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| CEG > SEC Filings for CEG > Form 10-K on 27-Feb-2009 | All Recent SEC Filings |
27-Feb-2009
Annual Report
Introduction and Overview
Constellation Energy Group, Inc. (Constellation Energy) is an energy company that conducts its business through various subsidiaries including a merchant energy business and Baltimore Gas and Electric Company (BGE). We describe our operating segments in Note 3 to Consolidated Financial Statements.
This report is a combined report of Constellation Energy and BGE. References in this report to "we" and "our" are to Constellation Energy and its subsidiaries, collectively. References in this report to the "regulated business(es)" are to BGE. We discuss our business in more detail in Item 1. Business section and the risk factors affecting our business in Item 1A. Risk Factors section.
In this discussion and analysis, we will explain the general financial condition of and the results of operations for Constellation Energy and BGE including:
º •
º factors which affect our businesses,
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º our earnings and costs in the periods presented,
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º changes in earnings and costs between periods,
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º sources of earnings,
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º impact of these factors on our overall financial condition,
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º expected sources of cash for future capital expenditures,
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º our net available liquidity and collateral requirements, and
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º expected future expenditures for capital projects.
As you read this discussion and analysis, refer to our Consolidated Statements of Income (Loss), which present the results of our operations for 2008, 2007, and 2006. We analyze and explain the differences between periods in the specific line items of our Consolidated Statements of Income (Loss).
We have organized our discussion and analysis as follows:
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º First, we discuss our strategy.
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º Then, we describe the business environment in which we operate
including how recent events, competition, regulation, weather, and
other factors affect our business.
º •
º Next, we discuss our critical accounting policies. These are the
accounting policies that are most important to both the portrayal of
our financial condition and results of operations and require
management's most difficult, subjective or complex judgment.
º •
º We highlight significant events that are important to understanding
our results of operations and financial condition.
º •
º We review our results of operations beginning with an overview of our
total company results, followed by a more detailed review of those
results by operating segment.
º •
º We review our financial condition addressing our sources and uses of
cash, security ratings, capital resources, capital requirements,
commitments, and off-balance sheet arrangements.
º •
º We conclude with a discussion of our exposure to various market risks.
Strategy
We are pursuing a strategy of operating nuclear and non-nuclear generation facilities, providing energy and energy-related products and services through our Customer Supply activities, and delivering electricity and gas to customers of BGE, our regulated utility located in central Maryland. Our merchant energy business focuses on short-term and long-term purchases and sales of energy, capacity, and related products to various customers, including distribution utilities, municipalities, cooperatives, and industrial, commercial, and governmental customers.
We obtain this energy from both owned and contracted supply resources. Our generation fleet is strategically located in deregulated markets and includes various fuel types, such as nuclear, coal, natural gas, oil, and renewable sources. In addition to owning generating facilities, we contract for power from other merchant providers, typically through power purchase agreements. We use both our owned generation and our contracted generation to support our wholesale and retail Customer Supply operations.
We are also in the forefront of the proposed development of new nuclear generation in the United States through our UniStar Nuclear Energy joint venture with EDF Group and related entities (EDF). In addition, in December 2008, we entered into an investment agreement with EDF to sell to EDF a 49.99% interest in our nuclear generation and operation business (Investment Agreement). EDF brings operational experience, global scale, and procurement leverage to the development of new nuclear plants in the United States and to the operation of our existing nuclear plants. This new joint venture is expected to close in the third quarter of 2009, subject to receipt of regulatory approvals.
Collectively, the integration of owned and contracted electric generation assets with origination, fuel procurement, and risk management expertise allows our merchant energy business to earn incremental margin and more effectively manage energy and commodity price risk over geographic regions and time. Our focus is on providing solutions to customers' energy needs, and our Customer Supply and Global Commodities operations add value to our owned and contracted generation assets by providing national market access, market infrastructure, real-time market intelligence, risk management and arbitrage opportunities, and transmission and transportation expertise. Generation capacity supports our Customer Supply and Global Commodities operations by providing a source of reliable power supply.
We expect BGE and our Customer Supply operation to grow through focused and disciplined expansion. At BGE, we are also focused on enhancing reliability, customer satisfaction, and customer demand response initiatives.
Customer choice, regulatory change, and energy market conditions significantly impact our business. In response, we regularly evaluate our strategies with these goals in mind: to improve our competitive position, to anticipate and adapt to the business environment and regulatory changes, and to maintain a strong balance sheet and investment-grade credit quality through the use of a financial model that applies cash flow to reduce debt.
As a result of the significant events of 2008 as discussed in the Business Environment section, we are actively seeking to increase available liquidity and reduce our business risk. Over the next one to two years, we expect to be in a transition period during which we will focus on executing the following objectives that we believe will strengthen the Company:
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º continuing to implement strategic initiatives to reduce collateral and
liquidity needs of our merchant energy business, including selling
certain assets and operations as discussed further in the Divestitures
section in Item 1.
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º working to close the sale to EDF of 49.99% of our nuclear generation
and operation business as expeditiously as possible,
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º continuing a disciplined approach to the management of collateral and
liquidity, including:
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º pricing new business to reflect the full cost of capital in the
current economic environment and possibly requiring deposits from
new retail customers that do not meet pre-existing credit
conditions,
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º balancing cash generation with earnings growth, and
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º maintaining a liquidity cushion in excess of credit-rating
downgrade collateral requirements,
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º focusing on Constellation Energy's core strengths of:
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º owning, developing, and operating nuclear and non-nuclear
generation assets,
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º providing reliable, regulated utility service to customers,
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º leveraging our expertise in managing physical risks inherent in
our Generation and Customer Supply operations, and
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º maintaining strong supply relationships with retail and wholesale
customers,
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º continuing to reduce the scale of and re-focus the activities of our
Global Commodities and Customer Supply operations through the
following actions:
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º using the Global Commodities group to support our Generation and
Customer Supply operations,
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º placing less reliance on proprietary trading,
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º investing capital in areas where we are able to generate
appropriate risk-adjusted returns,
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º maintaining credit metrics consistent with investment grade ratings.
The execution of our strategy in the future will be affected by our ability to achieve these goals as well as by continued instability in financial and commodities markets. Execution of our goals, including the pending asset divestitures, could have a substantial effect on the nature and mix of our business activities, as well as our financial position, results of operation and cash flows.
In addition, upon closing the transaction contemplated by our Investment Agreement with EDF, we expect to deconsolidate our subsidiary that owns our nuclear generation assets. In turn, this could affect our financial position, results of operations, and cash flows in material amounts, and these amounts could vary substantially from historical results.
Business Environment
Various factors affect our financial results. We discuss some of these factors in more detail in Item 1. Business-Competition section. We also discuss these various factors in the Forward Looking Statements and Item 1A. Risk Factors sections.
During the last year, two events significantly influenced our business environment: the collapse of the credit markets and the extreme volatility in the energy markets. Throughout 2008, volatility in the financial markets intensified, leading to dramatic declines in equity prices and substantially reducing liquidity in the credit markets. Most equity indices declined significantly, the cost of credit default swaps and bond spreads increased substantially, and credit markets effectively ceased to be accessible for all but the most highly rated borrowers.
Major financial institutions experienced significant financial difficulty, and widespread fears developed about the viability of any business that required access to credit markets to support liquidity needs or that required substantial access to the capital markets to function, including Constellation Energy. By mid-September 2008, despite having announced a number of actions to address our liquidity situation, we faced a sudden and immediate need to raise equity capital and take other steps to enhance our overall liquidity. As a result, on September 19, 2008, we entered into a definitive merger agreement with MidAmerican Energy Holdings Company (MidAmerican) to acquire Constellation Energy for $4.7 billion, which also provided us with an immediate $1 billion cash infusion. In December 2008, however, we terminated the merger agreement with MidAmerican and entered into an agreement to sell a 49.99% interest in our nuclear generation and operation business for $4.5 billion to EDF. Under that agreement, EDF provided us with a $1 billion cash infusion to replace the investment made by MidAmerican. We repaid MidAmerican's $1 billion plus interest in January 2009. We discuss the termination of the merger with MidAmerican and our transaction with EDF in more detail in Note 15 to Consolidated Financial Statements.
The volatility of the global energy markets impacts our liquidity and collateral requirements as well as our credit risk. We discuss our liquidity and collateral requirements in the Financial Condition section. We continue to actively manage our credit risk to attempt to reduce the impact of a potential counterparty default. We discuss our customer (counterparty) credit and other risks in more detail in the Risk Management section.
Competition
We face competition in the sale of electricity, natural gas, coal, and uranium in wholesale energy markets and to retail customers.
Various states have moved to restructure their retail electricity and gas markets. The pace of deregulation in these states varies based on historical moves to competition and responses to recent market events. While many states continue to support or expand retail competition and industry restructuring, other states that were considering deregulation
have slowed their plans or postponed consideration. In addition, other states are reconsidering deregulation.
Specifically, legislatures in a number of states are currently considering, to varying degrees, legislation to either eliminate or expand retail choice programs. In addition, many states have initiated proceedings to reconsider the method of wholesale procurement for meeting their utilities' default/provider-of-last-resort (POLR) requirements. Both the reconsideration of retail choice and possible new methodologies for wholesale procurement could affect our Customer Supply operation's future opportunities to service commercial and industrial customers and the ability to provide wholesale products to utilities. The outcome of these efforts cannot be predicted, but they could have a material effect on our financial results.
All BGE electricity and gas customers have the option to purchase electricity and gas from alternate suppliers.
We discuss merchant competition in more detail in Item 1. Business-Competition section.
The impacts of electric deregulation on BGE in Maryland are discussed in Item 1. Business-Baltimore Gas and Electric Company-Electric Business-Electric Competition section.
Regulation-Maryland
Maryland PSC
In addition to electric restructuring, which we discuss in Item 1.
Business-Electric Competition section, regulation by the Maryland Public Service
Commission (Maryland PSC) significantly influences BGE's businesses. The
Maryland PSC determines the rates that BGE can charge customers of its electric
distribution and gas businesses. The Maryland PSC incorporates into BGE's
standard offer service rates the transmission rates determined by the Federal
Energy Regulatory Commission (FERC). BGE's electric rates are unbundled in
customer billings to show separate components for delivery service (i.e. base
rates), electric supply (commodity charge and transmission), a universal service
surcharge, and certain taxes. The rates for BGE's regulated gas business
continue to consist of a delivery charge (base rate) and a commodity charge.
Maryland Settlement Agreement
In March 2008, Constellation Energy, BGE, and a Constellation Energy affiliate entered into a settlement agreement with the State of Maryland, the Maryland PSC and certain State of Maryland officials to resolve pending litigation and to settle other prior legal, regulatory, and legislative issues. On April 24, 2008, the Governor of Maryland signed enabling legislation, which became effective on June 1, 2008. Pursuant to the terms of the settlement agreement:
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º Each party acknowledged that the agreements adopted in 1999 relating
to Maryland's electric restructuring law are final and binding and the
Maryland PSC will close ongoing proceedings relating to the 1999
settlement.
º •
º BGE provided its residential electric customers approximately
$189 million in the form of a one-time $170 per customer rate credit.
We recorded a reduction to "Electric revenues" on our and BGE's
Consolidated Statements of Income (Loss) during the second quarter of
2008 and reduced customers' bills by the amount of the credit between
September and December 2008.
º •
º BGE customers are relieved of the potential future liability for
decommissioning Constellation Energy's Calvert Cliffs Unit 1 and Unit
2, scheduled to occur no earlier than 2034 and 2036, respectively, and
are no longer obligated to pay a total of $520 million, in 1993
dollars adjusted for inflation, pursuant to the 1999 Maryland PSC
order regarding the deregulation of electric generation. BGE will
continue to collect the $18.7 million annual nuclear decommissioning
charge from all electric customers through 2016 and continue to rebate
this amount to residential electric customers, as previously required
by Maryland Senate Bill 1, which was enacted in June 2006.
º •
º BGE resumed collection of the residential return portion of the
administrative charge included in Standard Offer Service (SOS) rates,
which had been eliminated under Senate Bill 1, on June 1, 2008 and
will continue collection through May 31, 2010 without having to rebate
it to all residential electric customers. This will total
approximately $40 million over this period. This charge will be
suspended from June 1, 2010 through December 31, 2016.
º •
º Any electric distribution base rate case filed by BGE will not result
in increased distribution rates prior to October 2009, and any
increase in electric distribution revenue awarded will be capped at 5%
with certain exceptions. Any subsequent electric distribution base
rate case may not be filed prior to August 1, 2010. The agreement does
not govern or affect our ability to recover costs associated with gas
rates, federally approved transmission rates and charges, electric
riders, tax increases, or increases associated with standard offer
service power supply auctions.
º •
º Effective June 1, 2008, BGE implemented revised depreciation rates for
regulatory and financial reporting purposes. The revised rates reduced
depreciation expense by approximately $14 million in 2008 without
impacting distribution rates charged to customers.
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º Effective June 1, 2008, Maryland laws governing investments in
companies that own and operate regulated gas and electric utilities
were amended to make them less restrictive with respect to certain
capital stock acquisition transactions.
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º Constellation Energy elected two independent directors to the Board of
Directors of BGE within the required six months from the execution of
the settlement agreement.
Senate Bills 1 and 400
In June 2006, Maryland Senate Bill 1 was enacted, which among other things:
º •
º imposed rate stabilization measures that (i) capped rate increases by
BGE for residential SOS service at 15% from July 1, 2006 to May 31,
2007, (ii) gave residential SOS customers the option from June 1, 2007
until December 31, 2007 of paying a full market rate or choosing a
short term rate stabilization plan in order to provide a smooth
transition to market rates without adversely affecting the
creditworthiness of BGE, and (iii) provided for full market rates for
all residential SOS service starting January 1, 2008; and
º •
º allowed BGE to recover the costs deferred from July 1, 2006 to May 31,
2007 from its customers over a period not to exceed 10 years, on terms
and conditions to be determined by the Maryland PSC, including through
the issuance of rate stabilization bonds that securitize the deferred
costs.
In connection with these provisions of Senate Bill 1:
º •
º In May 2007, the Maryland PSC approved a plan to allow residential
electric customers to defer the transition to full market rates from
June 1, 2007 to January 1, 2008. The 4 percent of customers who chose
to defer are repaying the deferred amounts without interest over a
twenty-one month period which began on April 1, 2008.
º •
º In June 2007, a subsidiary of BGE issued an aggregate principal amount
of $623.2 million of rate stabilization bonds to recover costs
relating to the residential rate deferral from July 1, 2006 to May 31,
2007. We discuss the rate stabilization bond issuance in more detail
in Note 9 to Consolidated Financial Statements.
In April 2007, Maryland Senate Bill 400 was enacted, which made certain modifications to Senate Bill 1. Pursuant to Senate Bill 400, the Maryland PSC was required to initiate several studies, including studies relating to stranded costs, the costs and benefits of various options for re-regulation, and the structure of the electric industry in Maryland.
In December 2007, the Maryland PSC issued an interim report addressing the costs and benefits of various options for re-regulation and recommending actions to be taken to address an anticipated shortage of generation and transmission capacity in Maryland, which included implementation of demand response initiatives and requiring utilities to enter into long-term power purchase contracts with suppliers.
The Maryland PSC issued a final report in December 2008. In the final report, the Maryland PSC does not recommend returning the former utility generation assets to full cost of service regulation, but rather recommends incremental, forward looking re-regulation when appropriate to ensure a reliable supply of electricity or to obtain economic benefits for customers. The report also indicates that the Maryland PSC will investigate in 2009 whether, and on what terms, additional generation should be built in Maryland. In addition, the Maryland legislature continues to review the structure of the Maryland energy markets and the need for re-regulation. We cannot at this time predict the ultimate outcome of these inquiries, studies, and recommendations or their actual effect on our, or BGE's financial results, but it could be material.
We discuss the market risk of our regulated electric business in more detail in the Risk Management section.
Base Rates
Base rates are the rates the Maryland PSC allows BGE to charge its customers for the cost of providing them delivery service, plus a profit. BGE has both electric base rates and gas base rates.
BGE may ask the Maryland PSC to increase base rates from time to time. The Maryland PSC historically has allowed BGE to increase base rates to recover its utility plant investment and operating costs, plus a profit. Generally, rate increases improve the earnings of our regulated business because they allow us to collect more revenue. However, rate increases are normally granted based on historical data and those increases may not always keep pace with increasing costs. Other parties may petition the Maryland PSC to decrease base rates.
BGE's most recently approved return on electric distribution rate base was 9.4% (approved in 1993). BGE's most recently approved return on gas rate base was 8.49% (approved in 2005).
According to the terms of the 2008 Maryland settlement agreement, any future electric distribution base rate case filed by BGE will not result in increased distribution rates prior to October 2009, and any increase in electric distribution revenue awarded will be capped at 5% with certain exceptions. Any subsequent electric distribution base rate case may not be filed prior to August 1, 2010. The agreement does not govern or affect our ability to recover costs associated with gas rates, federally approved transmission rates and charges, electric riders, tax increases, or increases associated with standard offer service power supply auctions.
Revenue Decoupling
Beginning in 2008, the Maryland PSC approved, and BGE implemented, revenue decoupling for residential and small commercial customers to eliminate the effect of abnormal weather and usage patterns per customer on its electric distribution volumes. This means that BGE's electric distribution revenues from residential and small commercial customers reflect weather and usage that is considered normal for the month. Therefore, these revenues are affected primarily by customer growth. The Maryland PSC approved revenue decoupling for the majority of our remaining commercial and industrial customers beginning February 1, 2009. We have a similar revenue decoupling mechanism in our gas business.
Demand Response and Advanced Metering Programs
In order to implement an advanced metering pilot program and a demand response program, BGE defers costs associated with these programs as a regulatory asset and recovers these costs from customers in future periods. We discuss the advanced metering and demand response programs in more detail in Item 1. Business-Baltimore Gas and Electric Company-Electric Load Management.
Electric Commodity and Transmission Charges
We discuss BGE electric commodity and transmission charges (standard offer service), including the impact of the enactment of Senate Bill 1 in Maryland, in the Business Environment-Regulation-Maryland-Senate Bills 1 and 400 section.
Gas Commodity Charge
BGE charges its gas customers separately for the natural gas they purchase. The price BGE charges for the natural gas is based on a market-based rates incentive mechanism approved by the Maryland PSC. We discuss market-based rates in more detail in the Regulated Gas Business-Gas Cost Adjustments section and in Note 6 to Consolidated Financial Statements.
Federal Regulation
FERC
The FERC has jurisdiction over various aspects of our business, including electric transmission and wholesale natural gas and electricity sales. BGE transmission rates are updated annually based on a formula methodology approved by FERC. The rates also include transmission investment incentives approved by FERC in orders issued in July and November of 2007. We believe that FERC's continued commitment to fair and efficient wholesale energy markets should continue to result in improvements to competitive markets across various regions.
Since 1997, operation of BGE's transmission system has been under the authority of PJM Interconnection (PJM), the Regional Transmission Organization (RTO) for the Mid-Atlantic region, pursuant to FERC oversight. As the transmission operator, PJM administers the energy markets and conducts day-to-day operations of the bulk power system. The liability of transmission owners, including BGE, and power generators is limited to those damages caused by the gross negligence of such entities.
In addition to PJM, RTOs exist in other regions of the country such as the Midwest, New York, and New England. Similar to PJM, these RTOs also administer the energy market for their region and are responsible for operation of the transmission system and transmission system reliability. Our merchant energy business participates in these regional energy markets. These markets are continuing to develop, and revisions to market structure are subject to review and approval by FERC. We cannot predict the outcome of any reviews at this time. However, changes to the structure of these markets could have a material effect on our financial results.
FERC Initiatives
Ongoing initiatives at FERC have included a review of its methodology for the granting of market-based rate authority to sellers of electricity. FERC has established interim tests that it uses to determine the extent to which companies may have market power in certain regions. Where FERC finds that market power exists, it may require companies to implement measures to mitigate the market power in order to maintain market-based rate authority. We believe that our entities selling wholesale power continue to satisfy FERC's test for determining whether to grant a public utility market-based rate authority.
In November 2004, FERC eliminated through and out transmission rates between the Midwest Independent System Operator (MISO) and PJM and put in place Seams Elimination Charge/Cost Adjustment/Assignment (SECA) transition rates, which are paid by the transmission customers of MISO and PJM and allocated among the various transmission owners in PJM and MISO. The SECA transition rates were in effect from December 1, 2004 through March 31, 2006. FERC set for hearing the various compliance filings that established the level of the SECA rates and has indicated that the SECA rates are being recovered from the MISO and PJM transmission customers subject to refund by the MISO and PJM transmission owners.
We are a recipient of SECA payments, payer of SECA charges, and supplier to whom such charges may be shifted. Administrative hearings regarding the SECA charges concluded in May 2006, and an initial decision from the FERC administrative law judge (ALJ) was issued in August 2006. The decision of the ALJ generally found in favor of reducing the overall SECA liability. The . . .
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