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Pepco Holdings DEF 14A 2005
DEFINITIVE PROXY STATEMENT
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SCHEDULE 14A

(RULE 14a-101)

INFORMATION REQUIRED IN PROXY STATEMENT

 

SCHEDULE 14A INFORMATION

Proxy Statement Pursuant to Section 14(a) of the

Securities Exchange Act of 1934

(Amendment No.     )

 

Filed by the Registrant    x

 

Filed by a Party other than the Registrant    ¨

 

Check the appropriate box:

 

¨    Preliminary Proxy Statement  

¨    Confidential, For Use of the Commission Only

(as permitted by Rule 14a-6(e)(2))

x    Definitive Proxy Statement    
¨    Definitive Additional Materials    
¨    Soliciting Material Under Rule 14a-12    

 

PEPCO HOLDINGS, INC.


(Name of Registrant as Specified in Its Charter)

 


(Name of Person(s) Filing Proxy Statement, if Other Than the Registrant)

 

Payment of Filing Fee (Check the appropriate box):

 

x    No fee required.

 

¨    Fee computed on table below per Exchange Act Rules 14a-6(i)(1) and 0-11.

 

  1.   Title of each class of securities to which transaction applies:

 

  2.   Aggregate number of securities to which transaction applies:

 

  3.   Per unit price or other underlying value of transaction computed pursuant to Exchange Act Rule 0-11 (set forth the amount on which the filing fee is calculated and state how it was determined):

 

  4.   Proposed maximum aggregate value of transaction:

 

  5.   Total fee paid:

 

¨    Fee paid previously with preliminary materials:

 

  ¨   Check box if any part of the fee is offset as provided by Exchange Act Rule 0-11(a)(2) and identify the filing for which the offsetting fee was paid previously. Identify the previous filing by registration statement number, or the form or schedule and the date of its filing.

 

  1.   Amount previously paid:

 

  2.   Form, Schedule or Registration Statement No.:

 

  3.   Filing Party:

 

  4.   Date Filed:


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LOGO

Proxy Statement and

2004 Annual Report to Shareholders

 

Dear Fellow Shareholders,

 

I am pleased to report that we made excellent progress on our business plan in 2004. We strengthened the performance of our core power delivery business, reduced the risk profile of our competitive businesses, shed non-core assets and continued to improve our balance sheet.

 

Our progress was reflected in improved financial performance in 2004. Pepco Holdings reported consolidated earnings of $258.7 million for the year, or $1.47 per share, improving upon the $113.5 million, or 66 cents per share earned during the same period in 2003. Much of the increase was driven by the improved performance of our competitive energy businesses. We also made significant progress toward our debt and preferred stock reduction goal, reducing debt and preferred stock by about $480 million in 2004.

 

Also of note, we achieved a total shareholder return of more than 22 percent in the combined period of 2003 and 2004, despite the “overhang” of the Mirant bankruptcy proceeding. We continue to aggressively protect our interests in that case to remove any uncertainty that may by hampering the full realization of our shareholder value.

 

Business Strategy Proves Sound

 

In my 2003 Shareholder Letter, I said that we were taking actions to set the stage for future earnings growth. I believe that our 2004 financial performance demonstrates that our actions were successful and that our strategy is sound as we move toward our vision of becoming the premier power delivery and energy services company in the mid-Atlantic region.

 

The positive indicators are many: our sales are growing steadily, our customer satisfaction ratings are on the rise, we have achieved reasonable regulatory agreements and our service territories are economically robust.

 

PHI Power Delivery Consolidates; Delivers Improved Earnings

 

Our regulated power delivery business continues to be our primary focus. It is low-risk and stable, producing a steady stream of cash that comfortably pays for our construction expenditures, debt service and shareholder dividends.

 

I am optimistic about our progress. The organization has moved aggressively to combine operations and the result was an earnings contribution of $233.4 million in 2004, and the establishment of a platform for further efficiencies and savings in 2005 and beyond. We met the challenges of conducting business under delivery rate caps by continuing our work on integration and process redesign with a focus on effectively managing overall spending.

 

Our mission is to provide excellent customer service and reliability, and we have made a commitment to become a leader in emergency community response. We have made significant strides toward these goals including:

 

    completing computer system enhancements to help analyze and locate the cause of outages,

 

Letter to Shareholders

   Cover Page

Notice of 2005 Annual Meeting and Proxy Statement

   1

Audit Committee Charter

   A-1

Policy on the Approval of Services Provided by the Independent Auditor

   B-1

2004 Annual Report to Shareholders

   C-1
   

•   Business of the Company

   C-7
   

•   Management’s Discussion and Analysis

   C-16
   

•   Quantitative and Qualitative Disclosures about Market Risk

   C-64
   

•   Consolidated Financial Statements

   C-71
   

Board of Directors and Officers

   C-142
   

Investor Information

   C-143


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    working with local communities to address power concerns,

 

    increasing the amount of communication with our customers,

 

    improving the way we estimate restoration times,

 

    educating the public on how to prepare for storms, and

 

    enhancing our emergency response plan to more effectively interface with external agencies across multiple jurisdictions.

 

I was pleased that our efforts in these areas were rewarded with improved customer satisfaction ratings in the 2004 Market Strategies Inc. survey of east coast utilities, in which we participate each year. These improvements are just the beginning. We are committed to continuing on our path toward exceptional performance.

 

We also are making targeted, focused investments in our transmission system to improve reliability. In 2004, we completed one section of a high-voltage transmission line in New Jersey; the final section is expected to be in operation by July 2005. We were proud to receive the Engineering Excellence Distinguished Award from the American Council of Engineering Companies of New Jersey for siting, permitting and constructing this line.

 

Also in New Jersey, we are in the process of obtaining regulatory approvals to construct several transmission facilities to maintain reliability after the planned closing of the B.L. England Generating Station in December 2007.

 

In Delaware in 2006, we will complete a new high-voltage transmission line that spans the state from north to south and improves reliability on the Delmarva peninsula, and in Maryland, between 2005 and 2007, we will continue to install new equipment on Pepco’s transmission system that will improve reliability in that area.

 

Competitive Energy Posts Profits in a Challenging Market

 

PHI continues to complement its power delivery foundation by operating profitable, competitive energy businesses. Conectiv Energy provides electric power, capacity, and ancillary services in the wholesale markets administered by PJM, the regional transmission organization that coordinates the movement of wholesale electricity in our region. Conectiv Energy also supplies electricity to other wholesale market participants under long-term bilateral contracts.

 

Through its focus on cost improvements, efficiency, and a conservatively managed hedging strategy, Conectiv Energy has extracted value in a difficult wholesale energy market. Conectiv Energy posted a marked improvement in earnings growth in 2004, from a loss of $82.8 million in 2003 to a positive contribution of $54.9 million in 2004. Conectiv Energy is well positioned to take advantage of improving market conditions.

 

PHI’s competitive retail arm, Pepco Energy Services (PES) has profitably capitalized on the retail energy market by supplying electricity, gas and a full range of energy services. PES is one of the largest retail energy providers in PJM, and we expect it to continue attracting customers as rate caps on electricity supply expire in surrounding states. Eighty percent of PES’ revenue comes from sales to large commercial and industrial gas and electricity customers, while 20 percent is from sales of equipment and services. Pepco Energy Services also posted a good year, boosting its earnings contribution from $2 million in 2003 to $12 million in 2004. In fact, 2004 marked Pepco Energy Service’s best earnings year ever.

 

As part of our strategy of focusing on core assets, we announced in 2003 that we would stop making additional investments in Potomac Capital Investment Corp. (PCI) in 2004. As planned, PCI divested non-core assets and increased cash flow by selling its interests in Starpower (a tele-communications joint venture), all remaining aircraft and other non-utility property. PHI continues to manage PCI’s existing cross-border energy leases.

 

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Good Regulatory Relationships Produce Positive Results

 

Good regulatory relationships are an important element of our strategy to focus on the power delivery business. In 2004, we successfully implemented the transition to market-based default supply service in both Maryland and the District of Columbia. Pepco and Delmarva Power were each approved as the provider of default service and will receive a margin on Standard Offer Service sales of about 0.2 cents per kilowatt hour, on average. We’re pleased with this outcome and see it as a demonstration of a constructive regulatory climate.

 

Delaware has also adopted the “wholesale model” and recently selected Delmarva Power as the provider of default service when price caps are removed in mid-2006. Under the wholesale model, Delmarva Power will procure energy supply through a competitive process. The mechanics of this process will be defined at a later date.

 

We continue to work closely with interested parties to craft a settlement on the Atlantic City Electric base rate case. While the process has taken longer than anticipated, we believe we will resolve this case in the near term. Also worth noting, we have finished the first round of post restructuring rate reviews in Maryland and the District with no findings that we are over-earning.

 

Looking to the future, we are gearing up for the expiration of retail delivery rate caps in 2006 in Delaware and Maryland, and 2007 in the District of Columbia. We plan to pursue achieving fair rates that reflect our costs and a reasonable return on our investments.

 

We are Strengthening Our Regional Focus

 

In order to strengthen our public policy focus and better serve our customers, we are heightening the regional focus in the way we do business. This entails returning to our roots as the local power company serving the local community. With this in mind, we are returning to our historic utility names of Delmarva Power and Atlantic City Electric in those regions and we plan to reintroduce these brands gradually over the coming months. In addition, each of our three regions—Atlantic City Electric, Delmarva Power and Pepco—will be spearheaded by a PHI leader who will be responsible for building mutually beneficial relationships with the local constituencies and responding to their needs.

 

PHI’s Credit Profile Is Improving

 

In response to the expectations of the financial community, we are channeling our cash flows into improving our balance sheet with the goal of achieving an equity ratio as a percentage of total capital in the 40-45 percent range by the close of 2007. Toward that end, we are on track to reduce debt by $1.3 billion over the five-year period ending in 2007. Steps taken in 2003-04 included issuing more than $340 million of equity and refinancing about $945 million of higher costs securities. By year end 2004, we achieved $730 million or 56 percent of our goal.

 

Our Internal Controls and Corporate Policies are Effective

 

In 2004, we met our deadlines for documenting, evaluating and testing our internal financial controls at the PHI holding company level as required by the Sarbanes-Oxley Act (SOX). Significant energy was applied to this effort, and as we expected, our independent registered public accounting firm, PricewaterhouseCoopers LLP, in an independent review found that we maintained effective internal control over financial reporting as of the December 31, 2004 deadline. In 2005, we will take advantage of our experience and identify further opportunities to improve the operating effectiveness and efficiency of internal control over financial reporting

 

Early in 2005, we launched a new Web-based Corporate Business Policies course and certification process, part of a broader online Corporate Ethics Center. On an annual basis, employees and other persons in positions of trust are required to certify that they know and understand PHI’s comprehensive set of business policies. Conducting the certification process by requiring completion of an online course is a best practice in corporate governance.

 

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Competitive Employee Programs, Contracts Implemented

 

In 2004, we integrated the compensation and benefits programs for PHI’s management employees into a single program that provides a competitive package of benefits, streamlines administration, achieves cost savings and improves employee mobility across the organization. We also introduced a new Performance Accountability System that ties financial incentives to individual, organization and team goals. This approach aligns our activities at all levels with the corporate business plan and is designed to achieve improved performance.

 

In 2004, we successfully negotiated a new five-year labor agreement with IBEW, Local 1900, that represents employees in our Pepco region. In 2005, a number of contracts expire for employees who work in the Delmarva Power and Atlantic City Electric regions and we will be seeking to negotiate agreements that more closely align the benefits and compensation of all our union employees, while being competitive with the market.

 

We are Enhancing our Safety and Environmental Programs

 

Safety and environmental stewardship are at the heart of our core values. In 2004, we were deeply saddened by three tragic employee job-related deaths. True to our values, we have rededicated ourselves to significantly improving our safety culture and performance through increasing field audits, instituting an executive panel to review accidents, emphasizing adherence to safety rules and expanding our safety training program.

 

In the environmental arena, we continue to reach out with partners to increase environmental stewardship efforts in our regions. In 2004, new wetlands preservation initiatives were begun in Delaware and river restoration initiatives increased throughout our regions, including the Anacostia and Potomac Rivers. We continue to minimize pollution by recycling annually about 4,000 tons of material—from the metal and wires that distribute our electricity to the tires used on our service vehicles. Through Pepco Energy Services, we own and manage a portfolio of assets which produce energy from environmentally friendly renewable sources that we sell to customers throughout the mid-Atlantic region.

 

We were honored in 2004 to be recognized by Fortune and DiversityInc magazines for our commitment to diversity in employee programs and business practices. Our team has been diligent in its efforts to ensure that diversity is a core business value and this recognition is an affirmation that we are moving in the right direction.

 

A Note of Thanks to Our Employees and Directors

 

I want you to know that I am very proud of PHI’s employees. They work hard each day to deliver essential energy services to our customers and to provide a stable return to you, our shareholders. Ours is a dedicated, talented and diverse team—and I want to express my appreciation for the value they create each day.

 

I also am proud of our Board of Directors, who worked diligently to ensure that our governance practices are among the best.

 

Let me close by restating the fundamentals of our business: a stable, rate-regulated power delivery business complemented by profitable, competitive energy businesses. We are focused on generating cash flows to support a secure dividend and improve our credit profile. We believe these fundamentals, as evidenced by our 2004 financial performance and total shareholder return, make PHI a very attractive investment. We are optimistic about our future, and we look forward to providing increased value to our shareholders.

 

Sincerely,

 

LOGO

 

Dennis R. Wraase

Chairman of the Board,

President and Chief Executive Officer

March 31, 2005

 

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LOGO

 

701 Ninth Street, N.W.

Washington, D.C. 20068

 

Notice of Annual Meeting of Shareholders

 

March 31, 2005

 

NOTICE IS HEREBY GIVEN that the Annual Meeting of Shareholders of Pepco Holdings, Inc. will be held at 10:00 a.m. local time on Friday, May 20, 2005 (the doors will open at 9:00 a.m.), at the Company’s offices located at 701 Ninth Street, N.W., Edison Place Conference Center (second floor), Washington, D.C. for the following purposes:

 

  1. To elect three directors to serve for a term of three years;

 

  2. To consider and take action on a proposal to amend the Restated Certificate of Incorporation to declassify the Company’s staggered Board;

 

  3. To ratify the appointment of PricewaterhouseCoopers LLP as independent registered public accounting firm of the Company for 2005;

 

  4. To consider and vote on a shareholder proposal concerning the election of directors by a majority vote, if the proposal is brought before the meeting;

 

  5. To transact such other business as may properly be brought before the meeting.

 

All holders of record of the Company’s common stock at the close of business on Monday, March 21, 2005, will be entitled to vote on each matter submitted to a vote of shareholders at the meeting.

 

By order of the Board of Directors,

ELLEN SHERIFF ROGERS

Vice President and Secretary

 


 

IMPORTANT

 

You are cordially invited to attend the meeting in person.

 

Even if you plan to be present, you are urged to vote your shares promptly. To vote your shares, use the Internet or call the toll-free telephone number as described in the instructions attached to your proxy card, or complete, sign, date and return your proxy card in the envelope provided.

 

If you attend the meeting, you may vote either in person or by proxy.

 

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YOUR VOTE IS IMPORTANT.

PLEASE VOTE YOUR SHARES PROMPTLY.

TO VOTE YOUR SHARES, USE THE INTERNET

OR CALL THE TOLL-FREE TELEPHONE NUMBER

AS DESCRIBED IN THE INSTRUCTIONS ATTACHED TO YOUR PROXY CARD,

OR COMPLETE, SIGN, DATE AND RETURN YOUR PROXY CARD

IN THE ENVELOPE PROVIDED.

 

THANK YOU FOR ACTING PROMPTLY.

 

 

 

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PROXY STATEMENT

 

Annual Meeting of Shareholders

 

Pepco Holdings, Inc.

 

March 31, 2005

 

This Proxy Statement is being furnished by the Board of Directors of Pepco Holdings, Inc. (the “Company” or “Pepco Holdings”) in connection with its solicitation of proxies to vote on the matters to be submitted to a vote of shareholders at the 2005 Annual Meeting. This Proxy Statement, together with the Company’s 2004 Annual Report, which is attached as Annex C to the Proxy Statement, the Notice of Annual Meeting, and a proxy card, is being first mailed to shareholders of record on or about April 5, 2005.

 

The Company is a holding company formed in connection with the merger of Potomac Electric Power Company (“Pepco”) and Conectiv. As a result of the merger, which occurred on August 1, 2002, Pepco and Conectiv became wholly owned subsidiaries of the Company. The address of the Company’s principal executive offices is 701 Ninth Street, N.W., Washington, D.C. 20068.

 

When and where will the Annual Meeting be held?

 

The Annual Meeting will be held at 10:00 a.m. local time on Friday, May 20, 2005 (the doors will open at 9:00 a.m.), at the Company’s offices located at 701 Ninth Street, N.W., Edison Place Conference Center (second floor), Washington, D.C. Admission to the meeting will be limited to Company shareholders or their authorized proxies. Admission tickets are not required.

 

Will the Annual Meeting be Web cast?

 

The live audio and slide presentation of the meeting can be accessed at PHI’s Web site, www.pepcoholdings.com/investors. An audio only version will also be available. The dial-in information will be announced in a news release at a later date.

 

What matters will be voted on at the Annual Meeting?

 

1. The election of three directors for three-year terms.

 

The Board recommends a vote FOR each of the three candidates nominated by the Board of Directors and identified in Item 1 in this Proxy Statement.

 

2. The approval of an amendment to the Company’s Restated Certificate of Incorporation to declassify the Board.

 

The Board recommends a vote FOR this proposal.

 

3. The ratification of the appointment by the Audit Committee of PricewaterhouseCoopers LLP as independent registered public accounting firm of the Company for 2005.

 

The Board recommends a vote FOR this proposal.

 

4. A shareholder proposal set forth in Item 4 in this Proxy Statement concerning the election of directors by a majority vote, if the proposal is introduced at the meeting by the shareholder proponent.

 

The Board recommends a vote AGAINST this proposal.

 

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How do I vote shares held in my own name?

 

If you own your shares in your own name, you can either attend the Annual Meeting and vote in person or you can vote by proxy without attending the meeting. You can vote by proxy in any of three ways:

 

    Via Internet:     Go to https://www.proxyvotenow.com/pom. Have your proxy card in hand when you access the Web site. You will be given simple voting instructions to follow to obtain your records and to create an electronic voting instruction form. At this Web site, you also can elect to access future proxy statements and annual reports via the Internet.

 

    By Telephone:  Call toll-free 1-866-205-9103. Have your proxy card in hand when you call, and you will be given simple voting instructions to follow.

 

    In Writing:        Complete, sign, date and return the enclosed proxy card in the postage-paid envelope that has been provided.

 

The Internet and telephone voting facilities for shareholders of record will close at 5:00 p.m. Eastern time on May 19, 2005. Your signed proxy card or the proxy you grant via the Internet or by telephone will be voted in accordance with your instructions. If you return a signed proxy card or grant a proxy via the Internet or by telephone, but do not indicate how you wish your shares to be voted, your shares will be voted FOR the election of each of the Board of Director’s director nominees, FOR the amendment to the Restated Certificate of Incorporation, FOR the ratification of the independent registered public accounting firm and AGAINST the shareholder proposal.

 

How do I vote shares held through a brokerage firm, bank or other financial intermediary?

 

If you hold shares through a brokerage firm, bank or other financial intermediary, you will receive from that intermediary directions on how to direct the voting of your shares by the intermediary, which may include voting instructions given via the Internet or by telephone. If you hold your shares through a brokerage firm, bank or other financial intermediary you may not vote in person at the Annual Meeting unless you obtain a proxy from the record holder.

 

Who is eligible to vote?

 

All shareholders of record at the close of business on March 21, 2005 (the “record date”) are entitled to vote at the Annual Meeting. As of the close of business on the record date 188,462,359 shares of Pepco Holdings common stock, par value $.01 per share (the “Common Stock”), were outstanding. Each outstanding share of Common Stock entitles the holder of record to one vote on each matter submitted to the vote of shareholders at the Annual Meeting.

 

What is the quorum requirement?

 

In order to hold the Annual Meeting, the holders of a majority of the outstanding shares of Common Stock must be present at the meeting either in person or by proxy.

 

What shares are included on the enclosed proxy card?

 

The number of shares printed on the enclosed proxy card indicates the number of shares of Common Stock that, as of the record date, you held of record, plus (i) any shares held for your account under the Pepco Holdings Dividend Reinvestment Plan and (ii) if you are a participant in the Atlantic Electric 401(k) Savings and Investment Plan-B, the shares held for your account under that plan. See “How is stock in the 401(k) plans for employees voted?”

 

How is stock in the Pepco Holdings Dividend Reinvestment Plan voted?

 

Shares held by the Pepco Holdings Dividend Reinvestment Plan will be voted by the Plan administrator in accordance with your instructions on the proxy card or given via the Internet or by telephone.

 

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What does it mean if I receive more than one proxy card?

 

If you receive more than one proxy card (other than because you are a participant in either a Conectiv or a Pepco 401(k) savings plans and receive a separate voting instruction card), it is because your shares are registered in different names or with different addresses. You must sign, date and return each proxy card that you receive (or grant a proxy for the shares represented by each proxy card via the Internet or by telephone) in order for all of your shares to be voted at the Annual Meeting. To enable us to provide better shareholder service, we encourage shareholders to have all their shares registered in the same name with the same address.

 

How is stock in the 401(k) plans for employees voted?

 

If you are a current or former employee who is a participant in one of the Pepco 401(k) savings plans:

 

You will receive directly from Fidelity Investments, the trustee for the Pepco 401(k) savings plans, a separate voting instruction card showing the number of shares of Common Stock held for your account as of the record date by the plan(s) in which you are a participant. To instruct the plan trustee on how to vote these shares, you must complete, date, sign and return the voting instruction card per the directions printed on that card. If you do not provide voting instructions for your plan shares, the plan trustee will vote your shares on each matter in proportion to the voting instructions given by all of the other participants in the applicable Pepco plan(s).

 

If you are a current or former employee who is a participant in the Conectiv Savings and Investment Plan, the Conectiv PAYSOP/ESOP or the Atlantic Electric 401(k) Savings and Investment Plan-B:

 

If you are a current or former employee who is a participant in either or both of the Conectiv Savings and Investment Plan and the Conectiv PAYSOP/ESOP, you will receive directly from The Vanguard Group, the trustee for each of the plans, a separate voting instruction card showing the number of shares of Common Stock held for your account as of the record date by the plan(s) in which you are a participant. These shares will be voted by the Plan trustee in accordance with your instructions on the voting instruction card. If you do not provide voting instructions for your plan shares, the plan trustee will vote your shares on each matter in proportion to the voting instructions given by all of the other participants in the applicable plan(s).

 

If you are a current or former employee who is a participant in the Atlantic Electric 401(k) Savings and Investment Plan-B, then the number of shares printed on the enclosed proxy card includes shares of Common Stock held through that plan. By completing, dating, signing and returning this proxy card, you will be providing the plan trustee with instructions on how to vote the shares held in your account. If you do not provide voting instructions for your plan shares, the plan trustee will vote your shares in proportion to the voting instructions given by the other participants in the plan.

 

Can I change my vote after I have returned my proxy card or granted a proxy via the Internet or by telephone?

 

If you own your shares in your own name, you may revoke your proxy, regardless of the manner in which it was submitted, by:

 

    sending a written statement to that effect to the Secretary of the Company before your proxy is voted;

 

    submitting a properly signed proxy dated a later date;

 

    submitting a later dated proxy via the Internet or by telephone; or

 

    voting in person at the Annual Meeting.

 

If you hold shares through a brokerage firm, bank, other financial intermediary or in an employee benefit plan, you should contact that intermediary or plan trustee for instructions on how to change your vote.

 

How can I obtain more information about the Company?

 

The Company’s 2004 Annual Report to Shareholders is included as Annex C after page B-3 of this Proxy Statement. You may also visit the Company’s Web site at www.pepcoholdings.com.

 

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1.    ELECTION OF DIRECTORS

 

Thirteen directors currently constitute the entire Board of Directors of the Company. The Board of Directors is divided into three classes, two currently consisting of four directors and one consisting of five directors. Immediately prior to the commencement of the 2005 Annual Meeting, the number of directors will be reduced to 12 and the Board of Directors will be divided into three classes, one consisting of three directors, one consisting of four directors and one consisting of five directors. Directors of each class are elected to serve three-year terms. At the Annual Meeting, three directors are to be elected, each to hold office for a three-year term that expires at the 2008 Annual Meeting, and until his or her successor is elected and qualified.

 

Edmund B. Cronin, Jr., Pauline A. Schneider and Dennis R. Wraase were recommended for nomination to the Board by the Corporate Governance/Nominating Committee.

 

The Board of Directors recommends a vote FOR each of the three nominees listed on the following page.

 

What vote is required to elect the directors?

 

Directors are elected by a plurality of the votes cast. This means that the three nominees receiving the largest number of votes will be elected as directors.

 

What happens if a nominee is unable to serve as a director?

 

Each nominee identified in this Proxy Statement has confirmed that he or she is willing and able to serve as a director. However, should any of the nominees, prior to the Annual Meeting, become unavailable to serve as a director for any reason, the Board of Directors either may reduce the number of directors to be elected or, on the recommendation of the Corporate Governance/ Nominating Committee, select another nominee. If another nominee is selected, all proxies will be voted for that nominee.

 

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NOMINEES FOR ELECTION AS DIRECTORS

 

For Terms Expiring in 2008

 

LOGO    Edmund B. Cronin, Jr., age 67, since 2000 has been Chairman of the Board, and since 1995 has been President and Chief Executive Officer of Washington Real Estate Investment Trust, based in Rockville, Maryland, which owns income-producing real estate in the mid-Atlantic region. Mr. Cronin was a director of Pepco from 1998 until August 1, 2002. He has been a director of the Company since August 1, 2002.
LOGO    Pauline A. Schneider, age 61, joined the Washington office of the law firm of Hunton & Williams in 1985 and has been a partner there since 1987. From October 2000 to October 2002, Ms. Schneider served as Chair of the Board of MedStar Health, Inc., a community-based healthcare organization that includes seven major hospitals in the Washington, D.C./Baltimore area. Also, between 1998 and 2002, she chaired the Board of The Access Group, Inc., a not-for-profit student loan provider headquartered in Wilmington, Delaware. She continues her service on both boards. She is a director of DiamondCluster International, Inc. Ms. Schneider was a director of Pepco from 2001 until August 1, 2002. She has been a director of the Company since August 1, 2002.
LOGO    Dennis R. Wraase, age 61, is Chairman, President and Chief Executive Officer of the Company. He is also Chairman and Chief Executive Officer of Pepco and Conectiv and was President and Chief Operating Officer of Pepco from January 2001 through August 1, 2002. From August 2002 through May 2003, Mr. Wraase was Chief Operating Officer of the Company. He was President and Chief Financial Officer of Pepco from May 2000 until January 2001. From 1999 to 2000, he was Executive Vice President and Chief Financial Officer of Pepco. Mr. Wraase has been a director of Pepco since 1998 and Conectiv since August 1, 2002. He has been a director of the Company since 2001.

 

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DIRECTORS CONTINUING IN OFFICE

 

Terms Expiring in 2006

 

LOGO    Terence C. Golden, age 60, since 2000 has been Chairman of Bailey Capital Corporation in Washington, D.C. Bailey Capital Corporation is a private investment company. From 1995 until 2000, Mr. Golden was President, Chief Executive Officer and a director of Host Marriott Corporation. He continues to serve as a director of Host Marriott Corporation and of the Morris & Gwendolyn Cafritz Foundation. Mr. Golden also currently serves as Chairman of the Federal City Council. Mr. Golden was a director of Pepco from 1998 until August 1, 2002. He has been a director of Pepco Holdings, Inc. since August 1, 2002.
LOGO    George F. MacCormack, age 61, is retired Group Vice President, DuPont, Wilmington, Delaware, a position he held from 1999 through 2003. He was previously Vice President and General Manager (1998), White Pigments & Mineral Products Strategic Business Unit and Vice President and General Manager (1995), Specialty Chemicals Strategic Business Unit for DuPont. Mr. MacCormack was a director of Conectiv from 2000 until August 1, 2002. He has been a director of the Company since August 1, 2002.
LOGO    Floretta D. McKenzie, age 69, since January 1, 2005, is Senior Advisor to The American Institutes for Research, a District of Columbia-based education research organization and was the Founder and, until December 31, 2004, the Chairwoman of The McKenzie Group, Inc., a District of Columbia-based educational consulting firm. Dr. McKenzie is a director of Marriott International, Inc. Dr. McKenzie was a director of Pepco from 1988 until August 1, 2002. She has been a director of the Company since August 1, 2002.
LOGO    Lawrence C. Nussdorf, age 58, since 1998 has been President and Chief Operating Officer of Clark Enterprises, Inc., a privately held investment and real estate company based in Bethesda, Maryland, whose interests include the Clark Construction Group, LLC, a general contracting company, of which Mr. Nussdorf has been Vice President and Treasurer since 1977. Mr. Nussdorf was a director of Pepco from 2001 until August 1, 2002. He has been a director of the Company since August 1, 2002.

 

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DIRECTORS CONTINUING IN OFFICE

 

Terms Expiring in 2007

 

LOGO    Jack B. Dunn, IV, age 54, since October 1995 has been Chief Executive Officer and since October 2004 has been President of FTI Consulting, Inc., a publicly held multi-disciplined consulting firm with practices in the areas of corporate finance/restructuring, forensic and litigation consulting and economic consulting, located in Annapolis, Maryland. He served as Chairman of the Board of FTI from December 1998 to October 2004. Mr. Dunn is a limited partner of the Baltimore Orioles and is a director of Aether Systems, Inc. He has been a director of the Company since May 21, 2004.
LOGO    Richard B. McGlynn, age 66, is an attorney. From 1995-2000, he was Vice President and General Counsel of United Water Resources, Inc., Harrington Park, New Jersey and from 1992-1995, he was a partner in the law firm LeBoeuf, Lamb, Green & MacRae. He was a director of Atlantic Energy, Inc. from 1986 to 1998. Mr. McGlynn was a director of Conectiv from 1998 until August 1, 2002. He has been a director of the Company since August 1, 2002.
LOGO    Peter F. O’Malley, age 66, since 1989 has been of counsel to O’Malley, Miles, Nylen & Gilmore, P.A., a law firm headquartered in Calverton, Maryland. Mr. O’Malley currently serves as the President of Aberdeen Creek Corp., a privately held company engaged in investment, business consulting and development activities. Mr. O’Malley is a director of FTI Consulting, Inc., Legg Mason, Inc. and Legg Mason Trust Co. He was a director of Pepco from 1982 until August 1, 2002. He has been a director of the Company since August 1, 2002 and currently serves as the Lead Independent Director.
LOGO    Frank K. Ross, age 61, is retired managing partner for the mid-Atlantic Audit and Risk Advisory Services Practice and managing partner of the Washington, D.C. offices of the accounting firm KPMG LLP, positions he held from July 1, 1996 to December 31, 2003. He is currently a Distinguished Visiting Professor at Howard University, Washington, D.C. and the Director of its Center for Accounting Education. He is a director of NCRIC Group, Inc. and Cohen & Steers Funds. Mr. Ross serves on The Greater Washington, D.C. Urban League, Gallaudet University and the Hoop Dreams Scholarship Fund. He has been a director of the Company since May 21, 2004.
LOGO    William T. Torgerson, age 60, has been Vice Chairman of the Company since June 1, 2003 and has been General Counsel of the Company since August 1, 2002. From August 1, 2002 to June 2003, he was also Executive Vice President of the Company. From December 2000 to August 2002, he was Executive Vice President and General Counsel of Pepco and from April 1994 to December 2000, he was Senior Vice President and General Counsel of Pepco. Mr. Torgerson has been a director of Pepco and Conectiv since August 1, 2002. Mr. Torgerson has been a director of the Company since May 21, 2004.

 

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Which directors are “independent?”

 

According to the Listing Standards of the New York Stock Exchange (“NYSE”), a majority of the Company’s directors are required to be “independent” as defined by the NYSE rules. Currently, 10 of the Company’s 13 directors consisting of Messrs. Dunn, Golden, MacCormack, McGlynn, Nussdorf, O’Malley, Ross and A. Thomas Young (who is not standing for re-election) and Mmes. McKenzie and Schneider qualify as independent. If Messrs. Cronin and Wraase and Ms. Schneider are elected at the Annual Meeting, 9 of the Company’s 12 directors will qualify as independent.

 

For a director to be considered independent under NYSE rules, a director cannot have any of the disqualifying relationships enumerated by the rules and the Board must determine that the director does not otherwise have any direct or indirect material relationship with the Company. In accordance with the NYSE rules, the Board of Directors, as part of the Company’s Corporate Governance Guidelines, has adopted categorical standards to assist it in determining whether a relationship between a director and the Company is a material relationship that would impair the director’s independence. Under these standards, which incorporate the disqualifying relationships specifically enumerated by the NYSE rules, a Company director is not “independent” if any of the conditions specified are met.

 

  a. The director is, or has been within the last three years, an employee of the Company, or an immediate family member is, or has been within the last three years, an executive officer of the Company. An executive officer of the Company is the president, principal financial officer, controller, any vice-president in charge of a principal business unit, division or function, any other officer who performs a policy-making function, or any other person who performs similar policy-making functions for PHI. Officers of PHI’s subsidiaries are deemed to be officers of PHI if they perform such policy-making functions for PHI.

 

  b. The director has received, or has an immediate family member who has received, during any twelve-month period within the last three years, more than $100,000 in direct compensation from PHI, other than director and committee fees and pension or other forms of deferred compensation for prior service (provided such compensation is not contingent in any way on continued service).

 

  c. (A) The director or an immediate family member is a current partner of a firm that is the Company’s internal or external auditor; (B) the director is a current employee of such a firm; (C) the director has an immediate family member who is a current employee of such a firm and who participates in the firm’s audit, assurance or tax compliance (but not tax planning) practice; or (D) the director or an immediate family member was within the last three years (but is no longer) a partner or employee of such a firm and personally worked on the Company’s audit within that time.

 

  d. The director or an immediate family member is, or has been within the last three years, employed as an executive officer of another company where any of the Company’s present executive officers at the same time serves or served on that company’s compensation committee.

 

  e. The director is a current employee, or an immediate family member is a current executive officer, of a company that has made payments to, or received payments from, PHI for property or services in an amount which, in any of the last three fiscal years, exceeds the greater of $1 million or 2% of such other company’s consolidated gross revenues. Contributions to tax exempt organizations shall not be considered “payments” for purposes of this categorical standard, provided however that the Company shall disclose in its annual proxy statement any such contributions made by the Company to any tax exempt organization in which any independent director serves as an executive officer if, within the preceding three years, contributions in any single fiscal year from the Company to the tax exempt organization exceed the greater of $1 million, or 2% of such tax exempt organization’s consolidated gross revenues.

 

  f. For purposes of considering the existence or materiality of a director’s relationship with PHI or the relationship with PHI of an organization with which the director is associated, payments for electricity, gas or other products or services made in the normal course of business at prices generally applicable to similarly situated customers shall not be included.

 

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  g. Additional provisions applicable to members of the Audit Committee.

 

  i. A director who is a member of the Audit Committee may not accept directly or indirectly any consulting, advisory, or other compensatory fee from PHI or any PHI subsidiary, provided that, unless the rules of the New York Stock Exchange provide otherwise, compensatory fees do not include the receipt of fixed amounts of compensation under a retirement plan (including deferred compensation) for prior service (provided that such compensation is not contingent in any way on continued service). The term “indirect acceptance” by a member of the Audit Committee of any consulting, advisory, or other compensatory fee includes acceptance of such fee by a spouse, a minor child or stepchild or a child or stepchild sharing a home with the member or by an entity in which such member is a partner, member, an officer such as a managing director occupying a comparable position or executive officer, or occupies a similar position (except limited partners, non-managing members and those occupying similar positions who, in each case, have no active role in providing services to the entity) and which provides accounting, consulting, legal, investment banking or financial advisory services to PHI or any PHI subsidiary.

 

  ii. A director who is an “affiliated person” of PHI or its subsidiaries (other than in his or her capacity as a member of the Board or a Board Committee) as defined by the Securities and Exchange Commission shall not be considered independent for purposes of Audit Committee membership. A director who beneficially owns more than 3% of PHI’s common stock will be considered to be an “affiliated person.”

 

What are the Committees of the Board? How often did the Board and each Committee of the Board meet in 2004?

 

In 2004, the Board of Directors held 10 meetings. The Board has five separately designated standing committees: the Audit Committee, the Compensation/Human Resources Committee, the Corporate Governance/Nominating Committee, the Executive Committee and the Finance Committee. Each committee charter can be found on the Company’s Web site (www.pepcoholdings.com) under the link: Corporate Governance.

 

At each meeting, the Board and each of the Committees made up of independent directors (or, in the case of the Finance Committee, non-management directors) set aside time to meet in executive session without management directors (in the case of Board meetings) or other management personnel present. The executive session of the Board is convened by the Lead Director who also serves as the Chairman of the Corporate Governance/Nominating Committee. The Compensation/Human Resources Committee meets separately with its compensation consultant. The Audit Committee meets separately with the General Manager, Internal Audit and the independent registered public accounting firm.

 

The Audit Committee held 9 meetings in 2004. The Audit Committee represents and assists the Board in discharging its responsibility of oversight, but the existence of the Committee does not alter the traditional roles and responsibilities of the Company’s management and its independent registered public accounting firm with respect to the accounting and control functions and financial statement presentation. The Audit Committee of the Company’s Board is responsible for, among other things, representing and assisting the Board in oversight of (i) the integrity of the Company’s financial statements, accounting and financial reporting processes and audits of the Company’s consolidated financial statements, (ii) the Company’s compliance with legal and regulatory requirements, (iii) the qualifications, independence and the retention, compensation and performance of the Company’s independent registered public accounting firm, and (iv) the design and performance of the Company’s internal audit function. The Audit Committee also reviews the Company’s guidelines and policies with respect to risk assessment. The Committee has full power and authority to obtain advice and assistance from independent legal, accounting or other advisors as it may deem appropriate to carry out its duties. A more detailed description of the Audit Committee’s duties and responsibilities is set forth in the Audit Committee Charter included as Annex A to this Proxy Statement. Committee members are Directors Golden, McGlynn, Nussdorf (Chairman) and Ross. The Board has determined that directors Golden, Nussdorf and Ross each is an

 

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“audit committee financial expert” as defined by the rules of the Securities and Exchange Commission (“SEC”). The Board has determined that each of the members of the Audit Committee is independent as defined by the Company’s Corporate Governance Guidelines and in accordance with the rules of the NYSE.

 

The Compensation/Human Resources Committee held 5 meetings in 2004. The Committee, together with the other independent members of the Board of Directors, sets the CEO’s compensation level. The Committee approves the salaries of the five most highly compensated officers (other than the CEO), the heads of the major subsidiaries and the Vice Presidents of the Company; administers the Company’s executive incentive compensation programs; and establishes the structure of compensation and amounts of awards under the Long-Term Incentive Plan. The Committee exercises the powers of the Board with respect to the Company’s annual salary administration program for all management employees. The Committee also makes recommendations to the Board concerning the Company’s retirement and other benefit plans and oversees corporate workforce diversity issues. Committee members are Directors MacCormack, McGlynn, McKenzie, O’Malley, Ross and Young (Chairman). The Board has determined that each of the members of the Compensation/Human Resources Committee is independent as defined by the Company’s Corporate Governance Guidelines and in accordance with the rules of the NYSE.

 

The Corporate Governance/Nominating Committee held 8 meetings in 2004. The Committee’s duties and responsibilities include making recommendations to the Board regarding the governance of the Company and the Board, helping to ensure that the Company is properly managed to protect and enhance shareholder value and to meet the Company’s obligations to shareholders, customers, the industry and under the law. The Committee is responsible for making recommendations to the Board regarding Board structure, practices and policies, including Board committee chairmanships and assignments and the compensation of Board members, assessing Board performance and effectiveness, and ensuring that processes are in place with regard to corporate strategy, management development and management succession, business plans and corporate and government affairs. The Committee evaluates annually the performance of the Company’s Chief Executive Officer and reports its appraisal to the other independent directors. The Committee also is responsible for ensuring that the technology and systems used by the Company are adequate to properly run the business and for it to remain competitive. The Committee reviews and recommends to the Board candidates for nomination for election as directors. Committee members are Directors Dunn, McKenzie, O’Malley (Chairman and Lead Independent Director), Schneider and Young. The Board has determined that each of the members of the Corporate Governance/Nominating Committee is independent as defined by the Company’s Corporate Governance Guidelines and in accordance with the rules of the NYSE.

 

The Executive Committee held 2 meetings in 2004. The Committee has, and may exercise when the Board is not in session, all the powers of the Board in the management of the property, business and affairs of the Company, except as otherwise provided by law. The Committee does not hold regularly scheduled meetings. Committee members are Directors McKenzie (Chairman), McGlynn, O’Malley, Torgerson and Wraase.

 

The Finance Committee was constituted in July 2004 and held 3 meetings in 2004. The Committee oversees the financial objectives, policies, procedures and activities of the Company and considers the long- and short-term strategic plans of the Company. The Committee reviews with management the Company’s risk mitigation profile. Committee members are Directors Cronin, Dunn, Golden (Chairman), MacCormack, Nussdorf and Schneider.

 

In 2004, each director attended at least 75% of the aggregate number of meetings held by the Board and each Committee of which he or she was a member. The Board has adopted an attendance policy, set forth in the Corporate Governance Guidelines, under which attendance in person is required at all regularly scheduled shareholder, Board and Committee meetings (except where scheduled as a conference call) and is the preferred method of attendance at specially called meetings. The Chairman has the authority to waive the requirement of this policy if, in the Chairman’s opinion, it is in the Company’s best interests to do so. Of the Company’s 12 directors at the time of the 2004 Annual Meeting, 11 attended as did the two additional nominees who were elected as directors.

 

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How do I send a communication to the Board of Directors or to a specific individual director?

 

The Company’s directors encourage interested parties, including employees and shareholders, to contact them directly and, if desired, confidentially and/or anonymously regarding matters of concern or interest, including concerns regarding questionable accounting or auditing matters. The names of the Company’s directors can be found on pages 7-9 of this Proxy Statement and on the Company’s Web site (www.pepcoholdings.com) under the link: Board of Directors. The Company’s directors may be contacted by writing to them either individually or as a group or partial group (such as all non-management directors), c/o Corporate Secretary, Pepco Holdings, Inc., 701 Ninth Street, N.W., Room 1300, Washington, D.C. 20068. If you wish your communication to be treated confidentially, please write the word “CONFIDENTIAL” prominently on the envelope and address it to the director by name so that it can be forwarded without being opened. Communications addressed to multiple recipients, such as to “directors,” “all directors,” “all non-management directors,” “independent directors,” etc. will necessarily have to be opened and copied by the Office of the Corporate Secretary in order to forward them, and hence cannot be transmitted unopened, but will be treated as confidential communications. If you wish to remain anonymous, do not sign your letter or include a return address on the envelope. Communications from Company employees regarding accounting, internal accounting controls, or auditing matters may be submitted in writing addressed to: General Manager, Internal Audit, Pepco Holdings, Inc., 701 Ninth Street, N.W., Room 8220, Washington, D.C. 20068 or by telephone to 202-872-3524. Such communications will be handled initially by the Internal Audit Group, which reports to the Audit Committee of the Board, and will be reported to the Audit Committee. If for any reason the employee does not wish to submit a communication to the General Manager, Internal Audit, it may be addressed to the Chairman of the Audit Committee using the procedure set forth above, or can be telephoned to the Company’s Ethics Officer hotline.

 

What are the directors paid for their services?

 

Commencing January 1, 2005, each of the Company’s directors who is not an employee of the Company or any of its subsidiaries (a “non-management director”) is paid an annual retainer of $45,000, plus a fee of $2,000 for each Board and Committee meeting attended. Each non-management director who chairs the Compensation/Human Resources, Executive or Finance Committee is paid an additional annual retainer of $5,000. The Lead Director (who is also the Chairman of the Corporate Governance/Nominating Committee) and the non-management director who chairs the Audit Committee is paid an additional annual retainer of $7,500.

 

Each non-management director is required to own at least 7,500 shares of Common Stock or Common Stock equivalents (“phantom stock”). Non-management directors serving as of January 1, 2005 have until December 31, 2007 to meet this requirement. Newly elected or appointed non-management directors are required to reach this ownership level within three years after the date of their election or appointment.

 

On December 16, 2004, the Board adopted a Non-Management Director Compensation Plan (the “Director Compensation Plan”), which superseded the Company’s Stock Compensation Plan for Directors. Under the new plan, which became effective January 1, 2005, each non-management director is entitled to elect to receive his or her annual retainer, retainer for service as a committee chairman, if any, and meeting fees in: (1) cash, (2) shares of Common Stock, (3) a credit to an account for the director established under the Company’s Executive and Director Deferred Compensation Plan (“Deferred Compensation Plan”) or (4) any combination thereof. A non-management director who elects to have all or any portion of his or her compensation for services as a director credited to an account under the Deferred Compensation Plan can elect to have his or her account balance under the plan: (i) maintained in the form of phantom stock and credited with additional phantom stock when the Company pays a dividend on its Common Stock, (ii) credited with a return based on the prevailing prime rate or (iii) credited with a return based on the return on one or more investment funds selected by the committee responsible for the administration of the Deferred Compensation Plan. Distributions to participants under the Deferred Compensation Plan are made in cash, in either a lump sum or installments, commencing at a time selected by the participant.

 

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Although under the terms of the Company’s Long-Term Incentive Plan, each non-management director is entitled to a grant, on May 1 of each year, of an option to purchase 1,000 shares of Common Stock, the Board of Directors has determined that these grants will not be made.

 

The Company also provides directors with travel accident insurance for Company-related travel, directors’ and officers’ liability insurance coverage and reimburses directors for travel, hotel and other out-of-pocket expenses incurred in connection with their performance of their duties as directors. The Company also provides the directors with free parking in the Company’s headquarters building other than in connection with their performance of their duties as directors.

 

The following table sets forth, as of March 15, 2005, for each non-management director who has elected to receive all or a portion of his/her annual retainer and meeting fees in phantom stock under the Company’s Deferred Compensation Plan, the number of credited phantom stock units (each corresponding to one share of Common Stock).

 

Name of Director


   Pepco Holdings
Phantom Stock Units


Edmund B. Cronin, Jr.

   19,976

Terence C. Golden

   17,167

George F. MacCormack

   4,052

Richard B. McGlynn

   2,037

Lawrence C. Nussdorf

   2,921

Peter F. O’Malley

   4,856

Pauline A. Schneider

   405

A. Thomas Young

   20,312

 

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SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

 

The following table sets forth, as of March 15, 2005, for each director, director nominee, the six executive officers named in the Summary Compensation Table on page 16 and all directors and executive officers as a group (i) the number of shares of Common Stock beneficially owned, (ii) the number of shares of Common Stock that could be purchased through the exercise of stock options then-currently exercisable or scheduled to become exercisable within 60 days thereafter, and (iii) total beneficial ownership. The Common Stock is the Company’s only class of equity or voting securities. Each of the individuals listed, and all directors and executive officers as a group, beneficially owned less than 1% of the outstanding shares of Common Stock. The following table also sets forth, as of March 15, 2004, the number and percentage of shares of Common Stock reported as beneficially owned by all persons known by the Company to own beneficially 5% or more of the Common Stock.

 

Name of Beneficial Owner


   Shares of
Common Stock
Owned(1)


   Common Stock
Acquirable Within
60 Days


   Total
Beneficial
Ownership(2)


Edmund B. Cronin, Jr.

   1,362    4,750    6,112

Jack B. Dunn, IV

   10,495    0    10,495

Terence C. Golden (3)

   52,132    3,750    55,882

George F. MacCormack

   11,282    0    11,282

Richard B. McGlynn

   5,756    0    5,756

Floretta D. McKenzie

   5,841    4,750    10,591

Lawrence C. Nussdorf

   5,000    1,750    6,750

Peter F. O’Malley (4)

   10,000    4,750    14,750

Joseph M. Rigby

   11,837    16,025    27,862

Frank K. Ross

   1,757    0    1,757

Pauline A. Schneider

   3,449    1,750    5,199

Thomas S. Shaw

   81,964    68,333    150,297

William H. Spence

   7,079    16,025    23,104

William T. Torgerson

   31,224    111,093    142,317

Andrew W. Williams

   36,619    76,734    113,353

Dennis R. Wraase

   66,469    153,843    220,312

A. Thomas Young

   1,000    4,750    5,750

All Directors and Executive Officers as a Group (21 Individuals)

   405,002    613,500    1,108,502

 

Name and Address of Beneficial Owner


   Shares of
Common Stock
Owned(5)


   Percent of
Common Stock
Outstanding


 

UBS AG Bahnhofstrasse 45 PO Box CH-8021 Zurich, Switzerland

   11,058,350    5.9 %

(1) Includes shares held under the Company’s Dividend Reinvestment Plan and Employee Savings Plans. Also includes shares awarded under the Company’s Long-Term Incentive Plan that vest over time if the executive officer has the right to vote the shares. Unless otherwise noted, each beneficial holder has sole voting power and sole investment power with respect to the shares.
(2) Consists of the sum of the two preceding columns.
(3) Includes 11,600 shares owned by Mr. Golden’s spouse. Mr. Golden disclaims beneficial ownership of these shares.
(4) Includes 4,086 shares owned by Aberdeen Creek Corporation, of which Mr. O’Malley is the sole owner.
(5) This disclosure is based on information furnished in Schedule 13G/A, dated February 14, 2004, and filed with the Securities and Exchange Commission on February 17, 2005, jointly by UBS AG, UBS Americas Inc. and UBS Global Asset Management (Americas) Inc., in which UBS AG reports that it is the beneficial owner of 11,058,350 shares of Common Stock (consisting of 10,987,550 shares as to which it has shared dispositive power, 70,800 shares as to which it has sole dispositive power and 6,987,150 as to which it has sole voting power), which includes (i) 4,219,300 shares reported as beneficially owned by its wholly owned subsidiary UBS America Inc., and (ii) 4,041,800 shares reported as beneficially owned by UBS Global Management (Americas) Inc., a wholly owned subsidiary of UBS America Inc.

 

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Section 16(a) Beneficial Ownership Reporting Compliance

 

Section 16(a) of the Securities Exchange Act of 1934 requires the directors and executive officers of a public company and any beneficial owners of more than 10% of any class of the Company’s securities to file with the Securities and Exchange Commission reports of their initial holdings and transactions in the Company’s equity securities. To the Company’s knowledge, there are no 10% beneficial owners of Common Stock. The rules of the SEC require the Company to disclose any late filing of these reports and any known failure to file these reports. Based on its review of such reports filed for 2004, the Company has identified the following reports that were not filed on a timely basis: (i) on June 16, 2004, James P. Lavin, Joseph M. Rigby, Thomas S. Shaw and William H. Spence each filed a late Form 4 in which he reported an award of phantom stock units received on February 1, 2003 under the Management Stock Purchase Program (“MSPP”) of the Conectiv Deferred Compensation Plan and (ii) on June 16, 2004, Mr. Rigby filed an amended Form 5 for the year ended December 31, 2002 to correct an error in the number of phantom stock units under the MSPP originally reported as beneficially owned on August 1, 2002.

 

EXECUTIVE COMPENSATION

 

The following table sets forth compensation information for each of the last three fiscal years ended December 31, for the Chief Executive Officer and the five other most highly compensated executive officers of the Company determined on the basis of aggregate salary and bonus for the year ended December 31, 2004 (collectively, the “Named Executive Officers”). The information presented in the table on and after August 1, 2002 reflects compensation paid by the Company or its subsidiaries, and for periods prior to August 1, 2002 reflects compensation paid by Pepco, in the cases of Messrs. Wraase, Torgerson and Williams, and by Conectiv or its subsidiaries, in the case of Messrs. Shaw, Rigby and Spence.

 

SUMMARY COMPENSATION TABLE

 

    Annual Compensation

  Long-Term Compensation

 

All Other
Compen-

sation(10)


Name and Principal Position


  Year

  Salary

  Bonus

  Other
Annual
Compen-
sation(6)


  Restricted
Stock
Awards(7)


  Securities
Underlying
Options(8)


  LTIP
Payouts(9)


 

Dennis R. Wraase

Chairman, President

and Chief Executive Officer

  2004
2003
2002
  $
 
 
730,250
558,333
455,333
  $
 
 
438,588
0
257,833
  $
 
 
9,343
8,124
7,063
  $
 
 
0
299,997
205,915
  0
0
48,000
  $
 
 
197,069
0
58,946
  $
 
 
39,028
29,488
22,673

William T. Torgerson

Vice Chairman

and General Counsel

  2004
2003
2002
  $
 
 
475,000
396,000
349,000
  $
 
 
237,737
0
158,097
  $
 
 
7,845
6,821
5,932
  $
 
 
0
0
141,382
  0
0
39,000
  $
 
 
135,312
0
57,394
  $
 
 
28,965
23,310
18,488

Thomas S. Shaw

Executive Vice President

  2004
2003
2002
  $
 
 
474,000
460,000
442,000
  $
 
 
237,237
0
226,083
  $
 
 
0
0
0
  $
 
 
0
0
1,760,916
  0
0
68,333
  $
 
 
164,613
0
0
  $
 
 
16,909
10,434
1,043,422

Andrew W. Williams

Senior Vice President

and Chief Risk Officer

  2004
2003
2002
  $
 

 
330,000
320,000

292,000
  $
 
 
132,132
0
132,276
  $
 
 
0
0
0
  $
 
 
0
0
121,193
  0
0
30,000
  $
 
 
115,962
0
31,800
  $
 
 
13,541
14,858
13,206

Joseph M. Rigby

Senior Vice President

and Chief Financial Officer

  2004
2003
2002
  $
 
 
299,167
260,000
250,800
  $
 
 
119,786
58,656
107,342
  $
 
 
0
0
0
  $
 
 
0
0
111,884
  0
0
32,051
  $
 
 
72,088
0
0
  $
 
 
6,726
7,870
4,716

William H. Spence

Senior Vice President

  2004
2003
2002
  $
 
 
267,000
260,000
251,000
  $
 
 
171,018
0
133,030
  $
 
 
0
0
0
  $
 
 
0
0
111,884
  0
0
32,051
  $
 
 
72,088
0
0
  $
 
 
8,160
10,315
6,990

 

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(6) Other Annual Compensation. Amounts in this column for each year represent above-market earnings earned by the executive on deferred compensation under the Pepco Deferred Compensation Plan assuming retirement at age 65. The amounts are reduced if the executive terminates employment prior to age 62 for any reason other than death, total or permanent disability or a change in control of Pepco. In the event of a change in control and termination of the participant’s employment, the participant will receive a lump sum payment equal to the net present value of the expected payments at age 65 discounted using the Pension Benefit Guaranty Corporation immediate payment interest rate plus one-half of one percent. Payments to the executives are funded by Pepco-owned life insurance policies held in trust. Pepco has purchased such policies on participating individuals under a program designed so that if assumptions as to mortality experience, policy return and other factors are realized, the compensation deferred and the death benefits payable to Pepco under such insurance policies will cover all premium payments and benefit payments projected under this program, plus a factor for the use of Pepco funds.

 

In addition to the compensation shown in the above Summary Compensation Table, each of the Named Executive Officers were entitled to one or more of the following personal benefits: financial planning services, tax preparation services, personal use of company-owned automobiles or an automobile allowance, club dues and personal use of Company entertainment venues. For each of the Named Executive Officers, the aggregate value of these perquisites in each of the three years, was less than the lesser of $50,000 or 10% of the individual’s total annual salary and bonus, and accordingly, consistent with the rules of the Securities and Exchange Commission, the value of these perquisites has not been included in the Table.

 

(7) Restricted Stock. The amount in this column for 2003 for Mr. Wraase represents the dollar value on the grant date of restricted shares of Common Stock awarded under the Company’s Long-Term Incentive Plan. The restricted shares granted to Mr. Wraase in 2003 vest on June 1, 2006 if he is continuously employed by the Company through that date. Amounts in this column for 2002 represent the dollar value on the grant date of restricted shares of Common Stock awarded to each of Messrs. Wraase, Torgerson, Shaw, Williams, Rigby and Spence under the Merger Success Integration Program implemented under the Company’s Long-Term Incentive Plan. Twenty percent of the restricted shares granted in 2002 vested on August 1, 2003, and 30% vested on August 1, 2004. The remaining 50% vest on August 1, 2005 if the executive remains employed by the Company through that date. Dividends are paid on the restricted shares. The dollar value in each case has been calculated by multiplying the number of restricted shares by the market price of the Common Stock on the grant date.

 

The amount in 2002 for Mr. Shaw also includes the dollar value on the grant date of 65,000 restricted shares of Conectiv common stock granted to him under the Conectiv Long-Term Incentive Plan. The 65,000 shares were converted in connection with the merger into 83,333 shares of restricted Common Stock issued under the Company’s Long-Term Incentive Plan. Of these shares, 23% of these shares vested on January 1, 2004 and an additional 23% vested on January 1, 2005. The balance will vest on January 1, 2006 if Mr. Shaw remains employed by the Company through that date. For Messrs. Rigby and Spence, amounts in this column for 2002 represent the dollar value on the grant date of 1,500 restricted shares of Conectiv common stock granted to each of them under the Conectiv Long-Term Incentive Plan. For each of Messrs. Rigby and Spence, the 1,500 shares were converted in connection with the merger into 1,923 shares of restricted Common Stock issued under the Company’s Long-Term Incentive Plan. The converted shares vest on January 2, 2009, for each of Messrs. Rigby and Spence, if he remains employed by the Company through that date. Dividends are paid on the restricted shares.

 

The number and aggregate market value of all restricted shares of Common Stock held by the Named Executive Officers at December 31, 2004 were: Mr. Wraase, 20,039 shares with a market value of $428,233; Mr. Torgerson, 3,582 shares with a market value of $76,547; Mr. Shaw, 68,459 shares with a market value of $1,462,969; Mr. Williams, 3,071 shares with a market value of $65,627; Mr. Rigby, 3,830 shares with a market value of $81,848; and Mr. Spence, 3,830 shares with a market value of $81,848.

 

(8)

Options. Amounts in this column for each of the former Pepco executives represent the stock options granted under the Pepco Long-Term Incentive Plan. At the time of the merger, these options were exchanged on a one-for-one basis for Company stock options granted under the Company’s Long-Term

 

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Incentive Plan. In 2002, prior to the merger, Messrs. Shaw, Rigby and Spence were awarded 53,300, 25,000 and 25,000 Conectiv stock options, respectively. At the time of the merger, these options were exchanged on a 1 for 1.28205 basis for 68,333, 32,051 and 32,051 Company stock options, respectively, granted under the Company’s Long-Term Incentive Plan.

 

In addition to the options granted in 2002, at the date of the merger, Mr. Shaw held options to purchase 316,700 shares of Conectiv common stock. These options vested as of the date of the merger and were canceled in exchange for a cash payment in the amount of $1,200,218 which is the aggregate difference between the exercise price of each option and the exchange value per share of the Conectiv common stock in the merger.

 

(9) Incentive Plan Payouts. Amounts in this column for the executives represent the value of Common Stock awarded under Pepco Holdings, Inc.’s Performance Restricted Stock Program and the Merger Integration Success Program, each of which is a component of the Company’s Long-Term Incentive Plan that vested during the year. The amounts shown for 2002 consist of 33 1/3% of Common Stock award from the one-year performance cycle ended December 31, 1999, 33 1/3% of the Common Stock award from the eight-month performance cycle ended December 31, 1999, and 100% of the Common Stock award from the three-year cycle ended December 31, 2002 that vested on January 1, 2003. Amounts in this column for 2004 are for the performance cycle ending December 31, 2004 under the Merger Integration Success Program which vested on March 11, 2005. The value of the vested Common Stock has been calculated by multiplying the number of vested shares by the market price of the Common Stock on the day preceding the vesting date.

 

(10) All Other Compensation. Amounts in this column for 2004 consist of (i) Pepco’s contributions to the Pepco Savings Plan for Exempt Employees of $10,000, $10,000, and $8,650 for Messrs. Wraase, Torgerson and Williams, respectively, and Conectiv’s contribution to the Conectiv Savings and Investment Plan of $4,016, $5,610 and $6,000 for Messrs. Shaw, Rigby and Spence, respectively (ii) Company contributions to the Executive Deferred Compensation Plan due to Internal Revenue Service limitations on maximum contributions to the Pepco Savings Plan for Exempt Employees and, in the case of Messrs. Shaw, Rigby and Spence, the Conectiv Savings and Investment Plan, of $18,221, $8,930, $4,985, $545, $0 and $1,089 for Messrs. Wraase, Torgerson, Shaw, Williams, Rigby and Spence, respectively, and (iii) the term life insurance premiums paid by the Company for Messrs. Wraase, Torgerson, Shaw, Williams, Rigby and Spence of $10,807, $10,035, $7,908, $4,256, $1,116 and $1,071, respectively.

 

AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR

AND FISCAL YEAR-END OPTION VALUES

 

     Shares
Acquired on
Exercise
(#)


  

Value
Realized

($)


   Number of Shares
Underlying Unexercised
Options at End of
Fiscal Year


   Value of Unexercised
In-the-Money Options at
End of Fiscal Year(11)


Name


         Exercisable

   Unexercisable

   Exercisable

   Unexercisable

Dennis R. Wraase

   0      0    129,843    36,000      0      0

William T. Torgerson

   0      0    93,843    27,000      0      0

Thomas S. Shaw

   0      0    34,167    34,166    $ 79,951    $ 79,948

Andrew W. Williams

   0      0    61,734    22,500      0      0

Joseph M. Rigby

   16,026    $ 36,464    0    16,025      0    $ 37,498

William H. Spence

   16,026    $ 36,464    0    16,025      0    $ 37,498

(11) Value of Unexercised In-the-Money Options at End of Fiscal Year. The value of unexercised in-the-money options at December 31, 2004 is calculated by multiplying the number of shares by the amount by which the fair market value of the Common Stock on the last trading day of 2004, as reported by the NYSE, exceeds the option exercise price. For Messrs. Wraase, Torgerson and Williams, the closing price of the Common Stock on the last trading day of 2004 was less than the option exercise prices, making the value of the unexercised in-the-money options zero.

 

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LONG-TERM INCENTIVE PLAN—AWARDS IN LAST FISCAL YEAR

 

Name


  

Performance or

Other Period Until
Maturation or
Payout


   Threshold
Number of Shares


   Target
Number of Shares


   Maximum
Number of Shares


Dennis R. Wraase

   2005-2007    0    45,500    91,000

William T. Torgerson

   2005-2007    0    20,200    40,400

Thomas S. Shaw

   2005-2007    0    20,100    40,200

Andrew W. Williams

   2005-2007    0    10,000    20,000

Joseph M. Rigby

   2005-2007    0    11,200    22,400

William H. Spence

   2005-2007    0    11,200    22,400

 

Under the Performance Restricted Stock Program established under the Company’s Long-Term Incentive Plan participating executives are entitled to earn shares of Common Stock to the extent one or more pre-established performance criteria are met on a specified performance period. The preceding table sets forth the performance award opportunities granted under the Program in 2004 to each of the Named Executive Officers. The awards relate to performance over a three-year period beginning on January 1, 2005 and ending on December 31, 2007. Depending on the extent to which the performance objective established by the Compensation/Human Resources Committee is satisfied, the executive will earn some or all of the maximum award of shares of Common Stock. The performance objective for the 2005 to 2007 performance period is based on the Company’s total shareholder return compared to other companies in a peer group comprised of 20 gas and electric distribution companies. A participant is eligible to earn a number of shares of Common Stock ranging from 0% to 200% of the target performance award to the extent that the performance objective is achieved. The performance objective was fixed at the time the awards are made; however, if during the course of the performance period, a significant event occurs, as determined in the sole discretion of the Compensation/Human Resources Committee, which the Committee expects to have a substantial effect on total shareholder performance during the period, the Committee may revise the targeted performance objective.

 

The shares of Common Stock earned by a participant will be fully vested on the date the performance award is earned.

 

PEPCO PENSION PLAN TABLE

 

Average Annual Salary
  in Final Three Years
     of Employment


   Annual Retirement Benefits

   Years in Plan

   15

   20

   25

   30

   35

   40

$250,000

   $ 66,000    $ 88,000    $ 109,000    $ 131,000    $ 153,000    $ 175,000

$350,000

   $ 92,000    $ 123,000    $ 153,000    $ 184,000    $ 214,000    $ 245,000

$450,000

   $ 118,000    $ 158,000    $ 197,000    $ 236,000    $ 276,000    $ 315,000

$550,000

   $ 144,000    $ 193,000    $ 241,000    $ 289,000    $ 337,000    $ 385,000

$650,000

   $ 171,000    $ 228,000    $ 284,000    $ 341,000    $ 398,000    $ 455,000

$750,000

   $ 197,000    $ 263,000    $ 328,000    $ 394,000    $ 459,000    $ 525,000

$850,000

   $ 223,000    $ 298,000    $ 372,000    $ 446,000    $ 521,000    $ 595,000

$950,000

   $ 249,000    $ 333,000    $ 416,000    $ 499,000    $ 582,000    $ 665,000

$1,050,000

   $ 276,000    $ 368,000    $ 459,000    $ 551,000    $ 643,000    $ 735,000

 

The Pepco Holdings Retirement Plan consists of the Pepco General Retirement Plan and the Conectiv Retirement Plan.

 

The Pepco General Retirement Plan provides participating employees with at least five years of service with retirement benefits based on the participant’s average salary (the term “salary” being equal to the amounts

 

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contained in the Salary column of the Summary Compensation Table) for the final three years of employment and the number of years of credited service under the Plan at the time of retirement. Normal retirement under this Plan is age 65. Plan benefits are subject to an offset for any Social Security benefits. Benefits under the Plan may be reduced under provisions of the Internal Revenue Code and by salary deferrals under Pepco’s deferred compensation plans (other than the participant’s pre-tax contributions made under the Savings Plan). If an executive’s retirement benefits under the Plan are reduced by either or both of these limitations, Pepco will pay a supplemental retirement benefit to the eligible executive that is designed to maintain total retirement benefits at the formula level of the Plan. In addition, for executives who retire at age 59 or older, their retirement benefit will be calculated by adding the average of the highest three annual incentive awards in the last five consecutive years to their average salary over the final three years of their employment. The annual incentive amounts are equal to the amounts shown in the Bonus column of the Summary Compensation Table. The current age, years of credited service and compensation (assuming the individual had retired on January 1, 2005) used to determine retirement benefits (including supplemental benefits) for the officers named in the Summary Compensation Table who are participants in the Plan are as follows: Mr. Wraase, age 61, 36 years of credited service and $875,988; Mr. Torgerson, age 60, 35 years of credited service and $588,202; and Mr. Williams, age 55, 30 years of credited service and $434,033. Annual benefits at age 65 (including the effect of the Social Security offset) are illustrated in the table above.

 

Messrs. Shaw, Rigby and Spence participate in the Conectiv Retirement Plan and the Conectiv Supplemental Executive Retirement Plan. The Conectiv Retirement Plan is a cash balance pension plan, but also includes certain “grandfathered” rights under the Delmarva Retirement Plan, in which Messrs. Shaw and Spence participated, and under the Atlantic City Electric Retirement Plan, in which Mr. Rigby participated, that apply to employees who had attained either 20 years of service or age 50 on or before January 1, 1999. The Conectiv Supplemental Executive Retirement Plan provides supplemental retirement benefits to which the participating executives would be entitled in the absence of federal tax law limitations on the benefits payable under the Conectiv Retirement Plan.

 

Under the Conectiv Retirement Plan, a record-keeping account in a participant’s name is credited with an amount equal to a percentage of the participant’s total pay, including base pay, overtime and bonuses, depending on the participant’s age at the end of the plan year. For Messrs. Shaw, Rigby and Spence, the percentage currently is 10%, 9% and 9%, respectively. These accounts also receive interest credits equal to prevailing U.S. Treasury Bill rates during the year. In addition, some of the annuity benefits earned by participants under the former Delmarva Retirement Plan and Atlantic City Electric Retirement Plan are fully protected as of December 31, 1998, and were converted to an equivalent cash amount and included in each participant’s initial cash balance account. Benefits generally become vested after five years of service. When a participant terminates employment, the amount credited to his or her account is converted into an annuity or paid in a lump sum. There is no Social Security offset under the Conectiv Retirement Plan. The estimated retirement benefits, including supplemental retirement benefits, payable to Messrs. Shaw, Rigby and Spence under the Conectiv Retirement Plan, calculated based on the cash balance formula and including the Delmarva Retirement Plan or Atlantic City Electric Retirement Plan credit, if the executive were to retire at normal retirement age of 65, expressed in the form of a lump sum payment, would be $7,096,000 for Mr. Shaw, $3,156,000 for Mr. Rigby and $1,578,000 for Mr. Spence.

 

Under the Conectiv Retirement Plan’s grandfathering provisions, employees who participated in the Delmarva Retirement Plan or the Atlantic City Electric Retirement Plan and who met age and service requirements as of January 1, 1999, are assured a minimum retirement benefit calculated for all years of service up to the earlier of December 31, 2008 or retirement according to their original benefit formula under the applicable plan. There is no Social Security offset under either the Delmarva Retirement Plan or the Atlantic City Electric Retirement Plan. This benefit will be compared to the cash balance account and the employee will receive whichever is greater. The benefit is payable in the form of various annuity options or a lump sum. On December 31, 2008, the participant’s grandfathered benefit under the Delmarva Retirement Plan or Atlantic City Electric Retirement Plan will be frozen, and all future benefit accruals will be under the cash balance formula of the Conectiv Retirement Plan.

 

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Messrs. Shaw and Spence were participants in the Delmarva Retirement Plan. Their annual benefits under the Plan at age 65, as supplemented by the Conectiv Supplemental Executive Retirement Plan, are illustrated in the table below. Mr. Shaw’s current years of credited service and earnings (assuming the individual had retired on January 1, 2005) used to determine retirement benefits (including supplemental benefits) are as follows: age 57, 33 years of credited service and $910,160. Mr. Spence’s current years of credited service and earnings (assuming the individual had retired on January 1, 2005) used to determine retirement benefits (including supplemental benefits) are as follows: age 47, 17 years of credited service and $266,854. Earnings consist of base salary and bonus as shown in Salary and Bonus columns of the Summary Compensation Table.

 

DELMARVA PENSION PLAN TABLE

 

Average Annual Earnings for the
5 Consecutive Years of Earnings
that result in the Highest Average


   Annual Retirement Benefits

   Years in Plan

   15

   20

   25

   30

   35

   40

$300,000

   $ 72,000    $ 96,000    $ 120,000    $ 144,000    $ 168,000    $ 192,000

$400,000

   $ 96,000    $ 128,000    $ 160,000    $ 192,000    $ 224,000    $ 256,000

$500,000

   $ 120,000    $ 160,000    $ 200,000    $ 240,000    $ 280,000    $ 320,000

$600,000

   $ 144,000    $ 192,000    $ 240,000    $ 288,000    $ 336,000    $ 384,000

$700,000

   $ 168,000    $ 224,000    $ 280,000    $ 336,000    $ 392,000    $ 448,000

$800,000

   $ 192,000    $ 256,000    $ 320,000    $ 384,000    $ 448,000    $ 512,000

$900,000

   $ 216,000    $ 288,000    $ 360,000    $ 432,000    $ 504,000    $ 576,000

$1,000,000

   $ 240,000    $ 320,000    $ 400,000    $ 480,000    $ 560,000    $ 640,000

$1,100,000

   $ 264,000    $ 352,000    $ 440,000    $ 528,000    $ 616,000    $ 704,000

 

Mr. Rigby was a participant in the Atlantic City Electric Retirement Plan. His annual benefits under the Plan at age 65, as supplemented by the Conectiv Supplemental Executive Retirement Plan, are illustrated in the table below. Mr. Rigby’s current years of credited service and earnings (assuming the individual had retired on January 1, 2005) used to determine retirement benefits (including supplemental benefits) are as follows: age 48, 26 years of credited service and $400,592. Earnings consist of base salary and bonus as shown in Salary and Bonus columns of the Summary Compensation Table.

 

ATLANTIC CITY ELECTRIC PENSION PLAN TABLE

 

Average Salary and Bonus of the Highest Five
Consecutive Years of the Ten Years Preceding
Retirement


  

Annual Retirement Benefits


   Years in Plan

   15

   20

   25

   30

   35

   40

$200,000

   $ 48,000    $ 64,000    $ 80,000    $ 96,000    $ 112,000    $ 128,000

$300,000

   $ 72,000    $ 96,000    $ 120,000    $ 144,000    $ 168,000    $ 192,000

$400,000

   $ 96,000    $ 128,000    $ 160,000    $ 192,000    $ 224,000    $ 256,000

$500,000

   $ 120,000    $ 160,000    $ 200,000    $ 240,000    $ 280,000    $ 320,000

$600,000

   $ 144,000    $ 192,000    $ 240,000    $ 288,000    $ 336,000    $ 384,000

 

EMPLOYMENT AGREEMENTS

 

Messrs. Wraase, Torgerson, Shaw, Williams, Rigby and Spence each have employment agreements with the Company. Mr. Wraase’s and Mr. Torgerson’s agreements each provide for employment through August 1, 2007, and automatically extend until April 1, 2009 for Mr. Wraase and June 1, 2009 for Mr. Torgerson, unless either the Company or the executive gives notice that it shall not be extended. Mr. Shaw’s agreement provides for his

 

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employment through August 1, 2007. Messrs. Rigby’s, Spence’s and Williams’ agreements provide for their respective employment through August 1, 2005, and automatically extend for successive periods of three years thereafter, unless either the Company or the executive gives notice that it shall not be so extended. Each of the employment agreements provides that the executive (i) will receive an annual salary in an amount not less than his base salary in effect as of August 1, 2002, and incentive compensation as determined by the Board of Directors and (ii) will be entitled to participate in retirement plans, fringe benefit plans, supplemental benefit plans and other plans and programs, on the same basis as other senior executives of the Company.

 

Under each of the employment agreements, the executive is entitled to certain benefits if his employment is terminated prior to the expiration of the initial term of the agreement (or, if extended, the expiration of the extension period) either (i) by the Company other than for cause, death or disability or (ii) by the executive if his base salary is reduced, he is not in good faith considered for incentive awards, the Company fails to provide him with retirement benefits and other benefits provided to similarly situated executives, he is required to relocate by more than 50 miles from Washington, D.C. (or, in the case of Mr. Shaw, he is required to relocate by more than 50 miles from Wilmington, Delaware, except that he may be required to locate to the Washington, D.C. area), or he is demoted from a senior management position. These benefits include: (i) a lump sum payment in cash equal to three times (a) the sum of the executive’s highest annual base salary rate in effect during the three-year period preceding termination and (b) the higher of (1) the annual target bonus for the year in which the termination of employment occurs or (2) the highest annual bonus received by the executive in any of the three preceding calendar years and (ii) the executive’s annual bonus for the year preceding termination of employment, if not yet paid, and a pro rata portion of the executive’s annual bonus for the year in which the executive’s employment terminates. In addition, any outstanding shares of restricted stock will become immediately vested, and the executive will be entitled to receive unpaid salary through the date of termination and certain supplemental retirement benefits under existing plans of the Company. Each of the agreements also provides that the executive is entitled to receive a gross-up payment equal to the amount of any federal excise taxes imposed upon compensation payable upon termination of employment and the additional taxes that result from such payment. In addition, under his employment agreement, Mr. Shaw on each of August 1, 2003 and 2004 was, and on August 1, 2005, Mr. Shaw will be, credited with one additional year of service and be deemed one year older than his actual age for purposes of determining his benefits under the Conectiv Supplemental Executive Retirement Plan.

 

CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

 

Pauline Schneider, a director of the Company, is a partner in the law firm of Hunton & Williams. Hunton & Williams rendered legal services to subsidiaries of the Company in 2004 and is expected to render services to the Company’s subsidiaries in 2005.

 

COMPENSATION/HUMAN RESOURCES COMMITTEE REPORT

ON EXECUTIVE COMPENSATION

 

The Compensation/Human Resources Committee of the Board of Directors is composed entirely of independent directors. The Compensation/Human Resources Committee, together with the other independent members of the Board of Directors, sets the CEO’s compensation level after taking into account the annual evaluation of the CEO’s performance conducted by the Corporate Governance/Nominating Committee and such other factors as the Compensation/Human Resources Committee deems appropriate. The Compensation/Human Resources Committee’s responsibilities include review of the performance of elected officers and other executives in the context of the administration of the Company’s executive compensation programs. The Compensation/Human Resources Committee approves the salaries for the executive officers (other than the CEO) and the heads of the major subsidiaries. The Compensation/Human Resources Committee also approves the salaries of the Vice Presidents of the Company, establishes performance guidelines under the Executive Incentive Compensation Plan, sets awards for the executive officers and the heads of the major subsidiaries

 

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pursuant to the Executive Incentive Compensation Plan, approves payments to the Company Vice Presidents made pursuant to the Executive Incentive Compensation Plan and establishes the structure of compensation and amounts of awards under the shareholder-approved Long-Term Incentive Plan. The Compensation/Human Resources Committee also reviews other elements of compensation and benefits and makes recommendations to the Board as appropriate. In order to carry out these responsibilities the Committee employs its own compensation consultant and receives input from the Chief Executive Officer and management, as it deems appropriate.

 

Officer Compensation Philosophy

 

The Company’s compensation programs are designed to provide a strong and direct link between compensation and executive performance and short- and long-term Company performance. The objective of the Company’s executive compensation policy is to attract and retain key executives with a program that compensates executive officers competitively with other companies in the industry and rewards executives for achieving levels of operational excellence and financial results which increase shareholder value. To be competitive, the Company’s compensation policy is to provide a total compensation opportunity comparable to the median compensation levels of utility companies of a similar size.

 

The compensation program for executives consists of base salary, annual incentive and long-term incentive components. The combination of these three elements is intended to balance short- and long-term business performance goals and align officer financial rewards with Company operating results and shareholder return. Total compensation for any specific year may be above the median in the event performance exceeds goals, or below the median if performance falls short of goals.

 

Annual incentive awards are earned based on the Company’s financial and operational plans and results, including annual earnings. Long-term incentive awards are in the form of restricted shares of Common Stock (“Restricted Stock”) that are earned generally at the end of three-year performance periods to the extent pre-established goals relating to total shareholder returns are met. The Committee discontinued stock option awards as a form of long-term incentive compensation. The executive compensation program is structured so that between 38 and 65 percent of the total compensation opportunity, depending on the seniority and responsibility level of the executive, is in the form of performance incentive compensation.

 

In order to further align the interests of executives with those of the shareholders, the Company adopted stock ownership management requirements for executives. Ownership requirements are expressed as a multiple of salary. Executives are given five years to attain the ownership guidelines. The following table is the multiple of salary required for executives.

 

Chief Executive Officer

   5 times salary

Executive Vice President, Vice Chairman

   3 times salary

Senior Vice President

   2 times salary

Vice President

   1 times salary

 

Under Section 162(m) of the Internal Revenue Code, a public company is prohibited from deducting for federal income tax purposes compensation in excess of $1 million paid to any of the company’s five highest paid executive officers, except if the compensation in excess of $1 million qualifies as “performance-based compensation.” The Company’s Long-Term Incentive Plan has been designed to allow the Compensation/Human Resources Committee to grant options and performance-based Restricted Stock that will qualify as performance-based compensation. However, the Compensation/Human Resources Committee and the Board of Directors retain the discretion under the Long-Term Incentive Plan to design compensation arrangements that do not qualify as “performance-based compensation” within the meaning of Section 162(m) if either determines that such compensation arrangements are in the best interests of the Company. Cash awards under the Company’s Executive Compensation Plan do not qualify as “performance-based compensation” within the meaning of Section 162(m).

 

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Executive Salaries

 

The Compensation/Human Resources Committee determines base salary for executives based on the pay practices of utility companies of comparable size, coupled with performance, with salaries targeted to correspond to approximately the median of the competitive range. Salaries are fixed on an annual basis after considering the performance of the executive and the competitive range for the position. On June 1, 2004, the Committee increased Mr. Wraase’s annual salary from $690,000 to $769,000 per year reflecting his election as Chairman of the Board. The amount of salary increase was determined considering the competitive compensation of utilities of comparable size and the additional responsibilities of his new position. For 2005, the Committee established Mr. Wraase’s salary at $825,000. The Committee, in determining the salary level, considered the CEO’s performance evaluation conducted by the Corporate Governance/Nominating Committee and Mr. Wraase’s salary in relation to compensation levels of utility companies of a similar size. In considering the CEO’s performance, the Committee makes a qualitative assessment. In making its evaluation, it considered the success of the Company in its debt reduction plan, the successful Common Stock offering, the progress in succession planning and management development, the progress in furthering diversity, the Company’s safety record, the progress in emergency response, the integration of the Company’s business units since the 2002 merger with Conectiv, the Company’s performance as a leader in corporate governance including its Sarbanes-Oxley compliance activity and the further implementation of its strategic plan, and the overall progress in improving shareholder return.

 

Executive Incentive Compensation Plan

 

For 2004, performance goals established for annual cash bonus awards to Company executives, including the President and Chief Executive Officer, under the Executive Incentive Compensation Plan were based on: (1) earnings relative to the corporate plan, (2) cost containment and (3) electric system reliability. The Company’s earnings target was exceeded, its cost containment goals were partially met, and customer reliability goals were exceeded. Awards under the plan can range from 0% to 180% of target based on performance. Based on the plan, the overall performance for PHI was 100.1% of target. The CEO was awarded 100.1% of his target award which is reflected in the summary compensation table on page 16.

 

For 2005, the Compensation/Human Resources Committee established (1) earnings relative to the corporate plan, (2) cash available for debt reduction, (3) electric system reliability, (4) diversity and (5) safety as the performance goals for executives of the Company, including the Chief Executive Officer, in order to earn cash bonus awards under the Executive Incentive Compensation Plan. For 2005 a target bonus level of 60% was set for the CEO consistent with the median compensation level of utility companies of comparable size. Awards for other participants may be solely based on corporate performance, or a combination of corporate performance, business unit performance and individual performance.

 

Long-Term Incentive Plan

 

Under the Company’s Long-Term Incentive Plan, the Compensation/Human Resources Committee has instituted a series of Performance Restricted Stock Programs under which executives of the Company have the opportunity to earn Restricted Stock awards based on the extent to which pre-established performance criteria are achieved over generally a three-year performance period. In 2004, the Compensation/Human Resources Committee adopted a performance program with a three-year performance period that ends in 2007, as more fully described above in the text following the “Long-Term Incentive Plan—Awards in Last Fiscal Year” table. The potential awards that can be earned by the CEO were established using competitive compensation levels for CEOs consistent with the goal of maintaining compensation at the median level of utility companies of similar size.

 

In 2001, the Pepco Board of Directors adopted a Performance Restricted Stock Program under Pepco’s Long-Term Incentive Plan under which awards of Restricted Stock would be made based on the Company’s total shareholder return as compared to a peer index (comprised of 20 electric and gas distribution companies) over a performance period beginning in 2002 and ending in 2004. For the three-year performance period, total shareholder return was in the 35th percentile for the 20 companies comprising the Index and as a result no shares of Restricted Stock were earned.

 

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In connection with the merger of Pepco and Conectiv, the Compensation/Human Resources Committee implemented, effective August 1, 2002, a retention and performance plan entitled Merger Integration Success Program, adopted under the Company’s Long-Term Incentive Plan. The Merger Integration Success Program has two components: (1) Restricted Stock grants vesting over three years (20% in 2003, 30% in 2004, and 50% in 2005), provided the executive remains an employee of the Company, and (2) Performance Restricted Stock, which was to vest in two equal installments depending on the extent to which operating efficiencies and expense reduction goals are attained through December 31, 2003 and December 31, 2004, respectively. Although these goals were met in 2003, the Committee determined that the shares would not vest until 2005, and then only if the cost reduction goals were maintained and the Company’s financial performance is satisfactory. For the two- year period ended December 31, 2004, the Company’s cost reduction goals were exceeded and 100% of target awards including reinvested dividends were awarded to participants. Mr. Wraase was awarded 8,871 shares of stock.

 

COMPENSATION/HUMAN RESOURCES COMMITTEE

A. Thomas Young, Chairman

George F. MacCormack

Richard B. McGlynn

Floretta D. McKenzie

Peter F. O’Malley

Frank K. Ross

 

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FIVE-YEAR PERFORMANCE GRAPH 2000-2004

 

The following chart compares the Company’s five year cumulative total return to shareholders consisting of the change in stock price and reinvestment of dividends with the five-year cumulative total return on the Standard & Poor’s 500 Stock Index (the “S&P 500”) and the Dow Jones Utilities Index. Prior to August 1, 2002, the total return is for the common stock of Potomac Electric Power Company. After August 1, 2002, the total return is for the Common Stock.

 

LOGO

 

     Cumulative Total Return

     1999

   2000

   2001

   2002

   2003

   2004

Pepco Holdings, Inc.

   $ 100.00    $ 115.19    $ 110.81    $ 99.83    $ 106.21    $ 121.82

S&P 500 Index

   $ 100.00    $ 90.89    $ 80.14    $ 62.47    $ 80.35    $ 89.07

Dow Jones Utilities

   $ 100.00    $ 150.96    $ 111.51    $ 85.50    $ 110.36    $ 143.54

 

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AUDIT COMMITTEE REPORT

 

Among its duties, the Audit Committee is responsible for recommending to the Board of Directors that the Company’s financial statements be included in the Company’s Annual Report on Form 10-K. The Committee took a number of steps as a basis for making this recommendation for 2004. First, the Audit Committee discussed with PricewaterhouseCoopers LLP, the Company’s independent registered public accounting firm for 2004, those matters that PricewaterhouseCoopers LLP is required to communicate to and discuss with the Audit Committee under Statement on Auditing Standards No. 61, as amended (Communication with Audit Committees), which included information regarding the scope and results of the audit. These communications and discussions are intended to assist the Audit Committee in overseeing the financial reporting and disclosure process. Second, the Audit Committee discussed with PricewaterhouseCoopers LLP the firm’s independence and received from PricewaterhouseCoopers LLP a letter concerning independence as required by Independent Standards Board No. 1 (Independence Discussions with Audit Committees). This discussion and disclosure informed the Audit Committee of PricewaterhouseCoopers LLP’s relationships with the Company and was designed to assist the Audit Committee in considering PricewaterhouseCoopers LLP’s independence. Finally, the Audit Committee reviewed and discussed, with the Company’s management and with PricewaterhouseCoopers LLP, the Company’s audited consolidated balance sheets at December 31, 2004 and 2003, and the Company’s (or its predecessor’s) consolidated statements of earnings, comprehensive earnings, shareholders’ equity and cash flows for the three years ended December 31, 2004, including the notes thereto. Management is responsible for the consolidated financial statements and reporting process, including the system of internal controls and disclosure controls. The independent registered public accounting firm is responsible for expressing an opinion on the conformity of these consolidated financial statements with accounting principles generally accepted in the United States. Based on the discussions with management and PricewaterhouseCoopers LLP concerning the audit, the independence discussions, and the financial statement review and discussions, and such other matters deemed relevant and appropriate by the Audit Committee, the Audit Committee recommended to the Board that these consolidated financial statements be included in the Company’s 2004 Annual Report on Form 10-K.

 

The Audit Committee, in accordance with its charter, conducts an annual evaluation of the performance of its duties. Based on this evaluation, the Committee concluded that it performed effectively in 2004.

 

AUDIT COMMITTEE

 

Lawrence C. Nussdorf, Chairman

Terence C. Golden

Richard B. McGlynn

Frank K. Ross

 

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2.    AMENDMENT TO RESTATED CERTIFICATED OF INCORPORATION

TO DECLASSIFY THE COMPANY’S STAGGERED BOARD

 

The Board of Directors has approved and is submitting to a vote of the shareholders an amendment to the Company’s Restated Certificate of Incorporation to reinstate the annual election of all members of the Company’s Board of Directors.

 

The Company has had a staggered Board in place since it became a public company at the time of the closing of the merger of Pepco and Conectiv in 2002. Prior to the merger, Pepco had a staggered board since 1988 and Conectiv had a staggered board from the time it became a public company in 1998. Under the Company’s staggered board arrangement, the Board of Directors is divided into three classes, with the directors of one of the classes elected annually for three-year terms.

 

Evelyn Y. Davis, a shareholder of the Company, submitted to the Company a shareholder proposal intended to be included in this proxy statement for the 2005 Annual Meeting recommending that the Board of Directors take the necessary steps to reinstate the election of all directors annually. Mrs. Davis submitted the same proposal for inclusion in the proxy statement of the Company, or its predecessor Pepco, in prior years. At the 2004 Annual Meeting, Mrs. Davis’ proposal received the affirmative vote of the holders of 49.81% of the shares present and entitled to vote on the proposal. In view of the decision of the Board of Directors to submit the proposed amendment of the Restated Certificate of Incorporation to a vote of the shareholders at the 2005 Annual Meeting, Mrs. Davis has agreed to withdraw her proposal.

 

The Corporate Governance/Nominating Committee conducted a review of the relative merits of annually elected and staggered boards. The Committee concluded that the Company’s staggered election of directors has contributed to continuity and stability in the composition of, and in the policies formulated by, the Company’s Board of Directors. Notwithstanding these important benefits, the Committee also recognized that there appears to be a growing sentiment among shareholders generally, including the Company’s shareholders, in favor of annual elections and concluded that the Board would be equally effective in protecting shareholder interests if directors are elected annually. Accordingly, the Committee recommended to the Board the staggered election of directors be eliminated. After reviewing and assessing the recommendation of the Committee, the Board has adopted the following resolution, declaring it advisable that section C of Article V of the Company’s Restated Certificate of Incorporation be amended to eliminate classification of the Board of Directors (the “Declassification Amendment”).

 

WHEREAS, the Board of Directors believes that it is advisable and in the best interests of the Company to declassify the Board;

 

NOW, THEREFORE, BE IT RESOLVED, that the Restated Certificate of Incorporation of the Company be amended by:

 

Deleting therefrom the current section C of Article V in its entirety and substituting therefore the following new section C of Article V:

 

“C. Election and Term. Except as otherwise provided by law, each Director shall be elected at the annual meeting of shareholders to serve a one-year term and until his or her successor is elected and qualified; provided, however, that any Director who prior to the annual meeting of shareholders in 2006 was elected to a term that continues beyond the date of the annual meeting of shareholders in 2006, shall continue in office for the remainder of his or her elected term or until his or her earlier death, resignation or removal.”

 

If the Declassification Amendment is approved each nominee for election as a director, including directors standing for reelection, will be elected for a one-year term beginning in 2006. The Declassification Amendment will not shorten the term of any director elected at or prior to the 2005 Annual Meeting. Accordingly, in 2006 only the nominees to succeed the directors whose terms expire in 2006 would be elected for one-year terms. In

 

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2007, the nominees to succeed the directors whose terms expire in 2007 and to succeed the directors elected in 2006 would be elected for one-year terms. Beginning in 2008 all of the members of the Board of Directors would be elected for one-year terms. Under paragraph D of Article V of the Restated Certificate of Incorporation, any vacancy on the Board of Directors resulting other than because of an increase in the authorized number of directors elected by shareholders may be filled by a majority of the directors then in office. In accordance with this provision, if during the transition period a vacancy occurs with respect to a director whose term of office continues beyond the next annual meeting, the term of any director elected to fill such a vacancy shall expire at the next shareholders’ meeting at which directors are elected, and the remainder of such term, if any, shall be filled by a director elected at that meeting.

 

What vote is required to adopt this proposal?

 

In accordance with paragraph G of Article V of the Restated Certificate of Incorporation, adoption of the Declassification Amendment requires the affirmative vote of the holders of two-thirds of the outstanding shares of Common Stock.

 

What other authorizations are required to adopt this proposal?

 

The SEC has authorized the Company to solicit proxies regarding this proposal under the Public Utility Holding Company Act of 1935. Implementation of the Declassification Amendment also requires the SEC’s authorization. The Company has applied for that authorization and expects to receive it. If the shareholders approve this proposal, the Company will file the Declassification Amendment promptly after the SEC’s authorization.

 

How are the votes counted?

 

Because the vote required for the adoption of this proposal is a percentage of the shares of Common Stock outstanding, abstentions and any shares present at the meeting and entitled to vote, but as to which a broker that holds shares in street name expressly withholds its vote due to the absence of discretionary voting authority under the rules of the NYSE (“broker non-votes”), will effectively constitute votes against the proposal.

 

THE BOARD OF DIRECTORS UNANIMOUSLY RECOMMENDS A VOTE FOR THE ADOPTION OF THIS PROPOSAL, WHICH IS SET FORTH AS ITEM 2 ON THE PROXY CARD.

 

3.    RATIFICATION OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

The Audit Committee of the Board of Directors of the Company appointed PricewaterhouseCoopers LLP as independent registered public accounting firm for the Company for the year 2004. The Audit Committee has reappointed the firm for 2005. A representative of PricewaterhouseCoopers LLP is expected to attend the Annual Meeting and will be given the opportunity to make a statement and to respond to appropriate questions.

 

Although the Company is not required to seek shareholder ratification of this appointment, the Board believes it to be sound corporate governance to do so. If the appointment is not ratified, the Audit Committee will take this fact into consideration when selecting the Company’s independent registered public accounting firm for 2006. Even if the selection is ratified, the Audit Committee may in its discretion direct the appointment of a different independent registered public accounting firm at any time during the year if the Committee determines that a change would be in the best interests of the Company and its shareholders. Ratification of the independent registered public accounting firm requires the affirmative vote of a majority of the shares of the Common Stock present and entitled to vote at a meeting of shareholders at which a quorum is present.

 

Audit Fees

 

The aggregate fees billed by PricewaterhouseCoopers LLP for professional services rendered for the audit of the Company’s and subsidiaries’ annual financial statements for the 2004 and 2003 fiscal years and the

 

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reviews of the financial statements included in the Company’s and subsidiary reporting companies’ 2004 and 2003 Forms 10-Q were $6,258,092 and $1,664,350, respectively. The 2004 amount includes fees of $3,971,000 related to attest services in connection with the Sarbanes-Oxley Act of 2002.

 

Audit-Related Fees

 

The aggregate fees billed by PricewaterhouseCoopers LLP for audit-related services rendered for the 2004 and 2003 fiscal years were $586,088 and $289,100, respectively. These services consist of employee benefit plan audits, accounting consultations, internal control reviews, computer systems post-implementation reviews, and attest services for financial reporting not required by statute or regulation.

 

Tax Fees

 

The aggregate fees billed by PricewaterhouseCoopers LLP for tax services rendered for the 2004 and 2003 fiscal years were $261,680 and $55,754, respectively. These services consist of tax compliance, tax advice and tax planning, including advice relating to tax accounting in connection with the 2000, 2001 and 2002 Conectiv tax returns and the 2002 Conectiv Services, Inc. tax return.

 

All Other Fees

 

The aggregate fees billed by PricewaterhouseCoopers LLP for all other services other than those covered under “Audit Fees,” “Audit-Related Fees” and “Tax Fees” for the 2004 and 2003 fiscal years were $55,600 and $38,421, respectively. Of the amount for 2004, $33,300 was for the executive tax services program, $19,300 was for depositions provided in litigation related to the Chalk Point oil spill, $1,500 was for a research service subscription renewal for PHI Service Company, and $1,500 was for a research service subscription renewal for Pepco Energy Services, Inc. Of the amount for 2003, $35,621 was for the executive tax services program, $1,400 was for a research service subscription renewal for PHI Service Company and $1,400 was for a research service subscription renewal for Pepco Energy Services, Inc.

 

All of the services described in “Audit Fees,” “Audit-Related Fees,” “Tax Fees” and “All Other Fees” were approved in advance by the Audit Committee, in accordance with the Audit Committee Policy on the Approval of Services by the Independent Auditor which is attached to this Proxy Statement as Annex B.

 

What vote is required to ratify the selection of the independent registered public accounting firm?

 

Ratification of the appointment of the independent registered public accounting firm requires the affirmative vote of the holders of a majority of the Common Stock present and entitled to vote at a meeting of shareholders at which a quorum is present.

 

How are the votes counted?

 

Shares, if any, which are the subject of an abstention with regard to the vote on this proposal, will be considered present and entitled to vote, and accordingly will have the same effect as a vote against the proposal. Any shares that are the subject of a “broker non-vote” will not be considered present and entitled to vote and, therefore, will not be included in the denominator when determining whether the requisite percentage of shares has been voted in favor of this matter.

 

THE BOARD OF DIRECTORS UNANIMOUSLY RECOMMENDS A VOTE IN FAVOR OF RATIFICATION OF THE INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM, WHICH IS SET FORTH AS ITEM 3 ON THE PROXY CARD.

 

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4.    SHAREHOLDER PROPOSAL

 

The Massachusetts State Carpenters Pension Fund, 350 Fordham Road, Wilmington, MA 01887, which is the record holder of 3,500 shares of the Company’s Common Stock, has notified the Company of its intention to present the following proposal for a shareholder vote at the meeting:

 

Director Election Majority Vote Standard Proposal

 

RESOLVED: That the shareholders of Pepco Holdings, Inc. (“Company”) hereby request that the Board of Directors initiate the appropriate process to amend the Company’s governance documents (certificate of incorporation or bylaws) to provide that director nominees shall be elected by the affirmative vote of the majority of votes cast at an annual meeting of shareholders.

 

SUPPORTING STATEMENT: Our Company is incorporated in Delaware. Among other issues, Delaware corporate law addresses the issue of the level of voting support necessary for a specific action, such as the election of corporate directors. Delaware law provides that a company’s certificate of incorporation or bylaws may specify the number of votes that shall be necessary for the transaction of any business, including the election of directors. (DGCL, Title 8, Chapter 1, Subchapter VII, Section 216). Further, the law provides that if the level of voting support necessary for a specific action is not specified in the certificate of incorporation or bylaws of the corporation, directors “shall be elected by a plurality of the votes of the shares present in person or represented by proxy at the meeting and entitled to vote on the election of directors.”

 

Our Company presently uses the plurality vote standard for the election of directors. We feel that it is appropriate and timely for the Board to initiate a change in the Company’s director election vote standard. Specifically, this shareholder proposal urges that the Board of Directors initiate a change to the director election vote standard to provide that in director elections a majority vote standard will be used in lieu of the Company’s current plurality vote standard. Specifically, the new standard should provide that nominees for the board of directors must receive a majority of the vote cast in order to be elected or re-elected to the Board.

 

Under the Company’s current plurality vote standard, a director nominee in a director election can be elected or re-elected with as little as a single affirmative vote, even while a substantial majority of the votes are “withheld” from that director nominee. So even if 99.99% of the shares “withhold” authority to vote for a candidate or all of the candidates, a 0.01% “for” vote results in the candidate’s election or re-election to the Board. The proposed majority vote standard would require that a director receive a majority of the vote cast in order to be elected to the Board.

 

It is our contention that the proposed majority vote standard for corporate board elections is a fair standard that will strengthen the Company’s governance and the Board. Our proposal is not intended to limit the judgment of the Board in crafting the requested governance change. For instance, the Board should address the status of incumbent directors who fail to receive a majority vote when standing for re-election under a majority vote standard or whether a plurality director election standard is appropriate in contested elections.

 

We urge your support of this important director election reform.

 

END OF SUPPORTING STATEMENT

 

The Board of Directors believes that this proposal is not in the best interests of the Company and its shareholders. The Company’s bylaws specify that “[e]xcept as otherwise required by applicable law or the certificate of incorporation, (i) Directors shall be elected by a plurality of the votes cast at a meeting of stockholders.” Neither the Company’s restated certificate of incorporation nor Delaware law specifies a different vote for election of directors. Thus, the nominees for director receiving the highest number of “for” votes at the annual meeting are elected as directors to fill the open positions on the Board. It should be noted that United States congressional elections and presidential elections at the state level to determine which candidate receives a state’s electoral votes are also determined by a plurality vote.

 

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The theoretical concern that the proposal is designed to address is that in an uncontested voting scenario, a plurality vote does not attribute any significance to a vote against a nominated director.

 

However, the Board believes the plurality standard is fair and impartial as it applies equally to any candidate who is nominated either by the Board of Directors or a shareholder for election to the Board of Directors and serves the best interests of the shareholders. Thus, if the majority vote standard were implemented, a shareholder nominee might fail to win election to the Board even if that nominee received more votes than an incumbent director nominee, simply because the shareholder nominee did not receive a majority of the votes cast.

 

In addition, the proposal, if implemented, presents the possibility that no incumbent director nominee will be elected if none receives a majority vote. The Company’s restated certificate of incorporation provides that directors shall hold office until their successors have been elected and qualified. An incumbent director who did not receive a majority of the votes cast would, therefore, remain a director until his or her successor was elected and qualified, absent resignation or removal from the Board. In the case of resignation or removal, the Board has the right to fill a vacancy on the Board. In either event, the shareholders’ ability to vote for directors is stymied. The shareholder proposal leaves it to the Board to suggest what would happen in either of these situations.

 

Furthermore, the evidence shows that the proponent’s concern about a director being elected without the affirmative vote of at least a majority of the shareholders is entirely theoretical. Each director nominee over the past two years at PHI and eight years before that at Pepco has received the affirmative vote of more than 95% of the shares entitled to vote.

 

Finally, the proposal, if implemented, may have the unintended consequence of unnecessarily increasing the cost of soliciting shareholder votes in the future. In order to obtain the required vote, the Company may need to employ a proactive telephone solicitation, a second proxy mailing, or other vote-obtaining strategy which would increase spending for routine annual meetings.

 

What vote is required to adopt the shareholder proposal?

 

Adoption of the shareholder proposal requires the affirmative vote of the holders of a majority of the shares of the Common Stock present and entitled to vote at a meeting of shareholders at which a quorum is present.

 

How are the votes counted?

 

Shares, if any, which are the subject of an abstention with regard to the vote on this proposal, will be considered present and entitled to vote, and accordingly will have the same effect as a vote against the proposal. Any shares that are the subject of a “broker non-vote” will not be considered present and entitled to vote and, therefore, will not be included in the denominator when determining whether the requisite percentage of shares has been voted in favor of the matter.

 

THE BOARD OF DIRECTORS UNANIMOUSLY RECOMMENDS A VOTE AGAINST THE ADOPTION OF THIS PROPOSAL, WHICH IS SET FORTH AS ITEM 4 ON THE PROXY CARD.

 

SHAREHOLDER PROPOSALS AND DIRECTOR NOMINATIONS

 

What is the deadline for submission of shareholder proposals for inclusion in the Company’s Proxy Statement for the 2006 Annual Meeting?

 

In order to be considered for inclusion in the Proxy Statement for the 2006 Annual Meeting, shareholder proposals must be received by the Company on or before November 30, 2005.

 

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May a shareholder introduce a resolution for a vote at a future annual meeting?

 

Under the Company’s Bylaws, a shareholder may introduce a resolution for consideration at a future Annual Meeting if the shareholder complies with the advance notice provisions set forth in the Bylaws. These provisions require that for a shareholder to properly bring business before an Annual Meeting, the shareholder must give written notice to the Company’s Secretary at 701 Ninth Street, N.W., Washington, D.C. 20068, not less than 100 days nor more than 120 days prior to the date of the meeting (or if the date of the meeting is more than 30 days before or after the anniversary date of the Annual Meeting in the prior year, then the written notice must be received no later than the close of business on the tenth day following the earlier of the date on which notice or public announcement of the date of the meeting was given or made by the Company). The shareholder’s notice must set forth a description of the business desired to be brought before the meeting and the reasons for conducting the business at the annual meeting, the name and record address of the shareholder, the class and number of shares owned beneficially and of record by the shareholder, and any material interest of the shareholder in the proposed business. The Company will publicly announce the date of its 2006 Annual Meeting at a later date.

 

May a shareholder nominate or recommend an individual for election as a director of the Company?

 

Under the Company’s Bylaws, a shareholder may nominate an individual for election as a director at a future Annual Meeting by giving written notice of the shareholder’s intention to the Company’s Secretary at 701 Ninth Street, N.W., Washington, D.C. 20068, not less than 100 days nor more than 120 days prior to the date of the meeting (or if the date of the meeting is more than 30 days before or after the anniversary date of the Annual Meeting in the prior year, then the written notice must be received no later than the close of business on the tenth day following the earlier of the date on which notice or public announcement of the date of the meeting was given or made by the Company). The notice provided to the Secretary must set forth the name and record address of the nominating shareholder and the class and number of shares of capital stock of the Company beneficially owned by such shareholder; and, for each nominee, the nominee’s name, age, business address, residence address, principal occupation or employment, the class and number of shares of the Company’s capital stock beneficially owned by the nominee, and any other information concerning the nominee that would be required to be included in a proxy statement. The Company will publicly announce the date of its 2006 Annual Meeting at a later date.

 

A shareholder also may recommend for the consideration of the Corporate Governance/Nominating Committee one or more candidates to serve as a nominee of the Company for election as a director. Any such recommendations for the 2006 Annual Meeting must be submitted in writing to the Secretary of the Company on or before November 30, 2005, accompanied by the information described in the preceding paragraph.

 

What principles has the Board adopted with respect to Board membership? What are the specific qualities or skills that the Corporate Governance/Nominating Committee has determined are necessary for one or more of the directors to possess?

 

The Board has approved the following principles with respect to Board membership. The Board should include an appropriate blend of independent and management directors, which should result in independent directors being predominant, and in the views of the Company’s management being effectively represented. Accordingly, the number of independent directors should never be less than seven and the management directors should always include the Chief Executive Officer, there should never be more than three management directors, and any management directors other than the Chief Executive Office should be selected from the Company’s Executive Leadership Team.

 

For independent directors, the Corporate Governance/Nominating Committee seeks the appropriate balance of experience, skills and personal characteristics required of a director. In order to be considered for nomination to the Board, a director candidate should possess most or all of the following attributes: independence, as defined

 

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by the New York Stock Exchange listing standards as currently in effect; integrity; judgment; credibility; collegiality; professional achievement; constructiveness; and public awareness. The independent directors should possess, in aggregate, skill sets that include but are not limited to: financial acumen equivalent to the level of a Chief Financial Officer or senior executive of a capital market, investment or financial services firm; operational or strategic acumen germane to the energy industry, or other industry with similar characteristics (construction, manufacturing, etc.); public and/or government affairs acumen germane to complex enterprises, especially in regulated industries; customer service acumen germane to a service organization with a large customer base; legal acumen in the field(s) of regulatory or commercial law at the partner or chief legal officer level; salient community ties in areas of operation of Pepco Holdings’ enterprises; and corporate governance acumen, gained through service as a senior officer or director of a large publicly held corporation or through comparable academic or other experience. Independent directors are also selected to ensure diversity, in the aggregate, which diversity should include expertise or experience germane to the Company’s total business needs, in addition to other generally understood aspects of diversity.

 

What is the process for identifying and evaluating nominees for director (including nominees recommended by security holders)?

 

The Corporate Governance/Nominating Committee has developed the following identification and evaluation process which is contained in the Company’s Corporate Governance Guidelines and can be found on the Company’s Web site (www.pepcoholdings.com) under the link: Corporate Governance:

 

a.    List of Potential Candidates.    The Corporate Governance/Nominating Committee develops and maintains a list of potential candidates for Board membership. Potential candidates are recommended by Committee members and other Board members. Shareholders may put forward potential candidates for the Committee’s consideration by following submission requirements published in the Company’s proxy statement for the previous year’s meeting.

 

b.    Candidate Attributes, Skill Sets and Other Criteria.    The Committee annually reviews the attributes, skill sets and other qualifications for potential candidates and may modify them from time to time based upon the Committee’s assessment of the needs of the Board and the skill sets required to meet those needs.

 

c.    Review of Candidates.    All potential candidates are reviewed by the Committee against the current attributes, skill sets and other qualifications established by the Board to determine if a candidate is suitable for Board membership. If a candidate is deemed suitable based on this review, a more detailed review will be performed through examination of publicly available information. This examination will include consideration of the independence requirement for outside directors, the number of boards on which the candidate serves, the possible applicability of restrictions on director interlocks or other requirements or prohibitions imposed by applicable laws or regulations, proxy disclosure requirements, and any actual or potentially perceived conflicts of interest or other issues raised by applicable laws or regulations or the Company’s policies or practices.

 

d.    Prioritization of Candidates.    The Committee then (i) determines whether any candidate needs to be removed from consideration as a result of the detailed review, and (ii) determines a recommended priority among the remaining candidates for recommendation to and final determination by the Board prior to direct discussion with any candidate.

 

e.    Candidate Contact.    Following the Board’s determination of a priority-ranked list of approved potential candidates, the Chairman of the Committee or, at his or her discretion, other member(s) of the Board will contact and interview the potential candidates in priority order. When a potential candidate indicates his or her willingness to accept nomination to the Board, no further candidates will be contacted. Subject to a final review of eligibility under the Company’s policies and applicable laws and regulations using information supplied directly by the candidate, the candidate will then be nominated.

 

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5.    OTHER MATTERS WHICH MAY COME BEFORE THE MEETING

 

Does the Board of Directors know of any additional matters to be acted upon at the Annual Meeting?

 

The Board of Directors does not know of any other matter to be brought before the meeting.

 

If another matter does come before the meeting, how will my proxy be voted?

 

If any other matter should properly come before the meeting, your signed proxy card, as well as your Internet or telephone proxy, gives the designated proxy holders discretionary authority to vote on such matters in accordance with their best judgment.

 


 

How are proxies being solicited and who pays for the costs involved?

 

The Company will bear the costs of solicitation of proxies, including the reimbursement of banks and brokers for certain costs incurred in forwarding proxy materials to beneficial owners. In addition to the use of the mails, officers, directors and regular employees of the Company may solicit proxies personally, by telephone or facsimile or via the Internet. These individuals will not receive any additional compensation for these activities.

 

Why was only a single Proxy Statement mailed to households that have multiple holders of Common Stock?

 

Under the rules of the SEC, a company is permitted to deliver a single proxy statement and annual report to any household at which two or more shareholders reside, if the shareholders at the address of the household have the same last name or the company reasonably believes that the shareholders are members of the same family. Accordingly, the Company is sending only one copy of this Proxy Statement to shareholders that shared the same last name and address, unless the Company has received instructions to the contrary from one or more of the shareholders.

 

Under these SEC rules, brokers and banks that hold stock for the account of their customers also are permitted to deliver single copies of proxy statements and annual reports to two or more shareholders that share the same address. If you and other residents at your mailing address own shares of Common Stock through a broker or bank, you may have received a notice notifying you that your household will be sent only one copy of proxy statements and annual reports. If you did not notify your broker or bank of your objection, you may have been deemed to have consented to the arrangement.

 

If, in accordance with these rules, your household received only a single copy of this Proxy Statement and Annual Report and you would like to receive a separate copy or you would like to receive separate copies of the Company’s proxy statements and annual reports in the future, please contact Wachovia Bank, N.A., the Company’s transfer agent:

 

By Telephone:

  

1-866-254-6502 (toll-free)

In Writing:

  

Wachovia Bank, N.A.

Shareholder Services Group

1525 West W.T. Harris Blvd. 3C3

Charlotte, NC 28262-8522

 

If you own your shares through a brokerage firm or a bank, your notification should include the name of your brokerage firm or bank and your account number.

 

If you are a record holder of shares of Common Stock who is receiving multiple copies of the Company’s shareholder communications at your address and you would like to receive only one copy for your household, please contact Wachovia Bank, N.A. at the telephone number or address set forth above. If you own your shares through a brokerage firm or a bank, please contact your broker or bank.

 

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Where do I find the Company’s Corporate Business Policies, Corporate Governance Guidelines and Committee Charters?

 

PHI has in place Corporate Business Policies, which in their totality constitute its code of business conduct and ethics. These Policies apply to all directors, employees and others working at PHI and its subsidiaries. PHI’s Board of Directors has also adopted Corporate Governance Guidelines and charters for PHI’s Audit Committee, Compensation/Human Resources Committee and Corporate Governance/Nominating Committee which conform to the requirements set forth in the New York Stock Exchange listing standards. The Board of Directors has also adopted charters for PHI’s Executive Committee and Finance Committee. Copies of these documents are available on the PHI Web site at http://www.pepcoholdings.com/governance/index.html and also can be obtained by writing to: Ellen Sheriff Rogers, Vice President, Secretary and Assistant Treasurer, 701 Ninth Street, N.W., Suite 1300, Washington, D.C. 20068.

 

Any amendment to, or waiver of, any provision of the Corporate Business Policies with respect to any director or executive officer of PHI will be promptly reported to shareholders through the filing of a Form 8-K with the SEC.

 


 

The Letter to Shareholders which begins on the cover page of this document and the Annual Report to Shareholders, including the Business of the Company, Management’s Discussion and Analysis and the Consolidated Financial Statements, and other shareholder information included in Annex C to this Proxy Statement are not deemed to be “soliciting material” or to be “filed” with the SEC under or pursuant to the Securities Act of 1933 or the Securities Exchange Act of 1934 and shall not be incorporated by reference or deemed to be incorporated by reference into any filing by the Company under either such Act, unless otherwise specifically provided for in such filing.

 

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ANNEX A

 

PEPCO HOLDINGS, INC.

AUDIT COMMITTEE CHARTER

 

Committee Purpose

 

The Audit Committee’s (the “Committee”) purpose shall be to (A) represent and assist the Board in oversight of (1) the integrity of Pepco Holdings, Inc.’s (the “Company”) financial statements, accounting and financial reporting processes and audits of the Company’s financial statements, (2) the Company’s compliance with legal and regulatory requirements, (3) the independent auditor’s qualifications and independence, and (4) the performance of the Company’s internal audit function and independent auditor, and (B) appoint, compensate and oversee the work of any independent auditor employed by PHI for the purpose of preparing or issuing an audit report or related work, and (C) prepare an Audit Committee report as the Securities and Exchange Commission rules require be included in the Company’s annual proxy statement. The Audit Committee represents and assists the Board in discharging its responsibility of oversight, but the existence of the Committee does not alter the traditional roles and responsibilities of the Company’s management and the independent auditor with respect to the accounting and control functions and financial statement presentation.

 

Committee Composition and Operation

 

The Committee shall consist of no fewer than three, nor more than seven, directors, none of whom are employees of the Company or any of its affiliates and all of whom are independent as required under the rules promulgated from time to time by the New York Stock Exchange and the Securities and Exchange Commission. No Committee member may serve on the audit committees of more than three public companies.

 

Each member of the Committee must be financially literate, as such qualification is interpreted by the Board in its business judgment, or must become financially literate within a reasonable period of time after his or her appointment to the Committee. In addition, at least one member of the Committee must have accounting or related financial management expertise, as the Board interprets such qualification in its business judgment.

 

The Board shall have the authority to remove at any time one or more of the members of the Committee, to fill any vacancy that may exist on the Committee or to fill any newly created Committee membership caused by the increase in the size of the Committee.

 

The Committee shall meet at least four times annually, or more frequently as circumstances require. Each meeting shall include a time of executive session.

 

The Committee may create one or more sub-Committees to which it may delegate some or all of its authority.

 

The Committee may make such rules of procedure as it deems necessary or appropriate for its efficient functioning.

 

Committee Duties and Responsibilities

 

1. The Committee shall have sole authority to (A) retain and terminate the Company’s independent auditor; (B) pre-approve all audit engagement fees and terms, including the scope and timing of the audit, in conformance with the approval requirements as promulgated from time to time by the New York Stock Exchange and the Securities and Exchange Commission; and (C) pre-approve any significant audit-related relationship with the independent auditor. The Committee shall have sole authority to evaluate and determine whether consulting services to be obtained by the Company are “audit-related” or “non-audit related” for purposes of applying the Company’s policies and the applicable rules as promulgated from time to time by the New York Stock Exchange and the Securities and Exchange Commission with regard to such services.

 

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2. The Committee shall be directly responsible for the appointment, compensation, retention and oversight of the work of any independent auditor employed by the Company for the purpose of preparing or issuing an audit report or related work (including resolution of disagreements between management and the auditor regarding financial reporting), and each such independent auditor shall report directly to the Committee.

 

3. The Committee shall, at least annually, obtain and review a report by the independent auditor describing: the firm’s internal quality-control procedures; any material issues raised by the most recent internal quality-control review, or peer review, of the firm, or by any inquiry or investigation by governmental or professional authorities, within the preceding five years, respecting one or more independent audits carried out by the firm, and any steps taken to deal with any such issues; and (to assess the auditor’s independence) all relationships between the auditor and the Company.

 

After reviewing the foregoing report, and the independent auditor’s work throughout the year, the Audit Committee will evaluate the auditor’s qualifications, performance and independence. This evaluation will include the review and evaluation of the lead partner of the independent auditor. In making its evaluation, the Audit Committee will take into account the opinions of management and the Company’s internal auditors. In addition to assuring the regular rotation of the lead audit partner as required by law, the Audit Committee will further consider whether, in order to assure continuing auditor independence, there should be regular rotation of the audit firm itself. The Audit Committee will present its conclusions with respect to the independent auditor to the full Board.

 

4. The Committee shall review the organization and schedule of annual audits conducted by the Company’s internal auditing staff and review with management and the internal auditors significant recommendations made by the internal auditors and the implementation of those recommendations.

 

5. The Committee shall review periodically with the independent auditor and management the Company’s policies and procedures with respect to internal auditing, accounting and financial controls, as well as any internal control report required to be included in the Company’s Annual Report on Form 10-K. This review shall also include a review, upon completion of the annual audit, of the reports or opinions proposed to be rendered in connection with the annual audit; the independent auditor’s views of the Company’s financial and accounting personnel; the cooperation which the independent auditor received in the course of its review; and any significant findings of the independent auditor with respect to change in accounting principles and practices, significant transactions outside the normal course of the Company’s business and any recommendations which the independent auditor may have with respect to improving internal accounting controls, choice of accounting principles or management systems.

 

6. The Committee shall meet to review and discuss the Company’s annual audited financial statements and quarterly financial statements with management and the independent auditor, including reviewing the Company’s specific disclosures in its Annual and Quarterly reports under “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

7. The Committee shall prepare an Audit Committee report as the Securities and Exchange Commission rules require be included in the Company’s annual proxy statement.

 

8. The Committee shall review with the independent auditor and with management the Company’s conflict of interest policies.

 

9. The Committee shall report regularly to the Board, and review with the full Board any issues that arise with respect to the quality or integrity of the Company’s financial statements, the Company’s compliance with legal or regulatory requirements, the performance and independence of the Company’s independent auditor, or the performance of the internal audit function. The Committee shall also make such recommendations to the Board as the Committee deems appropriate.

 

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10. The Committee shall meet separately, periodically, with management, with internal auditors and with the independent auditor.

 

11. The Committee shall discuss and review with management the Company’s guidelines and policies with respect to risk assessment and risk management, including the Company’s major financial risk exposures, the steps management has taken to monitor and control such exposures, and whether management has provided appropriate disclosure in the Company’s financial statements. However, the Committee’s duties and responsibilities in this regard do not alter the obligation of the CEO and senior management to assess and manage the Company’s exposure to risk.

 

12. The Committee shall review with the independent auditor (A) any audit problems or difficulties (including any restrictions on the scope of the independent auditor’s activities or on access to requested information, and any significant disagreements with management) and (B) management’s response. Among the items the Committee may want to review with the auditor are: any accounting adjustments that were noted or proposed by the auditor but were “passed” (as immaterial or otherwise); any communications between the audit team and the audit firm’s national office respecting auditing or accounting issues presented by the engagement; and any “management” or “internal control” letter issued, or proposed to be issued, by the audit firm to the Company. The review will also include discussion of the responsibilities, budget and staffing of the Company’s internal audit function.

 

13. The Committee shall set clear hiring policies for employees or former employees of the independent auditor.

 

14. The Committee shall, as it deems necessary to carry out its duties, obtain advice and assistance from independent legal, accounting or other advisors. The Committee shall have full power and authority to retain such advisors as and when the Committee deems it necessary to do so, and to authorize the payment of compensation to any such advisers, without first seeking Board approval.

 

15. The Committee shall conduct an annual evaluation of its performance of its duties and the continuing adequacy of its charter.

 

16. While the fundamental responsibility for the Company’s financial statements and disclosure rests with management and the independent auditor, the Committee shall review: (A) major issues regarding accounting principles and financial statement presentations, including any significant changes in the Company’s selection or application of accounting principles, and major issues as to the adequacy of the Company’s internal controls and any special audit steps adopted in light of material control deficiencies; (B) analyses prepared by management and/or the independent auditor setting forth significant financial reporting issues and judgments made in connection with the preparation of the financial statements, including analyses of the effects of alternative GAAP methods on the financial statements; (C) the effect of regulatory and accounting initiatives, as well as off-balance sheet structures, on the financial statements of the Company; and (D) the type and presentation of information to be included in earnings press releases (paying particular attention to any use of “pro-forma,” or “adjusted” non-GAAP, information), as well as financial information and earnings guidance provided to analysts and rating agencies.

 

17. The Committee shall establish procedures for (A) the receipt, retention and treatment of complaints received by the Company regarding accounting, internal accounting controls, or auditing matters; and (B) the confidential, anonymous submission by employees of the Company of concerns regarding questionable accounting or auditing matters.

 

18. The Committee shall discuss the types of information to be disclosed and the type of presentation to be made in earnings press releases, as well as financial information and earnings guidance provided to analysts and rating agencies. The Committee need not, however, discuss in advance each earnings release. The Committee shall discuss at least Annual and Quarterly releases before they are published.

 

19. The Committee shall have sole authority to authorize payment of ordinary administrative expenses of the Committee that are necessary or appropriate in carrying out its duties, without seeking Board approval.

 

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ANNEX B

 

PEPCO HOLDINGS, INC.

AUDIT COMMITTEE

 


 

Policy on the Approval of Services

Provided By the Independent Auditor

 

I. Overview

 

Under the federal securities laws and the rules of the Securities and Exchange Commission (the “SEC”), the annual consolidated financial statements of Pepco Holdings, Inc. (the “Company”) and each of its subsidiaries that has a reporting obligation (a “Reporting Company”) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), must be audited by an “independent” public accountant. Likewise, the quarterly financial statements of the Company and each Reporting Company must be reviewed by an “independent” public accountant.

 

Under SEC regulations, a public accountant is not “independent” if it provides certain specified non-audit services to an audit client. In addition, a public accountant will not qualify as “independent” unless (i) before the accountant is engaged to provide audit or non-audit services, the engagement is approved by the public company’s audit committee or (ii) the engagement to provide audit or non-audit services is pursuant to pre-approved policies and procedures established by the audit committee.

 

Under the Audit Committee Charter, the Audit Committee of the Company has sole authority (i) to retain and terminate the Company’s independent auditors, (ii) to pre-approve all audit engagement fees and terms and (iii) to pre-approve all significant audit-related relationships with the independent auditor. This Policy sets forth the policies and procedures adopted by the Audit Committee with respect to the engagement of the Company’s independent auditor to provide audit and non-audit services to the Company and its subsidiaries (as defined by Rule 1-02 (x) of SEC Regulation S-X).

 

The Audit Committee also serves as the audit committee for each subsidiary of the Company that is a Reporting Company for the purpose of approving audit and non-audit services to be provided by the independent auditor(s) of such Reporting Companies. In this capacity, the Audit Committee has determined that this Policy also shall govern the engagement of the independent auditor for each such Reporting Company.

 

II. Statement of Principles

 

The Audit Committee recognizes the importance of maintaining the independence of its external auditor both in fact and appearance. In order to ensure that the independence of the Company’s external auditor is not, in the judgment of the Audit Committee, impaired by any other services that the external auditor may provide to the Company and its subsidiaries:

 

    The Audit Committee shall approve in advance all services—both audit and permitted non-audit services—provided to the Company or any of its subsidiaries by the Company’s independent auditor in accordance with the procedures set forth in this Policy.

 

    The Audit Committee shall not engage the Company’s independent auditor to provide to the Company or any of its subsidiaries any non-audit services that are unlawful under Section 10A of the Exchange Act or that would impair the independence of the Company’s independent auditor under the standards set forth in Rule 2-01 of SEC Regulation S-X (“Prohibited Non-Audit Services”).

 

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III. Approval of Annual Audit Services

 

The annual audit services provided to the Company and its subsidiaries by the Company’s independent auditor shall consist of:

 

    The audit of the annual consolidated financial statements of the Company and each other Reporting Company and the other procedures required to be performed by the independent auditor to be able to form an opinion on the financial statements.

 

    Review of the quarterly consolidated financial statements of the Company and each Reporting Company.

 

    The attestation engagement for the independent auditor’s report on management’s statement on the effectiveness of the Company’s internal control over financial reports.

 

    Services associated with SEC registration statements, periodic reports and other documents filed with the SEC or issued in connection with securities offerings, including consents and comfort letters provided to underwriters, reviews of registration statements and prospectuses, and assistance in responding to SEC comment letters.

 

All such audit services must be approved annually by the Audit Committee following a review by the Audit Committee of the proposed terms and scope of the engagement and the projected fees. Any subsequent change of a material nature in the terms, scope or fees associated with such annual audit services shall be approved in advance by the Audit Committee.

 

Any additional audit services may be pre-approved annually at the meeting at which the annual audit services are approved. If not pre-approved, each additional annual audit service must be approved by the Audit Committee in advance on a case-by-case basis.

 

IV. Approval of Audit-Related Services

 

Audit-related services consist of assurance and related services that are reasonably related to the performance of the audit or review of the financial statements of the Company and each Reporting Company, other than the annual audit services described in Section III above. Audit-related services may include, but are not limited to:

 

    Employee benefit plan audits.

 

    Due diligence related to mergers and acquisitions.

 

    Accounting consultations and audits in connection with acquisitions.

 

    Internal control reviews.

 

    Attest services related to financial reporting that are not required by statute or regulation.

 

Audit-related services may be pre-approved annually at the meeting at which the annual audit services are approved. If not pre-approved, each audit-related service must be approved by the Audit Committee in advance on a case-by-case basis.

 

V. Approval of Tax Services

 

Tax services consist of professional services rendered by the independent auditor to the Company or any of its subsidiaries for tax compliance, tax advice and tax planning. Tax services may be pre-approved annually at the meeting of the Audit Committee at which the annual audit services are approved. If not pre-approved, each tax service must be approved by the Audit Committee in advance on a case-by-case basis.

 

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VI. Approval of All Other Services

 

Any other services to be provided by the Company’s independent auditor, other than Prohibited Non-Audit Services, may be pre-approved annually at the meeting of the Audit Committee at which the annual audit services are approved. If not pre-approved, each such other service must be approved by the Audit Committee in advance on a case-by-case basis.

 

VII.    Procedures

 

At the meeting of the Audit Committee to select the independent auditor for the Company and each of the Reporting Companies, the Chief Financial Officer shall submit to the Audit Committee a list of the additional audit services, audit-related services, tax services and other services, if any, that the Company and the Related Companies wish to have pre-approved for the ensuing year. The list shall be accompanied by:

 

    a written description (which may consist of or include a description furnished to the Company by the independent auditor) of the services to be provided in detail sufficient to enable the Audit Committee to make an informed decision with regard to each proposed service, and, to the extent determinable, an estimate provided by the independent auditor of the fees for each of the services; and

 

    confirmation of the independent auditor that (i) it would not be unlawful under Section 10A of the Exchange Act for the independent auditor to provide the listed non-audit services to the Company or any of its subsidiaries and (B) none of the services, if provided by the independent auditor to the Company or any of its subsidiaries, would impair the independence of the auditor under the standards set forth in Rule 2-01 of SEC Regulation S-X.

 

If, a type of non-audit service is pre-approved by the Audit Committee, and the Company or any of its subsidiaries subsequently engages the independent auditor to provide that service, the Company’s Chief Financial Officer shall report the engagement to the Audit Committee at its next regularly scheduled meeting.

 

VIII.    Delegation

 

The Audit Committee hereby delegates to the Chairman of the Audit Committee the authority to approve, upon the receipt of the documentation referred to in Section VII above, on a case-by-case basis any non-audit service of the types referred to in Sections IV, V and VI above (i.e. an audit-related, tax or other service) at any time other than at a meeting of the Audit Committee. The Chairman shall report any services so approved to the Audit Committee at its next regularly scheduled meeting. In no circumstances shall the responsibilities of the Audit Committee under this Policy be delegated to the management of the Company or any of its subsidiaries.

 

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ANNEX C

 

LOGO

 

     PAGE

TABLE OF CONTENTS

    

Glossary of Terms

   C-2

Consolidated Financial Highlights

   C-6

Business of the Company

   C-7

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

   C-16

Management’s Report on Internal Control Over Financial Reporting

   C-69

Report of Independent Registered Public Accounting Firm

   C-69

Consolidated Statements of Earnings

   C-71

Consolidated Statements of Comprehensive Earnings

   C-72

Consolidated Balance Sheets

   C-73

Consolidated Statements of Cash Flows

   C-75

Consolidated Statements of Shareholders’ Equity

   C-76

Notes to Consolidated Financial Statements

   C-77

Quarterly Financial Information (unaudited)

   C-140

Board of Directors and Officers

   C-142

Investor Information

   C-143

 

Forward-Looking Statements:    Except for historical statements and discussions, the statements in this annual report constitute “forward-looking statements” within the meaning of federal securities law. These statements contain management’s beliefs based on information currently available to management and on various assumptions concerning future events. Forward-looking statements are not a guarantee of future performance or events. They are subject to a number of uncertainties and other factors, many of which are outside the company’s control. Factors that could cause actual results to differ materially from those in the forward-looking statements herein include general economic, business and financing conditions; availability and cost of capital; changes in laws, regulations or regulatory policies; weather conditions; competition; governmental actions; and other presently unknown or unforeseen factors. These uncertainties and factors could cause actual results to differ materially from such statements. Pepco Holdings disclaims any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. This information is presented solely to provide additional information to understand further the results and prospects of Pepco Holdings.

 

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GLOSSARY OF TERMS

 

Term


  

Definition


ABO

  

Accumulated benefit obligation

Accounting hedges

  

Derivatives designated as cash flow and fair value hedges

ACE

  

Atlantic City Electric Company

ACE Funding

  

Atlantic City Electric Transition Funding LLC

Act

  

Prescription Drug, Improvement and Modernization Act of 2003

ADITC

  

Accumulated deferred investment tax credits

AFUDC

  

Allowance for Funds Used During Construction

Agreement and Plan of Merger

  

Agreement and Plan of Merger, dated as of February 9, 2001, among PHI, Pepco and Conectiv

Ancillary services

  

Generally, electricity generation reserves and reliability services

APB

  

Accounting Principles Board Opinion

APBO

  

Accumulated Post-retirement Benefit Obligation

APCA

  

Air Pollution Control Act

Asset Purchase and Sale Agreement

  

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

Bankruptcy Court

  

Bankruptcy Court for the Northern District of Texas

BGS

  

Basic generation service in New Jersey (the supply of energy to customers who have not chosen a competitive supplier)

BPU Financing Orders

  

Bondable stranded costs rate orders issued by the NJBPU

CAA

  

Federal Clean Air Act

CBI

  

Conectiv Bethlehem, LLC

CERCLA

  

Comprehensive Environmental Response, Compensation, and Liability Act of 1980

CESI

  

Conectiv Energy Supply, Inc.

Circuit Court

  

U.S. Court of Appeals for the Fifth Circuit

CO2

  

Carbon Dioxide

Competitive Energy Business

  

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

Conectiv

  

A wholly owned subsidiary of PHI which is a PUHCA holding company and the parent of DPL and ACE

Conectiv Energy

  

Conectiv Energy Holding Company and its subsidiaries

Conectiv Power Delivery

  

The tradename under which DPL and ACE conduct their power delivery operations

COPCO

  

Conowingo Power Company

Creditors Committee

  

The Official Committee of Unsecured Creditors of Mirant Corporation

CRMC

  

PHI’s Corporate Risk Management Committee

CTs

  

Combustion turbines

CWA

  

Federal Clean Water Act

DCPSC

  

District of Columbia Public Service Commission

Debentures

  

Junior Subordinated Debentures

Delivery revenue

  

Revenue Pepco receives for delivering energy to its customers

District Court

  

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

DNREC

  

Delaware Department of Natural Resources and Environmental Control

DPL

  

Delmarva Power & Light Company

DPSC

  

Delaware Public Service Commission

DRP

  

PHI’s Shareholder Dividend Reinvestment Plan

DSR

  

Default Supply Revenue

EDECA

  

New Jersey Electric Discount and Energy Competition Act

 

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Term


  

Definition


EDIT

  

Excess Deferred Income Taxes

EITF

  

Emerging Issues Task Force

EPA

  

U.S. Environmental Protection Agency

ERISA

  

Employment Retirement Income Security Act of 1974

Exchange Act

  

Securities Exchange Act of 1934, as amended

FASB

  

Financial Accounting Standards Board

FERC

  

Federal Energy Regulatory Commission

FIN 45

  

FASB Interpretation No. 45, entitled “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others”

FIN 46

  

FASB Interpretation No. 46, entitled “Consolidation of Variable Interest Entities”

Financing Order

  

Financing Order of the SEC under PUHCA dated July 31, 2002 with respect to PHI and its subsidiaries

FirstEnergy

  

FirstEnergy Corp., formerly Ohio Edison

FirstEnergy PPA

  

PPAs between Pepco and FirstEnergy Corp. and Allegheny Energy, Inc.

GCR

  

Gas Cost Recovery

GPC

  

Generation Procurement Credit

Internal Control over Financial Reporting

  

A process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

IRC

  

Internal Revenue Code

IRS

  

Internal Revenue Service

ITC

  

Investment Tax Credit

LEAC Liability

  

ACE’s $59.3 million deferred energy cost liability existing as of July 31, 1999 related to ACE’s Levelized Energy Adjustment Clause and ACE’s Demand Side Management Programs

LOB

  

Line of business

LTIP

  

Pepco Holdings’ Long-Term Incentive Plan

Mcf

  

One thousand cubic feet

MDE

  

Maryland Department of the Environment

MISO

  

Midwest Independent System Operator

Mirant

  

Mirant Corporation and certain of its subsidiaries

Mirant Parties

  

Mirant Corporation and its affiliate Mirant Americas Energy Marketing, LP

Mirant Pre-Petition Obligations

  

Unpaid obligations of Mirant to Pepco existing at the time of filing of Mirant’s bankruptcy petition consisting primarily of payments due Pepco in respect of the PPA-Related Obligations

Moody’s

  

Moody’s Investor Service

MPSC

  

Maryland Public Service Commission

MTC

  

Market Transition Charge

NERC

  

North American Electric Reliability Council

NJBPU

  

New Jersey Board of Public Utilities

 

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Term


  

Definition


NJDEP

  

New Jersey Department of Environmental Protection

NJPDES

  

New Jersey Pollutant Discharge Elimination System

Normalization provisions

  

Sections of the Internal Revenue Code and related regulations that dictate how excess deferred income taxes resulting from the corporate income tax rate reduction enacted by the Tax Reform Act of 1986 and accumulated deferred investment tax credits should be treated for ratemaking purposes

NOx

  

Nitrogen oxide

NPDES

  

National Pollutant Discharge Elimination System

NSR

  

New Source Review

NUG

  

Non-Utility Generation

OCI

  

Other Comprehensive Income

O&M

  

Operating and maintenance expenses

Panda

  

Panda-Brandywine, L.P.

Panda PPA

  

PPA between Pepco and Panda

PARS

  

Performance Accelerated Restricted Stock

PBO

  

Projected benefit obligations

PCI

  

Potomac Capital Investment Corporation and its subsidiaries

PEI

  

Pepco Enterprises, Inc.

Pepco

  

Potomac Electric Power Company

Pepco’s pre-merger subsidiaries

  

PCI and Pepco Energy Services

Pepco Energy Services

  

Pepco Energy Services, Inc. and its subsidiaries

Pepco Holdings or PHI

  

Pepco Holdings, Inc.

Pepco TPA Claim

  

Pepco’s $105 million allowed, pre-petition general unsecured claim against each of the Mirant Parties

Pepcom

  

Pepco Communications, Inc.

PJM

  

PJM Interconnection, LLC

POLR

  

Provider of Last Resort (the supply of energy to customers who have not chosen a competitive supplier)

POM

  

Pepco Holdings’ NYSE trading symbol

PPA

  

Power Purchase Agreement

PPA-Related Obligations

  

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

PRP

  

Potentially Responsible Party

PSD

  

Prevention of Significant Deterioration

PUHCA

  

Public Utility Holding Company Act of 1935

RARC

  

Regulatory Asset Recovery Charge

RCN

  

RCN Corporation

Recoverable stranded costs

  

The portion of stranded costs that is recoverable from ratepayers as approved by regulatory authorities

Regulated electric revenues

  

Revenues for delivery (transmission and distribution) service and electricity supply service

Retirement Plan

  

PHI’s noncontributory retirement plan

RI/FS

  

Remedial Investigation/Feasibility Study

S&P

  

Standard & Poors

SEC

  

Securities and Exchange Commission

Settlement Agreement

  

Amended Settlement Agreement and Release, dated as of October 24, 2003 between Pepco and the Mirant Parties

SFAS

  

Statement of Financial Accounting Standards

SFAS No. 5

  

Financial Accounting Standards Board Statement No. 5, entitled “Accounting for Contingencies”

SFAS No. 13

  

Statement of Financial Accounting Standards No. 13, entitled “Accounting for Leases”

SFAS No. 34

  

Statement of Financial Accounting Standards No. 34, entitled “Capitalization of Interest Cost”

 

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Term


  

Definition


SFAS No. 71

  

Statement of Financial Accounting Standards No. 71, entitled “Accounting for the Effects of Certain Types of Regulation”

SFAS No. 87

  

Statement of Financial Accounting Standards No. 87, entitled “Employers’ Accounting for Pensions”

SFAS No. 106

  

Statement of Financial Accounting Standards No. 106, entitled “Employers’ Accounting for Post-retirement Benefits Other Than Pensions”

SFAS No. 123

  

Statement of Financial Accounting Standards No. 123, entitled “Accounting for Stock-Based Compensation”

SFAS No. 131

  

Statement of Financial Accounting Standards No. 131, entitled “Disclosures About Segments of an Enterprise and Related Information”

SFAS No. 132

  

Statement of Financial Accounting Standards No. 132, entitled “Employers’ Disclosures About Pensions and Other Post-retirement Benefits”

SFAS No. 133

  

Statement of Financial Accounting Standards No. 133, entitled “Accounting for Derivative Instruments and Hedging Activities”

SFAS No. 141

  

Statement of Financial Accounting Standards No. 141, entitled “Business Combinations”

SFAS No. 142

  

Statement of Financial Accounting Standards No. 142, entitled “Goodwill and Other Intangible Assets”

SFAS No. 143

  

Statement of Financial Accounting Standards No. 143, entitled “Accounting for Asset Retirement Obligations”

SFAS No. 144

  

Statement of Financial Accounting Standards No. 144, entitled “Accounting for the Impairment or Disposal of Long-Lived Assets”

SFAS No. 150

  

Statement of Financial Accounting Standards No. 150, entitled “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity”

SMECO

  

Southern Maryland Electric Cooperative, Inc.

SMECO Agreement

  

Capacity purchase agreement between Pepco and SMECO

SO2

  

Sulfur dioxide

SOS

  

Standard Offer Service (the supply of energy to customers who have not chosen a competitive supplier)

Standard Offer Service revenue or SOS revenue

  

Revenue each of Pepco and DPL, respectively, receives for the procurement of energy by it for its SOS customers

Starpower

  

Starpower Communications, LLC

Stranded costs

  

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

TBC

  

Transition bond charge

TOPrS

  

Company Obligated Mandatorily Redeemable Preferred Securities of Subsidiary Trust Which Holds Solely Parent Junior Subordinated Debentures

TPAs

  

Transition Power Agreements for Maryland and the District of Columbia between Pepco and Mirant

Transition Bonds

  

Transition bonds issued by ACE Funding

Treasury lock

  

A hedging transaction that allows a company to “lock-in” a specific interest rate corresponding to the rate of a designated Treasury bond for a determined period of time

VaR

  

Value at Risk

VEBA

  

Voluntary Employee Beneficiary Association

VRDB

  

Variable Rate Demand Bonds

VSCC

  

Virginia State Corporation Commission

 

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CONSOLIDATED FINANCIAL HIGHLIGHTS

 

    2004

    2003

    2002 (a)

  2001

    2000

 
    (In Millions, except Per Share Data)  

Consolidated Operating Results

                             

Total Operating Revenue

  $ 7,221.8     7,271.3     4,324.5   2,371.2     2,989.3 (g)

Total Operating Expenses

  $ 6,446.1     6,654.9 (c)   3,778.9   2,004.8 (f)   2,094.2  

Operating Income

  $ 775.7     616.4     545.6   366.4     895.1  

Other Expenses

  $ 341.0     429.0 (d)   190.4   105.3     192.7  

Preferred Stock Dividend Requirements of Subsidiaries

  $ 2.8     13.9     20.6   14.2     14.7  

Income Before Income Tax Expense

  $ 431.9     173.5     334.6   246.9     687.7  

Income Tax Expense

  $ 173.2 (b)   65.9     124.1   83.5     341.2  

Income Before Extraordinary Item

  $ 258.7     107.6     210.5   163.4     346.5  

Extraordinary Item

  $ —       5.9     —     —       —    

Net Income

  $ 258.7     113.5 (e)   210.5   163.4     346.5  

Redemption Premium on Preferred Stock

  $ 0.5     —       —     —       —    

Earnings Available for Common Stock

  $ 259.2     113.5     210.5   163.4     346.5  

Common Stock Information

                             

Basic Earnings Per Share of Common Stock Before Extraordinary Item

  $ 1.47     .63     1.61   1.51     3.02  

Basic—Extraordinary Item Per Share of Common Stock

  $ —       .03     —     —       —    

Basic Earnings Per Share of Common Stock

  $ 1.47     .66     1.61   1.51     3.02  

Diluted Earnings Per Share of Common Stock Before Extraordinary Item

  $ 1.47     .63     1.61   1.50     2.96  

Diluted—Extraordinary Item Per Share of Common Stock

  $ —       .03     —     —       —    

Diluted Earnings Per Share of Common Stock

  $ 1.47     .66     1.61   1.50     2.96  

Basic Common Shares Outstanding (Average)

    176.8     170.7     131.1   108.5     114.9  

Diluted Common Shares Outstanding (Average)

    176.8     170.7     131.1   108.8     118.3  

Cash Dividends Per Share of Common Stock

  $ 1.00     1.00     1.00   1.165     1.66  

Year-End Stock Price

  $ 21.32     19.54     19.39   22.57     24.71  

Book Value per Common Share

  $ 17.88     17.48     17.62   17.00     16.82  

Other Information

                             

Investment in Property, Plant and Equipment

  $ 11,045.2     10,747.2     10,625.0   4,361.9     4,284.7  

Net Investment in Property, Plant and Equipment

  $ 7,088.0     6,964.9     7,043.3   2,819.0     2,786.5  

Total Assets

  $ 13,349.4     13,371.3     13,404.1   5,395.7     7,209.7  

Capitalization (SEC/PUHCA Method)

                             

Short-term Debt (h)

  $ 161.3     360.0     812.7   350.2     211.6  

Long-term Debt (i)

  $ 5,554.7     5,678.5     5,277.5   1,710.1     2,674.8  

Project funding (j)

  $ 70.7     73.6     30.4   22.9     19.4  

Debentures issued to Financing Trust (k)

  $ —       98.0     —     —       —    

Trust Preferred Securities (l)

  $ —       —       290.0   125.0     125.0  

Preferred Stock (m)

  $ 54.9     108.2     110.7   84.8     90.3  

Shareholders’ Equity

  $ 3,366.3     3,003.3     2,995.8   1,823.2     1,862.5  
   


 

 
 

 

Total Capitalization

  $ 9,207.9     9,321.6     9,517.1   4,116.2     4,983.6  
   


 

 
 

 


(a) As a result of the acquisition of Conectiv by Pepco that was completed on August 1, 2002, PHI’s 2004 and 2003 amounts include PHI and its subsidiaries’ results for the full year. PHI’s 2002 amounts include Conectiv and its subsidiaries post-August 1, 2002 results with Pepco and its pre-merger subsidiaries (PCI and Pepco Energy Services) results for all of 2002. The amounts presented for 2001 and 2000 represent only Pepco and its pre-merger subsidiaries results. For additional information, refer to the Management’s Discussion and Analysis of Financial Condition and Results of Operations section, herein.
(b) Includes a $19.7 million charge related to an IRS settlement.
(c) Includes a charge of $50.1 million ($29.5 million after-tax) related to a CT contract cancellation. Also includes a gain of $68.8 million ($44.7 million after-tax) on the sale of the Edison Place office building.
(d) Includes an impairment charge of $102.6 million ($66.7 million after-tax) related to Pepcom’s investment in Starpower Communications, LLC.
(e) Includes the unfavorable impact of $44.3 million ($26.6 million after-tax) resulting from trading losses prior to the cessation of proprietary trading.
(f) Includes $55.5 million ($36.1 million after-tax) impairment charge related to the write-down of aircraft leasing portfolio.
(g) Includes $423.8 million ($182.0 million after-tax) gain on sale of Pepco’s Generation Assets to Mirant.
(h) Excludes current maturities of long-term debt, capital lease obligations due within one year, and Variable Rate Demand Bonds.
(i) Includes first mortgage bonds, medium-term notes, other long-term debt, current maturities of long-term debt, and Variable Rate Demand Bonds. Excludes capital lease obligations.
(j) Represents funding for energy savings contracts performed by Pepco Energy Services and includes current portion of project funds that were provided in exchange for the sale of the customers’ accounts receivable.
(k) Represents debentures issued to Financing Trust and current portion of debentures issued to Financing Trust.
(l) Company obligated mandatorily redeemable preferred securities of subsidiary trust which holds solely parent junior subordinated debentures.
(m) Represents Mandatorily Redeemable Serial Preferred Stock, Serial Preferred Stock, and Redeemable Serial Preferred Stock.

 

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BUSINESS OF THE COMPANY

 

OVERVIEW

 

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

 

    regulated electricity and natural gas delivery,

 

    competitive energy generation, marketing and supply, and

 

    other activities consisting primarily of investments in energy-related assets.

 

PHI is a public utility holding company registered under the Public Utility Holding Company Act of 1935 (PUHCA) and is subject to the regulatory oversight of the Securities and Exchange Commission (SEC) under PUHCA. As a registered public utility holding company, PHI requires SEC approval to, among other things, issue securities, acquire or dispose of utility assets or securities of utility companies and acquire other businesses. In addition, under PUHCA, transactions among PHI and its subsidiaries generally must be performed at cost and subsidiaries are prohibited from paying dividends out of capital or unearned surplus without SEC approval.

 

PHI was incorporated in Delaware on February 9, 2001, for the purpose of effecting the acquisition of Conectiv by Potomac Electric Power Company (Pepco). The acquisition was completed on August 1, 2002, at which time Pepco and Conectiv became wholly owned subsidiaries of PHI. Conectiv was formed in 1998 to be the holding company for Delmarva Power & Light Company (DPL) and Atlantic City Electric Company (ACE) in connection with the combination of DPL and ACE. As a result, DPL and ACE are wholly owned subsidiaries of Conectiv, which also is a registered public utility holding company under PUHCA. The following chart shows, in simplified form, the corporate structure of PHI and its principal subsidiaries.

 

LOGO

 

PHI Service Company, a subsidiary service company of PHI, provides a variety of support services, including legal, accounting, treasury, tax, purchasing and information technology services to PHI and its operating subsidiaries. These services are provided pursuant to a service agreement among PHI, PHI Service Company, and the participating operating subsidiaries which has been filed with, and approved by, the SEC under PUHCA. The expenses of the service company are charged to PHI and the participating operating subsidiaries in accordance with cost allocation methodologies set forth in the service agreement.

 

For financial information relating to PHI’s segments, see Note (3) Segment Information to the consolidated financial statements of PHI. This segment information includes a revision of PHI’s segments for 2003 and 2002 to reflect that, as of January 1, 2004, the formerly separate segments of Pepco Power Delivery and Conectiv Power Delivery were combined to form one operating segment. Each of Pepco, DPL and ACE has one operating segment.

 

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Investor Information

 

Each of PHI, Pepco, DPL and ACE is a reporting company under the Securities Exchange Act of 1934, as amended (the Exchange Act). Their Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and all amendments to those reports, are made available free of charge on PHI’s internet Web site as soon as reasonably practicable after such documents are electronically filed with or furnished to the SEC. These reports may be found at http://www.pepcoholdings.com/investors/index_secfilings.html.

 

The following is a description of each of PHI’s areas of operation.

 

Power Delivery

 

The largest component of PHI’s business is power delivery, which consists of the transmission and distribution of electricity and the distribution of natural gas. In 2004, 2003 and 2002, respectively, PHI’s power delivery operations produced 61%, 55%, and 58% of PHI’s consolidated operating revenues and 70%, 82% and 78% of PHI’s consolidated operating income.

 

PHI’s power delivery business is conducted by its subsidiaries Pepco, DPL and ACE, each of which is a regulated public utility in the jurisdictions in which it serves customers. DPL and ACE conduct their power delivery operations under the tradename Conectiv Power Delivery. In the aggregate, PHI’s power delivery business delivers electricity to more than 1.8 million customers in the mid-Atlantic region and distributes natural gas to approximately 118,000 customers in Delaware.

 

Pepco, DPL and ACE each owns and operates a network of wires, substations and other equipment that are classified either as transmission or distribution facilities. 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 deliver electricity to end-use customers in the utility’s regulated service territory.

 

Transmission of Electricity and Relationship with PJM

 

The transmission facilities owned by Pepco, DPL and ACE are interconnected with the transmission facilities of contiguous utilities and as such are part of an interstate power transmission grid over which electricity is transmitted throughout the mid-Atlantic region and the eastern United States. The Federal Energy Regulatory Commission (FERC) has designated a number of regional transmission operators to coordinate the operation of portions of the interstate transmission grid. Pepco, DPL and ACE are all members of PJM Interconnection, LLC (PJM), the regional transmission operator that coordinates the movement of electricity in all or parts of Delaware, Maryland, New Jersey, Ohio, Pennsylvania, Virginia, West Virginia and the District of Columbia. FERC has designated PJM as the sole provider of transmission service in the PJM territory. Any entity that wishes to deliver electricity at any point in PJM’s territory must obtain transmission services from PJM at rates approved by FERC. In accordance with FERC rules, Pepco, DPL, ACE and the other utilities in the region make their transmission facilities available to PJM and PJM directs and controls the operation of these transmission facilities. In return for the use of their transmission facilities, PJM pays the member utilities transmission fees approved by FERC.

 

In recent months, the PJM wholesale electricity marketplace has expanded substantially with the addition of companies delivering power in large portions of the Midwest, and their associated generation; additional expansion of PJM into Virginia and North Carolina is planned. This expansion is forecast to lower PJM transaction costs through greater administrative efficiencies of scale, and the addition of low-cost Midwest generation to the marketplace is expected to result in a lower average hourly energy price in the PJM market for next-day deliveries. In connection with this expansion, FERC has ordered the elimination of “through-and-out” transmission rates for energy transactions within the combined regional markets of PJM and the Midwest Independent System Operator (MISO), effective December 1, 2004, and has established transitional surcharges in PJM and MISO for the ensuing 16-month period, which are intended to recoup a portion of the “through-and- out” transmission revenue no longer collected by certain transmission owners in the combined region. The data

 

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underlying this transition charge and various exclusions from the charge are disputed by a majority of the utilities, including Pepco, DPL and ACE, and many other parties, including subsidiaries of Conectiv Energy Holding Company (collectively, Conectiv Energy) and Pepco Energy Services, Inc. (together with its subsidiaries, Pepco Energy Services); any amounts collected prior to FERC’s decision are subject to refund. FERC’s eventual decision cannot be predicted.

 

Distribution of Electricity and Deregulation

 

Historically, electric utilities, including Pepco, DPL and ACE, were vertically integrated businesses that generated all or a substantial portion of the electric power that they delivered to customers in their service territories over their own distribution facilities. Customers were charged a bundled rate approved by the applicable regulatory authority that covered both the supply and delivery components of the retail electric service. However, recent legislative and regulatory actions in each of the service territories in which Pepco, DPL and ACE operate have resulted in the “unbundling” of the supply and delivery components of retail electric service and in the opening of the supply component to competition from non-regulated providers. Accordingly, while Pepco, DPL and ACE continue to be responsible for the distribution of electricity in their respective service territories, as the result of deregulation, customers in those service territories now are permitted to choose their electricity supplier from among a number of non-regulated, competitive suppliers. Customers who do not choose a competitive supplier receive default electricity supply from suppliers on terms that vary depending on the service territory, as described more fully below.

 

In connection with the deregulation of electric power supply, Pepco, DPL and ACE have divested substantially all of their generation assets, either by selling them to third parties or transferring them to the non-regulated affiliates of PHI that comprise PHI’s competitive energy businesses. Accordingly, Pepco, DPL and ACE are no longer engaged in generation operations, except for the limited generation activities of ACE described below.

 

Seasonality

 

The power delivery business is seasonal and weather patterns can have a material impact on operating performance. In the region served by PHI, demand for electricity is generally greater in the summer months associated with cooling and demand for electricity and natural gas is generally greater in the winter months associated with heating, as compared to other times of the year. Historically, the power delivery operations of each of PHI’s utility subsidiaries have generated less revenues and income when weather conditions are milder in the winter and cooler in the summer.

 

Regulation

 

The retail operations of PHI’s utility subsidiaries, including the rates they are permitted to charge customers for the delivery of electricity and natural gas, are subject to regulation by governmental agencies in the jurisdictions in which they provide utility service. Pepco’s electricity delivery operations are regulated in Maryland by the Maryland Public Service Commission (MPSC) and in Washington, D.C. by the District of Columbia Public Service Commission (DCPSC). DPL’s electricity delivery operations are regulated in Maryland by the MPSC, in Virginia by the Virginia State Corporation Commission (VSCC) and in Delaware by the Delaware Public Service Commission (DPSC). DPL’s natural gas distribution operations in Delaware are regulated by the DPSC. ACE’s electricity delivery operations are regulated in New Jersey by the New Jersey Board of Public Utilities (NJBPU). The wholesale and transmission operations for both electricity and natural gas of each of PHI’s utility subsidiaries are regulated by FERC.

 

Pepco

 

Pepco is engaged in the transmission and distribution of electricity in Washington, D.C. and major portions of Prince George’s and Montgomery Counties in suburban Maryland. Pepco was incorporated in Washington, D.C. in 1896 and became a domestic Virginia corporation in 1949. Pepco’s service territory covers approximately 640

 

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square miles and has a population of approximately 2 million. As of December 31, 2004, Pepco delivered electricity to approximately 737,000 customers, as compared to 726,000 customers as of December 31, 2003. Pepco delivered a total of approximately 26,902,000 megawatt hours of electricity in 2004, compared to approximately 25,994,000 megawatt hours in 2003. In 2004, approximately 30% was delivered to residential customers, 51% to commercial customers, and 19% to United States and District of Columbia government customers.

 

Under settlements approved by the MPSC and the DCPSC in connection with the divestiture of its generation assets in 2000, Pepco was required to provide default electricity supply to customers in Maryland through June 2004 and to customers in Washington, D.C. through February 7, 2005, for which it was paid established rates set forth in the settlements. Pepco obtained all of the energy and capacity needed to fulfill these fixed-rate default supply obligations in Maryland and Washington, D.C. through January 22, 2005, from an affiliate of Mirant Corporation (Mirant). See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Regulatory and Other Matters—Relationship with Mirant Corporation.”

 

Under a settlement approved by the MPSC in April 2003 addressing default supply, also known as Standard Offer Service (SOS), in Maryland following the expiration of Pepco’s fixed-rate default supply obligations in July 2004, Pepco is required to provide default electricity supply at market rates to residential and small commercial customers through May 2008, to medium-sized commercial customers through May 2006, and to large commercial customers through May 2005. Pepco also has an obligation to provide service at hourly priced market rates to the largest customers through May 2006. In accordance with the settlement, Pepco purchases the power supply required to satisfy its market rate default supply obligation from wholesale suppliers under contracts entered into pursuant to a competitive bid procedure approved by the MPSC. Pepco is entitled to recover from its default supply customers the cost of the default supply plus an average margin of approximately $0.002 per kilowatt hour, calculated based on total sales to residential, small, and large commercial Maryland default customers over the twelve months ended December 31, 2003. Because margins vary by customer class, the actual average margin over any given time period depends on the number of Maryland default supply customers from each customer class and the load taken by such customers over the time period. Pepco is paid tariff delivery rates for the delivery of electricity over its transmission and distribution facilities to both default supply customers and customers in Maryland who have selected another energy supplier. These delivery rates generally were capped originally through June 2004 as a result of a settlement agreement and the Electric Choice and Competition Act of 1999, and extended through December 31, 2006 pursuant to the MPSC order issued in April 2002 in connection with the merger involving Pepco and Conectiv.

 

Under an order issued by the DCPSC in March 2004 addressing default supply in the District of Columbia after the expiration of Pepco’s fixed-rate default supply obligations in February 2005, as amended by a DCPSC order issued in July 2004, Pepco’s obligation to provide default electricity supply at market rates was extended for up to an additional 76 months for small commercial and residential customers and an additional 28 months for large commercial customers. Pepco purchases the power supply required to satisfy its market rate default supply obligation from wholesale suppliers under contracts entered into pursuant to a competitive bid procedure approved by the DCPSC. Subsequent orders issued by the DCPSC provide for Pepco to recover from its default supply customers the costs associated with the acquisition of the default supply plus administrative charges that are intended to allow Pepco to recover the administrative costs incurred to provide the default electricity supply. These administrative charges include an average margin for Pepco of approximately $0.00248 per kilowatt hour, calculated based on total sales to residential, small and large commercial District of Columbia default customers over the twelve months ended December 31, 2003. Because margins vary by customer class, the actual average margin over any given time period depends on the number of District of Columbia default supply customers from each customer class and the load taken by such customers over the time period. Pepco is paid tariff delivery rates for the delivery of electricity over its transmission and distribution facilities to both default supply customers and customers in the District of Columbia who have selected another energy supplier. Assuming no change as a result of the current Pepco distribution rate review case in the District of Columbia (see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Regulatory and Other Matters—Rate Proceedings”), delivery rates in the District of Columbia generally are capped through July 2007, except with respect to residential low-income customers, for whom rates generally are capped through July 2009.

 

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For the twelve months ended December 31, 2004, Pepco delivered 71% of its load (measured by megawatt hours) to Maryland default supply customers, as compared to 70% in 2003. Pepco delivered 68% of its load to District of Columbia default supply customers in 2004, as compared to 52% in 2003.

 

DPL

 

DPL is engaged in the transmission and distribution of electricity in Delaware and portions of Maryland and Virginia and provides natural gas distribution service in northern Delaware. In Delaware, service is provided in three counties, Kent, New Castle, and Sussex; in Maryland, service is provided in ten counties, Caroline, Cecil, Dorchester, Harford, Kent, Queen Anne’s, Somerset, Talbot, Wicomico, and Worchester; and in Virginia, service is provided to two counties, Accomack and Northampton. DPL was incorporated in Delaware in 1909 and became a domestic Virginia corporation in 1979. DPL’s electricity distribution service territory covers approximately 6,000 square miles and has a population of approximately 1.28 million. DPL’s natural gas distribution service territory covers approximately 275 square miles and has a population of approximately 523,000. As of December 31, 2004, DPL delivered electricity to approximately 501,000 customers and delivered natural gas to approximately 118,000 customers, as compared to 493,000 electricity customers and 117,000 natural gas customers as of December 31, 2003.

 

In 2004, DPL delivered a total of approximately 13,902,000 megawatt hours of electricity to its customers, as compared to a total of approximately 14,032,000 megawatt hours in 2003. In 2004, approximately 39% of DPL’s retail electricity deliveries were to residential customers, 38% were to commercial customers and 23% were to industrial customers. In 2004, DPL delivered approximately 21,600,000 Mcf (one thousand cubic feet) of natural gas to retail customers in its Delaware service territory, as compared to approximately 22,900,000 Mcf in 2003. In 2004, approximately 40% of DPL’s retail gas deliveries were sales to residential customers, 26% were to sales commercial customers, 5% were to sales industrial customers, and 29% were sales to customers receiving a transportation-only service.

 

Under a settlement approved by the DPSC, DPL is required to provide default electricity supply, or SOS, to customers in Delaware through April 2006. DPL is paid for default supply to customers in Delaware at fixed rates established in the settlement. DPL obtains all of the energy needed to fulfill its default supply obligations in Delaware under a supply agreement with its affiliate Conectiv Energy, which terminates in May 2006. DPL does not make any profit or incur any loss on the supply component of the default power that it delivers to its Delaware customers. DPL is paid tariff delivery rates for the delivery of electricity over its transmission and distribution facilities to both default supply customers and customers who have selected another energy supplier. These delivery rates generally are frozen through April 2006, except that DPL is allowed to file for a one-time transmission rate change during this period. On February 22, 2005, the DPSC voted to approve an SOS process that will allow a Wholesale Standard Offer Service Model with DPL as the SOS Supplier. Issues including the length of this extension and any margin that DPL may be able to earn and retain in conjunction with this service have been deferred for further discussion and will be decided by the DPSC at a later date. A written DPSC order documenting this decision is expected sometime in March or April 2005.

 

Under a settlement approved by the MPSC, DPL was required to provide default electricity supply to non-residential customers in Maryland through May 2004 and to residential customers in Maryland through June 2004 for which it was paid established rates set forth in the settlement. DPL obtained all of the energy needed to fulfill its fixed-rate default supply obligations in Maryland under a supply agreement with Conectiv Energy.

 

Under a settlement approved by the MPSC in April 2003 addressing default supply in Maryland following the expiration of DPL’s fixed-rate default supply obligations in 2004, DPL is required to provide default electricity supply at market rates to residential and small commercial customers through May 2008, to medium-sized commercial customers through May 2006, and to large commercial customers through May 2005. In accordance with the settlement, DPL purchases the power supply required to satisfy its market rate default supply obligations from wholesale suppliers under contracts entered into pursuant to a competitive bid procedure

 

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approved and supervised by the MPSC. DPL is entitled to recover from its default supply customers the costs of the default supply plus an average margin of $0.002 per kilowatt hour, calculated based on total sales to residential, small, and large commercial Maryland default customers over the twelve months ended December 31, 2003. Because margins vary by customer class, the actual average margin over any given time period depends on the number of Maryland default supply customers from each customer class and the load taken by such customers over the time period. DPL is paid tariff delivery rates for the delivery of electricity over its transmission and distribution facilities to both default supply customers and customers in Maryland who have selected another energy supplier. These delivery rates generally are capped through December 2006.

 

Under amendments to the Virginia Electric Utility Restructuring Act implemented in March 2004, DPL is obligated to offer default service to customers in Virginia for an indefinite period until relieved of that obligation by the VSCC. DPL currently obtains all of the energy and capacity needed to fulfill its default service obligations in Virginia under a supply agreement with Conectiv Energy. A prior agreement, also with Conectiv Energy, terminated effective December 31, 2004. The current contract was entered into after conducting a competitive bid procedure and Conectiv Energy was the lowest bidder to provide wholesale power supply for DPL’s Virginia default service customers. The new supply agreement commenced January 1, 2005 and expires in May 2006. On October 26, 2004, DPL filed an application with the VSCC for approval to increase the rates that DPL charges its Virginia default service customers to allow it to recover its costs for power under the new supply agreement plus an administrative charge and a margin.

 

A VSCC order dated November 17, 2004 allowed DPL to put interim rates into effect on January 1, 2005, subject to refund if the VSCC subsequently determined the rate is excessive. The interim rates reflected an increase of 1.0247 cents per kwh to the fuel rate, which provide for recovery of the entire amount being paid by DPL to Conectiv Energy, but did not include an administrative charge or margin, pending further consideration of this issue. Therefore, the November 17 order also directed the parties to file memoranda concerning whether administrative costs and a margin are properly recovered through a fuel clause mechanism. Memoranda were filed by DPL, the VSCC Staff and Virginia’s Office of Attorney General. The VSCC ruled on January 18, 2005, that the administrative charge and margin are base rate items not recoverable through a fuel clause. No appeal is planned regarding this filing. A settlement resolving all other issues and making the interim rates final was filed on March 4, 2005, contingent only on possible future adjustment depending on the result of a related proceeding at FERC. A hearing is scheduled for March 16, 2005, and the VSCC is expected to approve the settlement.

 

DPL is paid tariff delivery rates for the delivery of electricity over its transmission and distribution facilities to both Virginia default service customers and customers in Virginia who have selected another energy supplier. These delivery rates generally are frozen until December 31, 2010, except that DPL can propose two changes in delivery rates—one prior to July 1, 2007 and another between July 1, 2007 and December 31, 2010.

 

In Maryland, DPL sales to default supply customers represented 80% of total delivered megawatt hours for the twelve months ended December 31, 2004, as compared to 96% in 2003. In Delaware, DPL sales to default supply customers represented 89% of total delivered megawatt hours for the twelve months ended December 31, 2004, as compared to 87% in 2003, and DPL sales to Virginia default supply customers represented 100% of total delivered megawatt hours in both 2004 and 2003.

 

DPL also provides regulated natural gas supply and distribution service to customers in its Delaware natural gas service territory. Large and medium volume commercial and industrial natural gas customers may purchase natural gas either from DPL or from other suppliers. DPL uses its natural gas distribution facilities to transport gas for customers that choose to purchase natural gas from other suppliers. These customers pay DPL distribution service rates approved by the DPSC. DPL purchases natural gas supplies for resale to its sales service customers from marketers and producers through a combination of long-term agreements and next day delivery arrangements. For the twelve months ended December 31, 2004, DPL supplied 71.8% of the natural gas that it delivered, compared to 71.6% in 2003.

 

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ACE

 

ACE is engaged in the generation, transmission and distribution of electricity in Gloucester, Camden, Burlington, Ocean, Atlantic, Cape May, Cumberland and Salem counties in southern New Jersey. ACE was incorporated in New Jersey in 1924. ACE’s service territory covers approximately 2,700 square miles and has a population of approximately 998,000. As of December 31, 2004, ACE delivered electricity to approximately 524,000 customers in its service territory, as compared to approximately 521,000 customers as of December 31, 2003. ACE delivered a total of approximately 9,874,000 megawatt hours of electricity in 2004 compared to approximately 9,643,000 megawatt hours in 2003. In 2004, approximately 44% was delivered to residential customers, 44% was delivered to commercial customers and 12% was delivered to industrial customers.

 

Customers in New Jersey who do not choose another supplier receive default electricity supply from suppliers selected through auctions approved by the NJBPU. ACE has entered into supply agreements with the default suppliers, including Conectiv Energy, on behalf of the default supply customers in its service territory. Each of these agreements requires the default supplier to provide a portion of the default supply customer load with full requirements service, consisting of power supply and transmission service. ACE delivers the default supply to customers. ACE is paid tariff rates established by the NJBPU that compensate it for the cost of obtaining the default supply. ACE does not make any profit or incur any loss on the supply component of the default power it provides to customers.

 

ACE is paid tariff delivery rates for the delivery of electricity over its transmission and distribution facilities to both default supply customers and customers in its service territory who have selected another energy supplier. ACE currently is involved in a base rate proceeding in which it has requested an increase in its delivery rates. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Regulatory and Other Matters—Rate Proceedings.”

 

ACE sales to New Jersey default supply customers represented 76% of total delivered megawatt hours for the twelve months ended December 31, 2004, as compared to 91% in 2003.

 

As of December 31, 2004, ACE owned one electric generating facility, the B.L. England generating facility, and interests in two facilities jointly owned with other companies. The combined generating capacity of these facilities is 555 megawatts. ACE also has contracts with non-utility generators under which ACE purchased 3.9 million megawatt hours of power in 2004. ACE sells the electricity produced by the generating facilities and purchased under the non-utility generator contracts in the wholesale market administered by PJM. During 2004, ACE’s generation and wholesale electricity sales operations produced approximately 23.2% of ACE’s operating revenue.

 

On March 1, 2004, ACE transferred ownership of the 185 megawatt capacity Deepwater generating facility to Conectiv Energy.

 

In April 2004, PHI, Conectiv and ACE entered into a preliminary settlement agreement with the New Jersey Department of Environmental Protection (NJDEP) and the Attorney General of New Jersey that provides that, contingent upon the receipt of necessary approvals from applicable regulatory authorities and the receipt of permits to construct certain electric transmission facilities in southern New Jersey, ACE will permanently cease operation of the B.L. England generating facility by December 15, 2007. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Regulatory and Other Matters—Preliminary Settlement Agreement with the NJDEP.”

 

In 2002, ACE and the City of Vineland, New Jersey entered into a condemnation settlement agreement which provided for ACE to sell the electric distribution facilities within the city limits, and the approximately 5,400 related customer accounts (to which ACE delivered approximately 103,000 megawatt hours of power in 2003), for $23.9 million. The proceeds were received in installments and the sale was completed in the second quarter of 2004.

 

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ACE Funding

 

ACE Funding was incorporated in New Jersey in 2001 by ACE. Under New Jersey law, ACE (or a financing entity) is permitted to securitize authorized portions of ACE’s recoverable stranded costs through the issuance of bonds (Transition Bonds) and to collect from its customers charges sufficient to fund principal and interest payments on the Transition Bonds and related taxes, expenses and fees. The right to collect the Transition Bond charges is known as Bondable Transition Property. The sole purpose for the establishment of ACE Funding is to issue Transition Bonds, the proceeds of which are transferred to ACE in exchange for the related Bondable Transition Property.

 

Competitive Energy

 

PHI’s competitive energy business provides non-regulated generation, marketing and supply of electricity and natural gas, and related energy management services, in the mid-Atlantic region. In 2004, 2003 and 2002, respectively, PHI’s competitive energy operations produced 50%, 55% and 48% of PHI’s consolidated operating revenues. In 2004 and 2002, respectively, PHI’s competitive energy operations produced 19% and 12% of PHI’s consolidated operating income. In 2003, PHI’s competitive energy operations incurred an operating loss equal to 19% of PHI’s consolidated operating income. PHI’s competitive energy operations are conducted through subsidiaries of Conectiv Energy and Pepco Energy Services.

 

Conectiv Energy

 

Conectiv Energy provides wholesale electric power, capacity, and ancillary services in the wholesale markets administered by PJM and also supplies electricity to other wholesale market participants under long-term bilateral contracts. Among its bilateral contracts are the power supply agreements under which Conectiv Energy sells to DPL its default electricity supply for distribution to customers in Delaware and Virginia. Conectiv Energy also sells default supply to customers in ACE’s service territory and to other default supply customers in New Jersey. Other than its default supply sales, Conectiv Energy does not currently participate in the retail competitive power supply market. Conectiv Energy obtains the electricity required to meet its power supply obligations from its own generating plants, from bilateral contract purchases from other wholesale market participants and from purchases in the wholesale market administered by PJM.

 

Conectiv Energy’s generation asset strategy focuses on mid-merit plants with operating flexibility and multi-fuel capability that can quickly change their output level on an economic basis. Like “peak-load” plants, mid-merit plants generally operate during times when demand for electricity rises and prices are higher. However, mid-merit plants usually operate for longer periods of time and for more weeks a year than peak-load plants. Conectiv Energy’s most recently added mid-merit plant, a combined cycle plant located in Bethlehem, Pennsylvania with a generating capacity of 1,092 megawatts, became fully operational in June 2004. On March 1, 2004, Conectiv Energy received ownership of the 185 megawatt capacity Deepwater generating facility from ACE. As of December 31, 2004, Conectiv Energy owned and operated mid-merit plants with a combined 2,689 megawatts of capacity, peak-load plants with a combined 669 megawatts of capacity and base-load generating plants with a combined 340 megawatts of capacity. Conectiv Energy also owns three uninstalled combustion turbines with a book value of $57.0 million. Conectiv Energy will determine whether to install these turbines as part of an existing or new generating facility or sell the turbines to a third party based upon market demand and transmission system needs and requirements.

 

Conectiv Energy also sells natural gas and fuel oil to very large end-users and to wholesale market participants under bilateral agreements. Conectiv Energy obtains the natural gas and fuel oil required to meet its supply obligations through market purchases for next day delivery and under long-term bilateral contracts with other market participants.

 

Conectiv Energy actively engages in commodity risk management activities to reduce its financial exposure to changes in the value of its assets and obligations due to commodity price fluctuations. Certain of these risk

 

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management activities are conducted using instruments classified as derivatives, such as forward contracts, futures, swaps, and exchange-traded and over-the-counter options. Conectiv Energy also manages commodity risk with contracts that are not classified as derivatives. Conectiv Energy has two primary risk management objectives: to manage the spread between the cost of fuel used to operate its electric generation plants and the revenue received from the sale of the power produced by those plants; and to manage the spread between its POLR, SOS, and BGS load supply contracts in order to ensure stable and known minimum cash flows and fix favorable prices and margins when they become available. To a lesser extent, Conectiv Energy also engages in market activities in an effort to profit from short-term geographical price differentials in electricity prices among markets.

 

Conectiv Energy’s goal is to hedge economically 75% of both the expected power output of its generation facilities and the expected costs of fuel used to operate those facilities. The economic hedge goals are approved by PHI’s Corporate Risk Management Committee and may change from time to time based on market conditions. However, the actual level of hedging coverage may vary from this goal. In July 2003, Conectiv Energy entered into an agreement with an international investment banking firm consisting of a series of energy contracts designed to more effectively hedge approximately 50% of Conectiv Energy’s generation output and approximately 50% of its supply obligations, with the intention of providing Conectiv Energy with a more predicable earnings stream during the term of the agreement, which expires in May 2006. The agreement consists of two major components: (i) a fixed price energy supply hedge that is used to reduce Conectiv Energy’s financial exposure under its current default supply commitment to DPL in Delaware through May 2006 and Virginia through December 2004 and (ii) a generation off-take agreement under which Conectiv Energy receives a fixed monthly payment from the counterparty, and the counterparty receives the profit realized from the sale of approximately 50% of the electricity generated by Conectiv Energy’s plants (excluding the Edge Moor facility).

 

Pepco Energy Services

 

Pepco Energy Services sells retail electricity and natural gas to residential, commercial, industrial and governmental customers in the mid-Atlantic region. Pepco Energy Services also provides integrated energy management services to commercial, industrial and governmental customers, including energy-efficiency contracting, development and construction of “green power” facilities, central plant and other equipment operation and maintenance, fuel management, and home service agreements for residential customers. Subsidiaries of Pepco Energy Services provide high voltage construction and maintenance services to utilities and other customers throughout the United States and low voltage electric and telecommunication construction and maintenance services in the Washington, D.C. area.

 

Pepco Energy Services owns peak-load electricity generation plants with approximately 800 megawatts of peak-load capacity, the output of which is sold in the wholesale market administered by PJM.

 

Pepco Energy Services actively engages in commodity risk management activities to reduce the financial exposure to changes in the value of its supply contracts and sales commitments due to commodity price and volume fluctuations. Certain of these risk management activities are conducted using instruments classified as derivatives, such as forward contracts, futures, swaps, and exchange-traded and over-the-counter options. Pepco Energy Services’ primary risk management objective is to manage the spread between its retail electric and natural gas sales commitments and the cost of supply used to service those commitments in order to secure favorable margins. Because of the age and design of Pepco Energy Services’ power plants, these facilities have a high variable cost of operation and Pepco Energy Services generally does not hedge the output of these plants.

 

Competition

 

The unregulated energy generation, supply and marketing businesses in the mid-Atlantic region are characterized by intense competition at both the wholesale and retail levels. At the wholesale level, Conectiv Energy and Pepco Energy Services compete with numerous non-utility generators, independent power producers,

 

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wholesale power marketers and brokers, and traditional utilities that continue to operate generation assets. In the retail energy supply market and in providing energy management services, Pepco Energy Services competes with numerous competitive energy marketers and other service providers. Competition in both the wholesale and retail markets for energy and energy management services is based primarily on price and, to a lesser extent, the range of services offered to customers and quality of service.

 

Seasonality

 

Like the power delivery business, the power generation, supply and marketing businesses are seasonal and weather patterns can have a material impact on operating performance. Demand for electricity generally is greater in the summer months associated with cooling and demand for electricity and natural gas generally is greater in the winter months associated with heating, as compared to other times of the year. Historically, the competitive energy operations of Conectiv Energy and Pepco Energy Services have generated less revenues and income when weather conditions are milder in the winter and cooler in the summer. Energy management services generally are not seasonal.

 

Other Non-Regulated

 

This component of PHI’s business is conducted through its subsidiary Potomac Capital Investment Corporation (PCI). PHI’s subsidiary Pepco Communications, Inc. (Pepcom) ceased operations in December 2004 following the sale of its principal asset described below.

 

PCI

 

PCI manages a portfolio of financial investments, which consists primarily of energy leveraged leases. These transactions involve PCI’s purchase and leaseback of utility assets located outside of the United States. In 2003 PCI discontinued making new investments, and in 2004 sold its three remaining aircraft. For additional information relating to PCI’s energy leveraged leases, see Note (4) to the consolidated financial statements of PHI.

 

Pepcom

 

In December 2004, Pepcom sold its 50% interest in Starpower Communications, LLC (Starpower) for $29 million in cash to RCN Telecom Services of Washington, D.C., Inc., a wholly owned subsidiary of RCN Corporation which owned the other 50% interest in Starpower. Following the completion of the sale, Pepcom has no remaining investments.

 

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

 

CONSOLIDATED RESULTS OF OPERATIONS

 

The results of operations discussion below is for the year ended December 31, 2004 compared to the year ended December 31, 2003. All amounts in the tables (except customers) include intercompany transactions and are in millions.

 

Operating Revenue

 

A detail of the components of PHI’s consolidated operating revenue is as follows:

 

     2004

    2003

    Change

 

Power Delivery

   $ 4,375.9     $ 4,016.8     $ 359.1  

Conectiv Energy

     2,408.3       2,859.0       (450.7 )

Pepco Energy Services

     1,168.6       1,126.2       42.4  

Other Non-Regulated

     87.9       100.1       (12.2 )

Corporate and Other

     (818.9 )     (830.8 )     11.9  
    


 


 


Total Operating Revenue

   $ 7,221.8     $ 7,271.3     $ (49.5 )
    


 


 


 

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Power Delivery Business

 

The following table categorizes Power Delivery’s operating revenue by type of revenue.

 

     2004

   2003

   Change

 

Regulated T&D Electric Revenue

   $ 1,566.7    $ 1,521.0    $ 45.7  

Default Supply Revenue

     2,514.7      2,206.1      308.6  

Other Electric Revenue

     66.8      98.7      (31.9 )
    

  

  


Total Electric Operating Revenue

     4,148.2      3,825.8      322.4  
    

  

  


Regulated Gas Revenue

     169.1      150.2      18.9  

Other Gas Revenue

     58.6      40.8      17.8  
    

  

  


Total Gas Operating Revenue

     227.7      191.0      36.7  
    

  

  


Total Power Delivery Operating Revenue

   $ 4,375.9    $ 4,016.8    $ 359.1  
    

  

  


 

Regulated Transmission and Distribution (T&D) Electric Revenue consists of revenue from the transmission of electricity and the delivery of electricity to its customers within PHI’s service territories at regulated rates.

 

Default Supply Revenue (DSR) also known, depending on the jurisdiction as Standard Offer Service (SOS), Basic Generation Service (BGS), and Provider of Last Resort (POLR) consists of revenue received from the supply of electricity within PHI’s service territories at regulated rates pursuant to supply obligations. The costs related to the supply of electricity are included in Fuel and Purchased Energy and Other Services Cost of Sales.

 

Other Electric Revenue consists of utility-related work and services performed on behalf of customers including other utilities.

 

Regulated Gas Revenue consists of revenues from the transportation of natural gas and on-system gas sales to customers within PHI’s service territories at regulated rates.

 

Other Gas Revenue consists of off-system natural gas sales and the resale of excess natural gas or system capacity.

 

Electric Operating Revenue

 

Regulated T&D Electric Revenue    2004

   2003

   Change

 

Residential

   $ 598.6    $ 576.2    $ 22.4  

Commercial

     715.2      674.7      40.5  

Industrial

     37.3      41.0      (3.7 )

Other—PJM

     215.6      229.1      (13.5 )
    

  

  


Total Regulated T&D Electric Revenue

   $ 1,566.7    $ 1,521.0    $ 45.7  
    

  

  


Regulated T&D Electric Sales (KwH)    2004

   2003

   Change

 

Residential

     17,780      17,147      633  

Commercial

     28,440      27,648      792  

Industrial

     4,458      4,874      (416 )
    

  

  


Total Regulated T&D Electric Sales

     50,678      49,669      1,009  
    

  

  


Regulated T&D Electric Customers (000s)    2004

   2003

   Change

 

Residential

     1,567      1,547      20  

Commercial

     193      191      2  

Industrial

     2      2      —    
    

  

  


Total Regulated T&D Electric Customers

     1,762      1,740      22  
    

  

  


 

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The ACE, DPL, and Pepco service territories are located within the Washington, DC to southern New Jersey corridor. These service territories taken together are economically diverse and include key industries that contribute to the regional economic base and to PHI’s growing T&D revenues.

 

    Commercial activity in the region includes banking and other professional services, casinos, government, insurance, real estate, strip mall, stand alone construction, and tourism.

 

    Industrial activity in the region includes automotive, chemical, glass, pharmaceutical, and steel manufacturing, food processing, and oil refining.

 

Regulated T&D Electric Sales, as measured on a KwH basis, increased by 2% in 2004, driven by residential and commercial customer classes. Regulated T&D Revenue increased by $45.7 million primarily due to the following: (i) $14.4 million increase due to growth and average customer usage, (ii) $4.8 million increase due to higher average effective rates, (iii) $9.1 million favorable weather, (iv) $39.9 million increase in tax pass-throughs, principally a county surcharge, (offset in Other Taxes). These increases were offset by (v) $20.5 million decrease primarily related to PJM network transmission revenue and the impact of customer choice and (vi) $2.1 million related to Delaware competitive transition charge that ended in 2003. Cooling degree days increased by 11.0% and heating degree days decreased by 6.3% for the year ended December 31, 2004 as compared to the same period in 2003.

 

Default Supply Revenue    2004

   2003

   Change

 

Residential

   $ 993.6    $ 875.2    $ 118.4  

Commercial

     1,069.3      946.4      122.9  

Industrial

     140.2      156.1      (15.9 )

Other (Includes PJM)

     311.6      228.4      83.2  
    

  

  


Total Default Supply Revenue

   $ 2,514.7    $ 2,206.1    $ 308.6  
    

  

  


Default Supply Sales (KwH)    2004

   2003

   Change

 

Residential

     16,768      16,048      720  

Commercial

     19,338      18,134      1,204  

Industrial

     2,294      2,882      (588 )

Other

     96      94      2  
    

  

  


Total Default Supply Sales

     38,496      37,158      1,338  
    

  

  


Default Supply Customers (000s)    2004

   2003

   Change

 

Residential

     1,510      1,460      50  

Commercial

     180      175      5  

Industrial

     2      2      —    

Other

     1      1      —    
    

  

  


Total Default Supply Customers

     1,693      1,638      55  
    

  

  


 

Default Supply Revenue increased $308.6 million primarily due to the following: (i) $109.2 million as the result of higher retail energy rates, the result of effective rate increases in Delaware beginning October 2003 and in Maryland beginning in June and July 2004, (ii) $92.3 million primarily due to a reduction in customer migration in DC, (iii) $83.1 million increase in wholesale energy prices as the result of higher market prices in 2004, and (iv) $24.4 million increase in average customer usage.

 

Other Electric Revenue decreased $31.9 million primarily due to a $43.0 million decrease that resulted from the expiration on December 31, 2003 of a contract to supply electricity to Delaware Municipal Electric Corporation (DMEC). This decrease was partially offset by a $14.0 million increase in customer requested work (related costs in Operations and Maintenance).

 

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Gas Operating Revenue

 

Regulated Gas Revenue    2004

   2003

   Change

 

Residential

   $ 100.0    $ 88.8    $ 11.2  

Commercial

     56.4      47.7      8.7  

Industrial

     8.1      9.2      (1.1 )

Transportation and Other

     4.6      4.5      .1  
    

  

  


Total Regulated Gas Revenue

   $ 169.1    $ 150.2    $ 18.9  
    

  

  


Regulated Gas Sales (Mcf)    2004

   2003

   Change

 

Residential

     8.7      9.0      (.3 )

Commercial

     5.5      5.5      —    

Industrial

     1.2      1.6      (.4 )

Transportation and Other

     6.2      6.8      (.6 )
    

  

  


Total Regulated Gas Sales

     21.6      22.9      (1.3 )
    

  

  


Regulated Gas Customers (000s)    2004

   2003

   Change

 

Residential

     108.9      107.6      1.3  

Commercial

     9.1      9.1      —    

Industrial

     —        —        —    

Transportation and Other

     .1      .1      —    
    

  

  


Total Regulated Gas Customers

     118.1      116.8      1.3  
    

  

  


 

DPL’s natural gas service territory is located in New Castle County, Delaware. Several key industries contribute to the economic base as well as to growth.

 

    Commercial activity in the region includes banking and other professional services, casinos, government, insurance, real estate, strip mall, stand alone construction, and tourism.

 

    Industrial activity in the region includes automotive, chemical, and pharmaceutical.

 

Regulated Gas Revenue increased $18.9 million principally due to the following: (i) $21.0 million increase in the Gas Cost Rate due to higher natural gas commodity costs; this was effective November 1, 2003, (ii) $8.2 million increase in Gas Base Rates due to higher operating expenses and cost of capital; this was effective December 9, 2003, and (iii) $2.0 million true up adjustment to unbilled revenues in 2003. These increases were partially offset by (iv) $9.4 million decrease due to 2003 being significantly colder than normal and (v) $2.9 million reduction related to lower industrial sales. Heating degree days decreased 7.1% for the year ended December 31, 2004 as compared to the same period in 2003.

 

Other Gas Revenue increased $17.8 million largely related to an increase in off-system sales revenues of $17.3 million. The gas sold off-system was made available by warmer winter weather and reduced customer demand.

 

Competitive Energy Business

 

The following table categorizes the Competitive Energy business’ operating revenue into major profit centers.

 

     2004

   2003

   Change

 

Merchant Generation

   $ 684.5    $ 540.2    $ 144.3  

POLR Load Service

     695.3      972.2      (276.9 )

Power, Oil & Gas Marketing Services and Other

     1,028.5      1,346.6      (318.1 )
    

  

  


Total Conectiv Energy Operating Revenue

   $ 2,408.3    $ 2,859.0    $ (450.7 )
    

  

  


Pepco Energy Services

   $ 1,168.6    $ 1,126.2    $ 42.4  
    

  

  


 

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Merchant Generation experienced an increase of $144.3 million, primarily due to $166.6 million from increased opportunities to take advantage of unit operating flexibility and increased power prices (approximately 11% higher). This increase was partially offset by $22.3 million from the implementation of EITF 03-11 on January 1, 2004. EITF 03-11 resulted in operating revenues and operating expenses related to certain energy contracts being reported on a net basis.

 

POLR Load Service experienced a decrease of $276.9 million primarily due to a $152.9 million decrease in revenue from PJM due primarily to a change in power scheduling procedures by Conectiv to schedule power directly to DPL and a decrease of $187.9 million that related to the implementation of EITF 03-11 on January 1, 2004. This decrease was partially offset by increased hedging activity, including the recognition of an adjustment related to fuel supply contracts of $5.6 million.

 

Power, Oil and Gas Marketing Services and Other decreased by $318.1 million primarily due to the expiration in 2003 of some large New Jersey Basic Generation Service contracts.

 

The increase in Pepco Energy Services’ operating revenue of $42.4 million resulted from higher volumes of electricity sold to customers in 2004 at more favorable prices than in 2003, partially offset by a decrease in natural gas revenues.

 

Operating Expenses

 

Fuel and Purchased Energy and Other Services Cost of Sales

 

A detail of PHI’s consolidated fuel and purchased energy and other services cost of sales is as follows:

 

     2004

    2003

    Change

 

Power Delivery

   $ 2,523.8     $ 2,294.7     $ 229.1  

Conectiv Energy

     2,130.2       2,695.6       (565.4 )

Pepco Energy Services

     1,064.4       1,033.1       31.3  

Other Non-Regulated

     —         —         —    

Corporate and Other

     (821.8 )     (820.8 )     (1.0 )
    


 


 


Total

   $ 4,896.6     $ 5,202.6     $ (306.0 )
    


 


 


 

Power Delivery’s Fuel and Purchased Energy costs increased by $229.1 million primarily due to the following: (i) a $212.9 million increase related to higher average energy costs, the result of new Default Supply rates for Maryland beginning in June and July 2004 and for New Jersey beginning in June 2004 and less customer migration primarily in DC, (ii) $45.1 million higher costs due to the increased cost of electricity supply under the TPA Settlement with Mirant, effective October 2003, and (iii) a $30.2 million increase for gas commodity purchases, partially offset by (i) $43.0 million related to the DMEC 2003 contract expiration, and (ii) $14.5 million reserve recorded in September 2003 to reflect a potential exposure related to a pre-petition receivable from Mirant Corp. for which Pepco filed a creditor’s claim in the bankruptcy proceedings.

 

The following table categorizes the Competitive Energy business’ fuel and purchased energy and other services cost of sales into major profit centers.

 

     2004

   2003

   Change

 

Merchant Generation

   $ 443.6    $ 356.0    $ 87.6  

POLR Load Service

     682.6      975.3      (292.7 )

Power, Oil & Gas Marketing Services and Other

     1,004.0      1,364.3      (360.3 )
    

  

  


Total Conectiv Energy Fuel and Purchased Energy and Other Services Cost of Sales

   $ 2,130.2    $ 2,695.6    $ (565.4 )
    

  

  


Pepco Energy Services

   $ 1,064.4    $ 1,033.1    $ 31.3  
    

  

  


 

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The decrease of $565.4 million in Conectiv Energy’s fuel, purchased energy and other services cost of sales is broken down as follows:

 

Merchant Generation increased by $87.6 million mainly due to an increase of $109.9 million primarily due to higher fuel costs (approximately 7% higher). This increase was partially offset by a $22.3 million decrease from the implementation of EITF 03-11 on January 1, 2004.

 

POLR Load Service decreased by $292.7 million partially due to a change in power scheduling procedures by Conectiv at PJM resulting in a $154.3 million decrease and a decrease of approximately $187.9 million that related to the implementation of EITF 03-11 on January 1, 2004. This decrease was partially offset by an increase in hedging activity.

 

Power, Oil and Gas Marketing Services and Other decreased by $360.3 million due to the expiration of some large New Jersey Basic Generation Service contracts in 2003.

 

The increase in Pepco Energy Services’ fuel and purchased energy and other services cost of sales of $31.3 million resulted from higher volumes of electricity purchased in 2004 to serve customers, partially offset by a decrease in volumes of natural gas purchased in 2004 to serve customers.

 

Other Operation and Maintenance

 

PHI’s other operation and maintenance increased by $32.1 million to $799.9 million in 2004 from $767.8 million in 2003 primarily due to (i) $12.1 million of customer requested work (offset in Other Electric Revenue), (ii) $10.6 million higher electric system operation and maintenance costs, (iii) $9.4 million in Sarbanes-Oxley external compliance costs, (iv) $12.8 million severance costs, partially offset by $10.6 million incremental storm costs primarily related to one time charges as a result of Hurricane Isabel in September 2003.

 

Depreciation and Amortization

 

PHI’s depreciation and amortization expenses increased by $18.4 million to $440.5 million in 2004 from $422.1 million in 2003 primarily due to a $17.0 million increase attributable to the Power Delivery business resulting from (i) a $12.8 million increase for amortization of New Jersey bondable transition property as a result of additional transitional bonds issued in December 2003; (ii) $3.8 million for the amortization of the New Jersey deferred service costs balance which began in August 2003; and (iii) a $2.4 increase for amortization of a regulatory tax asset related to New Jersey stranded costs. Additionally, depreciation expense attributable to the Competitive Energy business increased by $5.9 million from 2003 due to a full year of depreciation expense during 2004 at Conectiv Energy’s Bethlehem facility.

 

Other Taxes

 

Other taxes increased by $28.9 million to $302.8 million in 2004 from $273.9 million in 2003. This increase primarily resulted from a $30.1 million increase attributable to the Power Delivery business due to pass-throughs of $33.9 million higher county surcharge and $3.6 million higher gross receipts/delivery taxes (offset in Regulated T&D Electric Revenue), partially offset by $9.5 million lower property tax expense due to true-ups recorded in 2004.

 

Deferred Electric Service Costs

 

Deferred Electric Service Costs (DESC), which relates only to ACE, increased by $43.3 million to $36.3 million in 2004 from a $7.0 million operating expense credit in 2003. At December 31, 2004, DESC represents the net expense or over-recovery associated with New Jersey NUGs, MTC and other restructuring items. A key driver of the $43.3 million change was $27.5 million for the New Jersey deferral disallowance from 2003. ACE’s rates for the recovery of these costs are reset annually and the rates will vary year to year. On ACE’s balance sheet a regulatory asset includes an under-recovery of $99.4 million as of December 31, 2004. This amount is net of a $46.1 million write-off on previously disallowed items under appeal.

 

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Impairment Losses

 

The impairment losses recorded by PHI in 2003 consist of an impairment charge of $53.3 million from the cancellation of a CT contract and an $11.0 million aircraft impairment.

 

Gain on Sale of Assets

 

During 2004 PHI recorded $30.0 million in pre-tax gains on the sale of assets compared to a $68.8 million pre-tax gain in 2003. The 2004 pre-tax gains primarily consist of (i) a $14.7 million pre-tax gain from the condemnation settlement with the City of Vineland relating to the ACE transfer of distribution assets and customer accounts, (ii) an $8.3 million pre-tax gain on the sale of aircraft by PCI, and (iii) a $6.6 million pre-tax gain on the sale of land. The $68.8 million pre-tax gain in 2003 represents the gain on the sale of PHI’s office building which was owned by PCI.

 

Other Income (Expenses)

 

PHI’s other expense (which is net of other income) decreased $88.0 million to $341.0 million in 2004, from $429.0 million in 2003. The decrease was primarily due to a pre-tax impairment charge of $102.6 million related to PHI’s investment in Starpower that was recorded during 2003, compared to an additional pre-tax impairment charge of $11.2 million that was recorded during the second quarter of 2004.

 

Preferred Stock Dividend Requirements of Subsidiaries

 

Preferred Stock Dividend Requirements decreased by $11.1 million to $2.8 million in 2004 from $13.9 million in 2003. Of this decrease, $6.9 million was attributable to SFAS No. 150, which requires that dividends on Mandatorily Redeemable Serial Preferred Stock declared subsequent to July 1, 2003 be recorded as interest expense. An additional $4.6 million of the decrease resulted from lower dividends in 2004 due to the redemption of the Trust Originated Preferred Securities in 2003.

 

Income Tax Expense

 

Pepco Holdings’ effective tax rate for 2004 was 40% as compared to the federal statutory rate of 35%. The major reasons for this difference were state income taxes (net of federal benefit), the flow-through of certain book tax depreciation differences and the settlement with the IRS on certain non-lease financial assets (which is the primary reason for the higher effective tax rate as compared to 2003), partially offset by the flow-through of Deferred Investment Tax Credits and tax benefits related to certain leveraged leases and the benefit associated with the retroactive adjustment for the issuance of final consolidated tax return regulations by a taxing authority.

 

Pepco Holdings’ effective tax rate for 2003 was 37% as compared to the federal statutory rate of 35%. The major reasons for this difference were state income taxes (net of federal benefit) and the flow-through of certain book tax depreciation differences, partially offset by the flow-through of Deferred Investment Tax Credits and tax benefits related to certain leveraged leases.

 

The results of operations discussion below is for the year ended December 31, 2003 compared to the year ended December 31, 2002.

 

Revised Segment Presentation

 

In accordance with the provisions of SFAS No. 131, results for the years ended December 31, 2003 and 2002 have been revised to conform to the 2004 segment presentation. This was required by Statement of Financial Accounting Standards (SFAS) No. 131 “Disclosures about Segments of an Enterprise and Related Information,” because Pepco Holdings’ management identified its operating segments at January 1, 2004 as

 

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Power Delivery, Conectiv Energy, Pepco Energy Services, and Other Non-Regulated. Prior to January 1, 2004, Pepco Holdings’ Power Delivery business consisted of two operating segments, Pepco and Conectiv Power Delivery. However, with the continued integration of the Power Delivery businesses, effective January 1, 2004 these two businesses represented a single operating segment. Additionally, effective January 1, 2004, PHI transferred several operating businesses from one operating segment to another in order to better align their operations going forward.

 

Lack of Comparability of 2003 and 2002 Operating Results

 

The accompanying results of operations for the year ended December 31, 2003 include Pepco Holdings’ and its subsidiaries’ results for the full year. Because of merger accounting that was used to record Pepco’s acquisition of Conectiv, the results of operations for 2002 include the results of Pepco and its pre-merger subsidiaries (PCI and Pepco Energy Services) for the entire year consolidated with the results of Conectiv and its subsidiaries starting on August 1, 2002, the date the merger was completed. Accordingly, the results of operations for 2003 and 2002 are not comparable.

 

Operating Revenue

 

PHI’s operating revenue increased by $2,946.8 million to $7,271.3 million in 2003, from $4,324.5 million in 2002. This increase was primarily due to an increase in operating revenue of $1,497.2 million at Power Delivery, an increase of $1,645.7 million at Conectiv Energy, and an increase of $260.5 million at Pepco Energy Services. Intercompany revenues that are eliminated in consolidation are included as part of business segment operating revenues.

 

The $1,497.2 million increase in Power Delivery’s operating revenue for 2003 primarily resulted from the fact that PHI recognized $2,489.7 million in revenue from Conectiv Power Delivery in 2003 (full year) vs. $997.4 million during 2002 (post August 1, 2002 merger date operations), an increase of $1,492.3 million. Additionally, Pepco’s operating revenues increased by $14.1 million in 2003. The $14.1 million increase in Pepco’s operating revenue in 2003 resulted from the following:

 

Delivery revenue increased by $18.5 million for the year ended December 31, 2003. This increase results from a $19.2 million increase from a fuel tax pass through, partially offset by $.7 million decrease in Delivery revenue (revenue Pepco receives for delivering energy to its customers). The $.7 million decrease results from a .6% decrease in delivered kilowatt-hour sales.

 

Standard offer service (SOS) revenue (revenue Pepco receives for the procurement of energy by Pepco for its SOS customers) increased by $4.2 million for the year ended December 31, 2003 due to colder winter weather as heating degree days increased by 12.2%, offset by milder summer weather as cooling degree days decreased by 30.2%.

 

Pepco’s retail access to a competitive market for generation services was made available to all Maryland customers on July 1, 2000 and to D.C. customers on January 1, 2001. As of December 31, 2003, 14% of Pepco’s Maryland customers and 11% of its D.C. customers had chosen alternate suppliers. These customers accounted for 912 megawatts of load in Maryland (of Pepco’s total load of 3,439) and 970 megawatts of load in D.C. (of Pepco’s total load of 2,269). As of December 31, 2002, 16% of Pepco’s Maryland customers and 13% of its D.C. customers had chosen alternate suppliers. These customers accounted for 1,175 megawatts of load in Maryland (of Pepco’s total load of 3,369) and 1,140 megawatts of load in D.C. (of Pepco’s total load of 2,326).

 

Pepco’s other revenue decreased $8.6 million primarily due to lower capacity (megawatts) available to sell, lower capacity market rates and restructuring in the PJM market.

 

The $1,645.7 million increase in Conectiv Energy’s operating revenue during 2003 resulted from the fact that PHI recognized $2,859.0 million in revenue in 2003 (full year) vs. $1,213.3 million during 2002 (post August 1, 2002 merger date operations).

 

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The increase in Pepco Energy Services’ operating revenue during 2003 of $260.5 million was primarily due to growth in its commodity business from sales of electricity and natural gas due to higher volumes which resulted from more commercial and industrial customers being served and higher prices due to wholesale commodity market conditions. In 2003, wholesale and retail megawatt hour sales increased by approximately 16% and wholesale and retail dekatherm sales increased by approximately 19%.

 

Operating Expenses

 

Fuel and Purchased Energy and Other Services Cost of Sales

 

PHI’s fuel and purchased energy and other services cost of sales increased by $2,400.8 million to $5,202.6 million in 2003 from $2,801.8 million in 2002. This increase was primarily due to an increase in Power Delivery of $1,005.8 million, an increase in Conectiv Energy of $1,598.4 million, and an increase in Pepco Energy Services of $255.1 million. Intercompany fuel purchases that are eliminated in consolidation are included in business segment fuel purchases.

 

The $1,005.8 million increase in Power Delivery’s fuel and purchased energy and other services cost of sales for 2003 primarily resulted from the fact that PHI recognized $1,610.5 million in fuel and purchased energy and other services cost of sales from Conectiv Power Delivery in 2003 (full year) vs. $641.2 million during 2002 (post August 1, 2002 merger date operations), an increase of $969.3 million. Additionally, Pepco’s fuel and purchased energy increased by $29.8 million in 2003. The $29.8 million increase in Pepco’s fuel and purchased energy in 2003 resulted from the recording of a $14.5 million reserve to reflect a potential exposure related to a pre-petition receivable from Mirant Corp., for which Pepco filed a creditor’s claim in bankruptcy proceedings and from $15.3 million from higher SOS costs.

 

The $1,598.4 million increase in Conectiv Energy’s fuel and purchased energy and other services cost of sales for 2003 primarily resulted from the fact that PHI recognized $2,695.6 million in fuel and purchased energy and other services cost of sales from Conectiv Energy in 2003 (full year) vs. $1,097.2 million during 2002 (post August 1, 2002 merger date operations), an increase of $1,598.4 million.

 

The increase in Pepco Energy Services’ fuel and purchased energy and other services cost of sales during 2003 of $255.1 million primarily resulted from growth in its retail commodity business for sales of electricity and natural gas due to higher volumes which resulted from more commercial and industrial customers being served and higher prices due to wholesale commodity market conditions.

 

Other Operation and Maintenance

 

PHI’s other operation and maintenance increased by $243.9 million to $767.8 million in 2003 from $523.9 million in 2002. This increase was primarily due to an increase in Power Delivery of $212.7 million and an increase in Conectiv Energy of $55.4 million. The $212.7 million increase in Power Delivery’s other operation and maintenance for 2003 primarily resulted from the fact that PHI recognized $394.9 million in other operation and maintenance from Conectiv Power Delivery in 2003 (full year) vs. $146.3 million during 2002 (post August 1, 2002 merger date operations), an increase of $248.6 million.

 

Depreciation and Amortization

 

PHI’s depreciation and amortization increased by $182.3 million to $422.1 million in 2003 from $239.8 million in 2002. This increase was primarily due to an increase in Power Delivery of $147.0 million and an increase in Conectiv Energy of $26.8 million. The $147.0 million increase in Power Delivery’s depreciation and amortization for 2003 primarily resulted from the fact that PHI recognized $186.2 million in depreciation and amortization from Conectiv Power Delivery in 2003 (full year) vs. $62.8 million during 2002 (post August 1, 2002 merger date operations), an increase of $123.4 million. Additionally, Pepco’s depreciation and amortization increased by $23.2 million in 2003 due to software amortization.

 

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Other Taxes

 

PHI’s other taxes increased by $48.3 million to $273.9 million in 2003 from $225.6 million in 2002. This increase was primarily due to an increase in Power Delivery of $44.4 million. The $44.4 million increase in Power Delivery’s other taxes for 2003 primarily resulted from the fact that PHI recognized $59.7 million in other taxes from Conectiv Power Delivery in 2003 (full year) vs. $24.8 million during 2002 (post August 1, 2002 merger date operations), an increase of $34.9 million. Additionally, Pepco’s other taxes increased by $9.1 million in 2003 due to higher fuel taxes.

 

Deferred Electric Service Costs

 

PHI’s deferred electric service costs increased by $5.2 million in 2003 due to the net under-recovery associated with New Jersey NUGs, MTC and other restructuring items.

 

Impairment Losses

 

The $64.3 million in impairment losses in 2003 consists of charges of $53.3 million for Conectiv Energy CT contract cancellation and write downs and $11.0 million related to a PCI aircraft write-down.

 

Gain on Sale of Assets

 

The $68.8 million gain on sale of assets is recorded net against operating expenses and represents the gain on the sale of PHI’s office building in 2003 which was owned by PCI.

 

Other Income (Expenses)

 

PHI’s other expenses increased by $238.6 million to $429.0 million in 2003 from $190.4 million in 2002. This increase was primarily due to an increase in other expenses of $57.6 million recognized at Power Delivery, an increase of $99.7 million in Other Non Regulated, and an increase of $65.0 million in Corporate and Other.

 

The $57.6 million increase in Power Delivery’s other expenses for 2003 primarily resulted from the fact that PHI recognized $82.4 million in expenses from Conectiv Power Delivery in 2003 (full year) vs. $38.1 million in 2002 (post August 1, 2002 merger date operations), an increase of $44.3 million.

 

The $99.7 million increase in Other Non Regulated operating expense for the year ended 2003 primarily includes an impairment charge of $102.6 million ($66.7 million after-tax) related to PHI’s investment in Starpower. Because of the distressed telecommunications market and the changed expectations of Starpower’s future performance, PHI determined that its investment in Starpower was impaired at December 31, 2003.

 

“Corporate and other” in 2003 primarily represents unallocated PHI capital costs, incurred as a result of long-term acquisition financing entered into in late 2002.

 

Income Tax Expense

 

Pepco Holdings effective tax rates in 2003 and 2002 were 37% compared to the federal statutory rate of 35%. The major reasons for this difference are state income taxes (net of federal benefit) and the flow-through of certain book tax depreciation differences partially offset by the flow-through of Deferred Investment Tax Credits and the tax benefits related to certain leveraged leases.

 

Extraordinary Item

 

In July 2003, the New Jersey Board of Public Utilities (NJBPU) approved the determination of stranded costs related to ACE’s January 31, 2003, petition relating to its B.L. England generating facility. The NJBPU approved recovery of $149.5 million. As a result of the order, ACE reversed $10.0 million of accruals for the possible disallowances related to these stranded costs. The credit to income of $5.9 million is classified as an extraordinary gain in Pepco Holdings’ financial statements, since the original accrual was part of an extraordinary charge in conjunction with the accounting for competitive restructuring in 1999.

 

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CAPITAL RESOURCES AND LIQUIDITY

 

This section discusses Pepco Holdings’ capital structure, cash flow activity, capital spending plans and other uses and sources of capital for 2004 and 2003.

 

Capital Structure

 

The components of Pepco Holdings’ capital structure, expressed as a percentage of total capitalization (including short-term debt and current maturities of long-term debt but excluding transition bonds issued by Atlantic City Electric Transition Funding LLC (ACE Funding) and PES’ project funding secured by customer accounts receivable) is shown below as of December 31, 2004 and 2003. The debt issued by ACE Funding and Pepco Energy Services project funding, which are both effectively securitized, are excluded because the major credit rating agencies treat effectively securitized debt separately and not as general obligations of the Company, when computing credit quality measures. (Dollars in Millions).

 

     2004

    2003

 

Common Shareholders’ Equity

   $ 3,366.3    39.2 %   $ 3,003.3    34.6 %

Preferred Stock (a)

     54.9    .6       108.2    1.3  

Debentures Issued to Financing Trust (b)

     —      —         98.0    1.1  

Long-Term Debt (c)

     5,003.3    58.3       5,101.3    58.8  

Short-Term Debt (d)

     161.3    1.9       360.0    4.2  
    

  

 

  

Total

   $ 8,585.8    100.0 %   $ 8,670.8    100.0 %
    

        

      

(a) Represents Mandatorily Redeemable Serial Preferred Stock of a Subsidiary, Serial Preferred Stock, and Redeemable Serial Preferred Stock issued by subsidiaries of PHI.
(b) Represents debentures issued to financing trusts and current portion of debentures issued to financing trusts.
(c) Includes first mortgage bonds, medium term notes, other long-term debt (other than debt issued by ACE Funding and Pepco Energy Services project funding), current maturities of long-term debt (other than debt issued by ACE Funding and Pepco Energy Services project funding), and Variable Rate Demand Bonds. Excludes capital lease obligations, transition bonds issued by ACE Funding, and Pepco Energy Services’ project funding secured by customer accounts receivable.
(d) Excludes current maturities of long-term debt, capital lease obligations due within one year, and Variable Rate Demand Bonds.

 

In 2003, PHI established a goal of reducing its total debt and preferred stock outstanding by $1 billion by the end of 2007 to improve PHI’s interest coverage ratios and achieve a ratio of consolidated equity to total capital (excluding Transition Bonds issued by ACE Funding and Pepco Energy Services’ project funding) in the mid-40% range. The debt reduction goal is expected to be met through a combination of internally generated cash, equity issuances through its Shareholder Dividend Reinvestment Plan (DRP), and asset dispositions.

 

    In 2004, PHI reduced its debt and preferred stock outstanding by approximately $480 million through a combination of cash flow from operating activities, less investing activities and dividends (approximately $134 million), proceeds from the issuance of PHI common stock, including the DRP, net of issuance costs (approximately $308 million), and reduction in cash and cash equivalents, net of other financing costs (approximately $38 million).

 

    In 2003, PHI reduced its debt and preferred stock outstanding by approximately $250 million through a combination of cash flow from operating activities, less investing activities and dividends (approximately $231 million), proceeds from the issuance of common stock, primarily through the DRP, net of issuance costs (approximately $33 million), and less the increase in cash and cash equivalents net of other financing costs (approximately $14 million).

 

Because the $278 million public offering of PHI common stock in 2004 was not contemplated in the original $1 billion of debt reduction plan, PHI has raised its debt reduction goal to $1.3 billion by 2007. (See Risk Factors for a description of factors that could cause PHI to not meet this goal.)

 

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Set forth below is a summary of long-term financing activity during 2004 for Pepco Holdings and its subsidiaries.

 

Pepco Holdings issued 1,471,936 shares of common stock under its Shareholder Dividend Reinvestment Plan and various benefit plans. The proceeds from the issuances were added to PHI’s general funds.

 

Pepco Holdings sold 14,950,000 shares of common stock at $19.25 per share. The proceeds, in combination with short-term debt, were used to pre-pay in its entirety a term loan in the amount of $335 million of Conectiv Bethlehem, LLC.

 

Pepco issued $275 million of secured senior notes with maturities of 10 and 30 years. Proceeds of $272.8 million were used to redeem higher interest rate securities of $210 million and to repay short-term debt of $56.6 million. Pepco borrowed $100 million under a bank loan due in 2006. Proceeds were used to redeem mandatorily redeemable preferred stock of $42.5 million and to repay short-term debt.

 

DPL issued $100 million of unsecured notes that mature in 2014. Proceeds of $98.9 million were used to redeem trust preferred securities of $70 million and to repay short-term debt.

 

ACE issued $54.7 million of insured auction rate tax-exempt securities and $120 million of secured senior notes which mature in 2029 and 2034 respectively. Proceeds of $173.2 million were used to redeem higher interest rate securities.

 

Working Capital

 

At December 31, 2004, Pepco Holdings’ current assets on a consolidated basis totaled $1.7 billion and its current liabilities totaled $1.9 billion. At December 31, 2003, PHI’s current assets totaled $1.7 billion and its current liabilities totaled $2.2 billion.

 

PHI’s working capital deficit results in large part from the fact that, in the normal course of business, PHI’s utility subsidiaries acquire energy supplies for their customers before the supplies are delivered to, metered and then billed to customers. Short-term financings are used to meet liquidity needs. Short-term financings are also used, at times, to temporarily fund redemptions of long-term debt, until long-term replacement issues are completed.

 

A detail of PHI’s short-term debt balance is as follows:

 

    As of December 31, 2004
($ in Millions)


Type


  PHI
Parent


  Pepco

  DPL

  ACE

  ACE
Funding


  Conectiv
Energy


  PES

  PCI

  Conectiv

  PHI
Consolidated


Variable Rate Demand Bonds

  $ —     $ —     $ 104.8   $ 22.6   $ —     $ —     $ 31.0   $ —     $ —     $ 158.4

Current Portion of Long-Term Debt

    —       100.0     2.7     40.0     28.1     —       .1     60.0     280.0     510.9

Project Funding Secured by Accounts Receivable

    —       —       —       —       —       —       5.4     —       —       5.4

Floating Rate Note

    50.0     —       —       —       —       —       —       —       —       50.0

Commercial Paper

    78.6     —       —       32.7     —       —       —       —       —       111.3
   

 

 

 

 

 

 

 

 

 

Total

  $ 128.6   $ 100.0   $ 107.5   $ 95.3   $ 28.1   $ —     $ 36.5   $ 60.0   $ 280.0   $ 836.0
   

 

 

 

 

 

 

 

 

 

 

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    As of December 31, 2003
($ in Millions)


Type


  PHI
Parent


  Pepco

  DPL

  ACE

  ACE
Funding


  Conectiv
Energy


  PES

  PCI

  Conectiv

  PHI
Consolidated


Variable Rate Demand Bonds

  $ —     $ —     $ 104.8   $ 22.6   $ —     $ —     $ 31.0   $ —     $ —     $ 158.4

Current Portion of Long-Term Debt

    200.0     —       7.0     11.0     25.9     —       —       86.0     50.0     379.9

Project Funding Secured by Accounts Receivable

    —       —       —       —       —       —       5.0     —       —       5.0

Construction Loan

    —       —       —       —       —       310.0     —       —       —       310.0

Floating Rate Note

    —       50.0     —       —       —       —       —       —       —       50.0

Commercial Paper

    —       —       —       —       —       —       —       —       —       —