Nstar Electric Co: Form 10-Q for the period ended Sep 30, 2011

The accompanying MD&A focuses on factors that had a material effect on the financial condition, results of operations, and cash flows of NSTAR Electric during the periods presented and should be read in conjunction with the accompanying condensed consolidated financial statements and related notes, and with the MD&A in NSTAR Electric’s 2010 Annual Report on Form 10-K.

Pending Merger with Northeast Utilities

On October 16, 2010, upon unanimous approval from their respective Boards of Trustees, NSTAR and Northeast Utilities (NU) entered into an Agreement and Plan of Merger (the Merger Agreement). The transaction will be a merger of equals in a stock-for-stock transfer. Upon the terms and subject to the conditions set forth in the Merger Agreement, at closing, NSTAR will become a wholly-owned subsidiary of NU. On March 4, 2011, shareholders of each company approved the merger and adopted the merger agreement. Under the terms of the agreement, NSTAR shareholders will receive 1.312 NU common shares for each NSTAR common share that they own. Following completion of the merger, it is anticipated that NU shareholders will own approximately 56 percent of the post-transaction company and former NSTAR shareholders will own approximately 44 percent of the post-transaction company.

The post-transaction company will provide electric and gas energy delivery services through six regulated electric and gas utilities in Connecticut, Massachusetts and New Hampshire serving nearly 3.5 million electric and gas customers. Completion of the merger is subject to various customary conditions, including receipt of required regulatory approvals. NSTAR believes that the merger can be completed in 2011, but it is possible that the closing of the merger may be delayed to early 2012. Acting pursuant to the terms of the Merger Agreement, on October 14, 2011, NU and NSTAR formally extended the date by which either party has the right to terminate the Merger Agreement should all required closing conditions not be satisfied, including receipt of all required regulatory approvals, from October 16, 2011 to April 16, 2012.

Regulatory Approvals on Pending Merger with Northeast Utilities

Federal

On January 4, 2011, NSTAR and NU received approval from the Federal Communications Commission, and on February 10, 2011, the applicable Hart-Scott-Rodino waiting period expired. On July 6, 2011, NSTAR and NU received approval from the Federal Energy Regulatory Commission (FERC). A filing was made with the Nuclear Regulatory Commission (NRC) on December 9, 2010 seeking NRC consent to the transfer of NSTAR’s indirect control of ownership interest in three decommissioned nuclear plants to NU. The NRC held a public meeting on September 20, 2011 at which time the NRC indicated it would complete its review by the end of November 2011. NRC consent is currently pending.

Massachusetts

On November 24, 2010, NSTAR and NU (the Joint Petitioners) filed a joint petition requesting the DPU’s approval of their proposed merger. On March 10, 2011, the DPU issued an order that modified the standard of review to be applied in the review of mergers involving Massachusetts utilities from a “no net harm” standard to a “net benefits” standard, meaning that the companies must demonstrate that the pending transaction provides benefits that outweigh the costs. Applicable state law provides that mergers of Massachusetts utilities and their respective holding companies must be “consistent with the public interest.” The order states that the DPU has flexibility in applying the factors applicable to the standard of review. NSTAR and NU filed supplemental testimony with the DPU on April 8, 2011 indicating the merger could provide post-transaction net savings of approximately $784 million in the first ten years following the closing of the merger and provide environmental benefits with respect to Massachusetts emissions reductions, global warming policies, and furthering the goals of Massachusetts’ Green Communities Act.

The DPU held public evidentiary hearings during July 2011. Upon conclusion of the public evidentiary hearings on July 28, 2011, the DPU issued a briefing schedule that arranged for a series of intervenor and Joint Petitioner briefs and reply briefs culminating in the delivery of the final Joint Petitioner reply briefs on September 19, 2011. Subsequently, the Joint Petitioners have agreed to different intervenor motions to extend the briefing schedule, and the DPU consented to these motions. The final Joint Petitioner reply briefs were filed on October 31, 2011.

On July 15, 2011, the Massachusetts Department of Energy Resources (DOER) filed a motion for an indefinite stay in the proceedings. On July 21, 2011, NSTAR and NU filed a response objecting to this motion. The DPU has scheduled Oral Arguments for November 17, 2011 regarding the DOER’s Motion to Stay the proceeding, at which time the Joint Petitioners and intervenors will be allowed the opportunity for oral argument of their positions regarding the Motion to Stay.

The Joint Petitioners have provided extensive information in the DPU proceeding including testimony, exhibits and submission of detailed written responses to nearly 1,000 information requests from the DPU and intervenors.

Connecticut

On June 1, 2011, the Connecticut Public Utilities Regulatory Authority (PURA), formerly the Connecticut Department of Public Utility Control (DPUC), issued a decision stating that it lacks jurisdiction to consider the NSTAR merger with NU. On June 30, 2011, the Connecticut Office of Consumer Counsel filed a Petition for Administrative Appeal in Connecticut Superior Court requesting that the Superior Court remand the decision back to the DPUC with instructions to reopen the docket and review the merger transaction. NSTAR cannot determine the outcome or timing of this action.

New Hampshire

On April 5, 2011, the New Hampshire Public Utilities Commission (NHPUC) issued an order finding that it does not have statutory authority to approve or reject the merger.

Maine

On May 11, 2011, the Maine Public Utilities Commission issued an order approving the merger contingent upon approval by the FERC. The FERC approval was received on July 6, 2011.

Recent Major Storm Events and Service Restoration

In late August 2011, Tropical Storm Irene (Irene) presented a severe weather event of heavy rains and damaging winds to Massachusetts and the Eastern Seaboard. Irene caused considerable damage in NSTAR Electric’s service territory. Approximately 500,000 customer outages occurred on the NSTAR Electric system in the aftermath of Irene. This represents the most severe damage event on the NSTAR Electric system in nearly 20 years.

NSTAR Electric’s DPU-approved storm accounting mechanism helps to reduce the volatility of the earnings impact of severe storm restoration events. The Company is permitted to spread the incremental costs of severe storm restoration over several periods. NSTAR Electric currently estimates the incremental cost of Irene to be approximately $30 million.

On September 15, 2011, the DPU, on its own initiative, initiated an investigation into the efforts of NSTAR Electric and one other Massachusetts electric company to restore power to their customers in the aftermath of Irene. NSTAR Electric filed a Final Event Report with the DPU on October 3, 2011.

In late October 2011, an unprecedented early snowstorm brought heavy, wet snow and strong winds to the region, impacting the electric service of approximately 200,000 customers. NSTAR Electric is still in the process of estimating the total cost of restoration for this event.

Business Overview

NSTAR Electric Company is a regulated public utility incorporated in 1886 under Massachusetts law and is a wholly-owned subsidiary of NSTAR. NSTAR Electric serves approximately 1.1 million electric distribution customers in the City of Boston and 80 surrounding communities. NSTAR is a holding company engaged through its subsidiaries in the energy delivery business serving approximately 1.4 million customers in Massachusetts, including NSTAR Electric’s customers and approximately 300,000 natural gas distribution customers of NSTAR Gas in 51 communities. NSTAR has a service company that provides management and support services to substantially all NSTAR subsidiaries—NSTAR Electric & Gas.

Harbor Electric Energy Company (HEEC), a wholly owned-subsidiary of NSTAR Electric, provides distribution service and ongoing support to its only customer, the Massachusetts Water Resources Authority’s wastewater treatment facility located on Deer Island in Boston, Massachusetts. NSTAR Electric’s three wholly-owned consolidated special-purpose subsidiaries are BEC Funding LLC (BEC Funding), BEC Funding II, LLC (BEC Funding II) and CEC Funding, LLC (CEC Funding), all established to facilitate the sales of electric rate reduction certificates at a public offering. The certificates of all special-purpose subsidiaries are secured by a portion of the transition charge assessed on NSTAR Electric’s retail customers as permitted by the 1997 Massachusetts Electric Restructuring Act and authorized by the DPU. These certificates are non-recourse to NSTAR Electric. NSTAR Electric has no variable interest entities. The activities of BEC Funding LLC were substantially completed as of March 31, 2010 and the Company was dissolved on April 14, 2010.

NSTAR Electric derives its operating revenues primarily from the sale of energy, distribution, transmission, and energy efficiency services to customers. However, NSTAR Electric’s earnings are impacted by fluctuations in unit sales of electric kWh, which have an effect on the level of distribution and transmission revenues recognized. In accordance with the regulatory rate structure in which NSTAR Electric operates, its recovery of energy and certain energy-related costs are fully reconciled with the level of energy revenues currently recorded and, therefore, do not have an impact on earnings. As a result of this rate structure, any variability in the cost of energy supply purchased will have an impact on purchased power and transmission expenses, but will not affect the Company’s net income as the Company recognizes a corresponding change in revenues.

Earnings

NSTAR Electric’s earnings are impacted by its customers’ requirements for energy in the form of unit sales of electricity, which directly determine the level of retail distribution and transmission revenues recognized. In accordance with the regulatory rate structure in which NSTAR Electric operates, its recovery of energy and energy-related costs are fully reconciled with the level of energy revenues currently recorded and, therefore, do not have an impact on earnings.

Net income for the three and nine-month periods ended September 30, 2011 was $99.8 million and $203.4 million, as compared to $102.3 million and $207.8 million for the same periods in 2010, as further explained below.

Critical Accounting Policies and Estimates

For a complete discussion of critical accounting policies, refer to “Critical Accounting Policies and Estimates” in Item 7 of NSTAR Electric’s 2010 Form 10-K. There have been no substantive changes to those policies and estimates.

Rate and Regulatory Proceedings

Rate Structure

a. Rate Settlement Agreement

NSTAR Electric is operating under a DPU-approved Rate Settlement Agreement (Rate Settlement Agreement) that expires December 31, 2012. From 2007 through 2012, the Rate Settlement Agreement establishes for NSTAR Electric, among other things, annual inflation-adjusted distribution rates including a productivity offset, that are generally offset by an equal and corresponding adjustment to transition rates. The adjustment will be 0.96% effective January 1, 2012. The adjustments as of January 1 were as follows:

23 b. Regulated Electric Distribution Rates

Retail electric delivery rates are established by the DPU and are comprised of:

• a distribution charge, which includes a fixed customer charge and a demand and/or energy charge (to collect the costs of building and expanding the infrastructure to deliver power to its destination, as well as ongoing operating costs and certain DPU-approved safety and reliability programs costs), a Pension and PBOP Rate Adjustment Mechanism (PAM) to recover incremental pension and pension benefit costs, a reconciling rate adjustment mechanism to recover costs associated with the residential assistance adjustment clause, a net-metering reconciliation surcharge to collect the lost revenues and credits associated with net-metering facilities installed by customers, and an Energy Efficiency Reconciling Factor (EERF) to recover energy efficiency program costs and lost base revenues in addition to those charges recovered in the energy conservation charge;
• a basic service charge represents the collection of energy costs, including costs related to charge-offs of uncollected energy costs, through DPU-approved rate mechanisms. Electric distribution companies in Massachusetts are required to obtain and resell power to retail customers through Basic Service for those who choose not to buy energy from a competitive energy supplier. Basic Service rates are reset every six months (every three months for large commercial and industrial customers). The price of Basic Service is intended to reflect the average competitive market price for electric power;
• a transition charge represents the collection of costs to be collected primarily from previously held investments in generating plants and costs related to existing above-market power contracts, and contract costs related to long-term power contracts buy-outs;
• a transmission charge represents the collection of annual costs of moving the electricity over high voltage lines from generating plants to substations located within NSTAR Electric’s service area including costs allocated to NSTAR Electric by ISO-NE to maintain the wholesale electric market;
• an energy conservation charge represents a legislatively-mandated charge to collect costs for energy efficiency programs; and
• a renewable energy charge represents a legislatively-mandated charge to collect the costs to support the development and promotion of renewable energy projects.

c. Regulatory Matters

DPU Safety and Reliability Programs (CPSL)

As part of the Rate Settlement Agreement, NSTAR Electric recovers incremental costs related to the double pole inspection, replacement/restoration and transfer program and the underground electric safety program, which includes stray-voltage remediation and manhole inspections, repairs, and upgrades. Recovery of these Capital Program Scheduling List (CPSL) billed costs is subject to DPU review and approval. From 2006 through 2010, NSTAR Electric incurred and billed cumulative incremental revenue requirements of approximately $67 million. During 2011, approximately $11 million has been incurred through September 30. These amounts include incremental operations and maintenance and revenue requirements on capital investments.

On May 28, 2010, the DPU issued an order on NSTAR Electric’s 2006 CPSL costs recovery filing. The expected recovery amount did not vary materially from the revenue previously recognized. On October 8, 2010, NSTAR Electric submitted a Compliance Filing with the DPU reconciling the recoverable CPSL Program revenue requirement for each year 2006 through 2009 with the revenues already collected to determine the proposed adjustment effective on January 1, 2011. The DPU allowed the proposed rates to go into effect on that date, subject to reconciliation of program costs. NSTAR Electric cannot predict the timing of subsequent DPU orders related to this filing. Should an adverse DPU decision be issued, it could have a material adverse impact on NSTAR Electric’s result of operations, financial position, and cash flows.

Basic Service Bad Debt Adder

On July 1, 2005, in response to a generic DPU order that required electric utilities in Massachusetts to recover the energy-related portion of bad debt costs in their Basic Service rates, NSTAR Electric increased its Basic Service rates and reduced its distribution rates for those bad debt costs. In furtherance of this generic DPU order, NSTAR Electric included a bad debt cost recovery mechanism as a component of its Rate Settlement Agreement. This recovery mechanism (bad debt adder) allows NSTAR Electric to recover its Basic Service bad debt costs on a fully reconciling basis. These rates were implemented, effective January 1, 2006, as part of NSTAR Electric’s Rate Settlement Agreement.

On February 7, 2007, NSTAR Electric filed its 2006 Basic Service reconciliation with the DPU proposing an adjustment related to the increase of its Basic Service bad debt charge-offs. This proposed rate adjustment was anticipated to be implemented effective July 1, 2007. On June 28, 2007, the DPU issued an order approving the implementation of a revised Basic Service rate. However, the DPU instructed NSTAR Electric to reduce distribution rates by the increase in its Basic Service bad debt charge-offs. Such action would result in a further reduction to distribution rates from the adjustment NSTAR Electric made when it implemented the Settlement Agreement. This adjustment to NSTAR Electric’s distribution rates would eliminate the fully reconciling nature of the Basic Service bad debt adder.

NSTAR Electric has not implemented the directives of the June 28, 2007 DPU order. Implementation of this order would require NSTAR Electric to write-off a previously recorded regulatory asset related to its Basic Service bad debt costs. NSTAR Electric filed a Motion for Reconsideration of the DPU’s order on July 18, 2007. On May 28, 2010, the DPU issued an order and reaffirmed that NSTAR Electric should reduce its distribution rates by the increase in its Basic Service bad debt charge-offs. On June 18, 2010, NSTAR Electric filed an appeal of the DPU’s order with the Massachusetts Supreme Judicial Court (SJC). Briefs were filed during the summer of 2011 and oral arguments are anticipated by the end of 2011. A decision by the SJC is expected in the first half of 2012. As of September 30, 2011, the potential pre-tax impact to earnings of eliminating the fully reconciling nature of the bad debt adder would be approximately $22 million. NSTAR Electric cannot predict the timing of this appeals process or the ultimate outcome. NSTAR Electric continues to believe that its position is appropriate and that it is probable upon appeal that it will ultimately prevail.

Other

In the fourth quarter of each year, NSTAR Electric files proposed distribution rate adjustments for effect on the following January 1. These rate adjustments include a SIP adjustment factor and several other fully reconciling cost recovery items. Consistent with previous filings, the 2011 filings include a combination of actual and forecasted data for 2011 that NSTAR Electric will update during 2012 with year-end data to allow a final investigation and reconciliation. There are several case years that remain outstanding at the DPU. These cases are pending decisions at the DPU and NSTAR Electric cannot predict the timing or the ultimate outcome of these filings.

FERC Transmission ROE

NSTAR Electric earns an 11.14% ROE on local transmission facility investments. The ROE on NSTAR Electric’s regional transmission facilities is 11.64%. Additional incentive adders are available and are decided on a case-by-case basis in accordance with the FERC’s most recent national transmission incentive rules. The FERC may grant a variety of financial incentives, including ROE basis point incentive adders for qualified investments made in new regional transmission facilities. A 100 basis point adder, when combined with the FERC’s approved ROEs described above, results in a 12.64% ROE for qualified regional investments. The incentive is intended to promote and accelerate investment in transmission projects that can significantly reduce congestion costs and enhance reliability in the region.

FERC Proceeding Regarding Base ROE of New England Transmission Operators

On September 30, 2011, the Attorney General of Massachusetts, along with various ratepayer advocates representing the six New England states, filed a complaint with the FERC seeking to reduce the 11.14 percent base return on equity (Base ROE) used in calculating formula rates for transmission service under the ISO-NE Open Access Transmission Tariff (OATT). A change in the Base ROE would adversely impact the various investor-owned utilities (New England Transmission Owners, or NETOs), including NSTAR Electric, that provide transmission service to ISO-New England, which serves as the regional transmission organization for New England.

On October 20, 2011, NSTAR Electric along with the other NETOs, filed their response with the FERC. In that response, the NETOs vigorously defended the appropriateness of the current FERC-approved Base ROE. The NETOs requested that the FERC summarily dismiss the complaint. Should any unfavorable ruling by FERC result in a reduction of the Base ROE, the exposure would be limited to OATT rates assessed following the complaint date of September 30, 2011. NSTAR Electric cannot predict the timing or outcome of this proceeding.

Other

a. Energy Efficiency Plan

NSTAR Electric administers demand-side management energy efficiency programs. The Massachusetts Green Communities Act (GCA) directs electric distribution companies to develop three-year energy efficiency plans. The first three-year plan covering the period 2010 through 2012 was approved by the DPU and represents a significant expansion of energy efficiency activity in Massachusetts. Like the historical programs, the current three-year plan includes financial incentives based on energy efficiency program performance. In addition, the DPU has stated that it will permit distribution companies that do not yet have rate decoupling mechanisms in place to implement Lost Base Revenue (LBR) rate adjustment mechanisms that will partially offset reduced distribution rate revenues as a result of successful energy efficiency programs.

NSTAR Electric incurred recoverable Energy Efficiency program expenses of $59.2 million during the third quarter of 2011. These program expenses for the nine-month period ended September 30, 2011 for NSTAR Electric were $132.2 million inclusive of program administrator incentives. NSTAR Electric anticipates that its 2011 Energy Efficiency Plan will amount to approximately $184.3 million in recoverable expenses, inclusive of program administrator incentives.

b. Transmission Capital Improvement Project – Lower SEMA

The Lower Southeastern Massachusetts (SEMA) Project consists of an expansion and upgrade of existing transmission infrastructure, and construction of a new 31 mile, 345kV transmission line that will cross the Cape Cod Canal. On October 19, 2011, the Reliability Committee of the ISO voted to recommend approval for all costs associated with the project to be recovered from customers throughout the New England region under the ISO-NE regional transmission tariff. A pending application to the Massachusetts Energy Facilities Siting Board (EFSB) is in process. NSTAR Electric must receive approval of the EFSB in order to proceed with construction. Hearings were held in the summer of 2011 and briefs have been filed. NSTAR Electric awaits the decision of the EFSB, which is anticipated by year-end or early January 2012. NSTAR Electric anticipates completing the project in late 2012 at an approximate cost of $110 million.

Results of Operations

The following section of MD&A compares the results of operations for each of the three and nine-month periods ended September 30, 2011 and 2010 and should be read in conjunction with the accompanying

Condensed Consolidated Financial Statements and the accompanying Notes to Condensed Consolidated Financial Statements included elsewhere in this report.

Three Months Ended September 30, 2011 compared to Three Months Ended September 30, 2010

Executive Summary of Quarterly Results

Net income was $99.8 million for the quarter ended September 30, 2011 compared to $102.3 million for the same period in 2010. Major factors on an after-tax basis that contributed to the $2.5 million, or 2.4%, decrease in earnings include:

• Lower electric distribution revenues (2.1% decrease in sales) due to cooler summer weather and the impact of NSTAR Electric’s Energy Efficiency programs ($5.2 million)
• Higher depreciation and property taxes ($1.3 million)
• Higher operations and maintenance expenses ($3.5 million)

These decreases in earnings factors were partially offset by:

• Higher transmission revenues ($4.2 million)
• Higher lost base revenues related to the impact of Energy Efficiency programs ($3.6 million)

Significant cash flow events during the quarter include the following:

• Cash flows from operating activities provided approximately $226.8 million, an increase of $2.8 million as compared to the same period in 2010. The increase primarily reflects the timing of energy supply payments and customer collections related to these energy costs and lower estimated tax payments as a result of accelerated tax depreciation benefits in 2011
• NSTAR Electric invested approximately $80.2 million in capital projects to improve system reliability and capacity
• NSTAR Electric paid $28.3 million in common share dividends to NSTAR and retired approximately $21.7 million in securitized debt and $15.4 million in other long-term debt.

Energy sales

The following is a summary of retail electric energy sales for the periods indicated:

NSTAR Electric’s energy sales in the three months ended September 30, 2011 decreased 2.1% compared to 2010 primarily due to a cooler summer during 2011 as compared to 2010. Cooling degree-days in the Boston area for the three months ended September 30, 2011 were down 2.6% from the same period in 2010.

Weather and, to a lesser extent, fluctuations in fuel costs, conservation measures, and economic conditions affect sales to NSTAR Electric’s residential and small commercial customers. Economic conditions, fluctuations in fuel costs, and conservation measures affect NSTAR Electric’s large commercial and industrial customers. In terms of customer sector characteristics, industrial sales are less sensitive to weather than residential and commercial sales, which are influenced by temperature variations. Refer to the “Operating Revenues” section below for a more detailed discussion.

Weather conditions

NSTAR Electric forecasts its electric sales based on normal weather conditions. Actual results may vary from those projected due to actual weather conditions, energy conservation, and other factors.

The demand for electricity is affected by weather. Weather impacts electric sales primarily during the summer in NSTAR Electric’s service area. Customer heating or cooling usage may not directly correlate with historical levels or with the level of degree-days that occur (as further discussed below), particularly when weather patterns experienced are consistently colder or warmer. Also, NSTAR Electric’s business is sensitive to variations in daily weather, is highly influenced by New England’s seasonal weather variations, and is susceptible to damage from major storms and other natural events and disasters that could adversely affect the Company’s ability to provide energy.

Degree-days measure changes in daily mean temperature levels. A degree-day is a unit measuring how many degrees the outdoor daily mean temperature falls below (in the case of heating) or rises above (in the case of cooling) a base of 65 degrees. The table below shows weather conditions during the three-month period ended September 30, 2011 measured by heating and cooling degree-days, respectively. Cooling degree-days were 2.6% lower for 2011 as compared to 2010, unfavorably impacting revenues from electric sales. Weather conditions were warmer than the 30-year average by 54.2% and 33.1% for heating and cooling degree-days, respectively, during the third quarter of 2011. Refer to the “Operating Revenues” section below for a more detailed discussion.

Operating revenues

Operating revenues for the third quarter of 2011 increased $0.9 million, or 0.1%, from the same period in 2010 as follows:

(in millions)

NSTAR Electric’s largest earnings sources are the revenues derived from distribution and transmission rates approved by the DPU and the FERC. Electric retail distribution revenues primarily represent charges to customers for recovery of the Company’s capital investment, including a return component, and operation and maintenance costs related to its electric distribution infrastructure. The transmission revenue component represents charges to customers for the recovery of similar costs to move the electricity over high voltage lines from the generator to the Company’s distribution substations.

The decrease of $7.7 million, or 2%, in retail distribution and transmission revenues is primarily due to lower sales due to cooler weather and energy efficiency programs.

Energy, transition, and other revenues primarily represent charges to customers for the recovery of costs incurred by the Company in order to acquire the energy supply on behalf of its customers and a transition charge for recovery of the Company’s prior investments in generating plants and the costs related to long-term power contracts. The energy revenues relate to customers being provided energy supply under Basic Service. These revenues are fully reconciled to the costs incurred and have no impact on NSTAR Electric’s consolidated net income. Energy, transition, and other revenues also reflect revenues related to the Company’s ability to effectively reduce stranded costs (incentive entitlements), rental revenue from electric property, and annual cost reconciliation true-up adjustments. Uncollected transition costs as a result of the reductions in transition rates are deferred and collected through future rates with a carrying charge. The $8.6 million, or 2.4% increase in energy, transition, and other revenues is primarily attributable to higher energy efficiency revenues due to the expansion of these programs, partly offset by lower sales and lower average Basic Service rates in effect due to lower energy costs. NSTAR Electric recognized $5.9 million during the quarter ended September 30, 2011 of LBR relating to the impacts of the Energy Efficiency Programs implemented under the GCA. LBR is subject to DPU approval and NSTAR Electric is collecting LBR in rates.

Operating expenses

Purchased power and transmission expense was $318.5 million in the third quarter of 2011 compared to $341.7 million in the same period of 2010, a decrease of $23.2 million, or 6.8%. The decrease in expense reflects lower Basic Service and other energy costs of $18.3 million and lower transmission costs of $4.9 million due to a decrease in regional network support costs. NSTAR Electric adjusts its rates to collect the costs related to energy supply from customers on a fully reconciling basis. Due to this rate adjustment mechanism, changes in the amount of energy supply expense have no impact on consolidated net income.

Operations and maintenance expense was $93.4 million in the third quarter of 2011 compared to $84.8 million in the same period of 2010, an increase of $8.6 million, or 10.1%. One significant component contributing to this increase in expense is higher pension and PBOP related PAM amortization costs ($2.6 million). Fluctuations in PAM amortization do not have an earnings impact as these costs are fully recovered from customers. Also contributing to the higher expense were storm-related expenses ($1.9 million), higher labor and labor-related costs ($1.3 million) and higher transmission costs ($2.4 million).

Depreciation and amortization expense was $67.8 million in the third quarter of 2011 compared to $67 million in the same period of 2010, an increase of $0.8 million, or 1.2%. The increase primarily reflects higher depreciable distribution and transmission plant-in-service, offset by lower amortization costs related to the pay-down of securitized debt.

Energy efficiency programs expense was $59.2 million in the third quarter of 2011 compared to $42.9 million in the same period of 2010, an increase of $16.3 million, or 38%. These costs are in accordance with the three-year plan program guidelines established by the DPU and are collected from customers on a fully reconciling basis plus a performance incentive. NSTAR Electric anticipates a further increase in Energy Efficiency spending during 2011 and in future years driven by requirements of the GCA.

Property and other taxes expense was $28.5 million in the third quarter of 2011 compared to $27.2 million in the same period of 2010, an increase of $1.3 million, or 4.8%, reflecting higher overall property investments and higher tax rates.

Interest charges (income):

Long-term debt and transition property securitization certificate interest charges were $24.5 million in the third quarter of 2011 compared to $25.4 million in the same period of 2010, a decrease of $0.9 million, or 3.5%. The decrease in interest charges reflects scheduled principal pay downs of transition property securitization debt and the retirement of NSTAR Electric’s $15 million, 5.75% Massachusetts Industrial Finance Agency Bonds on August 1, 2011.

Interest income and other, net were $6.4 million of net interest income in the third quarter of 2011 compared to $6.5 million of net interest income in the same period of 2010, a decrease of $0.1 million, or 1.5%, due to decreased interest income on tax issues of $0.5 million and lower interest income of $0.1 million from regulatory deferrals, offset by lower expense on short-term debt bank fees and other interest costs of $0.6 million.

Other income (deductions):

Other income was $0.7 million in the third quarter of 2011 compared to $1.2 million in the same period of 2010, a decrease of $0.5 million. The decrease relates primarily to the absence of increases in cash surrender values of insurance policies in 2011, partly offset by higher equity investment earnings.

Other deductions were $1.1 million in the third quarter of 2011 compared to $0.3 million in the same period of 2010, an increase of $0.8 million due to the reduction in cash surrender values of life insurance policies.

Income tax expense:

Income tax expense was $65.6 million in the third quarter of 2011 compared to $66.4 million in the same period of 2010, a decrease of $0.8 million, or 1.2%, primarily reflecting lower pre-tax operating income in 2011.

Nine Months Ended September 30, 2011 compared to Nine Months Ended September 30, 2010

Executive Summary of Year to Date Results

Net income was $203.4 million for the nine months ended September 30, 2011 compared to $207.8 million for the same period in 2010. Major factors on an after-tax basis that contributed to the $4.4 million, or 2.1%, decrease in earnings include:

• Lower electric distribution revenues (0.3% decrease in sales) due to cooler summer weather and the impact of NSTAR Electric’s Energy Efficiency programs ($3.2 million)
• Higher depreciation and property taxes ($6.2 million)
• Higher operations and maintenance expenses ($10 million)

These decreases in earnings factors were partially offset by:

• Higher lost base revenues due to the impacts of Energy Efficiency programs ($3.6 million)
• Higher transmission revenues ($7.4 million)
• The absence in 2011 of the cumulative impact of a true-up adjustment resulting from a DPU order in May 2010 related to NSTAR Electric’s transition revenues for the years 2006-2009 ($3 million)

Significant cash flow events during the first nine months of 2011 include the following:

• Cash flows from operating activities provided approximately $592 million, an increase of $222.6 million as compared to the same period in 2010. The increase primarily reflects receipt of a tax refund and the associated interest totaling $166.8 million. Other favorable impacts include the timing of energy supply payments and customer collections related to these energy costs and lower income tax payments as a result of accelerated tax depreciation benefits
• NSTAR Electric invested approximately $241.8 million in capital projects to improve system reliability and capacity
• NSTAR Electric paid $143.1 million in common share dividends to NSTAR, retired approximately $62.5 million in securitized debt and $16.2 million in other long-term debt, and paid down short-term debt by $145 million.

Energy sales

The following is a summary of retail electric energy sales for the periods indicated:

NSTAR Electric’s energy sales in the nine months ended September 30, 2011 decreased 0.3% compared to 2010 primarily due to a cooler second and third quarter of 2011, but offset by favorable weather conditions in the first quarter of 2011 resulting from a colder winter as compared to 2010. Heating degree-days in the Boston area for the nine months ended September 30, 2011 were up 16.7% from the same period in 2010.

Weather and, to a lesser extent, fluctuations in fuel costs, conservation measures, and economic conditions affect sales to NSTAR Electric’s residential and small commercial customers. Economic conditions, fluctuations in fuel costs, and conservation measures affect NSTAR Electric’s large commercial and industrial customers. In terms of customer sector characteristics, industrial sales are less sensitive to weather than residential and commercial sales, which are influenced by temperature variations. Refer to the “Operating Revenues” section below for a more detailed discussion.

Weather conditions

The demand for electricity is affected by weather. Weather impacts electric sales primarily during the summer in NSTAR Electric’s service area. Customer heating or cooling usage may not directly correlate with historical levels or with the level of degree-days that occur (as further discussed below), particularly when weather patterns experienced are consistently colder or warmer. Also, NSTAR Electric’s business is sensitive to variations in daily weather, is highly influenced by New England’s seasonal weather variations, and is susceptible to damage from major storms and other natural events and disasters that could adversely affect the Company’s ability to provide energy.

As shown in the table below, weather conditions during the nine-month period ended September 30, 2011 measured by heating degree-days and cooling degree-days, respectively, were 16.7% higher/colder relating to heating degree-days and 8.1% lower/cooler related to cooling degree-days for 2011 as compared to 2010, unfavorably impacting revenues from electric sales. Weather conditions during the nine-month period ended September 30, 2011 compared to the normal 30-year average for the same period, were 1.6% lower/warmer and 27.7% higher/warmer for heating and cooling degree-days, respectively. Refer to the “Operating Revenues” section below for a more detailed discussion.

31

Operating revenues

Operating revenues for the nine months ended September 30, 2011 increased $7.6 million, or 0.4%, from the same period in 2010 as follows:

(in millions)

NSTAR Electric’s largest earnings sources are the revenues derived from distribution and transmission rates approved by the DPU and the FERC. Electric retail distribution revenues primarily represent charges to customers for recovery of the Company’s capital investment, including a return component, and operation and maintenance costs related to its electric distribution infrastructure. The transmission revenue component represents charges to customers for the recovery of similar costs to move the electricity over high voltage lines from the generator to the Company’s distribution substations.

The increase of $4.5 million, or 0.5%, in retail distribution and transmission revenues primarily reflects:

• Increased transmission revenues primarily due to the recovery of a higher transmission investment base, including higher depreciation and property taxes and recovery of higher regional network service and other costs ($3.2 million)
• Increased PAM-related recovery revenues due to increased amortization of previously deferred costs ($6.9 million)

These increases were offset by:

• Decreased distribution revenues due to decreased sales of 0.3% due to the impact of weather conditions and a negative annual inflation rate adjustment ($5.3 million)

Energy, transition, and other revenues primarily represent charges to customers for the recovery of costs incurred by the Company in order to acquire the energy supply on behalf of its customers and a transition charge for recovery of the Company’s prior investments in generating plants and the costs related to long-term power contracts. The energy revenues relate to customers being provided energy supply under Basic Service. These revenues are fully reconciled to the costs incurred and have no impact on NSTAR Electric’s consolidated net income. Energy, transition, and other revenues also reflect revenues related to the Company’s ability to effectively reduce stranded costs (incentive entitlements), rental revenue from electric property, and annual cost reconciliation true-up adjustments. Uncollected transition costs as a result of the reductions in transition rates are deferred and collected through future rates with a carrying charge. The $3.1 million, or 0.3% increase in energy, transition, and other revenues is primarily attributable to higher energy efficiency revenues due to the expansion of these programs partly offset by lower Basic Service rates in effect due to lower energy costs. NSTAR Electric has recognized $5.9 million in the nine months ended September 30, 2011 of Lost Base Revenues (LBR) relating to the impacts of the Energy Efficiency Programs implemented under the GCA. LBR is subject to DPU approval and NSTAR Electric is collecting LBR in rates.

Operating expenses

Purchased power and transmission expense was $841.8 million in the nine months ended September 30, 2011 compared to $893.9 million in the same period of 2010, a decrease of $52.1 million, or 5.8%.

The decrease in expense reflects lower Basic Service and other energy costs of $47.4 million. These decreases were partially offset by higher transmission costs of $4.7 million due to an increase in regional network support costs. NSTAR Electric adjusts its rates to collect the costs related to energy supply from customers on a fully reconciling basis. Due to this rate adjustment mechanism, changes in the amount of energy supply expense have no impact on consolidated net income.

Operations and maintenance expense was $270 million in the nine months ended September 30, 2011 compared to $248 million in the same period of 2010, an increase of $22 million, or 8.9%. One significant component contributing to this increase in expense is higher pension and PBOP related PAM amortization costs ($7.8 million). Fluctuations in PAM amortization do not have an earnings impact as these costs are fully recovered from customers. Also contributing to the higher expense were storm-related expenses ($3.7 million), higher transmission costs ($3 million), higher maintenance costs ($1.6 million), and higher labor and labor-related costs ($2.6 million).

Depreciation and amortization expense was $204.9 million in the nine months ended September 30, 2011 compared to $214.7 million in the same period of 2010, a decrease of $9.8 million, or 4.6%. The decrease primarily reflects the lower amortization costs related to the pay-down of securitized debt, offset by higher depreciable distribution and transmission plant-in-service.

Energy efficiency programs expense was $132.2 million in the nine months ended September 30, 2011 compared to $82.5 million in the same period of 2010, an increase of $49.7 million, or 60.2%. These costs are in accordance with the three-year plan program guidelines established by the DPU and are collected from customers on a fully reconciling basis plus a performance incentive. NSTAR Electric anticipates a further increase in Energy Efficiency spending during 2011 and in future years driven by requirements of the GCA.

Property and other taxes expense was $83.9 million in the nine months ended September 30, 2011 compared to $77.8 million in the same period of 2010, an increase of $6.1 million, or 7.8%, reflecting higher overall property investments and higher tax rates.

Interest charges (income):

Long-term debt and transition property securitization certificate interest charges were $74.1 million in the nine months ended September 30, 2011 compared to $77.5 million in the same period of 2010, a decrease of $3.4 million, or 4.4%. The decrease in interest charges reflects scheduled principal pay downs of transition property securitization debt and the retirement of NSTAR Electric’s $125 million, 7.80% Debentures in May 2010 and its 5.75% Massachusetts Industrial Financial Agency Bonds on August 1, 2011. These reductions in interest expense were partially offset by higher expense for NSTAR Electric’s $300 million, 5.50% Debentures issued in March 2010.

Interest income and other, net were $22.4 million of net interest income in the nine months ended September 30, 2011 compared to $24.1 million of net interest income in the same period of 2010, a decrease of $1.7 million, or 7.1%, due to decreased interest income on tax issues of $9.1 million, partially offset by higher interest income of $3.7 million from regulatory deferrals and $3.2 million in interest income from legal matters.

Other income (deductions):

Other income was approximately $2.8 million in the nine months ended September 30, 2011 compared to $2.4 million in the same period of 2010, an increase of $0.4 million. The increase relates primarily to higher equity investment earnings.

Other deductions were $2 million in the nine months ended September 30, 2011 compared to $1.1 million in the same period of 2010. The increase is due in part to a reduction in cash surrender values of life insurance policies.

Income tax expense:

Income tax expense was $133.1 million in the nine months ended September 30, 2011 compared to $135.8 million in the same period of 2010, a decrease of $2.7 million, or 2%, primarily reflecting lower pre-tax operating income in 2011.

NSTAR Electric’s disclosure controls and procedures are designed to ensure that information required to be disclosed in reports that it files or submits under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission.

As of the end of the period covered by this Quarterly Report on Form 10-Q, NSTAR Electric carried out an evaluation, under the supervision and with the participation of NSTAR Electric’s management, including NSTAR Electric’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of NSTAR Electric’s disclosure controls and procedures pursuant to Securities Exchange Act of 1934 Rules 13a-15(e) or 15d-15(e). Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that NSTAR Electric’s disclosure controls and procedures were effective (1) to timely alert them to material information relating to NSTAR Electric’s information required to be disclosed by NSTAR Electric in the reports that it files or submits under the Securities Exchange Act of 1934 and (2) to ensure that appropriate information is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms.

There have been no changes in NSTAR Electric’s internal control over financial reporting (as defined in Rules 13a-15(f) or 15d-15(f) of the Securities Exchange Act of 1934) during NSTAR Electric’s most recently completed fiscal quarter that have materially affected, or are reasonably likely to materially affect, NSTAR Electric’s internal control over financial reporting.

Investors or prospective investors should carefully consider the risk factors that were previously disclosed in NSTAR Electric’s Annual Report on Form 10-K for the year ended December 31, 2010.

Risk Factor

The following risk factor has been added to this Form 10-Q since the filing of the Form 10-K:

NSTAR Electric could face negative impact from terrorism, cyber attacks, sabotage, acts of war, or other catastrophic events.

NSTAR Electric’s infrastructure facilities and the generation and transmission infrastructure facilities of third parties could be direct targets of terrorism, cyber attacks, sabotage, or acts of war. The costs to repair any damage to operating facilities from destructive events could be substantial. Such actions could also result in political, economic and financial market instability, which could have a material adverse impact on the Company’s operations. While it is not possible to predict the impact of a particular event of this type, the impact that any threat of terrorism, cyber attack, act of war or other catastrophic event might have on the energy industry and on NSTAR Electric’s business in particular could be material.