ITEM 1. BUSINESS
CORPORATE OVERVIEW
KeySpan Corporation ("KeySpan") is a member of the Standard and Poor's 500 Index. KeySpan is a New York corporation and a holding company under the Public Utility Holding Company Act of 2005 ("PUHCA 2005"). KeySpan was formed in May 1998, as a result of the business combination of KeySpan Energy Corporation, the parent of The Brooklyn Union Gas Company, and certain businesses of the Long Island Lighting Company ("LILCO"). On November 8, 2000, KeySpan acquired Eastern Enterprises ("Eastern"), now known as KeySpan New England, LLC ("KNE"), a Massachusetts limited liability company, which primarily owns Boston Gas Company ("Boston Gas"), Colonial Gas Company ("Colonial Gas") and Essex Gas Company ("Essex Gas"), gas utilities operating in Massachusetts, as well as EnergyNorth Natural Gas, Inc. ("EnergyNorth"), a gas utility operating principally in central New Hampshire. KeySpan operates six regulated utilities that distribute natural gas to approximately 2.6 million customers in New York City, Long Island, Massachusetts and New Hampshire, making KeySpan the fifth largest gas distribution company in the United States and the largest in the Northeast. KeySpan also owns, leases and operates electric generating plants in Nassau and Suffolk Counties on Long Island and in Queens County in New York City and is the largest electric generation operator in New York State. Under contractual arrangements, KeySpan provides power, electric transmission and distribution services, billing and other customer services for approximately 1.1 million electric customers of the Long Island Power Authority ("LIPA"). KeySpan's other operating subsidiaries are primarily involved in gas production and development; underground gas storage; liquefied natural gas ("LNG") storage; retail electric marketing; large energy-system ownership, installation and management; service and maintenance of energy systems; and engineering and consulting services. KeySpan also invests and participates in the development of natural gas pipelines, electric generation and other energy-related projects. As used herein, "KeySpan," "we," "us" and "our" refers to KeySpan Corporation, its six principal gas distribution subsidiaries and its other regulated and unregulated subsidiaries, individually and in the aggregate.
On February 25, 2006, KeySpan entered into an Agreement and Plan of Merger (the "Merger Agreement"), with National Grid plc, a public limited company incorporated under the laws of England and Wales ("Parent") and National Grid US8, Inc., a New York Corporation ("Merger Sub"), pursuant to which Merger Sub will merge with and into KeySpan (the "Merger"), with KeySpan continuing as the surviving company and thereby becoming an indirect wholly-owned subsidiary of the Parent. Pursuant to the Merger Agreement, at the effective time of the Merger, each outstanding share of KeySpan common stock, par value $0.01 per share (the "Shares"), other than treasury shares and shares held by the Parent and its subsidiaries, shall be canceled and shall be converted into the right to receive $42.00 in cash, without interest.
Consummation of the Merger is subject to various closing conditions, including but not limited to the receipt of requisite regulatory approvals from certain United States federal and state public utility, antitrust and other regulatory authorities, all of which have been filed and many of which have been obtained. Specifically, we filed our application for approval of the Merger pursuant to
the Federal Power Act in May 2006 and in October the requisite approval was obtained from the Federal Energy Regulatory Commission ("FERC"). In early July 2006, we cleared review by the Federal Trade Commission under the Hart-Scott-Rodino Antitrust Improvement Act and received notification that the Committee on Foreign Investment in the U.S. has determined that there are no issues of national security sufficient to warrant an investigation of the transaction. On July 20, 2006 we filed an application for approval of the transaction with the New York Public Service Commission ("NYPSC"). KeySpan has also sought approval of the merger from the New Hampshire Public Utility Commission. In October 2006, the State of New Jersey Board of Public Utilities approved a change of control of KeySpan Communication Corp., which provides telecommunications services in New Jersey. In addition, the Merger was approved by our shareholders at our Annual Meeting on August 17, 2006. Shareholders of National Grid plc approved the Merger at a meeting held on July 31, 2006.
In addition to seeking approval of the Merger, the application filed with the NYPSC also contained proposed ten-year rate plans for KeySpan Energy Delivery of New York ("KEDNY") and KeySpan Energy Delivery of Long Island ("KEDLI"), as well as proposals concerning corporate structure and affiliate rules, the rate treatment for synergy savings and for low income and energy efficiency programs, among others. Specifically, the rate plan proposals provide for, among other things, a freeze of base delivery rates for KEDNY and KEDLI for 18 months. Thereafter, KEDNY's and KEDLI's gas adjustment clauses would be increased to recover, on a prospective basis, estimated gas commodity-related costs of $68.6 million for KEDNY and $28.7 million for KEDLI that would no longer be included in base rates. In addition, KEDNY and KEDLI base delivery rates would be increased by an average of 2.5% ($62.4 million) and 2.3% ($39.4 million), respectively in years 3, 5, 7 and 9 of the rate plans. The proposed rate plans contemplate an allowed return on equity of 11.0% for each entity. Cumulative earnings above 11.75% would be shared between gas sales customers and KeySpan over the rate plan period. On October 3, 2006 National Grid plc filed testimony and exhibits with the NYPSC that further explains the exhibits and attachments that were previously submitted as part of the July 20, 2006 petition.
Separately from the merger application, on October 3, 2006, KEDNY and KEDLI filed with the NYPSC individual applications for proposed annual increases in revenues, which applications assumed that KEDNY and KEDLI remained as stand-alone companies. The proposed revenue increases are for approximately 9.1% and 10.9% for KEDNY and KEDLI, respectively. KEDNY's last base rate increase took effect October 1, 1993 and since then base rates have been reduced twice - once in 1996 and again in 1998. KEDLI's last base rate increase took effect
December 1, 1995. Since that time, KEDLI's base rates were reduced twice in 1998. The principal factors creating the need for rate relief are increases in operating and maintenance expenses, increases in rate base, increased property taxes and depreciation expense, and the need to commence recovery of previously deferred costs such as pension and post retirement benefits, environmental expenditures and property taxes.
The total projected increase in revenues is comprised of two components; (i) an increase in base rates of $180.7 million for KEDNY and $145 million for KEDLI; and (ii) projected increases of $32.8 million and $13.6 million for KEDNY and KEDLI, respectively, for gas-related expenses that will be recovered through the Gas Adjustment Clause ("GAC") and/or the Transportation Adjustment Clause ("TAC"). The proposed rate of return on equity is 11.0% for both KEDNY and KEDLI.
The NYPSC may suspend the implementation of the proposed tariff changes for up to eleven months, which would mean, absent other intervening events, an effective date of September 3, 2007 for new rates. Although KEDNY and KEDLI proposed the new rates described above in these tariff filings, it will not be necessary to implement the rate increases proposed therein if the NYPSC approves the Merger between National Grid plc and KeySpan and approves the related ten-year rate plan previously noted, or some variation thereof.
On February 20, 2007, NYPSC Staff filed its direct testimony in the merger proceeding. NYSPSC Staff opposed the current terms of the Merger on policy grounds, but suggested that it could support the Merger under certain circumstances. KeySpan and National Grid intend to file testimony responding to the positions taken by Staff. In addition, on January 29, 2007, Staff filed its direct testimony in the rate case proceedings and our rebuttal testimony was filed on February 21, 2007. In connection with each of these proceedings, hearings before an administrative law judge (ALJ) are scheduled to begin in late March. Unless a settlement among the parties is otherwise reached, the ALJ will issue its recommended decision to the NYPSC following such hearings. Ultimately, the NYPSC may accept, reject, or modify all or any part of the ALJ's recommended decision.
KeySpan and National Grid will continue to pursue all required approvals and continue to anticipate that the Merger will be consummated in mid-2007. However, we are unable to predict the outcome of these regulatory proceedings and no assurance can be given that the Merger will occur or the timing of its completion. Accordingly, any statements contained herein concerning expectations, beliefs, plans, objectives, goals, strategies, future events or performance and underlying assumptions are "forward-looking statements" and do not take into account the occurrence or impact of any potential strategic transaction on the future operations, financial condition and cash flows of KeySpan.
KeySpan is a holding company under the Public Utility Holding Company Act of 2005, as amended ("PUHCA 2005"). In August 2005, the Energy Policy Act of 2005 (the "Energy Act") was enacted. The Energy Act is a broad energy bill that places an increased emphasis on the production of energy and promotes the development of new technologies and alternative energy sources and provides tax credits to companies that produce natural gas, oil, coal, electricity and renewable energy. For KeySpan, one of the more significant provisions of the Energy Act was the repeal of the Public Utility Holding Company Act of 1935, as amended ("PUHCA 1935"), which became effective on February 8, 2006. Since that time, the jurisdiction of the Securities and Exchange Commission ("SEC") over certain holding company activities, including the regulation of our affiliate transactions and service companies, has been transferred to the jurisdiction of the Federal Energy Regulatory Commission ("FERC") pursuant to PUHCA 2005. See "Regulation and Rate Matters" for additional information on the Energy Act and PUHCA 2005.
Under our holding company structure, we have no independent operations and conduct substantially all of our operations through our subsidiaries. Our subsidiaries operate in the following four business segments: Gas Distribution, Electric Services, Energy Services and Energy Investments.
The Gas Distribution segment consists of our six regulated gas distribution subsidiaries, which operate in New York, Massachusetts and New Hampshire and serve approximately 2.6 million customers.
The Electric Services segment consists of subsidiaries that manage the electric transmission and distribution system ("T&D System") owned by LIPA; provide generating capacity and, to the extent required, energy conversion services for LIPA from our approximately 4,200 megawatts ("MW") of generating facilities
located on Long Island; and manage fuel supplies for LIPA to fuel our Long Island generating facilities. The Electric Services segment also includes subsidiaries that own, lease and operate the 2,200 MW Ravenswood electric generation facility (the "Ravenswood Facility"), located in Queens County in New York City, and the 250 MW combined cycle generating unit (the "Ravenswood Expansion") which began full commercial operation in May 2004 (collectively, the Ravenswood Facility and the Ravenswood Expansion are referred to herein as the "Ravenswood Generating Station" and have a total electric capacity of 2,450 MW). Moreover, subsidiaries in this segment also provide retail marketing of electricity to commercial customers.
The Energy Services segment provides energy-related services to customers primarily located within the Northeastern United States, with concentrations in the New York City and Boston metropolitan areas.
The Energy Investments segment includes our gas production and development activities, domestic pipelines, gas storage facilities and LNG facilities and operations.
KeySpan's principal executive offices are located at One MetroTech Center, Brooklyn, New York 11201 and 175 East Old Country Road, Hicksville, New York 11801, and its telephone numbers are (718) 403-1000 (Brooklyn) and (516) 755-6650 (Hicksville).
KeySpan makes available free of charge on or through its website, http://www.keyspanenergy.com (Investor Relations section), its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the SEC. You may also read and copy any of these documents at the SEC's public reference room at 100 F Street, N.E., Washington, D.C. 20549. Please call the SEC at 1-800-SEC-0330 for further information on the public reference room. Our SEC filings are also available to the public on the SEC's web site at www.sec.gov.
GAS DISTRIBUTION OVERVIEW
Our gas distribution activities are conducted by our six regulated gas distribution subsidiaries, which operate in three states in the Northeast: New York, Massachusetts and New Hampshire. We are the fifth largest gas distribution company in the United States and the largest in the Northeast, with approximately 2.6 million customers served within an aggregate service area covering 4,273 square miles. In New York, The Brooklyn Union Gas Company, doing business as KeySpan Energy Delivery New York ("KEDNY"), provides gas distribution services to customers in the New York City Boroughs of Brooklyn, Queens and Staten Island; and KeySpan Gas East Corporation, doing business as KeySpan Energy Delivery Long Island ("KEDLI"), provides gas distribution services to customers in the Long Island Counties of Nassau and Suffolk and the Rockaway Peninsula of Queens County. In Massachusetts, Boston Gas provides gas distribution services in eastern and central Massachusetts; Colonial Gas provides gas distribution services on Cape Cod and in eastern Massachusetts; and Essex Gas provides gas distribution services in eastern Massachusetts. In New Hampshire, EnergyNorth provides gas distribution services to customers principally located in central New Hampshire. Our New England gas companies all do business as KeySpan Energy Delivery New England ("KEDNE").
In New York, there are two separate, but contiguous service territories served by KEDNY and KEDLI, comprising approximately 1,417 square miles and 1.68 million customers. In Massachusetts, Boston Gas, Colonial Gas and Essex Gas serve three service territories consisting of 1,934 square miles and approximately 792,000 customers. In New Hampshire, EnergyNorth has a service territory that is contiguous to Colonial Gas' and ranges from within 30 to 85 miles of the greater Boston area. EnergyNorth provides service to approximately 80,000 customers over a service area of approximately 922 square miles. Collectively, KeySpan owns and operates gas distribution, transmission and storage systems that consist of approximately 23,336 miles of gas mains and distribution pipelines.
Natural gas is offered for sale to residential and small commercial customers on a "firm" basis, and to most large commercial and industrial customers on either a "firm" or "interruptible" basis. "Firm" service is offered to customers under tariffed schedules or contracts that anticipate no interruptions, whereas "interruptible" service is offered to customers under tariffed schedules or contracts that anticipate and permit interruption on short notice, generally in peak-load seasons or for system reliability reasons. We maintain a diverse portfolio of firm gas supply, storage and pipeline transportation capacity contracts to adequately serve the requirements of our gas sales customers, to maintain system reliability and system operations, and to meet our obligation to serve our customers. We also engage in the use of derivative financial instruments from time to time to reduce the cash flow volatility associated with the purchase price for a portion of future natural gas purchases.
KeySpan actively promotes a competitive retail gas market by offering tariff firm transportation services to firm gas customers who elect to purchase their gas supplies from natural gas marketers rather than from the utility. In New York, KeySpan further facilitates competition by releasing its pipeline transportation capacity and offering bundled gas supply to natural gas marketers that would otherwise not be able to obtain their own capacity. In Massachusetts and New Hampshire, there are mandatory capacity assignment programs in place whereby capacity is released to natural gas marketers on behalf of customers they serve. However, net gas revenues are not significantly affected by
customers opting to purchase their gas supply from other sources since delivery rates charged to transportation customers generally are the same as delivery rates charged to sales service customers.
KeySpan also participates in interstate markets by releasing pipeline capacity and by selling bundled gas services to customers located outside of our service territory ("off-system" customers).
KeySpan purchases natural gas for firm gas customers under both long and short-term supply contracts, as well as on the spot market, and utilizes its firm pipeline transportation contracts to transport the gas from the point of purchase to the market. KeySpan also contracts for firm capacity in natural gas underground storage facilities to store gas during the summer for later withdrawal during the winter heating season when gas customer demand is higher. KeySpan also contracts for firm winter peaking supplies to meet firm gas customer demand on the coldest days of the year.
KeySpan sells gas to firm gas customers at its cost for such gas, plus a charge designed to recover the costs of distribution (including a return of and a return on capital invested in our distribution facilities). We share with our firm gas customers net revenues (operating revenues less the cost of gas and associated revenue taxes) from off-system sales and capacity release transactions. Further, net revenues from tariff gas balancing services and certain interruptible on-system sales are refunded, for most of our subsidiaries, to firm customers subject to certain sharing provisions.
Our gas operations can be significantly affected by seasonal weather conditions. Annual revenues are substantially realized during the heating season as a result of higher sales of gas due to cold weather. Accordingly, operating results historically are most favorable in the first and fourth calendar quarters. KEDNY and KEDLI each operate under a utility tariff that contains a weather normalization adjustment that largely offsets variations in firm net revenues due to fluctuations in normal weather. However, the tariffs for our four KEDNE gas distribution companies do not contain such a weather normalization adjustment and, therefore, fluctuations in seasonal weather conditions between years may have a significant effect on results of operations and cash flows for these four subsidiaries. We utilize weather derivatives for KEDNE to mitigate variations in firm net revenues due to warmer-than-normal weather during the heating season.
New York Gas Distribution Systems - KEDNY and KEDLY Supply and Storage
KEDNY and KEDLI have firm long-term contracts for the purchase of transportation and underground storage services. Gas supplies are purchased under long and short-term firm contracts, as well as on the spot market. Gas supplies are transported by interstate pipelines from domestic and Canadian supply basins. Peaking supplies are available to meet system requirements on the coldest days of the winter season.
Peak-Day Capability. The design criteria for the New York gas system assumes an average temperature of 0(0)F for peak-day demand. Under such criteria, we estimate that the requirements to supply our firm gas customers would amount to approximately 2,129 MDTH (one MDTH equals 1,000 DTH or 1 billion British Thermal Units) of gas for a peak-day during the 2006/07 winter season and that the gas available to us on such a peak-day amounts to approximately 2,235 MDTH.
The highest daily throughput most recently experienced occurred on February 5, 2007 in which the demand of the firm New York customers was 1,874 MDTH, and the average temperature was 14(degree)F. KEDNY and KEDLI have sufficient gas supply available to meet the requirements of their firm gas customers for the 2006/07 winter season.
Our New York firm gas peak-day capability is summarized in the following table:
Source MDTH per day % of Total - ------------------------------------------ ---------------- ------------
Pipeline 865 39% Underground Storage 800 36% Peaking Supplies 570 25% --- ---
Total 2,235 100% ======= =======
Pipelines. Our New York based gas distribution utilities purchase natural gas for sale under contracts with suppliers of natural gas located in domestic and Canadian supply basins and arrange for its transportation to our facilities under firm long-term contracts with interstate pipeline companies. For the 2006/07 gas year, approximately 73% of our New York natural gas supply was available from domestic sources and 27% from Canadian sources. We have available under firm contract 865 MDTH per day of year-round and seasonal pipeline transportation capacity. Our major providers of interstate pipeline capacity and related services include: Transcontinental Gas Pipe Line Corporation ("Transco"), Texas Eastern Transmission Corporation ("Tetco"), Iroquois Gas Transmission System, L.P. ("Iroquois"), Tennessee Gas Pipeline Company ("Tennessee"), Dominion Transmission Incorporated ("Dominion"), Texas Gas Transmission Company, TransCanada Corporation and Union Gas.
Underground Storage. In order to meet winter demand in our New York service territories, we also have long-term contracts with Transco, Tetco, Tennessee, Dominion, Equitrans, Inc., National Fuel Gas Supply Corporation ("National Fuel") and Honeoye Storage Corporation ("Honeoye") for underground storage capacity of 60,766 MDTH and 800 MDTH per day of maximum deliverability.
Peaking Supplies. In addition to the pipeline and underground storage supply, we supplement our winter supply portfolio with peaking supplies that are available on the coldest days of the year to economically meet the increased requirements of our heating customers. Our peaking supplies include: (i) two LNG plants; (ii) peaking supply contracts with dual-fuel power producers located in our franchise areas; and (iii) third-party peaking supply contracts with suppliers located outside our franchise area. For the 2006/07 winter season, we have the capability to provide maximum peaking supplies of 570 MDTH on extremely cold days. The LNG plants provide us with peak-day capacity of 395 MDTH and winter season availability of 2,053 MDTH. The peaking supply contracts with the dual fuel power producers provide us with peak-day capacity of 175 MDTH and winter season availability of 4,846 MDTH.
Gas Supply Management. We currently perform our New York-based gas supply management services internally.
Gas Costs. The current gas rate structure of each of these companies includes a gas adjustment clause pursuant to which variations between actual gas costs incurred and gas costs billed are deferred and subsequently refunded to or collected from firm customers.
Combined Gas Supply Portfolios. KEDNY and KEDLI combined the planning, management and utilization of their respective gas supply portfolios to enable each company to serve its customers more reliably and cost effectively. Specifically, these companies plan the acquisition of incremental pipeline capacity, underground storage, gas supply and peaking supply contracts to meet projected growth in firm customer demand on a combined portfolio basis. This approach enables these companies to realize synergies that would otherwise not be attainable if they were to plan independently for the development of their respective portfolios. These two companies, by virtue of their geographic proximity, complementary customer demand profiles and similar gas contracts are able to add incremental capacity more effectively to meet expected customer demand growth by planning the portfolios on a combined basis.
Deregulation. Regulatory actions, economic factors and changes in customers and their preferences continue to reshape our gas operations. A number of customers currently purchase their gas supplies from natural gas marketers and then contract with us for local transportation, balancing and other unbundled services. In addition, our New York gas distribution companies release firm capacity on our interstate pipeline transportation contracts to natural gas marketers to ensure the marketers' gas supply is delivered on a firm basis and in a reliable manner. As of January 1, 2007, approximately 98,968 gas customers on the New York gas distribution system are purchasing their gas from marketers. However, net gas revenues are not significantly affected by customers opting to purchase their gas supply from other sources since delivery rates charged to transportation customers generally are the same as delivery rates charged to sales service customers.
New England Gas Distribution Systems - KEDNE Supply and Storage
KEDNE has firm long-term contracts for the purchase of transportation and underground storage services. Gas supplies are purchased under long and short-term firm contracts, as well as on the spot market. Gas supplies are transported by interstate pipelines from domestic and Canadian supply basins. Peaking supplies are available to meet system requirements on the coldest days of the winter season.
Peak-Day Capability. The design criteria for the New England gas systems assumes an average temperature of -6(0)F in Massachusetts and -8(0)F in New Hampshire for peak-day demand. Under such criteria, we estimate that the requirements to supply our firm gas customers would amount to approximately 1,389 MDTH of gas for a peak-day during the 2006/07 winter season and that the gas available to us on such a peak-day amounts to approximately 1,420 MDTH.
The highest daily throughput most recently experienced occurred on January 26, 2007 in which the demand of the firm New England customers (which includes both firm sales and firm transportation) was 1,210 MDTH, and the average temperature was 9(0)F. KEDNE has sufficient gas supply available to meet the requirements of their firm gas customers for the 2006/07 winter season.
Our New England firm gas peak-day capability is summarized in the following table:
Source MDTH per day % of Total - --------------------------------------- ---------------- --------------
Pipeline 500 35% Underground Storage 248 18% Peaking Supplies 672 47% --------- -- Total 1,420 100% ========= =======
Pipelines. Our New England based gas distribution utilities purchase natural gas for sale under contracts with suppliers of natural gas located in domestic and Canadian supply basins and arrange for transportation to our facilities under firm long-term contracts with interstate pipeline companies. We have available under firm contract 500 MDTH per day of year-round and seasonal pipeline transportation capacity. Our major providers of interstate pipeline capacity and related services include: Algonquin Gas Transmission Company, Iroquois, Maritimes and Northeast Pipelines, Portland Natural Gas Transmission System, Tennessee and TETCO.
Underground Storage. In order to meet winter demand in our New England service territories, we also have long-term contracts with Tetco, Tennessee, Dominion, National Fuel and Honeoye for underground storage capacity of 23,280 MDTH and 248 MDTH per day of maximum deliverability.
Peaking Supplies. In addition to the pipeline and underground storage supply, we supplement our winter supply portfolio with peaking supplies that are available on the coldest days of the year to economically meet the increased requirements of our heating customers. Our peaking supplies include (i) local production plants that store LNG and liquid propane until vaporized, which are located strategically across the service territory and (ii) contracts for LNG storage and delivery with our LNG subsidiary, KeySpan LNG LP, located in Providence, Rhode Island and with Distrigas of Massachusetts located in Everett, Massachusetts. For the 2006/07 winter season, we have the capability to provide maximum peaking supplies of 672 MDTH on extremely cold days.
Gas Supply Management. KeySpan has a management contract with Merrill Lynch Trading, under which KeySpan and Merrill Lynch Trading share the responsibilities for managing KeySpan's upstream gas contracted assets associated with its Massachusetts gas distribution subsidiaries, as well as providing city-gate delivered supply. KeySpan, Merrill Lynch Trading and KeySpan's Massachusetts gas sales customers will share in the profits generated
from the optimization of these assets. The Massachusetts Department of Telecommunications and Energy ("MADTE") approved this contract in March 2006 effective April 1, 2006. KeySpan provides these services internally for its New Hampshire gas distribution subsidiaries.
Gas Costs. The current gas rate structure of each of the KEDNE companies includes a gas adjustment clause pursuant to which variations between actual gas costs incurred and gas costs billed are deferred and subsequently refunded to or collected from firm customers.
For additional information and for financial information concerning the gas distribution segment, see the discussion in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - "Gas Distribution" and Note 2 to the Consolidated Financial Statements, "Business Segments".
ELECTRIC SERVICES OVERVIEW
We are the largest electric generator in New York State. Our subsidiaries own and operate 5 large generating plants and 13 smaller facilities which are comprised of 57 generating units in Nassau and Suffolk Counties on Long Island and the Rockaway Peninsula in Queens. In addition, we own, lease and operate the Ravenswood Generating Station located in Queens County, which is the largest generating facility in New York City. The Ravenswood Generating Station is comprised of 3 large steam-generating units, a 250 MW combined cycle generating unit and 17 gas turbine generators. We also operate and maintain a 55 MW gas turbine unit in Greenport, Long Island under an agreement with a third party.
As more fully described below, we: (i) provide to LIPA all operation, maintenance and construction services and significant administrative services relating to the Long Island electric T&D System pursuant to a Management Services Agreement (the "1998 MSA"); (ii) supply LIPA with electric generating capacity, energy conversion and ancillary services from our Long Island generating units pursuant to a Power Supply Agreement (the "1998 PSA"); and (iii) manage all aspects of the fuel supply for our Long Island generating facilities, as well as all aspects of the capacity and energy owned by or under contract to LIPA pursuant to an Energy Management Agreement (the "1998 EMA"). The 1998 MSA, 1998 PSA and 1998 EMA became effective on May 28, 1998 and are collectively referred to herein as the "1998 LIPA Agreements."
On February 1, 2006, KeySpan and LIPA entered into (i) an amended and restated Management Services Agreement (the "2006 MSA"), pursuant to which KeySpan will continue to operate and maintain the electric T&D System owned by LIPA on Long Island through 2013; (ii) a new Option and Purchase and Sale Agreement (the "2006 Option Agreement"), to replace the Generation Purchase Rights Agreement (the "GPRA"), pursuant to which LIPA had the option, through December 15, 2005, to acquire substantially all of the electric generating facilities owned by KeySpan on Long Island; and (iii) a Settlement Agreement (the "2006 Settlement Agreement") resolving outstanding issues between the parties regarding the 1998 LIPA Agreements. The 2006 MSA, the 2006 Option Agreement and the 2006 Settlement Agreement are collectively referred to herein as the "2006 LIPA Agreements." These will become effective following approval by the New York State
Comptroller's Office and the New York State Attorney General. (For a further discussion on these LIPA agreements see the discussion under the caption "Electric Services - LIPA Agreements" and Note 11 to the Consolidated Financial Statements "2006 LIPA Settlement"). The Electric Services segment also provides retail marketing of electricity to commercial customers.
Portions of our Electric Services business can be affected by seasonal weather conditions and market conditions. The majority of the capacity revenue associated with the Ravenswood Generating Station is realized during the six months between May and October of each year. Energy and ancillary service sales from our Ravenswood Generating Station are directly correlated to the demand for electricity and competition from other resources. Typically, the demand and price for electricity increases during the extreme temperature conditions of summer. However, depending on the availability of alternative competitive supply, extreme temperature conditions may not result in increased revenue. As a result, fluctuations in weather and competitive supply between years may have a significant effect on results of operations in this portion of our Electric Services business.
Generating Facility Operations
In June 1999, we acquired the 2,200 MW Ravenswood Facility located in New York City from Consolidated Edison Company of New York, Inc. ("Consolidated Edison") for approximately $597 million. In order to reduce our initial cash requirements to finance this acquisition, we entered into an arrangement with an unaffiliated variable interest entity through which we lease a portion of the Ravenswood Facility. Under the arrangement, the variable interest entity acquired a portion of the facility directly from Consolidated Edison and leased it to our wholly owned subsidiary, KeySpan-Ravenswood, LLC ("KSR"). For more information concerning this lease arrangement, see Note 7 to the Consolidated Financial Statements, "Contractual Obligations, Financial Guarantees and Contingencies."
In 2004, we completed construction of the Ravenswood Expansion, a 250 MW combined cycle generating unit at the Ravenswood Facility, thereby increasing the total electric capacity of the Ravenswood Facility to 2,450 MW. In mid-May 2004, the Ravenswood Expansion began full commercial operations. To finance the Ravenswood Expansion, we entered into a leveraged lease financing arrangement pursuant to which the Ravenswood Expansion was acquired by an unaffiliated lessor from KSR and simultaneously leased back to it. This lease transaction qualifies as an operating lease under SFAS 98 "Accounting for Leases: Sale/Leaseback Transactions Involving Real Estate; Sales-Type Leases of Real Estate; Definition of the Lease Term; an Initial Direct Costs of Direct Financing Leases, an amendment of FASB Statements No.13, 66, 91 and a rescission of FASB Statement No. 26 and Technical Bulletin No. 79-11." See Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation - "Electric Services Revenue Mechanisms" for a further discussion of these matters.
The Ravenswood Generating Station sells capacity, energy and ancillary services into the New York Independent System Operator ("NYISO") electricity market at market-based rates, subject to mitigation. The Ravenswood Generating Station Facility has the ability to provide approximately 25% of New York City's capacity requirements and is a strategic asset that is available to serve residents and businesses in New York City.
The Ravenswood Generating Station and our New York City Operations
The NYISO's New York City local reliability rules require that 80% of the electric capacity needs of New York City be provided by "in-City" generators. Our Ravenswood Generating Station is an "in-City" generator. As the electric infrastructure in New York City and the surrounding areas continues to change and evolve and the demand for electric power increases, the "in-City" generator requirement could be further modified. Construction of new transmission and generation facilities may cause significant changes to the market for sales of capacity, energy and ancillary services from our Ravenswood Generating Station.
KeySpan continues to believe that New York City represents a strong capacity market and has entered into an International Swap Dealers Association ("ISDA") Master Agreement for a fixed for float unforced capacity financial swap (the "Swap Agreement") with Morgan Stanley Capital Group Inc. ("Morgan Stanley") dated as of January 18, 2006. The Swap Agreement has a three year term that began on May 1, 2006. The notional quantity is 1,800,000kW (the "Notional Quantity") of In-City Unforced Capacity and the fixed price is $7.57/kW-month ("Fixed Price"), subject to adjustment upon the occurrence of certain events. Settlement occurs on a monthly basis based on the In-City Unforced Capacity price determined by the relevant New York Independent System Operator Spot Demand Curve Auction Market ("Floating Price"). For each monthly settlement period, the price difference equals the Fixed Price minus the Floating Price. If such price difference is less than zero, Morgan Stanley pays KeySpan an amount equal to the product of (a) the Notional Quantity and (b) the absolute value of such price difference. Conversely, if such price difference is greater than zero, KeySpan pays Morgan Stanley an amount equal to the product of (a) the Notional Quantity and (b) the absolute value of such price difference.
The New York State competitive wholesale market for capacity, energy and ancillary services administered by the NYISO is still evolving and FERC has adopted several price mitigation measures which are subject to rehearing and possible judicial review. See Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation - "Regulatory Issues and Competitive Environment" for a further discussion of these matters.
Forty-six of our seventy-eight generating units are dual fuel units. In recent years, we have reconfigured several of our facilities to enable them to burn either natural gas or oil, thus enabling us to switch periodically between fuel alternatives based upon cost and seasonal environmental requirements. Through other innovative technological approaches, we instituted a program to reduce nitrogen oxides for improved environmental performance while recovering 80 MW of energy output.
The following table indicates the 2006 summer capacity of all of our steam generation facilities and gas turbine ("GT") units as reported to the NYISO:
For additional information and for financial information concerning the Electric Services segment, see the discussion in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - "Electric Services" and Note 2 to the Consolidated Financial Statements, "Business Segments".
Agreements with LIPA
LIPA is a corporate municipal instrumentality and a political subdivision of the State of New York. On May 28, 1998, certain of LILCO's business units were merged with KeySpan and LILCO's common stock and remaining assets were acquired by LIPA. At the time of this transaction, KeySpan and LIPA entered into three major long-term service agreements that (i) provide to LIPA all operation, maintenance and construction services and significant administrative services relating to the Long Island electric transmission and distribution system ("T&D System") pursuant to the Management Services Agreement (the "1998 MSA"); (ii) supply LIPA with electric generating capacity, energy conversion and ancillary services from our Long Island generating units pursuant to the Power Supply Agreement (the "1998 PSA") and other long-term agreements through which we provide LIPA with approximately one half of its customers' energy needs; and (iii) manage all aspects of the fuel supply for our Long Island generating facilities, as well as all aspects of the capacity and energy owned by or under contract to LIPA pursuant to the Energy Management Agreement (the "1998 EMA"). We also purchase energy, capacity and ancillary services in the open market on LIPA's behalf under the 1998 EMA. The 1998 MSA, 1998 PSA and 1998 EMA all became effective on May 28, 1998 and are collectively referred to as the 1998 LIPA Agreements.
On February 1, 2006, KeySpan and LIPA entered into (i) an amended and restated Management Services Agreement (the "2006 MSA"), pursuant to which KeySpan will continue to operate and maintain the electric T&D System owned by LIPA on Long Island; (ii) a new Option and Purchase and Sale Agreement (the "2006 Option Agreement"), to replace the Generation Purchase Rights Agreement (as amended, the "GPRA"), pursuant to which LIPA had the option, through December 15, 2005, to acquire substantially all of the electric generating facilities owned by KeySpan on Long Island; and (iii) a Settlement Agreement (the "2006 Settlement Agreement") resolving outstanding issues between the parties regarding the 1998 LIPA Agreements. The 2006 MSA, the 2006 Option Agreement and the 2006 Settlement Agreement are collectively referred to herein as the "2006 LIPA Agreements". Each of the 2006 LIPA Agreements will become effective as of January 1, 2006 upon all of the 2006 LIPA Agreements receiving the required governmental approvals; otherwise none of the 2006 LIPA Agreements will become effective. The 2006 LIPA Agreements become effective following approval by the New York State Comptroller's Office and the New York State Attorney General.
2006 Settlement Agreement. Pursuant to the terms of the 2006 Settlement Agreement, KeySpan and LIPA agreed to resolve issues that have existed between the parties relating to the various 1998 LIPA Agreements. In addition to the resolution of these matters, KeySpan's entitlement to utilize LILCO's available tax credits and other tax attributes will increase from approximately $50 million to approximately $200 million. These credits and attributes may be used to satisfy KeySpan's previously incurred indemnity obligation to LIPA for any federal income tax liability that results from the recent settlement with the IRS regarding the audit of LILCO's tax returns for the years ended December 31, 1996 through March 31, 1999. On October 30, 2006, the IRS submitted the settlement provisions of the recently concluded IRS audit to the Joint Committee on Taxation for approval. Key provisions of the settlement included the resolution of the tax basis of assets transferred to KeySpan at the time of the KeySpan/LILCO merger, the tax deductibility of certain merger related costs and the tax deductibility of certain environmental expenditures. The settlement enabled KeySpan to utilize 100% of the available tax credits. (See Note 3 to the Consolidated Financial Statements "Income Taxes" for additional information of the settlement.) In recognition of these items, as well as for the modification and extension of the 1998 MSA and the amendments to the GPRA, upon effectiveness of the 2006 Settlement Agreement, KeySpan will record a contractual asset in the amount of approximately $160 million, of which approximately $110 million will be attributed to the right to utilize such additional credits and attributes and approximately $50 million will be amortized over the eight year term of the 2006 MSA. In order to compensate LIPA for the foregoing, KeySpan will pay LIPA $69 million in cash and will settle certain accounts receivable in the amount of approximately $90 million due from LIPA.
Generation Purchase Rights Agreement and 2006 Option Agreement. Under the amended GPRA, LIPA had the right to acquire certain of KeySpan's Long Island-based generating assets formerly owned by LILCO at fair market value at the time of the exercise of such right. LIPA was initially required to make a determination by May 2005, but KeySpan and LIPA agreed to extend the date by which LIPA was to make this determination to December 15, 2005. As part of the 2006 settlement between KeySpan and LIPA, the parties entered into the 2006 Option Agreement whereby LIPA had the option during the period January 1, 2006 to December 31, 2006 to purchase only KeySpan's Far Rockaway and/or E.F. Barrett
Generating Stations (and certain related assets) at a price equal to the net book value of each facility. In December 2006, KeySpan and LIPA entered into an amendment to the 2006 Option Agreement whereby the parties agreed to extend the expiration of the option period to the later of (i) December 31, 2007 or (ii) 180 days following the effective date of the 2006 Option Agreement. The 2006 Option Agreement replaces the GPRA, the expiration of which has been stayed pending effectiveness of the 2006 LIPA Agreements. In the event such agreements do not become effective by reason of failure to secure any of the requisite governmental approvals, the GPRA will be reinstated for a period of 90 days from the date such approval is denied. If LIPA were to exercise the option and purchase one or both of the generation facilities then: (i) LIPA and KeySpan will enter into an operation and maintenance agreement, pursuant to which KeySpan will continue to operate these facilities through May 28, 2013 for a fixed management fee plus reimbursement for certain costs and (ii) the 1998 PSA and 1998 EMA will be amended to reflect that the purchased generating facilities would no longer be covered by those agreements. It is anticipated that the fees received pursuant to the operation and maintenance agreement will offset the reduction in the operation and maintenance expense recovery component of the 1998 PSA and the reduction in fees under the 1998 EMA.
Management Services Agreements. Pursuant to the 1998 MSA, KeySpan manages the day-to-day operations, maintenance and capital improvements of the T&D System. When originally executed, the 1998 MSA had a term expiring on May 28, 2006. In 2002, in connection with an extension of the GPRA term, the 1998 MSA was extended for 31 months through 2008. As a result of the recent negotiations and settlement between KeySpan and LIPA discussed above, the parties entered into the 2006 MSA.
In place of the previous compensation structure (whereby KeySpan was reimbursed for budgeted costs, and earned a management fee and certain performance and cost-based incentives), KeySpan's compensation for managing the T&D System under the 2006 MSA consists of two components: a minimum compensation component of $224 million per year and a variable component based on electric sales. The $224 million component will remain unchanged for three years and then increase annually by 1.7% plus inflation. The variable component, which will comprise no more than 20% of KeySpan's compensation, is based on electric sales on Long Island exceeding a base amount of 16,558 gigawatt hours, increasing by 1.7% in each year. Above that level, KeySpan will receive approximately 1.34 cents per kilowatt hour for the first contract year, 1.29 cents per kilowatt hour in the second contract year (plus an annual inflation adjustment), 1.24 cents per kilowatt hour in the third contract year (plus an annual inflation adjustment), with the per kilowatt hour rate thereafter adjusted annually by inflation. Subject to certain limitations, KeySpan will be able to retain all operational efficiencies realized during the term of the 2006 MSA.
LIPA will continue to reimburse KeySpan for certain expenditures incurred in connection with the operation and maintenance of the T&D System, and other payments made on behalf of LIPA, including: real property and other T&D System taxes, return postage, capital construction expenditures, conservation expenditures and storm costs.
The 2006 MSA provides for a number of performance metrics measuring various aspects of KeySpan's performance in the operations and customer service areas. Poor performance in any metric may subject KeySpan to financial and other non-cost penalties (such financial penalties not to exceed $7 million in the aggregate for all performance metrics in any contract year). Subject to certain limitations, superior performance in certain metrics can be used to offset underperformance in other metrics. Consistent failure to meet threshold performance levels for two metrics, System Average Interruption Duration Index (two out of three consecutive years) and Customer Satisfaction Index (three consecutive years), will constitute an event of default under the 2006 MSA.
In the event LIPA sells the T&D System to a private entity during the term of the 2006 MSA, LIPA shall have the right to terminate the 2006 MSA, provided that LIPA will be required to pay KeySpan's reasonable transition costs and a termination fee of (a) $28 million if the termination date occurs on or before December 31, 2009, and (b) $20 million if the termination date occurs after December 31, 2009.
Upon approval, the 2006 LIPA Agreements will be effective retroactive to January 1, 2006. KeySpan's reported operating income and net income for 2006, under the 2006 MSA, are substantially the same as they would have been if the terms and provisions of the 1998 MSA had continued to be applied. At this point in time, KeySpan is unable to estimate what the impact would be to its results of operations, financial position and cash flows if the 2006 LIPA Agreements do not become fully effective.
Power Supply Agreements. KeySpan sells to LIPA all of the capacity and, to the extent requested, energy conversion services from our existing Long Island based oil and gas-fired generating plants. Sales of capacity and energy conversion services are made under rates approved by the FERC. Since October 1, 2004, pursuant to a FERC approved settlement, the rates reflect a cost of equity of 9.5% with no revenue increase. The FERC also approved updated operating and maintenance expense levels and KeySpan's recovery of certain other costs as agreed to by the parties. Rates charged to LIPA include a fixed and variable component. The variable component is billed to LIPA on a monthly per megawatt hour basis and is dependent on the number of megawatt hours dispatched. LIPA has no obligation to purchase energy conversion services from KeySpan and is able to purchase energy or energy conversion services on a least-cost basis from all available sources consistent with existing interconnection limitations of the T&D System. The 1998 PSA provides incentives and penalties that can total $4 million annually for the maintenance of the output capability and the efficiency of the generating facilities. In 2006, we earned $4.0 million in incentives under this agreement.
The 1998 PSA has a term of fifteen years through May 2013, with LIPA having the option to renew the 1998 PSA for an additional fifteen year term. If the 2006 LIPA Agreements receive the requisite governmental approvals and become effective and if LIPA exercises its rights under the 2006 Option Agreement to purchase the two generating plants, then LIPA and KeySpan will enter into an operation and maintenance agreement, pursuant to which KeySpan will continue to operate these facilities for a fixed management fee plus reimbursement for certain costs; and the 1998 PSA will be amended to reflect that the purchased
generating facilities would no longer be covered by the 1998 PSA. It is anticipated that the fees received pursuant to the operation and maintenance agreement will offset the reduction in the operation and maintenance expense recovery component of the 1998 PSA.
Energy Management Agreement. The 1998 EMA provides for KeySpan to procure and manage fuel supplies on behalf of LIPA to fuel the generating facilities under contract to it and perform off-system capacity and energy purchases on a least-cost basis to meet LIPA's needs. In exchange for these services we earn an annual fee of $1.5 million. In addition, we arrange for off-system sales on behalf of LIPA of excess output from the generating facilities and other power supplies either owned or under contract to LIPA. LIPA is entitled to two-thirds of the profit from any off-system energy sales. In addition, the 1998 EMA provides incentives and penalties that can total $5 million annually for performance related to fuel purchases and off-system power purchases. In 2006, we earned EMA incentives in an aggregate of $5.0 million.
The original term for the fuel supply service is fifteen years, expiring May 28, 2013, and the original term for the power supply management services described was eight years, which expired on May 28, 2006. In March 2005, LIPA issued a Request for Proposal ("RFP") for system power supply management services beginning May 29, 2006 and fuel management services for certain of its peaking generating units beginning January 1, 2006. KeySpan submitted a bid in response to this RFP in April 2005. LIPA has not yet selected a service provider.
In 2005, the EMA was amended to extend the term for power supply management services through December 31, 2006 and thereafter on a month-to-month basis, unless terminated by LIPA on sixty days notice, but in no event later than December 31, 2007.
In the event LIPA exercises its rights under the 2006 Option Agreement, KeySpan and LIPA will enter into an amendment to the 1998 EMA reflecting that the facilities that LIPA acquires pursuant to the Option Agreement are no longer covered under the 1998 EMA and as noted above, an operation and maintenance agreement, whereby KeySpan will continue to operate the newly acquired facilities for a fixed management fee plus reimbursement for certain costs. It is anticipated that the fees received pursuant to the operation and maintenance agreement will offset the reduction in any fees earned by KeySpan pursuant to the 1998 EMA.
Under the 1998 LIPA Agreements and the 2006 LIPA Agreements, we are required to obtain a letter of credit in the aggregate amount of $60 million supporting our obligations to provide the various services if our long-term debt is not rated in the "A" range by a nationally recognized rating agency.
Power Purchase Agreements. KeySpan-Glenwood Energy Center, LLC and KeySpan-Port Jefferson Energy Center LLC each have 25 year power purchase agreements with LIPA expiring in 2027 (the "2002 LIPA PPAs"). Under the terms of the 2002 LIPA PPAs, these subsidiaries sell capacity, energy conversion services and ancillary services to LIPA. Each plant is designed to produce 79.9 MW. Pursuant to the 2002 LIPA PPAs, LIPA pays a monthly capacity fee, which guarantees full recovery of each plant's construction costs, as well as an appropriate rate of return on investment.
Other Rights. Pursuant to other agreements between LIPA and KeySpan, certain future rights have been granted to LIPA. Subject to certain conditions, these rights include the right for 99 years (from May 1998) to lease or purchase, at fair market value, parcels of land and to acquire unlimited access to, as well as appropriate easements at, the Long Island generating facilities for the purpose of constructing new electric generating facilities to be owned by LIPA or its designee. Subject to this right granted to LIPA, KeySpan has the right to sell or lease property on or adjoining the Long Island generating facilities to third parties.
We own common plant assets (such as administrative office buildings and computer systems) formerly owned by LILCO and recover an allocable share of the carrying costs of such plant assets through the MSA. KeySpan has agreed to provide LIPA, for a period of 99 years (from May 1998), the right to enter into leases at fair market value for common plant assets or sub-contract for common services which it may assign to a subsequent manager of the transmission and distribution system. We have also agreed: (i) for a period of 99 years (from May 1998) not to compete with LIPA as a provider of transmission or distribution service on Long Island; (ii) that LIPA will share in synergy (i.e., efficiency) savings over a 10-year period attributed to the May 28, 1998 transaction which resulted in the formation of KeySpan (estimated to be approximately $1 billion), which savings are incorporated into the cost structure under the 1998 LIPA Agreements; and (iii) generally not to commence any tax certiorari case (during the pendency of the 1998 PSA) challenging certain property tax assessments relating to the former LILCO Long Island generating facilities.
Guarantees and Indemnities. We have entered into agreements with LIPA to provide for the guarantee of certain obligations, indemnification against certain liabilities and allocation of responsibility and liability for certain pre-existing obligations and liabilities. In general, liabilities associated with the LILCO assets transferred to KeySpan, have been assumed by KeySpan; and liabilities associated with the assets acquired by LIPA, are borne by LIPA, subject to certain specified exceptions. We have assumed all liabilities arising from all manufactured gas plant ("MGP") operations of LILCO and its predecessors, and LIPA has assumed certain liabilities relating to the former LILCO Long Island generating facilities and all liabilities traceable to the business and operations conducted by LIPA after completion of the 1998 KeySpan/LILCO transaction. An agreement also provides for an allocation of liabilities which relates to the assets that were common to the operations of LILCO and/or shared services or liabilities which are not traceable directly to either the business or operations conducted by LIPA or KeySpan. In addition, costs incurred by KeySpan for liabilities for asbestos exposure arising from the activities of the generating facilities previously owned by LILCO are recoverable from LIPA through the PSA.
ENERGY SERVICES OVERVIEW
The Energy Services segment includes companies that provide energy-related services to customers located primarily within the Northeastern United States, with concentrations in the New York City and Boston metropolitan areas. Subsidiaries in this segment provide residential and small commercial customers
with service and maintenance of energy systems and appliances, as well as operation and maintenance, design, engineering, consulting and fiber optic services to commercial, institutional and industrial customers. Our subsidiaries in this segment have over 200,000 service contracts in place to provide home energy services, completed over 240,000 service calls during 2006 and completed more than 16,000 installations during 2006.
For additional information and financial information concerning the Energy Services segment, see the discussion in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - "Energy Services", Item 8. "Financial Statements and Supplementary Data", Note 2 to the Consolidated Financial Statements, "Business Segments", and Note 10, "Energy Services - Discontinued Operations".
ENERGY INVESTMENTS OVERVIEW
We are also engaged in Energy Investments which includes gas production and development activities, domestic pipelines, gas storage facilities and LNG facilities and operations.
Gas Production and Development
KeySpan is engaged in the production and development of domestic natural gas and oil through wholly-owned subsidiaries Seneca-Upshur Petroleum, Inc., d/b/a KeySpan Production & Development Company ("Seneca-Upshur") and KeySpan Exploration and Production, LLC ("KeySpan Exploration and Production"). Seneca-Upshur's assets consist of 38 billion cubic feet of low risk, mature, onshore gas producing properties. Specifically, Seneca-Upshur, headquartered in Buckhannon, West Virginia, owns and operates onshore gas producing properties, and operates approximately 1,300 wells in north central West Virginia. To manage the inherent volatility in commodity prices, Seneca-Upshur entered into a three-year hedge for a majority of its production. KeySpan Exploration is involved in a joint venture with Merit Energy Corporation, an independent oil and gas producer, which acquired its interest in the joint-venture from The Houston Exploration Company ("Houston Exploration"). See Item 7. Management's Discussion and Analysis of Financial Conditions and Results of Operations - "Energy Investments" for a further discussion of these matters.
Domestic Pipelines and Gas Storage Facilities
We own a 20.4% interest in Iroquois Gas Transmission System LP, a partnership of affiliates of six U.S. and Canadian energy companies, which is the owner of a 411-mile interstate natural gas pipeline extending from the U.S.-Canadian border at Waddington, NY through western Connecticut to its terminus in Commack, NY, and from Huntington to the Bronx. Its wholly owned subsidiary, the Iroquois Pipeline Operating Company, headquartered in Shelton, Connecticut, is the agent for and operator of the pipeline. The Iroquois pipeline can transport up to 1,124,500 DTH per day of Canadian gas supply from the New York-Canadian border to markets in the Northeastern United States. KeySpan is also a shipper on Iroquois and currently transports up to 304,950 DTH of gas per day.
We also have a 50% interest in Islander East Pipeline Company, LLC ("Islander East"), which was created to pursue the authorization and construction of an interstate pipeline from Connecticut, across Long Island Sound, to a terminus near Shoreham, Long Island. In addition, we own a 26.25% interest in the Millennium Pipeline project which is anticipated to transport up to 525,000 DTH of natural gas a day from Corning to Ramapo, New York, interconnecting with the pipeline systems of various other utilities in New York.
We are also the owner and operator of a 600,000 barrel LNG storage and receiving facility located in Providence, Rhode Island, known as KeySpan LNG. Our subsidiary, Boston Gas is the facility's largest customer and contracts for more than half of the LNG facility's storage. KeySpan LNG is regulated by FERC.
We also have equity investments in two gas storage facilities in the State of New York: Honeoye Storage Corporation and Steuben Gas Storage Company. We own a 52% interest in Honeoye, an underground gas storage facility which provides up to 4.3 billion cubic feet of storage service to New York and New England. Additionally, we own 34% of a partnership that has a 50% interest in the Steuben facility that provides up to 6.2 billion cubic feet of storage service to New Jersey and Massachusetts.
For additional information concerning these energy related investments in pipelines and gas storage facilities, see the discussion on "Energy Investments" in Item 7 Management's Discussion and Analysis of Financial Condition and Results of Operations contained herein.
ENVIRONMENTAL MATTERS OVERVIEW
KeySpan's ordinary business operations subject it to regulation in accordance with various federal, state and local laws, rules and regulations dealing with the environment, including air, water, and hazardous substances. These requirements govern both our normal, ongoing operations and the remediation of impacted properties historically used in utility operations. Potential liability associated with our historical operations may be imposed without regard to fault, even if the activities were lawful at the time they occurred.
Except as set forth below, or in Note 7 to the Consolidated Financial Statements "Contractual Obligations and Contingencies - Environmental Matters," no material proceedings relating to environmental matters have been commenced or, to our knowledge, are contemplated by any federal, state or local agency against KeySpan, and we are not a defendant in any material litigation with respect to any matter relating to the protection of the environment. We believe that our operations are in substantial compliance with environmental laws and that requirements imposed by existing environmental laws are not likely to have a material adverse impact upon us. We are also pursuing claims against insurance carriers and potentially responsible parties which seek the recovery of certain environmental costs associated with the investigation and remediation of contaminated properties. We believe that investigation and remediation costs prudently incurred at facilities associated with utility operations, not recoverable through insurance or some other means, will be recoverable from our customers in accordance with the terms of our rate recovery agreements for each regulated subsidiary.
Air. The Federal Clean Air Act ("CAA") provides for the regulation of a variety of air emissions from new and existing electric generating plants. Final, five year renewable permits in accordance with the requirements of Title V of the 1990 amendments to the CAA have been issued for all of our electric generating facilities except that renewal applications were submitted in a timely manner in 2006 for the Ravenswood Expansion and Far Rockaway generating station. Renewal permits are expected to be issued in 2007. The existing permits and timely renewal applications allow our electric generating plants to continue to operate without any additional significant expenditures, except as described below.
Our generating facilities are located within a CAA ozone non-attainment and PM 2.5 (fine particulate matter) non-attainment area, and are subject to increasingly stringent NOx emission limitations to be implemented under forthcoming requirements of the United States Environmental Protection Agency ("EPA") pursuant to the Clean Air Interstate Rule ("CAIR") and potentially under the Ozone Transport Commission's "CAIR PLUS" program. These efforts are designed to improve both ozone and particulate matter air quality. Our previous investments in low NOX boiler combustion modifications, the use of natural gas firing systems at our steam electric generating stations, and the compliance flexibility available under these cap and trade programs, have enabled KeySpan to achieve our prior emission reductions in a cost-effective manner. KeySpan is currently developing its compliance strategy to address the anticipated requirements of CAIR and CAIR PLUS by 2009. At the present time, it is anticipated that NOx control equipment may be required at one or more of KeySpan's Long Island facilities at a cost of between $20 to $30 million. However, such amounts are recoverable from LIPA.
In 2003, New York State promulgated regulations which establish separate NOX and SO2 emission reduction requirements on electric generating facilities in New York State, which commenced in late 2004 for NOX emissions and in 2005 for SO2 emissions. KeySpan's facilities have been able to comply with the NOX requirements without material additional capital expenditures because of previously installed emissions control equipment and gas combustion capability. SO2 compliance was achieved through a reduction in the sulfur content of the fuel oil used in our Northport and Port Jefferson facilities. Further reduction in SO2 emissions expected to be required in 2008 will be achieved either through reliance on natural gas or lower sulfur oil fuel.
In 2004, the EPA issued regulations that require reductions, on a national basis, of mercury emissions from electric generating facilities. The mercury regulations have no impact on KeySpan facilities since their application is limited to coal-fired plants. EPA determined that nickel emissions from oil fired plants do not pose health risks that require regulation. This determination has been challenged and litigation is pending. Until a final outcome is obtained, the nature and extent of the financial impact on KeySpan from nickel regulation, if any, cannot be determined.
KeySpan recognizes the growing concern about greenhouse gas emissions and their contribution to global climate change. Our investments in additional natural gas firing capability have resulted in approximately a 15% reduction in carbon dioxide emissions since 1990, while the electric generation industry as a whole increased carbon dioxide emissions by more than 25%. The addition of the efficient, combined cycle unit which began operation at the Ravenswood Generating Station in 2004 has further reduced average KeySpan CO2 emission rates.
In 2003, the Governor of New York initiated a Regional Greenhouse Gas Initiative ("RGGI") that seeks to establish a coordinated multi-state plan to reduce greenhouse gas emissions (primarily carbon dioxide ("CO2") from electric generating emission sources in the Northeast. In December of 2005, seven northeast states, including New York, issued a memorandum of understanding ("MOU") capping CO2 emissions from electric generating facilities beginning in 2009 and, beginning in 2015, gradually requiring a 10 percent reduction in regional emissions by 2018. Each of the states will be promulgating individual state rules to implement the MOU. Several congressional initiatives under consideration may also require greenhouse gas reductions from electric generating facilities nationwide. At the present time it is not possible to predict the nature of the requirements which ultimately will be imposed on KeySpan, nor what, if any, financial impact such requirements would have on KeySpan electric generation facilities. However, KeySpan believes that the ability of its major generating facilities to burn low CO2 emitting natural gas positions them for future compliance requirements better than plants which burn exclusively coal or oil. Additionally, KeySpan believes that the relatively low greenhouse gas emissions associated with the commercial and residential use of natural gas may present business opportunities for further growth of its gas business.
Water. The Federal Clean Water Act provides for effluent limitations, to be implemented by a permit system, to regulate the discharge of pollutants into United States waters. We possess permits for our generating units which authorize discharges from cooling water circulating systems and chemical treatment systems. These permits are renewed from time to time, as required by regulation. Additional capital expenditures associated with the renewal of the surface water discharge permits for our power plants will likely be required by the New York State Department of Environmental Conservation ("NYSDEC"). We continue to conduct studies as directed by the NYSDEC to determine the impacts of our discharges on aquatic resources and are engaged in discussions with the NYSDEC regarding the nature of capital upgrades or other mitigation measures necessary to reduce any impacts. It is difficult to predict with any certainty the costs of such capital investments, but these upgrades are expected to cost up to $60 million. However, such amounts are recoverable from LIPA. The Ravenswood Generating Station may also require upgrades at a cost of up to $15 million. The actual expenditures will depend upon the outcome of the ongoing studies and the subsequent determination by the NYSDEC of how to apply the standards set forth in recently promulgated federal regulations under Section 316 of the Clean Water Act designed to mitigate such impacts.
Land. The Federal Comprehensive Environmental Response, Compensation and Liability Act of 1980 and certain similar state laws (collectively "Superfund") impose liability, regardless of fault, upon generators of hazardous substances even before Superfund was enacted for costs associated with investigating and remediating contaminated property. In the course of our business operations, we generate materials which, after disposal, may become subject to Superfund. From time to time, we have received notices under Superfund concerning possible claims with respect to sites where hazardous substances generated by KeySpan or its predecessors and other potentially responsible parties were allegedly disposed. Normally, the costs associated with such claims are allocated among the potentially responsible parties on a pro rata basis. Superfund does, however, provide for joint and several liability against a single potentially responsible party. In the unlikely event that Superfund claims were pursued against us on that basis, the costs may be material to our financial condition, results of operations or cash flows.
KeySpan has identified certain MGP sites which were historically owned or operated by its subsidiaries (or such companies' predecessors). Operations at these sites between the mid-1800s to mid-1900s may have resulted in the release of hazardous substances. For a discussion on our MGP sites and further information concerning environmental matters, see Note 7 to the Consolidated Financial Statements, "Contractual Obligations and Contingencies - Environmental Matters."
COMPETITION, REGULATION AND RATE MATTERS
Competition. Over the last several years, the natural gas and electric industries have undergone significant change as market forces moved towards replacing or supplementing rate regulation through the introduction of competition. A significant number of natural gas and electric utilities reacted to the changing structure of the energy industry by entering into business combinations, with the goal of reducing common costs, gaining size to better withstand competitive pressures and business cycles, and attaining synergies from the combination of operations. We engaged in two such combinations, the KeySpan/LILCO transaction in 1998 and our November 2000 acquisition of Eastern and EnergyNorth and are anticipating the consummation of the Merger with National Grid plc.
The Ravenswood Generating Station, the merchant plant in our Electric Services segment, is subject to competitive and other risks that could adversely impact the market price for the plant's output. Such risks include, but are not limited to, the construction of new generation or transmission capacity serving the New York City market.
Regulation. Public utility holding companies, like KeySpan, are now regulated by the FERC pursuant to PUHCA 2005 and to some extent by state utility commissions through the regulation of certain affiliate transactions. Our utility subsidiaries are subject to extensive federal and state regulation by FERC and state utility commissions. In general, state public utility commissions, such as the New York Public Service Commission ("NYPSC"), the MADTE and the New Hampshire Public Utilities Commission ("NHPUC") regulate the provision of retail
services, including the distribution and sale of natural gas and electricity to consumers. Each of the federal and state regulators also regulates certain transactions among our affiliates. FERC also regulates interstate natural gas transportation and electric transmission, and has jurisdiction over certain wholesale natural gas sales and wholesale electric sales.
In addition, our non-utility subsidiaries are subject to a wide variety of federal, state and local laws, rules and regulations with respect to their business activities, including but not limited to those affecting public sector projects, environmental and labor laws and regulations, and state licensing requirements.
State Utility Commissions. As noted above, our regulated gas distribution utility subsidiaries are subject to regulation by the NYPSC, MADTE and NHPUC. The NYPSC regulates KEDNY and KEDLI. Although KeySpan is not regulated by the NYPSC, it is impacted by conditions that were included in the NYPSC order authorizing the 1998 KeySpan/LILCO transaction. Those conditions address, among other things, the manner in which KeySpan, its service company subsidiaries and its unregulated subsidiaries may interact with KEDNY and KEDLI. The NYPSC also regulates the safety, reliability and certain financial transactions of our Long Island generating facilities and our Ravenswood Generating Station under a lightened regulatory standard. Our KEDNE subsidiaries and to some extent our service companies are also subject to regulation by the MADTE and NHPUC.
Securities and Exchange Commission. As a result of the acquisition of Eastern and EnergyNorth, we became a holding company under PUHCA 1935. The Energy Act repealed PUHCA 1935 and replaced it with PUHCA 2005 effective February 8, 2006. Whereas our corporate and financial activities and those of our subsidiaries had been subject to regulation by the SEC, FERC now has jurisdiction over certain of our holding company activities. However, the SEC continues to have jurisdiction over the registration and issuance of our securities under the federal securities laws.
Under our holding company structure, we have no independent operations or source of income of our own and conduct substantially all of our operations through our subsidiaries and, as a result, we depend on the earnings and cash flow of, and dividends or distributions from, our subsidiaries to provide the funds necessary to meet our debt and contractual obligations and to pay dividends to our shareholders. Furthermore, a substantial portion of our consolidated assets, earnings and cash flow is derived from the operations of our regulated utility subsidiaries, whose legal authority to pay dividends or make other distributions to us is subject to regulation by state regulatory authorities.
In addition, KeySpan operates three mutual service companies: KeySpan Corporate Services LLC ("KCS"), KeySpan Utility Services LLC ("KUS") and KeySpan Engineering & Survey, Inc. ("KENG"). These companies operate to provide various services to KeySpan subsidiaries, including regulated utility companies and LIPA, at cost fairly and equitably allocated among them. The regulation of our three service companies has also been transferred to FERC under PUHCA 2005.
Federal Energy Regulatory Commission. FERC has jurisdiction over certain of our holding company activities, including (i) regulating certain transactions among our affiliates within our holding company system; (ii) governing the issuance, acquisition and disposition of securities and assets by certain of our public utility subsidiaries; and (iii) approving certain utility mergers and acquisitions. In addition to its new authority pursuant to PUHCA 2005, FERC also regulates the sale of electricity at wholesale and the transmission of electricity in interstate commerce as well as certain corporate and financial activities of companies that are engaged in such activities. The Long Island generating facilities and the Ravenswood Generating Station are subject to FERC regulation based on their wholesale energy transactions.
Our Ravenswood Generating Station's rates are based on a market-based rate application approved by FERC. The rates that our Ravenswood Generating Station may charge are subject to FERC mandated mitigation measures due to market power issues. The mitigation measures are administered by the NYISO. FERC retains the ability in future proceedings, either on its own motion or upon a complaint filed with FERC, to modify the Ravenswood Generating Station's rates, as well as the mitigation measures, if FERC concludes that it is in the public interest to do so.
KeySpan currently offers and sells the energy, capacity and ancillary services from the Ravenswood Generating Station through the energy market operated by the NYISO. For information concerning the NYISO, see Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation - "Regulatory Issues and Competitive Environment."
FERC also has jurisdiction to regulate certain natural gas sales for resale in interstate commerce, the transportation of natural gas in interstate commerce and, unless an exemption applies, companies engaged in such activities. The natural gas distribution activities of KEDNY, KEDLI, KEDNE and certain related intrastate gas transportation functions are not subject to FERC jurisdiction. However, to the extent that KEDNY, KEDLI or KEDNE purchases or sells gas for resale in interstate commerce, such transactions are subject to FERC jurisdiction and have been authorized by FERC. Our interests in Iroquois, Honeoye, Steuben and KeySpan LNG are also fully regulated by FERC as natural gas companies.
EMPLOYEE MATTERS
As of December 31, 2006, KeySpan and its wholly-owned subsidiaries had approximately 9,594 employees. Of that total, approximately 6,168 employees are covered under collective bargaining agreements. KeySpan has not experienced any work stoppage during the past five years and considers its relationship with employees, including those covered by collective bargaining agreements, to be good.
ITEM 1A.
ITEM 1A. RISK FACTORS
Certain statements contained in this Annual Report on Form 10-K concerning expectations, beliefs, plans, objectives, goals, strategies, future events or performance and underlying assumptions and other statements that are other than statements of historical facts, are "forward-looking statements" within the
meaning of Section 21E of the Securities Exchange Act of 1934, as amended. Without limiting the foregoing, all statements under the captions "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Item 7A. Quantitative and Qualitative Disclosures About Market Risk" relating to our future outlook, anticipated capital expenditures, future cash flows and borrowings, pursuit of potential acquisition opportunities and sources of funding, are forward-looking statements. Such forward-looking statements reflect numerous assumptions and involve a number of risks and uncertainties, and actual results may differ materially from those discussed in such statements. The risks, uncertainties and factors that could cause actual results to differ materially include but are not limited to the following:
We are a Holding Company, and Our Subsidiaries are Subject to State Regulation Which Limits Their Ability to Pay Dividends and Make Distributions to Us
We are a holding company with no business operations or sources of income of our own. We conduct all of our operations through our subsidiaries and depend on the earnings and cash flow of, and dividends or distributions from, our subsidiaries to provide the funds necessary to meet our debt and contractual obligations and to pay dividends on our common stock.
In addition, a substantial portion of our consolidated assets, earnings and cash flow is derived from the operation of our regulated utility subsidiaries, whose legal authority to pay dividends or make other distributions to us is subject to regulation by the utility regulatory commissions of New York, Massachusetts and New Hampshire. Pursuant to NYPSC orders, the ability of KEDNY and KEDLI to pay dividends to us is conditioned upon their maintenance of a utility capital structure with debt not exceeding 55% and 58%, respectively, of total utility capitalization. In addition, the level of dividends paid by both utilities may not be increased from current levels if a 40 basis point penalty is incurred under a customer service performance program. At the end of KEDNY's and KEDLI's rate years (September 30, 2006 and November 30, 2006, respectively), their ratios of debt to total utility capitalization were in compliance with the ratios set forth above and we have incurred no penalties under the outstanding customer service performance program.
Our Gas Distribution and Electric Services Businesses May Be Adversely Affected by Changes in Federal and State Regulation
The regulatory environment applicable to our gas distribution and our electric services businesses has undergone substantial changes in recent years, on both the federal and state levels. These changes have significantly affected the nature of the gas and electric utility and power industries and the manner in which their participants conduct their businesses. Moreover, existing statutes and regulations may be revised or reinterpreted, new laws and regulations may be adopted or become applicable to us or our facilities and future changes in laws and regulations may affect our gas distribution and our electric services businesses in ways that we cannot predict.
In addition, our operations are subject to extensive government regulation and require numerous permits, approvals and certificates from various federal, state and local governmental agencies. A significant portion of our revenues in our Gas Distribution and Electric Services segments are
directly dependent on rates established by federal or state regulatory authorities, and any change in these rates and regulatory structure could significantly impact our financial results. Increases in utility costs other than gas, not otherwise offset by increases in revenues or reductions in other expenses, could have an adverse effect on earnings due to the time lag associated with obtaining regulatory approval to recover such increased costs and expenses in rates. Various rulemaking proposals and market design revisions related to the wholesale power market are being reviewed at the federal level. These proposals, as well as legislative and other attention to the electric power industry could have a material adverse effect on our strategies and results of operations for our electric services business and our financial condition. In particular, we sell capacity, energy and ancillary services from our Ravenswood Generating Station facility into the New York Independent System Operator, or NYISO, energy market at market-based rates, subject to mitigation measures approved by the FERC. The pricing for capacity, energy sales and ancillary services in to the NYISO market is still evolving and some of the FERC's price mitigation measures are subject to rehearing and possible judicial review, as well as revision in response to market participant complaints or NYISO requests.
Our Risk Mitigation Techniques Such as Hedging and Purchase of Insurance May Not Adequately Provide Protection
To mitigate our financial exposure related to commodity price fluctuations, KeySpan routinely enters into contracts to hedge a portion of our purchase and sale commitments, weather fluctuations, electricity sales, natural gas supply and other commodities. However, we do not always cover the entire exposure of our assets or our positions to market price volatility and the coverage will vary over time. To the extent we have unhedged positions or our hedging strategies do not work as planned, fluctuating commodity prices could cause our sales and net income to be volatile.
In addition, our business is subject to many hazards from which our insurance may not adequately provide coverage. An unexpected outage at our Ravenswood Generating Station, especially in the significant summer period, could materially impact our financial results. Damage to pipelines, equipment, properties and people caused by natural disasters, accidents, terrorism or other damage by third parties could exceed our insurance coverage. Although we do have insurance to protect against many of these contingent liabilities, this insurance is capped at certain levels, has self-insured retentions and does not provide coverage for all liabilities.
SEC Rules for Exploration and Production Companies May Require Us to Recognize a Non-Cash Impairment Charge at the End of Our Reporting Periods
Our investments in natural gas and oil consist of our ownership of KeySpan Exploration and Production and Seneca-Upshur. We use the full cost method for KeySpan Exploration and Production and Seneca-Upshur. Under the full cost method, all costs of acquisition, exploration and development of natural gas and oil reserves are capitalized into a full cost pool as incurred, and properties in the pool are depleted and charged to operations using the unit-of-production method based on production and proved reserve quantities. To the extent that these capitalized costs, net of accumulated depletion, less deferred taxes exceed the present value (using a 10% discount rate) of estimated future net cash flows from proved natural gas
and oil reserves and the lower of cost or fair value of unproved properties, those excess costs are charged to operations. If a write-down is required, it would result in a charge to earnings but would not have an impact on cash flows. Once incurred, an impairment of gas properties is not reversible at a later date, even if gas prices increase.
Our Operating Results May Fluctuate on a Seasonal and Quarterly Basis
Our gas distribution business is a seasonal business and is subject to weather conditions. We receive most of our gas distribution revenues in the first and fourth quarters, when demand for natural gas increases due to colder weather conditions. As a result, we are subject to seasonal variations in working capital because we purchase natural gas supplies for storage in the second and third quarters and must finance these purchases. Accordingly, our results of operations fluctuate substantially on a seasonal basis. In addition, our New England-based gas distribution subsidiaries do not have weather normalization tariffs, as we do in New York. In addition, portions of our Electric Service business are seasonal and subject to weather and market conditions. The majority of the capacity revenue associated with the Ravenswood Generating Station facility is realized during the six months between May and October of each year. Energy and ancillary service sales from our Ravenswood Generating Station facility are directly correlated to the demand for electricity and competition from other resources. Typically, the demand and price for electricity increases during extreme temperature conditions. However, depending on the availability of alternative competitive supply, extreme temperature conditions may not result in increased revenue. As a result, fluctuations in weather and competitive supply between years may have a significant effect on our results of operations for these subsidiaries; both gas and electric.
A Substantial Portion Of Our Revenues Are Derived From Our Agreements With LIPA And No Assurances Can Be Made That These Arrangements Will Not Be Discontinued At Some Point In The Future Or That The New Agreements Will Become Effective
We derive a substantial portion of our revenues in our electric services segment from a series of agreements with LIPA pursuant to which we manage LIPA's transmission and distribution system and supply the majority of LIPA's customers' electricity needs. On February 1, 2006, KeySpan and LIPA entered into amended and restated agreements whereby KeySpan will continue to operate and maintain the electric T&D System owned by LIPA on Long Island. The parties also entered into the 2006 Option Agreement, where LIPA had the right to acquire two of our facilities, our Far Rockaway and/or E.F. Barrett Generating Stations during the period January 1, 2006 to December 31, 2006. On December 13, 2006, KeySpan and LIPA entered into an amendment to the 2006 Option Agreement whereby the parties agreed to extend the expiration of the option period to the later of (i) December 31, 2007 or (ii) 180 days following the effective date of the Option Agreement. Additionally, the new agreements resolve many outstanding issues between the parties regarding the current LIPA Agreements and provide new pricing and extensions of the Agreements. There is a risk that these agreements will not receive the necessary governmental approvals, which are pending, and the effectiveness of each of the 2006 LIPA Agreements and the amendment to the 2006 Option Agreement is conditioned upon all of the 2006 LIPA Agreements becoming effective. If the 2006 LIPA Agreements do not become effective, there is uncertainty as to whether LIPA will exercise their option under the GPRA and the status of the resolution of the various
disputes between KeySpan and LIPA. At this point in time, KeySpan is unable to estimate what the impact would be to its results of operations, financial position and cash flows if the 2006 LIPA Agreements do not become fully effective.
A Decline or an Otherwise Negative Change in the Ratings or Outlook on Our Securities Could Have a Materially Adverse Impact on Our Ability to Secure Additional Financing on Favorable Terms
The credit rating agencies that rate our debt securities regularly review our financial condition and results of operations. We can provide no assurances that the ratings or outlook on our debt securities will not be reduced or otherwise negatively changed. A negative change in the ratings or outlook on our debt securities could have a materially adverse impact on our ability to secure additional financing on favorable terms.
Our Costs of Compliance with Environmental Laws are Significant, and the Cost of Compliance with Future Environmental Laws Could Adversely Affect Us
Our operations are subject to extensive federal, state and local environmental laws and regulations relating to air quality, water quality, waste management, natural resources and the health and safety of our employees. These environmental laws and regulations expose us to costs and liabilities relating to our operations and our current and formerly owned properties. Compliance with these legal requirements requires us to commit significant capital toward environmental monitoring, installation of pollution control equipment and permits at our facilities. Costs of compliance with environmental regulations, and in particular emission regulations, could have a material impact on our Electric Services segment and our results of operations and financial position, especially if emission limits are tightened, more extensive permitting requirements are imposed, additional substances become regulated or the number and type of electric generating plants we operate increase.
In addition, we are responsible for the clean-up of contamination at certain MGP sites and at other sites and are aware of additional MGP sites where we may have responsibility for clean-up costs. While our gas utility subsidiaries' rate plans generally allow for the full recovery of the costs of investigation and remediation of most of our MGP sites, these rate recovery mechanisms may change in the future. To the extent rate recovery mechanisms change in the future, or if additional environmental matters arise in the future at our currently or historically owned facilities, at sites we may acquire in the future or at third-party waste disposal sites, costs associated with investigating and remediating these sites could have a material adverse effect on our results of operations, cash flows and financial condition.
Our Businesses are Subject to Competition and General Economic Conditions Impacting Demand for Services
The Ravenswood Facility and Ravenswood Expansion are subject to competition that could adversely impact the market price for the capacity, energy and ancillary services they sell. In addition, if new generation and/or transmission facilities are constructed, and/or the availability of our Ravenswood Generating Station deteriorates, then the quantities of capacity and energy sales could be adversely affected. We cannot predict, however,
when or if new power plants or transmission facilities will be built or the nature of the future New York City capacity and energy requirements. Competition facing our unregulated Energy Services businesses, including but not limited to competition from other heating, ventilation and air conditioning, and engineering companies, as well as other utilities and utility holding companies that are permitted to engage in such activities, could adversely impact our financial results and the value of those businesses, resulting in decreased earnings as well as write-downs of the carrying value of those businesses.
Our Gas Distribution segment faces competition with distributors of alternative fuels and forms of energy, including fuel oil and propane. Our ability to continue to add new gas distribution customers may significantly impact financial results. The gas distribution industry has experienced a decrease in consumption per customer over time, partially due to increased efficiency of customers' appliances, economic factors and price elasticity. In addition, our Gas Distribution segment's future growth is dependent upon the ability to add new customers to our system in a cost-effective manner. While our Long Island and New England utilities have significant growth potential, we cannot be sure new customers will continue to offset the decrease in consumption of our existing customer base. There are a number of factors outside of our control that impact customer conversions from an alternative fuel to gas, including general economic factors impacting customers' willingness to invest in new gas equipment.
Risk Associated with our Financial Swap Agreement for In-City Unforced Capacity
KeySpan believes that the New York City market represents a strong capacity market due to, among other things, its local reliability rules, increasing demand and the time required for new resources to be constructed. KeySpan anticipates that demand will increase and that the high cost to construct capacity in New York City will result in favorable In-City Unforced Capacity prices. Therefore, KeySpan entered into an ISDA Master Agreement for a fixed for floating unforced capacity financial swap for a notional quantity of 1,800,000kW at the Fixed Price is $7.57/kW-month. If the demand is less than KeySpan's estimates, additional resources enter the market, or costs are less than forecast, In-City Unforced Capacity prices could be on average less than the Fixed Price resulting in a loss to KeySpan, which under certain circumstances could be material.
Labor Disruptions at Our Facilities Could Adversely Affect Our Results of Operations and Cash Flow
Approximately 6,168 employees, or 64% of our employees, are represented by unions through various collective bargaining agreements that expire between 2007 and 2011. The bargaining agreements expiring in 2007 affect approximately 5% of the unionized workforce; 230 employees who work for KeySpan Home Energy Services in New York and another 70 employees at KEDNE in Cape Cod, Massachusetts. KeySpan is currently engaging in discussions with these unions for new collective bargaining agreements. It is possible that our employees may seek an increase in wages and benefits at the expiration of these agreements, and that we may be unable to negotiate new agreements without labor disruption.
Counterparties to Our Transactions May Fail to Perform their Obligations, Which Could Harm Our Results of Operations
Our operations are exposed to the risk that counterparties to our transactions that owe us money or supplies will not perform their obligations. Should the counterparties to arrangements with us fail to perform, we might be forced to enter into alternative hedging arrangements or honor our underlying commitment at then-current market prices that may exceed our contractual prices. In such event, we might incur additional losses to the extent of amounts, if any, already paid to counterparties. This risk is most significant where we have concentrations of receivables from natural gas and electric utilities and their affiliates, as well as industrial customers and marketers throughout the Northeastern United States.
We Are Exposed to Risks That Are Beyond Our Control
The cost of repairing damage to our operating subsidiaries' facilities and the potential disruption of their operations or supplier operations due to storms, natural disasters, wars, terrorist acts and other catastrophic events could be substantial. The occurrence or risk of occurrence of future terrorist attacks or related acts of war may lead to increased political, economic and financial market instability and volatility in prices for natural gas which could materially adversely affect us in ways we cannot predict at this time. A lower level of economic activity for these or other reasons could result in a decline in energy consumption, which could adversely affect our net revenues.
The Long-Term Financial Condition of Our Gas Distribution Business Depends on the Continued Availability of Natural Gas Reserves
The development of additional natural gas reserves requires significant capital expenditures by others for exploring, drilling and installing production, gathering, storage, transportation and other facilities that permit natural gas to be produced and delivered to our distribution systems. Low prices for natural gas, regulatory restrictions, or the lack of available capital for these projects could adversely affect the development of additional natural gas reserves. Additional natural gas reserves may not be developed in sufficient amounts to fill the capacities of our distribution systems, thus limiting our prospects for long-term growth.
Gathering, Processing and Transporting Activities Involve Numerous Risks that May Result in Accidents and Other Operating Risks and Costs
Our gas distribution facilities pose a variety of hazards and operating risks, such as leaks, explosions and mechanical problems caused by natural disasters, accidents, terrorism or other damage by third parties, which could cause substantial financial losses. In addition to impairing our operations, these risks could also result in loss of human life and environmental pollution. In accordance with standard industry practice, we maintain insurance against some, but not all, of these potential risks and losses. The occurrence of any of these events not fully covered by insurance could have a material adverse effect on our financial position and results of operations.
Additional risks, uncertainties and factors that could cause actual results to differ materially include, but are not limited to, the following:
- - the occurrence of any event, change or other circumstances that could give rise to the termination of the Merger Agreement with National Grid plc or the failure of the Merger to close for any reason;
- - volatility of fuel prices used to generate electricity;
- - fluctuations in weather and in gas and electric prices;
- - general economic conditions, especially in the Northeast United States;
- - our ability to successfully manage our cost structure and operate efficiently;
- - our ability to successfully contract for natural gas supplies required to meet the needs of our customers;
- - implementation of new accounting standards or changes in accounting standards or Generally Accepted Accounting Principles which may require adjustments to financial statements;
- - inflationary trends and interest rates;
- - the ability of KeySpan to identify and make complementary acquisitions, as well as the successful integration of such acquisitions;
- - available sources and cost of fuel;
- - creditworthiness of counterparties to derivative instruments and commodity contracts;
- - the resolution of certain disputes with LIPA concerning each party's rights and obligations under various agreements;
- - retention of key personnel;
- - federal and state regulatory initiatives that threaten cost and investment recovery, and place limits on the type and manner in which we invest in new businesses and conduct operations;
- - the impact of federal, state and local utility regulatory policies, legislation and orders on our regulated and unregulated businesses;
- - potential write-down of our investment in natural gas properties when natural gas prices are depressed or if we have significant downward revisions in our estimated proved gas reserves;
- - competition facing our unregulated Energy Services businesses;
- - the degree to which we develop unregulated business ventures, as well as federal and state regulatory policies affecting our ability to retain and operate such business ventures profitably;
- - a change in the fair market value of our investments that could cause a significant change in the carrying value of such investments or the carrying value of related goodwill;
- - timely receipts of payments from LIPA and the NYISO, our two largest customers;
- - changes in the unforced capacity financial swap pricing structure;
- - receipt of approval for, and the timing thereof, the 2006 LIPA Agreements; and
- - other risks detailed from time to time in other reports and other documents filed by KeySpan with the SEC
For any of these statements, KeySpan claims the protection of the safe harbor for forward-looking information contained in the Private Securities Litigation Reform Act of 1995, as amended. For additional discussion on these risks, uncertainties and assumptions, see Item 1. "Description of the Business," Item 2. "Properties," Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Item 7A. "Quantitative and Qualitative Disclosures About Market Risk" contained herein.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
ITEM 2. PROPERTIES
Information with respect to KeySpan's material properties used in the conduct of its business is set forth in, or incorporated by reference in, Item 1 hereof. Except where otherwise specified, all such properties are owned or, in the case of certain rights-of-way, used in the conduct of its gas distribution business, held pursuant to municipal consents, easements or long-term leases, and in the case of gas and oil properties, held under long-term mineral leases. In addition to the information set forth therein with respect to properties utilized by each business segment, KeySpan leases the executive headquarters located in Brooklyn, New York. In addition, we lease other office and building space, office equipment, vehicles and power operated equipment. Our properties are adequate and suitable to meet our current and expected business requirements. Moreover, their productive capacity and utilization meet our needs for the foreseeable future. KeySpan continually examines its real property and other property for its contribution and relevance to our businesses and when such properties are no longer productive or suitable, they are disposed of as promptly as possible. In the case of leased office space, we anticipate no significant difficulty in leasing alternative space at reasonable rates in the event of the expiration, cancellation or termination of a lease.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
See Note 7 to the Consolidated Financial Statements, "Contractual Obligations and Contingencies - Legal Matters."
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of the security holders during the last quarter of the 12 months ended December 31, 2006.
PART II -------
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
KeySpan's common stock is listed and traded on the New York Stock Exchange under the symbol "KSE." As of February 20, 2007, there were approximately 64,664 registered record holders of KeySpan's common stock. In the fourth quarter of 2006 KeySpan increased its dividend to an annual rate of $1.90 per common share beginning with the quarterly dividend to be paid in February 2007. Our dividend framework is reviewed annually by the Board of Directors. The amount and timing of all dividend payments is subject to the discretion of the Board of Directors and will depend upon business conditions, results of operations, financial conditions and other factors. Based on currently foreseeable market conditions, we intend to maintain the annual dividend approximately at the $1.90 level to be paid on a quarterly basis at a rate of approximately $0.475. KeySpan's scheduled dividend payment dates are February 1, May 1, August 1 and November 1, or the next business day, if such date is not a business day.
The following table sets forth, for the quarters indicated, the high and low sales prices and dividends declared per share for the periods indicated:
2006 High Low Dividends per Share ----------------------------------------------------------------------------- First Quarter $41.52 $35.38 $0.465 Second Quarter $41.10 $39.68 $0.465 Third Quarter $41.42 $39.95 $0.465 Fourth Quarter $41.36 $40.40 $0.465
2005 High Low Dividends per Share ----------------------------------------------------------------------------- First Quarter $40.90 $38.04 $0.455 Second Quarter $40.88 $36.83 $0.455 Third Quarter $41.03 $36.35 $0.455 Fourth Quarter $37.10 $32.66 $0.455
EQUITY COMPENSATION PLAN INFORMATION
The following table sets forth securities authorized for issuance under equity compensation plans for the year ended December 31, 2006:
(1) Performance shares shown at target, or 100% payout.
(2) Includes grants of options, restricted stock, and performance shares pursuant to KeySpan's Long-Term Incentive Compensation Plan, as amended, and options granted pursuant to the Brooklyn Union Long-Term Incentive Compensation Plan, the Eastern Enterprises 1995 Stock Option Plan and the Eastern Enterprises 1996 Non-Employee Trustee's Stock Option Plan.
(3) This total amount reflects the aggregate number of stock options, restricted stock and performance shares available for issuance pursuant to KeySpan's Long-Term Incentive Compensation Plan.
See Item 11. Executive Compensation for more information on the equity compensation plans.
PERFORMANCE GRAPH
The following graph presents, for the period beginning December 31, 2001 through December 31, 2006, a comparison of cumulative total shareholder returns for KeySpan, the Standard & Poor's Utilities Index and the Standard & Poor's 500 Index.
[GRAPHIC OMITTED]
Assumes $100 invested on December 31, 2001 in shares of KeySpan Common Stock, the S&P Utilities Index and the S&P 500 Index, and that all dividends were reinvested.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
KeySpan Corporation (referred to herein as "KeySpan," "we," "us" and "our") is a holding company under the Public Holding Company Act of 2005 ("PUHCA 2005"). KeySpan operates six regulated utilities that distribute natural gas to approximately 2.6 million customers in New York City, Long Island, Massachusetts and New Hampshire, making KeySpan the fifth largest gas distribution company in the United States and the largest in the Northeast. We also own, lease and operate electric generating plants in Nassau and Suffolk Counties on Long Island and in Queens County in New York City and are the largest electric generation operator in New York State. Under contractual arrangements, we provide power, electric transmission and distribution services, billing and other customer services for approximately 1.1 million electric customers of the Long Island Power Authority ("LIPA"). KeySpan's other operating subsidiaries are primarily involved in gas production and development; underground gas storage; liquefied natural gas storage; retail electric marketing; large energy-system ownership, installation and management; service and maintenance of energy systems; and engineering and consulting services. We also invest and participate in the development of natural gas pipelines, electric generation and other energy-related projects. (See Note 2 to the Consolidated Financial Statements "Business Segments" for additional information on each operating segment.)
On February 25, 2006, KeySpan entered into an Agreement and Plan of Merger (the "Merger Agreement"), with National Grid plc, a public limited company incorporated under the laws of England and Wales ("Parent") and National Grid US8, Inc., a New York Corporation ("Merger Sub"), pursuant to which Merger Sub will merge with and into KeySpan (the "Merger"), with KeySpan continuing as the surviving company and thereby becoming an indirect wholly-owned subsidiary of the Parent. Pursuant to the Merger Agreement, at the effective time of the Merger, each outstanding share of KeySpan common stock, par value $0.01 per share (the "Shares"), other than treasury shares and shares held by the Parent and its subsidiaries, shall be canceled and shall be converted into the right to receive $42.00 in cash, without interest.
Consummation of the Merger is subject to various closing conditions. Assuming receipt of all required approvals, it is currently anticipated that the Merger will be consummated in mid-2007. However, we are unable to predict the outcome of the regulatory proceedings and no assurance can be given that the Merger will occur or the timing of its completion. See the Introduction to the Notes to the Consolidated Financial Statements for additional information regarding the Merger.
At December 31, 2005, KeySpan was a holding company under the Public Utility Holding Company Act of 1935, as amended ("PUHCA 1935"). In August 2005, the Energy Policy Act of 2005 (the "Energy Act") was enacted. The Energy Act is a broad energy bill that places an increased emphasis on the production of energy and promotes the development of new technologies and alternative energy sources and provides tax credits to companies that produce natural gas, oil, coal, electricity and renewable energy. For KeySpan, one of the more significant provisions of the Energy Act was the repeal of PUHCA 1935, which became effective on February 8, 2006. Since that time, the jurisdiction of the Securities and Exchange Commission ("SEC") over certain holding company activities, including the regulation of our affiliate transactions and service
companies, has been transferred to the jurisdiction of the FERC pursuant to PUHCA 2005. See the discussion under the caption "Regulation and Rate Matters" for additional information on the Energy Act and PUHCA 2005.
EXECUTIVE SUMMARY
Below is a table comparing the more significant items impacting earnings from continuing operations and earnings available for common stock for the periods indicated. Management believes that this representation is necessary for a clear understanding of the major drivers impacting comparative results for the periods indicated.
Earnings from Continuing Operations 2006 vs 2005
KeySpan's earnings from continuing operations, less preferred stock dividends, for the year ended December 31, 2006 were $434.2 million or $2.48 per share, an increase of $37.8 million, or $0.15 per share compared to $396.4 million, or $2.33 per share realized in 2005. KeySpan's financial results for the year ended December 31, 2006, reflects the following items that had a significant impact on comparative results: (i) incremental pre-tax Merger related costs of $27.1 million, primarily representing investment banking, legal, accounting and other consulting fees; (ii) resolution of certain income tax issues; (iii) the impact of cooler-than-normal summer weather and competition on KeySpan's merchant electric generation operations; and (iv) the impact of warmer-than-normal winter weather on KeySpan's gas distribution businesses.
In 2006, KeySpan resolved its dispute with the New York City Department of Taxation and Finance with respect to income taxes relating to the operations of its merchant electric generating facility. As a result of the favorable settlement of this issue, KeySpan reversed a previously recorded New York City income tax reserve of $11.9 million ($7.1 million after federal income taxes), as well as an interest reserve of $5.9 million ($3.4 million after-tax) established in connection with this dispute. In addition, pursuant to indemnity obligations contained in the Long Island Lighting Company ("LILCO") / KeySpan merger agreement of May 1998, KeySpan had been working with the Internal Revenue Service ("IRS") to resolve certain disputes with regard to LILCO's tax returns for the tax years ended December 31, 1996 through March 31, 1999 and KeySpan's and The Brooklyn Union Gas Company's (d/b/a KEDNY) tax returns for the years ended September 30, 1997 through December 31, 1998. A settlement of the outstanding issues was reached in 2006 and, following IRS procedure, the settlement was submitted to the Joint Committee on Taxation on October 30, 2006 for final approval, which is expected in early 2007. Accordingly, KeySpan reversed $44.5 million of previously established federal income tax reserves.
KeySpan's consolidated results of operations are dependent primarily on the operating results of its Gas Distribution and Electric Services segments. As indicated in the above table, KeySpan's earnings from its core operations decreased $7.3 million or $0.10 per share reflecting, for the most part, lower earnings from the Electric Services segment. The lower operating income in this segment resulted from a decrease in net electric revenues associated with KeySpan's merchant electric generation business, the Ravenswood Generating Station, which was significantly impacted by the entry of competing electric generating units into the New York City energy and capacity markets in 2006 and by comparatively cooler weather during the 2006 summer. A substantial portion of the yearly operating income from this business is realized during its peak electric generating period July through September. As measured in cooling-degree days, weather was 25% cooler during the July - September 2006 time period compared to the same period in 2005, resulting in a comparative adverse impact to realized electric revenues.
Operating income for 2006 from KeySpan's Gas Distribution segment remained consistent with such earnings realized in 2005. KeySpan's gas distribution activities are also impacted by seasonal weather fluctuations. However, certain of KeySpan's gas distribution subsidiaries operate under utility tariffs that contain a weather normalization adjustment that significantly offsets variations in firm net revenues due to fluctuations in weather. Additionally, KeySpan employs weather derivatives to mitigate the adverse impact from warmer-than-normal weather. As measured in heating degree days, weather during the primary heating season of 2006, January-March, was approximately 15% warmer than the same period of 2005 throughout KeySpan's service territories. Additionally, weather during the secondary heating season in 2006, October-December, was approximately 20% warmer than the same period of 2005. The benefits associated with the weather normalization adjustments and weather derivatives, combined with significantly lower operating expenses more than offset the adverse impact from the warm weather during the two heating seasons. See the discussion under the caption "Review of Operating Segments" for additional information on each operating segment.
In addition to the above, interest charges were lower year-over-year, due, for the most part, to lower regulatory carrying charges. Also, income on certain investments increased in 2006 compared to 2005.
Earnings per share in 2006 were adversely impacted by the higher level of common shares outstanding. In May 2005, KeySpan issued 12.1 million shares of common stock upon the conversion of previously held MEDs Equity Units. The dilutive effect on earnings per share for a full year in 2006 from this issuance, in addition to KeySpan's employee stock purchase plans, was approximately $0.07 per share.
Earnings Available for Common Stock 2006 vs 2005
Earnings available for common stock for 2005 also included losses from discontinued operations associated with KeySpan's former mechanical contracting subsidiaries; these companies were discontinued in the fourth quarter of 2004 and sold in early 2005. In the fourth quarter of 2004, KeySpan's investment in its mechanical contracting subsidiaries was written-down to fair value. During 2005, operating losses amounting to $4.1 million after-tax were incurred through the dates of sale of these companies, including, but not limited to, costs incurred for employee related benefits. Partially offsetting these losses was an after-tax gain of $2.3 million associated with the related divestitures, reflecting the difference between the fair value estimates and the financial impact of the actual sale transactions. The net income impact of the operating losses and the disposal gain was a loss of $1.8 million, or $0.01 per share for the year ended December 31, 2005.
Further, earnings available for common stock for 2005 included a $6.6 million, or $0.04 per share, cumulative change in accounting principle charge as a result of implementing the accounting requirements of Financial Accounting Standards Board ("FASB") Interpretation No. 47 ("FIN 47") "Accounting for Conditional Asset Retirement Obligations." This pronouncement required KeySpan to record a liability for the estimated future cost associated with the legal obligation to dispose of long-lived assets at the time of their retirement or disposal date. Upon initial implementation, December 31, 2005, a cumulative change in accounting principle charge was recorded on KeySpan's Consolidated Statement of Income, representing the present value of KeySpan's future retirement obligation. See Note 7 to the Consolidated Financial Statements "Contractual Obligations, Financial Guarantees and Contingencies" for further information on this charge.
Earnings from Continuing Operations 2005 vs 2004
KeySpan's earnings from continuing operations, less preferred stock dividends, for the year ended December 31, 2005 were $396.4 million or $2.33 per share, a decrease of $212.7 million, or $1.47 per share compared to $609.1 million, or $3.80 per share realized in 2004. KeySpan's financial results for the year ended December 31, 2005 and 2004 reflected the following items that had a significant impact on comparative results: (i) earnings from core operations; (ii) asset sales of non-core subsidiaries recorded in 2004 and their respective results for 2004; (iii) impairment charges recorded in 2004; and (iv) debt redemption charges recorded in both 2005 and 2004.
As indicated in the preceding table, KeySpan's earnings from core operations increased $43.8 million or $0.12 per share in 2005 compared to 2004, primarily reflecting higher earnings from the Electric Services segment, improved results from the Energy Services segment, and a decrease in interest charges. KeySpan's electric services operations benefited from an increase in net electric revenues principally as a result of higher electric prices that were due, in part, to the warm weather during the 2005 summer and to the impact of two hurricanes experienced in 2005. Lower operating losses were incurred at the Energy Services segment as a result of lower operating expenses.
The decrease in interest expense resulted from the benefits attributable to lower outstanding debt resulting from debt redemptions in 2004 and the first quarter of 2005, as well as from the sale of Houston Exploration and KeySpan Canada. These favorable results were somewhat offset by a decrease in operating income from KeySpan's gas distribution operations as a result of higher operating expenses, primarily due to an increase in the provision for uncollectible accounts receivable as a result of increasing gas costs and the adverse impact from collection experience in 2005.
The full benefit to earnings per share from the favorable operating results of the Electric Services and Energy Services segments, as well as the decrease in interest charges was offset by the higher level of common shares outstanding. As noted earlier, on May 16, 2005, KeySpan issued 12.1 million shares of common stock upon the scheduled conversion of the MEDs Equity Units. The dilutive effect of this issuance on earnings per share for the year ended December 31, 2005, was approximately $0.12 per share.
The remaining items impacting comparative earnings from continuing operations - asset sales, impairment charges and debt redemption charges - are discussed below.
During 2004, KeySpan sold its remaining 55% equity interest in The Houston Exploration Company ("Houston Exploration"), an independent natural gas and oil exploration company based in Houston, Texas. We received cash proceeds of approximately $758 million in two stock transactions that resulted in after-tax gains of $222.7 million, or $1.39 per share. The first transaction occurred in June 2004 and the second transaction was completed in November 2004. The operations of Houston Exploration were fully consolidated in KeySpan's Consolidated Financial Statements during the first five months of 2004, but were then accounted for on the equity method of accounting after the first transaction reduced our ownership interest below 50%.
Also in 2004, KeySpan sold its remaining 60.9% investment in KeySpan Energy Canada Partnership ("KeySpan Canada"), a company that owned certain midstream natural gas assets in Western Canada. We received cash proceeds of approximately $255 million in two transactions that resulted in a total after-tax gain of $34.8 million, or $0.21 per share. The first transaction took place in April 2004 and the second transaction was completed in December 2004. The operations of KeySpan Canada were fully consolidated in KeySpan's Consolidated Financial Statements during the first three months of 2004, but then were accounted for on the equity method of accounting after the first transaction reduced our ownership interest below 50%.
Combined, these asset sales provided KeySpan with approximately $1 billion in cash proceeds and after-tax earnings of $257.5 million, or $1.60 per share. Further, during 2004, KeySpan's share of the after-tax operating earnings of Houston Exploration and KeySpan Canada was $83.9 million or $0.52 per share. See Note 2 to the Consolidated Financial Statements "Business Segments" and the discussions under the caption "Review of Operating Segments" for a more detailed discussion of each of the above noted non-core transactions.
KeySpan recorded three significant impairment charges during 2004: (i) a goodwill impairment charge recorded in the Energy Services segment; (ii) a ceiling test write-down recorded in the Energy Investments segment; and (iii) a carrying value impairment charge also recorded in the Energy Investments segment. These impairment charges resulted in after-tax charges to continuing operations of $62.4 million, or $0.39 per share.
Specifically, during 2004 the Energy Services segment recorded an after-tax non-cash goodwill impairment charge of $12.6 million, or $0.08 per share in continuing operations as a result of an evaluation of the carrying value of goodwill recorded in this segment. That evaluation resulted in a total impairment charge of $152.4 million after-tax, or $0.95 per share - $12.6 million of this charge was attributable to continuing operations, while the remaining $139.9 million, or $0.87 per share, was reflected in discontinued operations. (See Note 10 to the Consolidated Financial Statements "Energy Services - Discontinued Operations" for additional details on this charge.)
KeySpan's remaining wholly owned gas production and development subsidiaries recorded a non-cash impairment charge of $48.2 million ($31.1 million after-tax, or $0.19 per share) in 2004 to recognize the reduced valuation of proved reserves. (See Note 9 to the Consolidated Financial Statements "Gas Production and Development Property - Depletion," for additional details on this charge.)
In addition to the asset sales noted previously, in the fourth quarter of 2004, KeySpan anticipated selling its previous 50% ownership interest in Premier Transmission Limited ("Premier"), a gas pipeline from southwest Scotland to Northern Ireland. In the fourth quarter of 2004, KeySpan recorded a non-cash impairment charge of $26.5 million - $18.8 million after-tax or $0.12 per share, reflecting the difference between the anticipated cash proceeds from the sale of Premier compared to its carrying value. This investment was accounted for under the equity method of accounting in the Energy Investments segment. The sale of Premier was completed in the first quarter of 2005 and resulted in cash proceeds of approximately $48.1 million and a pre-tax gain of $4.1 million reflecting the difference from earlier estimates. (See Note 2 to the Consolidated Financial Statements "Business Segments" and the discussions under the caption "Review of Operating Segments" for a more detailed discussion of the sale.)
The remaining significant item impacting comparative results, as noted above, was debt redemption costs incurred in both 2005 and 2004. In 2005, KeySpan redeemed $500 million of 6.15% Notes due in 2006. KeySpan incurred $20.9 million in call premiums, which were expensed and recorded in other income and
deductions on the Consolidated Statement of Income, and wrote-off $1.3 million of previously deferred financing costs. Further, KeySpan accelerated the amortization of approximately $11.2 million of previously unamortized benefits associated with an interest rate swap on these Notes. The accelerated amortization was recorded as a reduction to interest expense. The net after-tax expense of this debt redemption was $6.8 million or $0.04 per share. In 2004, KeySpan redeemed approximately $758 million of various series of outstanding long-term debt. KeySpan incurred $54.5 million in call premiums associated with these redemptions, of which $45.9 was expensed and recorded in other income and deductions on the Consolidated Statement of Income. The remaining amount of the call premiums have been deferred for future rate recovery. Further, KeySpan wrote-off $8.2 million of previously deferred financing costs which have been reflected in interest expense on the Consolidated Statement of Income. The total after-tax expense of the 2004 debt redemption was $29.3 million or $0.18 per share.
The net impact of the above mentioned items resulted in a decrease to earnings from continuing operations of $6.8 million or $0.04 per share for the year ended December 31, 2005, compared to a gain of $249.7 million, or $1.55 per share, in 2004.
Earnings Available for Common Stock 2005 vs 2004
As noted previously, earnings available for common stock in 2005 also included losses from discontinued operations associated with KeySpan's former mechanical contracting subsidiaries amounting to $1.8 million, or $0.01 per share. Further, as noted, earnings available for common stock for 2005 included a $6.6 million, or $0.04 per share, cumulative change in accounting principle charge as a result of implementing the accounting requirements of FIN 47 "Accounting for Conditional Asset Retirement Obligations."
Also as noted previously, in 2004 KeySpan conducted an evaluation of the carrying value of its investments in the Energy Services segment. As a result of this evaluation, KeySpan recorded a loss in discontinued operations of $151.0 million, or $0.94 per share. This loss reflects a $139.9 million after-tax impairment charge to reflect a reduction to the carrying value of assets associated with our mechanical contracting activities and operating losses of $11.1 million. (See Note 10 to the Consolidated Financial Statements "Energy Services - Discontinued Operations" for additional details on these items.)
CONSOLIDATED SUMMARY OF RESULTS
Operating income by segment, as well as consolidated earnings available for common stock is set forth in the following table for the periods indicated.
Operating Income 2006 vs 2005
As indicated in the above table, operating income decreased $80.3 million, or 9%, for the twelve months ended December 31, 2006 compared to the same period of 2005. As noted earlier, during 2006, KeySpan incurred pre-tax incremental Merger costs of $27.1 million related to its proposed merger with National Grid plc, representing investment banking, legal, accounting and other consulting fees. For reporting purposes, the majority of these costs reside at the holding
company level (elimination and other) and have not been allocated to the operating segments. The remaining variation is due, for the most part, to a decrease of $49.3 million in the operating income of the Electric Services segment. As noted earlier, the Ravenswood Generating Station was adversely impacted by additional competing electric generating units and the comparatively cooler 2006 summer weather, resulting in a decrease of $110.3 million in net electric margins. However, net electric margins from KeySpan's service agreements with LIPA and its electric marketing operations increased in 2006 compared to 2005, offsetting some of the lost margin from the Ravenswood Generating Station. Further, this segment also recognized a $46.5 million gain on a fixed for floating unforced capacity financial swap which is reflected in the operating results of this segment.
KeySpan's gas distribution business realized a slight increase, $2.9 million, in operating income year-over-year. Operating expenses decreased $54.7 million in 2006 compared to 2005, while net gas revenues decreased $51.8 million over the same time period. The decrease in net gas revenues reflects the significantly warmer weather experienced during the first and fourth quarter winter heating seasons, whereas the decrease in operating expenses was mainly driven by a lower provision for uncollectible accounts receivable resulting from the decrease in firm sales quantities, and from the beneficial impact of a recent regulatory order and improved accounts receivable collection activities. The favorable comparative results from the Energy Services segment were due to higher operating margins on engineering, energy supply and service contracts and lower general and administrative expenses. The decrease in operating income from the Energy Investments segment reflects, in part, lower earnings from KeySpan's investment in the Iroquois Gas Transmission System pipeline, as well as lower earnings from the transportation of liquefied natural gas. (See the discussion under the caption "Review of Operating Segments" for further details on each segment.)
Other income and (deductions) reflects interest charges, costs associated with debt redemptions, income from subsidiary stock transactions and other miscellaneous items. For the twelve months ended December 31, 2006, other income and (deductions) reflects a net expense of $217.8 million compared to a net expense of $269.9 million for the same period of 2005. The favorable variation of $52.1 million is due, in part, to debt redemption costs incurred in 2005. As discussed previously, in 2005, KeySpan redeemed $500 million 6.15% Series Notes due in 2006. KeySpan incurred $20.9 million in call premiums and wrote-off $1.3 million of previously deferred financing costs. In addition, we accelerated the amortization of approximately $11.2 million of previously unamortized benefits associated with an interest rate swap on the redeemed bonds. The write-off of the deferred financing costs and the amortization of the benefits associated with an interest rate swap were recorded to interest expense.
Interest expense for the twelve months ended December 31, 2006 decreased $13.2 million compared to the same period in 2005, reflecting, in part, the reversal of a previously recorded $5.9 million reserve established in connection with an income tax dispute with the New York City Department of Taxation and Finance. In 2006, KeySpan resolved its dispute with the New York City Department of Taxation and Finance with respect to income taxes relating to the operations of the Ravenswood Generating Station. As a result of the favorable settlement of this issue, KeySpan reversed the previously recorded interest reserve. Further, comparative interest expense reflects lower carrying charges on regulatory
deferrals in 2006, offset by the benefits recorded in 2005 associated with the amortization of the interest rate swap. The favorable variation in other income and (deductions) for the twelve months ended December 31, 2006, compared to the same period in 2005, also reflects higher income on certain investments.
Other income and (deductions) for the twelve months ended December 31, 2005, includes the sale of KeySpan's 50% interest in Premier Transmission Limited ("Premier"), a gas pipeline from southwest Scotland to Northern Ireland. The sale generated cash proceeds of approximately $48.1 million. In the fourth quarter of 2004, KeySpan reduced its carrying value in Premier to an amount approximating the anticipated cash proceeds from the sale. The final sale of Premier, which took place in the first quarter of 2005, resulted in a pre-tax gain of $4.1 million reflecting the difference from earlier estimates.
Income tax expense decreased $63.8 million in 2006, compared to 2005, primarily reflecting the settlements with the New York City Department of Taxation and Finance and the IRS, as previously noted, amounting to $51.6 million; the remaining decrease reflects lower pre-tax income.
As a result of the items discussed above, earnings available for common stock were $434.2 million, or $2.48 per share for the year ended December 31, 2006, compared to $388.0 million, or $2.28 per share realized in 2005. As noted earlier, earnings available for common stock for the year ended December 31, 2005, included losses of $1.8 million, or $0.01 per share, from discontinued operations, as well as a $6.6 million, or $0.04 per share cumulative change in accounting principles charge.
Operating Income 2005 vs 2004
Operating income decreased $27.5 million, or 3%, for the twelve months ended December 31, 2005 compared to the same period of 2004. The comparative operating results reflect the following two items that had a significant impact on results: (i) operating results of non-core subsidiaries recorded in 2004 and which were sold in 2005; offset by (ii) impairment charges recorded in 2004. As noted earlier, during 2004 KeySpan held equity ownership interests in Houston Exploration and KeySpan Canada. For the twelve months ended December 31, 2004, KeySpan's share of the combined operating income of Houston Exploration and KeySpan Canada was $155.0 million. KeySpan sold its remaining ownership interest in these non-core operations in the fourth quarter of 2004. Offsetting this income to some extent were pre-tax non-cash impairment charges of $89.1 million recorded in 2004. As noted earlier, KeySpan recorded the following three impairment charges during 2004: (i) a goodwill impairment charge recorded in the Energy Services segment attributable to continuing operations of $14.4 million; (ii) a ceiling test write-down of $48.2 million to recognize the reduced valuation of proved reserves associated with KeySpan's wholly-owned gas production and development subsidiaries; and (iii) a non-cash impairment charge of $26.5 million also recorded in the Energy Investments segment reflecting the difference between the anticipated cash proceeds from the sale of Premier compared to its carrying value.
The combined impact of the non-core operating income recorded in 2004 offset by the impairment charges contributed $65.9 million to operating income for the twelve months ended December 31, 2004. KeySpan's core businesses, therefore, posted an increase in operating income of $38.4 million for the twelve months ended December 31, 2005, compared to the same period of 2004, primarily reflecting an increase of $52.5 million in the Electric Services segment, partially offset by a $13.9 million decrease in the Gas Distribution segment. The favorable results from KeySpan's electric services operations reflect an increase in net electric revenues as a result of higher electric prices that were due, in part, to the warm weather during the summer of 2005 and the impact of two hurricanes that occurred in the summer of 2005. Gas distribution results, however, were adversely impacted by higher operating expenses, primarily due to an increase in the provision for uncollectible accounts receivable as a result of higher gas costs and by higher property taxes. For the most part, the beneficial impact on comparative operating income from lower net operating losses incurred at the Energy Services segment, was offset by an increase in expenses residing at the holding company level. Further, in 2004 KeySpan reached a settlement with certain of its insurance carriers regarding cost recovery for expenses incurred at a non-utility environmental site and recorded an $11.6 million gain from the settlement as a reduction to expense.
Other income and (deductions) reflects interest charges, costs associated with debt redemptions, income from subsidiary stock transactions, minority interest charges and other miscellaneous items. For the twelve months ended December 31, 2005, other income and (deductions) reflects a net expense of $269.9 million compared to income of $4.9 million for the twelve months ended December 31, 2004. This unfavorable variation of $274.8 million is due to higher gains from asset sales recorded in 2004 compared to 2005 of $384.2 million, offset by a decrease in interest charges of $62.0 million, lower debt redemption costs of $25.0 million and the absence of minority interest expenses of $36.4 million. The following is a discussion of these items.
As noted earlier, in the first quarter of 2005, KeySpan finalized its sale of Premier. The final sale of Premier resulted in a pre-tax gain of $4.1 million reflecting the difference from earlier estimates and what was recorded in the first quarter of 2005. For the twelve months ended December 31, 2004, KeySpan realized pre-tax income of $388.3 million from subsidiary stock transactions associated with Houston Exploration and KeySpan Canada, as discussed earlier.
Interest expense decreased $62.0 million, or 19%, for the twelve months ended December 31, 2005, compared to the same period of 2004, reflecting the benefits attributable to debt redemptions, as well as the sale of Houston Exploration and KeySpan Canada. In addition, as noted earlier, in 2005 KeySpan redeemed $500 million 6.15% Series Notes due 2006. KeySpan incurred $20.9 million in call premiums, wrote-off $1.3 million of previously deferred financing costs and accelerated the amortization of approximately $11.2 million of previously unamortized benefits associated with an interest rate swap on these bonds. The accelerated amortization of the interest rate swap and the write-off of previously deferred financing costs reduced interest expense in 2005 by $9.9 million.
In 2004, KeySpan redeemed approximately $758 million of various series of outstanding debt and incurred $45.9 million in call premiums and wrote-off $8.2 million of previously deferred financing costs. The net impact of the 2005 and 2004 debt redemptions lowered comparative interest expense by $18.1 million.
For the year ended December 31, 2004 other income and (deductions) also includes the effects of minority interest of $36.8 million related to our previous majority ownership interests in Houston Exploration and KeySpan Canada. Finally, other income and (deductions) for the year ended December 31, 2004 reflects a $12.6 million gain recorded on the settlement of a derivative financial instrument entered into in connection with the sale/leaseback transaction associated with the Ravenswood Expansion, a 250 MW combined cycle generating facility located at the Ravenswood Generating Station site, as well as a $5.5 million foreign currency gain.
Income taxes decreased $86.2 million for the year ended December 31, 2005 compared to 2004 due, for the most part, to lower pre-tax earnings. In addition, tax expense for 2004 reflects: (i) a $6.0 million benefit resulting from a revised appraisal associated with property that was disposed of in 2003; (ii) a tax benefit of $12 million related to the repatriation of earnings from KeySpan's foreign investments; and (iii) the beneficial tax treatment afforded to the stock transaction with Houston Exploration.
As noted earlier, earnings available for common stock for the year ended December 31, 2005, also included losses of $1.8 million, or $0.01 per share, from discontinued operations, as well as a $6.6 million, or $0.04 per share cumulative change in accounting principles charge. Earnings available for common stock for the year ended December 31, 2004, included losses of $151.0 million, or $0.94 per share, from discontinued operations.
As a result of the items discussed above, earnings available for common stock were $388.0 million, or $2.28 per share for the year ended December 31, 2005, compared to $458.1 million, or $2.86 per share realized in 2004.
REVIEW OF OPERATING SEGMENTS
KeySpan's segment results are reported on an "Operating Income" basis. Management believes that this generally accepted accounting principle ("GAAP") based measure provides a reasonable indication of KeySpan's underlying performance associated with its operations. The following is a discussion of financial results achieved by KeySpan's operating segments presented on an Operating Income basis.
GAS DISTRIBUTION
The Brooklyn Union Gas Company, doing business as KeySpan Energy Delivery New York ("KEDNY") provides gas distribution service to customers in the New York City Boroughs of Brooklyn, Staten Island and a portion of Queens. KeySpan Gas East Corporation, doing business as KeySpan Energy Delivery Long Island ("KEDLI") provides gas distribution service to customers in the Long Island Counties of Nassau and Suffolk and the Rockaway Peninsula of Queens County. Four natural gas distribution companies - Boston Gas Company, Essex Gas Company, Colonial Gas Company and EnergyNorth Natural Gas, Inc., each doing business under the name KeySpan Energy Delivery New England ("KEDNE"), provide gas distribution service to customers in Massachusetts and New Hampshire.
The table below highlights certain significant financial data and operating statistics for the Gas Distribution segment for the periods indicated.
A MDTH is 10,000 therms and reflects the heating content of approximately one million cubic feet of gas. A therm reflects the heating content of approximately 100 cubic feet of gas. One billion cubic feet (BCF) of gas equals approximately 1,000 MDTH.
Operating Income 2006 vs 2005
Executive Summary
Operating income increased $2.9 million for the twelve months ended December 31, 2006, compared to the same period last year reflecting a decrease in operating expenses of $54.7 million, substantially offset by a decrease in net gas revenues (revenues less the cost of gas and associated revenue taxes) of $51.7 million. The lower operating expenses were primarily due to a decrease in the provision for uncollectible accounts receivable of $60.9 million. The exceptionally warm weather during the first and fourth quarters of 2006 - KeySpan's primary heating seasons - was the primary driver behind the decrease in net gas revenues.
Net Revenues
Net gas revenues from our gas distribution operations decreased $51.7 million, or 3%, for the twelve months ended December 31, 2006, compared to the same period last year. Both the New York and New England based gas distribution operations were adversely impacted by the significantly warmer than normal weather experienced throughout the northeastern United States during the 2006 winter heating seasons - January through April and October through December. As measured in heating degree days, weather in 2006 in our New York and New England service territories was approximately 16% and 7.6% warmer than normal, respectively, and was approximately 16% warmer than last year across KeySpan's service territories.
Net revenues from firm gas customers (residential, commercial and industrial customers) decreased $70.2 million in 2006 compared to 2005. The favorable impact to net gas revenues from load growth additions was more than offset by declining usage per customer due to the extremely warm weather during the winter heating seasons, the use of more efficient gas heating equipment and higher gas costs. KeySpan estimates that the warm weather during the two heating seasons resulted in an adverse impact to net gas revenues of approximately $32 million, net of the benefits from the weather normalization adjustment and weather derivatives discussed below. Further, KeySpan earned $6.5 million less in regulatory incentives for the twelve months ended December 31, 2006, compared to the same period last year.
KEDNY and KEDLI each operate under utility tariffs that contain a weather normalization adjustment that significantly offsets variations in firm net revenues due to fluctuations in weather. These weather normalization adjustments resulted in a benefit to KeySpan of $57 million during the twelve months ended December 31, 2006, but this did not fully mitigate the impact of the loss in revenues due to the extremely warm weather experienced, as previously noted. The New England-based gas distribution subsidiaries do not have weather normalization adjustments. To mitigate the effect of fluctuations in normal weather patterns on KEDNE's results of operations and cash flows, weather derivatives were in place for the 2005/2006 and 2006/2007 winter heating season. Since weather was warmer than normal in November and December of 2006, these derivative instruments resulted in a $9.1 million benefit to net gas revenues in 2006. (See Note 8 to the Consolidated Financial Statements "Hedging, Derivative Financial Instruments and Fair Values" for further information).
Firm gas distribution rates for KEDNY, KEDLI and KEDNE in 2006, other than for the recovery of gas costs, have remained substantially unchanged from rates charged in 2005.
In our large-volume heating and other interruptible (non-firm) markets, which include large apartment houses, government buildings and schools, gas service is provided under rates that are designed to compete with prices of alternative fuel, including No. 2 and No. 6 grade heating oil. These "dual-fuel" customers can consume either natural gas or fuel oil for heating purposes. Net revenues in these markets increased $18.5 million during the twelve months ended December 31, 2006, compared to the same period last year primarily reflecting higher pricing.
Firm Sales, Transportation and Other Sales Quantities
Firm gas sales and transportation quantities for the twelve months ended December 31, 2006, decreased 12% compared to the same period in 2006 due primarily to the warmer weather this year compared to last year. On a weather normalized basis, firm gas sales and transportation quantities decreased 2.4% in 2006 compared to 2005 due to lower usage per customer. Customer additions and oil-to-gas conversions, however, offset the full impact of the warmer weather and lower usage per customer. Net revenues are not affected by customers opting to purchase their gas supply from other sources, since delivery rates charged to transportation customers generally are the same as delivery rates charged to full sales service customers. Transportation quantities related to electric generation reflect the transportation of gas to our electric generating facilities located on Long Island. Net revenues from these services are not material.
Other sales quantities include on-system interruptible quantities, off-system sales quantities (sales made to customers outside of our service territories) and related transportation. We have a management contract with Merrill Lynch Trading under which KeySpan and Merrill Lynch Trading share the responsibilities for managing KeySpan's upstream gas contracted assets associated with its Massachusetts gas distribution subsidiaries, as well as providing city-gate delivered supply. KeySpan, Merrill Lynch Trading and KeySpan's Massachusetts gas sales customers will share in the profits generated from the optimization of these assets. The Massachusetts Department of Telecommunications and Energy ("MADTE") approved this contract in March 2006 effective April 1, 2006. KeySpan provides these services internally for its New York and New Hampshire gas distribution subsidiaries.
Purchased Gas for Resale
The decrease in gas costs for the twelve months ended December 31, 2006 compared to the same period of 2005 of $270.4 million, or 7%, is reflective of a decrease of 14% in the quantity of gas purchased due to the warm weather during the two winter heating seasons. However, the price per dekatherm of gas used by firm gas sales customers increased 4%, in 2006 compared to 2005. The current gas rate structure of each of our gas distribution utilities includes a gas adjustment clause, pursuant to which variations between actual gas costs incurred for resale to firm sales customers and gas costs billed to firm sales customers are deferred and refunded to or collected from customers in a subsequent period.
Operating Expenses
Operating expenses for the twelve months ended December 31, 2006, compared to the same period of 2005, decreased $54.7 million, or 5%. Operations and maintenance expense decreased $45.6 million, or 6%, in 2006 compared to 2005 primarily as a result of a decrease of $60.9 million in the provision for uncollectible accounts receivable. In December 2005, The Boston Gas Company ("Boston Gas") received a MADTE order, effective January 1, 2006, permitting Boston Gas to fully recover the gas cost component of bad debt write-offs through its cost-of-gas adjustment clause rather than filing for recovery as an exogenous cost. Additionally, in 2006 we recovered the 2005 gas cost component of bad debts as well. These benefits were the primary driver behind the reduction in the provision for uncollectible accounts receivable, combined with a decrease in firm gas sales quantities in 2006 compared to 2005 and improved collection efforts. (See the discussion under the caption "Regulation and Rate Matters - Gas Matters" for additional details of the MADTE order.) Offsetting the favorable impact of the MADTE order, to some extent, was higher employee benefit related expenses, including postretirement costs, and generally higher administrative and general costs.
The decrease in depreciation and amortization charges of $10.2 million, or 4%, for the twelve months ended December 31, 2006 compared to the same period of 2005, reflects a decrease in depreciation charges of $8.4 million and lower regulatory amortization charges of $1.8 million. The decrease in depreciation charges reflects an adjustment to the depreciation allowance to correct for an error in useful lives associated with certain gas distribution assets.
Operating Income 2005 vs 2004
Executive Summary
Operating income decreased $13.9 million, or 2%, for the twelve months ended December 31, 2005, compared to the same period of 2004 due to higher operating expenses. Operating expenses increased $62.0 million reflecting primarily an increase in the provision for uncollectible accounts receivable and higher property taxes totaling $45.8 million. Partially offsetting the higher operating expenses was an increase of $48.0 million in net gas revenues resulting from customer additions and oil-to-gas conversions in our firm gas sales market, as well as from higher net gas revenues in our large-volume heating markets.
Net Revenues
Net gas revenues from our gas distribution operations increased $48.0 million, or 3%, for the twelve months ended December 31, 2005, compared to the same period of 2004. Net gas revenues benefited from customer additions and oil-to-gas conversions in our firm gas sales market as well as from higher net gas revenues in our large-volume heating and interruptible (non-firm) markets. As measured in heating degree days, weather in 2005 in our New York and New England service territories was approximately 1.0% and 8.6% colder than normal, respectively. Compared to 2004, weather in 2005 was 1.2% colder in KeySpan's New England service territory, while weather was consistent between years in the New York service territory.
Net revenues from firm gas customers increased $24.3 million for the twelve months ended December 31, 2005, compared to same period of 2004. Customer additions and oil-to-gas conversions, net of attrition and conservation, added $25.1 million to net gas revenues. Further, we realized a benefit of $3.8 million as a result of the Boston Gas Performance Based Rate Plan (the "Plan") that was approved by the MADTE in 2003. The Plan provides for firm gas sales rates to be adjusted each year based on an inflation factor offset by a productivity factor. (See the caption under "Regulation and Rate Matters" for further information regarding the rate filing.)
Offsetting, to some extent, the beneficial impact of the customer additions and oil-to-gas conversions was the adverse impact to comparative net gas revenues from the additional billing day in 2004 due to the leap year. In 2004, KeySpan realized $5.7 million in additional net gas revenues from the additional billing day. Further, KeySpan earned $8.7 million less in regulatory incentives for the twelve months ended December 31, 2005, compared to the same period of 2004.
Also included in net revenues is the recovery of certain regulatory items and certain taxes that added $6.6 million to net revenues. However, the recovery of these items through revenues does not impact net income since a similar amount was expensed as amortization charges and income taxes, as appropriate, on the Consolidated Statement of Income. Firm gas distribution rates for KEDNY, KEDLI and KEDNE in 2005, other than for the recovery of gas costs and resulting from the Plan, remained substantially unchanged from rates charged in 2004.
KEDNY and KEDLI each operate under a utility tariff that contains a weather normalization adjustment that significantly offsets variations in firm net revenues due to fluctuations in normal weather. However, the gas distribution operations of our New England based subsidiaries do not have a weather normalization adjustment. To mitigate the effect of fluctuations in normal weather patterns on KEDNE's results of operations and cash flows, weather derivatives were in place for the 2004/2005 and 2005/2006 winter heating seasons. These financial derivatives afforded KeySpan some protection against warmer than normal weather. As a result of the weather fluctuations and financial weather derivatives, weather had a $3.2 million favorable impact on comparative net gas revenues.
In our large-volume heating and interruptible (non-firm) markets, which include large apartment houses, government buildings and schools, gas service is provided under rates that are designed to compete with prices of alternative fuel, including No. 2 and No. 6 grade heating oil. These "dual-fuel" customers can consume either natural gas or fuel oil for heating purposes. Net revenues in these markets increased $23.7 million during the twelve months ended December 31, 2005, compared to the same period of 2004, primarily reflecting higher pricing. Further, since weather during January 2004 was significantly colder than normal, KeySpan interrupted service to a segment of its dual-fuel customers for a number of days during that month, as permitted under its tariff, to ensure reliable service to firm customers. The majority of interruptible profits earned by KEDLI and KEDNE are returned to firm customers as an offset to gas costs.
Firm Sales, Transportation and Other Sales Quantities
Both actual firm gas sales and transportation quantities, as well as weather normalized sales quantities for the twelve months ended December 31, 2005, remained consistent with those quantities realized in 2004. Net revenues are not affected by customers opting to purchase their gas supply from other sources, since delivery rates charged to transportation customers generally are the same as delivery rates charged to full sales service customers. Transportation quantities related to electric generation reflect the transportation of gas to our electric generating facilities located on Long Island. Net revenues from transportation services are not material.
Other sales quantities include on-system interruptible quantities, off-system sales quantities (sales made to customers outside of our service territories) and related transportation. The increase in these sales quantities for the twelve months ended December 31, 2005, compared to the same period of 2004 reflects higher off-system sales. The majority of these profits earned are returned to firm customers as an offset to gas costs. From April 1, 2002 through March 31, 2005, we had an agreement with Coral Resources, L.P. ("Coral"), a subsidiary of Shell Oil Company, under which Coral assisted in the origination, structuring, valuation and execution of energy-related transactions on behalf of KEDNY and KEDLI. Upon expiration of this agreement, these services have been provided by KeySpan employees. KeySpan also provides these services internally for its New Hampshire gas distribution subsidiaries. In 2004 and 2005, we also had a portfolio management contract with Merrill Lynch Trading, under which Merrill Lynch Trading was responsible for managing KeySpan's upstream gas contracted assets associated with its Massachusetts gas distribution subsidiaries, as well as providing city-gate delivered supply. As noted above, beginning in April 2006, KeySpan and Merrill Lynch Trading have a new three-year agreement under which KeySpan and Merrill Lynch share the responsibilities for managing KeySpan's upstream gas contracted assets associated with its Massachusetts gas distribution subsidiaries.
Purchased Gas for Resale
The increase in gas costs for the twelve months ended December 31, 2005, compared to the same period of 2004, of $942.3 million, or 35%, reflects an increase of 23% in the price per dekatherm of gas purchased for firm gas sales customers, as well as an increase in the quantity of gas purchased for large-volume heating and interruptible (non-firm) customers. The current gas rate structure of each of our gas distribution utilities includes a gas adjustment clause, pursuant to which variations between actual gas costs incurred for resale to firm sales customers and gas costs billed to firm sales customers are deferred and refunded to or collected from customers in a subsequent period.
Operating Expenses
For the twelve months ended December 31, 2005, operating expenses increased $62.0 million, or 6% compared to the same period in 2004. Operations and maintenance expense increased $54.5 million, or 8%, in 2005 compared to 2004 primarily due to an increase of $38.7 million in the provision for uncollectible accounts as a result of increasing gas costs and the adverse impact from collection experience. Further, the gas distribution operations realized an increase in insurance and regulatory fees, as well as postretirement expenses in 2005 compared to 2004. In 2004, KeySpan recognized a benefit of approximately $3 million, net of amounts subject to regulatory deferral treatment, associated with the implementation of the Medicare Prescription Drug Improvement and Modernization Act of 2003 ( the "Medicare Act") and implementation of Financial Accounting Standards Board Staff Position ("FSP") 106-2. In addition, in 2004, Boston Gas reached an agreement with an insurance carrier for recovery of previously incurred environmental expenditures. Insurance and third-party recoveries, after deducting legal fees, are shared between Boston Gas and its firm gas customers as provided under a previously issued MADTE rate order. As a result of this insurance settlement, Boston Gas recorded a $5 million benefit to operations and maintenance expense.
Comparative operating taxes increased $7.1 million due to the expiration of a five-year property tax assessment agreement with New York City, as well as to a $2.5 million property tax refund received in 2004. Higher depreciation charges of $4.5 million reflecting the continued expansion of the gas distribution system were offset by lower regulatory amortization charges of $4.1 million.
Gas Supply and Pricing
KeySpan has adequate gas supply available to meet its gas load demand in its service territories for the 2006/2007 winter heating season as KeySpan's gas storage was 100% full at the start of the winter heating season. The current gas rate structure of each of our gas distribution utilities includes a gas adjustment clause, pursuant to which gas costs are recovered in billed sales to regulated firm gas sales customers. Although KeySpan is allowed to "pass through" the cost of gas to its customers, the volatility of natural gas prices can have an adverse impact on customers' gas bills and recovery of customer
accounts receivable. High gas prices have led to an increase in customer conservation measures and attrition. The MADTE order, received in the fourth quarter of 2005, permitting Boston Gas regulatory recovery of the gas cost component of net bad debt write-offs has helped to mitigate any increase in bad debt expense.
With KeySpan's continuing strategy of having its storage facilities 100% full at the start of the heating season and through the use of financial derivatives, KeySpan has effectively hedged the price of approximately two-thirds of the gas supply needed to serve its gas heating customers during the 2006/2007 winter heating season. This strategy mitigates the volatility of natural gas prices on customers' winter heating gas bills. Further, KeySpan has programs in place to help customers manage their gas bills, such as balanced billing plans, deferred payment arrangements and the low income home energy assistance program, the expansion of which we supported through the Energy Policy Act of 2005. Management believes that these measures help mitigate the impact of volatile gas prices on customers' bills.
Other Matters
We remain committed to our ongoing gas system expansion strategies. We believe that significant growth opportunities exist on Long Island and in our New England service territories, as well as continued growth in the New York service territory, despite the volatility in gas prices. We estimate that on Long Island approximately 37% of the residential and multi-family markets, and approximately 60% of the commercial market, currently use natural gas for space heating. Further, we estimate that in our New England service territories approximately 50% of the residential and multi-family markets, as well as approximately 60% of the commercial market, currently use natural gas for space heating purposes. We will continue to seek growth, in all of our market segments to serve new housing and commercial construction and to penetrate existing communities where no distribution system exists, as well as through the conversion of residential homes from oil to gas for space heating purposes and the pursuit of opportunities to grow multi-family, industrial and commercial markets.
In order to serve the anticipated market requirements in our New York service territories, KeySpan and Spectra Energy Corporation (formerly a part of Duke Energy Corporation) formed Islander East Pipeline Company, LLC ("Islander East") in 2000. Once in service, the pipeline is expected to have the capacity to transport up to 260,000 DTH of natural gas to the Long Island and New York City energy markets, enough natural gas to heat 600,000 homes. In addition, KeySpan has a 26.25% interest in the Millennium Pipeline development project which is anticipated to transport up to 525,000 DTH of natural gas a day to the Algonquin pipeline. KEDLI has executed a Precedent Agreement for 175,000 DTH of natural gas per day of transportation capacity from the Millennium Pipeline system, increasing to 200,000 DTH in the second year of the pipeline being in service. These pipeline projects will allow KeySpan to diversify the geographic sources of its gas supply. See the discussion under the caption "Energy Investments" for additional information regarding these pipeline projects.
ELECTRIC SERVICES
The Electric Services segment primarily consists of subsidiaries that own, lease and operate oil and gas-fired electric generating plants in the Borough of Queens (including the "Ravenswood Generating Station" which comprises the Ravenswood Facility and Ravenswood Expansion) and the counties of Nassau and Suffolk on Long Island. In addition, through long-term contracts of varying lengths, we (i) provide to the Long Island Power Authority ("LIPA") all operation, maintenance and construction services and significant administrative services relating to the Long Island electric transmission and distribution ("T&D") system pursuant to a Management Services Agreement (the "1998 MSA"); (ii) supply LIPA with electric generating capacity, energy conversion and ancillary services from our Long Island generating units pursuant to a Power Supply Agreement (the "1998 PSA"); and (iii) manage all aspects of the fuel supply for our Long Island generating facilities, as well as all aspects of the capacity and energy owned by or under contract to LIPA pursuant to an Energy Management Agreement (the "1998 EMA"). The 1998 MSA, 1998 PSA and 1998 EMA all became effective on May 28, 1998 and are collectively referred to herein as the "1998 LIPA Agreements."
On February 1, 2006, KeySpan and LIPA entered into (i) an amended and restated Management Services Agreement (the "2006 MSA"), pursuant to which KeySpan will continue to operate and maintain the electric T&D System owned by LIPA on Long Island through 2013; (ii) a new Option and Purchase and Sale Agreement (the "2006 Option Agreement"), to replace the Generation Purchase Rights Agreement (the "GPRA"), pursuant to which LIPA had the option, through December 15, 2005, to acquire substantially all of the electric generating facilities owned by KeySpan on Long Island; and (iii) a Settlement Agreement (the "2006 Settlement Agreement") resolving outstanding issues between the parties regarding the 1998 LIPA Agreements. The 2006 MSA, the 2006 Option Agreement and the 2006 Settlement Agreement are collectively referred to herein as the "2006 LIPA Agreements." These agreements will become effective following approval by the New York State Comptroller's Office and the New York State Attorney General. (For a further discussion on these LIPA agreements see the discussion under the caption "Electric Services - LIPA Agreements" and Note 11 to the Consolidated Financial Statements "2006 LIPA Settlement"). The Electric Services segment also provides retail marketing of electricity to commercial customers.
Selected financial data for the Electric Services segment is set forth in the table below for the periods indicated.
*Reflects the operations of the Ravenswood Generating Station only.
Operating Income 2006 vs 2005
Executive Summary
Operating income decreased $49.3 million, or 14%, for the twelve months ended December 31, 2006, compared to the same period last year, due primarily to a decrease in net revenues from the Ravenswood Generating Station of $110.3 million as a result of lower energy margins and lower capacity revenues, partially offset by higher revenues associated with KeySpan's service agreements with LIPA and its electric marketing activities of $10.6 million. KeySpan also recognized a gain of $46.5 million on a fixed for floating unforced capacity financial swap.
Net Revenues
Total electric net revenues realized in 2006 were $36.4 million higher than such revenues realized in 2005.
KeySpan has entered into an International SWAP Dealers Association Master Agreement for a fixed for floating unforced capacity financial swap with Morgan Stanley Capital Group Inc. ("Swap Agreement"). This agreement has a three year term that began on May 1, 2006. For the twelve months ended December 31, 2006 KeySpan recognized a gain of $46.5 million from this derivative financial instrument. (See Note 8 to the Consolidated Financial Statements, "Hedging, Derivative Financial Instruments and Fair Values," for further information on this swap agreement.)
Net revenues for the twelve months ended December 31, 2006 from the service agreements with LIPA, including the power purchase agreements associated with two electric peaking facilities, increased $96.6 million compared to the same period of 2005. The increase is due, for the most part, to recovery of operations and maintenance charges billed to LIPA of approximately $76 million
and the recovery of depreciation charges and property taxes of approximately $14 million. These recoveries had no impact on operating income since actual expenses increased by a like amount. Therefore, only approximately $7 million of the increase in net revenues resulted in a benefit to operating income. This increase in net revenues from the LIPA service agreements was driven by higher off-system electric energy sales and emission credit sales, as well as the recovery of certain past service costs, offset by lower performance incentives. In 2006, KeySpan earned $9.0 million associated with non-cost performance incentives provided for under these agreements, compared to $16.4 million earned in 2005, due to the discontinuation of certain performance incentives contained in the MSA.
Net revenues associated with KeySpan's electric marketing activities increased $3.6 million during the twelve months ended December 31, 2006, compared to the same period of 2005.
Net revenues from the Ravenswood Generating Station decreased $110.3 million, or 25% for the twelve months ended December 31, 2006, compared to the same period of 2005 reflecting lower capacity revenues of $80.5 million and a decrease in energy margins of $29.8 million. The decrease in capacity revenues was primarily due to the planned installation of 1,000 megawatts of additional electric capacity in New York City in 2006.
The decrease in energy margins in 2006 reflects, in part, a 50% decrease in realized "spark-spreads" (the selling price of electricity less the cost of fuel, exclusive of hedging gains or losses). Further, the level of megawatt hours ("MWh") sold into the NYISO energy market decreased 30% due to increased competition and cooler weather in the summer of 2006 compared to the summer of 2005 - the peak cooling season. As measured in cooling-degree days, weather was 25% cooler during the summer of 2006 compared to the summer of 2005, and 2% warmer than normal. Combined, these two items reduced energy margins by $124.9 million or 63%. It should be noted, that in 2005 KeySpan benefited from the pricing differential between number 6-grade fuel oil and natural gas used in the Ravenswood Generating Station. Due to the dual-fuel capability of the Ravenswood Generating Station, KeySpan was able to take advantage of the ability to switch to cheaper fuel as the gap between number 6 grade fuel oil and gas prices spread during the later part of the 2005 summer. The two hurricanes which occurred in the summer of 2005 in the Gulf Coast of the United States contributed to the gap between number 6-grade fuel oil and natural gas prices.
Partially offsetting these adverse impacts to comparative energy margins were the benefits recognized from derivative financial instruments. We employ derivative financial instruments to economically hedge the cash flow variability for a portion of forecasted purchases of natural gas and fuel oil consumed at the Ravenswood Generating Station, as well as for a portion of forecasted electric energy sales. These derivative instruments, the impacts of which are reflected in net electric margins, resulted in a comparative gain of $95.1 million year-over-year. Hedging gains realized in 2006 were $79.1 million compared to hedging losses of $16.0 million realized in 2005.
The Ravenswood Generating Station is a dual-fuel electric facility that can burn either number 6-grade fuel oil or natural gas to generate electricity. To take full advantage of the dual-fuel capability of the Ravenswood Generating Station, KeySpan uses the cheaper of the two fuels in the generation of electricity and,
as a result, KeySpan may not be able to apply hedge accounting treatment for all of its aforementioned risk management strategies in the future and therefore may experience some degree of fluctuations in its recorded net electric revenues due to changes in the market value of outstanding derivative instruments and the related underlying commodity. (See Note 8 to the Consolidated Financial Statements "Hedging, Derivative Financial Instruments and Fair Values" as well as Item 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Commodity Derivative Instruments - Hedging Activities: From time to time, KeySpan subsidiaries have utilized derivative financial instruments, such as futures, options and swaps, for the purpose of hedging the cash flow variability associated with changes in commodity prices. KeySpan is exposed to commodity price risk primarily with regard to its gas distribution operations, gas production and development activities and its electric generating facilities. Our gas distribution operations utilize over-the-counter ("OTC") natural gas and fuel oil swaps to hedge the cash-flow variability of specified portions of gas purchases and sales associated with certain large-volume customers when economically appropriate to do so. Seneca-Upshur utilizes OTC natural gas swaps to hedge cash flow variability associated with forecasted sales of natural gas.
Commodity Derivative Instruments that are not Accounted for as Hedges: The Ravenswood Generating Station uses derivative financial instruments to financially hedge the cash flow variability associated with the purchase of a portion of natural gas and oil that will be consumed during the generation of electricity. The Ravenswood Generating Station also financially hedges the cash flow variability associated with a portion of electric energy sales using OTC electricity swaps. KeySpan has also, entered into an International SWAP Dealers Association Master Agreement for a fixed for floating unforced capacity financial swap with Morgan Stanley Capital Group Inc., as well as a gas distribution asset optimization contract that employs derivative financial instruments.
The following tables set forth selected financial data associated with these derivative financial instruments that were outstanding at December 31, 2006.
The following tables detail the changes in and sources of fair value for the above derivatives:
- ------------------------------------------------------------------------------- (In Millions of Dollars) 2006 Change in Fair Value of Derivative Hedging Instruments ($Millions) - ------------------------------------------------------------------------------- Fair value of contracts at January 1, 2006 $ (18.1) Net (gains) on contracts realized (73.6) Increase in fair value of all open contracts 86.1 - ------------------------------------------------------------------------------- Fair value of contracts outstanding at December 31, $ (5.6) - -------------------------------------------------------------------------------
We measure the commodity risk of our derivative hedging instruments (indicated in the above table) using a sensitivity analysis. Based on a sensitivity analysis as of December 31, 2006 a 10% increase/decrease in natural gas prices would decrease/increase the value of derivative instruments maturing in one year by $2.4 million.
Commodity Derivative Instruments - Regulated Utilities: We use derivative financial instruments to reduce the cash flow variability associated with the purchase price for a portion of future natural gas purchases associated with our Gas Distribution operations. The accounting for these derivative instruments is subject to SFAS 71 "Accounting for the Effects of Certain Types of Regulation." Therefore, changes in the fair value of these derivatives have been recorded as a regulatory asset or regulatory liability on the Consolidated Balance Sheet. Gains or losses on the settlement of these contracts are initially deferred and then refunded to or collected from our firm gas sales customers consistent with regulatory requirements.
The following table sets forth selected financial data associated with these derivative financial instruments that were outstanding at December 31, 2006.
See Note 8 to the Consolidated Financial Statements "Hedging, Derivative Financial Instruments and Fair Values" for a further description of all our derivative instruments.
ITEM 8.
ITEM 8. Financial Statements and Supplementary Data
CONSOLIDATED BALANCE SHEET
See accompanying Notes to the Consolidated Financial Statements.
CONSOLIDATED BALANCE SHEET
See accompanying Notes to the Consolidated Financial Statements.
CONSOLIDATED STATEMENT OF INCOME
See accompanying Notes to the Consolidated Financial Statements.
See accompanying Notes to the Consolidated Financial Statements.
See accompanying Notes to the Consolidated Financial Statements.
See accompanying Notes to the Consolidated Financial Statements.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
INTRODUCTION TO THE NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
KeySpan Corporation (referred to herein as "KeySpan," "we," "us" and "our") is a holding company under the Public Holding Company Act of 2005 ("PUHCA 2005"). KeySpan operates six regulated utilities that distribute natural gas to approximately 2.6 million customers in New York City, Long Island, Massachusetts and New Hampshire, making KeySpan the fifth largest gas distribution company in the United States and the largest in the Northeast. We also own, lease and operate electric generating plants in Nassau and Suffolk Counties on Long Island and in Queens County in New York City and are the largest electric generation operator in New York State. Under contractual arrangements, we provide power, electric transmission and distribution services, billing and other customer services for approximately 1.1 million electric customers of the Long Island Power Authority ("LIPA"). KeySpan's other operating subsidiaries are primarily involved in gas production and development; underground gas storage; liquefied natural gas storage; retail electric marketing; large energy-system ownership, installation and management; service and maintenance of energy systems; and engineering and consulting services. We also invest and participate in the development of natural gas pipelines, electric generation and other energy-related projects. (See Note 2 to the Consolidated Financial Statements "Business Segments" for additional information on each operating segment.)
On February 25, 2006, KeySpan entered into an Agreement and Plan of Merger (the "Merger Agreement"), with National Grid plc, a public limited company incorporated under the laws of England and Wales ("Parent") and National Grid US8, Inc., a New York Corporation ("Merger Sub"), pursuant to which Merger Sub will merge with and into KeySpan (the "Merger"), with KeySpan continuing as the surviving company and thereby becoming an indirect wholly-owned subsidiary of the Parent. Pursuant to the Merger Agreement, at the effective time of the Merger, each outstanding share of KeySpan common stock, par value $0.01 per share (the "Shares"), other than treasury shares and shares held by the Parent and its subsidiaries, shall be canceled and shall be converted into the right to receive $42.00 in cash, without interest.
Consummation of the Merger is subject to various closing conditions, including but not limited to the receipt of requisite regulatory approvals from certain United States federal and state public utility, antitrust and other regulatory authorities, all of which have been filed and many of which have been obtained. Specifically, we filed our application for approval of the Merger pursuant to the Federal Power Act in May 2006 and in October the requisite approval was obtained from the Federal Energy Regulatory Commission ("FERC"). In early July 2006, we cleared review by the Federal Trade Commission under the Hart-Scott-Rodino Antitrust Improvement Act and received notification that the Committee on Foreign Investment in the U.S. has determined that there are no issues of national security sufficient to warrant an investigation of the transaction. On July 20, 2006 we filed an application for approval of the transaction with the New York Public Service Commission ("NYPSC"). KeySpan has also sought approval of the Merger from the New Hampshire Public Utility Commission. In October 2006, the State of New Jersey Board of Public Utilities approved a change of control of KeySpan Communication Corp., which provides telecommunications services in New Jersey. In addition, the Merger was approved by our shareholders at our Annual Meeting on August 17, 2006. Shareholders of National Grid plc approved the Merger at a meeting held on July 31, 2006.
In addition to seeking approval of the Merger, the application filed with the NYPSC also contained proposed ten-year rate plans for KeySpan Energy Delivery of New York ("KEDNY") and KeySpan Energy Delivery of Long Island ("KEDLI"), as well as proposals concerning corporate structure and affiliate rules, the rate treatment for synergy savings and for low income and energy efficiency programs, among others. Specifically, the rate plan proposals provide for, among other things, a freeze of base delivery rates for KEDNY and KEDLI for 18 months. Thereafter, KEDNY's and KEDLI's gas adjustment clauses would be increased to recover, on a prospective basis, estimated gas commodity-related costs of $68.6 million for KEDNY and $28.7 million for KEDLI that would no longer be included in base rates. In addition, KEDNY and KEDLI base delivery rates would be increased by an average of 2.5% ($62.4 million) and 2.3% ($39.4 million), respectively in years 3, 5, 7 and 9 of the rate plans. The proposed rate plans contemplate an allowed return on equity of 11.0% for each entity. Cumulative earnings above 11.75% would be shared between gas sales customers and KeySpan over the rate plan period. On October 3, 2006 National Grid plc filed testimony and exhibits with the NYPSC that further explains the exhibits and attachments that were previously submitted as part of the July 20, 2006 petition.
Separately from the merger application, on October 3, 2006, KEDNY and KEDLI filed with the NYPSC individual applications for proposed annual increases in revenues, which applications assumed that KEDNY and KEDLI remained as stand-alone companies. The proposed revenue increases are for approximately 9.1% and 10.9% for KEDNY and KEDLI, respectively. KEDNY's last base rate increase took effect October 1, 1993 and since then base rates have been reduced twice - once in 1996 and again in 1998. KEDLI's last base rate increase took effect December 1, 1995. Since that time, KEDLI's base rates were reduced twice in 1998. The principal factors creating the need for rate relief are increases in operating and maintenance expenses, increases in rate base, increased property taxes and depreciation expense, and the need to commence recovery of previously deferred costs such as pension and post retirement benefits, environmental expenditures and property taxes.
The total projected increase in revenues is comprised of two components; (i) an increase in base rates of $180.7 million for KEDNY and $145 million for KEDLI; and (ii) projected increases of $32.8 million and $13.6 million for KEDNY and KEDLI, respectively, for gas-related expenses that will be recovered through the Gas Adjustment Clause ("GAC") and/or the Transportation Adjustment Clause ("TAC"). The proposed rate of return on equity is 11.0% for both KEDNY and KEDLI.
The NYPSC may suspend the implementation of the proposed tariff changes for up to eleven months, which would mean, absent other intervening events, an effective date of September 3, 2007 for new rates. Although KEDNY and KEDLI proposed the new rates described above in these tariff filings, it will not be necessary to implement the rate increases proposed therein if the NYPSC approves the Merger between National Grid plc and KeySpan and approves the related ten-year rate plan previously noted, or some variation thereof.
On February 20, 2007, NYPSC Staff filed its direct testimony in the merger proceeding. NYSPSC Staff opposed the current terms of the Merger on policy grounds, but suggested that it could support the Merger under certain circumstances. KeySpan and National Grid intend to file testimony responding to the positions taken by Staff. In addition, on January 29, 2007, Staff filed its direct testimony in the rate case proceedings and our rebuttal testimony was filed on February 21, 2007. In connection with each of these proceedings, hearings before an administrative law judge (ALJ) are scheduled to begin in late March. Unless a settlement among the parties is otherwise reached, the ALJ will issue its recommended decision to the NYPSC following such hearings. Ultimately, the NYPSC may accept, reject, or modify all or any part of the ALJ's recommended decision.
KeySpan and National Grid will continue to pursue all required approvals and continue to anticipate that the Merger will be consummated in mid-2007. However, we are unable to predict the outcome of these regulatory proceedings and no assurance can be given that the Merger will occur or the timing of its completion.
Note 1. Summary of Significant Accounting Policies
A. Organization of the Company
KeySpan Corporation, a New York corporation, was formed in May 1998, as a result of the business combination of KeySpan Energy Corporation, the parent of The Brooklyn Union Gas Company, and certain businesses of the Long Island Lighting Company ("LILCO"). On November 8, 2000, KeySpan acquired Eastern Enterprises ("Eastern"), a Massachusetts business trust, and the parent of several gas utilities operating in Massachusetts. Also on November 8, 2000, Eastern acquired EnergyNorth, Inc. ("ENI"), the parent of a gas utility operating in central New Hampshire.
At December 31, 2005, KeySpan was a holding company under the Public Utility Holding Company Act of 1935, as amended ("PUHCA 1935"). In August 2005, the Energy Policy Act of 2005 (the "Energy Act") was enacted. The Energy Act is a broad energy bill that places an increased emphasis on the production of energy and promotes the development of new technologies and alternative energy sources and provides tax credits to companies that produce natural gas, oil, coal, electricity and renewable energy. For KeySpan, one of the more significant provisions of the Energy Act was the repeal of PUHCA 1935, which became effective on February 8, 2006. Since that time, the jurisdiction of the Securities and Exchange Commission ("SEC") over certain holding company activities, including the regulation of our affiliate transactions and service companies, has been transferred to the FERC pursuant to PUHCA 2005.
Pursuant to PUHCA 2005, the SEC no longer has jurisdiction over our holding company activities, other than those associated with the registration and issuance of our securities under the federal securities laws. FERC now has jurisdiction over certain of our holding company activities, including (i) regulating certain transactions among our affiliates within our holding company system; (ii) governing the issuance, acquisition and disposition of securities and assets by certain of our public utility subsidiaries; and (iii) approving certain utility mergers and acquisitions.
Moreover, our affiliate transactions also remain subject to certain regulations of the Public Service Commission of the State of New York ("NYPSC"), the Massachusetts Department of Telecommunications and Energy ("MADTE") and the New Hampshire Public Utility Commission ("NHPUC") in addition to FERC.
Under our holding company structure, we have no independent operations or source of income of our own and conduct all of our operations through our subsidiaries and, as a result, we depend on the earnings and cash flow of, and dividends or distributions from, our subsidiaries to provide the funds necessary to meet our debt and contractual obligations. Furthermore, a substantial portion of our consolidated assets, earnings and cash flow is derived from the operations of our regulated utility subsidiaries, whose legal authority to pay dividends or make other distributions to us is subject to regulation by state regulatory authorities.
Pursuant to NYPSC orders, the ability of KEDNY and KEDLI to pay dividends to KeySpan is conditioned upon maintenance of a utility capital structure with debt not exceeding 55% and 58%, respectively, of total utility capitalization. In addition, the level of dividends paid by both utilities may not be increased from current levels if a 40 basis point penalty is incurred under the customer service performance program.
KeySpan's businesses are engaged in gas distribution, electric services and generation and other energy related activities. KeySpan's gas distribution operations are conducted by our six regulated gas utility subsidiaries: The Brooklyn Union Gas Company d/b/a KeySpan Energy Delivery New York ("KEDNY") and KeySpan Gas East Corporation d/b/a KeySpan Energy Delivery Long Island ("KEDLI") distribute gas to customers in the Boroughs of Brooklyn, Staten Island, a portion of the Borough of Queens in New York City, and the counties of Nassau and Suffolk on Long Island and the Rockaway Peninsula in Queens, respectively; Boston Gas Company, Colonial Gas Company and Essex Gas Company, each doing business as KeySpan Energy Delivery New England ("KEDNE"), distribute gas to customers in southern, eastern and central Massachusetts; and EnergyNorth Natural Gas, Inc., d/b/a KeySpan Energy Delivery New England distributes gas to customers in central New Hampshire. Together, these companies distribute gas to approximately 2.6 million customers throughout the Northeast.
We own, lease and operate electric generating plants on Long Island and in New York City. Under contractual arrangements, we provide electric power, electric transmission and distribution services, billing and other customer services for approximately 1.1 million electric customers of the Long Island Power Authority ("LIPA"). On February 1, 2006, KeySpan and LIPA entered into agreements to extend, amend and restate these contractual arrangements. See Note 11 "2006 LIPA Settlement" for a discussion of the settlement.
Our other subsidiaries are involved in gas production and development; gas storage; liquefied natural gas storage; retail electric marketing; appliance service; fiber optic services; and engineering and consulting services. We also invest in, and participate in the development of natural gas pipelines, electric generation, and other energy-related projects. (See Note 2, "Business Segments" for additional information on each operating segment.)
B. Basis of Presentation
The Consolidated Financial Statements presented herein reflect the accounts of KeySpan and its subsidiaries. Most of our subsidiaries are fully consolidated in the financial information presented, except for certain subsidiary investments in the Energy Investments segment which are accounted for on the equity method as we do not have a controlling voting interest or otherwise have control over the management of such companies. All intercompany transactions have been eliminated.
The preparation of financial statements in conformity with generally accepted accounting principles ("GAAP") requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
C. Accounting for the Effects of Rate Regulation
The accounting records for our six regulated gas utilities are maintained in accordance with the Uniform System of Accounts prescribed by the NYPSC, the NHPUC, and the MADTE. Our electric generation subsidiaries are not subject to state rate regulation, but they are subject to FERC regulation. Our financial statements reflect the ratemaking policies and actions of these regulators in conformity with GAAP for rate-regulated enterprises.
Four of our six regulated gas utilities (KEDNY, KEDLI, Boston Gas Company and EnergyNorth Natural Gas, Inc.) and our Long Island based electric generation subsidiaries are subject to the provisions of Statement of Financial Accounting Standards ("SFAS") 71, "Accounting for the Effects of Certain Types of Regulation." This statement recognizes the ability of regulators, through the ratemaking process, to create future economic benefits and obligations affecting rate-regulated companies. Accordingly, we record these future economic benefits and obligations as regulatory assets and regulatory liabilities on the Consolidated Balance Sheet, respectively.
In separate merger related orders issued by the MADTE, the base rates charged by Colonial Gas Company and Essex Gas Company have been frozen at their current levels for ten-year periods ending 2009 and 2008, respectively. Due to the length of these base rate freezes, the Colonial and Essex Gas companies had previously discontinued the application of SFAS 71.
The following table presents our net regulatory assets at December 31, 2006 and December 31, 2005.
The regulatory assets above are not included in utility rate base. However, we record carrying charges on the property tax and costs associated with the KeySpan/LILCO transaction cost deferrals. We also record carrying charges on our regulatory liabilities except for the current market value of our derivative financial instruments. The remaining regulatory assets represent, primarily, costs for which expenditures have not yet been made, and therefore, carrying charges are not recorded. We anticipate recovering these costs in our gas rates concurrently with future cash expenditures. If recovery is not concurrent with the cash expenditures, we will record the appropriate level of carrying charges. Deferred gas costs of $46.3 million and $11.3 million at December 31, 2006 and December 31, 2005, respectively are reflected in accounts receivable on the Consolidated Balance Sheet. Deferred gas costs are subject to current recovery from customers.
D. Revenues
Gas Distribution. Utility gas customers are billed monthly or bi-monthly on a cycle basis. Revenues include unbilled amounts related to the estimated gas usage that occurred from the most recent meter reading to the end of each month.
The cost of gas used is recovered when billed to firm customers through the operation of gas adjustment clauses ("GAC") included in utility tariffs. The GAC provision requires periodic reconciliation of recoverable gas costs and GAC revenues. Any difference is deferred pending recovery from or refund to firm customers. Further, net revenues from tariff gas balancing services, off-system sales and certain on-system interruptible sales are refunded, for the most part, to firm customers subject to certain sharing provisions.
The New York and Long Island gas utility tariffs contain weather normalization adjustments that largely offset shortfalls or excesses of firm net revenues (revenues less gas costs and revenue taxes) during a heating season due to variations from normal weather. Revenues are adjusted each month the clause is in effect and are generally included in rates in the following month. The New England gas utility rate structures contain no weather normalization feature, therefore their net revenues are subject to weather related demand fluctuations. As a result, fluctuations from normal weather may have a significant positive or negative effect on the results of these operations. To mitigate the effect of fluctuations from normal weather on our financial position and cash flows, we may enter into weather related derivative instruments from time to time. (See Note 8 "Hedging, Derivative Financial Instruments and Fair Values" for additional information on these derivatives.)
In December 2005, The Boston Gas Company ("Boston Gas") received a MADTE order permitting regulatory recovery of the 2004 gas cost component of bad debt write-offs. This was approved for full recovery as an exogenous cost effective November 1, 2005. In addition, effective January 1, 2006 Boston Gas was permitted to fully recover the gas cost component of bad debt write-offs through its cost-of-gas adjustment clause rather than filing for recovery as an exogenous cost. On October 31, 2006, the MADTE granted Boston Gas recovery of $12 million of the 2005 gas cost component of bad debt write-offs from Boston Gas ratepayers beginning November 1, 2006. This amount will also be recovered through the cost-of-gas adjustment clause.
Electric Services. Electric revenues are primarily derived from: (i) billings to LIPA for management of LIPA's transmission and distribution system ("T&D System"), electric generation, and procurement of fuel, and (ii): subsidiaries that own, lease and operate the 2,200 megawatt ("MW") Ravenswood electric generation facility ("Ravenswood Facility") and the 250 MW combined cycle generating facility located at the Ravenswood facility site ("Ravenswood Expansion"). Collectively, the Ravenswood Facility and Ravenswood Expansion are referred to as the Ravenswood Generating Station.
LIPA Agreements. In 1998, KeySpan and LIPA entered into three major long-term service agreements that (i) provide to LIPA all operation, maintenance and construction services and significant administrative services relating to the Long Island electric T&D System pursuant to the Management Services Agreement (the "1998 MSA"); (ii) supply LIPA with electric generating capacity, energy conversion and ancillary services from our Long Island generating units pursuant to the Power Supply Agreement (the "1998 PSA"); and (iii) manage all aspects of the fuel supply for our Long Island generating facilities, as well as all aspects of the capacity and energy owned by or under contract to LIPA pursuant to the Energy Management Agreement (the "1998 EMA"). The 1998 MSA, 1998 PSA and 1998 EMA all are collectively referred to as the 1998 LIPA Agreements and are discussed in greater detail below.
On February 1, 2006, KeySpan and LIPA entered into (i) an amended and restated Management Services Agreement (the "2006 MSA"), pursuant to which KeySpan will continue to operate and maintain the electric T&D System owned by LIPA on Long Island; (ii) a new Option and Purchase and Sale Agreement (the "2006 Option Agreement"), to replace the Generation Purchase Rights Agreement (as amended, the "GPRA"), pursuant to which LIPA had the option, through December 15, 2005, to effectively acquire substantially all of the electric generating facilities owned by KeySpan on Long Island; and (iii) a Settlement Agreement (the "2006 Settlement Agreement") resolving outstanding issues between the parties regarding the 1998 LIPA Agreements. The 2006 MSA, the 2006 Option Agreement and the 2006 Settlement Agreement are collectively referred to herein as the "2006 LIPA Agreements." Each of the 2006 LIPA agreements will become effective upon all of the 2006 LIPA Agreements receiving the required governmental approvals; otherwise none of the 2006 LIPA Agreements will become effective. These agreements will become effective following approval by the New York State Comptroller's Office and the New York State Attorney General. Following the announcement of the proposed acquisition of KeySpan by National Grid plc, LIPA, National Grid plc and KeySpan have engaged in discussions concerning the impact of the transaction on LIPA's operations. At this time, we are unable to determine what impact, if any, the results of such discussions may have on the 2006 LIPA Agreements and the receipt and timing of governmental approvals relating thereto. See Note 11, "2006 LIPA Settlement" for additional details on these agreements.
In place of the previous compensation structure under the 1998 MSA (whereby KeySpan was reimbursed for budgeted costs, and earned a management fee and certain performance and cost-based incentives), KeySpan's compensation for managing the electric transmission and distribution system owned by LIPA under the 2006 MSA consists of two components: a minimum compensation component of $224 million per year and a variable component based on electric sales. The $224 million component will remain unchanged for three years and then increase annually by 1.7%, plus inflation. The variable component, which will comprise no more than 20% of KeySpan's compensation, is based on electric sales on Long Island exceeding a base amount of 16,558 gigawatt hours, increasing by 1.7% in each year. Above that level, KeySpan will receive approximately 1.34 cents per kilowatt hour for the first contract year, 1.29 cents per kilowatt hour in the second contract year (plus an annual inflation adjustment), 1.24 cents per kilowatt hour in the third contract year (plus an annual inflation adjustment), with the per kilowatt hour rate thereafter adjusted annually by inflation.
In addition, KeySpan sells to LIPA under the 1998 PSA all of the capacity and, to the extent requested, energy conversion services from its existing Long Island based oil and gas-fired generating plants. Sales of capacity and energy conversion services are made under rates approved by the FERC. Rates charged to LIPA include a fixed and variable component. The variable component is billed to LIPA on a monthly per megawatt hour basis and is dependent on the number of megawatt hours dispatched. The 1998 PSA provides incentives and penalties that can total $4 million annually for the maintenance of the output capability and the efficiency of the generating facilities.
KeySpan also procures and manages fuel supplies on behalf of LIPA, under the 1998 EMA, to fuel the generating facilities under contract to it and perform off-system capacity and energy purchases on a least-cost basis to meet LIPA's needs. In exchange for these services KeySpan earns an annual fee of $1.5 million. In addition, we arrange for off-system sales on behalf of LIPA of excess output from the generating facilities and other power supplies either owned or under contract to LIPA. LIPA is entitled to two-thirds of the profit from any off-system energy sales. In addition, the 1998 EMA provides incentives and penalties that can total $5 million annually for performance related to fuel purchases and off-system power purchases. The 1998 EMA is expected to be in effect through 2013 for the procurement of fuel supplies. In 2005, the EMA was amended to extend the term for off-system power purchases through December 31, 2006 and thereafter on a month-to-month basis unless terminated by LIPA on sixty days notice, but in no event later than December 31, 2007.
KeySpan Glenwood Energy Center, LLC and KeySpan Port Jefferson Energy Center, LLC have entered into 25 year Power Purchase Agreements with LIPA (the "PPAs"). Under the terms of the PPAs, these subsidiaries sell capacity, energy conversion services and ancillary services to LIPA. Each plant is designed to produce 79.9 MW. Under the PPAs, LIPA pays a monthly capacity fee, which guarantees full recovery of each plant's construction costs, as well as an appropriate rate of return on investment. The PPAs also obligate LIPA to pay for each plant's costs of operation and maintenance. These costs are billed on a monthly estimated basis and are subject to true-up for actual costs incurred.
The Electric Services segment also conducts retail marketing of electricity to commercial customers. Energy sales made by our electric marketing subsidiary are recorded upon delivery of the related commodity.
Ravenswood Generating Station. In addition, electric revenues are derived from our investment in the 2,200 MW Ravenswood electric generation facility ("Ravenswood Facility"), (which KeySpan acquired in June 1999). KeySpan has an arrangement with a variable interest entity through which we lease a portion of the Ravenswood Facility. Further, in May 2004 KeySpan completed construction of a 250 MW combined cycle generating facility located at the Ravenswood facility site ("Ravenswood Expansion"). To finance the Ravenswood Expansion, KeySpan entered into a leveraged lease financing arrangement. (See Note 7 "Contractual Obligations, Financial Guarantees and Contingencies" for a description of the financing arrangements associated with the Ravenswood Generating Station.) The Ravenswood Generating Station earns revenues through the sale, at wholesale, of energy, capacity, and ancillary services to the New York Independent System Operator ("NYISO"). Energy and ancillary services are sold through a bidding process into the NYISO energy markets on a day ahead or real time basis.
Energy Services. Revenues earned by our Energy Services segment for service and maintenance contracts associated with small commercial and residential appliances are recognized as earned or over the life of the service contract, as appropriate. Revenues earned for engineering services are derived from services
rendered under fixed price and cost-plus contracts and generally are recognized on the percentage-of-completion method. Fiber optic service revenue is recognized upon delivery of service access. We have unearned revenue recorded in deferred credits and other liabilities - other on the Consolidated Balance Sheet totaling $30.3 million and $29.3 million as of December 31, 2006, and December 31, 2005, respectively. These balances represent primarily unearned revenues for service contracts and are generally amortized to income over a one year period.
KeySpan completed its sale of its mechanical contracting companies in the first quarter of 2005, and therefore, no longer has revenues from mechanical contracting operations. (See Note 10 "Energy Services - Discontinued Operations" for additional details on the mechanical contracting companies.)
Gas Production and Development. Natural gas and oil revenues earned by our gas production and development activities are recognized using the entitlements method of accounting. Under this method of accounting, income is recorded based on the net revenue interest in production or nominated deliveries. Production gas volume imbalances are incurred in the ordinary course of business. Net deliveries in excess of entitled amounts are recorded as liabilities, while net under deliveries are recorded as assets. Imbalances are reduced either by subsequent recoupment of over and under deliveries or by cash settlement, as required by applicable contracts. Production imbalances are marked-to-market at the end of each month using the market price at the end of each period. During 2004 KeySpan disposed of its interest in The Houston Exploration Company ("Houston Exploration"), an independent natural gas and oil exploration company. KeySpan continues to maintain, on a significantly smaller scale, gas production and development activities. (See Note 2 "Business Segments" for a discussion on the disposition of Houston Exploration and KeySpan's remaining gas production and development activities.)
E. Utility and Other Property - Depreciation and Maintenance
Property, principally utility gas property is stated at original cost of construction, which includes allocations of overheads, including taxes, and an allowance for funds used during construction. The rates at which KeySpan subsidiaries capitalized interest for the year ended December 31, 2006 ranged from 1.88% to 7.02%. Capitalized interest for 2006, 2005 and 2004 was $2.5 million, $1.4 million and $7.4 million, respectively.
Depreciation is provided on a straight-line basis in amounts equivalent to composite rates on average depreciable property. In 2006, an adjustment to the depreciation allowance was recorded to correct for an error in useful lives associated with certain gas distribution assets. The cost of property retired is charged to accumulated depreciation.
KeySpan recovers cost of removal through rates charged to customers as a portion of depreciation expense. At December 31, 2006 and 2005, KeySpan had costs recovered in excess of costs incurred totaling $556.2 million and $516.4 million, respectively. These amounts are reflected as a regulatory liability.
The cost of repair and minor replacement and renewal of property is charged to maintenance expense. The composite rates on average depreciable property were as follows:
- ----------------------------------------------------------------- Year Ended December 31, 2006 2005 2004 - ----------------------------------------------------------------- Electric 3.86% 3.75% 3.87% Gas 3.14% 3.72% 3.55% - ----------------------------------------------------------------- - -----------------------------------------------------------------
We also had $441.5 million of other property at December 31, 2006, consisting of assets held primarily by our corporate service subsidiary of $307.6 million and $104.2 million in Energy Services assets. The corporate service assets consist largely of land, buildings, office equipment and furniture, vehicles, computer and telecommunications equipment and systems. These assets have depreciable lives ranging from three to 40 years. We allocate the carrying cost of these assets to our operating subsidiaries through our filed allocation methodology. Energy Services assets consist largely of computer equipment and fiber optic cable and related electronics and have service lives ranging from seven to 40 years.
KeySpan's repair and maintenance costs, including planned major maintenance in the Electric Services segment for turbine and generator overhauls, are expensed as incurred unless they represent replacement of property to be capitalized. Planned major maintenance cycles primarily range from seven to eight years. Smaller periodic overhauls are performed approximately every 18 months.
KeySpan capitalizes costs incurred in connection with its projects to develop and build energy facilities after a project has been determined to be probable of completion.
F. Gas Production and Development Property - Depletion
KeySpan maintains gas production and development activities through its two wholly-owned subsidiaries - KeySpan Exploration and Production, LLC ("KeySpan Exploration") and Seneca-Upshur Petroleum, Inc. ("Seneca-Upshur"). At December 31, 2006, these subsidiaries had net production and development property in the amount of $73.2 million. These assets are accounted for under the full cost method of accounting. Under the full cost method, costs of acquisition and development of natural gas and oil reserves plus asset retirement obligations are capitalized into a "full cost pool" as incurred. Unproved properties and related costs are excluded from the depletion and amortization base until a determination is made as to the existence of proved reserves. Properties are depleted and charged to operations using the unit of production method using proved reserve quantities.
To the extent that such capitalized costs (net of accumulated depletion) less deferred taxes exceed the present value (using a 10% discount rate) of estimated future net cash flows from proved natural gas and oil reserves and the lower of cost or fair value of unproved properties, less deferred taxes, such excess costs are charged to operations, but would not have an impact on cash flows. Once incurred, such impairment of gas properties is not reversible at a later date even if gas prices increase.
The ceiling test is calculated using natural gas and oil prices in effect as of the balance sheet date, held flat over the life of the reserves. We use derivative financial instruments that qualify for hedge accounting under SFAS 133 "Accounting for Derivative Instruments and Hedging Activities," to hedge the volatility of natural gas prices. In accordance with current SEC guidelines, we have included estimated future cash flows from our hedging program in ceiling test calculations.
As of December 31, 2006, we estimated that our capitalized costs did not exceed the ceiling test limitation. We used an average wellhead price of $6.15 per MCF, adjusted for derivative instruments.
As a result of the disposition of Houston Exploration in 2004, during 2004 KeySpan calculated the ceiling test on KeySpan Exploration and Production's and Seneca-Uphsur's assets independently of Houston Exploration's assets. Based on a report furnished by an independent reservoir engineer during the second quarter of 2004, it was determined that the remaining proved undeveloped oil reserves held in the joint venture required a substantial investment in order to develop. Therefore, KeySpan and Houston Exploration elected not to develop these oil reserves. As a result, in the second quarter of 2004, we recorded a $48.2 million non-cash impairment charge to write down our wholly-owned gas production and development subsidiaries' assets. This charge was recorded in depreciation, depletion and amortization on the Consolidated Statement of Income.
Natural gas prices continue to be volatile and the risk that a write down to the full cost pool increases when, among other things, natural gas prices are low or there are significant downward revisions in our estimated proved reserves.
In 2004, Houston Exploration capitalized interest related to unevaluated natural gas and oil properties, as well as some properties under development which were not being amortized. For the year ended December 31, 2004, capitalized interest was $3.4 million.
G. Goodwill and Other Intangible Assets
The balance of goodwill and other intangible assets was $1.7 billion at December 31, 2006 and December 31, 2005, representing primarily the excess of acquisition cost over the fair value of net assets acquired. Goodwill and other intangible assets reflect the Eastern and EnergyNorth acquisitions, the KeySpan/LILCO transaction, as well as acquisitions of non-utility energy-related service companies and also relates to certain ownership interests of 50% or less in energy-related investments, which are accounted for under the equity method.
The table below summarizes the goodwill and other intangible assets balance for each segment at December 31, 2006 and 2005:
- ------------------------------------------------------------------------ (In Millions of Dollars) At December 31, 2006 2005 - ------------------------------------------------------------------------ Operating Segment
Gas Distribution $1,436.9 $1,436.9 Energy Services 65.2 65.2 Energy Investments and other 164.2 164.2 - ------------------------------------------------------------------------ $1,666.3 $1,666.3 - ------------------------------------------------------------------------
As prescribed in SFAS 142 "Goodwill and Other Intangible Assets," KeySpan is required to compare the fair value of a reporting unit to its carrying amount, including goodwill. This evaluation is required to be performed at least annually, unless facts and circumstances indicated that the evaluation should be performed at an interim period during the year. At December 31, 2006, KeySpan had $1.7 billion of recorded goodwill and has concluded that the fair value of the business units that have recorded goodwill exceed their carrying value.
During 2004, KeySpan conducted an evaluation of the carrying value of goodwill recorded in its Energy Services segment. As a result of this evaluation, KeySpan recorded a non-cash goodwill impairment charge of $108.3 million ($80.3 million after tax, or $0.50 per share) in 2004. This charge was recorded as follows: (i) $14.4 million as an operating expense on the Consolidated Statement of Income reflecting the write-down of goodwill on Energy Services segment's continuing operations; and (ii) $93.9 million as discontinued operations reflecting the impairment on the mechanical contracting companies. (See Note 10 "Energy Services-Discontinued Operations" for further details.)
In 2004, KeySpan entered into an agreement to sell its then 50% interest in Premier Transmission Limited ("Premier"). This investment was accounted for under the equity method of accounting in the Energy Investments segment. In the fourth quarter of 2004 KeySpan recorded a partial pre-tax non-cash impairment charge of $26.5 million - $18.8 million after-tax or $0.12 per share. The impairment charge reflected the difference between the anticipated cash proceeds from the sale of Premier compared to its carrying value at that time and was recorded as a reduction to goodwill.
H. Hedging and Derivative Financial Instruments
From time to time, we employ derivative instruments to hedge a portion of our exposure to commodity price risk, interest rate risk and weather fluctuations as well as to hedge cash flow variability associated with a portion of our peak electric energy sales. Whenever hedge positions are in effect, we are exposed to credit risk in the event of nonperformance by counter-parties to derivative contracts, as well as nonperformance by the counter-parties of the transactions against which they are hedged. We believe that the credit risk related to the futures, options and swap instruments is no greater than that associated with the primary commodity contracts which they hedge.
Financially-Settled Commodity Derivative Instruments. We employ derivative financial instruments, such as futures, options and swaps, for the purpose of hedging the cash flow variability associated with forecasted purchases and sales of various energy-related commodities. All such derivative instruments are accounted for pursuant to the requirements of SFAS 133 "Accounting for Derivative Instruments and Hedging Activities," as amended by SFAS 149, "Amendment of Statement 133 Derivative Instruments and Hedging Activities" (collectively, "SFAS 133"). With respect to those commodity derivative instruments that are designated and accounted for as cash flow hedges, the effective portion of periodic changes in the fair market value of cash flow hedges is recorded as other comprehensive income on the Consolidated Balance Sheet, while the ineffective portion of such changes in fair value is recognized in earnings. Unrealized gains and losses (on such cash flow hedges) that are recorded as other comprehensive income are subsequently reclassified into earnings concurrent when hedged transactions impact earnings. With respect to those commodity derivative instruments that are not designated as hedging instruments, such derivatives are accounted for on the Consolidated Balance Sheet at fair value, with all changes in fair value reported in earnings.
Firm Gas Sales Derivatives Instruments - Regulated Utilities. We use derivative financial instruments to reduce cash flow variability associated with the purchase price for a portion of future natural gas purchases associated with our Gas Distribution operations. Our strategy is to minimize fluctuations in firm gas sales prices to our regulated firm gas sales customers in our New York and New England service territories. The accounting for these derivative instruments is subject to SFAS 71. Therefore, the fair value of these derivatives is recorded as current or deferred assets and liabilities, with offsetting positions recorded as regulatory assets and regulatory liabilities on the Consolidated Balance Sheet. Gains or losses on the settlement of these contracts are initially deferred and then refunded to or collected from our firm gas sales customers consistent with regulatory requirements.
Physically-Settled Commodity Derivative Instruments. Certain of our contracts for the physical purchase of natural gas were assessed as no longer being exempt from the requirements of SFAS 133 as normal purchases. As such, these contracts are recorded on the Consolidated Balance Sheet at fair market value. However, since such contracts were executed for the purchases of natural gas that is sold to regulated firm gas sales customers, and pursuant to the requirements of SFAS 71, changes in the fair market value of these contracts are recorded as a regulatory asset or regulatory liability on the Consolidated Balance Sheet.
Weather Derivatives. The utility tariffs associated with our New England gas distribution operations do not contain weather normalization adjustments. As a result, fluctuations from normal weather may have a significant positive or negative effect on the results of these operations. To mitigate the effect of fluctuations from normal weather on our financial position and cash flows, we may enter into derivative instruments from time to time. Based on the terms of the contracts, we account for these instruments pursuant to the requirements of Emerging Issues Task Force ("EITF") 99-2 "Accounting for Weather Derivatives." In this regard, we account for weather derivatives using the "intrinsic value method" as set forth in such guidance.
Interest Rate Derivative Instruments. We continually assess the cost relationship between fixed and variable rate debt. Consistent with our objective to minimize our cost of capital, we periodically enter into hedging transactions that effectively convert the terms of underlying debt obligations from fixed to variable or variable to fixed. Payments made or received on these derivative contracts are recognized as an adjustment to interest expense as incurred. Hedging transactions that effectively convert the terms of underlying debt obligations from fixed to variable are designated and accounted for as fair-value hedges pursuant to the requirements of SFAS 133. Hedging transactions that effectively convert the terms of underlying debt obligations from variable to fixed are considered cash flow hedges.
I. Equity Investments and Other
Certain subsidiaries own as their principal assets, investments (including goodwill), representing ownership interests of 50% or less in energy-related businesses that are accounted for under the equity method. None of these current investments are publicly traded. Additionally, KeySpan has corporate assets recorded on the Consolidated Balance Sheet representing funds designated for Supplemental Executive Retirement Plans. These funds are invested in corporate owned life insurance policies. KeySpan records changes in the value of these assets in accordance with FAS Technical Bulletin 85-4 "Accounting for the Purchase of Life Insurance." As such, increases and decreases in the value of these assets are recorded through earnings in the Consolidated Statement of Income concurrent with the change in the value of the underlying assets.
J. Income and Excise Tax
Upon implementation of SFAS 109, "Accounting for Income Taxes," certain of our regulated subsidiaries recorded a regulatory asset and a net deferred tax liability for the cumulative effect of providing deferred income taxes on certain differences between the financial statement carrying amounts of assets and liabilities, and their respective tax bases. This regulatory asset continues to be amortized over the lives of the individual assets and liabilities to which it relates. Additionally, investment tax credits which were available prior to the Tax Reform Act of 1986, were deferred and generally amortized as a reduction of income tax over the estimated lives of the related property.
We report our collections and payments of excise taxes on a gross basis. Gas distribution revenues include the collection of excise taxes, while operating taxes include the related expense. For the years ended December 31, 2006, 2005 and 2004, excise taxes collected and paid were $60.4 million, $65.8 million and $73.3 million, respectively.
K. Subsidiary Common Stock Issuances to Third Parties
We follow an accounting policy of income statement recognition for parent company gains or losses from issuances of common stock by subsidiaries to unaffiliated third parties.
L. Foreign Currency Translation
We followed the principles of SFAS 52, "Foreign Currency Translation," for recording our investments in foreign affiliates. Under this statement, all elements of the financial statements are translated by using a current exchange rate. Translation adjustments result from changes in exchange rates from one reporting period to another. At December 31, 2006 and 2005, SFAS 52 was not applicable to KeySpan since we completed the sale of our remaining foreign investment in the first quarter of 2005.
M. Earnings Per Share
Basic earnings per share ("EPS") is calculated by dividing earnings for common stock by the weighted average number of shares of common stock outstanding during the period. No dilution for any potentially anti-dilutive securities is included. Diluted EPS assumes the conversion of all potentially dilutive securities and is calculated by dividing earnings for common stock, as adjusted, by the sum of the weighted average number of shares of common stock outstanding plus all potentially dilutive securities.
Under the requirements of SFAS 128, "Earnings Per Share" our basic and diluted EPS are as follows:
N. Stock Based Compensation
From time to time, KeySpan awards stock based compensation to officers, directors, consultants and certain other management employees, primarily under the Long Term Performance Incentive Compensation Plan (the "Incentive Plan"). The Incentive Plan provides for the award of incentive stock options, non-qualified stock options, performance shares and restricted shares. The purpose of the Incentive Plan is to optimize KeySpan's performance through incentives that directly link the participant's goals to those of KeySpan's shareholders and to attract and retain participants who make significant contributions to the success of KeySpan.
Under the Incentive Plan, 19,250,000 shares were authorized for issuance of which the total shares awarded to date include 16.9 million stock options, 222,143 shares of restricted stock, and 891,555 performance shares. At December 31, 2006, after adjusting for forfeitures, there are approximately 3.0 million shares still eligible to be granted under the Incentive Plan. In addition, under previous plans, there were an additional 1.7 million shares authorized for which approximately 1.2 million stock options were awarded.
In 2005, KeySpan continued to apply APB Opinion 25 "Accounting for Stock Issued to Employees," in accounting for grants awarded prior to January 1, 2003. No compensation cost had been recognized for these stock option awards since the exercise prices and market values were equal on the grant dates. Had compensation cost for these plans been determined based on the fair value at the grant dates for awards under the plans consistent with SFAS 123 "Accounting for Stock-Based Compensation," our net income and earnings per share for the twelve months ended December 31, 2005 and 2004 would have decreased to the pro-forma amounts indicated below:
In 2003, KeySpan adopted the prospective method of transition of accounting for stock based compensation expense in accordance with SFAS 148 "Accounting for Stock-Based Compensation - Transition and Disclosure." Accordingly, compensation expense has been recognized by employing the fair value recognition provisions of SFAS 123 for grants awarded after January 1, 2003.
In January 2006, KeySpan adopted SFAS 123 (revised 2004) "Share-Based Payment ("SFAS 123R")." The implementation of this standard required KeySpan to expense certain stock options that had previously been accounted for under the requirements of APB Opinion 25 and related Interpretations, i.e. awards issued prior to January 1, 2003. No compensation cost had been recognized for these fixed stock option plans in the Consolidated Financial Statements since the exercise prices and market values were equal on the grant dates. For the twelve months ended December 31, 2006, KeySpan recorded an expense of $1.4 million for stock option awards previously accounted for under APB 25 and which have now fully vested.
The following table presents the actual expense for all of KeySpan's stock based compensation awards recorded in the Consolidated Statement of Income for the periods indicated.
Prior to the adoption of SFAS 123R, KeySpan presented all tax benefits for deductions resulting from the exercise of stock options and disqualifying dispositions as operating cash flows in its Consolidated Statement of Cash Flows. SFAS 123R requires the benefits of tax deductions in excess of recognized compensation expense to be reported as a financing cash flow, rather than as an operating cash flow. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. Total cash flow will remain unchanged from what would have been reported under prior accounting rules.
During the twelve months ended December 31, 2006, 2005 and 2004 cash received from stock options exercised was $31.1 million, $43.0 million and $32.2 million, respectively. The tax benefit realized for tax deductions from stock options exercised during the twelve months ended December 31, 2006, 2005 and 2004 was less than the recognized compensation expense and accordingly there were no excess tax deductions reported in the financing section of the Consolidated Statement of Cash Flows.
The following represents a discussion of the various awards granted under our stock based compensation plans:
Performance shares
Performance shares were awarded under the Incentive Plan in 2004 and 2005 based upon the attainment of overall corporate performance goals. These performance shares are measured over a three year period by comparing KeySpan's cumulative total shareholder return to the S&P Utilities Group. For actual performance achieved at a threshold level, 50% of the award will be granted; for actual performance achieved at a targeted level, 100% of the award will be granted; and for actual performance achieved at the maximum level, 150% of the award will be granted. The 2004 and 2005 awards are being expensed ratably over their remaining performance periods.
During 2005, it became apparent to management that the 2003 performance share award would not be achieved and the 2004 performance share award would not be achieved at the level of expense being recorded. Since these awards meet the definition of a performance condition not achieved under SFAS 123, KeySpan reversed the previously recognized expense for the 2003 award and one half of previously recognized expense for the 2004 award amounting to $3.8 million ($2.5 million after tax).
The 2006 performance share award reflects the new performance condition criteria under SFAS 123R. In 2006, 315,900 performance shares were granted. Performance shares were granted with a three-year performance period with a threshold, target and maximum performance level. The number of performance shares earned at the end of the performance period can range from 0% to 150% of the shares granted and will be linked to two performance measures: the percentage improvement in return on invested capital, or "ROIC," and KeySpan's cumulative three-year total stockholder return, or "TSR," relative to the cumulative three-year TSR for the Standard and Poor's Utilities Group, using a matrix approach that encompasses both measures. The ROIC goal will act as the primary trigger. If the ROIC goal performance is below the threshold level, all shares shall be forfeited without payment. Upon a change of control, performance shares shall be distributed based upon the greater of the number of performance shares awarded at target level or the number of shares earned based on actual performance through the change of control date. Performance share awards were priced at fair value on the date of grant. The unearned compensation as of December 31, 2006 associated with all of the performance share awards was $11.5 million.
Restricted Stock Awards
KeySpan has made certain grants of restricted stock to officers and directors under the Incentive Plan. Awards of restricted stock were made in 2002, 2005 and 2006. These awards may not be sold or otherwise transferred until certain restrictions have lapsed. The unearned stock-based compensation related to the 2002 and 2005 awards was amortized to compensation expense over the vesting period. The share-based expense for these awards was determined based on the fair value of the stock at the date of grant applied to the total number of shares that were anticipated to fully vest. The 2002 and 2005 awards expense has been fully amortized and the 2006 award was expensed in 2006. Upon a change of control, all restricted stock awards will vest immediately.
Employee Discount Stock Purchase Plan
KeySpan's Employee Discount Stock Purchase Plan ("EDSPP") allows KeySpan employees to purchase shares of KeySpan stock at a 10% discount through payroll deductions. KeySpan is currently expensing the discount. The number of shares of common stock authorized for issuance under the EDSPP is 1,750,000 shares and there are 358,731 shares remaining to be issued.
Stock Options
The stock option component of the Incentive Plan entitles the participants to purchase shares of common stock at an exercise price per share which is no less than the closing price of the common stock on the date of the grant. Stock options generally vest over a three-to-five year period and have an exercise period of ten years. Upon a change of control, all stock options granted and outstanding will vest immediately.
The value of all stock option grants are estimated on the date of the grant using the Black-Scholes option-pricing model. There were no stock options granted in 2006. The following table presents the weighted average fair value, exercise price and assumptions used for the 2005 and 2004 stock option grants:
- ------------------------------------------------------------------------- Year Ended December 31, 2005 2004 - ------------------------------------------------------------------------- Fair value of grants issued $ 6.15 $ 5.47 Dividend yield 4.64% 4.74% Expected volatility 22.63% 23.48% Risk free rate 4.10% 3.22% Expected lives 6.4 years 6.5 years Exercise price $ 39.25 $ 37.54 - -------------------------------------------------------------------------
A summary of the status of our fixed stock option plans and changes is presented below for the periods indicated:
The total intrinsic value of the options exercised during the 12 months ended December 31, 2006, 2005 and 2004 was approximately $6.8 million, $11.4 million and $11.3 million, respectively.
As of December 31, 2006, there are approximately 2.5 million options which have not yet vested. The unearned compensation cost related to these stock option awards is $3.2 million which is expected to be recognized over a weighted average period of 2 years.
O. Recent Accounting Pronouncements
In February 2007, Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standard ("SFAS") 159 "The Fair Value Option for Financial Assets and Financial Liabilities." This statement permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. This statement requires a business entity to report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. An entity may decide whether to elect the fair value option for each eligible item on its election date, subject to certain requirements described in the statement. This statement shall be effective as of the beginning of each reporting entity's first fiscal year that begins after November 15, 2007. KeySpan is currently reviewing the requirements of this statement and, at this point in time, we can not determine the impact, if any, that this statement may have on results of operations, financial position or cash flows.
On September 29, 2006, the FASB issued SFAS 158 Employers' Accounting for Defined Benefit Pensions and Other Postretirement Benefit Plans, an amendment of FASB Statements No. 87, 88, 106 and 132(R)." SFAS 158 requires employers to fully recognize all postretirement plans funded status on the balance sheet as a net liability or asset and requires an offsetting adjustment to accumulated other comprehensive income in shareholders' equity. Certain of KeySpan's subsidiaries are subject to deferral accounting requirements pursuant to rate agreements with the NYPSC, MADTE and NHPUC. Further, KeySpan has certain contractual rights to reimbursement for postretirement liabilities in its agreements with LIPA. As such, a portion of the offsetting position to the increase in the total postretirement liabilities has been reflected as a regulatory asset and contractual asset. SFAS 158 does not change how postretirement benefits are accounted for and reported in the income statement; companies will continue to apply existing accounting guidance. KeySpan adopted the provisions of SFAS 158 in December 2006. See Note 4 "Post Retirement Benefits" for further information on SFAS 158.
On September 15, 2006, the FASB issued SFAS 157 "Fair Value Measurements." This statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value. SFAS 157 expands the disclosures about the use of fair value to measure assets and liabilities in interim and annual periods subsequent to initial recognition. The disclosures focus on the inputs used to measure fair value, the recurring fair value measurements using significant unobservable inputs and the effect of the measurement on earnings (or changes in net assets) for the period. The guidance in SFAS 157 also applies for derivatives and other financial instruments measured at fair value under Statement 133 "Accounting for Derivative Instruments and Hedging Activities" at initial recognition and in all subsequent periods. This Statement is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. KeySpan is currently reviewing the requirements of SFAS 157, and at this point in time cannot determine what impact, if any, SFAS 157 will have on its results of operations or financial position. This Statement will have no impact on cash flow.
On July 13, 2006, the FASB issued Interpretation No. 48 "Accounting for Uncertainty In Income Taxes." The FASB, in its interpretation of SFAS 109, "Accounting for Income Taxes," seeks to reduce the diversity in practice associated with certain aspects of the recognition and measurement requirements related to accounting for income taxes. The Interpretation prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. The amount recognized is measured as the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement. The Interpretation requires application for fiscal years beginning after December 15, 2006, for first quarter 2007 reporting. KeySpan is currently reviewing the requirements of this Interpretation and, at this point in time, we can not determine the impact, if any, that this Interpretation may have on results of operations and financial position.
In December 2004 the FASB issued SFAS 123 (revised 2004 "SFAS 123R") "Share-Based Payment." SFAS 123R focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. SFAS 123R revises certain provisions of SFAS 123 "Accounting for Stock-Based Compensation" and supersedes APB Opinion 25 "Accounting for Stock Issued to Employees." The fair-value-based method in SFAS 123R is similar to the fair-value-based method in SFAS 123 in most respects. However, the following are key differences between the two: entities are now required to measure liabilities incurred to employees in share-based payment transactions at fair value as compared to using the intrinsic method allowed under SFAS 123; entities are now required to estimate the number of instruments for which the requisite service is expected to be rendered, as compared to accounting for forfeitures as they occur under SFAS 123; and incremental compensation cost for a modification of the terms or conditions of an award are also measured differently under SFAS 123R compared to Statement 123. SFAS 123R also clarifies and expands SFAS 123's
guidance in several areas. The effective date of SFAS 123R was the beginning of the first fiscal year beginning after June 15, 2005. KeySpan adopted the prospective method of transition for stock options in accordance with SFAS 148 "Accounting for Stock-Based Compensation - Transition and Disclosure." Accordingly, compensation expense has been recognized by employing the fair value recognition provisions of SFAS 123 for grants awarded after January 1, 2003. Therefore implementation of SFAS 123R in January 2006 did not have a material impact on KeySpan's results of operations or financial position and no impact on its cash flows.
P. Impact of Cumulative Effect of Change in Accounting Principles
KeySpan implemented FASB Interpretation No. 47 ("FIN 47"), effective December 31, 2005. FIN 47 required KeySpan to record a liability and corresponding asset representing the present value of conditional asset retirement obligations associated with the retirement of tangible, long-lived assets on the date the obligations were incurred. At December 31, 2005, we recorded a $45.6 million liability and corresponding asset representing the present value of conditional asset retirement obligations associated with the retirement of tangible, long-lived assets on the date the obligations were incurred. For the $45.6 million initial asset recorded, approximately $4.3 million represents asset retirement costs that have been deferred on the Consolidated Balance Sheet and will be depreciated over the remaining life of the underlying associated assets lives. The remaining $41.3 million represented cumulative accretion and depreciation expense associated with the liability and asset from the dates the various obligations would have been recorded had this Interpretation been in effect at the time the obligations were incurred.
Of the $41.3 million recorded, $11.3 million ($6.6 million, after-tax), was recorded as a cumulative change in accounting principle on the Consolidated Statement of Income. The remaining $30.0 million was attributable to the Gas Distribution segment and was recorded as a reduction to removal cost recovered. For asset retirement costs incurred in the Gas Distribution segment, KeySpan is recovering these costs from utility customers and has been expensing a like amount through its depreciation expense. A portion of this depreciation expense represents removal costs not yet incurred. The $30.0 million recorded to removal cost recovered is for purposes of reclassifying a portion of this reserve to the asset retirement obligation. (See Note 7, "Contractual Obligations, Financial Guarantees and Contingencies - Asset Retirement Obligations" for further details.)
Under Accounting Principle Board Opinion No. 20 ("APB 20"), the pro-forma impact of the retroactive application resulting from the adoption of a change in accounting principle is to be disclosed as follows:
In addition to the above disclosure, FIN 47 requires disclosure of the pro-forma impact of the liability for the asset retirement obligation for the beginning of the earliest year presented and at the end of all years presented as if this Interpretation had been applied during all periods effected. The disclosure is as follows:
Q. Accumulated Other Comprehensive Income
As required by SFAS 130, "Reporting Comprehensive Income," the components of accumulated other comprehensive income are as follows:
R. Pension and Other Postretirement Plan Assets
Consistent with past practice and as required by SFAS 158, KeySpan values its pension and other postretirement assets using the year-end market value of those assets. Benefit obligations are also measured at year-end.
Note 2. Business Segments
We have four reportable segments: Gas Distribution, Electric Services, Energy Services and Energy Investments.
The Gas Distribution segment consists of our six gas distribution subsidiaries. KEDNY provides gas distribution services to customers in the New York City Boroughs of Brooklyn, Queens and Staten Island. KEDLI provides gas distribution services to customers in the Long Island Counties of Nassau and Suffolk and the Rockaway Peninsula of Queens County. The remaining gas distribution subsidiaries, collectively referred to as KEDNE, provide gas distribution service to customers in Massachusetts and New Hampshire.
The Electric Services segment consists of subsidiaries that operate the electric transmission and distribution system owned by LIPA; own and provide capacity to and produce energy for LIPA from our generating facilities located on Long Island; and manage fuel supplies for LIPA to fuel our Long Island generating facilities. These services are provided in accordance with existing long-term service contracts having remaining terms that range from one to six years and power purchase agreements having remaining terms that range from six to 20 years. On February 1, 2006, KeySpan and LIPA agreed to extend, amend and restate these contractual arrangements. (See Note 11, "2006 LIPA Settlement" for a further discussion of these agreements.) The Electric Services segment also includes subsidiaries that own or lease and operate the 2,200 MW Ravenswood Facility located in Queens, New York, and the 250 MW combined-cycle Ravenswood Expansion. Collectively the Ravenswood Facility and Ravenswood Expansion are referred to as the "Ravenswood Generating Station". All of the energy, capacity and ancillary services related to the Ravenswood Generating Station are sold to the NYISO energy markets. To finance the purchase and/or construction of the Ravenswood Generating Station, KeySpan entered into leasing arrangement for each facility. The Electric Services segment also conducts retail marketing of electricity to commercial customers. (See Note 7 "Contractual Obligations, Financial Guarantees and Contingencies" for further details on the leasing arrangements.)
The Energy Services segment includes companies that provide energy-related services to customers located primarily within the Northeastern United States. Subsidiaries in this segment provide residential and small commercial customers with service and maintenance of energy systems and appliances, as well as operation and maintenance, design, engineering, consulting and fiber optic services to commercial, institutional and industrial customers.
In 2005, KeySpan sold its mechanical contracting subsidiaries. The operating results and financial position of these companies have been reflected as discontinued operations on the Consolidated Statement of Income and Consolidated Statement of Cash Flows for 2005. In the fourth quarter of 2004, KeySpan's investment in its mechanical contracting subsidiaries was written-down to an estimated fair value. During 2004, KeySpan recorded a non-cash goodwill impairment charge of $108.3 million ($80.3 million after tax, or $0.50 per share) associated with its mechanical contracting operations and certain remaining operations. In addition, an impairment charge of $100.3 million ($72.1 million after-tax or $0.45 per share) was also recorded to reduce the carrying value of the remaining assets of the mechanical contracting companies. (See Note 10 "Energy Services - Discontinued Operations" for additional details regarding these charges.) During the first six months of 2005, operating losses were incurred through the dates of sale of these companies of $4.1 million after-tax, including but not limited to costs incurred for employee related benefits. Partially offsetting these losses was a gain of $2.3 million associated with the related divestitures, reflecting the difference between the fair value estimates and the financial impact of the actual sale transactions. The net income impact of the operating losses and the disposal gain was a loss of $1.8 million, or $0.01 per share for the twelve months ended December 31, 2005.
The Energy Investments segment consists of our gas production and development investments, as well as certain other domestic energy-related investments. KeySpan's gas production and development activities include its wholly-owned subsidiaries Seneca Upshur Petroleum, Inc. ("Seneca-Upshur") and KeySpan Exploration and Production, LLC ("KeySpan Exploration"). Seneca-Upshur is engaged in gas production and development activities primarily in West Virginia. KeySpan Exploration is involved in a joint venture with Merit Energy Corporation, an independent oil and gas producer that purchased its interest in the Joint Venture from Houston Exploration.
This segment is also engaged in pipeline development activities. KeySpan and Spectra Energy Corporation (formerly part of Duke Energy Corporation) each own a 50% interest in the Islander East Pipeline Company, LLC ("Islander East"). Islander East was created to pursue the authorization and construction of an interstate pipeline from Connecticut, across Long Island Sound, to a terminus near Shoreham, Long Island. Once in service, the pipeline is expected to transport up to 260,000 DTH daily to the Long Island and New York City energy markets. Further, KeySpan has a 26.25% interest in the Millennium Pipeline Company LLC, the developer of the Millennium pipeline project, which is expected to have the capacity to transport up to 525,000 DTH of natural gas a day from Corning, New York to Ramapo, New York, where it will connect to an existing pipeline. Additionally, subsidiaries in this segment hold a 20% equity interest
in the Iroquois Gas Transmission System LP, a pipeline that transports Canadian gas supply to markets in the northeastern United States. These investments are accounted for under the equity method. Accordingly, equity income from these investments is reflected as a component of operating income in the Consolidated Statement of Income.
Through its wholly owned subsidiary, KeySpan LNG, KeySpan owns a 600,000 barrel liquefied natural gas storage and receiving facility in Providence, Rhode Island, the operations of which are fully consolidated.
In the first quarter of 2005, KeySpan sold its 50% interest in Premier Transmission Limited ("Premier"), a gas pipeline from southwest Scotland to Northern Ireland. On February 25, 2005, KeySpan entered into a Share Sale and Purchase Agreement with BG Energy Holdings Limited and Premier Transmission Financing Public Limited Company ("PTFPL"), pursuant to which all of the outstanding shares of Premier were to be purchased by PTFPL. On March 18, 2005, the sale was completed and generated cash proceeds of approximately $48.1 million. In the fourth quarter of 2004, KeySpan recorded a pre-tax non-cash impairment charge of $26.5 million reflecting the difference between the anticipated cash proceeds from the sale of Premier compared to its carrying value. The final sale of Premier resulted in a pre-tax gain of $4.1 million reflecting the difference from earlier estimates; this gain was recorded in the first quarter of 2005.
During the first five months of 2004, our gas exploration and production investments also included a 55% equity interest in The Houston Exploration Company ("Houston Exploration"), an independent natural gas and oil exploration company located in Houston, Texas, the operations of which were fully consolidated in KeySpan's Consolidated Financial Statements. On June 2, 2004, KeySpan exchanged 10.8 million shares of common stock of Houston Exploration for 100% of the stock of Seneca-Upshur, previously a wholly owned subsidiary of Houston Exploration. This transaction reduced our interest in Houston Exploration from 55% to 23.5%. Effective June 1, 2004, Houston Exploration's earnings and our ownership interest in Houston Exploration were accounted for on the equity method of accounting. This transaction resulted in a gain to KeySpan of $150.1 million and was reflected in other income and (deductions) on the Consolidated Statement of Income. The deconsolidation of Houston Exploration required the recognition of certain deferred taxes on our remaining investment resulting in a net deferred tax expense of $44.1 million. Therefore, the net gain on the share exchange less the deferred tax provision was $106 million, or $0.66 per share.
In November 2004, KeySpan sold its remaining 23.5% interest in Houston Exploration (6.6 million shares) and received cash proceeds of approximately $369 million. KeySpan recorded a pre-tax gain of $179.6 million which is reflected in other income and (deductions) on the Consolidated Statement of Income. The after-tax gain was $116.8 million or $0.73 per share.
Houston Exploration's revenues, which are reflected in KeySpan's Consolidated Statement of Income in 2004 were $268.1 million. Houston Exploration's operating income, including KeySpan's share of equity earnings, was $138.5 million in 2004.
During the first quarter of 2004, we also had an approximate 61% investment in certain midstream natural gas assets in Western Canada through KeySpan Energy Canada Partnership ("KeySpan Canada"). These assets included 14 processing plants and associated gathering systems that produced approximately 1.5 BCFe of natural gas daily and provided associated natural gas liquids fractionation. These operations were fully consolidated in KeySpan's Consolidated Financial Statements. On April 1, 2004, KeySpan and KeySpan Facilities Income Fund (the "Fund"), which previously owned a 39.09% interest in KeySpan Canada, consummated a transaction whereby the Fund sold 15.617 million units of the Fund and acquired an additional 35.91% interest in KeySpan Canada from KeySpan. As a result of this transaction, KeySpan's ownership of KeySpan Canada decreased to 25%. KeySpan recorded a gain of $22.8 million ($10.1 million after-tax, or $0.06 per share) at the time of this transaction. This gain was reflected in other income and (deductions) on the Consolidated Statement of Income. Effective April 1, 2004 KeySpan Canada's earnings and our ownership interest in KeySpan Canada were accounted for on the equity method of accounting.
In July 2004, the Fund issued an additional 10.7 million units, the proceeds of which were used to fund the acquisition of the midstream assets of Chevron Canada Midstream Inc. This transaction had the effect of further diluting KeySpan's ownership of KeySpan Canada to 17.4%. KeySpan continued to account for its investment in KeySpan Canada on the equity basis of accounting since it still exercised significant influence over this entity.
In December 2004, KeySpan sold its remaining 17.4% interest in KeySpan Canada to the Fund and received net proceeds of approximately $119 million and recorded a pre-tax gain of approximately $35.8 million, which is reflected in other income and (deductions) on the Consolidated Statement of Income. The after-tax gain was approximately $24.7 million, or $0.15 per share.
KeySpan Canada's revenues, which are reflected in KeySpan's Consolidated Statement of Income in 2004 were $25.2 million. KeySpan Canada's operating income, including KeySpan's share of equity earnings, was $16.5 million in 2004.
The accounting policies of the segments are the same as those used for the preparation of the Consolidated Financial Statements. The segments are strategic business units that are managed separately because of their different operating and regulatory environments. Operating results of our segments are evaluated by management on an operating income basis. For fiscal year 2004, the operating data of Houston Exploration has been separately displayed. The reportable segment information is as follows:
Eliminating items include intercompany interest income and expense and the elimination of certain intercompany accounts as well as activities of our corporate and administrative subsidiaries.
Electric Services revenues from LIPA and the NYISO of $1.8 billion for the year ended December 31, 2006 represents approximately 26% of our consolidated revenues during that period.
Eliminating items include intercompany interest income and expense, the elimination of certain intercompany accounts, as well as activities of our corporate and administrative subsidiaries.
Electric Services revenues from LIPA and the NYISO of $2.0 billion for the year ended December 31, 2005 represents approximately 26% of our consolidated revenues during that period.
Eliminating items include intercompany interest income and expense and the elimination of certain intercompany accounts as well as activities of our corporate and administrative subsidiaries.
Electric Services revenues from LIPA and the NYISO of $1.7 billion for the year ended December 31, 2004 represents approximately 25% of our consolidated revenues during that period.
Note 3. Income Tax
KeySpan files a consolidated federal income tax return. A tax sharing agreement between the KeySpan's holding company and its subsidiaries provides for the allocation of a realized tax liability or asset based upon separate return contributions of each subsidiary to the consolidated taxable income or loss in the consolidated income tax return. The subsidiaries record income tax payable or receivable from KeySpan resulting from the inclusion of their taxable income or loss in the consolidated return.
Income tax expense is reflected as follows in the Consolidated Statement of Income:
- ---------------------------------------------------------------------------- Year Ended December 31, (In Millions of Dollars) 2006 2005 2004 - ---------------------------------------------------------------------------- Current Income Tax Federal 41.3 175.7 205.1 State and Local 16.6 30.9 (3.2) ------------------------------------------------ Total Current Income Tax $ 57.9 $ 206.6 $ 201.9 ------------------------------------------------ Deferred Income Tax Federal 93.8 17.1 118.3 State and Local 23.8 15.6 5.3 ------------------------------------------------ Total Deferred Income Tax $ 117.6 $ 32.7 $ 123.6 - ---------------------------------------------------------------------------- Total income tax $ 175.5 $ 239.3 $ 325.5 - ----------------------------------------------------------------------------
At December 31, the significant components of KeySpan's deferred tax assets and liabilities calculated under the provisions of SFAS No.109 "Accounting for Income Taxes" were as follows:
- -------------------------------------------------------------------------------- December 31, (In Millions of Dollars) 2006 2005 - -------------------------------------------------------------------------------- Reserves not currently deductible $ 46.1 $ 28.4 State income tax (49.7) (20.6) Property related differences (1,179.3) (1,080.8) Regulatory tax asset (29.3) (24.5) Employess benefits and compensation 24.6 (30.3) Property taxes (82.7) (84.1) Other items - net 93.9 54.0 - -------------------------------------------------------------------------------- Net deferred tax liability $ (1,176.4) $ (1,157.9) - --------------------------------------------------------------------------------
The federal income tax amounts included in the Consolidated Statement of Income differ from the amounts which result from applying the statutory federal income tax rate to income before income tax.
The table below sets forth the reasons for such differences:
(1) Reflects both federal as well as state income taxes.
KeySpan's consolidated effective income tax rate, including city and state income taxes, was 28.8% for the twelve months ended December 31, 2006 compared to 37.5% for the corresponding period in 2005. In 2006, KeySpan resolved its dispute with the New York City Department of Taxation and Finance with respect to income taxes relating to the operations of its merchant electric generating facility. As a result of the favorable settlement of this issue, KeySpan reversed a previously recorded tax reserve of $11.9 million ($7.1 million after federal income taxes). In addition, pursuant to indemnity obligations contained in the Long Island Lighting Company ("LILCO") / KeySpan merger agreement of May 1998, KeySpan had been working with the Internal Revenue Service ("IRS") to resolve certain disputes with regard to LILCO's tax returns for the tax years
ended December 31, 1996 through March 31, 1999 and KeySpan's and The Brooklyn Union Gas Company's (d/b/a KEDNY) tax returns for the years ended September 30, 1997 through December 31, 1998. A settlement of the outstanding issues was reached in 2006 and, following IRS procedure, the settlement was submitted to the Joint Committee on Taxation on October 30, 2006 for final approval, which is expected in early 2007. Accordingly, KeySpan reversed $44.5 million of previously established tax reserves. Further, a $3.4 million benefit was recorded in 2006 reflecting an accrual for prior investment tax credits that KeySpan is entitled to. KeySpan has recently filed amended tax returns to reflect its entitlement to investment tax credits for the period 2000 through 2004. The decrease in the effective tax rate for the twelve months ended December 31, 2006 compared to the same period in 2005, was primarily due to the aforementioned items.
The IRS has also recently commenced the examination of KeySpan's tax returns for the years ended December 31, 2002 and 2003. At this time, we cannot predict the result of these audits.
The American Jobs Creation Act of 2004, signed into law on October 22, 2004 provides for a special one-time tax deduction, or dividend received deduction ("DRD") of 85% of qualifying foreign earnings that were repatriated in 2004 or 2005. We currently estimate that KeySpan has repatriated dividends of approximately $9.5 million of earnings under this provision and received, as a result, a tax benefit of $2.8 million.
As of December 31, 2006 KeySpan has $412 million of state net operating losses which will expire between 2011 and 2022.
Note 4. Postretirement Benefits
Pension Plans. The following information represents the consolidated results for our noncontributory defined benefit pension plans which cover substantially all employees. Benefits are based on years of service and compensation. Funding for pensions is in accordance with requirements of federal law and regulations. KEDLI and Boston Gas Company are subject to certain deferral accounting requirements mandated by the NYPSC and MADTE, respectively for pension costs and other postretirement benefit costs. Further, KeySpan's electric subsidiaries are subject to certain "true-up" provisions in accordance with the LIPA service agreements.
The calculation of net periodic pension cost is as follows:
The following table sets forth the pension plans' funded status at December 31, 2006 and December 31, 2005.
*The above amounts are before adjustments for regulatory and contractual deferrals and deferred taxes
The table below details the end-of-year assumptions used for both the net periodic cost calculations and liability amounts.
The following benefit payments, which reflect expected future service, as appropriate, are expected to be paid in the years indicated:
- ------------------------------------------------- (In Millions of Dollars) Pension Benefits - -------------------------------------------------
2007 $ 138.3 2008 $ 141.8 2009 $ 145.5 2010 $ 150.4 2011 $ 156.0 Years 2012- 2016 $ 906.4 - -------------------------------------------------
Under Funded Pension Obligation. SFAS 158 "Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans" requires full balance sheet recognition of the net overfunded or underfunded status of each pension and other postretirement plan. The funded status of pension plans is to be measured as the difference between the fair value of plan assets minus the projected benefit obligation. At December 31, 2006, KeySpan's projected benefit obligation was in excess of pension assets by $307.9 million. Amounts that are not recognized in net periodic benefit costs will be recorded through accumulated other comprehensive income. At December 31, 2006, the amount recognized in accumulated other comprehensive income was $134.7 million, net of tax and regulatory and contractual deferrals.
The following table reconciles the 2005 Consolidated Balance Sheet with the impact of SFAS 158:
- ------------------------------------------------------------------------------ (In Millions of Dollars) Pension - ------------------------------------------------------------------------------ Liability AOCI - ------------------------------------------------------------------------------ Prepaid Asset December 31, 2005 $ 218.9 $ - Additional minimum liability (257.4) (63.5) - ------------------------------------------------------------------------------ Balance at December 31, 2005 (38.5) (63.5) 2006 activity (25.6) - Reduction to additional minimum liability 137.0 137.0 Incremental SFAS 158 liability (380.8) (380.8) Intangible asset reversal - (41.1) Incremental deferrals and deferred taxes - 213.7 - ------------------------------------------------------------------------------ Balance at December 31, 2006 $ (307.9) $ (134.7) - ------------------------------------------------------------------------------
At December 31, 2006 the projected benefit obligation, accumulated benefit obligation and value of assets for plans with accumulated benefit obligations in excess of plan assets were $1.4 billion, $1.3 billion and $1.2 billion, respectively.
At December 31, 2005 the accumulated benefit obligation was in excess of pension assets. As prescribed by SFAS 87 "Employers' Accounting for Pensions," KeySpan had a $257.4 million minimum liability at December 31, 2005, for this unfunded pension obligation. As permitted under accounting guidelines then applicable, these accruals were offset by a corresponding debit to a long-term asset up to the amount of accumulated unrecognized prior service costs. Any remaining amount was to be recorded in accumulated other comprehensive income on the Consolidated Balance Sheet.
Therefore, at December 31, 2005, we had a long-term asset in deferred charges other of $41.1 million, representing the amount of unrecognized prior service cost and a debit to accumulated other comprehensive income of $97.8 million, or $63.6 million after-tax. The remaining amount of $118.3 million was recorded as a contractual receivable from LIPA of $103.8 million and a regulatory asset of $14.5 million, representing the amounts that could be recovered from LIPA and the Boston Gas ratepayer in accordance with our service and rate agreements.
At December 31, 2005 the projected benefit obligation, accumulated benefit obligation and value of assets for plans with accumulated benefit obligations in excess of plan assets were $1.4 billion, $1.3 billion and $997 million, respectively.
Other Postretirement Benefits. The following information represents the consolidated results for our non-contributory defined benefit plans covering certain health care and life insurance benefits for retired employees. We have been funding a portion of future benefits over employees' active service lives through Voluntary Employee Beneficiary Association ("VEBA") trusts. Contributions to VEBA trusts are tax deductible, subject to limitations contained in the Internal Revenue Code.
Net periodic other postretirement benefit cost included the following components:
The following table sets forth the plans' funded status at December 31, 2006 and December 31, 2005.
*The above amounts are before adjustments for regulatory and contractual deferrals and deferred taxes
The table below details the end-of-year assumptions used for both the net periodic cost calculations and liability amounts.
The measurement of plan liabilities assumes a health care cost trend rate of 9.0% grading down to 4.75% in the year 2012. A 1% increase in the health care cost trend rate would have the effect of increasing the accumulated postretirement benefit obligation as of December 31, 2006 by $157.3 million and the net periodic health care expense by $14.5 million. A 1% decrease in the health care cost trend rate would have the effect of decreasing the accumulated postretirement benefit obligation as of December 31, 2006 by $137.4 million and the net periodic health care expense by $12.3 million.
The following benefit payments, which reflect expected future service, as appropriate, are expected to be paid in the years indicated:
- ------------------------------------------------------------------------------- Gross Benefit Subsidiary Receipts (In Millions of Dollars) Payments Expected** - -------------------------------------------------------------------------------
2007 $ 68.0 $ 3.9 2008 $ 72.4 $ 4.3 2009 $ 77.1 $ 4.6 2010 $ 81.6 $ 4.9 2011 $ 85.6 $ 5.2 Years 2012- 2016 $ 472.4 $ 29.7 - --------------------------------------------------------------------------------
** Rebates are based on calendar year in which prescription drug costs are incurred. Actual receipt of rebates may occur in the following year.
Under Funded Other Postretirement Obligation. As noted previously, SFAS 158 requires full balance sheet recognition of the net overfunded or underfunded status of each pension and other postretirement plan. The funded status of other postretirement plans is to be measured as the difference between the fair value of plan assets minus the accumulated benefit obligation. At December 31, 2006, KeySpan's accumulated benefit obligation was in excess of other postretiment assets by $822.6 million. Amounts that are not recognized in net periodic benefit costs will be recorded through accumulated other comprehensive income. At December 31, 2006, the amount recognized in accumulated other comprehensive income was $39.0 million, net of tax and regulatory and contractual deferrals.
The following table reconciles the 2005 Consolidated Balance Sheet with the impact of FAS 158:
- ------------------------------------------------------------------------------- (In Millions of Dollars) OPEB - ------------------------------------------------------------------------------- Liability AOCI - ------------------------------------------------------------------------------ Accrual at December 31, 2005 $ (484.7) $ - - ------------------------------------------------------------------------------- 2006 activity (85.1) - Incremental SFAS 158 liability (252.8) (252.8) Incremental deferrals and deferred taxes - 213.8 - ------------------------------------------------------------------------------- Balance at December 31, 2006 $ (822.6) $ (39.0) - -------------------------------------------------------------------------------
At December 31, 2006, KeySpan had a contractual receivable from LIPA of $583.7 million representing pension and other postretirement benefits associated with the electric business unit employees recorded in deferred charges other on the Consolidated Balance Sheet. LIPA has been reimbursing us for costs related to the postretirement benefits of the electric business unit employees in accordance with the LIPA Agreements.
Pension/Other Post Retirement Benefit Plan Assets. KeySpan's weighted average asset allocations at December 31, 2006 and 2005, by asset category, for both the pension and other postretirement benefit plans are as follows:
- ----------------------------------------------------------------------------- Pension OPEB Asset Category 2006 2005 2006 2005 - ----------------------------------------------------------------------------- Equity securities 67% 65% 69% 70% Debt securities 26% 27% 24% 23% Cash and equivalents 1% 3% 2% 2% Venture capital 6% 5% 5% 5% - ----------------------------------------------------------------------------- Total 100% 100% 100% 100% - -----------------------------------------------------------------------------
The long-term rate of return on assets (pre-tax) is assumed to be 8.5%, net of expenses which management believes is an appropriate long-term expected rate of return on assets based on our investment strategy, asset allocation mix and the historical performance of equity and fixed income investments over long periods of time. The actual ten- year compound rate of return, net of expenses, for our Plans is greater than 8.5%.
Our master trust investment allocation policy target for the assets of the pension and other postretirement benefit plans is 70% equity and 30% fixed income.
KeySpan has developed a multi-year funding strategy for its plans. We believe that it is reasonable to assume assets can achieve or outperform the assumed long-term rate of return with the target allocation as a result of historical performance of equity investments over long-term periods.
Cash Contributions. In 2007, KeySpan is expected to contribute approximately $95 million to its pension plan and approximately $36 million to its other postretirement benefit plan.
Defined Contribution Plan. KeySpan also offers both its union and management employees a defined contribution plan. Both the KeySpan Energy 401(k) Plan for Management Employees and the KeySpan Energy 401(k) Plan for Union Employees are available to all eligible employees. These Plans are defined contribution plans subject to Title I of the Employee Retirement Income Security Act of 1974 ("ERISA"). Eligible employees contributing to the Plan may receive certain
employer contributions including matching contributions and a 10% discount on the purchase of KeySpan common stock in the Plan. The matching contributions were in KeySpan's common stock until January 2006. The matching contributions are now determined at election of KeySpan employees. For the years ended December 31, 2006, 2005 and 2004, we recorded an expense of $14.7 million, $15.2 million, and $14.7 million, respectively.
Required disclosures on the Impact of the Adoption of SFAS No.158 on the Balance Sheet. SFAS 158 requires that in the transition year KeySpan must first calculate the minimum pension liability as of the end of the year the statute is implemented and disclose the change that would have been reflected in OCI for that year. The difference between the recorded amounts in OCI and the amounts reflected in the implementation of SFAS 158 constitute the transition adjustment amount. The following table reflects the effect of the transition.
Note 5. Capital Stock
Common Stock. Currently KeySpan has 450,000,000 shares of authorized common stock. At December 31, 2006, KeySpan had 9.5 million shares, or $273.6 million of treasury stock outstanding. During 2006, KeySpan issued approximately 1.0 million shares out of treasury for the dividend reinvestment feature of our Investor Program, the Employee Discount Stock Purchase Plan, the 401(k) Plan and the Long-Term Incentive Compensation Plan.
On May 16, 2005, KeySpan issued 12.1 million shares of common stock, in association with the MEDS Equity Units conversion, at an issuance price of $37.93 per share pursuant to the terms of the forward purchase contract. KeySpan received proceeds of approximately $460 million from the equity conversion. The number of shares issued was dependent on the average closing price of our common stock over the 20 day trading period ending on the third trading day prior to May 16, 2005. (See Note 6 "Long-Term Debt and Commercial Paper" for further details on the MEDS Equity Units.)
Preferred Stock. We have the authority to issue 100,000,000 shares of preferred stock with the following classifications: 16,000,000 shares of preferred stock, par value $25 per share; 1,000,000 shares of preferred stock, par value $100 per share; and 83,000,000 shares of preferred stock, par value $.01 per share. There was no outstanding preferred stock at December 31, 2006 and 2005.
Note 6. Long-Term Debt And Commercial Paper
Notes Payable. During 2006, KeySpan issued at KEDNY and KEDLI, respectively, $400 million and $100 million of Senior Unsecured Notes at 5.60% due November 29, 2016. Additionally, KEDLI has $125 million of Medium-Term Notes at 6.90% due January 15, 2008, and $400 million of 7.875% Medium-Term Notes due February 1, 2010, outstanding at December 31, 2006 each of which is guaranteed by KeySpan.
KeySpan also has $1.9 billion of medium and long term notes outstanding at December 31, 2005 of which $950 million of these notes were associated with the acquisition of Eastern and ENI. These notes were issued in two series as follows: $700 million of 7.625% Notes due 2010 and $250 million of 8.00% Notes due 2030. In addition, KeySpan has $467.2 million of notes outstanding pursuant to the MEDS Equity Units conversion in 2005. The MEDS Equity Units consisted of a three-year forward purchase contract for our common stock and a six-year note. The purchase contract required us, three years from the date of issuance of the MEDS Equity Units, May 16, 2005, to issue and the investors to purchase, a number of shares of our common stock based on a formula tied to the market price of our common stock at that time. The 8.75% coupon was composed of interest payments on the six-year note of 4.9% and premium payments on the three-year equity forward contract of 3.85%.
In 2005, KeySpan was required to remarket the note component of the Equity Units and reset the interest rate to the then current market rate of interest; however, the reset interest rate could not be set below 4.9%. In March 2005, KeySpan remarketed the note component of $394.9 million of the Equity Units at the reset interest rate of 4.9% through their maturity date of May 2008. The balance of the notes ($65.1 million) were held by the original MEDS equity holders in accordance with their terms and not remarketed. KeySpan then exchanged $300 million of the remarketed notes for $307.2 million of new 30 year notes bearing an interest rate of 5.8%. Therefore, KeySpan now has $160 million of 4.9% notes outstanding with a maturity date of May 2008 and $307.2 million of 5.8% notes outstanding with a maturity date of April 2035 that are classified as medium and long term notes.
On May 16, 2005 KeySpan issued 12.1 million shares of common stock, at an issuance price of $37.93 per share, pursuant to the terms of the financial purchase contract described above. KeySpan received proceeds of approximately $460 million from the equity conversion. The number of shares issued was dependent on the average closing price of our common stock over the 20 day trading period ending on the third trading day prior to May 16, 2005.
The remaining debt of $483.2 million had interest rates ranging from 4.65% to 9.75%.
Gas Facilities Revenue Bonds. KEDNY can issue tax-exempt bonds through the New York State Energy Research and Development Authority ("NYSERDA"). Whenever bonds are issued for new gas facilities projects, proceeds are deposited in trust and subsequently withdrawn to finance qualified expenditures. There are no sinking fund requirements on any of our Gas Facilities Revenue Bonds ("GFRBs"). At December 31, 2006, $640.5 million of GFRBs were outstanding. The interest rate on the variable rate series due through July 1, 2026 is reset weekly and ranged from 2.55% to 3.65% during the year ended December 31, 2006, at which time the rate was 3.65%.
Promissory Notes to LIPA. In connection with the KeySpan/LILCO transaction, KeySpan and certain of its subsidiaries issued promissory notes to LIPA to support certain debt obligations assumed by LIPA. At December 31, 2006, $155.4 million of these promissory notes remained outstanding. Under these promissory notes, KeySpan is required to obtain letters of credit to secure its payment obligations if its long-term debt is not rated at least in the "A" range by at least two nationally recognized statistical rating agencies. At December 31, 2006, KeySpan was in compliance with this requirement.
Industrial Development Revenue Bonds. At December 31, 2006, KeySpan had outstanding $128.3 million of tax-exempt bonds with a 5.25% coupon maturing in June 2027. Fifty-three million dollars of these Industrial Development Revenue Bonds were issued in its behalf through the Nassau County Industrial Development Authority for the construction of the Glenwood Energy Center, an electric-generation peaking plant, and the balance of $75 million was issued in its behalf by the Suffolk County Industrial Development Authority for the Port Jefferson Energy Center an electric-generation peaking plant. KeySpan has guaranteed all payment obligations of these subsidiaries with regard to these bonds.
First Mortgage Bonds. Colonial Gas Company had outstanding $95.0 million of first mortgage bonds at December 31, 2006. These bonds are secured by gas utility property. The first mortgage bond indentures include, among other provisions, limitations on: (i) the issuance of long-term debt; (ii) engaging in additional lease obligations; and (iii) the payment of dividends from retained earnings. At December 31, 2006, these bonds remain outstanding and have interest rates ranging from 6.34% to 8.80% and maturities that range from 2008-2028.
Authority Financing Notes. Certain of our electric generation subsidiaries can issue tax-exempt bonds through the NYSERDA. At December 31, 2006, $41.1 million of Authority Financing Notes 1999 Series A Pollution Control Revenue Bonds due October 1, 2028 were outstanding. The interest rate on these notes is reset based on an auction procedure. The interest rate during 2006 ranged from 2.70% to 3.65%, through December 31, 2006, at which time the rate was 3.65%.
We also have outstanding $24.9 million variable rate 1997 Series A Electric Facilities Revenue Bonds due December 1, 2027. The interest rate on these bonds is reset weekly and ranged from 2.98% to 4.00% for the year ended December 31, 2006, at which time the rate was 3.95%.
Ravenswood Master Lease. We have an arrangement with an unaffiliated variable interest financing entity through which we lease a portion of the Ravenswood Facility. We acquired the Ravenswood Facility, in part, through the variable interest entity, from the Consolidated Edison Company of New York ("Consolidated Edison") on June 18, 1999 for approximately $597 million. In order to reduce the initial cash requirements, we entered into a lease agreement (the "Master Lease") with the variable interest entity that acquired a portion of the facility, or three steam generating units, directly from Consolidated Edison and leased it to a KeySpan subsidiary. The variable interest financing entity acquired the property for $425 million, financed with debt of $412.3 million (97% of capitalization) and equity of $12.7 million (3% of capitalization). KeySpan has no ownership interests in the units or the variable interest entity. KeySpan has guaranteed all payment and performance obligations of our subsidiary under the Master Lease. Monthly lease payments are substantially equal to the monthly interest expense on the debt securities.
We have classified the Master Lease as $412.3 million of long-term debt on the Consolidated Balance Sheet based on our current status as primary beneficiary as defined in Financial Accounting Standards Board Interpretation No. 46 ("FIN 46"), "Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51." Further, we have an asset on the Consolidated Balance Sheet for an amount substantially equal to the fair market value of the leased assets at the inception of the lease, less depreciation since that date, or approximately $307.7 million. Under the terms of our credit facilities, the Master Lease is considered debt in the ratio of debt-to-total capitalization. (See Note 7 "Contractual Obligations, Financial Guarantees and Contingencies" for additional information regarding the leasing arrangement associated with the Master Lease Agreement.)
Commercial Paper and Revolving Credit Agreements. KeySpan has two credit facilities, which total $1.5 billion - $920 million for five years through 2010, and $580 million through 2009 - which will continue to support KeySpan's commercial paper program for ongoing working capital needs.
The fees for the facilities are based on KeySpan's current credit ratings and are increased or decreased based on a downgrading or upgrading of our ratings. The current annual facility fee is 0.07% based on our credit rating of A3 by Moody's Investor Services and A by Standard & Poor's for each facility. Both credit facilities allow for KeySpan to borrow using several different types of loans; specifically, Eurodollar loans, ABR loans, or competitively bid loans. Eurodollar loans are based on the Eurodollar rate plus a margin that is tied to our applicable credit ratings. ABR loans are based on the higher of the Prime Rate, the base CD rate plus 1%, or the Federal Funds Effective Rate plus 0.5%. Competitive bid loans are based on bid results requested by KeySpan from the lenders. We do not anticipate borrowing against these facilities; however, if the credit rating on our commercial paper program were to be downgraded, it may be necessary to do so.
The facilities contain certain affirmative and negative operating covenants, including restrictions on KeySpan's ability to mortgage, pledge, encumber or otherwise subject its utility property to any lien, as well as certain financial covenants that require us to, among other things, maintain a consolidated indebtedness to consolidated capitalization ratio of no more than 65% at the last day of any fiscal quarter. Violation of these covenants could result in the termination of the facilities and the required repayment of amounts borrowed thereunder, as well as possible cross defaults under other debt agreements. At December 31, 2006, KeySpan's consolidated indebtedness was 49.9% of its consolidated capitalization and KeySpan was in compliance with all covenants.
Subject to certain conditions set forth in the credit facility, KeySpan has the right, at any time, to increase the commitments under the $920 million facility up to an additional $300 million. In addition, KeySpan has the right to request that the termination date be extended for an additional period of 365 days prior to each anniversary of the closing date. This extension option, however, requires the approval of lenders holding more than 50% of the total commitments to such extension request. Under the agreements, KeySpan has the ability to replace non-consenting lenders with other pre-approved banks or financial institutions.
At December 31, 2006, we had cash and temporary cash investments of $210.9 million. During 2006, we repaid $572.6 million of commercial paper and, at December 31, 2006, $85.0 million of commercial paper was outstanding at a weighted average annualized interest rate of 5.43%. At December 31, 2006, KeySpan had the ability to issue up to an additional $1.4 billion, under its commercial paper program.
Capital Leases. Our subsidiaries lease certain facilities and equipment under long-term leases, which expire on various dates through 2014. The weighted average interest rate on these obligations was 6.0%.
Debt Maturity. The following table reflects the maturity schedule for our debt repayment requirements, including capitalized leases and related maturities, at December 31, 2006:
- ------------------------------------------------------------------------------- Long-Term Capital (In Millions of Dollars) Debt Leases Total - ------------------------------------------------------------------------------- Repayments: 2007 $ - $ 1.2 $ 1.2 2008 305.0 1.1 306.1 2009 412.3 1.2 413.5 2010 1,110.0 1.3 1,111.3 2011 20.0 1.3 21.3 Thereafter 2,575.6 3.7 2,579.3 - ------------------------------------------------------------------------------- $ 4,422.9 $ 9.8 $ 4,432.7 - -------------------------------------------------------------------------------
Note 7. Contractual Obligations, Financial Guarantees and Contingencies
Lease Obligations. Lease costs included in operating expense were $76.2 million in 2006 including the lease of KeySpan's Brooklyn headquarters of $10.7 million. KeySpan has a leveraged lease financing arrangement associated with the Ravenswood Expansion. The yearly operating lease expense is approximately $17 million per year. (See the caption below "Sale/Leaseback Transaction" for further details of this lease.) Lease costs also include leases for other buildings, office equipment, vehicles and power operated equipment. Lease costs for the year ended December 31, 2005 and 2004 were $76.5 million and $67.7 million, respectively. As previously mentioned, the Master Lease is consolidated and, as a result, lease payments are reflected as interest expense on the Consolidated Statement of Income. The future minimum cash lease payments under various leases, excluding the Master Lease, but including the Ravenswood Expansion lease, all of which are operating leases, are $103.8 million per year over the next five years and $580.1 million, in the aggregate, for all years thereafter. (See discussion below for further information regarding the Master Lease and the Ravenswood Expansion sale/leaseback transaction.)
Variable Interest Entity. As mentioned, KeySpan has an arrangement with a variable interest entity through which it leases a portion of the Ravenswood Facility. We acquired the Ravenswood Facility, a 2,200-megawatt electric generating facility located in Queens, New York, in part, through the variable interest entity from Consolidated Edison on June 18, 1999, for approximately $597 million. In order to reduce the initial cash requirements, we entered into the Master Lease with a variable interest, unaffiliated financing entity that acquired a portion of the facility, or three steam generating units, directly
from Consolidated Edison and leased it to our subsidiary, KeySpan Ravenswood, LLC. The variable interest unaffiliated financing entity acquired the property for $425 million, financed with debt of $412.3 million (97% of capitalization) and equity of $12.7 million (3% of capitalization). KeySpan has no ownership interests in the units or the variable interest entity. KeySpan has guaranteed all payment and performance obligations of KeySpan Ravenswood, LLC, under the Master Lease. Monthly lease payments substantially equal the monthly interest expense on such debt securities. Interest expense for the year ended December 31, 2006 was $30.0 million.
The term of the Master Lease extends through June 20, 2009. On all future semi-annual payment dates, we have the right to: (i) either purchase the facility for the original acquisition cost of $425 million, plus the present value of the lease payments that would otherwise have been paid through June 2009; or (ii) terminate the Master Lease and dispose of the facility. In June 2009, when the Master Lease terminates, we may purchase the facility in an amount equal to the original acquisition cost, subject to adjustment, or surrender the facility to the lessor. If we elect not to purchase the property, the Ravenswood Facility will be sold by the lessor. We have guaranteed to the lessor, as residual value, 84% of the acquisition cost of the property.
We have classified the Master Lease as $412.3 million of long-term debt on the Consolidated Balance Sheet based on our current status as primary beneficiary. Further, we have an asset on the Consolidated Balance Sheet for an amount substantially equal to the fair market value of the leased assets at the inception of the lease, less depreciation since that date, or approximately $307.7 million. If KeySpan Ravenswood, LLC, was not able to fulfill its payment obligations with respect to the Master Lease payments, then the maximum amount KeySpan would be exposed to under its current guarantees would be $425 million plus the present value of the remaining lease payments through June 20, 2009.
Sale/leaseback Transaction. KeySpan also has a leveraged lease financing arrangement associated with the Ravenswood Expansion. In May 2004, the unit was acquired by a lessor from our subsidiary, KeySpan Ravenswood, LLC, and simultaneously leased back to that subsidiary. All the obligations of KeySpan Ravenswood, LLC have been unconditionally guaranteed by KeySpan. This lease transaction generated cash proceeds of $385 million, before transaction costs, which approximates the fair market value of the facility, as determined by a third-party appraiser. This lease transaction qualifies as an operating lease under SFAS 98 "Accounting for Leases: Sale/Leaseback Transactions Involving Real Estate; Sales-Type Leases of Real Estate; Definition of the Lease Term; an Initial Direct Costs of Direct Financing Leases, an amendment of FASB Statements No.13, 66, 91 and a rescission of FASB Statement No. 26 and Technical Bulletin No. 79-11." The lease has an initial term of 36 years and the yearly operating lease expense is approximately $17 million per year. Lease payments will fluctuate from year to year, but are substantially paid over the first 16 years. The future minimum cash lease payments under this lease is approximately $171 million over the next five years and $378 million, in the aggregate, for all years thereafter. The sale/leaseback transaction resulted in a pre-tax gain of approximately $6 million which has been deferred and is being amortized over the life of the lease.
Asset Retirement Obligations. On December 31, 2005, KeySpan implemented FIN 47 "Accounting for Conditional Asset Retirement Obligations." FIN 47 was issued to clarify that the term conditional asset obligation used in SFAS 143 "Accounting for Asset Retirement Obligations" refers to a legal obligation to perform an asset retirement activity in which the timing and (or) method of settlement are conditional on a future event that may or may not be within the control of the entity. Previously, KeySpan adopted SFAS 143 on January 1, 2003. SFAS 143 required us to record a liability and corresponding asset representing the present value of legal obligations associated with the retirement of tangible, long-lived assets that existed at the inception of the obligation.
The following table presents our asset retirement obligation at December 31, 2006 and December 31, 2005:
(i) Asbestos-containing materials exist in roof flashing, floor tiles, pipe insulation and mechanical room insulation within our common facilities as well as in our older generation plants. KeySpan has a legal obligation to remove asbestos upon either a major renovation or demolition.
(ii) KeySpan has numerous storage tanks that contain among other things waste oil, #2 and #6 grade fuel oil, diesel fuel, multi chemicals, lube oil, kerosene, ammonia, and other waste contaminants. All of these tanks are subject to cleaning and removal requirements prior to demolition and retirement if so specified by law or regulation.
(iii) KeySpan has a legal requirement to cut (disconnect from the gas distribution system), purge (clean of natural gas and PCB contaminants) and cap gas mains within its gas distribution and transmission system when mains are retired in place. Gas mains are generally abandoned in place when retired, unless the main and other equipment needs to be removed due to sewer or water system rerouting or other roadblock work. When such a main and equipment are removed certain PCB test procedures must be employed.
(iv) KeySpan owns approximately 52% of an underground gas storage facility in western New York State. The facility includes 39 gas injection and extraction wells. There is a regulatory obligation to close and seal the wells.
(v) KeySpan owns a 600,000 gallon Liquefied Natural Gas ("LNG") tank and ancillary facilities located in Providence, RI under a 30 year contract with New England Gas Company entered into on November 1, 1999. At the end of the contract, the contract can be; (i) Extended; or (ii) New England Gas Company can require KeySpan to dismantle and remove the LNG tank and ancillary facilities or; (iii) KeySpan can elect to dismantle and remove the LNG tank and ancillary facilities. Since we may or may not be required to dismantle and remove the LNG tank and ancillary facilities, the obligation to perform was discounted to a 50% probability as premitted under FIN 47.
(vi) KeySpan has several wastewater treatment ponds associated with certain of its power stations. There are closure requirements for wastewater treatment pond systems based on regulations promulgated by the State of New York which were effective May 11, 2003.
(vii) KeySpan Communications has portions of its fiber optic network (underground and above ground) that are required to be removed upon termination of various agreements.
(viii) KeySpan has a regulatory obligation to close and seal the wells primarily associated with its gas production and development activities.
Financial Guarantees. KeySpan has issued financial guarantees in the normal course of business, primarily on behalf of its subsidiaries, to various third party creditors. At December 31, 2006, the following amounts would have to be paid by KeySpan in the event of non-payment by the primary obligor at the time payment is due:
The following is a description of KeySpan's outstanding subsidiary guarantees:
(i) KeySpan has fully and unconditionally guaranteed $525 million to holders of Medium-Term Notes issued by KEDLI. These notes are due to be repaid on January 15, 2008 and February 1, 2010. KEDLI is required to comply with certain financial covenants under the debt agreements. The face value of these notes are included in long-term debt on the Consolidated Balance Sheet.
(ii) KeySpan has fully and unconditionally guaranteed the payment obligations of its subsidiaries with regard to $128 million of Industrial Development Revenue Bonds issued through the Nassau County and Suffolk County Industrial Development Authorities for the construction of two electric-generation peaking plants on Long Island. The face value of these notes are included in long-term debt on the Consolidated Balance Sheet.
(iii) KeySpan has guaranteed all payment and performance obligations of KeySpan Ravenswood, LLC, the lessee under the Master Lease. The term extends through June 20, 2009. The Master Lease is classified as $412.3 million long-term debt on the Consolidated Balance Sheet.
(iv) KeySpan has guaranteed all payment and performance obligations of KeySpan Ravenswood, LLC, the lessee under the sale/leaseback transaction associated with the 250 MW Ravenswood Expansion, including future decommissioning costs. The initial term of the lease is for 36 years. As noted previously, this lease qualifies as an operating lease and is not reflected on the Consolidated Balance Sheet.
(v) KeySpan has agreed to indemnify the issuers of various surety and performance bonds associated with certain construction projects being performed by certain former subsidiaries. In the event that the subsidiaries fail to perform their obligations under contracts, the injured party may demand that the surety make payments or provide services under the bond. KeySpan would then be obligated to reimburse the surety for any expenses or cash outlays it incurs. Although KeySpan is not guaranteeing any new bonds for any of the former subsidiaries, KeySpan's indemnity obligation supports the contractual obligation of these former subsidiaries. KeySpan has also received from a former subsidiary an indemnity bond issued by a third party insurance company, the purpose of which is to reimburse KeySpan in an amount up to $80 million in the event it is required to perform under all other indemnity obligations previously incurred by KeySpan to support such company's bonded projects existing prior to divestiture. At December 31, 2006, the total cost to complete such remaining bonded projects is estimated to be approximately $28.5 million.
(vi) KeySpan has guaranteed commodity-related payments for subsidiaries within the Electric Services segment. These guarantees are provided to third parties to facilitate physical and financial transactions involved in the purchase of natural gas, oil and other petroleum products for electric production and marketing activities. The guarantees cover actual purchases by these subsidiaries that are still outstanding as of December 31, 2006.
(vii) KeySpan has arranged for stand-by letters of credit to be issued to third parties that have extended credit to certain subsidiaries. Certain vendors require us to post letters of credit to guarantee subsidiary performance under our contracts and to ensure payment to our subsidiary subcontractors
and vendors under those contracts. Certain of our vendors also require letters of credit to ensure reimbursement for amounts they are disbursing on behalf of our subsidiaries, such as to beneficiaries under our self-funded insurance programs. Such letters of credit are generally issued by a bank or similar financial institution. The letters of credit commit the issuer to pay specified amounts to the holder of the letter of credit if the holder demonstrates that we have failed to perform specified actions. If this were to occur, KeySpan would be required to reimburse the issuer of the letter of credit.
To date, KeySpan has not had a claim made against it for any of the above guarantees and we have no reason to believe that our subsidiaries or former subsidiaries will default on their current obligations. However, we cannot predict when or if any defaults may take place or the impact any such defaults may have on our consolidated results of operations, financial condition or cash flows.
Fixed Charges Under Firm Contracts. Our utility subsidiaries and the Ravenswood Generating Station have entered into various contracts for gas delivery, storage and supply services. Certain of these contracts require payment of annual demand charges in the aggregate amount of approximately $449 million. We are liable for these payments regardless of the level of service we require from third parties. Such charges associated with gas distribution operations are currently recovered from utility customers through the gas adjustment clause.
LEGAL MATTERS
From time to time we are subject to various legal proceedings arising out of the ordinary course of our business. Except as described below, we do not consider any of such proceedings to be material to our business or likely to result in a material adverse effect on our results of operations, financial condition or cash flows.
On March 20, 2006, a purported class action lawsuit was filed alleging breach of fiduciary duty against KeySpan and its directors. The complaint, which was filed in the New York State Supreme Court for the County of Kings (the "Court"), related to the execution of the Merger Agreement with National Grid plc and alleged that the merger consideration which KeySpan's stockholders would receive in connection with the proposed merger transaction was inadequate and unfair because the transaction value of $42.00 for each share of KeySpan's common stock outstanding did not provide its stockholders with a meaningful premium over the market price of the common stock. On April 19, 2006, we moved to dismiss the complaint for failure to state a cause of action upon which relief could be granted. On May 26, 2006, the plaintiff served an amended complaint adding National Grid plc as a defendant. The amended complaint alleged that National Grid plc aided and abetted the alleged breach of fiduciary duties and added claims of inadequate disclosure with respect to KeySpan's preliminary proxy materials. In June 2006, the parties agreed in principle to settle the case, the terms of which provide for, among other things, the inclusion of additional disclosures in our 2006 Annual Meeting Proxy Statement concerning the background and principle events leading to execution of the Merger Agreement, as well as
the payment of plaintiff's counsel fees of up to $350,000 following closing of the transaction. In October 2006, definitive settlement documents were executed by the parties and submitted to the Court. The settlement remains subject to a number of conditions, including Court approval following notice to shareholders.
Several lawsuits have been filed which allege damages resulting from contamination associated with the historic operations of former manufactured gas plants located in Bay Shore and Staten Island, New York. KeySpan has been conducting site investigations and remediations at these locations pursuant to Orders on Consent with the DEC. With respect to Bay Shore, on July 12, 2006, a purported class action and a separate complaint were filed. Motions to dismiss these matters have been filed and are pending. On November 27, 2006 and December 28, 2006, two other lawsuits were filed by property owners in the Bay Shore area. In addition, on October 31, 2006, a lawsuit was filed alleging damages in Staten Island, New York. KeySpan intends to contest each of these proceedings vigorously. On February 8, 2007, we received a Notice of Intent to File Suit from the Office of the Attorney General for the State of New York ("AG") against KeySpan and four other companies in connection with the cleanup of historical contamination found in certain lands located in Greenpoint, Brooklyn and in an adjoining waterway. KeySpan has previously agreed to remediate portions of the properties referenced in this notice and will work cooperatively with the DEC and AG to address environmental conditions associated with the remainder of the properties. At this time, we are unable to predict what effect, if any, the outcome of these proceedings will have on our financial condition, results of operation and cash flows.
Other Contingencies. We derive a substantial portion of our revenues in our Electric Services segment from a series of agreements with LIPA pursuant to which we manage LIPA's transmission and distribution system and supply the majority of LIPA's customers' electricity needs. KeySpan and LIPA have entered into agreements to extend, amend, and restate these contractual arrangements. See Note 11 "2006 LIPA Settlement" for a further discussion of these agreements.
LIPA completed its strategic review initiative that it had undertaken in connection with, among other reasons, its option under the Generation Purchase Rights Agreement with KeySpan. As part of its review, LIPA engaged a team of advisors and consultants, held public hearings and explored its strategic options, including continuing its existing operations, municipalizing, privatizing, selling some, but not all of its assets, becoming a regulator of rates and services, or merging with one or more utilities. Upon completion of its strategic review, LIPA determined that it would continue its existing operations and entered into the renegotiated 2006 LIPA Agreements that are discussed in Note 11 "2006 LIPA Settlement." Following the announcement of the proposed acquisition of KeySpan by National Grid plc, LIPA, National Grid plc and KeySpan have engaged in discussions concerning the impact of the transaction on LIPA's operations. At this time, we are unable to determine what impact, if any, such discussions may have on the 2006 LIPA Agreements and the receipt and timing of governmental approvals relating thereto.
ENVIRONMENTAL MATTERS
Air. Our generating facilities are located within a Clean Air Act ("CAA") ozone non-attainment and PM 2.5 (fine particulate matter) non-attainment area, and are subject to increasingly stringent NOx emission limitations to be implemented under forthcoming requirements of the United States Environmental Protection Agency ("EPA") pursuant to the Clean Air Interstate Rule ("CAIR") and potentially under the Ozone Transport Commission's "CAIR PLUS" program. These efforts are designed to improve both ozone and particulate matter air quality. Our previous investments in low NOx boiler combustion modifications, the use of natural gas firing systems at our steam electric generating stations, and the compliance flexibility available under these cap and trade programs, have enabled KeySpan to achieve our prior emission reductions in a cost-effective manner. KeySpan is currently developing its compliance strategy to address the anticipated requirements of CAIR and CAIR PLUS by 2009. Since detailed requirements under CAIR have not yet been fully articulated, it is not possible to definitively estimate capital expenditures that may be required to meet these regulatory mandates. At the present time, it is anticipated that NOx control equipment may be required at one or more of KeySpan's Long Island facilities at a cost between $20 to $30 million. However, such amounts are recoverable from LIPA.
Water. Additional capital expenditures associated with the renewal of the surface water discharge permits for our power plants will likely be required by the Department of Environmental Conservation ("DEC"). We are currently conducting studies as directed by the DEC to determine the impacts of our discharges on aquatic resources and are engaged in discussions with the DEC regarding the nature of capital upgrades or other mitigation measures necessary to reduce any impacts. These upgrades are expected to cost up to $60 million for the Long Island units, however, such amounts are recoverable from LIPA. The Ravenswood Generating Station may also require upgrades at a cost of up to $15 million. The actual expenditures will depend upon the outcome of the ongoing studies and the subsequent determination by the DEC of how to apply the standards set forth in recently promulgated federal regulations under Section 316 of the Clean Water Act designed to mitigate such impacts.
Land, Manufactured Gas Plants and Related Facilities.
New York Sites. Within the State of New York we have identified 43 historical MGP sites and related facilities, which were owned or operated by KeySpan subsidiaries or such companies' predecessors. These former sites, some of which are no longer owned by KeySpan, have been identified to the DEC for inclusion on appropriate site inventories. Administrative Orders on Consent ("ACO") or Voluntary Cleanup Agreements ("VCA") have been executed with the DEC to address the investigation and remediation activities associated with certain sites and one waterway. In March 2005, KeySpan withdrew its previously filed applications under the DEC's Brownfield Cleanup Program ("BCP") because of the uncertainty associated with contribution suits which we may need to bring against other parties who impacted these sites for their share of remedial cost. As a result of the December 2004 Cooper Industries v. Aviall Services, Inc. decision by the United States Supreme Court and the emerging case law in New York, KeySpan has evaluated the potential for third party recovery at each of the remaining sites. KeySpan intends to enter into an ACO for fifteen of these sites and continues to evaluate how to proceed with respect to participation in the DEC's remediation programs for the other sites.
KeySpan has identified 28 of these sites as being associated with the historical operations of KEDNY. One site has been fully remediated. Subject to the issues described in the preceding paragraph, the remaining 27 sites will be investigated and, if necessary, remediated under the terms and conditions of ACOs, VCAs or Brownfield Cleanup Agreements ("BCA"). Expenditures incurred to date by us with respect to KEDNY MGP-related activities total $80.1 million.
The remaining 15 sites have been identified as being associated with the historical operations of KEDLI. One site has been fully investigated and requires no further action. The remaining sites will be investigated and, if necessary, remediated under the terms and conditions of ACOs, VCAs or BCAs. Expenditures incurred to date by us with respect to KEDLI MGP-related activities total $62.5 million.
We presently estimate the remaining cost of our KEDNY and KEDLI MGP-related environmental remediation activities will be $325.4 million, which amount has been accrued by us as a reasonable estimate of probable cost for known sites. However, remediation costs for each site may be materially higher than noted, depending upon changing technologies and regulatory standards, selected end use for each site, and actual environmental conditions encountered.
With respect to remediation costs, KEDNY and KEDLI rate plans generally provide for the recovery from customers of investigation and remediation costs of certain sites. At December 31, 2006, we have reflected a regulatory asset of $373.2 million for KEDNY/KEDLI MGP sites. KeySpan has recently filed proposed rate plans for KEDNY and KEDLI with the NYPSC as part of its application for approval of the KeySpan / National Grid plc merger, as well as individual applications for a proposed annual increase in revenues for KEDNY and KEDLI. Among other things, these filings seek recovery of deferred expenses associated with remediation of MGP sites, as well as recovery of ongoing remediation expenses.
We are also responsible for environmental obligations associated with the Ravenswood Facility, purchased from Consolidated Edison in 1999, including remediation activities associated with its historical operations and those of the MGP facilities that formerly operated at the site. We are not responsible for liabilities arising from disposal of waste at off-site locations prior to the acquisition closing and any monetary fines arising from Consolidated Edison's pre-closing conduct. We presently estimate the remaining environmental clean up activities for this site will be $1.4 million, which amount has been accrued by us. Expenditures incurred to date total $3.6 million.
New England Sites. Within the Commonwealth of Massachusetts and the State of New Hampshire, we are aware of 74 former MGP sites and related facilities within the existing or former service territories of KEDNE.
Boston Gas Company, Colonial Gas Company and Essex Gas Company may have or share responsibility under applicable environmental laws for the remediation of 64 of these sites. A subsidiary of National Grid USA ("National Grid"), formerly New England Electric System, has assumed responsibility for remediating 11 of these sites, subject to a limited contribution from Boston Gas Company, and has provided full indemnification to Boston Gas Company with respect to eight other sites. In addition, Boston Gas Company, Colonial Gas Company, and Essex Gas Company have assumed responsibility for remediating three sites each. At this time, it is uncertain as to whether Boston Gas Company, Colonial Gas Company or Essex Gas Company have or share responsibility for remediating any of the other sites. No notice of responsibility has been issued to us for any of these sites from any governmental environmental authority.
We presently estimate the remaining cost of these Massachusetts KEDNE MGP-related environmental cleanup activities will be $8.8 million, which amount has been accrued by us as a reasonable estimate of probable cost for known sites, however remediation costs for each site may be materially higher than noted, depending upon changing technologies and regulatory standards, selected end use for each site, and actual environmental conditions encountered. Expenditures incurred since November 8, 2000, the date KeySpan acquired Eastern Enterprises, with respect to these MGP-related activities total $34.7 million.
In 2004, Boston Gas Company reached settlements with certain insurance carriers for recovery of a portion of previously incurred environmental expenditures. Under a previously issued MADTE rate order, insurance and third-party recoveries, after deducting legal fees, are shared between Boston Gas and its firm gas customers. As a result of these settlements, in 2004 Boston Gas Company recorded a $5.0 million benefit to operations and maintenance expense.
We may have or share responsibility under applicable environmental laws for the remediation of 10 MGP sites and related facilities associated with the historical operations of EnergyNorth. At four of these sites we have entered into cost sharing agreements with other parties who share responsibility for remediation of these sites. EnergyNorth also has entered into an agreement with the EPA for the contamination from the Nashua site that was allegedly commingled with asbestos at the so-called Nashua River Asbestos Site, adjacent to the Nashua MGP site.
We presently estimate the remaining cost of EnergyNorth MGP-related environmental cleanup activities will be $25.5 million, which amount has been accrued by us as a reasonable estimate of probable cost for known sites, however remediation costs for each site may be materially higher than noted, depending upon changing technologies and regulatory standards, selected end use for each site, and actual environmental conditions encountered. Expenditures incurred since November 8, 2000, with respect to these MGP-related activities total $23.0 million.
By rate orders, the MADTE and the NHPUC provide for the recovery of site investigation and remediation costs and, accordingly, at December 31, 2006, we have reflected a regulatory asset of $43.4 million for the KEDNE MGP sites. As previously mentioned, Colonial Gas Company and Essex Gas Company are not subject to the provisions of SFAS 71 and therefore have recorded no regulatory asset. However, rate orders currently in effect for these subsidiaries provide for the recovery of investigation and remediation costs.
KeySpan New England LLC Sites. We are aware of three non-utility sites associated with KeySpan New England, LLC, a successor company to Eastern Enterprises, for which we may have or share environmental remediation or ongoing maintenance responsibility. These three sites, located in Philadelphia, Pennsylvania, New Haven, Connecticut and Everett, Massachusetts, were associated with historical operations involving the production of coke and related industrial processes. Honeywell International, Inc. and Beazer East, Inc. (both former owners and/or operators of certain facilities at Everett ("the Everett Facility") together with KeySpan, entered into an ACO with the Massachusetts Department of Environmental Protection for the investigation and development of a remedial response plan for a portion of that site. KeySpan, Honeywell and Beazer East entered into a cost-sharing agreement under which each company agreed to pay one-third of the costs of compliance with the consent order, while preserving any claims against the other companies for, among other things, reallocation of proportionate liability. In 2002, Beazer East commenced an action in the U.S. District Court for the Southern District of New York, which sought a judicial determination on the allocation of liability for the Everett Facility. A confidential settlement agreement has been executed on favorable terms to KeySpan and the Beazer lawsuit has been discontinued.
In 2004, KeySpan reached a settlement with insurance carriers regarding cost recovery for expenses at one of the above noted sites and recorded an $11.6 million reduction to operating expenses. We presently estimate the remaining cost of our environmental cleanup activities for the three non-utility sites will be approximately $11.4 million, which amount has been accrued by us as a reasonable estimate of probable costs for known sites, however remediation costs for each site may be materially higher than noted, depending upon changing technologies and regulatory standards, selected end use for each site, and actual environmental conditions encountered. Expenditures incurred since November 8, 2000, with respect to these sites total $21.4 million.
We believe that in the aggregate, the accrued liability for these MGP sites and related facilities identified above are reasonable estimates of the probable cost for the investigation and remediation of these sites and facilities. As circumstances warrant, we periodically re-evaluate the accrued liabilities associated with MGP sites and related facilities. We may be required to investigate and, if necessary, remediate each site previously noted, or other currently unknown former sites and related facility sites, the cost of which is not presently determinable but may be material to our financial position, results of operations or cash flows.
Insurance Reimbursement of MGP Response Costs. We have instituted lawsuits in New York, Massachusetts and New Hampshire against numerous insurance carriers for reimbursement of costs incurred for the investigation and remediation of these MGP sites.
In January 1998 and July 2001, KEDLI and KEDNY, respectively, filed complaints for the recovery of its remediation costs in the New York State Supreme Court against the various insurance companies that issued general comprehensive liability policies to KEDLI and KEDNY. The outcome of these proceedings cannot yet be determined.
In March 1999, Boston Gas Company and a subsidiary of National Grid filed a complaint for the recovery of remediation costs in the Massachusetts Superior Court against various insurance companies that issued comprehensive general liability policies to National Grid and its predecessors with respect to, among other things, the 11 sites for which Boston Gas Company has agreed to make a limited contribution. In October 2002, Boston Gas Company filed a complaint in the United States District Court - Massachusetts District against one of the insurance companies that issued comprehensive general liability policies to Boston Gas Company for its remaining sites. In November 2005, the trial commenced on the declaratory judgment action of Boston Gas against Century Indemnity for insurance coverage for the costs incurred in the investigation and remediation at the former Boston Gas Everett MGP site and in December 2005, the jury returned a verdict in favor of KeySpan. KeySpan anticipates that Century Indemnity will appeal this verdict. The outcome of these proceedings cannot yet be determined.
EnergyNorth has filed a number of lawsuits in both the New Hampshire Superior Court and the United States District Court for the District of New Hampshire for recovery of its remediation costs against the various insurance companies that issued comprehensive general liability and excess liability insurance policies to EnergyNorth and its predecessors. In October 2004, EnergyNorth's case against the London Market Insurers for the costs incurred investigating and remediating the former MGP site in Laconia went to trial and the jury returned a verdict in favor of EnergyNorth, finding that EnergyNorth was entitled to recover against London Market Insurers. In February 2005, the trial of EnergyNorth's coverage action for the Dover MGP site began against the only remaining defendant, Century Indemnity (all other carriers settled prior to trial) and at the conclusion of the trial the federal judge directed a verdict in EnergyNorth's favor on all issues. Century Indemnity filed an appeal with the First Circuit Court of Appeals and in a decision dated June 28, 2006, the First Circuit court of Appeals denied Century Indemnity appeal in its entirety. In a jury trial in the Nashua MGP action commenced against the London Market Insurers and Century Indemnity in November 2005, the jury returned a verdict in favor of KeySpan finding that London and Century Indemnity were obligated to indemnify EnergyNorth for response costs incurred at the site. Century Indemnity has sought reconsideration of this verdict. The outcome of this proceeding cannot yet be determined.
In 1993, KeySpan New England LLC filed a declaratory judgment action against the Hanover and Travelers insurance companies in the Superior Court for Middlesex County for the Everett Facility. The declaratory judgment action sought to have the court compel the insurers to defend KeySpan New England, LLC in connection with the Massachusetts Department of Environmental Protection's Notice of Responsibility ("NOR"). In 2004, the Court granted KeySpan New England LLC's unopposed motion for leave to file a Second Amended Complaint in this action to seek a declaratory ruling that the insurers have a duty to indemnify KeySpan New England LLC for the costs associated with the Everett NOR and certain other related private actions. The Second Amended Complaint also adds certain excess insurance carriers as defendants in the action. The outcome of this proceeding cannot yet be determined.
KeySpan has entered into confidential settlement agreements with certain of the defendant insurance carriers for recovery of costs associated with the investigation and remediation of the sites included in the above proceedings. Pursuant to these settlements, KeySpan recorded a benefit of $5.5 million in its Consolidated Statement of Income for the twelve months ended December 31, 2006, reflecting the benefit accruing to KeySpan's shareholders. Recovery of
environmental costs from insurance carriers associated with utility MGP sites are refunded to KeySpan's ratepayers, subject to certain sharing provisions. During the past year, KeySpan has received approximately $22 million from insurance carriers in settlements for recovery of environmental costs associated with remediation of MGP sites.
Note 8. Hedging, Derivative Financial Instruments and Fair Values
From time to time, KeySpan subsidiaries have utilized derivative financial instruments, such as futures, options and swaps, for the purpose of hedging the cash flow variability associated with changes in commodity prices. KeySpan is exposed to commodity price risk primarily with regard to its gas distribution operations, gas production and development activities and its electric generating facilities at the Ravenswood Generating Station. As discussed in greater detail below, certain derivative financial instruments employed by KeySpan are accounted for as cash-flow hedges under SFAS 133 "Accounting for Derivative Instruments and Hedging Activities," as amended by SFAS 149 "Amendment of Statement 133 on Derivative Instruments and Hedging Activities," collectively SFAS 133. However, KeySpan also employs derivative financial instruments that do not qualify for hedge accounting treatment. Additionally, certain derivative financial instruments employed by our Gas Distribution operations are subject to SFAS 71 "Accounting for the Effects of Certain Types of Regulation."
Commodity Derivative Instruments - Hedge Accounting: Our Energy Investments subsidiary, Seneca-Upshur, utilizes OTC natural gas swaps to hedge the cash flow variability associated with forecasted sales of a portion of its natural gas production. At December 31, 2006, Seneca-Upshur has hedge positions in place for approximately 70% of its estimated 2006 through 2009 gas production, net of gathering costs. We use market quoted forward prices to value these swap positions. The maximum length of time over which Seneca-Upshur has hedged such cash flow variability is through December 2009. The fair value of these derivative instruments at December 31, 2006 was a liability of $3.9 million. The estimated amount of losses associated with such derivative instruments that are reported in accumulated other comprehensive income and that are expected to be reclassified into earnings over the next twelve months is $2.3 million. Ineffectiveness associated with these outstanding derivative financial instruments was immaterial for the twelve months ended December 31, 2006.
Certain derivative instruments employed by our gas distribution operations are not subject to SFAS 71 and thus are not subject to deferral accounting treatment. KeySpan uses OTC natural gas swaps to hedge the cash-flow variability of gas purchases associated with certain large-volume gas sales customers. These gas swaps are accounted for as cash-flow hedges. KeySpan uses market quoted forward prices to value these swap positions. The maximum length of time over which we have hedged such cash flow variability is through October 2007. The fair value of these derivative instruments at December 31, 2006 was a liability of $2.0 million, all of which is reported in accumulated other comprehensive income and is expected to be reclassified into earnings within the next twelve months. Ineffectiveness associated with these outstanding derivative financial instruments was immaterial in 2006.
The above noted derivative financial instruments are cash flow hedges that are accounted for as hedges under SFAS 133 and are not considered held for trading purposes as defined by current accounting literature. Accordingly, we carry the fair value of our derivative instruments on the Consolidated Balance Sheet as either a current or deferred asset or liability, as appropriate, and record the effective portion of unrealized gains or losses in accumulated other comprehensive income. Gains and losses are reclassified from accumulated other comprehensive income to the Consolidated Statement of Income in the period the hedged transaction affects earnings. Gains and losses on settled transactions are reflected as a component of either revenue or gas cost depending on the hedged transaction. Hedge ineffectiveness results from changes during the period in the price differentials between the index price of the derivative contract and the price of the purchase or sale for the cash flow that is being hedged, and is recorded directly to earnings.
Commodity Derivative Instruments that are not Accounted for as Hedges: The Ravenswood Generating Station financially hedges the cash flow variability associated with a portion of electric energy sales and fuel purchases. Our strategy is to financially hedge up to 50% of the on-peak capacity of the Ravenswood Generating Station. The maximum length of time over which derivative financial instruments are in-place is through August 2007. To accomplish our stated risk management strategy, KeySpan employs financially-settled electric-power swap contracts with offsetting financially-settled oil swap contracts, physical natural gas forward contracts and OTC natural gas swaps. We use market quoted forward prices to value the electric-power swap contracts. The fair value of the electric power derivative instruments at December 31, 2006 was $21.9 million. We use market quoted forward prices to value the oil swap contracts and natural gas contracts. The fair value of these derivative instruments at December 31, 2006, was a liability of $23.7 million.
During most of 2006 and in prior years, the derivative transactions associated with the Ravenswood Generating Station qualified for hedge accounting treatment. As a result, there is a net $1.2 million balance currently in accumulated other comprehensive income which is expected to be reclassified into earnings within the next twelve months. In 2006, KeySpan reclassified a $1.4 million loss from accumulated other comprehensive income to earnings, based on management's assessment that certain future oil purchases were not probable of occurrence. Ineffectiveness associated with these outstanding derivative financial instruments was immaterial in 2006.
On January 18, 2006, KeySpan entered into an International SWAP Dealers Association Master Agreement for a fixed for float unforced capacity financial swap (the " Swap Agreement") with Morgan Stanley Capital Group Inc. ("Morgan Stanley"). The Swap Agreement has a three year term that began on May 1, 2006. The notional quantity was 1,800,000kW (the "Notional Quantity") of In-City Unforced Capacity and the fixed price is $7.57/kW-month ("Fixed Price"), subject to adjustment upon the occurrence of certain events. Cash settlement occurs on a monthly basis based on the In-City Unforced Capacity price determined by the relevant New York Independent System Operator ("NYISO") Spot Demand Curve Auction Market ("Floating Price"). For each monthly settlement period, the price difference equals the Fixed Price minus the Floating Price. If such price difference is less than zero, Morgan Stanley will pay KeySpan an amount equal to the product of (a) the Notional Quantity and (b) the absolute value of such price difference. Conversely, if such price difference is greater than zero, KeySpan will pay Morgan Stanley an amount equal to the product of (a) the Notional Quantity and (b) the absolute value of such price difference. This
derivative instrument does not qualify for hedge accounting treatment under SFAS 133. The recognized fair value associated with this instrument is immaterial to the consolidated financial statements at December 31, 2006. As noted, this is a financial derivative instrument and is unrelated to any physical production of electricity.
The NYPSC, Con Edison and other load serving entities ("LSEs") have proposed price mitigation measures that would apply to the Ravenswood Generating Station. These price mitigation measures, if approved as proposed, would essentially reduce the capacity bid price that the Ravenswood Generating Station could bid into the NYISO energy market. The NYISO's Management Committee and NYISO's Board of Directors approved the price mitigation measures proposed by the NYPSC, Con Edison and the other LSE's, notwithstanding KeySpan's analysis and objections. The NYISO filed the mitigation measures with the FERC for approval; such approval is pending. At this time, we are unable to predict the outcome of this proceeding and what effect it will have on the potential revenue that could be realized in connection with the fixed for floating financial Swap Agreement.
Commodity Derivative Instruments - Regulated Utilities: We use derivative financial instruments to reduce the cash flow variability associated with the purchase price for a portion of future natural gas purchases associated with our Gas Distribution operations. Our strategy is to minimize fluctuations in gas sales prices to our regulated firm gas sales customers in our New York and New England service territories. The accounting for these derivative instruments is subject to SFAS 71. Therefore, the fair value of these derivatives is recorded as current or deferred assets and liabilities, with offsetting positions recorded as regulatory assets and regulatory liabilities on the Consolidated Balance Sheet. Gains or losses on the settlement of these contracts are initially deferred and then refunded to or collected from our firm gas sales customers consistent with regulatory requirements. At December 31, 2006 the fair value of these derivative instruments was a liability of $192.1 million.
SFAS 133 establishes criteria that must be satisfied in order for option contracts, forward contracts with optionality features, or contracts that combine a forward contract and a purchase option contract to qualify for the normal purchases and sales exception. Certain contracts for the physical purchase of natural gas associated with our regulated gas utilities do not qualify for normal purchases under SFAS 133. Since these contracts are for the purchase of natural gas sold to regulated firm gas sales customers, the accounting for these contracts is subject to SFAS 71. At December 31, 2006, these derivatives had a net fair value of $101.2 million.
KeySpan has a management contract with Merrill Lynch Trading, under which KeySpan and Merrill Lynch Trading will share the responsibilities for managing KeySpan's upstream gas distribution assets associated with its Massachusetts gas distribution subsidiaries, as well as providing city-gate delivered supply. This contract, which replaces the prior arrangement with Merrill Lynch Trading, allows for both KeySpan and Merrill Lynch Trading to employ derivative instruments to maximize the profitability of KeySpan's portfolio of gas distribution assets. Profits associated with these activities are shared between KeySpan, Merrill Lynch Trading and KeySpan's Massachusetts ratepayers. The accounting for this contract is subject to SFAS 71 since the contract was executed by KeySpan's regulated gas distribution utilities. At December 31, 2006, KeySpan's proportionate share of the fair value associated with these derivative instruments amounted to $10.4 million, $9.5 million of which has been
deferred for future sharing among the alliance members and Massachusetts ratepayers. The remaining amount was recorded as a benefit to revenues. KeySpan provides these services internally for its New York and New Hampshire gas distribution subsidiaries.
Interest Rate Derivative Instruments: In the fourth quarter of 2006, KeySpan issued $400 million Senior Unsecured Notes at KEDNY and $100 million Senior Unsecured Notes at KEDLI. KeySpan utilized a $125 million treasury lock, at 4.77%, to hedge the 5-year US Treasury component of the underlying notes and a $125 million treasury lock, at 4.82%, to hedge the 10-year US Treasury component of the underlying notes. These derivative instruments settled in the fourth quarter of 2006 at which time KeySpan paid $0.2 million to the counterparty to the contracts. The loss on the settlement of these contracts has been deferred for future collection from firm gas sales customers consistent with regulatory requirements.
The table below summarizes the fair value of all of the above outstanding derivative instruments at December 31, 2006 and 2005, and the related line item on the Consolidated Balance Sheet. Fair value is the amount at which derivative instruments could be exchanged in a current transaction between willing parties, other than in a forced liquidation sale.
- -------------------------------------------------------------------------------- (In Millions of Dollars) December 31, 2006 December 31, 2005 - -------------------------------------------------------------------------------- Gas Contracts: Other current assets $ 30.7 $ 132.1 Other deferred charges 127.1 75.2 Regulatory asset 196.3 30.9 Other current liability (211.7) (39.8) Other deferred liabilities (42.1) (44.3) Regulatory liability (120.6) (175.4)
Oil Contracts: Other current assets 0.3 0.5 Other current liability (7.2) (6.8) Other deferred liabilities (0.5) -
Electric Contracts: Other current assets 23.2 10.2 Other deferred charges 0.3 - Other current liability (0.8) (0.7) Other deferred liabilities (0.6) -
- -------------------------------------------------------------------------------- $ (5.6) $ (18.1) - --------------------------------------------------------------------------------
Weather Derivatives: The utility tariffs associated with KEDNE's operations do not contain weather normalization adjustments. As a result, fluctuations from normal weather may have a significant positive or negative effect on the results of these operations.
In 2006, we entered into heating-degree day put options to mitigate the effect of fluctuations from normal weather on KEDNE's financial position and cash flows for the 2006/2007 winter heating season - November 2006 through March 2007. These put options will pay KeySpan up to $37,500 per heating degree day when the actual temperature is below 4,159 heating degree days, or approximately 5%
warmer than normal, based on the most recent 20-year average for normal weather. The maximum amount KeySpan will receive on these purchased put options is $15 million. The net premium cost for these options is $1.7 million and will be amortized over the heating season. Since weather was warmer than normal during the fourth quarter of 2006, KeySpan recorded a $9.1 million benefit to earnings associated with the weather derivative. We account for these derivatives pursuant to the requirements of EITF 99-2, "Accounting for Weather Derivatives." In this regard, such instruments are accounted for using the "intrinsic value method" as set forth in such guidance.
In 2005, we entered into heating-degree day put options, which expired during the first quarter of 2006, to mitigate the effect of fluctuations from normal weather on KEDNE's financial position and cash flows for the 2005/2006 winter heating season - November 2005 through March 2006. These put options would have paid KeySpan up to $40,000 per heating degree day when the actual temperature was below 4,169 heating degree days, or approximately 5% warmer than normal, based on the most recent 20-year average for normal weather. The maximum amount KeySpan would have received on these purchased put options was $16 million. The net premium cost for these options was $1.2 million and was amortized over the heating season. Weather for the entire primary winter heating season -November 2005 through March 2006 - was slightly colder than normal. Therefore, there was no earnings impact associated with these weather derivatives, except for the amortization of the net premium cost.
Credit and Collateral: Derivative contracts are primarily used to manage exposure to market risk arising from changes in commodity prices and interest rates. In the event of non-performance by a counterparty to a derivative contract, the desired impact may not be achieved. The risk of counterparty non-performance is generally considered a credit risk and is actively managed by assessing each counterparty credit profile and negotiating appropriate levels of collateral and credit support. In instances where the counterparties' credit quality has declined, or credit exposure exceeds certain levels, we may limit our credit exposure by restricting new transactions with counterparties, requiring additional collateral or credit support and negotiating the early termination of certain agreements. At December 31, 2006, KeySpan has received $7.9 million from its counterparties as collateral associated with outstanding derivative contracts. This amount has been recorded as restricted cash, with an offsetting position in current liabilities on the Consolidated Balance Sheet. At December 31, 2006, KeySpan has $33.9 million of outstanding margin calls to its counterparties for open derivative instruments associated with its strategy to minimize fluctuations in gas sales prices to its regulated firm gas sales customers.
Long-term Debt: The following tables depict the fair values and carrying values of KeySpan's long-term debt at December 31, 2006 and 2005.
Fair Values of Long-Term Debt
- ------------------------------------------------------------------------------ December 31, (In Millions of Dollars) 2006 2005 - ------------------------------------------------------------------------------ First Mortgage Bonds $ 111.4 $ 114.1 Notes 3,078.5 2,692.1 Gas Facilities Revenue Bonds 647.3 651.3 Authority Financing Notes 66.0 66.0 Promissory Notes 156.7 156.6 Master Lease 412.0 430.5 Tax Exempt Bonds 131.0 130.8 - ------------------------------------------------------------------------------ $ 4,602.9 $ 4,241.4 - ------------------------------------------------------------------------------
Carrying Values of Long-Term Debt
- ------------------------------------------------------------------------------ December 31, - ------------------------------------------------------------------------------ (In Millions of Dollars) 2006 2005 - ------------------------------------------------------------------------------ First Mortgage Bonds $ 95.0 $ 95.0 Notes 2,925.4 2,437.2 Gas Facilities Revenue Bonds 640.5 640.5 Authority Financing Notes 66.0 66.0 Promissory Notes 155.4 155.4 Master Lease 412.3 412.3 Tax Exempt Bonds 128.3 128.3 - ------------------------------------------------------------------------------ $ 4,422.9 $ 3,934.7 - ------------------------------------------------------------------------------
All other financial instruments included in the Consolidated Balance Sheet such as cash, commercial paper, accounts receivable and accounts payable, are stated at amounts that approximate fair value.
Note 9. Gas Production and Development Property - Depletion
As described in Note 2 "Business Segments," during much of 2004 KeySpan's investment in gas production and development activities consisted of its ownership interest in Houston Exploration, as well as KeySpan's wholly-owned subsidiary KeySpan Exploration and Production. Further, KeySpan's investment in these activities also includes its wholly-owned subsidiary Seneca-Upshur. These assets are accounted for under the full cost method of accounting. Under the full cost method, costs of acquisition, exploration and development of natural gas and oil reserves plus asset retirement obligations are capitalized into a "full cost pool" as incurred. Unproved properties and related costs are excluded from the depletion and amortization base until a determination as to the existence of proved reserves. Properties are depleted and charged to operations using the unit of production method.
To the extent that such capitalized costs (net of accumulated depletion) less deferred taxes exceed the present value (using a 10% discount rate) of estimated future net cash flows from proved natural gas and oil reserves and the lower of cost or fair value of unproved properties, less deferred taxes, such excess
costs are charged to operations, but would not have an impact on cash flows. Once incurred, such impairment of gas properties is not reversible at a later date even if prices increase. The ceiling test is calculated using natural gas and oil prices in effect as of the balance sheet date, adjusted for outstanding derivative instruments, held flat over the life of the reserves.
As a result of the sale of Houston Exploration discussed in Note 2 "Business Segments", KeySpan accounted for its investment in Houston Exploration on the equity method from June 2004 through November 19, 2004. Therefore, we were required to calculate a ceiling test on KeySpan Exploration and Production's and Seneca-Uphsur's assets independently of Houston Exploration's assets in the second quarter of 2004. Based on a report furnished by an independent reservoir engineer at that time, it was determined that the remaining proved undeveloped oil reserves held in the joint venture required a substantial investment in order to develop. Therefore, KeySpan and Houston Exploration elected not to develop these oil reserves. As a result, in the second quarter of 2004, KeySpan recorded a $48.2 million non-cash impairment charge to write down its wholly-owned gas exploration and production subsidiaries' assets. This charge was recorded in depreciation, depletion and amortization on the Consolidated Statement of Income.
Note 10. Energy Services - Discontinued Operations
In 2004, the Energy Services segment experienced significantly lower operating profits and cash flows than originally projected. At a meeting held on November 2, 2004, KeySpan's Board of Directors authorized management to begin the process of disposing of a significant portion of its ownership interests in certain companies within the Energy Services segment - specifically those companies engaged in mechanical contracting activities. In January and February of 2005, KeySpan sold its mechanical contracting investments. The operating results and cash flows of these businesses, are reflected as discontinued operations on the Consolidated Statement of Income and Consolidated Statement of Cash Flows.
In regard to the January 2005 transactions, KeySpan received proceeds of approximately $16 million, including approximately $5 million to be paid within a three year period. In addition, KeySpan retained its previously incurred indemnity support obligations related to certain surety, performance and payment bonds issued for the benefit of KeySpan's former subsidiaries prior to closing. In June 2005, the balance to be paid over the three year period was fully collected on a present value basis and a significant portion of the performance bonds were replaced without any remaining indemnification obligation on the part of KeySpan. The buyers have completed the projects for which such indemnity obligations were incurred.
In connection with the February 2005 transaction, KeySpan paid or contributed approximately $26 million to its former subsidiary prior to closing the sale transaction in exchange for, among other things, the disposition of outstanding shares in the former subsidiary and the settlement of intercompany advances and replacement of a performance and payment bond issued for the benefit of its former subsidiary with respect to a pending project, which bond had been supported by a $150 million indemnity obligation of KeySpan. In addition, KeySpan received from its former subsidiary an indemnity bond issued by a third party insurance company, the purpose of which is to reimburse KeySpan in an
amount up to $80 million in the event it is required to perform under all other indemnity obligations previously incurred by KeySpan to support the remaining bonded projects of its former subsidiary as of the closing. As of December 31, 2006, the total cost to complete such remaining bonded projects is estimated to be approximately $21.9 million. The aforementioned guarantees are reflected in Note 7 "Contractual Obligations, Financial Guarantees and Contingencies". KeySpan's former subsidiary has also agreed to complete the projects for which such indemnity obligations were incurred and to indemnify and hold KeySpan harmless with respect to its liabilities in connection with such bonds.
In anticipation of these sales and in connection with the preparation of the third quarter and fourth quarter 2004 financial statements, KeySpan conducted an evaluation of the carrying value of these investments, including recorded goodwill. Further, we evaluated the carrying value of goodwill for the entire Energy Services segment. As noted, KeySpan records goodwill on purchased transactions, representing the excess of acquisition cost over the fair value of net assets acquired.
As a result of these evaluations, KeySpan recorded a non-cash goodwill impairment charge of $108.3 million ($80.3 million after tax, or $0.50 per share) in 2004. This charge was recorded as follows: (i) $14.4 million as an operating expense on the Consolidated Statement of Income reflecting the write-down of goodwill on Energy Services segment's continuing operations; and (ii) $93.9 million ($67.8 million after-tax) as discontinued operations reflecting the impairment on the mechanical contracting companies.
In addition, an impairment charge of $100.3 million ($72.1 million after-tax or $0.45 per share) was also recorded in 2004 to reduce the carrying value of the remaining assets of the mechanical contracting companies. This charge is reflected in discontinued operations on the Consolidated Statement of Income to reflect the estimated loss on disposal.
KeySpan employed a combination of two methodologies in determining the estimated fair value for its investment in the Energy Services segment, a market valuation approach and an income valuation approach. Under the market valuation approach, KeySpan utilized a range of near-term potential realizable values for the mechanical contracting businesses. Under the income valuation approach, the fair value was obtained by discounting the sum of (i) the expected future cash flows and (ii) the terminal value. KeySpan utilized certain significant assumptions in this valuation, specifically the weighted-average cost of capital, short and long-term growth rates and expected future cash flows. Approximately $65 million of goodwill remains in this segment.
The information below highlights the major income and expense captions of the discontinued mechanical contracting companies.
- -------------------------------------------------------------------------------
For the Year Ended December 31, (In Millions of Dollars) 2005 2004 - -------------------------------------------------------------------------------
Revenues $ 33.8 $ 338.7 Less: Operating expenses 40.2 364.9 Goodwill impairment - 108.3 - ------------------------------------------------------------------------------- (6.4) (134.5) Income taxes (benefit) (2.3) (55.5) - ------------------------------------------------------------------------------- Operating loss (4.1) (79.0) Gain (Loss) on disposal, net of tax 2.3 (72.0) - ------------------------------------------------------------------------------- Net Loss $ (1.8) $ (151.0) - -------------------------------------------------------------------------------
Note 11. 2006 LIPA Settlement
LIPA is a corporate municipal instrumentality and a political subdivision of the State of New York. On May 28, 1998, certain of LILCO's business units were merged with KeySpan and LILCO's common stock and remaining assets were acquired by LIPA. At the time of this transaction, KeySpan and LIPA entered into three major long-term service agreements that (i) provide to LIPA all operation, maintenance and construction services and significant administrative services relating to the Long Island electric transmission and distribution system ("T&D System") pursuant to a Management Services Agreement (the "1998 MSA"); (ii) supply LIPA with electric generating capacity, energy conversion and ancillary services from our Long Island generating units pursuant to a Power Supply Agreement (the "1998 PSA") and other long-term agreements through which we provide LIPA with approximately one half of its customers' energy needs; and (iii) manage all aspects of the fuel supply for our Long Island generating facilities, as well as all aspects of the capacity and energy owned by or under contract to LIPA pursuant to an Energy Management Agreement (the "1998 EMA"). We also purchase energy, capacity and ancillary services in the open market on LIPA's behalf under the 1998 EMA. The 1998 MSA, 1998 PSA and 1998 EMA all became effective on May 28, 1998 and are collectively referred to as the 1998 LIPA Agreements.
On February 1, 2006, KeySpan and LIPA entered into (i) an amended and restated Management Services Agreement (the "2006 MSA"), pursuant to which KeySpan will continue to operate and maintain the electric T&D System owned by LIPA on Long Island; (ii) a new Option and Purchase and Sale Agreement (the "2006 Option Agreement"), to replace the Generation Purchase Rights Agreement (as amended, the "GPRA"), pursuant to which LIPA had the option, through December 15, 2005, to acquire substantially all of the electric generating facilities owned by KeySpan on Long Island; and (iii) a Settlement Agreement (the "2006 Settlement Agreement") resolving outstanding issues between the parties regarding the 1998 LIPA Agreements. The 2006 MSA, the 2006 Option Agreement and the 2006 Settlement Agreement are collectively referred to herein as the "2006 LIPA Agreements." Each of the 2006 LIPA Agreements will become effective upon all of the 2006 LIPA Agreements receiving the required governmental approvals; otherwise none of the 2006 LIPA Agreements will become effective. These agreements will become effective following approval by the New York State Comptroller's Office and the
New York State Attorney General. Following the announcement of the proposed acquisition of KeySpan by National Grid plc, LIPA, National Grid plc and KeySpan have engaged in discussions concerning the impact of the transaction on LIPA's operations. At this time, we are unable to determine what impact, if any, the results of such discussions may have on the 2006 LIPA Agreements and the receipt and timing of governmental approvals relating thereto.
2006 Settlement Agreement. Pursuant to the terms of the 2006 Settlement Agreement, KeySpan and LIPA agreed to resolve issues that have existed between the parties relating to the various 1998 LIPA Agreements. In addition to the resolution of these matters, KeySpan's entitlement to utilize LILCO's available tax credits and other tax attributes will increase from approximately $50 million to approximately $200 million. These credits and attributes may be used to satisfy KeySpan's previously incurred indemnity obligation to LIPA for any federal income tax liability that results from the recent settlement with the IRS regarding the audit of LILCO's tax returns for the years ended December 31, 1996 through March 31, 1999. On October 30, 2006, the IRS submitted the settlement provisions of the recently concluded IRS audit to the Joint Committee on Taxation for approval. Key provisions of the settlement included the resolution of the tax basis of assets transferred to KeySpan at the time of the KeySpan/LILCO merger, the tax deductibility of certain merger related costs and the tax deductibility of certain environmental expenditures. The settlement enabled KeySpan to utilize 100% of the available tax credits. (See Note 3 to the Consolidated Financial Statements "Income Taxes" for additional information of the settlement.) In recognition of these items, as well as for the modification and extension of the 1998 MSA and the amendments to the GPRA, upon effectiveness of the Settlement Agreement KeySpan will record a contractual asset in the amount of approximately $160 million, of which approximately $110 million will be attributed to the right to utilize such additional credits and attributes and approximately $50 million will be amortized over the eight year term of the 2006 MSA. In order to compensate LIPA for the foregoing, KeySpan will pay LIPA $69 million in cash and will settle certain accounts receivable in the amount of approximately $90 million due from LIPA.
Generation Purchase Rights Agreement and 2006 Option Agreement. Under an amended GPRA, LIPA had the right to acquire certain of KeySpan's Long Island-based generating assets formerly owned by LILCO, at fair market value at the time of the exercise of such right. LIPA was initially required to make a determination by May 2005, but KeySpan and LIPA agreed to extend the date by which LIPA was to make this determination to December 15, 2005. As part of the 2006 settlement between KeySpan and LIPA, the parties entered into the 2006 Option Agreement whereby LIPA had the option during the period January 1, 2006 to December 31, 2006 to purchase only KeySpan's Far Rockaway and/or E.F. Barrett Generating Stations (and certain related assets) at a price equal to the net book value of each facility. In December 2006, KeySpan and LIPA entered into an amendment to the 2006 Option Agreement whereby the parties agreed to extend the expiration of the option period to the later of (i) December 31, 2007 or (ii) 180 days following the effective date of the 2006 Option Agreement. The 2006 Option Agreement replaces the GPRA, the expiration of which has been stayed pending effectiveness of the 2006 LIPA Agreements. In the event such agreements do not become effective by reason of failure to secure any of the requisite governmental approvals, the GPRA will be reinstated for a period of 90 days from the date such approval is denied. If LIPA were to exercise the option and
purchase one or both of the generation facilities (i) LIPA and KeySpan will enter into an operation and maintenance agreement, pursuant to which KeySpan will continue to operate these facilities, through May 28, 2013, for a fixed management fee plus reimbursement for certain costs; and (ii) the 1998 PSA and 1998 EMA will be amended to reflect that the purchased generating facilities would no longer be covered by those agreements. It is anticipated that the fees received pursuant to the operation and maintenance agreement will offset the reduction in the operation and maintenance expense recovery component of the 1998 PSA and the reduction in fees under the 1998 EMA.
Management Services Agreements. In place of the previous compensation structure (whereby KeySpan was reimbursed for budgeted costs, and earned a management fee and certain performance and cost-based incentives), KeySpan's compensation for managing the T&D System under the 2006 MSA consists of two components: a minimum compensation component of $224 million per year and a variable component based on electric sales. The $224 million component will remain unchanged for three years and then increase annually by 1.7%, plus inflation. The variable component, which will comprise no more than 20% of KeySpan's compensation, is based on electric sales on Long Island exceeding a base amount of 16,558 gigawatt hours, increasing by 1.7% in each year. Above that level, KeySpan will receive approximately 1.34 cents per kilowatt hour for the first contract year, 1.29 cents per kilowatt hour in the second contract year (plus an annual inflation adjustment), 1.24 cents per kilowatt hour in the third contract year (plus an annual inflation adjustment), with the per kilowatt hour rate thereafter adjusted annually by inflation. Subject to certain limitations, KeySpan will be able to retain all operational efficiencies realized during the term of the 2006 MSA.
LIPA will continue to reimburse KeySpan for certain expenditures incurred in connection with the operation and maintenance of the T&D System, and other payments made on behalf of LIPA, including: real property and other T&D System taxes, return postage, capital construction expenditures and storm costs.
Upon approval, the 2006 LIPA Agreements will be effective retroactive to January 1, 2006. KeySpan's reported operating income and net income for 2006 under the 2006 MSA are substantially the same as they would have been if the terms and provisions of the 1998 MSA had continued to be applied. At this point in time, KeySpan is unable to estimate what the impact would be to its results of operations, financial position and cash flows if the 2006 LIPA Agreements do not become fully effective.
Note 12. KeySpan Gas East Corporation Summary Financial Data
KEDLI is a wholly owned subsidiary of KeySpan. KEDLI was formed on May 7, 1998 and on May 28, 1998 acquired substantially all of the assets related to the gas distribution business of LILCO. KEDLI provides gas distribution services to customers in the Long Island counties of Nassau and Suffolk and the Rockaway peninsula of Queens county. KEDLI established a program for the issuance, from time to time, of up to $600 million aggregate principal amount of Medium-Term
Notes, which will be fully and unconditionally guaranteed by the parent, KeySpan Corporation. On February 1, 2000, KEDLI issued $400 million of 7.875% Medium-Term Notes due 2010. In January 2001, KEDLI issued an additional $125 million of Medium- Term Notes at 6.9% due January 2008. The following condensed financial statements are required to be disclosed by SEC regulations and set forth those of KEDLI, KeySpan Corporation as guarantor of the Medium-Term Notes and our other subsidiaries on a combined basis. Additionally, in 2006, KEDLI issued $100 million of Senior Unsecured Notes at 5.60% due November 29, 2016. This debt is not guaranteed by the parent, KeySpan Corporation.
Note 13. Summary of Quarterly Information (Unaudited)
The following is a table of financial data for each quarter of KeySpan's year ended December 31, 2006.
(a) and (b) Pursuant to indemnity obligations contained in the Long Island Lighting Company ("LILCO") / KeySpan merger agreement of May 1998, KeySpan had been working with the Internal Revenue Service ("IRS") to resolve certain disputes with regard to LILCO's tax returns for the tax years ended December 31, 1996 through March 31, 1999 and KeySpan's and The Brooklyn Union Gas Company's (d/b/a KEDNY) tax returns for the years ended September 30, 1997 through December 31, 1998. During the second quarter of 2006, two issues were settled. Accordingly, KeySpan reversed $9.5 million of previously established federal income tax reserves. A settlement of the remaining outstanding issues was reached in the fourth quarter and, following IRS procedure, the settlement was submitted to the Joint Committee on Taxation on October 30, 2006 for final approval, which is expected in early 2007. Accordingly, KeySpan reversed $35.0 million of previously established federal income tax reserves in the fourth quarter of 2006.
The following is a table of financial data for each quarter of KeySpan's year ended December 31, 2005.
(a) Cumulative change in accounting principles for implementation of FASB Interpretation No. 47 ("FIN 47") "Accounting for Conditional Asset Retirement Obligations."
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of KeySpan Corporation:
We have audited the accompanying Consolidated Balance Sheets and the Consolidated Statements of Capitalization of KeySpan Corporation and subsidiaries (the "Company") as of December 31, 2006 and 2005, and the related Consolidated Statements of Income, Retained Earnings, Comprehensive Income and Cash Flows for each of the three years in the period ended December 31, 2006. Our audits also included the financial statement schedule listed in the Index at Item 15. These financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements 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 KeySpan Corporation and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such 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 Notes 1 and 4 to the consolidated financial statements, on December 31, 2006, the Company adopted Statement of Financial Accounting Standards No. 158 "Employers' Accounting for Defined Benefit Pensions and Other Postretirement Benefit Plans." As discussed in Notes 1 and 7, on December 31, 2005, the Company adopted Financial Accounting Standards Board Interpretation No. 47, "Accounting for Conditional Asset Retirement Obligations."
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, 2006, 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 22, 2007 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 New York, New York February 22, 2007
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
We maintain disclosure controls and procedures (as defined under Exchange Act Rule 13a-15(e)) that are designed to ensure that information required to be disclosed by us in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms, and that such information is accumulated and communicated to KeySpan's management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. Any control system, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. Our management, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures as of December 31, 2006. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that the design and operation of our disclosure controls and procedures were effective at the reasonable assurance level in alerting them timely to material information required to be included in KeySpan's periodic SEC reports.
Furthermore, there has been no change in KeySpan's internal control over financial reporting that occurred during KeySpan's last fiscal quarter, which has materially affected, or is reasonably likely to materially affect, KeySpan's internal control over financial reporting.
MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
Our management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined under Exchange Act Rule 13a-15(f)). KeySpan'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 accounting principles generally accepted in the United States of America.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements, errors or fraud. 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 or compliance with the policies or procedures may deteriorate.
Under the supervision and with participation of KeySpan's Chief Executive Officer and Chief Financial Officer, our management assessed the effectiveness of our internal control over financial reporting as of December 31, 2006. In making this assessment, our management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission ("COSO") in a report entitled Internal Control-Integrated Framework. Our management concluded, as of December 31, 2006, that KeySpan's internal control over financial reporting is effective based on the COSO criteria.
Our independent registered public accounting firm, Deloitte & Touche LLP, has issued their report on management's assessment of KeySpan's internal control over financial reporting as of December 31, 2006, which is included herein.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of KeySpan Corporation:
We have audited management's assessment, included in the accompanying Management's Report on Internal Control over Financial Reporting, that KeySpan Corporation and subsidiaries (the "Company") maintained effective internal control over financial reporting as of December 31, 2006, 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, 2006, 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, 2006, 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, 2006 of the Company and our report dated February 22, 2007 expressed an unqualified opinion on those financial statements and financial statement schedule and included an explanatory paragraph regarding the adoption of Statement of Financial Accounting Standards No. 158 "Employers' Accounting for Defined Benefit Pensions and Other Postretirement Benefit Plans," referred to in Notes 1 and 4.
/s/DELOITTE & TOUCHE LLP New York, New York February 22, 2007
PART III --------
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS and CORPORATE GOVERNANCE
Directors of KeySpan
The following individuals were elected as directors of KeySpan at our last annual meeting of shareholders held on August 17, 2006, to hold such position for a one year term or until his or her successor is duly elected or chosen and qualified:
Robert B. Catell - Age 70 - Director since May 1998 Chairman and Chief Executive Officer of KeySpan Corporation since July 1998. Joined KeySpan's subsidiary, The Brooklyn Union Gas Company, in 1958 and was elected Assistant Vice President in 1974, Vice President in 1977, Senior Vice President in 1981 and Executive Vice President in 1984. Elected Brooklyn Union's Chief Operating Officer in 1986 and President in 1990. Served as President and Chief Executive Officer from 1991 to 1996. He was then elected Chairman and Chief Executive Officer in 1996 and held such position through the transformation of Brooklyn Union to KeySpan. He served as President and Chief Operating Officer of KeySpan from May 1998 through July 1998 and was then elected as the Chairman in July 1998. Serves on the boards of Alberta Northeast Gas, Ltd., Edison Electric Institute, New York State Energy Research and Development Authority, the Business Council of New York State, Inc. and the New York City Partnership, and as Chairman of the Long Island Association. Mr. Catell also serves on the board of directors of The Houston Exploration Company (NYSE:THX) and Keyera Energy Management Ltd. (TSX:KEY.UN).
Andrea S. Christensen - Age 67 - Director since January 2001 Special Counsel to the law firm of Kaye Scholer LLP since January 1, 2005. Previously was a partner of Kaye Scholer LLP since 1976. Joined that firm in 1968 and previously was an associate with the law firm of Kelley, Drye & Warren. Adjunct Professor at New York University School of Law from 1984 to 1994. Member of the Association of the Bar of the City of New York, American Bar Association and International Society for Labor Law and Social Security. Former Chairperson of New York County Lawyers Association Committee on Labor Relations. Served as a director of Brooklyn Union from 1980 to 2000, and the American Arbitration Association from 1988 to 1999. Serves as a Member of the board of Inwood House since 2000.
Robert J. Fani - Age 52 - Director since January 2005 President and Chief Operating Officer of KeySpan since October 2003. Joined KeySpan's subsidiary, The Brooklyn Union in 1976 and has since held a variety of management positions in distribution, engineering, planning, marketing, and business development. Elected Vice President in 1992 and promoted to Senior Vice President of Marketing and Sales in 1997 and was responsible for all marketing, sales, rate and regulation activities. In September 1999, he became Senior Vice President for Gas Operations and was promoted to Executive Vice President for Strategic Services in February 2000 and then to President of the KeySpan Energy Services and Supply Group in 2001 until assuming his current position as
President and Chief Operating Officer. Former Director of The Houston Exploration Company (NYSE:THX) and serves as a director of the New York Building Congress, the City College of New York, Stony Brook University and the Energy Partnership of Long Island. He is also a member of the Society of Gas Lighters and sits on the Board of the Gas Technology Institute.
Alan H. Fishman - Age 60 - Director since May 1998 President, Sovereign Bank, from June 2006 to December 2006. Former president, Chief Executive Officer and a director of Independence Community Bank Corp. (NASDAQ:ICBC), the parent savings and loan holding company of Independence Community Bank. Joined Chemical Bank in 1969, named Chief Financial Officer in 1979 and elected Senior Vice President responsible for worldwide investment banking activities in 1983. Joined Neuberger & Berman in 1988 and was responsible for an investment partnership. Joined American International Group, Inc. in 1989 as Senior Vice President of AIG. Joined the firm of Adler & Shaykin in 1990 as a Managing Partner. Former Managing Partner and founder of Columbia Financial Partners, L.P. in 1992. President and Chief Executive Officer of ContiFinancial Corporation from July 1999 to March 2001. Chairman of the Brooklyn Academy of Music and the Brooklyn Navy Yard and co-chairman of the Downtown Brooklyn Partnership.
James R. Jones - Age 67 - Director since May 1998 Co-Chairman and Chief Executive Officer of Manatt Jones Global Strategies, LLP since October 2001 and Chairman of GlobeRanger Corporation since September 1999. Senior Counsel to the law firm of Manatt, Phelps & Phillips, LLP from March 1999 to present. Retired as President of Warnaco, Inc. - International Division in 1998. Director of Anheuser Busch (NYSE:BUD) since 1998 and Kansas City Southern (NYSE:KSU) since 1997. White House Staff, Special Assistant and Appointments Secretary from 1965 to 1969 and Congressman from Oklahoma from 1973 to 1987. Partner in the law firm of Dickstein Shapiro Morin & Oshinsky LLP from 1987 to 1989. Chairman and Chief Executive Officer of the American Stock Exchange from 1989 to 1993. Served as United States Ambassador to Mexico from 1993 to 1997.
James L. Larocca - Age 63 - Director since January 2001 Distinguished Professor of Public Policy and former Dean of the College at Long Island University's Southampton Graduate Campus since April 2000 and Adjunct Professor of Public Policy at Hofstra University since January 1999. Chairman of the Long Island Regional Planning Board. Practiced law with the firm of Cullen and Dykman immediately prior to his appointment to Southampton College. Served in the cabinets of two New York State governors as Commissioner of Transportation, Commissioner of Energy, Director of Federal Affairs, Trustee of the New York Power Authority and Chairman of the Energy Research and Development Authority. Served as the President of the Long Island Association from 1985 to 1993. Served as a director of Brooklyn Union from 1992 to 1993 and from 1995 to 2000. Former director of European American Bank and ContiFinancial Corporation. Current director and past Chairman of the Long Island Nature Conservancy.
Gloria C. Larson - Age 56 - Director since June 2003 Partner and Co-chair of the Government Practices Group at the law firm of Foley Hoag LLP. Has held senior positions within the federal government and the Commonwealth of Massachusetts government, including serving as the Massachusetts Secretary of Economic Affairs, Deputy Director of Consumer Protection and Attorney Advisor for the Federal Trade Commission. Current Chairperson of the
Massachusetts Convention Center Authority since 1998. Director of Unum Provident Corp. (NYSE:UNM). Serves as a member of the Rose F. Kennedy Greenway Conservancy board, as well as several Boston-based not-for-profit organizations, including the Greater Boston Chamber of Commerce, the New England Council, the Massachusetts Women's Forum and Blue Cross Blue Shield of Massachusetts. Serves as co-Chair of the board of directors of MassINC.
Stephen W. McKessy - Age 69 - Director since May 1998 Elected as the Lead Director of KeySpan effective January 1, 2006. Retired partner of PricewaterhouseCoopers. Served in various management and leadership positions at PricewaterhouseCoopers from 1960 to 1997. Serves as a director of The Houston Exploration Company (NYSE:THX), and the Boy Scouts of America. Member of the board of advisors of St. John's University College of Business Administration, past president and current member of the board of governors of the Silver Spring Country Club, and member of the Property Owners Association at SailFish Point, Florida.
Edward D. Miller - Age 65 - Director since May 1998 Served as a member of the supervisory board and senior advisor to the Chief Executive Officer of AXA Group from June 2001 to April 2003. Served as President and Chief Executive Officer of AXA Financial, Inc. from August 1997 through May 2001. Chairman and Chief Executive Officer of The Equitable Life Assurance Society, the principal insurance subsidiary of AXA Financial, Inc., from August 1997 through May 2001. Served as Senior Vice Chairman of The Chase Manhattan Bank from 1996 through 1997. Serves as a member of the board of directors of American Express Company (NYSE:AXP) and Korn/Ferry International (NYSE:KFY). Member of the board of governors of the United Way of Tri-State and Chairman of the board of directors of Phoenix House. Trustee of the Inner-City Scholarship Fund and the New York City Police Foundation. Chairman for New York City's Partnership Security and Risk Management Task Force.
Vikki L. Pryor - Age 53 - Director since March 2004 President and Chief Executive Officer of SBLI USA Mutual Life Insurance Company, Inc. and its family of companies since 1999. Served as Senior Vice President of Oxford Health Plans from June 1998 to January 1999. Served in various Senior Vice President and Vice President positions at Blue Cross Blue Shield of Massachusetts from 1993 to 1997. Served as Director and in a variety of senior level positions at Allstate Life Insurance Company from 1986 to 1992. Served in various positions including acting assistant district counsel, senior attorney and associate in the Office of Chief Counsel of the Internal Revenue Service, Chicago office, from 1978 to 1986. Served on the boards of the Life Insurance Council of New York (LICONY), New Jersey Chamber of Commerce, UST Corporation, Pension Reserves Investment Management and River Source Funds, a mutual fund company Serves on the Dean's Advisory Council of the University at Buffalo Law School. Ms. Pryor is also a member of the board of the New York City Partnership and the Forum 500 Board of Directors.
EXECUTIVE OFFICERS OF KEYSPAN
Certain information regarding executive officers of KeySpan and certain of its subsidiaries is set forth below:
Robert B. Catell Mr. Catell's biography appears under "Directors of KeySpan".
Robert J. Fani Mr. Fani's biography appears under "Directors of KeySpan".
Wallace P. Parker Jr. Mr. Parker, age 57, was elected President of the KeySpan Energy Delivery and Customer Relations Group in January 2003. He also serves as Vice Chairman and Chief Executive Officer of KeySpan Services, Inc. since January 2003. He had previously served as President, KeySpan Energy Delivery, since June 2001, and from February 2000 served as Executive Vice President of Gas Operations. He joined KEDNY in 1971 and served in a wide variety of management positions. In 1987, he was named Assistant Vice President for marketing and advertising and was elected Vice President in 1990. In 1994, Mr. Parker was promoted to Senior Vice President of Human Resources for KEDNY and in August 1998 was promoted to Senior Vice President of Human Resources of KeySpan.
Steven L. Zelkowitz
Mr. Zelkowitz, age 57, was elected President of KeySpan's Energy Assets and Supply Group in October 2003. Prior to that, he served as Executive Vice President and Chief Administrative Officer since January 2003. He joined KeySpan as Senior Vice President and Deputy General Counsel in October 1998, and was elected Senior Vice President and General Counsel in February 2000. In July 2001, Mr. Zelkowitz was promoted to Executive Vice President and General Counsel, and in November 2002, he was named Executive Vice President, Administration and Compliance, with responsibility for the offices of General Counsel, Human Resources, Regulatory Affairs, Enterprise Risk Management and administratively for Internal Auditing. Before joining KeySpan, Mr. Zelkowitz practiced law with Cullen and Dykman LLP in Brooklyn, New York, specializing in energy and utility law and had been a partner since 1984. He served on the firm's Executive Committee and was head of its Corporate/Energy Department.
John J. Bishar, Jr.
Mr. Bishar, age 57, was elected Executive Vice President, General Counsel, Chief Governance Officer and Secretary effective March 1, 2005. He became Senior Vice President, General Counsel and Secretary in May 2003, with responsibility for KeySpan's Legal Department and the Corporate Secretary's Office. Prior to that, he joined KeySpan as Senior Vice President and General Counsel in November 2002. Before joining KeySpan, Mr. Bishar practiced law with Cullen and Dykman LLP since 1987. He was the Managing Partner from 1993 through 2002 and was a member of the firm's Executive Committee. From 1980 to 1987, Mr. Bishar was Vice President, General Counsel and Corporate Secretary of LITCO Bancorporation of New York, Inc.
John A. Caroselli Mr. Caroselli, age 51, was elected Executive Vice President and Chief Strategy Officer in January 2003. Mr. Caroselli is responsible for Brand Management, Strategic Marketing, Corporate Marketing, Sales and Account Management and Customer Service, Strategic Planning, Strategic Performance and Information Technology Strategy and Governance. Mr. Caroselli came to KeySpan in 2001 and at that time served as Executive Vice President of Strategic Development. Before joining KeySpan, Mr. Caroselli held the position of Executive Vice President of Corporate Development at AXA Financial. Prior to that, he held senior officer positions with Chase Manhattan, Chemical Bank and Manufacturers Hanover Trust. He has extensive experience in strategic planning, brand management, marketing, communications, human resources, and strategic execution.
Gerald Luterman Mr. Luterman, age 63, was elected Executive Vice President and Chief Financial Officer in February 2002. He previously served as Senior Vice President and Chief Financial Officer since joining KeySpan in July 1999. He formerly served as Chief Financial Officer of barnesandnoble.com and Senior Vice President and Chief Financial Officer of Arrow Electronics, Inc. Prior to that, from 1985 through 1996, he held executive positions with American Express. Mr. Luterman also serves on the Board of Directors for IKON Office Solutions Inc. (NYSE:IKN), U.S. Shipping Partners L.P. (NYSE:USS) and Technology Solutions Company (NASDAQ:TSCC).
David J. Manning Mr. Manning, age 56, was elected Executive Vice President Corporate Affairs and Chief Environmental Officer effective March 1, 2005. He became Senior Vice President for Corporate Affairs in April 1999. Before joining KeySpan, Mr. Manning had been President of the Canadian Association of Petroleum Producers since 1995. From 1993 to 1995, he was Deputy Minister of Energy for the Province of Alberta, Canada. From 1988 to 1993, he was Senior International Trade Counsel for the Government of Alberta, based in New York City. Previously, he was in the private practice of law in Canada as Queen's Counsel.
Anthony Nozzolillo Mr. Nozzolillo, age 58, was elected Executive Vice President of Electric Operations in February 2000. He previously served as Senior Vice President of KeySpan's Electric Business Unit from December 1998 to January 2000. He joined LILCO in 1972 and held various positions, including Manager of Financial Planning and Manager of Systems Planning. Mr. Nozzolillo served as LILCO's Treasurer from 1992 to 1994 and as Senior Vice President of Finance and Chief Financial Officer from 1994 to 1998.
Nickolas Stavropoulos Mr. Stavropoulos, age 47, was elected President, KeySpan Energy Delivery, in June, 2004 and Executive Vice President in April 2002. He previously served as President of KeySpan Energy New England since April 2002, and Senior Vice President of sales and marketing in New England since 2000. Prior to joining KeySpan, Mr. Stavropoulos was Senior Vice President of marketing and gas resources for Boston Gas Company. Before joining Boston Gas, he was Executive Vice President and Chief Financial Officer for Colonial Gas Company. In 1995, Mr. Stavropoulos was elected Executive Vice President - Finance, Marketing and CFO, and assumed responsibility for all of Colonial's financial, marketing, information technology and customer service functions. Mr. Stavropoulos was a director of Colonial Gas Company and currently serves on the Board of Directors for Enterprise Bank and Trust Company (NASDAQ:EBTC) and Dynamics Research Corporation (NASDAQ:DRCO).
Joseph F. Bodanza Mr. Bodanza, age 59, was elected Senior Vice President Regulatory Affairs and Asset Optimization effective March 1, 2005. He became Senior Vice President, Regulatory Affairs and Chief Accounting Officer in April 2003. Prior to that, he served as Senior Vice President of Finance Operations and Regulatory Affairs since August 2001 and was Senior Vice President and Chief Financial Officer of KEDNE. Mr. Bodanza previously served as Senior Vice President of Finance and Management Information Systems and Treasurer of Eastern Enterprise's Gas Distribution Operations. Mr. Bodanza joined Boston Gas Company in 1972, and held a variety of positions in the financial and regulatory areas before becoming Treasurer in 1984. He was elected Vice President and Treasurer in 1988.
Coleen A. Ceriello Ms. Ceriello, age 48, was named Senior Vice President of Shared Services of KeySpan Corporate Services, LLC, effective March 1, 2005. She had been KeySpan's Vice President - Property, Security and Employee Related Services since January 2005. Prior to that time, she served as Vice President of Property and Security since June 2004 and Vice President of Strategic Planning since August 1999. She joined KEDNY in 1980 and over the years held a succession of positions in Corporate Planning, Regulatory Relations, Information Technology and Strategic Planning and Performance.
John F. Haran Mr. Haran, age 56, was elected Senior Vice President of KeySpan Energy Delivery and Chief Gas Engineer in March 2004. He had been Senior Vice President of gas operations for KEDNY and KEDLI in April 2002. Mr. Haran joined KEDNY in 1972, and has held management positions in operations, engineering and marketing and sales. He was named Vice President of KEDNY gas operations in 1996 and in 2000 moved to the position of Vice President of KEDLI gas operations.
Michael J. Taunton Mr. Taunton, age 51, was elected Senior Vice President, Treasurer and Chief Risk Officer effective March 1, 2005. He became Senior Vice President and Treasurer in March 2004, and had been KeySpan's Vice President and Treasurer since June 2000. Prior to that time, he served as Vice President of Investor Relations since September 1998. He joined KEDNY in 1975 and held a succession of positions in Accounting, Customer Service, Corporate Planning, Budgeting and Forecasting, Marketing and Sales, and Business Process Improvement. During the KeySpan/LILCO merger, Mr. Taunton co-managed the day-to-day transition process of the merger and then served on the Transition Team during the acquisition of Eastern Enterprises.
Elaine Weinstein Ms. Weinstein, age 59, was named Senior Vice President for Human Resources and Chief Diversity Officer in March 2004. She previously served as Senior Vice President of KeySpan's Human Resources division since November 2000, and as Vice President of Staffing and Organizational Development from September 1998, to her election as Senior Vice President. Prior to that time, Ms. Weinstein was General Manager of Employee Development since joining KEDNY in June of 1995. Prior to 1995, Ms. Weinstein was Vice President of Training and Organizational Development at Merrill Lynch.
Lawrence S. Dryer Mr. Dryer, age 47, was elected Vice President and General Auditor in June 2003. He previously served in this position from September 1998 to August 2001. In August 2001, he was named Senior Vice President and Chief Financial Officer of KeySpan Services, Inc. Prior to such positions, Mr. Dryer had been with LILCO from 1992 to 1998 as Director of Internal Audit. Prior to joining LILCO, Mr. Dryer was an Audit Manager with Coopers & Lybrand.
Theresa A. Balog Ms. Balog, age 44, was elected Vice President and Chief Accounting Officer effective March 1, 2005. She became Vice President and Controller of KeySpan in April 2003. She joined KeySpan in 2002 as Assistant Controller. Prior to joining KeySpan, Ms. Balog was Chief Accounting Officer for NiSource Inc. and held a variety of positions with the Columbia Energy Group.
Joseph E. Hajjar Mr. Hajjar, age 54, was named Vice President and Controller effective March 1, 2005. He had been Senior Vice President and Chief Financial Officer of KeySpan Services, Inc. since June 2003 and Senior Vice President and Chief Financial Officer of KeySpan Business Solutions, LLC, since November 2001. Before joining KeySpan from 1998 to 2001, Mr. Hajjar was Executive Vice President and Chief Operating Officer of Opportunity America. He also was previously an officer of the Bovis group and served for over 12 years with Price Waterhouse.
Michael A. Walker Mr. Walker, age 50, was named Vice President and Deputy General Counsel of KeySpan Corporation, effective March 1, 2005. He had been Senior Vice President of KeySpan Services, Inc. since June 2004 and Senior Vice President and COO of KeySpan Business Solutions, LLC, since June 2003. Prior to that time he was Senior Vice President and General Counsel of KeySpan Services, Inc. from January 2001 to December 2003. Before joining KeySpan, Mr. Walker was a shareholder in the Corporate Finance Section in the law firm of Buchanan Ingersoll. Prior to joining Buchanan Ingersoll he worked for several law firms in the north east representing both private and public sector clients on a wide variety of energy, utility, regulatory, corporate and structured finance matters.
There are no family relationships among any of our executive officers or directors.
Compliance with Section 16(a) of the Exchange Act
Section 16(a) of the Exchange Act requires KeySpan's directors, executive officers and persons who own more than ten percent (10%) of a registered class of KeySpan's equity securities to file with the SEC initial reports of beneficial ownership and reports of changes in beneficial ownership of common stock and other equity securities of KeySpan. Executive officers, directors and greater than ten percent (10%) shareholders are required by SEC regulation to furnish KeySpan with copies of all Section 16(a) forms that they file.
To KeySpan's knowledge, based solely on review of information furnished to us, reports filed through KeySpan and representations that no other reports were required, all Section 16(a) filing requirements applicable to our directors, executive officers and greater than ten percent (10%) beneficial owners were complied with during the twelve-month period ended December 31, 2006.
Codes of Ethics
We adopted a code of ethics applicable to our directors, a code of ethics applicable to our senior financial officers, and an ethical business conduct statement applicable to all of our directors, officers and employees. Our codes of ethics, ethical business conduct statement, corporate governance guidelines and committee charters can each be found on the Investor Relations section of our website, (http://www.keyspanenergy.com) or directly at the Corporation's corporate governance website (http://governance.keyspanenergy.com), and provide information on the framework and high standards set by us relating to our corporate governance. Additionally, these documents are available in print to any stockholder requesting a copy. The codes of ethics, ethical business conduct statement, corporate governance guidelines and committee charters have all been approved by the board of directors and are vital to securing the confidence of our stockholders, customers, employees, governmental authorities and the investment community.
Audit Committee
The Audit Committee provides oversight with respect to the quality and integrity of our financial statements; compliance with legal and regulatory requirements; the independent auditor's qualifications and independence; the performance of our internal audit function and independent auditors, our business practices, risk assessment and risk management, and the preparation of the Audit Committee report required to be included in our annual proxy statement. The Audit Committee is comprised of Mr. Fishman, Ms. Christensen, Mr. Larocca, Mr. McKessy and Ms. Pryor. Pursuant to the rules of New York Stock Exchange ("NYSE") all members of the Audit Committee of our board of directors are independent directors. Our board of directors has determined that Mr. Fishman and Ms. Pryor meet the qualifications of an "audit committee financial expert," as that term is defined by the rules of the Securities and Exchange Commission ("SEC"). In addition, our board of directors has determined that Mr. Fishman, Mr. McKessy and Ms. Pryor have "accounting or related financial management expertise," in accordance with the NYSE corporate governance standards rules, section 303A.07. Each of the members of the Audit Committee is financially literate, in accordance with the NYSE corporate governance standards rules, section 303A.07. None of the Audit Committee members simultaneously serves on the audit committees of more than three public companies. The Audit Committee is composed of five independent directors and operates under a written charter adopted by our board of directors, as amended and restated as of January 26, 2006; and can be found on the Investor Relations section of our website at http://www.keyspanenergy.com or directly at our corporate governance website (http://governance.keyspanenergy.com).
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
COMPENSATION DISCUSSION AND ANALYSIS
Objectives of Executive Compensation Programs
Through the Compensation and Management Development Committee of the Board of Directors (the "Committee"), which is responsible for the administration of our executive compensation programs, a "pay for performance" executive compensation philosophy was developed and adopted by the Board of Directors. Our executive compensation philosophy for named executive officers and other executives is intended to provide compensation at market competitive levels in order to attract, motivate and retain talented executives and to align the interests of these executives with those of our shareholders. The Committee, which has the primary governance authority over our executive compensation programs, is composed of five directors, each of whom are "independent" under all applicable New York Stock Exchange and Securities and Exchange Commission rules and regulations. The Committee operates pursuant to a written charter and is authorized by the Board of Directors to retain outside consultants, advisors or legal counsel to provide independent advice to the Committee. The overall objective of the program is to provide a total compensation plan designed to focus on our strategic business initiatives, financial performance objectives and shareholder value.
We adhere to the following compensation principles in the design of our compensation programs, which are intended to support our business objectives and further our strategic vision:
o The executive compensation programs emphasize pay for performance and encourage retention of those employees who enhance our overall performance.
o Compensation plan design maintains a reasonable balance among base salary, annual incentive and long-term equity-based incentive compensation and other benefits and should further the creation of long-term value for shareholders.
o Incentive compensation is linked to the achievement of specific financial and strategic objectives, which are established in advance and approved by the Board of Directors, upon recommendation of the Committee.
o Annual and long-term incentive compensation for executives are competitive with the levels of comparable executives within the energy industry, as well as general industry, on a nationwide basis, with a focus on energy companies for those positions unique to the energy industry.
o Total direct compensation, including base salary, annual and long-term incentives, should be benchmarked to the 50th percentile of the nationwide marketplace.
o If our performance results exceed that of our peer group, compensation should be above the 50th percentile for such peer group; likewise, if performance falls below that of our peer group, compensation should be below the 50th percentile.
o In addition to external comparisons, compensation levels also reflect the internal value of each executive compared to other executives within our organization, as well as other factors such as succession planning and the achievement of exceptional individual results.
Towers Perrin, a nationally recognized compensation consultant, was selected by the Committee as their independent compensation consultant in 2005. Towers Perrin attends Committee meetings in order to provide advice and counsel to the Committee in regard to compensation plan design and recommendations made by management. In addition, Towers Perrin provides advice regarding changes in legislative and accounting considerations that may impact compensation plan design.
To assist us in implementing our compensation programs, surveys are prepared by Towers Perrin to provide an independent review of the compensation levels of executives in peer energy companies and companies in general industry. The primary survey source is the Towers Perrin Energy Industry database with data from approximately 100 energy companies, as well as their general industry database with data from approximately 800 companies nationwide. This survey data is used as our peer group in assessing pay levels.
Both energy and general industry peer group data are used to benchmark base salary and annual incentives, but, because of factors unique to the energy industry, only energy industry data is used to benchmark the long-term incentive component of our pay programs. Ultimately, Towers Perrin uses statistical analysis to ensure comparability of our base salary, annual and long-term incentive compensation levels and to correlate the market data to an organization of our size and scope.
Our compensation plan design and philosophy is reviewed annually by the Committee, with no material changes made during 2006. In 2006 the Committee met five times. In addition to a review of the peer group data provided by Towers Perrin, the Committee conducted a comprehensive assessment of our executive compensation programs to ensure that our philosophy and programs are consistent with best practices and provide a reasonable level of total compensation to our named executive officers. In conducting this assessment, the Committee reviewed and relied upon comprehensive reports or "tally sheets" for each executive, which identified all elements of compensation provided to the executives in the prior year or to which they are otherwise entitled. In addition, the Committee held one executive session without management participation to enable discussion of the key elements of the named executive officers' performance evaluation and compensation recommendations.
Role of Executives in Establishing Compensation
Mr. Catell and Mr. Fani attend all Committee meetings. At such Committee meetings, they each periodically review KeySpan's financial and operating performance, major changes in organizational plans and the performance of key officers. Certain other senior executives also attend Committee meetings and are responsible for developing potential compensation programs, incentive compensation, plan design and individual salary recommendations with input from both Mr. Catell and Mr. Fani, utilizing the survey data and advice provided by Towers Perrin. With respect to Mr. Catell and Mr. Fani, all discussions regarding their compensation is conducted by the Committee in Executive Session without their attendance.
Compensation Program
Our compensation program reflects our compensation philosophy and principles as set forth above. To achieve our objectives, direct compensation includes three basic components: base salary, annual incentive compensation and long-term incentive compensation.
We place significant emphasis on variable pay (i.e. pay that is contingent upon performance), with the greatest proportion of total compensation being variable for Mr. Catell when compared to the other named executive officers. In terms of the variable pay component, which includes annual and long-term incentives, more emphasis is placed on the long-term component than the annual component. Mr. Catell has the highest portion of pay linked to long-term compensation, placing greater emphasis on long-term shareholder value. All variable pay programs are linked directly to performance measures that drive financial results, strategic performance measures and other goals and objectives that are intended to increase shareholder value.
The following provides a summary of the mix of compensation for the named executive officers for 2006:
2006 Mix of Total Direct Compensation Components
Executives are provided with benefits and perquisites that are intended to be comparable to those provided to executives in our peer group. These other programs include the following:
o ability to allocate a portion of any annual incentive payment into a deferred stock unit plan
o ability to allocate a portion of base salary into a deferred compensation plan
o retirement plans
o 401(k) plan with employer match (available to all employees)
o executive group replacement life insurance
o severance and change in control termination protection
o other reasonable and customary perquisites
In the design of our programs, the compensation amounts realized in prior years are not taken into consideration when establishing compensation targets or awards. We also have no policy that would automatically result in an adjustment to payments if the relevant performance measures upon which they are based are restated or otherwise adjusted in subsequent years in a manner that would reduce or increase the size of a previous payment. However, in an instance such as this, the Committee would have discretion to consider an adjustment, if warranted.
Base Salary - -----------
We provide a base salary program in order to compete for executive talent in the marketplace. Base salaries for our executives are established based on the scope of their responsibilities, taking into account competitive market compensation levels for similar positions. Generally, we believe that executive base salaries should be targeted near the median of the range of salaries for executives in similar positions with similar responsibilities at comparable companies. Base salaries are reviewed annually and adjusted from time to time to realign salaries with market levels, taking into account individual responsibilities, performance and experience. Other factors such as internal equity and succession planning are also considered when setting base salary.
In determining the base salary level for the named executive officers, the Committee considers individual contributions, internal equity, succession planning and performance, as well as competitive market data. In terms of performance results and contributions, the named executive officers are evaluated on an increase in overall earnings per share, continued focus on the core business and the achievement of our short and long-term strategic initiatives and financial goals. For further discussion of the named executive officers' base salary in 2006 and 2007, see the narrative following the Summary Compensation Table and the Grants of Plan-Based Awards table.
Annual Incentive Compensation - -----------------------------
Annual incentive compensation is intended to encourage management to achieve critical short-term goals that we believe are integrally linked to long-term value creation. The Board of Directors adopted the Corporate Annual Incentive Compensation and Gainsharing Plan (the "Corporate Plan") in September 1998. The Corporate Plan provides annual incentive awards to officers and all management employees based on the achievement of corporate goals that the Committee believes enhance shareholder value. For 2006, the performance measurement period included the twelve-month period from January 1, 2006 to December 31, 2006. The awards for this period were approved by the Committee and the Board of Directors in February 2007 and will be paid in March 2007. The specific corporate goals for the Corporate Plan are proposed by management and reviewed and approved by the Committee and the Board of Directors.
In 2006, the performance objectives for each of the named executive officers included financial and strategic objectives consisting of the following:
o earnings per share
o cash flow
o business unit operating income
o customer satisfaction
o control of operating expenses
o employee diversity, and
o individual strategic initiatives
The incentive award ranges are established annually by the Committee for executives and management employees. Incentive award levels provide awards that are competitive both within and outside the energy industry when target performance results are achieved.
Under the Corporate Plan, award payouts can range from zero for below threshold performance up to a maximum award potential of two times the target level established for each named executive officer. Actual award payouts are calculated using cumulative base earnings paid during the calendar year and are determined based upon each named executive officer's performance measured against the established financial, strategic and individual performance objectives set by the Committee and the Board of Directors. Actual awards also reflect modification based upon each named executive officer's individual performance rating using a modifier percentage as approved by the Committee. The modifier allows the Committee to use its discretion to increase or decrease an award with a maximum modification of +/- 15%, based on the named executive officers' performance relative to leadership, teamwork, strategic thinking, urgency for results, enterprise-wide commitment, developing organizational talent and integrity.
For each named executive officer, the specific performance objectives are weighted dependent upon the executive's level of responsibility for delivering results against these objectives. The weightings for the named executive officers with respect to each objective ranged as follows:
Earnings Per Share: 35% to 50% ------------------
Corporate/Business Unit Operating Income: zero to 25% ----------------------------------------
Free Cash Flow: 10% to 20% --------------
Control of Operation and Maintenance Costs: zero to 20% ------------------------------------------
Diversity: 10% for each named executive officer ---------
Customer Satisfaction: 10% for each named executive officer ---------------------
Other Strategic Initiatives: zero to 10% ---------------------------
The overall assessment of the achievement of each named executive's goals determines the percent of the target award that will be paid to the executive as an annual incentive award. In addition, the Committee may take into consideration certain unanticipated or extraordinary items, such as changes in accounting or tax rules, that may have impacted the difficulty or ease of achieving the desired targets and has discretion to adjust award payouts.
The performance metrics used in the 2006 Corporate Plan are summarized in the chart below. These objectives were selected as key performance indicators in support of our annual objectives and long-term strategy. The setting of the target level of performance generally reflects a reasonable level of improvement in performance when compared to the actual results achieved in the prior year. The threshold level of performance reflects the minimum acceptable level of performance. The maximum level of performance reflects performance results that would be considered exceptional when compared to the expected target level of results. The corporate performance objectives and the threshold, target and maximum levels are reviewed and approved by both the Committee and the Board of Directors at the beginning of each year.
2006 Performance Goals
(1) Actual performance results reflect adjustment for certain unanticipated expenses associated with the pending transaction with National Grid.
(2) Goal applicable to all named executive officers.
(3) Goal applicable to Mr. Fani. Payout result reflects business unit weightings of gas, electric, energy development and energy services business units.
(4) Goal applicable to Mr. Parker.
(5) Goal applicable to Mr. Zelkowitz.
(6) The performance measure for the Control of Operation and Maintenance Costs for Mr. Luterman reflects the expense levels associated with his areas of responsibility.
(7) The Diversity goal measures the percentage of diverse candidates selected for positions as compared to the total candidate population for those positions that are underrepresented by diverse incumbents.
(8) The Customer Satisfaction goal measures the percentage of customers who have had contact with us and have provided a satisfactory rating or better with respect to the level of service provided to them. A random sample of customers is used for this survey process. The survey is conducted by an outside agency.
The Corporate Plan includes both primary and secondary performance trigger mechanisms. The primary trigger is earnings per share. In order for the named executives and all other participants in the Corporate Plan to receive any incentive award payment, at least the threshold performance level of earnings per share must be achieved. If earnings per share results are between threshold and target, the award payout for all goals is pro-rated downward consistent with the level of performance. Once the target level of earnings per share performance is achieved, all goals are paid based upon actual performance results, with results in excess of target paid up to the maximum award level in the plan. The secondary performance trigger for the business units is operating income. The secondary performance trigger for all corporate staff and administrative areas is operation and maintenance expense. If the secondary trigger for any business unit or the corporate staff/administrative area is below threshold, the award payout for this measure is forfeited and award payouts for any other performance measures are reduced by 75% for that particular business unit.
We believe that the existence of these trigger mechanisms clearly emphasizes the importance of enhancing shareholder value and ensures that incentive awards are not paid (or are paid at substantially reduced levels) if key objectives are not achieved. For further discussion of the Corporate Plan and awards relative to 2006 performance, see the narrative to the Summary Compensation Table and the Grants of Plan-Based Awards table.
Long-Term Incentive Compensation - --------------------------------
The purpose of long-term compensation is to encourage actions that are directly aligned with the interests of our shareholders. We directly link officer compensation to shareholder return by awarding a portion of compensation in equity. The Committee recommended, and the Board of Directors adopted, the KeySpan Long-Term Performance Incentive Compensation Plan (the "Incentive Plan") in March 1999. The Incentive Plan was approved by shareholders at the May 1999 Annual Meeting. Under the Incentive Plan, we have awarded executives with three types of equity-based compensation: (1) stock options, (2) performance shares and (3) restricted stock.
The Committee is responsible for approving all equity awards granted under the Incentive Plan. The type and amount of long-term compensation (as a percentage of base salary) awarded to each named executive officer is determined, in part, by the compensation value of the long-term component at the 50th percentile in the Towers Perrin energy industry peer group. The actual shares awarded reflect modification based upon each named executive officer's individual performance rating using a modifier percentage as approved by the Committee. The modifier allows the Committee to increase or decrease an award using discretion, with a maximum modification of +/- 20%.
All equity awards are granted on the same day the Committee approves the awards (typically at a meeting in February), and are priced based upon the closing price of our stock on that date. With respect to newly hired or promoted executives, grants of equity awards may be approved and granted on their date of hire or promotion.
Below is a brief discussion of each type of equity-based compensation awarded pursuant to the Incentive Plan. For more detailed information regarding long-term compensation and each form of equity, see the 2006 Outstanding Equity Awards at Fiscal Year-End table and accompanying narrative.
Stock Options - -------------
The stock option component of the Incentive Plan permits the participants to purchase shares of KeySpan common stock at an exercise price per share determined by the Committee that is no less than the closing price of the common stock on the New York Stock Exchange on the date of the grant. We have been expensing stock options since 2003. We did not grant stock options in 2006 or 2007. The decision not to grant stock options in 2006 and 2007 was based upon the fact that the expense associated with such stock options would exceed the compensation value of the award and offer little incentive to executives due to the pending transaction with National Grid.
Stock option awards have never been re-priced or granted at less than market value. For a discussion of options granted prior to 2006, see the 2006 Outstanding Equity Awards at Fiscal Year-End table and the following narrative.
Restricted Stock - ----------------
The restricted stock component of the Incentive Plan provides for the award of common stock that may not be traded or otherwise disposed of by the participant until specific restrictions have lapsed. Due to the fact that restricted stock does not vest until after a multi-year period has lapsed, the interests of executives are aligned with the interests of shareholders and we believe the award encourages the retention of key executives.
For further discussion of the restricted stock awards in 2006, see the narrative following the Summary Compensation Table and Grants of Plan-Based Awards table.
For 2007, the named executive officers received their entire long-term incentive award in restricted stock. On February 20, 2007, the Committee approved the following grants of restricted stock: Mr. Catell 26,000; Mr. Luterman 5,110; Mr. Fani 15,000; Mr. Parker 10,000; and Mr. Zelkowitz 10,000. Restricted stock was considered the most appropriate form of equity in view of the fact that the establishment of multi-year performance goals was not realistic considering the pending acquisition of us by National Grid. Moreover, in order to account for the expected timing of this pending transaction, named executive officers' long-term grant levels were adjusted to provide approximately one-third of the target share level.
Performance Shares - ------------------
The performance share component of the Incentive Plan entitles the participants to receive shares of common stock if certain performance goals are achieved. Executives may earn from 0% to 150% of the target level of performance shares granted based upon our total shareholder return relative to the Standard and Poor's Utility Group. This type of equity compensation encourages officers to increase shareholder return because of the contingent nature of the award, which remains at risk unless the goals are achieved.
The performance goal for performance shares granted in 2003, 2004 and 2005 was linked solely to total shareholder return ("TSR"). The performance goal measures KeySpan's cumulative TSR for a three year performance period as compared to the Standard and Poor's Utilities Group. For the performance shares granted to officers in 2003 and 2004, the threshold performance level was not achieved and as a result all performance shares granted in 2003 and 2004 were forfeited without payment, reinforcing KeySpan's "pay for performance" compensation philosophy.
For a complete discussion of 2005 and 2006 performance share grants, see the narrative following the Summary Compensation Table and Grants of Plan-Based Awards table, and the narrative following the 2006 Outstanding Equity Awards at Fiscal Year-End table.
Other Compensation Programs
Executive Group Replacement Life Insurance - ------------------------------------------
The named executive officers as well as all other executives and eligible management employees are also provided with KeySpan paid individual life insurance. The executives do not participate in the group term life insurance plan that is provided to all other employees. The level of benefit provided to the executives under this replacement coverage is equal to the level of benefit that was formerly provided to all employees in the group plan. We determined that the cost of this coverage as a group term policy would be more expensive to us than the replacement coverage that is now provided.
The life insurance benefit for executives provides a benefit level of three times base salary and annual bonus up to a maximum of $1,500,000. All named executive officers are at the $1,500,000 limit. At retirement, if the executive is under age 65, the benefit level decreases to a maximum of $500,000 and thereafter, decreases again each year between ages 66 and age 70 to a maximum of $250,000. For executives who terminate employment prior to retirement age, we discontinue the payment of premiums. These are variable life insurance policies that are individually owned by the executive and accumulate cash value so that at age 65 or later, if premiums have not been paid for a 10 year period, there is sufficient value within the policy to allow us to discontinue premium payments and continue to provide the benefit level stated above in retirement. The cash surrender values as of December 31, 2006, for the named executives are as follows: Mr. Catell - $163,500; Mr. Luterman $99,700; Mr. Fani - $25,900; Mr. Parker - $45,300; and Mr. Zelkowitz - $45,200. The premiums paid by us are taxable to each named executive officer.
Perquisites - -----------
We maintain a perquisite program for our named executive officers, all other executives and key management employees. The perquisites provided to the executives are designed to provide a level of benefit to help attract and retain executives. Our named executive officers are reimbursed for an annual medical exam up to a cost of $1,000 and are also eligible for health club membership reimbursement up to annual limit of $ 900. The annual medical exam and health club subsidy are viewed as part of our initiative to encourage a healthy
lifestyle. There is also a financial and estate planning perquisite that provides reimbursement up to $2,000 annually to the named executive officers. The reimbursements for health club and financial and estate planning are taxable to each named executive officer.
Due to the nature of our business which requires emergency response to ensure public safety, as well as our geographically dispersed facilities, cars and drivers are available for Mr. Catell, Mr. Fani, Mr. Parker and Mr. Zelkowitz. The incremental cost of personal use of the company car for commutation purposes has been valued, and a portion of the cost of the annual lease, the driver and maintenance of the vehicle is imputed as income to the executives.
Each named executive officer is also provided a leased vehicle for business and personal use. The lease term is 48 months, with an upper dollar limit of $30,000 plus sales tax on the value of the lease paid by us for 2006. If the value of the vehicle exceeds $30,000, the named executive is responsible for payment of the full amount in excess of this limit including taxes. The named executives are eligible for reimbursement of up to $1,700 annually for maintenance expense. The executive is taxed each year for personal use of the leased vehicle.
All such perquisites are reflected in the All Other Compensation column of the Summary Compensation Table and the accompanying footnotes.
Post-Retirement and Post-Employment Plans - -----------------------------------------
We also provide the following post-retirement and post-employment plans to our executives:
o Our qualified pension plan, supplemental retirement plan and individual agreements are discussed in detail in the narrative following the Pension Benefits table. We provide a qualified pension plan to all employees in order to be competitive in the marketplace, to provide a tax effective method for us to fund retirement benefits, and to help attract and retain executives. In addition to the qualified plan, the named executive officers also participate in the KeySpan supplemental pension plan. We maintain this unfunded plan to provide named executive officers and other eligible employees with a pension benefit that will make up for the lost pension benefits that result from the Internal Revenue Code limits on the qualified plan.
We have established a deferred compensation trust and have contributed assets to purchase corporate owned life insurance to provide a source of funds for these supplemental benefits.
Individual supplemental retirement agreements have been provided to Mr. Catell, Mr. Zelkowitz and Mr. Luterman. The agreement for Mr. Catell was negotiated when he accepted the role of Chairman and CEO following the merger of the Brooklyn Union Gas Company and the Long Island Lighting Company in 1998. Effective January 1, 2005, we entered into a new agreement with Mr. Catell that supersedes the 1998 agreement and continues to provide for supplemental pension benefits.
We also provided both Mr. Zelkowitz and Mr. Luterman individual supplemental pension agreements due to their shorter length of service as compared to other executives and to provide incentives to remain with us. For a more detailed discussion, see the narrative following the 2006 Pension Benefits table below.
o Executives may elect to defer until retirement or termination of employment from 10% to 50% of their annual incentive awards to the Officers' Deferred Stock Unit Plan (the "ODSUP"). We provide this unfunded plan to encourage officers to increase their stock ownership in KeySpan and further align the interests of the executives with that of our shareholders. The ODSUP is discussed in detail in the narrative following the Nonqualified Deferred Compensation table.
o Executives may elect to defer until retirement or termination of employment up to 10% of their base salary to the Deferred Compensation Plan. We provide this unfunded plan to allow executives an opportunity to defer income and associated income taxes on their compensation. In addition, when recruiting senior executives, the opportunity to defer compensation is an attractive feature in the recruitment process. The Deferred Compensation Plan is discussed in the narrative following the Nonqualified Deferred Compensation table.
o Change of control protection and severance benefits are provided in Mr. Catell's, Mr. Luterman's and Mr. Zelkowitz's employment agreements as well as to all officers in the KeySpan Senior Executive Change of Control Severance Plan (the "Change of Control Plan"). Change of control severance benefits are discussed in detail in the narrative following the Nonqualified Deferred Compensation table. These individual agreement benefits and the Change of Control Plan benefits are provided to ensure the continued employment of the executive leadership team during a period of time when there may be a great deal of uncertainty pending a change in control.
Policy with Respect to Section 162(m) Deduction Limit
Under Section 162(m) of the Internal Revenue Code of 1986, as amended, we cannot deduct compensation in excess of $1,000,000 paid in any year to the Chief Executive Officer or any of the other named executive officers. Certain benefit plans and compensation paid under plans that are performance based are not subject to the $1,000,000 annual limit if certain requirements are satisfied. Although our compensation policy is designed to relate compensation to performance, certain payments do not meet such requirement because they allow the Committee and the Board of Directors to exercise discretion in setting compensation. The Committee is of the opinion that it is in our best interest for the Committee and the Board of Directors to retain this discretion in order to preserve flexibility in compensating such executive officers, especially in light of an increasingly competitive marketplace.
KeySpan Executive Stock Ownership Policy
The KeySpan Executive Stock Ownership Policy was adopted by the Committee in January 2005. The policy requires increased ownership of KeySpan common stock to ensure that the interests of the executives are closely aligned with the interest of shareholders. The policy establishes target levels of ownership of KeySpan stock for officers which must be achieved within a five-year period. Officers that do not meet the stock ownership requirements or are not on target to meet such requirements within a five year period are subject to certain remedial actions by the Corporation.
Our officers are expected to own shares of KeySpan common stock with a value equal to a specific multiple of such officer's base salary, as follows:
Position Multiple of Base Salary -------- -----------------------
Chief Executive Officer 5x
Chief Operating Officer 4x
Presidents 3x
Executive Vice Presidents 2x
Senior Vice Presidents 1.5x
Vice Presidents 1x
All named executive officers are currently in compliance with the ownership policy. In the event an executive is not in compliance, any one or more of the following measures will apply to the executive:
o May not liquidate any holdings in KeySpan stock.
o Can not reduce or discontinue any payroll deductions for the purchase of KeySpan stock.
o 50% of the after-tax proceeds from the exercise of stock options, or the sale of restricted stock or performance shares, are required to be retained as KeySpan stock.
Conclusion
We strive to ensure that each element of compensation delivered to the named executive officers is reasonable and appropriate as compared to the type and levels of compensation and benefits provided to executives in the marketplace. We also believe that such compensation should properly reflect the performance and results achieved by each individual. We have also established performance measures that ensure that each component of compensation is aligned with shareholders. Along with the Committee, we continually monitor trends in executive pay to ensure that recommendations and plan design reflect best practice.
(1) For a discussion of assumptions made in the valuation of restricted stock and performance shares, see "Note 1. Summary of Significant Accounting Policies" to our audited financial statements for the year ended December 31, 2006.
(2) Includes change in pension values (Mr. Catell: $709,752; Mr. Luterman: $128,210) as well as the earnings on deferred compensation under the Deferred Compensation Plan that is above market and calculated based upon the difference between the Federal Reserve Prime Rate and 120% of the Federal Long-Term Rate (Mr. Catell: $11,490; Mr. Luterman: $1,594).
(3) Includes the cost of life insurance of $12,848; the 20% match of $140,000 contributed by us on amounts payable under our Corporate Plan but deferred to the Officers' Deferred Stock Unit Plan; $161,309 as the total expense incurred to provide a car and driver used for business and security purposes, with income imputed for personal commutation; and $22,673 in certain other compensation and perquisites, including a leased vehicle, club membership, physical exam and 401(k) employer match, each of which are valued at less than $10,000.
(4) Includes the cost of life insurance of $29,603; the 20% match of $38,828 contributed by us on amounts payable under our Corporate Plan but deferred to the Officers' Deferred Stock Unit Plan; and $19,462 in certain other compensation and perquisites, including a leased vehicle, financial planning, health club membership, physical exam and 401(k) employer match, each of which are valued at less than $10,000.
(5) Reflects the change in pension value. These named executive officers do not participate in the nonqualified deferred compensation plan.
(6) Includes the 20% match of $37,059 contributed by us on amounts payable under our Corporate Plan but deferred to the Officers' Deferred Stock Unit Plan; $166,306 as the total expense incurred to provide a car and driver used for business and security purposes, with income imputed for personal commutation; $11,809 for a leased vehicle and $24,318 in certain other compensation and perquisites, including the cost of life insurance, financial planning, health club membership, club membership and 401(k) employer match, each of which are valued at less than $10,000.
(7) Includes the cost of life insurance of $13,082; the 20% match of $55,009 contributed by us on amounts payable under our Corporate Plan but deferred to the Officers' Deferred Stock Unit Plan; $118,355 as the total expense incurred to provide a car and driver used for business and security purposes, with income imputed for personal commutation; and $25,561 in certain other compensation and perquisites, including supplemental long term disability, a leased vehicle, financial planning, health club membership, physical exam, club membership and 401(k) employer match, each of which are valued at less than $10,000.
(8) Includes the cost of life insurance of $13,849; the 20% match of $51,313 contributed by us on amounts payable under our Corporate Plan but deferred to the Officers' Deferred Stock Unit Plan; $123,752 as the total expense incurred to provide a car and driver used for business and security purposes, with income imputed for personal commutation; $17,064 for a leased vehicle, health club membership and 401(k) employer match valued at less than $10,000.
(1) Reflects the grant date fair value pursuant to the Statement of Financial Accounting Standards No. 123 (revised 2004) - Share-based Payment ("FAS 123R") of the restricted stock granted in 2006.
(2) Reflects the grant date fair value at threshold level pursuant to FAS 123R of performance shares granted in 2006.
Salary - ------
On February 23, 2006, upon recommendation of the Compensation and Management Development Committee, the Board of Directors approved base salary increases for 2006 for the named executive officers as follows:
Approved Base Salary Increases for 2006
(1) Mr. Fani received a second mid-year increase to reflect his planned succession to the Chief Executive Officer position. Consistent with this succession plan, upon recommendation of the Committee, on May 3, 2006, the Board of Directors approved a base salary increase for Mr. Fani from $782,000 to $860,000 effective August 1, 2006.
(2) The increase for Mr. Zelkowitz reflects both a merit increase and an adjustment to address internal equity considerations at the President level.
On February 21, 2007, upon recommendation of the Committee, the Board of Directors approved base salary increases for the named executive officers as follows:
Approved Base Salary Increases for 2007
These increases were based on the individual executive's performance appraisal rating and accomplishments for the 2005 and 2006 calendar years, respectively, which took into account performance results achieved in 2005 and 2006, as well as competencies such as leadership, teamwork, strategic thinking, urgency for results, enterprise-wide commitment, developing organizational talent and integrity.
The amounts shown in the Non-Equity Incentive Plan Compensation column of the Summary Compensation Committee include any amounts deferred to the ODSUP. The ODSUP is described more fully in the narrative following the Non-Qualified Deferred Compensation table.
Stock Awards - ------------
On February 23, 2006, the Committee approved a grant to Mr. Catell of 85,520 shares of restricted stock pursuant to the Incentive Plan. The restrictions on the restricted stock will lapse after two years on February 23, 2008. The Committee has the discretion to lapse restrictions after one year on February 23, 2007 based on the success of the senior executive transition. On February 20, 2007, the Committee elected not to accelerate the lapse on these restricted shares. In the event of retirement or upon a change of control, the restrictions on the shares granted shall fully lapse. Restricted shares constitute issued and outstanding shares of common stock, and therefore, Mr. Catell has the right to vote such restricted shares. Dividends paid on the restricted stock are reinvested and are subject to all of the same restrictions as the restricted stock granted to him.
Also on February 23, 2006, the Committee approved performance share grants to the named executive officers (other than Mr. Catell). The estimated future payout of performance shares at threshold, target and maximum is provided in the 2006 Grants of Plan-Based Awards table under the Equity Incentive Plan Awards columns. Performance shares were granted at the target level with a three-year performance period with a threshold, target and maximum performance level. The number of performance shares earned at the end of the performance period can range from 0% to 150% of the target level of shares granted and will be linked to the following two performance measures, using a matrix approach that encompasses both measures:
o the percentage improvement in Return on Invested Capital ("ROIC"), and
o KeySpan's cumulative three-year TSR relative to the cumulative three-year TSR for the Standard and Poor's Utilities Group.
The payout matrix is as follows:
The ROIC goal will act as the primary trigger. If the ROIC goal performance is below the threshold level, all shares shall be forfeited without payment. In the event of an officer's retirement, performance shares shall be distributed based upon results achieved at the end of the performance period and pro-rated through the date of retirement. Upon a change of control, performance shares shall be distributed based upon the greater of the number of performance shares originally awarded at target level or the number of shares earned based on actual performance through the change of control date.
The dual performance measures were introduced in 2006 based upon an analysis of accounting considerations under the Statement of Financial Accounting Standards No. 123 (revised 2004) - Share-based Payment ("FAS 123R"). In this regard, the use of TSR as well as ROIC as an internal performance measure, with ROIC as the trigger, allows for more favorable accounting treatment in the event of forfeitures. If the TSR goal is the sole measure, the FAS 123R accounting rules will not allow for the reversal of expense in the event shares are forfeited. Using ROIC as the trigger allows for the reversal of expense in the event shares are forfeited.
The FAS 123R value expensed in 2006 for the restricted shares granted to Mr. Catell and for the performance shares granted to the other named executive officers is reported in the Stock Awards column of the Summary Compensation Table.
The grant date fair value pursuant to FAS 123R with respect to the entire 2006 restricted share grant to Mr. Catell is reported in the last column of the Grants of Plan Based Awards table. The amounts reported in this table for the other named executive officers reflects the grant date fair value at threshold for the 2006 performance share awards pursuant to FAS 123R.
There were no grants of stock options to the named executive officers during 2006. Outstanding options from previous grants are reflected in the Outstanding Equity Awards at Fiscal Year-End table.
Non-Equity Incentive Plan Compensation - --------------------------------------
The Non-Equity Incentive Plan Compensation column of the Summary Compensation Table reflects amounts earned pursuant to the Corporate Plan. These amounts will be paid in March of 2007 and are based upon performance results achieved during the twelve-month period from January 1, 2006 to December 31, 2006. The awards earned under the Corporate Plan are paid as cash (with the option to defer between 10% and 50% of the award to the ODSUP, as discussed in the narrative following the Nonqualified Deferred Compensation table) based upon annual performance results. The amounts reported in the Non-Equity Incentive Plan Compensation column include any amounts deferred pursuant to the ODSUP. Incentive awards for 2006 performance were determined based upon our performance, strategic business group performance and individual performance results, and were calculated as a percentage of cumulative base salary paid during 2006. The incentive award ranges for 2006 were zero for below threshold performance, and at threshold, target and maximum as a percentage of cumulative base salary paid as follows:
Threshold Target Maximum --------- ------ ------- Mr. Catell 50.0% 100% 200% Mr. Fani 37.5% 75% 150% Mr. Parker 35.0% 70% 140% Mr. Zelkowitz 35.0% 70% 140% Mr. Luterman 32.5% 65% 130%
Threshold, target and maximum annual incentive awards for 2006 are shown in the Grants of Plan-Based Awards table. The actual awards paid in 2007 based on 2006 performance were modified to reflect individual performance appraisal ratings by the following percentages: Mr. Catell: 15%; Mr. Luterman: 10%; Mr. Fani: 10%; Mr. Parker: 10%; and Mr. Zelkowitz: 10%.
Change in Pension Value and Nonqualified Deferred Compensation Earnings - -----------------------------------------------------------------------
With respect to Mr. Catell and Mr. Luterman, the amounts shown in the Change in Pension Value and Nonqualified Deferred Compensation Earnings column of the Summary Compensation Table includes change in pension values (Catell: $709,751; Luterman: $151,109) as well as earnings on deferred compensation under the Deferred Compensation Plan that is above market and calculated based upon the difference between the Federal Reserve Prime Rate and 120% of the Federal Long-Term Rate (Catell: $11,490; Luterman: $1,594). The change in pension value is calculated using the accrued pension benefit as of December 31, 2005, and compared to the accrued pension benefit as of December 31, 2006. These accrued amounts are then converted to a present value using the discount rate and mortality assumptions as used at year-end in the valuation of our pension plan. The change in value reflects the difference between these present value amounts. The accrued benefit amounts reflect the annuity amounts that are payable at age 65 or earlier if the executive is eligible for an unreduced retirement benefit at an earlier age. The Deferred Compensation Plan is more fully described in the narrative following the Non-Qualified Deferred Compensation table.
Option Awards footnotes follow: - -------------------------------
(a) The stock options were granted on March 10, 2004 and are subject to a three year vesting schedule if the total stockholder return performance goal is achieved, otherwise the stock options vest pro-rata over a five year vesting schedule with a 10 year exercise period.
(b) The stock options were granted on March 5, 2003 and are subject to a three year vesting schedule if the total stockholder return performance goal is achieved, otherwise the stock options vest pro-rata over a five year vesting schedule with a 10 year exercise period.
(c) The stock options were granted on March 1, 2002 and are subject to a three year vesting schedule if the total stockholder return performance goal is achieved, otherwise the stock options vest pro-rata over a five year vesting schedule with a 10 year exercise period.
(d) The stock options were granted on February 13, 2001 and were fully vested as of February 2006 with a 10 year exercise period.
(e) The stock options were granted on January 20, 2000 and were fully vested as of January 2003 with a 10 year exercise period.
(f) The stock options were granted on January 20, 2000 and were fully vested as of January 2001 with a 10 year exercise period.
(g) The stock options were granted on May 20, 1999 and were fully vested as of May 2002 with a 10 year exercise period.
(h) The stock options were granted on December 16, 1998 and were fully vested as of December 1999 with a 10 year exercise period.
(i) The stock options were granted on August 13, 1998 and were fully vested as of August 1999 with a 10 year exercise period.
(j) The stock options were granted on August 13, 1998 and were fully vested as of August 2001 with a 10 year exercise period.
(k) The stock options were granted November 21, 1997 and were fully vested as of November 2000 with a 10 year exercise period.
(l) The stock options were granted on February 24, 2005 and are subject to a three year vesting schedule if the total stockholder return performance goal is achieved, otherwise the stock options vest pro-rata over a five year vesting schedule with a 10 year exercise period.
(m) The stock options were granted on July 29, 1999 and were fully vested as of July 2002 with a 10 year exercise period.
(n) The stock options were granted on July 2, 2001 and were fully vested as of July 2006 with a 10 year exercise period.
Stock Awards footnotes follow: - ------------------------------
(1) Reflects the fair value of all outstanding performance shares and accumulated dividends at the threshold award level.
(2) Includes 13,295 restricted shares granted on March 1, 2002 with reinvested dividends of 3,446 shares accrued through December 31, 2006. Such restricted shares are restricted for six years and fully vest on March 1, 2008.
(3) Includes 85,520 restricted shares granted on February 23, 2006 with reinvested dividends of 2,970 shares accrued through December 31, 2006. Such restricted shares are restricted for two years and fully vest on February 23, 2008.
(4) Reflects performance shares at threshold level granted on February 24, 2005.
(5) Includes 2,930 restricted shares granted on March 1, 2002 with reinvested dividends of 759 shares accrued through December 31, 2006. Such restricted shares are restricted for six years and fully vest on March 1, 2008.
(6) Includes 5,000 restricted shares granted on February 24, 2005 with reinvested dividends of 431 shares accrued through December 31, 2006. Such restricted shares are restricted for two years and fully vest on February 24, 2007.
(7) Reflects performance shares at threshold level granted on February 24, 2005.
(8) Reflects performance shares at threshold level granted on February 23, 2006.
(9) Includes 4,275 restricted shares granted on March 1, 2002 with reinvested dividends of 1,108 shares accrued through December 31, 2006. Such restricted shares are restricted for six years and fully vest on March 1, 2008.
(10) Reflects performance shares at threshold level granted on February 24, 2005.
(11) Reflects performance shares at threshold level granted on February 23, 2006.
(12) Includes 4,275 restricted shares granted on March 1, 2002 with reinvested dividends of 1,108 shares accrued through December 31, 2006. Such restricted shares are restricted for six years and fully vest on March 1, 2008.
(13) Reflects performance shares at threshold level granted on February 24, 2005.
(14) Reflects performance shares at threshold level granted on February 23, 2006.
(15) Includes 2,930 restricted shares granted on March 1, 2002 with reinvested dividends of 759 shares accrued through December 31, 2006. Such restricted shares are restricted for six years and fully vest on March 1, 2008.
(16) Reflects performance shares at threshold level granted on February 24, 2005.
(17) Reflects performance shares at threshold level granted on February 23, 2006.
The Outstanding Equity Awards at Fiscal Year-End table reflects holdings of equity-based interests that relate to compensation or are potential sources of future compensation. The table represents equity-based interests that were awarded in 2006 and all prior years, as well as equity-based interests that are "at risk" of forfeiture or expiration prior to exercise.
The Option Awards section of the above table reflects all outstanding vested and unvested options. In the event of termination or retirement, the named executives may forfeit all or a portion of the unexercisable options depending on whether or not they are retirement eligible. At retirement or termination of employment due to death or disability, an adjustment to the vesting schedule is made to the options that include a 5 year pro-rata vesting schedule to reflect a 36 month vesting schedule. As a result, the options shall become vested and the shares may be exercised based upon a 36 month pro-rata vesting schedule with such options vesting monthly based on the number of full months that have lapsed between the grant date and the date of retirement. All outstanding KeySpan stock options will immediately vest on consummation of a change of control and will remain exercisable until the close of business on the expiration date.
The stock option award process included a performance goal feature in the stock option vesting schedule for officers which directly links three-year TSR for KeySpan common stock to the options granted since 2001. The TSR goal measures the total return to shareholders of KeySpan common stock, including price appreciation and dividends. KeySpan's performance will be measured against the S&P Utility Group over a three-year performance period, with the goal for KeySpan's TSR to be at or above the median of those comprising the group. Options were granted with a five-year pro-rata vesting schedule. If KeySpan achieves its TSR goal at the end of the three-year performance period, then those options that are not yet vested will vest immediately. If the TSR goal is not achieved in year three, the remaining unvested options will continue to vest on the five-year schedule. Stock options granted in 2001 and 2002 are fully vested. For stock options granted in 2003 and 2004, the required TSR performance target that would accelerate vesting was not achieved and the stock options granted in these years continue to vest over the five year period.
The Stock Awards section of the table reflects outstanding restricted stock and performance shares. Restricted stock outstanding is reflected in the Number of Shares or Units of Stock That Have Not Vested column and includes restricted stock granted including reinvested dividends.
In 2002, restricted stock was granted to each named executive officer. The restrictions on the restricted stock granted in 2002 will lapse on March 1, 2008. In the event of retirement, the restriction period shall be adjusted to reflect the number of full months that have lapsed between the date of the award and the date of retirement using a 48 month restriction period. In the event of retirement after the 48 month period, all restrictions would lapse on such shares and reinvested dividends. In the event of termination of employment due to death or disability, all restrictions would lapse on such shares and reinvested dividends.
In 2005, Mr. Luterman was granted 5,000 shares of restricted stock. The restrictions on this grant of restricted stock will lapse on February 24, 2007. For both Mr. Luterman's 2005 grant and Mr. Catell's 2006 grant of restricted stock described above, in the event of termination of employment due to death, disability or retirement, all restrictions would lapse on such shares and reinvested dividends. For all restricted stock grants to date, in the event of change of control, the restrictions on all such outstanding shares and reinvested dividends will fully lapse on the date of the change of control.
Performance shares outstanding are reflected at threshold, or 50% of target grant level, in the Equity Incentive Plan Awards columns of the 2006 Outstanding Equity Awards at Fiscal Year-End table. The awards are reflected at the threshold level due to the forfeiture of the 2004 performance shares.
Performance shares granted in 2005 have a three-year performance period (January 1, 2005 through December 31, 2007). The performance goal to be measured will compare KeySpan's cumulative TSR for a three year period, as compared to the S&P Utilities Group cumulative shareholder return for the same three-year measurement period. The performance shares issued will vary based upon a sliding scale from 50% to 150% of the number of performance shares awarded at the target level based upon the level of achievement of the performance goal. If the threshold level of the performance goal is not achieved, the right to performance shares will be forfeited without payment. The 2005 performance shares granted will be earned on a pro-rata basis based upon the degree of achievement of the performance goal established by the Committee and the shares will be issued and fully transferable, in accordance with the following schedule:
KeySpan Cumulative Return Percent of Target Compared to S&P Utility Group Performance Shares Earned ------------------------------ ------------------------- 0 to 34th percentile 0 % 35th percentile 50% 50th percentile 100% 90th percentile or over 150%
For information related to the performance measures related to the 2006 grant of performance shares, see the narrative following the Summary Compensation Table and Grants of Plan Based Awards table.
For both the 2005 and 2006 performance share awards, in the event of termination of employment due to retirement or disability, performance shares and accumulated dividends shall be distributed to the named executive officers based upon the degree of achievement of the performance goal at the end of the three year performance period, with an adjustment to the total shares calculated on a pro-rata basis, utilizing the number of full months from the beginning of the performance period to the date of retirement or disability, divided by 36 months.
In the event of termination of employment due to death, the target award amount will be calculated and distributed on a pro-rata basis utilizing the number of full months from the beginning of the performance period to the date of death, divided by 36 months regardless of performance results.
In the event of change of control, the performance shares including accumulated dividends will be calculated and distributed at the change of control date based upon the greater of the number of shares originally awarded at target level and the number of shares earned based upon actual performance through the change of control date.
The Merger Agreement provides that each outstanding share of our common stock (other than shares of our common stock owned by us as treasury stock or by a subsidiary of us, or by National Grid or a subsidiary of National Grid) will be converted into the right to receive $42.00 per share in cash, without interest,
or the "merger consideration." With respect to all outstanding options, upon consummation of the Merger all unvested options will immediately vest, and the holders of all options shall receive an amount in cash equal to the excess of the merger consideration over the exercise price per share applicable to all such outstanding stock options. With respect to shares of restricted stock and reinvested dividends, all restrictions on such stock will lapse upon consummation of the Merger. With respect to performance shares issued pursuant to our Incentive Plan, target performance levels will be assumed with respect to performance shares granted in 2005 and 2006 and, at such target performance, the target level of such shares and accumulated dividends will be paid. However, if actual performance levels through the date of change of control result in a greater number of shares than target, then such greater number of shares and accumulated dividends will be paid upon consummation of the change of control.
Options expire after a 10 year term if not otherwise exercised. None of the named executive officer options have expired prior to being exercised. As reflected in the above table, in 2006, Mr. Catell and Mr. Parker exercised options due to the approaching expiration date of those options.
The table above provides the present value ("PV") of the accrued pension benefit payable at age 65, or earlier if the named executive officer is eligible to receive an unreduced benefit at an earlier age. The benefit amounts provided reflect the PV of the accrued benefit as of December 31, 2006. The PV of the accrued benefits is referred to as Accumulated Benefits in the table above.
All amounts above were calculated based upon the pension plan measurement date used for our audited financial statements and financial reporting purposes under generally accepted accounting principles. A 6% discount rate and the mortality assumptions used at year-end in the plans were used in these calculations.
Under all of our pension plans and supplemental agreements, the earliest age a named executive officer may retire without a reduction to their pension benefit for age is age 60. However, if the named executive's age plus service is equal to 80 or greater, the named executive officer may retire as early as age 52 with no reduction for age. In this regard, the calculations provided in the 2006 Pension Benefits table assume early retirement with no reduction for age for Mr. Fani (age 53) and Mr. Parker (age 57) as of December 31, 2006. Mr. Catell (age 69) and Mr. Luterman (age 62) are also eligible for unreduced benefits as of December 31, 2006. Mr. Zelkowitz who is age 57 as of December 31, 2006 will not be eligible for an unreduced benefit until age 60. His accrued benefit calculation assumes his pension commences at age 60.
The KeySpan Retirement Plan is a qualified pension plan under ERISA and provides retirement benefits to employees who are vested and meet the plan's retirement eligibility age. The benefit formula for the named executives in the plan is consistent with the formula provided to all other management employees participating in the plan. The accrued benefit amount under this plan is calculated using base salary and annual incentive awards in the calculation of compensation under the plan. The accrued benefit is based upon the average of the final five consecutive years of compensation multiplied by 1.5% and length of service. This accrued amount, which is payable only as an annual annuity under the plan, has been converted to the PV amount using the methodology described above. The form of annuity used in this calculation reflects a lifetime annuity with no beneficiary option. The normal form of annuity option under the plan is a 50% joint and survivor option.
The named executive officers also participate in the KeySpan Supplemental Pension Plan. This supplemental plan is maintained to provide retirement benefits using the same broad based plan formula under the qualified KeySpan Retirement Plan to provide for accrued benefits that are in excess of IRC Code Sections 415 and 401(a)(17) and can not be paid pursuant to the KeySpan Retirement Plan. The accrued amount under this supplemental plan is also only payable as an annual annuity. The annual annuity has been been converted to PV amount in the table. The PV amount in the table has been calculated using the methodology described above. The form of annuity used in this calculation reflects a lifetime annuity with no beneficiary option. The normal form of annuity option under the plan is a 50% joint and survivor option.
Mr. Catell's supplemental pension benefit formula uses his base pay and annual incentive compensation in determining the pension benefit amount provided pursuant to his agreement. In this regard, Mr. Catell's cumulative base salary and highest annual bonus (as defined below) paid over any consecutive 36 month period is determined and then divided by three to determine an annual average amount. This annual average amount is then multiplied by 65%. The resulting amount is the gross annual pension benefit. The gross annual pension benefit is then reduced by several other pension amounts (i) 50% of Mr. Catell's primary social security amount; (ii) his KeySpan Retirement Plan benefit; and (iii) his KeySpan Supplemental Plan Benefit to determine his Agreement's supplemental
retirement benefit. This benefit is identified as the Supplemental Executive Retirement Plan Agreement benefit in the 2006 Pension Benefit Table. In the event his annual incentive target is decreased, Mr. Catell's supplemental pension benefit under the 2005 Agreement will be determined based upon the highest annual target level approved by our Board of Directors during his employment in the event his actual award in any year is less than his highest annual target. The normal form of benefit provided under the agreement is a 100% joint and survivor annuity with his spouse or the actuarial equivalent form of benefit including a single lump sum. Pursuant to the provision of the agreements, Mr. Catell has elected a lump sum option under both his 1998 and 2005 Agreements.
We have also entered into a Supplemental Retirement Agreement with Mr. Zelkowitz dated as of January 1, 2002. The agreement provides one added year of credited service for each year worked after completion of five years of service, up to a maximum of ten years in the calculation of his pension benefits. The maximum benefit would add 10 years of credited service providing an incremental benefit of 15% of his final five-year average earnings under the KeySpan Retirement and Supplemental plans. In addition, at retirement, Mr. Zelkowitz will receive medical and dental coverage at the same level of employee contribution in effect at retirement, with any amounts that may be subject to taxes grossed up for federal and state taxes. If Mr. Zelkowitz is terminated in connection with a change of control, based upon eight years of actual service through December 31, 2006, the agreement will provide additional credited service to the maximum of ten years.
We have also entered into a Supplemental Retirement Agreement with Mr. Luterman dated as of July 1, 2002. The agreement provides that Mr. Luterman will receive an annual supplemental retirement amount determined by multiplying Mr. Luterman's age 62 accrued benefit from the KeySpan Retirement Plan and the KeySpan Supplemental Pension Plan by 35%. Mr. Luterman vested in this benefit in June 2005. In addition, at retirement, Mr. Luterman will receive medical and dental coverage at the same level of employee contribution in effect at retirement, with any amounts that may be subject to taxes grossed up for federal and state taxes.
Employment Agreements Including Change of Control - Post Termination
In September 1998, we entered into an employment agreement with Mr. Catell relating to his service as Chairman and Chief Executive Officer, which was amended on February 24, 2000 and June 26, 2002 (the "1998 Agreement"). The agreement covered the period beginning July 31, 1998 and ending July 31, 2005. Effective January 1, 2005, we entered into a new agreement (the "2005 Agreement"), which supersedes the 1998 Agreement. The 2005 Agreement provided for Mr. Catell's continued employment until July 31, 2006. The 2005 Agreement also provides that the term of the agreement would be extended in the event of a change of control (as defined in the 2005 Agreement). Pursuant to the agreement, and as a result of the pending acquisition of KeySpan by National Grid, the term of the agreement has been extended until two years following the closing of the transaction.
Mr. Catell's employment agreement also provides for severance benefits to be paid to him in the event his employment is terminated by KeySpan without cause or if Mr. Catell terminates his employment for good reason. The severance benefits to be provided during the Severance Period (as defined below) include: (a) payment to Mr. Catell in a single lump sum of (i) all accrued obligations
(the accrued obligations include any base salary, annual or long-term incentive compensation actually earned but not yet paid through the date of termination, accrued but unpaid vacation pay, and any compensation previously deferred, inclusive of any accrued interest), and (ii) the aggregate amount of salary and annual incentive compensation that he would have received had he remained employed through the end of the employment period; (b) continued accrual of Supplemental Executive Retirement Plan benefits (as provided in the agreement) to the end of the term of the agreement; (c) continuation of all other employee benefits; and (d) acceleration of vesting of all equity awards, as if he had remained employed by KeySpan during the term of the agreement. If Mr. Catell voluntarily terminates his employment, other than for good reason, we will pay the accrued obligations to Mr. Catell and he shall be entitled to retire and receive all the pension benefits as provided under the various pension plans, as well as retiree medical and dental coverage provided under the group health plan. In addition, he is eligible for the benefits under the Executive Group Replacement Life Insurance Policy as described in the above Compensation Discussion and Analysis. If Mr. Catell is terminated without cause or resigns for good reason during the Protection Period, Mr. Catell will be provided with severance at a multiple of two times base salary and highest annual bonus, continued benefits and additional supplemental pension benefits accrual for the two year period following his termination. The highest annual bonus under the agreement is calculated based upon the higher of the average of the three most recent years of bonus received prior to the change of control and the most recently received annual bonus.
The protection period under his agreement begins on the date that we enter into a definitive agreement that would constitute a change of control transaction (as defined in the Change of Control Plan) and ends on the second anniversary of the date following consummation of such change of control.
Mr. Catell may resign for any reason in the thirteenth month following a change of control with all severance benefits. In the event that any payments or other severance benefits Mr. Catell receives from us or otherwise are subject to a parachute excise tax, then Mr. Catell will be entitled to a gross-up payment in order to put him in the same after-tax position he would have been in without the imposition of the excise tax.
In March 2006, we entered into a letter agreement with Mr. Luterman relating to his service as Executive Vice President and Chief Financial Officer. The letter agreement provides that in the event of his termination of employment as a result of the change of control of KeySpan, he would be entitled to separation benefits under the Change of Control Plan without regard to his age as of any date of termination or mandatory retirement age. Under the qualified pension plan, age 65 is the mandatory retirement age. The Change of Control Plan would have otherwise capped his separation benefit at this age.
Senior Executive Change of Control Severance Plan
On October 29, 2003, after a competitive market analysis and a due diligence review by an outside consultant, our Board of Directors authorized a five year extension of the Change of Control Plan. The Change of Control Plan expires October 30, 2008, unless extended for an additional period by our Board of Directors; provided that, following a change of control, the Change of Control Plan shall continue until after all the executives who become entitled to any payments or benefits thereunder shall have received such payments in full.
With the exception of Mr. Catell, all other named executive officers participate in the Change of Control Plan. The Change of Control Plan provides for the payment of severance and other benefits upon certain qualifying terminations of such executives within two (2) years of a "change of control" (as defined in the Change of Control Plan). The protection period under the Change of Control Plan commences upon the date that we enter into a definitive agreement contemplating a change of control and will continue for a period of two years after the effective date of the actual change of control. Upon the signing of the definitive Merger Agreement with National Grid, the protection period went into effect on February 25, 2006. The benefits payable under the Change of Control Plan provide for:
(i) the payment of the executive's base salary and compensation previously deferred by the executive, earned through the date of termination;
(ii) the payment of an amount equal to three times an executive's base salary and highest annual bonus (as defined in footnote 1 following the table below) for any President, any Executive Vice President and any Senior Vice President and two times an executive's base salary and highest annual bonus for Vice Presidents;
(iii) the payment of amounts under retirement plan formulas, including the applicable two to three year period as added service and compensation under the plans; and
(iv) the continuation of medical, dental and life insurance benefits for a period of two to three years depending on the executive's position with us.
In addition to severance benefits provided under the Change of Control Plan, the occurrence of a change of control will also result in the acceleration of vesting of all equity based awards under the provisions of the Incentive Plan.
Estimated Change of Control/Severance Payments
The following table shows the amount of potential severance benefits including potential gross-up amounts for excise taxes for the named executive officers pursuant to the Change of Control Plan, or in the case of Mr. Catell, his 2005 Agreement, and in the case of Mr. Luterman, his 2006 agreement, assuming a change of control took place in 2006 and the named executive officers were terminated on December 31, 2006. The table also shows the estimated present value of continuing coverage for the benefits provided under our group health, dental, executive life insurance and all retirement plans. The amounts indicated are applicable only in the event the named executive officers are not retained upon a change of control or they resign for good reason under the terms of the plan. Upon termination of employment, each named executive officer is eligible for outplacement benefits not to exceed $30,000.
Mr. Catell has agreed to serve as Deputy Chairman of National Grid and Executive Chairman of National Grid US8 for a two-year period following the change of control date. Assuming he serves in such capacities for such period, he will not be entitled to receive the severance benefits listed in the table below.
Likewise, in the event the other named executive officers continue their employment beyond a two-year protection period, they also will not be entitled to receive the payments listed in the table below. However, pursuant to the Change of Control Plan, an excise tax and gross-up payment of $2,146,137 and $1,195,864, regardless of their continued employment, will be made to Mr. Catell and Mr. Fani, respectively, as a result of the acceleration of vesting upon change of control associated with unvested options, restricted stock and performance shares.
(1) Cash severance benefit is a lump sum payment based on the annual base salary prior to termination plus the highest annual bonus times the severance multiple. Highest annual bonus is defined as the greater of the bonus most recently paid prior to the change of control or the average of the three prior years ("Highest Annual Bonus"). The lump sum also includes an amount which represents the Highest Annual Bonus prorated from January 1 to the date of termination divided by 365. The severance multiple for Mr. Catell pursuant to his employment agreement is two times while all other named executive officers listed above have a multiple of three times.
(2) Includes the cost of continuation of employee coverage for medical, dental and life insurance during the two year period for Mr. Catell and the three year period for all other named executive officers.
(3) Represents the present value of the increase in the annual lifetime pension annuity attributed to the added service and compensation associated with the two year period for Mr. Catell and the three year period for all other named executive officers.
(4) The executive officers are entitled to receive a gross-up payment to eliminate the effect on any "golden parachute" excise taxes that may be imposed on the executives under Sections 280G and 4999 of the Internal Revenue Code. This is a tax imposed on the executive above and beyond ordinary income taxes. The amount of such gross-up payment has been calculated taking into consideration the value of the all cash severance payments, the value of all benefits and the acceleration of equity awards attributed to change of control. This payment amount is provided to pay the excise taxes that may be imposed on the executive as well as any taxes on this gross-up check. All other federal, state and local income taxes that are attributed to the cash severance payments, benefits and equity awards will be paid by the executive.
(5) Mr. Catell's severance benefits are provided pursuant to his employment agreement dated January 1, 2005. Mr. Catell is not a participant in the Change of Control Plan.
The following table provides a summary of the value of unvested stock options, restricted stock and performance shares that vest upon a change of control.
Accelerated Vesting of Equity Awards Attributed to Change of Control
(1) The value of all unvested options reflects the difference between the exercise price of each unvested option and the closing price of our stock at the fiscal year end ($41.18 per share).
(2) The value of all unvested restricted shares reflects the closing price of our stock at fiscal year end ($41.18 per share) including reinvested dividends, with all restrictions assumed to be lapsed on December 31, 2006.
(3) The value of all unvested performance shares reflects shares granted in 2004, 2005 and 2006, and assumes that the shares and accumulated dividends vested at the target grant level at the closing price of our stock at fiscal year end ($41.18 per share). While the 2004 grant of performance shares would have vested under an assumed change of control on December 31, 2006, in actuality these shares and accumulated dividends thereon have been forfeited because the performance result required to vest this award as of December 31, 2006 was not achieved. The amounts forfeited by each named executive officer are as follows: Mr. Catell: $1,491,174; Mr. Luterman: $274,860; Mr. Fani: $633,334; Mr. Parker: $494,749; and Mr. Zelkowitz: $394,967.
(1) Reflects amounts deferred by each named executive officer to the ODSUP from the amount earned under the Corporate Plan for the purchase of our stock units. The amounts deferred would have been paid to each of the named executives in 2006 attributable to performance in 2005.
(2) Represents the 20% match on the amount deferred into the ODSUP.
(3) Includes dividends paid on shares held in the ODSUP. Dividends paid in the ODSUP are equal to dividends paid to all KeySpan stockholders and therefore, no amount is preferential or above the market rate. Since dividends paid in the ODSUP are not above the market rate, earnings on the ODSUP are not included in the Summary Compensation Table, but rather, are included in this column in its entirety.
(4) Aggregate balance of deferred compensation represents amounts previously deferred by the named executive officers and any earnings thereon. The ODSUP shares have been valued at the full market value closing price of our stock per share at fiscal year end ($41.18 per share).
(5) Also includes earnings on amounts deferred pursuant to the Deferred Compensation Plan.
Officers' Deferred Stock Unit Plan - ----------------------------------
Pursuant to the ODSUP and consistent with our desire to encourage increased officer stock ownership to further align the interests of our executives and stockholders, the named executive officers and certain other executives may elect to defer between 10% and 50% of their annual cash award earned under the Corporate Plan to deferred stock units held within the ODSUP. The deferred stock units track the performance of our common stock but do not possess voting rights. The deferred stock units receive dividends which accumulate during the deferral period.
Executives also receive a 20% match from us on the amounts deferred in each year, which amounts are reported in the All Other Compensation column of the Summary Compensation Table. The match component and dividends on the deferral will track the performance of our common stock and will generally be payable in cash upon retirement. Amounts held within the ODSUP must be deferred until retirement or resignation and are payable in common stock for the amounts deferred by the executive, and either in stock or cash for the match component and dividends. In the event of the executive's resignation prior to retirement, the match and dividends are forfeited. Each of the named executive officers elected to defer the following amounts of their annual cash awards payable in 2006 (attributable to 2005 performance) and 2007 (attributable to 2006 performance), respectively:
2006 2007 ---- ----
Mr. Catell 50% 50%
Mr. Fani 25% 25%
Mr. Parker 50% 50%
Mr. Zelkowitz 50% 50%
Mr. Luterman 50% 40%
Upon a change in control, all deferred stock units, the match and accumulated dividends will be converted to cash and distributed to the executives pursuant to the plan provisions as permitted under Internal Revenue Code section 409A.
Deferred Compensation Plan - --------------------------
Pursuant to the Deferred Compensation Plan, by December 31st of each year, each eligible executive and management employee may elect to defer receipt of between 1% and 10% of the following year's base pay. Deferred compensation for each participant shall be credited to an account on our books (the "Deferred Account"). Interest on amounts in a Deferred Account shall be credited and compounded monthly based on the average reference rate during such month (the "Prime Rate").
In the event of an executive's separation from service, the amounts in the executive's Deferred Account shall be distributed consistent with the distribution election made by the executive and as permitted under Internal Revenue Code section 409A.
Mr. Catell and Mr. Luterman maintain a balance in this plan while the other named executive officers do not participate in this plan.
(1) Messrs. Catell and Fani are not listed in the above table because neither receives any additional compensation for serving on our board of directors or its committees.
(2) Stock awards are received as common stock equivalents pursuant to the Directors' Deferred Compensation Plan.
(3) Includes $48,900 elected by the director to be received as a stock equivalent and deferred pursuant to the Directors' Deferred Compensation Plan.
(4) Includes $35,250 elected by the director to be received as a stock equivalent and deferred pursuant to the Directors' Deferred Compensation Plan.
(5) Includes $18,875 elected by the director to be received as a stock equivalent and deferred pursuant to the Directors' Deferred Compensation Plan.
(6) Includes $63,500 elected by the director to be received as a stock equivalent and deferred pursuant to the Directors' Deferred Compensation Plan.
(7) Includes $40,750 elected by the director to be received as a stock equivalent and deferred pursuant to the Directors' Deferred Compensation Plan.
(8) Includes $70,500 elected by the director to be received as a stock equivalent and deferred pursuant to the Directors' Deferred Compensation Plan.
(9) Includes $69,500 elected by the director to be received as a stock equivalent and deferred pursuant to the Directors' Deferred Compensation Plan.
The directors' compensation as reflected in the table above includes the following amounts:
Non-employee directors:
$43,500 annual retainer; $2,000 committee meeting fee; $5,000 committee chairman retainer; $10,000 audit committee chairman retainer; $10,000 Lead Director retainer; and $64,000 in common stock equivalents granted under the Directors' Deferred Compensation Plan.
The employee directors receive no additional compensation for serving on the Board or its committees.
The board of directors has adopted Directors' Deferred Compensation Plans (pre 2005 and post 2005 plans) to directly align the non-employee directors' financial interest with those of the shareholders. The Directors' Deferred Compensation Plans provide all non-employee directors with the opportunity to defer any portion of their cash compensation received as directors, in exchange for common stock equivalents or into a deferred cash account. Common stock equivalents are valued by utilizing the average of the high and low price per share of our common stock on the first trading day of the quarter following the quarter in which contributions are received. Dividends are paid on common stock equivalents in additional common stock equivalents in the same proportion as dividends paid on common stock. Compensation not deferred and exchanged for common stock equivalents may be deferred into a cash account bearing interest at the prime rate. Additionally, a director may elect to invest his or her compensation by participating in the KeySpan Investor Program (a dividend reinvestment plan). Upon retirement, death or termination of service as a director, all amounts in a director's common stock equivalent account and/or cash account shall, at the director's election, (i) be paid in a lump sum in cash; (ii) be deferred for up to five years; and/or (iii) be paid in the number of annual installments, up to ten, specified by the director. Our current non-employee directors are not entitled to benefits under any of our retirement plan.
With the exception of Ms. Christensen, each listed director elected to defer a portion or all of his or her cash earnings for 2006 into stock equivalents under the Directors' Deferred Compensation Plans. No director elected to defer any compensation into the deferred cash account under the Directors' Deferred Compensation Plans.
Compensation Committee Interlocks and Insider Participation
Neither Ms. Larson nor Messrs. Jones, Larocca, McKessy and Miller, the current members of the Committee, is an officer or employee, or former officer or employee, of us or any of our subsidiaries. No interlocking relationship exists between the members of our Board of Directors or the Committee and the compensation committee, or board committee performing equivalent functions, of any other company, nor has any such interlocking relationship existed in the past.
Compensation Committee Report
Under the rules of the New York Stock Exchange and the Sarbanes-Oxley Act of 2002, the Board of Directors must determine that each member of the Committee is independent under all applicable standards. Additionally, no director may serve unless he or she is a "Non-employee Director" for purposes of Rule 16b-3 under the Securities Exchange Act of 1934, as amended, and satisfies the requirements of an "outside director" for purposes of Section 162 (m) of the Internal Revenue Code. The members of the Committee are James R. Jones, James L. Larocca, Gloria C. Larson, Stephen W. McKessy and Edward D. Miller serving as chairperson. None of such members is or has been an officer or employee of KeySpan or any of its subsidiaries and they meet the required standards of independence. The Committee operates under a written charter adopted by the Board of Directors which is available on our internet site at http://www.keyspanenergy.com.
The Committee has reviewed and discussed the Company's Compensation Discussion and Analysis with management at meetings held on December 24, 2006, January 24, 2007 and February 20, 2007. Based on the review and discussions, the Committee recommended to the Board of Directors that the Compensation Discussion and Analysis be included in our annual report on Form 10-K.
Compensation and Management Development Committee
James R. Jones Stephen W. McKessy
James L. Larocca Edward D. Miller, Chairperson
Gloria C. Larson
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Security Ownership of Certain Beneficial Owners
As of February 20, 2007, there were no beneficial owners of more than 5% of our common stock.
Security Ownership of Management
The following table sets forth information as of February 20, 2007, with respect to the number of shares of common stock beneficially owned (including vested stock options), common stock equivalents and/or deferred stock units and performance shares credited to each director, each named executive officer and all directors and executive officers as a group.
* Messrs. Catell and Fani are also directors
** Less than 1%.
(1) Beneficial ownership of common stock includes holdings in KeySpan's 401(k) Plan, Employee Discount Stock Purchase Plan, Dividend Reinvestment Plan, and/or in other stock accounts, as well as issued and outstanding vested stock options. Such stock options give the holder the right to purchase underlying shares of common stock at the respective exercise price per share of the option. All such stock options were granted at an exercise price equal to the closing price of our common stock on the respective date of grant.
(2) Includes common stock equivalents or deferred stock units. The term "common stock equivalents" refers to units of value which track the performance of common stock. Such units do not possess voting rights and have been issued pursuant to the Directors' Deferred Compensation Plans. The term "deferred stock units" also refers to units of value which track the performance of common stock. Such units do not possess voting rights and have been issued pursuant to the Officers' Deferred Stock Unit Plans.
(3) Performance shares have been granted with a three-year performance period with a threshold, target and maximum performance level. At threshold performance, 50% of the award shall be earned; at target, 100% of the award shall be earned; and at maximum, 150% of the award shall be earned. The number of shares set forth above assumes the target level of performance with a 100% payout.
(4) Calculated as the total of the three previous columns divided by 175,588,130 the number of shares outstanding on February 20, 2007.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, and DIRECTOR INDEPENDENCE
Please see Item 11. Executive Compensation for a description of our employment and change of control agreements and plans.
Directors and Officers Liability Insurance and Indemnity
We have director and officer, or "D&O" liability insurance for the purpose of reimbursing us when we have indemnified our directors and officers. D&O liability insurance also provides direct payment to our directors and officers under certain circumstances when we have not previously provided indemnification. We also have liability insurance which provides fiduciary coverage for us, our directors, officers and employees for any alleged breach of fiduciary duty under the Employee Retirement Income Security Act. Our D&O liability insurance was purchased from Associated Electric & Gas Insurance Services, Energy Insurance Mutual, Zurich American, Hartford, Starr Excess, St. Paul Mercury Insurance Co. and Liberty Mutual for a one year period commencing on May 28, 2006 at a cost of $3,483,325. Fiduciary liability insurance from the American International Group, CHUBB, Zurich American and Energy Insurance Mutual for a one year period commencing on August 26, 2006 at a cost of $733,207. We plan to renew both programs upon expiration.
Director Independence
Pursuant to our Corporate Governance Guidelines, which can be found on the Investor Relations section of our website at http://www.keyspanenergy.com or directly on our corporate governance website (http://governance.keyspanenergy.com), our board undertook a review of director independence. As a result of this review, our board affirmatively determined that all of the directors are independent under the standards set forth in the Corporate Governance Guidelines, and the relevant NYSE and SEC rules and regulations, with the exception of Robert B. Catell and Robert J. Fani. Mr. Catell cannot be deemed independent under the Corporate Governance Guidelines or applicable rules and regulations because he serves as Chief Executive Officer of the Corporation. Mr. Fani cannot be deemed independent under the Corporate Governance Guidelines or applicable rules and regulations because he serves as Chief Operating Officer and President of the Corporation.
The basis for our board's determination that the independent directors are indeed independent is set forth in our Corporate Governance Guidelines and is set forth, in relevant part, below:
At all times, a majority of the directors shall be independent directors under the rules of the NYSE and the Sarbanes-Oxley Act of 2002 and the regulations promulgated thereunder. The following guidelines are established to assist our board in determining the independence of a director:
a. A director will not be considered independent if, within the preceding three years: (i) the director was employed by KeySpan or one of its subsidiaries; (ii) an immediate family member of the director was employed by KeySpan as an officer; (iii) the director received more than $100,000 in direct compensation from KeySpan or its subsidiaries, other than for board service or pension or deferred compensation; (vi) an immediate family member of the director received more than $100,000 in direct compensation from KeySpan or its subsidiaries, other than for Board service or pension or deferred compensation; (v) the director was employed by or affiliated with KeySpan's independent auditor; (vi) an immediate family member of the director was employed by KeySpan's independent auditor; (vii) the director was employed as an executive officer of another company where any of KeySpan's officers serve on that company's compensation committee; or (viii) an immediate family member of the director was employed as an executive officer of another company where any of KeySpan's officers serve on that company's compensation committee;
b. A director will not be considered independent if: (i) the director or an immediate family member of the director currently serves as an executive officer of another company that does business with KeySpan and the annual sales to, or purchases from, KeySpan in any of the preceding three years, exceeds the greater of $1 million or two percent of the annual consolidated gross revenues of the company; (ii) the director is an executive officer of another company which is indebted to KeySpan, or to which KeySpan is indebted, and the total amount of either company's indebtedness to the other is greater than one percent of the total consolidated assets of the company he or she serves as an executive officer; and (iii) if a director serves as an officer, director or trustee of a tax exempt organization, and KeySpan's charitable contributions to the organization are greater than $1 million or two percent of that organization's total consolidated gross revenues. The Board will annually review all commercial and charitable relationships of the directors.
For relationships not covered by the guidelines in subsection (b) above, the determination of whether the relationship is material or not, and therefore whether the director would be independent or not, shall be made by the directors who satisfy the independence guidelines set forth in subsections (a) and (b) above. For example, if a director is the chief executive officer of a company that purchases products and services from KeySpan that are not more than two percent of that company's annual revenues, the independent directors could determine, after considering all of the relevant circumstances, whether such a relationship was material or immaterial, and whether the director would therefore be considered independent.
KeySpan will not make any personal loans or extensions of credit to directors or officers.
Our directors complete and submit an annual director questionnaire to identify and assess relationships so that the entire Board can determine independence under these standards. The directors also complete and submit an annual statement that they are in compliance with our Corporate Policy Statement Concerning Ethical Business Conduct and our Corporate Policy Statement Concerning Affiliate Transactions. The directors also annually certify that they have, and continue to agree to comply with, the KeySpan Corporation Board Of Directors Code of Ethics which sets forth standards of diligence, loyalty, good faith and the avoidance of conflicts of interests for the directors.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The following table provides information on the aggregate fees for services performed by Deloitte & Touche LLP ("Deloitte & Touche"), the member firms of Deloitte & Touche Tohmatsu, and their respective affiliates for the years ended December 31, 2006 and December 31, 2005:
2006 2005 ---- ----
Audit Fees (a) $ 4,164,594 $ 3,682,325 Audit-Related Fees (b) 96,200 88,000 Tax Fees (c) 318,419 385,522 All Other Fees (d) 132,010 50,121 ------------ --------------- Total $ 4,711,223 $ 4,205,968
(a) In 2006, audit fees include base fees for the annual and statutory financial statement audits, audit of internal control over financial reporting, and quarterly reviews of $3,509,100 and fees for consultations on financial accounting standards as part of the audit of $655,494. In 2005, audit fees include base fees for the annual and statutory financial statement audits, audit of internal control over financial reporting, and quarterly reviews of $3,212,089; $185,498 for fees related to financings and fees for consultations on financial accounting standards as part of the audit of $284,738.
(b) Audit-related fees include benefit plan audits.
(c) Fees for tax services billed in 2006 and 2005 consisted of tax compliance, tax consultation services and software licensing. Fees for tax compliance services totaled $192,928 and $313,738 in 2006 and 2005, respectively. Tax compliance services include services such as assistance with federal, state and local income tax returns. Fees for tax consultation services and software licensing totaled $125,491 and $71,784 in 2006 and 2005, respectively.
(d) Other fees include training.
In accordance with the Audit Committee Charter and the rules and regulations of the SEC, the Audit Committee reviews the scope of the audit and approves the nature and cost of all services provided by Deloitte & Touche. The Audit Committee has reviewed the nature and scope of the services provided by Deloitte & Touche and considers such to have been compatible with the maintenance of Deloitte & Touche's independence throughout its service to KeySpan.
The Audit Committee has also determined that the scope of services to be provided by Deloitte & Touche in 2007 will generally be limited to audit and audit related services and tax services. The Audit Committee will expressly approve the provision of any services by Deloitte & Touche outside the scope of the foregoing services. Although it is the intent of the Audit Committee to pre-approve all non-audit services to be provided by Deloitte & Touche, any inadvertent failure to do so will not be deemed a breach of the Audit Committee charter if: (i) the aggregate amount of all such non-audit services provided to the Corporation constitutes not more than five percent of the total amount of revenues paid by the Corporation to its auditor during the fiscal year in which the non-audit services are provided; (ii) such services were not recognized by the Corporation at the time of the engagement to be non-audit services; and (iii) such services are promptly brought to the attention of the Committee and approved prior to the completion of the audit by the Committee or its Chairman pursuant to delegated authority.
PART IV -------
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) Required Documents
1. Financial Statements
The following consolidated financial statements of KeySpan and its subsidiaries and Reports of the Independent Registered Public Accounting Firm are included in Item 8 and are filed as part of this Report:
o Consolidated Statement of Income for the year ended December 31, 2006, the year ended December 31, 2005, and the year ended December 31, 2004
o Consolidated Statement of Retained Earnings for the year ended December 31, 2006, the year ended December 31, 2005, and the year ended December 31, 2004
o Consolidated Balance Sheet at December 31, 2006 and December 31, 2005
o Consolidated Statement of Capitalization at December 31, 2006 and December 31, 2005
o Consolidated Statement of Cash Flows for the year ended December 31, 2006, the year ended December 31, 2005, and the year ended December 31, 2004
o Consolidated Statement of Comprehensive Income for the Year ended December 31, 2006, the year ended December 31, 2005 and the year ended December 31, 2004
o Notes to Consolidated Financial Statements
o Report of the Independent Registered Public Accounting Firm
2. Financial Statement Schedules
Consolidated Schedule of Valuation and Qualifying Accounts for the year ended December 31, 2006, the year ended December 31, 2005, and the year ended December 31, 2004.
* Reflects adjustment for discontinued operations.
All other schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto.
(b) Exhibits
Exhibits listed below which have been filed with the SEC pursuant to the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, and which were filed as noted below, are hereby incorporated by reference and made a part of this report with the same effect as if filed herewith.
2.1 Agreement and Plan of Merger, dated as of February 25, 2006, by and among National Grid plc, National Grid US8 Inc. and KeySpan Corporation (filed as Exhibit 2.1 to KeySpan's Form 8-K dated March 1, 2006)
3.1 Certificate of Incorporation of KeySpan effective April 16, 1998, Amendment to Certificate of Incorporation of KeySpan effective May 26, 1998, Amendment to Certificate of Incorporation of KeySpan effective June 1, 1998, Amendment to the Certificate of Incorporation of KeySpan effective April 7, 1999 and Amendment to the Certificate of Incorporation of KeySpan effective May 20, 1999 (filed as Exhibit 3.1 to KeySpan's Form 10-Q for the quarterly period ended June 30, 1999)
3.2 By-Laws of KeySpan in effect as of June 25, 2003, as amended (filed as Exhibit 3.1 to KeySpan's Form 10-Q for the quarterly period ended June 30, 2003)
4.1 Credit Agreement dated as of June 24, 2005 among KeySpan Corporation, the several lenders, The Royal Bank of Scotland PLC and Citibank, N.A., as Co-Syndication Agents, The Bank of New York and The Bank of Nova Scotia, as Co-Documentation Agents, and JPMorgan Chase Bank, N.A., as Administrative Agent (filed as Exhibit 4.1 to KeySpan's Form 8-K dated as of June 29, 2005)
4.2 Amended and Restated Credit Agreement dated as of June 24, 2005 among KeySpan Corporation, the several lenders, The Royal Bank of Scotland PLC and Citibank, N.A., as Co-Syndication Agents, The Bank of New York and The Bank of Nova Scotia, as Co-Documentation Agents, and JPMorgan Chase Bank, N.A., as Administrative Agent (filed as Exhibit 4.2 to KeySpan's Form 8-K dated as of June 29, 2005)
4.3 Indenture, dated as of November 1, 2000, between KeySpan Corporation and the Chase Manhattan Bank, as Trustee, with respect to the issuance of Debt Securities (filed as Exhibit 4-a to Amendment No. 1 to Form S-3 Registration Statement No. 333-43768 and filed as Exhibit 4-a to KeySpan's Form 8-K on November 20, 2000)
4.4 Form of Note issued in connection with the issuance of the KeySpan Corporation $700 million of 7.625% Notes due 2010 issued on November 20, 2000 (filed as Exhibit 4-c to KeySpan's Form 8-K on November 20, 2000)
4.5 Form of Note issued in connection with the issuance of the KeySpan Corporation $250 million of 8.0% Notes due 2030 issued on November 20, 2000 (filed as Exhibit 4-d to KeySpan's Form 8-K on November 20, 2000)
4.6 Form of Note issued in connection with the issuance of the KeySpan Corporation $150 million of 4.65% Notes issued on April 1, 2003 (filed as Exhibit 4.1 to KeySpan's Form 8-K dated as of April 8, 2003)
4.7 Form of Note issued in connection with the issuance of the KeySpan Corporation $150 million of 5.875% Notes issued on April 1, 2003 (filed as Exhibit 4.2 to KeySpan's Form 8-K dated as of April 8, 2003)
4.8 Form of Note issued in connection with the issuance of the KeySpan Corporation $307.2 million of 5.803% Notes issued on March 29, 2005 (filed as Exhibit 4.1 to KeySpan's Form 8-K dated as of March 31, 2005)
4.9 Supplemental Remarketing Agreement dated as of March 21, 2005 among KeySpan Corporation, J.P. Morgan Securities Inc. and JPMorgan Chase Bank, N.A. in connection with the remarketing of the 4.9% Notes due 2008 (filed as Exhibit 99.1 to KeySpan's Form 8-K dated as of March 24, 2005)
4.10 Indenture, dated December 1, 1999, between KeySpan and KeySpan Gas East Corporation, the Registrants, and the Chase Manhattan Bank, as Trustee, with respect to the issuance of Medium-Term Notes, Series A, (filed as Exhibit 4-a to Amendment No. 1 to KeySpan's and KeySpan Gas East Corporation's Form S-3 Registration Statement No. 333-92003)
4.11 Form of Medium-Term Note issued in connection with the issuance of KeySpan Gas East Corporation 7 7/8% Notes issued on February 1, 2000 (filed as Exhibit 4 to KeySpan's Form 8-K on February 1, 2000)
4.12 Form of Medium-Term Note issued in connection with the issuance of KeySpan Gas East Corporation 6.9% Notes issued on January 19, 2001 (filed as Exhibit 4.3 to KeySpan's Form 10-K for the year ended December 31, 2000)
4.13 Participation Agreement, dated as of July 1, 1991, between New York State Energy Research and Development Authority ("NYSERDA") and The Brooklyn Union Gas Company relating to the Gas Facilities Revenue Bonds ("GFRBs") Series 1991A and 1991B (The Brooklyn Union Gas Company Project) (filed as Exhibit 4 to The Brooklyn Union Gas Company's Form 10-K for the year ended September 30, 1991)
4.14 Indenture of Trust, dated as of July 1, 1991, between NYSERDA and Manufacturers Hanover Trust Company, as Trustee, relating to the GFRBs Series 1991A and 1991B (The Brooklyn Union Gas Company Project) (filed as Exhibit 4 to The Brooklyn Union Gas Company's Form 10-K for the year ended September 30, 1991)
4.15 Participation Agreement, dated as of July 1, 1992, between NYSERDA and The Brooklyn Union Gas Company relating to the GFRBs Series 1993A and 1993B (The Brooklyn Union Gas Company Project) (filed as Exhibit 4 to The Brooklyn Union Gas Company's Form 10-K for the year ended September 30, 1992)
4.16 Indenture of Trust, dated as of July 1, 1992, between NYSERDA and Chemical Bank, as Trustee, relating to the GFRBs Series 1993A and 1993B (The Brooklyn Union Gas Company Project) (filed as Exhibit 4 to The Brooklyn Union Gas Company Form 10-K for the year ended September 30, 1992)
4.17 Participation Agreement dated as of July 1, 1991 between NYSERDA and The Brooklyn Union Gas Company relating to the GFRBs Series D (The Brooklyn Union Gas Company Project) (filed as Exhibit 4 to The Brooklyn Union Gas Company's Form 10-K for the year ended September 30, 1991)
4.18 First Supplemental Participation Agreement dated as of June 1, 1993 between NYSERDA and The Brooklyn Union Gas Company relating to GFRBs Series D (The Brooklyn Union Gas Company Project) (filed as Exhibit 4 to The Brooklyn Union Gas Company's Form 10-K for the year ended September 30, 1993)
4.19 Trust Indenture, dated as of July 1, 1991 between NYSERDA and Manufacturers Hanover Trust Company relating to the GFRBs Series D (filed as Exhibit 4 to The Brooklyn Union Gas Company's Form 10-K for the year ended September 30, 1991)
4.20 First Supplemental Trust Indenture, dated as of June 1, 1993 between NYSERDA and Chemical Bank (as successor to Manufacturers Hanover Trust Company) relating to the GFRBs Series D (filed as Exhibit 4 to The Brooklyn Union Gas Company's Form 10-K for the year ended September 30, 1993)
4.21 Participation Agreement, dated January 1, 1996, between NYSERDA and The Brooklyn Union Gas Company relating to GFRBs Series 1996 (The Brooklyn Union Gas Company Project) (filed as Exhibit 4 to The Brooklyn Union Gas Company's Form 10-K for the year ended September 30, 1996)
4.22 Indenture of Trust, dated January 1, 1996, between NYSERDA and Chemical Bank, as Trustee, relating to GFRBs Series 1996 (The Brooklyn Union Gas Company Project) (filed as Exhibit 4 to The Brooklyn Union Gas Company's Form 10-K for the year ended September 30, 1996)
4.23 Participation Agreement, dated as of January 1, 1997, between NYSERDA and The Brooklyn Union Gas Company relating to GFRBs 1997 Series A (The Brooklyn Union Gas Company Project) (filed as Exhibit 4 to The Brooklyn Union Gas Company's Form 10-K for the year ended September 30, 1997)
4.24 Indenture of Trust, dated January 1, 1997, between NYSERDA and Chase Manhattan Bank, as Trustee, relating to GFRBs 1997 Series A (The Brooklyn Union Gas Company Project) (filed as Exhibit 4 to The Brooklyn Union Gas Company's Form 10-K for the year ended September 30, 1997)
4.25 Supplemental Trust Indenture, dated as of January 1, 2000, by and between NYSERDA and The Chase Manhattan Bank, as Trustee, relating to the GFRBs 1997 Series A (The Brooklyn Union Gas Company Project) (filed as Exhibit 4.11 to KeySpan's Form 10-K for the year ended December 31, 1999)
4.26 Bond Purchase Agreement, dated as of October 26, 2005, among The Brooklyn Union Gas Company and NYSERDA and Morgan Stanley & Co. Incorporated, BNY Capital Markets, Inc., Sovereign Securities Corporation, LLC and The Williams Capital Group, L.P., as Series A Underwriters, for the issuance of $82 million aggregate principal amount of 4.7% GFRBs, 2005, Series A. (The Brooklyn Union Gas Company Project) (filed as Exhibit 10.1 to KeySpan's Form 8-K dated November 1, 2005)
4.27 Indenture of Trust, dated as of November 1, 2005, between NYSERDA and Citibank, N.A., as Trustee, relating to the issuance of $82 million GFRBs, 2005 Series A, 4.7% due February 2024 (The Brooklyn Union Gas Company Project) (filed as Exhibit 10.1 to KeySpan's Form 10-Q for the quarterly period ended September 30, 2005)
4.28 Participation Agreement, dated as of November 1, 2005, between NYSERDA and The Brooklyn Union Gas Company relating to the issuance of $82 million GFRBs, 2005 Series A, 4.7% due February 2024 (filed as Exhibit 10.2 to KeySpan's Form 10-Q for the quarterly period ended September 30, 2005)
4.29 Promissory Note, dated as of November 1, 2005, executed by the Brooklyn Union Gas Company for issuance of $82 million GFRBs, 2005 Series A, 4.7% due February 2024 (filed as Exhibit 10.3 to KeySpan's Form 10-Q for the quarterly period ended September 30, 2005)
4.30 Bond Purchase Agreement, dated as of October 26, 2005, among The Brooklyn Union Gas Company and NYSERDA and Goldman Sachs & Co., BNY Capital Markets, Inc., Sovereign Securities Corporation, LLC and The Williams Capital Group, L.P., as Series A Underwriters, for the issuance of $55 million aggregate principal amount of GFRBs, 2005, Series B (filed as Exhibit 10.2 to KeySpan's Form 8-K dated November 1, 2005)
4.31 Indenture of Trust, dated as of November 1, 2005, between NYSERDA and Citibank, N.A., as Trustee, relating to the issuance of $55 million GFRBs, 2005 Series B due June 2025 (filed as Exhibit 10.4 to KeySpan's Form 10-Q for the quarterly period ended September 30, 2005)
4.32 Participation Agreement, dated as of November 1, 2005, between NYSERDA and The Brooklyn Union Gas Company relating to the issuance of $55 million GFRBs, 2005 Series B, due February 2025 (filed as Exhibit 10.5 to KeySpan's Form 10-Q for the quarterly period ended September 30, 2005)
4.33 Promissory Note, dated as of November 1, 2005, executed by the Brooklyn Union Gas Company for the issuance of $55 million GFRBs, 2005 Series B, due June 2025 (filed as Exhibit 10.6 to KeySpan's Form 10-Q for the quarterly period ended September 30, 2005)
4.34 Letter of Credit and Reimbursement Agreement, dated December 9, 2003, by and between KeySpan Generation LLC and Royal Bank of Scotland Bank PLC (filed as Exhibit 4.34 to KeySpan's Form 10-K for the year ended December 31, 2003)
4.35 Participation Agreement dated as of December 1, 1997 by and between NYSERDA and Long Island Lighting Company relating to the 1997 Electric Facilities Revenue Bonds ("EFRBs"), Series A (KeySpan Generation LLC) (filed as Exhibit 10(a) to KeySpan's Form 10-Q for the quarterly period ended September 30, 1998)
4.36 Indenture of Trust, dated as of December 1, 1997, by and between NYSERDA and The Chase Manhattan Bank, as Trustee, relating to the 1997 EFRBs, Series A (KeySpan Generation LLC) (filed as Exhibit 10(a) to KeySpan's Form 10-Q for the quarterly period ended September 30, 1998)
4.37 Participation Agreement, dated as of October 1, 1999, by and between NYSERDA and KeySpan Generation LLC relating to the 1999 Pollution Control Refunding Revenue Bonds ("PCRB's"), Series A (filed as Exhibit 4.10 to KeySpan's Form 10-K for the year ended December 31, 1999)
4.38 Trust Indenture, dated as of October 1, 1999, by and between NYSERDA and The Chase Manhattan Bank, as Trustee, relating to the 1999 PCRBs, Series A (filed as Exhibit 4.10 to KeySpan's Form 10-K for the year ended December 31, 1999)
4.39 Indenture, dated as of December 1, 1989, between Boston Gas Company and The Bank of New York, as Trustee (filed as Exhibit 4.2 to Boston Gas Company's Form S-3 (File No. 33-31869))
4.40 Second Amended and Restated First Mortgage Indenture for Colonial Gas Company, dated as of June 1, 1992 (filed as Exhibit 4(b) to Colonial Gas Company's Form 10-Q for the quarter ended June 30, 1992)
4.41 First Supplemental Indenture for Colonial Gas Company dated as of June 15, 1992 (filed as Exhibit 4(c) to Colonial Gas Company's Form 10-Q for the quarter ended June 30, 1992)
4.42 Second Supplemental Indenture for Colonial Gas Company dated as of September 27, 1995 (filed as Exhibit 4(c) to Colonial Gas Company's Form 10-K for the fiscal year ended December 31, 1995)
4.43 Amendment to Second Supplemental Indenture for Colonial Gas Company dated as of October 12, 1995 (filed as Exhibit 4(d) to Colonial Gas Company's Form 10-K for the fiscal year ended December 31, 1995)
4.44 Third Supplemental Indenture for Colonial Gas Company dated as of December 15, 1995 (filed as Exhibit 4(f) to Colonial Gas Company's Form S-3 Registration Statement dated January 5, 1998)
4.45 Fourth Supplemental Indenture for Colonial Gas Company dated as of March 1, 1998 (filed as Exhibit 4(l) to Colonial Gas Company's Form 10-Q for the quarter ended March 31, 1998)
4.46 Trust Agreement, dated as of June 22, 1990, between Colonial Gas Company, as Trustor, and Shawmut Bank, N.A., as Trustee (filed as Exhibit 10(d) to Colonial Gas Company's Form 10-Q for the quarterly period ended June 30, 1990)
4.47 Lease Agreement, dated as of November 1, 2003, by and between the Suffolk County Industrial Development Agency and KeySpan-Port Jefferson Energy Center, LLC (filed as Exhibit 4.14-a to KeySpan's Form 10-K for the year ended December 31, 2003)
4.48 Company Lease Agreement, dated as of November 1, 2003, by and between KeySpan-Port Jefferson Energy Center, LLC and the Suffolk County Industrial Development Agency (filed as Exhibit 4.14-b to KeySpan's Form 10-K for the year ended December 31, 2003)
4.49 Guaranty, dated as of November 26, 2003, from KeySpan Corporation to the Suffolk County Industrial Development Agency (filed as Exhibit 4.14-c to KeySpan's Form 10-K for the year ended December 31, 2003)
4.50 Lease Agreement, dated as of November 1, 2003, by and between the Nassau County Industrial Development Agency and KeySpan-Glenwood Energy Center, LLC (filed as Exhibit 4.15-a to KeySpan's Form 10-K for the year ended December 31, 2003)
4.51 Company Lease Agreement, dated as of November 1, 2003, by and between KeySpan-Glenwood Energy Center, LLC and the Nassau County Industrial Development Agency (filed as Exhibit 4.15-b to KeySpan's Form 10-K for the year ended December 31, 2003)
4.52 Guaranty, dated as of November 26, 2003, from KeySpan Corporation to the Nassau County Industrial Development Agency (filed as Exhibit 4.14-c to KeySpan's Form 10-K for the year ended December 31, 2003)
4.53 Lease Agreement, dated June 9, 1999, between KeySpan-Ravenswood, LLC and LIC Funding, Limited Partnership (filed as Exhibit 10.2 to KeySpan's Form 10-Q for the quarterly period ended June 30, 1999)
4.54 First Amendment to the Lease Agreement between KeySpan-Ravenswood, LLC and LIC Funding, Limited Partnership, dated as of June 27, 2002 (filed as Exhibit 10.25 to KeySpan's Form 10-K for the year ended December 31, 2002)
4.55 KeySpan Corporation Guaranty dated June 9, 1999, from KeySpan in favor of LIC Funding, Limited Partnership (filed as Exhibit 10.1 to KeySpan's Form 10-Q for the quarterly period ended June 30, 1999)
4.56 KeySpan Corporation Guaranty dated May 25, 2004, relating to the 250 MW Ravenswood Expansion (filed as Exhibit 10.1 to KeySpan's Form 10-Q for the quarterly period ended June 30, 2004)
4.57 Facility Lease Agreement, dated as of May 25, 2004, between SE Ravenswood Trust, a Delaware statutory trust, and KeySpan-Ravenswood, LLC relating to the 250 MW Ravenswood Expansion(filed as Exhibit 10.2 to KeySpan's Form 10-Q for the quarterly period ended June 30, 2004)
4.58 Site Lease and Easement Agreement, dated as of May 25, 2004, between KeySpan-Ravenswood, LLC and SE Ravenswood Trust relating to the 250 MW Ravenswood Expansion (filed as Exhibit 10.3 to KeySpan's Form 10-Q for the quarterly period ended June 30, 2004)
4.59 Site Sublease, dated as of May 25, 2004, between SE Ravenswood Trust and KeySpan-Ravenswood, LLC relating to the 250 MW Ravenswood Expansion (filed as Exhibit 10.4 to KeySpan's Form 10-Q for the quarterly period ended June 30, 2004)
4.60 Amendment, Assignment and Assumption Agreement, dated as of September 29, 1997, by and among The Brooklyn Union Gas Company, Long Island Lighting Company and KeySpan Energy Corporation (filed as Exhibit 2.5 to Schedule 13D by Long Island Lighting Company on October 24, 1997)
10.1 Agreement and Plan of Merger, dated as of June 26, 1997, by and among BL Holding Corp., Long Island Lighting Company, Long Island Power Authority and LIPA Acquisition Corp. (filed as Annex D to the Joint Registration Statement on Form S-4 of The Brooklyn Union Gas Company and Long Island Lighting Company, Registration No. 333-30353 on June 30, 1997)
10.2 Management Services Agreement between Long Island Power Authority and Long Island Lighting Company dated as of June 26, 1997 (filed as Annex D to the Joint Registration Statement on Form S-4 of The Brooklyn Union Gas Company and Long Island Lighting Company, Registration No. 333-30353 on June 30, 1997)
10.3 Amendment, dated as of March 29, 2002, to Management Services Agreement between Long Island Lighting Company d/b/a LIPA and KeySpan Electric Services LLC dated as of June 26, 1997 (filed as Exhibit 10.4-b to KeySpan's Form 10-K for the year ended December 31, 2002)
10.4 Amended and Restated Management Services Agreement dated as of January 1, 2006 between the Long Island Lighting Company ("LILCO") d/b/a LIPA and KeySpan Electric Services LLC (filed as Exhibit 10.1 to KeySpan's Form 8-K filed on February 7, 2006)
10.5 Power Supply Agreement between Long Island Lighting Company and Long Island Power Authority dated as of June 26, 1997 (filed as Annex D to the Joint Registration Statement on Form S-4 of The Brooklyn Union Gas Company and Long Island Lighting Company, Registration No. 333-30353 on June 30, 1997)
10.6 Energy Management Agreement between Long Island Lighting Company and Long Island Power Authority dated as of June 26, 1997 (filed as Annex D to Registration Statement on Form S-4, No. 333-30353, on June 30, 1997)
10.7 Amendment, dated as of March 29, 2002, to Energy Management Agreement between Long Island Lighting Company d/b/a LIPA and KeySpan Energy Trading Services LLC dated as of June 26, 1997 (filed as Exhibit 10.6-b to KeySpan's Form 10-K for the year ended December 31, 2002)
10.8 Generation Purchase Rights Agreement between Long Island Lighting Company and Long Island Power Authority dated as of June 26, 1997 (filed as Exhibit 10.17 to KeySpan's Form 10-K for the year ended December 31, 2001)
10.9 Amendment, dated as of March 29, 2002, to Generation Purchase Rights Agreement by and between KeySpan Corporation, as Seller, and Long Island Lighting Company d/b/a LIPA, as Buyer, dated as of June 26, 1997 (filed as Exhibit 10.1 to KeySpan's Form 10-Q for the quarterly period ended March 31, 2002)
10.10 Generation Purchase Right Extension Agreement between KeySpan and the Long Island Power Authority dated as of March 28, 2005 (filed as Exhibit 10.1 to KeySpan's Form 10-Q for the quarterly period ended March 31, 2005)
10.11 Option and Purchase and Sale Agreement dated as of January 1, 2006 by and between LILCO d/b/a LIPA and KeySpan Electric Services LLC (filed as Exhibit 10.2 to KeySpan's Form 8-K filed on February 7, 2006)
10.12 Letter Amendment to the Option and Purchase and Sale Agreement between KeySpan Generation LLC and Long Island Lighting Company d/b/a LIPA, dated as of December 11, 2006 (filed as Exhibit 10.1 to KeySpan's Form 8-K dated December 19, 2006)
10.13 Settlement Agreement and Release dated as of January 1, 2006 by and among KeySpan, KeySpan Generation LLC, KeySpan Electric Services LLC, KeySpan Energy Trading Services LLC and LIPA (filed as Exhibit 10.3 to KeySpan's Form 8-K filed on February 7, 2006)
10.14 Agreement of Lease between Forest City Jay Street Associates and The Brooklyn Union Gas Company dated September 15, 1988 (filed as an Exhibit to The Brooklyn Union Gas Company's Form 10-K for the year ended September 30, 1996)
10.15 Second Amendment, dated as of March 24, 2005, to the Lease Agreement dated as of September 15, 1998 between The Brooklyn Union Gas Company and Forest City Jay Street Associates, L.P. (filed as Exhibit 10 to KeySpan's Form 8-K dated as of March 30, 2005)
10.16 ISDA Master Agreement, dated as of January 18, 2006, between KeySpan Corporation and Morgan Stanley Capital Group Inc. (filed as Exhibit 10.1 to KeySpan's Form 8-K dated January 24, 2006)
10.17 Restated Exploration Agreement between The Houston Exploration Company and KeySpan Exploration and Production, L.L.C. dated June 30, 2000 (filed as Exhibit 10.1 to The Houston Exploration Company's Form 10-Q for the quarter ended September 30, 2000, File No. 001-11899)
10.18 Distribution Agreement, dated June 2, 2004, by and among The Houston Exploration Company, Seneca-Upshur Petroleum, Inc., THEC Holdings Corp. and KeySpan Corporation (filed as Exhibit 99.2 to The Houston Exploration Company's Form 8-K dated as of June 3, 2004)
10.19 Asset Contribution Agreement, dated June 2, 2004, between The Houston Exploration Company and Seneca-Upshur Petroleum, Inc. (filed as Exhibit 99.3 to The Houston Exploration Company's Form 8-K dated as of June 3, 2004)
10.20 Tax Matters Agreement, dated June 2, 2004, by and among The Houston Exploration Company, Seneca-Upshur Petroleum, Inc., THEC Holdings Corp. and KeySpan Corporation (filed as Exhibit 99.4 to The Houston Exploration Company's Form 8-K dated as of June 3, 2004)
10.21 Share Sale and Purchase Agreement dated February 25, 2005 with BG Energy Holdings Limited and Premier Transmission Financing Public Limited Company (filed as Exhibit 10.37 to KeySpan's Form 10-K for the year ended December 31, 2004)
10.22 Purchase Agreement, dated January 28, 2005, among Robert B. Snyder, Frank J. Sullivan, Robert B. Snyder, Jr., Philip J. Andreoli, William J. McKean, Binsky & Snyder, LLC, Binsky & Snyder Service, LLC and KeySpan Business Solutions, LLC (filed as Exhibit 10.35 to KeySpan's Form 10-K for the year ended December 31, 2004)
10.23 Purchase Agreement, dated February 11, 2005, among WDF Holding Corp., WDF, Inc. and KeySpan Business Solutions, LLC (filed as Exhibit 10.36 to KeySpan's Form 10-K for the year ended December 31, 2004)
10.24 Note Purchase Agreement, dated as of November 29, 2006, between KEDNY and certain investors for the issuance of $400 million of Senior Unsecured Notes, due November 29, 2016 (filed as Exhibit 10.1 to KeySpan's Form 8-K dated December 5, 2006)
10.25 Note Purchase Agreement, dated as of November 29, 2006, between KEDLI and certain investors for the issuance of $100 million of Senior Unsecured Notes, due November 29, 2016 (filed as Exhibit 10.2 to KeySpan's Form 8-K dated December 5, 2006)
10.26 KEDNY Form of 5.60% Senior Unsecured Note due November 29, 2016 (filed as Exhibit 10.2 to KeySpan's Form 8-K dated December 5, 2006)
10.27 KEDLI Form of 5.60% Senior Unsecured Note due November 29, 2016 (filed as Exhibit 10.2 to KeySpan's Form 8-K dated December 5, 2006)
10.28 ISDA Master Agreement between the Company and Morgan Stanley Capital Group Inc. dated as of January 18, 2006 (filed as Exhibit 10.1 to KeySpan's Form 8-K dated January 24, 2006)
Compensation Agreements -----------------------
10.29* Cash Compensation for Non-Management Directors of KeySpan
10.30* Base Salaries of Named Executive Officers of KeySpan in effect as of February 20, 2007
10.31 Copy of the Amendment to the Employment Agreement dated January 1, 2005 between KeySpan Corporation and Anthony Sartor (filed as Exhibit 10.1 to KeySpan's Form 8-K dated September 8, 2006)
10.32 Agreement and Waiver of Rights and Claims between KeySpan and Lenore F. Puleo dated as of March 24, 2006 (filed as Exhibit 10.2 to KeySpan's Form 8-K dated March 30, 2006)
10.33 Letter Agreement between KeySpan and Gerald Luterman dated March 24, 2006 (filed as Exhibit 10.1 to KeySpan's Form 8-K dated March 30, 2006)
10.34 Employment Agreement, dated February 24, 2005, between KeySpan and Robert B. Catell (filed as Exhibit 10.10 to KeySpan's Form 10-K for the year ended December 31, 2004)
10.35 Employment Agreement, dated January 1, 2005, between KeySpan and Anthony Sartor (filed as Exhibit 10.01 to KeySpan's Form 8-K dated as of January 4, 2005)
10.36 Supplemental Retirement Agreement, dated January 1, 2005, between KeySpan and Anthony Sartor (filed as Exhibit 10.12 to Company's Form 8-K dated as of January 4, 2005)
10.37 Supplemental Retirement Agreement, dated July 1, 2002, between KeySpan and Steven L. Zelkowitz (filed as Exhibit 10.12 to KeySpan's Annual Report on Form 10-K for the year ended December 31, 2002)
10.38 Supplemental Retirement Agreement, dated July 1, 2002, between KeySpan and Gerald Luterman (filed as Exhibit 10.11 to KeySpan's Annual Report on Form 10-K for the year ended December 31, 2002)
10.39 Supplemental Retirement Agreement, dated July 1, 2002, between KeySpan and David J. Manning (filed as Exhibit 10.13 to KeySpan's Annual Report on Form 10-K for the year ended December 31, 2002)
10.40 Supplemental Retirement Agreement, dated July 1, 2002, between KeySpan and Elaine Weinstein (filed as Exhibit 10.15 to KeySpan's Annual Report on Form 10-K for the year ended December 31, 2002)
10.41 Directors' Deferred Compensation Plan effective April 2003 (filed as Exhibit 10.16 to KeySpan's Annual Report on Form 10-K for the year ended December 31, 2003)
10.42 Officers' Deferred Stock Unit Plan of KeySpan Corporation (filed as Exhibit 10.17 to KeySpan's Annual Report on Form 10-K for the year ended December 31, 2002)
10.43 Officers' Deferred Stock Unit Plan of KeySpan Services, Inc. (filed as Exhibit 10.18 to KeySpan's Annual Report on Form 10-K for the year ended December 31, 2002)
10.44 Corporate Annual Incentive Compensation and Gainsharing Plan (filed as Exhibit 10.20 to KeySpan's Form 10-K for the year ended December 31, 2000)
10.45* Corporate Annual Incentive Compensation Plan Target Performance Award Level for Fiscal Year 2007
10.46 Senior Executive Change of Control Severance Plan effective as of October 29, 2003 (filed as Exhibit 10.20 to KeySpan's Form 10-K for the year ended December 31, 2003)
10.47 KeySpan's Amended Senior Executive Change of Control Severance Plan (filed as Exhibit 10.1 to KeySpan's Form 10-Q for the quarterly period ended March 31, 2006)
10.48 KeySpan's Amended Long-Term Performance Incentive Compensation Plan (filed as Exhibit A to KeySpan's 2001 Proxy Statement filed on March 23, 2001)
10.49* KeySpan's Long-Term Performance Incentive Compensation Plan Performance Target Award Level for Fiscal Year 2007
14 Code of Ethics (filed as Exhibit 14 to KeySpan's Annual Report on Form 10-K for the year ended December 31, 2003).
21* Subsidiaries of the Registrant
23.1* Consent of Deloitte & Touche LLP, Independent Registered Public Accounting Firm
24.1* Power of Attorney executed by Andrea S. Christensen on February 21,
24.2* Power of Attorney executed by Robert J. Fani on February 21, 2007
24.3* Power of Attorney executed by Alan H. Fishman on February 21, 2007
24.4* Power of Attorney executed by James R. Jones on February 21, 2007
24.5* Power of Attorney executed by James L. Larocca on February 21, 2007
24.6* Power of Attorney executed by Gloria C. Larson on February 21, 2007
24.7* Power of Attorney executed by Stephen W. McKessy on February 21, 2007
24.8* Power of Attorney executed by Edward D. Miller on February 21, 2007
24.9* Power of Attorney executed by Vikki L. Pryor on February 21, 2007
31.1* Certification of the Chairman and Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2* Certification of the Executive Vice President and Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1* Certification of the Chairman and Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2* Certification of the Executive Vice President and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
* filed herewith
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
KEYSPAN CORPORATION (Registrant)
Signature: Date:
By: /s/Gerald Luterman February 22, 2007 ------------------ Gerald Luterman Executive Vice President and Chief Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Signatures: Date:
By: /s/Robert B. Catell February 22, 2007 ------------------- Robert B. Catell Chairman of the Board of Directors and Chief Executive Officer
By: /s/Gerald Luterman February 22, 2007 ------------------ Gerald Luterman Executive Vice President and Chief Financial Officer
By: /s/Theresa A. Balog February 22, 2007 ------------------- Theresa A. Balog Vice President and Chief Accounting Officer
* - ----------------------------------------- Andrea S. Christensen Director
* - ----------------------------------------- Robert J. Fani President, Chief Operating Officer and Director
* - ----------------------------------------- Alan H. Fishman Director
* - ----------------------------------------- James R. Jones Director
* - ----------------------------------------- James L. Larocca Director
* - ----------------------------------------- Gloria C. Larson Director
* - ----------------------------------------- Stephen W. McKessy Lead Director
* - ----------------------------------------- Edward D. Miller Director
* - ----------------------------------------- Vikki L. Pryor Director
* Such signature has been affixed pursuant to a Power of Attorney filed as an exhibit hereto and incorporated herein by reference thereto