Constellation Energy Group Inc. CEO MAYO A III SHATTUCK bought 10000 shares on 12-22-2008 at $24.38
Constellation Energy is an energy company that includes a merchant energy business and BGE, a regulated electric and gas public utility in central Maryland.
Constellation Energy was incorporated in Maryland on September 25, 1995. On April 30, 1999, Constellation Energy became the holding company for BGE and its subsidiaries. References in this report to "we" and "our" are to Constellation Energy and its subsidiaries, collectively. References in this report to the "regulated business(es)" are to BGE.
Our merchant energy business is a competitive provider of energy solutions for a variety of customers. It has electric generation assets located in various regions of the United States and provides energy solutions to meet customers' needs. Our merchant energy business focuses on serving the energy and capacity requirements (load-serving) of, and providing other energy products and risk management services for, various customers.
BGE is a regulated electric transmission and distribution utility company and a regulated gas distribution utility company with a service territory that covers the City of Baltimore and all or part of ten counties in central Maryland. BGE was incorporated in Maryland in 1906.
Our other nonregulated businesses:
design, construct, and operate renewable energy, heating, cooling, and cogeneration facilities, and provide various energy-related services, including energy consulting, for commercial, industrial, and governmental customers throughout North America, and
provide home improvements, service heating, air conditioning, plumbing, electrical, and indoor air quality systems, and provide natural gas to residential customers in central Maryland.
Constellation Energy maintains a website at constellation.com where copies of our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments may be obtained free of charge. These reports are posted on our website the same day they are filed with the SEC. The SEC maintains a website (sec.gov), where copies of our filings may be obtained free of charge. The website address for BGE is bge.com. These website addresses are inactive textual references, and the contents of these websites are not part of this Form 10-K.
In addition, the website for Constellation Energy includes copies of our Corporate Governance Guidelines, Principles of Business Integrity, Corporate Compliance Program, Insider Trading Policy, Policy and Procedures with respect to Related Person Transactions, and Information Disclosure Policy, and the charters of the Audit, Compensation and Nominating and Corporate Governance Committees of the Board of Directors. Copies of each of these documents may be printed from our website or may be obtained from Constellation Energy upon written request to the Corporate Secretary.
The Principles of Business Integrity is a code of ethics that applies to all of our directors, officers, and employees, including the chief executive officer, chief financial officer, and chief accounting officer. We will post any amendments to, or waivers from, the Principles of Business Integrity applicable to our chief executive officer, chief financial officer, or chief accounting officer on our website.
Merchant Energy Business
Our merchant energy business integrates electric generation assets with the marketing and risk management of energy and energy-related products to wholesale and retail customers, allowing us to manage energy price risk over geographic regions and time.
Our merchant energy business includes:
a power generation and development operation that owns, operates, and maintains fossil and renewable generating facilities, and holds interests in qualifying facilities, fuel processing facilities and power projects in the United States,
a nuclear generation operation that owns, operates and maintains nuclear generating facilities and oversees our new nuclear development activities,
a customer supply operation that primarily provides energy products and services relating to load-serving obligations to wholesale and retail customers, including distribution utilities, cooperatives, aggregators, and commercial, industrial and governmental customers, and
a global commodities operation that manages contractually controlled physical assets, including generation facilities, natural gas properties, international coal and freight assets, provides risk management services, and trades energy and energy-related commodities.
Our merchant energy business:
provided approximately 32,700 megawatts (MW) of peak load in the aggregate to distribution utilities, municipalities, and commercial, industrial, and governmental customers during 2007,
provided approximately 410,000 million British Thermal Units (mmBTUs) of natural gas to commercial, industrial, and governmental customers during 2007,
delivered approximately 28 million tons of coal to international and domestic third-party customers and to our own fleet during 2007, and
managed approximately 8,730 MW of generation capacity as of December 31, 2007.
For years 2007 and prior, we analyze the results of our merchant energy business as follows:
Mid-Atlantic Regionâ€”our fossil, nuclear, and hydroelectric generating facilities and load-serving activities in the Mid-Atlantic region of the PJM Interconnection (PJM). This also includes active portfolio management of generating assets and other physical and financial contractual arrangements, as well as other PJM competitive supply activities.
Plants with Power Purchase Agreementsâ€”our generating facilities outside the Mid-Atlantic Region with long-term power purchase agreements. As discussed in Note 2 to Consolidated Financial Statements , the sale of the High Desert facility in 2006 resulted in a reclassification of its results to discontinued operations.
Wholesale Competitive Supplyâ€”our marketing, risk management, and trading operation that provides energy products and services primarily to distribution utilities, power generators, and other wholesale customers. We also include in our wholesale competitive supply results our global coal sourcing and logistics services and upstream and downstream natural gas services.
Retail Competitive Supplyâ€”our operation that provides electric and natural gas energy products and services to commercial, industrial, and governmental customers.
Otherâ€”our investments in qualifying facilities and domestic power projects and our generation operations and maintenance services.
Beginning in 2008, we will analyze our merchant energy business in terms of Generation, Customer Supply and Global Commodities activities.
Generationâ€”will encompass all of our generating assets, including those currently included in the Mid-Atlantic Region, Plants with Power Purchase Agreements and Other.
Customer Supplyâ€”will encompass the current Retail Competitive Supply and the power load-serving portion of Wholesale Competitive Supply.
Global Commoditiesâ€”will encompass the remaining Wholesale Competitive Supply businesses including our marketing, risk management, and trading operations, global coal sourcing and logistics services, and upstream and downstream natural gas services.
We present details about our generating properties in Item 2. Properties.
We own 6,355 MW of fossil, nuclear, and hydroelectric generation capacity in the Mid-Atlantic Region. The output of these plants is managed by our global commodities operation and is hedged through a combination of power sales to wholesale and retail market participants. Our merchant energy business meets the load-serving requirements of various contracts using the output from the Mid-Atlantic Region and from purchases in the wholesale market.
BGE transferred all of these facilities to our merchant energy generation subsidiaries on July 1, 2000 as a result of the implementation of electric customer choice and competition among suppliers in Maryland, except for the Handsome Lake facility that commenced operations in mid-2001. The assets transferred from BGE are subject to the lien of BGE's mortgage. We expect the assets to be released from this lien following payment in March 2008 of the last series of bonds outstanding under the mortgage and the subsequent discharge of the mortgage.
Our merchant energy business supplies BGE with a portion of its market-based standard offer service obligation. For 2007, the peak load supplied to BGE was approximately 3,200 MW.
Plants with Power Purchase Agreements
We own 2,134 MW of nuclear generation capacity with power purchase agreements for a significant portion of their output. Our facilities with power purchase agreements are the Nine Mile Point Nuclear Station (Nine Mile Point) and the R.E. Ginna Nuclear Plant (Ginna). Both Nine Mile Point and Ginna are located within the New York Independent System Operator (NYISO) region.
We own 100% of Nine Mile Point Unit 1 (620 MW) and 82% of Unit 2 (933 MW). The remaining interest in Nine Mile Point Unit 2 is owned by the Long Island Power Authority (LIPA). Unit 1 entered service in 1969 and is licensed to operate until 2029. Unit 2 entered service in 1988 and is licensed to operate until 2046.
We sell 90% of our share of Nine Mile Point's output to the former owners of the plant at an average price of nearly $35 per megawatt-hour (MWH) under agreements that terminate between 2009 and 2011. The agreements are unit contingent (if the output is not available because the plant is not operating, there is no requirement to provide output from other sources). The remaining 10% of our share of Nine Mile Point's output is managed by our global commodities operation and sold into the wholesale market.
After termination of the power purchase agreements, a revenue sharing agreement with the former owners of the plant will begin and continue through 2021. Under this agreement, which applies only to our ownership percentage of Unit 2, a predetermined strike price is compared to the market price for electricity. If the market price exceeds the strike price, then 80% of this excess amount is shared with the former owners of the plant. The average strike price for the first year of the revenue sharing agreement is $40.75 per MWH. The strike price increases two percent annually beginning in the second year of the revenue sharing agreement. The revenue sharing agreement is unit contingent and is based on the operation of the unit.
We exclusively operate Unit 2 under an operating agreement with LIPA. LIPA is responsible for 18% of the operating costs (and decommissioning costs) of Unit 2 and has representation on the Nine Mile Point Unit 2 management committee, which provides certain oversight and review functions.
We own 100% of the Ginna nuclear facility. Ginna consists of a 581 MW reactor that entered service in 1970 and is licensed to operate until 2029. We sell up to 80% of the plant's output and capacity to the former owners for 10 years ending in 2014 at an average price of $44.00 per MWH under a long term unit contingent power purchase agreement. The remaining output is managed by our global commodities operation and sold into the wholesale market.
We are a leading supplier of energy products and services to wholesale customers and retail commercial, industrial, and governmental customers. In 2007, our wholesale competitive supply operation provided approximately 16,500 peak MWs of wholesale full requirements load-serving products. During 2007, our retail competitive supply activities served approximately 16,200 MW of peak load and approximately 410,000 mmBTUs of natural gas.
Wholesale and Retail Load-Serving Activities
Our wholesale competitive supply operation structures transactions that serve the full energy and capacity requirements of various customers such as distribution utilities, municipalities, cooperatives, and retail aggregators that do not own sufficient generating capacity or in-house supply functions to meet their own load requirements.
Our retail competitive supply operation structures transactions to supply full energy and capacity requirements and provide natural gas, transportation, and other energy products and services to retail, commercial, industrial, and governmental customers. Contracts with these customers generally extend from one to ten years, but some can be longer. To meet our customers' load-serving requirements, our merchant energy business obtains energy from various sources, including:
bilateral power and natural gas purchase agreements with third parties,
unit contingent purchases from generation companies,
our generation assets,
regional power pools,
tolling contracts with generation companies, which provide us the right, but not the obligation, to purchase power at a price linked to the variable cost of production, including fuel, with terms that generally extend from several months to several years, but can be longer, and
exchange traded electricity and natural gas contracts.
Portfolio Management and Trading
We continue to identify and pursue opportunities which can generate additional returns through portfolio management and trading activities within our business. These opportunities have increased due to the significant growth in scale of our competitive supply operations. In managing our portfolio, we may terminate, restructure, or acquire contracts. Such transactions are within the normal course of managing our portfolio and may materially impact the timing of our recognition of revenues, fuel and purchased energy expenses, and cash flows.
Our global commodities operation actively uses energy and energy-related commodities and contracts for those commodities in order to manage our portfolio of energy purchases and sales to customers through structured transactions. We use both derivative and nonderivative contracts in managing our portfolio of energy sales and purchase contracts. Generally, we expect to use both derivative and nonderivative contracts to hedge our portfolio in order to reduce volatility. Although a substantial portion of our portfolio is hedged, we are able to identify opportunities to deploy risk capital to increase the value of our accrual positions, which we characterize as portfolio management.
We trade energy and energy-related contracts and commodities and deploy risk capital in the management of our portfolio in order to earn additional returns. These activities are managed through daily value at risk and stop loss limits and liquidity guidelines, and could have a material impact on our financial results. We discuss the impact of our trading activities and value at risk in more detail in Item 7. Management's Discussion and Analysis.
These activities involve the use of physical commodity inventories and a variety of instruments, including:
forward contracts (which commit us to purchase or sell energy commodities in the future),
swap agreements (which require payments to or from counterparties based upon the difference between two prices for a predetermined contractual (notional) quantity),
option contracts (which convey the right to buy or sell a commodity, financial instrument, or index at a predetermined price), and
futures contracts (which are exchange traded standardized commitments to purchase or sell a commodity or financial instrument, or make a cash settlement, at a specified price and future date).
Active portfolio management allows our merchant energy business to:
manage and hedge its fixed-price energy purchase and sale commitments,
provide fixed-price energy commitments to customers and suppliers,
reduce exposure to the volatility of market prices, and
hedge fuel requirements at our non-nuclear generation facilities.
Coal and International Services
Our global commodities operation participates in global coal sourcing activities by providing coal and coal-related logistical services for the variable or fixed supply needs of global customers. In late 2006, we formed a shipping joint venture that will own and operate six freight ships for the delivery of coal and other dry bulk freight products. We own a 50% interest in this joint venture. In 2007, we delivered approximately 28 million tons of coal to global customers and to our own generation fleet. Additionally, we entered into power, natural gas, freight, and emissions transactions outside of the United States. We also include in our coal services the results from our synthetic fuel processing facility in South Carolina. In 2008, these synthetic fuel processing facilities will be decommissioned.
We will continue to evaluate new international opportunities, including expanding our coal sourcing, freight, power, natural gas and emissions activities outside of the United States.
Yves C. de Balmann , age 61, a director since July 2003, has been Co-Chairman of Bregal Investments LP (a private equity investing firm) since September 2002. He was Co-Chairman and Co-Chief Executive Officer of Deutsche Banc Alex. Brown from June 1999 to April 2001, and a Senior Advisor to Deutsche Bank AG from April 2001 to June 2003. He is also a director of ESI Group, a technology company based in France.
Douglas L. Becker , age 42, a director since April 1999, has been Chairman and Chief Executive Officer of Laureate Education, Inc. (a company in the education industry) (formerly Sylvan Learning Systems, Inc.) since February 2000. He is also Founder and Principal of Sterling Capital Partners, an investment company. Mr. Becker was a director of Baltimore Gas and Electric Company (BGE) from October 1998 to April 1999.
Ann C. Berzin , age 56, a director since February 2008, has been a private investor since 2001. From 1992 to 2001, she served as Chairman and Chief Executive Officer of Financial Guaranty Insurance Company (an insurer of municipal bonds and structured finance obligations). Ms. Berzin is a director of Ingersoll-Rand Company Ltd. and Kindred Healthcare, Inc.
James T. Brady , age 67, a director since May 1999, has been the Managing Directorâ€”Mid-Atlantic of Ballantrae International, Ltd. (a management consulting firm) since January 2000, and is the former secretary of the Maryland Department of Business & Economic Development, where he served from 1995 to 1998. He was also a managing partner of Arthur Andersen LLP from 1985 to 1995. Mr. Brady is a director of McCormick & Company, Inc., T. Rowe Price Group, Inc. and NexCen Brands, Inc. Mr. Brady was a director of Constellation Enterprises, Inc. from March 1998 to May 1999.
Edward A. Crooke , age 69, a director since April 1999, retired as Vice Chairman of Constellation Energy and BGE in December 2001 and has been retired since that time. He also is a director of AEGIS Insurance Services, Inc., Associated Electric & Gas Insurance Services, Limited and Baltimore Equitable Society. Mr. Crooke was a director of BGE from 1988 to April 1999.
James R. Curtiss , age 54, a director since April 1999, was a partner in the law firm of Winston & Strawn LLP from 1993 to April 2008, and has been retired since that time. From 1988 to 1993, he served as a Commissioner of the United States Nuclear Regulatory Commission. He is also a director of Cameco Corporation (owner and operator of uranium mines). Mr. Curtiss was a director of BGE from 1994 to April 1999.
Freeman A. Hrabowski , III, age 57, a director since April 1999, has been President of the University of Maryland Baltimore County since 1993. He is also a director of the Baltimore Equitable Society and McCormick & Company, Inc. Dr. Hrabowski was a director of BGE from 1994 to April 1999.
Nancy Lampton , age 65, a director since April 1999, has been Chairman and Chief Executive Officer of American Life and Accident Insurance Company of Kentucky since 1971 and has been Chairman and Chief Executive Officer of its holding company, Hardscuffle, Inc., since January 2000. She is also a director of DNP Select Income Fund, Duff & Phelps Utility and Corporate Bond Trust Inc. and DTF Tax-Free Income Inc. Ms. Lampton was a director of BGE from 1994 to April 1999.
Robert J. Lawless , age 61, a director since January 2002, has been Chairman of the Board of McCormick & Company, Inc. (a company in the food manufacturing industry) since January 1997, having also served as President until December 2006 and Chief Executive Officer until January 2008. He is also a director of Baltimore Life, Inc.
Lynn M. Martin , age 68, a director since October 2003, has been President of The Martin Hall Group LLC (a human resources consulting firm) since January 2005. From 1993 to October 2005, Ms. Martin was an Advisor to Deloitte & Touche LLP. Ms. Martin served as United States Secretary of Labor from 1991 to 1993. Prior to her tenure as Secretary of Labor, she was a member of the United States House of Representatives from 1981 to 1991. She is also a director of The Procter & Gamble Company, Ryder System, Inc., AT&T Inc. and various funds of The Dreyfus Corporation.
Mayo A. Shattuck III , age 53, a director since May 1999, has been Chairman of Constellation Energy since July 2002 and President and Chief Executive Officer since November 2001. Mr. Shattuck also served as Chairman of the Board of Directors of BGE from July 2002 to April 2007. He is also a director of Capital One Financial Corporation, Gap, Inc., the Edison Electric Institute, the Nuclear Energy Institute and the Institute of Nuclear Power Operations.
John L. Skolds , age 57, a director since November 2007, served as Executive Vice President of Exelon Corporation and President of Exelon Energy Delivery from December 2003 until his retirement in September 2007, and has been retired since that time. He also served as President of Exelon Generation from March 2005 to September 2007. From March 2002 to December 2003, Mr. Skolds served as Senior Vice President of Exelon Corporation and President and Chief Nuclear Officer of Exelon Nuclear.
Michael D. Sullivan , age 68, a director since April 1999, is a private investor, and is a Co-Founder and has been Chairman of the Board of Life Source, Inc. (a company in the nutritional supplements industry) since March 2001. He also has been Chairman of the Board of ADVANCARE Health Care, LLC (a company in the home health care industry) since January 2006. Mr. Sullivan was a director of BGE from 1992 to April 1999.
MANAGEMENT DISCUSSION FROM LATEST 10K
Introduction and Overview
Constellation Energy Group, Inc. (Constellation Energy) is an energy company that conducts its business through various subsidiaries including a merchant energy business and Baltimore Gas and Electric Company (BGE). We describe our operating segments in Note 3 .
This report is a combined report of Constellation Energy and BGE. References in this report to "we" and "our" are to Constellation Energy and its subsidiaries, collectively. References in this report to the "regulated business(es)" are to BGE. We discuss our business in more detail in Item 1. Business section and the risk factors affecting our business in Item 1A. Risk Factors section.
In this discussion and analysis, we will explain the general financial condition and the results of operations for Constellation Energy and BGE including:
factors which affect our businesses,
our earnings and costs in the periods presented,
changes in earnings and costs between periods,
sources of earnings,
impact of these factors on our overall financial condition,
expected future expenditures for capital projects, and
expected sources of cash for future capital expenditures.
As you read this discussion and analysis, refer to our Consolidated Statements of Income, which present the results of our operations for 2007, 2006, and 2005. We analyze and explain the differences between periods in the specific line items of our Consolidated Statements of Income.
We have organized our discussion and analysis as follows:
First, we discuss our strategy.
We then describe the business environment in which we operate including how regulation, weather, and other factors affect our business.
Next, we discuss our critical accounting policies. These are the accounting policies that are most important to both the portrayal of our financial condition and results of operations and require management's most difficult, subjective or complex judgment.
We highlight significant events that are important to understanding our results of operations and financial condition.
We then review our results of operations beginning with an overview of our total company results, followed by a more detailed review of those results by operating segment.
We review our financial condition addressing our sources and uses of cash, security ratings, capital resources, capital requirements, commitments, and off-balance sheet arrangements.
We conclude with a discussion of our exposure to various market risks.
We are pursuing a strategy of providing energy and energy related services through our competitive supply activities and BGE, our regulated utility located in Maryland. Our merchant energy business focuses on short-term and long-term purchases and sales of energy, capacity, and related products to various customers, including distribution utilities, municipalities, cooperatives, and industrial, commercial, and governmental customers.
We obtain this energy through both owned and contracted supply resources. Our generation fleet is strategically located in deregulated markets and includes various fuel types, such as nuclear, coal, gas, oil, and renewable sources. In addition to owning generating facilities, we contract for power from other merchant providers, typically through power purchase agreements. We will use both our owned generation and our contracted generation to support our competitive supply operations.
In addition, our merchant energy business is active in both upstream and downstream natural gas areas as well as coal sourcing and logistics services for the variable and fixed supply needs of global customers.
We are a leading national competitive supplier of energy. In our wholesale and commercial and industrial retail marketing activities we are leveraging our recognized expertise in providing full requirements energy and energy-related services to enter markets, capture market share, and organically grow these businesses. Through the application of technology, intellectual capital, process improvement, and increased scale, we are seeking to reduce the cost of delivering full requirements energy and energy related services and managing risk.
We are also responding proactively to customer needs by expanding the variety of products we offer. Our wholesale competitive supply activities include a growing operation that markets physical energy products and risk management and logistics services to generators, distributors, producers of coal, natural gas and fuel oil, and other consumers.
We trade energy and energy-related commodities and deploy risk capital in the management of our portfolio in order to earn additional returns. These activities are managed through daily value at risk and stop loss limits and liquidity guidelines.
Within our retail competitive supply activities, we are marketing a broader array of products and expanding our markets. Over time, we may consider integrating the sale of electricity and natural gas to provide one energy procurement solution for our customers.
Collectively, the integration of owned and contracted electric generation assets with origination, fuel procurement, and risk management expertise, allows our merchant energy business to earn incremental margin and more effectively manage energy and commodity price risk over geographic regions and over time. Our focus is on providing solutions to customers' energy needs, and our wholesale marketing, risk management, and trading operation adds value to our owned and contracted generation assets by providing national market access, market infrastructure, real-time market intelligence, risk management and arbitrage opportunities, and transmission and transportation expertise. Generation capacity supports our wholesale marketing, risk management, and trading operation by providing a source of reliable power supply.
To achieve our strategic objectives, we expect to continue to pursue opportunities that expand our access to customers and to support our wholesale marketing, risk management, and trading operation with generation assets that have diversified geographic, fuel, and dispatch characteristics. We also expect to grow through buying and selling a greater number of physical energy products and services to large energy customers. We expect to achieve operating efficiencies within our competitive supply operation and our generation fleet by selling more products through our existing sales force, benefiting from efficiencies of scale, adding to the capacity of existing plants, and making our business processes more efficient.
We expect BGE and our other retail energy service businesses to grow through focused and disciplined expansion primarily from new customers. At BGE, we are also focused on enhancing reliability, customer satisfaction and customer demand response initiatives.
Customer choice, regulatory change, and energy market conditions significantly impact our business. In response, we regularly evaluate our strategies with these goals in mind: to improve our competitive position, to anticipate and adapt to the business environment and regulatory changes, and to maintain a strong balance sheet and investment-grade credit quality.
We are constantly reevaluating our strategies and might consider:
acquiring or developing additional generating facilities and gas properties to support our merchant energy business,
renovating or extending the life of existing generation facilities,
mergers or acquisitions of utility or non-utility businesses or assets, and
sale of assets of one or more businesses.
With the evolving regulatory environment surrounding customer choice, increasing competition, and the growth of our merchant energy business, various factors affect our financial results. We discuss some of these factors in more detail in the Item 1. Businessâ€”Competition section. We also discuss these various factors in the Forward Looking Statements and Item 1A. Risk Factors sections.
Over the last several years, the energy markets have been highly volatile with significant changes in natural gas, power, oil, coal, and emission allowance prices. The volatility of the energy markets impacts our credit portfolio, and we continue to actively manage our credit portfolio to attempt to reduce the impact of a potential counterparty default. We discuss our customer (counterparty) credit and other risks in more detail in the Market Risk section.
In addition, the volatility of the energy markets impacts our liquidity and collateral requirements. We discuss our liquidity in the Financial Condition section.
We face competition in the sale of electricity, natural gas, and coal in wholesale energy markets and to retail customers.
Various states have moved to restructure their retail electricity and gas markets. The pace of deregulation in these states varies based on historical moves to competition and responses to recent market events. While many states continue to support or expand retail competition and industry restructuring, other states that were considering deregulation have slowed their plans or postponed consideration. In addition, other states are reconsidering deregulation.
Specifically, legislatures in a number of states are considering, to varying degrees, legislation currently to either eliminate or expand retail choice programs. In addition, many states have initiated proceedings to reconsider the method of wholesale procurement for meeting their utilities' default/provider-of-last- resort requirements. Both the reconsideration of retail choice and possible new methodologies for wholesale procurement could affect our customer supply group's future opportunities to service commercial and industrial customers and the ability to provide wholesale products to utilities. The outcome of these efforts cannot be predicted, but they could have a material effect on our financial results.
All BGE electricity and gas customers have the option to purchase electricity and gas from alternate suppliers.
We discuss merchant competition in more detail in Item 1. Businessâ€”Competition section.
The impacts of electric deregulation on BGE in Maryland are discussed in Item 1. Businessâ€”Baltimore Gas and Electric Companyâ€”Electric Businessâ€”Electric Competition section.
In addition to electric restructuring, which is discussed in Item 1. Businessâ€”Electric Competition section , regulation by the Maryland PSC significantly influences BGE's businesses. The Maryland PSC determines the rates that BGE can charge customers of its electric distribution and gas businesses. The Maryland PSC incorporates into BGE's standard offer service rates the transmission rates determined by the Federal Energy Regulatory Commission (FERC). BGE's electric rates are unbundled in customer billings to show separate components for delivery service (i.e. base rates), electric supply (commodity charge), transmission, a universal service surcharge, and certain taxes. The rates for BGE's regulated gas business continue to consist of a delivery charge (base rate) and a commodity charge.
Senate Bills 1 and 400
In June 2006, Senate Bill 1 was enacted, which among other things:
imposed rate stabilization measures that (i) capped rate increases by BGE for residential SOS service at 15% from July 1, 2006 to May 31, 2007, (ii) gave residential SOS customers the option from June 1, 2007 until December 31, 2007 of paying a full market rate or choosing a short term rate stabilization plan in order to provide a smooth transition to market rates without adversely affecting the creditworthiness of BGE, and (iii) provided for full market rates for all residential SOS service starting January 1, 2008;
allowed BGE to recover the costs deferred from July 1, 2006 to May 31, 2007 from its customers over a period not to exceed 10 years, on terms and conditions to be determined by the Maryland PSC, including through the issuance of rate stabilization bonds that securitize the deferred costs; and
required BGE to reduce residential electric rates by approximately $39 million per year for 10 years, beginning January 1, 2007, through suspension of the collection of the residential return component of the administrative charge for SOS service through May 31, 2007 and by providing to all residential electric customers a credit equal to the amounts collected from all BGE customers for the nuclear decommissioning trust for Calvert Cliffs. We provide further details in Item 1. Businessâ€”Cost for Decommissioning Nuclear Facilities section and in Item 7. Management's Discussion and Analysisâ€”Regulated Electric Businessâ€”Senate Bill 1 Credits section.
In connection with these provisions of Senate Bill 1:
In May 2007, the Maryland PSC approved a plan to allow residential electric customers to defer the transition to full market rates from June 1, 2007 to January 1, 2008. The 4 percent of customers who chose to defer will repay the deferred amounts over a twenty-one month period starting April 1, 2008 without interest.
In June 2007, a subsidiary of BGE issued an aggregate principal amount of $623.2 million of rate stabilization bonds to recover costs relating to the residential rate deferral from July 1, 2006 to May 31, 2007. We discuss the rate stabilization bond issuance in more detail in Note 9 .
In June 2007, the Maryland PSC required BGE to reinstate collection of the residential return component of the POLR administration charge in POLR rates and to provide all residential electric customers a credit for the residential return component of the administrative charge.
In connection with implementing the approximately $39 million in credits to residential electric customers discussed above, BGE and Calvert Cliffs had notified the Maryland PSC that they had entered into a standstill agreement with the Attorney General of the State of Maryland with respect to potential challenges to the provisions of Senate Bill 1 relating to the credits. In January 2008, BGE and Calvert Cliffs provided the Attorney General with notice of their termination of the standstill agreement and their intent to file a federal action to enforce their rights under the 1999 Maryland electric deregulation settlement and to challenge the constitutionality of the residential customer credits set forth in Senate Bill 1. We may incur significant costs to litigate this action and we cannot provide any assurances that it will be resolved in our favor. If the action is resolved in a manner adverse to us, which may include a court determining that Senate Bill 1 appropriately required the residential rate credits or overturning aspects of the 1999 electric deregulation settlement, the impact on our, or BGE's, financial results could be material.
Further, in April 2007, Senate Bill 400 was enacted, which made certain modifications to Senate Bill 1. Pursuant to Senate Bill 400, the Maryland PSC was required to initiate several studies, including studies relating to stranded costs, the costs and benefits of various options for reregulation, and the structure of the electric industry in Maryland. In addition, the Maryland PSC has indicated that they are studying the relationship between Constellation Energy and BGE.
In December 2007, the Maryland PSC issued an interim report addressing the costs and benefits of various options for reregulation and recommending actions to be taken to address an anticipated shortage of generation and transmission capacity in Maryland, which included implementation of demand response initiatives and requiring utilities to enter into long-term power purchase contracts with suppliers.
In January 2008, the Maryland PSC issued another interim report that indicated that the Maryland PSC would initiate proceedings into payments made by BGE customers for stranded costs resulting from BGE's transfer of generation assets to certain Constellation Energy affiliates in connection with deregulation and into Constellation Energy's management of its nuclear decommissioning funds. This interim report also recommended that the Maryland legislature enact legislation to provide the Maryland PSC with the authority to regulate nuclear decommissioning funds and consider legislation that would provide the Maryland PSC with the authority to consider reallocation of the liability for nuclear decommissioning among Constellation Energy, BGE and customers or to otherwise order relief for customers. Similarly, the interim report also recommended that the Maryland legislature consider legislation to order relief for customers depending on the outcome of the Maryland PSC's stranded cost proceeding.
The Maryland PSC is required to issue a final report in December 2008. We cannot at this time predict the ultimate outcome of these inquiries, studies, and recommendations or their actual effect on our, or BGE's financial results, but it could be material. In addition, one or more parties may challenge in court one or more provisions of Senate Bills 1 and 400. The outcome of any challenges and the uncertainty that could result cannot be predicted.
We discuss the market risk of our regulated electric business in more detail in the Market Risk section.
MANAGEMENT DISCUSSION FOR LATEST QUARTER
Introduction and Overview
Constellation Energy Group, Inc. (Constellation Energy) is an energy company that conducts its business through various subsidiaries including a merchant energy business and Baltimore Gas and Electric Company (BGE). We describe our operating segments in the Notes to Consolidated Financial Statements beginning on page 18.
This Quarterly Report on Form 10-Q is a combined report of Constellation Energy and BGE. References in this report to "we" and "our" are to Constellation Energy and its subsidiaries, collectively. References in this report to the "regulated business(es)" are to BGE. We discuss our business in more detail in Item 1â€”Business section of our 2007 Annual Report on Form 10-K and we discuss the risks affecting our business in Item 1A. Risk Factors section beginning on page 68.
Our 2007 Annual Report on Form 10-K includes a detailed discussion of various items impacting our business, our results of operations, and our financial condition. These include:
Introduction and Overview section which provides a description of our business segments,
Business Environment section, including how regulation, weather, and other factors affect our business, and
Critical Accounting Policies section.
Critical accounting policies are the accounting policies that are most important to the portrayal of our financial condition and results of operations and require management's most difficult, subjective, or complex judgment. Our critical accounting policies include derivative accounting, evaluation of assets for impairment and other than temporary decline in value, and asset retirement obligations.
Effective January 1, 2008, we adopted SFAS No. 157, Fair Value Measurements , as discussed in the Notes to Consolidated Financial Statements beginning on page 31. We discuss our accounting policy for determining fair value in more detail in the Notes to Consolidated Financial Statements as well as in our Critical Accounting Policies section and Note 1 in our 2007 Annual Report on Form 10-K.
In this discussion and analysis, we explain the general financial condition and the results of operations for Constellation Energy and BGE including:
factors which affect our businesses,
our earnings and costs in the periods presented,
changes in earnings and costs between periods,
sources of earnings,
impact of these factors on our overall financial condition,
expected future expenditures for capital projects, and
expected sources of cash for further capital expenditures.
As you read this discussion and analysis, refer to our Consolidated Statements of Income (Loss) on page 3, which present the results of our operations for the quarters and nine months ended September 30, 2008 and 2007. We analyze and explain the differences between periods in the specific line items of the Consolidated Statements of Income (Loss).
We have organized our discussion and analysis as follows:
We describe changes to our strategy and our business environment during the year.
We highlight significant events that occurred in 2008 that are important to understanding our results of operations and financial condition.
We then review our results of operations beginning with an overview of our total company results, followed by a more detailed review of those results by operating segment.
We review our financial condition, addressing our sources and uses of cash, capital resources, commitments, and liquidity.
We conclude with a discussion of our exposure to various market risks.
We discuss our business strategy in detail in the Strategy section of our 2007 Annual Report on Form 10-K. In that discussion, we indicate that we are constantly reevaluating our strategies. As a result of the unprecedented events of 2008 as discussed below, in addition to focusing on our basic business plan, we have made substantial changes in our strategy, including focusing on the following immediate goals:
reducing the capital requirements, economic risk and collateral needs of our merchant energy businesses, which we discuss in further detail beginning on page 62,
executing strategic initiatives for our Global Commodities business, which include the sale of our upstream gas properties, our international business, which includes our coal sourcing, freight, uranium, power, natural gas and emissions marketing activities outside North America, and our gas trading activities, and
obtaining necessary approvals and executing other activities to close our merger with MidAmerican Energy Holdings Company (MidAmerican).
The execution of our strategy in the future will be affected by our ability to achieve these goals as well as by continued instability in financial and commodities markets. Execution of our goals could have a substantial effect on the nature and mix of our business activities. In turn, this could affect our financial position, results of operations, and cash flows in material amounts, and these amounts could vary substantially from historical results.
Various factors affect our financial results. We discuss these various factors in the Forward Looking Statements section on page 74 and in Item 1A. Risk Factors section beginning on page 68. We discuss our market risks in the Market Risk section beginning on page 64.
In this section, we discuss in more detail events which have impacted our business during 2008.
In May 2008, five state public service commissions, including the Public Service Commission of Maryland (Maryland PSC), consumer advocates and others filed a complaint against PJM Interconnection (PJM), the regional transmission organization for the Mid-Atlantic region, at the Federal Energy Regulatory Commission (FERC) alleging that the PJM reliability pricing model (RPM) produced unreasonable prices during the period from June 1, 2008 through May 31, 2011. The complaint requests that FERC establish a refund effective date of June 1, 2008, reject the results of the 2007/08 through 2010/11 RPM capacity auction results, and significantly reduce prices for capacity beginning as of June 1, 2008 through 2011/12. We, along with other power suppliers and supplier trade groups, have filed protests to the complaint. In September 2008, FERC dismissed the complaint and in October 2008, the complainants requested a rehearing at FERC. We cannot predict the outcome of this proceeding or the amount of refunds that may be owed by or due to us, if any. However, the outcome, and any refunds that are ultimately assessed, could have a material impact on our financial results.
National Ambient Air Quality Standards (NAAQS)
In March 2008, the Environmental Protection Agency (EPA) adopted a stricter NAAQS for ozone. We are unable to determine the impact that complying with the stricter NAAQS for ozone will have on our financial results until the states in which our generating facilities are located adopt plans to meet the new standards.
In July 2008, the United States Court of Appeals for the District of Columbia Circuit issued a ruling that effectively repealed the Clean Air Interstate Rule (CAIR). We do not believe that the decision will result in a material change to our emissions reduction plan in Maryland as the emissions reduction requirements of Maryland's Healthy Air Act and Clean Power Rule are more stringent and apply sooner than those under CAIR. On September 24, 2008, the EPA petitioned the District of Columbia Circuit for rehearing. We cannot predict what additional judicial, legislative or regulatory actions will be taken in response to the court's decision or the EPA's petition for rehearing or whether such actions may affect our financial results. We discuss the impact that this ruling had on our third quarter of 2008 results in the Merchant Energy Business section on page 45. We discuss this ruling in more detail in the Notes to Consolidated Financial Statements beginning on page 17.
As discussed in our 2007 Annual Report on Form 10-K, we expect to incur additional environmental capital expenditures to comply with air quality laws and regulations. Based on updated information from vendors, we expect our estimated environmental capital requirements for these air quality projects to be approximately $550 million in 2008, $305 million in 2009, $40 million in 2010 and $35 million from 2011-2012.
Our estimates may change further as we implement our compliance plan. As discussed in our 2007 Annual Report on Form 10-K, our estimates of capital expenditures continue to be subject to significant uncertainties.
Accounting Standards Issued and Adopted
We discuss recently issued and adopted accounting standards in the Accounting Standards Issued and Accounting Standards Adopted sections of the Notes to Consolidated Financial Statements beginning on page 30.
Events of 2008
Pending Merger with MidAmerican
On September 19, 2008, Constellation Energy entered into an Agreement and Plan of Merger with MidAmerican. We discuss the details of this pending merger in the Notes to Consolidated Financial Statements beginning on page 11.
Current Market Developments
Volatility in the financial markets throughout 2008 intensified in the third quarter, leading to dramatic declines in equity prices and substantially reducing liquidity in the credit markets. Most equity indices declined significantly, the cost of credit default swaps and bond spreads increased substantially, and credit markets effectively ceased to be accessible for all but the most highly rated borrowers.
Precipitated by these conditions, major financial institutions experienced significant financial difficulty and widespread fears developed about the viability of any business that required access to credit markets to support liquidity needs or that required substantial access to the capital markets to function. During the week of September 15, 2008, Constellation Energy faced rapidly growing doubts among investors and business partners about its ability to navigate through this market crisis. Concerns focused on our liquidity, and the trading price of our common stock fell to a 52-week low of $13.00 during the day on September 16, 2008. Despite having announced a number of actions to address our liquidity situation, we needed to raise immediate equity capital and take other steps to enhance our overall liquidity, and as a result on September 19, 2008, we entered into a definitive merger agreement with MidAmerican. We discuss our pending merger with MidAmerican in more detail in the Notes to Consolidated Financial Statements beginning on page 11.
This market environment contributed to the following:
Our senior unsecured debt was downgraded one level by all three major credit rating agencies and we remain under review for possible downgrade by Moody's Investors Service. We discuss our security ratings and downgrade collateral in more detail beginning on page 59.
We were required to post additional collateral with counterparties. We discuss our collateral requirements in more detail beginning on page 58.
We initiated strategic alternatives for our upstream gas properties, our international business, and our gas trading operations as well as other strategies to improve liquidity and reduce invested capital. We discuss our strategy in more detail beginning on page 36.
We anticipate closing in November 2008 on a new credit facility of approximately $1.2 billion. We discuss this in more detail in the Notes to Consolidated Financial Statements on page 21.
We took various other steps to reduce our exposure to the credit risk of other parties and to improve our own liquidity. We discuss our liquidity beginning on page 60.
In connection with the proposed merger with MidAmerican, we received a capital infusion of $1 billion from MidAmerican on September 22, 2008. We discuss the $1 billion in proceeds from MidAmerican in the Notes to Consolidated Financial Statements beginning on page 21.
We recorded significant impairment charges in the third quarter of 2008. We discuss these impairment charges in more detail in the Notes to Consolidated Financial Statements beginning on page 12.
We incurred losses on our pension plan assets. We discuss our pension plan assets in more detail on page 57.
Merger and Strategic Alternatives Costs
We incurred costs during the third quarter of 2008 related to our pending merger with MidAmerican and the pursuit of other strategic alternatives to that merger. We discuss these costs in more detail in the Notes to Consolidated Financial Statements on page 12.
Workforce Reduction Costs
During the third quarter of 2008, our merchant energy business approved a restructuring of its Customer Supply operations and recognized a $2.2 million pre-tax charge. We discuss our workforce reduction costs in more detail in the Notes to Consolidated Financial Statements on page 16.
During the third quarter of 2008, as a result of a July 11, 2008 decision by the United States Court of Appeals for the D. C. Circuit that vacated the Clean Air Interstate Rule and the subsequent decline in market price for our emission allowance inventory, we recorded a write-down of our emissions inventory and recognized partially offsetting gains on certain forward sales contracts. We discuss this net charge in the Notes to Consolidated Financial Statements beginning on page 17.
Hillabee Energy Center
On February 14, 2008, we acquired a partially completed gas-fired power generating facility in Alabama. We discuss this acquisition in more detail in the Notes to Consolidated Financial Statements on page 16.
West Valley Power Plant
On June 1, 2008, we acquired a gas-fired peaking plant in Utah. We discuss this acquisition in more detail in the Notes to Consolidated Financial Statements on page 16.
Kevin W. Hadlock - Vice President of Investor Relations
Thank you. Welcome to our third quarter earnings call. We appreciate you being with us this morning.
On slide 2, before we begin our presentation, let me remind you that our comments today will include forward-looking statements which are subject to certain risks and uncertainties. For a complete discussion of these risks, we encourage you to read our documents on file with the SEC. Our presentation today is being webcast and the slides are available on our website, which you can access at constellation.com under Investor Relations.
On slide 3, you'll notice we will use non-GAAP financial measures in this presentation to help you understand our operating performance. We've attached an appendix to the charts on the website, reconciling non-GAAP measures to GAAP measures.
On slide 3, Constellation Energy has filed with the Securities and Exchange Commission a preliminary proxy statement and other relevant documents regarding a proposed transaction with MidAmerican Energy Holdings Company. A definitive proxy statement will be sent to security holders of Constellation Energy seeking an approval for the proposed transaction.
We urge investors to read the definitive proxy statement, and other relevant documents when they became available, because they will contain important information about Constellation Energy and the proposed transaction.
With that I would like to turn the time over to Mayo Shattuck, Chairman, President and CEO of Constellation Energy.
Mayo A. Shattuck III - Chairman, President and Chief Executive Officer
Thank you, Kevin and good morning everyone. I'd like to begin today with an overview of the last few months. So, you're looking only at the first slide with my name on it at this point. The shock to the financial system in the past several months is still being digested and analyzed and although we have our differing micro series about its causes, I can at least provide some perspective on its effects.
Companies like our's are depended on access to capital in two fundamental ways. First for fulfilling its capital expenditure programs and second for the liquidity capital required to operate and support its commercial businesses.
In 2008, we have planned CapEx program of $2.4 billion, a substantial increase over prior years primarily because of the environmental upgrades required on our coal plant.
Since this program was larger than our planned cash generation for the year, we had anticipated going to the market to raise capital during the year, and during the first and second quarter of 2008, we raised $1.1 billion in new debt in hybrid securities as part of this program.
Our liquidity capital requirements are funded by lines of credit and cash. The main drivers of the use of liquidity capital in our case, has been hedging the generation fleet, hedging the customer supply business in both power and gas, and hedging our international coal business.
We will describe this in much detail today. But it is important to note that our approach is been to lock in economic value by hedging our exposures to the extent possible. In this way, we've been able to reasonably forecast the economic exposure and long-term cash flows from our fleet based on our hedge ratios, and also reasonably lock in a spread in our commercial businesses over the life for the contracts.
This formula worked well for many years, while access to liquidity capital was available, and the cost of that capital was reasonable. We managed the total liquidity capital requirements by comparing our liquidity resources to the requirement if we were BB downgraded by the ratings' agencies.
When we entered into the famed infamous week of September 15, when Lehman and AIG failed, and when the other major investments banks altered there strategic courses through mergers or bank charters, we were threatened by a downgrade by the rating agencies after they witnessed violent moves in our stock price and CDS spreads.
To avoid the downgrade and the potential restriction of our access to credit resources, we engaged in an immediate capital infusion by MidAmerican in the amount of the $1 billion.
We also agreed to merge into MidAmerican for price of $26.50 per share. The tumultuous nature of the markets that we caused a tremendous amount of uncertainty over how our counterparties would react, if given any signal that a downgrade was possible, as a result it was imperative that we receive the capital commitment by the end of that Friday. This issue explains why last minute proposal by EDS and certain private equity firms on Friday was not accepted, in that it did not address the immediate financing need on that day, in order to spell out immediate issues such as ownership structure and financing sources, both of which are so important in assessing the probability of the transaction closing.
As the merger agreements were signed, the markets worsened and specifically for power companies a declining power price environment has caused all companies in our space to decline in price significantly. This has given us an even stronger perspective that a merger partner like MidAmerican has important near and long-term advantages in terms of our access to capital. We also believe that the merger is a compelling proposition to a number of our constituencies, particularly the State of Maryland which must look to the benefit that such a merger has to BGE rate fares.
In addition, the history of MidAmerican's management approach, of keeping its subsidiaries as autonomous units, to provide some of the qualitative benefits that employees and another state stakeholders always examine in these circumstances.
While we have been diligently working on the transaction process with MidAmerican, we have also been hard at work to produce risk and collateral requirements to adjust to the new environment where prices have declined, markets are liquid, and credit is scarce.
We will discuss today our efforts in all fronts. Risk has been reduced through the pursuit of sales of certain businesses and the overall lowering and flattening of our book of business.
Collateral requirements are also being reduced through these actions.
Since the merger announcement, we have changed the focus of our commodities business to prioritize risk and collateral reduction over the near-term realization of profits. In practical terms, this means that we have spent in the third quarter and will spend in the fourth quarter, some money to achieve a lower risk and collateral profile.
We are making these decisions with the full concurrence of MidAmerican such that we have the business appropriately right sized to fit its long term strategy. We are in the midst of our five year planning process and are accepting how the impact of the current market environment and expected execution of our strategic initiatives, will affect our 2009 earnings and cash flow.
Our planning efforts are focused on generation, BGE, customer supply and activities in the global commodities group that will either be in a wind down bucket or an ongoing bucket. Obviously, many of the strategic decisions made over the last few months including those activities we expect to divest, combined with the current economic environment, introduced a degree of uncertainty around earnings expectations for the balance of 2008 and 2009.
As such, we are not in a position to affirm our previously stated guidance.
That said, Jack will outline our fourth quarter expectations for BGE, generation and customer supply backlog, as we customarily do each quarter. And I do expect that we will be able to provide an outlook for 2009 by the time that the shareholders vote in late December or January.
Let me take a moment to review our credit sources. This morning we announced that we anticipate to close approximately $1.2 billion of the previously announced credit facilities as early as next week. In addition, MidAmerican has committed to provide Constellation up to $350 million in addition of liquidity resources. Jack will be providing more specific information on our liquidity position in a moment.
Finally I have asked Brenda Boultwood, our Chief Risk officer, to speak this morning about how we are managing risk. It is important to note that the interrelationships between risk, credit support and earnings are complex but we will attempt to describe some of the most significant moving parts.
As an example, the asymmetry that exists in the margin requirements of some of our businesses, have been a major driver of collateral use. When coal prices soared earlier this year, we were required to post collateral to our customers while receiving none from our suppliers.
More recently as the power prices dropped, we were required to post collateral to our suppliers while getting none from our load serving customers. And as volatility in all commodities does increased, the exchanges in ISOs have generally increased the credit requirements to conduct business through them.
Most market participants including ourselves have adjusted their pricing models to account for the significant increases in the cost of doing business in this credit environment and we've actually seen the market accept these increased credit costs in our origination businesses.
So, if you turn to slide 6. Let me turn now to some specific initiatives that we have recently undertaken. In light of the changed environment I just described, we are managing our business appropriately. We believe that this is prudent business practice irrespective of the pending transaction with MidAmerican.
Specifically, we are targeting a reduction in our capital consumption consistent with our $4.2 billion of long-term bank facilities, primarily by curtailing risk and collateral exposure. In addition, we are rightsizing the customer facing businesses as part of our long-term planning process. As I mentioned, we are increasing the cost of capital in our model to be consistent with our marginal cost of capital, and in alignment with changes in the industry's pricing methodology.
We are also reducing the scale and scope of global commodities and are pursuing the sale of our Houston downstream gas trading operations. In addition, we are focused on reducing portfolio management activities to a size appropriate to support hedging of generation and customer supply group. Our goal is to position Constellation's business to earn reasonable risk adjusted returns on capital while reducing earnings risk and variability.
Turning to slide seven; I would like to update you on the initiatives described to you at our August Analyst Meeting. We have made significant progress on our announced strategic divestitures.
On our international business, we received a high level of interest from potential buyers and have completed the second phase of the bidding. We are currently in the process of negotiating final terms and would expect to sign definitive documentation in the next two weeks. While we cannot predict the certainty of timing of the closing around the sale of this business, as it depends on the receipt of any required approvals and consents. We are committed to close as quickly as possible and are targeting and closing prior to year-end. We also continue to move forward with the sale of the upstream gas assets. We expect to have bids on certain properties this week and proceed with the process with a targeted closing date by year-end.
We have also initiated the sales process for our Houston gas business which focuses on gas supply activities to wholesale customers and on gas trading activities. While this has been and continues to be an attractive business, we do not see it as a core strategic bid as we move forward with our strategic business realignment. We have seen strong initial interest in this business and are currently making management presentations to interested buyers. Following the management presentations, we expect to identify the leading bidders and begin negotiations.
Our current schedule is to negotiate and sign a purchase and sale agreement by the middle of December.
Let me take a minute to update you on the status of the transaction with MidAmerican.
We are pleased to report that we have completed all required filings for the transaction. We are focused on two key approvals in particular; the Maryland Public Service Commission and the SEC's approval of the preliminary proxy statement. By statute, the Maryland PSC has 180 days with an option to extend by 45 days to rule on the transaction.
We are also, awaiting the SEC's comments on the preliminary proxy statement that was filed on October 17th. We've not yet set a date for the shareholder meeting until we have more visibility into the time associated with receiving and responding to the SEC's comments on the preliminary proxy. However, currently we estimate that both may take place in late December or January, and we remain on track for second quarter 2009 close, subject to necessary approvals.
We continue to execute and develop this strategic transformation that we outlined in the Analyst Meeting in August.
However, as you can imagine our operating objectives are different under the merger agreement and we are working with MidAmerican as the transformation of all. Unfortunately, our activities have impacted our third quarter results, as we actively reduced risk in our business at the expenses of earnings.
Turning the slide nine. In summary, we are actively working to reduce risk in our merchant business. We are reducing volatility of cash flows through a reduction in size of the portfolio and shifting the composition of our portfolio. We are also working towards building liquidity to support the businesses. While the majority of our time is spend operating and rightsizing the business, we also continue to prepare for the transaction with MidAmerican.
As indicated in our third quarter results, earnings were impacted by these initiatives and we expect this to continue at least through the fourth quarter. While we are not in the position to provide detail around 2009, we expect that earnings will not include those activates we expect to divest, such as upstream and downstream gas and international coal and freight.
With that, I will turn the call over to Brenda Boultwood, Constellation's Chief Risk Officer. Brenda?
Brenda Boultwood - Senior Vice President and Chief Risk Officer
Thank you, Mayo and good morning. Before we begin the risk management update, we would like to revisit the impact that the market environment has had on Constellation. Commodity prices climbed steadily through the first half of 2008 and were near annual highs at the end of June. On August 27th we discussed the consequences of higher commodity prices, as higher collateral requirements, higher gross derivative asset value, and increased credit exposures.
This trend can reverse during the third quarter as power, natural gas and coal prices dropped sharply by over 30%.
Given our generation fleet, we are generally long powered. Thus this reduction in power prices affected our portfolio value. Further, the falling commodity prices has also impacted our collateral requirements and decreased the size of our gross derivative positions and credit exposures. In addition, our challenges in the credit market in August and September, forced us to increase collateral postings by almost $750 million.
As Mayo discussed, credit markets are perhaps the most challenged in decades, from access to short-term commercial paper markets to the availability of longer-term debt facilities, credit products are available to some but at high prices. This has impacted Constellation's access to short-term financing forces and our cost of capital, most importantly affecting the capital needed to fund collateral requirements on our economic hedges of generation and customer supply.
In addition, power market liquidity has challenged our flexibility in hedging as we've been impacted by the withdrawal of investor funds from commodity markets and the loss of some market participants.
Today we'll show that Constellation has substantially reduced its economic exposure to directional commodity price risk in reaction to these market challenges.
We accomplished this by reducing position sizes and overall length in our portfolio. Furthermore, we are actively managing the liquidity needs of our business by reducing the variability of our collateral requirement.
Finally, the collateral we are required to post in the credit rating downgrades scenario, has decreased as a result of our management's actions as well as the declining prices.
Earlier, Mayo provided as update on our strategic focus, and on page 3 we layout... excuse me, page 12 we layout specific steps taken in our business to reduce economic risk and liquidity requirements. In our generation business objectives remain unchanged.
In the customer supply group, we revised our pricing to reflect the increase the cost of capital. We've also purchased financial and physical swaps to reduce physical shorts after regional power independent system operators, reducing our working capital requirement for this business.
We are currently in the process of identifying load contracts that can be sold along with their derivative hedges to further reduce margining requirements. In the global commodities business, we continue to focus on the strategic portfolio divestitures that Mayo discussed earlier.
Additionally, we are now focused on reducing the risk in our portfolio by reducing positions where economic opportunity exist, and market liquidity permits, reducing geographic and time spreads as market liquidity permits, and reducing the variability of our collateral requirements by flattening our book of margins provisions.
Turning to page 13; here we discuss actions taken to reduce the size of our economic positions across our global commodities business. The impact of this position reduction is a decrease in overall portfolio risk through 2013. As a power company, we have generally maintained the highly hedged portfolio. Specifically, we have typically hedged out three years of our generation length with a highest hedge ratio in the near year and declining through year three.
In the customer supply group, we have hedged retail and wholesale load obligations at their inception in order to lock in the margin on our transactions. And finally in the global commodities group, we have largely transacted commodity location and calendar spreads.
Recently in the global commodities business, we have deviated significantly from these objectives in an effort to minimize the impact of sharp market move on collateral. Specifically, we have sold financial power links to flatten ourselves both economically and in terms of our collateralized position, in order to reduce the volatility of our collateral posting requirements.
Between June 30th and October 31st, we reduced power position 29 million megawatt hours or 35%. Earnings at risk, is used to reflect the risk level of our total portfolio. Earnings at risk is a one day 95% confidence interval measure of change in economic value of our portfolio across all accrual and mark-to-market asset and hedge positions through 2013.
On June 30th, earnings at risk was $202 million, $141 million from our generation fleet and its hedges, and $61 million from the global commodities group.
By September 30th, overall risk had drop 25% despite an increase in the cost of a unit measure of earnings at risk during this period. Through continued outright position reductions, flattening of the economic risk and reduced market volatility, the overall risk level was reduced to $137 million by October 31st. Since June 30th we reduced the overall portfolio risk by $65 million or 32%, primarily by reducing non-generation financial power positions and converting power links into heat rate options by selling gas. This is consistent with our change in business strategy.
In our additional modeling material, we have included an update on average disclosed market value, risk value or risk levels for the overall mark-to-market book and the mark-to-market trading book. Recent portfolio actions have substantially reduced mark-to-market bar levels in October. However, during the third quarter we saw an increase in mark-to-market bar levels as a result of the increase in unit bar and the breakdown in correlations underlying certain locations and calendar spread positions.
This breakdown in correlations has been caused by the turnaround in commodity prices at the end of second quarter, causing dislocations in various commodity, geographic and location spread relationship, as prices for various products declined at different rates.
Turning to page 14; on this page, we take a slightly different view of our portfolio by focusing on positions that require collateral. Converting power, gas and coal positions to a megawatt hour equivalent, we show that we have flattened the position in order to minimize the volatility of our daily price driven collateral posting requirements.
This reduction in volatility has helped us manage our collateral requirements during this period of volatile prices and constrained capital. While our overall margined position has been reduced, we are still long power and are vulnerable to further liquidity needs should power prices continue to fall.
In fact, our collateral posting requirements are more sensitive to price decreases.
Recent collateral stress results indicate that our collateral posting requirements for a commodity price decline requires approximately twice the incremental collateral posting as the same price increase.
Constellation's use of liquidity to collateralize hedge positions can be explained simply as stemming from our desire to remain economically hedged across our generation customer supply and coal businesses in order to lock in margins to reduce earnings variability.
Many of our hedges may be financial contracts on exchanges or with OTC counterparties that require collateral.
Here are some details about how Constellation uses capital to collateralize our economic hedges and trading position.
First, they are business driven collateral asymmetry. For example, our coal portfolio is asymmetrical with respect to collateral and that coal producers do not post collateral on their fixed price contracts, while our hedges require collateral. As a result, we are posting collateral as coal prices rise, and having collateral returned as coal prices fall.
Also customer supply load sales of power and gas are typically not collateralized, while our purchased power hedges are typically collateralized. Generation power length is not collateralized, while forward power sales are typically collateralized.
In addition to these business drive collateral asymmetries, collateral results have also consumed by exchanged positions with cash postings to meet variation margin requirement that maybe hedged with OTC positions collateralized with letters of credit.
Collateral received in the form of letters of credit, provides excellent credit protection, but provides no liquidity benefit, while collateral posted in the format of letters of credit in cash has capital cost.
What begins as a desire to remain economically hedged across our business, results in an aggregate portfolio of collateralized positions that demand significant collateral capital. Between June 30th and October 31st overall collateral requirements have increased $1 billion due to falling collateral prices and then need to meet incremental collateral requirements of our August and September events.
Turning to page 15; here we update you on downgrade collateral numbers. As of October 17th the additional collateral required when downgraded by two notches to a BB plus is $2.2 billion. As you see, the downgrade collateral requirement has declined significantly from June 30th number of $4.6 billion.
This is mainly attributed to four key factors. First, there have been significant price decreases across all commodities since June 30th. Second, the reduction in position size of our overall non-generation portfolio. Third, there's been incremental adequate assurance collateral postings of approximately $260 million between September 15th and September 30th. And finally, line reductions of $480 million in the third quarter.
Based on estimates of an allocation of collateral to businesses consistent with the way we run the business, downgrade collateral could be reduced by over a billion dollars as a result of executing both the sale of the London business and the Houston gas trading operation. This is a critical fact in sizing out future liquidity requirements.
We turn this now over to Jack Thayer, our CFO to provide liquidity balance sheet and our income.
Jonathan (Jack) W. Thayer - Senior Vice President and Chief Financial Officer
Thank you Brenda and good morning everyone. Before diving into the specifics of Constellation's third quarter liquidity and earnings performance, I think it's important to take a step back and provide financial context for what transpired in September.
An essential part of this history is the discussion of key sources and uses of cash and liquidity during the first three quarters of 2008, given the importance of liquidity to our viability.
At the end of 2007, Constellation held approximately $3.8 billion of available cash in lines of credit to support its business operations. Heading into the year, we anticipated significant capital spending related to environmental CapEx, BG initiatives and generation investments. To fund this activity, we plan to book the deployed funds from operations and proceeds from financings and asset sales.
Accordingly, we believe we approached the year from a solid financial foundation. What we did not anticipate were several seismic changes stemming from volatile commodity prices. It increased the contingent capital needs of the business including the significant increase in margin requirements to support merchant participation in exchanges and ISOs, the sizable incremental posting of cash and LC collaterals to maintain economic hedges supporting our merchant business, and incremental collateral posting requirements related to ratings downgrade.
The effects have been compounded by asymmetries in the collateral posting relationship between our assets and contractual hedges in our merchant activities and the adverse impact this relationship has had on our liquidity position. Exacerbating these issues further were several additional issues including, the shift in the orientation of our merchant earnings from the anticipated cash earnings to a greater than expected percentage of non-cash mark-to-market earnings, an unprecedented tightening in the previously liquid credit markets; and the impact of volatile commodities markets on the scale of our incremental downgrade collateral posting exposure.
The net results of all these forces was a net use of $1.5 billion of cash and LC collateral through the third quarter. This is despite raising more than $1.7 billion in lines of credit, a billion dollars of preferred equity from MidAmerican, and $ 1.1 billion of debt.
Importantly the bulk of this outflow is working capital related. And the timing of its return will primarily occur in 2009 and 2010. So with that long history behind us, now let me turn to a more detailed discussion of our third quarter liquidity, cash flow and earnings results.
Turning to slide 17 and the discussion of our Q3 change in liquidity.
As you can see this slide details the third quarter changes in net available liquidity comprised of cash and un-used credit facilities. Starting at the left bar, we began the quarter with net available liquidity of approximately $2.9 billion.
Moving to the right, reductions of portfolio positions amid declining power prices together with calls for adequate assurance and reductions in implied credit lines from counterparties required the posting of an incremental $746 million in cash and LC collateral during the quarter.
Subcomponents of this $746 million include the posting of $860 million of cash collateral and $235 million of variation margin. Definitionally, variation margin is the cash settlement of daily changes in the valuation of certain exchange traded positions. This use of liquidity was offset by a $349 million reduction in posted letters of credit.
In total, the net increase in cash posted per collateral was primarily due to the return of cash posted to us by counterparties earlier in the year as power prices declined. Capital expenditures were another materially use of cash liquidity. We invested $491 million in PP&E, primarily related to BGE environmental spend in our plants and nuclear fuel during the quarter.
Capital expenditures together with all other operating and investing activity, excluding collateral and margin, collectively used $643 million of cash during the quarter. Cash outflows required for operating and investing activities were funded primarily through financing activities which you see labeled on the slide.
In conjunction with our merger agreement, we issued $1 billion in preferred stock to MidAmerican during the quarter. We raised additional cash totaling $1.1 billion in the form of short-term debt through the net issuance of $354 million in commercial paper and later in the quarter the draw down of $750 million from our credit facilities. We drew on our facilities in the wake of turmoil in the financial markets in order to secure funds in advance of commercial paper maturities and other near-term obligations. The issuance of commercial paper and drawdown on facilities increased cash, but decreased available facilities, as our line service back stops for these activities.
The overall impact on our available liquidity was neutral.
Turning to slide 18 for a review of projected liquidity. As you saw on the prior slide, we ended the third quarter with net available liquidity of approximately $2.3 billion. Since then liquidity has declined by an estimated $463 million to $1.9 billion as of October 31st. Primary drivers of this reduction include dividend and interest payments as well as the partial impact of the BG rate settlement.
As you recall, we extended $170 rate credits to our customers in September. And this is impacting cash proceeds and cash flow primarily in October.
Looking forward to the remainder of 2008, we anticipate closing in November on approximately $1.2 billion in credit facilities. We've also agreed to terms on a $350 million alternative financing with MidAmerican which allows us to sell our Safe-Harbor and West Valley generation units to them at a pre-arranged price. We anticipate finalizing this arrangement next week.
Collectively, these two financings more than offset the maturity of approximately $1.4 billion in credit lines which expire at the end of the year.
In addition, our planned strategic divestitures have the potential to raise an incremental $1.7 billion in available liquidity through a combination of net proceeds and the return of underlying collateral. Importantly, these divestitures if successful would also further reduce our downgrade collateral requirements by an estimated $1.1 billion using our October 17th calculations. These collective efforts, which we anticipate will supplement ongoing initiatives we are currently undertaking to de-risk our merchant business, give us a measure of confidence in our current and prospective liquidity position.
Turning to slide 19. Beyond 2008, it's important to note that the majority of our collateral usage is related to hedging our generation fleet; our customers supply activities, and our international coal and freight business. The majority of these activities and related hedges are short dated. Accordingly, as you can see on the slide, we expect to return of this collateral in the near term with the expected role-off of letters of credit and cash collateral posted to support our current portfolio contracts.
Assuming a static book, current price curves no new positions added, market curves realizing as projected today and current positions rolling off as they mature, we anticipate that approximately 39% of our letters of credit and cash collateral currently posted is returning during 2009. Further improvement is anticipated in 2010. This expected collateral role off trend should help facilitate a reduction in the liquidity requirements of our business prospectively.
Now let's turn to a discussion on the balance sheet on slide 20. We exited the third quarter with a debt to total capital ratio of 42% which is a market deterioration compared to the 36% we reported at the end of the second quarter. Total debt increased in the quarter as we expanded our short term borrowings by issuing an additional $354 million of commercial paper and drawing $750 million on our credit facilities. More impactful was the negative impact to equity related to special items and certain unrealized losses on our hedge portfolio. The special items reduced retained earnings while the hedge losses are realized and accumulated other comprehensive income for AOCI.
As you recall, when we experienced gains or losses on our cash flow hedge portfolio, those unrealized value changes are not recognized on the income statement. Rather, they are recorded in AOCI on the balance sheet. With the recent drop in power prices, certain of our cash flow hedges are in a net loss position. This has created a quarter-over-quarter reduction in equity of approximately $1.2 billion.
Finally, offsetting this negative, our equity capitalization was improved by the $1 billion convertible note issued to MidAmerican as the part of the merger agreement. We treat this as equity for management reporting purposes, while GAAP recognition would record it as debt.
Adjusting out the AOCI losses and a small amount of third party collateral posted to us by counterparties, quarter ending adjusted net debt to adjusted total capital improved to 39 %. As you'll recall all of these metrics exclude the impact of the BGE securitization debt.
Turning to the next slide. We'll now turn to the earnings portion of the presentation and quickly discuss our results from a consolidated basis and by business segment.
Turning to slide 22. Third quarter GAAP results were a loss of $1.27 per share after special items adjusted earnings were $0.76 per share.
Let's walk through the major adjustments to GAAP earnings. A variety of special items led to a loss of $2.10 per share. During the third quarter, we recognized $1.76 of impairment charges related to merging goodwill, upstream gas properties and our ownership in Constellation Energy Partners. We also recorded additional charges related to declines in the value of our nuclear decommissioning trust investments and the settlement of fly-ash environmental litigation.
We had an after-tax charge of $0.21 related to merger and strategic alternative costs. Finally, we had a $0.13 write-down of emissions allowance inventory, partially offset by mark-to-market emissions derivative gains related to the vacation of care. We had a $0.07 gain on economic non-qualifying hedges related primarily to gas transportation contracts.
Looking at our segment performance in the third quarter, compared to last year, the merchant was down $0.72 and the utility was up $0.2. Overall, adjusted earnings were down $0.69 per share.
Turning to slide 23. BGE turned in a solid third quarter performance. Compared to the prior year, BGE was up $0.02 on an adjusted basis due to benefits from the Maryland settlement which were partially offset by higher bad debt expense and interest expense.
Turning to slide 24 and discussion of the merchant results. Compared to the third quarter of last year, merchant adjusted earnings were down $0.72 per share. Year-over-year variances were primarily due to the following. Generation was a favorable $0.39, primarily due to improved energy and capacity pricing Global commodities was an unfavorable $1.08 per share, driven by lower new business results in portfolio management and trading. Customer supply was an unfavorable $0.07 per share, primarily driven by unfavorable mark-to-market results in retail gas and lower rates and volumes of retail power. A strong performance at wholesale power driven by favorable variable load risk, to partially offset this negative.
Other merchant items were up $0.04 per share, versus the same period last year. Primarily due to lower cost, partially offset by higher interest expense. Drilling further into this segment, I'll cover the drivers to customers supply and global commodities.
Let's start with global commodities on slide 25. As you can see on the column on the left, total contribution margin from the global commodities business during the quarter was a negative $148 million, including backlog of $99 million and new business of negative $247 million. Backlog realization in third quarter was up $49 million, versus the same period last year.
New business in the third quarter was $477 million lower than last year's very strong third quarter, driven primarily by a decrease in portfolio management and trading of $472 million. Of the negative $247 million new business realized in the third quarter, we expected $200 million to $250 million going into the quarter. As we described in the second quarter earnings call, the coal sales we executed in the first quarter produced our Q3 backlog.
The Texas market dynamics from earlier this year served to increase our cost to serve load.
And our hedging approach to our load in generation portfolios combined with market price shifts and PGM, led us to project the negative result. In addition, offsetting this expected negative during the third quarter, we originated $100 million of new business which we realized during the quarter and our portfolio management results for $100 million positive excluding the items previously mentioned. Offsetting these increases were trading losses of $210 million, primarily due to power positions.
Approximately, one-third of this was due to our activities to reduce risk.
Please turn it to slide 26. As you can see in the chart at top the slide, during the quarter customer supply realized gross margin of $119 million. This was inline with our third quarter expectations. Year-over-year on a comparable basis, gross margin is down $82 million or 50%. The difference is primarily driven by retail gas mark-to-market results. The retail power retention rate including the customers that remain on a month-to-months basis increased to 88%, which is inline with last year's rate of 89%.
During the quarter, customers that had previously been on month-to-month contracts began locking in fixed rates due to favorable market prices.
In the third quarter, as price margins were $3.46 per megawatt hour, up from the third quarter of 2007. This was primarily driven by our sales force incorporating higher cost of capital into their pricing.
Retail gas retention rates remain strong at 94% and realized margins improved by $0.10 over last year, in part due to our acquisition of Cornerstone Energy.
Turning to slide 27, as you see, this chart provides an update on how changes in market forward prices and hedging activity affect generation EBITDA. For 2008, we're forecasting un-hedged EBITDA of $2.4 billion. Netting the hedging impacts of approximately $1.3 billion, our hedged EBITDA is forecasted to be about $1 billion.
Over the last quarter, the power curve and forecasted coal prices have fallen. We currently forecast hedged EBITDA of $1.5 billion in 2011; this is $600 million lower than what we shared with you in July.
Turning to slide 28 and our Q4 outlook. Let me wrap up with a brief review of our fourth quarter outlook. Consistent with the approach we introduced in January, for the fourth quarter of 2008, we are providing a few key operating and financial metrics to help you understand our expectations.
First, we are providing a BGE earnings range of $0.20 to $0.24 per share. This compares to fourth quarter of 2007 earnings of $0.17 per share. The year-over-year variance is primarily driven by the impact of the Maryland settlement and lower costs.
For generation, we are providing a hedged EBITDA forecast of $244 million. This is a $53 million improvement relative to EBITDA of $191 million earned in the fourth quarter of 2007. This is driven mainly by the continued roll off of low market hedges and higher capacity prices.
Our customer supply backlog is expected to be $210 million in the fourth quarter of 2008. Because we did not measure 2007 backlog in a manner comparable to today, we're not providing a comparable metric for the fourth quarter of last year.