2001 and 2002 income tax returns. In the RAR, the IRS disallowed the tax benefits claimed by PHI with respect to certain of these leases for those years. The tax benefit claimed by PHI with respect to the leases under audit is approximately $60 million per year and from 2001 through June 30, 2007 were approximately $317 million. PHI has filed a protest against the IRS adjustments and the unresolved audit has been forwarded to the Appeals Office. The ultimate outcome of this issue is uncertain; however, if the IRS prevails, PHI would be subject to additional taxes, along with interest and possibly penalties on the additional taxes, which could have a material adverse effect on PHI's financial condition, results of operations, and cash flows. PHI believes that its tax position related to these transactions was appropriate based on applicable statutes,

45

regulations and case law, and intends to contest the adjustments proposed by the IRS; however, there is no assurance that PHI's position will prevail.

     On July 13, 2006, the FASB issued FSP FAS 13-2 which amends SFAS No. 13 effective for fiscal years beginning after December 15, 2006. This amendment requires a lease to be repriced and the book value adjusted when there is a change or probable change in the timing of tax benefits of the lease regardless of whether the change results in a deferral or permanent loss of tax benefits. Accordingly, a material change in the timing of cash flows under PHI's cross-border leases as the result of a settlement with the IRS would require an adjustment to the book value of the leases and a charge to earnings equal to the repricing impact of the disallowed deductions which could result in a material adverse effect on PHI's financial condition, results of operations, and cash flows. PHI believes its tax position was appropriate and at this time does not believe there is a probable change in the timing of its tax benefits that would require repricing the leases and a charge to earnings.

IRS Mixed Service Cost Issue

     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.

     On August 2, 2005, the Treasury Department released 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 tax periods beginning in 2005. Based on those 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.

     On the same day that the new 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 with respect to capitalizable construction costs. In line with this Revenue Ruling, the IRS RAR 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's protest of the IRS adjustments 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 taxes that management estimated to be payable based on the method of tax accounting that PHI, pursuant to the proposed regulations, has 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.

46

Third Party Guarantees, Indemnifications, and Off-Balance Sheet Arrangements

     Pepco Holdings and certain of its subsidiaries have various financial and performance guarantees and indemnification obligations which are entered into in the normal course of business to facilitate commercial transactions with third parties as discussed below.

     As of June 30, 2007, Pepco Holdings and its subsidiaries were parties to a variety of agreements pursuant to which they were guarantors for standby letters of credit, performance residual value, and other commitments and obligations. The fair value of these commitments and obligations was not required to be recorded in Pepco Holdings' Consolidated Balance Sheets; however, certain energy marketing obligations of Conectiv Energy were recorded. The commitments and obligations, in millions of dollars, were as follows:

 

Guarantor

     
   

PHI

 

DPL

 

ACE

 

Other

 

Total

 

Energy marketing obligations of Conectiv Energy (1)

$

205.5

$

-

$

-

$

-

$

205.5

 

Energy procurement obligations of Pepco Energy Services (1)

 

45.7

 

-

 

-

 

-

 

45.7

 

Guaranteed lease residual values (2)

 

-

 

2.9

 

3.1

 

.5

 

6.5

 

Other (3)

 

2.6

 

-

 

-

 

1.7

 

4.3

 

  Total

$

253.8

$

2.9

$

3.1

$

2.2

$

262.0

 
                       

1.

Pepco Holdings has contractual commitments for performance and related payments of Conectiv Energy and Pepco Energy Services to counterparties related to routine energy sales and procurement obligations, including requirements under BGS contracts entered into with ACE.

2.

Subsidiaries of Pepco Holdings have guaranteed residual values in excess of fair value related to certain equipment and fleet vehicles held through lease agreements. As of June 30, 2007, obligations under the guarantees were approximately $6.5 million. Assets leased under agreements subject to residual value guarantees are typically for periods ranging from 2 years to 10 years. Historically, payments under the guarantees have not been made by the guarantor as, under normal conditions, the contract runs to full term at which time the residual value is minimal. As such, Pepco Holdings believes the likelihood of payment being required under the guarantee is remote.

3.

Other guarantees consist of:

   

·

Pepco Holdings has guaranteed a subsidiary building lease of $2.6 million. Pepco Holdings does not expect to fund the full amount of the exposure under the guarantee.

 

·

PCI has guaranteed facility rental obligations related to contracts entered into by Starpower Communications, LLC. As of June 30, 2007, the guarantees cover the remaining $1.7 million in rental obligations.

 

 

 

47

     Pepco Holdings and certain of its subsidiaries have entered into various indemnification agreements related to purchase and sale agreements and other types of contractual agreements with vendors and other third parties. These indemnification agreements typically cover environmental, tax, litigation and other matters, as well as breaches of representations, warranties and covenants set forth in these agreements. Typically, claims may be made by third parties under these indemnification agreements over various periods of time depending on the nature of the claim. The maximum potential exposure under these indemnification agreements can range from a specified dollar amount to an unlimited amount depending on the nature of the claim and the particular transaction. The total maximum potential amount of future payments under these indemnification agreements is not estimable due to several factors, including uncertainty as to whether or when claims may be made under these indemnities.

Dividends

     On July 26, 2007, Pepco Holdings' Board of Directors declared a dividend on common stock of 26 cents per share payable September 28, 2007, to shareholders of record on September 10, 2007.

(5) USE OF DERIVATIVES IN ENERGY AND INTEREST RATE HEDGING ACTIVITIES

     PHI accounts for its derivative activities in accordance with SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" (SFAS No. 133), as amended by subsequent pronouncements. See "Accounting for Derivatives" in Note (2) and "Use of Derivatives in Energy and Interest Rate Hedging Activities" in Note (13) to the Consolidated Financial Statements of PHI included in PHI's Annual Report on Form 10-K for the year ended December 31, 2006, for a discussion of the accounting treatment of the derivatives used by PHI and its subsidiaries.

     The table below provides detail on effective cash flow hedges under SFAS No. 133 included in PHI's Consolidated Balance Sheet as of June 30, 2007. Under SFAS No. 133, cash flow hedges are marked-to-market on the balance sheet with corresponding adjustments to Accumulated Other Comprehensive Income. The data in the table indicates the magnitude of the effective cash flow hedges by hedge type (i.e., other energy commodity and interest rate hedges), maximum term, and portion expected to be reclassified to earnings during the next 12 months.

Cash Flow Hedges Included in Accumulated Other Comprehensive Loss
As of June 30, 2007
(Millions of dollars)

Contracts

Accumulated
OCI (Loss)
After Tax 
(1)

Portion Expected
to be Reclassified
to Earnings during
the Next 12 Months

Maximum    Term   

 

Other Energy Commodity

$

(40.3)   

 

$

(25.4)     

 

 54 months

 

Interest Rate

(30.7)   

(3.7)     

302 months

     Total

$

(71.0)   

$

(29.1)     

(1)

Accumulated Other Comprehensive Loss as of June 30, 2007, includes $(8.4) million for an adjustment for minimum pension liability. This adjustment is not included in this table as it is not a cash flow hedge.

 

48

     The following table shows, in millions of dollars, the net pre-tax gain or (loss) recognized in earnings for cash flow hedge ineffectiveness for the three and six months ended June 30, 2007 and 2006, and where they were reported in PHI's Consolidated Statements of Earnings during the periods.

 

Three Months Ended

Six Months Ended

 
   

2007

   

2006

   

2007

   

2006

 

Operating Revenue

$

(.1)

 

$

.3   

 

$

(.7)

 

$

-   

 

Fuel and Purchased Energy

 

.3 

   

(.3)  

   

   

(.5)  

 

     Total

$

.2 

$

-   

$

(.7)

$

(.5)  

     In connection with their energy commodity activities, the Competitive Energy businesses designate certain derivatives as fair value hedges. The net pre-tax gains (losses) recognized during the three and six months ended June 30, 2007 and 2006, and included in the Consolidated Statements of Earnings for fair value hedges and the associated hedged items are shown in the following table, in millions of dollars for the three and six months ended June 30, 2007 and 2006.

 

Three Months Ended

Six Months Ended

 
   

2007

   

2006

   

2007

   

2006

 

Gain/(Loss) on Derivative Instruments

$

.4 

 

$

(.4)  

 

$

(1.4)

 

$

(5.8)  

 

(Loss)/Gain on Hedged Items

$

(.5)

 

$

.1   

 

$

1.1 

 

$

5.8   

 

     For the three and six months ended June 30, 2007, $1.6 million and $.4 million, respectively, in losses were reclassified from Other Comprehensive Income (OCI) to earnings because the forecasted hedged transactions were deemed no longer probable. For the three months and six months ended June 30, 2006, there were no forecasted hedged transactions or firm commitments deemed to be no longer probable.

     In connection with their other energy commodity activities, the Competitive Energy businesses hold certain derivatives that do not qualify as hedges. Under SFAS No. 133, these derivatives are marked-to-market through earnings with corresponding adjustments on the balance sheet. The pre-tax gains (losses) on these derivatives are included in "Competitive Energy Operating Revenues" and are summarized in the following table, in millions of dollars, for the three and six months ended June 30, 2007 and 2006.

 

Three Months Ended

Six Months Ended

 
   

2007   

   

2006

   

2007     

   

2006

 

Proprietary Trading (1)

$

-     

 

$

-  

 

$

-      

 

$

-   

 

Other Energy Commodity (2)

 

9.1     

   

5.5  

   

17.0     

   

22.5  

 

     Total

$

9.1     

$

5.5  

$

17.0     

$

22.5  

     (1) PHI discontinued its proprietary trading activity in 2003.
     (2) Includes $.1 million and $.5 million of ineffective fair value hedge gains for the
            three and six months ended June 30, 2007, respectively.

 

49

(6)  SUBSEQUENT EVENTS

     Maryland Rate Order

     On July 19, 2007, MPSC issued orders in the electricity service distribution base rate cases filed by Pepco and DPL. For further discussion, see "Rate Proceedings" in Note (4), Commitments and Contingencies, herein.

     Maryland Income Tax Refund

     On August 1, 2007, Pepco entered into a settlement agreement with the Comptroller of Maryland on a State income tax refund claim relating to Pepco's divestiture of its generation assets in 2000. Under the agreement, Pepco will receive a refund of taxes paid in the amount of approximately $30 million reflecting a correction of the tax basis of assets sold. The refund will be recorded in the third quarter of 2007, and is expected to result, net of related professional fees, in an increase in PHI's net income of approximately $17.7 million.

 

 

 

 

 

 

 

50

 

 

 

 

 

 

 

 

 

 

 

 

THIS PAGE INTENTIONALLY LEFT BLANK.

 

 

 

 

 

 

 

 

 

 

51

POTOMAC ELECTRIC POWER COMPANY
STATEMENTS OF EARNINGS
(Unaudited)

 

Three Months Ended
June 30,

Six Months Ended
June 30,

 
   

2007

   

2006

   

2007

   

2006

   
   

(Millions of dollars)

 
                           

Operating Revenue

$

495.0 

 

$

520.5 

 

$

1,001.6 

 

$

995.7 

   
                           

Operating Expenses

                         

  Fuel and purchased energy

 

264.3 

   

294.6 

   

560.8 

   

560.3 

   

  Other operation and maintenance

 

71.3 

   

73.2 

   

142.3 

   

144.3 

   

  Depreciation and amortization

42.0 

40.8 

83.9 

81.5 

  Other taxes

72.0 

66.0 

140.3 

130.1 

  Gain on sale of assets

(.6)

     Total Operating Expenses

449.6 

474.6 

926.7 

916.2 

                           

Operating Income

 

45.4 

   

45.9 

   

74.9 

   

79.5 

   

Other Income (Expenses)

                         

  Interest and dividend income

 

.3 

   

1.5 

   

.8 

   

3.0 

   

  Interest expense

 

(18.3)

   

(19.3)

   

(36.8)

   

(38.2)

   

  Other income

 

3.4 

   

4.5 

   

6.5 

   

8.0 

   

  Other expenses

 

(.1)

   

(.3)

   

(.2)

   

(.3)

   

     Total Other Expenses

(14.7)

(13.6)

(29.7)

(27.5)

Income Before Income Tax Expense

30.7 

32.3 

45.2 

52.0 

Income Tax Expense

 

12.7 

   

13.4 

   

18.5 

   

22.5 

   
                           

Net Income

18.0 

18.9 

26.7 

29.5 

Dividends on Redeemable Serial Preferred Stock

1.0 

Earnings Available for Common Stock

18.0 

18.9 

26.7 

28.5 

Retained Earnings at Beginning of Period

560.2 

568.9 

559.7 

574.3 

Cumulative Effect Adjustment Related to
  the Implementation of FIN 48

6.8 

Dividends Paid to Parent

(14.0)

(49.0)

(29.0)

(64.0)

Retained Earnings at End of Period

$

564.2 

$

538.8 

$

564.2 

$

538.8 

                           

The accompanying Notes are an integral part of these Financial Statements.

52

POTOMAC ELECTRIC POWER COMPANY
BALANCE SHEETS
(Unaudited)

ASSETS

June 30,
2007

December 31,
2006

     

(Millions of dollars)

 

CURRENT ASSETS

                         

  Cash and cash equivalents

           

$

11.0 

 

$

12.4 

   

  Accounts receivable, less allowance for
    uncollectible accounts of $18.2 million
    and $17.4 million, respectively

             

348.1 

   

318.3 

   

  Materials and supplies-at average cost

             

50.7 

   

42.8 

   

  Prepayments of income taxes

             

88.5 

   

66.5 

   

  Prepaid expenses and other

             

9.2 

   

25.5 

   

    Total Current Assets

             

507.5 

   

465.5 

   
                           

INVESTMENTS AND OTHER ASSETS

                         

  Regulatory assets

             

137.9 

   

127.7 

   

  Prepaid pension expense

             

156.1 

   

160.1 

   

  Investment in trust

             

28.9 

   

29.0 

   

  Income taxes receivable

             

178.2 

   

   

  Other

             

70.7 

   

99.6 

   

    Total Investments and Other Assets

             

571.8 

   

416.4 

   
                           

PROPERTY, PLANT AND EQUIPMENT

                         

  Property, plant and equipment

             

5,281.4 

   

5,157.6 

   

  Accumulated depreciation

             

(2,227.6)

   

(2,162.5)

   

    Net Property, Plant and Equipment

             

3,053.8 

   

2,995.1 

   
                           

    TOTAL ASSETS

           

$

4,133.1 

 

$

3,877.0 

   
                           

The accompanying Notes are an integral part of these Financial Statements.

 

 

 

 

 

 

 

 

 

 

53

 

POTOMAC ELECTRIC POWER COMPANY
BALANCE SHEETS
(Unaudited)

LIABILITIES AND SHAREHOLDER'S EQUITY

June 30,
2007

December 31,
2006

     

(Millions of dollars, except shares)

 

CURRENT LIABILITIES

                         

  Short-term debt

           

$

171.6 

 

$

67.1 

   

  Current maturities of long-term debt

             

253.0 

   

210.0 

   

  Accounts payable and accrued liabilities

             

220.1 

   

180.1 

   

  Accounts payable to associated companies

             

65.1 

   

46.0 

   

  Capital lease obligations due within one year

             

5.7 

   

5.5 

   

  Taxes accrued

             

79.1 

   

72.8 

   

  Interest accrued

             

17.0 

   

16.9 

   

  Interest and tax liability on uncertain tax positions

63.5 

  Other

153.7 

153.6 

    Total Current Liabilities

             

1,028.8 

   

752.0 

   
                           

DEFERRED CREDITS

                         

  Regulatory liabilities

             

131.0 

   

146.8 

   

  Deferred income taxes

             

572.9 

   

636.3 

   

  Investment tax credits

             

13.5 

   

14.5 

   

  Other postretirement benefit obligation

             

68.0 

   

69.3 

   

  Income taxes payable

             

125.5 

   

   

  Other

             

75.6 

   

66.0 

   

    Total Deferred Credits

             

986.5 

   

932.9 

   
                           

LONG-TERM LIABILITIES

                         

  Long-term debt

             

912.1 

   

990.0 

   

  Capital lease obligations

             

108.1 

   

110.9 

   

    Total Long-Term Liabilities

             

1,020.2 

   

1,100.9 

   
                           

COMMITMENTS AND CONTINGENCIES (NOTE 4)

                         
                           

SHAREHOLDER'S EQUITY

                         

  Common stock, $.01 par value, authorized
    200,000,000 shares, issued 100 shares

             

   

   

  Premium on stock and other capital contributions

             

533.4 

   

531.5 

   

  Retained earnings

             

564.2 

   

559.7 

   

    Total Shareholder's Equity

             

1,097.6 

   

1,091.2 

   
                           

    TOTAL LIABILITIES AND SHAREHOLDER'S EQUITY

           

$

4,133.1 

 

$

3,877.0 

   
                           

The accompanying Notes are an integral part of these Financial Statements.

 

 

 

54

 

POTOMAC ELECTRIC POWER COMPANY
STATEMENTS OF CASH FLOWS
(Unaudited)

   

Six Months Ended
June 30,

 
               

2007

   

2006

   
     

(Millions of dollars)

 

OPERATING ACTIVITIES

                         

Net income

           

$

26.7 

 

$

29.5 

   

Adjustments to reconcile net income to net cash from operating activities:

                         

  Depreciation and amortization

             

83.9 

   

81.5 

   

  Deferred income taxes

             

(5.9)

   

(.4)

   

  Gain on sale of assets

             

(.6)

   

   

  Changes in:

                         

    Accounts receivable

             

(29.8)

   

(11.3)

   

    Regulatory assets and liabilities

             

(34.3)

   

(12.1)

   

    Accounts payable and accrued liabilities

             

53.5 

   

20.6 

   

    Interest and taxes accrued

             

1.6 

   

(106.2)

   

    Other changes in working capital

             

(3.9)

   

(1.4)

   

Net other operating

             

6.4 

   

13.6 

   

Net Cash From Operating Activities

             

97.6 

   

13.8 

   
                           

INVESTING ACTIVITIES

                         

Net investment in property, plant and equipment

             

(134.0)

   

(102.5)

   

Net other investing activities

             

.1 

   

(2.0)

   

Net Cash Used By Investing Activities

             

(133.9)

   

(104.5)

   
                           

FINANCING ACTIVITIES

                         

Dividends paid to Pepco Holdings

             

(29.0)

   

(64.0)

   

Dividends paid on preferred stock

             

   

(1.0)

   

Issuances of long-term debt

             

   

109.5 

   

Reacquisition of long-term debt

             

(35.0)

   

(109.5)

   

Issuances of short-term debt, net

             

104.5 

   

52.4 

   

Redemption of preferred stock

             

   

(21.5)

   

Net other financing activities

             

(5.6)

   

1.5 

   

Net Cash From (Used By) Financing Activities

             

34.9 

   

(32.6)

   
                           

Net Decrease in Cash and Cash Equivalents

             

(1.4)

   

(123.3)

   

Cash and Cash Equivalents at Beginning of Period

             

12.4 

   

131.4 

   
                           

CASH AND CASH EQUIVALENTS AT END OF PERIOD

           

$

11.0 

 

$

8.1 

   
                           

NONCASH ACTIVITIES

                         

Asset retirement obligations associated with removal
  costs transferred to regulatory liabilities

           

$

3.1 

 

$

(6.8)

   
                           

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION

                         

Cash paid for income taxes
   (includes payments to PHI for Federal income taxes)

           

$

23.2 

 

$

70.8 

   
                           

The accompanying Notes are an integral part of these Financial Statements.

 

 

55

NOTES TO FINANCIAL STATEMENTS

POTOMAC ELECTRIC POWER COMPANY

(1)  ORGANIZATION

     Potomac Electric Power Company (Pepco) is engaged in the transmission and distribution of electricity in Washington, D.C. and major portions of Prince George's and Montgomery Counties in suburban Maryland. Pepco provides Default Electricity Supply, which is the supply of electricity at regulated rates to retail customers in its territories who do not elect to purchase electricity from a competitive supplier, in both the District of Columbia and Maryland. Default Electricity Supply is known as Standard Offer Service (SOS) in both the District of Columbia and Maryland. Pepco is a wholly owned subsidiary of Pepco Holdings, Inc. (Pepco Holdings or PHI). Because PHI is a public utility holding company subject to the Public Utility Holding Company Act of 2005 (PUHCA 2005), the relationship between PHI and Pepco and certain activities of Pepco are subject to the regulatory oversight of the Federal Energy Regulatory Commission (FERC) under PUHCA 2005.

(2)  ACCOUNTING POLICY, PRONOUNCEMENTS, AND OTHER DISCLOSURES

Financial Statement Presentation

     Pepco's unaudited financial statements are prepared in conformity with accounting principles generally accepted in the United States of America (GAAP). Pursuant to the rules and regulations of the Securities and Exchange Commission, certain information and footnote disclosures normally included in annual financial statements prepared in accordance with GAAP have been omitted. Therefore, these financial statements should be read along with the annual financial statements included in Pepco's Annual Report on Form 10-K for the year ended December 31, 2006. In the opinion of Pepco's management, the financial statements contain all adjustments (which all are of a normal recurring nature) necessary to present fairly Pepco's financial condition as of June 30, 2007, in accordance with GAAP. The year-end balance sheet data was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. Interim results for the three and six months ended June 30, 2007 may not be indicative of results that will be realized for the full year ending December 31, 2007 since the sales of electric energy are seasonal.

FIN 46R, "Consolidation of Variable Interest Entities"

     Due to a variable element in the pricing structure of Pepco's purchase power agreement with Panda-Brandywine, L.P. (Panda) entered into in 1991, pursuant to which Pepco is obligated to purchase from Panda 230 megawatts of capacity and energy annually through 2021 (Panda PPA), Pepco potentially assumes the variability in the operations of the plants related to the Panda PPA and therefore has a variable interest in the entity. In accordance with the provisions of Financial Accounting Standards Board (FASB) Interpretation No. (FIN) 46R (revised December 2003), entitled "Consolidation of Variable Interest Entities" (FIN 46R), Pepco continued, during the second quarter of 2007, to conduct exhaustive efforts to obtain information from this entity, but was unable to obtain sufficient information to conduct the analysis required

56

under FIN 46R to determine whether the entity was a variable interest entity or if Pepco was the primary beneficiary. As a result, Pepco has applied the scope exemption from the application of FIN 46R for enterprises that have conducted exhaustive efforts to obtain the necessary information, but have not been able to obtain such information.

     Power purchases related to the Panda PPA for the three months ended June 30, 2007 and 2006 were approximately $20 million and $19 million, respectively. Power purchases related to the Panda PPA for the six months ended June 30, 2007 and 2006 were approximately $43 million and $38 million, respectively. Pepco's exposure to loss under the Panda PPA is discussed in Note (4), Commitments and Contingencies, under "Relationship with Mirant Corporation."

     In April 2006, the FASB issued FASB Staff Position (FSP) FIN 46(R)-6, "Determining the Variability to Be Considered in Applying FASB Interpretation No. 46(R)" (FSP FIN 46(R)-6), which provides guidance on how to determine the variability to be considered in applying FIN 46(R). Pepco started applying the guidance in FSP FIN 46(R)-6 to new and modified arrangements effective July 1, 2006.

FIN 48, "Accounting for Uncertainty in Income Taxes"

     On July 13, 2006, the FASB issued FIN 48, "Accounting for Uncertainty in Income Taxes" (FIN 48). FIN 48 clarifies the criteria for recognition of tax benefits in accordance with Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes," and prescribes a financial statement recognition threshold and measurement attribute for a tax position taken or expected to be taken in a tax return. Specifically, it clarifies that an entity's tax benefits must be "more likely than not" of being sustained prior to recording the related tax benefit in the financial statements. If the position drops below the "more likely than not" standard, the benefit can no longer be recognized. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition.

     Pepco adopted the provisions of FIN 48 on January 1, 2007. As a result of the implementation of FIN 48, Pepco recorded a $6.8 million increase in beginning retained earnings, representing the cumulative effect of the change in accounting principle. Unrecognized tax benefits represent those tax benefits related to tax positions that have been taken or are expected to be taken in tax returns, including refund claims, that are not recognized in the financial statements because, in accordance with FIN 48, management has either measured the tax benefit at an amount less than the benefit claimed or expected to be claimed or concluded that it is not more likely than not that the tax position will be ultimately sustained. As of January 1, 2007, unrecognized tax benefits totaled $95.1 million. For the majority of these tax positions, the ultimate deductibility is highly certain, but there is uncertainty about the timing of such deductibility. Unrecognized tax benefits at January 1, 2007, included $20.7 million that, if recognized, would lower the effective tax rate.

     Pepco recognizes interest on under/over payments of income taxes and penalties in income tax expense. As of January 1, 2007, Pepco had accrued approximately $4.1 million of interest expense and penalties.

57

     Pepco, as a direct subsidiary of PHI, is included on PHI's consolidated federal income tax return. Pepco's federal income tax liabilities for all years through 2000 have been determined, subject to adjustment to the extent of any net operating loss or other loss or credit carrybacks from subsequent years. The open tax years for the significant states where Pepco files state income tax returns (District of Columbia and Maryland), are the same as noted above.

     Total unrecognized tax benefits that may change over the next twelve months include the matter described in Note (4) Commitments and Contingencies under the heading "IRS Mixed Service Cost Issue."

     Included in the amount of unrecognized tax benefits at January 1, 2007 that, if recognized, would lower the effective tax rate is a state of Maryland claim for refund in the amount of $31.8 million. Pepco filed an amended 2000 Maryland tax return on November 14, 2005 claiming the refund. The amended return claimed additional tax basis for purposes of computing the Maryland tax gain on the sale of Pepco's generating plants based on the tax benefit rule. This claim for refund was rejected by the state. Pepco filed an appeal by letter dated June 28, 2006. The Hearing Officer denied the appeal by a Notice of Final Determination dated February 22, 2007. Pepco petitioned Maryland Tax Court on March 22, 2007 for the refund. The outcome of this case was uncertain at June 30, 2007. Based on the FIN 48 criteria, management did not believe at June 30, 2007 that this refund claim met the financial statement recognition threshold and measurement attribute for recording the tax benefits of this transaction. On August 1, 2007, Pepco entered into a settlement agreement related to this refund claim. For a further discussion, see "Maryland Income Tax Refund" in Note (6), Subsequent Events, herein.

     On May 2, 2007, the FASB issued FSP FIN 48-1, "Definition of Settlement in FASB Interpretation No. 48" (FIN 48-1), which provides guidance on how an enterprise should determine whether a tax position is effectively settled for the purpose of recognizing previously unrecognized tax benefits. Pepco applied the guidance of FIN 48-1 with its adoption of FIN 48 on January 1, 2007.

Components of Net Periodic Benefit Cost

     Pepco accounts for its participation in the Pepco Holdings benefit plans as participation in a multi-employer plan.  PHI's pension and other postretirement net periodic benefit cost for the three months ended June 30, 2007, of $10.8 million includes $3.1 million for Pepco's allocated share. The remaining pension and other postretirement net periodic benefit cost is allocated to other PHI subsidiaries. PHI's pension and other postretirement net periodic benefit cost for the six months ended June 30, 2007, of $27.8 million includes $11.2 million for Pepco's allocated share. The remaining pension and other postretirement net periodic benefit cost is allocated to other PHI subsidiaries. PHI's pension and other postretirement net periodic benefit cost for the three months ended June 30, 2006, of $17.2 million includes $8.2 million for Pepco's allocated share. The remaining pension and other postretirement net periodic benefit cost is allocated to other PHI subsidiaries. The pension net periodic benefit cost for the six months ended June 30, 2006 of $33.7 million includes $16.0 million for Pepco's allocated share. The remaining pension and other postretirement net periodic benefit cost is allocated to other PHI subsidiaries.

58

Reconciliation of Income Tax Expense

     A reconciliation of Pepco's income tax expense is as follows:

 

For the Three Months Ended June 30,

For the Six Months Ended June 30,

 
 

2007

2006

2007

2006

 
 

Amount

Rate

Amount

Rate

Amount

Rate

Amount

Rate

 
 

(Millions of dollars)

 

Income Before Income Tax Expense

$30.7  

 

$32.3  

 

$45.2  

 

$52.0  

   
                   

Income tax at federal statutory rate

$10.7  

.35  

$11.3  

.35  

$15.8  

.35  

$18.2  

.35  

 

  Increases (decreases) resulting from:

                 

    Depreciation

1.5  

.05  

1.5  

.05  

3.0  

.07  

3.0  

.06  

 

    Asset removal costs

(.5) 

(.02) 

(.5) 

(.02) 

(1.1) 

(.02) 

(1.9) 

(.04) 

 

    State income taxes, net of
         federal effect

1.9  

.06  

1.9  

.06  

2.8  

.06  

3.2  

.06  

 

    Software amortization

.7  

.02  

.7  

.02  

1.5  

.03  

1.4  

.03  

 

    Tax credits

(.5) 

(.02) 

(.5) 

(.01) 

(1.0) 

(.02) 

(1.0) 

(.02) 

 

    Change in estimates related to
        prior year tax liabilities

(.2) 

(.01) 

.1  

-  

(1.0) 

(.02) 

.2  

-  

 

    Other

(.9) 

(.02) 

(1.1) 

(.03) 

(1.5) 

(.04) 

(.6) 

(.01) 

 
                   

Total Income Tax Expense

$12.7  

.41  

$13.4  

.42  

$18.5  

.41  

$22.5  

.43  

 
                   

Amended and Restated Credit Facility

     On May 2, 2007, PHI, Pepco, Delmarva Power & Light Company (DPL) and Atlantic City Electric Company (ACE) entered into an amendment and restatement of their principal credit facility.

     The aggregate borrowing limit under the facility is $1.5 billion, all or any portion of which may be used to obtain loans or to issue letters of credit. PHI's credit limit under the facility is $875 million. The credit limit of each of Pepco, DPL and ACE is the lesser of $500 million and the maximum amount of debt the company is permitted to have outstanding by its regulatory authorities, except that the aggregate amount of credit used by Pepco, DPL and ACE at any given time collectively may not exceed $625 million. The interest rate payable by each company on utilized funds is based on the prevailing prime rate or Eurodollar rate, plus a margin that varies according to the credit rating of the borrower. The facility also includes a "swingline loan sub-facility", pursuant to which each company may make same day borrowings in an aggregate amount not to exceed $150 million. Any swingline loan must be repaid by the borrower within seven days of receipt thereof. All indebtedness incurred under the facility is unsecured.

     The facility commitment expiration date is May 5, 2012, with each company having the right to elect to have 100% of the principal balance of the loans outstanding on the expiration date continued as non-revolving term loans for a period of one year from such expiration date.

     The facility is intended to serve primarily as a source of liquidity to support the commercial paper programs of the respective companies. The companies also are permitted to use the facility to borrow funds for general corporate purposes and issue letters of credit. In order for a borrower to use the facility, certain representations and warranties made by the borrower at the time the amended and restated credit agreement was entered into also must be true at the time the facility is utilized, and the borrower must be in compliance with specified covenants, including

59

the financial covenant described below. However, a material adverse change in the borrower's business, property, and results of operations or financial condition subsequent to the entry into the amended and restated credit agreement is not a condition to the availability of credit under the facility. Among the covenants to which each of the companies is subject are (i) the requirement that each borrowing company maintain a ratio of total indebtedness to total capitalization of 65% or less, computed in accordance with the terms of the amended and restated credit agreement, which calculation excludes certain trust preferred securities and deferrable interest subordinated debt from the definition of total indebtedness (not to exceed 15% of total capitalization), (ii) a restriction on sales or other dispositions of assets, other than sales and dispositions permitted by the amended and restated credit agreement, and (iii) a restriction on the incurrence of liens on the assets of a borrower or any of its significant subsidiaries other than liens permitted by the amended and restated credit agreement. The agreement does not contain any rating triggers.

Related Party Transactions

          PHI Service Company provides various administrative and professional services to PHI and its regulated and unregulated subsidiaries, including Pepco, pursuant to a service agreement. The cost of these services is allocated in accordance with cost allocation methodologies set forth in the service agreement using a variety of factors, including the subsidiaries' share of employees, operating expenses, assets, and other cost causal methods. These intercompany transactions are eliminated by PHI in consolidation and no profit results from these transactions at PHI. PHI Service Company costs directly charged or allocated to Pepco for the three months ended June 30, 2007 and 2006 were approximately $30.3 million and $31.0 million, respectively. PHI Service Company costs directly charged or allocated to Pepco for the six months ended June 30, 2007 and 2006 were approximately $61.5 million and $60.6 million, respectively.

     Certain subsidiaries of Pepco Energy Services perform utility maintenance services, including services that are treated as capital costs, for Pepco. Amounts paid by Pepco to these companies for the three months ended June 30, 2007 and 2006 were approximately $7.6 million and $2.6 million, respectively. Amounts paid by Pepco to these companies for the six months ended June 30, 2007 and 2006 were approximately $16.0 million and $4.9 million, respectively.

     In addition to the transactions described above, Pepco's Statements of Earnings include the following related party transactions:

 

For the Three Months Ended
June 30,

For the Six Months Ended
June 30,

2007

2006

2007

2006

Income (Expense)

(Millions of dollars)

Intercompany power purchases - Conectiv Energy Supply
  (included in fuel and purchased energy)

$(13.8)  

$(5.7)  

$(29.6)

$(5.7)  

Intercompany lease transactions related to computer services and
  facility and building maintenance (included in other operation and
  maintenance)

(.2)  

(.6)  

(.4)

(1.4)  

 

60

     As of June 30, 2007 and December 31, 2006, Pepco had the following balances on its Balance Sheets due (to) from related parties:

 

2007

2006

Asset (Liability)

(Millions of dollars)

Payable to Related Party (current)

   

  PHI Service Company

$  (14.9)

$    (.9)  

  PHI Parent

(5.0)  

  Conectiv Energy Supply

(6.1)

(4.8)  

  Pepco Energy Services (a)

(44.1)

(35.4)  

The items listed above are included in the "Accounts payable to associated companies" balance on the Balance Sheet of $65.1 million and $46.0 million at June 30, 2007 and December 31, 2006, respectively.

Money Pool Balance with Pepco Holdings
  (included in short-term debt in 2007 and cash and cash equivalents
      in 2006 on the balance sheet)

$(163.5)

$     .4   

     

(a)

Pepco bills customers on behalf of Pepco Energy Services where customers have elected to purchase electricity from Pepco Energy Services as their competitive supplier or where Pepco Energy Services has performed work for certain government agencies under a General Services Administration area-wide agreement.

New Accounting Standards

     FSP FTB 85-4-1, "Accounting for Life Settlement Contracts by Third-Party Investors"

     In March 2006, the FASB issued FSP FASB Technical Bulletin (FTB) 85-4-1, "Accounting for Life Settlement Contracts by Third-Party Investors" (FSP FTB 85-4-1). This FSP provides initial and subsequent measurement guidance and financial statement presentation and disclosure guidance for investments by third-party investors in life settlement contracts. FSP FTB 85-4-1 also amends certain provisions of FASB Technical Bulletin No. 85-4, "Accounting for Purchases of Life Insurance," and SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." The guidance in FSP FTB 85-4-1 applies prospectively for all new life settlement contracts and is effective for fiscal years beginning after June 15, 2006 (year ending December 31, 2007 for Pepco). Pepco has evaluated the impact of FSP FTB 85-4-1 and it does not have a material impact on its overall financial condition, results of operations, or cash flows.

     EITF Issue No. 06-3, "Disclosure Requirements for Taxes Assessed by a Governmental Authority on Revenue-producing Transactions"

     On June 28, 2006, the FASB ratified Emerging Issues Task Force (EITF) Issue No. 06-3, "Disclosure Requirements for Taxes Assessed by a Governmental Authority on Revenue-producing Transactions" (EITF 06-3). EITF 06-3 provides guidance on an entity's disclosure of its accounting policy regarding the gross or net presentation of certain taxes and provides that if taxes included in gross revenues are significant, a company should disclose the amount of such taxes for each period for which an income statement is presented (i.e., both interim and annual periods). Taxes within the scope of EITF 06-3 are those that are imposed on and concurrent with a specific revenue-producing transaction. Taxes assessed on an entity's activities over a period of time are not within the scope of EITF 06-3. Pepco implemented EITF 06-3 during the first quarter of 2007. Taxes included in Pepco's gross revenues were $60.5 million and $55.5 million

61

for the three months ended June 30, 2007 and 2006, respectively and $116.6 million and $108.3 million for the six months ended June 30, 2007 and 2006, respectively.

     SFAS No. 157, "Fair Value Measurements"

     In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements" (SFAS No. 157) which defines fair value, establishes a framework for measuring fair value in GAAP, and expands disclosures about fair value measurements. SFAS No. 157 applies under other accounting pronouncements that require or permit fair value measurements and does not require any new fair value measurements. However, it is possible that the application of this Statement will change current practice with respect to the definition of fair value, the methods used to measure fair value, and the expanded disclosures about fair value measurements.

     SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years (year ending December 31, 2008 for Pepco). Pepco is currently in the process of evaluating the impact that SFAS No. 157 will have on its overall financial condition, results of operations, and cash flows.

FSP AUG AIR-1, "Accounting for Planned Major Maintenance Activities"

     On September 8, 2006, the FASB issued FSP American Institute of Certified Public Accountants Industry Audit Guide, Audits of Airlines--"Accounting for Planned Major Maintenance Activities" (FSP AUG AIR-1), which prohibits the use of the accrue-in-advance method of accounting for planned major maintenance activities in annual and interim financial reporting periods for all industries. FSP AUG AIR-1 is effective the first fiscal year beginning after December 15, 2006 (year ending December 31, 2007 for Pepco). Pepco has evaluated the impact of FSP AUG AIR-1 and it does not have a material impact on its overall financial condition, results of operations, or cash flows.

     EITF Issue No. 06-5, "Accounting for Purchases of Life Insurance -- Determining the Amount That Could Be Realized in Accordance with FASB Technical Bulletin No. 85-4, Accounting for Purchases of Life Insurance"

     On September 20, 2006, the FASB ratified EITF Issue No. 06-5, "Accounting for Purchases of Life Insurance -- Determining the Amount That Could Be Realized in Accordance with FASB Technical Bulletin No. 85-4, Accounting for Purchases of Life Insurance" (EITF 06-5) which provides guidance on whether an entity should consider the contractual ability to surrender all of the individual-life policies (or certificates under a group life policy) together when determining the amount that could be realized in accordance with FTB 85-4, and whether a guarantee of the additional value associated with the group life policy affects that determination. EITF 06-5 provides that a policyholder should (i) determine the amount that could be realized under the insurance contract assuming the surrender of an individual-life by individual-life policy (or certificate by certificate in a group policy) and (ii) not discount the cash surrender value component of the amount that could be realized when contractual restrictions on the ability to surrender a policy exist unless contractual limitations prescribe that the cash surrender value component of the amount that could be realized is a fixed amount, in which case the amount that could be realized should be discounted in accordance with Accounting Principles Board of the American Institute of Certified Public Accountants Opinion 21. EITF 06-5 is effective for fiscal years beginning after December 15, 2006 (year ending December 31, 2007 for Pepco). Pepco has evaluated the impact of EITF 06-5 and has determined that it does not have a material

62

impact on its overall financial condition, results of operations, cash flows, or disclosure requirements.

     SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities - Including an amendment of FASB Statement No. 115"

     On February 15, 2007, the FASB issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities - Including an amendment of FASB Statement No. 115" (SFAS No. 159) which permits entities to elect to measure eligible financial instruments at fair value. The objective of SFAS No. 159 is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. SFAS No. 159 applies under other accounting pronouncements that require or permit fair value measurements and does not require any new fair value measurements. However, it is possible that the application of SFAS No. 159 will change current practice with respect to the definition of fair value, the methods used to measure fair value, and the expanded disclosures about fair value measurements.

     SFAS No. 159 establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. SFAS No. 159 requires companies to provide additional information that will help investors and other users of financial statements to more easily understand the effect of the company's choice to use fair value on its earnings. It also requires entities to display the fair value of those assets and liabilities for which the company has chosen to use fair value on the face of the balance sheet. SFAS No. 159 does not eliminate disclosure requirements included in other accounting standards.

     SFAS No. 159 applies to fiscal years beginning after November 15, 2007 (year ending December 31, 2008 for Pepco), with early adoption permitted for an entity that has also elected to apply the provisions of SFAS No. 157, Fair Value Measurements. An entity is prohibited from retrospectively applying SFAS No. 159, unless it chooses early adoption. SFAS No. 159 also applies to eligible items existing at November 15, 2007 (or early adoption date). Pepco is currently in the process of evaluating the impact that SFAS No. 159 will have on its overall financial condition, results of operations, and cash flows.

(3)  SEGMENT INFORMATION

     In accordance with Statement of Financial Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information," Pepco has one segment, its regulated utility business.

(4)  COMMITMENTS AND CONTINGENCIES

REGULATORY AND OTHER MATTERS

Relationship with Mirant Corporation

     In 2000, Pepco sold substantially all of its electricity generating assets to Mirant Corporation (formerly Southern Energy, Inc.) and certain of its subsidiaries. In July 2003, Mirant and certain of its subsidiaries filed a voluntary petition for reorganization under Chapter 11 of the U.S. Bankruptcy Code in the U.S. Bankruptcy Court for the Northern District of Texas (the Bankruptcy Court). On December 9, 2005, the Bankruptcy Court approved the Plan of

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Reorganization (the Reorganization Plan) of Mirant and the Mirant business emerged from bankruptcy on January 3, 2006, as a new corporation of the same name (together with its predecessors, Mirant).

     As part of the bankruptcy proceeding, Mirant had been seeking to reject certain ongoing contractual arrangements under the Asset Purchase and Sale Agreement entered into by Pepco and Mirant for the sale of the generating assets that are described below. The Reorganization Plan did not resolve the issues relating to Mirant's efforts to reject these obligations nor did it resolve certain Pepco damage claims against the Mirant bankruptcy estate.

     Power Purchase Agreement

     The Panda PPA obligates Pepco to purchase from Panda 230 megawatts of energy and capacity annually through 2021. At the time of the sale of Pepco's generating assets to Mirant, the purchase price of the energy and capacity under the Panda PPA was, and since that time has continued to be, substantially in excess of the market price. As a part of the Asset Purchase and Sale Agreement, Pepco entered into a "back-to-back" arrangement with Mirant. Under this arrangement, Mirant is obligated through 2021 to purchase from Pepco the capacity and energy that Pepco is obligated to purchase under the Panda PPA at a price equal to Pepco's purchase price from Panda (the PPA-Related Obligations).

     The SMECO Agreement

     Under the Asset Purchase and Sale Agreement, Pepco assigned to Mirant a Facility and Capacity Agreement entered into by Pepco with Southern Maryland Electric Cooperative, Inc. (SMECO), under which Pepco was obligated to purchase from SMECO the capacity of an 84-megawatt combustion turbine installed and owned by SMECO at a former Pepco generating facility at a cost of approximately $500,000 per month until 2015 (the SMECO Agreement). Pepco is responsible to SMECO for the performance of the SMECO Agreement if Mirant fails to perform its obligations thereunder.

     Settlement Agreements with Mirant

     On May 30, 2006, Pepco, PHI, and certain affiliated companies entered into a Settlement Agreement and Release (the Settlement Agreement) with Mirant, which, subject to court approval, settles all outstanding issues between the parties arising from or related to the Mirant bankruptcy. Under the terms of the Settlement Agreement:

·

Mirant will assume the Asset Purchase and Sale Agreement, except for the PPA-Related Obligations, which Mirant will be permitted to reject.

·

Pepco will receive an allowed claim under the Reorganization Plan in an amount that will result in a total aggregate distribution to Pepco, net of certain transaction expenses, of $520 million, consisting of (i) $450 million in damages resulting from the rejection of the PPA-Related Obligations and (ii) $70 million in settlement of other Pepco damage claims against the Mirant bankruptcy estate, which, as described below, was paid by Mirant to Pepco in August 2006 (collectively, the Pepco Distribution).

·

Except as described below, the $520 million Pepco Distribution will be effected by means of the issuance to Pepco of shares of Mirant common stock, which Pepco will be obligated to resell promptly in one or more block sale transactions.

 

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If the net proceeds that Pepco receives from the resale of the shares of Mirant common stock are less than $520 million, Pepco will receive a cash payment from Mirant equal to the difference, and if the net proceeds that Pepco receives from the resale of the shares of Mirant common stock are more than $520 million, Pepco will make a cash payment to Mirant equal to the difference.

·

If the closing price of shares of Mirant common stock is less than $16.00 per share for four business days in a twenty consecutive business day period, and Mirant has not made a distribution of shares of Mirant common stock to Pepco under the Settlement Agreement, Mirant has the one-time option to elect to assume, rather than reject, the PPA-Related Obligations. If Mirant elects to assume the PPA-Related Obligations, the Pepco Distribution will be reduced to $70 million.

·

All pending appeals, adversary actions or other contested matters between Pepco and Mirant will be dismissed with prejudice, and each will release the other from any and all claims relating to the Mirant bankruptcy.

     Separately, Mirant and SMECO have entered into a Settlement Agreement and Release (the SMECO Settlement Agreement). The SMECO Settlement Agreement provides that Mirant will assume, rather than reject, the SMECO Agreement. This assumption ensures that Pepco will not incur liability to SMECO as the guarantor of the SMECO Agreement due to the rejection of the SMECO Agreement, although Pepco will continue to guarantee to SMECO the future performance of Mirant under the SMECO Agreement.

     According to their terms, the Settlement Agreement and the SMECO Settlement Agreement will become effective when the Bankruptcy Court or the U.S. District Court for the Northern District of Texas (the District Court), as applicable, has entered a final order, not subject to appeal or rehearing, approving both the Settlement Agreement and the SMECO Settlement Agreement.

     On August 9, 2006, the Bankruptcy Court issued an order approving the Settlement Agreement and the SMECO Settlement Agreement. On August 18, 2006, certain holders of Mirant bankruptcy claims, who had objected to approval of the Settlement Agreement and the SMECO Settlement Agreement before the Bankruptcy Court, appealed the approval order to the District Court. On December 26, 2006, the District Court issued an order affirming the Bankruptcy Court's order approving the Settlement Agreement. On January 25, 2007, the parties that appealed the Bankruptcy Court's order filed a notice of appeal of the District Court's order with the U.S. Court of Appeals for the Fifth Circuit (the Fifth Circuit). The brief of the appealing creditors was filed on April 25, 2007, while Mirant's and Pepco's briefs were filed on May 31, 2007.

     In August 2006, Mirant made a cash payment to Pepco of $70 million, which became due in accordance with the terms of the Settlement Agreement as a result of the approval of the Settlement Agreement by the Bankruptcy Court. If the Bankruptcy Court order approving the Settlement Agreement becomes a final order after the exhaustion of all appeals, the payment will be taken into account as if it were proceeds from the resale by Pepco of shares of the Mirant common stock, as described above, and treated as a portion of the $520 million payment due Pepco. If the Bankruptcy Court approval of the Settlement Agreement is not upheld on appeal,

65

Pepco must repay this cash payment to Mirant. Therefore, no income statement impact has been recognized in relation to the $70 million payment.

     Until the approval of the Settlement Agreement and the SMECO Settlement Agreement becomes final, Mirant is required to continue to perform all of its contractual obligations to Pepco and SMECO. Pepco intends to use the $450 million portion of the Pepco Distribution related to the rejection of the PPA-Related Obligations to pay for future capacity and energy purchases under the Panda PPA.

Rate Proceedings

     In electric service distribution base rate cases filed by Pepco in the District of Columbia and Maryland, Pepco proposed the adoption of a bill stabilization adjustment mechanism (BSA) for retail customers. The BSA would increase rates if revenues from distribution deliveries fall below the level approved by the applicable regulatory commission and will decrease rates if revenues from distribution deliveries are above the commission-approved level. The end result would be that Pepco would collect its authorized revenues for distribution deliveries. As a consequence, a BSA "decouples" revenue from unit sales consumption and ties the growth in revenues to the growth in the number of customers. Some advantages of the BSA are that it (i) eliminates revenue fluctuations due to weather and changes in customer usage patterns and, therefore, provides for more predictable utility distribution revenues that are better aligned with costs, (ii) provides for more reliable fixed-cost recovery, (iii) tends to stabilize customers' delivery bills, and (iv) removes any disincentives for Pepco to promote energy efficiency programs for its customers, because it breaks the link between overall sales volumes and delivery revenues. The status of the BSA proposals in each of the jurisdictions is described below in discussion of the respective base rate proceedings.

     District of Columbia

     In February 2006, Pepco filed an update to the District of Columbia Generation Procurement Credit (GPC) for the periods February 8, 2002 through February 7, 2004 and February 8, 2004 through February 7, 2005. The GPC provides for sharing of the profit from SOS sales. The updated GPC filing, which was amended in March 2006, in the District of Columbia takes into account the $112.4 million in proceeds received by Pepco from the December 2005 sale of an allowed bankruptcy claim against Mirant arising from a settlement agreement entered into with Mirant relating to Mirant's obligation to supply energy and capacity to fulfill Pepco's SOS obligations in the District of Columbia. The filing also incorporates true-ups to previous disbursements in the GPC for the District of Columbia. In the filing, Pepco requested that $24.3 million be credited to District of Columbia customers during the twelve-month period beginning April 2006. On June 15, 2006, the District of Columbia Public Service Commission (DCPSC) granted conditional approval of the GPC update as filed, effective July 1, 2006, and on May 24, 2007, the DCPSC issued a final approval.

     On December 12, 2006, Pepco submitted an application to the DCPSC to increase electric distribution base rates, including a proposed BSA. The application requested an annual increase of approximately $46.2 million or an overall increase of 13.5%, reflecting a proposed return on equity (ROE) of 10.75%. If the BSA is not approved, the proposed annual increase is $50.5

66

million or an overall increase of 14.8%, reflecting an ROE of 11.00%. Hearings were held in the case in June 2007. A DCPSC decision is expected in September 2007.

     Maryland

     On July 19, 2007, the Maryland Public Service Commission (MPSC) issued an order in the electric service distribution rate case filed by Pepco. The order approved a temporary annual increase in distribution rates of approximately $10.6 million (including a decrease in annual depreciation expense of approximately $30.7 million). The approved distribution rate reflects an ROE of 10.0%. The order provided that the rate increase is effective as of June 16, 2007, and will remain in effect for an initial period of nine months from the date of the order (or until April 19, 2008). The temporary rate is subject to a Phase II proceeding in which the MPSC will consider the results of an audit of Pepco's cost allocation manual, as filed with the MPSC, to determine whether a further adjustment to the rate is required. The MPSC approved the proposed BSA, under which customer delivery rates are subject to adjustment quarterly (through a surcharge or credit mechanism), depending on whether actual revenue per customer exceeds or falls short of, the approved revenue per customer amount.

     Federal Energy Regulatory Commission

     On May 15, 2007, Pepco updated its FERC-approved formula transmission rates based on its 2006 FERC Form 1. These rates became effective on June 1, 2007, and will provide approximately $9.5 million in additional annual revenues.

Divestiture Cases

     District of Columbia

     Final briefs on Pepco's District of Columbia divestiture proceeds sharing application were filed with the DCPSC in July 2002 following an evidentiary hearing in June 2002. That application was filed to implement a provision of Pepco's DCPSC-approved divestiture settlement that provided for a sharing of any net proceeds from the sale of Pepco's generation-related assets. One of the principal issues in the case is whether Pepco should be required to share with customers the excess deferred income taxes (EDIT) and accumulated deferred investment tax credits (ADITC) associated with the sold assets and, if so, whether such sharing would violate the normalization provisions of the Internal Revenue Code (IRC) and its implementing regulations. As of June 30, 2007, the District of Columbia allocated portions of EDIT and ADITC associated with the divested generating assets were approximately $6.5 million and $5.8 million, respectively.

     Pepco believes that a sharing of EDIT and ADITC would violate the Internal Revenue Service (IRS) normalization rules. Under these rules, Pepco could not transfer the EDIT and the ADITC benefit to customers more quickly than on a straight line basis over the book life of the related assets. Since the assets are no longer owned there is no book life over which the EDIT and ADITC can be returned. If Pepco were required to share EDIT and ADITC and, as a result, the normalization rules were violated, Pepco would be unable to use accelerated depreciation on District of Columbia allocated or assigned property. In addition to sharing with customers the generation-related EDIT and ADITC balances, Pepco would have to pay to the IRS an amount equal to Pepco's District of Columbia jurisdictional generation-related ADITC balance ($5.8 million as of June 30, 2007), as well as its District of Columbia jurisdictional transmission and

67

distribution-related ADITC balance ($4.4 million as of June 30, 2007) in each case as those balances exist as of the later of the date a DCPSC order is issued and all rights to appeal have been exhausted or lapsed, or the date the DCPSC order becomes operative.

     In March 2003, the IRS issued a notice of proposed rulemaking (NOPR), which would allow for the sharing of EDIT and ADITC related to divested assets with utility customers on a prospective basis and at the election of the taxpayer on a retroactive basis. In December 2005 a revised NOPR was issued which, among other things, withdrew the March 2003 NOPR and eliminated the taxpayer's ability to elect to apply the regulation retroactively. Comments on the revised NOPR were filed in March 2006, and a public hearing was held in April 2006. Pepco filed a letter with the DCPSC in January 2006, in which it has reiterated that the DCPSC should continue to defer any decision on the ADITC and EDIT issues until the IRS issues final regulations or states that its regulations project related to this issue will be terminated without the issuance of any regulations. Other issues in the divestiture proceeding deal with the treatment of internal costs and cost allocations as deductions from the gross proceeds of the divestiture.

     Pepco believes that its calculation of the District of Columbia customers' share of divestiture proceeds is correct. However, depending on the ultimate outcome of this proceeding, Pepco could be required to make additional gain-sharing payments to District of Columbia customers, including the payments described above related to EDIT and ADITC. Such additional payments (which, other than the EDIT and ADITC related payments, cannot be estimated) would be charged to expense in the quarter and year in which a final decision is rendered and could have a material adverse effect on Pepco's and PHI's results of operations for those periods. However, neither PHI nor Pepco believes that additional gain-sharing payments, if any, or the ADITC-related payments to the IRS, if required, would have a material adverse impact on its financial position or cash flows.

     Maryland

    Pepco filed its divestiture proceeds plan application with the MPSC in April 2001. The principal issue in the Maryland case is the same EDIT and ADITC sharing issue that has been raised in the District of Columbia case. See the discussion above under "Divestiture Cases -- District of Columbia." As of June 30, 2007, the Maryland allocated portions of EDIT and ADITC associated with the divested generating assets were approximately $9.1 million and $10.4 million, respectively. Other issues deal with the treatment of certain costs as deductions from the gross proceeds of the divestiture. In November 2003, the Hearing Examiner in the Maryland proceeding issued a proposed order with respect to the application that concluded that Pepco's Maryland divestiture settlement agreement provided for a sharing between Pepco and customers of the EDIT and ADITC associated with the sold assets. Pepco believes that such a sharing would violate the normalization rules (discussed above) and would result in Pepco's inability to use accelerated depreciation on Maryland allocated or assigned property. If the proposed order is affirmed, Pepco would have to share with its Maryland customers, on an approximately 50/50 basis, the Maryland allocated portion of the generation-related EDIT ($9.1 million as of June 30, 2007), and the Maryland-allocated portion of generation-related ADITC. Furthermore, Pepco would have to pay to the IRS an amount equal to Pepco's Maryland jurisdictional generation-related ADITC balance ($10.4 million as of June 30, 2007), as well as its Maryland retail jurisdictional ADITC transmission and distribution-related balance ($7.8 million as of June 30, 2007), in each case as those balances exist as of the later of the date

68

a MPSC order is issued and all rights to appeal have been exhausted or lapsed, or the date the MPSC order becomes operative. The Hearing Examiner decided all other issues in favor of Pepco, except for the determination that only one-half of the severance payments that Pepco included in its calculation of corporate reorganization costs should be deducted from the sales proceeds before sharing of the net gain between Pepco and customers. Pepco filed a letter with the MPSC in January 2006, in which it has reiterated that the MPSC should continue to defer any decision on the ADITC and EDIT issues until the IRS issues final regulations or states that its regulations project related to this issue will be terminated without the issuance of any regulations.

     In December 2003, Pepco appealed the Hearing Examiner's decision to the MPSC as it relates to the treatment of EDIT and ADITC and corporate reorganization costs. The MPSC has not issued any ruling on the appeal and Pepco does not believe that it will do so until action is taken by the IRS as described above. However, depending on the ultimate outcome of this proceeding, Pepco could be required to share with its customers approximately 50 percent of the EDIT and ADITC balances described above in addition to the additional gain-sharing payments relating to the disallowed severance payments, which Pepco is not contesting. Such additional payments would be charged to expense in the quarter and year in which a final decision is rendered and could have a material adverse effect on results of operations for those periods. However, neither PHI nor Pepco believes that additional gain-sharing payments, if any, or the ADITC-related payments to the IRS, if required, would have a material adverse impact on its financial position or cash flows.

Default Electricity Supply Proceedings

     Maryland

     Pursuant to orders issued by the MPSC in November 2006, Pepco provides SOS to its delivery customers who do not elect to purchase electricity from a competitive supplier. Pepco purchases the power supply required to satisfy its SOS obligations from wholesale suppliers under contracts entered into pursuant to a competitive bid procedure approved and supervised by the MPSC. In March 2006, Pepco announced the results of competitive bids to supply electricity to its Maryland SOS customers for one year beginning June 1, 2006. Due to significant increases in the cost of fuels used to generate electricity, the auction results had the effect of increasing the average monthly electric bill by about 38.5% for Pepco's Maryland residential customers.

     On April 21, 2006, the MPSC approved a settlement agreement among Pepco, its affiliate DPL, the staff of the MPSC and the Office of People's Counsel, which provides for a rate mitigation plan for Pepco's residential customers. Under the plan, the full increase for Pepco's residential customers who affirmatively elect to participate are being phased-in in increments of 15% on June 1, 2006, 15.7% on March 1, 2007 and the remainder on June 1, 2007. Customers electing to participate in the rate deferral plan will be required to pay the deferred amounts over an 18-month period beginning June 1, 2007. As of June 30, 2007, approximately 2% of Pepco's residential customers had elected to participate in the phase-in program.

     On June 23, 2006, Maryland enacted legislation that extended the period for customers to elect to participate in the phase-in of higher rates and revised the obligation to provide SOS to residential and small commercial customers until further action of the General Assembly. The

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legislation also provides for a customer refund reflecting the difference between the interest expense on an initially projected deferred balance at a 25% customer participation level and the interest expense on a deferred balance based on actual participation levels referred to above. The total amount of the refund is approximately $1.1 million for Pepco customers. At Pepco's 2% level of participation, Pepco estimates that the deferral balance, net of taxes, will be approximately $1.4 million. In July 2006, the MPSC approved revised tariff riders filed in June 2006 by Pepco to implement the legislation.

General Litigation

     During 1993, Pepco was served with Amended Complaints filed in the state Circuit Courts of Prince George's County, Baltimore City and Baltimore County, Maryland in separate ongoing, consolidated proceedings known as "In re: Personal Injury Asbestos Case." Pepco and other corporate entities were brought into these cases on a theory of premises liability. Under this theory, the plaintiffs argued that Pepco was negligent in not providing a safe work environment for employees or its contractors, who allegedly were exposed to asbestos while working on Pepco's property. Initially, a total of approximately 448 individual plaintiffs added Pepco to their complaints. While the pleadings are not entirely clear, it appears that each plaintiff sought $2 million in compensatory damages and $4 million in punitive damages from each defendant.

     Since the initial filings in 1993, additional individual suits have been filed against Pepco, and significant numbers of cases have been dismissed. As a result of two motions to dismiss, numerous hearings and meetings and one motion for summary judgment, Pepco has had approximately 400 of these cases successfully dismissed with prejudice, either voluntarily by the plaintiff or by the court. As of June 30, 2007, there are approximately 180 cases still pending against Pepco in the State Courts of Maryland, of which approximately 90 cases were filed after December 19, 2000, and have been tendered to Mirant for defense and indemnification pursuant to the terms of the Asset Purchase and Sale Agreement. Under the terms of the Settlement Agreement, Mirant has agreed to assume this contractual obligation. For a description of the Settlement Agreement, see the discussion of the relationship with Mirant above.

     While the aggregate amount of monetary damages sought in the remaining suits (excluding those tendered to Mirant) exceeds $360 million, PHI and Pepco believe the amounts claimed by current plaintiffs are greatly exaggerated. The amount of total liability, if any, and any related insurance recovery cannot be determined at this time; however, based on information and relevant circumstances known at this time, neither PHI nor Pepco believes these suits will have a material adverse effect on its financial position, results of operations or cash flows. However, if an unfavorable decision were rendered against Pepco, it could have a material adverse effect on Pepco's and PHI's financial position, results of operations or cash flows.

Environmental Litigation

     Pepco 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. Pepco 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. Although penalties assessed for

70

violations of environmental laws and regulations are not recoverable from Pepco's customers, environmental clean-up costs incurred by Pepco would be included in its cost of service for ratemaking purposes.

     Metal Bank/Cottman Avenue Site. In the early 1970s, Pepco sold scrap transformers, some of which may have contained some level of PCBs, to a metal reclaimer operating at the Metal Bank/Cottman Avenue site in Philadelphia, Pennsylvania, owned by a nonaffiliated company. In December 1987, Pepco was notified by the United States Environmental Protection Agency (EPA) that it and a number of other utilities and non-utilities, were potentially responsible parties (PRPs) in connection with the PCB contamination at the site.

     In 1994, an Remedial Investigation/Feasibility Study including a number of possible remedies was submitted to the EPA. In 1997, the EPA issued a Record of Decision that set forth a selected remedial action plan with estimated implementation costs of approximately $17 million. In 1998, the EPA issued a unilateral administrative order to Pepco and 12 other PRPs directing them to conduct the design and actions called for in its decision. In May 2003, two of the potentially liable owner/operator entities filed for reorganization under Chapter 11 of the U.S. Bankruptcy Code. In October 2003, the bankruptcy court confirmed a reorganization plan that incorporates the terms of a settlement among the two debtor owner/operator entities, the United States and a group of utility PRPs including Pepco (the Utility PRPs). Under the bankruptcy settlement, the reorganized entity/site owner will pay a total of $13.25 million to remediate the site (the Bankruptcy Settlement).

     In March 2006, the U.S. District Court for the Eastern District of Pennsylvania approved global consent decrees for the Metal Bank/Cottman Avenue site, entered into on August 23, 2005, involving the Utility PRPs, the U.S. Department of Justice, EPA, The City of Philadelphia and two owner/operators of the site. Under the terms of the settlement, the two owner/operators will make payments totaling $5.55 million to the U.S. Department of Justice and totaling $4.05 million to the Utility PRPs. The Utility PRPs will perform the remedy at the site and will be able to draw on the $13.25 million from the Bankruptcy Settlement to accomplish the remediation (the Bankruptcy Funds). The Utility PRPs will contribute funds to the extent remediation costs exceed the Bankruptcy Funds available. The Utility PRPs also will be liable for EPA costs associated with overseeing the monitoring and operation of the site remedy after the remedy construction is certified to be complete and also the cost of performing the "5 year" review of site conditions required by the Comprehensive Environmental Response, Compensation, and Liability Act of 1980. Any Bankruptcy Funds not spent on the remedy may be used to cover the Utility PRPs' liabilities for future costs. No parties are released from potential liability for damages to natural resources.

     As of June 30, 2007, Pepco had accrued $1.7 million to meet its liability for a remedy at the Metal Bank/Cottman Avenue site. While final costs to Pepco of the settlement have not been determined, Pepco believes that its liability at this site will not have a material adverse effect on its financial position, results of operations or cash flows.

IRS Mixed Service Cost Issue

     During 2001, Pepco changed its method 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

71

December 31, 2005, these accelerated deductions generated incremental tax cash flow benefits of approximately $94 million, primarily attributable to its 2001 tax returns.

     On August 2, 2005, the Treasury Department released regulations that, if adopted in their current form, would require Pepco to change its method of accounting with respect to capitalizable construction costs for income tax purposes for tax periods beginning in 2005. Based on those 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.

     On the same day that the new 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 with respect to capitalizable construction costs. In line with this Revenue Ruling, the IRS issued a revenue agent's report for the 2001 and 2002 tax returns, in which the IRS exam team 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's protest of the IRS adjustments 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 taxes that management estimated to be payable based on the method of tax accounting that PHI, pursuant to the proposed regulations, has adopted on its 2005 tax return. However, if the IRS is successful in requiring Pepco 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.

(5)  SUBSEQUENT EVENTS

     Maryland Rate Order

     On July 19, 2007, MPSC issued an order in the electric service distribution base rate case filed by Pepco. For further discussion, see "Rate Proceedings" in Note (4) Commitments and Contingencies, herein.

     Maryland Income Tax Refund

     On August 1, 2007, Pepco entered into a settlement agreement with the Comptroller of Maryland on a State income tax refund claim relating to Pepco's divestiture of its generation assets in 2000. Under the agreement, Pepco will receive a refund of taxes paid in the amount of approximately $30 million reflecting a correction of the tax basis of assets sold. The refund will be recorded in the third quarter of 2007, and is expected to result, net of related professional fees, in an increase in Pepco's net income of approximately $17.7 million.

 

 

 

 

 

 

 

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DELMARVA POWER & LIGHT COMPANY
STATEMENTS OF EARNINGS
(Unaudited)

 

Three Months Ended
June 30,

Six Months Ended
June 30,

 
   

2007

   

2006

   

2007

   

2006

   
   

(Millions of dollars)

 

Operating Revenue

                         

  Electric

$

265.0 

 

$

289.8 

 

$

573.7 

 

$

547.9 

   

  Natural Gas

 

65.1 

   

49.5 

   

177.9 

   

159.9 

   

     Total Operating Revenue

 

330.1 

   

339.3 

   

751.6 

   

707.8 

   
                           

Operating Expenses

                         

  Fuel and purchased energy

 

182.5 

   

205.4 

   

403.3 

   

367.2 

   

  Gas purchased

 

51.0 

   

39.0 

   

137.1 

   

127.7 

   

  Other operation and maintenance

 

49.8 

   

45.4 

   

99.4 

   

90.6 

   

  Depreciation and amortization

18.2 

18.8 

37.3 

38.2 

  Other taxes

8.5 

9.1 

17.8 

18.8 

  Gain on sale of assets

(.3)

(.6)

(1.1)

     Total Operating Expenses

310.0 

317.4 

694.3 

641.4 

                           

Operating Income

 

20.1 

   

21.9 

   

57.3 

   

66.4 

   

Other Income (Expenses)

                         

  Interest and dividend income

 

.1 

   

.2 

   

.7 

   

.5 

   

  Interest expense

 

(10.4)

   

(10.0)

   

(21.4)

   

(19.3)

   

  Other income

 

.6 

   

2.0 

   

1.1 

   

3.7 

   

  Other expense

 

   

(1.0)

   

   

(2.2)

   

     Total Other Expenses

(9.7)

(8.8)

(19.6)

(17.3)

Income Before Income Tax Expense

10.4 

13.1 

37.7 

49.1 

Income Tax Expense

 

1.8 

   

6.2 

   

13.1 

   

21.4 

   
                           

Net Income

8.6 

6.9 

24.6 

27.7 

Dividends on Redeemable Serial Preferred Stock

.2 

.4 

Earnings Available for Common Stock

8.6 

6.7 

24.6 

27.3 

Retained Earnings at Beginning of Period

433.9 

405.3 

426.4 

399.7 

Dividends Paid to Parent

(19.0)

(27.0)

(15.0)

Preferred Stock Redemption

(.6)

Cumulative Effect Adjustment Related
  to the Implementation of FIN 48

.1 

Retained Earnings at End of Period

$

423.5 

$

412.0 

$

423.5 

$

412.0 

                           

The accompanying Notes are an integral part of these Financial Statements.

74

 

DELMARVA POWER & LIGHT COMPANY
BALANCE SHEETS
(Unaudited)

ASSETS

June 30,
2007

December 31,
2006

     

(Millions of dollars)

 

CURRENT ASSETS

                         

  Cash and cash equivalents

           

$

4.3 

 

$

8.2 

   

  Restricted cash

             

2.9 

   

   

  Accounts receivable, less allowance for
    uncollectible accounts of $9.0 million
    and $7.8 million, respectively

             

195.3 

   

193.7 

   

  Fuel, materials and supplies-at average cost

             

42.7 

   

40.1 

   

  Prepayments of income taxes

             

59.2 

   

46.3 

   

  Prepaid expenses and other

             

16.1 

   

18.4 

   

    Total Current Assets

             

320.5 

   

306.7 

   
                           

INVESTMENTS AND OTHER ASSETS

                         

  Goodwill

             

48.5 

   

48.5 

   

  Regulatory assets

             

182.3 

   

187.2 

   

  Prepaid pension expense

             

175.0 

   

171.8 

   

  Other

             

33.3 

   

18.4 

   

    Total Investments and Other Assets

             

439.1 

   

425.9 

   
                           

PROPERTY, PLANT AND EQUIPMENT

                         

  Property, plant and equipment

             

2,560.9 

   

2,512.8 

   

  Accumulated depreciation

             

(815.1)

   

(794.2)

   

    Net Property, Plant and Equipment

             

1,745.8 

   

1,718.6 

   
                           

    TOTAL ASSETS

           

$

2,505.4 

 

$

2,451.2 

   
                           

The accompanying Notes are an integral part of these Financial Statements.

 

 

 

 

 

 

 

 

 

 

75

 

DELMARVA POWER & LIGHT COMPANY
BALANCE SHEETS
(Unaudited)

LIABILITIES AND SHAREHOLDER'S EQUITY

June 30,
2007

December 31,
2006

     

(Millions of dollars, except shares)

 

CURRENT LIABILITIES

                         

  Short-term debt

           

$

274.8 

 

$

195.9 

   

  Current maturities of long-term debt

             

4.4 

   

64.7 

   

  Accounts payable and accrued liabilities

             

102.1 

   

95.0 

   

  Accounts payable to associated companies

             

36.8 

   

9.6 

   

  Taxes accrued

             

3.8 

   

3.2 

   

  Interest accrued

             

8.6 

   

6.2 

   

  Interest and tax liability on uncertain tax positions

             

34.1 

   

   

  Other

             

57.5 

   

58.4 

   

    Total Current Liabilities

             

522.1 

   

433.0 

   
                           

DEFERRED CREDITS

                         

  Regulatory liabilities

             

286.3 

   

272.4 

   

  Deferred income taxes

             

392.9 

   

424.1 

   

  Investment tax credits

             

9.5 

   

9.9 

   

  Above-market purchased energy contracts and other
     electric restructuring liabilities

             

22.3 

   

23.5 

   

  Other

             

59.7 

   

49.2 

   

    Total Deferred Credits

             

770.7 

   

779.1 

   
                           

LONG-TERM LIABILITIES

                         

  Long-term debt

             

547.5 

   

551.8 

   
                           

COMMITMENTS AND CONTINGENCIES (NOTE 4)

                         
                           

REDEEMABLE SERIAL PREFERRED STOCK

             

   

18.2 

   
                           

SHAREHOLDER'S EQUITY

                         

  Common stock, $2.25 par value, authorized
    1,000,000 shares, issued 1,000 shares

             

   

   

  Premium on stock and other capital contributions

             

241.6 

   

242.7 

   

  Retained earnings

             

423.5 

   

426.4 

   

    Total Shareholder's Equity

             

665.1 

   

669.1 

   
                           

    TOTAL LIABILITIES AND SHAREHOLDER'S EQUITY

           

$

2,505.4 

 

$

2,451.2 

   
                           

The accompanying Notes are an integral part of these Financial Statements.

 

 

 

76

 

 

 

DELMARVA POWER & LIGHT COMPANY
STATEMENTS OF CASH FLOWS
(Unaudited)

   

Six Months Ended
June 30,

 
               

2007

   

2006

   
     

(Millions of dollars)

 

OPERATING ACTIVITIES

                         

Net income

           

$

24.6 

 

$

27.7 

   

Adjustments to reconcile net income to net cash from operating activities:

                         

  Depreciation and amortization

             

37.3 

   

38.2 

   

  Gain on sale of assets

             

(.6)

   

(1.1)

   

  Investment tax credit adjustments

             

(.4)

   

(.4)

   

  Deferred income taxes

             

6.8 

   

(18.0)

   

  Changes in:

                         

    Accounts receivable

             

(1.9)

   

(5.9)

   

    Regulatory assets and liabilities

             

.6 

   

9.4 

   

    Accounts payable and accrued liabilities

             

37.6 

   

(2.3)

   

    Interest and taxes accrued

             

.2 

   

(36.5)

   

    Other changes in working capital

             

(10.1)

   

15.5 

   

Net other operating

             

(3.9)

   

(9.5)

   

Net Cash From Operating Activities

             

90.2 

   

17.1 

   
                           

INVESTING ACTIVITIES

                         

Net investment in property, plant and equipment

             

(59.5)

   

(75.1)

   

Restricted cash

             

(2.9)

   

   

Proceeds from sale of property

             

   

2.2 

   

Net other investing activities

             

.1 

   

(1.6)

   

Net Cash Used By Investing Activities

             

(62.3)

   

(74.5)

   
                           

FINANCING ACTIVITIES

                         

Dividends paid to Pepco Holdings

             

(27.0)

   

(15.0)

   

Dividends paid on preferred stock

             

   

(.4)

   

Reacquisition of long-term debt

             

(64.7)

   

(2.9)

   

Issuances of short-term debt, net

             

78.9 

   

76.0 

   

Redemption of preferred stock

             

(18.2)

   

   

Net other financing activities

             

(.8)

   

(.7)

   

Net Cash (Used By) From Financing Activities

             

(31.8)

   

57.0 

   
                           

Net Decrease in Cash and Cash Equivalents

             

(3.9)

   

(.4)

   

Cash and Cash Equivalents at Beginning of Period

             

8.2 

   

7.4 

   
                           

CASH AND CASH EQUIVALENTS AT END OF PERIOD

           

$

4.3 

 

$

7.0 

   
                           

NONCASH ACTIVITIES

                         

Asset retirement obligations associated with removal
  costs transferred to regulatory liabilities

           

$

4.2 

 

$

3.1 

   
                           

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION

                         

Cash paid for income taxes
   (includes payments to PHI for Federal income taxes)

           

$

11.9 

 

$

40.6 

   
                           

The accompanying Notes are an integral part of these Financial Statements.

 

 

 

 

77

 

NOTES TO FINANCIAL STATEMENTS

DELMARVA POWER & LIGHT COMPANY

(1)  ORGANIZATION

     Delmarva Power & Light Company (DPL) is engaged in the transmission and distribution of electricity in Delaware and portions of Maryland and Virginia, and provides gas distribution service in northern Delaware. As discussed in Note (4), "Commitments and Contingencies -- DPL Sale of Virginia Operations," DPL in June 2007 entered into an agreement to sell substantially all of its Virginia electric service operations. Additionally, DPL supplies electricity at regulated rates to retail customers in its territories who do not elect to purchase electricity from a competitive supplier. The regulatory term for this service varies by jurisdiction as follows:

 

Delaware

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

 

Maryland

SOS

 

Virginia

Default Service

     In this Form 10-Q, DPL also refers to this supply service in each of its jurisdictions generally as Default Electricity Supply.

     DPL is a wholly owned subsidiary of Conectiv, which is wholly owned by Pepco Holdings, Inc. (Pepco Holdings or PHI). Because PHI is a public utility holding company subject to the Public Utility Holding Company Act of 2005 (PUHCA 2005), the relationship between PHI and DPL and certain activities of DPL are subject to the regulatory oversight of the Federal Energy Regulatory Commission (FERC) under PUHCA 2005.

(2)  ACCOUNTING POLICY, PRONOUNCEMENTS, AND OTHER DISCLOSURES

Financial Statement Presentation

     DPL's unaudited financial statements are prepared in conformity with accounting principles generally accepted in the United States of America (GAAP). Pursuant to the rules and regulations of the Securities and Exchange Commission, certain information and footnote disclosures normally included in annual financial statements prepared in accordance with GAAP have been omitted. Therefore, these financial statements should be read along with the annual financial statements included in DPL's Annual Report on Form 10-K for the year ended December 31, 2006. In the opinion of DPL's management, the financial statements contain all adjustments (which all are of a normal recurring nature) necessary to present fairly DPL's financial condition as of June 30, 2007, in accordance with GAAP. The year-end balance sheet data was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. Interim results for the three and six months ended June 30, 2007 may not be indicative of results that will be realized for the full year ending December 31, 2007 since the sales of electric energy are seasonal.

78

FIN 48, "Accounting for Uncertainty in Income Taxes"

     On July 13, 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation Number (FIN) 48, "Accounting for Uncertainty in Income Taxes" (FIN 48). FIN 48 clarifies the criteria for recognition of tax benefits in accordance with Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes," and prescribes a financial statement recognition threshold and measurement attribute for a tax position taken or expected to be taken in a tax return. Specifically, it clarifies that an entity's tax benefits must be "more likely than not" of being sustained prior to recording the related tax benefit in the financial statements. If the position drops below the "more likely than not" standard, the benefit can no longer be recognized. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition.

     DPL adopted the provisions of FIN 48 on January 1, 2007. As a result of the implementation of FIN 48, DPL recorded a $.1 million increase in beginning retained earnings, representing the cumulative effect of the change in accounting principle. Unrecognized tax benefits represent those tax benefits related to tax positions that have been taken or are expected to be taken in tax returns, including refund claims, that are not recognized in the financial statements because, in accordance with FIN 48, management has either measured the tax benefit at an amount less than the benefit claimed or expected to be claimed or concluded that it is not more likely than not that the tax position will be ultimately sustained. As of January 1, 2007, unrecognized tax benefits totaled $43.2 million. For the majority of these tax positions, the ultimate deductibility is highly certain, but there is uncertainty about the timing of such deductibility. Unrecognized tax benefits at January 1, 2007, included $6.7 million that, if recognized, would lower the effective tax rate.

     DPL recognizes interest on under/over payments of income taxes and penalties in income tax expense. As of January 1, 2007, DPL had accrued approximately $9.8 million of interest expense and penalties.

     DPL, as an indirect subsidiary of PHI, is included on PHI's consolidated federal tax return. DPL's federal income tax liabilities for all years through 1997 have been determined, subject to adjustment to the extent of any net operating loss or other loss or credit carrybacks from subsequent years. The open tax years for the significant states where DPL files state income tax returns (Maryland, Delaware, and Virginia), are the same as noted above.

     Total unrecognized tax benefits that may change over the next twelve months include the matter described in Note (4) Commitments and Contingencies under the heading "IRS Mixed Service Cost Issue."

     On May 2, 2007, the FASB issued FASB Staff Position (FSP) FIN 48-1, "Definition of Settlement in FASB Interpretation No. 48" (FIN 48-1), which provides guidance on how an enterprise should determine whether a tax position is effectively settled for the purpose of recognizing previously unrecognized tax benefits. DPL applied the guidance of FIN 48-1 with its adoption of FIN 48 on January 1, 2007.

79

Components of Net Periodic Benefit Cost

     DPL accounts for its participation in the Pepco Holdings benefit plans as participation in a multi-employer plan.  PHI's pension and other postretirement net periodic benefit cost for the three months ended June 30, 2007, of $10.8 million includes $.9 million for DPL's allocated share. The remaining pension and other postretirement net periodic benefit cost is allocated to other PHI subsidiaries. PHI's pension and other postretirement net periodic benefit cost for the six months ended June 30, 2007, of $27.8 million includes $1.2 million for DPL's allocated share. The remaining pension and other postretirement net periodic benefit cost is allocated to other PHI subsidiaries. PHI's pension and other postretirement net periodic benefit cost for the three months ended June 30, 2006, of $17.2 million includes $.6 million for DPL's allocated share. The remaining pension and other postretirement net periodic benefit cost is allocated to other PHI subsidiaries. The pension net periodic benefit cost for the six months ended June 30, 2006 of $33.7 million includes $.4 million for DPL's allocated share. The remaining pension and other postretirement net periodic benefit cost is allocated to other PHI subsidiaries.

Reconciliation of Income Tax Expense

     A reconciliation of DPL's income tax expense is as follows:

 

For the Three Months Ended June 30,

For the Six Months Ended June 30,

 
 

2007

2006

2007

2006

 
 

Amount

Rate

Amount

Rate

Amount

Rate

Amount

Rate

 
 

(Millions of dollars)

 

Income Before Income Tax Expense

$10.4   

 

$13.1   

 

$37.7   

 

$49.1   

   
                   

Income tax at federal statutory rate

$  3.6   

.35  

$  4.6   

.35  

$13.2   

.35  

$17.2   

.35  

 

  Increases (decreases) resulting from:

                 

    State income taxes, net
        of federal effect

.6   

.05  

.6   

.05  

1.9   

.05  

3.4   

.07  

 

    Depreciation

.7   

.07  

.5   

.04  

1.2   

.03  

.9   

.02  

 

    Tax credits

(.2)  

(.02) 

(.2)  

(.02) 

(.4)  

(.01) 

(.4)  

(.01) 

 

   Adjustment to prior years' tax

-   

-  

-   

-  

-   

-  

(.8)  

(.02) 

    Change in estimates related to
        prior year tax liabilities

(2.9)  

(.28)

.8   

.06  

(2.8)  

(.07) 

1.2   

.03  

 

    Other

-   

-  

(.1)  

(.01) 

-   

-  

(.1)  

-  

 

Total Income Tax Expense

$  1.8   

.17  

$  6.2   

.47  

$13.1   

.35  

$21.4   

.44  

 

     Resolution of Uncertain Tax Positions

     In June 2007, DPL agreed to a settlement with the State of Delaware related to the allocation of a gain on the sale of real property that occurred in 2001, pursuant to which DPL made a cash payment of approximately $12 million, consisting of $7.4 million in tax and $4.6 million in interest. DPL's FIN 48 tax reserves for this issue were in excess of the amount finally settled with the State. As a result, excess reserves of $2.8 million were credited to DPL's income tax expense in the second quarter. Because the matter involved a Conectiv heritage tax contingency that existed at the time of the acquisition of Conectiv in August 2002, an additional adjustment of $1.9 million has been recorded in Corporate and Other to eliminate a portion of the tax benefit recorded by DPL.

80

Amended and Restated Credit Facility

     On May 2, 2007, PHI, Potomac Electric Power Company (Pepco), DPL and Atlantic City Electric Company (ACE) entered into an amendment and restatement of their principal credit facility.

     The aggregate borrowing limit under the facility is $1.5 billion, all or any portion of which may be used to obtain loans or to issue letters of credit. PHI's credit limit under the facility is $875 million. The credit limit of each of Pepco, DPL and ACE is the lesser of $500 million and the maximum amount of debt the company is permitted to have outstanding by its regulatory authorities, except that the aggregate amount of credit used by Pepco, DPL and ACE at any given time collectively may not exceed $625 million. The interest rate payable by each company on utilized funds is based on the prevailing prime rate or Eurodollar rate, plus a margin that varies according to the credit rating of the borrower. The facility also includes a "swingline loan sub-facility", pursuant to which each company may make same day borrowings in an aggregate amount not to exceed $150 million. Any swingline loan must be repaid by the borrower within seven days of receipt thereof. All indebtedness incurred under the facility is unsecured.

     The facility commitment expiration date is May 5, 2012, with each company having the right to elect to have 100% of the principal balance of the loans outstanding on the expiration date continued as non-revolving term loans for a period of one year from such expiration date.

     The facility is intended to serve primarily as a source of liquidity to support the commercial paper programs of the respective companies. The companies also are permitted to use the facility to borrow funds for general corporate purposes and issue letters of credit. In order for a borrower to use the facility, certain representations and warranties made by the borrower at the time the amended and restated credit agreement was entered into also must be true at the time the facility is utilized, and the borrower must be in compliance with specified covenants, including the financial covenant described below. However, a material adverse change in the borrower's business, property, and results of operations or financial condition subsequent to the entry into the amended and restated credit agreement is not a condition to the availability of credit under the facility. Among the covenants to which each of the companies is subject are (i) the requirement that each borrowing company maintain a ratio of total indebtedness to total capitalization of 65% or less, computed in accordance with the terms of the amended and restated credit agreement, which calculation excludes certain trust preferred securities and deferrable interest subordinated debt from the definition of total indebtedness (not to exceed 15% of total capitalization), (ii) a restriction on sales or other dispositions of assets, other than sales and dispositions permitted by the amended and restated credit agreement, and (iii) a restriction on the incurrence of liens on the assets of a borrower or any of its significant subsidiaries other than liens permitted by the amended and restated credit agreement. The agreement does not include any rating triggers.

Debt

     In May 2007, DPL retired at maturity $50 million of 8.125% medium-term notes.

     In June 2007, DPL retired at maturity $3.2 million of first mortgage bonds.

81

Related Party Transactions

     PHI Service Company provides various administrative and professional services to PHI and its regulated and unregulated subsidiaries, including DPL, pursuant to a service agreement. The cost of these services is allocated in accordance with cost allocation methodologies set forth in the service agreement using a variety of factors, including the subsidiaries' share of employees, operating expenses, assets, and other cost causal methods. These intercompany transactions are eliminated by PHI in consolidation and no profit results from these transactions at PHI. PHI Service Company costs directly charged or allocated to DPL for the three months ended June 30, 2007 and 2006 were approximately $26.5 million and $25.7 million, respectively. PHI Service Company costs directly charged or allocated to DPL for the six months ended June 30, 2007 and 2006 were approximately $52.7 million and $50.7 million, respectively.

     In addition to the PHI Service Company charges described above, DPL's Statements of Earnings include the following related party transactions:

 

For the Three Months Ended
June 30,

For the Six Months Ended
June 30,

2007

2006

2007

2006

Income (Expense)

(Millions of dollars)

Full Requirements Contract with Conectiv Energy Supply for power,
        capacity and ancillary services to service POLR (included in fuel
        and purchased energy expenses)

$       - 

$(30.7)

$         - 

$(122.2)

SOS agreement with Conectiv Energy Supply (included in fuel and
       purchased energy)

(59.2)

(46.9)

(135.5)

(59.3)

Intercompany lease transactions (included in electric revenue)

1.9 

2.2 

3.8 

4.0 

Transcompany pipeline gas sales with Conectiv Energy Supply
       (included in gas revenue)

.1 

.8 

1.6 

1.4 

Transcompany pipeline gas purchase with Conectiv Energy Supply
       (included in gas purchased)

(.2)

(.8)

(1.5)

(1.2)

     As of June 30, 2007 and December 31, 2006, DPL had the following balances on its Balance Sheets due from/(to) related parties:

   

2007 

   

2006

   

Asset (Liability)

 

(Millions of dollars)

   

Receivable from Related Party (current)

             

  PHI Service Company

$

 

$

46.4 

   

Payable to Related Party (current)