<Page>
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
/X/ Quarterly Report Pursuant to Section 13 or 15(d) of the Securities and
Exchange Act of 1934
For the Quarterly Period Ended June 30, 2002
/ / Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the Transition Period From ______________to_____________
Commission File Number 33-59960
SITHE/INDEPENDENCE FUNDING CORPORATION
(Exact name of registrant as specified in its charter)
DELAWARE 13-3677475
-------- ----------
(State or other jurisdiction of (I.R.S. Employer Identification Number)
incorporation or organization)
335 MADISON AVENUE, NEW YORK, NY 10017
-------------------------------- -----
(Address of principal executive offices) (Zip code)
(212)-351-0000
--------------
(Registrant's telephone number, including area code)
SITHE/INDEPENDENCE POWER PARTNERS, L.P.
(Exact name of registrant as specified in its charter)
DELAWARE 33-0468704
-------- ----------
(State or other jurisdiction of (I.R.S. Employer Identification Number)
incorporation or organization)
335 MADISON AVENUE, NEW YORK, NY 10017
-------------------------------- -----
(Address of principal executive offices) (Zip code)
(212)-351-0000
--------------
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days.
/X/ Yes / / No
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SITHE/INDEPENDENCE POWER PARTNERS, L.P.
SITHE/INDEPENDENCE FUNDING CORPORATION
<Table>
<Caption>
PAGE NO.
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PART I FINANCIAL INFORMATION
SITHE/INDEPENDENCE POWER PARTNERS, L.P.
(a Delaware Limited Partnership)
Item 1. Financial Statements:
Condensed Consolidated Balance Sheets as of June 30, 2002 (Unaudited)
and December 31, 2001.................................................................. 3
Condensed Consolidated Statements of Operations for the Three and Six Months
Ended June 30, 2002 and 2001 (Unaudited)............................................... 4
Condensed Consolidated Statement of Partners' Deficiency for the Six
Months Ended June 30, 2002 (Unaudited)................................................. 5
Condensed Consolidated Statements of Cash Flows for the Six Months
Ended June 30, 2002 and 2001 (Unaudited)............................................... 6
Notes to Condensed Consolidated Financial Statements (Unaudited)......................... 7
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................................................ 10
Item 3. Quantitative and Qualitative Disclosures About Market Risk................................. 15
PART II OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K......................................................... 17
Signatures ....................................................................................... 18
</Table>
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SITHE/INDEPENDENCE POWER PARTNERS, L.P.
(A DELAWARE LIMITED PARTNERSHIP)
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
<Table>
<Caption>
JUNE 30,
2002 DECEMBER 31,
(UNAUDITED) 2001
-------------- ---------------
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 1,880 $ 4
Restricted cash and cash equivalents 83,754 45,741
Restricted investments 31,330 19,971
Accounts receivable - trade 28,925 29,765
Fuel inventory and other current assets 5,314 4,609
Current portion of transmission congestion contract derivative asset 17,643 9,452
Current portion of financial swap derivative asset 16,267 6,930
-------------- ---------------
TOTAL CURRENT ASSETS 185,113 116,472
PROPERTY, PLANT AND EQUIPMENT, AT COST:
Land 4,862 4,862
Electric and steam generating facilities 747,812 747,040
-------------- ---------------
752,674 751,902
Accumulated depreciation (140,509) (130,876)
-------------- ---------------
612,165 621,026
DEBT ISSUANCE COSTS 5,037 5,434
OTHER ASSETS 7,941 7,026
TRANSMISSION CONGESTION CONTRACT DERIVATIVE ASSET 148,834 139,778
FINANCIAL SWAP DERIVATIVE ASSET 107,271 59,649
-------------- ---------------
TOTAL ASSETS $ 1,066,361 $ 949,385
============== ===============
LIABILITIES AND PARTNERS' DEFICIENCY
CURRENT LIABILITIES:
Trade payables $ 17,435 $ 18,563
Accrued interest 28,579 2,646
Current portion of long-term debt 44,847 30,759
Current portion of transmission congestion contract derivative
obligation 17,843 19,327
-------------- ---------------
TOTAL CURRENT LIABILITIES 108,704 71,295
LONG-TERM DEBT:
8.50% secured bonds due 2007 136,751 150,839
9.00% secured bonds due 2013 408,609 408,609
Subordinated debt 419,282 419,282
-------------- ---------------
964,642 978,730
OTHER LIABILITIES 1,239 1,486
TRANSMISSION CONGESTION CONTRACT DERIVATIVE OBLIGATION 149,708 148,777
COMMITMENTS AND CONTINGENCIES - -
PARTNERS' DEFICIENCY (157,932) (250,903)
-------------- ---------------
TOTAL LIABILITIES AND PARTNERS' DEFICIENCY $ 1,066,361 $ 949,385
============== ===============
</Table>
See notes to condensed consolidated financial statements.
3
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SITHE/INDEPENDENCE POWER PARTNERS, L.P.
(A DELAWARE LIMITED PARTNERSHIP)
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
(IN THOUSANDS)
<Table>
<Caption>
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------------------ ------------------------------
2002 2001 2002 2001
------------ ------------ ------------ ------------
REVENUE $ 172,704 $ 104,175 $ 235,163 $ 229,151
------------ ------------ ------------ ------------
COST OF SALES:
Fuel 27,965 55,630 51,824 120,124
Operations and maintenance 14,777 13,298 27,348 24,988
Depreciation 4,816 4,923 9,633 9,910
Loss on project restructuring - 428,675 - 428,675
------------ ------------ ------------ ------------
47,558 502,526 88,805 583,697
------------ ------------ ------------ ------------
OPERATING INCOME (LOSS) 125,146 (398,351) 146,358 (354,546)
NON-OPERATING INCOME (EXPENSE):
Interest expense (20,889) (14,484) (41,061) (28,588)
Interest and other income (expense), net 875 (491) 1,115 3,305
------------ ------------ ------------ ------------
NET INCOME (LOSS) $ 105,132 $ (413,326) $ 106,412 $ (379,829)
============ ============ ============ ============
</Table>
See notes to condensed consolidated financial statements.
4
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SITHE/INDEPENDENCE POWER PARTNERS, L.P.
(A DELAWARE LIMITED PARTNERSHIP)
CONDENSED CONSOLIDATED STATEMENTS OF PARTNERS' DEFICIENCY (UNAUDITED)
(IN THOUSANDS)
<Table>
<Caption>
TOTAL
GENERAL LIMITED PARTNERS'
PARTNER PARTNERS DEFICIENCY
-------------- ------------- ---------------
BALANCE, JANUARY 1, 2002 $ (417,978) $ 167,075 $ (250,903)
Net income and total comprehensive income 1,092 105,320 106,412
Distribution to partners (79) (13,362) (13,441)
-------------- ------------- ---------------
BALANCE, JUNE 30, 2002 $ (416,965) $ 259,033 $ (157,932)
============== ============= ===============
</Table>
See notes to condensed consolidated financial statements.
5
<Page>
SITHE/INDEPENDENCE POWER PARTNERS, L.P.
(A DELAWARE LIMITED PARTNERSHIP)
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(IN THOUSANDS)
<Table>
<Caption>
SIX MONTHS ENDED
JUNE 30,
---------------------------------
2002 2001
--------------- ---------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $ 106,412 $ (379,829)
Adjustments to reconcile net income (loss) to net cash
provided by operating activities:
Depreciation 9,633 9,910
Loss on project restructuring - 428,675
Unrealized gain on derivatives (74,759) (2,384)
Gain on sale of property, plant and equipment - (173)
Amortization of deferred financing costs 397 438
Unrealized (gain) loss on marketable securities 35 (112)
Changes in operating assets and liabilities:
Accounts receivable - trade 840 16,881
Fuel inventory and other current assets (705) (1,623)
Other assets (915) (1,067)
Trade payables (1,128) 1,697
Accrued interest 25,933 27,455
Other liabilities (247) (2,455)
--------------- ---------------
NET CASH PROVIDED BY OPERATING ACTIVITIES 65,496 97,413
--------------- ---------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from sale of property, plant and equipment - 15,075
Capital expenditures (772) (421)
Restricted funds, net (49,407) (40,195)
--------------- ---------------
NET CASH USED IN INVESTING ACTIVITIES (50,179) (25,541)
--------------- ---------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Distributions to partners (13,441) (76,789)
Capital contribution - 3,539
--------------- ---------------
NET CASH USED IN FINANCING ACTIVITIES (13,441) (73,250)
--------------- ---------------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 1,876 (1,378)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 4 2,116
--------------- ---------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 1,880 $ 738
=============== ===============
SUPPLEMENTAL CASH FLOW INFORMATION
Cash payments for interest $ 14,635 $ 1,133
</Table>
See notes to condensed consolidated financial statements.
6
<Page>
SITHE/INDEPENDENCE POWER PARTNERS, L.P.
(A DELAWARE LIMITED PARTNERSHIP)
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
1. THE PARTNERSHIP
Sithe/Independence Power Partners, L.P. (the "Partnership") was formed in
November 1990 for a term of 50 years to develop, construct and own a natural
gas-fired cogeneration facility having capacity of approximately 1,000
megawatts ("MW") located in the Town of Scriba, County of Oswego, New York
(the "Project"). The Project began commercial operation for financial
reporting purposes on December 29, 1994. The Partnership is a Delaware
limited partnership formed by Sithe/Independence LLC (formerly known as
Sithe/Independence, Inc.) (the "General Partner"), its sole general partner.
The General Partner is an indirect wholly-owned subsidiary of Sithe Energies,
Inc. ("Sithe Energies"). Prior to June 30, 2001, the limited partners of the
Partnership were Sithe Energies and certain of its direct and indirect
wholly-owned subsidiaries (the "Limited Partners"). On June 30, 2001 one of
the Limited Partners sold its 40% ownership interest in the Partnership to
Oswego Cogen Company, LLC ("Oswego Cogen"), an indirect, wholly-owned
subsidiary of Enron Corp. Accordingly, as of June 30, 2002, the Partnership
is owned 60% by Sithe Energies (directly and indirectly through its
wholly-owned subsidiaries) and 40% by Oswego Cogen.
Through June 30, 2001, the majority of the Project's capacity was sold
to Consolidated Edison Company of New York, Inc. ("Con Edison") with the
remainder of the capacity sold to Alcan Aluminum Corporation ("Alcan") and
into the capacity market administered by the New York Independent System
Operator, Inc. (the "NYISO" or "ISO Administered Market"). The majority of
the electric energy generated by the Project was sold into the ISO
Administered Market, with the remainder of the generation sold to Niagara
Mohawk Power Corporation ("Niagara Mohawk") and Alcan. As of July 1, 2001,
while the majority of the Project's capacity continues to be sold to Con
Edison, and up to 44 MW of the Project's capacity and associated energy
continues to be sold to Alcan, the Partnership has entered into a tolling
agreement (the "Tolling Agreement") with Dynegy Power Marketing, Inc.
("DPM") for approximately sixty percent of the Project's output, under which
DPM pays the Partnership tolling fees for the right to supply natural gas to
the Project to be converted to electric energy. In addition to the Tolling
Agreement, the Partnership has also entered into a multi-agreement financial
swap (the "Financial Swap Agreement") with DPM with respect to 375 MW of the
Project's output.
2. BASIS OF PRESENTATION
The accompanying condensed consolidated balance sheets at June 30, 2002 and
December 31, 2001 and the condensed consolidated statements of operations for
the three and six months ended June 30, 2002 and 2001 and the condensed
consolidated statements of partners' deficiency for the six months ended June
30, 2002 should be read in conjunction with the audited consolidated
financial statements included in the Annual Report on Form 10-K for the year
ended December 31, 2001 for the Partnership and its wholly-owned subsidiary,
Sithe/Independence Funding Corporation ("Sithe Funding").
The results of operations for the three and six months ended June 30, 2002
and 2001 are not necessarily indicative of the results to be expected for the
full year. The unaudited financial information at June 30, 2002 and for the
three and six months ended June 30, 2002 and 2001 contains all adjustments,
consisting only of normal recurring adjustments, which management considers
necessary for a fair presentation of the financial position and operating
results for such periods.
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3. RECENT ACCOUNTING PRONOUNCEMENTS
In June 2001, the Financial Accounting Standards Board (the "FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 142, "Goodwill and
Other Intangible Assets" and SFAS No. 143, "Accounting for Asset Retirement
Obligations". In August 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets."
On January 1, 2002, the Partnership adopted the provisions of SFAS No. 142
which became effective for fiscal years beginning after December 15, 2001 for
all goodwill and other intangible assets recognized in an entity's statement of
financial position regardless of when such assets were initially recognized. The
adoption of SFAS No. 142 had no impact on the Partnership's results of
operations or financial position.
SFAS No. 143 requires that asset retirement obligations be reported at fair
value in the period incurred for fiscal years beginning after June 15, 2002 and
recognized as expense in subsequent periods. The Partnership is currently
evaluating the provisions of SFAS No. 143, which it has not yet adopted.
On January 1, 2002, the Partnership adopted the provisions of SFAS No. 144
which became effective for fiscal years beginning after December 15, 2001. SFAS
No. 144 requires one accounting model to be used for long-lived assets to be
disposed of by sale, whether previously held and used or newly acquired and
retains the previous recognition and measurement standards for impairment
losses. The adoption of SFAS No. 144 had no impact on the Partnership's results
of operations or financial position.
4. DERIVATIVE INSTRUMENTS
Effective January 1, 2001, the Partnership adopted SFAS No. 133,
"Accounting for Derivative Instruments and Hedging Activities." SFAS No. 133, as
amended and interpreted, establishes accounting and reporting standards
requiring that all derivatives, including certain derivative instruments
embedded in other contracts be recorded in the balance sheet as either an asset
or liability measured at their fair value. When specific hedge accounting
criteria are not met, SFAS No. 133 requires that changes in a derivative's fair
value be recognized currently in earnings. If a derivative is designated as a
fair-value hedge, the changes in the fair value of the derivative and the hedged
item will be recognized in earnings. If the derivative is designated as a
cash-flow hedge, changes in the fair value of the derivative will be recorded in
other comprehensive income and will be recognized in the income statement when
the hedged item affects earnings. SFAS No. 133 requires that an entity formally
document, designate and perform ongoing assessments of the effectiveness of
transactions that receive hedge accounting. Ongoing discussions and
interpretations of SFAS No. 133 by the FASB could alter the definition of
derivative instruments. The Partnership has implemented SFAS No. 133 based upon
current rules and guidance, and any changes in these rules and guidance could
impact the Partnership's subsequent reported operating results.
As of June 30, 2002, the Partnership had three derivatives, a
Transmission Congestion Contract ("TCC"), and the Financial Swap Agreement and
a gas supply agreement (the "Gas Supply Agreement"), which are part of the
tolling arrangement with DPM. None of these derivatives are designated as
hedges under SFAS No. 133.
As of June 30, 2002, the Partnership recorded the TCC at fair value by
recognizing a current asset of $17.6 million, a long-term asset of $148.8
million, a current liability of $17.8 million and a long-term obligation of
$149.7 million. Additional revenue of $17.8 million was recognized for the six
months ended June 30, 2002.
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Although the Partnership accounts for the Financial Swap Agreement and the
Gas Supply Agreement as derivatives which are not designated as hedges, the
Partnership believes that together, the Tolling Agreement, the Financial Swap
Agreement and the Gas Supply Agreement eliminate the financial risks associated
with the purchase of natural gas to operate the Project on a full-time, base
load basis as well as eliminating the exposure to variable market prices
associated with the sale of energy into the NYISO assuming continued performance
by the counterparty to each of such agreements. As of June 30, 2002, the
Partnership recorded the Financial Swap Agreement at fair value by recognizing a
current asset of $16.3 million and a long-term asset of $107.3 million.
Additional revenue of $57.0 million was recognized for the six months ended June
30, 2002. Since natural gas purchased by the Partnership under the Gas Supply
Agreement is at current market price, this derivative had a zero fair value at
June 30, 2002.
5. SUBSEQUENT EVENT
Pursuant to obligations that arose subsequent to June 30, 2002, Dynegy
Holdings Inc. ("DHI") failed to provide certain substitute guaranties that it
was obligated to provide to the Partnership under four separate guaranty
agreements (the "Guaranty Agreements"), pursuant to which DHI guaranteed to
the Partnership certain obligations of DPM under the Tolling Agreement and
Financial Swap Agreement, Dynegy Canada Marketing and Trade (a division of
Dynegy Canada, Inc.)("Dynegy Canada") under the Gas Supply Agreement and
Dynegy Marketing and Trade and DPM under the Energy Management Agreement. The
obligation to provide these substitute guaranties arose due to a downgrading
in the investment ratings of the unsecured, senior long-term debt of DHI and
the subsequent request for substitute guaranties by the Partnership. The
failure to provide these substitute guaranties constitutes a breach of the
terms of the Guaranty Agreements and an event of default under each of the
Tolling Agreement, the Financial Swap Agreement, the Gas Supply Agreement and
the Energy Management Agreement (the "Agreements"). To the Partnership's
knowledge, DHI's subsidiaries party to the Agreements are otherwise in
substantial compliance with such agreements. Accordingly, no provision has
been recorded at June 30, 2002 for any potential losses that may arise from
the failure of DHI'S subsidiaries to perform under the Agreements. If DPM,
Dyengy Canada and Dynegy Marketing and Trade fail to perform their
obligations under the Agreements to which they are a party and if DHI fails
to perform the obligations it has guaranteed under the Guaranty Agreements, it
could have a material adverse impact on the Partnership's financial position
and results of operations.
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<Page>
SITHE/INDEPENDENCE POWER PARTNERS, L.P.
(A DELAWARE LIMITED PARTNERSHIP)
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
RESULTS OF OPERATIONS
SECOND QUARTER OF 2002 COMPARED WITH SECOND QUARTER OF 2001
Revenue for the second quarter of 2002 of $172.7 million was $68.5 million
(66%) higher than in the corresponding period last year. This increase is
attributable to an increase in the estimated fair value of the Partnership's
Financial Swap Agreement, entered into on July 1, 2001, and TCC derivatives
which increased by $74.4 million and $8.6 million, respectively, compared
with the corresponding period of last year. TCC and capacity revenue
increased by $9.2 million and $1.3 million, respectively, from the
corresponding period of last year. The $93.5 million total increase in
revenue outlined above was offset in part by a $25.4 million decrease in
revenue attributable to the fact that the Partnership operated the Project
under tolling arrangements with DPM in the second quarter of 2002 versus the
corresponding period of last year when the majority of the Project's output
was sold to the NYISO and Niagara Mohawk with energy rates based on
locational based marginal prices ("LBMP") as determined by the NYISO.
Cost of sales for the second quarter ended June 30, 2002 of $47.6 million
was $26.3 million (36%) lower than the $73.9 million cost of sales, exclusive of
the $428.7 million loss on project restructuring recognized during the second
quarter ended June 30, 2001. The commencement of the tolling arrangements with
DPM and an amendment to the Partnership's gas supply agreement with Enron, which
eliminated the Partnership's obligation to purchase natural gas from Enron and
transferred to Enron its obligations under five of the Partnership's seven fuel
transportation arrangements, resulted in a $27.7 million decrease in fuel
expense when compared to the corresponding period of last year. In addition,
operations and maintenance expense for the second quarter of 2002 was
approximately $1.5 million higher than in the corresponding period of last year
due primarily to higher utilities costs of $3.3 million offset in part by lower
equipment maintenance expenses of $2.0 million. Lastly, depreciation expense was
approximately $.1 million lower for the second quarter of 2002 than in the
corresponding period of last year.
On June 29, 2001, the Partnership entered into a series of transactions
which included (i) an amendment to the Partnership's long-term gas supply
agreement with Enron which effectively terminated the Partnership's obligation
to purchase natural gas from Enron, (ii) the transfer of its obligations under
five of its seven gas transportation arrangements to Enron, (iii) a tolling
arrangement with DPM which commenced on July 1, 2001 and (iv) the sale of a 40%
limited partnership interest in the Partnership to Oswego Cogen, an indirect
wholly-owned subsidiary of Enron Corp.
As a result of the amendment to the gas supply agreement, the
Partnership and Enron agreed to terminate the Partnership's obligation to
purchase natural gas from Enron and the tracking account balance under the
gas supply agreement of $419.3 million was fixed and converted to a secured
subordinated loan (the "Tracking Account Loan") resulting in a $419.3 million
charge, recorded as a loss on project restructuring on the Partnership's
condensed consolidated statement of operations for the three and six months
ended June 30, 2001. The Tracking Account Loan is subordinate to the
Securities and to certain payments due to Con Edison under the Amended EPA.
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The Partnership recognized an additional $9.4 million loss on project
restructuring for the three and six months ended June 30, 2001 to write-off
prepaid equalization fees that were included in other assets. The $9.4 million
balance of prepaid equalization fees represented the difference between the six
annual $3.0 million equalization payments made to Niagara Mohawk between
December 31, 1995 and December 31, 2000 and the amortization of such fees over
the 22 year term of the Alcan Energy Sales Contract. The Partnership is no
longer obligated to make the four remaining annual equalization fee payments to
Niagara Mohawk.
Interest expense for the second quarter of 2002 of $20.9 million was $6.4
million (44%) higher than the corresponding period of last year due to $7.3
million of interest expense on the Tracking Account Loan, offset by $.9 million
of lower interest expense due to the lower outstanding principal amount of the
Securities and lower letter of credit fees.
For the second quarter of 2002, interest and other income, net, of $.9
million consisted of interest income of $.8 million and unrealized gains on the
Partnership's restricted investments of $.1 million. For the second quarter of
2001, interest and other expense, net, of $.5 million consisted principally of
interest income of $1.4 million offset by the reversal of a portion of the gain
on the sale of certain interconnection facility assets of $1.9 million that was
recorded during the first quarter of 2001 under the terms of a partial
settlement agreement with Niagara Mohawk that was later superceded and revised.
At June 30, 2002, the current portion of long-term debt and accrued
interest payable were $14.1 million and $25.9 million higher, respectively, than
at December 31, 2001 principally due to the fact that the $41.4 million debt
service payment scheduled for June 30, 2002, which was a weekend, was not made
until the next business day which was July 1, 2002.
FIRST HALF OF 2002 COMPARED WITH FIRST HALF OF 2001
Revenue for the six months ended June 30, 2002 of $235.2 million was $6.0
million (3%) higher than in the corresponding period of last year. This increase
is attributable to an increase in the estimated fair value of the Partnership's
Financial Swap Agreement, entered into on July 1, 2001, and TCC derivatives
which increased by $57.0 million and $15.4 million, respectively, compared
with the corresponding period of last year. TCC and capacity revenue
increased by $5.9 million and $4.7 million, respectively, from the
corresponding period of last year. The $83.0 million total increase in
revenue outlined above was offset in part by a $73.4 million decrease in
revenue attributable to the fact that the Partnership operated the Project
under tolling arrangements with DPM during the first six months of 2002
versus the corresponding period of last year when the majority of the
Project's output was sold to the NYISO and Niagara Mohawk with energy rates
based on LBMP as determined by the NYISO. The remaining decrease of $3.6
million is due primarily to the fact that the first quarter of 2001 reflected
$2.3 million of additional revenue for the settlement of claims against
Niagara Mohawk for transmission loss overcharges and $1.3 million of
incremental revenue from selling gas instead of generating electricity.
Cost of sales for the six months ended June 30, 2002 of $88.8 million was
$66.2 million (43%) lower than the $155.0 million cost of sales, exclusive of
the $428.7 million loss on project restructuring recognized during the six
months ended June 30, 2001. This decrease is attributable to lower fuel costs of
$68.3 million due to the fact that the Partnership operated the Project under
the tolling arrangements with DPM as discussed above, offset in part by higher
operations and maintenance expense of $2.4 million relating principally to
higher utilities and other operating expense of $5.1 million offset by lower
equipment maintenance expense of $3.1 million. Lastly, depreciation expense was
approximately $.3 million lower than the corresponding period of last year.
-11-
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Interest expense for the six months ended June 30, 2002 of $41.0 million
was $12.5 million (44%) higher than in the corresponding period of last year due
to $14.4 million of interest expense on the Tracking Account Loan, offset by
$1.9 million of lower interest expense due to the lower outstanding principal
amount of the Securities and lower letter of credit fees.
For the six months ended June 30, 2002, interest and other income, net, of
$1.1 million consisted of $1.3 million of interest income offset by $.2 million
of unrealized losses on the Partnership's restricted investments. For the six
months ended June 30, 2001, interest and other income, net, of $3.3 million
consisted of $2.7 million of interest income, $.4 million of unrealized gains on
the Partnership's restricted investments and a net gain of $.2 million on the
sale of the interconnection facility assets discussed above.
LIQUIDITY AND CAPITAL RESOURCES
Financing for the Project consisted of a loan to the Partnership by Sithe
Funding of the proceeds of its issuance of $717.2 million of the Securities and
$60.0 million of capital contributions by the Partners. In addition, under a
credit facility obtained by the Partners, one or more letters of credit may be
issued in connection with their obligations pursuant to certain Project
contracts, and, as of June 30, 2002, letters of credit aggregating $2.2 million
were outstanding in connection with such obligations. Also, the Partnership has
secured the Project's debt service reserve obligations with a letter of credit
in the amount of $50.0 million. As of June 30, 2002, the Partnership had
restricted funds and investments aggregating $115.1 million, including the
Project's cumulative cash debt service reserve and major overhaul reserve of
$33.0 million and $6.3 million, respectively. In addition, these restricted
funds included $13.8 million that was utilized for July 2002 operating expenses
and $41.4 million reserved for the June 2002 debt service payment and the
balance available for transfer to and deposit in the interest payment account
for the December 2002 debt service payment. Funds in the Partnership
distribution account are available as additional operating and debt service
reserves until such time as certain coverage ratios are achieved. To secure the
Partnership's obligation to pay any amounts drawn under the debt service letter
of credit, the letter of credit provider has been assigned a security interest
and lien on all of the collateral in which the holders of the Securities have
been assigned a security interest and lien. The $419.3 million Tracking Account
Loan bears interest at an annual rate of 7%, which is payable semi-annually, and
which payments began on December 1, 2001 from cash distributable to the partners
in accordance with the terms of the Securities. The Tracking Account Loan will
be repaid in 40 semi-annual principal payments commencing on June 1, 2015.
The Partnership is precluded from making distributions to Partners unless
project reserve accounts are funded to specified levels and unless the required
debt service coverage ratio is met and the Partnership's obligation to pay the
subordinated payments to Con Edison under the Amended EPA, which amount to $5.0
million in 2002, are satisfied. During the first six months of 2002, the
Partnership made a distribution to its Partners in the amount of $13.4 million.
The Partnership believes that funds available from cash on hand, restricted
funds, operations and the debt service letter of credit will be more than
sufficient to liquidate Partnership obligations as they come due and pay
scheduled debt service.
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CRITICAL ACCOUNTING POLICIES
In December 2001, the Securities and Exchange Commission encouraged all
registrants to disclose their most critical accounting policies. Critical
accounting policies are defined as those that are reflective of significant
judgement by management and potentially produce materially different results
under different assumptions and conditions. The Partnership believes that its
critical accounting policies are limited to accounting for the TCC and Financial
Swap Agreement derivative instruments.
The Partnership believes that together, the Tolling Agreement, the
Financial Swap Agreement and the Gas Supply Agreement eliminate the financial
risks associated with the purchase of natural gas to operate the Project on a
full-time, base load basis as well as eliminating the exposure to variable
market prices associated with the sale of energy into the NYISO assuming
continued performance by the counterparty to each of such agreements. If DPM,
Dynegy Canada and Dynegy Marketing and Trade fail to perform their
obligations under the Agreements to which they are a party and if DHI fails
to perform the obligations it has guaranteed under the Guaranty Agreements,
it could have a material adverse impact on the Partnership's financial
position and results of operations. Under SFAS No. 133, as amended and
interpreted, the Partnership must account for the Financial Swap Agreement
and the Gas Supply Agreement as derivatives which are not designated as
hedges, using mark to market accounting, with changes in fair value of these
derivatives recognized in the consolidated statement of operations.
The Partnership uses financial models and pricing assumptions to estimate
the fair values of the TCC and the Financial Swap Agreement derivatives, whose
terms extend beyond the periods for which any quoted market prices are
available. Although the Partnership believes that the financial models and
pricing assumptions used are reasonable, changes in valuation techniques,
pricing assumptions and the availability of actively quoted market prices will
result in changes to the reported estimated fair values of these derivatives,
which could be significant.
Although changes in the estimated fair value of the Financial Swap
Agreement will affect reported earnings, such changes will not affect the
Partnership's cash flows from operating activities, which are largely dependent
on payments from DPM under the Tolling Agreement and the Financial Swap
Agreement and on payments from Con Edison under the Amended EPA. Changes in the
estimated fair value of the TCC, which reflect the estimated present value of
the future receipts and payments over its remaining term, will only affect the
Partnership's cash flows from operating activities to the extent of actual
amounts settled during the period. Assuming there were no differences in LBMP
due to congestion, there would be no receipts from or payments to the NYISO, and
the impact on the Partnership's cash flows from operating activities due to
fixed payments to Niagara Mohawk would be a negative $18.0 million per year.
For the six months ended June 30, 2002, the Partnership recognized revenues
of $57.5 million and fuel expense of $38.0 million for settlements of the
Financial Swap Agreement and revenues of $18.9 million and operations and
maintenance expense of $9.0 million for settlements of the TCC.
The following table summarizes maturities of the Partnership's derivative
contracts as of June 30, 2002 (in millions):
-13-
<Page>
<Table>
<Caption>
Fair Value of Contracts at June 30, 2002
-----------------------------------------------------------------------------
Maturities of:
- -----------------------------------------------------------------------------------------------------
More than More than
One year but Three years
Source of One Year Less than But less than More than Total Fair
Fair Value Or Less Three years Five years Five years Value
- -----------------------------------------------------------------------------------------------------
Prices provided by
other external
sources, models and
other valuation
methods $ 16.1 $ 28.3 $ 19.8 $ 58.3 $ 122.5
========= ================ ============ ============ ===============
</Table>
RECENT DEVELOPMENT
Pursuant to obligations that arose subsequent to June 30, 2002, Dynegy
Holdings Inc. ("DHI") failed to provide certain substitute guaranties that it
was obligated to provide to the Partnership under four separate guaranty
agreements (the "Guaranty Agreements"), pursuant to which DHI guaranteed to
the Partnership certain obligations of DPM under the Tolling Agreement and
Financial Swap Agreement, Dynegy Canada Marketing and Trade (a division of
Dynegy Canada, Inc.)("Dynegy Canada") under the Gas Supply Agreement and
Dynegy Marketing and Trade and DPM under the Energy Management Agreement. The
obligation to provide these substitute guaranties arose due to a downgrading
in the investment ratings of the unsecured, senior long-term debt of DHI and
the subsequent request for substitute guaranties by the Partnership. The
failure to provide these substitute guaranties constitutes a breach of the
terms of the Guaranty Agreements and an event of default under each of the
Tolling Agreement, the Financial Swap Agreement, the Gas Supply Agreement and
the Energy Management Agreement (the "Agreements"). To the Partnership's
knowledge, DHI's subsidiaries party to the Agreements are otherwise in
substantial compliance with such agreements. Accordingly, no provision has
been recorded at June 30, 2002 for any potential losses that may arise from
the failure of DHI'S subsidiaries to perform under the Agreements. If DPM,
Dyengy Canada and Dynegy Marketing and Trade fail to perform their
obligations under the Agreements to which they are a party and if DHI fails
to perform the obligations it has guaranteed under the Guaranty Agreements, it
could have a material adverse impact on the Partnership's financial position
and results of operations.
FORWARD-LOOKING STATEMENTS
Certain statements included in this Quarterly Report on Form 10-Q are
forward-looking statements as defined in Section 21E of the Securities
Exchange Act of 1934. The words "anticipate", "believe", "expect",
"estimated" and similar expressions generally identify forward-looking
statements. While the Partnership believes in the veracity of all statements
made herein, forward-looking statements are necessarily based upon a number
of estimates and assumptions that, while considered reasonable by the
Partnership, are inherently subject to significant business, economic and
competitive uncertainties and contingencies, the continued performance of
counterparties to the Tolling Agreement, derivative contracts and gas supply
agreements, the demand for and price of electricity and changes in government
regulations and the continuing deregulation of the electric energy industry.
These uncertainties and contingencies could cause the Partnership's actual
results to differ materially from those expressed in any forward-looking
statements made by, or on behalf of, the Partnership.
-14-
<Page>
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Partnership uses the sensitivity analysis methodology to disclose the
quantitative information for interest rate and commodity price risks. The
sensitivity analysis estimates the potential loss of fair value from market risk
sensitive instruments due to a 10% unfavorable change in interest rates and
commodity prices.
INTEREST RATE RISK
The Partnership has investments in financial instruments subject to
interest rate risk consisting of $83.8 million of restricted cash and cash
equivalents and $31.3 million of restricted investments. In the case of
restricted cash and cash equivalents, due to the short duration of these
financial instruments, a 10% immediate change in interest rates would not have a
material effect on the Partnership's financial condition. In the case of
restricted investments, the resulting potential decrease in fair value from a
10% immediate change in interest rates would be approximately $.1 million.
The Partnership's outstanding long-term debt at June 30, 2002 bears
interest at fixed rates and therefore the Partnership's results of operations
would not be affected by changes in interest rates as they apply to borrowings.
COMMODITY PRICE RISK
The Partnership is subject to commodity price risk on the fair value of the
TCC from changes in the differential between the LBMP at the Pleasant Valley Bus
and the Independence Bus due to congestion. The Partnership estimates that a 10%
decrease in this differential would decrease the estimate fair value of the TCC
assets by approximately $1.8 million.
The Partnership is also subject to commodity price risk on the fair value
of the Financial Swap Agreement from changes in the spread between prices of
natural gas and electricity. The Partnership estimates that a 10% increase in
this price spread would decrease the estimated fair value of the Financial Swap
Agreement assets by approximately $7.5 million.
The Partnership uses financial models and pricing assumptions to estimate
the fair values of the TCC and the Financial Swap Agreement derivatives, whose
terms extend beyond the periods for which any quoted market prices are
available. Although the Partnership believes that the financial models and
pricing assumptions used are reasonable, changes in valuation techniques,
pricing assumptions and the availability of actively quoted market prices will
result in changes to the reported estimated fair values of these derivatives,
which could be significant.
Fluctuations in the underlying assumptions used to determine the estimated
fair value of the TCC, including quoted market prices, forward curve data and
interest rates, could cause the estimated fair value of the TCC to fluctuate
significantly from quarter to quarter. The fluctuations for the quarter ended
June 30, 2002 from the quarters ended March 31, 2002 and December 31, 2001 are
summarized in the following table (in millions):
-15-
<Page>
<Table>
<Caption>
QUARTERS ENDED
----------------------------------------
JUNE 30, MARCH 31, DECEMBER 31,
2002 2002 2001
----------- ----------- -----------
ASSETS:
Current portion of TCC derivative asset $ 17.6 $ 12.3 $ 9.5
Long-term portion of TCC derivative asset 148.8 138.9 139.8
----------- ----------- -----------
Total Assets 166.4 151.2 149.3
=========== =========== ===========
LIABILITIES:
Current portion of TCC derivative obligation 17.8 17.8 19.3
Long-term portion of TCC derivative obligation 149.7 145.5 148.8
----------- ----------- -----------
Total Liabilities 167.5 163.3 168.1
=========== =========== ===========
NET INCOME (LOSS):
Revenue $ 11.0 $ 6.8 $ (8.2)
=========== =========== ===========
</Table>
Fluctuations in the underlying assumptions used to determine the estimated
fair value of the Financial Swap Agreement derivative instrument, including
quoted market prices, forward curve data and interest rates, could cause the
estimated fair value of the Financial Swap Agreement to fluctuate significantly
from quarter to quarter. The fluctuations for the quarter ended June 30, 2002
from the quarters ended March 31, 2002 and December 31, 2001 are summarized in
the following table (in millions):
<Table>
<Caption>
QUARTERS ENDED
----------------------------------------
JUNE 30, MARCH 31, DECEMBER 31,
2002 2002 2001
----------- ----------- -----------
ASSETS:
Current portion of financial swap derivative asset $ 16.3 $ 3.3 $ 6.9
Long-term financial swap derivative asset 107.3 45.8 59.7
----------- ----------- -----------
Total Assets 123.6 49.1 66.6
=========== =========== ===========
NET INCOME (LOSS):
Revenue $ 74.5 $ (17.5) $ 79.9
=========== =========== ===========
</Table>
Although changes in the estimated fair values of the Financial Swap
Agreement have an impact on reported earnings, such changes will not affect the
Partnership's cash flows from operating activities, which are largely dependent
on payments from DPM under the Tolling Agreement and the Financial Swap
Agreement and on payments from Con Edison under the Amended EPA. Changes in the
estimated fair value of the TCC, which reflect the estimated present value of
the future receipts and payments over its remaining term, will only affect the
Partnership's cash flows from operating activities to the extent of actual
amounts settled during the period. Assuming there were no differences in LBMP
due to congestion, there would be no receipts from or payments to the NYISO, and
the impact on the Partnership's cash flows from operating activities due to
fixed payments to Niagara Mohawk would be a negative $18.0 million per year.
-16-
<Page>
PART II -- OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits:
EXHIBIT NO. DESCRIPTION OF EXHIBIT
3.12 First Amendment to the Third Amended and Restated Agreement
of Limited Partnership of Sithe/Independence Power Partners,
L.P. dated as of May 22, 2002 among the General Partner,
Sithe Energies, Inc., Sithe Energies U.S.A., Inc., Mitex,
Inc. and Oswego Cogen Company, LLC.
10.3.21 First Amendment to the Amended and Restated Energy Purchase
Agreement dated as of June 3, 2002 by and between the
Partnership and Con Ed.
(b) Reports on Form 8-K:
No report on Form 8-K was filed during the quarter covered by this
report.
-17-
<Page>
SIGNATURES
Pursuant to the requirements 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.
Sithe/Independence Funding Corporation
--------------------------------------
(REGISTRANT)
August 14, 2002 /s/ Thomas M. Boehlert
----------------------------------------
THOMAS M. BOEHLERT
SENIOR VICE PRESIDENT AND
CHIEF FINANCIAL OFFICER
(PRINCIPAL FINANCIAL AND
ACCOUNTING OFFICER)
Pursuant to the requirements of the Securities Exchange Act of 1934, the
co-registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Sithe/Independence Power Partners, L.P.
---------------------------------------
(CO-REGISTRANT)
By: Sithe/Independence LLC
----------------------
GENERAL PARTNER
August 14, 2002 /s/ Thomas M. Boehlert
------------------------------------
THOMAS M. BOEHLERT
SENIOR VICE PRESIDENT AND
CHIEF FINANCIAL OFFICER
(PRINCIPAL FINANCIAL AND
ACCOUNTING OFFICER)
-18-