Fitch Affirms PEPCO Holdings & Subsidiaries; Outlook Remains Negative.

NEW YORK -- Fitch Ratings has affirmed the senior unsecured debt rating of PEPCO Holdings (PHI) at 'BBB', along with the ratings of PHI's subsidiaries as outlined below. The Rating Outlook remains Negative.

PHI's Negative Rating Outlook reflects the company's relatively weak consolidated credit measures. PHI has reduced consolidated debt, trust preferred and preferred securities during 2003-2004 through a combination of internally generated cash, asset sales and equity issuance, and is committed to further reducing debt over the next several years. Nonetheless, PHI's 2004 adjusted parent debt leverage of 4.6 times (x) still exceeds Fitch's target of 3.6x for the 'BBB' rating category. Operations of PHI's principal subsidiaries are satisfactory, and cash flow from operations is likely to be stable over the next several years.

However, PHI is exposed to event risk from two sources that cloud the improvement in leverage over the next couple of years. One is a prospective material cash flow reduction at Potomac Electric Power Co. (PEPCO) if Mirant Corp. ultimately succeeds in rejecting certain power purchase agreement (PPA) related obligations. A more recent development is the announcement of an investigation by the Internal Revenue Service (IRS) of tax benefits PHI has claimed from Potomac Capital Investment's (PCI) portfolio of cross-border energy leases. These two matters could remain unresolved for an extended period, creating ongoing uncertainty. Fitch notes, however, that PHI's financial liquidity adequately covers the possibility of adverse outcomes on both matters.

PHI has formally received an IRS letter challenging PHI's 2001-2002 tax position on its lease investments. PHI has disclosed that tax benefits claimed by PCI from 2001 through the first quarter of 2005 totaled $189 million, though PHI could also be subject to additional taxes, interest and penalties, if the IRS were to prevail. The timing of any potential payout by PCI is uncertain and litigation related to these tax benefits could drag on for several years.

A long-simmering dispute relates to Mirant's attempts during bankruptcy proceedings to default on two 'back-to-back' agreements that require Mirant to purchase power from PEPCO at prices significantly above current forward market prices. PEPCO's avenues of recourse are to fight the rejection in court, and, if unsuccessful, to pursue a claim as an unsecured creditor in Mirant's bankruptcy proceedings; finally, PEPCO would seek recovery of any remaining balance from utility ratepayers.

Fitch notes that several district court decisions in recent months have favored PEPCO. In December 2004, a U.S. district ruled that MIR couldn't reject the 'back-to-backs' because these agreements could not be separated from the original asset sale agreement under which PEPCO sold its generating assets to MIR. This decision has been appealed by MIR. More recently, in April 2005, the same district court ordered MIR to continue payments to PEPCO under the back-to-backs pending the outcome of litigation. Irrespective of the outcome in the appeals court, either party is likely to attempt to appeal the case before the U.S. Supreme Court. Fitch views the likelihood of significant recovery of additional costs related to these two obligations in bankruptcy court or from ratepayers as reasonable, though the probable lag of such recovery could pressure cash flows and slow PHI's debt reduction.

PHI's current ratings are supported by the stable cash flows generated by its three regulated electric distribution subsidiaries (accounting for over 70% of EBITDA) and ample system liquidity, combined with the higher risk profile of the non-regulated generation and marketing subsidiaries. Competitive power generation and energy marketing are conducted primarily through CEH, which owns approximately 3,700 MW of efficient gas-fired 'mid-merit' generating assets in the PJM East region. Financial performance at CEH improved during 2004 compared to 2003 as a result of more favorable weather conditions, greater plant dispatch and improved spark spreads. CEH substantially hedges its sales and fuel inputs for one to three years forward. However, CEH's gas-fired generating portfolio is sensitive to commodity prices and regional spark spread levels. A continuation of high natural gas prices could prove challenging, at least in the near-term.

The rating affirmations of PEPCO, Atlantic City Electric Co., and Delmarva Power & Light Co. reflect each utility's stable cash flows and solid individual financial performance's. PCI's rating reflects PHI's unconditional guarantee of its debt. The Negative Rating Outlook for PEPCO, Conectiv and DPL reflect Fitch's notching policy on subsidiary and parent rating linkage. A further downgrade of their parent, PHI, would adversely affect the ratings of these subsidiaries.

The achievement of significant parent level debt reduction and a resulting improvement in credit measures could lead to a positive rating action. PHI's cash flow could be positively impacted during the next couple of years by the expiration of the distribution rate caps in Maryland and Delaware during 2006 and D.C. in 2007. Both PEPCO and DPL will have the opportunity to file for base rate increases. A continuation of high debt leverage relative to cash flow could result in a negative rating action.

Fitch affirms the following ratings with a Negative Rating Outlook:

Pepco Holdings, Inc.

-- Senior unsecured debt 'BBB';

-- Commercial paper 'F2'.

Potomac Capital Investment Corp. (Guaranteed by PEPCO Holdings, Inc.)

-- Senior unsecured debt 'BBB'.

Potomac Electric Power Co.

-- Senior secured 'A';

-- Senior unsecured 'A-';

-- Preferred stock 'BBB+';

-- Commercial paper 'F1'.

Delmarva Power and Light Co.

-- Senior secured 'A';

-- Senior unsecured 'A-';

-- Preferred stock 'BBB+';

-- Commercial paper 'F1'.

Conectiv

-- Senior unsecured 'BBB+'.

Fitch also affirms the following ratings with a Stable Outlook:

Atlantic City Electric Co.

-- Senior secured 'A-';

-- Senior unsecured 'BBB+';

-- Preferred stock 'BBB';

-- Commercial paper 'F2'.