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Pepco Holdings 10-Q 2014
10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarter ended March 31, 2014

 

 

 

Commission File Number

 

Exact Name of Registrant as specified in its Charter, State or Other  Jurisdiction of Incorporation,

Address of Principal Executive Offices, Zip Code

and Telephone Number (Including Area Code)

  

I.R.S. Employer

Identification

Number

001-31403  

PEPCO HOLDINGS, INC.

(Pepco Holdings or PHI), a Delaware corporation

701 Ninth Street, N.W.

Washington, D.C. 20068

Telephone: (202)872-2000

   52-2297449
001-01072  

POTOMAC ELECTRIC POWER COMPANY

(Pepco), a District of Columbia and Virginia corporation

701 Ninth Street, N.W.

Washington, D.C. 20068

Telephone: (202)872-2000

   53-0127880
001-01405  

DELMARVA POWER & LIGHT COMPANY

(DPL), a Delaware and Virginia corporation

500 North Wakefield Drive

Newark, DE 19702

Telephone: (202)872-2000

   51-0084283
001-03559  

ATLANTIC CITY ELECTRIC COMPANY

(ACE), a New Jersey corporation

500 North Wakefield Drive

Newark, DE 19702

Telephone: (202)872-2000

   21-0398280

 

 

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

 

Pepco Holdings

   Yes  x      No  ¨      Pepco    Yes  x   No  ¨

DPL

   Yes  x      No  ¨      ACE    Yes  x   No  ¨

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).

 

Pepco Holdings

   Yes x      No ¨      Pepco    Yes x   No ¨

DPL

   Yes x      No ¨      ACE    Yes x   No ¨

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.

 

     Large
Accelerated

Filer
   Accelerated
Filer
   Non-
Accelerated
Filer
   Smaller
Reporting
Company

Pepco Holdings

   x    ¨    ¨    ¨

Pepco

   ¨    ¨    x    ¨

DPL

   ¨    ¨    x    ¨

ACE

   ¨    ¨    x    ¨

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

 

Pepco Holdings

   Yes ¨      No x      Pepco    Yes ¨   No x

DPL

   Yes ¨      No x      ACE    Yes ¨   No x

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

 

Registrant   

Number of Shares of Common Stock of the

Registrant Outstanding at April 25, 2014

Pepco Holdings

   251,025,051 ($.01 par value)

Pepco

   100 ($.01 par value) (a)

DPL

   1,000 ($2.25 par value) (b)

ACE

   8,546,017 ($3.00 par value) (b)

 

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

 

 

THIS COMBINED FORM 10-Q IS SEPARATELY FILED BY PEPCO HOLDINGS, PEPCO, DPL, AND ACE. INFORMATION CONTAINED HEREIN RELATING TO ANY INDIVIDUAL REGISTRANT IS FILED BY SUCH REGISTRANT ON ITS OWN BEHALF. EACH REGISTRANT MAKES NO REPRESENTATION AS TO INFORMATION RELATING TO THE OTHER REGISTRANTS.

 

 

 


Table of Contents

TABLE OF CONTENTS

 

         Page  
  Glossary of Terms      i  
  Forward-Looking Statements      1  

PART I

  FINANCIAL INFORMATION      3  

Item 1.

  - Financial Statements      3  

Item 2.

  - Management’s Discussion and Analysis of Financial Condition and Results of Operations      119  

Item 3.

  - Quantitative and Qualitative Disclosures About Market Risk      176   

Item 4.

  - Controls and Procedures      177   

PART II

  OTHER INFORMATION      177   

Item 1.

  - Legal Proceedings      177   

Item 1A

  - Risk Factors      178   

Item 2.

  - Unregistered Sales of Equity Securities and Use of Proceeds      178   

Item 3.

  - Defaults Upon Senior Securities      178   

Item 4.

  - Mine Safety Disclosures      178   

Item 5.

  - Other Information      179   

Item 6.

  - Exhibits      180   

Signatures

     183   


Table of Contents

GLOSSARY OF TERMS

 

Term

  

Definition

2013 Form 10-K    The Annual Report on Form 10-K for the year ended December 31, 2013, for each Reporting Company, as applicable
ACE    Atlantic City Electric Company
ACE Funding    Atlantic City Electric Transition Funding LLC
AFUDC    Allowance for funds used during construction
AMI    Advanced metering infrastructure
AOCL    Accumulated Other Comprehensive Loss
ASC    Accounting Standards Codification
BGE    Baltimore Gas and Electric Company
BGS    Basic Generation Service (the supply of electricity by ACE to retail customers in New Jersey who have not elected to purchase electricity from a competitive supplier)
Bondable Transition Property    The principal and interest payments on the Transition Bonds and related taxes, expenses and fees
BSA    Bill Stabilization Adjustment
Calpine    Calpine Corporation, the purchaser of the Conectiv Energy wholesale power generation business
CERCLA    Comprehensive Environmental Response, Compensation, and Liability Act of 1980
Conectiv    Conectiv, LLC, a wholly owned subsidiary of PHI and the parent of DPL and ACE
Conectiv Energy    Conectiv Energy Holdings, Inc. and substantially all of its subsidiaries, which were sold to Calpine in July 2010
Contract EDCs    Pepco, DPL and BGE, the Maryland utilities required by the MPSC to enter into a contract for new generation
CSA    Credit Support Annex
CTA    Consolidated tax adjustment
DC Undergrounding Task Force    The District of Columbia Mayor’s Power Line Undergrounding Task Force
DCPSC    District of Columbia Public Service Commission
DDOE    District of Columbia Department of the Environment
Default Electricity Supply    The supply of electricity by PHI’s electric utility subsidiaries at regulated rates to retail customers who do not elect to purchase electricity from a competitive supplier, and which, depending on the jurisdiction, is also known as Standard Offer Service or BGS
Default Electricity Supply Revenue    Revenue primarily from Default Electricity Supply
DEMEC    Delaware Municipal Electric Corporation, Inc.
DOE    U.S. Department of Energy
DPL    Delmarva Power & Light Company
DPSC    Delaware Public Service Commission
DRP    Direct Stock Purchase and Dividend Reinvestment Plan
EDCs    Electric distribution companies
EmPower Maryland    A Maryland demand-side management program for Pepco and DPL
Energy Services   

Energy savings performance contracting services provided principally to federal, state

and local government customers, and designing, constructing and operating combined

heat and power, and central energy plants by Pepco Energy Services

EPA    U.S Environmental Protection Agency
EPS    Earnings per share
Exchange Act    Securities Exchange Act of 1934, as amended
Exelon    Exelon Corporation, a Pennsylvania corporation
FASB    Financial Accounting Standards Board
FERC    Federal Energy Regulatory Commission
FLRP    Forward Looking Rate Plan filed by DPL in Delaware
GAAP    Accounting principles generally accepted in the United States of America
GCR    Gas Cost Rate
GWh    Gigawatt hour

 

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Table of Contents

Term

  

Definition

IMU    Interface management unit
IRS    Internal Revenue Service
ISDA    International Swaps and Derivatives Association
ISRA    New Jersey’s Industrial Site Recovery Act
LIBOR    London Interbank Offered Rate
MAPP    Mid-Atlantic Power Pathway
MDC    MDC Industries, Inc.
Merger    Merger of the Merger Sub with and into PHI
Merger Agreement    Agreement and Plan of Merger, dated April 29, 2014 among Exelon, Merger Sub and PHI
Merger Sub    Purple Acquisition Corp., a Delaware corporation and an indirect, wholly-owned subsidiary of Exelon
MFVRD    Modified fixed variable rate design
MMBtu    One Million British Thermal units
MPSC    Maryland Public Service Commission
MW    Megawatt
MWh    Megawatt hour

New Jersey Societal Benefit Program

   A New Jersey statewide public interest program that is intended to benefit low income customers and address other public policy goals
NJBPU    New Jersey Board of Public Utilities
NJ SOCA Law    The New Jersey law under which the SOCAs were established
NOAA    National Oceanic and Atmospheric Administration
Non-voting Preferred Stock    PHI issued to Exelon originally issued shares of non-voting, non-convertible and non-transferable preferred stock, par value $0.01 per share
NUGs    Non-utility generators
OPC    Office of People’s Counsel
PCI    Potomac Capital Investment Corporation and its subsidiaries
Pepco    Potomac Electric Power Company
Pepco Energy Services    Pepco Energy Services, Inc. and its subsidiaries
Pepco Holdings or PHI    Pepco Holdings, Inc.
PHI Retirement Plan    PHI’s noncontributory retirement plan
PJM    PJM Interconnection, LLC
PJM RTO    PJM regional transmission organization
Power Delivery    PHI’s Power Delivery Business
PPA    Power purchase agreement
Preferred Stock Purchase Price    A reverse termination fee equal to the purchase price paid up to the date of termination by Exelon to purchase the Non-voting Preferred Stock
PRP    Potentially responsible party
PUHCA 2005    Public Utility Holding Company Act of 2005
RECs    Renewable energy credits
Regulated T&D Electric Revenue    Revenue from the transmission and the distribution of electricity to PHI’s customers within its service territories at regulated rates
Regulatory Termination    If the Merger Agreement is terminated under certain circumstances due to the failure to obtain regulatory approvals or the breach by Exelon of its obligations in respect of obtaining regulatory approvals
Reporting Company    PHI, Pepco, DPL or ACE
RI/FS    Remedial investigation and feasibility study
ROE    Return on equity
RPS    Renewable Energy Portfolio Standards
SEC    Securities and Exchange Commission
SEP    Supplemental Environmental Project
SOCAs    Standard Offer Capacity Agreements required to be entered into by ACE pursuant to a New Jersey law enacted to promote the construction of qualified electric generation facilities in New Jersey
SOS   

Standard Offer Service, how Default Electricity Supply is referred to in Delaware,

the District of Columbia and Maryland

SRECs    Solar renewable energy credits
Subscription Agreement    Subscription Agreement, dated April 29, 2014, between Exelon and PHI
Transition Bond Charge    Revenue ACE receives, and pays to ACE Funding, to fund the principal and interest payments on Transition Bonds and related taxes, expenses and fees
Transition Bonds    Transition Bonds issued by ACE Funding
VIE    Variable interest entity

 

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Table of Contents

FORWARD-LOOKING STATEMENTS

Some of the statements contained in this Quarterly Report on Form 10-Q with respect to Pepco Holdings, Inc. (PHI or Pepco Holdings), Potomac Electric Power Company (Pepco), Delmarva Power & Light Company (DPL) and Atlantic City Electric Company (ACE), including each of their respective subsidiaries, 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 under the Private Securities Litigation Reform Act of 1995. These statements include declarations regarding the intents, beliefs, estimates and current expectations of one or more of PHI, Pepco, DPL or ACE (each, a Reporting Company) or their subsidiaries. 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 Companies’ or their subsidiaries’ 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 Company’s or its subsidiaries’ control and may cause actual results to differ materially from those contained in forward-looking statements:

 

    Certain risks and uncertainties associated with the proposed merger (the Merger) of an indirect, wholly-owned subsidiary of Exelon Corporation (Merger Sub) with and into Pepco Holdings, including, without limitation:

 

  ¡    The inability of Pepco Holdings to obtain shareholder approval required for the Merger;

 

  ¡    The inability of Pepco Holdings or Exelon to obtain regulatory approvals required for the Merger;

 

  ¡    Delays caused by required regulatory approvals, which may delay the Merger or cause the companies to abandon the Merger;

 

  ¡    The inability of Pepco Holdings or Exelon to satisfy conditions to the closing of the Merger;

 

  ¡    An unsolicited offer of another company to acquire assets or capital stock of Pepco Holdings, which could interfere with the Merger;

 

  ¡    Unexpected costs, liabilities or delays that may arise from the Merger;

 

  ¡    Negative impacts on the businesses of Pepco Holdings and its utility subsidiaries as a result of uncertainty surrounding the Merger; and

 

  ¡    Future regulatory or legislative actions impacting the industries in which Pepco Holdings and its subsidiaries operate, which actions could adversely affect Pepco Holdings and its utility subsidiaries.

 

    Changes in governmental policies and regulatory actions affecting the energy industry or one or more of the Reporting Companies specifically, including allowed rates of return, industry and rate structure, acquisition and disposal of assets and facilities, operation and construction of transmission and distribution facilities and the recovery of purchased power expenses;

 

    The outcome of pending and future rate cases and other regulatory proceedings, including (i) challenges to the base return on equity (ROE) and the application of the formula rate process previously established by the Federal Energy Regulatory Commission (FERC) for transmission services provided by Pepco, DPL and ACE; (ii) challenges to DPL’s 2011, 2012 and 2013 annual FERC formula rate updates; and (iii) other possible disallowances related to recovery of costs and expenses or delays in the recovery of such costs;

 

    The resolution of outstanding tax matters with the Internal Revenue Service (IRS), and the funding of any additional taxes, interest or penalties that may be due;

 

    The expenditures necessary to comply with regulatory requirements, including regulatory orders, and to implement reliability enhancement, emergency response and customer service improvement programs;

 

    Possible fines, penalties or other sanctions assessed by regulatory authorities against a Reporting Company or its subsidiaries;

 

    The impact of adverse publicity and media exposure which could render one or more Reporting Companies or their subsidiaries vulnerable to negative customer perception and could lead to increased regulatory oversight or other sanctions;

 

    Weather conditions affecting usage and emergency restoration costs;

 

    Population growth rates and changes in demographic patterns;

 

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Table of Contents
    Changes in customer energy demand due to, among other things, conservation measures and the use of renewable energy and other energy-efficient products, as well as the impact of net metering and other issues associated with the deployment of distributed generation and other new technologies;

 

    General economic conditions, including the impact on energy use caused by an economic downturn or recession, or by changes in the level of commercial activity in a particular region or service territory, or affecting a particular business or industry located therein;

 

    Changes in and compliance with environmental and safety laws and policies;

 

    Changes in tax rates or policies;

 

    Changes in rates of inflation;

 

    Changes in accounting standards or practices;

 

    Unanticipated changes in operating expenses and capital expenditures;

 

    Rules and regulations imposed by, and decisions of, federal and/or state regulatory commissions, PJM Interconnection, LLC (PJM), the North American Electric Reliability Corporation (NERC) and other applicable electric reliability organizations;

 

    Legal and administrative proceedings (whether civil or criminal) and settlements that affect a Reporting Company’s or its subsidiaries’ business and profitability;

 

    Pace of entry into new markets;

 

    Interest rate fluctuations and the impact of credit and capital market conditions on the ability to obtain funding on favorable terms; and

 

    Effects of geopolitical and other events, including the threat of terrorism or cyber attacks.

These forward-looking statements are also qualified by, and should be read together with, the risk factors and other statements in each Reporting Company’s Annual Report on Form 10-K for the year ended December 31, 2013 (2013 Form 10-K), as filed with the Securities and Exchange Commission (SEC), and in this Form 10-Q, and investors should refer to such risk factors and other statements in evaluating the forward-looking statements contained in this Quarterly Report on Form 10-Q.

Any forward-looking statements speak only as to the date this Quarterly Report on Form 10-Q for each Reporting Company was filed with the SEC and none of the Reporting Companies undertakes an 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. Furthermore, it may not be possible to assess the impact of any such factor on such Reporting Company’s or its subsidiaries’ business (viewed independently or together with the business or businesses of some or all of the other Reporting Companies or their subsidiaries), 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.

 

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Table of Contents

PART I FINANCIAL INFORMATION

Item 1. FINANCIAL STATEMENTS

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

 

     Registrants  

Item

   Pepco
Holdings
     Pepco*      DPL*      ACE  

Consolidated Statements of Income (Loss)

     4        53        76        99  

Consolidated Statements of Comprehensive Income (Loss)

     5        N/A        N/A        N/A  

Consolidated Balance Sheets

     6        54        77        100  

Consolidated Statements of Cash Flows

     8        56        79        102  

Consolidated Statement of Equity

     9        57        80        103  

Notes to Consolidated Financial Statements

     10        58        81        104  

 

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

 

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Table of Contents

PEPCO HOLDINGS

PEPCO HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME (LOSS)

(Unaudited)

 

     Three Months Ended
March 31,
 
     2014     2013  
    

(millions of dollars, except

per share data)

 

Operating Revenue

   $ 1,330     $ 1,180  
  

 

 

   

 

 

 

Operating Expenses

    

Fuel and purchased energy

     614       562  

Other services cost of sales

     46       40  

Other operation and maintenance

     216       227  

Depreciation and amortization

     133       112  

Other taxes

     104       105  

Deferred electric service costs

     44       1  
  

 

 

   

 

 

 

Total Operating Expenses

     1,157       1,047  
  

 

 

   

 

 

 

Operating Income

     173       133  
  

 

 

   

 

 

 

Other Income (Expenses)

    

Interest expense

     (65     (67

Other income

     13       8  
  

 

 

   

 

 

 

Total Other Expenses

     (52     (59
  

 

 

   

 

 

 

Income from Continuing Operations Before Income Tax Expense

     121       74  

Income Tax Expense Related to Continuing Operations

     46       185  
  

 

 

   

 

 

 

Net Income (Loss) from Continuing Operations

     75       (111

Loss from Discontinued Operations, net of Income Taxes

     —         (319
  

 

 

   

 

 

 

Net Income (Loss)

   $ 75     $ (430
  

 

 

   

 

 

 

Basic and Diluted Share Information

    

Weighted average shares outstanding – Basic (millions)

     251       237  
  

 

 

   

 

 

 

Weighted average shares outstanding – Diluted (millions)

     251       237  
  

 

 

   

 

 

 

Earnings (loss) per share of common stock from Continuing Operations – Basic and Diluted

   $ 0.30     $ (0.47 )

Earnings (loss) per share of common stock from Discontinued Operations – Basic and Diluted

     —         (1.35 )
  

 

 

   

 

 

 

Basic and Diluted earnings (loss) per share

   $ 0.30     $ (1.82 )
  

 

 

   

 

 

 

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

 

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Table of Contents

PEPCO HOLDINGS

 

PEPCO HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(Unaudited)

 

     Three Months Ended
March 31,
 
     2014      2013  
     (millions of dollars)  

Net Income (Loss)

   $ 75      $ (430 )
  

 

 

    

 

 

 

Other Comprehensive Income from Continuing Operations

     

Losses on treasury rate locks reclassified into income

     —          —    

Pension and other postretirement benefit plans

     1        2  
  

 

 

    

 

 

 

Other comprehensive income, before income taxes

     1        2  

Income tax expense related to other comprehensive income

     —          1  
  

 

 

    

 

 

 

Other comprehensive income from continuing operations, net of income taxes

     1        1  

Other Comprehensive Income from Discontinued Operations, net of Income Taxes

     —          5  
  

 

 

    

 

 

 

Comprehensive Income (Loss)

   $ 76      $ (424 )
  

 

 

    

 

 

 

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

 

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PEPCO HOLDINGS

 

PEPCO HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Unaudited)

 

     March 31,
2014
    December 31,
2013
 
     (millions of dollars)  

ASSETS

    

CURRENT ASSETS

    

Cash and cash equivalents

   $ 122      $ 23   

Restricted cash equivalents

     202       13  

Accounts receivable, less allowance for uncollectible accounts of $43 million and $38 million, respectively

     872       835  

Inventories

     142       148  

Deferred income tax assets, net

     56       51  

Income taxes and related accrued interest receivable

     8       274  

Prepaid expenses and other

     62       54  
  

 

 

   

 

 

 

Total Current Assets

     1,464       1,398  
  

 

 

   

 

 

 

OTHER ASSETS

    

Goodwill

     1,407       1,407  

Regulatory assets

     1,990       2,087  

Income taxes and related accrued interest receivable

     58       75  

Restricted cash equivalents

     13       14  

Other

     166       163  
  

 

 

   

 

 

 

Total Other Assets

     3,634       3,746  
  

 

 

   

 

 

 

PROPERTY, PLANT AND EQUIPMENT

    

Property, plant and equipment

     14,803       14,567  

Accumulated depreciation

     (4,897 )     (4,863 )
  

 

 

   

 

 

 

Net Property, Plant and Equipment

     9,906       9,704  
  

 

 

   

 

 

 

TOTAL ASSETS

   $ 15,004     $ 14,848  
  

 

 

   

 

 

 

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

 

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PEPCO HOLDINGS

 

PEPCO HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Unaudited)

 

     March 31,
2014
    December 31,
2013
 
     (millions of dollars, except shares)  

LIABILITIES AND EQUITY

    

CURRENT LIABILITIES

    

Short-term debt

   $ 509     $ 565  

Current portion of long-term debt and project funding

     449       446  

Accounts payable

     187       215  

Accrued liabilities

     319       301  

Capital lease obligations due within one year

     9       9  

Taxes accrued

     49       56  

Interest accrued

     81       47  

Liabilities and accrued interest related to uncertain tax positions

     6       397  

Other

     303       277  
  

 

 

   

 

 

 

Total Current Liabilities

     1,912       2,313  
  

 

 

   

 

 

 

DEFERRED CREDITS

    

Regulatory liabilities

     383       399  

Deferred income tax liabilities, net

     3,118       2,928  

Investment tax credits

     17       17  

Pension benefit obligation

     118       116  

Other postretirement benefit obligations

     203       206  

Liabilities and accrued interest related to uncertain tax positions

     6       28  

Other

     185       189  
  

 

 

   

 

 

 

Total Deferred Credits

     4,030       3,883  
  

 

 

   

 

 

 

OTHER LONG-TERM LIABILITIES

    

Long-term debt

     4,452       4,053  

Transition bonds issued by ACE Funding

     204       214  

Long-term project funding

     10       10  

Capital lease obligations

     60       60  
  

 

 

   

 

 

 

Total Other Long-Term Liabilities

     4,726       4,337  
  

 

 

   

 

 

 

COMMITMENTS AND CONTINGENCIES (NOTE 14)

    

EQUITY

    

Common stock, $.01 par value, 400,000,000 shares authorized, 250,982,923 and 250,324,898 shares outstanding, respectively

     3       3  

Premium on stock and other capital contributions

     3,764       3,751  

Accumulated other comprehensive loss

     (33 )     (34 )

Retained earnings

     602       595  
  

 

 

   

 

 

 

Total Equity

     4,336       4,315  
  

 

 

   

 

 

 

TOTAL LIABILITIES AND EQUITY

   $ 15,004      $ 14,848   
  

 

 

   

 

 

 

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

 

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PEPCO HOLDINGS

 

PEPCO HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 

     Three Months Ended
March 31,
 
     2014     2013  
     (millions of dollars)  

OPERATING ACTIVITIES

    

Net income (loss)

   $ 75     $ (430 )

Loss from discontinued operations

     —         319  

Adjustments to reconcile net income (loss) to net cash from operating activities:

    

Depreciation and amortization

     133       112  

Deferred income taxes

     525       (496 )

Gain on sale of land

     (4 )     —    

Other

     (4 )     (3 )

Changes in:

    

Accounts receivable

     (41 )     (14 )

Inventories

     6       3  

Prepaid expenses

     (8 )     (1 )

Regulatory assets and liabilities, net

     22       (6 )

Accounts payable and accrued liabilities

     20        (90

Pension contributions

     —         (60 )

Pension benefit obligation, excluding contributions

     14       14  

Cash collateral related to derivative activities

     (4     17  

Income tax-related prepayments, receivables and payables

     (483     604  

Advanced payment made to taxing authority

     —         (242 )

Interest accrued

     34       37  

Other assets and liabilities

     —         (4 )

Net current assets held for disposition or sale

     (1 )     64  
  

 

 

   

 

 

 

Net Cash From (Used By) Operating Activities

     284       (176
  

 

 

   

 

 

 

INVESTING ACTIVITIES

    

Investment in property, plant and equipment

     (282 )     (296 )

Department of Energy capital reimbursement awards received

     3       1  

Proceeds from sale of land

     4        —     

Changes in restricted cash equivalents

     (13 )     2  

Net other investing activities

     3       (3 )
  

 

 

   

 

 

 

Net Cash Used By Investing Activities

     (285 )     (296 )
  

 

 

   

 

 

 

FINANCING ACTIVITIES

    

Dividends paid on common stock

     (68 )     (67 )

Common stock issued for the Direct Stock Purchase and Dividend Reinvestment Plan and employee-related compensation

     13       15  

Issuances of common stock

     —         324  

Issuances of long-term debt

     400       250  

Reacquisitions of long-term debt

     (10 )     (10 )

Changes in restricted cash equivalents

     (175 )     —    

(Repayments) issuances of short-term debt, net

     (56 )     26  

Issuance of term loan

     —         250  

Repayment of term loan

     —         (200 )

Cost of issuances

     (7 )     (16 )

Net other financing activities

     3       —    
  

 

 

   

 

 

 

Net Cash From Financing Activities

     100       572   
  

 

 

   

 

 

 

Net Increase in Cash and Cash Equivalents

     99       100  

Cash and Cash Equivalents at Beginning of Period

     23       25  
  

 

 

   

 

 

 

CASH AND CASH EQUIVALENTS AT END OF PERIOD

   $ 122     $ 125  
  

 

 

   

 

 

 

SUPPLEMENTAL CASH FLOW INFORMATION

    

Cash received for income taxes, net

   $ (1 )   $ (1 )

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

 

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PEPCO HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF EQUITY

(Unaudited)

 

     Common Stock
     Premium      Accumulated
Other
Comprehensive
    Retained
       
(millions of dollars, except shares)    Shares      Par Value      on Stock      Loss     Earnings     Total  

BALANCE, DECEMBER 31, 2013

     250,324,898      $ 3      $ 3,751      $ (34 )   $ 595     $ 4,315  

Net income

     —          —          —          —         75       75  

Other comprehensive income

     —          —          —          1       —         1  

Dividends on common stock ($0.27 per share)

     —          —          —          —         (68     (68

Issuance of common stock:

               

Original issue shares, net

     284,022        —          3        —         —         3  

Shareholder DRP original issue shares

     374,003        —          8        —         —         8  

Net activity related to stock-based awards

     —          —          2        —         —         2  
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

BALANCE, MARCH 31, 2014

     250,982,923      $ 3      $ 3,764      $ (33   $ 602     $ 4,336  
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

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

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

PEPCO HOLDINGS, INC.

(1) ORGANIZATION

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, to a lesser extent, the distribution and supply of natural gas (Power Delivery):

 

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

 

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

 

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

Each of PHI, Pepco, DPL and ACE is also a reporting company under the Securities Exchange Act of 1934, as amended. Together, Pepco, DPL and ACE constitute the Power Delivery segment for financial reporting purposes.

Through Pepco Energy Services, Inc. and its subsidiaries (collectively, Pepco Energy Services), PHI provides energy savings performance contracting services, underground transmission and distribution construction and maintenance services, and steam and chilled water under long-term contracts.

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 service agreements among PHI, PHI Service Company and the participating operating subsidiaries. The expenses of PHI Service Company are charged to PHI and the participating operating subsidiaries in accordance with cost allocation methodologies set forth in the service agreements.

On April 29, 2014, PHI entered into an Agreement and Plan of Merger (the Merger Agreement) with Exelon Corporation, a Pennsylvania corporation (Exelon), and Purple Acquisition Corp., a Delaware corporation and an indirect, wholly-owned subsidiary of Exelon (Merger Sub), providing for the merger of Merger Sub with and into PHI (the Merger), with PHI surviving the Merger as an indirect, wholly-owned subsidiary of Exelon. See Note (18), “Subsequent Events,” for additional information regarding the Merger.

 

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Power Delivery

Each of Pepco, DPL and ACE is a regulated public utility 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 utility’s service territory. Distribution facilities are low-voltage systems that carry electricity to end-use customers in the utility’s service territory.

Each utility is responsible for the distribution of electricity, and in the case of DPL, the distribution and supply of natural gas, in its service territory, for which it is paid tariff rates established by the applicable local public service commissions. Each utility 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 (SOS) 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:

 

    Energy savings performance contracting business: designing, constructing and operating energy efficiency projects and distributed generation equipment, including combined heat and power plants, principally for federal, state and local government customers;

 

    Underground transmission and distribution business: providing underground transmission and distribution construction and maintenance services for electric utilities in North America; and

 

    Thermal business: providing steam and chilled water under long-term contracts through systems owned and operated by Pepco Energy Services, primarily to hotels and casinos in Atlantic City, New Jersey.

During 2012, Pepco Energy Services deactivated its Buzzard Point and Benning Road oil-fired generation facilities. Pepco Energy Services has determined that it will pursue the demolition of the Benning Road generation facility and realize the scrap metal salvage value of the facility. The demolition of the facility commenced in the fourth quarter of 2013 and is expected to be completed in early 2015. Pepco Energy Services will recognize the salvage proceeds associated with the scrap metals at the facility as realized.

 

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Corporate and Other

Between 1990 and 1999, Potomac Capital Investment Corporation (PCI), a wholly-owned subsidiary of PHI, through various subsidiaries, entered into certain transactions involving investments in aircraft and aircraft equipment, railcars and other assets. In connection with these transactions, PCI recorded deferred tax assets in prior years of $101 million in the aggregate. Following events that took place during the first quarter of 2013, which included (i) court decisions in favor of the IRS with respect to other taxpayers’ cross-border lease and other structured transactions (see “Discontinued Operations – Cross-Border Energy Lease Investments” below), (ii) the change in PHI’s tax position with respect to the tax benefits associated with its cross-border energy leases, and (iii) PHI’s decision in March 2013 to begin to pursue the early termination of its remaining cross-border energy lease investments (which represented a substantial portion of the remaining assets within PCI) without the intent to reinvest these proceeds in income-producing assets, management evaluated the likelihood that PCI would be able to realize the $101 million of deferred tax assets in the future. Based on this evaluation, PCI established valuation allowances against these deferred tax assets totaling $101 million in the first quarter of 2013. Further, during the fourth quarter of 2013, in light of additional court decisions in favor of the IRS involving other taxpayers, and after consideration of all relevant factors, management determined that it would abandon the further pursuit of these deferred tax assets, and these assets totaling $101 million were charged off against the previously established valuation allowances.

Discontinued Operations

Cross-Border Energy Lease Investments

Through its subsidiary PCI, PHI held a portfolio of cross-border energy lease investments. During 2013, PHI completed the termination of its interest in its cross-border energy lease investments and, as a result, these investments are being accounted for as discontinued operations.

Pepco Energy Services

In December 2009, PHI announced the wind-down of the retail energy supply component of the Pepco Energy Services business which was comprised of the retail electric and natural gas supply businesses. Pepco Energy Services implemented the wind-down by not entering into any new retail electric or natural gas supply contracts while continuing to perform under its existing retail electric and natural gas supply contracts through their respective expiration dates. On March 21, 2013, Pepco Energy Services entered into an agreement whereby a third party assumed all the rights and obligations of the remaining retail natural gas supply customer contracts, and the associated supply obligations, inventory and derivative contracts. The transaction was completed on April 1, 2013. In addition, Pepco Energy Services completed the wind-down of its retail electric supply business in the second quarter of 2013 by terminating its remaining customer supply and wholesale purchase obligations beyond June 30, 2013.

The operations of Pepco Energy Services’ retail electric and natural gas supply businesses have been classified as discontinued operations and are no longer a part of the Pepco Energy Services segment for financial reporting purposes.

(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 consolidated financial statements prepared in accordance with GAAP have been omitted. Therefore, these consolidated financial statements should be read along with the annual consolidated financial statements included in PHI’s annual report on Form 10-K for the year ended December 31, 2013. In the opinion of PHI’s

 

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management, the unaudited consolidated financial statements contain all adjustments (which all are of a normal recurring nature) necessary to state fairly Pepco Holdings’ financial condition as of March 31, 2014, in accordance with GAAP. The year-end December 31, 2013 consolidated balance sheet included herein was derived from audited consolidated financial statements, but does not include all disclosures required by GAAP. Interim results for the three months ended March 31, 2014 may not be indicative of PHI’s results that will be realized for the full year ending December 31, 2014.

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 contingencies, the calculation of future cash flows and fair value amounts for use in asset and goodwill impairment calculations, fair value calculations for derivative instruments, pension and other postretirement benefit assumptions, the assessment of the probability of recovery of regulatory assets, accrual of storm restoration costs, accrual of unbilled revenue, recognition of changes in network service transmission rates for prior service year costs, accrual of loss contingency liabilities for general litigation and auto and other liability claims, accrual of interest related to income taxes, the recognition of lease income and income tax benefits for investments in finance leases held in trust associated with PHI’s former cross-border energy lease investments (see Note (17), “Discontinued Operations – Cross-Border Energy Lease Investments”), and income tax provisions and reserves. 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.

Consolidation of Variable Interest Entities

PHI assesses its contractual arrangements with variable interest entities to determine whether it is the primary beneficiary and thereby has to consolidate the entities in accordance with Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 810. The guidance addresses conditions under which an entity should be consolidated based upon variable interests rather than voting interests. See Note (15), “Variable Interest Entities,” for additional information.

Goodwill

Goodwill represents the excess of the purchase price of an acquisition over the fair value of the net assets acquired at the acquisition date. PHI 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 (that is, a greater than 50% chance) reduce the estimated fair value of a reporting unit below the carrying amount of its net assets. 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 protracted decline in PHI’s stock price causing market capitalization to fall significantly below book value, an adverse regulatory action, or an impairment of long-lived assets in the reporting unit. PHI performed its most recent annual impairment test as of November 1, 2013, and its goodwill was not impaired as described in Note (6), “Goodwill.”

Taxes Assessed by a Governmental Authority on Revenue-Producing Transactions

Taxes included in Pepco Holdings’ gross revenues were $83 million and $84 million for the three months ended March 31, 2014 and 2013, respectively.

 

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Reclassifications and Adjustments

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

Revisions of Prior Period Financial Statements

Operating and Financing Cash Flows

The consolidated statement of cash flows for the three months ended March 31, 2013 has been revised to correctly present changes in book overdraft balances as operating activities (included in Changes in accounts payable and accrued liabilities) rather than financing activities (included in Net other financing activities). The effect of the revision was to increase Net cash used by operating activities by $30 million from $146 million to $176 million and increase Net cash from financing activities by $30 million from $542 million to $572 million. The revision was not considered to be material, individually or in the aggregate, to previously issued financial statements.

PCI Deferred Income Tax Liability Adjustment

Since 1999, PCI had not recorded a deferred tax liability related to a temporary difference between the financial reporting basis and the tax basis of an investment in a wholly owned partnership. In the second quarter of 2013, PHI re-evaluated this accounting treatment and found it to be in error, requiring a $32 million charge to earnings related to prior periods. The adjustment was not considered to be material, individually or in the aggregate, to previously issued financial statements; however, the cumulative impact would have been material to PHI’s reported net income in 2013, if corrected in 2013. As a result, during the second quarter of 2013, PHI revised its prior period financial statements to correct this error.

(3) NEWLY ADOPTED ACCOUNTING STANDARDS

Liabilities (ASC 405)

In February 2013, the FASB issued new recognition and disclosure requirements for certain joint and several liability arrangements where the total amount of the obligation is fixed at the reporting date. For arrangements within the scope of this standard, PHI is required to measure such obligations as the sum of the amount it agreed to pay on the basis of its arrangement among co-obligors and any additional amount it expects to pay on behalf of its co-obligors. Adoption of this guidance during the first quarter of 2014 did not have a material impact on PHI’s consolidated financial statements.

Income Taxes (ASC 740)

In July 2013, the FASB issued new guidance requiring netting of certain unrecognized tax benefits against a deferred tax asset for a loss or other similar tax carryforward that would apply upon settlement of the uncertain tax position. The prospective adoption of this guidance at March 31, 2014 resulted in PHI netting liabilities related to uncertain tax positions with deferred tax assets for net operating loss and other carryforwards (included in deferred income tax liabilities, net) and income taxes receivable (including income tax deposits) related to effectively settled uncertain tax positions.

(4) RECENTLY ISSUED ACCOUNTING STANDARDS, NOT YET ADOPTED

New accounting pronouncements not yet effective are not expected to have a material effect on PHI’s consolidated financial statements.

(5) SEGMENT INFORMATION

Pepco Holdings’ management has identified its operating segments at March 31, 2014 as Power Delivery and Pepco Energy Services. 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. Through its subsidiary PCI, PHI maintained a portfolio of cross-border energy lease investments. PHI completed the termination of its interests in its cross-border energy lease investments during 2013. As a result, the cross-border energy lease investments, which comprised substantially all of the operations of the former Other Non-Regulated segment, are being accounted for as discontinued operations.

The remaining operations of the former Other Non-Regulated segment, which no longer meet the definition of a separate segment for financial reporting purposes, are now included in Corporate and Other. Segment financial information for continuing operations for the three months ended March 31, 2014 and 2013 is as follows:

 

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     Three Months Ended March 31, 2014  
     Power
Delivery
     Pepco
Energy
Services
     Corporate
and
Other (a)
    PHI
Consolidated
 
     (millions of dollars)  

Operating Revenue

   $ 1,272       $ 60      $ (2 )   $ 1,330  

Operating Expenses (b)

     1,103        60        (6 )     1,157  

Operating Income

     169         —          4       173  

Interest Expense

     55         —          10       65  

Other Income

     12         —          1       13  

Income Tax Expense (Benefit)

     47         —          (1 )     46  

Net Income (Loss) from Continuing Operations

     79         —          (4 )     75  

Total Assets (excluding Assets Held for Disposition)

     13,438         286        1,279        15,003  

Construction Expenditures

   $ 264       $  —        $ 18     $ 282   

 

(a) Total Assets in this column includes Pepco Holdings’ goodwill balance of $1.4 billion, all of which is allocated to Power Delivery for purposes of assessing impairment. Total assets also include capital expenditures related to certain hardware and software expenditures which primarily benefit Power Delivery. These expenditures are recorded as incurred in Corporate and Other and are allocated to Power Delivery once the assets are placed in service. Corporate and Other includes intercompany amounts of $(2) million for Operating Revenue, $(1) million for Operating Expenses and $(1) million for Interest Expense.
(b) Includes depreciation and amortization expense of $133 million, consisting of $124 million for Power Delivery, $2 million for Pepco Energy Services and $7 million for Corporate and Other.

 

     Three Months Ended March 31, 2013  
     Power
Delivery
     Pepco
Energy
Services
     Corporate
and
Other (a)
    PHI
Consolidated
 
     (millions of dollars)  

Operating Revenue

   $ 1,124       $ 56      $  —       $ 1,180  

Operating Expenses (b)

     1,001        54        (8 )     1,047  

Operating Income

     123         2        8       133  

Interest Expense

     56         —          11       67  

Other Income

     6         1        1       8  

Income Tax Expense (c)

     15         1        169 (d)      185  

Net Income (Loss) from Continuing Operations

     58         2        (171 )     (111 )

Total Assets (excluding Assets Held for Disposition)

     12,453        346        1,965       14,764  

Construction Expenditures

   $ 282       $ 1      $ 13     $ 296  

 

(a) Total Assets in this column includes Pepco Holdings’ goodwill balance of $1.4 billion, all of which is allocated to Power Delivery for purposes of assessing impairment. Total assets also include capital expenditures related to certain hardware and software expenditures which primarily benefit Power Delivery. These expenditures are recorded as incurred in Corporate and Other and are allocated to Power Delivery once the assets are placed in service. Corporate and Other includes intercompany amounts of zero for Operating Revenue, $(1) million for Operating Expenses and $(4) million for Interest Expense.
(b) Includes depreciation and amortization expense of $112 million, consisting of $104 million for Power Delivery, $2 million for Pepco Energy Services and $6 million for Corporate and Other.
(c) Includes after-tax interest associated with uncertain and effectively settled tax positions allocated to each member of the consolidated group, including a $12 million interest benefit for Power Delivery and interest expense of $66 million for Corporate and Other.
(d) Includes non-cash charges of $101 million representing the establishment of valuation allowances against certain deferred tax assets of PCI included in Corporate and Other.

(6) GOODWILL

PHI’s goodwill balance of $1,407 million was unchanged during the three months ended March 31, 2014. Substantially all of PHI’s goodwill balance was generated by Pepco’s acquisition of Conectiv (known as Conectiv, LLC, and the parent of DPL and ACE, and referred to herein as 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).

 

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PHI’s annual impairment test as of November 1, 2013 indicated that goodwill was not impaired. For the three months ended March 31, 2014, PHI concluded that there were no events or circumstances requiring it to perform an interim goodwill impairment test. PHI will perform its next annual impairment test as of November 1, 2014.

(7) REGULATORY MATTERS

Rate Proceedings

The following table shows, for each of PHI’s utility subsidiaries, the electric distribution base rate cases currently pending. Additional information concerning each of these filings is provided in the discussion below.

 

Jurisdiction/Company

   Requested Revenue
Requirement Increase
    Requested Return
on Equity
    Filing
Date
   Expected Timing
of Decision
     (millions of dollars)                 

MD – Pepco

   $  37.4 (a)      10.25   December 4, 2013    Q3, 2014

NJ – ACE

   $ 61.7        10.25   March 14, 2014    Q1, 2015

 

(a) Reflects Pepco’s updated revenue requirement as filed on April 15, 2014.

The following table shows, for each of PHI’s utility subsidiaries, the distribution base rate cases completed to date in 2014. Additional information concerning each of these cases is provided in the discussion below.

 

Jurisdiction/Company

   Approved Revenue
Requirement Increase
     Approved Return
on Equity
    Completion
Date
   Rate Effective
Date
     (millions of dollars)                  

DC – Pepco

   $  23.4         9.40   March 26, 2014    April 16, 2014

DE – DPL (Electric)

   $  15.1         9.70   April 2, 2014    May 1, 2014

As further described in Note (18), “Subsequent Events,” on April 29, 2014, PHI entered into the Merger Agreement with Exelon and Merger Sub. Subject to certain exceptions, prior to the Merger or the termination of the Merger Agreement, PHI and its subsidiaries may not, without the consent of Exelon, initiate, file or pursue any rate cases, other than pursuing the conclusion of the pending filings as indicated below. In addition, the regulatory commissions may seek to suspend or delay one or more of the ongoing proceedings as a result of the Merger Agreement.

Bill Stabilization Adjustment

PHI’s utility subsidiaries have proposed in each of their respective jurisdictions the adoption of a mechanism to decouple retail distribution revenue from the amount of power delivered to retail customers. To date:

 

    A bill stabilization adjustment (BSA) has been approved and implemented for Pepco and DPL electric service in Maryland and for Pepco electric service in the District of Columbia.

 

    A proposed modified fixed variable rate design (MFVRD) for DPL electric and natural gas service in Delaware was filed in 2009 for consideration by the Delaware Public Service Commission (DPSC) and while there was little activity associated with this filing in 2013, or to date in 2014, the proceeding remains open.

 

    In New Jersey, a BSA proposed by ACE in 2009 was not approved and there is no BSA proposal currently pending.

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 MFVRD proposed in Delaware contemplates a fixed customer charge (i.e., not tied to the customer’s volumetric consumption of electricity or natural gas) to recover the utility’s fixed costs, plus a reasonable rate of return.

 

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Delaware

Electric Distribution Base Rates

On March 22, 2013, DPL submitted an application with the DPSC to increase its electric distribution base rates. The application seeks approval of an annual rate increase of approximately $42 million (adjusted by DPL to approximately $39 million on September 20, 2013), based on a requested return on equity (ROE) of 10.25%. The requested rate increase seeks to recover expenses associated with DPL’s ongoing investments in reliability enhancement improvements and efforts to maintain safe and reliable service. The DPSC suspended the full proposed increase and, as permitted by state law, DPL implemented an interim increase of $2.5 million on June 1, 2013, subject to refund and pending final DPSC approval. On October 8, 2013, the DPSC approved DPL’s request to implement an additional interim increase of $25.1 million, effective on October 22, 2013, bringing the total interim rates in effect subject to refund to $27.6 million. At the conclusion of a meeting held on April 1 and 2, 2014, the DPSC issued an order providing for an annual increase in DPL’s electric distribution base rates of approximately $15.1 million, based on an ROE of 9.70%. The amounts contained in the DPSC order are subject to verification by all parties to the base rate proceeding and may be changed by further order of the DPSC upon such verification. A final order in this proceeding will be issued by the DPSC at a later date. The new rates became effective May 1, 2014. DPL will submit a rate refund plan to provide credit or refund to any customer whose rates were increased in October 2013 in an amount that exceeded the increase approved by the DPSC. The final order in this proceeding is not expected to be affected by the Merger Agreement.

Forward Looking Rate Plan

On October 2, 2013, DPL filed a multi-year rate plan, referred to as the Forward Looking Rate Plan (FLRP). As proposed, the FLRP would provide for annual electric distribution base rate increases over a four-year period in the aggregate amount of approximately $56 million. The FLRP as proposed provides the opportunity to achieve estimated earned ROEs of 7.41% and 8.80% in years one and two, respectively, and 9.75% in both years three and four of the plan.

In addition, DPL proposed that as part of the FLRP, in order to provide a higher minimum required standard of reliability for DPL’s customers than that to which DPL is currently subject, the standards by which DPL’s reliability is measured would be made more stringent in each year of the FLRP. In addition, DPL has offered to refund an aggregate of $500,000 to customers in each year of the FLRP that it fails to meet the proposed stricter minimum reliability standards.

On October 22, 2013, the DPSC opened a docket for the purpose of reviewing the details of the FLRP, but stated that it would not address the FLRP until the electric distribution base rate case discussed above was concluded. A schedule for the FLRP docket has not yet been established. Under the Merger Agreement, DPL is permitted to pursue this matter.

Gas Distribution Base Rates

A settlement approved in October 2013 by the DPSC in a proceeding filed by DPL in December 2012 to increase its natural gas distribution base rates provides in part for a phase-in of the recovery of the deferred costs associated with DPL’s deployment of the interface management unit (IMU). The IMU is part of DPL’s advanced metering infrastructure (AMI) and allows for the remote reading of gas meters. Recovery of such costs will occur through base rates over a two-year period, assuming specific milestones are met and pursuant to the following schedule: 50% of the IMU portion of DPL’s AMI will be put into rates on July 1, 2014, and the remainder will be put into rates on April 1, 2015. DPL also agreed in the settlement that its next natural gas distribution base rate application may be filed with the DPSC no earlier than January 1, 2015. Under the Merger Agreement, DPL is not permitted to file further gas distribution base rate cases without Exelon’s consent.

Gas Cost Rates

DPL makes an annual Gas Cost Rate (GCR) filing with the DPSC for the purpose of allowing DPL to recover natural gas procurement costs through customer rates. On August 28, 2013, DPL made its 2013 GCR filing. The rates proposed in the 2013 GCR filing would result in a GCR decrease of approximately 5.5%. On

 

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September 26, 2013, the DPSC issued an order authorizing DPL to place the new rates into effect on November 1, 2013, subject to refund and pending final DPSC approval. On April 23, 2014, DPL, the DPSC staff and the Delaware Division of the Public Advocate entered into a settlement agreement providing that the proposed GCR rates as filed by DPL should be approved. The settlement agreement is subject to DPSC approval. A DPSC decision on the settlement agreement is expected in the third quarter of 2014. Under the Merger Agreement, DPL is permitted, and will continue, to pursue this matter.

District of Columbia

On March 8, 2013, Pepco filed an application with the District of Columbia Public Service Commission (DCPSC) to increase its annual electric distribution base rates by approximately $52.1 million (adjusted by Pepco to approximately $44.8 million on December 3, 2013), based on a requested ROE of 10.25%. The requested rate increase sought to recover expenses associated with Pepco’s ongoing investments in reliability enhancement improvements and efforts to maintain safe and reliable service. On March 26, 2014, the DCPSC issued an order approving an increase in base rates of approximately $23.4 million, based on an ROE of 9.40%. The new rates became effective on April 16, 2014. On April 28, 2014, Pepco filed an application for reconsideration or clarification of the DCPSC’s March 26, 2014 order, contesting several of the reporting obligations and other directives imposed by the order. On April 29, 2014, the other parties to the proceeding filed applications for reconsideration of the March 26, 2014 order, which generally challenge Pepco’s post-test year reliability projects, the adequacy of Pepco’s environmental and efficiency measures, and the structure of Pepco’s residential aid discount rate. All of these applications remain pending. Under the Merger Agreement, Pepco is permitted, and will continue, to pursue the application for reconsideration, but under the Merger Agreement, Pepco is not permitted to initiate or file further electric distribution base rate cases in the District of Columbia without Exelon’s consent.

Maryland

Pepco Electric Distribution Base Rates

In December 2011, Pepco submitted an application with the Maryland Public Service Commission (MPSC) to increase its electric distribution base rates. The filing sought approval of an annual rate increase of approximately $68.4 million (subsequently adjusted by Pepco to approximately $66.2 million), based on a requested ROE of 10.75%. In July 2012, the MPSC issued an order approving an annual rate increase of approximately $18.1 million, based on an ROE of 9.31%. Among other things, the order also authorized Pepco to recover the actual cost of AMI meters installed during the 2011 test year, stating that cost recovery for AMI deployment will be allowed in future rate cases in which Pepco demonstrates that the system is cost effective. The new rates became effective on July 20, 2012. The Maryland Office of People’s Counsel (OPC) has sought rehearing on the portion of the order allowing Pepco to recover the costs of AMI meters installed during the test year; that motion remains pending.

On November 30, 2012, Pepco submitted an application with the MPSC to increase its electric distribution base rates. The filing sought approval of an annual rate increase of approximately $60.8 million, based on a requested ROE of 10.25%. The requested rate increase sought to recover expenses associated with Pepco’s ongoing investments in reliability enhancement improvements and efforts to maintain safe and reliable service. Pepco also proposed a three-year Grid Resiliency Charge rider for recovery of costs totaling approximately $192 million associated with its plan to accelerate investments in infrastructure in a condensed timeframe. Acceleration of resiliency improvements was one of several recommendations included in a September 2012 report from Maryland’s Grid Resiliency Task Force (as discussed below under “Resiliency Task Forces”). Specific projects under Pepco’s Grid Resiliency Charge plan included acceleration of its tree-trimming cycle, upgrade of 12 additional feeders per year for two years and undergrounding of six distribution feeders. In addition, Pepco proposed a reliability performance-based mechanism that would allow Pepco to earn up to $1 million as an incentive for meeting enhanced reliability goals in 2015, but provided for a credit to customers of up to $1 million in total if Pepco does not meet at least the minimum reliability performance targets. Pepco requested that any credits/charges would flow through the proposed Grid Resiliency Charge rider.

On July 12, 2013, the MPSC issued an order related to Pepco’s November 30, 2012 application approving an annual rate increase of approximately $27.9 million, based on an ROE of 9.36%. The order provides for the full recovery of storm restoration costs incurred as a result of recent major storm events, including the derecho storm in June 2012 and Hurricane Sandy in October 2012, by including the related capital costs in the rate base and amortizing the related deferred operation and maintenance expenses of $23.6 million over a five-year period. The order excludes the cost of AMI meters from Pepco’s rate base until such time as Pepco demonstrates the cost effectiveness of the AMI system; as a result, costs for AMI meters incurred with respect

 

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to the 2012 test year and beyond will be treated as other incremental AMI costs incurred in conjunction with the deployment of the AMI system that are deferred and on which a return is earned, but only until such cost effectiveness has been demonstrated and such costs are included in rates. However, the MPSC’s July 2012 order in Pepco’s previous electric distribution base rate case, which allowed Pepco to recover the costs of meters installed during the 2011 test year for that case, remains in effect, and the Maryland OPC’s motion for rehearing in that case remains pending.

The order also approved a Grid Resiliency Charge, which went into effect on January 1, 2014, for recovery of costs totaling approximately $24.0 million associated with Pepco’s proposed plan to accelerate investments related to certain priority feeders, provided that, before implementing the surcharge, Pepco (i) provides additional information to the MPSC related to performance objectives, milestones and costs, and (ii) makes annual filings with the MPSC thereafter concerning this project, which will permit the MPSC to establish the applicable Grid Resiliency Charge rider for each following year. The MPSC did not approve the proposed acceleration of the tree-trimming cycle or the undergrounding of six distribution feeders. The MPSC also rejected Pepco’s proposed reliability performance-based mechanism. The new rates were effective on July 12, 2013.

On July 26, 2013, Pepco filed a notice of appeal of the July 12, 2013 order in the Circuit Court for the City of Baltimore. Other parties also have filed notices of appeal, which have been consolidated with Pepco’s appeal. In its memorandum filed with the appeals court, Pepco asserts that the MPSC erred in failing to grant Pepco an adequate ROE, denying a number of other cost recovery mechanisms and limiting Pepco’s test year data to no more than four months of forecasted data in future rate cases. The memoranda filed with the appeals court by the other parties primarily assert that the MPSC erred or acted arbitrarily and capriciously in allowing the recovery of certain costs by Pepco and refusing to reduce Pepco’s rate base by known and measurable accumulated depreciation. The appeal remains pending.

On December 4, 2013, Pepco submitted an application with the MPSC to increase its electric distribution base rates. The filing seeks approval of an annual rate increase of approximately $43.3 million (adjusted by Pepco to approximately $37.4 million on April 15, 2014), based on a requested ROE of 10.25%. The requested rate increase seeks to recover expenses associated with Pepco’s ongoing investments in reliability enhancement improvements and efforts to maintain safe and reliable service. A decision is expected in the third quarter of 2014.

Under the Merger Agreement, Pepco is permitted, and will continue, to pursue the conclusion of the aforementioned matters, but under the Merger Agreement, Pepco is not permitted to initiate or file further electric distribution base rate cases in Maryland without Exelon’s consent.

New Jersey

Electric Distribution Base Rates

On March 14, 2014, ACE submitted an application with the New Jersey Board of Public Utilities (NJBPU) to increase its electric distribution base rates by approximately $61.7 million (excluding sales and use taxes), based on a requested ROE of 10.25%. The requested rate increase seeks to recover expenses associated with ACE’s ongoing investments in reliability enhancement improvements and efforts to maintain safe and reliable service. The application requests that the NJBPU put rates into effect by mid-December 2014. The matter has been transmitted by NJBPU to the Office of Administrative Law. A decision is expected in the first quarter of 2015. Under the Merger Agreement, ACE is permitted, and will continue, to pursue the conclusion of the aforementioned matter, but under the Merger Agreement, ACE is not permitted to initiate or file further electric distribution base rate cases in New Jersey without Exelon’s consent.

Update and Reconciliation of Certain Under-Recovered Balances

In February 2012 and March 2013, ACE submitted petitions with the NJBPU seeking to reconcile and update (i) charges related to the recovery of above-market costs associated with ACE’s long-term power purchase contracts with the non-utility generators (NUGs), (ii) costs related to surcharges for the New Jersey Societal Benefit Program (a statewide public interest program that is intended to benefit low income customers and address other public policy goals) and ACE’s uncollected accounts and (iii) operating costs associated with ACE’s residential appliance cycling program. In June 2012, the NJBPU approved a stipulation of settlement related to ACE’s February 2012 filing, which provided for an overall annual rate increase of $55.3 million that went into effect on July 1, 2012. In May 2013, the NJBPU approved a stipulation of settlement related to

 

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ACE’s March 2013 filing, which provided for an overall annual rate increase of $52.2 million (in addition to the $55.3 million approved by the NJBPU in June 2012) that went into effect on June 1, 2013. These rate increases, which primarily provide for the recovery of above-market costs associated with the NUG contracts and will have no effect on ACE’s operating income, were placed into effect provisionally and were subject to a review by the NJBPU of the final underlying costs for reasonableness and prudence. On February 19, 2014, the NJBPU approved a stipulation of settlement for both proceedings, which made final the provisional rates that went into effect on July 1, 2012 and June 1, 2013, respectively.

On March 3, 2014, ACE submitted a petition with the NJBPU seeking to reconcile and update the same types of charges and costs covered in the February 2012 and March 2013 filings described in the preceding paragraph. The net impact of adjusting the charges as proposed is an overall annual rate decrease of approximately $24.5 million (revised to approximately $41.1 million on April 16, 2014, based upon an update for actuals through March 2014). The matter is pending at the NJBPU. The NJBPU is expected to rule upon the petition by June 1, 2014; in the past, the NJBPU has approved rates on a provisional basis and deferred certain issues to a phase two proceeding. The final order in this proceeding is not expected to be affected by the Merger Agreement.

Service Extension Contributions Refund Order

On July 19, 2013, in compliance with a 2012 Superior Court of New Jersey Appellate Division (Appellate Division) court decision, the NJBPU released an order requiring utilities to issue refunds to persons or entities that paid non-refundable contributions for utility service extensions to certain areas described as “Areas Not Designated for Growth.” The order is limited to eligible contributions paid between March 20, 2005 and December 20, 2009. ACE is processing the refund requests that meet the eligibility criteria established in the order as they are received. Although ACE believes it received approximately $11 million of contributions between March 20, 2005 and December 20, 2009, it is currently unable to reasonably estimate the amount that it may be required to refund using the eligibility criteria established by the order. At this time, ACE does not expect that any such amount refunded will have a material effect on its consolidated financial condition, results of operations or cash flows, as any amounts that may be refunded will generally increase the value of ACE’s property, plant and equipment and may ultimately be recovered through depreciation and cost of service. It is anticipated that the NJBPU will commence a rulemaking proceeding to further implement the directives of the Appellate Division decision. Under the Merger Agreement, ACE is permitted, and will continue, to pursue this matter.

Generic Consolidated Tax Adjustment Proceeding

In January 2013, the NJBPU initiated a generic proceeding to examine whether a consolidated tax adjustment (CTA) should continue to be used, and if so, how it should be calculated in determining a utility’s cost of service. Under the NJBPU’s current policy, when a New Jersey utility is included in a consolidated group income tax return, an allocated amount of any reduction in the consolidated group’s taxes as a result of losses by affiliates is used to reduce the utility’s rate base, upon which the utility earns a return. This policy has negatively impacted ACE’s base rate case outcomes and ACE’s position is that the CTA should be eliminated. A stakeholder process has been initiated by the NJBPU to aid in this examination. No formal schedule has been set by the NJBPU for the remainder of the proceeding or for the issuance of a decision. Under the Merger Agreement, ACE is permitted, and will continue, to pursue this matter.

Federal Energy Regulatory Commission

On October 17, 2013, the Federal Energy Regulatory Commission (FERC) issued a ruling on challenges filed by the Delaware Municipal Electric Corporation, Inc. (DEMEC) to DPL’s 2011 and 2012 annual formula rate updates. In 2006, FERC approved a formula rate for DPL that is incorporated into the PJM Interconnection, LLC (PJM) tariff. The formula rate establishes the treatment of costs and revenues and the resulting rates for DPL. Pursuant to the protocols approved by FERC and after a period of discovery, interested parties have an opportunity to file challenges regarding the application of the formula rate. The October 2013 FERC order sets various issues in this proceeding for hearing, including challenges regarding formula rate inputs, deferred income items, prepayments of estimated income taxes, rate base reductions, various administrative and general expenses and the inclusion in rate base of construction work in progress related to the Mid-Atlantic Power Pathway (MAPP) project (which has been abandoned). Settlement discussions began in this matter in November 2013 before an administrative law judge at FERC.

 

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On December 12, 2013, DEMEC filed a formal challenge to the DPL 2013 annual formula rate update, including a request to consolidate the 2013 challenge with the two prior challenges. On April 8, 2014, FERC issued an order setting the 2013 challenge issues for hearing. On April 15, 2014, those issues were consolidated with the 2011 and 2012 challenges. Settlement procedures will continue with the three challenges in one proceeding. PHI cannot predict when a final FERC decision in this proceeding will be issued.

On February 27, 2013, the public service commissions and public advocates of the District of Columbia, Maryland, Delaware and New Jersey, as well as DEMEC, filed a joint complaint with FERC against Pepco, DPL and ACE, as well as Baltimore Gas and Electric Company (BGE). The complainants challenged the base ROE and the application of the formula rate process, each associated with the transmission service that PHI’s utilities provide. The complainants support an ROE within a zone of reasonableness of 6.78% and 10.33%, and have argued for a base ROE of 8.7%. The base ROE currently authorized by FERC for PHI’s utilities is (i) 11.3% for facilities placed into service after January 1, 2006, and (ii) 10.8% for facilities placed into service prior to 2006. As currently authorized, the 10.8% base ROE for facilities placed into service prior to 2006 is eligible for a 50-basis-point incentive adder for being a member of a regional transmission organization. PHI, Pepco, DPL and ACE believe the allegations in this complaint are without merit and are vigorously contesting it. On April 3, 2013, Pepco, DPL and ACE filed their answer to this complaint, requesting that FERC dismiss the complaint against them on the grounds that the complaint failed to meet the required burden to demonstrate that the existing rates and protocols are unjust and unreasonable. PHI cannot predict when a final FERC decision in this proceeding will be issued.

Under the Merger Agreement, PHI is permitted, and will continue, to pursue the conclusion of the aforementioned matters.

MPSC New Generation Contract Requirement

In September 2009, the MPSC initiated an investigation into whether Maryland electric distribution companies (EDCs) should be required to enter into long-term contracts with entities that construct, acquire or lease, and operate, new electric generation facilities in Maryland. In April 2012, the MPSC issued an order determining that there is a need for one new power plant in the range of 650 to 700 megawatts (MWs) beginning in 2015. The order requires Pepco, DPL and BGE (collectively, the Contract EDCs) to negotiate and enter into a contract with the winning bidder of a competitive bidding process in amounts proportional to their relative SOS loads. Under the contract, the winning bidder will construct a 661 MW natural gas-fired combined cycle generation plant in Waldorf, Maryland, with an expected commercial operation date of June 1, 2015. The order acknowledged the Contract EDCs’ concerns about the requirements of the contract and directed them to negotiate with the winning bidder and submit any proposed changes in the contract to the MPSC for approval. The order further specified that each of the Contract EDCs will recover its costs associated with the contract through surcharges on its respective SOS customers.

In April 2012, a group of generating companies operating in the PJM region filed a complaint in the U.S. District Court for the District of Maryland challenging the MPSC’s order on the grounds that it violates the Commerce Clause and the Supremacy Clause of the U.S. Constitution. In May 2012, the Contract EDCs and other parties filed notices of appeal in circuit courts in Maryland requesting judicial review of the MPSC’s order. The Maryland circuit court appeals were consolidated in the Circuit Court for Baltimore City.

On April 16, 2013, the MPSC issued an order approving a final form of the contract and directing the Contract EDCs to enter into the contract with the winning bidder in amounts proportional to their relative SOS loads. On June 4, 2013, Pepco and DPL each entered into identical contracts in accordance with the terms of the MPSC’s order; however, under each contract’s terms, it will not become effective, if at all, until all legal proceedings related to these contracts and the actions of the MPSC in the related proceeding have been resolved.

 

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On September 30, 2013, the U.S. District Court for the District of Maryland issued a ruling that the MPSC’s April 2012 order violated the Supremacy Clause of the U.S. Constitution by attempting to regulate wholesale prices. In contrast, on October 1, 2013, the Maryland Circuit Court for Baltimore City upheld the MPSC’s orders requiring the Contract EDCs to enter into the contracts.

On October 24, 2013, the Federal district court issued an order ruling that the contracts are illegal and unenforceable. The Federal district court order and its associated ruling could impact the state circuit court appeal, to which the Contract EDCs are parties, although such impact, if any, cannot be determined at this time. The Contract EDCs, the Maryland Office of People’s Counsel and one generating company have appealed the Maryland Circuit Court’s decision to the Maryland Court of Special Appeals. In addition, in November 2013 both the winning bidder and the MPSC appealed the Federal district court decision to the U.S. Court of Appeals for the Fourth Circuit. These appeals remain pending.

Assuming the contracts, as currently written, were to become effective by the expected commercial operation date of June 1, 2015, PHI continues to believe that Pepco and DPL may be required to account for their proportional share of the contracts as a derivative instrument at fair value with an offsetting regulatory asset because they would recover any payments under the contracts from SOS customers. PHI, Pepco and DPL have concluded that any accounting for these contracts would not be required until all legal proceedings related to these contracts and the actions of the MPSC in the related proceeding have been resolved.

PHI, Pepco and DPL continue to evaluate these proceedings to determine, should the contracts be found to be valid and enforceable, (i) the extent of the negative effect that the contracts may have on PHI’s, Pepco’s and DPL’s respective credit metrics, as calculated by independent rating agencies that evaluate and rate PHI, Pepco and DPL and their debt issuances, (ii) the effect on Pepco’s and DPL’s ability to recover their associated costs of the contracts if a significant number of SOS customers elect to buy their energy from alternative energy suppliers, and (iii) the effect of the contracts on the financial condition, results of operations and cash flows of each of PHI, Pepco and DPL.

ACE Standard Offer Capacity Agreements

In April 2011, ACE entered into three Standard Offer Capacity Agreements (SOCAs) by order of the NJBPU, each with a different generation company. ACE and the other New Jersey EDCs entered into the SOCAs under protest, arguing that the EDCs were denied due process and that the SOCAs violate certain of the requirements under the New Jersey law under which the SOCAs were established (the NJ SOCA Law). On October 22, 2013, in light of the decision of the U.S. District Court for the District of New Jersey described below, the state appeals of the NJBPU implementation orders filed by the EDCs and generators were dismissed without prejudice subject to the parties exercising their appellate rights in the Federal courts.

In February 2011, ACE joined other plaintiffs in an action filed in the U.S. District Court for the District of New Jersey challenging the NJ SOCA Law on the grounds that it violates the Commerce Clause and the Supremacy Clause of the U.S. Constitution. On October 11, 2013, the Federal district court issued a ruling that the NJ SOCA Law is preempted by the Federal Power Act and violates the Supremacy Clause, and is therefore null and void. On October 21, 2013 a joint motion to stay the Federal district court’s decision pending appeal was filed by the NJBPU and one of the SOCA generation companies. In that motion, the NJBPU notified the Federal district court that it would take no action to force implementation of the SOCAs pending the appeal or such other action—such as FERC approval of the SOCAs—that would cure the constitutional issues to the Federal district court’s satisfaction. On October 25, 2013, the Federal district court’s issued an order denying the joint motion to stay and ruling that the SOCAs are void, invalid and unenforceable. The SOCA generation companies and the NJBPU have appealed the Federal district court’s decision. The Federal district court consolidated the appeals and the matter has been placed on an expedited schedule and appeal proceedings remain pending. The U.S. Court of Appeals for the Third Circuit heard the appeal on March 27, 2014, but has not rendered a decision.

 

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One of the three SOCAs was terminated effective July 1, 2013 because of an event of default of the generation company that was a party to the SOCA. The remaining two SOCAs were terminated effective November 19, 2013, as a result of a termination notice delivered by ACE after the Federal district court’s October 25, 2013 decision.

In light of the Federal district court order (which has not been stayed pending appeal), ACE derecognized both the derivative assets (liabilities) for the estimated fair value of the SOCAs and the offsetting regulatory liabilities (assets) in the fourth quarter of 2013.

Resiliency Task Forces

In July 2012, the Maryland governor signed an Executive Order directing his energy advisor, in collaboration with certain state agencies, to solicit input and recommendations from experts on how to improve the resiliency and reliability of the electric distribution system in Maryland. The resulting Grid Resiliency Task Force issued its report in September 2012, in which it made 11 recommendations. The governor forwarded the report to the MPSC in October 2012, urging the MPSC to quickly implement the first four recommendations: (i) strengthen existing reliability and storm restoration regulations; (ii) accelerate the investment necessary to meet the enhanced metrics; (iii) allow surcharge recovery for the accelerated investment; and (iv) implement clearly defined performance metrics into the traditional ratemaking scheme. Pepco’s electric distribution base rate case filed with the MPSC on November 30, 2012 and DPL’s electric distribution base rate case filed with the MPSC on March 29, 2013, each attempted to address the Grid Resiliency Task Force recommendations. In July and August 2013, the MPSC issued orders in the Pepco and DPL Maryland electric distribution base rate cases, respectively, that only partially approved the proposed Grid Resiliency Charge. See “Rate Proceedings – Maryland” above for more information about these base rate cases.

In August 2012, the District of Columbia mayor issued an Executive Order establishing the Mayor’s Power Line Undergrounding Task Force (the DC Undergrounding Task Force). The stated purpose of the DC Undergrounding Task Force was to pool the collective resources available in the District of Columbia to produce an analysis of the technical feasibility, infrastructure options and reliability implications of undergrounding new or existing overhead distribution facilities in the District of Columbia. These resources included legislative bodies, regulators, utility personnel, experts and other parties who could contribute in a meaningful way to the DC Undergrounding Task Force. On May 13, 2013, the DC Undergrounding Task Force issued a written recommendation endorsing a $1 billion plan of the DC Undergrounding Task Force to underground 60 of the District of Columbia’s most outage-prone power lines, which lines would be owned and maintained by Pepco. The legislation providing for implementation of the report’s recommendations contemplates that: (i) Pepco would fund approximately $500 million of the $1 billion estimated cost to complete this project, recovering those costs through surcharges on the electric bills of Pepco District of Columbia customers; (ii) $375 million of the undergrounding project cost would be financed by the District of Columbia’s issuance of securitized bonds, which bonds would be repaid through surcharges on the electric bills of Pepco District of Columbia customers (Pepco would not earn a return on or of the cost of the assets funded with the proceeds received from the issuance of the securitized bonds, but ownership and responsibility for the operation and maintenance of such assets would be transferred to Pepco for a nominal amount); and (iii) the remaining amount would be funded through the District of Columbia Department of Transportation’s existing capital projects program. This legislation was approved in the Council of the District of Columbia on February 4, 2014 and signed by the Mayor of the District of Columbia on March 3, 2014. The legislation became law on May 3, 2014 following the 30-day Congressional review period. The final steps in the approval process will be DCPSC authorization of the underground project plan and issuance of financing orders required by the legislation to establish the customer surcharges contemplated by the legislation, a decision on which is expected during the fourth quarter of 2014. Under the Merger Agreement, Pepco is permitted, and will continue, to pursue the DC undergrounding project.

 

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MAPP Settlement Agreement

On February 28, 2014, FERC issued an order approving the settlement agreement submitted by Pepco and DPL in connection with Pepco’s and DPL’s proceeding seeking recovery of approximately $88 million in abandonment costs related to the MAPP project. PHI had been directed by PJM to construct the MAPP project, a 152-mile high-voltage interstate transmission line, and was subsequently directed by PJM to cancel it. The abandonment costs sought for recovery were subsequently reduced to $82 million from write-offs of certain disallowed costs in 2013 and transfers of materials to inventories for use on other projects. Under the terms of the FERC-approved settlement agreement, Pepco and DPL will receive $80.5 million of transmission revenues over a three-year period, which began on June 1, 2013, and will retain title to all real property and property rights acquired in connection with the MAPP project, which had an estimated fair value of $8 million. The FERC-approved settlement agreement resolves all issues concerning the recovery of abandonment costs associated with the cancellation of the MAPP project, and the terms of the settlement agreement are not subject to modification through any other FERC proceeding. As of March 31, 2014, PHI had a regulatory asset related to the MAPP abandonment costs of approximately $52 million, net of amortization, and land of $8 million. PHI expects to recognize pre-tax income related to the MAPP abandonment costs of $3 million in 2014 and $1 million in 2015.

(8) PENSION AND OTHER POSTRETIREMENT BENEFITS

The table below provides the components of net periodic benefit costs recognized by Pepco Holdings for the three months ended March 31, 2014 and 2013:

 

     Pension Benefits     Other Postretirement
Benefits
 
     2014     2013     2014     2013  
     (millions of dollars)  

Service cost

   $ 12     $ 13     $ 2     $ 2  

Interest cost

     27       25       7       8  

Expected return on plan assets

     (35 )     (37 )     (6 )     (5 )

Amortization of prior service cost (benefit)

     —         —         (3 )     (1 )

Amortization of net actuarial loss

     11       16       3       4  
  

 

 

   

 

 

   

 

 

   

 

 

 

Net periodic benefit cost

   $ 15     $ 17     $ 3     $ 8  
  

 

 

   

 

 

   

 

 

   

 

 

 

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. PHI anticipates approximately 37% of annual net periodic pension and other postretirement benefit costs will be capitalized.

Pension Contributions

PHI’s funding policy with regard to PHI’s non-contributory retirement plan (the PHI Retirement Plan) is to maintain a funding level that is at least equal to the target liability as defined under the Pension Protection Act of 2006. In the first quarter of 2014, PHI, Pepco, DPL and ACE made no discretionary tax-deductible contributions to the PHI Retirement Plan. In the first quarter of 2013, PHI, Pepco, DPL and ACE made discretionary tax-deductible contributions to the PHI Retirement Plan in the amounts of $20 million, zero, $10 million and $30 million, respectively, which brought the PHI Retirement Plan assets to the funding target level for 2013 under the Pension Protection Act.

 

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Benefit Plan Modifications

During 2013, PHI approved two amendments to its other postretirement benefits plan. These amendments impacted the retiree health care and the retiree life insurance benefits, and were effective on January 1, 2014. As a result of the amendments, which were cumulatively significant, PHI remeasured its accumulated postretirement benefit obligation for other postretirement benefits as of July 1, 2013. The remeasurement resulted in a $7 million reduction in net periodic benefit cost for other postretirement benefits during the three months ended March 31, 2014 when compared to the three months ended March 31, 2013.

(9) DEBT

Credit Facility

PHI, Pepco, DPL and ACE maintain an unsecured syndicated credit facility to provide for their respective liquidity needs, including obtaining letters of credit, borrowing for general corporate purposes and supporting their commercial paper programs. On August 1, 2013, as permitted under the existing terms of the credit agreement, a request by PHI, Pepco, DPL and ACE to extend the credit facility termination date to August 1, 2018 was approved. All of the terms and conditions as well as pricing remained the same.

The aggregate borrowing limit under the amended and restated credit facility is $1.5 billion, all or any portion of which may be used to obtain loans and up to $500 million of which may be used to obtain letters of credit. 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. The credit sublimit is $750 million for PHI and $250 million for each of Pepco, DPL and ACE. The sublimits may be increased or decreased by the individual borrower 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 the sublimit reallocations may not exceed eight per year during the term of the facility.

The interest rate payable by each company on utilized funds is, at the borrowing company’s election, (i) the greater of the prevailing prime rate, the federal funds effective rate plus 0.5% and the one month London Interbank Offered Rate (LIBOR) plus 1.0%, or (ii) the prevailing Eurodollar rate, plus a margin that varies according to the credit rating of the borrower.

In order for a borrower to use the facility, certain representations and warranties must be true and correct, and the borrower must be in compliance with specified financial and other covenants, including (i) the requirement that each borrowing company maintain a ratio of total indebtedness to total capitalization of 65% or less, computed in accordance with the terms of the credit agreement, which calculation excludes from the definition of total indebtedness certain trust preferred securities and deferrable interest subordinated debt (not to exceed 15% of total capitalization), (ii) with certain exceptions, a restriction on sales or other dispositions of assets, and (iii) a restriction on the incurrence of liens on the assets of a borrower or any of its significant subsidiaries other than permitted liens. The credit agreement contains certain covenants and other customary agreements and requirements that, if not complied with, could result in an event of default and the acceleration of repayment obligations of one or more of the borrowers thereunder. Each of the borrowers was in compliance with all covenants under this facility as of March 31, 2014.

The absence of a material adverse change in PHI’s business, property, results of operations or financial condition is not a condition to the availability of credit under the credit agreement. The credit agreement does not include any rating triggers.

As of March 31, 2014 and December 31, 2013, the amount of cash plus unused borrowing capacity under the credit facility available to meet the future liquidity needs of PHI and its utility subsidiaries on a consolidated basis totaled $1,202 million and $1,063 million, respectively. PHI’s utility subsidiaries had combined cash and unused borrowing capacity under the credit facility of $562 million and $332 million at March 31, 2014 and December 31, 2013, respectively.

 

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Commercial Paper

PHI, Pepco, DPL and ACE maintain on-going commercial paper programs to address short-term liquidity needs. As of March 31, 2014, the maximum capacity available under these programs was $875 million, $500 million, $500 million and $350 million, respectively, subject to available borrowing capacity under the credit facility.

PHI, Pepco, DPL and ACE had $108 million, zero, $177 million and $101 million, respectively, of commercial paper outstanding at March 31, 2014. The weighted average interest rate for commercial paper issued by PHI, Pepco, DPL and ACE during the three months ended March 31, 2014 was 0.49%, 0.27%, 0.26% and 0.26%, respectively. The weighted average maturity of all commercial paper issued by PHI, Pepco, DPL and ACE during the three months ended March 31, 2014 was one, six, six and three days, respectively.

Other Financing Activities

PHI Term Loan Agreement

On March 28, 2013, PHI entered into a $250 million term loan agreement due March 27, 2014, pursuant to which PHI had borrowed $250 million at a rate of interest equal to the prevailing Eurodollar rate, which is determined by reference to the LIBOR with respect to the relevant interest period, all as defined in the loan agreement, plus a margin of 0.875%. PHI used the net proceeds of the loan under the loan agreement to repay the outstanding $200 million term loan obtained in 2012, and for general corporate purposes. On May 29, 2013, PHI repaid the $250 million term loan with a portion of the net proceeds from the early termination of the cross-border energy lease investments.

ACE Term Loan Agreement

On May 10, 2013, ACE entered into a $100 million term loan agreement, pursuant to which ACE has borrowed (and may not re-borrow) $100 million at a rate of interest equal to the prevailing Eurodollar rate, which is determined by reference to the LIBOR with respect to the relevant interest period, all as defined in the loan agreement, plus a margin of 0.75%. ACE’s Eurodollar borrowings under the loan agreement may be converted into floating rate loans under certain circumstances, and, in that event, for so long as any loan remains a floating rate loan, interest would accrue on that loan at a rate per year equal to (i) the highest of (a) the prevailing prime rate, (b) the federal funds effective rate plus 0.5%, or (c) the one-month Eurodollar rate plus 1%, plus (ii) a margin of 0.75%. As of March 31, 2014, outstanding borrowings under the loan agreement bore interest at an annual rate of 0.91%, which is subject to adjustment from time to time. All borrowings under the loan agreement are unsecured, and the aggregate principal amount of all loans, together with any accrued but unpaid interest due under the loan agreement, must be repaid in full on or before November 10, 2014.

Under the terms of the term loan agreement, ACE must maintain compliance with specified covenants, including (i) the requirement that ACE maintain a ratio of total indebtedness to total capitalization of 65% or less, computed in accordance with the terms of the loan agreement, which calculation excludes from the definition of total indebtedness certain trust preferred securities and deferrable interest subordinated debt (not to exceed 15% of total capitalization), (ii) a restriction on sales or other dispositions of assets, other than certain permitted sales and dispositions, and (iii) a restriction on the incurrence of liens (other than liens permitted by the loan agreement) on the assets of ACE. The loan agreement does not include any rating triggers. ACE was in compliance with all covenants under this loan agreement as of March 31, 2014.

 

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Bond Issuance

In March 2014, Pepco issued $400 million of 3.60% first mortgage bonds due March 15, 2024. Pepco used a portion of the net proceeds of the offering, of which $175 million was classified as restricted cash equivalents at March 31, 2014, to repay in full at maturity $175 million in aggregate principal amount of its 4.65% senior notes due April 15, 2014, plus accrued and unpaid interest.

Bond Payments

In January 2014, Atlantic City Electric Transition Funding LLC (ACE Funding) made principal payments of $7 million on its Series 2002-1 Bonds, Class A-3, and $3 million on its Series 2003-1 Bonds, Class A-2.

Sale of Receivables

On March 13, 2014, Pepco, as seller, entered into a purchase agreement with a buyer to sell receivables from an energy savings project pursuant to a Task Order entered into under a General Services Administration area-wide agreement. The purchase price to be received by Pepco is approximately $12 million. The energy savings project, which is being performed by Pepco Energy Services, is expected to be completed by January 1, 2015. Pursuant to the purchase agreement, following acceptance of the energy savings project, the buyer will be entitled to receive the contract payments under the Task Order payable by the customer over approximately 9 years. At March 31, 2014, less than $1 million of the purchase price had been received by Pepco.

Financing Activities Subsequent to March 31, 2014

Bond Payments

In April 2014, ACE Funding made principal payments of $7 million on its Series 2002-1 Bonds, Class A-3, and $3 million on its Series 2003-1 Bonds, Class A-2.

Bond Retirements

In April 2014, Pepco retired $175 million of its 4.65% senior notes. The senior notes were secured by a like principal amount of its 4.65% first mortgage bonds due April 15, 2014, which under Pepco’s mortgage and deed of trust were deemed to be satisfied when the senior notes were repaid.

In April 2014, ACE caused the redemption, at maturity, of $18 million of tax-exempt unsecured variable rate demand bonds issued for the benefit of ACE by the Pollution Control Financing Authority of Salem County.

In April 2014, PCI repaid, at maturity, $11 million of bank loans.

 

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(10) INCOME TAXES

A reconciliation of PHI’s consolidated effective income tax rates from continuing operations is as follows:

 

     Three Months Ended
March 31,
 
     2014     2013  
     (millions of dollars)  

Income tax at Federal statutory rate

   $ 42       35.0   $ 26       35.0

Increases (decreases) resulting from:

        

State income taxes, net of Federal effect

     7       5.8     5       6.8

Asset removal costs

     (2 )     (1.7 )%      (3 )     (4.1 )% 

Change in estimates and interest related to uncertain and effectively settled tax positions

     (1 )     (0.8 )%      51       68.9

Establishment of valuation allowances related to deferred tax assets

     —         —          101       136.5

Other, net

     —         (0.3 )%      5       6.9
  

 

 

   

 

 

   

 

 

   

 

 

 

Consolidated income tax expense related to continuing operations

   $ 46       38.0   $ 185       250.0
  

 

 

   

 

 

   

 

 

   

 

 

 

PHI’s consolidated effective tax rates for the three months ended March 31, 2014 and 2013 were 38.0% and 250.0%, respectively.

In the first quarter of 2013, PHI recorded interest expense related to uncertain and effectively settled tax positions of $51 million primarily representing the anticipated additional interest expense on estimated federal and state income tax obligations that was allocated to PHI’s continuing operations resulting from a change in assessment of tax benefits associated with the former cross-border energy lease investments of PCI in the first quarter of 2013.

Also, in the first quarter of 2013, PHI established valuation allowances of $101 million related to deferred tax assets. Between 1990 and 1999, PCI, through various subsidiaries, entered into certain transactions involving investments in aircraft and aircraft equipment, railcars and other assets. In connection with these transactions, PCI recorded deferred tax assets in prior years of $101 million in the aggregate. Following events that took place during the first quarter of 2013, which included (i) court decisions in favor of the IRS with respect to other taxpayers’ cross-border lease and other structured transactions (as discussed in Note (17), “Discontinued Operations – Cross-Border Energy Lease Investments”), (ii) the change in PHI’s tax position with respect to the tax benefits associated with its cross-border energy leases, and (iii) PHI’s decision in March 2013 to begin to pursue the early termination of its remaining cross-border energy lease investments (which represented a substantial portion of the remaining assets within PCI) without the intent to reinvest these proceeds in income-producing assets, management evaluated the likelihood that PCI would be able to realize the $101 million of deferred tax assets in the future. Based on this evaluation, PCI established valuation allowances against these deferred tax assets totaling $101 million in the first quarter of 2013. Further, during the fourth quarter of 2013, in light of additional court decisions in favor of the IRS involving other taxpayers, and after consideration of all relevant factors, management determined that it would abandon the further pursuit of these deferred tax assets, and these assets totaling $101 million were charged off against the previously established valuation allowances.

Final IRS Regulations on Repair of Tangible Property

In September 2013, the IRS issued final regulations on expense versus capitalization of repairs with respect to tangible personal property. The regulations are effective for tax years beginning on or after January 1, 2014, and provide an option to early adopt the final regulations for tax years beginning on or after January 1, 2012. In February 2014, the IRS issued revenue procedures that describe how taxpayers should implement the final regulations. The final repair regulations retain the operative rule that the Unit of Property for network assets is determined by the taxpayer’s particular facts and circumstances except as provided in published

 

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guidance. In 2012, with the filing of its 2011 tax return, PHI filed a request for an automatic change in accounting method related to repairs of its network assets in accordance with IRS Revenue Procedure 2011-43. PHI does not expect the effects of the final regulations to be significant and will continue to evaluate the impact of the new guidance on its consolidated financial statements.

(11) EQUITY AND EARNINGS PER SHARE

Basic and Diluted Earnings Per Share

PHI’s basic and diluted earnings per share (EPS) calculations are shown below:

 

     Three Months
Ended March 31,
 
     2014      2013  
     (millions of dollars, except
per share data)
 

Income (Numerator):

     

Net Income (loss) from continuing operations

   $ 75      $ (111 )

Net Loss from discontinued operations

     —          (319 )
  

 

 

    

 

 

 

Net Income (loss)

   $ 75      $ (430 )
  

 

 

    

 

 

 

Shares (Denominator) (in millions):

     

Weighted average shares outstanding for basic computation:

     

Average shares outstanding

     250        237  

Adjustment to shares outstanding

     1        —    
  

 

 

    

 

 

 

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

     251        237  

Net effect of potentially dilutive shares (a)

     —          —    
  

 

 

    

 

 

 

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

     251        237  
  

 

 

    

 

 

 

Basic and Diluted Earnings per Share

     

Earnings (loss) per share of common stock from continuing operations

   $ 0.30      $ (0.47 )

Loss per share of common stock from discontinued operations

     —          (1.35 )
  

 

 

    

 

 

 

Basic and diluted earnings (loss) per share

   $ 0.30      $ (1.82 )
  

 

 

    

 

 

 

 

(a) There were no options to purchase shares of common stock that were excluded from the calculation of diluted EPS for each of the three months ended March 31, 2014 and 2013.

Equity Forward Transaction

During 2012, PHI entered into an equity forward transaction in connection with a public offering of PHI common stock. Pursuant to the terms of this transaction, a forward counterparty borrowed 17,922,077 shares of PHI’s common stock from third parties and sold them to a group of underwriters for $19.25 per share, less an underwriting discount equal to $0.67375 per share. Under the terms of the equity forward transaction, upon physical settlement thereof, PHI was required to issue and deliver shares of PHI common stock to the forward counterparty at the then applicable forward sale price. The forward sale price was initially determined to be $18.57625 per share at the time the equity forward transaction was entered into and was subject to reduction from time to time in accordance with the terms of the equity forward transaction. PHI believed that the equity forward transaction substantially eliminated future equity price risk because the forward sale price was determinable as of the date that PHI entered into the equity forward transaction and was only reduced pursuant to the contractual terms of the equity forward transaction through the settlement date, which reductions were not affected by a future change in the market price of the PHI common stock. On February 27, 2013, PHI physically settled the equity forward at the then applicable forward sale price of $17.39 per share. The proceeds of approximately $312 million were used to repay outstanding commercial paper, a portion of which had been issued in order to make capital contributions to the utilities, and for general corporate purposes.

 

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(12) DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES

DPL uses derivative instruments in the form of swaps and over-the-counter options primarily to reduce natural 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 uses these derivatives to manage the commodity price risk associated with its physical natural gas purchase contracts. All premiums paid and other transaction costs incurred as part of DPL’s 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. The natural gas purchase contracts qualify as normal purchases, which are not required to be recorded in the financial statements until settled.

The tables below identify the balance sheet location and fair values of derivative instruments as of March 31, 2014 and December 31, 2013:

 

     As of March 31, 2014  

Balance Sheet Caption

   Derivatives
Designated
as Hedging
Instruments
     Other
Derivative
Instruments
     Gross
Derivative
Instruments
     Effects of
Cash
Collateral
and
Netting
    Net
Derivative
Instruments
 
     (millions of dollars)  

Derivative assets (current assets)

   $  —        $ 1      $ 1      $ (1 )   $  —    
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Total Derivative asset

   $  —        $ 1      $ 1      $ (1 )   $  —    
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

 

     As of December 31, 2013  

Balance Sheet Caption

   Derivatives
Designated
as Hedging
Instruments
     Other
Derivative
Instruments
     Gross
Derivative
Instruments
     Effects of
Cash
Collateral
and
Netting
    Net
Derivative
Instruments
 
     (millions of dollars)  

Derivative assets (current assets)

   $  —        $ 1      $ 1      $ (1 )   $  —    
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Total Derivative asset

   $  —        $ 1      $ 1      $ (1 )   $  —    
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

All derivative assets and liabilities available to be offset under master netting arrangements were netted as of March 31, 2014 and December 31, 2013. The amount of cash collateral that was offset against these derivative positions is as follows:

 

     March 31,
2014
    December 31,
2013
 
     (millions of dollars)  

Cash collateral received from counterparties with the obligation to return

   $ (1   $ (1 )

 

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As of March 31, 2014 and December 31, 2013, all PHI cash collateral pledged related to derivative instruments accounted for at fair value was entitled to be offset under master netting agreements.

Derivatives Designated as Hedging Instruments

Cash Flow Hedges

Cash Flow Hedges Included in Accumulated Other Comprehensive Loss

PHI also may use derivative instruments from time to time to mitigate the effects of fluctuating interest rates on debt issued in connection with the operation of its 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 interest expense over the life of the debt issued as interest payments are made.

The tables below provide details regarding terminated cash flow hedges included in PHI’s consolidated balance sheets as of March 31, 2014 and 2013. The data in the following tables indicate the cumulative net loss after-tax related to terminated 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:

 

Contracts

   As of March 31, 2014      Maximum
Term
 
   Accumulated
Other
Comprehensive Loss
After-tax
     Portion Expected
to be Reclassified
to Income during
the Next 12 Months
    
     (millions of dollars)         

Interest rate

   $ 9      $ 1        221 months   
  

 

 

    

 

 

    

Total

   $ 9      $ 1     
  

 

 

    

 

 

    

 

Contracts

   As of March 31, 2013      Maximum
Term
 
   Accumulated
Other
Comprehensive Loss
After-tax
     Portion Expected to
be Reclassified
to Income during
the Next 12 Months
    
     (millions of dollars)         

Interest rate

   $ 10      $ 1        233 months   
  

 

 

    

 

 

    

Total

   $ 10      $ 1     
  

 

 

    

 

 

    

Other Derivative Activity

DPL has certain derivatives that are not in hedge accounting relationships and are not 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 changes 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 DPL’s derivatives. The following table indicates the net unrealized and net realized derivative gains and (losses) arising during the period associated with these derivatives that were recognized in the consolidated statements of income (loss) (through Fuel and purchased energy expense) and that were also deferred as Regulatory liabilities for the three months ended March 31, 2014 and 2013:

 

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     Three Months Ended
March 31,
 
     2014      2013  
     (millions of dollars)  

Net unrealized gain arising during the period

   $ 2      $ 2  

Net realized gain (loss) recognized during the period

     2        (4 )

As of March 31, 2014 and December 31, 2013, the quantities and positions of DPL’s net outstanding natural gas commodity forward contracts that did not qualify for hedge accounting were:

 

     March 31, 2014      December 31, 2013  

Commodity

   Quantity      Net Position      Quantity      Net Position  

DPL – Natural gas (One Million British Thermal Units (MMBtu))

     3,050,000         Long         3,977,500         Long   

Contingent Credit Risk Features

The primary contracts used by the Power Delivery segment 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 party’s 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 DPL are stand-alone obligations without the guarantee of PHI. If DPL’s debt 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 values of DPL’s derivative liabilities with credit risk-related contingent features as of March 31, 2014 and December 31, 2013 were zero.

DPL’s primary source for posting cash collateral or letters of credit is PHI’s credit facility. As of March 31, 2014 and December 31, 2013, the aggregate amount of cash plus borrowing capacity under the credit facility available to meet the future liquidity needs of PHI’s utility subsidiaries was $562 million and $332 million, respectively.

 

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(13) 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).

The following tables set forth, by level within the fair value hierarchy, PHI’s financial assets and liabilities that were accounted for at fair value on a recurring basis as of March 31, 2014 and December 31, 2013. 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. PHI’s 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.

 

     Fair Value Measurements at March 31, 2014  

Description

   Total      Quoted Prices in
Active Markets
for Identical
Instruments
(Level 1) (a)
     Significant
Other
Observable
Inputs
(Level 2) (a)
     Significant
Unobservable
Inputs
(Level 3)
 
            (millions of dollars)         

ASSETS

           

Derivative instruments (b)

           

Natural gas (c)

   $ 1      $ 1      $  —        $  —    

Restricted cash and cash equivalents

           

Treasury fund

     305        305        —          —    

Executive deferred compensation plan assets

           

Money market funds

     15        15        —          —    

Life insurance contracts

     66        —          47        19  
  

 

 

    

 

 

    

 

 

    

 

 

 
   $ 387      $ 321      $ 47      $  19  
  

 

 

    

 

 

    

 

 

    

 

 

 

LIABILITIES

           

Executive deferred compensation plan liabilities

           

Life insurance contracts

   $ 29      $  —        $ 29      $  —    
  

 

 

    

 

 

    

 

 

    

 

 

 
   $ 29      $  —        $ 29      $  —    
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(a) There were no transfers of instruments between level 1 and level 2 valuation categories during the three months ended March 31, 2014.
(b) The fair values of derivative assets reflect netting by counterparty before the impact of collateral.
(c) Represents natural gas swaps purchased by DPL as part of a natural gas hedging program approved by the DPSC.

 

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     Fair Value Measurements at December 31, 2013  

Description

   Total      Quoted Prices in
Active Markets
for Identical
Instruments
(Level 1) (a)
     Significant
Other
Observable
Inputs
(Level 2) (a)
     Significant
Unobservable
Inputs
(Level 3)
 
            (millions of dollars)         

ASSETS

           

Derivative instruments (b)

           

Natural gas (c)

   $ 1      $ 1      $  —        $  —    

Restricted cash and cash equivalents

           

Treasury fund

     34        34        —          —    

Executive deferred compensation plan assets

           

Money market funds

     15        15        —          —    

Life insurance contracts

     66        —          47        19  
  

 

 

    

 

 

    

 

 

    

 

 

 
   $ 116      $ 50      $ 47       $  19   
  

 

 

    

 

 

    

 

 

    

 

 

 

LIABILITIES

           

Executive deferred compensation plan liabilities

           

Life insurance contracts

   $ 30       $  —         $ 30       $  —     
  

 

 

    

 

 

    

 

 

    

 

 

 
   $ 30       $  —         $ 30       $  —     
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(a) There were no transfers of instruments between level 1 and level 2 valuation categories during the year ended December 31, 2013.
(b) The fair values of derivative assets reflect netting by counterparty before the impact of collateral.
(c) Represents natural gas swaps purchased by DPL as part of a natural gas hedging program approved by the DPSC.

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.

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 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.

Executive deferred compensation plan assets and liabilities categorized as level 2 consist of life insurance policies and certain employment agreement obligations. The life insurance policies are categorized as level 2 assets because they are valued 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 and can be liquidated for the value of the underlying assets as of March 31, 2014. 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.

The value of certain employment agreement obligations (which are included with life insurance contracts in the tables above) is derived using a discounted cash flow valuation technique. The discounted cash flow calculations are based on a known and certain stream of payments to be made over time that are discounted to determine their net present value. The primary variable input, the discount rate, is based on market-corroborated and observable published rates. These obligations have been classified as level 2 within the fair value hierarchy because the payment streams represent contractually known and certain amounts and the discount rate is based on published, observable data.

 

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Level 3 – Pricing inputs that are significant and generally less observable than those from objective sources. Level 3 includes those financial instruments that are valued using models or other valuation methodologies.

Executive deferred compensation plan assets include certain life insurance policies that are valued using the cash surrender value of the policies, net of loans against those policies. The cash surrender values do not represent a quoted price in an active market; therefore, those inputs are unobservable and the policies are categorized as level 3. Cash surrender values are provided by third parties and reviewed by PHI for reasonableness.

Reconciliations of the beginning and ending balances of PHI’s fair value measurements using significant unobservable inputs (Level 3) for the three months ended March 31, 2014 and 2013 are shown below:

 

    Three Months Ended
March 31, 2014
 
    Life
Insurance Contracts
 
    (millions of dollars)  

Beginning balance as of January 1

  $ 19  

Total gains (losses) (realized and unrealized):

 

Included in income

    1  

Included in accumulated other comprehensive loss

    —    

Included in regulatory liabilities

    —    

Purchases

    —    

Issuances

    (1 )

Settlements

    —    

Transfers in (out) of level 3

    —    
 

 

 

 

Ending balance as of March 31

  $ 19  
 

 

 

 

 

     Three Months Ended
March 31, 2013
 
     Natural
Gas
    Life
Insurance
Contracts
     Capacity  
     (millions of dollars)  

Beginning balance as of January 1

   $ (4 )   $ 18      $ (3 )

Total gains (losses) (realized and unrealized):

       

Included in income

     —         1        —    

Included in accumulated other comprehensive loss

     —         —          —    

Included in regulatory liabilities

     —         —          —    

Purchases

     —         —          —    

Issuances

     —         —          —    

Settlements

     4       —          —    

Transfers in (out) of level 3

     —         —          —    
  

 

 

   

 

 

    

 

 

 

Ending balance as of March 31

   $  —       $ 19      $ (3 )
  

 

 

   

 

 

    

 

 

 

 

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The breakdown of realized and unrealized gains 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:

 

     Three Months Ended
March 31,
 
     2014      2013  
     (millions of dollars)  

Total net gains included in income for the period

   $ 1      $ 1  
  

 

 

    

 

 

 

Change in unrealized gains relating to assets still held at reporting date

   $ 1      $ 1  
  

 

 

    

 

 

 

Other Financial Instruments

The estimated fair values of PHI’s Long-term debt instruments that are measured at amortized cost in PHI’s consolidated financial statements and the associated level of the estimates within the fair value hierarchy as of March 31, 2014 and December 31, 2013 are shown in the tables below. As required by the fair value measurement guidance, debt instruments are classified in their entirety within the fair value hierarchy based on the lowest level of input that is significant to the fair value measurement. PHI’s assessment of the significance of a particular input to the fair value measurement requires the exercise of judgment, which may affect the valuation of fair value debt instruments and their placement within the fair value hierarchy levels.

The fair value of Long-term debt and Transition Bonds issued by ACE Funding (Transition Bonds) categorized as level 2 is based on a blend of quoted prices for the debt and quoted prices for similar debt on the measurement date. The blend places more weight on current pricing information when determining the final fair value measurement. The fair value information is provided by brokers, and PHI reviews the methodologies and results.

The fair value of Long-term debt categorized as level 3 is based on a discounted cash flow methodology using observable inputs, such as the U.S. Treasury yield, and unobservable inputs, such as credit spreads, because quoted prices for the debt or similar debt in active markets were insufficient. The Long-term project funding represents debt instruments issued by Pepco Energy Services related to its energy savings contracts. Long-term project funding is categorized as level 3 because PHI concluded that the amortized cost carrying amounts for these instruments approximates fair value, which does not represent a quoted price in an active market.

 

     Fair Value Measurements at March 31, 2014  

Description

   Total      Quoted Prices in
Active Markets
for Identical
Instruments
(Level 1)
     Significant
Other
Observable
Inputs
(Level 2)
     Significant
Unobservable
Inputs
(Level 3)
 
     (millions of dollars)  

LIABILITIES

           

Debt instruments

           

Long-term debt (a)

   $ 5,402      $  —        $ 4,835      $ 567  

Transition bonds (b)

     273        —          273        —    

Long-term project funding

     13        —          —          13  
  

 

 

    

 

 

    

 

 

    

 

 

 
   $ 5,688      $  —        $ 5,108      $ 580  
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(a) The carrying amount for Long-term debt was $4,856 million as of March 31, 2014.
(b) The carrying amount for Transition bonds, including amounts due within one year, was $246 million as of March 31, 2014.

 

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     Fair Value Measurements at December 31, 2013  

Description

   Total      Quoted Prices in
Active Markets
for Identical
Instruments
(Level 1)
     Significant
Other
Observable
Inputs
(Level 2)
     Significant
Unobservable
Inputs
(Level 3)
 
     (millions of dollars)  

LIABILITIES

     

Debt instruments

     

Long-term debt (a)

   $ 4,850      $  —        $ 4,289      $ 561  

Transition bonds (b)

     284        —          284        —    

Long-term project funding

     12        —          —          12  
  

 

 

    

 

 

    

 

 

    

 

 

 
   $ 5,146      $  —        $ 4,573      $ 573  
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(a) The carrying amount for Long-term debt was $4,456 million as of December 31, 2013.
(b) The carrying amount for Transition bonds, including amounts due within one year, was $255 million as of December 31, 2013.

The carrying amounts of all other financial instruments in the accompanying consolidated financial statements approximate fair value.

(14) COMMITMENTS AND CONTINGENCIES

General Litigation and Other Matters

From time to time, PHI and its subsidiaries are named as defendants in litigation, usually relating to general liability or auto liability claims that resulted in personal injury or property damage to third parties. PHI and each of its subsidiaries are self-insured against such claims up to a certain self-insured retention amount and maintain insurance coverage against such claims at higher levels, to the extent deemed prudent by management. In addition, PHI’s contracts with its vendors generally require the vendors to name PHI and/or its subsidiaries as additional insureds for the amounts at least equal to PHI’s self-insured retention. Further, PHI’s contracts with its vendors require the vendors to indemnify PHI for various acts and activities that may give rise to claims against PHI. Loss contingency liabilities for both asserted and unasserted claims are recognized if it is probable that a loss will result from such a claim and if the amounts of the losses can be reasonably estimated. Although the outcome of the claims and proceedings cannot be predicted with any certainty, management believes that there are no existing claims or proceedings that are likely to have a material adverse effect on PHI’s or its subsidiaries’ financial condition, results of operations or cash flows. At March 31, 2014, PHI had loss contingency liabilities for general litigation totaling approximately $32 million (including amounts related to the matters specifically described below) and the portion of these loss contingency liabilities in excess of the self-insured retention amount was substantially offset by insurance receivables.

Pepco Substation Injury Claim

In May 2013, a contract worker erecting a scaffold at a Pepco substation came into contact with an energized station service feeder and suffered serious injuries. In August 2013, the individual filed suit against Pepco in the Circuit Court for Montgomery County, Maryland, seeking damages for medical expenses, loss of future earning capacity, pain and suffering and the cost of a life care plan aggregating to a maximum claim of approximately $28.1 million. Discovery is ongoing in the case and, if a settlement cannot be reached with respect to this matter, a trial is expected to begin in October 2014. Pepco has notified its insurers of the incident and believes that the insurance policies in force at the time of the incident, including the policies of the contractor performing the scaffold work (which name Pepco as an additional insured), will offset substantially all of Pepco’s costs associated with the resolution of this matter, including Pepco’s self-insured retention amount. At March 31, 2014, Pepco has concluded that a loss is probable with respect to this matter and has recorded an estimated loss contingency liability, which is included in the liability for general litigation referred to above as of March 31, 2014. Pepco has also concluded as of March 31, 2014 that realization of its insurance claims associated with this matter is probable and, accordingly, has recorded an estimated insurance receivable offsetting substantially all of the related loss contingency liability.

 

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ACE Asbestos Claim

In September 2011, an asbestos complaint was filed in the New Jersey Superior Court, Law Division, against ACE (among other defendants) asserting claims under New Jersey’s Wrongful Death and Survival statutes. The complaint, filed by the estate of a decedent who was the wife of a former employee of ACE, alleges that the decedent’s mesothelioma was caused by exposure to asbestos brought home by her husband on his work clothes. New Jersey courts have recognized a cause of action against a premise owner in a so-called “take home” case if it can be shown that the harm was foreseeable. In this case, the complaint seeks recovery of an unspecified amount of damages for, among other things, the decedent’s past medical expenses, loss of earnings, and pain and suffering between the time of injury and death, and asserts a punitive damage claim. At March 31, 2014, ACE has concluded that a loss is probable with respect to this matter and has recorded an estimated loss contingency liability, which is included in the liability for general litigation referred to above as of March 31, 2014. However, due to the inherent uncertainty of litigation, ACE is unable to estimate a maximum amount of possible loss because the damages sought are indeterminate and the matter involves facts that ACE believes are distinguishable from the facts of the “take-home” cause of action recognized by the New Jersey courts.

ACE Electrical Contact Injury Claims

In October 2010, a farm combine came into and remained in contact with a primary electric line in ACE’s service territory in New Jersey. As a result, two individuals operating the combine received fatal electrical contact injuries. While attempting to rescue those two individuals, another individual sustained third-degree burns to his torso and upper extremities. In September 2012, the individual who received third-degree burns filed suit in New Jersey Superior Court, Salem County. In October 2012, additional suits were filed in the same court by or on behalf of the estates of the deceased individuals. Plaintiffs in each of the cases are seeking indeterminate damages and allege that ACE was negligent in the design, construction, erection, operation and maintenance of its poles, power lines, and equipment, and that ACE failed to warn and protect the public from the foreseeable dangers of farm equipment contacting electric lines. Discovery is ongoing in this matter and the litigation involves a number of other defendants and the filing of numerous cross-claims. ACE has notified its insurers of the incident and believes that the insurance policies in force at the time of the incident will offset ACE’s costs associated with the resolution of this matter in excess of ACE’s self-insured retention amount. At March 31, 2014, ACE has concluded that a loss is probable with respect to these claims and has recorded an estimated loss contingency liability, which is included in the liability for general litigation referred to above as of March 31, 2014. ACE has also concluded as of March 31, 2014 that realization of its insurance claims associated with this matter is probable and, accordingly, has recorded an estimated insurance receivable offsetting substantially all of the loss contingency liability in excess of ACE’s self-insured retention amount.

Pepco Energy Services Billing Claims

During 2012, Pepco Energy Services received letters on behalf of two school districts in Maryland, which claim that invoices in connection with electricity supply contracts contained certain allegedly unauthorized charges, totaling approximately $7 million. The school districts also claim additional compounded interest totaling approximately $9 million. Although no litigation involving Pepco Energy Services related to these claims has commenced, in August and September 2013, Pepco Energy Services received correspondence from the Superintendent of each of the school districts advising of the intention to render a decision regarding an unresolved dispute between the school district and Pepco Energy Services. Pepco Energy Services filed timely answers to the Superintendents challenging the authority of the respective Superintendents to render decisions on the claims and also disputing the merits of the allegations regarding unauthorized charges as well as the claims of entitlement to compounded interest. To date, one of the two districts has submitted a late response to the answer of Pepco Energy Services maintaining that its Superintendent does have authority to

 

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render a decision but acknowledging the availability of administrative and judicial review of the merits of any decision. The response of the other district is overdue. As of March 31, 2014, Pepco Energy Services has concluded that a loss is reasonably possible with respect to these claims, but the amount of loss, if any, is not reasonably estimable.

Environmental Matters

PHI, through its subsidiaries, is subject to regulation by various federal, regional, state and local authorities with respect to the environmental effects of its operations, including air and water quality control, solid and hazardous waste disposal and limitations on land use. Although penalties assessed for violations of environmental laws and regulations are not recoverable from customers of PHI’s utility subsidiaries, environmental clean-up costs incurred by Pepco, DPL and ACE generally are included by each company in its respective cost of service for ratemaking purposes. The total accrued liabilities for the environmental contingencies described below of PHI and its subsidiaries at March 31, 2014 are summarized as follows:

 

            Legacy Generation         
     Transmission
and Distribution
     Regulated      Non-Regulated      Total  
            (millions of dollars)         

Beginning balance as of January 1

   $ 19       $ 6      $ 5       $ 30  

Accruals

     —           —          —           —    

Payments

     —           —          —           —    
  

 

 

    

 

 

    

 

 

    

 

 

 

Ending balance as of March 31

     19         6         5         30   

Less amounts in Other Current Liabilities

     3         1         —           4   
  

 

 

    

 

 

    

 

 

    

 

 

 

Amounts in Other Deferred Credits

   $ 16      $ 5      $ 5      $ 26   
  

 

 

    

 

 

    

 

 

    

 

 

 

Conectiv Energy Wholesale Power Generation Sites

In July 2010, PHI sold the wholesale power generation business of Conectiv Energy Holdings, Inc. and substantially all of its subsidiaries (Conectiv Energy) to Calpine Corporation (Calpine). Under New Jersey’s 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 PHI’s 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. The amount accrued by PHI for the ISRA-required remediation activities at the nine generating facility sites is included in the table above in the column entitled “Legacy Generation – Non-Regulated.”

In September 2011, PHI received a request for data from the U.S. Environmental Protection Agency (EPA) regarding operations at the Deepwater generating facility in New Jersey (which was included in the sale to Calpine) between February 2004 and July 1, 2010, to demonstrate compliance with the Clean Air Act’s new source review permitting program. PHI responded to the data request. Under the terms of the Calpine sale, PHI is obligated to indemnify Calpine for any failure of PHI, on or prior to the closing date of the sale, to comply with environmental laws attributable to the construction of new, or modification of existing, sources of air emissions. At this time, PHI does not expect this inquiry to have a material adverse effect on its consolidated financial condition, results of operations or cash flows.

 

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Franklin Slag Pile Site

In November 2008, ACE received a general notice letter from EPA concerning the Franklin Slag Pile site in Philadelphia, Pennsylvania, asserting that ACE is a potentially responsible party (PRP) that may have liability for clean-up costs with respect to the site and for the costs of implementing an EPA-mandated remedy. EPA’s claims are based on ACE’s 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, EPA’s expenditures for response measures at the site have exceeded $6 million. EPA’s feasibility study for this site conducted in 2007 identified a range of alternatives for permanent remedial measures with varying cost estimates, and the estimated cost of EPA’s preferred alternative is approximately $6 million.

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 ACE’s 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 and are expensed as incurred.

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, and 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 Peck’s 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 former 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 may be entitled to the recyclable material exemption from CERCLA liability. In a Federal Register notice published in November 2009, EPA placed the Peck Iron and Metal site on the National Priorities List. The National Priorities List, 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. In September 2011, EPA initiated a remedial investigation/feasibility study (RI/FS) using federal funds. Pepco cannot at this time estimate an amount or range of reasonably possible loss associated with this RI/FS, any remediation activities to be performed at the site or any other costs that EPA might seek to impose on Pepco.

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 Pepco, DPL and ACE, based on their alleged sale of transformers to Ward Transformer, with respect to past and future response costs incurred by the PRP group in performing a removal action at the site. In a March 2010 order, the court denied the defendants’ motion to dismiss. The litigation is moving forward with certain “test case” defendants (not including Pepco, DPL and ACE) filing summary judgment motions regarding liability. The case has been stayed as to the

 

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remaining defendants pending rulings upon the test cases. In a January 31, 2013 order, the Federal district court granted summary judgment for the test case defendant whom plaintiffs alleged was liable based on its sale of transformers to Ward Transformer. The Federal district court’s order, which plaintiffs have appealed to the U.S. Court of Appeals for the Fourth Circuit, addresses only the liability of the test case defendant. PHI has concluded that a loss is reasonably possible with respect to this matter, but is unable to estimate an amount or range of reasonably possible losses to which it may be exposed. PHI does not believe that any of its three utility subsidiaries had extensive business transactions, if any, with the Ward Transformer site.

Benning Road Site

In September 2010, PHI received a letter from EPA identifying the Benning Road location, consisting of a generation facility operated by Pepco Energy Services until the facility was deactivated in June 2012, and a transmission and distribution facility operated by Pepco, 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 and polycyclic aromatic hydrocarbons. In December 2011, the U.S. District Court for the District of Columbia approved a consent decree entered into by Pepco and Pepco Energy Services with the District of Columbia Department of the Environment (DDOE), which requires Pepco and Pepco Energy Services to conduct a RI/FS for the Benning Road site and an approximately 10 to 15 acre portion of the adjacent Anacostia River. The RI/FS will form the basis for DDOE’s selection of a remedial action for the Benning Road site and for the Anacostia River sediment associated with the site. The consent decree does not obligate Pepco or Pepco Energy Services to pay for or perform any remediation work, but it is anticipated that DDOE will look to the companies to assume responsibility for cleanup of any conditions in the river that are determined to be attributable to past activities at the Benning Road site.

In December 2012, DDOE approved the RI/FS work plan. RI/FS field work commenced in January 2013 and is still in progress. The final phase of field work consisting of the installation of monitoring wells and groundwater sampling and analysis began in April 2014. Once all of the field work has been completed, Pepco and Pepco Energy Services will prepare RI/FS reports for review and approval by DDOE after solicitation and consideration of public comment. The next status report to the court is due on May 24, 2014.

The remediation costs accrued for this matter are included in the table above in the columns entitled “Transmission and Distribution,” “Legacy Generation – Regulated,” and “Legacy Generation – Non-Regulated.”

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. The amount of remediation costs accrued for this matter is included in the table above in the column entitled “Legacy Generation – Regulated.”

Potomac River Mineral Oil Release

In January 2011, a coupling failure on a transformer cooler pipe resulted in a release of non-toxic mineral oil at Pepco’s 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.

Beginning in March 2011, DDOE issued a series of compliance directives requiring Pepco to prepare an incident report, provide certain records, and prepare and implement plans for sampling surface water and river sediments and assessing ecological risks and natural resources damages. Pepco completed field sampling during the fourth quarter of 2011 and submitted sampling results to DDOE during the second quarter of 2012.

 

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In June 2012, Pepco commenced discussions with DDOE regarding a possible consent decree that would resolve DDOE’s threatened enforcement action, including civil penalties, for alleged violation of the District’s Water Pollution Control Law, as well as for damages to natural resources. In March 2014, Pepco and DDOE entered into a consent decree to resolve DDOE’s threatened enforcement action, the terms of which include a combination of a civil penalty and a Supplemental Environmental Project (SEP) with a total cost to Pepco of $875,000. The consent decree was approved and entered by the District of Columbia Superior Court on April 4, 2014. Within 60 days after the entry of the consent decree, Pepco is obligated to make a penalty payment to DDOE in the amount of $250,000 and make a donation in the amount of $25,000 to the Northeast Environmental Enforcement Training Fund, Inc., a non-profit organization that funds scholarships for environmental enforcement training. In addition, to implement the SEP, the consent decree obligates Pepco to enter into an agreement with Living Classrooms Foundation, Inc., a non-profit educational organization, to provide $600,000 to fund the design, installation and operation of a trash collection system at a storm water outfall that drains to the Anacostia River. Finally, the consent decree confirms that no further actions are required by Pepco to investigate, assess or remediate impacts to the river from the mineral oil release. Discussions will proceed separately with DDOE and the federal resource trustees regarding the settlement of a natural resource damage (NRD) claim under federal law. Based on discussions to date, PHI and Pepco do not believe that the resolution of DDOE’s enforcement action or the federal NRD claim will have a material adverse effect on their respective financial condition, results of operations or cash flows.

As a result of the mineral oil release, Pepco implemented certain interim operational changes to the secondary containment systems at the facility which involve pumping accumulated storm water to an above-ground holding tank for off-site disposal. In December 2011, Pepco completed the installation of a treatment system designed to allow automatic discharge of accumulated storm water from the secondary containment system. Pepco currently is seeking DDOE’s and EPA’s approval to commence operation of the new system on a pilot basis to demonstrate its effectiveness in meeting both secondary containment requirements and water quality standards related to the discharge of storm water from the facility. In the meantime, Pepco is continuing to use the aboveground holding tank to manage storm water from the secondary containment system. Pepco also is evaluating other technical and regulatory options for managing storm water from the secondary containment system as alternatives to the proposed treatment system discharge currently under discussion with EPA and DDOE.

The amount accrued for this matter is included in the table above in the column entitled “Transmission and Distribution.”

Metal Bank Site

In the first quarter of 2013, the National Oceanic and Atmospheric Administration (NOAA) contacted Pepco and DPL on behalf of itself and other federal and state trustees to request that Pepco and DPL execute a tolling agreement to facilitate settlement negotiations concerning natural resource damages allegedly caused by releases of hazardous substances, including polychlorinated biphenyls, at the Metal Bank Superfund Site located in Philadelphia, Pennsylvania. Pepco and DPL executed a tolling agreement, which has been extended to March 15, 2015, and will continue settlement discussions with the NOAA, the trustees and other PRPs.

The amount accrued for this matter is included in the table above in the column entitled “Transmission and Distribution.”

Brandywine Fly Ash Disposal Site

In February 2013, Pepco received a letter from the Maryland Department of the Environment (MDE) requesting that Pepco investigate the extent of waste on a Pepco right-of-way that traverses the Brandywine fly ash disposal site in Brandywine, Prince George’s County, Maryland, owned by GenOn MD Ash Management, LLC (GenOn). In July 2013, while reserving its rights and related defenses under a 2000 asset purchase and sale agreement covering the sale of this site, Pepco indicated its willingness to investigate the extent of, and propose an appropriate closure plan to address, ash on the right-of-way. Pepco submitted a schedule for development of a closure plan to MDE on September 30, 2013 and, by letter dated October 18, 2013, MDE approved the schedule.

 

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PHI and Pepco have determined that a loss associated with this matter for PHI and Pepco is probable and have estimated that the costs for implementation of a closure plan and cap on the site are in the range of approximately $3 million to $6 million. PHI and Pepco believe that the costs incurred in this matter will be recoverable from GenOn under the 2000 sale agreement.

The amount accrued for this matter is included in the table above in the column entitled “Transmission and Distribution.”

PHI’s Cross-Border Energy Lease Investments

As discussed in Note (17), “Discontinued Operations – Cross-Border Energy Lease Investments,” PHI held a portfolio of cross-border energy lease investments involving public utility assets located outside of the United States. Each of these investments was comprised of multiple leases and was structured as a sale and leaseback transaction commonly referred to by the IRS as a sale-in, lease-out, or SILO, transaction.

Since 2005, PHI’s cross-border energy lease investments have been under examination by the IRS as part of the PHI federal income tax audits. In connection with the audit of PHI’s 2001-2002 income tax returns, the IRS disallowed the depreciation and interest deductions in excess of rental income claimed by PHI for six of the eight lease investments and, in connection with the audits of PHI’s 2003-2005 and 2006-2008 income tax returns, the IRS disallowed such deductions in excess of rental income for all eight of the lease investments. In addition, the IRS has sought to recharacterize each of the leases as a loan transaction in each of the years under audit as to which PHI would be subject to original issue discount income. PHI has disagreed with the IRS’ proposed adjustments to the 2001-2008 income tax returns and has filed protests of these findings for each year with the Office of Appeals of the IRS. In November 2010, PHI entered into a settlement agreement with the IRS for the 2001 and 2002 tax years for the purpose of commencing litigation associated with this matter and subsequently filed refund claims in July 2011 for the disallowed tax deductions relating to the leases for these years. In January 2011, as part of this settlement, PHI paid $74 million of additional tax for 2001 and 2002, penalties of $1 million, and $28 million in interest associated with the disallowed deductions. Since the July 2011 refund claims were not approved by the IRS within the statutory six-month period, in January 2012 PHI filed complaints in the U.S. Court of Federal Claims seeking recovery of the tax payment, interest and penalties. The 2003-2005 and 2006-2011 income tax return audits continue to be in process with the IRS Office of Appeals and the IRS Exam Division, respectively, and are not presently a part of the U.S. Court of Federal Claims litigation.

On January 9, 2013, the U.S. Court of Appeals for the Federal Circuit issued an opinion in Consolidated Edison Company of New York, Inc. & Subsidiaries v. United States (to which PHI is not a party) that disallowed tax benefits associated with Consolidated Edison’s cross-border lease transaction. While PHI believes that its tax position with regard to its cross-border energy lease investments is appropriate, after analyzing the recent U.S. Court of Appeals ruling, PHI determined in the first quarter of 2013 that its tax position with respect to the tax benefits associated with the cross-border energy leases no longer met the more-likely-than-not standard of recognition for accounting purposes. Accordingly, PHI recorded a non-cash after-tax charge of $377 million in the first quarter of 2013 (as discussed in Note (17), “Discontinued Operations – Cross-Border Energy Lease Investments”), consisting of a charge to reduce the carrying value of the cross-border energy lease investments and a charge to reflect the anticipated additional interest expense related to changes in PHI’s estimated federal and state income tax obligations for the period over which the tax benefits ultimately may be disallowed. PHI had also previously made certain business assumptions regarding foreign investment opportunities available at the end of the full lease terms. During the first quarter of 2013, management believed that its conclusions regarding these business assumptions were no longer supportable, and the tax effects of this change in conclusion were included in the charge. While the IRS could require PHI to pay a penalty of up to 20% of the amount of additional taxes due, PHI believes that it is more likely than not that no such penalty will be incurred, and therefore no amount for any potential penalty has been recorded.

 

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In the event that the IRS were to be successful in disallowing 100% of the tax benefits associated with these lease investments and recharacterizing these lease investments as loans, PHI estimated that, as of March 31, 2013, it would have been obligated to pay approximately $192 million in additional federal taxes (net of the $74 million tax payment described above) and approximately $50 million of interest on the additional federal taxes. These amounts, totaling $242 million, were estimated after consideration of certain tax benefits arising from matters unrelated to the leases that would offset the taxes and interest due, including PHI’s best estimate of the expected resolution of other uncertain and effectively settled tax positions, the carrying back and carrying forward of any existing net operating losses, and the application of certain amounts paid in advance to the IRS. In order to mitigate PHI’s ongoing interest costs associated with the $242 million estimate of additional taxes and interest, PHI made an advanced payment to the IRS of $242 million in the first quarter of 2013. This advanced payment was funded from currently available sources of liquidity and short-term borrowings. A portion of the proceeds from lease terminations (discussed in Note (17), “Discontinued Operations – Cross-Border Energy Lease Investments”) was used to repay the short-term borrowings utilized to fund the advanced payment.

In order to mitigate the cost of continued litigation related to the cross-border energy lease investments, PHI and its subsidiaries have entered into discussions with the IRS with the intention of seeking a settlement of all tax issues for open tax years 2001 through 2011, including the cross-border energy lease issue. PHI currently believes that it is possible that a settlement with the IRS may be reached in 2014. If a settlement of all tax issues or a standalone settlement on the leases is not reached, PHI may move forward with its litigation with the IRS. Further discovery in the case is stayed until July 1, 2014, pursuant to an order issued by the court on April 24, 2014.

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

PHI 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, 2014, PHI and its subsidiaries were parties to a variety of agreements pursuant to which they were guarantors for standby letters of credit, energy procurement obligations, and other commitments and obligations. The commitments and obligations, in millions of dollars, were as follows:

 

     Guarantor         
     PHI      Pepco      DPL      ACE      Total  
     (millions of dollars)  

Energy procurement obligations of Pepco Energy Services (a)

   $ 4       $ —         $ —         $ —         $ 4   

Guarantees associated with disposal of Conectiv Energy assets (b)

     13        —          —          —          13  

Guaranteed lease residual values (c)

     3        5        7        4        19  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 20       $ 5       $ 7       $ 4       $ 36   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

(a) PHI has continued contractual commitments for performance and related payments of Pepco Energy Services primarily to Independent System Operators and distribution companies.
(b) Represents guarantees by PHI of Conectiv Energy’s derivatives portfolio transferred in connection with the disposition of Conectiv Energy’s wholesale business. The derivative portfolio guarantee is currently $13 million and covers Conectiv Energy’s performance prior to the assignment. This guarantee will remain in effect until the end of 2015.
(c) Represents the maximum potential obligation in the event that the fair value of certain leased equipment and fleet vehicles is zero at the end of the maximum lease term. The maximum lease term associated with these assets ranges from 3 to 8 years. The maximum potential obligation at the end of the minimum lease term would be $54 million, $10 million of which is a guaranty by PHI, $14 million by Pepco, $17 million by DPL and $13 million by ACE. The minimum lease term associated with these assets ranges from 1 to 4 years. Historically, payments under the guarantees have not been made and PHI believes the likelihood of payments being required under the guarantees is remote.

 

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PHI 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 Services Performance Contracts

Pepco Energy Services has a diverse portfolio of energy savings services performance contracts that are associated with the installation of energy savings equipment or combined heat and power facilities for federal, state and local government customers. As part of the energy savings contracts, Pepco Energy Services typically guarantees that the equipment or systems it installs will generate a specified amount of energy savings on an annual basis over a multi-year period. As of March 31, 2014, the remaining notional amount of Pepco Energy Services’ energy savings guarantees over the life of the multi-year performance contracts on: (i) completed projects was $253 million with the longest guarantee having a remaining term of 12 years; and, (ii) projects under construction was $205 million with the longest guarantee having a term of 23 years after completion of construction. 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.

As of March 31, 2014, Pepco Energy Services had a performance guarantee contract associated with the production at a combined heat and power facility that is under construction totaling $15 million in notional value over 20 years.

Pepco Energy Services recognizes a liability for the value of the estimated energy savings or production shortfalls when it is probable that the guaranteed amounts will not be achieved and the amount is reasonably estimable. As of March 31, 2014, Pepco Energy Services had an accrued liability of $1 million for its energy savings contracts that it established during 2012. There was no significant change in the type of contracts issued during the three months ended March 31, 2014 as compared to the three months ended March 31, 2013.

Dividends

On April 24, 2014, Pepco Holdings’ Board of Directors declared a dividend on common stock of 27 cents per share payable June 30, 2014, to stockholders of record on June 10, 2014.

 

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(15) VARIABLE INTEREST ENTITIES

PHI is required to consolidate a variable interest entity (VIE) in accordance with FASB ASC 810 if PHI or a subsidiary is the primary beneficiary of the VIE. The primary beneficiary of a VIE is typically the entity with both the power to direct activities most significantly impacting economic performance of the VIE and the obligation to absorb losses or receive benefits of the VIE that could potentially be significant to the VIE. PHI performs a qualitative analysis to determine whether a variable interest provides a controlling financial interest in a VIE. Set forth below are the relationships with respect to which PHI conducted a VIE analysis as of March 31, 2014:

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. DPL’s costs associated with obtaining RECs to fulfill its RPS obligations are recoverable from its customers by law. As of March 31, 2014, PHI, through its DPL subsidiary, is a party to three land-based wind power purchase agreements (PPAs) in the aggregate amount of 128 MWs, one solar PPA with a 10 MW facility, and an agreement with the Delaware Sustainable Energy Utility (DSEU) to purchase solar renewable energy credits (SREC). Each of the facilities associated with these PPAs is operational, and DPL is obligated to purchase energy and RECs in amounts generated and delivered by the wind facilities and SRECs from the solar facility and DSEU, up to certain amounts (as set forth below) at rates that are primarily fixed under the respective agreements. PHI and DPL have concluded that while VIEs exist under these contracts, consolidation is not required under the FASB guidance on the consolidation of variable interest entities as DPL is not the primary beneficiary. DPL has not provided financial or other support under these arrangements that it was not previously contractually required to provide during the periods presented, nor does DPL have any intention to provide such additional support.

Because DPL has no equity or debt interest in these renewable energy transactions, the maximum exposure to loss relates primarily to any above-market costs incurred for power, RECs or SRECs. Due to unpredictability in the amount of MW’s ultimately purchased under the agreements for purchased renewable energy, RECs and SRECs, PHI and DPL are unable to quantify the maximum exposure to loss. The power purchase, REC and SREC costs are recoverable from DPL’s customers through regulated rates.

DPL is obligated to purchase energy and RECs from one of the wind facilities through 2024 in amounts not to exceed 50 MWs, from the second wind facility through 2031 in amounts not to exceed 40 MWs, and from the third wind facility through 2031 in amounts not to exceed 38 MWs. DPL’s purchases under the three wind PPAs totaled $10 million for each of the three months ended March 31, 2014 and 2013, respectively.

The term of the agreement with the solar facility is through 2030 and DPL is obligated to purchase SRECs in an amount up to 70 percent of the energy output at a fixed price. The DSEU may enter into 20-year contracts with solar facilities to purchase SRECs for resale to DPL. Under the agreement, DPL is obligated to purchase in amounts not to exceed 14 MWs of SRECs at annually determined auction rates. DPL’s purchases under these solar agreements were $1 million and less than $1 million for the three months ended March 31, 2014 and 2013, respectively.

On October 18, 2011, the DPSC approved a tariff submitted by DPL in accordance with the requirements of the RPS specific to fuel cell facilities totaling 30 MWs to be constructed by a qualified fuel cell provider. 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 MW hour (MWh) of energy produced by the fuel cell facilities over 21 years. DPL has no obligation to the qualified fuel cell provider other than to remit payments collected from its distribution customers pursuant to the tariff. The RPS provides for a reduction in DPL’s REC requirements based upon the actual energy output of the facilities. At March 31, 2014 and 2013, 30 MWs and 9 MWs of capacity were available from fuel cell facilities placed in service under the tariff, respectively. DPL billed $9 million and $3 million to distribution customers for the three months ended March 31, 2014 and 2013, respectively. PHI and DPL have concluded that while a VIE exists under this arrangement, consolidation is not required for this arrangement under the FASB guidance on consolidation of variable interest entities as DPL is not the primary beneficiary.

 

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ACE Power Purchase Agreements

PHI, through its ACE subsidiary, is a party to three PPAs with unaffiliated NUGs totaling 459 MWs. One of the agreements ends in 2016 and the other two end in 2024. PHI and ACE were not involved in the creation of these contracts and have no equity or debt invested in these entities. In performing its VIE analysis, PHI has been unable to obtain sufficient information to determine whether these three entities were variable interest entities or if ACE was the primary beneficiary. As a result, PHI has applied the scope exemption from the consolidation guidance.

Because ACE has no equity or debt invested in the NUGs, the maximum exposure to loss relates primarily to any above-market costs incurred for power. Due to unpredictability in the PPAs pricing for purchased energy, PHI and ACE are unable to quantify the maximum exposure to loss. The power purchase costs are recoverable from ACE’s customers through regulated rates. Purchase activities with the NUGs, including excess power purchases not covered by the PPAs, for the three months ended March 31, 2014 and 2013, were approximately $72 million and $54 million, respectively, of which approximately $59 million and $54 million, respectively, consisted of power purchases under the PPAs.

ACE Funding

In 2001, ACE established ACE Funding solely for the purpose of securitizing authorized portions of ACE’s recoverable stranded costs through the issuance and sale of Transition Bonds. The proceeds of the sale of each series of Transition Bonds were transferred to ACE in exchange for the transfer by ACE to ACE Funding of the right to collect a non-bypassable Transition Bond Charge (representing revenue ACE receives, and pays to ACE Funding, to fund the principal and interest payments on Transition Bonds and related taxes, expenses and fees) from ACE customers pursuant to bondable stranded costs rate orders issued by the NJBPU in an amount sufficient to fund the principal and interest payments on the Transition Bonds and related taxes, expenses and fees (Bondable Transition Property). The assets of ACE Funding, including the Bondable Transition Property, and the Transition Bond Charges collected from ACE’s customers, are not available to creditors of ACE. The holders of Transition Bonds have recourse only to the assets of ACE Funding. ACE owns 100 percent of the equity of ACE Funding, and PHI and ACE consolidate ACE Funding in their consolidated financial statements as ACE is the primary beneficiary of ACE Funding under the variable interest entity consolidation guidance.

 

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(16) ACCUMULATED OTHER COMPREHENSIVE LOSS

The components of Pepco Holdings’ AOCL relating to continuing and discontinued operations are as follows. For additional information, see the consolidated statements of comprehensive income.

 

     Three Months Ended
March 31,
 
     2014     2013  
     (millions of dollars)  

Balance as of January 1

   $ (34 )   $ (48 )
  

 

 

   

 

 

 

Treasury Lock

    

Balance as of January 1

     (9 )     (10 )

Amount of pre-tax loss reclassified to Interest expense

     —         —    

Income tax benefit

     —         —    
  

 

 

   

 

 

 

Balance as of March 31

     (9     (10
  

 

 

   

 

 

 

Pension and Other Postretirement Benefits

    

Balance as of January 1

     (25 )     (32

Amount of amortization of net prior service cost and actuarial loss reclassified to Other operation and maintenance expense

     1       2  

Income tax benefit

     —         (1
  

 

 

   

 

 

 

Balance as of March 31

     (24     (31
  

 

 

   

 

 

 

Commodity Derivatives

    

Balance as of January 1

     —         (6

Amount of net pre-tax loss reclassified to loss from discontinued operations before income tax

     —         8  

Income tax benefit

     —         (3
  

 

 

   

 

 

 

Balance as of March 31

     —         (1
  

 

 

   

 

 

 

Balance as of March 31

   $ (33   $ (42
  

 

 

   

 

 

 

(17) DISCONTINUED OPERATIONS

PHI’s loss from discontinued operations, net of income taxes, is comprised of the following:

 

     Three Months Ended
March 31,
 
     2014      2013  
     (millions of dollars)  

Cross-border energy lease investments

   $ —         $ (320 )

Pepco Energy Services’ retail electric and natural gas supply businesses

     —          1  
  

 

 

    

 

 

 

Loss from discontinued operations, net of income taxes

   $  —        $ (319
  

 

 

    

 

 

 

 

 

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Cross-Border Energy Lease Investments

Between 1994 and 2002, PCI entered into cross-border energy lease investments consisting of hydroelectric generation facilities, coal-fired electric generation facilities and natural gas distribution networks located outside of the United States. Each of these lease investments was structured as a sale and leaseback transaction commonly referred to as a sale-in, lease-out, or SILO, transaction. During the second and third quarters of 2013, PHI terminated early all of its interests in the remaining lease investments. PHI received aggregate net cash proceeds from these early terminations of $873 million (net of aggregate termination payments of $2.0 billion used to retire the non-recourse debt associated with the terminated leases) and recorded an aggregate pre-tax loss, including transaction costs, of approximately $3 million ($2 million after-tax), representing the excess of the carrying value of the terminated leases over the net cash proceeds received. As a result, PHI has reported the results of operations of the cross-border energy lease investments as discontinued operations in all periods presented in the accompanying consolidated statements of income (loss).

Operating Results

The operating results for the cross-border energy lease investments were as follows:

 

     Three Months Ended March 31,  
     2014      2013  
     (millions of dollars)  

Operating revenue from PHI’s cross-border energy lease investments

   $  —        $ 5  

Non-cash charge to reduce carrying value of PHI’s cross-border energy lease investments

     —          (373 )
  

 

 

    

 

 

 

Total operating revenue

   $  —        $ (368 )
  

 

 

    

 

 

 

Income from operations of discontinued operations, net of income taxes (a)

   $  —        $ 5  

Net losses associated with the early termination of the cross-border energy lease investments, net of income taxes (b)

     —          (325 )
  

 

 

    

 

 

 

Loss from discontinued operations, net of income taxes

   $  —        $ (320 )
  

 

 

    

 

 

 

 

(a) Includes income tax expense of approximately zero and $1 million for the three months ended March 31, 2014 and 2013, respectively.
(b) Includes income tax benefit of approximately zero and $48 million for the three months ended March 31, 2014 and 2013, respectively.

On January 9, 2013, the U.S. Court of Appeals for the Federal Circuit issued an opinion in Consolidated Edison Company of New York, Inc. & Subsidiaries v. United States (to which PHI is not a party) that disallowed tax benefits associated with Consolidated Edison’s cross-border lease transaction. As a result of the court’s ruling in this case, PHI determined in the first quarter of 2013 that its tax position with respect to the benefits associated with its cross-border energy leases no longer met the more-likely-than-not standard of recognition for accounting purposes, and PHI recorded non-cash after-tax charges of $323 million in the first quarter of 2013 consisting of the following components:

 

    A non-cash pre-tax charge of $373 million ($307 million after-tax) to reduce the carrying value of these cross-border energy lease investments under FASB guidance on leases (ASC 840). This pre-tax charge was originally recorded in the consolidated statements of income (loss) as a reduction in operating revenue and is now reflected in loss from discontinued operations, net of income taxes.

 

   

A non-cash charge of $16 million after-tax to reflect the anticipated additional net interest expense under FASB guidance for income taxes (ASC 740) related to estimated federal and state income tax obligations for the period over which the tax benefits may be disallowed. This after-tax charge was

 

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originally recorded in the consolidated statements of income (loss) as an increase in income tax expense and is now reflected in loss from discontinued operations, net of income taxes. The after-tax interest charge for PHI on a consolidated basis was $70 million and this amount was allocated to each member of PHI’s consolidated group as if each member was a separate taxpayer, resulting in the recognition of a $12 million interest benefit for the Power Delivery segment, and interest expense of $16 million for PCI and $66 million for Corporate and Other, respectively.

PHI had also previously made certain business assumptions regarding foreign investment opportunities available at the end of the full lease terms. In view of the change in PHI’s tax position with respect to the tax benefits associated with the cross-border energy lease investments and PHI’s resulting decision to pursue the early termination of these investments, management concluded in the first quarter of 2013 that these business assumptions were no longer supportable and the tax effects of this conclusion were reflected in the after-tax charge of $307 million described above.

PHI accrued no penalties associated with its re-assessment of the likely outcome of tax positions associated with the cross-border energy lease investments. While the IRS could require PHI to pay a penalty of up to 20% of the amount of additional taxes due, PHI believes that it is more likely than not that no such penalty will be incurred, and therefore no amount for any potential penalty was included in the charge.

For additional information concerning these cross-border energy lease investments, see Note (14), “Commitments and Contingencies – PHI’s Cross-Border Energy Lease Investments.”

Retail Electric and Natural Gas Supply Businesses of Pepco Energy Services

On March 21, 2013, Pepco Energy Services entered into an agreement whereby a third party assumed all the rights and obligations of the remaining natural gas supply customer contracts, and the associated supply obligations, inventory and derivative contracts. The transaction was completed on April 1, 2013. In addition, in the second quarter of 2013, Pepco Energy Services completed the wind-down of its retail electric supply business by terminating its remaining customer supply and wholesale purchase obligations beyond June 30, 2013. As a result, PHI has reported the results of operations of Pepco Energy Services’ retail electric and natural gas supply businesses as discontinued operations in all periods presented in the accompanying consolidated statements of income (loss).

Operating Results

The operating results for the retail electric and natural gas supply businesses of Pepco Energy Services are as follows:

 

     Three Months Ended March 31,  
     2014      2013  
     (millions of dollars)  

Operating revenue

   $  —         $ 50   
  

 

 

    

 

 

 

Income from operations of discontinued operations, net of income taxes

   $  —        $ 1  

Net gains associated with accelerated disposition of retail electric and natural gas contracts, net of income taxes

     —           —     
  

 

 

    

 

 

 

Income from discontinued operations, net of income taxes (a)

   $  —        $ 1  
  

 

 

    

 

 

 

 

(a) Includes income tax expense of approximately zero for each of the three months ended March 31, 2014 and 2013, respectively.

 

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Derivative Instruments and Hedging Activities

Derivatives were used by the retail electric and natural gas supply businesses of Pepco Energy Services to hedge commodity price risk. There were no outstanding forward contracts or derivative positions for Pepco Energy Services as of March 31, 2014 and December 31, 2013.

As of March 31, 2014, Pepco Energy Services had posted net cash collateral of $2 million and letters of credit of less than $1 million. As December 31, 2013, Pepco Energy Services had posted net cash collateral of $3 million and letters of credit of less than $1 million.

Derivatives Designated as Hedging Instruments

At December 31, 2012, the cumulative net pre-tax loss related to effective cash flow hedges of the retail electric and natural gas supply businesses of Pepco Energy Services included in AOCL was $10 million ($6 million after-tax). With the assumption by a third party, on April 1, 2013, of all the rights and obligations of the derivative contracts associated with the retail natural gas supply business, PHI determined that the hedged forecasted purchases of supply for retail natural gas customers were probable not to occur. Accordingly, during the first quarter of 2013, PHI recognized $4 million of pre-tax unrealized derivative losses ($2 million after-tax) that were previously included in AOCL as cash flow hedges. The remaining pre-tax loss was reclassified into income on completion of the wind-down of the retail electric business in the second quarter of 2013.

Other Derivative Activity

The retail electric and natural gas supply businesses of Pepco Energy Services held certain derivatives that were not in hedge accounting relationships and were not designated as normal purchases or normal sales. These derivatives were recorded at fair value on the balance sheet with the gain or loss for changes in fair value recorded through Income (loss) from discontinued operations, net of income taxes.

For the three months ended March 31, 2013, the amount of the derivative gain (loss) for the retail electric and natural gas supply businesses of Pepco Energy Services recognized in Income (loss) from discontinued operations, net of income taxes is provided in the table below:

 

     Three Months
Ended March 31, 2013
 
     (millions of dollars)  

Reclassification of mark-to-market to realized on settlement of contracts

   $ 4  

Unrealized mark-to-market loss

     (3
  

 

 

 

Total net gain (loss)

   $ 1   
  

 

 

 

 

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(18) SUBSEQUENT EVENTS

On April 29, 2014, PHI entered into an Agreement and Plan of Merger (the Merger Agreement) with Exelon Corporation, a Pennsylvania corporation (Exelon), and Purple Acquisition Corp., a Delaware corporation and an indirect, wholly-owned subsidiary of Exelon (Merger Sub), providing for the merger of Merger Sub with and into PHI (the Merger), with PHI surviving the Merger as an indirect, wholly-owned subsidiary of Exelon. Pursuant to the Merger Agreement, at the effective time of the Merger, each outstanding share of common stock, par value $0.01 per share, of PHI (other than (i) shares owned by Exelon, Merger Sub or any other direct or indirect wholly-owned subsidiary of Exelon and shares owned by PHI or any direct or indirect wholly-owned subsidiary of PHI, and in each case not held on behalf of third parties (but not including shares held by PHI in any rabbi trust or similar arrangement in respect of any compensation plan or arrangement) and (ii) shares that are owned by stockholders who have perfected and not withdrawn a demand for appraisal rights pursuant to Delaware law), will be canceled and converted into the right to receive $27.25 in cash, without interest.

In connection with the Merger, PHI entered into a Subscription Agreement, dated April 29, 2014 (the Subscription Agreement), with Exelon, pursuant to which on April 30, 2014, PHI issued to Exelon 9,000 originally issued shares of non-voting, non-convertible and non-transferable preferred stock, par value $0.01 per share (the Non-voting Preferred Stock), for a purchase price of $90 million. Exelon also committed pursuant to the Subscription Agreement to purchase 1,800 originally issued shares of Non-voting Preferred Stock for a purchase price of $18 million at the end of each 90-day period following the date of the Subscription Agreement, up to a maximum of 18,000 shares of Non-voting Preferred Stock for a maximum aggregate consideration of $180 million. The Non-voting Preferred Stock will be entitled to receive a cumulative, non-participating cash dividend of 0.1% per annum, payable quarterly. The proceeds from the issuance of the Non-voting Preferred Stock are not subject to restrictions and are intended to serve as a prepayment of any applicable reverse termination fee payable from Exelon to PHI. The Non-voting Preferred Stock will be redeemable on the terms and in the circumstances set forth in the Merger Agreement and the Subscription Agreement.

Consummation of the Merger is subject to the satisfaction or waiver of specified closing conditions, including (i) the approval of the Merger by the holders of a majority of the outstanding shares of common stock of PHI, (ii) the receipt of regulatory approvals required to consummate the Merger, including approvals from FERC, the Federal Communications Commission, the DPSC, the DCPSC, the MPSC, the NJBPU and the Virginia State Corporation Commission, (iii) the expiration or termination of the applicable waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976 and (iv) other customary closing conditions, including (a) the accuracy of each party’s representations and warranties (subject to customary materiality qualifiers) and (b) each party’s compliance with its obligations and covenants contained in the Merger Agreement (including covenants that may limit, restrict or prohibit PHI and its subsidiaries from taking specified actions during the period between the date of the Merger Agreement and the closing of the Merger or the termination of the Merger Agreement). In addition, the obligations of Exelon and Merger Sub to consummate the Merger are subject to the required regulatory approvals not imposing terms, conditions, obligations or commitments, individually or in the aggregate, that constitute a burdensome condition (as defined in the Merger Agreement). The parties currently anticipate that the closing will occur in the second or third quarter of 2015.

The Merger Agreement may be terminated by each of PHI and Exelon under certain circumstances, including if the Merger is not consummated by July 29, 2015 (subject to extension to October 29, 2015, if all of the conditions to closing, other than the conditions related to obtaining regulatory approvals, have been satisfied). The Merger Agreement also provides for certain termination rights for both PHI and Exelon, and further provides that, upon termination of the Merger Agreement under certain specified circumstances, PHI will be required to pay Exelon a termination fee of $259 million or reimburse Exelon for its expenses up to $40 million (which reimbursement of expenses shall reduce on a dollar for dollar basis any termination fee subsequently payable by PHI), provided, however, that if the Merger Agreement is terminated in connection with an acquisition proposal made under certain circumstances by a person who made an acquisition proposal between April 1, 2014 and the date of the Merger Agreement, the termination fee will be $293 million plus reimbursement of Exelon for its expenses up to $40 million (not subject to offset). In addition, if the Merger Agreement is terminated under certain circumstances due to the failure to obtain regulatory approvals or the breach by Exelon of its obligations in respect of obtaining regulatory approvals (a Regulatory Termination), Exelon will pay PHI a reverse termination fee equal to the purchase price paid up to the date of termination by Exelon to purchase the Non-voting Preferred Stock (the Preferred Stock Purchase Price), through PHI’s redemption of the Non-voting Preferred Stock for nominal consideration. If the Merger Agreement is terminated other than for a Regulatory Termination, PHI will be required to redeem the Non-voting Preferred Stock for a redemption price equal to the Preferred Stock Purchase Price.

 

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POTOMAC ELECTRIC POWER COMPANY

STATEMENTS OF INCOME

(Unaudited)

 

     Three Months Ended
March 31,
 
     2014     2013  
     (millions of dollars)  

Operating Revenue

   $ 535     $ 477  
  

 

 

   

 

 

 

Operating Expenses

    

Purchased energy

     230       192  

Other operation and maintenance

     93       102  

Depreciation and amortization

     56       47  

Other taxes

     90       89  
  

 

 

   

 

 

 

Total Operating Expenses

     469       430  
  

 

 

   

 

 

 

Operating Income

     66       47  
  

 

 

   

 

 

 

Other Income (Expenses)

    

Interest expense

     (27 )     (26 )

Other income

     9       4  
  

 

 

   

 

 

 

Total Other Expenses

     (18 )     (22 )
  

 

 

   

 

 

 

Income Before Income Tax Expense

     48       25  

Income Tax Expense

     16       2  
  

 

 

   

 

 

 

Net Income

   $ 32     $ 23  
  

 

 

   

 

 

 

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

 

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POTOMAC ELECTRIC POWER COMPANY

BALANCE SHEETS

(Unaudited)

 

     March 31,
2014
    December 31,
2013
 
     (millions of dollars)  

ASSETS

    

CURRENT ASSETS

    

Cash and cash equivalents

   $ 105     $ 9  

Restricted cash equivalents

     182       3  

Accounts receivable, less allowance for uncollectible accounts of $16 million and $16 million, respectively

     360       345  

Inventories

     66       67  

Deferred income tax assets, net

     57       48  

Income taxes and related accrued interest receivable

     94       113  

Prepaid expenses and other

     21       18  
  

 

 

   

 

 

 

Total Current Assets

     885       603  
  

 

 

   

 

 

 

OTHER ASSETS

  

Regulatory assets

     563       563  

Prepaid pension expense

     327       332  

Investment in trust

     33       33  

Income taxes and related accrued interest receivable

     28       36  

Other

     74       66  
  

 

 

   

 

 

 

Total Other Assets

     1,025       1,030  
  

 

 

   

 

 

 

PROPERTY, PLANT AND EQUIPMENT

  

Property, plant and equipment

     7,415       7,310  

Accumulated depreciation

     (2,787 )     (2,772 )
  

 

 

   

 

 

 

Net Property, Plant and Equipment

     4,628       4,538  
  

 

 

   

 

 

 

TOTAL ASSETS

   $ 6,538     $ 6,171  
  

 

 

   

 

 

 

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

 

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POTOMAC ELECTRIC POWER COMPANY

BALANCE SHEETS

(Unaudited)

 

     March 31,
2014
     December 31,
2013
 
     (millions of dollars, except shares)  

LIABILITIES AND EQUITY

     

CURRENT LIABILITIES

     

Short-term debt

   $  —        $ 151  

Current portion of long-term debt and project funding

     175        175  

Accounts payable

     111        132  

Accrued liabilities

     97        90  

Accounts payable due to associated companies

     29        32  

Capital lease obligations due within one year

     9        9  

Taxes accrued

     21        34  

Interest accrued

     38        20  

Liabilities and accrued interest related to uncertain tax positions

     —          37  

Customer deposits

     46        46  

Other

     86        75  
  

 

 

    

 

 

 

Total Current Liabilities

     612        801  
  

 

 

    

 

 

 

DEFERRED CREDITS

     

Regulatory liabilities

     113        113  

Deferred income tax liabilities, net

     1,465        1,412  

Investment tax credits

     3        3  

Other postretirement benefit obligations

     60        61  

Liabilities and accrued interest related to uncertain tax positions

     —          10  

Other

     67        65  
  

 

 

    

 

 

 

Total Deferred Credits

     1,708        1,664  
  

 

 

    

 

 

 

OTHER LONG-TERM LIABILITIES

     

Long-term debt

     2,124        1,724  

Capital lease obligations

     60        60  
  

 

 

    

 

 

 

Total Other Long-Term Liabilities

     2,184        1,784  
  

 

 

    

 

 

 

COMMITMENTS AND CONTINGENCIES (NOTE 11)

     

EQUITY

     

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

     —          —    

Premium on stock and other capital contributions

     1,010        930  

Retained earnings

     1,024        992  
  

 

 

    

 

 

 

Total Equity

     2,034        1,922  
  

 

 

    

 

 

 

TOTAL LIABILITIES AND EQUITY

   $ 6,538      $ 6,171  
  

 

 

    

 

 

 

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

 

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POTOMAC ELECTRIC POWER COMPANY

STATEMENTS OF CASH FLOWS

(Unaudited)

 

     Three Months Ended
March 31,
 
     2014     2013  
     (millions of dollars)  

OPERATING ACTIVITIES

    

Net income

   $ 32     $ 23  

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

    

Depreciation and amortization

     56       47  

Gain on sale of assets

     (4     —     

Deferred income taxes

     39       26  

Changes in:

    

Accounts receivable

     (19 )     (2 )

Inventories

     1       (2 )

Prepaid expenses

     (2 )     3  

Regulatory assets and liabilities, net

     (18     (9 )

Accounts payable and accrued liabilities

     (9     (27

Prepaid pension expense, excluding contributions

     5       4  

Income tax-related prepayments, receivables and payables

     (34 )     (60 )

Interest accrued

     18       21  

Other assets and liabilities

     1       —    
  

 

 

   

 

 

 

Net Cash From Operating Activities

     66        24  
  

 

 

   

 

 

 

INVESTING ACTIVITIES

    

Investment in property, plant and equipment

     (124 )     (125 )

Department of Energy capital reimbursement awards received

     3       1  

Proceeds from sale of assets

     4        —     

Changes in restricted cash equivalents

     (5 )     —    

Net other investing activities

     4        (3 )
  

 

 

   

 

 

 

Net Cash Used By Investing Activities

     (118     (127 )
  

 

 

   

 

 

 

FINANCING ACTIVITIES

    

Capital contribution from Parent

     80       175  

Issuance of long-term debt

     400       250  

Changes in restricted cash equivalents

     (175 )     —    

Repayments of short-term debt, net

     (151 )     (231 )

Cost of issuances

     (7 )     (4 )

Net other financing activities

     1       1   
  

 

 

   

 

 

 

Net Cash From Financing Activities

     148       191   
  

 

 

   

 

 

 

Net Increase in Cash and Cash Equivalents

     96       88  

Cash and Cash Equivalents at Beginning of Period

     9       9  
  

 

 

   

 

 

 

CASH AND CASH EQUIVALENTS AT END OF PERIOD

   $ 105     $ 97  
  

 

 

   

 

 

 

SUPPLEMENTAL CASH FLOW INFORMATION

    

Cash received for income taxes (includes payments from PHI for federal income taxes)

   $ (2 )   $  —    

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

 

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POTOMAC ELECTRIC POWER COMPANY

STATEMENT OF EQUITY

(Unaudited)

 

     Common Stock      Premium      Retained
        
(millions of dollars, except shares)    Shares      Par Value      on Stock      Earnings      Total  

BALANCE, DECEMBER 31, 2013

     100      $ —        $ 930      $ 992      $ 1,922  

Net Income

     —          —          —          32        32  

Capital contribution from Parent

     —          —          80        —          80  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

BALANCE, MARCH 31, 2014

     100      $ —        $ 1,010      $ 1,024      $ 2,034  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

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

 

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NOTES TO FINANCIAL STATEMENTS

POTOMAC ELECTRIC POWER COMPANY

(1) ORGANIZATION

Potomac Electric Power Company (Pepco) is engaged in the transmission and distribution of electricity in the District of Columbia and major portions of Prince George’s County and Montgomery County in suburban Maryland. Pepco also provides Default Electricity Supply, which is the supply of electricity at regulated rates to retail customers in its service territories who do not elect to purchase electricity from a competitive supplier. Default Electricity Supply is known as Standard Offer Service in both the District of Columbia and Maryland. Pepco is a wholly owned subsidiary of Pepco Holdings, Inc. (Pepco Holdings or PHI).

On April 29, 2014, PHI entered into an Agreement and Plan of Merger (the Merger Agreement) with Exelon Corporation, a Pennsylvania corporation (Exelon), and Purple Acquisition Corp., a Delaware corporation and an indirect, wholly-owned subsidiary of Exelon (Merger Sub), providing for the merger of Merger Sub with and into PHI (the Merger), with PHI surviving the Merger as an indirect, wholly-owned subsidiary of Exelon. See Note (13), “Subsequent Events,” for additional information regarding the Merger.

(2) SIGNIFICANT ACCOUNTING POLICIES

Financial Statement Presentation

Pepco’s unaudited financial statements are prepared in conformity with accounting principles generally accepted in the United States of America (GAAP). Pursuant to the rules and regulations of the Securities and Exchange Commission, certain information and footnote disclosures normally included in annual financial statements prepared in accordance with GAAP have been omitted. Therefore, these financial statements should be read along with the annual financial statements included in Pepco’s annual report on Form 10-K for the year ended December 31, 2013. In the opinion of Pepco’s management, the unaudited financial statements contain all adjustments (which all are of a normal recurring nature) necessary to state fairly Pepco’s financial condition as of March 31, 2014, in accordance with GAAP. The year-end December 31, 2013 balance sheet included herein was derived from audited financial statements, but does not include all disclosures required by GAAP. Interim results for the three months ended March 31, 2014 may not be indicative of results that will be realized for the full year ending December 31, 2014.

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 financial statements and accompanying notes. Although Pepco 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.

 

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Significant matters that involve the use of estimates include the assessment of contingencies, the calculation of future cash flows and fair value amounts for use in asset impairment evaluations, pension and other postretirement benefits assumptions, the assessment of the probability of recovery of regulatory assets, accrual of storm restoration costs, accrual of unbilled revenue, recognition of changes in network service transmission rates for prior service year costs, accrual of loss contingency liabilities for general litigation and auto and other liability claims and income tax provisions and reserves. Additionally, Pepco is subject to legal, regulatory, and other proceedings and claims that arise in the ordinary course of its business. Pepco 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.

Taxes Assessed by a Governmental Authority on Revenue-Producing Transactions

Taxes included in Pepco’s gross revenues were $78 million and $77 million for the three months ended March 31, 2014 and 2013, respectively.

Reclassifications and Adjustments

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

Revision of Prior Period Financial Statements

Operating and Financing Cash Flows

The statement of cash flows for the three months ended March 31, 2013 has been revised to correctly present changes in book overdraft balances as operating activities (included in Changes in accounts payable and accrued liabilities) rather than financing activities (included in Net other financing activities). The effect of the revision was to decrease Net cash from operating activities by $13 million from $37 million to $24 million and increase Net cash from financing activities by $13 million from $178 million to $191 million. The revision was not considered to be material, individually or in the aggregate, to previously issued financial statements.

(3) NEWLY ADOPTED ACCOUNTING STANDARDS

Liabilities (Accounting Standards Codification (ASC) 405)

In February 2013, the Financial Accounting Standards Board (FASB) issued new recognition and disclosure requirements for certain joint and several liability arrangements where the total amount of the obligation is fixed at the reporting date. For arrangements within the scope of this standard, Pepco is required to measure such obligations as the sum of the amount it agreed to pay on the basis of its arrangement among co-obligors and any additional amount it expects to pay on behalf of its co-obligors. Adoption of this guidance during the first quarter of 2014 did not have a material impact on Pepco’s financial statements.

Income Taxes (ASC 740)

In July 2013, the FASB issued new guidance requiring netting of certain unrecognized tax benefits against a deferred tax asset for a loss or other similar tax carryforward that would apply upon settlement of the uncertain tax position. The prospective adoption of this guidance at March 31, 2014 resulted in Pepco netting liabilities related to uncertain tax positions with deferred tax assets for net operating loss and other carryforwards (included in deferred income tax liabilities, net) and income taxes receivable (including income tax deposits) related to effectively settled uncertain tax positions.

(4) RECENTLY ISSUED ACCOUNTING STANDARDS, NOT YET ADOPTED

New accounting pronouncements not yet effective are not expected to have a material effect on Pepco’s financial statements.

(5) SEGMENT INFORMATION

Pepco operates its business as one regulated utility segment, which includes all of its services as described above.

(6) REGULATORY MATTERS

Rate Proceedings

As further described in Note (13), “Subsequent Events,” on April 29, 2014, PHI entered into the Merger Agreement with Exelon and Merger Sub. Subject to certain exceptions, prior to the Merger or the termination of the Merger Agreement, PHI and its subsidiaries may not, without the consent of Exelon, initiate, file or pursue any rate cases, other than pursuing the conclusion of the pending filings as indicated below. In addition, the DCPSC and the MPSC may seek to suspend or delay one or more of the ongoing proceedings as a result of the Merger Agreement.

Bill Stabilization Adjustment

Pepco proposed in each of its respective jurisdictions the adoption of a bill stabilization adjustment (BSA) mechanism to decouple retail distribution revenue from the amount of power delivered to retail customers. The BSA proposal has been approved and implemented for Pepco electric service in Maryland and in the District of Columbia.

 

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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.

District of Columbia

On March 8, 2013, Pepco filed an application with the District of Columbia Public Service Commission (DCPSC) to increase its annual electric distribution base rates by approximately $52.1 million (adjusted by Pepco to approximately $44.8 million on December 3, 2013), based on a requested return on equity (ROE) of 10.25%. The requested rate increase sought to recover expenses associated with Pepco’s ongoing investments in reliability enhancement improvements and efforts to maintain safe and reliable service. On March 26, 2014, the DCPSC issued an order approving an increase in base rates of approximately $23.4 million, based on an ROE of 9.40%. The new rates became effective on April 16, 2014. On April 28, 2014, Pepco filed an application for reconsideration or clarification of the DCPSC’s March 26, 2014 order, contesting several of the reporting obligations and other directives imposed by the order. On April 29, 2014, the other parties to the proceeding filed applications for reconsideration of the March 26, 2014 order, which generally challenge Pepco’s post-test year reliability projects, the adequacy of Pepco’s environmental and efficiency measures, and the structure of Pepco’s residential aid discount rate. All of these applications remain pending. Under the Merger Agreement, Pepco is permitted, and will continue, to pursue the application for reconsideration, but under the Merger Agreement, Pepco is not permitted to initiate or file further electric distribution base rate cases in the District of Columbia without Exelon’s consent.

Maryland

Pepco Electric Distribution Base Rates

In December 2011, Pepco submitted an application with the Maryland Public Service Commission (MPSC) to increase its electric distribution base rates. The filing sought approval of an annual rate increase of approximately $68.4 million (subsequently adjusted by Pepco to approximately $66.2 million), based on a requested ROE of 10.75%. In July 2012, the MPSC issued an order approving an annual rate increase of approximately $18.1 million, based on an ROE of 9.31%. Among other things, the order also authorized Pepco to recover the actual cost of advanced metering infrastructure (AMI) meters installed during the 2011 test year, stating that cost recovery for AMI deployment will be allowed in future rate cases in which Pepco demonstrates that the system is cost effective. The new rates became effective on July 20, 2012. The Maryland Office of People’s Counsel (OPC) has sought rehearing on the portion of the order allowing Pepco to recover the costs of AMI meters installed during the test year; that motion remains pending.

On November 30, 2012, Pepco submitted an application with the MPSC to increase its electric distribution base rates. The filing sought approval of an annual rate increase of approximately $60.8 million, based on a requested ROE of 10.25%. The requested rate increase sought to recover expenses associated with Pepco’s ongoing investments in reliability enhancement improvements and efforts to maintain safe and reliable service. Pepco also proposed a three-year Grid Resiliency Charge rider for recovery of costs totaling approximately $192 million associated with its plan to accelerate investments in infrastructure in a condensed timeframe. Acceleration of resiliency improvements was one of several recommendations included in a September 2012 report from Maryland’s Grid Resiliency Task Force (as discussed below under “Resiliency Task Forces”). Specific projects under Pepco’s Grid Resiliency Charge plan included acceleration of its tree-trimming cycle, upgrade of 12 additional feeders per year for two years and undergrounding of six distribution feeders. In addition, Pepco proposed a reliability performance-based mechanism that would allow Pepco to earn up to $1 million as an incentive for meeting enhanced reliability goals in 2015, but provided for a credit to customers of up to $1 million in total if Pepco does not meet at least the minimum reliability performance targets. Pepco requested that any credits/charges would flow through the proposed Grid Resiliency Charge rider.

On July 12, 2013, the MPSC issued an order related to Pepco’s November 30, 2012 application approving an annual rate increase of approximately $27.9 million, based on an ROE of 9.36%. The order provides for the full recovery of storm restoration costs incurred as a result of recent major storm events, including the derecho storm in June 2012 and Hurricane Sandy in October 2012, by including the related capital costs in the rate base and amortizing the related deferred operation and maintenance expenses of $23.6 million over a five-year period. The order excludes the cost of AMI meters from Pepco’s rate base until such time as Pepco demonstrates the cost effectiveness of the AMI system; as a result, costs for AMI meters incurred with respect to the 2012 test year and beyond will be treated as other incremental AMI costs incurred in conjunction with the deployment of the AMI system that are deferred and on which a return is earned, but only until such cost

 

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effectiveness has been demonstrated and such costs are included in rates. However, the MPSC’s July 2012 order in Pepco’s previous electric distribution base rate case, which allowed Pepco to recover the costs of meters installed during the 2011 test year for that case, remains in effect, and the Maryland OPC’s motion for rehearing in that case remains pending.

The order also approved a Grid Resiliency Charge, which went into effect on January 1, 2014, for recovery of costs totaling approximately $24.0 million associated with Pepco’s proposed plan to accelerate investments related to certain priority feeders, provided that, before implementing the surcharge, Pepco (i) provides additional information to the MPSC related to performance objectives, milestones and costs, and (ii) makes annual filings with the MPSC thereafter concerning this project, which will permit the MPSC to establish the applicable Grid Resiliency Charge rider for each following year. The MPSC did not approve the proposed acceleration of the tree-trimming cycle or the undergrounding of six distribution feeders. The MPSC also rejected Pepco’s proposed reliability performance-based mechanism. The new rates were effective on July 12, 2013.

On July 26, 2013, Pepco filed a notice of appeal of the July 12, 2013 order in the Circuit Court for the City of Baltimore. Other parties also have filed notices of appeal, which have been consolidated with Pepco’s appeal. In its memorandum filed with the appeals court, Pepco asserts that the MPSC erred in failing to grant Pepco an adequate ROE, denying a number of other cost recovery mechanisms and limiting Pepco’s test year data to no more than four months of forecasted data in future rate cases. The memoranda filed with the appeals court by the other parties primarily assert that the MPSC erred or acted arbitrarily and capriciously in allowing the recovery of certain costs by Pepco and refusing to reduce Pepco’s rate base by known and measurable accumulated depreciation. The appeal remains pending.

On December 4, 2013, Pepco submitted an application with the MPSC to increase its electric distribution base rates. The filing seeks approval of an annual rate increase of approximately $43.3 million (adjusted by Pepco to approximately $37.4 million on April 15, 2014), based on a requested ROE of 10.25%. The requested rate increase seeks to recover expenses associated with Pepco’s ongoing investments in reliability enhancement improvements and efforts to maintain safe and reliable service. A decision is expected in the third quarter of 2014.

Under the Merger Agreement, Pepco is permitted, and will continue, to pursue the conclusion of the aforementioned matters, but under the Merger Agreement, Pepco is not permitted to initiate or file further electric distribution base rate cases in Maryland without Exelon’s consent.

Federal Energy Regulatory Commission

On February 27, 2013, the public service commissions and public advocates of the District of Columbia, Maryland, Delaware and New Jersey, as well as the Delaware Municipal Electric Corporation, Inc., filed a joint complaint with the Federal Energy Regulatory Commission (FERC) against Pepco and its affiliates Delmarva Power & Light Company (DPL) and Atlantic City Electric Company (ACE), as well as Baltimore Gas and Electric Company (BGE). The complainants challenged the base ROE and the application of the formula rate process, each associated with the transmission service that PHI’s utilities provide. The complainants support an ROE within a zone of reasonableness of 6.78% and 10.33%, and have argued for a base ROE of 8.7%. The base ROE currently authorized by FERC for Pepco and its utility affiliates is (i) 11.3% for facilities placed into service after January 1, 2006, and (ii) 10.8% for facilities placed into service prior to 2006. As currently authorized, the 10.8% base ROE for facilities placed into service prior to 2006 is eligible for a 50-basis-point incentive adder for being a member of a regional transmission organization. Pepco believes the allegations in this complaint are without merit and is vigorously contesting it. On April 3, 2013, Pepco filed its answer to this complaint, requesting that FERC dismiss the complaint against it on the grounds that the complaint failed to meet the required burden to demonstrate that the existing rates and protocols are unjust and unreasonable. Pepco cannot predict when a final FERC decision in this proceeding will be issued.

Under the Merger Agreement, Pepco is permitted, and will continue to pursue the conclusion of the aforementioned matter.

 

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MPSC New Generation Contract Requirement

In September 2009, the MPSC initiated an investigation into whether Maryland electric distribution companies (EDCs) should be required to enter into long-term contracts with entities that construct, acquire or lease, and operate, new electric generation facilities in Maryland. In April 2012, the MPSC issued an order determining that there is a need for one new power plant in the range of 650 to 700 megawatts (MWs) beginning in 2015. The order requires Pepco, its affiliate DPL and BGE (collectively, the Contract EDCs) to negotiate and enter into a contract with the winning bidder of a competitive bidding process in amounts proportional to their relative standard offer service (SOS) loads. Under the contract, the winning bidder will construct a 661 MW natural gas-fired combined cycle generation plant in Waldorf, Maryland, with an expected commercial operation date of June 1, 2015. The order acknowledged the Contract EDCs’ concerns about the requirements of the contract and directed them to negotiate with the winning bidder and submit any proposed changes in the contract to the MPSC for approval. The order further specified that each of the Contract EDCs will recover its costs associated with the contract through surcharges on its respective SOS customers.

In April 2012, a group of generating companies operating in the PJM Interconnection, LLC (PJM) region filed a complaint in the U.S. District Court for the District of Maryland challenging the MPSC’s order on the grounds that it violates the Commerce Clause and the Supremacy Clause of the U.S. Constitution. In May 2012, the Contract EDCs and other parties filed notices of appeal in circuit courts in Maryland requesting judicial review of the MPSC’s order. The Maryland circuit court appeals were consolidated in the Circuit Court for Baltimore City.

On April 16, 2013, the MPSC issued an order approving a final form of the contract and directing the Contract EDCs to enter into the contract with the winning bidder in amounts proportional to their relative SOS loads. On June 4, 2013, Pepco entered into a contract in accordance with the terms of the MPSC’s order; however, under the contract’s terms, it will not become effective, if at all, until all legal proceedings related to these contracts and the actions of the MPSC in the related proceeding have been resolved.

On September 30, 2013, the U.S. District Court for the District of Maryland issued a ruling that the MPSC’s April 2012 order violated the Supremacy Clause of the U.S. Constitution by attempting to regulate wholesale prices. In contrast, on October 1, 2013, the Maryland Circuit Court for Baltimore City upheld the MPSC’s orders requiring the Contract EDCs to enter into the contracts.

On October 24, 2013, the Federal district court issued an order ruling that the contracts are illegal and unenforceable. The Federal district court order and its associated ruling could impact the state circuit court appeal, to which the Contract EDCs are parties, although such impact, if any, cannot be determined at this time. The Contract EDCs, the Maryland Office of People’s Counsel and one generating company have appealed the Maryland Circuit Court’s decision to the Maryland Court of Special Appeals. In addition, in November 2013 both the winning bidder and the MPSC appealed the Federal district court decision to the U.S. Court of Appeals for the Fourth Circuit. These appeals remain pending.

Assuming the contracts, as currently written, were to become effective by the expected commercial operation date of June 1, 2015, Pepco continues to believe that it may be required to account for its proportional share of the contracts as a derivative instrument at fair value with an offsetting regulatory asset because they would recover any payments under the contracts from SOS customers. Pepco has concluded that any accounting for these contracts would not be required until all legal proceedings related to these contracts and the actions of the MPSC in the related proceeding have been resolved.

Pepco continues to evaluate these proceedings to determine, should the contracts be found to be valid and enforceable, (i) the extent of the negative effect that the contracts may have on Pepco’s credit metrics, as calculated by independent rating agencies that evaluate and rate Pepco and its debt issuances, (ii) the effect on Pepco’s ability to recover its associated costs of the contracts if a significant number of SOS customers elect to buy their energy from alternative energy suppliers, and (iii) the effect of the contracts on the financial condition, results of operations and cash flows of Pepco.

 

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Resiliency Task Forces

In July 2012, the Maryland governor signed an Executive Order directing his energy advisor, in collaboration with certain state agencies, to solicit input and recommendations from experts on how to improve the resiliency and reliability of the electric distribution system in Maryland. The resulting Grid Resiliency Task Force issued its report in September 2012, in which it made 11 recommendations. The governor forwarded the report to the MPSC in October 2012, urging the MPSC to quickly implement the first four recommendations: (i) strengthen existing reliability and storm restoration regulations; (ii) accelerate the investment necessary to meet the enhanced metrics; (iii) allow surcharge recovery for the accelerated investment; and (iv) implement clearly defined performance metrics into the traditional ratemaking scheme. Pepco’s electric distribution base rate case filed with the MPSC on November 30, 2012 attempted to address the Grid Resiliency Task Force recommendations. In July 2013, the MPSC issued an order in the Pepco Maryland electric distribution base rate case that only partially approved the proposed Grid Resiliency Charge. See “Rate Proceedings – Maryland” above for more information about the base rate case.

In August 2012, the District of Columbia mayor issued an Executive Order establishing the Mayor’s Power Line Undergrounding Task Force (the DC Undergrounding Task Force). The stated purpose of the DC Undergrounding Task Force was to pool the collective resources available in the District of Columbia to produce an analysis of the technical feasibility, infrastructure options and reliability implications of undergrounding new or existing overhead distribution facilities in the District of Columbia. These resources included legislative bodies, regulators, utility personnel, experts and other parties who could contribute in a meaningful way to the DC Undergrounding Task Force. On May 13, 2013, the DC Undergrounding Task Force issued a written recommendation endorsing a $1 billion plan of the DC Undergrounding Task Force to underground 60 of the District of Columbia’s most outage-prone power lines, which lines would be owned and maintained by Pepco. The legislation providing for implementation of the report’s recommendations contemplates that: (i) Pepco would fund approximately $500 million of the $1 billion estimated cost to complete this project, recovering those costs through surcharges on the electric bills of Pepco District of Columbia customers; (ii) $375 million of the undergrounding project cost would be financed by the District of Columbia’s issuance of securitized bonds, which bonds would be repaid through surcharges on the electric bills of Pepco District of Columbia customers (Pepco would not earn a return on or of the cost of the assets funded with the proceeds received from the issuance of the securitized bonds, but ownership and responsibility for the operation and maintenance of such assets would be transferred to Pepco for a nominal amount); and (iii) the remaining amount would be funded through the District of Columbia Department of Transportation’s existing capital projects program. This legislation was approved in the Council of the District of Columbia on February 4, 2014 and signed by the Mayor of the District of Columbia on March 3, 2014. The legislation became law on May 3, 2014 following the 30-day Congressional review period. The final steps in the approval process will be DCPSC authorization of the underground project plan and issuance of financing orders required by the legislation to establish the customer surcharges contemplated by the legislation, a decision on which is expected during the fourth quarter of 2014. Under the Merger Agreement, Pepco is permitted, and will continue to pursue the DC undergrounding project.

MAPP Settlement Agreement

On February 28, 2014, FERC issued an order approving the settlement agreement submitted by Pepco in connection with Pepco’s proceeding seeking recovery of approximately $50 million in abandonment costs related to the Mid-Atlantic Power Pathway (MAPP) project. Pepco had been directed by PJM to construct the MAPP project, a 152-mile high-voltage interstate transmission line, and was subsequently directed by PJM to cancel it. The abandonment costs sought for recovery were subsequently reduced to $45 million from write-offs of certain disallowed costs in 2013 and transfers of materials to inventories for use on other projects. Under the terms of the FERC-approved settlement agreement, Pepco will receive approximately $43.9 million of transmission revenues over a three-year period, which began on June 1, 2013, and will retain title to all real property and property rights acquired in connection with the MAPP project, which had an estimated fair value of $2 million. The FERC-approved settlement agreement resolves all issues concerning the recovery of abandonment costs associated with the cancellation of the MAPP project, and the terms of the settlement agreement are not subject to modification through any other FERC proceeding. As of March 31, 2014, Pepco had a regulatory asset related to the MAPP abandonment costs of approximately $30 million, net of amortization, and land of $2 million. Pepco does not expect to recognize any further pre-tax income related to the MAPP abandonment costs.

 

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(7) PENSION AND OTHER POSTRETIREMENT BENEFITS

Pepco accounts for its participation in its parent’s single-employer plans, Pepco Holdings’ non-contributory retirement plan (the PHI Retirement Plan) and the Pepco Holdings, Inc. Welfare Plan for Retirees, as participation in multiemployer plans. PHI’s pension and other postretirement net periodic benefit cost for the three months ended March 31, 2014 and 2013, before intercompany allocations from the PHI Service Company, were $18 million and $25 million, respectively. Pepco’s allocated share was $7 million and $8 million, respectively, for the three months ended March 31, 2014 and 2013.

In the first quarter of 2014 and 2013, Pepco made no contributions to the PHI Retirement Plan.

Other Postretirement Benefit Plan Amendments

During 2013, PHI approved two amendments to its other postretirement benefits plan. These amendments impacted the retiree medical plan and the retiree life insurance benefits, and were effective on January 1, 2014. As a result of the amendments, which were cumulatively significant, PHI remeasured its projected benefit obligation for other postretirement benefits as of July 1, 2013. The remeasurement resulted in a $2 million reduction in Pepco’s net periodic benefit cost for other postretirement benefits during the three months ended March 31, 2014 when compared to the three months ended March 31, 2013. Pepco anticipates approximately 37% of annual net periodic other postretirement benefit costs will be capitalized.

(8) DEBT

Credit Facility

PHI, Pepco, DPL and ACE maintain an unsecured syndicated credit facility to provide for their respective liquidity needs, including obtaining letters of credit, borrowing for general corporate purposes and supporting their commercial paper programs. On August 1, 2013, as permitted under the existing terms of the credit agreement, a request by PHI, Pepco, DPL and ACE to extend the credit facility termination date to August 1, 2018 was approved. All of the terms and conditions as well as pricing remained the same.

The aggregate borrowing limit under the amended and restated credit facility is $1.5 billion, all or any portion of which may be used to obtain loans and up to $500 million of which may be used to obtain letters of credit. 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. The credit sublimit is $750 million for PHI and $250 million for each of Pepco, DPL and ACE. The sublimits may be increased or decreased by the individual borrower 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 the sublimit reallocations may not exceed eight per year during the term of the facility.

The interest rate payable by each company on utilized funds is, at the borrowing company’s election, (i) the greater of the prevailing prime rate, the federal funds effective rate plus 0.5% and the one month London Interbank Offered Rate plus 1.0%, or (ii) the prevailing Eurodollar rate, plus a margin that varies according to the credit rating of the borrower.

 

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In order for a borrower to use the facility, certain representations and warranties must be true and correct, and the borrower must be in compliance with specified financial and other covenants, including (i) the requirement that each borrowing company maintain a ratio of total indebtedness to total capitalization of 65% or less, computed in accordance with the terms of the credit agreement, which calculation excludes from the definition of total indebtedness certain trust preferred securities and deferrable interest subordinated debt (not to exceed 15% of total capitalization), (ii) with certain exceptions, a restriction on sales or other dispositions of assets, and (iii) a restriction on the incurrence of liens on the assets of a borrower or any of its significant subsidiaries other than permitted liens. The credit agreement contains certain covenants and other customary agreements and requirements that, if not complied with, could result in an event of default and the acceleration of repayment obligations of one or more of the borrowers thereunder. Each of the borrowers was in compliance with all covenants under this facility as of March 31, 2014.

The absence of a material adverse change in PHI’s business, property, results of operations or financial condition is not a condition to the availability of credit under the credit agreement. The credit agreement does not include any rating triggers.

As of March 31, 2014 and December 31, 2013, the amount of cash plus borrowing capacity under the credit facility available to meet the liquidity needs of PHI’s utility subsidiaries in the aggregate was $562 million and $332 million, respectively. Pepco’s borrowing capacity under the credit facility at any given time depends on the amount of the subsidiary borrowing capacity being utilized by DPL and ACE and the portion of the total capacity being used by PHI.

Commercial Paper

Pepco maintains an on-going commercial paper program to address its short-term liquidity needs. As of March 31, 2014, the maximum capacity available under the program was $500 million, subject to available borrowing capacity under the credit facility.

Pepco had no commercial paper outstanding at March 31, 2014. The weighted average interest rate for commercial paper issued by Pepco during the three months ended March 31, 2014 was 0.27% and the weighted average maturity of all commercial paper issued by Pepco during the three months ended March 31, 2014 was six days.

Other Financing Activities

Bond Issuance

In March 2014, Pepco issued $400 million of 3.60% first mortgage bonds due March 15, 2024. Pepco used a portion of the net proceeds of the offering, of which $175 million was classified as restricted cash equivalents at March 31, 2014, to repay in full at maturity $175 million in aggregate principal amount of its 4.65% senior notes due April 15, 2014, plus accrued and unpaid interest.

Sale of Receivables

On March 13, 2014, Pepco, as seller, entered into a purchase agreement with a buyer to sell receivables from an energy savings project pursuant to a Task Order entered into under a General Services Administration area-wide agreement. The purchase price to be received by Pepco is approximately $12 million. The energy savings project, which is being performed by Pepco Energy Services, is expected to be completed by January 1, 2015. Pursuant to the purchase agreement, following acceptance of the energy savings project, the buyer will be entitled to receive the contract payments under the Task Order payable by the customer over approximately 9 years. At March 31, 2014, less than $1 million of the purchase price had been received by Pepco.

 

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Financing Activities Subsequent to March 31, 2014

Bond Retirement

In April 2014, Pepco retired $175 million of its 4.65% senior notes. The senior notes were secured by a like principal amount of its 4.65% first mortgage bonds due April 15, 2014, which under the mortgage and deed of trust were deemed to be satisfied when the senior notes were repaid.

(9) INCOME TAXES

A reconciliation of Pepco’s effective income tax rates is as follows:

 

     Three Months Ended
March 31,
 
     2014     2013  
     (millions of dollars)  

Income tax at Federal statutory rate

   $ 17       35.0   $ 9       35.0 %

Increases (decreases) resulting from:

        

State income taxes, net of Federal effect

     3       6.3     2       8.0

Asset removal costs

     (2 )     (4.2 )%      (3     (12.0 )% 

Change in estimates and interest related to uncertain and effectively settled tax positions

     (1 )     (2.1 )%      (5     (20.0 )% 

Other, net

     (1     (1.7 )%      (1     (3.0 )% 
  

 

 

   

 

 

   

 

 

   

 

 

 

Income tax expense

   $ 16        33.3   $ 2       8.0
  

 

 

   

 

 

   

 

 

   

 

 

 

Pepco’s effective tax rates for the three months ended March 31, 2014 and 2013 and were 33.3% and 8.0%, respectively.

In the first quarter of 2013, Pepco recorded changes in estimates and interest related to uncertain and effectively settled tax positions. On January 9, 2013, the U.S. Court of Appeals for the Federal Circuit issued an opinion in Consolidated Edison Company of New York, Inc. & Subsidiaries v. United States (to which Pepco is not a party) that disallowed tax benefits associated with Consolidated Edison’s cross-border lease transaction. As a result of the court’s ruling in this case, PHI determined in the first quarter of 2013 that it could no longer support its current assessment with respect to the likely outcome of tax positions associated with its cross-border energy lease investments held by its wholly-owned subsidiary Potomac Capital Investment Corporation, and PHI recorded an after-tax charge of $377 million in the first quarter of 2013. Included in the $377 million charge was an after-tax interest charge of $54 million and this amount was allocated to each member of PHI’s consolidated group as if each member was a separate taxpayer, resulting in Pepco recording a $5 million interest benefit in the first quarter of 2013.

Final IRS Regulations on Repair of Tangible Property

In September 2013, the Internal Revenue Service (IRS) issued final regulations on expense versus capitalization of repairs with respect to tangible personal property. The regulations are effective for tax years beginning on or after January 1, 2014, and provide an option to early adopt the final regulations for tax years beginning on or after January 1, 2012. In February 2014, the IRS issued revenue procedures that describe how taxpayers should implement the final regulations. The final repair regulations retain the operative rule that the Unit of Property for network assets is determined by the taxpayer’s particular facts and circumstances except as provided in published guidance. In 2012, with the filing of its 2011 tax return, PHI filed a request for an automatic change in accounting method related to repairs of its network assets in accordance with IRS Revenue Procedure 2011-43. Pepco does not expect the effects of the final regulations to be significant and will continue to evaluate the impact of the new guidance on its financial statements.

 

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(10) FAIR VALUE DISCLOSURES

Financial Instruments Measured at Fair Value on a Recurring Basis

Pepco 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). Pepco 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, Pepco 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).

The following tables set forth, by level within the fair value hierarchy, Pepco’s financial assets and liabilities that were accounted for at fair value on a recurring basis as of March 31, 2014 and December 31, 2013. 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. Pepco’s 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.

 

     Fair Value Measurements at March 31, 2014  

Description

   Total      Quoted Prices in
Active Markets
for Identical
Instruments
(Level 1) (a)
     Significant
Other
Observable
Inputs
(Level 2) (a)
     Significant
Unobservable
Inputs
(Level 3)
 
     (millions of dollars)  

ASSETS

           

Restricted cash equivalents

           

Treasury fund

   $ 272      $ 272      $  —        $  —    

Executive deferred compensation plan assets

           

Money market funds

     13        13        —          —    

Life insurance contracts

     60        —          42        18  
  

 

 

    

 

 

    

 

 

    

 

 

 
   $ 345      $ 285      $ 42      $  18  
  

 

 

    

 

 

    

 

 

    

 

 

 

LIABILITIES

           

Executive deferred compensation plan liabilities

           

Life insurance contracts

   $ 7      $  —        $ 7      $  —