Allegheny is an integrated energy business that owns and operates electric generation facilities and delivers electric services to customers in Pennsylvania, West Virginia, Maryland and Virginia. Allegheny operates its business primarily through AE's various directly and indirectly owned subsidiaries.

Allegheny has two business segments:

• The Delivery and Services segment includes Allegheny's electric T&D operations.

• The Generation and Marketing segment includes Allegheny's power generation operations.

The Delivery and Services Segment

The principal companies and operations in Allegheny's Delivery and Services segment include the following:

• The Distribution Companies include Monongahela (excluding its West Virginia generation assets), Potomac Edison and West Penn. Each of the Distribution Companies is a public utility company and does business under the trade name Allegheny Power. Allegheny Power's principal business is the operation of electric public utility systems. The Distribution Companies transferred functional control over their transmission systems to PJM in 2002.

• Monongahela conducts an electric T&D business in northern West Virginia. Monongahela also owns generation assets, which are included in the Generation and Marketing Segment. Monongahela conducted electric T&D operations in Ohio until it sold the assets related to that operation on December 31, 2005. Monongahela agreed to sell power at a fixed price to Columbus Southern Power Company ("Columbus Southern"), the purchaser of its electric T&D operations in Ohio, to serve Monongahela's former Ohio customers until May 31, 2007.

• Potomac Edison operates an electric T&D system in portions of West Virginia, Maryland and Virginia.

• West Penn operates an electric T&D system in southwestern, south-central and northern Pennsylvania.

• TrAIL Company was formed in 2006 in connection with the management and financing of transmission expansion projects, including the TrAIL Project.

• PATH, LLC was formed in 2007 by Allegheny and a subsidiary of AEP in connection with the management and financing of the PATH Project. PATH, LLC is a series limited liability company. The "West Virginia Series" is owned equally by Allegheny and a subsidiary of AEP. The "Allegheny Series" is 100% owned by Allegheny.

The Generation and Marketing Segment

The principal companies and operations in Allegheny's Generation and Marketing segment include the following:

• AE Supply owns, operates and manages electric generation facilities. AE Supply also purchases and sells energy and energy-related commodities. AE Supply markets its electric generation capacity to various customers and markets. Currently, the majority of AE Supply's normal operating capacity is committed to supplying certain obligations of West Penn and Potomac Edison.

• Monongahela's West Virginia generation assets are included in the Generation and Marketing segment. Monongahela's Generation and Marketing segment's normal operating capacity supplies Monongahela's Delivery and Services segment. In addition, Monongahela has a contractual obligation to supply generation to meet Potomac Edison's load obligations in West Virginia.

All of Allegheny's generation facilities are located within the PJM market, and all of the power that the Generation and Marketing segment generates is sold into the PJM market. To facilitate the economic dispatch of generation, AE Supply and Monongahela sell power into the competitive wholesale energy market operated by PJM and purchase power from the PJM market to meet their obligations to supply power. For more information regarding Allegheny's business and the segments and subsidiaries discussed above, see "Business."

Intersegment Services

AESC is a service company for AE that employs substantially all of the Allegheny personnel who provide services to AE and its subsidiaries, including AE Supply, AGC, the Distribution Companies, TrAIL Company, PATH, LLC and their respective subsidiaries. These companies reimburse AESC at cost for services provided to them by AESC's employees. AESC had 4,455 employees as of December 31, 2008.

Key Indicators and Performance Factors

The Delivery and Services Segment

Allegheny monitors the financial and operating performance of its Delivery and Services segment using a number of indicators and performance statistics, including the following:

Revenue per megawatt-hour ("MWh") sold. This measure is calculated by dividing total revenues from retail sales of electricity by total MWhs sold to retail customers. Revenue per MWh sold was as follows:

2008 2007 2006 Revenue per MWh sold $ 60.35 $ 59.64 $ 58.62

Operations and maintenance costs ("O&M"). Management closely monitors and manages O&M in absolute terms, as well as in relation to total MWhs sold. O&M per MWh sold was as follows:

2008 2007 2006 O&M per MWh sold $ 8.04 $ 7.63 $ 7.97

Capital expenditures. Management prioritizes and manages capital expenditures to meet operational needs and regulatory requirements within available cash flow constraints.

Retail electricity sales. The following table provides retail electricity sales information.

                                                                                2008        2007
                                           Normal    2008     2007     2006    Change      Change
Retail electricity sales (million kWhs)       N/A   44,192   44,901   43,178     (1.6 )%      4.0 %
HDD (a)                                     5,558    5,324    5,144    4,861      3.5 %       5.8 %
CDD (a)                                       807      772    1,032      781    (25.2 )%     32.1 %

(a) Heating degree-days ("HDD") and cooling degree-days ("CDD"). The operations of the Distribution Companies are weather sensitive. Weather conditions directly influence the volume of electricity delivered by the Distribution Companies, representing one of several factors that impact the volume of electricity delivered. Accordingly, deviations in weather from normal levels can affect Allegheny's financial performance. Degree-day data is used to estimate amounts of energy required to maintain comfortable

The Generation and Marketing Segment

Allegheny monitors the financial and operating performance of its Generation and Marketing segment using a number of indicators and performance statistics, including the following:

kWhs generated. This is a measure of the total physical quantity of electricity generated and is monitored at the individual generating unit level, as well as by various unit groupings.

Equivalent Availability Factor ("EAF"). The EAF measures the percentage of time that a given amount of MWs from a generation unit is available to generate electricity if called upon in the marketplace. A unit's availability is commonly less than 100%, primarily as a result of scheduled outages for planned maintenance or unplanned outages and derates. The EAF is calculated based upon availability data reported to FERC and PJM. Allegheny monitors the EAF by individual unit, as well as by various unit groupings. One such grouping is all "supercritical" units. A supercritical unit utilizes steam pressure in excess of 3,200 pounds per square inch, which enables these units to be larger and more efficient than other generation units. Fort Martin, Harrison, Hatfield's Ferry and Pleasants are supercritical generation facilities that have supercritical units. These units generally operate at high capacity for extended periods of time.

Station operations and maintenance costs ("Station O&M"). Station O&M includes base, operations and special maintenance costs. Base and operations costs consist of normal recurring expenses related to the on-going operation of the generation facility. Special maintenance costs include costs associated with outage-related maintenance and projects that relate to all of the generation facilities.

kWhs generated, EAF and Station O&M. The following table shows kWhs generated, excluding kWhs consumed by pumping at the Bath County, Virginia hydroelectric station, EAFs and Station O&M related to the Generation and Marketing segment:

                                                                          2008        2007
                                    2008         2007         2006       Change      Change
   Supercritical Units:
   kWhs generated (in millions)     39,550       39,043       39,813        1.3 %      (1.9 )%
   EAF                                87.5 %       83.2 %       84.3 %      4.3 %      (1.1 )%
   Station O&M (in millions):
   Base and operations            $  105.2     $  104.0     $  100.8        1.2 %       3.2 %
   Special maintenance                52.5         83.8         79.2      (37.4 )%      5.8 %

   Total Station O&M              $  157.7     $  187.8     $  180.0      (16.0 )%      4.3 %

   All Generation Units:
   kWhs generated (in millions)     46,601       48,235       48,606       (3.4 )%     (0.8 )%
   EAF                                86.8 %       83.9 %       86.8 %      2.9 %      (2.9 )%
   Station O&M (in millions):
   Base and operations            $  164.3     $  161.6     $  158.6        1.7 %       1.9 %
   Special maintenance                69.7         96.3         91.3      (27.6 )%      5.5 %

   Total Station O&M              $  234.0     $  257.9     $  249.9       (9.3 )%      3.2 %

Primary Factors Affecting Allegheny's Performance

The principal business, economic and other factors that affect Allegheny's operations and financial performance include:

• rate regulation and other regulatory policies,

• plant availability, capacity, dispatch and maintenance,

• weather conditions,

• demand and market prices for power,

• cost of fuel, including but not limited to the cost of both natural gas and coal and emission allowances and the lime, urea and other materials necessary for the functioning of certain pollution controls,

• wholesale commodity and capacity prices,

• PJM market, rules and policies,

• availability and access to liquidity and changes in interest rates,

• environmental compliance costs and related capital expenditures and

• labor costs.

Critical Accounting Policies and Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America ("GAAP") requires management to apply accounting policies and make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. The areas described in this section require significant judgment in the application of accounting policy or in making estimates and assumptions in matters that are uncertain and that may change in subsequent periods. Further discussion of the application of these accounting policies can be found in the Notes to Consolidated Financial Statements.

Revenue Recognition: Allegheny follows the accrual method of accounting for revenues and recognizes revenue for electricity that has been delivered to customers but not yet billed through the end of its accounting period. Unbilled revenues are primarily associated with the Distribution Companies. Energy sales to individual customers are based on their meter readings, which are performed periodically on a systematic basis. At the end of each month, the amount of energy delivered to each customer after the last meter reading is estimated, and the Distribution Companies recognize unbilled revenues related to these estimated amounts. A provision for uncollectible amounts is recorded as a component of operations and maintenance expense. The unbilled revenue estimates are based on daily generation, purchases of electricity, estimated customer usage by customer type, weather effects, electric line losses and the most recent consumer rates.

Regulatory Accounting: The Distribution Companies, TrAIL Company and PATH, LLC are subject to regulations that set the rates that they are permitted to charge customers. These rates are based on costs that the applicable regulatory agencies determine that the Distribution Companies, TrAIL Company and PATH, LLC are permitted to recover. At times, regulators permit the future recovery through rates of incurred costs that would otherwise be charged to expense by an unregulated company. At times, regulators may also allow the collection of amounts in rates for costs expected to be incurred in the future or may require that amounts collected be set aside for a specific purpose or be credited or refunded to customers in the future. This ratemaking process often results in the recording of regulatory assets and liabilities based on estimated future cash inflows and outflows under regulatory guidelines and orders. Allegheny regularly reviews its regulatory assets and liabilities, including the estimates and assumptions on which they have been recorded and related regulatory interpretations.

Excess of Cost Over Net Assets Acquired (Goodwill): Recorded goodwill is tested for impairment at least annually, and more frequently upon indication of possible impairment. The first phase of a goodwill impairment

test involves comparison of reporting unit fair value to the carrying value of the reporting unit that has been assigned goodwill. This testing requires the use of estimates, assumptions and other inputs to determine the fair value of reporting units using both a discounted cash flow approach and a market-based valuation approach. These estimates, assumptions and other inputs involve the use of judgment, and changes in these inputs can significantly impact the estimated reporting unit fair value. Allegheny's estimated reporting unit fair values at each testing date during 2006 through 2008 exceeded the reporting unit carrying values by a significant margin.

Depreciation: Depreciation expense is determined generally on a straight-line group method over the estimated service lives of depreciable assets for unregulated operations. For regulated utility operations, depreciation expense is determined using a straight-line group method in accordance with currently enacted regulatory rates. Under the straight-line group method, plant components are categorized as "retirement units" or "minor items of property." As retirement units are replaced, the cost of the replacement is capitalized and the original component is retired. Replacements of minor items of property are expensed as maintenance.

Long-Lived Asset Impairment Review: Allegheny's Consolidated Balance Sheets include significant long-lived assets that are not subject to recovery under SFAS No. 71, Accounting for the Effects of Certain Types of Regulation, ("SFAS 71"). Allegheny's long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable through operations. If the carrying amount of the asset exceeds the expected undiscounted future cash flows to be generated by the asset, an impairment loss is recognized, and the asset is written down to its fair value. Allegheny did not record any impairment charges during 2008 and 2007.

Derivative Contracts: Derivative contracts are recorded in Allegheny's Consolidated Balance Sheets at fair value with changes in the fair value of the derivative contract included in revenues or expenses on the Consolidated Statements of Income unless the derivative falls within the "normal purchases and normal sales" scope exception of SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities, as amended" ("SFAS 133") or is designated as a cash flow hedge for accounting purposes. The normal purchases and normal sales scope exception requires, among other things, physical delivery in quantities expected to be used or sold over a reasonable period in the normal course of business. Contracts that are designated as normal purchases and normal sales are accounted for under accrual accounting and, therefore, are not recorded on the balance sheet at fair value. For certain transactions that are designed to hedge the cash flows of a forecasted transaction, the effective portion of the hedge is recorded as a separate component of stockholders' equity under the caption "Accumulated other comprehensive loss" and subsequently reclassified into earnings when the forecasted transaction is completed or settled. Changes in any ineffective portion of the hedge are immediately recognized in earnings.

Fair values for exchange-traded instruments, principally futures and certain options, are based on actively quoted market prices. Fair values are subject to change in the near term and reflect management's best estimate based on various factors. In establishing the fair value of commodity contracts that do not have quoted prices, such as physical contracts and FTRs, over-the-counter options and swaps, management uses available market data and pricing models to estimate fair values. Estimating the fair values of instruments that do not have quoted market prices requires management's judgment in determining amounts that could reasonably be expected to be received from, or paid to, a third party in settlement of the instruments. These amounts could be materially different from amounts that might be realized in an actual sale transaction.

Allegheny has netting agreements with various counterparties. These agreements provide the right to set off amounts due from or to the counterparty. In cases in which these netting agreements are in place, Allegheny records the fair value of derivative assets and liabilities and of accounts receivable and accounts payable with each counterparty on a net basis. In addition, FTR assets and obligations are recorded on a net basis. Cash flows associated with derivative contracts are recorded in cash flows from operating activities. See Note 12, "Fair Value Measurements, Derivative Instruments and Hedging Activities," to the Consolidated Financial Statements for additional details regarding energy transaction activities.

Income Taxes: Allegheny is subject to income taxes in the United States and in various state jurisdictions. Significant judgment is required in evaluating tax positions and determining the provisions for income taxes. Allegheny establishes reserves for tax-related uncertainties based on estimates of whether, and the extent to which, additional taxes will be due. Allegheny adjusts these reserves in light of changing facts and circumstances, such as the outcome of tax audits. Effective January 1, 2007, Allegheny adopted the provisions of Financial Accounting Standards Board ("FASB") issued Interpretation No. 48, "Accounting for Uncertainty in Income Taxes-an Interpretation of FASB Statement No. 109" ("FIN 48"), which prescribes an approach to recognizing and measuring uncertain tax positions. See Note 6, "Income Taxes" to the Consolidated Financial Statements for additional information.

Stock-Based Compensation: Allegheny accounts for stock-based compensation under the provisions of SFAS No. 123R "Accounting for Stock-Based Compensation," ("SFAS 123R"). Share-based payments are generally measured at fair value on the date of grant and are expensed over the requisite service period. The determination of grant date fair value requires the use of judgment based on historical information as well as future expectations. In addition, the estimates of stock-based awards that will ultimately vest requires judgment, and actual results or updated estimates may differ from current estimates. See Note 9, "Stock-Based Compensation" to the Consolidated Financial Statements for additional information.

Accounting for Pensions and Postretirement Benefits Other Than Pensions: There are a number of significant estimates and assumptions involved in determining Allegheny's pension and other postretirement benefit ("OPEB") obligations and costs each period, such as employee demographics, discount rates, expected rates of return on plan assets, estimated rates of future compensation increases, medical inflation and the fair value of plan assets. Changes made to provisions for pension or other postretirement benefit plans may also affect current and future pension and OPEB costs. Allegheny believes that its assumptions are supported by historical data and reasonable projections, and its projections are reviewed annually with an outside actuarial firm. See Note 10, "Pension Benefits and Postretirement Benefits Other Than Pensions" to the Consolidated Financial Statements for additional information concerning these assumptions.

Allegheny determines its discount rate assumptions through the use of a cash flow matching process in which the timing and amount of estimated benefit cash flows for each benefit plan are matched with an interest rate curve applicable to the returns of high quality corporate bonds over the expected benefit payment period to determine an overall effective discount rate. The interest rate curve used in this process is based primarily on the Citigroup Pension Discount Curve and the Citigroup Above Median Pension Discount Curve.

Allegheny's general approach for determining the overall expected long-term rate of return on assets considers historical and expected future asset returns, the current and future targeted asset mix of the plan assets, historical and future expected real rates of return for equities and fixed income securities and historical and expected inflation statistics. The following table shows the effect that a one percentage point increase or decrease in the discount rate on plan assets for 2008 would have on Allegheny's pension and OPEB obligations and costs:

                                                 1-Percentage-Point           1-Percentage-Point
(In millions)                                         Increase                     Decrease
Change in the discount rate:
Pension and OPEB obligation                     $             (143.6 )        $             173.8
Net periodic pension and OPEB cost              $              (12.5 )        $              14.6
Change in expected rate of return on
plan assets:
Net periodic pension and OPEB cost              $               (9.6 )        $               9.6

Contingencies: Allegheny regularly reviews and assesses the likelihood of losses relating to environmental, legal and other contingencies and accrues a liability for matters for which it believes that a loss is probable if the probable loss can be estimated. See Note 26, "Commitments and Contingencies" to the Consolidated Financial Statements for additional information.

RESULTS OF OPERATIONS

Income Summary




(In millions)                               Delivery        Generation
                                               and             and
2008                                        Services        Marketing         Eliminations         Total
Operating revenues                          $ 2,846.7      $    2,279.2      $     (1,740.0 )    $ 3,385.9
Fuel                                               -            1,080.9                  -         1,080.9
Purchased power and transmission              2,023.8             103.9            (1,732.1 )        395.6
Deferred energy costs, net                        7.3             (71.0 )                -           (63.7 )
Operations and maintenance                      355.5             327.2                (7.9 )        674.8
Depreciation and amortization                   162.2             111.7                  -           273.9
Taxes other than income taxes                   141.8              73.1                  -           214.9

Total operating expenses                      2,690.6           1,625.8            (1,740.0 )      2,576.4
Operating income                                156.1             653.4                  -           809.5
. . .