UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

FORM 10-K

 

Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the Fiscal Year Ended September 30, 2006

 

 

Securities registered pursuant to Section 12(b) of the Act (as of September 30, 2006):
Title of each class			Name of each exchange on which registered
WGL Holdings, Inc. common stock, no par value			New York Stock Exchange

 

Securities registered pursuant to Section 12(g) of the Act (as of September 30, 2006):
Title of each class			Name of each exchange on which registered
Washington Gas Light Company preferred stock, cumulative, without par value:
$4.25 Series			Over-the-counter bulletin board
$4.80 Series			Over-the-counter bulletin board
$5.00 Series			Over-the-counter bulletin board

 

Indicate by check mark if each registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

WGL Holdings, Inc.		Yes  X  No
Washington Gas Light Company		Yes       No  X

 

Indicate by check mark if each registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes       No  X 

 

Indicate by check mark whether each registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrants were required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes  X  No      

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrants’ knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  X 

 

Indicate by check mark whether each registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

WGL Holdings, Inc.		Large Accelerated Filer  X		Accelerated Filer		Non-Accelerated Filer
Washington Gas Light Company		Large Accelerated Filer		Accelerated Filer		Non-Accelerated Filer  X

 

Indicate by check mark whether each registrant is a shell company (as defined in Rule 12b-2 of the Act): Yes       No  X 

 

The aggregate market value of the voting common equity held by non-affiliates of the registrant, WGL Holdings, Inc., amounted to $1,475,648,252 as of March 31, 2006.

 

WGL Holdings, Inc. common stock, no par value outstanding as of October 31, 2006: 48,885,617 shares.

 

All of the outstanding shares of common stock ($1 par value) of Washington Gas Light Company were held by WGL Holdings, Inc. as of October 31, 2006.

 

DOCUMENTS INCORPORATED BY REFERENCE

Portions of WGL Holdings, Inc.’s definitive Proxy Statement and Washington Gas Light Company’s definitive Information Statement in connection with the 2007 Annual Meeting of Shareholders, to be filed with the Securities and Exchange Commission pursuant to Regulation 14A and 14C not later than 120 days after September 30, 2006, are incorporated in Part III of this report.

 

WGL Holdings, Inc.

Washington Gas Light Company
For the Fiscal Year Ended September 30, 2006

 

Table of Contents

 

 

WGL Holdings, Inc.

Washington Gas Light Company

 

 

 

 

This Annual Report on Form 10-K is a combined report being filed by two separate registrants: WGL Holdings, Inc. (WGL Holdings) and Washington Gas Light Company (Washington Gas). Except where the content clearly indicates otherwise, any reference in the report to “WGL Holdings,” “we,” “us” or “our” is to the holding company or the consolidated entity of WGL Holdings and all of its subsidiaries, including Washington Gas which is a distinct registrant that is a wholly owned subsidiary of WGL Holdings.

 

The Management’s Discussion and Analysis of Financial Condition and Results of Operations (Management’s Discussion) included under Item 7 is divided into the following two major sections:

 

 

Included under Item 8 are Consolidated Financial Statements of WGL Holdings and the Financial Statements of Washington Gas. Also included are the Notes to Consolidated Financial Statements that are presented on a combined basis for both WGL Holdings and Washington Gas.

 

The Management’s Discussion for both WGL Holdings and Washington Gas should be read in conjunction with the respective company’s financial statements and the combined Notes to Consolidated Financial Statements.

 

Unless otherwise noted, earnings per share amounts are presented on a diluted basis, and are based on weighted average common and common equivalent shares outstanding.

 

Certain matters discussed in this report, excluding historical information, include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 with respect to the outlook for earnings, revenues and other future financial business performance or strategies and expectations. Forward-looking statements are typically identified by words such as, but not limited to, “estimates,” “expects,” “anticipates,” “intends,” “believes,” “plans,” and similar expressions, or future or conditional verbs such as “will,” “should,” “would” and “could.” Although the registrants, WGL Holdings and Washington Gas, believe such forward-looking statements are based on reasonable assumptions, they cannot give assurance that every objective will be achieved. Forward-looking statements speak only as of today, and the registrants assume no duty to update them. The following factors, among others, could cause actual results to differ materially from forward-looking statements or historical performance:

 

 

WGL Holdings, Inc.

Washington Gas Light Company

 

 

The outcome of negotiations and discussions that the registrants may hold with other parties from time to time regarding utility and energy-related investments and strategic transactions that are both recurring and non-recurring may also affect future performance. All such factors are difficult to predict accurately and are generally beyond the direct control of the registrants. Accordingly, while they believe that the assumptions are reasonable, the registrants cannot ensure that all expectations and objectives will be realized. Readers are urged to use care and consider the risks, uncertainties and other factors that could affect the registrants’ business as described in this Annual Report on Form 10-K. All forward-looking statements made in this report rely upon the safe harbor protections provided under the Private Securities Litigation Reform Act of 1995.

WGL Holdings, Inc.

Washington Gas Light Company

 

 

Active Customer Meters: Natural gas meters that are physically connected to a building structure within the Washington Gas distribution system and service is active. Customers are billed for flowing gas and/or fixed charges.

 

Book Value Per Share: Common shareholders’ equity divided by the number of common shares outstanding.

 

Bundled Service: Service in which customers purchase both the natural gas commodity and the distribution or delivery of the commodity from the local regulated utility. When customers purchase bundled service from Washington Gas, no mark-up is applied to the cost of the natural gas commodity that is passed through to customers. Washington Gas has an opportunity to earn a fair rate of return on the net investment used to deliver natural gas.

 

City Gate: A point or measuring station at which a gas distribution company such as Washington Gas receives natural gas from an unaffiliated pipeline or transmission system.

 

Delivery Service: The regulated distribution or delivery of natural gas to retail customers. Washington Gas provides delivery service to retail customers in Washington, D.C. and parts of Maryland and Virginia.

 

Dividend Yield on Book Value: Dividends declared per share divided by book value per share.

 

Firm Customers: Customers whose gas supply will not be disrupted to meet the needs of other customers. Typically, this class of customer comprises residential customers and the vast majority of commercial customers.

 

Gross Margin: Revenues, less the associated cost of energy.

 

Heating Degree Day (HDD): A measure of the variation in weather based on the extent to which the daily average temperature falls below 65 degrees Fahrenheit.

 

HVAC: Heating, ventilating and air conditioning products and services.

 

Interruptible Customers: Large commercial customers whose service can be temporarily interrupted in order for the regulated utility to meet the needs of firm customers. These customers pay a lower delivery rate than firm customers and they must be able to readily substitute an alternate fuel for natural gas.

 

Market-to-Book Ratio: Market price of a share of common stock divided by its book value per share.

 

Merchant Function: The purchase of the natural gas commodity by Washington Gas on behalf of retail customers.

 

New Customer Meters Added: Natural gas meters that are newly connected to a building structure within the Washington Gas distribution system. Service may or may not have been activated.

 

Payout Ratio: Dividends declared per share divided by basic earnings per share.

 

PSC of DC: The Public Service Commission of the District of Columbia is a three-member board that regulates Washington Gas’ distribution operations in the District of Columbia.

 

PSC of MD: The Public Service Commission of Maryland is a five-member board that regulates Washington Gas’ distribution operations in Maryland.

 

Regulated Utility Segment: Includes the operations of Washington Gas which are regulated by regulatory commissions located in the District of Columbia, Maryland and Virginia, and the operations of Hampshire Gas Company which are regulated by the Federal Energy Regulatory Commission.

 

Retail Energy-Marketing: Unregulated sales of natural gas and electricity to end users by our subsidiary, Washington Gas Energy Services, Inc.

 

Return on Average Common Equity: Net income divided by average common shareholders’ equity.

 

Revenue Normalization Adjustment (RNA): A regulatory billing mechanism designed to stabilize the level of net revenues collected from customers by eliminating the effect of deviations in customer usage caused by variations in weather from normal levels, and other factors such as conservation. Currently, an RNA is in effect for Maryland customers.

 

SCC of VA: The State Corporation Commission of Virginia is a three-member board that regulates Washington Gas’ distribution operations in Virginia.

 

Service Area: The region in which Washington Gas operates. The service area includes Washington, D.C., and the surrounding metropolitan areas in Maryland and Virginia.

WGL Holdings, Inc.

Washington Gas Light Company

 

Tariffs: Documents issued by the regulatory commission in each jurisdiction that set the prices Washington Gas may charge and the practices it must follow when providing utility service to its customers.

 

Third-Party Marketer: Unregulated companies that sell natural gas and electricity directly to retail customers. Washington Gas Energy Services, Inc., a subsidiary company of Washington Gas Resources Corp., is a third-party marketer.

 

Therm: A natural gas unit of measurement that includes a standard measure for heating value. We report our natural gas sales and deliveries in therms. A therm of gas contains 100,000 British thermal units of heat, or the energy equivalent of burning approximately 100 cubic feet of natural gas under normal conditions. Ten million therms equal approximately one billion cubic feet of natural gas.

 

Unbundling: The separation of the delivery of natural gas or electricity from the sale of these commodities and related services that, in the past, were provided only by a regulated utility.

 

Utility Net Revenues: Utility revenues, less the associated cost of gas and applicable revenue taxes.

 

Value-At-Risk: A risk measurement that estimates the largest expected loss over a specified period of time under normal market conditions within a specified probabilistic confidence interval.

 

Washington Gas: Washington Gas Light Company is a subsidiary of WGL Holdings, Inc. that delivers and sells natural gas primarily to retail customers in accordance with tariffs set by the PSC of DC, the PSC of MD and the SCC of VA.

 

Washington Gas Resources Corporation: Washington Gas Resources Corp. is a subsidiary of WGL Holdings, Inc. that owns the majority of the non-utility subsidiaries.

 

WGEServices: Washington Gas Energy Services, Inc. is a subsidiary of Washington Gas Resources Corp. that sells natural gas and electricity to retail customers on an unregulated basis.

 

WGESystems: Washington Gas Energy Systems, Inc., is a subsidiary of Washington Gas Resources Corp. that offers HVAC-related products and services to commercial customers.

 

WGL Holdings: WGL Holdings, Inc. is a holding company that became the parent company of Washington Gas Light Company and its subsidiaries effective November 1, 2000.

 

Weather Insurance Policy: An insurance policy that provides protection from the negative financial effects of warmer-than-normal weather during the winter heating season.

 

Weather Derivative: A financial instrument that provides protection from the negative financial effects of warmer-than-normal weather during the winter heating season.

WGL Holdings, Inc.
Washington Gas Light Company
Part I
Item 1. Business

 

INTRODUCTION

 

WGL Holdings is a holding company that was established on November 1, 2000. WGL Holdings owns all of the shares of common stock of Washington Gas, a regulated natural gas utility, and all of the shares of common stock of Washington Gas Resources Corporation (Washington Gas Resources), Hampshire Gas Company (Hampshire) and Crab Run Gas Company (Crab Run). Washington Gas Resources owns all of the shares of common stock of various unregulated, energy-related businesses.

 

WGL Holdings, through its subsidiaries, sells and delivers natural gas, and provides a variety of energy-related products and services to customers primarily in Washington, D.C., and the surrounding metropolitan areas in Maryland and Virginia. Our core subsidiary, Washington Gas, engages in the delivery and sale of natural gas that is regulated by regulatory commissions in the District of Columbia, Maryland and Virginia. Through the wholly owned subsidiaries of Washington Gas Resources, we also offer energy-related products and services.

 

 

WGL Holdings is the parent of four direct, wholly owned subsidiaries. The following paragraphs describe each subsidiary in the WGL Holdings’ corporate structure at September 30, 2006.

 

Washington Gas—is a regulated public utility that delivers and sells natural gas to customers in Washington, D.C. and adjoining areas in Maryland, Virginia and several cities and towns in the northern Shenandoah Valley of Virginia. Washington Gas has been engaged in the natural gas distribution business for 158 years, since its incorporation by an Act of Congress in 1848. Washington Gas has been a domestic corporation of the Commonwealth of Virginia since 1953, and a corporation of the District of Columbia since 1957. Washington Gas serves over one million customers in an area having a population estimated at five million.

 

As of September 30, 2006, Washington Gas had 1.032 million active customer meters. Active customer meters reflect all natural gas meters connected to the Washington Gas distribution system, excluding those meters that are not currently receiving service. The following table lists the number of active customer meters and therms delivered by jurisdiction as of and for the year ended September 30, 2006.

 

 

Of the 1.577 billion therms delivered in fiscal year 2006, 813.8 million therms, or 51.6 percent, were sold and delivered by Washington Gas and 763.1 million therms, or 48.4 percent, were delivered by Washington Gas to various customers that acquired their natural gas from competitive natural gas suppliers described as third-party marketers. Of the total therms delivered, Washington Gas delivered 76.8 percent to firm residential and commercial customers, 16.3 percent to interruptible customers, and the remaining 6.9 percent to customers that use natural gas to generate electricity either under an interruptible or special firm contract.

 

Washington Gas Resources—owns most of our unregulated subsidiaries. The subsidiaries of Washington Gas Resources, as described below, include Washington Gas Energy Services, Inc. (WGEServices), Washington Gas Energy Systems, Inc. (WGESystems) and Washington Gas Credit Corporation (Credit Corp.). On September 29, 2006, Washington Gas Resources sold all of the outstanding shares of common stock of its wholly owned subsidiary, American Combustion Industries, Inc. (ACI), a full-service mechanical contractor that offered turnkey products and services associated with mechanical heating, ventilating and air conditioning (HVAC) systems. Refer to Note 2 of the Notes to Consolidated Financial Statements for a further discussion of the ACI sale. Effective December 4, 2006, Washington Gas Resources dissolved its wholly owned subsidiary, WG Maritime Plaza I, Inc. (WG Maritime), which held a carried interest in two buildings developed on land owned by Washington Gas. These two buildings were

 

WGL Holdings, Inc.
Washington Gas Light Company
Part I
Item 1. Business (continued)

sold in fiscal year 2004. Refer to the section entitled Properties under Item 2 of this Form 10-K for further information related to a development project on this land.

 

WGEServices—is engaged in the sale of natural gas and electricity to retail customers in competition with other unaffiliated, unregulated marketers. At September 30, 2006, WGEServices served approximately 142,700 residential, commercial and industrial natural gas customers, and 63,300 electricity customers located in Maryland, Virginia, Delaware and the District of Columbia. WGEServices purchases natural gas and electricity for resale and does not own or operate any natural gas or electric generation, production, transmission or distribution assets. Washington Gas delivers most of the natural gas sold by WGEServices. Unaffiliated electric utilities deliver all of the electricity sold by WGEServices.

 

WGESystems—is a provider of commercial energy services, including the design, construction and renovation of mechanical HVAC systems, electrical distribution systems, control and security systems, energy conservation measures, and alternative energy technologies to institutional and commercial customers in the District of Columbia and parts of Virginia and Maryland.

 

Credit Corp.—offered financing to customers to purchase gas appliances and other energy-related equipment. This business no longer offers new loans, but continues to service its existing loan portfolio. Substantially all of this loan portfolio has been amortized and, therefore, is not material.

 

Hampshire—is a regulated utility that operates an underground natural gas storage facility in Hampshire County, West Virginia. Washington Gas purchases all of the storage services of Hampshire. Washington Gas includes the cost of these services in the bills sent to its customers. Hampshire is regulated under a cost of service tariff by the Federal Energy Regulatory Commission (FERC).

 

Crab Run—is an exploration and production company whose assets are managed by an Oklahoma-based limited partnership in which Crab Run is a limited partner. At September 30, 2006, Crab Run’s investment in this partnership was not material. WGL Holdings’ investment in this subsidiary also is not material, and we expect that future investments in Crab Run will be minimal.

 

Through our subsidiaries, as described above, we have three operating segments: 1) regulated utility; 2) retail energy-marketing and 3) commercial HVAC products and services. These three segments are described below. Transactions not specifically identifiable in one of these three segments are accumulated and reported in the category “Other Activities.”

 

  Regulated Utility

 

With approximately 92 percent of our consolidated total assets, the regulated utility segment consists of Washington Gas and Hampshire. Washington Gas delivers natural gas to retail customers in accordance with tariffs approved by the regulatory commissions that have jurisdiction over Washington Gas’ rates. Washington Gas also sells natural gas to customers who have not elected to purchase natural gas from unregulated third-party marketers. Washington Gas does not earn a profit or incur a loss when it sells the natural gas commodity because utility customers are charged for the natural gas commodity at the same cost that Washington Gas incurs. At September 30, 2006, Washington Gas was selling and delivering the natural gas commodity to 85.7 percent of its customers. The remaining 14.3 percent of Washington Gas’ customers utilized the delivery services of Washington Gas for delivery of the natural gas commodity purchased from unregulated third-party marketers, such as WGEServices.

 

Hampshire, regulated by the FERC, is also part of our regulated utility segment. Hampshire operates an underground natural gas storage facility that provides services exclusively to Washington Gas. Hampshire operates under a “pass-through” cost of service-based tariff approved by the FERC, and adjusts its billing rates to Washington Gas on a periodic basis to account for changes in its investment in utility plant and associated expenses.

 

During fiscal years ended September 30, 2006, 2005 and 2004, the regulated utility segment reported total operating revenues of $1.6 billion, $1.4 billion and $1.3 billion, respectively, representing 62.1 percent, 64.8 percent and 62.6 percent, respectively, of consolidated total operating revenues.

 

Factors critical to the success of the regulated utility segment include: (i) operating a safe and reliable natural gas distribution system; (ii) having sufficient natural gas supplies to serve the demand of its customers; (iii)  being competitive with other sources of energy such as electricity, fuel oil and propane and (iv) recovering the costs and expenses of this business in the rates it charges to customers.

 

WGL Holdings, Inc.
Washington Gas Light Company
Part I
Item 1. Business (continued)

  Retail Energy-Marketing

 

The retail energy-marketing segment includes the operations of our WGEServices subsidiary which competes with other unregulated third-party marketers by selling natural gas and electricity directly to residential, commercial and industrial customers. WGEServices buys and resells natural gas and electricity with the objective of earning a profit through competitively-priced contracts. These commodities are delivered to retail customers through the assets owned by regulated utilities, such as Washington Gas or other unaffiliated natural gas or electric utilities.

 

Factors critical to the success of the retail energy-marketing segment include: (i) managing the market risk of the difference between the sales price committed to customers under sales contracts and the cost of natural gas and electricity needed to satisfy these sales commitments; (ii) managing credit risks associated with customers of and suppliers to this segment; (iii) having sufficient deliverability of natural gas and electric supplies and transportation to serve the demand of its customers which can be affected by the ability of natural gas producers, pipeline gatherers, natural gas processors, interstate pipelines, suppliers of electricity and regional electric transmission operators to deliver the respective commodities and (iv) controlling the level of selling, general and administrative expenses, including customer acquisition expenses.

 

  Commercial HVAC

 

The commercial HVAC segment includes the operations of our WGESystems subsidiary which manages design-build and renovation projects and provides maintenance services to the commercial and government markets. There are many competitors in this business segment. WGESystems focuses on retrofitting the mechanical, electrical and energy-related systems of a large number of aging commercial and government structures, primarily in the District of Columbia and portions of Maryland and Virginia. Factors critical to the success of the commercial HVAC segment include: (i) generating adequate revenue from the government and private sectors in the facility construction and retrofit markets; (ii) building a stable base of customer relationships; (iii)  estimating and managing fixed-price contracts and (iv) controlling selling, general and administrative expenses.

 

For a further discussion of segment financial results, see Note 17 of the Notes to Consolidated Financial Statements.

 

 

Washington Gas is regulated by the Public Service Commission of the District of Columbia (PSC of DC), the Public Service Commission of Maryland (PSC of MD) and the State Corporation Commission of Virginia (SCC of VA). The following section, “General Regulatory Matters,” is a discussion of Washington Gas’ general regulatory issues, and the section entitled “Jurisdictional Rates and Regulatory Matters” is a discussion of information regarding each commission and recent regulatory proceedings.

 

  General Regulatory Matters

 

For the majority of its business, Washington Gas charges its customers a price based on the combination of the cost it incurs for the natural gas commodity, including charges for interstate pipeline services, and a charge for delivering natural gas to its customers (also refer to the section below entitled “Natural Gas Unbundling”). In all jurisdictions, the cost of the natural gas commodity and the charge for the delivery service are determined as separate components of customers’ bills. The charge for the delivery service component of customers’ bills varies based on the type of service being provided, such as for firm or interruptible service.

 

Regulated Service to Firm Customers.  In the District of Columbia jurisdiction, the rate schedules for firm delivery service are based upon: (i) a flat volumetric charge for the delivery of each therm of natural gas consumed and (ii) a fixed customer charge designed to recover certain fixed costs associated with maintaining facilities located on the customer’s property, as well as certain other costs that do not vary with the amount of natural gas consumed by customers. Non-residential firm customers in the District of Columbia also pay a peak-usage charge designed to recover the cost to serve customers during peak periods. In the Maryland and Virginia jurisdictions, the rate schedules for firm delivery service are composed of: (i) a fixed charge per customer and (ii) a variable volumetric rate structured as a declining rate based on increasing blocks of volumes. Declining block rates have the effect of minimizing fluctuations in revenues that otherwise would result from deviations from normal weather. Effective October 1, 2005, rate schedules in the Maryland jurisdiction also reflect the effects of a new billing mechanism (refer to the section entitled “Jurisdictional Rates and Regulatory Matters—Maryland Jurisdiction”).

 

The tariff provisions for firm sales service customers in each Washington Gas jurisdiction contain gas cost recovery mechanisms. These mechanisms provide for the recovery of the invoice cost of natural gas, including the cost to store and transport the gas commodity to Washington Gas’ city gate, applicable to firm customers. Under these mechanisms, firm customer rates are adjusted periodically to reflect increases and decreases in the actual cost of gas. Moreover, provisions in each jurisdiction provide for an annual

 

WGL Holdings, Inc.
Washington Gas Light Company
Part I
Item 1. Business (continued)

reconciliation of gas costs collected from firm customers to the applicable invoice cost of gas paid to natural gas suppliers, as well as the invoice cost of storage and transportation paid to pipeline companies, on behalf of these customers. Differences between the amount collected from customers and what is paid to suppliers for natural gas are collected from or refunded to customers over subsequent periods. Washington Gas receives from or pays to its customers in the District of Columbia and Virginia, at short-term interest rates, carrying costs associated with under- or over-collected gas costs recovered from its customers.

 

Regulated Service to Interruptible Customers.  Interruptible service is primarily a delivery service to certain qualified customers where the delivery can be “interrupted” under certain conditions. A limited number of interruptible customers in the District of Columbia and Virginia elect to receive a service which includes the sale of the natural gas commodity and the delivery of that commodity. To qualify for interruptible service, customers must be capable of either substituting an alternate fuel for natural gas or operating without utilizing natural gas should Washington Gas determine that it must interrupt service temporarily to meet firm customers’ needs during periods of peak demand. The effect on net income of any changes in delivered volumes and prices to interruptible customers is limited by margin-sharing arrangements that are included in Washington Gas’ rate designs in the District of Columbia and, to a much smaller extent, in Virginia. In the District of Columbia, Washington Gas shares a majority of the margins earned on interruptible gas sales and deliveries with firm customers after a gross margin threshold is reached. A portion of the fixed costs for servicing interruptible customers is collected through the firm customers’ rate design. In the Virginia jurisdiction, rates for customers using interruptible delivery service are based on a traditional cost of service approach, and Washington Gas retains all revenues from interruptible delivery service. However, a few customers have been grandfathered into a bundled sales and delivery service with previously approved bundled interruptible rate design. A portion of these revenues is shared with firm customers, but the volumes are small and the amounts of revenues are not material to our consolidated results of operations. Prior to October 1, 2005, interruptible customers in the Maryland jurisdiction had similar margin-sharing arrangements for interruptible customers in the District of Columbia, as described above. Effective October 1, 2005, pursuant to Washington Gas’ implementation of a new billing mechanism in the Maryland jurisdiction, rates for interruptible customers in Maryland are based on a traditional cost of service approach, and Washington Gas retains a defined amount above a pre-approved margin threshold level (refer to the section entitled “Jurisdictional Rates and Regulatory Matters—Maryland Jurisdiction”).

 

Natural Gas Unbundling.  As discussed above, although most of Washington Gas’ revenue is generated from the sale and delivery of natural gas on a combined or “bundled” basis, federal and state regulation allows for the separation or “unbundling” of the sale of the natural gas commodity from the delivery of natural gas on Washington Gas’ distribution system (delivery service). Gross margins generated by Washington Gas from deliveries of customer-owned gas are equivalent to those earned on bundled gas service because it is only allowed to charge its customers the cost it pays for the natural gas commodity and related charges for interstate pipeline services. Therefore, Washington Gas does not experience any economic loss when customers choose to purchase the natural gas commodity from unregulated third-party marketers.

 

Throughout the Washington Gas service area, all customers may choose to purchase natural gas from a variety of unregulated third-party marketers, including WGEServices, an affiliated natural gas and electricity retail marketer. When customers select an unregulated third-party marketer as their gas supplier, Washington Gas continues to charge these customers to deliver natural gas through its distribution system at rates identical to the delivery portion of the bundled sales service customers. The status of the unbundling programs in Washington Gas’ major jurisdictions as of September 30, 2006 is discussed further in the section entitled “Competition.”

 

WGEServices sells natural gas, as an unregulated third-party marketer, to both firm and interruptible customers in each Washington Gas jurisdiction. Washington Gas provides delivery service for those customers of WGEServices that reside in its jurisdiction. In addition, WGEServices sells to Delaware and other areas in Maryland and Virginia that are outside of Washington Gas’ jurisdictional service area.

 

  Jurisdictional Rates and Regulatory Matters

 

A description of each commission under which Washington Gas is regulated and a discussion of significant regulatory matters in each jurisdiction are presented below. Also see the section entitled “Regulatory Matters” in Management’s Discussion for a table that summarizes Washington Gas’ major rate applications and results.

 

     District of Columbia Jurisdiction

 

The PSC of DC consists of three full-time members who are appointed by the Mayor with the advice and consent of the District of Columbia City Council. The term of each commissioner is four years. There are no limitations on the number of terms that can be

 

WGL Holdings, Inc.
Washington Gas Light Company
Part I
Item 1. Business (continued)

served. The PSC of DC has no required period of time by which it must make decisions for modifications to base rates charged by Washington Gas to its customers.

 

     Rate Case and Other Regulatory Activities

 

On May 1, 2006, Washington Gas filed two tariff applications with the PSC of DC requesting approval of proposed revisions to the balancing charge provisions of its firm and interruptible delivery service tariffs that would permit the utility to recover from its delivery service customers the costs of hexane (heavy hydrocarbons or “HHCs”) that are being injected into Washington Gas’ natural gas distribution system. Washington Gas has been recovering the costs of HHCs from sales customers in the District of Columbia through its Purchased Gas Charge (PGC) provision in this jurisdiction. On October 2, 2006, the PSC of DC issued an order rejecting Washington Gas’ proposed tariff revisions until the PSC of MD concludes on its evidentiary hearing related to this matter which is scheduled to be held on February 6, 2007 (refer to “Maryland Jurisdiction” below).  On October 12, 2006, Washington Gas filed a Motion for Clarification requesting that the PSC of DC affirm that Washington Gas can continue collecting HHC costs from sales customers through its PGC provision or to record such HHC costs incurred as a regulatory asset pending a ruling by the PSC of DC on future cost recovery. Pending the PSC of DC’s decision on the Motion for Clarification, Washington Gas continues to recover the costs of HHCs from sales customers in the District of Columbia through its PGC provision, and is recording these costs as a regulatory asset.

 

     Maryland Jurisdiction

 

The PSC of MD currently consists of four full-time members who are appointed by the Governor with the advice and consent of the Senate of Maryland; a fifth PSC of MD seat currently is vacant. Each commissioner is appointed to a five-year term, with no limit on the number of terms that can be served.

 

Washington Gas is required to give 30 days’ notice before filing for a rate increase. The PSC of MD may initially suspend the proposed increase for 150 days following the 30-day notice period, and then has the option to extend the suspension for an additional 30 days. If action has not been taken after 210 days, the requested rates become effective subject to refund.

 

     Rate Case and Other Regulatory Activities

 

Accounting Order.  On April 28, 2005, Washington Gas filed a request for an Accounting Order with the PSC of MD in connection with a rehabilitation project being performed in a portion of Prince George’s County, Maryland to address an increase in natural gas leaks (refer to the section entitled “Operating Issues in Prince George’s County, Maryland”). In this filing, Washington Gas requested that the PSC of MD issue an Accounting Order to ratify Washington Gas’ interpretation of the applicable regulatory guidelines regarding the accounting treatment of a portion of the cost of the rehabilitation project. Specifically, Washington Gas interpreted the guidelines to require it to record the estimated $13 million cost to encapsulate couplings on mains in the affected areas of Prince George’s County as a capital expenditure. After considering this matter at the June 1, 2005 Administrative Meeting of the PSC of MD, the PSC of MD granted Washington Gas’ request for an Accounting Order with the understanding that the accounting treatment will not be determinative of future ratemaking treatment, and the PSC of MD retains jurisdiction to adopt any ratemaking treatment it deems appropriate.

 

Interruptible Transportation Service and RNA Mechanism.  On August 8, 2005, the PSC of MD approved an unopposed Stipulation and Agreement (Stipulation) that was previously filed with the PSC of MD by Washington Gas and three other participants. The Stipulation resolved outstanding issues from an October 31, 2003 Final Order issued by the PSC of MD regarding the manner in which interruptible transportation service is charged to Maryland customers (refer to the section above entitled “Regulated Service to Interruptible Customers” for a discussion of this service). As proposed in the Stipulation, the PSC of MD also approved Washington Gas’ implementation of a new billing mechanism known as the Revenue Normalization Adjustment (RNA). The RNA mechanism is designed to stabilize the level of utility net revenues collected from Maryland customers by eliminating the effect of deviations in customer usage caused by variations in weather from normal levels and other factors such as conservation. The Stipulation also allows for the impact of the RNA mechanism on Washington Gas’ risk and rate of return to be evaluated in the next rate case. The RNA became effective on October 1, 2005. Washington Gas’ net income for the fiscal year ended September 30, 2006 reflects the effect of the RNA.

 

Disallowance of Purchased Gas Charges.  Washington Gas submitted to a routine review of its gas costs that were billed to customers in Maryland from September 2003 through August 2004. Each year, the PSC of MD reviews the annual gas costs collected from customers to determine if Washington Gas’ purchased gas costs are not justified because it failed to support that the charges

 

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incurred were based solely on increased costs of natural gas, or it failed to follow competitive and reasonable practices in procuring and purchasing natural gas. On March 14, 2006, a Hearing Examiner of the PSC of MD issued a proposed order approving purchased gas charges of Washington Gas for the twelve-month period ending August 2004, except for $4.6 million of such charges that the Hearing Examiner recommended be disallowed because, in the opinion of the Hearing Examiner, they were not reasonably and prudently incurred. Washington Gas filed a Notice of Appeal on April 12, 2006 and a Memorandum on Appeal on April 21, 2006 with the PSC of MD, asserting that the Hearing Examiner’s recommendation is without merit. A reply memorandum was filed on May 11, 2006. After consideration of these issues, we expect the PSC of MD to issue a Final Order. Over the past ten years, Washington Gas has incurred similar purchased gas charges which the PSC of MD has reviewed and approved as being reasonably and prudently incurred and therefore subject to recovery from customers. Among other issues included in the appeal, we reminded the PSC of MD of this prior recovery and requested that similar treatment be granted for this matter. During the fiscal year ended September 30, 2006, Washington Gas accrued a liability of $4.6 million (pre-tax) related to the proposed disallowance of these purchased gas charges. If the PSC of MD rules in Washington Gas’ favor, the liability recorded in the 2006 fiscal year for this issue will be reversed.

 

Recovery of Hexane costs.  In March 2006, Washington Gas began recovering the costs of HHCs that are being injected into its natural gas distribution system from Maryland sales customers through its PGC provision in Maryland. On April 28, 2006, Washington Gas filed an application with the PSC of MD requesting approval of proposed revisions to the balancing charge provisions of its firm and interruptible delivery service tariffs that would permit the utility to recover the cost of HHCs from its delivery service customers, as well as from its sales customers. On June 27, 2006, the PSC of MD issued an order that rejected Washington Gas’ proposed tariff revisions until an evidentiary hearing is held to further consider matters relating to the efficacy of the HHC injections in addressing existing leaks or in preventing additional leaks on Washington Gas’ distribution system (refer to the section entitled “Operating Issues in Prince George’s County, Maryland”).  In addition to ordering an evidentiary hearing, the PSC of MD directed Washington Gas to cease recovering HHC costs being recovered through the PGC provision, and to record costs that will be incurred in the future in a “pending” account for future regulatory disposition following the conclusion of the evidentiary hearing. The PSC of MD also indicated that the disposition of HHC costs collected previously through the PGC provision will be determined in the course of the evidentiary hearing which is scheduled to be held on February 6, 2007.

 

     Virginia Jurisdiction

 

The SCC of VA consists of three full-time members who are elected by the General Assembly of Virginia. Each commissioner has a six-year term with no limitation on the number of terms that can be served.

 

Either of two methods may be used to request a modification of existing rates. First, Washington Gas may file an application for a general rate increase in which it may propose new adjustments to the cost of service that are different from those previously approved for Washington Gas by the SCC of VA, as well as a revised return on equity. The proposed rates under this process may take effect 150 days after the filing, subject to refund pending the outcome of the SCC of VA’s action on the application. Second, an expedited rate case procedure is available which provides that proposed rate increases may be effective 30 days after the filing date, also subject to refund. Under the expedited rate case procedure, Washington Gas may not propose any new adjustments for issues not previously approved in its last general rate case, or a change in its return on common equity from the level authorized in its last general rate case. Once filed, other parties may propose new adjustments or a change in the cost of capital from the level authorized in its last general rate case. The expedited rate case procedure may not be available if the SCC of VA decides that there has been a substantial change in circumstances since the last general rate case filed by Washington Gas.

 

     Rate Case and Other Regulatory Activities

 

Annual Earnings Test.  On December 18, 2003, the SCC of VA issued a Final Order in response to an application filed by Washington Gas on June 14, 2002 to increase annual revenues in Virginia. In connection with this Final Order, the SCC of VA ordered Washington Gas to reduce its rate base related to net utility plant by $28 million, which is net of accumulated deferred income taxes of $14 million, and to establish an equivalent regulatory asset that Washington Gas has done for regulatory accounting purposes only. This regulatory asset, which is presented within “Accumulated depreciation and amortization” on the balance sheets, represents the difference between the accumulated reserve for depreciation recorded on the books of Washington Gas and a theoretical reserve that was derived by the Staff of the SCC of VA (VA Staff) as part of its review of Washington Gas’ depreciation rates, less accumulated deferred income taxes. This regulatory asset is being amortized as a component of depreciation expense over 32 years pursuant to the Final Order. The SCC of VA provided for both a return on, and a return of, this regulatory asset established for regulatory accounting purposes.

 

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In approving the treatment described in the preceding paragraph, the SCC of VA further ordered that an annual “earnings test” be performed to determine if Washington Gas has earned in excess of its allowed rate of return on common equity for its Virginia operations. The current procedure for performing this earnings test does not normalize the actual return on equity for the effect of weather over the applicable twelve-month period. To the extent that Washington Gas earns in excess of its allowed return on equity in any annual earnings test period, Washington Gas is required to increase depreciation expense (after considering the impact of income tax benefits), and increase the accumulated reserve for depreciation for the amount of the actual earnings in excess of the earnings produced by a 10.50 percent allowed return on equity. Under the SCC of VA’s requirements for performing earnings tests, if weather is warmer than normal in a particular annual earnings test period, Washington Gas is not allowed to restore any amount of earnings previously eliminated as a result of this earnings test. These annual earnings tests will be performed until the $28 million difference between the accumulated reserve for depreciation recorded on Washington Gas’ books and the theoretical reserve derived by the VA Staff, net of accumulated deferred income taxes, is eliminated or the level of the regulatory asset established for regulatory accounting purposes is adjusted as a result of a future depreciation study.

 

In accordance with a September 27, 2004 SCC of VA-approved stipulation involving Washington Gas and other participants, as discussed below, Washington Gas is required to file with the SCC of VA annual earnings test calculations based on a twelve-month period ended December 31. These annual calculations are being estimated by Washington Gas quarterly, and when appropriate, accounting adjustments are being recorded.

 

On April 27, 2006, Washington Gas filed an earnings test for the twelve months ended December 31, 2005. Washington Gas’ filing, which is subject to review by the applicable parties within the SCC of VA, indicated that it had not earned in excess of its allowed return on equity during the period of the earnings test. As discussed below, Washington Gas filed a general rate case application with the SCC of VA on September 15, 2006. The earnings test for the twelve-month period ended December 31, 2005 will be reviewed by the VA Staff in connection with its review of the September 15, 2006 rate application.

 

Expedited Rate Case and Stipulation.  On January 27, 2004, Washington Gas filed an expedited rate case with the SCC of VA to increase annual revenues in Virginia by $19.6 million. On February 26, 2004, based upon expedited rate case filing procedures, Washington Gas placed the proposed revenue increase into effect, subject to refund, pending the SCC of VA’s final decision in the proceeding.

 

On September 27, 2004, the SCC of VA issued a Final Order approving a proposed stipulation of six participants in the rate case that included Washington Gas and the VA Staff. The approved stipulation, among other things, included no change in Washington Gas’ annual base revenues, and maintained Washington Gas’ allowed rate of return on common equity of 10.50 percent and overall rate of return of 8.44 percent that had been previously approved by a December 18, 2003 Final Order. Washington Gas had recorded a provision for rate refunds equal to the full amount of revenues that had been collected subject to refund through the fiscal year ended September 30, 2004. Accordingly, there was no effect on earnings for fiscal year 2004 for the rates initially put into effect in February 2004. As discussed above, the stipulation also requires Washington Gas to file with the SCC of VA annual earnings test calculations based on a twelve-month period ended December 31.

 

Application for Rate Increase.  On September 15, 2006, Washington Gas filed an application with the SCC of VA to increase its annual utility net revenues in Virginia by approximately $23.0 million. The application seeks an overall rate of return of 9.12 percent and a return on common equity of 11.25 percent. This compares to the current overall rate of return of 8.44 percent and return on common equity of 10.50 percent as authorized by the SCC of VA in its Final Order issued to Washington Gas on December 18, 2003.

 

In the filed application, Washington Gas also seeks approval of various billing, rate design and other proposals, including: (i) the implementation of a billing adjustment mechanism to stabilize the level of revenue collections; (ii) the implementation of a Performance-Based Rate (PBR) plan; (iii) the recovery of its costs of HHCs as a gas cost from both sales and delivery service customers and (iv) the implementation of a Gas Administrative Charge (GAC). Following is a discussion of these proposals.

 

Washington Gas proposes to implement an RNA billing mechanism in Virginia similar to the mechanism that was implemented in the Maryland jurisdiction. The proposed RNA in Virginia would be designed to stabilize the level of utility net revenues collected from customers by eliminating the effect of deviations in customer usage caused by variations in weather from normal levels and other factors such as customer conservation.

 

The Virginia application also proposes a PBR plan that is designed to benefit customers through the incentives given Washington Gas to improve its performance while preserving service quality and the reliability and safety of its natural gas distribution system. The key features of the proposed PBR plan are: (i) a three-year freeze of base rates; (ii) identified key service

 

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quality standards to be upheld by Washington Gas while striving to control operating costs and (iii) an earnings sharing mechanism that would enable Washington Gas to share with both its Virginia customers and shareholders earnings in excess of the top of the range of its return on equity.

 

Washington Gas has incurred costs for the purchase of HHCs that are being injected into its natural gas distribution system to condition natural gas deliveries from a liquefied natural gas (LNG) terminal in Cove Point, Maryland. Consistent with its method of recovering the cost of the natural gas commodity in all jurisdictions, Washington Gas requests authorization by the SCC of VA to recover its costs of HHCs from both sales and unbundled delivery service customers.

 

Washington Gas also proposes to implement a GAC that would remove the cost of uncollectible account expense related to gas costs from base rates of both firm sales and delivery service customers, and collect an amount through its PGC provision in Virginia for such costs. Similar to the GAC utilized in the Maryland jurisdiction, this mechanism would more appropriately enable the recovery of such costs only from sales customers and the matching of this expense with changes in gas costs.

 

In its rate application with the SCC of VA, Washington Gas requests that it be permitted to implement the newly proposed increase in revenues, subject to refund, effective for services rendered on and after February 13, 2007. Washington Gas requests that it be permitted to implement other proposed tariff revisions, such as the RNA billing mechanism and PBR plan, upon final approval by the SCC of VA.

 

The SCC of VA has adopted a procedural schedule that directs the VA Staff and any third parties to file testimony and supporting exhibits during the first quarter of 2007 and sets the hearing date on this matter for April 23, 2007.

 

     Depreciation Study

 

In October 2006, Washington Gas completed a depreciation rate study based on its property, plant and equipment balances at December 31, 2005. The results of the depreciation study indicate that Washington Gas’ depreciation rates should be reduced due to asset lives being extended beyond previously estimated lives. Under regulatory requirements, these depreciation rates must be approved before they are placed into effect.

 

In Maryland and the District of Columbia, regulatory requirements prescribe that whenever depreciation rates are revised, there must be a corresponding revision to customer billing rates. Accordingly, the new depreciation rates in Maryland and the District of Columbia will not be placed into effect until a rate case proposal is approved enabling this change.

 

In connection with Washington Gas’ September 15, 2006 rate application with the SCC of VA, on November 8, 2006, Washington Gas filed with the SCC of VA that portion of the depreciation study related to the Virginia jurisdiction. Based on the results of the depreciation study, Washington Gas reduced the requested $23.0 million rate increase in the September 15, 2006 SCC of VA application by $5.8 million. Concurrent with the filing of the depreciation study, Washington Gas filed supplemental testimony and schedules reflecting the revised proposed base rate increase of $17.2 million. Consistent with regulatory precedent, Washington Gas expects to implement the changes in recorded depreciation, retroactive to January 1, 2006, upon approval from the VA Staff which is expected in fiscal year 2007.

 

  Supply and Capacity Requirements

 

Washington Gas arranges to have natural gas delivered to the entry points of its distribution system (city gates or gate stations) using the delivery capacity of interstate pipeline companies, and also uses on-system peaking facilities to meet requirements. To provide the greatest amount of flexibility in meeting its customers’ diverse demand requirements, Washington Gas acquires interstate pipeline natural gas delivery and storage capacity on a system-wide basis using different interstate pipelines. Washington Gas’ supply and capacity plan is based on forecasted system requirements, and takes into account estimated load growth by type of customer, attrition, conservation, demand by gate station, interstate pipeline and storage capacity and contractual limitations and the forecasted movement of customers between sales service and delivery service.

 

At September 30, 2006, Washington Gas had service agreements with four pipeline companies that provided firm transportation and/or storage services directly to Washington Gas’ city gate. These contracts have expiration dates ranging from fiscal years 2007 to 2028.

 

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Washington Gas is responsible for acquiring both sufficient natural gas supplies and interstate pipeline and storage capacity to meet customer requirements. As such, Washington Gas must contract for reliable and adequate delivery capacity to its distribution system, while considering the dynamics of the interstate pipeline and storage capacity market, its own on-system natural gas peaking facilities, as well as the characteristics of its customer base. Washington Gas’ contracting activities take into account customers’ tendencies to switch between sales and delivery service; however, short-term contractual arrangements required to manage such customer choice diversity may not be available in future periods under conditions of capacity constraints.

 

Washington Gas has adopted a diversified portfolio approach designed to satisfy the supply and deliverability requirements of its customers, using multiple supply points, dependable interstate pipeline transportation and storage arrangements, and its own substantial storage and peaking capabilities to meet its customers’ demands. Washington Gas anticipates enhancing its peaking capacity by constructing an LNG peaking facility that is currently expected to be completed and placed in service by the 2011-2012 winter heating season. This represents a delay from the originally planned completion date, which was expected by the 2008-2009 winter heating season, due to zoning and other legal challenges. On November 8, 2006, the District Council of Prince George’s County issued a final decision denying Washington Gas’ application related to its proposed construction of the LNG peaking plant. The District Council held that current zoning restrictions prohibit such construction. Washington Gas appealed this decision to the Prince George’s County Circuit Court on November 22, 2006. Until such time when these legal challenges are resolved and the LNG plant is built, Washington Gas has planned for alternative sources of supply to meet its customers’ peak day requirements. These planned alternatives, that are expected to be completed by fiscal year 2011, include acquiring additional interstate pipeline capacity, in combination with investments by Washington Gas to upgrade the infrastructure of its transmission and distribution system. This plan is expected to provide for sufficient delivery of natural gas to meet customers’ peak day demand requirements until the new LNG storage facility is constructed and in service (refer to the section entitled “Liquidity and Capital Resources—Capital Expenditures” in Management’s Discussion included under Item 7 of this report for a further discussion of this construction project).

 

Local distribution companies, such as Washington Gas, along with other participants in the energy industry have raised concerns regarding the gradual depletion in the availability of additional interstate pipeline and storage capacity. Depleting pipeline and storage capacity is a business issue that must be managed by Washington Gas, whose customer base has grown at an annual rate of approximately two percent. This rate of growth is expected to continue. The increase in the near future in the number of electric generation facilities that are fueled by natural gas for the mid-Atlantic region and upstream of the mid-Atlantic region exacerbates concerns associated with the availability of pipeline and storage capacity. These facilities, which utilize significant pipeline and storage capacity, may ultimately affect deliverability and flexibility of natural gas delivery into the region. Due to the reluctance on the part of both marketers and some local distribution companies in committing to long-term pipeline contracts, pipeline infrastructure improvements have been limited despite the fact that the major pipelines serving the Washington Gas system are fully subscribed. In response to demand, interstate pipelines are offering infrastructure improvements that will expand pipeline and storage capacity in the mid-Atlantic region. These improvement projects, funded through incremental demand charges by the participating entities, require a minimum of two to five years to complete the planning, solicitation of interest, regulatory approval and construction. Recent projects to expand Washington Gas’ firm transportation and/or storage capacity completed or in progress, are outlined below:

 

^(a)  Supplier delivers the stored natural gas directly to Washington Gas’ distribution system.

^(b)  Supplier delivers the stored natural gas indirectly to Washington Gas’ distribution system through third-party transportation companies.

 

Washington Gas will continue to monitor other opportunities to acquire or participate in obtaining additional pipeline and storage capacity that will improve or maintain the high level of service expected by its customer base.

 

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  Sources of Natural Gas

 

Annual Sendout.  As reflected in the table below, there were six sources of delivery through which Washington Gas received natural gas to satisfy the sendout requirements in pipeline year 2006 (November 1, 2005 through October 31, 2006). These same six sources also are expected to be utilized to satisfy sendout requirements in pipeline year 2007 (November 1, 2006 through October 31, 2007). Firm transportation denotes gas transported directly to the entry point of Washington Gas’ distribution system in contractually viable volumes. Transportation storage denotes volumes stored by a pipeline during the summer injection season for withdrawal and delivery to the Washington Gas distribution system during the winter heating season to meet load requirements. Peak load requirements are met by: (i) underground natural gas storage at the Hampshire storage field in Hampshire County, West Virginia; (ii) the local production of propane air plants located at Washington Gas-owned facilities in Rockville, Maryland (Rockville Station) and in Springfield, Virginia (Ravensworth Station) and (iii) other peak-shaving sources. Unregulated third-party marketers acquire interstate pipeline and storage capacity and the natural gas commodity on behalf of Washington Gas’ delivery service customers, some of which may be provided through transportation, storage and peaking resources provided by Washington Gas to unregulated third-party marketers under tariffs approved by the three public service commissions. These retail marketers have natural gas delivered to the entry point of Washington Gas’ delivery system on behalf of those utility customers that have decided to acquire their natural gas commodity on an unbundled basis, as previously discussed.

 

During pipeline year 2006 (November 1, 2005 through October 31, 2006), total sendout on the system was 1.552 billion therms, as compared to total sendout of 1.676 billion therms during pipeline year 2005. This excludes the sendout of sales and deliveries of natural gas used for electric generation. The decrease in 2006 was the result of weather in pipeline year 2006 that was warmer than pipeline year 2005. The sendout for pipeline year 2007 is estimated at 1.651 billion therms (based on normal weather), excluding the sendout for the sales and deliveries of natural gas used for electric generation. The sources of delivery and related volumes that were used to satisfy the requirements of pipeline year 2006 and those projected for pipeline year 2007 are shown in the following table.

 

 

Design Day Sendout.  The effectiveness of Washington Gas’ gas supply program is largely dependent on the sources used to satisfy delivery requirements for its design day. A design day is the maximum anticipated demand on the natural gas distribution system during a 24-hour period assuming a five-degree Fahrenheit average temperature. For planning purposes, we assume that all interruptible customers will be curtailed on the design day. Washington Gas’ current design day demand forecast for the 2006-2007 winter season is 18.0 million therms, and Washington Gas’ projected sources of delivery for design day sendout is 19.0 million therms. This provides a reserve margin of approximately 5.56 percent. Washington Gas is currently capable of meeting 72 percent of its design day requirements with storage and peaking capabilities. For its design day, Washington Gas plans for the optimal utilization

 

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of its storage and peaking facilities to reduce its dependency on firm transportation and lower pipeline capacity costs. The following table reflects the sources of delivery that are projected to be used to satisfy the design day sendout estimate for pipeline year 2007.

 

 

Gulf Coast Natural Gas Supply Issues.  During the late summer of 2005, immediately prior to the 2005-2006 winter heating season, the Gulf Coast region experienced a major disruption of natural gas production and processing due to hurricanes Katrina, Rita and Wilma. These natural gas production and processing disruptions resulted in a significant reduction of natural gas available to be delivered from the Gulf Coast region. Historically, Washington Gas received a majority of its natural gas purchases from this region through its contracted interstate pipeline services. According to the latest report from the United States Department of the Interior, Minerals Management Service, over 90 percent of the pre-hurricane natural gas production and processing from the Gulf Coast region became available again to the wholesale market. Given the recovery of available supplies from the Gulf Coast region following the hurricanes, coupled with the availability of natural gas supply from alternative production areas, Washington Gas was able to meet its customers’ daily demand for natural gas during the 2005-2006 winter heating season. Storage gas inventory balances were maintained at adequate operational levels throughout the heating season. Through the combination of traditional summer replenishment of its storage resources and the various locations and diversity of natural gas supply sources that are available to it, Washington Gas should have adequate supply to meet its firm service obligations for the 2006-2007 winter heating season.

 

Should future natural gas production and processing disruptions severely reduce levels of deliverability, then Washington Gas may need to implement contingency plans in order to maximize the number of customers served under such conditions. Contingency plans include requests to conserve to the general population and targeted curtailments to specific sections of the system, consistent with curtailment tariffs approved by regulators in each of Washington Gas’ three jurisdictions.

 

Since hurricanes Katrina, Rita and Wilma, Washington Gas has modified the composition of its natural gas portfolio to include a significantly higher percentage of natural gas supply that is produced from sources outside of the Gulf Coast region, including natural gas supply from the Appalachian and Canadian regions, as well as increased levels of natural gas in the form of vaporized LNG through the Dominion Cove Point (Dominion or Cove Point) LNG terminal. These natural gas supplies are being delivered to Washington Gas’ distribution system utilizing existing interstate pipeline resources under contract to Washington Gas that have transportation paths that support natural gas deliveries outside the Gulf Coast region. The diversification of its natural gas portfolio will help Washington Gas to meet customer demand despite unforeseen future supply issues that may arise similar to those resulting from weather events in the Gulf Coast region.

 

Volatility of Natural Gas Prices

 

As a result of market concerns about the sufficiency of the supply of natural gas, the hurricanes in the Gulf Coast region and other factors during the 2005-2006 winter heating season, the price of the natural gas commodity paid by Washington Gas’ customers rose sharply from levels experienced during the prior year’s winter heating season. In fiscal year 2006, higher natural gas prices increased customers’ bills dramatically. Under its regulated gas cost recovery mechanisms, Washington Gas records cost of gas expense equal to the cost of gas recovered in revenues from customers. An increase in the cost of gas due to an increase in the purchase price of the natural gas commodity generally has no direct effect on Washington Gas’ utility net revenues and net income. However, its net income was reduced in fiscal year 2006 primarily due to higher expenses for uncollectible customer accounts, as well as lower natural gas consumption caused by customer conservation in Virginia and the District of Columbia where these adverse effects on earnings are not addressed through regulatory mechanisms. In Maryland, the RNA and GAC regulatory mechanisms neutralize these effects on Washington Gas’ revenues and net income. Increases in the price of natural gas also can affect our operating cash flows, as

 

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well as the competitiveness of natural gas as an energy source (refer to the section below entitled “Competition—Competition with Other Energy Products”).

 

Changes in Natural Gas Consumption

 

Natural gas supply requirements may be affected by changes in natural gas consumption by customers. Natural gas usage per customer may decline as customers change their consumption patterns in response to: (i) more volatile and higher natural gas prices, as discussed above and (ii) customers’ replacement of older, less efficient gas appliances with more efficient appliances. In each jurisdiction where it operates, Washington Gas’ recent rate case proceedings reflect these changes in customer usage profiles. In both the District of Columbia and Virginia jurisdictions, changes in customer usage by existing customers that occur subsequent to these recent rate case proceedings will have the effect of reducing revenues, which is offset by the favorable effect of adding new customers. Effective October 1, 2005, pursuant to an RNA mechanism approved by the PSC of MD, changes in customer usage by existing customers that occur subsequent to recent rate case proceedings in the Maryland jurisdiction generally will not reduce revenues, but rather will have the effect of stabilizing the level of delivery charge revenues received from customers on a monthly basis (refer to the section entitled “Jurisdictional Rates and Regulatory Matters—Maryland Jurisdiction” for a further discussion of this billing adjustment mechanism).

 

Competition with Other Energy Products

 

Washington Gas faces competition based on customers’ preference for natural gas compared to other energy products and the comparative prices of those products. The most significant product competition occurs between natural gas and electricity in the residential market. The residential market generates a significant portion of Washington Gas’ net income. In its service territory, Washington Gas continues to attract the majority of the new residential construction market. Consumers’ continuing preference for natural gas allows Washington Gas to maintain a strong market presence.

 

Washington Gas has generally maintained a price advantage over competitive electricity supply in its service area for traditional residential uses of energy such as heating, water heating and cooking. Price volatility in the wholesale natural gas commodity market during the 2005-2006 winter heating season resulted in significant increases in the cost of natural gas billed to customers (refer to the section entitled “Volatility of Natural Gas Prices”). Such increases have resulted in a reduction in the traditional price advantage of natural gas over electricity.

 

The price advantages of electricity have been partially caused by artificial price caps on electricity sold by electric utilities. These price caps have expired in Maryland and the District of Columbia, and utility sales service price caps in Virginia will expire in 2010. Since the expiration of price caps in Maryland and the District of Columbia, market-based utility standard offer service rates have been put into effect in these jurisdictions which are subject to change in June of each year due to changes in the wholesale electricity market. The cost of generating electricity is affected by the cost of fuel used to generate electricity. As the prices of those fuels rise and existing supply contracts for those fuels between electric generators and fuel suppliers expire, the price of electricity will likely rise in relation to the current price for other forms of energy.

 

In June 2006, a change in standard offer service prices in Maryland and the District of Columbia resulted in significantly increased electricity prices in these jurisdictions. Although price volatility in the wholesale natural gas commodity market reduced the price advantage of natural gas over electricity, the significant rise in electric prices has restored some of the price advantage of natural gas.

 

Furthermore, as discussed below, the continued restructuring in both the natural gas and electric industries is leading to changes in traditional utility pricing models. As part of the electric industry restructuring effort, large and medium commercial markets are moving towards competitive retail supply contracts with third-party marketers of electricity, such as WGEServices. Competitive electric supply markets may result in lower comparative pricing for electric service and other alternative energy sources, including natural gas. These changes could result in increased competition for Washington Gas.

 

In the interruptible market, fuel oil is the prevalent energy alternative to natural gas. Washington Gas’ success in this market depends largely on the relationship between natural gas and oil prices. The supply of natural gas primarily is derived from domestic sources, and the relationship between supply and demand generally has the greatest impact on natural gas prices. As a large portion of oil comes from foreign sources, political events can have significant influences on oil supplies and, accordingly, oil prices. The

 

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introduction of non-domestic supplies of LNG into the United States natural gas market may affect supply levels and have an impact on natural gas prices. To date, the effect of LNG on supply levels has been minimal.

 

Deregulation

 

In each of the jurisdictions (the District of Columbia, Maryland and Virginia) served by Washington Gas, regulators and utilities have implemented customer choice programs. These programs allow customers to choose to purchase their natural gas and/or electric commodity from unregulated third-party marketers, rather than purchasing these commodities as part of a bundled service from the local utility. When customers choose to purchase their natural gas commodity from unregulated third-party marketers on an unbundled basis, Washington Gas’ utility net revenues or net income are not affected since Washington Gas charges its customers the cost of gas without any mark-up. However, these customer choice programs provide unregulated third-party marketers, such as WGEServices, with opportunities to profit from the sale of the natural gas commodity or electricity in competitive retail markets. It also enables customers to have competitive choices for natural gas and electricity. Participating in this evolving marketplace also poses risks and challenges that must be addressed in our current and future strategies.

 

The Natural Gas Delivery Function

 

The natural gas delivery function, the core business of Washington Gas, continues to be regulated by local regulatory commissions. In developing this core business, Washington Gas has invested nearly $2.9 billion as of September 30, 2006 to construct and operate a safe and reliable natural gas distribution system. Because of the high fixed costs and significant safety and environmental considerations associated with building and operating a distribution system, Washington Gas expects to continue being the only owner and operator of a natural gas distribution system in its current franchise area for the foreseeable future. The nature of Washington Gas’ customer base and the distance of most customers from interstate pipelines mitigate the threat of bypass of its facilities by other potential delivery service providers.

 

Washington Gas expects that local regulatory commissions will continue to set the prices and terms for delivery service that give it an opportunity to earn a just and reasonable rate of return on the capital invested in its distribution system and to recover reasonable operating expenses. Washington Gas plans to continue constructing, operating and maintaining its natural gas distribution system, and will incur costs necessary to ensure the safety and reliability of its system, and that operating issues are addressed in a timely and adequate manner.

 

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The Merchant Function and Natural Gas Unbundling

 

At September 30, 2006, customer choice programs for natural gas customers were available to all of Washington Gas’ regulated utility customers in the District of Columbia, Maryland and Virginia. Of the 1.032 million active customers at September 30, 2006, approximately 147,000 customers purchased their natural gas commodity from unregulated third-party marketers. The following table provides the status of customer choice programs in Washington Gas’ major jurisdictions at September 30, 2006.

 

 

 

Washington Gas prudently enters into contracts to purchase the natural gas commodity and, therefore, concludes that the costs being incurred should be recoverable from customers. Currently, Washington Gas’ jurisdictional tariffs contain gas cost mechanisms that allow it to recover the invoice cost of gas, including both the commodity cost of gas and the interstate pipeline capacity services, applicable to firm customers. If future unbundling or other initiatives remove the current gas cost recovery provisions, Washington Gas could be adversely impacted to the extent it cannot fully recover the cost of the natural gas commodity if purchased at above-market prices. Washington Gas currently has recovery mechanisms for such potentially stranded costs in the District of Columbia, Maryland and Virginia.

 

The same jurisdictional tariffs that allow Washington Gas to recover the invoice cost of gas applicable to firm customers also allow the utility to recover from third-party marketers, 100 percent of the cost of the storage and peak shaving capacity that Washington Gas dedicates to serving unbundled service customers who purchase their natural gas from a third-party marketer. Additionally, Washington Gas currently has mechanisms approved by each of its local commissions to recover some portion of the costs of transportation capacity from unregulated third-party marketers. Washington Gas is generally renewing long-term capacity contracts to meet its forecasts of continued growth in customer’s firm gas requirements and to comply with regulatory mechanisms to provide for or make available such resources to retail marketers serving customers in the customer choice programs.

 

To maximize the value of its long-term capacity, Washington Gas has entered into contracts with unregulated wholesale energy services companies that make use of the utility’s firm storage and transportation rights when Washington Gas does not need these rights, and to make off-system sales when such storage and transportation rights are under-utilized. Washington Gas continues to pay the fixed charges associated with the firm storage and transportation contracts used to make these sales. The sale of these rights are accounted for as revenues under regulated margin-sharing arrangements that vary by jurisdiction whereby a significant portion of these revenues is shared with Washington Gas’ customers as a reduction in natural gas costs, otherwise recoverable from firm customers. Washington Gas also has undertaken a portion of this responsibility in order to maximize the potential value of such resources and subsequently lower the cost of gas to its sales service customers. These transactions include fixed-priced and market-priced purchases and sales which Washington Gas has matched with the purchase of derivative instruments that simultaneously fix the economic profit on these transactions.

 

WGL Holdings, Inc.
Washington Gas Light Company
Part I
Item 1. Business (continued)

 

As the role of regulated utilities in the merchant function may decrease over time, opportunities emerge for unregulated natural gas and electric providers. In the deregulated marketplace, third-party marketers have profit-making opportunities from the sale of the commodity, but they also assume the risk of loss.

 

In fiscal year 1997, we established WGEServices as an unregulated retail energy-marketing subsidiary. WGEServices sells natural gas and electricity to residential, commercial and industrial customers inside and outside of the Washington Gas service area. At September 30, 2006, 2005 and 2004, WGEServices had natural gas customers totaling approximately 142,700, 144,800 and 150,800, respectively. WGEServices had electric customers totaling approximately 63,300, 36,200 and 44,500 at September 30, 2006, 2005 and 2004, respectively. WGEServices’ operating revenues for fiscal years 2006, 2005 and 2004 were $1.0 billion, $773.0 million and $789.9 million, respectively. WGEServices’ net income was $13.3 million, $22.3 million and $8.3 million for fiscal years 2006, 2005 and 2004, respectively.

 

Natural Gas Supply

 

WGEServices competes with other third-party marketers to sell the unregulated natural gas commodity to customers. Marketers of the natural gas commodity compete largely on price, and gross margins are relatively small. Consequently, gross margins for the sale of unregulated natural gas are typically lower than those earned by Washington Gas.

 

WGEServices faces risks associated with its gas supply because it may experience a difference between contracted gas purchase quantities and contractual gas sales commitments. To minimize this risk, WGEServices manages its natural gas contract portfolio by closely matching the timing of gas purchases from suppliers with sales commitments to customers. WGEServices also purchases its gas from a number of wholesale suppliers in order to avoid relying on any single provider for its natural gas supply. Additionally, WGEServices maintains gas storage inventory that is assigned to it by natural gas utilities such as Washington Gas. This storage inventory enables WGEServices to meet daily and monthly fluctuations in demand caused by variations in weather from normal. WGEServices may, from time to time, enter into derivative contracts, including weather derivatives, in order to balance its sales commitments with the amount of gas it must purchase to satisfy those commitments, or for purposes of fixing the price at which WGEServices may have to purchase or sell gas. WGEServices has a risk management policy in place and periodically reassesses its policy to determine its adequacy to mitigate risks in changing markets. For a further discussion about WGEServices’ exposure to and management of market risks, refer to the section entitled “Market Risk” included in Management’s Discussion.

 

WGEServices purchases a portion of its natural gas supply from the Gulf Coast region. Purchase commitments from certain of WGEServices’ Gulf Coast-based natural gas suppliers were interrupted by the supply shortage in the Gulf Coast region in the immediate aftermath of the hurricanes during the fall 2005 season. During the 2005-2006 winter heating season, all of WGEServices’ contracted natural gas supplies from the Gulf Coast region flowed as contracted, and WGEServices met its customers’ daily demand for natural gas and achieved its required storage inventory balances.

 

In meeting its natural gas supply needs for the 2006-2007 winter heating season and beyond, WGEServices expects to continue to rely on a diverse set of supply sources, including city-gate delivered supplies, natural gas in storage and LNG from the Cove Point terminal.

 

Electricity Supply

 

Customer choice programs for electric customers have been implemented in each jurisdiction in which Washington Gas operates. Similar to the natural gas industry, participants in these programs can choose either to continue purchasing bundled electricity service from their local electric distribution utility or to purchase electricity from a third-party marketer. WGEServices competes with other third-party marketers to sell electric supply services to customers. Marketers of electric supply service compete largely on price, and gross margins are relatively small.

 

As of September 30, 2006, WGEServices’ electric customers grew 75 percent when compared to the number of customers as of September 30, 2005. This customer growth was principally the result of new competitive opportunities that emerged near the end of the third quarter of fiscal year 2006 due to sharp increases in competing rates offered by electric utilities in Maryland and Delaware. In other locations, however, future opportunities to add new electric customers may continue to be limited by the relationship between electric Standard Offer Service (SOS) rates offered by local electric utilities and market prices for electricity. Certain SOS rates in WGEServices’ market area continue to be below current market prices. In certain cases, electric utilities have entered into

 

WGL Holdings, Inc.
Washington Gas Light Company
Part I
Item 1. Business (continued)

wholesale contracts to supply their SOS customers, prior to an increase in fuel prices required to generate electricity. In other cases, electric utilities continue to provide service under previously established rates that are capped.

 

WGEServices procures electricity supply under contract structures in which WGEServices assumes the responsibility of matching its customer requirements with its supply purchases. WGEServices assembles the various components of supply, including electric energy, capacity, ancillary services and transmission service from multiple suppliers to match its customer requirements in accordance with its risk management policy. To the extent WGEServices has not matched its customer requirements with its supply purchases, it could be exposed to electricity commodity price risk. WGEServices’ electric business also is exposed to fluctuations in weather. Generally, WGEServices makes purchases under fixed-volume contracts that are based on certain weather assumptions. If there are significant deviations in weather from these assumptions, WGEServices may incur price and volume variances that could negatively impact its expected gross margins.

 

For a small percentage of its electricity supply, WGEServices purchased full requirements services from wholesale electricity suppliers under master purchase and sale agreements, including electric energy, capacity and certain ancillary services, for resale to retail electric customers. On October 19, 2006, WGEServices terminated all remaining full requirements contracts and received a small termination settlement.

 

Currently, Washington Gas provides customer services, such as preparing bills, reading meters and responding to customer inquiries, as part of its core utility function. Unregulated third-party marketers have the option to assume responsibility for bill preparation and customer collections. In addition to billing and collecting from customers for the natural gas commodity, third-party marketers’ bills may include natural gas delivery charges due Washington Gas, which they subsequently remit to it. Although Washington Gas still provides most customer services on a bundled basis, the potential exists for future deregulation initiatives to separate these services from the core utility function. In that case, customers could choose to have unregulated competitors provide these services.

 

To remain competitive, we continuously strive to improve quality and efficiency and to reduce costs to achieve market-level performance. Accordingly, we will continue to look for opportunities to profit from further unbundling.

 

Description of Operating Issues and Related Causes

 

On April 1, 2005, Washington Gas announced that it would address a significant increase in the number of natural gas leaks on its distribution system in a portion of Prince George’s County, Maryland. Washington Gas retained a consultant, ENVIRON International Corporation (Environ), to determine the reason for the increase in leaks in the affected area of Prince George’s County. Based on the work conducted to date by Environ, there is a combination of three contributing factors to the higher leak rates of seals on couplings. However, the contributing factor that is unique to the affected area is the change in the gas composition resulting from a change in the gas supply arising from the reactivation of the Cove Point LNG terminal owned by Dominion Resources, Inc. The Cove Point gas has a lower concentration of HHCs than domestic natural gas. The consultant’s report indicated that a characteristic of the rubber material comprising the seals in the couplings is the ability of the seals to both adsorb and desorb HHCs. When seals are exposed to higher levels of HHCs, they swell in size and cause a tighter seal. However, when gas, such as the gas from the Cove Point terminal is introduced and it has a lower level of HHCs, the seals shrink in size and there is a greater propensity for those seals to cause the couplings to leak.

 

Environ also considered the age of the couplings and the colder ground temperature during the winter as potential contributing factors to the higher leak rate. However, both the age of the couplings and the colder ground temperatures are common to couplings in other areas of Washington Gas’ service territory where leak patterns have not been observed like those in the affected area of Prince George’s County. Thus, in our opinion, the relevant change that explains the higher incidence of leaks in the affected area of Prince George’s County is the composition of the gas resulting from the introduction of gas from the Cove Point LNG terminal.

 

Washington Gas has continued to evaluate the causes and possible solutions related to the higher leak rate in the seals discussed above. Data and analyses continue to confirm that changes in gas composition explain the higher leak rates. A report by another consultant, Polymer Solutions, Inc., dated September 27, 2005, discussed and confirmed that changing gas composition has an effect on coupling seal materials. A later report from Environ, dated April 10, 2006, concluded in its testing of full component mechanical

 

WGL Holdings, Inc.
Washington Gas Light Company
Part I
Item 1. Business (continued)

couplings removed from Washington Gas’ distribution system within the affected area of Prince George’s County that the seals on the couplings will shrink and swell with the exposure to the change in levels of HHCs between domestic natural gas and re-vaporized LNG. Testing is continuing on coupling seal materials to attempt to determine optimum HHC injection rates necessary to maintain the integrity of the seals and return leak rates for the couplings to normal maintenance levels experienced before the introduction of gas coming from the Cove Point terminal.

 

Given the increase in the number of natural gas leaks experienced in the affected area of Prince George’s County, Maryland in fiscal year 2005, Washington Gas announced in that year that it would replace gas service lines and rehabilitate gas mains that contain the applicable mechanical couplings in the affected area of the distribution system in Prince George’s County (the rehabilitation project), with a projected date of completion by the end of December 2007. The original estimate of the cost of the rehabilitation project is $144 million. This cost estimate could differ materially from the actual costs incurred for the work associated with this project. Washington Gas’ planned capital expenditures for fiscal years 2006 through 2008 reflect this cost estimate. As of September 30, 2006, Washington Gas had completed approximately 50 percent of the work related to the rehabilitation project.

 

We consider the cost of the rehabilitation project described above necessary to provide safe and reliable utility service. We anticipate that costs such as these eventually will be recognized in the ratemaking process as reasonable. Washington Gas has not yet requested recovery of the capital expenditures and maintenance costs being incurred. However, we are also considering the effect of these capital expenditures on Washington Gas’ ability to earn its allowed rate of return in Maryland, and we are evaluating the most appropriate options to enable full and timely recovery of, and return on, the amounts being expended. There can be no assurance at this time that recovery in rates will be allowed or at what point in time such recovery may begin to be reflected in rates.

 

We anticipate that additional volumes of gas from the Cove Point terminal may flow through facilities in both the affected area of Prince George’s County and in other areas of Washington Gas’ distribution system as a result of the FERC’s June 16, 2006 order approving Dominion’s application to expand the capacity and output of the Cove Point terminal (see the section below entitled “Proposed Cove Point Expansion”). As such, Washington Gas has examined potential approaches that will enable it to protect against the adverse effects of the Cove Point gas. The original $144 million cost estimate of the rehabilitation project previously discussed does not consider any costs that have been incurred to date or that will potentially be incurred associated with implementing any of these actions. Based upon the scientific evidence available to date, Washington Gas constructed the facilities necessary to inject HHCs into the gas stream at the gate station that exclusively receives gas from the Cove Point terminal and serves the affected area of Prince George’s County, Maryland where the increase in gas leaks had been observed. This facility became operational in January 2006 at a cost of approximately $3.2 million.

 

Laboratory tests have shown that the injection of HHCs into the type of gas coming from the Cove Point terminal can be effective in re-swelling the seals in couplings which increases their sealing force and, thus, reduces the propensity for the couplings to leak. Furthermore, since the injection facility became operational in January 2006, Washington Gas has been evaluating the effectiveness of this HHC injection process on the couplings under field conditions. As of September 30, 2006, testing had concluded that the HHCs being injected at this gate station remain in the gas stream and are carried throughout that portion of the distribution system where Washington Gas intends for them to flow.

 

Washington Gas has observed a notable reduction in leak rates since the HHC injection facility became operational in January 2006. Given this observation, coupled with the results of the laboratory tests performed to date that support the effectiveness of the HHC injection process, we plan to modify the scope of work on the rehabilitation project through the 2006-2007 winter heating season, and anticipate that the overall scope and original $144 million cost estimate of this project may be modified if the expected results materialize in the coming winter. Washington Gas will continue collecting and analyzing leak data in the affected area of Prince George’s County through the 2006-2007 winter heating season and we will continue performing special leak surveys before drawing a definitive conclusion regarding the level of effectiveness of the injection process and the overall scope and cost estimate of the rehabilitation project that ultimately will be incurred. Until such time, Washington Gas will continue its rehabilitation efforts within the affected area in Prince George’s County at modified levels, and will concurrently continue its gas conditioning solution.

 

Proposed Cove Point Expansion

 

In fiscal year 2005, Dominion (the applicant) requested authorization from the FERC to expand the capacity and output of its Cove Point LNG terminal. This expansion would result in a substantial increase of Cove Point gas introduced into the Washington Gas distribution system in areas that have distribution and service lines constructed of similar materials and in a similar manner to those in the affected area of Prince George’s County. This could increase the exposure of other areas within the Washington Gas distribution system to Cove Point gas that may be either minimally blended with domestic natural gas pipeline supply or completely

 

WGL Holdings, Inc.
Washington Gas Light Company
Part I
Item 1. Business (continued)

unblended with any other gas, thereby potentially causing an increase in leaks on couplings in additional parts of the Washington Gas distribution system. To address this potential risk, Washington Gas has begun the planning necessary to construct two additional facilities to inject HHCs at gate stations in anticipation that more gas from the Cove Point terminal may begin flowing into the interconnected pipelines in fiscal year 2008 or thereafter and, therefore, into other areas of Washington Gas’ distribution system. Washington Gas anticipates that the next gate station injection facility will be operational by the 2007-2008 winter heating season.

 

The estimated cost of each of the additional HHC injection facilities will range from an estimated $3 million to $4 million. Washington Gas expects that the cost of these facilities should be includible in the rate base upon which Washington Gas is allowed to earn an allowed rate of return. The estimated cost of these facilities does not include the cost of the purchase of HHCs. At September 30, 2006, Washington Gas had incurred $2.0 million of HHC purchasing costs, and had deferred $575,000 of these costs on the balance sheet as a regulatory asset to be recovered from customers in the future. Currently, Washington Gas is collecting the cost of HHCs in its PGC provision in the District of Columbia from its sales customers. Washington Gas currently is not collecting the cost allocable to Virginia or Maryland customers associated with the purchase of HHCs. The regulatory bodies having jurisdiction over Washington Gas’ rates will determine the ultimate amount that is recoverable from customers for the cost of these HHCs (refer to the section entitled “Rates and Regulatory Matters”).

 

Washington Gas has not yet gathered enough evidence to reach a definitive conclusion that the injection of HHCs into the gas distribution system will be completely effective in preventing additional leaks or retarding the rate at which additional leaks may occur in the gas distribution system if additional volumes from the Cove Point terminal are introduced. The winter of 2005-2006 was too mild for a meaningful comparison with the period during which the unusual leak pattern presented itself in the affected area of Prince George’s County. Washington Gas continues to gather and evaluate field and laboratory evidence about this gas conditioning solution. The timing and implementation of decisions by the FERC governing the proposed expansion and the planning and implementation by Dominion may affect our ability to implement our plans before our system experiences increased flows of gas from Cove Point. Construction of these additional facilities may not be timely, permitted or feasible. If the facilities are constructed, the injection of additional HHCs may not be effective or only partially effective in preventing additional leaks on couplings in the gas distribution system. If the injection of HHCs into the gas distribution system is not effective or only partially effective in preventing additional leaks on couplings, Washington Gas will seek an acceptable and viable alternative to address this issue. If the planned actions of treating the Cove Point gas are not successful or only partially effective in preventing additional leaks on couplings, and if we are not able to determine a satisfactory alternative solution on a timely basis, additional operating expenses and capital expenditures may be necessary to contend with the receipt of increased volumes of gas from the Cove Point LNG terminal into Washington Gas’ distribution system.

 

Notwithstanding Washington Gas’ current and potential future actions before its local regulatory commissions with respect to the recovery of costs related to the construction of the injection facilities and the purchase of HHCs, our position is that any costs associated with the remediation related to the gas from the Cove Point LNG terminal should be the responsibility of the parties that are introducing gas from the Cove Point terminal into the interstate pipeline transmission system that is then introduced into the distribution system of Washington Gas. Therefore, as further discussed below, Washington Gas is pursuing certain remedies, and will pursue all remedies, it has before the FERC and other entities to assure that its customers are only paying their appropriate share of the costs of the remediation to maintain the safety of the Washington Gas distribution system. To the extent that Washington Gas receives approval and recovers costs from its retail customers for actions it has taken to maintain the safety and integrity of its distribution system, Washington Gas will apply any compensation received as a result of current or future actions before the FERC or against others, as an offset to future costs collected from retail customers.

 

Request for FERC Action

 

In November 2005, Washington Gas requested the FERC to invoke its authority to require Dominion to demonstrate that the increased volumes of the Cove Point gas would flow safely and reliably through the Washington Gas distribution system. Washington Gas specifically requested that the proposed expansion of the Cove Point LNG terminal be denied until the applicant has shown that the Cove Point gas: (i) is of such quality that it is fully interchangeable with the natural gas historically received by Washington Gas and (ii) will not cause harm to its customers or to the infrastructure of Washington Gas’ distribution system.

 

The FERC convened a procedural conference in February 2006 to receive information related to the issues raised by Washington Gas concerning the compatibility of gas from the Cove Point terminal and the safety of its distribution system should significantly larger volumes of gas from the Cove Point terminal flow into the interconnected interstate pipelines that serve Washington Gas. Washington Gas presented operational data and scientific evidence supporting Washington Gas’ assertions that the

 

WGL Holdings, Inc.
Washington Gas Light Company
Part I
Item 1. Business (continued)

unblended re-vaporized LNG is the unique cause of the increase in leaks. Washington Gas also provided the FERC with all data that Washington Gas had made available for Environ’s review.

 

On June 16, 2006, the FERC issued an order authorizing the applicant’s request to expand the capacity and output of its Cove Point LNG terminal and, thereby, denying Washington Gas’ request to require the applicant to demonstrate the safety and reliability of the Cove Point gas flowing through the Washington Gas distribution system. Furthermore, the FERC stated that, although it could not rule out the unblended re-vaporized LNG as a cause of the leaks on the Washington Gas distribution system, Washington Gas’ use of hot tar as a corrosion protectant, coupled with an increase in the operating pressure of its system “were the principal causative factors” in the increased leaks.

 

On July 17, 2006, Washington Gas filed a Request for Rehearing with the FERC to seek modification of the FERC’s June 16, 2006 order that authorized the Cove Point expansion. In its request, Washington Gas asserted, among other things, that its application of hot tar was an acceptable industry practice for corrosion protection when mechanical couplings were installed between the 1950s and 1970s, and that this practice was used throughout its service territory. The increase in leaks occurred only in the area that consistently receives Cove Point gas as its sole source of supply. Washington Gas further asserted that its operating pressure has remained constant in the affected area since the mid-1980s.

 

Washington Gas is pursuing the rehearing because specific scientific evidence, points of law and potentially serious safety issues were not adequately addressed by the FERC in its June 16, 2006 order on the Cove Point expansion. Washington Gas is one of several entities requesting such a rehearing. Filings by the PSC of MD and other organizations, such as KeySpan Corporation, state that the FERC order failed, in some way, to protect a wide range of consumers’ interests.

 

Washington Gas is committed to the use of natural gas from the Cove Point terminal to satisfy the needs of its customers. Washington Gas is willing to work with Dominion Cove Point LNG, the shippers who bring LNG into the Cove Point terminal and the interstate pipelines that deliver gas to Washington Gas in order to achieve and implement an appropriate solution to the issue of gas interchangeability affecting its system. Washington Gas will continue taking steps to protect its system by conditioning gas from Cove Point, and by proceeding with its ongoing rehabilitation project in the affected portion of Prince George’s County. The extent to which this project is fully completed will depend on the effectiveness of the injection process in the affected area of Prince George’s County during the winter of 2006-2007.

 

We are subject to federal, state and local laws and regulations related to environmental matters. These evolving laws and regulations may require expenditures over a long timeframe to control environmental effects. Almost all of the environmental liabilities we have recorded are for costs expected to be incurred to remediate sites where we or a predecessor affiliate operated manufactured gas plants (MGP). Estimates of liabilities for environmental response costs are difficult to determine with precision because of the various factors that can affect their ultimate level. These factors include, but are not limited, to the following:

 

 

Washington Gas has identified up to ten sites where it or its predecessors may have operated MGPs. Washington Gas last used any such plant in 1984. In connection with these operations, we are aware that coal tar and certain other by-products of the gas manufacturing process are present at or near some former sites, and may be present at others. Based on the information available to us, we have concluded that none of the sites are likely to present an unacceptable risk to human health or the environment.

 

At one of the former MGP sites, studies show the presence of coal tar under the site and an adjoining property. Washington Gas has taken steps to control the movement of contaminants into an adjacent river by installing a water treatment system that removes and treats contaminated groundwater at the site. Washington Gas received approval from governmental authorities for a

 

WGL Holdings, Inc.
Washington Gas Light Company
Part I
Item 1. Business (concluded)

comprehensive remediation plan for the majority of the site that will allow commercial development of Washington Gas’ property. Washington Gas has entered into an agreement with a national developer for the development of this site in phases. The first two phases have been completed, with Washington Gas retaining a ground lease on each phase. The owner of the affected adjoining property has issued a Record of Decision for that portion of the site, and Washington Gas will negotiate an agreement with the owner to perform the remediation. On September 21, 2006, governmental authorities notified Washington Gas of their desire to have the utility investigate and remediate river sediments in the area directly in front of the former MGP site. There has been no agreement among Washington Gas and governmental authorities as to the type and level of sediment investigation and remediation that should be undertaken for this area of the river; accordingly, we cannot estimate at this time the potential future costs of such investigation and remediation.

 

At a second former MGP site and on an adjacent parcel of land, Washington Gas developed a “monitoring-only” remediation plan for the site. This remediation plan received approval under a state voluntary closure program.

 

We do not expect that the ultimate impact of these matters will have a material adverse effect on our capital expenditures, earnings or competitive position. At the remaining eight sites, either the appropriate remediation is being undertaken, or no remediation should be necessary. See Note 14 of the Notes to Consolidated Financial Statements for a further discussion of environmental response costs.

 

Washington Gas is not dependent upon a single customer or group of customers such that the loss of any one or more of such customers would have a significant adverse effect on its business. As previously discussed, Washington Gas served over one million customers at September 30, 2006. Our energy-marketing segment is not heavily dependent on any one customer or group of customers. The commercial HVAC segment derived approximately 67 percent and 54 percent of revenues from various agencies of the Federal Government, in fiscal years 2006 and 2005, respectively.

 

Washington Gas is weather-sensitive and seasonal since the majority of its business is derived from residential and small commercial customers who use natural gas for space heating purposes. In fiscal year 2006, 76 percent of the total therms delivered in Washington Gas’ franchise area, excluding deliveries for electric generation, occurred in its first and second fiscal quarters. Washington Gas’ earnings are typically generated during these two quarters, and the regulated utility historically incurs net losses in the third and fourth fiscal quarters. The timing and level of approved rate increases can affect the results of operations. The seasonal nature of Washington Gas’ business creates large variations in short-term cash requirements, primarily due to the fluctuations in the level of customer accounts receivable, unbilled revenues and storage gas inventories. Washington Gas finances these seasonal requirements primarily through the sale of commercial paper and unsecured short-term bank loans.

 

The operations of WGEServices are also seasonal, with large amounts of electricity being sold in the summer months and large amounts of natural gas being sold in the winter months. Working capital requirements vary significantly during the year, and these variations are financed primarily through WGL Holdings’ issuance of commercial paper and unsecured short-term bank loans.

 

Our research and development costs during fiscal years 2006, 2005 and 2004 were not material.

 

At September 30, 2006, we had 1,818 employees comprising 1,606 utility and 212 non-utility employees.

 

Our Code of Conduct, Corporate Governance Guidelines, and charters for the Governance, Audit and Human Resources committees of the Board of Directors are available on the corporate Web site www.wglholdings.com. Copies also may be obtained by request to the Corporate Secretary at WGL Holdings, Inc., 101 Constitution Ave., N.W., Washington, D.C. 20080. We make available free of charge on our corporate Web site, our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and any amendments, as soon as reasonably practicable after such reports have been electronically filed with or furnished to the Securities and Exchange Commission (SEC). Additional information about WGL Holdings is also available on its Web site. Our Chairman and Chief Executive Officer certified to the New York Stock Exchange (NYSE) on March 15, 2006 that, as of that date, he was unaware of any violation by WGL Holdings of the NYSE’s corporate governance listing standards.

WGL Holdings, Inc.
Washington Gas Light Company
Part I
Item 1A. Risk Factors

 

The risk factors described below should be read in conjunction with other information included or incorporated by reference in this Annual Report on Form 10-K, including an in-depth discussion of these risks in the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” The risks and uncertainties described below are not the only risks and uncertainties facing us. Additional risks and uncertainties not presently known or that we currently have concluded are immaterial may also adversely affect us.

 

HOLDING COMPANY

 

Our business may be adversely affected if we are unable to pay dividends on our common stock and principal and interest on our outstanding debt.

 

We, WGL Holdings, are a holding company whose assets consist primarily of investments in our subsidiaries. Accordingly, we conduct all of our operations through our subsidiaries. Our ability to pay dividends on our common stock and to pay principal and accrued interest on our outstanding debt depends on the payment of dividends to us by Washington Gas or the repayment of funds to us by our principal subsidiaries. Payments to us by our subsidiaries depend, in turn, upon their results of operations and cash flows, which are subject to the risk factors, discussed below. The extent to which our subsidiaries do not pay dividends or repay funds to us may adversely affect our ability to pay dividends to holders of our common stock and principal and interest to holders of our debt.

 

If we are unable to access capital or to access capital cost effectively, our subsidiaries’ business may be adversely affected. Additionally, a downgrade in our credit ratings could adversely affect our access to capital markets.

 

Our ability to obtain adequate and cost effective capital depends largely on our credit ratings, which are greatly affected by our subsidiaries’ financial performance and the liquidity of financial markets. A downgrade in our current credit ratings could adversely affect our access to capital markets, as well as our cost of capital.

 

WASHINGTON GAS LIGHT COMPANY

 

Washington Gas’ operations, earnings and cash requirements are highly weather sensitive and seasonal.

 

The operations of Washington Gas, our regulated utility subsidiary, are weather sensitive and seasonal, with a significant portion of revenues derived from the delivery of natural gas to residential and commercial customers who use natural gas for space heating. Weather conditions directly influence the volume of natural gas delivered to customers. The rates Washington Gas charges its customers are determined on the basis of expected normal weather conditions. Generally, Washington Gas delivers more than 75 percent of its total natural gas volumes, excluding deliveries for electric generation, in our first and second fiscal quarters. Deviations in weather from normal levels and the seasonal nature of Washington Gas’ business can create large variations in earnings and short-term cash requirements.

 

Changes in the regulatory environment or unfavorable rate regulation, that can be affected by new laws or political considerations, may restrict or delay Washington Gas’ ability to earn a reasonable rate of return on its invested capital to provide utility service and to fully recover its operating costs.

 

Washington Gas is regulated by the PSC of DC, the PSC of MD and the SCC of VA. These regulatory commissions generally have authority over many of the activities of Washington Gas’ business including, but not limited to, the rates it charges to its customers, the amount and type of securities it can issue, the nature of investments it can make, the nature and quality of services it provides, safety standards and other matters.

 

Because the rate setting process is based, in part, on historical financial information and estimates that are inherent in the accounting process, the rates Washington Gas charges its customers may not allow Washington Gas’ business to earn a reasonable rate of return on actual invested capital and fully recover actual operating costs. Regulatory commissions have the authority to grant rate increases, order rate decreases or require no change in the rates Washington Gas charges its customers. These regulators also may modify Washington Gas’ rates to change the level, type and methods that it utilizes to recover its costs, including the costs to acquire, store, transport and deliver natural gas. Some of these supply costs are incurred under long-term contracts. The extent to which the actions of regulatory commissions restrict or delay Washington Gas’ ability to earn a reasonable rate of return on invested capital and/or fully recover operating costs may adversely affect its results of operations, financial condition and cash flows.

 

WGL Holdings, Inc.
Washington Gas Light Company
Part I
Item 1A. Risk Factors (continued)

Washington Gas’ ability to meet customers’ natural gas requirements may be impaired if its contracted gas supplies and interstate pipeline and storage services are not available or delivered in a timely manner.

 

Washington Gas is responsible for acquiring sufficient natural gas supplies and interstate pipeline and storage capacity to meet current and future customers’ annual and seasonal natural gas requirements. If Washington Gas is not able to maintain a reliable and adequate natural gas supply and sufficient pipeline capacity to deliver that supply, it may be unable to meet its customers’ requirements. If Washington Gas is unable to meet customers’ demand requirements, this could adversely affect its results of operations, financial condition and cash flows.

 

Washington Gas needs to acquire additional capacity to deliver natural gas on the coldest days of the year, and it may not receive the necessary authorizations to do so in a timely manner.

 

Washington Gas plans to construct a one billion cubic foot liquefied natural gas (LNG) storage facility in Chillum, Maryland, to meet its customers’ forecasted demand for natural gas. The new storage facility is currently expected to be completed and in service by the 2011-2012 winter heating season. If we are not permitted or are not able to construct this planned facility on a timely basis for any reason, the availability of the next best alternative (which is to acquire additional interstate pipeline transportation or storage capacity) may be limited by market supply and demand, and the timing of Washington Gas’ participation in new interstate pipeline construction projects. This could cause an interruption in Washington Gas’ ability to satisfy the needs of some of its customers, which could adversely affect its results of operations and cash flows.

 

Decreases in natural gas consumption by Washington Gas’ customers may negatively affect revenues and net income.

 

Increases in the cost of gas due to increases in the purchase price of the natural gas commodity generally have no direct effect on Washington Gas’ revenues and net income because regulatory mechanisms allow these increased costs to be reflected in the rates charged to customers. However, a rise in natural gas prices may reduce Washington Gas’ net income due to: (i) lower firm sales margins from decreased natural gas deliveries that may result from customer conservation; (ii) increased short-term interest expense to finance higher accounts receivable balance and (iii) higher expenses that may be incurred for uncollectible customer accounts.

 

In addition to these short-term impacts of higher natural gas prices, a sustained period of higher prices may result in longer term decreases in natural gas use per customer as customers change their consumption patterns by replacing older, less efficient gas appliances with more efficient appliances. The resulting conservation would reduce Washington Gas’ net revenues and net income in those jurisdictions where Washington Gas has not filed for or received approval from its regulators to implement mechanisms that mitigate the financial effect of such efficiency improvements.

 

Operating issues could affect public safety and the reliability of Washington Gas’ natural gas distribution system which could have adverse financial implications.

 

Washington Gas’ business is exposed to operational issues that could affect the public safety and reliability of its natural gas distribution system. Operational issues such as leaks, mechanical problems and accidents could result in significant costs to Washington Gas’ business and loss of customer confidence. The occurrence of any such operational issues could adversely affect Washington Gas’ results of operations, financial condition and cash flows. If Washington Gas is unable to recover from customers through the regulatory process all or some of these costs and its authorized rate of return on these costs, this also could adversely affect Washington Gas’ results of operations, financial condition and cash flows.

 

Washington Gas is incurring significant capital expenditures in connection with the rehabilitation of a portion of its natural gas distribution system in Prince George’s County, Maryland. If it is unable to recover these costs, this could have a significant adverse effect on Washington Gas’ financial condition, results of operations and cash flows.

 

Based on scientific evidence from an international consulting firm, it is our opinion that the introduction of gas from the Dominion Cove Point LNG terminal into Washington Gas’ natural gas distribution system caused the reduction in sealing force of the rubber seals within certain mechanical couplings on Washington Gas’ distribution system in a portion of Prince George’s County, Maryland. Therefore, we have concluded that this reduction in sealing force led to a significant increase in leaks in fiscal year 2005 in the affected area of Prince George’s County, Maryland.

 

Given the increase in the number of natural gas leaks, Washington Gas began to replace gas service lines and rehabilitate gas mains that contain the applicable mechanical couplings in the affected area of the distribution system in Prince George’s County (the rehabilitation project), with a projected date of completion by the end of December 2007. The original estimate of the cost of the

 

WGL Holdings, Inc.
Washington Gas Light Company
Part I
Item 1A. Risk Factors (continued)

rehabilitation project is $144 million; however, actual costs incurred for the work associated with this project could differ materially from this cost estimate. If Washington Gas is unable to recover from customers through the regulatory process all or some of these costs and its authorized rate of return on these costs, this could have a significant adverse effect on Washington Gas’ financial condition, results of operations and cash flows.

 

The receipt of additional amounts of gas from the Dominion Cove Point LNG terminal into Washington Gas’ natural gas distribution system may result in higher operating expenses and capital expenditures which may have a material adverse effect on its financial condition, results of operations and cash flows.

 

On June 16, 2006, the FERC issued an order authorizing the request of Dominion Resources, Inc., the owner of the Dominion Cove Point LNG facility, to expand the capacity and output of its Cove Point terminal. This expansion would result in a substantial increase in the volume of Cove Point gas introduced into Washington Gas’ distribution system in areas that have distribution and service lines constructed of similar materials and in a similar manner to those in the affected area of Prince George’s County. We estimate that this increase would occur in fiscal year 2008 or thereafter. The increased volume of Cove Point gas that will flow into Washington Gas’ distribution system may cause additional leaks on couplings in its system (except in the area of Prince George’s County, Maryland that is undergoing the rehabilitation project).

 

We are taking actions to prepare for the receipt of increased volumes of gas from the Cove Point terminal. Washington Gas constructed the facilities necessary to treat the gas from the Cove Point terminal that is exclusively received at the gate station that serves the affected area of Prince George’s County, Maryland where the increase in gas leaks has been observed. Additionally, Washington Gas has begun the planning necessary to construct two additional treatment facilities at gate stations in anticipation that more gas from the Cove Point terminal may begin flowing into the interconnected pipelines and, therefore, into other areas of its distribution system. However, we have not gathered enough evidence yet to conclude that the treatment of the Cove Point gas received into Washington Gas’ distribution system will be completely effective in preventing additional leaks or retarding the rate at which additional leaks may occur in the gas distribution system if additional volumes from the Cove Point terminal are introduced. Also, construction of these additional facilities may not be timely, permitted or feasible. If the facilities are constructed, the treatment of the Cove Point gas may not be effective or only partially effective in preventing additional leaks on couplings in the gas distribution system. If the planned actions of treating the Cove Point gas are not successful or only partially effective in preventing additional leaks on couplings, and if we are not able to determine a satisfactory alternative solution on a timely basis, additional operating expenses and capital expenditures may be necessary to contend with the receipt of increased volumes of gas from the Cove Point LNG terminal into Washington Gas’ distribution system. These additional expenditures may not be recoverable or may not be recoverable on a timely enough basis from customers, or other parties. Therefore, these conditions could have a material adverse effect on Washington Gas’ financial condition, results of operations and cash flows.

 

Changes in the relative prices of alternative forms of energy may strengthen or weaken the competitive position of Washington Gas’ natural gas delivery service. If the competitive position of natural gas service weakens, it may reduce the number of natural gas customers in the future and negatively affect Washington Gas’ future cash flows and net income.

 

The price of natural gas delivery service that Washington Gas provides competes with the price of other forms of energy such as electricity, oil and propane. Changing prices of natural gas versus other sources of energy that Washington Gas competes against can cause the competitive position of our natural gas delivery service to improve or decline. A decline in the competitive position of natural gas service in relation to alternative energy sources can lead to fewer natural gas customers, lower volumes of natural gas delivered, lower cash flows and lower net income.

 

A decline in the economy or significant increases in interest rates may reduce revenues or increase costs.

 

A decline in the economy of the region in which Washington Gas operates, or a significant increase in interest rates to be paid by potential purchasers of new homes, might adversely affect Washington Gas’ ability to grow its customer base at the same rate it has grown in the past. An increase in the interest rates Washington Gas pays without the recognition of the higher cost of debt incurred by it in the rates charged to its customers would adversely affect Washington Gas’ future earnings and cash flows.

 

Washington Gas’ inability to access capital or to access capital cost effectively may adversely affect its business. A downgrade in Washington Gas’ credit ratings could increase its borrowing costs.

 

Washington Gas’ ability to obtain adequate and cost effective capital depends largely on its credit ratings, which are greatly affected by Washington Gas’ financial performance and the liquidity of financial markets. A downgrade in Washington Gas’ current credit ratings could affect its access to capital markets, as well as its cost of capital and ability to earn its authorized rate of return.

 

WGL Holdings, Inc.
Washington Gas Light Company
Part I
Item 1A. Risk Factors (continued)

As a wholly owned subsidiary of WGL Holdings, Washington Gas depends solely on WGL Holdings to raise new common equity capital and contribute that common equity to Washington Gas. If WGL Holdings is unable to raise common equity capital, this also could adversely affect Washington Gas’ credit ratings and its ability to earn its authorized rate of return.

 

Washington Gas’ risk management strategies and related hedging activities may not be effective in managing its risks, and may result in additional liability for which rate recovery may be disallowed and cause increased volatility in its earnings.

 

Washington Gas’ business requirements expose it to commodity price, weather, credit and interest-rate risks. Washington Gas attempts to manage its exposure to these risks by hedging, setting risk limits and employing other risk management tools and procedures. Risk management activities may not be as effective as planned, and cannot eliminate all of its risks. Washington Gas also may be exposed to additional liability should the anticipated revenue recovery of costs or losses incurred with certain of these risk management activities be subsequently excluded from the determination of revenues by a regulator.

 

Washington Gas’ facilities and operations could be targets of acts of terrorism.

 

Washington Gas’ natural gas distribution, transmission and storage facilities may be targets of terrorist activities that could result in a disruption of its ability to meet customer requirements. Terrorist attacks may also disrupt capital markets and Washington Gas’ ability to raise capital. A terrorist attack on Washington Gas’ facilities or those of its natural gas suppliers or customers could result in a significant decrease in revenues or a significant increase in repair costs, which could adversely affect its results of operations, financial position and cash flows.

 

WASHINGTON GAS ENERGY SERVICES, INC.

 

WGEServices’ business, earnings and cash requirements are highly weather sensitive and seasonal.

 

WGEServices, our retail energy-marketing subsidiary, is weather sensitive and seasonal, with a significant portion of revenues derived from the sale of natural gas to retail customers for space heating during the winter months, and from the sale of electricity to customers for cooling during the summer months. Weather conditions directly influence the volume of natural gas and electricity delivered to customers. Weather conditions can also affect the short-term pricing of energy supplies that WGEServices may need to procure to meet the needs of its customers. Deviations in weather from normal levels and the seasonal nature of WGEServices’ business can create large variations in earnings and short-term cash requirements.

 

The ability of WGEServices to meet customers’ natural gas and electricity requirements may be impaired if contracted supply is not available or delivered in a timely manner.

 

Sufficient deliverability of natural gas and electric supplies to serve the demand of WGEServices’ customers is dependent upon the ability of natural gas producers, pipeline gatherers, natural gas processors, interstate pipelines, suppliers of electricity and regional electric transmission operators to deliver the respective commodities. If WGEServices is unable to secure adequate supply in a timely manner, either due to the failure of its suppliers to deliver the contracted commodity or the inability to secure additional quantities during significant abnormal weather conditions, it may be unable to meet its customer requirements. Such inability to meet its delivery obligations to customers could result in WGEServices experiencing defaults on contractual terms with its customers, penalties and financial damage payments, the loss of certain licenses and operating authorities, and/or a need to return customers to the bundled services of regulated utility companies, such as Washington Gas.

 

The risk management strategies and related hedging activities of WGEServices may not be effective in managing risks and may cause increased volatility in its earnings.

 

WGEServices is exposed to commodity price risk to the extent its natural gas and electricity purchases are not closely matched to its sales commitments in terms of volume and pricing. WGEServices attempts to manage its exposure to commodity price risk, as well as its exposure to weather and credit risks by hedging, setting risk limits, and employing other risk management tools and procedures. These risk management activities may not be as effective as planned, and cannot eliminate all of WGEServices’ risks.

 

Significant increases in interest rates may increase costs.

 

WGEServices depends on short-term debt to finance its accounts receivable and storage gas inventories. Working capital requirements vary significantly during the year, and we finance these requirements primarily through the issuance of commercial

 

WGL Holdings, Inc.
Washington Gas Light Company
Part I
Item 1A. Risk Factors (concluded)

paper and unsecured short-term bank loans by WGL Holdings. The results of operations of WGEServices would be adversely affected if short-term interest rates rose or if we were unable to access capital in a cost-effective manner.

 

WGEServices is dependent on guarantees from WGL Holdings.

 

The ability of WGEServices to purchase natural gas and electricity from suppliers is dependent upon guarantees issued on its behalf by WGL Holdings. Should WGL Holdings not renew such guarantees after the effective date of their cancellation, the ability of WGEServices to make commodity purchases at reasonable prices would be impaired, adversely affecting its results of operations, financial position and cash flows.

 

Competition may negatively affect WGEServices.

 

WGEServices competes with other non-regulated retail suppliers of natural gas and electricity, as well as with the commodity rate offerings of electric and gas utilities. Increases in competition including utility commodity rate offers that are below prevailing market rates may cause a loss of sales volumes or a reduction of growth opportunities for WGEServices that could adversely affect its results of operations and cash flows.

 

Regulatory developments may negatively affect WGEServices.

 

The regulations that govern the conduct of competitive energy markets are subject to change as the result of legislation or regulatory proceedings. Changes in these regulatory rules could reduce customer growth opportunities for WGEServices, or could reduce the profit opportunities associated with certain groups of existing or potential new customers and, thereby, adversely affect its results of operations and cash flows.

 

None.

WGL Holdings, Inc.
Washington Gas Light Company
Part I
Item 2. Properties

 

At September 30, 2006, we provided services in various areas of Virginia, the District of Columbia and Maryland, and held certificates of convenience and necessity, licenses and permits necessary to maintain and operate their respective properties and businesses. The regulated utility segment is the only segment where property, plant and equipment is a significant asset.

 

Property, plant and equipment is stated at original cost, including labor, materials, taxes and overhead costs incurred during the construction period. Washington Gas calculates depreciation applicable to its utility gas plant in service primarily using a straight-line method over the estimated remaining life of the plant. The composite depreciation and amortization rate of the regulated utility was 3.44 percent during fiscal year 2006, and 3.48 percent during fiscal years 2005 and 2004, which included an allowance for estimated accrued non-legal asset removal costs (see Note 1 of the Notes to Consolidated Financial Statements).

 

At September 30, 2006, Washington Gas had approximately 642 miles of transmission mains, 11,813 miles of distribution mains, and 13,346 miles of distribution services. Washington Gas has the storage capacity for approximately 15 million gallons of propane for peak shaving.

 

Washington Gas owns approximately 40 acres of land and a building (built in 1970) at 6801 Industrial Road in Springfield, Virginia. The Springfield site performs both operating and certain administrative functions of the utility. Washington Gas also holds title to land and buildings used as substations for its utility operations.

 

Washington Gas also has peaking facilities to enhance deliverability in periods of peak demand in the winter that consist of propane air plants in Springfield, Virginia (Ravensworth Station), and Rockville, Maryland (Rockville Station). Hampshire operates an underground natural gas storage field in Hampshire County, West Virginia. Hampshire accesses the storage field through 12 storage wells that are connected to an 18-mile pipeline gathering system. Hampshire also operates a compressor station for injection of gas into storage. For pipeline year 2007, we estimate that the Hampshire storage facility has the capacity to supply approximately 2.2 billion cubic feet of natural gas to Washington Gas’ system for meeting seasonal demands.

 

Washington Gas owns a 12-acre parcel of land located in Southeast Washington, D.C. Washington Gas entered into an agreement with a national developer to develop this land in phases. Washington Gas selected the developer to design, execute and manage the various phases of the development. The development, Maritime Plaza, is intended to be a mixed-use commercial project that will be implemented in five phases. The first two phases have been developed, with Washington Gas retaining a 99-year ground lease on each phase. See the section entitled “Environmental Matters”  under Item 1 of this report for additional information regarding this development.

 

Facilities utilized by our corporate headquarters, as well as by the retail energy-marketing and commercial HVAC segments, are located in the Washington, D.C. metropolitan area and are leased.

 

The Mortgage of Washington Gas dated January 1, 1933 (Mortgage), as supplemented and amended, securing any First Mortgage Bonds (FMBs) it issues, constitutes a direct lien on substantially all property and franchises owned by Washington Gas other than a small amount of property that is expressly excluded. At September 30, 2006 and 2005, no debt was outstanding under the Mortgage.

 

Washington Gas executed a supplemental indenture to its unsecured Medium-Term Note (MTN) Indenture on September 1, 1993, providing that Washington Gas will not issue any FMBs under its Mortgage without securing all MTNs with all other debt secured by the Mortgage.

 

WGL Holdings, Inc.
Washington Gas Light Company
Part I

 

None.

 

None.

WGL Holdings, Inc.
Washington Gas Light Company
Part I

 

The names, ages and positions of the executive officers of the registrants at October 31, 2006, are listed below along with their business experience during the past five years. The age of each officer listed is as of the date of filing of this report. There is no family relationship among the officers.

 

Unless otherwise indicated, all officers have served continuously since the dates indicated, and all positions are executive officers listed with Washington Gas Light Company.

 

WGL Holdings, Inc.
Washington Gas Light Company
Part I

WGL Holdings, Inc.
Part II
Item 5. Market for Registrant’s Common Equity, Related
Stockholder Matters and Issuer Purchases of Equity Securities

 

At October 31, 2006, WGL Holdings had 14,951 common shareholders of record. During fiscal years 2006 and 2005, WGL Holdings’ common stock was listed for trading on the New York Stock Exchange and was shown as “WGL Hold” or “WGL Hldgs” in newspapers. We did not purchase any of our outstanding common stock during fiscal years 2006 and 2005. The table below shows quarterly price ranges and quarterly dividends paid for fiscal years ended September 30, 2006 and 2005.

 

WGL Holdings, Inc.
Washington Gas Light Company
Part II
Item 6. Selected Financial Data

 

 

WGL Holdings, Inc.
Washington Gas Light Company
Part II
Item 7. Management’s Discussion and Analysis of
Financial Condition and Results of Operations

 

INTRODUCTION

 

This Management’s Discussion and Analysis of Financial Condition and Results of Operations (Management’s Discussion) analyzes the financial condition, results of operations and cash flows of WGL Holdings, Inc. (WGL Holdings) and its subsidiaries. It also includes management’s analysis of past financial results and potential factors that may affect future results, potential future risks and approaches that may be used to manage them. Except where the content clearly indicates otherwise, “WGL Holdings,” “we,” “us” or “our” refers to the holding company or the consolidated entity of WGL Holdings and all of its subsidiaries.

 

Management’s Discussion is divided into the following two major sections:

 

 

Both of the major sections of Management’s Discussion—WGL Holdings and Washington Gas—should be read to obtain an understanding of our operations and financial performance. Management’s Discussion also should be read in conjunction with the respective company’s financial statements and the combined Notes to Consolidated Financial Statements.

 

Unless otherwise noted, earnings per share amounts are presented on a diluted basis, and are based on weighted average common and common equivalent shares outstanding. The earnings per share of any segment does not represent a direct legal interest in the assets and liabilities allocated to any one segment, but rather represents a direct equity interest in our assets and liabilities as a whole.

 

WGL Holdings, Inc.
Washington Gas Light Company
Part II
Item 7. Management’s Discussion and Analysis of
Financial Condition and Results of Operations (continued)

Management’s Discussion Table of Contents

 

 

  Introduction

 

WGL Holdings, through its wholly owned subsidiaries, sells and delivers natural gas and provides a variety of energy-related products and services to customers primarily in Washington, D.C. and the surrounding metropolitan areas in Maryland and Virginia. Our core subsidiary, Washington Gas, engages in the delivery and sale of natural gas that is regulated by regulatory commissions in the District of Columbia, Maryland and Virginia. Through the wholly owned, unregulated subsidiaries of Washington Gas Resources Corporation (Washington Gas Resources), we also offer energy-related products and services. In response to changes in federal and state regulation, we offer competitively priced natural gas and electricity to customers through Washington Gas Energy Services (WGEServices), our unregulated retail energy-marketing subsidiary.

 

WGL Holdings has three operating segments that are described below:

 

 

Transactions not specifically identifiable in one of the above three segments are accumulated and reported in the category “Other Activities.”

 

Regulated Utility.  With approximately 92 percent of our consolidated total assets, the regulated utility segment consists of Washington Gas and Hampshire Gas Company (Hampshire). Washington Gas, a wholly owned subsidiary of WGL Holdings, delivers natural gas to retail customers in accordance with tariffs approved by the regulatory commissions that have jurisdiction over Washington Gas’ rates. Washington Gas also sells natural gas to customers who have not elected to purchase natural gas from unregulated third-party marketers. Washington Gas does not earn a profit or incur a loss when it sells the natural gas commodity because utility customers are charged for the natural gas commodity at the same cost that Washington Gas incurs.

 

Hampshire, a wholly owned subsidiary of WGL Holdings, operates an underground natural gas storage facility that is regulated by the Federal Energy Regulatory Commission (FERC). Washington Gas purchases all of the storage services of Hampshire and includes the cost of these services in the bills sent to its customers. Hampshire operates under a “pass-through” cost of service-based tariff approved by the FERC, and adjusts its billing rates to Washington Gas on a periodic basis to account for changes in its investment in utility plant and associated expenses.

 

WGL Holdings, Inc.
Washington Gas Light Company
Part II
Item 7. Management’s Discussion and Analysis of
Financial Condition and Results of Operations (continued)

Retail Energy-Marketing.  The retail energy-marketing segment includes the operations of WGEServices, a wholly owned subsidiary of Washington Gas Resources. WGEServices competes with other unregulated third-party marketers by selling natural gas and electricity directly to residential, commercial and industrial customers in Maryland, Virginia, Delaware and the District of Columbia. WGEServices does not own or operate any natural gas or electric generation, production, transmission or distribution assets. Rather, it buys and resells natural gas and electricity with the objective of earning a profit through competitively-priced contracts. These commodities are delivered to retail customers through the assets owned by regulated utilities such as Washington Gas or other unaffiliated natural gas or electric utilities.

 

Commercial HVAC.  The commercial HVAC segment includes the operations of WGESystems, a wholly owned subsidiary of Washington Gas Resources. WGESystems manages design-build and renovation projects and provides maintenance services to the commercial and government markets. WGESystems focuses on retrofitting the mechanical, electrical and energy-related systems of a large number of aging commercial and government structures, primarily in the District of Columbia and portions of Maryland and Virginia. On September 29, 2006, Washington Gas Resources sold all of the outstanding shares of common stock of its wholly owned subsidiary, American Combustion Industries, Inc. (ACI) that was previously reported as part of the commercial HVAC segment (refer to the section entitled “Discontinued Operations”).

 

Refer to the Business section under Item 1 of this report for a further discussion of our regulated utility and non-utility business segments. For a further discussion of our financial performance by operating segment, refer to Note 17 of the Notes to Consolidated Financial Statements.

 

  Key Indicators of Financial Condition and Operating Performance

 

We have determined that the following are key indicators for monitoring our financial condition and operating performance:

 

Return on Average Common Equity.  This measure is calculated by dividing twelve months ended net income (applicable to common stock) by average common shareholders’ equity. For Washington Gas, we compare the actual return on common equity with the return on common equity that is allowed to be earned by regulators and the return on equity that is necessary for us to compensate investors sufficiently and be able to continue to attract capital.

 

Common Equity Ratio.  This ratio is calculated by dividing total common shareholders’ equity by the sum of common shareholders’ equity, preferred stock and long-term debt (including current maturities). Maintaining this ratio in the mid-50 percent range affords us financial flexibility and access to long-term capital at relatively low costs. Refer to the section entitled “Liquidity and Capital Resources—General Factors Affecting Liquidity” for a discussion of our capital structure.

 

The following is a summary discussion of the primary factors that affect the operations and/or financial performance of our regulated and unregulated businesses. Refer to the section entitled “Business” under Item 1 of this report for a more detailed discussion of these and other related factors that affect the operations and/or financial performance of WGL Holdings and Washington Gas.

 

  Weather Conditions and Weather Patterns

 

Washington Gas’ operations are weather sensitive, with a significant portion of its revenues derived from the delivery of natural gas to residential and commercial heating customers during the winter heating season. Generally, weather conditions directly influence the volume of natural gas delivered by Washington Gas. However, weather patterns may become erratic during “shoulder” months within our fiscal year in which Washington Gas is going into or coming out of the primary portion of its winter heating season. During the shoulder months within quarters ending December 31 (particularly in October and November) and within quarters ending June 30 (particularly in April and May), customer heating usage may not correlate highly with the level of recorded heating degree days during those months when weather patterns experienced are not consistently cold or warm.

 

Washington Gas’ rates are determined on the basis of expected normal weather conditions. Prior to October 1, 2005, Washington Gas did not have a ratemaking provision in any of its jurisdictions that allowed for revenues to be adjusted for the difference between actual weather conditions in a particular year and the expected normal weather conditions that are used to establish rates. Consequently, deviations in weather from normal levels affected Washington Gas’ financial performance. Washington

 

WGL Holdings, Inc.
Washington Gas Light Company
Part II
Item 7. Management’s Discussion and Analysis of
Financial Condition and Results of Operations (continued)

Gas managed weather risk for all jurisdictions with a weather insurance policy designed to protect against 50 percent of the negative financial effects of warmer-than-normal weather. That policy expired on September 30, 2005.

 

Commencing in fiscal year 2006, Washington Gas implemented new weather protection strategies designed to provide full protection from the negative financial effects of warmer-than-normal weather. Effective October 1, 2005, Washington Gas implemented a Revenue Normalization Adjustment (RNA) billing mechanism in Maryland. Approved by the Public Service Commission of Maryland (PSC of MD), the RNA is a mechanism designed to stabilize the level of net revenues collected from Maryland customers by eliminating the effect of deviations in customer usage caused by variations in weather from normal levels and certain other factors such as customer conservation. Deliveries to Maryland customers represent approximately 40 percent of therms delivered by Washington Gas. As Washington Gas currently has no similar ratemaking provisions in the District of Columbia or Virginia, the utility is utilizing a new three-year weather insurance policy in the District of Columbia that became effective October 1, 2005, and weather derivatives in Virginia. Refer to the section entitled “Market Risk—Weather Risk” for a further discussion of our weather protection strategies.

 

While the use of weather insurance and a weather derivative in the District of Columbia and Virginia, respectively, were effective in providing full protection from the effects of warmer-than-normal weather in those jurisdictions during fiscal year 2006, our intent is to obtain this protection through ratemaking provisions in these two jurisdictions similar to the RNA that was implemented in Maryland. On September 15, 2006, Washington Gas filed an application with the State Corporation Commission of Virginia (SCC of VA) requesting, among other things, to implement a tariff provision for an RNA billing mechanism in Virginia. A final order by the SCC of VA on this and all other requests included in the application is pending.

 

The financial results of our energy-marketing subsidiary, WGEServices, also are affected by deviations in weather from normal levels. Since WGEServices sells both natural gas and electricity, WGEServices’ financial results may fluctuate due to deviations in weather from fiscal year to fiscal year during the winter heating and summer cooling seasons.

 

  Regulatory Environment and Regulatory Decisions

 

Washington Gas is regulated by the Public Service Commission of the District of Columbia (PSC of DC), the PSC of MD and the SCC of VA. Hampshire is regulated by the FERC. These regulatory commissions set the rates in their respective jurisdictions that Washington Gas can charge customers for its rate-regulated services. Changes in these rates as ordered by regulatory commissions affect Washington Gas’ financial performance.

 

Washington Gas expects that regulatory commissions will continue to set the prices and terms for delivery service that give it an opportunity to earn a just and reasonable rate of return on the capital invested in its distribution system and to recover reasonable operating expenses.

 

  Gas Supply and Pipeline Transportation and Storage Capacity

 

Natural Gas Supply and Capacity Requirements.  Washington Gas is responsible for acquiring both sufficient natural gas supplies and interstate pipeline and storage capacity to meet customer requirements. As such, Washington Gas must contract for reliable and adequate delivery capacity to its distribution system, while considering the dynamics of the interstate pipeline and storage capacity market, its own on-system natural gas peaking facilities, as well as the characteristics of its customer base.

 

Depleting pipeline and storage capacity is a business issue for local distribution companies, such as Washington Gas. Washington Gas, whose customer base has grown at an annual rate of approximately two percent, must manage this issue. This rate of growth is expected to continue. To help maintain the adequacy of pipeline and storage capacity for its growing customer base, Washington Gas has contracted with various interstate pipeline and storage companies for the acquisition of additional existing capacity, as well as the construction of new capacity, for firm transportation and storage services to Washington Gas. These capacity expansion projects are expected to be placed into service during fiscal years 2007-2010. Washington Gas will continue to monitor other opportunities to acquire or participate in obtaining additional pipeline and storage capacity that will improve or maintain the high level of service expected by its customer base.

 

Gulf Coast Natural Gas Supply Issues.  During the late summer of 2005, immediately prior to the 2005-2006 winter heating season, the Gulf Coast region experienced a major disruption of natural gas production and processing due to hurricanes Katrina, Rita and Wilma. These natural gas production and processing disruptions resulted in a significant reduction of natural gas available to be delivered from the Gulf Coast region. Given the recovery of available supplies from the Gulf Coast region following the hurricanes,

 

WGL Holdings, Inc.
Washington Gas Light Company
Part II
Item 7. Management’s Discussion and Analysis of
Financial Condition and Results of Operations (continued)

coupled with the availability of natural gas supply from alternative production areas, Washington Gas was able to meet its customers’ daily demand for natural gas during the 2005-2006 winter heating season. Storage gas inventory balances were maintained at adequate operational levels throughout the heating season. Since hurricanes Katrina, Rita and Wilma, Washington Gas has modified the composition of its natural gas portfolio to include a significantly higher percentage of natural gas supply that is produced from sources outside of the Gulf Coast region. The diversification of its natural gas portfolio will help Washington Gas to meet customer demand despite unforeseen future supply issues that may arise similar to those resulting from the weather events in the Gulf Coast region.

 

WGEServices purchases a portion of its natural gas supply from the Gulf Coast region. Purchase commitments from certain of WGEServices’ Gulf Coast-based natural gas suppliers were interrupted by the supply shortage in the Gulf Coast region in the immediate aftermath of the hurricanes during the fall 2005 season. During the 2005-2006 winter heating season, all of WGEServices’ contracted natural gas supplies from the Gulf Coast region flowed as contracted, and WGEServices met its customers’ daily demand for natural gas and achieved its required storage inventory balances. In meeting its future natural gas supply needs, WGEServices expects to continue to rely on a diverse set of supply sources, including city-gate delivered supplies, natural gas in storage and liquefied natural gas (LNG) from the Dominion Cove Point (Dominion or Cove Point) LNG terminal.

 

Volatility of Natural Gas Prices.  As a result of market concerns about the sufficiency of the supply of natural gas, the hurricanes in the Gulf Coast region and other factors during the 2005-2006 winter heating season, the price of the natural gas commodity paid by Washington Gas’ customers rose sharply from levels experienced during the prior year’s winter heating season. In fiscal year 2006, higher natural gas prices increased customers’ bills dramatically. Under its regulated gas cost recovery mechanisms, Washington Gas records cost of gas expense equal to the cost of gas recovered in revenues from customers. An increase in the cost of gas due to an increase in the purchase price of the natural gas commodity generally has no direct effect on Washington Gas’ net income. However, its net income was reduced in fiscal year 2006 primarily due to higher expenses for uncollectible customer accounts, as well as lower natural gas consumption caused by customer conservation in Virginia and the District of Columbia where these adverse effects on earnings are not addressed through regulatory mechanisms. The RNA and other regulatory mechanisms in Maryland neutralize these effects on Washington Gas’ revenue and net income. Increases in the price of natural gas also can affect our operating cash flows, as well as the competitiveness of natural gas as an energy source.

 

WGEServices also may be negatively affected by the indirect effects of significant increases in the wholesale price of natural gas such as those that resulted from the Gulf Coast natural gas supply shortage. WGEServices’ risk management policies and procedures are designed to minimize the risk that WGEServices’ natural gas purchases and the related sales commitments do not closely match (refer to the section entitled “Market Risk” for a further discussion of Washington Gas’ and WGEServices’ mitigation of commodity price risk). Higher natural gas prices, however, may increase the costs associated with uncollectible accounts, borrowing costs, certain fees paid to public service commissions and other costs. To the extent that these costs cannot be recovered from retail customers in higher rates due to competitive factors, WGEServices’ operating results would be negatively affected.

 

Changes in Natural Gas Consumption.  Natural gas supply requirements may be affected by changes in natural gas consumption by customers. Natural gas usage per customer may decline as customers change their consumption patterns in response to: (i) more volatile and higher natural gas prices, as discussed above, and (ii) customers’ replacement of older, less efficient gas appliances with more efficient appliances. In each jurisdiction in which Washington Gas operates, changes in customer usage profiles have been reflected in recent rate case proceedings where rates have been adjusted to reflect current customer usage. In both the District of Columbia and Virginia jurisdictions, changes in customer usage by existing customers that occur subsequent to these recent rate case proceedings will have the effect of reducing revenues, which is offset by the favorable effect of adding new customers. Effective October 1, 2005, pursuant to an RNA mechanism approved by the PSC of MD, changes in customer usage by existing customers that occur subsequent to recent rate case proceedings in the Maryland jurisdiction generally will not reduce revenues, but rather will have the effect of stabilizing the level of delivery charge revenues received from customers on a monthly basis. On September 15, 2006, Washington Gas requested approval from the SCC of VA of a similar RNA mechanism to be put in place in the Virginia jurisdiction that would also stabilize rather than reduce revenues (refer to the section entitled “Jurisdictional Rates and Regulatory Matters” under Item 1 of this report).

 

WGL Holdings, Inc.
Washington Gas Light Company
Part II
Item 7. Management’s Discussion and Analysis of
Financial Condition and Results of Operations (continued)

  Electricity Supply

 

Customer choice programs for electric customers are available in each jurisdiction in which WGEServices operates. Similar to the natural gas industry, electric customers participating in these programs may choose either to continue purchasing bundled electricity service from their local electric distribution utility or to purchase electricity from an unregulated third-party marketer.

 

Electric customers grew 75 percent in fiscal year 2006 when compared to the end of the prior fiscal year. This customer growth was principally the result of new competitive opportunities that emerged near the end of the third quarter of fiscal year 2006 due to sharp increases in competing rates offered by electric utilities in Maryland and Delaware. In other locations, however, future opportunities to add new electric customers may continue to be limited by the relationship between electric Standard Offer Service (SOS) rates offered by local electric utilities and market prices for electricity. Certain SOS rates in WGEServices’ market area continue to be below current market prices. In certain cases, electric utilities have entered into wholesale contracts to supply their SOS customers, prior to an increase in fuel prices required to generate electricity. In other cases, electric utilities continue to provide service under previously established rates that are capped. Refer to the section entitled “Market Risk—Price Risk Related to the Retail Energy-Marketing Segment” for a further discussion of WGEServices’ electricity supply.

 

  Maintaining the Safety and Reliability of the Natural Gas Distribution System

 

Maintaining and improving the public safety and reliability of Washington Gas’ natural gas distribution system is our highest priority that benefits both customers and investors through lower costs and improved customer service. Washington Gas continually refines its safety practices, with a particular focus on design, construction, maintenance, operation, replacement, inspection and monitoring practices. Operational issues affecting the public safety and reliability of Washington Gas’ natural gas distribution system that are not addressed within a timely and adequate manner could significantly and adversely affect our future earnings and cash flows, as well as result in a loss of customer confidence. Washington Gas is responding to its operational issues in a timely and adequate manner, and has the financial resources necessary to address these issues due to its current strong cash position, and the financing options it has available. Refer to the section entitled “Contractual Obligations, Off-Balance Sheet Arrangements and Other Commercial Commitments—Operating Issues in Prince George’s County, Maryland” for a discussion of an operational issue.

 

  Competitive Environment

 

Washington Gas.  Washington Gas faces competition based on customers’ preference for natural gas compared to other energy products, and the comparative prices of those products. The most significant product competition occurs between natural gas and electricity in the residential market. Changes in the competitive position of natural gas relative to electricity and other energy products have the potential of causing a decline in the number of natural gas customers added in future years. At the present time, Washington Gas has seen no significant evidence that changes in the competitive position of natural gas has contributed to such a decline.

 

The residential market generates a significant portion of Washington Gas’ net income. In its service territory, Washington Gas continues to attract the majority of the new residential construction market. Consumers’ continuing preference for natural gas allows Washington Gas to maintain a strong market presence.

 

In each of the jurisdictions served by Washington Gas, regulators and utilities have implemented customer choice programs. These programs allow customers the choice of purchasing their natural gas and/or electric commodity from unregulated third-party marketers, rather than purchasing these commodities as part of a bundled service from the local utility. When customers choose to purchase their natural gas commodity from unregulated third-party marketers, there is no effect on Washington Gas’ net income since Washington Gas charges its customers the cost of gas without any mark-up.

 

Notwithstanding the regulatory mechanisms that protect Washington Gas from the adverse impact of customer choice programs, Washington Gas continues to be obligated to purchase commodity, transportation, storage and peaking services from interstate pipeline companies under long-term capacity contracts that were entered into to support Washington Gas’ expected merchant function requirements at the time these contracts were executed. In the District of Columbia and Maryland, unregulated third-party marketers may utilize their own capacity resources, rather than those of Washington Gas, to serve new customers who shift from the utility to third-party marketers in response to competitive offers or regulatory incentives. Large shifts in customers to these

 

WGL Holdings, Inc.
Washington Gas Light Company
Part II
Item 7. Management’s Discussion and Analysis of
Financial Condition and Results of Operations (continued)

third-party marketers could potentially impact the cost of the natural gas commodity billed to the remaining sales customers of Washington Gas. To minimize the cost risk associated with these obligations, Washington Gas executes a strategy that focuses on:

 

 

WGEServices.  Our unregulated retail energy-marketing subsidiary, WGEServices, competes with other unregulated third-party marketers to sell the natural gas and electric commodity to customers. Marketers of these commodities compete largely on price, and gross margins (representing revenues less costs of energy) are relatively small. WGEServices is exposed to credit and market risks associated with both its natural gas and electric supply (refer to the sections entitled “Credit Risk” and “Market Risk” for a further discussion of these risk exposures and WGEServices’ management of them).

 

  Environmental Matters

 

We are subject to federal, state and local laws and regulations related to environmental matters. These evolving laws and regulations may require expenditures over a long timeframe to control environmental effects. It is our position that, at this time, the appropriate remediation is being undertaken at all the relevant sites. Refer to Note 14 of the Notes to Consolidated Financial Statements for a further discussion of these matters.

 

  Industry Consolidation

 

In recent years, the energy industry has seen a number of consolidations, combinations, disaggregations and strategic alliances. Consolidation will present combining entities with the challenges of remaining focused on the customer and integrating different organizations. Others in the energy industry are discontinuing operations in certain portions of the energy industry or divesting portions of their business and facilities.

 

From time to time, we perform studies and, in some cases, hold discussions regarding utility and energy-related investments and strategic transactions with other companies. The ultimate effect on us of any such investments and transactions that may occur cannot be determined at this time.

 

  Economic Conditions and Interest Rates

 

We operate in one of the fastest growing regions in the nation. The continued prosperity of this region, supported by a relatively low interest-rate environment for new housing, has allowed Washington Gas to expand its regulated delivery service customer base at a rate of growth almost twice the national industry average during the past five years. In addition, this economy has provided a robust market for our subsidiaries to market natural gas, electricity and other energy-related products and services. A downturn in the economy of the region in which we operate, or a significant increase in interest rates, might adversely affect our ability to grow Washington Gas’ customer base and other businesses at the same rate they have grown in the past.

 

We have been operating in a relatively low interest-rate environment in the recent past as it relates to long-term debt financings. Short-term interest rates had been relatively low in relation to historical levels. However, actions and communications by the Federal Reserve in the past year have resulted in increases in short-term interest rates. A rise in interest rates without the timely recognition of the higher cost of debt in the utility rates charged by Washington Gas to its customers would adversely affect future earnings. A rise in short-term interest rates without the higher cost of debt being reflected in the prices charged to customers would negatively affect the

 

WGL Holdings, Inc.
Washington Gas Light Company
Part II
Item 7. Management’s Discussion and Analysis of
Financial Condition and Results of Operations (continued)

results of operations of our retail energy-marketing segment which depends on short-term debt to finance its accounts receivable and storage gas inventories.

 

  Inflation/Deflation

 

From time to time, Washington Gas seeks approval for rate increases from regulatory commissions to help it manage the effects of inflation on its capital investment and returns. The most significant impact of inflation is on Washington Gas’ replacement cost of plant and equipment. While the regulatory commissions having jurisdiction over Washington Gas’ retail rates allow depreciation only on the basis of historical cost to be recovered in rates, we anticipate that Washington Gas should be allowed to recover the increased costs of its investment and earn a return thereon after replacement of the facilities occurs.

 

To the extent Washington Gas experiences a sustained deflationary economic environment, actual returns on invested capital could rise and exceed returns allowed by regulators in previous regulatory proceedings. Such circumstances could prompt the initiation of a regulatory review to reduce Washington Gas’ revenues under its current regulatory framework.

 

  Labor Contracts, Including Labor and Benefit Costs

 

Washington Gas has five labor contracts with bargaining units represented by three labor unions. Teamsters Local Union No. 96 (Local 96) is a local union affiliated with the International Brotherhood of Teamsters. Local 96 has a three-year labor contract with Washington Gas that began on June 1, 2004. The contract covers approximately 700 employees. In January 2006, the Office and Professional Employees International Union Local No. 2 (A.F.L.-C.I.O.) ratified a thirty-nine month labor contract with Washington Gas that was effective on January 1, 2006. The contract covers approximately 290 members, and replaced a previous collective bargaining agreement that was scheduled to expire on March 31, 2006. Local 96, representing union-eligible employees in the Shenandoah Gas division of Washington Gas, has a three-year labor contract with Washington Gas that began on August 1, 2004. This contract covers 23 employees. Additionally, Washington Gas has two three-year labor contracts with the International Brotherhood of Electrical Workers Local 1900 that, together, cover approximately 32 employees. Washington Gas is subject to the terms of its labor contracts with respect to operating practices and compensation matters dealing with employees represented by the various bargaining units described above.

 

  Changes in Accounting Principles

 

We cannot predict the effect of potential future changes in accounting regulations or practices that have yet to be issued on our operating results and financial condition. New accounting standards could be issued by the Financial Accounting Standards Board (FASB) or the Securities and Exchange Commission (SEC) that could change the way we record and recognize revenues, expenses, assets and liabilities.

 

Preparation of financial statements and related disclosures in compliance with Generally Accepted Accounting Principles in the United States of America (GAAP) requires the selection and the application of appropriate technical accounting rules to the relevant facts and circumstances of our operations, as well as our use of estimates to compile the consolidated financial statements. The application of these accounting policies involves judgment regarding estimates and projected outcomes of future events, including the likelihood of success of particular regulatory initiatives, the likelihood of realizing estimates for legal and environmental contingencies, and the probability of recovering costs and investments in both the regulated utility and non-utility business segments.

 

We have identified the following critical accounting policies discussed below that require our judgment and estimation, where the resulting estimates have a material effect on the consolidated financial statements.

 

  Accounting for Unbilled Revenue and Cost of Gas Recognition

 

For regulated deliveries of natural gas, Washington Gas reads meters and bills customers on a cycle basis. Washington Gas accrues revenues for gas that has been delivered but not yet billed at the end of an accounting period. In connection with making this accrual, Washington Gas must estimate the amount of gas that cannot be accounted for on its delivery system and must estimate the amount of the unbilled revenue by jurisdiction and customer class. Such revenues are recognized as unbilled revenues that are adjusted in subsequent periods when actual meter readings are taken. A similar computation is made for WGEServices.

 

WGL Holdings, Inc.
Washington Gas Light Company
Part II
Item 7. Management’s Discussion and Analysis of
Financial Condition and Results of Operations (continued)

Washington Gas’ jurisdictional tariffs contain mechanisms that provide for the recovery of the invoice cost of gas applicable to firm customers. Under these mechanisms, Washington Gas periodically adjusts its firm customers’ rates to reflect increases and decreases in the invoice cost of gas. Annually, Washington Gas reconciles the difference between the total gas costs collected from firm customers and the invoice cost of gas paid to suppliers. Washington Gas defers any excess or deficiency and either recovers it from, or refunds it to, customers over a subsequent twelve-month period.

 

  Accounting for Regulatory Operations—Regulatory Assets and Liabilities

 

A significant portion of our business is subject to regulation by independent government regulators. As the regulated utility industry continues to address competitive market issues, the cost-of-service regulation used to compensate Washington Gas for the cost of its regulated operations will continue to evolve. Non-traditional ratemaking initiatives and market-based pricing of products and services could have additional long-term financial implications for us. We have relied on our projection of continued regulatory oversight of our operations in order to validate the carrying cost of Washington Gas’ investment in fixed assets.

 

Washington Gas accounts for its regulated operations in accordance with Statement of Financial Accounting Standards (SFAS) No. 71, Accounting for the Effects of Certain Types of Regulation, which results in differences in the application of GAAP between regulated and unregulated businesses. SFAS No. 71 requires the recording of regulatory assets and liabilities for certain transactions that would have been treated as revenue or expense in unregulated businesses. In certain circumstances, SFAS No. 71 allows entities whose rates are determined by third-party regulators to defer costs as “regulatory” assets on the balance sheet to the extent that the entity expects to recover these costs in future rates. Similarly, SFAS No. 71 requires that certain amounts be deferred and recorded as regulatory liabilities to the extent Washington Gas expects those amounts will be refunded to customers in future rates. Future regulatory changes or changes in the competitive environment could result in WGL Holdings and Washington Gas discontinuing the application of SFAS No. 71 for some of its business and require the write-off of the portion of any regulatory asset or liability that would be no longer probable of recovery or refund. In effect, Washington Gas could be required to write off certain regulatory assets and liabilities that had been deferred on the balance sheets in prior periods, and charge or credit these amounts to income at the time it determines that the provisions of SFAS No. 71 no longer apply. If Washington Gas were required to discontinue the application of SFAS No. 71 for any of its operations, it would record an extraordinary non-cash charge or credit to income for the net book value of its regulatory assets and liabilities. Other adjustments might also be required.

 

Currently available facts support both the continued application of SFAS No. 71 for our regulatory activities and the conclusion that all of our regulatory assets and liabilities as of September 30, 2006 and 2005 are recoverable or refundable through the regulatory environment.

 

  Accounting for Income Taxes

 

We account for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes. Under SFAS No. 109, we recognize deferred income taxes for all temporary differences between the financial statement and tax basis of assets and liabilities at currently enacted income tax rates.

 

SFAS No. 109 also requires recognition of the additional deferred income tax assets and liabilities for temporary differences where regulators prohibit deferred income tax treatment for ratemaking purposes of Washington Gas. Regulatory assets or liabilities, corresponding to such additional deferred tax assets or liabilities, may be recorded to the extent recoverable from or payable to customers through the ratemaking process. Amounts applicable to income taxes due from and due to customers primarily represent differences between the book and tax basis of net utility plant in service.

 

  Accounting for Contingencies

 

We account for contingent liabilities utilizing SFAS No. 5, Accounting for Contingencies. By their nature, the amount of the contingency and the timing of a contingent event are subject to our judgment of such events and our estimates of the amounts. Actual results related to contingencies may be difficult to predict and could differ significantly from the estimates included in reported earnings. In fiscal years 2006 and 2005, we were involved with regulatory contingencies with respect to rate cases in Virginia, and various legal contingencies.

 

On September 15, 2006, Washington Gas filed an application with the SCC of VA requesting, among other things, to increase its annual utility net revenues in Virginia. Washington Gas further requested that it be permitted to implement the newly proposed

 

WGL Holdings, Inc.
Washington Gas Light Company
Part II
Item 7. Management’s Discussion and Analysis of
Financial Condition and Results of Operations (continued)

increase in revenues on an interim basis, subject to refund, effective for services rendered on and after February 13, 2007. If Washington Gas puts the rate increase into effect on and after February 13, 2007 prior to receiving a Final Order of approval from the SCC of VA, then Washington Gas will record, as an offset to the increased revenue, a provision for rate refunds that will be derived based on our judgment of the future outcome of this rate case.

 

In a Final Order issued by the SCC of VA on December 18, 2003, the SCC of VA ordered, among other things, that Washington Gas perform and submit an annual earnings test to determine if it had earned in excess of its allowed rate of return on common equity for its Virginia operations. Any significant differences between ours and the VA Staff’s earnings test calculations or methodology would have an effect on our operating results.

 

Washington Gas also is involved in matters with its local regulatory commissions related to the recovery of certain costs, including: (i) a proposed disallowance of certain natural gas costs previously incurred by Washington Gas and collected from Maryland customers and (ii) the recovery of the costs of hexane (heavy hydrocarbons or “HHCs”) that Washington Gas is incurring. We have appealed to the PSC of MD the proposed disallowance of natural gas costs, and are awaiting a Final Order from the local regulatory commissions on the recovery of Washington Gas’ HHC costs.

 

For further discussion of these regulatory matters and related contingencies, see Note 15 of the Notes to Consolidated Financial Statements.

 

  Accounting for Derivative Instruments

 

We enter into forward contracts and other related transactions for the purchase of natural gas and electricity. A majority of these contracts qualify as normal purchases and sales, and are exempt from the accounting requirements of SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended. Contracts that qualify as derivative instruments under SFAS No. 133 are recorded on the balance sheet at fair value. Changes in the fair value of derivative instruments subject to SFAS No. 71 are recorded as regulatory assets or liabilities, as discussed below, while changes in the fair value of derivative instruments not affected by rate regulation are reflected in income. Washington Gas also utilizes derivative instruments that are designed to minimize the risk of interest-rate volatility associated with planned issuances of Medium-Term Notes (MTNs).

 

Our judgment is required in determining the appropriate accounting treatment for our derivative instruments. This judgment involves various factors, including our ability to: (i) designate contracts and other activities as derivative instruments subject to the accounting guidelines of SFAS No. 133; (ii) derive the estimated fair value of our derivative instruments from period to period based on prices available from external sources and internal modeling techniques and (iii) determine whether or not our derivative instruments are recoverable from or refundable to customers in future periods.

 

Certain of our natural gas forward contracts and other derivatives that are subject to SFAS No. 133 are valued using models developed by us. These models reflect, when appropriate, derivative pricing theory, formulated market inputs and forward price projections beyond the period that prices are available from market data sources. We derived a $104,000 net fair value loss for these contracts at September 30, 2006, as compared to a net fair value gain of $23.6 million at September 30, 2005. These valuations reflect our best estimate.

 

As previously discussed, changes in the fair value of forward contracts and other related transactions that qualify as derivative instruments under SFAS No. 133 and subject to SFAS No. 71 are recorded as regulatory assets or liabilities since they relate to activities of Washington Gas in which costs are likely to be recovered from or refunded to customers in future periods.

 

  Accounting for Pension and Other Post-Retirement Benefit Plans

 

Washington Gas maintains a qualified, trusteed, non-contributory defined benefit pension plan (qualified pension plan) covering all active and vested former employees of Washington Gas and a separate non-funded supplemental retirement plan (SERP) covering executive officers. Washington Gas also provides certain healthcare and life insurance benefits for retired employees. (The qualified pension plan, SERP and health and post-retirement plans are collectively referred to as the “Plans”).

 

The measurement of the Plans’ obligations and costs is dependent on a variety of assumptions. We consider the following assumptions to be critical to this measurement. These assumptions are derived on an annual basis with the assistance of a third party actuarial firm:

 

 

WGL Holdings, Inc.
Washington Gas Light Company
Part II
Item 7. Management’s Discussion and Analysis of
Financial Condition and Results of Operations (continued)

 

We determine the discount rate based on the Moody’s AA corporate bond yield as of September 30. We determine the expected long-term rate of return by averaging the expected earnings for the target asset portfolio. In developing the expected rate of return assumption, we evaluate an analysis of historical actual performance and long-term return projections, which gives consideration to the asset mix and anticipated length of obligation of the Plans. Historically, the expected long-term return on plan assets has been lower for the health and life benefit plan than for the qualified pension plan due to differences in the allocation of the assets in the plan trusts. We calculate the rate of compensation increase based on salary expectations for the near-term, expected inflation levels and promotional expectations. The healthcare cost trend rate is determined by working with insurance carriers, reviewing historical claims data for the health and life benefit plan, and analyzing market expectations.

 

The following table illustrates the effect of changing the critical actuarial assumptions discussed above, while holding all other assumptions constant:

 

 

Differences between actuarial assumptions and actual plan results are deferred and amortized into cost when the accumulated differences exceed ten percent of the greater of the Projected Benefit Obligation or the market-related value of the plan assets. If necessary, the excess is amortized over the average remaining service period of active employees.

 

In addition to the assumptions listed above, the measurement of the Plans’ obligations and costs are dependent on other factors such as employee demographics, the level of contributions made to the Plans, earnings on the Plans’ assets and mortality rates. Effective September 30, 2006, Washington Gas updated the mortality table it uses to develop its mortality rates to reflect more current life expectancy experience. This change did not have a significant effect on the obligations of the Plans.

 

Refer to Note 12 of the Notes to Consolidated Financial Statements for a listing of the actuarial assumptions used and for a further discussion of the accounting for the Plans.

 

  Accounting for Stock-Based Compensation

 

Effective October 1, 2005, we adopted SFAS No. 123 (revised 2004), Share-Based Payment (SFAS No. 123(R)), which replaces SFAS No. 123, and supersedes Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees and SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure. Under SFAS No. 123(R), we measure and record compensation expense for both our stock option and performance share awards based on their fair value at the date of grant. Prior to October 1, 2005, we had accounted for our share-based awards in accordance with SFAS No. 123, as amended, which permitted us to apply APB Opinion No. 25 and related interpretations in accounting for our stock-based compensation plans. In accordance with APB Opinion No. 25, we did not record in our financial statements compensation expense related to our stock option grants. We did record compensation expense over the requisite service period related to our performance shares awarded based on the market value of WGL Holdings’ common stock at the end of each reporting period.

 

As permitted by SFAS No. 123(R), we used the modified prospective method of adopting the new accounting standard; accordingly, financial results for fiscal years 2005 and 2004 have not been retroactively adjusted to reflect the effects of

 

WGL Holdings, Inc.
Washington Gas Light Company
Part II
Item 7. Management’s Discussion and Analysis of
Financial Condition and Results of Operations (continued)

SFAS No. 123(R). In accordance with SFAS No. 123(R), we recognized total stock-based compensation expense of $4.4 million for the fiscal year ended September 30, 2006, along with related income tax benefits of $1.8 million. For fiscal years 2005 and 2004, we recognized total stock-based compensation expense of $3.4 million and $1.9 million, respectively, along with related income tax benefits of $1.2 million and $660,000, respectively, in accordance with APB Opinion No. 25.

 

To value our stock options under SFAS No. 123(R), we continue to use the Black-Scholes model that was previously used for disclosure purposes under SFAS No. 123, as amended. We use a Monte Carlo simulation model to value our performance shares under SFAS No. 123(R), as they contain market conditions based on total shareholder return compared to a peer group.

 

As of September 30, 2006, there was $4.1 million of total unrecognized compensation expense related to our share-based awards. This cost is expected to be recognized over a weighted average period of 1.6 years, which comprises 1.7 years and 1.5 years for performance shares and stock options, respectively. Refer to Notes 1 and 13 of the Notes to Consolidated Financial Statements for a further discussion of our share-based awards.

 

  Discontinued Operations

 

During the quarter ended June 30, 2006, we completed a plan for the disposition of ACI, a wholly owned subsidiary of Washington Gas Resources. On September 29, 2006, we sold all of the outstanding shares of common stock of ACI to an unrelated party. ACI was previously reported as part of our commercial HVAC business segment. ACI has been reported as a discontinued operation of WGL Holdings and, accordingly, ACI’s operating results, financial position and cash flows have been presented separately from our continuing operations in the consolidated financial statements of WGL Holdings for all fiscal years presented. Refer to the section entitled “Results of Operations—Summary Results ” for a further discussion of this sale.

WGL Holdings, Inc.

Part II

Item 7. Management’s Discussion and Analysis of

Financial Condition and Results of Operations (continued)

 

WGL HOLDINGS, INC.

 

  Summary Results

 

WGL Holdings reported net income of $87.6 million, or $1.79 per share, for the fiscal year ended September 30, 2006, as compared to net income of $103.5 million, or $2.11 per share, and $96.6 million, or $1.98 per share, for the fiscal years ended September 30, 2005 and 2004, respectively. We earned a return on average common equity of 9.6 percent, 11.8 percent and 11.6 percent, respectively, during each of these three fiscal years.

 

Net income for fiscal year 2006 included an after-tax loss of $7.1 million, or $0.15 per share, from the discontinued operations of ACI. This was comprised of a net loss from ACI’s operations of $3.5 million, or $0.07 per share, and an after-tax loss of $3.6 million, or $0.08 per share, that resulted from the September 29, 2006 sale of ACI. Net income for fiscal years 2005 and 2004 included a net loss from ACI’s discontinued operations of $2.6 million, or $0.05 per share, and $3.0 million, or $0.06 per share, respectively.

 

We reported consolidated income from continuing operations of $94.7 million, or $1.94 per share, for the fiscal year ended September 30, 2006, as compared to income from continuing operations of $106.1 million, or $2.16 per share, and $99.6 million, or $2.04 per share, reported for fiscal years 2005 and 2004, respectively. The following is a discussion of year-over-year trends related to our results from continuing operations.

 

Fiscal Year 2006 vs. Fiscal Year 2005.  Income from continuing operations for fiscal year 2006, when compared to fiscal year 2005, primarily reflects lower net income from both our retail energy-marketing and regulated utility segments. Earnings comparisons attributable to our retail energy-marketing business reflect lower gross margins from the sale of natural gas, partially offset by improved gross margins from electric sales. The year-over-year decline in earnings of our regulated utility segment was primarily attributable to lower consumption of natural gas by customers due to customer conservation, coupled with higher operating expenses, interest costs and income taxes. Favorably affecting fiscal year 2006 earnings for the regulated utility segment were continued customer growth, increased revenues related to recoverable carrying costs on storage gas inventory balances, and favorable adjustments related to cost of gas and customer billings.

 

Income from continuing operations for fiscal year 2006 compared to fiscal year 2005 also reflects the following transactions related to our regulated utility and non-utility business segments. Fiscal year 2006 included: (i) a charge of $4.6 million (pre-tax) recorded by our regulated utility segment related to a proposed regulatory order and (ii) a $3.1 million (pre-tax) reversal by our energy-marketing segment of fees that were previously assessed by a regulatory body and accrued in prior fiscal years. Fiscal year 2005 included: (i) a favorable tax adjustment of $2.5 million related to the regulated utility segment and (ii) a charge of $912,000 that resulted principally from the resolution of a legal contingency allocated to the remaining portion of our commercial HVAC business.

 

Fiscal Year 2005 vs. Fiscal Year 2004.  The $6.5 million, or $0.12 per share, improvement in income from continuing operations for fiscal year 2005, when compared to fiscal year 2004, primarily reflects higher earnings from our retail energy-marketing business, driven primarily by increased gross margins from natural gas sales. This improvement was partially offset by lower earnings from our regulated utility segment that were attributable to lower natural gas deliveries to firm customers and higher operating expenses. Customer growth, coupled with lower interest costs and income taxes, favorably affected fiscal year 2005 earnings for our regulated utility segment.

 

As discussed above, fiscal year 2005 also included the $2.5 million favorable tax adjustment related to our regulated utility segment, and the $912,000 charge related to our commercial HVAC business segment. Fiscal year 2004 included the following transactions: (i) the recognition of additional depreciation expense unrelated to fiscal year 2004 of $3.5 million (pre-tax) that was recorded in connection with a Virginia rate order; (ii) an after-tax gain of $5.8 million from the sale of two buildings in which we held a carried interest (Maritime sale) and (iii) a charge of $870,000 for the impairment of goodwill related to the remaining portion of our commercial HVAC business.

WGL Holdings, Inc.

Part II

Item 7. Management’s Discussion and Analysis of

Financial Condition and Results of Operations (continued)

 

The following table summarizes our net income (loss) by operating segment for fiscal years ended September 30, 2006, 2005 and 2004.

 

 

  Regulated Utility Operating Results

 

The following table summarizes the regulated utility segment’s operating results for fiscal years ended September 30, 2006, 2005 and 2004.

 

WGL Holdings, Inc.

Part II

Item 7. Management’s Discussion and Analysis of

Financial Condition and Results of Operations (continued)

 

Fiscal Year 2006 vs. Fiscal Year 2005.  The regulated utility segment reported net income of $84.6 million, or $1.73 per share, for the fiscal year ended September 30, 2006, as compared to net income of $87.5 million, or $1.79 per share, for fiscal year 2005. The year-over-year decrease in earnings primarily reflects a decline in total natural gas deliveries to firm customers due to customer conservation. Natural gas deliveries to firm customers fell 70.5 million therms, or 5.5 percent, in fiscal year 2006 from 2005. In addition to customer conservation, natural gas deliveries declined from the effect of warmer weather in fiscal year 2006. Weather, as measured by heating degree days (HDDs) was 2.5 percent warmer than normal in fiscal year 2006, as compared to 5.9 percent colder than normal in fiscal year 2005. Unlike customer conservation, the earnings effect of warmer-than-normal weather experienced in fiscal year 2006 was neutralized by the application of the RNA mechanism in Maryland and other weather protection strategies implemented in Virginia and the District of Columbia, as discussed below.

 

Favorably affecting earnings for fiscal year 2006 when compared to the prior fiscal year were: (i) the addition of 19,811 active customer meters since the end of the prior fiscal year; (ii) $7.3 million (pre-tax) of increased revenues from recoverable carrying costs on a higher average balance of storage gas inventory that was the result of both higher natural gas prices and volumes; (iii) favorable adjustments related to the annual reconciliation of lost-and-unaccounted-for gas and (iv) favorable adjustments related to the recovery of natural gas costs.

 

Our weather protection products, coupled with the timing of HDDs during fiscal year 2006, resulted in weather having a favorable effect on net income for fiscal year 2006 in relation to normal weather. For fiscal year 2006, net income was enhanced in relation to normal weather by an estimated $2.5 million (after-tax), or $0.05 per share, despite the 2.5 percent warmer-than-normal weather during this period. This benefit resulted primarily from the colder-than-normal weather experienced during the first quarter of fiscal year 2006. For the fiscal year ended September 30, 2005, the 5.9 percent colder-than-normal weather during that year contributed an estimated $5 million (after-tax), or $0.10 per share, to net income.

 

Prior to October 1, 2005, we managed weather risk for all jurisdictions of Washington Gas with a weather insurance policy designed to protect against 50 percent of the effects of warmer-than-normal weather. That policy expired on September 30, 2005. Commencing in fiscal year 2006, our weather management strategy varied by jurisdiction: (i) in Maryland, we implemented the RNA mechanism on October 1, 2005 upon approval by the PSC of MD (refer to Note 15 of the Notes to Consolidated Financial Statements); (ii) in the District of Columbia, we purchased a new weather insurance policy that became effective on October 1, 2005 and (iii) in Virginia, we purchased a weather derivative that became effective on December 18, 2005 and expired on May 31, 2006 (refer to the section entitled “Market Risk—Weather Risk” ).

 

In Maryland, the RNA mechanism is designed to stabilize the level of revenues collected from customers by eliminating the effect of deviations in normal customer usage caused by weather and other factors, such as customer conservation. Periods of colder-than-normal weather generally would cause Washington Gas to reduce its revenues and establish a refund liability to customers, while the opposite would generally result during periods of warmer-than-normal weather. Accordingly, the warmer-than-normal weather during fiscal year 2006 resulted in an increase in revenues and the recording of a receivable from customers to reflect Washington Gas’ protection from warmer-than-normal weather and factors other than weather, such as customer conservation, that are covered under the RNA mechanism.

 

In the District of Columbia and Virginia, both the weather insurance and the weather derivative were designed to provide full protection from the negative financial effects of warmer-than-normal weather. Unlike the Maryland RNA, the weather insurance and derivative products enable us to retain the benefits from colder-than-normal weather. In fiscal year 2006, the regulated utility segment benefited $8.9 million (pre-tax) from these weather protection products in relation to the prior fiscal year. These realized benefits are reflected in “Operation and maintenance” expenses which, for fiscal year 2006, include a benefit of $4.7 million (pre-tax) from the new weather insurance and derivative products, net of the related premium costs of these products. This compares to $4.2 million (pre-tax) of expense included in “Operation and maintenance” expenses for fiscal year 2005 to reflect the premium cost associated with the expired insurance policy.

 

Earnings of the regulated utility segment for fiscal year 2006 reflect a $3.8 million (pre-tax) increase in operation and maintenance expenses, after excluding the $8.9 million (pre-tax) enhancement to earnings from the weather protection products, as discussed above. Principally contributing to the increased expenses was $1.8 million of increased expenses associated with information technology projects, and $1.6 million of higher expenses for uncollectible accounts. Results from the regulated utility segment also reflect higher depreciation and amortization expense and increased interest expense that, together, reduced pre-tax income by $5.3 million. Further discussion of operation and maintenance and depreciation and amortization expenses of

WGL Holdings, Inc.

Part II

Item 7. Management’s Discussion and Analysis of

Financial Condition and Results of Operations (continued)

 

Washington Gas is included under Management’s Discussion for Washington Gas. Also refer to the section of this Management’s Discussion entitled “Interest Expense” for a further discussion of this cost.

 

Fiscal year ended September 30, 2006 also included a charge of $4.6 million (pre-tax) recorded to “Cost of gas” related to a proposed order by a Hearing Examiner of the PSC of MD that recommends the disallowance of certain natural gas costs incurred by Washington Gas and billed to Maryland customers from September 2003 through August 2004. The Hearing Examiner recommended the disallowance of these costs in connection with its annual review of Washington Gas’ natural gas costs. We have appealed the proposed order before the PSC of MD, asserting that the recommendation is without merit (refer to Note 15 of the Notes to Consolidated Financial Statements). On a comparative basis, the regulated utility segment benefited in fiscal year 2005 from a favorable income tax adjustment of $2.5 million related to a change in estimate.

 

Fiscal Year 2005 vs. Fiscal Year 2004.  The regulated utility segment reported net income of $87.5 million, or $1.79 per share, for fiscal year 2005 as compared to net income of $89.0 million, or $1.82 per share, for fiscal year 2004. This comparison primarily reflects a decrease of 28.7 million therms, or 2.2 percent, in total natural gas deliveries to firm customers during fiscal year 2005 due, in part, to warmer weather experienced primarily during the second quarter of fiscal year 2005, the most significant period of Washington Gas’ winter heating season. However, during other periods within fiscal year 2005, Washington Gas experienced lower than expected natural gas deliveries because the increase in HDDs did not correlate highly with the change in the volume of natural gas delivered during those periods. For the fiscal year ended September 30, 2005, weather was 5.9 percent colder than normal, enhancing net income in relation to normal weather by an estimated $5 million (after-tax), or $0.10 per share. For fiscal year 2004, weather was 6.1 percent colder than normal, and was estimated to have improved net income by approximately $10 million (after-tax), or $0.20 per share.

 

Favorably affecting earnings for the regulated utility segment for fiscal year 2005 was the addition of 22,043 active customer meters, the effect of changes in rates charged to customers that were implemented in Maryland on November 6, 2003 and in the District of Columbia on November 24, 2003, as well as $2.1 million (pre-tax) of increased earnings from carrying costs on a higher average balance of storage gas inventory. Earnings for fiscal year 2005, when compared to fiscal year 2004, also reflect $10.6 million (pre-tax) of increased operation and maintenance expenses, partially offset by $1.7 million (pre-tax) of lower depreciation and amortization expense, and $1.5 million (pre-tax) of lower interest expense (refer to the section of this Management’s Discussion entitled “Interest Expense”). The regulated utility segment also benefited from reduced income tax expense due to a combination of lower pre-tax income and a lower effective income tax rate which, in part, reflects a favorable tax adjustment of $2.5 million recorded in fiscal year 2005.

 

Further discussion of the operating results of Washington Gas is included in the Management’s Discussion for Washington Gas.

 

  Non-Utility Operating Results

 

Our continuing non-utility operations are comprised of two business segments: (i) retail energy-marketing and (ii) the remaining portion of commercial HVAC after excluding the effects of discontinued operations. Certain of our transactions are not significant enough to report as stand-alone business segments, and therefore are aggregated as “Other Activities” which are included as part of non-utility operations for purposes of segment reporting (refer to Note 17 of the Notes to Consolidated Financial Statements).

 

Total net income from our continuing non-utility operations for fiscal year 2006 was $10.1 million, or $0.21 per share, a decrease of $8.5 million, or $0.16 per share, from fiscal year 2005. The year-over-year decline in these earnings primarily reflects lower earnings of our retail energy-marketing segment.

 

Continuing non-utility operations reported total net income of $18.6 million, or $0.37 per share, for the fiscal year ended September 30, 2005, an increase of $8.0 million, or $0.15 per share, over fiscal year 2004. The year-over-year increase in net income was driven by improved earnings from our retail energy-marketing segment. On a comparative basis, fiscal year 2004 included an after-tax gain of $5.8 million from the Maritime sale.

WGL Holdings, Inc.

Part II

Item 7. Management’s Discussion and Analysis of

Financial Condition and Results of Operations (continued)

 

The following table depicts the composition of the changes in revenues for the non-utility business segments.

 

 

  Retail Energy-Marketing

 

Our retail energy-marketing subsidiary, WGEServices, was established in 1997, and sells natural gas and electricity on an unregulated, competitive basis directly to residential, commercial and industrial customers.

 

Fiscal Year 2006 vs. Fiscal Year 2005.  The retail energy-marketing segment reported net income of $13.3 million, or $0.27 per share, for the fiscal year ended September 30, 2006, as compared to net income of $22.3 million, or $0.45 per share, reported for the prior fiscal year. The $9.0 million, or $0.18 per share, decline in earnings for this business primarily reflects lower gross margins (revenues less costs of energy) from the sale of natural gas primarily due to: (i) unfavorable changes in the valuation of derivative contracts; (ii) the unfavorable year-over-year comparison resulting from $2.0 million (after-tax) of reduced expenses recorded in fiscal year 2005 related to the termination of two natural gas supply contracts; (iii) the unfavorable year-over-year comparison from the recording in fiscal year 2005 of $1.2 million (after-tax) of gross margin adjustments related to certain contracts and (iv) a 2.4 percent decrease in the volume of natural gas sold. Favorably affecting earnings in fiscal year 2006 were increased gross margins from the sale of electricity, and the reversal of expenses in fiscal year 2006 of $3.1 million (pre-tax) related to certain fees assessed by the PSC of DC that were accrued in prior fiscal years.

 

Lower gross margins from natural gas sales were affected, in part, by net mark-to-market losses in fiscal year 2006, as compared to net mark-to-market gains recognized in fiscal year 2005. Market valuation losses or gains are recorded principally in connection with derivative contracts that are used to mitigate the risk of volatility in the market price of natural gas during the winter heating season. The year-over-year net change in the valuation of these instruments decreased net income by $6.1 million (after-tax) for the fiscal year ended September 30, 2006. Refer to “Market Risk—Price Risk Related to the Retail Energy-Marketing Segment” for a further discussion of these derivative transactions.

 

The decrease in gross margins from natural gas sales in fiscal year 2006 also was attributable to the inclusion in fiscal year 2005 of $2.0 million (after-tax) of reduced expenses related to the termination of contracts with two suppliers for the forward purchase of natural gas. These fixed-price contracts were terminated due to the suppliers’ inability to fulfill contractual obligations during the 2005-2006 winter heating season due to the natural gas supply shortage in the Gulf of Mexico region. In consideration of the contract termination, the suppliers paid a fee to WGEServices, recorded as a reduction to “Non-utility cost of energy-related sales” in fiscal year 2005, for an amount equivalent to the excess of the market price over the fixed price that WGEServices incurred in fiscal year 2006 to replace the contractual shortfall. The higher cost of the replacement gas was reflected in fiscal year 2006 when delivered.

WGL Holdings, Inc.

Part II

Item 7. Management’s Discussion and Analysis of

Financial Condition and Results of Operations (continued)

 

Gross margins from electric sales increased significantly during fiscal year 2006, reflecting a dramatic rise in the gross margin per kilowatt hour sold, partially offset by a 10 percent decline in electric sales volumes. Electric customers grew 75 percent in fiscal year 2006 when compared to the end of the prior fiscal year. This customer growth was principally the result of new competitive opportunities that emerged near the end of the third quarter of fiscal year 2006 due to sharp increases in competing rates offered by electric utilities in Maryland and Delaware.

 

Favorably affecting the operating results of the energy-marketing segment for fiscal year 2006 was the reversal of certain administrative fees that were previously assessed by the PSC of DC. WGEServices, which recorded these assessments as an expense in prior fiscal years, protested its payment of these fees. During fiscal year 2006, WGEServices received a favorable court decision from its appeal regarding the payment of these fees in which the court decided that the energy-marketing business is entitled to a refund. Accordingly, the energy-marketing segment benefited $3.1 million (pre-tax) from its reversal in fiscal year 2006 of fees accrued as an expense in prior fiscal years.

 

Fiscal Year 2005 vs. Fiscal Year 2004.  Net income for the retail energy-marketing segment was $22.3 million, or $0.45 per share, for fiscal year 2005, an increase over net income of $8.3 million, or $0.17 per share, reported for fiscal year 2004. The $14.0 million, or $0.28 per share, improvement was attributable to (i) $2.0 million (after-tax) of reduced expenses in fiscal year 2005 related to the termination of the two natural gas supply contracts; (ii)  favorable changes in the valuation of derivative contracts which increased net income by $1.8 million (after-tax) and (iii) $1.2 million (after-tax) of favorable gross margin adjustments recorded in fiscal year 2005 related to certain contracts. The remainder of the year-over-year improvement in earnings for this segment for fiscal year 2005 was attributable to reduced expenses associated with uncollectible accounts, partially offset by lower gross margins from electric sales as the 59.7 percent decline in electric sales volumes more than offset the increase in the gross margin per kilowatt hour sold.

 

  Commercial HVAC

 

As a result of the discontinued operations of ACI, WGESystems comprises the remaining portion of the commercial HVAC segment. WGESystems offers large-scale HVAC installations and related services to commercial and government customers.

 

The commercial HVAC segment reported net income of $450,000, or $0.01 per share, for fiscal year 2006, an improvement of $1.8 million, or $0.04 per share, over the net loss of $1.3 million, or $0.03 per share, reported for fiscal year 2005. Operating results for fiscal year 2005 represented an improvement of $1.1 million, or $0.02 per share, over the net loss of $2.4 million, or $0.05 per share, reported for fiscal year 2004. The improvements in both fiscal years 2006 and 2005 were attributable to higher operating income that was driven by increased sales and lower selling, general and administrative expenses. The comparison between fiscal year 2006 and 2005 also was affected by a charge of $912,000, or $0.02 per share, recorded in fiscal year 2005 that resulted principally from the resolution of a legal contingency related to our investment in the HVAC business.

 

  Other Non-Utility Activities

 

As previously discussed, certain of our transactions are not significant enough on a stand-alone basis to warrant treatment as a business segment. For purposes of segment reporting, these transactions are aggregated as “Other Activities” and included as part of non-utility operations (see Note 17 of the Notes to Consolidated Financial Statements).

 

Results for our other non-utility activities for fiscal year 2006 reflect a net loss of $3.7 million, or $0.07 per share, as compared to a net loss of $2.4 million, or $0.05 per share, reported for fiscal year 2005. The net loss in fiscal year 2005 from other non-utility activities represented a $7.2 million, or $0.15 per share, decrease from the net income of $4.8 million, or $0.10 per share, reported for fiscal year 2004. This decline was primarily due to an after-tax gain of $5.8 million, or $0.12 per share, realized in fiscal year 2004 from the Maritime sale.