I am pleased to share with you this report on American Electric Power’s 2014 performance, our plans for 2015, and our vision and strategy for the future. Our company and our industry continue to undergo fundamental change. The catalyst for this transformation includes new environmental regulations, evolving customer needs, changing markets, new technologies and the need to produce electricity from a more balanced set of generation resources. In the future, our investments will be more focused on natural gas, renewables and energy efficiency, as well as optimizing the grid around transmission. The utility that powers the future will operate a modern grid that supplies two-way flows of power and information, is adaptable, flexible and reliable. This is a challenging but exciting time for our company and our industry, and I am confident in our ability to respond as we strive to build a more prosperous future.
The transition we are undergoing creates many new opportunities for AEP. To provide greater reliability and efficiency to offset the retirement of generating capacity, we are investing significant capital in our transmission business unit. Transmission is a key to achieving the flexibility needed to enable expanded use of renewable resources and the resiliency that a modern grid needs. In addition, as the availability and use of natural gas to generate power continues to grow, more electric transmission capacity will be needed. Our view is that as new technologies emerge and customer needs evolve, the grid will need to work more like a technology integration network.
To prepare for this, we are investing in technologies to optimize the use of data to improve service to our customers. We know that many customers prefer to communicate with us electronically. Taking that a step further, we are working on ways to use technology to digitize more of the interactions we have with customers, making it easier for them to do business with us. We are also working to create a data hub, allowing us to securely and responsibly store and analyze the data we collect from smart meters and distribution equipment to better anticipate and serve customers’ needs. In addition, we will explore how predictive analytics could help us determine where a storm will strike and estimate the damage, so we can notify customers in advance and efficiently mobilize resources to restore power afterward. These are examples of how AEP is preparing the electric grid to power the future.
We believe the industry should focus its resources on those technologies with the greatest promise, rather than investing in small advances in a large number of technologies. As the electric grid evolves and new technologies mature or emerge, policymakers should avoid picking winners and losers and allow the market to identify the best solutions.
When major changes are made to the electric grid, as are happening today, we need to take the time to assess, plan and respond appropriately if we are to protect the grid’s reliability and ensure this essential service remains affordable. This is especially true as we retire more than 6,500 MW of coal-fueled generating assets starting in 2015. The risks include the possibility of not being able to adequately support electric reliability, especially during extreme weather events, when our families, businesses and communities need it most. Although we are upgrading and building vital new transmission infrastructure at an unprecedented rate and increasing our use of wind, solar and natural gas, we must make these changes in a thoughtful and deliberate way to ensure the electric grid continues to operate safely and reliably for our economy and our way of life.
As these issues are debated, we are educating our customers about the impacts of regulatory mandates and state laws, and helping to create options and opportunities so that their voices can be heard. We are also working to ensure that regulators and policymakers have all the facts as they make important decisions about our nation’s energy future.
To become the utility that the future demands, we must also continue to enhance and improve the reliability, connectivity and resiliency of the grid. Our ongoing responsibility is to make sure our service is available wherever and whenever it is needed or wanted. While that responsibility won’t change, the way we do it will continue to evolve.
We believe that our investments in infrastructure and in our employees, our focus on enhancing the customer experience, our commitment to continuous improvement and our fiscal discipline provide a solid foundation for building a sustainable model of the utility of the future.
- Our Employees and Our Culture Lead Us Forward
AEP’s culture is shaped by our focus on workplace safety, customer satisfaction and our employees’ strong desire to contribute to the company’s success. Our performance is driven by hard working, highly skilled and deeply committed employees. Employee engagement is a leading indicator of better business results and our 18,529 employees consistently demonstrate this value to AEP.
Our employees have taken the lead to find and implement “LEAN” initiatives and other process improvements to reduce costs, improve efficiency and, in some cases, generate revenue. For example, our five Transmission Dispatch Centers collectively achieved a 99.9992 percent switching accuracy in 2014. Switching requires the energizing or de-energizing of equipment in a specific sequence in order to safely route the flow of power. Such an accuracy rate improves safety, saves time and money, and can only be attained by the concerted, collaborative and sustained effort of engaged employees who care deeply about performance and each other.
We believe that our culture is a critical element of our future success. In 2014, we conducted our second culture survey to gauge our progress. It revealed that our culture has changed for the better and that our focus on zero harm is our strongest culture attribute. Employee safety has been a foundation of our culture for many years and has become a source of pride and inspiration to our entire organization.
While there is still work to do, this is a journey and we have both a firm foundation and the commitment needed to move forward. We plan to conduct another survey in 2015 to keep the momentum going.
Although we had a very good year from a financial standpoint, our most important achievement was related to the safety of our people. For the first time since we began keeping statistics in 1970, we have gone three consecutive years without an employee fatality. I am profoundly grateful to everyone in our organization for helping us reach this important milestone. Our approach to workplace safety and health is about mutual care. Reaching top decile in performance requires a focused commitment, planning, thinking ahead and looking out for each other – and that’s our goal.
During the past decade we have achieved a positive, downward trend in the number and severity of injuries occurring in the workplace. But we are still a long way from achieving our goal of zero harm. The number and overall severity of injuries in 2014 increased, with slips, trips, falls and overexertion as the leading causes of injury and lost time or restricted duty work days. We take the approach that every injury can be avoided. We treat each injury, no matter how small, as if it could have been more severe and as if it were the beginning of an alarming trend. We will improve on safety and health, and be relentless in our drive to prevent any and all harm. We are doing it by engaging our employees to identify solutions to help us achieve our goals.
We reached another important employee milestone in 2014. For the first time in our history, AEP negotiated a multi-year collective bargaining agreement with our largest union, the International Brotherhood of Electrical Workers, which was ratified in early 2015. With a three-year agreement in place, we are committed to strengthening our relationships with union leaders and employees in order to meet our business goals. We are also working to negotiate multi-year contracts with our four remaining unions throughout 2015.
AEP was again named as one of Fortune magazine’s 2015 World’s Most Admired Companies in the electric and gas utilities sector. In April 2015, AEP was also ranked as America’s eighth most trustworthy large cap company by GMI Ratings, now part of MSCI ESG Research. This list recognizes companies for transparent accounting practices and strong governance, both of which are key areas of focus from our board of directors to all of our employees. We are pleased to be honored for our work providing safe, reliable and affordable electricity to our customers, and financial rewards to our investors. Our success is due to the talented men and women of AEP and we are working hard to give them a culture and workplace where they can continue to thrive.
- Financial Performance
We achieved solid financial results in 2014 that validated our earnings growth strategy. Our focus on infrastructure investments in our core, regulated businesses, and the identification of process improvements delivered significant value for our customers and investors. Our year-end share price was $60.72, putting us in the top five best-performing utility stocks in 2014 with a total shareholder return of 35 percent, exceeding both the S&P 500 Electric Utilities Index total return of 31 percent, and the S&P 500 total return of nearly 14 percent. We also increased our annual dividend by 6 percent on an annual basis.
Our positive financial performance reflects a strong balance sheet, solid credit metrics and adequate liquidity. Our debt-to-capitalization ratio remained steady, ending the year at 54.4 percent.
We ended 2014 with Generally Accepted Accounting Principles (GAAP) earnings of $1.63 billion or $3.34 per share, compared with $1.48 billion or $3.04 per share in 2013. Operating earnings were $1.67 billion or $3.43 per share, compared with $1.57 billion or $3.23 per share in 2013. Operating earnings were higher than GAAP earnings primarily due to the termination of a long-term coal contract. Despite mild summer temperatures in 2014, our financial results were strong, driven largely by record cold winter weather that drove up sales and the reliable, steady operation of our system to meet that energy demand.
In 2014, AEP Transmission Holding Company contributed 31 cents per share, exceeding our expectations by 2 cents per share, and grew net plant assets by approximately $1.1 billion to $2.7 billion, an increase of 65 percent.
Several additional factors contributed to our performance – successful regulatory proceedings in several states; an increase in off-system sales, driven largely by strong performance during extreme cold weather events; accelerated growth of our transmission business, which exceeded earnings expectations; positive overall load growth; and cost savings and enhanced revenue sources identified through employee-led continuous improvement efforts.
In addition to our strong performance, we are proud that we were able to continue our 108-year history of paying a quarterly dividend to our investors.
- Operational Performance and Challenges
We provide a vital service that is essential to the nation’s health, welfare, security and economy. This is both a great honor and a great responsibility.
During the winters of 2014 and 2015, extreme weather events tested the capacity and reliability of the grid. We are likely to face more challenges ahead when about 20 percent of the nation’s coal-fueled generating capacity will be retired between 2010 and 2022. During these harsh weather events, most of AEP’s coal-fueled plants that will be retired in mid-2015 were providing power, keeping businesses running and homes warm and safe.
With the retirement of these units, the performance of the transmission system and other generating technologies will be more critical to maintaining grid reliability. In the PJM Interconnection region alone, an estimated $3 billion will be invested by utilities, including AEP, to maintain reliability.
In addition to compensating for major changes in the location of generating resources, transmission system growth enables other renewable resources to come online, such as wind and solar energy, which are important to a balanced resource portfolio. Our efforts to expand our renewable portfolio as well as our plans to build utility-scale solar in Indiana and large solar projects with two universities, will broaden our experience in deploying, owning and operating these renewable power assets.
The flawed capacity market in the PJM Interconnection does not adequately incentivize generators to invest in new or replacement capacity, especially in Ohio where generation is deregulated. The retirement of coal units creates more reliability risk if adequate new generation resources are not developed in a timely manner. The 2013 PJM capacity auction set prices for the 2016-2017 period 56 percent lower than in the previous auction. This decline in prices, however, does not reflect the value that generating capacity provides to the grid.
The PJM capacity market structure creates significant financial risk for generators, including AEP, and must be fixed. AEP formed a coalition with several generation owners, utilities and electric cooperatives in 2013 to work with PJM to do so. We believe the capacity auction, which is a forward looking auction, should create long-term price signals for energy resources and must compensate generators appropriately for their investments in generating capacity. The current rules encourage volatility and speculation. PJM has made or proposed several changes, but we believe more changes are necessary to encourage the type of investment that is really needed.
Our operating companies are committed to providing reliable, affordable service to our customers. Unfortunately, in 2014, we experienced increases in the frequency and duration of service disruptions. Other than weather, aging infrastructure and vegetation continue to be main causes. We work with state regulators to implement vegetation management programs and gain support for investments to replace older equipment. However, significant additional investment is required if we are to make improvements needed to meet new regulatory requirements and customer needs.
Aging infrastructure is not unique to AEP, but in 2014, the impact that aging infrastructure can potentially have on us became clear. Disruptions occurred at three of our 16 underground networks in three states. We are planning to invest more than $300 million between 2014 and 2018 to upgrade and enhance these networks. We are also installing an underground monitoring system to give us greater monitoring capability to prevent such failures in the future.
Another challenge we face as a company and an industry is the need to prepare our work force for the future. As more employees approach retirement age, we are taking steps now to fill the talent gap that will develop as a result. Our business units are preparing comprehensive staffing plans that evaluate our needs and form the basis for action plans. When we hire new employees, we actively recruit military veterans because they have many of the technical skills we need. We work towards providing a diverse slate of candidates to hiring managers because diversity in our work force brings new and fresh perspectives, ideas and views that strengthen our ability to strategize, communicate and deliver results.
- Environmental Performance
Overall, our environmental performance is excellent and we continuously work to improve it.
Our Environmental Performance Index, which measures spills, opacity and water quality permit compliance in our generation business, achieved its best performance since the index was created in 2003. This index is not required for compliance but serves as a measure that helps us continuously improve our environmental performance. In 2014 we received one formal enforcement action for storm water runoff issues at the Dolet Hills Mine in Louisiana and took remedial actions to address these issues and improve performance.
Environmental performance and stewardship are important in every one of our business units. AEP’s River Operations business unit achieved a significant milestone in January 2015, when it recorded two calendar years without a single environmental spill to the water. This achievement earned this business unit the U.S. Coast Guard’s Rear Admiral William M. Benkert Silver Award for Environmental Excellence in 2014.
- Climate Change
Our position on climate change has not changed; we believe it is a global issue. AEP is a much less carbon intensive company today than a decade ago and, as we retire coal units, that trend will continue. We factor the potential impacts of carbon policies and regulations into our long-range planning processes. We strongly believe that any policy or regulation to reduce carbon emissions must be rational in terms of timing, scope and reduction targets. Absent that, the economy as well as the reliability of the electric grid, is at risk.
We believe the EPA’s proposed Clean Power Plan (CPP), designed to decrease carbon in the electric sector, unnecessarily threatens the reliability and stability of the electric grid. The proposed regulation, expected to be finalized in 2015, relies on inaccurate data and flawed technical and legal assumptions in calculating an estimated 30 percent reduction in electric sector carbon emissions. In addition, the proposal does not give credit to companies and states that have already achieved significant CO2 emission reductions. In AEP’s case, we have achieved a 15 percent reduction in carbon emissions since 2005 that unfairly would not be credited under the proposed regulation.
In the next two years, we will have fewer emissions when approximately one-quarter of our coal-fueled generating fleet is retired. Additional retirements that could be imposed by the CPP would further jeopardize the reliability of the electric grid. We conducted a reliability model of the CPP on our transmission system in PJM, using an EPA scenario. The results were alarming – a grid so stressed that it resulted in widespread voltage collapses, cascading outages, and brownouts and blackouts. That is why we are advocating for a thorough reliability assessment of the rule’s impact on the electric grid. These concerns have been echoed by a number of regional transmission operators and independent system operators.
The CPP requires states to develop implementation plans and sets 2020 interim targets for compliance which we believe will be impossible to achieve while maintaining grid reliability. States need more time and flexibility to develop and implement compliance plans that make sense for their resource mix and local economies. Utilities need more time to build transmission lines, natural gas pipelines and new generation facilities that will be needed to maintain reliability of the grid.
We will continue to advocate for more extensive reliability analysis and a more flexible and realistic plan that includes all regional transmission operators.
- Grid Data and Security
The constant threat of cyber and physical security attacks against the electric grid continues to be of significant concern to AEP and our industry. High profile breaches in the financial, health care and entertainment industries, as well as in our industry, highlight the risk. Although our major focus is on protecting the grid and our facilities, we also engage and train our employees to become protectors of critical infrastructure information and observers to help us recognize potential threats.
We aggressively protect the grid and important physical assets, such as substations, by investing in cyber and physical security measures, providing training to our employees, working with industry peers at all levels of government, and requiring cyber security measures of our suppliers to help us protect our systems. AEP also participates in drills with other stakeholders, including government agencies, to enhance our measures for prevention, detection and recovery actions to respond to emerging threats.
- 2015 and Beyond
When I reflect on our success in 2014 and early 2015 and consider the future, I am confident in our employees and their ability to execute on our strategy. We are prepared to take advantage of the transformation that is taking place in our industry and with the electric grid. The shale gas industry, for example, should continue to provide growth opportunities for AEP. In addition to an aging infrastructure and the retirement of coal-fueled generating assets, the demand for transmission to serve this industry is one of the key drivers behind new infrastructure investments in 2014 and is expected to continue in 2015 and beyond.
Our path forward is clear and challenging. Deregulation in Ohio and the weak results in the 2016-2018 PJM capacity market pose financial challenges for AEP, especially in 2016. We will continue our disciplined approach to allocating capital, controlling costs and working through regulatory proceedings to improve customer service and strengthen our financial position. We project an operating earnings range of $3.40 to $3.60 per share in 2015 and $3.45 to $3.85 per share in 2016. Transmission will continue to be an important contributor and is expected to contribute 38 cents per share in 2015.
We will continue to expand our ability to leverage data and technology to improve our service to customers as well as to make smart investments that allow a smooth integration of distributed resources with the grid. We will stay focused on executing our plan to maintain our earnings growth beyond 2016. Our employee-led continuous improvement efforts, already successful, will be critical as we move forward.
- Continue Our Focus on Safety
We are intensifying our focus on safety and health to reduce the number and severity of injuries, with particular attention on slips, trips, falls and overexertion. The safety and health of our employees, contractors and the public is a priority for AEP. We were saddened when two contractors working on AEP’s behalf were fatally injured in 2014. We will continue to provide the tools, training, education and information needed to prevent harm on all fronts and strengthen our culture of looking out for each other.
- Transitioning Our Fleet
2015 will mark a significant milestone in AEP’s 108-year history as we begin to retire approximately 6,500 MW of coal-fueled generation in response to new environmental regulations. These units have provided reliable, affordable power to millions of customers for decades. They have also provided well-paying jobs, supported local economic growth and public services, such as education and public safety, and have been deeply involved with their local communities. We are proud of the contributions we have made over the years in these communities, but the transition we are undergoing has become a necessary reality as our generation fleet changes.
The more than 450 employees affected by these retirements have been a priority for AEP. In anticipation of the retirements, we formed a plant decommissioning team two years ago to work with affected employees and prepare detailed plans to ensure the plants are closed safely and have long-term environmental compliance monitoring plans in place.
We worked hard to find these employees other jobs within AEP and to provide support as they transitioned into new roles. We are proud of every employee in those plants who came to work every day, committed to running the plants safely and efficiently to keep the lights on for our customers.
We will continue to diversify our generation resources. We are increasing our use of natural gas and we continue to cost-effectively increase our renewable portfolio. For example, in 2014, we began converting units at the Big Sandy and Clinch River plants from coal to natural gas and we achieved our highest level of renewable resources on our system. We now have 2,183 MW of wind energy and 10 MW of solar, serving customers across our system. In 2015, Indiana Michigan Power Company received approval to build a utility-scale solar project totaling 15.7 MW. This project, in addition to two others with The Ohio State University and Denison University, will give us valuable experience in deploying, owning and operating utility-scale solar. Our renewable portfolio will continue to grow to meet the individual needs of each of our operating companies and support the resource choices our customers tell us they want.
- An Advocate for Engagement Leaves Us
On a more personal note, AEP lost a good friend and leader in 2014 with the death of former AEP board member Robert Fri. Bob served on our board from 1995–2008 and was a champion of transparency and stakeholder engagement. In 2004, when investors asked for more transparency about how the company planned to manage its emissions risk, Bob led a team that included board members, AEP experts and external stakeholders. They released a ground-breaking board report that was a catalyst for our current level of commitment to performance reporting and stakeholder engagement. In addition to his board service to AEP, Bob was a former deputy director of the U.S. Environmental Protection Agency and of the Energy Research and Development Administration. He was 78 years old.
- The Utility of the Future
Advanced technology will be critical as the grid is required to handle more distributed generation and smarter appliances, as well as customers who demand greater flexibility and more information. To protect our economic and national security, the grid must become more reliable and resilient. We will continue to advocate for policies that allow technologies to mature while ensuring those who use the grid pay their share of the costs to maintain the grid.
To prepare for the future, we are participating in research and development of an integrated grid through the Electric Power Research Institute and through an association with a venture capital firm that invests in alternative and developing energy technologies. In addition, AEP led the industry in research to better connect and manage those connections between regional transmission systems, setting us on the path to improved connectivity. Through these efforts and others, we are learning as much as possible about evolving technologies, such as energy storage and micro grids.
The transition of our generation resources, the investments we are making in transmission and distribution to prepare the grid for the future and a culture of innovation among our employees are essential. Innovation, optimization of resources and agility will win the day for the utility of the future.
One thing that will remain constant is that our future will depend on the skills and qualities of our current and future employees. AEP and the AEP Foundation are investing in STEM education (science, technology, engineering, mathematics) for middle and high school students to help develop the skills they, and industries like ours, will need. Through the AEP Foundation, we created the Credits CountSM program to help fill in learning gaps, eliminate barriers to higher education and put students on the path for a college education while they complete high school. By graduation, students may earn credits that count toward a STEM-related certificate or college degree. The Foundation has now established Credits Count programs in Columbus, Ohio; Tulsa, Oklahoma; and Bossier City, Louisiana, all of which are in our service territory. So far, the Foundation has committed nearly $10 million over multiple years for Credits Count.
I am confident that we are on the right path for sustainable growth, and I believe our investors agree. We are adapting to the changing environment around us by leveraging our strengths as a regulated electric utility and engaging our employees to grow our business sustainably. As we redefine AEP’s future, our culture of safety, customer commitment, engagement, technology innovation and entrepreneurship give us every reason to believe that we will succeed.
Nicholas K. Akins
Chairman, President & Chief Executive Officer
American Electric Power