艾索倫電力 (EXC) 2003 Q2 法說會逐字稿

Good day. I'll I would like to turn the program over to your host, Mr. Mayo Shattuck. Go ahead, please.

Good morning, everyone. Thank you for joining us to review our results for the second quarter of 2003. I'm Mayo Shattuck, Chairman and CEO of Constellation Energy. I'm joined here today by several members of our Senior management team, our Chief Financial Officer, Follin Smith, Tom Brooks, President of Risk Management Unit, Constellation Power Source. Tom Brady, Vice President of Strategy and head of commercial and industrial competitive supply businesses, including New Energy and alliance energy services. Mike Wallace also, President of Constellation Generation Group, and Frank Heintz, President of BGE. Our presentation is being web cast. Our comments are focused around slides available on our web site at www.constellationenergy.com under "investor relations." Turning to page 2, our comments today will include forward looking statements which are subject to certain risks and uncertainties. For a complete discussion of these risks, we encourage you to read our documents on file with the SEC. And on page 3, we'll use non-GAAP financial measures in this presentation to help you understand our operating performance. We have attached an appendix reconciling GAAP measures to non-GAAP measures. This appendix is available on our web site. Now, turning to page 4. On our last conference call, Follin and I spent the better part of a half an hour describing how constellation weathered a foreign in the first year. Our balanced business model enabled us to meet expectations despite a run up of natural gas prices and third party generation facility outages that could have disrupted our New England business if not for our superior risk management capabilities. Today we're happy to discuss a quarter in which we are seeing not only the strength of our balanced business model, but also the value of our customer focus business strategy. This is the seventh consecutive quarter that we have met or exceeded guidance. Our constellation power source and industrial marketing business at New Energy exceeded expectations and demonstrated the earnings potential of our competitive supply platform. More importantly our second quarter results are not the results of high levels of speculative risk, rather, derived participation from fiscal in markets, delivering products and services to real customers, employing real assets on a recurring and repeatable basis.

Now, turning to page 5, Constellation Energy is implementing its strategy built upon a fundamental view of energy markets. At its core is our believe that deregulation gives wholesale commercial customers lower cost energy and more options for managing their costs, but deregulation drives complexity for customers because of the variability of commodity prices between regions and at different times of the day and year, and because of the physical knowledge needed to bring it all together. Many will look to outsource the expertise needed to navigate this market environment where at an integrated solution, leveraging physical capabilities risk management skills and creditworthiness is important. Constellation has a significant competitive advantage. We do this in load serving. We do this when customers need special solutions to energy problems. I'll ask you to turn to page 6. By now, I hope you've all had a chance to review the earnings press release. We earned 58 cents per share this quarter which compares to 56 cents per share in the sec quarter of 2002. Heading into the quarter, we expected a quarter over quarter decrease in earnings because we had sizable earnings in the second quarter of 2002, related to our settlement with the California Department of Water Resources. The favorable outcome for the quarter was driven by strong orange origination of wholesale transaction, favorable market conditions in regions where we serve load and strong commercial and industrial supply results at New Energy. BG was able to report earnings within guidance, despite adverse weather conditions. Turning to slide 7. With one half of 2003 complete, I'm very comfortable with our existing 2003 earnings guidance of $2.65 to $2.85 per share. While we enjoyed a strong second quarter in the first half of 2003, much remains to be achieved in the balance of the year. Our performance year to date does however convey growing conviction that our targeted 10% EPS growth rate is real and attainable. The overall earnings visibility inherent business model provides a clear rode map to achieving 10% growth. We have a solid base of earnings from which to build. To achieve our targeted growth, we are counting on continued new origination strength of competitive supply based on our strong physical and risk management skill advantage.

The growth we're counting on is modest when compared to the growth we've been able to achieve in the past 5 years. Cost savings and operational efficiencies derived from productivity initiatives should bear substantial fruit as well. These efforts are real and set to deliver tangible contributions to the bottom line. With that, I'll turn the call over for Follin.

Thank you, Mayo. Good morning, everyone. Thanks for joining us today. Before I launch into a discussion of results, I want to point out to you that last evening, we filed a 10-Q (A), which revises our first quarter 10-Q. The revised filing did not change gross margin, net income or cash flow, but it did reduce our first quarter revenues and operating expenses by $283 million. Quite simply, we had an error, which went undetected until after the Q was filed. In the course of implementing the standard market design in the first quarter, we booked transactions with the ISO as independent transactions. Under standard market design, we buy power from a third party buy the I some in one zone and sell in another zone. We booked that as two buys and two sells, rather than one buy and one sell. The I some transaction should have been netted out. This is an inadvertent error which did not affect any of the metrics by which you judged our first quarter performance. We caught it quickly and are comfortable our controls are good. Turning to slide 9. Second quarter earnings were 58 cents per share. This compares to our April 30th guidance of 33-43 cents per share. Earnings were up, due to strong new wholesale transactions, favorable market conditions, and strong New Energy results. BGE also reported earnings in line with guidance, despite adverse weather conditions. Turning to slide 10, the merchant business earned 45 cents per share, compared to earnings of 39 cents per share in the second quarter of last year. These earnings -- the higher earnings primarily reflect on the favorable side, new wholesale transactions, and a favorable market in , PJM , and New your and Calvert Cliffs . Favorable performance due to a shorter Calvert Cliffs outage. Strong performance at New Energy, and benefits derived from our productivity initiatives. These positives were partially offset by the absence of earnings recognized last year with our settlement with the California Department of Water Resources. And higher interest and other expenses. The interest expense increase relates to a reduction in capitalized interest expense, with a completion of our large power construction project. In turning to slide 11, in total, we generated merchant gross margin of $495 million, up from $357 million in the second quarter of 2002. Our PJM fleet delivered total gross margin of 273 million, or about 55% of our total merchant gross margin. The PJM business was due to a shorter outage alt Calvert Cliffs, stronger origination of PJM, including the assumption of the portfolio of PJM contract from Allegheny and a favorable price environment. With the assumption of the Allegheny PJM portfolio, our PJM fleet is responsible for serving 100% of BGE's standard offers service load through 2006. Our plants with PPAs contributed total gross margin of $146 million or about 30% of our total merchant gross margin. The increase compared to last year is driven by our new High Desert and Oleander plant, and favorable places on the 10% of 9 mile points output sold at market.

Our competitive supply business contributed total gross margin of $85 million, compared to $78 million in 2002. Competitive supply was up, due to the addition of New Energy and alliance, new wholesale transactions and favorable market conditions for managing existing transactions, offset by the absence of the 2002 CDWR settlement. Because of our load serving expanse in the Midwest we now quantity of peak load in this region. Accordingly we've moved our Midwest peakers used to serve line out of the other line and up into the competitive supply line for this analysis. Now, moving to slide 12. Our competitive supply business is executing new business at a pace consistent with our 2003 guidance. The second quarter was a strong one for new transactions. In April, we projected 150 million in new wholesale transactions for 2003. As you can see in the third column, year to date, we generated $108 million, representing 72% of our 2003 wholesale new origination target. Through the second quarter, accrual was $91 million, and $17 million was market to market. New Energy transactions with a total gross margin of approximately $62 million were originated in the second quarter. The second quarter is typically a strong origination quarter for New Energy and this past quarter was no different.

Marge innocence the quarter were consistent with historic levels. In 2003, we expect to realize $28 million from the contracts originated in the second quarter, with the remainder contributing to future earnings. Year to date, we have originated 57% of our 2003 new origination target, and new energies contract renewal rate was over 08% in the first half of the year. When we include the impact of the favorable market environment on our existing business, New Energy is far surpassing the 2003 projections included in our acquisition analysis. In sum, we're delighted with this acquisition, which is now operating in 17 states, and providing energy management solutions to 42 of the fortune 100. Turning to slide 13, in market risk. We've discussed in past presentations, we seek to maintain a highly hedged profile. We believe the strategy is an important contributor to earnings consistency. As shown here, our wholesale and commercial and industrial accrual load serving portfolio is substantially forward-hedged. Our resent transaction to Allegheny to assume its BGE load obligation was an important contributor to increase in our percent hedge statistics. Our value at risk, while up a bit form the last quarter due to the impact of recent market volatility on this rolling average calculation is in line with our historic average. Turning to slide 14. BGE earned 13 cents a share, in line with guidance of 12-16 cents. BGE earnings were 2 cents lower than the second quarter of 2002, primarily due to the effects of cooler weather in central Maryland, compared to a warm second quarter in 2002. This was partially offset by lower turning to slide 15. As expected our other Non-regulated businesses broke even in the second quarter. This compares with a gain of 2 cents a share of last year from non-core real estate and financial investments which has sense been liquidated.

Turning to slide 16 and a look at our balance sheet. Our net debt increased by almost $600 million since March 31 reflecting the termination of our off balance sheet lease for High Desert and the issuance of $550 million in debt to refinance this obligation. We decided to take advantage of historically low interest rates, to refinance this lease and $200 million of BGE debt. We're adjusting the basis for debt to capital ratio here to be consistent with the one we use with the rating age seize, which gives 50% equity credit to our trust preferred. On this basis our debt to total capital ratio is 53%. We expect about a 3 percentage point improvement by year end in our debt to capital ratio, reflecting our normal seasonal pattern of generating most of our cash flow in the second half of the year. Let me provide guidance for the third quarter of 2003. We expect earnings between $1.05 and $1.20 per share, compared to $1.07 per share in the third quarter of last year. We expect the merchants earnings to range between 88 cents and $1.02, compared to 89 cents in the third quarter of 2002. Several favorable items affect the quarter over quarter comparison. New wholesale transactions and already booked transactions which will be realized in the third quarter, positive contributions from our new High Desert plant, and productivity. These positives will be partially offset by higher interest and other cost. We expect BGE to earn between 14 and 19 cents per share compared to 20 cents per share in last year's third quarter. The decrease is largely by an assumed return to normal weather compared to normal than weather 2002 third quarter. The other non-regulated businesses are expected to range between a loss of 1 cent and break even, compared to a loss of 2 cents in the third quarter of last year. As you can deduce, we're looking forward to a strong fourth quarter compared to last year, driven by the scheduled realization of already booked contracts and the addition of High Desert. Turning to slide 18. I want to spend a couple of minutes on two of the key components driving the long-term earnings growth guidance of 10% we presented in January. The following slides show the key drivers that allow us to feel confident in our ability to grow our earnings 10% over the next several years.

Turn to slide 19. In 2005 and beyond years week, expect new competitive supply growth, productivity and the reinvestment of excess cash to contribute at about equal levels to constellations growth. As you'll recall, rather than make guesses about unidentified investments returns, we assumed excess cash goes to repurchase shares in this analysis. These positives are partially offset by a reduction in our CTC revenues. We -- the only significant change in our outlook from our January review with you is current forward prices on un-hedged links would indicate that over the horizon, our merchant's income level should not be negatively affected by BGE’s load rolling of price free service rates. For un-hedged link, changes in power prices will affect the outlook. For example for the year 2005, a $1 change in power prices would affect un-hedged links by about $14 million. Turning to slide 20. This chart focuses on merchant gross margin. We are not ready to give you, of course, a five-year point forecast for growth margin, so there are no numbers on the vertical access. But you'll note that we don't require a lot of overall growth in gross margins to grow our bottom line 10%. Now, on this chart, we've split gross margin into two parts. Now, as existing business, we've included the PJM platform, plants with long dated PPAs, existing wholesale and commercial and industrial contracts, and we've assumed an 85% renewal rate for maturing New Energy contracts. Any un-hedged link is projected at forward prices and we're not counting on an optimistic improvement. You would expect this existing business number to decline as we go further out into the future, because contracts mature and roll off. Businesses that we book each year will continue to add to the existing bucket as we move forward in time. The light colored part of the bar is new wholesale contracts and renewals and new CNI business. Notably, we are not counting on as much new business as we actually had last year, until 2005. For Constellation to achieve its long-term growth target, our new business booking rate must grow at a 9% compound rate off of 2002 levels.

This is significantly below the 38% compound annual growth rate we achieved in the past three years. Turning to slide 21. We're also counting upon productivity to help drive earnings growth. Several of you have asked for a window into our productivity potential. I'll focus today on two areas. Our nuclear facilities and our support staff costs. And the generation plant, we see potential to increase our gross margin by 55-75 million. We have undertaken and will continue to undertake initiatives that will reduce the duration of outages, and increase both the reliability and availability of our plan. We also see opportunities to increase gross margin by improving capacity through power-up rates and planned equipment replacement. Execution of these actions will drive us well into Tom top your lawyer tile performance. Benchmarking indicates we're in for cost improvement against comparable industry top perform performers. We expect to achieve 45-55 million in cost reduction through vendor alliances, strategic sourcing and other efficiency initiatives. For Nine Mile Point, however, we are first making investments in the near term to upgrade equipment and operational processes to increase the value of the plant. Now, in addition we have bench marked our support staff function against best in class companies about our size and see a good opportunity to reduce expense. By getting the cost of these organization to top your lawyer tile performance we will lower our expense base by 30-40 million. We've launched several initiatives to accomplish this and we'll use the six sigma program for driving these savings. This is not easy.

It means changing the way the company has operated for decades. It's too early in the planning cycle for me to tell you whether this will take three years or five years, but the benefits are tangible and the will is there, so you can see this is a meaningful part of our bottom line improvement for years to come. With that, I'll turn the call back over to Mayo to wrap up and for Q & A.

Thank you, Follin. As you all can see, this is a tremendous quarter for constellation and one which we believe is indicative of the quarters to come. We're excited about our position in the energy market, our capabilities, our strength and the students ahead. Thank you for your time this morning and that concludes our prepared remarks. I'll turn the presentation back to the operator for questions.

At this time, we would like to turn the call over to questions. If you would like to ask a question, please press star 1 now on your touchtone telephone. To withdraw your question from the queue, you may press pound. To ask a question, please press star 1 on your touchtone phone. We'll take our first question from the site of Mr. Steve Fleishman of Merrill Lynch.

Hi, everyone.

Hi, Steve.

I guess a couple of questions. First, you touched on kind of favorable market conditions in several of these markets for your business. Can you maybe give a little more flavor on what you consider favorable, in this case, given your customer focus strategy? Does that mean lower, less volatile pricing or kind of what is your -- what were those market conditions?

Well, Steve, this is Tom Brooks. In the first quarter, as you know, we experienced substantial volatility, particularly in the northeast region where we have substantial load serving presence. You know, I would say on balance in the second quarter, experienced much, much less volatility in general, far more stable environment for managing the load business. Now, in the first quarter, I think our results did, as Follin indicated, reflect the ability of our risk management approach to handle the sort of volatility we experienced, but in the second quarter, we, you know, we experienced a more modest volatility and, you know, an easier environment to manage particularly congestion patterns in the northeast.

Okay. I guess second question, Follin, I don't know if you could potentially provide more numbers on the merchant variances that you noted?

Sure. Sure. Between new origination and the favorable market environment, which, of course -- I know Tom doesn't want to talk about our position, but you understand that we naturally will have some links in New York where Nine Mile Point over the seller or in PJM. Between the two of those, it was a favorable year over year variance of 13 cents. Now, you'll recall last quarter, we talked about the accounting mismatch on some hedges, and that -- last quarter, you'll recall it was a negative 7 cents in market to market. This quarter, we still were negatively influenced by rising gas prices, so that drove a negative 7 cents in market to market, but then we had a 4 cent comeback in the accrual block associated with that same phenomena, so that phenomena was a negative 3 cents. When you roll together a shorter Calvert outage than last year, High Desert being on line, partially offset by the Nine Mile Point outage, the generation operations added 17% compared to last year. New Energy add 5 cents, productivity added 4 cents. Interest expense was an increase of 9 cents year over year with about 70% of that relating to lower capitalized interest as plants had been in service this time last year. So interest was being capitalized, and of course, it now flows to the bottom line. And then we had various cost increases of about 17 cents, and that is a combination of comp and benefits, depreciation and amortization from the same generator investment and the new plant insurance cost increases. And then there is about 4 cents of miscellaneous stuff.

Okay. Thoughts on why you are not maybe raising guidance for this year, given the strong Q2? Is it just kind of let's see the third quarter, the big quarter and --

Well, obviously, the way earnings are going for the year, gives us good confidence that we're going to achieve guidance. But the fact is, you know, the way that our year runs, the first six months only represents about a third of our earnings for the year. So there is still a lot to be accomplished in the second half, and we just think it's too early to be so bullish as to raise our guidance.

And one last question for Mayo. Can you discuss any thoughts on difficult dent policy in light of the tax changes? Is your plan to continue to grow the difficult did depend at the 8% rate that you started this year or are you revisiting whether it makes sense to pay kind of a generally step-up level and then grow it?

Yes, Steve, as -- for everyone else, as we hope you saw last Friday, we did affirm our dividend at the current levels, and our predisposition has been to grow our dividend at the rate of earnings growth, mainly because we continue to believe that we have attractive opportunities to reinvest capital at superior returns. Our main goal, obviously is to maximize total shareholder return, and if growth opportunities that are available without excessive risk, you know, somehow become unavailable, you know, or if we see excess cash, we'll return it to shareholders, and it's just probably premature to speculate on how we would return it to shareholders, but the recent tax law changes certainly make dividends a more attractive alternative and my guess is that in every board roam in America, they are addressing that issue at this point.

Okay. Thank you.

Thank you, Steve.

Our next question comes from the site of Jay Dobson of Deutsche Banc.

Good morning, everyone.

Hi, Jay.

Question on the merchant side, can we break out how much that Allegheny contract reacquisition added to the numbers, even if it's in rough terms, since that would be sort of income prab with a year ago?

Jay, we can't do that for you, simply because as has been our practice in the past, we don't reveal earnings associated with specific transactions due to customer confidentiality limitations. I can, you know, to give you a sense of magnitude on this, though, very much was within the normal course from our point of view. A couple of way to his characterize that. Number one, you know that associated with the BGE standard offer service portion of the portfolio, that represents about a 600 megawatt peak. As we told you in January, in the wholesale portion of our competitive supply business, we expect about 7,000 megawatts of new wholesale load serving arrangements to be entered into during '03, so it represents less than 10% of that expectation. From a margin standpoint, a couple of ways to characterize it. Number one, again, I can't reveal the specifics, number 1, it does represent less than a percent of the merchant gross margin that we projected for you in January, and number two, again, just in terms of sort of indicating that this is within the normal course from our point of view, in the last 10 quarters we've entered into 7 transactions of a similar size or larger in terms of its '03 margin impact. So, you know, roughly speaking, this is kind of a -- over the last couple of years, a transaction size of sort of once a quarter type event.

Okay, fair enough. What while we have you on that topic, you talked or Follin did, about the origination successes in the quarter in merchant. I was wondering if you just sort of characterize those sort of -- what they looked like, again, in broad averages, but what's driving the successes there?

Sure. Let's see. In terms of our focus, as we told you before, our basic focus is on providing products to customers that help them manage their energy inputs or outputs. I think we've focused on a distinct set of comer needs, those that rely upon a detailed knowledge of the logistics of delivering, receiving or transporting energy commodities, as opposed to, for instance, a high risk capacity on our part. And certainly, the four requirements, load civic boys -- our load serving business, is a requirement for us. In terms of the business at a wholesale level, we gave you a run-through of our January presentation of our assessment of market size, our share and our expectations for our growth rates and margin -- the margin outlook, and actually, through the first half results have played out pretty consistently with what we told you in January. Volumes are probably -- are somewhat ahead of the expectation, given new volume somewhat ahead of our expectation, given that typically our distribution utility customers enter into new contracts more in the second half of the year, particularly the fourth quarter than in the first half of the year. So on a volume side, I'd say we probably are a bit ahead of pace, on the margin side, actually quite consistent with the expectation that is we articulated in January. In addition, we're seeing some good growth opportunities in a few areas that I'll highlight just quickly. One, fuel-related opportunities. We do have a meaningful native presence in coal, natural gas, and refined products markets over the last year. We've made a very concerted effort to build what is a very strong fuels group, of bringing in a very capable team of professionals to complement the team we had already. And that group is actually having some substantial success in originating transactions of a similar nature in principal to our power load serving business, that is, dealing with physical customer service opportunities. For instance, in the second quarter, we entered into a long-term arrangement to manage the coal delivery from mine mouth to burner tip of two large power plants in the Midwest. Another example would be simply expanding our geographic breadth and we've had some good opportunities in the first two quarters to do that. I think you are aware of our CMS load portfolio acquisition, which is very complementary with our Midwest generation base. We've seen good opportunities from that transaction and associated ones to expand our presence in the Midwest, where heretofore we haven't had a lot of load serving opportunities. Another geographic example of breadth that -- market, where we've over the course of the first two quarters expanded our presence on the supply side of the market. This is as well as in the loads serving base, through CNE and this from our point of view is quite an attractive market. It's a third the sides of New England, but one where we see an opportunity to build a balance presence involving supply resources and loads and one of the approaches that's worked for us in PJM in the northeast. And then finally, we've had over the last couple of years, one of the key features in managing our own generation resources and load is the ability to manage locational basis or congestion within our portfolio. Our generation load are not collocated in most cases, so we have to manage the congestion differential between different points within our own system. This we've become quite adept at doing and have actually found a number of ways to commercialize this capability by offering services to power generators and distribution utilities that help them to manage their own congestion costs. Typically we're not taking incremental congestion risks ourselves by doing that, but rather identifying opportunities where our portfolio aliens well with the portfolio of the customer and where in combination the total congestion picture can be reduced. And in the second quarter, we had a lot of good opportunities to do that sort of business through quite a number of transactions, but in total, they've probably yielded about $15 million in gross margin.

Some people said market liquidity and some competitive actions have changed. Would you be able to cite any of that as driving some of these results?

I guess I would say market liquidity, you know, affected us not really positively or negatively. Certainly it picked up from the level that existed at the end of the first quarter or, you know, or early in the second quarter. You know, we have seen the entrance of a number of financial services companies that seem more and more interested in the energy commodities business. From our point of view, this is a big net positive. We don't see ourselves as really a direct competitor with these sorts of players, but it's very useful to us to have a capable and creditworthy parties out there with whom we can manage our own risks.

And just last question, Follin, any reason for the change in the tax rate, and I mean that to say any substantive reason.

No.

Great. Thanks very much.

Our next question comes from the site of Mr. Dan Eggers CSFB.

I guess my first question, I was wondering if you could comment on the nature of contracts you guys are seeing at the origination site from the sense of length. I think you guys were anticipating a shortening. It doesn't look like they really shortened at CNI.

This is Tom Brady. We are seeing in certain markets, we are seeing contracts, extensions, some of them, for example, out in the Midwest where we would have run contracts all the way out to 2005. So we have seen as prices have dropped there for the first quarter, and the volatility of prices came back and the wholesale prices game down. We've clearly seen customers wanting to lock in for a slightly longer time than they were in the first quarter when they were more interested in index-type product.

And Dan, on the wholesale side, I guess my comment would be, I think the year has kind of played out thus far, as I said before, quite consistent with the expectation that is we articulated in January.

You guys expect 85% customer renewals in the future. How is that comparing with the origination you've picked up this quarter which you've seen since you acquired the business.

This is Tom Brady again. This is right on track. We're seeing renewals in excess of 80% across basically all of the markets we're in right now.

Okay. Looking at the working capital scenario, as competitive supply continues to grow, what are your feelings concerning working capital to keep funding the business over the next couple of years?

Interestingly, the business growth as we project it doesn't require a whole lot of incremental working capital. You've got to keep liquidity in case in order to handle fluctuations that happen as market prices move in collateral that you have to post. But surprisingly, it's not that extreme. For example, in the very extreme price moves in the first quarter, we had a change in net collateral posted of about $30 million. We do keep, you know, right now, we've got unused facilities of a billion-seven. We've got 400 of those. We keep between 300 and 400 million of those used for LCs, so we've got substantial excess unused facilities. We think it's prudent to keep the extra liquidity around, but, you know, the business does not demand radical amounts of excess liquidity.

Great. Thank you. I have just one more, nine mile is about 10% of output exposed to the market. Is that going to continue to stay completely spot or is there anticipation of contracting some that have?

Well, Dan, we really manage that as part of the overall portfolio, and I guess I'd encourage you to think of it not exactly discreetly, because we're not managing in that way. I think managing in that way. I think Follin's characterization of our overall hedge picture, I think, is probably a more relevant way to think about it. If we saw an attractive opportunity to forward sell, we would certainly do it, but I don't think we feel compelled to manage that specific piece of our portfolio in a particular way. We're much more oriented to managing the overall portfolio.

Okay, thank you guys.

Our next question comes from the site of Mr. Neil Stein of John Leaven and Company.

How is it going?

Hi, Neil.

I have a handful of questions. First, the quarter was up substantially relative to your guidance, you know, nearly 50%. Having trouble, you know, kind of understanding what in particular drove that. Could you be specific and also maybe provide some numbers on the particular item?

Sure. I'd be glad to, Neil. Compared to our guidance, origination drove about 7 cents Meyer -- 7 cents higher earnings compared to our guidance, an I'm talking now off of the high end of the guidance range, Neil. Origination was about 7 cents. Various market factors, you've heard me say a favorable market environment, when I say "a favorable market environment," I'm talking about where movements in prices were favorable for us, where managing congestion was favorable for us. That worked out to about 13 cents, compared to what we would have expected. The hedge accounting mismatch that I described to you before was about 3 cents. New Energy was up 4 cents cop compared to our expectations, and that summarizes the big drivers.

The hedging variance, is that really above expectation? Because you expected that to bleed back in over the year.

Well, actually, I think I spoke incorrectly there. We expected to have the accrual come back of 4 cents that I described, but we would not have -- what we would not have counted on, of course, is further changes in market prices that hit us by a negative 7 cents in the market to market area.

I'll maybe deal with that offline. I have a few more. You talk about favorable movement in prices being a positive 13 cents. Where exactly does that show up in the business? Because generally you talk about pretty much locking in, entering into back to back contracts on a lot of your load serving deals and things at New Energy. So how is it that you actually do benefit from prices, and particularly to that extent?

Well, I think we spoke earlier about the fact that we have got some links and PJM and in New York with Nine Mile Point, and we have favorable outcomes on the way that we managed congestion. In fact, we tend to forecast that stuff pretty conservatively.

And it's typical for us with respect to the load businesses. It's typical for us coming into the prompt quarter to maintain a bit of length.

Could you explain what that means?

Well, given the potential for exposure to events like unit outages, you know, coming into a month, let's say, we would typically have a bias to be a little bit longer as apposed to, let's say, a little bit short than our expected load requirements.

I got you. Just moving on, what were market to market earnings during the quarter? And what were they last year?

Hang on just a second. Market to market gross margin was a loss of $7.8 million, and that includes the negative on the fuel hedges that I described before of $20 million, and last year market to market, gross margin, was $85 million.

So, despite the big drop, so that's like a 92 -- am I incorrect here?

Yeah, you're correct.

Despite that, you're still at that number. Could you talk about -- your market to market target, you said it was lowered to around $70 million and it had been $110 million. So far this year, you've locked in -- it looks like 17 million?

Right.

It's kind of short. Do you think we're just going to see accrual results kind of overshadow the market to market activity?

Yeah, I guess to be truthful, I sort of rue the day we broke down our guidance for origination between market to market and accrual because you know, to be honest, that's not how we run the business, right? We organize the business around customers and the business that they wanted to do to date has been accrual. We view this positively. You know, we've been making an effort to transition the business away from market to market, which people tend to associate more with trading type business to more of a physical delivery business, which tends to drive more of an accrual treatment, those types of transactions. So, you know, yes, market to market is down, and yes, we are pleased with that outcome.

And the negative 7.8 million of market to market for Q2, that was expected?

No. That was driven by, again, you'll remember we had -- as we moved to EITF 02-3 Neil, we had to, of course, move lots of positions out of market to market and into accrual. Now, some of the underlying hedges on those positions didn't qualify for hedge accounting treatment. So we had a situation where we had good economic hedges being treated on a market to market basis, whereas the underlying position was receiving accrual accounting treatment. So when you have changes in market prices, and in this situation we had the hedges being negatively affected, the market to market being negatively affected, we had a negative market to market and then the offsetting favorable earnings will flow through earnings over time on the accrual side. So that's what I keep talking about the hedge accounting mismatch. We had a negative 20 in market to market. That'll flow back to us in accrual earnings over the next year and a half or so.

And then my last one, just on this accounting error, is it that you weren't aware of the proper accounting treatment or you were aware of it but somehow the mistake got made any way?

No, absolutely, we were aware of the proper accounting treatment. We don't have that sort of situation very often in the PJM because our load and our generation reside in the same zone, so we aren't crossing zones very often, but we have to deal with that sometimes in PJM and other regions where standard market design has already been implemented. So we were fully aware of it. It was just an error, and the way it happened, Neil, is we had to program in how operationally standard market design will work in the NEPUL. Now in NEPUL where there had been no zones, now we will buy from a their-party generator in one zone, we have to keep track of the transaction in our systems, where we sell to the ISO in that zone and we have to buy from the ISO in the next zone and sell to our end use customer in the subsequent zone. We have to keep track of that series of transactions in our systems. We have to keep track of it for settlement purposes, because that's the way the ISO tracks it. We've got to keep track of it for actually capturing the right gross margin, because we sell to the ISO at a different price than we buy from the ISO, that is how they charge congestion cost. We had to program it that way, but, as we converted our operational system into financial accounting results, we should have netted out the transaction to the ISO. Now, why did it not happen, when we knew that was the right thing to have happen? Well, we have two different key controls, one that should have prevented the error is a control by where you test systems changes, and after you test the systems change, the person who requests the systems change should go in and test the change. And indeed, we did test the change, but we tested it at the gross margin level, and insured that the gross margin was correct. Why didn't we also test revenues and expenses? Well, up until January 1st, all that had really mattered in NEPUL was gross margins, because most of the transactions on our books had been market to market up until that point. And gross market is equivalent to revenue in a market to market world. January first we implemented EITF 02-3 which converted us from market to market to accrual.

I see.

At that point we should have begun to test revenues and expenses. And then the other thing which should have caught it and is what ultimately caught it is a line by line analysis of our financial statement so you would be compares revenues in the first quarter in '02 to revenues in the first quarter of '03, and Frank explained all of the differences. In that situation, indeed, the proper analysis was done, but the increase in revenues was attributed to EITF 02-3 which resulted in a massive increase in revenues. The revenues in '03 where a billion-one, and they stepped up to 2.3 billion in the first quarter of 02-03 with the 80% of that or 70% of that being driven by the implementation of this accounting change. So it was the confluence of a big operational change in NEPUL and this big accounting change which drove massive increases in our reported revenues that allowed this error to happen.

Our next question comes from the site of Carrie Stevens at Morgan Stanley.

Hi, carry.

Good morning, a lot of the questions have been answered buy a few outstanding. First, I liked how you gave the comparison of competitive supply to your original guidance. Could you do that for year to date productivity improvements as well?

Well, Carrie, let me see if I can do that.

If not, we can follow up off line. I also --

Actually, Carrie, I do have it.

Okay, great.

We've achieved about half of our productivity target through the second quarter.

Okay.

And given that these things tend to build, we are pretty pleased with the outcome. They tend to build through the course of the year.

So one half. Great. Does that mean that maybe you would be a little bit in excess by year end?

Well, nobody is committed to increasing their productivity targets, so I'm not going to sign up for the rest of the management team.

Yeah, no, that's fair. Just one last technical and then I have a couple bigger picture. Weather impacts versus normal for the quarter?

Whether was a negative 1 cent versus normal.

Okay, great. Then since Frank Heintz I believe is in the room, I just wanted to get an update on the filings for the generation auction for the next step of the polar, how that's proceeding?

In April, the public service commission approved the phase 1 settlement in the polar case. As you know, Carrie Polar case is the provider of last resort framework applies not only to BGE, but the other investor-owned utilities in the state. The commission approved the framework for the polar provision of services by utilities after the current standard offer service restructuring provisions come to an end. On a July 2nd, earlier this month, the parties to the case filed a settlement in phase 2, which goes into increasing detail as to how the polar auctions will occur, and how the load arrangements for wholesale supply will be made. So essentially, bottom line, the polar case is on track. The rules are being defined and I would anticipate a Commission approval of the phase 2 settlement in perhaps late September.

So, do you have any initial timing for when that auction may take place?

Look for auctions by the investor-owned utilities in early 2004.

Okay. And was there any -- you know, how much would be termed up, you know, like how much load will be a one year, two year, three year contract?

Under the phase 2 settlement, there will be a set of contracts for one year duration, a set for two-year duration, and a set for three-year duration, and you might just think of them as about a third, a third, a third.

Okay, great. And lastly for Mayo, just maybe, you know, you guys have discussed growth through acquisition, you know, in the past, and just wanted to get an update on that, especially in light of, I guess, you know, increased chance that maybe PUCO would be repealed. Would that shift your focus more at looking at companies or are you still predominantly looking at asset acquisition opportunities?

I don't think Carrie, that at this point, that the status of PUCO would be particularly relevant for us. We continue to have an active development utilities in both the contractual asset arena and additions to our New Energy platform. There are a number of things that are ongoing there, and on the other side of the house, generation, as we've described before, I feel we have a very robust process and team evaluating generation activities. It's been very disappointing that the market hasn't reached its appropriate equilibrium to date, but I think our sense in the last quarter, I think particularly with the three bankruptcies that took place, that we are getting closer to market clearing prices, getting to the point where companies like ourselves will buy at values that reach our own hurdle rates, but it's been a long time coming. There are a lot of natural forces that are working against that particularly the banks' interests, but the activity levels remains high there and, you know, I suspect that we'll begin to see some of these assets clearing the market over the course of the next couple of quarters.

Any particular assets that are more -- I mean, I think you've talked about base loads. Is that still kind of where your focus is?

I'll say two things to that. One is that obviously we're interested in assets that match our load-serving requirements so that they might be strategically located, and secondarily, that, based on what those load requirements might be, we're interested in assets that fit the profile in the stack that have a physical balance to our overall portfolio. So, I think that from our standpoint, we're able to narrow the available field both regionally and their positioning with the stack as to how interested we are with them.

Okay, great. Thanks a lot.

So with that, I guess we have reached our time limit, and I want to thank everybody for being on the call this morning. The team will be available for discussions in private calls afterwards. So, again, thank you. And we'll look forward to seeing you next quarter.

This concludes our conference call for today. You may now disconnect your lines, and thank you for participation.