Orange and Rockland Utilities, Inc Annual Financial Statements and Notes

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1 Orange and Rockland Utilities, Inc Annual Financial Statements and Notes Financial Statements Report of Independent Registered Public Accounting Firm Consolidated Balance Sheet Consolidated Income Statement Consolidated Statement of Comprehensive Income Consolidated Statement of Common Shareholder s Equity Consolidated Statement of Cash Flows Consolidated Statement of Capitalization Notes to Financial Statements

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3 Orange and Rockland Utilities, Inc. CONSOLIDATED BALANCE SHEET December 31, 2005 December 31, 2004 (Millions of Dollars) ASSETS UTILITY PLANT, AT ORIGINAL COST (Note A) Electric $ 846 $ 812 Gas General Total 1,330 1,269 Less: Accumulated depreciation Net Construction work in progress NET PLANT CURRENT ASSETS Cash and temporary cash investments (Note A) 9 12 Restricted cash 2 2 Accounts receivable - customers, less allowance for uncollectible accounts of $2 in 2005 and Accrued unbilled revenue (Note A) Other receivables, less allowance for uncollectible accounts of $2 in 2005 and Accounts receivable from affiliated companies Gas in storage, at average cost Materials and supplies, at average cost 6 5 Prepayments Fair value of derivative assets 50 5 Recoverable energy costs (Notes A and B) Other current assets TOTAL CURRENT ASSETS DEFERRED CHARGES, REGULATORY ASSETS AND NONCURRENT ASSETS Regulatory assets (Note B) Other deferred charges and noncurrent assets TOTAL DEFERRED CHARGES, REGULATORY ASSETS AND NONCURRENT ASSETS TOTAL ASSETS $ 1,588 $ 1,390 The accompanying notes are an integral part of these financial statements.

4 Orange and Rockland Utilities, Inc. CONSOLIDATED BALANCE SHEET December 31, 2005 December 31, 2004 (Millions of Dollars) CAPITALIZATION AND LIABILITIES CAPITALIZATION Common shareholder's equity (See Statement of Common Shareholder's Equity) $ 369 $ 388 Long-term debt (See Statement of Capitalization) TOTAL CAPITALIZATION NONCURRENT LIABILITIES Provision for injuries and damages (Note G) 6 6 Pensions and retiree benefits Superfund and other environmental costs (Note G) Hedges on variable rate long-term debt (Note N) Other noncurrent liabilities - 3 TOTAL NONCURRENT LIABILITIES CURRENT LIABILITIES Long-term debt due within one year 2 2 Notes payable Accounts payable Accounts payable to affiliated companies Customer deposits Accrued taxes 4 2 Accrued interest 6 6 Deferred derivative gains (Note B) Deferred income taxes - recoverable energy costs (Note K) 12 7 Other current liabilities TOTAL CURRENT LIABILITIES DEFERRED CREDITS AND REGULATORY LIABILITIES Deferred income taxes and investment tax credits (Notes A and K) Regulatory liabilities (Note B) Other deferred credits 10 8 TOTAL DEFERRED CREDITS AND REGULATORY LIABILITIES TOTAL CAPITALIZATION AND LIABILITIES $ 1,588 $ 1,390 The accompanying notes are an integral part of these financial statements.

5 Orange and Rockland Utilities, Inc. CONSOLIDATED INCOME STATEMENT For the Years Ended December 31, (Millions of Dollars) OPERATING REVENUES (Note A) Electric $ 596 $ 499 $ 530 Gas TOTAL OPERATING REVENUES OPERATING EXPENSES Purchased power Gas purchased for resale Other operations and maintenance Depreciation and amortization (Note A) Taxes, other than income taxes Income taxes (Notes A and K) TOTAL OPERATING EXPENSES OPERATING INCOME OTHER INCOME (DEDUCTIONS) Investment and other income (Note A) Other deductions (1) - (2) TOTAL OTHER INCOME (DEDUCTIONS) 1 1 (2) INTEREST EXPENSE Interest on long-term debt Other interest NET INTEREST EXPENSE NET INCOME $ 50 $ 46 $ 45 The accompanying notes are an integral part of these financial statements.

6 Orange and Rockland Utilities, Inc. CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME For the Years Ended December 31, (Millions of Dollars) NET INCOME $ 50 $ 46 $ 45 OTHER COMPREHENSIVE INCOME/(LOSS), NET OF TAXES Investment in marketable securities, net of $1 taxes in Less: Reclassification adjustment for losses included in net income, net of $(1) taxes in (2) Supplemental pension plan minimum liability adjustments, net of $(1) and $0 taxes in 2005 and 2004, respectively (1) (1) - Unrealized gains on derivatives qualified as cash flow hedges, net of $3, $2 and $2, taxes in 2005, 2004 and 2003, respectively Less: Reclassification adjustment for gains included in net income, net of $1 taxes in 2005, 2004 and TOTAL OTHER COMPREHENSIVE INCOME, NET OF TAXES 2-5 COMPREHENSIVE INCOME $ 52 $ 46 $ 50 The accompanying notes are an integral part of these financial statements.

7 Orange and Rockland Utilities, Inc. CONSOLIDATED STATEMENT OF COMMON SHAREHOLDER'S EQUITY Accumulated Other Common Stock Additional Retained Comprehensive (Millions of Dollars/Except Share Data) Shares Amount Paid-In Capital Earnings Income/(Loss) Total BALANCE AS OF DECEMBER 31, ,000 $- $ 194 $ 169 $(15) $ 348 Net Income Common stock dividend to parent (28) (28) Other comprehensive income 5 5 BALANCE AS OF DECEMBER 31, ,000 $- $ 194 $ 186 (10) $ 370 Net Income Common stock dividend to parent (28) (28) BALANCE AS OF DECEMBER 31, ,000 $- $ 194 $ 204 $(10) $ 388 Net Income Common stock dividend to parent (71) (71) Other comprehensive income 2 2 BALANCE AS OF DECEMBER 31, ,000 $- $ 194 $ 183 $(8) $ 369 The accompanying notes are an integral part of these financial statements.

8 Orange and Rockland Utilities, Inc. CONSOLIDATED STATEMENT OF CASH FLOWS For the Twelve Months Ended December 31, (Millions of Dollars) OPERATING ACTIVITIES Net income $ 50 $ 46 $ 45 PRINCIPAL NON-CASH CHARGES/(CREDITS) TO INCOME Depreciation and amortization Deferred income taxes Gain on non-utility property - - (1) Other non-cash items (net) - (2) (16) CHANGES IN ASSETS AND LIABILITIES Accounts receivable - customers, less allowance for uncollectibles (30) 11 (3) Accounts receivable from affiliated companies (7) (12) 1 Materials and supplies, including gas in storage (20) (13) (13) Prepayments, other receivables and other current assets (15) (11) (6) Recoverable energy costs - 5 (11) Accounts payable 15 (5) 11 Accounts payable to affiliated companies (7) Pensions and retiree benefits Accrued taxes 2 (2) 3 Accrued interest - - (2) Deferred charges and other regulatory assets (5) (24) 19 Deferred credits and regulatory liabilities 2 17 (3) Superfund and other environmental costs (5) 18 4 Other assets (1) (1) 3 Other liabilities (1) 4 1 NET CASH FLOWS FROM OPERATING ACTIVITIES INVESTING ACTIVITIES Utility construction expenditures (87) (79) (71) Cost of removal less salvage (3) (2) (2) Proceeds from sale of land NET CASH FLOWS USED IN INVESTING ACTIVITIES (90) (81) (71) FINANCING ACTIVITIES Net proceeds from/(retirement of) short-term debt 101 (15) 14 Issuance of long-term debt Retirement of long-term debt (2) - (35) Dividend to parent (71) (28) (28) NET CASH FLOWS FROM/(USED) IN FINANCING ACTIVITIES 68 3 (49) CASH AND TEMPORARY CASH INVESTMENTS: NET CHANGE FOR THE PERIOD (3) 3 7 BALANCE AT BEGINNING OF PERIOD BALANCE AT END OF PERIOD $ 9 $ 12 $ 9 SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION Cash paid during the period for: Interest $ 24 $ 18 $ 21 Income Taxes/(Refund) $ 30 $ 29 $ (17) The accompanying notes are an integral part of these financial statements.

9 Orange and Rockland Utilities, Inc. Consolidated Statement of Capitalization Shares outstanding December 31, December 31, At December 31, (Millions of Dollars) TOTAL COMMON SHAREHOLDER'S EQUITY LESS ACCUMULATED OTHER COMPREHENSIVE INCOME/(LOSS) 1,000 1,000 $ 377 $ 398 ACCUMULATED OTHER COMPREHENSIVE INCOME/(LOSS) Minimum pension liability adjustment, net of $(1) taxes in 2005 (1) - Unrealized losses on derivatives qualified as cash flow hedges net of $(3) and $(6) taxes in 2005 and 2004, respectively (5) (9) Less: Reclassification adjustment for gains included in net income net of $1 taxes in 2005 and TOTAL ACCUMULATED OTHER COMPREHENSIVE INCOME/ (LOSS), NET OF TAXES (8) (10) TOTAL COMMON SHAREHOLDER'S EQUITY (SEE STATEMENT OF COMMON SHAREHOLDER'S EQUITY AND NOTE C) LONG-TERM DEBENTURES (NOTE C) Interest Maturity Rate Series DEBENTURES: % 2000A A F G TOTAL DEBENTURES FIRST MORTGAGE BONDS: % 1997J C 3 3 TOTAL FIRST MORTGAGE BONDS TRANSITION BONDS: % TOTAL TRANSITION BONDS TAX-EXEMPT DEBT - Notes Issued to New York State Energy Research and Development Authority for Facilities Revenue Bonds*: 2014 (Note N) 3.45% 1994A** A** TOTAL TAX-EXEMPT BONDS Unamortized debt discount (1) (1) TOTAL Less: long-term debt due within one year 2 2 TOTAL LONG-TERM DEBT TOTAL CAPITALIZATION $ 753 $ 733 * Rate reset weekly or by auction held every 35 days; December 31, 2005 rate shown. ** Issued for pollution control financing. The accompanying notes are an integral part of these financial statements.

10 Notes to the Financial Statements General These notes accompany and form an integral part of the financial statements of Orange and Rockland Utilities, Inc., a New York corporation (O&R) and its subsidiaries (the Company). O&R is a regulated utility, which is wholly owned by Consolidated Edison, Inc. (Con Edison). O&R has two regulated utility subsidiaries: Rockland Electric Company (RECO) and Pike County Light and Power Company (Pike). O&R, along with its regulated utility subsidiaries, provides electric service in southeastern New York and adjacent areas of northern New Jersey and eastern Pennsylvania and gas service in southeastern New York and adjacent areas of eastern Pennsylvania. RECO owns Rockland Electric Company Transition Funding LLC (Transition Funding), which was formed in 2004 in connection with the securitization of certain purchased power costs. O&R is subject to regulation by the New York State Public Service Commission (PSC); RECO is subject to regulation by the New Jersey Board of Public Utilities (NJBPU) and Pike is subject to regulation by the Pennsylvania Public Utility Commission (PPUC). The Company is also subject to regulation by the Federal Energy Regulatory Commission (FERC). Note A Summary of Significant Accounting Policies Principles of Consolidation The Company s consolidated financial statements include the accounts of its subsidiaries, including Transition Funding. All intercompany balances and transactions have been eliminated. Accounting Policies The accounting policies of the Company conform to accounting principles generally accepted in the United States of America. These accounting principles include the Financial Accounting Standards Board s (FASB) Statement of Financial Accounting Standards (SFAS) No. 71 (SFAS No. 71), Accounting for the Effects of Certain Types of Regulation, and, in accordance with SFAS No. 71, the accounting requirements of the FERC and the state public utility regulatory commissions having jurisdiction. SFAS No. 71 specifies the economic effects that result from the causal relationship of costs and revenues in the rate-regulated environment and how these effects are to be accounted for by a regulated enterprise. Revenues intended to cover some costs may be recorded either before or after the costs are incurred. If regulation provides assurance that incurred costs will be recovered in the future, these costs would be recorded as deferred charges or regulatory assets under SFAS No. 71. If revenues are recorded for costs that are expected to be incurred in the future, these revenues would be recorded as deferred credits or regulatory liabilities under SFAS No. 71. The Company s principal regulatory assets and liabilities are detailed in Note B. The Company is receiving or being credited with a return on all of their regulatory assets for which a cash outflow has been made, and are 1

11 paying or being charged with a return on all of their regulatory liabilities for which a cash inflow has been received. The Company s regulatory assets and liabilities will be recovered from customers, or applied for customer benefit, in accordance with rate provisions approved by the applicable public utility regulatory commission. Other significant accounting policies of the Company are referenced below in this Note A and in the notes that follow. Plant and Depreciation Utility Plant Utility plant is stated at original cost. The cost of repairs and maintenance is charged to expense and the cost of betterments is capitalized. The capitalized cost of additions to utility plant includes indirect costs such as engineering, supervision, payroll taxes, pensions, other benefits and an allowance for funds used during construction (AFDC). The original cost of property is charged to expense over the estimated useful lives of the assets. Upon retirement, the original cost of property is charged to accumulated depreciation. See Note O. Rates used for AFDC include the cost of borrowed funds and a reasonable rate of return on the Company s own funds when so used, determined in accordance with regulations of the FERC or the state public utility regulatory authority having jurisdiction. The rate is compounded semiannually, and the amounts applicable to borrowed funds are treated as a reduction of interest charges, while the amounts applicable to the Company s own funds are credited to other income (deductions). The AFDC rates for the Company were 3.9 percent, 3.6 percent and 1.1 percent for 2005, 2004 and The Company generally computes annual charges for depreciation using the straight-line method for financial statement purposes, with rates based on average service lives and net salvage factors. The average depreciation rates for the Company were 2.9 percent for 2005 and 2004 and 3.1 percent for 2003, respectively. The estimated lives for utility plant for the Company range from 5 to 65 years for electric, 7 to 75 years for gas and 5 to 55 years for general plant. At December 31, 2005 and 2004, the capitalized cost of the Company s utility plant, net of accumulated depreciation, was as follows: (Millions of Dollars) Electric Transmission $92 $99 Distribution Gas* General Held for future use 1 1 Construction work in progress NET UTILITY PLANT $967 $913 * Primarily distribution. 2

12 Impairments In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, the Company evaluates the impairment of long-lived assets, based on projections of undiscounted future cash flows, whenever events or changes in circumstances indicate that the carrying amounts of such assets may not be recoverable. In the event an evaluation indicates that such cash flows cannot be expected to be sufficient to fully recover the assets, the assets would be written down to their estimated fair value. Revenues The Company recognizes revenues for electric and gas service on a monthly billing cycle basis. The Company generally defers over a 12-month period net interruptible gas revenues, other than those authorized by the PSC to be retained by the Company, for refund to firm gas sales and transportation customers. The Company accrues revenues at the end of each month for estimated energy service not yet billed to customers. Unbilled revenues included in O&R s balance sheet at December 31, 2005 and 2004 were $29 million and $28 million, respectively. O&R and Pike are required to record gross receipts tax and RECO is required to record transitional energy facilities assessment (TEFA) tax, as revenues and expenses on a gross income statement presentation basis (i.e., included in both revenue and expense). The recovery of these taxes is included in the revenue requirement within each of the respective approved rate plans. Recoverable Energy Costs O&R generally recovers all of its prudently incurred fuel, purchased power and gas costs, including hedging gains and losses, in accordance with rate provisions approved by the applicable state public utility commissions. If the actual energy supply costs for a given month are more or less than the amounts billed to customers for that month, the difference in most cases is recoverable from or refundable to customers. For each billing cycle, O&R bills its energy costs to customers based upon its estimate of the cost to supply energy for that billing cycle. Differences between actual and billed electric supply costs are generally deferred for charge or refund to customers during the next billing cycle (normally within one or two months). For O&R s gas costs, differences between actual and billed gas costs during the 12-month period ending each August are charged or refunded to customers during a subsequent 12-month period. RECO purchases electric energy under a competitive bidding process supervised by the NJBPU for contracts ranging from one to three years. Basic Generation Service rates are adjusted to conform to contracted prices when new contracts take effect and differences between actual monthly costs and revenues are reconciled and charged or credited to customers on a two-month lag. See Note B for a description of the 2003 NJBPU ruling regarding previously deferred purchased power costs. 3

13 Pike bills its customers for the electricity it supplies to them based on a default service rate approved by the PPUC. Pike neither collects nor refunds to customers differences between actual amounts billed for electric supply and electric supply costs it incurs. In January 2006, based upon the results of an auction overseen by the PPUC in which an affiliate of Con Edison was the winning bidder, an increase in default service rate of approximately 70 percent was approved by the PPUC. In February 2006, the PPUC initiated a fact-finding investigation in the competitive electric market in Pike s service territory, which investigation is ongoing. Independent System Operators O&R purchases electricity for all its New York and Pennsylvania requirements and a portion of its New Jersey needs through the wholesale electricity market administered by the New York Independent System Operator (NYISO). The difference between purchased power and related costs initially billed to the Company by the NYISO and the actual cost of power subsequently calculated by the NYISO is refunded by the NYISO to the Company, or paid to the NYISO by the Company. Certain other payments to or receipts from the NYISO are also subject to reconciliation, with shortfalls or amounts in excess of specified rate allowances recoverable from or refundable to customers. For RECO, approximately 90 percent of the demand is covered by fixed price contracts ranging from one to three years that are competitively bid through the NJBPU auction process and provided through the Pennsylvania- Jersey-Maryland (PJM) Independent System Operator. Temporary Cash Investments Temporary cash investments are short-term, highly-liquid investments that generally have maturities of three months or less at the date of purchase. They are stated at cost, which approximates market. The Company considers temporary cash investments to be cash equivalents. Federal Income Tax In accordance with SFAS No. 109, Accounting for Income Taxes, the Company has recorded an accumulated deferred federal income tax liability for temporary differences between the book and tax bases of assets and liabilities at current tax rates. In accordance with rate agreements, O&R has recovered amounts from customers for a portion of the tax liability they will pay in the future as a result of the reversal or turn-around of these temporary differences. As to the remaining tax liability, in accordance with SFAS No. 71, the Company has established regulatory assets for the net revenue requirements to be recovered from customers for the related future tax expense. See Notes B and K. In 1993, the PSC issued a Policy Statement approving accounting procedures consistent with SFAS No. 109 and providing assurances that these future increases in taxes will be recoverable in rates. Accumulated deferred investment tax credits are amortized ratably over the lives of the related properties and applied as a reduction to future federal income tax expense. 4

14 The Company, along with Con Edison and its other subsidiaries, files a consolidated federal income tax return. The consolidated income tax liability is allocated to each member of the consolidated group using the separate return method. Each member pays or receives an amount based on its own taxable income or loss in accordance with tax sharing agreements between the members of the consolidated group. State Income Tax The New York State tax laws applicable to utility companies were changed effective January Certain revenue-based taxes were repealed or reduced and replaced by a net income-based tax. In June 2001, the PSC authorized each utility to use deferral accounting to record the difference between taxes being collected and the actual tax expense under the new tax law until that expense is incorporated in base rates. For O&R, state income tax is being recovered through base rates for its electric and gas businesses effective November The Company, along with Con Edison and its other subsidiaries, files a combined New York State Corporation Business Franchise Tax Return. Similar to a federal consolidated income tax return, the income of all entities in the combined group is subject to New York State taxation, after adjustments for differences between federal and New York law and apportionment of income among the states in which the Company does business. Each member of the group pays or receives an amount based on its own New York State taxable income or loss. Reclassification Certain prior year amounts have been reclassified to conform with the current year presentation. Stock-Based Compensation The Company accounts for its stock-based compensation plans using the intrinsic value model of Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and its related interpretations. All options and units granted under these plans had an exercise price equal to the market value of the underlying common stock on the date of grant. No compensation expense has been reflected in the income statement for any period presented except as described in Note L. The effect on earnings if the Company had applied the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation (SFAS No. 123), as amended by SFAS No. 148, Accounting for Stock-Based Compensation Transition and Disclosure An Amendment of FASB Statement No. 123, would have been immaterial. Certain of the Company s stock-based compensation plans allow employees to continue vesting in an award in accordance with the stated vesting terms even though the employee has retired from the Company. The Company has historically recognized compensation cost over the employee s nominal vesting period with any remaining compensation cost recognized at the date of retirement (the nominal vesting period approach). The Company s compensation expense would not have materially increased had it immediately recognized compensation cost for awards granted to retirement eligible employees or over the period from the grant date to the date of retirement eligibility (non-substantive vesting period approach). 5

15 The Company plans to adopt the non-substantive vesting period approach in connection with its implementation of SFAS 123(R), Share-Based Payment. See Note L. Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Note B Regulatory Matters Rate and Restructuring Agreements Electric In 1997, the PSC approved a four-year O&R restructuring plan pursuant to which O&R sold all of its generating assets and made retail access available to all of its electric customers. Similar retail access plans were approved for RECO and Pike by the NJBPU and PPUC, respectively. In October 2003, the PSC approved agreements among O&R, the staff of the PSC and other parties with respect to the rates O&R can charge to its New York customers for electric service. The electric agreement, which covers the period from July 2003 through October 2006, provides for no changes to electric base rates and contains provisions for the amortization and offset of regulatory assets and liabilities, the net effect of which is reducing electric operating income by a total of $11 million (pre tax) over the period covered by the agreement. The agreement continues to provide for recovery of energy costs from customers on a current basis. It also provides for O&R to share equally with customers earnings above a percent return on common equity during the three-year period from July 2003 through June Beginning July 2006, O&R will not be subject to earnings sharing. In July 2003, the NJBPU ruled on the petitions of RECO for an increase in electric rates and recovery of deferred purchased power costs. The NJBPU ordered a $7 million decrease in RECO's electric base rates, effective August 2003, authorized RECO's recovery of approximately $83 million of previously deferred purchased power costs and associated interest and disallowed recovery of approximately $19 million of such costs and associated interest. At December 31, 2002, the Company had accrued a reserve for $13 million of the disallowance, and at June 30, 2003 reserved an additional $6 million for the disallowance. In July 2004, the NJBPU approved RECO s Phase II petition to increase base rates annually by $2.7 million (2.0 percent), effective August 1, The Phase II decision provides for the recovery of carrying costs for two substation projects and specified additional reliability programs. Also in July 2004, Transition Funding issued $46 million of 5.22% Transition Bonds and used the proceeds thereof to purchase from RECO the right to be paid a 6

16 Transition Bond Charge (TBC) and associated tax charges by its customers relating to the balance of previously deferred purchased power costs, discussed above. The TBC replaced a Transition Recovery Charge, a temporary surcharge that was effective August 1, Pike is obligated under Pennsylvania law to serve those customers who do not purchase electricity from other suppliers. See Recoverable Energy Costs in Note A. Gas In October 2003, the PSC approved a new gas rate agreement among O&R, the PSC staff and other parties. This agreement, which covers the period November 2003 through October 2006, provides for increases in gas base rates of $9 million (5.8 percent) effective November 2003, $9 million (4.8 percent) effective November 2004 and $5 million (2.5 percent) effective November The agreement provides for O&R to share equally with customers earnings in excess of an 11 percent return on common equity. It continues to provide for recovery of energy costs from customers on a current basis and continues a weather normalization clause that moderates, but does not eliminate, the effect of weather-related changes on net income. The rate increases also include the amortization of certain regulatory assets and liabilities. The net effect of this amortization will be to increase gas revenues by $2 million over the period of the three-year rate plan. In November 2005, O&R filed a request with the PSC for an increase in the rates it charges for gas service, effective November 1, 2006, of $24 million (4.7 percent). The filing reflects a return on common equity of 11 percent and a common equity ratio of 48.9 percent of capitalization. The filing includes a proposal for a threeyear plan, with additional increases effective November 1, 2007 and 2008 of $2.1 million and $1.8 million, respectively. The filing proposes continuation of the current gas rate plan provisions with respect to the reconciliation of actual expenses allocable to gas operations to the amounts reflected in rates for pension and other postemployment benefit costs, property taxes, environmental remediation and research and development costs. In May 2005, the PPUC approved an increase to the rates Pike charges for gas service by $0.1 million (8.7 percent), effective June 1,

17 Regulatory Assets and Liabilities Regulatory assets and liabilities at December 31, 2005 and 2004 were comprised of the following items: (Millions of Dollars) Regulatory assets Transition bond charges $70 $74 Environmental remediation costs Future federal income tax Pension and other postretirement benefits deferrals Asbestos-related costs - 1 Other Regulatory Assets Recoverable energy costs - current Total Regulatory Assets $273 $253 Regulatory liabilities Allowance for cost of removal less salvage $57 $57 Refundable energy costs Hedging unrealized gains 16 2 NYS tax law changes Other Regulatory Liabilities Deferred derivative gains - current Total Regulatory Liabilities $192 $127 Note C Capitalization Common Stock At December 31, 2005 and 2004, all of the outstanding common stock of the Company was owned by Con Edison. In accordance with PSC requirements, the dividends that the Company generally may pay to Con Edison are limited to not more than 100 percent of its income available for dividends calculated on a two-year rolling average basis. Excluded from the calculation of income available for dividends are non-cash charges to income resulting from accounting changes or charges to income resulting from significant unanticipated events. The restriction also does not apply to dividends paid in order to transfer to Con Edison proceeds from major transactions, such as asset sales, or to dividends reducing the Company s equity ratio to a level appropriate to its business risk. Long-term Debt Long-term debt maturing in the period is as follows: (Millions of Dollars) 2006 $ O&R has issued certain series of tax-exempt debt through the New York State Energy Research and Development Authority (NYSERDA) that currently bear interest at a rate determined weekly and, in certain circumstances, is subject to mandatory tender for purchase by the Company. This tax-exempt debt includes 8

18 O&R s $55 million aggregate principal amount of Series 1994A and $44 million aggregate principal amount of Series 1995A. Long-term debt is stated at cost, which in total, as of December 31, 2005, approximates fair value (estimated based on current rates for debt of the same remaining maturities). At December 31, 2005 and 2004, long-term debt of the Company included $23 million of mortgage bonds collateralized by substantially all utility plant and other physical property of RECO and Pike. It also included $45 million and $46 million at December 31, 2005 and 2004, respectively, of Transition Bonds issued by Transition Funding. See Note B. Significant Debt Covenants There are no significant debt covenants under the financing arrangements for the debentures of O&R, other than obligations to pay principal and interest when due and covenants not to consolidate with or merge into any other corporation unless certain conditions are met, and no cross default provisions. The tax-exempt financing arrangements of the Company are subject to these covenants and the covenants discussed below. The Company believes that they were in compliance with their significant debt covenants at December 31, The tax-exempt financing arrangements involved the issuance of uncollateralized promissory notes of the Company to NYSERDA in exchange for the net proceeds of a like amount of tax-exempt bonds with substantially the same terms sold to the public by NYSERDA. The tax-exempt financing arrangements include covenants with respect to the tax-exempt status of the financing and the maintenance of liquidity and credit facilities, the failure to comply with which would, except as otherwise provided, constitute an event of default with respect to the debt to which such provisions applied. If an event of default were to occur, the principal and accrued interest on the debt to which such event of default applied might and, in certain circumstances would, become due and payable immediately. The liquidity and credit facilities currently in effect for the tax-exempt financing include covenants that the ratio of debt to total capital of the obligated utility will not at any time exceed 0.65 to 1 and that, subject to certain exceptions, the utility will not mortgage, lien, pledge or otherwise encumber its assets. Certain of the facilities also include as events of default, defaults in payments of other debt obligations in excess of $12.5 million. Note D Short Term Borrowing and Credit Agreements In April 2005, O&R along with Con Edison and its other regulated utility subsidiary, Consolidated Edison of New York, Inc. (Con Edison of New York), entered into a five-year revolving credit agreement, under which banks committed to provide loans and letters of credit in an aggregate amount of up to $937.5 million, and terminated a three-year credit agreement that was to expire in November Bank commitments under the new revolving credit agreement and a similar existing three-year credit agreement that expires in November 2006 total $1.5 9

19 billion, with $150 million available to O&R. O&R is solely responsible for its obligations under the credit agreements and no company is responsible for the obligations of any company other than itself. O&R uses the credit agreements to support its commercial paper program and obtain letters of credit. At December 31, 2005, O&R had $101 million of commercial paper outstanding at a weighted average interest rate of 4.36 percent. At December 31, 2005, $6 million of letters of credit were outstanding under the agreements. O&R had no outstanding commercial paper at December 31, The banks commitments under the credit agreements are subject to certain conditions, including that there be no event of default. The commitments are not subject to maintenance of credit rating levels or the absence of a material adverse change. Upon a change of control of, or upon an event of default by any of Con Edison s subsidiaries, the banks may terminate their commitments with respect to that company and declare any amounts owed by that company under the credit agreements immediately due and payable. Events of default include the exceeding at any time of a ratio of consolidated debt to consolidated total capital of 0.65 to 1 (at December 31, 2005, this ratio was 0.57 to 1 for O&R); having liens on its assets in an aggregate amount exceeding 5 percent of its consolidated total capital, subject to certain exceptions; and the failure by O&R, following any applicable notice period, to meet certain other customary covenants. The fees charged to O&R for the revolving credit facilities and any loans made or letters of credit issued under the credit agreements reflect O&R s respective credit ratings. See Note P for information about short-term borrowing between related parties. Note E Pension Benefits Substantially all employees of O&R are covered by a tax-qualified, non-contributory pension plan maintained by Con Edison, which also covers substantially all employees of Con Edison of New York and O&R and certain employees of Con Edison s competitive businesses. The plan is designed to comply with the Internal Revenue Code and the Employee Retirement Income Security Act of In addition, Con Edison maintains additional non-qualified pension plans covering certain current and retired O&R officers. Investment gains and losses are fully recognized in expense over a 15-year period. Other actuarial gains and losses are fully recognized in expense over a 10-year period. This amortization is in accordance with the Statement of Policy issued by the PSC and is permitted under SFAS No. 87, Employers Accounting for Pensions, which provides a corridor method for moderating the effect of investment gains and losses on pension expense, or alternatively, allows for any systematic method of amortization of unrecognized gains and losses that is faster than the corridor method and is applied consistently to both gains and losses. In accordance with O&R s current electric and gas rate plans, the Company defers any difference between expenses recognized under SFAS No. 87 for the Company s New York business and the amount reflected in O&R s rates for such expenses. The rate plans for RECO and Pike do not have comparable deferral provisions. A measurement date of December 31 is used for the pension plan. 10

20 Net Periodic Benefit Cost The components of the Company s net periodic benefit costs for 2005, 2004 and 2003 were as follows: (Millions of Dollars) Service cost including administrative expenses $9 $8 $7 Interest cost on projected benefit obligation Expected return on plan assets (24) (23) (23) Amortization of net actuarial loss Amortization of prior service costs NET PERIODIC BENEFIT COST $31 $24 $21 Cost capitalized (7) (6) (5) Cost deferred (11) (1) (9) Cost charged to operating expenses $13 $17 $7 Funded Status The funded status of the Company s pension obligations at December 31, 2005, 2004 and 2003 was as follows: (Millions of Dollars) CHANGE IN PROJECTED BENEFIT OBLIGATION Projected benefit obligation at beginning of year $471 $425 $404 Service cost excluding administrative expenses Interest cost on projected benefit obligation Plan amendments Net actuarial loss Benefits paid (25) (24) (24) PROJECTED BENEFIT OBLIGATION AT END OF YEAR $521 $471 $425 CHANGE IN PLAN ASSETS Fair value of plan assets at beginning of year $267 $236 $197 Actual return on plan assets Employer contributions Benefits paid (25) (24) (23) Administrative expenses (1) (1) (1) FAIR VALUE OF PLAN ASSETS AT END OF YEAR $294 $267 $236 Funded status $(227) $(204) $(189) Unrecognized net loss Unrecognized prior service costs NET ACCRUED BENEFIT COST $(58) $(58) $(58) ACCUMULATED BENEFIT OBLIGATION $498 $452 $407 The amounts recognized in the Company s consolidated balance sheet at December 31, 2005 and 2004 were as follows: (Millions of Dollars) Accrued benefit cost $(58) $(58) Additional minimum pension liability (3) (1) Accumulated other comprehensive income 3 1 Net accrued benefit cost $(58) $(58) At December 31, 2005 and 2004, the Company s other current assets include $11 million, held in an external trust account for benefit payments pursuant to the supplemental retirement plans. The accumulated benefit obligations for the supplemental retirement plans for O&R were $33 million and $32 million as of December 31, 2005 and 2004, respectively. 11

21 Assumptions The actuarial assumptions were as follows: Weighted-average assumptions used to determine benefit obligations at December 31: Discount rate 5.70 % 5.90% 6.30% Rate of compensation increase 4.00 % 4.00% 4.00% Weighted-average assumptions used to determine net periodic benefit cost for the years ended December 31: Discount rate 5.90 % 6.30% 6.75% Expected return on plan assets 8.80 % 8.80% 8.80% Rate of compensation increase 4.00 % 4.00% 4.15% The expected return assumption reflects anticipated returns on the plan's current and future assets. The Company uses historical investment data as well as the plan's target asset class and investment management mix to determine the expected return on plan assets. This analysis incorporates such factors as real return, inflation, and expected investment manager performance for each broad asset class applicable to the plan. Historical plan performance and peer data are also reviewed to check for reasonability and appropriateness. Discount Rate Assumption To determine the assumed discount rate, the Company uses a model that produces a yield curve based on yields on selected highly rated (Aaa or Aa, by Moody s Investors Service) corporate bonds. Bonds with insufficient liquidity, bonds with questionable pricing information and bonds that are not representative of the overall market are excluded from consideration. For example, the bonds used in the model cannot be callable, they must have a price between 50 and 200, the yield must lie between 1 percent and 20 percent, and the amount of the issue must be in excess of $100 million. The spot rates defined by the yield curve and the plan s projected benefit payments are used to develop a weighted average discount rate. Expected Benefit Payments Based on current assumptions, the Company expects to make the following benefit payments over the next ten years: (Millions of dollars) O&R $ 26 $ 28 $ 29 $ 30 $ 32 $ 179 Expected Contributions Based on current estimates, the Company is not required under funding regulations and laws to make any contributions to the pension plan during The Company s policy is to fund its accounting cost to the extent tax deductible, therefore, O&R expects to make a discretionary contribution of $35 million to the pension plan during Plan Assets The asset allocations for the pension plan at the end of 2005, 2004 and 2003, and the target allocation for 2006 are as follows: 12

22 Target Allocation Plan Assets at December 31 ASSET CATEGORY Equity Securities 65% 67% 67% 64% Debt Securities 30% 28% 28% 32% Real Estate 5% 5% 5% 4% Total 100% 100% 100% 100% Con Edison has established a pension trust for the investment of assets to be used for the exclusive purpose of providing retirement benefits to pension plan participants and beneficiaries. Pursuant to resolutions adopted by Con Edison s Board of Directors, the Management Development and Compensation Committee of the Board of Directors (the Committee) has general oversight responsibility for Con Edison s pension and other employee benefit plans. The plans Named Fiduciaries have been granted the authority to control and manage the operation and administration of the plans, including overall responsibility for the investment of assets in the trust and the power to appoint and terminate investment managers. The Named Fiduciaries consist of Con Edison s chief executive, chief financial and chief accounting officers and others the Board of Directors may appoint in addition to or in place of the designated Named Fiduciaries. The investment objective for the pension trust is to maximize the long-term total return on the trust assets within a prudent level of risk. The investment strategy is to diversify its funds across asset classes, investment styles and fund managers. The target asset allocation is reviewed periodically based on asset/liability studies and may be modified as appropriate. The target asset allocation for 2006 reflects the results of such a study conducted in Individual managers operate under written guidelines provided by Con Edison, which cover such areas as investment objectives, performance measurement, permissible investments, investment restrictions, trading and execution, and communication and reporting requirements. Manager performance, total fund performance, and compliance with asset allocation guidelines are monitored on an ongoing basis, and reviewed by the Named Fiduciaries and reported to the Committee on a regular basis. Changes in fund managers and rebalancing of the portfolio are undertaken as appropriate. The Named Fiduciaries approve such changes, which are also reported to the Committee. O&R also offers a defined contribution savings plan that covers substantially all employees and made contributions to the plan as follows: For the Years Ended December 31, (Millions of Dollars) O&R $2 $2 $1 13

23 Note F Other Postretirement Benefits The Company has contributory comprehensive hospital, medical and prescription drug programs for all retirees, their dependents and surviving spouses. Investment plan gains and losses are fully recognized in expense over a 15-year period. Other actuarial gains and losses are fully recognized in expense over a 10-year period. O&R defers any difference between expenses recognized under SFAS No. 106, Employers Accounting for Postretirement Benefits Other Than Pension, and the current rate allowance for its electric and gas operations. The electric rate plan for Pike has a comparable deferral provision. The rate plan for RECO and the gas rate plan for Pike do not have comparable deferral provisions. A measurement date of December 31 is used for the other postretirement benefit plans. Net Periodic Benefit Cost The components of the Company s net periodic postretirement benefit costs for 2005, 2004 and 2003 were as follows: (Millions of Dollars) Service cost $4 $3 $2 Interest cost on accumulated other postretirement benefit obligation Expected return on plan assets (5) (5) (4) Amortization of net actuarial loss Amortization of prior service cost - - (1) NET PERIODIC POSTRETIREMENT BENEFIT COST $18 $11 $11 Cost capitalized (4) (3) (4) Cost deferred (6) (1) (3) Cost charged to operating expenses $8 $7 $4 Funded Status The funded status of the programs at December 31, 2005, 2004 and 2003 was as follows: (Millions of Dollars) CHANGE IN BENEFIT OBLIGATION Benefit obligation at beginning of year $157 $131 $132 Service cost Interest cost on accumulated postretirement benefit obligation Net actuarial loss Benefits paid and administrative expenses (10) (10) (8) Medicare prescription subsidy - - (14) BENEFIT OBLIGATION AT END OF YEAR $184 $157 $131 CHANGE IN PLAN ASSETS Fair value of plan assets at beginning of year $55 $49 $43 Actual return on plan assets Employer contributions Benefits paid (7) (6) (4) FAIR VALUE OF PLAN ASSETS AT END OF YEAR $64 $55 $49 Funded status $(120) $(102) $(82) Unrecognized net loss Unrecognized prior service costs (1) (1) (1) ACCRUED POSTRETIREMENT BENEFIT COST $(41) $(39) $(39) 14

24 Assumptions The actuarial assumptions were as follows: Weighted-average assumptions used to determine benefit obligations at December 31: Discount Rate 5.70 % 5.90% 6.30% Weighted-average assumptions used to determine net periodic benefit cost for the years ended December 31: Discount Rate 5.90 % 6.30% 6.75% Expected Return on Plan Assets Tax-Exempt 8.80 % 8.80% 8.80% Taxable 8.30 % 8.30% 8.30% Refer to Note E for descriptions of the basis for determining the expected return on assets, investment policies and strategies, and the assumed discount rate. The health care cost trend rate used to determine net periodic benefit cost for the year ended December 31, 2005 was 10 percent, which is assumed to decrease gradually to 4.5 percent by 2011 and remain at that level thereafter. The health care cost trend rate used to determine benefit obligations for the year ended December 31, 2005 was 9 percent, which is assumed to decrease gradually to 4.5 percent by 2011 and remain at that level thereafter. A one-percentage point change in the assumed health care cost trend rate would have the following effects at December 31, 2005: 1-Percentage-Point (Millions of Dollars) Increase Decrease Effect on accumulated other postretirement benefit obligation $ 19 $ (16) Effect on service cost and interest cost components for (2) Expected Benefit Payments Based on current assumptions, O&R expects to make the following benefit payments over the next ten years: (Millions of Dollars) Gross Benefit Payments $11 $11 $12 $13 $14 $75 Medicare Prescription Benefit Receipts Expected Contributions Based on current estimates, O&R expects to make contributions of $13 million to the other postretirement benefit plans in

25 Plan Assets The asset allocations for O&R s other postretirement benefit plans at the end of 2005, 2004 and 2003, and the target allocation for 2006 are as follows: Target Allocation Plan Assets at December 31 ASSET CATEGORY Equity Securities 65% 64% 63% 90% Debt Securities 35% 36% 37% 10% Total 100% 100% 100% 100% O&R has established postretirement health and life insurance benefit plan trusts for the investment of assets to be used for the exclusive purpose of providing other postretirement benefits to participants and beneficiaries. Refer to Note E for a discussion of the investment policy for its benefit plans. Effect of Medicare Prescription Benefit In December 2003, President Bush signed into law the Medicare Prescription Drug, Improvement and Modernization Act of FASB Staff Position (FSP) No. FAS 106-2, issued by the FASB in May 2004, provides accounting and disclosure requirements relating to the Act. The Company s actuaries have determined that each prescription drug plan provides a benefit that is at least actuarially equivalent to the Medicare prescription drug plan and projections indicate that this will be the case for 20 years; therefore, the Company has determined that it is eligible to receive the benefit. To reflect the effect of the Act on the plans, the accumulated postretirement benefit obligations were reduced by $27 million as of December 31, 2005 and the 2005 postretirement benefit costs were reduced by $4 million. The Company will recognize the 28 percent benefit (reflected as an unrecognized net gain to each plan) as an offset to plan costs. The 28 percent benefit is expected to reduce prescription drug plan costs by about 25% starting in Note G Environmental Matters Hazardous substances, such as coal tar and asbestos, have been used or generated in the course of operations of O&R and its predecessors and are present at sites and in facilities and equipment they currently or previously owned, including seven sites at which gas was manufactured (the MGP Sites). MGP Sites The New York State Department of Environmental Conservation (DEC) requires O&R to develop and implement remediation programs for its MGP Sites. O&R has investigated and detected soil and/or groundwater contamination to varying degrees at its MGP Sites. Additional investigation and determination of the remediation 16