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WGL Holdings, Inc.
Washington Gas Light Company
Part I — Financial Information
Item 1— Financial Statements (continued)
Notes to Consolidated Financial Statements (Unaudited)

Operating Segment Financial Information

WGL Holdings, Inc.
Part I — Financial Information
Item 2 — Management’s Discussion and Analysis of
Financial Condition and Results of Operations

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

SAFE HARBOR FOR FORWARD-LOOKING STATEMENTS

     Certain matters discussed in this report, excluding historical information, include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 with respect to the outlook for earnings, revenues and other future financial business performance or strategies and expectations. Forward-looking statements are typically identified by words such as, but not limited to, “estimates,” “expects,” “anticipates,” “intends,” “believes,” “plans,” and similar expressions, or future or conditional verbs such as “will,” “should,” “would,” and “could.” Although the registrants, WGL Holdings, Inc. (WGL Holdings or the Company) and Washington Gas Light Company (Washington Gas or the regulated utility), believe such forward-looking statements are based on reasonable assumptions, they cannot give assurance that every objective will be achieved. Forward-looking statements speak only as of today, and the registrants assume no duty to update them. The following factors, among others, could cause actual results to differ materially from forward-looking statements or historical performance:

	•		variations in weather conditions from normal levels;
	•		changes in economic, competitive, political and regulatory conditions and developments;
	•		changes in capital and energy commodity market conditions;
	•		changes in credit market conditions and creditworthiness of customers and suppliers;
	•		changes in relevant laws and regulations, including tax, environmental and employment laws and regulations;
	•		legislative, regulatory and judicial mandates and decisions;
	•		timing and success of business and product development efforts;
	•		technological improvements;
	•		the pace of deregulation efforts and the availability of other competitive alternatives;
	•		terrorist activities; and
	•		other uncertainties.

     The outcome of negotiations and discussions the registrants hold with other parties from time to time regarding utility and energy-related investments and transactions that are both recurring and non-recurring may also affect future performance. All such factors are difficult to predict accurately and are generally beyond the direct control of the registrants. Accordingly, while they believe that the assumptions are reasonable, the registrants cannot ensure that all expectations and objectives will be realized. Readers are urged to use care and consider the risks, uncertainties and other factors that could affect the Company’s business as described in this Quarterly Report on Form 10-Q. All forward-looking statements made in this report rely upon the safe harbor protections provided under the Private Securities Litigation Reform Act of 1995.

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WGL Holdings, Inc.
Part I — Financial Information
Item 2 — Management’s Discussion and Analysis of
Financial Condition and Results of Operations (continued)

     Management’s Discussion and Analysis of Financial Condition and Results of Operations (Management’s Discussion) is divided into the following two major sections:

	•		WGL Holdings  — This section describes the financial condition and results of operations of WGL Holdings and its subsidiaries on a consolidated basis. It includes brief discussions of WGL Holdings’ regulated utility operations and non-utility operations. The majority of WGL Holdings’ operations are derived from the results of its regulated utility, Washington Gas. In addition, WGL Holdings is affected by the results of its non-utility operations. For more information on the Company’s regulated utility operations, please refer to the Management’s Discussion for Washington Gas.
	•		Washington Gas  — This section describes the financial condition and results of operations of Washington Gas, a wholly owned subsidiary that comprises the vast majority of WGL Holdings’ regulated utility segment. As such, the financial condition and results of operations of Washington Gas’ utility operations and WGL Holdings’ regulated utility segment are essentially the same.

     Both of the major sections of Management’s Discussion—WGL Holdings and Washington Gas—should be read to obtain an understanding of the Company’s operations and financial performance. Management’s Discussion also should be read in conjunction with the respective company’s financial statements and the combined notes thereto.

     Unless otherwise noted, earnings per share amounts are presented herein on a diluted basis, and are based on weighted average common and common equivalent shares outstanding.

EXECUTIVE OVERVIEW

     Introduction

     WGL Holdings, through its subsidiaries, sells and delivers natural gas and provides a variety of energy-related products and services to customers primarily in the metropolitan areas of Washington, D.C., Maryland and Virginia. WGL Holdings has three primary operating segments that are described below:

     Regulated Utility. The Company’s core subsidiary, Washington Gas, delivers natural gas to retail customers in accordance with tariffs set by state or District of Columbia regulatory commissions that have jurisdiction over Washington Gas’ rates. These rates are intended to provide the regulated utility with an opportunity to earn a just and reasonable rate of return on the investment devoted to the delivery of natural gas to customers. Additionally, Washington Gas sells natural gas to customers who have not elected to purchase natural gas from unregulated third-party marketers. The regulated utility does not earn a profit or incur a loss when it sells the natural gas commodity as utility customers are charged for the natural gas commodity at the same cost the regulated utility incurs.

     Retail Energy-Marketing. Washington Gas Energy Services (WGEServices) sells natural gas and electricity directly to residential, commercial and industrial customers, both inside and outside of the regulated utility’s traditional service territory. WGEServices does not own any natural gas or electric generation, transmission or distribution assets. Rather, it sells natural gas and electricity with the objective of earning a profit, and those commodities are delivered to retail customers through the assets owned by regulated utilities.

     Heating, Ventilating and Air Conditioning (HVAC). The Company’s commercial HVAC operations provide turn-key, design-build, and renovation projects to the commercial and government markets.

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WGL Holdings, Inc.
Part I — Financial Information
Item 2 — Management’s Discussion and Analysis of
Financial Condition and Results of Operations (continued)

     Key Indicators of Financial Condition and Operating Performance

     Management believes that the following are key indicators for monitoring the Company’s financial condition and operating performance:

     Return on average common equity. This ratio is calculated by dividing net income (applicable to common stock) by average common shareholders’ equity. For the regulated utility, management compares the actual return on equity with the return on equity allowed by regulators and the return on equity that is necessary for the Company to compensate investors sufficiently and be able to continue to attract capital.

     Common equity ratio. This ratio is calculated by dividing total common shareholders’ equity by the sum of common shareholders’ equity, preferred stock and long-term debt (including current maturities). Maintaining this ratio in the mid-50 percent range affords the Company financial flexibility and access to long-term capital at relatively low costs. Refer to the “Liquidity and Capital Resources- General Factors Affecting Liquidity” section of Management’s Discussion for a discussion of the Company’s capital structure.

     Primary Factors Affecting WGL Holdings and Washington Gas

     The principal business, economic and other factors that affect the operations and/or financial performance of WGL Holdings and Washington Gas include:

	•		weather conditions;
	•		regulatory environment;
	•		gas supply and storage capacity;
	•		competitive environment;
	•		environmental matters;
	•		industry consolidation;
	•		economic conditions and interest rates;
	•		inflation/deflation;
	•		labor contracts; and
	•		potential changes in accounting practices.

     For a further discussion of the Company’s business, operating segments and the factors listed above, refer to Management’s Discussion within the Company’s fiscal year 2003 Annual Report on Form 10-K.

CRITICAL ACCOUNTING POLICIES

     Preparation of financial statements and related disclosures in compliance with Generally Accepted Accounting Principles in the United States of America (GAAP) requires the selection and the application of appropriate technical accounting rules to the relevant facts and circumstances of the Company’s operations, as well as the use of estimates by management to compile the consolidated financial statements. The application of these accounting policies involves judgment regarding estimates and projected outcomes of future events, including the likelihood of success of particular regulatory initiatives, the likelihood of actualizing environmental estimates and the probability of recovering costs and investments in both the regulated utility and non-utility operations.

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WGL Holdings, Inc.
Part I — Financial Information
Item 2 — Management’s Discussion and Analysis of
Financial Condition and Results of Operations (continued)

     The following critical accounting policies require management’s judgment and estimation, where such estimates have a material effect on the consolidated financial statements.

	•		accounting for utility revenue and cost of gas recognition;
	•		accounting for regulatory operations — regulatory assets and liabilities;
	•		accounting for income taxes; and
	•		accounting for contingencies.

     For a description of these critical accounting policies, refer to Management’s Discussion within the combined Annual Report on Form 10-K for WGL Holdings and Washington Gas for the fiscal year ended September 30, 2003. There have been no changes in the method of management’s judgment and estimation underlying these policies subsequent to September 30, 2003.

WGL HOLDINGS, INC.

RESULTS OF OPERATIONS — Three Months Ended December 31, 2003 vs. December 31, 2002

     Summary Results

     WGL Holdings, Inc. reported net income of $39.5 million, or $0.81 per share, for the three months ended December 31, 2003, the first quarter of the Company’s fiscal year 2004. This compares to net income of $51.6 million, or $1.06 per share, for the same quarter of the prior fiscal year. There was no difference between basic and diluted earnings per share for the current or prior year’s quarter. For the twelve-month period ended December 31, 2003, the Company earned a return on average common equity of 12.2 percent as compared to 7.5 percent for the corresponding prior twelve-month period.

     Weather for the first quarter of fiscal year 2004 was 1.9 percent colder than normal, compared to 21.0 percent colder than normal for the same quarter last fiscal year. This was the primary driver of the overall earnings comparisons between the current and prior year’s first quarter, coupled with additional depreciation expense recorded in the 2004 first quarter in connection with a Virginia rate order. Favorably contributing to earnings for the first three months of fiscal year 2004 was a 2.3 percent increase in active customers, along with improved earnings from the Company’s unregulated retail energy-marketing business.

     Regulated Utility Operating Results

     The Company’s utility operations are weather sensitive, with a significant portion of its revenue coming from deliveries of natural gas to residential and commercial heating customers. The regulated utility segment reported net income of $34.7 million, or $0.71 per share, for the first quarter of fiscal year 2004, compared to net income of $46.9 million, or $0.96 per share, for the same quarter of the prior fiscal year. Total gas deliveries to firm customers fell 9.9 percent to 402.1 million therms for the current quarter due to warmer weather. Weather, as measured by heating degree days, was 15.5 percent warmer in the current quarter than the same period of the prior fiscal year. Weather for the prior year’s first quarter was 21.0 percent colder than normal, enhancing earnings per share by $0.17. Weather was only 1.9 percent colder than normal for the first quarter of fiscal year 2004, and had a negligible effect on net income.

     Earnings for the regulated utility segment also reflect higher depreciation and amortization expense for the first quarter of fiscal year 2004, primarily as a result of a December 18, 2003 final Order of the State Corporation Commission of Virginia (SCC of VA). In connection with this Order, the Company recorded, in the quarter ended December 31, 2003, additional depreciation expense of $3.5 million (pre-tax), or $0.04 per share, applicable to the period from January 1, 2002 through November 11, 2002. Additionally, an adjustment to income taxes favorably contributed $2.7 million, or $0.06 per

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WGL Holdings, Inc.
Part I — Financial Information
Item 2 — Management’s Discussion and Analysis of
Financial Condition and Results of Operations (continued)

share, to earnings for the first quarter of fiscal year 2003.

     Improving current quarter earnings for the regulated utility segment was a 22,344 increase in active customer meters as compared to the same quarter of the prior year. With respect to retail rates, the Company has received five changes in its base rates in the past year. There was virtually no effect of these rate changes on earnings for the current quarter when compared to the prior year’s quarter. However, these rate changes will have a favorable effect on earnings comparisons in subsequent 2004 quarters.

     Non-Utility Operating Results

     Total net income for the Company’s non-utility operations was $4.9 million, or $0.10 per share, for the three months ended December 31, 2003, a slight improvement of $153,000 over the same quarter of the prior year. The following table compares the financial results from non-utility activities for the quarters ended December 31, 2003 and 2002.

     Retail Energy-Marketing. WGL Holdings’ retail energy-marketing subsidiary, WGEServices, sells natural gas and electricity in competition with other unregulated marketers. WGEServices reported net income of $4.8 million, or $0.10 per share, for the first quarter of fiscal year 2004, a $509,000, or $0.01 per share, improvement over the same quarter in fiscal year 2003. This improvement reflects higher gross margins from the sale of both natural gas and electricity. Though natural gas sales volumes of 207.8 million therms were relatively unchanged from the prior year’s quarter, the gross margin per therm of natural gas sold increased eight percent over the gross margin in the same quarter of the prior year. Gross margin per kilowatt-hour increased 30 percent over the prior year’s quarter, which more than offset an 11 percent decline in electricity volumes sold due to a reduction in the number of lower-margin residential customers served, as well as a reduction in commercial kilowatt-hour sales.

     Commercial HVAC. Two subsidiaries, American Combustion Industries, Inc. and Washington Gas Energy Systems, Inc., comprise the Company’s commercial HVAC operations. This operating segment reported a net loss of $498,000, or $0.01 per share, as compared to a net loss of $385,000, or $0.01 per share, for the same quarter last year, principally reflecting lower sales and gross margins.

     Other Non-Utility Activities. Transactions not significant enough to be reported as a separate business segment are aggregated as other non-utility activities of the Company and included as part of non-utility operations. Results for other non-utility activities for the current quarter reflect a $243,000 decrease in income from the prior year’s quarter primarily due to the inclusion in last year’s first quarter of an after-tax gain of $926,000, or $0.02 per share, from the Company’s sale of its interest in a land development venture. This was largely offset by a favorable after-tax adjustment of $600,000, or $0.01 per share, in the first quarter of fiscal year 2004 to a loan loss provision associated with the Company’s consumer finance business that has stopped accepting new loans.

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WGL Holdings, Inc.
Part I — Financial Information
Item 2 — Management’s Discussion and Analysis of
Financial Condition and Results of Operations (continued)

     Other Income (Expenses) – Net

     For the quarter ended December 31, 2003, Other income (expenses) — net reflected net expenses of $920,000 as compared to income of $714,000 for the quarter ended December 31, 2002. The inclusion in the first quarter of the prior fiscal year of an after-tax gain of $926,000 related to the Company’s sale of its interest in a real estate venture contributed to the year-over-year comparison.

     Interest Expense

     The following table depicts the components of interest expense for the quarters ended December 31, 2003 and 2002.

     WGL Holdings’ interest expense of $11.6 million for the first three months of fiscal year 2004 decreased $308,000 from the same period last year due primarily to a decrease in the average balance of long-term debt outstanding, coupled with a decrease in the weighted average cost of these borrowings. Increased interest costs related to short-term borrowings reflect higher average balances, partially offset by a decrease in the weighted average cost of such borrowings.

LIQUIDITY AND CAPITAL RESOURCES

     General Factors Affecting Liquidity

     It is important for the Company to have access to short-term debt markets to maintain satisfactory liquidity to operate its businesses on a near-term basis. Acquisition of natural gas, electricity, pipeline capacity and the need to finance accounts receivable are the most significant short-term financing requirements of the Company. The need for long-term capital is primarily driven by capital expenditures and maturities of long-term debt.

     Significant swings can take place in the level of short-term debt required by the Company due primarily to changes in the price of natural gas and the impact of weather on the volumes of natural gas and electricity that need to be purchased to satisfy customer demand. Satisfactory supplemental financing to the Company’s commercial paper program in the form of revolving credit agreements enables the Company to maintain access to short-term debt markets. The ability of the Company to obtain such financing depends on its credit ratings, which are greatly affected by financial performance and the liquidity of financial markets. Also potentially affecting access to short-term debt capital is the nature of any restrictions that might be placed upon the Company such as ratings triggers or a requirement to provide creditors with additional credit support in the event of a determination of insufficient creditworthiness.

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WGL Holdings, Inc.
Part I — Financial Information
Item 2 — Management’s Discussion and Analysis of
Financial Condition and Results of Operations (continued)

     The ability to procure sufficient levels of long-term capital at reasonable costs is determined by the level of the Company’s capital expenditure requirements, its financial performance, and the effect of these factors on its credit ratings and investment alternatives available to investors. Contract provisions related to a change in the Company’s creditworthiness might restrict the Company’s access to short- and long-term capital.

     The Company has a goal to maintain its common equity ratio in the mid-50 percent range of total consolidated capital. In addition, the Company typically reduces short-term debt balances in the spring because a significant portion of the Company’s current assets is converted into cash at the end of the winter heating season. Accomplishing these capital structure objectives and maintaining sufficient cash flow are necessary to maintain attractive credit ratings for the Company and Washington Gas, and to allow access to capital at reasonable costs. As of December 31, 2003, total consolidated capitalization, including current maturities of long-term debt, comprised 55.4 percent common equity, 1.9 percent preferred stock and 42.7 percent long-term debt. The cash flow requirements of the Company and the ability to provide satisfactory resources to satisfy those requirements are primarily influenced by the activities of Washington Gas and to a lesser extent the non-utility operations.

     The Company believes it has sufficient liquidity to satisfy its financial obligations. At December 31, 2003, the Company did not have any restrictions on its cash balances that would affect the payment of common or preferred stock dividends by WGL Holdings or Washington Gas.

     Short-Term Cash Requirements and Related Financing

     The regulated utility’s business is weather sensitive and seasonal, causing short-term cash requirements to vary significantly during the year, and from year-to-year for the same quarter. Over 75 percent of the total therms delivered in the regulated utility’s service area (excluding deliveries to two electric generation facilities) occur during the first and second fiscal quarters. Cash requirements peak in the fall and winter months when accounts receivable, accrued utility revenues and storage gas inventories are at their highest levels. After the winter heating season, many of these assets are converted into cash, which the Company generally uses to reduce and sometimes eliminate short-term debt and acquire storage gas for the next heating season.

     The Company’s retail energy-marketing subsidiary, WGEServices, has seasonal short-term cash requirements resulting from purchasing gas in periods that are not matched with the sale of this commodity. In addition, WGEServices must finance its accounts receivable for the gas and electricity that it sells, and the accounts receivable balances are seasonal.

     Both the regulated utility and the retail energy-marketing segment maintain storage gas inventory. Storage gas inventories represent gas purchased from producers and are stored in facilities primarily owned by interstate pipelines. The regulated utility and retail energy-marketing subsidiary generally pay for storage gas between heating seasons and withdraw it during the heating season. Significant variations in storage balances are usually caused by the price paid to producers and marketers, which is a function of short-term market fluctuations in gas costs. For the regulated utility, such costs become a component of the cost of gas recovered from customers when volumes are withdrawn from storage. In addition, the regulated utility is able to specifically recover its pre-tax cost of capital related to the varying level of storage gas inventory balance in each of the three jurisdictions in which it operates. This carrying cost is recovered from customers as a component of gas costs.

     Variations in the timing of collections of gas costs under the regulated utility’s gas cost recovery mechanisms and the level of refunds from pipeline companies that will be returned to customers can significantly affect short-term cash requirements.

24

WGL Holdings, Inc.
Part I — Financial Information
Item 2 — Management’s Discussion and Analysis of
Financial Condition and Results of Operations (continued)

     The Company and Washington Gas utilize short-term debt in the form of commercial paper or unsecured short-term bank loans to fund seasonal requirements. The Company’s policy is to maintain bank credit facilities in an amount equal to or greater than its expected maximum short-term debt position. As of December 31, 2003, Washington Gas and WGL Holdings each had revolving credit agreements with a group of banks of $175 million and $130 million, respectively, in support of their short-term debt requirements. Washington Gas and WGL Holdings pay facility fees of 11 basis points and 13 basis points, respectively, for the revolving credit agreements that will expire on April 30, 2004.

     At December 31, 2003, the Company had outstanding notes payable of $186.3 million as compared to $166.7 million outstanding at September 30, 2003. The increase in notes payable is primarily due to an increase in the Company’s working capital requirements.

     Long-Term Cash Requirements and Related Financing

     The Company’s long-term cash requirements primarily depend upon the level of capital expenditures, long-term debt maturity requirements and decisions to refinance long-term debt. The Company devotes the majority of its capital expenditures to adding new regulated utility customers in its existing service area. At December 31, 2003, Washington Gas was authorized to issue up to $213.0 million of long-term debt under a shelf registration that was declared effective by the Securities and Exchange Commission (SEC) on April 24, 2003. On May 20, 2003, Washington Gas executed a Distribution Agreement with certain financial institutions for the issuance and sale of debt securities included in the shelf registration statement.

     In November 2003, Washington Gas paid $37.2 million plus accrued interest to redeem $36.0 million of 6.95 percent Medium-Term Notes (MTNs) that were due in 2024, and replaced this debt with $37.0 million of newly issued, 4.88 percent MTNs due in 2013. The effective cost of the new debt, after considering a gain associated with a derivative instrument entered into in connection with this debt, was 4.11 percent (refer to the “Market Risk—Interest-Rate Risk” section of Management’s Discussion).

     Security Ratings

     The table below reflects credit ratings for outstanding debt instruments of WGL Holdings and Washington Gas at December 31, 2003. If the Company and/or the regulated utility were to experience a change in its debt ratings, the cost of its future short-term and long-term debt issues would likely change. Furthermore, a ratings change could result in a change in facility fees paid to banks.

25

WGL Holdings, Inc.
Part I — Financial Information
Item 2 — Management’s Discussion and Analysis of
Financial Condition and Results of Operations (continued)

     Contractual Obligations, Off-Balance Sheet Arrangements and Other Commercial Commitments

     Washington Gas has entered into contracts in the normal course of business that require it to make fixed and determinable payments for many years in the future. These obligations consist of long-term debt issued to finance the regulated utility’s capital investment, and obligations to purchase natural gas and pipeline transportation capacity for its regulated utility operations.

     Reference is made to the “Contractual Commitments and Commercial Obligations” section in Management’s Discussion in the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2003, for a detailed discussion of these contractual obligations. Note 6 of the Notes to Consolidated Financial Statements in the Company’s 2003 Annual Report on Form 10-K includes a discussion of long-term debt, including debt maturities. Reference is made to Note 15 of the Notes to Consolidated Financial Statements in the Company’s 2003 Annual Report on Form 10-K that reflects information about the various contracts of Washington Gas and WGEServices. The comparable information as of December 31, 2003 is not materially different from that disclosed in the Company’s fiscal year 2003 Annual Report on Form 10-K.

     WGL Holdings and Washington Gas Resources Corporation (Washington Gas Resources) have guaranteed certain purchases and sales of natural gas and electricity on behalf of the retail energy-marketing segment. At December 31, 2003, these guarantees totaled $307.3 million, of which $304.3 million were guaranteed by WGL Holdings and $3.0 million were guaranteed by Washington Gas Resources. Termination of these guarantees is coincident with the satisfaction of all obligations of WGEServices covered by the guarantees. WGL Holdings may also cancel any or all future obligations imposed by the guarantees upon written notice to the counterparty, but WGL Holdings would continue to be responsible for the obligations which had been created under the guarantees prior to the date of the notice of cancellation.

     Cash Flows from Operating Activities

     The primary drivers for the Company’s operating cash flows are cash payments received from gas customers, offset by payments made by the Company for gas costs, and for operation and maintenance, taxes and interest costs. Current interest expense reflects the favorable effect of relatively low interest rates, especially short-term interest rates, a condition that could change rapidly.

     During quarters ended December 31, the first quarter of the Company’s fiscal year, the Company generates a large portion of its annual net income due to the significant volumes of natural gas that are delivered by the regulated utility during the winter heating season. Variations in the level of net income reported for the quarter ended December 31 may be significant because of the variability of weather from one quarter in a year to the same quarter in the subsequent year. Generating large sales volumes during the quarter ended December 31 increases accounts receivable from the level at September 30; likewise, accounts payable increases to pay providers of the natural gas commodity and pipeline capacity. Accounts payable for the natural gas commodity can also vary significantly from one period to the next because of the volatility in the price of natural gas. Since payments for natural gas and pipeline capacity need to be made to suppliers before accounts receivable are collected from customers, this generally causes the Company to increase its short-term debt financing between September 30 and December 31. Storage gas inventories, which usually peak on November 1, are partially drawn down in the quarter ended December 31, and provide a source of cash as this asset is used to satisfy winter sales demand. Gas costs due from or to customers, as well as deferred purchased gas costs which represent the difference between gas costs that have been paid to suppliers in the past and what has been collected from customers for these gas costs, can also cause significant variations in cash flows from period to period.

26

WGL Holdings, Inc.
Part I — Financial Information
Item 2 — Management’s Discussion and Analysis of
Financial Condition and Results of Operations (continued)

     Net cash provided by operating activities totaled $22.6 million for the first three months of fiscal year 2004. A description of certain material changes in working capital from September 30, 2003 to December 31, 2003 is listed below:

	•		Accounts receivable and accrued utility revenues increased $207.1 million, primarily due to the onset of the Company’s heating season and the increased sales that resulted during this period.
	•		Storage gas inventory levels decreased $20.0 million from September 30, 2003 as volumes were withdrawn to satisfy a portion of sales demand during the winter heating season.
	•		Accounts payable increased $75.3 million, largely attributable to increased gas purchases to match the increased sales demand.

     Cash Flows Provided by Financing Activities

     Cash flows provided by financing activities were $4.1 million for the three months ended December 31, 2003. An increase in notes payable of $19.6 million, due to increased working capital requirements, was the primary driver of this increase. This increase was offset by a normal recurring common stock dividend payment of $15.6 million. Additionally, during the quarter the Company retired $36.1 million of long-term debt and issued $37.0 million of lower-cost long-term debt (refer to the “Liquidity and Capital Resources—Long-Term Cash Requirements and Related Financing” section in Management’s Discussion).

     Cash Flows Used in Investing Activities

     During the three months ended December 31, 2003, cash flows used in investing activities totaled $21.9 million primarily for capital expenditures made on behalf of the regulated utility.

MARKET RISK

     The Company is exposed to various forms of market risk. The following discussion describes the Company’s exposure to commodity price risk and interest-rate risk.

     Price Risk Related to Regulated Utility Operations

     Washington Gas actively manages its gas supply portfolio to balance its sales, delivery and supply obligations. The regulated utility includes the cost of the natural gas commodity and pipeline services in the purchased gas costs that it includes in firm customers’ rates, subject to regulatory review. The regulated utility’s jurisdictional tariffs contain gas cost mechanisms that allow it to recover the invoice cost of gas applicable to firm customers.

     In order to mitigate commodity price risk, Washington Gas obtained regulatory approval in the District of Columbia, Maryland and Virginia to hedge transactions for a limited portion of its natural gas purchases. As of December 31, 2003, the Company had derivative contracts under approved hedging instruments having a total fair value gain of $3.0 million.

     Additionally, the Company purchases gas under contracts that provide for volumetric variability. As of December 31, 2003, these contracts have a total fair value loss of $673,000 (refer to Note 6— Derivative Instruments for a discussion of the accounting for these derivative instruments).

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WGL Holdings, Inc.
Part I — Financial Information
Item 2 — Management’s Discussion and Analysis of
Financial Condition and Results of Operations (continued)

     Price Risk Related to Retail Energy-Marketing Operations

     The Company’s retail energy-marketing subsidiary, WGEServices, sells natural gas and electricity to retail customers at both fixed prices and indexed prices. The Company must manage daily and seasonal demand fluctuations for these products. The volume and price risks are evaluated and measured separately for natural gas and electricity.

     Natural Gas. WGEServices has market exposure to the extent it does not closely match the timing and amount of natural gas it purchases with the related fixed price sales commitments. WGEServices manages much of this risk by attempting to closely match the timing of its purchases with its sales commitments to customers. WGEServices also faces exposure in that approximately 60 percent of its annual natural gas sales volumes are subject to variations in customer demand caused by fluctuations in weather. Purchases of natural gas to fulfill sales commitments are made under fixed-volume contracts that assume normal weather. If there is a significant deviation of weather from normal that causes purchase commitments to differ significantly from sales levels, WGEServices may be required to buy or sell natural gas at prices that negatively impact gross margins. WGEServices uses storage gas inventory and peaking services offered to marketers by the regulated utility to balance its volumetric requirements. WGEServices also manages this risk through the purchase of derivative instruments. At December 31, 2003, these derivatives were valued at $606,000 and WGEServices recorded a net gain of $854,000 during the first quarter of fiscal year 2004 related to these derivatives. At December 31, 2002, these derivatives were valued at $349,000, and WGEServices recorded a net gain of $118,000 during the first quarter of fiscal year 2003.

     Certain suppliers that sell gas to WGEServices have relatively low credit ratings as determined by major credit rating agencies. Depending on the future ability of these suppliers to deliver natural gas under existing contracts, WGEServices could be financially exposed for the difference between the price at which WGEServices has contracted to buy natural gas, and the cost of any replacement natural gas that may need to be purchased. WGEServices has a wholesale supplier credit policy that is designed to mitigate wholesale credit risks through a requirement for credit enhancements. Per the terms of this policy, WGEServices has obtained credit enhancements from certain of its gas suppliers.

     Electricity. For its electric business, WGEServices has significantly limited its volumetric and price risks through a full requirements supply contract with a major generator, Mirant Americas Energy Marketing L.P. (MAEM), which is an indirect wholly owned subsidiary of Mirant Corporation (Mirant). Under the terms of this contract, MAEM assumes the risk for any volume and price risks associated with sales made by WGEServices. On July 14, 2003, Mirant and substantially all of its subsidiaries filed voluntary petitions for reorganization under Chapter 11 of the U.S. Bankruptcy Code. MAEM was included in these bankruptcy filings. Future performance by MAEM under its full requirements contract with WGEServices may be subject to further developments in the bankruptcy proceedings.

     The performance risk of the MAEM contract is mitigated through a Security and Escrow agreement entered into between WGEServices and MAEM prior to the bankruptcy filing. Under the Security and Escrow agreement, WGEServices has access to collateral that is intended to cover the difference between the current market price of electricity and the price at which WGEServices has contracted to sell electricity. In the opinion of counsel to the Company, WGEServices has the contractual right to draw on the escrow funds in the account (which totaled $15 million as of February 17, 2004) if the contracts between WGEServices and MAEM are terminated. The amount of WGEServices’ exposure in the event of termination of the contracts between WGEServices and MAEM is estimated to be less than the amount of collateral included in the escrow account. This estimate of WGEServices’ exposure to contract termination is based upon acquiring supply, priced at forward electricity prices through the expiration of the existing sales contracts or until WGEServices exercises certain damage limitation provisions of its customers’ sales contracts. The actual exposure for WGEServices may differ from the estimate due to changes in timing of any contract termination, deviations from normal weather, changes in future market

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WGL Holdings, Inc.
Part I — Financial Information
Item 2 — Management’s Discussion and Analysis of
Financial Condition and Results of Operations (continued)

conditions, or other factors.

     Since the bankruptcy filing, MAEM has continued to honor its supply obligations to WGEServices. In October 2003, WGEServices and MAEM signed a post-bankruptcy petition contract that enables WGEServices to renew expiring contracts with its current electric customers and to make purchases for new customers.

     Value-At-Risk. WGEServices also measures the market risk of its energy commodity portfolio and employs risk control mechanisms to measure and determine mitigating steps related to market risk including the determination and review of value-at-risk. Value-at-risk is an estimate of the maximum loss that can be expected at some level of probability if a portfolio is held for a given time period. For the natural gas portfolio, based on a 95 percent confidence interval, WGEServices’ value-at-risk at December 31, 2003 was approximately $292,000 for a one-day holding period. WGEServices also calculates the value of its open position which measures the amount of net cash outflow or inflow that would be required to close the volumetric differential between its purchase and sales commitments. As of December 31, 2003, WGEServices would have had a net cash outflow of approximately $4.8 million to close its open position.

     Interest-Rate Risk

     The Company is exposed to interest-rate risk associated with its debt financing costs. The Company utilizes derivative financial instruments from time to time in order to minimize its exposure to interest-rate risk. In June 2003, Washington Gas entered into two forward-starting swaps with an aggregate notional principal of $62.0 million to mitigate a substantial portion of interest-rate risk associated with certain debt transactions planned during fiscal year 2004. These swaps were designated as cash flow hedges and carried at fair value.