EX-13 43 pn_ex13-7.txt EX 13-7 PENELEC ANNUAL REPORT PENNSYLVANIA ELECTRIC COMPANY 2003 ANNUAL REPORT TO STOCKHOLDERS Pennsylvania Electric Company is a wholly owned electric utility operating subsidiary of FirstEnergy Corp. It engages in the distribution and sale of electric energy in an area of approximately 17,600 square miles in western Pennsylvania. It also engages in the sale, purchase and interchange of electric energy with other electric companies. The area it serves has a population of approximately 1.6 million. The Company, as lessee of the property of the Waverly Electric Light & Power Company, also serves a population of about 13,400 in Waverly, New York and vicinity. In August 2000, FirstEnergy entered into an agreement to merge with GPU, Inc., under which FirstEnergy would acquire all of the outstanding shares of GPU, Inc.'s common stock for approximately $4.5 billion in cash and FirstEnergy common stock. The merger became effective on November 7, 2001 and was accounted for by the purchase method. Prior to that time, Pennsylvania Electric Company was a wholly owned subsidiary of GPU, Inc. Contents Page -------- ---- Selected Financial Data........................................... 1 Management's Discussion and Analysis.............................. 2-12 Consolidated Statements of Income................................. 13 Consolidated Balance Sheets....................................... 14 Consolidated Statements of Capitalization......................... 15 Consolidated Statements of Common Stockholder's Equity............ 16 Consolidated Statements of Preferred Stock........................ 16 Consolidated Statements of Cash Flows............................. 17 Consolidated Statements of Taxes.................................. 18 Notes to Consolidated Financial Statements........................ 19-34 Reports of Independent Auditors................................... 35-36 PENNSYLVANIA ELECTRIC COMPANY SELECTED FINANCIAL DATA
Nov. 7 - Jan. 1 - 2003 2002 Dec. 31, 2001 Nov. 6, 2001 2000 1999 ---------------------------------------------------------------------------------------------------------------------- (Dollars in thousands) Operating Revenues..................... $ 976,855 $ 1,027,102 $ 140,062 | $ 834,548 $ 901,881 $ 921,965 =========== =========== ========== | ========= ========= ========== | Operating Income....................... $ 60,210 $ 88,190 $ 14,341 | $ 70,049 $ 80,336 $ 140,925 =========== =========== ========== | ========= ========== ========== | Income Before Cumulative Effect | of Accounting Change................ $ 20,237 $ 50,910 $ 10,795 | $ 23,718 $ 39,250 $ 152,491 =========== =========== ========== | ========= ========== ========== | Net Income............................. $ 21,333 $ 50,910 $ 10,795 | $ 23,718 $ 39,250 $ 152,491 =========== =========== ========== | ========= ========== ========== | Earnings on Common Stock............... $ 21,333 $ 50,910 $ 10,795 | $ 23,718 $ 39,250 $ 151,611 =========== =========== ========== | ========= ========== ========== | Total Assets........................... $ 3,052,243 $ 3,163,254 $3,300,269 | $2,331,484 $2,463,052 =========== =========== ========== | ========== ========== | | Capitalization as of December 31: | Common Stockholder's Equity......... $ 1,297,332 $ 1,353,704 $1,306,576 | $ 469,837 $ 461,182 Company-Obligated Trust Preferred | Securities........................ -- 92,214 92,000 | 100,000 100,000 Long-Term Debt...................... 438,764 470,274 472,400 | 519,481 426,795 ----------- ----------- ---------- | ---------- ---------- Total Capitalization.............. $ 1,736,096 $ 1,916,192 $1,870,976 | $1,089,318 $ 987,977 =========== =========== ========== | ========== ========== | | Capitalization Ratios: | Common Stockholder's Equity......... 74.7% 70.7% 69.8% | 43.1% 46.7% Company-Obligated Trust Preferred | Securities........................ -- 4.8 4.9 | 9.2 10.1 Long-Term Debt...................... 25.3 24.5 25.3 | 47.7 43.2 ----- ----- ----- | ----- ----- Total Capitalization.............. 100.0% 100.0% 100.0% | 100.0% 100.0% ===== ===== ===== | ===== ===== | | Distribution Kilowatt-Hour Deliveries (Millions): | Residential......................... 4,166 4,196 721 | 3,264 3,949 3,864 Commercial.......................... 4,748 4,753 758 | 3,733 4,509 4,319 Industrial.......................... 4,443 4,336 685 | 3,658 4,698 4,865 Other............................... 41 42 7 | 34 40 43 ------ ------ ----- | ------ ------ ------ Total Retail........................ 13,398 13,327 2,171 | 10,689 13,196 13,091 Total Wholesale..................... 2 516 107 | 1,351 2,885 4,219 ------- ----- ----- | ------ ------ ------ Total............................... 13,400 13,843 2,278 | 12,040 16,081 17,310 ====== ====== ===== | ====== ====== ====== | | Customers Served: | Residential......................... 503,738 503,007 502,901 | 502,052 500,930 Commercial.......................... 77,737 77,125 76,005 | 74,282 73,979 Industrial.......................... 2,545 2,605 2,652 | 2,703 2,844 Other............................... 1,069 1,081 1,099 | 1,110 1,110 ------- ------- ------- | ------- ------- Total............................... 585,089 583,818 582,657 | 580,147 578,863 ======= ======= ======= | ======= ======= 1
PENNSYLVANIA ELECTRIC COMPANY Management's Discussion and Analysis of Results of Operations and Financial Condition This discussion includes forward-looking statements based on information currently available to management. Such statements are subject to certain risks and uncertainties. These statements typically contain, but are not limited to, the terms "anticipate," "potential," "expect," "believe," "estimate" and similar words. Actual results may differ materially due to the speed and nature of increased competition and deregulation in the electric utility industry, economic or weather conditions affecting future sales and margins, changes in markets for energy services, changing energy and commodity market prices, replacement power costs being higher than anticipated or inadequately hedged, maintenance costs being higher than anticipated, legislative and regulatory changes (including revised environmental requirements), adverse regulatory or legal decisions and the outcome of governmental investigations, availability and cost of capital, the inability to accomplish or realize anticipated benefits from strategic goals, the ability to improve electric commodity margins and to experience growth in the distribution business, the ability to access the public securities market, further investigation into the causes of the August 14, 2003, regional power outage and the outcome, cost and other effects of present and potential legal and administrative proceedings and claims related to the outage, a denial of or material change to the Company's Application related to its Rate Stabilization Plan, and other similar factors. Results of Operations Net income decreased by 58.1% to $21.3 million in 2003, compared to $50.9 million in 2002, as a result of lower operating revenues and higher other operating costs, general taxes and net interest charges. Net income increased by 47.5% to $50.9 million in 2002 from $34.5 million in 2001. In 2002, earnings were higher due to increased operating revenues and lower other operating costs. Partially offsetting these results was the absence of deferral accounting for energy costs in 2002 (see Regulatory Matters), as well as higher general taxes. Electric Sales Operating revenues decreased $50.2 million in 2003, following a $52.5 million increase in 2002. The decrease resulted from lower kilowatt-hour sales in all customer classifications -- residential, commercial and industrial, as well as a significant reduction in kilowatt-hour sales to wholesale customers. Wholesale sales revenues decreased by $32.1 million in 2003, primarily attributable to lower sales to non-affiliated companies. Total retail generation kilowatt-hour sales decreased 2.5% ($21.9 million in operating revenues) as a result of decreases in industrial sales (7.2%), residential sales (0.7%) and commercial sales (0.6%). The decrease in industrial sales was primarily due to more industrial customers being served by alternative suppliers. Distribution deliveries increased by 0.5% due to an increase in industrial deliveries as a result of a slightly improving economy - partially offset by lower deliveries to residential, commercial and street light customers. Changes in kilowatt-hour sales by customer class in 2003 and 2002 are summarized in the following table: Changes in Kilowatt-Hour Sales 2003 2002 ----------------------------------------------------------------- Increase (Decrease) Electric Generation: Retail.................. (2.5)% 13.7% Wholesale............... (99.5)% (64.7)% ----------------------------------------------------------------- Total Electric Generation Sales (6.4)% 4.5% ================================================================= Distribution Deliveries: Residential............. (.7)% 5.3% Commercial.............. (.1)% 5.8% Industrial.............. 2.5% (.2)% ----------------------------------------------------------------- Total Distribution Deliveries (.5)% 3.6% ================================================================= Operating Expenses and Taxes Total operating expenses and taxes decreased by 2.4% or $22.3 million in 2003 and increased 5.5% or $48.7 million in 2002, compared to the preceding year. Lower purchased power costs, depreciation and income taxes, offset in part by increased other operating costs and general taxes, accounted for the decrease in 2003. In 2002, the increase was due to higher purchased power costs and general taxes, offset in part by a decrease in other operating costs. 2 Purchased power costs decreased by 6.3% or $40.7 million in 2003, compared to the prior year. The decrease was due primarily to a reduction in kilowatt-hours purchased to support lower kilowatt-hour sales to retail and wholesale customers. Purchased power costs increased $50.1 million in 2002, compared to the prior year. The increase was due primarily to energy costs of $32.8 million incurred in 2002 that otherwise would have been deferred absent a Pennsylvania Commonwealth Court decision (see Regulatory Matters). That increase was partially offset by a reduction in power purchased during 2002, as well as by the absence of a one-time $16.0 million pre-tax charge related to the termination of a wholesale energy contract with Allegheny Electric Cooperative in 2001. Other operating costs increased by 23.7% or $31.5 million in 2003, compared to 2002. The increase was primarily due to increased costs to restore customer service resulting from significant storm activity and higher employee benefit costs. Other operating costs decreased $25.6 million in 2002, compared to the previous year. The decrease was primarily due to reduced uncollectible accounts, personnel reductions and the absence of employee severance costs accrued in 2001. Other Income The increase in other income in 2002 of $5.3 million was primarily due to the absence of 2001 charges for a sustainable energy fund and renewable energy projects (which were required by the Stipulation of Settlement related to the FirstEnergy/GPU merger) and the absence of 2001 net losses on futures contracts and options. That increase was partially offset by a decrease in interest income. Net Interest Charges Net interest charges increased $2.9 million in 2003, compared to the prior year. The increase was due to a lower level of deferred interest costs, offset in part by lower preferred stock dividend requirements. In 2002, net interest charges decreased $7.3 million, compared to the previous year, due to reduced short-term borrowing levels and amortization of purchase accounting fair market value adjustments recorded in connection with the merger. Cumulative Effect of Accounting Change Results in 2003 include an after-tax credit to net income of approximately $1.1 million upon the adoption of SFAS 143, "Accounting for Asset Retirement Obligations," in January 2003. We identified applicable legal obligations as defined under the new accounting standard for nuclear power plant decommissioning. As a result of adopting SFAS 143 in January 2003, asset retirement costs of $93 million were recorded as part of the carrying amount of the related long-lived asset, offset by accumulated depreciation of $93 million. ARO liability at the date of adoption was $99 million, including accumulated accretion for the period from the date the liability was incurred to the date of adoption. As of December 31, 2002, we recorded decommissioning liabilities of $130 million. We expect substantially all of our nuclear decommissioning costs to be recoverable in rates over time. Therefore, we recognized a regulatory liability of $30.8 million upon adoption of SFAS 143 for the transition amounts related to establishing the ARO for nuclear decommissioning. The remaining cumulative effect adjustment for unrecognized depreciation and accretion offset by the reduction in the liabilities was a $1.9 million increase to income, or $1.1 million net of income taxes. Capital Resources and Liquidity Changes in Cash Position As of December 31, 2003, we had $36,000 of cash and cash equivalents compared with $10.3 million as of December 31, 2002. The major sources for changes in these balances are summarized below. Cash Flows From Operating Activities Cash flows provided from operating activities totaled $16 million in 2003 and $39 million in 2002. The sources of these changes are as follows: 3 Operating Cash Flows 2003 2002 2001 -------------------------------------------------------------- (In millions) Cash earnings (1)........ $ 88 $97 $(21) Working capital.......... (72) (58) 5 -------------------------------------------------------------- Total.................... $ 16 $39 $(16) ============================================================== (1) Includes net income, depreciation and amortization, deferred costs recoverable as regulatory assets, deferred income taxes, investment tax credits, cumulative effect of accounting change and pension changes. Cash Flows From Financing Activities In 2003, net cash used for financing activities of $49 million reflects $36 million of common stock dividend payments to FirstEnergy and reduced short-term borrowings. The following table provides details regarding new issues and redemptions during 2003 and 2002: Securities Issued or Redeemed 2003 2002 -------------------------------------------------------------------- (In millions) Redemptions Unsecured notes............................. $ 1 $50 -------------------------------------------------------------------- Short-term Borrowings, net (use)/source of cash.. (12) 13 -------------------------------------------------------------------- In 2002, net cash used for financing activities totaled $66 million, reflecting $50 million redemptions of debt and $29 million of common stock dividend payments to FirstEnergy, partially offset by $13 million of short-term borrowings. We had $78.5 million of short-term indebtedness at the end of 2003, compared to $90.4 million at the end of 2002. We may borrow from our affiliates on a short-term basis. We will not issue first mortgage bonds (FMB) other than as collateral for senior notes, since our senior note indentures prohibit (subject to certain exceptions) us from issuing any debt which is senior to the senior notes. As of December 31, 2003, we had the capability to issue $23 million of additional senior notes based upon FMB collateral. We have no restrictions on the issuance of preferred stock. We have the ability to borrow from our regulated affiliates and FirstEnergy to meet our short-term working capital requirements. FirstEnergy Service Company administers this money pool and tracks surplus funds of FirstEnergy and its regulated subsidiaries. Companies receiving a loan under the money pool agreements must repay the principal, together with accrued interest, within 364 days of borrowing the funds. The rate of interest is the same for each company receiving a loan from the pool and is based on the average cost of funds available through the pool. The average interest rate for borrowings in 2003 was 1.47%. Our access to capital markets and costs of financing are dependent on the ratings of our securities and that of our holding company, FirstEnergy. The following table shows our securities' ratings following the downgrade by Moody's Investors Service in February 2004. The ratings outlook on all securities is stable. Ratings of Securities -------------------------------------------------------------------- Securities S&P Moody's Fitch -------------------------------------------------------------------- FirstEnergy Senior unsecured BB+ Baa3 BBB- Penelec Senior secured BBB Baa1 BBB+ Senior unsecured BBB- Baa2 BBB -------------------------------------------------------------------- On September 30, 2003, Fitch Ratings lowered the senior unsecured ratings of FirstEnergy to "BBB-" from "BBB." Fitch also lowered the senior secured and senior unsecured ratings of Penelec. Fitch announced that the Rating Outlook is Stable for the securities of FirstEnergy and Penelec. Fitch stated that the changes to the long-term ratings were "driven by the high debt leverage of the parent, FirstEnergy. Despite management's commitment to reduce debt related to the GPU merger, subsequent cash flows have been vulnerable to unfavorable events, slowing the pace of FirstEnergy's debt reduction efforts. The Stable Outlook reflects the success of FirstEnergy's recent common equity offering and management's focus on a relatively conservative integrated utility strategy." On December 23, 2003, S&P lowered its corporate credit ratings on FirstEnergy and its regulated utility subsidiaries to "BBB-" from "BBB" and lowered FirstEnergy's senior unsecured debt rating to "BB+" from "BBB-". Penelec's ratings were lowered one notch as well (see table above). The ratings were removed from CreditWatch with negative implications, where they had been placed by S&P on August 18, 2003, and the Ratings Outlook returned to Stable. The rating action followed a revision in S&P's assessment of our consolidated business risk profile to `6' from `5' (`1' equals low risk, `10' equals high risk), with S&P citing operational and management challenges as well as 4 heightened regulatory uncertainty for its revision of our business risk assessment score. S&P's rationale for its revisions of the ratings included uncertainty regarding the timing of the Ohio Rate Plan filing, the pending final report on the August 14 blackout (see Power Outage), the outcome of the remedial phase of litigation relating to the Sammis plant, and the extended Davis-Besse outage and the related pending subpoena. S&P further stated that the restart of Davis-Besse and a supportive Ohio Rate Plan extension will be vital positive developments that would aid an upgrade of FirstEnergy's ratings. S&P's reduction of the credit ratings in December 2003 triggered cash and letter-of-credit collateral calls of FirstEnergy in addition to higher interest rates for some outstanding borrowings. On February 6, 2004, Moody's downgraded FirstEnergy senior unsecured debt to Baa3 from Baa2 and downgraded the senior secured debt of Penelec to Baa1 from A2. Moody's also downgraded the senior unsecured rating of Penelec to Baa2 from A2. Moody's said that the lower ratings were prompted by: "1) high consolidated leverage with significant holding company debt, 2) a degree of regulatory uncertainty in the service territories in which the company operates, 3) risks associated with investigations of the causes of the August 2003 blackout, and related securities litigation, and 4) a narrowing of the ratings range for the FirstEnergy operating utilities, given the degree to which FirstEnergy increasingly manages the utilities as a single system and the significant financial interrelationship among the subsidiaries." Cash Flows From Investing Activities Cash provided from investing activities totaled $22 million in 2003 and cash used for investing activities totaled approximately $2 million in 2002. In both periods, cash outflows for property additions to support the distribution of electricity were offset by proceeds from non-utility generation trusts. In addition, a net $1.7 million loan payment was received from associated companies in 2003. Our cash requirements in 2004 for operating expenses, construction expenditures, scheduled debt maturities and preferred stock redemptions are expected to be met without increasing our net debt and preferred stock outstanding. Over the next three years, we expect to meet our contractual obligations with cash flows from operations. Thereafter, we expect to use a combination of cash flows from operations and funds from the capital markets. Our capital spending for the period 2004-2006 is expected to be about $198 million, of which approximately $66 million applies to 2004. Contractual Obligations Our cash contractual obligations as of December 31, 2003 that we consider firm obligations are as follows: 2005- 2007- Contractual Obligations Total 2004 2006 2008 Thereafter ------------------------------------------------------------------------------- (In millions) Long-term debt.............. $ 564 $125 $ 8 $ 3 $ 428 Short-term borrowings....... 79 79 -- -- -- Purchases (1)............... 3,628 233 750 867 1,778 ------------------------------------------------------------------------------- Total.................. $4,271 $437 $758 $870 $2,206 ------------------------------------------------------------------------------- (1) Fuel and power purchases under contracts with fixed or minimum quantities and approximate timing Market Risk Information We use various market risk sensitive instruments, including derivative contracts, primarily to manage the risk of price fluctuations. Our Risk Policy Committee, comprised of FirstEnergy executive officers, exercises an independent risk oversight function to ensure compliance with corporate risk management policies and prudent risk management practices. Commodity Price Risk We are exposed to market risk primarily due to fluctuations in electricity and natural gas prices. To manage the volatility relating to these exposures, we use a variety of non-derivative and derivative instruments, including options and futures contracts. The derivatives are used for hedging purposes. Most of our non-hedge derivative contracts represent non-trading positions that do not qualify for hedge treatment SFAS 133, "Accounting for Derivative Instruments and Hedging Activities." The change in the fair value of commodity derivative contracts related to energy production during 2003 is summarized in the following table: 5 Increase (Decrease) in the Fair Value of Derivative Contracts
Non-Hedge Hedge Total --------- ----- ----- (In millions) Change in the Fair Value of Commodity Derivative Contracts Outstanding net asset as of January 1, 2003................. $ 8.7 $ 0.1 $ 8.8 New contract value when entered............................. -- -- -- Additions/Increase in value of existing contracts........... 4.5 -- 4.5 Change in techniques/assumptions............................ 2.3 -- 2.3 Settled contracts........................................... -- (0.1) (0.1) ------------------------------ Net Assets - Derivatives Contracts as of December 31, 2003(1) $15.5 $ -- $15.5 ============================== Impact of Changes in Commodity Derivative Contracts (2) Income Statement Effects (Pre-Tax).......................... $ 0.8 $ -- $ 0.8 Balance Sheet Effects: OCI (Pre-Tax)............................................ $ -- $(0.1) $(0.1) Regulatory Liability..................................... $ 6.0 $ -- $ 6.0
(1) Includes $14.5 million in non-hedge commodity derivative contracts which are offset by a regulatory liability. (2) Represents the increase in value of existing contracts and settled contracts. Derivatives included on the Consolidated Balance Sheet as of December 31, 2003: Non-Hedge Hedge Total --------- ----- ----- (In millions) Non-Current- Noncurrent Liabilities......... $15.5 $ -- $15.5 ----- ----- ---- Net liability................ $15.5 $ -- $15.5 ===== ====== ===== The valuation of derivative contracts is based on observable market information to the extent that such information is available. In cases where such information is not available, we rely on model-based information. The model provides estimates of future regional prices for electricity and an estimate of related price volatility. We utilize these results in developing estimates of fair value for financial reporting purposes and for internal management decision making. Sources of information for the valuation of derivative contracts by year are summarized in the following table: Source of Information - Fair Value by Contract Year ---------------------------------------------------
2004 2005 2006 2007 Thereafter Total ---- ---- ---- ---- ---------- ----- (In millions) Prices based on external sources(1)... $2.3 $2.6 $ -- $ -- $ -- $ 4.9 Prices based on models................ -- -- 2.5 2.4 5.7 10.6 ---------------------------------------------------------------- Total(2).......................... $2.3 $2.6 $2.5 $2.4 $5.7 $15.5 ================================================================
(1) Broker quote sheets. (2) Includes $14.5 million from an embedded option that is offset by a regulatory liability and does not affect earnings. We perform sensitivity analyses to estimate our exposure to the market risk of our commodity position. A hypothetical 10% adverse shift in quoted market prices in the near term on derivative instruments would not have had a material effect on our consolidated financial position or cash flows as of December 31, 2003. Interest Rate Risk Our exposure to fluctuations in market interest rates is reduced since our debt has fixed interest rates, as noted in the following table. 6
Comparison of Carrying Value to Fair Value ------------------------------------------------------------------------------------------------------------------- There- Fair Year of Maturity 2004 2005 2006 2007 2008 after Total Value ------------------------------------------------------------------------------------------------------------------- (Dollars in millions) Assets ------------------------------------------------------------------------------------------------------------------- Investments Other Than Cash and Cash Equivalents- Fixed Income............... $ 93 $ 93 $ 93 Average interest rate...... 2.9% 2.9% ------------------------------------------------------------------------------------------------------------------- Liabilities ------------------------------------------------------------------------------------------------------------------- Long-term Debt and Other Long-Term Obligations: Fixed rate.................... $125 $ 8 $ 3 $428 $564 $612 Average interest rate ..... 5.8% 7.5% 6.1% 6.8% 6.5% Short-term Borrowings......... $ 79 $ 79 $ 79 Average interest rate...... 1.7% 1.7% -------------------------------------------------------------------------------------------------------------------
Equity Price Risk Included in nuclear decommissioning trusts, as required by the Nuclear Regulatory Commission, are marketable equity securities carried at their market value of approximately $54 million and $42 million at December 31, 2003 and 2002, respectively. A hypothetical 10% decrease in prices quoted by stock exchanges would result in a $5 million reduction in fair value as of December 31, 2003 (see Note 1 (L) - "Cash and Financial Instruments"). Outlook Beginning in 1999, all of our customers were able to select alternative energy suppliers. We continue to deliver power to homes and businesses through our existing distribution system, which remains regulated. The Pennsylvania Public Utility Commission (PPUC) authorized our rate restructuring plan, establishing separate charges for transmission, distribution, generation and stranded cost recovery, which is recovered through a competitive transition charge (CTC). Customers electing to obtain power from an alternative supplier have their bills reduced based on the regulated generation component, and the customers receive a generation charge from the alternative supplier. We have a continuing responsibility to provide power to those customers not choosing to receive power from an alternative energy supplier, subject to certain limits, which is referred to as our PLR obligation. Regulatory assets are costs which have been authorized by the PPUC and the Federal Energy Regulatory Commission (FERC) for recovery from customers in future periods and, without such authorization, would have been charged to income when incurred. All of our regulatory assets are expected to continue to be recovered under the provisions of the regulatory plan as discussed below. Our regulatory assets totaled $497 million and $600 million as of December 31, 2003 and December 31, 2002, respectively. Regulatory Matters In June 2001, the PPUC approved the Settlement Stipulation with all of the major parties in the combined merger and rate proceedings which approved the FirstEnergy/GPU merger and provided PLR deferred accounting treatment for energy costs, permitting us to defer, for future recovery, energy costs in excess of amounts reflected in our capped generation rates retroactive to January 1, 2001. This PLR deferral accounting procedure was later reversed in a February 2002 Commonwealth Court of Pennsylvania decision. The court decision affirmed the PPUC decision regarding approval of the merger, remanding the decision to the PPUC only with respect to the issue of merger savings. In the first quarter of 2002, the Company established a $111.1 million reserve for its PLR deferred energy costs incurred prior to its acquisition by FirstEnergy. The reserve reflected the potential adverse impact of the then pending Pennsylvania Supreme Court decision whether to review the Commonwealth Court ruling. The reserve increased goodwill by an aggregate net of tax amount of $65.0 million. On April 2, 2003, the PPUC remanded the issue relating to merger savings to the Office of Administrative Law Judge (ALJ) for hearings, directed us to file a position paper on the effect of the Commonwealth Court order on the Settlement Stipulation and allowed other parties to file responses to the position paper. We filed a letter with the ALJ on June 11, 2003, voiding the Stipulation in its entirety and reinstating our restructuring settlement previously approved by the PPUC. On October 2, 2003, the PPUC issued an order concluding that the Commonwealth Court reversed the PPUC's June 20, 2001 order in its entirety. The PPUC directed us to file tariffs within thirty days of the order to reflect the CTC rates and shopping credits that were in effect prior to the June 21, 2001 order to be effective upon one day's notice. In response to that order, we filed these supplements to our tariffs to become effective October 24, 2003. 7 On October 8, 2003, we filed a petition for clarification relating to the October 2, 2003 order on two issues: to establish June 30, 2004 as the date to fully refund the NUG trust fund and to clarify that the ordered accounting treatment regarding the CTC rate/shopping credit swap should follow the ratemaking, and that the PPUC's findings would not impair our rights to recover all of our stranded costs. On October 9, 2003, ARIPPA (an intervenor in the proceedings) petitioned the PPUC to direct us to reinstate accounting for the CTC rate/shopping credit swap retroactive to January 1, 2002. Several other parties also filed petitions. On October 16, 2003, the PPUC issued a reconsideration order granting the date requested by us for the NUG trust fund refund and, denying our other clarification requests and granting ARIPPA's petition with respect to the retroactive accounting treatment of the changes to the CTC rate/shopping credit swap. On October 22, 2003, we filed an Objection with the Commonwealth Court asking that the Court reverse the PPUC's finding that requires us to treat the stipulated CTC rates that were in effect from January 1, 2002 on a retroactive basis. We are considering filing an appeal to the Commonwealth Court on the PPUC orders as well. On October 27, 2003, one Commonwealth Court judge issued an Order denying our objection without explanation. Due to the vagueness of the Order, on October 31, 2003, we filed an Application for Clarification with the judge. Concurrent with this filing, in order to preserve our rights, we also filed with the Commonwealth Court both a Petition for Review of the PPUC's October 16 and October 22 Orders, and an application for reargument, if the judge, in his clarification order, indicates that our objection was intended to be denied on the merits. In addition to these findings, in compliance with the PPUC's Orders, we filed revised PPUC quarterly reports for the twelve months ended December 31, 2001 and 2002, and for the first two quarters of 2003, reflecting balances consistent with the PPUC's findings in their Orders. Effective September 1, 2002, we assigned our PLR responsibility to our FirstEnergy Solutions Corp. (FES) affiliate through a wholesale power sale agreement. The PLR sale will be automatically extended for each successive calendar year unless any party elects to cancel the agreement by November 1 of the preceding year. Under the terms of the wholesale agreement, FES assumed the supply obligation and the supply profit and loss risk, for the portion of power supply requirements not self-supplied by us under our NUG contracts and other power contracts with nonaffiliated third party suppliers. This arrangement reduces our exposure to high wholesale power prices by providing power at a fixed price for our uncommitted PLR energy costs during the term of the agreement with FES. FES has hedged most of our unfilled PLR on-peak obligation through 2004 and a portion of 2005, the period during which deferred accounting was previously allowed under the PPUC's order. We are authorized to continue deferring differences between NUG contract costs and current market prices. In late 2003, the PPUC issued a Tentative Order implementing new reliability benchmarks and standards. In connection therewith, the PPUC commenced a rulemaking procedure to amend the Electric Service Reliability Regulations to implement these new benchmarks, and create additional reporting on reliability. Although neither the Tentative Order nor the Reliability Rulemaking has been finalized, the PPUC ordered all Pennsylvania utilities to begin filing quarterly reliability reports on November 1, 2003. The comment period for both the Tentative Order and the Proposed Rulemaking Order has closed. We are currently awaiting the PPUC to issue a final order in both matters. The order will determine (1) the standards and benchmarks to be utilized, and (2) the details required in the quarterly and annual reports. It is expected that these Orders will be finalized in March 2004. On January 16, 2004, the PPUC initiated a formal investigation of our level of compliance with the Public Utility Code and the PPUC's regulations and orders with regard to reliable electric service. Hearings will be held in August in this investigation and the ALJ has been directed to issue a Recommended Decision by September 30, 2004, in order to allow the PPUC time to issue a Final Order before December 16, 2004. We are unable to predict the outcome of the investigation or the impact of the PPUC Order. FERC Regulatory Matters On December 19, 2002, the FERC granted unconditional Regional Transmission Organization status to PJM Interconnection, LLC which includes us as transmission owners. PJM and the Midwest Independent System Operator, Inc. (MISO) were ordered by the FERC to develop a common market between the regions by October 31, 2004. The FERC also initiated a Section 206 investigation into the reasonableness of the "through-and-out" transmission rates charged by PJM and MISO. By order issued November 17, 2003, MISO, PJM and certain unaffiliated transmission owners in the Midwest were directed to eliminate rates for point-to-point service between the two RTOs effective April 1, 2004. A settlement judge has been appointed by the FERC to resolve compliance filings by the affected transmission providers. AEP, Commonwealth Edison and other utilities have appealed the FERC's November 17, 2003 order to the federal court of appeals for the District of Columbia. Environmental Matters We have been named as a "potentially responsible party" (PRP) at waste disposal sites which may require cleanup under the Comprehensive Environmental Response, Compensation and Liability Act of 1980. Allegations of 8 disposal of hazardous substances at historical sites and the liability involved are often unsubstantiated and subject to dispute; however, federal law provides that all PRPs for a particular site be held liable on a joint and several basis. Therefore, environmental liabilities that are considered probable have been recognized on the Consolidated Balance Sheet as of December 31, 2003, based on estimates of the total costs of cleanup, our proportionate responsibility for such costs and the financial ability of other nonaffiliated entities to pay. We have accrued liabilities aggregating approximately $43,000 as of December 31, 2003. We do not believe environmental remediation costs will have a material adverse effect on our financial condition, cash flows or results of operations. Power Outage On August 14, 2003, various states in the northeast United States and part of southern Canada experienced a widespread power outage. That outage affected approximately 1.4 million customers in FirstEnergy's service area. FirstEnergy continues to accumulate data and evaluate the status of its electrical system prior to and during the outage event, and continues to cooperate with the U.S.-Canada Power System Outage Task Force (Task Force) investigating the August 14th outage. The interim report issued by the Task Force on November 18, 2003 concluded that the problems leading up to the outage began in FirstEnergy's service area. Specifically, the interim report concludes, among other things, that the initiation of the August 14th outage resulted from the coincidence on that afternoon of the following events: (1) inadequate situational awareness at FirstEnergy; (2) FirstEnergy's failure to adequately manage tree growth in its transmission rights of way; and (3) failure of the interconnected grid's reliability organizations (Midwest ISO and PJM Interconnection) to provide effective diagnostic support. We believe that the interim report does not provide a complete and comprehensive picture of the conditions that contributed to the August 14th outage and that it does not adequately address the underlying causes of the outage. On November 25, 2003, the Public Utilities Commission of Ohio (PUCO) ordered FirstEnergy to file a plan with the PUCO no later than March 1, 2004, illustrating how FirstEnergy will correct problems identified by the Task Force as events contributing to the August 14th outage and addressing how FirstEnergy proposes to upgrade its control room computer hardware and software and improve the training of control room operators to ensure that similar problems do not occur in the future. The PUCO, in consultation with the North American Electric Reliability Council, will review the plan before determining the next steps in the proceeding. On December 24, 2003, the FERC ordered FirstEnergy to pay for an independent study of part of Ohio's power grid. The study has commenced and will examine the stability of the grid in critical points in the Cleveland and Akron areas; the status of projected power reserves during summer 2004 through 2008; and the need for new transmission lines or other grid projects. The FERC ordered the study to be completed within 120 days. At this time, we do not know how the results of the study will impact FirstEnergy. Legal Matters Various lawsuits, claims and proceedings related to our normal business operations are pending against us, the most significant of which are described above. Critical Accounting Policies We prepare our consolidated financial statements in accordance with accounting principles that are generally accepted in the United States. Application of these principles often requires a high degree of judgment, estimates and assumptions that affect financial results. All of our assets are subject to their own specific risks and uncertainties and are regularly reviewed for impairment. Assets related to the application of the policies discussed below are similarly reviewed with their risks and uncertainties reflecting these specific factors. Our more significant accounting policies are described below. Purchase Accounting The merger between FirstEnergy and GPU was accounted for by the purchase method of accounting, which requires judgment regarding the allocation of the purchase price based on the fair values of the assets acquired (including intangible assets) and the liabilities assumed. The fair values of the acquired assets and assumed liabilities were based primarily on estimates. The adjustments reflected in our records, which were finalized in the fourth quarter of 2002, primarily consist of: (1) revaluation of certain property, plant and equipment; (2) adjusting preferred stock subject to mandatory redemption and long-term debt to estimated fair value; (3) recognizing additional obligations related to retirement benefits; and (4) recognizing estimated severance and other compensation liabilities. The excess of the purchase price over the estimated fair values of the assets acquired and liabilities assumed was recognized as goodwill. Based on the guidance provided by SFAS 142, "Goodwill and Other Intangible Assets," we evaluate goodwill for impairment at least annually and would make such an evaluation more frequently if indicators of impairment should arise. In accordance with the accounting standard, if the fair value of a reporting unit is less than its carrying value (including goodwill), the goodwill is tested for impairment. If impairment were indicated, we would recognize a loss - calculated as the difference between the implied fair value of its goodwill and the carrying value of the goodwill. Our annual review was completed in the third quarter of 2003, with no impairment of goodwill indicated. The forecasts used in our evaluation of goodwill reflect operations consistent with our general business assumptions. Unanticipated changes in those 9 assumptions could have a significant effect on our future evaluations of goodwill. As of December 31, 2003, we had recorded goodwill of approximately $899 million related to the merger. Regulatory Accounting We are subject to regulation that sets the prices (rates) we are permitted to charge our customers based on the costs that the regulatory agencies determine we are permitted to recover. At times, regulators permit the future recovery through rates of costs that would be currently charged to expense by an unregulated company. This rate-making process results in the recording of regulatory assets based on anticipated future cash inflows. As a result of the changing regulatory framework in Pennsylvania, a significant amount of regulatory assets have been recorded - $497 million as of December 31, 2003. We regularly review these assets to assess their ultimate recoverability within the approved regulatory guidelines. Impairment risk associated with these assets relates to potentially adverse legislative, judicial or regulatory actions in the future. Derivative Accounting Determination of appropriate accounting for derivative transactions requires the involvement of management representing operations, finance and risk assessment. In order to determine the appropriate accounting for derivative transactions, the provisions of the contract need to be carefully assessed in accordance with the authoritative accounting literature and management's intended use of the derivative. New authoritative guidance continues to shape the application of derivative accounting. Management's expectations and intentions are key factors in determining the appropriate accounting for a derivative transaction and, as a result, such expectations and intentions are documented. Derivative contracts that are determined to fall within the scope of SFAS 133, as amended, must be recorded at their fair value. Active market prices are not always available to determine the fair value of the later years of a contract, requiring that various assumptions and estimates be used in their valuation. We continually monitor our derivative contracts to determine if our activities, expectations, intentions, assumptions and estimates remain valid. As part of our normal operations, we enter into commodity contracts which increase the impact of derivative accounting judgments. Revenue Recognition We follow the accrual method of accounting for revenues, recognizing revenue for kilowatt-hours that have been delivered but not yet billed through the end of the accounting period. The determination of unbilled revenues requires management to make various estimates including: o Net energy generated or purchased for retail load o Losses of energy over distribution lines o Allocations to distribution companies within the FirstEnergy system o Mix of kilowatt-hour usage by residential, commercial and industrial customers o Kilowatt-hour usage of customers receiving electricity from alternative suppliers Pension and Other Postretirement Benefits Accounting FirstEnergy's reported costs of providing non-contributory defined pension benefits and postemployment benefits other than pensions are dependent upon numerous factors resulting from actual plan experience and certain assumptions. Pension and OPEB costs are affected by employee demographics (including age, compensation levels, and employment periods), the level of contributions FirstEnergy makes to the plans, and earnings on plan assets. Such factors may be further affected by business combinations (such as FirstEnergy's merger with GPU, Inc. in November 2001), which impacts employee demographics, plan experience and other factors. Pension and OPEB costs are also affected by changes to key assumptions, including anticipated rates of return on plan assets, the discount rates and health care trend rates used in determining the projected benefit obligations for pension and OPEB costs. Plan amendments to retirement health care benefits in 2003 and 2002, related to changes in benefits provided and cost-sharing provisions, which reduced FirstEnergy's obligation by $123 and $121 million, respectively. In early 2004, FirstEnergy announced that it would amend the benefit provisions of its health care benefits plan and both employees and retirees would share in more of the benefit costs. In accordance with SFAS 87, "Employers' Accounting for Pensions" and SFAS 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," changes in pension and OPEB obligations associated with these factors may not be immediately recognized as costs on the income statement, but generally are recognized in future years over the remaining average service period of plan participants. SFAS 87 and SFAS 106 delay recognition of changes due to the long-term nature of pension and OPEB obligations and the varying market conditions likely to occur over long periods of time. As such, significant portions of pension and OPEB costs recorded in any period may not reflect the actual level of cash benefits provided to plan participants and are significantly influenced by assumptions about future market conditions and plan participants' experience. 10 In selecting an assumed discount rate, FirstEnergy considers currently available rates of return on high-quality fixed income investments expected to be available during the period to maturity of the pension and other postretirement benefit obligations. Due to recent declines in corporate bond yields and interest rates in general, FirstEnergy reduced the assumed discount rate as of December 31, 2003 to 6.25% from 6.75% and 7.25% used as of December 31, 2002 and 2001, respectively. FirstEnergy's assumed rate of return on pension plan assets considers historical market returns and economic forecasts for the types of investments held by their pension trusts. In 2003, 2002 and 2001, plan assets actually earned 24.0%, (11.3)% and (5.5)%, respectively. FirstEnergy's pension costs in 2003 were computed assuming a 9.0% rate of return on plan assets based upon projections of future returns and their pension trust investment allocation of approximately 70% equities, 27% bonds, 2% real estate and 1% cash. As a result of GPU Service Inc. merging with FirstEnergy Service Company in the second quarter of 2003, operating company employees of GPU Service were transferred to the former GPU operating companies. Accordingly, FirstEnergy requested an actuarial study to update the pension liabilities for each of its subsidiaries. Based on the actuary's report, our accrued pension costs as of June 30, 2003 increased by $71 million. The corresponding adjustment related to this change decreased other comprehensive income and deferred income taxes and increased the payable to associated companies. Due to the increased market value of our pension plan assets, we reduced our minimum liability as prescribed by SFAS 87 as of December 31, 2003 by $20 million, recording an increase of $47,000 in an intangible asset and crediting OCI by $12 million (offsetting previously recorded deferred tax benefits by $8 million). The remaining balance in OCI of $42 million will reverse in future periods to the extent the fair value of trust assets exceeds the accumulated benefit obligation. The accrued pension cost was reduced to $58 million as of December 31, 2003. Based on pension assumptions and pension plan assets as of December 31, 2003, FirstEnergy will not be required to fund their pension plans in 2004. However, health care cost trends have significantly increased and will affect future OPEB costs. FirstEnergy's pension and OPEB expenses in 2004 are expected to decrease by $38 million and $34 million, respectively. These reductions reflect the actual performance of pension plan assets and amendments to the health care benefits plan announced in early 2004 which result in employees and retirees sharing more of the benefit costs. The reduction in OPEB costs for 2004 does not reflect the impact of the new Medicare law signed by President Bush in December 2003 due to uncertainties regarding some of its new provisions (see Note 1(I)). The 2003 and 2002 composite health care trend rate assumptions are approximately 10%-12% gradually decreasing to 5% in later years. In determining their trend rate assumptions, FirstEnergy included the specific provisions of their health care plans, the demographics and utilization rates of plan participants, actual cost increases experienced in their health care plans, and projections of future medical trend rates. The effect on FirstEnergy's pension and OPEB costs and liabilities from changes in key assumptions are as follows: Increase in Costs from Adverse Changes in Key Assumptions -------------------------------------------------------------------------------- Assumption Adverse Change Pension OPEB Total -------------------------------------------------------------------------------- (In millions) Discount rate................ Decrease by 0.25% $ 10 $ 6 $ 16 Long-term return on assets... Decrease by 0.25% $ 8 $ 1 $ 9 Health care trend rate....... Increase by 1% na $26 $ 26 Increase in Minimum Liability ---------------------------- Discount rate................ Decrease by 0.25% $104 na $104 -------------------------------------------------------------------------------- Long-Lived Assets In accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," we periodically evaluate our long-lived assets to determine whether conditions exist that would indicate that the carrying value of an asset might not be fully recoverable. The accounting standard requires that if the sum of future cash flows (undiscounted) expected to result from an asset is less than the carrying value of the asset, an asset impairment must be recognized in the financial statements. If impairment has occurred, we recognize a loss - calculated as the difference between the carrying value and the estimated fair value of the asset (discounted future net cash flows). The calculation of future cash flows is based on assumptions, estimates and judgement about future events. The aggregate amount of cash flows determines whether an impairment is indicated. The timing of the cash flows is critical in determining the amount of the impairment. 11 Nuclear Decommissioning In accordance with SFAS 143, we recognize an ARO for the future decommissioning of TMI-2. The ARO liability represents an estimate of the fair value of our current obligation related to nuclear decommissioning and the retirement of other assets. A fair value measurement inherently involves uncertainty in the amount and timing of settlement of the liability. We used an expected cash flow approach (as discussed in FASB Concepts Statement No. 7, "Using Cash Flow Information and Present Value in Accounting Measurements") to measure the fair value of the nuclear decommissioning ARO. This approach applies probability weighting to discounted future cash flow scenarios that reflect a range of possible outcomes. New Accounting Standards and Interpretations Adopted FIN 46 (revised December 2003), "Consolidation of Variable Interest Entities" In December 2003, the FASB issued a revised interpretation of Accounting Research Bulletin No. 51, "Consolidated Financial Statements." FASB Interpretation No. 46, "Consolidation of Variable Interest Entities", referred to as "FIN 46R", requires the consolidation of a VIE by an enterprise if that enterprise is determined to be the primary beneficiary of the VIE. As required, we adopted FIN 46R for interests in VIEs or potential VIEs commonly referred to as special-purpose entities effective December 31, 2003. We will adopt FIN 46R for all other types of entities effective March 31, 2004. As described in Note 4(E), we created a statutory business trust to issue trust preferred securities in the amount of $92 million. Application of the guidance in FIN 46R resulted in the holders of the preferred securities being considered the primary beneficiaries of these trusts. Therefore, we have deconsolidated the trust and recognized an equity investment in the trust of $3 million and subordinated debentures to the trust of $95 million as of December 31, 2003. We are evaluating entities that meet the deferral criteria and may be subject to consolidation under FIN 46R as of March 31, 2004. These entities are non-utility generators in which we have neither debt nor equity investments but are generally the sole purchaser of their power. SFAS 143, "Accounting for Asset Retirement Obligations" In January 2003, we implemented SFAS 143 which provides accounting standards for retirement obligations associated with tangible long-lived assets. This statement requires recognition of the fair value of a liability for an asset retirement obligation in the period in which it is incurred. See Notes 1(E) and 1(H) for further discussions of SFAS 143. DIG Implementation Issue No. C20 for SFAS 133, "Scope Exceptions: Interpretation of the Meaning of Not Clearly and Closely Related in Paragraph 10(b) Regarding Contracts with a Price Adjustment Feature" In June 2003, the FASB cleared DIG Issue C20 for implementation in fiscal quarters beginning after July 10, 2003. The issue supersedes earlier DIG Issue C11, "Interpretation of Clearly and Closely Related in Contracts That Qualify for the Normal Purchases and Normal Sales Exception." DIG Issue C20 provides guidance regarding when the presence of a general index, such as the Consumer Price Index, in a contract would prevent that contract from qualifying for the normal purchases and normal sales exception under SFAS 133, as amended, and therefore exempt from the mark-to-market treatment of certain contracts. Adoption of DIG Issue C20 did not impact our financial statements. 12 PENNSYLVANIA ELECTRIC COMPANY CONSOLIDATED STATEMENTS OF INCOME
Nov 7 - Jan. 1 - 2003 2002 Dec. 31, 2001 Nov. 6, 2001 ---------------------------------------------------------------------------------------------------------------------- (In thousands) OPERATING REVENUES (Note 1(K))............................ $976,855 $1,027,102 $140,062 | $834,548 -------- ---------- -------- | -------- | OPERATING EXPENSES AND TAXES: | Fuel and purchased power (Note 1(K))................... 609,015 649,725 79,815 | 519,838 Other operating costs (Note 1(K))...................... 164,474 132,996 20,015 | 138,543 -------- ---------- -------- | -------- Total operation and maintenance expenses............. 773,489 782,721 99,830 | 658,381 Provision for depreciation and amortization............ 53,754 61,476 8,613 | 49,191 General taxes.......................................... 66,999 65,301 6,281 | 39,532 Income taxes........................................... 22,403 29,414 10,997 | 17,395 -------- ---------- -------- | -------- Total operating expenses and taxes................... 916,645 938,912 125,721 | 764,499 -------- ---------- -------- | -------- | OPERATING INCOME.......................................... 60,210 88,190 14,341 | 70,049 | OTHER INCOME (EXPENSE).................................... 1,920 1,742 3,049 | (6,610) -------- ---------- -------- | -------- | INCOME BEFORE NET INTEREST CHARGES........................ 62,130 89,932 17,390 | 63,439 -------- ---------- -------- | -------- | NET INTEREST CHARGES: | Interest on long-term debt............................. 29,565 31,758 3,972 | 28,751 Allowance for borrowed funds used during | construction......................................... (320) (52) 47 | (494) Deferred interest ..................................... 4,553 (3,299) (504) | (783) Other interest expense ................................ 4,318 3,061 1,979 | 6,008 Subsidiary's preferred stock dividend requirements..... 3,777 7,554 1,101 | 6,239 -------- ---------- -------- | -------- Net interest charges................................. 41,893 39,022 6,595 | 39,721 -------- ---------- -------- | -------- | INCOME BEFORE CUMULATIVE | EFFECT OF ACCOUNTING CHANGE............................ 20,237 50,910 10,795 | 23,718 | Cumulative effect of accounting change (net of | income taxes of $777,000) (Note 1(H))................ 1,096 -- -- | -- -------- ---------- -------- | -------- | NET INCOME................................................ $ 21,333 $ 50,910 $ 10,795 | $ 23,718 ======== ========== ======== | ======== The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. 13
< PENNSYLVANIA ELECTRIC COMPANY CONSOLIDATED BALANCE SHEETS
As of December 31, 2003 2002 ------------------------------------------------------------------------------------------------------------------ (In thousands) ASSETS UTILITY PLANT: In service..................................................................... $1,966,624 $1,844,999 Less-Accumulated provision for depreciation.................................... 785,715 647,581 ---------- ---------- 1,180,909 1,197,418 Construction work in progress.................................................. 29,063 19,200 ---------- ---------- 1,209,972 1,216,618 ---------- ---------- OTHER PROPERTY AND INVESTMENTS: Non-utility generation trusts.................................................. 43,864 109,881 Nuclear plant decommissioning trusts........................................... 102,673 88,818 Long-term notes receivable from associated companies........................... 13,794 15,515 Other.......................................................................... 19,635 9,425 ---------- ---------- 179,966 223,639 ---------- ---------- CURRENT ASSETS: Cash and cash equivalents...................................................... 36 10,310 Receivables- Customers (less accumulated provisions of $5,833,000 and $6,216,000 respectively, for uncollectible accounts).................................. 124,462 128,303 Associated companies......................................................... 88,598 45,236 Other........................................................................ 15,767 16,184 Prepayments and other.......................................................... 2,511 2,551 ---------- ---------- 231,374 202,584 ---------- ---------- NONCURRENT LIABILITIES: Regulatory assets.............................................................. 497,219 599,663 Goodwill....................................................................... 898,547 898,086 Accumulated deferred income tax benefits....................................... 16,642 1,517 Other.......................................................................... 18,523 21,147 ---------- ---------- 1,430,931 1,520,413 ---------- ---------- $3,052,243 $3,163,254 ========== ========== CAPITALIZATION AND LIABILITIES CAPITALIZATION (See Consolidated Statements of Capitalization): Common stockholder's equity.................................................... $1,297,332 $1,353,704 Company-obligated trust preferred securities (Note 4(E))....................... -- 92,214 Long-term debt and other long-term obligations-- Subordinated debentures to affiliated trusts (Note 4(E))..................... 95,520 -- Other........................................................................ 343,244 470,274 ---------- ---------- 1,736,096 1,916,192 ---------- ---------- CURRENT LIABILITIES: Currently payable long-term debt .............................................. 125,762 813 Short-term borrowings (Note 5)- Associated companies......................................................... 78,510 90,427 Accounts payable- Associated companies......................................................... 55,831 129,906 Other........................................................................ 40,192 29,690 Accrued taxes................................................................. 8,705 21,271 Accrued interest............................................................... 12,694 12,695 Other.......................................................................... 21,764 8,409 ---------- ---------- 343,458 293,211 ---------- ---------- NONCURRENT LIABILITIES: Accumulated deferred investment tax credits.................................... 9,936 10,924 Asset retirement obligation.................................................... 105,089 -- Nuclear plant decommissioning costs............................................ -- 135,450 Nuclear fuel disposal costs.................................................... 18,968 18,771 Power purchase contract loss liability......................................... 670,482 765,063 Retirement benefits............................................................ 145,081 1,041 Other.......................................................................... 23,133 22,602 ---------- ---------- 972,689 953,851 ---------- ---------- COMMITMENTS AND CONTINGENCIES (Notes 3 and 6)................................................................ ---------- ---------- $3,052,243 $3,163,254 ========== ========== The accompanying Notes to Consolidated Financial Statements are an integral part of these balance sheets. 14
PENNSYLVANIA ELECTRIC COMPANY CONSOLIDATED STATEMENTS OF CAPITALIZATION
As of December 31, 2003 2002 ------------------------------------------------------------------------------------------------------------- (Dollars in thousands, except per share amounts) COMMON STOCKHOLDER'S EQUITY: Common stock, par value $20 per share, authorized 5,400,000 shares 5,290,596 shares outstanding........................................... $ 105,812 $ 105,812 Other paid-in capital.................................................... 1,215,667 1,215,256 Accumulated other comprehensive loss (Note 4(F))......................... (42,185) (69) Retained earnings (Note 4(A))............................................ 18,038 32,705 ---------- ---------- Total common stockholder's equity...................................... 1,297,332 1,353,704 ---------- ---------- COMPANY OBLIGATED TRUST PREFERRED SECURITIES OF SUBSIDIARY TRUST (NOTE 4(E)): 7.34% due 2039......................................................... -- 92,214 ---------- ---------- LONG-TERM DEBT (Note 4(D)): First mortgage bonds: 6.125% due 2007........................................................ 3,700 3,905 5.35% due 2010......................................................... 12,310 12,310 5.35% due 2010......................................................... 12,000 12,000 5.80% due 2020......................................................... 20,000 20,000 6.05% due 2025......................................................... 25,000 25,000 ---------- ---------- Total first mortgage bonds........................................... 73,010 73,215 ---------- ---------- Unsecured notes: 5.75% due 2004......................................................... 125,000 125,000 7.50% due 2005......................................................... 8,000 8,000 6.125% due 2009........................................................ 100,000 100,000 7.77% due 2010......................................................... 35,000 35,000 6.625% due 2019........................................................ 125,000 125,000 7.34% due 2039......................................................... 95,520 -- 7.49% due 2039......................................................... 2,968 2,984 ---------- ---------- Total unsecured notes................................................ 491,488 395,984 ---------- ---------- Capital lease obligations (Note 3)....................................... 540 1,132 Net unamortized premium discount on debt................................. (512) 756 Long-term debt due within one year....................................... (125,762) (813) ---------- ---------- Total long-term debt................................................... 438,764 470,274 ---------- ---------- TOTAL CAPITALIZATION........................................................ $1,736,096 $1,916,192 ========== ========== The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. 15
PENNSYLVANIA ELECTRIC COMPANY CONSOLIDATED STATEMENTS OF COMMON STOCKHOLDER'S EQUITY
Common Stock Accumulated ------------------- Other Other Comprehensive Number Par Paid-In Comprehensive Retained Income of Shares Value Capital Income (Loss) Earnings ------------- --------- ----- ------- ------------- -------- (Dollars in thousands) Balance, January 1, 2001....................... 5,290,596 $105,812 $ 320,487 $ 23 $ 43,515 Net income.................................. $ 23,718 23,718 Net unrealized gain on investments.......... 12 12 Net unrealized loss on derivative instruments .............................. ( 1,064) (1,064) -------- Comprehensive income........................ $ 22,666 -------- Equity contribution from parent............. 50,000 --------------------------------------------------------------------------------------------------------------------------- Balance, November 6, 2001...................... 5,290,596 105,812 370,487 (1,029) 67,233 Purchase accounting fair value adjustment... 817,703 1,029 (67,233) ___________________________________________________________________________________________________________________________ Balance, November 7, 2001...................... 5,290,596 105,812 1,188,190 -- -- Net income.................................. $ 10,795 10,795 Net unrealized loss on investments.......... (2) (2) Net unrealized gain on derivative instruments .............................. 1,781 1,781 -------- Comprehensive income........................ $ 12,574 -------- --------------------------------------------------------------------------------------------------------------------------- Balance, December 31, 2001..................... 5,290,596 105,812 1,188,190 1,779 10,795 Net income.................................. $ 50,910 50,910 Net unrealized gain on investments......... 5 5 Net unrealized loss on derivative instruments .............................. (1,853) (1,853) -------- Comprehensive income........................ $ 49,062 -------- Cash dividends on common stock.............. (29,000) Purchase accounting fair value adjustment... 27,066 --------------------------------------------------------------------------------------------------------------------------- Balance, December 31, 2002..................... 5,290,596 105,812 1,215,256 (69) 32,705 Net income.................................. $ 21,333 21,333 Net unrealized gain on derivative instruments.......,,...................... 72 72 Minimum liability for unfunded retirement benefits, net of $(29,908,000) of income taxes .......................... (42,188) (42,188) -------- Comprehensive loss.......................... $(20,783) -------- Cash dividends on common stock.............. (36,000) Purchase accounting fair value adjustment... 411 --------------------------------------------------------------------------------------------------------------------------- Balance, December 31, 2003..................... 5,290,596 $105,812 $1,215,667 $(42,185) $ 18,038 ===========================================================================================================================
CONSOLIDATED STATEMENTS OF PREFERRED STOCK Subject to Mandatory Redemption ------------------------ Number Carrying of Shares Value --------- -------- (Dollars in thousands) Balance, January 1, 2001.......... 4,000,000 $100,000 ============================================================== Purchase accounting fair value adjustment.............. (8,000) -------------------------------------------------------------- Balance, December 31, 2001........ 4,000,000 92,000 ============================================================== Amortization of fair market value adjustment.............. 214 -------------------------------------------------------------- Balance, December 31, 2002........ 4,000,000 $ 92,214 ============================================================== FIN 46 Deconsolidation 7.34% Series.................. (4,000,000) (92,428) Amortization of fair market value adjustment.............. 214 -------------------------------------------------------------- Balance, December 31, 2003........ -- $ -- ============================================================== The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. 16
PENNSYLVANIA ELECTRIC COMPANY CONSOLIDATED STATEMENTS OF CASH FLOWS
Nov. 7 - Jan. 1 - 2003 2002 Dec. 31, 2001 Nov. 6, 2001 --------------------------------------------------------------------------------------------------------------------- (In thousands) CASH FLOWS FROM OPERATING ACTIVITIES: Net Income................................................ $ 21,333 $ 50,910 $ 10,795 | $ 23,718 Adjustments to reconcile net income to net | cash from operating activities: | Provision for depreciation and amortization.......... 53,754 61,476 8,613 | 49,191 Other amortization, net.............................. -- 94 309 | 1,672 Deferred costs recoverable as regulatory assets...... (37,218) (58,953) (7,467) | (143,462) Deferred income taxes, net........................... 41,877 11,893 (23,127) | 60,170 Investment tax credits, net.......................... (988) (1,032) (171) | (970) Cumulative effect of accounting change (Note 1(H))... (1,873) -- -- | -- Receivables.......................................... 13,052 (27,509) (26,592) | 16,566 Accounts payable..................................... (84,700) (5,514) (19,382) | 29,462 Accrued retirement benefit obligations............... 2,727 -- -- | -- Other (Note 7)....................................... 8,012 7,947 41,590 | (36,884) -------- -------- -------- | --------- Net cash provided from (used for) operating | activities ...................................... 15,976 39,312 (15,432) | (537) -------- -------- -------- | --------- | | CASH FLOWS FROM FINANCING ACTIVITIES: | New Financing- | Short-term borrowings, net........................... -- 12,804 2,623 | 19,200 Contributions from parent............................ -- -- -- | 50,000 Redemptions and Repayments- | Long-term debt....................................... (812) (49,973) -- | -- Short-term borrowings, net........................... (11,917) -- -- | -- Dividend Payments- | Common stock......................................... (36,000) (29,000) -- | -- -------- -------- -------- | --------- Net cash provided from (used for) financing | activities ...................................... (48,729) (66,169) 2,623 | 69,200 -------- -------- -------- | --------- | | CASH FLOWS FROM INVESTING ACTIVITIES: | Property additions..................................... (44,657) (50,671) (9,687) | (50,543) Non-utility generation trusts.......................... 66,327 49,044 29,944 | 18,339 Contributions to decommissioning trust withdrawals..... -- -- -- | (15) Loan payments from associated companies, net........... 1,721 -- -- | -- Other.................................................. (912) (239) (246) | (5,194) -------- -------- -------- | --------- Net cash provided from (used for) investing | activities ...................................... 22,479 (1,866) 20,011 | (37,413) -------- -------- -------- | --------- | | | Net increase (decrease) in cash and cash equivalents...... (10,274) (28,723) 7,202 | 31,250 Cash and cash equivalents at beginning of period.......... 10,310 39,033 31,831 | 581 -------- -------- -------- | --------- Cash and cash equivalents at end of period............... $ 36 $ 10,310 $ 39,033 | $ 31,831 ======== ======== ======== | ========= | SUPPLEMENTAL CASH FLOWS INFORMATION: | Cash Paid During the Year- | Interest (net of amounts capitalized)................ $ 37,497 $ 32,695 $ 2,018 | $ 35,134 ======== ======== ======== | ========= Income taxes (refund)................................ $ 10,695 $ 43,613 $(12,176) | $ (14,542) ======== ======== ======== | ========= The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. 17
PENNSYLVANIA ELECTRIC COMPANY CONSOLIDATED STATEMENTS OF TAXES
Nov. 7 - Jan. 1 - 2003 2002 Dec. 31, 2001 Nov. 6, 2001 ---------------------------------------------------------------------------------------------------------------------- (In thousands) GENERAL TAXES: State gross receipts*....................................... $ 53,716 $ 55,505 $ 5,560 | $ 30,932 Real and personal property.................................. 1,624 1,583 (146) | 1,622 Other....................................................... 11,659 8,213 867 | 6,978 --------- --------- --------- | -------- Total general taxes.................................. $ 66,999 $ 65,301 $ 6,281 | $ 39,532 ========= ========= ========= | ======== | PROVISION FOR INCOME TAXES: | Currently payable- | Federal.................................................. $ (15,968) $ 17,554 $ 23,861 | $(36,615) State.................................................... 692 5,833 7,667 | (3,183) --------- --------- --------- | -------- (15,276) 23,387 31,528 | (39,798) --------- --------- --------- | -------- Deferred, net- | Federal.................................................. 35,136 10,600 (17,511) | 46,346 State.................................................... 6,741 1,293 (5,616) | 13,824 --------- --------- --------- | -------- 41,877 11,893 (23,127) | 60,170 --------- --------- --------- | -------- Investment tax credit amortization.......................... (988) (1,032) (171) | (970) --------- --------- --------- | -------- Total provision for income taxes..................... $ 25,613 $ 34,248 $ 8,230 | $ 19,402 ========= ========= ========= | ======== | INCOME STATEMENT CLASSIFICATION | OF PROVISION FOR INCOME TAXES: | Operating income............................................ $ 22,403 $ 29,414 $ 10,997 | $ 17,395 Other income................................................ 2,433 4,834 (2,767) | 2,007 Cumulative effect of accounting change...................... 777 -- -- | -- --------- --------- --------- | -------- Total provision for income taxes..................... $ 25,613 $ 34,248 $ 8,230 | $ 19,402 ========= ========= ========= | ======== | RECONCILIATION OF FEDERAL INCOME TAX | EXPENSE AT STATUTORY RATE TO TOTAL | PROVISION FOR INCOME TAXES: | Book income before provision for income taxes $ 46,946 $ 85,158 $ 19,025 | $ 43,120 ========= ========= ========= | ======== Federal income tax expense at statutory rate................ $ 16,431 $ 29,805 $ 6,659 | $ 15,092 Increases (reductions) in taxes resulting from- | Amortization of investment tax credits................... (988) (1,032) (171) | (969) Depreciation............................................. 2,655 1,591 555 | 1,407 State income tax, net of federal tax..................... 4,831 4,702 1,404 | 7,156 Allocated share of consolidated tax savings.............. -- -- -- | (2,912) Other, net............................................... 2,684 (818) (217) | (372) --------- --------- --------- | -------- Total provision for income taxes..................... $ 25,613 $ 34,248 $ 8,230 | $ 19,402 ========= ========= ========= | ======== | ACCUMULATED DEFERRED INCOME TAXES AT | DECEMBER 31: | Property basis differences.................................. $ 291,752 $ 242,192 $ 256,951 | Nuclear decommissioning..................................... (39,869) (41,665) (42,138) | Non-utility generation costs................................ (223,350) (223,644) (214,492) | Purchase accounting basis difference........................ (762) (762) (38,407) | Sale of generation assets................................... 7,495 7,495 7,495 | Regulatory transition charge................................ -- -- 9,329 | Customer receivables for future income taxes................ 55,817 52,793 61,493 | Other comprehensive income.................................. (29,908) -- -- | Employee benefits........................................... (42,368) -- -- | Other....................................................... (35,449) (37,926) (18,549) | --------- --------- --------- | Net deferred income tax liability (asset)............ $ (16,642) $ (1,517) $ 21,682 | ========= ========= ========= | * Collected from customers through regulated rates and included in revenue on the Consolidated Statements of Income. The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. 18
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: The consolidated financial statements include Pennsylvania Electric Company (Company) and its wholly owned subsidiaries. The Company is a wholly owned subsidiary of FirstEnergy Corp. FirstEnergy also holds directly all of the issued and outstanding common shares of its other principal electric utility operating subsidiaries, including Ohio Edison Company (OE), The Cleveland Electric Illuminating Company (CEI), The Toledo Edison Company (TE), American Transmission Systems, Inc. (ATSI), Jersey Central Power & Light Company (JCP&L) and Metropolitan Edison Company (Met-Ed). The Company, JCP&L and Met-Ed were formerly wholly owned subsidiaries of GPU, Inc., which merged with FirstEnergy on November 7, 2001. Pre-merger and post-merger period financial results are separated by a heavy black line. The Company follows the accounting policies and practices prescribed by the Securities and Exchange Commission (SEC), the Pennsylvania Public Utility Commission (PPUC) and the Federal Energy Regulatory Commission (FERC). The preparation of financial statements in conformity with accounting principles generally accepted in the United States (GAAP) requires management to make periodic estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and the disclosure of contingent assets and liabilities. Actual results could differ from these estimates. Certain prior year amounts have been reclassified to conform with the current year presentation. (A) CONSOLIDATION- The Company consolidates all majority-owned subsidiaries, over which the Company exercises control and, when applicable, entities for which the Company has a controlling financial interest. Intercompany transactions and balances are eliminated in consolidation. Investments in nonconsolidated affiliates (20-50 percent owned companies, joint ventures and partnerships) over which the Company has the ability to exercise significant influence, but not control, are accounted for on the equity basis. (B) REVENUES- The Company's principal business is providing electric service to customers in Pennsylvania. The Company's retail customers are metered on a cycle basis. Revenue is recognized for unbilled electric service provided through the end of the year. See Note 7 - Other Information for discussion of reporting of independent system operator transactions. Receivables from customers include sales to residential, commercial and industrial customers and sales to wholesale customers. There was no material concentration of receivables as of December 31, 2003 or 2002, with respect to any particular segment of the Company's customers. Total customer receivables were $124 million (billed - $73 million and unbilled - $51 million) and $128 million (billed - $79 million and unbilled - $49 million) as of December 31, 2003 and 2002, respectively. (C) REGULATORY PLAN- Pennsylvania enacted its electric utility competition law in 1996 with the phase-in of customer choice for generation suppliers completed as of January 1, 2001. The PPUC authorized a 1998 rate restructuring plan for the Company. In 2000, the PPUC disallowed a portion of the requested additional stranded costs above those amounts granted in the Company's 1998 rate restructuring plan orders. The PPUC required the Company to seek an IRS ruling regarding the return of certain unamortized investment tax credits and excess deferred income tax benefits to customers. If the IRS ruling ultimately supports returning these tax benefits to customers, there would be no effect to the Company's net income since the contingency existed prior to the merger and there would be an adjustment to goodwill. In June 2001, the PPUC approved the Settlement Stipulation with all of the major parties in the combined merger and rate relief proceedings which approved the FirstEnergy/GPU merger and provided provider of last resort (PLR) deferred accounting treatment for energy costs, permitting the Company to defer, for future recovery, energy costs in excess of amounts reflected in its capped generation rates retroactive to January 1, 2001. This PLR deferral accounting procedure was later denied in a February 2002 Commonwealth Court of Pennsylvania decision. The court decision also affirmed the PPUC decision regarding the approval of merger, remanding the decision to the PPUC only with respect to the issue of merger savings. In the first quarter of 2002, the Company established a $111.1 million reserve for its PLR deferred energy costs incurred prior to its acquisition by FirstEnergy. The reserve reflected the potential adverse impact of the then pending Pennsylvania Supreme Court decision whether to review the Commonwealth Court ruling. The reserve increased goodwill by an aggregate net of tax amount of $65.0 million. 19 On April 2, 2003, the PPUC remanded the issue relating to merger savings to the Office of Administrative Law for hearings, directed the Company to file a position paper on the effect of the Commonwealth Court order on the Settlement Stipulation and allowed other parties to file responses to the position paper. The Company filed a letter with the Administrative Law Judge (ALJ) on June 11, 2003, voiding the Stipulation in its entirety and reinstating its restructuring settlement previously approved by the PPUC. On October 2, 2003, the PPUC issued an order concluding that the Commonwealth Court reversed the PPUC's June 20, 2001 order in its entirety. The PPUC directed the Company to file tariffs within thirty days of the order to reflect the competitive transition charge (CTC) rates and shopping credits that were in effect prior to the June 21, 2001 order to be effective upon one day's notice. In response to that order, the Company filed the supplements to its tariffs to become effective October 24, 2003. On October 8, 2003, the Company filed a petition for clarification relating to the October 2, 2003 order on two issues: to establish June 30, 2004 as the date to fully refund the nonutility generation (NUG) trust fund and to clarify that the ordered accounting treatment regarding the CTC rate/shopping credit swap should follow the ratemaking, and that the PPUC's findings would not impair its rights to recover all of its stranded costs. On October 9, 2003, ARIPPA (an intervenor in the proceedings) petitioned the PPUC to direct the Company to reinstate accounting for the CTC rate/shopping credit swap retroactive to January 1, 2002. Several other parties also filed petitions. On October 16, 2003, the PPUC issued a reconsideration order granting the date requested by the Company for the NUG trust fund refund; and, denying the Company's other clarification requests and granting ARIPPA's petition with respect to the accounting treatment of the changes to the CTC rate/shopping credit swap. On October 22, 2003, the Company filed an Objection with the Commonwealth Court asking that the Court reverse the PPUC's finding that requires the Company to treat the stipulated CTC rates that were in effect from January 1, 2002 on a retroactive basis. The Company is considering filing an appeal to the Commonwealth Court on the PPUC orders as well. On October 27, 2003, one Commonwealth Court judge issued an Order denying the Company's objection without explanation. Due to the vagueness of the Order, the Company, on October 31, 2003, filed an Application for Clarification with the judge. Concurrent with this filing, the Company, in order to preserve its rights, also filed with the Commonwealth Court both a Petition for Review of the PPUC's October 16 and 22 Orders, and an application for reargument, if the judge, in his clarification order, indicates that the Company's objection was intended to be denied on the merits. In addition to these findings, the Company, in compliance with the PPUC's Orders, filed revised PPUC quarterly reports for the twelve months ended December 31, 2001 and 2002, and for the first two quarters of 2003, reflecting balances consistent with the PPUC's findings in its Orders. Effective September 1, 2002, the Company assigned its PLR responsibility to its FirstEnergy Solutions Corp. (FES) affiliate through a wholesale power sale agreement. The PLR sale will be automatically extended for each successive calendar year unless any party elects to cancel the agreement by November 1 of the preceding year. Under the terms of the wholesale agreement, FES assumed the supply obligation and the supply profit and loss risk, for the portion of power supply requirements not self-supplied by the Company under its NUG contracts and other power contracts with nonaffiliated third party suppliers. This arrangement reduces the Company's exposure to high wholesale power prices by providing power at a fixed price for their uncommitted PLR energy costs during the term of the agreement with FES. FES has hedged most of the Company's unfilled PLR on-peak obligation through 2004 and a portion of 2005, the period during which deferred accounting was previously allowed under the PPUC's order. The Company' is authorized to continue deferring differences between NUG contract costs and current market prices. In late 2003, the PPUC issued a Tentative Order implementing new reliability benchmarks and standards. In connection therewith, the PPUC commenced a rulemaking procedure to amend the Electric Service Reliability Regulations to implement these new benchmarks, and create additional reporting on reliability. Although neither the Tentative Order nor the Reliability Rulemaking has been finalized, the PPUC ordered all Pennsylvania utilities to begin filing quarterly reports on November 1, 2003. The comment period for both the Tentative Order and the Proposed Rulemaking Order has closed. The Company is currently awaiting the PPUC to issue a final order in both matters. The order will determine (1) the standards and benchmarks to be utilized, and (2) the details required in the quarterly and annual reports. It is expected that these Orders will be finalized in March 2004. On January 16, 2004, the PPUC initiated a formal investigation of the Company's levels of compliance with the Public Utility Code and the PPUC's regulations and orders with regard to reliable electric service. Hearings will be held in August in this investigation and the ALJ has been directed to issue a Recommended Decision by September 30, 2004, in order to allow the PPUC time to issue a Final Order before December 16, 2004. The Company is unable to predict the outcome of the investigation or the impact of the PPUC Order. 20 Regulatory Assets- The Companies recognize, as regulatory assets, costs which the FERC and the PPUC have authorized for recovery from customers in future periods. Without such authorization, the costs would have been charged to income as incurred. All regulatory assets are expected to continue to be recovered from customers under the Company's regulatory plan. The Company continues to bill and collect cost-based rates for its transmission and distribution services, which remain regulated; accordingly, it is appropriate that the Company continue the application of Statement of Financial Accounting Standards (SFAS) No. 71 (SFAS 71), "Accounting for the Effects of Certain Types of Regulation," to those operations. Net regulatory assets on the Consolidated Balance Sheets are comprised of the following: 2003 2002 -------------------------------------------------------------------- (In millions) Regulatory transition charge................... $366 $434 Customer receivables for future income taxes... 128 125 Nuclear decommissioning costs.................. (1) 36 Loss on reacquired debt and other.............. 4 5 ----------------------------------------------------------------- Total....................................... $497 $600 ================================================================= Regulatory Accounting for Generation Operations- The application of SFAS 71 was discontinued in 1998 with respect to the Company's generation operations. The Company subsequently divested substantially all of its generating assets. The SEC issued interpretive guidance regarding asset impairment measurement, providing that any supplemental regulated cash flows such as a CTC should be excluded from the cash flows of assets in a portion of the business not subject to regulatory accounting practices. If those assets are impaired, a regulatory asset should be established if the costs are recoverable through regulatory cash flows. (D) PROPERTY, PLANT AND EQUIPMENT- As a result of the merger, a portion of the Company's property, plant and equipment was adjusted to reflect fair value. The majority of the Company's property, plant and equipment continues to be reflected at original cost since such assets remain subject to rate regulation on a historical cost basis. The Company's accounting policy for planned major maintenance projects is to recognize liabilities as they are incurred. The Company provides for depreciation on a straight-line basis at various rates over the estimated lives of property included in plant in service. The annualized composite rate was approximately 2.7% in 2003, 3.0% in 2002 and 2.9% in 2001. (E) ASSET RETIREMENT OBLIGATION- In January 2003, the Company implemented SFAS 143, "Accounting for Asset Retirement Obligations", which provides accounting standards for retirement obligations associated with tangible long-lived assets. This statement requires recognition of the fair value of a liability for an asset retirement obligation (ARO) in the period in which it is incurred. The associated asset retirement costs are capitalized as part of the carrying amount of the long-lived asset. Over time the capitalized costs are depreciated and the present value of the asset retirement liability increases, resulting in a period expense. However, rate-regulated entities may recognize a regulatory asset or liability instead if the criteria for such treatment are met. Upon retirement, a gain or loss would be recognized if the cost to settle the retirement obligation differs from the carrying amount. The Company identified applicable legal obligations as defined under the new standard for nuclear power plant decommissioning. The ARO liability as of the date of adoption of SFAS 143 was $99.1 million, including accumulated accretion for the period from the date the liability was incurred to the date of adoption. As of December 31, 2002, the Company recognized decommissioning liabilities of $129.9 million. The Company expects substantially all nuclear decommissioning costs to be recoverable through regulated rates. Therefore, a regulatory liability of $30.8 million was recognized upon adoption of SFAS 143. Accretion during 2003 was $6.0 million, bringing the ARO liability as of December 31, 2003 to $105.1 million. The ARO includes the Company's obligation for nuclear decommissioning of Three Mile Island Unit 2 (TMI-2). The Company's share of the obligation to decommission TMI-2 was developed based on a site-specific study performed by an independent engineer. The Company utilized an expected cash flow approach (as discussed in FASB Concepts Statement No. 7, "Using Cash Flow Information and Present Value in Accounting Measurements") to measure the fair value of the nuclear decommissioning ARO. The Company maintains nuclear decommissioning trust funds that are legally restricted for purposes of settling the nuclear decommissioning ARO. As of December 31, 2003, the fair value of the decommissioning trust assets was $102.7 million. 21 The following table provides the year-end balance of the ARO for 2002, as if SFAS 143 had been adopted on January 1, 2002. Adjusted ARO Reconciliation 2002 -------------------------------------------------------- (In millions) Beginning balance as of January 1, 2002 $93.5 Accretion in 2002 5.6 -------------------------------------------------------- Ending balance as of December 31, 2002 $99.1 -------------------------------------------------------- (F) STOCK-BASED COMPENSATION- FirstEnergy applies the recognition and measurement principles of Accounting Principles Board Opinion No. 25 (APB 25), "Accounting for Stock Issued to Employees" and related Interpretations in accounting for its stock-based compensation plans (see Note 4(B)). No material stock-based employee compensation expense is reflected in net income as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the grant date, resulting in substantially no intrinsic value. If FirstEnergy had accounted for employee stock options under the fair value method of SFAS 123, "Accounting for Stock Compensation,", a higher value would have been assigned to the options granted. The weighted average assumptions used in valuing the options and their resulting estimated fair values would be as follows: 2003 2002 2001 -------------------------------------------------------------------- Valuation assumptions: Expected option term (years) 7.9 8.1 8.3 Expected volatility......... 26.91% 23.31% 23.45% Expected dividend yield..... 5.09% 4.36% 5.00% Risk-free interest rate..... 3.67% 4.60% 4.67% Fair value per option......... $5.09 $6.45 $4.97 -------------------------------------------------------------------- The effects of applying fair value accounting to the FirstEnergy's stock options would not materially affect the Company's net income. (G) INCOME TAXES- Details of the total provision for income taxes are shown on the Consolidated Statements of Taxes. The Company records income taxes in accordance with the liability method of accounting. Deferred income taxes reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for tax purposes. Investment tax credits, which were deferred when utilized, are being amortized over the recovery period of the related property. Deferred income tax liabilities related to tax and accounting basis differences and tax credit carryforward items are recognized at the statutory income tax rates in effect when the liabilities are expected to be paid. Results for the period January 1, 2001 through November 6, 2001 were included in the final consolidated federal income tax return of GPU, and results for the period November 7, 2001 through December 31, 2001 were included in FirstEnergy's 2001 consolidated federal income tax return. The consolidated tax liability is allocated on a "stand-alone" company basis, with the Company recognizing the tax benefit for any tax losses or credits it contributes to the consolidated return. (H) CUMULATIVE EFFECT OF ACCOUNTING CHANGE As a result of adopting SFAS 143 in January 2003, asset retirement costs were recorded in the amount of $93 million as part of the carrying amount of the related long-lived asset, offset by accumulated depreciation of $93 million. The ARO liability on the date of adoption was $99 million, including accumulated accretion for the period from the date the liability was incurred to the date of adoption. The remaining cumulative effect adjustment for unrecognized depreciation and accretion, offset by the reduction in the existing decommissioning liabilities and the reversal of accumulated estimated removal costs for non-regulated generation assets, was a $1.9 million increase to income ($1.1 million net of tax) in the year ended December 31, 2003. If SFAS 143 had been applied during 2002 and 2001, the impact would not have been material to the Company's Consolidated Statements of Income. (I) PENSION AND OTHER POSTRETIREMENT BENEFIT PLANS FirstEnergy provides noncontributory defined benefit pension plans that cover substantially all of the Company's employees. The trusteed plans provide defined benefits based on years of service and compensation levels. FirstEnergy's funding policy is based on actuarial computations using the projected unit credit method. No pension contributions were required during the three years ended December 31, 2003. 22 FirstEnergy provides a minimum amount of noncontributory life insurance to retired employees in addition to optional contributory insurance. Health care benefits, which include certain employee contributions, deductibles and copayments, are also available to retired employees, their dependents and, under certain circumstances, their survivors. The Company recognizes the expected cost of providing other postretirement benefits to employees and their beneficiaries and covered dependents from the time employees are hired until they become eligible to receive those benefits. Pension and OPEB costs are affected by employee demographics (including age, compensation levels, and employment periods), the level of contributions made to the plans, and earnings on plan assets. Such factors may be further affected by business combinations (such as FirstEnergy's merger with GPU, Inc. in November 2001), which impacts employee demographics, plan experience and other factors. Pension and OPEB costs may also be affected by changes to key assumptions, including anticipated rates of return on plan assets, the discount rates and health care trend rates used in determining the projected benefit obligations and pension and OPEB costs. FirstEnergy uses a December 31 measurement date for the majority of its plans. Plan amendments to retirement health care benefits in 2003 and 2002, relate to changes in benefits provided and cost-sharing provisions, which reduced FirstEnergy's obligation by $123 and $121 million, respectively. In early 2004, FirstEnergy announced that it would amend the benefit provisions of its health care benefits plan and both employees and retirees would share in more of the benefit costs. On December 8, 2003, President Bush signed into law a bill that expands Medicare, primarily adding a prescription drug benefit for Medicare-eligible retirees starting in 2006. FirstEnergy anticipates that the benefits it pays after 2006 will be lower as a result of the new Medicare provisions. Due to uncertainties surrounding some of the new Medicare provisions and a lack of authoritative accounting guidance about these issues, FirstEnergy deferred the recognition of the impact of the new Medicare provisions as provided by FASB Staff Position 106-1. The final accounting guidance could require changes to previously reported information. The following sets forth the funded status of the plans and amounts recognized on FirstEnergy's Consolidated Balance Sheets as of December 31: 23
Obligations and Funded Status Pension Benefits Other Benefits ---------------- -------------- As of December 31 2003 2002 2003 2002 ------------------------------------------------------------------------------------------ (In millions) Change in benefit obligation Benefit obligation at beginning of year.. $3,866 $3,548 $ 2,077 $ 1,582 Service cost............................. 66 59 43 28 Interest cost............................ 253 249 136 114 Plan participants' contributions......... -- -- 6 -- Plan amendments.......................... -- -- (123) (121) Actuarial loss........................... 222 268 323 440 GPU acquisition (Note 2)................. -- (12) -- 110 Benefits paid............................ (245) (246) (94) (76) ------ ------ ------- ------- Benefit obligation at end of year........ $4,162 $3,866 $ 2,368 $ 2,077 ====== ====== ======= ======= Change in fair value of plan assets Fair value of plan assets at beginning of year $2,889 $3,484 $ 473 $ 535 Actual return on plan assets............. 671 (349) 88 (57) Company contribution..................... -- -- 68 31 Plan participants' contribution.......... -- -- 2 -- Benefits paid............................ (245) (246) (94) (36) ------ ------ ------- ------- Fair value of plan assets at end of year. $3,315 $2,889 $ 537 $ 473 ====== ====== ======= ======== Funded status............................ $ (847) $ (977) $(1,831) $(1,604) Unrecognized net actuarial loss.......... 919 1,186 994 752 Unrecognized prior service cost (benefit) 72 78 (221) (107) Unrecognized net transition obligation... -- -- 83 92 ------ ------ ------- ------- Net asset (liability) recognized......... $ 144 $ 287 $ (975) $ (867) ====== ====== ======= ======= Amounts Recognized in the Consolidated Balance Sheets As of December 31 ---------------------------------------- Accrued benefit cost..................... $(438) $ (548) $ (975) $ (867) Intangible assets........................ 72 78 -- -- Accumulated other comprehensive loss..... 510 757 -- -- ----- ------ ------ ------- Net amount recognized.................... $ 144 $ 287 $ (975) $ (867) ===== ====== ====== ======= Company's share of net amount recognized. $ 14 $ -- $ (86) $ -- ===== ====== ====== ======= Increase (decrease) in minimum liability included in other comprehensive income (net of tax).................... $ (145) $ 444 $ -- $ -- Weighted-Average Assumptions Used to Determine Benefit Obligations As of December 31 --------------------------------------- Discount rate............................ 6.25% 6.75% 6.25% 6.75% Rate of compensation increase............ 3.50% 3.50% Allocation of Plan Assets As of December 31 --------------------------------------- Asset Category Equity securities........................ 70% 61% 71% 58% Debt securities.......................... 27 35 22 29 Real estate.............................. 2 2 -- -- Other.................................... 1 2 7 13 ----- ----- ---- ---- Total.................................... 100% 100% 100% 100% === === === === Information for Pension Plans With an Accumulated Benefit Obligation in Excess of Plan Assets 2003 2002 --------------------------------------- ---- ---- (In millions) Projected benefit obligation............. $4,162 $3,866 Accumulated benefit obligation........... 3,753 3,438 Fair value of plan assets................ 3,315 2,889 24
FirstEnergy's net pension and other postretirement benefit costs for the three years ended December 31, 2003 were computed as follows:
Pension Benefits Other Benefits ---------------------- -------------------- Components of Net Periodic Benefit Costs 2003 2002 2001 2003 2002 2001 --------------------------------------------------------------------------------------------- (In millions) Service cost............................ $ 66 $ 59 $ 35 $ 43 $ 29 $ 18 Interest cost........................... 253 249 133 137 114 65 Expected return on plan assets.......... (248) (346) (205) (43) (52) (10) Amortization of prior service cost...... 9 9 9 (9) 3 3 Amortization of transition obligation (asset)............................... -- -- (2) 9 9 9 Recognized net actuarial loss........... 62 -- -- 40 11 5 Voluntary early retirement program...... -- -- 6 -- -- 2 ------ ------ ------ ----- ---- ----- Net periodic cost (income).............. $ 142 $ (29) $ (24) $ 177 $114 $ 92 ====== ====== ====== ===== ==== ===== Company's share of net periodic cost (income) (see Note 7) Weighted-Average Assumptions Used to Determine Net Periodic Benefit Cost for Years Ended December 31 --------------------------------------- Discount rate.......................... 6.75% 7.25% 7.75% 6.75% 7.25% 7.75% Expected long-term return on plan assets............................... 9.00% 10.25% 10.25% 9.00% 10.25% 10.25% Rate of compensation increase.......... 3.50% 4.00% 4.00%
In selecting an assumed discount rate, FirstEnergy considers currently available rates of return on high-quality fixed income investments expected to be available during the period to maturity of the pension and other postretirement benefit obligations. The assumed rate of return on pension plan assets considers historical market returns and economic forecasts for the types of investments held by the Company's pension trusts. The long-term rate of return is developed considering the portfolio's asset allocation strategy. Assumed health care cost trend rates As of December 31 2003 2002 -------------------------------------------------------------------------------- Health care cost trend rate assumed for next year (pre/post-Medicare).......................... 10%-12% 10%-12% Rate to which the cost trend rate is assumed to decline (the ultimate trend rate)................. 5% 5% Year that the rate reaches the ultimate trend rate (pre/post-Medicare).......................... 2009-2011 2008-2010 Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. A one-percentage-point change in assumed health care cost trend rates would have the following effects: 1-Percentage- 1-Percentage- Point Increase Point Decrease -------------------------------------------------------------------------------- (In millions) Effect on total of service and interest cost.. $ 26 $ (19) Effect on postretirement benefit obligation... $233 $(212) FirstEnergy employs a total return investment approach whereby a mix of equities and fixed income investments are used to maximize the long-term return of plan assets for a prudent level of risk. Risk tolerance is established through careful consideration of plan liabilities, plan funded status, and corporate financial condition. The investment portfolio contains a diversified blend of equity and fixed-income investments. Furthermore, equity investments are diversified across U.S. and non-U.S. stocks, as well as growth, value, and small and large capitalizations. Other assets such as real estate are used to enhance long-term returns while improving portfolio diversification. Derivatives may be used to gain market exposure in an efficient and timely manner; however, derivatives are not used to leverage the portfolio beyond the market value of the underlying investments. Investment risk is measured and monitored on a continuing basis through periodic investment portfolio reviews, annual liability measurements, and periodic asset/liability studies. As a result of GPU Service Inc. (GPUS) merging with FirstEnergy Service Company (FESC) in the second quarter of 2003, operating company employees of GPU Service were transferred to the former GPU operating companies. Accordingly, FirstEnergy requested an actuarial study to update the pension liabilities for each of its subsidiaries. Based on the actuary's report, the accrued pension costs for the Company as of June 30, 2003 increased by $71 million. The corresponding adjustment related to this change decreased other comprehensive income and deferred income taxes and increased the payable to associated companies. 25 Due to the increased market value of its pension plan assets, the Company reduced its minimum liability as prescribed by SFAS 87 as of December 31, 2003 by $20 million, recording an increase of $47,000 in an intangible asset and crediting OCI by $12 million (offsetting previously recorded deferred tax benefits by $8 million). The remaining balance in OCI of $42 million will reverse in future periods to the extent the fair value of trust assets exceeds the accumulated benefit obligation. The accrued pension cost was reduced to $58 million as of December 31, 2003. FirstEnergy does not expect to contribute to its pension plans in 2004 and expects to contribute $16 million to its other postretirement benefit plans in 2004. (J) GOODWILL- In a business combination, the excess of the purchase price over the estimated fair values of the assets acquired and liabilities assumed is recognized as goodwill. Under SFAS 142, "Goodwill and Other Intangible Assets," amortization of existing goodwill ceased January 1, 2002. Instead, the Company evaluates goodwill for impairment at least annually and makes such an evaluation more frequently if indicators of impairment should arise. In accordance with the accounting standard, if the fair value of a reporting unit is less than its carrying value (including goodwill), the goodwill is tested for impairment. When impairment is indicated, the Company recognizes a loss - calculated as the difference between the implied fair value of a reporting unit's goodwill and the carrying value of the goodwill. The Company's annual review was completed in the third quarter of 2003. The forecasts used in the Company's evaluations of goodwill reflect operations consistent with its general business assumptions. Unanticipated changes in those assumptions could have a significant effect on the Company's future evaluations of goodwill. As of December 31, 2003, the Company had $899 million of goodwill. (K) TRANSACTIONS WITH AFFILIATED COMPANIES- Operating revenues, operating expenses and other income included transactions with affiliated companies, primarily FESC, GPUS and FES. GPUS (until it ceased operations in mid-2003) and FESC have provided legal, accounting, financial and other services to the Company. The Company also entered into sale and purchase transactions with affiliates (JCP&L and Met-Ed) during the period. Effective September 1, 2002, the Company assigned its PLR responsibility to FES through a wholesale power sale agreement. See Note 7(C) for affiliated companies' transactions schedule. FirstEnergy does not bill directly or allocate any of its costs to any subsidiary company. Costs are allocated to the Company from its affiliates, GPUS and FESC, both subsidiaries of FirstEnergy Corp. and both "mutual service companies" as defined in Rule 93 of the Public Utility Holding Company Act of 1935 (PUHCA). The vast majority of costs are directly billed or assigned at no more than cost as determined by PUHCA Rule 91. The remaining costs are for services that are provided on behalf of more than one company, or costs that cannot be precisely identified and are allocated using formulas that are filed annually with the SEC on Form U-13-60. The current allocation or assignment formulas used and their bases include multiple factor formulas; each company's proportionate amount of the FirstEnergy's aggregate total for direct payroll, number of employees, asset balances, revenues, number of customers, other factors and specific departmental charge ratios. It is management's belief that allocation methods utilized are reasonable. (L) CASH AND FINANCIAL INSTRUMENTS- All temporary cash investments purchased with an initial maturity of three months or less are reported as cash equivalents on the Consolidated Balance Sheets at cost, which approximates their fair market value. All borrowings with initial maturities of less than one year are defined as financial instruments under GAAP and are reported on the Consolidated Balance Sheets at cost, which approximates their fair market value. The following sets forth the approximate fair value and related carrying amounts of all other long-term debt, preferred stock subject to mandatory redemption and investments other than cash and cash equivalents as of December 31: 2003 2002 ----------------------------------------------------------------------------- Carrying Fair Carrying Fair Value Value Value Value ----------------------------------------------------------------------------- (In millions) Long-term debt..................... $564 $612 $469 $475 Preferred stock.................... $ -- $ -- $ 92 $100 Investments other than cash and cash equivalents............. $149 $149 $199 $199 ----------------------------------------------------------------------------- The fair values of long-term debt and preferred stock reflect the present value of the cash outflows relating to those securities based on the current call price, the yield to maturity or the yield to call, as deemed appropriate at the end of each respective year. The yields assumed were based on securities with similar characteristics offered by corporations with credit ratings similar to the Company's ratings. Long-term debt and preferred stock 26 subject to mandatory redemption were recognized at fair value in connection with the merger. The fair value of investments other than cash and cash equivalents represent cost (which approximates fair value) or the present value of the cash inflows based on the yield to maturity. The yields assumed were based on financial instruments with similar characteristics and terms. Investments other than cash and cash equivalents include decommissioning trust investments. The Company has no securities held for trading purposes. The investment policy for the nuclear decommissioning trust funds restricts or limits the ability to hold certain types of assets including private or direct placements, warrants, securities of FirstEnergy, investments in companies owning nuclear power plants, financial derivatives, preferred stocks, securities convertible into common stock and securities of the trust fund's custodian or managers and their parents or subsidiaries. The investments that are held in the decommissioning trusts (included as "Investments other than cash and cash equivalents" in the table above) consist of equity securities ($54 million) and fixed income securities ($49 million) as of December 31, 2003. Realized and unrealized gains and losses applicable to the decommissioning trusts have been recognized in the trust investment with a corresponding change to regulatory assets. For 2003 and 2002, net realized gains were approximately $0.8 million and $0.2 million and interest and dividend income totaled approximately $2.9 million and $2.7 million, respectively. On January 1, 2001, the Company adopted SFAS 133, "Accounting for Derivative Instruments and Hedging Activities," as amended by SFAS 138, "Accounting for Certain Derivative Instruments and Certain Hedging Activities - an amendment of FASB Statement No. 133." The adoption resulted in the recognition of derivative assets on the Consolidated Balance Sheet as of January 1, 2001 in the amount of $26.0 million, with an offsetting amount, net of tax, recorded in Regulatory Assets of $25.9 million. As of January 1, 2001, the Company also recorded derivative liabilities in the amount of $1.0 million as a result of adopting SFAS 133, with a substantially offsetting amount recorded in Accumulated Other Comprehensive Income, of $0.5 million. As of January 1, 2001, a cumulative effect of accounting change was recognized as an expense in Other Income (Expense), on the Consolidated Statement of Income in the amount of $0.8 million. The Company is exposed to financial risks resulting from the fluctuation of interest rates and commodity prices, including electricity and natural gas. To manage the volatility relating to these exposures, the Company uses a variety of non-derivative and derivative instruments, including options, futures contracts and swaps. These derivatives are used principally for hedging purposes. The Company has a Risk Policy Committee, comprised of FirstEnergy executive officers, which exercises an independent risk oversight function to ensure compliance with corporate risk management policies and prudent risk management practices. The Company uses derivatives to hedge the risk of price. The Company's primary ongoing hedging activity involves cash flow hedges of electricity and natural gas purchases. The majority of the Company's forward commodity contracts are considered "normal purchases and sales," as defined by SFAS 133, and are therefore excluded from the scope of SFAS 138. The options and futures contracts determined to be within the scope of SFAS 133 are accounted for as cash flow hedges and expire on various dates through 2003. Gains and losses from hedges of commodity price risks are included in net income when the underlying hedged commodities are delivered. There was no deferred gain or loss in Accumulated Other Comprehensive Income as of December 31, 2003 related to derivative hedging activity. 2. MERGER: On November 7, 2001, the merger of FirstEnergy and GPU became effective pursuant to the Agreement and Plan of Merger, dated August 8, 2000. As a result of the merger, GPU's former wholly owned subsidiaries, including the Company, became wholly owned subsidiaries of FirstEnergy. The merger was accounted for by the purchase method of accounting. The assets acquired and liabilities assumed were recorded at estimated fair values as determined by FirstEnergy's management based on information currently available and on current assumptions as to future operations. Merger purchase accounting adjustments recorded in the records of the Company primarily consist of: (1) revaluation of certain property, plant and equipment; (2) adjusting preferred stock subject to mandatory redemption and long-term debt to estimated fair value; (3) recognizing additional obligations related to retirement benefits; and (4) recognizing estimated severance and other compensation liabilities. Other assets and liabilities were not adjusted since they remain subject to rate regulation on a historical cost basis. The excess of the purchase price over the estimated fair values of the assets acquired and liabilities assumed was recognized as goodwill. During 2002 and 2003, certain pre-acquisition contingencies and other final adjustments to the fair values of the assets acquired and liabilities assumed were reflected in the final allocations of the purchase price. These adjustments primarily related to: (1) final actuarial calculations related to pension and postretirement benefit obligations; (2) establishment of a reserve 27 for deferred energy costs recognized prior to the merger; and (3) return to accrual adjustments for income taxes. As a result of these adjustments, goodwill increased by approximately $100.7 million. As of December 31, 2003, the Company had recorded goodwill of approximately $898.5 million related to the merger. 3. LEASES: Consistent with regulatory treatment, the rentals for capital leases are charged to operating expenses on the Consolidated Statements of Income. The Company has a capital lease for an operations building, which expires in 2004. In each of the years 2003, 2002 and 2001, total rentals related to this capital lease were $0.7 million, comprised of an interest element of $0.1 million and other costs of $0.6 million. As of December 31, 2003, the future minimum lease payments on the Company's capital lease discussed above are $0.5 million for the year 2004. 4. CAPITALIZATION: (A) RETAINED EARNINGS- The merger purchase accounting adjustments included resetting the retained earnings balance to zero as of the November 7, 2001 merger date. In general, the Company's first mortgage bond (FMB) indentures restrict the payment of dividends or distributions on or with respect to the Company's common stock to amounts credited to earned surplus since approximately the date of its indenture. At such date, the Company had a balance of $10.1 million in its earned surplus account, which would not be available for dividends or other distributions. As of December 31, 2003, the Company had retained earnings available to pay common stock dividends of $7.9 million, net of amounts restricted under the Company's FMB indentures. (B) STOCK COMPENSATION PLANS- FirstEnergy administers the FirstEnergy Executive and Director Incentive Compensation Plan (FE Plan). Under the FE Plan, total awards cannot exceed 22.5 million shares of common stock or their equivalent. Only stock options and restricted stock have been granted, with vesting periods ranging from six months to seven years. Several other stock compensation plans have been acquired through the mergers with GPU and Centerior - GPU, Inc. Stock Option and Restricted Stock Plan for MYR Group Inc. Employees (MYR Plan), 1990 Stock Plan for Employees of GPU, Inc. and Subsidiaries (GPU Plan) and Centerior Equity Plan. No further stock-based compensation can be awarded under these plans. Collectively, the above plans are referred to as the FE Programs. Restricted common stock grants under the FE Programs were as follows: 2003 2002 2001 --------------------------------------------------------------------------- Restricted common shares granted..... -- 36,922 133,162 Weighted average market price ........ n/a (1) $36.04 $35.68 Weighted average vesting period (years) n/a (1) 3.2 3.7 Dividends restricted.................. n/a (1) Yes -- (2) --------------------------------------------------------------------------- (1) Not applicable since no restricted stock was granted. (2) FE Plan dividends are paid as restricted stock on 4,500 shares. Under the Executive Deferred Compensation Plan (EDCP), covered employees can direct a portion of their Annual Incentive Award and/or Long-Term Incentive Award into an unfunded FirstEnergy Stock Account to receive vested stock units. An additional 20% premium is received in the form of stock units based on the amount allocated to the FirstEnergy Stock Account. Dividends are calculated quarterly on stock units outstanding and are paid in the form of additional stock units. Upon withdrawal, stock units are converted to FirstEnergy shares. Payout typically occurs three years from the date of deferral; however, an election can be made in the year prior to payout to further defer shares into a retirement stock account that will pay out in cash upon retirement. As of December 31, 2003, there were 410,399 stock units outstanding. 28 Stock option activities under the FE Programs for the past three years were as follows: Number of Weighted Average Stock Option Activities Options Exercise Price -------------------------------------------------------------------------- Balance, January 1, 2001............. 5,021,862 24.09 (473,314 options exercisable)........ 24.11 Options granted.................... 4,240,273 28.11 Options exercised.................. 694,403 24.24 Options forfeited.................. 120,044 28.07 Balance, December 31, 2001........... 8,447,688 26.04 (1,828,341 options exercisable)...... 24.83 Options granted..................... 3,399,579 34.48 Options exercised................... 1,018,852 23.56 Options forfeited................... 392,929 28.19 Balance, December 31, 2002............ 10,435,486 28.95 (1,400,206 options exercisable)....... 26.07 Options granted.................... 3,981,100 29.71 Options exercised.................. 455,986 25.94 Options forfeited.................. 311,731 29.09 Balance, December 31, 2003........... 13,648,869 29.27 (1,919,662 options exercisable)...... 29.67 As of December 31, 2003, the weighted average remaining contractual life of outstanding stock options was 7.6 years. Options outstanding by plan and range of exercise prices as of December 31, 2003 were as follows: Range of Options FirstEnergy Program Exercise Prices Outstanding ----------------------------------------------------------------------- FE plan $19.31 - $29.87 9,904,861 $30.17 - $35.15 3,214,601 Plans acquired through merger: GPU plan $23.75 - $35.92 501,734 Other plans 27,673 ---------------------------------------------------------------------- Total 13,648,869 ====================================================================== No material stock-based employee compensation expense is reflected in net income for stock options granted under the above plans since the exercise price was equal to the market value of the underlying common stock on the grant date. The effect of applying fair value accounting to FirstEnergy's stock options is summarized in Note 1(F) - Stock-Based Compensation. (C) PREFERRED AND PREFERENCE STOCK- The Company's preferred stock authorization consists of 11.435 million shares without par value. No preferred shares are currently outstanding. (D) LONG-TERM DEBT- The Company's FMB indenture, which secures all of the Company's FMBs, serve as a direct first mortgage lien on substantially all of the Company's property and franchises, other than specifically excepted property. The Company has various debt covenants under its financing arrangements. The most restrictive of these relate to the nonpayment of interest and/or principal on debt, which could trigger a default. Cross-default provisions also exist between FirstEnergy and the Company. Based on the amount of bonds authenticated by the Trustee through December 31, 2003, the Company's annual sinking fund requirements for all bonds issued under the mortgage amount to approximately $1 million. The Company expects to fulfill its sinking fund obligation by providing bondable property additions to the Trustee. 29 Sinking fund requirements for FMBs and maturing long-term debt (excluding capital leases) for the next five years are: (In millions) ------------------------------- 2004................ $125 2005................ 8 2006................ -- 2007................ 3 2008................ -- ------------------------------- The Company's obligations to repay certain pollution control revenue bonds are secured by several series of FMBs. Certain pollution control revenue bonds are entitled to the benefit of noncancelable municipal bond insurance policies of $69 million to pay principal of, or interest on, the pollution control revenue bonds. (E) LONG-TERM DEBT: SUBORDINATED DEBENTURES TO AFFILIATED TRUST- The Company formed a statutory business trust to sell preferred securities and invest the gross proceeds in subordinated debentures. Ownership of the Company's trust is through a separate wholly owned limited partnership. In this transaction, the trust invested the gross proceeds from the sale of its preferred securities in the preferred securities of the limited partnership, which in turn invested those proceeds in the 7.34% subordinated debentures of the Company. The Company has effectively provided a full and unconditional guarantee of obligations under the trust's preferred securities. The trust's preferred securities are redeemable at the option of the Company beginning in September 2004 at 100% of their principal amount. Interest on the subordinated debentures (and therefore distributions on the trust's preferred securities) may be deferred for up to 60 months, but the Company may not pay dividends on, or redeem or acquire, any of its cumulative preferred or common stock until deferred payments on its subordinated debentures are paid in full. Upon adoption of "Consolidation of Variable Interest Entities" (FIN 46R), the limited partnership and statutory business trust discussed above are not consolidated on the Company's financial statements as of December 31, 2003 (see Note 8). (F) COMPREHENSIVE INCOME- Comprehensive income includes net income as reported on the Consolidated Statements of Income and all other changes in common stockholder's equity except those resulting from transactions with the Company's parent. As of December 31, 2003, accumulated other comprehensive loss consisted of a minimum liability for unfunded retirement benefits of $42.2 million. 5. SHORT-TERM BORROWINGS: The Company may borrow from its affiliates on a short-term basis. As of December 31, 2003, the Company had total short-term borrowings of $78.5 million from its affiliates. The weighted average interest rates on short-term borrowings outstanding at December 31, 2003 and 2002 were 1.7% and 1.8%, respectively. 6. COMMITMENTS, GUARANTEES AND CONTINGENCIES: (A) CAPITAL EXPENDITURES- The Company's current forecast reflects expenditures of approximately $198 million for property additions and improvements from 2004 through 2006, of which approximately $66 million is applicable to 2004. (B) NUCLEAR INSURANCE- The Price-Anderson Act limits the public liability relative to a single incident at a nuclear power plant to $10.9 billion. The amount is covered by a combination of private insurance and an industry retrospective rating plan. Based on its present ownership interest in TMI-2, the Company is exempt from any potential assessment under the industry retrospective rating plan. The Company is also insured as to its interest in TMI-2 under a policy issued to the operating company for the plant. Under this policy, $150 million is provided for property damage and decontamination and decommissioning costs. Under this policy, the Company can be assessed a maximum of approximately $0.2 million for incidents at any covered nuclear facility occurring during a policy year which are in excess of accumulated funds available to the insurer for paying losses. The Company intends to maintain insurance against nuclear risks as described above as long as it is available. To the extent that property damage, decontamination, decommissioning, repair and replacement costs and other such costs arising from a nuclear incident at TMI-2 exceed the policy limits of the 30 insurance in effect with respect to that plant, to the extent a nuclear incident is determined not to be covered by the Company's insurance policies, or to the extent such insurance becomes unavailable in the future, the Company would remain at risk for such costs. (C) ENVIRONMENTAL MATTERS- The Company has been named as a "potentially responsible party" (PRP) at waste disposal sites which may require cleanup under the Comprehensive Environmental Response, Compensation and Liability Act of 1980. Allegations of disposal of hazardous substances at historical sites and the liability involved are often unsubstantiated and subject to dispute; however, federal law provides that all PRPs for a particular site be held liable on a joint and several basis. Therefore, potential environmental liabilities have been recognized on the Consolidated Balance Sheet as of December 31, 2003, based on estimates of the total costs of cleanup, the Company's proportionate responsibility for such costs and the financial ability of other nonaffiliated entities to pay. The Company has accrued liabilities aggregating approximately $43,000 as of December 31, 2003. The Company accrues for environmental costs only when they can conclude that it is probable that they have an obligation for such costs and can reasonably determine the amount of such costs. Unasserted claims are reflected in the Company's determination of environmental liabilities and are accrued in the period that they are both probable and reasonably estimable. The Company does not believe environmental remediation costs will have a material adverse effect on its financial condition, cash flows or results of operations. (D) OTHER LEGAL PROCEEDINGS- Various lawsuits, claims and proceedings related to the Company's normal business operations are pending against the Company. On August 14, 2003, various states in the northeast United States and part of southern Canada experienced a widespread power outage. That outage affected approximately 1.4 million customers in FirstEnergy's service area. FirstEnergy continues to accumulate data and evaluate the status of its electrical system prior to and during the outage event, and continues to cooperate with the U.S.-Canada Power System Outage Task Force (Task Force) investigating the August 14th outage. The interim report issued by the Task Force on November 18, 2003 concluded that the problems leading up to the outage began in FirstEnergy's service area. Specifically, the interim report concludes, among other things, that the initiation of the August 14th outage resulted from the coincidence on that afternoon of the following events: (1) inadequate situational awareness at FirstEnergy; (2) FirstEnergy's failure to adequately manage tree growth in its transmission rights of way; and (3) failure of the interconnected grid's reliability organizations (Midwest ISO and PJM Interconnection) to provide effective diagnostic support. We believe that the interim report does not provide a complete and comprehensive picture of the conditions that contributed to the August 14th outage and that it does not adequately address the underlying causes of the outage. On November 25, 2003, the Public Utilities Commission of Ohio (PUCO) ordered FirstEnergy to file a plan with the PUCO no later than March 1, 2004, illustrating how FirstEnergy will correct problems identified by the Task Force as events contributing to the August 14th outage and addressing how FirstEnergy proposed to upgrade its control room computer hardware and software and improve the training of control room operators to ensure that similar problems do not occur in the future. The PUCO, in consultation with the North American Electric Reliability Council, will review the plan before determining the next steps in the proceeding. On December 24, 2003, the FERC ordered FirstEnergy to pay for an independent study of part of Ohio's power grid. The study has commenced and will examine the stability of the grid in critical points in the Cleveland and Akron areas; the status of projected power reserves during summer 2004 through 2008; and the need for new transmission lines or other grid projects. The FERC ordered the study to be completed within 120 days. At this time, we do not know how the results of the study will impact FirstEnergy. 7. OTHER INFORMATION: The following represents the financial data which includes supplemental unaudited prior years' information as compared to consolidated financial statements and notes previously reported in 2001. (A) CONSOLIDATED STATEMENTS OF CASH FLOWS
Nov. 7- Jan. 1- Dec. 31, Nov. 6, 2003 2002 2001 2001 --------------------------------------------------------------------------------------------------------- (Unaudited) (Unaudited) (In millions) Other cash flows from operating activities: Accrued compensation, net............................. $ 7,956 $(1,275) $ -- | $ (619) Accrued taxes......................................... (4,215) (7,984) 26,737 | (21,377) Accrued interest...................................... -- 411 4,002 | (3,300) Prepayments and other................................. 41 6,054 13,253 | (9,990) Other................................................. 4,230 10,741 (2,402) | (1,598) ------- ------- -------- | -------- Other cash provided from (used for) operating activities $ 8,012 $ 7,947 $41,590 | $(36,884) ----------------------------------------------------------------------------------------------------------
31 (B) REVENUES - INDEPENDENT SYSTEM OPERATOR (ISO) TRANSACTIONS- The Company records purchase and sales transactions with PJM Interconnection ISO, an independent system operator, on a gross basis in accordance with EITF Issue No. 99-19, "Reporting Revenue Gross as a Principal versus Net as an Agent." The aggregate purchase and sales transactions for the three years ended December 31, 2003, are summarized as follows: Nov. 7-Dec. 31, Jan. 1-Nov. 6, 2003 2002 2001 2001 ------------------------------------------------------------------------ (Unaudited) (Unaudited) (In millions) | Sales......... $13 $34 $1 | $29 Purchases..... 18 75 9 | 79 ------------------------------------------------------------------------ The Company's revenues on the Consolidated Statements of Income include wholesale electricity sales revenues from the PJM ISO from power sales (as reflected in the table above) during periods when the Company had additional available power capacity. Revenues also include sales by the Company of power sourced from the PJM ISO (reflected as purchases in the table above) during periods when the Company required additional power to meet its retail load requirements. (C) TRANSACTIONS WITH AFFILIATED COMPANIES- The primary affiliated companies transactions are as follows: Nov. 7- Jan. 1- Dec. 31, Nov. 6, 2003 2002 2001 2001 -------------------------------------------------------------------------------- (Unaudited) (Unaudited) (In millions) Operating Revenues: Wholesale sales-affiliated companies... $ -- $ 9.1 $ 1.1 | $10.0 | Operating Expenses: | Power purchased from FES............... 306.6 188.2 14.6 | -- Service Company support services....... 55.3 81.5 17.0 | 93.0 Power purchased from other affiliates.. 4.5 9.7 1.5 | 8.8 -------------------------------------------------------------------------------- (D) RETIREMENTS BENEFITS- (1) Net pension and other postretirement benefit costs (income) for the three years ended December 31, 2003 are approximately as follows: Nov. 7- Jan. 1- Dec. 31, Nov. 6, 2003 2002 2001 2001 ------------------------------------------------------------------------------ (Unaudited) (Unaudited) (In millions) | Pension Benefits.................. $ 7 $(16) $(5) | $(15) Other Postretirement Benefits..... 10 3 1 | 3 ----------------------------------------------------------------------------- (1) Includes estimated portion of benefit costs included in billings from GPUS. 8. NEW ACCOUNTING STANDARDS AND INTERPRETATIONS: FIN 46 (revised December 2003), "Consolidation of Variable Interest Entities" In December 2003, the FASB issued a revised interpretation of Accounting Research Bulletin No. 51, "Consolidated Financial Statements." FASB Interpretation No. 46, "Consolidation of Variable Interest Entities", referred to as "FIN 46R", requires the consolidation of a VIE by an enterprise if that enterprise is determined to be the primary beneficiary of the VIE. As required, the Company adopted FIN 46R for interests in VIEs or potential VIEs commonly referred to as special-purpose entities effective December 31, 2003. Penelec will adopt FIN 46R for all other types of entities effective March 31, 2004. As described in Note 4(E), the Company created a statutory business trust to issue trust preferred securities in the amount of $92 million. Application of the guidance in FIN 46R resulted in the holders of the preferred securities being considered the primary beneficiaries of these trusts. 32 Therefore, the Company has deconsolidated the trust and recognized an equity investment in the trust of $3 million and subordinated debentures to the trust of $95 million as of December 31, 2003. The Company is evaluating entities that meet the deferral criteria and may be subject to consolidation under FIN 46R as of March 31, 2004. These entities are non-utility generators in which we have neither debt nor equity investments but are generally the sole purchaser of their power. SFAS 143, "Accounting for Asset Retirement Obligations" In January 2003, the Company implemented SFAS 143 which provides accounting standards for retirement obligations associated with tangible long-lived assets. This statement requires recognition of the fair value of a liability for an asset retirement obligation in the period in which it is incurred. See Notes 1(E) and 1(H) for further discussions of SFAS 143. DIG Implementation Issue No. C20 for SFAS 133, "Scope Exceptions: Interpretation of the Meaning of Not Clearly and Closely Related in Paragraph 10(b) Regarding Contracts with a Price Adjustment Feature" In June 2003, the FASB cleared DIG Issue C20 for implementation in fiscal quarters beginning after July 10, 2003. The issue supersedes earlier DIG Issue C11, "Interpretation of Clearly and Closely Related in Contracts That Qualify for the Normal Purchases and Normal Sales Exception." DIG Issue C20 provides guidance regarding when the presence of a general index, such as the Consumer Price Index, in a contract would prevent that contract from qualifying for the normal purchases and normal sales exception under SFAS 133, as amended, and therefore exempt from the mark-to-market treatment of certain contracts. Adoption of DIG Issue C20 did not impact the Company's financial statements. 9. SUMMARY OF QUARTERLY FINANCIAL DATA (UNAUDITED): The quarterly financial information for the quarters ended June 30, 2003 and September 30, 2003 have been restated to correct costs that should have been capitalized to construction projects but were improperly recorded as operating expenses. These corrections have resulted in restated earnings increases of $0.4 million and $1.2 million during the quarters ended June 30, 2003 and September 30, 2003, respectively. The impact of these adjustments was not material to the Company's consolidated balance sheets or consolidated statements of cash flows for any quarter of 2003. The following summarizes certain consolidated operating results by quarter for 2003 and 2002.
Three Months Ended March 31, 2003 June 30, 2003 September 30, 2003 December 31, 2003 ------------------------------------------------------------------------------------------------------------------ As Previously As As Previously As Reported Restated Reported Restated -------- -------- --------- -------- (In millions) Operating Revenues.................. $254.9 $231.9 $231.9 $243.0 $243.0 $247.1 Operating Expenses and Taxes........ 242.2 216.0 215.6 230.5 229.3 229.6 ------------------------------------------------------------------------------------------------------------ Operating Income.................... 12.7 15.9 16.3 12.5 13.7 17.5 Other Income (Expense).............. (0.2) 0.5 0.5 0.6 0.6 1.0 Net Interest Charges................ 8.3 8.1 8.1 9.0 9.0 16.5 Income Before Cumulative Effect of Accounting Change...... 4.2 8.3 8.7 4.1 5.3 2.0 Cumulative Effect of Accounting Change (Net of Income Taxes)..... 1.1 -- -- -- -- -- ------------------------------------------------------------------------------------------------------------ Net Income.......................... $ 5.3 $ 8.3 $ 8.7 $ 4.1 $ 5.3 $ 2.0 ============================================================================================================ March 31, June 30, September 30, December 31, Three Months Ended 2002 2002 2002 2002 ------------------------------------------------------------------------------------------------------------- (In millions) Operating Revenues.......................... $242.8 $237.6 $269.4 $277.3 Operating Expenses and Taxes................ 214.3 221.7 256.4 246.5 ------------------------------------------------------------------------------------------------------------- Operating Income ........................... 28.5 15.9 13.0 30.8 Other Income (Expense)...................... 0.3 0.8 1.0 (0.4) Net Interest Charges........................ 10.0 9.8 9.6 9.6 ------------------------------------------------------------------------------------------------------------- Net Income ................................. $ 18.8 $ 6.9 $ 4.4 $ 20.8 =============================================================================================================
33 Report of Independent Auditors To the Stockholders and Board of Directors of Pennsylvania Electric Company: In our opinion, the accompanying consolidated balance sheets and consolidated statements of capitalization and the related consolidated statements of income, common stockholder's equity, preferred stock, cash flows and taxes present fairly, in all material respects, the financial position of Pennsylvania Electric Company (a wholly owned subsidiary of FirstEnergy Corp.) and subsidiaries as of December 31, 2003 and 2002 and the results of their operations and their cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. The consolidated financial statements of Pennsylvania Electric Company and subsidiaries for the period from January 1, 2001 to November 6, 2001 (pre-merger) and the period from November 7, 2001 to December 31, 2001 (post-merger), were audited by other independent auditors who have ceased operations. Those independent auditors expressed an unqualified opinion on those financial statements in their report dated March 18, 2002. As discussed in Note 1(E) to the consolidated financial statements, the Company changed its method of accounting for asset retirement obligations as of January 1, 2003. As discussed in Note 8 to the consolidated financial statements, the Company changed its method of accounting for the consolidation of variable interest entities as of December 31, 2003. PricewaterhouseCoopers LLP Cleveland, Ohio February 25, 2004 34 The following report is a copy of a report previously issued by Arthur Andersen LLP (Andersen). This report has not been reissued by Andersen and Andersen did not consent to the incorporation by reference of this report into any of the Company's registration statements. Report of Previous Independent Public Accountants To the Stockholders and Board of Directors of Pennsylvania Electric Company: We have audited the accompanying consolidated balance sheet and consolidated statement of capitalization of Pennsylvania Electric Company (a Pennsylvania corporation and wholly owned subsidiary of FirstEnergy Corp.) and subsidiaries as of December 31, 2001 (post-merger), and the related consolidated statements of income, common stockholder's equity, preferred stock, cash flows and taxes for the period from January 1, 2001 to November 6, 2001 (pre-merger) and the period from November 7, 2001 to December 31, 2001 (post-merger). These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. The financial statements of Pennsylvania Electric Company and subsidiaries as of December 31, 2000 and for each of the two years in the period ended December 31, 2000 (pre-merger), were audited by other auditors whose report dated January 31, 2001, expressed an unqualified opinion on those statements. We conducted our audit in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the 2001 financial statements referred to above present fairly, in all material respects, the financial position of Pennsylvania Electric Company and subsidiaries as of December 31, 2001 (post-merger), and the results of their operations and their cash flows for the period from January 1, 2001 to November 6, 2001 (pre-merger) and the period from November 7, 2001 to December 31, 2001 (post-merger), in conformity with accounting principles generally accepted in the United States. ARTHUR ANDERSEN LLP Cleveland, Ohio, March 18, 2002. 35