Form 10-Q dated November 1, 2005

UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549

FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2005

OR

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the transition period from
 
to
 

Commission
Registrant; State of Incorporation;
I.R.S. Employer
File Number
Address; and Telephone Number
Identification No.
     
333-21011
FIRSTENERGY CORP.
34-1843785
 
(An Ohio Corporation)
 
 
76 South Main Street
 
 
Akron, OH 44308
 
 
Telephone (800)736-3402
 
     
1-2578
OHIO EDISON COMPANY
34-0437786
 
(An Ohio Corporation)
 
 
c/o FirstEnergy Corp.
 
 
76 South Main Street
 
 
Akron, OH 44308
 
 
Telephone (800)736-3402
 
     
1-2323
THE CLEVELAND ELECTRIC ILLUMINATING COMPANY
34-0150020
 
(An Ohio Corporation)
 
 
c/o FirstEnergy Corp.
 
 
76 South Main Street
 
 
Akron, OH 44308
 
 
Telephone (800)736-3402
 
     
1-3583
THE TOLEDO EDISON COMPANY
34-4375005
 
(An Ohio Corporation)
 
 
c/o FirstEnergy Corp.
 
 
76 South Main Street
 
 
Akron, OH 44308
 
 
Telephone (800)736-3402
 
     
1-3491
PENNSYLVANIA POWER COMPANY
25-0718810
 
(A Pennsylvania Corporation)
 
 
c/o FirstEnergy Corp.
 
 
76 South Main Street
 
 
Akron, OH 44308
 
 
Telephone (800)736-3402
 
     
1-3141
JERSEY CENTRAL POWER & LIGHT COMPANY
21-0485010
 
(A New Jersey Corporation)
 
 
c/o FirstEnergy Corp.
 
 
76 South Main Street
 
 
Akron, OH 44308
 
 
Telephone (800)736-3402
 
     
1-446
METROPOLITAN EDISON COMPANY
23-0870160
 
(A Pennsylvania Corporation)
 
 
c/o FirstEnergy Corp.
 
 
76 South Main Street
 
 
Akron, OH 44308
 
 
Telephone (800)736-3402
 
     
1-3522
PENNSYLVANIA ELECTRIC COMPANY
25-0718085
 
(A Pennsylvania Corporation)
 
 
c/o FirstEnergy Corp.
 
 
76 South Main Street
 
 
Akron, OH 44308
 
 
Telephone (800)736-3402
 

 
 


Indicate by check mark whether each of the registrants (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes X   No   

Indicate by check mark whether each registrant is an accelerated filer (as defined in Rule 12b-2 of the Act):

YesX  
No    
FirstEnergy Corp.
Yes    
No
Ohio Edison Company, Pennsylvania Power Company, The Cleveland Electric Illuminating Company, The Toledo Edison Company, Jersey Central Power & Light Company, Metropolitan Edison Company, and Pennsylvania Electric Company

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date:
 
 
 
OUTSTANDING
CLASS
AS OF NOVEMBER 2, 2005
FirstEnergy Corp., $.10 par value
329,836,276
Ohio Edison Company, no par value
100
The Cleveland Electric Illuminating Company, no par value
79,590,689
The Toledo Edison Company, $5 par value
39,133,887
Pennsylvania Power Company, $30 par value
6,290,000
Jersey Central Power & Light Company, $10 par value
15,371,270
Metropolitan Edison Company, no par value
859,500
Pennsylvania Electric Company, $20 par value
5,290,596
 

FirstEnergy Corp. is the sole holder of Ohio Edison Company, The Cleveland Electric Illuminating Company, The Toledo Edison Company, Jersey Central Power & Light Company, Metropolitan Edison Company and Pennsylvania Electric Company common stock. Ohio Edison Company is the sole holder of Pennsylvania Power Company common stock.

This combined Form 10-Q is separately filed by FirstEnergy Corp., Ohio Edison Company, Pennsylvania Power Company, The Cleveland Electric Illuminating Company, The Toledo Edison Company, Jersey Central Power & Light Company, Metropolitan Edison Company and Pennsylvania Electric Company. Information contained herein relating to any individual registrant is filed by such registrant on its own behalf. No registrant makes any representation as to information relating to any other registrant, except that information relating to any of the FirstEnergy subsidiary registrants is also attributed to FirstEnergy Corp.

This Form 10-Q 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, the continued ability of our regulated utilities to collect transition and other charges, maintenance costs being higher than anticipated, legislative and regulatory changes (including revised environmental requirements), the uncertainty of the timing and amounts of the capital expenditures (including that such amounts could be higher than anticipated) or levels of emission reductions related to the settlement agreement resolving the New Source Review litigation, adverse regulatory or legal decisions and outcomes (including, but not limited to, the revocation of necessary licenses or operating permits, fines or other enforcement actions and remedies) of government investigations and oversight, including by the Securities and Exchange Commission, the United States Attorney’s Office and the Nuclear Regulatory Commission as disclosed in the registrants’ Securities and Exchange Commission filings, generally, and with respect to the Davis-Besse Nuclear Power Station outage and heightened scrutiny at the Perry Nuclear Power Plant in particular, the availability and cost of capital, rising interest rates and other inflationary trends, the continuing availability and operation of generating units, the ability of generating units to continue to operate at, or near full capacity, the inability to accomplish or realize anticipated benefits of strategic goals (including the proposed transfer of nuclear generation assets), the ability to improve electric commodity margins and to experience growth in the distribution business, any decision of the Pennsylvania Public Utility Commission regarding the plan filed by Penn on October 11, 2005 to secure electricity supply for its customers at a set rate, the ability to access the public securities and other capital markets, the outcome, cost and other effects of present and potential legal and administrative proceedings and claims related to the August 14, 2003 regional power outage, the final outcome in the proceeding related to FirstEnergy's Application for a Rate Stabilization Plan (RSP) in Ohio, specifically, the PUCO's acceptance of the September 9, 2005 proposed supplement to the RSP, the risks and other factors discussed from time to time in the registrants' Securities and Exchange Commission filings, including their annual report on Form 10-K for the year ended December 31, 2004, and other similar factors. A security rating is not a recommendation to buy, sell or hold securities and it may be subject to revision or withdrawal. Dividends declared from time to time on FirstEnergy's common stock during any annual period may in aggregate vary from the indicated amounts due to circumstances considered by FirstEnergy's Board of Directors at the time of the actual declarations. The registrants expressly disclaim any current intention to update any forward-looking statements contained in this document as a result of new information, future events, or otherwise.




 

TABLE OF CONTENTS


   
Pages
Glossary of Terms
iii-v
     
Part I. Financial Information
 
     
Items 1. and 2. - Financial Statements and Management’s Discussion and Analysis of
            Results of Operation and Financial Condition
 
     
 
Notes to Consolidated Financial Statements
1-25
     
FirstEnergy Corp.
 
     
 
Consolidated Statements of Income
26
 
Consolidated Statements of Comprehensive Income
27
 
Consolidated Balance Sheets
28
 
Consolidated Statements of Cash Flows
29
 
Report of Independent Registered Public Accounting Firm
30
 
Management's Discussion and Analysis of Results of Operations and
31-65
 
Financial Condition
 
     
Ohio Edison Company
 
     
 
Consolidated Statements of Income and Comprehensive Income
66
 
Consolidated Balance Sheets
67
 
Consolidated Statements of Cash Flows
68
 
Report of Independent Registered Public Accounting Firm
69
 
Management's Discussion and Analysis of Results of Operations and
70-82
 
Financial Condition
 
     
The Cleveland Electric Illuminating Company
 
     
 
Consolidated Statements of Income and Comprehensive Income
83
 
Consolidated Balance Sheets
84
 
Consolidated Statements of Cash Flows
85
 
Report of Independent Registered Public Accounting Firm
86
 
Management's Discussion and Analysis of Results of Operations and
87-98
 
Financial Condition
 
     
The Toledo Edison Company
 
     
 
Consolidated Statements of Income and Comprehensive Income
99
 
Consolidated Balance Sheets
100
 
Consolidated Statements of Cash Flows
101
 
Report of Independent Registered Public Accounting Firm
102
 
Management's Discussion and Analysis of Results of Operations and
103-114
 
Financial Condition
 
     
Pennsylvania Power Company
 
     
 
Consolidated Statements of Income and Comprehensive Income
115
 
Consolidated Balance Sheets
116
 
Consolidated Statements of Cash Flows
117
 
Report of Independent Registered Public Accounting Firm
118
 
Management's Discussion and Analysis of Results of Operations and
119-127
 
Financial Condition
 



i



TABLE OF CONTENTS (Cont'd)


   
Pages
     
     
Jersey Central Power & Light Company
 
     
 
Consolidated Statements of Income and Comprehensive Income
128
 
Consolidated Balance Sheets
129
 
Consolidated Statements of Cash Flows
130
 
Report of Independent Registered Public Accounting Firm
131
 
Management's Discussion and Analysis of Results of Operations and
132-140
 
Financial Condition
 
     
Metropolitan Edison Company
 
     
 
Consolidated Statements of Income and Comprehensive Income
141
 
Consolidated Balance Sheets
142
 
Consolidated Statements of Cash Flows
143
 
Report of Independent Registered Public Accounting Firm
144
 
Management's Discussion and Analysis of Results of Operations and
145-153
 
Financial Condition
 
     
Pennsylvania Electric Company
 
     
 
Consolidated Statements of Income and Comprehensive Income
154
 
Consolidated Balance Sheets
155
 
Consolidated Statements of Cash Flows
156
 
Report of Independent Registered Public Accounting Firm
157
 
Management's Discussion and Analysis of Results of Operations and
158-166
 
Financial Condition
 
     
Item 3. Quantitative and Qualitative Disclosures About Market Risk
167
     
Item 4. Controls and Procedures
167
     
Part II. Other Information
 
     
Item 1. Legal Proceedings
168
   
168
Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
 
     
      Item 5.  Other Information        
 168
   
      Item 6. Exhibits
169-184
   
   



ii


GLOSSARY OF TERMS

The following abbreviations and acronyms are used in this report to identify FirstEnergy Corp. and its current and former subsidiaries:

ATSI
American Transmission Systems, Incorporated, owns and operates transmission facilities
CEI
The Cleveland Electric Illuminating Company, an Ohio electric utility operating subsidiary
CFC
Centerior Funding Corporation, a wholly owned finance subsidiary of CEI
Companies
OE, CEI, TE, Penn, JCP&L, Met-Ed and Penelec
EUOC
Electric Utility Operating Companies (OE, CEI, TE, Penn, JCP&L, Met-Ed, Penelec, and ATSI)
FENOC
FirstEnergy Nuclear Operating Company, operates nuclear generating facilities
FES
FirstEnergy Solutions Corp., provides energy-related products and services
FESC
FirstEnergy Service Company, provides legal, financial, and other corporate support services
FGCO
FirstEnergy Generation Corp., owns and operates non-nuclear generating facilities
FirstCom
First Communications, LLC, provides local and long-distance telephone service
FirstEnergy
FirstEnergy Corp., a registered public utility holding company
FSG
FirstEnergy Facilities Services Group, LLC, the parent company of several heating, ventilation,
 
air conditioning and energy management companies
GPU
GPU, Inc., former parent of JCP&L, Met-Ed and Penelec, which merged with FirstEnergy on
 
November 7, 2001
JCP&L
Jersey Central Power & Light Company, a New Jersey electric utility operating subsidiary
JCP&L Transition
JCP&L Transition Funding LLC, a Delaware limited liability company and issuer of transition  bonds
Met-Ed
Metropolitan Edison Company, a Pennsylvania electric utility operating subsidiary
MYR
MYR Group, Inc., a utility infrastructure construction service company
NGC
FirstEnergy Nuclear Generation Corp. established to acquire FirstEnergy's nuclear generating  facilities
OE
Ohio Edison Company, an Ohio electric utility operating subsidiary
OE Companies
OE and Penn
Ohio Companies
CEI, OE and TE
Penelec
Pennsylvania Electric Company, a Pennsylvania electric utility operating subsidiary
Penn
Pennsylvania Power Company, a Pennsylvania electric utility operating subsidiary of OE
PNBV
PNBV Capital Trust, a special purpose entity created by OE in 1996
Shippingport
Shippingport Capital Trust, a special purpose entity created by CEI and TE in 1997
TE
The Toledo Edison Company, an Ohio electric utility operating subsidiary
TEBSA
Termobarranquilla S. A., Empresa de Servicios Publicos

 

The following abbreviations and acronyms are used to identify frequently used terms in this report:


AOCL
Accumulated Other Comprehensive Loss
APB
Accounting Principles Board
APB 25
APB Opinion No. 25, "Accounting for Stock Issued to Employees"
APB 29
APB Opinion No. 29, “Accounting for Nonmonetary Transactions”
ARO
Asset Retirement Obligation
BGS
Basic Generation Service
CAIR
Clean Air Interstate Rule
CAL
Confirmatory Action Letter
CAT
Commercial Activity Tax
CO2
Carbon Dioxide
CTC
Competitive Transition Charge
DOJ
United States Department of Justice
ECAR
East Central Area Reliability Coordination Agreement
EITF
Emerging Issues Task Force
EITF 03-1
EITF Issue No. 03-1, "The Meaning of Other-Than-Temporary and Its Application to Certain
 
Investments”
EITF 04-13
EITF Issue No. 04-13, “Accounting for Purchases and Sales of Inventory with the Same  Counterparty”
EITF 99-19
EITF Issue No. 99-19, “Reporting Revenue Gross as a Principal versus Net as an Agent”
EPA
Environmental Protection Agency
ERO
Electric Reliability Organization
FASB
Financial Accounting Standards Board
FERC
Federal Energy Regulatory Commission
FIN
FASB Interpretation
FIN 46R
FIN 46 (revised December 2003), "Consolidation of Variable Interest Entities"

 
iii

 

FIN 47
FASB Interpretation 47, “Accounting for Conditional Asset Retirement Obligations - an  interpretation of FASB Statement No. 143”
FMBs
First Mortgage Bonds
FSP
FASB Staff Position
FSP EITF 03-1-1
FASB Staff Position No. EITF Issue 03-1-1, "Effective Date of Paragraphs 10-20 of EITF Issue
 
No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain
 
Investments"
FSP 109-1
FASB Staff Position No. 109-1, “Application of FASB Statement No. 109, Accounting for Income
  Taxes, to the Tax Deduction on Qualified Production Activities Provided by the American Jobs
  Creation Act of 2004”
GCAF
Generation Charge Adjustment Factor
GAAP
Accounting Principles Generally Accepted in the United States
GHG
Greenhouse Gases
HVAC
Heating, Ventilation and Air-conditioning
IBEW
International Brotherhood of Electrical Workers
KWH
Kilowatt-hours
LOC
Letter of Credit
MEIUG
Met-Ed Industrial Users Group
MISO
Midwest Independent Transmission System Operator, Inc.
MOU
Memorandum of Understanding
MSG
Market Support Generation
MTC
Market Transition Charge
MW
Megawatts
NAAQS
National Ambient Air Quality Standards
NERC
North American Electric Reliability Council
NJBPU
New Jersey Board of Public Utilities
NOAC
Northwest Ohio Aggregation Coalition
NOV
Notices of Violation
NOx
Nitrogen Oxide
NRC
Nuclear Regulatory Commission
NUG
Non-Utility Generation
OCA
Office of Consumer Advocate
OCC
Ohio Consumers' Counsel
OCI
Other Comprehensive Income
OPAE
Ohio Partners for Affordable Energy
OPEB
Other Post-Employment Benefits
OSBA
Office of Small Business Advocate
OTS
Office of Trial Staff
PCAOB
Public Company Accounting Oversight Board (United States)
PCRBs
Pollution Control Revenue Bonds
PICA
Penelec Industrial Customer Association
PJM
PJM Interconnection, L.L.C.
PLR
Provider of Last Resort
PPUC
Pennsylvania Public Utility Commission
PRP
Potentially Responsible Party
PSA
Purchase and Sale Agreement
PUCO
Public Utilities Commission of Ohio
PUHCA
Public Utility Holding Company Act of 1935
RCP
Rate Certainty Plan
RSP
Rate Stabilization Plan
RTC
Regulatory Transition Charge
S&P
Standard & Poor’s Ratings Service
SBC
Societal Benefits Charge
SEC
United States Securities and Exchange Commission
SFAS
Statement of Financial Accounting Standards
SFAS 71
SFAS No. 71, "Accounting for the Effects of Certain Types of Regulation"
SFAS 123
SFAS No. 123, "Accounting for Stock-Based Compensation"
SFAS 123(R)
SFAS No. 123 (revised 2004), “Share-Based Payment”
SFAS 131
SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information”
SFAS 133
SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”
SFAS 140
SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and
 
Extinguishment of Liabilities”
SFAS 144
SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets"
SFAS 153
SFAS No. 153, “Exchanges of Nonmonetary Assets - an amendment of APB Opinion No. 29”

 
iv

 

   
SFAS 154
SFAS No. 154, “Accounting Changes and Error Corrections - a replacement of APB Opinion No.
  20 and FASB Statement No. 3”
SO2
Sulfur Dioxide
TBC
Transition Bond Charge
TMI-2
Three Mile Island Unit 2
UWUA
Utility Workers Union of America
VIE
Variable Interest Entity

v


PART I. FINANCIAL INFORMATION

FIRSTENERGY CORP. AND SUBSIDIARIES
OHIO EDISON COMPANY AND SUBSIDIARIES
THE CLEVELAND ELECTRIC ILLUMINATING COMPANY AND SUBSIDIARIES
THE TOLEDO EDISON COMPANY AND SUBSIDIARY
PENNSYLVANIA POWER COMPANY AND SUBSIDIARY
JERSEY CENTRAL POWER & LIGHT COMPANY AND SUBSIDIARIES
METROPOLITAN EDISON COMPANY AND SUBSIDIARIES
PENNSYLVANIA ELECTRIC COMPANY AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)


1 - ORGANIZATION AND BASIS OF PRESENTATION:
 
FirstEnergy’s principal business is the holding, directly or indirectly, of all of the outstanding common stock of its eight principal electric utility operating subsidiaries: OE, CEI, TE, Penn, ATSI, JCP&L, Met-Ed and Penelec. Penn is a wholly owned subsidiary of OE. FirstEnergy's consolidated financial statements also include its other principal subsidiaries: FENOC, FES and its subsidiary FGCO, FESC, FSG and MYR.

FirstEnergy and its subsidiaries follow GAAP and comply with the regulations, orders, policies and practices prescribed by the SEC, FERC and, as applicable, PUCO, PPUC and NJBPU. The preparation of financial statements in conformity with GAAP requires management to make periodic estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and disclosure of contingent assets and liabilities. Actual results could differ from these estimates. The reported results of operations are not indicative of results of operations for any future period.

These statements should be read in conjunction with the financial statements and notes included in the combined Annual Report on Form 10-K for the year ended December 31, 2004 for FirstEnergy and the Companies. The consolidated unaudited financial statements of FirstEnergy and each of the Companies reflect all normal recurring adjustments that, in the opinion of management, are necessary to fairly present results of operations for the interim periods. Certain businesses divested in the nine months ended September 30, 2005 have been classified as discontinued operations on the Consolidated Statements of Income (see Note 6). As discussed in Note 16, interim period segment reporting in 2004 was reclassified to conform with the current year business segment organizations and operations.

FirstEnergy and its subsidiaries consolidate all majority-owned subsidiaries over which they exercise control and, when applicable, entities for which they have a controlling financial interest. Intercompany transactions and balances are eliminated in consolidation. FirstEnergy consolidates a VIE (see Note 11) when it is determined to be the VIE's primary beneficiary. Investments in nonconsolidated affiliates over which FirstEnergy and its subsidiaries have the ability to exercise significant influence, but not control, (20-50 percent owned companies, joint ventures and partnerships) are accounted for under the equity method. Under the equity method, the interest in the entity is reported as an investment in the Consolidated Balance Sheet and the percentage share of the entity’s earnings is reported in the Consolidated Statement of Income. Certain prior year amounts have been reclassified to conform to the current presentation.
 
FirstEnergy's and the Companies' independent registered public accounting firm has performed reviews of, and issued reports on, these consolidated interim financial statements in accordance with standards established by the PCAOB. Pursuant to Rule 436(c) under the Securities Act of 1933, their reports of those reviews should not be considered a report within the meaning of Section 7 and 11 of that Act, and the independent registered public accounting firm’s liability under Section 11 does not extend to them.

2 - ACCOUNTING FOR CERTAIN WHOLESALE ENERGY TRANSACTIONS

FES engages in purchase and sale transactions in the PJM Market to support the supply of end-use customers, including PLR requirements in Pennsylvania. In conjunction with FirstEnergy's dedication of its Beaver Valley Plant to PJM on January 1, 2005, FES began accounting for purchase and sale transactions in the PJM Market based on its net hourly position -- recording each hour as either an energy purchase in Fuel and purchased power expense or an energy sale, respectively, in the Consolidated Statements of Income relating to the Power Supply Management Services segment. Hourly energy positions are aggregated to recognize gross purchases and sales for the month.
 
 
1

 
This revised method of accounting, which has no impact on net income, is consistent with the practice of other energy companies that have dedicated generating capacity to PJM and correlates with PJM's scheduling and reporting of hourly energy transactions. FES also applies the net hourly methodology to purchase and sale transactions in MISO's energy market, which became active on April 1, 2005.

For periods prior to January 1, 2005, FirstEnergy did not have substantial generating capacity in PJM and as such, FES recognized purchases and sales in the PJM Market by recording each discrete transaction. Under these transactions, FES would often buy a specific quantity of energy at a certain location in PJM and simultaneously sell a specific quantity of energy at a different location. Physical delivery occurred and the risks and rewards of ownership transferred with each transaction. FES accounted for those transactions on a gross basis in accordance with EITF 99-19.

At its September 2005 meeting, the FASB's EITF reached a final consensus on EITF 04-13, which relates to the accounting for purchases and sales of inventory with the same counterparty. The Task Force concluded that two or more transactions with the same counterparty should be viewed as a single nonmonetary transaction within the scope of APB 29, when the transactions are entered into "in contemplation" of one another. The consensus will be effective for new arrangements entered into, or modifications of existing arrangements, in interim or annual periods beginning after March 15, 2006. Retrospective application to prior transactions and/or restatement of prior period financial statements is not permitted. Accordingly, EITF 04-13 is not applicable to FES' purchases and sales in the PJM Market made prior to January 1, 2005. The recognition of these transactions on a net basis in 2004 would have no impact on net income, but would have reduced both wholesale revenue and purchased power expense by $264 million and $828 million for the three months and nine months ended September 30, 2004, respectively.

3 - DEPRECIATION

During the second half of 2004, FirstEnergy engaged an independent third party to assist in reviewing the service lives of its fossil generation units. This study was completed in the first quarter of 2005. As a result of the analysis, FirstEnergy extended the estimated service lives of its fossil generation units for periods ranging from 11 to 33 years during the first quarter of 2005. Extension of the service lives will provide improved matching of depreciation expense with the expected economic lives of those generation units.

4 - EARNINGS PER SHARE

Basic earnings per share are computed using the weighted average of actual common shares outstanding during the respective period as the denominator. The denominator for diluted earnings per share reflects the weighted average of common shares outstanding plus the potential additional common shares that could result if dilutive securities and other agreements to issue common stock were exercised. Stock-based awards during the nine months ended September 30, 2004, to purchase 3.4 million shares of common stock were excluded from the calculation of diluted earnings per share of common stock because their exercise prices were greater than the average market price of common shares during the period. No stock-based awards were excluded from the calculation in the three months ended September 30, 2005 and 2004, and the nine months ended September 30, 2005. The following table reconciles the denominators for basic and diluted earnings per share from Income Before Discontinued Operations:

 
 
 
Three Months Ended
 
Nine Months Ended
 
   
September 30,
 
September 30,
 
Reconciliation of Basic and Diluted Earnings per Share
 
2005
 
2004
 
2005
 
2004
 
 
 
(In thousands, except per share amounts)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Income Before Discontinued Operations
 
$
331,832
 
$
296,125
 
$
651,627
 
$
670,334
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Average Shares of Common Stock Outstanding:
 
 
 
 
 
 
 
 
 
 
 
 
 
Denominator for basic earnings per share
 
 
 
 
 
 
 
 
 
 
 
 
 
(weighted average shares outstanding) 
 
 
328,119
 
 
327,499
 
 
328,030
 
 
327,280
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Assumed exercise of dilutive stock options and awards
 
 
2,074
 
 
1,600
 
 
1,896
 
 
1,570
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Denominator for diluted earnings per share
 
 
330,193
 
 
329,099
 
 
329,926
 
 
328,850
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Income Before Discontinued Operations per Common Share:
 
 
 
 
 
 
 
 
 
 
 
 
 
Basic
 
 
$1.01
 
 
$0.90
 
 
$1.99
 
 
$2.05
 
Diluted
 
 
$1.01
 
 
$0.90
 
 
$1.98
 
 
$2.04
 


2

 
5 - GOODWILL

In a business combination, the excess of the purchase price over the estimated fair values of assets acquired and liabilities assumed is recognized as goodwill. Based on the guidance provided by SFAS 142, FirstEnergy evaluates its 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 is indicated, FirstEnergy 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. FirstEnergy's 2005 annual review was completed in the third quarter of 2005 with no impairment indicated.

FirstEnergy's goodwill primarily relates to its regulated services segment. In the nine months ended September 30, 2005, FirstEnergy adjusted goodwill related to the divestiture of non-core operations (FES' retail natural gas business, MYR's Power Piping Company subsidiary, and a portion of its interest in FirstCom) as further discussed in Note 6. In addition, adjustments to the former GPU and Centerior companies' goodwill were recorded to reverse pre-merger tax accruals due to final resolution of these tax contingencies. FirstEnergy estimates that completion of transition cost recovery (see Note 14) will not result in an impairment of goodwill relating to its regulated business segment. A summary of the changes in goodwill for the three months and nine months ended September 30, 2005 is shown below.

Three Months Ended
 
FirstEnergy
 
CEI
 
TE
 
JCP&L
 
Met-Ed
 
Penelec
 
 
 
(In millions)
 
Balance as of July 1, 2005
 
$
6,033
 
$
1,694
 
$
505
 
$
1,984
 
$
868
 
$
887
 
Pre-merger tax adjustments related to Centerior acquisition
 
 
(9
)
 
(5
)
 
(4
)
 
-
 
 
-
 
 
-
 
Balance as of September 30, 2005
 
$
6,024
 
$
1,689
 
$
501
 
$
1,984
 
$
868
 
$
887
 

 
Nine Months Ended
 
FirstEnergy
 
CEI
 
TE
 
JCP&L
 
Met-Ed
 
Penelec
 
 
 
(In millions)
 
Balance as of January 1, 2005
 
$
6,050
 
$
1,694
 
$
505
 
$
1,985
 
$
870
 
$
888
 
Non-core asset sales
 
 
(13
)
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
Pre-merger tax adjustments related to Centerior acquisition
 
 
(9
)
 
(5
)
 
(4
)
 
-
 
 
-
 
 
-
 
Pre-merger tax adjustments related to GPU acquisition
 
 
(4
)
 
-
 
 
-
 
 
(1
)
 
(2
)
 
(1
)
Balance as of September 30, 2005
 
$
6,024
 
$
1,689
 
$
501
 
$
1,984
 
$
868
 
$
887
 

6 - DIVESTITURES AND DISCONTINUED OPERATIONS

In December 2004, FES' retail natural gas business qualified as assets held for sale in accordance with SFAS 144. On March 31, 2005, FES completed the sale for an after-tax gain of $5 million. In March 2005, FirstEnergy sold 51% of its interest in FirstCom, resulting in an after-tax gain of $4 million. FirstEnergy accounts for its remaining 31.85% interest in FirstCom on the equity basis.

During the nine months ended September 30, 2005, FirstEnergy sold certain of its FSG subsidiaries (Elliott-Lewis, Spectrum and Cranston), and MYR’s Power Piping Company subsidiary, resulting in an after-tax gain of $12 million. FSG's remaining subsidiaries qualify as assets held for sale in accordance with SFAS 144 and are expected to be recognized as completed sales within one year. The assets and liabilities of these remaining FSG subsidiaries are not material to FirstEnergy’s Consolidated Balance Sheet as of September 30, 2005, and therefore have not been separately classified as assets held for sale.

As of September 30, 2005, the remaining FSG businesses do not meet the criteria for discontinued operations; therefore, the net results from these subsidiaries have been included in continuing operations. See Note 16 for FSG's segment financial information.

Operating results from discontinued operations (including the gains on sales of assets discussed above) for Elliott-Lewis, Cranston, Power Piping and FES' retail natural gas business are summarized as follows:
 

 
 
Three Months Ended
 
Nine Months Ended
 
 
 
September 30,
 
September 30,
 
 
 
2005
 
2004
 
2005
 
2004
 
 
 
(In millions)
 
Revenues
 
$
1
 
$
151
 
$
214
 
$
508
 
Income before income taxes
 
$
1
 
$
4
 
$
10
 
$
10
 
Income from discontinued operations, net of tax
 
$
1
 
$
3
 
$
19
 
$
6
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
3

 
The following table summarizes the sources of income from discontinued operations.

 
 
Three Months Ended
 
Nine Months Ended
 
 
 
September 30,
 
September 30,
 
 
 
2005
 
2004
 
2005
 
2004
 
 
 
(In millions)
Discontinued operations (net of tax)
 
 
 
 
 
 
 
 
 
 
 
 
 
Gain on sale:
 
 
 
 
 
 
 
 
 
 
 
 
 
Retail gas business
 
$
-
 
$
-
 
$
5
 
$
-
 
FSG and MYR subsidiaries
 
 
-
 
 
-
 
 
12
 
 
-
 
Reclassification of operating income, net of tax
 
 
1
 
 
3
 
 
2
 
 
6
 
Total
 
$
1
 
$
3
 
$
19
 
$
6
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 


7 - DERIVATIVE INSTRUMENTS

FirstEnergy is exposed to financial risks resulting from the fluctuation of interest rates and commodity prices, including prices for electricity, natural gas, coal and energy transmission. To manage the volatility relating to these exposures, FirstEnergy uses a variety of non-derivative and derivative instruments, including forward contracts, options, futures contracts and swaps. The derivatives are used principally for hedging purposes, and to a lesser extent, for trading purposes. FirstEnergy’s Risk Policy Committee, comprised of members of senior management, provides general management oversight to risk management activities throughout the Company.

FirstEnergy accounts for derivative instruments on its Consolidated Balance Sheet at their fair value unless they meet the normal purchase and normal sales criteria. Derivatives that meet that criteria are accounted for on the accrual basis. The changes in the fair value of a derivative instrument are recorded in current earnings, in other comprehensive income, or as part of the value of the hedged item depending on whether or not it is designated as part of a hedge transaction, the nature of the hedge transaction and hedge effectiveness.

FirstEnergy has entered into fair value hedges of fixed-rate, long-term debt issues to protect against the risk of changes in the fair value of fixed-rate debt instruments due to lower interest rates. Swap maturities, call options, fixed interest rates received, and interest payment dates match those of the underlying debt obligations. During the third quarter of 2005, FirstEnergy unwound swaps with a total notional amount of $350 million from which it received immaterial net cash gains. The gains will be recognized in earnings over the remaining maturity of each respective hedged security as reduced interest expense. As of September 30, 2005, the aggregate notional value of interest rate swap agreements outstanding was $1.05 billion.

FirstEnergy hedges anticipated transactions using cash flow hedges. Such transactions include hedges of anticipated electricity and natural gas purchases and anticipated interest payments associated with future debt issues. The effective portion of such hedges are initially recorded in equity as other comprehensive income or loss and are subsequently included in net income as the underlying hedged commodities are delivered or interest payments are made. Gains and losses from any ineffective portion of cash flow hedges are included directly in earnings. The impact of ineffectiveness on earnings during the three months and nine months ended September 30, 2005 was not material.

During the third quarter of 2005, FirstEnergy entered into several forward starting swap agreements (forward swaps) in order to hedge a portion of the consolidated interest rate risk associated with the possible issuances of fixed-rate, long-term debt securities for one or more of its consolidated entities in the second half of 2006 as outstanding debt matures. These derivatives are treated as cash flow hedges, protecting against the risk of changes in future interest payments resulting from changes in benchmark U.S. Treasury rates between the date of hedge inception and the date of the debt issuance. As of September 30, 2005, FirstEnergy had entered into forward swaps with an aggregate notional amount of $500 million. As of September 30, 2005 the forward swaps had a fair value of $2 million.

The net deferred losses of $79 million included in AOCL as of September 30, 2005, for derivative hedging activity, as compared to the December 31, 2004 balance of $92 million of net deferred losses, resulted from a $6 million decrease related to current hedging activity, a $4 million increase due to the sale of gas business contracts and an $11 million decrease due to net hedge losses included in earnings during the nine months ended September 30, 2005. Approximately $14 million of the net deferred losses on derivative instruments in AOCL as of September 30, 2005 is expected to be reclassified to earnings during the next twelve months as hedged transactions occur. The fair value of these derivative instruments will fluctuate from period to period based on various market factors.

FirstEnergy trades commodity derivatives and periodically experiences net open positions. FirstEnergy’s risk management policies limit the exposure to market risk from open positions and require daily reporting to management of potential financial exposures. During the three months and nine months ended September 30, 2005, the effect of trading on earnings was not material.
 
4

 
8 - STOCK BASED COMPENSATION
 
FirstEnergy applies the recognition and measurement principles of APB 25 and related interpretations in accounting for its stock-based compensation plans. No material stock-based employee compensation expense is reflected in net income for options as all options granted under those plans have exercise prices equal to the market value of the underlying common stock on the respective grant dates, resulting in substantially no intrinsic value.

In December 2004, the FASB issued SFAS 123(R), a revision to SFAS 123 which requires expensing the fair value of stock options (see Note 15). In April 2005, the SEC delayed the effective date of SFAS 123(R) to annual, rather than interim, periods that begin after June 15, 2005. FirstEnergy will be required to adopt this standard beginning January 1, 2006. The table below summarizes the effects on FirstEnergy’s net income and earnings per share had FirstEnergy applied the fair value recognition provisions of SFAS 123(R) to stock-based employee compensation in the current reporting periods.

 
 
 
Three Months Ended
 
Nine Months Ended
 
 
 
 
September 30,
 
September 30,
 
 
 
 
2005
 
2004
 
2005
 
2004
 
 
 
 
(In thousands, except per share amounts)
 
 
 
 
 
 
 
 
 
 
 
 
Net income, as reported
 
 
 
$
332,360
 
$
298,622
 
$
670,078
 
$
676,666
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Add back compensation expense
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
reported in net income, net of tax
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(based on APB 25)(1)
 
 
 
 
17,404
 
 
13,549
 
 
39,785
 
 
29,355
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Deduct compensation expense based
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
upon estimated fair value, net of tax(2)
 
 
 
 
(18,378
 
(16,981
)
 
(44,825
 
(40,380
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net income, as adjusted
 
 
 
$
331,386
 
$
295,190
 
$
665,038
 
$
665,641
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Earnings Per Share of Common Stock -
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Basic
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
As reported 
 
 
 
 
$1.01
 
 
$0.91
 
 
$2.04
 
 
$2.07
 
As adjusted
 
 
 
 
$1.01
 
 
$0.90
 
 
$2.03
 
 
$2.03
 
Diluted
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
As reported 
 
 
 
 
$1.01
 
 
$0.91
 
 
$2.03
 
 
$2.06
 
As adjusted
 
 
 
 
$1.00
 
 
$0.90
 
 
$2.02
 
 
$2.02
 
   
(1) Includes restricted stock, restricted stock units, stock options, performance shares, Employee Stock
  Ownership Plan, Executive Deferred Compensation Plan and Deferred Compensation Plan for outside Directors.
 
(2) Assumes vesting at age 65.
 

FirstEnergy reduced the use of stock options in 2005 and increased the use of performance-based, restricted stock units. Therefore, the pro forma effects of applying SFAS 123(R) may not be representative of its future effect. FirstEnergy does not expect to accelerate out-of-the-money options in anticipation of implementing SFAS 123(R) on January 1, 2006.

9 - ASSET RETIREMENT OBLIGATIONS
 
FirstEnergy has identified applicable legal obligations for nuclear power plant decommissioning, reclamation of a sludge disposal pond related to the Bruce Mansfield Plant and closure of two coal ash disposal sites. The ARO liability of $1.130 billion as of September 30, 2005 included $1.115 billion for nuclear decommissioning of the Beaver Valley, Davis-Besse, Perry and TMI-2 nuclear generating facilities. The Companies' share of the obligation to decommission these units was developed based on site specific studies performed by an independent engineer. FirstEnergy utilized an expected cash flow approach to measure the fair value of the nuclear decommissioning ARO.

In the third quarter of 2005, FirstEnergy revised the ARO associated with Beaver Valley Units 1 and 2 as a result of an updated decommissioning study. The present value of revisions in the estimated cash flows associated with projected decommissioning costs increased the ARO for Beaver Valley Unit 1 by $21 million and decreased the ARO for Beaver Valley Unit 2 by $22 million, resulting in a net decrease in the ARO liability and corresponding plant asset of $1 million (OE - ($2) million, CEI - ($5) million, TE - ($5) million and Penn - $11 million).

The Companies maintain trust funds that are legally restricted for purposes of settling the nuclear decommissioning ARO. As of September 30, 2005, the fair value of the decommissioning trust assets was $1.7 billion.
 
 
5

 
The following tables analyze changes to the ARO balance during the three months and nine months ended September 30, 2005 and 2004, respectively.

Three Months Ended
 
FirstEnergy
 
OE
 
CEI
 
TE
 
Penn
 
JCP&L
 
Met-Ed
 
Penelec
 
 
 
(In millions)
 
Balance, July 1, 2005
 
$
1,113
 
$
208
 
$
281
 
$
201
 
$
143
 
$
75
 
$
137
 
$
68
 
Liabilities incurred
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
Liabilities settled
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
Accretion
 
 
18
 
 
3
 
 
5
 
 
4
 
 
2
 
 
1
 
 
2
 
 
1
 
Revisions in estimated
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
cash flows
 
 
(1
)
 
(2
)
 
(5
)
 
(5
)
 
11
 
 
-
 
 
-
 
 
-
 
Balance, September 30, 2005
 
$
1,130
 
$
209
 
$
281
 
$
200
 
$
156
 
$
76
 
$
139
 
$
69
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance, July 1, 2004
 
$
1,217
 
$
194
 
$
263
 
$
188
 
$
134
 
$
113
 
$
216
 
$
108
 
Liabilities incurred
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
Liabilities settled
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
Accretion
 
 
19
 
 
4
 
 
5
 
 
3
 
 
2
 
 
2
 
 
3
 
 
1
 
Revisions in estimated
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
cash flows
 
 
(176
 
-
 
 
-
 
 
-
 
 
-
 
 
(43
)
 
(89
)
 
(44
)
Balance, September 30, 2004
 
$
1,060
 
$
198
 
$
268
 
$
191
 
$
136
 
$
72
 
$
130
 
$
65
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 


Nine Months Ended
 
FirstEnergy
 
OE
 
CEI
 
TE
 
Penn
 
JCP&L
 
Met-Ed
 
Penelec
 
 
 
(In millions)
 
Balance, January 1, 2005
 
$
1,078
 
$
201
 
$
272
 
$
195
 
$
138
 
$
72
 
$
133
 
$
67
 
Liabilities incurred
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
Liabilities settled
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
Accretion
 
 
53
 
 
10
 
 
14
 
 
10
 
 
7
 
 
4
 
 
6
 
 
2
 
Revisions in estimated
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
cash flows
 
 
(1
 
(2
 
(5
 
(5
 
11
 
 
-
 
 
-
 
 
-
 
Balance, September 30, 2005
 
$
1,130
 
$
209
 
$
281
 
$
200
 
$
156
 
$
76
 
$
139
 
$
69
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance, January 1, 2004
 
$
1,179
 
$
188
 
$
255
 
$
182
 
$
130
 
$
110
 
$
210
 
$
105
 
Liabilities incurred
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
Liabilities settled
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
 
-
 
Accretion
 
 
57
 
 
10
 
 
13
 
 
9
 
 
6
 
 
5
 
 
9
 
 
4
 
Revisions in estimated
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
cash flows
 
 
(176
 
-
 
 
-
 
 
-
 
 
-
 
 
(43
)
 
(89
)
 
(44
)
Balance, September 30, 2004
 
$
1,060
 
$
198
 
$
268
 
$
191
 
$
136
 
$
72
 
$
130
 
$
65
 

10 - PENSION AND OTHER POSTRETIREMENT BENEFITS:
 
The components of FirstEnergy's net periodic pension cost and other postretirement benefits cost (including amounts capitalized) for the three months and nine months ended September 30, 2005 and 2004, consisted of the following:

 
 
Three Months Ended
Nine Months Ended
 
 
 
September 30,
 
September 30,
 
Pension Benefits
 
2005
 
2004
 
2005
 
2004
 
 
 
(In millions)
 
 
 
 
 
 
 
 
 
 
 
Service cost
 
$
19
 
$
19
 
$
58
 
$
58
 
Interest cost
 
 
64
 
 
63
 
 
191
 
 
189
 
Expected return on plan assets
 
 
(86
)
 
(71
)
 
(259
)
 
(215
)
Amortization of prior service cost
 
 
2
 
 
2
 
 
6
 
 
7
 
Recognized net actuarial loss
 
 
9
 
 
10
 
 
27
 
 
29
 
Net periodic cost
 
$
8
 
$
23
 
$
23
 
$
68
 



 
6



 
 
Three Months Ended
 
Nine Months Ended
 
 
 
September 30,
 
September 30,
 
Other Postretirement Benefits
 
2005
 
2004
 
2005
 
2004
 
 
 
(In millions)
 
Service cost
 
$
10
 
$
9
 
$
30
 
$
27
 
Interest cost
 
 
27
 
 
26
 
 
83
 
 
83
 
Expected return on plan assets
 
 
(11
)
 
(10
)
 
(34
)
 
(32
)
Amortization of prior service cost
 
 
(11
)
 
(9
)
 
(33
)
 
(28
)
Recognized net actuarial loss
 
 
10
 
 
9
 
 
30
 
 
29
 
Net periodic cost
 
$
25
 
$
25
 
$
76
 
$
79
 

Pension and postretirement benefit obligations are allocated to the FirstEnergy subsidiaries employing the plan participants. The Companies capitalize employee benefits related to construction projects. The net periodic pension benefits (credit) and net periodic postretirement benefits (including amounts capitalized) recognized by each of the Companies in the three months and nine months ended September 30, 2005 and 2004 were as follows:

 
 
Three Months Ended
 
Nine Months Ended
 
 
 
September 30,
 
September 30,
 
Pension Benefits (Credit)
 
2005
 
2004
 
2005
 
2004
 
 
 
(In millions)
 
 
 
 
 
 
 
 
 
 
 
OE
 
$
0.2
 
$
1.7
 
$
0.7
 
$
5.2
 
Penn
 
 
(0.2
)
 
0.1
 
 
(0.7
)
 
0.4
 
CEI
 
 
0.3
 
 
1.6
 
 
1.0
 
 
4.8
 
TE
 
 
0.3
 
 
0.8
 
 
1.0
 
 
2.3
 
JCP&L
 
 
(0.3
)
 
1.9
 
 
(0.8
)
 
5.6
 
Met-Ed
 
 
(1.1
)
 
0.1
 
 
(3.2
)
 
0.2
 
Penelec
 
 
(1.3
)
 
0.1
 
 
(4.0
)
 
0.4
 


 
 
Three Months Ended
 
Nine Months Ended
 
 
 
September 30,
 
September 30,
 
Other Postretirement Benefits
 
2005
 
2004
 
2005
 
2004
 
 
 
(In millions)
 
 
 
 
 
 
 
 
 
 
 
OE
 
$
5.8
 
$
5.7
 
$
17.3
 
$
17.7
 
Penn
 
 
1.2
 
 
1.2
 
 
3.5
 
 
3.7
 
CEI
 
 
3.8
 
 
4.4
 
 
11.4
 
 
13.7
 
TE
 
 
2.2
 
 
1.7
 
 
6.5
 
 
5.0
 
JCP&L
 
 
1.5
 
 
1.0
 
 
5.7
 
 
3.5
 
Met-Ed
 
 
0.4
 
 
0.7
 
 
1.2
 
 
2.5
 
Penelec
 
 
2.0
 
 
0.7
 
 
5.9
 
 
2.5
 

11 - VARIABLE INTEREST ENTITIES

Leases
 
FirstEnergy’s consolidated financial statements include PNBV and Shippingport, VIEs created in 1996 and 1997, respectively, to refinance debt originally issued in connection with sale and leaseback transactions. PNBV and Shippingport financial data are included in the consolidated financial statements of OE and CEI, respectively.

PNBV was established to purchase a portion of the lease obligation bonds issued in connection with OE’s 1987 sale and leaseback of its interests in the Perry Plant and Beaver Valley Unit 2. OE used debt and available funds to purchase the notes issued by PNBV. Ownership of PNBV includes a three-percent equity interest by a nonaffiliated third party and a three-percent equity interest held by OES Ventures, a wholly owned subsidiary of OE. Shippingport was established to purchase all of the lease obligation bonds issued in connection with CEI’s and TE’s Bruce Mansfield Plant sale and leaseback transaction in 1987. CEI and TE used debt and available funds to purchase the notes issued by Shippingport.

OE, CEI and TE are exposed to losses under the applicable sale-leaseback agreements upon the occurrence of certain contingent events that each company considers unlikely to occur. OE, CEI and TE each have a maximum exposure to loss under these provisions of approximately $1 billion, which represents the net amount of casualty value payments upon the occurrence of specified casualty events that render the applicable plant worthless. Under the applicable sale and leaseback agreements, OE, CEI and TE have net minimum discounted lease payments of $678 million, $103 million and $541 million, respectively, that would not be payable if the casualty value payments are made.


 
7

 
Power Purchase Agreements

In accordance with FIN 46R, FirstEnergy evaluated its power purchase agreements and determined that certain NUG entities may be VIEs to the extent they own a plant that sells substantially all of its output to the Companies and the contract price for power is correlated with the plant’s variable costs of production. FirstEnergy, through its subsidiaries JCP&L, Met-Ed and Penelec, maintains approximately 30 long-term power purchase agreements with NUG entities. The agreements were structured pursuant to the Public Utility Regulatory Policies Act of 1978. FirstEnergy was not involved in the creation of, and has no equity or debt invested in, these entities.

FirstEnergy has determined that for all but eight of these entities, neither JCP&L, Met-Ed nor Penelec have variable interests in the entities or the entities are governmental or not-for-profit organizations not within the scope of FIN 46R. JCP&L, Met-Ed or Penelec may hold variable interests in the remaining eight entities, which sell their output at variable prices that correlate to some extent with the operating costs of the plants.

As required by FIN 46R, FirstEnergy periodically requests from these eight entities the information necessary to determine whether they are VIEs or whether JCP&L, Met-Ed or Penelec is the primary beneficiary. FirstEnergy has been unable to obtain the requested information, which in most cases was deemed by the requested entity to be proprietary. As such, FirstEnergy applied the scope exception that exempts enterprises unable to obtain the necessary information to evaluate entities under FIN 46R. The maximum exposure to loss from these entities results from increases in the variable pricing component under the contract terms and cannot be determined without the requested data. Purchased power costs from these entities during the three months and nine months ended September 30, 2005 and 2004 are shown in the table below:
 
 
 
Three Months Ended
 
Nine Months Ended
 
 
September 30,
 
September 30,
 
 
2005
 
2004
 
2005
 
2004
 
 
        (In millions)
 
 
 
 
 
 
 
 
 
 
 
 
 
JCP&L
$
33
 
$
26
 
$
74
 
$
71
 
Met-Ed
 
10
 
 
13
 
 
40
 
 
38
 
Penelec
 
7
 
 
7
 
 
21
 
 
20
 
Total
$
50
 
$
46
 
$
135
 
$
129
 
 

Securitized Transition Bonds

The consolidated financial statements of FirstEnergy and JCP&L include the results of JCP&L Transition, a wholly owned limited liability company of JCP&L. In June 2002, JCP&L Transition sold $320 million of transition bonds to securitize the recovery of JCP&L's bondable stranded costs associated with the previously divested Oyster Creek Nuclear Generating Station.

JCP&L did not purchase and does not own any of the transition bonds, which are included as long-term debt on FirstEnergy's and JCP&L's Consolidated Balance Sheets. The transition bonds are obligations of JCP&L Transition only and are collateralized solely by the equity and assets of JCP&L Transition, which consist primarily of bondable transition property. The bondable transition property is solely the property of JCP&L Transition.

Bondable transition property represents the irrevocable right under New Jersey law of a utility company to charge, collect and receive from its customers, through a non-bypassable TBC, the principal amount and interest on the transition bonds and other fees and expenses associated with their issuance. JCP&L sold the bondable transition property to JCP&L Transition and, as servicer, manages and administers the bondable transition property, including the billing, collection and remittance of the TBC, pursuant to a servicing agreement with JCP&L Transition. JCP&L is entitled to a quarterly servicing fee of $0.1 million that is payable from TBC collections.

12 - OHIO TAX LEGISLATION
 
On June 30, 2005, the State of Ohio enacted tax legislation that creates a new CAT tax, which is based on qualifying “taxable gross receipts” and will not consider any expenses or costs incurred to generate such receipts, except for items such as cash discounts, returns and allowances, and bad debts. The CAT tax was effective July 1, 2005, and replaces the Ohio income-based franchise tax and the Ohio personal property tax. The CAT tax is phased-in while the current income-based franchise tax is phased-out over a five-year period at a rate of 20% annually, beginning with the year ended 2005, and the personal property tax is phased-out over a four-year period at a rate of approximately 25% annually, beginning with the year ended 2005. For example, during the phase-out period the Ohio income-based franchise tax will be computed consistently with the prior tax law, except that the tax liability as computed will be multiplied by 4/5 in 2005; 3/5 in 2006; 2/5 in 2007 and 1/5 in 2008, therefore eliminating the current income-based franchise tax over a five-year period. As a result of the new tax structure, all net deferred tax benefits that were not expected to reverse during the five-year phase-in period were written-off as of June 30, 2005.
 
 
8


 
The increase (in millions) to income taxes associated with the adjustment to net deferred taxes for the nine months ended September 30, 2005 is summarized below:

OE
 
$
36.0
CEI
 
 
7.5
TE
 
 
17.5
Other FirstEnergy subsidiaries
 
 
10.7
Total FirstEnergy
 
$
71.7

Income tax expenses were (increased) reduced during the three months and nine months ended September 30, 2005 by the initial phase-out of the Ohio income-based franchise tax and phase-in of the CAT tax as summarized below:
 

   
Three Months Ended
   
Nine Months Ended
 
   
September 30, 2005
 
September 30, 2005
   
   
(In millions)
               
OE
 
$
1.6
 
$
6.5
 
CEI
 
 
(3.1
)
 
(1.7
)
TE
 
 
0.7
   
1.2
 
Other FirstEnergy subsidiaries
 
 
0.7
   
1.5
 
Total FirstEnergy
 
$
(0.1
)
$
7.5
 
 
 
13 - COMMITMENTS, GUARANTEES AND CONTINGENCIES:

(A)  GUARANTEES AND OTHER ASSURANCES
 
As part of normal business activities, FirstEnergy enters into various agreements on behalf of its subsidiaries to provide financial or performance assurances to third parties. Such agreements include contract guarantees, surety bonds and ratings contingent collateralization provisions. As of September 30, 2005, outstanding guarantees and other assurances aggregated approximately $2.7 billion and included contract guarantees ($1.3 billion), surety bonds ($0.3 billion) and LOCs ($1.1 billion).

FirstEnergy guarantees energy and energy-related payments of its subsidiaries involved in energy commodity activities - principally to facilitate normal physical transactions involving electricity, gas, emission allowances and coal. FirstEnergy also provides guarantees to various providers of subsidiary financing principally for the acquisition of property, plant and equipment. These agreements legally obligate FirstEnergy to fulfill the obligations of those subsidiaries directly involved in energy and energy-related transactions or financing where the law might otherwise limit the counterparties' claims. If demands of a counterparty were to exceed the ability of a subsidiary to satisfy existing obligations, FirstEnergy's guarantee enables the counterparty's legal claim to be satisfied by other FirstEnergy assets. Such parental guarantees amount to $0.8 billion (included in the $1.3 billion discussed above) as of September 30, 2005 and the likelihood is remote that such guarantees will increase amounts otherwise to be paid by FirstEnergy to meet its obligations incurred in connection with financings and ongoing energy and energy-related contracts.

While these types of guarantees are normally parental commitments for the future payment of subsidiary obligations, subsequent to the occurrence of a credit rating-downgrade or “material adverse event” the immediate posting of cash collateral or provision of an LOC may be required of the subsidiary. The following table summarizes collateral provisions in effect as of September 30, 2005:

 
 
 
Total
 
Collateral Paid
 
Remaining
 
Collateral Provisions
 
 
Exposure 
 
Cash
 
LOC
 
Exposure
 
 
 
 
(In millions)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Credit rating downgrade
 
 
 
$
445
 
$
213
 
$
18
 
$
214
 
Adverse event
 
 
 
 
77
 
 
-
 
 
5
 
 
72
 
Total
 
 
 
$
522
 
$
213
 
$
23
 
$
286
 
                               

On October 3, 2005, S&P raised the senior unsecured ratings of FirstEnergy's holding company to 'BBB-' from 'BB+'. As a result of the rating upgrade, $109 million of cash collateral was subsequently returned to FirstEnergy.


 
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Most of FirstEnergy's surety bonds are backed by various indemnities common within the insurance industry. Surety bonds and related FirstEnergy guarantees of $307 million provide additional assurance to outside parties that contractual and statutory obligations will be met in a number of areas including construction jobs, environmental commitments and various retail transactions.

The Companies, with the exception of TE and JCP&L, each have a wholly owned subsidiary whose borrowings are secured by customer accounts receivable purchased from its respective parent company. The CEI subsidiary's borrowings are also secured by customer accounts receivable purchased from TE. Each subsidiary company has its own receivables financing arrangement and, as a separate legal entity with separate creditors, would have to satisfy its obligations to creditors before any of its remaining assets could be available to its parent company.
   
Subsidiary Company
 
Parent Company
 
Capacity
 
 
 
 
 
(In millions)
 
OES Capital, Incorporated
 
 
OE
 
$
170
 
Centerior Funding Corp.
 
 
CEI
 
 
200
 
Penn Power Funding LLC
 
 
Penn
 
 
25
 
Met-Ed Funding LLC
 
 
Met-Ed
 
 
80
 
Penelec Funding LLC
 
 
Penelec
 
 
75
 
 
 
 
 
 
$
550
 


FirstEnergy has guaranteed the obligations of the operators of the TEBSA project, up to a maximum of $6 million (subject to escalation) under the project's operations and maintenance agreement. In connection with the sale of TEBSA in January 2004, the purchaser indemnified FirstEnergy against any loss under this guarantee. FirstEnergy has also provided an LOC ($47 million as of September 30, 2005) which is renewable and declines yearly based upon the senior outstanding debt of TEBSA. The LOC was reduced to $36 million on October 15, 2005.

(B) ENVIRONMENTAL MATTERS

Various federal, state and local authorities regulate the Companies with regard to air and water quality and other environmental matters. The effects of compliance on the Companies with regard to environmental matters could have a material adverse effect on FirstEnergy's earnings and competitive position. These environmental regulations affect FirstEnergy's earnings and competitive position to the extent that it competes with companies that are not subject to such regulations and therefore do not bear the risk of costs associated with compliance, or failure to comply, with such regulations. Overall, FirstEnergy believes it is in compliance with existing regulations but is unable to predict future changes in regulatory policies and what, if any, the effects of such changes would be. FirstEnergy estimates additional capital expenditures for environmental compliance of approximately $670 million for 2005 through 2007.
 
The Companies accrue environmental liabilities only when they conclude that it is probable that they have an obligation for such costs and can reasonably estimate the amount of such costs. Unasserted claims are reflected in the Companies’ determination of environmental liabilities and are accrued in the period that they are both probable and reasonably estimable.
 
FirstEnergy plans to issue a report regarding its response to air emission requirements. FirstEnergy expects to complete the report by December 1, 2005.

Clean Air Act Compliance
 
FirstEnergy is required to meet federally approved SO2 regulations. Violations of such regulations can result in shutdown of the generating unit involved and/or civil or criminal penalties of up to $32,500 for each day the unit is in violation. The EPA has an interim enforcement policy for SO2 regulations in Ohio that allows for compliance based on a 30-day averaging period. The Companies cannot predict what action the EPA may take in the future with respect to the interim enforcement policy.

FirstEnergy believes it is complying with SO2 reduction requirements under the Clean Air Act Amendments of 1990 by burning lower-sulfur fuel, generating more electricity from lower-emitting plants, and/or using emission allowances. NOx reductions required by the 1990 Amendments are being achieved through combustion controls and the generation of more electricity at lower-emitting plants. In September 1998, the EPA finalized regulations requiring additional NOx reductions from FirstEnergy's facilities. The EPA's NOx Transport Rule imposes uniform reductions of NOx emissions (an approximate 85 percent reduction in utility plant NOx emissions from projected 2007 emissions) across a region of nineteen states (including Michigan, New Jersey, Ohio and Pennsylvania) and the District of Columbia based on a conclusion that such NOx emissions are contributing significantly to ozone levels in the eastern United States. FirstEnergy believes its facilities are also complying with the NOx budgets established under State Implementation Plans through combustion controls and post-combustion controls, including Selective Catalytic Reduction and Selective Non-Catalytic Reduction systems, and/or using emission allowances.
 
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National Ambient Air Quality Standards
 
In July 1997, the EPA promulgated changes in the NAAQS for ozone and proposed a new NAAQS for fine particulate matter. On March 10, 2005, the EPA finalized the "Clean Air Interstate Rule" covering a total of 28 states (including Michigan, New Jersey, Ohio and Pennsylvania) and the District of Columbia based on proposed findings that air emissions from 28 eastern states and the District of Columbia significantly contribute to nonattainment of the NAAQS for fine particles and/or the "8-hour" ozone NAAQS in other states. CAIR provides each affected state until 2006 to develop implementing regulations to achieve additional reductions of NOx and SO2 emissions in two phases (Phase I in 2009 for NOx, 2010 for SO2 and Phase II in 2015 for both NOx and SO2) in all cases from the 2003 levels. FirstEnergy's Michigan, Ohio and Pennsylvania fossil-fired generation facilities will be subject to the caps on SO2 and NOx emissions, whereas their New Jersey fossil-fired generation facilities will be subject to a cap on NOx emissions only. According to the EPA, SO2 emissions will be reduced by 45% (from 2003 levels) by 2010 across the states covered by the rule, with reductions reaching 73% (from 2003 levels) by 2015, capping SO2 emissions in affected states to just 2.5 million tons annually. NOx emissions will be reduced by 53% (from 2003 levels) by 2009 across the states covered by the rule, with reductions reaching 61% (from 2003 levels) by 2015, achieving a regional NOx cap of 1.3 million tons annually. The future cost of compliance with these regulations may be substantial and will depend on how they are ultimately implemented by the states in which FirstEnergy operates affected facilities.

Mercury Emissions
 
In December 2000, the EPA announced it would proceed with the development of regulations regarding hazardous air pollutants from electric power plants, identifying mercury as the hazardous air pollutant of greatest concern. On March 14, 2005, the EPA finalized the "Clean Air Mercury Rule," which provides a cap-and-trade program to reduce mercury emissions from coal-fired power plants in two phases. Initially, mercury emissions will be capped nationally at 38 tons by 2010 (as a "co-benefit" from implementation of SO2 and NOx emission caps under the EPA's CAIR program). Phase II of the mercury cap-and-trade program will cap nationwide mercury emissions from coal-fired power plants at 15 tons per year by 2018. However, the final rules give states substantial discretion in developing rules to implement these programs. In addition, both the CAIR and the Clean Air Mercury Rule have been challenged in the United States Court of Appeals for the District of Columbia. FirstEnergy's future cost of compliance with these regulations may be substantial.

W. H. Sammis Plant
 
In 1999 and 2000, the EPA issued NOV or Compliance Orders to nine utilities alleging violations of the Clean Air Act based on operation and maintenance of 44 power plants, including the W. H. Sammis Plant, which was owned at that time by OE and Penn. In addition, the DOJ filed eight civil complaints against various investor-owned utilities, including a complaint against OE and Penn in the U.S. District Court for the Southern District of Ohio. These cases are referred to as New Source Review cases. On March 18, 2005, OE and Penn announced that they had reached a settlement with the EPA, the DOJ and three states (Connecticut, New Jersey, and New York) that resolved all issues related to the W. H. Sammis Plant New Source Review litigation. This settlement agreement, which is in the form of a Consent Decree, was approved by the Court on July 11, 2005, requires OE and Penn to reduce Nox and SO2 emissions at the W. H. Sammis Plant and other coal fired plants through the installation of pollution control devices. Capital expenditures necessary to meet those requirements are currently estimated to be $1.5 billion (the primary portion of which is expected to be spent in the 2008 to 2011 time period). As disclosed in FirstEnergy's Form 8-K dated August 26, 2005, FGCO entered into an agreement with Bechtel Power Corporation (Bechtel), under which Bechtel will engineer, procure, and construct air quality control systems for the reduction of sulfur dioxide emissions. The settlement agreement also requires OE and Penn to spend up to $25 million toward environmentally beneficial projects, which include wind energy purchased power agreements over a 20-year term. OE and Penn agreed to pay a civil penalty of $8.5 million. Results for the first quarter of 2005 included the penalties payable by OE and Penn of $7.8 million and $0.7 million, respectively. OE and Penn also recognized liabilities of $9.2 million and $0.8 million, respectively, during the first quarter of 2005, for probable future cash contributions toward environmentally beneficial projects.

Climate Change

In December 1997, delegates to the United Nations' climate summit in Japan adopted an agreement, the Kyoto Protocol (Protocol), to address global warming by reducing the amount of man-made GHG emitted by developed countries by 5.2% from 1990 levels between 2008 and 2012. The United States signed the Protocol in 1998 but it failed to receive the two-thirds vote of the United States Senate required for ratification. However, the Bush administration has committed the United States to a voluntary climate change strategy to reduce domestic GHG intensity - the ratio of emissions to economic output - by 18 percent through 2012. The Energy Policy Act of 2005 established a Committee on Climate Change Technology to coordinate federal climate change activities and promote the development and deployment of GHG reducing technologies.
 

 
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FirstEnergy cannot currently estimate the financial impact of climate change policies, although the potential restrictions on CO2 emissions could require significant capital and other expenditures. However, the CO2 emissions per kilowatt-hour of electricity generated by FirstEnergy is lower than many regional competitors due to its diversified generation sources, which include low or non-CO2 emitting gas-fired and nuclear generators.

Clean Water Act
 
Various water quality regulations, the majority of which are the result of the federal Clean Water Act and its amendments, apply to FirstEnergy's plants. In addition, Ohio, New Jersey and Pennsylvania have water quality standards applicable to FirstEnergy's operations. As provided in the Clean Water Act, authority to grant federal National Pollutant Discharge Elimination System water discharge permits can be assumed by a state. Ohio, New Jersey and Pennsylvania have assumed such authority.

On September 7, 2004, the EPA established new performance standards under Section 316(b) of the Clean Water Act for reducing impacts on fish and shellfish from cooling water intake structures at certain existing large electric generating plants. The regulations call for reductions in impingement mortality, when aquatic organisms are pinned against screens or other parts of a cooling water intake system and entrainment, which occurs when aquatic species are drawn into a facility's cooling water system. FirstEnergy is conducting comprehensive demonstration studies, due in 2008, to determine the operational measures, equipment or restoration activities, if any, necessary for compliance by its facilities with the performance standards. FirstEnergy is unable to predict the outcome of such studies. Depending on the outcome of such studies, the future cost of compliance with these standards may require material capital expenditures.

Regulation of Hazardous Waste
 
As a result of the Resource Conservation and Recovery Act of 1976, as amended, and the Toxic Substances Control Act of 1976, federal and state hazardous waste regulations have been promulgated. Certain fossil-fuel combustion waste products, such as coal ash, were exempted from hazardous waste disposal requirements pending the EPA's evaluation of the need for future regulation. The EPA subsequently determined that regulation of coal ash as a hazardous waste is unnecessary. In April 2000, the EPA announced that it will develop national standards regulating disposal of coal ash under its authority to regulate nonhazardous waste.

The Companies have been named as PRPs 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 are liable on a joint and several basis. Therefore, environmental liabilities that are considered probable have been recognized on the Consolidated Balance Sheet as of September 30, 2005, based on estimates of the total costs of cleanup, the Companies' proportionate responsibility for such costs and the financial ability of other nonaffiliated entities to pay. In addition, JCP&L has accrued liabilities for environmental remediation of former manufactured gas plants in New Jersey; those costs are being recovered by JCP&L through a non-bypassable SBC. Total liabilities of approximately $64 million (JCP&L - $46.8 million, CEI - $2.3 million, TE - $0.2 million, Met-Ed - $0.1 million and other - $14.6 million) have been accrued through September 30, 2005.

(C) OTHER LEGAL PROCEEDINGS

Power Outages and Related Litigation
 
In July 1999, the Mid-Atlantic States experienced a severe heat wave, which resulted in power outages throughout the service territories of many electric utilities, including JCP&L's territory. In an investigation into the causes of the outages and the reliability of the transmission and distribution systems of all four of New Jersey’s electric utilities, the NJBPU concluded that there was not a prima facie case demonstrating that, overall, JCP&L provided unsafe, inadequate or improper service to its customers. Two class action lawsuits (subsequently consolidated into a single proceeding) were filed in New Jersey Superior Court in July 1999 against JCP&L, GPU and other GPU companies, seeking compensatory and punitive damages arising from the July 1999 service interruptions in the JCP&L territory.

In August 2002, the trial court granted partial summary judgment to JCP&L and dismissed the plaintiffs' claims for consumer fraud, common law fraud, negligent misrepresentation, and strict product liability. In November 2003, the trial court granted JCP&L's motion to decertify the class and denied plaintiffs' motion to permit into evidence their class-wide damage model indicating damages in excess of $50 million. These class decertification and damage rulings were appealed to the Appellate Division. The Appellate Division issued a decision on July 8, 2004, affirming the decertification of the originally certified class, but remanding for certification of a class limited to those customers directly impacted by the outages of JCP&L transformers in Red Bank, New Jersey. On September 8, 2004, the New Jersey Supreme Court denied the motions filed by plaintiffs and JCP&L for leave to appeal the decision of the Appellate Division. JCP&L has filed a motion for summary judgment. FirstEnergy is unable to predict the outcome of these matters and no liability has been accrued as of September 30, 2005.



 
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On August 14, 2003, various states and parts of southern Canada experienced widespread power outages. The outages affected approximately 1.4 million customers in FirstEnergy's service area. The U.S. - Canada Power System Outage Task Force’s final report in April 2004 on the outages concluded, among other things, that the problems leading to the outages began in FirstEnergy’s Ohio service area. Specifically, the final report concluded, among other things, that the initiation of the August 14, 2003 power outages resulted from an alleged failure of both FirstEnergy and ECAR to assess and understand perceived inadequacies within the FirstEnergy system; inadequate situational awareness of the developing conditions; and a perceived failure to adequately manage tree growth in certain transmission rights of way. The Task Force also concluded that there was a failure of the interconnected grid's reliability organizations (MISO and PJM) to provide effective real-time diagnostic support. The final report is publicly available through the Department of Energy’s website (www.doe.gov). FirstEnergy believes that the final report does not provide a complete and comprehensive picture of the conditions that contributed to the August 14, 2003 power outages and that it does not adequately address the underlying causes of the outages. FirstEnergy remains convinced that the outages cannot be explained by events on any one utility's system. The final report contained 46 “recommendations to prevent or minimize the scope of future blackouts.” Forty-five of those recommendations related to broad industry or policy matters