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 September 30, 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
Some of the statements contained in this Quarterly Report on Form 10-Q with respect to PHI, Pepco, DPL and ACE, including each of their respective subsidiaries (each, a Reporting Company) are forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended (the Exchange Act), and Section 27A of the Securities Act of 1933, as amended, and are subject to the safe harbor created thereby and by the Private Securities Litigation Reform Act of 1995. These statements include declarations regarding the intents, beliefs and current expectations of one or more Reporting Companies. In some cases, you can identify forward-looking statements by terminology such as may, might, will, should, could, expects, intends, assumes, seeks to, plans, anticipates, believes, projects, estimates, predicts, potential, future, goal, objective, or continue or the negative of such terms or other variations thereof or comparable terminology, or by discussions of strategy that involve risks and uncertainties. Forward-looking statements involve estimates, assumptions, known and unknown risks, uncertainties and other factors that may cause one or more Reporting Companys actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by such forward-looking statements. Therefore, forward-looking statements are not guarantees or assurances of future performance, and actual results could differ materially from those indicated by the forward-looking statements.
The forward-looking statements contained herein are qualified in their entirety by reference to the following important factors, which are difficult to predict, contain uncertainties, are beyond each Reporting Companys control and may cause actual results to differ materially from those contained in forward-looking statements:
These forward-looking statements are also qualified by, and should be read together with, the risk factors included in Part I, Item 1A. Risk Factors in each Reporting Companys Annual Report on Form 10-K for the year ended December 31, 2010 (2010 Form 10-K), and Part II, Item 1A. Risk Factors in each Reporting Companys Quarterly Report on Form 10-Q for the quarterly periods ended March 31, 2011 and June 30, 2011 (the March and June 2011 Form 10-Qs), as filed with the Securities and Exchange Commission, and in this Form 10-Q, and investors should refer to those sections of the 2010 Form 10-K, the March and June 2011 Form 10-Qs and this Form 10-Q for more information on such risk factors.
Any forward-looking statements speak only as to the date of this Quarterly Report on Form 10-Q for each Reporting Company and each Reporting Company undertakes no obligation to update any forward-looking statements to reflect events or circumstances after the date on which such statements are made or to reflect the occurrence of unanticipated events. New factors emerge from time to time, and it is not possible for a Reporting Company to predict all such factors, nor can the impact of any such factor be assessed on such Reporting Companys business (viewed independently or together with the business or businesses of some or all of the other Reporting Companies) or the extent to which any factor, or combination of factors, may cause results to differ materially from those contained in any forward-looking statement. The foregoing factors should not be construed as exhaustive.
PART I FINANCIAL INFORMATION
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 (LOSS)
The accompanying Notes are an integral part of these Consolidated Financial Statements.
PEPCO HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
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):
PHI and each of its utility subsidiaries is registered and files periodic reports with the Securities and Exchange Commission (SEC) under the Securities Exchange Act of 1934, as amended. Together the three utilities constitute a single segment, Power Delivery, 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.
Pepco, DPL and ACE are each regulated public utilities in the jurisdictions that comprise its service territory. Each utility 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 utility 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 Offer 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 respective expiration dates the last of which is June 1, 2014. 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 September 30, 2011 and 2010 were $217 million and $377 million, respectively, while operating income for the same periods was $5 million and $15 million, respectively. Operating revenues related to the retail energy supply business for the nine months ended September 30, 2011 and 2010 were $753 million and $1,275 million, respectively, while operating income for the same periods was $21 million and $45 million, respectively.
In connection with the operation of the retail energy supply business, Pepco Energy Services provided letters of credit of $1 million and posted cash collateral of $116 million as of September 30, 2011. 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. 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 (7), Leasing Activities, and Note (15), Commitments and ContingenciesRegulatory and Other MattersPHIs Cross-Border Energy Lease Investments.
In 2010, PHI disposed 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 state fairly Pepco Holdings financial condition as of September 30, 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 and nine months ended September 30, 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 self-insurance reserves for general and auto liability claims, 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.
During the third quarter of 2011, Pepco, DPL and ACE incurred significant costs associated with Hurricane Irene that affected their respective service territories. Total incremental storm costs associated with Hurricane Irene were $47 million, with $30 million incurred for repair work and $17 million incurred as capital expenditures. Costs incurred for repair work of $24 million were deferred as a regulatory asset to reflect the probable recovery of these storm costs in certain jurisdictions, and the remaining $6 million was charged to Other operation and maintenance expense. Approximately $31 million of these total incremental storm costs have been estimated for the cost of restoration services provided by outside contractors since a large portion of the invoices for such services had not been received at September 30, 2011. Actual invoices may vary from these estimates. PHIs utility subsidiaries currently plan to seek recovery of the incremental Hurricane Irene costs in each of their various jurisdictions in pending or planned distribution rate case filings.
Network Service Transmission Rates
In May 2011, PHIs utility subsidiaries filed their network service transmission rates with the Federal Energy Regulatory Commission effective for the service year beginning June 1, 2011. The new rates include an adjustment for costs incurred in the service year ended May 31, 2011 that were not reflected in the rates charged to customers for that service year. In the second quarter of 2011, PHIs utility subsidiaries recorded a $3 million decrease in transmission revenues as a change to the estimates recorded in previous periods primarily due to a decrease in the actual rate base versus the estimated rate base.
For the nine months ended September 30, 2010, PHIs utilities recorded an $8 million increase in transmission revenues associated with a change to the estimates recorded in previous periods.
General and Auto Liability
During the second quarter of 2011, PHIs utility subsidiaries reduced their self-insurance reserves for general and auto liability claims by approximately $5 million, based on obtaining an actuarial estimate of the unpaid loss attributed to general and auto liability claims for each of PHIs utility subsidiaries at June 30, 2011.
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
PHI, through its ACE subsidiary, is a party to three power purchase agreements (PPAs) with unaffiliated, non-utility generators (NUGs). PHI was unable to obtain sufficient information to determine whether these three entities were variable interest entities or if ACE was the primary beneficiary and as a result has applied the scope exemption from the consolidation guidance for enterprises that have not been able to obtain such information.
Net purchase activities with the NUGs for the three months ended September 30, 2011 and 2010, were approximately $57 million and $82 million, respectively, of which approximately $55 million and $74 million, respectively, consisted of power purchases under the PPAs. Net purchase activities with the NUGs for the nine months ended September 30, 2011 and 2010, were approximately $169 million and $222 million, respectively, of which approximately $159 million and $203 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
DPL is subject to Renewable Energy Portfolio Standards (RPS) in the state of Delaware that require it to obtain renewable energy credits (RECs) for energy delivered to its customers. DPLs costs associated with obtaining RECs to fulfill its RPS obligations are recoverable from its customers by law. PHI, through its DPL subsidiary, has entered into three land-based wind PPAs and one offshore wind PPA in the aggregate amount of 328 megawatts and one solar PPA with a 10 megawatt facility as of September 30, 2011. As the wind facilities become operational, DPL is obligated to purchase energy and RECs in amounts generated and delivered by the facilities at rates that are primarily fixed under these agreements. Under one of the PPAs, DPL is also obligated to purchase the capacity associated with the facility at rates that are generally fixed. If a wind facility does not become operational by a specified date, DPL has the right to terminate that PPA. DPL
concluded that consolidation is not required for any of these agreements under FASB guidance on the consolidation of variable interest entities.
Two of the land-based facilities are operational and DPL is obligated to purchase energy and RECs from one of these facilities through 2024 in amounts not to exceed 50.25 megawatts and the second of these facilities through 2031 in amounts not to exceed 40 megawatts. DPLs purchases under the operational wind PPAs totaled $3 million and $2 million for the three months ended September 30, 2011 and 2010, respectively, and $12 million and $8 million for the nine months ended September 30, 2011 and 2010, respectively. The other land-based wind agreement has a 20-year term and the facility is currently expected to become operational during 2011. In July 2011, the Delaware Public Service Commission (DPSC) approved amendments to this land-based wind PPA to change the location of the facility and to reduce the maximum generation capacity from 60 megawatts to 38 megawatts.
The offshore wind facility is expected to become operational during 2016. If the offshore wind facility developer is unable to obtain all necessary permits and financing commitments, this could result in delays in the construction schedule and the operational start date of the offshore wind facility.
The solar facility began operations in the third quarter of 2011. 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 at a fixed price. DPLs purchases under the agreement were $1 million during the third quarter of 2011.
On October 18, 2011, the DPSC approved a tariff submitted by DPL specific to a 30 megawatt fuel cell facility to be constructed using fuel cells manufactured in the State of Delaware. The RPS require that the DPSC establish an irrevocable tariff under which DPL would be an agent that collects payments from its customers and disburses the amounts collected to a Qualified Fuel Cell Provider that deploys Delaware-manufactured fuel cells as part of a 30 megawatt generation facility. The tariff and the RPS establish that DPL would be an agent to collect payments in advance from its distribution customers and remit them to the Qualified Fuel Cell Provider for each megawatt hour of energy produced over 20 years. DPL would have no liability to the Qualified Fuel Cell Provider other than to remit payments collected from its distribution customers pursuant to the tariff. The RPS provide for a reduction in DPLs REC requirements based upon the actual energy output of the facility. PHI is currently assessing the appropriate accounting treatment for the transaction, 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 fourth quarter of 2011.
Atlantic City Electric Transition Funding LLC
Atlantic City Electric 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, each with a different generation company. The SOCAs were established under a New Jersey law enacted 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 allow generators to receive payments from, or make payments to, ACE based on the difference between the fixed price in the SOCAs and the price for capacity that clears PJM Interconnection, LLC (PJM). Each of the other electricity distribution companies (EDCs) in New Jersey has entered into SOCAs having the same terms with the same generation companies. The annual share of payments or receipts for ACE and the other EDCs is based upon each companys annual proportion of the total New Jersey load attributable to all EDCs. ACE and the other EDCs entered the SOCAs under protest based on concerns about the potential cost to distribution customers. In February 2011, ACE joined other plaintiffs in an action filed in the United States District Court for the District of New Jersey challenging the constitutionality of the New Jersey law. The proceeding is now in the discovery phase. In May 2011, the NJBPU denied a joint motion for reconsideration of its order requiring each of the EDCs to enter into the SOCAs. In June 2011, ACE and the other EDCs filed appeals related to the NJBPU orders with the Appellate Division of the New Jersey Superior Court.
On October 17, 2011, one of the generation companies sent a notice of dispute under the SOCA to ACE. The notice of dispute alleges that certain actions taken by PJM have an adverse effect on the generation companys ability to clear the PJM auction as required by the SOCA and, under a provision of the SOCA, ACE and the generation supplier must attempt to amend the SOCA in order to permit transactions to continue thereunder, subject to NJBPU approval. ACE has agreed to meet with the generation supplier, but does not acknowledge that a dispute exists under the SOCA.
Currently, PHI believes that FASB guidance on derivative accounting and the accounting for regulated operations would apply to a SOCA once capacity has cleared a PJM auction. Once cleared, the gain (loss) associated with the fair value of a derivative would be offset by the establishment of a regulatory liability (asset).
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 September 30, 2011.
Taxes Assessed by a Governmental Authority on Revenue-Producing Transactions
Taxes included in Pepco Holdings gross revenues were $111 million and $118 million for the three months ended September 30, 2011 and 2010, respectively, and $302 million and $280 million for the nine months ended September 30, 2011 and 2010, respectively.
Reclassifications and Adjustments
Certain prior period amounts have been reclassified in order to conform to the current period presentation. The following adjustments have been recorded and are not considered material either individually or in the aggregate:
Default Electricity Supply Revenue and Costs Adjustments
During 2011, DPL recorded adjustments associated with the accounting for Default Electricity Supply revenue and costs. These adjustments were primarily due to the under-recognition of allowed returns on working capital and under-recoveries of administrative costs and resulted in a pre-tax decrease in Other operation and maintenance expense of $1 million and $9 million for the three and nine months ended September 30, 2011, respectively.
Pepco Energy Services 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 for the nine months ended September 30, 2011.
Other Taxes Adjustment
In the third quarter of 2010, Pepco recorded an adjustment to correct certain errors related to other taxes which resulted in a decrease to Other taxes expense of $5 million (pre-tax) for the three and nine months ended September 30, 2010.
Income Tax Adjustments
During the first quarter of 2011, Pepco recorded an adjustment to correct certain income tax errors related to prior periods associated with the interest on uncertain tax positions. The adjustment resulted in an increase in income tax expense of $1 million for the nine months ended September 30, 2011.
During the second quarter of 2010, PHI recorded an adjustment to correct certain income tax errors associated with casualty loss claims, which resulted in a decrease to income tax expense of $1 million for the nine months ended September 30, 2010.
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 nine months ended September 30, 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.
During 2010, PHI recorded various adjustments to income tax expense to reflect primarily the benefit from additional deductions related to executive compensation that had erroneously not been included in tax returns prior to 2008, a reduction in income tax expense associated with errors related to the deferred tax assets established in connection with the District of Columbia net operating losses, and an increase to income tax expense associated with the reversal of erroneously recorded interest income for state income tax purposes related to uncertain and effectively settled tax positions. These adjustments resulted in a decrease to income tax expense of $7 million related to continuing operations for the three months ended September 30, 2010 and a decrease to income tax expense of $1 million related to continuing operations for the nine months ended September 30, 2010.
In the third quarter of 2010, Pepco recorded certain adjustments to correct errors in Income tax expense which resulted in an increase to Income tax expense of $4 million for the three and nine months ended September 30, 2010.
In the third quarter of 2010, PHI recorded adjustments to reverse revenue erroneously recognized in the second quarter of 2010 associated with its discontinued operations. The adjustments resulted in an increase in net loss from discontinued operations of $7 million (pre-tax) for the three months ended September 30, 2010.
(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 was effective beginning with PHIs March 31, 2011 financial statements. PHI has included the new disclosure requirements in Note (14), Fair Value Disclosures, to its consolidated 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 did 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, and 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
Fair Value Measurements and Disclosures (ASC 820)
In May 2011, the FASB issued new guidance on fair value measurement and disclosures that will be effective beginning with PHIs March 31, 2012 consolidated financial statements. The new guidance will change how fair value is measured in specific instances and expand disclosures about fair value measurements. PHI is evaluating the impact of this new guidance on its consolidated financial statements.
Comprehensive Income (ASC 220)
In June 2011, the FASB issued new guidance that requires entities to report comprehensive income in one of two ways: (i) one single continuous statement that combines the income statement with the statement of other comprehensive income and totals to a comprehensive income amount; or (ii) in two separate but consecutive statements of income and other comprehensive income. PHI currently applies the second option in its financial statements, so PHI expects that this guidance will have minimal impact. The new guidance is effective beginning with PHIs March 31, 2012 consolidated financial statements.
Goodwill (ASC 350)
In September 2011, the FASB issued new guidance that changes the annual and interim assessments of goodwill for impairment. The new guidance modifies the required annual impairment test by giving entities the option to perform a qualitative assessment of whether it is more likely than not that goodwill is impaired before performing a quantitative assessment. The new guidance also amends the events and circumstances that entities should assess to determine whether an interim quantitative impairment test is necessary. The new guidance is effective beginning with PHIs March 31, 2012 consolidated financial statements and PHI is evaluating the impact. The new guidance can be adopted prior to March 31, 2012 but PHI does not plan to employ the new qualitative assessment as part of its November 1, 2011 annual impairment test.
(5) SEGMENT INFORMATION
Pepco Holdings management has identified its operating segments at September 30, 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 financing costs. Segment financial information for continuing operations for the three and nine months ended September 30, 2011 and 2010 is as follows:
PHIs goodwill balance of $1.4 billion was unchanged during the three and nine months ended September 30, 2011. Substantially all of PHIs goodwill 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. For the three months ended September 30, 2011, PHI concluded that there were no events requiring it to perform an interim goodwill impairment test. PHI will perform its next annual impairment test as of November 1, 2011.
(7) LEASING ACTIVITIES
Investment in Finance Leases Held in Trust
PHI has a portfolio of cross-border energy lease investments (the lease portfolio) consisting of hydroelectric generation facilities, coal-fired electric generation facilities and natural gas distribution networks located outside of the United States. Each lease investment is comprised of a number of leases. As of September 30, 2011 and December 31, 2010, the lease portfolio consisted of seven investments with an aggregate book value of $1.3 billion and eight investments with an aggregate book value of $1.4 billion, respectively.
In the third quarter of 2011, PHI modified its tax cash flow assumptions for two of the investments in the lease portfolio associated with the change in tax laws in the District of Columbia as further discussed in Note (15), Commitments and ContingenciesDistrict of Columbia Tax Legislation. Accordingly, PHI recalculated the equity investment and recorded a $7 million pre-tax ($3 million after-tax) charge.
During the second quarter of 2011, PHI entered into early termination agreements with two lessees involving all of the leases comprising one of the eight lease investments and a small portion of the leases comprising a second lease investment. The early terminations of the leases were negotiated at the request of the lessees and were completed in June 2011. PHI received net cash proceeds of $161 million (net of a termination payment of $423 million used to retire the non-recourse debt associated with the terminated leases) and recorded a pre-tax gain of $39 million, representing the excess of the net cash proceeds over the carrying value of the lease investments.
With respect to the terminated leases, PHI had previously made certain business assumptions regarding foreign investment opportunities available at the end of the full lease terms. Because the leases were terminated prior to the end of the stated term, management decided not to pursue these opportunities and $22 million in certain Federal income tax benefits recognized previously were reversed. The after-tax gain on the lease terminations was $3 million, reflecting an income tax provision at the statutory federal rate of $14 million and the income tax benefit reversal. PHI has no intent to terminate early any other leases in the lease portfolio. With respect to certain of these remaining leases, managements assumption continues to be that the foreign earnings recognized at the end of the lease term will remain invested abroad.
The components of the cross-border energy lease investments at September 30, 2011 and at December 31, 2010 are summarized below:
Income recognized from cross-border energy lease investments, excluding the gain on the terminated leases discussed above, was comprised of the following for the three and nine months ended September 30, 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 lessee company and asset performance. If the annual compliance requirements or minimum credit ratings are not met, remedies are available under the leases. PHI believes that all lessees were in compliance with the terms and conditions of their lease agreements at September 30, 2011.
The table below shows PHIs net investment in these leases by the published credit ratings of the lessees as of September 30, 2011 and December 31, 2010:
(8) PENSION AND OTHER POSTRETIREMENT BENEFITS
The following Pepco Holdings information is for the three months ended September 30, 2011 and 2010:
The following Pepco Holdings information is for the nine months ended September 30, 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. PHIs pension and other postretirement net periodic benefits cost for the three and nine months ended September 30, 2010, includes one-time charges in the aggregate amount of $6 million related to the sale of Conectiv Energy. 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 non-contributory 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. Under the Pension Protection Act, if a plan incurs a funding shortfall in the preceding plan year, there can be required minimum quarterly contributions in the current and following plan years. Although PHI had no minimum funding requirement under the Pension Protection Act guidelines, Pepco, ACE and DPL, in the first quarter of 2011, made discretionary tax-deductible contributions to the PHI Retirement Plan in the amounts of $40 million, $30 million and $40 million, respectively. The $110 million in contributions brought the PHI Retirement Plan assets to the funding target level for 2011 under the Pension Protection Act. 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.
Investment Policies and Strategies
In PHIs December 31, 2010 Form 10-K, PHI reported asset allocations for the PHI Retirement Plan at December 31, 2010 of 53% in equity investments, 40% in fixed income investments and 7% in Other investments (real estate, private equity).
In the first quarter of 2011, PHI modified its pension investment policy and strategy to reduce the effects of future volatility of the fair value of its pension assets relative to its pension liabilities. The new strategy was implemented during the second quarter of 2011 and is commonly referred to as a Liability-Driven Investment (LDI) strategy. Under the new LDI strategy, the plans allocation to fixed income investments, primarily high quality, longer-maturity fixed income securities was increased, with a reduction in the allocation to equity investments. PHI anticipates further increases in the allocation to fixed income investments, with a corresponding reduction in the allocation to equity investments, as the funded status of its plan increases.
Benefit Plan Modifications
On July 28, 2011, PHIs Board of Directors approved revisions to certain of PHIs existing benefit programs, including the PHI Retirement Plan. The changes to the PHI Retirement Plan were effected by PHI in order to establish a more unified approach to PHIs retirement programs and to further align the benefits offered under PHIs retirement programs. The changes to the PHI Retirement Plan will be effective on or after January 1, 2012 and will affect the retirement benefits payable to approximately 750 of PHIs employees. On September 22, 2011, the PHI Administrative Board approved another amendment revising the effective date to July 1, 2011. All full time employees of PHI and certain subsidiaries are eligible to participate in the PHI Retirement Plan. Retirement benefits for all other employees remain unchanged.
On July 28, 2011, PHIs Board also approved a new, non-tax-qualified Supplemental Executive Retirement Plan (SERP) which will replace PHIs two pre-existing supplemental retirement plans, effective August 1, 2011. As of the effective date of the new SERP, the Conectiv SERP and the PHI Combined SERP were closed to new participants. The establishment of the new SERP is consistent with PHIs efforts to align retirement benefits for PHI and its subsidiaries with current market practices and to provide similarly situated
participants with retirement benefits that are the same or similar in value as compared to the benefits provided under the prior SERPs.
The benefit plan modifications did not have a material impact on PHIs overall financial condition, results of operations, or cash flows.
On August 1, 2011, PHI, Pepco, DPL and ACE entered into an amendment and restatement of their $1.5 billion credit facility to extend the expiration date of the facility to August 1, 2016, and to make various other changes. As amended and restated, all or any portion of the facility may be used to obtain revolving loans and up to $500 million may be used to obtain letters of credit. PHIs credit sublimit under the facility is $750 million and the sublimit of each of Pepco, DPL and ACE is $250 million. The borrowers may increase or decrease their respective sublimits during the term of the facility, except that (i) the sum of all of the borrower sublimits following any such increase or decrease must equal the total amount of the facility and (ii) the aggregate amount of credit used at any given time by (a) PHI may not exceed $1.25 billion and (b) each of Pepco, DPL or ACE may not exceed the lesser of $500 million and the maximum amount of short-term debt the company is permitted to have outstanding by its regulatory authorities. The total number of sublimit reallocations cannot exceed eight per fiscal year during the term of the agreement.
The interest rate payable by each company on utilized funds is, at the borrowing companys election, (i) the greater of the prevailing prime rate, the federal funds effective rate plus 0.5% and one month LIBOR plus 1.0%, or (ii) the prevailing Eurodollar rate, plus a margin that varies according to the credit rating of the borrower. The facility also includes a swingline loan sub-facility, pursuant to which each company may make same day borrowings in an aggregate amount not to exceed 10% of the total amount of the facility. Any swingline loan must be repaid by the borrower within fourteen days of receipt thereof. All indebtedness incurred under the facility is unsecured.
There are no rating triggers associated with the credit facility. As of September 30, 2011, each borrower was in compliance with the covenants applicable to it under the credit facility.
Additionally, PHI had two bi-lateral 364-day unsecured credit agreements totaling $200 million, each of which expired according to its terms on October 26, 2011. Under each of those credit agreements, PHI had access to revolving and floating rate loans over the terms of the agreements. These facilities were established to provide additional liquidity and collateral support for Pepco Energy Services retail energy supply business. Based on the progress made toward winding down the retail energy supply business, the level of liquidity and collateral needed to support this business has decreased. As a result, PHI concluded that these credit agreements were no longer needed.
At September 30, 2011 and December 31, 2010, the amount of cash plus unused borrowing capacity under the credit facilities available to meet the future liquidity needs of PHI and its utility subsidiaries on a consolidated basis totaled $1.4 billion and $1.2 billion, respectively. PHIs utility subsidiaries had combined cash and unused borrowing capacity under the $1.5 billion credit facility of $831 million and $462 million at September 30, 2011 and December 31, 2010, respectively.
Other Financing Activities
In July 2011, ACE Funding made principal payments of $6 million on its Series 2002-1 Bonds, Class A-3, and $2 million on its Series 2003-1 Bonds, Class A-2.
Loss on Extinguishment of Debt
In July 2010, PHI purchased, pursuant to a cash tender offer, $640 million in principal amount of its 6.45% Senior Notes due 2012 (6.45% Notes), redeemed the remaining $110 million of outstanding 6.45% Notes, and purchased, pursuant to a cash tender offer, $129 million of its 6.125% Senior Notes due 2017 (6.125% Notes) and $65 million of 7.45% Senior Notes due 2032 (7.45% Notes). The purchases of the 6.45% Notes, 6.125% Notes and the 7.45% Notes were funded using the proceeds realized by PHI from the sale of Conectiv Energys wholesale power generation business. In connection with these transactions, PHI recorded a pre-tax loss on extinguishment of debt of $120 million in the third quarter of 2010.
In connection with the purchases of the 6.45% Notes and the 7.45% Notes, PHI accelerated the recognition of $15 million of pre-tax hedging losses attributable to the issuance of the 6.45% Notes and 7.45% Notes by reclassifying these hedging losses from AOCL to the income statement in the third quarter of 2010. These hedging losses originally arose when PHI entered into several treasury rate lock transactions in June 2002 to hedge changes in interest rates related to the anticipated issuance in August 2002 of several series of senior notes, including the 6.45% Notes and the 7.45% Notes. Upon issuance of the fixed rate debt in August 2002, the rate locks were terminated at a loss that has been deferred in AOCL and is being recognized in income over the life of the debt issued as interest payments on the debt are made. The accelerated recognition of these losses has also been included as a component of pre-tax loss on extinguishment of debt.
Financing Activities Subsequent to September 30, 2011
In October 2011, ACE Funding made principal payments of $8 million on its Series 2002-1 Bonds, Class A-3, and $3 million on its Series 2003-1 Bonds, Class A-2.
Collateral Requirements of Pepco Energy Services
In the ordinary course of its retail energy supply business which is in the process of winding down, Pepco Energy Services 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 September 30, 2011 and 2010, Pepco Energy Services recognized less than $1 million and approximately $1 million, respectively, of the fees in Interest expense. For the nine months ended September 30, 2011 and 2010, Pepco Energy Services recognized approximately $1 million and $6 million, respectively, of the fees in Interest expense.
As of September 30, 2011, Pepco Energy Services had posted net cash collateral of $116 million and provided letters of credit of $1 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 September 30, 2011 and December 31, 2010, the aggregate amount of cash plus unused borrowing capacity under the credit facilities available to meet the combined future liquidity needs of Pepco Energy Services totaled $547 million and $728 million, respectively.
(10) INCOME TAXES
A reconciliation of PHIs consolidated effective income tax rate from continuing operations is as follows:
Three Months Ended September 30, 2011 and 2010
PHIs consolidated effective tax rates from continuing operations for the three months ended September 30, 2011 and 2010 were 40.7% and (40.0)%, respectively. The increase in the effective tax rate was primarily due to the non-recurring benefit recorded in the third quarter of 2010 related to the 2010 corporate restructuring that impacted state tax expense and state deferred tax balances, the benefit of certain deferred tax basis adjustments recorded in 2010 and changes in estimates and interest related to uncertain and effectively settled tax positions.
In addition, as discussed further in Note (15) Commitments and ContingenciesDistrict of Columbia Tax Legislation, the Fiscal Year 2012 Budget Support Act of 2011 (the Budget Support Act) became law during the third quarter of 2011. The Budget Support Act includes a provision that requires corporate taxpayers in
the District of Columbia (the District) to calculate taxable income allocable or apportioned to the District by reference to the income and apportionment factors applicable to commonly controlled entities organized within the United States that are engaged in a unitary business. Previously, only the income of companies with direct nexus to the District was taxed. As a result of the change, during the third quarter of 2011, PHI recorded an additional state income tax expense of $2 million.
The deferred tax basis adjustments recorded in 2010 were the result of a $2 million adjustment to eliminate deferred tax liabilities associated with a goodwill impairment charge recorded in 2005, and the recording of a $2 million benefit related to deferred tax attributes.
Nine Months Ended September 30, 2011 and 2010
PHIs consolidated effective tax rates from continuing operations for the nine months ended September 30, 2011 and 2010 were 37.6% and 29.4%, respectively. The increase in the effective tax rate was primarily due to the impact of the early termination of certain cross border energy leases and the non-recurring benefit recorded in the third quarter of 2010 related to the 2010 corporate restructuring that impacted state tax expense and state deferred tax balances. This increase was partially offset by interest benefits associated with the settlement with the Internal Revenue Service (IRS) discussed below (included in changes in estimates and interest related to uncertain and effectively settled tax positions).
As discussed further in Note (7), Leasing Activities, during the second quarter of 2011, PHI terminated early its interest in certain cross-border energy leases prior to the end of the stated term. As a result of the early terminations, PHI reversed $22 million of previously recognized Federal income tax benefits associated with those leases which will not be realized.
In the second quarter of 2011, PHI reached a settlement with the IRS with respect to interest due on its federal tax liabilities related to the November 2010 audit settlement for years 1996 through 2002. In connection with this agreement, PHI reallocated certain amounts that had been on deposit with the IRS since 2006 among liabilities in the settlement years and subsequent years. Primarily related to the settlement and reallocations, PHI has recorded an additional tax benefit in the amount of $17 million (after-tax). This additional interest income was recorded in the second quarter of 2011.
As discussed above, PHI also recorded additional state tax expense as a result of the Districts mandatory unitary combined reporting in the third quarter of 2011.
The 2010 effective tax rate also included the non-recurring impact of the April 2010 corporate restructuring. As a result of this restructuring, PHI recorded approximately $16 million of non-recurring tax benefits in 2010 including approximately $8 million resulting from a change in state apportionment factors and the release of $8 million of valuation allowances on deferred tax assets related to state net operating losses.
Also included in changes in estimates and interest related to uncertain and effectively settled tax positions for 2010 is $6 million of additional income tax expense related to erroneously recorded interest income for state tax purposes on uncertain and effectively settled tax positions as further discussed in Note (2), Significant Accounting PoliciesIncome Tax Adjustments.
(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
PHIs basic and diluted earnings per share (EPS) 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.
The retail energy supply business of Pepco Energy Services, which is in the process of being wound down, enters into 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 recorded on an accrual basis.
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 natural gas under a hedging program approved by the DPSC. 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 issued 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 AOCL and is being recognized in income over the life of the debt issued as interest payments are made. As further described in Note (9), Debt, $15 million of these pre-tax losses ($9 million after-tax) were reclassified into income in the third quarter of 2010.
The tables below identify the balance sheet location and fair values of derivative instruments as of September 30, 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 September 30, 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 that are related to hedge ineffectiveness or the forecasted hedged transaction being probable not to occur, 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 cash flow hedges as of September 30, 2011 represent net losses on derivatives prior to the January 1, 2011 election to discontinue cash flow hedge accounting less amounts reclassified into income as the hedged transactions occur or because the hedged transactions were probable not to occur. Gains or losses on these natural gas derivatives after January 1, 2011 are recognized directly in income.
Cash flow hedge activity during the three and nine months ended September 30, 2011 and 2010 is provided in the tables below:
As of September 30, 2011 and December 31, 2010, Pepco Energy Services had the following types and quantities of outstanding 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 based on the fuel adjustment clause approved by the DPSC. The following table indicates the amount of the net unrealized derivative losses arising during the period included in regulatory assets and the realized losses recognized in the Consolidated Statements of Income for the three and nine months ended September 30, 2011 and 2010 associated with cash flow hedges:
As of September 30, 2011 and December 31, 2010, DPL had the following outstanding commodity forward contracts that were entered into to hedge forecasted transactions:
Effective October 1, 2011, DPL elected to no longer apply cash flow hedge accounting to its natural gas derivatives. These derivatives will continue to be employed as part of DPLs natural gas hedging activities under the hedging program approved by the DPSC, and their dedesignation as cash flow hedges will not result in a change to the financial statement presentation because all of DPLs gains and losses on these derivatives are recoverable from customers through the fuel adjustment clause approved by the DPSC.
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 September 30, 2011 and 2010. Cash flow hedges are marked to market on the balance sheet with corresponding adjustments to AOCL for effective cash flow hedges. As of September 30, 2011, $31 million of the losses in AOCL were associated with natural gas derivatives that Pepco Energy Services previously designated as cash flow hedges. Although Pepco Energy Services no longer designates its natural gas derivatives as cash flow hedges effective January 1, 2011, gains or losses previously deferred in AOCL as of December 31, 2010 will remain in AOCL until the hedged forecasted transaction occurs unless it is probable that the hedged forecasted transaction will not occur. 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 and nine months ended September 30, 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 September 30, 2011 and December 31, 2010, Pepco Energy Services had the following net outstanding commodity forward contract quantities 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 derivative gain or loss is deferred because of the DPSC-approved fuel adjustment clause. For the three and nine months ended September 30, 2011 and 2010, the net unrealized derivative losses arising during the period included in regulatory assets and the net realized losses recognized in the Consolidated Statements of Income are provided in the table below:
As of September 30, 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 September 30, 2011 and December 31, 2010, was $74 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 September 30, 2011, PHI had posted cash collateral of $5 million against the gross derivative liability resulting in a net liability of $69 million. As of December 31, 2010, 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 September 30, 2011 and December 31, 2010, would have been approximately $129 million and $182 million, respectively, after taking into consideration the master netting agreements. At September 30, 2011 and December 31, 2010, normal purchase and normal sale contracts in a loss position increased PHIs obligation.
PHIs primary sources for posting cash collateral or letters of credit are its credit facilities. At September 30, 2011 and December 31, 2010, the aggregate amount of cash plus borrowing capacity under the credit facilities available to meet the future liquidity needs of PHI and its subsidiaries totaled $1.4 billion and $1.2 billion, respectively, of which $547 million and $728 million, respectively, was available to Pepco Energy Services.
(14) FAIR VALUE DISCLOSURES
Financial Instruments Measured at Fair Value on a Recurring Basis
PHI applies 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 September 30, 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 and natural gas physical basis contracts held by Pepco Energy Services. The valuation of the options is based, in part, on internal volatility assumptions extracted from historical NYMEX prices over a certain period of time. The physical basis contracts are valued using liquid hub prices plus a congestion adder that is internally derived from historical data and experience.
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 Conectiv Energy assets and liabilities held for sale) that were accounted for at fair value on a recurring basis as of September 30, 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.