Pepco Holdings DEF 14A 2006
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 ¨
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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.
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2005 Annual Report to Shareholders
I am pleased to report that PHIs strategy of focusing on a low-risk, stable, power delivery business, complemented by our growing competitive energy business is creating value for shareholders. Executing on our strategy has enabled us to deliver steady cash flow, a stronger balance sheet and an improved total return. Significantly, in January, for the first time since Pepco Holdings creation, our Board of Directors declared a dividend increase. Since the merger, weve delivered on our commitment to create value by:
I will provide further details on our progress in this letter.
2005 Results of Operations Improve
PHI had a successful year in 2005 with consolidated earnings of $371.2 million, or $1.96 per share, compared to $260.6 million, or $1.48 per share, in 2004.
Our power delivery business continues to achieve consistent results and, as planned, generates the majority of our earnings. In 2005, these earnings were boosted by warmer summer weather. Pepco Energy Services, our competitive retail arm, saw very favorable results driven primarily by an increase in retail electric load, and Conectiv Energy, our wholesale energy business, performed well despite a difficult market.
Lower interest expense and a number of special items in 2005 helped our earnings performance. Pepco, our Washington, D.C.-based utility, sold excess non-utility land located in the District of Columbia in August 2005 with an after-tax gain of about $40 million. In addition, Pepco sold its allowed claim in the Mirant Corporation bankruptcy proceeding for a cash payment of $112.4 million in December 2005. We
anticipate that customers under existing gain-sharing arrangements will receive slightly more than $40 million of that amount. The remaining after-tax proceeds of about $42 million were recorded as earnings in 2005.
Excluding all special items, earnings would have been $287.8 million or $1.52 per share in 2005, compared to $273.6 million, or $1.56 per share in 2004. The 2005 per-share amount is diluted by 14 cents as a result of equity we issued in September 2004.
Forbes magazine affirmed our progress in January 2006 by naming PHI to Forbes Platinum 400, an exclusive list of Americas Best Big Companies. PHI was ranked against its industry peers in the areas of sales and earnings growth, stock market returns, debt to total capital and forecasts for continued earnings growth.
We are Meeting Industry Challenges
During 2005, we saw the continued evolution of the utility industry, shaped by events such as the passage of the Energy Policy Act and rising fuel prices.
The Energy Policy Act, enacted in August 2005, was the most comprehensive energy legislation in more than a decade. The Act mandated standards for electric reliability that are enforceable by the Federal Energy Regulatory Commission (FERC) through a national Electric Reliability Organization, a move which we have been actively supporting. It also contained provisions designed to provide incentives for transmission investment and to expedite siting of transmission lines. This is central to PHI as we have a number of key transmission projects either under way or planned over the next several years. Overall, the Energy Policy Act was a good step forward, but how far forward wont be known until all the additional regulations to implement the Act are fully developed.
Rising Energy Prices Present Challenges
In the forefront of our customers and regulators minds are rising energy prices. In 2006, PHIs Delaware customers will become the final PHI customer group to complete the transition to market pricing of electricity supply as rate caps expire in that state.
Since 1999, when deregulation laws were passed and rates were frozen, the cost of the primary fuels used to produce electricity has increased dramaticallydelivered coal prices have almost doubled; crude oil prices have almost tripled; and natural gas prices have quadrupled. In Delaware, according to rules established by the Delaware Public Service Commission, in 2006 we bid out 100 percent of Delmarva Powers Delaware default supply load. Because of the increase in fuel prices, the average residential bill is expected to increase by 59 percent.
Customers in other PHI jurisdictions have moved to market-priced electricity supply over the past two years. Because we have been competitively bidding multiple contracts with staggered expiration dates, the impact of rising energy prices has been somewhat diffused in these jurisdictions.
We recognize that significant increases in energy bills can cause hardship for our customers. As a result, we presented a wide-ranging proposal to the Delaware regulatory commission to help ease the impact of rising energy prices, which includes a three step phase-in of rates for residential and small commercial customers over a 13-month period. Similarly, in Maryland, we have proposed programs to help stabilize rates. We also are launching a comprehensive energy conservation program in all our jurisdictions to help customers reduce their energy usage.
Expiration of Delivery Rate Caps is Drawing Near
In our Maryland and District of Columbia service areas, we are preparing rate cases in anticipation of delivery rate caps being lifted in December 2006 and August 2007, respectively. In Delaware, we have a base-rate case pending. Because of these cases, we foresee a period of continued high regulatory activity, as we seek to
include in rates the costs associated with doing business and a reasonable rate of return for building a reliable infrastructure to serve our customers.
The regulatory process will not be devoid of hurdles, but I believe PHIs history of constructive regulatory relationships, strengthened by our return to the heritage utility brands, will result in a balanced outcome for our customers and shareholders.
We had several successful regulatory outcomes in 2005. Our Atlantic City Electric utility settled a New Jersey rate case, which resulted in an annual pre-tax earnings increase of $20 million. We also reached a settlement that clears the way for us to proceed with the auction of the B.L. England generating station which, if not sold, we plan to retire in 2007.
Stock Performance and Equity Ratio Improve
As I noted earlier, we have made real progress in strengthening our balance sheet and executing on the operational front. As you may recall, the Mirant bankruptcy issues have been a concern to both equity and debt analysts. Now that most of the issues associated with Mirants bankruptcy are being resolved in our favor, our stock price is improving and in 2005 tracked higher than other Standard & Poors Midcap Utilities. In addition, at the end of 2005 we were in the top 10 of our peer group for stock yield.
I am particularly pleased with the pace with which we have paid down our debt. Our goal has been to improve our equity ratio by reducing debt by $1.3 billion during the 2003-2007 period. Through 2005, we paid down over $1.1 billion of debt and expect to reach our 2007 goal. As a result of these actions, the issuance of common equity in 2004, and earnings growth in 2005, our equity ratio has been steadily rising and were on target to achieve a ratio in the mid 40 percent range by the end of 2007.
During 2005, we significantly improved our investor relations efforts, meeting more routinely with investors and providing more transparency to PHI. We believe Wall Street and our rating agencies now have a much better understanding of PHIs strategy, and these efforts, along with delivering good financial results, have been reflected in our stock price.
Prudent Investments Drive Expansion of Utility Rate Base
We believe our balance sheet progress is sustainable, even with higher capital expenditures. Thats because our investments are prudent and focusedaimed to improve reliability, meet load growth and enhance customer service. Over the next five years, we plan to invest $2.4 billion in our utility infrastructure. About $540 million of this investment will be in transmission, including projects to replace electricity supply from B.L. England, and enhance reliability of electric service in the District of Columbia. In addition, we are building a 230 kilovolt line in Delaware which spans most of the length of the state. These investments lay the groundwork for the future and build our utility rate base.
Increased Dividend Reflects Strengthened Performance
I have said consistently that we would raise the dividend when appropriate to reflect improvement in our financial performance. Our growth in earnings, steady pay down of debt, and ability to manage costs while funding new investments, among other measures, have all combined to improve the balance sheet significantly and enabled your Board to declare in January 2006 a 4 percent increase in the annual dividend rate. Importantly, progress in all these areas is a testament to our strong and predictable cash flow.
A Look to the Future
I am encouraged by the future of our businesses. Utility sales are growing at a steady rate. The higher electrical system load, paired with record summer heat, produced all-time peak demand for electricity in each of our service areas in July 2005. The system performed well,
demonstrating our infrastructure planning, investment and maintenance are on track. In addition, we held a comprehensive emergency preparedness drill that tested our Incident Command System for handling large-scale outages, potential threats to the Companys reputation and other crisis situations.
In the face of escalating energy prices and consumer expectations, customer satisfaction remained steady. To serve our customers better, we are pursuing a strategy of operational excellence that focuses on enhancing information to customers; improving the accuracy of estimated restoration times and increasing community involvement which is so pivotal to our success.
Our utility business also is ramping up its productivity improvement efforts to enhance operational efficiencies and reduce costs. Extended labor agreements successfully negotiated over the past 18 months support our cost containment and productivity goals.
In our competitive energy businesses, I expect enhanced growth and value as well. Our wholesale energy business performed well through a cyclical downturn and is competitively positioned as the regional wholesale market begins to recover. We managed the challenges by engaging in a successful hedging strategy, reducing risk, increasing fuel storage capacity and leveraging our unique generation assets and our expertise.
In the retail arena, our commercial and industrial load continues to grow and the business is expanding into a number of new regions outside of the mid-Atlantic area. Performance continues to improve. The business now ranks sixth nationally in electric retail competitive energy supply.
Our Employees and Directors Make the Difference
None of our successes could have been accomplished without our valued employees, who often go the extra mile in the community serving customers and helping the environment, the homeless or other admirable causes. I am particularly proud of our crews safe and selfless performance in the Gulf Coast region, where many employees traveled to restore electricity to hurricane victims. In addition, many of our employees made monetary, material and other contributions to those affected by the hurricanes.
I am pleased by the continued recognition by outside entities of our diversity focus. In 2005, PHI was recognized by Fortune and Black Enterprise magazines as a top employer for minorities; by AARP for employing individuals age 50 and older; by the Veterans Business Journal as one of the Top 10 Corporate Supplier Diversity Programs for veteran-owned businesses and by Asian American Business Roundtable as the 2005 Corporate Small Business Advocate.
I would like to acknowledge your Board of Directors who in 2005 took a very active role in assessing PHIs strategy. Your Board provides strong oversight in governance and performance management, and I applaud their talent and commitment.
Overall, 2005 was a good year. Our total return to investors, balance sheet and cash flow each improved and I expect continued improvement in the future. PHI remains a very good value with a stable, regulated delivery business focus supported by a profitable and growing competitive business segment. We look forward to embracing this future and providing our shareholders with enhanced value.
Dennis R. Wraase
Chairman of the Board,
President and Chief Executive Officer
March 30, 2006
Washington, D.C. 20068
Notice of Annual Meeting of Shareholders
March 30, 2006
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 19, 2006 (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 20, 2006, 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.
Annual Meeting of Shareholders
Pepco Holdings, Inc.
March 30, 2006
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 2006 Annual Meeting. This Proxy Statement, together with the Companys 2005 Annual Report to Shareholders, which is attached as Annex B 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 4, 2006.
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 19, 2006 (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 the Companys 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 five candidates nominated by the Board of Directors and identified in Item 1 in this Proxy Statement.
The Board recommends a vote FOR 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 18, 2006. 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 director nominees and FOR the ratification of PricewaterhouseCoopers LLP as the Companys 2006 independent registered public accounting firm.
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 recordholder.
Who is eligible to vote?
All shareholders of record at the close of business on March 20, 2006 (the record date) are entitled to vote at the Annual Meeting. As of the close of business on the record date 190,037,810 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 (the Dividend Reinvestment Plan) and (ii) if you are a participant in the Pepco Holdings, Inc. Retirement Savings Plan (the Retirement Savings Plan), 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 Dividend Reinvestment Plan voted?
Shares held by the 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. Any shares held in the Dividend Reinvestment Plan for which no voting instructions are given will not be voted.
What does it mean if I receive more than one proxy card?
If you receive more than one proxy 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 the Retirement Savings Plan (which is the successor plan to the (i) Potomac Electric Power Company Savings Plan for Bargaining Unit Employees,
(ii) Potomac Electric Power Company Retirement Savings Plan for Management Employees (which also is the successor to the Potomac Electric Power Company Savings Plan for Non-Exempt, Non-Bargaining Unit Employees; the Potomac Electric Power Company Retirement Savings Plan for Management Employees was formerly known as the Potomac Electric Power Company Savings Plan for Exempt Employees), (iii) Conectiv Savings and Investment Plan and the Conectiv PAYSOP/ESOP and (iv) 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 the plan. By completing, dating, signing and returning this proxy card or granting a proxy via the Internet or by telephone, 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 on each matter in proportion to the voting instructions given by all of 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 or through the Dividend Reinvestment Plan or Retirement Savings Plan, you may revoke your proxy, regardless of the manner in which it was submitted, by:
If you hold shares through a brokerage firm, bank or other financial intermediary, you should contact that intermediary for instructions on how to change your vote.
How can I obtain more information about the Company?
The Companys 2005 Annual Report to Shareholders is included as Annex B after page A-3 of this Proxy Statement. You may also visit the Companys Web site at www.pepcoholdings.com.
1. ELECTION OF DIRECTORS
Twelve directors currently constitute the entire Board of Directors of the Company. Immediately prior to the commencement of the 2006 Annual Meeting, the number of directors will be increased to 13. In 2005, the Companys Restated Certificate of Incorporation was amended to reinstate the annual election of Board members except that any director who prior to the 2006 Annual Meeting was elected to a term that continues beyond the 2006 Annual Meeting will continue in office for the remainder of his or her elected term or until his or her earlier death, resignation or removal. Accordingly, at the Annual Meeting, five directors are to be elected, each to hold office for a one-year term that expires at the 2007 Annual Meeting, and until his or her successor is elected and qualified. The five directors who will continue in office until 2007 and the three directors who will continue in office until 2008 are listed on pages 8 and 9, respectively, of this Proxy Statement.
Terence C. Golden, Frank O. Heintz, George F. MacCormack, Lawrence C. Nussdorf and Lester P. Silverman were recommended for nomination to the Board by the Corporate Governance/Nominating Committee. Messrs. Heintz and Silverman were identified for consideration as nominees by one or more non-management directors. Messrs. Golden, MacCormack and Nussdorf are incumbent directors.
The Board of Directors recommends a vote FOR each of the five nominees listed on the following page.
What vote is required to elect the directors?
Each director shall be elected by a majority of the votes cast for his or her election.
In January 2006, the Companys Bylaws were amended to provide that each director shall be elected by a majority of the votes cast for his or her election, except that in a contested election where the number of nominees exceeds the number of directors to be elected, directors shall be elected by a plurality of the votes cast. Accordingly, at the 2006 Annual Meeting, a nominee will be elected as a director only if a majority of the votes present and entitled to vote are cast for his election. In accordance with the Companys Bylaws, any incumbent nominee who fails to receive a majority of votes cast for his or her election is required to resign from the Board no later than 90 days after the date of the certification of the election results.
What happens if a nominee is unable to serve as a director?
Each nominee identified in this Proxy Statement has confirmed that he 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.
For Terms Expiring in 2007
Terms Expiring in 2007
DIRECTORS CONTINUING IN OFFICE
Terms Expiring in 2008
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 listing standards. Applying these standards, the Board has determined that nine of the Companys current 12 directors, consisting of Messrs. Dunn, Golden, MacCormack, McGlynn, Nussdorf, OMalley, and Ross and Mmes. McKenzie (who is retiring effective with the Annual Meeting) and Schneider qualify as independent and that if Messrs. Golden, Heintz, MacCormack, Nussdorf and Silverman are elected at the Annual Meeting, ten of the Companys 13 directors consisting of Messrs. Dunn, Golden, Heintz, MacCormack, McGlynn, Nussdorf, OMalley, Ross and Silverman and Ms. Schneider following the Annual Meeting will qualify as independent.
For a director to be considered independent under NYSE listing standards, a director cannot have any of the disqualifying relationships enumerated by the NYSE listing standards 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 listing standards, 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 listing standards, 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 2005?
In 2005, the Board of Directors held eight meetings. The Board has five separately designated standing Committees:
Each Committees 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, directors who are not employees of the Company or any of its subsidiaries (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 Independent Director. The Compensation/Human Resources Committee meets separately with its compensation consultant. The Audit Committee meets separately with the Vice President and General Auditor and the independent registered public accounting firm.
The Audit Committee held nine meetings in 2005. 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 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. 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 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 listing standards of the NYSE.
The Compensation/Human Resources Committee held six meetings in 2005. 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 Pepco Holdings, Inc. Long-Term Incentive Plan (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 (Chairman), McKenzie, OMalley and Ross. 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 listing standards of the NYSE.
The Corporate Governance/Nominating Committee held seven meetings in 2005. The Committees duties and responsibilities include making recommendations to the Board regarding the governance of the Company and the Board, and 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, McGlynn, McKenzie, OMalley (Chairman) and Schneider. 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 listing standards of the NYSE.
The Executive Committee held one meeting in 2005. 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 Cronin, McKenzie (Chairman), OMalley, Torgerson and Wraase.
The Finance Committee held eight meetings in 2005. 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 2005, 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 2005 Annual Meeting, 11 attended.
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 79 of this Proxy Statement and on the Companys Web site (www.pepcoholdings.com) under the link: Corporate Governance. 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: Vice President and General Auditor, 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, and will be reported by the Internal Audit Group to the Audit Committee. If for any reason the employee does not wish to submit a communication to the Vice President and General Auditor, it may be addressed to the Chairman of the Audit Committee using the procedure set forth above, or can be sent via mail, telephone, facsimile or e-mail to the Companys Ethics Officer. Employees may also leave messages on the Companys Ethics Officer hotline.
What are the directors paid for their services?
Commencing January 1, 2005, each of the Companys non-management directors 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 a standing Committee of the Board receives an additional retainer of $5,000, except that the Chairman of the Audit Committee receives $7,500. The director who serves as Lead Independent Director receives, in addition to any other compensation, an additional retainer of $2,500.
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.
Under the Non-Management Director Compensation Plan (the Director Compensation Plan), 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 Compensation/Human Resource Committee. 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 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, in 2003, the Board of Directors discontinued these grants.
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, which is also available for use by the directors other than in connection with the performance of their duties as directors.
The following table sets forth, as of March 24, 2006, for each non-management director who has elected to receive all or a portion of his or her annual retainer and meeting fees in phantom stock under the 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 24, 2006, for each director, director nominee, the five executive officers named in the Summary Compensation Table on page 17 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 sets forth, as of March 24, 2006, 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 (the Exchange Act) requires the directors and executive officers of a company with a class of equity securities registered under Section 12 of the Exchange Act and any beneficial owner of more than 10% of any class of the companys equity securities to file with the SEC certain reports of holdings and transactions in the companys equity securities. Based on a review of the reports filed for 2005 and on written confirmations provided by its directors and executive officers, the Company believes that during 2005 all of its directors and executive officers filed on a timely basis the reports required by Section 16(a), except that Frank K. Ross, a director of the Company, filed one day late a report on Form 4 disclosing the purchase of 3,000 shares of the Companys Common Stock.
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 four other most highly compensated executive officers of the Company determined on the basis of aggregate salary and bonus for the year ended December 31, 2005 (collectively, the Named Executive Officers). The information presented in the table includes compensation paid by the Company or its subsidiaries.
SUMMARY COMPENSATION TABLE
In addition to the compensation shown in the above Summary Compensation Table, each of the Named Executive Officers was 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 use of Company-leased entertainment venues other than for business purposes. 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 SEC, the value of these perquisites has not been included in the Table.
The number and aggregate market value of all restricted shares of Common Stock held by the Named Executive Officers at December 31, 2005, were: Mr. Wraase, 14,822 shares with a market value of $329,567; Mr. Shaw, 44,871 shares with a market value of $997,707; Mr. Rigby, 1,923 shares with a market value of $42,758; and Mr. Spence, 1,923 shares with a market value of $42,758. Mr. Torgerson held no restricted shares at December 31, 2005.
AND FISCAL YEAR-END OPTION VALUES
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 (but not the participants pre-tax contributions made under the Retirement 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, 2006) 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 62, 37 years of credited service and $1,142,274 and Mr. Torgerson, age 61, 36 years of credited service and $688,682. 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 $7,238,000 for Mr. Shaw, $3,758,000 for Mr. Rigby and $2,067,000 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 he had retired on January 1, 2006) used to determine retirement benefits (including supplemental benefits) are as follows: age 58, 34 years of credited service and $913,091. Mr. Spences current years of credited service and earnings (assuming he had retired on January 1, 2006) used to determine retirement benefits (including supplemental benefits) are as follows: age 48, 18 years of credited service and $455,604. Earnings consist of base salary and bonus as shown in the 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 he had retired on January 1, 2006) used to determine retirement benefits (including supplemental benefits) are as follows: age 49, 27 years of credited service and $469,786. Earnings consist of base salary and bonus as shown in the Salary and Bonus columns of the Summary Compensation Table.
ATLANTIC CITY ELECTRIC PENSION PLAN TABLE
Messrs. Wraase, Torgerson, Shaw, 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 and Spences 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, 2004 and 2005 was credited with one additional year of service and 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 2005 and is expected to render services to the Companys subsidiaries in 2006.
ON EXECUTIVE COMPENSATION
The Compensation/Human Resources Committee of the Board of Directors (the Committee) is composed entirely of independent directors. The 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 Committee deems appropriate. The 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 Committee also approves the salaries for the executive officers and the heads of the major subsidiaries, as well as the salaries of the Vice Presidents of the Company. The Committee 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 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 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 independent compensation consultant and receives input from the Chief Executive Officer and management, as it deems appropriate.
Officer Compensation Philosophy
The objective of the Companys executive compensation program 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. In this way, the program provides a strong and direct link between compensation and executive performance and short- and long-term Company performance. To be competitive, the Companys compensation policy is to provide a total compensation opportunity comparable to the median compensation levels of energy utility companies of a similar size.
The compensation program for executives consists of three components: (i) base salary, (ii) annual cash incentive awards under Executive Incentive Compensation Plan and (iii) long-term incentive awards under the Long-Term Incentive Plan. The combination of these three elements is intended to balance short- and long-term business performance goals and align executive 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. For 2005, long-term incentive awards were in the form of performance restricted shares of Common Stock (Restricted Stock) that will be earned at the end of a three-year performance period to the extent pre-established goals relating to total shareholder returns are met. The executive compensation program for 2005 was structured so that between 33 and 65% of the total compensation opportunity, depending on the responsibility level of the executive, was 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 requirements for executives effective January 1, 2005. Ownership requirements are expressed as a multiple of salary. Officers are given until December 31, 2010, or five years after their election, whichever is
later, to attain the ownership guidelines. The following table is the amount of Common Stock required to be owned by the Companys officers, expressed as a multiple of salary.
Under Section 162(m) of the Internal Revenue Code, a public company is prohibited from deducting for federal income tax purposes compensation in excess of $1 million paid to any of the companys five highest paid executive officers, except if the compensation in excess of $1 million qualifies for an exemption, such as the performance-based compensation exemption. The Companys Long-Term Incentive Plan has been designed to allow the Committee to grant options and performance Restricted Stock that will qualify as performance-based compensation. However, the 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. The Restricted Stock awarded in January 2006 which vests solely on the basis of continued employment, rather than performance, will not qualify as performance-based compensation in the year in which it vests. Cash awards under the Companys Executive Incentive Compensation Plan also do not qualify as performance-based compensation within the meaning of Section 162(m).
Executive Compensation Plan Review
In 2005, the Committee retained the services of an independent compensation consultant to review all of the Companys compensation plans and make recommendations for plan changes, where appropriate. The review covered base salary and total cash compensation levels, short-term and long-term incentive programs design, employment/severance agreements, retirement benefit plans, deferred compensation plans, and perquisites. Based on the review of its consultants data, the Committee has taken the following actions commencing in 2006 to further align the interests of the Companys executives and senior management with investors long-term interests:
Modifications were also made to executive retirement benefit plans and deferred compensation plans to bring them into compliance with the provisions of Internal Revenue Code Section 409A.
Factors Considered in Making Compensation Decisions
The CEO makes recommendations for compensation actions for his direct reports, which the Committee individually reviews, discusses, adjusts in its judgment and approves. The Committee also reviews the compensation decisions for senior management who report to the CEOs direct reports. The Committee judgments regarding executive compensation are primarily based on the Committees assessment of each executives performance and potential to enhance long-term stockholder value. Key factors affecting the Committees judgment include: the nature and scope of the executives responsibilities; the executives contribution to the Companys financial and operating results; and the executives effectiveness in leading the Companys initiatives to increase customer satisfaction and shareholder value.
SalaryIn setting each executives 2006 salary, the Committee used input from the Committees consultant along with management recommendations for individual adjustments. The consultant used published survey sources as well as a review of proxy statements from the new peer group of companies in the energy utility industry. Consistently effective individual performance is a threshold requirement for any salary increase. The CEO recommended base salary adjustments for certain executives using industry market movements as a guideline while also considering the relationship of current pay to market data, performance and internal equity. Following a review and discussion, the Committee approved base salary adjustments for the executives taking into account the recommendations of the CEO. The Committee also developed a recommendation for the 2006 pay increase of the CEO for consideration by the independent members of the Board of Directors for approval.
Short-Term IncentivesFor 2005, performance goals established for annual cash bonus awards to the members of the Companys senior management, including the President and Chief Executive Officer, under the Executive Incentive Compensation Plan were based on (1) earnings relative to the corporate plan, (2) cash available for debt reduction, (3) electric system reliability, (4) diversity and (5) safety. For 2005, a target bonus level of 60% of base salary was set for the CEO. For 2005, results related to the performance criteria were as follows: (1) earnings were significantly above target, (2) cash for debt reduction significantly exceeded target, (3) electric system reliability was above target, (4) diversity was at target and (5) safety was below target. Each component was assigned a weighting prior to the performance period. Based on the overall results, the corporate performance was set at 121.6% of target. Corporate performance is used to determine the award level for the CEO.
Long-Term IncentivesUnder the Long-Term Incentive Plan, the 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 2006, the Committee adopted a performance program with a three-year performance period that ends in 2008. The target 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 connection with the merger of Pepco and Conectiv, the Committee implemented, effective August 1, 2002, a retention and performance plan entitled Merger Integration Success Program, adopted under the Long-Term Incentive Plan. The Merger Integration Success Program had two components: (1) Restricted Stock grants vesting over three years (20% in 2003, 30% in 2004, and 50% in 2005), provided the executive remained 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 were attained through December 31, 2003 and December 31, 2004, respectively. Although these goals were met in 2003, the Committee determined that the shares which would have vested in 2003 would not vest until 2005, and then only if the cost reduction goals were maintained and the Companys financial performance was satisfactory.
For 2005, the cost reduction goals were exceeded and the Companys financial performance had improved as measured by earnings growth, debt reduction and improved credit statistics and the shares vested. The CEO was awarded 9,421 shares of Common Stock.
In 2002, the Pepco Board of Directors granted executives the opportunity to earn awards of Restricted Stock based on the Companys total shareholder return as compared to 20 peer utility companies over a three-year performance period beginning in 2003 and ending in 2005. For the three-year period, total shareholder return was below the threshold level of performance of the plan and accordingly no shares were earned.
Compensation of the Chief Executive Officer
In 2005, the Committee increased Mr. Wraases salary from $769,000 to $825,000. The amount of the salary increase was set to position Mr. Wraase at a level comparable to the CEOs of the utility company peer group then in effect, with consideration given to the CEOs performance evaluation conducted by the Corporate Governance/Nominating Committee. In making its evaluation, the Corporate Governance/Nominating Committee considered the successes in debt reduction, the Common Stock offering, succession planning and management development, diversity efforts, safety record, emergency response capability, business unit integration, Sarbanes-Oxley compliance, strategic plan implementation, and the overall progress in improving shareholder return.
During 2005, the Committees consultant reviewed the group of companies used to make executive pay decisions and recommended changes to better align the size and business of peer companies with the Company (see Executive Compensation Plan Review Modified Peer Group). The CEOs compensation was found to be below the 50th percentile of the new peer group and below the 25th percentile of a survey of utility company CEOs, size-adjusted to the Companys fiscal year-end 2004 revenues. In 2005, the Corporate Governance/Nominating Committees evaluation of the CEO considered the Companys performance in debt reduction, reliability improvements, strategic planning and third-party recognition of the Companys diversity practices. The Corporate Governance/Nominating Committee also recognized the continued success in succession planning and the successful return to the traditional brand names of the Companys utilities. The Corporate Governance/Nominating Committees 2005 evaluation of CEO performance indicated to the Committee that the CEO should be compensated more closely with the market median. Accordingly, the Committee began to address this shortfall in 2006 through increases in base salary and short- and long-term incentive opportunity. Effective in 2006, a salary of $950,000, a target short-term incentive of 100% of salary, and a target long-term incentive of 200% of salary have been set for Mr. Wraase. Consistent with the other executives, two-thirds of the long-term incentive will be in the form of performance Restricted Stock and one-third will be in the form of Restricted Stock.
In addition to reviewing market data, the Committee also considered the relationship between Mr. Wraases pay and that of the other Company executives. The Committee believes the relative differences are appropriate. The Committee and the independent members of the Board of Directors have had discussions and made decisions relative to Mr. Wraases compensation in executive session, without the CEO present.
In summary, a substantial portion of Mr. Wraases potential compensation for 2005 and 2006 is incentive based with the achievement of specific performance results required to earn awards. As a result, the Committee believes his total compensation package meets the Committees compensation objectives, is in line with the Committees compensation philosophy, and supports the Companys business strategy.
FIVE-YEAR PERFORMANCE GRAPH 2001-2005
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 2005. First, the Audit Committee discussed with PricewaterhouseCoopers LLP, the Companys independent registered public accounting firm for 2005, 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, 2005 and 2004, and the Companys consolidated statements of earnings, comprehensive earnings, shareholders equity and cash flows for the three years ended December 31, 2005, 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 2005 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 2005.
Lawrence C. Nussdorf, Chairman
Terence C. Golden
Richard B. McGlynn
Frank K. Ross
2. 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 2005. The Audit Committee has reappointed the firm for 2006. 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 2007. 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.
The aggregate fees billed by PricewaterhouseCoopers LLP for professional services rendered for the audit of the Companys and subsidiaries annual financial statements for the 2005 and 2004 fiscal years and the reviews of the financial statements included in the Companys and subsidiary reporting companies 2005 and 2004 Forms 10-Q were $5,354,083 and $6,801,420, respectively. The amount for 2004 includes $543,328 for the 2004 audit that was billed after the 2005 Pepco Holdings proxy statement was filed.
The aggregate fees billed by PricewaterhouseCoopers LLP for audit-related services rendered for the 2005 and 2004 fiscal years were $170,053 and $586,088, 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 2005 and 2004 fiscal years were $8,400 and $261,680, respectively. These services consisted 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 2005 and 2004 fiscal years were $3,000 and $55,600, respectively. Of the amount for 2005, $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 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.
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 A.
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 2 ON THE PROXY CARD.
What is the deadline for submission of shareholder proposals for inclusion in the Companys Proxy Statement for the 2007 Annual Meeting?
In order to be considered for inclusion in the Proxy Statement for the 2007 Annual Meeting, shareholder proposals must be received by the Company on or before November 29, 2006.
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 2007 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 2007 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 2007 Annual Meeting must be submitted in writing to the Secretary of the Company on or before November 29, 2006, 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 Officer 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 NYSE 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 the Companys 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.
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 and 2005 Annual Report 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 2005 Annual Report to Shareholders 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 American Stock Transfer & Trust Company, 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 American Stock Transfer & Trust Company 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?
The Company 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 the Company and its subsidiaries. The Companys Board of Directors has also adopted Corporate Governance Guidelines and charters for the Companys 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 the Companys Executive Committee and Finance Committee. Copies of these documents are available on the Company Web site at http://www.pepcoholdings.com/governance/index.html and also can be obtained by writing to: Ellen Sheriff Rogers, Vice President and Secretary, 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 the Company 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 B 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 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.
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. (PHI or Pepco Holdings) is a public utility holding company that, through its operating subsidiaries, is engaged primarily in two principal business operations:
PHI was incorporated in Delaware in 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. The following chart shows, in simplified form, the corporate structure of PHI and its principal subsidiaries.
On February 8, 2006, the Public Utility Holding Company Act of 1935 (PUHCA 1935) was repealed and the Public Utility Holding Company Act of 2005 (PUHCA 2005) went into effect. As a result, PHI has ceased to be regulated by the Securities and Exchange Commission (SEC) as a public utility holding company and is now subject to the regulatory oversight of the Federal Energy Regulatory Commission (FERC). As permitted under FERC regulations promulgated under PUHCA 2005, PHI will give notice to FERC that it will continue, until further notice, to operate pursuant to the authority granted in the financing order issued by the SEC under PUHCA 1935, which has an authorization period ending June 30, 2008, relating to the issuance of securities and guarantees, other financing transactions and the operation of the money pool. See Managements Discussion and Analysis of Financial Condition and Results of OperationsPUHCA Restrictions for additional information.
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 was filed with, and approved by, the SEC under PUHCA 1935. 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. PHI expects to continue operating under the service agreement and is evaluating whether to seek FERC approval of the cost allocation methodologies in the service agreement under PUHCA 2005.
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 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). The Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and all amendments to those reports, of each of the companies 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.
The following is a description of each of PHIs two principal 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 2005, 2004 and 2003, respectively, PHIs Power Delivery operations produced 58%, 61% and 55% of PHIs consolidated operating revenues (including intercompany transactions) and 74%, 70% and 82% of PHIs consolidated operating income (including income from intercompany transactions).
PHIs Power Delivery business is conducted by its three regulated utility subsidiaries: Pepco, DPL and ACE. Each subsidiary is a regulated public utility in the jurisdictions that comprise its service territory. 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 carry electricity to end-use customers in the utilitys regulated service territory.
Delivery of Electricity and Natural Gas and Default Electricity Supply
Each company is responsible for the delivery of electricity and, in the case of DPL, natural gas in its service territory, for which it is paid tariff rates established by the local public service commission. Each company also supplies electricity at regulated rates to retail customers in its service territory who do not elect to purchase electricity from a competitive energy supplier. The regulatory term for this supply service varies by jurisdiction as follows:
PHI and its subsidiaries refer to this supply service in each of the jurisdictions generally as Default Electricity Supply.
In the aggregate, the Power Delivery business delivers electricity to more than 1.8 million customers in the mid-Atlantic region and distributes natural gas to approximately 120,000 customers in Delaware.
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 eastern United States. FERC has designated a number of regional transmission organizations to coordinate the operation and planning of portions of the interstate transmission grid. Pepco, DPL and ACE are members of the PJM Regional Transmission Organization. PJM Interconnection, LLC (PJM) provides transmission planning functions and acts as the independent system operator that coordinates the movement of electricity in all or parts of Delaware, Illinois, Indiana, Kentucky, Maryland, Michigan, New Jersey, North Carolina, Ohio, Pennsylvania, Tennessee, Virginia, West Virginia and the District of Columbia. FERC has designated PJM as the sole provider of transmission service in the PJM region. Any entity that wishes to have electricity delivered at any point in the PJM region must obtain transmission services from PJM at rates approved by FERC. In accordance with FERC rules, Pepco, DPL, ACE and the other transmission-owning 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 transmission owners fees approved by FERC.
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, 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 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 in the ACE section, herein.
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 electric 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, 2005, Pepco delivered electricity to approximately 747,000 customers, as compared to 737,000 customers as of December 31, 2004. Pepco delivered a total of approximately 27,594,000 megawatt hours of electricity in 2005, compared to approximately 26,902,000 megawatt hours in 2004. In 2005, approximately 30% was delivered to residential customers, 51% to commercial customers, and 19% to United States and District of Columbia government customers.
Under a settlement approved by the MPSC in April 2003, Pepco is required to provide SOS to residential and small commercial customers through May 2008 and to medium-sized commercial customers through May 2006, and was required to provide SOS to large commercial customers through May 2005. Pepco also has an obligation to provide service at hourly priced rates to the largest customers through May 2006. In accordance with the settlement, Pepco purchases the power supply required to satisfy its SOS 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 SOS customers the cost of the SOS supply plus an average margin of approximately $.002 per kilowatt hour (calculated at the time of the announcement of the contracts, based on total sales to residential and small and large commercial Maryland SOS 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 SOS 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 SOS customers and customers in Maryland who have selected another energy supplier. These delivery rates are capped through December 31, 2006 pursuant to the MPSC order issued in connection with the Pepco acquisition of Conectiv, but are subject to adjustment if FERC transmission rates increase by more than 10%.
Under an order issued by the DCPSC in March 2004, as amended by a DCPSC order issued in July 2004, Pepco is obligated to provide SOS for small commercial and residential customers through May 31, 2011 and for large commercial customers through May 31, 2007. Pepco purchases the power supply required to satisfy its SOS obligation from wholesale suppliers under contracts entered into pursuant to a competitive bid procedure approved by the DCPSC. Pepco is entitled to recover from its SOS customers the costs associated with the acquisition of the SOS supply plus administrative charges that are intended to allow Pepco to recover the administrative costs incurred to provide the SOS. These administrative charges include an average margin for Pepco of approximately $.00248 per kilowatt hour (calculated at the time of the announcement of the contracts, based on total sales to residential and small and large commercial District of Columbia SOS 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 SOS 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 SOS customers and customers in the District of Columbia who have selected another energy supplier. Delivery rates in the District of Columbia generally are capped through July 2007, but are subject to adjustment if FERC transmission rates increase by more than 10%, except that for residential low-income customers, rates generally are capped through July 2009.
For the twelve months ended December 31, 2005, 62% of Pepcos Maryland sales (measured by megawatt hours) were to SOS customers, as compared to 71% in 2004 and 42% of its District of Columbia sales were to SOS customers, as compared to 68% in 2004.
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, 2005, DPL delivered electricity to approximately 510,000 customers and delivered natural gas to approximately 120,000 customers, as compared to 501,000 electricity customers and 118,000 natural gas customers as of December 31, 2004.
In 2005, DPL delivered a total of approximately 14,101,000 megawatt hours of electricity to its customers, as compared to a total of approximately 13,902,000 megawatt hours in 2004. In 2005, approximately 40% of DPLs retail electricity deliveries were to residential customers, 38% were to commercial customers and 22% were to industrial customers. In 2005, DPL delivered approximately 20,700,000 Mcf (one thousand cubic feet) of natural gas to retail customers in its Delaware service territory, as compared to approximately 21,600,000 Mcf in 2004. In 2005, approximately 41% of DPLs retail gas deliveries were sales to residential customers, 27% were sales to commercial customers, 5% were sales to industrial customers, and 27% were sales to customers receiving a transportation-only service.
Under a settlement approved by the DPSC, DPL is required to provide POLR service to customers in Delaware through April 2006. DPL is paid for supplying POLR service to customers in Delaware at fixed rates established in the settlement. DPL obtains all of the energy needed to fulfill its POLR obligations in Delaware under a supply agreement with its affiliate Conectiv Energy, which terminates in April 2006. DPL does not make any profit or incur any loss on the supply component of the POLR supply 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 POLR 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 March 22, 2005, the DPSC issued an order approving DPL as the SOS provider after May 1, 2006, when DPLs current fixed rate POLR obligation ends. DPL will retain the SOS obligation for an indefinite period until changed by the DPSC, and will purchase the power supply required to satisfy its SOS obligations from wholesale suppliers under contracts entered into pursuant to a competitive bid procedure. On October 11, 2005, the DPSC approved a settlement agreement, under which DPL will provide SOS to all customer classes, with no specified termination date for SOS. Two categories of SOS will exist: (i) a fixed price SOS available to all but the largest customers; and (ii) an Hourly Priced Service (HPS) for the largest customers. DPL will purchase the power supply required to satisfy its fixed-price SOS obligation from wholesale suppliers under contracts entered into pursuant to a competitive bid procedure. Power to supply the HPS customers will be
acquired on next-day and other short-term PJM markets. In addition to the costs of capacity, energy, transmission, and ancillary services associated with the fixed-price SOS and HPS, DPLs initial rates will include a component referred to as the Reasonable Allowance for Retail Margin (RARM). Components of the RARM include a fixed annual margin of $2.75 million, plus estimated incremental expenses, a cash working capital allowance, and recovery with a return over five years of the capitalized costs of a billing system to be used for billing HPS customers.
Under a settlement approved by the MPSC in April 2003, DPL is required to provide SOS to residential and small commercial customers through May 2008 and to medium-sized commercial customers through May 2006. In accordance with the settlement, DPL purchases the power supply required to satisfy its market rate SOS obligation 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 SOS customers the costs of the SOS supply plus an average margin of $.002 per kilowatt hour (calculated at the time of the announcement of the contracts, based on total sales to residential and small and large commercial Maryland SOS 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 SOS 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 SOS customers and customers in Maryland who have selected another energy supplier. These delivery rates generally are capped through December 2006, subject to adjustment if FERC transmission rates increase by more than 10%.
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 that commenced on January 1, 2005 and expires in May 2006 (the 2005 Supply Agreement). DPL entered into the 2005 Supply Agreement after conducting a competitive bid procedure in which Conectiv Energy was the lowest bidder.
In October 2004, DPL filed an application with the VSCC for approval to increase the rates that DPL charges its Default Service customers to allow it to recover its costs for power under the 2005 Supply Agreement plus an administrative charge and a margin. A VSCC order issued in November 2004 allowed DPL to put interim rates into effect on January 1, 2005, subject to refund if the VSCC subsequently determined the rates are excessive. The interim rates reflected an increase of 1.0247 cents per kilowatt hour (Kwh) to the fuel rate, which provides 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. In January 2005, the VSCC ruled that the administrative charge and margin are base rate items not recoverable through a fuel clause. On March 25, 2005, the VSCC approved a settlement resolving all other issues and making the interim rates final.
DPL is paid tariff delivery rates for the delivery of electricity over its transmission and distribution facilities to both 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 SOS customers represented 77% of total sales (measured by megawatt hours) for the twelve months ended December 31, 2005, as compared to 80% in 2004. In Delaware, DPL sales to POLR customers represented 90% of total sales (measured by megawatt hours) for the twelve months ended December 31, 2005, as compared to 89% in 2004. In Virginia, DPL sales to Default Supply customers represented 100% of total sales (measured by megawatt hours) in both 2005 and 2004.
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, 2005, DPL supplied 72.8% of the natural gas that it delivered, compared to 71.8% in 2004.
ACE is primarily engaged in the transmission and distribution of electricity in a service territory consisting of 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, 2005, ACE delivered electricity to approximately 532,000 customers in its service territory, as compared to approximately 524,000 customers as of December 31, 2004. ACE delivered a total of approximately 10,080,000 megawatt hours of electricity in 2005 compared to approximately 9,874,000 megawatt hours in 2004. In 2005, approximately 44% was delivered to residential customers, 43% was delivered to commercial customers and 13% was delivered to industrial customers.
In accordance with a process mandated by the NJBPU, electric customers in New Jersey who do not choose another supplier receive BGS from their electric distribution company. Each of New Jerseys electric distribution companies, including ACE, jointly procure the supply to meet their BGS obligations from competitive suppliers selected through two concurrent auctions authorized by the NJBPU for New Jerseys total BGS requirement each February. The winning bidders in the auction are required to supply a specified portion of the BGS customer load with full requirements service, consisting of power supply and transmission service.
ACE provides two types of BGS:
As of December 31, 2005, Conectiv Energy served four 100 megawatt blocks of BGS load in the ACE territory.
ACE is paid tariff delivery rates for the delivery of electricity over its transmission and distribution facilities to both BGS customers and customers in its service territory who have selected another energy supplier. ACE is also paid tariff rates established by the NJBPU that compensate it for the cost of obtaining the BGS from competitive suppliers. ACE does not make any profit or incur any loss on the supply component of the BGS it provides to customers.
ACE sales to New Jersey BGS customers represented 78% of total sales (measured by megawatt hours) for the twelve months ended December 31, 2005 and 2004.
In addition to its electricity transmission and distribution operations, as of December 31, 2005, ACE owned the B.L. England electric generating facility (with a generating capacity of 447 megawatts) and a 2.47% undivided interest in the Keystone electric generating facility and a 3.83% undivided interest in the Conemaugh
electric generating facility. The combined generating capacity of these facilities is 555 megawatts. ACE also has contracts with non-utility generators under which ACE purchased 3.8 million megawatt hours of power in 2005. 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 2005, ACEs generation and wholesale electricity sales operations produced approximately 30% of ACEs operating revenue.
On November 15, 2005, ACE entered into an agreement to sell its undivided interests in the Keystone and Conemaugh generating facilities to Duquesne Light Holdings Inc. for $173.1 million. The sale, subject to approval by the NJBPU, as well as other regulatory agencies and certain other legal conditions, is expected to be completed mid-year 2006. In December 2005, ACE filed testimony with the NJBPU in estimating that its net gains on the sale of the generating stations will be approximately $126.9 million; however, the net gains ultimately realized will be dependent upon the timing of the closing of the sale, transaction costs and other factors. The net gains will be an offset to stranded costs.
ACE is continuing its efforts to sell the B.L. England generating facility. On January 24, 2006, PHI, Conectiv and ACE entered into an administrative consent order (ACO) with the New Jersey Department of Environmental Protection (NJDEP) and the Attorney General of New Jersey, which provides that ACE will permanently cease operation of the B.L. England generating facility by December 15, 2007 if it does not sell the facility before then. The shut-down is contingent upon the receipt by ACE of necessary approvals from applicable regulatory authorities and permits to construct certain electric transmission facilities in southern New Jersey. See Environmental MattersAir Quality Regulation.
In 2001, ACE established Atlantic City Electric Transition Funding L.L.C. (ACE Funding) solely for the purpose of securitizing authorized portions of ACEs recoverable stranded costs through the issuance and sale of bonds (Transition Bonds). The proceeds of the sale of each series of Transition Bonds have been transferred to ACE in exchange for the transfer by ACE to ACE Funding of the right to collect a non-bypassable transition bond charge from ACE customers pursuant to bondable stranded costs rate orders issued by the NJBPU in an amount sufficient to fund the principal and interest payments on the Transition Bonds and related taxes, expenses and fees (Bondable Transition Property). The assets of ACE Funding, including the Bondable Transition Property, and the Transition Bond charges collected from ACEs customers, are not available to creditors of ACE. The holders of Transition Bonds have recourse only to the assets of ACE Funding.
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 2005, 2004 and 2003, respectively, PHIs Competitive Energy operations produced 51%, 50% and 55% of PHIs consolidated operating revenues. In 2005 and 2004, respectively, PHIs Competitive Energy operations produced 16% and 19% of PHIs consolidated operating income. In 2003, PHIs Competitive Energy operations incurred an operating loss equal to 20% 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 and short-term bilateral contracts. Among its bilateral contracts are the power supply agreements under which Conectiv Energy sells to DPL electricity required by DPL to fulfill its Default Electricity Supply obligations for customers in Delaware and Virginia and for a portion of its Maryland customers. Conectiv Energy also supplies electric power to satisfy a portion of ACEs Default Electric Supply load, as well as Default Electric Supply load to other mid-Atlantic utilities. Other than its Default Electricity Supply sales, Conectiv Energy does not
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, under bilateral contracts entered into with 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 more frequently and for longer periods of time than peak-load plants because of better heat rates. As of December 31, 2005, Conectiv Energy owned and operated mid-merit plants with a combined 2,713 megawatts of capacity, peak-load plants with a combined 639 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- and short-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. A portion 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 cost of its contracts relating to Default Electricity Supply in order to ensure stable and known minimum cash flows and lock-in 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 a targeted portion of both the expected power output of its generation facilities and the expected costs of fuel used to operate those facilities. The hedge goals are approved by PHIs Corporate Risk Management Committee and may change from time to time based on market conditions, and the actual level of coverage may vary from the target depending on the extent to which the company is successful in implementing its hedging strategies. In July 2003, Conectiv Energy entered into an agreement with an international investment banking firm consisting of a series of energy contracts designed to hedge more effectively approximately 50% of Conectiv Energys generation output and approximately 50% of its supply obligations, with the intention of providing Conectiv Energy with a more predictable earnings stream during the term of the agreement. The agreement will expire in May 2006. For additional discussion of Conectiv Energys hedging activities, see Quantitative and Qualitative Disclosures.
Pepco Energy Services
Pepco Energy Services sells retail electricity and natural gas primarily to commercial, industrial and governmental customers primarily 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, and fuel management. 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. For additional discussion of Pepco Energy Services hedging activities, see Quantitative and Qualitative Disclosures.
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 produced less revenue when weather conditions are milder than normal. Such weather conditions can also negatively impact income from these operations. Energy management services generally are not seasonal.
Other Business Operations
Over the last several years, PHI has discontinued its investments in non-energy related businesses, including the sale of its aircraft investments and the sale of its 50% interest in Starpower Communications LLC (Starpower). Through its subsidiary, Potomac Capital Investment Corporation (PCI), PHI continues to maintain a portfolio of cross-border energy sale-leaseback transactions, with a book value at December 31, 2005 of approximately $1.3 billion. For additional information concerning these cross-border lease transactions, see Note (12) Commitments and Contingencies to the consolidated financial statements of PHI, Managements Discussion and Analysis of Financial Condition and Results of OperationsRisk Factors. This activity constitutes a separate operating segment for financial reporting purposes which is designated Other Non-Regulated.
CONDITION AND RESULTS OF OPERATIONS
Pepco Holdings restated its previously reported consolidated financial statements as of December 31, 2004 and for the years ended December 31, 2004 and 2003, the quarterly financial information for the first three quarters in 2005, and all quarterly periods in 2004, to correct the accounting for certain deferred compensation arrangements. The restatement includes the correction of other errors for the same periods, primarily relating to unbilled revenue, taxes, and various accrual accounts, which were considered by management to be immaterial. These other errors would not themselves have required a restatement absent the restatement to correct the accounting for deferred compensation arrangements. This restatement was required solely because the cumulative impact of the correction, if recorded in the fourth quarter of 2005, would have been material to that periods reported net income. See Note 15 Restatement for further discussion.
CONSOLIDATED RESULTS OF OPERATIONS
The accompanying results of operations discussion is for the year ended December 31, 2005, compared to the year ended December 31, 2004. All amounts in the tables (except sales and customers) are in millions.
A detail of the components of PHIs consolidated operating revenues 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 and the delivery of electricity to PHIs customers within its service territories at regulated rates.
Default Supply Revenue is the revenue received for Default Electricity Supply. 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 for on-system natural gas sales and the transportation of natural gas for customers within PHIs service territories at regulated rates.
Other Gas Revenue consists of off-system natural gas sales and the release of excess system capacity.
Electric Operating Revenue
The Pepco, DPL and ACE service territories are located within a corridor extending from Washington, D.C. to southern New Jersey. These service territories are economically diverse and include key industries that contribute to the regional economic base.
Regulated T&D Revenue increased by $51.9 million primarily due to the following: (i) $19.3 million due to customer growth, the result of a 1.5% customer increase in 2005, (ii) $17.6 million increase as a result of a 14.7% increase in Cooling Degree Days in 2005, (iii) $1.9 million (including $3.3 million in tax pass-throughs) increase due to net adjustments for estimated unbilled revenues recorded in the second and fourth quarters of 2005, reflecting a modification in the estimation process, primarily reflecting higher estimated power line losses (estimates of electricity expected to be lost in the process of its transmission and distribution to customers) and (iv) $21.7 million increase in tax pass-throughs, principally a county surcharge (offset in Other Taxes) offset by (v) $8.6 million other sales and rate variances.
Default Electricity Supply
Default Supply Revenue increased $238.3 million primarily due to the following: (i) $251.9 million due to higher retail energy rates, the result of market-based SOS competitive bid procedures implemented in Maryland in June 2005 and the District of Columbia in February 2005, (ii) $142.2 million increase in wholesale energy revenues resulting from sales of generated and purchased energy into PJM due to higher market prices in 2005, (iii) $44.8 million due to weather (14.7% increase in Cooling Degree Days), (iv) $48.2 million increase due to customer growth, and (v) $8.1 million due to other sales and rate variances, offset by (vi) $245.0 million decrease due primarily to higher commercial customer migration, and (vii) $11.9 million decrease due to net adjustments for estimated unbilled revenues recorded in the second and fourth quarters of 2005, primarily reflecting higher estimated power line losses (estimates of electricity expected to be lost in the process of its transmission and distribution to customers).
Other Electric Revenue increased $2.1 million to $69.9 million from $67.8 million in 2004 primarily due to mutual assistance work related to storm damage in 2005 (offset in Other Operations and Maintenance expense).
Gas Operating Revenue
Power Deliverys 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 by $29.0 million primarily due to a $30.6 million increase in the Gas Cost Rate (GCR) effective November 2004 and 2005, due to higher natural gas commodity costs.
Other Gas Revenue increased by $3.9 million to $62.8 million from $58.9 in 2004 primarily due to increased capacity release revenues compared to the same period last year.
Competitive Energy Businesses
The following table divides Conectiv Energys operating revenues among its major business activities.
Merchant Generation includes sales of electric power, capacity and ancillary services from its power plants into PJM, tolling arrangements, hedges of generation power and capacity, and fuel-switching activities where the lowest cost fuel is utilized and the more expensive fuel is sold. Excess generation capacity is used to manage risk associated with Full Requirements Load Service.
Full Requirements Load Service includes service provided to affiliated and non-affiliated companies to satisfy Default Energy Supply obligations, other full requirements electric power sales contracts, and related hedges.
Other Power, Oil and Gas Marketing Services consist of all other Conectiv Energy activities not included above. These activities include primarily wholesale gas marketing, oil marketing, a large operating services agreement with an unaffiliated power plant, and the activities of the real-time power desk, which engages in arbitrage between power pools.
Total Conectiv Energy Operating Revenue includes $801.8 million and $820.3 million of affiliate transactions for 2005 and 2004, respectively.
The impact of revenue changes with respect to the Conectiv Energy component of the Competitive Energy business are encompassed within the discussion below under the heading Conectiv Energy Gross Margin.
Pepco Energy Services
The following table presents Pepco Energy Services operating revenues.
The increase in Pepco Energy Services operating revenue of $320.9 million is primarily due to (i) an increase of $228.1 million due to commercial and industrial retail load acquisition by Pepco Energy Services in 2005 at higher prices than in 2004, (ii) an increase of $39.3 million due to higher generation from its Benning and Buzzard Point power plants in 2005 due to warmer weather conditions, and (iii) an increase of $49.5 million due to higher energy services activities in 2005 resulting from contracts signed with customers under which Pepco Energy Services provides services for energy efficiency and high voltage installation projects. As of December 31, 2005, Pepco Energy Services had 2,004 megawatts of commercial and industrial load, as compared to 1,553 megawatts of commercial and industrial load at the end of 2004. In 2005, Pepco Energy Services power plants generated 237,624 megawatt hours of electricity as compared to 45,836 in 2004.
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 Delivery Business
Power Deliverys Fuel and Purchased Energy costs increased by $196.3 million primarily due to (i) $326.7 million increase for higher average energy costs resulting from Default Electricity Supply contracts implemented in 2005, (ii) $65.6 million increase due to customer growth, (iii) $33.1 million increase for gas commodity purchases, (iv) $25.8 million increase in other sales and rate variances, offset by (v) $254.9 million decrease due to higher customer migration. This expense is primarily offset in Default Supply Revenue.
Competitive Energy Business
The following table divides Conectiv Energys Fuel and Purchased Energy and Other Services Cost of Sales among its major business activities.
The totals presented include $217.7 million and $245.4 million of affiliate transactions for 2005 and 2004, respectively.
The impact of Fuel and Purchased Energy and Other Services Cost of Sales changes with respect to the Conectiv Energy component of the Competitive Energy business are encompassed within the discussion below under the heading Conectiv Energy Gross Margin.
Conectiv Energy Gross Margin
Management believes that gross margin (Revenue less Fuel and Purchased Energy and Other Services Cost of Sales) is a better comparative measurement of the primary activities of Conectiv Energy than Revenue and Fuel and Purchased Energy by themselves. Gross margin is a more stable comparative measurement and it is used extensively by management in internal reporting. The following is a summary of gross margins by activity type (Millions of dollars):
Warmer weather during the summer months of 2005 and continued PJM load growth resulted in increased demand for power and higher prices for power, causing higher Merchant Generation output and an increase in the gross margin. The higher gross margin from the sale of generation output was partially offset by negative hedge results.
The 2005 decrease in the Lower Full Requirements Load Service gross margin resulted from higher fuel and energy prices during 2005. Full Requirements Load Service is hedged by both contract purchases with third parties and by the output of the generation plants operated by Conectiv Energy.
Other Power, Oil and Gas Marketing margins decreased because of a one-time gain of $8.7 million on a group of coal contracts in 2004. This was partially offset by higher margin sales for oil marketing ($5.6 million) and gas marketing ($2.0 million) during the fourth quarter of 2005.
Pepco Energy Services
The following table presents Pepco Energy Services Fuel and Purchased Energy and Other Services cost of sales.
The increase in Pepco Energy Services fuel and purchased energy and other services cost of sales of $293.1 million resulted from (i) higher volumes of electricity purchased at higher prices in 2005 to serve commercial
and industrial retail customers, (ii) higher fuel and operating costs for the Benning and Buzzard Point power plants in 2005 due to higher electric generation that resulted from warmer weather in 2005, and (iii) higher energy services activities in 2005 resulting from contracts signed with customers under which Pepco Energy Services provides services for energy efficiency and high voltage installation projects.
Other Operation and Maintenance
A detail of PHIs other operation and maintenance expense is as follows:
PHIs other operation and maintenance increased by $19.1 million to $815.7 million for the year ended 2005 from $796.6 million for the year ended 2004 primarily due to the following: (i) a $10.3 million increase in employee related costs, (ii) $9.0 million increase in corporate services allocation, (iii) $3.9 million increase due to the write-off of software, (iv) $3.2 million increase due to mutual assistance work related to storm damage in 2005 (offset in Other Electric Revenues), and (v) $2.1 million increase in maintenance expenses, partially offset by (vi) $4.9 million reduction in the uncollectible account reserve to reflect the amount expected to be collected on Pepcos Pre-Petition Claims with Mirant and (vii) a $5.5 million decrease in PJM administrative expenses.
Depreciation and Amortization
PHIs depreciation and amortization expenses decreased by $17.9 million to $422.6 million in 2005 from $440.5 million in 2004. The decrease is primarily due to a $7.6 million decrease from a change in depreciation technique resulting from a 2005 final rate order from the NJBPU and a $4.8 million decrease due to a change in the estimated useful lives of Conectiv Energys generation assets.
Other taxes increased by $30.8 million to $342.2 million in 2005 from $311.4 million in 2004 due to higher pass-throughs, mainly as the result of a county surcharge rate increase (primarily offset in Regulated T&D Electric Revenue).
Deferred Electric Service Costs
Deferred Electric Service Costs, which relates only to ACE, increased by $83.9 million to $120.2 million in 2005, from $36.3 million in 2004. At December 31, 2005, DESC represents the net expense or over-recovery associated with New Jersey NUGs, market transition change (MTC) and other restructuring items. The $83.9 million increase represents (i) $77.1 million net over-recovery associated with New Jersey BGS, NUGS, market transition charges and other restructuring items, and (ii) $4.5 million in regulatory disallowances (net of amounts previously reserved) associated with the April 2005 NJBPU settlement agreement. ACEs rates for the recovery of those costs are reset annually and the rates will vary from year to year. At December 31, 2005, ACEs balance sheet included as a regulatory liability an over-recovery of $40.9 million with respect to these items, which is net of a $47.3 million reserve for items disallowed by the NJBPU in a ruling that is under appeal.
Gain on Sales of Assets
Pepco Holdings recorded a Gain on Sales of Assets of $86.8 million for the year ended December 31, 2005, compared to $30.0 million for the year ended December 31, 2004. The $86.8 million gain in 2005 primarily consists of: (i) a $68.1 million gain from the 2005 sale of non-utility land owned by Pepco located at Buzzard Point in the District of Columbia, and (ii) a $13.3 million gain recorded by PCI from proceeds related to the final liquidation of a financial investment that was written off in 2001. The $30.0 million gain in 2004 consists of: (i) a $14.7 million gain from the 2004 condemnation settlement with the City of Vineland relating to the transfer of ACEs distribution assets and customer accounts to the city, (ii) a $6.6 million gain from the 2004 sale of land, and (iii) an $8.3 million gain on the 2004 sale of aircraft investments by PCI.
Gain on Settlement of Claims with Mirant
The Gain on Settlement of Claims with Mirant of $70.5 million represents a settlement (net of customer sharing) with Mirant in the fourth quarter of 2005, of the Pepco TPA Claim ($70 million gain) and a Pepco asbestos claim against the Mirant bankruptcy estate ($.5 million gain).
Other Income (Expenses)
Other expenses (which are net of other income) decreased by $55.9 million to $285.5 million in 2005 from $341.4 million in 2004, primarily due to the following: (i) a decrease in net interest expense of $35.7 million, which primarily resulted from a $23.6 million decrease due to less debt outstanding during the 2005 period and a decrease of $12.8 million of interest expense that was recorded by Conectiv Energy in 2004 related to costs associated with the prepayment of debt related to the Bethlehem mid-merit facility, (ii) an $11.2 million impairment charge on the Starpower investment that was recorded during 2004, (iii) income of $7.9 million received by PCI in 2005 from the sale and liquidation of energy investments, and (iv) income of $3.9 million in 2005 from cash distributions from a joint-owned co-generation facility, partially offset by (v) an impairment charge of $4.1 million in 2005 related to a Conectiv Energy investment in a jointly owned generation project, and (vi) a pre-tax gain of $11.2 million on a distribution from a co-generation joint-venture that was recognized by Conectiv Energy during the second quarter of 2004.
Income Tax Expense
Pepco Holdings effective tax rate for the year ended December 31, 2005 was 41% 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 changes in estimates related to tax liabilities of prior tax years subject to audit, partially offset by the flow-through of Deferred Investment Tax Credits and tax benefits related to certain leveraged leases.
Pepco Holdings effective tax rate for the year ended December 31, 2004 was 39% 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, partially offset by the flow-through of Deferred Investment Tax Credits and tax benefits related to certain leveraged leases.
On April 19, 2005, ACE, the staff of the New Jersey Board of Public Utilities (NJBPU), the New Jersey Ratepayer Advocate, and active intervenor parties agreed on a settlement in ACEs electric distribution rate case. As a result of this settlement, ACE reversed $15.2 million in accruals related to certain deferred costs that are now deemed recoverable. The after-tax credit to income of $9.0 million is classified as an extraordinary gain in the 2005 financial statements since the original accrual was part of an extraordinary charge in conjunction with the accounting for competitive restructuring in 1999.
The accompanying results of operations discussion is for the year ended December 31, 2004, compared to the year ended December 31, 2003. All amounts in the tables (except sales and customers) 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.
Electric Operating Revenue
Regulated T&D Electric Sales, as measured on a Gwh basis, increased by 2% in 2004, driven by residential and commercial customer classes. Regulated T&D Revenue increased by $45.6 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 due to weather, and (iv) $39.9 million increase in tax pass-throughs, principally a county surcharge (offset in Other Taxes expense). 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 a 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 Electricity Supply
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 D.C., (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.