Company Profile Eastern Edison Company (Eastern Edison or the Company) is a retail electric utility company. Eastern Edison supplies retail electric service to approximately 182,000 customers in 22 cities and towns in southeastern Massachusetts. The largest communities served are the cities of Brockton and Fall River, Massachusetts. Eastern Edison is a wholly owned subsidiary of Eastern Utilities Associates (EUA). EUA owns directly all of the shares of common stock of Eastern Edison, Blackstone Valley Electric Company (Blackstone) and Newport Electric Corporation (Newport). Blackstone and Newport are retail electric utility companies operating in northern Rhode Island and south coastal Rhode Island, respectively. Eastern Edison owns all of the permanent securities of Montaup Electric Company (Montaup), a generation and transmission company, which supplies electricity to Eastern Edison, to Blackstone, to Newport and to two unaffiliated utilities for resale. EUA also owns directly all of the shares of common stock of EUA Cogenex Corporation (EUA Cogenex), EUA Energy Investment Corporation (EUA Energy), EUA Ocean State Corporation (EUA Ocean State), EUA Energy Services Corporation (EUA Energy Services) and EUA Service Corporation (EUA Service). EUA Service provides various accounting, financial, engineering, planning, data processing and other services to all EUA System companies. EUA Cogenex is an energy services company. EUA Energy was organized to invest in energy-related projects. EUA Ocean State owns a 29.9% interest in Ocean State Power's two gas-fired generating units in northern Rhode Island. EUA Energy Services owns an interest in a limited liability company which markets energy and energy services. The holding company system of EUA, the three retail subsidiaries, Montaup, EUA Service, EUA Cogenex, EUA Energy, EUA Energy Services and EUA Ocean State is referred to as the EUA System. Form 10-K A copy of EUA's, Eastern Edison's and Blackstone's Co-Registrant 1996 Annual Report on Form 10-K, which is filed with the Securities and Exchange Commission, is available to shareholders without charge by contacting us at: EUA Service Corporation Post Office Box 2333 Boston, MA 02107 (617) 357-9590 Internet Address Visit EUA's Home Page on the worldwide web at: http://www.eua.com. MARKET FOR EASTERN EDISON'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS All of Eastern Edison's common stock is owned beneficially and of record by Eastern Utilities Associates (EUA). The dividends paid on Eastern Edison's common stock during the past two years are as follows: Dividends Paid Dividends Paid 1996 Per Share 1995 Per Share First Quarter $2.87 First Quarter $2.53 Second Quarter 3.00 Second Quarter 0.43 Third Quarter 3.00 Third Quarter 0.46 Fourth Quarter 3.00 Fourth Quarter 0.45 No dividends may be paid on Eastern Edison's common stock unless full dividends on Eastern Edison's outstanding Preferred Stock for all past and the current quarterly dividend periods have been paid or declared and set apart for payment, nor may any dividends be paid on Eastern Edison's common stock if Eastern Edison is in default on any sinking fund obligation provided for its Preferred Stock. See also Notes C, D and E of Notes to Consolidated Financial Statements. SELECTED CONSOLIDATED FINANCIAL DATA For the Years Ended December 31, (In Thousands) 1996 1995 1994 1993 1992 _________________________________________________________________________ Operating Revenues $404,808 $420,069 $418,424 $417,021 $420,188 Net Earnings 30,983 31,455 31,395 28,145 29,231 Total Assets 775,082 739,198 756,045 742,273 776,510 Capitalization: Long-Term Debt 222,402 222,313 229,224 264,134 269,995 Redeemable Preferred Stock-Net 27,035 26,218 25,257 24,824 28,171 Non-Redeemable Preferred Stock 8,949 Common Equity 240,213 244,368 225,064 223,005 220,257 Total Capitalization $489,650 $492,899 $479,545 $511,963 $527,372 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND REVIEW OF OPERATIONS Overview 1996 Consolidated Net Earnings of approximately $31.0 million decreased $0.5 million, or 1.5% compared to those of 1995 which included a one-time charge of approximately $1.5 million, on an after tax basis, related to the voluntary retirement incentive offer (VRI). The results were impacted by increased expenses related to an unusual number of severe storms which struck Eastern Edison's service territory during 1996 and increased legal expenses, partially offset by a decrease in interest expense from debt issues that matured in 1995. Consolidated Net Earnings for 1995 of approximately $31.5 million were slightly higher than 1994 net earnings of $31.4 million due primarily to lower litigation expenses resulting from favorable court decisions rendered in 1995, lower interest expense and successful cost control efforts. Offsetting these impacts somewhat were the VRI charge and Montaup's approximately $13.9 million annual wholesale rate reduction effective May 21, 1994. Comparison of Financial Results Operating Revenues Operating Revenues for 1996 decreased by approximately $15.3 million, as compared to 1995. The change was primarily due to decreased purchased power recoveries of $6.9 million, decreased conservation and load management (C&LM) expense recoveries of $7.1 million, and decreased contract demand sales of $1.6 million. Operating Revenues for 1995 increased by approximately $1.6 million as compared to 1994. This change was primarily due to increased purchased power and fuel expense recoveries aggregating $5.8 million and additional revenues related to the full year impact of Newport becoming an all-requirements customer of Montaup on May 21, 1994. Offsetting these increases somewhat were decreased C&LM expense recoveries of $3.9 million and the full year impact of Montaup's wholesale rate reduction implemented on May 21, 1994 which lowered 1995 revenues by approximately $4.9 million. Voluntary Retirement Incentive Offer On March 15, 1995, EUA announced a corporate reorganization which, among other things, consolidated management of Eastern Edison, Blackstone and Newport. As part of the reorganization, a VRI was offered to 66 professionals of the EUA System including 22 employees of Eastern Edison and Montaup. Forty-nine of those eligible for the program, including 16 employees of Eastern Edison and Montaup, accepted the incentive and retired effective June 1, 1995. The cost to Eastern Edison of this incentive program amounted to a one-time $2.4 million pre-tax ($1.5 million after-tax) charge to second quarter 1995 earnings. Expenses The Company's most significant expense items continue to be fuel and purchased power expenses which together comprised about 59% of total operating expenses for 1996. Fuel expense increased by $1.3 million or 1.4% in 1996 as compared to 1995 due to primarily to a 2.0% increase in total energy generated and purchased. Fuel expense increased by $3.4 million or 3.8% in 1995 as compared to 1994. This change was caused by an increase of 14.1% in the average cost of fuel offset by decreases in total energy generated and purchased of 11.1%. Purchased Power demand expense decreased $6.8 million or 5.4% in 1996. The decrease was due primarily to the impact of lower billings from the Pilgrim nuclear unit of approximately $4.2 million which includes a prior period refund of approximately $2.0 million, and decreased billings from the Ocean State Power Project and the Maine Yankee nuclear unit aggregating $2.5 million. Purchased Power demand expense for 1995 increased $2.6 million to $125.6 million. This increase was due primarily to the impact of Newport's purchased power contracts assumed by Montaup effective May 21, 1994, coincident with Newport becoming an all-requirements customer of Montaup, aggregating approximately $4.8 million, and increased billings from the Ocean State Power project and the Yankee nuclear units aggregating $5.2 million. These increases were offset somewhat by decreases of approximately $6.7 million resulting from purchase power contracts totaling 41 mw which expired in October 1994, and a net $700,000 reduction in purchases from other power suppliers. Other Operation and Maintenance expenses are comprised of two components, Direct Controllable and Indirect. Direct Controllable expenses include expense items such as salaries, fringe benefits, insurance, maintenance, etc. Indirect expenses include items over which the Company has limited short-term control and include such expense items as Montaup's joint ownership interests in generating facilities such as Seabrook I and Millstone III, power contracts where transmission rental fees are fixed, conservation and load management expenses that are fully recovered in revenues and expenses related to accounting standards such as Statement of Financial Accounting Standard No. 106, "Employers' Accounting for Post Retirement Benefits-Retirement Benefits Other Than Pensions" (FAS106). Other Operation and Maintenance expenses, including affiliated company transactions, decreased by $4.8 million or 5% in 1996. The change was primarily due to decreased C&LM expenses of $7.7 million, lower power contract and transmission expenses of Montaup and effective cost control efforts aggregating $1.1 million. Offsetting these decreases somewhat were increases in storm related, legal and jointly owned unit expenses aggregating $4.5 million. Other Operation and Maintenance expenses for 1995 decreased by approximately $5.7 million or 5.6% from 1994 levels. This decrease was due primarily to lower C&LM expense totaling $4.3 million, decreased legal costs of approximately $2.1 million and successful cost control efforts. Offsetting these year-to date decreases somewhat were increases in Montaup power contract expenses and FAS106 expenses aggregating $1.4 million. Net interest charges decreased by approximately $2.7 million, due primarily to the December 1995 maturity of $25 million of 9-9 1/4% Unsecured Medium Term Notes and $10 million of 8.9% First Mortgage and Collateral Trust Bonds and the September 1996 maturity of $7 million of 4 % First Mortgage Collateral Trust Bonds of Eastern Edison. Net interest charges decreased by $1.4 million in 1995 versus 1994. Other Interest expense provisions recorded in June 1994 aggregating $1.0 million related to Internal Revenue Service audits of prior years' consolidated income tax returns were primarily responsible for this change. Financial Condition and Liquidity Eastern Edison's and Montaup's need for permanent capital is primarily related to the construction of facilities required to meet the needs of existing and future customers. For 1996, 1995 and 1994, Eastern Edison's and Montaup's combined cash construction expenditures were $26.0 million, $23.4 million, and $23.6 million, respectively. Internally generated funds provided approximately 118% of Eastern Edison's and Montaup's combined cash construction requirements in 1996. Cash construction expenditures are expected to be approximately $16.2 million in 1997, and $9.9 million in 1998 and 1999, and are expected to be financed with internally generated funds. In the utility industry, cash construction requirements not met with internally generated funds are obtained through short-term borrowings which are ultimately funded with permanent capital. EUA System companies, including Eastern Edison and Montaup, maintain short-term lines of credit with various banks aggregating approximately $140 million. These credit lines are available to other affiliated companies under joint credit line arrangements. At December 31, 1996, unused short-term lines of credit amounted to approximately $89 million. At December 31, 1996, Eastern Edison had $2.0 million of outstanding short-term debt and Montaup had no outstanding short-term debt. In addition to construction expenditures, projected requirements for maturing long-term debt securities through 2001 are $60 million in 1998. The Company has no sinking fund requirements until the year 2003. Electric Utility Industry Restructuring Initiatives On August 7, 1996 the Governor of Rhode Island signed into law the Utility Restructuring Act of 1996 (URA). The URA provides for customer choice of electricity supplier to be phased-in commencing July 1, 1997 for large manufacturing customers, certain new commercial and industrial customers, and State of Rhode Island accounts. By July 1, 1998 or sooner, all customers will have retail access. Under the URA the local distribution company will retain the responsibility of providing distribution services to the ultimate electricity consumer within its franchised service territory. For customers who choose not to choose, the local distribution company would be allowed to arrange for supply at a non-discriminatory, "standard offer" price. Distribution companies will also be providers of last resort, required to arrange for supply, at prevailing market prices, for customers who are unable to do so. Both Blackstone and Newport are currently all requirements customers of Montaup for generation services. This legislation provides for recovery of prudently incurred embedded generation costs that may not be to recovered in a competitive electric generation market, commonly referred to as "stranded costs", through a non-bypassable transition charge initially set at 2.8 cents per kWh. The transition charge recovers, among other things, costs of depreciated generation net of its market value, regulatory assets, nuclear decommissioning and above market payments to power suppliers. The costs of net, above-market generation assets and regulatory assets will be recovered, with a return, through a fixed component of the transition charge from July 1, 1997 through December 31, 2009. A variable component of the transition charge will recover, on a reconciling basis, among other things, nuclear decommissioning and above market purchased power commitments from July 1, 1997 through the life of the respective unit or contract. The URA also provides for commitments to demand side management initiatives and renewables, low income protections, divestiture of at least 15% of owned non-nuclear generating units as a valuation basis for mitigation of stranded cost recovery, and performance based rate making standards for electric distribution companies. Performance based regulation provides for a minimum and maximum allowed return on equity. In addition, the URA provides for adjustments to electric distribution companies' base rates using the prior year's Consumer Price Index and other performance factors. Under this provision of the law, base rates were increased 1.88% for customers of Blackstone, and 2.18% for our Newport customers effective January 1, 1997. The implementation of the URA will require approvals from applicable regulatory agencies, including the Federal Energy Regulatory Commission (FERC), the Rhode Island Public Utilities Commission (RIPUC), and the Securities and Exchange Commission (SEC). In February 1997, Blackstone, Newport and Montaup reached settlement with the Rhode Island Division of Public Utilities and Carriers (RIDPUC) and the Rhode Island Attorney General with regards to implementation of a restructuring plan for Blackstone, Newport and Montaup. In addition to complying with the URA, the settlement provides for an immediate 10% rate reduction and a commitment by Montaup to file a plan by July 1, 1997 to divest all of its generating assets, and is similar in many respects to the settlement negotiated in Massachusetts, described below. On December 23, 1996, Eastern Edison and Montaup reached an agreement in principle with the Attorney General of Massachusetts and the Massachusetts Division of Energy Resources on a plan, similar in many aspects to the URA, which would allow retail customers to choose their supplier of electricity in 1998 and provide Eastern Edison and Montaup full recovery of "stranded costs." A formal plan is expected to be filed with the Massachusetts Department of Public Utilities (MDPU) in March of 1997. The agreement envisions that all of Eastern Edison's customers will have the ability to choose an alternative supplier of electricity beginning on January 1, 1998. Until a customer chooses an alternative supplier, that customer would receive "standard offer" service which would be priced to guarantee that customer at least a ten percent savings from today's electricity prices. Eastern Edison would be required to arrange for "standard offer" service and would purchase power for "standard offer" service from suppliers through a competitive bidding process. The agreement is also designed to achieve full divestiture of Montaup's generating assets via implementation of a plan, to be submitted to the MDPU by July 1, 1997, that would require (1) separation by Montaup of its generating and transmission businesses and (2) full market valuation and sale of all generating assets through an auction or equivalent process, to be conducted by an independent third party. Upon the commencement of retail choice in Massachusetts, Montaup's wholesale contract with Eastern Edison would be terminated. In return, the cost of Montaup's above market, embedded generation commitments to serve Eastern Edison's customers would be recovered, with a return, through a non- bypassable transition access charge to all Eastern Edison customers. The transition access charge would be reduced by the fair market value of Montaup's generating assets as determined by selling, spinning off, or otherwise disposing of such generating facilities. Embedded costs associated with generating plants and regulatory assets would be recovered, with a return, over a period of 12 years. Purchased power contracts and nuclear decommissioning costs would be recovered as incurred over the life of those obligations, a period expected to extend beyond 12 years. The initial transition access charge would be set at 3.04 cents per kWh through December 31, 2000, and is expected to decline thereafter. The agreement also establishes performance-based regulation for Eastern Edison incorporating a floor and cap on allowed return on equity. Under the agreement, Eastern Edison's distribution rates would be frozen at 1996 levels until December 31, 2000. Subsequent to the commencement of retail choice, Eastern Edison's annual return on equity would be subject to a floor of 6 percent and a ceiling of 11.75 percent. In addition to MDPU approval of the agreement, implementation is also subject to the approval of the FERC. Any disposition of generation assets resulting from the agreement or the URA would also require the approval of the SEC under the Public Utility Holding Company Act of 1935. Historically, electric rates have been designed to recover a utility's full costs of providing electric service including recovery of investment in plant assets. Also, in a regulated environment, electric utilities are subject to certain accounting rules that are not applicable to other industries. These accounting rules allow regulated companies, in appropriate circumstances, to establish regulatory assets and liabilities, which defer the current financial impact of certain costs that are expected to be recovered in future rates. The SEC has raised issues concerning the continued applicability of these standards with certain other electric utilities, in other states, facing restructuring. The Company believes that its operations will continue to meet the criteria established in these accounting standards. However, the potential exists that the final outcome of state and federal agency determinations could result in the Company no longer meeting the criteria of certain accounting standards which could trigger the discontinuance of Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation" (FAS71). Should it be required to discontinue the application of FAS71, the Company would be required to take an immediate write down of the affected assets in accordance with FAS101, "Accounting for the Discontinuation of Application of FAS71." In addition, if legislative or regulatory changes and/or competition result in electric rates which do not fully recover the company's costs, a write-down of plant assets could be required pursuant to Financial Accounting Standard No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of" (FAS121) issued in March 1995. Environmental Matters Eastern Edison, Montaup and other companies owning generating units from which power is obtained are subject, like other electric utilities, to environmental and land use regulations at the federal, state and local levels. The United States Environmental Protection Agency (EPA), and certain state and local authorities, have jurisdiction over releases of pollutants, contaminants and hazardous substances into the environment and have broad authority to set rules and regulations in connection therewith, such as the Clean Air Act Amendments of 1990, which could require installation of pollution control devices and remedial actions. In 1994, an environmental audit program designed to ensure compliance with environmental laws and regulations and to identify and reduce liability was instituted by EUA. Because of the nature of Eastern Edison's and Montaup's business, various by-products and substances are produced or handled which are classified as hazardous under the rules and regulations promulgated by such authorities. Eastern Edison and Montaup generally provide for the disposal of such substances through licensed contractors, but statutory provisions generally impose potential joint and several responsibility on the generators of the wastes for cleanup costs. Eastern Edison and Montaup have been notified with respect to a number of sites where they may be responsible for such costs, including sites where they may have joint and several liability with other responsible parties. It is the policy of the EUA System companies to notify liability insurers and to initiate claims, however, Eastern Edison and Montaup are unable to predict whether liability, if any, will be assumed by, or can be enforced against, the insurance carriers in these matters. As of December 31, 1996, Eastern Edison and Montaup had incurred costs of approximately $800,000, in connection with these sites. These amounts have been financed primarily by internally generated cash. Montaup is currently recovering certain of its incurred environmental costs in rates. Eastern Edison and Montaup estimate that additional costs of up to $130,000 may be incurred at these sites through 1998. Estimates beyond 1998 cannot be made since site studies, which are the basis of these estimates, have not been completed. As a result of the recoverability in current rates of environmental costs, and the uncertainty regarding both its estimated liability, as well as potential contributions from insurance carriers, Eastern Edison and Montaup do not believe that the ultimate impact of environmental costs will be material to their financial position and thus, no loss provision is required at this time. A number of scientific studies in the past several years have examined the possibility of health effects from electric and magnetic fields (EMF) that are found wherever there is electricity. While some of the studies have indicated some association between exposure to EMF and health effects, many others have indicated no direct association. The research to date has not conclusively established a direct causal relationship between EMF exposure and human health. Additional studies, which are intended to provide a better understanding of EMF, are continuing. On October 31, 1996, the National Academy of Sciences issued a literature review of all research to date, "Possible Health Effects of Exposure to Residential Electric and Magnetic Fields." Its most widely reported conclusion stated, "No clear, convincing evidence exists to show that residential exposures to EMF are a threat to human health." Management cannot predict the ultimate outcome of the EMF issue. Nuclear Power Issues Montaup has a 4.01% ownership interest in Millstone III, an 1154-mw nuclear unit that is jointly owned by a number of New England utilities, including subsidiaries of Northeast Utilities (Northeast), the operator of the plant. On March 30, 1996, Northeast shut down the unit following an engineering evaluation which determined that four safety-related valves would not be able to perform their design function during certain postulated events. The Nuclear Regulatory Commission (NRC) has raised numerous issues with respect to the unit and certain of the other nuclear units operated by Northeast. The NRC has established a Special Projects Office to oversee inspection and licensing activities at Millstone and directed Northeast to submit a plan for disposition of safety issues raised by employees and retain an independent third party to oversee implementation of this plan. Northeast management has indicated it cannot currently estimate the effect these efforts will have on the timing of restarts or what additional costs, if any, these developments may cause. While Millstone III is out of service, Montaup will incur incremental replacement power costs estimated at $400,000 to $800,000 per month. Montaup bills its replacement power costs through its fuel adjustment clause, a wholesale tariff jurisdictional to FERC. However, there is no comparable clause in Montaup's FERC-approved rates which at this time would permit Montaup to recover its share of the incremental O&M costs incurred at Millstone III. The Company cannot predict the ultimate outcome of the NRC inquiries or the impact which they may have on Montaup. Montaup is also evaluating its rights and obligations under the various agreements relating to the ownership and operation of Millstone III. Montaup holds a 4.0% ownership interest in the Maine Yankee nuclear unit. In December, 1996 the unit was shut down for inspections and repairs and in January 1997 the NRC announced that it had placed the unit on its watch list. The operator of the unit had been addressing issues of non-conformance to the unit's licensing basis identified by the NRC in October 1996, prior to the NRC's January 1997 announcement. The operator of the plant cannot estimate when the unit will restart. Connecticut Yankee, a 582-mw nuclear unit, was taken off-line in July 1996 because of issues related to certain containment air recirculation and service water systems. Montaup has a 4.5% equity ownership in Connecticut Yankee with a book value of $4.8 million at December 31, 1996. In October 1996, Montaup, as one of the joint owners, participated in an economic evaluation of Connecticut Yankee which recommended permanently closing the unit and replacing its output with less expensive energy sources. As a result of the analysis, work at the plant had slowed pending a final board decision. In December 1996, the Board of Directors voted to retire the generating station. Connecticut Yankee certified to the NRC that it had permanently closed power generation operations and removed fuel from the reactor. Connecticut Yankee has two years to submit its decommissioning plan to the NRC. The preliminary estimate of the sum of future payments for the permanent shutdown, decommissioning, and recovery of the remaining investment in Connecticut Yankee, is approximately $758 million. Montaup's share of the total estimated costs is $34.1 million at December 31, 1996 and is included in Other Liabilities on the Consolidated Balance Sheet at December 31, 1996. Also, due to anticipated recoverability, a regulatory asset has been recorded for the same amount and is included with Other Assets. Recent actions by the NRC, some of which are cited above, indicate that the NRC has become more critical and active in its oversight of nuclear power plants. EUA is unable to predict at this time, what, if any, ramifications these NRC actions will have on any of the other nuclear power plants in which Montaup has an ownership interest or power contract. Montaup is recovering through rates its share of estimated decommissioning costs for the Millstone III and Seabrook I nuclear generating units. Montaup's share of the currently allowed estimated total costs to decommission Millstone III is approximately $18.6 million in 1996 dollars and Seabrook I is approximately $13.1 million in 1996 dollars. These figures are based on studies performed for the lead owners of the units. Montaup also pays into decommissioning reserves, pursuant to contractual arrangements, at other nuclear generating facilities in which it has an equity ownership interest or life-of-unit entitlement. Such expenses are currently recovered through rates. Other The Company occasionally makes forward-looking projections of expected future performance or statements of our plans and objectives. These forward- looking statements may be contained in filings with the SEC, press releases and oral statements. Actual results could differ materially from these statements. Therefore, no assurances can be given that such forward-looking statements and estimates will be achieved. Management's Discussion and Analysis of Financial Condition and Review of Operations provides a summary of information regarding the Company's financial condition and results of operation and should be read in conjunction with the "Consolidated Financial Statements" and "Notes to Consolidated Financial Statements" in arriving at a more complete understanding of such matters. Financial Table of Contents Consolidated Statement of Income. . . . . . . . . . . . . . . 12 Consolidated Statement of Retained Earnings . . . . . . . . . . . . . . 12 Consolidated Statement of Cash Flow . . . . . . . . . . . . . . . . . . 13 Consolidated Balance Sheet . . . . . . . . . . . . . . . . . . . . . . . 14 Consolidated Statement of Capitalization . . . . . . . . . . . . . . . . 15 Notes to Consolidated Financial Statements . . . . . . . . . . . . . . . 16 Report of Independent Accountants . . . . . . . . . . . . . . . . . . . . 31 Eastern Edison Company and Subsidiary Consolidated Statement of Income Years Ended December 31, (In Thousands) 1996 1995 1994 Operating Revenues: From Affiliated Companies $ 127,981 $ 133,388 $ 126,481 Other 276,827 286,681 291,943 Total Operating Revenues 404,808 420,069 418,424 Operating Expenses: Fuel 92,159 90,881 87,522 Purchased Power - Demand 118,843 125,594 122,995 Other Operation and Maintenance 66,311 73,638 80,300 Affiliated Company Transactions 25,908 23,386 22,446 Voluntary Retirement Incentive 0 2,413 Depreciation and Amortization 26,810 26,039 25,546 Taxes - Other than Income 10,705 10,233 10,543 - Income 16,058 15,653 15,830 Total Operating Expenses 356,794 367,837 365,182 Operating Income 48,014 52,232 53,242 Equity in Earnings of Jointly Owned Companies 1,587 1,646 1,700 Allowance for Other Funds Used During Construction 365 473 263 Other Income (Deductions) - Net 1,583 407 897 Income Before Interest Charges 51,549 54,758 56,102 Interest Charges: Interest on Long-Term Debt 15,233 18,277 18,488 Other Interest Expense 3,653 3,541 4,525 Allowance for Borrowed Funds Used During Construction (Credit) (308) (503) (294) Net Interest Charges 18,578 21,315 22,719 Net Income 32,971 33,443 33,383 Preferred Dividend Requirements 1,988 1,988 1,988 Consolidated Net Earnings Applicable to Common Stock $ 30,983 $ 31,455 $ 31,395 Consolidated Statement of Retained Earnings Years Ended December 31, (In Thousands) 1996 1995 1994 Retained Earnings - Beginning of Year $ 124,878 $ 105,574 $ 103,515 Net Income 32,971 33,443 33,383 Amortization of Preferred Stock Redemption Premium (817) (961) (596) Total 157,032 138,056 136,302 Dividends Paid: Preferred 1,988 1,988 1,988 Common 34,320 11,190 28,740 Retained Earnings - End of Year $ 120,724 $ 124,878 $ 105,574 The accompanying notes are an integral part of the financial statements. Eastern Edison Company and Subsidiary Consolidated Statement of Cash Flows Years Ended December 31, (In Thousands) 1996 1995 1994 CASH FLOW FROM OPERATING ACTIVITIES: Net Income $ 32,971 $ 33,443 $ 33,383 Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities: Depreciation and Amortization 28,607 29,852 28,981 Amortization of Nuclear Fuel 1,676 3,647 3,310 Deferred Taxes 5,217 2,694 5,500 Investment Tax Credit, Net (939) (942) (348) Allowance for Funds Used During Construction (365) (473) (263) Other - Net (2,333) 1,219 (3,285) Changes to Operating Assets and Liabilities: Accounts Receivable (1,862) (7,055) (7,667) Fuel, Materials and Supplies 673 (1,678) 194 Accounts Payable 186 827 3,495 Accrued Taxes (241) 1,807 (2,814) Other - Net 9,266 (6,630) 4,485 Net Cash Provided from Operating Activities 72,856 56,711 64,971 CASH FLOW FROM INVESTING ACTIVITIES: Construction Expenditures (26,006) (23,423) (23,613) Decrease in Other Investments 148 Net Cash (Used in) Investing Activities (25,858) (23,423) (23,613) CASH FLOW FROM FINANCING ACTIVITIES: Redemptions: Long-Term Debt (7,000) (35,000) Premium on Reacquisition and Financing Expenses (62) Common Stock Dividends Paid (34,320) (11,190) (28,740) Preferred Dividends Paid (1,988) (1,988) (1,988) Net (Decrease) Increase in Short Term De (2,118) 4,158 Net Cash (Used in) Financing Activities (45,426) (44,020) (30,790) Net Increase (Decrease) in Cash and Temporary Cash Investments 1,572 (10,732) 10,568 Cash and Temporary Cash Investments at Beginning of Year 533 11,265 697 Cash and Temporary Cash Investments at End of Year $ 2,105 $ 533 $ 11,265 Cash paid during the year for: Interest (Net of Amounts Capitalized) $ 15,241 $ 18,343 $ 18,406 Income Taxes $ 13,267 $ 9,044 $ 15,877 The accompanying notes are an integral part of the financial statements. Eastern Edison Company and Subsidiary Consolidated Balance Sheet December 31, (In Thousands) ASSETS 1996 1995 Utility Plant and Other Investments: Utility Plant $ 817,992 $ 798,706 Less Accumulated Provision for Depreciation 261,464 241,673 Net Utility Plant 556,528 557,033 Non-Utility Property - Net 2,705 2,705 Investment in Jointly Owned Companies 13,210 13,223 Other Investments (at cost) 95 50 Total Utility Plant and Other Investments 572,538 573,011 Current Assets: Cash and Temporary Cash Investments 2,105 533 Accounts Receivable: Customers 27,633 25,730 Others 3,464 2,348 Accrued Unbilled Revenue 8,376 9,158 Associated Companies 25,486 25,861 Fuel (at average cost) 6,844 7,385 Plant Materials and Operating Supplies (at average cost) 3,805 3,937 Prepayments and Other Current Assets 3,598 4,170 Total Current Assets 81,311 79,122 Other Assets (Note A) 121,233 87,065 Total Assets $ 775,082 $ 739,198 LIABILITIES AND CAPITALIZATION Capitalization: Common Equity $ 240,213 $ 244,368 Redeemable Preferred Stock - Net 29,665 29,665 Preferred Stock Redempton Cost (2,630) (3,447) Long-term Debt - Net 222,402 222,313 Total Capitalization 489,650 492,899 Current Liabilities: Long-term Debt Due Within One Year 0 7,000 Notes Payable 2,040 4,158 Accounts Payable: Public 27,391 27,242 Associated Companies 3,950 3,913 Customer Deposits 1,153 1,103 Taxes Accrued 2,977 3,219 Interest Accrued 4,895 4,999 Other Current Liabilities 16,081 7,332 Total Current Liabilities 58,487 58,966 Other Liabilities 41,914 10,100 Deferred Credits: Unamortized Investment Credit 16,903 17,842 Other Deferred Credits 25,689 30,625 Total Deferred Credits 42,592 48,467 Accumulated Deferred Taxes 142,439 128,766 Commitments and Contingencies (Note J) Total Liabilities and Capitalization $ 775,082 $ 739,198 The accompanying notes are an integral part of the financial statements. Eastern Edison Company and Subsidiary Consolidated Statement of Capitalization December 31, (In Thousands) 1996 1995 Common Stock: $25 par value, authorized and outstanding 2,891,357 shares $ 72,284 $ 72,284 Other Paid-In Capital 47,249 47,249 Common Stock Expense (44) (43) Retained Earnings 120,724 124,878 Total Common Equity 240,213 244,368 Redeemable Preferred Stock: 6 5/8%, $100 par value, 300,000 shares <F1> 30,000 30,000 Expense, Net of Premium (335) (335) Preferred Stock Redemption Cost (2,630) (3,447) Total Redeemable Preferred Stock 27,035 26,218 Long-Term Debt: First Mortgage and Collateral Trust Bonds: 5 7/8% due 1998 20,000 20,000 6 7/8% due 2003 40,000 40,000 8% due 2023 40,000 40,000 5 3/4% due 1998 40,000 40,000 6.35% due 2003 8,000 8,000 4.875% due 1996 0 7,000 7.78% Secured Medium-Term Notes due 2002 35,000 35,000 Pollution Control Revenue Bond: 5 7/8% due 2008 40,000 40,000 Unamortized (Discount) - Net (598) (687) 222,402 229,313 Less Portion Due Within One Year 0 7,000 Total Long-Term Debt 222,402 222,313 Total Capitalization $ 489,650 $ 492,899 <FN> <F1> Authorized and Outstanding. </FN> The accompanying notes are an integral part of the financial statements. EASTERN EDISON COMPANY AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 1996, 1995, and 1994 (A) Nature of Operations and Summary of Significant Accounting Policies: General: Eastern Edison Company (Eastern Edison or the Company) and its wholly owned subsidiary, Montaup Electric Company (Montaup) are principally engaged in the generation, transmission, distribution and sale of electric energy. The preparation of financial statements in conformity with generally accepted accounting principles 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. The accounting policies and practices of Eastern Edison and of Montaup are subject to regulation by FERC and the MDPU with respect to their rates and accounting. Eastern Edison and Montaup conform with generally accepted accounting principles, as applied in the case of regulated public utilities, and conform with the accounting requirements and ratemaking practices of the regulatory authority having jurisdiction. Principles of Consolidation: The consolidated financial statements include the accounts of Eastern Edison and its subsidiary, Montaup. All material intercompany balances and transactions have been eliminated in consolidation. Reclassifications: Certain prior period amounts on the financial statements have been reclassified to conform with current presentation. Jointly Owned Companies: Montaup follows the equity method of accounting for its stock ownership investments in jointly owned companies including four regional nuclear generating companies. Montaup's investments in these nuclear generating companies range from 2.50 to 4.50 percent. Montaup is entitled to electricity produced from these facilities based on its ownership interests and is billed for its entitlement pursuant to contractual agreements which are approved by FERC. One of the four nuclear generating facilities, Yankee Atomic, is being decommissioned. Montaup is required to pay, and has received FERC authorization to recover, its proportionate share of any unrecovered costs and costs incurred after the plant's retirement. Montaup's share of all unrecovered assets and the total estimated costs to decommission the unit aggregated approximately $7.8 million at December 31, 1996 and is included with Other Liabilities on the Consolidated Balance Sheet. Also, due to recoverability, a regulatory asset has been recorded for the same amount and is included with Other Assets. In December 1996 the Board of Directors of Connecticut Yankee voted to retire the generating station. Connecticut Yankee certified to the NRC that it had permanently closed power generation operations and removed fuel from the reactor. Montaup has a 4.5% equity ownership in Connecticut Yankee. Montaup's share of all unrecovered assets and the total estimated costs to decommission the unit aggregated approximately $34.1 million at December 31, 1996 and is included with Other Liabilities on the Consolidated Balance Sheet. Also, due to anticipated recoverability, a regulatory asset has been recorded for the same amount and is included with Other Assets. Montaup also has a stock ownership investment of 3.27% in each of the two companies which own and operate certain interconnection facilities used to transmit hydroelectric power between the Hydro-Quebec Electric System and New England. Transactions with Affiliates: Eastern Edison is a wholly owned subsidiary of Eastern Utilities Associates (EUA). In addition to its investment in Eastern Edison, EUA has interests in two other retail companies, a service corporation, and four other non-utility companies. Transactions between Montaup and other affiliated companies include the following: sales of electricity by Montaup to Blackstone Valley Electric Company (Blackstone) and Newport Electric Corporation (Newport) aggregating approximately $127,536,000 in 1996, $133,841,000 in 1995 and $126,237,000 in 1994; accounting, engineering and other services rendered by EUA Service Corporation to Eastern Edison and Montaup of approximately $30,886,000, $29,264,000, and $27,365,000, in 1996, 1995 and 1994, respectively; and operating expense from the rental of transmission and generation facilities by Blackstone and Newport to Montaup aggregating approximately $3,960,000 in 1996, $4,351,000 in 1995 and $3,627,000 in 1994. Montaup rental of transmission facilities to Newport was zero in 1996 and 1995, and $149,000 for 1994, respectively. Transactions with affiliated companies are subject to review by applicable regulatory commissions. Utility Plant and Depreciation: Utility plant is stated at original cost. The cost of additions to utility plant includes contracted work, direct labor and material, allocable overhead, allowance for funds used during construction and indirect charges for engineering and supervision. For financial statement purposes, depreciation is computed on the straight-line method based on estimated useful lives of the various classes of property. Provisions for depreciation, on a consolidated basis, were equivalent to a composite rate of approximately 3.2% in 1996, 1995 and 1994 based on the average depreciable property balances at the beginning and end of each year. Electric Plant Held for Future Use: In January 1994 Montaup determined that it would not be economically feasible to bring its 42-year old, coal-fired Somerset Station Unit 5 generating unit into compliance with Clean Air Act Amendments of 1990 (Clean Air Act). The unit was placed in cold storage and its net investment, $5.4 million, was transferred to electric plant held for future use pending final determination by Montaup of its usefulness. Under terms of the settlement agreement filed with FERC, entered into by Montaup and the intervenors in Montaup's 1994 rate decrease application, Montaup continues to earn a return on the net investment of the unit. Other Assets: The components of Other Assets at December 31, 1996 and 1995 are detailed as follows: (In Thousands) 1996 1995 Regulatory Assets: Unamortized losses on reacquired debt $13,277 $14,981 Unrecovered plant and decommissioning cost 41,914 10,100 Deferred SFAS 109 costs (Note B) 47,326 44,387 Deferred SFAS 106 costs (Note J) 2,153 2,365 Other regulatory assets 4,886 4,790 Total regulatory assets 109,556 76,623 Other deferred charges and assets: Unamortized debt expenses 2,456 2,847 Other 9,221 7,595 Total Other Assets $121,233 $87,065 Regulatory Accounting: Eastern Edison and Montaup are subject to certain accounting rules that are not applicable to other industries. These accounting rules allow regulated companies, in appropriate circumstances, to establish regulatory assets and liabilities, which defer the current financial impact of certain costs that are expected to be recovered in future rates. Eastern Edison and Montaup believe that their operations continue to meet the criteria established in these accounting standards. Effects of legislation and/or regulatory initiatives or EUA's own initiatives could ultimately cause Eastern Edison and Montaup to no longer follow these accounting rules. In such an event, a non-cash write-off of regulatory assets and liabilities could be required at that time. Allowance for Funds Used During Construction (AFUDC): AFUDC represents the estimated cost of borrowed and equity funds used to finance Eastern Edison's and Montaup's construction program. In accordance with regulatory accounting, AFUDC is capitalized, as a cost of utility plant, in the same manner as certain general and administrative costs. AFUDC is not an item of current cash income, but is recovered over the service life of utility plant in the form of increased revenues collected as a result of higher depreciation expense. The combined rate used in calculating AFUDC was 8.9% in 1996, 9.4% in 1995 and 9.6% in 1994. Operating Revenues: Revenues are based on billing rates authorized by applicable federal and state regulatory commissions. Eastern Edison follows the policy of accruing the estimated amount of unbilled base rate revenues for electricity provided at the end of the month to more closely match costs and revenues. Montaup recognizes revenues when billed. In addition, Eastern Edison and Montaup also record the difference between fuel costs incurred and fuel costs billed. Montaup also records the difference between purchased power costs incurred and billed. (A) Nature of Operations and Summary of Significant Accounting Policies: (continued) Income Taxes: The general policy of Eastern Edison and Montaup with respect to accounting for federal and state income taxes is to reflect in income the estimated amount of taxes currently payable, as determined from the EUA consolidated tax return on an allocated basis, and to provide for deferred taxes on certain items subject to temporary differences to the extent permitted by the various regulatory commissions. As permitted by the regulatory commissions, it is the policy of Eastern Edison and Montaup to defer recognition of the annual investment tax credits and to amortize these credits over the productive lives of the related assets. Cash and Temporary Cash Investments: Eastern Edison and Montaup consider all highly liquid investments and temporary cash investments with a maturity of three months or less, when acquired, to be cash equivalents. (B) Income Taxes: Components of income tax expense for the years 1996, 1995, and 1994 are as follows: ___________________________________________________________________ (In Thousands) 1996 1995 1994 Federal: Current $9,111 $11,387 $ 9,143 Deferred 5,152 3,679 4,697 Investment Tax Credit, Net (939) (942) (348) $13,324 $14,124 $13,492 State: Current 2,612 2,447 1,468 Deferred 122 (918) 870 2,734 1,529 2,338 Charged to Operations 16,058 15,653 15,830 Charged to Other Income: Current 1,233 522 617 Deferred (67) (67) (67) Total $17,224 $16,108 $16,380 Total income tax expense was different than the amounts computed by applying federal income tax statutory rates to book income subject to tax for the following reasons: _____________________________________________________________________________ (In Thousands) 1996 1995 1994 Federal Income Tax Computed at Statutory Rates $17,568 $17,343 $17,417 (Decreases) Increases in Tax from: Equity Component of AFUDC (128) (165) (92) Consolidated Tax Savings (156) (108) (651) Depreciation Differences (452) (264) (321) Amortization and Utilization of ITC (939) (942) (945) State Taxes, Net of Federal Income Tax Benefit 1,897 (2,625) 1,614 Cost of Removal 58 (226) Other (566) 2,811 (416) Total Income Tax Expense $17,224 $16,108 $16,380 (B) Income Taxes (continued) Eastern Edison and Montaup adopted Statement of Financial Accounting Standard No. 109, "Accounting for Income Taxes" (FAS109) which required recognition of deferred income taxes for temporary differences that are reported in different years for financial reporting and tax purposes using the liability method. Under the liability method, deferred tax liabilities or assets are computed using the tax rates that will be in effect when temporary differences reverse. Generally, for regulated companies, the change in tax rates may not be immediately recognized in operating results because of rate making treatment and provisions in the Tax Reform Act of 1986. The total deferred tax assets and liabilities at December 31, 1996 and 1995 are comprised as follows: Deferred Tax Deferred Tax Assets Liabilities ($000) ($000) 1996 1995 1996 1995 Plant Related Plant Related Differences $13,490 $16,181 Differences $153,471 $146,632 Alternative Refinancing Minimum Tax 412 4,470 Costs 1,471 1,691 Pensions 1,299 1,070 Pensions 877 940 Other 1,040 1,060 Other 2,507 1,901 Total 16,241 $22,781 Total $158,326 $151,164 As of December 31, 1996 and 1995, the Company had recorded on its Consolidated Balance Sheet a regulatory liability to ratepayers of approximately $18.0 million and $23.6 million, respectively. This amount primarily represents excess deferred income taxes resulting from the reduction in the federal income tax rate and also includes deferred taxes provided on investment tax credits. Also at December 31, 1996 and 1995, a regulatory asset of approximately $47.3 million and $44.4 million, respectively, has been recorded, representing the cumulative amount of federal income taxes on temporary depreciation differences which were previously flowed through to ratepayers. Montaup has approximately $0.4 million, respectively, of alternative minimum tax credits which can be utilized to reduce the EUA System's consolidated regular tax liability and have no expiration. (C) Capital Stock: There were no changes in the number of shares of common or preferred stock during the years ended December 31, 1996, 1995 and 1994. Under the terms and provisions of the issues of preferred stock of Eastern Edison, certain restrictions are placed upon the payment of dividends on common stock by Eastern Edison. At December 31, 1996, 1995 and 1994, the respective capitalization ratios were in excess of the minimum requirements which would make these restrictions effective. (D) Redeemable Preferred Stock Eastern Edison's 6-5/8% Preferred Stock issue is entitled to an annual mandatory sinking fund sufficient to redeem 15,000 shares commencing September 1, 2003. The redemption price is $100 per share plus accrued dividends. All outstanding shares of the 6-5/8% issue will be subject to mandatory redemption on September 1, 2008 at a price of $100 per share plus accrued dividends. In the event of liquidation, the holders of Eastern Edison's 6-5/8% Preferred Stock are entitled to $100 per share plus accrued dividends. (E) Retained Earnings: Under the provisions of Eastern Edison's Indenture securing the First Mortgage and Collateral Trust Bonds, retained earnings in the amount of $117,385,954 as of December 31, 1996 were unrestricted as to the payment of cash dividends on its Common Stock. (F) Long-Term Debt: The various mortgage bond issues of Eastern Edison are collateralized by substantially all of their utility plant. In addition, Eastern Edison's bonds are collateralized by securities of Montaup, which are wholly-owned by Eastern Edison, in the principal amount of approximately $236 million. In September, Eastern Edison used available cash to redeem $7 million of 4.875% First Mortgage Bonds at maturity. The Company's aggregate amount of current cash sinking fund requirements and maturities of long-term debt, (excluding amounts that may be satisfied by available property additions) for each of the five years following 1996 are: none in 1997, $60 million in 1998, and none in 1999, 2000 and 2001. (G) Lines of Credit: EUA System companies including Eastern Edison maintain short-term lines of credit with various banks aggregating approximately $140 million. At December 31, 1996, unused short-term lines of credit were approximately $89 million. These credit lines are available to other EUA System companies under joint credit line arrangements. In accordance with informal agreements with the various banks, commitment fees are required to maintain certain lines of credit. During 1996, the weighted average interest rate for short-term borrowings by the Company was 5.6%. (H) Jointly Owned Facilities: At December 31, 1996, in addition to the stock ownership interests discussed in Note A, Summary of Significant Accounting Policies - Jointly Owned Companies, Montaup had direct ownership interests in the following electric generating facilities (In Thousands): Accumulated Provision For Net Construc- Utility Depreciation Utility tion Percent Plant in and Plant in Work in ($ In Thousands) Owned Service Amortization Service Progress Montaup: Canal 2 50.00% $ 83,194 $41,843 $ 41,351 $446 Wyman 4 1.96% 4,051 2,130 1,921 Seabrook I 2.90% 194,928 29,983 164,945 251 Millstone III 4.01% 178,854 49,560 129,294 170 The foregoing amounts represent Montaup's interest in each facility, including nuclear fuel where appropriate, and are included on the like- captioned lines on the Consolidated Balance Sheet. At December 31, 1996, Montaup's total net investment in nuclear fuel of the Seabrook and Millstone units amounted to $2.8 million and $1.8 million, respectively. Montaup's shares of related operating and maintenance expenses with respect to units reflected in the table above are included in the corresponding operating expenses on the Consolidated Statement of Income. (I) Fair Value of Financial Instruments: The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate: Cash and Temporary Cash Investments: The carrying amount approximates fair value because of the short-term maturity of those instruments. Redeemable Preferred Stock and Long-Term Debt: The fair value of the Company's redeemable preferred stock and long-term debt were based on quoted market prices for such securities. The estimated fair values of the Company's financial instruments at December 31, 1996 are as follows (In Thousands): Carrying Fair Amount Value Cash and Temporary Cash Investments $ 2,105 $ 2,105 Redeemable Preferred Stock 30,000 30,300 Long-Term Debt $223,000 $225,870 (J) Commitments and Contingencies: Nuclear Fuel Disposal and Nuclear Decommissioning Costs: The owners (or lead participants) of the nuclear units in which Montaup has an interest have made, or expect to make, various arrangements for the acquisition of uranium concentrate, the conversion, enrichment, fabrication and utilization of nuclear fuel and the disposition of that fuel after use. The owners (or lead participants) of United States nuclear units have entered into contracts with the Department of Energy (DOE) for disposal of spent nuclear fuel in accordance with the Nuclear Waste Policy Act of 1982 (NWPA). The NWPA requires (subject to various contingencies) that the federal government design, license, construct and operate a permanent repository for high level radioactive wastes and spent nuclear fuel and establish a prescribed fee for the disposal of such wastes and nuclear fuel. The NWPA specifies that the DOE provide for the disposal of such waste and spent nuclear fuel starting in 1998. Objections on environmental and other grounds have been asserted against proposals for storage as well as disposal of spent nuclear fuel. The DOE now estimates that a permanent disposal site for spent fuel will not be ready to accept fuel for storage or disposal until as late as the year 2010. Montaup owns a 4.01% interest in Millstone III and a 2.9% interest in Seabrook I. Northeast Utilities, the operator of the units, indicates that Millstone III has sufficient on-site storage facilities which, with rack additions, can accommodate its spent fuel for the projected life of the unit. At the Seabrook Project, there is on-site storage capacity which, with rack additions, will be sufficient to at least the year 2011. The Energy Policy Act of 1992 requires that a fund be created for the decommissioning and decontamination of the DOE uranium enrichment facilities. The fund will be financed in part by special assessments on nuclear power plants in which Montaup has an interest. These assessments are calculated based on the utilities' prior use of the government facilities and have been levied by the DOE, starting in September 1993, and will continue over 15 years. This cost is passed on to the joint owners or power buyers as an additional fuel charge on a monthly basis and is currently being recovered by Montaup through rates. Also, Montaup is recovering through rates its share of estimated decommissioning costs for Millstone III and Seabrook I. Montaup's share of the current estimate of total costs to decommission Millstone III is $18.6 million in 1996 dollars, and Seabrook I is $13.1 million in 1996 dollars. These figures are based on studies performed for the lead owner of the units. Montaup also pays into decommissioning reserves pursuant to contractual arrangements with other nuclear generating facilities in which it has an equity ownership interest or life of the unit entitlement. Such expenses are currently recoverable through rates. Pensions: Eastern Edison and Montaup participate with the other EUA System companies in a non-contributory defined benefit pension plan covering substantially all of their employees (Retirement Plan). Retirement Plan benefits are based on years of service and average compensation over the four years prior to retirement. It is the EUA System's policy to fund the Retirement Plan on a current basis in amounts determined to meet the funding standards established by the Employee Retirement Income Security Act of 1974. Total pension (income) expense for the Retirement Plan, including amounts related to the 1995 Voluntary Retirement Incentive Offer, for 1996, 1995 and 1994 includes the following components ($ In Thousands): 1996 1995 1994 Service cost - benefits earned during the period $ 1,713 $ 1,504 $ 1,783 Interest cost on projected benefit obligation 5,767 5,575 5,217 Actual (return) loss on assets (10,036) (22,158) 927 Net amortization and deferrals 2,407 14,855 (7,677) Net periodic pension (income) expense $ (149) $ (224) $ 250 Voluntary retirement incentive 857 Total periodic pension (income) expense $ (149) $ 633 $ 250 Assumptions used to determine pension cost: 1996 1995 1994 Discount Rate 7.25% 8.25% 7.25% Compensation Increase Rate 4.25% 4.75% 4.75% Long-Term Return on Assets 9.50% 9.50% 9.50% The discount rate used to determine pension obligations was changed effective January 1, 1997 to 7.5%. The funded status of the Retirement Plan cannot be presented separately for Eastern Edison and Montaup as they participate in the Retirement Plan with other subsidiaries of EUA. The one-time voluntary retirement incentive also resulted in approximately $800,000 of non-qualified pension benefits which were expensed in 1995. At December 31, 1996, approximately $424,000 is included in other liabilities for these unfunded benefits. EUA also maintains non-qualified supplemental retirement plans for certain officers of the EUA System (Supplemental Plans). Benefits provided under the Supplemental Plans are based primarily on compensation at retirement date. EUA maintains life insurance on the participants of the Supplemental Plans to fund in whole, or in part, its future liabilities under the Supplemental Plans. For the years ended December 31, 1996, 1995 and 1994 Eastern Edison's and Montaup's expenses related to the Supplemental Plan were approximately $717,000, $825,000 and $266,000, respectively. The Company also provides a defined contribution 401(k) savings plan for substantially all employees. The Company's matching percentage of employees' voluntary contributions to the plan, amounted to approximately $306,000 in 1996, approximately $369,000 in 1995 and approximately $ 431,000 in 1994. Post-Retirement Benefits: Retired employees are entitled to participate in health care and life insurance benefit plans. Health care benefits are subject to deductibles and other limitations. Health care and life insurance benefits are partially funded by EUA System companies for all qualified employees. Eastern Edison and Montaup adopted FAS106, "Employers' Accounting for Post-Retirement Benefits Other Than Pensions," as of January 1, 1993. This standard establishes accounting and reporting standards for such post- retirement benefits as health care and life insurance. Under FAS106 the present value of future benefits is recorded as a periodic expense over employee service periods through the date they become fully eligible for benefits. With respect to periods prior to adopting FAS106, EUA elected to recognize accrued costs (the Transition Obligation) over a period of 20 years, as permitted by FAS106. The resultant annual expense, including amortization of the Transition Obligation and net of amounts capitalized and deferred, was approximately $3.6 million in 1996, $4.0 million in 1995, and $3.4 million in 1994. The total cost of Post-Retirement Benefits other than Pensions, including amounts related to the 1995 Voluntary Retirement Incentive Offer, for 1996, 1995 and 1994 includes the following components (In Thousands): 1996 1995 1994 Service cost $ 637 $ 565 $ 880 Interest cost 2,688 2,926 3,252 Actual return on plan assets (115) (388) (75) Amortization of transition obligation 1,955 1,965 2,026 Net other amortization & deferrals (721) (632) (50) Net periodic post-retirement benefit costs 4,444 4,436 6,033 Voluntary retirement incentive 470 Total post-retirement benefit costs $4,444 $ 4,906 $ 6,033 Assumptions: Discount rate 7.25% 8.25% 7.25% Health care cost trend rate-near-term 9.00% 11.00% 13.00% -long-term 5.00% 5.00% 5.00% Compensation increase rate 4.25% 4.75% 4.75% Rate of return on plan assets-union 8.50% 8.50% 8.50% - non-union 7.50% 5.50% 5.50% Reconciliation of funded status: 1996 1995 1994 (In Thousands) Accumulated post-retirement benefit obligation (APBO): Retirees ($19,864) $(23,223) $(20,227) Active employee fully eligible for benefits (1,728) (3,649) (4,116) Other active employees (6,031) (7,711) (9,255) Total (27,623) (34,583) (33,598) Fair Value of assets (primarily notes and bonds) 5,161 3,830 2,169 Unrecognized transition obligation 26,095 27,726 30,007 Unrecognized net (gain) loss (9,297) (2,142) (3,158) (Accrued) prepaid post-retirement benefit cost $5,664 $ (5,169) $ (4,580) The discount rate and compensation increase rates used to determine post- retirement benefit obligations effective January 1, 1997, are 7.5% and 4.25%, and were used to calculate the funded status of Post-Retirement Benefits at December 31, 1996. Increasing the assumed health care cost trend rate by 1% each year would increase the total post-retirement benefit cost for 1996 by approximately $311,000 and increase the total accumulated post-retirement benefit obligation by approximately $3.0 million. Eastern Edison and Montaup have also established an irrevocable external Voluntary Employees' Beneficiary Association (VEBA) Trust Fund as required by the aforementioned regulatory decisions. Contributions to the VEBA fund commenced in March 1993 and contributions were made totaling approximately $2.9 million in 1996, $3.2 million in 1995, and $2.9 million during 1994, respectively. Long-Term Purchased Power Contracts: Montaup is committed under long-term purchased power contracts, expiring on various dates through September 2021, to pay demand charges whether or not energy is received. Under terms in effect at December 31, 1996, the aggregate annual minimum commitments for such contracts are approximately $122 million in 1997, $116 million in 1998, $114 million in 1999, $111 million in 2000, $111 million in 2001, and will aggregate $1.0 billion for the ensuing years. In addition, the EUA System is required to pay additional amounts depending on the actual amount of energy received under such contracts. The demand costs associated with these contracts are reflected as Purchased Power-Demand on the Consolidated Statement of Income. Such costs are currently recoverable through rates. Environmental Matters: There is an extensive body of federal and state statutes governing environmental matters, which permit, among other things, federal and state authorities to initiate legal action providing for liability, compensation, cleanup, and emergency response to the release or threatened release of hazardous substances into the environment and for the cleanup of inactive hazardous waste disposal sites which constitute substantial hazards. Because of the nature of the Eastern Edison business, various by-products and substances are produced or handled which are classified as hazardous under the rules and regulations promulgated by the United States Environmental Protection Agency (EPA) as well as state and local authorities. The Company generally provides for the disposal of such substances through licensed contractors, but these statutory provisions generally impose potential joint and several responsibility on the generators of the wastes for cleanup costs. Eastern Edison and Montaup have been notified with respect to a number of sites where they may be responsible for such costs, including sites where they may have joint and several liability with other responsible parties. It is the policy of Eastern Edison and Montaup to notify liability insurers and to initiate claims. However, it is not possible at this time to predict whether liability, if any, will be assumed by, or can be enforced against, the insurance carrier in these matters. As of December 31, 1996, Eastern Edison and Montaup have incurred costs of approximately $800,000 in connection with the foregoing environmental matters and estimate that additional expenditures may be incurred through 1997 up to $130,000. As a general matter Eastern Edison and Montaup will seek to recover costs relating to environmental proceedings in their rates. Montaup is currently recovering certain of the incurred costs in its rates. Estimated amounts after 1998 are not now determinable since site studies which are the basis of these estimates have not been completed. As a result of the recoverability in current rates, and the uncertainty regarding both its estimated liability, as well as potential contributions from insurance carriers and other responsible parties, Eastern Edison and Montaup do not believe that the ultimate impact of the environmental costs will be material to their financial position and thus, no loss provision is required at this time. The Clean Air Act Amendments of 1990 (Clean Air Act) created new regulatory programs and generally updated and strengthened air pollution control laws. These amendments will expand the regulatory role of the EPA regarding emissions from electric generating facilities and a host of other sources. Montaup generating facilities were first affected in 1995, when EPA regulations took effect for facilities owned by Montaup. Montaup's coal-fired Somerset Unit No. 6 is utilizing lower sulfur content coal to meet the 1995 air standards. Eastern Edison does not anticipate the impact from the Amendments to be material to its financial position. In November of 1996, the EPA proposed to toughen the nation's ozone standards as well as the particulate matters standards. The effect that such rules will have on the EUA System cannot be determined by management at this time. On December 23, 1996, Eastern Edison, Montaup, the Massachusetts Attorney General and Division of Energy Resources reached a settlement in principle regarding electric utility industry restructuring in the State of Massachusetts. The proposed settlement includes a plan for emissions reductions related to Montaup's Somerset Station Units 5 and 6, and to Montaup's 50% ownership share of Canal Electric's Unit #2. The basis for sulfur dioxide (SO2) and nitrogen oxide (NOx) emission reductions in the proposed settlement is an allowance cap calculation. Montaup may meet its allowance caps by any combination of control technologies, fuel switching, operational changes, and/or the use of purchased or surplus allowances. The proposed settlement is expected to be filed with MDPU in March 1997. In April 1992, the Northeast States for Coordinated Air Use Management (NESCAUM), an environmental advisory group for eight Northeast states including Massachusett and Rhode Island issued recommendations for NOx controls for existing utility boilers required to meet the ozone non-attainment requirements of the Clean Air Act Amendments. The NESCAUM recommendations are more restrictive than Clean Air Act requirements. The Massachusetts Department of Environmental Management has amended its regulations to require that Reasonably Available Control Technology (RACT) be implemented at all stationary sources potentially emitting 50 tons per year or more of NOx. Rhode Island has also issued similar regulations requiring that RACT be implemented at all stationary sources potentially emitting 50 tons or more per year of NOx. Montaup has initiated compliance through, among other things, selective, noncatalytic reduction processes. A number of scientific studies in the past several years have examined the possibility of health effects from electric and magnetic fields (EMF) that are found wherever there is electricity. While some of the studies have indicated some association between exposure to EMF and health effects, many others have indicated no direct association. The research to date has not conclusively established a direct causal relationship between EMF exposure and human health. Additional studies, which are intended to provide a better understanding of EMF, are continuing. On October 31, 1996, the National Academy of Sciences issued a literature review of all research to date, "Possible Health Effects of Exposure to Residential Electric and Magnetic Fields." Its most widely reported conclusion stated, "No clear, convincing evidence exists to show that residential exposures to EMF are a threat to human health." Some states have enacted regulations to limit the strength of magnetic fields at the edge of transmission line rights-of-way. Rhode Island has enacted a statute which authorizes and directs the Energy Facility Siting Board to establish rules and regulations governing construction of high voltage transmission lines of 69 kv or more. Management cannot predict the ultimate outcome of the EMF issue. Guarantee of Financial Obligations: Montaup is a 3.27% equity participant in two companies which own and operate transmission facilities interconnecting New England and the Hydro Quebec system in Canada. Montaup has guaranteed approximately $4.8 million of the outstanding debt of these two companies. In addition, Montaup has a minimum rental commitment which totals approximately $12.7 million under a noncancellable transmission facilities support agreement for years subsequent to 1996. Other: In early 1997, ten plaintiffs brought suit against numerous defendants, including EUA, for injuries and illness allegedly caused by exposure to asbestos over approximately a thirty-year period, at premises, including some owned by EUA companies. The total damages claimed in all of these complaints is $25 million in compensatory and punitive damages, plus exemplary damages and interest and costs. Each names between fifteen and twenty-eight defendants, including EUA. These complaints have been referred to the applicable insurance companies, and EUA is consulting with those insurers to determine the availability and extent of coverage. EUA cannot predict the ultimate outcome of this matter at this time. Report of Independent Accountants To the Directors and Shareholder of Eastern Edison Company and Subsidiary: We have audited the accompanying consolidated balance sheet and consolidated statement of capitalization of Eastern Edison Company and its subsidiary (the Company) as of December 31, 1996 and 1995, and the related consolidated statement of income, retained earnings and cash flows for each of the three years in the period ended December 31, 1996. These financial statements 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 generally accepted auditing standards. 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, the financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 1996 and 1995, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1996 in conformity with generally accepted accounting principles. /s/Coopers & Lybrand L.L.P. Boston, Massachusetts March 5, 1997