Page 1 of 24

 

FORM 10-Q

 

 

SECURITIES AND EXCHANGE COMMISSION 

WASHINGTON, D.C.  20549

 

 

 

Quarterly Report under Section 13 or 15(d)

of the Securities Exchange Act of 1934

 

 

For Quarter Ended March 31, 2001

Commission File Number 1-3376-2

 

 

THE POTOMAC EDISON COMPANY

(Exact name of registrant as specified in its charter)

 

Maryland and Virginia
13-5323955
(State(s) of Incorporation)
(I.R.S. Employer Identification No.)

 

 

10435 Downsville Pike, Hagerstown, Maryland 21740-1766

Telephone Number - 301-790-3400

 

 

     The registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months and (2) has been subject to such filing requirements for the past90 days.

     At May 15, 2001, 22,385,000 shares of the Common Stock (no par value) of the registrant were outstanding, all of which are held by Allegheny Energy, Inc., the Company's parent.
**2**
 
**THE POTOMAC EDISON COMPANY

Form 10-Q for Quarter Ended March 31, 2001**
 

 
**Index

 

 

** 

 
 
**Page No.**PART I - FINANCIAL INFORMATION:
Consolidated Statement of Operations - Three months              ended March 31, 2001 and 2000      
 

3
Consolidated Statement of Cash Flows - Three months ended

  March 31, 2001 and 2000
 

4
Consolidated Balance Sheet - March 31, 2001

  and December 31, 2000
 

5-6
Notes to Financial Statements
7-9
Management's Discussion and Analysis of Financial

  Condition and Results of Operations
 

10-23**PART II - OTHER INFORMATION
24

 

 

 

 
**3**

THE POTOMAC EDISON COMPANY AND SUBSIDIARIES
Consolidated Statement of Operations
(Thousands of Dollars)
Unaudited
Three Months Ended
March 31
2001
2000
OPERATING REVENUES:
    Residential
   $109,967
     $101,984
    Commercial
     40,713
       42,656
    Industrial
     54,230
       50,725
    Wholesale and other, including affiliates
     17,981
       14,595
    Bulk power transactions, net
     12,730
        4,774
           Total Operating Revenues
    235,621
      214,734
OPERATING EXPENSES:
  Operation:
     Fuel
       34,983
     Purchased power and exchanges, net
    137,848
       53,185
     Deferred power costs, net
     (3,342)
          397
     Other
     40,098
       23,244
  Maintenance
      7,148
       14,433
  Depreciation and amortization
      8,255
       19,909
  Taxes other than income taxes
      9,246
       12,609
  Federal and state income taxes
      8,283
       15,743
          Total Operating Expenses
    207,536
      174,503
               Operating Income
     28,085
       40,231
OTHER INCOME AND DEDUCTIONS:
   Allowance for other than borrowed funds
     used during construction
         (5)
          258
   Other income, net
        (49)
        1,945
        Total Other Income and Deductions
        (54)
        2,203
          Income Before Interest Charges and 
            Extraordinary Charge
     28,031
       42,434
INTEREST CHARGES:
   Interest on long-term debt
      8,166
       10,758
   Other interest
        775
         770
   Allowance for borrowed funds used during
      construction
       (105)
         (205)
          Total Interest Charges 
      8,836
       11,323
Consolidated Income Before Extraordinary Charge
     19,195
       31,111
Extraordinary Charge, net 
           
      (12,278)
Consolidated Net Income
   $ 19,195
     $ 18,833
See accompanying notes to consolidated financial statements.

 

 
**4
THE POTOMAC EDISON COMPANY AND SUBSIDIARIES
Consolidated Statement of Cash Flows
(Thousands of Dollars)
Unaudited
Three Months Ended
March 31
2001
2000*
CASH FLOWS FROM OPERATIONS:
 Consolidated net income 
   $19,195
   $18,833
 Extraordinary charge, net of taxes
           
    12,278
 Consolidated income before extraordinary charge
    19,195
    31,111
 Depreciation and amortization
     8,255
    19,909
 Deferred investment credit and income taxes, net
       654
    (1,000)
 Deferred power costs, net
    (3,342)
       397
 Unconsolidated subsidiaries' dividends in excess of earnings
       379
 Allowance for other than borrowed funds used during construction
         5
      (258)
 Changes in certain current assets and liabilities:
       accounts receivable, net
   (15,667)
    (4,234)
       Accounts receivable affiliates
   (11,273)
       Materials and supplies
      (502)
    (1,430)
       Prepaid taxes
     2,584
       Accounts payable
    (5,844)
   (10,220)
       Accounts payable to affiliates
     8,521
       Taxes accrued
    10,184
    11,967
       Interest accrued
     6,413
     4,933
       Other, net
    (1,387)
    10,672
    29,069
    50,953
CASH FLOWS USED IN INVESTING:
     Construction expenditures (less allowance for other
   
          than borrowed funds used during construction)
   (10,918)
   (15,476)
CASH FLOWS USED IN FINANCING:
     Short-term debt
   (10,885)
     7,950
     Retirement of long-term debt
   (75,000)
     Funds on deposit with trustees
     3,133
     Notes payable to affiliates
    53,200
     Dividends on common stock
    (9,626)
   (57,082)
   (20,511)
   (67,799)
NET CHANGE IN CASH AND TEMPORARY CASH INVESTMENTS
    (2,360)
   (32,322)
Cash and temporary cash investments at January 1
     4,685 
    34,509
Cash and temporary cash investments at March 31
  $  2,325
   $ 2,187
SUPPLEMENTAL CASH FLOW INFORMATION
     Cash paid during the period for:
                 Interest (net of amount capitalized)
  $  2,325
   $ 6,043
                 Income taxes
  $ (1,914)
   $    86
See accompanying notes to consolidated financial statements.
*Certain amounts have been reclassified for comparative purposes.
 
**5
THE POTOMAC EDISON COMPANY AND SUBSIDIARIES
Consolidated Balance Sheet
(Thousands of Dollars)
Unaudited
March 31,
December 31,
2001
2000*
ASSETS:
   Property, Plant, and Equipment:
        Regulated operations
  $1,407,637
   $1,396,259
        Construction work in progress
      13,317
       14,122
   1,420,954
    1,410,381
        Accumulated depreciation
    (523,068) 
     (514,167) 
     897,886
      896,214
   Investments and Other Assets:
        Other
         339
          355
         339
          355 
   Current Assets:
        Cash and temporary cash investments
       2,325
        4,685
        Accounts receivable:
            Electric service
     113,787
       98,225
            Other
       2,297
        1,893
            Allowance for uncollectible accounts
      (4,488)
       (4,189)
        Materials and supplies - at average cost:
            Operating and construction
      12,634
       12,132
        Deferred income taxes
       5,557
        5,193
        Prepaid taxes
      13,451
       16,035
        Other
         842
          805
     146,405
      134,779
   Deferred Charges:
        Regulatory assets
      53,712
       53,712
        Unamortized loss on reacquired debt
      10,794
       10,925
        Other
       2,309
        2,978
      66,815
       67,615
                Total Assets
  $1,111,445
   $1,098,963
 

**6
THE POTOMAC EDISON COMPANY AND SUBSIDIARIES
Consolidated Balance Sheet (Continued)
(Thousands of Dollars)
Unaudited
March 31,
December 31,
   Capitalization:
2001
2000*
        Common stock 
   $      224
    $      224
        Other paid-in capital
      224,979
       224,979
        Retained earnings
      197,119
       187,551
      422,322
       412,754
        Long-term debt and QUIDS
      410,074
       410,010
      832,396
       822,764
   Current Liabilities:
        Short-term debt
        Notes payable to affiliates
        Short-term debt
       31,800
        42,685
        Accounts payable 
       11,460
        17,304
        Accounts payable to affiliates, net
       33,008
        24,487
        Deferred income taxes
        Taxes accrued:
            Federal and state income
        8,059
            77
            Other
       10,946
         8,744
        Deferred power costs
        9,964
        11,396
        Interest accrued
       10,941
         4,528
        Maryland settlement
        7,223
        10,456
        Other
        7,262
         7,604
      130,663
       127,281
   Deferred Credits and Other Liabilities:
        Unamortized investment credit
       10,309
        10,555
        Deferred income taxes
       92,590
        89,285
        Obligations under capital leases
       10,335
         9,876
        Regulatory liabilities
       28,342
        32,309
        Other
        6,810
         6,893
      148,386
       148,918
              Total Capitalization and Liabilities
   $1,111,445
    $1,098,963
See accompanying notes to consolidated financial statements.
*Certain amounts have been reclassified for comparative purposes.
** 

7

THE POTOMAC EDISON COMPANY

Notes to Consolidated Financial Statements

 

1.  The Potomac Edison Company (The Company) is a wholly-owned subsidiary of Allegheny Energy, Inc. (Allegheny Energy).  The Company's Notes to Consolidated Financial Statements in its Annual Report on Form 10-K for the year ended December 31, 2000,should be read with the accompanying consolidated financial statements and the following notes.  The accompanying consolidated financial statements appearing on pages 3 through 6 and these notes to consolidated financial statements are unaudited.  In theopinion of the Company, such consolidated financial statements together with these notes contain all adjustments (which consist only of normal recurring adjustments) necessary to present fairly the Company's financial position as of March 31, 2001, theresults of operations for the three months ended March 31, 2001, and 2000, and cash flows for the three months ended March 31, 2001, and 2000.  Certain prior period amounts in these consolidated financial statements and notes have been revised forcomparative purposes.

2.  For purposes of the Consolidated Balance Sheet and Consolidated Statement of Cash Flows, temporary cash investments with original maturities of three months or less, generally in the form of commercial paper, certificates of deposit, andrepurchase agreements, are considered to be the equivalent of cash.

3.  The Company's principal operating segment is regulated operations. The regulated operations segment, previously referred to as the utility segment, operates electric transmission and distributions (T&D) systems in Maryland, West Virginia andVirginia.  

The Company and its regulated affiliates, Monongahela Power Company Monongahela Power) and West Penn Power Company (West Penn), collectively now doing business as Allegheny Power, are engaged in the purchase, transmission, and distribution of electricenergy.  Also, with Monongahela Power's purchase of West Virginia Power Company (West Virginia Power) in December 1999 and Mountaineer Gas Company (Mountaineer Gas) in August 2000, Allegheny Power is now involved with the delivery and procurement ofnatural gas.  In addition, Monongahela Power is engaged in the generation and sale of electric energy.  

4.  On May 25, 2000, the Company filed an application with the Virginia State Corporation Commission (Virginia SCC) to separate its approximately 380 megawatts (MW) of generating assets, excluding the hydroelectric assets located within the state ofVirginia, from its T&D assets, effective July 1, 2000.  On July 11, 2000, the Virginia SCC issued an order approving the Company's separation plan permitting the transfer, at book value, of its Virginia jurisdictional generating assets to AlleghenyEnergy Supply Company, LLC (Allegheny Energy Supply).  The Company transferred these assets to Allegheny Energy Supply on August 1, 2000.

The Potomac Edison Company

  and Subsidiaries
**8**
In conjunction with the separation plan, the Virginia SCC approved a Memorandum of Understanding (MOU) that includes the following:

- Effective with bills rendered on or after August 7, 2000, base rates were reduced by $1 million.

- The Company will not file for a base rate increase prior to January 1, 2001.

- The fuel rate was rolled into base rates effective with bills rendered on or after August 7, 2000.  A fuel rate adjustment credit was also   implemented on that date, reducing annual fuel revenues by $750,000.    Effective August 2001, the fuel rateadjustment credit will drop to   $250,000.  Effective August 2002, the fuel rate adjustment credit will be   eliminated.

- The Company agreed to operate and maintain its distribution system in Virginia at or above historic levels of service quality and reliability.

- The Company agreed, during a default service period, to contract for generation service to be provided to customers at rates set in accordance with the Virginia Electric Utility Restructuring Act.

On August 10, 2000, the Company applied to the Virginia SCC to transfer the five MW of hydroelectric assets located within the state of Virginia to Green Valley Hydro, LLC (a subsidiary of the Company).  On December 14, 2000, the Virginia SCC approvedthe transfer.  The Company anticipates that the transfer to Allegheny Energy Supply will occur during the second quarter of 2001, after receiving final approval from the Securities and Exchange Commission (SEC).

The 2001 session of the Virginia General Assembly enacted amendments to the Virginia Electric Utility Restructuring Act to allow for default service to be provided based on market rates after the capped rate period end July 1, 2007.

5.  The Consolidated Balance Sheet includes the amounts listed below for generation assets not subject to Statement of Financial Accounting Standards (SFAS) No. 71, "Accounting for the Effects of Certain Types of Regulation."  On August 1, 2000, theCompany transferred 2,100 MW of its generation assets to Allegheny Energy Supply, unregulated generation segment.

 
March
December 
2001
2000 *(Millions of Dollars)   
Property, plant, and equipment
   $8.9
   $8.9
Amounts under construction included above  
Accumulated depreciation
   (5.9)
   (5.9)

 
- All of the employees of Allegheny Energy are employed by Allegheny Energy Service Corporation (AESC), which performs services at cost for the Company and its affiliates in accordance with the  Public Utility Holding Company Act of 1935 (PUHCA).  Through AESC, the Company is responsible for its proportionate share of services provided by AESC.  The total billings by AESC (including capital) to the Company for the three months ended March 31, 2001, and 2000

The Potomac Edison Company

  and Subsidiaries
**9**
were $21.5 million and $28.6 million, respectively.  The Company purchases power from its affiliate, Allegheny Energy Supply, under a fixed price multi-year contract.  The Company and its affiliates use an Allegheny Energy, Inc. internal money pool asa facility to accommodate intercompany short-term borrowing needs, to the extent that certain companies have funds available.  The Company had $9.8 million in money pool borrowings outstanding at December 31, 2000, but had no money pool borrowingsoutstanding at March 31, 2001.

     The Company has various operating transactions with its affiliates.  It is the Company's policy that the affiliated receivable and payable balances outstanding from these transactions are presented net on the balancesheet and statement of cash flows.

7.  In June 1998, Financial Accounting Standards Board (FASB) issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 133 was subsequently amended by SFAS No. 137, "Accounting for Derivative Instruments andHedging Activities - Deferral of the Effective Date of FASB Statement No. 133 - an amendment of FASB Statement No. 133" and SFAS No. 138, "Accounting for Certain Derivative Instruments and Certain Hedging Activities - an amendment of FASB Statement No.133."  Effective January 1, 2001, the Company implemented the requirements of these accounting standards.

     These statements establish accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedgingactivities.  They require that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value.  The statements require that changes in the derivative's fair value berecognized currently in earnings unless specific hedge accounting criteria are met.  Special accounting for qualifying hedges allows a derivative's gains and losses to offset related results on the hedged item in the income statement or othercomprehensive income and requires that a company formally document, designate, and assess the effectiveness of transactions that receive hedge accounting.  

     The Company completed and inventory of financial instruments, commodity contracts, and other commitments for the purpose of identifying and assessing all of the Company's derivatives.  From this inventory, the Companydetermined that it had no financial instruments, commodity contracts, or other commitments that required recognition as assets or liabilities on the balance sheet at fair value under the provisions of SFAS 133.
**10****THE POTOMAC EDISON COMPANY

Management's Discussion and Analysis of Financial Condition

and Results of Operations

COMPARISON OF FIRST QUARTER OF 2001 WITH FIRST QUARTER OF 2000

 

     The Notes to Consolidated Financial Statements and Management's Discussion and Analysis of Financial Condition and Results of Operations in The Potomac Edison Company's (the Company) Annual Report on Form 10-K for the year ended December 31,2000, should be read with the following Management's Discussion and Analysis information.
**Factors That May Affect Future Results

     Certain statements within constitute forward-looking statements with respect to the Company. Such forward-looking statements include statements with respect to deregulated activities and movements towards competition inthe states served by the Company, markets, products, services, prices, results of operations, capital expenditures, regulatory matters, liquidity and capital resources, resolution and impact of litigation, and accounting matters.  All such forward-lookinginformation is necessarily only estimated.  There can be no assurance that actual results of the Company will not materially differ from expectations.  Actual results have varied materially and unpredictably from past expectations.

     Factors that could cause actual results of the Company to differ materially include, among others, the following: general and economic and business conditions; industry capacity; changes in technology; changes inpolitical, social, and economic conditions; changes in the price of power and fuel for electric generation; changes in laws and regulations applicable to the Company; litigation involving the Company; environmental regulations; the loss of any significantcustomers and suppliers; and changes in business strategy, operations, or development plans.

 
**Transfer of Generation Assets

Virginia Separation Plan**
     On May 25, 2000, the Company filed an application with the Virginia State Corporation Commission (Virginia SCC) to separate its approximately 380 megawatts (MW) of generating assets, excluding the hydroelectric assetslocated within the state of Virginia, from its transmission and distribution (T&D) assets, effective July 1, 2000.  On July 11, 2000, the Virginia SCC issued an order approving the Company's separation plan permitting the transfer, at book value, ofits Virginia jurisdictional generating assets to Allegheny Energy Supply Company, LLC (Allegheny Energy Supply).
**     On August 10, 2000, the Company applied to the Virginia SCC to transfer the five MW of hydroelectric assets located within the state of Virginia to Green Valley Hydro, LLC (a subsidiary of the Company).  OnDecember 14, 2000, the Virginia SCC approved the transfer.  The Company anticipates that the transfer to Allegheny Energy Supply will

The Potomac Edison Company

 and Subsidiaries
**11**
occur during the second quarter of 2001, after receiving final approval from the Securities and Exchange Commission (SEC).

     The 2001 session of the Virginia General Assembly enacted amendments to the Virginia Electric Utility Restructuring Act to allow for default service to be provided based on market rates after the capped rate period endsJuly 1, 2007.
**Rate Matters

     On July 11, 2000, the Virginia SCC issued an order approving the Company's separation plan that provided for the transfer of its Virginia jurisdictional generating assets at book value to Allegheny Energy Supply.In conjunction with the separation plan, the Virginia SCC approved a Memorandum of Understanding (MOU). The MOU provided that, effective with bills rendered on or after August 7, 2000, base rates were reduced by $1 million; the Company would not file fora base rate increase prior to January 1, 2001; and the fuel rate would be rolled into base rates effective with bills rendered on or after August 7, 2000. A fuel rate adjustment credit was also implemented on August 7, 2000, reducing annual fuel revenuesby $750,000. Effective August 2001, the fuel rate adjustment credit will drop to $250,000. Effective August 2002, the fuel rate adjustment credit will be eliminated. In addition, the Company has agreed to operate and maintain its distribution system inVirginia at or above historic levels of service quality and reliability, and, during the default service period, to contract for generation service to be provided to customers at rates set in accordance with the Virginia Electric Utility Restructuring Act. 

     All Virginia utilities were required to submit a restructuring plan by January 1, 2001, to be effective on January 1, 2002. Accordingly, the Company filed Phase II of the Functional Separation Plan with the Virginia SCCon December 19, 2000.  Many of the financial aspects of Virginia restructuring for the Company have already been addressed in Phase I.

     Effective with bills rendered on or after January 8, 2001, there was an increase in Maryland base rates. This increase is a result of the phase-in of the rate increase approved by the Maryland Public Service Commission(Maryland PSC) on October 27, 1998. A settlement agreement, which includes recognition and dollar-for-dollar recovery of costs to be incurred from the AES Warrior Run Public Utility Regulatory Policies Act (PURPA) project, was filed with the Maryland PSCon July 30, 1998, and was approved on October 27, 1998. The Maryland PSC approved rates to each customer class on December 22, 1998. Under the terms of the agreement, the Company increased its rates about 4% in each of the years 1999, 2000, and 2001 (a$79 million total revenue increase during 1999

The Potomac Edison Company

 and Subsidiaries
**12**
 

through 2001). The increases are designed to recover additional costs of about $131 million, over the period 1999-2001, for capacity purchases from the AES Warrior Run project net of alleged over earnings of $52 million for the same period. Theagreement also requires that the Company share with customers 50 percent of earnings above an 11.4 percent return on equity for 1999 and 2000. As a result, 50 percent of the amount above the threshold earnings amount, or $9.7 million applicable to 1999,was distributed to customers in the form of an Earnings Sharing Credit effective June 7, 2000, through April 30, 2001.   Based on financial results filed with the Maryland PSC, the Company does not anticipate any earnings sharing applicable to the year 2000 .
** 
**Regional Transmission Organization

     On March 15, 2001, the Company, Monongahela Power Company (Monongahela Power), and West Penn Power Company (West Penn), and Pennsylvania-New Jersey-Maryland Interconnection, LLC (PJM) filed documents with the FederalEnergy Regulatory Commission (FERC) to expand PJM through the creation of PJM West.  The filing represents collaboration between Allegheny Power, PJM, and numerous stakeholders.  Allegheny Power and PJM have requested in the filing that FERC approve theproposal by June 15, 2001, affirming that the PJM West arrangement meets all FERC Order 2000 requirements.

     PJM West will develop a new electric transmission system affiliation, which will expand the Mid-Atlantic energy market.  Customers in the region will benefit from the expanded energy market and enhancements to thetransmission system's reliability.  Through this affiliation, PJM will expand its congestion management systems to function over multiple control areas and under multiple Regional Reliability Council reliability standards.  The PJM West arrangement isopen to, and structured to accommodate, additional energy delivery participants. 

     PJM West will provide transmission service to all market participants in accordance with the requirements of FERC Order 2000, while simultaneously expanding the PJM market.  The arrangement will, for the first time,expand the PJM system management concepts beyond a single control area with the potential to result in a significantly larger energy market.  

     The timeline set out in the filing calls for implementation by January 1, 2002.  Under the PJM West concept, an office would be created and staffed and the PJM West Transmission Owners would transfer monitoring andfunctional control of their transmission systems to PJM.  Additionally, the existing PJM regional market would be expanded to cover the PJM West operating territory.

The Potomac Edison Company

 and Subsidiaries
**13**
 
**Review of Operations

EARNINGS SUMMARY**
     Earnings for the first quarter of 2001, before the extraordinary charge, decreased by $11.9 million primarily due to the August 1, 2000 transfer of the Company's 2,100 MW of generating capacity at net book value to Allegheny Energy Supply, anunregulated wholly owned subsidiary of Allegheny Energy, Inc. (Allegheny Energy).  As a result of the transfer, the Company has five MW of hydroelectric generating capacity in Virginia available for sale.  The extraordinary charge of $12.3 million, net oftaxes, for the first quarter of 2000 reflects a write-off by the Company of costs determined to be unrecoverable as a result of West Virginia legislation requiring deregulation of electric generation and recognition of a rate stabilization obligation.
**SALES AND REVENUES**
     Percentage changes in revenues and kilowatt-hour (kWh) sales by major retail customer classes were:

Change from Comparable Period
Of the Prior Year
    Three Months Ended March 31 
Revenues
kWh
Residential
      7.8%
      11.2%
Commercial
     (4.5)
       6.4
Industrial
      6.9
       3.3
Total
      4.1%
       7.9%

     Residential kWh sales, which are more weather sensitive than the other classes, experienced an increase for the three months ended March 31, 2001, due to an increase in customer usage because of weather conditions and growth in the number ofcustomers.

     Commercial kWh sales are also affected by weather, but to a lesser extent than residential.  The increase in commercial kWh sales for the three months ended March 31, 2001, was due to increases in customer usage and an increase in the averagenumber of customers.  The decrease in revenues was primarily due to rate adjustments, as a result of the Maryland deregulation settlement.

     Industrial kWh sales for the first three months of 2001 increased primarily due to an increase in kWh sales to primary metal industry customers and an increase in the average number of customers.

     In October 1998, the Maryland PSC approved a settlement agreement for the Company.  Under the terms of that agreement, the Company increased its rates about 4% in each of the years 1999, 2000 and 2001 (a $79 million totalrevenue increase during 1999 through 2001).  The increases are 

The Potomac Edison Company

  and Subsidiaries
**14**
designed to recover additional costs of about $131 million over the 1999 through 2001 period for capacity purchases from the AES Warrior Run cogeneration project, net of alleged over-earnings of $52 million for the same period.  

     Total operating revenues reflect not only changes in kWh sales and base rate changes, but also any changes in revenues from fuel and energy cost adjustment clauses (fuel clauses) through June 31, 2000.  Effective July 1,2000, the Company's Maryland jurisdiction ceased to have a fuel clause under the terms of the September 23, 1999, settlement agreement.  Also, effective July 1, 2000, a fuel clause ceased to exist for the West Virginia jurisdiction for the Company, andeffective August 2000, a fuel clause ceased to exist for the Company's Virginia jurisdiction.  

     Through June 30, 2000, changes in fuel revenues in jurisdictions for which a fuel clause was in existence had no effect on consolidated net income because increases and decreases in fuel and purchased power costs andsales of transmission services and bulk power were passed on to customers by adjustment of customers' bills through fuel clauses. 

     The Company assumes the risks and benefits of changes in fuel and purchased power costs and sales of transmission services and bulk power in jurisdictions where a fuel clause has been eliminated.  Effective July 1, 2000,the Company assumed the risks and benefits for its Maryland and West Virginia jurisdictions, and in August 2000 for its Virginia jurisdiction.      

     There may be significant volatility in the spot prices for electricity at the wholesale level, which may significantly affect the Company's operating results.  The effect may be either positive or negative, depending onwhether the Company's subsidiaries are net buyers or sellers of electricity and their open commitments or previously concluded market positions that exist as such times.

Wholesale and other revenues were as follows:

Three Months Ended
             March 31     
    2001
    2000
Wholesale customers
      $ 6.3
   $ 5.9
Affiliated companies
        8.3
     6.8
Street lighting and other
        3.4
     1.2
Settlement Revenues
       7
   (Deferred revenues)
           
        
  Total wholesale and other revenues
      $18.0
   $14.6
     Wholesale customers are cooperatives and municipalities that own their own distribution systems and buy all or part of their bulk power needs from the Company under FERC regulation.  Competition in the wholesale marketfor electricity was initiated by the national *Energy Policy Act of 1992*, which permits wholesale generators, utility-owned and otherwise, and wholesale customers to request from owners of bulk power transmission facilities a commitment to supply transmission services.  Total wholesale revenues in

The Potomac Edison Company

  and Subsidiaries
**15**
the first three months of 2001 increased primarily due to increases in revenues from each of the Company's wholesale customers.

     Revenues from affiliated companies represent sales of energy and intercompany allocations of generating capacity, generation spinning reserves, and transmission services pursuant to a power supply agreement among the Company and the otherregulated utility subsidiaries of Allegheny Energy.  Revenues from affiliated companies increased $1.5 million in the first three months of 2001 due primarily to sales to its unregulated affiliate, Allegheny Energy Supply, and increased revenues relatedto leases and rentals.  Because of the Company's transfer of assets to Allegheny Energy Supply, the Company no longer has generation available for sale.  The Company purchased energy from Allegheny Energy Supply to serve Company customers who have notchosen an alternate supplier for their energy needs.  If the Company has purchased more energy than is needed to serve its customers, the excess energy purchased is sold back to Allegheny Energy Supply.  Affiliated companies revenue increased in the firstquarter in part to the sale of this excess energy back to Allegheny Energy Supply.    

     

     Bulk power transactions include sales of bulk power and transmission and other energy services to power marketers and other utilities.  Bulk power and transmission and other energy services sales were as follows:

Three Months Ended
March 31
 2001
    2000
kWh Transactions (in billions):

  Bulk power
    .04
    .03
  Transmission and other energy services to
      nonaffiliated companies
    .98
    .86
       Total
   1.02
    .89
Revenues (in millions):

  Bulk power
   $8.2 
   $1.0
  Transmission and other energy services to 
      nonaffiliated companies
    4.5
    3.8
       Total
  $12.7
   $4.8
 

     The costs of purchased power and revenues from sales to power marketers and other utilities, including transmission services, were previously recovered from or credited to customers under fuel and energy cost recovery procedures.  The impact tothe fuel and energy cost recovery clauses may be either positive or negative depending on whether the Company is a net buyer or seller of electricity during such periods and the open commitments that exist at such times.  Effective July 1, 2000, the fuelclause was discontinued in the Company's Maryland and West Virginia jurisdictions, and was discontinued for its Virginia jurisdiction effective on August 7, 2000.  The discontinuation of fuel clauses may cause an increase in the volatility of earnings forthe Company.  With the 

The Potomac Edison Company

  and Subsidiaries
**16**
discontinuation of the fuel clauses, the Company assumes the risk and benefits of changes in fuel and purchased power costs and sales of transmission services in its Maryland, West Virginia and Virginia jurisdictions.

    The increases in bulk power kWh's and revenues for the first three months of 2001 was primarily the result of the sale of the output of the AES Warrior Run cogeneration facility into the open wholesale market.  This sale ofoutput was part of a Maryland PSC settlement agreement with the Company.

	
**OPERATING EXPENSES**
     Due to the transfer of the Company's 2,100 MW of generating capacity to Allegheny Energy Supply on August 1, 2000, the fuel expense was eliminated.

     Purchased power and exchanges, net, represents power purchases from and exchanges with other companies, including affiliated companies and, purchases from qualified facilities under PURPA*,*and prior to August 1, 2000, capacity charges paidto Allegheny Generating Company.
**Purchased Power and Exchanges, Net**
Three Months Ended
      March 31     
2001
2000*  (Millions of Dollars)
Regulated Operations:

  Purchased Power:

    From PURPA generation*
 $ 20.3
 $ 18.3
    Other
    3.7
  Power exchanges, net
    4.1
  AGC capacity charges
    5.4
  Other affiliated capacity charges
    9.1
  Affiliated energy and spinning reserve charges
  117.5
   12.6
      Purchased power and exchanges, net
 $137.8
 $ 53.2
*PURPA cost (cents per kWh)
    6.5
    6.3**     The increase of $2.0 million from PURPA generation for the first quarter of 2001 was due to higher payments to the Warrior Run PURPA cogeneration project, which is located in the Company's Maryland service territory.The Maryland PSC has approved the Company's full recovery of the AES Warrior Run purchased power costs as part of the September 23, 1999, settlement agreement.  Accordingly, the Company defers, as a component of other operation expenses, the differencebetween revenues collected related to AES Warrior Run and the cost of the AES Warrior Run purchased power. 

The Potomac Edison Company

  and Subsidiaries
**17**
	Allegheny Generating Company (AGC) capacity charges and other affiliated capacity charges decreased in the quarter ended March 31, 2001, due to the transfer of the Company's generation, including its ownership interest in AGC, to Allegheny EnergySupply on August 1, 2000.

     The increase of $104.9 million in affiliated energy and spinning reserve charges for the period ended March 31, 2001, is due primarily to the Company's purchase of power from Allegheny Energy Supply in order to providesenergy to the Company's Maryland customers eligible to choose an alternate supplier, but electing not to do so.  The generation previously available to serve those customers has been transferred by the Company to Allegheny Energy Supply.  

 	Other operations expenses increased $16.9 million for the three months ended March 31, 2001, primarily due the lease of generation assets.  The transfer of the Company's generating assets to Allegheny Energy Supply on August 1, 2000 included theCompany's assets located in West Virginia.  A portion of these assets has been leased back by the Company to serve its West Virginia jurisdictional retail customers.  The lease term is one year, but may be modified upon mutual agreement of both parties. 

	The decrease in total maintenance expenses of $7.3 million for the first quarter ended March 31, 2001, was primarily due to the transfer of the Company's generation assets to Allegheny Energy Supply.  Until the August 1, 2000, transfer ofgeneration assets, maintenance expenses represented costs incurred to maintain the power stations, the transmission and distribution (T&D) system, and general plant, and reflected routine maintenance of equipment and rights-of-way, as well as plannedrepairs and unplanned expenditures, primarily from forced outages at the power stations and periodic storm damage on the T&D system.  Effective with the August transfer of generation assets, the Company's maintenance costs no longer reflect powerstation related maintenance expenses.  Current and future maintenance expenses will be to support the Company's wires or delivery business.

     Depreciation and amortization expense in the three months ended March 31, 2001, decreased $11.7 million due to the Company's transfer of its generation assets to Allegheny Energy Supply.

     Taxes other than income taxes decreased $3.4 million in the first quarter of 2001 due to reductions in West Virginia Business and Occupational taxes and property taxes. 

     Federal and state income taxes decreased $7.5 million for the quarter ended March 31, 2001, due to a decrease in taxable income and to the Company's share of tax savings in consolidation related to its Parent.

	Other income, net, decreased $2.0 million for the three months ended March 31, 2001, due primarily to the transfer of the Company's ownership interest in AGC to Allegheny Energy Supply.  Prior to this August 1, 2000, transfer, the Company reportedAGC in its financial statements using the equity method of accounting.

The Potomac Edison Company

  and Subsidiaries
**18**
     Interest on long-term debt decreased $2.6 million for the three months ended March 31, 2001, due to a reduction in the long-term debt outstanding. 

 
**Extraordinary Charge**
     The extraordinary charge in the first quarter of 2000 for $20.0 million ($12.3 million, net of taxes) reflects a write-off by the Company of costs determined to be unrecoverable as a result of Virginia and West Virginia legislation requiringderegulation of electric generation and recognition of a rate stabilization obligation.  
**Financial Condition and Requirements

     The Company's discussion of Financial Condition, Requirements, and Resources and Significant Continuing Issues in its Annual Report on Form 10-K for the year ended December 31, 2000, should be read with the followinginformation.

     In the normal course of business, the Company is subject to various contingencies and uncertainties relating to its operations and construction programs, including legal actions and regulations and uncertainties related to environmental matters.
**Liquidity and Capital Requirements**
     To meet cash needs for operating expenses, the payment of interest and dividends, retirement of debt and certain preferred stocks, and for its construction program, the Company has used internally generated funds andexternal financings, such as the sale of common and preferred stock, debt instruments, installment loans, and lease arrangements.  The timing and amount of external financings depend primarily upon economic and financial market conditions, the Company'scash needs, and capitalization ratio objectives.  The availability and cost of external financings depend upon the financial health of the companies seeking those funds and market conditions.
**Internal Cash Flow**
    Internal generation of cash from operations for the three month period ended March 31, 2001, was $29.1 million, prior to cash payments of $9.6 million for dividends on capital stock, compared to the same period in 2000,internal cash generation was $51.0 million, prior to cash payments of $57.1 million on capital stock.  The decrease in cash flows from operations in 2001 resulted primarily from increases in accounts receivable, net, and accrued and prepaid taxes.     

The Potomac Edison Company

  and Subsidiaries
**19****Financings**************************************