See accompanying notes to consolidated financial statements.

* Certain amounts have been reclassified for comparative purposes.

8

ALLEGHENY ENERGY, INC.

Notes to Consolidated Financial Statements

June 30, 2002

(Unaudited)

The Notes to Consolidated Financial Statements of Allegheny Energy, Inc. (the Company) in its Annual Report on Form 10-K, as amended, for the year ended December 31, 2001, should be read in conjunction with the accompanying consolidated financial statements and the following notes. The accompanying consolidated financial statements appearing on pages 3 through 7 and these notes to consolidated financial statements are unaudited. In the opinion of the Company, such consolidated financial statements together with these notes contain all adjustments (which consist only of normal recurring adjustments) necessary to present fairly the Company's financial position as of June 30, 2002; results of operations and comprehensive income for three and six months ended June 30, 2002 and 2001; and cash flows for the six months ended June 30, 2002 and 2001. Certain prior period amounts in these financial statements and notes have been reclassified for comparative purposes.

Allegheny Energy Supply Company, LLC's (Allegheny Energy Supply) energy marketing and trading activities include the marketing and trading of electricity, natural gas, oil, coal, and other energy-related commodities using primarily over-the-counter contracts and exchange-traded contracts such as those traded on the New York Mercantile Exchange (NYMEX).

The Company records the contracts used in Allegheny Energy Supply's energy marketing and trading activities at fair value on the consolidated balance sheet, with all changes in fair value recorded as gains and losses on the consolidated statement of operations in total operating revenues. Fair values for exchange-traded instruments, principally futures and certain options, are based on quoted market prices. In establishing the fair value of commodity contracts that do not have quoted market prices, such as physical contracts, over-the-counter options and swaps, management makes estimates using available market data and pricing models, which may change from time to time. Factors such as commodity price risk, operational risk, and credit risk of counterparties are evaluated in establishing the fair value of commodity contracts. The commodity contracts include certain financial instruments, such as interest rate swaps, which are used to mitigate the effect of interest rate changes on the fair value of co mmodity contracts.

Allegheny Energy, Inc.

9

The Company has contracts that are unique due to their long-term nature and are valued using proprietary pricing models. Inputs to the models include estimated forward natural gas and electricity prices, interest rates, and estimates of market volatility for natural gas and electricity prices. These inputs depend heavily on judgments and assumptions by management. These inputs become more difficult to predict and the models become less precise the further into the future these estimates are made. There may be an adverse effect on the Company's results of operations and financial position if the judgments and assumptions underlying those models' inputs prove to be wrong or inaccurate.

The fair values of energy trading commodity contracts, which represent the net unrealized gain and loss positions, are recorded as assets and liabilities, respectively, after applying the appropriate counterparty netting agreements in accordance with the Financial Accounting Standards Board's (FASB) Interpretation No. 39, "Offsetting of Amounts Related to Certain Contracts - an Interpretation of APB Opinion No. 10 and FASB Statement No. 105." At June 30, 2002, the fair value of the energy trading commodity contract assets and liabilities was $1,837.5 million and $945.5 million, respectively. At December 31, 2001, the fair value of the energy trading commodity contract assets and liabilities was $1,755.4 million and $995.0 million, respectively. Net unrealized gains of $111.7 million and $180.5 million, before income taxes, were recorded to the consolidated statement of operations in operating revenues to reflect the change in fair value of the energy trading contracts for the six months ended June 30, 2002 and 2001, respectively. As of June 30, 2002, the fair value of the Company's commodity contracts with one counterparty was $1,284.0 million, or approximately 11.4 percent of the Company's total assets.

Alliance Energy Services Partnership (Alliance Energy Services), a subsidiary of Allegheny Ventures, Inc. (Allegheny Ventures), is engaged in the purchase, sale, and marketing of natural gas and other energy-related services to various commercial and industrial customers across the United States. Alliance Energy Services, on behalf of its customers, uses both physical and financial derivative contracts, including forwards, NYMEX futures, options, and swaps, in order to manage price risk associated with its purchase and sale activities.

Allegheny Energy, Inc.

10

Alliance Energy Services' primary strategy is to minimize its market risk exposure with respect to its forecasted physical natural gas sales contracts to its customers by entering into offsetting financial and physical natural gas purchase and transportation contracts. The transactions executed under this strategy were accounted for as cash flow hedges under the FASB's Statement of Financial Accounting Standards (SFAS) No. 133, "Accounting for Derivative Instruments and Hedging Activities." The fair values of the offsetting contracts were recorded as assets and liabilities on the consolidated balance sheet, with changes in fair value for these contracts recorded in other comprehensive income. Unrealized losses of $.4 million and unrealized gains of $19.2 million, net of reclassifications to earnings, income taxes, and minority interest, were recorded in other comprehensive income for these contracts for the three and six months ended June 30, 2002, respectively. These hedges were highly effective durin g the three and six months ended June 30, 2002, with no ineffectiveness recorded to the consolidated statement of operations. Based on the contracts' fair values at June 30, 2002, and the settlement dates of these contracts, the Company expects to reclassify a loss of approximately $2.1 million, before income taxes and minority interest, of the amount in accumulated other comprehensive income to earnings in the remaining six months of 2002 and a gain of $.8 million in the first six months of 2003. As of June 30, 2002, Alliance Energy Services' cash flow hedge contracts were hedging forecasted transactions through December 2004 and had a net fair value of $(15.5) million. As of December 31, 2001, Alliance Energy Services' cash flow hedge contracts were hedging forecasted transactions through December 2004 and had a net fair value of $(66.2) million.

Additionally, as a service to its customers, Alliance Energy Services offers price risk intermediation services in order to mitigate the market risk associated with natural gas. Under this program, Alliance Energy Services will execute contracts with a third counterparty. These transactions do not qualify for hedge accounting under SFAS No. 133 and are accounted for on a mark-to-market basis. As of June 30, 2002, the fair values of the contracts reflected as an asset and as a liability were $9.8 million and $9.3 million, respectively. As of December 31, 2001, the fair values of the contracts reflected as an asset and as a liability was $31.5 million and $30.6 million, respectively.

On March 19, 2002, Allegheny Energy Supply entered into two treasury lock agreements to hedge its exposure to changing United States Treasury interest rates on the forecasted issuance of long-term, fixed-rate debt in April 2002. These treasury lock agreements were accounted for as cash flow hedges under SFAS No. 133. At June 30, 2002, the total fair value of these contracts of $(1.6) million, before income taxes ($(1.0) million, net of reclassifications and income taxes), was recorded as an unrealized loss in other comprehensive income. In April 2002, Allegheny Energy Supply began reclassifying to earnings the amounts in accumulated other comprehensive income for these treasury lock agreements over the life of the ten year debt. For the three and six months ended June 30, 2002, $.04 million, before income taxes ($.02 million, net of income taxes) was reclassified from accumulated other comprehensive income to earnings.

Allegheny Energy, Inc.

11

On August 1, 2000, the Company issued a $165.0 million 7.75 percent fixed-rate note and a $135.0 million 7.75 percent fixed-rate note. Each note matures on August 1, 2005, and requires semi-annual interest payments on August 1 and February 1. On April 24, 2002, the Company entered into an interest rate swap to convert the notes' fixed-rates to variable rates for the notes' remaining terms. Under the term of the swap, the Company receives interest at a fixed-rate of 7.75 percent and pays interest at a

variable rate equal to the three-month London Interbank Offered Rate (LIBOR) plus a fixed spread. The Company designated the swap as a fair-value hedge of the fixed-rate debt, with changes in the fair value that are due to changes in the general level of market interest rates being the specific risk that is hedged. At June 30, 2002, the fair value of the interest rate swap was an asset of $4.1 million included in other current assets and the increase in the fixed-rate notes was $4.1 million, resulting in no hedge ineffectiveness for the three months ended June 30, 2002.

During the three months ended June 30, 2002, the Company recorded a liability and an unrealized loss for derivative instruments of $6.1 million in other current liabilities for eleven wholesale electricity contracts. These contracts previously qualified for the normal purchases and normal sales exception under SFAS No. 133. However, due to changes resulting from the April 2002 integration with the Pennsylvania - New Jersey - Maryland Interconnection, LLC (PJM) these contracts did not qualify for the normal purchases and normal sales exception.

The statement of other comprehensive income provides the components of comprehensive income for three and six months ended June 30, 2002 and 2001.

The Company holds stocks classified as available-for-sale marketable securities in accordance with SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," and records unrealized holding gains and losses from the temporary changes in the fair value of available-for-sale securities in other comprehensive income. The fair value of the Company's available-for-sale securities was $.4 million and $.3 million at June 30, 2002, and December 31, 2001, respectively. The change in fair value for the three months ended June 30, 2002 of $(.2) million, before income taxes ($(.1) million, net of income taxes), was recorded as an unrealized loss in other comprehensive income. For the six months ended June 30, 2002, the change in value of $.1 million, before income taxes ($.1 million, net of income taxes), was recorded as an unrealized gain in other comprehensive income. During the three and six months ended June 30, 2002, the Company reclassified losses of $.02 million and $1.4 million, befor e income taxes ($.01 million and $.9 million, net of income taxes), respectively, from accumulated other comprehensive income to earnings relating to a permanent impairment.

Allegheny Energy, Inc.

12

For the three months ended June 30, 2002, other comprehensive income also includes net unrealized losses of $1.8 million, before minority interest and income taxes ($1.0 million, net of minority interest and income taxes) and reclassifications to earnings of net realized gains of $1.4 million, before minority interest and income taxes ($.8 million, net of minority interest and income taxes), for a total change in other comprehensive income of $3.2 million, before minority interest and income taxes ($1.8 million, net of minority interest and income taxes). For the six months ended June 30, 2002, other comprehensive income includes net unrealized gains of $16.4 million, before minority interest and income taxes ($10.0 million, net of minority interest and income taxes) and reclassifications to earnings of net realized losses of $13.0 million, before minority interest and income taxes ($7.8 million, net of minority interest and income taxes), for a total change in other comprehensive income of $29.4 million, before minority interest and income taxes ($17.8 million, net of minority interest and income taxes). See Note 3 for additional details relating to the Company's cash flow hedges.

On January 1, 2002, the Company adopted SFAS No. 141, "Business Combinations," and SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS No. 141 eliminated the pooling-of-interests method and requires all business combinations initiated after June 30, 2001, to be accounted for under the purchase method of accounting. SFAS No. 141 also sets forth guidelines for applying the purchase method of accounting in the determination of goodwill and other intangible assets. The application of SFAS No. 141 did not affect any of the Company's previously reported amounts for goodwill and other intangible assets.

SFAS No. 142 eliminated amortization of goodwill and other intangible assets with indefinite lives effective January 1, 2002. Subsequent to the transitional provisions of SFAS No. 142 (see below), goodwill and other intangible assets with indefinite lives will be tested at least annually for impairment, with impairment losses recognized in operating income. Absent any impairment indicators, the Company expects to perform its annual impairment tests during its fourth quarter, in connection with its annual budgeting process. Other intangible assets with finite lives will continue to be amortized over their useful lives and tested for impairment when events or circumstances warrant.

As applied to the Company, SFAS No. 142 transitional provisions require the Company to test goodwill for impairment as of January 1, 2002, and recognize any transitional goodwill impairment loss as the effect of a change in accounting principle in the first quarter of 2002 irrespective of when the loss was measured and recorded in the Company's books. During the second quarter of 2002, the Company completed its transitional goodwill impairment test, using a discounted cash flow methodology to determine the fair value of its reporting units, and recorded an impairment loss of $210.1 million, before income taxes ($130.5 million, net of income taxes), all of which relates to the Delivery and Services operating segment. In accordance with SFAS No. 142, this impairment loss has been recognized in the first quarter of 2002 through restatement of the first quarter 2002 financial information in this Form 10-Q and subsequent Form 10-Q filings; no amendment or re-filing of the Company's first quarter 2002 Form 10 - -Q is required.

Allegheny Energy, Inc.

13

The transitional goodwill impairment loss consists of $170.0 million related to the Company's acquisition of Mountaineer Gas Company (Mountaineer Gas) in 2000, $25.0 million related to the Company's acquisition of West Virginia Power Company (West Virginia Power) in 1999, and $15.1 million of other regulated utility goodwill that had been carried on the Company's books for many years. The impairment amounts result from factors that are unique to these rate regulated entities and the ratemaking process, including the fact that none of the $210.1 million of goodwill was being recovered in rates or included in rate base.

SFAS No. 142 transitional provisions also have been completed with respect to the Company's other intangible assets resulting in no impairments or changes to amortizable lives.

The carrying amount of, and changes in, goodwill attributable to each reportable operating segment are as follows:

(a) Represents additional purchase price and purchase price reallocation related to the November 2001 acquisition of Fellon-McCord Associates, Inc. and Alliance Energy Services.

The components of other intangible assets were as follows:

The $4.2 million decrease in the gross carrying amount of contract-based amortized intangible assets during the six months ended June 30, 2002, was due to a purchase price reallocation related to the November 2001 acquisition of Alliance Energy Services. Amortization expense for intangible assets for the three and six months ended June 30, 2002, was $6.3 million and $21.0 million, respectively. Amortization expense is estimated to be $9.3 million for the remainder of 2002, $7.3 million for 2003, $.5 million for 2004, and $.3 million annually for 2005 through 2007.

Allegheny Energy, Inc.

14

If the provisions of SFAS No. 142 had been applied for the three and six months ended June 30, 2001, consolidated income before cumulative effect of accounting change, consolidated net income, and basic and diluted earnings per average share would have been as follows:

Based on the Company's forecast of future energy revenues and other factors, the Company's reserve for adverse power purchase commitments decreased as follows for the three and six months ended June 30, 2002 and 2001:

Allegheny Energy, Inc.

15

The above decreases in the reserve for adverse power purchase commitments are recorded as expense reductions in "Purchased energy and transmission" on the consolidated statement of operations. A change in the estimated energy revenues or other factors could have a material effect on the amount of the liability for adverse power purchase commitments.

The Company manages and evaluates its operations in two business segments: 1) Delivery and Services and 2) Generation and Marketing. Prior to the second quarter of 2002, the Company's reported segments were regulated utility operations, unregulated generation operations, and other unregulated operations. Business segments have been changed to reflect current internal management reporting. Prior period segment information has been restated for comparability.

The Delivery and Services segment operates regulated electric and natural gas transmission and distribution systems. It also invests in and develops fiber and data services and energy-related projects and provides energy consulting and management services and natural gas and other energy-related services. This segment includes the results of Allegheny Ventures, an unregulated subsidiary, which prior to the second quarter 2002 was reported as the other unregulated operations segment.

The Generation and Marketing segment develops, owns, operates, and manages regulated and unregulated electric generating capacity. It also markets and trades electricity, natural gas, oil, coal, and other energy-related commodities using primarily over-the-counter and exchange-traded contracts. This segment includes intersegment sales to provide energy to the Company's regulated subsidiaries, including sales to Monongahela Power Company (Monongahela Power) for its West Virginia regulatory jurisdiction that, prior to the second quarter 2002, were reported in the regulated utility operations segment.

The Company accounts for intersegment sales based on cost or regulatory commission approved tariffs or contracts.

Allegheny Energy, Inc.

16

Business segment information is summarized below. Significant transactions between reportable segments are shown as eliminations to reconcile the segment information to consolidated amounts.

Allegheny Energy, Inc.

17

Common stock dividends per share declared during the periods for which income statements are included are as follows:

In February 2002, the Company entered into restricted stock agreements with certain of its employees. These agreements provide that if the Company, prior to February 10, 2003, no longer employs these employees, the Company will obtain all rights to the common stock. The Company originally provided 71,643 common shares under these agreements. As of June 30, 2002, 3,280 common shares had been forfeited under these agreements.

The Company and Allegheny Energy Supply are required to maintain specific debt to capitalization ratios that, if violated, would hinder the Company's and Allegheny Energy Supply's ability to issue dividends. As of June 30, 2002, the Company and Allegheny Energy Supply had not violated these ratios.

Mountaineer Gas, a wholly-owned subsidiary of Monongahela Power, is required to maintain net worth of at least $53 million to allow for declaration of dividends. At June 30, 2002, Mountaineer Gas' net worth exceeded $53 million.

For the six months ended June 30, 2002, the Company made the following repayments and redemptions of long-term debt: West Penn Funding, LLC, repaid $35.8 million of transition bonds, Allegheny Energy Supply made repayments of $46.5 million on unsecured notes and redeemed $80.0 million of floating rate medium-term debt, West Penn Power Company (West Penn) redeemed $70 million principal amount of 8.0 percent Quarterly Income Debt Securities (QUIDS), and Allegheny Energy Supply and Monongahela Power redeemed $5.3 million of pollution control bonds per their original terms.

Allegheny Energy, Inc.

18

In April 2002, Allegheny Energy Supply issued $650.0 million of 8.25 percent notes due April 15, 2012. Allegheny Energy Supply used the net proceeds from the notes to repay short-term indebtedness of $630.0 million, including a bridge loan in the amount of $550.0 million that was entered into in connection with the acquisition of three generating facilities in the Midwest in May 2001, and for general corporate purposes.

In April 2002, West Penn issued $80.0 million of 6.625 percent notes due April 15, 2012. In May 2002, West Penn used the net proceeds from the sale of the notes to redeem $70 million principal amount of 8.0 percent QUIDS due June 30, 2025, at a redemption price of 100 percent of their principal amount plus accrued interest to the redemption date, and for other corporate purposes.

The following table summarizes the Company's other income and expenses for the three and six months ended June 30, 2002 and 2001:

In February 2002, the Company completed the sale of 12,000 acres of land in the Canaan Valley of West Virginia to the United States Fish and Wildlife Service, which will use the land to expand the Canaan Valley National Wildlife Refuge. As a result, West Penn recorded a gain of approximately $12.5 million before income taxes ($10.4 million after income taxes) and Monongahela Power recorded a gain of approximately $1.8 million before income taxes ($1.5 million after income taxes). The pre-tax effect of this transaction is recorded in other income and expenses on the consolidated statement of operations.

In June 2002, the Company recorded a charge of $9.2 million, before income taxes ($5.5 million, net of income taxes) for unregulated investments determined to be impaired under FASB's SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets."

Allegheny Energy, Inc.

19

The following table provides a reconciliation of the numerators and the denominators of the basic and diluted average per-share computations:

Allegheny Energy, Inc.

20

The Company is subject to various laws, regulations, and uncertainties as to environmental matters. Compliance may require the Company to incur substantial additional costs to modify or replace existing and proposed equipment and facilities and may adversely affect the cost of future operations.

The Environmental Protection Agency's (EPA) nitrogen oxides (NO_X) State Implementation Plan (SIP) call regulation has been under litigation and, on March 3, 2000, the United States Court of Appeals issued a decision that upheld the regulation. However, state and industry litigants filed an appeal of that decision in April 2000. On June 23, 2000, the Court denied the request for the appeal. Although the Court did issue an order to delay the compliance date from May 1, 2003, until May 31, 2004, both the Maryland and Pennsylvania state rules to implement the EPA NO_X SIP call regulation still require compliance by May 1, 2003. West Virginia has issued a final rule that would require compliance by May 31, 2004. The EPA Section 126 petition regulation also requires the same level of NO_X reductions as the EPA NO_X SIP call regulation and was also under litigation in the United States Court of Appeals. A Court decision in May 2001 upheld the rule. In August 2001, the Court issued an order that suspended the Section 126 petition rule May 1, 2003, compliance date pending EPA review of growth factors used to calculate the state NO_X budgets. In January 2002, the EPA announced its intention to revise the Section 126 petition rule compliance date from May 1, 2003, to May 31, 2004. The Company's compliance with such stringent regulations will require the installation of post-combustion control technologies on most of its power stations. The Company's construction forecast includes the expenditure of $244.7 million of capital costs during the 2002 through 2003 period to comply with these regulations.

On August 2, 2000, the Company received a letter from the EPA requiring it to provide certain information on the following ten electric generating stations: Albright, Armstrong, Fort Martin, Harrison, Hatfield's Ferry, Mitchell, Pleasants, Rivesville, R. Paul Smith, and Willow Island. Allegheny Energy Supply and Monongahela Power either individually or together now own these electric generating stations. The letter requested information under Section 114 of the federal Clean Air Act (Act) to determine compliance with the Act and state implementation plan requirements, including potential application of federal New Source Review (NSR). In June 2002, the Company received a request from the EPA to provide additional information concerning three of its electric generating stations. The information will be provided to the EPA by the end of the fourth quarter of 2002. In general, these standards can require the installation of additional air pollution control equipment upon the major modifica tion of an existing facility. The Company submitted these records in January 2001. The eventual outcome of the EPA investigation is unknown.

Allegheny Energy, Inc.

21

Similar inquiries have been made of other electric utilities and have resulted in enforcement proceedings being brought in many cases. The Company believes its generating facilities have been operating in accordance with the Clean Air Act and the rules implementing the Act. The experience of other utilities, however, suggests that, in recent years, the EPA may well have revised its interpretation of the rules regarding the determination of whether an action at a facility constitutes routine maintenance, which would not trigger the requirements of NSR, or a major modification of the facility, which would require compliance with NSR. If federal NSR were to be applied to these generating stations, in addition to the possible imposition of fines, compliance would entail significant expenditures. In connection with the deregulation of generation, the Company has agreed to rate caps in each of its jurisdictions, and there are no provisions under those arrangements to increase rates to cover such expe nditures.

In December 2000, the EPA issued a decision to regulate coal- and oil-fired electric utility mercury emissions under Title III, Section 112 of the Clean Air Act Amendments of 1990 (CAAA). The EPA plans to issue a proposed regulation by December 2003 and a final regulation by December 2004. The timing and level of required mercury emission reductions are unknown at this time.

On March 4, 1994, Monongahela Power, The Potomac Edison Company (Potomac Edison), and West Penn received notice that the EPA had identified them as potentially responsible parties (PRPs) under the Comprehensive Environmental Response, Compensation, and Liability Act of 1980, as amended, with respect to a Superfund Site. There are approximately 175 other PRPs involved. A final determination has not been made for the Company's share of the remediation costs based on the amount of materials sent to the site. However, the Company estimates that its share of the cleanup liability will not exceed $1.3 million, which has been accrued as a liability at June 30, 2002.

Monongahela Power, Potomac Edison, and West Penn have also been named as defendants along with multiple other defendants in pending asbestos cases involving multiple plaintiffs. While the Company believes that all of the cases are without merit, the Company cannot predict the outcome of the litigation. The Company has accrued a reserve of $3.8 million as of June 30, 2002, related to the asbestos cases as the potential cost to settle the cases to avoid the anticipated cost of defense. For the three and six months ended June 30, 2002, the Company received $1.8 million of insurance recoveries (net of $.4 million of legal fees) related to these asbestos cases. For the three and six months ended June 30, 2001, the Company received $.03 million of insurance recoveries related to these asbestos cases.

Allegheny Energy, Inc.

22

The Attorney General of the State of New York and the Attorney General of the State of Connecticut in their letters dated September 15, 1999, and November 3, 1999, respectively, notified the Company of their intent to commence civil actions against the Company or certain of its subsidiaries alleging violations at the Fort Martin Power Station under the federal Clean Air Act, including the new source performance standards, which requires existing generating facilities that make major modifications to comply with the same emission standards applicable to new generating facilities. Other governmental authorities may commence similar actions in the future. Fort Martin is a station located in West Virginia and is now jointly owned by Allegheny Energy Supply and Monongahela Power. Both Attorney Generals stated their intent to seek injunctive relief and penalties. In addition, the Attorney General of the State of New York in his letter indicated that he might assert claims under the state common law o f public nuisance seeking to recover, among other things, compensation for alleged environmental damage caused in New York by the operation of the Fort Martin Power Station. At this time, the Company and its subsidiaries are not able to determine what effect, if any, these actions threatened by the Attorney Generals of New York and Connecticut may have on them.

Allegheny Energy, Inc.

23

In June 2002, NPC commenced its previously announced plan to delay a portion of amounts payable under contracts for power sales, including the contracts between Merrill Lynch and NPC, for energy deliveries occurring between May 1, 2002 and September 15, 2002. Payments that NPC intends to make are equal to 110% of certain benchmark prices established as of May 1, 2002. NPC has announced its intention to pay the excess of such amounts semi-annually, through December 31, 2003, beginning on December 31, 2002. Allegheny Energy Supply has entered into a separate bilateral arrangement with Merrill Lynch under which it provides power on behalf of Merrill Lynch for the NPC contracts, and has agreed to delay receipt of payment from Merrill Lynch on such contracts until such time as NPC begins making payments to Merrill Lynch under the three contracts in dispute.

On February 25, 2002, the California Public Utilities Commission (California PUC) and the California Electricity Oversight Board (CAEOB) filed complaints with the FERC regarding various contracts to which the California Department of Water Resources (CDWR) is a counterparty, including two contracts with Allegheny Energy Supply to sell power to the CDWR. The California PUC complaint requested that each of the contracts challenged in the complaint be abrogated, as containing both unreasonable pricing and unjust and unreasonable non-price terms and conditions, or, in the alternative, that the challenged contracts be reformed to provide for just and reasonable pricing, reduce their duration, and strike from the contracts the specific non-price contract terms and conditions found to be unjust and unreasonable. The CAEOB's complaint requested that the contracts be voidable at the state of California's option, abrogated, or reformed. On March 18, 2002, Allegheny Energy Supply filed its response to the Califor nia PUC and CAEOB complaints in which it requested that the complaints be expeditiously denied.

On April 25, 2002, the FERC set for hearing the issue of whether the dysfunctional spot market in California had an adverse effect on the long-term, bilateral markets in California, including with respect to two contracts entered into between Allegheny Energy Supply and the CDWR, and if so, whether the effect was of such a magnitude to warrant modification of bilateral long-term contracts. The FERC held that, with respect to the Allegheny Energy Supply contracts, the higher "public interest" standard, rather than the "just and reasonable" standard should apply. On July 23, 2002, the FERC denied various requests for rehearing of its April 25, 2002 Order. Allegheny Energy Supply cannot predict the outcome of this litigation.

Allegheny Energy, Inc.

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On May 30,2002, the FERC dismissed in relevant part a complaint filed by the Attorney General of the State of California alleging that various sellers of electric energy in California violated the Federal Power Act by failing properly to file with the FERC the terms of their short-term power sales to the California Independent System Operator (ISO), the California Power Exchange, and the CDWR. The Attorney General had requested that sellers under these transactions pay refunds with interest for their short-term power sales during 2000 and 2001. On July 1, 2002, the Attorney General filed a request for rehearing with the FERC. Allegheny Energy Supply cannot predict the outcome of this proceeding.

In the second quarter of 2002, eight class action lawsuits were filed in the Superior Court of California seeking unspecified amounts of damages against various defendants, including Allegheny Energy Supply alleging violations of California's Cartwright Act and California's unfair business practices statute. These lawsuits were removed by the defendants to the U.S. District Courts for the Northern and Eastern Districts of California, and on July 12, 2002, were conditionally transferred to the U.S. District Court for the Southern District of California as "tag-along cases" to an existing multi-district litigation proceeding, "In Re California Wholesale Electricity Antitrust Litigation, MDL 1405, Transfer Order" (June 8, 2001). Allegheny Energy Supply cannot predict the outcome of these lawsuits at this time.

On May 8, 2002 the FERC staff, pursuant to a fact-finding investigation of potential manipulation of electric and natural gas prices in the western markets, requested that all sellers of wholesale electricity and/or ancillary services to the California ISO and/or the California Power Exchange during 2000 and 2001 provide certain data and other information relating to such sales and to "representative trading strategies." The data request was issued to over 140 companies, including Allegheny Energy Supply. Allegheny Energy Supply did not engage in any such sales, and prepared a response to the FERC to such effect.

On December 2, 2001, various Enron Corporation entities, including, but not limited to, Enron North America Corporation and Enron Power Marketing, Inc., collectively Enron, filed voluntary petitions for Chapter 11 reorganization with the United States Bankruptcy Court for the Southern District of New York.

Allegheny Energy Supply and Enron have master trading agreements in place, which include an International Swaps and Dealers Association Agreement, a Master Power Purchase and Sale Agreement, and a Master Gas Purchase and Sale Agreement (Agreements). Within all of these Agreements, there is netting and set-off language. This language allows Allegheny Energy Supply and Enron to net and set-off all amounts owed to each other under the Agreements.

Allegheny Energy, Inc.

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Pursuant to the Agreements, the voluntary petition for Chapter 11 reorganization by Enron constituted an event of default. Allegheny Energy Supply effected an early termination as of November 30, 2001, with respect to each of the Agreements, as permitted under the terms of the Agreements.

Allegheny Energy Supply believes it has appropriately exercised its contractual rights to terminate the Agreements and to net out transactions arising within each Agreement. Pursuant to the Bankruptcy Code, Allegheny Energy Supply believes it should be able to offset any termination values or payment amounts owed it against amounts it owes to Enron as a result of the netting. As of November 30, 2001, the fair value of all the Company's trades with Enron that were terminated was a net asset of approximately $27 million and the Company had a net payable to Enron of approximately $25 million. After applying the netting provisions of each Agreement, including any collateral posted by Enron with Allegheny Energy Supply, approximately $4.5 million was expensed as uncollectible in 2001.

In early August 2002, Enron sent a demand letter to Allegheny Energy Supply for approximately $26 million for a net payable from November 2001. Allegheny Energy Supply has asked Enron for clarification on its calculation including a determination of interest amounts. Allegheny Energy Supply has also provided its set-off position with Enron. Once Allegheny Energy Supply receives clarification from Enron, the parties will enter into negotiations regarding the settlement of all outstanding claims under the bankruptcy proceeding. Allegheny Energy Supply believes it will be able to set-off all outstanding exposures with the various Enron entities and come to a reasonable settlement of these claims.

In the normal course of business, the Company and its subsidiaries become involved in various legal proceedings. The Company and its subsidiaries do not believe that the ultimate outcome of these proceedings will have a material effect on their results of operations, cash flows, or financial position.

In November 2001, Allegheny Energy Supply entered into an operating lease transaction in connection with the construction of a 628-megawatt (MW) natural gas-fired generating facility in St. Joseph County, Indiana. In July 2002, the Company announced the cancellation of two 44-MW simple-cycle combustion turbines, which were included in the project. The reduced 540-MW combined-cycle facility is expected to be in service in 2004. Accordingly, the Company plans to amend the lease to reduce commitments.

In April 2001, Allegheny Energy Supply entered into an operating equipment lease transaction structured to finance the purchase of turbines and transformers. In May 2002, this lease was terminated for $33.1 million and the equipment was used in the project with CONSOL Energy, Inc. that placed into operation, in June 2002, an 88-MW generating facility in southwest Virginia.

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The purchase agreement for the energy marketing and trading business of Merrill Lynch provides that the Company shall use its best efforts to contribute to Allegheny Energy Supply the generating capacity from Monongahela Power's West Virginia jurisdictional generating assets by September 16, 2002. If, after using its best efforts to comply with this provision of the purchase agreement, the Company is prohibited by law from contributing to Allegheny Energy Supply substantially all of the economic benefits associated with such assets, then Merrill Lynch shall have the right to require the Company to repurchase all, but not less than all, of Merrill Lynch's equity interest in Allegheny Energy Supply for $115 million plus interest calculated from March 16, 2001. The Company does not anticipate such a transfer being made by September 16, 2002.

The purchase agreement also provides that, if the Company has not completed an initial public offering involving Allegheny Energy Supply within two years of March 16, 2001, Merrill Lynch has the right to sell its equity interest in Allegheny Energy Supply to the Company for $115 million plus interest calculated from March 16, 2001.

Letters of credit are purchased guarantees that ensure the Company's performance or payment to third parties, in accordance with certain terms and conditions, and amounted to $191.4 million of the $608.2 million available as of June 30, 2002. The Company pays fees for its letters of credit based on the amount available and the amount used.

As of June 30, 2002, the Company's exposure under guarantees of indebtedness and operating obligations of unconsolidated entities was approximately $11.0 million.

In December 2001, Allegheny Energy Solutions, Inc. (Allegheny Energy Solutions), a subsidiary of Allegheny Ventures, has contracted to provide seven natural gas-fired turbine generators for the SMEPA. The seven units will have a combined output of approximately 450 MW. The units will be owned by SMEPA. Construction began in March 2002, with installation to be completed in May 2003 through May 2006. Allegheny Energy Solutions will provide design, construction, and installation services for the units. The agreement allows for liquidated damages, for a maximum amount of $10 million, in the event Allegheny Energy Solutions fails to meet either specified delivery dates or the generators fail to meet specified performance requirements.

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In July 2002, the Company announced plans to reduce its workforce of approximately 6,000 employees by approximately 10 percent. The workforce reductions are expected to occur mostly this year through the combination of an early retirement option, normal attrition, and other selected staff reductions. At this time, the Company cannot estimate the cost of the workforce reduction since the results of the early retirement offer to employees are not known. The Company expects to record a charge in conjunction with the early retirement offer in the third or fourth quarter of 2002. The timing for recording charges for involuntary termination benefits related to selective staff reductions is being evaluated, including the potential impact of SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities," which was issued in June 2002.

Certain statements within constitute forward-looking statements with respect to Allegheny Energy, Inc. and its subsidiaries (collectively, the Company). Such forward-looking statements include statements with respect to deregulated activities and movements toward competition in the states served by the Company; markets; products; services; prices; capacity purchase commitments; results of operations; capital expenditures; regulatory matters; liquidity and capital resources; the effect of litigation; and accounting matters. All such forward-looking information is necessarily only estimated. There can be no assurance that actual results of the Company will not materially differ from expectations. Actual results have varied materially and unpredictably from past expectations.

Factors that could cause actual results of the Company to differ materially include, among others, the following: general economic and business conditions; changes in industry capacity, development, and other activities by the Company's competitors; changes in the weather and other natural phenomena; changes in technology; changes in the price of power and fuel for electric generation; changes in the underlying inputs and assumptions used to estimate the fair values of commodity contracts; changes in laws and regulations applicable to the Company, its markets, or its activities; litigation involving the Company; environmental regulations; the loss of any significant customers and suppliers; the effect of accounting policies issued periodically by accounting standard-setting bodies; and changes in business strategy, operations, or development plans.

In July and August 2002, the Company announced a series of initiatives to improve financial performance and respond to the challenges it faces in the current energy marketplace. The combination of the challenges to various electricity sales contracts and markets, the Enron bankruptcy, accounting scandals, energy trading improprieties, and other matters has significantly

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affected the merchant energy market. As a result, trading and origination opportunities have not occurred as the Company expected and are not expected to occur in the near future. In addition, additional generating capacity resources, lower than expected demand, and a relatively weak economy have led to reduced wholesale energy prices in several markets in which the Company owns, operates, or contractually controls generation capacity.

The Company's long-term strategy will be to focus on improving and maximizing the performance of its two business segments: Generation and Marketing, and Delivery and Services. In this context, the Company completed a thorough re-examination of its businesses, operations, and strategic plans and has developed the following objectives:

The Company also is implementing an aggressive cost reduction program which includes:

The Company has modified its energy marketing and trading and origination activities to focus on short-term trading, asset optimization, and hedging its generating capacity. These activities are more appropriately aligned with the Company's existing portfolio of physical assets.

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As a result of the above actions, the Company recorded charges to earnings in the second quarter of 2002 of $38.3 million, before income taxes ($23.3 million, net of income taxes) for the canceled generation projects. During the three months ended June 30, 2002, the Company also recorded a charge of $9.2 million, before income taxes ($5.5 million, net of income taxes) for unregulated investments determined to be impaired under Financial Accounting Standards Board's (FASB) Statement of Financial Accounting Standards (SFAS) No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets."

At this time, the Company cannot estimate the cost of the workforce reduction since the results of the early retirement offer to employees are not known. The Company expects to record a charge for the early retirement offer in the third or fourth quarter of 2002. The timing for recording charges for involuntary termination benefits related to selective staff reductions is being evaluated, including the potential impact of SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities," which was issued in June 2002. See the discussion of "Accounting Standards" on page 33 for additional information concerning SFAS No. 146.

The table below summarizes the Company's electric generating capacity, which was in operation on June 30, 2002, and December 31, 2001, including generating capacity purchased through contractual obligations of which the Company does not exercise 100 percent control, along with announced construction and development, contractual control, and planned expansions:

Since the summer of 2001, market prices for energy and capacity have declined across the nation. During this period, the Company has repeatedly reviewed its business strategy relating to the development, construction, and acquisition of generation projects, and as previously discussed, the Company recently announced the cancellation of the 1,080-MW generating facility planned for La Paz, Arizona and 88 MW of combustion turbine generation planned for St. Joseph, Indiana. During the three months ended June 30, 2002, the Company and CONSOL Energy, Inc. completed construction of and placed into operation an 88-MW generating facility in southwest Virginia. The completion of this facility increased the Company's generating capacity by 44 MW. The Company may undertake selective development projects and opportunistic acquisitions in the future, but in light of current market conditions, the Company is reducing the emphasis it places on such activities.

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On March 11, 2000, the West Virginia Legislature approved an electric restructuring plan that would open the State to full retail competition, but assigned tax issues surrounding the plan to a legislative subcommittee for further study. The start date of competition was made contingent upon the necessary tax changes being made and implementation being approved by the Legislature. Monongahela Power Company (Monongahela Power) worked with the West Virginia Public Service Commission (West Virginia PSC) to transfer its generating assets to Allegheny Energy Supply Company, LLC (Allegheny Energy Supply) pending implementation of the restructuring plan. No final legislative action was taken in 2001 or during this year's legislative session, and the current climate regarding restructuring makes it unlikely that the existing plan will be advanced. Accordingly, the Company no longer anticipates transferring Monongahela Power's jurisdictional generating assets to Allegheny Energy Supply pursuant to the previousl y approved restructuring plan. On June 28, 2002, the West Virginia PSC dismissed its electric restructuring case from its docket, and the Company cannot predict when the State may revisit electric deregulation. The Company is, however, currently in negotiations with the West Virginia PSC to transfer certain generating capacity from Monongahela Power to Allegheny Energy Supply.

On April 1, 2002, the Company's regulated subsidiaries, doing business as Allegheny Power, and the Pennsylvania - New Jersey - Maryland Interconnection, LLC (PJM), the electric grid operator for the mid-Atlantic region, announced that PJM's wholesale electricity market had begun operating in Allegheny Power's service territory. The collaboration between Allegheny Power and PJM, which is known as PJM West, brings Allegheny Power's transmission system under PJM's functional control. This creates an integrated energy market and congestion management system operating under a single governance structure in two separate control areas and across multiple North American Electric Reliability Councils. The larger energy market provides one market with a common transmission tariff, business practices, and market tools, thus eliminating interface issues between Allegheny Power and PJM.

PJM West provides transmission service to all market participants in accordance with the requirements of the FERC Order 2000. Transmission ties between PJM and PJM West are dynamically scheduled to support the integrated energy market.

On April 28, 2002, the negotiating teams for the Company and the Utility Workers Union of America (UWUA) System Local 102 reached a tentative agreement on a five-year contract. On June 8, 2002, the Company and the UWUA System Local 102 announced that the union's 1,165 members had ratified the agreement.

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The Pennsylvania Department of Revenue increased the Gross Receipts Tax rate from 4.4 percent to 5.9 percent (or 15 mills) for electric distribution companies in the state, including West Penn. The new rate is effective for calendar year 2002. State law directs West Penn to recover these increased tax charges by means of a State Tax Adjustment Surcharge (STAS) added to customer bills. On October 29, 2001, West Penn filed a request with the Pennsylvania Public Utility Commission (Pennsylvania PUC) to recover the increased tax liability of approximately $16.8 million from ratepayers. By order entered December 21, 2001, the Pennsylvania PUC directed West Penn to include the STAS on customer bills rendered between January 1, 2002, and December 31, 2002. On January 8, 2002, the Office of Consumer Advocate (OCA) filed an appeal of the Pennsylvania PUC order to the Commonwealth Court of Pennsylvania. On March 21, 2002, the Commonwealth Court granted the Pennsylvania PUC's motion to dismiss the OCA's appeal because the OCA still had the opportunity to litigate its complaint against West Penn and the matter was returned to the Pennsylvania PUC. Hearings were held on May 2 and June 25, 2002. On July 15, 2002, the Administrative Law Judge issued a Recommended Decision ruling that West Penn's rate increase to recover its 2002 Revenue Neutral Reconciliation (RNR) tax liability is just and reasonable. On August 8, 2002, the Pennsylvania PUC approved the STAS increase. The parties have 30 days to appeal the Pennsylvania PUC decision.

On June 29, 2002, the Governor of Pennsylvania signed House Bill 1848 which, among other changes, permanently set the RNR rate paid by electric distribution companies at the current rate of 15 mills. Act 138 of 1996 requires the Department of Revenue to publish the final RNR rate for tax year 2003 on October 1, 2002. This rate will become a permanent increase in the Gross Receipts Tax.

In addition, House Bill 1848 reduced the series of rate reductions in the Capital Stock and Franchise tax (also recovered via STAS). For the year 2002, the Capital Stock and Franchise tax was increased to 7.24 mills from 6.49 mills resulting in additional tax expense of approximately $300,000. On July 11, 2002, West Penn filed a petition to reflect the change and to continue to defer the STAS underrecovery as a regulatory asset for future recovery.

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On January 1, 2002, the Company adopted SFAS No. 141, "Business Combinations," and SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS No. 141 eliminated the pooling-of-interests method and requires all business combinations initiated after June 30, 2001, to be accounted for under the purchase method of accounting. SFAS No. 141 also sets forth guidelines for applying the purchase method of accounting in the determination of goodwill and other intangible assets. The application of SFAS No. 141 did not affect any of the Company's previously reported amounts for goodwill and other intangible assets.

SFAS No. 142 eliminated amortization of goodwill and other intangible assets with indefinite lives effective January 1, 2002. Subsequent to the transitional provisions of SFAS No. 142 (see below), goodwill and other intangible assets with indefinite lives will be tested at least annually for impairment, with impairment losses recognized in operating income. Absent any impairment indicators, the Company expects to perform its annual impairment tests during its fourth quarter, in connection with its annual budgeting process. Other intangible assets with finite lives will continue to be amortized over their useful lives and tested for impairment when events or circumstances warrant.

As applied to the Company, SFAS No. 142 transitional provisions required the Company to test goodwill for impairment as of January 1, 2002, and recognize any transitional goodwill impairment loss as the effect of a change in accounting principle in the first quarter of 2002 irrespective of when the loss was measured and recorded in the Company's books. During the second quarter of 2002, the Company completed its transitional goodwill impairment test, using a discounted cash flow methodology to determine the fair value of its reporting units, and recorded an impairment loss of $210.1 million before income taxes($130.5 million, net of income taxes), all of which relates to the Delivery and Services operating segment. In accordance with SFAS No. 142, this impairment loss has been recognized in the first quarter of 2002 through restatement of first quarter 2002 financial information in this Form 10-Q and subsequent Form 10-Q filings; no amendment or re-filing of the Company's first quarter 2002 Form 10-Q is required.

The transitional goodwill impairment loss consists of $170.0 million related to the Company's acquisition of Mountaineer Gas Company (Mountaineer Gas) in 2000, $25.0 million related to the Company's acquisition of West Virginia Power Company (West Virginia Power) in 1999, and $15.1 million of other regulated utility goodwill that had been carried on the Company's books for many years. The impairment amounts result from factors that are unique to these rate regulated entities and the ratemaking process, including the fact that none of the $210.1 million of goodwill was being recovered in rates or included in rate base.

SFAS No. 142 transitional provisions also have been completed with respect to the Company's other intangible assets resulting in no impairments or changes to amortizable lives.

See Note 5 to the consolidated financial statements for additional information regarding SFAS No. 142.

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On January 1, 2002, the Company adopted SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." This Statement establishes one accounting model for long-lived assets to be disposed of by sale, including discontinued operations, and carries forward the general impairment provisions of SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of." The adoption of SFAS No. 144 did not have a material effect on the Company's results of operations, cash flows, or financial position.

In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statement Nos. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections as of April 2002." SFAS No. 145 rescinds SFAS No. 4, "Reporting Gains and Losses from Extinguishment of Debt," and an amendment of that Statement, SFAS No. 64, "Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements." SFAS No. 145 also rescinds SFAS No. 44, "Accounting for Intangible Assets of Motor Carriers." SFAS No. 145 amends SFAS No. 13, "Accounting for Leases," to eliminate an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. SFAS No. 145 also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions. The provisions of this Statement are effective over various dat es beginning May 15, 2002. SFAS No. 145 is not expected to have a material effect on the Company's results of operations, cash flows, or financial position.

In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities." SFAS No. 146 addresses financial and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force (EITF) Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)." Costs associated with exit or disposal activities include termination benefits provided to employees that are involuntarily terminated, costs to terminate an operating lease or other contract, and incremental direct costs associated with, for example, facility closures and restructuring plans. The principal difference between this Statement and EITF Issue No. 94-3 involves the timing of recognition of a liability. SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. Under EITF Issue No. 9 4-3, a liability for an exit cost was recognized at the date of an entity's commitment to an exit plan. The provisions of this Statement are effective for exit or disposal activities that are initiated after December 31, 2002, with earlier application encouraged. The Company is currently evaluating the effect of applying SFAS No. 146 on its results of operations and financial position. The Company has not determined whether it will adopt the Statement early or what effect, if any, SFAS No. 146 may have on the accounting for the 10 percent workforce reduction announced in July 2002.

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In June 2002, the EITF reached a consensus on Issue No. 02-3, "Recognition and Reporting of Gains and Losses on Energy Trading Contracts," that mark-to-market gains and losses on energy trading contracts (whether realized or unrealized) should be shown net in the consolidated statement of operations. This consensus will be applicable to financial statements for periods ending after July 15, 2002. The Company currently reports realized purchased energy and transmission related to energy trading contracts that require physical delivery of the commodity under cost of revenues on the consolidated statement of operations. The Company reports net unrealized gains and losses resulting from energy trading in operating revenues on the consolidated statement of operations. During the third quarter of 2002, the Company plans to modify its reporting as a result of the EITF consensus to reflect, for all periods presented, the revenues from energy trading activities net of the cost of purchased energy and transmiss ion related to contracts that require physical delivery. As a result, the Company will report lower operating revenues and lower cost of revenues with no effect on consolidated net income. While the Company has not completed its evaluation of the effect of the adoption of EITF 02-3, the following table provides the Company's most current estimate of the restated operating revenues and cost of revenues for the three and six months ended June 30, 2002 and 2001, respectively, on a net basis.

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For the three months ended June 30, 2002, the Company's results primarily reflect weak wholesale energy markets nationwide, lower net revenue for Generation and Marketing, reduced economic activity, and generation outages at the Company's generating stations. The Company recorded an after-tax charge for Generation and Marketing for the three months ended June 30, 2002, of $23.3 million ($.19 per share) for the cancellation of generating capacity planned for La Paz, Arizona. Delivery and Services also recorded an after-tax charge of $5.5 million ($.04 per share) for unregulated investments determined to be impaired. For the three months ended June 30, 2002, Generation and Marketing was also affected by increased operation expenses and reduced excess generation available for sale into the wholesale markets due to generation outages. These outages also resulted in the purchase of higher priced replacement power for both Delivery and Services and Generation and Marketing.

In addition to the above, Delivery and Services earnings for the six months ended June 30, 2002, was also affected by milder winter weather for the three months ended March 31, 2002, versus the three months ended March 31, 2001, and an increase in the price per megawatt-hour (MWh) paid to Generation and Marketing for purchased energy for the six months ended June 30, 2002, versus the six months ended June 30, 2001.

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For the six months ended June 30, 2002, the decrease in Generation and Marketing earnings was partially offset by increased net revenues for the three months ended March 31, 2002, reflecting operating results for additional generating capacity and an energy trading business acquired in May 2001 and March 2001, respectively.

For the six months ended June 30, 2002, the decrease in earnings per share reflects the effects of an increased number of shares outstanding and the decreased earnings from Delivery and Services.

Also for the six months ended June 30, 2002, the Company completed its assessment of goodwill in accordance with SFAS No. 142, "Goodwill and Other Intangible Assets." The assessment determined that approximately $210 million of goodwill, primarily related to the acquisitions of Mountaineer Gas and West Virginia Power, was impaired. As a result, the Company recorded an after-tax charge of $130.5 million ($1.04 per share) as the cumulative effect of an accounting change as of January 1, 2002.

Allegheny Energy Supply had certain option contracts that were derivatives as defined by SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," which did not qualify for hedge accounting. In accordance with SFAS No. 133, Allegheny Energy Supply recorded a charge of $31.1 million against earnings, net of the related income tax effects ($52.3 million, before income taxes) for these contracts as a change in accounting principle on January 1, 2001.

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Total operating revenues for the three and six months ended June 30, 2002 and 2001 were as follows:

The increase in Delivery and Services regulated electric revenues for the three months ended June 30, 2002, was primarily due to an increase in the average number of customers, an increase in customer usage due to more favorable weather, higher Pennsylvania gross receipts taxes, and a return of choice customers to full service.

Effective January 1, 2002, the Pennsylvania Department of Revenue increased the Gross Receipts Tax rate from 4.4 percent to 5.9 percent for electric distribution companies in the state, including West Penn. The collection of increased gross receipts taxes did not impact the Company's earnings since these taxes are remitted to the state.

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Regulated electric revenues include choice revenues that represent transmission and distribution (T&D) revenues from customers in West Penn's Pennsylvania, The Potomac Edison Company's (Potomac Edison) Maryland and Virginia, and Monongahela Power's Ohio distribution territories that chose other suppliers to provide their energy needs. Pennsylvania, Maryland, Virginia, and Ohio deregulation gave West Penn's, Potomac Edison's, and Monongahela Power's regulated customers the ability to choose another energy supplier. For the six months ended June 30, 2002 and 2001, all of West Penn's regulated customers, Potomac Edison's Maryland regulated customers, and Monongahela Power's Ohio regulated customers had the ability to choose. Potomac Edison's Virginia regulated customers had the ability to choose alternate suppliers beginning on January 1, 2002. The return of customers to full service does not impact sales since the Company determines sales on the basis of kilowatt-hours (kWh's) delivered to customers (regardless of their electricity supplier). However, such a return of customers to full service results in a significant increase in revenues due to the addition of a supply charge that the Company had not collected while the customers were using an alternate electricity supplier. The effect on revenues of customers returning to full service was especially noticeable in the commercial and industrial classes where a higher percentage of sales were associated with choice customers returning to full service. At June 30, 2002, approximately .1 percent of the combined West Penn regulated customers, Potomac Edison Maryland and Virginia regulated customers, and Monongahela Power Ohio regulated customers chose alternate energy suppliers.

In addition to the above, Delivery and Services regulated electric revenues for the six months ended June 30, 2002, were also affected by milder winter weather for the three months ended March 31, 2002, versus the three months ended March 31, 2001.

Delivery and Services regulated natural gas revenues include Monongahela Power and its subsidiary, Mountaineer Gas, for the six months ended June 30, 2002 and 2001. Because a significant portion of the natural gas sold by Monongahela Power's natural gas distribution operations is ultimately used for space heating, both revenues and earnings are subject to seasonal fluctuations. The Purchased Gas Adjustment (PGA) mechanism continues to exist for Monongahela Power and came into effect for Mountaineer Gas following a three-year moratorium, which ended on October 31, 2001. Under the PGA mechanism, differences between revenues received for energy costs and actual energy costs are deferred until the next rate proceeding, when energy rates are adjusted to return or recover previous overrecoveries or underrecoveries, respectively. For the three and six months ended June 30, 2002, the decrease in Delivery and Services regulated natural gas revenues was primarily due to milder winter weather for the three month s ended March 31, 2002, versus the three months ended March 31, 2001, and to Mountaineer Gas commercial customers switching to other natural gas suppliers and becoming transportation customers only.

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Delivery and Services bulk power included $11.0 million and $19.2 million for the three and six months ended June 30, 2001, respectively, due to the sale of the output of the AES Warrior Run cogeneration facility into the open wholesale market. This sale of output was part of a Maryland Public Service Commission (Maryland PSC) settlement agreement with Potomac Edison which allows full recovery from Maryland customers of the purchased power costs incurred by Potomac Edison related to the AES Warrior Run facility in excess of the value of the power sold in the open market. In November 2001, Allegheny Energy Supply obtained, through a competitive bidding process approved by the Maryland PSC, the contract to purchase the output of the AES Warrior Run project. Other affiliated and non-affiliated energy services included $11.4 million and $20.9 million for the three and six months ended June 30, 2002, respectively, for the sale of the output of the AES Warrior Run project.

Delivery and Services unregulated services revenues increased by $114.8 million and $257.5 million for the three and six months ended June 30, 2002, respectively, primarily due to revenues of $10.3 million and $37.5 million for the three and six months ended June 30, 2002, respectively, for Allegheny Energy Solutions, Inc.'s (Allegheny Energy Solutions) agreement to provide seven natural gas-fired turbine generators to the South Mississippi Electric Power Association (SMEPA) and revenues of $114.7 million and $236.0 million for the three and six months ended June 30, 2002, respectively, from Alliance Energy Services Partnership (Alliance Energy Services), which was acquired by Allegheny Ventures, Inc. (Allegheny Ventures) on November 1, 2001.

The decrease in Generation and Marketing bulk revenues for the three and six months ended June 30, 2002, was primarily due to weak wholesale energy markets nationwide, generation outages at the Company's generating stations, and decreased unrealized gains.

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Allegheny Energy Supply significantly increased the volume and scope of its energy marketing and trading activities as a result of its acquisition of an energy trading business from Merrill Lynch Capital Services, Inc. (Merrill Lynch) on March 16, 2001. The Company now trades electricity, natural gas, oil, coal, and other energy-related commodities. The Company records contracts entered into in connection with energy trading at fair value on the consolidated balance sheet, with all changes in fair value recorded as gains and losses on the consolidated statement of operations in operating revenues. The realized revenues from energy trading activities, with the exception of certain financial instruments, including swaps, certain options and certain natural gas transactions, are recorded on a gross basis as individual discrete transactions as either revenues or expenses because the contracts require physical delivery of the underlying asset. Fair values for exchange-traded instruments, principally futures and certain options, are based on actively quoted market prices. In establishing the fair value of commodity contracts that do not have quoted market prices, such as physical contracts, over-the-counter options, and swaps, management makes estimates using available market data and pricing models, which may change from time to time. The Company has certain contracts that are unique, which extend to 2010 and beyond, and are valued using proprietary pricing models. Inputs to the models include estimated forward natural gas and electricity prices, interest rates, estimates of market volatility for natural gas and electricity prices, the correlation of natural gas and electricity prices, and other factors such as generating unit availability and location, as appropriate. These inputs require management judgments and assumptions. The Company's models also adjust the fair value of commodity contracts to reflect uncertainty in prices, operational risks related to generating facilities, and risks related to the performance of counterparties. These inputs become more challenging, and the models become less precise the further into the future these estimates are made. Additionally, various factors, including accounting and energy trading improprieties of others, have significantly affected the merchant energy marketplace during the six months ended June 30, 2002. Market liquidity and the number of creditworthy participants have been dramatically reduced and trading and origination opportunities have been significantly curtailed within energy markets. Actual effects on the Company's financial position and results of operations may vary significantly from expected results if the judgments and assumptions underlying those models' inputs prove to be wrong or the models prove to be unreliable.

The fair values of energy trading commodity contracts, which represent the net unrealized gain and loss positions, are recorded as assets and liabilities as stated above, after applying the appropriate counterparty netting agreements in accordance with FASB Interpretation No. 39, "Offsetting of Amounts Related to Certain Contracts - an Interpretation of APB Opinion No. 10 and FASB Statement No. 105." At June 30, 2002, the fair value of energy trading commodity contract assets and liabilities was $1,837.5 million and $945.5 million, respectively. At December 31, 2001, the fair value of energy trading commodity contract assets and liabilities was $1,755.4 million and $995.0 million, respectively.

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The following table disaggregates the net fair value of commodity contract assets and liabilities, excluding the Company's generating assets and provider of last resort obligations, as of June 30, 2002, based on the underlying market price source and the contract delivery periods:

In the table above, each commodity contract is classified by the source of fair value, based on the entire contract being assigned to a single classification (even though a portion of a contract may be valued based on one of the other classifications) and the fair values are shown for the scheduled delivery or settlement dates. The Company determines prices actively quoted from various industry services, broker quotes, and the New York Mercantile Exchange (NYMEX). Electricity markets are generally liquid for approximately three years and natural gas markets are generally liquid for approximately five years. For times beyond those periods, some market prices can be observed, but market liquidity is less robust.

Approximately $1.1 billion of the Company's commodity contracts were classified as prices based on models (even though a portion of these contracts are valued based on observable market prices). The most significant variable to the Company's models used to value these contracts is the forward prices for both electricity and natural gas. These forward prices are based on observable market prices to the extent prices are available in the market. Generally, electricity forward prices are actively quoted for about three years and some observable market prices are available for about five years. After five years, the forward prices for electricity are based on the forward price of natural gas and a marginal heat rate for generation (based on more efficient natural gas-fired generation) to convert natural gas into electricity. For natural gas, forward prices are generally actively quoted for about five years, and some observable market prices are available for about 10 years. Beyond 10 years, natural gas prices are escalated, based on trends in prior years.

For deliveries from July 1, 2002, to June 30, 2003, the fair value of the Company's commodity contracts was a net liability of $221.2 million, primarily related to commodity contracts used to hedge the California Department of Water Resources (CDWR) agreement. As discussed below, the Company expects to incur realized losses related to the contract with the CDWR and related hedges through 2002.

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Net unrealized gains of $30.3 million and $111.7 million in the three and six months ended June 30, 2002 and 2001, respectively, were recorded in the consolidated statement of operations in operating revenues to reflect the change in the estimated fair value of the energy commodity contracts. Net unrealized gains of $142.4 million and $180.5 million in the three and six months ended June 30, 2001, respectively, were recorded in the consolidated statement of operations in operating revenues to reflect the change in the estimated fair value of energy commodity contracts. The following table provides a roll-forward of the net fair value, or commodity contract assets less commodity contract liabilities, of the Company's commodity contracts from December 31, 2001, to June 30, 2002:

As shown in the table above, the net fair value of the Company's commodity contracts increased by $111.7 million as a result of unrealized gains recorded during the six months ended June 30, 2002, of which $114.9 million related to the Company's contracts in the Western Systems Coordinating Council (WSCC), including the fixed-price contract with the CDWR, the contract to call up to 1,000 MW of generating capacity in southern California, and the contract for 222 MW of generating capacity from a plant being constructed in Las Vegas, Nevada (LV Cogen). The increase in the fair value of the WSCC portfolio was primarily due to rising prices for the three months ended March 31, 2002, which increased the value of the contract to call up to 1,000 MW of generating capacity in southern California, plus certain changes in the valuation of the contracts with the CDWR, as discussed below. For the three months ended June 30, 2002, the fair value of the WSCC portfolio remained relatively flat with only a $2.8 million decrease in fair value.

On February 21, 2002, the California Public Utilities Commission (California PUC) approved a rate agreement with the CDWR in order for the CDWR to issue bonds to repay the state of California's general fund and other outstanding loans and pay its ongoing long-term purchased power costs. The agreement creates two streams of revenue for the CDWR by calling for the California PUC to impose bond charges and power charges on retail electric customers sufficient to pay the CDWR's debt service and operating expenses, including payment of its long-term power purchase agreements with the Company. To date, all payments to the Company by the CDWR for purchased power have been made on time and in full.

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The California PUC rate agreement is a positive development relative to the prior assumptions used in assessing the long-term creditworthiness of the CDWR and the estimation of the fair value of the Company's contracts with the CDWR. As a result, the valuation adjustments used in estimating the fair value of these contracts have been reduced. The effect of this change, which was made during the three months ended March 31, 2002, resulted in a $35.8 million increase in the estimated fair value of the CDWR contracts before consideration of the other valuation factors.

During the six months ended June 30, 2002 and 2001, the Company's energy trading activities resulted in $22.3 million and $89.7 million of net realized losses, respectively. The realized losses for the six months ended June 30, 2002, were primarily from the Company's contract with the CDWR and the related hedges. Due to the existing hedges of the CDWR contract, the Company is currently paying for power at prices above the fixed-price contract to sell power to the CDWR. The Company expects to continue to incur realized losses related to the CDWR contract due to the hedges through 2002, but at a reduced level as the hedges mature. Starting with 2003, the Company expects to realize gains related to the CDWR contract for the remainder of the term of the contract.

There has been and may continue to be significant volatility in the market prices for electricity and natural gas at the wholesale level, which will affect the Company's operating results. Similarly, volatility in interest rates will affect the Company's operating results. The effects may be either positive or negative, depending on whether the Company's subsidiaries are net buyers or sellers of electricity and natural gas.

The decrease in Generation and Marketing bulk revenues for the three months ended June 30, 2002, also reflects Allegheny Energy Supply having increased generation available for sale in a wholesale market with low prices, low volatility, and excess capacity. On May 3, 2001, Allegheny Energy Supply completed the acquisition of three natural gas-fired generating facilities with a total generating capacity of 1,710 MW in Illinois, Indiana, and Tennessee (Midwest). In December 2001, Allegheny Energy Supply also completed the construction of and placed into service two 44-MW simple-cycle natural gas combustion turbines. In June 2002, the Company and CONSOL Energy, Inc. also completed construction of and placed into operation an 88-MW generating facility in southwest Virginia. The completion of this facility increased Generation and Marketing's generating capacity by 44 MW. As a result, the Generation and Marketing segment had more generation available for sale into the deregulated marketplace in the three and six months ended June 30, 2002.

For the three and six months ended June 30, 2002, Generation and Marketing retail, affiliated, and other revenues decreased $27.0 million and $64.6 million, respectively. These decreases were primarily due to Allegheny Energy Supply's shift in focus away from retail customers toward the wholesale markets and energy commodity trading.

Allegheny Energy, Inc.

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The table below separates operating revenues and cost of revenues for the Generation and Marketing segment into two components: Provider of Last Resort and Excess Generation and Trading. The Provider of Last Resort component represents Generation and Marketing's obligation under long-term power sales agreements to provide West Penn, Potomac Edison, and Monongahela Power with the amount of electricity, up to their provider of last resort retail load, that they may demand in their Pennsylvania, Maryland, Virginia, and Ohio service territories. The Excess Generation and Trading component represents the Company's energy marketing and trading activities and any generation in excess of the provider of last resort obligations. The table also separates operating revenues and cost of revenues into contracts that required physical delivery and those that provided for financial net settlement. This separation was performed based on the Company's accounting policy, which provides that realized revenues, with the exception of certain financial instruments, including swaps, certain options, and certain natural gas transactions, are recorded on a gross basis in revenues or expenses as individual discrete transactions because the contracts require physical delivery of the underlying asset. All unrealized gains from energy trading activities were recorded net in operating revenues.