SECURITIES AND EXCHANGE COMMISSION Washington, D. C. 20549 FORM 10-K (Mark One) [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 1997 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to --------------- --------------- Commission Registrant; State of Incorporation IRS Employer file number Address; and Telephone Number Identification No. - ----------- ---------------------------------- ------------------ 1-11337 WPS RESOURCES CORPORATION 39-1775292 (A Wisconsin Corporation) 700 North Adams Street P. O. Box 19001 Green Bay, WI 54307-9001 920-433-1466 1-3016 WISCONSIN PUBLIC SERVICE CORPORATION 39-0715160 (A Wisconsin Corporation) 700 North Adams Street P. O. Box 19001 Green Bay, WI 54307-9001 920-433-1466 Securities registered pursuant to Section 12(b) of the Act: - ----------------------------------------------------------- Title of Name of each exchange each class on which registered ---------- --------------------- WPS RESOURCES CORPORATION Common Stock, New York Stock Exchange $1 par value and Chicago Stock Exchange Rights to purchase New York Stock Exchange Common Stock pursuant and Chicago Stock to Rights Agreement Exchange dated December 12, 1996 PAGE Securities registered pursuant to Section 12(g) of the Act: - ----------------------------------------------------------- WISCONSIN PUBLIC SERVICE CORPORATION Preferred Stock, Cumulative, $100 par value 5.00% Series 5.08% Series 5.04% Series 6.76% Series 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 such 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. Yes [X] No [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X] State the aggregate market value of the voting stock held by nonaffiliates of - ----------------------------------------------------------------------------- the Registrant. - --------------- WPS RESOURCES CORPORATION $781,131,945 as of March 4, 1998 WISCONSIN PUBLIC SERVICE CORPORATION None Number of shares outstanding of each class of common stock, as of December 31, - ------------------------------------------------------------------------------ 1997 - ---- WPS RESOURCES CORPORATION Common Stock, $1 par value, 23,896,962 shares WISCONSIN PUBLIC SERVICE CORPORATION Common Stock, $4 par value, 23,896,962 shares DOCUMENTS INCORPORATED BY REFERENCE (1) Definitive proxy statement for the WPS Resources Corporation Annual Meeting of Shareholders on May 7, 1998 is incorporated into Parts I and III. PAGE WPS RESOURCES CORPORATION and WISCONSIN PUBLIC SERVICE CORPORATION FORM 10-K ANNUAL REPORT TO THE SECURITIES AND EXCHANGE COMMISSION For the Year Ended December 31, 1997 TABLE OF CONTENTS DEFINITIONS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .v PART I 1. BUSINESS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 A. GENERAL WPS Resources Corporation . . . . . . . . . . . . . . . . . . .1 Wisconsin Public Service Corporation. . . . . . . . . . . . . .1 Regulatory Oversight. . . . . . . . . . . . . . . . . . . . . .2 Year 2000 Compliance. . . . . . . . . . . . . . . . . . . . . .2 Forward-Looking Statements. . . . . . . . . . . . . . . . . . .2 B. ELECTRIC MATTERS Electric Operations . . . . . . . . . . . . . . . . . . . . . .3 Generating Capacity . . . . . . . . . . . . . . . . . . . . . .3 Kewaunee Nuclear Power Plant. . . . . . . . . . . . . . . . . .4 Fuel Supply . . . . . . . . . . . . . . . . . . . . . . . . . .6 Electric Generation Mix. . . . . . . . . . . . . . . . . . .6 Fuel Costs . . . . . . . . . . . . . . . . . . . . . . . . .6 Coal . . . . . . . . . . . . . . . . . . . . . . . . . . . .6 Nuclear. . . . . . . . . . . . . . . . . . . . . . . . . . .6 Regulatory Matters in the Wisconsin Jurisdiction. . . . . . . .7 Industry Restructuring . . . . . . . . . . . . . . . . . . .7 Independent System Operator. . . . . . . . . . . . . . . . .8 Merger Activity. . . . . . . . . . . . . . . . . . . . . . .9 Electric Supply Issues . . . . . . . . . . . . . . . . . . .9 Customer Rate Matters. . . . . . . . . . . . . . . . . . . 10 Regulatory Matters in the Michigan Jurisdiction . . . . . . . 10 Industry Restructuring . . . . . . . . . . . . . . . . . . 10 Customer Rate Matters. . . . . . . . . . . . . . . . . . . 11 Regulatory Matters in the FERC Jurisdiction . . . . . . . . . 11 Customer Rate Matters. . . . . . . . . . . . . . . . . . . 11 Open Access Transmission Tariff. . . . . . . . . . . . . . 11 Marketer Status. . . . . . . . . . . . . . . . . . . . . . 11 Wholesale Status . . . . . . . . . . . . . . . . . . . . . 11 Regulatory Compliance. . . . . . . . . . . . . . . . . . . 12 Hydroelectric Licenses . . . . . . . . . . . . . . . . . . 12 Other Matters . . . . . . . . . . . . . . . . . . . . . . . . 12 Research and Development . . . . . . . . . . . . . . . . . 12 Customer Segmentation. . . . . . . . . . . . . . . . . . . 12 Electric Financial Summary. . . . . . . . . . . . . . . . . . 13 Electric Operating Statistics . . . . . . . . . . . . . . . . 14 WPS Resources Corporation. . . . . . . . . . . . . . . . . 14 Wisconsin Public Service Corporation . . . . . . . . . . . 15 i C. GAS MATTERS Wisconsin Public Service Corporation's Gas Market . . . . . . 16 Gas Supply. . . . . . . . . . . . . . . . . . . . . . . . . . 16 General. . . . . . . . . . . . . . . . . . . . . . . . . . 16 Pipeline Capacity and Storage. . . . . . . . . . . . . . . 17 Gas Supply Contracts . . . . . . . . . . . . . . . . . . . 18 New Pipeline Supply Source . . . . . . . . . . . . . . . . 18 Federal Regulatory Activities . . . . . . . . . . . . . . . . 19 Dakota . . . . . . . . . . . . . . . . . . . . . . . . . . 19 Viking Costs on ANR Pipeline . . . . . . . . . . . . . . . 19 ANR Rate Case Settlement . . . . . . . . . . . . . . . . . 19 Wisconsin Regulatory Activities . . . . . . . . . . . . . . . 20 General. . . . . . . . . . . . . . . . . . . . . . . . . . 20 Gas Cost Recovery Mechanism. . . . . . . . . . . . . . . . 20 Gas Distribution Restructuring . . . . . . . . . . . . . . 20 Customer Rate Matters. . . . . . . . . . . . . . . . . . . 21 Michigan Regulatory Activities. . . . . . . . . . . . . . . . 21 Gas Cost Recovery. . . . . . . . . . . . . . . . . . . . . 21 Gas Distribution Restructuring . . . . . . . . . . . . . . 21 Customer Rate Matters. . . . . . . . . . . . . . . . . . . 21 Gas Financial Summary . . . . . . . . . . . . . . . . . . . . 22 Gas Operating Statistics. . . . . . . . . . . . . . . . . . . 23 WPS Resources Corporation. . . . . . . . . . . . . . . . . 23 Wisconsin Public Service Corporation . . . . . . . . . . . 24 D. NONREGULATED BUSINESS ACTIVITIES General . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 WPS Energy Services, Inc. . . . . . . . . . . . . . . . . . . 25 WPS Power Development, Inc. . . . . . . . . . . . . . . . . . 25 Earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . 26 E. ENVIRONMENTAL MATTERS General . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 Air Quality . . . . . . . . . . . . . . . . . . . . . . . . . 26 Water Quality . . . . . . . . . . . . . . . . . . . . . . . . 27 Gas Plant Cleanup . . . . . . . . . . . . . . . . . . . . . . 27 F. CAPITAL REQUIREMENTS . . . . . . . . . . . . . . . . . . . . . . 28 G. EMPLOYEES. . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 2. PROPERTIES. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 A. UTILITY. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 B. NONREGULATED . . . . . . . . . . . . . . . . . . . . . . . . . . 31 3. LEGAL PROCEEDINGS . . . . . . . . . . . . . . . . . . . . . . . . . 31 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS . . . . . . . . 31 4A. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. . . . . . . . . 32 A. EXECUTIVE OFFICERS OF WPS RESOURCES CORPORATION. . . . . . . . . 32 B. EXECUTIVE OFFICERS OF WISCONSIN PUBLIC SERVICE CORPORATION . . . 33 ii PART II 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS . . . . . . . . . . . . . . . . . . . . 34 WPS Resources Corporation Common Stock Two-Year Comparison . . . 34 Dividend Restrictions. . . . . . . . . . . . . . . . . . . . . . 34 Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . 34 6. SELECTED FINANCIAL DATA WPS RESOURCES CORPORATION COMPARATIVE FINANCIAL STATEMENTS AND FINANCIAL STATISTICS (1993 TO 1997) A. CONSOLIDATED STATEMENTS OF INCOME. . . . . . . . . . . . . . . . 35 B. CONSOLIDATED BALANCE SHEETS. . . . . . . . . . . . . . . . . . . 36 C. FINANCIAL STATISTICS . . . . . . . . . . . . . . . . . . . . . . 37 WISCONSIN PUBLIC SERVICE CORPORATION COMPARATIVE FINANCIAL DATA AND FINANCIAL STATISTICS (1993 TO 1997) D. SELECTED FINANCIAL DATA. . . . . . . . . . . . . . . . . . . . . 38 E. FINANCIAL STATISTICS . . . . . . . . . . . . . . . . . . . . . . 39 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION FOR WPS RESOURCES CORPORATION AND WISCONSIN PUBLIC SERVICE CORPORATION. . . . . . . . . . . . . . . . 40 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA WPS RESOURCES CORPORATION A. CONSOLIDATED STATEMENTS OF INCOME AND RETAINED EARNINGS. . . . . 52 B. CONSOLIDATED BALANCE SHEETS. . . . . . . . . . . . . . . . . . . 53 C. CONSOLIDATED STATEMENTS OF CAPITALIZATION. . . . . . . . . . . . 55 D. CONSOLIDATED STATEMENTS OF CASH FLOWS. . . . . . . . . . . . . . 56 E. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS . . . . . . . . . . . 57 F. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS . . . . . . . . . . . . 76 WISCONSIN PUBLIC SERVICE CORPORATION G. CONSOLIDATED STATEMENTS OF INCOME. . . . . . . . . . . . . . . . 77 H. CONSOLIDATED BALANCE SHEETS. . . . . . . . . . . . . . . . . . . 78 I. CONSOLIDATED STATEMENTS OF CAPITALIZATION. . . . . . . . . . . . 80 J. CONSOLIDATED STATEMENTS OF CASH FLOWS. . . . . . . . . . . . . . 81 K. CONSOLIDATED STATEMENTS OF RETAINED EARNINGS . . . . . . . . . . 82 L. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS . . . . . . . . . . . 83 M. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS . . . . . . . . . . . . 84 9. CHANGE IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE . . . . . . . . . . . . . . . . 85 PART III 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. . . . . . . . . 85 11. EXECUTIVE COMPENSATION. . . . . . . . . . . . . . . . . . . . . . . 85 iii 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. . . 85 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. . . . . . . . . . . 85 PART IV 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K . . . . . . . . . . . . . . . . . . . . . . . . 86 DESCRIPTION OF DOCUMENTS. . . . . . . . . . . . . . . . . . . . . . 88 SIGNATURES. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94 SCHEDULE III - CONDENSED PARENT COMPANY FINANCIAL STATEMENTS WPS RESOURCES CORPORATION (PARENT COMPANY ONLY) A. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS . . . . . . . . . . . . 95 B. STATEMENTS OF INCOME AND RETAINED EARNINGS . . . . . . . . . . . 96 C. BALANCE SHEETS . . . . . . . . . . . . . . . . . . . . . . . . . 97 D. STATEMENTS OF CASH FLOWS . . . . . . . . . . . . . . . . . . . . 98 E. NOTES TO PARENT COMPANY FINANCIAL STATEMENTS . . . . . . . . . . 99 EXHIBITS 10F-1 Power Purchase Agreement Between De Pere Energy LLC and Wisconsin Public Service Corporation dated November 8, 1995 and amended by a Letter Agreement dated February 18, 1997 Wisconsin Public Service Corporation. . . . . . . . . . . .100 10G-1 WPS Resources Corporation Amended and Restated Deferred Compensation Plan Effective January 1, 1998 WPS Resources Corporation . . . . . . . . . . . . . . . . .213 10G-3 WPS Resources Corporation Short-Term Variable Pay Plan Effective January 1, 1998 WPS Resources Corporation . . . . . . . . . . . . . . . . .240 11 Statement Regarding Computation of Per Share Earnings WPS Resources Corporation . . . . . . . . . . . . . . . . .248 21 Subsidiaries of the Registrant . . . . . . . . . . . . . . . . .249 23 Consent of Independent Public Accountants. . . . . . . . . . . .250 24 Powers of Attorney . . . . . . . . . . . . . . . . . . . . . . .251 27 Financial Data Schedule WPS Resources Corporation . . . . . . . . . . . . . . . . .259 Wisconsin Public Service Corporation. . . . . . . . . . . .260 iv DEFINITIONS The following abbreviations and acronyms are used in the text of this Form 10-K: Act . . . . . . . . . . . Federal Clean Air Act Amendments of 1990 AFUDC . . . . . . . . . . Allowance for funds used during construction ANR . . . . . . . . . . . ANR Pipeline Company APBO. . . . . . . . . . . Accrued postretirement benefit obligation Btu . . . . . . . . . . . British thermal unit Columbia *. . . . . . . . The Columbia Energy Center CWIP. . . . . . . . . . . Construction work in progress Dakota *. . . . . . . . . Dakota Gasification Plant De Pere . . . . . . . . . De Pere Energy Center DNR . . . . . . . . . . . Wisconsin Department of Natural Resources DOE . . . . . . . . . . . United States Department of Energy DSM . . . . . . . . . . . Demand-side management of energy use Dth . . . . . . . . . . . Dekatherm Edgewater * . . . . . . . The Edgewater Unit 4 power plant EPA . . . . . . . . . . . United States Environmental Protection Agency ESOP. . . . . . . . . . . Employee Stock Ownership Plan and Trust of Wisconsin Public Service Corporation ESI . . . . . . . . . . . WPS Energy Services, Inc., a nonregulated subsidiary of WPS Resources Corporation FASB. . . . . . . . . . . Financial Accounting Standards Board FERC. . . . . . . . . . . Federal Energy Regulatory Commission Great Lakes . . . . . . . Great Lakes Transmission Company GSR . . . . . . . . . . . Gas supply realignment Interface . . . . . . . . Constrained Minnesota to Eastern Wisconsin transmission interface ISO . . . . . . . . . . . Independent system operator Kewaunee. . . . . . . . . Kewaunee Nuclear Power Plant v kVa . . . . . . . . . . . Kilovolt-ampere kw. . . . . . . . . . . . Kilowatts kWh . . . . . . . . . . . Kilowatt-hour MG&E. . . . . . . . . . . Madison Gas and Electric Company MPSC. . . . . . . . . . . Michigan Public Service Commission NRC . . . . . . . . . . . Nuclear Regulatory Commission Order . . . . . . . . . . Order No. 636 issued by the Federal Energy Regulatory Commission in April 1992 PD. . . . . . . . . . . . Pricing differential PDI . . . . . . . . . . . WPS Power Development, Inc., a nonregulated subsidiary of WPS Resources Corporation PGAC. . . . . . . . . . . Purchased gas adjustment clause Polsky. . . . . . . . . . Polsky Energy Corporation PBR . . . . . . . . . . . Performance based rates PSCW. . . . . . . . . . . Public Service Commission of Wisconsin Pulliam * . . . . . . . . The Pulliam generating facility River Power . . . . . . . Wisconsin River Power Company SEC . . . . . . . . . . . Securities and Exchange Commission SFAS. . . . . . . . . . . Statement of Financial Accounting Standards Sheboygan II. . . . . . . Property adjacent to the Sheboygan River previously used by Wisconsin Public Service Corporation for the gasification of coal Stoneman. . . . . . . . . Stoneman Power Plant, a merchant steam plant Superfund * . . . . . . . Comprehensive Environmental Response, Compensation, and Liability Act TransCanada . . . . . . . TransCanada Pipelines Union . . . . . . . . . . Local 310 of the International Union of Operating Engineers which represents certain Wisconsin Public Service Corporation employees UPEN. . . . . . . . . . . Upper Peninsula Energy Corporation UPPCO . . . . . . . . . . Upper Peninsula Power Company Viking. . . . . . . . . . Viking Gas Transmission Company vi WDG . . . . . . . . . . . Wisconsin Distributors Group WEPCO . . . . . . . . . . Wisconsin Electric Power Company Weston *. . . . . . . . . The Weston generating facility WP&L. . . . . . . . . . . Wisconsin Power and Light Company WPPI. . . . . . . . . . . Wisconsin Public Power, Inc. WPSC. . . . . . . . . . . Wisconsin Public Service Corporation, a regulated electric and gas utility and the principal subsidiary of WPS Resources Corporation WPSR. . . . . . . . . . . WPS Resources Corporation, a holding company - ----- * Indicates items not defined elsewhere in this report. vii PART I ITEM 1. BUSINESS A. GENERAL WPS RESOURCES CORPORATION WPS Resources Corporation ("WPSR"), a Wisconsin Corporation, was incorporated on December 3, 1993 and operates as a holding company with both regulated (utility) and nonregulated business units. WPSR's principal wholly-owned subsidiaries, each of which is a Wisconsin corporation, are: Wisconsin Public Service Corporation ("WPSC"), a regulated electric and gas utility; and WPS Energy Services, Inc. ("ESI") and WPS Power Development, Inc. ("PDI"), both nonregulated subsidiaries. WPSC, ESI, and PDI represent approximately 79%, 21%, and .2% of WPSR's consolidated revenues for 1997 and 95%, 4%, and 1% of WPSR's consolidated assets at December 31, 1997, respectively. All of WPSR's net income for 1997 was derived from WPSC. On July 10, 1997, WPSR announced an agreement to merge with Upper Peninsula Energy Corporation ("UPEN"). The S-4 Registration Statement of WPSR was declared effective by the Securities and Exchange Commission ("SEC") on December 5, 1997. The shareholders of UPEN approved the merger on January 29, 1998. The merger is subject to (1) approval by the Federal Energy Regulatory Commission ("FERC"); (2) approval by the SEC under the Public Utility Holding Company Act of 1935; (3) the expiration or termination of the waiting period applicable to the merger under the Hart-Scott-Rodino Antitrust Improvements Act of 1976; (4) receipt by the parties of an opinion of counsel that the exchange of stock qualifies as a tax-free transaction; (5) receipt by the parties of appropriate assurances that the transaction will be accounted for as a pooling of interests; and (6) the satisfaction of various other conditions. The merger is expected to be completed in the second half of 1998. UPEN will merge with and into WPSR, and Upper Peninsula Power Company ("UPPCO"), UPEN's utility subsidiary, will become a wholly-owned subsidiary of WPSR. Each of the 2,950,001 outstanding shares of UPEN common stock (no par value) will be converted into 0.90 shares of WPSR common stock ($1.00 par value), subject to adjustment for fractional shares, as provided in the merger agreement. On a stand-alone basis, WPSR incurred a net loss in 1997 of $1.0 million, compared with net income of $0.8 million in 1996. The 1997 WPSR stand-alone loss was attributable primarily to costs related to the proposed merger with UPEN. WISCONSIN PUBLIC SERVICE CORPORATION At December 31, 1997, WPSC served 374,516 electric retail customers and 218,299 gas retail customers in an 11,000 square mile service territory in northeastern and central Wisconsin and an adjacent part of Upper Michigan. Additionally, WPSC provides wholesale (full or partial requirements) electric service, either directly or indirectly, to 12 municipal utilities, 3 Rural Electrification Administration financed electric cooperatives, and a privately held utility. Operating revenues in the year 1997 were derived 97% from Wisconsin customers and 3% from Michigan customers. Of total revenues in 1997, 69% were from electric operations and 31% were from gas operations. Of -1- total electric revenues, 90% were from retail sales and 10% were from wholesale sales. WPSC's retail service areas are principally protected by indeterminate permits secured by statute in Wisconsin and through franchises granted by municipalities in Michigan. REGULATORY OVERSIGHT WPSR is exempt from registration under the Public Utility Holding Company Act of 1935, as amended, but is subject to the various requirements and prohibitions of the Wisconsin Public Utility Holding Company Act. Utility rates, service, and securities issues of WPSC are subject to regulation by the Public Service Commission of Wisconsin ("PSCW") and the Michigan Public Service Commission ("MPSC"); and WPSC is subject to regulation of its wholesale electric rates, hydroelectric projects, and certain other matters by the FERC. WPSC is also subject to limited regulation by local authorities. WPSC follows Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation," and its financial statements reflect the effects of the different ratemaking principles of various jurisdictions. These include the PSCW, 90% of revenues, the MPSC, 3% of revenues, and the FERC, 7% of revenues. The operation of the Kewaunee Nuclear Power Plant ("Kewaunee") is subject to the jurisdiction of the Nuclear Regulatory Commission ("NRC"). YEAR 2000 COMPLIANCE WPSR has completed an initial assessment of the impact of year 2000 compliance on its computer systems. WPSR worked with a consultant beginning in 1996 to analyze the year 2000 problem. Plans have been established to analyze all in-house and third party software products and applications. A preliminary plan indicates that all major in-house developed systems are expected to be in compliance by the end of 1998. The plan is intended to enable all systems to be in compliance by the year 2000. The most recent estimated future internal labor and third party cost of year 2000 compliance is approximately $13.4 million. FORWARDING-LOOKING STATEMENTS This report includes forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. Although WPSR believes that its expectations are based on reasonable assumptions, no assurance can be given that actual results may not differ materially from those in the forward-looking statements included in this report for reasons that include: the speed and degree to which competition enters the electric and natural gas industries; state and federal legislative and regulatory initiatives that increase competition, affect cost and investment recovery, and have an impact on rate structures; the economic climate and industrial, commercial, and residential growth in areas served by WPSC and ESI; the weather and other natural phenomena; the timing and extent of changes in commodity prices and interest rates; conditions in the capital markets; and growth in opportunities for ESI and PDI. A forward-looking statement speaks only as of the date on which such statement is made, and WPSR does not undertake to update any forward-looking -2- statement to reflect events or circumstances after the date on which such statement is made or to reflect the occurrence of unanticipated events. New factors emerge from time to time, and it is not possible for WPSR to predict all such factors, nor can it assess the impact of each such factor or the extent to which any factor, or combination of factors, may cause results to differ materially from those contained in any forward-looking statement. B. ELECTRIC MATTERS ELECTRIC OPERATIONS The largest communities served at retail with electricity are the cities of Green Bay, Oshkosh, Wausau, and Stevens Point. GENERATING CAPACITY Coordinated planning for generation and transmission is a function of the Wisconsin Upper Michigan Systems of which WPSC is a member. Other members include Madison Gas and Electric Company ("MG&E"), UPPCO, Wisconsin Electric Power Company ("WEPCO"), Wisconsin Power and Light Company ("WP&L"), and Wisconsin Public Power, Inc. ("WPPI"). Existing and planned interconnections with other neighboring utilities provide a further means of sharing reserve capacities and interchanging energy. WPSC experienced a 1997 net firm load peak of 1,607,000 kilowatts ("kw") on July 17. Considering a firm purchase of 234,000 kw and a total generating capability of 1,831,300 kw, the system reserve margin was 30.1%. In addition, 13,300 kw of firm opportunity sales were served during the peak hour. WPSC's future generating reserves, adjusted for firm purchases, firm sales, and planned capacity additions, are estimated to be above the planning criteria of a 18% minimum reserve in 1998 and 1999. See Part I, Item 2, PROPERTIES, at page 30 for information concerning generating facilities. During 1997, the PSCW authorized Polsky Energy Corporation ("Polsky"), an independent power producer, to build the De Pere Energy Center ("De Pere"), a 179-megawatt combustion turbine generating facility that is scheduled to be operational in 1999. De Pere will be converted to a 232-megawatt combined cycle operation on or after the fifth year of operation, per the requirements of the contract. A combined-cycle unit is a type of combustion turbine in which the hot exhaust gases pass through a heat recovery steam generator to produce steam that drives a steam turbine generator which produces approximately one-third of the power generated. WPSC has a 25-year contract to purchase capacity and energy from De Pere. WPSC will furnish the natural gas fuel for the facility and is working closely with Polsky to ensure that there are adequate transmission lines serving De Pere. WPSC owns 33.1% of the outstanding capital stock of Wisconsin River Power Company ("River Power"). The business of River Power consists of the ownership and operation of two dams and related hydroelectric plants on the Wisconsin River having an aggregate installed capacity of approximately 38.7 megawatts. The output of the hydroelectric plants is sold, at the sites of the plants, to the three joint owners (Consolidated Water Power Company of Wisconsin Rapids, Wisconsin; Wisconsin Power and Light Company of Madison, Wisconsin; and WPSC of Green Bay, Wisconsin) substantially in proportion to their stock ownership interests. -3- KEWAUNEE NUCLEAR POWER PLANT The Kewaunee Nuclear Power Plant ("Kewaunee"), a 562-megawatt pressurized water reactor plant, is operated by WPSC and is jointly owned by WPSC (41.2%), WP&L (41.0%), and MG&E (17.8%). The Kewaunee operating license expires in 2013. Kewaunee returned to service on June 12, 1997 after having been out of service since September 21, 1996 for refueling, routine maintenance, and repair of the two steam generators. The original Kewaunee steam generator tubes are susceptible to corrosion and cracking. Tubes are repaired by inserting sleeves (tubes within tubes) in the original steam generator tubes. The most recent repair was undertaken when previously repaired tubes failed. The repair consisted of removing old sleeves and inserting new slightly longer sleeves which cover the areas of concern in the original steam generator tubes. The new sleeves will be inspected during the next refueling and maintenance outage which is scheduled for the fall of 1998. Kewaunee is operating at 97% of rated capacity because certain steam generator tubes have been removed from service rather than repaired. Kewaunee operated for 238 consecutive days before being removed from service on February 6, 1998 for repair of a reactor coolant pump seal. The plant was returned to service on February 13, 1998. Additional replacement power costs due to the extended Kewaunee outage were recovered by a $2.0 million per month customer surcharge during the period February 21, 1997 through July 1, 1997. Kewaunee steam generator repair costs have been deferred as authorized by the PSCW. The WPSC portion of these costs is approximately $3.6 million. The owners have requested the PSCW to approve recovery of these costs through a customer surcharge which for WPSC would be effective for April and May of 1998. On March 15, 1996, WPSC filed an application with the PSCW for permission to replace the Kewaunee steam generators. Public hearings were held in January of 1998. A decision is expected in March of 1998. The total cost of replacing the two steam generators would be approximately $89.0 million. WPSC's share would be $36.7 million in year of occurrence dollars. Because of work already completed, the elapsed time from placing a firm order for steam generators to receiving delivery has been shortened to approximately 22 months. The owners of Kewaunee have differing views on the desirability of proceeding with the steam generator replacement project. Although the new resleeving repair technology may allow the plant to remain in service for an extended period of time, WPSC favors replacement at the earliest possible date because of reliability and cost concerns related to steam generator repairs. To date, the other two owners have been unwilling to support replacement of the steam generators. If the steam generator replacement project receives PSCW approval, the issues related to the continued operation and future ownership would still need to be resolved before steam generator replacement could proceed. The NRC's Systematic Assessment of Licensee Performance for Kewaunee for the period February 19, 1995 through February 15, 1997 was received in 1997. The report evaluated Kewaunee's performance in four categories: operations, maintenance, engineering, and plant support. Maintenance was ranked -4- "superior," and the other areas were rated as "good." The NRC stated that Kewaunee's overall performance was generally characterized by effective management involvement and interdepartmental communication, and a clear emphasis on quality by the staff. Areas for improvement that were identified were: timely evaluation of errors of personnel, adequacy of procedures and equipment for monitoring equipment performance, and the timely resolution of plant identified deficiencies. On July 14, 1997, the NRC assessed a $50,000 penalty against Kewaunee. The penalty was the result of a NRC inspection in January of 1997 where the NRC questioned the procedures and equipment used to conduct routine operational tests on several pumps. In response, the procedures were updated to improve the test methods, and more sensitive equipment was obtained. All safety-related pumps in the plant were then retested and found to be operating within standards. The federal government has the responsibility to dispose of or permanently store spent nuclear fuel. Spent nuclear fuel is currently being stored at Kewaunee. With minor plant modifications, Kewaunee should have sufficient fuel storage capacity until the end of its licensed life in 2013. Legislation is being considered on the federal level to provide for the establishment of an interim storage facility as early as 2002. Permanent storage pursuant to the Nuclear Waste Policy Act of 1982 is discussed at page 7. The Midwest Compact Commission, on June 26, 1997, halted development in Ohio of a six-state, regional disposal facility for low-level radioactive waste. The Commission cited dwindling regional waste volumes, continued access to existing disposal facilities, and potentially high development costs as the primary reasons for the decision. A site at Barnwell, South Carolina, continues to be available for the storage of low-level radioactive waste from Kewaunee. In addition, because of technological advances, waste compaction, and the reduction of waste generated, Kewaunee has on-site low-level radioactive waste storage capacity sufficient to store low-level waste expected to be generated over a 10-year period. The PSCW has directed the owners of Kewaunee to develop depreciation and decommissioning cost levels based on full recovery by the end of 2002 versus recovery by license expiration in 2013. This was prompted by the uncertainty regarding the expected useful life of the plant without steam generator replacement. At December 31, 1997, the net carrying amount of WPSC's investment in Kewaunee was approximately $43.0 million. The current cost of WPSC's share of the estimated costs to decommission Kewaunee, assuming early retirement ($182.2 million), exceeds the trust assets at December 31, 1997 ($134.1 million) by $48.1 million. WPSC's customers in the Wisconsin jurisdiction are responsible for approximately 89% of WPSC's share of Kewaunee costs. As a result of accelerating the recovery of WPSC's share of Kewaunee related costs, depreciation expense and decommissioning funding have increased approximately $3.3 million (from $4.7 million in 1996 to $8.0 million in 1997) and $8.3 million (from $9.0 million in 1996 to $17.3 million in 1997), respectively, on an annualized basis. During 1997, $7.5 million of depreciation expense related to unrecovered plant investment was recognized compared to $4.7 million which was recognized in 1996. During 1997, the decommissioning funding level was $16.1 million compared to $9.0 million in -5- 1996. Customer rates, which became effective in the Wisconsin jurisdiction on February 21, 1997, are designed to recover the accelerated Kewaunee depreciation and decommissioning costs. Additional discussion of Kewaunee matters is included in MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION at pages 46 and 48, and NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Notes 1(h), 1(j), 1(k), and 9 at pages 59, 60, 60, and 71, respectively. FUEL SUPPLY ELECTRIC GENERATION MIX WPSC's electric generation mix in 1997 compared with 1996 was: steam plants (coal), 68.9%, up from 67.9%; steam plant (nuclear), 8.2% down from 11.2%; hydro, 3.0% down from 3.1%; combined natural gas and fuel oil, 1.3% up from .6%; and purchased power, 18.6% up from 17.3%. Purchased power represents short-term energy purchases. FUEL COSTS Fuel costs in 1997 compared with 1996, expressed in dollars per million British thermal unit ("Btu"), were: nuclear, $.43, down from $.47; coal, $1.09, down from $1.14; natural gas, $2.96, up from $2.84; and No. 2 fuel oil, $4.27, down from $4.36. COAL WPSC's primary fuel source is coal. In 1997, 99% of this coal came from Powder River Basin mines located in Wyoming and Montana. This coal is very low in sulfur and meets the standards of the 1990 Clean Air Act for the year 2000 and beyond. Further, this coal is the least cost coal for WPSC from any of the subbituminous coal producing regions in the United States. The majority of coal for WPSC's wholly-owned plants and the jointly-owned Edgewater and Columbia plants is purchased under relatively short-term contracts of up to three years duration. WPSC has one long-term contract which covers approximately 16% of total requirements and has take-or-pay obligations totaling $198.4 million from 1998 through 2016. Coal transportation for these plants is purchased under contracts of up to five years duration. Over 90% of the coal transported to these plants is moved under competitive transportation market conditions which are expected to continue to yield competitive fuel costs for WPSC for the long term. NUCLEAR WPSC purchases uranium concentrates, conversion services, enrichment services, and fabrication services for nuclear fuel assemblies at Kewaunee. New fuel assemblies replace used assemblies that are removed from the reactor every 18 months and placed in storage at the plant site pending removal by the United States Department of Energy ("DOE"). Uranium concentrates, conversion services, and enrichment services are purchased at spot market prices, through a bid process, or using existing contracts. -6- A uranium inventory policy requires that sufficient inventory exist for up to two reactor reloads of fuel. As of December 31, 1997, 960,000 pounds of yellowcake or its equivalent are held in inventory for Kewaunee. Two contracts are in place to provide conversion services for Kewaunee nuclear fuel for reloads in 1998 and 2000. A contract with Cogema, Inc. provides a fixed quantity of enrichment services through the year 2001. Additional enrichment services will be acquired under a contract with the United States Enrichment Corporation which is in effect for the life of Kewaunee or by purchases on the spot market. A contract with Siemens Power Corporation provides fuel fabrication services through March 15, 2001, for Kewaunee. This contract contains force majeure and termination provisions. If, for any reason, Kewaunee were forced to suspend operations permanently, fuel-related obligations are as follows: (1) there are no financial penalties associated with the present uranium supply, conversion service, and enrichment agreements, and (2) the fuel fabrication contract contains force majeure and termination for convenience provisions. As of the end of 1997, the maximum exposure would not be expected to exceed $550,000. Uranium inventories could be sold on the spot market. The Nuclear Waste Policy Act of 1982 requires that the DOE accept, transport, and dispose of spent nuclear fuel beginning no later than January 31, 1998. The DOE has announced that it will delay the acceptance of spent nuclear fuel beyond 1998. The nuclear utilities have been supported by a decision of the United States Court of Appeals for the District of Columbia Circuit in their claim that they may pursue the remedies provided in the DOE standard contract in the event the DOE does not perform its duty to dispose of spent nuclear fuel by the January 31, 1998 deadline. The Energy Policy Act of 1992 requires that the federal government and nuclear utilities fund the decontamination and decommissioning of the government's three gaseous diffusion plants in the United States. WPSC is required to pay approximately $600,000 per year (adjusted for inflation) through the year 2007. WPSC, as well as other nuclear utilities, has filed suit in the United States Court of Federal Claims disputing the decontamination and decommissioning assessment. The suit has been stayed pending the outcome of the Yankee Atomic Electric Company appeal. Yankee Atomic Electric Company has received an adverse decision in the United States Court of Appeals for the Federal Circuit and has filed a petition for certiorari with the United States Supreme Court. REGULATORY MATTERS IN THE WISCONSIN JURISDICTION INDUSTRY RESTRUCTURING In late 1995, the PSCW outlined a plan for restructuring the electric industry in Wisconsin. The plan included a 32-step, 5-year process which could conclude with retail competition by the year 2001. Progress on the plan has been slow. During 1997, the PSCW chairperson developed a replacement 7-step plan for restructuring which is essentially a regrouping of the original 32 steps with new priorities. To date, the revised plan has not been adopted as the official PSCW restructuring plan. Restructuring and retail -7- competition, although still under consideration, have been replaced as a priority by electric reliability issues. As a result of the electric reliability problems during the summer of 1997 (see Electric Supply Issues, at page 9), the PSCW announced that its first priority is to develop the utility infrastructure necessary to assure reliable electric service and to remove the barriers to competition at the wholesale level. WPSC currently applies accounting standards that recognize the economic effects of rate regulations and record regulatory assets and liabilities related to its generation, transmission, and distribution operations. If rate recovery of generation-related costs becomes unlikely or uncertain, whether due to competition or regulatory action, these accounting standards may no longer apply to WPSC's generation operations. This change could result in either full recovery of generation-related regulatory assets (net of related regulatory liabilities) and costs or an impairment charge, depending on whether regulators adopt a transition mechanism for the recovery of all or a portion of these net regulatory assets and costs. WPSC believes that the magnitude of any possible impairment charge is lower than the stranded cost exposure of many other companies in this industry. Based on a current evaluation of the various factors and conditions that are expected to impact future cost recovery, management believes that its regulatory assets, including those related to generation, are probable of future recovery. Management expects that increased competition in a deregulated environment will put pressure on operating margins at WPSC. Management also believes that no significant changes to depreciable lives of WPSC's capital assets would be necessary in a competitive environment. However, at this time, management cannot predict the ultimate results of deregulation. During 1997, in an effort to mitigate the effects of market power, the PSCW issued an order that prohibited ownership by electric utility affiliates of merchant electric generating plants. A merchant electric generating plant is defined as a plant not owned by or under long-term contract with a public utility. Later, the PSCW decided that it did not have statutory authority to order a flat prohibition of utility affiliate ownership of merchant plants and would consider such ownership on a case-by-case basis. The major utilities in Wisconsin, including WPSC, have made legislative proposals, as part of reliability and restructuring efforts, advocating deregulation of merchant plants. PDI has an ownership interest in a merchant generating facility as discussed on page 25. In late 1997, the PSCW initiated a docket on essential services and customer protections the purpose of which is to create a utility customer safety net for a restructured electric and gas industry. INDEPENDENT SYSTEM OPERATOR A major feature of a restructured electric industry is establishment of independent system operators ("ISOs"). An ISO is an independent third party that would regulate on a "real-time" basis the operation of the transmission systems in a defined geographic area. The ISO would monitor the generation, transmission, and distribution systems, direct the operations of transmission facilities, administer open access transmission tariffs, and direct generation redispatch. -8- WPSC has been working with a number of groups that are attempting to form ISOs. The PSCW and the MPSC are considering the formation of statewide ISOs. The Mid American Power Pool, one of ten National Electric Reliability Council regions, is developing an ISO that would include utilities in portions of Illinois, Minnesota, North Dakota, South Dakota, and Wisconsin. Additionally, a group of 26 utilities in 10 Midwestern states is attempting to form what is known as the Midwest ISO. MERGER ACTIVITY Industry restructuring has been accompanied by merger activity in the region which could impact the competitive environment. The merger of WPSR and UPEN, as previously described, is presently awaiting regulatory approval. The proposed merger between Wisconsin Energy Corporation and Northern States Power Company was terminated in May 1997 due to merger conditions imposed by the FERC that were unacceptable to the applicants. The Interstate Energy Corporation merger between WPL Holdings, Inc., IES Industries, Inc., and Interstate Power Company has received FERC and state approvals. At December 31, 1997, approval was pending from the Securities and Exchange Commission. In May 1997, Wisconsin Energy Corporation announced the proposed acquisition of ESELCO, Inc., the parent company of the Edison Sault Electric Company. Regulatory approvals are pending. ELECTRIC SUPPLY ISSUES The summer of 1997 provided a serious challenge to the reliability of the electric system in the region. Over 5,000 megawatts of generating capacity were unavailable for most of the summer as various utility companies experienced forced outages for a variety of reasons. Kewaunee was returned to service after a longer than normal outage before the greatest demands were placed on the WPSC electric system. WPSC's Pulliam Unit 3, a 26.7-megawatt facility, was refurbished and returned to service. WPSC's system operated at nearly full capacity during the warmest portions of the summer months. WPSC's interruptible customers experienced only limited interruptions as a result of WPSC being required to provide power to other utilities in Wisconsin who were experiencing more severe energy supply problems. See page 3 for a discussion of new generating capacity. After the summer's reliability concerns, Governor Thompson requested reports from the PSCW, electric utilities, and industrial customers assessing the electric capacity problems experienced in eastern Wisconsin during this past spring and summer. The reports provided analyses and recommendations on how to assure the future reliability of the electrical supply and made recommendations on how to improve the effectiveness of the state's utility regulatory process. WPSC participated in the development of the utility report. WPSC is working closely with Governor Thompson, the PSCW, legislators, and industry participants to ensure that Wisconsin has an adequate supply of reliable power, an enhanced transmission system, and appropriate regulatory changes. -9- CUSTOMER RATE MATTERS In the Wisconsin jurisdiction, of the major investor-owned utilities, WPSC is the low cost electric provider (based on the Edison Electric Institute Summer 1997 Typical Bill Rate Report) with rates being 91% of the state average for residential rates, 86% for commercial rates, and 88% for large industrial rates. WPSC also has some of the lowest gas rates in Wisconsin with rates being 95% of the state average for residential rates and 94% for commercial rates. Customer rates are based on forecasted expenses and capital costs. On February 20, 1997, the PSCW authorized a $35.5 million, or 8.1%, decrease in retail electric rates. These rates are effective through 1998. WPSR's return on common equity was 11.3% and 10.2% for 1997 and 1996, respectively. WPSR's return on common equity is determined in large part by the return authorized for WPSC by the PSCW. The authorized return was 11.8% and 11.5% for 1997 and 1996, respectively, before giving consideration to earnings on deferred investment tax credits. The authorized return for 1998 remains at 11.8%. The PSCW approved an electric surcharge to allow WPSC to recover costs of acquiring replacement power during the extended outage at Kewaunee. The surcharge, which amounted to approximately $2.0 million per month (approximately $.23 per kilowatt-hour) was in place for the period February 21, 1997 through July 1, 1997. The PSCW authorized deferral of Kewaunee steam generator repair costs which totaled $10.4 million, with WPSC's share being $3.6 million. The owners have requested the PSCW to approve recovery of these costs through a customer surcharge which would be effective for April and May of 1998. WPSR anticipates filing on April 1, 1998 an application with the PSCW for increased electric rates to be effective for the years 1999 and 2000. REGULATORY MATTERS IN THE MICHIGAN JURISDICTION INDUSTRY RESTRUCTURING On June 5, 1997, the MPSC ordered utilities under its jurisdiction to file electric open access plans and related tariffs. This action followed two years of public hearings and a lack of consensus among the stakeholders. The MPSC order called for generation open access in increments of 2.5% of retail load each year starting in 1997 and ending in 2001. Generation open access is the ability of customers to purchase electric generation from any supplier and to use existing transmission and distribution lines to transport the energy to the purchaser's facilities at the same price that the local supplier would charge itself for such transportation services. There would be full generation open access for retail load in 2002. WPSC submitted a plan which provides retail open access starting in 2000 when the MPSC order requires open access for 10% of retail load. The WPSC plan then continues on the MPSC schedule including full open access in 2002. There is uncertainty whether the MPSC has authority to order open access. In early 1998, the Michigan Circuit Court issued a decision holding -10- that the MPSC does not have the authority to order retail access, at least on a pilot basis. It is expected that this court decision will be appealed. In the meantime, the largest Michigan utilities are preparing for the start of open access in 1998, and Michigan's small utilities are working with the MPSC staff to determine when and how they should proceed toward open access. CUSTOMER RATE MATTERS WPSC is the lowest cost provider of electric service in Michigan for all customer classes. WPSC's electric rates are 72% of the Michigan residential customer average rate and 75% of the large industrial average rate. Other than power supply cost recovery, WPSC has not had an electric rate increase in Michigan since 1987. REGULATORY MATTERS IN THE FERC JURISDICTION CUSTOMER RATE MATTERS WPSC has not had a FERC wholesale rate case since 1987. OPEN ACCESS TRANSMISSION TARIFF WPSC has reached agreement with a group of Wisconsin municipal intervenors, the FERC staff, and two administrative law judges regarding the proposed open access transmission tariff rates and conditions and WPSC's request for market-based rates. FERC approval is expected early in 1998. The settlement rate will be in effect for two years. MARKETER STATUS ESI has received FERC power "marketer" status. WPSC, ESI, and PDI have also been authorized to sell electric energy and capacity at market rates. WHOLESALE STATUS In recent years, WPSC has experienced increased competition and reduced margins in the wholesale power market. Transmission availability, pricing and policy, the availability of reliable and economically priced energy and capacity in the region, changing market participants (both suppliers and consumers), the development and increasing use of risk management tools, and regulatory and legislative developments at both the state and federal levels are forces that will continue to influence the wholesale electric market. WPSC aggressively and competitively procures, packages, markets, and sells electric energy, capacity, ancillary services, and other associated energy-related products and services to primarily municipal electric utilities and electric distribution cooperatives. The objectives are to retain existing wholesale customer load, obtain new customers, maintain margins, and optimize the use of WPSC's generating assets. WPSC currently provides 12 wholesale electric customers with approximately 300 megawatts of firm and various levels of interruptible service. Wholesale sales represented 16% of WPSC's electric sales volume in 1997 compared to 17% in 1996. Effective in October 1997, WPPI discontinued purchasing power under a full-requirements supply contract. WPPI had been purchasing 66 megawatts of -11- electricity from WPSC for resale to municipal utilities. WPSC has been successful in partially offsetting the loss of this load by securing new customers and by other sales to WPPI. During 1996, WPSC entered into agreements with UPPCO covering the handling of after-hours calls, system operating services, and a multi-year power supply agreement beginning in 1998. Subsequently, as described at page 1 of this report, WPSR and UPEN, the parent of UPPCO, announced an agreement to merge. REGULATORY COMPLIANCE WPPI requested transmission service across the WPSC portion of the constrained Minnesota to eastern Wisconsin interface ("Interface") to serve five of WPPI's municipal customers (Sturgeon Bay, Algoma, Eagle River, New Holstein, and Washington Island) located in the WPSC service territory. The Interface is owned by WEPCO, (52%), WP&L (28%), and WPSC (20%). WPPI has a 1993 contract with WP&L that provides transmission service for these loads through the WP&L portion of the Interface. WPSC filed a complaint with the FERC contending that WPPI and WP&L were conspiring to use the WPSC portion of the interface capacity for a service that should use the WP&L portion of the Interface. WPPI responded with a FERC complaint against both WPSC and WP&L indicating that neither has provided the necessary transmission services across the constrained Interface. WPSC and WP&L both maintain that they have previous claims to the interface capacity consistent with the FERC first-come-first-served transmission scheduling process. HYDROELECTRIC LICENSES New licenses were received in 1997 from the FERC for WPSC's Caldron Falls, High Falls, Johnson Falls, Sandstone Rapids, Potato Rapids, Peshtigo, and Grand Rapids hydroelectric projects. These licenses represent 29.7 megawatts of hydroelectric generating capacity. OTHER MATTERS RESEARCH AND DEVELOPMENT Electric research and development expenditures totaled $1.3 million for 1997, $1.9 million for 1996, and $2.6 million for 1995. These expenditures were made for WPSC sponsored projects and were primarily charged to electric operations. CUSTOMER SEGMENTATION Although 13% of electric revenues come from sales to 26 paper mills, resulting in a relatively high and favorable load factor, there is no single customer or small group of customers, the loss of which would have a materially adverse effect on the electric business of WPSC under the current regulatory environment. -12- ELECTRIC FINANCIAL SUMMARY The following table sets forth the revenues, operating income, and identifiable assets attributable to electric utility operations: WISCONSIN PUBLIC SERVICE CORPORATION ============================================================================== (Thousands) Year Ended December 31 - ------------------------------------------------------------------------------ 1997 1996 1995 - ------------------------------------------------------------------------------ Electric Operating Revenues $479,388 $490,506 $489,000 Operating Income, Including Allowance For Funds Used During Construction $ 92,998 $101,425 $ 97,928 Identifiable Assets $906,198 $905,325 $906,029 ============================================================================== See Note 12 in Notes to Consolidated Financial Statements. -13- ELECTRIC OPERATING STATISTICS WPS Resources Corporation ===================================================================================================================== 1997 1996 1995 1994 - --------------------------------------------------------------------------------------------------------------------- Operating revenues (Thousands) Residential and farm $163,766 $169,587 $168,391 $163,381 Small commercial and industrial 138,949 144,055 140,280 137,323 Large commercial and industrial 120,312 118,997 117,978 118,121 Resale and other 62,734 58,648 62,351 61,991 - --------------------------------------------------------------------------------------------------------------------- Total $485,761 $491,287 $489,000 $480,816 ===================================================================================================================== Kilowatt-hour sales (Thousands) Residential and farm 2,565,432 2,570,397 2,548,373 2,406,479 Small commercial and industrial 2,876,832 2,761,278 2,672,359 2,555,488 Large commercial and industrial 3,943,275 3,744,153 3,644,764 3,468,390 Resale and other 2,126,805 1,970,083 2,112,635 2,121,660 - --------------------------------------------------------------------------------------------------------------------- Total 11,512,344 11,045,911 10,978,131 10,552,017 ===================================================================================================================== -14- ELECTRIC OPERATING STATISTICS Wisconsin Public Service Corporation ================================================================================================================================ 1997 1996 1995 1994 1993 - -------------------------------------------------------------------------------------------------------------------------------- Operating revenues (Thousands) Residential and farm $163,766 $169,587 $168,391 $163,381 $165,568 Small commercial and industrial 138,949 144,055 140,280 137,323 140,678 Large commercial and industrial 120,312 118,997 117,978 118,121 123,920 Resale and other 56,361 57,867 62,351 61,991 63,090 - -------------------------------------------------------------------------------------------------------------------------------- Total $479,388 $490,506 $489,000 $480,816 $493,256 ================================================================================================================================ Kilowatt-hour sales (Thousands) Residential and farm 2,565,432 2,570,397 2,548,373 2,406,479 2,349,307 Small commercial and industrial 2,876,832 2,761,278 2,672,359 2,555,488 2,444,548 Large commercial and industrial 3,943,275 3,744,153 3,644,764 3,468,390 3,296,254 Resale and other 1,873,788 1,936,014 2,112,635 2,121,660 2,060,804 - -------------------------------------------------------------------------------------------------------------------------------- Total 11,259,327 11,011,842 10,978,131 10,552,017 10,150,913 ================================================================================================================================ Customers served (End of period) Residential and farm 334,134 328,522 322,550 316,442 310,336 Small commercial and industrial 39,400 38,376 37,455 36,491 35,683 Large commercial and industrial 197 168 170 164 137 Resale and other 836 826 802 796 794 - -------------------------------------------------------------------------------------------------------------------------------- Total 374,567 367,892 360,977 353,893 346,950 ================================================================================================================================ Annual average use (Kilowatt-hours) Residential and farm 7,751 7,905 7,982 7,688 7,649 Small commercial and industrial 74,082 72,995 72,326 70,931 69,532 Large commercial and industrial 21,606,984 22,115,491 21,824,937 22,091,659 24,416,697 ================================================================================================================================ Average kilowatt-hour price (Cents) Residential and farm 6.38 6.60 6.61 6.79 7.05 Small commercial and industrial 4.83 5.22 5.25 5.37 5.75 Large commercial and industrial 3.05 3.18 3.24 3.41 3.76 ================================================================================================================================ Production capacity (Summer - kilowatts) Steam 1,326,000 1,325,400 1,325,400 1,318,300 1,315,300 Nuclear 212,200 213,800 216,700 215,100 215,100 Hydraulic 53,000 53,100 52,900 53,400 53,100 Combustion turbine 205,930 208,600 207,480 201,200 177,200 Other 7,800 4,200 4,240 4,240 4,240 Purchased capacity 14,750 27,250 26,400 26,400 27,700 - -------------------------------------------------------------------------------------------------------------------------------- Total system capacity 1,819,680 1,832,350 1,833,120 1,818,640 1,792,640 ================================================================================================================================ Generation and purchases (Thousands of kilowatt-hours) Steam 8,213,518 7,956,378 7,428,612 7,047,511 7,004,634 Nuclear 973,485 1,305,751 1,564,268 1,631,003 1,572,696 Hydraulic 351,034 359,750 306,101 292,617 346,386 Purchases and other 2,327,334 2,050,762 2,310,399 2,243,021 1,849,047 - -------------------------------------------------------------------------------------------------------------------------------- Total 11,865,371 11,672,641 11,609,380 11,214,152 10,772,763 ================================================================================================================================ Steam fuel costs (Cents per million Btu) Fossil 110.124 115.132 118.365 132.360 139.038 Nuclear 43.174 46.674 49.539 49.168 44.888 Total 103.093 105.439 106.320 116.782 121.949 - -------------------------------------------------------------------------------------------------------------------------------- System peak - firm (kilowatts) 1,607,000 1,591,000 1,670,000 1,543,000 1,569,000 ================================================================================================================================ Annual load factor 79.42% 77.56% 73.32% 76.96% 73.29% ================================================================================================================================ -15- C. GAS MATTERS WPSC'S GAS MARKET As of December 31, 1997, WPSC provided natural gas distribution service to 213,195 customers in 210 cities, villages, and towns in northeastern and central Wisconsin, and 5,104 customers in and around the city of Menominee, Michigan, for a total of 218,299 gas distribution customers. This represents an increase of 6,205 customers, or 2.9%, compared to December 31, 1996. The principal cities served by WPSC include Green Bay, Oshkosh, Sheboygan, Two Rivers, Marinette, Stevens Point, and Rhinelander all in Wisconsin, and the city of Menominee in Michigan. WPSC's gas distribution business has a significant seasonal component and is impacted by varying weather conditions from year-to-year. Approximately 68% of WPSC's gas sales and 60% of WPSC's total gas system throughput (i.e., total gas delivered by WPSC--includes gas sales and gas delivered for transportation customers) occur during the 5 winter months of November through March. Competition with other forms of energy exists in varying degrees, particularly for large commercial and industrial customers who have the ability to switch between natural gas and alternate fuels. WPSC offers interruptible gas sales and gas transportation service for these customers to enable them to reduce their energy costs and use natural gas instead of other fuels. Transportation customers total 224. These customers purchase their gas from other suppliers and contract with WPSC to transport the gas from ANR Pipeline Company ("ANR") to the customer's facilities. Another 133 customers still purchase their gas from WPSC but have elected to do so on an interruptible basis. Additional customers are switching from firm system supply to either interruptible system supply or transportation service each year as the economics and service options become attractive for them. WPSC's gas operations also provide gas to WPSC's electric operations for power generation in combustion turbine peaking generators and for start-up, flame stabilization, and peaking use at WPSC's Weston and Pulliam coal-fired steam plants. Gas sales for power generation use are provided on an interruptible basis, with the power plants maintaining alternate fuel capability. Total gas deliveries by WPSC in 1997, including customer-owned gas transported by WPSC, were 67,289,030 Dth, a 0.4% decrease over 1996. A dekatherm ("Dth") is equivalent to 10 therms or 1 million Btu of energy. Gas transported for end-user transport customers included in the above total was 28,077,338 Dth in 1997, or approximately 42% of WPSC's total deliveries. WPSC's peak day gas throughput in 1997 occurred on January 16 with 422,859 Dth total gas throughput at an average Green Bay temperature of minus 7.7 degrees Fahrenheit. This compares with WPSC's record gas system throughput of 432,928 Dth set on February 2, 1996 at an average Green Bay temperature of minus 23.8 degrees Fahrenheit. GAS SUPPLY GENERAL Since the implementation of FERC Order 636 in November 1993, WPSC has had full responsibility for the design, acquisition, and operation of gas -16- supplies and the pipeline transportation and storage services required to meet the varying daily, seasonal, and annual load requirements of its customers. WPSC operates a portfolio of gas supply contracts and pipeline transportation and storage services designed to meet reliably WPSC's varying load pattern at the lowest reasonable cost. WPSC is presently served by a single interstate pipeline, ANR Pipeline Company. Because ANR's pipeline system in Wisconsin has reached its maximum capacity, and because lower prices are generally available in other areas where there is competition for pipeline services, WPSC is investigating potential suppliers of pipeline services in addition to those offered by ANR. Prominent among possible alternatives is the Viking Voyageur project proposed by TransCanada Pipelines, Northern States Power Company, and NICOR. WPSC, as part of the Wisconsin Capacity Coalition (a group of Wisconsin gas utilities consisting of MG&E, Wisconsin Gas Company, Wisconsin Fuel and Light Company, Northern States Power Company-Wisconsin, and WPSC who are working together to encourage development of alternate pipeline capacity to serve Wisconsin), is presently evaluating construction of lateral lines to interconnect WPSC's distribution system with Viking Voyageur and thereby provide access to WPSC's markets. Other pipeline service alternatives are also being evaluated. PIPELINE CAPACITY AND STORAGE ANR's system serving WPSC accesses three major gas producing areas of North America: (1) the Gulf of Mexico, (2) the mid-continent areas of Oklahoma, Texas, and Kansas, and (3) the Province of Alberta in western Canada. WPSC holds firm long-term transportation capacity on ANR in roughly equal proportions from each of these three supply areas. The term of these long-line ANR firm transportation contracts from the Gulf Coast and mid-continent areas extend through October 2003. The term of the ANR contract for 83% of the supplies from Canada extends through October 1998. WPSC intends to renew this ANR contract for supply from Canada in 1998 for another five-year term through October 2003 at a reduced capacity to coincide with the expiration of an upstream transportation contract with Viking Gas Transmission. The remaining 17% of the Canadian contracts extend through October 2003. Because of the substantial daily and seasonal swings in gas usage in WPSC's service territory, WPSC also has contracted with ANR for firm underground storage capacity located in Michigan. There are no known geological formations in Wisconsin capable of being developed into underground storage facilities. Besides providing WPSC the ability to manage significant changes in daily gas demand, storage also provides WPSC the ability to purchase gas from the production areas at high load factors, thus minimizing supply costs. During the summer, gas purchased in excess of market demand is injected into storage. During the winter, gas is withdrawn from storage and combined with gas purchased in the production areas to meet the increased winter demand. Gas from storage provides up to 63% of WPSC's supply on winter peak days, approximately 32% of WPSC's winter sales volumes, and approximately 22% of WPSC's total annual sales volumes. WPSC's total firm storage capacity with ANR is 11.3 million Dth. WPSC also contracts for high deliverability storage in the Gulf Coast and mid-continent production areas during the winter from third-party -17- suppliers. This storage capacity provides a back-up supply of gas into WPSC's long-line transportation contracts when other supplies cannot be delivered due to production supply losses caused by extremely cold weather in the production areas. As of December 31, 1997, WPSC's total firm winter long-line transportation capacity from ANR was 128,952 Dth per day, and firm capacity from ANR storage was 223,120 Dth per day, for a total winter peak day capacity of 352,072 Dth per day. WPSC's forecasted peak day firm load requirement for the 1997-1998 winter is 337,453 Dth per day, providing WPSC a 14,619 Dth per day or 4.3% reserve margin of capacity for load growth and unforeseen needs. On November 1, 1998, WPSC's total firm winter long-line transportation capacity from ANR will be 121,254 Dth per day, and firm capacity from ANR storage will be 223,120 Dth per day, for a total winter peak day capacity of 344,374 Dth per day. WPSC's forecasted peak day firm load requirement for the 1998-1999 winter is 323,885 Dth per day, providing WPSC a 20,489 Dth per day or 6.3% reserve margin of capacity for load growth and unforeseen needs. WPSC also holds firm transportation capacity with Viking Gas Transmission Company, ("Viking") to deliver gas on a firm basis from Viking's interconnection with TransCanada Pipelines ("TransCanada") at Emerson, Manitoba, Canada to the interconnection with ANR at Marshfield, Wisconsin. The Canadian suppliers, from whom WPSC purchases gas, hold firm capacity on TransCanada and NOVA from Emerson back into the production areas in Alberta, Canada. GAS SUPPLY CONTRACTS WPSC contracts for firm term supplies with approximately 12 to 16 suppliers each year for gas produced in each of the three production areas. WPSC initially designed its supply portfolio with terms ranging from one to ten years so that only a portion of WPSC's supply contracts expired in any given year. With the current uncertainty surrounding the future of WPSC's gas merchant function, however, as long-term contracts expire, WPSC has been replacing them with contracts of a one-year term or less. This will minimize potential stranded gas supply contract costs if retail gas deregulation should proceed quickly in Wisconsin. WPSC's supply portfolio as of December 31, 1997 contained contracts with remaining terms ranging from two months to six years. An exception to this short-term supply contracting practice will occur if the proposed Viking Voyageur gas pipeline project is constructed. In which case, WPSC plans to enter into five-year gas supply contracts with suppliers to help support construction of the pipeline. Viking Voyageur supply contracts will be assignable to third parties should WPSC's merchant function be substantially reduced during the term of the supply agreements. Additional supplies are purchased on the monthly spot market as required to supplement supplies from long-term firm contracts. WPSC has been an active spot market purchaser since 1985 and has contracts in place with a number of suppliers of spot market gas. NEW PIPELINE SUPPLY SOURCE WPSC is planning a joint project with Wisconsin Electric Power Company- Gas Operations to construct a new eight-inch pipeline from an interconnection -18- with Great Lakes Gas Transmission Company ("Great Lakes") in the Upper Peninsula of Michigan near Watersmeet into northern Wisconsin. WPSC plans to build additional pipeline facilities to connect the new pipeline to WPSC's existing northern area distribution system to reinforce pressures and increase system reliability. WPSC plans to modify and extend the term of portions of its existing pipeline capacity and storage contracts with ANR and add a new transportation service on Great Lakes to deliver up to 7,000 Dth per day into the new pipeline system during the winter. The new pipeline project is expected to be in service by November 1998. FEDERAL REGULATORY ACTIVITIES WPSC's involvement in federal regulatory activities has been through the Wisconsin Distributor Group ("WDG") which is made up of several Wisconsin gas utilities. Over the past several years, the WDG has participated in numerous dockets filed by ANR at the FERC. Successes in three key issues this year are summarized below. DAKOTA In December 1996, ANR's Dakota Gasification Plant settlement was approved by FERC. The settlement results in cost savings for WPSC's customers compared to the original gas purchase contracts ANR had with Dakota, and brings to an end the extensive litigation that surrounded this issue. As part of the settlement, in July 1997, WPSC received a refund of previously paid above-market Dakota costs in the amount of $1,912,225 which WPSC refunded to customers in September 1997. VIKING COSTS ON ANR PIPELINE The WDG was also successful in obtaining refunds of overcollections by ANR for Viking-related expenses. In July 1997, WPSC received a refund of $890,325 which was refunded to its customers in September. ANR RATE CASE SETTLEMENT After nearly three years of effort, a settlement was achieved in the rate case ANR filed on November 1, 1993 and put into effect on May 1, 1994. The settlement will result in refunds to WPSC of $6.8 million, an annual reduction in WPSC's rates paid to ANR of approximately $7.5 million, or 19%, a moratorium period against rate increases, and an opportunity for additional cost reduction through contract portfolio reshaping. The new, lower rates went into effect November 1, 1997, subject to future FERC approval. On February 13, 1998, FERC issued an order approving ANR's settlement agreement as filed. ANR now has until March 15, 1998 to notify the FERC if any party objects to any conditions imposed by the FERC in its order. Since the FERC approved ANR's settlement without modification, WPSC expects ANR will notify the FERC that no party objects, and the settlement will become effective by April 15, 1998. -19- WISCONSIN REGULATORY ACTIVITIES GENERAL The PSCW is considering gas restructuring issues including unbundling of rates, pricing of contracted services in potential utility bypass situations (i.e., situations in which a major industrial gas customer may construct a pipeline connecting them directly to an interstate pipeline, thus avoiding purchasing any delivery service from the local gas utility), and the separation of gas utilities from their unregulated gas marketing affiliates. GAS COST RECOVERY MECHANISM Historically, Wisconsin gas utilities, including WPSC, have recovered their costs for gas supply and pipeline services on a one-for-one basis through a mechanism called the Purchased Gas Adjustment Clause. The PSCW conducted an investigation in Docket 05-GI-106 to determine whether alternate gas cost recovery mechanisms may be more appropriate in the evolving gas market. In particular, Performance Based Rates ("PBR") were evaluated as alternatives to the traditional one-for-one recovery mechanism. Under PBRs, gas utilities are given an incentive to reduce gas costs by being allowed to keep a portion of any cost savings they are able to obtain relative to a gas cost target value. In November 1996, the PSCW issued an order which gave gas utilities a choice between continuing under a modified one-for-one gas cost recovery mechanism, or switching to a PBR mechanism. WPSC elected to continue under a modified one-for-one mechanism, as WPSC believes it provides the greatest value to customers through regulatory oversight and the return to customers of all savings achieved. Development of WPSC's modified one-for-one mechanism is in process, with implementation expected in November 1998. GAS DISTRIBUTION RESTRUCTURING The PSCW has an ongoing investigation into gas industry restructuring in Docket 05-GI-108. Although the gas utility distribution function is expected to continue as a regulated monopoly, sales of the natural gas commodity and associated services, which were formerly also utility monopoly functions, are expected to become increasingly open for competition among unregulated third-party suppliers. WPSC's position is that utilities should be allowed to continue to offer a regulated gas supply merchant function if they so choose, thereby providing customers with a regulated supply choice. Phase I of this docket addressed issues of unbundling rates, pricing of contracted service in potential utility bypass situations, and the separation of gas utilities from their unregulated gas marketing affiliates. Phase II established standards of conduct regarding how gas utilities can interact with their marketing affiliates. Phase III explored the issue of how to determine when a competitive market exists for various segments of customers, so the utility could then be taken out of serving that market. Because of the complexity of the many issues involved, industry work groups were formed to study particular issues and bring recommendations back to the PSCW. The six work groups are studying pipeline capacity, market-based pricing for interruptible customers, end-user price reporting, marketer certification, changes needed in the form of legislation or administrative -20- rules, and social issues and essential services. Although most of this work has not yet started, completion of these work groups' assignments is projected for November 1999. CUSTOMER RATE MATTERS Customer rates are based on forecasted expenses and capital costs. On February 20, 1997, the PSCW authorized a $5.7 million, or 2.7%, increase in WPSC's retail natural gas rates. The rates are effective through 1998. WPSC anticipates filing on April 1, 1998 an application with the PSCW for increased gas rates to be effective for the years 1999 and 2000. MICHIGAN REGULATORY ACTIVITIES GAS COST RECOVERY In June 1997, WPSC filed with the MPSC the annual reconciliation of gas costs and gas revenues for the period April 1, 1996 through March 31, 1997. WPSC's gas cost recovery clause in Michigan allows WPSC to recover all prudently incurred gas costs on a one-for-one basis. The MPSC staff contested the prudency of certain summer-only gas sales WPSC made to a single large-volume customer and recommended that WPSC not be allowed to recover approximately $245,088 of gas costs associated with these sales. In January 1998, an administrative law judge issued a Proposal For Decision and recommended that the MPSC issue an order allowing WPSC to recover the entire amount in contention. A final order in this case is expected in March 1998. GAS DISTRIBUTION RESTRUCTURING The MPSC is also investigating the deregulation of retail gas markets and expansion of gas transportation service in Michigan in Case No. U-11017. The MPSC decided it would be appropriate to conduct a series of pilot projects to test the development of competitive retail gas markets in Michigan. Michigan's four largest gas utilities were approached by the MPSC regarding development and implementation of pilot programs. Because of the small size and limited number of customers in WPSC's Michigan service territory and the service territories of two other utility companies, the MPSC did not conduct pilot transportation programs for these three utilities. CUSTOMER RATE MATTERS WPSC has not had a natural gas rate case in Michigan since 1986. -21- GAS FINANCIAL SUMMARY The following table sets forth the amounts of revenues, operating income, and identifiable assets attributable to gas utility operations: WISCONSIN PUBLIC SERVICE CORPORATION ============================================================================== (Thousands) Year Ended December 31 - ------------------------------------------------------------------------------ 1997 1996 1995 - ------------------------------------------------------------------------------ Gas Operating Revenues $211,090 $211,357 $174,693 Operating Income, Including Allowance For Funds Used During Construction $ 18,584 $ 10,191 $ 12,116 Identifiable Assets $235,490 $255,200 $232,983 ============================================================================== See Note 12 in Notes to Consolidated Financial Statements. -22- GAS OPERATING STATISTICS WPS Resources Corporation ===================================================================================================================== 1997 1996 1995 1994 - --------------------------------------------------------------------------------------------------------------------- Operating revenues (Thousands) Residential $122,782 $122,224 $109,998 $104,020 Small commercial and industrial 23,790 22,392 19,933 18,586 Large commercial and industrial 53,517 55,211 47,627 45,115 Other 190,310 164,673 52,367 25,258 - --------------------------------------------------------------------------------------------------------------------- Total $390,399 $364,500 $229,925 $192,979 ===================================================================================================================== Therms delivered (Thousands) Residential 202,558 216,963 202,152 187,355 Small commercial and industrial 43,056 46,614 42,600 38,568 Large commercial and industrial 127,132 142,033 129,494 115,939 Other 595,154 527,069 294,372 56,961 - --------------------------------------------------------------------------------------------------------------------- Total therm sales 967,900 932,679 668,618 398,823 Transportation 268,114 251,279 241,531 234,149 - --------------------------------------------------------------------------------------------------------------------- Total 1,236,014 1,183,958 910,149 632,972 ===================================================================================================================== -23- GAS OPERATING STATISTICS Wisconsin Public Service Corporation ======================================================================================================================== 1997 1996 1995 1994 1993 - ------------------------------------------------------------------------------------------------------------------------ Operating revenues (Thousands) Residential $122,782 $122,224 $109,998 $104,020 $110,541 Small commercial and industrial 23,790 22,392 19,933 18,586 20,254 Large commercial and industrial 53,517 55,211 47,627 45,115 47,091 Other 11,001 11,530 (2,865) 14,337 9,490 - ------------------------------------------------------------------------------------------------------------------------ Total $211,090 $211,357 $174,693 $182,058 $187,376 ======================================================================================================================== Therms delivered (Thousands) Residential 202,558 216,963 202,152 187,355 192,053 Small commercial and industrial 43,056 46,614 42,600 38,568 41,385 Large commercial and industrial 127,132 142,033 129,494 115,939 108,068 Other 21,148 9,709 15,415 9,810 6,337 - ------------------------------------------------------------------------------------------------------------------------ Total therm sales 393,894 415,319 389,661 351,672 347,843 Transportation 268,114 251,279 241,531 234,149 220,672 - ------------------------------------------------------------------------------------------------------------------------ Total 662,008 666,598 631,192 585,821 568,515 ======================================================================================================================== Customers served (End of period) Residential 198,524 192,947 186,267 178,992 172,902 Small commercial and industrial 16,770 16,133 15,905 14,689 14,571 Large commercial and industrial 2,780 2,846 2,432 2,867 2,508 Other 1 1 1 1 1 Transportation customers 224 167 121 117 127 - ------------------------------------------------------------------------------------------------------------------------ Total 218,299 212,094 204,726 196,666 190,109 ======================================================================================================================== Average annual use (Therms) Residential 1,037.3 1,146.6 1,112.3 1,068.8 1,128.4 Small commercial and industrial 2,619.4 2,937.2 2,770.8 2,673.9 2,888.8 Large commercial and industrial 32,423.5 37,163.7 39,707.6 34,651.2 41,354.4 ======================================================================================================================== Average therm price (Cents) Residential 60.62 56.33 54.41 55.52 57.56 Small commercial and industrial 55.25 48.04 46.79 48.19 48.94 Large commercial and industrial 45.92 42.84 40.63 41.84 44.97 ======================================================================================================================== -24- D. NONREGULATED BUSINESS ACTIVITIES GENERAL At the end of 1997, WPSR had two principal nonregulated subsidiaries: WPS Energy Services, Inc. ("ESI") and WPS Power Development, Inc. ("PDI"). These subsidiaries were formed in 1994 and 1995, respectively, for the purpose of positioning WPSR strategically for participation in the evolving nonregulated energy marketplace. WPS ENERGY SERVICES, INC. ESI is a diversified energy company. ESI targets retail energy sales and related services in Midwestern and Eastern states with an emphasis on serving commercial, industrial, and wholesale customers. Principal operations are located in Illinois, Michigan, Ohio, and Wisconsin. ESI also is participating in retail pilot projects in each of these states. Wholesale energy sales and related services are provided nationwide. ESI provides electric, natural gas, and alternate fuel products; risk management consulting services; real-time energy management services; and project management. ESI also provides energy utilization consulting which identifies opportunities for improving purchasing practices, equipment, and systems necessary for the efficient use of energy. The gas markets in which ESI participates are characterized by strong competition, narrow margins, and volatile commodity and transportation prices. ESI uses various financial instruments to minimize the risks present in the natural gas marketplace (see Note 1(e), Price Risk Management Activities on page 57 of NOTES TO CONSOLIDATED FINANCIAL STATEMENTS). Revenues were predominantly from the sale of natural gas. Revenues from the sale of natural gas were $179.3 million in 1997 compared to $153.1 million in 1996. Sales totaled 574.0 million therms in 1997 compared to 517.4 million therms in 1996. Electric sales are not significant because electric retail access has been slow to develop in ESI's target market areas. ESI continues to pursue the electric wholsesale market, but to a lesser extent than in the past. WPS POWER DEVELOPMENT, INC. PDI develops and owns electric generation projects and provides services to the electric power generation industry nationwide. PDI's services include acquisition and investment analysis, project development, engineering and management services, and operations and maintenance services. PDI's areas of expertise include cogeneration, distributed generation, generation from renewables, generation plant repowering projects, and conversion of paper mill sludge to lightweight aggregate. PDI owns a two-thirds interest in the Stoneman Power Plant ("Stoneman"), a 53-megawatt merchant steam plant located in Cassville, Wisconsin. The redevelopment of Stoneman as a 300-megawatt to 500-megawatt gas-fired combined cycle facility is planned for the 1999 to 2000 time period. PDI also owns landfill gas generating facilities. -25- EARNINGS Both ESI and PDI incurred losses for 1997 and 1996. The loss incurred at ESI in 1997 was $4.9 million, compared with a loss of $6.3 million in 1996, a decrease of 22.2%. The loss incurred by PDI in 1997 was $1.9 million, compared with $4.0 million in 1996, a decrease of 52.5%. Operating losses at the nonregulated subsidiaries were anticipated by management as the companies develop infrastructure and finance additional working capital needed to support growth. See MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION at page 42 for additional information regarding nonregulated operations. E. ENVIRONMENTAL MATTERS GENERAL WPSC is subject to regulation with regard to the impact of its operations on air and water quality and solid waste disposal, and may be subject to regulation with regard to other environmental considerations by various federal, state, and local authorities. The application of federal and state restrictions to protect the environment involves or may involve review, certification, or issuance of permits by various federal and state authorities, including the United States Environmental Protection Agency ("EPA") and the Wisconsin Department of Natural Resources ("DNR"). Such restrictions (particularly in regard to emissions into the air and water, and solid waste disposal) may limit, prevent, or substantially increase the cost of the operation of WPSC's generating facilities and may require substantial investments in new equipment at existing installations. Such restrictions may also require substantial additional investments for any new projects and may delay or prevent authorization and completion of the projects. WPSC cannot forecast effects of such regulation upon its generating, transmission, and other facilities, or its operations, but believes that it is presently meeting existing requirements. AIR QUALITY WPSC's generating plants are in compliance with all current sulfur dioxide, nitrogen oxide, and particulate emission standards. The Federal Clean Air Act Amendments of 1990 ("Act") required reductions in sulfur dioxide in 1995 (Phase I) to meet limitations based on an emission rate of 2.5 pounds per Btu multiplied by a historical generation baseline for Pulliam Unit 8 and Edgewater Unit 4 generating units. The Act requires further reductions beginning in the year 2000 (Phase II). The year 2000 limits are based on an emission rate of 1.2 pounds per million Btu multiplied by a historical generation baseline for all generating units. WPSC's generating facilities met the year 2000 standard in 1995. WPSC achieved compliance with Wisconsin and federal sulfur dioxide emission limitations by switching to low sulfur coal. Because of the emission allowance system included in the Act, operations during Phase I are expected to produce surplus allowances which will be available to aid in compliance with the requirements of Phase II. To the -26- extent WPSC determines that it will have allowances available beyond its own requirements in both Phase I and Phase II, it will consider the sale of the excess allowances. The PSCW has ordered that profits from the sale of allowances be used to benefit utility customers. The Act also requires the installation of low nitrogen oxide burners on several units. Low nitrogen oxide burners were installed at Pulliam Unit 8 early in 1994. Phase I of the Act allows units smaller than 100 megawatts, such as Pulliam Unit 7, to be designated Phase I units, thus building up sulfur dioxide credits. Having made this election, low nitrogen oxide burners were installed on Pulliam Unit 7 in 1994. Low nitrogen oxide emissions from Pulliam Units 7 and 8 and Weston Unit 3 are averaged with Weston Units 1 and 2. This averaging plan generates additional emission allowances in Phase I and locks in Phase I nitrogen oxide limits for these units. This should reduce Phase II compliance costs. Expenditures of $1.0 million to $2.0 million for Phase II of the Acid Rain Program are projected through 1999 to assure nitrogen oxide emission compliance at the Pulliam and Weston plants. The EPA recently proposed additional nitrogen oxide emission reductions from facilities in 22 eastern states, including those in Wisconsin. The reduction in nitrogen oxide emissions that WPSC will need to achieve has yet to be determined. However, it is likely that the reduction will be significant and beyond that required by the existing rules. The proposed rules will probably take effect in 2002 to 2004 and result in significant emission control costs. Air toxic provisions in the Act will not be applied until the EPA determines if those standards need to be applied to utilities. WATER QUALITY WPSC is subject to regulation by the EPA and the DNR with respect to thermal and other discharges into Lake Michigan and other waters of Wisconsin from WPSC's power plants. Wastewater discharge permits with a term of five years were reissued by the DNR to WPSC for Kewaunee in 1995 and the Pulliam and Weston power plants in 1996. No new permit conditions or associated material costs were imposed compared to permits issued during earlier renewals. Revisions to state water quality rules as a result of the Great Lakes Initiative should not result in any significant changes when wastewater permits are reissued in 2000 for Kewaunee and in 2001 for the Pulliam and Weston plants. GAS PLANT CLEANUP WPSC is investigating the cleanup of eight manufactured gas plant sites which it previously operated in Green Bay, Two Rivers, Oshkosh, Marinette, Sheboygan (two sites), Stevens Point, and Menominee (Michigan). In general, WPSC is proceeding with these projects as the designated responsible party for cleanup, although for two sites, Sheboygan II and Oshkosh, formal agreements have been executed with the DNR covering the investigation and restoration activities. The agreement for Sheboygan II allows WPSC to work with Wisconsin on restoration. The site is not associated with the larger Sheboygan River and Harbor Superfund site. The agreement for Oshkosh was entered into in order to resolve a unilateral administrative order that was issued by the DNR. -27- Total costs of cleanup for all eight sites, as estimated by an environmental consultant, should be in the range of $34.1 million to $41.1 million. The estimates assume removal of significantly contaminated soil and groundwater treatment/monitoring for up to 25 years, depending on site conditions. The cost estimates for five of the sites include removal and disposal of contaminated river sediments. Expenditures for the gas plant sites are estimated to be made over the next 32 years. WPSC has recorded on its books a liability with an offsetting deferred charge (i.e., a regulatory asset) in the amount of $41.7 million. Insurance recoveries and collections in rates have reduced the regulatory asset to $29.2 million at December 31, 1997. Expenditures have reduced the liability to $40.2 million at December 31, 1997. Based on discussions with regulators and a Wisconsin rate order, management believes that these costs, but not the carrying costs associated with the deferred charges, will be recoverable in future customer rates. In a rate order that became effective in February 1997, the PSCW authorized current annualized recovery for gas site cleanup of $225,000 for each of the years 1997 and 1998. Work at the Stevens Point site is expected to commence in 1998. As remedial feasibility studies and initial remedial activities are completed, remediation cost estimates may be adjusted and these adjustments could be significant. Other factors that can affect these estimates are changes in remedial technology and regulatory requirements. The cost estimates presented above do not take into consideration any recovery from insurance carriers or other third parties which WPSC has obtained or is pursuing. Insurance recoveries are deferred as a reduction to the regulatory asset; therefore, neither adjustments to the estimated liability nor insurance recoveries have an immediate impact on net income. To date, WPSC has received insurance settlements of approximately $12.6 million. F. CAPITAL REQUIREMENTS WPSR's utility subsidiary, WPSC, makes large investments in capital assets. Construction expenditures for WPSC are expected to continue in the $75.0 million to $90.0 million range annually during the 1998 through 2000 period. This does not include any expenditures for the replacement of Kewaunee steam generators. Steam generator replacement, WPSC's share of which would be approximately $36.7 million in year of occurrence dollars, is contingent upon receipt of approval from the PSCW to proceed with replacement and agreement among the owners on a replacement plan. Potential expenditures for gas pipeline laterals which would connect WPSC's distribution system with the proposed Viking Voyageur pipeline from Canada are also not included. In addition, other capital requirements for WPSC during the three-year period include Kewaunee decommissioning trust fund contributions of approximately $30.0 million and replacement financing for maturing first-mortgage bonds of $50.0 million. See note 9 of NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Future Utility Expenditures, at page 72 for additional information regarding forecasted construction expenditures for WPSC. -28- WPSR expects that internally-generated funds and short-term borrowing will satisfy most of its capital requirements. WPSR may periodically issue additional long-term debt and common stock to reduce short-term debt and to maintain desired capitalization ratios. The specific forms of financing, amounts, and timing will depend on the availability of projects, market conditions, and other factors. However, at this time, it is anticipated that trust originated preferred stock could be issued on behalf of WPSR in 1998. WPSR may also expand its leveraged employee stock ownership plan during the three-year period. Investment expenditures for nonregulated projects are uncertain since there are no material firm commitments at this time. Debt financing for most nonregulated projects is expected to be on a nonrecourse basis. G. EMPLOYEES At December 31, 1997, WPSR, including its subsidiaries, employed 2,486 persons. Of this number, 2,399 employees were employed by WPSC. Of the employees of WPSC, 1,888 were considered electric utility employees and 511 were considered gas utility employees. Approximately 1,200 WPSC employees are represented by Local 310 of the International Union of Operating Engineers ("Union"). The Union has been operating without a contract since October 29, 1997. Unresolved issues remain and contract negotiations continue. There has never been a strike against WPSC by its employees. -29- ITEM 2. PROPERTIES A. UTILITY The following table includes information about electric generation facilities of WPSC (including those jointly-owned): Rated Capacity (a) Type Name Location Fuel (Kilowatts) - ------------- ---------------- ------------- ----------- ------------- Steam Pulliam Green Bay, WI Coal 400,900 (b) Weston Wausau, WI Coal or Gas 480,100 (c) Kewaunee Kewaunee, WI Nuclear 210,500 (d) Columbia - Units No. 1 & 2 Portage, WI Coal 325,100 (d) Edgewater Unit No. 4 Sheboygan Coal 106,200 (d) --------- Total Steam 1,522,800 Hydro Various 68,400 (e) (15 Plants) Combustion Various Gas or Oil 269,410 (f) Turbine (7 Plants) & Diesel --------- Total System 1,860,610 ========= (a) Based on winter-rated capacity. (b) This plant has six units. (c) This plant has three units. Two units burn only coal and the other unit can burn coal or natural gas. (d) These facilities are jointly-owned. Kewaunee is operated by WPSC. WP&L is operator of the Columbia and Edgewater units. The capacity indicated is WPSC's portion of total plant capacity based on percent of ownership. (e) Includes 12,900 kw purchased from Wisconsin River Power Company. (f) WPSC and the Marshfield Electric and Water Department jointly own 115,600 kilowatts of combustion turbine peaking capacity which WPSC operates. The capacity indicated is WPSC's portion of total plant capacity based on percent of ownership. WPSC owns 55 transmission substations with a transformer capacity of 5,616,110 kilovolt-ampere ("kVa"), 110 distribution substations with a transformer capacity of 2,881,270 kVa, 1,549 miles of electric transmission lines, and 19,358 miles of electric distribution lines. -30- Gas properties include approximately 4,623 miles of main, 68 gate and city regulator stations, and 201,566 services. All gas facilities are located in Wisconsin except for distribution facilities in and near the city of Menominee, Michigan. Substantially all of WPSC's utility plant is subject to a first mortgage lien. B. NONREGULATED The following table includes information about jointly-owned electric generation facilities of PDI: Rated Capacity Type Name Location Fuel (Kilowatts) - ----- -------------- ------------ ---- ----------- Steam Stoneman Cassville, WI Coal 53,000 (a) (a) The Stoneman facility is owned by Mid-American Power, LLC. PDI Stoneman, Inc. (a wholly-owned subsidiary of WPS Power Development, Inc.) and B. M. Stoneman, Inc., (a wholly-owned subsidiary of Burns and McDonnell) own 66-2/3% and 33-1/3%, respectively, of Mid-American Power, LLC. ITEM 3. LEGAL PROCEEDINGS See Part I, Item 1E, ENVIRONMENTAL MATTERS, at page 26, for a description of various proceedings relating to environmental matters. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year. -31- ITEM 4A. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information about outside directors is omitted for the reason that such information will be included in a proxy statement for the Annual Meeting of Shareholders of WPSR which is scheduled to be held on May 7, 1998. A. EXECUTIVE OFFICERS OF WPS RESOURCES CORPORATION ("WPSR") Current Position and Business Effective Name and Age Experience During Past Five Years Date - ----------------------------- ------------------------------------------- --------- Larry L. Weyers 52 Chairman, President, and Chief Executive Officer 02-12-98 President and Chief Executive Officer 05-01-97 President and Chief Operating Officer 01-01-96 Patrick D. Schrickel 53 Executive Vice President 12-29-96 Vice President 12-09-93 Phillip M. Mikulsky 49 Senior Vice President-Development 02-12-98 Vice President-Development 09-01-95 Manager-System Operations 10-01-91 * Director-System Operations 09-28-91 * Daniel P. Bittner 54 Vice President and Chief Financial Officer 05-01-97 Vice President 12-29-96 Richard E. James 44 Vice President-Corporate Planning 12-29-96 Vice President-Corporate Planning 08-01-95 * Assistant Vice President-Corporate Planning 05-09-94 * Assistant Vice President-Rates and Economic Evaluation 03-01-92 * Thomas P. Meinz 51 Vice President-Public Affairs 02-12-98 Bernard J. Treml 48 Vice President-Human Resources 02-12-98 Glen R. Schwalbach 52 Assistant Vice President-Corporate Planning 12-29-96 Assistant Vice President-Corporate Planning 07-28-96 * Assistant Vice President-Gas Engineering and Supply 06-01-90 * Francis J. Kicsar 58 Secretary 01-01-96 Ralph G. Baeten 54 Treasurer 12-09-93 Diane L. Ford 44 Controller and Chief Accounting Officer 05-01-97 Controller 12-15-93 George R. Wiesner 40 Assistant Controller 12-15-96 Director-Financial Accounting ESI/PDI 08-25-96 * Financial Reporting Supervisor 05-01-87 * * Identifies experience with Wisconsin Public Service Corporation ("WPSC") for Richard E. James, Phillip M. Mikulsky, Glen R. Schwalbach, and George R. Wiesner. The other listed officers of WPSR are also officers of WPSC and their experience with WPSC is indicated below. All of the above named executive officers have been employed by WPSR or WPSC for at least five years. -32- B. EXECUTIVE OFFICERS OF WISCONSIN PUBLIC SERVICE CORPORATION ("WPSC") Current Position and Business Effective Name and Age Experience During Past Five Years Date - ----------------------------- ------------------------------------------- --------- Larry L. Weyers 52 Chairman and Chief Executive Officer 02-12-98 President and Chief Executive Officer 05-04-97 President and Chief Operating Officer 01-01-96 Senior Vice President-Power Supply and Engineering 08-01-95 Vice President-Power Supply and Engineering 05-09-94 Vice President-Energy Supply 01-01-92 Patrick D. Schrickel 53 President and Chief Operating Officer 02-12-98 Executive Vice President 12-29-96 Senior Vice President-Finance and Corporate Services 05-09-94 Senior Vice President-Operations 06-01-89 Daniel P. Bittner 54 Senior Vice President-Finance and Corporate Services 12-29-96 Senior Vice President-Customer Service 05-09-94 Senior Vice President-Finance 03-01-92 Vice President-Treasurer 02-01-89 Clark R. Steinhardt 56 Senior Vice President-Nuclear Power 06-01-91 Ralph G. Baeten 54 Vice President-Treasurer 08-01-95 Treasurer 03-01-92 Insurance and Benefits Director 05-01-87 Thomas P. Meinz 51 Vice President-Public Affairs 02-12-98 Vice President-Power Supply and Engineering 02-23-97 Power Supply and Engineering Executive 01-14-96 Senior Corporate Planning Executive 05-09-94 Manager-System Planning and Licensing 03-01-91 Bernard J. Treml 48 Vice President-Human Resources 05-09-94 Assistant Vice President-Human Resources 07-01-93 Manager-Human Resources 08-01-92 Manager-Marketing Programs and Services 08-01-91 Wayne J. Peterson 39 Vice President-Distribution and Customer Service 02-12-98 Assistant Vice President-Customer Service 02-23-97 Manager-System Operations 10-01-95 Site Leader 10-01-94 Electric Superintendent 04-01-92 Director-Distribution Services 01-02-92 David W. Schonke 64 Assistant Vice President-Electric Distribution Engineering 06-01-86 Francis J. Kicsar 58 Secretary 01-01-96 Assistant Secretary 03-01-92 Director-Corporate Tax 10-01-76 Diane L. Ford 44 Controller 03-01-92 Administrator-Corporate Accounting 05-01-87 NOTE: All ages for the officers of WPSR and WPSC are as of December 31, 1997. None of the executives listed above for WPSR or for WPSC are related by blood, marriage, or adoption to any of the other officers listed or to any director of the Registrant. Each officer shall hold office until his or her successor shall have been duly elected and qualified, or until his or her death, resignation, disqualification, or removal. -33- PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS WPS RESOURCES CORPORATION COMMON STOCK TWO-YEAR COMPARISON Dividends Share Data Per Share Price Range - ---------- --------- --------------------- High Low ------- ------- 1997 1st Quarter $ .475 28-3/4 26-1/8 2nd Quarter .475 27-7/8 23-3/8 3rd Quarter .485 29-1/4 26-3/4 4th Quarter .485 34-1/4 28-1/16 ----- Total $1.92 1996 1st Quarter $ .465 34-3/8 31-7/8 2nd Quarter .465 33-1/2 30-1/8 3rd Quarter .475 32-1/8 30-3/8 4th Quarter .475 30-5/8 28-1/4 ----- Total $1.88 DIVIDEND RESTRICTIONS WPSC, WPSR's principal subsidiary, is restricted by a PSCW order to paying normal common stock dividends of no more than 109% of the previous year's common stock dividend without prior notice to the PSCW. Also, Wisconsin law prohibits WPSC from making loans to WPSR and its nonregulated subsidiaries and from guaranteeing their obligations. On January 15, 1997, a special common stock dividend of $10.0 million was declared by WPSC to be paid to WPSR. The special dividend allowed WPSC's average equity capitalization ratio to remain at approximately 54%, the level approved by the PSCW for ratemaking. The dividend was paid in January 1997. COMMON STOCK Listed on the New York and Chicago Stock Exchanges Ticker Symbol: WPS Transfer Agent and Registrar: Firstar Trust Company P. O. Box 2077 Milwaukee, Wisconsin 53201 As of December 31, 1997, there were 23,704 common stock shareholders of record. -34- ITEM 6. SELECTED FINANCIAL DATA WPS RESOURCES CORPORATION COMPARATIVE FINANCIAL STATEMENTS AND FINANCIAL STATISTICS (1993 TO 1997)* A. CONSOLIDATED STATEMENTS OF INCOME ======================================================================================================================== Consolidated Statements of Income ======================================================================================================================== Year Ended December 31 (Thousands, except share amounts) 1997 1996 1995 1994 1993 - ------------------------------------------------------------------------------------------------------------------------ Operating revenues Electric utility $479,388 $490,506 $489,000 $480,816 $493,256 Gas utility 211,090 211,357 174,693 182,058 187,376 Nonregulated energy and other 187,862 156,391 56,155 10,921 - - ------------------------------------------------------------------------------------------------------------------------ Total operating revenues 878,340 858,254 719,848 673,795 680,632 ======================================================================================================================== Operating expenses Electric production fuels 107,538 105,418 104,858 111,011 114,051 Purchased power 45,876 37,737 39,593 38,631 30,703 Gas purchased for resale 147,755 149,388 116,253 126,351 133,347 Nonregulated energy cost of sales 182,863 155,133 53,983 10,663 - Other operating expenses 148,569 168,905 154,445 148,917 148,270 Maintenance 41,661 48,806 50,761 49,983 51,597 Depreciation and decommissioning 77,541 65,178 65,627 56,365 60,609 Taxes other than income 26,448 26,868 25,921 26,063 25,204 - ------------------------------------------------------------------------------------------------------------------------ Total operating expenses 778,251 757,433 611,441 567,984 563,781 ======================================================================================================================== Operating income 100,089 100,821 108,407 105,811 116,851 - ------------------------------------------------------------------------------------------------------------------------ Other income Allowance for equity funds used during construction 129 139 170 108 287 Other, net 11,511 (1,084) 6,080 4,473 3,356 - ------------------------------------------------------------------------------------------------------------------------ Total other income 11,640 (945) 6,250 4,581 3,643 ======================================================================================================================== Income before interest expense 111,729 99,876 114,657 110,392 120,494 - ------------------------------------------------------------------------------------------------------------------------ Interest on long-term debt 22,331 21,532 22,859 23,407 24,393 Other interest 4,172 3,596 2,604 1,796 1,562 Allowance for borrowed funds used during construction (100) (128) (68) (139) (200) - ------------------------------------------------------------------------------------------------------------------------ Total interest expense 26,403 25,000 25,395 25,064 25,755 ======================================================================================================================== Income before income taxes 85,326 74,876 89,262 85,328 94,739 Income taxes 29,270 24,358 30,808 29,526 32,539 Minority interest (797) (348) - - - Preferred stock dividends of subsidiary 3,111 3,111 3,111 3,111 3,311 - ------------------------------------------------------------------------------------------------------------------------ Net income $ 53,742 $ 47,755 $ 55,343 $ 52,691 $ 58,889 ======================================================================================================================== Shares of common stock Outstanding at December 31 23,897 23,897 23,897 23,897 23,897 Average 23,873 23,891 23,897 23,897 23,888 Basic and diluted earnings per average share of common stock $2.25 $2.00 $2.32 $2.21 $2.47 Dividend per share of common stock 1.92 1.88 1.84 1.80 1.76 ======================================================================================================================== * WPS Resources Corporation became a holding company in 1994. The data in the 1993 column is that of Wisconsin Public Service Corporation. -35- PAGE ITEM 6. SELECTED FINANCIAL DATA WPS RESOURCES CORPORATION COMPARATIVE FINANCIAL STATEMENTS AND FINANCIAL STATISTICS (1993 TO 1997)* B. CONSOLIDATED BALANCE SHEETS ======================================================================================================================== Consolidated Balance Sheets At December 31 (Thousands) 1997 1996 1995 1994 1993 ======================================================================================================================== Assets - ------------------------------------------------------------------------------------------------------------------------ Utility plant Electric $1,513,310 $1,483,829 $1,449,201 $1,423,316 $1,386,007 Gas 252,029 241,367 228,734 203,384 184,234 - ------------------------------------------------------------------------------------------------------------------------ Total 1,765,339 1,725,196 1,677,935 1,626,700 1,570,241 Less - Accumulated depreciation and decommissioning 1,032,149 952,296 905,427 846,505 801,056 - ------------------------------------------------------------------------------------------------------------------------ Total 733,190 772,900 772,508 780,195 769,185 Nuclear decommissioning trusts 134,108 100,570 82,109 64,147 56,699 Nuclear fuel, net 19,062 19,381 14,275 19,417 17,981 - ------------------------------------------------------------------------------------------------------------------------ Net utility plant 886,360 892,851 868,892 863,759 843,865 ======================================================================================================================== Current assets 196,591 219,144 186,085 170,015 180,140 Net nonutility and nonregulated plant 19,194 19,738 3,307 2,218 2,121 Regulatory and other assets 197,457 199,132 208,459 181,283 172,715 - ------------------------------------------------------------------------------------------------------------------------ Total assets $1,299,602 $1,330,865 $1,266,743 $1,217,275 $1,198,841 ======================================================================================================================== ======================================================================================================================== Capitalization and Liabilities ======================================================================================================================== Capitalization Common stock equity $ 477,823 $ 467,524 $ 463,441 $ 446,540 $ 433,724 Preferred stock of subsidiary with no mandatory redemption 51,200 51,200 51,200 51,200 51,200 Long-term debt of subsidiary 304,008 305,788 306,590 309,945 314,225 - ------------------------------------------------------------------------------------------------------------------------ Total capitalization 833,031 824,512 821,231 807,685 799,149 ======================================================================================================================== Liabilities Short-term borrowings 30,706 57,950 26,500 22,500 21,000 Deferred income taxes 125,804 130,208 135,958 126,639 138,952 Other liabilities and credits 310,061 318,195 283,054 260,451 239,740 - ------------------------------------------------------------------------------------------------------------------------ Total liabilities 466,571 506,353 445,512 409,590 399,692 ======================================================================================================================== Total capitalization and liabilities $1,299,602 $1,330,865 $1,266,743 $1,217,275 $1,198,841 ======================================================================================================================== * WPS Resources Corporation became a holding company in 1994. The data in the 1993 column is that of Wisconsin Public Service Corporation. -36- ITEM 6. SELECTED FINANCIAL DATA WPS RESOURCES CORPORATION COMPARATIVE FINANCIAL STATEMENTS AND FINANCIAL STATISTICS (1993 TO 1997)* C. FINANCIAL STATISTICS ================================================================================================================ Year Ended December 31 1997 1996 1995 1994 1993 - ---------------------------------------------------------------------------------------------------------------- Stock price $33-13/16 $28-1/2 $34 $26-3/4 $33-5/8 Book value per share $20.00 $19.56 $19.39 $18.69 $18.18 Return on average equity 11.3% 10.2% 12.2% 12.0% 13.9% Number of common stock shareholders 23,704 23,998 24,341 25,395 25,240 Number of employees 2,486 2,606 2,547 2,578 2,603 ================================================================================================================ * WPS Resources Corporation became a holding company in 1994. The data in the 1993 column is that of Wisconsin Public Service Corporation. -37- PAGE ITEM 6. SELECTED FINANCIAL DATA WISCONSIN PUBLIC SERVICE CORPORATION COMPARATIVE FINANCIAL DATA AND FINANCIAL STATISTICS (1993 TO 1997) D. SELECTED FINANCIAL DATA ======================================================================================================== (Millions) 1997 1996 1995 1994 1993 - -------------------------------------------------------------------------------------------------------- Operating Revenues $ 690.5 $ 701.9 $ 663.7 $ 662.8 $ 680.6 Net Income 64.7 60.4 59.2 55.8 62.2 Total Assets (At December 31) 1,234.0 1,258.9 1,233.4 1,205.2 1,198.8 Long-Term Debt, Net (At December 31) 307.6 310.8 312.7 316.1 314.2 ======================================================================================================== -38- PAGE ITEM 6. SELECTED FINANCIAL DATA WISCONSIN PUBLIC SERVICE CORPORATION COMPARATIVE FINANCIAL STATEMENTS AND FINANCIAL STATISTICS (1993 TO 1997) E. FINANCIAL STATISTICS =================================================================================================================== Year Ended December 31 (Millions) 1997 1996 1995 1994 1993 - ------------------------------------------------------------------------------------------------------------------- Coverage Times interest earned before income taxes 4.48 4.36 4.00 4.19 4.49 Times interest earned after income taxes 3.30 3.21 3.03 3.09 3.29 Times interest and preferred dividends earned after income taxes 2.97 2.88 2.70 2.77 2.93 =================================================================================================================== Capitalization ratios Common equity including ESOP 56.0 55.3 55.0 53.9 54.3 Preferred stock 6.3 6.3 6.3 6.4 6.4 Long-term debt 37.7 38.4 38.7 39.7 39.3 =================================================================================================================== Percent long-term debt to net utility plant 34.7 34.8 36.0 36.6 37.2 =================================================================================================================== Average rate Bonds 7.0 7.0 7.1 7.1 7.1 Preferred stock 6.1 6.1 6.1 6.1 6.1 =================================================================================================================== Number of preferred stock shareholders 2,734 2,965 3,165 3,372 3,577 =================================================================================================================== Weather information Cooling degree days 255 352 808 519 432 Cooling degree days as a percent of normal 53.3% 73.6% 170.1% 107.0% 86.2% Heating degree days 8,099 8,566 7,813 7,578 7,916 Heating degree days as a percent of normal 101.6% 107.5% 98.0% 95.5% 100.2% =================================================================================================================== -39- ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION OF WPS RESOURCES CORPORATION AND WISCONSIN PUBLIC SERVICE CORPORATION RESULTS OF OPERATIONS WPS Resources Corporation ("WPSR") is a holding company. Approximately 79% and 95% of WPSR's 1997 revenues and assets, respectively, and all of its net income are derived from Wisconsin Public Service Corporation ("WPSC"), an electric and gas utility. WPSR's wholly-owned subsidiaries include WPSC, WPS Energy Services, Inc. ("ESI"), and WPS Power Development, Inc. ("PDI"). 1997 COMPARED WITH 1996 WPS RESOURCES CORPORATION OVERVIEW Revenues at WPSR increased from $858.3 million in 1996 to $878.3 million in 1997, or 2.3%. Net income increased 12.3% from $47.8 million in 1996 to $53.7 million in 1997. Basic and diluted earnings per share increased 12.5%, from $2.00 in 1996 to $2.25 in 1997. The primary reasons for the increase in earnings at WPSR were decreased operating and maintenance expenses, increased other income, an increased nonregulated energy margin, and an increased gas utility margin. Partially offsetting these increases in earnings were a decrease in the electric utility margin, an increase in depreciation and decommissioning expense, and an increase in income tax expense. Earnings on common stock of WPSC were $61.6 million in 1997 and $57.3 million in 1996. Nonregulated losses were $7.9 million in 1997 and $9.5 million in 1996. WISCONSIN PUBLIC SERVICE CORPORATION OVERVIEW Revenues at WPSC were $690.5 million in 1997 compared with $701.9 million in 1996, a decrease of 1.6%. Earnings on common stock increased 7.5%, from $57.3 million in 1996 to $61.6 million in 1997. The primary reasons for the increase in earnings at WPSC were a decrease in operating and maintenance expenses, an increase in other income, and an increase in the gas utility margin. Offsetting these increases in earnings were a decrease in the electric utility margin, an increase in depreciation and decommissioning expense, and an increase in income tax expense. ELECTRIC UTILITY OPERATIONS Electric margins decreased $21.4 million (see table below), or 6.2%, due to implementation of a Public Service Commission of Wisconsin ("PSCW") rate order which authorized a $35.5 million, or 8.1%, electric revenue reduction. A second factor contributing to decreased margins was increased replacement power costs as a result of an extended outage at the Kewaunee Nuclear Power Plant ("Kewaunee"). WPSC is the operator and 41.2% owner of Kewaunee. A surcharge authorized by the PSCW partially offset increases in replacement power costs in the latter part of the first quarter and in the second quarter of 1997. -40- ================================================================= ELECTRIC MARGINS ($000) 1997 1996 1995 ----------------------------------------------------------------- Revenues $479,388 $490,506 $489,000 Fuel and purchased power 153,414 143,155 144,451 ----------------------------------------------------------------- Margins $325,974 $347,351 $344,549 ================================================================= Sales (kWh 000) 11,259,327 11,011,842 10,978,131 ================================================================= In spite of a 27.6% decrease in cooling degree days, electric kilowatt-hour ("kWh") sales increased by 2.2% due to increased demand by commercial and industrial customers. Commercial and industrial kWh sales increased 4.8%, while wholesale kWh sales decreased 3.4%. Electric operating revenues decreased $11.1 million, or 2.3%, due primarily to the electric rate decrease. Electric production fuel expense increased $2.1 million, or 2.0%. Nuclear fuel expense was $2.0 million lower than in 1996 due to decreased generation at Kewaunee in the first and second quarters of 1997 as a result of an extended outage. Steam fuel expense was higher by $1.0 million and combustion turbine generation expense was higher by $3.2 million due to increased generation requirements from these sources during the extended outage at Kewaunee. Purchased power expense increased $8.1 million, or 21.6%, due to increased purchase requirements and higher costs of purchased power during the extended outage at Kewaunee. The PSCW allows WPSC to pass changes in the cost of fuel and purchased power, within a specified range, on to its customers through a fuel adjustment clause. WPSC is required to file an application to adjust rates either higher or lower when costs are plus or minus 2% from forecasted costs on an annual basis. The additional fuel costs in 1997 did not result in WPSC being outside this 2% window. GAS UTILITY OPERATIONS Gas margins increased $1.4 million (see table below), or 2.2%, due primarily to implementation of a PSCW rate order which authorized a $5.7 million, or 2.7%, increase in gas revenues. ================================================================= GAS MARGINS ($000) 1997 1996 1995 ----------------------------------------------------------------- Revenues $211,090 $211,357 $174,693 Purchase costs 147,755 149,388 116,253 ----------------------------------------------------------------- Margins $ 63,335 $ 61,969 $ 58,440 ================================================================= Volume (Therms 000) 662,008 666,598 631,192 ================================================================= Gas operating revenues remained relatively stable reflecting the rate increase offset by a 5.5% reduction in heating degree days. Gas revenues also -41- reflect a one-time reduction of $0.9 million in the first quarter of 1997 as a result of a PSCW directive to change the accounting treatment for previous customer line extensions. This reduction represents a decrease of approximately $.02 per share after income tax effects. Gas purchase costs showed a net decrease of $1.6 million, or 1.1%, due primarily to reduced purchases because of decreased demand as a result of the reduction in heating degree days. The PSCW allows WPSC to pass changes in the cost of gas on to customers through a purchased gas adjustment clause ("PGAC"). OTHER UTILITY EXPENSES/INCOME Other operating expenses at WPSC decreased $24.1 million, or 15.2%. Cost saving initiatives and decreased amortization of deferred demand-side management expenditures resulted in lower customer service and sales expenses of $9.5 million. Administrative expenses decreased $5.8 million due to cost saving measures and reduced postretirement medical, dental, and other benefit expenses. Generation operating expenses were lower by $7.3 million primarily as a result of the completion in 1996 of an amortization of deferred expenses related to a previous coal contract settlement. Gas operating expenses decreased $1.5 million as the result of a PSCW directive requiring gas servicing revenues and expenses to be classified as other income and deductions beginning in 1997. Maintenance expense decreased $7.1 million, or 14.5%. Electric transmission and distribution expenses decreased $3.4 million as a result of cost saving initiatives and less maintenance of overhead lines in 1997 due to less storm damage. Expenses were $1.9 million lower at Kewaunee in 1997 because Kewaunee was out of service in 1996 for scheduled maintenance. Gas distribution had lower expenses of $0.9 million due to cost saving initiatives and decreased maintenance activities. Steam costs decreased $0.6 million at WPSC's coal-fired plants due to changes in maintenance schedules as a result of the extended outage at Kewaunee. Depreciation and decommissioning expenses increased $12.0 million, or 18.8%, largely due to the accelerated recovery of investment in Kewaunee and accelerated funding of Kewaunee decommissioning costs. Other income increased $7.5 million, or 141.7%, due primarily to gains in 1997 on the sale of nonutility property of $4.8 million which represented an increase of approximately $.12 per share after income tax effects. Also included in other income in 1997 was interest of $2.2 million resulting from an income tax audit settlement. Income tax expense increased $1.9 million reflecting higher net income in 1997. OVERVIEW OF NONREGULATED OPERATIONS Nonregulated operations primarily represent the gas and electric sales of ESI, an energy marketing subsidiary. Nonregulated operations also include PDI which participates in the development of electric generation projects, invests in generating projects, and provides services to the electric power generation industry. Nonregulated operations experienced a loss of $7.9 million in 1997 compared with a loss of $9.5 million in 1996. -42- On a stand-alone basis, WPSR incurred a net loss in 1997 of $1.0 million, compared with net income of $0.8 million in 1996. The 1997 WPSR stand-alone loss was attributable primarily to costs related to the proposed merger with Upper Peninsula Energy Corporation ("UPEN"). ESI incurred a loss of $4.9 million in 1997 and $6.3 million in 1996, a decrease of 22.2%. PDI incurred a loss of $1.9 million in 1997 and $4.0 million in 1996, a decrease of 52.5%. Operating losses at the nonregulated subsidiaries were anticipated by management as the companies develop infrastructure and finance additional working capital needed to support growth. NONREGULATED MARGINS Gas margins at ESI increased $3.2 million from a negative $1.1 million in 1996 to a positive $2.1 million in 1997. In 1996, customer commitments at ESI were not fully hedged during a period of volatile gas commodity markets and certain gas suppliers defaulted which negatively impacted margins. Electric margins increased $0.9 million in 1997. Nonregulated energy and other operating revenues increased $31.5 million, or 20.1%. The increase in nonregulated energy revenues consisted largely of increased gas sales at ESI of $26.2 million, or 17.1%, as a result of customer growth and increased electric sales of $5.6 million, or 716.0%. Nonregulated energy cost of sales increased $27.7 million, or 17.9%, due primarily to increased gas purchases and purchased power of $20.5 million and $4.7 million, respectively, at ESI. OTHER NONREGULATED EXPENSES/INCOME Other nonregulated operating expenses increased $3.7 million, or 34.6%. Other operating expenses increased $2.3 million at WPSR due primarily to expenses associated with the UPEN merger. Other operating expenses at ESI increased $1.3 million, or 19.4%, due to expansion of the business and the development of infrastructure as ESI positions itself for the future. Although increased margins more than offset other operating expenses, interest costs increased due to the financing of additional working capital needed to support the growth of ESI. Other operating expenses at PDI increased $0.4 million as a result of expansion of the business and operation of the Stoneman Power Plant ("Stoneman"). Project revenues at PDI partially offset costs related to the investigation of possible energy-related investments and a loss from Stoneman operations. ESI experienced trading losses of $1.4 million in 1997 and $2.5 million in 1996. PDI experienced a loss of $4.0 million in 1996 related to the write-off of an investment in an industrial processing facility. This write-off represented a decrease in 1996 earnings of $.10 per share after income tax effects. -43- 1996 COMPARED WITH 1995 WPS RESOURCES CORPORATION OVERVIEW Revenues at WPSR increased 19.2% from $719.8 million in 1995 to $858.3 million in 1996. Net income was $55.3 million in 1995 compared with $47.8 million in 1996, a decrease of 13.6%. Basic and diluted earnings per share were $2.32 in 1995 and $2.00 in 1996, a decrease of 13.8%. The most significant reasons for the decrease in earnings at WPSR were increased operating expenses at the nonregulated subsidiaries, decreased gas margins at ESI, a loss on an industrial processing facility investment at PDI, and increased operating expenses at WPSC. Earnings on common stock of WPSC were $57.3 million in 1996 and $56.1 million in 1995. Nonregulated losses were $9.5 million in 1996 and $0.8 million in 1995. WISCONSIN PUBLIC SERVICE CORPORATION OVERVIEW Revenues at WPSC increased 5.8%, from $663.7 million in 1995 to $701.9 million in 1996. Earnings on common stock increased 2.1%, from $56.1 million in 1995 to $57.3 million in 1996. ELECTRIC UTILITY OPERATIONS Electric margins increased $2.8 million, or 0.8%, due primarily to increased sales volumes and decreased purchased power expenses. Electric operating revenues remained relatively stable between 1996 and 1995. Electric production fuels and purchased power decreased $1.3 million, or 0.9%, as a result of $1.9 million lower purchased power costs, $1.8 million lower generation costs at Kewaunee due to an extended outage, and $1.5 million lower combustion turbine generation costs. Offsetting these decreases was an increase in generating costs at coal-fired plants of $3.9 million. GAS UTILITY OPERATIONS Gas margins increased $3.5 million, or 6.0%, due to customer growth at WPSC and colder weather. Based on degree days, the weather was 9.6% colder in 1996 than in 1995. Gas operating revenues increased $36.7 million, or 21.0%, and gas purchased for resale increased $33.1 million, or 28.5%, both due to increased volumes as a result of customer growth and higher gas costs. OTHER UTILITY EXPENSES/INCOME Other operating expenses at WPSC increased $7.3 million, or 4.8%. Higher operating expenses included an increase of $4.5 million related to expansion of certain operating activities in anticipation of more competitive markets and an increase in gas operating expenses of $1.9 million as a result of customer growth. Partially offsetting these increases was a decrease in employee benefit costs of approximately $2.6 million due to a reduction in postretirement benefit expenses. Maintenance expense decreased $2.0 million, or 4.0%, due to lower maintenance activity at WPSC's coal-fired plants of $3.3 million. This decrease was partially offset by increased maintenance expense at Kewaunee of $1.0 million. -44- OVERVIEW OF NONREGULATED OPERATIONS Nonregulated energy and other operating revenues increased 178.3%, from $56.2 million in 1995 to $156.4 million in 1996. The loss at the nonregulated subsidiaries was $0.8 million in 1995 and $9.5 million in 1996. NONREGULATED MARGINS Gas margins at ESI decreased from a positive $1.2 million in 1995 to a negative $1.1 million in 1996. Gas margins were negatively impacted due primarily to the volatile gas commodity market experienced during 1996 in which ESI was not fully hedged for its customer commitments and ESI's decision to honor customer contracts, despite defaults by certain gas suppliers, during a period of exceptionally high demand. Nonregulated energy and other operating revenues increased $100.2 million, or 178.5%. Nonregulated energy revenues primarily represent electric and gas sales made by ESI. The increase in nonregulated energy revenues was due to increased gas sales at ESI from $55.2 million in 1995 to $153.1 million in 1996, an increase of $97.9 million, or 177.2%. The increased gas sales resulted from ESI's acquisition of a gas marketing company in the fourth quarter of 1995, additional customer growth in the wholesale market, and higher unit prices due to gas commodity market conditions. Other operating revenues increased $1.5 million, or 167.3%, and were comprised of consulting and construction revenue from ESI and PDI. Nonregulated energy cost of sales increased $101.2 million, or 187.4%, due primarily to increased gas purchases and increased gas costs at ESI from $54.0 million in 1995 to $154.3 million in 1996, an increase of $100.3 million, or 185.7%. OTHER NONREGULATED EXPENSES/INCOME Other operating expenses increased $7.1 million reflecting the expansion of ESI's and PDI's business and the development of infrastructure including personnel and systems. In 1996, PDI experienced a $4.0 million loss on a write-off of an investment in an industrial processing facility which had been made in anticipation of energy sales opportunities. This loss represented a $.10 per share decrease in earnings after income tax effects. ESI experienced trading losses of $2.5 million in 1996. -45- BALANCE SHEET 1997 COMPARED WITH 1996 Nuclear decommissioning trusts increased $33.5 million due to continued funding and favorable investment returns. Customer receivables decreased $19.3 million primarily as a result of decreased sales and increased collection efforts at WPSC. Regulatory assets decreased $18.4 million due primarily to gas plant cleanup insurance recoveries recorded as an offset to regulatory assets in 1997. Investments and other assets increased $16.7 million as a result of increased prepaid pension assets and an increased unrealized gain on the nuclear decommissioning trust. Short-term notes payable and commercial paper decreased $16.6 million and $10.6 million, respectively, due to decreased operational cash needs at WPSC and decreased notes payable at WPSR. Internally generated funds exceeded cash requirements at both WPSC and WPSR. FINANCIAL CONDITION Internally generated funds exceeded WPSR's cash requirements resulting in the reduction of short-term borrowings during 1997. Pretax interest coverage was 4.48 times for the 12 months ended December 31, 1997 for WPSC. WPSC's bond ratings are AA+ (Standard & Poor's and Duff & Phelps) and Aa2 (Moody's). WPSC is restricted by a PSCW order to paying normal common stock dividends of no more than 109% of the previous year's common stock dividends without prior notice to the PSCW. Also, Wisconsin law prohibits WPSC from making loans to WPSR and its nonregulated subsidiaries and from guaranteeing their obligations. A special common stock dividend of $10.0 million was paid by WPSC to WPSR in January 1997. The special dividend allowed WPSC's average equity capitalization ratio to remain at approximately 54%, the level approved by the PSCW for ratemaking. WPSC makes large investments in capital assets. Construction expenditures for WPSC are expected to continue in the $75.0 million to $90.0 million range annually during the 1998 through 2000 period. This does not include expenditures for the replacement of Kewaunee steam generators. Steam generator replacement, WPSC's share of which would be approximately $36.7 million in year of occurrence dollars, is contingent upon receipt of approval from the PSCW to proceed with replacement and agreement among the owners on a replacement plan. Potential expenditures for gas pipeline laterals which would connect WPSC's distribution system with the proposed Viking Voyageur pipeline from Canada are also not included. In addition, other capital requirements for WPSC during the three-year period include Kewaunee decommissioning trust fund contributions of approximately $30.0 million and maturing first-mortgage bonds of $50.0 million. WPSR expects that internally-generated funds and short-term borrowing will satisfy most of its capital requirements. WPSR may periodically issue additional long-term debt and common stock to reduce short-term debt and to maintain desired capitalization ratios. The specific forms of financing, amounts, and timing will depend on the availability of projects, market -46- conditions, and other factors. WPSR may expand its leveraged employee stock ownership plan during the three-year period. Trusted preferred stock may be issued on behalf of WPSR in 1998 to reduce short-term borrowing. Investment expenditures for nonregulated projects are uncertain since there are no material firm commitments at this time. Debt financing for most nonregulated projects is expected to be on a nonrecourse basis. Statement of Financial Accounting Standards ("SFAS") No. 121, "Accounting for the Impairment of Long-Lived Assets to be Disposed of," became effective in March 1995. This statement imposes a stricter criterion for regulatory assets by requiring that such assets be probable of future recovery at each balance sheet date. WPSR adopted this statement on January 1, 1996. The adoption of this statement did not have a material impact on the financial position or results of operations based on the current regulatory structure. SFAS No. 121 may impact WPSR in the future as competitive factors influence wholesale and retail pricing in the electric and gas industries and as regulatory policy regarding recovery of stranded investment is developed. SFAS No. 123, "Accounting for Stock-Based Compensation," became effective in 1996. This statement permits, but does not require, companies to change their accounting for stock-based compensation. The statement also requires additional disclosures. WPSR has adopted only the disclosure provision of the statement and currently does not provide significant stock-based compensation. In February 1997, the Financial Accounting Standards Board ("FASB") issued SFAS No. 128, "Earnings Per Share." This statement establishes standards for computing and presenting earnings per share. Adoption of this standard by WPSR at December 31, 1997 had no impact on the presentation of earnings per share as basic and diluted earnings per share are identical to previously reported earnings per share. In June 1997, the FASB issued SFAS No. 130, "Reporting of Comprehensive Income," which establishes standards for reporting and display of comprehensive income and its components of revenues, expenses, gains, and losses. The statement is effective for fiscal years beginning after December 15, 1997. WPSR will be adopting the requirements for reporting comprehensive income in the first quarter of 1998. In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information." This statement establishes standards for reporting information about operating segments and is effective for periods beginning after December 15, 1997. WPSR will be adopting the requirements of this statement at year-end 1998 and has not yet determined the segments which will be disclosed. On July 10, 1997, WPSR announced a merger agreement with UPEN. The S-4 Registration Statement was declared effective by the Securities and Exchange Commission ("SEC") on December 5, 1997. The shareholders of UPEN approved the merger on January 29, 1998. The merger is subject to (1) approval by the Federal Energy Regulatory Commission ("FERC"); (2) approval by the SEC under the Public Utility Holding Company Act of 1935; (3) the expiration or termination of the waiting period applicable to the merger under the Hart-Scott-Rodino Antitrust Improvements Act of 1976; (4) receipt by the parties of an opinion of counsel that the exchange of stock qualifies as a -47- tax-free transaction; (5) receipt by the parties of appropriate assurances that the transaction will be accounted for as a pooling of interests; and (6) the satisfaction of various other conditions. The merger is expected to be completed during the second half of 1998. UPEN will merge with and into WPSR, and Upper Peninsula Power Company, UPEN's utility subsidiary, will become a wholly-owned subsidiary of WPSR. Each of the 2,950,001 outstanding shares of UPEN common stock (no par value) will be converted into 0.90 shares of WPSR common stock ($1.00 par value), subject to adjustment for fractional shares, as provided in the merger agreement. Effective March 20, 1997, WPSC received authorization from the PSCW to defer all costs associated with the repair of the Kewaunee steam generators. Repairs are complete and Kewaunee returned to service on June 12, 1997 after having been out of service since September 21, 1996. Repair costs of $3.6 million (WPSC's portion) have been deferred. The joint owners of Kewaunee have requested rate recovery of these deferred costs through a customer surcharge which would be effective for April and May 1998. On July 1, 1997, the PSCW authorized WPSC to defer all advertising costs associated with developing a communication plan to educate customers on the potential energy shortage. WPSC was also authorized to defer all costs related to returning its fossil-fueled plant, Pulliam Unit 3, to service and all subsequent operating costs for Pulliam Unit 3 until the next rate filing. The recovery of these deferred costs will be considered in a future rate proceeding. To date, approximately $0.5 million related to advertising costs and Pulliam Unit 3 operating costs has been deferred. A PSCW order granting a Certificate of Public Convenience and Necessity for construction of the De Pere Energy Center was issued on October 9, 1997. WPSC has a 25-year commitment with Polsky Energy Corporation to purchase the output of the facility which is scheduled for operation in 1999. The transaction will be accounted for as a capital lease. WPSC will make any necessary adjustments to debt and equity levels, and appropriate rate relief is expected. Should electric retail deregulation occur, this contract may be deemed uneconomical which could require a loss accrual if the regulator would not allow recovery as part of the deregulation transition plan. WPSC's contract with the International Union of Operating Engineers Local 310 expired on October 28, 1997. Unresolved issues remain and contract negotiations continue. Approximately 1,200 employees are covered under this contract. The employees continue to work without a contract. WPSR has completed an initial assessment of the impact of the year 2000 compliance on its computer systems. WPSR worked with a consultant beginning in 1996 to analyze the year 2000 problem. Plans have been established to analyze all in-house and third party software products and applications. A preliminary plan indicates that all major in-house developed systems are expected to be compliant by the end of 1998. The plan is intended to enable all systems to be compliant by the year 2000. The most recent estimated future internal labor and third party cost of year 2000 compliance is approximately $13.4 million. TRENDS WPSC follows SFAS No. 71, "Accounting for the Effects of Certain Types of Regulation," and its financial statements reflect the effects of the -48- different ratemaking principles followed by the various jurisdictions regulating the utility. These include the PSCW, 90% of revenues; the Michigan Public Service Commission ("MPSC"), 3% of revenues; and the FERC, 7% of revenues. In addition, Kewaunee is regulated by the Nuclear Regulatory Commission ("NRC"). Environmental matters are primarily governed by the United States Environmental Protection Agency and the Wisconsin Department of Natural Resources. In late 1995, the PSCW outlined its plan for restructuring the electric industry in Wisconsin. The plan included 32 steps in a 5-year process concluding with retail competition by the year 2001. In 1997, the 32-step process was changed to a 7-step process which has not yet been adopted as the official PSCW restructuring plan. Should electric deregulation occur such that WPSC would no longer qualify to reflect the effects of ratemaking under SFAS No. 71 in its financial statements, no impairment of significant recorded assets or reduction in reported equity is anticipated. WPSC does not have any significant assets which it foresees as being potentially stranded and no potential disparity between the depreciable lives of WPSC's capital assets and those lives applicable to a competitive environment has been identified. Increased competition is likely to put pressure on margins at WPSC. However, at this time, management cannot predict the ultimate results of deregulation. Part of electric utility restructuring involves establishing independent system operators ("ISOs"). An ISO is an independent third party which potentially owns the transmission facilities, oversees the operations of transmission facilities, administers open access transmission tariffs, and directs power dispatch. WPSC is working with several groups which are attempting to form ISOs. During the past summer, Governor Thompson requested reports from the PSCW, electric utilities, and industrial customers assessing the electric capacity problems experienced in eastern Wisconsin during this past spring and summer. The reports provided analyses and recommendations on how to assure the future reliability of the electrical supply and made recommendations on how to improve the effectiveness of the state's utility regulatory process. WPSC participated in the development of the utility report. The Governor is expected to make energy supply and regulatory recommendations based on the reports. Both the PSCW and the MPSC continue to review gas industry restructuring. In a current docket, the PSCW is addressing gas restructuring issues including unbundling of rates, pricing of contracted services in potential utility bypass situations, and the separation of gas utilities from their nonregulated gas marketing affiliates. The MPSC is conducting pilot studies to test the development of competitive retail gas markets in Michigan. WPSC has historically recovered gas costs through a PGAC. The PSCW has recently allowed utilities to select either an incentive gas cost recovery mechanism or a modified one-for-one mechanism for gas cost recovery. WPSC has selected the modified one-for-one gas cost recovery plan and implementation of the new mechanism, which is currently under development and is similar to the recovery received under the existing PGAC, is expected in November 1998. -49- WPSC is investigating the environmental cleanup of eight manufactured gas plant sites. Cleanup estimates have been determined for seven of the sites. A detailed investigation has not yet been performed for the eighth site. Future investigation and cleanup costs for all eight sites is estimated in the range of $34.1 million to $41.1 million. These estimates may be adjusted in the future contingent upon remedial technology, regulatory requirements, and experience gained through cleanup activities. An initial liability of $41.7 million for cleanup had been established with an offsetting regulatory asset (deferred charge). Of this amount, approximately $1.5 million has been spent to date. Management believes that cleanup costs net of insurance recoveries, but not the carrying costs associated with the cleanup expenditures, will be recoverable in current and future customer rates. WPSC has received $12.6 million in insurance recoveries which have been recorded as a reduction in the regulatory asset. The PSCW has authorized current annualized recovery for gas site cleanup of $225,000 for 1997 and 1998. WPSC is in compliance with both the Phase I and II sulfur dioxide and nitrogen oxide emission limits established by the Federal Clean Air Act Amendments of 1990. Additional capital expenditures of $1.0 million to $2.0 million are projected through 1999 for Wisconsin and federal air quality compliance. Management believes that all costs incurred for additional compliance will be recoverable in future customer rates. On March 15, 1996, WPSC filed an application with the PSCW for permission to replace the Kewaunee steam generators. Public hearings were held in January of 1998. A decision is expected in March of 1998. The total cost of replacing the two steam generators would be approximately $89.0 million. WPSC's share would be $36.7 million in year of occurrence dollars. The other two owners of Kewaunee do not favor steam generator replacement. WPSC received a rate order in the Wisconsin jurisdiction effective in February 1997. The impact was approximately a $35.5 million decrease in electric revenues and a $5.7 million increase in gas revenues on an annual basis. The new rates are effective for 1997 and 1998. WPSC intends to file an application with the PSCW on April 1, 1998 for electric and gas rate increases which would be effective in 1999 and 2000. ESI incurred a $4.9 million loss in 1997 and a $6.3 million loss in 1996. A primary strategy for ESI is rapid growth to gain market presence which is reflected in a 237.7% growth in revenues during the three-year period 1995 through 1997, from $55.2 million in 1995 to $186.4 million in 1997. To support this growth, significant expenditures were made for personnel additions and system improvements. These expenditures, coupled with extreme gas market volatility, contributed to the losses incurred at ESI. Gas market volatility was reflected in the NYMEX gas futures prices per dekatherm which, in 1997, ranged from a high of $3.55 to a low of $1.82. In 1996, gas futures prices ranged from a high of $4.57 to a low of $1.86. Gas market volatility has a direct impact on revenue. PDI expects to improve the overall performance of its investment in Stoneman due to a multi-year capacity sale agreement. Stoneman was also grandfathered by the PSCW as a merchant plant which increases the probability -50- that the plant will be repowered as a 300-megawatt to 500-megawatt gas-fired combined cycle generating facility. IMPACT OF INFLATION WPSR's current financial statements are prepared in accordance with generally accepted accounting principles and report operating results in terms of historic cost. They provide a reasonable, objective, and quantifiable statement of financial results; but they do not evaluate the impact of inflation. Under rate treatment prescribed by utility regulatory commissions, WPSC's projected operating costs are recoverable in revenues. Because forecasts are prepared assuming inflation, the majority of inflationary effects on normal operating costs are recoverable in rates. However, in these forecasts, WPSC is only allowed to recover the historic cost of plant via depreciation. -51- ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA WPS RESOURCES CORPORATION A. CONSOLIDATED STATEMENTS OF INCOME AND RETAINED EARNINGS =========================================================================================================== Year Ended December 31 (Thousands, except share amounts) 1997 1996 1995 - ----------------------------------------------------------------------------------------------------------- Operating revenues Electric utility $479,388 $490,506 $489,000 Gas utility 211,090 211,357 174,693 Nonregulated energy and other 187,862 156,391 56,155 - ----------------------------------------------------------------------------------------------------------- Total operating revenues 878,340 858,254 719,848 =========================================================================================================== Operating expenses Electric production fuels 107,538 105,418 104,858 Purchased power 45,876 37,737 39,593 Gas purchased for resale 147,755 149,388 116,253 Nonregulated energy cost of sales 182,863 155,133 53,983 Other operating expenses 148,569 168,905 154,445 Maintenance 41,661 48,806 50,761 Depreciation and decommissioning 77,541 65,178 65,627 Taxes other than income 26,448 26,868 25,921 - ----------------------------------------------------------------------------------------------------------- Total operating expenses 778,251 757,433 611,441 =========================================================================================================== Operating income 100,089 100,821 108,407 - ----------------------------------------------------------------------------------------------------------- Other income Allowance for equity funds used during construction 129 139 170 Other, net 11,511 (1,084) 6,080 - ----------------------------------------------------------------------------------------------------------- Total other income 11,640 (945) 6,250 =========================================================================================================== Income before interest expense 111,729 99,876 114,657 - ----------------------------------------------------------------------------------------------------------- Interest on long-term debt 22,331 21,532 22,859 Other interest 4,172 3,596 2,604 Allowance for borrowed funds used during construction (100) (128) (68) - ----------------------------------------------------------------------------------------------------------- Total interest expense 26,403 25,000 25,395 =========================================================================================================== Income before income taxes 85,326 74,876 89,262 Income taxes 29,270 24,358 30,808 Minority interest (797) (348) - Preferred stock dividends of subsidiary 3,111 3,111 3,111 - ----------------------------------------------------------------------------------------------------------- Net income 53,742 47,755 55,343 =========================================================================================================== Retained earnings at beginning of year 311,794 308,965 297,592 Cash dividends on common stock (45,882) (44,926) (43,970) - ----------------------------------------------------------------------------------------------------------- Retained earnings at end of year $319,654 $311,794 $308,965 =========================================================================================================== Average shares of common stock 23,873 23,891 23,897 Basic and diluted earnings per average share of common stock $2.25 $2.00 $2.32 Dividend per share of common stock 1.92 1.88 1.84 =========================================================================================================== The accompanying notes are an integral part of these statements. -52- PAGE ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA WPS RESOURCES CORPORATION B. CONSOLIDATED BALANCE SHEETS ================================================================================================= Assets - ------------------------------------------------------------------------------------------------- At December 31 (Thousands) 1997 1996 - ------------------------------------------------------------------------------------------------- Utility plant Electric $1,506,470 $1,474,104 Gas 251,603 240,791 - ------------------------------------------------------------------------------------------------- Total 1,758,073 1,714,895 Less - Accumulated depreciation and decommissioning 1,032,149 952,296 - ------------------------------------------------------------------------------------------------- Total 725,924 762,599 Nuclear decommissioning trusts 134,108 100,570 Construction in progress 7,266 10,301 Nuclear fuel, less accumulated amortization 19,062 19,381 - ------------------------------------------------------------------------------------------------- Net utility plant 886,360 892,851 ================================================================================================= Current assets Cash and equivalents 6,424 5,978 Customer and other receivables, net of reserves 87,709 106,967 Accrued utility revenues 30,750 35,386 Fossil fuel, at average cost 10,336 8,224 Gas in storage, at average cost 22,080 19,987 Materials and supplies, at average cost 18,793 19,944 Prepayments and other 20,499 22,658 - ------------------------------------------------------------------------------------------------- Total current assets 196,591 219,144 ================================================================================================= Regulatory assets 78,544 96,920 Net nonutility and nonregulated plant 19,194 19,738 Investments and other assets 118,913 102,212 ================================================================================================= Total $1,299,602 $1,330,865 ================================================================================================= -53- ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA WPS RESOURCES CORPORATION B. CONSOLIDATED BALANCE SHEETS (CONTINUED) ================================================================================================= Capitalization and Liabilities - ------------------------------------------------------------------------------------------------- At December 31 (Thousands) 1997 1996 - ------------------------------------------------------------------------------------------------- Capitalization Common stock equity $ 477,823 $ 467,524 Preferred stock of subsidiary with no mandatory redemption 51,200 51,200 Long-term debt 304,008 305,788 - ------------------------------------------------------------------------------------------------- Total capitalization 833,031 824,512 ================================================================================================= Current liabilities Notes payable 10,000 26,600 Commercial paper 20,706 31,350 Accounts payable 85,651 96,531 Accrued taxes 3,514 1,350 Accrued interest 7,801 8,134 Other 9,536 12,771 - ------------------------------------------------------------------------------------------------- Total current liabilities 137,208 176,736 ================================================================================================= Long-term liabilities and deferred credits Accumulated deferred income taxes 125,804 130,208 Accumulated deferred investment tax credits 26,901 28,669 Regulatory liabilities 50,279 48,870 Environmental remediation liabilities 40,215 41,697 Other long-term liabilities 86,164 80,173 - ------------------------------------------------------------------------------------------------- Total long-term liabilities and deferred credits 329,363 329,617 ================================================================================================= Commitments and contingencies (See Note 9) ================================================================================================= Total $1,299,602 $1,330,865 ================================================================================================= The accompanying notes are an integral part of these statements. -54- ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA WPS RESOURCES CORPORATION C. CONSOLIDATED STATEMENTS OF CAPITALIZATION =========================================================================================== At December 31 (Thousands, except share amounts) 1997 1996 - ------------------------------------------------------------------------------------------- Common stock equity Common stock, $1 par value, 100,000,000 shares authorized; 23,896,962 shares outstanding $ 23,897 $ 23,897 Premium on capital stock 145,021 145,021 Retained earnings 319,654 311,794 Shares in deferred compensation trust, 33,430 and 14,223 shares at an average cost of $28.44 and $31.16 per share at December 31, 1997 and 1996, respectively (951) (443) ESOP loan guarantees (9,798) (12,745) - ------------------------------------------------------------------------------------------- Total common stock equity 477,823 467,524 =========================================================================================== Preferred stock - Wisconsin Public Service Corporation Cumulative, $100 par value, 1,000,000 shares authorized; with no mandatory redemption Series Shares Outstanding ------ ------------------ 5.00% 132,000 13,200 13,200 5.04% 30,000 3,000 3,000 5.08% 50,000 5,000 5,000 6.76% 150,000 15,000 15,000 6.88% 150,000 15,000 15,000 - ------------------------------------------------------------------------------------------- Total preferred stock 51,200 51,200 =========================================================================================== Long-term debt First mortgage bonds - Wisconsin Public Service Corporation Series Year Due ------ -------- 5-1/4% 1998 50,000 50,000 7.30% 2002 50,000 50,000 6.80% 2003 50,000 50,000 6-1/8% 2005 9,075 9,075 6.90% 2013 22,000 22,000 8.80% 2021 53,100 53,100 7-1/8% 2023 50,000 50,000 - ------------------------------------------------------------------------------------------- Total 284,175 284,175 Unamortized discount and premium on bonds, net (890) (978) - ------------------------------------------------------------------------------------------- Total first mortgage bonds 283,285 283,197 - ------------------------------------------------------------------------------------------- ESOP loan guarantees 9,798 12,745 Notes payable to bank, secured by nonregulated plant 10,710 9,581 Other long-term debt 215 265 - ------------------------------------------------------------------------------------------- Total long-term debt 304,008 305,788 =========================================================================================== Total capitalization $833,031 $824,512 =========================================================================================== The accompanying notes are an integral part of these statements. -55- PAGE ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA WPS RESOURCES CORPORATION D. CONSOLIDATED STATEMENTS OF CASH FLOWS ============================================================================================================= Year Ended December 31 (Thousands) 1997 1996 1995 - ------------------------------------------------------------------------------------------------------------- Cash flows from operating activities Net income $ 53,742 $ 47,755 $ 55,343 Adjustments to reconcile net income to net cash from operating activities Depreciation and decommissioning 77,541 65,178 65,627 Amortization of nuclear fuel and other 14,665 28,691 33,499 Deferred income taxes (5,917) (7,715) 319 Investment tax credit restored (1,767) (1,778) (1,725) Allowance for equity funds used during construction (129) (139) (170) Pension income (11,432) (12,413) (11,678) Postretirement liability 4,952 7,150 6,917 Deferred demand-side management expenditures (5) (6,250) (8,595) (Gain)/loss on sale of nonutility property (4,802) (8) 13 Other, net (6,936) 7,954 7,150 Changes in Customer and other receivables 19,258 (27,666) (19,272) Accrued utility revenues 4,636 2,200 (8,766) Fossil fuel inventory (2,112) 477 1,804 Gas in storage (2,093) (9,911) 5,711 Accounts payable (10,880) 29,048 840 Accrued taxes 2,164 (394) 592 Environmental remediation insurance recovery 12,374 200 - Gas refunds (318) (6,175) 4,926 - ------------------------------------------------------------------------------------------------------------- Net cash from operating activities 142,941 116,204 132,535 ============================================================================================================= Cash flows from (used for) investing activities Construction of utility plant and nuclear fuel expenditures (58,258) (84,750) (80,226) Purchase of other property and equipment (2,030) (16,431) (1,089) Decommissioning funding (16,059) (8,978) (8,181) Purchase of investments and acquisitions - (728) (10,217) Proceeds from sale of nonutility property 6,255 10 29 Other (558) (359) 485 - ------------------------------------------------------------------------------------------------------------- Net cash used for investing activities (70,650) (111,236) (99,199) ============================================================================================================= Cash flows from (used for) financing activities Redemption of first mortgage bonds - (6,900) - Issuance of notes payable 92,760 141,225 15,000 Redemption of notes payable (109,360) (129,625) (10,000) Issuance of other long-term debt 1,789 15,296 - Issuance of commercial paper 700,540 345,339 51,500 Redemption of commercial paper (711,184) (325,489) (52,500) Cash dividends on common stock (45,882) (44,926) (43,970) Purchase of deferred compensation stock (508) (443) - - ------------------------------------------------------------------------------------------------------------- Net cash used for financing activities (71,845) (5,523) (39,970) ============================================================================================================= Net increase (decrease) in cash and equivalents 446 (555) (6,634) ============================================================================================================= Cash and equivalents at beginning of year 5,978 6,533 13,167 ============================================================================================================= Cash and equivalents at end of year $ 6,424 $ 5,978 $ 6,533 ============================================================================================================= Cash paid during year for Interest, less amount capitalized $ 22,089 $ 21,983 $ 21,255 Income taxes 35,374 31,735 34,300 Preferred stock dividends of subsidiary 3,111 3,111 3,111 Other information Construction and nuclear fuel expenditures, including accruals, allowance for funds used during construction, and customer contributions $ 65,646 $ 81,714 $ 73,251 ============================================================================================================= The accompanying notes are an integral part of these statements. -56- ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA WPS RESOURCES CORPORATION AND WISCONSIN PUBLIC SERVICE CORPORATION E. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (a) NATURE OF OPERATIONS--WPS Resources Corporation ("WPSR") is a holding company. Approximately 79% and 95% of WPSR's 1997 revenues and assets, respectively, and all of its net income are derived from Wisconsin Public Service Corporation ("WPSC"), all of the outstanding common stock of which is owned by WPSR. WPSC is an electric and gas utility engaged in the supply and distribution of electric power and natural gas in its franchised service territory. WPSR also provides gas and electric marketing and energy-related services in nonregulated markets through its wholly-owned subsidiary, WPS Energy Services, Inc. ("ESI"). WPS Power Development, Inc. ("PDI"), another wholly-owned subsidiary of WPSR, participates in the development of electric generation projects, provides service to the electric power generation industry, and owns a two-thirds interest in a merchant generating plant, the Stoneman Power Plant ("Stoneman"). The term "utility" refers to the regulated activities of WPSC, while the term "nonutility" refers to the activities of WPSC which are not regulated. The term "nonregulated" refers to activities other than those of WPSC. (b) USE OF ESTIMATES--The preparation of WPSR's financial statements is in conformity with generally accepted accounting principles. Management may make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. (c) ACQUISITIONS AND NONREGULATED INVESTMENTS--In the fourth quarter of 1995, ESI acquired interests in a producing gas reserves operation and in a gas marketing operation. The acquisitions have been accounted for under the purchase method of accounting. The price paid in excess of the fair value of identifiable assets acquired for the gas marketing operation is being amortized over a five-year period. (d) CONSOLIDATION--WPSR consolidates all majority-owned subsidiaries. All significant intercompany transactions and accounts have been eliminated. (e) PRICE RISK MANAGEMENT ACTIVITIES--ESI utilizes derivative financial and commodity instruments (derivatives), including futures and forward contracts, to reduce market risk associated with fluctuations in the price of natural gas and electricity sold -57- under firm commitments with certain of its customers. ESI also utilizes derivatives, including price swap agreements, call and put option contracts, and futures and forward contracts, to manage market risk associated with a portion of its anticipated supply requirements. In addition, ESI utilizes derivatives, within specified guidelines, for trading purposes. Gains or losses on derivatives associated with firm commitments are recognized as adjustments to the cost of sales or to revenues when the related transactions affect earnings. Gains and losses on derivatives associated with forecasted transactions are recognized when such forecasted transactions affect earnings. At December 31, 1997, $0.5 million in losses related to firm commitments and forecasted transactions were deferred. If it is no longer probable that a forecasted transaction will occur, any gain or loss on the derivative instrument as of such date is immediately recognized in earnings. Derivatives for trading purposes are marked to market each accounting period, and gains and losses are recognized as a component of other income at that time. In 1997 and 1996, trading losses of $1.4 million and $2.5 million, respectively, were recognized. At December 31, 1997, ESI had outstanding 3.9 million notional dekatherms of natural gas under futures and option agreements and 3.2 million notional dekatherms of natural gas under basis swap agreements for purposes of managing market risk. The financial instruments outstanding at December 31, 1997 expire at various times through May 1999. ESI has certain gas sales commitments through May 1999 with a range of sale prices from $2.25 to $3.58 per dekatherm and a range of associated gas purchase costs of $2.18 to $3.51 per dekatherm. As of December 31, 1997, the fair value of trading instruments included assets of $0.5 million. The average fair value of trading instruments during 1997 included assets of $0.5 million and liabilities of $0.5 million. Except for an insignificant level of electric trading instruments, financial instruments used for trading in 1997 and 1996 were natural gas derivatives. At December 31, 1997, ESI had outstanding 0.9 million notional dekatherms of natural gas under futures and option agreements and 3.9 million notional dekatherms of natural gas under basis swap agreements for trading purposes. (f) UTILITY PLANT--Utility plant is stated at the original cost of construction which includes an allowance for funds used during construction ("AFUDC"). Approximately 50% of retail jurisdictional construction work in progress ("CWIP") expenditures are subject to AFUDC using a rate based on WPSC's overall cost of capital. Major new generating facilities earn AFUDC on total CWIP expenditures. For 1997, the AFUDC retail rate was approximately 10.4%. -58- AFUDC is recorded on wholesale jurisdictional electric CWIP at debt and equity percentages specified in the Federal Energy Regulatory Commission ("FERC") Uniform System of Accounts. For 1997, the AFUDC wholesale rate was approximately 5.7%. Substantially all of WPSC's utility plant is subject to a first mortgage lien. (g) PROPERTY ADDITIONS, MAINTENANCE, AND RETIREMENTS OF UTILITY PLANT--The cost of renewals and betterments of units of property (as distinguished from minor items of property) is capitalized as an addition to the utility plant accounts. No gain or loss is recognized in connection with ordinary retirements of utility property units. The cost of units of property retired, sold, or otherwise disposed of, plus removal cost, less salvage, are charged to the accumulated provision for depreciation. Maintenance and repair costs and replacement and renewal costs associated with items not qualifying as units of property are generally charged to operating expense. Nonutility property and nonregulated property follow a similar policy except that gains and losses are recognized in connection with retirements. (h) DEPRECIATION--Straight-line composite depreciation expense is recorded over the estimated useful life of utility property and includes estimated salvage and cost of removal. Except for the Kewaunee Nuclear Power Plant ("Kewaunee"), rates approved by the Public Service Commission of Wisconsin ("PSCW") on January 1, 1994 remain in effect. ============================================================ 1997 1996 1995 ------------------------------------------------------------ Annual composite depreciation rates Electric 3.52% 3.33% 3.43% Gas 3.26% 3.35% 3.46% ============================================================ Nonutility property and nonregulated property are depreciated using straight-line depreciation. Most assets have depreciation lives ranging from five to ten years. Property at Stoneman is depreciated using various lives, certain of which are as long as 40 years. Depreciation and nuclear decommissioning costs are accrued over the estimated service life of Kewaunee. On January 3, 1997, the PSCW accepted WPSC's recommendation to accelerate cost recovery of the remaining unrecovered investment in Kewaunee and accelerate funding of Kewaunee decommissioning costs. The PSCW order directs the owners of Kewaunee to develop depreciation and decommissioning estimates to provide for full recovery by the end of 2002. Prior to 1997, the service life of Kewaunee was estimated to end in 2013, the year its license expires. This decision results in a -59- significant acceleration of the Wisconsin retail jurisdictional portion of Kewaunee depreciation and decommissioning collections in customer rates for 1997 and future years. Depreciation expense, exclusive of depreciation expense related to nuclear decommissioning costs, increased by approximately $3.3 million on an annualized basis from $4.7 million in 1996 to $8.0 million in 1997. (i) IMPAIRMENT--WPSR follows the provisions of Statement of Financial Accounting Standards ("SFAS") No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of." SFAS No. 121 requires that long-lived assets and certain identifiable intangibles be reviewed for impairment whenever circumstances indicate that the carrying amount of an asset may not be recoverable. Impairment losses resulting from application of this statement are reported in income in the period in which the recognition criteria are first applied and met. This statement does not have a material impact on the current carrying amount of WPSR's assets. (j) NUCLEAR FUEL--The cost of nuclear fuel is amortized to electric production fuel expense based on the quantity of heat produced for the generation of electric energy by Kewaunee. Costs amortized to electric fuel expense (which assume no salvage values for uranium and plutonium) include an amount for ultimate disposal and are recovered through current customer rates. As required by the Nuclear Waste Policy Act of 1982, a contract has been signed with the United States Department of Energy ("DOE") for the ultimate storage of the fuel; and quarterly payments, based on generation, are made to the DOE for fuel storage. Interim storage space for spent nuclear fuel is provided at Kewaunee, and expenses associated with this storage are recognized as current operating costs. Currently, there is on-site storage capacity for spent fuel through the year 2013. As of December 31, 1997 and 1996, the accumulated provisions for nuclear fuel totaled $151.2 million and $147.7 million, respectively. (k) NUCLEAR DECOMMISSIONING--Nuclear decommissioning costs to date have been accrued over the estimated service life of Kewaunee, recovered currently from customers in rates, and deposited in external trusts. Such costs totaled $16.1 million in 1997 and $9.0 million in both 1996 and 1995. The increase in 1997 was the result of the PSCW's approval of the acceleration of Kewaunee depreciation and decommissioning funding as described in note 1(h). The increase is $8.3 million on an annualized basis, from $9.0 million to $17.3 million. Based on the standard cost escalation assumptions required by a July 1994 PSCW order, the undiscounted amount of WPSC's decommissioning costs forecasted to be expended between the years 2003 and 2039 is $614.0 million under the revised funding plan which became effective in 1997. In developing the funding plan, a long-term after-tax earnings rate of approximately 5.5% was assumed. -60- WPSC's share of Kewaunee decommissioning is estimated to be $182.2 million in current dollars based on a site-specific study. The study, which was performed in 1992, uses immediate dismantlement as the method of decommissioning beginning after a dormant period extending from 2002 until 2015. As of December 31, 1997, the market value of the external nuclear decommissioning trusts totaled $134.1 million. Depreciation expense includes future decommissioning costs collected in customer rates and an offsetting charge for earnings from external trusts. As of December 31, 1997, the accumulated provision for depreciation and decommissioning included accumulated provisions for decommissioning totaling $134.1 million. Realized trust earnings totaled $3.7 million, $3.0 million, and $4.0 million, and unrealized trust earnings totaled $13.8 million, $6.5 million, and $5.0 million for the years ended December 31, 1997, 1996, and 1995, respectively. Unrealized gains, net of tax, in external trusts are reflected as an increase to the decommissioning reserve, since decommissioning expense will be recognized as the gains are realized, in accordance with regulatory requirements. Investments in the nuclear decommissioning trusts are recorded at market value. The investments classified as utility plant are presented net of related income tax effects on unrealized gains and represent the amount of assets available to accomplish decommissioning. The nonqualified trust investments designated to pay income taxes when unrealized gains become realized are classified as other assets. An offsetting regulatory liability reflects the expected reduction in future rates as unrealized gains in the nonqualified trust are realized. (l) CASH AND EQUIVALENTS--WPSR considers short-term investments with an original maturity of three months or less to be cash equivalents. (m) REVENUE AND CUSTOMER RECEIVABLES--WPSR accrues revenues related to electric and gas service, including estimated amounts for service rendered but not billed. Automatic fuel adjustment clauses are used for FERC wholesale-electric and Michigan Public Service Commission ("MPSC") retail-electric portions of WPSC's business. The PSCW retail-electric portion of the business uses a "cost variance range" approach. This range is based on a specific estimated fuel cost for the forecast year. If WPSC's actual fuel costs fall outside this range, a hearing may be held and an adjustment to future rates may result. WPSC has a purchased gas adjustment clause ("PGAC") which allows it to pass changes in the cost of gas purchased from its suppliers on to system gas customers, subject to PSCW and MPSC review. The continued use of a PGAC for all Wisconsin utilities has been reexamined by the PSCW and utilities were given the choice between continuing under a modified one-for-one gas cost recovery plan or switching to an incentive gas cost recovery mechanism. WPSC has applied for a modified one-for-one gas cost recovery plan which is similar to cost -61- recovery under the existing PGAC. Implementation of the modified one-for-one gas cost recovery plan is expected in November 1998. WPSC is required to provide service and grant credit to customers within its service territory and is precluded from discontinuing service to residential customers during certain periods of the year. WPSC continually reviews its customers' credit-worthiness and obtains deposits or refunds deposits accordingly. WPSC is permitted to recover bad debts in utility rates. Approximately 12% of WPSC's total revenues are from companies in the paper products industry. In October 1997, WPSC lost a major wholesale customer representing annual sales of approximately 380,000 megawatt-hours. An effort is being made to replace these lost sales with additional opportunity sales. (n) REGULATORY ASSETS AND LIABILITIES--WPSC is subject to the provisions of SFAS No. 71, "Accounting for the Effects of Certain Types of Regulation." Regulatory assets represent probable future revenue associated with certain incurred costs which will be recovered from customers through the ratemaking process. Regulatory liabilities represent costs previously collected that are refundable in future customer rates. The following regulatory assets and liabilities were reflected in the Consolidated Balance Sheets as of December 31: ============================================================ (Thousands) 1997 1996 ------------------------------------------------------------ Regulatory assets Demand-side management expenditures $31,360 $39,355 Environmental remediation costs (net of insurance recoveries) 29,249 43,062 Coal and rail contract buy-out costs 2,293 2,404 Debt refinancing costs 1,859 2,919 Enrichment facility fee 5,544 5,979 Kewaunee steam generator resleeving costs 3,577 - Other 4,662 3,201 ------------------------------------------------------------ Total $78,544 $96,920 ============================================================ Regulatory liabilities Income tax related items $26,119 $30,056 Pensions 2,443 4,885 Conservation costs 6,491 9,101 Unrealized gain on decommissioning trust 11,348 3,587 Other 3,878 1,241 ------------------------------------------------------------ Total $50,279 $48,870 ============================================================ -62- As of December 31, 1997, the majority of WPSC's regulatory assets are being recovered through rates charged to customers over periods ranging from two to ten years. Carrying costs for all regulatory assets are being recovered except for those associated with environmental costs. Based on prior and current rate treatment of such costs, management believes it is probable that WPSC will continue to recover from ratepayers the regulatory assets described above. See notes 7 and 8 for specific information on pension and deferred tax regulatory liabilities. See note 9 for information on environmental remediation deferred costs. (o) INVESTMENTS AND OTHER ASSETS--Investments include ownership interests in Wisconsin River Power Company and Wisconsin Valley Improvement Company. Income related to these investments is included in other income and deductions using the equity method of accounting. Other assets include prepaid pension assets, operating deposits for jointly-owned plants, the cash surrender value of life insurance policies, the long-term portion of energy conservation loans to customers, and the decommissioning trust investments designated for payment of income taxes. (p) RECLASSIFICATIONS--Certain prior year financial statement amounts have been reclassified to conform to current year presentation. (q) RETIREMENT OF DEBT--Historically, gains or losses resulting from the settlement of long-term debt obligations have been deferred and amortized concurrent with rate recovery as required by regulators. (r) COMPREHENSIVE INCOME--In June 1997, the Financial Accounting Standards Board ("FASB") issued SFAS No. 130, "Reporting of Comprehensive Income," which establishes standards for reporting and displaying comprehensive income and its components of revenues, expenses, gains, and losses. The statement is effective for fiscal years beginning after December 15, 1997. WPSR will be adopting the requirements for reporting comprehensive income in the first quarter of 1998. WPSR currently has no components of comprehensive income other than net income. (s) SEGMENT DISCLOSURES--In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information." This statement establishes standards for reporting information about operating segments and is effective for periods beginning after December 15, 1997. WPSR will be adopting the requirements of this statement at year-end 1998 and has not yet determined the segments which will be disclosed. -63- NOTE 2--JOINTLY-OWNED FACILITIES Information regarding WPSC's share of major jointly-owned electric generating facilities in service at December 31, 1997 is set forth below. =========================================================================================== (Thousands, West Marinette Columbia Edgewater except for percentages) Unit No. 33 Energy Center Unit No. 4 Kewaunee - ------------------------------------------------------------------------------------------- Ownership 68% 31.8% 31.8% 41.2% Plant capacity (Megawatts) 83.5 335.2 104.9 221.0 Utility plant in service $15,914 $110,045 $22,209 $132,898 Accumulated depreciation $ 2,774 $ 63,432 $13,204 $ 89,858 In-service date 1993 1975 and 1978 1969 1974 =========================================================================================== WPSC's share of direct expenses for these plants is included in the corresponding operating expenses in the consolidated statements of income. WPSC has supplied its own financing for all jointly-owned projects. NOTE 3--SHORT-TERM DEBT AND LINES OF CREDIT To provide short-term borrowing flexibility and security for commercial paper outstanding, WPSR and its subsidiaries maintain bank lines of credit. Most of these lines of credit require a fee. The information in the table below relates to short-term debt and lines of credit for the years indicated: ================================================================================================ (Thousands, except for percentages) 1997 1996 1995 - ------------------------------------------------------------------------------------------------ As of end of year Commercial paper outstanding $20,706 $31,350 $11,500 Discount rate on outstanding commercial paper 6.55% 5.73% 5.65% Notes payable outstanding $10,000 $26,600 $15,000 Interest rate on notes payable 5.92% 5.81% 5.77%-6.18% Available lines of credit $23,500 $40,400 $28,050 ================================================================================================ For the year Maximum amount of short-term debt $75,017 $70,250 $32,500 Average amount of short-term debt $30,092 $28,424 $14,305 Average interest rate on short-term debt 5.50% 4.89% 5.97% ================================================================================================ NOTE 4--LONG-TERM DEBT Substantially all utility plant assets are secured by first mortgage bonds. In June 1996, WPSC repurchased $6.9 million of the First Mortgage Bonds, 8.80% Series, due in 2021. The repurchase was funded through short-term borrowings. The repurchase premium and the unamortized discount from the original issue have been deferred and are being amortized over approximately a two-year period to correspond with ratemaking treatment. In 1998, $50.0 million of 5-1/4% bonds will mature. As of December 31, 1997, $8.2 million has been drawn against PDI's revolving credit note of $11.5 million which is secured by the assets of -64- Stoneman. An additional $3.3 million, which is to be paid in the year 2000, has been committed against this note. The note, which is guaranteed by WPSR, is due in the year 2000 when the plant may be converted to a 300-megawatt to 500-megawatt gas-fired combined cycle facility. NOTE 5--COMMON EQUITY Under WPSR's Stock Investment Plan, WPSR's common stock is purchased in the open market to satisfy shareholder and employee purchase requirements. In December 1996, WPSR adopted a Shareholder Rights Plan designed to enhance the ability of the Board of Directors to protect shareholders and WPSR if efforts are made to gain control of WPSR in a manner that is not in the best interests of WPSR and its shareholders. The plan gives existing shareholders, under certain circumstances, the right to purchase stock at a discounted price. The rights expire on December 11, 2006. At December 31, 1997, WPSR had $318.6 million of retained earnings available for dividends. WPSC is restricted by a PSCW order to paying normal common stock dividends of no more than 109.0% of the previous year's common stock dividend without PSCW approval. Also, Wisconsin law prohibits WPSC from making loans to WPSR and its subsidiaries and from guaranteeing their obligations. In January 1997, WPSC paid to WPSR a special common dividend of $10.0 million. The special dividend allowed WPSC's average common equity capitalization ratio to remain at approximately 54.0%, the level approved by the PSCW for ratemaking. NOTE 6--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 such value: Cash, Short-Term Investments, Energy Conservation Loans, Notes Payable, and Outstanding Commercial Paper: The carrying amount approximates fair value due to the short maturity of those investments and obligations. Nuclear Decommissioning Trusts: The value of WPSC's nuclear decommissioning trust investments is recorded at market value. Long-Term Debt, Preferred Stock, and ESOP Loan Guarantees: The fair value of WPSC's long-term debt, preferred stock, and ESOP loan guarantees is estimated based on the quoted market price for the same or similar issues or on the current rates offered to WPSC for debt of the same remaining maturity. -65- The estimated fair values of WPSR's financial instruments as of December 31 were: ================================================================================================= (Thousands) 1997 1996 - ------------------------------------------------------------------------------------------------- Carrying Amount Fair Value Carrying Amount Fair Value - ------------------------------------------------------------------------------------------------- Cash and cash equivalents $ 6,424 $ 6,424 $ 5,978 $ 5,978 Energy conservation loans 7,195 7,195 5,388 5,388 Nuclear decommissioning trusts - utility plant 134,108 134,108 100,570 100,570 Nuclear decommissioning trusts - other assets 11,348 11,348 5,991 5,991 Notes payable 10,000 10,000 26,600 26,600 Commercial paper 20,706 20,706 31,350 31,350 ESOP loan guarantees 9,798 10,243 12,745 13,412 Long-term debt 294,210 309,206 293,043 300,906 Preferred stock 51,200 48,595 51,200 45,314 Gas commodity instruments 504 436 (61) 650 ================================================================================================= NOTE 7--EMPLOYEE BENEFIT PLANS WPSC has non-contributory retirement plans covering substantially all employees under which annual contributions may be made to an irrevocable trust established to provide retired employees with a monthly payment if conditions relating to age and length of service have been met. The plans are fully funded, and no contributions were made in 1997, 1996, or 1995. WPSC recovers pension costs in customer rates under SFAS No. 87, "Employers' Accounting for Pensions," and is returning to ratepayers through 1998 the amounts previously recovered from customers in excess of SFAS No. 87 costs. The retirement plans hold assets with a fair market value of $488.6 million as of December 31, 1997. These assets consist of domestic and international equity and fixed income investments, and domestic real estate investments. The following table sets forth the plans' funded status and expense (income). -66- ============================================================================ As of December 31 1997 1996 1995 (Thousands, except for percentages) - ---------------------------------------------------------------------------- Vested benefit obligation $(218,541) $(189,097) $(177,490) Non-vested benefit obligation (13,112) (10,213) (8,980) - ---------------------------------------------------------------------------- Total actuarial present value of accumulated benefit obligation $(231,653) $(199,310) $(186,470) ============================================================================ Projected benefit obligation for service rendered to date $(296,711) $(252,268) $(255,188) Plan assets at fair value 488,555 429,948 391,070 - ---------------------------------------------------------------------------- Plan assets in excess of projected benefit obligation 191,844 177,680 135,882 Unrecognized net gain (136,264) (121,066) (84,098) Unrecognized prior service cost 13,813 7,254 8,020 Unrecognized net transition asset (16,526) (19,991) (23,455) - ---------------------------------------------------------------------------- Prepaid retirement plan asset $ 52,867 $ 43,877 $ 36,349 ============================================================================ The net retirement plan expense (income) includes the following components Service cost $ 5,854 $ 6,371 $ 5,888 Interest cost 19,363 19,097 18,211 Actual return on plan assets (71,729) (48,244) (73,242) Net amortization and deferral 37,522 15,248 42,791 Regulatory adjustment (2,442) (4,885) (5,326) - --------------------------------------------------------------------------- Net retirement plan (income) $ (11,432) $ (12,413) $ (11,678) =========================================================================== The assumed rates for calculations used in the above tables were Expected long-term return on investments 8.75% 8.50% 9.00% Average rate for future salary increases 5.50% 5.50% 6.25% Discount rate to compute projected benefit obligation 7.25% 7.75% 7.75% ========================================================================== WPSC also offers medical, dental, and life insurance benefits to employees, retirees, and their dependents. The expenses for active employees are expensed as incurred. WPSC accounts for retiree benefits using SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," which requires the cost of postretirement benefits for employees to be accrued as expense over the period in which the employee renders service and becomes eligible to receive benefits. WPSC elected to recognize the transition obligation for current and future retirees over 20 years beginning in 1993. -67- WPSC funds amounts to irrevocable trusts as allowed for income tax purposes. These funded amounts have been expensed and recovered through customer rates. The non-administrative plan is a collectively bargained plan and, therefore, is tax exempt. The investments in the trust covering administrative employees are subject to federal unrelated business income taxes at a 39.6% tax rate. The postretirement plans hold assets with a fair market value of $121.0 million as of December 31, 1997. These assets consist of domestic and international equity securities and domestic fixed income investments. The table below sets forth the plans' accrued postretirement benefit obligation ("APBO") and the expense provisions. ========================================================================= (Thousands) 1997 1996 1995 - ------------------------------------------------------------------------- APBO attributable to Retirees and dependents $ (44,414) $ (43,746) $ (46,681) Fully eligible active plan participants (11,637) (5,273) (5,983) Other active plan participants (57,594) (52,112) (58,611) - ------------------------------------------------------------------------- Total APBO (113,645) (101,131) (111,275) Fair value of plan assets 120,960 103,748 91,038 - ------------------------------------------------------------------------- APBO in excess of plan assets 7,315 2,617 (20,237) Unrecognized net (gain)/loss (80,090) (66,045) (38,371) Unrecognized transition obligation 36,018 38,453 40,887 Unrecognized prior service cost 4,583 (1,897) (2,027) - ------------------------------------------------------------------------- Accrued postretirement benefit obligation $ (32,174) $ (26,872) $ (19,748) ========================================================================= Service cost $ 3,192 $ 3,613 $ 4,392 Interest cost 8,220 8,488 9,833 Actual return on plan assets (20,176) (18,136) (20,918) Net amortization and deferral 14,241 13,726 17,809 - ------------------------------------------------------------------------- Postretirement benefit cost $ 5,477 $ 7,691 $ 11,116 ========================================================================= The assumed before tax expected long-term return on investments and the discount rate used to measure the APBO under SFAS No. 106 are consistent with rates used to calculate the pension plans' funded status and expense under SFAS No. 87. Only the administrative plan is subject to federal income taxes which are reflected in the expense and funding status. The assumed health care cost trend rates for 1998 are 8.0% for medical and 7.5% for dental, both decreasing to 5.0% by the year 2006. Increasing each of the medical and dental cost trend rates by 1.0% in each year would increase the total APBO as of December 31, 1997 by $20.0 million and the total net periodic postretirement benefit cost for the year then ended by $2.3 million. -68- WPSC has a leveraged Employee Stock Ownership Plan and Trust ("ESOP") that held 2,070,144 shares of WPSR common stock (market value of approximately $70.0 million) at December 31, 1997. At that date, the ESOP also had one loan guaranteed by WPSC and secured by common stock. Principal and interest on the loan are to be paid using contributions from WPSC and dividends on WPSR common stock held by the ESOP. Shares in the ESOP are allocated to participants as the loan is repaid. Tax benefits from dividends paid to the ESOP are recognized as a reduction in WPSC's cost of providing service to customers. The PSCW has allowed WPSC to include in cost of service an additional employer contribution to the plan. The net effect of the tax benefits and of the employer contribution is an approximately equal sharing of the tax benefits of the program between customers and employees. NOTE 8--INCOME TAXES WPSR accounts for income taxes using the liability method as prescribed by SFAS No. 109, "Accounting for Income Taxes." Under the liability method, deferred income tax liabilities are established for all temporary differences in the book and tax bases of assets and liabilities based upon enacted tax laws and rates applicable to the periods in which the taxes become payable. Taxes provided in prior years at rates greater than current rates are being refunded to customers prospectively as the temporary differences reverse. The net regulatory liability totaled $26.1 million as of December 31, 1997. As of December 31, 1997 and 1996, WPSR had the following significant temporary differences that created deferred tax assets and liabilities: =================================================================== (Thousands) 1997 1996 ------------------------------------------------------------------- Deferred tax assets Plant related $ 68,175 $ 55,040 Customer advances 8,187 8,232 Postretirement medical and dental 12,831 10,844 Other 16,522 14,752 ------------------------------------------------------------------- Total $105,715 $ 88,868 =================================================================== Deferred tax liabilities Plant related $192,347 $179,573 Demand-side management expenditures 12,383 15,540 Pension 20,054 13,676 Other 6,735 10,287 ------------------------------------------------------------------- Total $231,519 $219,076 =================================================================== Net deferred tax liabilities $125,804 $130,208 =================================================================== Previously deferred investment tax credits are being amortized as a reduction to income tax expense over the life of the related utility plant. The components of income tax expense are set forth in the tables below. -69- ============================================================================================ (Thousands, except for percentages) 1997 1996 1995 - -------------------------------------------------------------------------------------------- Rate Amount Rate Amount Rate Amount - -------------------------------------------------------------------------------------------- Statutory federal income tax 35.0% $30,143 35.0% $26,329 35.0% $31,242 State income taxes, net 5.7 4,862 5.7 4,275 5.4 4,850 Investment tax credit restored (2.1) (1,768) (2.4) (1,778) (1.9) (1,725) Rate difference on reversal of income tax temporary differences (2.2) (1,888) (2.1) (1,579) (1.9) (1,656) Dividends paid to ESOP (1.6) (1,381) (1.9) (1,424) (1.6) (1,444) Other differences, net (0.8) (698) (2.0) (1,465) (0.5) (459) - -------------------------------------------------------------------------------------------- Effective income tax 34.0% $29,270 32.3% $24,358 34.5% $30,808 ============================================================================================ Current provision Federal $29,427 $26,122 $25,628 State 7,527 7,729 6,586 - -------------------------------------------------------------------------------------------- Total current provision 36,954 33,851 32,214 Deferred (benefit) provision (5,917) (7,715) 319 Investment tax credit restored, net (1,767) (1,778) (1,725) - -------------------------------------------------------------------------------------------- Total income tax expense $29,270 $24,358 $30,808 ============================================================================================ NOTE 9--COMMITMENTS AND CONTINGENCIES COAL CONTRACTS To ensure a reliable, low-cost supply of coal, WPSC entered into a long-term contract that has take-or-pay obligations totaling $198.4 million from 1998 through 2016. The obligations are subject to force majeure provisions which provide WPSC other options if the specified coal does not meet emission limits which may be mandated in future legislation. In the opinion of management, any amounts paid under the take-or-pay obligations described above would be considered costs of service subject to recovery in customer rates. PURCHASED POWER WPSC has several take-or-pay contracts for either capacity or energy related to purchased power. These contracts total $38.5 million through 1999. Management expects to recover these costs in future customer rates. LONG-TERM POWER SUPPLY In November 1995, WPSC signed a 25-year agreement to purchase power from Polsky Energy Corporation ("Polsky"), an independent power producer proposing to build a cogeneration facility and sell electrical power to WPSC. In October 1997, the PSCW issued a Certificate of Public Convenience and Necessity authorizing construction of the project. Phase I of the project, which is expected to be operational during 1999, will be accounted for as a capitalized lease with the capitalized amount being approximately $77.0 million. If Phase II becomes operational (Phase II is currently projected to be operational within five years of the start of Phase I), an additional plant asset of approximately $77.0 million will be recorded. -70- GAS COSTS WPSC has natural gas supply and transportation contracts that will require total estimated demand payments of $238.9 million through October 2008. The FERC has allowed ANR Pipeline Company ("ANR"), WPSC's primary pipeline supplier, to recover from its customers, including WPSC, a portion of certain take-or-pay costs it incurred from renegotiating its long-term gas supply contracts. To date, the PSCW and MPSC have granted WPSC recovery of all ANR take-or-pay costs. WPSC has satisfied all current direct billed take-or-pay costs from ANR. Remaining take-or-pay volumetric surcharges are estimated to be $0.5 million during 1998. In April 1992, the FERC issued Order No. 636 ("Order") which required natural gas pipelines to restructure their sales and transportation services. As a result, WPSC was obligated to pay for a portion of ANR's transition costs incurred to comply with the Order. ANR recovers these transition costs through a Gas Supply Realignment ("GSR") surcharge and a Pricing Differential ("PD") surcharge, with most charges recovered through the PD mechanism. On December 31, 1997, ANR made its seventh PD cost recovery filing. WPSC believes this may be ANR's final PD filing as most PD eligible contracts have now expired, and ANR's PD mechanism ends effective January 31, 1999. WPSC's estimated remaining PD costs are $0.7 million. Though there may be additional PD and GSR transition costs, which could be significant, the amount and timing of these costs are unknown at this time. Management expects to recover these costs in future customer rates since the PSCW and MPSC have allowed such recovery to date. In December 1996, FERC approved a settlement agreement which establishes the price for ANR's gas purchases and demand charges from the Dakota Gasification Plant. Demand charges for WPSC through 2003 are estimated to be $1.5 million. NUCLEAR LIABILITY The Price-Anderson Act provides for the payment of funds for public liability claims arising out of a nuclear incident. In the event of a nuclear incident involving any of the nation's licensed reactors, WPSC is subject to a proportional assessment which is approximately $32.7 million per incident, not to exceed $4.1 million per incident, per calendar year. These amounts represent WPSC's 41.2% ownership share in Kewaunee. NUCLEAR PLANT OPERATION On March 15, 1996, WPSC filed an application with the PSCW for permission to replace the Kewaunee steam generators. Public hearings were held in January 1998. A decision is expected in March 1998. The total cost of replacing the two steam generators is approximately $89.0 million. WPSC's share is $36.7 million in year of occurrence dollars. The other two owners of Kewaunee do not favor steam generator replacement. The net book value of WPSC's share of Kewaunee at December 31, 1997 is $43.0 million. In addition, the current cost of WPSC's share of the estimated costs to decommission Kewaunee, assuming early retirement, exceeds the trust assets at December 31, 1997 by $48.1 million. If retired early, Kewaunee would be placed in a dormant state following the transfer of spent fuel to temporary storage facilities. Under this plan, Kewaunee would remain intact -71- with minimal monitoring and maintenance until physical decommissioning begins. Actual decommissioning would probably not begin until approximately 2015. If the owners of Kewaunee decide not to replace the steam generators or if the PSCW does not authorize replacement, management believes the carrying amount and any unfunded decommissioning costs at the date of Kewaunee's retirement would be recoverable from customers in rates, and that no write-down for impairment would be necessary. On January 3, 1997, the PSCW accepted WPSC's recommendation to accelerate recovery of the Wisconsin retail portion of both the current undepreciated plant balance and the unfunded decommissioning costs over a six-year period, 1997 through 2002. CLEAN AIR REGULATIONS WPSC is in compliance with both the Phase I and Phase II sulfur dioxide and nitrogen oxide emission limits established by the Federal Clean Air Act Amendments of 1990. Additional capital expenditures of $1.0 million to $2.0 million are projected through 1999 for Wisconsin and federal air quality compliance. Management believes that all costs incurred for additional compliance will be recoverable in future customer rates. MANUFACTURED GAS PLANT REMEDIATION WPSC is investigating the environmental cleanup of eight manufactured gas plant sites. A detailed investigation has not yet been performed for the eighth site. Future investigation and cleanup costs for all eight sites is estimated to be in the range of $34.1 million to $41.1 million. These estimates may be adjusted in the future contingent upon remedial technology, regulatory requirements, and experience gained through cleanup activities. A liability for cleanup of $41.7 million had been established with an offsetting regulatory asset (deferred charge). Of this amount, approximately $1.5 million has been spent to date. Management believes that cleanup costs net of insurance recoveries, but not the carrying costs associated with the cleanup expenditures, will be recoverable in current and future customer rates. WPSC has received $12.6 million in insurance recoveries which have been recorded as a reduction in the regulatory asset. The PSCW has authorized current annualized recovery for gas site cleanup of $225,000 for each of the years 1997 and 1998. FUTURE UTILITY EXPENDITURES Management estimates 1998 utility plant construction expenditures to be approximately $88.3 million. Demand-side management ("DSM") expenditures are estimated to be $8.0 million. No DSM expenditures will be deferred in 1998, and the outstanding deferred asset balance at December 31, 1997 of $31.4 million will be amortized over the next four years consistent with rate recovery. NOTE 10--REGULATORY ENVIRONMENT WPSC received a rate order in the Wisconsin jurisdiction in February 1997. The impact was approximately a $35.5 million decrease in electric revenues and a $5.7 million increase in gas revenues on an annualized basis. The new rates were effective for 1997 and will be effective for 1998. WPSC intends to file an application with the PSCW on April 1, 1998, for electric and gas rate increases which would be effective in 1999 and 2000. -72- NOTE 11--AGREEMENT TO MERGE WITH UPPER PENINSULA ENERGY CORPORATION On July 10, 1997, WPSR announced an agreement to merge with Upper Peninsula Energy Corporation ("UPEN"). The S-4 Registration Statement was declared effective by the Securities and Exchange Commission ("SEC") on December 5, 1997. The shareholders of UPEN approved the merger on January 29, 1998. The merger is subject to (1) approval by the FERC; (2) approval by the SEC under the Public Utility Holding Company Act of 1935; (3) the expiration or termination of the waiting period applicable to the merger under the Hart-Scott-Rodino Antitrust Improvements Act of 1976; (4) receipt by the parties of an opinion of counsel that the exchange of stock qualifies as a tax-free transaction; (5) receipt by the parties of appropriate assurances that the transaction will be accounted for as a pooling of interests; and (6) the satisfaction of various other conditions. The merger is expected to be completed in the second half of 1998. UPEN will merge with and into WPSR, and Upper Peninsula Power Company ("UPPCO"), UPEN's utility subsidiary, will become a wholly-owned subsidiary of WPSR. The summary below contains selected unaudited pro forma financial data for the year ended December 31, 1997. The financial data should be read in conjunction with the historical WPSR and UPEN consolidated financial statements and related notes. The pro forma combined earnings per share reflect the issuance of shares associated with the merger agreement. Under the terms of the merger agreement, each of the 2,950,001 outstanding shares of UPEN common stock (no par value) will be converted into 0.90 shares of WPSR common stock ($1.00 par value), subject to adjustment for fractional shares. ========================================================================================== Pro Forma WPSR UPEN Combined (In thousands, except per share data) (as reported) (as reported) (unaudited) - ------------------------------------------------------------------------------------------ Operating revenues $ 878,340 $ 60,104 $ 938,444 Net income $ 53,742 $ 2,067 $ 55,809 Basic and diluted earnings per share $2.25 $0.70 $2.10 Assets at December 31, 1997 $1,299,602 $136,844 $1,435,804 Long-term obligations at December 31, 1997 $ 304,008 $ 43,007 $ 347,015 ========================================================================================== UPEN is a holding company incorporated under the laws of the State of Michigan. UPEN's principal subsidiary, UPPCO, is an electric utility engaged in the generation, purchase, transmission, distribution, and sale of electric energy in the Upper Peninsula of Michigan. UPPCO serves approximately 48,000 customers in two-thirds of Michigan's Upper Peninsula. UPPCO's service territory covers approximately 4,460 square miles of primarily rural areas. UPPCO furnishes energy to 99 communities and adjacent areas and provides energy for resale to 2 other investor-owned electric utilities, 2 cooperatives, and 4 municipalities. The main industries in UPPCO's service territory are forest products, iron mining and processing, tourism, and small manufacturing. -73- NOTE 12--SEGMENTS OF BUSINESS The table below presents information for the respective years pertaining to WPSR's operations segmented by lines of business. =========================================================================================== (Thousands) 1997 - ------------------------------------------------------------------------------------------- Electric Gas Nonregulated Utility Utility Operations Total - ------------------------------------------------------------------------------------------- Operating revenues $479,388 $211,090 $187,862 $ 878,340 Operating expenses Operation and maintenance 294,897 181,784 197,581 674,262 Depreciation 68,469 7,350 1,722 77,541 Other taxes 23,024 3,372 52 26,448 - ------------------------------------------------------------------------------------------- Total operating expenses 386,390 192,506 199,355 778,251 - ------------------------------------------------------------------------------------------- Operating income $ 92,998 $ 18,584 $(11,493) $ 100,089 =========================================================================================== Identifiable assets(a) $906,198 $235,490 $ 65,648 $1,207,336 - -------------------------------------------------------------------------- Assets not allocated(b) 92,266 - ------------------------------------------------------------------------------------------- Total assets $1,299,602 =========================================================================================== Construction and nuclear fuel expenditures including AFUDC $ 48,696 $ 16,950 $ - $ 65,646 =========================================================================================== =========================================================================================== (Thousands) 1996 - ------------------------------------------------------------------------------------------- Electric Gas Nonregulated Utility Utility Operations Total - ------------------------------------------------------------------------------------------- Operating revenues $490,506 $211,357 $156,391 $ 858,254 Operating expenses Operation and maintenance 309,212 190,331 165,844 665,387 Depreciation 56,708 7,127 1,343 65,178 Other taxes 23,161 3,708 (1) 26,868 - ------------------------------------------------------------------------------------------- Total operating expenses 389,081 201,166 167,186 757,433 - ------------------------------------------------------------------------------------------- Operating income $101,425 $ 10,191 $(10,795) $ 100,821 =========================================================================================== Identifiable assets(a) $905,325 $255,200 $ 71,917 $1,232,442 - -------------------------------------------------------------------------- Assets not allocated(b) 98,423 - ------------------------------------------------------------------------------------------- Total assets $1,330,865 =========================================================================================== Construction and nuclear fuel expenditures including AFUDC $ 63,941 $ 17,773 $ - $ 81,714 =========================================================================================== -74- =========================================================================================== (Thousands) 1995 - ------------------------------------------------------------------------------------------- Electric Gas Nonregulated Utility Utility Operations Total - ------------------------------------------------------------------------------------------- Operating revenues $489,000 $174,693 $56,155 $ 719,848 Operating expenses Operation and maintenance 310,293 152,062 57,538 519,893 Depreciation 58,608 6,766 253 65,627 Other taxes 22,171 3,749 1 25,921 - ------------------------------------------------------------------------------------------- Total operating expenses 391,072 162,577 57,792 611,441 - ------------------------------------------------------------------------------------------- Operating income $ 97,928 $ 12,116 $(1,637) $ 108,407 =========================================================================================== Identifiable assets(a) $906,029 $232,983 $33,332 $1,172,344 - ------------------------------------------------------------------------- Assets not allocated(b) 94,399 - ------------------------------------------------------------------------------------------- Total assets $1,266,743 =========================================================================================== Construction and nuclear fuel expenditures including AFUDC $ 56,916 $ 16,335 $ - $ 73,251 =========================================================================================== (a) At December 31 and net of the respective accumulated depreciation. (b) Primarily includes cash, investments, pension assets, nonutility property, and other receivables. NOTE 13--QUARTERLY FINANCIAL INFORMATION ================================================================================================================== (Thousands, except for share amounts) Three Months Ended - ------------------------------------------------------------------------------------------------------------------ 1997 March June September December Total - ------------------------------------------------------------------------------------------------------------------ Operating revenues $263,013 $191,360 $185,225 $238,742 $878,340 Operating income $ 33,270 $ 15,620 $ 26,390 $ 24,809 $100,089 Net income $ 18,235 $ 9,571 $ 12,903 $ 13,033 $ 53,742 Average number of shares of common stock 23,880 23,875 23,870 23,866 23,873 Basic and diluted earnings per share $.76 $.40 $.54 $.55 $2.25 ================================================================================================================== - ------------------------------------------------------------------------------------------------------------------ 1996 March June September December Total - ------------------------------------------------------------------------------------------------------------------ Operating revenues $251,337 $181,628 $178,980 $246,309 $858,254 Operating income $ 40,999 $ 20,606 $ 23,695 $ 15,521 $100,821 Net income $ 23,520 $ 10,120 $ 10,385 $ 3,730 $ 47,755 Average number of shares of common stock 23,896 23,893 23,893 23,885 23,891 Basic and diluted earnings per share $.98 $.42 $.43 $.17 $2.00 ================================================================================================================== Because of various factors which affect the utility business, the quarterly results of operations are not necessarily comparable. Fourth quarter 1996 results include a loss of $.25 per share at WPSR's nonregulated subsidiaries due to trading losses and a loss on the write-off of an investment. -75- PAGE ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA WPS RESOURCES CORPORATION F. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors of WPS Resources Corporation: We have audited the accompanying consolidated balance sheets and consolidated statements of capitalization of WPS Resources Corporation (a Wisconsin corporation) and subsidiaries as of December 31, 1997 and 1996, and the related consolidated statements of income and retained earnings and cash flows for each of the three years in the period ended December 31, 1997. 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 consolidated financial statements referred to above present fairly, in all material respects, the financial position of WPS Resources Corporation and subsidiaries as of December 31, 1997 and 1996 and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1997 in conformity with generally accepted accounting principles. ARTHUR ANDERSEN LLP Milwaukee, Wisconsin January 29, 1998 -76- ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA WISCONSIN PUBLIC SERVICE CORPORATION G. CONSOLIDATED STATEMENTS OF INCOME =================================================================================================== Year Ended December 31 (Thousands) 1997 1996 1995 - --------------------------------------------------------------------------------------------------- Operating revenues Electric $479,388 $490,506 $489,000 Gas 211,090 211,357 174,693 - --------------------------------------------------------------------------------------------------- Total operating revenues 690,478 701,863 663,693 =================================================================================================== Operating expenses Electric production fuels 107,538 105,418 104,858 Purchased power 45,876 37,737 39,593 Gas purchased for resale 147,493 149,388 116,253 Other operating expenses 134,113 158,167 150,880 Maintenance 41,661 48,734 50,761 Depreciation and decommissioning 75,819 63,835 65,374 Federal income taxes 26,460 25,267 25,645 Investment tax credit restored (1,768) (1,778) (1,725) State income taxes 7,569 7,732 7,378 Gross receipts tax and other 26,396 26,869 25,920 - --------------------------------------------------------------------------------------------------- Total operating expense 611,157 621,369 584,937 =================================================================================================== Operating income 79,321 80,494 78,756 - --------------------------------------------------------------------------------------------------- Other income and (deductions) Allowance for equity funds used during construction 129 139 170 Other, net 12,591 5,123 6,019 Income taxes (1,110) (294) 160 - --------------------------------------------------------------------------------------------------- Total other income and (deductions) 11,610 4,968 6,349 =================================================================================================== Income before interest expense 90,931 85,462 85,105 - --------------------------------------------------------------------------------------------------- Interest expense Interest on long-term debt 22,530 22,512 23,409 Other interest 3,759 2,688 2,526 Allowance for borrowed funds used during construction (100) (128) (68) - --------------------------------------------------------------------------------------------------- Total interest expense 26,189 25,072 25,867 =================================================================================================== Net income 64,742 60,390 59,238 =================================================================================================== Preferred stock dividend requirements 3,111 3,111 3,111 Earnings on common stock $ 61,631 $ 57,279 $ 56,127 =================================================================================================== The accompanying WPS Resources Corporation notes are an integral part of these statements. -77- ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA WISCONSIN PUBLIC SERVICE CORPORATION H. CONSOLIDATED BALANCE SHEETS =============================================================================================== Assets - ----------------------------------------------------------------------------------------------- At December 31 (Thousands) 1997 1996 =============================================================================================== Utility plant Electric $1,506,470 $1,474,104 Gas 251,603 240,791 - ----------------------------------------------------------------------------------------------- Total 1,758,073 1,714,895 Less - Accumulated depreciation and decommissioning 1,032,149 952,296 - ----------------------------------------------------------------------------------------------- Total 725,924 762,599 Nuclear decommissioning trusts 134,108 100,570 Construction in progress 7,266 10,301 Nuclear fuel, less accumulated amortization 19,062 19,381 - ----------------------------------------------------------------------------------------------- Net utility plant 886,360 892,851 =============================================================================================== Current assets Cash and equivalents 3,921 4,165 Customer and other receivables, net of reserves 55,893 66,234 Accrued utility revenues 30,750 35,326 Fossil fuel, at average cost 9,964 8,224 Gas in storage, at average cost 17,194 16,440 Materials and supplies, at average cost 18,793 19,796 Prepayments and other 20,155 22,189 - ----------------------------------------------------------------------------------------------- Total current assets 156,670 172,374 =============================================================================================== Regulatory assets 78,544 96,920 Net nonutility plant 2,972 4,191 Investments and other assets 109,408 92,612 =============================================================================================== Total $1,233,954 $1,258,948 =============================================================================================== -78- ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA WISCONSIN PUBLIC SERVICE CORPORATION H. CONSOLIDATED BALANCE SHEETS (CONTINUED) =============================================================================================== Capitalization and Liabilities - ----------------------------------------------------------------------------------------------- At December 31 (Thousands) 1997 1996 - ----------------------------------------------------------------------------------------------- Capitalization Common stock equity $ 457,121 $ 448,425 Preferred stock with no mandatory redemption 51,200 51,200 Long-term debt to parent 14,321 14,612 Long-term debt 293,298 296,207 - ----------------------------------------------------------------------------------------------- Total capitalization 815,940 810,444 =============================================================================================== Current liabilities Note payable 10,000 10,000 Commercial paper 15,500 29,000 Accounts payable 46,453 62,500 Accrued taxes 3,514 1,350 Accrued interest 7,801 8,134 Other 10,049 12,324 - ----------------------------------------------------------------------------------------------- Total current liabilities 93,317 123,308 =============================================================================================== Long-term liabilities and deferred credits Accumulated deferred income taxes 127,512 131,549 Accumulated deferred investment tax credits 26,901 28,669 Regulatory liabilities 50,279 48,870 Environmental remediation liabilities 40,215 41,697 Other long-term liabilities 79,790 74,411 - ----------------------------------------------------------------------------------------------- Total long-term liabilities and deferred credits 324,697 325,196 =============================================================================================== Commitments and contingencies (See Note 9) =============================================================================================== Total $1,233,954 $1,258,948 =============================================================================================== The accompanying WPS Resources Corporation notes are an integral part of these balance sheets. -79- ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA WISCONSIN PUBLIC SERVICE CORPORATION I. CONSOLIDATED STATEMENTS OF CAPITALIZATION ======================================================================================= At December 31 (Thousands, except share amounts) 1997 1996 - --------------------------------------------------------------------------------------- Common stock equity Common stock $ 95,588 $ 95,588 Premium on capital stock 73,842 73,842 Retained earnings 297,489 291,740 ESOP loan guarantees (9,798) (12,745) - --------------------------------------------------------------------------------------- Total common stock equity 457,121 448,425 ======================================================================================= Preferred stock Cumulative, $100 par value, 1,000,000 shares authorized: with no mandatory redemption - Series Shares Outstanding ------ ------------------ 5.00% 132,000 13,200 13,200 5.04% 30,000 3,000 3,000 5.08% 50,000 5,000 5,000 6.76% 150,000 15,000 15,000 6.88% 150,000 15,000 15,000 - --------------------------------------------------------------------------------------- Total preferred stock 51,200 51,200 ======================================================================================= Long-term debt to parent Series Year Due ------ -------- 8.76% 2015 5,914 6,012 7.35% 2016 8,407 8,600 - --------------------------------------------------------------------------------------- Total long-term debt to parent 14,321 14,612 ======================================================================================= Long-term debt First mortgage bonds Series Year Due ------ -------- 5-1/4% 1998 50,000 50,000 7.30% 2002 50,000 50,000 6.80% 2003 50,000 50,000 6-1/8% 2005 9,075 9,075 6.90% 2013 22,000 22,000 8.80% 2021 53,100 53,100 7-1/8% 2023 50,000 50,000 - --------------------------------------------------------------------------------------- Total 284,175 284,175 Unamortized discount and premium on bonds, net (890) (978) - --------------------------------------------------------------------------------------- Total first mortgage bonds 283,285 283,197 - --------------------------------------------------------------------------------------- ESOP loan guarantees 9,798 12,745 Other long-term debt 215 265 - --------------------------------------------------------------------------------------- Total long-term debt 293,298 296,207 ======================================================================================= Total capitalization $815,940 $810,444 ======================================================================================= The accompanying WPS Resources Corporation notes are an integral part of these statements. -80- PAGE ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA WISCONSIN PUBLIC SERVICE CORPORATION J. CONSOLIDATED STATEMENTS OF CASH FLOWS ======================================================================================================== Year Ended December 31 (Thousands) 1997 1996 1995 - -------------------------------------------------------------------------------------------------------- Cash flows from operating activities: Net income $ 64,742 $ 60,390 $ 59,238 Adjustments to reconcile net income to net cash from operating activities - Depreciation and decommissioning 75,819 63,835 65,374 Amortization of nuclear fuel and other 14,665 27,687 33,344 Deferred income taxes (5,846) (6,623) 103 Investment tax credit restored (1,767) (1,778) (1,725) Allowance for equity funds used during construction (129) (139) (170) Pension income (11,432) (12,413) (11,678) Postretirement liability 4,952 7,150 6,917 Deferred demand-side management expenditures (5) (6,250) (8,595) (Gain)/loss on sale of nonutility property (4,802) (8) 13 Other, net (6,196) 7,069 6,627 Changes in - Customer and other receivables 10,341 (4,078) (4,120) Accrued utility revenues 4,576 2,260 (8,766) Fossil fuel inventory (1,740) 477 1,804 Gas in storage (754) (6,537) 5,880 Accounts payable (16,047) 9,619 (12,455) Accrued taxes 2,164 (394) 545 Environmental remediation insurance recovery 12,374 200 - Gas refunds (318) (6,175) 4,926 - -------------------------------------------------------------------------------------------------------- Net cash from operating activities 140,597 134,292 137,262 ======================================================================================================== Cash flows from (used for) investing activities: Construction of utility plant and nuclear fuel expenditures (58,258) (84,750) (80,226) Decommissioning funding (16,059) (8,978) (8,181) Purchase of other property and equipment (111) (2,050) 77 Proceeds from sale of nonutility property 6,255 10 29 Other (175) 939 142 - -------------------------------------------------------------------------------------------------------- Net cash used for investing activities (68,348) (94,829) (88,159) ======================================================================================================== Cash flows from (used for) financing activities: Redemption of first mortgage bonds - (6,900) - Proceeds of long-term debt from parent - 8,668 - Proceeds from issuance of commercial paper 257,100 153,300 51,500 Redemptions of commercial paper (270,600) (135,800) (52,500) Preferred stock dividends (3,111) (3,111) (3,111) Common stock dividends (55,882) (55,926) (43,970) - -------------------------------------------------------------------------------------------------------- Net cash used for financing activities (72,493) (39,769) (48,081) ======================================================================================================== Net increase (decrease) in cash and equivalents (244) (306) 1,022 ======================================================================================================== Cash and equivalents at beginning of year 4,165 4,471 3,449 ======================================================================================================== Cash and equivalents at end of year $ 3,921 $ 4,165 $ 4,471 ======================================================================================================== Cash paid during year for: Interest, less amount capitalized $ 22,311 $ 22,100 $ 21,177 Income taxes $ 41,151 $ 35,662 $ 34,562 Other information Construction and nuclear fuel expenditures, including accruals, allowance for funds used during construction and customer contributions $ 65,646 $ 81,714 $ 73,251 ======================================================================================================== The accompanying WPS Resources Corporation notes are an integral part of these statements. -81- PAGE ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA WISCONSIN PUBLIC SERVICE CORPORATION K. CONSOLIDATED STATEMENTS OF RETAINED EARNINGS ==================================================================================== Year Ended December 31 (Thousands) 1997 1996 1995 - ------------------------------------------------------------------------------------ Balance at beginning of year $291,740 $290,387 $280,730 Add - Net income 64,742 60,390 59,238 - ------------------------------------------------------------------------------------ 356,482 350,777 339,968 - ------------------------------------------------------------------------------------ Deduct - Cash dividends declared on preferred stock 5.00% Series ($5.00 per share) 660 660 660 5.04% Series ($5.04 per share) 151 151 151 5.08% Series ($5.08 per share) 254 254 254 6.76% Series ($6.76 per share) 1,014 1,014 1,014 6.88% Series ($6.88 per share) 1,032 1,032 1,032 Dividends declared on common stock 45,882 44,926 43,970 Dividend to parent 10,000 11,000 2,500 - ------------------------------------------------------------------------------------ 58,993 59,037 49,581 - ------------------------------------------------------------------------------------ Balance at end of year $297,489 $291,740 $290,387 ==================================================================================== The accompanying WPS Resources Corporation notes are an integral part of these statements. -82- ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA WISCONSIN PUBLIC SERVICE CORPORATION L. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The Notes to Consolidated Financial Statements for Wisconsin Public Service Corporation are incorporated in the Notes to Consolidated Financial Statements for WPS Resources Corporation at page 57 of this report. -83- ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA WISCONSIN PUBLIC SERVICE CORPORATION M. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors of Wisconsin Public Service Corporation: We have audited the accompanying consolidated balance sheets and consolidated statements of capitalization of Wisconsin Public Service Corporation (a Wisconsin corporation) and subsidiary as of December 31, 1997 and 1996, and the related consolidated statements of income and retained earnings and cash flows for each of the three years in the period ended December 31, 1997. 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 consolidated financial statements referred to above present fairly, in all material respects, the financial position of Wisconsin Public Service Corporation and subsidiary as of December 31, 1997 and 1996, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1997 in conformity with generally accepted accounting principles. ARTHUR ANDERSEN LLP Milwaukee, Wisconsin January 29, 1998 -84- ITEM 9. CHANGE IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information about WPSR's directors and those Class A directors seeking re-election may be found on pages 3 and 4 of WPSR's March 23, 1998 Proxy Statement. Such information is incorporated by reference as if fully set forth herein. Information regarding the executive officers, which is not a part of WPSR's Proxy Statement, is set forth in Part I, Item 4A, at page 32. ITEM 11. EXECUTIVE COMPENSATION Information required under Item 11 regarding compensation paid by WPSR to its Chief Executive Officer and other executive officers of WPSR may be found in WPSR's March 23, 1998 Proxy Statement, which information is incorporated by reference herein. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information concerning principal securities holders and securities holdings of management which may be found on pages 2 and 3 of WPSR's March 23, 1998 Proxy Statement is incorporated by reference as if fully set forth herein. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS There have been no transactions since the beginning of fiscal year 1997, or any currently proposed transactions, or series of similar transactions, to which WPSR or any of its subsidiaries was or is to be party in which the amount exceeds $60,000 and in which any director, executive officer, any nominee for election as a director, any security holder owning of record or beneficially more than 5% of the Common Stock of WPSR, or any member of the immediate family of any of the foregoing persons had or will have a direct material interest. -85- PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Documents filed as part of this report: (1) The following financial consolidated statements are included in Part II at Item 8 above: Description Pages in 10-K ----------- ------------- WPS RESOURCES CORPORATION Consolidated Statements of Income and 52 Retained Earnings for the three years ended December 31, 1997, 1996, and 1995 Consolidated Balance Sheets as of 53 December 31, 1997 and 1996 Consolidated Statements of Capitalization 55 as of December 31, 1997 and 1996 Consolidated Statements of Cash Flows for 56 the three years ended December 31, 1997, 1996, and 1995 Notes to Consolidated Financial Statements 57 Report of Independent Public Accountants 76 WISCONSIN PUBLIC SERVICE CORPORATION Consolidated Statements of Income for the 77 three years ended December 31, 1997, 1996, and 1995 Consolidated Balance Sheets as of 78 December 31, 1997 and 1996 Consolidated Statements of Capitalization 80 as of December 31, 1997 and 1996 Consolidated Statements of Cash Flows for 81 the three years ended December 31, 1997, 1996, and 1995 Consolidated Statements of Retained Earnings 82 Notes to Consolidated Financial Statements 83 Report of Independent Public Accountants 84 -86- (2) Financial statement schedules. The following financial statement schedules are included in Part IV of this report. Schedules not included herein have been omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. Description Pages in 10-K ----------- ------------- Schedule III - Condensed Parent Company Only Financial Statements A. Report of Independent Public 95 Accountants B. Statements of Income and Retained 96 Earnings C. Balance Sheets 97 D. Statements of Cash Flows 98 E. Notes to Parent Company Financial 99 Statements (3) All exhibits, including those incorporated by reference. -87- Exhibit Number Description of Documents - ------- ------------------------ 3A-1 Restated Articles of Incorporation of the Company. (Incorporated by reference to Appendix B to Amendment No. 1 to the Company's Registration Statement on Form S-4, filed February 28, 1994 [Reg. No. 33-52199]). 3A-2 Articles of Incorporation of Wisconsin Public Service Corporation as effective May 26, 1972 and amended through May 31, 1988 (Incorporated by reference to Exhibit 3A to Form 10-K for the year ended December 31, 1991); Articles of Amendment to Articles of Incorporation dated June 9, 1993 (Incorporated by reference to Exhibit 3 to Form 8-K filed June 10, 1993). 3B-1 By-Laws of the Company as in effect July 11, 1996. (Incorporated by reference to Exhibit 3(ii) to Form 10-Q for the quarter ended September 30, 1996). (File No. 1-11337) 3B-2 By-Laws of Wisconsin Public Service Corporation as in effect July 11, 1996. (Incorporated by reference to Exhibit 3(ii) to Form 10-Q for the quarter ended September 30, 1996). (File No. 1-3016) 4A Copy of Rights Agreement, dated December 12, 1996 between WPS Resources Corporation and Firstar Trust Company (Incorporated by reference to Exhibit 4.1 to Form 8-A filed December 13, 1996 [File No.1-11337]). 4B Copy of First Mortgage and Deed of Trust, dated as of January 1, 1941 from Wisconsin Public Service Corporation to First Wisconsin Trust Company, Trustee (Incorporated by reference to Exhibit 7.01 - File No. 2-7229); Supplemental Indenture, dated as of November 1, 1947 (Incorporated by reference to Exhibit 7.02 - File No. 2-7602); Supplemental Indenture, dated as of November 1, 1950 (Incorporated by reference to Exhibit 4.04 - File No. 2-10174); Supplemental Indenture, dated as of May 1, 1953 (Incorporated by reference to Exhibit 4.03 - File No. 2-10716); Supplemental Indenture, dated as of October 1, 1954 (Incorporated by reference to Exhibit 4.03 - File No. 2-13572); Supplemental Indenture, dated as of December 1, 1957 (Incorporated by reference to Exhibit 4.03 - File No. 2-14527); Supplemental Indenture, dated as of October 1, 1963 (Incorporated by reference to Exhibit 2.02B - File No. 2-65710); Supplemental Indenture, dated as of June 1, 1964 (Incorporated by reference to Exhibit 2.02B - File No. 2-65710); Supplemental Indenture, dated as of November 1, 1967 (Incorporated by reference to Exhibit 2.02B - File No. 2-65710); Supplemental Indenture, dated as of April 1, 1969 (Incorporated by reference to Exhibit 2.02B - File No. 2-65710); Fifteenth Supplemental Indenture, dated as of May 1, 1971 (Incorporated by reference to Exhibit 2.02B - File No. 2-65710); Sixteenth Supplemental Indenture, dated as of August 1, 1973 (Incorporated by reference to Exhibit 2.02B - File No. 2-65710); Seventeenth Supplemental Indenture, dated as of September 1, 1973 (Incorporated by reference to Exhibit 2.02B - File No. 2-65710); Eighteenth -88- Exhibit Number Description of Documents - ------- ------------------------ Supplemental Indenture, dated as of October 1, 1975 (Incorporated by reference to Exhibit 2.02B - File No. 2-65710); Nineteenth Supplemental Indenture, dated as of February 1, 1977 (Incorporated by reference to Exhibit 2.02B - File No. 2-65710); Twentieth Supplemental Indenture, dated as of July 15, 1980 (Incorporated by reference to Exhibit 4B to Form 10-K for the year ended December 31, 1980); Twenty-First Supplemental Indenture, dated as of December 1, 1980 (Incorporated by reference to Exhibit 4B to Form 10-K for the year ended December 31, 1980); Twenty-Second Supplemental Indenture dated as of April 1, 1981 (Incorporated by reference to Exhibit 4B to Form 10-K for the year ended December 31, 1981); Twenty-Third Supplemental Indenture, dated as of February 1, 1984 (Incorporated by reference to Exhibit 4B to Form 10-K for the year ended December 31, 1983); Twenty-Fourth Supplemental Indenture, dated as of March 15, 1984 (Incorporated by reference to Exhibit 1 to Form 10-Q for the quarter ended June 30, 1984); Twenty-Fifth Supplemental Indenture, dated as of October 1, 1985 (Incorporated by reference to Exhibit 1 to Form 10-Q for the quarter ended September 30, 1985); Twenty-Sixth Supplemental Indenture, dated as of December 1, 1987 (Incorporated by reference to Exhibit 4A-1 to Form 10-K for the year ended December 31, 1987); Twenty-Seventh Supplemental Indenture, dated as of September 1, 1991 (Incorporated by reference to Exhibit 4 to Form 8-K filed September 18, 1991); Twenty-Eighth Supplemental Indenture, dated as of July 1, 1992 (Incorporated by reference to Exhibit 4B - File No. 33-51428); Twenty-Ninth Supplemental Indenture, dated as of October 1, 1992 (Incorporated by reference to Exhibit 4 to Form 8-K filed October 22, 1992); Thirtieth Supplemental Indenture, dated as of February 1, 1993 (Incorporated by reference to Exhibit 4 to Form 8-K filed January 27, 1993); Thirty-First Supplemental Indenture, dated as of July 1, 1993 (Incorporated by reference to Exhibit 4 to Form 8-K filed July 7, 1993); Thirty-Second Supplemental Indenture, dated as of November 1, 1993 (Incorporated by reference to Exhibit 4 to Form 10-Q for the quarter ended September 30, 1993). All references to periodic reports are to those of Wisconsin Public Service Corporation (File No. 1-3016). 10A Copy of Joint Power Supply Agreement among Wisconsin Public Service Corporation, Wisconsin Power and Light Company, and Madison Gas and Electric Company, dated February 2, 1967 (Incorporated by reference to Exhibit 4.09 in File No. 2-27308). 10B Copy of Joint Power Supply Agreement (Exclusive of Exhibits) among Wisconsin Public Service Corporation, Wisconsin Power and Light Company, and Madison Gas and Electric Company dated July 26, 1973 (Incorporated by reference to Exhibit 5.04A in File No. 2-48781). 10C Copy of Basic Generating Agreement, Unit 4, Edgewater Generating Station, dated June 5, 1967, between Wisconsin Power and Light Company and Wisconsin Public Service Corporation (Incorporated by reference to Exhibit 4.10 in File No. 2-27308). -89- Exhibit Number Description of Documents - ------- ------------------------ 10C-1 Copy of Agreement for Construction and Operation of Edgewater 5 Generating Unit, dated February 24, 1983, between Wisconsin Power and Light Company, Wisconsin Electric Power Company, and Wisconsin Public Service Corporation (Incorporated by reference to Exhibit 10C-1 to Form 10-K of Wisconsin Public Service Corporation for the year ended December 31, 1983 [File No. 1-3016]). 10C-2 Amendment No. 1 to Agreement for Construction and Operation of Edgewater 5 Generating Unit, dated December 1, 1988 (Incorporated by reference to Exhibit 10C-2 to Form 10-K of Wisconsin Public Service Corporation for the year ended December 31, 1988 [File No. 1-3016]). 10D Copy of revised Agreement for Construction and Operation of Columbia Generating Plant among Wisconsin Public Service Corporation, Wisconsin Power and Light Company, and Madison Gas and Electric Company, dated July 26, 1973 (Incorporated by reference to Exhibit 5.07 in File No. 2-48781). 10E Copy of Guaranty and Agreements and Note Agreements for Wisconsin Public Service Corporation Employee Stock Ownership Plan and Trust (ESOP) dated November 1, 1990 (Incorporated by reference to Exhibits 10.1 and 10.2 to Form 8-K of Wisconsin Public Service Corporation filed November 2, 1990 [File No. 1-3016]). 10F-1 Copy of Power Purchase Agreement Between De Pere Energy LLC and Wisconsin Public Service Corporation dated November 8, 1995 and amended by a Letter Agreement dated February 18, 1997. (Included as Exhibit 10F-1 to this Form 10-K for the year ended December 31, 1997, filed March 6, 1998 [File No. 1-3016]). 10F-2 Agreement and Plan of Merger, dated as of July 10, 1997, by and among WPS Resources Corporation and Upper Peninsula Energy Corporation (Incorporated by reference to Appendix A to the Proxy Statement/Prospectus forming part of Amendment 2 to the Registration Statement on Form S-4, filed November 21, 1997 [Reg. No. 333-3401]). EXECUTIVE COMPENSATION PLANS AND ARRANGEMENTS 10G-1 Copy of amended and restated WPS Resources Corporation Deferred Compensation Plan for executives and non-employee directors, effective January 1, 1998. (Included as Exhibit 10G-1 to this Form 10-K for the year ended December 31, 1997, filed March 6, 1998 [File No. 1-11337]). -90- Exhibit Number Description of Documents - ------- ------------------------ 10G-2 Copy of Form of Executive Employment and Severance Agreement entered into between WPS Resources Corporation and each of the following: Ralph G. Baeten, Daniel P. Bittner, Diane L. Ford, Richard E. James, Thomas P. Meinz, Phillip M. Mikulsky, Wayne J. Peterson, Patrick D. Schrickel, Charles A. Schrock, Clark R. Steinhardt, Bernard J. Treml, and Larry L. Weyers (Incorporated by reference to Exhibit 10.6 to Form 10-Q for the quarter ended June 30, 1997, filed July 25, 1997 [File No. 1-11337]). 10G-3 Copy of WPS Resources Corporation Short-Term Variable Pay Plan effective January 1, 1998. (Included as Exhibit 10G-3 to this Form 10-K for the year ended December 31, 1997, filed March 6, 1998 [File No. 1-11337]). -91- Exhibit Number Description of Document Pages in 10-K - ------- ----------------------- ------------- 10F-1 Power Purchase Agreement Between De Pere Energy LLC and Wisconsin Public Service Corporation dated November 8, 1995 and amended by a Letter Agreement dated February 18, 1997 Wisconsin Public Service Corporation 100 10G-1 WPS Resources Corporation Amended and Restated Deferred Compensation Plan Effective January 1, 1998 WPS Resources Corporation 213 10G-3 WPS Resources Corporation Short-Term Variable Pay Plan Effective January 1, 1998 WPS Resources Corporation 240 11 Statement Regarding Computation of Per Share Earnings WPS Resources Corporation 248 21 Subsidiaries of the Registrant 249 23 Consent of Independent Public Accountants 250 24 Powers of Attorney 251 27 Financial Data Schedule WPS Resources Corporation 259 Wisconsin Public Service Corporation 260 -92- (b) Reports on Form 8-K Form 8-K dated October 20, 1997 and filed October 21, 1997 transmitting a press release dated October 20, 1997 regarding the financial results of WPS Resources Corporation for the quarterly period ended September 30, 1997. -93- SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. WPS RESOURCES CORPORATION and WISCONSIN PUBLIC SERVICE CORPORATION (Registrant) By /s/ L. L. Weyers -------------------------------------------------------------------- L. L. Weyers L. L. Weyers Chairman, President, and Chairman and Chief Executive Officer Chief Executive Officer WPS Resources Corporation Wisconsin Public Service Corporation Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Signature Title Date - ------------------------------------------------------------------------------ A. Dean Arganbright Director March 6, 1998 Michael S. Ariens Director Richard A. Bemis Director Daniel A. Bollom Director M. Lois Bush Director Robert C. Gallagher Director By /s/ L. L. Weyers Kathryn M. Hasselblad-Pascale Director -------------------------- James L. Kemerling Director L. L. Weyers Attorney-in-Fact /s/ L. L. Weyers Principal Executive March 6, 1998 - ---------------------------------Officer and Director L. L. Weyers /s/ D. P. Bittner Principal Financial March 6, 1998 - ---------------------------------Officer D. P. Bittner /s/ D. L. Ford Principal Accounting March 6, 1998 - ---------------------------------Officer D. L. Ford -94- SCHEDULE III - CONDENSED PARENT COMPANY FINANCIAL STATEMENTS WPS RESOURCES CORPORATION (PARENT COMPANY ONLY) A. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors of WPS Resources Corporation: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements of WPS Resources Corporation included in this Form 10-K, and have issued our report thereon dated January 29, 1998. Our audit was made for the purpose of forming an opinion on the basic consolidated financial statements taken as a whole. Supplemental Schedule III is the responsibility of the Company's management and is presented for purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic consolidated financial statements. This schedule has been subjected to the auditing procedures applied in the audit of the basic consolidated financial statements and, in our opinion, fairly states in all material respects, the financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole. ARTHUR ANDERSEN LLP Milwaukee, Wisconsin January 29, 1998 -95- SCHEDULE III - CONDENSED PARENT COMPANY FINANCIAL STATEMENTS WPS RESOURCES CORPORATION (PARENT COMPANY ONLY) B. STATEMENTS OF INCOME AND RETAINED EARNINGS =============================================================================================== Year Ended December 31 (Thousands) 1997 1996 1995 - ----------------------------------------------------------------------------------------------- Income Equity in earnings of subsidiaries after dividends $ (1,432) $ (8,941) $ 11,236 Cash dividends from subsidiaries 55,882 55,926 43,970 - ----------------------------------------------------------------------------------------------- Income from subsidiaries 54,450 46,985 55,206 - ----------------------------------------------------------------------------------------------- Investment income and other 2,901 2,251 872 - ----------------------------------------------------------------------------------------------- Total income 57,351 49,236 56,078 =============================================================================================== Operating expenses 2,864 585 589 - ----------------------------------------------------------------------------------------------- Income before interest expense 54,487 48,651 55,489 Interest expense 417 454 68 - ----------------------------------------------------------------------------------------------- Income before income taxes 54,070 48,197 55,421 Income taxes 328 442 78 - ----------------------------------------------------------------------------------------------- Net Income 53,742 47,755 55,343 =============================================================================================== Retained earnings, beginning of year 311,794 308,965 297,592 Common stock dividend (45,882) (44,926) (43,970) - ----------------------------------------------------------------------------------------------- Retained earnings at end of year $319,654 $311,794 $308,965 =============================================================================================== -96- PAGE SCHEDULE III - CONDENSED PARENT COMPANY FINANCIAL STATEMENTS WPS RESOURCES CORPORATION (PARENT COMPANY ONLY) C. BALANCE SHEETS ============================================================================== At December 31 (Thousands) 1997 1996 - ------------------------------------------------------------------------------ Assets - ------------------------------------------------------------------------------ Current assets Cash and equivalents $ 5 $ 3 Accounts receivable - affiliates 417 614 Other receivables 217 12 Notes receivable - affiliates (note 1) 4,498 14,875 - ------------------------------------------------------------------------------ Total current assets 5,137 15,504 ============================================================================== Long-term notes receivable - affiliates (note 2) 15,950 16,382 ============================================================================== Investments in subsidiaries, at equity Wisconsin Public Service Corporation 457,121 448,425 WPS Energy Services, Inc. 4,495 2,443 WPS Power Development, Inc. 7 2,238 - ------------------------------------------------------------------------------ Total investments in subsidiaries, at equity 461,623 453,106 ============================================================================== Net equipment 321 68 Other investments 2,856 3,025 Deferred income taxes 45 52 - ------------------------------------------------------------------------------ Total assets $485,932 $488,137 ============================================================================== ============================================================================== Liabilities and Capitalization - ------------------------------------------------------------------------------ Current liabilities Notes payable $ 5,206 $ 18,950 Accounts payable - affiliates 549 86 Accounts payable 1,699 519 Dividends payable 626 948 Other 29 62 - ------------------------------------------------------------------------------ Total current liabilities 8,109 20,565 ============================================================================== Other liabilities - 48 ============================================================================== Capitalization Common stock, $1 par value, 100,000,000 shares authorized; 23,896,962 shares outstanding 23,897 23,897 Premium on capital stock 145,021 145,021 Retained earnings 319,654 311,794 ESOP loan guarantees (9,798) (12,745) Shares in deferred compensation trust (951) (443) - ------------------------------------------------------------------------------ Total capitalization 477,823 467,524 ============================================================================== Total liabilities and capitalization $485,932 $488,137 ============================================================================== -97- PAGE SCHEDULE III - CONDENSED PARENT COMPANY FINANCIAL STATEMENTS WPS RESOURCES CORPORATION (PARENT COMPANY ONLY) D. STATEMENTS OF CASH FLOWS ===================================================================================================== Year Ended December 31 (Thousands) 1997 1996 1995 - ----------------------------------------------------------------------------------------------------- Operating Net income $ 53,742 $ 47,755 $ 55,343 Add equity in earnings of subsidiaries after dividends 1,432 8,941 (11,236) Deferred income taxes 7 46 139 Other - net 3 1,883 (30) Changes in other items Receivables (8) (463) (1,740) Accounts payable 1,258 357 64 Other (16) 110 285 - ----------------------------------------------------------------------------------------------------- Net cash - operating 56,418 58,629 42,825 ===================================================================================================== Investing Notes receivable - affiliates 10,809 (21,346) (1,825) Capital contributions - affiliates (7,005) (5,250) (5,400) Investments - other (87) (2,371) (4,434) - ----------------------------------------------------------------------------------------------------- Net cash - investing 3,717 (28,967) (11,659) ===================================================================================================== Financing Proceeds from short-term debt 536,200 333,264 15,000 Payments on short-term debt (549,944) (319,314) (10,000) Purchase of deferred compensation stock (507) (443) - Common stock dividends (45,882) (44,926) (43,970) - ----------------------------------------------------------------------------------------------------- Net cash - financing (60,133) (31,419) (38,970) ===================================================================================================== Net change in cash 2 (1,757) (7,804) Cash, beginning of period 3 1,760 9,564 - ----------------------------------------------------------------------------------------------------- Cash, end of period $ 5 $ 3 $ 1,760 ===================================================================================================== -98- PAGE SCHEDULE III - CONDENSED PARENT COMPANY FINANCIAL STATEMENTS WPS RESOURCES CORPORATION (PARENT COMPANY ONLY) E. NOTES TO PARENT COMPANY FINANCIAL STATEMENTS The following are supplemental notes to the WPS Resources Corporation (parent company only) financial statements and should be read in conjunction with the WPS Resources Corporation Consolidated Financial Statements and Notes thereto included herein: SUPPLEMENTAL NOTES Note 1 WPS Resources Corporation ("WPSR") has short-term notes receivable from WPS Energy Services, Inc. ("ESI") and WPS Power Development, Inc. for $3.2 million and $1.3 million, respectively. These notes bear interest at between 6.90% and 8.50%, depending upon the operational use of the loaned funds. Note 2 WPSR has long-term notes receivable from Wisconsin Public Service Corporation for $5.9 million and $8.4 million bearing interest at 8.76% and 7.35%, respectively. The notes are to be repaid in monthly payments of $51,670 and $63,896 through January 2015 and May 2016, respectively. WPSR also has a long-term note receivable from ESI totaling $1.6 million and bearing interest at 7-7/8%. The note is to be repaid in quarterly payments of $69,076 through October 2005. -99-