<PAGE>
Page 1 of 23
FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
Quarterly Report under Section 13 or 15(d)
of the Securities Exchange Act of 1934
For Quarter Ended June 30, 1999
Commission File Number 1-3376-2
THE POTOMAC EDISON COMPANY
(Exact name of registrant as specified in its charter)
Maryland and Virginia 13-5323955
(State of Incorporation) (I.R.S. Employer Identification No.)
10435 Downsville Pike, Hagerstown, Maryland 21740-1766
Telephone Number - 301-790-3400
The registrant (1) has filed all reports required to be filed
by Section 13 or 15(d) of the Securities Exchange Act of 1934
during the preceding 12 months and (2) has been subject to such
filing requirements for the past 90 days.
At August 13, 1999, 22,385,000 shares of the Common Stock (no
par value) of the registrant were outstanding, all of which are
held by Allegheny Energy, Inc., the Company's parent.
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THE POTOMAC EDISON COMPANY
Form 10-Q for Quarter Ended June 30, 1999
Index
Page
No.
PART I--FINANCIAL INFORMATION:
Statement of Income - Three and six months ended
June 30, 1999 and 1998 3
Balance Sheet - June 30, 1999
and December 31, 1998 4
Statement of Cash Flows - Six months ended
June 30, 1999 and 1998 5
Notes to Financial Statements 6-8
Management's Discussion and Analysis of Financial
Condition and Results of Operations 9-21
PART II--OTHER INFORMATION:
22-23
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THE POTOMAC EDISON COMPANY
Statement of Income
(Thousands of Dollars)
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
June 30 June 30
1999 1998 1999 1998
ELECTRIC OPERATING REVENUES:
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Residential $ 70,094 $ 65,932 $ 170,582 $ 156,261
Commercial 40,640 38,797 83,165 76,488
Industrial 53,756 52,412 103,819 100,924
Wholesale and other, including affiliates 3,893 10,365 9,656 21,349
Bulk power transactions, net 6,308 10,013 10,447 14,195
Total Operating Revenues 174,691 177,519 377,669 369,217
OPERATING EXPENSES:
Operation:
Fuel 32,568 35,924 69,216 71,481
Purchased power and exchanges, net 28,655 29,518 61,504 65,443
Deferred power costs, net 5,490 5,655 8,894 5,688
Other 24,595 22,521 47,279 43,699
Maintenance 13,388 12,492 27,307 27,228
Depreciation 19,151 18,720 38,108 37,365
Taxes other than income taxes 13,978 12,155 25,285 25,064
Federal and state income taxes 9,323 10,498 27,438 25,591
Total Operating Expenses 147,148 147,483 305,031 301,559
Operating Income 27,543 30,036 72,638 67,658
OTHER INCOME AND DEDUCTIONS:
Allowance for other than borrowed funds
used during construction 177 18 326 215
Other income, net 1,882 2,346 3,703 4,562
Total Other Income and Deductions 2,059 2,364 4,029 4,777
Income Before Interest Charges 29,602 32,400 76,667 72,435
INTEREST CHARGES:
Interest on long-term debt 10,722 11,740 21,354 23,540
Other interest 433 367 1,000 951
Allowance for borrowed funds used during
construction (289) (211) (587) (482)
Total Interest Charges 10,866 11,896 21,767 24,009
NET INCOME $ 18,736 $ 20,504 $ 54,900 $ 48,426
</TABLE>
See accompanying notes to financial statements.
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THE POTOMAC EDISON COMPANY
Balance Sheet
(Thousands of Dollars)
<TABLE>
<CAPTION>
June 30, December 31,
ASSETS: 1999 1998
Property, Plant, and Equipment:
At original cost, including $48,670
<S> <C> <C>
and $46,353 under construction $ 2,266,770 $ 2,249,716
Accumulated depreciation (953,860) (926,840)
1,312,910 1,322,876
Investments:
Allegheny Generating Company - common stock at equity 44,696 46,277
Other 446 473
45,142 46,750
Current Assets:
Cash and temporary cash investments 8,473 1,805
Accounts receivable:
Electric service 85,424 79,373
Affiliated and other 37,199 7,091
Allowance for uncollectible accounts (3,273) (2,203)
Notes receivable from affiliate 27,550 9,300
Notes receivable from subsidiary 59,650 66,750
Materials and supplies - at average cost:
Operating and construction 29,944 29,922
Fuel 15,515 14,098
Prepaid taxes 9,991 15,727
Other, including current portion of regulatory assets 6,329 1,092
276,802 222,955
Deferred Charges:
Regulatory assets 62,776 66,792
Unamortized loss on reacquired debt 18,491 19,012
Other 20,848 23,742
102,115 109,546
Total Assets $ 1,736,969 $ 1,702,127
CAPITALIZATION AND LIABILITIES:
Capitalization:
Common stock $ 447,700 $ 447,700
Other paid-in capital 2,690 2,690
Retained earnings 334,108 312,522
784,498 762,912
Preferred stock 16,378 16,378
Long-term debt and QUIDS 588,297 578,817
Funds on deposit with trustees (8,013) -
1,381,160 1,358,107
Current Liabilities:
Accounts payable 29,929 35,572
Accounts payable to affiliates 22,496 31,011
Deferred income taxes - 11,311
Taxes accrued:
Federal and state income 19,426 6,430
Other 11,490 18,922
Interest accrued 7,321 7,193
Other 13,365 8,770
104,027 119,209
Deferred Credits and Other Liabilities:
Unamortized investment credit 18,656 19,592
Deferred income taxes 181,557 170,349
Regulatory liabilities 15,942 11,233
Other 35,627 23,637
251,782 224,811
Total Capitalization and Liabilities $ 1,736,969 $ 1,702,127
</TABLE>
See accompanying notes to financial statements.
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THE POTOMAC EDISON COMPANY
Statement of Cash Flows
(Thousands of Dollars)
<TABLE>
<CAPTION>
Six Months Ended
June 30
1999 1998
CASH FLOWS FROM OPERATIONS:
<S> <C> <C> <C> <C>
Net income $ 54,900 $ 48,426
Depreciation 38,108 37,365
Deferred investment credit and income taxes, net (7,047) 2,045
Deferred power costs, net 8,894 5,688
Unconsolidated subsidiaries' dividends in excess of earnings 1,605 10,139
Allowance for other than borrowed funds used
during construction (326) (215)
Internal restructuring liability - (1,187)
Changes in certain current assets and
liabilities:
Accounts receivable, net (35,089) (6,887)
Materials and supplies (1,439) (3,073)
Accounts payable (14,158) 5,209
Taxes accrued 5,564 2,231
Other deferred credits 7,181 218
Other, net 11,795 2,118
69,988 102,077
CASH FLOWS FROM INVESTING:
Construction expenditures (less allowance for other
than borrowed funds used during construction) (28,155) (26,927)
CASH FLOWS FROM FINANCING:
Issuance of long-term debt 9,300 33,200
Retirement of long-term debt - (34,000)
Notes receivable from affiliates (18,250) (47,100)
Notes receivable from subsidiary 7,100 -
Dividends on capital stock:
Preferred stock (409) (409)
Common stock (32,906) (27,534)
(35,165) (75,843)
NET CHANGE IN CASH AND TEMPORARY CASH INVESTMENTS 6,668 (693)
Cash at January 1 1,805 2,319
Cash and temporary cash investments at June 30 $ 8,473 $ 1,626
SUPPLEMENTAL CASH FLOW INFORMATION
Cash paid during the period for:
Interest (net of amount capitalized) $20,920 $22,941
Income taxes 23,282 25,973
</TABLE>
See accompanying notes to financial statements.
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THE POTOMAC EDISON COMPANY
Notes to Financial Statements
1. The Potomac Edison Company (the Company) is a wholly-owned
subsidiary of Allegheny Energy, Inc. (the Parent). The
Company's Notes to Financial Statements in its Annual Report
on Form 10-K for the year ended December 31, 1998 should be
read with the accompanying financial statements and the
following notes. With the exception of the December 31, 1998
balance sheet in the aforementioned annual report on Form 10-
K, the accompanying financial statements appearing on pages 3
through 5 and these notes to financial statements are
unaudited. In the opinion of the Company, such financial
statements together with these notes contain all adjustments
(which consist only of normal recurring adjustments)
necessary to present fairly the Company's financial position
as of June 30, 1999, the results of operations for the three
and six months ended June 30, 1999 and 1998, and cash flows
for the six months ended June 30, 1999 and 1998.
2. Statement of Financial Accounting Standards (SFAS) No.
130, "Reporting Comprehensive Income," established standards for
reporting comprehensive income and its components (revenues,
expenses, gains, and losses) in the financial statements. The
Company does not have any elements of other comprehensive income
to report in accordance with SFAS No. 130.
3. For purposes of the Balance Sheet and Statement of Cash
Flows, temporary cash investments with original maturities of
three months or less, generally in the form of commercial paper,
certificates of deposit, and repurchase agreements, are
considered to be the equivalent of cash.
4. The Company owns 28% of the common stock of Allegheny
Generating Company (AGC), and affiliates of the Company own
the remainder. AGC is reported by the Company in its
financial statements using the equity method of accounting.
AGC owns an undivided 40% interest, 840 megawatts (MW), in
the 2,100 MW pumped-storage hydroelectric station in Bath
County, Virginia, operated by the 60% owner, Virginia
Electric and Power Company, a nonaffiliated utility.
AGC recovers from the Company and its affiliates all of its
operation and maintenance expenses, depreciation, taxes, and
a return on its investment under a wholesale rate schedule
approved by the FERC. AGC's rates are set by a formula filed
with and previously accepted by the FERC. The only component
which changes is the return on equity (ROE). Pursuant to a
settlement agreement filed April 4, 1996 with the FERC, AGC's
ROE was set at 11% for 1996 and will continue until the time
any affected party seeks renegotiation of the ROE.
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Following is a summary of income statement information for
AGC:
Three Months Ended Six Months Ended
June 30 June 30
1999 1998 1999 1998
(Thousands of Dollars)
Electric operating revenues $17,810 $19,126 $35,667 $37,730
Operation and maintenance
expense 1,304 1,542 2,915 2,495
Depreciation 4,245 4,242 8,490 8,468
Taxes other than income
taxes 1,129 1,177 2,261 2,337
Federal income taxes 2,546 2,907 4,960 5,772
Interest charges 3,285 3,298 6,688 6,811
Other income, net (1) (1) (2) (51)
Net income $ 5,302 $ 5,961 $10,355 $11,898
The Company's share of the equity in earnings above was $1.5
million and $1.7 million for the three months ended June 30,
1999 and 1998, respectively, and $2.9 million and $3.3
million for the six months ended June 30, 1999 and 1998,
respectively, and is included in other income, net, on the
Company's Statement of Income.
5. As previously reported, on March 11, 1999, the United States
Court of Appeals for the Third Circuit vacated the United
States District Court for the Western District of
Pennsylvania's denial of the Company's parent, Allegheny
Energy, Inc. (Allegheny Energy) motion for preliminary
injunction, enjoining DQE, Inc. (DQE), parent company of
Duquesne Light Company in Pittsburgh, Pa., from taking
actions prohibited by the Merger Agreement. The Circuit
Court stated that if DQE breached the Merger Agreement,
Allegheny Energy may be entitled to specific performance of
the Merger Agreement. The Circuit Court also stated that
Allegheny Energy could be irreparably harmed if DQE took
actions that would prevent Allegheny Energy from receiving
the specific performance remedy. The Circuit Court remanded
the case to the District Court for further proceedings
consistent with its opinion.
In the District Court, DQE has filed a motion for summary
judgment which Allegheny Energy has opposed. The court has
not yet ruled. Allegheny Energy cannot predict the outcome
of this litigation. However, Allegheny Energy believes that
DQE's basis for seeking to terminate the merger is without
merit. Accordingly, Allegheny Energy continues to seek the
remaining regulatory approvals from the Department of Justice
and the Securities and Exchange Commission. It is not likely
either agency will act on the requests unless Allegheny
Energy obtains judicial relief requiring DQE to move forward.
The $5.2 million deferred incremental costs of the merger
process recorded by the Company through March 31, 1999 were
transferred to the Parent company in the second quarter of
1999. The accumulated merger costs will be written off by
the Parent company when the merger occurs or if it is
determined that the merger will not occur.
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6. SFAS No. 131, "Disclosures about Segments of an Enterprise
and Related Information," established standards for reporting
information about operating segments in financial statements.
The Company's principal business segment is utility
operations which includes the generation, purchase,
transmission, distribution, and sale of electricity.
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THE POTOMAC EDISON COMPANY
Management's Discussion and Analysis of Financial Condition
and Results of Operations
COMPARISON OF SECOND QUARTER AND SIX MONTHS ENDED JUNE 30, 1999
WITH SECOND QUARTER AND SIX MONTHS ENDED JUNE 30, 1998
The Notes to Financial Statements and Management's
Discussion and Analysis of Financial Condition and Results of
Operations in the Company's Annual Report on Form 10-K for the
year ended December 31, 1998 should be read with the following
Management's Discussion and Analysis information.
Factors That May Affect Future Results
This management's discussion and analysis of financial
condition and results of operations contains forecast information
items that are "forward-looking statements" as defined in the
Private Securities Litigation Reform Act of 1995. These include
statements with respect to deregulation activities and movements
toward competition in states served by The Potomac Edison Company
(the Company), the proposed merger of Allegheny Energy, Inc.
(Allegheny Energy) and related litigation against DQE, Inc.
(DQE), parent company of Duquesne Light Company in Pittsburgh,
Pa., Year 2000 readiness disclosure, and results of operations.
All such forward-looking information is necessarily only
estimated. There can be no assurance that actual results will
not materially differ from expectations. Actual results have
varied materially and unpredictably from past expectations.
Factors that could cause actual results to differ
materially include, among other matters, electric utility
restructuring, including the ongoing state and federal
activities; potential Year 2000 operation problems; developments
in the legislative, regulatory, and competitive environments in
which the Company operates, including regulatory proceedings
affecting rates charged by the Company; environmental,
legislative, and regulatory changes; future economic conditions;
developments relating to the proposed merger of Allegheny Energy
with DQE, including expenses that may be incurred in litigation;
and other circumstances that could affect anticipated revenues
and costs such as significant volatility in the market price of
wholesale power, unscheduled maintenance or repair requirements,
weather, and compliance with laws and regulations.
Significant Events in the First Six Months of 1999
* Merger with DQE
See Note 5 to the financial statements for information
about the proposed merger of Allegheny Energy, Inc., the
Company's parent, with DQE, Inc. (DQE), parent company of
Duquesne Light Company in Pittsburgh, Pa., and related
litigation.
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* Virginia Rate Settlement and Agreement
On February 25, 1999, the Virginia State Corporation
Commission (Virginia SCC) approved the Company's rate reduction
request which will decrease the fuel portion of Virginia
customers' bills by approximately 7.6% from 1.278 cents per
kilowatt-hour (kWh) to 1.181 cents per kWh (a decrease in annual
fuel revenue of about $2.2 million). The decrease is primarily
due to refunding a prior overrecovery of fuel costs, coupled with
a small decrease in projected energy costs. The new rates were
effective with bills rendered on or after March 9, 1999.
On May 21, 1999, the Virginia SCC approved an agreement
reached between the Company and the staff of the Virginia SCC
which reduced base rates for Virginia customers effective June 1,
1999 by about $3 million annually. The review of rates is
required by an annual information filing in Virginia.
* West Virginia Fuel Review
On February 26, 1999, the Public Service Commission of
West Virginia (W.Va. PSC) entered an Order to initiate a fuel
review proceeding to establish a fuel increment in rates for the
Company to be effective July 1, 1999 through June 30, 2000. On
June 29, 1999, the W.Va. PSC approved a joint stipulation and
agreement between the Company and the intervenors. Under the
agreement, the parties are to negotiate further in an effort to
more closely align the Company's West Virginia rate schedules
with the West Virginia rate schedules of Monongahela Power
Company, an affiliate, and to petition to reopen this case if
they are successful. Absent such agreement by October 15, 1999,
the rates will revert to the originally proposed rates in this
case. This change would be effective November 1, 1999 and would
decrease the Company's fuel rates by $8.0 million. These changes,
if implemented, will have no effect on the companies' net income.
* Maryland, Virginia, and West Virginia Deregulation
See Electric Energy Competition starting on page 18 for
ongoing information regarding restructuring in Maryland,
Virginia, and West Virginia.
* Toxics Release Inventory (TRI)
On Earth Day 1997, President Clinton announced the
expansion of Right-to-Know TRI reporting to include electric
utilities, limited to facilities that combust coal and/or oil for
the purpose of generating power for distribution in commerce.
The purpose of TRI is to provide site-specific information on
chemical releases to the air, land, and water. On June 4, 1999,
the Allegheny Energy companies (the System) joined with other
members of the Edison Electric Institute in reporting power
station releases to the public. Packets of information about the
System's releases were provided to media in the System's area and
posted on the Parent Company's web site. The System filed its
first TRI report with the Environmental Protection Agency prior
to the July 1, 1999 deadline date, reporting 18 million pounds of
total releases for calendar year 1998.
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Review of Operations
EARNINGS SUMMARY
Net income in the second quarter of 1999 was $18.7
million compared with $20.5 million in the corresponding 1998
period. For the first six months of 1999, net income was $54.9
million compared with $48.4 million for the corresponding 1998
period. The decrease in net income for the second quarter of
1999 was due primarily to increased operation and maintenance
expenses, reductions in revenues due to a provision to share
earnings above a return on equity of 11.4% per the settlement
agreement discussed on page 13, and renegotiated contracts with
some wholesale customers.
The increase in year-to-date net income was due primarily
to colder winter weather that led to increased kilowatt-hour
(kWh) sales to retail customers and, to a lesser extent, to
reduced interest expenses. The 1999 first quarter winter weather
was 19% cooler than the relatively warm winter of 1998, as
measured by heating degree days, but was still 7% warmer than
normal.
SALES AND REVENUES
Percentage changes in revenues and kWh sales by major
retail customer classes were:
Change from Prior Periods
Three Months Ended Six Months Ended
June 30 June 30
Revenues kWh Revenues kWh
Residential 6.3% 4.8% 9.2% 7.7%
Commercial 4.8 5.0 8.7 8.4
Industrial 2.6 (2.5) 2.9 (1.3)
Total 4.7% 1.2% 7.2% 3.7%
The increases in residential kWh sales, which are more
weather sensitive than the other classes, were due primarily to
changes in customer usage because of weather conditions and, to a
lesser extent, growth in the number of customers. Commercial kWh
sales are also affected by weather but to a lesser extent than
residential. The increase in commercial kWh sales for the three
and six months ended periods reflects increased usage and growth
in the number of customers. The decrease in industrial kWh sales
in both periods results primarily from decreased sales to primary
metal industry customers.
The changes in revenues from retail customers resulted
from the following:
Change from Prior Periods
Three Months Ended Six Months Ended
June 30 June 30
(Millions of Dollars)
Fuel clauses $4.1 $10.8
All other 3.3 13.1
Net change in retail
revenues $7.4 $23.9
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Revenues reflect not only the changes in kWh sales and
base rate changes, but also any changes in revenues from fuel and
energy cost adjustment clauses (fuel clauses) which have little
effect on net income because increases and decreases in fuel and
purchased power costs and sales of transmission services and bulk
power are passed on to customers by adjustment of customer bills
through fuel clauses.
All other is the net effect of kWh sales changes due to
changes in customer usage (primarily weather for residential
customers), growth in the number of customers, and changes in
pricing other than changes in general tariff and fuel clause
rates. The increase in all other retail revenues in the second
quarter was primarily due to increased kWh sales due to customer
growth, and the increase in the six months ended period was due
to increased kWh sales resulting from first quarter winter
weather that was cooler than the 1998 period and customer growth.
Wholesale and other revenues were as follows:
Three Months Ended Six Months Ended
June 30 June 30
1999 1998 1999 1998
(Millions of Dollars)
Wholesale customers $4.8 $ 5.8 $10.6 $12.7
Affiliated companies 2.8 2.7 6.0 5.3
Street lighting and other .8 1.8 2.1 3.3
Settlement agreement reduction (4.5) (9.0)
Total wholesale and other
revenues $3.9 $10.3 $ 9.7 $21.3
Wholesale customers are cooperatives and municipalities
that own their own distribution systems and buy all or part of
their bulk power needs from the Company under Federal Energy
Regulatory Commission (FERC) regulation. Competition in the
wholesale market for electricity was initiated by the National
Energy Policy Act of 1992 which permits wholesale generators,
utility-owned and otherwise, and wholesale customers to request
from owners of bulk power transmission facilities a commitment to
supply transmission services. The decrease in wholesale revenues
in the 1999 periods was primarily due to renegotiated contracts
with some wholesale customers.
Revenues from affiliated companies represent sales of
energy and intercompany allocations of generating capacity,
generation spinning reserves, and transmission services pursuant
to a power supply agreement among the Company and the other
regulated utility subsidiaries of Allegheny Energy.
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Settlement agreement reductions in the three and six
months ended June 30, 1999 of $4.5 million and $9.0 million,
respectively, reflect a settlement agreement by the Company
settling the Maryland Office of People's Counsel's petition for a
reduction in the Company's Maryland rates. Of that amount in the
three and six months ended June 30, 1999, $1.9 million and $3.8
million, respectively, are related to the Company creating a
provision to share earnings above a return on equity of 11.4% in
Maryland as discussed below, and in the three and six months
ended June 30, 1999, $2.6 million and $5.2 million, respectively,
are related to a deferral of 1999 revenues per the settlement
agreement. The agreement, which includes recognition of costs to
be incurred from the AES Warrior Run cogeneration project being
developed under the Public Utility Regulatory Policies Act of
1978 (PURPA), was approved by the Maryland Public Service
Commission (Maryland PSC) on October 27, 1998. Under the terms
of that agreement, the Company will increase its rates about 4%
($13 million) in each of the years 1999, 2000, and 2001 (a $39
million annual effect in 2001). The increases are designed to
recover additional costs of about $131 million over the period
1999-2001 for capacity purchases from the AES Warrior Run
cogeneration project, net of alleged over-earnings of $52 million
for the same period. The net effect of these changes over the
1999-2001 time frame results in a pre-tax income reduction of $12
million in 1999, $18 million in 2000, and $22 million in 2001.
In addition, the settlement requires that the Company share, on a
50% customer, 50% shareholder basis, earnings above a return on
equity of 11.4% in Maryland for 1999-2001. This sharing will
occur through an annual true-up.
Revenues from bulk power transactions include sales of
bulk power and transmission services to power marketers and other
utilities. Revenues from bulk power transactions consist of the
following items:
Three Months Ended Six Months Ended
June 30 June 30
1999 1998 1999 1998
(Millions of Dollars)
Revenues:
Transmission services to
nonaffiliated companies $4.1 $ 3.5 $ 7.0 $ 6.3
Bulk power 2.2 6.5 3.4 7.9
Total bulk power trans-
actions, net $6.3 $10.0 $10.4 $14.2
Revenues from bulk power transactions decreased in the
second quarter of 1999 and in the first six months of 1999.
Revenues from bulk power transactions in the second quarter and
first six months of 1998 were high due to increased sales of
energy which occurred primarily in the month of June 1998 as a
result of a heat wave which increased the demand and prices for
electricity. The costs of purchased power and revenues from
sales to power marketers and other utilities, including
transmission services, are currently recovered from or credited
to customers under fuel and energy cost recovery procedures. The
impact to the fuel and energy cost recovery clauses, either
positively or negatively, depends on whether the Company is a net
buyer or seller of electricity during such periods.
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OPERATING EXPENSES
Fuel expenses for the three and six months ended June 30,
1999 decreased 9% and 3%, respectively, primarily due to a
decrease in average fuel prices. Fuel expenses are primarily
subject to deferred power cost accounting procedures with the
result that changes in fuel expenses have little effect on net
income.
Purchased power and exchanges, net, represents power
purchases from and exchanges with other companies, capacity
charges paid to Allegheny Generating Company (AGC), an affiliate
partially owned by the Company, and other transactions with
affiliates made pursuant to a power supply agreement whereby each
company uses the most economical generation available in the
Allegheny Energy System at any given time and consists of the
following items:
Three Months Ended Six Months Ended
June 30 June 30
1999 1998 1999 1998
(Millions of Dollars)
Nonaffiliated transactions:
Purchased power $ 3.1 $ 2.1 $ 6.0 $ 4.8
Power exchanges, net (1.3) (.6) (.2) .7
Affiliated transactions:
AGC capacity charges 5.0 6.1 10.0 12.3
Other affiliated capacity
charges 9.7 10.9 19.8 22.8
Energy and spinning
reserve charges 12.2 11.0 25.9 24.8
Purchased power and
exchanges, net $28.7 $29.5 $61.5 $65.4
The AES Warrior Run Public Utility Regulatory Policies
Act of 1978 (PURPA) cogeneration contract in the Company's
Maryland service territory, scheduled to commence operation in
October 1999, will increase the cost of power purchases $60
million or more annually. In 1999, utility revenues will reflect
a reduction for a settlement agreement with various parties on
the Maryland Office of People's Counsel's for a reduction in the
Company's Maryland rates. The net effect of changes related to
the settlement results in a pre-tax income reduction of $12
million in 1999. See Sales and Revenues starting on page 11 for
more information on the settlement agreement.
The increase in other operation expenses for the second
quarter of $2.1 million was due primarily to costs associated
with certain PURPA regulations and Year 2000 expenses. These
increases were offset in part by a prior period adjustment
related to FICA taxes and lower transmission and distribution
operations expenses. The increase in total other operations
expenses in the six months ended June 30, 1999 of $3.6 million
was due primarily to costs associated with certain PURPA
regulations and Year 2000 expenses. These increases were offset
in part by lower transmission and distribution operations
expenses.
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Maintenance expenses represent costs incurred to
maintain the power stations, the transmission and distribution
(T&D) system, and general plant, and reflect routine maintenance
of equipment and rights-of-way, as well as planned major repairs
and unplanned expenditures, primarily from forced outages at the
power stations and periodic storm damage on the T&D system.
Variations in maintenance expense result primarily from unplanned
events and planned major projects, which vary in timing and
magnitude depending upon the length of time equipment has been in
service without a major overhaul and the amount of work found
necessary when the equipment is dismantled.
Depreciation expense in the three and six months ended
June 30, 1999 increased due to increased investment.
Taxes other than income taxes increased $1.8 million in
the second quarter of 1999 due primarily to an adjustment of a
prior period to include FICA taxes in taxes other than income
taxes.
The decrease in federal and state income taxes in the
second quarter of 1999 was primarily due to decreased income
before taxes, and the increase for the six months ended period
was primarily due to increased income before taxes.
The decrease in interest on long-term debt in the second
quarter and six months ended June 30, 1999 of $1.0 million and
$2.2 million, respectively, resulted primarily from reduced long-
term debt.
Financial Condition and Requirements
The Company's discussion on Financial Condition,
Requirements, and Resources and Significant Continuing Issues in
its Annual Report on Form 10-K for the year ended December 31,
1998 should be read with the following information.
In the normal course of business, the Company is subject
to various contingencies and uncertainties relating to its
operations and construction programs, including legal actions and
regulations and uncertainties related to environmental matters.
See Note 5 to the Financial Statements for information about
merger activities.
* Market Risk
The Company supplies power in the bulk power markets.
At June 30, 1999, the marketing books for such operations
consisted primarily of fixed-priced, forward-purchase and/or sale
contracts which require settlement by physical delivery of
electricity. These transactions result in market risk, which
occurs when the market price of a particular obligation or
entitlement varies from the contract price.
* Issuance of Notes
In April 1999, the Company issued $9.3 million of 5.50%
30-year pollution control revenue notes to Pleasants County, West
Virginia.
<PAGE>
- 16 -
* Year 2000 Readiness Disclosure
The transition from 1999 into the Year 2000 (Y2K) has the
potential to cause serious problems to most organizations,
including the Company, related to software and various equipment
with embedded chips which may not properly recognize calendar
dates. To minimize such problems, the Company and its affiliates
in the System have been working under a comprehensive Y2K program
to identify and remediate the problem areas in order to continue
operations without significant problems in 2000 and beyond. An
Executive Task Force is coordinating the efforts of 24 separate
Y2K Teams, representing all business and support units in the
System.
In May 1998, the North American Electric Reliability
Council (NERC), of which the System is a member, accepted a
request from the United States Department of Energy to coordinate
the industry's Y2K efforts. The electric utility industry and
the System have segmented the Y2K problem into the following
components:
* Computer hardware and software;
* Embedded chips in various equipment; and
* Vendors and other organizations on which the System
relies for critical materials and services.
The industry's and the System's efforts for each of these
three components include inventory, assessment and, where
possible, remediation of the problem areas by repair, replacement
or removal, supplemented by confirmation testing and contingency
plans. Contingency plans include alternate methods of certain
operations to help avoid electric service or business
interruptions, and the review and update of restoration of
service plans to mitigate the severity and length of
interruptions in the unlikely event that any should occur.
Based on this work, the Company has determined that as of
June 30, 1999 all of its critical components and systems related
to safety and the production and distribution of electricity and
nearly all of its important business systems (accounting,
billing, etc.) are Y2K ready. The Company anticipates that the
remediation and testing work on the remaining business and non-
critical systems will be completed by September 30, 1999. The
Company has defined Y2K Ready to mean that a determination has
been made by testing or other means that a component or system
will be able to perform its critical functions, or that
contingency plans are in place to overcome any inability to do
so.
The Company's readiness program has been conducted in
accordance with time schedules recommended by state regulatory
commissions and by NERC. As is the case of most electric
utilities, the System is interconnected with neighboring
utilities, which provides added strength of supply diversity and
flexibility. But the interconnections also mean that any one
utility's Y2K readiness is related to the readiness of the group.
Integrated electric utilities are uniquely reliant on each other
to avoid, in a worst case situation, a cascading failure of the
entire electrical system. The System is working with the Edison
Electric Institute, the Electric Power Research Institute, the
NERC, and the East Central Area Reliability Agreement group
(ECAR) to capitalize on industry-wide experiences and to
participate in industry-wide testing and contingency planning.
Since the Company and its neighboring utilities in the ECAR group
are all participants in the NERC Y2K
<PAGE>
- 17 -
effort (which had a target completion date of June 30 for
critical systems related to production and delivery of
electricity), the Company believes that this worst case
possibility has been reduced to an unlikely event. The Company
has recently re-tested its existing contingency plans for
restoration of service even if this unlikely event were to occur.
As part of the on-going NERC program, the Company
participated in an industry-wide Y2K drill on April 9, 1999 and
will participate in a more extensive industry-wide drill planned
for September 9, 1999. While the electric utility industry is
aware of the extensive Y2K programs of the major
telecommunications companies, the industry has determined that
telecommunication facilities are so important to continued
operations that we must have contingency plans just in case some
of those facilities may not be available. The drills are dry
runs designed to test the ability of utilities to continue to
operate with less than normal telecommunication facilities.
During the April test, the Company was able to maintain adequate
communications under a simulated failure of selected systems, and
obtained valuable information for improvement of its plans. NERC
has reported that the industry-wide tests produced similar
results. On December 31, 1999, the Company will have extra staff
in critical areas of the system to implement these and other
contingency plans if they are required.
The Securities and Exchange Commission requires that each
company disclose its estimate of the "most reasonably likely
worst case scenario" of a negative Y2K event. Since the Company
and the industry are working diligently to avoid any disruption
of electric service, the Company believes its customers will not
experience any significant long-term disruptions of electric
service. It is the Company's opinion that the "most reasonably
likely worst case scenario" is a Y2K event or series of events at
Company facilities or at the facilities of neighboring utilities
that escaped discovery that may cause isolated disruptions of
service. All utilities, including the Company, have experience
in the implementation of existing restoration of service plans.
As stated above, the Company's Y2K program includes a review and
update of these plans to respond quickly to any such events.
The Company is aware of the importance of electricity to
its customers and is using its best efforts to avoid any serious
Y2K problems. Despite the Company's best efforts, including
working with internal resources, external vendors, and industry
associations, the Company cannot guarantee that it will be able
to conduct all of its operations without Y2K interruptions. To
the extent that any Y2K problem may be encountered, the Company
is committed to resolution as expeditiously as possible to
minimize the effect of any such event.
Expenditures for Y2K readiness are not expected to have a
material effect on the Company's results of operations or
financial position primarily because of the significant time and
money expended over the past several years on upgrading and
replacing its large mainframe computer systems and software.
While the Y2K work has been and continues to be significant, it
primarily represents a labor-intensive effort of remediation,
component testing, multiple systems testing, documentation, and
contingency planning. While outside contractors and equipment
vendors have been employed for some of the work, the Company has
used its own employees for most of the effort because of their
experience with the Company's systems and equipment. The Company
currently estimates that its total incremental expenditures for
the Y2K effort
<PAGE>
- 18 -
since it began identification of Y2K costs will be within a range
of $4 to $5 million of which about $4 million has been incurred
through June 30, 1999. These expenditures are financed by
internal sources and primarily result from the purchase of
external expert assistance by the Generation and Information
Services departments. The expenditures have not required a
material reduction in the normal budgets and work efforts of
these departments.
The descriptions herein of the Company's Y2K effort are
made pursuant to the Year 2000 Information and Readiness
Disclosure Act. Forward-looking statements herein are made
pursuant to the Private Securities Litigation Reform Act of 1995.
There can be no assurance that actual results will not materially
differ from expectations.
* Electric Energy Competition
The electricity supply segment of the electric utility
industry in the United States is in the midst of becoming
competitive. The Energy Policy Act of 1992 began the process of
deregulating the wholesale exchange of power within the electric
industry by permitting the FERC to compel electric utilities to
allow third parties to sell electricity to wholesale customers
over their transmission systems. Since 1992, the wholesale
electricity market has become increasingly competitive as
companies began to engage in nationwide power trading. In
addition, an increasing number of states have taken active steps
toward allowing retail customers the right to choose their
electricity supplier. All of the states served by the utility
subsidiaries of Allegheny Energy have investigated or implemented
retail access to alternate electricity suppliers. The Company
has been an advocate of federal legislation to create competition
in the retail electricity markets to avoid regional dislocations
and ensure level playing fields.
In the absence of federal legislation, state-by-state
implementation has begun. All of the states served by the
utility subsidiaries of Allegheny Energy are at various stages of
implementation or investigation of programs that allow customers
to choose their electric supplier. Maryland and Virginia passed
legislation this year to implement retail choice. West Virginia
continues to actively study this issue. The Company has
franchised regulated customers in Maryland, Virginia, and West
Virginia.
Activities at the Federal Level
The System is an advocate of federal legislation to
mandate competition in retail electricity markets nationwide to
avoid regional dislocations and ensure level playing fields. The
System continues to seek enactment of federal legislation to
bring choice to all retail electric customers, deregulate the
generation and sale of electricity on a national level, and
create a more liquid, free market for electric power. Fully
meeting challenges in the emerging competitive environment will
be difficult for the System unless certain outmoded and anti-
competitive laws, specifically the Public Utility Holding Company
Act of 1935 (PUHCA) and Section 210 of the Public Utility
Regulatory Policies Act of 1978 (PURPA), are repealed or
significantly revised. The System continues to advocate the
repeal of PUHCA and PURPA, on the grounds that they are obsolete
and anti-competitive, and that PURPA results in utility customers
paying above-market prices for power. In the U.S. Congress, a
series of hearings on the competition issue in both the House and
Senate recently have been completed, and committee staffs in
<PAGE>
- 19 -
both chambers are writing comprehensive competition bills.
Consensus remains elusive, however, with significant hurdles
remaining in both houses of Congress. While it is too early to
tell whether initial momentum on the issue will result in
legislation in the current Congress, the competition issue has
received more attention this year than ever before.
Virginia
The Virginia Electric Utility Restructuring Act (the
"Restructuring Act") was passed by the Virginia General Assembly
on March 25, 1999 and was signed by the Governor of
Virginia on March 29, 1999. The Legislative Transition Task
Force on Electric Utility Restructuring, which was established by
the Restructuring Act, is holding hearings this summer on a
number of issues concerning the implementation of retail
competition in Virginia. Working groups also continue to meet
with State Corporation Commission staff, comments were filed and
Commission hearings have been held to discuss the proposed retail
pilot programs of other utilities in the state. Recommended
interim rules for retail pilot programs were issued August 6,
1999, subject to final approval by the Commission. It is
anticipated that these interim rules will provide a framework for
rules and regulations applicable to full implementation of retail
choice beginning in 2002. The Commission is seeking comments on
issues relating to the development of and participation in
regional transmission entities required by the Restructuring Act
to facilitate access to electric transmission systems.
Maryland
The Maryland General Assembly passed legislation to
restructure the electric utility industry on April 2, 1999, and
on April 8, 1999, the Governor of Maryland signed the legislation
that will bring competition to Maryland's electric generation
market. The Maryland Public Service Commission (Maryland PSC) is
in the process of implementing the new law. Final Electric
Restructuring Roundtable reports were filed with the Commission
on May 3, 1999. Legislative style hearings have been scheduled
this summer with the commission expected to issue decisions by
the end of the year.
As previously reported, the Company filed testimony in
Maryland's investigation into transition costs, price protection,
and unbundled rates. The filing requested recovery of transition
costs and a surcharge to recover the cost of the AES Warrior Run
cogeneration project beyond 2001. The staff of the Maryland PSC
advised the commission that a tentative settlement agreement was
achieved with the majority of the parties participating in the
negotiations. The parties are in the process of finalizing the
agreement, which should be filed by August 20, 1999.
<PAGE>
- 20 -
West Virginia
In December 1996, the Public Service Commission of West
Virginia (W.Va. PSC) issued an Order initiating a general
investigation regarding the restructuring of the electric utility
industry. A Task Force was established to further investigate
restructuring issues. In December 1997, the Task Force approved
legislative language that would have given the W.Va. PSC broad
authority to implement retail choice. The proposed legislation
was substantially modified by the West Virginia Legislature and
passed in March 1998. The legislation directed the W.Va. PSC to
meet with all interested parties to develop a restructuring plan
which would meet the dictates and goals of the legislation.
Interested parties formed a new Task Force that met during 1998,
but the Task Force was unable to reach a consensus on a model for
restructuring. The W.Va. PSC issued an Order on December 23,
1998 setting hearings to begin on August 17, 1999 and August 24,
1999. The August 17 hearing will address certification,
licensing, bonding, reliability, universal service, consumer
protection, and code of conduct. The August 24 hearing will
address subsidies and stranded costs. Following these hearings,
the W.Va. PSC will make a determination whether restructuring is
in the public interest.
Accounting for the Effects of Price Deregulation
In July 1997, the Emerging Issues Task Force (EITF) of
the Financial Accounting Standards Board (FASB) released Issue
No. 97-4, "Deregulation of the Pricing of Electricity - Issues
Related to the Application of FASB Statement Nos. 71 and 101,"
which concluded that utilities should discontinue application of
Statement of Financial Accounting Standards (SFAS) No. 71 for the
generation portion of their business when a deregulation plan is
in place and its terms are known. Because Maryland and Virginia
have passed legislation for a deregulation plan, the Company has
determined that it will be required to discontinue use of SFAS
No. 71 for the generation portion of its business (the Maryland
and Virginia portion only) on an uncertain future date. One of
the conclusions of the EITF is that after discontinuing SFAS No.
71, utilities should continue to carry on their books the assets
and liabilities recorded under SFAS No. 71 if the regulatory cash
flows to settle them will be derived from the continuing
regulated transmission and distribution business. Additionally,
continuing costs and obligations of the deregulated generation
business which are similarly covered by the cash flows from the
continuing regulated business will meet the criteria as
regulatory assets and liabilities. The Maryland and Virginia
legislations establish definitive processes for transition to
deregulation and market-based pricing for electric generation.
Until relevant regulatory proceedings are complete and final
orders are received, the Company is unable to predict the effect
of discontinuing SFAS No. 71, but it may be required to write off
significant unrecoverable regulatory assets, impaired assets, and
uneconomic commitments.
The status of electric energy competition in
Pennsylvania and Ohio in which affiliates of the Company serve
are as follows.
<PAGE>
- 21 -
Ohio
The Ohio General Assembly passed legislation on June 22,
1999 to restructure the electric utility industry. Governor Taft
signed the bill soon thereafter, and all of the state's customers
will be able to choose their electricity supplier starting
January 1, 2001, beginning with a five-year transition to market
rates. Total electric rates will be frozen over that period, and
residential customers are guaranteed a 5% cut in the generation
portion of their rate. The determination of stranded cost
recovery will be handled by The Public Utilities Commission of
Ohio. The bill stipulates that no entity shall own or control
transmission facilities after the start of competitive retail
electric service unless that entity is a member of and transfers
control of those facilities to one or more qualifying independent
transmission entities. The legislation provides for consumer
education, universal service, consolidation of Ohio's low income
customer assistance programs as well as incentives for
development of renewable resources and disclosure of the
environmental characteristics of power supplies.
Pennsylvania
As previously disclosed, beginning in January 1999, two-
thirds of the customers of the Company's Pennsylvania affiliate,
West Penn Power Company, were permitted to choose an alternate
electricity supplier. Remaining customers can do so in January
2000.
<PAGE>
- 22 -
THE POTOMAC EDISON COMPANY
Part II - Other Information to Form 10-Q
for Quarter Ended June 30, 1999
ITEM 1. LEGAL PROCEEDINGS
The MidAtlantic case, previously reported as an ongoing
litigation matter, has been settled and an Order was entered on
July 9, 1999 dismissing the case with prejudice.
As of August 9, 1999, Monongahela Power Company, an
affiliate of the Company, has been named as a defendant, along
with multiple other defendants in a total of approximately 8,000
asbestos cases. The Company and West Penn Power Company, also an
affiliate of the Company, were named as defendants along with
multiple other defendants in approximately one-half of those
cases. As of June 30, 1999, a total of 721 cases have been
settled and/or dismissed against the Company, Monongahela Power
Company, and West Penn Power Company for reasonable settlement
amounts. While the Company, Monongahela Power Company, and West
Penn Power Company believe that all of the cases are without
merit, they cannot predict the outcome nor are they able to
determine whether additional cases will be filed.
As previously reported, on March 11, 1999, the United
States Court of Appeals for the Third Circuit vacated the United
States District Court for the Western District of Pennsylvania's
denial of the Company's parent, Allegheny Energy, Inc. (Allegheny
Energy) motion for preliminary injunction, enjoining DQE, Inc.
(DQE), parent company of Duquesne Light Company in Pittsburgh,
Pa., from taking actions prohibited by the Merger Agreement. The
Circuit Court stated that if DQE breached the Merger Agreement,
Allegheny Energy may be entitled to specific performance of the
Merger Agreement. The Circuit Court also stated that Allegheny
Energy could be irreparably harmed if DQE took actions that would
prevent Allegheny Energy from receiving the specific performance
remedy. The Circuit Court remanded the case to the District
Court for further proceedings consistent with its opinion.
In the District Court, DQE has filed a motion for summary
judgment which Allegheny Energy has opposed. The court has not
yet ruled. Allegheny Energy cannot predict the outcome of this
litigation. However, Allegheny Energy believes that DQE's basis
for seeking to terminate the merger is without merit.
Accordingly, Allegheny Energy continues to seek the remaining
regulatory approvals from the Department of Justice and the
Securities and Exchange Commission. It is not likely either
agency will act on the requests unless the Allegheny Energy
obtains judicial relief requiring DQE to move forward.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits:
(27) Financial Data Schedule
(b) No reports on Form 8-K were filed on behalf of
the Company for the quarter ended June 30, 1999.
<PAGE>
- 23 -
Signature
Pursuant to the requirements of the Securities Exchange
Act of 1934, the registrant has duly caused this report to be
signed on its behalf by the undersigned thereunto duly
authorized.
THE POTOMAC EDISON COMPANY
/s/ T. J. KLOC
T. J. Kloc, Controller
(Chief Accounting Officer)
August 16, 1999
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