ITEM 1. BUSINESS WEBSITE ACCESS TO REPORTS We make our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports, filed or furnished pursuant to section 13(a) or 15(d) of the Securities Exchange Act of 1934 available free of charge on or through our internet website, www.cinergy.com, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission (SEC).
ORGANIZATION Cinergy Corp., a Delaware corporation organized in 1993, owns all outstanding common stock of The Cincinnati Gas & Electric Company (CG&E) and PSI Energy, Inc. (PSI), both of which are public utilities. As a result of this ownership, we are considered a utility holding company. Because we are a holding company with material utility subsidiaries operating in multiple states, we are registered with and are subject to regulation by the SEC under the Public Utility Holding Company Act of 1935, as amended. Our other principal subsidiaries are Cinergy Services, Inc. (Services) and Cinergy Investments, Inc. (Investments).
CG&E, an Ohio corporation organized in 1837, is a combination electric and gas public utility company that provides service in the southwestern portion of Ohio and, through The Union Light, Heat and Power Company (ULH&P), in nearby areas of Kentucky. CG&E is responsible for the majority of our power marketing and trading activity. CG&E’s principal subsidiary, ULH&P, a Kentucky corporation organized in 1901, provides electric and gas service in northern Kentucky.
CG&E is in a market development period for residential customers and in the competitive retail electric market for non-residential customers, transitioning to deregulation of electric generation and a competitive retail electric service market in the state of Ohio. Applicable legislation governing the transition period provides for a market development (frozen rate) period that began January 1, 2001, ended December 31, 2004 for non-residential customers and is scheduled to end December 31, 2005 for residential customers. At the end of these market development periods, CG&E will not implement market rates, but rather a rate stabilization plan (RSP) approved by the Public Utilities Commission of Ohio (PUCO) that covers the period after the market development period through 2008. The RSP, among other things, increases rates for environmental costs and capacity reserves and provides for a fuel and emission allowance tracker through 2008. See “Electric Industry” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A)” for the various filings that led to the PUCO’s approval of CG&E’s RSP, further details of the plan, and a discussion of key elements of Ohio deregulation.
PSI, an Indiana corporation organized in 1942, is a vertically integrated and regulated electric utility that provides service in north central, central, and southern Indiana.
The following table presents further information related to the operations of our domestic utility companies, CG&E, PSI, and ULH&P (our utility operating companies):
(1) See “Generation - Fuel Supply and Emission Allowances” under the “Regulated” section for further discussion of the possible transfer of generation assets.
Services is a service company that provides our subsidiaries with a variety of centralized administrative, management, and support services. Investments holds most of our non-regulated, energy-related businesses and investments, including natural gas marketing and trading operations (which are primarily conducted through Cinergy Marketing and Trading, LP (Marketing & Trading), one of its subsidiaries).
BUSINESS SEGMENTS We conduct operations through our subsidiaries and manage our businesses through the following three reportable segments:
• Commercial Business Unit (Commercial);
• Regulated Business Unit (Regulated); and
• Power Technology and Infrastructure Services Business Unit (Power Technology and Infrastructure).
The following section describes the activities of our business segments as of December 31, 2004.
See Note 16 of the “Notes to Financial Statements” in “Item 8. Financial Statements and Supplementary Data” for financial information by business segment.
Commercial Commercial manages our wholesale generation and energy marketing and trading activities. Commercial’s wholesale generation consists of CG&E’s electric generation in Ohio due to Ohio’s transition to deregulation of electric generation and a competitive retail service market. See “Electric Industry” in “Item 7. MD&A” for further detail of key elements of Ohio deregulation. Commercial also performs energy risk management activities, provides
customized energy solutions and is responsible for all of our international operations. See the “Market Risk Sensitive Instruments” section of “Item 7. MD&A” for information on risks associated with these activities.
Detail of Commercial’s operations can be found in the following sections:
• Generation - Fuel Supply and Emission Allowances - Describes Commercial’s generation capacity, sources of fuel, and its various cost recovery mechanisms;
• Trading Operations and Risk Management - Describes Commercial’s energy marketing and trading activities in the United States and Canada;
• Competition - Describes the key competitors to Commercial’s various business operations;
• Energy Services - Describes Commercial’s operations consulting services and its operation of a synthetic fuel production facility;
• International - Describes Commercial’s operations outside of the United States; and
• Revenue Data and Customer Base - Describes the primary revenue generators for the various business operations of Commercial.
Generation - Fuel Supply and Emission Allowances As of December 31, 2004, the total winter electric capacity (including our portion of the total capacity for the jointly-owned plants) of Commercial’s domestic generating plants was 6,276 megawatts (MW). Approximately 67 percent of this generation portfolio is coal-fired. See “Item 2.
ITEM 2. PROPERTIES COMMERCIAL BUSINESS UNIT (COMMERCIAL) Electric Domestic Power Generation Commercial’s domestic power generating stations’ total winter electric capacity, reflected in megawatts (MW), as of December 31, 2004, are shown in the table that follows. Commercial’s electric generating plants are primarily located in Ohio and Kentucky and are wholly-owned or jointly-owned facilities.
(1) This table includes only our portion of the total capacity for the jointly-owned plants.
(2) Represents natural gas peaking plants located in Tennessee and Mississippi, owned by Investments, that sell electricity on the wholesale market.
During 2004, Commercial’s electric generating plants, including those that we own but do not operate, performed reliably, as evidenced by our annual capacity factor of 68 percent and a utilization factor of 83 percent (excluding natural gas and fuel oil peaking stations) and an equivalent availability factor of 84 percent. A capacity factor is a percentage that indicates how much of a power plant’s capacity is used over time. A utilization factor is a percentage that indicates how much of a power plant’s capacity is used while being available. An equivalent availability factor is a percentage that indicates how much of a unit is available to generate compared to its potential maximum generation.
Below is a geographical map showing the locations of Commercial’s generation plants.
(1) Commercial’s generation plant not included in the map is located in Caledonia, Mississippi.
Cogeneration As of December 31, 2004, Cinergy had ownership interests in and/or operated 27 domestic cogeneration facilities capable of producing 5,357 MW of electricity, 4,303 MW equivalents of steam and 236 MW equivalents of chilled water. Cogeneration is the simultaneous production of two or more forms of useable energy from a single fuel source. During 2005, Cinergy anticipates completion of an expansion at one of our existing cogeneration facilities, which is expected to provide an additional 70 MW equivalents of steam and 42 MW equivalents of chilled water.
Synthetic Fuel Cinergy Capital & Trading, Inc. owns a coal-based synthetic fuel production facility, which converts coal into synthetic fuel for sale to a third party. See “Synthetic Fuel Production” in “Item 7. MD&A” for additional information regarding this business initiative.
International As of December 31, 2004, we had ownership interests in (1) generation assets located in three countries capable of producing approximately 150 MW of electricity and 700 MW equivalents of steam; and (2) approximately 1,200 miles of gas and electric transmission and distribution systems through jointly-owned investments in two countries, through which we serve approximately 8,500 transmission and distribution customers. These assets serve retail and wholesale customers by providing utility services including generation of electricity and heat as well as the distribution of gas and electric commodities.
REGULATED BUSINESS UNIT (REGULATED) Electric Domestic Power Generation Regulated’s domestic power generating stations’ total winter electric capacity, reflected in MW, as of December 31, 2004, are shown in the table that follows. The electric generating plants are located in Indiana and Ohio and are wholly-owned or jointly-owned facilities.
(1) This table includes only our portion of the total capacity for the jointly-owned plants.
During 2004, Regulated’s electric generating plants, including those that we own but do not operate, performed reliably, as evidenced by our annual capacity factor of 74 percent and a utilization factor of 85 percent (excluding natural gas and fuel oil peaking stations) and an equivalent availability factor of 89 percent. A capacity factor is a percentage that indicates how much of a power plant’s capacity is used over time. A utilization factor is a percentage that indicates how much of a power plant’s capacity is used while being available. An equivalent availability factor is a percentage that indicates how much of a unit is available to generate compared to its potential maximum generation.
Below is a geographical map showing the locations of Regulated’s generation plants.
Transmission and Distribution Relevant information for our utility operating companies’ electric transmission and distribution systems located in Ohio, Kentucky, and Indiana is as follows:
(1) Kilovolt-amperes (1,000 volt-amperes) are a broad measure of our substation transformer capacity.
At the end of 2004, our utility operating companies’ electric systems were interconnected with 14 other utilities. Our electric transmission and distribution systems are designed and constructed to further the goal of providing reliable service to our customers. Every effort is made to ensure that sufficient facilities are in service to meet this goal without installing facilities beyond what is required to operate reliably and within the designed parameters. Through our ongoing review of these systems, enhancements are developed and constructed to meet our planning, loading, and reliability guidelines. This process allows us to prudently invest in capacity additions only when and where they are required. The Midwest Independent Transmission System Operator, Inc. (Midwest ISO) holds functional control of Regulated’s transmission systems.
Gas As of December 31, 2004, the natural gas transmission and distribution systems of Cinergy and CG&E and its subsidiaries had approximately 9,226 miles of mains and service lines located in southwestern Ohio and northern Kentucky. Cinergy and CG&E and its subsidiaries also jointly own three underground caverns with a total storage capacity of approximately 23 million gallons of liquid propane (of which 18.7 million gallons belongs to CG&E, including 7.5 million gallons belonging to ULH&P). As of December 31, 2004, Cinergy had 16.6 million gallons of liquid propane in storage (of which 14.4 million gallons belongs to CG&E, including 5.8 million gallons belonging to ULH&P). This liquid propane is used in the three propane/air peak shaving plants located in Ohio and Kentucky. Propane/air peak shaving plants store propane and, when needed, vaporize the propane and mix with natural gas to supplement the natural gas supply during peak demand periods and emergencies.
PEAK LOAD In July 2004, we experienced peak loads for the year of 10,911 MW, 4,998 MW, and 6,000 MW for Cinergy, CG&E, and PSI, respectively. Cinergy and CG&E set record peak loads of 11,305 MW and 5,311 MW in August 2002, respectively, while PSI set a record peak load of 6,088 MW in July 2002.
LEGAL PROCEEDINGS
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS CLEAN AIR ACT (CAA) LAWSUIT In November 1999, and through subsequent amendments, the United States brought a lawsuit in the United States Federal District Court for the Southern District of Indiana (District Court) against Cinergy, CG&E, and PSI alleging various violations of the CAA. Specifically, the lawsuit alleges that we violated the CAA by not obtaining Prevention of Significant Deterioration (PSD), Non-Attainment New Source Review (NSR), and Ohio and Indiana State Implementation Plans (SIP) permits for various projects at our owned and co-owned generating stations. Additionally, the suit claims that we violated an Administrative Consent Order entered into in 1998 between the Environmental Protection Agency (EPA) and Cinergy relating to alleged violations of Ohio’s SIP provisions governing particulate matter at Unit 1 at CG&E’s W.C. Beckjord Generating Station (Beckjord Station). The suit seeks (1) injunctive relief to require installation of pollution control technology on various generating units at CG&E’s Beckjord Station and Miami Fort Station, and PSI’s Cayuga Generating Station, Gallagher Generating Station, Wabash River Generating Station, and Gibson Generating Station (Gibson Station), and (2) civil penalties in amounts of up to $27,500 per day for each violation. In addition, three northeast states and two environmental groups have intervened in the case. The case is currently in discovery, and the District Court has set the case for trial by jury commencing in February 2006.
In March 2000, the United States also filed in the District Court an amended complaint in a separate lawsuit alleging violations of the CAA relating to PSD, NSR, and Ohio SIP requirements regarding various generating stations, including a generating station operated by Columbus Southern Power Company (CSP) and jointly-owned by CSP, The Dayton Power and Light Company (DP&L), and CG&E. The EPA is seeking injunctive relief and civil penalties of up to $27,500 per day for each violation. This suit is being defended by CSP. In April 2001, the District Court in that case ruled that the Government and the intervening plaintiff environmental groups cannot seek monetary damages for alleged violations that occurred prior to November 3, 1994; however, they are entitled to seek injunctive relief for such alleged violations. Neither party appealed that decision.
In addition, Cinergy and CG&E have been informed by DP&L that in June 2000, the EPA issued a Notice of Violation (NOV) to DP&L for alleged violations of PSD, NSR, and Ohio SIP requirements at a generating station operated by DP&L and jointly-owned by CG&E. The NOV indicated the EPA may (1) issue an order requiring compliance with the requirements of the Ohio SIP, or (2) bring a civil action seeking injunctive relief and civil penalties of up to $27,500 per day for each violation. In September 2004, Marilyn Wall and the Sierra Club brought a lawsuit against Cinergy, DP&L and CSP for alleged violations of the CAA at this same generating station.
We are unable to predict whether resolution of these matters would have a material effect on our financial position or results of operations. We intend to vigorously defend against these allegations.
CARBON DIOXIDE (CO2) LAWSUIT In July 2004, the states of Connecticut, New York, California, Iowa, New Jersey, Rhode Island, Vermont, Wisconsin, and the City of New York brought a lawsuit in the United States District Court for the Southern District of New York against Cinergy, American Electric Power Company, Inc., American Electric Power Service Corporation, The Southern Company, Tennessee Valley Authority, and Xcel Energy Inc. That same day, a similar lawsuit was filed in the United States District Court for the Southern District of New York against the same companies by Open Space Institute, Inc., Open Space Conservancy, Inc., and The Audubon Society of New Hampshire. These lawsuits allege that the defendants’ emissions of CO2 from the combustion of fossil fuels at electric generating facilities contribute to global warming and amount to a public nuisance. The complaints also allege that the defendants could generate the same amount of electricity while emitting significantly less CO2. Plaintiffs are seeking an injunction requiring each defendant to cap its CO2 emissions and then reduce them by a specified percentage each year for at least a decade. Cinergy intends to defend these lawsuits vigorously in court and filed motions to dismiss with the other defendants in September 2004. We are not able to predict whether resolution of these matters would have a material effect on our financial position or results of operations.
SELECTIVE CATALYTIC REDUCTION UNITS (SCR) AT GIBSON GENERATING STATION In May 2004, SCRs and other pollution control equipment became operational at Units 4 and 5 of PSI’s Gibson Station in accordance with compliance deadlines under the NOX SIP Call. In June and July 2004, Gibson Station temporarily shut down the equipment on these units due to a concern over an acid aerosol mist haze (plume) sometimes occurring in areas near the plant. Portions of the plume from those units’ stacks appeared to break apart and descend to ground level at certain times under certain weather conditions. As a result, and, working with the City of Mt. Carmel, Illinois, Illinois EPA, Indiana Department of Environmental Management (IDEM), EPA, and the State of Illinois, we developed a protocol regarding the use of the SCRs while we explored alternatives to address this issue. After the protocol was finalized, the Illinois Attorney General brought an action in Wabash County Circuit Court against PSI seeking a preliminary injunction to enforce the protocol. In August 2004, the court granted that preliminary injunction. PSI is appealing that decision to the Fifth District Appellate Court, but we cannot predict the ultimate outcome of that appeal or of the underlying action by the Illinois Attorney General.
We will seek recovery of any related capital as well as increased emission allowance expenditures through the regulatory process. We do not believe costs related to resolving this matter will have a material impact on our financial position or results of operations.
ZIMMER GENERATING STATION (ZIMMER STATION) LAWSUIT In November 2004, a citizen of the Village of Moscow, Ohio, the town adjacent to CG&E’s Zimmer Station, brought a purported class action in the United States District Court for the Southern District of Ohio seeking monetary damages and injunctive relief against CG&E for alleged violations of the CAA, the Ohio SIP, Ohio laws against nuisance and common law nuisance. CG&E filed a motion to dismiss the lawsuit on primarily procedural grounds and we intend to defend against these claims vigorously. At this time, we cannot predict whether the outcome of this matter will have a material impact on our financial position or result of operations.
MANUFACTURED GAS PLANT (MGP) SITES Coal tar residues, related hydrocarbons, and various metals have been found in at least 22 sites that PSI or its predecessors previously owned and sold in a series of transactions with Northern Indiana Public Service Company (NIPSCO) and Indiana Gas Company, Inc. (IGC). The 22 sites are in the process of being studied and will be remediated, if necessary. In 1998 NIPSCO, IGC, and PSI entered into Site Participation and Cost Sharing Agreements to allocate liability and responsibilities between them. The IDEM oversees investigation and cleanup of all of these sites. Thus far, PSI has primary responsibility for investigating, monitoring and, if necessary, remediating nine of these sites. In December 2003, PSI entered into a voluntary remediation plan with the state of Indiana, providing a formal framework for the investigation and cleanup of the sites.
In April 1998, PSI filed suit in Hendricks County in the state of Indiana against its general liability insurance carriers. PSI sought a declaratory judgment to obligate its insurance carriers to (1) defend MGP claims against PSI and compensate PSI for its costs of investigating, preventing, mitigating, and remediating damage to property and paying claims related to MGP sites; or (2) pay PSI’s cost of defense. The trial court issued a variety of rulings with respect to the claims and defenses in the litigation. PSI appealed certain adverse rulings to the Indiana Court of Appeals and the appellate court remanded the case to the trial court. PSI settled its claims with all but one of the insurance carriers in January 2005 prior to commencement of the trial. With respect to the lone insurance carrier, a jury returned a verdict against PSI in February 2005. PSI is considering whether to appeal this decision. At the present time, PSI cannot predict the outcome of this litigation if it were to appeal the decision.
PSI has accrued costs related to investigation, remediation, and groundwater monitoring for those sites where such costs are probable and can be reasonably estimated. We will continue to investigate and remediate the sites as outlined in the voluntary remediation plan. As additional facts become known and investigation is completed, we will assess whether the likelihood of incurring additional costs becomes probable. Until all investigation and remediation is complete, we are unable to determine the overall impact on our financial position or results of operations.
CG&E and ULH&P have performed site assessments on certain of their sites where we believe MGP activities have occurred at some point in the past and have found no imminent risk to the environment. At the present time,
CG&E and ULH&P cannot predict whether investigation and/or remediation will be required in the future at any of these sites.
ASBESTOS CLAIM LITIGATION CG&E and PSI have been named as defendants or co-defendants in lawsuits related to asbestos at their electric generating stations. Currently, there are approximately 100 pending lawsuits. In these lawsuits, plaintiffs claim to have been exposed to asbestos-containing products in the course of their work at the CG&E and PSI generating stations. The plaintiffs further claim that as the property owner of the generating stations, CG&E and PSI should be held liable for their injuries and illnesses based on an alleged duty to warn and protect them from any asbestos exposure. A majority of the lawsuits to date have been brought against PSI. The impact on CG&E’s and PSI’s financial position or results of operations of these cases to date has not been material.
Of these lawsuits, one case filed against PSI has been tried to verdict. The jury returned a verdict against PSI in the amount of approximately $500,000 on a negligence claim and a verdict for PSI on punitive damages. PSI received an adverse ruling in its initial appeal of the negligence claim verdict, but the Indiana Supreme Court accepted the transfer of the case and heard oral argument in June 2004. In addition, PSI has settled a number of other lawsuits for amounts, which neither individually nor in the aggregate, are material to PSI’s financial position or results of operations.
At this time, CG&E and PSI are not able to predict the ultimate outcome of these lawsuits or the impact on CG&E’s and PSI’s financial position or results of operations.
We currently, and from time to time, are involved in lawsuits, claims, and complaints incidental to the conduct of our business. In the opinion of management, no such proceeding is likely to have a material adverse effect on us.
See Note 11 of the “Notes to Financial Statements” in “Item 8. Financial Statements and Supplementary Data” for further information regarding our commitments and contingencies.
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders of Cinergy, The Cincinnati Gas & Electric Company, or PSI Energy, Inc. during the fourth quarter of 2004.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
PART II ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES Cinergy Corp.’s common stock is listed on the New York Stock Exchange. The high and low stock prices for each quarter for the past two years are indicated below:
Cinergy Corp. holds all outstanding common stock of The Cincinnati Gas & Electric Company (CG&E) and PSI Energy, Inc. (PSI), and CG&E holds all of the common stock of The Union Light, Heat and Power Company (ULH&P). Therefore, no public trading market exists for the common stock of CG&E, PSI, and ULH&P.
As of January 31, 2005, Cinergy Corp. had 45,628 shareholders of record.
Cinergy Corp. declared dividends on its common stock of $.47 and $.46 per share for each quarter of 2004 and 2003, respectively. The quarterly dividends paid to Cinergy Corp. by CG&E and PSI, and to CG&E by ULH&P for the past two years were as follows:
On January 14, 2005, the Board of Directors of Cinergy Corp. declared dividends on its common stock of $.48 per share, payable February 15, 2005, to shareholders of record at the close of business on February 1, 2005.
See “Dividend Restrictions” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” for a brief description of the registrants’ common stock dividend restrictions.
The number of shares (or units) provided in the table below represent shares exchanged in connection with employee option exercises and shares purchased by the plan trustee on behalf of the 401(k) Excess Plan.
SELECTED FINANCIAL DATA
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
(1) The results of Cinergy also include amounts related to non-registrants.
(2) See Note 14 of the “Notes to Financial Statements” in “Item 8. Financial Statements and Supplementary Data” for further explanation.
(3) In 2003, Cinergy recognized a gain/(loss) on cumulative effect of changes in accounting principles of $39 million (net of tax) and $(13) million (net of tax) as a result of the reversal of accrued cost of removal for non-regulated generating assets and the change in accounting of certain energy related contracts from fair value to accrual. In 2002, Cinergy recognized a cumulative effect of a change in accounting principle of $(11) million (net of tax) as a result of an impairment charge for goodwill related to certain of our international assets.
(4) In 2003, CG&E recognized a gain/(loss) on cumulative effect of changes in accounting principles of $39 million (net of tax) and $(8) million (net of tax) as a result of the reversal of accrued cost of removal for non-regulated generating assets and the change in accounting of certain energy related contracts from fair value to accrual.
(5) In 2003, PSI recognized a loss on cumulative effect of a change in accounting principle of $(1) million (net of tax) as a result of a change in accounting of certain energy related contracts from fair value to accrual.
MD&A - EXECUTIVE SUMMARY
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS In this report, Cinergy (which includes Cinergy Corp. and all of its regulated and non-regulated subsidiaries) is, at times, referred to in the first person as “we”, “our”, or “us”.
The following discussion should be read in conjunction with the accompanying financial statements and related notes included elsewhere in this report. We have reclassified certain prior-year amounts in the financial statements of Cinergy, The Cincinnati Gas & Electric Company (CG&E), PSI Energy, Inc. (PSI), and The Union Light, Heat and Power Company (ULH&P) to conform to current presentation. The following discussions of results are not necessarily indicative of the results to be expected in any future period.
EXECUTIVE SUMMARY In Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A), we explain our general operating environment, as well as our results of operations, liquidity, capital resources, future expectations/trends, market risk sensitive instruments, and accounting matters. Specifically, we discuss the following:
• factors affecting current and future operations;
• why results changed from period to period;
• potential sources of cash for future capital expenditures; and
• how these items affect our overall financial condition.
Financial Highlights Net income for Cinergy for the years ended December 31, 2004, and 2003 was as follows:
The decrease in net income was primarily due to the following factors:
• Higher operating costs due, in part, to increases in costs for employee labor and benefits, production maintenance, and the implementation of a continuous improvement initiative;
• Lower margins from the sale of electricity in the Commercial Business Unit (Commercial) primarily due to higher fuel and emission allowance costs;
• Impairment and disposal charges on certain investments primarily in the Power Technology and Infrastructure Services Business Unit (Power Technology and Infrastructure); and
• Net gains recognized in 2003 resulting from the implementation of certain accounting changes and the disposal of discontinued operations.
These decreases were partially offset by:
• A higher price received per megawatt hour (MWh) resulting from the Indiana Utility Regulatory Commission’s (IURC) approval of PSI’s base retail electric rate increase in May 2004;
• Growth in non-weather related demand for electricity;
• An increase in gross margins on power marketing, trading, and origination contracts; and
• A gain related to a Power Technology and Infrastructure investment.
For further information, see “2004 Results of Operations - Cinergy”.
Forward-looking Challenges and Risks Environmental Challenges Cinergy faces many uncertainties with regard to future environmental legislation and the impact of this legislation on our generating assets and our decisions to construct new assets. In two separate rulemakings, the Environmental Protection Agency (EPA) has proposed significant reductions in sulfur dioxide (SO2), nitrogen oxides (NOX) and mercury emissions from power plants, neither of which have been finalized. Additionally, multi-emissions reductions legislation could be passed in 2005 that may take the place of these proposed rulemakings. In 2004, Cinergy’s utility operating companies began an environmental construction program to reduce overall plant emissions that is estimated to cost approximately $1.8 billion over the next five years. We believe that our construction program optimally balances these uncertainties and provides a level of emission reduction that will be required and/or economical to Cinergy under a variety of possible regulatory outcomes. See “Environmental Issues” in “Liquidity and Capital Resources” for further information.
Regulatory Challenges Ohio has enacted electric generation deregulation legislation. CG&E’s residential customers are in a market development period through 2005, during which prices are fixed, while non-residential customers are under a recently approved rate stabilization plan (RSP) that runs through December 31, 2008. Residential customers will be under the RSP beginning in 2006, also ending in 2008. At this time, it is difficult to predict how the regulatory environment will look after the rate stabilization period ends. To date, deregulation in Ohio has not progressed as originally anticipated and the Ohio General Assembly may consider re-regulation laws as early as 2005. However, the possibility of deregulation or a hybrid of both deregulation and regulation still exists. These regulatory uncertainties are particularly challenging as we attempt to address short-term and long-term generation capacity needs as well as environmental requirements previously discussed. See “Regulatory Outlook and Significant Rate Developments” in “Future Expectations/Trends” for further discussion of these risks and uncertainties.
Midwest Independent Transmission System Operator, Inc. (Midwest ISO) Energy Markets The projected implementation date is April 1, 2005 for the Midwest ISO to begin operating under the Energy Markets Tariff (sometimes referred to as a Locational Marginal Pricing (LMP) market or MISO Day 2 market). The implementation of an LMP market will introduce new scheduling requirements, new products for mitigating transmission congestion risks, and new pricing points for the purchase and sale of power. Cinergy is in the process of preparing for the implementation and the Midwest ISO is currently conducting market trials and testing of the Energy Markets. This is a significant undertaking by the Midwest ISO and its stakeholders and testing is not yet complete. See “Midwest ISO Energy Markets” in “Future Expectations/Trends” for further details regarding these new markets.
Rising Coal and Emission Allowance Prices The prices of coal and SO2 allowances have increased dramatically in 2004, as compared to 2003. Contributing to the increases in coal and SO2 prices have been (1) increases in demand for electricity, (2) environmental regulation, and (3) decreases in the number of suppliers of coal from prior years. Since rates have been frozen for non-residential customers through 2004 and residential customers through 2005, pursuant to Ohio deregulation, these increases in coal and emission allowance prices could not be recovered through rates. The impact of these price increases on earnings is discussed in more detail in “Results of Operations”. See “Generation Portfolio Risks” in “Market Risk Sensitive Instruments” for information on how we plan to mitigate these risks going forward.
MD&A - 2004 RESULTS OF OPERATIONS - CINERGY
2004 RESULTS OF OPERATIONS - CINERGY Gross Margins Given the dynamics of our business, which include regulatory revenues with directly offsetting expenses and commodity trading operations for which results are primarily reported on a net basis, we have concluded that a discussion of our results on a gross margin basis is most appropriate. Electric gross margins represent electric operating revenues less the related direct costs of fuel, emission allowances, and purchased power. Gas gross margins represent gas operating revenues less the related direct cost of gas purchased. Within each of these areas, we will discuss the key drivers of our results. Gross margins for Cinergy for the Regulated Business Unit (Regulated) and Commercial for the years ended December 31, 2004, and 2003 were as follows:
(1) Electric gross margin is calculated as Electric operating revenues less Fuel, emission allowances, and purchased power expense from the Statements of Income.
(2) Gas gross margin is calculated as Gas operating revenues less Gas purchased expense from the Statements of Income.
Cooling degree days and heating degree days are metrics commonly used in the utility industry as a measure of the impact weather has on results of operations. Cooling degree days and heating degree days in Cinergy’s service territory for the years ended December 31, 2004, and 2003 were as follows:
(1) Cooling degree days are the differences between the average temperature for each day and 65 degrees, assuming the average temperature is greater than 65 degrees.
(2) Heating degree days are the differences between the average temperature for each day and 65 degrees, assuming the average temperature is less than 65 degrees.
The change in cooling degree days and heating degree days did not have a material effect on Cinergy’s gross margins for the year ended December 31, 2004, as compared to 2003.
Regulated Gross Margins The 13 percent increase in Regulated’s electric gross margins was primarily due to the following factors:
• An approximate $80 million increase resulting from a higher price received per MWh due to PSI’s base retail electric rate increase in May 2004; and
• An approximate $32 million increase due to growth in non-weather related demand.
The eight percent increase in Regulated’s gas gross margins was primarily due to an approximate $16 million increase in tariff adjustments mainly associated with the gas main replacement program. Partially offsetting this increase was an approximate $7 million decrease reflecting a decline in non-weather related demand.
Commercial Gross Margins
The 11 percent decrease in Commercial’s electric gross margins was primarily due to the following factors:
• An approximate $51 million increase in CG&E’s average price of fuel without a matching increase in the price of power charged to customers (the majority of which were under fixed price contracts); and
• An approximate $62 million increase in emission allowance costs, primarily due to increases in SO2 emission allowance market prices, without a matching increase in the price of power charged to customers. The number of SO2 emission allowances used also increased in 2004.
Partially offsetting these decreases were:
• An approximate $24 million increase in gross margins on power marketing, trading, and origination contracts attributable to higher margins on physical and financial trading, primarily related to regional spreads between the mideast and midwest markets; and
• An approximate $15 million increase due to growth in non-weather related demand.
Commercial’s gas gross margins under generally accepted accounting principles (GAAP) and Commercial’s adjusted gas gross margins were relatively flat in 2004, as compared to 2003, although volatility during 2004 was significant due to timing differences in revenue recognition between physical storage activities and the associated derivative contracts that hedge the physical storage. We evaluate the results of our gas marketing and trading business on an economic basis, which we term “adjusted gas gross margins”.
Our gas marketing and trading business regularly hedges its price exposure of natural gas held in storage by selling derivative contracts for winter month delivery. The majority of the gas held in storage is designated as being hedged under Statement of Financial Accounting Standards No. 133’s, Accounting for Derivative Instruments and Hedging Activities (Statement 133), fair value hedge accounting model, which allows the gas to be accounted for at its fair value (based on spot prices). Under GAAP, the derivative contracts hedging the gas are accounted for at fair value (based on forward winter prices). Conversely, the agreements with pipelines to store this natural gas until the winter periods are not derivatives and are not adjusted for changes in fair value (see footnote 1 in the table below).
For a more complete understanding of our gas marketing and trading results, we have prepared the following table, which reconciles the gas margins under GAAP, the impact of adjusting these margins for the fair value of pipeline agreements and certain gas held in storage, and the resulting adjusted gas gross margins:
(1) Relates to fair value of storage agreements. The value of a storage agreement is the ability to store and optimize gas between periods of lower prices (typically summer) and periods of higher prices (typically winter). A large component of the fair value is therefore the differences between winter prices and spot prices. As this spread gets wider, the value of a storage agreement increases.
Other Operating Revenues and Costs of Fuel Resold
The 41 percent increase in Other Operating Revenues was primarily due to the following factors:
• An approximate $67 million increase in Commercial’s revenues from coal origination resulting from increases in coal prices and the number of coal origination contracts. Coal origination includes contract structuring and marketing of physical coal; and
• An approximate $28 million increase in Commercial’s revenues from the sale of synthetic fuel.
Costs of fuel resold includes Commercial’s costs of coal origination activities and the production of synthetic fuel. These costs have increased in 2004, which is consistent with the increases in the associated revenues as previously discussed.
The following explanations correspond with the line items on the Statements of Income for Cinergy. However, only the line items that varied significantly from prior periods are discussed.
Other Operating Expenses
Operation and Maintenance The 15 percent increase in Operation and maintenance expense was primarily due to the following factors:
• Costs primarily associated with employee labor and benefits increased approximately $50 million. Labor and benefit costs increased approximately six percent;
• Maintenance expenses, primarily production related, were higher by approximately $26 million;
• An approximate $20 million of costs incurred in 2004 related to a continuous improvement initiative;
• Higher transmission costs of approximately $15 million. This increase was due, in part, to refunds received in 2003, which offset a portion of the costs for that year; and
• An approximate $14 million increase in operation expenses for non-regulated service subsidiaries that started operations, or became fully consolidated, after the second quarter of 2003.
These increases were partially offset by:
• The recognition of approximately $14 million of costs associated with voluntary early retirement programs and employee severance programs in 2003; and
• An approximate $12 million for costs incurred in 2003 associated with the bankruptcy of Enron Corp.
Depreciation The 15 percent increase in Depreciation expense was primarily due to the following factors:
• An approximate $36 million increase due to the addition of depreciable plant, primarily for pollution control equipment, and the accelerated gas main replacement program; and
• An approximate $27 million increase resulting from a) higher depreciation rates, as a result of changes in useful lives of production assets and an increased rate for cost of removal and b) recovery of deferred depreciation costs, both of which were approved in PSI’s latest retail rate case.
These increases were partially offset by approximately $15 million due to longer estimated useful lives of CG&E’s generation assets resulting from a depreciation study completed during the third quarter of 2003.
Equity in Earnings of Unconsolidated Subsidiaries The increase in Equity in Earnings of Unconsolidated Subsidiaries was primarily due to a gain of approximately $21 million relating to the sale of most of the assets by a company in which Power Technology and Infrastructure holds an investment. See Note 15(b) of the “Notes to Financial Statements” in “Item 8. Financial Statements and Supplementary Data” for further information.
Miscellaneous Income (Expense) - Net The decrease in Miscellaneous Income (Expense) - Net was primarily due to the recognition of approximately $56 million in impairment and disposal charges in 2004 primarily associated with certain investments in the Power Technology and Infrastructure portfolio. The values of these investments reflect our estimates and judgments about the future performance of these investments, for which actual results may differ. A substantial portion of these charges relate to a company, in which Cinergy holds a non-controlling interest that sold its major assets in 2004. This company is involved in the development and sale of outage management software.
This decrease was partially offset by interest income of approximately $9 million on the notes receivable of two subsidiaries consolidated in the third quarter of 2003.
Interest Expense The two percent increase in Interest Expense was primarily due to the following factors:
• An approximate $12 million increase due to Cinergy’s recognition of a note payable to a trust; and
• An approximate $9 million increase related to additional debt recorded in accordance with the consolidation of two new entities.
The note payable and additional debt were both recorded in July 2003 resulting from the adoption of Financial Accounting Standards Board Interpretation No. 46, Consolidation of Variable Interest Entities (Interpretation 46).
These increases were partially offset by:
• A decline in average long-term debt; and
• Charges recorded during 2003 associated with CG&E’s refinancing of certain debt.
Preferred Dividend Requirement of Subsidiary Trust The decrease in Preferred Dividend Requirement of Subsidiary Trust was a result of the implementation of Interpretation 46. Effective July 1, 2003, the preferred trust securities and the related dividends are no longer reported in Cinergy’s financial statements. However, interest expense is still being incurred on a note payable to this trust as previously discussed. See Note 1(q)(i) of the “Notes to Financial Statements” in “Item 8. Financial Statements and Supplementary Data” for further details.
Income Taxes Cinergy’s 2004 effective tax rate was approximately 21 percent, a decrease of four percent from 2003, resulting from a greater amount of tax credits associated with the production and sale of synthetic fuel and the successful resolution of certain tax matters.
Discontinued Operations During 2003, Cinergy completed the disposal of its gas distribution operation in South Africa, sold its remaining wind assets in the United States, and substantially sold or liquidated the assets of its energy trading operation in the Czech Republic. Pursuant to Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-lived Assets (Statement 144), these investments have been classified as discontinued operations in our financial statements. See Note 14 of the “Notes to Financial Statements” in “Item 8. Financial Statements and Supplementary Data” for additional information.
Cumulative Effect of Changes in Accounting Principles In 2003, Cinergy recognized a Cumulative effect of changes in accounting principles, net of tax gain of approximately $26 million. The cumulative effect of changes in accounting principles was a result of the adoption of Statement of Financial Accounting Standards No. 143, Accounting for Asset Retirement Obligations (Statement 143) and the rescission of Emerging Issues Task Force (EITF) Issue 98-10, Accounting for Contracts Involved in Energy Trading and Risk Management Activities (EITF 98-10). See Note 1(q)(iv) of the “Notes to Financial Statements” in “Item 8. Financial Statements and Supplementary Data” for further information.
MD&A - 2004 RESULTS OF OPERATIONS - CG&E
2004 RESULTS OF OPERATIONS - CG&E Summary of Results Net income for CG&E for the years ended December 31, 2004, and 2003 were as follows:
The decrease in net income was primarily due to the following factors:
• Higher operating costs due, in part, to increases in costs for employee labor and benefits;
• Lower margins from the sale of electricity primarily due to higher fuel and emission allowance costs; and
• A net gain recognized in 2003 resulting from the implementation of certain accounting changes.
These decreases were partially offset by:
• Growth in non-weather related demand for electricity; and
• An increase in gross margins on power marketing, trading, and origination contracts.
Gross Margins Gross margins for CG&E for the years ended December 31, 2004, and 2003 were as follows:
(1) Electric gross margin is calculated as Electric operating revenues less Fuel, emission allowances, and purchased power expense from the Statements of Income.
(2) Gas gross margin is calculated as Gas operating revenues less Gas purchased expense from the Statements of Income.
Cooling degree days and heating degree days in CG&E’s service territory for the years ended December 31, 2004, and 2003 were as follows:
(1) Cooling degree days are the differences between the average temperature for each day and 65 degrees, assuming the average temperature is greater than 65 degrees.
(2) Heating degree days are the differences between the average temperature for each day and 65 degrees, assuming the average temperature is less than 65 degrees.
The change in cooling degree days and heating degree days did not have a material effect on CG&E’s gross margins for the period.
Electric Gross Margins The two percent decrease in CG&E’s electric gross margins was primarily due to the following factors:
• An approximate $51 million increase in the average price of fuel without a matching increase in the price of power charged to customers (the majority of which were under fixed price contracts); and
• An approximate $32 million increase in emission allowance costs, primarily due to an increase in SO2 emission allowance market prices, without a matching increase in the price of power charged to customers.
These decreases were partially offset by:
• An approximate $31 million increase in margins from retail customers due to growth in non-weather related demand; and
• An approximate $29 million increase in gross margins on power marketing, trading, and origination contracts attributable to higher margins on physical and financial trading, primarily related to regional spreads between the mideast and midwest markets.
Gas Gross Margins The seven percent increase in CG&E’s gas gross margins was primarily due to an approximate $16 million increase in tariff adjustments mainly associated with the gas main replacement program. Partially offsetting this increase was an approximate $7 million decrease reflecting a decline in non-weather related demand.
Other Operating Revenues and Costs of Fuel Resold The increase in Other Operating Revenues was due to an approximate $67 million increase in revenues from coal origination resulting from increases in coal prices and the number of coal origination contracts.
Costs of fuel resold represents the costs of coal origination activities. These costs have increased in 2004, which is consistent with the increase in the associated revenues as previously discussed.
The following explanations correspond with the line items on the Statements of Income for CG&E. However, only the line items that varied significantly from prior periods are discussed.
Other Operating Expenses
Operation and Maintenance The 19 percent increase in Operation and maintenance expense was primarily due to the following factors:
• Costs primarily associated with employee labor and benefits increased approximately $28 million;
• Maintenance expenses, primarily production and distribution related, were higher by approximately $21 million;
• An approximate $9 million of costs incurred in 2004 related to a continuous improvement initiative; and
• Higher transmission costs of approximately $9 million. This increase was due, in part, to refunds received in 2003, which offset a portion of the costs for that year.
Partially offsetting these increases was the recognition of approximately $4 million of costs associated with voluntary early retirement programs and employee severance programs in 2003.
Depreciation The four percent decrease in Depreciation expense was primarily due to longer estimated useful lives of CG&E’s generation assets resulting from a depreciation study completed during the third quarter of 2003, which resulted in a decrease of approximately $15 million. This decrease was partially offset by an approximate $8 million increase due to the addition of depreciable plant primarily for pollution control equipment and the accelerated gas main replacement program.
Miscellaneous Income - Net The 47 percent decrease in Miscellaneous Income - Net was primarily due to the following factors:
• A final reconciliation recorded in 2003 between CG&E and PSI due to a previous demutualization of a medical insurance carrier used by both companies; and
• A decline in the allowance for equity funds used during construction resulting from certain assets being placed into service and a decrease in the equity rate applied.
Interest Expense The 21 percent decrease in Interest Expense was primarily due to the following factors:
• A decline in average long-term debt; and
• Charges recorded during 2003 associated with the refinancing of certain debt.
Cumulative Effect of Changes in Accounting Principles In 2003, CG&E recognized a Cumulative effect of changes in accounting principles, net of tax gain of approximately $31 million as a result of the adoption of Statement 143 and the rescission of EITF 98-10. See Note 1(q)(iv) of the “Notes to Financial Statements” in “Item 8. Financial Statements and Supplementary Data” for further information.
MD&A - 2004 RESULTS OF OPERATIONS - PSI
2004 RESULTS OF OPERATIONS - PSI Summary of Results Net income for PSI for the years ended December 31, 2004, and 2003 were as follows:
The increase in net income was primarily due to the following factors:
• The impact of the PSI base retail electric rate increase in May 2004; and
• Growth in non-weather related demand.
These increases were partially offset by higher operating costs due, in part, to increases in costs for employee labor and benefits.
Electric Gross Margins Gross margins for PSI for the years ended December 31, 2004, and 2003 were as follows:
(1) Electric gross margin is calculated as Electric operating revenues less Fuel, emission allowances, and purchased power expense from the Statements of Income.
Cooling degree days and heating degree days in PSI’s service territory for the years ended December 31, 2004, and 2003 were as follows:
(1) Cooling degree days are the differences between the average temperature for each day and 65 degrees, assuming the average temperature is greater than 65 degrees.
(2) Heating degree days are the differences between the average temperature for each day and 65 degrees, assuming the average temperature is less than 65 degrees.
The change in degree days did not have a material effect on electric gross margins for the period. The 13 percent increase in PSI’s electric gross margins was primarily due to the following factors:
• An approximate $80 million increase resulting from a higher price received per MWh due to PSI’s base retail electric rate increase in May 2004; and
• An approximate $16 million increase due to growth in non-weather related demand.
The following explanations correspond with the line items on the Statements of Income for PSI. However, only the line items that varied significantly from prior periods are discussed.
Other Operating Expenses
Operation and Maintenance The six percent increase in Operation and maintenance expense was primarily due to the following factors:
• Costs primarily associated with employee labor and benefits increased approximately $14 million;
• An approximate $8 million of costs incurred in 2004 related to a continuous improvement initiative;
• An increase in production related maintenance expense of approximately $7 million; and
• Higher transmission costs of approximately $6 million. This increase was due, in part, to refunds received in 2003, which offset a portion of the costs for that year.
Partially offsetting these increases was the recognition of approximately $4 million of costs associated with voluntary early retirement programs and employee severance programs in 2003.
Depreciation The 35 percent increase in Depreciation expense was primarily due to the following factors:
• An approximate $27 million increase due to the addition of depreciable plant primarily for pollution control equipment; and
• An approximate $27 million increase resulting from a) higher depreciation rates, as a result of changes in useful lives of production assets and an increased rate for cost of removal and b) recovery of deferred depreciation costs, both of which were approved in PSI’s latest retail rate case.
Interest Expense The seven percent increase in Interest Expense was primarily due to an increase in the effective interest rate on short-term debt and an increase in the average amount of short-term debt outstanding.
MD&A - 2004 RESULTS OF OPERATIONS - ULH&P
2004 RESULTS OF OPERATIONS - ULH&P The Results of Operations discussion for ULH&P is presented only for the year ended December 31, 2004, in accordance with General Instruction I(2)(a).
Electric and gas gross margins and net income for ULH&P for the years ended December 31, 2004 and 2003, were as follows:
(1) Electric gross margin is calculated as Electric operating revenues less Electricity purchased from parent company for resale expense from the Statements of Income.
(2) Gas gross margin is calculated as Gas operating revenues less Gas purchased expense from the Statements of Income.
Electric gross margins for ULH&P remained flat as growth in non-weather related demand was offset by the cost of increased electricity purchases to meet that demand. The 13 percent increase in gas gross margins was due, in part, to an approximate $3 million increase in rate tariff adjustments associated with the gas main replacement program and the demand-side management program, which encourages efficient customer gas usage.
Net income remained flat as an approximate $2 million increase in operating costs, primarily related to increased transmission and distribution expenses, was partially offset by an approximate $1 million reduction in property taxes during 2004.
MD&A - 2003 RESULTS OF OPERATIONS - CINERGY
2003 RESULTS OF OPERATIONS - CINERGY Summary of Results Net income for Cinergy for the years ended December 31, 2003, and 2002 was as follows:
Cinergy’s increase in net income was primarily due to the following factors:
• Increases in gas gross margins as a result of an increase in base rates for Ohio customers, colder weather and increased volatility in gas prices in the first quarter of 2003, as compared to 2002, and an increase in natural gas sold from storage;
• Lower operating costs primarily resulting from the recognition of higher costs in 2002 associated with employee severance programs;
• Lower property taxes, primarily resulting from the change in property value assessment in the state of Indiana in 2003;
• The 2002 write-off of certain investments;
• A net gain recognized in 2003 resulting from the implementation of certain accounting changes;
• Gains realized in 2003 and losses incurred in 2002 from the disposal of discontinued operations; and
• Lower income taxes resulting primarily from tax credits associated with the production of synthetic fuel, which began in July 2002.
These increases were partially offset by:
• A decrease in electric gross margins primarily due to milder weather in 2003; and
• A decline in electric gross margins associated with Cinergy’s natural gas peaking assets.
Gross Margins Given the dynamics of our business, which include regulatory revenues with directly offsetting expenses and commodity trading operations for which results are primarily reported on a net basis, we have concluded that a discussion of our results on a gross margin basis is most appropriate. Electric gross margins represent electric operating revenues less the related direct costs of fuel, emission allowances, and purchased power. Gas gross margins represent gas operating revenues less the related direct cost of gas purchased. Within each of these areas, we will discuss the key drivers of our results. Gross margins for Cinergy for Regulated and Commercial for the years ended December 31, 2003, and 2002 were as follows:
(1) Electric gross margin is calculated as Electric operating revenues less Fuel, emission allowances, and purchased power expense from the Statements of Income.
(2) Gas gross margin is calculated as Gas operating revenues less Gas purchased expense from the Statements of Income.
Cooling degree days and heating degree days are metrics commonly used in the utility industry as a measure of the impact weather has on results of operations. Cooling degree days and heating degree days in Cinergy’s service territory for the years ended December 31, 2003, and 2002 were as follows:
(1) Cooling degree days are the differences between the average temperature for each day and 65 degrees, assuming the average temperature is greater than 65 degrees.
(2) Heating degree days are the differences between the average temperature for each day and 65 degrees, assuming the average temperature is less than 65 degrees.
Regulated Gross Margins The six percent decrease in Regulated’s electric gross margins was primarily due to a decline in retail electric margins mainly resulting from milder weather in 2003, compared to 2002. As noted in the table, cooling degree days were down 39 percent in Cinergy’s service territory. Partially offsetting this decrease was an increase in rate tariff adjustments associated with certain construction programs at PSI.
The 20 percent increase in Regulated’s gas gross margins was primarily due to the following factors:
• An increase in base rates, as approved by the Public Utilities Commission of Ohio (PUCO) in May 2002, and tariff adjustments associated with the gas main replacement program and Ohio excise taxes; and
• The colder weather in the first quarter of 2003, compared to 2002, which resulted in a greater amount of thousand cubic feet (mcf) delivered to customers.
Commercial Gross Margins
The three percent decrease in Commercial’s electric gross margins was primarily due to a decline in margins associated with Commercial’s natural gas peaking assets in 2003, as compared to 2002. Partially offsetting this decrease were higher margins from physical and financial trading primarily in and around the midwest.
The 14 percent increase in Commercial’s gas gross margins was primarily due to the following factors:
• An increase in the volatility of natural gas prices in the first quarter of 2003, as compared to the same period in 2002; and
• An increase in natural gas sold out of storage in 2003. Cinergy Marketing & Trading, LP (Marketing & Trading) began engaging in significant storage activities at the end of the second quarter of 2002.
Other Operating Revenues and Costs of Fuel Resold
The 22 percent increase in Other Operating Revenues was primarily due to an increase in Commercial’s revenues from the sale of synthetic fuel, which began in July 2002. This increase was partially offset by a decline in Commercial’s revenues from coal origination.
Costs of fuel resold includes Commercial’s costs of coal origination activities and the production of synthetic fuel. In 2003, the costs of producing synthetic fuel increased and the costs of coal origination activities decreased, both of which are consistent with the changes in the associated revenues as previously discussed.
The following explanations correspond with the line items on the Statements of Income for Cinergy. However, only the line items that varied significantly from prior periods are discussed.
Other Operating Expenses
Operation and Maintenance The seven percent decrease in Operation and maintenance expense was primarily due to the following factors:
• The recognition of higher costs associated with employee severance programs in 2002;
• Decreased transmission costs, largely the result of changes in the Midwest ISO operations; and
• A decrease in employee incentive costs.
These decreases were partially offset by:
• The charges associated with our resolution of claims with respect to the bankruptcy of Enron Corp.; and
• An increase in maintenance expense for our generating units and overhead lines.
Depreciation The one percent decrease in Depreciation expense was primarily due to the following factors:
• An increase in estimated useful lives of CG&E’s generation assets resulting from a depreciation study completed during the third quarter of 2003; and
• CG&E’s discontinuance of accruing costs of removal for generating assets (which was previously included as part of Depreciation expense) as a result of the adoption of Statement 143. See Note 1(j) of the “Notes to Financial Statements” in “Item 8. Financial Statements and Supplementary Data” for further details. Prior periods were not restated for the adoption of Statement 143.
Partially offsetting these decreases was the addition of depreciable plant primarily including pollution control equipment, accelerated gas main replacement program assets, and equipment associated with the production of synthetic fuel.
Taxes Other Than Income Taxes The five percent decrease in Taxes other than income taxes expense was primarily due to lower property taxes, which were partially offset by increased excise taxes. This decrease was primarily a result of a change in property value assessments in the state of Indiana in 2003.
Miscellaneous Income (Expense) - Net The increase in Miscellaneous Income (Expense) - Net was primarily due to the following factors:
• 2002 write-offs of certain equipment and technology investments and costs accrued related to the termination of a contract for the construction of combustion turbines; and
• Interest income on the notes receivable of two newly consolidated subsidiaries in 2003. See Note 1(q)(i) of the “Notes to Financial Statements” in “Item 8. Financial Statements and Supplementary Data” for further details.
Partially offsetting these increases were net gains realized in 2002 from the sale of equity investments in certain renewable energy projects.
Interest Expense The 11 percent increase in Interest Expense was primarily due to the following factors:
• An increase in average long-term debt outstanding during the year ended December 31, 2003;
• Charges during 2003 associated with the re-financing of certain debt; and
• Additional debt recorded in July 2003 with the consolidation of two new entities and the recognition of a note payable to a trust resulting from the adoption of Interpretation 46. See Note 1(q)(i) of the “Notes to Financial Statements” in “Item 8. Financial Statements and Supplementary Data”.
These increases were partially offset by a decrease in short-term interest rates.
Preferred Dividend Requirement of Subsidiary Trust The 50 percent decrease in Preferred Dividend Requirement of Subsidiary Trust was a result of the implementation of Interpretation 46. Effective July 1, 2003, the preferred trust securities and the related dividends are no longer reported in Cinergy’s financial statements. However, interest expense is still being incurred on a note payable to this trust as previously discussed. See Note 1(q)(i) of the “Notes to Financial Statements” in “Item 8. Financial Statements and Supplementary Data” for further details.
Income Taxes The decrease in the effective income tax rate was primarily due to tax credits associated with the production and sale of synthetic fuel, which began in July 2002. Cinergy’s effective tax rate for 2003 was approximately 25 percent.
Discontinued Operations In 2002, Cinergy sold and/or classified as held for sale, several non-core investments, including renewable and international investments. During 2003, Cinergy completed the disposal of its gas distribution operation in South Africa, sold its remaining wind assets in the United States, and substantially sold or liquidated the assets of its energy trading operation in the Czech Republic. Pursuant to Statement 144, these investments have been classified as discontinued operations in our financial statements. See Note 14 of the “Notes to Financial Statements” in “Item 8. Financial Statements and Supplementary Data” for additional information.
The increase in discontinued operations in 2003 as compared to 2002 was due to the recognition of losses on disposal of foreign investments in 2002 and the recognition of gains on disposal in 2003.
Cumulative Effect of Changes in Accounting Principles In 2003, Cinergy recognized a Cumulative effect of changes in accounting principles, net of tax gain of approximately $26 million. The cumulative effect of changes in accounting principles was a result of the adoption of Statement 143 and the rescission of EITF 98-10.
In 2002, Cinergy recognized a Cumulative effect of a change in accounting principle, net of tax loss of approximately $11 million as a result of implementation of Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets. See Note 1(q)(iv) of the “Notes to Financial Statements” in “Item 8. Financial Statements and Supplementary Data” for further information.
MD&A - 2003 RESULTS OF OPERATIONS - CG&E
2003 RESULTS OF OPERATIONS - CG&E
Summary of Results Net income for CG&E for the years ended December 31, 2003, and 2002 were as follows:
CG&E’s increase in net income was primarily due to the following factors:
• Increases in gas gross margins due to an increase in base rates, as approved by the PUCO in May 2002, and colder weather in the first quarter of 2003 as compared to 2002;
• Lower operating costs primarily resulting from the recognition of higher costs in 2002 associated with employee severance programs; and
• A net gain recognized in 2003 resulting from the implementation of certain accounting changes.
Offsetting these increases was a decrease in electric gross margins primarily due to milder weather in 2003, as compared to 2002.
Gross Margins Gross margins for CG&E for the years ended December 31, 2003, and 2002 were as follows:
(1) Electric gross margin is calculated as Electric operating revenues less Fuel, emission allowances, and purchased power expense from the Statements of Income.
(2) Gas gross margin is calculated as Gas operating revenues less Gas purchased expense from the Statements of Income.
Cooling degree days and heating degree days in CG&E’s service territory for the years ended December 31, 2003, and 2002 were as follows:
(1) Cooling degree days are the differences between the average temperature for each day and 65 degrees, assuming the average temperature is greater than 65 degrees.
(2) Heating degree days are the differences between the average temperature for each day and 65 degrees, assuming the average temperature is less than 65 degrees.
Electric Gross Margins The one percent decrease in CG&E’s electric gross margins was primarily due to a decline in retail electric margins mainly resulting from milder weather in 2003 as compared to 2002. As noted in the table, cooling degree days were down 40 percent in CG&E’s service territory. Higher margins from physical and financial trading partially offset this decrease.
Gas Gross Margins The 20 percent increase in CG&E’s gas gross margins was primarily due to the following factors:
• An increase in base rates, as approved by the PUCO in May 2002, and tariff adjustments associated with the gas main replacement program and Ohio excise taxes; and
• The colder weather in the first quarter of 2003, compared to 2002, which resulted in a greater amount of mcf delivered to customers.
Other Operating Revenues and Costs of Fuel Resold The 23 percent decrease in Other Operating Revenues was due to a decrease in revenues from coal origination.
Costs of fuel resold represents the costs of coal origination activities. These costs decreased in 2003, which is consistent with the decline in the associated revenues as previously discussed.
The following explanations correspond with the line items on the Statements of Income for CG&E. However, only the line items that varied significantly from prior periods are discussed.
Other Operating Expenses
Operation and Maintenance The six percent decrease in Operation and maintenance expense was primarily due to the following factors:
• Decreased transmission costs largely the result of changes in the Midwest ISO operations;
• The recognition of higher costs associated with employee severance programs in 2002; and
• A decrease in employee incentive costs.
These decreases were partially offset by an increase in maintenance expense for our generating units and overhead lines.
Depreciation The five percent decrease in Depreciation expense was primarily due to the following factors:
• An increase in the estimated useful lives of CG&E’s generation assets resulting from a depreciation study completed during the third quarter of 2003; and
• The discontinuance of accruing costs of removal for generating assets (which was previously included as part of Depreciation expense) as a result of the adoption of Statement 143. See Note 1(j) of the “Notes to Financial Statements” in “Item 8. Financial Statements and Supplementary Data” for further details. Prior periods were not restated for the adoption of Statement 143.
Miscellaneous Income - Net The increase in Miscellaneous Income - Net was due, in part, to a final reconciliation with PSI of a previous demutualization of a medical insurance carrier used by both companies which was recorded in 2003.
Interest Expense The 20 percent increase in Interest Expense was primarily due to the following factors:
• An increase in average long-term debt outstanding; and
• Charges during 2003 associated with the re-financing of certain debt.
Cumulative Effect of Changes in Accounting Principles In 2003, CG&E recognized a Cumulative effect of changes in accounting principles, net of tax gain of approximately $31 million as a result of the adoption of Statement 143 and the rescission of EITF 98-10. See Note 1(q)(iv) of the “Notes to Financial Statements” in “Item 8. Financial Statements and Supplementary Data” for further information.
MD&A - 2003 RESULTS OF OPERATIONS - PSI
2003 RESULTS OF OPERATIONS - PSI Summary of Results Net income for PSI for the years ended December 31, 2003, and 2002 was as follows:
PSI’s decrease in net income was primarily attributable to decreases in electric gross margins due to milder weather in 2003, as compared to 2002. This decrease was partially offset by the following factors:
• The recognition of higher operating costs in 2002 associated with employee severance programs; and
• Lower property taxes, primarily resulting from the change in property value assessment in the state of Indiana in 2003.
Electric Gross Margins Gross margins for PSI for the years ended December 31, 2003, and 2002 were as follows:
(1) Electric gross margin is calculated as Electric operating revenues less Fuel, emission allowances, and purchased power expense from the Statements of Income.
Cooling degree days and heating degree days in PSI’s service territory for the years ended December 31, 2003, and 2002 were as follows:
(1) Cooling degree days are the differences between the average temperature for each day and 65 degrees, assuming the average temperature is greater than 65 degrees.
(2) Heating degree days are the differences between the average temperature for each day and 65 degrees, assuming the average temperature is less than 65 degrees.
The nine percent decrease in PSI’s electric gross margins was primarily due to a decline in retail electric margins resulting from milder weather in 2003, compared to 2002. As noted in the table, cooling degree days were down 38 percent in PSI’s service territory. An increase in rate tariff adjustments associated with certain construction programs partially offset these decreases.
The following explanations correspond with the line items on the Statements of Income for PSI. However, only the line items that varied significantly from prior periods are discussed.
Other Operating Expenses
Operation and Maintenance The four percent decrease in Operation and maintenance expense was primarily due to the following factors:
• Recognition of higher costs associated with employee severance programs in 2002;
• Decreased transmission costs, largely the result of changes in the Midwest ISO operations; and
• A decrease in employee incentive costs.
These decreases were partially offset by an increase in maintenance expense for our generating units and overhead lines.
Depreciation The six percent increase in Depreciation expense was primarily due to the following factors:
• The addition of depreciable plant resulting from PSI’s December 2002 purchase of two gas-fired peaking plants from non-regulated affiliates. See Note 19 of the “Notes to Financial Statements” in “Item 8. Financial Statements and Supplementary Data” for more information; and
• The addition of other depreciable plant primarily reflecting pollution control equipment and the repowering of Noblesville Station.
Taxes Other Than Income Taxes The 19 percent decrease in Taxes other than income taxes expense was primarily due to lower property taxes, which were partially offset by increased excise taxes. This decrease was primarily a result of a change in property value assessments in the state of Indiana in 2003.
Miscellaneous Income - Net The 69 percent decrease in Miscellaneous Income - Net was primarily a result of a final reconciliation with CG&E of a previous demutualization of a medical insurance carrier used by both companies which was recorded in 2003.
Interest Expense The 16 percent increase in Interest Expense was primarily a result of an increase in average long-term debt outstanding during the year ended December 31, 2003. This increase was partially offset by a decrease in short-term interest rates.
Income Taxes The increase in the effective income tax rate was primarily due to an increase in the Indiana state income tax rate.
MD&A - LIQUIDITY AND CAPITAL RESOURCES
LIQUIDITY AND CAPITAL RESOURCES Historical Cash Flow Analysis From Continuing Operations Operating Activities from Continuing Operations For the years ended December 31, 2004, 2003, and 2002, our cash flows from operating activities from continuing operations were as follows:
(1) The results of Cinergy also include amounts related to non-registrants.
The tariff-based gross margins of our utility operating companies continue to be the principal source of cash from operating activities. The diversified retail customer mix of residential, commercial, and industrial classes and a commodity mix of gas and electric services provide a reasonably predictable gross cash flow.
For the year ended December 31, 2004, Cinergy’s and CG&E’s decrease in net cash provided by operating activities was primarily due to unfavorable working capital fluctuations, including the build up of fuel and emission allowances inventory. PSI’s increase was due to an increase in earnings (after adjusting for non-cash items) and a difference in the timing of payables and income tax payments. ULH&P’s increase in net cash provided by operating activities was attributable to favorable working capital fluctuations.
For the year ended December 31, 2003, CG&E’s, PSI’s, and ULH&P’s net cash provided by operating activities decreased, as compared to 2002. CG&E’s decrease was primarily due to unfavorable working capital fluctuations. PSI’s decrease was largely due to a decrease in earnings (after adjusting for non-cash items) and a decrease in receivables sold under the receivables sale facility. A significant portion of ULH&P’s decrease was due to unfavorable working capital fluctuations and an increase in deferred costs under the gas cost recovery mechanism. Cinergy’s net cash provided by operating activities in 2003 was comparable to 2002, comprised of the decreases at CG&E and PSI discussed above offset by improved operating cash flows at our non-regulated subsidiaries.
Financing Activities from Continuing Operations For the years ended December 31, 2004, 2003, and 2002, our cash flows from financing activities from continuing operations were as follows:
Net Cash Provided by (Used in) Financing Activities from Continuing Operations
(1) The results of Cinergy also include amounts related to non-registrants.
For the year ended December 31, 2004, CG&E’s decrease in net cash used in financing activities was primarily due to a decrease in redemptions of long-term debt. PSI’s increase in net cash used in financing activities was attributable to the repayment of short-term debt in 2004 and capital contributions from Cinergy Corp. that were made in 2003. ULH&P’s increase in net cash used in financing activities was due to an increase in dividends on common stock. Cinergy’s net cash used in financing activities in 2004 was comparable to 2003.
For the year ended December 31, 2003, Cinergy’s net cash used in financing activities increased, as compared to 2002, primarily due to increases in redemptions of long-term debt. CG&E’s net cash used in financing activities decreased during 2003, as compared to 2002, primarily due to a net increase in short-term debt financing. PSI’s and ULH&P’s net cash provided by financing activities increased during 2003, as compared to 2002. PSI’s increase was primarily due to capital contributions from Cinergy Corp. ULH&P’s increase was primarily attributable to increases in short-term debt.
Investing Activities from Continuing Operations For the years ended December 31, 2004, 2003, and 2002, our cash flows used in investing activities from continuing operations were as follows:
Net Cash Used in Investing Activities from Continuing Operations
(1) The results of Cinergy also include amounts related to non-registrants.
For the year ended December 31, 2004, Cinergy’s decrease in net cash used in investing activities was primarily due to decreases in capital expenditures related to energy-related investments. CG&E’s decrease in net cash used in investing activities was primarily due to a decrease in capital expenditures for ongoing environmental compliance programs and normal construction activity. PSI’s and ULH&P’s net cash used in investing activities in 2004 was comparable to 2003.
For the year ended December 31, 2003, Cinergy’s net cash used in investing activities decreased, as compared to 2002, primarily due to decreases in capital expenditures related to environmental compliance programs and other energy-related investments. Cinergy also purchased a synthetic fuel production facility during 2002. PSI’s decrease was primarily due to decreases in capital expenditures for ongoing environmental compliance programs and other construction projects. CG&E’s and ULH&P’s net cash used in 2003 investing activities was comparable to 2002.
Capital Requirements Environmental Issues Proposed Environmental Protection Agency Regulations
In December 2003, the United States EPA proposed the Clean Air Interstate Rule (CAIR), formerly the Interstate Air Quality Rule, which would require states to revise their State Implementation Plans (SIP) to address alleged contributions to downwind non-attainment with the revised National Ambient Air Quality Standards for ozone and fine particulate matter. The proposed rule would establish a two-phase, regional cap and trade program for SO2 and NOX, affecting approximately 30 states, including Ohio, Indiana, and Kentucky, and would require SO2 and NOX emissions to be cut approximately 70 percent and 65 percent, respectively, by 2015. The EPA also issued draft regulations regarding required reductions in mercury emissions from coal-fired power plants (Clean Air Mercury Rule). The draft regulations include two possible alternatives to achieve emissions reductions: a mercury cap and trade program or source specific reductions achieved through a command and control approach. The cap and trade approach would provide a longer compliance horizon and provide more flexible compliance options for coal-fired generators, including the purchase of allowances in lieu of further capital expenditures with respect to these investments. This approach would require a reduction of approximately 30 percent by 2010 and 70 percent by 2018. The source specific reduction approach would require a reduction of approximately 30 percent by 2008. The EPA is expected to issue final rules on CAIR and the Clean Air Mercury Rule by March 2005.
Over the 2005-2009 time period, estimated capital costs associated with reducing mercury, SO2, and NOX in compliance with the currently proposed CAIR and Clean Air Mercury Rule are not expected to exceed approximately
$1.72 billion if the EPA approves the mercury cap and trade approach and approximately $2.15 billion if the EPA approves the source specific reduction approach without a cap and trade program. These estimates include estimated costs to comply at plants that we own but do not operate and could change when taking into consideration compliance plans of co-owners or operators involved. Moreover, as market conditions change, additional compliance options may become available and our plans will be adjusted accordingly. Approximately 60 percent of these estimated environmental costs would be incurred at PSI’s coal-fired plants, for which recovery would be pursued in accordance with regulatory statutes governing environmental cost recovery. CG&E would receive partial recovery of depreciation and financing costs related to environmental compliance projects for 2005-2008 through its recently approved RSP. See Note 11(b)(iii) of the “Notes to Financial Statements” in “Item 8. Financial Statements and Supplementary Data” for more details.
In June 2004, the EPA made final state non-attainment area designations to implement the revised ozone standard. In January 2005, the EPA made final state non-attainment area designations to implement the new fine particulate standard. Several counties in which we operate have been designated as being in non-attainment with the new ozone standard and/or fine particulate standard. States with counties that are designated as being in non-attainment with the new ozone and/or fine particulate standards are required to develop a plan of compliance. Although the EPA has attempted to structure the CAIR to resolve purported utility contributions to ozone and fine particulate non-attainment, at this time, Cinergy cannot predict the effect of current or future non-attainment designations on its financial position or results of operations.
In May 2004, the EPA issued proposed revisions to its regional haze rules and implementing guidelines in response to a 2002 judicial ruling overturning key provisions of the original program. The regional haze program is aimed at reducing certain emissions impacting visibility in national parks and wilderness areas. The EPA is currently considering whether SO2 and NOX reductions under the CAIR regulation will also satisfy the reduction requirements under the regional haze rule. However, the regional haze rule, when finalized, could potentially require significant additional SO2 and NOX reductions necessitating the installation of pollution controls for certain generating units at Cinergy’s power plants. In light of the EPA’s ongoing rulemaking efforts and the fact that the states have yet to announce how they will implement the final rule, at this time it is not possible to predict whether the regional haze rule will have a material effect on our financial position or results of operations.
Clear Skies Legislation
President Bush has proposed environmental legislation that would combine a series of Clean Air Act (CAA) requirements, including the recently proposed regulations for mercury and particulate matter for coal-fired power plants with a legislative solution that includes trading and specific emissions reductions and timelines to meet those reductions. The President’s “Clear Skies Initiative” would seek an overall 70 percent reduction in emissions from power plants over a phased-in reduction schedule beginning in 2010 and continuing through 2018. When the Clear Skies Initiative was stalled in Congress, the EPA proposed the CAIR regulations to accomplish Clear Skies’ goals within the existing framework of the CAA. Clear Skies has been reintroduced in the Senate and could be considered in Committee over the next several weeks. However, at this time, we cannot predict whether this or any multi-emissions bill will achieve approval.
Energy Bill
The United States House of Representatives (House) passed the Energy Policy Act in April 2003. The legislation, as passed in the House, included the repeal of the Public Utility Holding Company Act of 1935, as amended (PUHCA), as well as tax incentives for gas and electric distribution lines, and combined heat and power and renewable energy projects. The United States Senate (Senate) Energy and Natural Resources Committee passed its version of comprehensive energy legislation in April 2003. A conference agreement which merged both the House and Senate versions passed in the House in October 2003, but failed to pass in the Senate. The legislation will be introduced again during the 109th Congress, however, it is anticipated that several changes will be made. At this time, it is not possible to predict whether a final energy bill will pass in 2005.
Environmental Lawsuits
We are currently involved in the following lawsuits which are discussed in more detail in Note 11(a) of the “Notes to Financial Statements” in “Item 8. Financial Statements and Supplementary Data”. An unfavorable outcome of any of these lawsuits could have a material impact on our liquidity and capital resources.
• CAA Lawsuit
• Carbon Dioxide (CO2) Lawsuit
• Selective Catalytic Reduction Units at Gibson Generating Station
• Zimmer Generating Station Lawsuit
• Manufactured Gas Plant Sites
• Asbestos Claims Litigation
Capital and Investment Expenditures Actual construction and other committed expenditures for 2004 and forecasted construction and other committed expenditures for 2005 and for the five-year period 2005-2009 (in nominal dollars) are presented in the table below:
Capital and Investment Expenditures
(1) The results of Cinergy also include amounts related to non-registrants.
In 2004, we spent $203 million for NOX and other environmental compliance projects. Forecasted expenditures for environmental compliance projects (in nominal dollars) are approximately $465 million for 2005 and $1.8 billion for the 2005-2009 period. The vast majority of this forecast includes our entire estimate of costs to comply with draft regulations requiring reductions in mercury, NOX, and SO2 emissions, assuming a cap and trade approach to mercury emissions. Approximately 60 percent of these estimated environmental costs would be incurred at PSI’s regulated coal-fired plants. See “Environmental Issues” for further discussion.
Contractual Cash Obligations The following table presents Cinergy’s, CG&E’s, PSI’s, and ULH&P’s significant contractual cash obligations:
(1) Includes amounts related to non-registrants.
(2) Amounts do not include interest payments. See the Consolidated Statements of Capitalization in “Item 8. Financial Statements and Supplementary Data” for disclosure of interest rates for interest payments.
(3) Includes PSI’s 6.50% Debentures due August 1, 2026, reflected as maturing in 2005, as the interest rate is due to reset on August 1, 2005. If the interest rate does not reset, the bonds are subject to mandatory redemption by PSI.
(4) CG&E’s 6.90% Debentures due June 1, 2025, are putable to CG&E at the option of the holders on June 1, 2005. However, based upon current market conditions, we believe it is unlikely that the debentures will be put to CG&E on this date.
(5) We have significantly more coal under contract; however, these contracts contain price re-opener provisions effectively making them variable contracts after certain dates. Contract coal after the price re-opener date is therefore excluded from this table.
(6) Includes long-term contracts accounted for on an accrual basis. See the Fair Value of Contracts maturity table in “Market Risk Sensitive Instruments” for disclosure of energy trading contracts that are accounted for at fair value.
Pension and Other Postretirement Benefits Cinergy maintains qualified defined benefit pension plans covering substantially all United States employees meeting certain minimum age and service requirements. Plan assets consist of investments in equity and debt securities. Funding for the qualified defined benefit pension plans is based on actuarially determined contributions, the maximum of which is generally the amount deductible for tax purposes and the minimum being that required by the Employee Retirement Income Security Act of 1974, as amended (ERISA). Although mitigated by strong performance in 2003 and 2004, ongoing retiree payments and the decline in market value of the investment portfolio in 2002 reduced the assets held in trust to satisfy plan obligations. Additionally, continuing low long-term interest rates have increased the liability for funding purposes. As a result of these events, our near term funding targets have increased substantially. Cinergy has adopted a five-year plan to reduce, or eliminate, the unfunded pension obligation initially measured as of January 1, 2003. This unfunded obligation will be recalculated as of January 1 of each year in the five-year plan. Because this unfunded obligation is the difference between the liability determined actuarially on an ERISA basis and the market value of plan assets as of January 1, 2003, the liability determined by this calculation is different than the pension liability calculated for accounting purposes reported on Cinergy’s Balance Sheets.
Cinergy’s minimum required contribution in calendar year 2004 was $16 million, as compared to $11 million in calendar year 2003. Actual contributions during calendar year 2004 and 2003 totaled $117 million and $74 million, reflecting additional discretionary contributions of $101 million and $63 million, respectfully, under the aforementioned five-year plan. Due to the significant 2004 and 2003 calendar year contributions, Cinergy’s minimum required contributions in calendar year 2005 are expected to be zero. Should Cinergy continue funding under the five-year plan, discretionary contributions are expected to be $72 million in 2005. Cinergy may consider making discretionary contributions in 2006 and future periods; however, at this time, we are unable to determine the amount of those contributions. Estimated contributions fluctuate based on changes in market performance of plan assets and actuarial assumptions. Absent the occurrence of interim events that could materially impact these targets, we will update our expected target contributions annually as the actuarial funding valuations are completed and make decisions about future contributions at that time.
Cinergy sponsors non-qualified pension plans that cover officers, certain key employees, and non-employee directors. Cinergy’s payments for these non-qualified pension plans are expected to be approximately $9 million in 2005.
We provide certain health care and life insurance benefits to retired United States employees and their eligible dependents. Cinergy’s payments for these postretirement benefits in 2005 are expected to be approximately $25 million. See Note 9 of the “Notes to Financial Statements” in “Item 8. Financial Statements and Supplementary Data” for additional information about our pension and other postretirement benefit plans.
Other Investing Activities Our ability to invest in growth initiatives is limited by certain legal and regulatory requirements, including the PUHCA. The PUHCA limits the types of non-utility businesses in which Cinergy and other registered holding companies under the PUHCA can invest as well as the amount of capital that can be invested in permissible non-utility businesses. Also, the timing and amount of investments in the non-utility businesses is dependent on the development and favorable evaluations of opportunities. Under the PUHCA restrictions, we are allowed to invest, or commit to invest, in certain non-utility businesses, including:
• Exempt Wholesale Generators (EWG) and Foreign Utility Companies (FUCO)
An EWG is an entity, certified by the Federal Energy Regulatory Commission (FERC), devoted exclusively to owning and/or operating, and selling power from one or more electric generating facilities. An EWG whose generating facilities are located in the United States is limited to making only wholesale sales of electricity. An entity claiming status as an EWG must provide notification thereof to the SEC under the PUHCA.
A FUCO is a company all of whose utility assets and operations are located outside the United States and which are used for the generation, transmission, or distribution of electric energy for sale at retail or wholesale, or the distribution of gas at retail. A FUCO may not derive any income, directly or indirectly, from the generation, transmission, or distribution of electric energy for sale or the distribution of gas at retail within the United States. An entity claiming status as a FUCO must provide notification thereof to the SEC under the PUHCA.
Cinergy has been granted SEC authority under the PUHCA to invest (including by way of guarantees) an aggregate amount in EWGs and FUCOs equal to the sum of (1) our average consolidated retained earnings from time to time plus (2) $2 billion through June 30, 2005. As of December 31, 2004, we had invested or committed to invest approximately $0.8 billion in EWGs and FUCOs, leaving available investment capacity under the order of approximately $2.8 billion. In February 2005, Cinergy filed an application with the SEC under the PUHCA requesting an extension of this authority through December 31, 2008. At this time, we are unable to predict whether the SEC will approve this request.
• Qualifying Facilities and Energy-Related Non-utility Entities
SEC regulations under the PUHCA permit Cinergy and other registered holding companies to invest and/or guarantee an amount equal to 15 percent of consolidated capitalization (consolidated capitalization is the sum of Notes payable and other short-term obligations, Long-term debt (including amounts due within one year), Cumulative Preferred Stock of Subsidiaries, and total Common Stock Equity) in domestic qualifying cogeneration and small power production plants (qualifying facilities) and certain other domestic energy-related non-utility entities. At December 31, 2004, we had invested and/or guaranteed approximately $1.1 billion of the $1.4 billion available. In August 2004, Cinergy filed an application with the SEC requesting authority under the PUHCA to increase its investment and/or guarantee authority by $2 billion above the current authorized amount. At this time, we are unable to predict whether the SEC will approve this request.
• Energy-Related Assets
Cinergy has been granted SEC authority under the PUHCA to invest up to $1 billion in non-utility Energy-Related Assets within the United States, Canada, and Mexico. Energy-Related Assets include natural gas exploration, development, production, gathering, processing, storage and transportation facilities and equipment, liquid oil reserves and storage facilities, and associated assets, facilities and equipment, but would exclude any assets, facilities, or equipment that would cause the owner or operator thereof to be deemed a public utility company. As of December 31, 2004, we did not have any investments in these Energy-Related Assets.
• Infrastructure Services Companies
Cinergy has been granted SEC authority under the PUHCA to invest up to $500 million in companies that derive or will derive substantially all of their operating revenues from the sale of Infrastructure Services including:
• Design, construction, retrofit, and maintenance of utility transmission and distribution systems;
• Installation and maintenance of natural gas pipelines, water and sewer pipelines, and underground and overhead telecommunications networks; and
• Installation and servicing of meter reading devices and related communications networks, including fiber optic cable.
At December 31, 2004, we had invested approximately $30 million in Infrastructure Services companies. In February 2005, Cinergy filed an application with the SEC under PUHCA requesting authority to invest up to $100 million in Infrastructure Services companies through December 31,
2008, which is a $400 million reduction in Cinergy’s current authority. At this time, we are unable to predict whether the SEC will approve this request.
Guarantees We are subject to an SEC order under the PUHCA, which limits the amounts Cinergy Corp. can have outstanding under guarantees at any one time to $2 billion. As of December 31, 2004, we had approximately $877 million outstanding under the guarantees issued, of which approximately 96 percent represents guarantees of obligations reflected on Cinergy’s Balance Sheets. The amount outstanding represents Cinergy Corp.’s guarantees of liabilities and commitments of its consolidated subsidiaries, unconsolidated subsidiaries, and joint ventures. In February 2005, Cinergy filed an application with the SEC under the PUHCA requesting authority to have an aggregate amount of guarantees outstanding at any point in time not to exceed $3 billion. At this time, we are unable to predict whether the SEC will approve this request.
See Note 11(c)(v) of the “Notes to Financial Statements” in “Item 8. Financial Statements and Supplementary Data” for a discussion of guarantees in accordance with Financial Accounting Standards Board Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others (Interpretation 45). Interpretation 45 requires disclosure of maximum potential liabilities for guarantees issued on behalf of unconsolidated subsidiaries and joint ventures and under indemnification clauses in various contracts. The Interpretation 45 disclosure differs from the PUHCA restrictions in that it requires a calculation of maximum potential liability, rather than actual amounts outstanding; it excludes guarantees issued on behalf of consolidated subsidiaries; and it includes potential liabilities under indemnification clauses.
Marketing & Trading Liquidity Risks Cinergy has certain contracts in place, primarily with trading counterparties, that require the issuance of collateral in the event our debt ratings are downgraded below investment grade. Based upon our December 31, 2004 trading portfolio, if such an event were to occur, Cinergy would be required to issue up to approximately $310 million in collateral related to its gas and power trading operations, of which $69 million is related to CG&E.
Capital Resources Cinergy, CG&E, PSI, and ULH&P meet their current and future capital requirements through a combination of funding sources including, but not limited to, internally generated cash flows, tax-exempt bond issuances, capital lease and operating lease structures, the securitization of certain asset classes, short-term bank borrowings, issuance of commercial paper, and issuances of long-term debt and equity. Funding decisions are based on market conditions, market access, relative pricing information, borrowing duration and current versus forecasted cash needs. Cinergy, CG&E, PSI, and ULH&P are committed to maintaining balance sheet health, responsibly managing capitalization, and maintaining adequate credit ratings. Cinergy, CG&E, PSI, and ULH&P believe that they have adequate financial resources to meet their future needs.
Sale of Accounts Receivable CG&E, PSI, and ULH&P have an agreement with Cinergy Receivables Company, LLC (Cinergy Receivables), an affiliate, to sell, on a revolving basis, nearly all of the retail accounts receivable and related collections of CG&E, PSI, and ULH&P. Cinergy Receivables funds its purchases with borrowings from commercial paper conduits that obtain a security interest in the receivables. This program accelerates the collection of cash for CG&E, PSI, and ULH&P related to these retail receivables. Cinergy Corp. does not consolidate Cinergy Receivables because it meets the requirements to be accounted for as a qualifying special purpose entity (SPE). A decline in the long-term senior unsecured credit ratings of CG&E, PSI, and ULH&P below investment grade would result in the termination of the sale program and discontinuance of future sales of receivables.
Notes Payable and Other Short-term Obligations We are required to secure authority to issue short-term debt from the SEC under the PUHCA and from the PUCO. The SEC under the PUHCA regulates the issuance of short-term debt by Cinergy Corp., PSI, and ULH&P. The PUCO has regulatory jurisdiction over the issuance of short-term debt by CG&E.
(1) Cinergy Corp., under the PUHCA, was granted approval to increase total capitalization (excluding retained earnings and accumulated other comprehensive income (loss)), which may be any combination of debt and equity securities, by $5 billion. Outside this requirement, Cinergy Corp. is not subject to specific regulatory debt authorizations.
(2) In December 2004, Cinergy and ULH&P requested approval from the SEC for an increase in ULH&P’s authority from $65 million to $150 million to coincide with the completion of its pending transaction with CG&E in which ULH&P will acquire interests in three of CG&E’s electric generating stations. At this time, we are unable to predict whether the SEC will approve this request.
For the purposes of quantifying regulatory authority, short-term debt includes revolving credit line borrowings, uncommitted credit line borrowings, intercompany money pool obligations, and commercial paper.
Cinergy Corp.’s short-term borrowing consists primarily of unsecured revolving lines of credit and the sale of commercial paper. Cinergy Corp.’s $2 billion revolving credit facilities and $1.5 billion commercial paper program also support the short-term borrowing needs of CG&E, PSI, and ULH&P. In addition, Cinergy Corp., CG&E, and PSI maintain uncommitted lines of credit. These facilities are not firm sources of capital but rather informal agreements to lend money, subject to availability, with pricing determined at the time of advance. The following is a summary of outstanding short-term borrowings for Cinergy, CG&E, PSI, and ULH&P, including variable rate pollution control notes:
(1) Standby liquidity is reserved against the revolving lines of credit to support the commercial paper program and outstanding letters of credit (currently $676 million and $12 million, respectively).
(2) Consists of a three-year $1 billion facility and a five-year $1 billion facility. The five-year facility contains $500 million sublimits each for CG&E and PSI.
(3) These facilities are not guaranteed sources of capital and represent an informal agreement to lend money, subject to availability, with pricing to be determined at the time of advance.
(4) In September 2004, Cinergy Corp. increased its commercial paper program limit from $800 million to $1.5 billion. The commercial paper program is supported by Cinergy Corp.’s revolving lines of credit.
(5) In December 2004, Cinergy Canada, Inc. successfully placed a $150 million three-year senior revolving credit facility.
At December 31, 2004, Cinergy Corp. had approximately $1.3 billion remaining unused and available capacity relating to its $2 billion revolving credit facilities. These revolving credit facilities include the following:
(1) In April 2004, Cinergy Corp. successfully placed a $500 million 364-day senior unsecured revolving credit facility. This facility replaced the $600 million 364-day senior unsecured revolving credit facility that expired in April 2004. In December 2004, Cinergy Corp. successfully replaced the $500 million 364-day facility with a $1 billion five-year facility. CG&E and PSI each have $500 million borrowing sublimits on this facility.
(2) In April 2004, Cinergy Corp. successfully placed a $1 billion three-year senior unsecured revolving credit facility. This facility replaced the $400 million three-year senior unsecured revolving credit facility that was set to expire in May 2004.
In our credit facilities, Cinergy Corp. has covenanted to maintain:
• a consolidated net worth of $2 billion; and
• a ratio of consolidated indebtedness to consolidated total capitalization not in excess of 65 percent.
As part of CG&E’s $500 million sublimit under the $1 billion five-year credit facility, CG&E has covenanted to maintain:
• a consolidated net worth of $1 billion; and
• a ratio of consolidated indebtedness to consolidated total capitalization not in excess of 65 percent.
As part of PSI’s $500 million sublimit under the $1 billion five-year credit facility, PSI has covenanted to maintain:
• a consolidated net worth of $900 million; and
• a ratio of consolidated indebtedness to consolidated total capitalization not in excess of 65 percent.
A breach of these covenants could result in the termination of the credit facilities and the acceleration of the related indebtedness. In addition to breaches of covenants, certain other events that could result in the termination of available credit and acceleration of the related indebtedness include:
• bankruptcy;
• defaults in the payment of other indebtedness; and
• judgments against the company that are not paid or insured.
The latter two events, however, are subject to dollar-based materiality thresholds.
As discussed in Note 1(q)(i) of the “Notes to Financial Statements” in “Item 8. Financial Statements and Supplementary Data”, long-term debt increased in the third quarter of 2003 resulting from the adoption of Interpretation 46. The debt which was recorded as a result of this new accounting pronouncement did not cause
Cinergy Corp. to be in breach of any covenants at the time of adoption. As of December 31, 2004, Cinergy, CG&E, and PSI are in compliance with all of their debt covenants.
Variable Rate Pollution Control Notes
CG&E and PSI have issued certain variable rate pollution control notes (tax-exempt notes obtained to finance equipment or land development for pollution control purposes). Because the holders of these notes have the right to have their notes redeemed on a daily, weekly, or monthly basis, they are reflected in Notes payable and other short-term obligations on the Balance Sheets of Cinergy, CG&E, and PSI. At December 31, 2004, Cinergy, CG&E and PSI had $273 million, $112 million and $136 million, respectively, outstanding in variable rate pollution control notes, classified as short-term debt. ULH&P had no outstanding short-term pollution control notes. Any short-term pollution control note borrowings outstanding do not reduce the unused and available short-term debt regulatory authority of CG&E, PSI, and ULH&P. See Note 5 of the “Notes to Financial Statements” in “Item 8. Financial Statements and Supplementary Data”.
Commercial Paper
Cinergy Corp.’s commercial paper program is supported by Cinergy Corp.’s $2 billion revolving credit facilities. The commercial paper program supports, in part, the short-term borrowing needs of CG&E and PSI and eliminates their need for separate commercial paper programs. In September 2004, Cinergy Corp. expanded its commercial paper program from $800 million to a maximum outstanding principal amount of $1.5 billion. As of December 31, 2004, Cinergy Corp. had $676 million in commercial paper outstanding.
Money Pool
Cinergy Corp., Cinergy Services, Inc., and our utility operating companies participate in a money pool arrangement to better manage cash and working capital requirements. Under this arrangement, those companies with surplus short-term funds provide short-term loans to affiliates (other than Cinergy Corp.) participating under this arrangement. This surplus cash may be from internal or external sources. The amounts outstanding under this money pool arrangement are shown as a component of Notes receivable from affiliated companies and/or Notes payable to affiliated companies on the Balance Sheets of CG&E, PSI, and ULH&P. Any money pool borrowings outstanding reduce the unused and available short-term debt regulatory authority of CG&E, PSI, and ULH&P.
Operating Leases We have entered into operating lease agreements for various facilities and properties such as computer, communication and transportation equipment, and office space. See Note 6(a) of the “Notes to Financial Statements” in “Item 8. Financial Statements and Supplementary Data” for additional information regarding operating leases.
Capital Leases Our utility operating companies are able to enter into capital leases subject to the authorization limitations of the applicable state utility commissions. New financing authority is subject to the approval of the respective commissions. The following table presents further information related to the capital lease authorizations of CG&E, PSI, and ULH&P at December 31, 2004.
See Note 6(b) of the “Notes to Financial Statements” in “Item 8. Financial Statements and Supplementary Data” for additional information regarding capital leases.
Long-term Debt We are required to secure authority to issue long-term debt from the SEC under the PUHCA and the state utility commissions of Ohio, Kentucky, and Indiana. The SEC under the PUHCA regulates the issuance of long-term debt by Cinergy Corp. The respective state utility commissions regulate the issuance of long-term debt by our utility operating companies.
A current summary of our long-term debt authorizations at December 31, 2004, was as follows:
(1) Cinergy Corp., under the PUHCA, was granted approval to increase total capitalization (excluding retained earnings and accumulated other comprehensive income (loss)), which may be any combination of debt and equity securities, by $5 billion. Outside this requirement, Cinergy Corp. is not subject to specific regulatory debt authorizations.
(2) In February 2005, Cinergy filed an application with the SEC under the PUHCA to issue an additional $5 billion in any combination of debt and equity securities from time to time through December 31, 2008. At this time, we are unable to predict whether the SEC will approve this request.
(3) Includes amounts for ULH&P.
(4) In January 2005, ULH&P filed an application with the Kentucky Public Service Commission (KPSC) seeking financing authority to issue and sell up to $500 million principal amount of secured and unsecured debt; enter into inter-company promissory notes up to an aggregate principal amount of $200 million; and borrow up to a maximum of $200 million aggregate principal amount of tax-exempt debt through December 31, 2006.
Cinergy Corp. has an effective shelf registration statement with the SEC relating to the issuance of up to $750 million in any combination of common stock, preferred stock, stock purchase contracts or unsecured debt securities, of which approximately $323 million remains available for issuance. CG&E has an effective shelf registration statement with the SEC relating to the issuance of up to $800 million in any combination of unsecured debt securities, first mortgage bonds, or preferred stock, all of which remains available for issuance. PSI has an effective shelf registration statement with the SEC relating to the issuance of up to $800 million in any combination of unsecured debt securities, first mortgage bonds, or preferred stock, all of which remains available for issuance. ULH&P has an effective shelf registration statement with the SEC for the issuance of up to $75 million in unsecured debt securities, $35 million of which remains available for issuance. ULH&P also has an effective shelf registration statement with the SEC relating to the issuance of up to $40 million in first mortgage bonds, of which $20 million remains available for issuance.
Off-Balance Sheet Arrangements Cinergy uses off-balance sheet arrangements from time to time to facilitate financing of various projects. Off-balance sheet arrangements are often created for a single specified purpose, for example, to facilitate securitization, leasing, hedging, research and development, reinsurance, or other transactions or arrangements. The following describes our major off-balance sheet arrangements excluding the investments Cinergy holds in various unconsolidated subsidiaries which are accounted for under the equity method. See Note 1(b)(ii) of the “Notes to
Financial Statements” in “Item 8. Financial Statements and Supplementary Data” for additional information on the accounting for equity method investments.
(i) Guarantees
Cinergy has entered into various contracts that are classified as guarantees under Interpretation 45. For further information, see Note 11(c)(v) of the “Notes to Financial Statements” in “Item 8. Financial Statements and Supplementary Data”.
(ii) Retained Interest in Assets Transferred to an Unconsolidated Entity
In February 2002, CG&E, PSI, and ULH&P replaced their existing agreement to sell certain of their accounts receivable and related collections. Cinergy Corp. formed Cinergy Receivables to purchase, on a revolving basis, nearly all of the retail accounts receivable and related collections of CG&E, PSI, and ULH&P. Cinergy Corp. does not consolidate Cinergy Receivables since it meets the requirements to be accounted for as a qualifying SPE. CG&E, PSI, and ULH&P each retain an interest in the receivables transferred to Cinergy Receivables. The transfer of receivables are accounted for as sales, pursuant to Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. For a more detailed discussion of our sales of accounts receivable, see Note 3(c) of the “Notes to Financial Statements” in “Item 8. Financial Statements and Supplementary Data”.
(iii) Derivative Instruments that are Classified as Equity
In 2001, Cinergy Corp. issued approximately $316 million notional amounts of combined securities, a component of which was stock purchase contracts. These contracts obligated the holder to purchase common shares of Cinergy Corp. stock by February 2005. Since the stock purchase contracts were detachable and classified in equity, the change in their fair value was not recorded in equity or earnings. In January and February 2005, the stock purchase contracts were settled, resulting in the issuance of common stock that is recorded on Cinergy’s Balance Sheets as Common Stock Equity. For further information see Note 3(b) of the “Notes to Financial Statements” in “Item 8. Financial Statements and Supplementary Data”.
(iv) Variable Interest Entities (VIE)
Cinergy holds interests in VIEs, consolidated and unconsolidated, as defined by Interpretation 46. For further information, see Note 1(q)(i) and Note 3 of the “Notes to Financial Statements” in “Item 8. Financial Statements and Supplementary Data”.
Securities Ratings As of January 31, 2005, the major credit rating agencies rated our securities as follows:
(1) Fitch Ratings (Fitch)
(2) Moody’s Investors Service (Moody’s)
(3) Standard & Poor’s Ratings Services (S&P)
The highest investment grade credit rating for Fitch is AAA, Moody’s is Aaal, and S&P is AAA.
The lowest investment grade credit rating for Fitch is BBB-, Moody’s is Baa3, and S&P is BBB-.
A security rating is not a recommendation to buy, sell, or hold securities. These securities ratings may be revised or withdrawn at any time, and each rating should be evaluated independently of any other rating.
Equity Under the SEC’s June 2000 Order, Cinergy Corp. is permitted to increase its total capitalization by $5 billion (as previously discussed). The proceeds from any new issuances will be used for general corporate purposes.
Cinergy Corp. issued approximately 3.9 million shares in 2004 and approximately 4.6 million shares in 2003 to satisfy its obligations under its various employee stock plans and the Cinergy Corp. Direct Stock Purchase and Dividend Reinvestment Plan.
In January 2003, Cinergy Corp. filed a shelf registration statement with the SEC with respect to the issuance of common stock, preferred stock, and other securities in an aggregate offering amount of $750 million. In February 2003, Cinergy issued 5.7 million shares of common stock of Cinergy Corp. with net proceeds of approximately $175 million under this registration statement. The net proceeds from this transaction were used to reduce short-term debt of Cinergy Corp. and for other general corporate purposes. In December 2004, Cinergy Corp. issued 6.1 million shares of common stock with net proceeds of approximately $247 million, which were used to reduce short-term debt.
In May and August of 2003, Cinergy Corp. contributed $200 million in capital to PSI in two separate $100 million capital contributions to support PSI’s current credit ratings.
In January and February 2005, Cinergy Corp. issued a total of 9.2 million shares of common stock pursuant to certain stock purchase contracts that were issued as a component of combined securities in December 2001. Net proceeds from the transaction of approximately $316 million were used to reduce short-term debt. See
Note 3(b) of the “Notes to Financial Statements” in “Item 8. Financial Statements and Supplementary Data” for further discussion of the securities.
Dividend Restrictions Cinergy Corp.’s ability to pay dividends to holders of its common stock is principally dependent on the ability of CG&E and PSI to pay Cinergy Corp. dividends on their common stock. Cinergy Corp., CG&E, and PSI cannot pay dividends on their common stock if their respective preferred stock dividends or preferred trust dividends are in arrears. The amount of common stock dividends that each company can pay is also limited by certain capitalization and earnings requirements under CG&E’s and PSI’s credit instruments. Currently, these requirements do not impact the ability of either company to pay dividends on its common stock.
Other Where subject to rate regulations, our utility operating companies have the ability to timely recover certain cash outlays through various regulatory mechanisms.
As opportunities arise, we will continue to monetize certain non-core investments, which would include our international assets and other technology investments.
MD&A - FUTURE EXPECTATIONS/TRENDS
FUTURE EXPECTATIONS/TRENDS In the “Future Expectations/Trends” section, we discuss developments in the electric and gas industry and other matters. Each of these discussions will address the current status and potential future impact on our financial position or results of operations.
ELECTRIC INDUSTRY Regulatory Outlook and Significant Rate Developments Currently, regulatory and legislative initiatives shaping the transition to a competitive retail market are the responsibilities of the individual states. Many states, including Ohio, have enacted electric utility deregulation legislation. In general, these initiatives have sought to separate the electric utility service into its basic components (generation, transmission, and distribution) and offer each component separately for sale. This separation is referred to as unbundling of the integrated services. Under the customer choice initiative in Ohio, we continue to transmit and distribute electricity; however, the customer can purchase electricity from any certified supplier. The following sections further discuss the current status of deregulation legislation and other significant regulatory developments in the states of Ohio, Indiana, and Kentucky, which encompass our utility service territories.
Ohio CG&E is in a market development period for residential customers and in the competitive retail electric market for non-residential customers, transitioning to deregulation of electric generation and a competitive retail electric service market in the state of Ohio. The market development (frozen rate) period began January 1, 2001, ended December 31, 2004 for non-residential customers and is scheduled to end December 31, 2005 for residential customers.
CG&E made multiple rate filings in 2003 with the PUCO seeking approval of CG&E’s methodology for establishing market-based rates for generation service at the end of the market development period and to recover investments made in the transmission and distribution system. The PUCO requested in these proceedings that CG&E propose a RSP to mitigate the potential for significant rate increases when the market development period comes to an end. In January 2004, CG&E filed its proposed RSP. In May 2004, CG&E entered into a settlement agreement with many of the parties to these proceedings requesting that the PUCO approve a modified version of the RSP. In September 2004, the PUCO issued an order seeking to modify several key provisions of this settlement and as a result of these modifications, CG&E filed a petition for rehearing in October 2004. The PUCO approved a modified version of the plan in November 2004, the major features of which are as follows:
• Provider of Last Resort (POLR) Charge: CG&E will begin to collect a POLR charge from non-residential customers effective January 1, 2005, and from residential customers effective January 1, 2006. The POLR charge includes several discrete charges, the most significant being an annually adjusted component (AAC) intended to provide cost recovery primarily for environmental compliance expenditures; an infrastructure maintenance fund charge (IMF) intended to provide compensation to CG&E for committing its physical capacity to meet its POLR obligation; and a system reliability tracker (SRT) intended to provide cost recovery for capacity purchases, purchased power, reserve capacity, and related market costs for purchases to meet capacity needs. We anticipate the collection of the AAC and IMF will result in an approximate $36 million increase in revenues in 2005 and an additional $50 million in 2006. The SRT will be billed based on dollar-for-dollar costs incurred. A portion of these charges are avoidable by certain customers who switch to an alternative generation supplier. Therefore, these estimates are subject to change, depending on the level of switching that occurs in future periods. In 2007 and 2008, CG&E could seek additional increases in the AAC component of the POLR based on CG&E’s actual net costs for the specified expenditures.
• Generation Rates and Fuel Recovery: A new rate has been established for generation service after the market development period ends. In addition, a fuel cost recovery mechanism will be established to recover costs for fuel, emission allowances, and certain purchased power costs, that exceed the amount originally included in the rates frozen in the CG&E transition plan. These new rates will apply to
non-residential customers beginning January 1, 2005 and to residential customers beginning January 1, 2006.
• Generation Rate Reduction: The existing five percent generation rate reduction required by statute for residential customers implemented under CG&E’s 2000 plan will end on December 31, 2005.
• Transmission Cost Recovery: Transmission cost recovery mechanisms will be established beginning January 1, 2005 for non-residential customers and January 1, 2006 for residential customers. The transmission cost recovery mechanisms will permit CG&E to recover Midwest ISO charges, all FERC approved transmission costs, and all congestion costs allocable to retail ratepayers that are provided service by CG&E.
• Distribution Cost Recovery: CG&E will have the ability to defer certain capital-related distribution costs from July 1, 2004 through December 31, 2005 with recovery from non-residential customers to be provided through a rider beginning January 1, 2006 through December 31, 2010.
CG&E had also filed an electric distribution base rate case for residential and non-residential customers to be effective January 1, 2005. Under the terms of the RSP described previously, CG&E withdrew this base rate case and, in February 2005, CG&E filed a new distribution base rate case with rates to become effective January 1, 2006. The requested amount of the increase is approximately $78 million.
The RSP provides for rate recovery through December 31, 2008. Although it is difficult to predict, it is likely that any one of three scenarios could exist after the rate stabilization period ends in 2008:
• The legislation could be repealed or revised to establish a return to regulation of electric generation;
• Deregulation and a competitive retail electric service market with market-based rates for all customer classes; or
• A hybrid of regulation and deregulation.
Although we cannot predict the regulatory outcome, we believe any of these scenarios could have a material impact on our financial position and results of operations. However, we believe that a return to regulation of electric generation would provide the least volatility in ongoing results, although likely accompanied by less opportunity for growth in earnings.
In December 2004, CG&E filed an application with the PUCO requesting recovery of future costs of additional generating facilities in Ohio, for either construction of new electric generating facilities or the purchase of existing assets currently owned by others. CG&E would seek recovery of these costs over the lives of the assets. These investments are needed to meet ongoing load growth by customers receiving generation service from CG&E and would enable the company to reliably meet its obligation as the provider of last resort for customers returning to CG&E from alternate suppliers. To maintain flexibility in providing electric service at the lowest cost, CG&E is also seeking the authority to purchase existing capacity and power from other suppliers and to earn a return commensurate with the risk from these agreements.
Indiana We are not aware of any current plans for electric deregulation in Indiana.
In May 2004, the IURC issued an order approving PSI’s base retail electric rate case, and PSI implemented base retail electric rate changes to its tariffs. When combined with revenue increases attributable to PSI’s environmental construction-work-in-progress tracking mechanism, the order results in an approximate $140 million increase in annual revenues. PSI’s original request for an approximate $180 million annual revenue increase was reduced by approximately $20 million for a lower return on equity, approximately $15 million of assumed profits included in base rates related to off-system sales (subject to future adjustment through a tracking mechanism and a 50/50 sharing agreement), and approximately $5 million of additional items. The order authorizes full recovery of all requested regulatory assets and an overall 7.3 percent return, including a 10.5 percent return on equity. In addition, the IURC’s order provides PSI the continuation of a purchased power tracker and the establishment of new trackers for future NOX emission allowance costs and certain costs related to the Midwest ISO.
Cinergy is studying the feasibility of constructing a commercial integrated coal gasification combined cycle (IGCC) generating station to
help meet increased demand over the next decade. PSI would own all or part of the facility and operate it. Cinergy will partner with Bechtel Corporation and General Electric Company to complete this study. An IGCC plant turns coal to gas, removing most of the SO2 and other emissions before the gas is used to fuel a combustion turbine generator. The technology uses less water and has fewer emissions than a conventional coal-fired plant with currently required pollution control equipment. Another benefit is the potential to remove mercury and CO2 upstream of the combustion process at a lower cost than conventional plants. If a decision is reached to move forward with constructing such a plant, PSI would seek approval from the IURC to begin construction. If approved, we would anticipate the IURC’s subsequent approval to include the assets in PSI’s rate base.
In November 2004, PSI filed a compliance plan case with the IURC seeking approval of PSI’s plan for complying with pending SO2, NOX, and mercury emission reduction requirements, including approval of cost recovery and an overall rate of return of eight percent related to certain projects. PSI requested approval to recover the financing, depreciation, and operating and maintenance costs, among others, related to approximately $1.08 billion in capital projects designed to reduce emissions of SO2, NOX, and Mercury at PSI’s coal burning generating stations. An evidentiary hearing is scheduled for April 2005 and a final IURC Order is expected in the third quarter of 2005.
Kentucky We are not aware of any current plans for electric deregulation in Kentucky.
The KPSC has conditionally approved ULH&P’s planned acquisition of CG&E’s 68.9 percent ownership interest in the East Bend Generating Station, located in Boone County, Kentucky, the Woodsdale Generating Station, located in Butler County, Ohio, and one generating unit at the four-unit Miami Fort Station located in Hamilton County, Ohio. ULH&P is currently seeking approval of the transaction from the SEC, wherein the Ohio Consumers Counsel has intervened in opposition, and the FERC. The transfer, which will be paid for at net book value, will not affect current electric rates for ULH&P’s customers, as power will be provided under the same terms as under the current wholesale power contract with CG&E through December 31, 2006. Assuming receipt of regulatory approvals, we would anticipate the transfer to take place in the second quarter of 2005. Once approved, ULH&P would be required to file a rate case with the KPSC to include these assets in rate base with rate increases to be effective January 1, 2007. Costs of fuel and emission allowances would be recovered through a fuel adjustment clause currently in existence in Kentucky, beginning January 1, 2007 when the assets are in rate base. Because the KPSC has already conditionally approved the transfer, we expect the regulatory process to result in a reasonable rate base valuation for these assets; however, at this time we cannot predict whether we will receive approval of the transaction from the FERC and SEC.
FERC and Midwest ISO Midwest ISO Energy Markets The Midwest ISO is a regional transmission organization established in 1998 as a non-profit organization which maintains functional control over the combined transmission systems of its members, including Cinergy. In March 2004, the Midwest ISO filed with the FERC proposed changes to its existing transmission tariff to add terms and conditions to implement a centralized economic dispatch platform supported by a Day-Ahead and Real-Time Energy Market design, including Locational Marginal Pricing and Financial Transmission Rights (Energy Markets Tariff). The Midwest ISO is now in the final stages of market trials and testing of its Energy Markets Tariff. The FERC has issued orders that, among other things, conditionally approve the start-up of the Energy Markets Tariff. The projected implementation date is April 1, 2005. Requests for rehearing are pending before FERC, and FERC’s orders have also been appealed to a federal appeals court.
Specifically, the Energy Markets Tariff proposes to manage system reliability through the use of a market-based congestion management system. The proposal includes a centralized dispatch platform, the intent of which is to dispatch the most economic resources to meet load requirements reliably and efficiently in the Midwest ISO region, which covers a large portion of 15 midwestern states and one Canadian province. The Energy Markets Tariff uses Locational Marginal Pricing (i.e., the energy price for the next MW may vary throughout the Midwest ISO market based on transmission congestion and energy losses), and the allocation or auction of Financial Transmission Rights, which are instruments that hedge against congestion costs occurring in the Day-Ahead market. The Energy Markets Tariff also includes market monitoring and mitigation measures as well as a resource adequacy proposal, that
proposes both an interim solution for participants providing and having access to adequate generation resources as well as a proposal to develop a long-term solution to resource adequacy concerns. The Midwest ISO will perform a day-ahead unit commitment and dispatch forecast for all resources in its market. The Midwest ISO will also perform the real time resource dispatch for resources under its control on a five minute basis. The Cinergy utility operating companies will seek to recover costs that they incur related to the Energy Markets Tariff. This is a significant undertaking by the Midwest ISO and its stakeholders and testing is not yet complete. At this time, we cannot predict the outcome of these matters and whether they will have a material effect on our financial position or results of operations.
Blackout Report In April 2004, the United States-Canada Power System Outage Task Force issued its Final Report on the August 14, 2003 Blackout in the United States and Canada. The report reviewed the causes of the Blackout and made 46 recommendations intended to minimize the likelihood and scope of similar events in the future. One of the recommendations is to make reliability standards mandatory and enforceable with penalties for noncompliance. In the past, compliance with North American Electric Reliability Council’s reliability standards and guidelines has largely been voluntary. At this time, we do not believe the recommendations of the Final Report, if implemented, will have a material impact on our financial position or results of operations.
FERC’s Market Screen Orders In April 2004, the FERC issued an order establishing a new, interim set of market power screens for use in evaluating sales of wholesale power at market-based rates. In July 2004, the FERC issued an order generally affirming that order. In April 2004, the FERC also commenced a rulemaking to evaluate whether its overall test for market-based rates should be continued, and to determine a permanent market power test to replace the interim test. That rulemaking process remains pending. Under FERC’s interim generation market power analysis, as a member of the Midwest ISO, Cinergy could consider the Midwest ISO geographic market for purposes of FERC’s market power analysis once the Midwest ISO has a sufficient market structure and a single energy market. Cinergy does not believe it has market power in generation. However, if Cinergy were unable to establish that it does not have the ability to exercise market power in generation, it could result in the loss of market-based rate authority in certain regions of the wholesale market and, assuming such loss of market-based rate authority, would require Cinergy to charge certain wholesale customers cost-based rates for wholesale sales of electricity. In February, 2005, FERC issued final rules that may affect how and when circumstances have changed to an extent that requires FERC review of previously granted authorization to sell at existing market-based rates. At this time, we cannot predict the outcome of these matters and whether they will have a material effect on our financial position or results of operations.
Global Climate Change Presently, GHG emissions, which principally consist of CO2, are not regulated, and while several legislative proposals have been introduced in Congress to reduce utility GHG emissions, none have been passed. Nevertheless, we anticipate a mandatory program to reduce GHG emissions will exist in the future. We expect that any regulation of GHGs will impose costs on Cinergy. Depending on the details, any GHG regulation could mean:
• Increased capital expenditures associated with investments to improve plant efficiency or install CO2 emission reduction technology (to the extent that such technology exists) or construction of alternatives to coal generation;
• Increased operating and maintenance expense;
• Our older, more expensive generating stations may operate fewer hours each year because the addition of CO2 costs could cause their generation to be less economic; and
• Increased expenses associated with the purchase of CO2 emission allowances, should such an emission allowances market be created.
We would plan to seek recovery of the costs associated with a GHG program in rate regulated states where cost recovery is permitted.
In September 2003, Cinergy announced a voluntary GHG management commitment to reduce its GHG emissions during the period from 2010 through 2012 by five percent below our 2000 level, maintaining those levels through 2012. This was also published in our December 2004 Air Issues Report to Stakeholders. Cinergy expects to spend $21 million between 2004 and 2010 on projects to reduce or offset its GHG emissions. Cinergy is committed to supporting the President’s voluntary initiative, addressing shareholder interest in the issue, and building internal expertise in GHG management and GHG markets. Our voluntary commitment includes the following:
• measuring and inventorying company related sources of GHG emissions;
• identifying and pursuing cost-effective GHG emission reduction and offsetting activities;
• funding research of more efficient and alternative electric generating technologies;
• funding research to better understand the causes and consequences of climate change;
• encouraging a global discussion of the issues and how best to manage them; and
• participating in discussions to help shape the policy debate.
Cinergy is also studying the feasibility of constructing a commercial IGCC generating station. The IGCC plant would be expected to run more efficiently than traditionally constructed coal-fired generation and would thus contribute fewer CO2 tons per megawatt of electricity produced. See the previous section “Indiana” for more details on the plans to construct the IGCC facility.
GAS INDUSTRY Significant Rate Developments ULH&P Gas Rate Case In the second quarter of 2001, ULH&P filed a retail gas rate case with the KPSC requesting, among other things, recovery of costs associated with an accelerated gas main replacement program of up to $112 million over ten years. The costs would be recovered through a tracking mechanism for an initial three year period, with the possibility of renewal up to ten years. The tracking mechanism allows ULH&P to recover depreciation costs and rate of return annually over the life of the deferred assets. Through December 31, 2004, ULH&P has recovered approximately $5.1 million under this tracking mechanism. The Kentucky Attorney General has appealed to the Franklin Circuit Court the KPSC’s approval of the tracking mechanism and the new tracking mechanism rates. At the present time, ULH&P cannot predict the timing or outcome of this litigation.
In February 2005, ULH&P filed a gas base rate case with the KPSC. ULH&P is requesting approval to continue the tracking mechanism in addition to its request for a $14 million increase in base rates, which is a seven percent increase in current retail gas rates.
Gas Prices While natural gas prices remained relatively high during the first three quarters of 2004, some moderation in prices was seen in the latter half of the fourth quarter. Price movement is usually driven by the effects of weather conditions, availability of supply, and changes in demand and storage inventories. Currently, neither CG&E nor ULH&P profit from changes in the cost of natural gas since natural gas purchase costs are passed directly to the customer dollar-for-dollar under the gas cost recovery mechanism that is mandated under state law.
ULH&P utilizes a price mitigation program designed to mitigate the effects of gas price volatility on customers, which the KPSC has approved through March 31, 2005. The program allows the pre-arranging of between 20-75 percent of winter heating season base load gas requirements and up to 50 percent of summer season base load gas requirements. CG&E similarly mitigates its gas procurement costs, however, CG&E’s gas price mitigation program has not been pre-approved by the PUCO but rather it is subject to PUCO review as part of the normal gas cost recovery process.
CG&E and ULH&P use primarily long-term fixed price contracts and contracts with a ceiling and floor on the price. These contracts employ the normal purchases and sales scope exception, and do not involve hedges under Statement 133.
INFLATION We believe that the recent inflation rates do not materially impact our financial condition. However, under existing regulatory practice for all of PSI, ULH&P, and the non-generating portion of CG&E, only the historical cost of plant is recoverable from customers. As a result, cash flows designed to provide recovery of historical plant costs may not be adequate to replace plant in future years.
OTHER MATTERS Synthetic Fuel Production In July 2002, Cinergy Capital & Trading, Inc. acquired a coal-based synthetic fuel production facility. The synthetic fuel produced at this facility qualifies for tax credits (through 2007) in accordance with Internal Revenue Code (IRC) Section 29 if certain requirements are satisfied. The three key requirements are that (a) the synthetic fuel differs significantly in chemical composition from the coal used to produce such synthetic fuel, (b) the fuel produced is sold to an unrelated entity and (c) the fuel was produced from a facility that was placed in service before July 1, 1998. In addition to the existing plant, we have recently exercised an option to buy an additional synthetic fuel plant.
During the third quarter of 2004, several unrelated entities announced that the Internal Revenue Service (IRS) had or threatened to challenge the placed in service dates of some of the entities’ synthetic fuel plants. A successful IRS challenge could result in disallowance of all credits previously claimed for fuel produced by the subject plants. Cinergy’s sale of synthetic fuel has generated approximately $219 million in tax credits through December 31, 2004, of which approximately $96 million were generated in 2004.
The IRS has not yet audited Cinergy for any tax year in which Cinergy has claimed Section 29 credits related to synthetic fuel. However, it is reasonable to anticipate that the IRS will evaluate the placed in service date and other key requirements for claiming the credit. We anticipate this audit to begin in the spring of 2005.
Cinergy received a private letter ruling from the IRS in connection with the acquisition of the facility that specifically addressed the significant chemical change requirement. Additionally, although not addressed in the letter ruling, we believe that our facility’s in service date meets the Section 29 requirements.
IRC Section 29 also provides for a phase-out of the credit based on the price of crude oil. The phase-out is based on a prescribed calculation and definition of crude oil prices. We do not expect any impact on our ability to utilize Section 29 credits in 2004. Future increases in crude oil prices above the price stipulated by the IRS could negatively impact our ability to utilize credits in subsequent years.
Workforce Issues Between 2005 and 2013, 44 percent of our workforce will be eligible for retirement. The loss of these employees could have a negative impact on Cinergy’s overall operations. Cinergy is preparing for this loss that (a) understanding our current employee profile (demographics), (b) identifying critical positions (considered core to our business and that have licensing or lengthy apprenticeship requirements associated with them), and (c) preparing an action plan. The action plan involves long-term staffing plans including such things as detailed recruitment plans, the utilization of co-ops and interns, identification of key employees, and strong succession planning. We will also use senior and phased retirement programs that allow new employees to train and consult with experienced highly-skilled employees post- and pre-retirement. In addition, we are exploring ways of accelerating and enhancing our training programs through collaboration with area educational institutions and other third-party providers.
MD&A - MARKET RISK SENSITIVE INSTRUMENTS
MARKET RISK SENSITIVE INSTRUMENTS Energy Commodities Sensitivity The transactions associated with Commercial’s energy marketing and trading activities and substantial investment in generation assets give rise to various risks, including price risk. Price risk represents the potential risk of loss from adverse changes in the market price of electricity or other energy commodities. As Commercial continues to develop its energy marketing and trading business, its exposure to movements in the price of electricity and other energy commodities may become greater. As a result, we may be subject to increased future earnings volatility.
Commercial’s energy marketing and trading activities principally consist of Marketing & Trading’s natural gas marketing and trading operations and CG&E’s power marketing and trading operations.
Our domestic operations market and trade over-the-counter (an informal market where the buying/selling of commodities occurs) contracts for the purchase and sale of electricity (primarily in the midwest region of the United States), natural gas, and other energy-related products, including coal and emission allowances. Our natural gas domestic operations provide services that manage storage, transportation, gathering and processing activities. In addition, our domestic operations also market and trade natural gas and other energy-related products on the New York Mercantile Exchange.
Marketing & Trading’s natural gas marketing and trading operations also extend to Canada where natural gas marketing and management services are provided to producers and industrial customers. Our Canadian operations also market and trade over-the-counter contracts.
Many of these energy commodity contracts commit us to purchase or sell electricity, natural gas, and other energy-related products at fixed prices in the future. The majority of the contracts in the natural gas and other energy-related product portfolios are financially settled contracts (i.e., there is no physical delivery related with these items). In addition, Commercial also markets and trades over-the-counter option contracts. The use of these types of commodity instruments is designed to allow Commercial to:
• manage and economically hedge contractual commitments;
• reduce exposure relative to the volatility of cash market prices;
• take advantage of selected arbitrage opportunities; and
• originate customized transactions with municipalities and end-use customers.
Commercial structures and modifies its net position to capture the following:
• expected changes in future demand;
• seasonal market pricing characteristics;
• overall market sentiment; and
• price relationships between different time periods and trading regions.
At times, a net open position is created or is allowed to continue when Commercial believes future changes in prices and market conditions may possibly result in profitable positions. Position imbalances can also occur due to the basic lack of liquidity in the wholesale power market. The existence of net open positions can potentially result in an adverse impact on our financial condition or results of operations. This potential adverse impact could be realized if the market price of electric power does not react in the manner or direction expected. Cinergy’s Risk Management Control Policy contains limits associated with the overall size of net open positions for each trading operation.
Trading Portfolio Risks
Commercial measures the market risk inherent in the trading portfolio employing value at risk (VaR) analysis and other methodologies, which utilize forward price curves in electric power and natural gas markets to quantify estimates of the magnitude and probability of future value changes related to open contract positions. VaR is a
statistical measure used to quantify the potential change in fair value of the trading portfolio over a particular period of time, with a specified likelihood of occurrence, due to market movement. Commercial, through some of our non-regulated subsidiaries, markets physical natural gas and electricity and trades derivative commodity instruments which are usually settled in cash including: forwards, futures, swaps, and options.
Any proprietary trading transaction, whether settled physically or financially, is included in the VaR calculation.
Our VaR is reported based on a 95 percent confidence interval, utilizing a one-day holding period. This means that on a given day (one-day holding period) there is a 95 percent chance (confidence level) that our trading portfolio will not lose more than the stated amount. Prior to March 31, 2004, our VaR model used the Parametric variance-covariance statistical modeling technique and historical volatilities and correlations over the past 21-trading day period. Beginning with April 1, 2004, we calculate VaR using a Monte Carlo simulation methodology using implied forward-looking volatilities and historical correlations. Comparisons indicated that the differences in VaR between the Monte Carlo and Parametric calculations were not material and were within expectations. The primary reason for changing to a Monte Carlo approach is that it offers a more scalable method for handling more complex derivative positions and provides a consistent platform for quantifying both market and credit risk.
The VaR for Cinergy’s trading portfolio is presented in the table below:
Changes in Fair Value
The changes in fair value of the energy risk management assets and liabilities for Cinergy and CG&E for the years ended December 31, 2004 and 2003 are presented in the table below. In April 2002, CG&E and PSI executed a new joint operating agreement whereby we chose to originate all new power marketing and trading contracts since April 2002 on behalf of CG&E only. Historically, such contracts were executed on behalf of PSI and CG&E jointly. PSI’s remaining contracts, entered into prior to the new joint operating agreement, are not material. Therefore, we have not presented PSI separately in the fair value tables below.
(1) The results of Cinergy also include amounts related to non-registrants.
(2) Represents changes in fair value recognized in income, caused by changes in assumptions used in calculating fair value or changes in modeling techniques.
(3) Represents changes in fair value recognized in income, primarily attributable to fluctuations in price. This amount includes both realized and unrealized gains on energy trading contracts.
(4) See Note 1(q)(i) and Note 1(q)(iv) of the “Notes to Financial Statements” in “Item 8. Financial Statements and Supplementary Data” for further information.
The following are the balances at December 31, 2004 and 2003 of our energy risk management assets and liabilities:
(1) The results of Cinergy also include amounts related to non-registrants.
The following table presents the expected maturity of the energy risk management assets and liabilities as of December 31, 2004 for Cinergy and CG&E:
(1) While liquidity varies by trading regions, active quotes are generally available for two years for standard electricity transactions and three years for standard gas transactions. Non-standard transactions are classified based on the extent, if any, of modeling used in determining fair value. Long-term transactions can have portions in both categories depending on the length.
(2) The results of Cinergy also include amounts related to non-registrants.
(3) A substantial portion of these amounts include option values.
Generation Portfolio Risks
Cinergy optimizes the value of its non-regulated portfolio. The portfolio includes generation assets (power and capacity), fuel, and emission allowances and we manage all of these components as a portfolio. We use models that forecast future generation output, fuel requirements, and emission allowance requirements based on forward power, fuel and emission allowance markets. The component pieces of the portfolio are bought and sold based on this model in order to manage the economic value of the portfolio. With the issuance of Statement of Financial Accounting Standards No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities (Statement 149), most forward power transactions from management of the portfolio are accounted for at fair value. The other component pieces of the portfolio are typically not subject to Statement 149 and are accounted for using the accrual method, where changes in fair value are not recognized. As a result, we are subject to earnings volatility via mark-to-market gains or losses from changes in the value of the contracts accounted for using fair value. A hypothetical $1.00 per MWh increase or decrease consistently applied to all forward power prices would have resulted in an increase or decrease in fair value of these contracts of approximately $3 million as of December 31, 2004.
Cinergy is exposed to risk from changes in the market prices of fuel (primarily coal) and emission allowances to the extent the risk is not mitigated by regulatory recovery mechanisms in Ohio and Indiana. To the extent we must purchase fuel or emission allowances in a rising price environment, increased cost of electricity production could result without a corresponding increase in revenue. Cinergy manages this risk through the use of long-term fixed price fuel contracts and acquisitions of emission allowances. These risks at CG&E are partially mitigated in 2005 and significantly mitigated from 2006 through 2008 by a retail fuel cost recovery mechanism established in Ohio as part of the RSP for non-residential customers beginning January 1, 2005 and for residential customers beginning January 1, 2006. This mechanism will recover costs for fuel and emission allowances that exceed the amount originally included in the rates frozen in the CG&E transition plan through December 31, 2008. PSI continues to be protected against market price changes of fuel and emission allowances costs incurred for its retail customers by the use of cost tracking and recovery mechanisms in the state of Indiana.
Concentrations of Credit Risk Credit risk is the exposure to economic loss that would occur as a result of nonperformance by counterparties, pursuant to the terms of their contractual obligations. Specific components of credit risk include counterparty default risk, collateral risk, concentration risk, and settlement risk.
Trade Receivables and Physical Power Portfolio
Our concentration of credit risk with respect to trade accounts receivable from electric and gas retail customers is limited. The large number of customers and diversified customer base of residential, commercial, and industrial customers significantly reduces our credit risk. Contracts within the physical portfolio of power marketing and trading operations are primarily with traditional electric cooperatives and municipalities and other investor-owned utilities. At December 31, 2004, we believe the likelihood of significant losses associated with credit risk in our trade accounts receivable or physical power portfolio is remote.
Energy Trading Credit Risk
Cinergy’s extension of credit for energy marketing and trading is governed by a Corporate Credit Policy. Written guidelines approved by Cinergy’s Risk Policy Committee document the management approval levels for credit limits, evaluation of creditworthiness, and credit risk mitigation procedures. Cinergy analyzes net credit exposure and establishes credit reserves based on the counterparties’ credit rating, payment history, and length of the outstanding obligation. Exposures to credit risks are monitored daily by the Corporate Credit Risk function, which is independent of all trading operations. Energy commodity prices can be extremely volatile and the market can, at times, lack liquidity. Because of these issues, credit risk for energy commodities is generally greater than with other commodity trading.
The following tables provide information regarding Cinergy’s and CG&E’s exposure on energy trading contracts as well as the expected maturities of those exposures as of December 31, 2004. The tables include accounts receivable and energy risk management assets, which are net of accounts payable and energy risk management liabilities with the same counterparties when we have the right of offset. The credit collateral shown in the following tables includes cash and letters of credit. As previously discussed, PSI’s remaining contracts are not material; therefore, we have not presented PSI separately in the credit risk tables below.
Cinergy(1)
(1) Includes amounts related to non-registrants.
(2) Includes counterparties rated Investment Grade or the counterparties’ obligations are guaranteed or secured by an Investment Grade entity.
(3) Counterparties include a variety of entities, including investor-owned utilities, privately held companies, cities and municipalities. Cinergy assigns internal credit ratings to all counterparties within our credit risk portfolio, applying fundamental analytical tools. Included in this analysis is a review of (but not limited to) counterparty financial statements with consideration given to off-balance sheet obligations and assets, specific business environment, access to capital, and indicators from debt and equity capital markets.
(4) Exposures, positive or negative, with counterparties that are related to one another are not aggregated when no right of offset exists and as a result, credit is extended and evaluated on a separate basis.
CG&E
(1) Includes counterparties rated Investment Grade or the counterparties’ obligations are guaranteed or secured by an Investment Grade entity.
(2) Counterparties include various cities and municipalities.
(3) Exposures, positive or negative, with counterparties that are related to one another are not aggregated when no right of offset exists and as a result, credit is extended and evaluated on a separate basis.
Financial Derivatives
Potential exposure to credit risk also exists from our use of financial derivatives such as interest rate swaps and treasury locks. Because these financial instruments are transacted with highly rated financial institutions, we do not anticipate nonperformance by any of the counterparties.
Risk Management We manage, on a portfolio basis, the market risks in our energy marketing and trading transactions subject to parameters established by our Risk Policy Committee. Our market and credit risks are monitored by the Global Risk Management function to ensure compliance with stated risk management policies and procedures. The Global Risk Management function operates independently from the business units, which originate and actively manage the market risk exposures. Policies and procedures are periodically reviewed to assess their responsiveness to changing market and business conditions. Credit risk mitigation practices include requiring parent company guarantees, various forms of collateral, and the use of mutual netting/closeout agreements.
Exchange Rate Sensitivity Cinergy has exposure to fluctuations in exchange rates between the United States dollar and the currencies of foreign countries where we have investments. When it is appropriate we will hedge our exposure to cash flow transactions, such as a dividend payment by one of our foreign subsidiaries.
Interest Rate Sensitivity Our net exposure to changes in interest rates primarily consists of short-term debt instruments (including net money pool borrowings) and variable-rate pollution control debt. The following table reflects the different instruments used and the method of benchmarking interest rates, as of December 31, 2004:
(1) 30-day Federal Reserve “AA” Industrial Commercial Paper Composite Rate
(2) London Inter-Bank Offered Rate
The weighted-average interest rates on the previously discussed instruments at December 31, were as follows:
At December 31, 2004, forward yield curves project an increase in applicable short-term interest rates over the next five years.
The following table presents principal cash repayments, by maturity date and other selected information, for each registrant’s long-term debt, other debt, and capital lease obligations as of December 31, 2004:
(1) Long-term Debt includes amounts reflected as Long-term debt due within one year.
(2) The weighted-average interest rate is calculated as follows: (1) for Long-term Debt and Other, the weighted-average interest rate is based on the interest rates at December 31, 2004 of the debt that is maturing in the year reported and includes the effects of an interest rate swap that fixes the interest payments differently from the stated rate; and (2) for Capital Leases, the weighted-average interest rate is based on the average interest rate of the lease payments made during the year reported.
(3) Promissory notes and long-term notes payable related to investments under Cinergy Global Resources, Inc., Cinergy Investments, Inc., and debt related to CC Funding Trust. See Note 3(b) of the “Notes to Financial Statements” in “Item 8. Financial Statements and Supplementary Data” for a discussion of the debt associated with the CC Funding Trust.
(4) Includes PSI’s 6.50% Debentures due August 1, 2026, reflected as maturing in 2005, as the interest rate is due to reset on August 1, 2005. If the interest rate is not reset, the bonds are subject to mandatory redemption by PSI.
(5) CG&E’s 6.90% Debentures due June 1, 2025, are putable to CG&E at the option of the holders on June 1, 2005. However, based on current market conditions, we believe it is unlikely that the debentures will be put to CG&E on this date.
(6) Includes amounts related to non-registrants.
Our current policy in managing exposure to fluctuations in interest rates is to maintain approximately 30 percent of the total amount of outstanding debt in variable interest rate debt instruments. In maintaining this level of exposure, we use interest rate swaps. Under the swaps, we agree with other parties to exchange, at specified intervals, the difference between fixed-rate and variable-rate interest amounts calculated on an agreed upon notional amount. In the future, we will continually monitor market conditions to evaluate whether to modify our level of exposure to fluctuations in interest rates.
CG&E has an outstanding interest rate swap agreement that decreased the percentage of variable-rate debt. See Note 7(a) of the “Notes to Financial Statements” in “Item 8. Financial Statements and Supplementary Data” for additional information on financial derivatives.
MD&A - ACCOUNTING MATTERS
ACCOUNTING MATTERS Critical Accounting Estimates Preparation of financial statements and related disclosures in compliance with GAAP requires the use of assumptions and estimates regarding future events, including the likelihood of success of particular investments or initiatives, estimates of future prices or rates, legal and regulatory challenges, and anticipated recovery of costs. Therefore, the possibility exists for materially different reported amounts under different conditions or assumptions. We consider an accounting estimate to be critical if: 1) the accounting estimate requires us to make assumptions about matters that were reasonably uncertain at the time the accounting estimate was made, and 2) changes in the estimate are reasonably likely to occur from period to period.
These critical accounting estimates should be read in conjunction with the “Notes to Financial Statements” in “Item 8. Financial Statements and Supplementary Data”. We have other accounting policies that we consider to be significant; however, these policies do not meet the definition of critical accounting estimates, because they generally do not require us to make estimates or judgments that are particularly difficult or subjective.
Fair Value Accounting for Energy Marketing and Trading We use fair value accounting for energy trading contracts, which is required, with certain exceptions, by Statement 133. Short-term contracts used in our trading activities are generally priced using exchange based or over-the-counter price quotes. Long-term contracts typically must be valued using less actively quoted prices or valuation models. Use of model pricing requires estimating surrounding factors such as volatility and price curves beyond what is actively quoted in the market. In addition, some contracts do not have fixed notional amounts and therefore must be valued using estimates of volumes to be consumed by the counterparty. See “Changes in Fair Value” for additional information.
We measure these risks by using complex analytical tools, both external and proprietary. These models are dynamic and are continuously updated with the most recent data to improve assessments of potential future outcomes. We measure risks for contracts that do not contain fixed notional amounts by obtaining historical data and projecting expected consumption. These models incorporate expectations surrounding the impacts that weather may play in future consumption. The results of these measures assist us in managing such risks within our portfolio. We also have a Global Risk Management function within Cinergy that is independent of the marketing and trading function and is under the oversight of a Risk Policy Committee comprised primarily of senior company executives. This group provides an independent evaluation of both forward price curves and the valuation of energy contracts. See “Trading Portfolio Risks” for additional information.
There is inherent risk in valuation modeling given the complexity and volatility of energy markets. Fair value accounting has risk, including its application to short-term contracts, as gains and losses recorded through its use are not yet realized. Therefore, it is possible that results in future periods may be materially different as contracts are ultimately settled. We monitor potential losses using VaR analysis. As previously discussed, our one-day VaR at December 31, 2004, assuming a 95 percent confidence level, was approximately $1.9 million, which means there is a 95 percent statistical chance (based on market implied volatilities) that any adverse moves in the value of our portfolio will be less than the reported amount. In addition, our five-day VaR at December 31, 2004, assuming the same 95 percent confidence level, was approximately $3.9 million.
For financial reporting purposes, assets and liabilities associated with energy trading transactions accounted for using fair value are reflected on the Balance Sheets as Energy risk management assets current and non-current and Energy risk management liabilities current and non-current, classified as current or non-current pursuant to each contract’s length. Net gains and losses resulting from revaluation of contracts during the period are recognized currently in the Statements of Income.
Regulatory Accounting CG&E, PSI, and ULH&P are regulated utility companies. Except with respect to the electric generation-related assets and liabilities of CG&E, the companies apply the provisions of Statement 71. In accordance with Statement 71, regulatory actions may result in accounting treatment different from that of non-rate regulated companies. The deferral of costs (as regulatory assets) or amounts provided in current rates to cover costs to be incurred in the future (as regulatory liabilities) may be appropriate when the future recovery or refunding of such costs is probable. In assessing probability, we consider such factors as regulatory precedent and the current regulatory environment. To the extent recovery of costs is no longer deemed probable, related regulatory assets would be required to be recognized in current period earnings. Our calculations under the fuel adjustment and emission allowance cost recovery mechanisms at PSI (and CG&E for non-residential retail customers beginning in 2005 and residential retail customers in 2006) involve the use of estimates. Fuel costs (including purchased power when economically displacing fuel) and emission allowance costs must be allocated between PSI’s retail customers and wholesale customers, with the lowest costs allocated to retail customers. This process is complex and involves the use of estimates that when finalized in future periods may result in adjustments to amounts deferred and collected from customers.
At December 31, 2004, regulatory assets totaled $609 million for CG&E (including $10 million for ULH&P) and $421 million for PSI. Current rates include the recovery of $602 million for CG&E (including $9 million for ULH&P) and $378 million for PSI. In addition to the regulatory assets, CG&E and PSI have regulatory liabilities totaling $165 million (including $30 million for ULH&P) and $392 million at December 31, 2004, respectively. See Note 1(c) of the “Notes to Financial Statements” in “Item 8. Financial Statements and Supplementary Data” for additional detail regarding regulatory assets and regulatory liabilities.
Income Taxes Management judgment is required in developing our provision for income taxes, including the determination of deferred tax assets, deferred tax liabilities, and any valuation allowances recorded against the deferred tax assets. We evaluate quarterly the realizability of our deferred tax assets by assessing our valuation allowance and adjusting the amount of such allowance, if necessary. The factors used to assess the likelihood of realization are our forecast of future taxable income and the availability of tax planning strategies that can be implemented to realize deferred tax assets. These tax planning strategies include the utilization of Section 29 tax credits associated with our production of synthetic fuel. Failure to achieve forecasted taxable income might affect our ability to utilize the Section 29 tax credits and the ultimate realization of deferred tax assets.
Contingencies When it is probable that an environmental, tax, or other legal liability has been incurred, a loss is recognized when the amount of the loss can be reasonably estimated. Estimates of the probability and the amount of loss are often made based on currently available facts, present laws and regulations, and consultation with third-party experts. Accounting for contingencies requires significant judgment by management regarding the estimated probabilities and ranges of exposure to potential liability. Management’s assessment of Cinergy’s exposure to contingencies could change to the extent there are additional future developments, administrative actions, or as more information becomes available. If actual obligations incurred are different from our estimates, the recognition of the actual amounts may have a material impact on Cinergy’s financial position and results of operations.
Impairment of Long-lived Assets Current accounting standards require long-lived assets be measured for impairment whenever indicators of impairment exist. If deemed impaired under the standards, assets are written down to fair value with a charge to current period earnings. As a producer of electricity, Cinergy, CG&E, and PSI are owners of generating plants, which are largely coal-fired. At December 31, 2004, the carrying value of these generating plants is $5 billion for Cinergy, $2 billion for CG&E and $2 billion for PSI. As a result of the various emissions and by-products of coal consumption, the companies are subject to extensive environmental regulations and are currently subject to a number of environmental contingencies. See Note 11(a) of the “Notes to Financial Statements” in “Item 8. Financial Statements and Supplementary Data” for additional information. While we cannot predict the potential
effect the resolution of these matters will have on the recoverability of our coal-fired generating assets, we believe that the carrying values of these assets are recoverable. In making this assessment, we consider such factors as the expected ability to recover through the regulatory process any additional investments in environmental compliance expenditures for PSI, the relative pricing of wholesale electricity in the region, the anticipated demand, and the cost of coal.
For the gas-fired peaking plants that Cinergy owns that are not subject to cost-of-service-based ratemaking, the recoverability will be dependent on many factors, but primarily the price of power compared to the cost of natural gas, often referred to as the spark spread, over the life of the plants. While we currently believe these assets are recoverable on a nominal basis (the basis required for evaluation under Statement 144 given our intent to continue operating these assets), changes in the estimates and assumptions used (primarily power and gas prices along with their related volatilities) in evaluating these assets over their useful life could result in an impairment in the future. At December 31, 2004, the carrying value of these gas-fired peaking plants is approximately $441 million.
We will continue to evaluate these assets for impairment when events or circumstances indicate the carrying value may not be recoverable.
Impairment of Unconsolidated Investments We evaluate the recoverability of investments in unconsolidated subsidiaries when events or changes in circumstances indicate the carrying amount of the asset is other than temporarily impaired. An investment is considered impaired if the fair value of the investment is less than its carrying value. We only recognize an impairment loss when an impairment is considered to be other than temporary. We consider an impairment to be other than temporary when a forecasted recovery up to the investment’s carrying value is not expected for a reasonable period of time. We evaluate several factors, including but not limited to our intent and ability to hold the investment, the severity of the impairment, the duration of the impairment and the entity’s historical and projected financial performance, when determining whether or not impairment is other than temporary.
Fair value is determined by quoted market prices, when available, however in most instances we rely on valuations based on discounted cash flows and market multiples. There are many significant assumptions involved in performing such valuations, including but not limited to forecasted financial performance, discount rates, earnings multiples and terminal value considerations. Variations in any one or a combination of these assumptions could result in different conclusions regarding impairment.
Once an investment is considered other than temporarily impaired and an impairment loss is recognized, the carrying value of the investment is not adjusted for any subsequent recoveries in fair value. As of December 31, 2004, we do not have any material unrealized losses that are deemed to be temporary in nature. See Note 15(a) of the “Notes to Financial Statements” in “Item 8. Financial Statements and Supplementary Data” for the amount of impairment charges incurred during the year.
Accounting Changes Consolidation of VIEs
In January 2003, the FASB issued Interpretation 46, which significantly changed the consolidation requirements for traditional SPEs and certain other entities subject to its scope. This interpretation defines a VIE as (a) an entity that does not have sufficient equity to support its activities without additional financial support or (b) any entity that has equity investors that do not have substantive voting rights, do not absorb first dollar losses, or receive residual returns. These entities must be consolidated whenever Cinergy would be anticipated to absorb greater than 50 percent of the losses or receive greater than 50 percent of the returns.
In accordance with its two stage adoption guidance, we implemented Interpretation 46 for traditional SPEs on July 1, 2003, and for all other entities, including certain operating joint ventures, as of March 31, 2004. The consolidation of certain operating joint ventures as of March 31, 2004, did not have a material impact on our financial position or results of operations.
On July 1, 2003, Interpretation 46 required us to consolidate two SPEs that have individual power sale agreements with Central Maine Power Company. Further, we were no longer permitted to consolidate a trust that was established by Cinergy Corp. in 2001 to issue approximately $316 million of combined preferred trust securities and stock purchase contracts. Prior period financial statements were not restated for these changes. For further information on the accounting for these entities see Notes 3(a) and (b) of the “Notes to Financial Statements” in “Item 8. Financial Statements and Supplementary Data”.
Cinergy has concluded that its accounts receivable sale facility, as discussed in Note 3(c) of the “Notes to Financial Statements” in “Item 8. Financial Statements and Supplementary Data”, will remain unconsolidated since it involves transfers of financial assets to a qualifying SPE, which is exempted from consolidation by Interpretation 46 and Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.
Share-Based Payment In December 2004, the FASB issued a replacement of Statement 123, Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (Statement 123R). This standard will require accounting for all stock-based compensation arrangements under the fair value method in addition to other provisions.
In 2003, we prospectively adopted accounting for our stock-based compensation plans using the fair value recognition provisions of Statement 123, as amended by Statement of Financial Accounting Standards No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure, for all employee awards granted or with terms modified on or after January 1, 2003. Therefore, the impact of implementation of Statement 123R on stock options within our stock-based compensation plans is not expected to be material. Statement 123R contains certain provisions that will modify the accounting for various stock-based compensation plans other than stock options. We are in the process of evaluating the impact of this new standard on these plans. Cinergy will adopt Statement 123R on July 1, 2005.
Income Taxes In October 2004, the American Jobs Creation Act (AJCA) was signed into law. The AJCA includes a one-time deduction of 85 percent of certain foreign earnings that are repatriated, as defined in the AJCA. In December 2004, the FASB issued Staff Position 109-2, Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004. The staff position allows additional time for an entity to evaluate the effect of the legislation on its plan for repatriation of foreign earnings for purposes of applying Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes. Cinergy will complete its evaluation of the effects of the provision on its plan for repatriation of foreign earnings in 2005.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Reference is made to the “Market Risk Sensitive Instruments” section of “Item 7. MD&A”.
INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES
FINANCIAL STATEMENTS
Independent Auditors’ Report
Cinergy Corp. and Subsidiaries
Consolidated Statements of Income for the three years ended December 31, 2004
Consolidated Balance Sheets at December 31, 2004 and 2003
Consolidated Statements of Changes in Common Stock Equity for the three years ended December 31, 2004
Consolidated Statements of Cash Flows for the three years ended December 31, 2004
Consolidated Statements of Capitalization at December 31, 2004 and 2003
The Cincinnati Gas & Electric Company and Subsidiaries
Consolidated Statements of Income for the three years ended December 31, 2004
Consolidated Balance Sheets at December 31, 2004 and 2003
Consolidated Statements of Changes in Common Stock Equity for the three years ended December 31, 2004
Consolidated Statements of Cash Flows for the three years ended December 31, 2004
Consolidated Statements of Capitalization at December 31, 2004 and 2003
PSI Energy, Inc. and Subsidiary
Consolidated Statements of Income for the three years ended December 31, 2004
Consolidated Balance Sheets at December 31, 2004 and 2003
Consolidated Statements of Changes in Common Stock Equity for the three years ended December 31, 2004
Consolidated Statements of Cash Flows for the three years ended December 31, 2004
Consolidated Statements of Capitalization at December 31, 2004 and 2003
The Union Light, Heat and Power Company
Statements of Income for the three years ended December 31, 2004
Balance Sheets at December 31, 2004 and 2003
Statements of Changes in Common Stock Equity for the three years ended December 31, 2004
Statements of Cash Flows for the three years ended December 31, 2004
Statements of Capitalization at December 31, 2004 and 2003
Notes to Financial Statements
FINANCIAL STATEMENT SCHEDULES
Schedule II - Valuation and Qualifying Accounts
Cinergy Corp. and Subsidiaries
The Cincinnati Gas & Electric Company and Subsidiaries
PSI Energy, Inc. and Subsidiary
The Union Light, Heat and Power Company
The information required to be submitted in schedules other than those indicated previously, have been included in the Balance Sheets, the Statements of Income, related schedules, the notes thereto, or omitted as not required by the Rules of Regulation S-X.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors of Cinergy Corp.:
We have audited the accompanying consolidated balance sheets and statements of capitalization of Cinergy Corp. and subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of income, changes in common stock equity, and cash flows for each of the three years in the period ended December 31, 2004. Our audits also included the financial statement schedule included in Item 15 of this Annual Report. These financial statements and the financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Cinergy Corp. and subsidiaries as of December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
As discussed in Note 1 to the financial statements, in 2003, Cinergy Corp. adopted Statement of Financial Accounting Standards (SFAS) No. 143, “Accounting for Asset Retirement Obligations;” Financial Accounting Standards Board Interpretation No. 46, “Consolidation of Variable Interest Entities;” and the fair value recognition provisions of SFAS No. 123 “Accounting for Stock-Based Compensation.”
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 11, 2005 expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
/s/ Deloitte & Touche LLP
Deloitte & Touche LLP
Cincinnati, Ohio
February 11, 2005
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors of The Cincinnati Gas & Electric Company:
We have audited the accompanying consolidated balance sheets and statements of capitalization of The Cincinnati Gas & Electric Company and subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of income, changes in common stock equity, and cash flows for each of the three years in the period ended December 31, 2004. Our audits also included the financial statement schedule included in Item 15 of this Annual Report. These financial statements and the financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of The Cincinnati Gas & Electric Company and subsidiaries as of December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
As discussed in Note 1 to the financial statements, in 2003, The Cincinnati Gas & Electric Company adopted Statement of Financial Accounting Standards (SFAS) No. 143, “Accounting for Asset Retirement Obligations.”
/s/ Deloitte & Touche LLP
Deloitte & Touche LLP
Cincinnati, Ohio
February 11, 2005
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors of PSI Energy, Inc.:
We have audited the accompanying consolidated balance sheets and statements of capitalization of PSI Energy, Inc. and subsidiary as of December 31, 2004 and 2003, and the related consolidated statements of income, changes in common stock equity, and cash flows for each of the three years in the period ended December 31, 2004. Our audits also included the financial statement schedule included in Item 15 of this Annual Report. These financial statements and the financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of PSI Energy, Inc. and subsidiary as of December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
As discussed in Note 1 to the financial statements, in 2003, PSI Energy, Inc. adopted Statement of Financial Accounting Standards (SFAS) No. 143, “Accounting for Asset Retirement Obligations.”
/s/ Deloitte & Touche LLP
Deloitte & Touche LLP
Cincinnati, Ohio
February 11, 2005
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors of The Union Light, Heat and Power Company:
We have audited the accompanying balance sheets and statements of capitalization of The Union Light, Heat and Power Company as of December 31, 2004 and 2003, and the related statements of income, changes in common stock equity, and cash flows for each of the three years in the period ended December 31, 2004. Our audits also included the financial statement schedule included in Item 15 of this Annual Report. These financial statements and the financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such financial statements present fairly, in all material respects, the financial position of The Union Light, Heat and Power Company as of December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
As discussed in Note 1 to the financial statements, in 2003, The Union Light, Heat and Power Company adopted Statement of Financial Accounting Standards (SFAS) No. 143, “Accounting for Asset Retirement Obligations.”
/s/ Deloitte & Touche LLP
Deloitte & Touche LLP
Cincinnati, Ohio
February 11, 2005
CINERGY CORP.
AND SUBSIDIARY COMPANIES
CINERGY CORP.
CONSOLIDATED STATEMENTS OF INCOME
The accompanying notes as they relate to Cinergy Corp. are an integral part of these consolidated financial statements.
CINERGY CORP.
CONSOLIDATED BALANCE SHEETS
The accompanying notes as they relate to Cinergy Corp. are an integral part of these consolidated financial statements.
CINERGY CORP.
CONSOLIDATED BALANCE SHEETS
The accompanying notes as they relate to Cinergy Corp. are an integral part of these consolidated financial statements.
CINERGY CORP.
CONSOLIDATED STATEMENTS OF CHANGES IN COMMON STOCK EQUITY
The accompanying notes as they relate to Cinergy Corp. are an integral part of these consolidated financial statements.
CINERGY CORP.
CONSOLIDATED STATEMENTS OF CASH FLOWS
The accompanying notes as they relate to Cinergy Corp. are an integral part of these consolidated financial statements.
CINERGY CORP.
CONSOLIDATED STATEMENTS OF CAPITALIZATION
The accompanying notes as they relate to Cinergy Corp. are an integral part of these consolidated financial statements.
THE CINCINNATI GAS &
ELECTRIC COMPANY
AND SUBSIDIARY COMPANIES
THE CINCINNATI GAS & ELECTRIC COMPANY
CONSOLIDATED STATEMENTS OF INCOME
The accompanying notes as they relate to The Cincinnati Gas & Electric Company are an integral part of these consolidated financial statements.
THE CINCINNATI GAS & ELECTRIC COMPANY
CONSOLIDATED BALANCE SHEETS
The accompanying notes as they relate to The Cincinnati Gas & Electric Company are an integral part of these consolidated financial statements.
THE CINCINNATI GAS & ELECTRIC COMPANY
CONSOLIDATED BALANCE SHEETS
The accompanying notes as they relate to The Cincinnati Gas & Electric Company are an integral part of these consolidated financial statements.
THE CINCINNATI GAS & ELECTRIC COMPANY
CONSOLIDATED STATEMENTS OF CHANGES IN COMMON STOCK EQUITY
The accompanying notes as they relate to The Cincinnati Gas & Electric Company are an integral part of these consolidated financial statements.
THE CINCINNATI GAS & ELECTRIC COMPANY
CONSOLIDATED STATEMENTS OF CASH FLOWS
The accompanying notes as they relate to The Cincinnati Gas & Electric Company are an integral part of these consolidated financial statements.
THE CINCINNATI GAS & ELECTRIC COMPANY
CONSOLIDATED STATEMENTS OF CAPITALIZATION
The accompanying notes as they relate to The Cincinnati Gas & Electric Company are an integral part of these consolidated financial statements.
PSI ENERGY, INC.
AND SUBSIDIARY COMPANY
PSI ENERGY, INC.
CONSOLIDATED STATEMENTS OF INCOME
The accompanying notes as they relate to PSI Energy, Inc. are an integral part of these consolidated financial statements.
PSI ENERGY, INC.
CONSOLIDATED BALANCE SHEETS
The accompanying notes as they relate to PSI Energy, Inc. are an integral part of these consolidated financial statements.
PSI ENERGY, INC.
CONSOLIDATED BALANCE SHEETS
The accompanying notes as they relate to PSI Energy, Inc. are an integral part of these consolidated financial statements.
PSI ENERGY, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN COMMON STOCK EQUITY
The accompanying notes as they relate to PSI Energy, Inc. are an integral part of these consolidated financial statements.
PSI ENERGY, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
The accompanying notes as they relate to PSI Energy, Inc. are an integral part of these consolidated financial statements.
PSI ENERGY, INC.
CONSOLIDATED STATEMENTS OF CAPITALIZATION
The accompanying notes as they relate to PSI Energy, Inc. are an integral part of these consolidated financial statements.
THE UNION LIGHT, HEAT
AND POWER COMPANY
THE UNION LIGHT, HEAT AND POWER COMPANY
STATEMENTS OF INCOME
The accompanying notes as they relate to The Union Light, Heat and Power Company are an integral part of these financial statements.
THE UNION LIGHT, HEAT AND POWER COMPANY
BALANCE SHEETS
The accompanying notes as they relate to The Union Light, Heat and Power Company are an integral part of these financial statements.
THE UNION LIGHT, HEAT AND POWER COMPANY
BALANCE SHEETS
The accompanying notes as they relate to The Union Light, Heat and Power Company are an integral part of these financial statements.
THE UNION LIGHT, HEAT AND POWER COMPANY
STATEMENTS OF CHANGES IN COMMON STOCK EQUITY
The accompanying notes as they relate to The Union Light, Heat and Power Company are an integral part of these financial statements.
THE UNION LIGHT, HEAT AND POWER COMPANY
STATEMENTS OF CASH FLOWS
The accompanying notes as they relate to The Union Light, Heat and Power Company are an integral part of these financial statements.
THE UNION LIGHT, HEAT AND POWER COMPANY
STATEMENTS OF CAPITALIZATION
The accompanying notes as they relate to The Union Light, Heat and Power Company are an integral part of these financial statements
NOTES TO FINANCIAL STATEMENTS
NOTES TO FINANCIAL STATEMENTS In this report Cinergy (which includes Cinergy Corp. and all of our regulated and non-regulated subsidiaries) is, at times, referred to in the first person as “we”, “our”, or “us”. In addition, when discussing Cinergy’s financial information, it necessarily includes the results of The Cincinnati Gas & Electric Company (CG&E), PSI Energy, Inc. (PSI), The Union Light, Heat and Power Company (ULH&P) and all of Cinergy’s other consolidated subsidiaries. When discussing CG&E’s financial information, it necessarily includes the results of ULH&P and all of CG&E’s other consolidated subsidiaries.
1. Summary of Significant Accounting Policies
(a) Nature of Operations
Cinergy Corp., a Delaware corporation organized in 1993, owns all outstanding common stock of CG&E and PSI, both of which are public utilities. As a result of this ownership, we are considered a utility holding company. Because we are a holding company with material utility subsidiaries operating in multiple states, we are registered with and are subject to regulation by the Securities and Exchange Commission (SEC) under the Public Utility Holding Company Act of 1935, as amended (PUHCA). Our other principal subsidiaries are Cinergy Services, Inc. (Services) and Cinergy Investments, Inc. (Investments).
CG&E, an Ohio corporation organized in 1837, is a combination electric and gas public utility company that provides service in the southwestern portion of Ohio and, through ULH&P, in nearby areas of Kentucky. CG&E is responsible for the majority of our power marketing and trading activity. CG&E’s principal subsidiary, ULH&P, a Kentucky corporation organized in 1901, provides electric and gas service in northern Kentucky.
PSI, an Indiana corporation organized in 1942, is a vertically integrated and regulated electric utility that provides service in north central, central, and southern Indiana.
The following table presents further information related to the operations of our domestic utility companies CG&E, PSI, and ULH&P (our utility operating companies):
Principal Line(s) of Business
CG&E and subsidiaries
• Generation, transmission, distribution, and sale of electricity
• Sale and/or transportation of natural gas
• Electric commodity marketing and trading operations
PSI
• Generation, transmission, distribution, and sale of electricity
ULH&P(1)
• Transmission, distribution, and sale of electricity
• Sale and transportation of natural gas
(1)
See Note 19 for further discussion of the possible transfer of generation assets.
Services is a service company that provides our subsidiaries with a variety of centralized administrative, management, and support services. Investments holds most of our non-regulated, energy-related businesses and investments, including natural gas marketing and trading operations (which are primarily conducted through Cinergy Marketing & Trading, LP (Marketing & Trading), one of its subsidiaries).
We conduct operations through our subsidiaries and manage our businesses through the following three reportable segments:
• Commercial Business Unit (Commercial);
• Regulated Business Unit (Regulated); and
• Power Technology and Infrastructure Services Business Unit (Power Technology and Infrastructure).
See Note 16 for further discussion of our reportable segments.
(b) Presentation
Management makes estimates and assumptions when preparing financial statements under generally accepted accounting principles (GAAP). Actual results could differ, as these estimates and assumptions involve judgment about future events or performance. These estimates and assumptions affect various matters, including:
• the reported amounts of assets and liabilities in our Balance Sheets at the dates of the financial statements;
• the disclosure of contingent assets and liabilities at the dates of the financial statements; and
• the reported amounts of revenues and expenses in our Statements of Income during the reporting periods.
Additionally, we have reclassified certain prior-year amounts in the financial statements of Cinergy, CG&E, PSI, and ULH&P to conform to current presentation.
We use three different methods to report investments in subsidiaries or other companies: the consolidation method; the equity method; and the cost method.
(i) Consolidation Method
For traditional operating entities, we use the consolidation method when we own a majority of the voting stock of or have the ability to control a subsidiary. For variable interest entities (VIE) (discussed further in Note 3), we use the consolidation method when we anticipate absorbing a majority of the losses or receiving a majority of the returns of an entity, should they occur. We eliminate all significant intercompany transactions when we consolidate these accounts. Our consolidated financial statements include the accounts of Cinergy, CG&E, and PSI, and their wholly-owned subsidiaries.
(ii) Equity Method
We use the equity method to report investments, joint ventures, partnerships, subsidiaries, and affiliated companies in which we do not have control, but have the ability to exercise influence over operating and financial policies (generally, 20 percent to 50 percent ownership). Under the equity method we report:
• our investment in the entity as Investments in unconsolidated subsidiaries in our Balance Sheets; and
• our percentage share of the earnings from the entity as Equity in earnings of unconsolidated subsidiaries in our Statements of Income.
(iii) Cost Method
We use the cost method to report investments, joint ventures, partnerships, subsidiaries, and affiliated companies in which we do not have control and are unable to exercise significant influence over operating and financial policies (generally, up to 20 percent ownership). Under the cost method we report our investments in the entity as Other investments in our Balance Sheets.
(c) Regulation
Our utility operating companies and certain of our non-utility subsidiaries must comply with the rules prescribed by the SEC under the PUHCA. Our utility operating companies must also comply with the rules prescribed by the Federal Energy Regulatory Commission (FERC) and the applicable state utility commissions of Ohio, Indiana, and Kentucky.
Our utility operating companies use the same accounting policies and practices for financial reporting purposes as non-regulated companies under GAAP. However, sometimes actions by the FERC and the state utility commissions result in accounting treatment different from that used by non-regulated companies. When this occurs, we apply the provisions of Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. 71, Accounting for the Effects of Certain Types of Regulation (Statement 71). In accordance with Statement 71, we record regulatory assets and liabilities (expenses deferred for future recovery from customers or amounts provided in current rates to cover costs to be incurred in the future, respectively) on our Balance Sheets.
The state of Ohio passed comprehensive electric deregulation legislation in 1999, and in 2000, the Public Utilities Commission of Ohio (PUCO) approved a stipulation agreement relating to CG&E’s transition plan creating a Regulatory Transition Charge (RTC) designed to recover CG&E’s generation-related regulatory assets and transition costs over a ten-year period beginning January 1, 2001. Accordingly, application of Statement 71 was discontinued for the generation portion of CG&E’s business and Statement of Financial Accounting Standards No. 101, Regulated Enterprises - Accounting for the Discontinuation of Application of FASB Statement No. 71, was applied. Excluding CG&E’s deregulated generation-related assets and liabilities, as of December 31, 2004, CG&E, PSI, and ULH&P continue to meet the criteria of Statement 71. However, to the extent Indiana or Kentucky implements deregulation legislation, the application of Statement 71 will need to be reviewed. Based on our utility operating companies’ current regulatory orders and the regulatory environment in which they currently operate, the recovery of regulatory assets recognized in the accompanying Balance Sheets as of December 31, 2004, is probable. For a further discussion of CG&E’s regulatory developments see Note 11(b)(iii). For a further discussion of PSI’s regulatory developments see Notes 11(b)(i) and 11(b)(ii).
Our regulatory assets, liabilities, and amounts authorized for recovery through regulatory orders at December 31, 2004, and 2003, were as follows:
(1)
Includes $10 million at December 31, 2004, and $16 million at December 31, 2003, related to ULH&P’s regulatory assets. Of these amounts, $9 million at December 31, 2004, and $15 million at December 31, 2003, have been authorized for recovery. Includes $(30) million and $(27) million of regulatory liabilities at December 31, 2004 and 2003, respectively, related to ULH&P.
(2)
The various regulatory commissions overseeing the regulated business operations of our utility operating companies regulate income tax provisions reflected in customer rates. In accordance with the provisions of Statement 71, we have recorded net regulatory assets for CG&E, PSI, and ULH&P.
(3)
PSI reached an agreement with Dynegy, Inc. to purchase the remainder of its 25-year contract for coal gasification services. In accordance with an order from the Indiana Utility Regulatory Commission (IURC), PSI began recovering this asset over an 18-year period that commenced upon the termination of the gas services agreement in 2000.
(4)
Regulatory assets earning a return at December 31, 2004.
(5)
In August 2000, CG&E’s deregulation transition plan was approved. Effective January 1, 2001, a RTC went into effect and provides for recovery of all then existing generation-related regulatory assets and various transition costs over a ten-year period. Because a separate charge provides for recovery, these assets were aggregated and are included as a single amount in this presentation. The classification of all transmission and distribution related regulatory assets has remained the same.
(6)
In November 2004, CG&E’s rate stabilization plan (RSP) was approved by the PUCO. CG&E will have the ability to defer certain capital-related distribution costs from July 1, 2004 through December 31, 2005 with recovery from non-residential customers to be provided through a rider from January 1, 2006 through December 31, 2010.
(7)
At December 31, 2004, these amounts were being recovered through rates charged to customers over remaining periods ranging from 1 to 60 years for CG&E, 1 to 51 years for PSI, and 1 to 16 years for ULH&P.
(8)
Represents amounts received for anticipated future removal and retirement costs of regulated property, plant, and equipment that do not represent legal obligations pursuant to Statement of Financial Accounting Standards No. 143, Accounting for Asset Retirement Obligations (Statement 143). See Note 1(j) for a further discussion of Statement 143.
(9)
For PSI, this amount includes $38 million that is not yet authorized for recovery and is not earning a return at December 31, 2004.
(d) Revenue Recognition
(i) Utility Revenues
Our utility operating companies record Operating Revenues for electric and gas service when delivered to customers. Customers are billed throughout the month as both gas and electric meters are read. We recognize revenues for retail energy sales that have not yet been billed, but where gas or electricity has been consumed. This is termed “unbilled revenues” and is a widely recognized and accepted practice for utilities. In making our estimates of unbilled revenues, we use systems that consider various factors, including weather, in our calculation of retail customer consumption at the end of each month. Given the use of these systems and the fact that customers are billed monthly, we believe it is unlikely that materially different results will occur in future periods when these amounts are subsequently billed.
The amount of unbilled revenues for Cinergy, CG&E, PSI, and ULH&P as of December 31, 2004, 2003, and 2002 were as follows:
(ii) Energy Marketing and Trading Revenues
We market and trade electricity, natural gas, and other energy-related products. Many of the contracts associated with these products qualify as derivatives in accordance with Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (Statement 133), further discussed in (k)(i). We designate derivative transactions as either trading or non-trading at the time they are originated in accordance with Emerging Issues Task Force (EITF) Issue 02-3, Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities (EITF 02-3). Trading contracts are reported on a net basis and non-trading contracts are reported on a gross basis.
1. Net Reporting
Net reporting requires presentation of realized and unrealized gains and losses on trading derivatives on a net basis in Operating Revenues pursuant to the requirements of EITF 02-3, regardless of whether the transactions were settled physically. Energy derivatives involving frequent buying and selling with the objective of generating profits from differences in price are classified as trading and reported net.
2. Gross Reporting
Gross reporting requires presentation of sales contracts in Operating Revenues and purchase contracts in Fuel, emission allowances, and purchased power expense or Gas purchased expense. Non-trading derivatives typically involve physical delivery of the underlying commodity and are therefore generally presented on a gross basis.
Derivatives are classified as non-trading only when (a) the contracts involve the purchase of gas or electricity to serve our native load requirements (end-use customers within our utility operating companies’ franchise service territories), or (b) the contracts involve the sale of gas or electricity and we have the intent and projected ability to fulfill substantially all obligations from company-owned assets, which generally is limited to the sale of generation to third parties when it is not required to meet native load requirements.
(iii) Other Operating Revenues
Cinergy and CG&E recognize revenue from coal origination, which represents contract structuring and marketing of physical coal. These revenues are included in Other Operating Revenues on the Statements of Income. Other Operating Revenues for Cinergy also includes sales of synthetic fuel.
(e) Energy Purchases and Fuel Costs
The expenses associated with electric and gas services include:
• fuel used to generate electricity and the associated transportation costs;
• costs of emission allowances;
• electricity purchased from others; and
• natural gas purchased from others and the associated transportation costs.
These expenses are shown in the Statements of Income of Cinergy, CG&E, and PSI as Fuel, emission allowances, and purchased power expense and Gas purchased expense. These expenses are shown in ULH&P’s Statements of Income as Electricity purchased from parent company for resale expense and Gas purchased expense.
PSI utilizes a cost tracking recovery mechanism (commonly referred to as a fuel adjustment clause) that recovers retail and a portion of its wholesale fuel costs from customers. Indiana law limits the amount of fuel costs that PSI can recover to an amount that will not result in earning a return in excess of that allowed by the IURC. The fuel adjustment clause is calculated based on the estimated cost of fuel in the next three-month period, and is trued up after actual costs are known. PSI records any under-recovery or over-recovery resulting from the differences between estimated and actual costs as a deferred asset or liability until it is billed or refunded to its customers, at which point it is adjusted through fuel expense.
In addition to the fuel adjustment clause, PSI utilizes a purchased power tracking mechanism approved by the IURC for the recovery of costs related to certain specified purchases of power necessary to meet native load peak demand requirements to the extent such costs are not recovered through the existing fuel adjustment clause.
As part of the PUCO’s November 2004 approval of CG&E’s RSP, a cost tracking recovery mechanism was established to recover costs of retail fuel and emission allowances that exceed the amount originally included in the rates frozen in the CG&E transition plan. This mechanism was effective January 1, 2005 for non-residential customers and will be effective January 1, 2006 for residential customers. CG&E will begin utilizing a tracking mechanism approved by the PUCO for the recovery of system reliability capacity costs related to certain specified purchases of power. This mechanism was effective January 1, 2005 for non-residential customers and will be effective January 1, 2006 for residential customers. See Note 11(b)(iii) for additional information.
(f) Cash and Cash Equivalents
We define Cash and cash equivalents on our Balance Sheets and Statements of Cash Flows as investments with maturities of three months or less when acquired.
(g) Fuel, Emission Allowances, and Supplies
We maintain coal inventories for use in the production of electricity and emission allowances inventories for regulatory compliance purposes due to the production of electricity. These inventories are accounted for at the lower of cost or market, with cost being determined using the weighted-average method.
Prior to January 1, 2003, natural gas held in storage for our gas trading operations was accounted for at fair value. All other gas held in storage was accounted for at the lower of cost or market, cost being determined through the weighted-average method. Effective January 1, 2003, accounting for our gas trading operations’ gas held in storage was adjusted to the lower of cost or market method with a cumulative effect adjustment, as required by EITF 02-3. See (q)(iv) for a summary of the cumulative effect adjustments.
Materials and supplies inventory is accounted for on a weighted-average cost basis.
(h) Property, Plant, and Equipment
Property, Plant, and Equipment includes the utility and non-regulated business property and equipment that is in use, being held for future use, or under construction. We report our Property, Plant, and Equipment at its original cost, which includes:
• materials;
• contractor fees;
• salaries;
• payroll taxes;
• fringe benefits;
• financing costs of funds used during construction (described in (ii) and (iii)); and
• other miscellaneous amounts.
We capitalize costs for regulated property, plant, and equipment that are associated with the replacement or the addition of equipment that is considered a property unit. Property units are intended to describe an item or group of items. The cost of normal repairs and maintenance is expensed as incurred. On an annual basis, we perform major pre-planned maintenance activities on our generating units. These pre-planned activities are accounted for when incurred. When regulated property, plant, and equipment is retired, Cinergy charges the original cost, less salvage, to Accumulated depreciation and the cost of removal to Regulatory liabilities, which is consistent with the composite method of depreciation. See (j) for further information on accrued cost of removal. A gain or loss is recorded on the sale of regulated property, plant, and equipment if an entire operating unit, as defined by the FERC, is sold. A gain or loss is recorded on non-regulated property, plant, and equipment whenever there is a related sale or retirement.
(i) Depreciation
We determine the provisions for depreciation expense using the straight-line method. The depreciation rates are based on periodic studies of the estimated useful lives and the net cost to remove the properties. Inclusion of cost of removal in depreciation rates was discontinued for all non-regulated property beginning in 2003 as a result of adopting Statement 143. Our utility operating companies use composite depreciation rates. These rates are approved by the respective state utility commissions with respect to regulated property. The average depreciation rates for Property, Plant, and Equipment are presented in the following table.
(1)
The results of Cinergy also include amounts related to non-registrants.
In June 2004, PSI implemented new depreciation rates, as a result of changes in useful lives of production assets and an increased rate for cost of removal, that were approved in PSI’s latest retail rate case. The impact of this change in accounting estimate was an increase of approximately $18 million in Cinergy’s and PSI’s 2004 Depreciation expense. The prospective impact of this change in accounting estimate is expected to be an increase of approximately $30 million in annual Depreciation expense, which will be collected in revenues over that same period.
(ii) Allowance for Funds Used During Construction (AFUDC)
Our utility operating companies finance construction projects with borrowed funds and equity funds. Regulatory authorities allow us to record the costs of these funds as part of the cost of construction projects. AFUDC is calculated using a methodology authorized by the regulatory authorities.
The equity component of AFUDC, which is credited to Miscellaneous Income (Expense) - Net, for the years ended December 31, 2004, 2003, and 2002, was as follows:
The borrowed funds component of AFUDC, which is recorded on a pre-tax basis and is credited to Interest Expense, for the years ended December 31, 2004, 2003, and 2002, was as follows:
With the deregulation of CG&E’s generation assets, the AFUDC method is no longer used to capitalize the cost of funds used during generation-related construction at CG&E. See (iii) for a discussion of capitalized interest. The equity and borrowed funds components of AFUDC have decreased from 2004 as compared to 2003 and 2002. The majority of PSI’s projects are being recovered through a construction work in progress (CWIP) tracker. Once CWIP projects are approved and included in the CWIP tracking mechanism, the costs of funds are no longer accrued on the project.
(iii) Capitalized Interest
Cinergy capitalizes interest costs for non-regulated construction projects in accordance with Statement of Financial Accounting Standards No. 34, Capitalization of Interest Cost (Statement 34). The primary differences from AFUDC are that the Statement 34 methodology does not include a component for equity funds and does not emphasize short-term borrowings over long-term borrowings. Capitalized interest costs, which are recorded on a pre-tax basis, for the years ended December 31, 2004, 2003, and 2002, were as follows:
(i) Impairments
(i) Long-Lived Assets
In accordance with Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, we evaluate long-lived assets for impairment when events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. So long as an asset or group of assets is not held for sale, the determination of whether an impairment has occurred is based on an estimate of undiscounted future cash flows attributable to the assets, as compared with the carrying value of the assets. If an impairment has occurred, the amount of the impairment recognized is determined by estimating the fair value of the assets and recording a provision for an impairment loss if the carrying value is greater than the fair value. Once assets are classified as held for sale, the comparison of undiscounted cash flows to carrying value is disregarded and
an impairment loss is recognized for any amount by which the carrying value exceeds the fair value of the assets less cost to sell.
(ii) Unconsolidated Investments
We evaluate the recoverability of investments in unconsolidated subsidiaries when events or changes in circumstances indicate the carrying amount of the asset is other than temporarily impaired. An investment is considered impaired if the fair value of the investment is less than its carrying value. We only recognize an impairment loss when an impairment is considered to be other than temporary. We consider an impairment to be other than temporary when a forecasted recovery up to the investment’s carrying value is not expected for a reasonable period of time. We evaluate several factors, including but not limited to our intent and ability to hold the investment, the severity of the impairment, the duration of the impairment and the entity’s historical and projected financial performance, when determining whether or not an impairment is other than temporary. Once an investment is considered other than temporarily impaired and an impairment loss is recognized (as Miscellaneous Income (Expense)-Net), the carrying value of the investment is not adjusted for any subsequent recoveries in fair value. As of December 31, 2004, we do not have any material unrealized losses that are deemed to be temporary in nature. See Note 15(a) for the amount of impairment charges incurred during the year.
(j) Asset Retirement Obligations and Accrued Cost of Removal
In accordance with Statement 143, we recognize the fair value of legal obligations associated with the retirement or removal of long-lived assets at the time the obligations are incurred and can be reasonably estimated. The initial recognition of this liability is accompanied by a corresponding increase in property, plant, and equipment. Subsequent to the initial recognition, the liability is adjusted for any revisions to the expected value of the retirement obligation (with corresponding adjustments to property, plant, and equipment), and for accretion of the liability due to the passage of time (recognized as Operation and maintenance expense). Additional depreciation expense is recorded prospectively for any property, plant, and equipment increases.
We do not recognize liabilities for asset retirement obligations for which the fair value cannot be reasonably estimated. CG&E and PSI have asset retirement obligations associated with river structures at certain generating stations. However, the retirement date for these river structures cannot be reasonably estimated; therefore, the fair value of the associated liability currently cannot be estimated and no amounts are recognized in the financial statements.
CG&E’s transmission and distribution business, PSI, and ULH&P ratably accrue the estimated retirement and removal cost of rate regulated property, plant, and equipment when removal of the asset is considered likely, in accordance with established regulatory practices. The accrued, but not incurred, balance for these costs is classified as Regulatory liabilities, under Statement 71, as previously disclosed in (c). Effective with our adoption of Statement 143, on January 1, 2003, we do not accrue the estimated cost of removal when no legal obligation associated with retirement or removal exists for any of our non-regulated assets (including CG&E’s generation assets). See (q)(iv) for a summary of cumulative effect adjustments.
(k) Derivatives
We account for derivatives under Statement 133, which requires all derivatives, subject to certain exemptions, to be accounted for at fair value. Changes in a derivative’s fair value must be recognized currently in earnings unless specific hedge accounting criteria are met. Gains and losses on derivatives that qualify as hedges can (a) offset related fair value changes on the hedged item in the Statements of Income for fair value hedges; or (b) be recorded in other comprehensive income for cash flow hedges. To qualify for hedge accounting, derivatives must be designated as a hedge (for example, an offset of interest rate risks) and must be effective at reducing the risk associated with the hedged item. Accordingly, changes in the fair values or cash flows of instruments designated as hedges must be highly correlated with changes in the fair values or cash flows of the related hedged items.
(i) Energy Marketing and Trading
We account for all energy trading derivatives at fair value. These derivatives are shown in our Balance Sheets as Energy risk management assets and Energy risk management liabilities. Changes in a derivative’s fair value represent unrealized gains and losses and are recognized as revenues in our Statements of Income unless specific hedge accounting criteria are met.
Non-trading derivatives involve the physical delivery of energy and are therefore typically accounted for as accrual contracts, unless the contract does not qualify for the normal purchases and sales scope exception in Statement 133. Accrual contracts are not adjusted for changes in fair value.
Although we intend to settle accrual contracts with company-owned assets, occasionally we settle these contracts with purchases on the open trading markets. The cost of these purchases could be in excess of the associated revenues. We recognize the gains or losses on these transactions as delivery occurs. Open market purchases may occur for the following reasons:
• generating station outages;
• least-cost alternative;
• native load requirements; and
• extreme weather.
We value derivatives using end-of-the-period fair values, utilizing the following factors (as applicable):
• closing exchange prices (that is, closing prices for standardized electricity and natural gas products traded on an organized exchange, such as the New York Mercantile Exchange);
• broker-dealer and over-the-counter price quotations; and
• model pricing (which considers time value and historical volatility factors of electricity and natural gas).
In October 2002, the EITF reached a consensus in EITF 02-3 to rescind EITF Issue 98-10, Accounting for Contracts Involved in Energy Trading and Risk Management Activities (EITF 98-10). EITF 98-10 permitted non-derivative contracts to be accounted for at fair value if certain criteria were met. Effective with the adoption of EITF 02-3 on January 1, 2003, non-derivative contracts and natural gas held in storage that were previously accounted for at fair value were required to be accounted for on an accrual basis, with gains and losses on the transactions being recognized at the time the contract was settled. See (q)(iv) for a summary of cumulative effect adjustments.
As a response to this discontinuance of fair value accounting, in June 2003, Cinergy began designating derivatives as fair value hedges for certain volumes of our natural gas held in storage. Under this accounting election, changes in the fair value of both the derivative as well as the hedged item (the specified gas held in storage) are included in the Statements of Income. We assess the effectiveness of the derivatives in offsetting the change in fair value of the gas held in storage on a quarterly basis. Selected information on Cinergy’s hedge accounting activities was as follows:
(ii) Financial
In addition to energy marketing and trading, we use derivative financial instruments to manage exposure to fluctuations in interest rates. We use interest rate swaps (an agreement by two parties to exchange fixed-interest rate
cash flows for variable-interest rate cash flows) and treasury locks (an agreement that fixes the yield or price on a specific treasury security for a specific period, which we sometimes use in connection with the issuance of fixed rate debt). We account for such derivatives at fair value and assess the effectiveness of any such derivative used in hedging activities.
At December 31, 2004, the ineffectiveness of instruments that we have classified as cash flow hedges of variable-rate debt instruments was not material. Reclassification of unrealized gains or losses on cash flow hedges of debt instruments from Accumulated other comprehensive income (loss) occurs as interest is accrued on the debt instrument. The unrealized losses that will be reclassified as a charge to Interest Expense during the twelve-month period ending December 31, 2005, are not expected to be material.
(l) Intangible Assets
We adopted Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (Statement 142) in the first quarter of 2002. Under the provisions of Statement 142, goodwill and other intangible assets with indefinite lives are not amortized. Statement 142 requires that goodwill is assessed annually, or when circumstances indicate that the fair value of a reporting unit has declined significantly, by applying a fair-value-based test. This test is applied at the “reporting unit” level, which is not broader than the current business segments discussed in Note 16. Acquired intangible assets are separately recognized if the benefit of the intangible asset is obtained through contractual or other legal rights, or if the intangible asset can be sold, transferred, licensed, rented, or exchanged, regardless of intent to do so.
We finalized our transition impairment test in the fourth quarter of 2002 and recognized a non-cash impairment charge of approximately $11 million (net of tax) for goodwill related to certain of our international assets. This amount is reflected in Cinergy’s Statements of Income as a cumulative effect adjustment, net of tax. See (q)(iv) for a summary of cumulative effect adjustments.
(m) Income Taxes
Cinergy and its subsidiaries file a consolidated federal income tax return and combined/consolidated state and local tax returns in certain jurisdictions. Cinergy and its subsidiaries have an income tax allocation agreement, which conforms to the requirements of the PUHCA. The corporate taxable income method is used to allocate tax benefits to the subsidiaries whose investments or results of operations provide those tax benefits. Any tax liability not directly attributable to a specific subsidiary is allocated proportionately among the subsidiaries as required by the agreement.
Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes (Statement 109), requires an asset and liability approach for financial accounting and reporting of income taxes. The tax effects of differences between the financial reporting and tax basis of accounting are reported as Deferred income tax assets or liabilities in our Balance Sheets and are based on currently enacted income tax rates. We evaluate quarterly the realizability of our deferred tax assets by assessing our valuation allowance and adjusting the amount of such allowance, if necessary.
Investment tax credits, which have been used to reduce our federal income taxes payable, have been deferred for financial reporting purposes. These deferred investment tax credits are being amortized over the useful lives of the property to which they are related. For a further discussion of income taxes, see Note 10.
(n) Contingencies
In the normal course of business, Cinergy, CG&E, PSI, and ULH&P are subject to various regulatory actions, proceedings, and lawsuits related to environmental, tax, or other legal matters. We reserve for these potential contingencies when they are deemed probable and reasonably estimable liabilities. We believe that the amounts provided for in our financial statements are adequate. However, these amounts are estimates based upon assumptions involving judgment and therefore actual results could differ. For further discussion of contingencies, see Note 11.
(o) Pension and Other Postretirement Benefits
Cinergy provides benefits to retirees in the form of pension and other postretirement benefits. Our reported costs of providing these pension and other postretirement benefits are developed by actuarial valuations and are dependent upon numerous factors resulting from actual plan experience and assumptions of future experience. Changes made to the provisions of the plans may impact current and future pension costs. Pension costs associated with Cinergy’s defined benefit plans are impacted by employee demographics, the level of contributions we make to the plan, and earnings on plan assets. These pension costs may also be significantly affected by changes in key actuarial assumptions, including anticipated rates of return on plan assets and the discount rates used in determining the projected benefit obligation. Changes in pension obligations associated with the previously discussed factors are not immediately recognized as pension costs on the Statements of Income but are deferred and amortized in the future over the average remaining service period of active plan participants to the extent they exceed certain thresholds prescribed by Statement of Financial Accounting Standards No. 87, Employers’ Accounting for Pensions (Statement 87).
Other postretirement benefit costs are impacted by employee demographics, per capita claims costs, and health care cost trend rates and may also be affected by changes in key actuarial assumptions, including the discount rate used in determining the accumulated postretirement benefit obligation (APBO). Changes in postretirement benefit obligations associated with these factors are not immediately recognized as postretirement benefit costs but are deferred and amortized in the future over the average remaining service period of active plan participants to the extent they exceed certain thresholds prescribed by Statement of Financial Accounting Standards No. 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions (Statement 106).
Cinergy reviews and updates its actuarial assumptions for its pension and postretirement benefit plans on an annual basis, unless plan amendments or other significant events require earlier remeasurement at an interim period. For additional information on pension and other postretirement benefits, see Note 9.
(p) Stock-Based Compensation
In 2003, we prospectively adopted accounting for our stock-based compensation plans using the fair value recognition provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (Statement 123), as amended by Statement of Financial Accounting Standards No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure (Statement 148), for all employee awards granted or with terms modified on or after January 1, 2003. Prior to 2003, we had accounted for our stock-based compensation plans using the intrinsic value method under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25). See Note 2(c) for further information on our stock-based compensation plans. The impact on our Net Income and earnings per common share (EPS) if the fair value based method had been applied to all outstanding and unvested awards in each period was not material. In December 2004, the FASB issued a revision of Statement 123 entitled Share-Based Payment. See (q)(ii) for further information.
(q) Accounting Changes
(i) Consolidation of VIEs
In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities (Interpretation 46), which significantly changed the consolidation requirements for traditional special purpose entities (SPE) and certain other entities subject to its scope. This interpretation defines a VIE as (a) an entity that does not have sufficient equity to support its activities without additional financial support or (b) any entity that has equity investors that do not have substantive voting rights, do not absorb first dollar losses, or receive residual returns. These entities must be consolidated whenever Cinergy would be anticipated to absorb greater than 50 percent of the losses or receive greater than 50 percent of the returns.
In accordance with its two stage adoption guidance, we implemented Interpretation 46 for traditional SPEs on July 1, 2003, and for all other entities, including certain operating joint ventures, as of March 31, 2004. The consolidation of certain operating joint ventures as of March 31, 2004, did not have a material impact on our financial position or results of operations.
On July 1, 2003, Interpretation 46 required us to consolidate two SPEs that have individual power sale agreements with Central Maine Power Company (CMP). Further, we were no longer permitted to consolidate a trust that was established by Cinergy Corp. in 2001 to issue approximately $316 million of combined preferred trust securities and stock purchase contracts. Prior period financial statements were not restated for these changes. For further information on the accounting for these entities see Notes 3(a) and (b).
Cinergy has concluded that its accounts receivable sale facility, as discussed in Note 3(c), will remain unconsolidated since it involves transfers of financial assets to a qualifying SPE, which is exempted from consolidation by Interpretation 46 and Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (Statement 140).
(ii) Share-Based Payment
In December 2004, the FASB issued a replacement of Statement 123, Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (Statement 123R). This standard will require accounting for all stock-based compensation arrangements under the fair value method in addition to other provisions.
In 2003, we prospectively adopted accounting for our stock-based compensation plans using the fair value recognition provisions of Statement 123, as amended by Statement 148, for all employee awards granted or with terms modified on or after January 1, 2003. Therefore, the impact of implementation of Statement 123R on stock options within our stock-based compensation plans is not expected to be material. Statement 123R contains certain provisions that will modify the accounting for various stock-based compensation plans other than stock options. We are in the process of evaluating the impact of this new standard on these plans. Cinergy will adopt Statement 123R on July 1, 2005.
(iii) Income Taxes
In October 2004, the American Jobs Creation Act (AJCA) was signed into law. The AJCA includes a one-time deduction of 85 percent of certain foreign earnings that are repatriated, as defined in the AJCA. In December 2004, the FASB issued Staff Position 109-2, Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004. The staff position allows additional time for an entity to evaluate the effect of the legislation on its plan for repatriation of foreign earnings for purposes of applying Statement 109. Cinergy will complete its evaluation of the effects of the provision on its plan for repatriation of foreign earnings in 2005.
(iv) Cumulative Effect of Changes in Accounting Principles, Net of Tax
In 2003, Cinergy, CG&E, and PSI recognized Cumulative effect of changes in accounting principles, net of tax as a result of the reversal of accrued cost of removal for non-regulated generating assets in conjunction with the adoption of Statement 143 and the change in accounting for certain energy related contracts from fair value to accrual in accordance with the rescission of EITF 98-10. In 2002, Cinergy recognized a Cumulative effect of a change in accounting principle, net of tax loss as a result of the valuation and impairment of goodwill with the implementation of Statement 142. The following table summarizes these cumulative effect adjustments and their related tax effects.
(1)
The results of Cinergy also include amounts related to non-registrants.
(r) Translation of Foreign Currency
We translate the assets and liabilities of foreign subsidiaries, whose functional currency (generally, the local currency of the country in which the subsidiary is located) is not the United States dollar, using the appropriate exchange rate as of the end of the year. We translate income and expense items using the average exchange rate prevailing during the month the respective transaction occurs. We record translation gains and losses in Accumulated other comprehensive income (loss), which is a component of common stock equity. When a foreign subsidiary is sold, the cumulative translation gain or loss as of the date of sale is removed from Accumulated other comprehensive income (loss) and is recognized as a component of the gain or loss on the sale of the subsidiary in our Statements of Income.
(s) Related Party Transactions
CG&E, PSI, and ULH&P engage in related party transactions. These transactions, which are eliminated upon consolidation, are generally performed at cost and in accordance with the SEC regulations under the PUHCA and the applicable state and federal commission regulations. The Balance Sheets of our utility operating companies reflect amounts payable to and/or receivable from related parties as Accounts payable to affiliated companies and Accounts receivable from affiliated companies. The significant related party transactions are disclosed below.
(i) Services
Services provides our regulated and non-regulated subsidiaries with a variety of centralized administrative, management, and support services in accordance with agreements approved by the SEC under the PUHCA. The costs of these services are charged to our companies on a direct basis, or for general costs which cannot be directly attributed, based on predetermined allocation factors, including the following ratios:
• sales;
• electric peak load;
• number of employees;
• number of customers; and
• construction expenditures.
These costs were as follows for the years ended December 31, 2004, 2003, and 2002:
During 2002 and 2003, Cinergy Power Generation Services, LLC (Generation Services) supplied electric production-related construction, operation and maintenance services to certain of our subsidiaries pursuant to agreements approved by the SEC under the PUHCA. CG&E and subsidiaries received services from Generation Services in the amounts of $96 million and $104 million for the years ended December 31, 2003 and 2002, respectively. PSI received services in the amounts of $55 million and $58 million for the years ended December 31, 2003 and 2002, respectively. Effective January 1, 2004, these services are now provided by Services and/or directly by CG&E and PSI as all Generation Services employees were transferred to other affiliated corporations.
(ii) Purchased Energy
ULH&P purchases energy from CG&E pursuant to a contract effective January 1, 2002, which was approved by the FERC and the Kentucky Public Service Commission (KPSC). This five-year agreement is a negotiated fixed-rate contract with CG&E. ULH&P purchased energy from CG&E for resale in the amounts of $162 million, $155 million, and $160 million for the years ended December 31, 2004, 2003, and 2002, respectively. These amounts are reflected in the Statements of Income for ULH&P as Electricity purchased from parent company for resale. For information on the proposed transfer of generating assets to ULH&P and the effect it will have on purchased energy see Note 19.
PSI and CG&E purchase energy from each other under a federal and state approved joint operating agreement. These sales and purchases are reflected in the Statements of Income of PSI and CG&E as Electric operating revenues and Fuel, emission allowances, and purchased power expense and were as follows for the years ended December 31, 2004, 2003, and 2002:
(1) Includes intercompany purchases that are presented net in accordance with EITF 02-3.
To supplement native load requirements, CG&E and PSI have, from time to time, purchased peaking power from Cinergy Capital & Trading, Inc. (Capital & Trading), an indirect wholly-owned subsidiary of Cinergy Corp., under the terms of a wholesale market-based tariff. There were no purchases in 2004. For the year ended December 31, 2003, payments under this contract totaled approximately $5 million for CG&E. For the year ended December 31, 2002, payments under this contract for CG&E and PSI totaled approximately $27 million and $28 million, respectively. For PSI, certain of these amounts were deferred and have subsequently been recovered.
CG&E and PSI have an agreement with Marketing & Trading to purchase gas for certain gas-fired peaking plants. Purchases under this agreement were approximately $4 million, $6 million, and $9 million for CG&E and $37 million, $20 million, and $5 million for PSI for the years ended December 31, 2004, 2003, and 2002, respectively. The amounts are reflected in the Statements of Income of CG&E and PSI as Fuel, emission allowances, and purchased power expense.
(iii) Other
CG&E and ULH&P enter into various agreements with Marketing & Trading to manage their interstate pipeline transportation, storage capacity, and gas supply contracts. Under the terms of these agreements, Marketing & Trading is obligated to deliver natural gas to meet CG&E’s and ULH&P’s requirements. Payments under these agreements for the years ended December 31, 2004, 2003 and 2002 were approximately $480 million, $413 million and $40 million for CG&E and subsidiaries, and $79 million, $78 million and $7 million for ULH&P. These amounts are recorded in the Statements of Income for CG&E and ULH&P as Gas purchased expense. Certain of these amounts for CG&E and ULH&P have been deferred for future recovery. In addition, certain of these amounts for CG&E are presented net in Gas operating revenues in accordance with EITF 02-3.
In 2004, CG&E and PSI purchased emission allowances from each other under a federal and state approved joint operating agreement. These purchases, which totaled approximately $11 million and $36 million for CG&E and PSI, respectively, are reflected in the emission allowances inventories of both CG&E and PSI.
In February 2003, PSI acquired gas-fired peaking plants in Henry County, Indiana and Butler County, Ohio from two non-regulated affiliates. For a further discussion on the transfer of these generating assets see Note 19.
Cinergy Corp., Services, and our utility operating companies participate in a money pool arrangement to better manage cash and working capital requirements. These amounts are reflected in Notes payable to affiliated companies and Notes receivable from affiliated companies on the Balance Sheets of our utility operating companies. For a further discussion on the money pool agreement see Note 5.
2. Common Stock
(a) Changes In Common Stock Outstanding
The following table reflects information related to shares of Cinergy Corp. common stock issued for stock-based plans.
(1)
Plan does not contain an authorization limit. The number of shares presented reflects amounts registered with the SEC as of December 31, 2004.
(2)
Shares available exclude the number of shares to be issued upon exercise of outstanding options, warrants, and rights.
We retired 829,575 shares of common stock in 2004, 519,976 shares in 2003, and 422,908 shares in 2002, mainly representing shares tendered as payment for the exercise of previously granted stock options.
In February 2002, Cinergy Corp. issued 6.5 million shares of common stock with net proceeds of approximately $200 million which were used to reduce short-term debt and for other general corporate purposes.
In January 2003, Cinergy Corp. filed a registration statement with the SEC with respect to the issuance of common stock, preferred stock, and other securities in an aggregate offering amount of $750 million. In February 2003, Cinergy sold 5.7 million shares of Cinergy Corp. common stock with net proceeds of approximately $175 million under this registration statement. The net proceeds from the transaction were used to reduce short-term debt of Cinergy Corp. and for other general corporate purposes. In December 2004, Cinergy Corp. issued 6.1 million shares of common stock with net proceeds of approximately $247 million, which were used to reduce short-term debt.
In January and February 2005, Cinergy Corp. issued a total of 9.2 million shares of common stock pursuant to certain stock purchase contracts that were issued as a component of combined securities in December 2001. Net proceeds from the transaction of approximately $316 million were used to reduce short-term debt. See Note 3(b) for further discussion of the securities.
Cinergy Corp. owns all of the common stock of CG&E and PSI. All of ULH&P’s common stock is held by CG&E.
(b) Dividend Restrictions
Cinergy Corp.’s ability to pay dividends to holders of its common stock is principally dependent on the ability of CG&E and PSI to pay Cinergy Corp. dividends on their common stock. Cinergy Corp., CG&E, and PSI cannot pay dividends on their common stock if their respective preferred stock dividends or preferred trust dividends are in arrears. The amount of common stock dividends that each company can pay is also limited by certain capitalization and earnings requirements under CG&E’s and PSI’s credit instruments. Currently, these requirements do not impact the ability of either company to pay dividends on its common stock.
(c) Stock-based Compensation Plans
We currently have the following stock-based compensation plans:
• LTIP;
• SOP;
• Employee Stock Purchase and Savings Plan;
• UK Sharesave Scheme;
• Retirement Plan for Directors;
• Directors’ Equity Compensation Plan;
• Directors’ Deferred Compensation Plan;
• 401(k) Plans; and
• 401(k) Excess Plan.
The LTIP, the SOP, the Employee Stock Purchase and Savings Plan, 401(k) Plans, and the 401(k) Excess Plan are discussed below. The activity in 2004, 2003, and 2002 for the remaining stock-based compensation plans was not significant.
In 2003, we prospectively adopted accounting for our stock-based compensation plans using the fair value recognition provisions of Statement 123, as amended by Statement 148, for all employee awards granted or with terms modified on or after January 1, 2003. Prior to 2003, we had accounted for our stock-based compensation plans using the intrinsic value method under APB 25. See Note 1(p) for additional information on costs we recognized related to stock-based compensation plans. Effective July 1, 2005, Cinergy will adopt Statement 123R. See Note 1(q)(ii) for additional information regarding this new accounting standard.
(i) LTIP
Under this plan, certain key employees may be granted incentive and non-qualified stock options, stock appreciation rights (SARs), restricted stock, dividend equivalents, phantom stock, the opportunity to earn performance-based shares and certain other stock-based awards. Stock options are granted to participants with an option price equal to or greater than the fair market value on the grant date, and generally with a vesting period of three years. The vesting period begins on the grant date and all options expire within 10 years from that date.
Historically, the performance-based shares have been paid 100 percent in the form of common stock. In order to maintain market competitiveness with respect to the form of LTIP awards and to ensure continued compliance with internal guidelines on common share dilution, in 2003, the Compensation Committee of the Cinergy Corp. Board of Directors approved the future payment of performance-based share awards 50 percent in common stock and 50 percent in cash. As a result, the expected cash payout portion of the performance shares is reported in Current Liabilities - Other and Non-Current Liabilities - Other.
Entitlement to performance-based shares is based on Cinergy’s total shareholder return (TSR) over designated Cycles as measured against a pre-defined peer group. Target grants of performance-based shares were made for the following Cycles:
Participants may earn additional performance shares if Cinergy’s TSR exceeds that of the 55th percentile of the TSR of its peer group. For the three-year performance period ended December 31, 2004 (Cycle VI), approximately 634,000 shares (including dividend equivalent shares) were earned, based on our relative TSR.
(ii) SOP
The SOP is designed to align executive compensation with shareholder interests. Under the SOP, incentive and non-qualified stock options, SARs, and SARs in tandem with stock options may be granted to key employees, officers, and outside directors. The activity under this plan has predominantly consisted of the grant of stock options. Options are granted with an option price equal to the fair market value of the shares on the grant date. Options generally vest over five years at a rate of 20 percent per year, beginning on the grant date, and expire 10 years from the grant date. As of October 2004, no additional incentive stock options may be granted under the plan.
(iii) Employee Stock Purchase and Savings Plan
The Employee Stock Purchase and Savings Plan allows essentially all full-time, regular employees to purchase shares of common stock pursuant to a stock option feature. The last offering period began May 1, 2001, and ended June 30, 2003, with 168,101 shares purchased and the remaining cash distributed to the respective participants. The purchase price for all shares under this offering was $32.78.
Activity for 2004, 2003, and 2002 for the LTIP, SOP, and Employee Stock Purchase and Savings Plan is summarized as follows:
(1)
Shares were not offered after June 30, 2003.
(2)
Options were not granted under the SOP during 2004, 2003, or 2002.
(3)
The options under the Employee Stock Purchase and Savings Plan are generally only exercisable at the end of the offering period.
The weighted average fair value of options granted under the LTIP was $5.65 in 2004, $4.96 in 2003, and $4.95 in 2002. The fair values of options granted were estimated as of the grant date using the Black-Scholes option-pricing model and the following assumptions:
Price ranges, along with certain other information, for options outstanding under the combined LTIP and SOP plans at December 31, 2004, were as follows:
(iv) 401(k) Plans
We sponsor 401(k) employee retirement plans that cover substantially all United States employees. Employees can contribute up to 50 percent of pre-tax base salary (subject to Internal Revenue Service (IRS) limits) and up to 15 percent of after-tax base salary. We make matching contributions to these plans in the form of Cinergy Corp. common stock, contributing 100 percent of the first three percent of an employee’s pre-tax contributions plus 50 percent of the next two percent of an employee’s pre-tax contributions, and we have the discretion to make incentive matching contributions based on Cinergy’s net income. Employees are immediately vested in both their contributions and our matching contributions.
Cinergy’s, CG&E’s, and PSI’s matching contributions for the years ended December 31, 2004, 2003, and 2002 were as follows:
(1)
The results of Cinergy also include amounts related to non-registrants.
Effective January 1, 2003, each Cinergy employee whose pension benefit is determined using a cash balance formula is also eligible to receive an annual deferred profit sharing contribution, calculated as a percentage of that employee’s total pension eligible earnings. The deferred profit sharing contribution made by Cinergy is based on the corporate net income performance level for the year, and is made to the 401(k) plans in the form of Cinergy Corp. common stock. Each year’s contribution must remain invested in Cinergy Corp. common stock for a minimum of three years, or until an employee reaches age 50. Employees age 50 or older may transfer their benefit from Cinergy Corp. common stock into another investment option offered under our 401(k) plans. Employees vest in their benefit upon reaching three years of service, or immediately upon reaching age 65 while employed. Cinergy has recorded approximately $2.4 million and $1.5 million, respectively, of profit sharing contribution costs for the years ended December 31, 2004 and December 31, 2003.
(v) 401(k) Excess Plan
The 401(k) Excess Plan is a non-qualified deferred compensation plan for a select group of Cinergy management and other highly compensated employees. It is a means by which these employees can defer additional compensation, and receive company matching contributions, provided they have already contributed the maximum amount (pursuant to the anti-discrimination rules for highly compensated employees) under the qualified 401(k) Plans. All funds deferred are held in a rabbi trust administered by an independent trustee.
3. Variable Interest Entities
(a) Power Sale SPEs
In accordance with Interpretation 46, we consolidate two SPEs that have individual power sale agreements with CMP for approximately 45 megawatts (MW) of capacity, ending in 2009, and 35 MW of capacity, ending in 2016. In addition, these SPEs have individual power purchase agreements with Capital & Trading to supply the power. Capital & Trading also provides various services, including certain credit support facilities. Upon the initial consolidation of these two SPEs on July 1, 2003, approximately $239 million of notes receivable, $225 million of non-recourse debt, and miscellaneous other assets and liabilities were included on Cinergy’s Balance Sheets. The debt was incurred by the SPEs to finance the buyout of the existing power contracts that CMP held with the former suppliers. The cash flows from the notes receivable are designed to repay the debt. Notes 4 and 8 provide additional information regarding the debt and the notes receivable, respectively.
(b) Preferred Trust Securities
In December 2001, Cinergy Corp. issued approximately $316 million notional amount of combined securities consisting of (a) 6.9 percent preferred trust securities, due February 2007, and (b) stock purchase contracts obligating the holders to purchase between 9.2 and 10.8 million shares of Cinergy Corp. common stock by February 2005. A $50 preferred trust security and stock purchase contract were sold together as a single security unit (Unit). The preferred trust securities were issued through a trust whose common stock is 100 percent owned by Cinergy Corp. The stock purchase contracts were issued directly by Cinergy Corp. The trust loaned the proceeds from the issuance of the securities to Cinergy Corp. in exchange for a note payable to the trust that was eliminated in consolidation. The proceeds of $306 million, which is net of approximately $10 million of issuance costs, were used to pay down Cinergy Corp.’s short-term indebtedness. In January and February 2005, certain holders settled the stock purchase contracts early and elected to remove the units from the remarketing. In February 2005, the remaining preferred trust securities were successfully remarketed and the dividend rate was reset at 6.9 percent. The preferred trust securities will mature in February 2007. To settle the stock purchase contracts, Cinergy Corp. issued 9.2 million shares of common stock at the ceiling price of $34.40 per share as the market price of the stock exceeded the ceiling price of the contract. Net proceeds of approximately $316 million were used to repay short-term indebtedness.
Each Unit continues to receive quarterly cash payments of 6.9 percent per annum of the notional amount, which represents a preferred trust security dividend. Each Unit received quarterly cash payments of 2.6 percent per annum of the notional amount, which represented principal and interest on the stock purchase contracts. These payments ceased upon delivery of the shares in January and February 2005. The trust’s ability to pay dividends on the preferred trust securities is solely dependent on its receipt of interest payments from Cinergy Corp. on the note payable. However, Cinergy Corp. has fully and unconditionally guaranteed the preferred trust securities.
As of July 1, 2003, we no longer consolidate the trust that was established to issue the preferred trust securities. The preferred trust securities are no longer included in Cinergy Corp.’s Balance Sheets. In addition, the note payable owed to the trust, which has a current carrying value of $322 million, is included in Long-term debt.
(c) Sales of Accounts Receivable
In February 2002, CG&E, PSI, and ULH&P entered into an agreement to sell certain of their accounts receivable and related collections. Cinergy Corp. formed Cinergy Receivables Company, LLC (Cinergy Receivables) to purchase, on a revolving basis, nearly all of the retail accounts receivable and related collections of CG&E, PSI, and ULH&P. Cinergy Corp. does not consolidate Cinergy Receivables since it meets the requirements to be accounted for as a qualifying SPE. The transfers of receivables are accounted for as sales, pursuant to Statement 140.
The proceeds obtained from the sales of receivables are largely cash but do include a subordinated note from Cinergy Receivables for a portion of the purchase price (typically approximates 25 percent of the total proceeds). The note is subordinate to senior loans that Cinergy Receivables obtains from commercial paper conduits controlled by unrelated financial institutions. Cinergy Receivables provides credit enhancement related to senior loans in the form of over-collateralization of the purchased receivables. However, the over-collateralization is calculated monthly and does not extend to the entire pool of receivables held by Cinergy Receivables at any point in time. As such, these senior loans do not have recourse to all assets of Cinergy Receivables. These loans provide the cash portion of the proceeds paid to CG&E, PSI, and ULH&P.
This subordinated note is a retained interest (right to receive a specified portion of cash flows from the sold assets) under Statement 140 and is classified within Notes receivable from affiliated companies in the accompanying Balance Sheets of CG&E, PSI, and ULH&P and is classified within Notes receivable on Cinergy Corp.’s Balance Sheets. In addition, Cinergy Corp.’s investment in Cinergy Receivables constitutes a purchased beneficial interest (purchased right to receive specified cash flows, in our case residual cash flows), which is subordinate to the retained interests held by CG&E, PSI, and ULH&P. The carrying values of the retained interests are determined by allocating the carrying value of the receivables between the assets sold and the interests retained based on relative fair value. The key assumptions in estimating fair value are credit losses and selection of discount rates. Because (a) the receivables generally turn in less than two months, (b) credit losses are reasonably predictable due to each
company’s broad customer base and lack of significant concentration, and (c) the purchased beneficial interest is subordinate to all retained interests and thus would absorb losses first, the allocated bases of the subordinated notes are not materially different than their face value. Interest accrues to CG&E, PSI, and ULH&P on the retained interests using the accretable yield method, which generally approximates the stated rate on the notes since the allocated basis and the face value are nearly equivalent. Cinergy Corp. records income from Cinergy Receivables in a similar manner. We record an impairment charge against the carrying value of both the retained interests and purchased beneficial interest whenever we determine that an other-than-temporary impairment has occurred (which is unlikely unless credit losses on the receivables far exceed the anticipated level).
The key assumptions used in measuring the retained interests are as follows (all amounts are averages of the assumptions used in sales during the period):
(1) Receivables at each month-end divided by annualized sales for the month.
The hypothetical effect on the fair value of the retained interests assuming both a 10 percent and 20 percent unfavorable variation in credit losses or discount rates is not material due to the short turnover of receivables and historically low credit loss history.
CG&E retains servicing responsibilities for its role as a collection agent on the amounts due on the sold receivables. However, Cinergy Receivables assumes the risk of collection on the purchased receivables without recourse to CG&E, PSI, and ULH&P in the event of a loss. While no direct recourse to CG&E, PSI, and ULH&P exists, these entities risk loss in the event collections are not sufficient to allow for full recovery of their retained interests. No servicing asset or liability is recorded since the servicing fee paid to CG&E approximates a market rate.
The following table shows the gross and net receivables sold, retained interests, purchased beneficial interest, sales, and cash flows during the periods ending December 31, 2004 and 2003.
A decline in the long-term senior unsecured credit ratings of CG&E, PSI, or ULH&P below investment grade would result in a termination of the sale program and discontinuance of future sales of receivables, and could prevent Cinergy Receivables from borrowing additional funds from commercial paper conduits.
(d) Other
Cinergy also holds interests in several joint ventures, primarily engaged in cogeneration and energy efficiency operations, that are considered VIEs which do not require consolidation. Our exposure to loss from our involvement with these entities is not material.
4. Long-Term Debt
Refer to the Statements of Capitalization for detailed information for Cinergy’s, CG&E’s, PSI’s, and ULH&P’s long-term debt.
In March 2003, PSI borrowed the proceeds from the Indiana Development Finance Authority’s issuance of $35 million of its Environmental Refunding Revenue Bonds, Series 2003, due April 1, 2022. Interest was initially set at 1.05 percent and resets every 35 days by auction. Because the holders cannot tender the bonds for purchase by the issuer while the Bonds are in the auction rate mode, PSI’s obligation is classified as Long-term debt. Later in March 2003, the proceeds from this borrowing plus the interest income earned were used to cause the refunding of the $35 million principal amount outstanding of the City of Princeton, Indiana Pollution Control Revenue Refunding Bonds, 1997 Series.
In April 2003, PSI redeemed $26.8 million of the following Series A, Medium-term Notes:
In June 2003, CG&E issued $200 million principal amount of its 5 3/8% 2003 Series B Debentures due June 15, 2033 (effective interest rate of 5.66 percent). Proceeds from this issuance were used for general corporate purposes, including the funding of capital expenditures related to construction projects and environmental compliance initiatives, and the repayment of outstanding indebtedness.
Also, in June 2003, CG&E modified existing debt resulting in a $200 million principal amount 5.40% 2003 Series A Debenture with a 30-year maturity. The effective interest rate is 6.90 percent.
In June 2003, CG&E also redeemed its $100 million 8.28% Junior Subordinated Debentures due July 1, 2025.
Cinergy adopted Interpretation 46 on July 1, 2003, as discussed in Note 1(q)(i). The adoption of this new accounting principle had the following effects on long-term debt:
• Cinergy no longer consolidates the trust that held Company obligated, mandatorily redeemable, preferred trust securities of subsidiary, holding solely debt securities of the company. This resulted in the removal of these securities from our 2003 Balance Sheet and the addition to long-term debt of a $319 million (net of discount) note payable that Cinergy Corp. owes to the trust.
• Cinergy consolidated two SPEs effective July 1, 2003. As a result, Cinergy has approximately $200 million of additional non-recourse debt as of December 31, 2004, comprised of two separate notes.
The first note, with a December 31, 2004 balance of $93 million bears an interest rate of 7.81 percent and matures in June 2009. The second note, with a December 31, 2004 balance of $107 million, bears an interest rate of 9.23 percent and matures in November 2016.
In September 2003, PSI redeemed $56 million of its 5.93% Series B, Medium-term Notes at maturity.
In September 2003, PSI issued $400 million principal amount of its 5.00% Debentures due September 15, 2013 (effective interest rate of 5.20 percent). Proceeds from this issuance were used for the early redemption at par of two subordinated promissory notes to Cinergy Corp. totaling $376 million, issued as consideration for two gas fired electric peaking facilities transferred from Cinergy Corp. to PSI in early 2003. The remaining proceeds were used
to reduce short-term indebtedness associated with general corporate purposes including funding capital expenditures related to construction projects and environmental compliance initiatives.
In October 2003, CG&E redeemed its $265.5 million First Mortgage Bonds, 7.20% due October 1, 2023.
In December 2003, ULH&P redeemed $20 million of its 6.11% Senior Debentures at maturity.
In February 2004, CG&E repaid at maturity $110 million of its 6.45% First Mortgage Bonds.
In April 2004, Cinergy Corp. repaid at maturity $200 million of its 6.125% Debentures.
In September 2004, Cinergy Corp. repaid at maturity $500 million of its 6.25% Debentures.
In November 2004, CG&E borrowed the proceeds from the Ohio Air Quality Development Authority’s issuance of $47 million principal amount of its State of Ohio Air Quality Development Revenue Bonds 2004 Series A and $47 million principal amount of its State of Ohio Air Quality Development Revenue Bonds 2004 Series B (for loans totaling $94 million), both due November 1, 2039. Payment of principal and interest on the Bonds when due is insured by separate bond insurance policies issued by XL Capital Assurance. The initial interest rate for both Series A and Series B was 1.92%. The interest rates on Series A and Series B were initially reset on January 5, 2005 and January 12, 2005, respectively, and then every 35 days by auction thereafter. Because the holders cannot tender the Bonds for purchase by the issuer while the Bonds are in the auction rate mode, these debt obligations are classified as Long-term debt. CG&E is using the proceeds from these borrowings to assist in financing its portion of the costs of acquiring, constructing and installing certain solid waste disposal facilities comprising air quality facilities at Units 7 and 8 at CG&E’s majority-owned Miami Fort Generating Station (Miami Fort Station).
In December 2004, PSI borrowed the proceeds from the Indiana Development Finance Authority’s issuance of $77 million principal amount of its Environmental Revenue Bonds, Series 2004B and $77 million principal amount of its Environmental Revenue Bonds, Series 2004C, both due December 1, 2039 (for loans totaling $154 million). Payment of principal and interest on the Bonds when due is insured by separate bond insurance policies issued by XL Capital Assurance. The initial interest rate for Series 2004B was 1.80% and for Series 2004C was 1.85%. The interest rates on both Series 2004B and Series 2004C were initially reset on January 11, 2005 and then every 35 days by auction thereafter. Because the holders cannot tender the Bonds for purchase by the issuer while the Bonds are in the auction rate mode, these debt obligations are classified as Long-term debt. PSI is using the proceeds from these borrowings to assist in the acquisition and construction of solid waste disposal facilities located at various generating stations in Indiana.
In December 2004, ULH&P issued $40 million principal amount of its 5.00% Debentures due December 15, 2014 (effective interest rate of 5.26%). Proceeds from this issuance were used for general corporate purposes and the repayment of outstanding indebtedness.
The following table reflects the long-term debt maturities excluding any redemptions due to the exercise of call provisions or capital lease obligations. Callable means we have the right to buy back a given security from the holder at a specified price before maturity.
Long-term Debt Maturities
(1) The results of Cinergy also include amounts related to non-registrants.
(2) CG&E and subsidiaries includes long-term debt with put provisions of $150 million in 2005. PSI includes long-term debt with put provisions of $50 million in 2005.
Maintenance and replacement fund provisions contained in PSI’s first mortgage bond indenture require: (1) cash payments, (2) bond retirements, or (3) pledges of unfunded property additions each year based on an amount related to PSI’s net revenues.
CG&E’s transmission and distribution assets of approximately $2.8 billion are subject to the lien of its first mortgage bond indenture. The utility property of PSI is also subject to the lien of its first mortgage bond indenture.
As discussed previously, CG&E and PSI periodically borrowed proceeds from the issuance of tax exempt bonds for the purpose of funding the acquisition and construction of solid waste disposal facilities located at various generating stations in Indiana and Ohio. Because some of these facilities have not commenced construction and others are not yet complete, proceeds from the borrowings have been placed in escrow with a trustee and may be drawn upon only as facilities are built and qualified costs incurred. In the event any of the proceeds are not drawn, CG&E and PSI would eventually be required to return the unused proceeds to bondholders. CG&E and PSI expect to draw down all of the proceeds over the next three years.
5. Notes Payable and Other Short-term Obligations
Short-term obligations may include:
• short-term notes;
• variable rate pollution control notes;
• commercial paper; and
• money pool.
Short-term Notes Short-term borrowings mature within one year from the date of issuance. We primarily use unsecured revolving lines of credit and the sale of commercial paper for short-term borrowings. A portion of Cinergy Corp.’s revolving lines is used to provide credit support for commercial paper and letters of credit. When revolving lines are reserved for commercial paper or backing letters of credit, they are not available for additional borrowings. The fees paid to secure short-term borrowings were immaterial during each of the years ended December 31, 2004, 2003, and 2002.
At December 31, 2004, Cinergy Corp. had $1.3 billion remaining unused and available capacity relating to its $2 billion revolving credit facilities. These revolving credit facilities include the following:
(1) In April 2004, Cinergy Corp. successfully placed a $500 million 364-day senior unsecured revolving credit facility which replaced the $600 million 364-day senior unsecured revolving credit facility that expired in April 2004. In December 2004, Cinergy Corp. successfully replaced the $500 million 364-day facility with a $1 billion five-year facility. CG&E and PSIeach have $500 million borrowing sublimits on this facility.
(2) In April 2004, Cinergy Corp. successfully placed a $1 billion three-year senior unsecured revolving credit facility. This facility replaced the $400 million three-year senior unsecured revolving credit facility that was set to expire in May 2004.
In addition to revolving credit facilities, Cinergy Corp., CG&E, and PSI also maintain uncommitted lines of credit. These facilities are not guaranteed sources of capital and represent an informal agreement to lend money, subject to availability, with pricing to be determined at the time of advance. Cinergy Corp., CG&E, and PSI have established uncommitted lines of $40 million, $15 million, and $60 million, respectively, all of which remained unused as of December 31, 2004.
Variable Rate Pollution Control Notes CG&E and PSI have issued certain variable rate pollution control notes (tax-exempt notes obtained to finance equipment or land development for pollution control purposes). Because the holders of these notes have the right to have their notes redeemed on a daily, weekly, or monthly basis, they are reflected in Notes payable and other short-term obligations on the Balance Sheets of Cinergy, CG&E, and PSI. At December 31, 2004, Cinergy, CG&E and PSI had $273 million, $112 million and $136 million, respectively, outstanding in variable rate pollution control notes, classified as short-term debt. ULH&P had no outstanding short-term pollution control notes. Any short-term pollution control note borrowings outstanding do not reduce the unused and available short-term debt regulatory authority of CG&E, PSI, and ULH&P.
In August 2003, CG&E caused the remarketing by the Ohio Air Quality Development Authority of $84 million of its State of Ohio Air Quality Development Revenue Refunding Bonds, due September 1, 2030. The issuance consists of a $42 million 1995 Series A and a $42 million 1995 Series B. The remarketing effected the conversion from a daily interest rate reset mode supported by a letter of credit to an unsecured weekly interest rate mode. The interest rate for both series was initially set at 1.30 percent and will reset every seven days going forward. Because the holders of these notes have the right to have their notes redeemed on a weekly basis, they are reflected in Notes payable and other short-term obligations on the Balance Sheets of Cinergy and CG&E.
Also in August 2003, CG&E caused the remarketing by the Ohio Air Quality Development Authority of $12.1 million of its State of Ohio Air Quality Development Revenue Bonds 2001 Series A due August 1, 2033. The remarketing affected the conversion from an unsecured one-year interest rate reset mode to a daily interest rate reset
mode supported by a standby letter of credit. The interest rate was initially set at 0.95 percent and will be reset daily going forward. Because the holders of these notes have the right to have their notes redeemed on a daily basis, they are reflected in Notes payable and other short-term obligations on the Balance Sheets of Cinergy and CG&E.
In December 2003, PSI borrowed the proceeds from the issuance by the Indiana Development Finance Authority of $80.5 million of its Indiana Development Finance Authority Environmental Revenue Bonds due December 1, 2038. The issuance consists of two $40.25 million tranches designated Series 2003A and Series 2003B. The initial interest rate for both tranches was 1.27 percent and is reset weekly. Proceeds from the borrowing are being used for the acquisition and construction of various solid waste disposal facilities located at various generating stations in Indiana. The remaining funds are being held in escrow by an independent trustee and will be drawn down as the facilities are built. Because the holders of these notes have the right to have their notes redeemed on a weekly basis, they are reflected in Notes payable and other short-term obligations on the Balance Sheets of Cinergy and PSI.
In August 2004, PSI borrowed the proceeds from the issuance by the Indiana Development Finance Authority of $55 million principal amount of its Environmental Revenue Bonds, Series 2004A, due August 2039. The initial interest rate for the bonds was 1.13 percent and is reset weekly. Proceeds from the borrowing will be used for the acquisition and construction of various solid waste disposal facilities located at various generating stations in Indiana. The funds are being held in escrow by an independent trustee and will be drawn upon as facilities are built. Holders of these notes are entitled to credit enhancement in the form of a standby letter of credit which, if drawn upon, provides for the payment of both interest and principal on the notes. Because the holders of these notes have the right to have their notes redeemed on a weekly basis, they are reflected in Notes payable and other short-term obligations on Cinergy’s and PSI’s Balance Sheets.
Commercial Paper Cinergy Corp.’s commercial paper program is supported by Cinergy Corp.’s $2 billion revolving credit facilities. The commercial paper program supports, in part, the short-term borrowing needs of CG&E and PSI and eliminates their need for separate commercial paper programs. In September 2004, Cinergy Corp. expanded its commercial paper program from $800 million to a maximum outstanding principal amount of $1.5 billion. As of December 31, 2004, Cinergy Corp. had $676 million in commercial paper outstanding.
Money Pool Cinergy Corp., Services, and our utility operating companies participate in a money pool arrangement to better manage cash and working capital requirements. Under this arrangement, those companies with surplus short-term funds provide short-term loans to affiliates (other than Cinergy Corp.) participating under this arrangement. This surplus cash may be from internal or external sources. The amounts outstanding under this money pool arrangement are shown as a component of Notes receivable from affiliated companies and/or Notes payable to affiliated companies on the Balance Sheets of CG&E, PSI, and ULH&P. Any money pool borrowings outstanding reduce the unused and available short-term debt regulatory authority of CG&E, PSI, and ULH&P.
The following table summarizes our Notes payable and other short-term obligations and Notes payable to affiliated companies.
(1) These facilities are not guaranteed sources of capital and represent an informal agreement to lend money, subject to availability, with pricing to be determined at the time of advance.
(2) In September 2004, Cinergy Corp. increased its commercial paper program limit from $800 million to $1.5 billion. The commercial paper program is supported by Cinergy Corp.’s revolving lines of credit.
(3) In December 2004, Cinergy Canada, Inc. successfully placed a $150 million three-year senior revolving credit facility.
In our credit facilities, Cinergy Corp. has covenanted to maintain:
• a consolidated net worth of $2 billion; and
• a ratio of consolidated indebtedness to consolidated total capitalization not in excess of 65 percent.
As part of CG&E’s $500 million sublimit under the $1 billion five-year credit facility, CG&E has covenanted to maintain:
• a consolidated net worth of $1 billion; and
• a ratio of consolidated indebtedness to consolidated total capitalization not in excess of 65 percent.
As part of PSI’s $500 million sublimit under the $1 billion five-year credit facility, PSI has covenanted to maintain:
• a consolidated net worth of $900 million; and
• a ratio of consolidated indebtedness to consolidated total capitalization not in excess of 65 percent.
A breach of these covenants could result in the termination of the credit facilities and the acceleration of the related indebtedness. In addition to breaches of covenants, certain other events that could result in the termination of available credit and acceleration of the related indebtedness include:
• bankruptcy;
• defaults in the payment of other indebtedness; and
• judgments against the company that are not paid or insured.
The latter two events, however, are subject to dollar-based materiality thresholds.
As discussed in Note 1(q)(i), long-term debt increased in the third quarter of 2003 resulting from the adoption of Interpretation 46. The debt which was recorded as a result of this new accounting pronouncement did not cause Cinergy Corp. to be in breach of any covenants at the time of adoption. As of December 31, 2004, Cinergy, CG&E, and PSI are in compliance with all of their debt covenants.
6. Leases
(a) Operating Leases
We have entered into operating lease agreements for various facilities and properties such as computer, communication and transportation equipment, and office space. Total rental payments on operating leases for each of the past three years are detailed in the following table. This table also shows future minimum lease payments required for operating leases with remaining non-cancelable lease terms in excess of one year as of December 31, 2004:
(1) The results of Cinergy also include amounts related to non-registrants.
(b) Capital Leases
In each of the years 1999 through 2004, CG&E, PSI, and ULH&P entered into capital lease agreements to fund the purchase of gas and electric meters, and associated equipment. The lease terms are for 120 months commencing with the date of purchase and contain buyout options ranging from 48 to 105 months. It is our objective to own the meters and associated equipment indefinitely and the operating companies plan to exercise the buyout option at month 105. As of December 31, 2004, Cinergy’s effective interest rate on capital lease obligations outstanding was 5.5 percent. The meters and associated equipment are depreciated at the same rate as if owned by the operating companies. CG&E, PSI, and ULH&P each recorded a capital lease obligation, included in Non-Current Liabilities-Other.
The total minimum lease payments and the present values for these capital lease items are shown below:
(1) Annual minimum lease payments are immaterial.
7. Financial Instruments
(a) Financial Derivatives
We have entered into financial derivative contracts for the purpose of managing financial instrument risk.
Our current policy of managing exposure to fluctuations in interest rates is to maintain approximately 30 percent of the total amount of outstanding debt in variable interest rate debt instruments. In maintaining this level of exposure, we use interest rate swaps. Under the swaps, we agree with other parties to exchange, at specified intervals, the difference between fixed-rate and variable-rate interest amounts calculated on an agreed notional amount. CG&E has an outstanding interest rate swap agreement that decreased the percentage of variable-rate debt. Under the provisions of the swap, which has a notional amount of $100 million, CG&E pays a fixed-rate and receives a variable-rate through October 2007. This swap qualifies as a cash flow hedge under the provisions of Statement 133. As the terms of the swap agreement mirror the terms of the debt agreement that it is hedging, we anticipate that this swap will continue to be effective as a hedge. Changes in fair value of this swap are recorded in Accumulated other comprehensive income (loss). Cinergy Corp. had three interest rate swaps with a combined notional amount of $250 million which settled in September 2004. These swaps qualified as fair value hedges under the provisions of Statement 133.
Treasury locks are agreements that fix the yield or price on a specified treasury security for a specified period, which we sometimes use in connection with the issuance of fixed-rate debt. On September 23, 2002, CG&E issued $500 million principal amount senior unsecured debentures due September 15, 2012, with an interest rate of 5.70 percent. In July 2002, CG&E executed a treasury lock with a notional amount of $250 million, which was designated as a cash flow hedge of 50 percent of the forecasted interest payments on this debt offering. The treasury lock effectively fixed the benchmark interest rate (i.e., the treasury component of the interest rate, but not the credit spread) for 50 percent of the offering from July 2002 through the issuance date in order to reduce the exposure associated with treasury rate volatility. With the issuance of the debt, the treasury lock was settled. Given the use of hedge accounting, this settlement was reflected in other Accumulated other comprehensive income (loss) on an after-tax basis in the amount of $13 million, rather than a charge to net income. This amount will be reclassified to Interest Expense over the 10-year life of the related debt as interest is accrued.
See Note 1(k)(ii) for additional information on financial derivatives. In the future, we will continually monitor market conditions to evaluate whether to modify our use of financial derivative contracts to manage financial instrument risk.
(b) Fair Value of Other Financial Instruments
The estimated fair values of other financial instruments were as follows (this information does not claim to be a valuation of the companies as a whole):
(1) The results of Cinergy also include amounts related to non-registrants.
(2) Includes amounts reflected as Long-term debt due within one year.
The following methods and assumptions were used to estimate the fair values of each major class of instruments:
(i) Cash and cash equivalents, Restricted deposits, and Notes payable and other short-term obligations
Due to the short period to maturity, the carrying amounts reflected on the Balance Sheets approximate fair values.
(ii) Long-term debt
The fair values of long-term debt issues were estimated based on the latest quoted market prices or, if not listed on the New York Stock Exchange, on the present value of future cash flows. The discount rates used approximate the incremental borrowing costs for similar instruments.
(c) Concentrations of Credit Risk
Credit risk is the exposure to economic loss that would occur as a result of nonperformance by counterparties, pursuant to the terms of their contractual obligations. Specific components of credit risk include counterparty default risk, collateral risk, concentration risk, and settlement risk.
(i) Trade Receivables and Physical Power Portfolio
Our concentration of credit risk with respect to trade accounts receivable from electric and gas retail customers is limited. The large number of customers and diversified customer base of residential, commercial, and industrial customers significantly reduces our credit risk. Contracts within the physical portfolio of power marketing and trading operations are primarily with traditional electric cooperatives and municipalities and other investor-owned utilities. At December 31, 2004, we believe the likelihood of significant losses associated with credit risk in our trade accounts receivable or physical power portfolio is remote.
(ii) Energy Trading Credit Risk
Cinergy’s extension of credit for energy marketing and trading is governed by a Corporate Credit Policy. Written guidelines approved by Cinergy’s Risk Policy Committee document the management approval levels for credit
limits, evaluation of creditworthiness, and credit risk mitigation procedures. Exposures to credit risks are monitored daily by the Corporate Credit Risk function, which is independent of all trading operations. As of December 31, 2004, approximately 93 percent of the credit exposure, net of credit collateral, related to energy trading and marketing activity was with counterparties rated investment grade or the counterparties’ obligations were guaranteed or secured by an investment grade entity. The majority of these investment grade counterparties are externally rated. If a counterparty has an external rating, the lower of Standard & Poor’s or Moody’s Investors Service is used; otherwise, Cinergy’s internal rating of the counterparty is used. The remaining seven percent represents $59 million with counterparties rated non-investment grade.
As of December 31, 2004, CG&E had a concentration of trading credit exposure of approximately $45 million with two counterparties accounting for greater than 10 percent of CG&E’s total trading credit exposure. These counterparties are rated investment grade.
Energy commodity prices can be extremely volatile and the market can, at times, lack liquidity. Because of these issues, credit risk for energy commodities is generally greater than with other commodity trading.
We continually review and monitor our credit exposure to all counterparties and secondary counterparties. If appropriate, we may adjust our credit reserves to attempt to compensate for increased credit risk within the industry. Counterparty credit limits may be adjusted on a daily basis in response to changes in a counterparty’s financial status or public debt ratings.
(iii) Financial Derivatives
Potential exposure to credit risk also exists from our use of financial derivatives such as interest rate swaps and treasury locks. Because these financial instruments are transacted with highly rated financial institutions, we do not anticipate nonperformance by any of the counterparties.
8. Notes Receivable
As discussed in Note 1(q)(i), Cinergy consolidated two previously unconsolidated SPEs effective July 1, 2003. As a result, Cinergy has approximately $214 million and $231 million of additional notes receivable as of December 31, 2004 and 2003, respectively, comprised of two separate notes.
The first note, with a December 31, 2004 balance of $101 million and a December 31, 2003 balance of $118 million, bears an effective interest rate of 7.81 percent and matures in August 2009. The second note, with a balance of $113 million as of December 31, 2004 and 2003, respectively, bears an effective interest rate of 9.23 percent and matures in December 2016.
The following table reflects the maturities of these notes as of December 31, 2004.
9. Pension and Other Postretirement Benefits
Cinergy Corp. sponsors both pension and other postretirement benefit plans.
Our qualified defined benefit pension plans cover substantially all United States employees meeting certain minimum age and service requirements. During 2002, eligible Cinergy employees were offered the opportunity to make a one-time election, effective January 1, 2003, to either continue to have their pension benefit determined by the traditional defined benefit pension formula or to have their benefit determined using a cash balance formula. A similar election was provided to certain union employees at a later time.
The traditional defined benefit program utilizes a final average pay formula to determine pension benefits. These benefits are based on:
• years of participation;
• age at retirement; and
• the applicable average Social Security wage base.
Benefits are accrued under the cash balance formula based upon a percentage of pension eligible earnings plus interest. In addition, participants with the cash balance formula may request a lump-sum cash payment upon termination of their employment, which may result in increased cash requirements from pension plan assets. At the effective time of the election, benefits ceased accruing under the traditional defined benefit pension formula for employees who elected the cash balance formula. There was no change to retirement benefits earned prior to the effective time of the election. The pension benefits of all non-union and certain union employees hired after December 31, 2002 are calculated using the cash balance formula. At December 31, 2004, approximately 80 percent of Cinergy’s employees remain in the traditional defined benefit program.
The introduction of the cash balance features to our defined benefit plans did not have a material effect on our financial position or results of operations.
Funding for the qualified defined benefit pension plans is based on actuarially determined contributions, the maximum of which is generally the amount deductible for tax purposes and the minimum being that required by the Employee Retirement Income Security Act of 1974, as amended. The pension plans’ assets consist of investments in equity and debt securities.
Cinergy’s investment strategy with respect to pension assets is designed to achieve a moderate level of overall portfolio risk in keeping with our desired risk objective, which is established through careful consideration of plan liabilities, plan funded status, and corporate financial condition. The portfolio’s target asset allocation is 60 percent equity and 40 percent debt with specified allowable ranges around these targets. Within the equity segment, we are broadly diversified across domestic, developed international, and emerging market equities, with the largest concentration being domestic. Further diversification is achieved through allocations to growth/value and small-, mid-, and large-cap equities. Within the debt segment, we principally maintain separate “core plus” and “core” portfolios. The “core plus” portfolio makes tactical use of the “plus” sectors (e.g., high yield, developed international, emerging markets, etc.) while the “core” portfolio is a domestic, investment grade portfolio. In late 2004, Cinergy commenced the implementation of an alternative investment strategy in its investment program. This strategy incorporates an investment in a fund of hedge funds in conjunction with an S&P 500 swaps and futures overlay program and will be classified as part of our large-cap United States equity allocation. Other than the alternative investment strategy, the use of derivatives is currently limited to collateralized mortgage obligations and asset-backed securities. Investment risk is measured and monitored on an ongoing basis through quarterly investment portfolio reviews, annual liability measurements, and periodic asset/liability studies.
Cinergy uses a September 30 measurement date for its defined benefit pension plans. The asset allocation at September 30, 2004 and 2003 by asset category was as follows:
(1) The portfolio’s target asset allocation is 60 percent equity with an allowable range of 50 percent to 70 percent.
(2) The portfolio’s target asset allocation is 40 percent debt with an allowable range of 30 percent to 50 percent.
In addition, Cinergy Corp. sponsors non-qualified pension plans (plans that do not meet the criteria for certain tax benefits) that cover officers, certain other key employees, and non-employee directors. We began funding certain of these non-qualified plans through a rabbi trust in 1999. This trust, which consists of equity (65 percent) and debt (35 percent) securities at December 31, 2004, is not restricted to the payment of plan benefits and therefore, not considered plan assets under Statement 87. At December 31, 2004 and 2003, trust assets were approximately $10 million and $9 million, respectively, and are reflected in Cinergy’s Balance Sheets as Other investments.
In 2003 and 2002, Cinergy offered voluntary early retirement programs to certain individuals. In accordance with Statement of Financial Accounting Standards No. 88, Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits (Statement 88), Cinergy recognized expense of approximately $9 million and $39 million in 2003 and 2002, respectively.
Cinergy Corp. provides certain health care and life insurance benefits to retired United States employees and their eligible dependents. These benefits are subject to minimum age and service requirements. The health care benefits include medical coverage, dental coverage, and prescription drugs and are subject to certain limitations, such as deductibles and co-payments. Neither CG&E nor ULH&P pre-fund their obligations for these postretirement benefits. In 1999, PSI began pre-funding its obligations through a grantor trust as authorized by the IURC. This trust, which consists of equity (65 percent) and debt (35 percent) securities at December 31, 2004, is not restricted to the payment of plan benefits and therefore, not considered plan assets under Statement 106. At December 31, 2004 and 2003, trust assets were approximately $71 million and $64 million, respectively, and are reflected in Cinergy’s Balance Sheets as Other investments.
Based on preliminary estimates, we expect 2005 contributions of $72 million for qualified pension benefits. As discussed previously, we do not hold “plan assets” as defined by Statement 87 and Statement 106 for our non-qualified pension plans and other postretirement benefit costs, and therefore contributions are equal to the benefit payments presented in the following table.
The following estimated benefits payments, which reflect future service, are expected to be paid:
Our benefit plans’ costs for the past three years included the following components:
The net periodic benefit cost by registrant was as follows:
(1) The results of Cinergy also include amounts related to non-registrants.
The following table provides a reconciliation of the changes in the plans’ benefit obligations and fair value of assets for 2004 and 2003, and a statement of the funded status for both years. Cinergy uses a September 30 measurement date for its defined benefit pension plans and other postretirement benefit plans.
(1) For 2003, the Qualified Pension Benefits includes approximately $9 million of voluntary early retirement expenses in accordance with Statement 88, as previously discussed.
The accumulated benefit obligation for the qualified defined benefit pension plans was approximately $1,387 million and approximately $1,237 million for 2004 and 2003, respectively. The accumulated benefit obligation for the non-qualified defined benefit pension plans was approximately $111 million and $102 million for 2004 and 2003, respectively.
The weighted-average assumptions used to determine benefit obligations were as follows:
The weighted-average assumptions used to determine net periodic benefit cost for the years ended December 31, 2004, 2003, and 2002 were as follows:
The calculation of Cinergy’s expected long-term rate of return is a two-step process. Capital market assumptions (e.g., forecasts) are first developed for various asset classes based on underlying fundamental and economic drivers of performance. Such drivers for equity and debt instruments include profit margins, dividend yields, and interest paid for use of capital. Risk premiums for each asset class are then developed based on factors such as expected illiquidity, credit spreads, inflation uncertainty and country/currency risk. Current valuation factors such as present interest and inflation rate levels underpin this process.
The assumptions are then modeled via a probability based multi-factor capital market methodology. Through this modeling process, a range of possible 10-year annualized returns are generated for each strategic asset class. Those returns falling at the 50th percentile are utilized in the calculation of Cinergy’s expected long-term rate of return.
The assumed health care cost trend rates were as follows:
Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. A one-percentage-point change in assumed health care cost trend rates would have the following effects:
On December 8, 2003, President Bush signed into law the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the Act). The Act introduced a prescription drug benefit to retirees as well as a federal subsidy to sponsors of retiree health care benefit plans that provide a prescription drug benefit that is actuarially equivalent to the benefit provided by Medicare. We believe that our coverage for prescription drugs is at least
actuarially equivalent to the benefits provided by Medicare for most current retirees because our benefits for that group substantially exceed the benefits provided by Medicare, thereby allowing us to qualify for the subsidy. We have accounted for the subsidy as a reduction of our APBO. The APBO was reduced by approximately $17 million and will be amortized as an actuarial gain over future periods, thus reducing future benefit costs. The impact on our 2004 net periodic benefit cost was not material. Our accounting treatment for the subsidy is consistent with FASB Staff Position No. 106-2, Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003.
In January 2004, Cinergy announced to employees the creation of a new retiree Health Reimbursement Account (HRA) option, which will impact the postretirement healthcare benefits provided by Cinergy. HRAs are bookkeeping accounts that can be used to pay for qualified medical expenses after retirement. The majority of employees had the opportunity during the Fall of 2004 to make a one-time election to remain in Cinergy’s current retiree healthcare program or to move to the new HRA option. Approximately 40 percent of Cinergy’s employees elected the new HRA option. The HRA option has no effect on current retirees receiving postretirement benefits from Cinergy. As is the case under the current retiree health program, employees who participate in the HRA option, generally, will become eligible to receive their HRA benefit only upon retirement on or after the age of 50 with at least five years of service. We expect that the impact of the new HRA option will not be material to our other postretirement benefit costs.
10. Income Taxes
The following table shows the significant components of Cinergy’s, CG&E’s, PSI’s, and ULH&P’s net deferred income tax liabilities as of December 31:
(1) The results of Cinergy also include amounts related to non-registrants.
Cinergy and its subsidiaries file a consolidated federal income tax return and combined/consolidated state and local tax returns in certain jurisdictions. Cinergy and its subsidiaries have an income tax allocation agreement, which conforms to the requirements of the PUHCA. The corporate taxable income method is used to allocate tax benefits to the subsidiaries whose investments or results of operations provide those tax benefits. Any tax liability not directly attributable to a specific subsidiary is allocated proportionately among the subsidiaries as required by the agreement.
The following table summarizes federal and state income taxes charged (credited) to income for Cinergy, CG&E, PSI, and ULH&P:
(1) The results of Cinergy also include amounts related to non-registrants.
Internal Revenue Code (IRC) Section 29 provides a tax credit (nonconventional fuel source credit) for qualified fuels produced and sold by a taxpayer to an unrelated person during the taxable year. The nonconventional fuel source credit reduced current federal income tax expense approximately $98 million, $84 million, and $42 million for 2004, 2003, and 2002, respectively. See Note 11(c)(iv) for further information on this tax credit.
The following table presents a reconciliation of federal income taxes (which are calculated by multiplying the statutory federal income tax rate by book income before federal income tax) to the federal income tax expense reported in the Statements of Income for Cinergy, CG&E, PSI, and ULH&P.
(1) The results of Cinergy also include amounts related to non-registrants.
11. Commitments and Contingencies
(a) Environmental
(i) Ozone Transport Rulemakings
In October 1998, the United States Environmental Protection Agency (EPA) finalized its ozone transport rule, also known as the nitrogen oxides (NOX) State Implementation Plan (SIP) Call, which addresses wind-blown ozone and ozone precursors that impact air quality in downwind states. The EPA’s final rule, which applies to 22 states in the eastern United States including the three states in which our electric utilities operate, required states to develop rules to reduce NOX emissions from utility and industrial sources. In a related matter, in response to petitions filed by several states alleging air quality impacts from upwind sources located in other states, the EPA issued a rule pursuant to Section 126 of the Clean Air Act (CAA) that required reductions similar to those required under the NOX SIP Call. Various states and industry groups challenged the final rules in the Court of Appeals for the District of Columbia Circuit, but the court upheld the key provisions of the rules.
The EPA has proposed withdrawal of the Section 126 rule in states with approved rules under the final NOX SIP Call, which includes Indiana, Kentucky, and Ohio. All three states have adopted a cap and trade program as the mechanism to achieve the required reductions. Cinergy, CG&E, and PSI have installed selective catalytic reduction units (SCR) and other pollution controls and implemented certain combustion improvements at various generating stations to comply with the NOX SIP Call. Cinergy also utilizes the NOX emission allowance market to buy or sell NOX emission allowances as appropriate. We currently estimate that we will incur capital costs of approximately $23 million in addition to $777 million already incurred to comply with this program.
(ii) Section 126 Petitions
In March 2004, the state of North Carolina filed a petition under Section 126 of the CAA in which it alleges that sources in 13 upwind states including Ohio, Indiana, and Kentucky, significantly contribute to North Carolina’s non-attainment with certain ambient air quality standards. Depending on the EPA’s final disposition of the pending petition and its proposal discussed previously, Cinergy’s generating stations could become subject to requirements for additional sulfur dioxide (SO2) and NOX emissions reductions. We expect a decision from the EPA on this matter by August 2005. It is unclear at this time whether any additional reductions would be necessary beyond those required under the CAA.
(iii) Clean Air Act Lawsuit
In November 1999, and through subsequent amendments, the United States brought a lawsuit in the United States Federal District Court for the Southern District of Indiana (District Court) against Cinergy, CG&E, and PSI alleging various violations of the CAA. Specifically, the lawsuit alleges that we violated the CAA by not obtaining Prevention of Significant Deterioration (PSD), Non-Attainment New Source Review (NSR), and Ohio and Indiana SIP permits for various projects at our owned and co-owned generating stations. Additionally, the suit claims that we violated an Administrative Consent Order entered into in 1998 between the EPA and Cinergy relating to alleged violations of Ohio’s SIP provisions governing particulate matter at Unit 1 at CG&E’s W.C. Beckjord Generating Station (Beckjord Station). The suit seeks (1) injunctive relief to require installation of pollution control technology on various generating units at CG&E’s Beckjord Station and Miami Fort Station, and PSI’s Cayuga Generating Station, Gallagher Generating Station, Wabash River Generating Station, and Gibson Generating Station (Gibson Station), and (2) civil penalties in amounts of up to $27,500 per day for each violation. In addition, three northeast states and two environmental groups have intervened in the case. The case is currently in discovery, and the District Court has set the case for trial by jury commencing in February 2006.
In March 2000, the United States also filed in the District Court an amended complaint in a separate lawsuit alleging violations of the CAA relating to PSD, NSR, and Ohio SIP requirements regarding various generating stations, including a generating station operated by Columbus Southern Power Company (CSP) and jointly-owned by CSP, The Dayton Power and Light Company (DP&L), and CG&E. The EPA is seeking injunctive relief and civil penalties of up to $27,500 per day for each violation. This suit is being defended by CSP. In April 2001, the District Court in that case ruled that the Government and the intervening plaintiff environmental groups cannot seek
monetary damages for alleged violations that occurred prior to November 3, 1994; however, they are entitled to seek injunctive relief for such alleged violations. Neither party appealed that decision.
In addition, Cinergy and CG&E have been informed by DP&L that in June 2000, the EPA issued a Notice of Violation (NOV) to DP&L for alleged violations of PSD, NSR, and Ohio SIP requirements at a generating station operated by DP&L and jointly-owned by CG&E. The NOV indicated the EPA may (1) issue an order requiring compliance with the requirements of the Ohio SIP, or (2) bring a civil action seeking injunctive relief and civil penalties of up to $27,500 per day for each violation. In September 2004, Marilyn Wall and the Sierra Club brought a lawsuit against Cinergy, DP&L and CSP for alleged violations of the CAA at this same generating station.
We are unable to predict whether resolution of these matters would have a material effect on our financial position or results of operations. We intend to vigorously defend against these allegations.
(iv) Carbon Dioxide (CO2 ) Lawsuit
In July 2004, the states of Connecticut, New York, California, Iowa, New Jersey, Rhode Island, Vermont, Wisconsin, and the City of New York brought a lawsuit in the United States District Court for the Southern District of New York against Cinergy, American Electric Power Company, Inc., American Electric Power Service Corporation, The Southern Company, Tennessee Valley Authority, and Xcel Energy Inc. That same day, a similar lawsuit was filed in the United States District Court for the Southern District of New York against the same companies by Open Space Institute, Inc., Open Space Conservancy, Inc., and The Audubon Society of New Hampshire. These lawsuits allege that the defendants’ emissions of CO2 from the combustion of fossil fuels at electric generating facilities contribute to global warming and amount to a public nuisance. The complaints also allege that the defendants could generate the same amount of electricity while emitting significantly less CO2. Plaintiffs are seeking an injunction requiring each defendant to cap its CO2 emissions and then reduce them by a specified percentage each year for at least a decade. Cinergy intends to defend these lawsuits vigorously in court and filed motions to dismiss with the other defendants in September 2004. We are not able to predict whether resolution of these matters would have a material effect on our financial position or results of operations.
(v) Selective Catalytic Reduction Units at Gibson Generating Station
In May 2004, SCRs and other pollution control equipment became operational at Units 4 and 5 of PSI’s Gibson Station in accordance with compliance deadlines under the NOX SIP Call. In June and July 2004, Gibson Station temporarily shut down the equipment on these units due to a concern over an acid aerosol mist haze (plume) sometimes occurring in areas near the plant. Portions of the plume from those units’ stacks appeared to break apart and descend to ground level at certain times under certain weather conditions. As a result, and, working with the City of Mt. Carmel, Illinois, Illinois EPA, Indiana Department of Environmental Management (IDEM), EPA, and the State of Illinois, we developed a protocol regarding the use of the SCRs while we explored alternatives to address this issue. After the protocol was finalized, the Illinois Attorney General brought an action in Wabash County Circuit Court against PSI seeking a preliminary injunction to enforce the protocol. In August 2004, the court granted that preliminary injunction. PSI is appealing that decision to the Fifth District Appellate Court, but we cannot predict the ultimate outcome of that appeal or of the underlying action by the Illinois Attorney General.
We will seek recovery of any related capital as well as increased emission allowance expenditures through the regulatory process. We do not believe costs related to resolving this matter will have a material impact on our financial position or results of operations.
(vi) Zimmer Generating Station (Zimmer Station) Lawsuit
In November 2004, a citizen of the Village of Moscow, Ohio, the town adjacent to CG&E’s Zimmer Station, brought a purported class action in the United States District Court for the Southern District of Ohio seeking monetary damages and injunctive relief against CG&E for alleged violations of the CAA, the Ohio SIP, Ohio laws against nuisance and common law nuisance. CG&E filed a motion to dismiss the lawsuit on primarily procedural grounds and we intend to defend against these claims vigorously. At this time, we cannot predict whether the outcome of this matter will have a material impact on our financial position or result of operations.
(vii) Manufactured Gas Plant (MGP) Sites
Coal tar residues, related hydrocarbons, and various metals have been found in at least 22 sites that PSI or its predecessors previously owned and sold in a series of transactions with Northern Indiana Public Service Company (NIPSCO) and Indiana Gas Company, Inc. (IGC). The 22 sites are in the process of being studied and will be remediated, if necessary. In 1998 NIPSCO, IGC, and PSI entered into Site Participation and Cost Sharing Agreements to allocate liability and responsibilities between them. The IDEM oversees investigation and cleanup of all of these sites. Thus far, PSI has primary responsibility for investigating, monitoring and, if necessary, remediating nine of these sites. In December 2003, PSI entered into a voluntary remediation plan with the state of Indiana, providing a formal framework for the investigation and cleanup of the sites.
In April 1998, PSI filed suit in Hendricks County in the state of Indiana against its general liability insurance carriers. PSI sought a declaratory judgment to obligate its insurance carriers to (1) defend MGP claims against PSI and compensate PSI for its costs of investigating, preventing, mitigating, and remediating damage to property and paying claims related to MGP sites; or (2) pay PSI’s cost of defense. The trial court issued a variety of rulings with respect to the claims and defenses in the litigation. PSI appealed certain adverse rulings to the Indiana Court of Appeals and the appellate court remanded the case to the trial court. PSI settled its claims with all but one of the insurance carriers in January 2005 prior to commencement of the trial. With respect to the lone insurance carrier, a jury returned a verdict against PSI in February 2005. PSI is considering whether to appeal this decision. At the present time, PSI cannot predict the outcome of this litigation if it were to appeal the decision.
PSI has accrued costs related to investigation, remediation, and groundwater monitoring for those sites where such costs are probable and can be reasonably estimated. We will continue to investigate and remediate the sites as outlined in the voluntary remediation plan. As additional facts become known and investigation is completed, we will assess whether the likelihood of incurring additional costs becomes probable. Until all investigation and remediation is complete, we are unable to determine the overall impact on our financial position or results of operations.
CG&E and ULH&P have performed site assessments on certain of their sites where we believe MGP activities have occurred at some point in the past and have found no imminent risk to the environment. At the present time, CG&E and ULH&P cannot predict whether investigation and/or remediation will be required in the future at any of these sites.
(viii) Asbestos Claims Litigation
CG&E and PSI have been named as defendants or co-defendants in lawsuits related to asbestos at their electric generating stations. Currently, there are approximately 100 pending lawsuits. In these lawsuits, plaintiffs claim to have been exposed to asbestos-containing products in the course of their work at the CG&E and PSI generating stations. The plaintiffs further claim that as the property owner of the generating stations, CG&E and PSI should be held liable for their injuries and illnesses based on an alleged duty to warn and protect them from any asbestos exposure. A majority of the lawsuits to date have been brought against PSI. The impact on CG&E’s and PSI’s financial position or results of operations of these cases to date has not been material.
Of these lawsuits, one case filed against PSI has been tried to verdict. The jury returned a verdict against PSI in the amount of approximately $500,000 on a negligence claim and a verdict for PSI on punitive damages. PSI received an adverse ruling in its initial appeal of the negligence claim verdict, but the Indiana Supreme Court accepted the transfer of the case and heard oral argument in June 2004. In addition, PSI has settled a number of other lawsuits for amounts, which neither individually nor in the aggregate, are material to PSI’s financial position or results of operations.
At this time, CG&E and PSI are not able to predict the ultimate outcome of these lawsuits or the impact on CG&E’s and PSI’s financial position or results of operations.
(b) Regulatory
(i) PSI Retail Electric Rate Case
In May 2004, the IURC issued an order approving PSI’s base retail electric rate case, and PSI implemented base retail electric rate changes to its tariffs. When combined with revenue increases attributable to PSI’s environmental construction-work-in-progress tracking mechanism, the order results in an approximate $140 million increase in annual revenues. PSI’s original request for an approximate $180 million annual revenue increase was reduced by approximately $20 million for a lower return on equity, approximately $15 million of assumed profits included in base rates related to off-system sales (subject to future adjustment through a tracking mechanism and a 50/50 sharing agreement), and approximately $5 million of additional items. The order authorizes full recovery of all requested regulatory assets and an overall 7.3 percent return, including a 10.5 percent return on equity. In addition, the IURC’s order provides PSI the continuation of a purchased power tracker and the establishment of new trackers for future NOX emission allowance costs and certain costs related to the Midwest Independent Transmission System Operator, Inc. (Midwest ISO).
(ii) PSI Environmental Compliance Case
In November 2004, PSI filed a compliance plan case with the IURC seeking approval of PSI’s plan for complying with pending SO2, NOX, and mercury emission reduction requirements, including approval of cost recovery and an overall rate of return of eight percent related to certain projects. PSI requested approval to recover the financing, depreciation, and operating and maintenance costs, among others, related to approximately $1.08 billion in capital projects designed to reduce emissions of SO2, NOX, and Mercury at PSI’s coal burning generating stations. An evidentiary hearing is scheduled for April 2005 and a final IURC Order is expected in the third quarter of 2005.
(iii) CG&E Electric Rate Filings
CG&E made multiple rate filings in 2003 with the PUCO seeking approval of CG&E’s methodology for establishing market-based rates for generation service at the end of the market development period and to recover investments made in the transmission and distribution system. The PUCO requested in these proceedings that CG&E propose a RSP to mitigate the potential for significant rate increases when the market development (frozen rate) period comes to an end. In January 2004, CG&E filed its proposed RSP. In May 2004, CG&E entered into a settlement agreement with many of the parties to these proceedings requesting that the PUCO approve a modified version of the RSP. In September 2004, the PUCO issued an order seeking to modify several key provisions of this settlement and as a result of these modifications, CG&E filed a petition for rehearing in October 2004. The PUCO approved a modified version of the plan in November 2004, the major features of which are as follows:
• Provider of Last Resort (POLR) Charge: CG&E will begin to collect a POLR charge from non-residential customers effective January 1, 2005, and from residential customers effective January 1, 2006. The POLR charge includes several discrete charges, the most significant being an annually adjusted component (AAC) intended to provide cost recovery primarily for environmental compliance expenditures; an infrastructure maintenance fund charge (IMF) intended to provide compensation to CG&E for committing its physical capacity to meet its POLR obligation; and a system reliability tracker (SRT) intended to provide cost recovery for capacity purchases, purchased power, reserve capacity, and related market costs for purchases to meet capacity needs. We anticipate the collection of the AAC and IMF will result in an approximate $36 million increase in revenues in 2005 and an additional $50 million in 2006. The SRT will be billed based on dollar-for-dollar costs incurred. A portion of these charges are avoidable by certain customers who switch to an alternative generation supplier. Therefore, these estimates are subject to change, depending on the level of switching that occurs in future periods. In 2007 and 2008, CG&E could seek additional increases in the AAC component of the POLR based on CG&E’s actual net costs for the specified expenditures.
• Generation Rates and Fuel Recovery: A new rate has been established for generation service after the market development period ends. In addition, a fuel cost recovery mechanism will be established to recover costs for fuel, emission allowances, and certain purchased power costs, that exceed the amount originally included in the rates frozen in the CG&E transition plan. These new rates will apply to
non-residential customers beginning January 1, 2005 and to residential customers beginning January 1, 2006.
• Generation Rate Reduction: The existing five percent generation rate reduction required by statute for residential customers implemented under CG&E’s 2000 plan will end on December 31, 2005.
• Transmission Cost Recovery: Transmission cost recovery mechanisms will be established beginning January 1, 2005 for non-residential customers and January 1, 2006 for residential customers. The transmission cost recovery mechanisms will permit CG&E to recover Midwest ISO charges, all FERC approved transmission costs, and all congestion costs allocable to retail ratepayers that are provided service by CG&E.
• Distribution Cost Recovery: CG&E will have the ability to defer certain capital-related distribution costs from July 1, 2004 through December 31, 2005 with recovery from non-residential customers to be provided through a rider beginning January 1, 2006 through December 31, 2010.
CG&E had also filed an electric distribution base rate case for residential and non-residential customers to be effective January 1, 2005. Under the terms of the RSP described previously, CG&E withdrew this base rate case and, in February 2005, CG&E filed a new distribution base rate case with rates to become effective January 1, 2006. The requested amount of the increase is approximately $78 million.
(iv) ULH&P Gas Rate Case
In the second quarter of 2001, ULH&P filed a retail gas rate case with the KPSC requesting, among other things, recovery of costs associated with an accelerated gas main replacement program of up to $112 million over ten years. The costs would be recovered through a tracking mechanism for an initial three year period, with the possibility of renewal up to ten years. The tracking mechanism allows ULH&P to recover depreciation costs and rate of return annually over the life of the deferred assets. Through December 31, 2004, ULH&P has recovered approximately $5.1 million under this tracking mechanism. The Kentucky Attorney General has appealed to the Franklin Circuit Court the KPSC’s approval of the tracking mechanism and the new tracking mechanism rates. At the present time, ULH&P cannot predict the timing or outcome of this litigation.
In February 2005, ULH&P filed a gas base rate case with the KPSC. ULH&P is requesting approval to continue the tracking mechanism in addition to its request for a $14 million increase in base rates, which is a seven percent increase in current retail gas rates.
(v) Gas Distribution Plant
In June 2003, the PUCO approved an amended settlement agreement between CG&E and the PUCO Staff in a gas distribution safety case arising out of a gas leak at a service head-adapter (SHA) style riser on CG&E’s distribution system. The amended settlement agreement required CG&E to expend a minimum of $700,000 to replace SHA risers by December 31, 2003, and to file a comprehensive plan addressing all SHA risers on its distribution system. CG&E filed a comprehensive plan with the PUCO in December 2004 providing for replacement of approximately 5,000 risers in 2005 with continued monitoring thereafter. CG&E estimates the replacement cost of the approximately 5,000 SHA risers will not be material. At this time, Cinergy, CG&E, and ULH&P cannot predict the outcome of this matter.
(c) Other
(i) Gas Customer Choice
In January 2000, Investments sold Cinergy Resources, Inc. (Resources), a former subsidiary, to Licking Rural Electrification, Inc., doing business as The Energy Cooperative (Energy Cooperative). In February 2001, Cinergy, CG&E, and Resources were named as defendants in three class action lawsuits brought by customers relating to Energy Cooperative’s removal from the Ohio Gas Customer Choice program and the failure to deliver gas to customers. Subsequently, these class action suits were amended and consolidated into one suit (Class-action). In October 2001, Cinergy, CG&E, and Investments initiated litigation against Energy Cooperative requesting
indemnification by Energy Cooperative for the claims asserted by former customers in the Class-action litigation (Cinergy lawsuit).
In March 2001, Cinergy, CG&E, and Investments were named as defendants in a lawsuit filed by Energy Cooperative and Resources (Energy Cooperative lawsuit). This lawsuit concerned any obligations or liabilities Investments may have had to Energy Cooperative following its sale of Resources. All three matters were settled in the second quarter of 2004. In the Energy Cooperative lawsuit, Energy Cooperative agreed to indemnify Cinergy, CG&E and Investments for the claims asserted by the former residential customers in the Class-action litigation. In exchange, Cinergy has agreed to settle claims that it brought in the Cinergy lawsuit. The settlement received final court approval in January 2005. None of these settlements are material to Cinergy’s financial position or results of operations.
(ii) Energy Market Investigations
In July 2003, Cinergy received a subpoena from the Commodity Futures Trading Commission (CFTC). The CFTC request sought certain information regarding our trading activities, including price reporting to energy industry publications for the period May 2000 through January 2001. Based on our review of these matters, we terminated one employee and took disciplinary action on a second employee. In November 2004, we settled this matter with the CFTC with a payment of $3 million.
In August 2003, Cinergy, along with Marketing & Trading and 37 other companies, were named as defendants in civil litigation filed as a purported class action on behalf of all persons who purchased and/or sold New York Mercantile Exchange natural gas futures and options contracts between January 1, 2000, and December 31, 2002. The complaint alleges that improper price reporting caused damages to the class. Two similar lawsuits have subsequently been filed, and these three lawsuits have been consolidated for pretrial purposes. Plaintiffs filed a consolidated class action complaint in January 2004. Cinergy’s motion to dismiss was granted in September 2004 leaving only Marketing & Trading in the lawsuit. We believe this action against Marketing & Trading is without merit and intend to defend this lawsuit vigorously.
In the second quarter of 2003, Cinergy received initial and follow-up third-party subpoenas from the SEC requesting information related to particular trading activity with one of its counterparties who was the target of an investigation by the SEC. Cinergy fully cooperated with the SEC in connection with this matter and has received no further requests since the second quarter of 2003.
From time to time, Cinergy receives subpoenas regarding investigations into energy market practices that various Assistant United States Attorneys are conducting. We understand that we are neither a target nor into energy market practices are we under investigation by the Department of Justice in relation to any of these communications.
At this time, we do not believe the outcome of these investigations and litigation will have a material impact on Cinergy’s financial position or results of operations.
(iii) Patents
Ronald A. Katz Technology Licensing, L.P. (RAKTL) has offered us a license to a portfolio of patents claiming that the patents may be infringed by certain products and services utilized by us. The patents purportedly relate to various aspects of telephone call processing in Cinergy call centers. As of this date, no legal proceedings have been instituted against us, but if the RAKTL patents are valid, enforceable, and apply to our business, we could be required to seek a license from RAKTL or to discontinue certain activities. Based on the information we have at this time, we do not believe resolution of this matter will have a material impact on our financial position or results of operations.
(iv) Synthetic Fuel Production
In July 2002, Capital & Trading acquired a coal-based synthetic fuel production facility. The synthetic fuel produced at this facility qualifies for tax credits (through 2007) in accordance with IRC Section 29 if certain
requirements are satisfied. The three key requirements are that (a) the synthetic fuel differs significantly in chemical composition from the coal used to produce such synthetic fuel, (b) the fuel produced is sold to an unrelated entity and (c) the fuel was produced from a facility that was placed in service before July 1, 1998.
During the third quarter of 2004, several unrelated entities announced that the IRS had or threatened to challenge the placed in service dates of some of the entities’ synthetic fuel plants. A successful IRS challenge could result in disallowance of all credits previously claimed for fuel produced by the subject plants. Cinergy’s sale of synthetic fuel has generated approximately $219 million in tax credits through December 31, 2004, of which approximately $96 million were generated in 2004.
The IRS has not yet audited Cinergy for any tax year in which Cinergy has claimed Section 29 credits related to synthetic fuel. However, it is reasonable to anticipate that the IRS will evaluate the placed in service date and other key requirements for claiming the credit. We anticipate this audit to begin in the spring of 2005.
Cinergy received a private letter ruling from the IRS in connection with the acquisition of the facility that specifically addressed the significant chemical change requirement. Additionally, although not addressed in the letter ruling, we believe that our facility’s in service date meets the Section 29 requirements.
IRC Section 29 also provides for a phase-out of the credit based on the price of crude oil. The phase-out is based on a prescribed calculation and definition of crude oil prices. We do not expect any impact on our ability to utilize Section 29 credits in 2004. Future increases in crude oil prices above the price stipulated by the IRS could negatively impact our ability to utilize credits in subsequent years.
(v) Guarantees
In the ordinary course of business, Cinergy enters into various agreements providing financial or performance assurances to third parties on behalf of certain unconsolidated subsidiaries and joint ventures. These agreements are entered into primarily to support or enhance the creditworthiness otherwise attributed to these entities on a stand-alone basis, thereby facilitating the extension of sufficient credit to accomplish their intended commercial purposes. The guarantees have various termination dates, from short-term (less than one year) to open-ended.
In many cases, the maximum potential amount of an outstanding guarantee is an express term, set forth in the guarantee agreement, representing the maximum potential obligation of Cinergy under that guarantee (excluding, at times, certain legal fees to which a guaranty beneficiary may be entitled). In those cases where there is no maximum potential amount expressly set forth in the guarantee agreement, we calculate the maximum potential amount by considering the terms of the guaranteed transactions, to the extent such amount is estimable.
Cinergy has guaranteed the payment of approximately $9 million as of December 31, 2004, for borrowings by individuals under the Director, Officer, and Key Employee Stock Purchase Program. Cinergy may be obligated to pay the debt’s principal and any related interest in the event of an unexcused breach of a guaranteed payment obligation by certain directors, officers, and key employees. The guarantees do not have a set termination date; however, the borrowings associated with these guarantees are due in March 2005.
Cinergy Corp. has also provided performance guarantees on behalf of certain unconsolidated subsidiaries and joint ventures. These guarantees support performance under various agreements and instruments (such as construction contracts, operations and maintenance agreements, and energy service agreements). Cinergy Corp. may be liable in the event of an unexcused breach of a guaranteed performance obligation by an unconsolidated subsidiary. Cinergy Corp. has estimated its maximum potential liability to be $52 million under these guarantees as of December 31, 2004. Cinergy Corp. may also have recourse to third parties for claims required to be paid under certain of these guarantees. The majority of these guarantees expire at the completion of the underlying performance agreement, the majority of which expire from 2016 to 2019.
Cinergy has entered into contracts that include indemnification provisions as a routine part of its business activities. Examples of these contracts include purchase and sale agreements and operating agreements. In general, these provisions indemnify the counterparty for matters such as breaches of representations and warranties and covenants
contained in the contract. In some cases, particularly with respect to purchase and sale agreements, the potential liability for certain indemnification obligations is capped, in whole or in part (generally at an aggregate amount not exceeding the sale price), and subject to a deductible amount before any payments would become due. In other cases (such as indemnifications for willful misconduct of employees in a joint venture), the maximum potential liability is not estimable given that the magnitude of any claims under those indemnifications would be a function of the extent of damages actually incurred. Cinergy has estimated the maximum potential liability, where estimable, to be $128 million under these indemnification provisions. The termination period for the majority of matters provided by indemnification provisions in these types of agreements generally ranges from 2005 to 2009.
We believe the likelihood that Cinergy would be required to perform or otherwise incur any significant losses associated with any or all of the guarantees described in the preceding paragraphs is remote.
(vi) Construction and Other Commitments
Forecasted construction and other committed expenditures for the year 2005 and for the five-year period 2005-2009 (in nominal dollars) are presented in the table below:
(1) The results of Cinergy also include amounts related to non-registrants.
This forecast includes an estimate of expenditures in accordance with the companies’ plans regarding environmental compliance.
12. Jointly-Owned Plant
CG&E, CSP, and DP&L jointly own electric generating units and related transmission facilities. PSI is a joint-owner of Gibson Station Unit No. 5 with Wabash Valley Power Association, Inc. (WVPA), and Indiana Municipal Power Agency (IMPA). Additionally, PSI is a joint-owner with WVPA and IMPA of certain transmission property and local facilities. These facilities constitute part of the integrated transmission and distribution systems, which are operated and maintained by PSI. The Statements of Income reflect CG&E’s and PSI’s portions of all operating costs associated with the jointly-owned facilities.
As of December 31, 2004, CG&E’s and PSI’s investments in jointly-owned plant or facilities were as follows:
(1) Station is not operated by CG&E.
13. Quarterly Financial Data (unaudited)
(1) The results of Cinergy also include amounts related to non-registrants.
(2) See Note 14 for further explanation.
(3) See Note 1(q)(iv) for further explanation of cumulative effect of changes in accounting principles.
14. Discontinued Operations
During 2002, Cinergy began taking steps to monetize certain non-core investments, including renewable and international investments within Commercial. During the second half of 2002, Cinergy either sold or initiated plans to dispose of generation and electric and gas distribution operations in the Czech Republic, Estonia, and South Africa. Cinergy also sold investments, which were accounted for under the equity method, in renewable investments located in Spain and California. In total, Cinergy disposed of approximately $125 million of investments at a net loss, after-tax, of $7 million in 2002. Included in this net loss were cumulative foreign currency translation losses of approximately $4 million, after-tax.
During 2003, Cinergy completed the disposal of its gas distribution operation in South Africa, sold its remaining wind assets in the United States, and substantially sold or liquidated the assets of its energy marketing business in the Czech Republic.
As a result of the 2003 transactions, assets of approximately $140 million were sold or converted into cash and liabilities of approximately $100 million were assumed by buyers or liquidated. The net, after-tax, gain from these disposal and liquidation transactions was approximately $9 million (including a net after-tax cumulative currency translation gain of approximately $6 million).
GAAP requires different accounting treatment for investment disposals involving entities which are consolidated and entities which are accounted for under the equity method. The consolidated entities have been presented as Discontinued operations, net of tax in Cinergy’s Statements of Income and as Assets/Liabilities of Discontinued Operations in Cinergy’s Balance Sheets. The accompanying financial statements and prior year financial statements have been reclassified to account for these entities as such. The disposal of the entities accounted for using the equity method cannot be presented as discontinued operations. A gain of approximately $17 million on the sale of these entities is included in Miscellaneous Income (Expense)-Net in Cinergy’s 2002 Statements of Income.
The following table reflects the assets and liabilities, the results of operations, and the income (loss) on disposal related to investments accounted for as discontinued operations for the years ended December 31, 2003 and 2002. We did not have any investments accounted for as discontinued operations in 2004.
(1) Presented for informational purposes only. All results of operations are reported net in our Statements of Income.
(2) For 2002, approximately $17 million of this amount represents a write-down to fair value, less cost to sell, on assets classified as held for sale at December 31, 2002. The remaining loss on disposal for 2002 represents actual losses on completed sales.
The losses included in the 2002 discontinued operations primarily pertain to two investments. In one case, the primary customer of a combined heat and power plant filed for bankruptcy resulting in a significant reduction in future expected revenues from the investment. This investment was sold in December 2002. In the second case, the retail market of a gas distribution business did not develop as expected, and we elected to exit the business rather than invest the additional capital which would be required to reach a sustainable level of market penetration. The investment was written down to its realizable value in December 2002 and was subsequently sold in April 2003.
15. Investment Activity
(a) Investment Impairment
Cinergy holds a portfolio of direct and indirect investments in Power Technology and Infrastructure (discussed further in Note 16). During 2004, Cinergy recognized approximately $56 million in impairment and disposal charges primarily associated with this portfolio. A substantial portion of these charges relate to a company in which Cinergy holds a non-controlling interest, that sold its major assets. This company is involved in the development and sale of outage management software. Based on the terms of the transaction, Cinergy concluded that this cost method investment was other-than-temporarily impaired. These impairment charges are included in Miscellaneous Income (Expense) - Net in Cinergy’s Statements of Income.
(b) Sale of Investment
Power Technology and Infrastructure holds an investment in a company that develops, owns and operates wireless communication towers. In July 2004, this company agreed to sell the majority of its assets. Most of the assets contemplated in the purchase/sale agreement were sold in the fourth quarter of 2004 and we recorded a gain of approximately $21 million relating to this sale. These earnings are reflected in Equity in Earnings of Unconsolidated Subsidiaries in Cinergy’s Statements of Income.
16. Financial Information by Business Segment
We conduct operations through our subsidiaries and manage our businesses through the following three reportable segments:
• Commercial;
• Regulated; and
• Power Technology and Infrastructure.
Commercial manages our wholesale generation and energy marketing and trading activities. Commercial also performs energy risk management activities, provides customized energy solutions and is responsible for all of our international operations.
Regulated consists of PSI’s regulated generation and transmission and distribution operations, and CG&E and its subsidiaries’ regulated electric and gas transmission and distribution systems. Regulated plans, constructs, operates, and maintains Cinergy’s transmission and distribution systems and delivers gas and electric energy to consumers. Regulated also earns revenues from wholesale customers primarily by these customers transmitting electric power through Cinergy’s transmission system. These businesses are subject to cost of service rate making where rates to be charged to customers are based on prudently incurred costs over a test period plus a reasonable rate of return.
Power Technology and Infrastructure primarily manages Cinergy Ventures, LLC (Ventures), Cinergy’s venture capital subsidiary. Ventures identifies, invests in, and integrates new energy technologies into Cinergy’s existing businesses, focused primarily on operational efficiencies and clean energy technologies. In addition, Power Technology and Infrastructure manages our investments in other energy infrastructure and telecommunication service providers.
Following are the financial results by business unit. Certain prior year amounts have been reclassified to conform to the current presentation.
Financial results by business unit for the years ended December 31, 2004, 2003, and 2002, are as indicated below:
Business Units
(1) The All Other category represents miscellaneous corporate items, which are not allocated to business units for purposes of segment performance measurement.
(2) The Reconciling Eliminations category eliminates the intersegment revenues of Commercial.
(3) Electric gross margins are calculated as Electric operating revenues less Fuel, emission allowances, and purchased power expense from the Statements of Income.
(4) Gas gross margins are calculated as Gas operating revenues less Gas purchased expense from the Statements of Income.
(5) Interest income is deemed immaterial.
(6) The reduction in income taxes in 2004, as compared to 2003, primarily reflects lower business unit taxable income and also includes an increase in the annual tax credits associated with the production and sale of synthetic fuel. For further information, see Note 11(c)(iv).
(7) Management utilizes Segment profit (loss), after taxes, to evaluate segment performance.
(1) The All Other category represents miscellaneous corporate items, which are not allocated to business units for purposes of segment performance measurement.
(2) The Reconciling Eliminations column eliminates the intersegment revenues of Commercial.
(3) Electric gross margins are calculated as Electric operating revenues less Fuel, emission allowances, and purchased power expense from the Statements of Income.
(4) Gas gross margins are calculated as Gas operating revenues less Gas purchased expense from the Statements of Income.
(5) Interest income is deemed immaterial.
(6) The decrease in 2003, as compared to 2002, in part reflects the effect of tax credits associated with production of synthetic fuel beginning in July 2002.
(7) For further information, see Note 14.
(8) For further information, see Note 1(q)(iv).
(9) Management utilizes Segment profit (loss), after taxes, to evaluate segment performance.
(1) The All Other category represents miscellaneous corporate items, which are not allocated to business units for purposes of segment performance measurement.
(2) The Reconciling Eliminations column eliminates the intersegment revenues of Commercial.
(3) Electric gross margins are calculated as Electric operating revenues less Fuel, emission allowances, and purchased power expense from the Statements of Income.
(4) Gas gross margins are calculated as Gas operating revenues less Gas purchased expense from the Statements of Income.
(5) Interest income is deemed immaterial.
(6) For further information, see Note 14.
(7) For further information, see Note 1(q)(iv).
(8) Management utilizes segment profit (loss), after taxes, to evaluate segment performance.
Products and Services
(in millions)
Geographic Areas and Long-Lived Assets
Revenues
(in millions)
17. Earnings Per Common Share
A reconciliation of EPS - basic to EPS - diluted is presented below for the years ended December 31, 2004, 2003, and 2002:
Options to purchase shares of common stock are excluded from the calculation of EPS - diluted, if they are considered to be anti-dilutive. For the years ended December 31, 2004, 2003, and 2002, approximately 0.9 million, 1.6 million, and 3.0 million shares, respectively, were excluded from the EPS - diluted calculation.
Also excluded from the EPS - diluted calculation for the years ended December 31, 2004, 2003, and 2002 are up to 9.7 million, 10.6 million, and 10.8 million shares, respectively, issuable pursuant to the stock purchase contracts issued by Cinergy Corp. in December 2001 associated with the preferred trust securities transaction. In January
and February 2005, the stock purchase contracts were settled and holders purchased a total of 9.2 million shares of Cinergy Corp. common stock. Net proceeds of approximately $316 million were used to reduce short-term debt.
18. Comprehensive Income
Comprehensive income includes all changes in equity during a period except those resulting from investments by and distributions to shareholders. The major components include net income, foreign currency translation adjustments, minimum pension liability adjustments, unrealized gains and losses on investment trusts and the effects of certain hedging activities.
We translate the assets and liabilities of foreign subsidiaries, whose functional currency (generally, the local currency of the country in which the subsidiary is located) is not the United States dollar, using the appropriate exchange rate as of the end of the year. Foreign currency translation adjustments are unrealized gains and losses on the difference in foreign country currency compared to the value of the United States dollar. The gains and losses are accumulated in comprehensive income. When a foreign subsidiary is substantially liquidated, the cumulative translation gain or loss is removed from comprehensive income and is recognized as a component of the gain or loss on the sale of the subsidiary in our Statements of Income.
We record a minimum pension liability adjustment associated with our defined benefit pension plans when the unfunded accumulated benefit obligation is in excess of our accrued pension liabilities and the unrecognized prior service costs recorded as an intangible asset. The corresponding offset is recorded on the Balance Sheets in Accrued pension and other postretirement benefit costs. Details of the pension plans’ assets and obligations are explained further in Note 9.
We record unrealized gains and losses on equity investments in trusts we have established for our benefit plans, primarily by PSI. See Note 9 for further details.
The changes in fair value of derivatives that qualify as hedges, under Statement 133, are recorded in comprehensive income. The specific hedge accounting and the derivatives that qualify are explained in greater detail in Note 7(a).
The elements of Comprehensive income and their related tax effects for the years ended December 31, 2004, 2003, and 2002 are as follows:
(1) The results of Cinergy also include amounts related to non-registrants.
(2) Individual amounts for ULH&P are immaterial.
The after-tax components of Accumulated other comprehensive income (loss) as of December 31, 2004, 2003, and 2002 are as follows:
(1) The results of Cinergy also include amounts related to non-registrants.
(2) Individual amounts for ULH&P are immaterial.
19. Transfer of Generating Assets
In December 2002, the IURC approved a settlement agreement among PSI, the Indiana Office of the Utility Consumer Counselor, and the IURC Staff authorizing PSI’s purchases of the Henry County, Indiana and Butler County, Ohio, gas-fired peaking plants from two non-regulated affiliates. In February 2003, the FERC issued an order under Section 203 of the Federal Power Act authorizing PSI’s acquisitions of the plants, which occurred on February 5, 2003. Subsequently, in April 2003, the FERC issued a tolling order allowing additional time to consider a request for rehearing filed in response to the February 2003 FERC order. In September 2004, FERC issued an order denying the request for rehearing and affirming the acquisition of the plants.
The KPSC has conditionally approved ULH&P’s planned acquisition of CG&E’s 68.9 percent ownership interest in the East Bend Generating Station, located in Boone County, Kentucky, the Woodsdale Generating Station, located in Butler County, Ohio, and one generating unit at the four-unit Miami Fort Station located in Hamilton County, Ohio. ULH&P is currently seeking approval for the transaction from the SEC, wherein the Ohio Consumers Counsel has intervened in opposition, and the FERC. The transfer, which will be paid for at net book value, will not affect current electric rates for ULH&P’s customers, as power will be provided under the same terms as under the current wholesale power contract with CG&E through December 31, 2006. Assuming receipt of regulatory approvals, we would anticipate the transfer to take place in the second quarter of 2005.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES Disclosure controls and procedures are our controls and other procedures that are designed to provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934 (Exchange Act) is recorded, processed, summarized, and reported, within the time periods specified in the Securities and Exchange Commission’s (SEC) rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to provide reasonable assurance that information required to be disclosed by us in the reports that we file under the Exchange Act is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure.
Under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, we have evaluated the effectiveness of our disclosure controls and procedures as of December 31, 2004, and, based upon this evaluation, our chief executive officer and chief financial officer have concluded that these controls and procedures are effective in providing reasonable assurance that information requiring disclosure is recorded, processed, summarized, and reported within the timeframe specified by the SEC’s rules and forms.
Under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, we have evaluated any change in our internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter ended December 31, 2004 and found no change that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Management Report on Internal Control over Financial Reporting
Management of Cinergy Corp. (the Company) is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act. The Company’s internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes, in accordance with generally accepted accounting principles.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
The Company’s management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004. In making this assessment, management used the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
Based on our assessment and those criteria, management believes that the internal control over financial reporting maintained by the Company, as of December 31, 2004, was effective.
The Company’s independent auditors have issued an attestation report on management’s assessment of the Company’s internal control over financial reporting. That report follows.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of Cinergy Corp.
Cincinnati, Ohio
We have audited management’s assessment, included in the accompanying Management Report on Internal Control over Financial Reporting, that the Company maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements and financial statement schedule as of and for the year ended December 31, 2004 of the Company and our report dated February 11, 2005 expressed an unqualified opinion on those financial statements and financial statement schedule and contained an explanatory paragraph regarding the Company’s change in accounting in 2003, for asset retirement obligations, variable interest entities, and stock-based compensation.
/s/ Deloitte & Touche LLP
Deloitte & Touche LLP
Cincinnati, Ohio
February 11, 2005
ITEM 9B.
ITEM 9B. OTHER INFORMATION None.
PART III ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANTS BOARD OF DIRECTORS Information regarding Cinergy Corp.’s directors is incorporated by reference from its definitive Proxy Statement for the 2005 Annual Meeting of Shareholders.
The directors of The Cincinnati Gas & Electric Company (CG&E) at January 31, 2005, are as follows:
• Michael J. Cyrus - Mr. Cyrus, age 49, is Executive Vice President of CG&E, a position he has held since February 2001. He has served as director of CG&E since September 2001. His current term as director expires May 4, 2005.
• James E. Rogers - Mr. Rogers, age 57, is Chairman of the Board and Chief Executive Officer of CG&E. He has served as a director of CG&E since 1994. His current term as director expires May 4, 2005.
• James L. Turner - Mr. Turner, age 45, is Executive Vice President and Chief Financial Officer of CG&E, a position he has held since September 2004. Prior to that, Mr. Turner served as Executive Vice President of CG&E since July 2000. He served as a director of CG&E from February 15, 1999 to April 30, 2001 and was re-elected, effective October 1, 2001. Mr. Turner’s current term as director expires May 4, 2005.
Additional information on each of the directors of CG&E is presented in the following “Executive Officers” section.
Information regarding PSI Energy, Inc.’s (PSI) directors is incorporated by reference from PSI’s 2005 Information Statement.
EXECUTIVE OFFICERS The names and ages of the executive officers of Cinergy, CG&E, and PSI and the positions they hold, held, or have been elected to (as of January 31, 2005), and their business experience during the past five years is included in the chart below.
None of the officers are related in any manner. Our executive officers hold the offices set opposite their names until the next annual meeting of the Board of Directors and until their successors have been elected and qualified.
(1)
Prior to joining Cinergy, Mr. Duncan was Executive Vice President and Chief Financial Officer of LG&E Energy Corp. (LG&E) (a non-affiliate of Cinergy) in Louisville, Kentucky since December 1998.
(2)
Prior to joining Cinergy, Ms. Good was a partner with the international accounting firm Deloitte & Touche LLP in Cincinnati, Ohio since May 2002. Prior to that, she was a partner with the international accounting firm Arthur Andersen LLP from 1992 to May 2002. While at Arthur Andersen LLP, she had regional energy responsibilities for risk consulting and internal audit practices.
(3)
Prior to joining Cinergy, Mr. Manly was Managing Director, Law and Governmental Affairs, General Counsel and Corporate Secretary of NewPower Holdings, Inc. (a non-affiliate of Cinergy) from April 2000 to August 2002. Prior to that, he was Vice President, Chief Counsel for AT&T Consumer Services Group (a non-affiliate of Cinergy) from January 1995 to April 2000. On June 11, 2002, NewPower Holdings, Inc. and its affiliates, TNPC Holdings, Inc. and the NewPower Company, filed a petition for relief under Chapter 11 of The United States Bankruptcy Code.
(4)
Prior to joining Cinergy, Mr. Murphy was Vice President and Chief Risk Officer of Enron Europe, Ltd. (a non-affiliate of Cinergy) from January 2001 to July 2002. Prior to that, he was Vice President of Market Risk of Enron Corp. (a non-affiliate of Cinergy) from March 1997 to December 2000.
(5)
Prior to joining Cinergy, Mr. Newton was Senior Vice President, Chief Administrative Officer of LG&E (a non-affiliate of Cinergy) from January 1999 to May 2002.
(6)
Prior to joining Cinergy, Mr. Reising was Chief Financial Officer of Focal Communications Corporation (a non-affiliate of Cinergy) from February 2001 to January 2002. Prior to that, he was Chief Financial Officer of Derivon (a non-affiliate of Cinergy) from May 2000 to February 2001. Prior to that, he was Chief Financial Officer of Bell Canada (a non-affiliate of Cinergy) from May 1999 to May 2000. On December 19, 2002, Focal Communications filed a petition for relief under Chapter 11 of The United States Bankruptcy Code.
(7)
Mr. Turner served as Vice President of Customer Services from January 2000 until July 2000.
Cinergy Corp. has adopted both a code of business conduct and ethics applicable to all of its directors, officers, and employees as well as corporate governance guidelines. Both of these documents are available on Cinergy’s website at www.cinergy.com. In addition, any amendments to or waivers from the code of business conduct and ethics will be posted on the website. Any such amendment or waiver would require the prior consent of the Board of Directors or an applicable committee thereof.
Information in response to Item 405 of Regulation S-K and regarding Cinergy Corp.’s audit committee required by Items 401(h) and 401(i) of Regulation S-K is incorporated by reference from its definitive Proxy Statement for the 2005 Annual Meeting of Shareholders.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION Information in response to this item for Cinergy Corp. and CG&E is incorporated by reference from Cinergy Corp.’s definitive Proxy Statement for the 2005 Annual Meeting of Shareholders.
All CG&E directors currently are employees of Cinergy and receive no compensation for their services as directors.
Information in response to this item for PSI is incorporated by reference from PSI’s 2005 Information Statement.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS Information in response to this item for Cinergy Corp. is incorporated by reference from its definitive Proxy Statement for the 2005 Annual Meeting of Shareholders.
Cinergy Corp. owns all outstanding shares of common stock of CG&E, CG&E’s only voting security.
CG&E’s directors and executive officers did not beneficially own any shares of any class of equity security of CG&E as of January 31, 2005. The beneficial ownership of Cinergy Corp. common stock by each director and named executive officer of CG&E as of January 31, 2005, is set forth in the following table:
*
Less than 1 percent
(1)
Includes shares which there is a right to acquire within 60 days pursuant to the exercise of stock options in the following amounts: Mr. Cyrus - 141,799; Mr. Duncan - 213,500; Mr. Grealis - 235,701; Mr. Turner - 101,626; Mr. Rogers - 970,300; and all directors and executive officers as a group - 1,768,036.
Information in response to this item for PSI is incorporated by reference from its 2005 Information Statement.
The following table reflects Cinergy’s equity compensation plan information as of December 31, 2004:
Equity Compensation Plan Information
The following information describes the equity compensation plans that have not been approved by shareholders.
Cinergy Corp. UK Sharesave Scheme The Cinergy Corp. UK Sharesave Scheme allows essentially all full-time, regular United Kingdom employees working a minimum of 25 hours per week to purchase shares of common stock pursuant to a stock option feature. Under the Cinergy Corp. UK Sharesave Scheme, after-tax funds are withheld from a participant’s compensation during a 36-month or 60-month offering period, at the election of the participants, and are deposited in an account. At the end of the offering period, participants may apply amounts deposited in the account toward the purchase of shares of common stock. The purchase price cannot be less than 80 percent of the average market price at date of grant or shortly prior to the grant. Any funds not applied toward the purchase of shares are returned to the participant. A participant may elect to terminate participation in the plan at any time. Participation also will terminate if the participant’s employment ceases. Upon termination of participation, all funds are returned to the participant without penalty although, in certain specified circumstances, options may be exercised early on a pro-rata basis.
Cinergy Corp. 401(k) Excess Plan The Cinergy Corp. 401(k) Excess Plan is a non-qualified deferred compensation plan for a select group of Cinergy management and other highly compensated employees. It is a means by which these employees can defer additional compensation, and receive additional company matching contributions, when they have already contributed the maximum amount (pursuant to the anti-discrimination rules for highly compensated employees) under the 401(k) Plan. All funds deferred are held in a rabbi trust administered by an independent trustee.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information in response to this item for Cinergy Corp. and CG&E is incorporated by reference from Cinergy Corp.’s definitive Proxy Statement for the 2005 Annual Meeting of Shareholders.
Information in response to this item for PSI is incorporated by reference from PSI’s 2005 Information Statement.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES Information in response to this item for Cinergy, CG&E and PSI is incorporated by reference from Cinergy Corp.’s definitive Proxy Statement for the 2005 Annual Meeting of Shareholders.
PART IV ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES FINANCIAL STATEMENTS AND SCHEDULES Refer to the page captioned “Index to Financial Statements and Financial Statement Schedules” for an index of the financial statements and financial statement schedules included in this report.
EXHIBITS The documents listed below are being filed or have previously been filed on behalf of Cinergy Corp., CG&E, PSI, and The Union Light, Heat and Power Company (ULH&P) and are incorporated herein by reference from the documents indicated and made a part hereof. Exhibits not identified as previously filed are filed herewith:
(1)
Regulation S-K 229.10(d) requires Registrants to identify the physical location, by SEC file number reference, of all documents that are incorporated by reference and have been on file with the SEC for more than five years. The SEC file number references for Cinergy and its subsidiaries, which are registrants are provided below:
Cinergy Corp. in file number 1-11377
CG&E in file number 1-1232
PSI in file number 1-3543
ULH&P in file number 2-7793
Each registrant hereby undertakes to furnish to the SEC upon request a copy of any long-term debt instrument not previously listed.
FINANCIAL STATEMENT SCHEDULES SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
FOR THE THREE YEARS ENDED DECEMBER 31, 2004
(in thousands)
SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Cinergy Corp., The Cincinnati Gas & Electric Company, PSI Energy, Inc., and The Union Light, Heat and Power Company each has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
CINERGY CORP.
THE CINCINNATI GAS & ELECTRIC COMPANY
PSI ENERGY, INC.
THE UNION LIGHT, HEAT AND POWER COMPANY
Registrants
Pursuant to the requirements of the Exchange Act, this report has been signed by the following persons on behalf of the indicated registrants and in the capacities and on the dates indicated:
* The undersigned, by signing his name hereto, does hereby execute this Form 10-K on behalf of the officers and directors of the registrant previously indicated by asterisks, pursuant to powers of attorney duly executed by such officers and directors and incorporated by reference as an exhibit to this Form 10-K.
/s/ James E. Rogers
James E. Rogers
Attorney-In-Fact
February 25,
/s/ James L. Turner
James L. Turner
Attorney-In-Fact
February 25,