Audit of Affiliate Relationships and Transactions Between Atlantic City Electric and Pepco Holdings

654 Pages·2010·2.35 MB·English

RFP No. 08-X-39185

Audit of Affiliate Relationships and
Transactions Between Atlantic City Electric and
Pepco Holdings Inc. and Subsidiaries

Management Audit of Atlantic City Electric Co.

Submitted to:

New Jersey Board of Public Utilities

Submitted by:

Overland Consulting
11551 Ash Street, Suite 215
Leawood, KS 66211
[phone]

February 2010

Public Version – Confidential Materials Redacted
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Table of Contents
Page

1. Executive Summary
Chapter 1. Executive Summary and Background........................................................1-1
Chapter 2. Overview of Affiliate Relationships and Transactions.................................1-6
Chapter 3. PHI Service Company................................................................................1-6
Chapter 4. Power Supply and Transmission Affiliate Issues........................................1-7
Chapter 5. Millennium Accounts Services (MAS).........................................................1-8
Chapter 6. Income Taxes.............................................................................................1-9
Chapter 7. PHI Organizational Structure......................................................................1-9
Chapter 8. Executive Management and Corporate Governance...............................1-10
Chapter 9. Strategic Planning....................................................................................1-12
Chapter 10. External Relations..................................................................................1-13
Chapter 11. Finance...................................................................................................1-13
Chapter 12. Cash Management.................................................................................1-14
Chapter 13. Accounting and Property Records..........................................................1-16
Chapter 14. Power Supply Management...................................................................1-17
Chapter 15. System Reliability...................................................................................1-18
Chapter 16. Emergency Management – Storm Response.........................................1-19
Chapter 17. Lost and Unaccounted for Energy..........................................................1-20
Chapter 18. One Call Damage Prevention Program..................................................1-21
Chapter 19. Construction Contract Management – Inspection..................................1-22
Chapter 20. Customer Service...................................................................................1-22
Chapter 21. HR Overview, Workforce Planning and Staffing.....................................1-23
Chapter 22. HR Performance Evaluation, Compensation and Training.....................1-24
Chapter 23. HR Employee Benefits and Productivity Analysis..................................1-25
Chapter 24. Information Technology..........................................................................1-27
Chapter 25. Support Services....................................................................................1-27
Attachment 1-1

2. Overview of Affiliate Relationships and Transactions
Audit Scope and Objectives ..........................................................................................2-1
Summary of Findings ..........................................................................................2-2
Recommendations.........................................................................................................2-5
PHI’s Organizational Structure.......................................................................................2-6
Summary of Transactions Between Ace and Affiliates..................................................2-9
ACE’s Lease With Atlantic Southern Properties...........................................................2-11
Pepco Energy Services................................................................................................2-19
Compliance with EDECA Standards............................................................................2-21
Followup on Prior Audit Recommendations.................................................................2-24

3. PHI Service Company
Audit Scope, Objectives and Procedures.......................................................................3-1
Summary of Findings.....................................................................................................3-2
Recommendations.........................................................................................................3-4
PHISCO Organization and Services..............................................................................3-5
Corporate Functions Provided by PHISCO....................................................................3-7
Shared Operating Functions Provided by PHISCO.......................................................3-8
PHISCO Accounting Procedures and Internal Control.................................................3-10
Detailed Analysis and Testing......................................................................................3-11
PHISCO’s Cost Accumulation and Distribution Process..............................................3-12

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Results of Audit Testing...............................................................................................3-13
Analysis of PHISCO Allocation Methods......................................................................3-17
Reasonableness of PHI’s Broad-Based Corporate Allocations....................................3-17
Allocation Method Testing............................................................................................3-19
Attachment 3-1

4. Power Supply and Transmission Affiliate Issues
Summary of Findings.....................................................................................................4-1
Recommendations.........................................................................................................4-2
Background....................................................................................................................4-2
Structural Separation and Other Safeguards ……….……………………………….…………….....4-4
Joint Participation in PJM Committee Activities ……………………………………………………4-14
Interconnection Agreements …………………………………………………………………………….. 4-20

5. Millennium Accounts Services (MAS)
Audit Scope and Objectives...........................................................................................5-1
Summary of Findings.....................................................................................................5-2
Recommendations.........................................................................................................5-4
Management..................................................................................................................5-5
Organization and Operations.........................................................................................5-6
MAS Services Agreement..............................................................................................5-7
Summary of Financial Results.......................................................................................5-7
Distributions to Owners..................................................................................................5-8
Follow-Up on Recommendations from the Prior Audit...................................................5-9
The Affiliate Relationship Between ACE and MAS......................................................5-10
Compliance with EDECA Standards............................................................................5-13

6. Income Taxes
Introduction and Summary.............................................................................................6-1
Summary of Findings.....................................................................................................6-1
Recommendations.........................................................................................................6-2
Background....................................................................................................................6-2
Parent Company NOL Allocation...................................................................................6-4
Consolidated Tax Savings.............................................................................................6-6

7. PHI Organizational Structure
PHI’s Legal Organization Structure................................................................................7-1
Overview of PHI’s Management Organization Structure................................................7-2
Organizational Division Between the PHISCO and ACE Legal Entities.........................7-4
PHI’s Holding Company Executive Management...........................................................7-5
PHI Operations Management.........................................................................................7-6

8. Executive Management and Corporate Governance
Findings and Recommendations....................................................................................8-1
Board of Directors..........................................................................................................8-4
Senior Management Organization...............................................................................8-15
Executive Compensation.............................................................................................8-16
Senior Management Ability to Focus on Customer Interests.......................................8-36
Compliance with Sarbanes-Oxley Act..........................................................................8-38
Other Relevant NYSE Rules and SEC Requirements.................................................8-46

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Oversight of Significant Litigation.................................................................................8-47
Attachment 8-1
Attachment 8-2
Attachment 8-3
Attachment 8-4
Attachment 8-5

9. Strategic Planning
Introduction and Framework for the Strategic Planning Process...................................9-1
Findings and Recommendations....................................................................................9-2
Overview of Strategic Planning Process at PHI.............................................................9-2
Summary of PHI and ACE Strategic Plans, Business Plans, and
Financial Forecasts Presented to Board...................................................................9-6
“Blueprint for the Future” Initiative..................................................................................9-8
New Jersey Energy Master Plan Initiative....................................................................9-11
PHI Commitment to Non-Regulated Business Units....................................................9-13
Mergers & Acquisitions Process..................................................................................9-19

10. External Relations
Scope...........................................................................................................................10-1
Findings........................................................................................................................10-1
Organization.................................................................................................................10-1
Goals and Responsibilities...........................................................................................10-3
Outside Lobbying.........................................................................................................10-5
ACE Relationship with the BPU...................................................................................10-6

11. Finance
Findings and Recommendations..................................................................................11-1
Cost of Capital and Capital Structure...........................................................................11-2
Financing Activities of Utilities and Affiliates................................................................11-4
Uses of Funds for Utility and Affiliate Operations.........................................................11-4
Impact of Diversification on ACE..................................................................................11-5
ACE Cost of Capital as Compared to Other Utilities....................................................11-7
Credit Ratings and Credit Quality...............................................................................11-10
Review of External Financing.....................................................................................11-14
Utility Rate & Other Commission Filings....................................................................11-22

12. Cash Management
Summary of Findings and Recommendations.............................................................12-1
Cash Forecasting and Cash Flow Activity....................................................................12-2
Credit Facilities.............................................................................................................12-3
Money Pool..................................................................................................................12-5
Dividend Policy.............................................................................................................12-6
Impact of Diversification on ACE................................................................................12-10
PHI Response to 2009 Credit and Economic Events.................................................12-12

13. Accounting and Property Records
Summary of Findings...................................................................................................13-2
Summary of Recommendations...................................................................................13-2
Internal Control Framework..........................................................................................13-3
SOX Compliance Unit..................................................................................................13-7
Internal Audit Department..........................................................................................13-13
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PwC, the External Auditor..........................................................................................13-26
Asset Impairments.....................................................................................................13-28

14. Power Supply Management
Introduction and Summary...........................................................................................14-1
Summary of Findings...................................................................................................14-1
Background..................................................................................................................14-3
Power Supply Strategy.................................................................................................14-7
Power Supply Plans...................................................................................................14-10
NUG Power Resale Strategy.....................................................................................14-16
NUG Power Resale Results.......................................................................................14-18
NUG Reactive Power Credits.....................................................................................14-21
NUG Contract Restructuring......................................................................................14-28

15. System Reliability
Introduction and Summary...........................................................................................15-1
Summary of Findings...................................................................................................15-1
Background..................................................................................................................15-4
Reliability Metrics.........................................................................................................15-8
2007 and 2008 Reliability Improvement Programs....................................................15-15
2008 Reliability Summits............................................................................................15-16
Vegetation Management............................................................................................15-21
2009 Reliability Budgets.............................................................................................15-28
Opportunities for Improvement...................................................................................15-33
Power Quality.............................................................................................................15-39
Recommendations.....................................................................................................15-40

16. Emergency Management – Storm Response
Summary of Findings...................................................................................................16-1
Background..................................................................................................................16-2
Hurricane Isabel...........................................................................................................16-5
May 2008 “Mother’s Day” Storm..................................................................................16-9
PHI Improvement Initiatives.......................................................................................16-12
Opportunities for Additional Improvement..................................................................16-17
Recommendations.....................................................................................................16-19

17. Lost and Unaccounted For Energy
Summary of Findings...................................................................................................17-1
Background..................................................................................................................17-2
ACE’s Fixed Loss Factors............................................................................................17-4
Overall Energy Loss Percentages................................................................................17-6
ACE Loss Reduction Initiatives....................................................................................17-9
Recommendations.....................................................................................................17-10

18. One Call Damage Prevention Program
Summary of Findings...................................................................................................18-1
Background..................................................................................................................18-1
Remediation Plan.........................................................................................................18-3
Findings........................................................................................................................18-5
Recommendation.........................................................................................................18-8

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19. Construction Contract Management - Inspection
Summary of Findings...................................................................................................19-1
Background..................................................................................................................19-2
Temporary Construction Representatives – Staffing Levels........................................19-5
Change Orders.............................................................................................................19-6
Contract Inspection......................................................................................................19-7
Internal Audits..............................................................................................................19-8
Recommendations.....................................................................................................19-10

20. Customer Service
Summary of Findings...................................................................................................20-1
Summary of Recommendations...................................................................................20-3
Organization.................................................................................................................20-3
Information Systems....................................................................................................20-4
Performance Measurement..........................................................................................20-5
Functional Areas........................................................................................................20-14
Other Matters.............................................................................................................20-21
Attachment 20-1

21. HR Overview, Work Force Planning and Staffing
Summary of Findings...................................................................................................21-1
Recommendations.......................................................................................................21-4
Overview......................................................................................................................21-5
Information Systems....................................................................................................21-9
Succession Management...........................................................................................21-23
Leadership and Employee Development...................................................................21-24
Job Rotation Program................................................................................................21-26
Employee Recognition and Rewards.........................................................................21-27
Staffing.......................................................................................................................21-28
Diversity Management...............................................................................................21-38

22. HR Performance Evaluation, Compensation and Training
Summary of Findings...................................................................................................22-1
Recommendations.......................................................................................................22-4
Performance Evaluation...............................................................................................22-4
Compensation............................................................................................................22-10
Training......................................................................................................................22-24
Labor Relations..........................................................................................................22-34

23. HR Employee Benefits and Productivity Analysis
Summary of Findings...................................................................................................23-1
Recommendations.......................................................................................................23-3
Employee Benefits.......................................................................................................23-4
Productivity Analysis..................................................................................................23-28

24. Support Services – Information Technology
Summary of Findings...................................................................................................24-1
Recommendation.........................................................................................................24-2
IT Organization and Budget.........................................................................................24-2
IT Resources and Information Systems.......................................................................24-4
Business Plans and Staffing Levels.............................................................................24-6

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Integration of PEPCO and ACE/DPL CIS ...................................................................24-8
IT Performance Measurement.....................................................................................24-8

25. Support Services - Other
Summary of Findings...................................................................................................25-1
Summary of Recommendations...................................................................................25-5
Facilities and Real Estate Management.......................................................................25-7
Supply Chain..............................................................................................................25-11
Vehicle Resources Management...............................................................................25-16
Records Management................................................................................................25-20
Corporate Security.....................................................................................................25-24
Legal..........................................................................................................................25-31
Insurance and Claims................................................................................................25-34
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Phase I – Affiliate Transactions
Phase II – Management Effectiveness & Efficiency

Chapter 1. Executive Summary and Background

Introduction

The Overland audit was fully supported by both PHI and ACE personnel. The company has
provided dedicated personnel to support our discovery and audit task requirements. We
appreciate the extraordinary cooperation provided to us in the conduct of our review, which
allowed the development of a thorough consideration of the areas of operations included in this
report.

This report is organized in a manner that is generally consistent with the structure of the scope
of effort requested by the New Jersey Board of Public Utilities (NJBPU) RFP guidelines. Our
work was organized into two Phases – Phase I: Affiliate Transactions; and Phase II:
Management Effectiveness & Efficiency.

The primary period of analysis was the two year period from January 1, 2006 to December 31,
2007. However, depending on the subject area, we also provided historical data prior to
January 1, 2006. In other instances, we included 2008 and more recent information regarding
corporate operations. However, as with any corporate organization, PHI is continuously
reviewing its corporate processes, and is subject to external events that may impact this
analysis relative to present circumstances.

Overview of Audit Analysis and Summary of Key Findings and Recommendations

We found that PHI currently has a highly qualified senior management team, possessing a skill
set focused on regulated utility operations, which we believe is positive for PHI stakeholders,
including ACE New Jersey customers. Our audit identifies a number of continuing challenges
facing the Company. The following represents those recommendations that we believe have
the greatest potential impact in terms of financial materiality, quality of service, or regulatory
compliance

• The lack of consistent commitment of funding for service quality and reliability
projects has led to subpar performance metrics. Customer satisfaction, service
quality and reliability performance should be a high priority that translates into
tangible results in the near-term. (Chapter 8)

• PHI should prepare a comprehensive reliability improvement plan and report by
March 31, 2010. The report should explain its reliability improvement strategies,
plans and initiatives and explain how they relate to ACE. (Chapter 15)

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• The ACE equity ratio has declined somewhat in 2008, and should be increased to
protect current credit ratings. (Chapter 11)

• Should PHI corporate credit ratings decline from present levels, the BPU should
open a proceeding to consider the implementation of additional ring-fencing
measures to protect ACE from potential adverse effects of its unregulated affiliates.
(Chapter 8)

• PHI has had varying success in the implementation of the “Blueprint for the Future”
initiative within its various jurisdictions. Without abandoning its core objectives, the
Company should be willing to adapt the various components of its plan to the
preferences of each state jurisdiction. With regard to ACE, PHI may need to
consider an increased effort by senior management to move its objectives forward.
(Chapter 9)

• PHI should consider centralizing the management of the locating and markout
function in the service company. The UtiliQuest contract covers all three PHI utilities.
However, management of the contract is currently decentralized. At ACE the contract
is managed by a single contract administrator on a part time basis. The delays in
needed improvements may be indicative of staffing shortages in the one call
function. A centralized group could provide ACE with the technical and backup
capabilities it needs. (Chapter 18)

• Millennium Account Services (MAS) did not comply with EDECA rules that required
transfer pricing at the lower of fully allocated cost or fair market value. Therefore, as
required by EDECA transfer pricing rules, a calculation of the fully-allocated cost-
based price for meter reading services provided by MAS to ACE should be
developed. ACE should cease paying for amounts exceeding fully-allocated cost.
(Chapter 5)

• We recommend the Company reevaluate the number and weighting of Annual
Incentive Plan goals it maintains for its various employee groups. (Chapter 20)

• Conduct an annual survey of market prices for finished and unfinished commercial
space in the market area surrounding Mays Landing. Ensure the price charged to
ACE for finished and unfinished space is no more than the lower of fully allocated
cost or the market price for equivalent finished and unfinished commercial space in
the local market area. (Chapter 2)

• Absent disclosure to the customer of the New Jersey rules concerning down-
payments prior to the initiation of a deferred payment agreement, we recommend
Company representatives be trained on these rules on a periodic basis, and the
training manual be updated to incorporate these rules. In addition, during
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