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Exhibit 99.2

 

Elizabethtown Gas

 

(A division of Pivotal Utility Holdings, Inc., a wholly-owned subsidiary

of Southern Company Gas)

Financial Statements as of December 31, 2017 and 2016

and for the Years Then Ended, and Independent Auditor’s Report

Index to the Notes to Financial Statements

INDEPENDENT AUDITORS’ REPORT

STATEMENTS OF INCOME

Elizabethtown Gas

For the Years Ended December 31, 2017 and 2016

The accompanying notes are an integral part of these financial statements.

STATEMENTS OF COMPREHENSIVE INCOME

Elizabethtown Gas

For the Years Ended December 31, 2017 and 2016

The accompanying notes are an integral part of these financial statements.

STATEMENTS OF CASH FLOWS

Elizabethtown Gas

For the Years Ended December 31, 2017 and 2016

The accompanying notes are an integral part of these financial statements.

BALANCE SHEETS

Elizabethtown Gas

At December 31, 2017 and 2016

The accompanying notes are an integral part of these financial statements.

BALANCE SHEETS

Elizabethtown Gas

At December 31, 2017 and 2016

The accompanying notes are an integral part of these financial statements.

STATEMENTS OF EQUITY

Elizabethtown Gas

For the Years Ended December 31, 2017 and 2016

The accompanying notes are an integral part of these financial statements.

Elizabethtown Gas

Notes to Financial Statements

December 31, 2017 and 2016

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

General

Elizabethtown Gas (the Company) engages in the sale and distribution of natural gas to approximately 292 thousand customers in New Jersey. Elizabethtown Gas is a division of Pivotal Utility Holdings, Inc. (Pivotal Utility), which is a wholly-owned subsidiary of Southern Company Gas. On July 1, 2016, Southern Company Gas completed its previously announced merger (Merger) with The Southern Company (Southern Company) and became a wholly-owned, direct subsidiary of Southern Company.

The Company is subject to regulation by the New Jersey Board of Public Utilities (New Jersey BPU). As such, the Company’s financial statements reflect the effects of rate regulation in accordance with accounting principles generally accepted in the United States of America (GAAP) and comply with the accounting policies and practices prescribed by the New Jersey BPU. The preparation of financial statements in conformity with GAAP requires the use of estimates, and the actual results may differ from those estimates.

The impact of the acquisition method of accounting was not pushed down to Elizabethtown Gas and is not reflected in the financial statements included herein.

Certain prior year data presented in the financial statements has been reclassified to conform to the current year presentation used by Southern Company Gas.

Recently Issued Accounting Standards

Revenue

In 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Codification (ASC) 606, Revenue from Contracts with Customers (ASC 606), replacing the existing accounting standard and industry specific guidance for revenue recognition with a five-step model for recognizing and measuring revenue from contracts with customers. The underlying principle of the new standard is to recognize revenue to depict the transfer of goods or services to customers at the amount expected to be collected. The new standard also requires enhanced disclosures regarding the nature, amount, timing, and uncertainty of revenue and the related cash flows arising from contracts with customers.

Most of the Company’s revenue, including energy provided to customers, is from tariff offerings that provide natural gas without a defined contractual term.

The Company has completed the evaluation of all revenue streams and determined that the adoption of ASC 606 will not change the current timing of revenue recognition for such transactions. Some revenue arrangements, such as alternative revenue programs, are excluded from the scope of ASC 606 and, therefore, will be accounted for and disclosed or presented separately from revenues under ASC 606 on the Company’s financial statements. The Company has concluded contributions in aid of construction are not in scope for ASC 606 and will continue to be accounted for as an offset to property, plant, and equipment.

The new standard is effective for reporting periods beginning after December 15, 2017. The Company applied the modified retrospective method of adoption effective January 1, 2018. The Company also utilized practical expedients which allowed it to apply the standard to open contracts at the date of adoption and to reflect the aggregate effect of all modifications when identifying performance obligations and allocating the transaction price for contracts modified before the effective date. Under the modified retrospective method of adoption, prior year reported results are not restated; however, a cumulative-effect adjustment to retained earnings at January 1, 2018 is recorded. The adoption of ASC 606 did not result in a cumulative-effect adjustment.

Leases

In February 2016, the FASB issued Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842) (ASU 2016-02). ASU 2016-02 requires lessees to recognize on the balance sheet a lease liability and a right-of-use asset for all leases. ASU 2016-02 also changes the recognition, measurement, and presentation of expense associated with leases and provides clarification regarding the identification of certain components of contracts that would represent a lease. The accounting required by lessors is relatively unchanged. ASU 2016-02 is effective for fiscal years beginning after December 15, 2018 and the Company will adopt the new standard effective January 1, 2019.

The Company is currently implementing an information technology system along with the related changes to internal controls and accounting policies that will support the accounting for leases under ASU 2016-02. In addition, the Company has substantially completed a detailed inventory and analysis of its leases. In terms of rental charges and duration of contracts, the most significant leases relate to fleet vehicles and real estate and where the Company is the lessee and there are no material leases where the Company is the lessor. While the Company has not yet determined the ultimate impact, adoption of ASU 2016-02 is not expected to have a significant impact on the Company’s balance sheet.

Other

On January 26, 2017, the FASB issued ASU No. 2017-04, Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment (ASU 2017-04). ASU 2017-04 removes the requirement to compare the implied fair value of goodwill with the carrying amount as part of Step 2 of the goodwill impairment test. Under the new standard, the goodwill impairment loss will be measured as the excess of a reporting unit’s carrying amount over its fair value, not exceeding the total amount of goodwill allocated to that reporting unit, which may increase the frequency of goodwill impairment charges if a future goodwill impairment test does not pass the Step 1 evaluation. ASU 2017-04 is effective prospectively for periods beginning on or after December 15, 2019, with early adoption permitted. The Company adopted ASU 2017-04 effective January 1, 2018 with no impact on its financial statements.

On March 10, 2017, the FASB issued ASU No. 2017-07, Compensation – Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost (ASU 2017-07). ASU 2017-07 requires that an employer report the service cost component in the same line item or items as other compensation costs and requires the other components of net periodic pension and postretirement benefit costs to be separately presented in the income statement outside of income from operations. Additionally, only the service cost component is eligible for capitalization, when applicable. However, all cost components remain eligible for capitalization under Federal Energy Regulatory Commission (FERC) regulations. ASU 2017-07 will be applied retrospectively for the presentation of the service cost component and the other components of net periodic pension and postretirement benefit costs in the income statement. The capitalization of only the service cost component of net periodic pension and postretirement benefit costs in assets will be applied on a prospective basis. ASU 2017-07 is effective for periods beginning after December 15, 2017. The presentation changes required for net periodic pension and postretirement benefit costs will not result in a material impact on the Company’s operating income or other income for 2016 and 2017. The Company adopted ASU 2017-07 effective January 1, 2018 with no material impact on its financial statements.

On August 28, 2017, the FASB issued ASU No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities (ASU 2017-12), amending the hedge accounting recognition and presentation requirements. ASU 2017-12 makes more financial and non-financial hedging strategies eligible for hedge accounting, amends the related presentation and disclosure requirements, and simplifies hedge effectiveness assessment requirements. ASU 2017-12 is effective for fiscal years beginning after December 15, 2018, with early adoption permitted. The Company adopted ASU 2017-12 effective January 1, 2018 with no material impact on its financial statements.

Regulatory Assets and Liabilities

The Company is subject to accounting requirements for the effects of rate regulation. Regulatory assets represent probable future revenues associated with certain costs that are expected to be recovered from customers through the ratemaking process. Regulatory liabilities represent probable future reductions in revenues associated with amounts that are expected to be credited to customers through the ratemaking process.

Regulatory assets and (liabilities) reflected in the balance sheets at December 31 relate to:

(*)   Includes excess deferred income tax assets/liabilities resulting from the Tax Cuts and Jobs Act that was signed into law on December 22, 2017 and became effective January 1, 2018 (Tax Reform Legislation), the recovery and amortization of which will be determined by the New Jersey BPU. See Note 3 under “Regulatory Matters” and Note 4 for additional details.

In the event that the Company’s operations are no longer subject to applicable accounting rules for rate regulation, the Company would be required to write off to income related regulatory assets and liabilities that are not specifically recoverable through regulated rates. In addition, the Company would be required to determine if any impairment to other assets, including plant, exists and write down the assets, if impaired, to their fair values. All regulatory assets and liabilities are to be reflected in rates. See Note 3 under “Regulatory Matters” for additional information.

Revenues

The Company records revenues when goods or services are provided to customers. Those revenues are based on rates approved by the New Jersey BPU. The Company has a rate structure that includes a volumetric rate design that allows the opportunity to recover certain costs based on gas usage. Revenues from sales and transportation services are recognized in the same period in which the related volumes are delivered to customers. Revenues from residential and certain commercial and industrial customers are recognized on the basis of scheduled meter readings. Additionally, unbilled revenues are recognized for estimated deliveries of natural gas not yet billed to these customers, from the last bill date to the end of the accounting period. For other commercial and industrial customers, revenues are based on actual deliveries to the end of the period.

The tariffs for the Company include weather normalization adjustments, which reduce customer bills when winter weather is colder than normal and increase customer bills when weather is warmer than normal and are included in the tariffs. These provisions, referred to as alternative revenue programs, allow for the recognition of certain revenues prior to the time such revenues are billed to customers, so long as the amounts recognized will be collected from customers within 24 months of recognition.

Concentration of Revenue

The Company has a diversified base of customers. No single customer or industry comprises 10% or more of revenues. For all periods presented, uncollectible accounts averaged less than 2% of revenues.

Cost of Natural Gas

The Company charges its customers for natural gas consumed using a natural gas cost recovery mechanism set by the New Jersey BPU, under which all prudently-incurred natural gas costs are passed through to customers without markup, subject to regulatory review. The Company defers or accrues the difference between the actual cost of natural gas and the amount of commodity revenue earned in a given period such that no operating income is recognized related to these costs. The deferred or accrued amount is either billed or refunded to customers prospectively through adjustments to the commodity rate. Deferred and accrued natural gas costs are included in the balance sheets as regulatory assets and regulatory liabilities, respectively.

Income and Other Taxes

The Company uses the liability method of accounting for deferred income taxes and provides deferred income taxes for all significant income tax temporary differences. Federal investment tax credits (ITCs) utilized are deferred and amortized to income over the average life of the related property. Taxes that are collected from customers on behalf of governmental agencies to be remitted to these agencies are presented on the balance sheet.

The Company recognizes tax positions that are “more likely than not” of being sustained upon examination by the appropriate taxing authorities. See Note 4 under “Unrecognized Tax Benefits” for additional information.

Property, Plant, and Equipment

Property, plant, and equipment is stated at original cost less any regulatory disallowances and impairments. Original cost includes: materials; labor; minor items of property; appropriate administrative and general costs; payroll-related costs such as taxes, pensions, and other benefits; and the interest capitalized and cost of equity funds used during construction.

The Company’s property, plant, and equipment in service consisted of the following at December 31:

The cost of replacements of property, exclusive of minor items of property, is capitalized. The cost of maintenance, repairs, and replacement of minor items of property is charged to other operations and maintenance expenses as incurred or performed.

Depreciation

Depreciation of the original cost of utility plant in service is provided using composite straight-line rates, which approximated 2.6% and 2.3% in 2017 and 2016, respectively. Depreciation studies are conducted periodically to update the composite rate that is approved by the New Jersey BPU. When property subject to composite depreciation is retired or otherwise disposed of in the normal course of business, its original cost, together with the cost of removal, less salvage, is charged to accumulated depreciation. As such, gains or losses are not recognized, they are ultimately refunded to, or recovered from, customers through future rate adjustments. Minor items of property included in the original cost of the asset are retired when the related property unit is retired.

Allowance for Funds Used During Construction (AFUDC)

The Company records AFUDC, which represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of new regulated facilities. While cash is not realized currently, AFUDC increases the revenue requirement and is recovered over the service life of the asset through a higher rate base and higher depreciation. All current construction costs are included in rates. The Company’s AFUDC composite rate was 1.56% and 1.68% for the years ended 2017 and 2016, respectively. The Company recorded $0.4 million and $0.3 million of AFUDC for the years ended December 31, 2017 and 2016, respectively.

Goodwill

Goodwill is not amortized, but is subject to an annual impairment test during the fourth quarter of each year, or more frequently if impairment indicators arise. In assessing goodwill for impairment, the Company has the option of first performing a qualitative assessment to determine that it is more likely than not that fair value of its reporting unit exceeds its carrying value (commonly referred to as Step 0). If the Company chooses not to perform a qualitative assessment, or the result of Step 0 indicates a probable decrease in fair value of its reporting unit below its carrying value, a quantitative two-step test is performed (commonly referred to as Step 1 and Step 2). Step 1 compares the fair value of the reporting unit to its carrying value including goodwill. If the carrying value exceeds the fair value, Step 2 is performed to allocate the fair value of the reporting unit to its assets and liabilities in order to determine the implied fair value of goodwill, which is compared to the carrying value of goodwill to calculate an impairment loss, if any.

For the 2017 annual impairment test, the Company performed Step 1 of the two-step impairment test, which resulted in its fair value exceeding its carrying value. For the 2016 annual impairment test, the Company performed the qualitative Step 0 assessment and determined that it was more likely than not that its fair value exceeded its carrying value and therefore no quantitative assessment was required.

Cash Management Money Pool

The Company participates in Southern Company Gas’ utility money pool, under which short-term borrowings are made from the money pool and surplus funds are contributed to the money pool. Borrowings from the money pool are recorded as due to affiliates in the balance sheets and intercompany interest expense is recorded in the statements of income for these borrowings. See Note 10 for additional information.

Receivables and Provision for Uncollectible Accounts

The Company’s receivables consist primarily of natural gas sales and transportation services billed to residential, commercial, industrial, and other customers. Customers are billed monthly and payment is due within 30 days. For the majority of receivables, a provision for uncollectible accounts is established based on historical collection experience and other factors. For the remaining receivables, if the Company is aware of a specific customer’s inability to pay, a provision for uncollectible accounts is recorded to reduce the receivable balance to the amount the Company reasonably expects to collect. If circumstances change, the estimate of the recoverability of accounts receivable could change as well. Circumstances that could affect this estimate include, but are not limited to, customer credit issues, customer deposits, and general economic conditions. Customers’ accounts are written off once they are deemed to be uncollectible.

Materials and Supplies

Generally, materials and supplies include propane gas inventory, fleet fuel, and other materials and supplies. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, at weighted average cost when installed.

Natural Gas for Sale

The Company’s natural gas inventories are carried at cost on a weighted average cost of gas basis.

Fair Value Measurements

The Company has financial and nonfinancial assets and liabilities subject to fair value measurement. The financial assets and liabilities measured and carried at fair value include derivative instruments. The carrying values of receivables, accounts payable, due to affiliates, other current assets and liabilities, accrued interest, and long-term debt approximate their respective fair value. The nonfinancial assets and liabilities include pension and other postretirement benefits. See Notes 2 and 7 for additional fair value disclosures.

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price). The Company utilizes market data or assumptions that market participants would use in valuing the asset or liability, including assumptions about risk and the risks inherent in the inputs to the valuation technique. These inputs can be readily observable, market corroborated, or generally unobservable. The Company primarily applies the market approach for recurring fair value measurements to utilize the best available information. Accordingly, the Company uses valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs. Fair value balances are classified based on the observance of those inputs. The guidance establishes a fair value hierarchy that prioritizes the inputs used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). The three levels of the fair value hierarchy defined by the guidance are as follows:

Level 1

Quoted prices in active markets for identical assets or liabilities as of the reporting date. Active markets are those in which transactions for the asset or liability occur in sufficient frequency and volume to provide pricing information on an ongoing basis. The Company’s Level 1 items consist of exchange-traded derivatives, money market funds, and certain retirement plan assets.

Level 2

Pricing inputs are other than quoted prices in active markets included in Level 1, which are either directly or indirectly observable as of the reporting date. Level 2 includes those financial and commodity instruments that are valued using valuation methodologies. These methodologies are primarily industry-standard methodologies that consider various assumptions, including quoted forward prices for commodities, time value, volatility factors, and current market and contractual prices for the underlying instruments, as well as other relevant economic measures. Substantially all of these assumptions are observable in the marketplace throughout the full term of the instrument, can be derived from observable data, or are supported by observable levels at which transactions are executed in the marketplace. Market price data is obtained from multiple sources in order to value certain Level 2 transactions and this data is representative of transactions that occurred in the marketplace. Level 2 instruments include non-exchange-traded derivatives such as over-the-counter forwards and options and certain retirement plan assets.

Level 3

Pricing inputs include significant unobservable inputs that may be used with internally developed methodologies to determine management’s best estimate of fair value from the perspective of market participants. Level 3 instruments include those that may be more structured or otherwise tailored to customers’ needs. Level 3 assets, liabilities, and any applicable transfers are primarily related to the Company’s pension and other postretirement benefit plan assets as described in Note 2. Transfers into and out of Level 3 are determined using values at the end of the interim period in which the transfer occurred.

Financial Instruments

The Company uses derivative financial instruments to limit exposure to fluctuations in natural gas prices. All derivative financial instruments are recognized as either assets or liabilities on the balance sheets (shown separately as “Risk Management Activities”) and are measured at fair value. See Note 7 for additional information regarding fair value. Derivative contracts that qualify as cash flow hedges of anticipated transactions or are recoverable through the respective state regulatory agency approved fuel-hedging programs result in the deferral of related gains and losses in other comprehensive income (OCI) or regulatory assets and liabilities, respectively, until the hedged transactions occur. Any ineffectiveness arising from cash flow hedges is recognized currently in net income. Cash flows from derivatives are classified on the statement of cash flows in the same category as the hedged item. See Note 8 for additional information regarding derivatives.

The Company offsets fair value amounts recognized for multiple derivative instruments executed with the same counterparty under a master netting arrangement. The Company had no outstanding collateral repayment obligations or rights to reclaim collateral arising from derivative instruments recognized at December 31, 2017.

Comprehensive Income

The objective of comprehensive income is to report a measure of all changes in common stock equity of an enterprise that result from transactions and other economic events of the period other than transactions with owners. In 2017, comprehensive income was equal to net income. In 2016, comprehensive income consisted of net income, certain changes in pension and other postretirement benefit plans, and reclassifications for amounts included in net income.

Dividend Distributions

The Company paid dividends of $25.2 million and $23.5 million to Southern Company Gas during 2017 and 2016, respectively. The Company is restricted by its dividend policy as established by the New Jersey BPU in the amount it can dividend to Southern Company Gas to the extent of 70% of its quarterly net income.

2. RETIREMENT BENEFITS

The Company participates in the Southern Company Gas qualified defined benefit, trusteed, pension plan covering most eligible employees, which was closed in 2012 to new employees and reopened to all non-union employees on January 1, 2018. The qualified pension plan is funded in accordance with requirements of the Employee Retirement Income Security Act of 1974, as amended (ERISA). Southern Company Gas also provides certain non-qualified defined benefit and defined contribution pension plans for a selected group of the Company’s management and highly compensated employees. Benefits under these non-qualified pension plans are funded on a cash basis. The Company also participates in the Southern Company Gas postretirement benefit plan, which provides certain medical care and life insurance benefits for eligible retired employees through a postretirement benefit plan.

In connection with the Merger, Southern Company Gas performed updated valuations of its pension and other postretirement benefit plan assets and obligations to reflect actual census data at the new measurement date of July 1, 2016. The Company also recorded a related regulatory asset of $47.5 million as of July 1, 2016 related to unrecognized prior service cost and actuarial gain/loss, as it is probable that this amount will be recovered through future rates for the Company.

The following discussions reflect the Company’s balances and activity under the multiple-employer method of accounting.

Actuarial Assumptions

The weighted average rates assumed in the actuarial calculations used to determine both the net periodic costs for the pension and other postretirement benefit plans for all periods presented and the benefit obligations as of the measurement date are presented below.

The Company estimates the expected return on pension plan and other postretirement benefit plan assets by evaluating expected bond returns, equity risk premiums, asset allocations, the effects of active plan management, the impact of periodic plan asset rebalancing, and historical performance. The Company also considers guidance from its investment advisors in making a final determination of its expected rate of return on assets. To the extent the actual rate of return on assets realized over the course of a year is greater or less than the assumed rate, it does not affect that year’s annual pension or other postretirement benefit plan cost; rather, this gain or loss reduces or increases future pension or other postretirement benefit plan costs.

An additional assumption used in measuring the accumulated other postretirement benefit obligations (APBO) was a weighted average medical care cost trend rate. The weighted average medical care cost trend rates used in measuring the APBO as of December 31, 2017 were as follows:

An annual increase or decrease in the assumed medical care cost trend rate of 1% would affect the APBO; however, the impact on the service and interest cost components would be immaterial.

Pension Plans

The total accumulated benefit obligation for the pension plans was $95.4 million at December 31, 2017 and $85.7 million at December 31, 2016. Changes in the projected benefit obligations and the fair value of plan assets for the Company’s qualified pension plans for all periods presented were as follows:

At December 31, 2017, the projected benefit obligations for the qualified and non-qualified pension plans were $105.5 million and $1.1 million, respectively. All pension plan assets are related to the qualified pension plan.

Amounts recognized in the balance sheets at December 31, 2017 and 2016 related to the Company’s pension plans consist of the following:

Presented below are the amounts included in accumulated OCI and regulatory assets at December 31, 2017 and 2016 related to the defined benefit pension plans that had not yet been recognized in net periodic pension cost along with the estimated amortization of such amounts for 2018.

The components of OCI, and the changes in the balance of regulatory assets (liabilities), related to the defined benefit pension plans for all years presented were as follows:

The Company’s pro rata components of Southern Company Gas’ net periodic pension costs for the years ended December 31, 2017 and 2016 were as follows:

Net periodic pension cost is the sum of service cost, interest cost, and other costs netted against the expected return on plan assets. The expected return on plan assets is determined by multiplying the expected rate of return on plan assets and the market-related value of plan assets.

Future benefit payments reflect expected future service and are estimated based on assumptions used to measure the projected benefit obligation for the pension plans. At December 31, 2017, estimated benefit payments were as follows:

Other Postretirement Benefits

Changes in the APBO and the fair value of plan assets for all periods presented were as follows:

Amounts recognized in the balance sheets at December 31, 2017 and 2016 related to the Company’s other postretirement benefit plans consist of the following:

Presented below are the amounts included in accumulated OCI and regulatory assets at December 31, 2017 and 2016 related to the other postretirement benefit plans that had not yet been recognized in net periodic other postretirement benefit cost. The estimated amortization of such amounts for 2018 is immaterial.

The components of OCI, along with the changes in the balance of regulatory assets (liabilities), related to the other postretirement benefit plans for all years presented were as follows:

The Company’s pro rata components of Southern Company Gas’ other postretirement benefit plans’ net periodic cost for the years ended December 31, 2017 and 2016 were as follows:

Future benefit payments, including prescription drug benefits, reflect expected future service and are estimated based on assumptions used to measure the APBO for the other postretirement benefit plans. At December 31, 2017, estimated benefit payments were as follows:

Benefit Plan Assets

Southern Company Gas’ pension plan and other postretirement benefit plan assets are managed and invested in accordance with all applicable requirements, including ERISA and the Internal Revenue Code of 1986, as amended. The investment policies for both the pension plan and the other postretirement benefit plans cover a diversified mix of assets, including equity and fixed income securities, real estate, and private equity. Southern Company Gas minimizes the risk of large losses primarily through diversification but also monitors and manages other aspects of risk.

The composition of Southern Company Gas’ pension plan and other postretirement benefit plan assets as of December 31, 2017 and 2016, along with the targets for each plan, is presented below:

The investment strategy for plan assets related to Southern Company Gas’ qualified pension plan is to be broadly diversified across major asset classes. The asset allocation is established after consideration of various factors that affect the assets and liabilities of the pension plan including, but not limited to, historical and expected returns and interest rates, volatility, correlations of asset classes, the current level of assets and liabilities, and the assumed growth in assets and liabilities. Because a significant portion of the liability of the pension plan is long-term in nature, the assets are invested consistent with long-term investment expectations for return and risk. To manage the actual asset class exposures relative to the target asset allocation, Southern Company Gas employs a formal rebalancing program for its pension plan assets. To manage the actual asset class exposures relative to the target asset allocation, Southern Company Gas employs a formal rebalancing program for its pension plan assets. As additional risk management, external investment managers and service providers are subject to written guidelines to ensure appropriate and prudent investment practices. Management believes the portfolio is well-diversified with no significant concentrations of risk.

Investment Strategies

Detailed below is a description of the investment strategies for each major asset category for the Southern Company Gas pension and other postretirement benefit plans disclosed above:

•

Domestic equity. A mix of large and small capitalization stocks with generally an equal distribution of value and growth attributes, managed both actively and through passive index approaches.

•

International equity. A mix of growth stocks and value stocks with both developed and emerging market exposure, managed both actively and through passive index approaches.

•

Fixed income. A mix of domestic and international bonds.

•

Special situations.Investments in opportunistic strategies with the objective of diversifying and enhancing returns and exploiting short-term inefficiencies as well as investments in promising new strategies of a longer-term nature.

•

Real estate investments. Investments in traditional private market equity-oriented investments in real properties (indirectly through pooled funds or partnerships) and in publicly traded real estate securities.

•

Private equity. Investments in private partnerships that invest in private or public securities typically through privately-negotiated and/or structured transactions, including leveraged buyouts, venture capital, and distressed debt.

The investment strategies prior to July 1, 2016 followed a policy to preserve the plans’ capital and maximize investment earnings in excess of inflation within acceptable levels of capital market volatility. To accomplish this goal, the plans’ assets were managed to optimize long-term return while maintaining a high standard of portfolio quality and diversification. In developing the allocation policy for the assets of the pension and other postretirement benefit plans, Southern Company Gas examined projections of asset returns and volatility over a long-term horizon. In connection with this analysis, the risk and return trade-offs of alternative asset classes and asset mixes were evaluated given long-term historical relationships as well as prospective capital market returns. Southern Company Gas also conducted asset-liability studies to match projected asset growth with projected liability growth to determine whether there is sufficient liquidity for projected benefit payments. Asset mix guidelines were developed by incorporating the results of these analyses with an assessment of Southern Company Gas’ risk posture, and taking into account industry practices. Southern Company Gas periodically evaluated its investment strategy to ensure that plan assets were sufficient to meet the benefit obligations of the plans. As part of the ongoing evaluation, the Company made changes to its targeted asset allocations and investment strategy.

Benefit Plan Asset Fair Values

Following are the fair value measurements for the pension plan and the other postretirement benefit plan assets as of December 31, 2017 and 2016. The fair values presented are prepared in accordance with GAAP. For purposes of determining the fair value of the pension plan and other postretirement benefit plan assets and the appropriate level designation, management relies on information provided by the plan’s trustee. This information is reviewed and evaluated by management with changes made to the trustee information as appropriate. Management believes the portfolio is well-diversified with no significant concentrations of risk.

Valuation methods of the primary fair value measurements disclosed in the following tables are as follows:

•

Domestic and international equity. Investments in equity securities such as common stocks, American depositary receipts, and real estate investment trusts that trade on a public exchange are classified as Level 1 investments and are valued at the closing price in the active market. Equity investments with unpublished prices (i.e. pooled funds) are valued as Level 2, when the underlying holdings used to value the investment are comprised of Level 1 or Level 2 equity securities.

•

Fixed income. Investments in fixed income securities are generally classified as Level 2 investments and are valued based on prices reported in the market place. Additionally, the value of fixed income securities takes into consideration certain items such as broker quotes, spreads, yield curves, interest rates, and discount rates that apply to the term of a specific instrument.

•

Real estate investments and private equity. Investments in real estate, private equity, and special situations are generally classified as Net Asset Value as a Practical Expedient, since the underlying assets typically do not have publicly available observable inputs. The fund manager values the assets using various inputs and techniques depending on the nature of the underlying investments. Techniques may include purchase multiples for comparable transactions, comparable public company trading multiples, discounted cash flow analysis, prevailing market capitalization rates, recent sales of comparable investments, and independent third-party appraisals. The fair value of partnerships is determined by aggregating the value of the underlying assets less liabilities.

The Company’s pro rata portion of fair values of pension plan assets as of December 31, 2017 and 2016 are presented below. These fair value measurements exclude cash, receivables related to investment income, pending investments sales, and payables related to pending investment purchases. Absolute return investment assets are presented in the tables below based on the nature of the investment.

(*)

Level 1 securities consist of actively traded stocks while Level 2 securities consist of pooled funds.

(*)

Level 1 securities consist of actively traded stocks while Level 2 securities consist of pooled funds.

The Company’s pro rata portion of fair values of other postretirement benefit plan assets as of December 31, 2017 and 2016 are presented below. These fair value measurements exclude cash, receivables related to investment income, pending investments sales, and payables related to pending investment purchases.

(*)	Level 1 securities consist of actively traded stocks while Level 2 securities consist of pooled funds.

(*)

Level 1 securities consist of actively traded stocks while Level 2 securities consist of pooled funds.

Employee Savings Plan

Southern Company Services, Inc. sponsors 401(k) defined contribution plans covering certain eligible employees. Through December 31, 2017, the 401(k) plans provided matching contributions of either 65% on up to 8% of an employee’s eligible compensation, or a 100% matching contribution on up to 3% of an employee’s eligible compensation, followed by a 75% matching contribution on up to the next 3% of an employee’s eligible compensation. Total matching contributions made to the 401(k) plans for each of the years ended December 31, 2017 and 2016 were $1.2 million.

For employees not accruing a benefit under the pension plan, additional contributions made to the 401(k) plans for the years ended December 31, 2017 and 2016 were immaterial.

Effective January 1, 2018, the 401(k) plans were merged into the Southern Company Employee Savings Plan, which is a defined contribution plan covering substantially all employees of the Company. Under this plan, Southern Company Gas matches a portion of the first 6% of employee base salary contributions. The maximum Company match is 5.1% of an employee’s base salary.

3. CONTINGENCIES AND REGULATORY MATTERS

General Litigation Matters

The Company is assessing its alleged involvement in an incident that occurred in its service territory that resulted in several deaths, injuries, and property damage. The Company has been named as one of the defendants in several lawsuits related to this incident. At December 31, 2017, the Company has reserved for all of its potential exposure from this case. The ultimate outcome of this matter cannot be determined at this time.

The Company is subject to certain claims and legal actions arising in the ordinary course of business. The ultimate outcome of these matters and such pending or potential litigation against the Company cannot be determined at this time; however, for current proceedings not specifically reported herein, management does not anticipate that the ultimate liabilities, if any, arising from such current proceedings would have a material effect on the Company’s financial statements.

Environmental Matters

The Company’s operations are regulated by state and federal environmental agencies through a variety of laws and regulations governing air, water, land, and protection of other natural resources. The Company maintains a comprehensive environmental compliance strategy to assess upcoming requirements and compliance costs associated with these environmental laws and regulations. The costs, including capital expenditures and operations and maintenance costs, required to comply with environmental laws and regulations impact future results of operations, cash flows, and financial condition. Compliance costs may result from the installation of additional environmental controls. Compliance with these environmental requirements involves significant capital and operating costs to clean up affected sites. The Company conducts studies to determine the extent of any required clean up and has recognized in its financial statements the costs to clean up known impacted sites. The Company has received authority from the New Jersey BPU to recover approved environmental compliance costs through regulatory mechanisms.

The Company is subject to environmental remediation liabilities associated with six former manufactured gas plant sites in New Jersey. Accrued environmental remediation costs of $85.1 million and $106.1 million have been recorded in the balance sheets as of December 31, 2017 and December 31, 2016, respectively. These environmental remediation expenditures are recoverable from customers through rate mechanisms approved by the New Jersey BPU.

The Company’s ultimate environmental compliance strategy and future environmental capital expenditures will be affected by the final requirements of new or revised environmental regulations and the outcome of any legal challenges to the environmental rules. The ultimate outcome of these matters cannot be determined at this time.

Regulatory Matters

The Merger was approved by the New Jersey BPU on June 29, 2016. In connection with the Merger approval order, the Company was required to:

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provide rate credits of $17.5 million to its customers; and

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file a rate case no later than September 1, 2016, with another rate case no later than three years after the 2016 rate case.

The rate credits to customers were paid during the third quarter of 2016 and the Company filed a general base rate case with the New Jersey BPU on September 1, 2016. See “Customer Refunds” and “Base Rate Case” herein for additional information.

Regulatory Infrastructure Program

The Company’s 2013 extension of the Aging Infrastructure Replacement (AIR) enhanced infrastructure program allowed for infrastructure investment of $115 million over four years and was focused on the replacement of aging cast iron in its pipeline system. Carrying charges on the additional capital spend are being accrued and deferred for regulatory purposes at a weighted average cost of capital of 6.65%. Effective July 1, 2017, investments under this program, which ended September 30, 2017, are being recovered through base rate revenues. See “Base Rate Case” herein for additional information.

In 2015, the Company filed the Safety, Modernization and Reliability Tariff plan with the New Jersey BPU seeking approval to invest more than $1.1 billion to replace 630 miles of vintage cast iron, steel, and copper pipeline, as well as 240 regulator stations. During the first quarter 2018, the Company withdrew this filing in response to a proposed rule by the New Jersey BPU to incentivize utilities to accelerate investment in infrastructure replacement programs that enhance reliability, resiliency, and/or safety of the distribution system. The ultimate outcome of this matter cannot be determined at this time.

Base Rate Case

On June 30, 2017, the New Jersey BPU approved a settlement that provides for a $13 million increase in annual base rate revenues, effective July 1, 2017, based on a ROE of 9.6%. Also included in the settlement was a new composite depreciation rate that is expected to result in a $3 million annual reduction of depreciation. See Note 9 for information on the proposed sale of the Company.

Other

The New Jersey BPU issued an order effective January 1, 2018 that requires the Company to track as a regulatory liability the impact of the Tax Reform Legislation, including the reduction in the corporate income tax rate to 21% and the impact of excess deferred income taxes. The Company made the required filing on March 2, 2018 seeking to reduce annual rates by $10.9 million with an April 1, 2018 interim effective date and final rates that are anticipated to take effect July 1, 2018. Credits will be issued to customers for the impact of the Tax Reform Legislation from January 2018 through March 2018.

Unrecognized Ratemaking Amounts

The following table illustrates the Company’s authorized ratemaking amounts that are not recognized on its balance sheets. These amounts are primarily composed of an allowed equity rate of return on assets associated with the Company’s AIR program. These amounts will be recognized as revenues in the Company’s financial statements in the periods they are billable to customers. See Note 9 for information on the proposed sale of the Company.

Customer Refunds

In the third quarter 2016, the Company provided direct per-customer rate credits totaling $17.5 million to its customers in accordance with the Merger approval from the New Jersey BPU. These rate credits were allocated among the Company’s customer classes based on the base rate revenues reflected in the rates that resulted from its most recent base rate proceeding.

4. INCOME TAXES

Subsequent to the Merger, Southern Company files a consolidated federal income tax return and various combined and separate state income tax returns on behalf of the Company and Southern Company Gas. Under a joint consolidated income tax allocation agreement, each Southern Company subsidiary’s current and deferred tax expense is computed on a stand-alone basis and no subsidiary is allocated more current expense than would be paid if it filed a separate income tax return. In accordance with Internal Revenue Service (IRS) regulations, the Company is jointly and severally liable for the federal tax liability. Prior to the Merger, the Company was a part of Southern Company Gas’ U.S. federal consolidated income tax return and various state income tax returns.

Federal Tax Reform Legislation

Following the enactment of the Tax Reform Legislation, the Securities and Exchange Commission staff issued Staff Accounting Bulletin 118 - “Income Tax Accounting Implications of the Tax Cuts and Jobs Act” (SAB 118), which provides for a measurement period of up to one year from the enactment date to complete accounting under GAAP for the tax effects of the legislation. Due to the complex and comprehensive nature of the enacted tax law changes, and their application under GAAP, the Company considers all amounts recorded in the financial statements as a result of the Tax Reform Legislation to be “provisional” as discussed in SAB 118 and subject to revision. The Company is awaiting additional guidance from industry and income tax authorities in order to finalize its accounting. The ultimate impact of the Tax Reform Legislation on deferred income tax assets and liabilities and the related regulatory assets and liabilities cannot be determined at this time.

Current and Deferred Income Taxes

Details of income tax provisions are as follows:

The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax bases, which give rise to deferred tax assets and liabilities, are as follows:

The implementation of the Tax Reform Legislation significantly reduced accumulated deferred income taxes, partially offset by bonus depreciation provisions in the Protecting Americans from Tax Hikes Act. The Tax Reform Legislation also significantly increased tax-related regulatory liabilities.

At December 31, 2017, the tax-related regulatory liabilities to be credited to customers were $121.0 million. These liabilities are primarily attributable to deferred taxes previously recognized at rates higher than the current enacted tax law and to unamortized ITCs.

Deferred federal and state ITCs are amortized over the average life of the related property with such amortization normally applied as a credit to reduce depreciation in the statements of income. Credits amortized in this manner amounted to $0.1 million for each of the years ended December 31, 2017 and 2016. At December 31, 2017, all ITCs available to reduce federal income taxes payable had been utilized.

Effective Tax Rate

A reconciliation of the federal statutory income tax rate to the effective income tax rate is as follows:

Unrecognized Tax Benefits

The Company has no unrecognized tax benefits for any year presented.

The Company classifies interest on tax uncertainties as interest expense; however, the Company had no accrued interest or penalties for unrecognized tax benefits for any year presented.

It is reasonably possible that the amount of the unrecognized tax benefits could change within 12 months. The settlement of federal and state audits could impact the balances. At this time, an estimate of the range of reasonably possible outcomes cannot be determined.

Southern Company is a participant in the Compliance Assurance Process of the IRS. The IRS has finalized its audits of  Southern Company’s consolidated federal tax returns through 2016. However, the pre-Merger Southern Company Gas 2014, 2015, and June 30, 2016 federal tax returns are currently under audit. The audits for Southern Company Gas by any state have either concluded, or the statute of limitations has expired with respect to income tax examinations, for years prior to 2011.

5. FINANCING

The following table provides maturity dates, year-to-date weighted average interest rates, and amounts outstanding for various debt securities and facilities that are included in the balance sheets.

Gas Facility Revenue Bonds

The Company is party to a series of loan agreements with the New Jersey Economic Development Authority under which, a series of gas facility revenue bonds have been issued. These revenue bonds are issued by state agencies to investors, and proceeds from each issuance then are loaned to the Company. Southern Company Gas fully and unconditionally guarantees all of the Company’s gas facility revenue bonds.

The Company’s asset sale agreement requires that the gas facility revenue bonds, which are currently eligible for redemption at par, be redeemed on or prior to consummation of the sale. The ultimate outcome of this matter cannot be determined at this time. See Note 9 for information on the proposed sale of the Company.

Affiliate Promissory Note

Pivotal Utility entered into a promissory note with Southern Company Gas (Affiliate Promissory Note) for the purpose of refinancing its short-term debt and recapitalizing the capital structure of Pivotal Utility and those of its utility operating divisions including the Company’s, in accordance with the target capitalization of 47% and with authorization of the New Jersey BPU. The Affiliate Promissory Note is adjusted periodically to maintain the appropriate targeted capitalization percentages and, during 2017, $100.9 million was converted to the Affiliate Promissory Note and $34.4 million was converted to equity. The Affiliate Promissory Note is due December 31, 2034 and had an initial interest rate at December 31, 2004 of 6.3%, which adjusts on a periodic basis based upon weighted average costs and expenses of borrowing the then-outstanding long-term debt of both Southern Company Gas and Southern Company Gas Capital Corporation, a 100%-owned financing subsidiary of Southern Company Gas. As of December 31, 2017, the effective interest rate on this note was 4.5% which consists of two components. The first is incurred equal to the weighted average costs that is applied to the principal amount of the Affiliate Promissory Note. The second component is an adjustment to increase the effective interest incurred on long-term debt other than the Affiliate Promissory Note to the weighted average cost applicable to the Affiliate Promissory Note.

6. COMMITMENTS

Pipeline Charges, Storage Capacity, and Gas Supply

Pipeline charges, storage capacity, and gas supply include charges recoverable through a natural gas cost recovery mechanism, or alternatively, billed to marketers of natural gas as well as demand charges associated with Sequent Energy Management, L.P. (Sequent), a wholly-owned subsidiary of Southern Company Gas that engages in wholesale marketing of natural gas supply services.

Contractual Obligations

Contractual obligations at December 31, 2017 were as follows:

(a)

Amounts are reflected based on final maturity dates. The Company plans to continue, when economically feasible, to retire higher-cost securities and replace these obligations with lower-cost capital if market conditions permit. Variable rate interest obligations are estimated based on rates at December 31, 2017 and do not include interest on the affiliated promissory note.

(b)	Includes charges recoverable through a natural gas cost recovery mechanism, subject to review by the New Jersey BPU.

(c)

Certain operating leases have provisions for step rent or escalation payments and certain lease concessions are accounted for by recognizing the future minimum lease payments on a straight-line basis over the respective minimum lease terms. However, this accounting treatment does not affect the future annual operating lease cash obligations as shown herein. In terms of rental charges and duration of contracts, the Company’s most significant operating leases relate to real estate and fleet vehicles.

(d)	Represent fixed-fee minimum payments for Sequent’s affiliated asset management agreements.

(e)	See Notes 1 and 9 for additional information.

(f)	Includes contractual environmental remediation liabilities that are generally recoverable through base rates or rate rider mechanisms.

Indemnities

In certain instances, the Company has undertaken to indemnify current property owners and others against costs associated with the effects and/or remediation of contaminated sites for which it may be responsible under applicable federal or state environmental laws, generally with no limitation as to the amount. These indemnifications relate primarily to ongoing coal tar cleanup. See Note 3 under “Environmental Matters” for additional information. The Company believes that the likelihood of payment under its other environmental indemnifications is remote. No liability has been recorded for such indemnifications as the fair value was inconsequential at inception.

7. FAIR VALUE MEASUREMENTS

Fair value measurements are based on inputs of observable and unobservable market data that a market participant would use in pricing the asset or liability. The use of observable inputs is maximized where available and the use of unobservable inputs is minimized for fair value measurement and reflects a three-tier fair value hierarchy that prioritizes inputs to valuation techniques used for fair value measurement. See Note 1 under “Fair Value Measurements” for additional information on the fair value hierarchy.

As of December 31, 2017, liabilities measured at fair value on a recurring basis during the year, together with their associated level of the fair value hierarchy, were as follows: