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Executives

Max Kuniansky - Executive Director, IR and Corporate Communications

Paul J. Evanson - Chairman of the Board, President, CEO

Philip L. Goulding - Sr. VP and CFO

Analysts

Dan Eggers - Credit Suisse

Vic Khaitan - Deutsche Asset Management

Neil Stein - Levin Capital

Lasan Johong - RBC Capital Markets

Greg Gordon - Citigroup

Neil Kalton - Wachovia

Ameet Thakkar - Deutsche Bank

Ivana Ergovic - Jefferies & Co

Ashar Khan - SAC Capital

Allegheny Energy Inc. (AYE) Q2 FY08 Earnings Call July 31, 2008 8:30 AM ET

Operator

Good morning. My name is Tabitha and I will be your conference operator today. At this time, I would like to welcome everyone to the Allegheny Second Quarter 2008 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions].

Thank you. I'll now turn the call over to Mr. Kuniansky, Executive Director of Investor Relations and Corporate Communications. Please go ahead, sir.

Max Kuniansky - Executive Director, IR and Corporate Communications

Good morning, 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 August 7th and you can listen to it by telephone, on our web site 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 in the outlook we discussed 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 web site, 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 that 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 - Chairman of the Board, President, Chief Executive Officer

Good morning, everyone. And thanks for joining us. GAAP basis earnings for the second quarter of 2008 were $154 million or $0.91 cents per share. This includes a net unrealized pretax gain of $127 million, related to economic hedges that don't qualify for the hedge accounting.

Now, Phil will be discussing in some detail the unrealized items, which here for haven't been significant. I only want to make one point. There has been no fundamental change in our business or growth drivers or hedging practices. What we're seeing is evolving accounting rules and practices as applied to hedging activities and strategies. The accounting treatment of these items doesn't affect the economics of the business.

With that said, excluding this net unrealized gain, adjusted earnings were $0.45 cents per share, same as the second quarter a year ago. Higher market prices and increased Pennsylvania generation rates were offset by increased coal prices and a reduction in plant output.

Turning to the performance at our super critical coal units, we had a disappointing second quarter availability of 79% due primarily to a series of unplanned outages, particularly at our Pleasants and Harrison stations. Our year-to-date availability through June was 84%, the same as last year but below our plan. Our performance since mid June, however, has been outstanding increasing, year-to-date availability to 86%.

Our latest benchmarking for super critical coal units indicates 88% is the beginning of the top-quartile. While it's too early to declare victory, we do nonetheless feel good that we have taken a consistently third quartile performing fleet and moved it to the brink of the top-quartile. We expect this year's availability to be better than at anytime in the history of the company.

We still have a lot more work to do but we've made real progress. Let me give you two examples. Boiler problems, especially two on the single largest cars of forced outages for coal-fired units. This has been a major area of focus in the past few years. We've seen a meaningful reduction in outages related to the boilers over this time period. We've also shortened the duration of our planned outages, while maintaining the same scope of work during those outages. We're definitely on the right path.

Now, let me update you on some other key areas and developments starting with coal. We've made a lot of progress lately in securing our coal supply through 2011. Through entering into new contracts and constructively resolving supplier performance issues. Our portfolio of coal supply contract now reach out to 2017 and beyond with average pricing well below current spot market levels.

This provides us with substantial long-term protection from coal priced risk, which is further mitigated by coal being the primary price setting fuel in PJM West. These coal contracts are a significant and valuable asset of Allegheny. On a related topic, our scrubber projects at the Hatfield and Fort Martin power station remain on schedule and on budget. The Hatfield scrubber is almost 75% physically complete. And Fort Martin is more than 40% complete.

Now, let's move to some regulatory development. In Virginia, we've been sustaining significant losses due to under recovery of purchase power cost. But we had two very favorable rulings by the State Corporation Commission in the last three months. First; the commission allowed a $73 million rate increase beginning July 1, 2008, to go forward subject to refund, pending in October, hearing a decision.

Second; the commission recently ruled that, as a matter of law, our memorandum of understanding which had capped our rates since 2000 will expire on December 31, 2008. While the commission indicated there are still a number of issues that remain to be addressed before we are allowed to recover our full cost of precious power, this decision is nonetheless a very positive event for us.

In Pennsylvania, the Public Utility Commission issued a final order approving the power procurement and rate mitigation proposals in our filings. This is another very positive development for us. Under our rate mitigation plan, Pennsylvania customers will have the option of limiting their bill increase to 25% annually during the three-year period beginning in 2011 with Allegheny recovering any deferrals with interest.

The Commission also affirmed our plan for procuring power post rate caps. Allegheny Power would purchase electricity for its customers through a combination of contracts with varying maturities as well as spot market purchases. We'll launch the first auction next year, probably in the second quarter. Here again, the goal is to protect the customer by reducing rate volatility.

Also in Pennsylvania, the General Assembly passed portions of Governor Rendell's Energy Legislation in early July. The legislature did not resolve the transition to market, energy efficiency or related issues before the summer recess. They could take up these issues again when they convene in mid September but that's unlikely, given the few days they are in session. In the absence of a legislative mandate, it is the Commission that likely will keep the responsibility for setting the rules for transition to market-based rates.

Moving to transmission, in another positive development, the hearing examiner in Virginia, this week, recommended that the Commission approve the TransAllegheny Interstate Line or TrAIL. In Pennsylvania, we're awaiting the recommended decision from the Administrative Law Judge. We anticipate final decisions from each of these Commissions in the September-October time frame.

In West Virginia, as you recall, we reached a settlement agreement with the staff of the Public Service Commission, the Consumer Advocate and our large industrial customers in April. We expect a final decision from the commission tomorrow or Monday. On the federal level, FERC gave final approval this month on our TrAIL settlement agreement which includes a 12.7% incentive return on equity. Also, our transmission subsidiary, TrAILCo, launched a $550 million financing for the project earlier this month. We expect to close in August.

And in May, PJM completed its capacity auction for the 2011-2012 planning year. The market clearing price was $110 per megawatt day. When coupled with the prior auction, this will provide over $300 million of pre-tax income for us in the year 2011.

I'll conclude by commenting on our longer term outlook. I'm very optimistic about that outlook largely because we have several major streams of earnings growth ahead of us. Just a few examples; first; our TrAIL and PATH transmission projects, more than $2 billion in spending that will earn incentive returns.

Second; locked in increases in our Pennsylvania generation rates in the next two years that will add close to $300 million in net revenues. Three; the uplifts from transitioning to market-based rates in Maryland in '09 and Pennsylvania in '11 and four; additional income due to the PJM capacity auction. Rates are now set through mid 2012 and are likely to be higher thereafter as reserved margins tighten and construction costs rise.

Finally, our coal supply contract protects us from rising coal prices and provides substantial value over the next decade. In short our outlook remains bright and I can assure you, our management team is continuing to do exactly what we have been doing for the last five years, mainly focus intently on building long-term shareholder value and executing on plan.

I am convinced such efforts over time will be reflected in our stock price and I am confident in our ability to deliver solid growth in earnings and cash flow.

Now I will turn the call over to Phil.

Philip L. Goulding - Senior Vice President and Chief Financial Officer

Thank you Paul and good morning everyone. Yesterday we reported net income of a $154 million for the second quarter of 2008 compared to $77 million a year ago. We are $0.91 per share in the second quarter versus $0.45 in the same period last year.

These results include a $197 million unrealized gain related to an increase in the fair value of financial transmission rights, a $56 million unrealized loss related to power hedges and a $13 million unrealized loss related to a recently implemented hedging strategy pertaining to our Kern River Pipeline transportation contract.

All of these items were driven by substantial increases in gas prices and power prices during the quarter and are associated with effective economic hedges that do not qualify for hedge accounting. We are adjusting GAAP results for these items to better reflect earnings from ongoing operations. Let me describe these items in more detail.

First, as a result of changes in accounting guidance, including implementation of FAS 157 and evolving industry practice, we began reflecting changes in the fair market value of our financial transmission rights or FTRs at the beginning of this year. In late April, we acquired FTRs for the June 2008 to May 2009 PJM planning year.

The value of these FTRs increased significantly during the quarter. We received these FTRs as a result of our polar contract obligations. These FTRs combined with our generation, hedge our costs to serve these polar contracts. Our polar contract obligations utilize most, but not all of our FTRs. The remaining FTRs are incorporated in our generation hedging strategies.

Second, we recorded a $56 million unrealized loss relating to the change in fair market value of power hedging contracts. Most of these contracts were put in place in the second half of last year and the first quarter of this year. These contracts do not fully qualify for hedge accounting treatments, but are effective economic hedges when combined with our remaining FTRs. These contracts serve to commercially lock in the price of a portion of our future generation output.

Third, during the second quarter, we entered into financial contract to hedge the value of our Kern River Pipeline capacity from November 2008 through 2010. We kept this contract when we divested our trading business in 2003. It has not historically been a meaningful contributor to earnings but with these hedges will result in realized pre-tax gains of about $30 million per year in 2009 and 2010.

Going forward, we will continue to adjust earnings for unrealized gains and losses associated with our economic hedges. Now, let's talk about the underlying results of the business. Adjusted earnings per share were $0.45 for both the second quarter of 2008 and 2007. For the six months ended June 30th, earnings were $1.25 per share on an adjusted basis as compared to $1.10 per share last year.

Let me focus in more detail on this quarter's results. First, I would like to summarize some of the key factors that impacted the change in adjusted earnings per share. The net effective market prices, including marketing, trading and hedging activities increased EPS by $0.08. Higher generation rates in Pennsylvania improved EPS by $0.06. Our Pennsylvania generation rates increased 8% on January 1st of this year.

Lower planned output reduced earnings by $0.06 per share. Unregulated planned output decreased by about 800,000 megawatt hours, primarily due to lower unregulated super critical performance, an increase in sub-critical planned outages and reduced planned dispatch. The reduction in dispatch was primarily from our gas units and had a modest effect on income.

Higher coal prices hurt EPS by $0.08 cents. Our fully delivered coal price increased by about $6 to $46 per ton. Reduced tax expense helped earnings by $0.03. All other factors which include the adverse effect of weather and increased depreciation expense, decreased earnings per share by $0.03. In total, adjusted earnings per share were $0.45 in both periods.

Now, I would like to discuss the second quarter year-over-year 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, revenues increased by $127 million on a GAAP basis but were unchanged after adjusting for the previously-mentioned net unrealized gain.

Let me summarize the key components impacting revenues. Decreased generation output reduced revenues by $45 million. As previously mentioned, plant performance, planned outages, and lower dispatch contributed to this decline. Gas plants accounted for approximately 50% of this revenue decrease. Our gas plants dispatched more heavily in 2007 in order to support PJM's reliability needs.

Market prices including marketing, trading and hedging activities increased second quarter revenues by $27 million. Capacity revenues accounted for $8 million of this increase. Prices in our zone average $72 per megawatt hour, a 31% increase over second quarter 2007 prices. Higher Pennsylvania generation rates increased revenue by $15 million. Transmission expansion projects added $8 million to revenues this quarter.

The impact of weather, net of load growth decreased revenues by $4 million in the quarter. Cooling degree days were relatively normal for the second quarter of 2008 but were 18% below the warmer second quarter of 2007. Load growth, excluding the weather impact, increased by about 1% quarter-over-quarter.

Moving from revenues to expenses, fuel expense was up by $14 million, period-to-period. Coal expenditures increased by $24 million, primarily a result of increased coal prices which are partially offset by reduced coal generation. Natural gas fuel costs were lower by $15 million. All other fuel costs were higher by $5 million, primarily due to increased emission costs. Purchase power costs decreased by $9 million in the second quarter of 2008, largely due to the expiration of a third-party agreement related to our former Ohio territory.

Deferred energy increased costs by $9 million, primarily reflecting our West Virginia energy clause and the Maryland PURPA generation facility energy clause. O&M decreased by approximately $1 million. Decreased station outage work was partially offset by increased costs related to storm restoration expenses.

Continuing with the income statement, taxes other than income taxes increased by $4 million. The second quarter of 2007 benefited from the resolution of prior year tax issues. Interest expense was down $5 million due to increased capitalized interest associated with our Hatfield scrubber project and lower interest rates. All other pretax factors hurt results by $1 million.

The net result of all of these items was a $13 million decrease in adjusted pretax income. Our effective tax rate this quarter was 34% which compares to 41% for the same period a year ago. We now expect our effective tax rate for the year 2008 to be approximately 36%. That concludes my discussion of the income statement.

Moving on to cash flow. Net cash flow from operations was $208 million in the second quarter of 2008, a $37 million decrease as compared to the second quarter of 2007, largely due to changes in working capital. Capital expenditures were $239 million, including $149 million of spending on our scrubbers and transmission expansion projects.

Free cash flow, excluding capital expenditures for Fort Martin scrubbers which are funded through securitization proceeds, was a positive $26 million for the quarter. Cash flow after dividends was $1 million. Our credit metrics remain strong. In June 2008, S&P the unsecured credit rating of Allegheny Energy Supply to investment grade.

Now, let's turn to the outlook. Here, again, are the key factors that we expect to drive adjusted earnings growth for 2008 as compared to adjusted 2007 results. Remember, this is not a complete model but it is directionally correct and hopefully helpful. We have made some additional changes from what we presented in May.

Let me update you on several items. We are maintaining our projection for a $60 million benefit in plant availability year-over-year. Our plants have performed very well in July and we have no unregulated planned outages for the second half of the year. We have reduced our estimate for SO2 allowance cost by $10 million based on the current price of allowances which were impacted by the court decision on care.

Our expected total needs for 2008 are now 99% hedged. We are increasing the estimated negative impact of coal prices to $90 million, to reflect the incremental coal contracting we have completed in 2008 and the resolution of our coal supplier issues. This estimate is increased by $20 million from our previous estimate. Our coal suppliers are now performing against anticipated 2008 delivery schedules and inventories are at targeted levels.

Let me remind you that some of these growth drivers do not occur prorated over the rest of the year. Almost all of our 2008 supercritical planned outages and most of our special maintenance expenses occurred in the first half of the year. As a result, the fourth quarter will benefit from reduced special maintenance expense and improved availability relative to the fourth quarter of last year.

Let me take a few moments to update you on our contracted coal position in 2009 and beyond. This slide; shows the percent of the estimated coal requirements for our unregulated coal plants that we have contracted at fixed prices or fixed prices with inflationary escalators.

We have additional contracted coal with pricing subject to market-based negotiations or re-openers but those tons are not included. We have completed are in final contracting stages for about 90% of our 2009 coal requirements and 70% of our 2010 requirements. We have also increased our contracted coal position to 65% in 2011 and 55% in 2012 and have 40% or more contracted between 2013 and 2017.

The pricing for each of the years, has been updated to reflect our new contracts and increases related to the resolution of our coal supplier issues. We do not disclose specific details on our individual coal contracts. But we'll provide some combined information. We have recently contracted for additional coal in 2009, 2010 and 2011. In aggregate, these purchases totaled nearly eight million tons at an average price between $70 and $75 per ton on a fully delivered basis.

In the long-term, we believe we have largely eliminated our exposure to coal fluctuations. Let me explain why. As the slide shows, we have contracted for over 40% of our coal needs. And for the remaining 60% of our coal needs, we believe we are protected by a natural hedge because coal should be setting the price of power in our region, 50% to 60% of the time. This means the changes in the price of coal should be offset by corresponding changes in the price of power during this period. The combination of our existing contracts and this natural market hedge largely eliminates our exposure to coal price fluctuations over the long-run.

2009 and 2010 dark spreads have tightened recently however we have hedged a significant portion of our coal and generation over this period and our coal hedges are well below current market prices. We expect these coal and generation hedges to offset a majority of the dark spread impact in 2009. In 2010, we have hedged 70% of our coal and generation for the remaining un-hedged generation coal is setting price a majority of the time. Therefore, we have less than 15% of our generation output exposed to the 2010 dark spread.

In 2011 and beyond, as I mentioned, our long-term coal contracts protect us from increasing coal prices. As a result, our primary commodity exposure is the power prices when natural gas units are setting price and therefore, to natural gas prices. Although 2011 natural gas forward prices have fallen recently, they have still risen significantly since 2006 and as a result from a commodities perspective, our long-term earnings power has strengthened over the past two years.

And with that, the operator will now accept questions.

Question and Answer

Operator

[Operator Instructions]. Your first question comes from the line of Dan Eggers with Credit Suisse.

Dan Eggers - Credit Suisse

For contracting first of all, good job getting more of that put away. I guess, can you give thoughts on whether you're done contracting for a period of time now we are going to be steady at these levels and at these pricing and then along those lines, kind of the $70 ton range you guys saw on a delivered basis if you were to mark that to today's market versus the negotiations you started earlier this spring, how much of a difference would you expect to see?

Philip L. Goulding - Senior Vice President and Chief Financial Officer

Well, we're never done contracting, Dan. But we have got in a lot of the work we wanted to get done for the short term. But we are still in some places looking at opportunities for longer term deals and other type deals and selective -- basically selective opportunities right now. As far as out of the deals we've done, the $70 to $75 on a delivered basis compared to current market, compared to the current spot market, that's kind of visible in a different sources. Obviously they're well below. I would guess compared to the contracting market, if you were trying to contract for the short term, they would be pretty favorable and I guess too early to say how they compare to longer term deals.

Dan Eggers - Credit Suisse

Ok. And then looking at kind of the forward dark spreads, how do you guys think about selling forward power right now? Is there a rush to sell anything forward or lock in against the coal supply that you now have? Or do you think that the forward curves aren't adequate to justify sell more power?

Philip L. Goulding - Senior Vice President and Chief Financial Officer

Good question. I think that we're more focused from a longer term basis on hedging through gas than through power. We're not that comfortable with the long-term power forward curves. I'm not sure that we would be that eager to transact on them in their current state. We do look on an ongoing basis and we're studying pretty hard our opportunities for hedging gas and 2011 and on time frame since our coal contracts are pretty fortified and obviously are more than adequate at this stage.

We have to address collateral issues and doing that and our credit upgrades at supply or upgraded supply helps in that regard. We also have to work through certain terms in our credit facilities and other technical items to be ready to do those kinds of hedges. And I think we'll seriously consider moving forward with hedges of that nature over the coming six months.

Dan Eggers - Credit Suisse

All right. And one last one, just on the Virginia MOU ruling, can you just give some thoughts on when it is that you'll start to recognize the interim term rates in your income statement and any push point or where you think Virginia could push back on you guys relative to the number you requested?

Philip L. Goulding - Senior Vice President and Chief Financial Officer

Dan, I don't think we would be recording anything until we get a final decision. So, in the interim, we're just leaving it the way it was with no further revenue impact on it. And the hearing is scheduled for mid to late October. We would hope that they would be able to reach a decision reasonably soon thereafter. So, by the end of the year, we hope to have this thing finalized one way or the other.

Operator

And your next question comes from the line of Vic Khaitan with Deutsche Asset Management.

Vic Khaitan - Deutsche Asset Management

Hello, can you hear me?

Philip L. Goulding - Senior Vice President and Chief Financial Officer

Yes, we can, Vic.

Vic Khaitan - Deutsche Asset Management

Sorry. Really Dan already asked one of my questions about this Virginia ruling. But where the staff is recommending that plant be put back into the rate base, so, what are your thoughts as to how that -- is it legally possible? Or is it going to be a negotiated thing? What's your feeling?

Philip L. Goulding - Senior Vice President and Chief Financial Officer

Well, the staff raised a number of issues and I'm sure you've read the Commission's decision where they raised probably 10, 12 issues that they really want addressed and considered. Most of them relate to prudency, the appropriateness of behavior and a lot of it is affiliated transactions between supply and Potomac Edison.

And we certainly don't think it's appropriate that generation be transferred back in at anything if we did it at all, anything less than current market value of that generation. So, I don't think -- but as part of this, we are considering what our future -- how we're going to meet the future needs in Virginia, whether through solely purchased power or maybe some building or buying something or so there are alternatives we're looking at. But I don't see those alternatives being valued you might say as value transference between one company within our group and another. I mean it is really a Potomac Edison stand alone issues.

Vic Khaitan - Deutsche Asset Management

One other question about this 2009 auction for Pennsylvania polar load. What's your view in terms of how you think it will be managed in terms of whether that one is a separate thing than the energy, the Allegheny energy supply will be selling it in the market while the distribution company is going to be procuring that power for polar load. So, there is obviously, could be some mismatch. So, how do you see that working in favor of you or it will be more like a -- we don't know the answer to that?

Philip L. Goulding - Senior Vice President and Chief Financial Officer

Well, it's Allegheny Power that will be going out it was ten powers specifically going out on those on the auctions. They're structured to have a multiple procurement over that period. And I'm sure it's an attractive load and one that we know well so I would just assume that Allegheny Energy supply will be bidding on that load.

Vic Khaitan - Deutsche Asset Management

You think that would be pretty much done at the market clearing price? Or do you think that will be --

Philip L. Goulding - Senior Vice President and Chief Financial Officer

Absolutely. It is an auction and there's no reason why we wouldn't bid other than what we thought was an appropriate market-based rate.

Paul J. Evanson - Chairman of the Board, President, Chief Executive Officer

And we wouldn't want to win it at a below market rate. We would only bid it at a market rate because we can always sell our generation into the market as market.

Vic Khaitan - Deutsche Asset Management

That's what I was trying to get at.

Philip L. Goulding - Senior Vice President and Chief Financial Officer

Right. That's how it works. We always have to sell our generation into the market even if we win those polar contracts.

Vic Khaitan - Deutsche Asset Management

All right. Okay

Paul J. Evanson - Chairman of the Board, President, Chief Executive Officer

We love our delivery business but not that much, Vic.

Vic Khaitan - Deutsche Asset Management

Okay. Thank you very much.

Operator

Your next question comes from the line of Neil Stein with Levin Capital.

Neil Stein - Levin Capital

Good morning.

Paul J. Evanson - Chairman, President and Chief Executive Officer

Good morning, Neil.

Neil Stein - Levin Capital

If you go back to the beginning of the year, you were 60% open on both coal and power. Since that time, you've done a number of contracts, market prices have moved a little bit. Could you talk about, if you look at your gross margin associated with that, original open position, has it improved or stayed the same or could you talk generally about the direction.

Philip L. Goulding - Senior Vice President and Chief Financial Officer

Which year are you asking about?

Neil Stein - Levin Capital

For 2009 in particular.

Philip L. Goulding - Senior Vice President and Chief Financial Officer

Yeah. I think 2009 still looks about like what it looked like at the beginning of the year. I don't think for the parts -- obviously coal has moved up. But we had some good marketing contracts that we have talked about. So, for the pieces we've locked in, there is -- its reasonably comparable and then there's some remaining pieces yet to be seen as to where the power will really clear when we sell the generation moving forward. And still 10% of the coal to get by.

Neil Stein - Levin Capital

Shifting to a fully different topic, if you look at your coal unit dispatch, it's gone down a little bit, year-over-year both in the second quarter which is a continuation of the trend from the first quarter. Could you -- I remember in the first quarter, you explained it was related to I guess during off-peak periods, prices weren't at doing at levels that were consistent with current market coal prices. Was that the same in the second quarter and why doesn't that have an impact on the various drivers for the year?

Philip L. Goulding - Senior Vice President and Chief Financial Officer

Well, let me take you through that. First of all, there is an impact on the business that we talked about on the call. From Allegheny Energy Supply perspective which is really where the output affects our bottom-line because of the fuel clause on our West Virginia businesses. We had about an 800,000 megawatt hour decline in total output from our total generation fleet. The first 300,000 is easy to talk about, that's from our gas units. And really the gas units ran hard in '07 because of PJM reliability issues. I believe related to some transmission issues. And they ran much less hard and more normal for the shorter period this year. That's 300,000 megawatt hours. We looked at what is the actual pre-tax income difference between '07 and '08 for those 300,000 megawatt hours. It was right on $2 million pre-tax.

So, those hours had very minimal economic effect on us. Of the remaining hours, 100,000 was just more planned outages at our sub-critical stations that we knew were coming up. They'll benefit us long-term and not really much of an issue. And so, that takes us to about a 400,000 megawatt hour fall-off from our super-critical plants at supply. And that fall-off was part dispatched and part planned performance. The plant performance hits us economically and it is the lion's share of what we talked about in the earnings per share bridge of generation output.

The plant dispatch, like the gas, is a much smaller year-over-year economic issue and, in fact, there is an offset which is we have to buy power to serve our polar load also and if there's hours during usually these are in the middle of the night, that off-peak prices are dropping below our actual incremental cost to produce power. We're more than happy to bring the plants somewhat down in output and to buy the power cheaper than we can make it to serve that polar load. And that will show as output variance but will get positive price variance because the cost to serve the polar contracts is in the price analysis.

And then the last question of how does that affect our overall estimates on our growth drivers, well, we think in aggregate, our growth drivers are coming in the way we just described them. That we're going to have a very good second half of the year in terms of output and we're very well-positioned for it. And principally, that will be availability and performance-related output which is the real dollar output. As to what happens to the dispatch output period to period, frankly, that's less of an issue to us because it is not meaningful economic output.

Neil Stein - Levin Capital

Ok. As part of this -- just to clarify, you're not to the extent you're dispatching less? You're not selling the coal associated with what those megawatt hours might have been?

Philip L. Goulding - Senior Vice President and Chief Financial Officer

No. It stays on the pile, so to speak and ultimately being the money contract therefore could monetize a little bit better later in the year or in the next year.

Neil Stein - Levin Capital

Ok. Thanks very much. I appreciate it.

Paul J. Evanson - Chairman of the Board, President, Chief Executive Officer

Sure.

Operator

(Operator Instructions). Your next question comes from the line of Lasan Johong with RBC Capital Markets.

Lasan Johong - RBC Capital Markets

Good morning thank you. Going back to the coal issue just one more time from the remaining piece, Phil, you had mentioned that the data you provided us does not include things that have re-openers in them. So, the question is how much coal do you have that's supplied but not priced and how does that pricing mechanism work? Is it based on monthly spot prices or do you do short term six to 12 month type contracts? And therefore, how much is absolutely open in terms of supply that you need going forward?

And then the second question I have is on the Pennsylvania issue, 25% rate increases to the end consumer, I'm assuming that's based on market prices. So the question becomes, is it unlimited deferral, meaning if per PURPAs go to $1,000 megawatt hour, is everything about 25% increase booked at a deferral? And is there a prudency test where the state can deny recovery of that cost? And at what interest rate you get it at? At a corporate rate? Or a different rate that the regulars decide? I appreciate it. Thank you.

Philip L. Goulding - Senior Vice President and Chief Financial Officer

Ok. Let me take the coal question. We...we don't have any coal subject to re-openers or market-based pricing. None of our contracts are indexed to the market. The case that we have re-openers or market based negotiations are annual situations where we sit down with our supplier and try to negotiate what we think a fair market value is for that coal. And then there's generally baseball arbitration if neither…if the two parties can't get together.

So, it is a way of assuring supply and for the producer, a way of assuring sales from a mine without agreeing to agree on the commercial terms. But it is basically wide open negotiation with arbitration and on an annual basis. We do have a reasonable percentage of that coal for 2010 secured. So if you looked at Allegheny Energy Supply's position with those types of arrangements, we're probably getting closer to 80 to 90% hedged in terms of coal supply procurement. Maybe even a little above that.

Lasan Johong - RBC Capital Markets

Great and what about the Pennsylvania rate issues?

Paul J. Evanson - Chairman of the Board, President, Chief Executive Officer

Okay. On Pennsylvania, when you get to 2011, under what's been approved, the cap...the rates can go up by no more than 25% in '11. So to the extent, you have an excess that rolls over to the next year, and again you have a 25% limit and that limit is over the…over a three-year period, '11, '12, '13. To the extent you have in excess, that hasn't recouped…that 75% hasn't recouped where you need to be in market, then you'll recover that over the succeeding three years. So there is a limitation on it when that maximum would be, and then we would be earning a return on all of those deferrals beginning in '11 and it is basically at a 6% interest rate.

Lasan Johong - RBC Capital Markets

Ok. And then --?

Paul J. Evanson - Chairman of the Board, President, Chief Executive Officer

The increase of 50% and if price didn't move at all, we would get 25 in year one, 25 in year two and then would just be at market, for example.

Lasan Johong - RBC Capital Markets

Can the state take it away from you or have a prudency test or some kind of allocation for--?

Paul J. Evanson - Chairman of the Board, President, Chief Executive Officer

That was a decision by the Commission. That was our filing. That was our proposal. That's what they've approved.

Lasan Johong - RBC Capital Markets

So, there is no prudency test?

Paul J. Evanson - Chairman of the Board, President, Chief Executive Officer

I mean, it might be a prudency test on how we procure the power that leads to those percentages but I think the procurement methodology has already be been approved, too. So I would think that, so long as we follow that, we've done it prudently.

Lasan Johong - RBC Capital Markets

So, no dangers?

Paul J. Evanson - Chairman of the Board, President, Chief Executive Officer

No. I mean no except I would just add that the legislation…there is always a possibility of a legislative action that could alter increases to anybody in the state. I mean that's always up.

Lasan Johong - RBC Capital Markets

Right, right. But that's minimum threat. Okay. Fantastic, I appreciate it.

Philip L. Goulding - Senior Vice President and Chief Financial Officer

There is an issue of what the commission has done.

Operator

And your next question comes from the line of Greg Gordon with Citigroup.

Greg Gordon - Citigroup

Hey, guys.

Philip L. Goulding - Senior Vice President and Chief Financial Officer

Greg, good morning.

Paul J. Evanson - Chairman of the Board, President, Chief Executive Officer

Good morning, Greg.

Greg Gordon - Citigroup

There's like two calls every ten minutes this morning, so apologize if I didn't hear the whole call.

Philip L. Goulding - Senior Vice President and Chief Financial Officer

Well, I apologize for scheduling that so. Go ahead.

Greg Gordon - Citigroup

I think that should go into binding arbitration between all the CEOs to make sure the calls are all lined up.

Philip L. Goulding - Senior Vice President and Chief Financial Officer

That's a great thought.

Greg Gordon - Citigroup

Can you explain to us qualitatively how you were able to source coal at such big discounts to sort of the prevailing CSX hub pricing? Is this a geographic advantage, a transportation advantage, a combination of both and should we think about your ability to re-contract consistently at that type of delta to what we see a spot? Or were there other factors that made it a one-time opportunity?

Paul J. Evanson - Chairman of the Board, President, Chief Executive Officer

Well, I'll answer the first question. We contracted competitively. We moved fairly quickly as we saw the markets moving. We showed a fair amount of flexibility in terms of what types of coal we contracted and where we contracted from. We scoured a lot of different areas and came up with some pretty reasonable contracts.

We didn't contract a lot of offers we got and we did contract other offers we got. It was just a dynamic competitive situation. Probably, the speed we moved was an important factor that got us to the prices we got at. As far as what is going to happen going forward? I just think it is too early to tell. I don't know what the 2010 or 2011 contract market will look like and it is just too early to say what we'll be able to contract at.

Greg Gordon - Citigroup

It would be fair to say just doing a basic ECF, even if I assume delivered coal prices out for 2017 were $0.90 a ton, the value of your hedge looks like it's about at least a billion dollars for the shareholder.

Philip L. Goulding - Senior Vice President and Chief Financial Officer

Yeah. There's no question that our long-term position has got potentially billions of dollars of value associated with it. And those long-term contracts we arrived at in many different ways. And with the -- without a doubt, impossible to reproduce in today's market.

Greg Gordon - Citigroup

If you were to -- if your stock were to continued to not reflect sort of the underlying competitive advantage that's granted to you from those hedges, is there is way for you to consider sort of monetizing the value of those hedges and bringing that forward?

Philip L. Goulding - Senior Vice President and Chief Financial Officer

Well, the hedges will be monetized as we move out in years. I don't think -- I don't think we would think about selling -- selling or trying to assign contracts to someone at large profits. That's core to our business. And I think we'll manage our business around them.

Greg Gordon - Citigroup

Okay. Can you state again what -- you're going to be generating a meaningful amount of earnings over the next couple of years from this Curran river [ph] position. Can you go over that again? I missed that.

Philip L. Goulding - Senior Vice President and Chief Financial Officer

Yeah, the Curran river [ph], which was a great opportunity, we've had this position for a number of years, dates all the way back to our trading positions and our national plans in 2003 and before and when we disassembled all of that, we held Curran because it looked like it could have meaningful option value.

And the way gas prices moved over the last four months, we saw a real run-up in the spread for Curran river, which is really between the Rockies and Southern California. And it reached a point where the remaining option value for the nine and ten time frame was less than 10% of the total value of the contracts and so we hedged it in a very clean way.

Not in clean accounting way but a very clean commercial way with bases lost on each side of the pipe. We locked in, including the cost of the capacity; we locked in a pretax income gain of about $30 million in 2009 and 2010. So, each year.

Greg Gordon - Citigroup

And then the contracts expires so would that be

Philip L. Goulding - Senior Vice President and Chief Financial Officer

No, the contracts keep going but today, the option value in '11 and '12 is still a reasonable percent of the value. And it would be premature to hedge.

Greg Gordon - Citigroup

How long do you hold that position? It goes out until when?

Philip L. Goulding - Senior Vice President and Chief Financial Officer

That position I think goes out to 2018.

Greg Gordon - Citigroup

Okay so, this is an asset that you'll be able to continue to monetize

Philip L. Goulding - Senior Vice President and Chief Financial Officer

Yeah.

Greg Gordon - Citigroup

Should conditions remain favorable?

Philip L. Goulding - Senior Vice President and Chief Financial Officer

And it does still show in terms of forward markets, it does still show some meaningful value in the '11 and '12 time frame and beyond.

Greg Gordon - Citigroup

And then the last years in the last several years it hasn't been a meaningful contributor?

Philip L. Goulding - Senior Vice President and Chief Financial Officer

No it's been almost no contribution to income in the last few years. Practically nothing. We might -- we're going to get a little benefit from it in November and December of this year. It may contribute – will contribute less than 5 million of pretax income this year, the position. And it contributed almost nothing last year.

Greg Gordon - Citigroup

Hmm. Interesting.

Paul J. Evanson - Chairman of the Board, President, Chief Executive Officer

Yeah, purely another case of something not having any value for a long period but when it had some value, the team moved very quickly, so speed was another case where it helped us significantly to lock in those gains.

Greg Gordon - Citigroup

Fantastic. Thank you, gentlemen.

Philip L. Goulding - Senior Vice President and Chief Financial Officer

Sure.

Operator

Your next question comes from the line of Neil Kalton with Wachovia.

Neil Kalton - Wachovia

Prices for '09 in the Allegheny zone have been trending?

Paul J. Evanson - Chairman of the Board, President, Chief Executive Officer

I'm sorry. We missed the – we didn't get the beginning of the question.

Neil Kalton - Wachovia

Okay. Sorry. Yeah I just want to know -- if you can give us a sense of where the recent around the clock prices for '09 in the Allegheny zone have been trending?

Philip L. Goulding - Senior Vice President and Chief Financial Officer

Well, we are not in '09 yet so it is hard to really answer that obviously the forward prices, that you look at the PJM Western Hub have, in the last month or two, I think everybody is aware have trended down some. But it is early to say where they are going to be when we have our power sold there. They're still up from where they were at the beginning of the year.

Neil Kalton - Wachovia

Okay what's the basis difference that we should be assuming for your zone versus the West?

Paul J. Evanson - Chairman of the Board, President, Chief Executive Officer

Well as we've said a number of times in that nine and ten timeframe, because of these large Polar contracts we have, especially the West Penn contract, we do have adequate FTRs to hedge that contract and the way the allocation works, some additional FTRs and because of that, the basis is not really as relevant. Most of our generation, some may not but most of our generation gets to the AP zone or close to the western hub commercially. There is some that will sell at the generator.

Neil Kalton - Wachovia

Ok. I understand. Thanks.

Paul J. Evanson - Chairman of the Board, President, Chief Executive Officer

Sure.

Operator

And your next question comes from the line of Ameet Thakkar with Deutsche Bank

Ameet Thakkar - Deutsche Bank

I just wanted to follow-up with you guys on the recent [inaudible] binding pole on your procurement plan. It looked like the -- it appeared that -- adopted the OSBA proposal as far as the timing of your RFP. Is that something you can revisit with the Commission prior to their issuance of a final order? And how did that differ from what you guys had proposed?

Philip L. Goulding - Senior Vice President and Chief Financial Officer

The Commission -- the Commission basically issued that order. They voted on it the week before. They issued a final order. And it's really -- as you say, consistent with what we proposed and close to what the ALJ proposed. So, we're not anticipating changing from that. We'd probably launch that first procurement sometime next year, probably in the second quarter. I mean, they wanted it to start a little bit later than we had originally thought we originally had been thinking in the fall but looks like we'll probably do it in the spring of next year.

Ameet Thakkar - Deutsche Bank

And does that delay -- will that delay impact your customer education efforts et cetera to kind of prepare people for the rate change?

Philip L. Goulding - Senior Vice President and Chief Financial Officer

No. No. I think our education efforts really have started and will continue over that throughout that period to make sure they're aware of not only what's happening but what their options are because the 25% that I talked about earlier is really a provision for them to that they have to opt out of, the standard, which is we go straight to market-based rates.

Ameet Thakkar - Deutsche Bank

And then as far as giving us a little bit more flavor on what the earnings in cash flow upside will look like following expiration of the polar contract, is that contingent on completing one of these auctions or is that something you'll be prepared to do ahead of that?

Philip L. Goulding - Senior Vice President and Chief Financial Officer

Well, we'll know it when the auction takes place. That's for sure. And I think there are other auctions in the region that provide some light on what that number might look like.

Ameet Thakkar - Deutsche Bank

Thank you very much.

Philip L. Goulding - Senior Vice President and Chief Financial Officer

Ok.

Operator

Your next question comes from the line of Ivana Ergovic with Jefferies.

Ivana Ergovic - Jefferies & Co

A question -- you mentioned in your first quarter earnings call that you had some delivery issues with one of your coal suppliers. I'm wondering whether you have resolved those or there is still something pending.

Philip L. Goulding - Senior Vice President and Chief Financial Officer

The answer to that is we are feeling good about those issues. Some of them are fully resolved. One of the ones we talked about is totally under control. We've reached interim arrangements where receiving basically all of the production from the supplier and we're working towards a longer term arrangement. So, we feel like we're in very good shape with our suppliers at this stage and we've updated the pricing on our percent contracted in pricing chart to reflect everything we know to date and even included a little bit of contingency.

Ivana Ergovic - Jefferies & Co

Okay. Also, have you seen improvement in market heat rates versus the first quarter? There have been depressed relative to last year?

Philip L. Goulding - Senior Vice President and Chief Financial Officer

Right. Well, I don't know how much faith I put in the current forward power markets. It is difficult to -- it is difficult to speculate as to exactly what's causing market heat rates to move up or down at any given period.

Obviously, -- one factor that affects heat rates, particularly on the off-peak is that the care decision does structurally take a cost out of the off-peak generation and therefore should bring off-peak prices down and I think when the decision was made, off-peak prices did come down to reflect that but I'm not positive that the current forward markets really reflect the true structural market or cost of the market participants. We focus much more on market structure.

We look real hard at what the incremental costs are to the different producers, the different generators. We watch the supply and demand and we're totally confident that when we get to the real time markets, the day head markets we sell our power in that the prices will reflect the input cost and the market structure at that time.

Ivana Ergovic - Jefferies & Co

Ok. Thank you.

Operator

Your next question comes from the line of Ashar Kahn with SAC Capital.

Ashar Khan - SAC Capital

I guess -- I'm sorry I don't know Phil, if you can help me on this or I can do it. As we look at the factors you gave for improvements, this is on slide 33, plant availability Pennsylvania rates, transmission expansion. Could you just -- if I'm right, we haven't gotten the plant availability benefit this year, right? It is all based on the slide you gave us last time? All that 60 million is going to show up in the last half of the year. Is that a fair point?

Philip L. Goulding - Senior Vice President and Chief Financial Officer

That's totally correct. That's what we expect. You got to recognize this is -- where we get the economics from plant availability is Allegheny Energy Supply and Allegheny Energy Supply in the back half of 2007 had availability, total availability that averaged about 75%. We have no planned outages at Allegheny Energy Supply for the remainder of the year.

So, it is very probable that we're going to have availability that far exceeds the availability or is far better than the availability of last year and we should see very meaningful economic benefit from that. Particularly in the fourth quarter where there were a number of planned outages last year and there's no planned outages this year.

Ashar Khan - SAC Capital

Ok. And then -- on market prices -- you got help in the -- if I remember, on the first quarter, second quarter. I'm trying to -- is there still further market price positive in the remaining second half of the year?

Philip L. Goulding - Senior Vice President and Chief Financial Officer

Some. But we're -- we are, as you're pointing out, we're working our way through it. And it would probably be more in the fourth quarter than the third quarter.

Ashar Khan - SAC Capital

Ok. And then I'm sorry, there were like two calls happening simultaneously, three now. What was the hedging -- could you talk about what hedging you've done for '09 or '10 and were there any more Maryland auctions during this timeframe that you could give us a better idea as to what the Maryland rate would be starting January 1, 2009? Any feedback on that?

Philip L. Goulding - Senior Vice President and Chief Financial Officer

I don't think there's any new data point to give you since the information Paul shared on the last call. We haven't locked in a lot of additional power. Some -- but there's still -- we disclosed our position. We still have a fair amount of open power, 25% in '09 and 30% in '10. So, we'll see where prices are as we fill up that position.

Ashar Khan - SAC Capital

Okay. And then just if I can finish off, I know you did some meaningful hedging on the coal, is it fair that the coal hedging is -- the objectives are done for this year? Or what's the plan because you do stuff in the first half and then -- is it done for this year or are you going to look for it the next time to fill it up next year or how should we look at the coal hedging going forward?

Philip L. Goulding - Senior Vice President and Chief Financial Officer

We're never done. We're always out looking for opportunities that look attractive to us and obviously to our counterparties to enter into contracts but for 2009, we've made some of the main progress we wanted to make immediately. So, we're going to be more selective for '09, '10 and beyond as to what type of contracts we enter into over the coming months.

Ashar Khan - SAC Capital

Ok. Thank you very much.

Philip L. Goulding - Senior Vice President and Chief Financial Officer

Sure.

Operator

And at this time, there are no further questions.

Paul J. Evanson - Chairman of the Board, President, Chief Executive Officer

Okay. Well, we thank you all for joining us. We know we had a lot of other calls at the same time. Which we'll try to work through that as Greg suggested. And look forward to meeting you all in the future. Thank you.

Operator

This concludes today conference call you may now disconnect.

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Source: Allegheny Energy, Inc. Q2 2008 Earnings Call
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