Pepco Holdings DEF 14A 2005
Documents found in this filing:
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:
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.
¨ Fee paid previously with preliminary materials:
Proxy Statement and
2004 Annual Report to 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:
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 Pepcos 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.
PHIs 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 Services 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 PCIs existing cross-border energy leases.
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. Were 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 regionsAtlantic City Electric, Delmarva Power and Pepcowill be spearheaded by a PHI leader who will be responsible for building mutually beneficial relationships with the local constituencies and responding to their needs.
PHIs 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 PHIs comprehensive set of business policies. Conducting the certification process by requiring completion of an online course is a best practice in corporate governance.
Competitive Employee Programs, Contracts Implemented
In 2004, we integrated the compensation and benefits programs for PHIs 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 materialfrom 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 PHIs 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 teamand 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.
Dennis R. Wraase
Chairman of the Board,
President and Chief Executive Officer
March 31, 2005
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 Companys offices located at 701 Ninth Street, N.W., Edison Place Conference Center (second floor), Washington, D.C. for the following purposes:
All holders of record of the Companys 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.
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.
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.
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 Companys 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 Companys 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 Companys 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 PHIs 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?
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.
The Board recommends a vote FOR this proposal.
The Board recommends a vote FOR this proposal.
The Board recommends a vote AGAINST this proposal.
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:
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 Directors 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.
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:
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 Companys 2004 Annual Report to Shareholders is included as Annex C after page B-3 of this Proxy Statement. You may also visit the Companys Web site at www.pepcoholdings.com.
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.
NOMINEES FOR ELECTION AS DIRECTORS
For Terms Expiring in 2008
DIRECTORS CONTINUING IN OFFICE
Terms Expiring in 2006
DIRECTORS CONTINUING IN OFFICE
Terms Expiring in 2007
Which directors are independent?
According to the Listing Standards of the New York Stock Exchange (NYSE), a majority of the Companys directors are required to be independent as defined by the NYSE rules. Currently, 10 of the Companys 13 directors consisting of Messrs. Dunn, Golden, MacCormack, McGlynn, Nussdorf, OMalley, 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 Companys 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 Companys 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 directors 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.
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 Companys 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 Companys 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 Companys Board is responsible for, among other things, representing and assisting the Board in oversight of (i) the integrity of the Companys financial statements, accounting and financial reporting processes and audits of the Companys consolidated financial statements, (ii) the Companys compliance with legal and regulatory requirements, (iii) the qualifications, independence and the retention, compensation and performance of the Companys independent registered public accounting firm, and (iv) the design and performance of the Companys internal audit function. The Audit Committee also reviews the Companys 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 Committees 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
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 Companys 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 CEOs 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 Companys 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 Companys annual salary administration program for all management employees. The Committee also makes recommendations to the Board concerning the Companys retirement and other benefit plans and oversees corporate workforce diversity issues. Committee members are Directors MacCormack, McGlynn, McKenzie, OMalley, 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 Companys Corporate Governance Guidelines and in accordance with the rules of the NYSE.
The Corporate Governance/Nominating Committee held 8 meetings in 2004. The Committees 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 Companys 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 Companys 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, OMalley (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 Companys 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, OMalley, 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 Companys 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 Chairmans opinion, it is in the Companys best interests to do so. Of the Companys 12 directors at the time of the 2004 Annual Meeting, 11 attended as did the two additional nominees who were elected as directors.
How do I send a communication to the Board of Directors or to a specific individual director?
The Companys 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 Companys directors can be found on pages 7-9 of this Proxy Statement and on the Companys Web site (www.pepcoholdings.com) under the link: Board of Directors. The Companys 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 Companys Ethics Officer hotline.
What are the directors paid for their services?
Commencing January 1, 2005, each of the Companys 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 Companys 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 Companys 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.
Although under the terms of the Companys 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 Companys 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 Companys Deferred Compensation Plan, the number of credited phantom stock units (each corresponding to one share of Common Stock).
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 Companys 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.
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 Companys securities to file with the Securities and Exchange Commission reports of their initial holdings and transactions in the Companys equity securities. To the Companys 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.
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
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 individuals 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.
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 Companys 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 Companys 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.
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.
AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR
AND FISCAL YEAR-END OPTION VALUES
LONG-TERM INCENTIVE PLANAWARDS IN LAST FISCAL YEAR
Under the Performance Restricted Stock Program established under the Companys 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 Companys 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
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 participants average salary (the term salary being equal to the amounts
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 Pepcos deferred compensation plans (other than the participants pre-tax contributions made under the Savings Plan). If an executives 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 participants name is credited with an amount equal to a percentage of the participants total pay, including base pay, overtime and bonuses, depending on the participants 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 participants 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 Plans 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 participants 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.
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. Shaws 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. Spences 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
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. Rigbys 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
Messrs. Wraase, Torgerson, Shaw, Williams, Rigby and Spence each have employment agreements with the Company. Mr. Wraases and Mr. Torgersons 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. Shaws agreement provides for his
employment through August 1, 2007. Messrs. Rigbys, Spences 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 executives 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 executives annual bonus for the year preceding termination of employment, if not yet paid, and a pro rata portion of the executives annual bonus for the year in which the executives 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 Companys 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 CEOs compensation level after taking into account the annual evaluation of the CEOs performance conducted by the Corporate Governance/Nominating Committee and such other factors as the Compensation/Human Resources Committee deems appropriate. The Compensation/Human Resources Committees responsibilities include review of the performance of elected officers and other executives in the context of the administration of the Companys 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
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 Companys 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 Companys 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 Companys 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 Companys 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.
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 companys five highest paid executive officers, except if the compensation in excess of $1 million qualifies as performance-based compensation. The Companys 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 Companys Executive Compensation Plan do not qualify as performance-based compensation within the meaning of Section 162(m).
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. Wraases 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. Wraases salary at $825,000. The Committee, in determining the salary level, considered the CEOs performance evaluation conducted by the Corporate Governance/Nominating Committee and Mr. Wraases salary in relation to compensation levels of utility companies of a similar size. In considering the CEOs 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 Companys safety record, the progress in emergency response, the integration of the Companys business units since the 2002 merger with Conectiv, the Companys 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 Companys 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 Companys 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 PlanAwards 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 Pepcos Long-Term Incentive Plan under which awards of Restricted Stock would be made based on the Companys 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.
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 Companys 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 Companys financial performance is satisfactory. For the two- year period ended December 31, 2004, the Companys 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.
FIVE-YEAR PERFORMANCE GRAPH 2000-2004
The following chart compares the Companys 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 & Poors 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.
AUDIT COMMITTEE REPORT
Among its duties, the Audit Committee is responsible for recommending to the Board of Directors that the Companys financial statements be included in the Companys 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 Companys 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 firms 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 LLPs relationships with the Company and was designed to assist the Audit Committee in considering PricewaterhouseCoopers LLPs independence. Finally, the Audit Committee reviewed and discussed, with the Companys management and with PricewaterhouseCoopers LLP, the Companys audited consolidated balance sheets at December 31, 2004 and 2003, and the Companys (or its predecessors) 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 Companys 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.
Lawrence C. Nussdorf, Chairman
Terence C. Golden
Richard B. McGlynn
Frank K. Ross
2. AMENDMENT TO RESTATED CERTIFICATED OF INCORPORATION
TO DECLASSIFY THE COMPANYS STAGGERED BOARD
The Board of Directors has approved and is submitting to a vote of the shareholders an amendment to the Companys Restated Certificate of Incorporation to reinstate the annual election of all members of the Companys 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 Companys 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 Companys staggered election of directors has contributed to continuity and stability in the composition of, and in the policies formulated by, the Companys Board of Directors. Notwithstanding these important benefits, the Committee also recognized that there appears to be a growing sentiment among shareholders generally, including the Companys 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 Companys 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
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 SECs 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 SECs 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 Companys 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.
The aggregate fees billed by PricewaterhouseCoopers LLP for professional services rendered for the audit of the Companys and subsidiaries annual financial statements for the 2004 and 2003 fiscal years and the
reviews of the financial statements included in the Companys 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.
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.
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.
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 Companys 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 Companys 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 companys 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 Companys 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 Companys 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 Companys 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 candidates 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 Companys 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 Companys 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 Companys 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 states electoral votes are also determined by a plurality vote.
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 Companys 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 proponents 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 Companys 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.
May a shareholder introduce a resolution for a vote at a future annual meeting?
Under the Companys 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 Companys 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 shareholders 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 Companys Bylaws, a shareholder may nominate an individual for election as a director at a future Annual Meeting by giving written notice of the shareholders intention to the Companys 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 nominees name, age, business address, residence address, principal occupation or employment, the class and number of shares of the Companys 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 Companys 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 Companys 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
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 Companys 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 Companys Corporate Governance Guidelines and can be found on the Companys 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 Committees consideration by following submission requirements published in the Companys proxy statement for the previous years 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 Committees 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 Companys 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 Boards 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 Companys policies and applicable laws and regulations using information supplied directly by the candidate, the candidate will then be nominated.
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 Companys proxy statements and annual reports in the future, please contact Wachovia Bank, N.A., the Companys transfer agent:
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 Companys 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.
Where do I find the Companys 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. PHIs Board of Directors has also adopted Corporate Governance Guidelines and charters for PHIs 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 PHIs 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, Managements 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.
AUDIT COMMITTEE CHARTER
The Audit Committees (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 Companys financial statements, (2) the Companys compliance with legal and regulatory requirements, (3) the independent auditors qualifications and independence, and (4) the performance of the Companys 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 Companys 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 Companys 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
After reviewing the foregoing report, and the independent auditors work throughout the year, the Audit Committee will evaluate the auditors 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 Companys 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.
Policy on the Approval of Services
Provided By the Independent Auditor
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 companys 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 Companys 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 Companys 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.
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 Companys 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 annual audit services provided to the Company and its subsidiaries by the Companys independent auditor shall consist of:
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.
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:
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.
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.
Any other services to be provided by the Companys 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.
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:
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 Companys Chief Financial Officer shall report the engagement to the Audit Committee at its next regularly scheduled meeting.
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.
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 managements 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 companys 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.
GLOSSARY OF TERMS
CONSOLIDATED FINANCIAL HIGHLIGHTS
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:
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.
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 PHIs segments, see Note (3) Segment Information to the consolidated financial statements of PHI. This segment information includes a revision of PHIs 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.
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 PHIs 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 PHIs areas of operation.
The largest component of PHIs 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, PHIs power delivery operations produced 61%, 55%, and 58% of PHIs consolidated operating revenues and 70%, 82% and 78% of PHIs consolidated operating income.
PHIs 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, PHIs 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 utilitys service territory. Distribution facilities are low-voltage systems that deliver electricity to end-use customers in the utilitys 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 PJMs 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
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 FERCs decision are subject to refund. FERCs 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 PHIs 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.
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 PHIs utility subsidiaries have generated less revenues and income when weather conditions are milder in the winter and cooler in the summer.
The retail operations of PHIs 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. Pepcos 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). DPLs 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). DPLs natural gas distribution operations in Delaware are regulated by the DPSC. ACEs 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 PHIs utility subsidiaries are regulated by FERC.
Pepco is engaged in the transmission and distribution of electricity in Washington, D.C. and major portions of Prince Georges and Montgomery Counties in suburban Maryland. Pepco was incorporated in Washington, D.C. in 1896 and became a domestic Virginia corporation in 1949. Pepcos service territory covers approximately 640
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 Managements Discussion and Analysis of Financial Condition and Results of OperationsRegulatory and Other MattersRelationship 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 Pepcos 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 Pepcos fixed-rate default supply obligations in February 2005, as amended by a DCPSC order issued in July 2004, Pepcos 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 Managements Discussion and Analysis of Financial Condition and Results of OperationsRegulatory and Other MattersRate 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.
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 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 Annes, 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. DPLs electricity distribution service territory covers approximately 6,000 square miles and has a population of approximately 1.28 million. DPLs 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 DPLs 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 DPLs 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 DPLs 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
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 DPLs 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 Virginias 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 ratesone 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.
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. ACEs 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 Managements Discussion and Analysis of Financial Condition and Results of OperationsRegulatory and Other MattersRate 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, ACEs generation and wholesale electricity sales operations produced approximately 23.2% of ACEs 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 Managements Discussion and Analysis of Financial Condition and Results of OperationsRegulatory and Other MattersPreliminary 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.
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 ACEs 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.
PHIs 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, PHIs competitive energy operations produced 50%, 55% and 48% of PHIs consolidated operating revenues. In 2004 and 2002, respectively, PHIs competitive energy operations produced 19% and 12% of PHIs consolidated operating income. In 2003, PHIs competitive energy operations incurred an operating loss equal to 19% of PHIs consolidated operating income. PHIs competitive energy operations are conducted through subsidiaries of Conectiv Energy and Pepco Energy Services.
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 ACEs 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 Energys 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 Energys 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
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 Energys 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 PHIs 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 Energys 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 Energys 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 Energys 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.
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,
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.
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.
This component of PHIs business is conducted through its subsidiary Potomac Capital Investment Corporation (PCI). PHIs subsidiary Pepco Communications, Inc. (Pepcom) ceased operations in December 2004 following the sale of its principal asset described below.
PCI manages a portfolio of financial investments, which consists primarily of energy leveraged leases. These transactions involve PCIs 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 PCIs energy leveraged leases, see Note (4) to the consolidated financial statements of PHI.
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.
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.
A detail of the components of PHIs consolidated operating revenue is as follows:
Power Delivery Business
The following table categorizes Power Deliverys operating revenue by type of revenue.
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 PHIs 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 PHIs 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 PHIs 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
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 PHIs growing T&D revenues.
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 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).
Gas Operating Revenue
DPLs natural gas service territory is located in New Castle County, Delaware. Several key industries contribute to the economic base as well as to growth.
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.
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.
Fuel and Purchased Energy and Other Services Cost of Sales
A detail of PHIs consolidated fuel and purchased energy and other services cost of sales is as follows:
Power Deliverys 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 creditors 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.
The decrease of $565.4 million in Conectiv Energys 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
PHIs 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
PHIs 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 Energys Bethlehem facility.
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. ACEs rates for the recovery of these costs are reset annually and the rates will vary year to year. On ACEs 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.
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 PHIs office building which was owned by PCI.
Other Income (Expenses)
PHIs 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 PHIs 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
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 Pepcos 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.
PHIs 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 Deliverys 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, Pepcos operating revenues increased by $14.1 million in 2003. The $14.1 million increase in Pepcos 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%.
Pepcos 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 Pepcos Maryland customers and 11% of its D.C. customers had chosen alternate suppliers. These customers accounted for 912 megawatts of load in Maryland (of Pepcos total load of 3,439) and 970 megawatts of load in D.C. (of Pepcos total load of 2,269). As of December 31, 2002, 16% of Pepcos 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 Pepcos total load of 3,369) and 1,140 megawatts of load in D.C. (of Pepcos total load of 2,326).
Pepcos 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 Energys 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).
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%.
Fuel and Purchased Energy and Other Services Cost of Sales
PHIs 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 Deliverys 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, Pepcos fuel and purchased energy increased by $29.8 million in 2003. The $29.8 million increase in Pepcos 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 creditors claim in bankruptcy proceedings and from $15.3 million from higher SOS costs.
The $1,598.4 million increase in Conectiv Energys 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
PHIs 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 Deliverys 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
PHIs 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 Deliverys 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, Pepcos depreciation and amortization increased by $23.2 million in 2003 due to software amortization.
PHIs 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 Deliverys 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, Pepcos other taxes increased by $9.1 million in 2003 due to higher fuel taxes.
Deferred Electric Service Costs
PHIs 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.
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 PHIs office building in 2003 which was owned by PCI.
Other Income (Expenses)
PHIs 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 Deliverys 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 PHIs investment in Starpower. Because of the distressed telecommunications market and the changed expectations of Starpowers 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.
In July 2003, the New Jersey Board of Public Utilities (NJBPU) approved the determination of stranded costs related to ACEs 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.
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.
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).
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 PHIs 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.
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.)
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 PHIs 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.
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, PHIs current assets totaled $1.7 billion and its current liabilities totaled $2.2 billion.
PHIs working capital deficit results in large part from the fact that, in the normal course of business, PHIs 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 PHIs short-term debt balance is as follows:
Cash Flow Activity
PHIs cash flows for 2004, 2003, and 2002 are summarized below.
Cash flows from operating activities are summarized below for 2004, 2003, and 2002.
Cash from operations is the primary source used to meet operating requirements and capital expenditures. Net cash flows provided by operating activities increased by $73.2 million to $734.6 million for 2004 from $661.4 million for 2003. The $73.2 million increase was largely the result of improved operating results at PHIs regulated utilities. Regulated T&D Electric experienced a 2% KwH growth rate in 2004, and regulated T&D Revenue increased by $45.7 million primarily due to customer growth and increased average usage, higher average effective rates, and favorable warmer weather. PHI Power Delivery produced over 85% of consolidated cash from operations in 2004 and 2003.
In 2003, cash flows from operating activities decreased by $131.7 million to $661.4 million from $793.1 million for 2002. The $131.7 million decrease was due to higher interest payments in 2003 and a federal income tax refund in 2002.
The most significant items included in cash flows from investing activities during 2004, 2003, and 2002 are summarized below.
Capital expenditures decreased $80.8 million for 2004 to $517.4 million from $598.2 million for 2003. This decrease was primarily due to lower construction expenditures for Conectiv Energy, offset by an increase in Power Delivery capital requirements to upgrade electric transmission and distribution systems.
Capital expenditures increased $94.4 million for 2003 to $598.2 million from $503.8 million for 2002. This increase was primarily due to 2002 including five months of Conectiv companies as a result of the August 1, 2002 acquisition of Conectiv by Pepco.
In 2002, net cash used by investing activities included the cash outflow of $1,075.6 million related to Pepcos acquisition of Conectiv. Excluding the impact of the Conectiv acquisition by Pepco and the investments in hydro-electric facility leveraged leases, investing activities used a net cash flow of $569.7 million compared to $254.8 million in 2003 primarily due to PCIs liquidation of its marketable securities portfolio and the sale of its final real estate investment. PHI announced in the second quarter of 2003 the discontinuation of further investment activity by PCI.
In December 2004, Pepcom sold its 50% interest in Starpower for $29 million in cash. Additionally in 2004 PHI received proceeds from the sale of aircraft and land.
In September 2003 Potomac Capital Investment (PCI) sold an office building known as Edison Place (which serves as headquarters for PHI and Pepco).