UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2001
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ______________ to _______________
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Commission file number 1-3187
RELIANT ENERGY, INCORPORATED
(Exact name of registrant as specified in its charter)
Texas 74-0694415
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
1111 Louisiana
Houston, Texas 77002
(Address of principal executive offices) (Zip Code)
(713) 207-3000
(Registrant's telephone number, including area code)
Commission file number 1-13265
RELIANT ENERGY RESOURCES CORP.
(Exact name of registrant as specified in its charter)
Delaware 76-0511406
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
1111 Louisiana
Houston, Texas 77002
(Address of principal executive offices) (Zip Code)
(713) 207-3000
(Registrant's telephone number, including area code)
----------
RELIANT ENERGY RESOURCES CORP. MEETS THE CONDITIONS SET FORTH IN GENERAL
INSTRUCTION H(1)(a) AND (b) OF FORM 10-Q AND IS THEREFORE FILING THIS FORM 10-Q
WITH THE REDUCED DISCLOSURE FORMAT.
Indicate by check mark whether the registrants: (1) have filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding twelve months (or for such shorter period that the
registrants were required to file such reports), and (2) have been subject to
such filing requirements for the past 90 days. Yes X No
As of November 7, 2001, Reliant Energy, Incorporated had 298,149,968 shares of
common stock outstanding, including 7,298,389 ESOP shares not deemed outstanding
for financial statement purposes and excluding 4,511,691 shares held as treasury
stock. As of November 7, 2001, all 1,000 shares of Reliant Energy Resources
Corp. common stock were held by Reliant Energy, Incorporated.
THIS COMBINED QUARTERLY REPORT ON FORM 10-Q IS SEPARATELY FILED BY RELIANT
ENERGY, INCORPORATED (RELIANT ENERGY) AND RELIANT ENERGY RESOURCES CORP. (RERC
CORP). INFORMATION CONTAINED HEREIN RELATING TO RERC CORP. IS FILED BY RELIANT
ENERGY AND SEPARATELY BY RERC CORP. ON ITS OWN BEHALF. RERC CORP. MAKES NO
REPRESENTATION AS TO INFORMATION RELATING TO RELIANT ENERGY OR ANY OTHER
AFFILIATE OR SUBSIDIARY OF RELIANT ENERGY (EXCEPT AS IT MAY RELATE TO RERC CORP.
AND ITS SUBSIDIARIES).
RELIANT ENERGY, INCORPORATED
AND RELIANT ENERGY RESOURCES CORP.
QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2001
TABLE OF CONTENTS
<Table>
PART I. FINANCIAL INFORMATION
Reliant Energy:
Item 1. Financial Statements.................................................................1
Statements of Consolidated Income
Three and Nine Months Ended September 30, 2000 and 2001 (unaudited)......................1
Consolidated Balance Sheets
December 31, 2000 and September 30, 2001 (unaudited).....................................2
Statements of Consolidated Cash Flows
Nine Months Ended September 30, 2000 and 2001 (unaudited)................................4
Notes to Unaudited Consolidated Financial Statements.....................................5
Item 2. Management's Discussion and Analysis of Financial Condition and Results of
Operations of Reliant Energy and Subsidiaries...........................................23
Item 3. Quantitative and Qualitative Disclosures About Market Risk..........................38
RERC Corp.:
Item 1. Financial Statements................................................................41
Statements of Consolidated Operations
Three and Nine Months Ended September 30, 2000 and 2001 (unaudited).....................41
Consolidated Balance Sheets
December 31, 2000 and September 30, 2001 (unaudited)....................................42
Statements of Consolidated Cash Flows
Nine Months Ended September 30, 2000 and 2001 (unaudited)...............................44
Notes to Unaudited Consolidated Financial Statements....................................45
Item 2. Management's Narrative Analysis of the Results of Operations of RERC Corp. and
Subsidiaries............................................................................52
PART II. OTHER INFORMATION
Item 1. Legal Proceedings...................................................................56
Item 5. Other Information...................................................................56
Item 6. Exhibits and Reports on Form 8-K....................................................57
</Table>
PART I. FINANCIAL INFORMATION
RELIANT ENERGY, INCORPORATED AND SUBSIDIARIES
STATEMENTS OF CONSOLIDATED INCOME
(THOUSANDS OF DOLLARS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
<Table>
<Caption>
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
-------------------------------- ------------------------------
2000 2001 2000 2001
-------------- --------------- ------------- -------------
REVENUES ......................................................... $ 9,501,786 $ 12,466,991 $ 19,469,961 $ 37,725,663
EXPENSES:
Fuel and cost of gas sold ...................................... 3,894,701 4,018,175 9,149,210 17,074,186
Purchased power ................................................ 3,807,911 6,695,007 5,998,790 15,879,299
Operation and maintenance ...................................... 585,172 674,234 1,614,779 2,008,830
Taxes other than income taxes .................................. 144,322 147,335 369,932 429,149
Depreciation and amortization .................................. 293,422 286,475 706,157 706,240
------------- -------------- ------------- -------------
Total ...................................................... 8,725,528 11,821,226 17,838,868 36,097,704
------------- -------------- ------------- -------------
OPERATING INCOME ................................................. 776,258 645,765 1,631,093 1,627,959
------------- -------------- ------------- -------------
OTHER (EXPENSE) INCOME:
Unrealized gain (loss) on AOL Time Warner investment ........... 40,000 (512,447) 242,928 (44,464)
Unrealized (loss) gain on indexed debt securities .............. (40,000) 503,077 (242,870) 38,845
Income from equity investments in unconsolidated subsidiaries .. 27,142 2,132 33,108 66,482
Interest expense ............................................... (186,303) (138,275) (533,066) (466,520)
Distribution on trust preferred securities ..................... (13,754) (13,900) (40,458) (41,699)
Minority interest .............................................. 161 (25,717) 676 (48,908)
Other, net ..................................................... 14,070 26,528 61,068 96,348
------------- -------------- ------------- -------------
Total ...................................................... (158,684) (158,602) (478,614) (399,916)
------------- -------------- ------------- -------------
INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES,
EXTRAORDINARY ITEM, CUMULATIVE EFFECT OF ACCOUNTING CHANGE AND
PREFERRED DIVIDENDS ............................................ 617,574 487,163 1,152,479 1,228,043
Income Tax Expense ............................................. 221,807 196,863 386,963 455,780
------------- -------------- ------------- -------------
INCOME FROM CONTINUING OPERATIONS BEFORE EXTRAORDINARY ITEM,
CUMULATIVE EFFECT OF ACCOUNTING CHANGE AND PREFERRED
DIVIDENDS ...................................................... 395,767 290,300 765,516 772,263
Loss from Discontinued Operations, net of tax of $(3,829) and
$(2,015) ..................................................... (6,704) -- (26,814) --
Loss on Disposal of Discontinued Operations, net of tax of
$(1,640) ..................................................... -- -- -- (7,294)
------------- -------------- ------------- -------------
INCOME BEFORE EXTRAORDINARY ITEM, CUMULATIVE EFFECT OF
ACCOUNTING CHANGE AND PREFERRED DIVIDENDS ...................... 389,063 290,300 738,702 764,969
Extraordinary Item ............................................. -- -- 7,445 --
------------- -------------- ------------- -------------
INCOME BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGE AND
PREFERRED DIVIDENDS ............................................ 389,063 290,300 746,147 764,969
Cumulative Effect of Accounting Change, net of tax of $33,205 .. -- -- -- 61,619
------------- -------------- ------------- -------------
INCOME BEFORE PREFERRED DIVIDENDS ................................ 389,063 290,300 746,147 826,588
Preferred Dividends ............................................ 97 97 292 292
------------- -------------- ------------- -------------
NET INCOME ATTRIBUTABLE TO COMMON STOCKHOLDERS ................... $ 388,966 $ 290,203 $ 745,855 $ 826,296
============= ============== ============= =============
BASIC EARNINGS PER SHARE:
Income from Continuing Operations .............................. $ 1.38 $ 1.00 $ 2.68 $ 2.67
Loss from Discontinued Operations, net of tax .................. (0.02) -- (0.09) --
Loss on Disposal of Discontinued Operations, net of tax ........ -- -- -- (0.03)
Extraordinary Item ............................................. -- -- 0.03 --
Cumulative Effect of Accounting Change, net of tax ............. -- -- -- 0.22
------------- -------------- ------------- -------------
Net Income Attributable to Common Stockholders ................. $ 1.36 $ 1.00 $ 2.62 $ 2.86
============= ============== ============= =============
DILUTED EARNINGS PER SHARE:
Income from Continuing Operations .............................. $ 1.36 $ 0.99 $ 2.66 $ 2.65
Loss from Discontinued Operations, net of tax .................. (0.02) -- (0.09) --
Loss on Disposal of Discontinued Operations, net of tax ........ -- -- -- (0.03)
Extraordinary Item ............................................. -- -- 0.03 --
Cumulative Effect of Accounting Change, net of tax ............. -- -- -- 0.21
------------- -------------- ------------- -------------
Net Income Attributable to Common Stockholders ................. $ 1.34 $ 0.99 $ 2.60 $ 2.83
============= ============== ============= =============
</Table>
See Notes to the Company's Interim Financial Statements
1
RELIANT ENERGY, INCORPORATED AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(THOUSANDS OF DOLLARS)
(UNAUDITED)
ASSETS
<Table>
<Caption>
DECEMBER 31, SEPTEMBER 30,
2000 2001
------------- -------------
CURRENT ASSETS:
Cash and cash equivalents ............................ $ 175,972 $ 294,816
Investment in AOL Time Warner common stock ........... 896,824 852,361
Accounts receivable, net ............................. 2,623,492 1,840,682
Accrued unbilled revenues ............................ 592,618 264,724
Fuel stock and petroleum products .................... 213,484 327,811
Materials and supplies ............................... 269,729 264,215
Price risk management assets ......................... 4,290,803 2,128,025
Non-trading derivative assets ........................ -- 1,425,211
Margin deposits on energy trading activities ......... 521,004 351,756
Other ................................................ 253,335 172,876
------------- -------------
Total current assets ............................... 9,837,261 7,922,477
------------- -------------
Property, plant and equipment ........................... 22,391,874 23,732,570
Less accumulated depreciation and amortization .......... (7,131,698) (7,389,815)
------------- -------------
Property, plant and equipment, net ................... 15,260,176 16,342,755
------------- -------------
OTHER ASSETS:
Goodwill and other intangibles, net .................. 3,080,686 2,986,762
Regulatory assets .................................... 1,926,103 1,374,418
Price risk management assets ......................... 544,909 689,983
Non-trading derivative assets ........................ -- 630,326
Equity investments in unconsolidated subsidiaries .... 108,727 141,633
Stranded costs indemnification receivable ............ -- 353,000
Net assets of discontinued operations ................ 194,858 118,097
Other ................................................ 746,709 949,742
------------- -------------
Total other assets ................................. 6,601,992 7,243,961
------------- -------------
TOTAL ASSETS ..................................... $ 31,699,429 $ 31,509,193
============= =============
</Table>
See Notes to the Company's Interim Financial Statements
2
RELIANT ENERGY, INCORPORATED AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS - (CONTINUED)
(THOUSANDS OF DOLLARS)
(UNAUDITED)
LIABILITIES AND STOCKHOLDERS' EQUITY
<Table>
<Caption>
DECEMBER 31, SEPTEMBER 30,
2000 2001
------------- -------------
CURRENT LIABILITIES:
Short-term borrowings ................................................... $ 5,004,494 $ 3,015,490
Current portion of long-term debt ....................................... 1,623,202 571,079
Indexed debt securities derivative ...................................... -- 749,413
Accounts payable ........................................................ 3,057,948 1,518,245
Taxes accrued ........................................................... 172,449 801,100
Interest accrued ........................................................ 103,489 126,702
Dividends declared ...................................................... 110,893 112,057
Price risk management liabilities ....................................... 4,272,771 2,156,798
Non-trading derivative liabilities ...................................... -- 1,415,196
Margin deposits from customers on energy trading activities ............. 284,603 239,350
Accumulated deferred income taxes ....................................... 309,008 376,140
Other ................................................................... 630,357 596,409
------------- -------------
Total current liabilities ............................................. 15,569,214 11,677,979
------------- -------------
OTHER LIABILITIES:
Accumulated deferred income taxes ....................................... 2,548,891 2,497,178
Unamortized investment tax credits ...................................... 265,737 251,989
Price risk management liabilities ....................................... 530,263 730,859
Non-trading derivative liabilities ...................................... -- 578,921
Benefit obligations ..................................................... 491,964 550,815
Other ................................................................... 1,100,505 1,180,689
------------- -------------
Total other liabilities ............................................... 4,937,360 5,790,451
------------- -------------
LONG-TERM DEBT ............................................................. 4,996,095 5,400,854
------------- -------------
COMMITMENTS AND CONTINGENCIES (NOTES 1 AND 12)
MINORITY INTEREST IN CONSOLIDATED SUBSIDIARIES ............................. 9,345 1,226,844
------------- -------------
COMPANY OBLIGATED MANDATORILY REDEEMABLE PREFERRED SECURITIES OF
SUBSIDIARY TRUSTS HOLDING SOLELY JUNIOR SUBORDINATED DEBENTURES OF THE
COMPANY ................................................................. 705,355 705,680
------------- -------------
STOCKHOLDERS' EQUITY:
Cumulative preferred stock .............................................. 9,740 9,740
Common stock ............................................................ 3,257,190 3,887,007
Treasury stock .......................................................... (120,856) (113,336)
Unearned ESOP stock ..................................................... (161,158) (137,907)
Retained earnings ....................................................... 2,520,350 3,020,515
Accumulated other comprehensive (loss) income ........................... (23,206) 41,366
------------- -------------
Total stockholders' equity ............................................ 5,482,060 6,707,385
------------- -------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY .......................... $ 31,699,429 $ 31,509,193
============= =============
</Table>
See Notes to the Company's Interim Financial Statements
3
RELIANT ENERGY, INCORPORATED AND SUBSIDIARIES
STATEMENTS OF CONSOLIDATED CASH FLOWS
(THOUSANDS OF DOLLARS)
(UNAUDITED)
<Table>
<Caption>
NINE MONTHS ENDED SEPTEMBER 30,
-------------------------------
2000 2001
------------ ------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income attributable to common stockholders .......................... $ 745,855 $ 826,296
Adjustments to reconcile net income to net cash provided by operating
activities:
Depreciation and amortization ......................................... 706,157 706,240
Deferred income taxes ................................................. (131,299) (169,898)
Investment tax credits ................................................ (13,748) (13,748)
Cumulative effect of accounting change, net ........................... -- (61,619)
Unrealized (gain) loss on AOL Time Warner investment .................. (242,928) 44,464
Unrealized loss (gain) on indexed debt securities ..................... 242,870 (38,845)
Undistributed earnings of unconsolidated subsidiaries ................. (33,108) (31,884)
Proceeds from sale of debt securities ................................. 123,428 --
Impairment of marketable equity securities ............................ 26,504 --
Extraordinary item .................................................... (7,445) --
Net cash provided by discontinued operations .......................... 26,180 87,140
Minority interest ..................................................... (676) 48,908
Changes in other assets and liabilities:
Accounts receivable, net ............................................ (651,019) 1,166,205
Inventory ........................................................... (101,734) (102,096)
Accounts payable .................................................... 599,033 (1,541,046)
Federal tax refund .................................................. 52,817 --
Fuel cost under-recovery/surcharge .................................. (506,439) 169,265
Net price risk management assets and liabilities .................... (24,436) 102,269
Margin deposits on energy trading activities, net ................... (62,755) 123,995
Prepaid lease obligation ............................................ -- (195,239)
Interest and taxes accrued .......................................... 291,143 641,660
Other current assets ................................................ (56,290) 99,156
Other current liabilities ........................................... 258,624 (36,006)
Other assets ........................................................ (156,320) (53,779)
Other liabilities ................................................... 4,225 65,897
Other, net ............................................................ (14,313) 131,113
------------ ------------
Net cash provided by operating activities ......................... 1,074,326 1,968,448
------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures .................................................... (1,237,814) (1,543,193)
Business acquisitions, net of cash acquired ............................. (2,119,667) --
Proceeds from sale-leaseback transactions ............................... 1,000,000 --
Payment of business purchase obligation ................................. (981,789) --
Investments in unconsolidated subsidiaries .............................. (5,196) --
Net cash used in discontinued operations ................................ (38,099) (10,397)
Other, net .............................................................. 81,130 (38,117)
------------ ------------
Net cash used in investing activities ............................. (3,301,435) (1,591,707)
------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from long-term debt, net ....................................... 467,285 544,632
Increase (decrease) in short-term borrowing, net ........................ 2,819,479 (1,824,195)
Payments of long-term debt .............................................. (645,081) (408,398)
Payment of common stock dividends ....................................... (319,467) (324,956)
Proceeds from issuance of stock ......................................... 39,742 91,798
Proceeds from subsidiary issuance of stock .............................. -- 1,697,848
Purchase of treasury stock by subsidiary ................................ -- (20,420)
Purchase of treasury stock .............................................. (27,561) --
Net cash provided by discontinued operations ............................ 45,813 --
Other, net .............................................................. 1,990 (8,341)
------------ ------------
Net cash provided by (used in) financing activities ................. 2,382,200 (252,032)
------------ ------------
EFFECT OF EXCHANGE RATE CHANGES ON CASH ................................... 9,681 (5,865)
------------ ------------
NET INCREASE IN CASH AND CASH EQUIVALENTS ................................. 164,772 118,844
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD .......................... 80,767 175,972
------------ ------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD ................................ $ 245,539 $ 294,816
============ ============
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash Payments:
Interest (net of amounts capitalized) ................................... $ 560,922 $ 466,296
Income taxes ............................................................ 266,841 118,672
</Table>
See Notes to the Company's Interim Financial Statements
4
RELIANT ENERGY, INCORPORATED AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(1) BASIS OF PRESENTATION
Included in this combined Quarterly Report on Form 10-Q (Form 10-Q) for
Reliant Energy, Incorporated (Reliant Energy), together with its subsidiaries
(the Company), and for Reliant Energy Resources Corp. (RERC Corp.) and its
subsidiaries (collectively, RERC) are Reliant Energy's and RERC Corp.'s
consolidated interim financial statements and notes (Interim Financial
Statements), including these companies' wholly owned and majority owned
subsidiaries. The Interim Financial Statements are unaudited, omit certain
financial statement disclosures and should be read with the combined Annual
Report on Form 10-K of Reliant Energy (Reliant Energy Form 10-K) and RERC Corp.
(RERC Corp. Form 10-K) for the year ended December 31, 2000 and the Quarterly
Reports on Form 10-Q of Reliant Energy (Reliant Energy First Quarter 10-Q) and
RERC Corp. (RERC Corp. First Quarter 10-Q) for the quarter ended March 31, 2001
and the Quarterly Reports on Form 10-Q of Reliant Energy (Reliant Energy Second
Quarter 10-Q) and RERC Corp. (RERC Corp. Second Quarter 10-Q) for the quarter
ended June 30, 2001.
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
The Interim Financial Statements reflect all normal recurring adjustments
that are, in the opinion of management, necessary to present fairly the
financial position and results of operations for the respective periods. Amounts
reported in the Company's Statements of Consolidated Income are not necessarily
indicative of amounts expected for a full year period due to the effects of,
among other things, (a) seasonal fluctuations in demand for energy and energy
services, (b) changes in energy commodity prices, (c) timing of maintenance and
other expenditures and (d) acquisitions and dispositions of businesses, assets
and other interests. In addition, certain amounts from the prior year have been
reclassified to conform to the Company's presentation of financial statements in
the current year. These reclassifications do not affect the earnings of the
Company.
The following notes to the consolidated financial statements in the Reliant
Energy Form 10-K relate to certain contingencies. These notes, as updated
herein, are incorporated herein by reference:
Notes to Consolidated Financial Statements of Reliant Energy (Reliant
Energy 10-K Notes): Note 2(f) (Summary of Significant Accounting Policies
-- Regulatory Assets), Note 3 (Business Acquisitions), Note 4 (Regulatory
Matters), Note 5 (Derivative Financial Instruments), Note 8 (Indexed Debt
Securities (ACES and ZENS) and AOL Time Warner Securities), Note 14
(Commitments and Contingencies) and Note 20 (Subsequent Events).
For information regarding certain legal, tax and regulatory proceedings and
environmental matters, see Note 12.
In September 2001, the Company announced that it is evaluating strategic
alternatives for its European Energy segment, including the possible sale, in
order to pursue business opportunities that are more in line with its domestic
wholesale energy strategies.
(2) NEW ACCOUNTING PRONOUNCEMENTS
In July 2001, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (SFAS) No. 141 "Business
Combinations" (SFAS No. 141) and SFAS No. 142 "Goodwill and Other Intangible
Assets" (SFAS No. 142). SFAS No. 141 requires business combinations initiated
after June 30, 2001 to be accounted for using the purchase method of accounting,
and broadens the criteria for recording intangible assets separate from
goodwill. Recorded goodwill and intangibles will be evaluated against these new
criteria and may result in certain intangibles being transferred to goodwill, or
alternatively, amounts initially recorded as goodwill may be separately
identified and recognized apart from goodwill. SFAS No. 142 provides for a
nonamortization approach, whereby goodwill and certain intangibles with
indefinite lives will not be amortized into results of operations, but instead
will be reviewed periodically for impairment and written down and charged to
results of
5
operations only in the periods in which the recorded value of goodwill and
certain intangibles with indefinite lives is more than its fair value. The
provisions of each statement which apply to goodwill and intangible assets
acquired prior to June 30, 2001 will be adopted by the Company on January 1,
2002. The Company is in the process of determining the effect of adoption of
SFAS No. 141 and SFAS No. 142 on its consolidated financial statements.
In August 2001, the FASB issued SFAS No. 143, "Accounting for Asset
Retirement Obligations" (SFAS No. 143). SFAS No. 143 requires the fair value of
a liability for an asset retirement legal obligation to be recognized in the
period in which it is incurred. When the liability is initially recorded,
associated costs are capitalized by increasing the carrying amount of the
related long-lived asset. Over time, the liability is accreted to its present
value each period, and the capitalized cost is depreciated over the useful life
of the related asset. SFAS No. 143 is effective for fiscal years beginning after
June 15, 2002, with earlier application encouraged. SFAS No. 143 requires
entities to record a cumulative effect of change in accounting principle in the
income statement in the period of adoption. The Company plans to adopt SFAS No.
143 on January 1, 2003 and is in the process of determining the effect of
adoption on its consolidated financial statements.
In August 2001, the FASB issued SFAS No. 144 "Accounting for the Impairment
or Disposal of Long-Lived Assets" (SFAS No. 144). SFAS No. 144 provides new
guidance on the recognition of impairment losses on long-lived assets to be held
and used or to be disposed of and also broadens the definition of what
constitutes a discontinued operation and how the results of a discontinued
operation are to be measured and presented. SFAS No. 144 supercedes SFAS No. 121
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
Be Disposed Of" and Accounting Principles Board Opinion No. 30 (APB Opinion No.
30), while retaining many of the requirements of these two statements. Under
SFAS No. 144, assets held for sale that are a component of an entity will be
included in discontinued operations if the operations and cash flows will be or
have been eliminated from the ongoing operations of the entity and the entity
will not have any significant continuing involvement in the operations
prospectively. SFAS No. 144 is effective for fiscal years beginning after
December 15, 2001, with early adoption encouraged. SFAS No. 144 is not expected
to materially change the methods used by the Company to measure impairment
losses on long-lived assets, but may result in additional future dispositions
being reported as discontinued operations than is currently permitted. The
Company plans to adopt SFAS No. 144 on January 1, 2002.
(3) DERIVATIVE FINANCIAL INSTRUMENTS
Adoption of SFAS No. 133 "Accounting for Derivative Instruments and Hedging
Activities" as amended (SFAS No. 133) on January 1, 2001 resulted in an
after-tax increase in net income of $61 million and a cumulative after-tax
increase in accumulated other comprehensive loss of $252 million. The adoption
also increased current assets, long-term assets, current liabilities and
long-term liabilities by $703 million, $252 million, $805 million and $340
million, respectively, in the Company's Consolidated Balance Sheet. Due to the
adoption, the Company also reclassified $788 million related to the Company's
Zero-Premium Exchangeable Subordinated Notes (ZENS) from the current portion of
long-term debt to indexed debt securities derivative. During the nine months
ended September 30, 2001, losses of $145 million of the initial transition
adjustment recognized in other comprehensive income were realized in net income.
For additional information regarding the adoption of SFAS No. 133 and the
Company's accounting policies for derivative financial instruments, see Note 2
of Reliant Energy First Quarter 10-Q, which note is incorporated by reference
herein.
The application of SFAS No. 133 is still evolving as the FASB clears issues
submitted to the Derivatives Implementation Group for consideration. During the
second quarter of 2001, an issue that applies exclusively to the electric
industry and allows the normal purchases and normal sales exception for
option-type contracts if certain criteria are met was approved by the FASB with
an effective date of July 1, 2001. The adoption of this cleared guidance had no
impact on the Company's results of operations. One criteria of this previously
approved guidance was revised in October 2001 and will become effective on
January 1, 2002. The Company is currently in the process of determining the
effect of adoption of the revised guidance.
During the third quarter of 2001, the FASB cleared an issue related to
application of the normal purchases and normal sales exception to contracts that
combine forward and purchased option contracts. The effective date of this
guidance is April 1, 2002. The Company is currently assessing the impact of this
recently cleared issue and does not believe it will have a material impact on
the Company's consolidated financial statements.
Cash Flow Hedges. During the nine months ended September 30, 2001, the
amount of hedge ineffectiveness recognized in earnings from derivatives that are
designated and qualify as cash flow hedges was immaterial. No component of the
derivative instruments' gain or loss was excluded from the assessment of
effectiveness. During the
6
nine months ended September 30, 2001, there were no deferred gains or losses
recognized in earnings as a result of the discontinuance of cash flow hedges
because it was no longer probable that the forecasted transaction would occur.
As of September 30, 2001, current non-trading derivative assets and liabilities
and corresponding amounts in accumulated other comprehensive income are expected
to be reclassified into net income during the next twelve months.
Hedge of Net Investment in Foreign Subsidiaries. The Company has
substantially hedged its net investment in its European Energy segment through a
combination of Euro-denominated borrowings, foreign currency swaps and foreign
currency forward contracts. These are designed to reduce the Company's exposure
to changes in foreign currency rates. During the nine months ended September 30,
2001, the derivative and non-derivative instruments designated as hedging the
net investment in the Company's European Energy segment resulted in a loss of $3
million, which is included in the balance of the cumulative translation
adjustment.
Other Derivatives. Upon adoption of SFAS No. 133 effective January 1, 2001,
the Company's indexed debt securities obligations related to its ZENS obligation
were bifurcated into a debt component valued at $122 million and an embedded
derivative component valued at $788 million. Changes in the fair value of the
derivative component are recorded in the Company's Statements of Consolidated
Income. During the nine months ended September 30, 2001, the Company recorded a
$39 million gain associated with the fair value of the derivative component of
the indexed debt securities obligations. During the nine months ended September
30, 2001, the Company recorded a $44 million loss on the Company's investment in
AOL Time Warner Inc. common stock. Changes in the fair value of the Company's
Investment in AOL Time Warner Inc. common stock should substantially offset
changes in the fair value of the derivative component of the ZENS.
In December 2000, the Dutch parliament adopted legislation allocating to
the Dutch generation sector, including an indirect Dutch generating subsidiary
of the Company, Reliant Energy Power Generation Benelux N.V. (REPGB), previously
named N.V. UNA (UNA), financial responsibility for various stranded costs
contracts and other liabilities. The legislation became effective in all
material respects on January 1, 2001. In particular, the legislation allocated
to the Dutch generation sector, including REPGB, financial responsibility to
purchase electricity and gas under a gas supply contract and three electricity
contracts. These contracts are derivatives pursuant to SFAS No. 133. As of
September 30, 2001, the Company has recognized $138 million in short-term and
long-term non-trading derivative liabilities for REPGB's portion of these
stranded costs contracts. For additional information regarding REPGB's stranded
costs and the related indemnification by former shareholders of these stranded
costs, see Note 12(e).
(4) ACQUISITIONS
(a) Reliant Energy Mid-Atlantic Power Holdings, LLC.
On May 12, 2000, an indirect subsidiary of the Company purchased entities
owning electric power generating assets and development sites located in
Pennsylvania, New Jersey and Maryland having an aggregate net generating
capacity of approximately 4,262 megawatts (MW). With the exception of
development entities that were sold to another subsidiary of the Company in July
2000, the assets of the entities acquired are held by Reliant Energy
Mid-Atlantic Power Holdings, LLC (REMA). The purchase price for the May 2000
transaction was $2.1 billion, subject to post-closing adjustments which
management does not believe will be material. The Company accounted for the
acquisition as a purchase with assets and liabilities of REMA reflected at their
estimated fair values. The Company's fair value adjustments related to the
acquisition primarily included adjustments in property, plant and equipment, air
emissions regulatory allowances, materials and supplies inventory, environmental
reserves and related deferred taxes. The Company finalized these fair value
adjustments in May 2001. There were no additional material modifications to the
preliminary adjustments from December 31, 2000. For additional information
regarding the acquisition of REMA, see Note 3(a) to Reliant Energy 10-K Notes.
The Company's results of operations include the results of REMA only for
the period beginning May 12, 2000. The following table presents selected actual
financial information and pro forma information for the three and nine months
ended September 30, 2000, as if the acquisition had occurred on January 1, 2000.
Pro forma amounts also give effect to the sale and leaseback of interests in
three of the REMA generating plants, consummated in August 2000. For additional
information regarding sale and leaseback transactions, see Note 14(c) to Reliant
Energy 10-K Notes.
7
<Table>
<Caption>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, 2000 SEPTEMBER 30, 2000
------------------------------- -------------------------------
ACTUAL PRO FORMA ACTUAL PRO FORMA
--------------- --------------- --------------- ---------------
(IN MILLIONS, EXCEPT PER SHARE AMOUNTS)
Revenues............................................ $ 9,502 $ 9,502 $ 19,470 $ 19,636
Income from continuing operations................... 396 400 766 745
Net income attributable to common stockholders...... 389 393 746 725
Basic earnings per share............................ $ 1.36 $ 1.38 $ 2.62 $ 2.55
Diluted earnings per share.......................... $ 1.34 $ 1.36 $ 2.60 $ 2.53
</Table>
These pro forma results, based on assumptions deemed appropriate by the
Company's management, have been prepared for informational purposes only and are
not necessarily indicative of the amounts that would have resulted if the
acquisition of the REMA entities had occurred on January 1, 2000.
Purchase-related adjustments to the results of operations include the effects on
depreciation and amortization, interest expense and income taxes.
(b) Orion Power Holdings, Inc.
In September 2001, Reliant Resources and Orion Power Holdings, Inc. (Orion
Power) entered into a definitive merger agreement, under which Reliant Resources
agreed to acquire all of the outstanding shares of Orion Power for $26.80 per
share in cash in a transaction valued at approximately $2.9 billion. In the
merger, Reliant Resources will also assume approximately $1.8 billion of Orion
Power's net debt obligations. Orion Power is an independent electric power
generating company formed in March 1998 to acquire, develop, own and operate
power-generating facilities in the newly deregulated wholesale markets
throughout North America. Orion Power has 81 power plants currently in operation
with a total capacity of 5,644 MW and an additional 2,855 MW in construction and
various stages of development. The merger is conditioned upon approval by Orion
Power's shareholders and the receipt of certain regulatory approvals including
the Federal Trade Commission, the New York Public Service Commission and Federal
Energy Regulatory Commission (FERC).
(5) DISCONTINUED OPERATIONS
Effective December 1, 2000, Reliant Energy's Board of Directors approved a
plan to dispose of the Company's Latin American segment through sales of its
assets. Accordingly, the Company is reporting the results of its Latin American
segment as discontinued operations for all periods presented in the Interim
Financial Statements in accordance with APB Opinion No. 30. During the three
months ended March 31, 2001, the Company recorded an additional loss on disposal
of $7 million (after-tax) related to its Latin American segment. No additional
loss was recorded during the three months ended June 30, 2001 or September 30,
2001.
(6) DEPRECIATION AND AMORTIZATION
The Company's depreciation expense for the quarter and nine months ended
September 30, 2000 was $105 million and $291 million, respectively, compared to
$107 million and $307 million for the same periods in 2001. Goodwill
amortization related to acquisitions was $19 million and $61 million for the
quarter and nine months ended September 30, 2000, respectively, compared to $39
million and $81 million for the same periods in 2001. Other amortization
expense, including amortization of regulatory assets, was $169 million and $354
million for the quarter and nine months ended September 30, 2000, respectively,
compared to $140 million and $318 million for the same periods in 2001. In the
third quarter of 2001, the Company accelerated amortization of $19 million of
certain regulatory assets related to energy conservation management as required
by a Public Utility Commission of Texas (Texas Utility Commission) order dated
October 3, 2001.
In June 1998, the Texas Utility Commission issued an order approving a
transition to competition plan (Transition Plan) filed by Reliant Energy HL&P in
December 1997. For information regarding the additional depreciation of electric
utility generating assets and the redirection of transmission and distribution
(T&D) depreciation to generation assets under the Transition Plan, see Note 2(g)
to Reliant Energy 10-K Notes. In June 1999, the Texas legislature adopted the
Texas Electric Choice Plan (Legislation), which substantially amended the
regulatory structure governing electric utilities in Texas in order to allow
retail electric competition beginning on January 1, 2002. The Legislation
provides that depreciation expense for T&D related assets may be redirected to
generation assets from 1999 through 2001 for regulatory purposes. Because the
electric generation operations portion of Reliant Energy HL&P discontinued
application of SFAS No. 71 effective June 30, 1999, such operations can no
longer record additional or redirected depreciation for financial reporting
purposes. However, for regulatory purposes, the Company continues to redirect
T&D depreciation to generation assets. As of December 31, 2000 and
8
September 30, 2001, the cumulative amount of redirected depreciation for
regulatory purposes was $611 million and $783 million, respectively.
In 1999, the Company determined that approximately $800 million of Reliant
Energy HL&P's electric generation assets were impaired. The Legislation provides
for recovery of this impairment through regulated cash flows. Therefore, a
regulatory asset was recorded for an amount equal to the impairment in the
Company's Consolidated Balance Sheets. The Company amortizes this regulatory
asset as it is recovered from regulated cash flows. Amortization expense related
to the recoverable impaired plant costs was $135 million and $282 million for
the quarter and nine months ended September 30, 2000, respectively, compared to
$98 million and $221 million for the same periods in 2001. For additional
information regarding redirected and accelerated depreciation, please read Note
12(f).
(7) COMPREHENSIVE INCOME
The following table summarizes the components of total comprehensive
income:
<Table>
<Caption>
FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------------- ---------------------------
2000 2001 2000 2001
----------- ----------- ----------- -----------
(IN MILLIONS)
Net income attributable to common stockholders ..... $ 389 $ 290 $ 746 $ 826
Other comprehensive income (loss):
Foreign currency translation adjustments from
continuing operations .......................... (5) (79) (10) (74)
Foreign currency translation adjustments from
discontinued operations ........................ (10) -- (33) --
Additional minimum non-qualified pension
liability adjustment ........................... -- (3) -- (2)
Cumulative effect of adoption of SFAS No. 133 .... -- -- -- (252)
Net deferred (loss) gain from cash flow hedges ... -- (21) -- 427
Reclassification of net deferred gain from cash
flow hedges realized in net income ............. -- (127) -- (44)
Unrealized (loss) gain on available-for-sale
securities ..................................... (2) (3) -- 10
Reclassification adjustment for impairment loss
on available-for-sale securities realized in
net income ..................................... 3 -- 17 --
----------- ----------- ----------- -----------
Comprehensive income ............................... $ 375 $ 57 $ 720 $ 891
=========== =========== =========== ===========
</Table>
(8) SHORT-TERM BORROWINGS
As of September 30, 2001, the Company had credit facilities, which included
the facilities of various financing subsidiaries, Reliant Resources, REPGB and
RERC Corp., with financial institutions which provide for an aggregate of $8.7
billion in committed credit, of which $4.1 billion was unused. As of September
30, 2001, borrowings of $3.9 billion were outstanding or supported under these
credit facilities of which $0.9 billion were classified as long-term debt, based
on availability of committed credit with expiration dates exceeding one year and
management's intention to maintain these borrowings in excess of one year.
Various credit facilities aggregating $2.3 billion may be used for letters of
credit of which $0.7 billion were outstanding as of September 30, 2001. Interest
rates on borrowings are based on the London interbank offered rate (LIBOR) plus
a margin, Euro interbank deposits plus a margin, a base rate or a rate
determined through a bidding process. Credit facilities aggregating $3.1 billion
are unsecured. The credit facilities contain covenants and requirements that
must be met to borrow funds and obtain letters of credit, as applicable. Such
covenants are not anticipated to materially restrict the borrowers from
borrowing funds or obtaining letters of credit, as applicable, under such
facilities. As of September 30, 2001, the borrowers are in compliance with the
covenants under all of these credit agreements.
9
(9) EARNINGS PER SHARE
The following table presents Reliant Energy's basic and diluted earnings
per share (EPS) calculation:
<Table>
<Caption>
FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------------- -------------------------------
2000 2001 2000 2001
------------- ------------- ------------- -------------
(IN MILLIONS, EXCEPT SHARE AND
PER SHARE AMOUNTS)
Basic EPS Calculation:
Income from continuing operations .................... $ 396 $ 290 $ 766 $ 772
Loss from discontinued operations, net of tax ........ (7) -- (27) --
Loss on disposal of discontinued operations, net
of tax ............................................. -- -- -- (7)
Extraordinary item ................................... -- -- 7 --
Cumulative effect of accounting change, net of tax ... -- -- -- 61
------------- ------------- ------------- -------------
Net income attributable to common stockholders ....... $ 389 $ 290 $ 746 $ 826
============= ============= ============= =============
Weighted average shares outstanding .................... 285,183,000 290,318,000 284,170,000 289,143,000
============= ============= ============= =============
Basic EPS:
Income from continuing operations .................... $ 1.38 $ 1.00 $ 2.68 $ 2.67
Loss from discontinued operations, net of tax ........ (0.02) -- (0.09) --
Loss on disposal of discontinued operations, net
of tax ............................................. -- -- -- (0.03)
Extraordinary item ................................... -- -- 0.03 --
Cumulative effect of accounting change, net of tax ... -- -- -- 0.22
------------- ------------- ------------- -------------
Net income attributable to common stockholders ....... $ 1.36 $ 1.00 $ 2.62 $ 2.86
============= ============= ============= =============
Diluted EPS Calculation:
Net income attributable to common stockholders ....... $ 389 $ 290 $ 746 $ 826
Plus: Income impact of assumed conversions:
Interest on 61/4% convertible trust preferred
securities ......................................... -- -- -- --
------------- ------------- ------------- -------------
Total earnings effect assuming dilution .............. $ 389 $ 290 $ 746 $ 826
============= ============= ============= =============
Weighted average shares outstanding .................... 285,183,000 290,318,000 284,170,000 289,143,000
Plus: Incremental shares from assumed conversions(1):
Stock options ...................................... 3,595,000 1,147,000 1,837,000 1,942,000
Restricted stock ................................... 807,000 733,000 807,000 733,000
6 1/4% convertible trust preferred securities ...... 14,000 14,000 14,000 14,000
------------- ------------- ------------- -------------
Weighted average shares assuming dilution ............ 289,599,000 292,212,000 286,828,000 291,832,000
============= ============= ============= =============
Diluted EPS:
Income from continuing operations .................... $ 1.36 $ 0.99 $ 2.66 $ 2.65
Loss from discontinued operations, net of tax ........ (0.02) -- (0.09) --
Loss on disposal of discontinued operations, net
of tax ............................................. -- -- -- (0.03)
Extraordinary item ................................... -- -- 0.03 --
Cumulative effect of accounting change, net of tax ... -- -- -- 0.21
------------- ------------- ------------- -------------
Net income attributable to common stockholders ....... $ 1.34 $ 0.99 $ 2.60 $ 2.83
============= ============= ============= =============
</Table>
- ----------
(1) For the three months ended September 30, 2001, the computation of diluted
EPS excludes 2,319,488 purchase options for shares of common stock that
have exercise prices (ranging from $31.73 to $50.00 per share) greater than
the per share average market price for the period and would thus be
anti-dilutive if exercised.
For the nine months ended September 30, 2000 and 2001, the computation of
diluted EPS excludes 485,119 and 2,005,338 purchase options, respectively,
for shares of common stock that have exercise prices (ranging from $28.72
to $32.22 per share and $39.53 to $50.00 per share for the first nine
months of 2000 and 2001, respectively) greater than the per share average
market price for the period and would thus be anti-dilutive if exercised.
(10) CAPITAL STOCK
Common Stock. Reliant Energy has 700,000,000 authorized shares of common
stock. At December 31, 2000, 299,914,791 shares of Reliant Energy common stock
were issued and 286,464,709 shares of Reliant Energy
10
common stock were outstanding. At September 30, 2001, 302,533,344 shares of
Reliant Energy common stock were issued and 290,723,264 shares of Reliant Energy
common stock were outstanding. Outstanding common shares exclude (a) shares
pledged to secure a loan to Reliant Energy's Employee Stock Ownership Plan
(8,638,889 and 7,298,389 at December 31, 2000 and September 30, 2001,
respectively) and (b) treasury shares (4,811,193 and 4,511,691 at December 31,
2000 and September 30, 2001, respectively). Reliant Energy declared dividends of
$0.375 per share in the third quarter of 2000 and 2001 and $1.125 per share in
the first nine months of 2000 and 2001.
During the nine months ended September 30, 2001, Reliant Energy issued
300,000 shares of Reliant Energy common stock out of its treasury stock. As of
September 30, 2001, Reliant Energy was authorized to purchase up to $271 million
of Reliant Energy common stock under its stock repurchase program.
(11) TRUST PREFERRED SECURITIES
(a) Reliant Energy.
Statutory business trusts created by Reliant Energy have issued trust
preferred securities, the terms of which, and the related series of junior
subordinated debentures, are described below (in millions):
<Table>
<Caption>
AGGREGATE LIQUIDATION
AMOUNT
---------------------------- MANDATORY
DECEMBER 31, SEPTEMBER 30, DISTRIBUTION RATE/ REDEMPTION DATE/ JUNIOR SUBORDINATED
TRUST 2000 2001 INTEREST RATE MATURITY DATE DEBENTURES
- ---------------------- ------------ ------------- ------------------ -------------- -----------------------------
REI Trust I $ 375 $ 375 7.20% March 2048 7.20% Junior Subordinated
Debentures due 2048
HL&P Capital Trust I $ 250 $ 250 8.125% March 2046 8.125% Junior Subordinated
Deferrable Interest
Debentures Series A
HL&P Capital Trust II $ 100 $ 100 8.257% February 2037 8.257% Junior Subordinated
Deferrable Interest
Debentures Series B
</Table>
For additional information regarding the $625 million of preferred
securities and the $100 million of capital securities, see Note 11 to Reliant
Energy 10-K Notes. The sole asset of each trust consists of junior subordinated
debentures of Reliant Energy having interest rates and maturity dates
corresponding to each issue of preferred or capital securities, and the
principal amounts corresponding to the common and preferred or capital
securities issued by that trust.
(b) RERC Corp.
A statutory business trust created by RERC Corp. has issued convertible
trust preferred securities, the terms of which, and the related series of
convertible junior subordinated debentures, are described below (in millions):
<Table>
<Caption>
AGGREGATE LIQUIDATION
AMOUNT
---------------------------- MANDATORY
DECEMBER 31, SEPTEMBER 30, DISTRIBUTION RATE/ REDEMPTION DATE/ JUNIOR SUBORDINATED
TRUST 2000 2001 INTEREST RATE MATURITY DATE DEBENTURES
- ---------------------- ------------ ------------- ------------------ ---------------- -----------------------------
Resources Trust $ 1 $ 1 6.25% June 2026 6.25% Convertible Junior
Subordinated Debentures due
2026
</Table>
For additional information regarding the convertible preferred securities,
see Note 11 to Reliant Energy 10-K Notes and Note 6 to RERC Corp. 10-K Notes.
The sole asset of the trust consists of convertible junior subordinated
debentures of RERC Corp. having an interest rate and maturity date corresponding
to the convertible preferred securities, and the principal amount corresponding
to the common and convertible preferred securities issued by the trust.
11
(12) COMMITMENTS, CONTINGENCIES AND REGULATORY MATTERS
(a) Legal Matters.
Reliant Energy HL&P Municipal Franchise Fee Lawsuits. In February 1996, the
cities of Wharton, Galveston and Pasadena filed suit, for themselves and a
proposed class of all similarly situated cities in Reliant Energy HL&P's service
area, against Reliant Energy and Houston Industries Finance, Inc. (formerly a
wholly owned subsidiary of Reliant Energy) alleging underpayment of municipal
franchise fees. Plaintiffs claim that they are entitled to 4% of all receipts of
any kind for business conducted within these cities over the previous four
decades. Because the franchise ordinances at issue affecting Reliant Energy HL&P
expressly impose fees only on its own receipts and only from sales of
electricity for consumption within a city, the Company regards all of
plaintiffs' allegations as spurious and is vigorously contesting the case. The
plaintiffs' pleadings asserted that their damages exceeded $250 million. The
269th Judicial District Court for Harris County granted partial summary judgment
in favor of Reliant Energy dismissing all claims for franchise fees based on
sales tax collections. Other motions for partial summary judgment were denied. A
six-week jury trial of the original claimant cities (but not the class of
cities) ended on April 4, 2000 (Three Cities case). Although the jury found for
Reliant Energy on many issues, they found in favor of the original claimant
cities on three issues, and assessed a total of $4 million in actual and $30
million in punitive damages. However, the jury also found in favor of Reliant
Energy on the affirmative defense of laches, a defense similar to a statute of
limitations defense, due to the original claimant cities having unreasonably
delayed bringing their claims during the 43 years since the alleged wrongs
began.
The trial court in the Three Cities case granted most of Reliant Energy's
motions to disregard the jury's findings. The trial court's rulings reduced the
judgment to $1.7 million, including interest, plus an award of $13.7 million in
legal fees. In addition, the trial court granted Reliant Energy's motion to
decertify the class and vacated its prior orders certifying a class. Following
this ruling, 45 cities filed individual suits against Reliant Energy in the
District Court of Harris County.
The extent to which issues in the Three Cities case may affect the claims
of the other cities served by Reliant Energy HL&P cannot be assessed until
judgments are final and no longer subject to appeal. However, the trial court's
rulings disregarding most of the jury's findings are consistent with Texas
Supreme Court opinions over the past decade. The Company estimates the range of
possible outcomes for the plaintiffs to be between zero and $17 million
inclusive of interest and attorneys' fees.
The Three Cities case has been appealed. The Company believes that the $1.7
million damage award resulted from serious errors of law and that it will be set
aside by the Texas appellate courts. In addition, the Company believes that
because of an agreement between the parties limiting fees to a percentage of the
damages, reversal of the award of $13.7 million in attorneys' fees in the Three
Cities case is probable.
California Wholesale Market. Reliant Energy, Reliant Energy Services, Inc.
(a wholly owned subsidiary of Reliant Resources), Reliant Energy Power
Generation, Inc. (a wholly owned subsidiary of Reliant Resources) and several
other subsidiaries of Reliant Resources, as well as three officers of some of
these companies, have been named as defendants in class action lawsuits and
other lawsuits filed against a number of companies that own generation plants in
California and other sellers of electricity in California markets. Pursuant to
the terms of the master separation agreement between Reliant Energy and Reliant
Resources (see Note 4(b) to Reliant Energy 10-K Notes), Reliant Resources has
agreed to indemnify Reliant Energy for any damages arising under these lawsuits
and may elect to defend these lawsuits at Reliant Resources' own expense. Three
of these lawsuits were filed in the Superior Court of the State of California,
San Diego County; two were filed in the Superior Court in San Francisco County;
and one was filed in the Superior Court of Los Angeles County. While the
plaintiffs allege various violations by the defendants of state antitrust laws
and state laws against unfair and unlawful business practices, each of the
lawsuits is grounded on the central allegation that defendants conspired to
drive up the wholesale price of electricity. In addition to injunctive relief,
the plaintiffs in these lawsuits seek treble the amount of damages alleged,
restitution of alleged overpayments, disgorgement of alleged unlawful profits
for sales of electricity, costs of suit and attorneys' fees. In one of the
cases, the plaintiffs allege aggregate damages of over $4 billion. Although
defendants removed all of these cases to federal court, five of the six cases
were remanded back to state court and the parties stipulated to remanding the
sixth case.
12
In August 2001, plaintiffs and defendants filed petitions to coordinate the
remanded state court cases with plaintiffs seeking coordination in San Francisco
Superior Court and defendants seeking coordination in San Diego Superior Court.
On September 21, 2001, pursuant to a stipulated briefing schedule, defendants
served plaintiffs with their joint demurrer, motion to stay and motion to
strike, which are premised in part on federal preemption and the filed rate
doctrine (the filed rate doctrine bars all claims, both state and federal, that
attempt to challenge a rate that a federal agency has reviewed and approved). On
October 12, 2001, San Diego Superior Court Judge Janis Sammartino, the judge
assigned to hear the coordination petitions, stayed all the actions pending a
decision on coordination. Plaintiffs have voluntarily dismissed Reliant Energy
from two of the three class actions in which it was named as a defendant.
Plaintiffs have also voluntarily dismissed RERC Corp. from the one action in
which it was named as a defendant. The ultimate outcome of the lawsuits cannot
be predicted with any degree of certainty at this time. However, the Company
believes, based on its analysis to date of the claims asserted in these lawsuits
and the underlying facts, that resolution of these lawsuits will not have a
material adverse effect on the Company's financial condition, results of
operations or cash flows.
(b) Environmental Matters.
Clean Air Standards. The Company has participated in a lawsuit against the
Texas Natural Resource Conservation Commission (TNRCC) regarding the limitation
of the emission of oxides of nitrogen (NOx) in the Houston area. A settlement of
the lawsuit was reached with the TNRCC in the second quarter of 2001 and revised
emissions limitations were adopted by the TNRCC in the third quarter of 2001.
The revised limitations provide for an increase in allowable NOx emissions,
compared to the original TNRCC requirements, through 2004. Further emission
reduction requirements may or may not be required through 2007, depending upon
the outcome of further investigations of regional air quality issues. To achieve
the TNRCC NOx reduction requirements, the Company anticipates investing up to
$738 million in capital and other special project expenditures by 2004, and
potentially up to an additional $93 million between 2004 and 2007. The Texas
electric restructuring law provides for stranded cost recovery for expenditures
incurred before May 1, 2003 to achieve the NOx reduction requirements.
Manufactured Gas Plant Sites. RERC and its predecessors operated a
manufactured gas plant (MGP) adjacent to the Mississippi River in Minnesota,
formerly known as Minneapolis Gas Works (MGW) until 1960. RERC has substantially
completed remediation of the main site other than ongoing water monitoring and
treatment. The manufactured gas was stored in separate holders. RERC is
negotiating clean-up of one such holder. There are six other former MGP sites in
the Minnesota service territory. Remediation has been completed on one site. Of
the remaining five sites, RERC believes that two were neither owned nor operated
by RERC. RERC believes it has no liability with respect to the sites it neither
owned nor operated.
At September 30, 2001, RERC had accrued $17 million for remediation of the
Minnesota sites. At September 30, 2001, the estimated range of possible
remediation costs was $8 million to $36 million. The cost estimates of the MGW
site are based on studies of that site. The remediation costs for the other
sites are based on industry average costs for remediation of sites of similar
size. The actual remediation costs will be dependent upon the number of sites
remediated, the participation of other potentially responsible parties, if any,
and the remediation methods used.
Issues relating to the identification and remediation of MGPs are common in
the natural gas distribution industry. RERC has received notices from the United
States Environmental Protection Agency and others regarding its status as a
potentially responsible party (PRP) for other sites. Based on current
information, RERC has not been able to quantify a range of environmental
expenditures for potential remediation expenditures with respect to other MGP
sites.
Other Minnesota Matters. At September 30, 2001, RERC had recorded accruals
of $4 million (with a maximum estimated exposure of approximately $17 million at
September 30, 2001) for other environmental matters in Minnesota for which
remediation may be required.
Mercury Contamination. The Company's pipeline and distribution operations
have in the past employed elemental mercury in measuring and regulating
equipment. It is possible that small amounts of mercury may have been spilled in
the course of normal maintenance and replacement operations and that these
spills may have contaminated the immediate area with elemental mercury. The
Company has found this type of contamination at some sites in the past, and the
Company has conducted remediation at these sites. It is possible that other
contaminated sites may exist and that remediation costs may be incurred for
these sites. Although the total amount of these costs cannot be known at this
time, based on experience of the Company and that of others in the natural gas
industry to date and on the current regulations regarding remediation of these
sites, the Company believes that the
13
costs of any remediation of these sites will not be material to the Company's
financial condition, results of operations or cash flows.
REMA Ash Disposal Site Closures and Site Contaminations. Under the
agreement to acquire REMA (see Note 3(a) to Reliant Energy 10-K Notes), the
Company became responsible for liabilities associated with ash disposal site
closures and site contamination at the acquired facilities in Pennsylvania and
New Jersey prior to a plant closing, except for the first $6 million of
remediation costs at the Seward generating station. A prior owner retained
liabilities associated with the disposal of hazardous substances to off-site
locations prior to November 24, 1999. As of September 30, 2001, REMA has
liabilities associated with six ash disposal site closures and six site
investigations and environmental remediations. The Company has recorded its
estimate of these environmental liabilities in the amount of $36 million as of
September 30, 2001. The Company expects approximately $13 million will be paid
over the next five years.
REPGB Asbestos Abatement and Soil Remediation. Prior to the Company's
acquisition of REPGB (see Note 3(b) to Reliant Energy 10-K Notes), REPGB had a
$23 million obligation primarily related to asbestos abatement, as required by
Dutch law, and soil remediation at six sites. During 2000, the Company initiated
a review of potential environmental matters associated with REPGB's properties.
REPGB began remediation in 2000 of the properties identified to have exposed
asbestos and soil contamination, as required by Dutch law and the terms of some
leasehold agreements with municipalities in which the contaminated properties
are located. All remediation efforts are expected to be fully completed by 2005.
As of September 30, 2001, the estimated undiscounted liability for this asbestos
abatement and soil remediation was $20 million.
Other. From time to time, the Company has received notices from regulatory
authorities or others regarding its status as a PRP in connection with sites
found to require remediation due to the presence of environmental contaminants.
In addition, the Company has been named as a defendant in litigation related to
such sites and in recent years has been named, along with numerous others, as a
defendant in several lawsuits filed by a large number of individuals who claim
injury due to exposure to asbestos while working at sites along the Texas Gulf
Coast. Most of these claimants have been workers who participated in
construction of various industrial facilities, including power plants, and some
of the claimants have worked at locations owned by the Company. The Company
anticipates that additional claims like those received may be asserted in the
future and intends to continue vigorously contesting claims that it does not
consider to have merit. Although their ultimate outcome cannot be predicted at
this time, the Company does not believe, based on its experience to date, that
these matters, either individually or in the aggregate, will have a material
adverse effect on the Company's financial condition, results of operations or
cash flows.
(c) Other Legal and Environmental Matters.
The Company is involved in other legal, environmental, tax and regulatory
proceedings before various courts, regulatory commissions and governmental
agencies regarding matters arising in the ordinary course of business. Some of
these proceedings involve substantial amounts. The Company's management
regularly analyzes current information and, as necessary, provides accruals for
probable liabilities on the eventual disposition of these matters. The Company's
management believes that the disposition of these matters will not have a
material adverse effect on the Company's financial condition, results of
operations or cash flows.
(d) California Wholesale Market Uncertainty.
Receivables. During the summer and fall of 2000, and continuing into early
2001, prices for wholesale electricity in California increased dramatically as a
result of a combination of factors, including higher natural gas prices and
emission allowance costs, reduction in available hydroelectric generation
resources, increased demand, decreased net electric imports, structural market
flaws including over-reliance on the electric spot market, and limitations on
supply as a result of maintenance and other outages. Although wholesale prices
increased, California's deregulation legislation kept retail rates frozen below
1996 levels until rates were raised by the California Public Utilities
Commission (CPUC) early in 2001.
Due to the disparity between wholesale and retail rates, the credit ratings
of two of California's public utilities, Pacific Gas and Electric (PG&E) and
Southern California Edison Company (SCE), have fallen below investment grade.
Additionally, PG&E filed for protection under the bankruptcy laws on April 6,
2001. As a result, PG&E and SCE are no longer considered creditworthy and
therefore cannot directly purchase power from third-party suppliers through the
California Independent System Operator (Cal ISO) to serve their short load.
Pursuant to emergency legislation enacted by the California Legislature, the
California Department of Water Resources (CDWR) has
14
negotiated and purchased power through short- and long-term contracts on behalf
of PG&E and SCE to meet their net short loads. However, the CDWR disputes its
direct liability for some of the power obtained from third-party suppliers
including the Company to serve the utilities' net short load. Also, the CDWR has
not been billed by, nor made payments to, the Cal ISO for real-time
transactions. The issue of CDWR's liability for amounts supplied to cover the
utilities' short load, as well as the issue of the Cal ISO's compliance with
certain FERC orders are currently before the FERC. Pursuant to the April 26,
2001 FERC order described below, generators in California are required to offer
all their available capacity for sale in the real-time market. These types of
sales have thus far been nominal and have not materially increased the Company's
receivables balances. However, these sales to the Cal ISO are being made without
adequate assurance of a creditworthy counterparty despite numerous FERC orders
requiring such. The Company and other parties have filed with the FERC seeking
to compel enforcement of these orders and the Cal ISO tariff. On November 7,
2001, the FERC issued an order finding that the Cal ISO is in violation of its
tariff and the creditworthiness orders previously issued by the FERC. The FERC
ordered the Cal ISO to enforce the creditworthiness requirements in its tariff
and to invoice the CDWR within 15 days for the purchases made to meet the net
short position of PG&E and SCE. If the Cal ISO does not comply with this order,
the FERC stated it would seek an injunction to enforce its creditworthiness
orders.
In addition, certain contracts intended to serve as collateral for sales to
the California Power Exchange (Cal PX) were seized by California Governor Gray
Davis on February 2 and 5, 2001. The Ninth Circuit Court of Appeals subsequently
ruled that Governor Davis' seizure of these contracts was wrongful. The Company
has filed a lawsuit, currently pending in California, to require the State of
California to compensate it for the seizure of these contracts. If successful in
this action, the Company (either directly or through the Cal PX) would realize
money from these contracts that could reduce, or perhaps eliminate, the level of
receivables due to the Company from the Cal PX. However, the timing and ultimate
resolution of these claims is uncertain at this time.
On September 20, 2001, PG&E filed a Plan of Reorganization and an
accompanying disclosure statement with the bankruptcy court. Under this plan,
PG&E purports to pay all allowed creditor claims in full, through a combination
of cash and long-term notes. Components of the plan will require the approval of
the FERC, the SEC and the Nuclear Energy Regulatory Commission, in addition to
the bankruptcy court. PG&E has stated it seeks to have this plan confirmed by
December 31, 2002.
On October 5, 2001, a federal district court in California entered a
stipulated judgment approving a settlement between SCE and the CPUC in an action
brought by SCE regarding the recovery of its wholesale power costs under the
filed rate doctrine. Under the stipulated judgment, a rate increase approved
earlier this year will remain in place until the earlier of SCE recovering $3.3
billion or December 31, 2002. After that date, the CPUC will review the
sufficiency of retail rates through December 31, 2005. The stipulated judgment
includes no provision relating to payments to SCE's creditors, although SCE has
stated its intention to use the settlement to fund the repayment of its
creditors.
As of December 31, 2000, the Company was owed a total of $282 million by
the Cal PX and the Cal ISO. As of September 30, 2001, the Company was owed a
total of $338 million by the Cal ISO, the Cal PX, the CDWR, and California
Energy Resources Scheduling for energy sales in the California wholesale market
during the fourth quarter of 2000 through September 30, 2001. As of September
30, 2001, the Company had a pre-tax provision of $75 million against receivable
balances related to energy sales in the California market, including $36 million
recorded in the first nine months of 2001. Management will continue to assess
the collectability of these receivables based on further developments affecting
the California electricity market and the market participants described herein.
FERC Market Mitigation. In response to the filing of a number of complaints
challenging the level of wholesale prices, the FERC initiated a staff
investigation and issued a number of orders from December 15, 2000, through
April 26, 2001 implementing a series of wholesale market reforms. Under these
orders, for the period January 1, 2001 through June 19, 2001, approximately $20
million of the $149 million charged by the Company for sales in California to
the Cal ISO and the Cal PX were identified as being subject to possible refunds.
This amount is subject to review and adjustment based on the pending refund
proceeding described below. During the second quarter of 2001, the Company
accrued refunds of $15 million, $3 million of which had been previously reserved
in the first quarter of 2001. See "--FERC Refunds" below.
On April 26, 2001, the FERC issued an order replacing the previous price
review procedures and establishing a market monitoring and mitigation plan,
effective on May 29, 2001, for the California markets. The plan retains a
"breakpoint" approach to price mitigation, for bids in the real-time market
during periods when power reserves fall below 7.5% (i.e., Stages 1, 2 and 3
emergencies in the Cal ISO). The Cal ISO is instructed to use data submitted
15
confidentially by gas-fired generators in California and daily indices of
natural gas and emissions allowance costs to establish the market-clearing price
in real-time based on the marginal cost of the highest-cost generator called to
run. The plan also requires generators in California to offer all their
available capacity for sale in the real-time market, and conditions sellers'
market-based rate authority such that sellers violating certain conditions on
their bids will be subject to increased scrutiny by the FERC, potential refunds
and even revocation of their market-based rate authority.
On June 19, 2001, the FERC issued an order modifying the market monitoring
and mitigation plan adopted in its April 26 order, to apply price controls to
all hours, instead of just hours of low operating reserve, and to extend the
mitigation measures to other Western states (Arizona, Colorado, Idaho, Montana,
Nevada, New Mexico, Oregon, Utah, Washington and Wyoming) in addition to
California. The proxy market clearing price calculated by the Cal ISO will apply
during reserve deficiencies to all sales in the Cal ISO and Western spot
markets. In non-emergency hours in California, the maximum price in California
and the other Western states will be capped at 85% of the highest Cal ISO hourly
market clearing price established during the hours when the last Stage 1
emergency was in effect. Sellers other than marketers will be allowed to bid
higher than the maximum prices, but such bids are subject to justification and
potential refund. Justification of higher prices is limited to establishing
higher actual gas costs than the proxy calculation averages if conditions or
natural gas markets change significantly.
The modified monitoring and mitigation plan went into effect June 20, 2001,
and will terminate on September 30, 2002, covering two summer peak seasons, or
approximately 16 months. The Company believes that while the mitigation plan
will reduce volatility in the market, assuming the credit issues described above
are addressed, the Company will nevertheless be able to profitably operate its
facilities in the West because the proxy market clearing price is based on the
heat rate of the least efficient unit on-line during each hour. Additionally, as
noted above, the mitigation plan allows sellers, such as the Company, to justify
prices above the proxy price. Finally, any adverse impacts of the mitigation
plan on the Company's operations would be mitigated, in part, by the Company's
forward hedging activities. The FERC set July 2, 2001 as the refund effective
date for sales subject to the price mitigation plan throughout the West. This
means that transactions after that date may be subject to refund if found to be
unjust or unreasonable.
FERC Refunds. The FERC issued an order on July 25, 2001 adopting a refund
methodology and initiating an expedited hearing schedule to determine (1)
retroactive mitigated prices for each hour from October 2, 2000 through June 20,
2001; (2) the amount owed in refunds by each supplier according to the
methodology (these amounts may be in addition to or in place of the refund
amounts previously determined under the March 9, 2001 order); and (3) the amount
currently owed to each supplier. The amounts of any refunds will be determined
by the end of the expedited hearing process, which is scheduled to result in a
recommendation to the FERC commissioners by the Administrative Law Judge
assigned to the case by March 8, 2002. The Company has not reserved any amounts
for potential future refunds under the July 25, 2001 order, nor can it currently
predict the amount of these potential refunds, if any, because the methodology
used to calculate these refunds is dependent on information that is currently
unknown and still subject to review and challenge in the hearing process. Any
refunds that are determined in the FERC proceeding will be offset against unpaid
amounts owed to the Company for its prior sales.
Other Investigations. In addition to the FERC investigation discussed
above, several state and other federal regulatory investigations and complaints
have commenced in connection with the wholesale electricity prices in California
and other neighboring Western states to determine the causes of the high prices
and potentially to recommend remedial action. In California, the California
State Senate and the California Office of the Attorney General have separate
ongoing investigations into the high prices and their causes. Neither of these
investigations has been completed and no findings have been made in connection
with either of them. However, adverse findings or rulings could result in
punitive legislation, sanctions, fines or even criminal charges against the
Company or its employees. The Company is cooperating with both investigations
and has produced a substantial amount of information requested in subpoenas
issued by each body. The Washington and Oregon attorneys general have also begun
similar investigations.
Legislative Efforts. Since the inception of the California energy crisis,
various pieces of legislation have been introduced in the U.S. Congress and the
California Legislature addressing several issues related to the increase in
wholesale power prices in 2000 and 2001. For example, a bill was introduced in
the California Legislature that would have created a "windfall profits" tax on
wholesale electricity sales. To date, only a few energy-related bills have
passed and the Company does not believe that the legislation that has been
enacted to date on these issues will have a material adverse effect on the
Company. However, it is possible that legislation could be enacted on either the
state or federal level that could have a material adverse effect on the
Company's financial condition, results of operations and cash flows.
16
(e) Indemnification of Dutch Stranded Costs.
In January 2001, the Dutch Electricity Production Sector Transitional
Arrangements Act (Transition Act) became effective. The Transition Act, among
other things, allocated to REPGB and the three other Dutch generation companies,
a share of the assets, liabilities and stranded cost commitments of BV
Nederlands Elektriciteit Administratiekantoor (formerly, N.V. Samenwerkende
elecktriciteits-produktiebedrijven (SEP)). Prior to the enactment of the
Transition Act, SEP acted as the national electricity pooling and coordinating
body for the generation output of REPGB and the three other national Dutch
generation companies. REPGB and the three other Dutch generation companies are
shareholders of SEP.
The Transition Act and related agreements specify that REPGB has a 22.5%
share of SEP's assets, liabilities and stranded cost commitments. SEP's stranded
cost commitments consisted primarily of various uneconomical or stranded costs
investments and long-term gas supply and power contracts entered into prior to
the liberalization of the Dutch wholesale electricity market. SEP's primary
asset is its ownership interest in the Dutch national grid company, which was
sold to the Dutch government on October 25, 2001 for approximately NLG 2.6
billion (approximately $1.1 billion based on an exchange rate of 2.42 NLG per
U.S. dollar as of September 30, 2001). Under the Transition Act, REPGB can
either assume its 22.5% allocated interest in the contracts or, subject to the
terms of the contracts, sell its interests to third parties.
The Transition Act, as enacted, provided that, subject to the approval of
the European Commission, the Dutch government will provide financial
compensation to the Dutch generation companies, including REPGB, for certain
liabilities associated with long-term district heating contracts entered into by
the generation companies with various municipalities. In July 2001, the European
Commission ruled that under certain conditions the Dutch government can provide
financial compensation to the generation companies for the district heating
contracts. However, at this point, it is unclear what the timing of this
compensation will be or what form it will take. To the extent that this
compensation is not ultimately provided to the generation companies by the Dutch
government, REPGB will collect its compensation directly from the former
shareholders as further discussed below.
The former shareholders have agreed pursuant to a share purchase agreement
to indemnify REPGB for up to NLG 1.9 billion in stranded cost liabilities
(approximately $785 million based on an exchange rate of 2.42 NLG per U.S.
dollar as of September 30, 2001). The indemnity obligation of the former
shareholders and various provincial and municipal entities (including the city
of Amsterdam), is secured by a NLG 900 million escrow account (approximately
$372 million based on an exchange rate of 2.42 NLG per U.S. dollar as of
September 30, 2001). Pursuant to SFAS No. 133, the gas and electric contracts
are marked to market. As of September 30, 2001, the Company has recorded a
liability of $362 million for its stranded cost gas and electric and district
heating commitments. In addition, the Company recorded a corresponding asset of
equal amount for the indemnification of this obligation from REPGB's former
shareholders and the Dutch government. The estimate of stranded cost liability
is based on a number of assumptions, many of which are contingent upon the
outcome of future events, such as fuel and energy prices, that are not known at
this time. The actual amount of the ultimate stranded cost liability may be
greater or smaller depending on the outcome of these assumptions.
To date, the Company has filed indemnity claims totaling of NLG 95 million
(approximately $39 million at an exchange rate of 2.42 NLG per U.S. dollar as of
September 30, 2001) for stranded cost liabilities associated with the district
heating and gas and electricity contract losses incurred during the first and
second quarters of 2001. The former shareholders have so far rejected REPGB's
indemnity claims and in response, the Company has initiated arbitration
proceedings against the former shareholders. The Company believes that the
rejection of its indemnity claims is without merit and intends to vigorously
pursue its claims against the former shareholders.
During the second quarter of 2001, the Company recorded a $51 million
pre-tax gain (NLG 125 million) recorded as equity income for the preacquisition
gain contingency related to the acquisition of REPGB for the value of its equity
investment in SEP. This gain was based on the Company's evaluation of SEP's
financial position and fair value. Pursuant to the purchase agreement of REPGB,
as amended, REPGB is entitled to a NLG 125 million (approximately $51 million)
dividend from SEP with any remainder owing to the former shareholders.
(f) Reliant Energy HL&P Rate Matters.
The Texas Utility Commission issued a final order on October 3, 2001 that
establishes the rates that will become effective when retail choice begins in
2002. In this final order, Reliant Energy HL&P is required to reverse the amount
of redirected depreciation and accelerated depreciation allowed under the
Transition Plan and the
17
Legislation. The Texas Utility Commission determined that the utility had
overmitigated its stranded costs. The Company disagrees with certain positions
prescribed in the order by the Texas Utility Commission. Motions for Rehearing
were filed by the Company with the Texas Utility Commission on October 23, 2001
and the Company will determine future action based on the Texas Utility
Commission's response to these motions. Reliant Energy HL&P also filed an amicus
brief on September 24, 2001 at the Texas Supreme Court supporting Texas
Utilities Company's Petition for Writ of Mandamus challenging these same issues.
At September 30, 2001, cumulative redirected depreciation and cumulative
accelerated depreciation for regulatory purposes totaled $783 million and
approximately $1.1 billion, respectively. Implementing the reversal of
redirected depreciation would result in lower rates for the transmission and
distribution utility, and the accelerated depreciation being returned through
credits over seven years would serve as reductions to the transmission and
distribution utility's non-bypassable charges. The annual impact to earnings for
the reversal of redirected depreciation would be approximately $36 million
after-tax, while the return of accelerated depreciation is not expected to
impact earnings. The annual cash flow impact would be approximately $225
million. The credits related to accelerated depreciation will become effective
beginning with retail choice. For information regarding redirected depreciation
and accelerated depreciation, see Note 4(a) to Reliant Energy 10-K Notes.
(g) Construction Agency Agreement.
In April 2001, Reliant Resources, through several of its subsidiaries,
entered into operative documents with special purpose entities to facilitate the
development, construction, financing and leasing of several power generation
projects. The special purpose entities have an aggregate financing commitment
from equity and debt participants (Investors) of $2.5 billion. The availability
of the commitment is subject to satisfaction of various conditions. Reliant
Resources, through several of its subsidiaries, acts as construction agent for
the special purpose entities and is responsible for completing construction of
these projects by August 31, 2004, but has generally limited its risk related to
construction completion to 89.9% of costs incurred to date, except in certain
events. Upon completion of an individual project and exercise of the lease
option, Reliant Resources' subsidiaries will be required to make lease payments
in an amount sufficient to provide a return to the Investors. If Reliant
Resources does not exercise its option to lease any project upon its completion,
Reliant Resources must purchase the project or remarket the project on behalf of
the special purpose entities. Reliant Resources must guarantee that the
Investors will receive at least 89.9% of their investment in the case of a
remarketing sale at the end of construction. At the end of an individual
project's initial operating lease term (approximately five years from
construction completion), Reliant Resources' subsidiary lessees have the option
to extend the lease with the approval of Investors, purchase the project at a
fixed amount equal to the original construction cost, or act as a remarketing
agent and sell the project to an independent third party. If the lessees elect
the remarketing option, they may be required to make a payment of up to 85% of
the project cost if the proceeds from remarketing are not sufficient to repay
the Investors. Reliant Resources has guaranteed the performance and payment of
its subsidiaries' obligations during the construction periods and, if the lease
option is exercised, each lessee's obligations during the lease period.
(h) REMA Sale/Leaseback Transactions.
In August 2000, the Company entered into separate sale/leaseback
transactions with each of the three owner-lessors for the Company's respective
16.45%, 16.67% and 100% interests in the Conemaugh, Keystone and Shawville
generating stations, respectively, acquired in the REMA acquisition. The lease
documents contain some restrictive covenants that restrict REMA's ability to,
among other things, make dividend distributions unless REMA satisfies various
conditions. As of September 30, 2001, REMA had $143 million of restricted funds
that are available for REMA's working capital needs and to make future lease
payments, including a lease payment of $55 million in January 2002. For
additional discussion of these lease transactions, please read Note 3(a) and
14(c) to Reliant Energy 10-K Notes.
(13) INITIAL PUBLIC OFFERING OF RELIANT RESOURCES
On July 27, 2000, Reliant Energy announced its intention to form Reliant
Resources to own and operate a substantial portion of Reliant Energy's
unregulated operations, and to offer no more than 20% of the common stock of
Reliant Resources in an initial public offering (Offering) in connection with
the Company's business separation plan. In May 2001, Reliant Resources completed
its initial public offering of 59.8 million shares of its common stock and
received net proceeds of $1.7 billion. Pursuant to the terms of the master
separation agreement, Reliant Resources used $147 million of the net proceeds to
repay certain indebtedness owed to Reliant Energy. Reliant Resources used the
remainder of net proceeds to increase its working capital. Reliant Energy
expects the Offering to be followed by a distribution of the remaining common
stock of Reliant Resources owned by Reliant Energy to Reliant Energy's or its
successor's shareholders within twelve months of the Offering (Distribution). As
a result of the Offering, the Company recorded directly into stockholders'
equity as a component of common stock a $509
18
million gain on the sale of its subsidiary's stock. For additional information
regarding the Company's business separation plan, see Note 4(b) to Reliant
Energy 10-K Notes. The Reliant Resources common stock issued in the Offering has
been reflected as minority interest in consolidated subsidiaries in the
Company's Consolidated Balance Sheet as of September 30, 2001.
The Distribution is subject to further corporate approvals, market and
other conditions, and government actions, including receipt of a favorable
Internal Revenue Service ruling that the Distribution would be tax-free to
Reliant Energy or its successor and its shareholders for U.S. federal income tax
purposes, as applicable. There can be no assurance that the Distribution will be
completed as described or within the time periods outlined above.
During the third quarter of 2001, Reliant Resources purchased 1,000,000
shares of its common stock at an average price of $20.42 per share, or an
aggregate purchase price of $20.4 million. These shares were purchased in
anticipation of funding benefit plan obligations of Reliant Resources expected
to be funded prior to the Distribution. The master separation agreement between
Reliant Resources and Reliant Energy restricts the ability of Reliant Resources
to issue shares of its common stock prior to the separation of the two companies
without the prior consent of Reliant Energy.
On September 18, 2001, Reliant Resources' Board of Directors authorized
Reliant Resources to purchase up to 10 million additional shares of its common
stock through February 2003. Purchases will be made on a discretionary basis in
the open market or otherwise at times and in amounts as determined by management
subject to market conditions, legal requirements and other factors.
(14) BENEFIT CURTAILMENT AND ENHANCEMENT CHARGE
During the first quarter of 2001, the Company recognized a pre-tax,
non-cash charge of $101 million relating to the redesign of some of Reliant
Energy's benefit plans in anticipation of distributing to Reliant Energy's or
its successor's shareholders the remaining common stock of its unregulated
subsidiary, Reliant Resources. For information regarding this anticipated
transaction, see Note 4(b) to Reliant Energy 10-K Notes.
Effective March 1, 2001, the Company no longer accrues benefits under a
noncontributory pension plan for its domestic non-union employees of Reliant
Resources and Reliant Energy Tegco, Inc. (Resources Participants). Effective
March 1, 2001, each non-union Resources Participant's unvested pension account
balance became fully vested and a one-time benefit enhancement was provided to
some qualifying participants. During the first quarter of 2001, the Company
incurred a charge to earnings of $84 million (pre-tax) for a one-time benefit
enhancement and a gain of $23 million (pre-tax) related to the curtailment of
Reliant Energy's pension plan.
Effective March 1, 2001, the Company discontinued providing subsidized
postretirement benefits to its domestic non-union employees of Reliant Resources
and its participating subsidiaries and Reliant Energy Tegco, Inc. The Company
incurred a pre-tax charge of $40 million during the first quarter of 2001
related to the curtailment of the Company's postretirement obligation. For
additional information regarding these benefit plans, see Notes 12(b) and 12(d)
to Reliant Energy 10-K Notes.
19
(15) REPORTABLE SEGMENTS
The Company's determination of reportable segments considers the strategic
operating units under which the Company manages sales, allocates resources and
assesses performance of various products and services to wholesale or retail
customers in differing regulatory environments. The Company has identified the
following reportable segments: Electric Operations, Natural Gas Distribution,
Pipelines and Gathering, Wholesale Energy, European Energy, Retail Energy and
Other Operations. Prior to July 1, 2001, Retail Energy has been reported in the
Other Operations segment. Reportable segments from previous interim periods and
the prior year have been restated to conform to the current presentation. Retail
Energy provides energy products and services to end-use customers, ranging from
residential and small commercial customers to large commercial, institutional
and industrial customers. For descriptions of the other reporting segments, see
Note 1 to Reliant Energy 10-K Notes. Financial data for the business segments
are as follows:
<Table>
<Caption>
AS OF
DECEMBER 31,
FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2000 2000
----------------------------------------------- ---------------
NET
REVENUES FROM INTERSEGMENT OPERATING
NON-AFFILIATES REVENUES INCOME (LOSS) TOTAL ASSETS
--------------- --------------- --------------- ---------------
(IN MILLIONS)
Electric Operations ............... $ 1,827 $ -- $ 500 $ 10,691
Natural Gas Distribution .......... 863 7 (42) 4,547
Pipelines and Gathering ........... 42 51 33 2,358
Wholesale Energy .................. 6,622 112 314 10,866
European Energy ................... 129 -- 15 2,521
Retail Energy ..................... 15 6 (19) 151
Other Operations .................. 4 -- (25) 1,482
Discontinued Operations (1) ....... -- -- -- 195
Reconciling Elimination ........... -- (176) -- (1,112)
--------------- --------------- --------------- ---------------
Consolidated ...................... $ 9,502 $ -- $ 776 $ 31,699
=============== =============== =============== ===============
</Table>
<Table>
<Caption>
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2000
-----------------------------------------------------
NET
REVENUES FROM INTERSEGMENT OPERATING
NON-AFFILIATES REVENUES INCOME (LOSS)
-------------- -------------- --------------
(IN MILLIONS)
Electric Operations .......... $ 4,195 $ -- $ 1,027
Natural Gas Distribution ..... 2,690 24 51
Pipelines and Gathering ...... 128 146 99
Wholesale Energy ............. 11,990 352 464
European Energy .............. 415 -- 72
Retail Energy ................ 42 17 (40)
Other Operations ............. 10 -- (42)
Reconciling Elimination ...... -- (539) --
-------------- -------------- --------------
Consolidated ................. $ 19,470 $ -- $ 1,631
============== ============== ==============
</Table>
20
<Table>
<Caption>
AS OF
SEPTEMBER 30,
FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2001 2001
----------------------------------------------------- --------------
NET
REVENUES FROM INTERSEGMENT OPERATING TOTAL
NON-AFFILIATES REVENUES INCOME (LOSS) ASSETS
-------------- -------------- -------------- --------------
(IN MILLIONS)
Electric Operations ............. $ 1,608 $ -- $ 436 $ 10,950
Natural Gas Distribution ........ 602 6 (25) 3,630
Pipelines and Gathering ......... 52 40 34 2,334
Wholesale Energy ................ 9,891 96 266 10,486
European Energy ................. 275 -- (5) 3,451
Retail Energy ................... 35 17 (7) 256
Other Operations ................ 4 1 (53) 1,301
Discontinued Operations (1) ..... -- -- -- 118
Reconciling Elimination ......... -- (160) -- (1,017)
-------------- -------------- -------------- --------------
Consolidated .................... $ 12,467 $ -- $ 646 $ 31,509
============== ============== ============== ==============
</Table>
<Table>
<Caption>
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2001
-----------------------------------------------------
NET
REVENUES FROM INTERSEGMENT OPERATING
NON-AFFILIATES REVENUES INCOME (LOSS)
-------------- -------------- --------------
(IN MILLIONS)
Electric Operations .......... $ 4,521 $ -- $ 964
Natural Gas Distribution ..... 3,727 92 62
Pipelines and Gathering ...... 177 141 106
Wholesale Energy ............. 28,415 530 687
European Energy .............. 799 -- 23
Retail Energy ................ 74 41 (13)
Other Operations ............. 13 1 (201)
Reconciling Elimination ...... -- (805) --
-------------- -------------- --------------
Consolidated ................. $ 37,726 $ -- $ 1,628
============== ============== ==============
</Table>
- ----------
(1) Effective December 1, 2000, Reliant Energy's Board of Directors approved a
plan to dispose of its Latin American segment, through sales of its assets.
For more information regarding the Company's discontinued operations, see
Note 5.
Reconciliation of Operating Income to Net Income Attributable to Common
Stockholders:
<Table>
<Caption>
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
-------------------------------- --------------------------------
2000 2001 2000 2001
------------- ------------- ------------- -------------
(IN MILLIONS)
Operating Income ....................................... $ 776 $ 646 $ 1,631 $ 1,628
Other Expense .......................................... (158) (159) (478) (400)
Income Tax Expense ..................................... (222) (197) (387) (456)
Loss from Discontinued Operations, net of tax .......... (7) -- (27) --
Loss on Disposal of Discontinued Operations, net
of tax ............................................... -- -- -- (7)
Extraordinary Item ..................................... -- -- 7 --
Cumulative Effect of Accounting Change, net of tax ..... -- -- -- 61
------------- ------------- ------------- -------------
Net Income Attributable to Common Stockholders ......... $ 389 $ 290 $ 746 $ 826
============= ============= ============= =============
</Table>
(16) RELIANT ENERGY COMMUNICATIONS
During the third quarter of 2001, management decided to exit the Company's
Communications business which serves as a facility-based competitive local
exchange carrier and Internet services provider and owns network operations
centers and managed data centers in Houston and Austin. Consequently, the
Company determined the goodwill associated with the Communications business was
impaired. The Company recorded $33 million of pre-tax disposal charges in the
third quarter of 2001. These charges included the write-off of goodwill of $19
million and
21
fixed asset write-downs, severance reserves and other incremental costs
associated with exiting the Communications business, totaling $14 million.
(17) SUBSEQUENT EVENTS.
(a) Securitization Financing.
On October 24, 2001, Reliant Energy Transition Bond Company LLC (Bond
Company), a Delaware limited liability company and direct wholly owned
subsidiary of Reliant Energy, issued $749 million aggregate principal amount of
its Series 2001-1 Transition Bonds pursuant to a financing order of the Texas
Utility Commission. Classes of the bonds mature on September 15, 2007, September
15, 2009, September 15, 2011 and September 15, 2015, and bear interest at rates
of 3.84%, 4.76%, 5.16% and 5.63%, respectively. Net proceeds to the Bond Company
from the issuance were $738 million. The Bond Company paid Reliant Energy $738
million for all of Reliant Energy's interest in the financing order. The Company
used the net proceeds for general corporate purposes, including the repayment of
indebtedness.
The Transition Bonds are secured primarily by the "transition property,"
which includes the irrevocable right to recover, through nonbypassable
transition charges payable by certain retail electric customers, the qualified
costs of Reliant Energy authorized by the financing order of the Texas Utility
Commission. The holders of the Bond Company's bonds have no recourse to any
assets or revenues of Reliant Energy, and the creditors of Reliant Energy have
no recourse to any assets or revenues (including, without limitation, the
transition charges) of the Bond Company. Reliant Energy has no payment
obligations with respect to the Transition Bonds except to remit collections of
transition charges as set forth in a servicing agreement between Reliant Energy
and the Bond Company and in an intercreditor agreement among Reliant Energy, the
Bond Company and other parties.
(b) Purchase of Treasury Stock by Subsidiary.
From October 1, 2001 through November 8, 2001, Reliant Resources purchased
7,628,200 shares of its common stock at an average price of $16.69 per share, or
an aggregate purchase price of $127 million. These shares were purchased
pursuant to Reliant Resources' Board of Directors authorization as discussed in
Note 13.
22
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS OF RELIANT ENERGY AND SUBSIDIARIES
The following discussion and analysis should be read in combination with
our Interim Financial Statements contained in this Form 10-Q.
We are a diversified international energy services and energy delivery
company that provides energy and energy services in North America and Europe. We
operate one of the nation's largest electric utilities in terms of kilowatt-hour
(KWh) sales, and our three natural gas distribution divisions together form one
of the United States' largest natural gas distribution operations in terms of
customers served. We invest in the acquisition, development and operation of
domestic and international non-rate regulated power generation facilities. We
own two interstate natural gas pipelines that provide gas transportation,
supply, gathering and storage services, and we also engage in wholesale energy
marketing and trading.
In this section we discuss our results of operations on a consolidated
basis and individually for each of our business segments. We also discuss our
liquidity and capital resources. Our financial reporting segments include
Electric Operations, Natural Gas Distribution, Pipelines and Gathering,
Wholesale Energy, European Energy, Retail Energy and Other Operations.
Historically, Retail Energy has been reported in the Other Operations segment.
For segment reporting information, please read Note 15 to our Interim Financial
Statements.
Effective December 1, 2000, our Board of Directors approved a plan to
dispose of our Latin American business segment and sell its assets. Accordingly,
we are reporting the results of our Latin American business segment as
discontinued operations for all periods presented in our Interim Financial
Statements in accordance with Accounting Principles Board Opinion No. 30 (APB
Opinion No. 30). For additional information regarding the disposal of our Latin
American business segment, please read Note 19 to Reliant Energy 10-K Notes.
In 2000, we submitted a business separation plan to the Texas Utility
Commission that was later amended during the year to restructure our businesses
into two separate publicly traded companies in order to separate our unregulated
businesses from our regulated businesses. In December 2000, the plan was
substantially approved by the Texas Utility Commission in its entirety and a
final order was issued on April 10, 2001. For additional information regarding
our business separation plan, please read Note 4(b) to Reliant Energy 10-K
Notes. Reliant Energy filed an amendment to its business separation plan with
the Texas Utility Commission on October 15, 2001 to delay full implementation of
the restructuring until all regulatory approvals have been received.
As part of the separation, Reliant Energy will undergo a restructuring of
its corporate organization to achieve a new holding company structure. The new
holding company will hold our regulated businesses and will be named CenterPoint
Energy, Inc. In connection with the formation of the new holding company, the
Company has filed an application with the SEC requesting an exemption from the
registration requirements of the Public Utility Holding Company Act of 1935
(1935 Act). The restructuring will require approval of the SEC, certain of the
affected state commissions and the Nuclear Regulatory Commission. On October 22,
2001, the Board of Directors of Reliant Energy announced that a special meeting
of shareholders of Reliant Energy will be held on December 17, 2001. At the
special meeting, shareholders of record as of the close of business on November
1, 2001 will be asked to approve the merger whereby CenterPoint Energy, Inc.
will become the new holding company. Reliant Energy expects to begin mailing a
joint proxy statement/prospectus relating to the special meeting to its
shareholders on or about November 12, 2001.
In order to satisfy requirements for maintaining the exemption from the
registration requirements of the 1935 Act, Reliant Energy expects to separate
its three gas distribution divisions into three separate corporate entities
within two years of the SEC's exemption order. The separation of these
businesses will require additional regulatory approvals from the state utility
regulators in five of the six states where the Company currently operates gas
distribution businesses and may require waivers, consents and/or modifications
to certain RERC agreements, including credit facilities and other financing
arrangements.
In connection with our business separation plan, we formed Reliant
Resources, which owns and operates a substantial portion of our unregulated
operations. In May 2001, Reliant Resources offered 59.8 million shares of its
common stock to the public at an initial public offering (Offering) price of $30
per share and received net proceeds from the Offering of $1.7 billion. Pursuant
to the master separation agreement, Reliant Resources used $147 million of the
net proceeds to repay certain indebtedness owed to Reliant Energy. Reliant
Energy expects to distribute the
23
remaining common stock of Reliant Resources it owns to Reliant Energy's or its
successor's shareholders within twelve months of the closing of the Reliant
Resources initial public offering.
On May 12, 2000, one of our subsidiaries purchased entities owning electric
power generating assets and development sites located in Pennsylvania, New
Jersey, and Maryland having an aggregate net generating capacity of
approximately 4,262 MW. The purchase price for the May 2000 transaction was $2.1
billion. We accounted for the acquisition as a purchase, and accordingly, our
results of operations include the results of operations for REMA only for the
period after the acquisition date. For additional information about this
acquisition, including our accounting treatment of the acquisition, please read
Note 3(a) to Reliant Energy 10-K Notes and Note 4 to our Interim Financial
Statements.
In September 2001, we announced that we are evaluating strategic
alternatives for our European Energy segment, including the possible sale, in
order to pursue business opportunities that are more in line with our domestic
wholesale energy strategies.
During the third quarter of 2001, management decided to exit our
Communications business which serves as a facility-based competitive local
exchange carrier and Internet services provider and owns network operations
centers and managed data centers in Houston and Austin. For additional
information about our Communications business, please read Note 16 to our
Interim Financial Statements.
CONSOLIDATED RESULTS OF OPERATIONS
<Table>
<Caption>
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
-------------------------------- -------------------------------
2000 2001 2000 2001
------------- ------------- ------------- -------------
(IN MILLIONS, EXCEPT PER SHARE DATA)
Revenues ................................................ $ 9,502 $ 12,467 $ 19,470 $ 37,726
Operating Expenses ...................................... (8,726) (11,821) (17,839) (36,098)
------------- ------------- ------------- -------------
Operating Income ........................................ 776 646 1,631 1,628
Income from Equity Investments in Unconsolidated
Subsidiaries .......................................... 27 2 33 66
Interest Expense ........................................ (186) (138) (533) (466)
Distribution on Trust Preferred Securities .............. (14) (14) (40) (42)
Minority Interest ....................................... -- (26) 1 (49)
Other Income ............................................ 15 17 61 91
Income Tax Expense ...................................... (222) (197) (387) (456)
Loss from Discontinued Operations, net of tax ........... (7) -- (27) --
Loss on Disposal of Discontinued Operations, net
of tax ................................................ -- -- -- (7)
Extraordinary Item ...................................... -- -- 7 --
Cumulative Effect of Accounting Change, net of tax ...... -- -- -- 61
------------- ------------- ------------- -------------
Net Income Attributable to Common Stockholders .......... $ 389 $ 290 $ 746 $ 826
============= ============= ============= =============
Basic Earnings Per Share ................................ $ 1.36 $ 1.00 $ 2.62 $ 2.86
Diluted Earnings Per Share .............................. $ 1.34 $ 0.99 $ 2.60 $ 2.83
</Table>
Three months ended September 30, 2000 compared to three months ended September
30, 2001
We reported consolidated net income of $389 million ($1.34 per diluted
share) for the three months ended September 30, 2000 compared to $290 million
($0.99 per diluted share) for the three months ended September 30, 2001. The
2000 results include a $7 million after-tax loss from discontinued operations in
Latin America. The 2001 results include a $22 million after-tax charge,
including the effect of minority interest, for the disposal of our
Communications business.
Our consolidated net income, after adjusting for the items described above,
was $396 million ($1.37 per diluted share) for the three months ended September
30, 2000 compared to $312 million ($1.07 per diluted share) for the three months
ended September 30, 2001. The decrease in adjusted net income was primarily due
to decreased revenues from reduced customer usage due to milder weather in our
Electric Operations segment and increased expenses in our Wholesale Energy
segment, partially offset by decreased interest expense.
24
For an explanation of changes in operating income for the third quarter of
2000 versus 2001, see the discussion below of operating income (loss) by
segment.
Equity income from unconsolidated subsidiaries decreased by $25 million
during the third quarter of 2001 compared to 2000 primarily due to decreased
earnings from unconsolidated subsidiaries of our Wholesale Energy segment due to
decreased power prices in the three months ended September 30, 2001 compared to
the same period in 2000.
We incurred charges for interest expense and distribution on trust
preferred securities of $200 million and $152 million for the third quarters of
2000 and 2001, respectively. The decrease resulted from a combination of lower
levels of both short-term borrowings and long-term debt and lower interest rates
in the third quarter of 2001 compared to the same period in 2000. During 2001,
short-term borrowings decreased primarily from the reduction in commercial paper
with the proceeds from the Reliant Resources Offering.
Other income includes an additional impairment loss of $4 million pre-tax
on marketable equity securities classified as "available-for-sale" recorded
during the three months ended September 30, 2000.
During the third quarter of 2001, we recorded minority interest expense of
$26 million primarily related to the minority interest in Reliant Resources.
The effective tax rate for the third quarter of 2000 and 2001 was 36% and
40%, respectively. The increase in effective tax rate was primarily a result of
decreased earnings of REPGB, increased state income taxes and the write-off of
goodwill associated with our Communications business. In 2001 and prior years,
the earnings of REPGB were subject to a zero percent Dutch corporate income tax
rate as a result of the Dutch tax holiday related to the Dutch electricity
industry. In 2002, all of European Energy's earnings in the Netherlands will be
subject to the standard Dutch corporate income tax rate, which is currently 35%.
Nine months ended September 30, 2000 compared to nine months ended September 30,
2001
We reported consolidated net income of $746 million ($2.60 per diluted
share) for the nine months ended September 30, 2000 compared to $826 million
($2.83 per diluted share) for the nine months ended September 30, 2001. The 2000
results include a $27 million after-tax loss from discontinued operations in
Latin America and an extraordinary gain of $7 million related to the early
extinguishment of long-term debt. The 2001 results reflect a $7 million
after-tax loss on the disposal of discontinued operations in Latin America, a
$61 million after-tax cumulative effect of an accounting change from the
adoption of SFAS No. 133, a $65 million after-tax non-cash charge relating to
the redesign of the company's benefit plans for employees of our unregulated
businesses and a $33 million after-tax gain recorded in equity income related to
a preacquisition contingency for the value of SEP, the coordinating body for the
Dutch electricity generating sector, offset by related minority interest of $6
million and a $28 million after-tax charge for the disposal of our
Communications business offset by related minority interest of $6 million.
Our consolidated net income, after adjusting for the items described above,
was $765 million ($2.67 per diluted share) for the first nine months of 2000
compared to $833 million ($2.86 per diluted share) for the first nine months of
2001. The increase in adjusted earnings for this period was largely driven by
improved performance from our Wholesale Energy segment, partially offset by a
decline in operating results from our Electric Operations and European Energy
segments. A decline in interest expense also contributed to the increase in net
income.
For information regarding the adoption of SFAS No. 133, the discontinuance
of our Latin American segment, the gain related to the preacquisition
contingency, the benefit charge incurred in the first quarter of 2001 and the
Communications business disposal charge, see Notes 3, 5, 12(e), 14 and 16 to our
Interim Financial Statements.
For an explanation of changes in operating income for the first nine months
of 2000 versus 2001, see the discussion below of operating income (loss) by
segment.
Equity income from unconsolidated subsidiaries increased by $33 million
during the first nine months of 2001 compared to 2000 primarily due to the
pre-tax gain of $51 million ($33 million after-tax) related to a preacquisition
contingency recorded by our European Energy segment, as discussed above. Our
Wholesale Energy segment reported income from equity investments for the nine
months ended September 30, 2000 of $33 million compared to $15 million in the
same period in 2001 primarily due to decreased earnings from unconsolidated
subsidiaries as a
25
result of a plant outage at one of our equity investments and decreased power
prices in the nine months ended September 30, 2001 compared to the same period
in 2000.
We incurred charges for interest expense and distribution on trust
preferred securities of $573 million and $508 million for the first nine months
of 2000 and 2001, respectively. The decrease resulted from a combination of
lower levels of both short-term borrowings and long-term debt and lower interest
rates in the first nine months of 2001 compared to the same period in 2000.
During 2001, short-term borrowings decreased primarily from the reduction in
commercial paper with the proceeds from the Reliant Resources Offering.
Other income increased by $30 million during the first nine months of 2001
compared to 2000 primarily due to increased interest income from our Electric
Operations and Wholesale Energy segments and a pre-tax impairment loss of $27
million recorded in 2000 related to certain marketable securities, partially
offset by a $15 million gain related to the sale of a development-stage project
in 2000 and a federal tax refund in 2000. For additional information regarding
our investment equity securities noted above, see Note 2(l) to Reliant Energy
10-K Notes.
During the nine months ended September 30, 2001, we recorded minority
interest expense of $49 million primarily related to the minority interest in
Reliant Resources.
The effective tax rate for the first nine months of 2000 and 2001 was 34%
and 37%, respectively. The increase in the effective tax rate was primarily due
to the same factors as discussed above in the quarterly results of operations.
As discussed in Note 12(e) to our Interim Financial Statements, the
Transition Act allocated to the Dutch generation sector, including REPGB,
financial responsibility for SEP's obligations to purchase electricity and gas
under a gas supply contract and three electricity contracts. As a result of the
above, we recorded an out-of-market, net stranded cost liability of $138 million
and a related deferred tax asset of $48 million at September 30, 2001 for our
statutorily allocated share of these gas supply and electricity contracts. We
believe that the costs incurred by REPGB subsequent to the tax holiday ending in
2001 related to these contracts will be deductible for Dutch tax purposes.
However, due to the uncertainties related to the deductibility of these costs,
we have recorded a reserve in other liabilities in our Interim Financial
Statements of $48 million as of September 30, 2001.
RESULTS OF OPERATIONS BY BUSINESS SEGMENT
The table below shows operating income (loss) by segment:
<Table>
<Caption>
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
-------------------------------- ------------------------------
2000 2001 2000 2001
------------ ------------ ------------ ------------
(IN MILLIONS)
Electric Operations ............... $ 500 $ 436 $ 1,027 $ 964
Natural Gas Distribution .......... (42) (25) 51 62
Pipelines and Gathering ........... 33 34 99 106
Wholesale Energy .................. 314 266 464 687
European Energy ................... 15 (5) 72 23
Retail Energy ..................... (19) (7) (40) (13)
Other Operations .................. (25) (53) (42) (201)
------------ ------------ ------------ ------------
Total Consolidated .......... $ 776 $ 646 $ 1,631 $ 1,628
============ ============ ============ ============
</Table>
ELECTRIC OPERATIONS
Our Electric Operations segment conducts operations under the name "Reliant
Energy HL&P," an unincorporated division of Reliant Energy. Our Electric
Operations segment generates, purchases, transmits and distributes electricity
to approximately 1.7 million customers in a 5,000 square mile area on the Texas
Gulf Coast, including Houston, Texas. For information on other developments,
factors and trends that may have an impact on the future earnings of our
Electric Operations segment, please read Note 12(f) to our Interim Financial
Statements and "Management's Discussion and Analysis of Financial Condition
and Results of Operations -- Certain Factors Affecting Our Future
Earnings -- Electric Operations".
26
<Table>
<Caption>
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
-------------------------------- -------------------------------
2000 2001 2000 2001
------------- ------------- ------------- -------------
(IN MILLIONS)
Operating Revenues:
Base Revenues ...................................... $ 1,041 $ 981 $ 2,477 $ 2,414
Reconcilable Fuel Revenues ......................... 786 627 1,718 2,107
------------- ------------- ------------- -------------
Total Operating Revenues ......................... 1,827 1,608 4,195 4,521
------------- ------------- ------------- -------------
Operating Expenses:
Fuel and Purchased Power ........................... 804 641 1,763 2,148
Operation and Maintenance .......................... 230 255 696 727
Depreciation and Amortization ...................... 177 161 420 369
Other Operating Expenses ........................... 116 115 289 313
------------- ------------- ------------- -------------
Total Operating Expenses ......................... 1,327 1,172 3,168 3,557
------------- ------------- ------------- -------------
Operating Income ..................................... $ 500 $ 436 $ 1,027 $ 964
============= ============= ============= =============
Electric Sales Including Unbilled (in GWh(1)):
Residential ........................................ 8,534 7,710 17,967 17,445
Commercial ......................................... 5,291 5,232 13,526 13,741
Industrial ......................................... 6,847 6,539 21,132 21,047
Industrial - Interruptible ......................... 1,550 1,369 4,232 2,806
Other .............................................. 381 99 1,407 777
------------- ------------- ------------- -------------
Total Sales Including Unbilled ..................... 22,603 20,949 58,264 55,816
============= ============= ============= =============
Average Cost of Fuel (in Cents/MMBtu(2)) ............. 288.8 233.3 254.1 269.0
</Table>
- --------------
(1) Gigawatt hours
(2) Million British thermal units
Our Electric Operations segment's operating income for the three months
ended September 30, 2001 decreased $64 million compared to the three months
ended September 30, 2000. The decrease was primarily due to decreased revenues
from reduced customer usage related to milder weather, customer conservation and
reduced rates for certain governmental agencies as mandated by Texas electric
deregulation legislation, and higher transmission cost of service expense. These
decreases were partially offset by lower amortization expense.
Our Electric Operations segment's operating income for the nine months
ended September 30, 2001 decreased $63 million compared to the nine months ended
September 30, 2000. The decrease was primarily due to decreased revenues from
reduced customer usage related to milder weather, reduced rates for certain
governmental agencies as mandated by Texas deregulation legislation, increased
tax expenses and higher benefit expenses, partially offset by lower amortization
expense and increased customer growth.
Base revenues decreased $60 million and $63 million for the quarter and
nine months ended September 30, 2001, respectively, primarily due to milder
weather compared to the prior year and a reduction in revenues due to reduced
rates for certain governmental agencies as mandated by Texas deregulation
legislation. In addition, during the third quarter of 2001 compared to the same
period in 2000, revenues declined due to decreased customer usage.
Reconcilable fuel revenues and fuel and purchased power expenses for the
quarter ended September 30, 2001 decreased as a result of a decrease in the
price of natural gas ($4.40 and $3.32 per MMBtu in the third quarters of 2000
and 2001, respectively). Reconcilable fuel revenues and fuel and purchased power
expenses for the nine months ended September 30, 2001 increased as a result of
purchased power volumes and an increase in the price of natural gas ($3.71 and
$4.52 per MMBtu for the first nine months of 2000 and 2001, respectively).
Operation and maintenance expenses and other operating expenses for the
quarter ended September 30, 2001 increased by $25 million and decreased by $1
million, respectively, when compared to the same period in 2000. The increase in
operation and maintenance expenses is largely due to higher benefit costs and
transmission cost of service expense.
Operation and maintenance expenses and other operating expenses for the
first nine months of 2001 increased by $31 million and $24 million,
respectively, when compared to the same period in 2000. The increase in
operation and maintenance expense is primarily due to higher benefit costs
partially offset by decreased legal fees. The
27
increase in other operating expenses is primarily due to an increase in
franchise tax requirements resulting from increased revenues.
Depreciation and amortization expense for the quarter and nine months ended
September 30, 2001 decreased $16 million and $51 million, respectively, compared
to the same periods in 2000. The decrease for the quarter was primarily due to a
decrease in amortization of the book impairment regulatory asset recorded in
June 1999, partially offset by accelerated amortization of certain regulatory
assets related to energy conservation management as required by the Texas
Utility Commission. The decrease for the nine months was primarily due to a
decrease in amortization of the book impairment regulatory asset recorded in
June 1999 and decreased amortization expense due to regulatory assets related to
cancelled projects being fully amortized in June 2000 partially offset by
accelerated amortization of certain regulatory assets related to energy
conservation management as required by the Texas Utility Commission. For
information regarding items that affect depreciation and amortization expense of
Electric Operations pursuant to the Legislation and the Transition Plan, see
Notes 2(g) and 4(a) to Reliant Energy 10-K Notes and Note 6 to our Interim
Financial Statements.
NATURAL GAS DISTRIBUTION
Our Natural Gas Distribution segment's operations consist of intrastate
natural gas sales to, and natural gas transportation for residential, commercial
and industrial customers in Arkansas, Louisiana, Minnesota, Mississippi,
Oklahoma and Texas and some non-rate regulated retail marketing of natural gas.
<Table>
<Caption>
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
-------------------------------- -------------------------------
2000 2001 2000 2001
------------- ------------- ------------- -------------
(IN MILLIONS)
Operating Revenues ..................... $ 870 $ 608 $ 2,714 $ 3,819
Operating Expenses:
Natural Gas .......................... 705 437 2,085 3,139
Operation and Maintenance ............ 149 139 399 420
Depreciation and Amortization ........ 38 37 111 110
Other Operating Expenses ............. 20 20 68 88
------------- ------------- ------------- -------------
Total Operating Expenses ........... 912 633 2,663 3,757
------------- ------------- ------------- -------------
Operating (Loss) Income ................ $ (42) $ (25) $ 51 $ 62
============= ============= ============= =============
Throughput Data (in Bcf (1)):
Residential and Commercial Sales ..... 34 36 194 225
Industrial Sales ..................... 12 13 50 36
Transportation ....................... 11 10 38 36
Retail ............................... 130 100 411 339
------------- ------------- ------------- -------------
Total Throughput ................... 187 159 693 636
============= ============= ============= =============
</Table>
- ----------
(1) Billion cubic feet.
Our Natural Gas Distribution segment's operating loss decreased $17 million
and operating income increased $11 million for the quarter and nine months ended
September 30, 2001, respectively, as compared to the same periods in 2000.
Operating results for 2000 reflect expenses incurred in connection with exiting
certain non-rate regulated natural gas business activities outside our
established market areas. Increases in employee benefits and bad debt expenses
during the third quarter of 2001 were partially offset by increased customer
usage. The increase in income for the first nine months in 2001 compared to the
same period in 2000 is primarily due to the expenses reflected in 2000 as noted
above and improved margins from colder weather and increased customer growth and
usage, partially offset by increased bad debt expense in addition to changes in
estimates of unbilled revenues and recoverability of deferred gas accounts and
other items.
28
PIPELINES AND GATHERING
Our Pipelines and Gathering segment operates two interstate natural gas
pipelines and provides gathering and pipeline services.
<Table>
<Caption>
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
-------------------------------- --------------------------------
2000 2001 2000 2001
------------- ------------- ------------- -------------
(IN MILLIONS)
Operating Revenues ................... $ 93 $ 92 $ 274 $ 318
Operating Expenses:
Natural Gas ........................ 19 7 50 65
Operation and Maintenance .......... 22 31 71 90
Depreciation and Amortization ...... 14 15 42 44
Other Operating Expenses ........... 5 5 12 13
------------- ------------- ------------- -------------
Total Operating Expenses ......... 60 58 175 212
------------- ------------- ------------- -------------
Operating Income ..................... $ 33 $ 34 $ 99 $ 106
============= ============= ============= =============
Throughput Data (in MMBtu):
Natural Gas Sales .................. 4 2 11 11
Transportation ..................... 181 174 651 613
Gathering .......................... 72 76 213 223
Elimination (1) .................... (3) (1) (9) (2)
------------- ------------- ------------- -------------
Total Throughput ..................... 254 251 866 845
============= ============= ============= =============
</Table>
- ----------
(1) Elimination of volumes both transported and sold.
Our Pipelines and Gathering segment's operating income for the quarter and
nine months ended September 30, 2001 increased $1 million and $7 million,
respectively, compared to the same periods in 2000. Increased operating margins
(revenues less natural gas costs) for our gas gathering business were partially
offset by costs related to a pipeline rate case which began in the third quarter
of 2001 and other operating expenses. Improved operating margins from both the
pipelines and gas gathering businesses, partially offset by increased operating
expenses, contributed to the increase for the first nine months of 2001.
WHOLESALE ENERGY
Our Wholesale Energy segment includes our non-rate regulated power
generation operations in the United States and our wholesale energy trading,
marketing, power origination and risk management operations in North America.
Trading and marketing purchases fuel to supply existing generation assets, sells
the electricity produced by these assets, and manages the day-to-day trading and
dispatch associated with these portfolios. As a result, we have made, and expect
to continue to make, significant investments in developing the trading and
marketing infrastructure including software, trading and risk control resources.
29
<Table>
<Caption>
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
-------------------------------- -------------------------------
2000 2001 2000 2001
------------- ------------- ------------- -------------
(IN MILLIONS)
Operating Revenues ................... $ 6,734 $ 9,987 $ 12,342 $ 28,945
Operating Expenses:
Fuel and Cost of Gas Sold .......... 2,698 3,207 6,061 13,195
Purchased Power .................... 3,575 6,326 5,506 14,527
Operation and Maintenance .......... 98 155 231 434
Depreciation and Amortization ...... 45 28 70 90
Other Operating Expenses ........... 4 5 10 12
------------- ------------- ------------- -------------
Total Operating Expenses ......... 6,420 9,721 11,878 28,258
------------- ------------- ------------- -------------
Operating Income ..................... $ 314 $ 266 $ 464 $ 687
============= ============= ============= =============
Operations Data:
Electricity Wholesale Power Sales
(in MMWH (1)) .................... 68 108 132 270
Natural Gas Sales (in Bcf) ......... 625 1,097 1,707 2,723
</Table>
- ----------
(1) Million megawatt hours.
Our Wholesale Energy segment's operating income decreased $48 million for
the third quarter of 2001 compared to the same period in 2000. The decline was
primarily due to decreased gross margins (revenues less fuel and cost of gas
sold and purchased power) resulting from lower gas and power unit margins in
2001 and favorable hedging activities in the Pennsylvania-New Jersey-Maryland
market in 2000, increased operation and maintenance expenses from facilities in
the West and Mid-Atlantic regions, higher legal and regulatory expenses related
to Western markets and higher general and administrative expenses to support
expanded commercial activities and operations. These costs were partially offset
by decreased amortization expense related to air emissions regulatory
allowances.
Our Wholesale Energy segment's operating revenues increased $3.3 billion
for the third quarter of 2001 compared to the same period in 2000. The increased
revenues during the third quarter of 2001 compared to the same period in 2000
were primarily due to increased volumes for natural gas and power sales
partially offset by decreased prices for natural gas sales. Our Wholesale Energy
segment's fuel and gas costs and purchased power increased $3.3 billion in the
third quarter of 2001 compared to the same period in 2000 primarily due to the
same reasons as the increase in revenues. Operation and maintenance expenses for
our Wholesale Energy segment increased $57 million in the third quarter of 2001
compared to the same period in 2000, primarily due to costs associated with the
operation and maintenance of generating plants in the West region, higher lease
expense associated with the Mid-Atlantic generating facilities' sale/leaseback
transactions that were entered into in August 2000, higher administrative costs
to support growing wholesale commercial activities and operations and higher
legal and regulatory expenses related to Western markets, partially offset by
decreased development expenses. The higher lease expense associated with the
Mid-Atlantic generating facilities was offset by lower interest expense in the
consolidated results of operations in the third quarter of 2001 compared to the
same period in 2000. Depreciation and amortization expense for the third quarter
of 2001 compared to the same period in 2000 decreased by $17 million primarily
due to changes in expense related to the amortization of our air emissions
regulatory allowances, primarily in California.
Our Wholesale Energy segment's operating income increased $223 million for
the first nine months of 2001 compared to the same period in 2000. The increase
was primarily due to increased gross margins. Gross margins for our Wholesale
Energy segment increased by $448 million primarily due to increased revenues
from energy and ancillary services, increased volumes and higher margins from
its trading and marketing activities and the addition of our Mid-Atlantic assets
and strong commercial and operational performance in other regions. These
results were partially offset by higher operation and maintenance expenses from
facilities in the West and Mid-Atlantic regions, increased depreciation and
amortization expense, and a $36 million provision and a $12 million net
write-off against receivable balances related to energy sales in the West
region.
Our Wholesale Energy segment's operating revenues increased $16.6 billion
for the first nine months of 2001 compared to the same period in 2000. The
increased revenues were primarily due to increased volumes for natural gas and
power
30
sales and to a lesser extent increased prices for natural gas and power sales.
Our Wholesale Energy segment's fuel and gas costs and purchased power increased
$16.2 billion in the first nine months of 2001 compared to the same period in
2000. Increased fuel and gas costs and purchased power were primarily due to
increased purchased volumes for natural gas and power sales and to a lesser
extent increases in plant output and increased prices for natural gas and power
purchases. Operation and maintenance expenses for our Wholesale Energy segment
increased $203 million in the first nine months of 2001 compared to the same
period in 2000, primarily due to costs associated with the operation and
maintenance of generating plants from facilities in the West and Mid-Atlantic
regions, higher lease expense associated with the Mid-Atlantic generating
facilities' sale/leaseback transactions and due to the other reasons for the
increase in the third quarter of 2001, as discussed above. The higher lease
expense associated with the Mid-Atlantic generating facilities was offset by
lower interest expense in the consolidated results of operations in the first
nine months of 2001 compared to the same period in 2000. Depreciation and
amortization expense during the first nine months of 2001 compared to the same
period in 2000 increased by $20 million as a result of higher expense related to
the depreciation of our Mid-Atlantic plants, which were acquired in May 2000 and
increased amortization of air emissions regulatory allowances.
On June 19, 2001, the FERC issued an order modifying the market monitoring
and mitigation plan it had previously adopted on April 26, 2001. This
modification to the mitigation plan extends the hours to which the price
controls are applied, as well as the states in which the price controls will be
in effect. Additionally, the FERC issued an order on July 25, 2001, which
ordered among other items, a methodology for calculating possible refunds by
sellers of electricity in the West region. We, however, believe that while the
mitigation plan will reduce volatility in the market, we will nevertheless be
able to profitably operate our facilities in the West because the proxy market
clearing price is based on the heat rate of the least efficient unit on-line
during each hour. Additionally, as noted above, the mitigation plan allows
sellers, such as us, to justify prices above the proxy price. Finally, any
adverse impacts of the mitigation plan on our operations would be mitigated, in
part, by our forward hedging activities. The amounts of any refunds will be
determined by the end of an expedited hearing process which is scheduled to
conclude March 8, 2002. We have not reserved any amounts for potential future
refunds, nor can we currently predict the amount of these potential refunds, if
any, because the methodology used to calculate these refunds is dependent on
information that is currently unknown to us and still subject to review and
challenge in the hearing process.
For information regarding the reserve against receivables and uncertainties
in the California wholesale energy market, please read Notes 12(a) and 12(d) to
our Interim Financial Statements.
EUROPEAN ENERGY
Our European Energy segment includes the operations of REPGB and its
subsidiaries and our European trading, marketing and risk management operations.
Our European Energy segment generates and sells power from its generation
facilities in the Netherlands and participates in the emerging wholesale energy
trading and marketing industry in Europe.
In September 2001, we announced that we are evaluating strategic
alternatives for our European Energy segment, including the possible sale, in
order to pursue business opportunities that are more in line with our domestic
wholesale energy strategies.
Beginning January 1, 2001, the Dutch wholesale electric market was
completely opened to competition. Consistent with our expectations at the time
that we made the acquisition, REPGB has experienced a significant decline in
electric margins in 2001 attributable to the deregulation of the market. For
additional information regarding these and other factors that may affect the
future results of operations of our European Energy segment, please read
"Management's Discussion and Analysis of Financial Condition and Results of
Operations - Certain Factors Affecting Our Future Earnings - Competitive,
Regulatory and Other Factors Affecting Our European Energy Operations" in the
Reliant Energy Form 10-K, which information is incorporated herein by reference.
31
<Table>
<Caption>
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
------------------------------- -------------------------------
2000 2001 2000 2001
------------- ------------- ------------- -------------
(IN MILLIONS)
Operating Revenues ........................ $ 129 $ 275 $ 415 $ 799
Operating Expenses:
Fuel and Purchased Power ................ 68 229 199 629
Operation and Maintenance and Other ..... 31 31 90 90
Depreciation and Amortization ........... 15 20 54 57
------------- ------------- ------------- -------------
Total Operating Expenses ............. 114 280 343 776
------------- ------------- ------------- -------------
Operating Income (Loss) ................... $ 15 $ (5) $ 72 $ 23
============= ============= ============= =============
Electricity (in MMWH):
Wholesale Sales ......................... 2.8 4.6 8.7 11.9
Trading Sales ........................... 0.2 5.7 0.3 14.6
</Table>
Our European Energy segment's operating income decreased $20 million and
$49 million for the third quarter and the first nine months of 2001 compared to
the same periods in 2000. These decreases were primarily due to a decrease in
margins (revenues less fuel and purchased power), as the Dutch electric market
was completely opened to wholesale competition on January 1, 2001. Increased
margins from ancillary services and trading activities partially offset this
decline. In the first half of 2001, efficiency and energy payments from SEP
totaling $30 million and increased district heating sales partially offset the
decline for the nine months ended September 30, 2001 compared to the same period
in 2000.
Our European Energy segment's operating revenues increased $146 million and
$384 million for the third quarter and the first nine months of 2001 compared to
the same periods in 2000. The increases were primarily due to increased trading
revenues associated with our participation in the Dutch and German power
markets. Fuel and purchased power costs increased $161 million and $430 million
in the third quarter and the first nine months of 2001 compared to the same
periods in 2000 primarily due to increased purchased power for trading
activities, and to a lesser extent, increased cost of natural gas and other
fuels due to increased output from our generating facilities.
RETAIL ENERGY
Our Retail Energy segment provides energy products and services to end-use
customers, ranging from residential and small commercial customers to large
commercial, institutional and industrial customers. In addition, our Retail
Energy segment includes billing and remittance services provided to the Electric
Operations segment and two of our natural gas distribution divisions. Retail
Energy charges the regulated electric and gas utilities for these services at
cost. Retail Energy is expected to succeed to Electric Operations' electric
retail customer base in the Houston metropolitan area when the Texas market
opens to competition in January 2002. Our Retail Energy segment has historically
been reported in our Other Operations segment. As a result of the Texas Electric
Choice pilot program which began in August 2001, these operations are being
reported and evaluated as a separate segment by management. Accordingly, we are
reporting the results of our retail operations as a separate segment for all
periods presented.
The Texas electric restructuring law calls for the commencement of retail
competition beginning on January 1, 2002. This law authorizes the Texas Utility
Commission to delay the date which the retail electric market is opened to
competition in any power region in Texas if it is determined that the region is
unable to offer fair competition and reliable service to all retail customer
classes on that date. We anticipate retail competition will commence on January
1, 2002. If retail competition is delayed, our Retail Energy segment's results
of operations and cash flows could be materially affected depending on the
length of the delay.
32
<Table>
<Caption>
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
-------------------------------- --------------------------------
2000 2001 2000 2001
------------- ------------- ------------- -------------
(IN MILLIONS)
Operating Revenues .................... $ 21 $ 52 $ 59 $ 115
Operating Expenses:
Natural Gas ........................ -- 8 -- 8
Operation and Maintenance ........... 39 48 97 113
Depreciation and Amortization ....... 1 3 2 7
------------- ------------- ------------- -------------
Total Operating Expenses ......... 40 59 99 128
------------- ------------- ------------- -------------
Operating Loss ........................ $ (19) $ (7) $ (40) $ (13)
============= ============= ============= =============
</Table>
Our Retail Energy segment's operating loss decreased $12 million and $27
million, respectively, in the third quarter and the first nine months of 2001
compared to the same periods in 2000. The operating loss reduction was primarily
due to increased sales of energy and energy services to commercial and
industrial customers from our Reliant Energy Solutions unit and energy sales and
services for certain Texas governmental agencies under a program mandated by the
Texas electric deregulation legislation. Operating revenues increased $31
million and $56 million, respectively, in the third quarter and the first nine
months of 2001 compared to the same periods in 2000, due to revenues from sales
of energy and energy services to commercial and industrial customers, energy
sales and services for certain Texas governmental agencies, as well as increased
revenues for the billing and remittance services provided to Reliant Energy.
Operations and maintenance expenses increased $9 million and $16 million,
respectively, in the third quarter and the first nine months of 2001 compared to
the same periods in 2000, primarily due to increased personnel and employee
related costs, costs related to building an infrastructure necessary to prepare
for competition in the retail electric market in Texas and advertising costs.
OTHER OPERATIONS
Our Other Operations segment includes the operations of our eBusiness,
Communications and venture capital businesses, non-operating investments,
certain real estate holdings and unallocated corporate costs. Historically, our
Other Operations segment has included the operations of our Communications
business. For additional information about our exiting of our Communications
business, please read Note 16 to our Interim Financial Statements.
Our Other Operations segment's operating loss increased $28 million and
$159 million, respectively, for the quarter and nine months ended September 30,
2001 compared to the same periods in 2000. The increased loss in the third
quarter was primarily a result of a $33 million pre-tax charge related to the
disposal of our Communications business. The increased loss for the nine months
was primarily due to a $101 million pre-tax, non-cash charge related to the
redesign of certain of our benefit plans in anticipation of the separation of
our regulated and our unregulated businesses and the $33 million pre-tax
disposal charge incurred in the third quarter as discussed above. For
information regarding the benefit charge incurred in the first quarter of 2001,
please read Note 14 to our Interim Financial Statements.
CERTAIN FACTORS AFFECTING OUR FUTURE EARNINGS
GENERAL
For information on other developments, factors and trends that may have an
impact on our future earnings, please read "Management's Discussion and Analysis
of Financial Condition and Results of Operations -- Certain Factors Affecting
Our Future Earnings" in the Reliant Energy Form 10-K, which is incorporated
herein by reference. For additional information regarding the California
wholesale market and related litigation, please read Notes 12(a) and 12(d) to
our Interim Financial Statements.
ELECTRIC OPERATIONS
In contemplation of open competition, our Electric Operations segment has
been allowed since 1998 under our Transition Plan approved by the Texas Utility
Commission and the Legislation to earn base revenues which produced earnings in
excess of traditional regulated levels. These excess earnings have been utilized
to mitigate stranded cost of generation plants by accelerating the depreciation
of these assets for regulatory purposes.
33
This transition to competition period is scheduled to end on December 31,
2001. At that time, and in accordance with the Legislation, we expect our
Electric Operations segment will be unbundled pursuant to our business
separation plan (please read Notes 4(a) and 4(b) to Reliant Energy 10-K Notes)
into three distinct businesses: a transmission and distribution company, a power
generation company and a retail company. New rates based on the allowed invested
capital, or "rate base", of the transmission and distribution business will be
implemented beginning on January 1, 2002. For more information regarding the
final rulings in the rate case for the transmission and distribution company,
please read Note 12(f) to our Interim Financial Statements. The retail business
will be conducted by a subsidiary of Reliant Resources. The generation business
will sell power via capacity auctions at market rates, which began in September
2001. However, the Legislation provides that during 2004 (please read Note 4(a)
to Reliant Energy 10-K Notes), a true-up amount will be calculated which will be
recovered from or returned to customers to adjust the market revenues earned
from the capacity auctions to a level that should approximate a regulated return
on the invested capital of the generation business. Thus, beginning in 2002,
earnings of our Electric Operations segment will be reduced to near traditional
regulated returns exclusive of any additional positive or negative cash flows
that may result from implementation of competitive transition charges received
from customers or other credits to customers, as applicable. The underlying
assumptions for the true-up calculation have not been finalized. Accordingly,
the results of operations of the unbundled components of our Electric Operations
segment post-competition will significantly decline.
FINANCIAL CONDITION
The following table summarizes the net cash provided by (used in)
operating, investing and financing activities for the nine months ended
September 30, 2000 and 2001.
<Table>
<Caption>
NINE MONTHS ENDED SEPTEMBER 30,
------------------------------------
2000 2001
--------------- ---------------
(IN MILLIONS)
Cash provided by (used in):
Operating activities ........... $ 1,074 $ 1,968
Investing activities ........... (3,301) (1,592)
Financing activities ........... 2,382 (252)
</Table>
Net cash provided by operating activities during the nine months ended
September 30, 2001 increased $894 million compared to the same period in 2000
primarily due to improved operating cash flows from Wholesale Energy and a
decrease in margin deposits on energy trading activities partially offset by a
prepayment of a lease obligation related to the REMA sale/leaseback transactions
and other changes in working capital.
Net cash used in investing activities decreased $1.7 billion during the
nine months ended September 30, 2001 compared to the same period in 2000
primarily due to the funding of the remaining purchase obligation for REPGB for
$982 million on March 1, 2000 and the acquisition of REMA for $2.1 billion on
May 12, 2000, partially offset by proceeds from REMA sale-leaseback transactions
of $1 billion as well as an increase in capital expenditures related to the
construction of domestic power generation projects during the nine months ended
September 30, 2001.
Cash flows from financing activities decreased $2.6 billion during the nine
months ended September 30, 2001 compared to the same period in 2000 primarily
due to financings in 2000 used to fund acquisitions. During the nine months
ended September 30, 2001, a portion of the $1.7 billion in net proceeds from the
initial public offering of Reliant Resources were used to pay down commercial
paper.
FUTURE SOURCES AND USES OF CASH FLOWS
Credit Facilities. As of September 30, 2001, we had credit facilities in
effect, including facilities of various financing subsidiaries and operating
subsidiaries, which provided for an aggregate of $8.7 billion in committed
credit. As of September 30, 2001, $4.6 billion was outstanding under these
facilities including borrowings of $3.9 billion and letters of credit of $0.7
billion. The remaining unused credit facilities totaled $4.1 billion. Of the
$8.7 billion of committed credit facilities described above, $6.0 billion will
expire by September 30, 2002, including $978 million related to Reliant
Resources and its subsidiaries. To the extent that we continue to need access to
this amount of committed credit, we expect to extend or replace these facilities
on normal commercial terms on a timely basis.
34
As of September 30, 2001, Reliant Resources had loaned $892 million to
subsidiaries of Reliant Energy that are not subsidiaries of Reliant Resources.
If any of these loans are outstanding at the Distribution, such loans must be
repaid prior to the Distribution. Reliant Energy plans to repay these amounts,
if any, through borrowings under existing credit facilities or commercial paper
supported by such credit facilities.
Shelf Registrations. At September 30, 2001, Reliant Energy had shelf
registration statements providing for the issuance of $230 million aggregate
liquidation value of our preferred stock, $580 million aggregate principal
amount of our debt securities and $125 million of trust preferred securities and
related junior subordinated debt securities. In addition, Reliant Energy had a
shelf registration for 15 million shares of its common stock, which would have
been worth $395 million as of September 30, 2001 based on the closing price of
its common stock as of that date. In January 2001, RERC Corp. filed a shelf
registration statement for $600 million of unsecured unsubordinated debt
securities of which $550 million was issued in February 2001.
Securitization. On October 24, 2001, Reliant Energy Transition Bond Company
LLC (Bond Company), a Delaware limited liability company and direct wholly owned
subsidiary of Reliant Energy, issued $749 million aggregate principal amount of
its Series 2001-1 Transition Bonds pursuant to a financing order of the Texas
Utility Commission. Classes of the bonds mature on September 15, 2007, September
15, 2009, September 15, 2011 and September 15, 2015, and bear interest at rates
of 3.84%, 4.76%, 5.16% and 5.63%, respectively. Net proceeds to the Bond Company
from the issuance were $738 million. The Bond Company paid Reliant Energy $738
million for all of Reliant Energy's interest in the financing order. We used the
net proceeds for general corporate purposes, including the repayment of
indebtedness.
Preferred Stock Redemption. Reliant Energy has 97,397 shares of preferred
stock outstanding, designated as $4 Preferred Stock. In connection with the
formation of our new holding company, we plan to redeem the preferred stock
prior to the special shareholder meeting to be held on December 17, 2001, at an
aggregate redemption price of approximately $10.2 million plus accrued and
unpaid dividends to the date fixed for redemption. The record date for the
preferred stock redemption was November 6, 2001, and redemption notices were
mailed on November 7, 2001.
Fuel Filing. As of September 30, 2001, Reliant Energy HL&P was
under-collected on fuel recovery by approximately $444 million. In two separate
filings with the Texas Utility Commission in 2000, Reliant Energy HL&P received
approval to implement fuel surcharges to collect the under-recovery of fuel
expenses, as well as to adjust the fuel factor to compensate for significant
increases in the price of natural gas.
On March 15, 2001, Reliant Energy HL&P filed with the Texas Utility
Commission to revise its fuel factor and address its undercollected fuel costs
of $389 million, which is the accumulated amount from September 2000 through
February 2001, plus estimates for March and April 2001. Reliant Energy HL&P
requested to revise its fixed fuel factor to be implemented with the May 2001
billing cycle and proposed to defer the collection of the $389 million until the
2004 stranded costs true-up proceeding. On April 16, 2001, the Texas Utility
Commission issued an order approving interim rates effective with the May 2001
billing cycle.
On June 21, 2001, Reliant Energy HL&P filed with the Texas Utility
Commission to terminate the interim factor and return to the prior fuel factor
due to the forecasted decline in natural gas prices. On July 20, 2001, the Texas
Utility Commission issued an order of dismissal approving Reliant Energy HL&P's
request that the interim rates approved on April 16, 2001, effective with
Reliant Energy HL&P's May billing month, be terminated and Reliant Energy HL&P
prospectively bill its customers using the prior fuel factor established in a
previous order beginning with Reliant Energy HL&P's August billing month. The
Texas Utility Commission also granted Reliant Energy HL&P a good cause exception
in that Reliant Energy HL&P will not be required to refund amounts collected
through the interim rates. Reliant Energy HL&P did not waive its right to
collect any final fuel balance. The final fuel balance is subject to review, and
the amount to be included in the 2004 stranded cost true-up will be determined
during the final fuel reconciliation. The Texas Utility Commission currently has
scheduled Reliant Energy HL&P to file its final fuel reconciliation in July
2002. For additional information regarding this matter, please read Note 4(a) to
Reliant Energy 10-K Notes.
Initial Public Offering of Reliant Resources. On July 27, 2000, Reliant
Energy announced its intention to form Reliant Resources to own and operate a
substantial portion of Reliant Energy's unregulated operations, and to offer no
more than 20% of the common stock of Reliant Resources in the Offering in
connection with our business separation plan. In May 2001, Reliant Resources
completed its initial public offering of 59.8 million shares of its common stock
and received net proceeds of $1.7 billion. Pursuant to the terms of the master
separation agreement, Reliant Resources used $147 million of the net proceeds to
repay certain indebtedness owed to Reliant Energy.
35
Reliant Resources used the remainder of the net proceeds of the Offering for
repayment of third party borrowings, capital expenditures, repurchases of common
stock and to increase its working capital. Reliant Energy expects the Offering
to be followed by a distribution of the remaining common stock of Reliant
Resources owned by Reliant Energy to Reliant Energy's or its successor's
shareholders within twelve months of the Offering. For additional information
regarding our business separation plan, please read Note 4(b) to Reliant Energy
10-K Notes.
Reliant Resources Stock Repurchase. In July 2001, Reliant Resources' Board
of Directors authorized Reliant Resources to purchase up to one million shares
of its common stock in anticipation of funding of its benefit plan obligations
expected to be funded prior to Distribution. During the third quarter of 2001,
Reliant Resources purchased 1,000,000 shares of its common stock at an average
price of $20.42 per share, or an aggregate purchase price of $20.4 million.
In addition, on September 18, 2001, Reliant Resources' Board of Directors
authorized Reliant Resources to purchase up to 10 million additional shares of
its common stock through February 2003. Purchases will be made on a
discretionary basis in the open market or otherwise at times and in amounts as
determined by management subject to market conditions, legal requirements and
other factors. From October 1, 2001 through November 8, 2001, Reliant Resources
purchased 7,628,200 shares of its common stock at an average price of $16.69 per
share.
Acquisition of Mid-Atlantic Assets. On May 12, 2000, we completed the
acquisition of our Mid-Atlantic assets from Sithe Energies, Inc. for an
aggregate purchase price of $2.1 billion. The acquisition was originally
financed through commercial paper borrowings by one of our financing
subsidiaries. In August 2000, we entered into separate sale/leaseback
transactions with each of the three owner-lessors for our respective 16.45%,
16.67% and 100% interests in the Conemaugh, Keystone and Shawville generating
stations, respectively, which we acquired as part of the Mid-Atlantic
acquisition. For additional discussion of these lease transactions, please read
Notes 3(a) and 14(c) to Reliant Energy 10-K Notes. As consideration for the sale
of our interest in the facilities, we received a total of $1.0 billion in cash
that was used to repay commercial paper borrowings at one of our financing
subsidiaries. We will continue to make lease payments through 2029. The lease
terms expire in 2034.
Acquisition of Orion Power Holdings, Inc. In September 2001, Reliant
Resources entered into a definitive merger agreement with Orion Power Holdings,
Inc. (Orion Power), under which Reliant Resources agreed to acquire all of the
outstanding shares of Orion Power for $26.80 per share in cash in a transaction
valued at approximately $2.9 billion. In the merger, Reliant Resources will also
assume approximately $1.8 billion of Orion Power's net debt obligations. Orion
Power is an independent electric power generating company formed in March 1998
to acquire, develop, own and operate power-generating facilities in the newly
deregulated wholesale markets throughout North America. Orion Power has 81 power
plants currently in operation with a total capacity of 5,644 MW and an
additional 2,855 MW in construction and various stages of development. The
merger is conditioned upon approval by Orion Power's shareholders and receipt of
certain regulatory approvals including the Federal Trade Commission, New York
Public Service Commission and the FERC. Reliant Resources expects to finance the
purchase price with existing cash balances, existing credit facilities and new
financing, which will be in place at or prior to closing.
Generating Projects. As of September 30, 2001, we had four non-rate
regulated generating facilities under construction. Total estimated costs of
constructing these facilities are $1.4 billion, including $365 million in
commitments for the purchase of combustion turbines. As of September 30, 2001,
we had incurred $917 million of the total projected costs of these projects,
which were funded primarily from borrowings and equity. We believe that our
level of cash, our borrowing capability and proceeds from the offering of
Reliant Resources as discussed above will be sufficient to fund these
commitments. In addition, we have options to purchase additional combustion
turbines for a total estimated cost of $112 million for future generation
projects, which we are actively trying to remarket. We believe that our current
level of cash, our borrowing capability and proceeds from the Reliant Resources
Offering will be sufficient to fund these options should we choose to exercise
them.
Construction Agency Agreement. In April 2001, Reliant Resources, through
several of its subsidiaries, entered into operative documents with special
purpose entities to facilitate the development, construction, financing and
leasing of several power generation projects. The special purpose entities have
an aggregate financing commitment from equity and debt participants (Investors)
of $2.5 billion. The availability of the commitment is subject to satisfaction
of various conditions. Reliant Resources, through several of its subsidiaries,
acts as construction agent for the special purpose entities and is responsible
for completing construction of these projects by August 31, 2004, but has
generally limited its risk related to construction completion to 89.9% of costs
incurred to date, except in certain events. Upon completion of an individual
project and exercise of the lease option, Reliant Resources' subsidiaries will
be required to make lease payments in an amount sufficient to provide a return
to the Investors. If Reliant Resources does not exercise its option to lease any
project upon its completion, Reliant Resources must
36
purchase the project or remarket the project on behalf of the special purpose
entities. Reliant Resources must guarantee that the Investors will receive at
least 89.9% of their investment in the case of a remarketing sale at the end of
construction. At the end of an individual project's initial operating lease term
(approximately five years from construction completion), Reliant Resources'
subsidiary lessees have the option to extend the lease with the approval of
Investors, purchase the project at a fixed amount equal to the original
construction cost, or act as a remarketing agent and sell the project to an
independent third party. If the lessees elect the remarketing option, they may
be required to make a payment of up to 85% of the project cost if the proceeds
from remarketing are not sufficient to repay the Investors. Reliant Resources
has guaranteed the performance and payment of its subsidiaries' obligations
during the construction periods and, if the lease option is exercised, each
lessee's obligations during the lease period.
California Trade Receivables. During the summer and fall of 2000, and
continuing into early 2001, prices for wholesale electricity in California
increased dramatically as a result of a combination of factors, including higher
natural gas prices and emissions allowance costs, reduction in available
hydroelectric generation resources, increased demand, decreases in net electric
imports, structural market flaws including over-reliance on the spot market, and
limitations on supply as a result of maintenance and other outages. Although
wholesale prices increased, California's deregulation legislation kept retail
rates frozen below 1996 levels until rates were raised by the CPUC early this
year. This caused two of California's public utilities, which are our customers
based on our deliveries to the Cal PX and the Cal ISO, to accrue billions of
dollars of unrecovered wholesale power costs and ultimately default in January
and February 2001 on payments owed for wholesale power purchased through the Cal
PX and from the Cal ISO, and in the case of PG&E, to file a voluntary petition
for bankruptcy. As of September 30, 2001, we were owed $338 million by the Cal
ISO, the Cal PX, the CDWR and California Energy Resource Scheduling for energy
sales in the California wholesale market during the fourth quarter of 2000
through September 30, 2001 and have recorded an allowance against such
receivables of $75 million. From October 1, 2001 through November 8, 2001, we
have collected $3.2 million of these receivable balances. For additional
information regarding uncertainties in the California wholesale market, please
read Notes 12(a) and 12(d) to our Interim Financial Statements and Notes 14(g)
and 14(h) to Reliant Energy 10-K Notes.
Reliant Energy HL&P Rate Matters. The Texas Utility Commission issued a
final order on October 3, 2001 that establishes the rates that will become
effective when retail choice begins in 2002. In this final order, Reliant Energy
HL&P is required to reverse the amount of redirected depreciation and
accelerated depreciation allowed under the Transition Plan and the Legislation.
The Texas Utility Commission determined that the utility had overmitigated its
stranded costs. The Company disagrees with certain positions prescribed in the
order by the Texas Utility Commission. Motions for Rehearing were filed by the
Company with the Texas Utility Commission on October 23, 2001 and the Company
will determine future action based on the Texas Utility Commission's response to
these motions. Reliant Energy HL&P also filed an amicus brief on September 24,
2001 at the Texas Supreme Court supporting Texas Utilities Company's Petition
for Writ of Mandamus challenging these same issues. At September 30, 2001,
cumulative redirected depreciation and cumulative accelerated depreciation for
regulatory purposes totaled $783 million and approximately $1.1 billion,
respectively. Implementing the reversal of redirected depreciation would result
in lower rates for the transmission and distribution utility, and the
accelerated depreciation being returned through credits over seven years would
serve as reductions to the transmission and distribution utility's
non-bypassable charges. The annual impact to earnings for the reversal of
redirected depreciation would be approximately $36 million after-tax, while the
return of accelerated depreciation is not expected to impact earnings. The
annual cash flow impact would be approximately $225 million. The credits related
to accelerated depreciation will become effective beginning with retail choice.
For additional information regarding redirected depreciation and accelerated
depreciation, see Note 4(a) to Reliant Energy 10-K Notes.
Other Sources/Uses of Cash. Our liquidity and capital requirements are
affected primarily by capital expenditures, debt service requirements and
various working capital needs. We expect to continue to bid on future
acquisitions of independent power projects and privatizations of generation
facilities. We expect any resulting capital requirements to be met with excess
cash flows from operations, as well as proceeds from debt and equity offerings,
project financings and other borrowings. We also expect Reliant Resources to
establish a commercial paper program in late 2001 or the first half of 2002.
Additional capital expenditures depend upon the nature and extent of future
project commitments, some of which may be substantial. We believe that our
current level of cash, our borrowing capability and proceeds from the Reliant
Resources initial public offering discussed above, along with future cash flows
from operations, will be sufficient to meet the existing operational needs of
our businesses for the next twelve months.
37
NEW ACCOUNTING PRONOUNCEMENTS
In July 2001, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (SFAS) No. 141 "Business
Combinations" (SFAS No. 141) and SFAS No. 142 "Goodwill and Other Intangible
Assets" (SFAS No. 142). SFAS No. 141 requires business combinations initiated
after June 30, 2001 to be accounted for using the purchase method of accounting,
and broadens the criteria for recording intangible assets separate from
goodwill. Recorded goodwill and intangibles will be evaluated against these new
criteria and may result in certain intangibles being transferred to goodwill, or
alternatively, amounts initially recorded as goodwill may be separately
identified and recognized apart from goodwill. SFAS No. 142 provides for a
nonamortization approach, whereby goodwill and certain intangibles with
indefinite lives will not be amortized into results of operations, but instead
will be reviewed periodically for impairment and written down and charged to
results of operations only in the periods in which the recorded value of
goodwill and certain intangibles with indefinite lives is more than its fair
value. We will adopt the provisions of each statement which apply to goodwill
and intangible assets acquired prior to June 30, 2001 on January 1, 2002. We are
in the process of determining the effect of adoption of SFAS No. 141 and SFAS
No. 142 on our consolidated financial statements.
In August 2001, the FASB issued SFAS No. 143, "Accounting for Asset
Retirement Obligations" (SFAS No. 143). SFAS No. 143 requires the fair value of
a liability for an asset retirement legal obligation to be recognized in the
period in which it is incurred. When the liability is initially recorded,
associated costs are capitalized by increasing the carrying amount of the
related long-lived asset. Over time, the liability is accreted to its present
value each period, and the capitalized cost is depreciated over the useful life
of the related asset. SFAS No. 143 is effective for fiscal years beginning after
June 15, 2002, with earlier application encouraged. SFAS No. 143 requires
entities to record a cumulative effect of change in accounting principle in the
income statement in the period of adoption. We plan to adopt SFAS No. 143 on
January 1, 2003 and are in the process of determining the effect of adoption on
our consolidated financial statements.
In August 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets" (SFAS No. 144). SFAS No. 144
provides new guidance on the recognition of impairment losses on long-lived
assets to be held and used or to be disposed of and also broadens the definition
of what constitutes a discontinued operation and how the results of a
discontinued operation are to be measured and presented. SFAS No. 144 supercedes
SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to Be Disposed Of" and APB Opinion No. 30, while retaining
many of the requirements of these two statements. Under SFAS No. 144, assets
held for sale that are a component of an entity will be included in discontinued
operations if the operations and cash flows will be or have been eliminated from
the ongoing operations of the entity and the entity will not have any
significant continuing involvement in the operations prospectively. SFAS No. 144
is effective for fiscal years beginning after December 15, 2001, with early
adoption encouraged. SFAS No. 144 is not expected to materially change the
methods we use to measure impairment losses on long-lived assets, but may result
in additional future dispositions being reported as discontinued operations than
is currently permitted. We plan to adopt SFAS No. 144 on January 1, 2002.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
INTEREST RATE RISK
At September 30, 2001, we had issued fixed-rate debt and Trust Preferred
Securities aggregating $5.4 billion in principal amount having a fair value of
$5.5 billion. The fair value of these instruments would increase by
approximately $635 million if interest rates were to decline by 10% from their
levels at September 30, 2001.
Our floating-rate obligations aggregated $4.3 billion at September 30, 2001
(please read Note 10 to Reliant Energy 10-K Notes) inclusive of (a) amounts
borrowed under our short-term and long-term credit facilities (including the
issuance of commercial paper supported by these facilities), (b) borrowings
under a receivables facility and (c) amounts subject to a master leasing
agreement under which lease payments vary depending on short-term interest
rates. If the floating rates were to increase by 10% from September 30, 2001
levels, our consolidated interest expense and expense under operating leases
would increase by a total of approximately $1.5 million each month in which such
an increase continued.
38
In November 1998, RERC Corp. sold $500 million aggregate principal amount
of its 6 3/8% Term Enhanced Remarketable Securities (TERM Notes) which included
an embedded option to remarket the securities. The option is expected to be
exercised in the event that the ten year Treasury rate in 2003 is below 5.66%.
At September 30, 2001, we could terminate the option at a cost of $33 million. A
decrease of 10% in the September 30, 2001 level of interest rates would increase
the cost of termination of the option by approximately $13 million.
As discussed in Note 8(c) to Reliant Energy 10-K Notes, upon adoption of
SFAS No. 133 effective January 1, 2001, the ZENS obligation was bifurcated into
a debt component of $122 million and a derivative component of $788 million.
Changes in the fair value of the derivative component are recorded in our
Statements of Consolidated Income; therefore, we are exposed to changes in the
fair value of the derivative component as a result of changes in the underlying
risk-free interest rate. If the risk-free interest rate were to increase by 10%
from September 30, 2001 levels, the fair value of the derivative component would
increase by approximately $10 million, which would be recorded as a loss in our
Statements of Consolidated Income.
During the nine months ended September 30, 2001, we entered into interest
rate swaps for the purpose of decreasing the amount of debt subject to interest
rate fluctuations. At September 30, 2001, these interest rate swaps had an
aggregate notional amount of $1.6 billion and a nominal fair value. At September
30, 2001, we could terminate these interest rate swaps at a cost of $14 million.
A decrease of 10% in the September 30, 2001 level of interest rates would not
increase the cost of termination of the swaps by a material amount. For
information regarding the accounting for these interest rate swaps, see Note 3
to our Interim Financial Statements.
EQUITY MARKET RISK
As discussed in Note 8 to Reliant Energy 10-K Notes, we own approximately
26 million shares of AOL Time Warner Inc. common stock (AOL TW Common), which we
hold to facilitate our ability to meet our obligations under the ZENS. Please
read Note 8 to Reliant Energy 10-K Notes for a discussion of the effect of
adoption of SFAS No. 133 on our ZENS obligation and our historical accounting
treatment of our ZENS obligation. Subsequent to adoption of SFAS No. 133, a
decrease of 10% from the September 30, 2001 market value of AOL TW Common would
result in a loss of approximately $4 million, which would be recorded as a loss
in our Statements of Consolidated Income.
FOREIGN CURRENCY EXCHANGE RATE RISK
As of September 30, 2001, we have entered into foreign currency swaps and
foreign exchange forward contracts and have issued Euro-denominated debt to
hedge our net investment in our European Energy segment. Changes in the value of
the swaps, forwards and debt are recorded as foreign currency translation
adjustments as a component of accumulated other comprehensive income (loss) in
stockholders' equity. As of September 30, 2001, we have recorded a $76 million
loss in cumulative net translation adjustments. The cumulative translation
adjustments will be realized in earnings and cash flows only upon the
disposition of the related investments.
As of September 30, 2001, our European Energy segment had entered into
transactions to purchase approximately $123 million at fixed exchange rates in
order to hedge future fuel purchases payable in U.S. dollars. As of September
30, 2001, the fair value of these financial instruments was a $4 million
liability. An increase in the value of the Euro of 10% compared to the U.S.
dollar from its September 30, 2001 level would result in an additional loss in
the fair value of these foreign currency financial instruments of $12 million.
For information regarding the accounting for these financial instruments, see
Note 3 to our Interim Financial Statements and Note 2 of the Reliant Energy
First Quarter 10-Q, which note is incorporated by reference herein.
COMMODITY PRICE RISK
We assess the risk of our non-trading derivatives (Energy Derivatives)
using a sensitivity analysis method, and we assess the risk of our trading
derivatives (Trading Derivatives) using the value-at-risk (VAR) method, in order
to maintain our total exposure within management-prescribed limits.
The sensitivity analysis performed on our Energy Derivatives measures the
potential loss in earnings based on a hypothetical 10% movement in energy
prices. An increase of 10% in the market prices of energy commodities from their
September 30, 2001 levels would have decreased the fair value of our Energy
Derivatives from their levels on those respective dates by $1 million.
39
We utilize the variance/covariance model of VAR, which is a probabilistic
model that measures the estimated risk of loss to earnings in market sensitive
instruments based on historical experience. With respect to Trading Derivatives,
our highest, lowest and average monthly VAR were $6 million, $4 million and $5
million, respectively, during the third quarter of 2001 and $12 million, $4
million and $6 million, respectively, during the first nine months of 2001 based
on a 95% confidence level and a one day holding period. During the third quarter
of 2000, our highest, lowest and average monthly VAR were $12 million, $4
million and $7 million, respectively, and during the first nine months of 2000,
our highest, lowest and average monthly VAR were $12 million, $1 million and $5
million, respectively, based on a 95% confidence level and a one day holding
period.
We cannot assure you that market volatility, failure of counterparties to
meet their contractual obligations, transactions entered into after the date of
this Form 10-Q or a failure of risk controls will not lead to significant losses
from our marketing and risk management activities.
40
RELIANT ENERGY RESOURCES CORP. AND SUBSIDIARIES
(A WHOLLY OWNED SUBSIDIARY OF RELIANT ENERGY, INCORPORATED)
STATEMENTS OF CONSOLIDATED OPERATIONS
(THOUSANDS OF DOLLARS)
(UNAUDITED)
<Table>
<Caption>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------------ ------------------------------
2000 2001 2000 2001
------------ ------------ ------------ ------------
REVENUES ............................................. $ 7,265,045 $ 668,903 $ 14,368,967 $ 4,051,754
EXPENSES:
Natural gas and purchased power .................... 6,968,565 414,217 13,408,344 3,118,665
Operation and maintenance .......................... 204,721 173,520 537,035 514,094
Depreciation and amortization ...................... 58,552 51,996 164,000 154,837
Taxes other than income taxes ...................... 24,471 23,694 79,960 100,830
------------ ------------ ------------ ------------
Total .......................................... 7,256,309 663,427 14,189,339 3,888,426
------------ ------------ ------------ ------------
OPERATING INCOME ..................................... 8,736 5,476 179,628 163,328
------------ ------------ ------------ ------------
OTHER (EXPENSE) INCOME:
Interest expense, net .............................. (38,959) (40,080) (100,100) (118,700)
Distribution on trust preferred securities ......... (7) (7) (22) (21)
Other, net ......................................... 5,732 1,323 (7,401) 13,293
------------ ------------ ------------ ------------
Total .......................................... (33,234) (38,764) (107,523) (105,428)
------------ ------------ ------------ ------------
(LOSS) INCOME FROM CONTINUING OPERATIONS BEFORE
INCOME TAXES ....................................... (24,498) (33,288) 72,105 57,900
Income Tax (Benefit) Expense ....................... (5,577) (5,997) 41,119 38,448
------------ ------------ ------------ ------------
(LOSS) INCOME FROM CONTINUING OPERATIONS ............. (18,921) (27,291) 30,986 19,452
Loss from Discontinued Operations, net of tax of
zero ............................................. (7,957) -- (16,225) --
------------ ------------ ------------ ------------
NET (LOSS) INCOME .................................... $ (26,878) $ (27,291) $ 14,761 $ 19,452
============ ============ ============ ============
</Table>
See Notes to RERC's Interim Financial Statements
41
RELIANT ENERGY RESOURCES CORP. AND SUBSIDIARIES
(A WHOLLY OWNED SUBSIDIARY OF RELIANT ENERGY, INCORPORATED)
CONSOLIDATED BALANCE SHEETS
(THOUSANDS OF DOLLARS)
(UNAUDITED)
ASSETS
<Table>
<Caption>
DECEMBER 31, SEPTEMBER 30,
2000 2001
------------ -------------
CURRENT ASSETS:
Cash and cash equivalents ................................... $ 22,576 $ 6,152
Accounts and notes receivable, principally customer, net .... 794,904 370,574
Accrued unbilled revenue .................................... 550,183 110,162
Fuel and petroleum products ................................. 82,707 151,476
Materials and supplies ...................................... 33,394 32,758
Non-trading derivative assets ............................... -- 9,143
Taxes receivable ............................................ -- 3,248
Accumulated deferred income taxes ........................... -- 35,115
Other ....................................................... 45,926 20,216
------------ ------------
Total current assets ...................................... 1,529,690 738,844
------------ ------------
PROPERTY, PLANT AND EQUIPMENT:
Property, plant and equipment ............................... 3,429,304 3,605,238
Less accumulated depreciation ............................... (399,947) (475,975)
------------ ------------
Property, plant and equipment, net ........................ 3,029,357 3,129,263
------------ ------------
OTHER ASSETS:
Goodwill, net ............................................... 1,787,015 1,734,097
Prepaid pension asset ....................................... 141,882 55,601
Non-trading derivative assets ............................... -- 2,795
Other ....................................................... 87,821 103,719
------------ ------------
Total other assets ........................................ 2,016,718 1,896,212
------------ ------------
TOTAL ASSETS .................................................. $ 6,575,765 $ 5,764,319
============ ============
</Table>
See Notes to RERC's Interim Financial Statements
42
RELIANT ENERGY RESOURCES CORP. AND SUBSIDIARIES
(A WHOLLY OWNED SUBSIDIARY OF RELIANT ENERGY, INCORPORATED)
CONSOLIDATED BALANCE SHEETS
(THOUSANDS OF DOLLARS) -- (CONTINUED)
(UNAUDITED)
LIABILITIES AND STOCKHOLDER'S EQUITY
<Table>
<Caption>
DECEMBER 31, SEPTEMBER 30,
2000 2001
------------- -------------
CURRENT LIABILITIES:
Short-term borrowings .................................................... $ 635,000 $ 283,308
Current portion of long-term debt ........................................ 146,252 --
Accounts payable ......................................................... 704,524 222,501
Accounts and notes payable - affiliated companies, net ................... 134,707 27,942
Taxes accrued ............................................................ 69,877 --
Interest accrued ......................................................... 35,725 33,915
Customer deposits ........................................................ 33,357 39,106
Non-trading derivative liabilities ....................................... -- 102,207
Other .................................................................... 96,375 77,920
------------- -------------
Total current liabilities .......................................... 1,855,817 786,899
------------- -------------
OTHER LIABILITIES:
Accumulated deferred income taxes ........................................ 583,857 528,588
Benefit obligations ...................................................... 175,144 196,091
Non-trading derivative liabilities ....................................... -- 14,788
Notes payable - affiliated companies, net ................................ 21,718 26,682
Other .................................................................... 144,853 148,498
------------- -------------
Total other liabilities .............................................. 925,572 914,647
------------- -------------
LONG-TERM DEBT ............................................................. 1,392,798 1,927,779
------------- -------------
COMMITMENTS AND CONTINGENCIES (NOTES 1 AND 10)
RERC OBLIGATED MANDATORILY REDEEMABLE CONVERTIBLE PREFERRED
SECURITIES OF SUBSIDIARY TRUST HOLDING SOLELY JUNIOR SUBORDINATED
DEBENTURES OF RERC ...................................................... 608 601
------------- -------------
STOCKHOLDER'S EQUITY:
Common stock ............................................................. 1 1
Paid-in capital .......................................................... 2,410,716 2,255,396
Accumulated deficit ...................................................... -- (45,955)
Accumulated other comprehensive loss ..................................... (9,747) (75,049)
------------- -------------
Total stockholder's equity ........................................... 2,400,970 2,134,393
------------- -------------
TOTAL LIABILITIES AND STOCKHOLDER'S EQUITY .............................. $ 6,575,765 $ 5,764,319
============= =============
</Table>
See Notes to RERC's Interim Financial Statements
43
RELIANT ENERGY RESOURCES CORP. AND SUBSIDIARIES
(A WHOLLY OWNED SUBSIDIARY OF RELIANT ENERGY, INCORPORATED)
STATEMENTS OF CONSOLIDATED CASH FLOWS
(THOUSANDS OF DOLLARS)
(UNAUDITED)
<Table>
<Caption>
NINE MONTHS ENDED SEPTEMBER 30,
--------------------------------
2000 2001
------------- -------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income ............................................................. $ 14,761 $ 19,452
Adjustments to reconcile net income to net cash provided by operating
activities:
Depreciation and amortization ........................................ 164,000 154,837
Deferred income taxes ................................................ 9,093 (8,618)
Net cash used in discontinued operations ............................. (1,182) --
Impairment of marketable equity securities ........................... 26,504 --
Changes in other assets and liabilities:
Accounts and notes receivable ...................................... (563,958) 821,084
Accounts receivable/payable, affiliates ............................ 34,666 (40,694)
Inventory .......................................................... (71,626) (61,813)
Accounts payable ................................................... 472,360 (482,023)
Fuel cost (under) recovery ......................................... (7,374) 53,741
Interest and taxes accrued ......................................... 368 (110,050)
Net price risk management assets ................................... (24,436) --
Margin deposits on energy trading activities, net .................. (62,755) --
Other assets ....................................................... (69,742) (2,782)
Other liabilities .................................................. 99,225 16,905
Other, net ........................................................... (418) 60,065
------------- -------------
Net cash provided by operating activities ........................ 19,486 420,104
------------- -------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures ................................................... (197,703) (199,092)
Net cash used in discontinued operations ............................... (2,800) --
Other, net ............................................................. (15,855) (45,784)
------------- -------------
Net cash used in investing activities ............................ (216,358) (244,876)
------------- -------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Payments of long-term debt ............................................. (200,000) (155,455)
Proceeds from long-term debt ........................................... 322,400 544,632
Increase (decrease) in short-term borrowings, net ...................... 100,416 (351,692)
Decrease in notes with affiliates, net ................................. (81,484) (61,107)
Dividend paid .......................................................... -- (400,000)
Capital contribution from Reliant Energy ............................... -- 236,000
Other, net ............................................................. (359) (4,030)
------------- -------------
Net cash provided by (used in) financing activities .............. 140,973 (191,652)
------------- -------------
NET DECREASE IN CASH AND CASH EQUIVALENTS ................................. (55,899) (16,424)
CASH AND CASH EQUIVALENTS AT BEGINNING OF THE PERIOD ...................... 80,127 22,576
------------- -------------
CASH AND CASH EQUIVALENTS AT END OF THE PERIOD ............................ $ 24,228 $ 6,152
============= =============
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash Payments:
Interest (net of amounts capitalized) .................................. $ 101,165 $ 121,026
Income taxes ........................................................... 54,328 116,237
</Table>
See Notes to RERC's Interim Financial Statements
44
RELIANT ENERGY RESOURCES CORP. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(1) BASIS OF PRESENTATION
See Note 1 to Reliant Energy's Interim Financial Statements.
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
RERC's Interim Financial Statements reflect all normal recurring
adjustments that are, in the opinion of management, necessary to present fairly
the financial position and results of operations for the respective periods.
Amounts reported in RERC's Statements of Consolidated Operations are not
necessarily indicative of amounts expected for a full year period due to the
effects of, among other things, (a) seasonal variations in energy consumption,
(b) timing of maintenance and other expenditures and (c) acquisitions and
dispositions of assets and other interests. In addition, certain amounts from
the prior year have been reclassified to conform to RERC's presentation of
financial statements in the current year. These reclassifications do not affect
earnings of RERC. RERC's Interim Financial Statements are unaudited, omit
certain financial statement disclosures and should be read with the combined
Annual Report on Form 10-K of Reliant Energy (Reliant Energy Form 10-K) and RERC
Corp. (RERC Corp. Form 10-K) for the year ended December 31, 2000, and the
Quarterly Reports on Form 10-Q of Reliant Energy (Reliant Energy First Quarter
10-Q) and RERC Corp. (RERC Corp. First Quarter 10-Q) for the quarter ended March
31, 2001 and the Quarterly Reports on Form 10-Q of Reliant Energy (Reliant
Energy Second Quarter 10-Q) and RERC Corp. (RERC Corp. Second Quarter 10-Q) for
the quarter ended June 30, 2001.
The following notes to the financial statements in the RERC Corp. Form 10-K
relate to certain contingencies. These notes, as updated herein, are
incorporated herein by reference:
Notes to Consolidated Financial Statements (RERC Corp. 10-K Notes): Note
2(f) (Regulatory Assets), Note 4 (Derivative Financial Instruments) and
Note 9 (Commitments and Contingencies).
For information regarding environmental matters and legal proceedings, see
Note 10 to RERC's Interim Financial Statements.
(2) NEW ACCOUNTING PRONOUNCEMENTS
In July 2001, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (SFAS) No. 141 "Business
Combinations" (SFAS No. 141) and SFAS No. 142 "Goodwill and Other Intangible
Assets " (SFAS No. 142). SFAS No. 141 requires business combinations initiated
after June 30, 2001 to be accounted for using the purchase method of accounting,
and broadens the criteria for recording intangible assets separate from
goodwill. Recorded goodwill and intangibles will be evaluated against these new
criteria and may result in certain intangibles being transferred to goodwill, or
alternatively, amounts initially recorded as goodwill may be separately
identified and recognized apart from goodwill. SFAS No. 142 provides for a
nonamortization approach, whereby goodwill and certain intangibles with
indefinite lives will not be amortized into results of operations, but instead
will be reviewed periodically for impairment and written down and charged to
results of operations only in the periods in which the recorded value of
goodwill and certain intangibles with indefinite lives is more than its fair
value. The provisions of each statement which apply to goodwill and intangible
assets acquired prior to June 30, 2001 will be adopted by RERC on January 1,
2002. RERC is in the process of determining the effect of adoption of SFAS No.
141 and SFAS No. 142 on its consolidated financial statements.
In August 2001, the FASB issued SFAS No. 143, "Accounting for Asset
Retirement Obligations" (SFAS No. 143). SFAS No. 143 requires the fair value of
a liability for an asset retirement legal obligation to be recognized in the
period in which it is incurred. When the liability is initially recorded,
associated costs are capitalized by increasing the carrying amount of the
related long-lived asset. Over time, the liability is accreted to its present
value each period, and the capitalized cost is depreciated over the useful life
of the related asset. SFAS No. 143 is effective for fiscal years beginning after
June 15, 2002, with earlier application encouraged. SFAS No. 143 requires
entities to record a cumulative effect of change in accounting principle in the
income statement in the period of
45
adoption. RERC plans to adopt SFAS No. 143 on January 1, 2003 and is in the
process of determining the effect of adoption on its consolidated financial
statements.
In August 2001, the FASB issued SFAS No. 144 "Accounting for the Impairment
or Disposal of Long-Lived Assets" (SFAS No. 144). SFAS No. 144 provides new
guidance on the recognition of impairment losses on long-lived assets to be held
and used or to be disposed of and also broadens the definition of what
constitutes a discontinued operation and how the results of a discontinued
operation are to be measured and presented. SFAS No. 144 supercedes SFAS No. 121
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
Be Disposed Of" and Accounting Principles Board Opinion No. 30 (APB Opinion No.
30), while retaining many of the requirements of these two statements. Under
SFAS No. 144, assets held for sale that are a component of an entity will be
included in discontinued operations if the operations and cash flows will be or
have been eliminated from the ongoing operations of the entity and the entity
will not have any significant continuing involvement in the operations
prospectively. SFAS No. 144 is effective for fiscal years beginning after
December 15, 2001, with early adoption encouraged. SFAS No. 144 is not expected
to materially change the methods used by RERC to measure impairment losses on
long-lived assets, but may result in additional future dispositions being
reported as discontinued operations than is currently permitted. RERC plans to
adopt SFAS No. 144 on January 1, 2002.
(3) DERIVATIVE FINANCIAL INSTRUMENTS
Adoption of SFAS No. 133 "Accounting for Derivative Instruments and Hedging
Activities" as amended (SFAS No. 133) on January 1, 2001 resulted in a
cumulative after-tax decrease in accumulated other comprehensive loss of $38
million. The adoption also increased current assets, long-term assets, current
liabilities and long-term liabilities by $88 million, $5 million, $53 million
and $2 million, respectively, in RERC's Consolidated Balance Sheet. During the
nine months ended September 30, 2001, losses of $31 million of the initial
transition adjustment recognized in other comprehensive loss were realized in
net income.
During the third quarter of 2001, the FASB cleared an issue related to
application of the normal purchases and normal sales exception to contracts that
combine forward and purchased option contracts. The effective date of this
guidance is April 1, 2002. RERC is currently assessing the impact of this
recently cleared issue and does not believe it will have a material impact on
RERC's consolidated financial statements.
Cash Flow Hedges. During the nine months ended September 30, 2001, the
amount of hedge ineffectiveness recognized in earnings from derivatives that are
designated and qualify as cash flow hedges was immaterial. No component of the
derivative instruments' gain or loss was excluded from the assessment of
effectiveness. During the nine months ended September 30, 2001, there were no
deferred gains or losses recognized in earnings as a result of the
discontinuance of cash flow hedges because it was no longer probable that the
forecasted transaction would occur. As of September 30, 2001, current
non-trading derivative assets and liabilities and corresponding amounts in
accumulated other comprehensive loss are expected to be reclassified into net
income during the next twelve months.
(4) RELIANT ENERGY'S SEPARATION PLAN
In 2000, Reliant Energy announced its intention to divide into two publicly
traded companies in order to separate its unregulated businesses from its
regulated businesses. In August 2000, Reliant Energy formed Reliant Resources to
own and operate a substantial portion of Reliant Energy's unregulated operations
and to offer no more than 20% of Reliant Resources' common stock in an initial
public offering. In May 2001, Reliant Resources offered 59.8 million shares of
its common stock to the public in an initial public offering and received net
proceeds of $1.7 billion. Reliant Energy expects to distribute the remaining
common stock of Reliant Resources it owns to Reliant Energy's or its successor's
shareholders within twelve months after the completion of Reliant Resources'
initial public offering.
As part of the separation, Reliant Energy will undergo a restructuring of
its corporate organization to achieve a new holding company structure. The new
holding company will hold Reliant Energy's regulated businesses and will be
named CenterPoint Energy, Inc. In connection with the formation of the new
holding company, Reliant Energy has filed an application with the SEC requesting
an exemption from the registration requirements of the Public Utility Holding
Company Act of 1935 (1935 Act). The restructuring will require approval of the
SEC, certain of the affected state commissions and the Nuclear Regulatory
Commission. On October 22, 2001, the Board of Directors of Reliant Energy
announced that a special meeting of shareholders of Reliant Energy will be held
on December 17, 2001. At the special meeting, shareholders of record as of the
close of business on November 1, 2001
46
will be asked to approve the merger whereby CenterPoint Energy, Inc. will
become the new holding company. Reliant Energy expects to begin mailing a joint
proxy statement/prospectus relating to the special meeting to its shareholders
on or about November 12, 2001.
In order to satisfy requirements for maintaining the exemption from the
registration requirements of the 1935 Act, RERC expects to separate its three
gas distribution divisions into three separate corporate entities within two
years of the SEC's exemption order. The separation of these businesses will
require additional regulatory approvals from the state utility regulators in
five of the six states where RERC currently operates gas distribution businesses
and may require waivers, consents and/or modifications to certain RERC
agreements, including credit facilities and other financing arrangements.
On December 31, 2000, RERC Corp. transferred all of the outstanding stock
of Reliant Energy Services International, Inc. (RESI), Arkla Finance Corporation
(Arkla Finance) and Reliant Energy Europe Trading & Marketing, Inc. (RE Europe
Trading), all wholly owned subsidiaries of RERC Corp., to Reliant Resources
(collectively, the Stock Transfer). Both RERC Corp. and Reliant Resources are
subsidiaries of Reliant Energy. As a result of the Stock Transfer, RESI, Arkla
Finance and RE Europe Trading each became a wholly owned subsidiary of Reliant
Resources.
Also, on December 31, 2000, a wholly owned subsidiary of Reliant Resources
merged with and into Reliant Energy Services, Inc. (Reliant Energy Services), a
wholly owned subsidiary of RERC Corp., with Reliant Energy Services as the
surviving corporation (Merger). As a result of the Merger, Reliant Energy
Services became a wholly owned subsidiary of Reliant Resources. As consideration
for the Merger, Reliant Resources paid $94 million to RERC Corp.
Prior to January 1, 2001, Reliant Energy Services, RESI and RE Europe
Trading conducted the trading, marketing, power origination and risk management
business and operations of RERC. Arkla Finance is a company that holds an
investment in marketable equity securities. The Stock Transfer and the Merger
are part of Reliant Energy's previously announced restructuring.
RERC is reporting the results of RE Europe Trading as discontinued
operations for all periods presented in RERC's Interim Financial Statements in
accordance with APB Opinion No. 30.
(5) DISCONTINUED OPERATIONS
As discussed in Note 4, on December 31, 2000, RERC transferred all of the
outstanding stock of RE Europe Trading to Reliant Resources. As a result of the
transfer, RERC is reporting the results of RE Europe Trading as discontinued
operations for all periods presented in RERC's Interim Financial Statements in
accordance with APB Opinion No. 30. Below is a table of the operating results of
RE Europe Trading for the three and nine months ended September 30, 2000.
<Table>
<Caption>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, 2000 SEPTEMBER 30, 2000
------------------ ------------------
(IN MILLIONS)
Revenues ................ $ 8 $ 13
Operating expenses ...... 16 29
Operating loss .......... (8) (16)
Net loss ................ (8) (16)
</Table>
In addition to RE Europe Trading, RERC transferred its interests in RESI,
Arkla Finance and Reliant Energy Services to Reliant Resources as described in
Note 4. The transfer of these operations did not result in the disposal of a
segment of business as defined under APB Opinion No. 30. Revenues and net income
for these operations were $6 billion and $9 million, respectively, for the three
months ended September 30, 2000 and revenues and net loss were $12 billion and
$4 million, respectively, for the nine months ended September 30, 2000.
(6) DEPRECIATION AND AMORTIZATION
RERC's depreciation expense for the quarter and nine months ended September
30, 2000 was $43 million and $118 million, respectively, compared to $37 million
and $109 million for the same periods in 2001. Amortization
47
expense, primarily relating to goodwill amortization, for the quarter and nine
months ended September 30, 2000 was $16 million and $46 million, respectively,
compared to $15 million and $46 million for the same periods in 2001.
(7) RERC OBLIGATED MANDATORILY REDEEMABLE CONVERTIBLE PREFERRED SECURITIES OF
SUBSIDIARY TRUSTS HOLDING SOLELY JUNIOR SUBORDINATED DEBENTURES OF RERC -- see
Note 11 to Reliant Energy's Interim Financial Statements.
(8) COMPREHENSIVE INCOME
The following table summarizes the components of total comprehensive (loss)
income.
<Table>
<Caption>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
----------------------------- ----------------------------
2000 2001 2000 2001
------------ ------------ ------------ ------------
(IN MILLIONS)
Net (loss) income .................................... $ (27) $ (27) $ 15 $ 19
Other comprehensive income:
Additional minimum non-qualified pension
liability adjustment ............................. -- (3) -- 1
Cumulative effect of adoption of SFAS No. 133 ...... -- -- -- 38
Net deferred loss from cash flow hedges ............ -- (7) -- (66)
Reclassification of net deferred gains from cash
flow hedges realized in net income ............... -- (23) -- (38)
Unrealized loss on available-for-sale securities .. (2) -- -- --
Reclassification adjustment for impairment loss
on available-for-sale securities realized in
net income ....................................... 3 -- 17 --
------------ ------------ ------------ ------------
Comprehensive (loss) income .......................... $ (26) $ (60) $ 32 $ (46)
============ ============ ============ ============
</Table>
(9) RELATED PARTY TRANSACTIONS
From time to time, RERC has advanced to or borrowed money from Reliant
Energy or its subsidiaries. As of December 31, 2000, included in accounts and
notes payable-affiliated companies, RERC had net short term borrowings of $59
million and net accounts payable of $76 million. As of September 30, 2001,
included in accounts and notes payable-affiliated companies, RERC had net short
term notes receivable of $7 million, offset by net accounts payable of $35
million. As of December 31, 2000 and September 30, 2001, RERC had net long term
borrowings, included in notes payable-affiliated companies, totaling $22 million
and $27 million, respectively. For the three and nine months ended September 30,
2000, RERC had net interest income of $1 million and $3 million, respectively.
For the three and nine months ended September 30, 2001, RERC had net interest
income of $0.5 million and $5 million, respectively.
In 2000, Reliant Energy Services supplied natural gas to, purchased
electricity for resale from, and provided marketing and risk management services
to, unregulated power plants in deregulated markets acquired or operated by
Reliant Energy Power Generation, Inc., an indirect subsidiary of Reliant Energy,
or its subsidiaries. In 2001, RERC supplies natural gas to Reliant Energy
Services, now a subsidiary of Reliant Resources (see Note 4). For the three and
nine months ended September 30, 2000, the sales and services to Reliant Energy
and its affiliates totaled $268 million and $452 million, respectively. For the
three and nine months ended September 30, 2001, the sales and services to
Reliant Energy and its affiliates totaled $15 million and $148 million,
respectively. Purchases from Reliant Energy and its affiliates were $192 million
and $318 million for the three and nine months ended September 30, 2000,
respectively, and $85 million and $516 million for the three and nine months
ended September 30, 2001, respectively.
Reliant Energy provides some corporate services to RERC, including various
corporate support services (including accounting, finance, investor relations,
planning, legal, communications, governmental and regulatory affairs and human
resources), information technology services and other shared services such as
corporate security, facilities management, accounts receivable, accounts payable
and payroll, office support services and purchasing and logistics. The costs of
services have been directly charged or allocated to RERC using methods that
management believes are reasonable. These methods include negotiated usage
rates, dedicated asset assignment, and proportionate corporate formulas based on
assets, operating expenses and employees. These charges and
48
allocations are not necessarily indicative of what would have been incurred had
RERC been a separate entity. Amounts charged and allocated to RERC for these
services were $9 million and $23 million for the three and nine months ended
September 30, 2000, respectively, and $7 million and $22 million for the three
and nine months ended September 30, 2001, respectively, and are included
primarily in operation and maintenance expenses.
In May 2001, Reliant Energy made a $236 million capital contribution to
RERC Corp. and RERC Corp. subsequently advanced the $236 million to a financing
subsidiary of Reliant Energy, which is not a subsidiary of RERC.
(10) ENVIRONMENTAL MATTERS AND LEGAL PROCEEDINGS
(a) Environmental Matters.
Manufactured Gas Plant Sites. RERC and its predecessors operated a
manufactured gas plant (MGP) adjacent to the Mississippi River in Minnesota
formerly known as Minneapolis Gas Works (MGW) until 1960. RERC has substantially
completed remediation of the main site other than ongoing water monitoring and
treatment. The manufactured gas was stored in separate holders. RERC is
negotiating cleanup of one such holder. There are six other former MGP sites in
the Minnesota service territory. Remediation has been completed on one site. Of
the remaining five sites, RERC believes that two were neither owned nor operated
by RERC. RERC believes it has no liability with respect to the sites it neither
owned nor operated.
At September 30, 2001, RERC had accrued $17 million for remediation of the
Minnesota sites. At September 30, 2001, the estimated range of possible
remediation costs was $8 million to $36 million. The cost estimates of the MGW
site are based on studies of that site. The remediation costs for the other
sites are based on industry average costs for remediation of sites of similar
size. The actual remediation costs will be dependent upon the number of sites
remediated, the participation of other potentially responsible parties, if any,
and the remediation methods used.
Issues relating to the identification and remediation of MGPs are common in
the natural gas distribution industry. RERC has received notices from the United
States Environmental Protection Agency and others regarding its status as a
potentially responsible party (PRP) for other sites. Based on current
information, RERC has not been able to quantify a range of environmental
expenditures for potential remediation expenditures with respect to other MGP
sites.
Other Minnesota Matters. At September 30, 2001, RERC had recorded accruals
of $4 million (with a maximum estimated exposure for these accruals of
approximately $17 million at September 30, 2001) for other environmental matters
in Minnesota for which remediation may be required.
Mercury Contamination. RERC's pipeline and distribution operations have in
the past employed elemental mercury in measuring and regulating equipment. It is
possible that small amounts of mercury may have been spilled in the course of
normal maintenance and replacement operations and that these spills may have
contaminated the immediate area with elemental mercury. This type of
contamination has been found by RERC at some sites in the past, and RERC has
conducted remediation at these sites. It is possible that other contaminated
sites may exist and that remediation costs may be incurred for these sites.
Although the total amount of these costs cannot be known at this time, based on
experience of RERC and that of others in the natural gas industry to date and on
the current regulations regarding remediation of these sites, RERC believes that
the costs of any remediation of these sites will not be material to RERC's
financial condition, results of operations or cash flows.
Potentially Responsible Party Notifications. From time to time, RERC has
received notices from regulatory authorities or others regarding its status as a
PRP in connection with sites found to require remediation due to the presence of
environmental contaminants. Considering the information currently known about
such sites and the involvement of RERC in activities at these sites, RERC does
not believe that these matters will have a material adverse effect on RERC's
financial condition, results of operations or cash flows.
(b) Other Legal Matters.
California Wholesale Market. Reliant Energy, Reliant Energy Services, Inc.
(a wholly owned subsidiary of Reliant Resources), Reliant Energy Power
Generation, Inc. (a wholly owned subsidiary of Reliant Resources) and several
other subsidiaries of Reliant Resources, as well as three officers of some of
these companies, have been named as defendants in class action lawsuits and
other lawsuits filed against a number of companies that own
49
generation plants in California and other sellers of electricity in California
markets. RERC had also been named as a defendant in one of these actions.
Plaintiffs have voluntarily dismissed Reliant Energy from two of the three class
actions in which it was named as a defendant. Plaintiffs have also voluntarily
dismissed RERC from the one action in which it was named as a defendant.
Other. RERC is a party to litigation (other than that specifically noted)
which arises in the normal course of business. Management regularly analyzes
current information and, as necessary, provides accruals for probable
liabilities on the eventual disposition of these matters. Management believes
that the effects, if any, from the disposition of these matters will not have a
material adverse effect on RERC's financial condition, results of operations or
cash flows.
(11) TRANSFER OF BENEFIT ASSETS AND LIABILITIES
During the first quarter of 2001, RERC Corp. had net distributions to
Reliant Energy related to benefit assets and obligations, net of deferred taxes,
of $62 million.
(12) REPORTABLE SEGMENTS
Because RERC Corp. is a wholly owned subsidiary of Reliant Energy, RERC's
determination of reportable segments considers the strategic operating units
under which Reliant Energy manages sales, allocates resources and assesses
performance of various products and services to wholesale or retail customers in
differing regulatory environments. Segment financial data includes information
for Reliant Energy and RERC on a combined basis, except for Reliant Energy
segments that have no RERC operations in the applicable period. Reconciling
items included under the caption "Elimination of Non-RERC Operations" reduce the
consolidated Reliant Energy amounts by those operations not conducted within the
RERC legal entity. Operations not owned or operated by RERC, but included in
segment information before elimination include primarily the operations and
assets of Reliant Energy's non-rate regulated power generation business in 2000
and Reliant Energy's investment in AOL Time Warner securities, and non-RERC
corporate expenses in 2000 and 2001.
Reliant Energy has identified the following reportable segments in which
RERC has operations: Wholesale Energy (prior to January 1, 2001), Natural Gas
Distribution, Pipelines and Gathering and Other Operations. For descriptions of
the financial reporting segments, see Note 12 to RERC Corp. 10-K Notes. The
following table summarizes financial data for the business segments:
<Table>
<Caption>
FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2000
-------------------------------------------------
AS OF
NET DECEMBER 31, 2000
REVENUES FROM INTERSEGMENT OPERATING -----------------
NON-AFFILIATES REVENUES INCOME (LOSS) TOTAL ASSETS
-------------- ------------- ------------- -------------
(IN MILLIONS)
Wholesale Energy ..................... $ 6,622 $ 112 $ 314 $ 10,866
Natural Gas Distribution ............. 863 7 (42) 4,547
Pipelines and Gathering .............. 42 51 33 2,358
Other Operations ..................... 4 -- (25) 1,482
Reconciling Elimination .............. -- (170) -- (1,112)
Elimination of Non-RERC Operations ... (266) -- (271) (11,565)
------------- ------------- ------------- -------------
Consolidated ......................... $ 7,265 $ -- $ 9 $ 6,576
============= ============= ============= =============
</Table>
<Table>
<Caption>
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2000
-----------------------------------------------------
NET
REVENUES FROM INTERSEGMENT OPERATING
NON-AFFILIATES REVENUES INCOME (LOSS)
-------------- ------------- -------------
(IN MILLIONS)
Wholesale Energy ....................... $ 11,990 $ 352 $ 464
Natural Gas Distribution ............... 2,690 24 51
Pipelines and Gathering ................ 128 146 99
Other Operations ....................... 10 -- (42)
Reconciling Elimination ................ -- (522) --
Elimination of Non-RERC Operations ..... (449) -- (392)
------------- ------------- -------------
Consolidated ........................... $ 14,369 $ -- $ 180
============= ============= =============
</Table>
50
<Table>
<Caption>
FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2001
------------------------------------------------------
AS OF
NET SEPTEMBER 30, 2000
REVENUES FROM INTERSEGMENT OPERATING ------------------
NON-AFFILIATES REVENUES INCOME (LOSS) TOTAL ASSETS
-------------- ------------- ------------- -------------
( IN MILLIONS)
Natural Gas Distribution ............... $ 602 $ 6 $ (25) $ 3,630
Pipelines and Gathering ................ 52 40 34 2,334
Other Operations ....................... 4 1 (53) 1,301
Reconciling Elimination ................ -- (47) -- (1,017)
Elimination of Non-RERC Operations ..... (4) -- 49 (484)
Sales to Non-RERC Affiliates ........... 15 -- -- --
------------- ------------- ------------- -------------
Consolidated ........................... $ 669 $ -- $ 5 $ 5,764
============= ============= ============= =============
</Table>
<Table>
<Caption>
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2001
-------------------------------------------------------
NET
REVENUES FROM INTERSEGMENT OPERATING
NON-AFFILIATES REVENUES INCOME (LOSS)
-------------- -------------- --------------
( IN MILLIONS)
Natural Gas Distribution ............... $ 3,727 $ 92 $ 62
Pipelines and Gathering ................ 177 141 106
Other Operations ....................... 13 1 (201)
Reconciling Elimination ................ -- (234) --
Elimination of Non-RERC Operations ..... (13) -- 196
Sales to Non-RERC Affiliates ........... 148 -- --
-------------- -------------- --------------
Consolidated ........................... $ 4,052 $ -- $ 163
============== ============== ==============
</Table>
51
MANAGEMENT'S NARRATIVE ANALYSIS OF
THE RESULTS OF OPERATIONS OF RERC CORP. AND SUBSIDIARIES
The following narrative analysis should be read in combination with RERC
Corp.'s Interim Financial Statements and notes contained in this Form 10-Q.
RERC Corp. meets the conditions specified in General Instruction H(1)(a)
and (b) to Form 10-Q and is therefore permitted to use the reduced disclosure
format for wholly owned subsidiaries of reporting companies. Accordingly, RERC
Corp. has omitted from this report the information called for by Item 3
(Quantitative and Qualitative Disclosures About Market Risk) of Part I and the
following Part II items of Form 10-Q: Item 2 (Changes in Securities and Use of
Proceeds), Item 3 (Defaults Upon Senior Securities) and Item 4 (Submission of
Matters to a Vote of Security Holders). The following discussion explains
material changes in the amount of revenue and expense items of RERC between the
quarter and nine months ended September 30, 2001 and the quarter and nine months
ended September 30, 2000. Reference is made to Management's Narrative Analysis
of the Results of Operations in Item 7 of the RERC Corp. Form 10-K, the RERC
Corp. 10-K Notes and RERC Corp. First and Second Quarter 10-Q referred to
herein.
On July 27, 2000, Reliant Energy announced its intention to form Reliant
Resources to own and operate a substantial portion of Reliant Energy's
unregulated operations, and to offer no more than 20% of the common stock of
Reliant Resources in an initial public offering (Offering) in connection with
Reliant Energy's business separation plan. In May 2001, Reliant Resources
completed its initial public offering of 59.8 million shares of its common stock
and received net proceeds of $1.7 billion. Reliant Energy expects the Offering
to be followed by a distribution of the remaining common stock of Reliant
Resources owned by Reliant Energy to Reliant Energy's or its successor's
shareholders within twelve months of the Offering (Distribution).
As part of the separation, Reliant Energy will undergo a restructuring of
its corporate organization to achieve a new holding company structure. The new
holding company will hold Reliant Energy's regulated businesses and will be
named CenterPoint Energy, Inc. In connection with the formation of the new
holding company, Reliant Energy has filed an application with the SEC requesting
an exemption from the registration requirements of the Public Utility Holding
Company Act of 1935 (1935 Act). The restructuring will require approval of the
SEC, certain of the affected state commissions and the Nuclear Regulatory
Commission. On October 22, 2001, the Board of Directors of Reliant Energy
announced that a special meeting of shareholders of Reliant Energy will be held
on December 17, 2001. At the special meeting, shareholders of record as of the
close of business on November 1, 2001 will be asked to approve the merger
whereby CenterPoint Energy, Inc. will become the new holding company. Reliant
Energy expects to begin mailing a joint proxy statement/prospectus relating to
the special meeting to its shareholders on or about November 12, 2001.
In order to satisfy requirements for maintaining the exemption from the
registration requirements of the 1935 Act, RERC expects to separate its three
gas distribution divisions into three separate corporate entities within two
years of the SEC's exemption order. The separation of these businesses will
require additional regulatory approvals from the state utility regulators in
five of the six states where RERC currently operates gas distribution businesses
and may require waivers, consents and/or modifications to certain RERC
agreements, including credit facilities and other financing arrangements.
The Distribution is subject to further corporate approvals, market and
other conditions, and government actions, including receipt of a favorable
Internal Revenue Service ruling that the Distribution would be tax-free to
Reliant Energy or its successor and its shareholders for U.S. federal income tax
purposes, as applicable. There can be no assurance that the Distribution will be
completed as described or within the time periods outlined above.
On December 31, 2000, RERC Corp. transferred all of the outstanding stock
of RESI, Arkla Finance and RE Europe Trading, all wholly owned subsidiaries of
RERC Corp., to Reliant Resources (Stock Transfer). Both RERC Corp. and Reliant
Resources are subsidiaries of Reliant Energy. As a result of the Stock Transfer,
RESI, Arkla Finance and RE Europe Trading each became a wholly owned subsidiary
of Reliant Resources.
Also, on December 31, 2000, a wholly owned subsidiary of Reliant Resources
merged with and into Reliant Energy Services, a wholly owned subsidiary of RERC
Corp., with Reliant Energy Services as the surviving corporation (Merger). As a
result of the Merger, Reliant Energy Services became a wholly owned subsidiary
of Reliant Resources. As consideration of the Merger, Reliant Resources paid $94
million to RERC Corp.
52
Reliant Energy Services, together with RESI and RE Europe Trading, conduct
the trading, marketing, power origination and risk management business and
operations of Reliant Energy. Arkla Finance is a company that held an investment
in marketable equity securities.
The Stock Transfer and the Merger are part of Reliant Energy's previously
announced restructuring.
RERC is reporting the results of RE Europe Trading as discontinued
operations for all periods presented in the consolidated financial statements in
accordance with Accounting Principles Board Opinion No. 30.
CONSOLIDATED RESULTS OF OPERATIONS
<Table>
<Caption>
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
--------------------------------- ---------------------------------
2000 2001 2000 2001
------------- ------------- ------------- -------------
( IN MILLIONS)
Revenues ......................................... $ 7,265 $ 669 $ 14,369 $ 4,052
Operating Expenses ............................... (7,256) (664) (14,189) (3,889)
------------- ------------- ------------- -------------
Operating Income ................................. 9 5 180 163
Interest Expense, net ............................ (39) (40) (100) (119)
Other Income (Expense), net ...................... 5 2 (8) 13
Income Tax Benefit (Expense) ..................... 6 6 (41) (38)
------------- ------------- ------------- -------------
(Loss) Income From Continuing Operations ......... (19) (27) 31 19
Loss From Discontinued Operations, net of tax .... (8) -- (16) --
------------- ------------- ------------- -------------
Net (Loss) Income .............................. $ (27) $ (27) $ 15 $ 19
============= ============= ============= =============
</Table>
For the third quarter 2001 and 2000, RERC's net loss was $27 million.
For the first nine months of 2001, RERC's net income was $19 million
compared to net income of $15 million for the same period in 2000. The $4
million increase was primarily due to:
o the effects of colder weather, increased customer growth and usage and
reduced operating expenses due to exiting certain non-rate regulated
retail gas markets outside of RERC's established areas during 2000 in
our Natural Gas Distribution segment,
o improved operating margins (revenues less natural gas costs) from both
pipelines and gas gathering businesses partially offset by increased
operating expenses,
o an after-tax impairment loss of $17 million on marketable equity
securities classified as "available-for-sale" incurred during the
first nine months of 2000, and
o start-up costs of the RE Europe Trading operations in 2000 included in
loss from discontinued operations.
The above items were partially offset by the following:
o an increase in the Natural Gas Distribution segment's bad debt expense
and changes in estimates of unbilled revenues and recoverability of
deferred gas accounts and other items,
o an increase in third-party interest primarily resulting from higher
levels of long-term debt during the nine months ended September 30,
2001 compared to the same period in 2000, and
o during the first nine months of 2000, RERC's results of operations
included the trading and marketing results of Reliant Energy Services,
as discussed above.
During the nine months ended September 30, 2000, RERC incurred a pre-tax
impairment loss of $27 million on marketable equity securities classified as
"available-for-sale" by its Other Operations segment. Management's determination
to recognize this impairment resulted from a combination of events occurring in
2000 related to this investment. For additional information regarding this
impairment loss, see Note 2(l) to RERC Corp. 10-K Notes.
53
This investment is held by Arkla Finance and was transferred to a wholly owned
subsidiary of Reliant Resources effective December 31, 2000.
RERC's operating revenues decreased $6.6 billion and $10.3 billion for the
quarter and nine months ended September 30, 2001, respectively, compared to the
same periods in 2000. The decrease for both periods was primarily due to the
transfer of Reliant Energy Services to Reliant Resources pursuant to the Merger
discussed above. These decreases were partially offset by an increase in
revenues related to the Natural Gas Distribution and Pipelines and Gathering
segments resulting from an increase in the costs of natural gas and to a lesser
extent the effect of cooler weather on the operations of the Natural Gas
Distribution segment. Total operating expenses decreased by $6.6 billion and
$10.3 billion for the quarter and nine months ended September 30, 2001,
respectively, as compared to the same periods in 2000. These decreases were
primarily due to the same reasons for the decreases in revenues discussed above.
RERC's effective tax rate for the first nine months of 2000 and 2001 was
57% and 66%, respectively, primarily due to the effect of the permanent
difference related to goodwill on lower pre-tax income.
RERC is reporting the results of RE Europe Trading as discontinued
operations for all periods presented in RERC's consolidated financial statements
in accordance with APB No. 30. For additional information regarding the
operating results of the other entities transferred to Reliant Resources, please
read Note 13 to RERC Corp. 10-K Notes and Notes 4 and 5 to RERC's Interim
Financial Statements.
Seasonality and Other Factors. RERC's results of operations are affected by
seasonal fluctuations in the demand for and, to a lesser extent, the price of
natural gas. RERC's results of operations are also affected by, among other
things, the actions of various federal and state governmental authorities having
jurisdiction over rates charged by RERC, competition in RERC's various business
operations, debt service costs and income tax expense.
For a discussion of certain other factors that may affect RERC's future
earnings please read "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Certain Factors Affecting Our Future
Earnings -- Competitive and Other Factors Affecting RERC Operations"
"--Environmental Expenditures" and "-- Other Contingencies" in the Reliant
Energy Form 10-K.
NEW ACCOUNTING PRONOUNCEMENTS
In July 2001, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (SFAS) No. 141 "Business
Combinations" (SFAS No. 141) and SFAS No. 142 "Goodwill and Other Intangible
Assets" (SFAS No. 142). SFAS No. 141 requires business combinations initiated
after September 30, 2001 to be accounted for using the purchase method of
accounting, and broadens the criteria for recording intangible assets separate
from goodwill. Recorded goodwill and intangibles will be evaluated against these
new criteria and may result in certain intangibles being transferred to
goodwill, or alternatively, amounts initially recorded as goodwill may be
separately identified and recognized apart from goodwill. SFAS No. 142 provides
for a nonamortization approach, whereby goodwill and certain intangibles with
indefinite lives will not be amortized into results of operations, but instead
will be reviewed periodically for impairment and written down and charged to
results of operations only in the periods in which the recorded value of
goodwill and certain intangibles with indefinite lives is more than its fair
value. We will adopt the provisions of each statement which apply to goodwill
and intangible assets acquired prior to June 30, 2001 on January 1, 2002. We are
in the process of determining the effect of adoption of SFAS No. 141 and SFAS
No. 142 on our consolidated financial statements.
In August 2001, the FASB issued SFAS No. 143, "Accounting for Asset
Retirement Obligations" (SFAS No. 143). SFAS No. 143 requires the fair value of
a liability for an asset retirement legal obligation to be recognized in the
period in which it is incurred. When the liability is initially recorded,
associated costs are capitalized by increasing the carrying amount of the
related long-lived asset. Over time, the liability is accreted to its present
value each period, and the capitalized cost is depreciated over the useful life
of the related asset. SFAS No. 143 is effective for fiscal years beginning after
June 15, 2002, with earlier application encouraged. SFAS No. 143 requires
entities to record a cumulative effect of change in accounting principle in the
income statement in the period of adoption. We plan to adopt SFAS No. 143 on
January 1, 2003 and are in the process of determining the effect of adoption on
our consolidated financial statements.
In August 2001, the FASB issued SFAS No. 144 "Accounting for the Impairment
or Disposal of Long-Lived Assets" (SFAS No. 144). SFAS No. 144 provides new
guidance on the recognition of impairment losses on long-
54
lived assets to be held and used or to be disposed of and also broadens the
definition of what constitutes a discontinued operation and how the results of a
discontinued operation are to be measured and presented. SFAS No. 144 supercedes
SFAS No. 121 "Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to Be Disposed Of" and APB Opinion No. 30, while retaining
many of the requirements of these two statements. Under SFAS No. 144, assets
held for sale that are a component of an entity will be included in discontinued
operations if the operations and cash flows will be or have been eliminated from
the ongoing operations of the entity and the entity will not have any
significant continuing involvement in the operations prospectively. SFAS No. 144
is effective for fiscal years beginning after December 15, 2001, with early
adoption encouraged. SFAS No. 144 is not expected to materially change the
methods we use to measure impairment losses on long-lived assets, but may result
in additional future dispositions being reported as discontinued operations than
is currently permitted. We plan to adopt SFAS No. 144 on January 1, 2002.
55
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS.
Reliant Energy:
For a description of legal proceedings affecting Reliant Energy, please
read Note 12 to Reliant Energy's Interim Financial Statements, Item 3 of the
Reliant Energy Form 10-K and Notes 4 and 14 to Reliant Energy 10-K Notes, all of
which are incorporated herein by reference.
RERC Corp.:
For a description of legal proceedings affecting RERC, please review Note
10 to RERC's Interim Financial Statements, Item 3 of the RERC Corp. Form 10-K
and Note 9 to RERC Corp. 10-K Notes, which are incorporated herein by reference.
ITEM 5. OTHER INFORMATION.
Forward-Looking Statements. From time to time, Reliant Energy and RERC
Corp. make statements concerning their respective expectations, beliefs, plans,
objectives, goals, strategies, future events or performance and underlying
assumptions and other statements, which are not historical facts. These
statements are "forward-looking statements" within the meaning of the Private
Securities Litigation Reform Act of 1995. Although Reliant Energy and RERC Corp.
believe that the expectations and the underlying assumptions reflected in their
respective forward-looking statements are reasonable, they cannot assure you
that these expectations will prove to be correct. Forward-looking statements
involve a number of risks and uncertainties, and actual results may differ
materially from the results discussed in the forward-looking statements.
The following are some of the factors that could cause actual results to
differ materially from those expressed or implied in forward-looking statements:
o state, federal and international legislative and regulatory
developments, including deregulation; re-regulation and restructuring
of the electric utility industry; and changes in, or application of
environmental and other laws and regulations to which we are subject,
o the timing of the implementation of our business separation plan,
o the effects of competition, including the extent and timing of the
entry of additional competitors in our markets,
o industrial, commercial and residential growth in our service
territories,
o our pursuit of potential business strategies, including acquisitions
or dispositions of assets or the development of additional power
generation facilities,
o state, federal and other rate regulations in the United States and in
foreign countries in which we operate or into which we might expand
our operations,
o the timing and extent of changes in commodity prices and interest
rates,
o weather variations and other natural phenomena,
o political, legal and economic conditions and developments in the
United States and in foreign countries in which we operate or into
which we might expand our operations, including the effects of
fluctuations in foreign currency exchange rates,
o financial market conditions and the results of our financing efforts,
o the performance of our projects, and
56
o other factors we discuss in this and other filings by Reliant Energy
and RERC Corp. with the Securities and Exchange Commission.
When used in Reliant Energy's or RERC Corp.'s documents or oral
presentations, the words "anticipate," "estimate," "believe," "continue,"
"could," "intend," "may," "plan," "potential," "predict," "should," "will,"
"expect," "objective," "projection," "forecast," "goal" and similar words are
intended to identify forward-looking statements.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.
(a) Exhibits.
Reliant Energy:
Exhibit 2(a) Agreement and Plan of Merger dated as of September 26,
2001 by and among Reliant Resources, Inc., Reliant
Energy Power Generation Merger Sub, Inc. and Orion Power
Holdings, Inc. (incorporated by reference from Reliant
Energy's Current Report on Form 8-K dated September 27,
2001), Exhibit 2.1, SEC File No. 1-3187
Exhibit 99(a) Items incorporated by reference from the Reliant Energy
Form 10-K: Item 3 "Legal Proceedings," Item 7
"Management's Discussion and Analysis of Financial
Condition and Results of Operations - Certain Factors
Affecting Our Future Earnings" and Notes 2(f) (Summary
of Significant Accounting Policies - Regulatory Assets),
3 (Business Acquisitions), 4 (Regulatory Matters), 5
(Derivative Financial Instruments), 8 (Indexed Debt
Securities (ACES and ZENS) and AOL Time Warner
Securities), 14 (Commitments and Contingencies) and 20
(Subsequent Events) of the Reliant Energy 10-K Notes.
Exhibit 99(b) Items incorporated by reference from Reliant Energy
March 31, 2001 Form 10-Q: Note 2 (Derivative Financial
Instruments).
RERC Corp.:
Exhibit 99 Items incorporated by reference from the Reliant Energy
Form 10-K: Item 7 "Management's Discussion and Analysis
of Financial Condition and Results of Operations -
Certain Factors Affecting Our Future Earnings." Items
incorporated by reference from the RERC Corp. Form 10-K:
Item 3 "Legal Proceedings," Item 7 "Management's
Narrative Analysis of the Results of Operations of RERC
and its Consolidated Subsidiaries" and Notes 2(f)
(Regulatory Assets), 4 (Derivative Financial
Instruments) and 9 (Commitments and Contingencies) of
the RERC Corp. 10-K Notes.
(b) Reports on Form 8-K.
Reliant Energy:
On September 12, 2001 a report on Form 8-K dated August 28, 2001 was
filed containing unaudited pro forma financial statements reflecting the
effects of the Distribution and other events.
On September 27, 2001, a report on Form 8-K was filed reporting the
planned acquisition of Orion Power Holdings, Inc. by Reliant Resources,
Inc.
RERC Corp.:
None.
57
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
RELIANT ENERGY, INCORPORATED
(Registrant)
By: /s/ Mary P. Ricciardello
---------------------------------------------
Mary P. Ricciardello
Senior Vice President and Chief Accounting Officer
Date: November 9, 2001
58
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
RELIANT ENERGY RESOURCES CORP.
(Registrant)
By: /s/ Mary P. Ricciardello
----------------------------------
Mary P. Ricciardello
Senior Vice President
Date: November 9, 2001
59
EXHIBIT INDEX
Reliant Energy:
Exhibit 2(a) Agreement and Plan of Merger dated as of September 26,
2001 by and among Reliant Resources, Inc., Reliant
Energy Power Generation Merger Sub, Inc. and Orion Power
Holdings, Inc. (incorporated by reference from Reliant
Energy's Current Report on Form 8-K dated September 27,
2001), Exhibit 2.1, SEC File No. 1-3187
Exhibit 99(a) Items incorporated by reference from the Reliant Energy
Form 10-K: Item 3 "Legal Proceedings," Item 7
"Management's Discussion and Analysis of Financial
Condition and Results of Operations - Certain Factors
Affecting Our Future Earnings" and Notes 2(f) (Summary
of Significant Accounting Policies - Regulatory Assets),
3 (Business Acquisitions), 4 (Regulatory Matters), 5
(Derivative Financial Instruments), 8 (Indexed Debt
Securities (ACES and ZENS) and AOL Time Warner
Securities), 14 (Commitments and Contingencies) and 20
(Subsequent Events) of the Reliant Energy 10-K Notes.
Exhibit 99(b) Items incorporated by reference from Reliant Energy
March 31, 2001 Form 10-Q: Note 2 (Derivative Financial
Instruments).
RERC Corp.:
Exhibit 99 Items incorporated by reference from the Reliant Energy
Form 10-K: Item 7 "Management's Discussion and Analysis
of Financial Condition and Results of Operations -
Certain Factors Affecting Our Future Earnings." Items
incorporated by reference from the RERC Corp. Form 10-K:
Item 3 "Legal Proceedings," Item 7 "Management's
Narrative Analysis of the Results of Operations of RERC
and its Consolidated Subsidiaries" and Notes 2(f)
(Regulatory Assets), 4 (Derivative Financial
Instruments) and 9 (Commitments and Contingencies) of
the RERC Corp. 10-K Notes.