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Executives

Max Kuniansky - Executive Director of IR and Corporate Communications

Paul J. Evanson - Chairman, President and CEO

Kirk R. Oliver - Sr. VP and CFO

Analysts

Greg Gordon - Citigroup

Daniel Eggers - Credit Suisse

Brian Russo - Ladenburg Thalmann & Co.

Ameet Thakkar - Deutsche Bank Securities

Richard Haydon - Neuberger

Reza Hatefi - Decade Capital

Neil Kalton - Wachovia Capital Markets, LLC

Leslie Rich - Columbia Management

[Anthony Crodo] - Jefferies

Paul Patterson - Glenrock Associates

Mike Worms - BMO Capital Markets

Allegheny Energy, Inc. (AYE) Q4 2008 Earnings Call February 11, 2009 1:00 PM ET

Operator

Good afternoon. My name is [Lori] and I will be your conference operator today. At this time I would like to welcome everyone to the Allegheny Energy fourth quarter 2008 earnings conference call. (Operator Instructions)

At this time it is my pleasure to turn the conference over to Max Kuniansky, Director of Investor Relations. Please go ahead, sir.

Max Kuniansky

Good afternoon, everyone, and thanks for joining us. If you have to leave the call before it's over, you can listen to the taped replay. It's available until midnight on February 18 and you can listen to it by telephone, on our website or by podcast.

Some of our statements will be forward looking. These statements involve risks and uncertainties and are based on currently available information. Actual results may differ significantly from the results and the outlook we discuss today. Please refer to our earnings news release and our SEC filings regarding factors that may cause actual results to differ from the forward-looking statements made on this call.

Our presentation includes some non-GAAP financial measures. On our website you'll find the reconciliations required under the SEC's Regulation G.

After our prepared remarks we'll take your questions. We ask that you try to limit your questions to two each so we have time to get to as many of you as possible.

And now let me introduce Paul Evanson, Chairman, President and Chief Executive Officer of Allegheny Energy.

Paul J. Evanson

Okay. Good afternoon, everyone. Thanks for joining us also.

For the fourth quarter of 2008 adjusted results were $0.51 per share compared to $0.46 in the prior year. These numbers exclude net unrealized losses associated with economic hedges that don't qualify for hedge accounting. Higher plant output and reduced operations and maintenance expense were the primary drivers, partially offset by higher coal costs.

Our supercritical plan availability in the fourth quarter improved substantially as compared to a year ago due primarily to fewer scheduled outages. For the full year 2008, supercritical available was 87.5%, the best performance in the history of the company. This fleet performance is now at about top quartile of supercritical unit performance.

Adjusted results for the fiscal year 2008 were $2.30 per share as compared $2.26 in the prior year. We had strong earnings growth in our Generation and Marketing segment largely due to higher market prices and Pennsylvania generation rates. But income in our Delivery business was down sharply, reflecting principally the significant under recovery of purchased power costs in Virginia, a situation which I'm happy to say is now resolved.

We made a great deal of progress during this year, especially in reducing regulatory risk and uncertainty. Let me take a few minutes to summarize these regulatory accomplishments, beginning with Virginia.

In November, the Virginia Commission approved the settlement agreement with certain industrial and commercial customers, the attorney general and the staff of the commission. The settlement provided immediate and significant rate increases coupled with a clear path to full recovery of purchased power costs by the 2010 for large customers and by 2011 for all other customers. We were losing over $100 million a year in the state, so fixing this situation was critical.

We moved quickly to procure power for our Virginia customers, successfully completing a competitive bid auction in December. Generation prices in the auction averaged $60 to $65 per megawatt hour at the generator level for blocks from mid '09 to mid '11. Allegheny Energy Supply won a number of the contracts awarded in the auction.

In Pennsylvania, the state Public Utilities Commission approved our plans for power procurement and rate mitigation for our transition to market on January 1, 2011. Late in the year the legislature passed an energy bill, but it did not include any rate mitigation provisions. While Governor Rendell and some legislators are again advocating for some kind of mitigation, the significantly lower customer rate increases now expected ought to produce the probability of legislative action.

In Maryland we successfully made the transition to market-based rates for residential customers on January 1 of this year. Allegheny Power sells about 3.5 million megawatt hours of power to these customers.

And finally in West Virginia we secured recovery of increased fuel and purchased power cost. The Public Service Commission approved our settlement in December. This was the first annual filing since our fuel clause was reinstated and we're pleased with the commission's constructive approach.

Another major regulatory accomplishment was securing approval for our Trans Allegheny Interstate Line - or TRAIL, as we call it - in the three states the line crosses. The most recent decision came in November, when the Pennsylvania commission approved the 1.2 mile segment of TrAIL which was critical to completion of the project. We have successfully completed the financing of the project and construction work has now begun. We expect the project to be completed on time by June 2011. The remaining 36-mile segment that we had proposed in Pennsylvania was needed solely for Pennsylvania reliability. We're evaluating alternatives for this segment under a collaborative process agreed to as part of our settlement.

As for our second transmission project - the Potomac Appalachian Transmission Highline or PATH - we secured incentive rate treatment from FERC which included a 14.3% return on equity.

So now let's turn to the outlook for 2009. We're in a severe recession and we're seeing the impact of this on our business. In our Delivery segment usage per industrial customer decreased 7% in the fourth quarter. While the revenue impact of this decline was small - less than $3 million  and was offset in the quarter by customer growth and favorable weather, nonetheless it's a good indicator of how rapidly economic conditions have worsened.

On the Generation side of the business, power prices are down significant. Forward prices for '09 at the PJM western hub have declined more than 20% since our last earnings call and are down nearly 50% since June of last year. Even though we came into this year with about 85% of our power hedged, this is still a significant negative for us in the year.

Coal costs continue to increase despite the decline of spot market prices from last summer's peak. This is happening because the pricing of our portfolio of coal contracts is so close to our suppliers' cost of production that we can be impacted as their costs rise whether due to more stringent government reduction and enforcement or otherwise. We work where appropriate with coal suppliers to protect our long-term interests and assure stable deliveries. Accordingly, we've revised our coal projections to reflect these added costs.

In addition, the U.S. Court of Appeals for the D.C. circuit struck down EPA's CARE rules in July. This decision eliminated the need for many in the industry to cover their expected shortfall in NOx allowances. The new annual NOx rules were to be effective in '09. In December the court reversed itself and remanded in a manner that allows EPA to continue the CARE program. Since we expect to be short NOx allowances in '09, this is another added cost for us.

As a result of these developments, we now expect '09 earnings to be significantly lower than we thought only three months ago when we had our last call. Kirk will go through the drivers with you in some detail shortly.

Now we've been trying to get ahead of the curve in terms of our response to these developments. As many of you know, we have a strong cost control culture at the company, and we're proud of the success we've had over the last several years. Beginning in the fourth quarter, we intensified that focus and have already realized benefits in that quarter. Among other actions, we've put a hiring freeze in place at all our businesses and have frozen the salaries of the senior executives.

All these actions that we're taking, of course, are consistent with our obligation to provide reliable and quality service throughout our four-state service territory. As always, we remain focused on improving customer satisfaction.

In these troubled and uncertain times, maintaining a strong financial condition is of paramount importance. The good news is our liquidity remains strong and we further bolstered that position in December when we issued $300 million of first mortgage bonds at slightly less than 8%.

Let me mention a few other priorities that we have for 2009. Our transmission projects are key to Allegheny's growth, so it's very important that we maintain our construction schedule for TrAIL's in-service date of June 11 and make the state regulatory filings of PATH in the coming months.

We'll also continue to focus on effectively managing the transition to market-based rates in Pennsylvania. We are authorized to launch beginning in June the first in a series of auctions to procure power for the period after rate caps expire in December 2010. We are seeking, however, permission to begin some procurement in April to secure the benefit for our residential customers of today's current and lower power prices.

On the environmental front, our priority is to complete the Hatfield and Fort Martin scrubbers on budget by the end of this year. The outage tie-in for the five units will, however, reduce supercritical availability by almost 3% in the year 2009.

Finally, 2009 brings a new administration to Washington. While there will be more focus on climate change legislation and environmental policies, there is strong impetus in the stimulus bills for increased spending on transmission, smart grid and infrastructure generally. We think there are opportunities for us in these areas and we'll remain active in this arena throughout the year.

So in closing, we made great progress last year, but 2009 will be a very challenging time. I'm confident we can weather the economic downturn and keep our multiple long-term growth catalysts substantially intact. We remain dedicated to enhancing shareholder value in the years ahead.

Now let me turn the call over to Kirk.

Kirk R. Oliver

Thank you, Paul, and good afternoon, everyone. I'll begin with our fourth quarter results.

For the fourth quarter of 2008, we reported GAAP net income of $16 million compared to $110 million a year ago. We earned $0.10 per share in the fourth quarter compared to $0.65 in the same period last year. Adjusting for net unrealized losses which are associated with economic hedges that do not qualify for hedge accounting, earnings for the fourth quarter of 2008 were $0.51 per share. Last year's adjusted earnings of $0.46 per share exclude items related to the Merrill Lynch litigation settlement.

The unrealized losses associated with economic hedges were $116 million. This includes a marked-to-market loss on financial transmission rights, a loss on power hedges, and a gain on our Kern River pipeline hedges. All of these items were driven by substantial decreases in gas and power pricing during the quarter.

Let me summarize some of the key factors that impacted the change in adjusted earnings per share for the fourth quarter.

Increased generation output helped earnings per share by $0.16. This reflects better availability resulting primarily from no planned outages in the fourth quarter of 2008 and also from fewer unplanned outages at our unregulated plants. The net effect of market prices, capacity revenue, marketing contracts and hedging activities increased earnings per share by $0.05. Higher generation rates in Pennsylvania improved earnings by $0.02 per share. This is the net effect of our 8% increase in generation rates and the negative impact of the expiration of the earnings benefit of the Pennsylvania stranded cost recovery surcharge in the second quarter of 2008.

Higher coal prices at AE Supply hurt earnings by $0.14 per share. Our fully delivered coal price was $52 per ton for the quarter and averaged $47 per ton for the year 2008. Other fuel-related costs decreased earnings by $0.03 per share. Emissions, fuel handling and line costs for the scrubbers at our unregulated plants increased over the prior year. Lower O&M expense helped earnings this quarter by $0.07.

A higher effective income tax rate hurt earnings by $0.05. This impact was primarily the result of lower 2007 taxes, which benefited from a favorable state income tax settlement and a charge in 2008 to resolve the last remaining IRS issue from our 1998 to 2003 audit cycle. Other factors decreased earnings by $0.03. In total adjusted earnings increased by $0.05 per share.

Now I'd like to discuss the quarter to quarter changes in each of the primary lines of the income statement. Here is an overview of the changes on a GAAP and adjusted basis.

Beginning with the top line, revenue increased by $38 million after adjusting for the previously mentioned net unrealized loss. Summarizing the key components impacting revenue, increased unregulated generation output primarily at our supercritical plants benefited revenue by $66 million. Supercritical plant availability increased 19% over the fourth quarter last year, primarily due to no planned outages and lower forced outages. Total supercritical output increased by 1.5 million megawatt hours.

Power pricing benefited primarily from an increase in capacity prices from $41 to $112 per megawatt day. Moreover, our financial hedging and marketing activities offset the 9% decrease in power prices in our zone. Mon Power generation revenues net of purchases to serve customer load decreased $40 million from the previous year primarily due to lower regulated volumes. While this reduced gross revenue, it did not affect our net revenue since it will be fully recovered in the West Virginia fuel and energy clause.

All other revenue decreased by a net $2 million from the prior year's quarter. This includes a slight increase in T&D retail revenue. The benefit of colder weather and customer growth in the quarter was offset by reduced usage driven primarily by industrial customers. Industrial usage per customer was 7% lower in the fourth quarter of 2008, although, as Paul mentioned earlier, this had a minimal impact on revenue. On a weather-adjusted basis, total load declined by 3.7% in the quarter. For the entire 2008, Allegheny Power's total load was 0.8% lower than in 2007 on a weather-adjusted basis. The corresponding T&D retail revenue decrease, also weather adjusted, was $2.8 million.

Moving from revenue to expenses, fuel expense was up $65 million period to period. This was primarily driven by higher coal expense resulting from both an increase in price and output. In addition, other unregulated fuel-related costs increased by $8 million. Deferred energy decreased costs by $32 million, primarily due to our West Virginia energy clause. This change reflects a net increase in fuel and energy costs that will be recovered in future fuel and energy adjustment clause proceedings.

O&M decreased by approximately $17 million. As expected, generation maintenance was lower due to fewer planned outages. We had anticipated O&M to be flat for the quarter but, with the increased focus on cost control that Paul mentioned earlier, we achieved about a $20 million O&M reduction from our plan.

Continuing with the income statement, adjusted interest expense was down $4 million primarily due to lower interest rates and an increase in capitalized interest associated with the Hatfield scrubbers.

The net result of all these times was a $28 million increase in adjusted pre-tax income. Our effective tax rate this was 42%, which compares to 35% for the same period a year ago.

That concludes my discussion of the income statement. Moving on to cash flow, net cash flow from operations was $266 million in the quarter and $855 million for the year. Capital expenditures were $280 million in the quarter. This includes $165 million of spending on our scrubbers and transmission expansion projects.

Free cash flow excluding capital expenditures for the Fort Martin scrubbers, which are funded through securitization proceeds, was $45 million for the quarter. Capital expenditures were $994 million for the full year 2008. This is slightly below our last estimate and is attributable to changes in the timing of cash outlays for our two scrubber projects and spending on our transmission expansion projects.

For the year 2008 free cash flow was $34 million and cash flow after dividend payments was a negative $67 million.

Our current estimate for 2009 capital expenditures is about $1.1 billion. Transmission expansion expenditures are expected to increase from $350 million in 2009 to $600 million in 2010 as these projects begin to ramp up. A portion of these expenditures will be funded by our partner in the PATH project.

Our liquidity position and credit metrics remain strong. Cash on hand has increased to $362 million, reflecting the Mon power first mortgage bond financing that we completed in December of 2008. Capacity available under both of our credit facilities is $773 million for a total liquidity of over $1.1 billion.

We expect free cash flow before the payment of dividends to be in the range of zero to negative $100 million for 2009. This calculation excludes the securitized portion of our Fort Martin scrubber project and TrAIL company expenditures that will be funded with project financing that is already in place.

We have no significant debt maturities until 2011. Also, in December 2008, Moody's upgraded the unsecured credit rating of AE Supply to investment grade, following S&P's upgrade earlier in the year. We now have greater financial flexibility in addressing future liquidity needs, including lower refinancing risk and reduced collateral requirements relative to AE Supply's hedging strategy. Moody's also upgraded Potomac Edison's outlook to stable and S&P upgraded Mon Power's unsecured debt rating, reflecting improvements in our regulatory environment.

Now let's turn to the outlook for 2009. Here is an overview of the key earnings drivers for 2009 compared with adjusted 2008 results. Since our call in November, there have been significant changes in commodity prices and meaningful developments in Virginia that affected both of our business segments. We are also modifying and in some cases adding certain drivers in order to provide better insight into 2009. This list is not complete and there will undoubtedly be some impacts, both positive and negative, that we have not addressed here, but it's a useful framework for thinking about the coming year.

In the interest of time, I will address only those items that have changed. Based upon our settlement agreement in Virginia and the auction to serve that load, we are updating our Virginia driver to $100 million. The value we showed on our last call - $120 million - assumed full recovery of our purchased power cost. We will achieve slightly less than full recovery in 2009 under the terms of the settlement. The impact of the auction on our unregulated generation revenue is reflected in market prices and hedging activities driver below.

Turning now to costs, on our last call we stated that our plan had been to keep 2009 O&M expenses flat compared to 2008 and our target remains unchanged. However, as stated earlier, actual O&M expenses in 2008 came in about $20 million than previously forecasted, resulting in an update to this driver. Although we are experiencing some upward pressure on costs for 2009, including an increase in pension costs, we continue to seek other opportunities to reduce costs.

Pension expense is expected to increase by about $10 million due largely to the substantial decline in plan asset value. Our pension plan is currently funded at about 67% of liabilities.

We are expecting coal prices to have a $140 million impact on the year, up $20 million from our last call. This driver reflects our current expectations, including the cost pressures on our suppliers that Paul referenced earlier. Our vendors are currently performing; however, it is always possible that a supplier could fail to perform in the future, which could put further upward pressure on our costs.

Interest expense increased $10 million over our previous estimate due to the $300 million bond issuance at Mon Power in December, which was more than we had originally planned to issue. The proceeds from this financing will be used the fund the unsecuritized portion of the Fort Martin scrubber and for other corporate purposes.

Moving now to emissions and other fuel-related costs, at the time of our November update we did not expect any costs related to annual NOx allowances due to the decision by the D.C. Circuit Court in July striking down CARE. However, as a result of the court's ruling in late December, the provisions of CARE have effectively been reinstated. As a result, we anticipate about a $30 million increase due primarily to the cost of purchasing annual NOx allowances. Rising prices for generation station materials, particularly lime that we need to run our scrubbers, plus increases in fuel handling and other related costs make up the balance of this driver.

On our last call we told you that we were carrying a 5 million megawatt open position into 2009 and that we expected to realize prices, including contracts and hedging, to be about the same as in 2008. Since that call, 2009 forward prices have fallen about $20 per megawatt hour from that estimate. Over this time we have contracted for some power in Virginia and Maryland at prices below what we realized in 2008, but above current market forwards, resulting in a margin decline on these megawatt hours of about $25 million. In addition, we now expect to have around 3 to 4 million megawatt hours open in 2009 which, using western hub forward prices as of February 3 would result in about another $70 million decline.

Please keep in mind that his combined impact includes only a high level estimate of the potential negative impact of current forward market prices on our business. By providing this estimate, we are not attempting to convey that our open megawatt hours in 2009 will be sold at current 2009 forward prices, and we obviously expect 2009 forward prices and related generation dispatch volumes to change over time. We therefore anticipate that the actual prices at which we lock in our open megawatt hours may vary, either positively or negatively, from the current snapshot of 2009 forward prices that we used for this estimate.

That covers the changes to the major drivers and our estimate of their impact on 2009 results. Other factors that are not addressed here will also affect our results in 2009. All of these drivers impact pre-tax income. Our 2009 tax rate is expected to be more in line with the long-term expectations of 38%. This is an increase over our 34% effective tax rate in 2008, where we benefited from favorable audit settlements.

With that, let me turn it back to the operator for questions.

Question-and-Answer Session

Operator

Thank you very much. (Operator Instructions) Your first question comes from Greg Gordon - Citigroup.

Greg Gordon - Citigroup

Just so I can be clear what's in your guidance and what's not, the $25 million market price and hedging activity negative driver is related to hedges that you've locked in?

Kirk R. Oliver

That's correct.

Greg Gordon - Citigroup

Now you've got 3 to 4 million megawatt hours open and based on where power prices have gone from when you last gave guidance, you're indicating that basically there's a $20 delta in power prices, so you haven't locked that in yet?

Kirk R. Oliver

That's correct and that's the footnote at the bottom of that driver page which, if you take 3 to 4 million megawatt hours and multiply by about a $20 decline in prices, that gets you to that $70 million negative driver.

Greg Gordon - Citigroup

I'm looking at my forward curve for PJM west and I'm seeing on or around November 1, 2009 prices were around $60 and I'm seeing them now at around $49, so I'm only seeing about an $11 decline. Am I not looking at the right quote? Am I getting a bad quote or has basis in the APS zone widened out? Can you explain why you're looking at $20 and I'm only looking at around $11?

Kirk R. Oliver

Yes, Greg. When we did the call back in November we were using a dispatch run that we run. We ran that dispatch run a bit in advance of November and we were getting forward prices at that time that were in line with pretty much what we had realized in 2008, which is how we positioned that on the call the last time.

And when we did this update we were using a forward price at PJM west as of, I think, February 3, which was around $47.

Greg Gordon - Citigroup

So you're saying that you realized prices in '08 of around $67?

Kirk R. Oliver

Yes, that's about right.

Paul J. Evanson

That was the forwards in September of '08 and that's when we ran that kind of extensive dispatch model that we go through. And ordinarily we'd be basing these drivers off of the dispatch model that we ran a month or so ago, where the prices were much higher, so what we've kind of done is try to adjust it to today's prices to make sure we have a number that reflects exactly where we are today. So it's a little bit of difference timing and methodology there.

Greg Gordon - Citigroup

And is that open position primarily in certain quarters? Is it sort of pro rata over the year? How long can you hold that position before you have to lock in price?

Kirk R. Oliver

It's kind of a pro rata over the year, Greg.

Greg Gordon - Citigroup

My second question is on the emissions costs. I think we're all surprised by the magnitude of that incremental expense. Can you give us the volume and price of NOx that you're assuming and can you also tell us whether that is an ongoing expense or whether that is going to go away when the scrubbers come online?

Kirk R. Oliver

Yes, Greg. We have a short position in NOx. It's a very thinly traded market so, if I could, I'd just as soon not give volumes and prices but give you an absolute dollar number. And the absolute dollar number for 2009 for NOx is about $29 million. The rest of the emissions piece for '09 is a little bit for carbon and for SO2 and that gets you to the total of around $30 million. I'm rounding those numbers.

The other piece of the $50 million is really other fuel-related costs and a big piece of that is a lime contract we have that expired and that we had to go out and re-up. And that's about $12 million of that balance. So the fuel piece, the total would be around $20 million. About $12 million of that is this lime contract. And then we have other fuel-related costs like urea and fuel handling and auxiliary fuel and those things that have gone up some. That's about $6 million. So that gets you kind of to the bulk of the fuel piece as well.

Greg Gordon - Citigroup

And when the scrubbers come on line, are we going to see this $30 million NOx go away?

Paul J. Evanson

No, that's what I was just adding. The scrubbers really get a major reduction in SO2 and in mercury, and they really don't have any effect on NOx. So to work on NOx you need these SCRs, the selective catalytic reduction facilities. And we have those on two of our plants  Harris and Pleasants  but we don't have them on Hatfield or Fort Martin. So the short that we're looking at in '09 is likely to continue for the next few years.

Now, we had thought, like most other emission costs, like SO2 and other things we've seen in the past, that when these costs come on you'd see it reflected in power prices, but I think at the depressed level power prices have gotten to, we really haven't seen, when this decision took place, a corresponding improvement or increase in PJM power prices. So at some point that should happen, but we haven't seen it happen yet. And since we're using just those forwards, we haven't built it into our model.

Operator

Your next question comes from Daniel Eggers - Credit Suisse.

Daniel Eggers - Credit Suisse

The first question is, with the increase in coal contracts because of the higher costs of your suppliers, how locked down is that for '09 and what is the confidence in future year prices, especially as we're hearing Appalachian producers seeing their costs actually start to come down?

Paul J. Evanson

Well, we've had, as you know, a number of revisions over the last probably 12 - 18 months, and we certainly haven't been happy with it. And it partly reflects some of those added costs. And as we've said many a time, these are contracts that are pretty close to cost of production and we're frankly much better off with them than without them. So at times we're going to have to live with this kind of ratcheting up where there costs ratchet up in a way.

And we try to build that into our projection when we go forward, so when you see those numbers, they have some of it built in but in the last 12 - 18 months it's been a little more than we thought. As I say, these are suppliers that have been with us a long time and we've worked a long time with them through some tough times and some tough issues, so I'm hopeful we're going to continue to work through this and realize the value of these contracts.

Daniel Eggers - Credit Suisse

Do you have numbers handy or numbers you're willing to share as far as what your open power positions are beyond 2009, say 2010 and 2011?

Paul J. Evanson

Well, 2010 it's about -

Kirk R. Oliver

It's about 75% to 80% hedged on a volume basis.

Paul J. Evanson

That's about 7 million megawatt hours, give or take a little bit. And when you get to '11, there's very little at this point. And, you know, you have the Pennsylvania auction coming up shortly, even more shortly than we might have though a month ago.

Daniel Eggers - Credit Suisse

And I guess my last question for you, what volume growth assumptions are you guys using for the utilities in your numbers right now because I don't see any line specific to the volume of utilities.

Kirk R. Oliver

Yes. What we're doing there is we saw significant falloff in the fourth quarter, as I mentioned earlier, particularly in the industrial load, and so we've adjusted the '09 growth forecast to reflect what we're seeing in the fourth quarter annualized. That results in growth - total growth - being about flat into 2009 in terms of volume. We don't put that in as a driver because the weather-adjusted volume impact is dwarfed by any kind of weather impact and we can't predict weather.

Operator

Your next question comes from Brian Russo - Ladenburg Thalmann & Co.

Brian Russo - Ladenburg Thalmann & Co.

I was just curious. It seems like there is some conservatism built into the '09 growth drivers, if I heard correctly, the O&M expense drag of $20 million, you have initiatives in place to try to maintain flat O&M. Is that accurate?

Paul J. Evanson

Well, when we did the call back in November we were expecting O&M expense of about $385 million in '08.

Kirk R. Oliver

That was $685 million.

Paul J. Evanson

I'm sorry, $685 million for the full year '08 and our goal was to have that same number in '09. And we started a whole series of cost control efforts beginning in the fourth quarter and kind of wonderfully or very positively we got about $20 million out of the fourth quarter of '08. So I'm not so sure we're going to be able to drive '09 down to the new level, last year's level of $665 million. You know, we've been at $685 million for the last three years now. This will be the fourth year in a row.

So I think if we hit the $685 million we'll be pleased but because of the improvement that we got, the kind of unexpected improvement or the quick benefit on some of these items, we now anticipate we'd be $20 million over. So our goal is the same and we sure as heck are going to work as hard as we can to keep driving that $685 million down, but there's a lot of drivers that keep pushing it up, like pension costs, up another $10 million from what we thought back three months ago.

So there's a lot of push one way and we're surely going to keep pushing the other way and try to hold it at $685 million. And if we can do better, Brian, we'll surely do it.

Brian Russo - Ladenburg Thalmann & Co.

And then the $20 million increase in coal prices, is it factual, meaning you've got a pretty good handle that that's the increase or can we see something even greater or maybe something less than that as we move through the year?

Paul J. Evanson

I would say that's pretty close to the number unless we have a real problem with a supplier. I mean, these are the prices and I think that's a pretty good estimate.

Brian Russo - Ladenburg Thalmann & Co.

And I think you mentioned earlier that you may ask commission approval to start your power procurement for 2011 earlier due to where you're seeing power prices. I was just curious. Can you elaborate on that and then comment on what kind of pricing you're seeing in 2011 PJM?

Paul J. Evanson

Yes. Last year, when we went to the PUC to get approval for our procurement of power for 2011 when the rate caps came off, we came up where we agreed with the commission and got authorized to do a series of bids that would start in June of this year - June/October of this year and then January/June/October of '10 - to meet the power needs in '11 and somewhat beyond.

And, of course, you know that the recurring issues about or concern about the increase in power prices to customers in Pennsylvania. The PUC calculates what they think the increase may be to customers of various utilities and for us they had 40%, and 40% is a big number. They recalculated and came up with all the utilities about three or four weeks ago - three weeks ago, I guess it was - and they had our number down at 18%. I've always thought once you get under 20% you're in a whole different ballgame and customer reaction and legislative reaction changes significantly.

So we thought it would be a good thing to go to the commission and ask for approval to start doing some of that procurement early. So we requested an April approval date. We put a filing in, I think it was a week ago Friday, asked the commission to decide in the next few weeks. It would be extraordinarily quick action by all parties if it gets approved, but I thought this way we could perhaps lock in some of the existing power prices. I mean, they may go lower, but we're not trying to pick the bottom, but this is clearly a pretty lower level.

So that was the thinking of it and we would hope to get approval. I think the commission's initial reaction, the staff, was very positive to it, so I'm hopeful we'll get approval and would go out in April.

So while the prices are a little lower, I wouldn't want anyone to misunderstand or miscalculate that this is still a major driver for our earnings in 2011. You know, people try to calculate it off of other auctions. I like to think about it in a simple way of what's a polar rate in Pennsylvania in 2010, you know, which is $52.50, and then deconstruct that price to come back to what the PJM western hub price would be in that number. And when you start taking out capacity, shaping costs, etc., you'll probably come up with a number of $35 to $40 and if you look at the forwards in '11, they're now at around $60.

So we're still looking - even at this lower percentage to our customers - we're still looking at a $20 plus increase in our margin and we have over 20 million megawatt hours to be sold into the market in Pennsylvania in 2011. So it's still a major driver for us, even at today's depressed prices, so I think if we get out early maybe we can get a win-win for everybody.

Operator

Your next question comes from Ameet Thakkar - Deutsche Bank Securities.

Ameet Thakkar - Deutsche Bank Securities

I just wanted to revisit one item on Slide 42. I think I understand but I just want to make sure. So the Maryland residential market you guys are showing a $90 million benefit for the expiration of the residential polar. Now that's capacity and energy?

Kirk R. Oliver

Yes, that is capacity and energy. And what we did there is the idea with Maryland was to isolate that impact and we did it sort of at a point in time. So on the last call we took and calculated what that would be on the total megawatt hours for Maryland and we've put that in as a driver and we're going to just kind of hold it there. So to the extent there are changes in prices or we hedge up some of that, that'll all come in in the driver down below that's called power prices and hedging activity on a going forward basis.

Ameet Thakkar - Deutsche Bank Securities

And then you had just - when you said you isolated initially, you had already had hedges in place, though, prior to giving the $90 million.

Kirk R. Oliver

Yes.

Ameet Thakkar - Deutsche Bank Securities

So that's included in the $25 million?

Kirk R. Oliver

That's included, yes, in the $25 million.

Ameet Thakkar - Deutsche Bank Securities

And then the Virginia purchased power, $100 million, now that includes both - does that include the benefit to AYE Energy Supply to the extent they won generation of that or is that purely just on the Potomac Edison side?

Kirk R. Oliver

That's just on the Potomac Edison side.

Ameet Thakkar - Deutsche Bank Securities

And then you guys mentioned that your open power position in '09 is - what you guys said, was it 3 to 4 [terawatt] hours?

Kirk R. Oliver

Yes.

Ameet Thakkar - Deutsche Bank Securities

I believe I saw this in a press release you guys put out, but you guys won, was it 6.3 terawatt hours out of the 6.6 terawatt hours of load over 25 months in Virginia. Is that correct?

Kirk R. Oliver

That's correct.

Ameet Thakkar - Deutsche Bank Securities

And that's included in that open position?

Kirk R. Oliver

That wouldn't be open. That's hedged.

Ameet Thakkar - Deutsche Bank Securities

I mean - I'm sorry.

Kirk R. Oliver

That's netted against it.

Operator

Your next question comes from Richard Haydon - Neuberger.

Richard Haydon - Neuberger

Did you break down the decrease in demand by end market?

Kirk R. Oliver

You're talking about on customer usage?

Richard Haydon - Neuberger

Right.

Kirk R. Oliver

No. It was about a 7% decline in industrial in the quarter. We have that information. I don't know if you want weather adjusted or not. It was 7% industrial in the quarter. It was about 1.8% residential, up, an increase in residential, and about 0.1% decline in commercial.

Operator

Your next question comes from Reza Hatefi - Decade Capital.

Reza Hatefi - Decade Capital

I just wanted some clarification on a few things. On Slide 42, the $50 million associated with emissions and other fuel-related costs - sorry if I missed this, but does that $50 million continue after '09 into '10, '11 and onwards or are there certain items in there that will go away?

Kirk R. Oliver

Well, there's two pieces to that. There's the emissions piece, which we're estimating at about $30 million, and that cost will be there going forward and it will be a function of how much we generate and what the cost of the NOx allowances are, primarily.

The balance, the $20 million balance, is in other fuel-related costs. And those costs have gotten to the level where we felt it was a good idea to break them out, but we're focused on those and we hope to take them down going forward rather than see them go up. But they are real costs; they're not going to just go away.

Reza Hatefi - Decade Capital

And I think you said so now you're 75% to 80% hedged in 2010 for power, but minimal hedges in 2011. Is that right?

Kirk R. Oliver

Yes, that's correct. That's on a volume basis.

Reza Hatefi - Decade Capital

So your first large chunk that could - I guess it depends how much you participate, but the potential Pennsylvania auction coming up for you guys, what is that, 20 terawatt hours. Is that a sixth of that or an eighth of that that's being auctioned?

Paul J. Evanson

It's a small percentage in April and then it picks up in June.

Reza Hatefi - Decade Capital

And Paul, you mentioned that within the $52 in 2010, which is the current polar rate, is embedded roughly $35 to $40 per megawatt hour is the energy component of that $52. Is that $35 to $40 PJM west hub price equivalent or is that equivalent to, you know, given your negative basis differential with PJM west hub?

Paul J. Evanson

No, I've taken that to the PJM western hub because I figure that's the trading hub that everybody can get projections off of and forwards off of. So I've adjusted for basis to get us there.

Reza Hatefi - Decade Capital

Okay, it's $35 to $40 at the hub.

Paul J. Evanson

Right.

Reza Hatefi - Decade Capital

And just lastly on the coal prices, like you mentioned, over the last year or so obviously there's been some issues there with upward adjustments of your coal hedges and it sounds like this quarter one of the major issues was that their costs continue to go up, the producer's, and so you've had to work with them. How comfortable are you in that trend sort of ending, especially when looking at the outer years here - '10, '11, '12 and all those nice hedges you have from '11 to '17. How comfortable are you that those hedged prices won't further be affected by cost pressures at the producers, etc.

Paul J. Evanson

Well, these are our best estimates today as to what it is with some expected escalation. But obviously, the further out you go, the more uncertainty and question there is and we've already seen what a volatile world commodity prices are and the economy and everything, so a lot things can happen. But I'd say these are the contracts. We're including our best estimates of where we think it's going to be, but the further out you go, obviously, there's going to be a lot more uncertainty to the numbers.

Reza Hatefi - Decade Capital

And just lastly one more question on your 2011 hedging, what is your philosophy on hedging forward? I guess obviously you're very well hedged in '09 and '10. What's your philosophy for '11 and '12? Is there a certain percentage you want to hit at certain times or maybe you can shed a little color on that?

Kirk R. Oliver

We'll be moving more to a hedging philosophy where we try to manage our margin at risk rather than trying to look at some percentage of volume that's hedged, so we'll be taking into account a lot of other factors and running a more sophisticated hedging approach. And we'll be trying to manage the hedged position so that we've always got important costs covered, and then depending on what our view of what's going on in the market, we may hedge more or less above and beyond what protects us on the downside. So that's kind of the philosophy.

We did get the upgrade at Supply which was important to us because that frees up some lean capacity so that gives us the ability to do more hedging and use some right way hedging techniques where we don't need to have such a large liquidity facility to handle collateral calls on the hedges. So that's where we're headed on hedging as we get past '10 and we get out to '11 and '12.

Operator

Your next question comes from Neil Kalton - Wachovia Capital Markets, LLC.

Neil Kalton - Wachovia Capital Markets, LLC

I guess this is a follow on to Reza's question and a bit about the hedging philosophy post 2010, and I guess my question is it seems from the comments you've made about various cost [inaudible] that aren't reflected in the forward prices right now, from a fundamentals standpoint, what do you think about the forward prices? Would you be comfortable hedging around these prices as you look out two or three years or are you okay with the level of openness, so to speak, that you currently have?

Paul J. Evanson

Well, I think we'd like to be more than almost zero, which is where we are in '11, one. Two, prices are, I think, pretty low, although they're about $20 or so, I think, above today's forward. Today's forward's $45; in 2011 it's more like close to $60, $15 up. So I think when we get to the bid in another two months, we'll have to work that one through. There's some balancing things we'll have to work through.

Operator

Your next question comes from Leslie Rich - Columbia Management.

Leslie Rich - Columbia Management

I wondered if you could go through the unrealized marked-to-market loss on the FTRs? Was that basis between your plants and PJM west?

Kirk R. Oliver

Yes, Leslie, that's exactly what that is. The bulk of that's unrealized losses, and what's happening there is the FTRs don't qualify for hedge accounting treatment, so we have to mark the FTRs to market. And when our congestion costs go down, we benefit from a lower congestion cost but our FTR values go down. So economically it's directly offset by the congestion charges going down, but it shows up as a big mark just because of the way GAAP makes us treat the FTRs.

Leslie Rich - Columbia Management

But what's driving the lower congestion?

Kirk R. Oliver

Well, it's just gas prices coming down and power prices coming down and then, naturally, the basis differentials between the different hubs come down.

Leslie Rich - Columbia Management

And then secondly, are there any implications for you with DQE being in again, out again, in again, no in again PJM?

Kirk R. Oliver

Well, I think it helps. Where it could come into play is on the capacity auctions because there's going to be more load and they're in in the more recent filings that PJM has done with the FERC. [Ducane] load will be in there, so that should act to drive capacity prices up, all other things being equal. But I'd say that's the primary benefit of them coming back in.

Operator

Your next question comes from [Anthony Crodo] - Jefferies.

Anthony Crodo - Jefferies

I'm trying to follow up, I guess, on Slide 42, the emission and other fuel-related costs. One is, there's a plus/minus sign right after that. Is there a scenario where you do not get the incremental negative 50? And, if it is 50, I just want to understand it correctly, in November when you provided the previous guidance at the time they had overturned, I guess, the CARE rules. Since then they've reinstituted a more - renumerate them, I believe the name was, or remanded them. Is that the incremental 30 you're seeing for NOx costs?

Kirk R. Oliver

Yes, that's what's driving it. They remanded CARE back to the EPA and effectively the rules of CARE come back into effect.

Paul J. Evanson

And the plus or minus relates to that $30 million. You know, that's an estimate of what we think the allowance price will be over the year.

Kirk R. Oliver

And that's a very thinly traded market and as we generate more, we'll need more. And, of course, if the prices go down, that feeds into our dispatch, so we'll generate more. So there's just a lot of moving pieces around that, so we wanted to indicate that it could be changing.

Anthony Crodo - Jefferies

And the $20 million or so of fuel-related cost, line contract and other stuff, that's just something you didn't have in your EDI guidance.

Kirk R. Oliver

That's correct.

Operator

Your next question comes from Greg Gordon - Citigroup.

Greg Gordon - Citigroup

Just a follow up question. So to go back to your earnings driver comment, Paul, if I look at 2009 as a base as opposed to 2010, right, in Pennsylvania, your rates in '09 versus '10 are actually $7 lower, so if I start with a base of earnings in 2009 that I deduce from your gross margin targets, we know that we're going to get, at least based on current market, it appears we'd get about a $27 increase in revenues between now and 2011 if you were to go to auction today, right? Or at least that's the guesstimate, right?

Paul J. Evanson

Yes, right.

Greg Gordon - Citigroup

You also have the TrAIL line coming on.

Paul J. Evanson

Yes. No, I wasn't trying to go through all the drivers there, Greg. I was just trying to pick out that one since we were talking about Pennsylvania.

Greg Gordon - Citigroup

I understand that. But if we think about Pennsylvania as being a major uplift, it could be $2 a share before expenses obviously. We're talking about TrAIL, where we know you're going to earn a regulated rate of return and that should be almost fully complete by '11, right?

Paul J. Evanson

Right. Yes.

Greg Gordon - Citigroup

It looks like your higher coal costs, unless we see coal prices run back up, are basically already rolled into the run rate for fuel costs.

Paul J. Evanson

Yes.

Greg Gordon - Citigroup

Is that a fair or unfair statement?

Paul J. Evanson

I think that's a fair statement.

Greg Gordon - Citigroup

So other than sort of increasing financing costs and operating costs, is there any other major driver that, as you look out and look at your growth prospects post-2009 that I should be considering as big structural negatives or positives?

Paul J. Evanson

Well, I think if we're going off of '09 as a base, I think capacity revenues could be another one in there. I mean, we don't want to double count when we get to '10 with Pennsylvania, but we have other megawatts that will be receiving higher auction prices.

Greg Gordon - Citigroup

It looks to me like the earnings power of the company is easily $2 higher structurally than whatever it is you'll wind up turning in 2009.

Paul J. Evanson

Well, you know, Max is kicking me already on that comment. I should zip my tongue on that, Greg.

Operator

(Operator Instructions) Your next question comes from Paul Patterson - Glenrock Associates.

Paul Patterson - Glenrock Associates

Not to focus too much here on Pennsylvania, but the First Energy Penn Power results came in and I know they're - I think they're [MISO] and there's some differences there. And, of course, the time in terms of when they're supposed to be set up in terms of the length of contract is different, but the mid-January auction results seem to be on the low side and I was just wondering how shall we look at those results vis-à-vis you guys. Is there any parallel?

Kirk R. Oliver

There's not really any parallel there. It's pretty tough to try to walk that over to what we're seeing in Pennsylvania. That's pretty much why Paul tried to articulate what 2010 looks like if you translate that back to the western hub, and then you think about whatever price you want to use for 2011 and kind of work it from that angle.

Paul Patterson - Glenrock Associates

And then on the - I know you guys exclude from adjusted earnings the impact of the marked-to-market on the hedges. Is there any marked-to-market impact outside of that or any benefit from marketing or trading that you guys had in 2008?

Kirk R. Oliver

It's pretty small, but we have some power hedges where we have a mark for hedging efficiency or something like that. And we have some interest rate stuff where there might be a mark, but it's pretty small. We're talking pretty small numbers.

Paul Patterson - Glenrock Associates

It's not significant in terms of -

Kirk R. Oliver

No, I think it's less than $2 million.

Paul Patterson - Glenrock Associates

And you guys don't have anything for 2009 in that either, anything budgeted?

Kirk R. Oliver

Well, no. We do 2009 on an adjusted basis and we won't know what the marks are until we see what the different pricing impacts are.

Operator

Your next question comes from Mike Worms - BMO Capital Markets.

Mike Worms - BMO Capital Markets

Regarding the NOx negative driver for 2009, can you tell us what that equates to in terms of megawatt hour output in 2009 and what kind of availability factor you're assuming?

Kirk R. Oliver

Well, the megawatt hour output in 2009 is going to be somewhere between 30 and 32 million megawatt hours. That's unregulated. And on the regulated side we would expect that those NOx costs would be recovered in a fuel charge. So that's the unregulated number I gave you.

Mike Worms - BMO Capital Markets

And what about the availability factor? Are you looking for any kind of an improvement over what you accomplished in 2008?

Paul J. Evanson

We'll have a slight improvement in fact, although the number will be less because we have all the tie-ins. We have the five supercritical units that we have to take outages to tie in those units at the completion of the scrubbers, and that's going to hurt us by about 3% in terms of availability, so we're really targeting an 89% number, but if you back off 3% you're at the 86% availability number. And as you know, the first quartile is 88%, so I'm looking at it effectively, bottom line, that we're going to be improving our performance and reducing our forced outage ratios.

And just a comment, Mike, on the NOx, as I said earlier, I think two of our units have SCRs so they're output doesn't generate any NOx. It's really the other units and the sup criticals that could generate the NOx. So it's very difficult to calculate what it is from public data.

Mike Worms - BMO Capital Markets

Paul, why don't you have the equipment on the other two units and are you planning on adding them anytime soon?

Paul J. Evanson

Well, it's a matter of cost and return. It costs about, give or take, [$150] million a unit, so if we were to put them on Hatfield, we could run close to $500 million to put those on and the question is what's the return. Heretofore, until this year, until '09, there was only seasonal NOx allowances, so it's really January '09 is the first time you had annual and no one is really quite 100% sure what they're going to be trading at.

Longer term the cost of removing this is the $500 range, $500 - $600 a ton range, so you'd think over time that [inaudible] price, which is now at the $3,000 level, plus or minus a few thousand or so, but you'd think ultimately it's going to come down to that level and then it's, one, a trade off on the economics, and then two, the mandates from the states and what gets required. You know, we're still being sued on an NSR case. That may go to trial later on this year, and certainly one of the elements in that case is NOx emissions.

So there are two reasons why you might put them on. One is the economics and I think we'd want to have a little more time to figure out whether it is economic to put them on - heretofore it hasn't been - and then we'll have to see what happens in dealing with the states.

Operator

Your next question comes from Ameet Thakkar - Deutsche Bank Securities.

Ameet Thakkar - Deutsche Bank Securities

Just a quick question and I'm sorry if you guys kind of mentioned it - I had to jump off the call for a second - but the accelerated auction you're thinking about holding in April, how much of your load would be bid in that auction?

Paul J. Evanson

I don't have the exact - we're having a total of something like 75 different bid blocks over the next period of time, and this is not a big piece in April. It's five of those blocks.

Ameet Thakkar - Deutsche Bank Securities

The 75 blocks, that would be inclusive of both what you guys do in April and what you do in June?

Paul J. Evanson

No. We actually took some that we'd be doing at 10 and shifting. We were doing - originally we were doing 6 blocks in June and 9 block - 6 blocks in '09, 9 blocks in '10. Our proposal has 9 blocks in '09 and the balance in '10, so we've really shifted the 6 - 9 to 9 - 6.

Ameet Thakkar - Deutsche Bank Securities

And could you just refresh my memory, how much - what's the volume behind each block?

Paul J. Evanson

I don't have the details as to how much is going to be - the size relative to each block. Some of it  we're just moving the residential piece from June to April and then the commercial/industrial stays the way it was, although we adjust that a little bit going forward also.

It's in our filing. The details of that are in our filing that we did last week, although it probably hasn't gotten much attention.

Operator

Your last question comes from Reza Hatefi - Decade Capital.

Reza Hatefi - Decade Capital

Could you remind us again what you're seeing out there for the basis differential between where your plants are and the PJM west hub?

Kirk R. Oliver

Yes, our plants pretty much see an AP zone price and I think we put out on the website - we publish that. I think if you look back over I don't how many years that goes back, but it's in a range of somewhere between $2 and $5 basis differential.

Reza Hatefi - Decade Capital

And what was your total unregulated generation in megawatt hours in 2008 and are you forecasting that to be higher or lower in 2009?

Kirk R. Oliver

2008, I think it was around 34 million megawatt hours and we're forecasting that to be a little bit lower in 2009 because as prices come down we dispatch less and we're expecting that in 2009 it'll be somewhere between 30 million and 32 million megawatt hours.

Reza Hatefi - Decade Capital

And understandably there's obviously economic issues and regulatory issues still to be dealt with, but what are your latest thoughts on giving some more clarity on the future earnings power of the company?

Paul J. Evanson

Well, as you know, historically - you have drivers just for the next year, although we try to lay out pretty clearly what the drivers are going to be longer term, and I think frankly the exchange I had with Greg Gordon earlier in the call lays out several of them. I mean, the transmission side, the going to market, particularly in Pennsylvania, some growth in spending on the Delivery side. I mean, there's several things.

We think about it and we might do it some time during the year and break out with a little more meat on '10 and '11 because '11 is such a significant year for us and given this year's outlook, maybe it's be more appropriate to start emphasizing that little more.

Operator

At this time, there are no further questions. I will turn the call back over to our presenters for any additional or closing comments.

Paul J. Evanson

Okay, thank you all very much for joining us. We appreciate your interest and support.

Operator

Thank you very much, ladies and gentlemen, for joining today's Allegheny Energy conference call. This concludes your conference. You may now disconnect.

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Source: Allegheny Energy, Inc. Q4 2008 Earnings Call Transcript
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