Pepco Holdings 10-Q 2011
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the quarter ended March 31, 2011
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.
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
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.
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
GLOSSARY OF TERMS
Item 1. FINANCIAL STATEMENTS
Listed below is a table that sets forth, for each registrant, the page number where the information is contained herein.
PEPCO HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
The accompanying Notes are an integral part of these Consolidated Financial Statements
PEPCO HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
The accompanying Notes are an integral part of these Consolidated Financial Statements.
PEPCO HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
The accompanying Notes are an integral part of these Consolidated Financial Statements.
PEPCO HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
The accompanying Notes are an integral part of these Consolidated Financial Statements.
PEPCO HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
The accompanying Notes are an integral part of these Consolidated Financial Statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
PEPCO HOLDINGS, INC.
Pepco Holdings, Inc. (PHI or Pepco Holdings), a Delaware corporation incorporated in 2001, is a holding company that, through the following regulated public utility subsidiaries, is engaged primarily in the transmission, distribution and default supply of electricity and the distribution and supply of natural gas (Power Delivery):
Each of Pepco, DPL and ACE is also a reporting company under the Securities Exchange Act of 1934, as amended. Together the three companies constitute a single segment for financial reporting purposes.
Through Pepco Energy Services, Inc. and its subsidiaries (collectively, Pepco Energy Services), PHI provides energy savings performance contracting services, primarily to commercial, industrial and government customers. Pepco Energy Services is in the process of winding down its competitive electricity and natural gas retail supply business. Pepco Energy Services constitutes a separate segment for financial reporting purposes.
PHI Service Company, a subsidiary service company of PHI, provides a variety of support services, including legal, accounting, treasury, tax, purchasing and information technology services to PHI and its operating subsidiaries. These services are provided pursuant to a service agreement among PHI, PHI Service Company, and the participating operating subsidiaries. The expenses of the PHI Service Company are charged to PHI and the participating operating subsidiaries in accordance with cost allocation methodologies set forth in the service agreement.
Each of Pepco, DPL and ACE is a regulated public utility in the jurisdictions that comprise its service territory. Each company owns and operates a network of wires, substations and other equipment that is classified as transmission facilities, distribution facilities or common facilities (which are used for both transmission and distribution). Transmission facilities are high-voltage systems that carry wholesale electricity into, or across, the utilitys service territory. Distribution facilities are low-voltage systems that carry electricity to end-use customers in the utilitys service territory.
Each company is responsible for the distribution of electricity, and in the case of DPL, natural gas, in its service territory for which it is paid tariff rates established by the applicable local public service commissions. Each company also supplies electricity at regulated rates to retail customers in its service territory who do not elect to purchase electricity from a competitive energy supplier. The regulatory term for this supply service is Standard Office Service in Delaware, the District of Columbia and Maryland, and Basic Generation Service in New Jersey. In these Notes to the Consolidated Financial Statements, these supply service obligations are referred to generally as Default Electricity Supply.
Pepco Energy Services
Pepco Energy Services is engaged in the following businesses:
Pepco Energy Services also owns and operates two oil-fired generation facilities that are scheduled for deactivation in May 2012.
In December 2009, PHI announced the wind down of the retail energy supply component of the Pepco Energy Services business. Pepco Energy Services is implementing this wind down by not entering into any new supply contracts, while continuing to perform under its existing supply contracts through their expiration dates. The retail energy supply business has historically generated a substantial portion of the operating revenues and net income of the Pepco Energy Services segment. Operating revenues related to the retail energy supply business for the three months ended March 31, 2011 and 2010 were $305 million and $497 million, respectively, while operating income for the same periods was $12 million and $21 million, respectively.
In connection with the operation of the retail energy supply business, as of March 31, 2011, Pepco Energy Services provided letters of credit of $92 million and posted net cash collateral of $87 million. These collateral requirements, which are based on existing wholesale energy purchase and sale contracts and current market prices, will decrease as the contracts expire, with the collateral expected to be fully released by June 1, 2014. The energy services business will not be affected by the wind down of the retail energy supply business.
Other Business Operations
Through its subsidiary Potomac Capital Investment Corporation (PCI), PHI maintains a portfolio of cross-border energy lease investments, with a book value at March 31, 2011 of approximately $1.4 billion. This activity constitutes a third operating segment for financial reporting purposes, which is designated as Other Non-Regulated. For a discussion of PHIs cross-border energy lease investments, see Note (15), Commitments and Contingencies PHI Cross-Border Energy Lease Investments.
In April 2010, the Board of Directors of PHI approved a plan for the disposition of PHIs competitive wholesale power generation business conducted through subsidiaries of Conectiv Energy Holding Company (Conectiv Energy). On July 1, 2010, PHI completed the sale of Conectiv Energys wholesale power generation business to Calpine Corporation (Calpine) for $1.64 billion. The disposition of all of Conectiv Energys remaining assets and businesses, consisting of its load service supply contracts, energy hedging portfolio, certain tolling agreements and other assets not included in the Calpine sale, is substantially complete. The operations of Conectiv Energy are being accounted for as a discontinued operation and no longer constitute a separate segment for financial reporting purposes. Substantially all of the information in these Notes to the Consolidated Financial Statements with respect to the operations of the former Conectiv Energy segment has been consolidated in Note (16), Discontinued Operations.
(2) SIGNIFICANT ACCOUNTING POLICIES
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 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 PHIs Annual Report on Form 10-K for the year ended December 31, 2010. In the opinion of PHIs 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 March 31, 2011, in accordance with GAAP. The year-end December 31, 2010 Consolidated Balance Sheet was derived from audited financial statements, but does not include all disclosures required by GAAP. Interim results for the three months ended March 31, 2011 may not be indicative of PHIs results that will be realized for the full year ending December 31, 2011, since its Power Delivery business and the retail energy supply business of Pepco Energy Services are seasonal.
Use of Estimates
The preparation of financial statements in conformity with GAAP requires management to make certain estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities in the Consolidated Financial Statements and accompanying notes. Although Pepco Holdings believes that its estimates and assumptions are reasonable, they are based upon information available to management at the time the estimates are made. Actual results may differ significantly from these estimates.
Significant matters that involve the use of estimates include the assessment of goodwill and long-lived assets for impairment, fair value calculations for certain derivative instruments, the costs of providing pension and other postretirement benefits, evaluation of the probability of recovery of regulatory assets, accrual of storm restoration costs, accrual of interest related to income taxes, accrual of restructuring charges, recognition of changes in network service transmission rates for prior service year costs, and the recognition of income tax benefits for investments in finance leases held in trust associated with PHIs portfolio of cross-border energy lease investments. Additionally, PHI is subject to legal, regulatory, and other proceedings and claims that arise in the ordinary course of its business. PHI records an estimated liability for these proceedings and claims, when it is probable that a loss has been incurred and the loss is reasonably estimable.
Network Service Transmission Rates
In May of every year, each of PHIs utility subsidiaries provides its updated network service transmission rate to the Federal Energy Regulatory Commission (FERC) to be effective for June 1 of that year through May 31 of the following year. The updated network transmission rate includes an adjustment for costs incurred in the prior service year not yet reflected in rates charged to customers, that PHIs utility subsidiaries accrue as an adjustment to transmission revenue prior to their inclusion in transmission rates. In the first quarter of 2011, PHIs utility subsidiaries revised their fourth quarter 2010 estimates of the adjustments to be included in the transmission rates to be filed in May 2011 based on updated cost information from 2010, and recorded the changes in the estimates as transmission revenue adjustments. The revised estimates resulted in a $4 million increase in transmission revenues, which was recorded in the first quarter of 2011 for transmission service provided during the first ten months of the 2010-2011 service year. In the fourth quarter of 2010, PHIs utility subsidiaries had estimated and recorded a $2 million decrease in revenues for transmission services provided during the first seven months of the 2010-2011 service year. In the second quarter of 2011, PHIs utility subsidiaries will revise their first quarter 2011 estimates as needed to reflect the adjustments to be filed by them for transmission services provided during the entire 2010-2011 service year as part of the transmission service rates submitted to FERC for the 2011-2012 service year.
Consolidation of Variable Interest Entities
In accordance with the provisions of the Financial Accounting Standards Board (FASB) guidance on the consolidation of variable interest entities (Accounting Standards Codification (ASC) 810), Pepco Holdings consolidates variable interest entities with respect to which Pepco Holdings or a subsidiary is the primary beneficiary. The guidance addresses conditions under which an entity should be consolidated based upon variable interests rather than voting interests. The subsidiaries of Pepco Holdings have contractual arrangements with several entities to which the guidance applies.
ACE Power Purchase Agreements
Pepco Holdings, through its ACE subsidiary, is a party to three power purchase agreements (PPAs) with unaffiliated, non-utility generators (NUGs). Due to a variable element in the pricing structure of the PPAs, Pepco Holdings potentially assumes the variability in the operations of the generating facilities related to the NUGs and, therefore, has a variable interest in the entities. Despite exhaustive efforts to obtain information from these entities during the three months ended March 31, 2011, PHI continues to be unable to obtain sufficient information to conduct the analysis required under FASB guidance to determine whether these three entities were variable interest entities or if ACE was the primary beneficiary. As a result, Pepco Holdings has applied the scope exemption from the guidance 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 NUGs for the three months ended March 31, 2011 and 2010, were approximately $57 million and $72 million, respectively, of which approximately $53 million and $67 million, respectively, consisted of power purchases under the PPAs. The power purchase costs are recoverable from ACEs customers through regulated rates.
DPL Renewable Energy Transactions
PHI, through its DPL subsidiary, has entered into four wind PPAs in the aggregate amount of 350 megawatts as of March 31, 2011 that includes the purchase of renewable energy credits (RECs) and one solar REC purchase agreement with a 10 megawatt facility. The Delaware Public Service Commission (DPSC) has approved DPLs entry into each of the agreements and the recovery of DPLs purchase costs through customer rates. The RECs purchased under all the agreements will help DPL fulfill a portion of its requirements under the State of Delawares Renewable Energy Portfolio Standards Act.
Of the wind PPAs, three are with land-based facilities and one is with an offshore facility. One of the land-based facilities became operational and went into service in December 2009. DPL is obligated to purchase energy and RECs from this facility through 2024 in amounts generated and delivered not to exceed 50.25 megawatts at rates that are primarily fixed. The other wind agreements, which have terms ranging from 20 to 25 years, are currently expected to become operational during 2011 for the two land-based contracts and 2016 for the offshore contract, if the projects are ultimately completed. DPLs purchases under the wind PPAs totaled $5 million and $3 million for the three months ended March 31, 2011 and 2010, respectively. On April 6, 2011, DPL agreed to amend one of the land-based wind contracts to change the location of the wind facility and reduce the maximum generation capacity from 60 megawatts to 38 megawatts. The amendment requires DPSC approval. Upon DPSC approval, the amendment would reduce the aggregate amount of generation capacity associated with the four wind PPAs from 350 megawatts to 328 megawatts.
When the wind facilities become operational, DPL is obligated to purchase energy and RECs in amounts generated and delivered by the sellers at rates that are primarily fixed under these agreements. Under one of the agreements, DPL is also obligated to purchase the capacity associated with the facility at rates that are generally fixed. If the offshore wind facility developer is unable to obtain all necessary permits and financing commitments, this could result in delays in the construction schedules and the operational start dates of the offshore wind facility. If the wind facilities are not operational by specified dates, DPL has the right to terminate the PPAs.
The term of the agreement with the solar facility is 20 years and DPL is obligated to purchase RECs in an amount up to 70 percent of the energy output from the solar facility at a fixed price once the facility is operational, which is expected to be in the third quarter of 2011.
DPL concluded that consolidation is not required for any of these agreements under FASB guidance on the consolidation of variable interest entities.
ACE Transition Funding, LLC
ACE Transition Funding, LLC (ACE Funding) was established in 2001 by ACE solely for the purpose of securitizing authorized portions of ACEs recoverable stranded costs through the issuance and sale of bonds (Transition Bonds). The proceeds of the sale of each series of Transition Bonds have been transferred to ACE in exchange for the transfer by ACE to ACE Funding of the right to collect non-bypassable transition bond charges (the Transition Bond Charges) from ACE customers pursuant to bondable stranded costs rate orders issued by the New Jersey Board of Public Utilities (NJBPU) in an amount sufficient to fund the principal and interest payments on the Transition Bonds and related taxes, expenses and fees (Bondable Transition Property). ACE collects the Transition Bond Charges from its customers on behalf of ACE Funding and the holders of the Transition Bonds. The assets of ACE Funding, including the Bondable Transition Property, and the Transition Bond Charges collected from ACEs customers, are not available to creditors of ACE. The holders of the Transition Bonds have recourse only to the assets of ACE Funding. ACE owns 100 percent of the equity of ACE Funding and PHI consolidates ACE Funding in its financial statements as ACE is the primary beneficiary of ACE Funding under the variable interest entity consolidation guidance.
ACE Standard Offer Capacity Agreements
On April 28, 2011, ACE entered into three Standard Offer Capacity Agreements (SOCAs) by order of the NJBPU. The SOCAs were established as part of the Long-term Capacity Agreement Pilot Program (LCAPP) that was enacted in January 2011 under a New Jersey state law to promote the construction of qualified electric generation facilities in New Jersey. The SOCAs are 15-year, financially settled transactions approved by the NJBPU that would allow generators selected by the NJBPU to receive payments from or make payments to ACE and the other electric distribution companies in New Jersey based on the difference between the fixed price set by the NJBPU in the SOCAs and the market resource clearing price for capacity.
The NJBPU awarded the SOCAs to three generation companies that would each construct a combined cycle, natural gas facility totaling an aggregate amount of capacity of 1,949 megawatts. ACEs share of the payments under the SOCAs would be based on its proportion of load in New Jersey, which is approximately 15 percent, or 292 megawatts, of the aggregate capacity under the contracts. Payments would begin when the facilities are operational, which is currently estimated to be 2015 for two of the facilities and 2016 for the third facility. The NJBPU has approved full recovery from distribution customers of payments made by ACE when the SOCA price set by the NJBPU exceeds the market resource clearing price and ACEs distribution customers would be entitled to any payments received when the market resource clearing price exceeds the SOCA price.
ACE and the other electric distribution companies in New Jersey entered into the SOCAs under protest and also requested that the NJBPU postpone implementation of the LCAPP and delay execution of the SOCAs based on concerns about the potential cost to distribution customers. The NJBPU denied that request and, on March 29, 2011, ordered the electric distribution companies in New Jersey, including ACE, to sign the SOCAs. ACE and the other electric distribution companies filed a joint motion for reconsideration of the order on April 8, 2011, which is pending review by the NJBPU.
PHI is currently assessing the appropriate accounting treatment for the SOCAs, including the applicability of FASB guidance on the consolidation of variable interest entities, leases and derivative instruments. PHIs accounting review is expected to be completed in the second quarter of 2011.
Goodwill represents the excess of the purchase price of an acquisition over the fair value of the net assets acquired at the acquisition date. Substantially all of Pepco Holdings goodwill was generated by Pepcos acquisition of Conectiv in 2002 and is allocated entirely to Pepco Holdings Power Delivery reporting unit for purposes of impairment testing based on the aggregation of its components. Pepco Holdings tests its goodwill for impairment annually as of November 1 and whenever an event occurs or circumstances change in the interim that would more likely than not reduce the fair value of a reporting unit below its carrying amount. Factors that may result in an interim impairment test include, but are not limited to: a change in the identified reporting units; an adverse change in business conditions; a decline in PHIs stock price causing market capitalization to fall further below book value; an adverse regulatory action; or an impairment of long-lived assets in the reporting unit. PHI concluded that an interim impairment test was not required during the three months ended March 31, 2011 as described in Note (6), Goodwill.
Taxes Assessed by a Governmental Authority on Revenue-Producing Transactions
Taxes included in Pepco Holdings gross revenues were $96 million and $74 million for the three months ended March 31, 2011 and 2010, respectively.
Reclassifications and Adjustments
Certain prior period amounts have been reclassified in order to conform to current period presentation. The following adjustments have been recorded and are not considered material either individually or in the aggregate:
PES Derivative Accounting Adjustments
During the first quarter of 2011, PHI recorded an adjustment associated with an increase in the value of certain derivatives from October 1, 2010 to December 31, 2010, which had been erroneously recorded in other comprehensive income at December 31, 2010. This adjustment resulted in an increase in revenue and pre-tax earnings of $2 million.
Income Tax Adjustments
During the first quarter of 2010, ACE recorded an adjustment to correct certain income tax errors related to prior periods. The adjustment resulted in an increase in income tax expense of $6 million for the quarter ended March 31, 2010. The adjustment represents the reversal of erroneously recorded interest income for state income tax purposes related to uncertain and effectively settled tax positions, including $2 million, $3 million and $1 million recorded in 2009, 2008 and 2007, respectively.
(3) NEWLY ADOPTED ACCOUNTING STANDARDS
Fair Value Measurements and Disclosures (ASC 820)
The FASB issued new disclosure requirements that require significant items within the reconciliation of the Level 3 valuation category to be presented in separate categories for purchases, sales, issuances and settlements. The guidance is effective beginning with PHIs March 31, 2011 financial statements. PHI has incorporated the new disclosure requirements in Note (14), Fair Value Disclosures, of its financial statements.
Goodwill (ASC 350)
The FASB issued new guidance on performing goodwill impairment tests that was effective beginning January 1, 2011 for PHI. Under the new guidance, the carrying value of the reporting unit must include the liabilities that are part of the capital structure of the reporting unit. PHI already allocates liabilities to the reporting unit when performing its goodwill impairment test, so the new guidance will not change PHIs goodwill impairment test methodology.
Revenue Recognition (ASC 605)
The FASB issued new guidance to help determine separate units of accounting for multiple-deliverables within a single contract that was effective beginning January 1, 2011 for PHI. The energy services contracts of Pepco Energy Services are primarily impacted by this guidance because they often have multiple elements, which could include design, installation, operation and maintenance, measurement and verification services. PHI and its subsidiaries adopted the new guidance, effective January 1, 2011, and it did not have a material impact on Pepco Energy Services revenue recognition methods or results of operations nor did it have a material impact on PHIs overall financial condition, results of operations or cash flows.
(4) RECENTLY ISSUED ACCOUNTING STANDARDS, NOT YET ADOPTED
There are no recently issued accounting standards that have not yet been adopted by PHI.
(5) SEGMENT INFORMATION
Pepco Holdings management has identified its operating segments at March 31, 2011 as Power Delivery, Pepco Energy Services and Other Non-Regulated. In the tables below, the Corporate and Other column is included to reconcile the segment data with consolidated data and includes unallocated Pepco Holdings (parent company) capital costs, such as acquisition financing costs. Segment financial information for continuing operations for the three months ended March 31, 2011 and 2010 is as follows:
PHIs goodwill balance of $1.4 billion was unchanged during the three months ended March 31, 2011. Substantially all of PHIs $1.4 billion goodwill balance was generated by Pepcos acquisition of Conectiv in 2002 and is allocated entirely to the Power Delivery reporting unit based on the aggregation of its regulated public utility company components for purposes of assessing impairment under FASB guidance on goodwill and other intangibles (ASC 350).
PHIs annual impairment test as of November 1, 2010 indicated that goodwill was not impaired. As of March 31, 2011, PHI concluded that there were no events requiring it to perform an interim goodwill impairment test. PHI will continue to monitor for indicators of goodwill impairment.
(7) LEASING ACTIVITIES
Investment in Finance Leases Held in Trust
As of March 31, 2011 and December 31, 2010, Pepco Holdings had cross-border energy lease investments of $1.4 billion consisting of hydroelectric generation and coal-fired electric generating facilities and natural gas distribution networks located outside of the United States.
The components of the cross-border energy lease investments at March 31, 2011 and at December 31, 2010 are summarized below:
Income recognized from cross-border energy lease investments was comprised of the following for the three months ended March 31, 2011 and 2010:
PHI regularly monitors the financial performance and condition of the lessees under its cross-border energy lease investments. Changes in credit quality are assessed to determine if they should be reflected in the carrying value of the leases. PHI reviews each lessees performance versus annual compliance requirements set by the terms and conditions of the leases. This includes a comparison of published credit ratings to minimum credit rating requirements in the leases for lessees with public credit ratings. In addition, PHI routinely meets with senior executives of the lessees to discuss the company and asset performance. If the annual compliance requirements or minimum credit ratings are not met, remedies are available under the leases. At March 31, 2011, all lessees were in compliance with the terms and conditions of their lease agreements.
The table below shows PHIs net investment in these leases by the published credit ratings of the lessees as of March 31, 2011 and December 31, 2010:
(8) PENSION AND OTHER POSTRETIREMENT BENEFITS
The following Pepco Holdings information is for the three months ended March 31, 2011 and 2010:
Pension and Other Postretirement Benefits
Net periodic benefit cost related to continuing operations is included in Other operation and maintenance expense, net of the portion of the net periodic benefit cost that is capitalized as part of the cost of labor for internal construction projects. After intercompany allocations, the three utility subsidiaries are responsible for substantially all of the total PHI net periodic pension and other postretirement benefit costs related to continuing operations.
PHIs funding policy with regard to PHIs noncontributory retirement plan (the PHI Retirement Plan) is to maintain a funding level that is at least equal to the funding target level under the Pension Protection Act of 2006. Although PHI projects there will be no minimum funding requirement under the Pension Protection Act guidelines in 2011, PHI currently anticipates that it or its subsidiaries may make aggregate discretionary tax-deductible contributions in 2011 of up to $150 million to bring its plan assets to at least the funding target level for 2011 under the Pension Protection Act.
On March 14, 2011, Pepco, ACE and DPL made discretionary tax-deductible contributions to the PHI Retirement Plan in the amounts of $40 million, $30 million and $40 million, respectively. During 2010, PHI Service Company made discretionary tax-deductible contributions totaling $100 million to the PHI Retirement Plan, which brought plan assets to the funding target level for 2010 under the Pension Protection Act. Pepco, ACE and DPL did not make contributions to the PHI Retirement Plan in 2010.
PHIs principal credit source is an unsecured $1.5 billion syndicated credit facility, which can be used by PHI and its utility subsidiaries to borrow funds, obtain letters of credit and support the issuance of commercial paper. This facility is in effect until May 2012. At the PHI level, the 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 collectively, at any given time, may not exceed $625 million.
In October 2010, PHI entered into two bi-lateral 364 day unsecured credit agreements totaling $200 million. Under each of the credit agreements, PHI has access to revolving and floating rate loans over the terms of the agreements. Neither agreement provides for the issuance of letters of credit.
The absence of a material adverse change in PHIs business, property and results of operations or financial condition is not a condition to the availability of credit under the $1.5 billion credit facility or either of the bi-lateral credit agreements. Neither the credit facility nor the bi-lateral credit agreements include any rating triggers.
The $1.5 billion credit facility and the two bi-lateral credit agreements are referred to herein collectively as PHIs primary credit facilities. As of March 31, 2011, each borrower was in compliance with its covenants under the primary credit facilities to which it is a party.
At March 31, 2011 and December 31, 2010, the amount of cash plus borrowing capacity under the primary credit facilities available to meet the future liquidity needs of PHI and its utility subsidiaries on a consolidated basis each totaled $1.2 billion. PHIs utility subsidiaries had combined cash and borrowing capacity under the $1.5 billion credit facility of $455 million and $462 million at March 31, 2011 and December 31, 2010, respectively.
In January 2011, ACE Funding made principal payments of $6 million on Series 2002-1 Bonds, Class A-2, and $2 million on Series 2003-1 Bonds, Class A-2.
Financing Activities Subsequent to March 31, 2011
On April 5, 2011, ACE issued $200 million of 4.35% first mortgage bonds due April 1, 2021. The net proceeds were used to repay short term debt and for general corporate purposes.
On May 2, 2011, DPL repurchased, pursuant to a mandatory repurchase obligation, $35 million of 4.9% Delaware Economic Development Authority tax- exempt put bonds due May 1, 2026. DPL plans to remarket these bonds during the second quarter of 2011.
Collateral Requirements of Pepco Energy Services
Pepco Energy Services, in the ordinary course of its retail energy supply business, enters into various contracts to buy and sell electricity, fuels and related products, including derivative instruments, designed to reduce its financial exposure to changes in the value of its assets and obligations due to energy price fluctuations. These contracts typically have collateral requirements. Depending on the contract terms, the collateral required to be posted by Pepco Energy Services can be of varying forms, including cash and letters of credit.
During periods of declining energy prices, Pepco Energy Services has been exposed to the asymmetrical risk of having to post collateral under its wholesale purchase contracts without receiving a corresponding amount of collateral from its retail customers. To partially address these asymmetrical collateral obligations, Pepco Energy Services, in the first quarter of 2009, entered into a credit intermediation arrangement with Morgan Stanley Capital Group, Inc. (MSCG). Under this arrangement, MSCG, in consideration for the payment to MSCG of certain fees, (i) assumed, by novation, the electricity purchase obligations of Pepco Energy Services in years 2009 through 2011 under several wholesale purchase contracts, and (ii) agreed to supply electricity to Pepco Energy Services on the same terms as the novated transactions, but without imposing on Pepco Energy Services any obligation to post collateral based on changes in electricity prices. The upfront fees incurred by Pepco Energy Services in 2009 in the amount of $25 million are being amortized into expense in declining
amounts over the life of the arrangement based on the fair value of the underlying contracts at the time of the novation. For the three months ended March 31, 2011 and 2010, Pepco Energy Services recognized less than $1 million and approximately $2 million, respectively, of the fees in Interest expense.
As of March 31, 2011, Pepco Energy Services had posted net cash collateral of $87 million and provided letters of credit of $92 million. At December 31, 2010, Pepco Energy Services had posted net cash collateral of $117 million and provided letters of credit of $113 million. As its retail energy supply business is wound down, Pepco Energy Services collateral requirements will be further reduced.
At March 31, 2011 and December 31, 2010, the aggregate amount of cash, plus borrowing capacity under the credit facilities available to meet the combined future liquidity needs of Pepco Energy Services totaled $724 million and $728 million, respectively.
(10) INCOME TAXES
A reconciliation of PHIs consolidated effective income tax rate from continuing operations is as follows:
PHIs consolidated effective tax rates from continuing operations for the three months ended March 31, 2011 and 2010 were 35.4% and 47.2%, respectively. The reduction in the effective tax rate is partially due to changes in estimates and interest related to uncertain and effectively settled tax positions that had increased PHIs effective tax rate for the three months ended March 31, 2010. The changes, primarily related to a $2 million reversal of accrued interest income on state income tax positions that PHI no longer believes is more likely than not to be realized and the reversal of $6 million of erroneously accrued interest income on uncertain and effectively settled state income tax positions, each recorded in 2010.
The decrease in the rate is further impacted by the 2010 change in taxation of the Medicare Part D subsidy enacted by the Patient Protection and Affordable Care Act (Patient Protection Act) that increased PHIs effective tax rate for the three months ended March 31, 2010. PHI receives a tax-free federal subsidy for the costs it incurs for certain prescription drugs covered under its post-employment benefit plan. Prior to the Patient Protection Act, the costs incurred for those prescription drugs were also tax deductible. The Patient
Protection Act includes a provision, effective beginning in 2013, which eliminates the tax deductibility of the prescription drug costs. As a result, PHI wrote off $5 million of deferred tax assets. Of this amount, $3 million was established as a regulatory asset, which PHI anticipates will be recoverable from its utility customers in the future. This change increased PHIs first quarter 2010 tax expense by $4 million, which was partially offset through a reduction in Operating Expenses resulting in a $2 million decrease to net income.
The decrease in the rate between 2011 and 2010 is also affected by the 2010 release of $8 million of valuation allowances on deferred tax assets related to state net operating losses resulting from the planned restructuring of certain PHI subsidiaries. On April 1, 2010, as part of an ongoing effort to simplify PHIs organizational structure, certain of PHIs subsidiaries were converted to single member limited liability companies. In addition to increased organizational flexibility and reduced administrative costs, a consequence of converting these entities is to allow PHI to include income or losses in the former corporations in a single state income tax return, thus permitting the release of the valuation allowances.
(11) NON-CONTROLLING INTEREST
On February 25, 2011, ACE redeemed all of its outstanding cumulative preferred stock for approximately $6 million.
(12) EARNINGS PER SHARE
Reconciliations of the numerator and denominator for basic and diluted earnings per share (EPS) of common stock calculations are shown below:
(13) DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
Derivatives are used by the Pepco Energy Services and Power Delivery segments to hedge commodity price risk, as well as by PHI, from time to time, to hedge interest rate risk.
Pepco Energy Services purchases energy commodity contracts in the form of electricity and natural gas futures, swaps, options and forward contracts to hedge commodity price risk in connection with the purchase of physical natural gas and electricity for distribution to customers. The primary risk management objective is to manage the spread between retail sales commitments and the cost of supply used to service those commitments to ensure stable cash flows and lock in favorable prices and margins when they become available.
Pepco Energy Services commodity contracts that are not designated for hedge accounting, do not qualify for hedge accounting, or do not meet the requirements for normal purchase and normal sale accounting are marked to market through current earnings. Forward contracts that meet the requirements for normal purchase and normal sale accounting are accounted for using accrual accounting.
In the Power Delivery business, DPL uses derivative instruments in the form of swaps and over-the-counter options primarily to reduce gas commodity price volatility and to limit its customers exposure to increases in the market price of gas. DPL also manages commodity risk with physical natural gas and capacity contracts that are not classified as derivatives. All premiums paid and other transaction costs incurred as part of DPLs natural gas hedging activity, in addition to all gains and losses related to hedging activities, are deferred under FASB guidance on regulated operations (ASC 980) until recovered from its customers through a fuel adjustment clause approved by the DPSC.
PHI also uses derivative instruments from time to time to mitigate the effects of fluctuating interest rates on debt incurred in connection with the operation of their businesses. In June 2002, PHI entered into several treasury rate lock transactions in anticipation of the issuance of several series of fixed-rate debt commencing in August 2002. Upon issuance of the fixed rate debt in August 2002, the treasury rate locks were terminated at a loss. The loss has been deferred in Accumulated Other Comprehensive Loss (AOCL) and is being recognized in income over the life of the debt issued as interest payments are made.
The tables below identify the balance sheet location and fair values of derivative instruments as of March 31, 2011 and December 31, 2010:
Under FASB guidance on the offsetting of balance sheet accounts (ASC 210-20), PHI offsets the fair value amounts recognized for derivative instruments and the fair value amounts recognized for related collateral positions executed with the same counterparty under master netting agreements. The amount of cash collateral that was offset against these derivative positions is as follows:
As of March 31, 2011 and December 31, 2010, all PHI cash collateral pledged related to derivative instruments accounted for at fair value was entitled to offset under master netting agreements.
Derivatives Designated as Hedging Instruments
Cash Flow Hedges
Pepco Energy Services
For energy commodity contracts that are designated and qualify as cash flow hedges, the effective portion of the gain or loss on the derivative is reported as a component of AOCL and is reclassified into income in the same period or periods during which the hedged transactions affect income. Gains and losses on the derivative, representing either hedge ineffectiveness or hedge components excluded from the assessment of effectiveness, are recognized in income. Effective January 1, 2011, Pepco Energy Services elected to no longer apply cash flow hedge accounting to its natural gas derivatives. Amounts included in AOCL for natural gas flow hedges will remain and be reflected in earnings as the hedge transactions are completed. Cash flow hedge activity during the three months ended March 31, 2011 and 2010 is provided in the tables below:
As of March 31, 2011 and December 31, 2010, Pepco Energy Services had the following types and volumes of energy commodity contracts employed as cash flow hedges of forecasted purchases and forecasted sales.
All premiums paid and other transaction costs incurred as part of DPLs natural gas hedging activity, in addition to all of DPLs gains and losses related to hedging activities, are deferred under FASB guidance on regulated operations until recovered from customers through a fuel adjustment clause approved by the DPSC. The following table indicates the amounts of the net unrealized derivative gain (loss) deferred as a regulatory liability (regulatory asset) and the realized loss recognized in the Consolidated Statements of Income for the three months ended March 31, 2011 and 2010:
As of March 31, 2011 and December 31, 2010, DPL had the following outstanding commodity forward contracts that were entered into to hedge forecasted transactions:
Cash Flow Hedges Included in Accumulated Other Comprehensive Loss
The tables below provide details regarding effective cash flow hedges included in PHIs Consolidated Balance Sheet as of March 31, 2011 and 2010. Cash flow hedges are marked to market on the balance sheet with corresponding adjustments to AOCL. The data in the tables indicate the cumulative net loss after-tax related to effective cash flow hedges by contract type included in AOCL, the portion of AOCL expected to be reclassified to income during the next 12 months, and the maximum hedge or deferral term:
Other Derivative Activity
Pepco Energy Services
Pepco Energy Services holds certain derivatives that are not in hedge accounting relationships nor are they designated as normal purchases or normal sales. These derivatives are recorded at fair value on the balance sheet with changes in fair value recorded through income.
For the three months ended March 31, 2011 and 2010, the amount of the derivative gain (loss) for Pepco Energy Services recognized in income is provided in the table below:
As of March 31, 2011 and December 31, 2010, Pepco Energy Services had the following net outstanding commodity forward contract volumes and net position on derivatives that did not qualify for hedge accounting:
DPL holds certain derivatives that are not in hedge accounting relationships nor are they designated as normal purchases or normal sales. These derivatives are recorded at fair value on the Consolidated Balance Sheets with the gain or loss for the change in fair value recorded in income. In accordance with FASB guidance on regulated operations, offsetting regulatory liabilities or regulatory assets are recorded on the Consolidated Balance Sheets and the recognition of the gain or loss is deferred because of the DPSC-approved fuel adjustment clause. For the three months ended March 31, 2011 and 2010, the net amount of the unrealized derivative gain (loss) deferred as a regulatory liability (regulatory asset) and the net realized loss recognized in the Consolidated Statements of Income is provided in the table below:
As of March 31, 2011 and December 31, 2010, DPL had the following net outstanding natural gas commodity forward contracts that did not qualify for hedge accounting:
Contingent Credit Risk Features
The primary contracts used by the Pepco Energy Services and Power Delivery segments for derivative transactions are entered into under the International Swaps and Derivatives Association Master Agreement (ISDA) or similar agreements that closely mirror the principal credit provisions of the ISDA. The ISDAs include a Credit Support Annex (CSA) that governs the mutual posting and administration of collateral security. The failure of a party to comply with an obligation under the CSA, including an obligation to transfer collateral security when due or the failure to maintain any required credit support, constitutes an event of default under the ISDA for which the other party may declare an early termination and liquidation of all transactions entered into under the ISDA, including foreclosure against any collateral security. In addition, some of the ISDAs have cross default provisions under which a default by a party under another commodity or derivative contract, or the breach by a party of another borrowing obligation in excess of a specified threshold, is a breach under the ISDA.
Under the ISDA or similar agreements, the parties establish a dollar threshold of unsecured credit for each party in excess of which the party would be required to post collateral to secure its obligations to the other party. The amount of the unsecured credit threshold varies according to the senior, unsecured debt rating of the respective parties or that of a guarantor of the partys obligations. The fair values of all transactions between the parties are netted under the master netting provisions. Transactions may include derivatives accounted for on-balance sheet as well as those designated as normal purchases and normal sales that are accounted for off-balance sheet. If the aggregate fair value of the transactions in a net loss position exceeds the unsecured credit threshold, then collateral is required to be posted in an amount equal to the amount by which the unsecured credit threshold is exceeded. The obligations of Pepco Energy Services are usually guaranteed by PHI. The obligations of DPL are stand-alone obligations without the guaranty of PHI. If PHIs or DPLs credit rating were to fall below investment grade, the unsecured credit threshold would typically be set at zero and collateral would be required for the entire net loss position. Exchange-traded contracts are required to be fully collateralized without regard to the credit rating of the holder.
The gross fair value of PHIs derivative liabilities, excluding the impact of offsetting transactions or collateral under master netting agreements, with credit risk-related contingent features on March 31, 2011 and December 31, 2010, was $127 million and $156 million, respectively, before giving effect to the impact of a credit rating downgrade that would increase these amounts or offsetting transactions that are encompassed within master netting agreements that would alter these amounts. As of those dates, PHI had not posted any cash collateral against the gross derivative liability. PHIs net settlement amount in the event of a downgrade of PHIs and DPLs senior unsecured debt rating to below investment grade as of March 31, 2011 and December 31, 2010, would have been approximately $182 million and $176 million, respectively, after taking into consideration the master netting agreements. The offsetting transactions or collateral that would reduce PHIs obligation to the net settlement amount under master netting agreements include derivatives and normal purchase and normal sale contracts in a gain position as well as letters of credit already posted as collateral. At March 31, 2011 and December 31, 2010, normal purchase and normal sale contracts in a loss position also increased PHIs obligation.
PHIs primary sources for posting cash collateral or letters of credit are its credit facilities. At March 31, 2011 and December 31, 2010, the aggregate amount of cash plus borrowing capacity under the primary credit facilities available to meet the future liquidity needs of PHI and its subsidiaries totaled $1.2 billion, of which $724 million and $728 million, respectively, was available to Pepco Energy Services.
(14) FAIR VALUE DISCLOSURES
Fair Value of Assets and Liabilities Excluding Issued Debt and Equity Instruments
PHI has adopted FASB guidance on fair value measurement and disclosures (ASC 820) that established a framework for measuring fair value and expanded disclosures about fair value measurements. As defined in the guidance, fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price). PHI utilizes market data or assumptions that market participants would use in pricing the asset or liability, including assumptions about risk and the risks inherent in the inputs to the valuation technique. These inputs can be readily observable, market corroborated or generally unobservable. Accordingly, PHI utilizes valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs. The guidance establishes a fair value hierarchy that prioritizes the inputs used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (level 1) and the lowest priority to unobservable inputs (level 3). PHI classifies its fair value balances in the fair value hierarchy based on the observability of the inputs used in the fair value calculation as follows:
Level 1 Quoted prices are available in active markets for identical assets or liabilities as of the reporting date. Active markets are those in which transactions for the asset or liability occur in sufficient frequency and volume to provide pricing information on an ongoing basis, such as the New York Mercantile Exchange (NYMEX).
Level 2 Pricing inputs are other than quoted prices in active markets included in level 1, which are either directly or indirectly observable as of the reporting date. Level 2 includes those financial instruments that are valued using broker quotes in liquid markets and other observable data. Level 2 also includes those financial instruments that are valued using internally developed methodologies that have been corroborated by observable market data through correlation or by other means. Significant assumptions are observable in the marketplace throughout the full term of the instrument and can be derived from observable data or are supported by observable levels at which transactions are executed in the marketplace.
PHIs level 2 derivative instruments primarily consist of electricity derivatives at March 31, 2011. Level 2 power swaps are priced at liquid trading hub prices or valued using the liquid hub prices plus a congestion adder that is calculated using historical regression analysis.
Executive deferred compensation plan assets consist of life insurance policies that are categorized as level 2 assets because they are priced based on the assets underlying the policies, which consist of short-term cash equivalents and fixed income securities that are priced using observable market data. The level 2 liability associated with the life insurance policies represents a deferred compensation obligation, the value of which is tracked via underlying insurance sub-accounts. The sub-accounts are designed to mirror existing mutual funds and money market funds that are observable and actively traded.
Level 3 Pricing inputs include significant inputs that are generally less observable than those from objective sources. Level 3 includes those financial instruments that are valued using models or other valuation methodologies.
Derivative instruments categorized as level 3 include natural gas options purchased by DPL as part of a natural gas hedging program approved by the DPSC. Some non-standard assumptions are used in their forward valuation to adjust for the pricing; otherwise, most of the options follow NYMEX valuation. A few of the options have no significant NYMEX components and have to be priced using internal volatility assumptions.
Executive deferred compensation plan assets and liabilities that are classified as level 3 include certain life insurance policies that are valued using the cash surrender value of the policies, net of loans against those policies, which does not represent a quoted price in an active market.
The following tables set forth, by level within the fair value hierarchy, PHIs financial assets and liabilities (excluding assets and liabilities held for sale) that were accounted for at fair value on a recurring basis as of March 31, 2011 and December 31, 2010. As required by the guidance, financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. PHIs assessment of the significance of a particular input to the fair value measurement requires the exercise of judgment, and may affect the valuation of fair value assets and liabilities and their placement within the fair value hierarchy levels.
Reconciliations of the beginning and ending balances of PHIs fair value measurements using significant unobservable inputs (level 3) for the three months ended March 31, 2011 and 2010 are shown below:
The breakdown of realized and unrealized gains or (losses) on level 3 instruments included in income as a component of Other income or Other operation and maintenance expense for the periods below were as follows:
Fair Value of Debt and Equity Instruments
The estimated fair values of PHIs issued debt and equity instruments at March 31, 2011 and December 31, 2010 are shown below:
The fair value of Long-Term Debt issued by PHI and its utility subsidiaries was based on actual trade prices as of March 31, 2011 and December 31, 2010. Where trade prices were not available, PHI obtained and validated bid prices from brokers or used a discounted cash flow model to estimate fair value. The fair values of Transition Bonds issued by ACE Funding, including amounts due within one year, were derived based on bid prices obtained from brokers and validated by PHI because actual trade prices were not available.
The fair value of the Redeemable Serial Preferred Stock was derived based on quoted market prices.
The carrying amounts of all other financial instruments in the accompanying financial statements approximate fair value.
(15) COMMITMENTS AND CONTINGENCIES
Regulatory and Other Matters
District of Columbia Divestiture Case
In June 2000, the District of Columbia Public Service Commission (DCPSC) approved a divestiture settlement under which Pepco is required to share with its District of Columbia customers the net proceeds realized by Pepco from the sale of its generation-related assets in 2000. This approval left unresolved issues of (i) 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 and its implementing regulations and (ii) whether Pepco was entitled to deduct certain costs in determining the amount of proceeds to be shared.
In May 2010, the DCPSC issued an order addressing all of the remaining issues related to the sharing of the proceeds of Pepcos divestiture of its generating assets. In the order, the DCPSC ruled that Pepco is not required to share EDIT and ADITC with customers. However, the order also disallowed certain items that Pepco had included in the costs deducted from the proceeds of the sale of the generation assets. The disallowance of these costs, together with interest on the disallowed amount, increased the aggregate amount Pepco was required to distribute to customers, pursuant to the sharing formula, by approximately $11 million, which PHI recognized as an expense in 2010 and refunded the amounts to its customers. In June 2010, Pepco filed an application for reconsideration of the DCPSCs order, contesting (i) approximately $5 million of the total of $6 million in disallowances and (ii) approximately $4 million of the $5 million in interest to be credited to customers (reflecting a difference in the period of time over which interest was calculated as well as the balance to which interest would be applied). In July 2010, the DCPSC denied Pepcos application for reconsideration. In September 2010, Pepco filed an appeal of the DCPSCs decision with the District of Columbia Court of Appeals. On April 12, 2011, the Court of Appeals affirmed the DCPSC order. Pepco does not intend to appeal this decision.
Maryland Public Service Commission Reliability Investigation
In August 2010, following the major storm events that occurred in July and August 2010, the Maryland Public Service Commission (MPSC) initiated a proceeding for the purpose of investigating the reliability of the Pepco distribution system and the quality of distribution service Pepco is providing its customers. On February 10, 2011, the MPSC issued a notice expanding the scope of issues on which it requested testimony to include suggested remedies for the MPSC to consider imposing if the MPSC finds that Pepco has failed to meet its public service obligations. The possible remedies identified in the notice were the imposition of civil penalties, changes in the manner of Pepcos operations, modification of Pepcos service territory and revocation of Pepcos authority to exercise its public utility franchise. On March 2, 2011, an independent consultant retained by the MPSC to review and make recommendations regarding the reliability of Pepcos distribution system and the quality of its service filed its report with the MPSC. Pepco is preparing its testimony, which will address the report and will be filed in advance of the hearings to occur in mid-June 2011. While Pepco intends to cooperate fully with the MPSC in its efforts to ensure that the electric service provided by Pepco to its Maryland customers is reliable, it intends to oppose vigorously any effort of the MPSC to impose any sanctions of the types specified in the February 10, 2011 notice. Although Pepco believes that it has a strong factual and legal basis to oppose such sanctions, it cannot predict the outcome of this proceeding.
Over the last several years, PHIs utility subsidiaries have proposed the adoption of mechanisms to decouple retail distribution revenue from the amount of power delivered to retail customers. To date:
Under the BSA, customer distribution rates are subject to adjustment (through a credit or surcharge mechanism), depending on whether actual distribution revenue per customer exceeds or falls short of the revenue-per-customer amount approved by the applicable public service commission. The BSA increases rates if actual distribution revenues fall below the approved level and decreases rates if actual distribution revenues are above the approved level. The result is that, over time, the utility collects its authorized revenues for distribution service. As a consequence, a BSA decouples distribution revenue from unit sales consumption and ties the growth in distribution 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 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 distribution revenues. The MFVRD approved in concept in Delaware provides for a fixed customer charge (i.e., not tied to the customers volumetric consumption) to recover the utilitys fixed costs, plus a reasonable rate of return. Although different from the BSA, PHI views the MFVRD as an appropriate distribution revenue decoupling mechanism.
On February 1, 2011, the MPSC initiated proceedings for Pepco and DPL, as well as unaffiliated utilities including Baltimore Gas & Electric Company and Southern Maryland Electric Cooperative, for the purpose of reviewing how the BSA operates to recover revenues lost as a result of major storm outages. In its orders initiating the proceedings, the MPSC expressed concern that the utilities respective BSAs may be allowing them to recover revenues lost during extended outages, therefore unintentionally eliminating an incentive to restore service quickly. The MPSC will consider whether the BSA, as currently in effect, is appropriate, whether the calculations or determinant factors for calculating the BSA should be modified, and if so, what modifications should be made. The MPSC has scheduled a legislative-style hearing on this matter in July 2011. An adjustment to remove revenues lost as a result of major storm outages is already included in the BSA for Pepco in the District of Columbia as approved by the DCPSC. The materiality of any such BSA modifications that may be made by the MPSC would depend on the duration and extent of any major storm outages.
DPL makes an annual Gas Cost Rate (GCR) filing with the DPSC for the purpose of allowing DPL to recover gas procurement costs through customer rates. In August 2010, DPL made its 2010 GCR filing, which proposes rates that would allow DPL to recover an amount equal to a two-year amortization of currently under-recovered gas costs. In October 2010, the DPSC issued an order allowing DPL to place the new rates into effect on November 1, 2010, subject to refund and pending final DPSC approval. The effect of the proposed two-year amortization upon rates is an increase of 0.1% in the level of GCR. If the DPSC does not accept DPLs proposal for a two-year amortization, the adjustment would result in an increase of 6.9% in the GCR.
In July 2010, DPL submitted an application with the DPSC to increase its natural gas distribution base rates. As subsequently amended in September 2010 (to replace test year data for the twelve months ended June 2010 with the actual data) and in October 2010 (based on an update to DPLs natural gas advanced metering infrastructure implementation schedule), the filing seeks approval of an annual rate increase of approximately $10.2 million, assuming the implementation of the MFVRD, based on a requested return on equity (ROE) of 11.00%. As permitted by Delaware law, DPL placed an annual increase of approximately $2.5 million annually into effect, on a temporary basis, on August 31, 2010, and the remainder of approximately $7.7 million of the requested increase was placed into effect on February 2, 2011, in each case subject to refund and pending final DPSC approval. On February 9, 2011, DPL, DPSC staff, and the Attorney General of Delaware entered into a proposed settlement agreement, which provides for an annual rate increase of approximately $5.8 million, based on an ROE of 10%. In the settlement agreement, the parties agreed to defer the implementation of the MFVRD until an implementation plan and a customer education plan are developed. The proposed settlement agreement is subject to final review and approval by the DPSC. A decision is expected by the end of July 2011. The excess amount collected will be refunded to customers through a bill credit after final DPSC approval of a refund plan.
In December 2009, Pepco filed an electric distribution base rate case in Maryland. The filing sought approval of an annual rate increase of approximately $40 million, based on a requested ROE of 10.75%. During the course of the proceeding, Pepco reduced its request to approximately $28.2 million. In August 2010, the MPSC issued an order approving a rate increase of approximately $7.8 million, based on an ROE of 9.83%, which Pepco placed into effect on August 19, 2010. In September 2010, Pepco filed with the MPSC a motion for reconsideration of the following issues, which, if approved, in the aggregate would increase annual revenue by approximately $8.5 million: (i) denial of inclusion in rate base of certain reliability plant investments, which occurred subsequent to the test period but before the rate effective period; (ii) denial of Pepcos request to increase depreciation rates to reflect a corrected formula relating to the cost of removal expenses; and (iii) imposition of imputed cost savings to partially offset the costs of Pepcos enhanced vegetation management program. Maryland law and regulation do not mandate a response time from the MPSC regarding Pepcos motion and, therefore, it is not known when the MPSC will issue a ruling on the motion.
On December 21, 2010, DPL filed an application with the MPSC to increase its electric distribution base rates by $17.8 million annually, based on an ROE of 10.75%. On December 28, 2010, the MPSC, consistent with its typical practice, issued an order suspending the proposed rate increase request for an initial period of 150 days from January 20, 2011 pending investigation by the MPSC.
Retained Environmental Exposures from the Sale of the Conectiv Energy Wholesale Power Generation Business
On July 1, 2010, PHI sold the Conectiv Energy wholesale power generation business to Calpine. Under New Jerseys Industrial Site Recovery Act (ISRA), the transfer of ownership triggered an obligation on the part of Conectiv Energy to remediate any environmental contamination at each of the nine Conectiv Energy generating facility sites located in New Jersey. Under the terms of the sale, Calpine has assumed responsibility for performing the ISRA-required remediation and for the payment of all related ISRA compliance costs up to $10 million. PHI is obligated to indemnify Calpine for any ISRA compliance remediation costs in excess of $10 million. According to preliminary estimates, the costs of ISRA-required remediation activities at the nine generating facility sites located in New Jersey are in the range of approximately $7 million to $18 million. PHI has accrued approximately $4 million as of March 31, 2011 for the ISRA-required remediation activities at the nine generating facility sites.
The sale of the Conectiv Energy wholesale power generation business to Calpine did not include a coal ash landfill site located at the Edge Moor generating facility, which PHI intends to close. The preliminary estimate of the costs to PHI to close the coal ash landfill ranges from approximately $2 million to $3 million, plus annual post-closure operations, maintenance and monitoring costs, estimated to range between $120,000 and $193,000 per year for 30 years. As of March 31, 2011, PHI had accrued approximately $5 million for landfill closure and monitoring.
In orders issued in 2007, the New Jersey Department of Environmental Protection (NJDEP) assessed penalties against Conectiv Energy in an aggregate amount of approximately $2 million, based on NJDEPs contention that Conectiv Energys Deepwater generating facility exceeded the maximum allowable hourly heat input limits during certain periods in calendar years 2004, 2005 and 2006. Conectiv Energy has appealed the NJDEP orders imposing these penalties to the New Jersey Office of Administrative Law. PHI is continuing to prosecute this appeal and has agreed to indemnify Calpine for any monetary penalties, fines or assessments arising out of the NJDEP orders. At this time, the costs to resolve this matter are not expected to be material.
In 1993, Pepco was served with Amended Complaints filed in the state Circuit Courts of Prince Georges 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 Pepcos 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 March 31, 2011, 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 were tendered to Mirant Corporation (Mirant) for defense and indemnification in connection with the sale by Pepco of its generation assets to Mirant in 2000.
While the aggregate amount of monetary damages sought in the remaining suits (excluding those tendered to Mirant) is approximately $360 million, PHI and Pepco believe the amounts claimed by the remaining 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, PHI and Pepco do not believe these suits will have a material adverse effect on their respective financial conditions, results of operations or cash flows. However, if an unfavorable decision were rendered against Pepco, it could have a material adverse effect on Pepcos and PHIs financial condition, results of operations and cash flows.
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. PHIs 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.
Franklin Slag Pile Site. In November 2008, ACE received a general notice letter from the U.S. Environmental Protection Agency (EPA) concerning the Franklin Slag Pile site in Philadelphia, Pennsylvania, asserting that ACE is a potentially responsible party (PRP) that may have liability with respect to the site. If liable, ACE would be responsible for reimbursing EPA for clean-up costs incurred and to be incurred by the agency and for the costs of implementing an EPA-mandated remedy. EPAs claims are based on ACEs sale of boiler slag from the B.L. England generating facility, then owned by ACE, to MDC Industries, Inc. (MDC) during the period June 1978 to May 1983. EPA claims that the boiler slag ACE sold to MDC contained copper and lead, which are hazardous substances under the Comprehensive Environmental Response, Compensation, and Liability Act of 1980 (CERCLA), and that the sales transactions may have constituted an arrangement for the disposal or treatment of hazardous substances at the site, which could be a basis for liability under CERCLA. The EPA letter also states that, as of the date of the letter, EPAs expenditures for response measures at the site have exceeded $6 million. EPA estimates the cost for future response measures will be approximately $6 million. ACE understands that EPA sent similar general notice letters to three other companies and various individuals.
ACE believes that the B.L. England boiler slag sold to MDC was a valuable material with various industrial applications and, therefore, the sale was not an arrangement for the disposal or treatment of any hazardous substances as would be necessary to constitute a basis for liability under CERCLA. ACE intends to contest any claims to the contrary made by EPA. In a May 2009 decision arising under CERCLA, which did not involve ACE, the U.S. Supreme Court rejected an EPA argument that the sale of a useful product constituted an arrangement for disposal or treatment of hazardous substances. While this decision supports ACEs position, at this time ACE cannot predict how EPA will proceed with respect to the Franklin Slag Pile site, or what portion, if any, of the Franklin Slag Pile site response costs EPA would seek to recover from ACE. Costs to resolve this matter are not expected to be material.
Peck Iron and Metal Site. EPA informed Pepco in a May 2009 letter that Pepco may be a PRP under CERCLA with respect to the cleanup of the Peck Iron and Metal site in Portsmouth, Virginia, for costs EPA has incurred in cleaning up the site. The EPA letter states that Peck Iron and Metal purchased, processed, stored and shipped metal scrap from military bases, governmental agencies and businesses and that Pecks metal scrap operations resulted in the improper storage and disposal of hazardous substances. EPA bases its allegation that Pepco arranged for disposal or treatment of hazardous substances sent to the site on
information provided by Peck Iron and Metal personnel, who informed EPA that Pepco was a customer at the site. Pepco has advised EPA by letter that its records show no evidence of any sale of scrap metal by Pepco to the site. Even if EPA has such records and such sales did occur, Pepco believes that any such scrap metal sales are entitled to the recyclable material exemption from CERCLA liability. At this time Pepco cannot predict how EPA will proceed regarding this matter, or what portion, if any, of the Peck Iron and Metal site response costs EPA would seek to recover from Pepco. In a notice published on November 4, 2009, EPA placed the Peck Iron and Metal site on the National Priorities List (NPL). The NPL, among other things, serves as a guide to EPA in determining which sites warrant further investigation to assess the nature and extent of the human health and environmental risks associated with a site. The amount of the remediation costs that may be imposed cannot be predicted at this time; however, based on current information, PHI and Pepco do not believe these suits will have a material adverse effect on their respective financial conditions, results of operations or cash flows.
Ward Transformer Site. In April 2009, a group of PRPs with respect to the Ward Transformer site in Raleigh, North Carolina, filed a complaint in the U.S. District Court for the Eastern District of North Carolina, alleging cost recovery and/or contribution claims against a number of entities, including ACE, DPL and Pepco with respect to past and future response costs incurred by the PRP group in performing a removal action at the site. With the courts permission, the plaintiffs filed amended complaints in September 2009. ACE, DPL and Pepco, as part of a group of defendants, filed a motion to dismiss in October 2009. In a March 2010 order, the court denied the defendants motion to dismiss. Although it is too early in the process to characterize the magnitude of the potential liability at this site, PHI does not believe that any of its three utility subsidiaries had extensive business transactions, if any, with the Ward Transformer site and therefore, costs incurred to resolve this matter are not expected to be material.
Benning Road Site. In September 2010, PHI received a letter from EPA stating that EPA and the District of Columbia Department of the Environment (DDOE) have identified the Benning Road location, consisting of a transmission and distribution facility operated by Pepco and a generation facility operated by Pepco Energy Services, as one of six land-based sites potentially contributing to contamination of the lower Anacostia River. The letter stated that the principal contaminants of concern are polychlorinated biphenyls (PCBs) and polycyclic aromatic hydrocarbons, that EPA is monitoring the efforts of DDOE and that EPA intends to use federal authority to address the Benning Road site if an agreement for a comprehensive study to evaluate (and, if necessary, to clean up the facility) is not reached. In an October 2010 letter, the Office of the Attorney General of the District of Columbia notified PHI of the Districts intent to sue Pepco Energy Services and Pepco under the Resource Conservation and Recovery Act for abatement of conditions related to their historical activities, including the discharge of PCBs at the Benning Road site. The Districts letter stated that EPA will list the Benning Road site on the NPL if contamination at the facility is not addressed in a timely manner. In January 2011, in response to these EPA and District of Columbia letters, Pepco and Pepco Energy Services entered into a consent decree with DDOE that requires the PHI entities to conduct a remedial investigation and feasibility study (RI/FS) for the Benning Road site and an approximately 10-15 acre portion of the adjacent Anacostia River. The RI/FS will form the basis for DDOEs selection of a remedial action for the Benning Road site and for the Anacostia River sediment associated with the site. In February 2011, the consent decree was filed with the United States District Court, but will not become final until the DDOE files a motion requesting the District Court to enter the consent decree. In light of the consent decree, Pepco and Pepco Energy Services anticipate that EPA will recognize that Pepco and Pepco Energy Services are making constructive movement toward cleanup and will refrain from listing the Benning Road facility on the NPL. PHI preliminarily estimates that costs for performing the RI/FS will be approximately $600,000 and the remediation costs will be approximately $13 million. As of March 31, 2011, PHI had an accrued liability of $14 million with respect to this matter.
Prices Pit Site. ACE owns a transmission and distribution right-of-way that traverses the Prices Pit superfund site in Egg Harbor Township, New Jersey. EPA placed Prices Pit on the NPL in 1983 and NJDEP undertook an environmental investigation to identify and implement remedial action at the site. NJDEPs investigation revealed that landfill waste had been disposed on ACEs right-of-way and NJDEP determined
that ACE was a responsible party at the site as the owner of a facility on which a hazardous substance has been deposited. ACE currently is engaged in settlement negotiations with NJDEP and EPA to resolve its alleged liability at the site by donating property to NJDEP and by making a payment in an amount to be determined. Costs to resolve this matter are not expected to be material.
Appeal of New Jersey Flood Hazard Regulations. In November 2007, NJDEP adopted amendments to the agencys regulations under the Flood Hazard Area Control Act (FHACA) to minimize damage to life and property from flooding caused by development in flood plains. The amended regulations impose a new regulatory program to mitigate flooding and related environmental impacts from a broad range of construction and development activities, including electric utility transmission and distribution construction, which were previously unregulated under the FHACA. These regulations impose restrictions on construction of new electric transmission and distribution facilities and increase the time and personnel resources required to obtain permits and conduct maintenance activities. In November 2008, ACE filed an appeal of these regulations with the Appellate Division of the Superior Court of New Jersey. The grounds for ACEs appeal include the lack of administrative record justification for the FHACA regulations and conflict between the FHACA regulations and other state and federal regulations and standards for maintenance of electric power transmission and distribution facilities. The matter was argued before the Appellate Division on January 3, 2011 and the decision of the court is pending. The financial impact related to these amendments cannot be predicted at this time; however, based on current information, PHI and ACE do not believe these suits will have a material adverse effect on their respective financial conditions, results of operations or cash flows.
Indian River Oil Release
In 2001, DPL entered into a consent agreement with the Delaware Department of Natural Resources and Environmental Control for remediation, site restoration, natural resource damage compensatory projects and other costs associated with environmental contamination resulting from an oil release at the Indian River generating facility, which was sold in June 2001. As of March 31, 2011, DPLs accrual for expected future costs to fulfill its obligations under the consent agreement was approximately $5 million, of which approximately $1 million is expected to be incurred during the remainder of 2011.
Potomac River Mineral Oil Release
On January 23, 2011, a coupling failure on a transformer cooler pipe resulted in a release of non-toxic mineral oil at Pepcos Potomac River substation in Alexandria, Virginia. An overflow of an underground secondary containment reservoir resulted in approximately 4,500 gallons of mineral oil flowing into the Potomac River.
On March 22, 2011 and March 31, 2011, DDOE issued compliance directives that require Pepco to prepare an incident report, provide certain records, amend Pepcos surface water and river sediments sampling plan and prepare ecological risk assessment and natural resources damage assessment work plans. Pepco is complying with DDOEs compliance directives. On March 16, 2011, the Virginia Department of Environmental Quality (VADEQ) requested documentation regarding the release and the preparation of an emergency response report, which Pepco submitted to the agency on April 20, 2011. On March 25, 2011, Pepco received a notice of violation from VADEQ, which advised Pepco of information on which VADEQ may rely to institute an administrative or judicial enforcement action in connection with the mineral oil release and indicated that Pepco may be asked to enter into a consent order to formalize a corrective action plan and schedule. The amount of penalties, if any, that may be imposed by either or both of these agencies cannot be predicted at this time; however, based on current information, PHI and Pepco do not believe this matter will have a material adverse effect on their respective financial conditions, results of operations or cash flows.
PHIs Cross-Border Energy Lease Investments
Between 1994 and 2002, PCI, a subsidiary of PHI, entered into eight cross-border energy lease investments involving public utility assets (primarily consisting of hydroelectric generation and coal-fired electric generation facilities and natural gas distribution networks) located outside of the United States. Each of these investments is structured as a sale and leaseback transaction commonly referred to by the Internal Revenue Service (IRS) as a sale-in/lease-out or SILO transaction. PHIs current annual tax benefits from these eight cross-border energy lease investments are approximately $56 million. As of March 31, 2011, PHIs equity investment in its cross-border energy leases was approximately $1.4 billion. From January 1, 2001, the earliest year that remains open to audit, to March 31, 2011, PHI has claimed approximately $589 million in federal and state income tax benefits from the depreciation and interest deductions in excess of rental income with respect to these cross-border energy lease investments.
In 2005, the Treasury Department and IRS issued Notice 2005-13 identifying sale-leaseback transactions with certain attributes entered into with tax-indifferent parties as tax avoidance transactions, and the IRS announced its intention to disallow the associated tax benefits claimed by the investors in these transactions. PHIs cross-border energy lease investments, each of which is with a tax-indifferent party, have been under examination by the IRS as part of the normal PHI federal income tax audits. In the final IRS revenue agents reports issued in June 2006 and in March 2009 in connection with the audit of PHIs 2001-2002 and 2003-2005 income tax returns, respectively, the IRS disallowed the depreciation and interest deductions in excess of rental income claimed by PHI with respect to each of its cross-border energy lease investments. In addition, the IRS has sought to recharacterize each of the leases as a loan transaction as to which PHI would be subject to original issue discount income. PHI disagrees with the IRS proposed adjustments and filed tax protests in August 2006 and May 2009, respectively, in connection with the audit of the 2001-2002 and the 2003-2005 income tax returns. Both of these protests were forwarded to the IRS Appeals Office. On August 9, 2010, PHI signed an IRS settlement statement with respect to the 2001-2002 income tax returns agreeing to the IRSs disallowance of depreciation and interest deductions in excess of rental income with respect to the cross-border energy lease investments, but reserving its right to file timely refund claims in which it would contest the disallowances. The Joint Tax Committee approved the settlement on November 10, 2010. In January 2011, PHI paid $74 million of additional tax associated with the disallowed deductions from the cross-border energy lease investment for 2001 and 2002, plus penalties of $1 million and any interest associated with the disallowed deductions once the IRS assesses the amount due. PHI currently intends to file a refund claim for the additional taxes and related interest and penalties incurred by reason of the disallowed deductions, which it expects the IRS to deny, and if so, PHI intends to pursue litigation in the U.S. Court of Federal Claims against the IRS to defend its tax position and recover the tax payment, interest, and penalties. Absent a settlement, litigation against the IRS may take several years to resolve. The 2003-2005 income tax return review continues to be in process with the IRS Appeals Office.
At December 31, 2010 and 2009, PHI modified its tax cash flow assumptions under its cross-border energy lease investments for the periods 2010-2013 and 2010-2012, respectively, to reflect the anticipated timing of potential litigation with the IRS concerning the investments. As a result of the 2009 recalculation, PHI recorded a $2 million after-tax non-cash charge to earnings at December 31 2009, and recorded an additional $3 million in after-tax non-cash earnings during 2010 (as compared to the earnings that it would have recorded absent the 2009 recalculation). As a result of the 2010 recalculation, PHI recorded a $1 million after-tax non-cash charge to earnings at December 31, 2010.
In the event that the IRS were to be successful in disallowing 100% of the tax benefits associated with these leases and recharacterizing these leases as loans, PHI estimates that, as of March 31, 2011, it would be obligated to pay approximately $636 million in additional federal and state taxes and $137 million of interest. The $636 million in additional federal and state taxes is net of the $74 million tax payment made in January 2011. In addition, the IRS could require PHI to pay a penalty of up to 20% on the amount of additional taxes due.
PHI anticipates that any additional taxes that it would be required to pay as a result of the disallowance of prior deductions or a re-characterization of the leases as loans would be recoverable in the form of lower taxes over the remaining terms of the affected leases. Moreover, the entire amount of any additional tax would not be due immediately. Rather, the federal and state taxes would be payable when the open audit years are closed and PHI amends subsequent tax returns not then under audit. To mitigate the taxes due in the event of a total disallowance of tax benefits, PHI could, were it to so elect, choose to liquidate all or a portion of its cross-border energy lease portfolio, which PHI estimates could be accomplished over a period of six months to one year. Based on current market values, PHI estimates that liquidation of the entire portfolio would generate sufficient cash proceeds to cover the estimated $773 million in federal and state taxes and interest due as of March 31, 2011, in the event of a total disallowance of tax benefits and a recharacterization of the transactions as loans. If payments of additional taxes and interest preceded the receipt of liquidation proceeds, the payments would be funded by currently available sources of liquidity.
To the extent that PHI does not to prevail in this matter and suffers a disallowance of the tax benefits and incurs imputed original issue discount income due to the recharacterization of the leases as loans, PHI would be required under FASB guidance on leases (ASC 840) to recalculate the timing of the tax benefits generated by the cross-border energy lease investments and adjust the equity value of the investments, which would result in a non-cash charge to earnings.
District of Columbia Tax Legislation
In December 2009, the Mayor of the District of Columbia approved legislation adopted by the District Council that imposes mandatory unitary combined reporting (MUCR) beginning with tax year 2011 for companies doing business in the District of Columbia. The Council must still enact further legislation providing guidance on how to implement MUCR before this legislation is effective. The required implementing legislation has been included in the Mayors budget proposal (the Budget Bill) for the fiscal year ending September 30, 2012, which was submitted to the Council on April 1, 2011.
Based upon PHIs interpretation of the language in the Budget Bill, the legislation would, if enacted, result in a change in PHIs overall state income tax rate and could require a material adjustment to PHIs net deferred income tax liabilities. Further, to the extent that the change in rate increases net deferred income tax liabilities, PHI must determine if these increased tax liabilities are probable of recovery in future rates. Public hearings will be held on the Budget Bill in May 2011, with a vote to be taken by the Council on June 7, 2011. If the Council approves the Budget Bill, including the MUCR implementation guidance, the legislation is subject to a 30-day Congressional review period and, if Congress does not intervene during this review period, the legislation will become binding law. The effect of the legislation has not been accounted for as of March 31, 2011, because the legislative process was not complete.
Management continues to analyze the impact that the tax reporting aspects of this legislation, if completed, may have on the financial position, results of operations and cash flows of PHI and its subsidiaries.
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 that they have entered into in the normal course of business to facilitate commercial transactions with third parties as discussed below.
As of March 31, 2011, 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 commitments and obligations, in millions of dollars, were as follows:
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.
Energy Savings Performance Contracts
Pepco Energy Services has a diverse portfolio of energy savings performance contracts that are associated with the installation of energy savings equipment for federal, state and local government customers. As part of those contracts, Pepco Energy Services typically guarantees that the equipment or systems installed by Pepco Energy Services will generate a specified amount of energy savings on an annual basis over a multi-year period. As of March 31, 2011, Pepco Energy Services energy savings guarantees on both completed projects and projects under construction totaled $405 million over the life of the performance contracts with the longest remaining term being 15 years. On an annual basis, Pepco Energy Services undertakes a measurement and verification process to determine the amount of energy savings for the year and whether there is any shortfall in the annual energy savings compared to the guaranteed amount. Pepco Energy Services recognizes a liability for the value of the estimated energy savings shortfall when it is probable that the guaranteed energy savings will not be achieved and the amount is reasonably estimable. The accrued liability for energy savings performance contracts has not changed significantly during the three months ended March 31, 2011 and currently is less than $1 million. Pepco Energy Services did not make any significant payouts under the contracts and there was no significant change in the type of contracts issued for the three months ended March 31, 2011. Based on its historical experience, Pepco Energy Services believes the probability of incurring a material loss under its energy savings performance contracts is remote.
On April 28, 2011, Pepco Holdings Board of Directors declared a dividend on common stock of 27 cents per share payable June 30, 2011, to shareholders of record on June 10, 2011.
(16) DISCONTINUED OPERATIONS
In April 2010, the Board of Directors of PHI approved a plan for the disposition of Conectiv Energy. The plan consists of (i) the sale of Conectiv Energys wholesale power generation business and (ii) the liquidation, within the succeeding twelve months, of all of Conectiv Energys remaining assets and businesses, including its load service supply contracts, energy hedging portfolio, certain tolling agreements and other non-generation assets. In accordance with the plan, PHI on the same day entered into a purchase agreement with Calpine, under the terms of which, Calpine agreed to purchase Conectiv Energys wholesale power generation business.
On July 1, 2010, PHI completed the sale of the wholesale power generation business to Calpine from which PHI received proceeds at the closing in the amount of approximately $1.64 billion. The liquidation of the remaining Conectiv Energy assets and businesses has been substantially completed.
As a result of the adoption of the plan of disposition, PHI commenced reporting the results of operations of the former Conectiv Energy segment in discontinued operations in all periods presented in the accompanying Consolidated Statements of Income. Further, the assets and liabilities of Conectiv Energy, excluding the related current and deferred income tax accounts and certain retained liabilities, are reported as held for sale as of each date presented in the accompanying Consolidated Balance Sheets.
The operating results of Conectiv Energy are as follows:
Income from operations of discontinued operations, net of income taxes for the three months ended March 31, 2011, includes after-tax income of $4 million arising from adjustments to certain accrued expenses for obligations associated with the sale of the wholesale power generation business to Calpine. These adjustments were made to reflect the actual amounts paid to Calpine during the first quarter of 2011.
Net losses from dispositions of assets and businesses of discontinued operations, net of income taxes for the three months ended March 31, 2011 includes an expense of approximately $1 million (after-tax) which was incurred in connection with the financial transaction entered into with a third party on January 6, 2011, under which Conectiv Energy transferred its remaining portfolio of derivatives, including financially settled natural gas and electric power transactions, for all remaining periods from February 1, 2011 forward. In connection with the closing of the transaction, Conectiv paid the third party $82 million, primarily representing the fair value of the derivatives at February 1, 2011, and an after-tax administrative fee of $1 million. Substantially all of the mark-to-market gains and losses associated with these derivatives were recorded in earnings through December 31, 2010 and accordingly no additional material gain or loss was recognized as a result of this transaction in 2011.
Balance Sheet Information
Details of the assets and liabilities of Conectiv Energy held for sale at March 31, 2011 and December 31, 2010 are as follows:
Derivative Instruments and Hedging Activities
Conectiv Energy used derivative instruments primarily to reduce its financial exposure to changes in the value of its assets and obligations due to commodity price fluctuations. The derivative instruments used included forward contracts, futures, swaps, and exchange-traded and over-the-counter options. The two primary risk management objectives were: (i) to manage the spread between the cost of fuel used to operate electric generation facilities and the revenue received from the sale of the power produced by those facilities, and (ii) to manage the spread between wholesale sale commitments and the cost of supply used to service those commitments to ensure stable cash flows and lock in favorable prices and margins when they became available.
Through June 30, 2010, Conectiv Energy purchased energy commodity contracts in the form of futures, swaps, options and forward contracts to hedge price risk in connection with the purchase of physical natural gas, oil and coal to fuel its generation assets for sale to customers. Conectiv Energy also purchased energy commodity contracts in the form of electricity swaps, options and forward contracts to hedge price risk in connection with the purchase of electricity for distribution to requirements-load customers. Through June 30, 2010, Conectiv Energy sold electricity swaps, options and forward contracts to hedge price risk in connection with electric output from its generating facilities. Conectiv Energy accounted for most of its futures, swaps and certain forward contracts as cash flow hedges of forecasted transactions. Derivative contracts purchased or sold in excess of probable amounts of forecasted hedge transactions were marked to market through current earnings. All option contracts were marked to market through current earnings. Certain natural gas and oil futures and swaps were used as fair value hedges to protect the value of natural gas transportation contracts and physical fuel inventory. Some forward contracts were accounted for using standard accrual accounting since these contracts met the requirements for normal purchase and normal sale accounting.
As of March 31, 2011, Conectiv Energy had no material energy commodity contracts and substantially all cash collateral had been returned.
The tables below identify the balance sheet location and fair values of Conectiv Energys derivative instruments as of March 31, 2011 and December 31, 2010:
Under FASB guidance on the offsetting of balance sheet accounts (ASC 210-20), PHI offsets the fair value amounts recognized for derivative instruments and the fair value amounts recognized for related collateral positions executed with the same counterparty under master netting agreements. The amount of cash collateral that was offset against these derivative positions is as follows:
As of December 31, 2010, all cash collateral pledged related to Conectiv Energys derivative instruments accounted for at fair value was entitled to offset under master netting agreements.
Derivatives Designated as Hedging Instruments
Cash Flow Hedges
For energy commodity contracts that are designated and qualify as cash flow hedges, the effective portion of the gain or loss on the derivative is reported as a component of AOCL and is reclassified into income in the same period or periods during which the hedged transactions affect income. Gains and losses on the derivative representing either hedge ineffectiveness or hedge components excluded from the assessment of effectiveness are recognized in current income. This information for the activity of Conectiv Energy during the three months ended March 31, 2011 and 2010 is provided in the table below:
As of March 31, 2011 and December 31, 2010, Conectiv Energy had no energy commodity contracts employed as cash flow hedges.
Cash Flow Hedges Included in Accumulated Other Comprehensive Loss
As of March 31, 2011, Conectiv Energy had no remaining AOCL. The table below provides details regarding effective cash flow hedges of Conectiv Energy included in PHIs Consolidated Balance Sheet as of March 31, 2010. Cash flow hedges are marked to market on the Consolidated Balance Sheet with corresponding adjustments to AOCL to the extent the hedges are effective. The data in the table indicates the cumulative net loss after-tax related to effective cash flow hedges by contract type included in AOCL, the portion of AOCL expected to be reclassified to income during the next 12 months, and the maximum hedge or deferral term:
Other Derivative Activity
In connection with its energy commodity activities, Conectiv Energy held certain derivatives that did not qualify as hedges. Under FASB guidance on derivatives and hedging, these derivatives are recorded at fair value on the balance sheet with changes in fair value recognized in income.
The amount of realized and unrealized derivative gains (losses) for Conectiv Energy included in (Loss) income from discontinued operations, net of income taxes, for the three months ended March 31, 2011 and 2010, is provided in the table below:
As of March 31, 2011 and December 31, 2010, Conectiv Energy had the following net outstanding commodity forward contract volumes and net positions on derivatives that did not qualify for hedge accounting: