BEIJING BOSTON BRUSSELS CENTURY CITY CHICAGO DALLAS GENEVA. FOUNDED February 23, 2018

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1 SIDLEY AUSTIN LLP 701 FIFTH AVENUE, SUITE 4200 SEATTLE, WA BEIJING BOSTON BRUSSELS CENTURY CITY CHICAGO DALLAS GENEVA HONG KONG HOUSTON LONDON LOS ANGELES MUNICH NEW YORK PALO ALTO SAN FRANCISCO SHANGHAI SINGAPORE SYDNEY TOKYO WASHINGTON, D.C. FOUNDED 1866 February 23, 2018 Via etariff Filing Kimberly D. Bose Secretary Federal Energy Regulatory Commission 888 First Street, NE Washington, DC Re: Potomac Electric Power Company Revisions to PJM Tariff Attachment H-9A To Provide for Rate Treatment of FAS 109 Deferred Tax Adjustments and Prompt Rate Benefits to Customers of the Tax Cuts and Jobs Act of 2017, Docket No. ER Dear Secretary Bose: Pursuant to Section 205 of the Federal Power Act ( FPA ) 1 and Part 35 of the Federal Energy Regulatory Commission s ( FERC or Commission ) regulations, 2 Potomac Electric Power Company ( Pepco ) submits 3 the attached proposed modifications to Pepco s formula transmission rate, contained in the PJM Open Access 1 16 U.S.C. 824d (2012) C.F.R. Part 35 (2017). 3 Pursuant to Order No. 714, this filing is submitted by PJM Interconnection LLC ( PJM ) on behalf of Pepco as part of an XML filing package that conforms with the Commission s regulations. PJM has agreed to make all filings on behalf of the PJM Transmission Owners in order to retain administrative control over the PJM Tariff. Thus, Pepco has requested PJM submit this filing in the etariff system as part of PJM s electronic Intra PJM Tariff. Sidley Austin (DC) LLP is a Delaware limited liability partnership doing business as Sidley Austin LLP and practicing in affiliation with other Sidley Austin partnerships.

2 Kimberly D. Bose February 23, 2018 Page 2 Transmission Tariff, Attachment H-9A ( Formula Rate ) to incorporate measures (the Application ) to specify the timing for recovery or passback of various accrued tax liabilities and assets to ratepayers. Pepco requests that the Commission accept the revised tariff sheets in 60 days, with an effective date of April 24, I. EXECUTIVE SUMMARY This Application will provide customers a categorical and timely infusion of rate relief from the recent Tax Cuts and Jobs Act of 2017, which reduces the effective federal corporate tax rate. Once the filing is accepted, the next annual Formula Rate update of Pepco will immediately track the impact on deferred taxes of that tax cut, providing millions of dollars in rate relief when new rate levels are charged to customers in June (Conversely, if the filing is delayed or rejected, customers will not categorically and timely see the deferred tax benefits of the recent tax cuts.) The Application more generally provides an automatic approach to ensure that other, similar, deferred tax adjustments will be included in rates in a timely fashion. The Application is good for customers, both because it clarifies the rate treatment of these amounts going forward, but also because we estimate that the net impact of the proposed modifications will be approximately $4.4 million per year or a 2.64% reduction in transmission rates. The goal of this Application is to ensure that Pepco s deferred tax amounts are properly reflected in rates including ensuring that its customers receive the full benefit of the tax relief from the Tax Cuts and Jobs Act of 2017 as early as possible, and pay no more (and no less) than the amount paid by Pepco for taxes over time. Pepco currently tracks adjustments to deferred taxes (called FAS 109 amounts here, because the accounting for such adjustments was spelled out in Financial Accounting Standards Board Statement No. 109 ( FAS 109 )) in accordance with Commission precedent and policy. But the Pepco Formula Rate has no mechanism to include the amounts (whether positive or negative) in its transmission rates. As described below, the FAS 109 amounts reflect mismatches between Pepco s liability for taxes, its accounting for that liability, and recovery of that liability in transmission rates. Allowing Pepco s Formula Rate to now include a mechanism to allow these FAS 109 amounts to pass through to customers as proposed in this application will ensure, among other things, that consumers receive the full benefits of the current tax relief by paying, over time, what was paid by Pepco. While the changes proposed in this Application provide important clarity, they do not alter the overall amount of taxes Pepco is owed in rates over time, or that ratepayers must

3 Kimberly D. Bose February 23, 2018 Page 3 pay to Pepco over time, because these deferred tax differences were always subject to future rate treatment. The net impact of the adjustments here will lead to a large rate decrease for ratepayers over a number of years. In general, the accumulated tax differences may be positive or negative that is, with respect to some adjustments the utility has collected too little in rates, and will need to recover more to address the mismatches of taxes collected and taxes owed; and for other adjustments the utility has collected too much in rates. Pepco has reported in this Application both excesses and shortfalls (leading to regulatory assets and liabilities) that would flow through rates pursuant to this Application. Here, the Tax Cuts and Jobs Act of 2017 will require Pepco to record excess deferred taxes that substantially exceed the other differences tracked and recorded by Pepco. And thus, the overall net impact of this filing is a large rate decrease that will benefit customers. The Tax Cuts and Jobs Act of 2017 creates a deferred tax difference that leads to a rate decrease because Pepco has been collecting rates for years based on the assumption that it would owe future taxes at the old, higher, federal corporate tax rate. With the tax cuts required by the Tax Cuts and Jobs Act of 2017, Pepco will have large excess deferred tax amounts. Under the current Pepco Formula Rate, FAS 109 adjustments including those arising from statutory tax rate changes do not get reflected in rates but are instead tracked for later rate treatment. 4 The amendments proposed here will ensure that those important benefits are passed back to ratepayers at the earliest possible date substantially reducing Pepco s transmission rates. 5 4 In addition to the deferred tax impact, a portion of the benefit of the federal corporate tax cut in the Tax Cuts and Jobs Act of 2017 will show up promptly in the next Pepco annual rate update (without need for any modification to the Formula Rate), as the Pepco rate formula annually adjusts the return component of the rates by the corporate tax rate in effect for the formula s forecast year, which has now been reduced. 5 Consumers across the country have been asking for such flow through of the Tax Cuts and Jobs Act of 2017 benefits. See e.g. February 9, 2018 Letter of Citizens Utility Board to the Commission (Accession No ). Exelon s utility affiliates are committed to flowing all FAS 109 amounts, including this large tax benefit, back to customers in a just and

4 Kimberly D. Bose February 23, 2018 Page 4 In order to ensure the earliest possible benefit to ratepayers, Pepco also proposes a one-time Early Tax Rebate adjustment. The Early Tax Rebate will estimate the 2018 impact of the Tax Cuts and Jobs Act of 2017 on deferred taxes, and pass back the 2018 estimate as part of the Pepco 2018 rate update (subject to true-up in the 2019 update). This one-time Early Tax Rebate will ensure that customers enjoy the full benefits of the Tax Cuts and Jobs Act of 2017 as early as their June 2018 rates, rather than having to wait another year until the deferred tax cuts show up in the 2018 Form 1, as would otherwise occur under Pepco s formula rates. The other portions of the Pepco filing are not subject to the one-time adjustment, and thus will first impact customer charges in June As discussed below, the Commission has approved similar tax-related changes to formula rates for other transmission owners, and the tax-related changes are consistent with long-established Commission precedent for the return of accumulated deferred income tax ( ADIT ) excesses and collection of ADIT deficiencies. Pepco has followed reasonable fashion. In addition to this filing, Pepco s affiliates Commonwealth Edison Co., Atlantic City Electric Co., and Delmarva Power & Light Co. are simultaneously making FPA Section 205 rate filings at the Commission to amend their formula rates to include FAS 109 amounts that will allow the Tax Cuts and Jobs Act of 2017 tax cuts to flow through rates as well as providing the other benefits of this filing. Pepco s affiliate PECO Energy Co. included FAS 109 passthrough that will flow through these impacts in its recent application to establish a formula rate in Docket No. ER (now in pending settlement negotiations at the Commission). And Pepco s affiliate Baltimore Gas and Electric Co. ( BGE ) made a similar filing in late 2016, in Docket No. ER proposing amendments to BGE s formula rate that are substantially similar to those filed today by Pepco. The BGE filing was submitted prior to the Tax Cuts and Jobs Act of 2017 and projected an estimated small increase in rates, but factoring in the Tax Cuts and Jobs Act of 2017 impacts, the BGE filing would have provided a large rate decrease. The Commission rejected the BGE filing on November 16, PJM Interconnection, L.L.C., 161 FERC 61,163 (2017) ( BGE Order ). The primary basis for the rejection in BGE was the conclusion that the filing by BGE was untimely. In its pending rehearing of the BGE Order, BGE explained that its filing was not untimely. Baltimore Gas and Electric Co. Request for Clarification and Rehearing, Docket No. ER (Dec. 18, 2017). As will be explained in detail below, the current filing by Pepco is likewise timely, and the BGE Order provides no reasoned basis for rejection of this filing.

5 Kimberly D. Bose February 23, 2018 Page 5 this Commission precedent and seeks comparable rate treatment. The key facts are these: (1) Pepco has followed the accounting required by FAS 109 and Commission policy, properly accounting for these amounts over time; (2) Pepco had stated rates until 2005, and Pepco conservatively assumes that an annual amortization of FAS 109 amounts was collected in its rates each year until 2005; (3) in 2005 Pepco proposed a formula rate, which resulted in a settlement, and the settlement adopted a rate structure that excluded recovery of FAS 109 amounts, leaving the treatment of FAS 109 amounts to some later rate case; (4) Pepco has had no general transmission rate cases since the 2005 formula filing, and thus this is Pepco s next rate case after its most recent rate settlement, and thus the first case that could address post-2005 FAS 109 amounts. The tariff modifications are just and reasonable and provide important rate relief to customers and should be accepted as filed. II. SINGLE ISSUE RATE TREATMENT The Commission has held that it is appropriate to address formula rate filings that concern the timing of deferred tax recovery but do not otherwise modify the formula rate on a single-issue basis. For example, the Commission held in a recent proceeding concerning formula rate modifications to the MISO Tariff to address ADIT recovery and timing that arguments concerning other aspects of the formula rate were beyond the scope of the issues raised in this proceeding and dismissed protests raising such unrelated issues. 6 Because the application here seeks adjustments relating to the timing of deferred tax recovery but does not impact any other aspects of Pepco s rates, it is appropriate that the Application here similarly be addressed on a single-issue basis. 7 6 Midcontinent Indep. Sys. Operator, Inc.,153 FERC 61,371 at P 41 (2015). 7 See Indicated RTO Transmission Owners, 161 FERC 61,018 at P 14 (2017) (holding that single-issue rate procedures are appropriate for formula rate filings involving limited revisions addressing ADIT treatment in formula rates when such revisions are only considered mere differences in timing. ).

6 Kimberly D. Bose February 23, 2018 Page 6 III. SUMMARY OF PROPOSED MODIFICATIONS The following adjustments are reflected in this Application: 8 1. Excess/Deficient Deferrals Arising from Tax Rate Changes Adjustment. Due to changes in state or federal tax rates, occurring from time to time, such as the Tax Cuts and Jobs Act of 2017, Pepco s accumulated deferred income tax balances do not match the actual tax liabilities of Pepco. Rather than continuing to allow such tax mismatches to accumulate over time in Pepco s deferred tax balances, Pepco proposes to correct the mismatch through automatic adjustments to be incorporated into the formula rate, using the South Georgia methodology, 9 or using the average rate assumption method ( ARAM ) when ARAM is required under the normalization provisions of the Internal Revenue Code. The automatic adjustments would reflect past tax rate changes that are not yet fully accounted for, and would also provide an automatic 8 The equitable treatment of both positive and negative FAS 109 amounts that is, amounts owed by and to customers -- is an essential aspect of the filing, and makes the filing consistent with the Commission s policies and precedent. Providing for flow through of only assets but not liabilities, or vice versa, would provide an unfair approach that differs fundamentally from Pepco s proposed rate scheme, and that differs from the Commission s policies and precedent. Because the makeup amounts here involve a shortfall, and ongoing recovery involves an excess, it would create a similar inequitable imbalance. Requiring such unbalanced flow through (for example, accepting flow through of the Tax Cuts and Jobs Act of 2017 impacts, but not other flow through, or accepting new and ongoing FAS 109 amounts, but not those accrued in the past or makeup amounts) would transform this filing into an entirely new rate scheme. 9 See South Georgia Natural Gas Co., Docket No. RP77-32 (May 5, 1978) (delegated letter order) (approving calculation of the difference between the amount actually in the deferred account and the amount that would have been in the account had normalization continuously been followed).

7 Kimberly D. Bose February 23, 2018 Page 7 mechanism to capture the impact of any future tax rate changes that may be enacted at the state or federal level AFUDC Equity Adjustment. Federal income tax rules do not permit deduction on the income tax return of the AFUDC equity that is capitalized to plant and included in depreciation expense for financial reporting purposes. Thus, over time, the financial statement reporting of depreciation expense, which includes a component for book basis of AFUDC equity, will be different from the related amount deducted on the income tax return that does not include AFUDC equity. To clarify the timing on when the tax liability will be recovered in rates, and consistent with the Commission s precedent approving similar formula rate adjustments, Pepco proposes to modify its formula rates, using the South Georgia methodology, to automatically amortize in rates the accumulated tax balances associated with past AFUDC equity originations that have not flowed through rates and future AFUDC equity originations See, e.g., Wisconsin Power and Light, Docket No. ER18-216, (February 13, 2018 Letter Order) (approving formula rate change of WPL to provide for recovery of excess and deficient ADIT) ( WPL ); Virginia Electric and Power Co., Docket No. ER ( VEPCO ) (August 2, 2016 Letter Order) (approving formula rate change of VEPCO to provide for recovery of excess and deficient ADIT); Midcontinent Indep. System Operator, 153 FERC 61,374 (2015) ( ITC ) (approving formula rate changes of various ITC affiliates to include a mechanism for the return or collection of excess and deficient ADIT). See also American Transmission Company, 93 FERC 61,335 (2000) ( ATC ) (accepting ATC formula rate, now part of MISO Attachment O), which includes Rate Formula Template, page 3, line 24a, Excess Deferred Income Taxes (enter negative), and line 26a, Excess Deferred Income Tax Adjustment ; DATC Midwest Holdings, LLC ( DATC ) Attachment O Template as approved in Docket No. ER (Letter Order of July 8, 2013), page 3, line 38, Excess Deferred Income Taxes and line 42, Excess Deferred Income Tax Adjustment. 11 See, e.g., Indianapolis Power and Light, 162 FERC 61,134 (2018) ( IPL ) (approving formula rate adjustment for AFUDC equity); Wisconsin Power and Light, Docket No. ER18-216, (February 13, 2018 Letter Order) ( WPL ) (approving formula rate adjustment for AFUDC equity); VEPCO (approving formula rate adjustment for AFUDC equity); ITC (approving formula rate adjustment for AFUDC equity); see also ATC Rate Formula Template, page 3, line 24b, Tax Affect [sic] of Permanent Difference, and line 26b, Permanent Differences Tax

8 Kimberly D. Bose February 23, 2018 Page 8 3. Flow Through Accounting Adjustment. Consistent with Commission requirements, Pepco s Formula Rate employs the tax normalization methodology which does not immediately flow through tax savings, and instead normalizes tax liability assessed in rates over time. However, in prior decades, Pepco employed flow through ratemaking for certain assets, immediately flowing through certain tax savings. The Commission has recognized that while both the flow through and normalization methodology recover the proper amount of taxes from ratepayers over time, the switch from one methodology to another creates timing differences that lead to a difference between a utility s deferred tax account balance and its future tax liability. While the normalization switch for Pepco occurred years ago, shortfalls remain to be passed through in Pepco s accounting resulting from the pre-2005 use of the flow through method. To clarify the timing of when these shortfalls will be recovered in rates, and consistent with Commission precedent approving similar adjustments, Pepco is proposing modifications to its Formula Rate to implement the Commission s South Georgia methodology to amortize the tax balances associated with flow through ratemaking over the remaining life of Pepco s transmission assets as of Early Tax Rebate. Under the Pepco formula, the rate levels in any given year generally relate to the Form 1 amounts relating to the prior year. Under this methodology, ratemaking treatment of the deferred tax impact relating to the impacts of the Tax Cuts and Jobs Act of 2017 would not be reflected in rates until the rate update submitted on or before May 15, 2019, which will be the first rate update reflecting 2018 Adjustment. Similar lines are included on lines 39 and 43 of page 3 of the Attachment O template approved for DATC in Docket No. ER See, e.g., Duquesne Light Co., Docket No. ER (April 26, 2013 Letter Order) ( Duquesne ) (accepting deferred tax adjustment charge arising from deferred tax previously accounted for using flow-through methodology using South Georgia method; PPL Electric Utilities Corp., Docket No. ER (Letter Order issued May 23, 2012) (accepting deferred tax adjustment charge arising from deferred tax previously accounted for using flowthrough methodology using South Georgia method); San Diego Gas & Elec. Co., 105 FERC 61,301 (2003) ( SDG&E ) (approving uncontested settlement establishing transmission formula rate, which included South Georgia method adjustment to account for tax benefits that previously flowed through to retail customers using flow-through methodology).

9 Kimberly D. Bose February 23, 2018 Page 9 Form 1 amounts. In order to ensure that customers will receive the benefits of the Tax Cuts and Jobs Act of 2017 as soon as possible, Pepco proposes a formula amendment that will provide for a one-time adjustment, in which the rate update submitted by May 15, 2018 will include an estimate of the 2018 deferred tax impact of the Tax Cuts and Jobs Act of 2017, and will flow that benefit through rates effective June 1, 2018 (subject to true-up in 2019 based on actual numbers, and with the ordinary tariff procedure applying in later years). IV. DESCRIPTION OF APPLICANT Pepco, a District of Columbia and Virginia corporation, is a wholly owned subsidiary of Pepco Holdings, LLC, a public utility holding company. Pepco Holdings, LLC is a wholly owned subsidiary of Exelon, a Pennsylvania corporation. Pepco owns approximately 12,000 miles of transmission and distribution facilities and provides delivered electric power to approximately 900,000 customers in the District of Columbia and Maryland. Pepco does not own any generation facilities. Pepco s retail electric service is regulated by the Maryland Public Service Commission and the Public Service Commission of the District of Columbia, while PJM s provision of transmission service over its transmission facilities and its sales for resale of electric energy in interstate commerce are regulated by this Commission. As a Commission-regulated public utility, Pepco, like other transmission owner members of PJM, retains the right to submit rate changes pursuant to Section 205 of the Federal Power Act with respect to its revenue requirements. 13 This filing implements adjustments to Pepco formula rates to more accurately track tax liabilities and recoveries that are part of its annual revenue requirement. 13 See Order No. 2000, FERC Stats. & Regs. 31,089, 31,075 (2000), order on reh g, Order No A, FERC Stats. & Regs. 31,092 (20002), appeal dismissed, Public Utility District No. 1 of Snohomish County, Washington v. FERC, 272 F.3d 607 (D.C. Cir. 2001) (approving the establishment of RTOs consisting of transmission owners with certain shared rate filing rights); Atl. City Elec. Co. v. FERC, 295 F.3d 1 (D.C. Cir. 2002) (holding that transmission owners within PJM have not ceded their Section 205 rate-filing rights).

10 Kimberly D. Bose February 23, 2018 Page 10 V. PERSONS TO WHOM CORRESPONDENCE SHOULD BE ADDRESSED Stan Berman Sidley Austin LLP 701 Fifth Avenue, Suite 4200 Seattle, WA (206) Eric Todderud Sidley Austin LLP 701 Fifth Avenue, Suite 4200 Seattle, WA (206) Amy L. Blauman Assistant General Counsel Exelon Corporation 701 Ninth St. N.W. Washington, DC (202) Christopher A. Wilson Director, Federal Regulatory Affairs Exelon Corporation 101 Constitution Ave. Suite 400 E Washington, DC (202) FERCeFilings@exeloncorp.com VI. BACKGROUND AND HISTORY OF INCOME TAX RATEMAKING The Application generally deals with the Commission s interperiod tax accounting and ratemaking rules. The Commission has established accounting procedures for public utilities to record and recover deferred taxes over multi-year periods, including the establishment of regulatory assets and liabilities to record excess or deficient collections, with the excesses and deficiencies experienced in prior years to be dealt with in later years in later rate cases. Pepco has conformed to and relied on those procedures. A. Commission Orders on Normalization Public Systems I, a 1979 case from the United States Court of Appeals for the District of Columbia Circuit ( D.C. Circuit ), describes the issue of interperiod tax

11 Kimberly D. Bose February 23, 2018 Page 11 accounting, and recounts the history of the issue. 14 The court explained rulings tracing back to the 1950s, leading to FPC Order No. 530, which generally required that public utilities employ the normalization method of accounting to address interperiod deferred tax issues. 15 In Public Systems I, the court found that the agency (by then, the FPC had become FERC) had not adequately explained its policies, and remanded to FERC for further proceedings. On remand, the Commission initiated the rulemaking that led to Order No In Order No. 144, the Commission re-affirmed and explained its choice to require public utilities to adopt normalization ratemaking. The Commission also adopted procedures to address the issue in an orderly fashion. In particular, the Commission did not mandate immediate action by utilities, instead providing that the issue would be addressed in due course in the next rate case for each utility, explaining that the exact rate treatment of any accumulated differences would be addressed on a case-by-case basis. 17 Making clear that there was no specific required timing, the Commission held that parties could agree in settlement to defer the issue in any mutually agreeable manner: The rule, of course, leaves undisturbed the ability of the parties to reach a settlement on any of the issues covered by the rule Public Systems v. FERC, 606 F.2d 973 (D.C. Cir. 1979) ( Public Systems I ). 15 Id. at ; Accounting For Premium, Discount and Expense of Issue, Gains and Losses on Refunding and Reacquisition of Longterm Debt, and Interperiod Allocation of Income Taxes, 53 FPC 2123 (1975) ( FPC Order No. 530 ). 16 Public Systems I, 606 F.2d at ; Tax Normalization for Certain Items Reflecting Timing Differences in the Recognition of Expenses or Revenues for Ratemaking and Income Tax Purposes, Order No. 144, FERC Stats. & Regs. 30,254, at 31,519 (1981), order on reh g, Order No. 144-A, FERC Stats. & Regs. 30,340 (1982). 17 Order No. 144 at 31, Order No. 144 at 31,561.

12 Kimberly D. Bose February 23, 2018 Page 12 The rule text adopted by the Commission provided that the eventual rate case would address, using methods such as the South Georgia method, the circumstance where: as a result of changes in tax rates, the accumulated provision for deferred taxes becomes deficient in or in excess of amounts necessary to meet future tax liabilities as determined by application of the current tax rate to all timing difference transactions originating in the test period and prior to the test period. 19 The rule s recognition that the rate proceeding would address excesses or deficiencies arising both in the test period and those arising prior to the test period was different from ordinary Commission rate requirements limiting utilities to recovery of test period amounts. This is a reflection of both the interperiod nature of the costs, and the fact that the issue would not be addressed until some indeterminate future time that is the next rate case, or even later in the event of settlement of the next rate case. After the issuance of Order No. 144 and rehearings, the issue went back to the D.C. Circuit, where challengers again contested the Commission s tax normalization policies, as well as the portions of the rule permitting make-up recovery of prior year excesses and deficiencies. 20 The D.C. Circuit upheld FERC s policies and rejected the contention that this was improperly retroactive, explaining: the provision does not adjust for shortfalls in prior rates. It only adjusts future rates so that tax costs will not fall disproportionately on one ratepayer generation. Ratepayers are not charged for a greater tax allowance under the provision than they otherwise would be; they merely incur the cost over a different time period Order No. 144 slip op. at ; regulatory text for 18 CFR 2.201(c)(ii) (as then codified) (emphasis added). 20 Public Systems v. FERC, 709 F.2d 73, 85 (D.C. Cir. 1983) ( Public Systems II ). 21 Id.; see also Town of Norwood v. FERC, 53 F.3d 377, 381 (D.C. Cir. 1995) (noting that the court has upheld the Order No. 144 make-up provision against charges of retroactive ratemaking on the grounds that past costs collected during the transition were costs that the utility had always planned to charge to future ratepayers ) (emphasis in original).

13 Kimberly D. Bose February 23, 2018 Page 13 Pursuant to these rules and cases, utilities account for their interperiod tax issues over the years, and then are permitted to correct excesses or deficiencies that have built up over the years. The ultimate goal of the Commission policy is an accurate rate that ensures that customers pay, and utilities receive, the accurate measure of tax expense, as measured over both current and prior test periods. B. FAS 109 FAS 109, issued February 1992 by the Financial Accounting Standards Board, updated the accounting and reporting standards for the interperiod tax issues such as those addressed in Order No FAS 109 specifically addresses the amounts at issue in this proceeding. It requires that companies recognize a deferred tax liability for: It further requires: tax benefits that are flowed through to customers when temporary differences originate ( Flowthrough Items ); and the equity component of the allowance for funds used during construction ( AFUDC Equity ). adjustment of a deferred tax liability or asset for an enacted change in tax laws or rates ( Excess/Deficient Deferred Taxes ). 22 On April 23, 1993, the Commission provided guidance on FAS That guidance letter, generally consistent with the prior Commission policy under Order No. 22 FAS 109. This standard also states that regulated enterprises, such as Pepco, that meet the criteria for application of FAS 71, Accounting for the Effects of Certain Types of Regulation, are not exempt from FAS 109. Id. at FAS 71 is the accounting standard that provides for regulatory asset treatment of the future increases (or decreases) in taxes payable if it is probable that the taxes will be recovered from (or refunded to) customers in future rates. Id. 23 Accounting for Income Taxes, Docket No. AI93-5, April 23, 1993 Letter ( 1993 FAS 109 Guidance Letter ).

14 Kimberly D. Bose February 23, 2018 Page , authorizes and directs compliance with FAS 109 by public utilities, requiring that excess or deficient deferred tax liability associated with all three categories Flowthrough Items, AFUDC Equity, and Excess/Deficient Deferred Taxes will be accounted for as provided in FAS 109, by recording the associated amounts as an asset or liability in separate accounts where later recovery from or payment to customers could ultimately be sought. 24 FAS 109 did not fundamentally change Commission policy but did put in place a consistent set of accounting standards consistent with the existing policy that required public utilities to account for excesses and deficiencies in their deferred taxes through establishment of regulatory assets and liabilities, with the rate treatment to be addressed in later cases. Commission policy on ratemaking treatment for FAS 109 amounts, as applicable in the formula rate era, can be seen in the 2014 Staff Guidance on Formula Rate Updates in which Staff cited the 1993 FAS 109 Guidance Letter, and explained that FAS 109 amounts should be excluded in the formula rate calculation, unless and until express Commission authorization is obtained to recover such amounts. 25 Consistent with this guidance, Pepco and other public utilities have been tracking and recording amounts under FAS 109 since the early 1990s. Rather than automatically flowing through rates, the FAS 109 excesses and deficiencies are retained in the accounting records of the utility, for later recovery, once a specific application is made to the Commission for such recovery. Many electric utilities with formula rates do not have a Commission-authorized provision for recovery of FAS 109 amounts. Indeed, the 2014 Staff Guidance on Formula Rate Updates would make no sense if formula rate recovery of FAS 109 amounts was automatic. It is evident from the Staff Guidance that Staff understood this. Utilities continue to track and record FAS 109 amounts, but with the timing of recovery to be determined in some later Commission proceeding. 24 Id.; BGE Order at P Staff Guidance on Formula Rate Updates, issued July 17, 2014, at page 2 of 5 ( 2014 Staff Guidance on Formula Rate Updates ).

15 Kimberly D. Bose February 23, 2018 Page 15 C. Formula Rates Treatment of FAS 109 Amounts In 2012, PPL Electric Utilities Corporation made a Section 205 rate application in Docket No. ER , explaining that it had implemented a formula transmission rate in 2008, four years earlier, and that the formula rate did not include any express authorization for recovery of FAS 109 amounts, and instead excluded those amounts consistent with the Commission precedent requiring exclusion of such amounts from rates until authorized. 26 PPL proposed to recover the transmission-related portion of the unrecovered amounts that had accumulated up and until adoption of the formula rate in 2008, through a charge that would be assessed to customers. 27 Consistent with the South Georgia method, PPL amortized the cumulative unrecovered amount over the remaining life of its transmission assets in place at the time it implemented its formula rate. The Commission approved the proposed recovery even though the filing was made four years after the inception of the formula rate, and related to FAS 109 amounts associated with decades-old assets. 28 In 2013, Duquesne Light Company made a Section 205 rate application in Docket No. ER seeking essentially the same relief as PPL. Duquesne explained that it had implemented a formula transmission rate in 2006, seven years earlier, but that the formula excluded FAS 109 amounts consistent with Commission policy requiring exclusion of such amounts until authorized to recover in rates. Duquesne sought Commission authorization to recover in rates the transmission-related portion of the unrecovered amounts arising under FAS 109, up through the 2006 adoption of the formula rates. 29 Like PPL, Duquesne proposed to use the South Georgia method to amortize the amount over the remaining life of its transmission assets in place at the time 26 PPL Electric Utilities Corp., Docket No. ER ( PPL March 30, 2012 Application ). 27 Id. 28 PPL, May 23, 2012 Letter Order. 29 Duquesne Light Co., Docket No. ER (Duquesne April 1, 2013 Application).

16 Kimberly D. Bose February 23, 2018 Page 16 it put in place its formula rate. 30 The Commission approved the proposed recovery even though the filing was made seven years after inception of the formula rate and concerned assets that were decades old. 31 More recent filings by ITC and Virginia Electric Power Company ( VEPCO ) provide a formula solution to the issue of continued accruals after the inception of the formula rate. In 2015, ITC filed an application in Docket No. ER to amend its transmission formula rate, including new formula provisions for recovery of continued FAS 109 accruals. 32 In contrast to the PPL and Duquesne filings, which sought to recover FAS 109 amounts originating only prior to the date of adoption of the formula rate, the ITC filing provided an ongoing mechanism that would recover both accrued amounts recorded up through the date of the filing, and any new deferred tax difference amounts that would be recorded. 33 The Commission approved the proposed recovery. 34 The ITC filing is explicit that it addressed amounts that had accrued prior to the filing for example the filing references accrued amounts relating to a 2011 state tax rate change, and the filing provided for recovery of those accrued amounts. 35 In accepting the ITC filing, the Commission did not limit the acceptance in any way thus both new accruals 30 Id. 31 Duquesne, April 26, 2013 Letter Order. 32 Midcontinent Indep. System Operator, Docket No. ER (ITC October 30, 2015 Application). 33 Id. ITC does not discuss Flowthrough Items. ITC s FAS 109 amounts consisted of AFUDC Equity and Excess/Deficient Deferred Taxes. Its rate mechanism provided for recovery of FAS 109 amounts that had originated in the past, or that would accrue in the future. For example, its recovery of amounts associated with AFUDC Equity was based on its overall AFUDC Equity amounts, which would include accruals up to the year in which each year s rate would be calculated. 34 ITC, 153 FERC 61, ITC October 30, 2015 Application at 3-4.

17 Kimberly D. Bose February 23, 2018 Page 17 and accumulated amounts associated with old issues, such as the 2011 state tax rate change, would be recovered in ITC rates. In July 2016, VEPCO, in Docket No. ER , proposed formulaic recovery of FAS 109 amounts, using essentially the same mechanism and theory as ITC. 36 Like ITC, VEPCO specifically included formula mechanisms to recover both previously accrued amounts, and newly originating amounts. 37 The Commission approved the proposed recovery. 38 The Commission continues to approve formulaic recovery mechanisms for FAS 109 amounts, as can be seen in its February 2018 approval of a proposal by Wisconsin Power and Light that mirrored the earlier ITC filing. 39 D. Pepco Income Tax Accounting and Rate History Pepco has adopted FAS 109 accounting. The Commission s guidance and precedent on FAS 109 is directly applicable to Pepco. 36 Virginia Electric and Power Co., Docket No. ER (VEPCO July 1, 2016 Application). 37 Id. The fact that VEPCO was seeking accrued amounts from the past, as well as new amounts, can be seen in its formulaic instruction concerning the computation of AFUDC Equity, which is based on the gross cumulative amount based upon tax records of capitalized AFUDC equity embedded in the gross plant attributable to the transmission function. VEPCO Formula, Attachment 5, Instruction 2. The gross cumulative amount would reflect all prior year accruals for AFUDC Equity from both before and after implementation of VEPCO s formula rate. Further, VEPCO explains in the transmittal to its filing at page 5 that excess/deficient deferred tax amounts relating to a tax rate change in 2013 had not been amortized, and that the full amount of the excess/deficient deferred tax would be flowed through the formula. VEPCO July 1, 2016 Application at VEPCO, August 2, 2016 Letter Order. 39 WPL, February 13, 2018 Letter Order.

18 Kimberly D. Bose February 23, 2018 Page 18 Since adopting FAS 109, Pepco has been properly recording and tracking deferred tax difference amounts, for later rate recovery from customers, or later payment to customers, once appropriate Commission authorization for such recovery was obtained. 40 Pepco submitted to FERC its first generally applicable transmission tariff in 1996, in Docket No. ER This rate case was settled in a black box settlement with a stated rate that that did not expressly address FAS Pepco submitted another tariff filing in Docket No. OA in compliance with Order No That rate filing relied on the settlement rates from ER In 1997 Pepco submitted rates as part of the initial tariff of PJM in Docket No. ER These rates were again the subject of a black box settlement with a stated rate that did not expressly address flow through amounts Consistent with the 1993 FAS 109 Guidance Letter, the deferred tax liability for Pepco has been recorded to FERC Account 282, and the regulatory asset amounts are recorded to FERC Account These amounts are reflected in each annual Form 1 of Pepco (the amounts reported in Form 1 are for all of Pepco, rather than just the transmission-related component at issue in this filing). 41 Potomac Electric Power Co., Docket No. ER (Application of January 25, 1996). 42 Potomac Electric Power Co., Docket No. ER (Settlement Offer of July 9, 1996); and (Letter Order of September 12, 1997) (accepting settlement). 43 Potomac Electric Power Co., Docket No. OA (Application of July 9, 1996). 44 Id. 45 Atlantic City Electric Co., et al. (PJM Supporting Companies), Docket No. ER (Application of June 2, 1997). 46 Potomac Electric Power Co., Docket No. ER (Letter Order of September 18, 1998) (Accepting settlement).

19 Kimberly D. Bose February 23, 2018 Page 19 In 2005, Pepco (along with BGE and its affiliates in Pepco Holdings, Inc. ( PHI )) submitted its formula rate, in Docket No. ER This was made effective June 1, The formula rate filing resulted in a settlement 49 accepted on April 19, The formula rate, as settled, segregated FAS 109 amounts from current rate recovery, leaving those amounts to continue to accrue in Pepco s accounts. 51 The settlement provided for a rate moratorium on most rate changes, until June 1, Post-2005, Pepco has made certain incentive rate filings to address the rate treatment of particular transmission projects, and was involved in a complaint proceeding that altered its return on equity and formula rate protocols, but Pepco has not (until the present proceeding) made relevant changes to the tax recovery components of the formula that impact or address the recovery of FAS 109 amounts. Because the settlements of the stated wholesale transmission rates filed prior to 2005 are silent as to the treatment of FAS 109 amounts (indeed, these are black box 47 Baltimore Gas and Electric Co. and Pepco Holdings, Inc., Docket No. ER (Application of January 31, 2005) (Docket No. ER was jointly submitted by BGE and the PHI companies because the Commission had encouraged joint filings by the PJM utilities. BGE and the PHI companies were unaffiliated at the time, and did not become affiliates until the 2016 closing of the Exelon/PHI merger). 48 Allegheny Power System Operating Companies, 111 FERC 61,308 (2005). 49 Baltimore Gas and Electric Co., et al., Offer of Settlement and Settlement Agreement, Docket No. ER05-15 (Mar. 20, 2006) ( 2006 BGE/PHI Offer of Settlement ). 50 Baltimore Gas and Electric Co., 115 FERC 61,066 (2006) ( BGE/PHI Settlement Order ) BGE/PHI Offer of Settlement, Docket No. ER The rate formula Attachment H- 9A expressly excludes FASB 109 amounts and 109 amounts in numerous locations. Consistent with the formula rate requirements, in each Annual Update Pepco identifies on its Attachment 1- ADIT Worksheet, the excluded FAS 109 amounts that are recorded in FERC Account BGE/PHI Offer of Settlement, App. 1, 4.2.

20 Kimberly D. Bose February 23, 2018 Page 20 settlements that are silent on all rate issues), it can be unclear whether or if those preformula transmission rates provided for any recovery each year of an amortization of those amounts. As further discussed below, Pepco conservatively assumes that it was recovering an amortized portion of transmission-related FAS 109 amounts in all of its rates (whether retail or wholesale) until the ER formula rate went into effect in This is reflected in Pepco s deferred tax balances through 2004, which reflect collection (or an assumed collection) of the FAS 109 amounts through that date. The assumption that FAS 109 amounts were included in rates no longer holds after the 2005 formula went into effect, because that formula expressly excludes FAS 109 recovery. The attached excel file documents by year, the derivation of the transmission related portion of excess deferred taxes, AFUDC equity, and Other Flow Through items, each type of flow through amount that Pepco proposes to pass back to customers. 53 Whether or not such pass-back actually occurred, the calculations reflect the recovery in wholesale and retail rates through the date of adoption of the Pepco Formula Rate, accepted by the Commission in Docket No. ER05-515, and put into effect on June 1, To assist the reader, Exhibit C is structured as follows: - Tab 1a provides a summary of the total transmission-related FAS 109 regulatory asset for which Pepco is seeking recovery The excel file is Exhibit C to this letter. 54 In December 2017, the BGE Order raised doubt about the future recovery of a portion of the accrued FAS 109 balances of Pepco. Nevertheless, in light of the rehearing requested in that docket and the potential that the Commission agrees with that request, and the arguments presented in this Application, Pepco continues to track and account for these accrued FAS 109 amounts and plans to restore them, allowing full recovery of these amounts if and when this Application is accepted.

21 Kimberly D. Bose February 23, 2018 Page 21 - Tab 1b provides a summary of the unamortized transmission-related regulatory asset as of December 31, 2017 that ties to the Form 1 amounts reflected by the company over the years, prior to certain corrections explained in the exhibit. - Tabs 2 through 7 provide supporting documentation for the transmission-related regulatory asset as of December 31, 2004, originating AFUDC Equity amounts, and the amortization of AFUDC Equity, Other Flow through Items and Excess/Deficient Deferred Taxes. VII. EXPLANATION OF PROPOSED TARIFF REVISIONS Pepco has appropriately followed Staff accounting guidance and Commission precedent in accounting for FAS 109 amounts. These deferred tax amounts, relating to Excess/Deficient Deferred Taxes, AFUDC Equity, and Flowthrough Items were properly reflected in Pepco accounts, subject to later recovery in rates when expressly authorized by the Commission. Pepco s accounts assume that recovery of an amortized portion of the FAS 109 amounts did occur in each year until 2005, when Pepco adopted formula rates in Docket No. ER The ER formula rates, adopted by settlement, expressly exclude these amounts, and thus the unamortized portion of the pre-2005 amounts, and any new originations since 2005, remain in Pepco s accounts and may be collected in rates only when and if authorized by the Commission. The rate filing in this proceeding seeks that authorization. A number of factors have influenced Pepco s timing for this filing, including, in particular, the desire to unlock as soon as possible the significant customer benefits of the tax reduction under the Tax Cuts and Jobs Act of A. Proposed Revisions to Attachment H-9A of the PJM Tariff to Permit Return or Recovery of Accumulated Deferred Income Taxes Resulting From Tax Rate Changes. Pepco proposes to modify its formula transmission rate to ensure that transmission rates automatically adjust to reflect fluctuating tax liabilities arising from federal or state income tax rate changes. This change to the Formula Rate serves to implement a mechanism through which Pepco can recover deficient deferred taxes tracked and recorded by Pepco. The Formula Rate change also provides a mechanism through which Pepco will automatically return excess deferred income taxes should they occur in the

22 Kimberly D. Bose February 23, 2018 Page 22 future. While there have been several tax rate changes over the years, the Tax Cuts and Jobs Act of 2017 will lead to a large excess in deferred taxes that will substantially exceed the other amounts recorded at Pepco, meaning the overall impact of this Application will be a large rate reduction for customers. As explained by the Commission Staff: [ADIT] is the amount of income taxes collected by the [utility] but not yet needed to pay current income taxes. ADIT arise from differences in the methods of computing taxable income for the various taxing bodies and income for financial statement purposes. In ratemaking, ADIT associated with depreciation expense is the main component of total ADIT. ADIT associated with depreciation expense results because of differences due to the amount of depreciation expense recovered in a [utility] s rates versus the amount of depreciation expense that the [utility] can claim for tax purposes. 55 ADIT balances should zero out over time as book depreciation catches up with tax depreciation, all else held constant. However, changes in tax law or tax rates during an asset s useful life can lead to excess or deficient ADIT balances. For example, when an actual tax rate is lowered by a taxing authority, the utility may have collected more of a contribution to its tax liability through rates than it will actually incur. On the other hand, ADIT balances may become deficient when a taxing authority increases a utility s tax liability above the level previously collected through rates. The impacts of a number of tax rate changes over the years have or will impact Pepco s deferred tax balances. There has been one federal tax rate change since the formula rate went into effect in The Tax Cuts and Jobs Act of 2017, signed into law in December 2017, decreased the top federal corporate income tax rate as follows: Effective January 1, 2018 from 35% to 21% 55 FERC Cost of Service Manual, 1999, available at

23 Kimberly D. Bose February 23, 2018 Page 23 In addition to federal tax rate changes, there have been Maryland and District of Columbia corporate tax rate changes in recent years that impact Pepco s FAS 109 balances: Maryland: Effective January 1, 2008 from 7% to 8.25%; Effective January 1, 2001 from 0% to 7%. District of Columbia: Effective January 1, 2017 from 9.2% to 9%; Effective January 1, 2016 from 9.4% to 9.2%; Effective January 1, 2015 from 9.975% to 9.4%. These tax rate changes have led to a re-measurement of Pepco s ADIT balances. And while there was previously a deficit, this balance changes into a material excess amount once the Tax Cuts and Jobs Act of 2017 is reflected in Pepco deferrals. However, there is no mechanism available in the current Formula Rate to return to customers any excess deferred taxes that result from a re-measurement of the ADIT balances. Likewise, there is no mechanism available in the current formula rate to recover deficient deferred income taxes that result from the re-measurement of the ADIT balances. In order to return excess ADIT, or collect deficient ADIT, a formula rate must include a mechanism to accomplish that task. These two parallel mechanisms are very similar and are included in formula rates for other transmission owners, 56 and are 56 VEPCO, (August 2, 2016 Letter Order) (approving formula rate change of VEPCO to provide for recovery of excess and deficient ADIT); ITC, 153 FERC 61,374 (2016) (approving formula rate changes of various ITC affiliates to include a mechanism for the return or collection of excess and deficient ADIT). See also ATC, Rate Formula Template, page 3, line 24a, Excess Deferred Income Taxes (enter negative), and line 26a, Excess Deferred Income Tax Adjustment ; DATC, Attachment O Template as approved in Docket No. ER , page 3, line 38, Excess Deferred Income Taxes and line 42, Excess Deferred Income Tax Adjustment.