Form 10Q Dated March 31, 2007
 


 

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

FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2007

OR

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the transition period from
 
to
 

Commission
Registrant; State of Incorporation;
I.R.S. Employer
File Number
Address; and Telephone Number
Identification No.
     
333-21011
FIRSTENERGY CORP.
34-1843785
 
(An Ohio Corporation)
 
 
76 South Main Street
 
 
Akron, OH 44308
 
 
Telephone (800)736-3402
 
     
1-2578
OHIO EDISON COMPANY
34-0437786
 
(An Ohio Corporation)
 
 
c/o FirstEnergy Corp.
 
 
76 South Main Street
 
 
Akron, OH 44308
 
 
Telephone (800)736-3402
 
     
1-2323
THE CLEVELAND ELECTRIC ILLUMINATING COMPANY
34-0150020
 
(An Ohio Corporation)
 
 
c/o FirstEnergy Corp.
 
 
76 South Main Street
 
 
Akron, OH 44308
 
 
Telephone (800)736-3402
 
     
1-3583
THE TOLEDO EDISON COMPANY
34-4375005
 
(An Ohio Corporation)
 
 
c/o FirstEnergy Corp.
 
 
76 South Main Street
 
 
Akron, OH 44308
 
 
Telephone (800)736-3402
 
     
1-3141
JERSEY CENTRAL POWER & LIGHT COMPANY
21-0485010
 
(A New Jersey Corporation)
 
 
c/o FirstEnergy Corp.
 
 
76 South Main Street
 
 
Akron, OH 44308
 
 
Telephone (800)736-3402
 
     
1-446
METROPOLITAN EDISON COMPANY
23-0870160
 
(A Pennsylvania Corporation)
 
 
c/o FirstEnergy Corp.
 
 
76 South Main Street
 
 
Akron, OH 44308
 
 
Telephone (800)736-3402
 
     
1-3522
PENNSYLVANIA ELECTRIC COMPANY
25-0718085
 
(A Pennsylvania Corporation)
 
 
c/o FirstEnergy Corp.
 
 
76 South Main Street
 
 
Akron, OH 44308
 
 
Telephone (800)736-3402
 
 

 


Indicate by check mark whether each of the registrants (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes (X) No (  )

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act.

Large Accelerated Filer (X)
FirstEnergy Corp.
Accelerated Filer ( )
N/A
Non-accelerated Filer (X)
 
Ohio Edison Company, The Cleveland Electric Illuminating Company, The Toledo Edison Company, Jersey Central Power & Light Company, Metropolitan Edison Company, and Pennsylvania Electric Company

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).

Yes ( ) No (X)

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date:

 
OUTSTANDING
CLASS
AS OF MAY 9, 2007
FirstEnergy Corp., $.10 par value
304,835,407
Ohio Edison Company, no par value
60
The Cleveland Electric Illuminating Company, no par value
67,930,743
The Toledo Edison Company, $5 par value
29,402,054
Jersey Central Power & Light Company, $10 par value
15,009,335
Metropolitan Edison Company, no par value
859,500
Pennsylvania Electric Company, $20 par value
5,290,596

FirstEnergy Corp. is the sole holder of Ohio Edison Company, The Cleveland Electric Illuminating Company, The Toledo Edison Company, Jersey Central Power & Light Company, Metropolitan Edison Company and Pennsylvania Electric Company common stock.

This combined Form 10-Q is separately filed by FirstEnergy Corp., Ohio Edison Company, The Cleveland Electric Illuminating Company, The Toledo Edison Company, Jersey Central Power & Light Company, Metropolitan Edison Company and Pennsylvania Electric Company. Information contained herein relating to any individual registrant is filed by such registrant on its own behalf. No registrant makes any representation as to information relating to any other registrant, except that information relating to any of the FirstEnergy subsidiary registrants is also attributed to FirstEnergy Corp.

 



 
This Form 10-Q includes forward-looking statements based on information currently available to management. Such statements are subject to certain risks and uncertainties. These statements typically contain, but are not limited to, the terms “anticipate,” “potential,” “expect,” “believe,” “estimate” and similar words. Actual results may differ materially due to the speed and nature of increased competition and deregulation in the electric utility industry, economic or weather conditions affecting future sales and margins, changes in markets for energy services, changing energy and commodity market prices, replacement power costs being higher than anticipated or inadequately hedged, the continued ability of FirstEnergy’s regulated utilities to collect transition and other charges or to recover increased transmission costs, maintenance costs being higher than anticipated, legislative and regulatory changes (including revised environmental requirements), and the legal and regulatory changes resulting from the implementation of the EPACT (including, but not limited to, the repeal of the PUHCA), the uncertainty of the timing and amounts of the capital expenditures needed to, among other things, implement the Air Quality Compliance Plan (including that such amounts could be higher than anticipated) or levels of emission reductions related to the Consent Decree resolving the New Source Review litigation, adverse regulatory or legal decisions and outcomes (including, but not limited to, the revocation of necessary licenses or operating permits and oversight) by the NRC and the various state public utility commissions as disclosed in the registrants’ SEC filings, the timing and outcome of various proceedings before the PUCO (including, but not limited to, the distribution rate cases for the Ohio Companies and the successful resolution of the issues remanded to the PUCO by the Ohio Supreme Court regarding the Rate Stabilization Plan) and the PPUC( including the transition rate plan filings for Met-Ed and Penelec and Penn’s default service plan filing), the continuing availability and operation of generating units, the ability of generating units to continue to operate at, or near full capacity, the inability to accomplish or realize anticipated benefits from strategic goals (including employee workforce initiatives), the anticipated benefits from voluntary pension plan contributions, the ability to improve electric commodity margins and to experience growth in the distribution business, the ability to access the public securities and other capital markets and the cost of such capital, the outcome, cost and other effects of present and potential legal and administrative proceedings and claims related to the August 14, 2003 regional power outage, the successful structuring and completion of a potential sale and leaseback transaction for Bruce Mansfield Unit 1 currently under consideration by management, any purchase price adjustment under the accelerated share repurchase program announced March 2, 2007, the risks and other factors discussed from time to time in the registrants’ SEC filings, and other similar factors. Also, a security rating is not a recommendation to buy, sell or hold securities, and it may be subject to revision or withdrawal at any time and each such rating should be evaluated independently of any other rating. The registrants expressly disclaim any current intention to update any forward-looking statements contained herein as a result of new information, future events, or otherwise.





 

TABLE OF CONTENTS



   
Pages
Glossary of Terms
iii-v
     
Part I. Financial Information
 
     
Items 1. and 2. - Financial Statements and Management’s Discussion and Analysis of  Financial Condition and Results of Operations
 
     
 
Notes to Consolidated Financial Statements
1-21
     
FirstEnergy Corp.
 
     
 
Consolidated Statements of Income
22
 
Consolidated Statements of Comprehensive Income
23
 
Consolidated Balance Sheets
24
 
Consolidated Statements of Cash Flows
25
 
Report of Independent Registered Public Accounting Firm
26
 
Management's Discussion and Analysis of Financial Condition and Results of Operations
27-59
     
Ohio Edison Company
 
     
 
Consolidated Statements of Income and Comprehensive Income
60
 
Consolidated Balance Sheets
61
 
Consolidated Statements of Cash Flows
62
 
Report of Independent Registered Public Accounting Firm
63
 
Management's Discussion and Analysis of Financial Condition and Results of Operations
64-67
     
The Cleveland Electric Illuminating Company
 
     
 
Consolidated Statements of Income and Comprehensive Income
68
 
Consolidated Balance Sheets
69
 
Consolidated Statements of Cash Flows
70
 
Report of Independent Registered Public Accounting Firm
71
 
Management's Discussion and Analysis of Financial Condition and Results of Operations
72-75
     
The Toledo Edison Company
 
     
 
Consolidated Statements of Income and Comprehensive Income
76
 
Consolidated Balance Sheets
77
 
Consolidated Statements of Cash Flows
78
 
Report of Independent Registered Public Accounting Firm
79
 
Management's Discussion and Analysis of Financial Condition and Results of Operations
80-82
     


i


TABLE OF CONTENTS (Cont'd)


   
Pages
     
     
Jersey Central Power & Light Company
 
     
 
Consolidated Statements of Income and Comprehensive Income
83
 
Consolidated Balance Sheets
84
 
Consolidated Statements of Cash Flows
85
 
Report of Independent Registered Public Accounting Firm
86
 
Management's Discussion and Analysis of Financial Condition and Results of Operations
87-89
     
Metropolitan Edison Company
 
     
 
Consolidated Statements of Income and Comprehensive Income
90
 
Consolidated Balance Sheets
91
 
Consolidated Statements of Cash Flows
92
 
Report of Independent Registered Public Accounting Firm
93
 
Management's Discussion and Analysis of Financial Condition and Results of Operations
94-96
     
Pennsylvania Electric Company
 
     
 
Consolidated Statements of Income and Comprehensive Income
97
 
Consolidated Balance Sheets
98
 
Consolidated Statements of Cash Flows
99
 
Report of Independent Registered Public Accounting Firm
100
 
Management's Discussion and Analysis of Financial Condition and Results of Operations
101-103
     
Combined Management’s Discussion and Analysis of Registrant Subsidiaries
104-115
   
Item 3. Quantitative and Qualitative Disclosures About Market Risk
116
     
Item 4. Controls and Procedures
116
     
Part II. Other Information
 
     
Item 1. Legal Proceedings
117
     
Item 1A. Risk Factors
117
   
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
117
     
Item 6. Exhibits
117-118



ii




GLOSSARY OF TERMS

The following abbreviations and acronyms are used in this report to identify FirstEnergy Corp. and its current and former subsidiaries:

ATSI
American Transmission Systems, Inc., owns and operates transmission facilities
CEI
The Cleveland Electric Illuminating Company, an Ohio electric utility operating subsidiary
Centerior
Centerior Energy Corporation, former parent of CEI and TE, which merged with OE to form
FirstEnergy on November 8, 1997
Companies
OE, CEI, TE, JCP&L, Met-Ed and Penelec
FENOC
FirstEnergy Nuclear Operating Company, operates nuclear generating facilities
FES
FirstEnergy Solutions Corp., provides energy-related products and services
FESC
FirstEnergy Service Company, provides legal, financial, and other corporate support services
FGCO
FirstEnergy Generation Corp., owns and operates non-nuclear generating facilities
FirstEnergy
FirstEnergy Corp., a public utility holding company
FSG
FirstEnergy Facilities Services Group, LLC, former parent company of several heating, ventilation,
air conditioning and energy management companies
GPU
GPU, Inc., former parent of JCP&L, Met-Ed and Penelec, which merged with FirstEnergy on
November 7, 2001
JCP&L
Jersey Central Power & Light Company, a New Jersey electric utility operating subsidiary
JCP&L Transition
Funding
JCP&L Transition Funding LLC, a Delaware limited liability company and issuer of transition bonds
JCP&L Transition
Funding II
JCP&L Transition Funding II LLC, a Delaware limited liability company and issuer of transition
bonds
Met-Ed
Metropolitan Edison Company, a Pennsylvania electric utility operating subsidiary
MYR
MYR Group, Inc., a utility infrastructure construction service company
NGC
FirstEnergy Nuclear Generation Corp., owns nuclear generating facilities
OE
Ohio Edison Company, an Ohio electric utility operating subsidiary
Ohio Companies
CEI, OE and TE
Penelec
Pennsylvania Electric Company, a Pennsylvania electric utility operating subsidiary
Penn
Pennsylvania Power Company, a Pennsylvania electric utility operating subsidiary of OE
PNBV
PNBV Capital Trust, a special purpose entity created by OE in 1996
Shippingport
Shippingport Capital Trust, a special purpose entity created by CEI and TE in 1997
TE
The Toledo Edison Company, an Ohio electric utility operating subsidiary
TEBSA
Termobarranquilla S.A., Empresa de Servicios Publicos
   
The following abbreviations and acronyms are used to identify frequently used terms in this report:
   
ALJ
Administrative Law Judge
AOCL
Accumulated Other Comprehensive Loss
APB
Accounting Principles Board
APB 12
APB Opinion No. 12, “Omnibus Opinion - 1967”
ARO
Asset Retirement Obligation
B&W
Babcock & Wilcox Company
Bechtel
Bechtel Power Corporation
BGS
Basic Generation Service
CAIR
Clean Air Interstate Rule
CAL
Confirmatory Action Letter
CAMR
Clean Air Mercury Rule
CBP
Competitive Bid Process
CO2
Carbon Dioxide
DOJ
United States Department of Justice
DRA
Division of Ratepayer Advocate
ECAR
East Central Area Reliability Coordination Agreement
EITF
Emerging Issues Task Force
EITF 06-10
EITF Issue No. 06-10, “Accounting for Deferred Compensation and Postretirement Benefit
Aspects of Collateral Split-Dollar Life Insurance Arrangements”
EPA
Environmental Protection Agency
EPACT
Energy Policy Act of 2005
ERO
Electric Reliability Organization
FASB
Financial Accounting Standards Board
FERC
Federal Energy Regulatory Commission
FIN
FASB Interpretation
 

 
iii


FIN 46R
FIN 46 (revised December 2003), "Consolidation of Variable Interest Entities"
FIN 47
FIN 47, "Accounting for Conditional Asset Retirement Obligations - an interpretation of FASB
Statement No. 143"
FIN 48
FIN 48, “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement
No. 109”
Fitch
Fitch Ratings, Ltd.
FMB
First Mortgage Bonds
GAAP
Accounting Principles Generally Accepted in the United States
GHG
Greenhouse Gases
IRS
Internal Revenue Service
kV
Kilovolt
KWH
Kilowatt-hours
LOC
Letter of Credit
MEIUG
Met-Ed Industrial Users Group
MISO
Midwest Independent Transmission System Operator, Inc.
Moody’s
Moody’s Investors Service
MOU
Memorandum of Understanding
MW
Megawatts
NAAQS
National Ambient Air Quality Standards
NERC
North American Electric Reliability Corporation
NJBPU
New Jersey Board of Public Utilities
NOAC
Northwest Ohio Aggregation Coalition
NOPR
Notice of Proposed Rulemaking
NOV
Notice of Violation
NOX
Nitrogen Oxide
NRC
Nuclear Regulatory Commission
NUG
Non-Utility Generation
NUGC
Non-Utility Generation Charge
OCA
Office of Consumer Advocate
OCC
Office of the Ohio Consumer’s Counsel
OVEC
Ohio Valley Electric Corporation
PCAOB
Public Company Accounting Oversight Board
PICA
Penelec Industrial Customer Alliance
PJM
PJM Interconnection L. L. C.
PLR
Provider of Last Resort
PPUC
Pennsylvania Public Utility Commission
PRP
Potentially Responsible Party
PSA
Power Supply Agreements
PUCO
Public Utilities Commission of Ohio
PUHCA
Public Utility Holding Company Act of 1935
RCP
Rate Certainty Plan
RFP
Request for Proposal
RSP
Rate Stabilization Plan
RTC
Regulatory Transition Charge
RTO
Regional Transmission Organization
RTOR
Regional Through and Out Rates
S&P
Standard & Poor’s Ratings Service
SBC
Societal Benefits Charge
SEC
U.S. Securities and Exchange Commission
SECA
Seams Elimination Cost Adjustment
SFAS
Statement of Financial Accounting Standards
SFAS 106
SFAS No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions”
SFAS 107
SFAS No. 107, “Disclosure about Fair Value of Financial Instruments”
SFAS 109
SFAS No. 109, “Accounting for Income Taxes”
SFAS 123(R)
SFAS No. 123(R), "Share-Based Payment"
SFAS 133
SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”
SFAS 143
SFAS No. 143, "Accounting for Asset Retirement Obligations"
SFAS 157
SFAS No. 157, “Fair Value Measurements”
SFAS 159
SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities - Including an
Amendment of FASB Statement No. 115”


iv



SIP
State Implementation Plan(s) Under the Clean Air Act
SNCR
Selective Non-Catalytic Reduction
SO2
Sulfur Dioxide
SRM
Special Reliability Master
TBC
Transition Bond Charge
TMI-2
Three Mile Island Unit 2
VIE
Variable Interest Entity


v





PART I. FINANCIAL INFORMATION


ITEMS 1. AND 2. FINANCIAL STATEMENTS AND MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS


FIRSTENERGY CORP. AND SUBSIDIARIES
OHIO EDISON COMPANY AND SUBSIDIARIES
THE CLEVELAND ELECTRIC ILLUMINATING COMPANY AND SUBSIDIARIES
THE TOLEDO EDISON COMPANY AND SUBSIDIARY
JERSEY CENTRAL POWER & LIGHT COMPANY AND SUBSIDIARIES
METROPOLITAN EDISON COMPANY AND SUBSIDIARIES
PENNSYLVANIA ELECTRIC COMPANY AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)


1.  ORGANIZATION AND BASIS OF PRESENTATION

FirstEnergy's principal business is the holding, directly or indirectly, of all of the outstanding common stock of its eight principal electric utility operating subsidiaries: OE, CEI, TE, Penn, ATSI, JCP&L, Met-Ed and Penelec. Penn is a wholly owned subsidiary of OE. FirstEnergy’s consolidated financial statements also include its other subsidiaries: FENOC, FES and its subsidiaries FGCO and NGC, and FESC.

FirstEnergy and its subsidiaries follow GAAP and comply with the regulations, orders, policies and practices prescribed by the SEC, FERC and, as applicable, the PUCO, PPUC and NJBPU. The preparation of financial statements in conformity with GAAP requires management to make periodic estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and disclosure of contingent assets and liabilities. Actual results could differ from these estimates. The reported results of operations are not indicative of results of operations for any future period.

These statements should be read in conjunction with the financial statements and notes included in the combined Annual Report on Form 10-K for the year ended December 31, 2006 for FirstEnergy and the Companies. The consolidated unaudited financial statements of FirstEnergy and each of the Companies reflect all normal recurring adjustments that, in the opinion of management, are necessary to fairly present results of operations for the interim periods. Certain businesses divested in 2006 have been classified as discontinued operations on the Consolidated Statements of Income (see Note 3). As discussed in Note 12, interim period segment reporting in 2006 was reclassified to conform with the current year business segment organizations and operations. Unless otherwise indicated, defined terms used herein have the meanings set forth in the accompanying Glossary of Terms.

FirstEnergy and its subsidiaries consolidate all majority-owned subsidiaries over which they exercise control and, when applicable, entities for which they have a controlling financial interest. Intercompany transactions and balances are eliminated in consolidation. FirstEnergy consolidates a VIE (see Note 7) when it is determined to be the VIE's primary beneficiary. Investments in non-consolidated affiliates over which FirstEnergy and its subsidiaries have the ability to exercise significant influence, but not control (20-50% owned companies, joint ventures and partnerships) are accounted for under the equity method. Under the equity method, the interest in the entity is reported as an investment in the Consolidated Balance Sheets and the percentage share of the entity’s earnings is reported in the Consolidated Statements of Income. Certain prior year amounts have been reclassified to conform to the current year presentation.

FirstEnergy's and the Companies' independent registered public accounting firm has performed reviews of, and issued reports on, these consolidated interim financial statements in accordance with standards established by the PCAOB. Pursuant to Rule 436(c) under the Securities Act of 1933, their reports of those reviews should not be considered a report within the meaning of Section 7 and 11 of that Act, and the independent registered public accounting firm’s liability under Section 11 does not extend to them.

1


2. EARNINGS PER SHARE

Basic earnings per share of common stock is computed using the weighted average of actual common shares outstanding during the respective period as the denominator. The denominator for diluted earnings per share of common stock reflects the weighted average of common shares outstanding plus the potential additional common shares that could result if dilutive securities and other agreements to issue common stock were exercised. The pool of stock-based compensation tax benefits is calculated in accordance with SFAS 123(R). On August 10, 2006, FirstEnergy repurchased 10.6 million shares, approximately 3.2%, of its outstanding common stock through an accelerated share repurchase program. The initial purchase price was $600 million, or $56.44 per share. A final purchase price adjustment of $27 million was settled in cash on April 2, 2007. On March 2, 2007, FirstEnergy repurchased approximately 14.4 million shares, or 4.5%, of its outstanding common stock through an additional accelerated share repurchase program with an affiliate of Morgan Stanley and Co., Incorporated at an initial price of $62.63 per share, or a total initial purchase price of approximately $900 million. The final purchase price for this program will be adjusted to reflect the volume weighted average price of FirstEnergy’s common stock during the period of time that the bank will acquire shares to cover its short position, which is approximately one year. The basic and diluted earnings per share calculations for the first quarter of 2007 reflect the impact associated with the March 2007 accelerated share repurchase program. FirstEnergy intends to settle, in cash or shares, any obligation on its part to pay the difference between the average of the daily volume-weighted average price of the shares as calculated under the March 2007 program and the initial price of the shares. The effect of any potential settlement in shares is currently unknown.

Reconciliation of Basic and Diluted
 
  
Three Months Ended
March 31,
 
Earnings per Share of Common Stock
 
2007
 
2006
 
 
       (In millions, except per share amounts)
Income from continuing operations
 
$
290
 
$
219
 
Discontinued operations
   
-
   
2
 
Net income available for common shareholders
 
$
290
 
$
221
 
               
Average shares of common stock outstanding - Basic
   
314
   
329
 
Assumed exercise of dilutive stock options and awards
   
2
   
1
 
Average shares of common stock outstanding - Dilutive
   
316
   
330
 
               
Earnings per share:
             
 
Basic earnings per share:
             
   
Earnings from continuing operations
 
$
0.92
 
$
0.67
 
   
Discontinued operations
   
-
   
-
 
   
Net earnings per basic share
 
$
0.92
 
$
0.67
 
               
 
Diluted earnings per share:
             
   
Earnings from continuing operations
 
$
0.92
 
$
0.67
 
   
Discontinued operations
   
-
   
-
 
   
Net earnings per diluted share
 
$
0.92
 
$
0.67
 
               

3. DIVESTITURES AND DISCONTINUED OPERATIONS

In 2006, FirstEnergy sold its remaining FSG subsidiaries (Roth Bros., Hattenbach, Dunbar, Edwards and RPC) for an aggregate net after-tax gain of $2.2 million. Hattenbach, Dunbar, Edwards, and RPC are included in discontinued operations for the quarter ended March 31, 2006; Roth Bros. does not meet the criteria for that classification.

In March 2006, FirstEnergy sold 60% of its interest in MYR for an after-tax gain of $0.2 million. In June 2006, as part of the March agreement, FirstEnergy sold an additional 1.67% interest. As a result of the March sale, FirstEnergy deconsolidated MYR in the first quarter of 2006 and accounted for its remaining 38.33% interest under the equity method. In the fourth quarter of 2006, FirstEnergy sold its remaining MYR interest for an after-tax gain of $8.6 million. The income for the period that MYR was accounted for as an equity method investment has not been included in discontinued operations; however, results in the first quarter of 2006 prior to the initial sale in March 2006, including the gain on the sale, are reported as discontinued operations.

Revenues associated with discontinued operations were $140 million in first quarter of 2006. The following table summarizes the net income (loss) included in "Discontinued Operations" on the Consolidated Statements of Income for the three months ended March 31, 2006 (in millions):

FSG subsidiaries
 
$
(1
)
MYR
   
3
 
Income from discontinued operations
 
$
2
 

2


4. DERIVATIVE INSTRUMENTS

FirstEnergy is exposed to financial risks resulting from the fluctuation of interest rates and commodity prices, including prices for electricity, natural gas, coal and energy transmission. To manage the volatility relating to these exposures, FirstEnergy uses a variety of derivative instruments, including forward contracts, options, futures contracts and swaps. The derivatives are used principally for hedging purposes. FirstEnergy's Risk Policy Committee, comprised of members of senior management, provides general management oversight for risk management activities throughout the Company. They are responsible for promoting the effective design and implementation of sound risk management programs. They also oversee compliance with corporate risk management policies and established risk management practices.

FirstEnergy accounts for derivative instruments on its Consolidated Balance Sheet at their fair value unless they meet the normal purchase and normal sales criterion. Derivatives that meet that criterion are accounted for on the accrual basis. The changes in the fair value of derivative instruments that do not meet the normal purchase and sales criterion are recorded as other expense, as AOCL, or as part of the value of the hedged item, depending on whether or not it is designated as part of a hedge transaction, the nature of the hedge transaction and hedge effectiveness.

FirstEnergy hedges anticipated transactions using cash flow hedges. Such transactions include hedges of anticipated electricity and natural gas purchases and anticipated interest payments associated with future debt issues. The effective portion of such hedges are initially recorded in equity as other comprehensive income or loss and are subsequently included in net income as the underlying hedged commodities are delivered or interest payments are made. Gains and losses from any ineffective portion of cash flow hedges are included directly in earnings.

The net deferred losses of $45 million included in AOCL as of March 31, 2007, for derivative hedging activity, as compared to the December 31, 2006 balance of $58 million of net deferred losses, resulted from a net $9 million decrease related to current hedging activity and a $4 million decrease due to net hedge losses reclassified into earnings during the three months ended March 31, 2007. Based on current estimates, approximately $7 million (after tax) of the net deferred losses on derivative instruments in AOCL as of March 31, 2007 is expected to be reclassified to earnings during the next twelve months as hedged transactions occur. The fair value of these derivative instruments fluctuate from period to period based on various market factors.

FirstEnergy has entered into swaps that have been designated as fair value hedges of fixed-rate, long-term debt issues to protect against the risk of changes in the fair value of fixed-rate debt instruments due to lower interest rates. Swap maturities, call options, fixed interest rates received, and interest payment dates match those of the underlying debt obligations. In prior years, FirstEnergy has unwound swaps, the gains and losses are amortized in earnings over the remaining maturity of each respective hedged security as adjustments to interest expense. As of March 31, 2007, FirstEnergy had interest rate swaps with an aggregate notional value of $750 million and a fair value of $(24) million.

During 2006 and the first three months of 2007, FirstEnergy entered into several forward starting swap agreements (forward swaps) in order to hedge a portion of the consolidated interest rate risk associated with the anticipated issuances of fixed-rate, long-term debt securities for one or more of its subsidiaries during 2007 - 2008 as outstanding debt matures. These derivatives are treated as cash flow hedges, protecting against the risk of changes in future interest payments resulting from changes in benchmark U.S. Treasury rates between the date of hedge inception and the date of the debt issuance. During the first three months of 2007, FirstEnergy terminated swaps with a notional value of $250 million for which it paid $3 million, all of which was deemed effective. FirstEnergy will recognize the loss over the life of the associated future debt. As of March 31, 2007, FirstEnergy had forward swaps with an aggregate notional amount of $475 million and a long-term debt securities fair value of $(2) million.

5. ASSET RETIREMENT OBLIGATIONS

FirstEnergy has recognized applicable legal obligations under SFAS 143 for nuclear power plant decommissioning, reclamation of a sludge disposal pond and closure of two coal ash disposal sites. In addition, FirstEnergy has recognized conditional retirement obligations (primarily for asbestos remediation) in accordance with FIN 47.

The ARO liability of $1.2 billion as of March 31, 2007 is primarily related to the nuclear decommissioning of the Beaver Valley, Davis-Besse, Perry and TMI-2 nuclear generating facilities. The obligation to decommission these units was developed based on site specific studies performed by an independent engineer. FirstEnergy utilized an expected cash flow approach to measure the fair value of the nuclear decommissioning ARO.

FirstEnergy maintains nuclear decommissioning trust funds that are legally restricted for purposes of settling the nuclear decommissioning ARO. As of March 31, 2007, the fair value of the decommissioning trust assets was $2.0 billion.

3


The following tables analyze changes to the ARO balance during the first quarters of 2007 and 2006, respectively.

ARO Reconciliation
 
FirstEnergy
 
OE
 
CEI
 
TE
 
JCP&L
 
Met-Ed
 
Penelec
 
   
(In millions)
 
Balance, January 1, 2007
 
$
1,190
 
$
88
 
$
2
 
$
27
 
$
84
 
$
151
 
$
77
 
Liabilities incurred
   
-
   
-
   
-
   
-
   
-
   
-
   
-
 
Liabilities settled
   
-
   
-
   
-
   
-
   
-
   
-
   
-
 
Accretion
   
18
   
1
   
-
   
-
   
2
   
2
   
1
 
Revisions in estimated cash flows
   
-
   
-
   
-
   
-
   
-
   
-
   
-
 
Balance, March 31, 2007
 
$
1,208
 
$
89
 
$
2
 
$
27
 
$
86
 
$
153
 
$
78
 
                                             
Balance, January 1, 2006
 
$
1,126
 
$
83
 
$
8
 
$
25
 
$
80
 
$
142
 
$
72
 
Liabilities incurred
   
-
   
-
   
-
   
-
   
-
   
-
   
-
 
Liabilities settled
   
-
   
-
   
-
   
-
   
-
   
-
   
-
 
Accretion
   
18
   
1
   
-
   
-
   
1
   
2
   
1
 
Revisions in estimated cash flows
   
4
   
-
   
-
   
-
   
-
   
-
   
-
 
Balance, March 31, 2006
 
$
1,148
 
$
84
 
$
8
 
$
25
 
$
81
 
$
144
 
$
73
 

6. PENSION AND OTHER POSTRETIREMENT BENEFITS

FirstEnergy provides noncontributory defined benefit pension plans that cover substantially all of its employees. The trusteed plans provide defined benefits based on years of service and compensation levels. The Company’s funding policy is based on actuarial computations using the projected unit credit method. On January 2, 2007, FirstEnergy made a $300 million voluntary cash contribution to its qualified pension plan. Projections indicate that additional cash contributions are not expected to be required before 2016. FirstEnergy also provides a minimum amount of noncontributory life insurance to retired employees in addition to optional contributory insurance. Health care benefits, which include certain employee contributions, deductibles and co-payments, are available upon retirement to employees hired prior to January 1, 2005, their dependents and, under certain circumstances, their survivors. FirstEnergy recognizes the expected cost of providing pension benefits and other postretirement benefits from the time employees are hired until they become eligible to receive those benefits. During 2006, FirstEnergy amended the health care plan effective in 2008 to cap the monthly contribution for many of the retirees and their spouses receiving subsidized health care coverage. In addition, FirstEnergy has obligations to former or inactive employees after employment, but before retirement, for disability-related benefits.

The components of FirstEnergy's net periodic pension cost and other postretirement benefit cost (including amounts capitalized) for the three months ended March 31, 2007 and 2006, consisted of the following:

   
Pension Benefits
 
Other Postretirement Benefits
 
   
2007
 
2006
 
2007
 
2006
 
       
(In millions)
     
Service cost
 
$
21
 
$
21
 
$
5
 
$
9
 
Interest cost
   
71
   
66
   
17
   
26
 
Expected return on plan assets
   
(112
)
 
(99
)
 
(13
)
 
(12
)
Amortization of prior service cost
   
2
   
2
   
(37
)
 
(19
)
Recognized net actuarial loss
   
10
   
15
   
12
   
14
 
Net periodic cost (credit)
 
$
(8)
 
$
5
 
$
(16
)
$
18
 

Pension and postretirement benefit obligations are allocated to FirstEnergy’s subsidiaries employing the plan participants. The Companies capitalize employee benefits related to construction projects. The net periodic pension costs and net periodic postretirement benefit costs (including amounts capitalized) recognized by each of the Companies for the three months ended March 31, 2007 and 2006 were as follows:

   
Pension Benefit Cost (Credit)
 
Other Postretirement
Benefit Cost (Credit)
 
   
2007
 
2006
 
2007
 
2006
 
       
(In millions)
     
OE
 
$
(4.0
)
$
(1.5
)
$
(2.7
)
$
4.2
 
CEI
   
0.3
   
1.0
   
1.0
   
2.8
 
TE
   
-
   
0.2
   
1.2
   
2.0
 
JCP&L
   
(2.1
)
 
(1.4
)
 
(4.0
)
 
0.6
 
Met-Ed
   
(1.7
)
 
(1.7
)
 
(2.5
)
 
0.7
 
Penelec
   
(2.6
)
 
(1.3
)
 
(3.2
)
 
1.8
 
Other FirstEnergy  subsidiaries
   
2.5
   
9.9
   
 
(5.7
 
)
 
6.1
 
   
$
(7.6
)
$
5.2
 
$
(15.9
)
$
18.2
 

4



7. VARIABLE INTEREST ENTITIES

FIN 46R addresses the consolidation of VIEs, including special-purpose entities, that are not controlled through voting interests or in which the equity investors do not bear the entity's residual economic risks and rewards. FirstEnergy and its subsidiaries consolidate VIEs when they are determined to be the VIE's primary beneficiary as defined by FIN 46R.

Leases

FirstEnergy’s consolidated financial statements include PNBV and Shippingport, VIEs created in 1996 and 1997, respectively, to refinance debt originally issued in connection with sale and leaseback transactions. PNBV and Shippingport financial data are included in the consolidated financial statements of OE and CEI, respectively.

PNBV was established to purchase a portion of the lease obligation bonds issued in connection with OE’s 1987 sale and leaseback of its interests in the Perry Plant and Beaver Valley Unit 2. OE used debt and available funds to purchase the notes issued by PNBV. Ownership of PNBV includes a 3% equity interest by an unaffiliated third party and a 3% equity interest held by OES Ventures, a wholly owned subsidiary of OE. Shippingport was established to purchase all of the lease obligation bonds issued in connection with CEI’s and TE’s Bruce Mansfield Plant sale and leaseback transaction in 1987. CEI and TE used debt and available funds to purchase the notes issued by Shippingport.

OE, CEI and TE are exposed to losses under the applicable sale-leaseback agreements upon the occurrence of certain contingent events that each company considers unlikely to occur. OE, CEI and TE each have a maximum exposure to loss under these provisions of approximately $817 million, $960 million and $960 million, respectively, which represents the net amount of casualty value payments upon the occurrence of specified casualty events that render the applicable plant worthless. Under the applicable sale and leaseback agreements, OE, CEI and TE have net minimum discounted lease payments of $646 million, $89 million and $500 million, respectively, that would not be payable if the casualty value payments are made.

Power Purchase Agreements

In accordance with FIN 46R, FirstEnergy evaluated its power purchase agreements and determined that certain NUG entities may be VIEs to the extent they own a plant that sells substantially all of its output to the Companies and the contract price for power is correlated with the plant’s variable costs of production. FirstEnergy, through its subsidiaries JCP&L, Met-Ed and Penelec, maintains approximately 30 long-term power purchase agreements with NUG entities. The agreements were entered into pursuant to the Public Utility Regulatory Policies Act of 1978. FirstEnergy was not involved in the creation of, and has no equity or debt invested in, these entities.

FirstEnergy has determined that for all but eight of these entities, neither JCP&L, Met-Ed nor Penelec have variable interests in the entities or the entities are governmental or not-for-profit organizations not within the scope of FIN 46R. JCP&L, Met-Ed or Penelec may hold variable interests in the remaining eight entities, which sell their output at variable prices that correlate to some extent with the operating costs of the plants. As required by FIN 46R, FirstEnergy periodically requests from these eight entities the information necessary to determine whether they are VIEs or whether JCP&L, Met-Ed or Penelec is the primary beneficiary. FirstEnergy has been unable to obtain the requested information, which in most cases was deemed by the requested entity to be proprietary. As such, FirstEnergy applied the scope exception that exempts enterprises unable to obtain the necessary information to evaluate entities under FIN 46R.

Since FirstEnergy has no equity or debt interests in the NUG entities, its maximum exposure to loss relates primarily to the above-market costs it incurs for power. FirstEnergy expects any above-market costs it incurs to be recovered from customers. As of March 31, 2007, the net projected above-market loss liability recognized for these eight NUG agreements was $155 million. Purchased power costs from these entities during the first quarters of 2007 and 2006 are shown in the table below:

   
Three Months Ended
 
   
March 31,
 
   
2007
 
2006
 
   
(In millions)
 
JCP&L
 
$
20
 
$
15
 
Met-Ed
   
15
   
16
 
Penelec
   
8
   
8
 
   
$
43
 
$
39
 


5



Transition Bonds

The consolidated financial statements of FirstEnergy and JCP&L include the results of JCP&L Transition Funding and JCP&L Transition Funding II, wholly owned limited liability companies of JCP&L. In June 2002, JCP&L Transition Funding sold $320 million of transition bonds to securitize the recovery of JCP&L's bondable stranded costs associated with the previously divested Oyster Creek Nuclear Generating Station. In August 2006, JCP&L Transition Funding II sold $182 million of transition bonds to securitize the recovery of deferred costs associated with JCP&L’s supply of BGS.

JCP&L did not purchase and does not own any of the transition bonds, which are included as long-term debt on FirstEnergy's and JCP&L's Consolidated Balance Sheets. As of March 31, 2007, $420 million of the transition bonds are outstanding. The transition bonds are the sole obligations of JCP&L Transition Funding and JCP&L Transition Funding II and are collateralized by each company’s equity and assets, which consists primarily of bondable transition property.

Bondable transition property represents the irrevocable right under New Jersey law of a utility company to charge, collect and receive from its customers, through a non-bypassable TBC, the principal amount and interest on transition bonds and other fees and expenses associated with their issuance. JCP&L sold its bondable transition property to JCP&L Transition Funding and JCP&L Transition Funding II and, as servicer, manages and administers the bondable transition property, including the billing, collection and remittance of the TBC, pursuant to separate servicing agreements with JCP&L Transition Funding and JCP&L Transition Funding II. For the two series of transition bonds, JCP&L is entitled to aggregate quarterly servicing fees of $157,000 that is payable from TBC collections.

8. INCOME TAXES

On January 1, 2007, FirstEnergy adopted FIN 48, which provides guidance for accounting for uncertainty in income taxes recognized in a company’s financial statements in accordance with SFAS 109. This interpretation prescribes a recognition threshold and measurement attribute for financial statement recognition and measurement of tax positions taken or expected to be taken on a company’s tax return. FIN 48 also provides guidance on derecognition, classification, interest, penalties, accounting in interim periods, disclosure and transition. The evaluation of a tax position in accordance with this interpretation is a two-step process. The first step is to determine if it is more likely than not that a tax position will be sustained upon examination and should therefore be recognized. The second step is to measure a tax position that meets the more likely than not recognition threshold to determine the amount of income tax benefit to recognize in the financial statements.

As of January 1, 2007, the total amount of FirstEnergy’s unrecognized tax benefits was $268 million. FirstEnergy recorded a $2.7 million cumulative effect adjustment to the January 1, 2007 balance of retained earnings to increase reserves for uncertain tax positions. Of the total amount of unrecognized income tax benefits, $92 million would favorably affect FirstEnergy’s effective tax rate upon recognition. The majority of items that would not affect the effective tax rate would be purchase accounting adjustments to goodwill upon recognition. During the first quarter of 2007, there were no material changes to FirstEnergy’s unrecognized tax benefits. The entire balance is included in other non-current liabilities.

FIN 48 also requires companies to recognize interest expense or income related to uncertain tax positions. That amount is computed by applying the applicable statutory interest rate to the difference between the tax position recognized in accordance with FIN 48 and the amount previously taken or expected to be taken on the tax return. FirstEnergy includes net interest and penalties in the provision for income taxes, consistent with its policy prior to implementing FIN 48. As of January 1, 2007, the net amount of interest accrued was $34 million. During the first quarter of 2007, there were no material changes to the amount of interest accrued.

FirstEnergy has tax returns that are under review at the audit or appeals level by the IRS and state tax authorities. All state jurisdictions are open from 2001-2006. The IRS began reviewing returns for the years 2001-2003 in July 2004 and several items are under appeal. The federal audit for years 2004 and 2005 began in June 2006 and is not expected to close before December 2007. The IRS began auditing the year 2006 in April 2006 under its Compliance Assurance Process experimental program, which is not expected to close before December 2007. Management believes that adequate reserves have been recognized and final settlement of these audits is not expected to have a material adverse effect on FirstEnergy’s financial condition or results of operations.

In the first quarter of 2007, OE’s income taxes included an immaterial adjustment applicable to prior periods of $7.2 million related to an inter-company federal tax allocation arrangement between FirstEnergy and its subsidiaries.

6



9. COMMITMENTS, GUARANTEES AND CONTINGENCIES

(A)  GUARANTEES AND OTHER ASSURANCES

As part of normal business activities, FirstEnergy enters into various agreements on behalf of its subsidiaries to provide financial or performance assurances to third parties. These agreements include contract guarantees, surety bonds and LOCs. As of March 31, 2007, outstanding guarantees and other assurances aggregated approximately $4.3 billion, consisting of contract guarantees - $2.5 billion, surety bonds - $0.1 billion and LOCs - $1.7  billion.

FirstEnergy guarantees energy and energy-related payments of its subsidiaries involved in energy commodity activities principally to facilitate normal physical transactions involving electricity, gas, emission allowances and coal. FirstEnergy also provides guarantees to various providers of credit support for subsidiary financings or refinancings of costs related to the acquisition of property, plant and equipment. These agreements legally obligate FirstEnergy to fulfill the obligations of those subsidiaries directly involved in energy and energy-related transactions or financing where the law might otherwise limit the counterparties' claims. If demands of a counterparty were to exceed the ability of a subsidiary to satisfy existing obligations, FirstEnergy's guarantee enables the counterparty's legal claim to be satisfied by other FirstEnergy assets. The likelihood is remote that such parental guarantees of $0.9 billion (included in the $2.5 billion discussed above) as of March 31, 2007 would increase amounts otherwise payable by FirstEnergy to meet its obligations incurred in connection with financings and ongoing energy and energy-related activities.

While these types of guarantees are normally parental commitments for the future payment of subsidiary obligations, subsequent to the occurrence of a credit rating-downgrade or “material adverse event” the immediate posting of cash collateral or provision of an LOC may be required of the subsidiary. As of March 31, 2007, FirstEnergy's maximum exposure under these collateral provisions was $392 million.

Most of FirstEnergy's surety bonds are backed by various indemnities common within the insurance industry. Surety bonds and related FirstEnergy guarantees of $106 million provide additional assurance to outside parties that contractual and statutory obligations will be met in a number of areas including construction jobs, environmental commitments and various retail transactions.

The Companies, with the exception of TE and JCP&L, each have a wholly owned subsidiary whose borrowings are secured by customer accounts receivable purchased from its respective parent company. The CEI subsidiary's borrowings are also secured by customer accounts receivable purchased from TE. Each subsidiary company has its own receivables financing arrangement and, as a separate legal entity with separate creditors, would have to satisfy its obligations to creditors before any of its remaining assets could be available to its parent company.

       
Borrowing
 
Subsidiary Company
 
Parent Company
 
Capacity
 
 
 
 
 
(In millions)
 
OES Capital, Incorporated
 
 
OE
 
$
170
 
Centerior Funding Corp.
 
 
CEI
 
 
200
 
Penn Power Funding LLC
 
 
Penn
 
 
25
 
Met-Ed Funding LLC
 
 
Met-Ed
 
 
80
 
Penelec Funding LLC
 
 
Penelec
 
 
75
 
 
 
 
 
 
$
550
 

FirstEnergy has also guaranteed the obligations of the operators of the TEBSA project, up to a maximum of $6 million (subject to escalation) under the project's operations and maintenance agreement. In connection with the sale of TEBSA in January 2004, the purchaser indemnified FirstEnergy against any loss under this guarantee. FirstEnergy has also provided an LOC ($27 million as of March 31, 2007), which is renewable and declines yearly based upon the senior outstanding debt of TEBSA.

(B) ENVIRONMENTAL MATTERS

Various federal, state and local authorities regulate FirstEnergy with regard to air and water quality and other environmental matters. The effects of compliance on FirstEnergy with regard to environmental matters could have a material adverse effect on FirstEnergy's earnings and competitive position to the extent that it competes with companies that are not subject to such regulations and therefore do not bear the risk of costs associated with compliance, or failure to comply, with such regulations. Overall, FirstEnergy believes it is in compliance with existing regulations but is unable to predict future changes in regulatory policies and what, if any, the effects of such changes would be. FirstEnergy estimates additional capital expenditures for environmental compliance of approximately $1.8 billion for 2007 through 2011.

7



FirstEnergy accrues environmental liabilities only when it concludes that it is probable that it has an obligation for such costs and can reasonably estimate the amount of such costs. Unasserted claims are reflected in FirstEnergy’s determination of environmental liabilities and are accrued in the period that they become both probable and reasonably estimable.

Clean Air Act Compliance

FirstEnergy is required to meet federally-approved SO2 emissions regulations. Violations of such regulations can result in shutdown of the generating unit involved and/or civil or criminal penalties of up to $32,500 for each day the unit is in violation. The EPA has an interim enforcement policy for SO2 regulations in Ohio that allows for compliance based on a 30-day averaging period. FirstEnergy believes it is currently in compliance with this policy, but cannot predict what action the EPA may take in the future with respect to the interim enforcement policy.

The EPA Region 5 issued a Finding of Violation and NOV to the Bay Shore Power Plant dated June 15, 2006 alleging violations to various sections of the Clean Air Act. FirstEnergy has disputed those alleged violations based on its Clean Air Act permit, the Ohio SIP and other information provided at an August 2006 meeting with the EPA. The EPA has several enforcement options (administrative compliance order, administrative penalty order, and/or judicial, civil or criminal action) and has indicated that such option may depend on the time needed to achieve and demonstrate compliance with the rules alleged to have been violated.

FirstEnergy complies with SO2 reduction requirements under the Clean Air Act Amendments of 1990 by burning lower-sulfur fuel, generating more electricity from lower-emitting plants, and/or using emission allowances. NOX reductions required by the 1990 Amendments are being achieved through combustion controls and the generation of more electricity at lower-emitting plants. In September 1998, the EPA finalized regulations requiring additional NOX reductions at FirstEnergy's facilities. The EPA's NOX Transport Rule imposes uniform reductions of NOX emissions (an approximate 85% reduction in utility plant NOX emissions from projected 2007 emissions) across a region of nineteen states (including Michigan, New Jersey, Ohio and Pennsylvania) and the District of Columbia based on a conclusion that such NOX emissions are contributing significantly to ozone levels in the eastern United States. FirstEnergy believes its facilities are also complying with the NOX budgets established under SIPs through combustion controls and post-combustion controls, including Selective Catalytic Reduction and Selective Non-Catalytic Reduction systems, and/or using emission allowances.

National Ambient Air Quality Standards

In July 1997, the EPA promulgated changes in the NAAQS for ozone and fine particulate matter. In March 2005, the EPA finalized the CAIR covering a total of 28 states (including Michigan, New Jersey, Ohio and Pennsylvania) and the District of Columbia based on proposed findings that air emissions from 28 eastern states and the District of Columbia significantly contribute to non-attainment of the NAAQS for fine particles and/or the "8-hour" ozone NAAQS in other states. CAIR provided each affected state until 2006 to develop implementing regulations to achieve additional reductions of NOX and SO2 emissions in two phases (Phase I in 2009 for NOX, 2010 for SO2 and Phase II in 2015 for both NOX and SO2). FirstEnergy's Michigan, Ohio and Pennsylvania fossil-fired generation facilities will be subject to caps on SO2 and NOX emissions, whereas its New Jersey fossil-fired generation facility will be subject to only a cap on NOX emissions. According to the EPA, SO2 emissions will be reduced by 45% (from 2003 levels) by 2010 across the states covered by the rule, with reductions reaching 73% (from 2003 levels) by 2015, capping SO2 emissions in affected states to just 2.5 million tons annually. NOX emissions will be reduced by 53% (from 2003 levels) by 2009 across the states covered by the rule, with reductions reaching 61% (from 2003 levels) by 2015, achieving a regional NOX cap of 1.3 million tons annually. The future cost of compliance with these regulations may be substantial and will depend on how they are ultimately implemented by the states in which FirstEnergy operates affected facilities.

Mercury Emissions

In December 2000, the EPA announced it would proceed with the development of regulations regarding hazardous air pollutants from electric power plants, identifying mercury as the hazardous air pollutant of greatest concern. In March 2005, the EPA finalized the CAMR, which provides a cap-and-trade program to reduce mercury emissions from coal-fired power plants in two phases. Initially, mercury emissions will be capped nationally at 38 tons by 2010 (as a "co-benefit" from implementation of SO2 and NOX emission caps under the EPA's CAIR program). Phase II of the mercury cap-and-trade program will cap nationwide mercury emissions from coal-fired power plants at 15 tons per year by 2018. However, the final rules give states substantial discretion in developing rules to implement these programs. In addition, both the CAIR and the CAMR have been challenged in the United States Court of Appeals for the District of Columbia. FirstEnergy's future cost of compliance with these regulations may be substantial and will depend on how they are ultimately implemented by the states in which FirstEnergy operates affected facilities.

8


The model rules for both CAIR and CAMR contemplate an input-based methodology to allocate allowances to affected facilities. Under this approach, allowances would be allocated based on the amount of fuel consumed by the affected sources. FirstEnergy would prefer an output-based generation-neutral methodology in which allowances are allocated based on megawatts of power produced, allowing new and non-emitting generating facilities (including renewables and nuclear) to be entitled to their proportionate share of the allowances. Consequently, FirstEnergy will be disadvantaged if these model rules were implemented as proposed because FirstEnergy’s substantial reliance on non-emitting (largely nuclear) generation is not recognized under the input-based allocation.

Pennsylvania has submitted a new mercury rule for EPA approval that does not provide a cap and trade approach as in the CAMR, but rather follows a command and control approach imposing emission limits on individual sources. Pennsylvania’s mercury regulation would deprive FES of mercury emission allowances that were to be allocated to the Mansfield Plant under the CAMR and that would otherwise be available for achieving FirstEnergy system-wide compliance. It is anticipated that compliance with these regulations, if approved by the EPA and implemented, would not require the addition of mercury controls at Mansfield, FirstEnergy’s only Pennsylvania power plant, until 2015, if at all.

W. H. Sammis Plant

In 1999 and 2000, the EPA issued NOV or compliance orders to nine utilities alleging violations of the Clean Air Act based on operation and maintenance of 44 power plants, including the W. H. Sammis Plant, which was owned at that time by OE and Penn. In addition, the DOJ filed eight civil complaints against various investor-owned utilities, including a complaint against OE and Penn in the U.S. District Court for the Southern District of Ohio. These cases are referred to as the New Source Review cases.

On March 18, 2005, OE and Penn announced that they had reached a settlement with the EPA, the DOJ and three states (Connecticut, New Jersey, and New York) that resolved all issues related to the New Source Review litigation. This settlement agreement, which is in the form of a consent decree, was approved by the Court on July 11, 2005, and requires reductions of NOX and SO2 emissions at the W. H. Sammis Plant and other FES coal-fired plants through the installation of pollution control devices and provides for stipulated penalties for failure to install and operate such pollution controls in accordance with that agreement. Consequently, if FirstEnergy fails to install such pollution control devices, for any reason, including, but not limited to, the failure of any third-party contractor to timely meet its delivery obligations for such devices, FirstEnergy could be exposed to penalties under the Sammis NSR Litigation consent decree. Capital expenditures necessary to complete requirements of the Sammis NSR Litigation are currently estimated to be $1.5 billion ($400 million of which is expected to be spent during 2007, with the largest portion of the remaining $1.1 billion expected to be spent in 2008 and 2009).

The Sammis NSR Litigation consent decree also requires FirstEnergy to spend up to $25 million toward environmentally beneficial projects, $14 million of which is satisfied by entering into 93 MW (or 23 MW if federal tax credits are not applicable) of wind energy purchased power agreements with a 20-year term. An initial 16 MW of the 93 MW consent decree obligation was satisfied during 2006.

On August 26, 2005, FGCO entered into an agreement with Bechtel Power Corporation under which Bechtel will engineer, procure, and construct air quality control systems for the reduction of SO2 emissions. FGCO also entered into an agreement with B&W on August 25, 2006 to supply flue gas desulfurization systems for the reduction of SO2 emissions. Selective Catalytic Reduction (SCR) systems for the reduction of NOx emissions also are being installed at the W.H. Sammis Plant under a 1999 agreement with B&W.

Climate Change

In December 1997, delegates to the United Nations' climate summit in Japan adopted an agreement, the Kyoto Protocol, to address global warming by reducing the amount of man-made GHG emitted by developed countries by 5.2% from 1990 levels between 2008 and 2012. The United States signed the Kyoto Protocol in 1998 but it failed to receive the two-thirds vote required for ratification by the United States Senate. However, the Bush administration has committed the United States to a voluntary climate change strategy to reduce domestic GHG intensity - the ratio of emissions to economic output - by 18% through 2012. At the international level, efforts have begun to develop climate change agreements for post-2012 GHG reductions. The EPACT established a Committee on Climate Change Technology to coordinate federal climate change activities and promote the development and deployment of GHG reducing technologies.

At the federal level, members of Congress have introduced several bills seeking to reduce emissions of GHG in the United States. State activities, primarily the northeastern states participating in the Regional Greenhouse Gas Initiative and western states led by California, have coordinated efforts to develop regional strategies to control emissions of certain GHGs.

9


On April 2, 2007, the United States Supreme Court found that the EPA has the authority to regulate CO2 emissions from automobiles as “air pollutants” under the Clean Air Act. Although this decision did not address CO2 emissions from electric generating plants, the EPA has similar authority under the Clean Air Act to regulate “air pollutants” from those and other facilities.

FirstEnergy cannot currently estimate the financial impact of climate change policies, although potential legislative or regulatory programs restricting CO2 emissions could require significant capital and other expenditures. The CO2 emissions per KWH of electricity generated by FirstEnergy is lower than many regional competitors due to its diversified generation sources, which include low or non-CO2 emitting gas-fired and nuclear generators.

Clean Water Act

Various water quality regulations, the majority of which are the result of the federal Clean Water Act and its amendments, apply to FirstEnergy's plants. In addition, Ohio, New Jersey and Pennsylvania have water quality standards applicable to FirstEnergy's operations. As provided in the Clean Water Act, authority to grant federal National Pollutant Discharge Elimination System water discharge permits can be assumed by a state. Ohio, New Jersey and Pennsylvania have assumed such authority.

On September 7, 2004, the EPA established new performance standards under Section 316(b) of the Clean Water Act for reducing impacts on fish and shellfish from cooling water intake structures at certain existing large electric generating plants. The regulations call for reductions in impingement mortality, when aquatic organisms are pinned against screens or other parts of a cooling water intake system, and entrainment, which occurs when aquatic life is drawn into a facility's cooling water system. On January 26, 2007, the federal Court of Appeals for the Second Circuit remanded portions of the rulemaking dealing with impingement mortality and entrainment back to EPA for further rulemaking and eliminated the restoration option from EPA’s regulations. FirstEnergy is conducting comprehensive demonstration studies, due in 2008, to determine the operational measures or equipment, if any, necessary for compliance by its facilities with the performance standards. FirstEnergy is unable to predict the outcome of such studies or changes in these requirements from the remand to EPA. Depending on the outcome of such studies and EPA’s further rulemaking, the future cost of compliance with these standards may require material capital expenditures.

Regulation of Hazardous Waste

As a result of the Resource Conservation and Recovery Act of 1976, as amended, and the Toxic Substances Control Act of 1976, federal and state hazardous waste regulations have been promulgated. Certain fossil-fuel combustion waste products, such as coal ash, were exempted from hazardous waste disposal requirements pending the EPA's evaluation of the need for future regulation. The EPA subsequently determined that regulation of coal ash as a hazardous waste is unnecessary. In April 2000, the EPA announced that it will develop national standards regulating disposal of coal ash under its authority to regulate nonhazardous waste.

Under NRC regulations, FirstEnergy must ensure that adequate funds will be available to decommission its nuclear facilities. As of March 31, 2007, FirstEnergy had approximately $1.4 billion invested in external trusts to be used for the decommissioning and environmental remediation of Davis-Besse, Beaver Valley and Perry. As part of the application to the NRC to transfer the ownership of these nuclear facilities to NGC, FirstEnergy agreed to contribute another $80 million to these trusts by 2010. Consistent with NRC guidance, utilizing a “real” rate of return on these funds of approximately 2% over inflation, these trusts are expected to exceed the minimum decommissioning funding requirements set by the NRC. Conservatively, these estimates do not include any rate of return that the trusts may earn over the 20-year plant useful life extensions that FirstEnergy plans to seek for these facilities.

The Companies have been named as PRPs at waste disposal sites, which may require cleanup under the Comprehensive Environmental Response, Compensation, and Liability Act of 1980. Allegations of disposal of hazardous substances at historical sites and the liability involved are often unsubstantiated and subject to dispute; however, federal law provides that all PRPs for a particular site are liable on a joint and several basis. Therefore, environmental liabilities that are considered probable have been recognized on the Consolidated Balance Sheet as of March 31, 2007, based on estimates of the total costs of cleanup, the Companies' proportionate responsibility for such costs and the financial ability of other unaffiliated entities to pay. In addition, JCP&L has accrued liabilities for environmental remediation of former manufactured gas plants in New Jersey; those costs are being recovered by JCP&L through a non-bypassable SBC. Total liabilities of approximately $87 million (JCP&L - $59 million, TE - $3 million, CEI - $1 million, and other subsidiaries - $24 million) have been accrued through March 31, 2007.

10



(C) OTHER LEGAL PROCEEDINGS

Power Outages and Related Litigation

In July 1999, the Mid-Atlantic States experienced a severe heat wave, which resulted in power outages throughout the service territories of many electric utilities, including JCP&L's territory. In an investigation into the causes of the outages and the reliability of the transmission and distribution systems of all four of New Jersey’s electric utilities, the NJBPU concluded that there was not a prima facie case demonstrating that, overall, JCP&L provided unsafe, inadequate or improper service to its customers. Two class action lawsuits (subsequently consolidated into a single proceeding) were filed in New Jersey Superior Court in July 1999 against JCP&L, GPU and other GPU companies, seeking compensatory and punitive damages arising from the July 1999 service interruptions in the JCP&L territory.

In August 2002, the trial court granted partial summary judgment to JCP&L and dismissed the plaintiffs' claims for consumer fraud, common law fraud, negligent misrepresentation, and strict product liability. In November 2003, the trial court granted JCP&L's motion to decertify the class and denied plaintiffs' motion to permit into evidence their class-wide damage model indicating damages in excess of $50 million. These class decertification and damage rulings were appealed to the Appellate Division. The Appellate Division issued a decision on July 8, 2004, affirming the decertification of the originally certified class, but remanding for certification of a class limited to those customers directly impacted by the outages of JCP&L transformers in Red Bank, New Jersey. In 2005, JCP&L renewed its motion to decertify the class based on a very limited number of class members who incurred damages and also filed a motion for summary judgment on the remaining plaintiffs’ claims for negligence, breach of contract and punitive damages. In July 2006, the New Jersey Superior Court dismissed the punitive damage claim and again decertified the class based on the fact that a vast majority of the class members did not suffer damages and those that did would be more appropriately addressed in individual actions. Plaintiffs appealed this ruling to the New Jersey Appellate Division which, on March 7, 2007, reversed the decertification of the Red Bank class and remanded this matter back to the Trial Court to allow plaintiffs sufficient time to establish a damage model or individual proof of damages. In late March 2007, JCP&L filed a petition for allowance of an appeal of the Appellate Division ruling to the New Jersey Supreme Court. FirstEnergy is unable to predict the outcome of these matters and no liability has been accrued as of March 31, 2007.

On August 14, 2003, various states and parts of southern Canada experienced widespread power outages. The outages affected approximately 1.4 million customers in FirstEnergy's service area. The U.S. - Canada Power System Outage Task Force’s final report in April 2004 on the outages concluded, among other things, that the problems leading to the outages began in FirstEnergy’s Ohio service area. Specifically, the final report concluded, among other things, that the initiation of the August 14, 2003 power outages resulted from an alleged failure of both FirstEnergy and ECAR to assess and understand perceived inadequacies within the FirstEnergy system; inadequate situational awareness of the developing conditions; and a perceived failure to adequately manage tree growth in certain transmission rights of way. The Task Force also concluded that there was a failure of the interconnected grid's reliability organizations (MISO and PJM) to provide effective real-time diagnostic support. The final report is publicly available through the Department of Energy’s Web site (www.doe.gov). FirstEnergy believes that the final report does not provide a complete and comprehensive picture of the conditions that contributed to the August 14, 2003 power outages and that it does not adequately address the underlying causes of the outages. FirstEnergy remains convinced that the outages cannot be explained by events on any one utility's system. The final report contained 46 “recommendations to prevent or minimize the scope of future blackouts.” Forty-five of those recommendations related to broad industry or policy matters while one, including subparts, related to activities the Task Force recommended be undertaken by FirstEnergy, MISO, PJM, ECAR, and other parties to correct the causes of the August 14, 2003 power outages. FirstEnergy implemented several initiatives, both prior to and since the August 14, 2003 power outages, which were independently verified by NERC as complete in 2004 and were consistent with these and other recommendations and collectively enhance the reliability of its electric system. FirstEnergy’s implementation of these recommendations in 2004 included completion of the Task Force recommendations that were directed toward FirstEnergy. FirstEnergy is also proceeding with the implementation of the recommendations that were to be completed subsequent to 2004 and will continue to periodically assess the FERC-ordered Reliability Study recommendations for forecasted 2009 system conditions, recognizing revised load forecasts and other changing system conditions which may impact the recommendations. Thus far, implementation of the recommendations has not required, nor is expected to require, substantial investment in new or material upgrades to existing equipment. The FERC or other applicable government agencies and reliability coordinators may, however, take a different view as to recommended enhancements or may recommend additional enhancements in the future that could require additional material expenditures.

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FirstEnergy companies also are defending four separate complaint cases before the PUCO relating to the August 14, 2003 power outages. Two of those cases were originally filed in Ohio State courts but were subsequently dismissed for lack of subject matter jurisdiction and further appeals were unsuccessful. In these cases the individual complainants—three in one case and four in the other—sought to represent others as part of a class action. The PUCO dismissed the class allegations, stating that its rules of practice do not provide for class action complaints. Two other pending PUCO complaint cases were filed by various insurance carriers either in their own name as subrogees or in the name of their insured. In each of these cases, the carrier seeks reimbursement from various FirstEnergy companies (and, in one case, from PJM, MISO and American Electric Power Company, Inc., as well) for claims paid to insureds for damages allegedly arising as a result of the loss of power on August 14, 2003. A fifth case in which a carrier sought reimbursement for claims paid to insureds was voluntarily dismissed by the claimant in April 2007. A sixth case involving the claim of a non-customer seeking reimbursement for losses incurred when its store was burglarized on August 14, 2003 was dismissed. The four cases were consolidated for hearing by the PUCO in an order dated March 7, 2006. In that order the PUCO also limited the litigation to service-related claims by customers of the Ohio operating companies; dismissed FirstEnergy as a defendant; and ruled that the U.S.-Canada Power System Outage Task Force Report was not admissible into evidence. In response to a motion for rehearing filed by one of the claimants, the PUCO ruled on April 26, 2006 that the insurance company claimants, as insurers, may prosecute their claims in their name so long as they also identify the underlying insured entities and the Ohio utilities that provide their service. The PUCO denied all other motions for rehearing. The plaintiffs in each case have since filed amended complaints and the named FirstEnergy companies have answered and also have filed a motion to dismiss each action. On September 27, 2006, the PUCO dismissed certain parties and claims and otherwise ordered the complaints to go forward to hearing. The cases have been set for hearing on January 8, 2008.

On October 10, 2006, various insurance carriers refiled a complaint in Cuyahoga County Common Pleas Court seeking reimbursement for claims paid to numerous insureds who allegedly suffered losses as a result of the August 14, 2003 outages. All of the insureds appear to be non-customers. The plaintiff insurance companies are the same claimants in one of the pending PUCO cases. FirstEnergy, the Ohio Companies and Penn were served on October 27, 2006. On January 18, 2007, the Court granted the Companies’ motion to dismiss the case. It is unknown whether or not the matter will be further appealed. No estimate of potential liability is available for any of these cases.

FirstEnergy was also named, along with several other entities, in a complaint in New Jersey State Court. The allegations against FirstEnergy were based, in part, on an alleged failure to protect the citizens of Jersey City from an electrical power outage. None of FirstEnergy’s subsidiaries serve customers in Jersey City. A responsive pleading has been filed. On April 28, 2006, the Court granted FirstEnergy's motion to dismiss. The plaintiff has not appealed.

FirstEnergy is vigorously defending these actions, but cannot predict the outcome of any of these proceedings or whether any further regulatory proceedings or legal actions may be initiated against the Companies. Although FirstEnergy is unable to predict the impact of these proceedings, if FirstEnergy or its subsidiaries were ultimately determined to have legal liability in connection with these proceedings, it could have a material adverse effect on FirstEnergy's or its subsidiaries' financial condition, results of operations and cash flows.

Nuclear Plant Matters

On August 12, 2004, the NRC notified FENOC that it would increase its regulatory oversight of the Perry Nuclear Power Plant as a result of problems with safety system equipment over the preceding two years and the licensee's failure to take prompt and corrective action. On April 4, 2005, the NRC held a public meeting to discuss FENOC’s performance at the Perry Nuclear Power Plant as identified in the NRC's annual assessment letter to FENOC. Similar public meetings are held with all nuclear power plant licensees following issuance by the NRC of their annual assessments. According to the NRC, overall the Perry Nuclear Power Plant operated "in a manner that preserved public health and safety" even though it remained under heightened NRC oversight. During the public meeting and in the annual assessment, the NRC indicated that additional inspections will continue and that the plant must improve performance to be removed from the Multiple/Repetitive Degraded Cornerstone Column of the Action Matrix.

On September 28, 2005, the NRC sent a CAL to FENOC describing commitments that FENOC had made to improve the performance at the Perry Nuclear Power Plant and stated that the CAL would remain open until substantial improvement was demonstrated. The CAL was anticipated as part of the NRC's Reactor Oversight Process. By two letters dated March 2, 2007, the NRC closed the Confirmatory Action Letter commitments for Perry, the two outstanding white findings, and crosscutting issues. Moreover, the NRC removed Perry from the Multiple Degraded Cornerstone Column of the NRC Action Matrix and placed the plant in the Licensee Response Column (routine agency oversight).

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On April 30, 2007, the Union of Concerned Scientists (UCS) filed a petition with the NRC under Section 2.206 of the NRC’s regulations based on an expert witness report that FENOC developed for an unrelated insurance arbitration. In December 2006, the expert witness for FENOC prepared a report that analyzed the crack growth rates in control rod drive mechanism penetrations and wastage of the former reactor pressure vessel head at Davis-Besse. Citing the findings in the expert witness' report, the Section 2.206 petition requested that: (1) Davis-Besse be immediately shut down; (2) that the NRC conduct an independent review of the consultant's report and that all pressurized water reactors be shut down until remedial actions can be implemented; and (3) that Davis-Besse’s operating license be revoked.

In a letter dated May 4, 2007, the NRC stated that "the current inspection requirements are sufficient to detect degradation of a reactor pressure vessel head penetration nozzles prior to the development of significant head wastage even if the assumptions and conclusions in the [expert witness] report relating to the wastage of the head at Davis-Besse were applied to all pressurized water reactors." The NRC also indicated that while they are developing a more complete response to the UCS' petition, “the staff informed UCS that, as an initial matter, it has determined that no immediate action with respect to Davis-Besse or other nuclear plant is warranted.” FirstEnergy can provide no assurances as to the ultimate resolution of this matter.
 
Other Legal Matters

There are various lawsuits, claims (including claims for asbestos exposure) and proceedings related to FirstEnergy's normal business operations pending against FirstEnergy and its subsidiaries. The other potentially material items not otherwise discussed above are described below.

On August 22, 2005, a class action complaint was filed against OE in Jefferson County, Ohio Common Pleas Court, seeking compensatory and punitive damages to be determined at trial based on claims of negligence and eight other tort counts alleging damages from W.H. Sammis Plant air emissions. The two named plaintiffs are also seeking injunctive relief to eliminate harmful emissions and repair property damage and the institution of a medical monitoring program for class members. On April 5, 2007, the Court rejected the plaintiffs' request to certify this case as a class action and, accordingly, did not appoint the plaintiffs as class representatives or their counsel as class counsel. The Court has scheduled oral argument for June 25, 2007 to hear the plaintiffs' request for reconsideration of its order denying class certification and request to amend their complaint.

JCP&L's bargaining unit employees filed a grievance challenging JCP&L's 2002 call-out procedure that required bargaining unit employees to respond to emergency power outages. On May 20, 2004, an arbitration panel concluded that the call-out procedure violated the parties' collective bargaining agreement. At the conclusion of the June 1, 2005 hearing, the arbitration panel decided not to hear testimony on damages and closed the proceedings. On September 9, 2005, the arbitration panel issued an opinion to award approximately $16 million to the bargaining unit employees. On February 6, 2006, a federal district court granted a union motion to dismiss, as premature, a JCP&L appeal of the award filed on October 18, 2005. JCP&L intends to re-file an appeal again in federal district court once the damages associated with this case are identified at an individual employee level. JCP&L recognized a liability for the potential $16 million award in 2005.

If it were ultimately determined that FirstEnergy or its subsidiaries have legal liability or are otherwise made subject to liability based on the above matters, it could have a material adverse effect on FirstEnergy's or its subsidiaries' financial condition, results of operations and cash flows.

10. REGULATORY MATTERS

(A) RELIABILITY INITIATIVES

In late 2003 and early 2004, a series of letters, reports and recommendations were issued from various entities, including governmental, industry and ad hoc reliability entities (PUCO, FERC, NERC and the U.S. - Canada Power System Outage Task Force) regarding enhancements to regional reliability. In 2004, FirstEnergy completed implementation of all actions and initiatives related to enhancing area reliability, improving voltage and reactive management, operator readiness and training and emergency response preparedness recommended for completion in 2004. On July 14, 2004, NERC independently verified that FirstEnergy had implemented the various initiatives to be completed by June 30 or summer 2004, with minor exceptions noted by FirstEnergy, which exceptions are now essentially complete. FirstEnergy is proceeding with the implementation of the recommendations that were to be completed subsequent to 2004 and will continue to periodically assess the FERC-ordered Reliability Study recommendations for forecasted 2009 system conditions, recognizing revised load forecasts and other changing system conditions which may impact the recommendations. Thus far, implementation of the recommendations has not required, nor is expected to require, substantial investment in new equipment or material upgrades to existing equipment. The FERC or other applicable government agencies and reliability entities may, however, take a different view as to recommended enhancements or may recommend additional enhancements in the future, which could require additional, material expenditures.


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As a result of outages experienced in JCP&L’s service area in 2002 and 2003, the NJBPU had implemented reviews into JCP&L’s service reliability. In 2004, the NJBPU adopted an MOU that set out specific tasks related to service reliability to be performed by JCP&L and a timetable for completion and endorsed JCP&L’s ongoing actions to implement the MOU. On June 9, 2004, the NJBPU approved a stipulation that incorporates the final report of an SRM who made recommendations on appropriate courses of action necessary to ensure system-wide reliability. The stipulation also incorporates the Executive Summary and Recommendation portions of the final report of a focused audit of JCP&L’s Planning and Operations and Maintenance programs and practices (Focused Audit). On February 11, 2005, JCP&L met with the DRA to discuss reliability improvements. The SRM completed his work and issued his final report to the NJBPU on June 1, 2006. JCP&L filed a comprehensive response to the NJBPU on July 14, 2006. JCP&L continues to file compliance reports reflecting activities associated with the MOU and stipulation.
 
The NERC has been preparing the implementation aspects of reorganizing its structure to meet the FERC’s certification requirements for the ERO. The NERC made a filing with the FERC on April 4, 2006 to obtain certification as the ERO and to obtain FERC approval of pro forma delegation agreements with regional reliability organizations (regional entities). A rule adopted by the FERC in 2006 provides for reorganizing regional entities that would replace the current regional councils and for rearranging their relationship with the ERO. The “regional entity” may be delegated authority by the ERO, subject to FERC approval, for compliance and enforcement of reliability standards adopted by the ERO and approved by the FERC. The ERO filing was noticed on April 7, 2006 and comments and reply comments were filed in May, June and July 2006. On July 20, 2006, the FERC certified the NERC as the ERO to implement the provisions of Section 215 of the Federal Power Act and directed the NERC to make compliance filings addressing governance and non-governance issues and the regional delegation agreements. On September 18, 2006 and October 18, 2006, NERC submitted compliance filings addressing the governance and non-governance issues identified in the FERC ERO Certification Order, dated July 20, 2006. On October 30, 2006, the FERC issued an order accepting most of NERC’s governance filings. On January 18, 2007, the FERC issued an order largely accepting NERC’s compliance filings addressing non-governance issues, subject to an additional compliance filing, which NERC submitted on March 19, 2007.

On November 29, 2006, NERC submitted an additional compliance filing with the FERC regarding the Compliance Monitoring and Enforcement Program (CMEP) along with the proposed Delegation Agreements between the ERO and the regional reliability entities. The FERC provided opportunity for interested parties to comment on the CMEP by January 10, 2007. FirstEnergy, as well as other parties, moved to intervene and submitted responsive comments on January 10, 2007. This filing, which established the regulatory framework for NERC’s future enforcement program, was approved by the FERC on April 19, 2007.

The ECAR, Mid-Atlantic Area Council, and Mid-American Interconnected Network reliability councils completed the consolidation of these regions into a single new regional reliability organization known as ReliabilityFirst Corporation. ReliabilityFirst began operations as a regional reliability council under NERC on January 1, 2006 and on November 29, 2006 filed a proposed Delegation Agreement with NERC to obtain certification consistent with the final rule as a “regional entity” under the ERO. This Delegation Agreement was also approved by the FERC on April 19, 2007. All of FirstEnergy’s facilities are located within the ReliabilityFirst region.

On May 2, 2006, the NERC Board of Trustees adopted eight new cyber security standards that replaced interim standards put in place in the wake of the September 11, 2001 terrorist attacks, and thirteen additional reliability standards. The security standards became effective on June 1, 2006, and the remaining standards become effective during 2007. NERC filed these proposed standards with the FERC and relevant Canadian authorities for approval. The cyber security standards were not included in the October 20, 2006 NOPR and are being addressed in a separate FERC docket. On December 11, 2006, the FERC Staff provided its preliminary assessment of these proposed mandatory reliability standards and again cited various deficiencies in the proposed standards. Numerous parties, including FirstEnergy, provided comments on the assessment by February 12, 2007. This filing is pending before the FERC.

On April 4, 2006, NERC submitted a filing with the FERC seeking approval of mandatory reliability standards. On October 20, 2006, the FERC in turn issued a Proposed Rule on the reliability standards. After a period of public review of the proposal, the FERC issued on March 16, 2007 its Final Rule on Mandatory Reliability Standards for the Bulk-Power System. In this ruling, the FERC approved 83 of the 107 mandatory electric reliability standards proposed by NERC, making them enforceable with penalties and sanctions for noncompliance when the rule becomes effective, which is expected by the summer of 2007. The final rule will become effective on June 4, 2007. The FERC also directed NERC to submit improvements to 56 standards, endorsing NERC's process for developing reliability standards and its associated work plan. The 24 standards that were not approved remain pending at the FERC awaiting further information from NERC and its regional entities.


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FirstEnergy believes it is in compliance with all current NERC reliability standards. However, based upon a review of the March 16, 2007 Final Rule, it appears that the FERC will eventually adopt stricter NERC reliability standards than those just approved as NERC addresses the FERC's guidance in the Final Rule. The financial impact of complying with the new standards cannot be determined at this time. However, the EPACT required that all prudent costs incurred to comply with the new reliability standards be recovered in rates. If FirstEnergy is unable to meet the reliability standards for its bulk power system in the future, it could have a material adverse effect on FirstEnergy’s and its subsidiaries’ financial condition, results of operations and cash flows.
 
(B) OHIO

On October 21, 2003, the Ohio Companies filed their RSP case with the PUCO. On August 5, 2004, the Ohio Companies accepted the RSP as modified and approved by the PUCO in an August 4, 2004 Entry on Rehearing, subject to a CBP. The RSP was intended to establish generation service rates beginning January 1, 2006, in response to the PUCO’s concerns about price and supply uncertainty following the end of the Ohio Companies' transition plan market development period. On May 3, 2006, the Supreme Court of Ohio issued an opinion affirming the PUCO's order in all respects, except it remanded back to the PUCO the matter of ensuring the availability of sufficient means for customer participation in the marketplace. The RSP contained a provision that permitted the Ohio Companies to withdraw and terminate the RSP in the event that the PUCO, or the Supreme Court of Ohio, rejected all or part of the RSP. In such event, the Ohio Companies have 30 days from the final order or decision to provide notice of termination. On July 20, 2006, the Ohio Companies filed with the PUCO a Request to Initiate a Proceeding on Remand. In their Request, the Ohio Companies provided notice of termination to those provisions of the RSP subject to termination, subject to being withdrawn, and also set forth a framework for addressing the Supreme Court of Ohio’s findings on customer participation. If the PUCO approves a resolution to the issues raised by the Supreme Court of Ohio that is acceptable to the Ohio Companies, the Ohio Companies’ termination will be withdrawn and considered to be null and void. On July 20, 2006, the OCC and NOAC also submitted to the PUCO a conceptual proposal addressing the issue raised by the Supreme Court of Ohio. On July 26, 2006, the PUCO issued an Entry directing the Ohio Companies to file a plan in a new docket to address the Court’s concern. The Ohio Companies filed their RSP Remand CBP on September 29, 2006. Initial comments were filed on January 12, 2007 and reply comments were filed on January 29, 2007. In their reply comments the Ohio Companies described the highlights of a new tariff offering they would be willing to make available to customers that would allow customers to purchase renewable energy certificates associated with a renewable generation source, subject to PUCO approval. No further proceedings are scheduled at this time.

On August 31, 2005, the PUCO approved a rider recovery mechanism through which the Ohio Companies may recover all MISO transmission and ancillary service related costs incurred during each year ending June 30. Pursuant to the PUCO’s order, the Ohio Companies, on May 1, 2007, filed revised riders which will automatically become effective on July 1, 2007. The revised riders represent an increase over the amounts collected through the 2006 riders of approximately $64 million annually.

During the period between May 1, 2007 and June 1, 2007, any party may raise issues related to the revised tariffs through an informal resolution process. If not adequately resolved through this process by June 30, 2007, any interested party may file a formal complaint with the PUCO which will be addressed by the PUCO after all parties have been heard. If at the conclusion of either the informal or formal process, adjustments are found to be necessary, such adjustments (with carrying costs) will be included in the Ohio Companies’ next rider filing which must be filed no later than May 1, 2008. No assurance can be given that such formal or informal proceedings will not be instituted.


On May 8, 2007, the Ohio Companies filed with the PUCO a notice of intent to file for an increase in electric distribution rates. The Ohio Companies intend to file the application and rate request with the PUCO on or after June 7, 2007. The requested $334 million increase is expected to be more than offset by the elimination or reduction of transition charges at the time the rates go into effect and would result in lowering the overall non-generation portion of the bill for most Ohio customers. The distribution rate increases reflect capital expenditures since the Ohio Companies’ last distribution rate proceedings, increases in operating and maintenance expenses and recovery of regulatory assets created by deferrals that were approved in prior cases. The new rates, subject to evidentiary hearings at the PUCO, would become effective January 1, 2009 for OE and TE, and May 2009 for CEI.

(C) PENNSYLVANIA

Met-Ed and Penelec have been purchasing a portion of their PLR requirements from FES through a partial requirements wholesale power sales agreement and various amendments. Under these agreements, FES retained the supply obligation and the supply profit and loss risk for the portion of power supply requirements not self-supplied by Met-Ed and Penelec. The FES agreements have reduced Met-Ed's and Penelec's exposure to high wholesale power prices by providing power at a fixed price for their uncommitted PLR capacity and energy costs during the term of these agreements with FES.


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On April 7, 2006, the parties entered into a tolling agreement that arose from FES’ notice to Met-Ed and Penelec that FES elected to exercise its right to terminate the partial requirements agreement effective midnight December 31, 2006. On November 29, 2006, Met-Ed, Penelec and FES agreed to suspend the April 7 tolling agreement pending resolution of the PPUC’s proceedings regarding the Met-Ed and Penelec comprehensive transition rate cases filed April 10, 2006, described below. Separately, on September 26, 2006, Met-Ed and Penelec successfully conducted a competitive RFP for a portion of their PLR obligation for the period December 1, 2006 through December 31, 2008. FES was one of the successful bidders in that RFP process and on September 26, 2006 entered into a supplier master agreement to supply a certain portion of Met-Ed’s and Penelec’s PLR requirements at market prices that substantially exceed the fixed price in the partial requirements agreements.
 
Based on the outcome of the 2006 comprehensive transition rate filing, as described below, Met-Ed, Penelec and FES agreed to restate the partial requirements power sales agreement effective January 1, 2007. The restated agreement incorporates the same fixed price for residual capacity and energy supplied by FES as in the prior arrangements between the parties, and automatically extends for successive one year terms unless any party gives 60 days’ notice prior to the end of the year. The restated agreement allows Met-Ed and Penelec to sell the output of NUG generation to the market and requires FES to provide energy at fixed prices to replace any NUG energy thus sold to the extent needed for Met-Ed and Penelec to satisfy their PLR obligations. The parties have also separately terminated the tolling, suspension and supplier master agreements in connection with the restatement of the partial requirements agreement. Accordingly, the energy that would have been supplied under the supplier master agreement will now be provided under the restated partial requirements agreement.

If Met-Ed and Penelec were to replace the entire FES supply at current market power prices without corresponding regulatory authorization to increase their generation prices to customers, each company would likely incur a significant increase in operating expenses and experience a material deterioration in credit quality metrics. Under such a scenario, each company's credit profile would no longer be expected to support an investment grade rating for its fixed income securities. Based on the PPUC’s January 11, 2007 order described below, if FES ultimately determines to terminate, reduce, or significantly modify the agreement prior to the expiration of Met-Ed’s and Penelec’s generation rate caps in 2010, timely regulatory relief is not likely to be granted by the PPUC.

Met-Ed and Penelec made a comprehensive transition rate filing with the PPUC on April 10, 2006 to address a number of transmission, distribution and supply issues. If Met-Ed's and Penelec's preferred approach involving accounting deferrals had been approved, annual revenues would have increased by $216 million and $157 million, respectively. That filing included, among other things, a request to charge customers for an increasing amount of market-priced power procured through a CBP as the amount of supply provided under the then existing FES agreement was to be phased out in accordance with the April 7, 2006 tolling agreement described above. Met-Ed and Penelec also requested approval of a January 12, 2005 petition for the deferral of transmission-related costs, but only for those costs incurred during 2006. In this rate filing, Met-Ed and Penelec also requested recovery of annual transmission and related costs incurred on or after January 1, 2007, plus the amortized portion of 2006 costs over a ten-year period, along with applicable carrying charges, through an adjustable rider. Changes in the recovery of NUG expenses and the recovery of Met-Ed's non-NUG stranded costs were also included in the filing. On May 4, 2006, the PPUC consolidated the remand of the FirstEnergy and GPU merger proceeding, related to the quantification and allocation of the merger savings, with the comprehensive transmission rate filing case.

The PPUC entered its Opinion and Order in the comprehensive rate filing proceeding on January 11, 2007. The order approved the recovery of transmission costs, including the transmission-related deferral for January 1, 2006 through January 10, 2007, when new transmission rates were effective, and determined that no merger savings from prior years should be considered in determining customers’ rates. The request for increases in generation supply rates was denied as were the requested changes in NUG expense recovery and Met-Ed’s non-NUG stranded costs. The order decreased Met-Ed’s and Penelec’s distribution rates by $80 million and $19 million, respectively. These decreases were offset by the increases allowed for the recovery of transmission expenses and the transmission deferral. Met-Ed’s and Penelec’s request for recovery of Saxton decommissioning costs was granted and, in January 2007, Met-Ed and Penelec recognized income of $15 million and $12 million, respectively, to establish regulatory assets for those previously expensed decommissioning costs. Overall rates increased by 5.0% for Met-Ed ($59 million) and 4.5% for Penelec ($50 million). Met-Ed and Penelec filed a Petition for Reconsideration on January 26, 2007 on the issues of consolidated tax savings and rate of return on equity. Other parties filed Petitions for Reconsideration on transmission (including congestion), transmission deferrals and rate design issues. On February 8, 2007, the PPUC entered an order granting Met-Ed’s, Penelec’s and the other parties’ petitions for procedural purposes. Due to that ruling, the period for appeals to the Commonwealth Court was tolled until 30 days after the PPUC entered a subsequent order ruling on the substantive issues raised in the petitions. On March 1, 2007, the PPUC issued three orders: 1) a tentative order regarding the reconsideration by the PPUC of its own order; 2) an order denying the Petitions for Reconsideration of Met-Ed, Penelec and the OCA and denying in part and accepting in part the MEIUG’s and PICA’s Petition for Reconsideration; and 3) an order approving the Compliance filing. Comments to the PPUC for reconsideration of its order were filed on March 8, 2007, and the PPUC ruled on the reconsideration on April 13, 2007, making minor changes to rate design as agreed upon by Met-Ed, Penelec and certain other parties.


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On March 30, 2007, MEIUG and PICA filed a Petition for Review with the Commonwealth Court asking the court to review the PPUC’s determination on transmission (including congestion) and the transmission deferral. Met-Ed and Penelec filed a Petition for Review on April 13, 2007 on the issues of consolidated tax savings and the requested generation rate increase. The OCA filed its Petition for Review on April 13, 2007, on the issues of transmission (including congestion) and recovery of universal service costs from only the residential rate class. If Met-Ed and Penelec do not prevail on the issue of congestion, it could have a material adverse effect on FirstEnergy’s and their financial condition and results of operations.
 
As of March 31, 2007, Met-Ed's and Penelec's unrecovered regulatory deferrals pursuant to the 2006 comprehensive transition rate case, the 1998 Restructuring Settlement (including the Phase 2 Proceedings) and the FirstEnergy/GPU Merger Settlement Stipulation were $472 million and $124 million, respectively. Penelec’s $124 million deferral is subject to final resolution of an IRS settlement associated with NUG trust fund proceeds. During the PPUC’s annual audit of Met-Ed’s and Penelec’s NUG stranded cost balances in 2006, it noted a modification to the NUG purchased power stranded cost accounting methodology made by Met-Ed and Penelec. On August 18, 2006, a PPUC Order was entered requiring Met-Ed and Penelec to reflect the deferred NUG cost balances as if the stranded cost accounting methodology modification had not been implemented. As a result of this PPUC order, Met-Ed recognized a pre-tax charge of approximately $10.3 million in the third quarter of 2006, representing incremental costs deferred under the revised methodology in 2005. Met-Ed and Penelec continue to believe that the stranded cost accounting methodology modification is appropriate and on August 24, 2006 filed a petition with the PPUC pursuant to its order for authorization to reflect the stranded cost accounting methodology modification effective January 1, 1999. Hearings on this petition were held in late February 2007 and briefing was completed on March 28, 2007. The ALJ’s initial decision was issued on May 3, 2007 and denied Met-Ed's and Penelec’s request to modify their NUG stranded cost accounting methodology. The companies may file exceptions to the initial decision by May 22, 2007 and parties may reply to those exceptions 10 days thereafter. It is not known when the PPUC may issue a final decision in this matter.

On May 2, 2007, Penn filed a plan with the PPUC for the procurement of PLR supply from June 2008 through May 2011. The filing proposes multiple, competitive RFPs with staggered delivery periods for fixed-price, tranche-based, pay as bid PLR supply to the residential and commercial classes. The proposal phases out existing promotional rates and eliminates the declining block and the demand components on generation rates for residential and commercial customers. The industrial class PLR service will be provided through an hourly-priced service provided by Penn. Quarterly reconciliation of the differences between the costs of supply and revenues from customers is also proposed. The PPUC is requested to act on the proposal no later than November 2007 for the initial RFP to take place in January 2008.

On February 1, 2007, the Governor of Pennsylvania proposed an Energy Independence Strategy (EIS). The EIS includes four pieces of proposed legislation that, according to the Governor, is designed to reduce energy costs, promote energy independence and stimulate the economy. Elements of the EIS include the installation of smart meters, funding for solar panels on residences and small businesses, conservation programs to meet demand growth, a requirement that electric distribution companies acquire power through a "Least Cost Portfolio", the utilization of micro-grids and an optional three year phase-in of rate increases. Since the EIS has only recently been proposed, the final form of any legislation is uncertain. Consequently, FirstEnergy is unable to predict what impact, if any, such legislation may have on its operations.

(D) NEW JERSEY

JCP&L is permitted to defer for future collection from customers the amounts by which its costs of supplying BGS to non-shopping customers and costs incurred under NUG agreements exceed amounts collected through BGS and NUGC rates and market sales of NUG energy and capacity. As of March 31, 2007, the accumulated deferred cost balance totaled approximately $357 million.

In accordance with an April 28, 2004 NJBPU order, JCP&L filed testimony on June 7, 2004 supporting a continuation of the current level and duration of the funding of TMI-2 decommissioning costs by New Jersey customers without a reduction, termination or capping of the funding. On September 30, 2004, JCP&L filed an updated TMI-2 decommissioning study. This study resulted in an updated total decommissioning cost estimate of $729 million (in 2003 dollars) compared to the estimated $528 million (in 2003 dollars) from the prior 1995 decommissioning study. The DRA filed comments on February 28, 2005 requesting that decommissioning funding be suspended. On March 18, 2005, JCP&L filed a response to those comments. A schedule for further NJBPU proceedings has not yet been set.

On August 1, 2005, the NJBPU established a proceeding to determine whether additional ratepayer protections are required at the state level in light of the repeal of PUHCA pursuant to the EPACT. The NJBPU approved regulations effective October 2, 2006 that would prevent a holding company that owns a gas or electric public utility from investing more than 25% of the combined assets of its utility and utility-related subsidiaries into businesses unrelated to the utility industry. These regulations are not expected to materially impact FirstEnergy or JCP&L. Also, in the same proceeding, the NJBPU Staff issued an additional draft proposal on March 31, 2006 addressing various issues including access to books and records, ring-fencing, cross subsidization, corporate governance and related matters. With the approval of the NJBPU Staff, the affected utilities jointly submitted an alternative proposal on June 1, 2006. Comments on the alternative proposal were submitted on June 15, 2006. On November 3, 2006, the Staff circulated a revised draft proposal to interested stakeholders. Another revised draft was circulated by the NJBPU Staff on February 8, 2007.

17



New Jersey statutes require that the state periodically undertake a planning process, known as the Energy Master Plan (EMP), to address energy related issues including energy security, economic growth, and environmental impact. The EMP is to be developed with involvement of the Governor’s Office and the Governor’s Office of Economic Growth, and is to be prepared by a Master Plan Committee, which is chaired by the NJBPU President and includes representatives of several State departments. In October 2006, the current EMP process was initiated with the issuance of a proposed set of objectives which, as to electricity, included the following:
 
  ·     Reduce the total projected electricity demand by 20% by 2020;

  ·     Meet 22.5% of New Jersey’s electricity needs with renewable energy resources by that date;

·     Reduce air pollution related to energy use;
 
  ·     Encourage and maintain economic growth and development;
 
  ·  
  Achieve a 20% reduction in both Customer Average Interruption Duration Index and System Average Interruption Frequency Index by 2020;

·  
  Unit prices for electricity should remain no more than +5% of the regional average price (region includes New York, New Jersey, Pennsylvania, Delaware, 
  Maryland and the District of Columbia); and
 
  ·  
  Eliminate transmission congestion by 2020.
 
Comments on the objectives and participation in the development of the EMP have been solicited and a number of working groups have been formed to obtain input from a broad range of interested stakeholders including utilities, environmental groups, customer groups, and major customers. EMP working groups addressing 1) energy efficiency and demand response and 2) renewables have completed their assigned tasks of data gathering and analysis. Both groups have provided a report to the EMP Committee. The working groups addressing reliability and pricing issues continue their data gathering and analysis activities. Public stakeholder meetings were held in the fall of 2006 and in early 2007, and further public meetings are expected in the summer of 2007. A final draft of the EMP is expected to be presented to the Governor in the fall of 2007 with further public hearings anticipated in early 2008. At this time, FirstEnergy cannot predict the outcome of this process nor determine the impact, if any, such legislation may have on its operations or those of JCP&L.

On February 13, 2007, the NJBPU Staff issued a draft proposal relating to changes to the regulations addressing electric distribution service reliability and quality standards. A meeting between the NJBPU Staff and interested stakeholders to discuss the proposal was held on February 15, 2007. On February 22, 2007, the NJBPU Staff circulated a revised proposal upon which discussions with interested stakeholders were held on March 26, 2007. On April 18 and April 23, 2007 the NJBPU staff circulated further revised draft proposals. A schedule for formal proceedings has not yet been established. At this time, FirstEnergy cannot predict the outcome of this process nor determine the impact, if any, ultimate regulations resulting from these draft proposals may have on its operations or those of JCP&L.

(E) FERC MATTERS

On November 18, 2004, the FERC issued an order eliminating the RTOR for transmission service between the MISO and PJM regions. The FERC also ordered the MISO, PJM and the transmission owners within MISO and PJM to submit compliance filings containing a SECA mechanism to recover lost RTOR revenues during a 16-month transition period from load serving entities. The FERC issued orders in 2005 setting the SECA for hearing. ATSI, JCP&L, Met-Ed, Penelec, and FES participated in the FERC hearings held in May 2006 concerning the calculation and imposition of the SECA charges. The Presiding Judge issued an Initial Decision on August 10, 2006, rejecting the compliance filings made by the RTOs and transmission owners, ruling on various issues and directing new compliance filings. This decision is subject to review and approval by the FERC. Briefs addressing the Initial Decision were filed on September 11, 2006 and October 20, 2006. A final order could be issued by the FERC in the second quarter of 2007.

18



On January 31, 2005, certain PJM transmission owners made three filings with the FERC pursuant to a settlement agreement previously approved by the FERC. JCP&L, Met-Ed and Penelec were parties to that proceeding and joined in two of the filings. In the first filing, the settling transmission owners submitted a filing justifying continuation of their existing rate design within the PJM RTO. In the second filing, the settling transmission owners proposed a revised Schedule 12 to the PJM tariff designed to harmonize the rate treatment of new and existing transmission facilities. Interventions and protests were filed on February 22, 2005. In the third filing, Baltimore Gas and Electric Company and Pepco Holdings, Inc. requested a formula rate for transmission service provided within their respective zones. On May 31, 2005, the FERC issued an order on these cases. First, it set for hearing the existing rate design and indicated that it will issue a final order within six months. American Electric Power Company, Inc. filed in opposition proposing to create a "postage stamp" rate for high voltage transmission facilities across PJM. Second, the FERC approved the proposed Schedule 12 rate harmonization. Third, the FERC accepted the proposed formula rate, subject to refund and hearing procedures. On June 30, 2005, the settling PJM transmission owners filed a request for rehearing of the May 31, 2005 order. On March 20, 2006, a settlement was filed with FERC in the formula rate proceeding that generally accepts the companies' formula rate proposal. The FERC issued an order approving this settlement on April 19, 2006. Hearings in the PJM rate design case concluded in April 2006. On July 13, 2006, an Initial Decision was issued by the ALJ. The ALJ adopted the FERC Trial Staff’s position that the cost of all PJM transmission facilities should be recovered through a postage stamp rate. The ALJ recommended an April 1, 2006 effective date for this change in rate design. On April 19, 2007, the FERC issued an order rejecting the ALJ’s findings and recommendations in nearly every respect. FERC found that the PJM transmission owners’ existing “license plate” rate design was just and reasonable and ordered that the current license plate rates for existing transmission facilities be retained. On the issue of rates for new transmission facilities, FERC directed that costs for new transmission facilities that are rated at 500 kV or higher are to be socialized throughout the PJM footprint by means of a postage-stamp rate. Costs for new transmission facilities that are rated at less than 500 kV, however, are to be allocated on a “beneficiary pays” basis. Nevertheless, FERC found that PJM’s current beneficiary-pays cost allocation methodology is not sufficiently detailed and, in a related order that also was issued on April 19, 2007, directed that hearings be held for the purpose of establishing a just and reasonable cost allocation methodology for inclusion in PJM’s tariff.

FERC’s orders on PJM rate design, if sustained on rehearing and appeal, will prevent the allocation of the cost of existing transmission facilities of other utilities to JCP&L, Met-Ed, and Penelec. In addition, the FERC’s decision to allocate the cost of new 500 kV and above transmission facilities on a PJM-wide basis will reduce future transmission costs shifting to the JCP&L, Met-Ed and Penelec zones.

On February 15, 2007, MISO filed documents with the FERC to establish a market-based, competitive ancillary services market. MISO contends that the filing will integrate operating reserves into MISO’s existing day-ahead and real-time settlements process, incorporate opportunity costs into these markets, address scarcity pricing through the implementation of a demand curve methodology, foster demand response in the provision of operating reserves, and provide for various efficiencies and optimization with regard to generation dispatch. The filing also proposes amendments to existing documents to provide for the transfer of balancing functions from existing local balancing authorities to MISO. MISO will then carry out this reliability function as the NERC-certified balancing authority for the MISO region with an implementation in the second or third quarter of 2008. FirstEnergy filed comments on March 23, 2007, supporting the ancillary service market in concept, but proposing certain changes in MISO’s proposal. MISO has requested FERC action on its filing by June 2007.

On February 16, 2007, the FERC issued a final rule that revises its decade-old open access transmission regulations and policies. The FERC explained that the final rule is intended to strengthen non-discriminatory access to the transmission grid, facilitate FERC enforcement, and provide for a more open and coordinated transmission planning process. The final rule will become effective on May 14, 2007. The final rule has not yet been fully evaluated to assess its impact on FirstEnergy’s operations. MISO, PJM and ATSI will be filing revised tariffs to comply with FERC’s order.

11. NEW ACCOUNTING STANDARDS AND INTERPRETATIONS

SFAS 159 - “The Fair Value Option for Financial Assets and Financial Liabilities - Including an amendment of FASB
Statement No. 115”

In February 2007, the FASB issued SFAS 159, which provides companies with an option to report selected financial assets and liabilities at fair value. The Standard requires companies to provide additional information that will help investors and other users of financial statements to more easily understand the effect of the company’s choice to use fair value on its earnings. The Standard also requires companies to display the fair value of those assets and liabilities for which the company has chosen to use fair value on the face of the balance sheet. This guidance does not eliminate disclosure requirements included in other accounting standards, including requirements for disclosures about fair value measurements included in SFAS 157 and SFAS 107. This Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those years. FirstEnergy is currently evaluating the impact of this Statement on its financial statements.

19



SFAS 157 - “Fair Value Measurements”

In September 2006, the FASB issued SFAS 157 that establishes how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under GAAP. This Statement addresses the need for increased consistency and comparability in fair value measurements and for expanded disclosures about fair value measurements. The key changes to current practice are: (1) the definition of fair value which focuses on an exit price rather than entry price; (2) the methods used to measure fair value such as emphasis that fair value is a market-based measurement, not an entity-specific measurement, as well as the inclusion of an adjustment for risk, restrictions and credit standing; and (3) the expanded disclosures about fair value measurements. This Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those years. FirstEnergy is currently evaluating the impact of this Statement on its financial statements.

EITF 06-10 - “Accounting for Deferred Compensation and Postretirement Benefit Aspects of Collateral
Split-Dollar Life Insurance Arrangements”

In March 2007, the EITF reached a final consensus on Issue 06-10 concluding that an employer should recognize a liability for the postretirement obligation associated with a collateral assignment split-dollar life insurance arrangement if, based on the substantive arrangement with the employee, the employer has agreed to maintain a life insurance policy during the employee’s retirement or provide the employee with a death benefit. The liability should be recognized in accordance with SFAS 106 if, in substance, a postretirement plan exists or APB 12 if the arrangement is, in substance, an individual deferred compensation contract. The EITF also reached a consensus that the employer should recognize and measure the associated asset on the basis of the terms of the collateral assignment arrangement. This pronouncement is effective for fiscal years beginning after December 15, 2007, including interim periods within those years. FirstEnergy does not expect this pronouncement to have a material impact on its financial statements.

12. SEGMENT INFORMATION

Effective January 1, 2007, FirstEnergy has three reportable operating segments: competitive energy services, energy delivery services and Ohio transitional generation services. None of the aggregate “Other” segments individually meet the criteria to be considered a reportable segment. The competitive energy services segment primarily consists of unregulated generation and commodity operations, including competitive electric sales, and generation sales to affiliated electric utilities. The energy delivery services segment consists of regulated transmission and distribution operations, including transition cost recovery, and PLR generation service for FirstEnergy’s Pennsylvania and New Jersey electric utility subsidiaries. The Ohio transitional generation services segment represents PLR generation service by FirstEnergy’s Ohio electric utility subsidiaries. “Other” primarily consists of telecommunications services and other non-core assets. The assets and revenues for the other business operations are below the quantifiable threshold for operating segments for separate disclosure as “reportable operating segments.”

The energy delivery services segment designs, constructs, operates and maintains FirstEnergy's regulated transmission and distribution systems and is responsible for the regulated generation commodity operations of FirstEnergy’s Pennsylvania and New Jersey electric utility subsidiaries. Its revenues are primarily derived from the delivery of electricity, cost recovery of regulatory assets and PLR electric generation sales to non-shopping customers in its Pennsylvania and New Jersey franchise areas. Its results reflect the commodity costs of securing electric generation from FES under partial requirements purchased power agreements and non-affiliated power suppliers as well as the net PJM transmission expenses related to the delivery of that generation load.

The competitive energy services segment supplies electric power to its electric utility affiliates, provides competitive electric sales primarily in Ohio, Pennsylvania, Maryland and Michigan and owns and operates FirstEnergy’s generating facilities and purchases electricity to meet its sales obligations. The segment's net income is primarily derived from the affiliated company power sales and the non-affiliated electric generation sales revenues less the related costs of electricity generation, including purchased power and net transmission (including congestion) and ancillary costs charged by PJM and MISO to deliver electricity to the segment’s customers. The segment’s internal revenues represent the affiliated company power sales.

The Ohio transitional generation services segment represents the regulated generation commodity operations of FirstEnergy’s Ohio electric utility subsidiaries. Its revenues are primarily derived from electric generation sales to non-shopping customers under the PLR obligations of the Ohio Companies. Its results reflect securing electric generation from the competitive energy services segment through full requirements PSA arrangements and the net MISO transmission revenues and expenses related to the delivery of that generation load.

20



Segment reporting in 2006 has been revised to conform to the current year business segment organization and operations. Changes in the current year operations reporting reflected in the revised 2006 segment reporting primarily reflects the transfer within FirstEnergy’s management and organization of the responsibility of obtaining PLR generation for the utilities for their non-shopping customers from FES to business units within the regulated utilities. This reflects FirstEnergy’s alignment of its business units to accommodate its retail strategy and participation in competitive electricity marketplaces in Ohio, Pennsylvania and New Jersey. The differentiation of the regulated generation commodity operations between the two regulated business segments recognizes that generation sourcing for the Ohio Companies is currently in a transitional state through 2008 as compared to the segregated commodity sourcing of their Pennsylvania and New Jersey utility affiliates. The results of the energy delivery services and the Ohio transitional generation services segments now include their electric generation revenues and the corresponding generation commodity costs under affiliated and non-affiliated purchased power arrangements and related net retail PJM/MISO transmission expenses associated with serving electricity load in their respective franchise areas.

FSG completed the sale of its five remaining subsidiaries in 2006. Its assets and results for 2006 are combined in the “Other” segments in this report, as the remaining business does not meet the criteria of a reportable segment. Interest expense on holding company debt and corporate support services revenues and expenses are included in "Reconciling Items."
 

Segment Financial Information
                         
           
Ohio
             
   
Energy
 
Competitive
 
Transitional
             
   
Delivery
 
Energy
 
Generation
     
Reconciling
     
Three Months Ended
 
Services
 
Services
 
Services
 
Other
 
Adjustments
 
Consolidated
 
   
(In millions)
 
March 31, 2007
                         
External revenues
 
$
2,040
 
$
328
 
$
619
 
$
12
 
$
(26
)
$
2,973
 
Internal revenues
   
-
   
714
   
-
   
-
   
(714
)
 
-
 
Total revenues
   
2,040
   
1,042
   
619
   
12
   
(740
)
 
2,973
 
Depreciation and amortization
   
220
   
51
   
(15
)
 
1
   
6
   
263
 
Investment income
   
70
   
3
   
1
   
-
   
(41
)
 
33
 
Net interest charges
   
107
   
49
   
1
   
2
   
21
   
180
 
Income taxes
   
148
   
65
   
15
   
5
   
(33
)
 
200
 
Net income
   
218
   
98
   
24
   
1
   
(51
)
 
290
 
Total assets
   
23,526
   
7,089
   
246
   
254
   
675
   
31,790
 
Total goodwill
   
5,874
   
24
   
-
   
-
   
-
   
5,898
 
Property additions
   
155
   
124
   
-
   
1
   
16
   
296
 
                                       
March 31, 2006
                                     
External revenues
 
$
1,796
 
$
355
 
$
543
 
$
28
 
$
(17
)
$
2,705
 
Internal revenues
   
9
   
611
   
-
   
-
   
(620
)
 
-
 
Total revenues
   
1,805
   
966
   
543
   
28
   
(637
)
 
2,705
 
Depreciation and amortization
   
258
   
46
   
(21
)
 
1
   
5
   
289
 
Investment income
   
84
   
15
   
-
   
-
   
(56
)
 
43
 
Net interest charges
   
99
   
44
   
-
   
1
   
16
   
160
 
Income taxes
   
126
   
21
   
20
   
(6
)
 
(26
)
 
135
 
Income from
                                     
continuing operations
   
189
   
32
   
30
   
12
   
(44
)
 
219
 
Discontinued operations
   
-
   
-
   
-
   
2
   
-
   
2
 
Net income
   
189
   
32
   
30
   
14
   
(44
)
 
221
 
Total assets
   
23,633
   
6,759
   
215
   
367
   
823
   
31,797
 
Total goodwill
   
5,916
   
24
   
-
   
-
   
-
   
5,940
 
Property additions
   
193
   
244
   
-
   
-
   
10
   
447
 

Reconciling adjustments to segment operating results from internal management reporting to consolidated external financial reporting primarily consist of interest expense related to holding company debt, corporate support services revenues and expenses, fuel marketing revenues (which are reflected as reductions to expenses for internal management reporting purposes) and elimination of intersegment transactions.



21


 
FIRSTENERGY CORP.
 
           
CONSOLIDATED STATEMENTS OF INCOME
 
(Unaudited)
 
           
   
Three Months Ended
 
   
March 31, 
 
   
2007 
 
2006 
 
   
(In millions, except per share amounts) 
 
REVENUES:
         
Electric utilities 
 
$
2,681
 
$
2,340
 
Unregulated businesses  
   
292
   
365
 
 Total revenues*
   
2,973
   
2,705
 
               
EXPENSES:
             
Fuel and purchased power  
   
1,121
   
998
 
Other operating expenses 
   
749
   
754
 
Provision for depreciation 
   
156
   
148
 
Amortization of regulatory assets 
   
251
   
221
 
Deferral of new regulatory assets 
   
(144
)
 
(80
)
General taxes 
   
203
   
193
 
 Total expenses
   
2,336
   
2,234
 
               
OPERATING INCOME
   
637
   
471
 
               
OTHER INCOME (EXPENSE):
             
Investment income 
   
33
   
43
 
Interest expense 
   
(185
)
 
(165
)
Capitalized interest 
   
5
   
7
 
Subsidiaries’ preferred stock dividends 
   
-
   
(2
)
 Total other expense
   
(147
)
 
(117
)
               
INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES
   
490
   
354
 
               
INCOME TAXES
   
200
   
135
 
               
INCOME FROM CONTINUING OPERATIONS
   
290
   
219
 
               
Discontinued operations (net of income tax benefit of $1 million)
             
(Note 3) 
   
-
   
2
 
               
NET INCOME
 
$
290
 
$
221
 
               
BASIC EARNINGS PER SHARE OF COMMON STOCK:
             
Income from continuing operations  
 
$
0.92
 
$
0.67
 
Discontinued operations (Note 3) 
   
-
   
-
 
Net income 
 
$
0.92
 
$
0.67
 
               
WEIGHTED AVERAGE NUMBER OF BASIC SHARES OUTSTANDING
   
314
   
329
 
               
DILUTED EARNINGS PER SHARE OF COMMON STOCK:
             
Income from continuing operations  
 
$
0.92
 
$
0.67
 
Discontinued operations (Note 3) 
   
-
   
-
 
Net income 
 
$
0.92
 
$
0.67
 
               
WEIGHTED AVERAGE NUMBER OF DILUTED SHARES OUTSTANDING
   
316
   
330
 
               
DIVIDENDS DECLARED PER SHARE OF COMMON STOCK
 
$
0.50
 
$
0.45
 
               
               
* Includes $104 million and $99 million of excise tax collections in the first quarter of 2007 and 2006, respectively.
 
               
The preceding Notes to Consolidated Financial Statements as they relate to FirstEnergy Corp. are an integral part of these statements.
 



 
22

 


FIRSTENERGY CORP.
 
           
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
 
(Unaudited)
 
           
   
Three Months Ended 
 
   
March 31, 
 
   
2007 
 
2006 
 
   
(In millions) 
 
           
NET INCOME
 
$
290
 
$
221
 
               
OTHER COMPREHENSIVE INCOME (LOSS):
             
Pension and other postretirement benefits 
   
(11
)
 
-
 
Unrealized gain on derivative hedges 
   
21
   
37
 
Unrealized gain on available for sale securities 
   
17
   
37
 
 Other comprehensive income
   
27
   
74
 
Income tax expense related to other comprehensive income 
   
9
   
27
 
 Other comprehensive income, net of tax
   
18
   
47
 
               
COMPREHENSIVE INCOME
 
$
308
 
$
268
 
               
               
The preceding Notes to Consolidated Financial Statements as they relate to FirstEnergy Corp. are an integral part of these statements.
 
 
 
23

 

FIRSTENERGY CORP.   
 
            
CONSOLIDATED BALANCE SHEETS  
 
(Unaudited)  
 
   
March 31, 
 
December 31, 
 
   
2007
 
2006
 
   
(In millions)
 
ASSETS
          
            
CURRENT ASSETS:
          
Cash and cash equivalents
 
$
89
 
$
90
 
Receivables-
             
Customers (less accumulated provisions of $40 million and
             
$43 million, respectively, for uncollectible accounts)
   
1,250
   
1,135
 
Other (less accumulated provisions of $23 million and
             
$24 million, respectively, for uncollectible accounts)
   
184
   
132
 
Materials and supplies, at average cost
   
591
   
577
 
Prepayments and other
   
233
   
149
 
     
2,347
   
2,083
 
PROPERTY, PLANT AND EQUIPMENT:
             
In service
   
24,223
   
24,105
 
Less - Accumulated provision for depreciation
   
10,191
   
10,055
 
     
14,032
   
14,050
 
Construction work in progress
   
754
   
617
 
     
14,786
   
14,667
 
INVESTMENTS:
             
Nuclear plant decommissioning trusts
   
2,008
   
1,977
 
Investments in lease obligation bonds
   
775
   
811
 
Other
   
742
   
746
 
     
3,525
   
3,534
 
DEFERRED CHARGES AND OTHER ASSETS:
             
Goodwill
   
5,898
   
5,898
 
Regulatory assets
   
4,371
   
4,441
 
Pension assets
   
277
   
-
 
Other
   
586
   
573
 
     
11,132
   
10,912
 
   
$
31,790
 
$
31,196
 
LIABILITIES AND CAPITALIZATION
             
               
CURRENT LIABILITIES:
             
Currently payable long-term debt
 
$
2,093
 
$
1,867
 
Short-term borrowings
   
2,247
   
1,108
 
Accounts payable
   
625
   
726
 
Accrued taxes
   
413
   
598
 
Other
   
1,020
   
956
 
     
6,398
   
5,255
 
CAPITALIZATION:
             
Common stockholders’ equity-
             
Common stock, $.10 par value, authorized 375,000,000 shares-
             
304,835,407 and 319,205,517 shares outstanding, respectively
   
30
   
32
 
Other paid-in capital
   
5,574
   
6,466
 
Accumulated other comprehensive loss
   
(241
)
 
(259
)
Retained earnings
   
2,941
   
2,806
 
Unallocated employee stock ownership plan common stock-
             
324,738 and 521,818 shares, respectively
   
(5
)
 
(10
)
Total common stockholders' equity
   
8,299
   
9,035
 
Long-term debt and other long-term obligations
   
8,546
   
8,535
 
     
16,845
   
17,570
 
NONCURRENT LIABILITIES:
             
Accumulated deferred income taxes
   
2,826
   
2,740
 
Asset retirement obligations
   
1,208
   
1,190
 
Power purchase contract loss liability
   
1,063
   
1,182
 
Retirement benefits
   
920
   
944
 
Lease market valuation liability
   
745
   
767
 
Other
   
1,785
   
1,548
 
     
8,547
   
8,371
 
COMMITMENTS, GUARANTEES AND CONTINGENCIES (Note 9)
             
   
$
31,790
 
$
31,196
 
               
The preceding Notes to Consolidated Financial Statements as they relate to FirstEnergy Corp. are an integral part of these balance sheets.
 
 
 
24

 

FIRSTENERGY CORP.
 
             
CONSOLIDATED STATEMENTS OF CASH FLOWS
 
(Unaudited)
 
             
   
Three Months Ended
 
   
March 31,  
 
   
2007
 
2006
 
   
(In millions)
 
             
CASH FLOWS FROM OPERATING ACTIVITIES:
           
Net income
 
$
290
 
$
221
 
Adjustments to reconcile net income to net cash from operating activities-
             
Provision for depreciation
   
156
   
148
 
Amortization of regulatory assets
   
251
   
222
 
Deferral of new regulatory assets
   
(144
)
 
(80
)
Nuclear fuel and lease amortization
   
26
   
20
 
Deferred purchased power and other costs
   
(116
)
 
(104
)
Deferred income taxes and investment tax credits, net
   
53
   
6
 
Investment impairment
   
5
   
-
 
Deferred rents and lease market valuation liability
   
(25
)
 
(38
)
Accrued compensation and retirement benefits
   
(65
)
 
(19
)
Commodity derivative transactions, net
   
1
   
26
 
Income from discontinued operations
   
-
   
(2
)
Cash collateral
   
6
   
(106
)
Pension trust contribution
   
(300
)
 
-
 
Decrease (Increase) in operating assets-
             
Receivables
   
(155
)
 
226
 
Materials and supplies
   
15
   
(52
)
Prepayments and other current assets
   
(74
)
 
(93
)
Increase (Decrease) in operating liabilities-
             
Accounts payable
   
(108
)
 
(114
)
Accrued taxes
   
73
   
9
 
Accrued interest
   
86
   
100
 
Electric service prepayment programs
   
(17
)
 
(14
)
Other
   
(33
)
 
(32
)
Net cash provided from (used for) operating activities
   
(75
)
 
324
 
               
CASH FLOWS FROM FINANCING ACTIVITIES:
             
New Financing-
             
Long-term debt
   
250
   
-
 
Short-term borrowings, net
   
1,139
   
200
 
Redemptions and Repayments-
             
Common stock
   
(891
)
 
-
 
Preferred stock
   
-
   
(30
)
Long-term debt
   
(13
)
 
(64
)
Net controlled disbursement activity
   
12
   
(8
)
Stock-based compensation tax benefit
   
8
   
-
 
Common stock dividend payments
   
(159
)
 
(148
)
Net cash provided from (used for) financing activities
   
346
   
(50
)
               
CASH FLOWS FROM INVESTING ACTIVITIES:
             
Property additions
   
(296
)
 
(447
)
Proceeds from asset sales
   
-
   
57
 
Proceeds from nuclear decommissioning trust fund sales
   
266
   
481
 
Investments in nuclear decommissioning trust funds
   
(269
)
 
(484
)
Cash investments
   
25
   
103
 
Other
   
2
   
(20
)
Net cash used for investing activities
   
(272
)
 
(310
)
               
Net decrease in cash and cash equivalents
   
(1
)
 
(36
)
Cash and cash equivalents at beginning of period
   
90
   
64
 
Cash and cash equivalents at end of period
 
$
89
 
$
28
 
               
               
The preceding Notes to Consolidated Financial Statements as they relate to FirstEnergy Corp. are an integral part of these statements.
 
 
 
25


 
Report of Independent Registered Public Accounting Firm









To the Stockholders and Board of
Directors of FirstEnergy Corp.:

We have reviewed the accompanying consolidated balance sheets of FirstEnergy Corp. and its subsidiaries as of March 31, 2007 and the related consolidated statements of income, comprehensive income and cash flows for each of the three-month periods ended March 31, 2007 and 2006. These interim financial statements are the responsibility of the Company’s management.

We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

Based on our review, we are not aware of any material modifications that should be made to the accompanying consolidated interim financial statements for them to be in conformity with accounting principles generally accepted in the United States of America.

We previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet as of December 31, 2006, and the related consolidated statements of income, capitalization, common stockholders’ equity, preferred stock and cash flows for the year then ended, management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006 and the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006; and in our report (which contained references to the Company’s change in its method of accounting for defined benefit pension and other postretirement benefit plans as of December 31, 2006 and conditional asset retirement obligations as of December 31, 2005, as discussed in Note 3, Note 2(K) and Note 12 to the consolidated financial statements) dated February 27, 2007, we expressed unqualified opinions thereon. The consolidated financial statements and management’s assessment of the effectiveness of internal control over financial reporting referred to above are not presented herein. In our opinion, the information set forth in the accompanying consolidated balance sheet information as of December 31, 2006, is fairly stated in all material respects in relation to the consolidated balance sheet from which it has been derived.




PricewaterhouseCoopers LLP
Cleveland, Ohio
May 8, 2007


26


FIRSTENERGY CORP.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS


EXECUTIVE SUMMARY

Net income in the first quarter of 2007 was $290 million, or basic and diluted earnings of $0.92 per share of common stock, compared with net income of $221 million, or basic and diluted earnings of $0.67 per share in the first quarter of 2006. The increase in FirstEnergy’s earnings was driven primarily by increased electric sales revenues, partially offset by higher fuel and purchase power costs.

Change in Basic Earnings Per Share From
Prior Year First Quarter
     
       
Basic Earnings Per Share - First Quarter 2006
 
$ 0.67
 
Revenues
 
0.51
 
Fuel and purchased power
 
(0.24)
 
Depreciation and amortization
 
(0.08)
 
Deferral of new regulatory assets
 
0.07
 
Other expenses
 
(0.05)
 
Saxton decommissioning regulatory asset
 
0.05
 
Trust securities impairment
 
(0.01)
 
Basic Earnings Per Share - First Quarter 2007
 
$ 0.92
 
       

Financial Matters

Share Repurchase Programs - On March 2, 2007, FirstEnergy repurchased approximately 14.4 million shares, or 4.5%, of its outstanding common stock under an accelerated share repurchase (ASR) agreement with an affiliate of Morgan Stanley & Co. Incorporated. The initial purchase price was approximately $900 million, or $62.63 per share. The final purchase price for this program will be adjusted to reflect the volume weighted average price of FirstEnergy’s common stock during the period of time that the bank will acquire shares to cover its short position, which is approximately one year. The ASR was completed under a January 30, 2007 Board of Directors authorization to repurchase up to 16 million shares of outstanding common stock.

On April 2, 2007, an affiliate of J.P. Morgan Securities completed its acquisition of shares under FirstEnergy’s prior ASR program of 10.6 million shares, which was executed in August 2006. In settling the transaction, FirstEnergy remitted approximately $27 million to J.P. Morgan as a final purchase price adjustment based on the average of the daily volume-weighted average price over the purchase period, as well as other purchase price adjustments.

Under the two ASR programs, FirstEnergy has repurchased approximately 25 million shares, or 8%, of the total shares outstanding as of July 2006.

Sale and Leaseback of Bruce Mansfield Unit 1 - On January 31, 2007, FirstEnergy announced its intention to pursue a sale and leaseback transaction for its owned portion (776 MW) of Bruce Mansfield Unit 1. FirstEnergy anticipates the after-tax proceeds of this proposed transaction to be approximately $1.2 billion. The proceeds are expected to be used to repay short-term borrowings incurred to fund the recently executed ASR program and the recent voluntary pension plan contribution. FirstEnergy is targeting a second quarter of 2007 closing for the transaction including related lease debt financing.

New Long-Term Debt Issuance - On March 27, 2007, CEI issued $250 million of 5.70% unsecured senior notes due 2017. The proceeds from the transaction were used to repay short-term borrowings and for general corporate purposes.

Credit Rating Agency Update - On March 26, 2007, S&P assigned its corporate credit rating of BBB to FES. Moody’s also issued a rating of Baa2 on FES on March 27, 2007. FES is the holding company of FirstEnergy Generation Corp. and FirstEnergy Nuclear Generation Corp., the owners of FirstEnergy’s fossil and nuclear generation assets, respectively. Both S&P and Moody’s cited the strength of FirstEnergy’s generation portfolio as a key contributor to the investment grade credit ratings.

27


Regulatory Matters

Ohio - On August 31, 2005, the PUCO approved a rider recovery mechanism through which the Ohio Companies may recover all MISO transmission and ancillary service related costs incurred during each year ending June 30. Pursuant to the PUCO’s order, the Ohio Companies, on May 1, 2007, filed revised riders which will automatically become effective on July 1, 2007. The revised riders represent an increase over the amounts collected through the 2006 riders of approximately $64 million annually.

During the period between May 1, 2007 and June 1, 2007, any party may raise issues related to the revised tariffs through an informal resolution process. If not adequately resolved through this process by June 30, 2007, any interested party may file a formal complaint with the PUCO which will be addressed by the PUCO after all parties have been heard. If at the conclusion of either the informal or formal process, adjustments are found to be necessary, such adjustments (with carrying costs) will be included in the Ohio Companies’ next rider filing which must be filed no later than May 1, 2008. No assurance can be given that such formal or informal proceedings will not be instituted.
 
On May 8, 2007, the Ohio Companies filed with the PUCO a notice of intent to file for an increase in electric distribution rates. The Ohio Companies intend to file the application and rate request with the PUCO on or after June 7, 2007. The requested $334 million increase is expected to be more than offset by the elimination or reduction of transition charges at the time the rates go into effect and would result in lowering the overall non-generation portion of the bill for most Ohio customers. The distribution rate increases reflect capital expenditures since the Ohio Companies’ last distribution rate proceedings, increases in operating and maintenance expenses and recovery of regulatory assets created by deferrals that were approved in prior cases. The new rates, subject to evidentiary hearings at the PUCO, would become effective January 1, 2009 for OE and TE, and May 2009 for CEI.

Pennsylvania - On January 11, 2007, the PPUC issued its order in the Met-Ed and Penelec 2006 comprehensive transition rate cases (see Note 10). Several parties to the proceeding, including Met-Ed and Penelec, have filed appeals with the Pennsylvania Commonwealth Court, which are currently pending.

A hearing was held February 21, 2007 in the Met-Ed and Penelec NUG accounting case. In this case, Met-Ed and Penelec are seeking to modify the NUG purchased power stranded costs accounting methodology to eliminate improper reductions of the deferred cost balance during periods in which market prices exceed NUG payments. The ALJ’s initial decision was issued on May 3, 2007 and denied Met-Ed's and Penelec’s request to modify their NUG stranded cost accounting methodology. The companies may file exceptions to the initial decision by May 22, 2007 and parties may reply to those exceptions 10 days thereafter. It is not known when the PPUC may issue a final decision in this matter.

On May 2, 2007, Penn made a filing with the PPUC proposing how it will procure the power supply needed for default service customers beginning June 1, 2008. Penn’s customers transitioned to a fully competitive market on January 1, 2007, and the default service plan that the PPUC previously approved covered a 17-month period through May 31, 2008. The filing proposes that Penn procure a full requirements product, by class, through multiple RFPs with staggered delivery periods extending through May 2011. It also proposes a 3-year phase-out of promotional generation rates. Penn expects the PPUC to address the filing later this year.
 
On February 1, 2007, the Governor of Pennsylvania proposed an Energy Independence Strategy (EIS). The EIS includes four pieces of proposed legislation that, according to the Governor, is designed to reduce energy costs, promote energy independence and stimulate the economy. Elements of the EIS include the installation of smart meters, funding for solar panels on residences and small businesses, conservation programs to meet demand growth, a requirement that electric distribution companies acquire power through a "Least Cost Portfolio", the utilization of micro-grids and an optional three year phase-in of rate increases. Since the EIS has only recently been proposed, the final form of any legislation is uncertain. Consequently, FirstEnergy is unable to predict what impact, if any, such legislation may have on its operations.
 
Generation

NRC Oversight Update - On March 2, 2007, the NRC returned FirstEnergy’s Perry Plant to routine agency oversight as a result of sufficient corrective actions that have been taken over the last two-and-one-half years. The Perry Plant had been operating under heightened NRC oversight since August 2004 (see Note 9).

Refueling Outage - FirstEnergy’s Perry Plant began its regularly scheduled refueling outage on April 2, 2007. Major work activities to be completed on the 1,258 MW facility include replacing approximately one-third of the fuel assemblies in the reactor and two of the three low-pressure turbine rotors in the main generator.

Power Uprates - In March 2007, Beaver Valley Unit 1 completed the final phase of an extended power uprate project to add additional capacity to FirstEnergy’s system. This is its second power uprate in the past 12 months. Capacity testing will be conducted later this year to verify the actual megawatts gained. This power uprate was achieved in support of FirstEnergy’s strategy to maximize the full potential of its existing generation assets.


28

 
Environmental Update - In March 2007, an SNCR system was placed in-service at FirstEnergy’s 597 MW Eastlake Unit 5, upon completion of a scheduled maintenance outage. The SNCR installation is part of FirstEnergy’s overall Air Quality Compliance Strategy and was required under the New Source Review consent decree. The SNCR is expected to reduce NOx emissions and help achieve reductions required by the EPA’s NOx Transport Rule.

FIRSTENERGY’S BUSINESS

FirstEnergy is a public utility holding company headquartered in Akron, Ohio, that operates primarily through three core business segments (see Results of Operations).

·  
Energy Delivery Services transmits and distributes electricity through FirstEnergy's eight utility operating companies, serving 4.5 million customers within 36,100 square miles of Ohio, Pennsylvania and New Jersey and purchases power for its PLR requirements in Pennsylvania and New Jersey. This business segment derives its revenues principally from the delivery of electricity within FirstEnergy’s service areas, cost recovery of regulatory assets and the sale of electric generation to non-shopping retail customers under the PLR obligations in its Pennsylvania and New Jersey franchise areas. Its results reflect the commodity costs of securing electric generation from the Competitive Energy Services Segment under partial requirements purchased power agreements with FES and non-affiliated power suppliers as well as the net PJM transmission expenses related to the delivery of that generation load.

·  
Competitive Energy Services supplies the electric power needs of end-use customers through retail and wholesale arrangements, including associated company power sales to meet all or a portion of the PLR requirements of FirstEnergy's Ohio and Pennsylvania utility subsidiaries and competitive retail sales to customers primarily in Ohio, Pennsylvania, Maryland and Michigan. This business segment owns and operates FirstEnergy's generating facilities and also purchases electricity to meet sales obligations. The segment's net income is primarily derived from the affiliated company power sales and the non-affiliated electric generation sales revenues less the related costs of electricity generation, including purchased power and net transmission (including congestion) and ancillary costs charged by PJM and MISO to deliver energy to the segment’s customers.

·  
Ohio Transitional Generation Services supplies the electric power needs of non-shopping customers under the PLR requirements of FirstEnergy's Ohio Companies. The segment's net income is primarily derived from electric generation sales revenues less the cost of power purchased from the competitive energy services segment through a full-requirements PSA arrangement with FES and net transmission (including congestion) and ancillary costs charged by MISO to deliver energy to its retail customers.

RESULTS OF OPERATIONS

The financial results discussed below include revenues and expenses from transactions among FirstEnergy's business segments. A reconciliation of segment financial results is provided in Note 12 to the consolidated financial statements. Net income by major business segment was as follows:

   
Three Months Ended
     
   
March 31,
 
Increase
 
   
2007
 
2006
 
(Decrease)
 
Net Income
 
(In millions, except per share data)
 
By Business Segment
             
Energy delivery services
 
$
218
 
$
189
 
$
29
 
Competitive energy services
   
98
   
32
   
66
 
Ohio transitional generation services
   
24
   
30
   
(6
)
Other and reconciling adjustments*
   
(50
)
 
(30
)
 
(20
)
Total
 
$
290
 
$
221
 
$
69
 
                     
Basic and Diluted Earnings Per Share
 
$
0.92
 
$
0.67
 
$
0.25
 

*Represents other operating segments and reconciling items including interest expense on holding company debt and
  corporate support services revenues and expenses.

Net income in the first quarter of 2006 included after-tax earnings from discontinued operations of $2 million resulting from FirstEnergy’s disposition of non-core assets and operations (see Note 3).

29