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 MARCH 31, 2002
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
-------------- ---------------
Commission file number 1-3187
RELIANT ENERGY, INCORPORATED
(Exact name of registrant as specified in its charter)
Texas 74-0694415
(State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.)
1111 Louisiana
Houston, Texas 77002
(Address of principal executive offices) (Zip Code)
(713) 207-3000
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No
----- -----
As of May 9, 2002, Reliant Energy, Incorporated had 303,558,973 shares of common
stock outstanding, including 5,949,332 ESOP shares not deemed outstanding for
financial statement purposes and excluding shares held as treasury stock.
RELIANT ENERGY, INCORPORATED
QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTER ENDED MARCH 31, 2002
TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements...................................................... 1
Statements of Consolidated Income
Three Months Ended March 31, 2001 and 2002 (unaudited)................... 1
Consolidated Balance Sheets
December 31, 2001 and March 31, 2002 (unaudited)......................... 2
Statements of Consolidated Cash Flows
Three Months Ended March 31, 2001 and 2002 (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................................. 35
Item 3. Quantitative and Qualitative Disclosures about Market Risk................ 60
PART II. OTHER INFORMATION
Item 1. Legal Proceedings......................................................... 64
Item 5. Other Information......................................................... 64
Item 6. Exhibits and Reports on Form 8-K.......................................... 66
i
PART I. FINANCIAL INFORMATION
RELIANT ENERGY, INCORPORATED AND SUBSIDIARIES
STATEMENTS OF CONSOLIDATED INCOME
(THOUSANDS OF DOLLARS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
THREE MONTHS ENDED
MARCH 31,
------------------------------
2001 2002
------------- ------------
(AS RESTATED)
REVENUES ................................................................... $ 12,078,216 $ 8,655,733
EXPENSES:
Fuel and cost of gas sold ................................................ 7,682,104 3,552,950
Purchased power .......................................................... 2,876,263 3,586,087
Operation and maintenance ................................................ 722,320 654,032
Taxes other than income taxes ............................................ 140,304 125,705
Depreciation ............................................................. 102,113 199,319
Amortization ............................................................. 94,546 20,371
Other .................................................................... 2,305 745
------------ ------------
Total ................................................................ 11,619,955 8,139,209
------------ ------------
OPERATING INCOME ........................................................... 458,261 516,524
------------ ------------
OTHER INCOME (EXPENSE):
Unrealized gain (loss) on AOL Time Warner investment ..................... 137,082 (217,597)
Unrealized (loss) gain on indexed debt securities ........................ (135,047) 203,233
Income from equity investment of unconsolidated subsidiaries ............. 12,606 3,784
Interest expense ......................................................... (178,062) (154,056)
Distribution on trust preferred securities ............................... (13,900) (13,899)
Minority interest ........................................................ 291 (16,433)
Other, net ............................................................... 27,415 17,617
------------ ------------
Total ................................................................ (149,615) (177,351)
------------ ------------
INCOME BEFORE INCOME TAXES, CUMULATIVE EFFECT OF ACCOUNTING CHANGE AND
PREFERRED DIVIDENDS ..................................................... 308,646 339,173
Income Tax Expense ...................................................... 107,718 113,821
------------ ------------
INCOME BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGE AND PREFERRED DIVIDENDS 200,928 225,352
Cumulative Effect of Accounting Change, net of tax of $33,205 ........... 61,666 --
------------ ------------
INCOME BEFORE PREFERRED DIVIDENDS .......................................... 262,594 225,352
Preferred Dividends .................................................... 97 --
------------ ------------
NET INCOME ATTRIBUTABLE TO COMMON STOCKHOLDERS ............................. $ 262,497 $ 225,352
============ ============
BASIC EARNINGS PER SHARE:
Income before Cumulative Effect of Accounting Change .................... $ 0.69 $ 0.76
Cumulative Effect of Accounting Change, net of tax ...................... 0.22 --
------------ ------------
Net Income Attributable to Common Stockholders .......................... $ 0.91 $ 0.76
============ ============
DILUTED EARNINGS PER SHARE:
Income before Cumulative Effect of Accounting Change .................... $ 0.69 $ 0.76
Cumulative Effect of Accounting Change, net of tax ...................... 0.21 --
------------ ------------
Net Income Attributable to Common Stockholders .......................... $ 0.90 $ 0.76
============ ============
See Notes to the Company's Interim Financial Statements
1
RELIANT ENERGY, INCORPORATED AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(THOUSANDS OF DOLLARS)
(UNAUDITED)
ASSETS
DECEMBER 31, MARCH 31,
2001 2002
------------ ------------
CURRENT ASSETS:
Cash and cash equivalents ........................ $ 153,952 $ 295,995
Restricted cash .................................. 167,421 346,885
Investment in AOL Time Warner common stock ....... 826,609 609,013
Accounts receivable, net ......................... 1,911,923 2,245,432
Accrued unbilled revenues ........................ 240,698 476,723
Fuel stock and petroleum products ................ 307,036 231,575
Materials and supplies ........................... 272,637 302,727
Trading and marketing assets ..................... 1,611,393 1,418,582
Non-trading derivative assets .................... 399,896 550,962
Margin deposits on energy trading activities ..... 213,727 65,727
Other ............................................ 167,648 250,696
------------ ------------
Total current assets ........................... 6,272,940 6,794,317
------------ ------------
PROPERTY, PLANT AND EQUIPMENT:
Property, plant and equipment .................... 24,139,145 28,305,935
Less accumulated depreciation and amortization ... (8,344,269) (8,391,320)
------------ ------------
Property, plant and equipment, net ............. 15,794,876 19,914,615
------------ ------------
OTHER ASSETS:
Goodwill, net .................................... 2,588,421 3,897,152
Other intangibles, net ........................... 377,732 387,508
Regulatory assets ................................ 3,276,800 3,233,036
Trading and marketing assets ..................... 446,610 642,588
Non-trading derivative assets .................... 256,402 414,920
Equity investments in unconsolidated subsidiaries. 386,841 383,152
Stranded costs indemnification receivable ........ 203,693 199,540
Restricted cash .................................. 6,775 111,309
Other ........................................... 1,098,762 1,013,303
------------ ------------
Total other assets ............................. 8,642,036 10,282,508
------------ ------------
TOTAL ASSETS ................................. $ 30,709,852 $ 36,991,440
============ ============
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
DECEMBER 31, MARCH 31,
2001 2002
------------ ------------
CURRENT LIABILITIES:
Short-term borrowings .................................................. $ 3,435,347 $ 8,932,755
Current portion of long-term debt ...................................... 660,757 841,556
Indexed debt securities derivative ..................................... 730,225 526,992
Accounts payable ....................................................... 1,447,289 1,692,725
Taxes accrued .......................................................... 315,353 293,707
Interest accrued ....................................................... 114,721 147,610
Dividends declared ..................................................... 9 366
Trading and marketing liabilities ...................................... 1,478,335 1,295,424
Non-trading derivative liabilities ..................................... 396,021 302,411
Margin deposits from customers on energy trading activities ............ 144,700 214,150
Regulatory liabilities ................................................. 234,706 235,987
Accumulated deferred income taxes, net ................................. 385,820 476,129
Other .................................................................. 568,861 426,465
------------ ------------
Total current liabilities ............................................ 9,912,144 15,386,277
------------ ------------
OTHER LIABILITIES:
Accumulated deferred income taxes, net ................................. 2,345,202 2,570,129
Unamortized investment tax credits ..................................... 247,407 242,792
Trading and marketing liabilities ...................................... 361,786 566,643
Non-trading derivative liabilities ..................................... 540,036 581,893
Benefit obligations .................................................... 547,369 633,858
Regulatory liabilities ................................................. 1,125,176 905,336
Non-derivative stranded costs liability ................................ 203,693 199,540
Other .................................................................. 1,069,312 971,912
------------ ------------
Total other liabilities .............................................. 6,439,981 6,672,103
------------ ------------
LONG-TERM DEBT ............................................................ 5,746,444 5,986,240
------------ ------------
COMMITMENTS AND CONTINGENCIES (NOTES 1 AND 13)
MINORITY INTEREST IN CONSOLIDATED SUBSIDIARIES ............................ 1,047,366 1,074,946
------------ ------------
COMPANY OBLIGATED MANDATORILY REDEEMABLE PREFERRED SECURITIES OF SUBSIDIARY
TRUSTS HOLDING SOLELY JUNIOR SUBORDINATED DEBENTURES OF THE COMPANY .... 705,744 705,854
------------ ------------
STOCKHOLDERS' EQUITY:
Common stock ........................................................... 3,897,301 3,911,960
Unearned ESOP stock .................................................... (131,888) (113,028)
Retained earnings ...................................................... 3,176,533 3,290,869
Accumulated other comprehensive (loss) income .......................... (83,773) 76,219
------------ ------------
Total stockholders' equity ........................................... 6,858,173 7,166,020
------------ ------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY ......................... $ 30,709,852 $ 36,991,440
============ ============
See Notes to the Company's Interim Financial Statements
3
RELIANT ENERGY, INCORPORATED AND SUBSIDIARIES
STATEMENTS OF CONSOLIDATED CASH FLOWS
(THOUSANDS OF DOLLARS)
(UNAUDITED)
THREE MONTHS ENDED MARCH 31,
------------------------------
2001 2002
------------ ------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income attributable to common stockholders ................ $ 262,497 $ 225,352
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation and amortization ............................... 196,659 219,690
Deferred income taxes ....................................... 53,809 72,207
Investment tax credits ...................................... (4,583) (4,614)
Cumulative effect of accounting change ...................... (61,666) --
Unrealized (gain) loss on AOL Time Warner investment ........ (137,082) 217,597
Unrealized loss (gain) on indexed debt securities ........... 135,047 (203,233)
Undistributed earnings of unconsolidated subsidiaries ....... 2,269 (2,285)
Minority interest ........................................... (291) 16,433
Changes in other assets and liabilities, net of effects of
acquisitions:
Restricted cash ........................................... 50,000 56,716
Accounts receivable and accrued unbilled revenues, net .... 149,183 (559,786)
Inventory ................................................. 61,264 107,244
Accounts payable .......................................... (753,305) 138,432
Fuel cost (under) over recovery ........................... (164,602) 98,381
Net trading and marketing assets and liabilities .......... (44,855) 24,023
Margin deposits on energy trading activities, net ......... 206,157 217,450
Net non-trading derivative assets and liabilities ......... 4,421 (93,623)
Prepaid lease obligation .................................. (111,367) (40,292)
Interest and taxes accrued ................................ 200,812 (21,380)
Net regulatory assets and liabilities ..................... (37,814) (129,094)
Collateral for generating equipment, net .................. 23,244 130,421
Other current assets ...................................... 38,246 8,197
Other current liabilities ................................. (93,751) (196,677)
Other assets .............................................. 73,529 20,458
Other liabilities ......................................... 36,414 (105,671)
Other, net .................................................. 35,927 39,996
------------ ------------
Net cash provided by operating activities ............... 120,162 235,942
------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures .......................................... (491,558) (392,674)
Business acquisitions, net of cash acquired ................... -- (2,948,821)
Investments in unconsolidated subsidiaries .................... (724) --
Other, net .................................................... (4,974) 17,484
------------ ------------
Net cash used in investing activities ................... (497,256) (3,324,011)
------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from long-term debt, net ............................. 544,632 22,575
(Decrease) increase in short-term borrowing, net .............. (168,902) 3,358,229
Payments of long-term debt .................................... (26,556) (38,051)
Payment of common stock dividends ............................. (107,597) (110,936)
Proceeds from issuance of stock ............................... 36,895 4,076
Decrease in restricted cash related to securitization financing -- 2,958
Other, net .................................................... (958) (8,073)
------------ ------------
Net cash provided by financing activities ............... 277,514 3,230,778
------------ ------------
EFFECT OF EXCHANGE RATE CHANGES ON CASH ......................... (8,240) (666)
------------ ------------
NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS ............ (107,820) 142,043
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD ................ 191,825 153,952
------------ ------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD ...................... $ 84,005 $ 295,995
============ ============
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash Payments:
Interest (net of amounts capitalized) ......................... $ 181,091 $ 118,134
Income taxes .................................................. 2,757 867
See Notes to the Company's Interim Financial Statements
4
RELIANT ENERGY, INCORPORATED AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(1) BACKGROUND AND BASIS OF PRESENTATION
Included in this Quarterly Report on Form 10-Q (Form 10-Q) for Reliant
Energy, Incorporated (Reliant Energy), together with its subsidiaries
(collectively, the Company), are Reliant Energy'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 Annual Report on Form 10-K of Reliant Energy (Reliant Energy Form 10-K)
for the year ended December 31, 2001.
RESTATEMENT
On May 9, 2002, Reliant Resources determined that it had engaged in
same-day commodity trading transactions involving purchases and sales with the
same counterparty for the same volume at substantially the same price, which the
personnel who effected these transactions apparently did so with the objective
of increasing volumes. Reliant Resources commenced a review to quantify the
amount and assess the impact of these trades (round trip trades). The Audit
Committee of the Company's Board of Directors has also directed an internal
investigation by outside legal counsel of the facts and circumstances relating
to the round trip trades and related matters.
The Company currently reports all trading, marketing and risk management
services transactions on a gross basis with such transactions being reported in
revenues and expenses except primarily for financial gas transactions such as
swaps. Therefore, the round trip trades were reflected in both the Company's
revenues and its expenses. The round trip trades should not have been recognized
in revenues or expenses (i.e., they should have been reflected on a net basis).
However, since the round trip trades were done at the same volume and
substantially the same price, they had no impact on the Company's reported cash
flows, operating income or net income.
Based on the Company's review, the Company has determined that the Company
engaged in such round trip trades in 1999, 2000 and 2001 and the Company's
review did not identify any round trip trades conducted during 2002. The results
of the Audit Committee's investigation are consistent with the results of the
Company's review. During the first quarter of 2001, the trades of this nature
were 20 million megawatt hours (MWh) of power. In the first quarter of 2001,
these transactions had the effect of increasing revenues and purchased power
expense by approximately $1.2 billion, or approximately 10% and 43%,
respectively.
The consolidated financial statements for the three months ended March 31,
2001 have been restated from amounts previously reported to reflect these
transactions on a net basis. The restatement had no impact on previously
reported consolidated cash flows, operating income or net income. A summary of
the principal effects of the restatement are as follows: (Note - Those line
items for which no change in amounts are shown were not affected by the
restatement.)
THREE MONTHS ENDED MARCH 31, 2001
---------------------------------
AS PREVIOUSLY
AS RESTATED REPORTED
----------- -------------
(IN MILLIONS)
Revenues ........................................... $ 12,078 $ 13,310
Expenses:
Fuel and cost of gas sold ....................... 7,682 7,682
Purchased power ................................. 2,876 4,108
Other expenses .................................. 1,062 1,062
----------- -----------
Total ......................................... 11,620 12,852
----------- -----------
Operating Income ................................... 458 458
Other Expense, net ................................. (149) (149)
Income Tax Expense ................................. (108) (108)
----------- -----------
Income Before Cumulative Effect of Accounting Change 201 201
Cumulative Effect of Accounting Change, net of tax . 61 61
----------- -----------
Net Income Attributable to Common Stockholders ..... $ 262 $ 262
=========== ===========
5
The restatement did not impact earnings per share, the Consolidated Balance
Sheet as of December 31, 2001 or the Statement of Consolidated Cash Flows for
the three months ended March 31, 2001.
In addition to the round trip trades described above, the Company's review
and the Audit Committee's investigation also considered other transactions
executed at the same volume, price and delivery terms and with the same
counterparty. These transactions were executed in the normal course of the
Company's trading and marketing activities, reported on a gross basis, and were
not significant.
For the future, the Company is considering presenting certain of its
mark-to-market transactions on a net, rather than gross, basis. Management
believes that net reporting may be a better representation of performance of the
business. The Company is currently consulting with its outside auditors,
Deloitte & Touche LLP, and intends to consult with the Securities and Exchange
Commission (SEC) staff, about this possible change in accounting method and
other related issues.
As previously reported, during the May 2001 through September 2001 time
frame, the Company entered into four structured transactions involving a series
of forward or swap contracts to buy and sell an energy commodity in 2001 and to
buy and sell an energy commodity in 2002 or 2003 (the four structured
transactions). Each series of contracts in a structure were executed
contemporaneously with the same counterparty and were for the same commodities,
quantities and locations. The contracts in each structure were offsetting in
terms of physical attributes. These transactions were previously recorded on a
gross basis with such transactions being reported in revenues and expenses which
resulted in $1.9 billion of revenues, $746 million in fuel and cost of gas sold
and $1.2 billion of purchased power expense being recognized during the period
from May 2001 through December 31, 2001. Having further reviewed the
transactions, the Company now believes these transactions should have been
accounted for on a net basis. The information included in the Company's first
quarter 2002 earnings release, included as an exhibit to the Company's Current
Report on Form 8-K dated April 29, 2002, included $71 million of revenues and
purchased power expense related to these transactions which have been eliminated
from the Interim Financial Statements for the three months ended March 31, 2002.
While the Company is still completing its review of these round trip
trades, as soon as practical, the Company will reissue its consolidated
financial statements for the years ended December 31, 1999, 2000 and 2001 to
restate the revenues, fuel and cost of gas sold and purchased power expense from
the amounts previously reported for the round trip trades effected during such
years and for the four structured transactions in 2001. In addition, if the
Company changes its accounting policy to account for certain trading, marketing
and risk management services activities on a net, rather than gross basis, such
reissued consolidated financial statements for such years may also reflect this
change in accounting policy.
BASIS OF PRESENTATION
The preparation of financial statements in conformity with generally
accepted accounting principles in the United States of America 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(e) (Long-Lived Assets and Intangibles), Note
2(f) (Regulatory Assets and Liabilities), 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), Note 21 (Bankruptcy
of Enron Corp. and its Affiliates) and Note 22 (Subsequent Events).
6
For information regarding certain legal, tax and regulatory proceedings and
environmental matters, see Note 13.
Reliant Energy is in the process of separating its regulated and
unregulated businesses into two publicly traded companies. In December 2000,
Reliant Energy transferred a significant portion of its unregulated businesses
to Reliant Resources, Inc. (Reliant Resources) which, at the time, was a wholly
owned subsidiary. In May 2001, Reliant Resources conducted an initial public
offering (Offering) of approximately 20% of its common stock (59.8 million
shares of its common stock) at a price of $30 per share, and received net
proceeds from the Offering of $1.7 billion. After the Offering, Reliant Energy
owned approximately 80% of Reliant Resources. As of March 31, 2002, Reliant
Energy owns approximately 83% of Reliant Resources due to treasury stock
repurchases of $189 million during 2001 by Reliant Resources. Pursuant to a
master separation agreement between Reliant Energy and Reliant Resources,
Reliant Resources used $147 million of the net proceeds of the Offering to repay
certain indebtedness owed to Reliant Energy. In connection with the Offering,
Reliant Energy converted $1.7 billion of intercompany indebtedness owed by
Reliant Resources and its subsidiaries prior to the closing of the Offering to
equity as a capital contribution to Reliant Resources. In December 2001, Reliant
Energy's shareholders approved an agreement and plan of merger by which the
following will occur (which is referred to as the Restructuring):
- CenterPoint Energy, Inc. (CenterPoint Energy), currently a wholly
owned subsidiary of Reliant Energy, will become the holding company
for Reliant Energy and its subsidiaries;
- Reliant Energy and its subsidiaries will become subsidiaries of
CenterPoint Energy; and
- each share of Reliant Energy common stock will be converted into one
share of CenterPoint Energy common stock.
After the Restructuring, Reliant Energy plans, subject to further corporate
approvals, market and other conditions, to complete the separation of its
regulated and unregulated businesses by distributing the shares of common stock
of Reliant Resources that the Company owns to its shareholders (Distribution).
The Company's goal is to complete the Restructuring and subsequent Distribution
as quickly as possible after all the necessary conditions are fulfilled,
including receipt of an order from the Securities and Exchange Commission (SEC)
granting the required approvals under the Public Utility Holding Company Act of
1935 (1935 Act) and an extension from the Internal Revenue Service of its
private letter ruling that the Company has obtained regarding the tax-free
treatment of the Distribution. The Company believes it will receive the
necessary approvals. Reliant Energy currently expects to complete the
Restructuring and Distribution in the summer of 2002. However, until the
requisite approvals are received, no assurance can be provided that the
Distribution will occur as described above or that it will occur within this
time period. Upon receipt of approval under the 1935 Act, CenterPoint Energy
expects to register and become subject, with its subsidiaries, to regulation as
a registered holding company system under the 1935 Act.
Thereafter, in order to enable CenterPoint Energy ultimately to comply with
the requirements for exemption from registration in Section 3(a)(1) of the 1935
Act, Reliant Energy plans to divide the gas distribution businesses conducted by
Reliant Energy Resources Corp.'s (RERC Corp.) three unincorporated divisions,
Reliant Energy Entex, Reliant Energy Arkla and Reliant Energy Minnegasco among
three separate entities. The entity that will hold the Reliant Energy Entex
assets will also hold RERC Corp.'s natural gas pipelines and gathering business.
In addition to regulatory approvals the Company has obtained, this restructuring
will require approval of the public service commissions of Louisiana,
Mississippi, Oklahoma and Arkansas.
Although the Company believes that this business restructuring will be
completed, it can provide no assurance that this will, in fact, occur, or that
CenterPoint Energy will ultimately be exempt from regulation as a registered
holding company under the 1935 Act. For further information on the RERC Corp.
restructuring, see "Our Business -- RERC Corp. Restructuring" in Item 1 of the
Reliant Energy Form 10-K.
During 2001, the Electric Operations business segment reflected the
regulated electric utility business, including generation, transmission and
distribution, and retail electric sales. As of January 1, 2002, with the opening
of the Texas market to full retail electric competition, generation and retail
sales were deregulated. Retail electric sales involve the sale of electricity
and related services to end users of electricity and were included as part of
the bundled regulated service prior to 2002. Retail electric sales are now
reported as the Retail Energy business segment of Reliant Resources. Although
the Company's retail sales are now conducted by Reliant Resources, retail
customers remained regulated customers of Reliant Energy HL&P through the date
of their first meter reading in 2002. Sales of
7
electricity to retail customers in 2002 prior to this meter reading are
reflected in the Electric Transmission and Distribution business segment.
Beginning in 2002, Reliant Energy is reporting two new business segments
for what was the former Electric Operations business segment:
- Electric Generation; and
- Electric Transmission and Distribution.
The previously regulated generation operations in Texas are being reported
in the new Electric Generation business segment. The transmission and
distribution function is now reported separately in the Electric Transmission
and Distribution business segment, which also includes all revenues and effects
from generation-related regulatory assets recoverable by the regulated utility,
including the Excess Cost Over Market (ECOM) true-up component of stranded
costs. For additional information regarding regulatory matters affecting the
Company's electric segments, see Note 4 to the Reliant Energy 10-K Notes, which
note is incorporated herein by reference and Note 3 below.
(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). 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. The Company adopted
the provisions of the statement which apply to goodwill and intangible assets
acquired prior to June 30, 2001 on January 1, 2002. The adoption of SFAS No. 141
did not have a material impact on the Company's historical results of operations
or financial position.
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 supersedes
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, "Reporting the Results of Operations - Reporting the Effects of Disposal of
a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring
Events and Transactions," 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 did not 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 was previously permitted. The Company adopted SFAS No. 144 on
January 1, 2002. As a result of the adoption of SFAS No. 144, the Company's
remaining Latin America operations have been presented on a gross basis in the
consolidated financial statements.
See Note 4 for a discussion of the Company's adoption of SFAS No. 133,
"Accounting for Derivative Instruments and Hedging Activities," as amended (SFAS
No. 133) on January 1, 2001 and adoption of subsequent cleared guidance. See
Note 6 for a discussion of the Company's adoption of SFAS No. 142 "Goodwill and
Other Intangible Assets" (SFAS No. 142) on January 1, 2002.
(3) REGULATORY MATTERS
(a) Excess Cost Over Market (ECOM) True-Up.
Reliant Energy's Electric Generation business segment conducted auctions of
installed electric generation capacity in September, October and December 2001
and March 2002. Excluding reserves for planned and forced outages, as a result
of these auctions, the Company's Texas generation business has sold entitlements
to all of its capacity through August 2002, an average of 72% per month of its
capacity through December 2002 and 10% of its capacity for each month in 2003.
In the contractually mandated auctions held so far, Reliant Resources has
purchased, on average, 72% per month of the 2002 capacity sold by Reliant Energy
and 58% per month of Reliant Energy's 2003 capacity sold in the auctions. These
purchases have been made either through the exercise by Reliant Resources of its
contractual rights or through the submission of bids.
The capacity auctions were consummated at market-based prices that are
substantially below the historical regulated return on the facilities in the
Company's Texas generation business. The Texas electric restructuring law
provides for the recovery in a "true-up" proceeding in 2004 (2004 True-Up
Proceeding) of any difference between
8
market power prices received in the capacity auctions and the earlier estimates
of those market prices by the Public Utility Commission of Texas (Texas Utility
Commission). For the three months ended March 31, 2002, Reliant Energy recorded
approximately $141 million in revenue related to the recovery of the difference
between the market power prices and the Texas Utility Commission's earlier
estimates. For additional information regarding the capacity auctions and the
related true-up proceeding, please read Note 4 to the Reliant Energy 10-K Notes,
which note is incorporated herein by reference.
(b) Generation Asset Impairment Contingency.
The Company evaluates the recoverability of its long-lived assets in
accordance with SFAS No. 144. As of March 31, 2002, no impairment had been
indicated in its Texas generation assets. The Company anticipates that future
events, such as the expected public offering after the Restructuring by the
subsidiary that will conduct the Company's Texas generation operations, or
a change in the estimated holding period of the Texas generation assets, will
require the Company to re-evaluate these assets for impairment between now and
2004. If an impairment is indicated, it could be material and may not be fully
recoverable through the 2004 True-Up Proceeding.
The Texas electric restructuring law provides the Company recovery of the
regulatory book value of its Texas generating assets for the amount the
regulatory book value exceeds the estimated market value. If the Texas
generating assets are sold in the future, a loss on sale of these assets, or an
impairment of the recorded recoverable electric generation plant mitigation
regulatory asset, will occur to the extent the recorded book value of the Texas
generating assets exceeds the regulatory book value. As of March 31, 2002, the
recorded book value was $656 million in excess of the regulatory book value.
This amount declines each year as the recorded book value is depreciated and
increases by the amount of non-environmental capital expenditures. For further
discussion of the difference between the regulatory book value and the recorded
book value, see Note 4 to the Reliant Energy 10-K Notes, which note is
incorporated herein by reference.
(c) Regulatory Assets Contingency.
As of March 31, 2002, in contemplation of the 2004 True-up Proceeding, the
Company's Electric Transmission and Distribution business segment has recorded a
regulatory asset of $2.0 billion representing the estimated future recovery of
previously incurred stranded costs, which includes a regulatory liability of
$1.1 billion plus the reversal of previously recorded redirected depreciation.
This estimated recovery is based upon current projections of the market value of
the Company's Texas generation assets to be covered by the 2004 True-up
Proceeding calculations. The regulatory liability reflects a current refund
obligation arising from prior mitigation of stranded costs deemed excessive by
the Texas Utility Commission. Because accounting principles generally accepted
in the United States of America require the Company to estimate fair market
values in advance of the final reconciliation, the financial impacts of the
Texas electric restructuring law with respect to the final determination of
stranded costs in the 2004 True-Up Proceeding are subject to material changes.
Factors affecting such changes may include estimation risk, uncertainty of
future energy and commodity prices and the economic lives of the plants. If
events were to occur that made the recovery of some of the remaining generation
related regulatory assets no longer probable, the Company would write off the
remaining balance of such assets as a charge against earnings.
(4) DERIVATIVE FINANCIAL INSTRUMENTS
Adoption of 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 during the three months
ended March 31, 2001. For additional information regarding the adoption of SFAS
No. 133 and the Company's accounting policies for derivative financial
instruments, see Note 5 to the Reliant Energy 10-K Notes, which note is
incorporated herein by reference.
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. Certain criteria of this
previously approved guidance were revised in October and December 2001 and
became effective on April 1, 2002. The adoption of the revised guidance did not
have a material impact on the Company's consolidated financial statements.
9
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 was April 1, 2002, and the adoption of this guidance did not have a
material impact on the Company's consolidated financial statements.
Cash Flow Hedges. During the three months ended March 31, 2002, 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 this assessment of
effectiveness. During the three months ended March 31, 2002, a $0.9 million
deferred loss was 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 due to credit problems of a customer. As of March 31,
2002, the Company expects $98 million in accumulated other comprehensive income
to be reclassified into net income during the next twelve months.
Interest Rate Swaps. As of March 31, 2002, the Company holds interest rate
swaps with an aggregate notional amount of $2.7 billion to fix the interest rate
applicable to floating rate short-term debt and floating rate long-term debt. Of
these swaps, $1.5 billion relating to short-term debt do not qualify as cash
flow hedges under SFAS No. 133, and are marked to market in the Company's
Consolidated Balance Sheets with changes reflected in interest expense in the
Statements of Consolidated Income. The remaining $1.2 billion in swaps relating
to both short-term and long-term debt qualify for hedge accounting under SFAS
No. 133 and the periodic settlements are recognized as an adjustment to interest
expense in the Statements of Consolidated Income over the term of the swap
agreements. The Company has also entered into forward-starting interest rate
swaps having an aggregate notional amount of $2.5 billion to hedge the interest
rate on future offerings of long-term fixed-rate notes. These swaps qualify as
cash flow hedges under SFAS No. 133. Should the expected issuance of the debt no
longer be probable, any deferred amount will be recognized immediately into
income. The maximum length of time the Company is hedging its exposure to the
payment of variable interest rates is ten years.
Hedge of Net Investment in Foreign Subsidiaries. The Company has
substantially hedged its net investment in its European subsidiaries through a
combination of Euro-denominated borrowings, foreign currency swaps and foreign
currency forward contracts to reduce the Company's exposure to changes in
foreign currency rates. During the three months ended March 31, 2002, the
derivative and non-derivative instruments designated as hedging the net
investment in the Company's European subsidiaries resulted in an after-tax gain
of $35 million, which is included in the balance of the cumulative translation
adjustment in accumulated other comprehensive income.
Other Derivatives. In December 2000, the Dutch parliament adopted
legislation allocating to the Dutch generation sector, including Reliant Energy
Power Generation Benelux N.V (REPGB), financial responsibility for various
out-of-market 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 sectors, including REPGB, financial
responsibility to purchase imported electricity and gas under long-term
contracts. These contracts are derivatives pursuant to SFAS No. 133. As of
December 31, 2001 and March 31, 2002, the Company had recognized $369 million
and $330 million, respectively, in total short-term and long-term non-trading
derivative liabilities for REPGB's portion of these out-of-market import
contracts. During the three months ended March 31, 2002, the Company recognized
a $19 million gain related to changes in the valuation of certain out-of-market
contracts in the first quarter of 2002 recorded in fuel expense. For additional
information regarding REPGB's obligations under out-of-market contracts and the
related indemnification by former shareholders of these stranded costs during
2001, see Note 14(h) to the Reliant Energy 10-K Notes, which note is
incorporated herein by reference.
During the May 2001 through September 2001 time frame, the Company entered
into two structured transactions which were recorded on the Consolidated Balance
Sheets in non-trading derivative assets and liabilities involving a series of
forward contracts to buy and sell an energy commodity in 2001 and to buy and
sell an energy commodity in 2002 or 2003. The change in fair value of these
derivative assets and liabilities must be recorded in the Statements of
Consolidated Income for each reporting period. As of December 31, 2001, the
Company has recognized $221 million of non-trading derivative assets and $103
million of non-trading derivative liabilities related to these transactions.
During the three months ended March 31, 2002, $24 million of net non-trading
derivative assets were settled related to these transactions, and a $1 million
pre-tax unrealized gain was recognized. As of March 31, 2002, the Company has
recognized $201 million of non-trading derivative assets and $106 million of
non-trading derivative liabilities related to these transactions.
10
(5) ACQUISITION OF ORION POWER HOLDINGS, INC.
In February 2002, Reliant Resources acquired all of the outstanding shares
of common stock of Orion Power Holdings, Inc. (Orion Power) for $26.80 per share
in cash for an aggregate purchase price of $2.9 billion. Reliant Resources
funded the Orion Power acquisition with a $2.9 billion term loan and $41 million
of cash on hand. The term loan must be repaid by February 19, 2003. As a result
of the acquisition, Reliant Resources' consolidated net debt obligations also
increased by the amount of Orion Power's net debt obligations. As of February
19, 2002, Orion Power's debt obligations were $2.4 billion ($2.1 billion net of
restricted cash pursuant to debt covenants). Orion Power is an electric power
generating company formed in March 1998 to acquire, develop, own and operate
power-generating facilities in certain deregulated wholesale markets throughout
North America. As of March 31, 2002, Orion Power had 81 power plants with a
total generating capacity of 5,644 Megawatts (MW) and two development projects
with an additional 804 MW of capacity under construction.
The Company accounted for the acquisition as a purchase with assets and
liabilities of Orion Power reflected at their estimated fair values. The
Company's fair value adjustments included adjustments in property, plant and
equipment, unrecognized pension and post retirement benefits liabilities and
related deferred taxes. The Company expects to finalize these fair value
adjustments no later than February 2003, based on valuations of property, plant
and equipment, intangible assets and other assets and obligations.
The Company's results of operations include the results of Orion Power only
for the period beginning February 19, 2002. The following table presents
selected financial information and unaudited pro forma information for the three
months ended March 31, 2001 and 2002, as if the acquisition had occurred on
January 1, 2001 and 2002, as applicable.
THREE MONTHS ENDED MARCH 31,
-----------------------------------------------
2001 2002
--------------------- ---------------------
ACTUAL PRO FORMA ACTUAL PRO FORMA
-------- --------- -------- ---------
(IN MILLIONS, EXCEPT PER SHARE AMOUNTS)
Revenues ........................................ $ 12,078 $ 12,352 $ 8,656 $ 8,790
Income before cumulative effect of accounting
change ........................................ 201 203 225 177
Net income ...................................... 262 265 225 177
Basic earnings per share before cumulative effect
of accounting change .......................... $ 0.69 $ 0.71 $ 0.76 $ 0.60
Diluted earnings per share before cumulative
effect of accounting change ................... 0.69 0.70 0.76 0.60
Basic earnings per share ........................ 0.91 0.92 0.76 0.60
Diluted earnings per share ...................... 0.90 0.91 0.76 0.60
These unaudited 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 Orion Power had occurred on January 1, 2001 and 2002, as
applicable. Purchase-related adjustments to the results of operations include
the effects on depreciation and amortization, interest expense, interest income
and income taxes. The unaudited pro forma condensed consolidated financial
statements reflect the acquisition of Orion Power in accordance with SFAS No.
141 and SFAS No. 142. For additional information regarding the Company's
adoption of SFAS No. 142, please read Note 6.
In connection with Reliant Resources' acquisition of Orion Power, Reliant
Resources assumed various credit facilities, senior notes and convertible senior
notes, which are discussed below.
New York Credit Agreement. As of March 31, 2002, Orion Power New York, LP
(Orion NY), a wholly owned subsidiary of Orion Power, had a secured credit
agreement (New York Credit Agreement), which includes a $502 million acquisition
facility and a $30 million revolving working capital facility. As of March 31,
2002, Orion NY had $502 million of acquisition loans outstanding. As of March
31, 2002, there were no revolving loans outstanding. A total of $10 million in
letters of credit were outstanding under the New York Credit Agreement. The
loans bear interest at the borrower's option at (a) a base rate or (b) the
London inter-bank offered rate (LIBOR) plus
11
a margin. The rate as of March 31, 2002, was 3.75%. The credit agreement is
secured by substantially all of the assets of Orion NY. The credit agreement
expires in December 2002.
MidWest Credit Agreement. As of March 31, 2002, Orion Power MidWest LP
(Orion MidWest), a wholly owned subsidiary of Orion Power, had a secured credit
agreement (Midwest Credit Agreement), which includes a $988 million acquisition
facility and a $75 million revolving working capital facility. As of March 31,
2002, Orion MidWest had $988 million and $28 million of acquisition loans and
revolving loans outstanding, respectively. The borrowings under each facility
bear interest at a floating rate. A total of $15 million in letters of credit
were outstanding under the MidWest Credit Agreement. The loans bear interest at
the borrower's option at (a) a base rate or (b) LIBOR plus a margin. The rate as
of March 31, 2002, was 3.34%. Borrowings under the MidWest Credit Agreement are
secured by substantially all the assets of Orion MidWest. The credit agreement
expires in October 2002.
The New York Credit Agreement and the Midwest Credit Agreement
(collectively, the Orion Credit Agreements) contain restrictive covenants that
restrict the ability to, among other things, make dividend distributions unless
Orion NY or Orion MidWest satisfy various conditions. As of March 31, 2002
restricted cash under the Orion Credit Agreements totaled $267 million.
In connection with the Orion Power acquisition, the existing interest rate
swaps for the New York Credit Agreement and MidWest Credit Agreement were
bifurcated into a debt component and a derivative component. The fair value of
the debt component, approximately $31 million for the New York Credit Agreement
and $59 million for the MidWest Credit Agreement, was based on Reliant
Resources' incremental borrowing rates at the acquisition date for similar types
of borrowing arrangements. The value of the debt component will be amortized to
interest expense over the life of the interest rate swaps. For the period from
February 20, 2002 through March 31, 2002, $1 million and $2 million was
amortized to interest expense for the New York Credit Agreement and MidWest
Credit Agreement, respectively. See Note 4 for information regarding the
Company's derivative financial instruments.
The Orion Credit Agreements contain various business and financial
covenants requiring Orion NY or Orion MidWest to, among other things, maintain a
debt service coverage ratio of at least 1.5 to 1.0. For the three months ended
March 31, 2002, Orion MidWest did not meet its debt service coverage ratio, and
alternatively made a $25 million prepayment on March 22, 2002, as permitted by
the MidWest Credit Agreement in order to maintain compliance. Orion MidWest may
not be able to meet this debt service coverage ratio for the quarter ending June
30, 2002. It is Reliant Resources' current intention to arrange for the
repayment, refinancing or amendment of these facilities prior to June 30, 2002.
If the MidWest Credit Agreement facility is not repaid, refinanced or amended
prior to that date, and if a waiver is required under this credit facility,
Reliant Resources believes that it will be able to obtain such a waiver.
However, Reliant Resources currently has no assurance that it will be able to
obtain such a waiver or amendment from the lender groups if required under the
MidWest Credit Agreement.
Liberty Credit Agreement. Liberty Electric Power, LLC (Liberty), a wholly
owned subsidiary of Orion Power, has entered into a facility that provides for
(a) a construction/term loan in an amount of up to $105 million; (b) an
institutional term loan in an amount of up to $165 million; (c) an equity bridge
loan in an amount of up to $41 million; (d) a revolving working capital facility
for an amount of up to $5 million; and (e) a debt service reserve letter of
credit facility of $17.5 million (Liberty Credit Agreements).
Amounts outstanding under this facility bear interest at a floating rate
for a portion of the facility, which may be either (a) a base rate or (b) LIBOR
plus a margin, except for the institutional term loan which bears interest at a
fixed rate. At March 31, 2002, the interest rate was 3.04% on the floating rate
component and 9.02% on the fixed rate portion. As of March 31, 2002, Liberty had
$135 million and $165 million of the floating rate and fixed rate portions of
the facility outstanding, respectively.
The lenders under the Liberty Credit Agreements have a security interest in
substantially all of the assets of Liberty and have negative pledges on other
fixed assets of Liberty. The Liberty Credit Agreement contains restrictive
covenants that restrict Liberty's ability to, among other things, make dividend
distributions unless Liberty satisfies various conditions. As of March 31, 2002,
restricted cash under the Liberty Credit Agreement totaled $25 million.
12
The Liberty equity bridge loan matures on the earlier of October 1, 2002,
or a date on which the conditions precedent to conversion to a term loan are
met. The debt service reserve letter of credit facility becomes available for
use when the conditions precedent to conversion to a term loan are met and
matures five years thereafter. The working capital facility becomes available
for use six months prior to the scheduled conversion date and matures five years
thereafter. The construction/term loan matures on the earlier of October 1,
2002, or a date on which the conditions precedent to conversion to a term loan
are met and matures ten years thereafter. The institutional term loan has a
final maturity date of April 15, 2026.
Senior Notes. Orion Power has outstanding $400 million of 12% senior notes
due 2010 (Senior Notes). The Senior Notes are senior unsecured obligations of
Orion Power. Orion Power is not required to make any mandatory redemption or
sinking fund payments with respect to the Senior Notes. The Senior Notes are not
guaranteed by any of Orion Power's subsidiaries. In connection with the Orion
Power acquisition, Reliant Resources recorded the Senior Notes at estimated fair
value, $479 million. The $79 million premium will be amortized against interest
expense over the life of the Senior Notes. The fair value of the Senior Notes is
based on Reliant Resources' incremental borrowing rates for similar types of
borrowing arrangements. The Senior Notes indenture contains covenants that
include among others, restrictions on the payment of dividends by Orion Power.
Pursuant to certain change of control provisions, Orion Power commenced an
offer to repurchase the Senior Notes on March 21, 2002. The offer to repurchase
expired on April 18, 2002. There were no acceptances of the offer to repurchase
and the entire $400 million remains outstanding.
Before May 1, 2003, Orion Power may redeem up to 35% of the Senior Notes
issued under the indenture at a redemption price of 112% of the principal amount
of the notes redeemed, plus accrued and unpaid interest and special interest,
with the net cash proceeds of an equity offering provided that certain
provisions under the indenture are met.
Revolving Senior Credit Facility. Orion Power has an unsecured $75 million
revolving senior credit facility that matures in December 2002. Amounts
outstanding under the facility bear interest at a floating rate. As of March 31,
2002, there were no outstanding borrowings under this facility, but a total of
$70 million in letters of credit were outstanding. This credit facility contains
various covenants that include among others, restrictions on the payment of
dividends by Orion Power. As of March 31, 2002, restricted cash under this
revolving senior credit facility totaled $9 million.
The senior credit facility of Orion Power contains various business and
financial covenants that require Orion Power to, among other things, maintain a
debt service coverage ratio of at least 1.4 to 1.0. Orion Power did not meet the
debt service coverage ratio for the quarter ended March 31, 2002. In the event
that Orion Power is unable to meet this financial covenant for a second
consecutive fiscal quarter, it would constitute a default under its credit
facility. It is Reliant Resources' current intention to arrange for the
repayment, refinancing or amendment of this facility prior to June 30, 2002. If
this facility is not repaid, refinanced or amended prior to that date, and if a
waiver is required under this credit facility, Reliant Resources believes that
it will be able to obtain such a waiver. However, Reliant Resources currently
has no assurance that it will be able to obtain such a waiver or amendment from
the lender groups if required under this credit facility.
Convertible Senior Notes. Orion Power had outstanding $200 million of 4.5%
convertible senior notes, due on June 1, 2008 (Convertible Senior Notes).
Pursuant to certain change of control provisions, Orion Power commenced an offer
to repurchase the Convertible Senior Notes on March 1, 2002, which expired on
April 10, 2002. During the second quarter of 2002, Reliant Resources repurchased
$189 million in principal amount under the offer to repurchase and $11 million
aggregate principal amount of the Convertible Senior Notes remains outstanding.
(6) GOODWILL AND INTANGIBLES
In July 2001, the FASB issued SFAS No. 142, which 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 Company adopted the provisions of the statement which apply to
goodwill and intangible assets acquired prior to June 30, 2001 on January 1,
2002.
13
With the adoption of SFAS No. 142, the Company ceased amortization of
goodwill as of January 1, 2002. A reconciliation of previously reported net
income and earnings per share to the amounts adjusted for the exclusion of
goodwill amortization follows:
THREE MONTHS ENDED MARCH 31,
-----------------------------
2001 2002
---------- ----------
(IN MILLIONS, EXCEPT PER SHARE)
Reported net income .................. $ 262 $ 225
Add: Goodwill amortization, net of tax 21 --
---------- ----------
Adjusted net income .................. $ 283 $ 225
========== ==========
Basic Earnings Per Share:
Reported net income .................. $ 0.91 $ 0.76
Add: Goodwill amortization, net of tax 0.07 --
---------- ----------
Adjusted basic earnings .............. $ 0.98 $ 0.76
========== ==========
Diluted Earnings Per Share:
Reported net income .................. $ 0.90 $ 0.76
Add: Goodwill amortization, net of tax 0.07 --
---------- ----------
Adjusted diluted earnings ............ $ 0.97 $ 0.76
========== ==========
The components of the Company's other intangible assets consist of the
following:
DECEMBER 31, 2001 MARCH 31, 2002
------------------------ ------------------------
CARRYING ACCUMULATED CARRYING ACCUMULATED
AMOUNT AMORTIZATION AMOUNT AMORTIZATION
-------- ------------ -------- ------------
(IN MILLIONS)
Air Emission Regulatory Allowances $ 255 $ (78) $ 267 $ (79)
Other Power Generation Site Permits 77 (3) 77 (4)
Water Rights ...................... 68 (4) 68 (5)
Land Use Rights ................... 59 (11) 59 (11)
Other ............................. 16 (1) 19 (3)
-------- ---------- -------- ----------
Total ......................... $ 475 $ (97) $ 490 $ (102)
======== ========== ======== ==========
The Company recognizes specifically identifiable intangibles, including air
emissions regulatory allowances and water and land use rights and permits, when
specific rights and contracts are acquired. The Company amortizes air emissions
regulatory allowances primarily on a units-of-production basis as utilized. The
Company amortizes other acquired intangibles on a straight-line basis over the
lesser of their contractual or estimated useful lives. The Company has no
intangible assets with indefinite lives recorded as of March 31, 2002.
Amortization expense for other intangibles for the three months ended March
31, 2001 and 2002 was $24 million and $5 million, respectively. Estimated
amortization expense for the remainder of 2002 and the five succeeding fiscal
years is as follows (in millions):
2002.......................... $ 15
2003.......................... 15
2004.......................... 15
2005.......................... 16
2006.......................... 15
2007.......................... 15
------
Total....................... $ 91
======
14
Changes in the carrying amount of goodwill for the three months ended March
31, 2002, by reportable business segment, are as follows:
GOODWILL
ACQUIRED FOREIGN
AS OF DURING THE CURRENCY AS OF
JANUARY 1, 2002 PERIOD EXCHANGE IMPACT OTHER MARCH 31, 2002
--------------- ---------- --------------- --------- --------------
(IN MILLIONS)
Natural Gas Distribution $ 1,085 $ -- $ -- $ -- $ 1,085
Pipelines and Gathering 601 -- -- -- 601
Wholesale Energy ....... 184 1,321 -- 1 1,506
European Energy ........ 632 -- (13) -- 619
Retail Energy .......... 32 -- -- -- 32
Other Operations ....... 54 -- -- -- 54
------------- ---------- ------------- --------- ----------
Total ................ $ 2,588 $ 1,321 $ (13) $ 1 $ 3,897
============= ========== ============= ========= ==========
The Company is in the process of determining further effects of adoption of
SFAS No. 142 on its consolidated financial statements, including the review of
goodwill for impairment. The Company has not completed its review pursuant to
SFAS No. 142. However, based on the Company's preliminary review, the Company
believes an impairment of its European Energy business segment goodwill is
reasonably possible. The Company has retained outside valuation firms to assist
in completion of its review and will finalize its review of goodwill for its
reporting units during the second quarter of 2002. Any impairment loss resulting
from the transitional impairment test will be recorded retroactively as a
cumulative effect of a change in accounting principle for the quarter ended
March 31, 2002. As of March 31, 2002, the Company has completed its assessment
of intangible assets and no indefinite lived intangible assets were identified.
No impairment losses were recorded in the first quarter of 2002 and no changes
were made to the expected useful lives of the Company's intangible assets as a
result of this assessment.
(7) COMPREHENSIVE INCOME
The following table summarizes the components of total comprehensive
income:
FOR THE THREE MONTHS ENDED
MARCH 31,
--------------------------
2001 2002
---------- ----------
(IN MILLIONS)
Net income attributable to common stockholders .......................... $ 262 $ 225
Other comprehensive (loss) income, net of tax:
Foreign currency translation adjustments .............................. (1) (12)
Additional minimum non-qualified pension liability adjustment ......... (2) --
Cumulative effect of adoption of SFAS No. 133 ......................... (252) --
Net deferred gains from cash flow hedges .............................. 176 200
Reclassification of deferred loss (gain) from cash flow hedges realized
in net income ....................................................... 7 (27)
Unrealized gain (loss) on available-for-sale securities ............... 7 (1)
---------- ----------
Other comprehensive (loss) income ....................................... (65) 160
---------- ----------
Comprehensive income .................................................... $ 197 $ 385
========== ==========
(8) SHORT-TERM BORROWINGS
As of March 31, 2002, the Company had credit facilities, which included the
facilities of various financing subsidiaries, Reliant Resources, REPGB and
Reliant Energy Resources Corp. (RERC Corp.) and their subsidiaries, with
financial institutions that provide for an aggregate of $13.4 billion in
committed credit. The facilities expire as follows: $7.6 billion in 2002, $4.3
billion in 2003 and $1.5 billion in 2004 and beyond. As of March 31, 2002,
borrowings and letters of credit of $10.0 billion were outstanding or supported
under these credit facilities of which $0.6 billion was classified as long-term
debt, based on availability of committed credit with expiration dates exceeding
one year and management's intention to borrow these amounts for periods in
excess of one year. Various credit facilities aggregating $2.5 billion may be
used for letters of credit of which $0.6 billion was outstanding as of March 31,
2002. Interest rates on borrowings are based on LIBOR plus a margin, Euro
interbank deposits plus a margin, a base rate or a rate determined through a
bidding process. Credit facilities aggregating $6.1 billion are
15
unsecured. The credit facilities contain covenants and requirements which must
be met to borrow funds and obtain letters of credit, as applicable. Facilities
having covenants that may materially restrict the borrowers from borrowing funds
or obtaining letters of credit, as applicable, under such facilities are
expected to be replaced with less restrictive facilities by July 2002. As of
March 31, 2002, the borrowers were in compliance with the covenants under all of
these credit agreements, but under certain debt instruments of Orion Power and
its subsidiaries as discussed in Note 5, Orion Power will cease to be in
compliance unless certain coverage ratios improve.
The Company sells commercial paper to provide financing for general
corporate purposes. As of March 31, 2002, $2.1 billion of commercial paper was
outstanding. The commercial paper borrowings are supported by various credit
facilities discussed above, including $4.7 billion in credit facilities expiring
in 2002 and a $350 million revolving credit facility expiring in 2003.
RERC Corp. has a receivables facility under which it sells its customer
accounts receivable. Advances under this facility are reflected in the
Consolidated Balance Sheets as short-term debt. In the first quarter of 2002,
RERC Corp. reduced its trade receivables facility from $350 million to $150
million. Borrowings under the receivables facility aggregating $196 million were
repaid in January 2002 with proceeds from the issuance of commercial paper under
RERC Corp.'s $350 million revolving credit facility and from the liquidation of
short-term investments. At March 31, 2002, RERC Corp. had letters of credit
outstanding under this facility of $2.5 million.
(9) RECEIVABLES FACTORING AGREEMENT
In December 2001, Reliant Energy HL&P terminated an agreement under which
it had historically sold its customer accounts receivable. Proceeds from the
sale of customer accounts receivable pursuant to this agreement were
historically treated as a sale and not reflected as debt in the Consolidated
Balance Sheets. In connection with this termination, in January 2002, Reliant
Energy HL&P repurchased $369 million of previously sold customer accounts
receivable. Funds used to repurchase these receivables were obtained from a
combination of bank loans and the sale of commercial paper.
16
(10) EARNINGS PER SHARE
The following table presents Reliant Energy's basic and diluted earnings
per share (EPS) calculation:
FOR THE THREE MONTHS ENDED
MARCH 31,
-----------------------------
2001 2002
------------ ------------
(IN MILLIONS, EXCEPT SHARE AND
PER SHARE AMOUNTS)
Basic EPS Calculation:
Income before cumulative effect of accounting change ...... $ 201 $ 225
Cumulative effect of accounting change, net of tax ........ 61 --
------------ ------------
Net income attributable to common stockholders ............ $ 262 $ 225
============ ============
Weighted average shares outstanding ......................... 287,336,000 296,222,000
============ ============
Basic EPS:
Income before cumulative effect of accounting change ...... $ 0.69 $ 0.76
Cumulative effect of accounting change, net of tax ........ 0.22 --
------------ ------------
Net income attributable to common stockholders ............ $ 0.91 $ 0.76
============ ============
Diluted EPS Calculation:
Net income attributable to common stockholders ............ $ 262 $ 225
Plus: Income impact of assumed conversions:
Interest on 6-1/4% convertible trust preferred securities -- --
------------ ------------
Total earnings effect assuming dilution ................... $ 262 $ 225
============ ============
Weighted average shares outstanding ......................... 287,336,000 296,222,000
Plus: Incremental shares from assumed conversions(1):
Stock options ........................................... 2,337,000 403,000
Restricted stock ........................................ 486,000 528,000
6-1/4% convertible trust preferred securities ........... 14,000 13,000
------------ ------------
Weighted average shares assuming dilution ................. 290,173,000 297,166,000
============ ============
Diluted EPS:
Income before cumulative effect of accounting change ...... $ 0.69 $ 0.76
Cumulative effect of accounting change, net of tax ........ 0.21 --
------------ ------------
Net income attributable to common stockholders ............ $ 0.90 $ 0.76
============ ============
- ----------
(1) For the three months ended March 31, 2001 and 2002, the computation of
diluted EPS excludes 191,266 and 5,595,200 purchase options, respectively,
for shares of common stock that have exercise prices (ranging from $41.69
to $47.22 per share and $24.38 to $50.00 per share for the first quarter
2001 and 2002, respectively) greater than the per share average market
price for the period and would thus be anti-dilutive if exercised.
(11) CAPITAL STOCK
Common Stock. Reliant Energy has 700,000,000 authorized shares of common
stock. At December 31, 2001, 302,943,709 shares of Reliant Energy common stock
were issued and 295,873,820 shares of Reliant Energy common stock were
outstanding. At March 31, 2002, 303,496,203 shares of Reliant Energy common
stock were issued and 297,437,214 shares of Reliant Energy common stock were
outstanding. Outstanding common shares exclude shares pledged to secure a loan
to Reliant Energy's Employee Stock Ownership Plan (7,069,889 and 6,058,989 at
December 31, 2001 and March 31, 2002, respectively). Reliant Energy declared
dividends of $0.375 per share in the first quarter of 2001 and 2002.
17
(12) 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):
AGGREGATE LIQUIDATION
AMOUNT
----------------------- MANDATORY
DECEMBER 31, MARCH 31, DISTRIBUTION RATE/ REDEMPTION DATE/ JUNIOR SUBORDINATED
TRUST 2001 2002 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
For additional information regarding the $625 million of preferred
securities and the $100 million of capital securities, see Note 11 to the
Reliant Energy 10-K Notes, which note is incorporated herein by reference. The
sole asset of each trust consists of junior subordinated debentures of Reliant
Energy having interest rates and maturity dates that correspond to the
distribution rates and the mandatory redemption dates for each series of
preferred securities or capital securities, and the principal amounts
corresponding to the common and preferred securities or capital securities
issued by that trust.
(b) RERC Corp.
A statutory business trust created by RERC Corp. (RERC Trust) has issued
convertible trust preferred securities, the terms of which, and the related
series of convertible junior subordinated debentures, are described below (in
millions):
AGGREGATE LIQUIDATION
AMOUNT
----------------------- MANDATORY
DECEMBER 31, MARCH 31, DISTRIBUTION RATE/ REDEMPTION DATE/ JUNIOR SUBORDINATED
TRUST 2001 2002 INTEREST RATE MATURITY DATE DEBENTURES
- --------------------- ----------- -------- ------------------ ---------------- ------------------------
RERC Trust $ 1 $ 1 6.25% June 2026 6.25% Convertible Junior
Subordinated Debentures
due 2026
For additional information regarding the convertible preferred securities,
see Note 11 to the Reliant Energy 10-K Notes, which note is incorporated herein
by reference. The sole asset of the trust consists of convertible junior
subordinated debentures of RERC Corp. having an interest rate and maturity date
that correspond to the distribution rate and mandatory redemption date of the
convertible preferred securities, and the principal amount corresponding to the
common and convertible preferred securities issued by the trust.
(13) COMMITMENTS AND CONTINGENCIES
(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
18
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 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.
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 in the Three Cities case to be between zero
and $18 million inclusive of interest and attorneys' fees.
California Wholesale Market. Reliant Energy, Reliant Energy Services, Inc.
(Reliant Energy Services), REPG and several other subsidiaries of Reliant
Resources, as well as two former officers and one present officer 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, Reliant Resources has agreed to indemnify Reliant Energy for any
damages arising under these lawsuits and may elect to defend these lawsuits at
its 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.
The cases were initially removed to federal court and were then assigned to
Judge Robert H. Whaley, United States District Judge, pursuant to the federal
procedures for multi-district litigation. On July 30, 2000, Judge Whaley
remanded the cases to state court. Upon remand to state court, the cases were
assigned to Superior Court Judge Janis L. Sammartino pursuant to the California
state coordination procedures. On March 4, 2002, Judge Sammartino adopted a
schedule proposed by the parties that would result in a trial beginning on March
1, 2004. On March 8, 2002, the plaintiffs filed a single, consolidated complaint
naming numerous defendants, including Reliant Energy Services and other Reliant
Resources' subsidiaries, that restated the allegations described above and
alleged that damages against all defendants could be as much as $1 billion. On
April 17, 2002, a demurrer was filed in the coordinated proceedings seeking
dismissal of the complaints on the basis of the filed rate doctrine and federal
preemption. On April 22 and 23, 2002, the Company and Duke Energy filed cross
complaints in the coordinated proceedings seeking, in an alternative pleading,
relief against other market participants in California, including Powerex Corp.,
the Los Angeles Department of Water and Power and the Bonneville Power
Administration. Plaintiffs have voluntarily dismissed Reliant Energy from two of
the three class actions in which it was named as a defendant.
19
On April 23, 2002 and on May 14, 2002, two class action lawsuits were filed
against a number of companies that own generation facilities in California and
other sellers of electricity in California, including Reliant Energy and the
Company's subsidiaries that own generation facilities in California. One of the
lawsuits was filed in the San Mateo County Superior Court and the other lawsuit
was filed in the San Francisco County Superior Court. These lawsuits assert
causes of action similar to those alleged in the Clayton Act lawsuit filed by
the California Attorney General described below and claim that defendants
acquired California generating plants with "the purpose and effect of
substantially lessening competition," and that these acquisitions allowed
defendants "to exercise market power to withhold capacity and raise prices above
competitive levels." Additionally, these lawsuits allege that the named
defendants manipulated the market and used market power to "game" the system
through both the physical and economic withholding of power. The Company has not
yet answered or otherwise responded to these lawsuits.
On March 11, 2002, the California Attorney General filed a civil lawsuit in
San Francisco Superior Court naming Reliant Energy, Reliant Resources, Reliant
Energy Services, REPG, and several other subsidiaries of Reliant Resources as
defendants. Pursuant to the terms of the master separation agreement between
Reliant Energy and Reliant Resources, Reliant Resources has agreed to indemnify
Reliant Energy for any damages arising under these lawsuits and may elect to
defend these lawsuits at its own expense. The Attorney General alleges various
violations by the defendants of state laws against unfair and unlawful business
practices arising out of transactions in the markets for ancillary services run
by the California Independent System Operator (Cal ISO). In addition to
injunctive relief, the Attorney General seeks restitution and disgorgement of
alleged unlawful profits for sales of electricity, and civil penalties. The
Company has removed this lawsuit to federal court, where it has been assigned to
Judge Samuel Conti in the Northern District of California.
On March 19, 2002, the California Attorney General filed a complaint with
the Federal Energy Regulatory Commission (FERC) naming Reliant Energy Services
and "all other public utility sellers" in California as defendants. The
complaint alleges that sellers with market-based rates have violated their
tariffs by not filing with the FERC transaction-specific information about all
of their sales and purchases at market-based rates. The California Attorney
General argues that, as a result, all past sales should be subject to refund if
found to be above just and reasonable levels.
On April 15, 2002, the California Attorney General filed a lawsuit in San
Francisco County Superior Court against Reliant Energy, Reliant Resources and a
number of its subsidiaries. The complaint is substantially similar to the
compliant described above filed by the California Attorney General with the FERC
on March 19, 2002. The complaint also alleges that the Company consistently
charged unjust and unreasonable prices for electricity, and that each instance
of overcharge violates California law. The lawsuit seeks fines of up to $2,500
for each alleged violation, and "other equitable relief as appropriate." The
Company has removed this case to federal court, where it has been assigned to
Judge Vaughn Walker in the Northern District of California.
On April 15, 2002, the California Attorney General and the California
Department of Water Resources (CDWR) filed a complaint in the United States
District Court for the Northern District of California against Reliant Energy,
Reliant Resources and a number of its subsidiaries. In this lawsuit, the
Attorney General alleges that the Company's acquisition of electric generating
facilities from Southern California Edison (SCE) in 1998 violated Section 7 of
the Clayton Act, which prohibits mergers or acquisitions that substantially
lessen competition. The lawsuit claims that the acquisitions gave the Company
market power which it then exercised to overcharge California consumers for
electricity. The lawsuit seeks injunctive relief against alleged unfair
competition, divestiture of the Company's California facilities, disgorgement of
alleged illegal profits, damages, and civil penalties for each alleged exercise
of market power. This lawsuit also has been assigned to Judge Vaughn Walker. The
Company has not yet answered or otherwise responded to this lawsuit.
The above-described lawsuits and proceedings regarding California
electricity sales are currently the subject of intense, highly-charged media and
political attention. Their ultimate outcome cannot be predicted at this time.
Natural Gas Measurement Lawsuits. In 1997, a suit was filed under the
Federal False Claim Act against RERC Corp. and certain of its subsidiaries
alleging mismeasurement of natural gas produced from federal and Indian lands.
The suit seeks undisclosed damages, along with statutory penalties, interest,
costs, and fees. The complaint is part of a larger series of complaints filed
against 77 natural gas pipelines and their subsidiaries and affiliates. An
earlier single action making substantially similar allegations against the
pipelines was dismissed by the U.S. District Court for the District of Columbia
on grounds of improper joinder and lack of jurisdiction. As a result, the
various
20
individual complaints were filed in numerous courts throughout the country. This
case was consolidated, together with the other similar False Claim Act cases
filed and transferred to the District of Wyoming. Motions to dismiss were
denied. The defendants intend to vigorously contest this case.
In addition, RERC Corp., Reliant Energy Gas Transmission Company (REGT),
Reliant Energy Field Services, Inc. (REFS) and Mississippi River Transmission
Corporation (MRT) have been named as defendants in a class action filed in May
1999 against approximately 245 pipeline companies and their affiliates. The
plaintiffs in the case purport to represent a class of natural gas producers and
fee royalty owners who allege that they have been subject to systematic gas
mismeasurement by the defendants, including certain Reliant Energy entities, for
more than 25 years. The plaintiffs seek compensatory damages, along with
statutory penalties, treble damages, interest, costs and fees. The action is
currently pending in state court in Stevens County, Kansas. Plaintiffs initially
sued Reliant Energy Services, but that company was dismissed without prejudice
on June 8, 2001. Other Reliant Energy entities that were misnamed or duplicative
have also been dismissed. MRT and REFS have filed motions to dismiss for lack of
personal jurisdiction and are currently responding to discovery on personal
jurisdiction. All four Reliant Energy defendants have joined in a motion to
dismiss.
The defendants plan to raise significant affirmative defenses based on the
terms of the applicable contracts, as well as on the broad waivers and releases
in take or pay settlements that were granted by the producer-sellers of natural
gas who are putative class members.
(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
reductions may or may not be required by 2007, depending upon the outcome of
continuing investigations of regional air quality issues. To achieve the 2004
TNRCC NOx reduction requirements, the Company anticipates investing up to $721
million in capital for emission control equipment, including costs incurred
through December 31, 2001, and potentially up to an additional $88 million by
2007.
The Texas electric restructuring law provides for stranded cost recovery
for expenditures incurred before May 1, 2003 to achieve the NOx reduction
requirements. Incurred costs include costs for which contractual obligations
have been made. The Texas Utility Commission had determined that the Company's
emission control plan is the most effective control option and that up to $699
million is eligible for cost recovery. In addition, the Company is required to
provide $16.2 million in funding for certain NOx reduction projects associated
with East Texas pipeline companies. These funds are also eligible for cost
recovery.
Hydrocarbon Contamination. On August 24, 2001, 37 plaintiffs filed suit
against REGT, Reliant Energy Pipeline Services, Inc., RERC Corp., Reliant Energy
Services, other Reliant Energy entities and third parties (Docket No. 460,
916-Div. "B"), in the 1st Judicial District Court, Caddo Parish, Louisiana. The
petition has now been supplemented five times. As of May 13, 2002, there were
534 plaintiffs, a majority of whom are Louisiana residents who live near the
Wilcox Aquifer. In addition to the Reliant Energy entities, the plaintiffs have
sued the State of Louisiana through its Department of Environmental Quality,
several individuals, some of whom are present employees of the State of
Louisiana, the Bayou South Gas Gathering Company, L.L.C., Martin Timber Company,
Inc., and several trusts.
The suit alleges that, at some unspecified date prior to 1985, the
defendants allowed or caused hydrocarbon or chemical contamination of the Wilcox
Aquifer which lies beneath property owned or leased by the defendants and which
is the sole or primary drinking water aquifer in the area. The primary source of
the contamination is alleged by the plaintiffs to be a gas processing facility
in Haughton, Bossier Parish, Louisiana known as the "Sligo Facility." This
facility was purportedly used for gathering natural gas from surrounding wells,
separating gasoline and hydrocarbons from the natural gas for marketing, and
transmission of natural gas for distribution. This site was originally leased
and operated by predecessors of REGT in the late 1940s and was operated until
Arkansas Louisiana Gas Company ceased operations of the plant in the late 1970s.
21
Beginning about 1985, the predecessors of certain Reliant Energy defendants
engaged in a voluntary remediation of any subsurface contamination of the
groundwater below the property they own or lease. This work has been done in
conjunction with and under the direction of the Louisiana Department of
Environmental Quality. The plaintiffs seek monetary damages for alleged damage
to the aquifer underlying their property, unspecified alleged personal injuries,
alleged fear of cancer, alleged property damage or dimunition of value of their
property, and in addition seek damages for trespass, punitive, and exemplary
damages. The quantity of monetary damages sought is unspecified. As of March 31,
2002, the Company is unable to estimate the monetary damages, if any, that the
plaintiffs may be awarded in this matter.
Manufactured Gas Plant Sites. RERC Corp. and its predecessors operated a
manufactured gas plant (MGP) until 1960 adjacent to the Mississippi River in
Minnesota, formerly known as Minneapolis Gas Works (MGW). RERC Corp. has
substantially completed remediation of the main site other than ongoing water
monitoring and treatment. The manufactured gas was stored in separate holders.
RERC Corp. 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 Corp. believes that two
were neither owned nor operated by RERC Corp. RERC Corp. believes it has no
liability with respect to the sites it neither owned nor operated.
At March 31, 2002, RERC Corp. had accrued $23 million for remediation of
the Minnesota sites. At March 31, 2002, the estimated range of possible
remediation costs was $11 million to $49 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 (PRP), if
any, and the remediation methods used.
Issues relating to the identification and remediation of MGPs are common in
the natural gas distribution industry. The Company has received notices from the
United States Environmental Protection Agency and others regarding its status as
a PRP for other sites. Based on current information, the Company has not been
able to quantify a range of environmental expenditures for potential remediation
expenditures with respect to other MGP sites.
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. This
type of contamination has been found by the Company 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 by 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 costs of any remediation of these
sites will not be material to the Company's financial position, results of
operations or cash flows.
REMA Ash Disposal Site Closures and Site Contaminations. Under the
agreement to acquire Reliant Energy Mid-Atlantic Power Holdings, LLC (REMA) (see
Note 3(a) to the Reliant Energy 10-K Notes, which note is incorporated herein by
reference), 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 March 31, 2002, REMA had
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
March 31, 2002. The Company expects approximately $16 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 the Reliant Energy 10-K Notes, which note
is incorporated herein by reference), 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
22
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 to be fully completed by 2005. As of March 31, 2002,
the estimated undiscounted liability for this asbestos abatement and soil
remediation was $18 million.
Orion Power Environmental Contingencies. In connection with Orion Power's
acquisition of 70 hydro plants in northern and central New York and four gas- or
oil-fired plants in New York City, Orion Power recorded a liability for the
estimated cost of environmental remediation. The liability was based on
valuation reports provided by independent environmental liability assessment
experts. In conjunction with these valuations, Orion Power has developed
remediation plans for each item specifically identified. For environmental items
at the New York City sites, the New York State Department of Environmental
Conservation has issued consent orders requiring active investigation and
remediation of past releases of petroleum and other substances by the prior
owners. The consent order also contains obligations related to continuing
compliance with environmental regulations. The liability assumed and recorded by
the Company was approximately $7 million which is expected to be paid out
through 2009.
In connection with the acquisition of Midwest assets by Orion Power, Orion
Power recorded a liability for the estimated cost of environmental remediation,
based on valuations performed by independent environmental liability assessment
experts. In conjunction with these valuations, Orion Power has developed
remediation plans for the known liabilities. The liability assumed and recorded
by the Company was approximately $5 million, which will be paid out through
2009.
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 which 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 position, 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 portions of 2000 and 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 and limitations on supply as a result of
maintenance and other outages. The resulting supply and demand imbalance
disproportionately impacted California utilities that relied too heavily on
short-term power markets to meet their load requirements. Although wholesale
prices increased, California's deregulation legislation kept retail rates frozen
at 10% below 1996 levels for two of California's public utilities, Pacific Gas
and Electric (PG&E) and SCE, 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 PG&E and SCE fell 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 since January 17, 2001 have not
directly purchased
23
power from third-party suppliers through the Cal ISO to serve their net short
load. Pursuant to emergency legislation enacted by the California Legislature,
the CDWR has negotiated and purchased power through short- and long-term
contracts and through real-time markets operated by the Cal ISO to serve the net
short load requirements of PG&E and SCE to meet their net short loads. In
December 2001, the CDWR began making payments to the Cal ISO for real-time
transactions. The CDWR has now made payment through the Cal ISO for its
real-time energy deliveries subsequent to January 17, 2001, although the Cal
ISO's application of CDWR's payment for the month of January 2001 and failure to
pay interest on past due CDWR payments are the subjects of motions filed by the
Company with the FERC. On May 15, 2002, the FERC issued an order stating that
sellers, including the Company, should receive interest payments on these past
due amounts. In addition, the Company is prosecuting a lawsuit in California to
recover the market value of forward contracts seized by California Governor Gray
Davis in violation of the Federal Power Act. Governor Davis' actions prevented
the liquidation of the contracts by the California Power Exchange (Cal PX) to
satisfy the outstanding obligations of SCE and PG&E to wholesale suppliers,
including the Company. The timing and ultimate resolution of this claim 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 would 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 Regulatory Commission (NRC), in addition to
the bankruptcy court. PG&E has stated it seeks to have this plan confirmed by
December 31, 2002. On April 24, 2002, the bankruptcy judge approved PG&E's
disclosure statement. A number of parties are contesting PG&E's reorganization
plan, including a number of California parties and agencies. The bankruptcy
judge in the PG&E case has ordered that the CPUC may file a competing plan. The
ability of PG&E to have its reorganization plan confirmed, including the
provision providing for the payment in full of unsecured creditors, is uncertain
at this time. The CPUC has filed a competing plan and disclosure statement. The
CPUC's plan provides for payment of allowed creditor claims in full in cash. The
CPUC disclosure statement was approved on May 15, 2002. The timing and
probability of confirmation of either plan, including the provision for payment
in full of all unsecured creditors, is uncertain at this time.
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 in 2001 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. A consumer organization
has appealed the judgment to the Ninth Circuit Court of Appeals, and no hearing
has been held to date. Under the stipulated judgment, any settlement with SCE's
creditors that is entered into after March 1, 2002 must be approved by the CPUC.
The Company has appealed this provision of the judgment. On March 1, 2002, SCE
made a payment to the Cal PX that included amounts it owed the Company. The
Company has made a filing with FERC seeking an order providing for the
disbursement of the funds owed to the suppliers. The FERC and the bankruptcy
court governing the Cal PX bankruptcy proceedings are considering how to
dispense this money and it remains uncertain when those funds will be paid over
to the Company.
As of December 31, 2001 and March 31, 2002, the Company was owed a total of
$302 million and $267 million, respectively, 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 March 31,
2002. From March 31, 2002 through May 10, 2002, the Company has collected $3
million of these receivable balances. As of December 31, 2001, the Company had a
pre-tax provision of $68 million against receivable balances related to energy
sales in the California market. In the first quarter of 2002, $33 million of a
previously accrued credit provision for energy sales in California was reversed.
The reversal resulted from collections of outstanding receivables during the
period coupled with a determination that credit risk had been reduced on the
remaining outstanding receivables as a result of payments in 2002 to the Cal PX,
as referred to above. In the first quarter of 2001, the Company recorded a $38
million provision against receivable balances related to energy sales in the
West region. As of March 31, 2002, the Company had a remaining pre-tax provision
of $35 million against these receivable balances. 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 implementing a series of wholesale
market reforms. In these orders, the FERC also instituted a refund proceeding,
described below, as a result of which
24
the Company may face an as yet undetermined amount of refund liability. See "-
FERC Refunds" below. Prior to accepting a methodology for calculating refunds in
the refund proceeding, the FERC has identified, 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 as being
subject to possible refunds. During the second quarter of 2001, the Company
accrued refunds of $15 million, $3 million of which had been previously expensed
during the first quarter of 2001.
On April 26, 2001, the FERC issued an order replacing previous price review
procedures and establishing a market monitoring and mitigation plan, effective
May 29, 2001, for the California markets. The plan establishes a cap on prices
during periods when power reserves fall below 7% in the Cal ISO (reserve
deficiency periods). The Cal ISO is instructed to use data submitted
confidentially by gas-fired generators in California and daily indices of
natural gas to establish the proxy 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 prices charged by sellers engaging in certain bidding practices will
be subject to increased scrutiny by the FERC, and such sellers could face
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 in addition to California, including
Arizona, Colorado, Idaho, Montana, Nevada, New Mexico, Oregon, Utah, Washington
and Wyoming. The FERC set July 2, 2001 as the refund effective date for sales
subject to the price mitigation plan throughout the West region. This means that
transactions after that date may be subject to refund if found to be unjust or
unreasonable. The proxy market clearing price calculated by the Cal ISO under
the June 19, 2001 order will apply during periods of reserve deficiency to all
sales in the Cal ISO and Western spot markets. In non-reserve deficiency 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 most recent reserve deficiency period. 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 demonstrating higher actual gas costs than the gas price index used in the
proxy price calculation together with showing that conditions in natural gas
markets changed significantly. The modified monitoring and mitigation plan went
into effect June 20, 2001, and is scheduled to terminate on September 30, 2002,
covering two summer peak seasons, or approximately 16 months.
On December 19, 2001, the FERC issued additional orders on price mitigation
in California and the West region. These orders largely maintained existing
mitigation mechanisms, but allowed prices to rise in connection with natural gas
prices for the period from December 20, 2001 through April 30, 2002, at which
point the previous mitigation formula was reinstated.
In addition, the December 19, 2001 orders also affirmed the June 19, 2001
order's requirement that generators must offer all available capacity for sale
in the real-time market. As a result of this requirement, the Company's
opportunity to sell ancillary services in the West region is reduced. During
2001, the Company recorded $42 million in revenues related to ancillary services
in the West region.
On May 15, 2002, the FERC issued several orders clarifying and modifying
its mitigation measures. These orders removed the possibility that the Cal ISO
would retroactively adjust mitigated market clearing prices for 2001 and
provided the Cal ISO with further instructions for payment of minimum load costs
owed to sellers complying with the must offer obligation for the period June 20,
2001 through the expiration of mitigation on September 30, 2002.
The Company believes that while the mitigation plan will reduce volatility
in the market, the Company will nevertheless be able to profitably operate its
facilities in the West. Any adverse impacts of the mitigation plan on the
Company's operations would be mitigated, in part, by the Company's forward
hedging activities. Additionally, as noted above, the mitigation plan allows
sellers, such as the Company, to justify prices above the proxy price. However,
previous efforts by the Company to justify prices above the proxy price have
been rejected by the FERC and there is no certainty that the FERC will allow for
the recovery of costs above the proxy price.
FERC Refunds. The FERC issued an order on July 25, 2001 adopting a refund
methodology and initiating a hearing schedule to determine (a) revised mitigated
prices for each hour from October 2, 2000 through June 20, 2001; (b) the amount
owed in refunds by each supplier according to the methodology (these amounts may
be in
25
addition to or in place of the refund amounts previously determined by the
FERC); and (c) the amount currently owed to each supplier. The amounts of any
refunds will be determined by the FERC after the conclusion of the hearing
process. On December 19, 2001, the FERC issued an order modifying the
methodology to be used to determine refund amounts. The schedule currently
anticipates that the Administrative Law Judge will make his refund amount
recommendations to the FERC in October 2002. However, the Company does not know
when the FERC will issue its final decision. The Company has not reserved any
amounts for potential future refund liability resulting from the FERC refund
hearing, nor can it currently predict the amount of these potential refunds, if
any, because the methodology used to calculate these refunds is not final and
will depend on information that is still subject to review and challenge in the
hearing process. Any refunds that are determined in the FERC proceeding will
likely be offset against unpaid amounts owed, if any, to the Company for its
prior sales.
On November 20, 2001, the FERC instituted an investigation under Section
206 of the Federal Power Act regarding the tariffs of all sellers with
market-based rates authority, including the Company. In this proceeding, the
FERC proposes to condition the market-based rate authority of all sellers on
their not engaging in anti-competitive behavior. Such condition would depend
upon a further order from FERC establishing a refund effective date. This
condition would allow the FERC, if it determines that a seller has engaged in
anti-competitive behavior subsequent to the start of the refund effective
period, to order refunds back to the date of such behavior. The FERC invited
comments regarding this proposal, and the Company has filed comments in
opposition to the proposal. On March 11, 2002, the FERC's Staff held a
conference with market participants to discuss the comments FERC has received,
and possible modification of the proposed conditions to address concerns raised
in the comments while protecting consumers against anticompetitive behavior. The
timing of further action by FERC is uncertain, although the FERC has publicly
indicated that it is considering modifications that would limit the scope and
application of its original proposal. If the FERC does not modify or reject its
proposed approach for dealing with anti-competitive behavior, the Company's
future earnings may be affected by the refund obligation.
On February 13, 2002, the FERC issued an order initiating a staff
investigation into potential manipulation of electric and natural gas prices in
the West region for the period January 1, 2000 forward. While this order does
not propose any action against the Company, if the investigation results in
findings that markets were dysfunctional during this period, those findings may
be used in support of existing or future claims by the FERC or others that
prices for sales in the West region after January 1, 2000 should be altered. As
part of the investigation and in response to the disclosure of documents
describing certain electricity trading strategies used by Enron Power Marketing
(Enron documents), the FERC on May 8, 2002 issued a request for admissions and
associated data to all sellers of wholesale electricity and ancillary services
in the Cal ISO and Cal PX markets during 2000 through 2001, including the
Company. The FERC's data request seeks information concerning whether the
Company and approximately 150 other sellers used the same or similar trading
strategies and practices as described in the Enron documents. The FERC has not
yet publicly stated whether it may assert that any of these strategies and
practices were impermissible under market rules in effect during the period in
question. The Company is in the process of reviewing records and conducting
internal interviews in order to prepare its response, which is due May 22, 2002.
A similar set of data requests dated May 7, 2002 and received by the Company on
May 8, 2002 has been issued by the California Senate Select Committee to
investigate price manipulation of the wholesale energy market and the Company is
similarly reviewing and preparing responses to those requests. The response date
for the Senate Select Committee's request is on May 22, 2002.
The above-described lawsuits and proceedings regarding California
electricity sales are currently the subject of intense, highly-charged media and
political attention. Their ultimate outcome cannot be predicted at this time.
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. Although these
investigations have not been completed and no findings have been made in
connection with either of them, the California Attorney General has filed a
civil lawsuit in San Francisco Superior Court alleging that the Company has
violated state laws against unfair and unlawful business practices and a
complaint with the FERC alleging the Company violated the terms of its tariff
with the FERC (see Note 13(a)). 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
26
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, including tax proposals, 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 and would subject exempt
wholesale generators, such as the Company's subsidiaries that own generation
facilities in California, to regulation by the CPUC as "public utilities." To
date, only a few energy-related bills have passed, such as the recently enacted
plant inspection law, which would empower the CPUC to monitor activities of the
Company's generating plants. The Company believes this bill is vulnerable to
challenge based on the preemptive effect of the Federal Power Act. The Company
does not believe that this or other legislation that has been enacted to date
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.
(e) Indemnification of Dutch Stranded Costs.
Background. In January 2001, the Dutch Electricity Production Sector
Transitional Arrangements Act (Transition Act) became effective and, among other
things, allocated to REPGB and the three other large-scale Dutch generation
companies, a share of the assets, liabilities and stranded cost commitments of
BV Nederlands Elektriciteit Administratiekantoor (NEA), the coordinating body
for the Dutch electricity generating sector. Prior to the enactment of the
Transition Act, NEA acted as the national electricity pooling and coordinating
body for the generation output of REPGB and the three other large-scale national
Dutch generation companies. REPGB and the three other large-scale Dutch
generation companies are shareholders of NEA.
The Transition Act and related agreements specify that REPGB has a 22.5%
share of NEA's assets, liabilities and stranded cost commitments. NEA's stranded
cost commitments consisted primarily of various uneconomical or stranded cost
investments and commitments, including a gas supply and three power contracts
entered into prior to the liberalization of the Dutch wholesale electricity
market. REPGB's stranded cost obligations also include uneconomical district
heating contracts which were previously administrated by NEA prior to
deregulation of the Dutch power market.
The gas supply contract expires in 2016 and provides for gas imports
aggregating 2.283 billion cubic meters per year. Prior to December 31, 2001, one
of the stranded cost power contracts was settled. The two remaining stranded
cost power contracts have the following capacities and terms: (a) 300 MW through
2003, and (b) 600 MW through March 2002, increasing to 750 MW through March
2009. 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 district heating obligations relate to three
water heating supply contacts entered into with various municipalities and
expire from 2008 through 2015. Under the district heating contracts, the
municipal districts are required to take annually a combined minimum of 5,549
terajoules (TJ) increasing annually to 7,955 TJ over the life of the contracts.
The Transition Act 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 liabilities associated with (a)
long-term district heating contracts and (b) an experimental coal facility. 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. To the extent that this compensation is not
ultimately provided to the generation companies by the Dutch government, REPGB
was to collect its compensation directly from the former shareholders as further
discussed below.
Settlement of Stranded Cost Indemnification Agreement with REPGB's Former
Shareholders. Until December 2001, the former shareholders agreed pursuant to a
share purchase agreement to indemnify REPGB for up to NLG 1.9 billion of its
share of NEA's stranded cost liabilities. In December 2001, REPGB and its former
shareholders entered into a settlement agreement immediately absolving the
former shareholders of their stranded cost indemnity obligations related to the
gas supply and power contracts under the original share purchase agreement. This
agreement provides conditional terms for the possible settlement of the former
shareholders' stranded cost indemnity obligation related to district heating
obligations under certain conditions. The settlement agreement was approved in
December 2001 by the Ministry of Economic Affairs of the Netherlands.
27
Under the settlement agreement, the former shareholders paid to REPGB NLG
500 million ($202 million) in January and February 2002. The payment represents
a settlement of the obligations of the former shareholders to indemnify REPGB
for all stranded cost liabilities other than those relating to the district
heating contracts. The full amount of this payment was placed into an escrow
account in the name of REPGB to fund its stranded cost obligations related to
the gas and electric import contracts. As of March 31, 2002, the remaining
escrow funds were $154 million, of which $46 million and $108 million were
recorded in restricted cash and long-term assets, respectively. Any remaining
escrow funds as of January 1, 2004 will be distributed to REPGB.
Under the settlement agreement, the former shareholders will continue to
indemnify REPGB for certain stranded cost liabilities relating to district
heating contracts. The terms of the indemnity are as follows:
- The settlement agreement acknowledges that the Netherlands is
finalizing regulations for compensation of stranded costs associated
with district heating projects. Within 21 days after the date these
compensation rules take effect, REPGB can elect to receive one of two
forms of indemnification under the settlement agreement.
- If the compensation to be paid by the Netherlands under these rules is
at least as much as the compensation to be paid under the original
indemnification agreement, REPGB can elect to receive a one-time
payment of NLG 60 million ($24 million). In addition, unless the
decree implementing the new compensation rules provides for
compensation for the lifetime of the district heating projects, REPGB
can receive an additional cash payment of NLG 15 million ($6 million).
- If the compensation rules do not provide for compensation at least
equal to that provided under the original indemnification agreement,
REPGB can claim indemnification for stranded cost losses up to a
maximum of NLG 700 million ($282 million) less the amount of
compensation provided by the new compensation rules and certain
proceeds received from arbitrations.
- If no new compensation rules have taken effect on or prior to December
31, 2003, REPGB is entitled, but not obligated, to elect to receive
indemnification under the formula described above.
Prior to the settlement agreement, pursuant to the purchase agreement of
REPGB, as amended, REPGB was entitled to a NLG 125 million ($51 million)
dividend from NEA with any remainder owing to the former shareholders. Under the
settlement agreement, the former shareholders waived all rights to distributions
of NEA.
As a result of this settlement, in 2001 the Company recognized a net gain
of $37 million for the difference between the sum of (a) the cash settlement
payment of $202 million and the additional rights to claim distributions of the
Company's NEA investment recognized of $248 million and (b) the amount recorded
as stranded cost indemnity receivable related to the stranded cost gas and
electric commitments of $369 million and claims receivable related to stranded
cost incurred in 2001 of $44 million, both previously recorded in the Company's
Consolidated Balance Sheets.
Liability for Stranded Costs. In January 2001, the Company recognized an
out-of-market, net stranded cost liability for its gas and electric contracts
and district heating commitments. At such time, the Company recorded a
corresponding asset of equal amount for the indemnification of this obligation
from REPGB's former shareholders and the Dutch government, as applicable. As of
December 31, 2001 and March 31, 2002, the Company has recorded a liability of
$369 million and $330 million, respectively, for its stranded cost gas and
electric commitments in non-trading derivative liabilities and a liability of
$206 million and $202 million, respectively, for its district heating
commitments in current and non-current other liabilities. As of December 31,
2001 and March 31, 2002, the Company has recorded an indemnification receivable
from the Dutch government for the district heating stranded cost liability of
$206 million and $202 million, respectively.
Pursuant to SFAS No. 133, the gas and electric contracts are marked-to-
market (see Note 3). The valuation of the gas and electric contracts are
affected by, among other things, changes in the price of electric power, coal,
low sulfur fuel oil and the value of the United States dollar relative to the
Euro. Changes in the valuation of these stranded cost import contracts are
recorded in the Company's Statement of Consolidated Income. During the three
months ended March 31, 2002, the Company recognized a $19 million gain related
to changes in the valuation of
28
certain stranded cost contracts in the first quarter of 2002 recorded in fuel
expense. The Company and the other shareholders of NEA are in formal discussions
with the counterparties to two of the stranded cost purchase contracts. Pursuant
to one of these contracts, NEA is required to purchase up to 750 MW per year
through 2009. In addition, the Company may initiate discussions with the other
counterparties to other stranded cost contracts to modify the terms of such
out-of-market contracts. The structure of these settlements, if consummated,
likely would entail an upfront cash payment to the counterparty in exchange for
amendments to price and other terms intended to make the contracts more market
conforming. REPGB would seek to fund these payments, if made, to the extent
possible through the proceeds from the settlement of its stranded cost indemnity
agreement and, possibly, anticipated distributions from NEA. The Company cannot
currently predict the outcome of these negotiations. However, to the extent that
these discussions result in amendments to the contracts, the Company could
realize a gain.
For additional information regarding the indemnification and settlement of
stranded costs, see Note 14(h) to the Reliant Energy 10-K Notes, which note is
incorporated herein by reference.
(f) Construction Agency Agreements and Equipment Financing Structure.
In 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 are not consolidated by the Company. The
special purpose entities have an aggregate financing commitment from equity and
debt participants (Investors) of $2.5 billion of which the last $1.1 billion is
currently available only if cash collaterized. The availability of the
commitment is subject to satisfaction of various conditions, including the
obligation to provide cash collateral for the loans and letters of credit
outstanding on November 29, 2004. 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 December 31, 2004,
but Reliant Resources has generally limited its risk during construction to an
amount not in excess of 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' ability to exercise the lease
option is subject to certain conditions. Reliant Resources must guarantee that
the Investors will receive an amount at least equal to 89.9% of their investment
in the equipment 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 an amount not to exceed 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. At any
time during the construction period or during the lease, Reliant Resources may
purchase a facility by paying an amount approximately equal to the outstanding
balance plus costs.
Reliant Resources, through its subsidiary, REPG, has entered into an
agreement with a bank whereby the bank, as owner, entered or will enter into
contracts for the purchase and construction of power generation equipment and
REPG, or its subagent, acts as the bank's agent in connection with administering
the contracts for such equipment. Under the agreement, the bank has agreed to
provide up to a maximum aggregate amount of $650 million. REPG and its subagents
must cash collateralize their obligation to administer the contracts. This cash
collateral is approximately equivalent to the total payments by the bank for the
equipment, interest and other fees. As of March 31, 2002, the bank had assumed
contracts for the purchase of three turbines, two heat recovery steam generators
and one air cooled condenser with an aggregate cost of $140 million. REPG, or
its designee, has the option at any time to purchase, or, at equipment
completion, subject to certain conditions, including the agreement of the bank
to extend financing, to lease the equipment, or to assist in the remarketing of
the equipment under terms specified in the agreement. All costs, including the
purchase commitment on the turbines, are the responsibility of the bank. The
cash collateral is deposited by REPG or an affiliate into a collateral account
with the bank and earns interest at LIBOR less 0.15%. Under certain
circumstances, the collateral deposit or a portion of it, will be returned to
REPG or its designee. Otherwise, it will be retained by the bank. At December
31, 2001 and March 31, 2002, REPG and its subsidiary had deposited $230 million
and $100 million, respectively, into the collateral account. In January 2002,
the bank sold to the parties to the construction agency agreements discussed
above, equipment contracts with a total
29
contractual obligation of $258 million, under which payments and interest during
construction totaled $142 million. Accordingly, $142 million of Reliant
Resources' collateral deposits were returned to Reliant Resources. As of March
31, 2002, there were equipment contracts with a total contractual obligation of
$140 million under which payments during construction totaled $99.5 million.
Currently this equipment is not designated for current planned power generation
construction projects. Therefore, Reliant Resources anticipates that it will
either purchase the equipment, assist in the remarketing of the equipment or
negotiate to cancel the related contracts.
(g) REMA Sale/Leaseback Transactions.
In August 2000, subsidiaries of Reliant Resources 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, which Reliant
Resources 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 March 31,
2002, these various conditions were satisfied by REMA. As of December 31, 2001,
REMA had $167 million of restricted funds that were available for REMA's working
capital needs and to make future lease payments. For additional discussion of
these lease transactions, please read Notes 3(a) and 14(b) to the Reliant Energy
10-K Notes, which notes are incorporated herein by reference.
(h) Nuclear Insurance.
The Company has a 30.8% interest in the South Texas Project Electric
Generating Station (South Texas Project), which consists of two 1,250 MW nuclear
generating units and bears a corresponding 30.8% share of capital and operating
costs associated with the project. The South Texas Project is owned as a tenancy
in common among its four co-owners, with each owner retaining its undivided
ownership interest in the two nuclear-fueled generating units and the electrical
output from those units. The Company and the other owners of the South Texas
Project maintain nuclear property and nuclear liability insurance coverage as
required by law and periodically review available limits and coverage for
additional protection. The owners of the South Texas Project currently maintain
$2.75 billion in property damage insurance coverage, which is above the legally
required minimum, but is less than the total amount of insurance currently
available for such losses.
Pursuant to the Price Anderson Act, the maximum liability to the public of
owners of nuclear power plants was $9.3 billion as of March 31, 2002. Owners are
required under the Price Anderson Act to insure their liability for nuclear
incidents and protective evacuations. The Company and the other owners of the
South Texas Project currently maintain the required nuclear liability insurance
and participate in the industry retrospective rating plan.
There can be no assurance that all potential losses or liabilities will be
insurable, or that the amount of insurance will be sufficient to cover them. Any
substantial losses not covered by insurance would have a material effect on the
Company's financial condition, results of operations and cash flows.
(i) Nuclear Decommissioning.
The Company contributed $14.8 million per year in 2000 and 2001 to a trust
established to fund its share of the decommissioning costs for the South Texas
Project. Pursuant to an October 3, 2001 Order from the Texas Utility Commission,
beginning in 2002, the Company will contribute $2.9 million per year to this
trust. There are various investment restrictions imposed upon the Company by the
Texas Utility Commission and the NRC relating to the Company's nuclear
decommissioning trust. Additionally, the Company's board of directors has
appointed the Nuclear Decommissioning Trust Investment Committee to establish
the investment policy of the trust and oversee the investment of the trusts'
assets. The securities held by the trust for decommissioning costs had an
estimated fair value of $168 million as of March 31, 2002, of which
approximately 45% were fixed-rate debt securities and the remaining 55% were
equity securities. For a discussion of the accounting treatment for the
securities held in the Company's nuclear decommissioning trust, see Note 6 to
the Reliant Energy 10-K Notes, which note is incorporated herein by reference.
In July 1999, an outside consultant estimated the Company's portion of
decommissioning costs to be approximately $363 million. While the current
funding levels currently exceed minimum NRC requirements, no assurance can be
given that the amounts held in trust will be adequate to cover the actual
decommissioning costs of the South Texas Project. Such costs may vary because of
changes in the assumed date of decommissioning and changes in regulatory
requirements, technology and costs of labor, materials and equipment. Pursuant
to the Texas
30
electric restructuring law, costs associated with nuclear decommissioning that
have not been recovered as of January 1, 2002, will continue to be subject to
cost-of-service rate regulation and will be included in a charge to transmission
and distribution customers.
(14) REPORTABLE BUSINESS SEGMENTS
The Company's determination of reportable business 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 business segments: Electric Generation,
Electric Transmission and Distribution, Natural Gas Distribution, Pipelines and
Gathering, Wholesale Energy, European Energy, Retail Energy and Other
Operations. Effective with the deregulation of the Texas electric industry
beginning January 1, 2002, the basis of business segment reporting has changed
for the Company's electric operations. Although the Company's retail sales are
now conducted by Reliant Resources, retail customers remained regulated
customers of Reliant Energy HL&P through the date of their first meter reading
in 2002. Sales of electricity in 2002 prior to such meter reading are reflected
in the Electric Transmission and Distribution business segment. The Texas
generation operations of Reliant Energy's former integrated utility, Reliant
Energy HL&P, are now a separate reportable business segment, whereas they
previously had been part of the Electric Operations business segment. The
remaining transmission and distribution function is now reported separately in
the Electric Transmission and Distribution business segment, which also includes
all impacts from generation-related regulatory assets recoverable by the
regulated utility, including the ECOM true-up component of stranded costs. In
2001, Latin America was a separate business segment, but is now reported in the
Other Operations business segment beginning in 2002. Reportable business
segments from 2001 have been restated to conform to the 2002 presentation. Note
that estimates have been used to separate historical, pre-January 1, 2002,
Electric Generation business segment data. For descriptions of these reportable
business segments, see Note 1 to the Reliant Energy 10-K Notes, which note is
incorporated herein by reference.
Beginning in the first quarter of 2002, the Company began to evaluate
business segment performance on an earnings (loss) before interest expense,
minority interest and income taxes (EBIT) basis. Prior to 2002, the Company
evaluated performance on operating income. EBIT, as defined, is shown because it
is a widely accepted measure of financial performance used by analysts and
investors to analyze and compare companies on the basis of operating
performance. EBIT is not defined under accounting principles generally accepted
in the United States (GAAP), and should not be considered in isolation or as a
substitute for a measure of performance prepared in accordance with GAAP and is
not indicative of operating income from operations as determined under GAAP.
Financial data for the reportable business segments are as follows:
AS OF
DECEMBER 31,
FOR THE THREE MONTHS ENDED MARCH 31, 2001 2001
----------------------------------------- ------------
NET
REVENUES FROM INTERSEGMENT
NON-AFFILIATES REVENUES EBIT TOTAL ASSETS
-------------- ------------ --------- ------------
(IN MILLIONS)
Electric Generation(1) ............... $ -- $ 1,023 $ 37 $ 4,295
Electric Transmission and Distribution 1,390 -- 162 7,717
Natural Gas Distribution ............. 2,269 54 137 3,732
Pipelines and Gathering .............. 75 55 39 2,361
Wholesale Energy ..................... 8,053 309 229 8,252
European Energy ...................... 248 -- 21 3,380
Retail Energy (3) .................... 14 13 (3) 391
Other Operations ..................... 29 1 (131) 2,228
Eliminations/Other ................... -- (1,455) 9 (1,646)
---------- ---------- --------- ----------
Consolidated ......................... $ 12,078 $ -- $ 500 $ 30,710
========== ========== ========= ==========
31
AS OF
FOR THE THREE MONTHS ENDED MARCH 31, 2002 MARCH 31, 2002
----------------------------------------- --------------
NET
REVENUES FROM INTERSEGMENT
NON-AFFILIATES REVENUES EBIT TOTAL ASSETS
-------------- ------------ --------- ------------
(IN MILLIONS)
Electric Generation(1) ................... $ 95 $ 231 $ (52) $ 4,517
Electric Transmission and Distribution(2). 404 221 259 7,569
Natural Gas Distribution ................. 1,178 2 110 3,589
Pipelines and Gathering .................. 51 41 38 2,362
Wholesale Energy ......................... 5,419 114 114 13,639
European Energy .......................... 535 -- 18 3,296
Retail Energy (3) ........................ 972 7 48 1,683
Other Operations ......................... 2 -- (13) 1,569
Eliminations/Other ....................... -- (616) 1 (1,233)
---------- ---------- --------- ----------
Consolidated ............................. $ 8,656 $ -- $ 523 $ 36,991
========== ========== ========= ==========
- ----------
(1) For 2001, revenues were derived based on an allowed regulatory rate of
return on invested capital with Reliant Energy HL&P being the sole
customer of the Electric Generation business segment. Expenses, such
as fuel and cost of gas sold, operations and maintenance and
depreciation and amortization, and assets, such as property, plant and
equipment and inventory, were specifically identified by function and
reported accordingly. Various allocations were used to disaggregate
other common expenses, assets and liabilities between the Electric
Generation and the Electric Transmission and Distribution business
segments. Interest expense was calculated based upon an allocation
methodology that charged the Electric Generation business segment with
financing and equity costs from Reliant Energy in proportion to its
share of total net assets prior to the effects of deregulation. For
2002, the Electric Generation business segments' operations reflect
the results of market prices for power.
(2) Retail customers remained regulated customers of Reliant Energy HL&P
through the date of their first meter reading in 2002. Sales of
electricity to retail customers in 2002 prior to this meter reading
are reflected in the Electric Transmission and Distribution business
segment.
(3) The Retail Energy business segment became a provider of retail
electricity in Texas when that market began opening to retail
competition in late 2001 and fully opened to retail competition in
January 2002. As a retail electric provider, the Retail Energy
business segment generally procures or buys electricity from wholesale
generators at unregulated rates, sells electricity at generally
unregulated rates to retail customers and pays the local transmission
and distribution regulated utilities a regulated tariff rate for
delivering electricity. In January 2002, the Retail Energy business
segment began to provide retail electric services to all of the
approximately 1.7 million customers of Reliant Energy HL&P's electric
utility located in its service area who did not take action to select
another retail electric provider.
32
Reconciliation of Operating Income to EBIT and EBIT to Net Income
Attributable to Common Stockholders:
FOR THE THREE MONTHS ENDED MARCH 31,
-----------------------------------
2001 2002
---------- ----------
(IN MILLIONS)
Operating income .................................................... $ 458 $ 517
Unrealized gain (loss) on AOL Time Warner investment ................ 137 (218)
Unrealized (loss) gain on indexed debt securities ................... (135) 203
Income from equity investment of unconsolidated subsidiaries ........ 13 4
Other income, net ................................................... 27 17
---------- ----------
EBIT ................................................................ 500 523
Interest expense .................................................... (178) (154)
Distribution on trust preferred securities .......................... (14) (14)
Minority interest ................................................... 1 (16)
---------- ----------
Income before income taxes and cumulative effect of accounting change 309 339
Income tax expense .................................................. (108) (114)
Cumulative effect of accounting change .............................. 61 --
---------- ----------
Net income attributable to common stockholders ...................... $ 262 $ 225
========== ==========
(15) SUBSEQUENT EVENTS
(a) Price to Beat Fuel Factor Adjustment.
The Texas Utility Commission regulations allow the Company to adjust the
fuel factor in its price to beat to its Houston residential and small commercial
customers based on the percentage change in the price of natural gas. In
addition, the Company may also request an adjustment as a result of changes in
the price of purchased energy. On May 2, 2002, Reliant Resources filed a request
with the Texas Utility Commission to increase the fuel factor in its price to
beat. Reliant Resources' price to beat was initially set by the Texas Utility
Commission in November 2001 at the then average forward 12 month gas price strip
of approximately $3.11/mmbtu. Since the initial setting, the market price of
natural gas has increased 20% to $3.73/mmbtu during April 2002. The earliest the
new price to beat could go into effect would be June 17, 2002.
(b) Liquidation of Interest Rate Swaps.
On May 9, 2002, Reliant Resources liquidated $500 million of forward
starting interest rate swaps that were entered into in January 2002. The
liquidation of these hedges resulted in a loss of $3 million, which will be
recorded in other comprehensive income and amortized into interest expense over
the life of the notes when issued in the future.
(c) Class Action Lawsuits.
The Company is aware that in May 2002 at least four class action lawsuits
were filed on behalf of purchasers of securities of Reliant Resources. Reliant
Resources and several of its executive officers are named as defendants. Reliant
Energy is also named as a defendant in one of the lawsuits. The first two
lawsuits were filed on May 15, 2002 and the other two lawsuits were filed on May
16, 2002. All of the lawsuits were filed in the United States District Court,
Southern District of Texas, Houston Division. The complaints allege that the
defendants violated federal securities laws by issuing false and misleading
statements to the public. The plaintiffs allege that the defendants overstated
the revenues of Reliant Resources by including transactions involving the
purchase and sale of commodities with the same counterparty at the same price
and that Reliant Resources improperly accounted for certain other transactions.
The complaints seek monetary damages and, in one of the lawsuits rescission, on
behalf of persons who purchased or otherwise acquired Reliant Resources
securities between May 1, 2001 and May 10, 2002. The lawsuit that includes
Reliant Energy as a named defendant was filed on behalf of purchasers of
securities of Reliant Resources and/or Reliant Energy between May 14, 1999 and
May 9, 2002. The Company has not yet answered or otherwise responded to these
lawsuits. Their ultimate outcome cannot be predicted at this time.
Additionally, the Company is aware that on May 16, 2002 a class action
lawsuit was filed on behalf of purchasers of securities of Reliant Energy.
Reliant Energy and several of its executive officers are named as defendants.
The lawsuit was filed in the United States District Court, Southern District of
Texas, Houston Division. The complaint alleges that the
33
defendants violated federal securities laws by issuing false and misleading
statements to the public. The plaintiffs allege that the defendants' false and
misleading statements were part of a scheme to artificially inflate trading
volumes and revenues by including transactions involving the purchase and sale
of commodities with the same counterparty at the same price, to spin-off Reliant
Resources to avoid exposure to Reliant Resources' liabilities and to cause the
price of Reliant Resources' stock to rise artificially, among other things. The
complaint seeks monetary damages on behalf of persons who purchased Reliant
Energy securities between January 2, 1999 and May 10, 2002. The Company has not
yet answered or otherwise responded to the lawsuit. Its ultimate outcome cannot
be predicted at this time.
34
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.
EFFECTS OF RESTATEMENT ON THE INTERIM FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED MARCH 31, 2001
On May 9, 2002, Reliant Resources determined that they had engaged in
same-day commodity trading transactions involving purchases and sales with the
same counterparty for the same volume at substantially the same price, which the
personnel who effected these transactions apparently did so with the objective
of increasing volumes. Reliant Resources commenced a review to quantify the
amount and assess the impact of these trades (round trip trades). The Audit
Committee of the Board of Directors has also directed an internal investigation
by outside legal counsel of the facts and circumstances relating to the round
trip trades and related matters.
We currently report all trading, marketing and risk management services
transactions on a gross basis with such transactions being reported in revenues
and expenses except primarily for financial gas transactions such as swaps.
Therefore, the round trip trades were reflected in both our revenues and
expenses. The round trip trades should not have been recognized in revenues or
expenses (i.e., they should have been reflected on a net basis). However, since
the round trip trades were done at the same volume and substantially the same
price they had no impact on our reported cash flows, operating income or net
income.
Based on our review, we have determined that we engaged in such round trip
trades in 1999, 2000 and 2001, and our review did not identify any round trip
trades conducted during 2002. The results of the Audit Committee's investigation
are consistent with the results of our review. During the first quarter of 2001,
the trades of this nature were 20 million megawatt hours (MWh) of power. In the
first quarter of 2001, these transactions had the effect of increasing revenues
and purchased power expense by approximately $1.2 billion, or approximately 10%
and 43%, respectively.
The consolidated financial statements for the three months ended March 31,
2001 have been restated from amounts previously reported to reflect these
transactions on a net basis. The reinstatement had no impact on previously
reported consolidated cash flows, operating income or net income. The principal
effects of the restatement on the accompanying financial statements are set
forth in Note 1 of the Interim Financial Statements.
OVERVIEW
We are a diversified international energy services and energy delivery
company that provides energy and energy services primarily in North America and
Western Europe. We operate one of the United States' largest electric
transmission and distribution utilities, 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 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, capital resources and critical accounting policies. Our financial
reporting business segments include Electric Generation, Electric Transmission
and Distribution, Natural Gas Distribution, Pipelines and Gathering, Wholesale
Energy, European Energy, Retail Energy and Other Operations. Effective with the
full deregulation of sales of electric energy to retail customers in Texas
beginning January 1, 2002, the basis of business segment reporting has changed
for our electric operations. Although our retail sales are now conducted by
Reliant Resources, retail customers remained regulated customers of Reliant
Energy HL&P through the date of their first meter reading in 2002. Sales of
electricity to retail customers in 2002 prior to this meter reading are
reflected in the Electric Transmission and Distribution business segment. The
Texas generation operations of Reliant Energy's former integrated utility,
Reliant Energy HL&P, are now a separate reportable business segment, whereas
they previously had been part of the Electric Operations business segment. The
remaining transmission and distribution function is now reported separately in
the Electric Transmission and Distribution business segment. In 2001, Latin
America was a separate business segment, but is now reported in the Other
Operations business segment beginning in 2002. Reportable business segments from
2001 have been restated to conform to the 2002 presentation. For business
segment reporting information, please read Notes 1 and 14 to our Interim
Financial Statements.
We are in the process of separating our regulated and unregulated
businesses into two publicly traded companies. In December 2000, we transferred
a significant portion of our unregulated businesses to Reliant Resources, which,
at the time, was a wholly owned subsidiary. Reliant Resources conducted an
initial public offering (Offering) of approximately 20% of its common stock in
May 2001. In December 2001, our shareholders approved an agreement and plan of
merger by which, subject to regulatory approvals, the following will occur
35
(which we refer to herein as the Restructuring):
- CenterPoint Energy, Inc. (CenterPoint Energy) will become the holding
company for the Reliant Energy group of companies;
- Reliant Energy and its subsidiaries will become subsidiaries of
CenterPoint Energy; and
- each share of Reliant Energy common stock will be converted into one
share of CenterPoint Energy common stock.
After the Restructuring, we plan, subject to further corporate approvals,
market and other conditions, to complete the separation of our regulated and
unregulated businesses by distributing the shares of common stock of Reliant
Resources that we own to our shareholders (which we refer to herein as the
Distribution). Our goal is to complete the Restructuring and subsequent
Distribution as quickly as possible after all the necessary conditions are
fulfilled, including receipt of an order from the Securities and Exchange
Commission (SEC) granting the required approvals under the Public Utility
Holding Company Act of 1935 (1935 Act) and an extension from the Internal
Revenue Service for a private letter ruling we have obtained regarding the
tax-free treatment of the Distribution. We believe we will receive the necessary
approvals. We currently expect to complete the Restructuring and Distribution in
the summer of 2002. However, until the requisite approvals are received, no
assurance can be provided that the Distribution will occur as described above or
that it will occur within this time period. Upon receipt of approval under the
1935 Act, CenterPoint Energy expects to register and become subject, with its
subsidiaries, to regulation as a registered holding company system under the
1935 Act.
Thereafter, in order to enable CenterPoint Energy ultimately to comply with
the requirements for exemption from registration in Section 3(a)(1) of the 1935
Act, we plan to divide the gas distribution businesses conducted by Reliant
Energy Resources Corp.'s (RERC Corp.) three unincorporated divisions, Reliant
Energy Entex, Reliant Energy Arkla and Reliant Energy Minnegasco among three
separate entities. The entity that will hold the Reliant Energy Entex assets
will also hold RERC Corp.'s natural gas pipelines and gathering business. In
addition to regulatory approvals we have obtained, this restructuring will
require approval of the public service commissions of Louisiana, Mississippi,
Oklahoma and Arkansas.
Although we believe that this business restructuring will be completed, we
can provide no assurance that this will, in fact, occur, or that CenterPoint
Energy will ultimately be exempt from registration under the 1935 Act. For
further information on the RERC Corp. restructuring, see "Our Business -- RERC
Corp. Restructuring" in Item 1 of the Reliant Energy Form 10-K.
36
CONSOLIDATED RESULTS OF OPERATIONS
THREE MONTHS ENDED MARCH 31,
--------------------------------
2001 2002
------------ ------------
(IN MILLIONS, EXCEPT PER SHARE DATA)
Revenues ............................................................ $ 12,078 $ 8,656
Operating Expenses .................................................. (11,620) (8,139)
------------ ------------
Operating Income .................................................... 458 517
Unrealized Gain (Loss) on AOL Time Warner Investment ................ 137 (218)
Unrealized (Loss) Gain on Indexed Debt Securities ................... (135) 203
Income from Equity Investments in Unconsolidated Subsidiaries ....... 13 4
Other Income, net ................................................... 27 17
------------ ------------
Earnings Before Interest and Taxes .................................. 500 523
Interest Expense .................................................... (178) (154)
Distribution on Trust Preferred Securities .......................... (14) (14)
Minority Interest ................................................... 1 (16)
------------ ------------
Income Before Income Taxes and Cumulative Effect of Accounting Change 309 339
Income Tax Expense .................................................. (108) (114)
Cumulative Effect of Accounting Change, net of tax .................. 61 --
------------ ------------
Net Income Attributable to Common Stockholders ...................... $ 262 $ 225
============ ============
Basic Earnings Per Share ............................................ $ 0.91 $ 0.76
Diluted Earnings Per Share .......................................... $ 0.90 $ 0.76
Three months ended March 31, 2001 compared to three months ended March 31, 2002
Net Income. We reported consolidated net income of $225 million ($0.76 per
diluted share) for the three months ended March 31, 2002 compared to $262
million ($0.90 per diluted share) for the three months ended March 31, 2001. The
2001 results reflect a $61 million after-tax non-cash gain from the adoption of
Statement of Financial Accounting Standards (SFAS) No. 133, "Accounting for
Derivative Instruments and Hedging Activities," as amended, and a $65 million
after-tax non-cash charge relating to the redesign of some of our benefit plans
in anticipation of our separation from Reliant Resources. For additional
discussion of the adoption of SFAS No. 133, please read Note 5 to the Reliant
Energy 10-K Notes, which note is incorporated herein by reference. Effective
January 1, 2002, we discontinued amortizing goodwill in accordance with SFAS No.
142, "Goodwill and Other Intangible Assets (SFAS No. 142)." During the first
quarter of 2001, we recognized $21 million of goodwill amortization expense. A
discussion of earnings before interest and taxes (EBIT) by segment is presented
following the consolidated results of operations discussion below. The decrease
in net income attributable to common stockholders for the first quarter of 2002
was primarily due to the following:
- a $115 million decrease in EBIT from our Wholesale Energy business
segment primarily due to less favorable market conditions;
- a $27 million decrease in EBIT from our Natural Gas Distribution
business segment primarily due to milder weather;
- a $16 million negative impact related to our investment in AOL Time
Warner securities and related indexed debt securities;
- a $17 million increase in minority interest expense primarily related
to minority interest in Reliant Resources as a result of the initial
public offering of Reliant Resources' common stock in May 2001; and
- a $61 million after-tax non-cash gain in the first quarter of 2001
from the adoption of SFAS No. 133.
The above items were partially offset by:
37
- a $101 million pre-tax ($65 million after-tax), non-cash charge
incurred in the first quarter of 2001 relating to the redesign of some
of our benefit plans in anticipation of our separation from Reliant
Resources;
- a $51 million increase in EBIT from our Retail Energy business
segment;
- a $21 million decrease in goodwill amortization in the first quarter
of 2002 due to the adoption of SFAS No. 142; and
- a $24 million decrease in interest expense.
Interest Expense. We incurred interest expense of $154 million during the
three months ended March 31, 2002 compared to $178 million in the same period of
2001. The decrease in interest expense of $24 million in 2002 as compared to
2001 resulted primarily from lower interest rates partially offset by increased
borrowing levels due to the acquisition of Orion Power Holdings, Inc. (Orion
Power) on February 19, 2002 as discussed in Note 5 to our Interim Financial
Statements.
Income Tax Expense. During the three months ended March 31, 2001 and 2002,
our effective tax rate was 34.9% and 33.6%, respectively. The decrease in the
effective tax rate for the first quarter of 2002 compared to the first quarter
of 2001 was primarily due to lower state tax expense, the discontinuance of
goodwill amortization in accordance with SFAS No. 142, and other favorable
adjustments, offset by the nondeductible minority interest provision, and higher
taxes on Reliant Energy Power Generation Benelux N.V.'s (REPGB) earnings. In
2001, the earnings of REPGB were subject to a zero percent Dutch corporate
income tax rate as a result of a tax holiday for the Dutch electricity industry.
In 2002, REPGB's earnings in the Netherlands are subject to the standard Dutch
corporate income tax rate, which is currently 34.5%.
EARNINGS BEFORE INTEREST AND INCOME TAXES BY BUSINESS SEGMENT
The following table presents EBIT for each of our business segments for the
three months ended March 31, 2001 and 2002. EBIT represents earnings (loss)
before interest expense, minority interest and income taxes. EBIT, as defined,
is shown because it is a widely accepted measure of financial performance used
by analysts and investors to analyze and compare companies on the basis of
operating performance. It is not defined under generally accepted accounting
principles, and should not be considered in isolation or as a substitute for a
measure of performance prepared in accordance with generally accepted accounting
principles (GAAP) in the United States and is not indicative of operating income
from operations as determined under GAAP. Additionally, our computation of EBIT
may not be comparable to other similarly titled measures computed by other
companies, because all companies do not calculate it in the same fashion. For a
reconciliation of our business segments' operating income (loss) to EBIT and
EBIT to net income, please read Note 14 to our Interim Financial Statements.
THREE MONTHS ENDED MARCH 31,
----------------------------
2001 2002
---------- ----------
(IN MILLIONS)
Electric Generation .................. $ 37 $ (52)
Electric Transmission and Distribution 162 259
Natural Gas Distribution ............. 137 110
Pipelines and Gathering .............. 39 38
Wholesale Energy ..................... 229 114
European Energy ...................... 21 18
Retail Energy ........................ (3) 48
Other Operations ..................... (131) (13)
Eliminations/Other ................... 9 1
---------- ----------
Total Consolidated EBIT ........ $ 500 $ 523
========== ==========
ELECTRIC BUSINESS SEGMENTS
For information regarding factors that may affect the future results of
operations of our Electric business segments, please read "Management's
Discussion and Analysis of Financial Condition and Results of Operations --
38
Certain Factors Affecting Our Future Earnings -- Factors Affecting the Results
of Our Electric Operations" in the Reliant Energy Form 10-K, which is
incorporated herein by reference.
The following tables provide summary data, including EBIT, of our Electric
business segments for the three months ended March 31, 2001 and 2002:
THREE MONTHS ENDED
MARCH 31, 2001
------------------
(IN MILLIONS)
Operating Revenues:
Electric Revenues ....................... $ 1,390
-------------
Total Operating Revenues .............. 1,390
Operating Expenses:
Fuel and Purchased Power ................ 786
Operation and Maintenance ............... 248
Depreciation and Amortization ........... 79
Other Operating Expenses ................ 91
-------------
Total Operating Expenses .............. 1,204
Operating Income .......................... 186
Other Income, net ......................... 13
-------------
Earnings Before Interest and Income Taxes . $ 199
=============
Electric Sales Including Unbilled (GWh(1)):
Residential ............................. 3,951
Commercial .............................. 3,969
Industrial .............................. 7,438
Other ................................... 296
-------------
Total Sales Including Unbilled .......... 15,654
=============
- ----------
(1) Gigawatt hours
THREE MONTHS ENDED MARCH 31, 2002
--------------------------------------------------------
ELECTRIC
ELECTRIC TRANSMISSION
GENERATION & DISTRIBUTION ELIMINATIONS TOTAL
---------- -------------- ------------ -----------
(IN MILLIONS)
Operating Revenues:
Electric Revenues............................... $ 326 $ 484 $ (101) $ 709
ECOM True-Up.................................... -- 141 -- 141
--------- ---------- ----------- -----------
Total Operating Revenues...................... 326 625 (101) 850
Operating Expenses:
Fuel and Purchased Power........................ 229 76 (60) 245
Operation and Maintenance....................... 96 181 (41) 236
Depreciation and Amortization................... 40 64 -- 104
Other Operating Expenses........................ 13 50 -- 63
--------- ---------- ----------- -----------
Total Operating Expenses...................... 378 371 (101) 648
Operating Income.................................. (52) 254 -- 202
Other Income, net................................. -- 5 -- 5
--------- ---------- ----------- -----------
Earnings Before Interest and Income Taxes......... $ (52) $ 259 $ -- $ 207
========= ========== =========== ===========
Throughput Data Including Unbilled (GWh):
Residential..................................... 4,473
Commercial...................................... 3,975
Industrial...................................... 6,338
Other........................................... 42
-----------
Total Throughput Including Unbilled............. 14,828
===========
39
During 2001, our Electric Operations business segment reflected the
regulated electric utility business, including generation, transmission and
distribution, and retail electric sales. As of January 1, 2002, with the opening
of the Texas market to full retail electric competition, generation and retail
sales were deregulated. Retail electric sales involve the sale of electricity
and related services to end users of electricity and were included as part of
the bundled regulated service prior to 2002. Retail electric sales are now
reported as the Retail Energy business segment of Reliant Resources.
Beginning in 2002, we are reporting two new business segments for what was
the former Electric Operations business segment:
- Electric Generation, and
- Electric Transmission and Distribution.
The previously regulated generation operations in Texas are being reported
in the new Electric Generation business segment. The Electric Transmission and
Distribution business segment will report results from two sources. This
business segment includes the regulated electric transmission and distribution
operations as well as impacts of generation-related stranded costs recoverable
by the regulated utility.
As a result of the implementation of deregulation and the corresponding new
business segments, the regulated transmission and distribution utility recovers
the cost of its service through an energy delivery charge, and not as a
component of the prior bundled rate. Accordingly, there are no meaningful
comparisons for these business segments against prior periods. The design of the
new energy delivery rate, which is based on an 11.25% return on equity, differs
from the prior bundled energy rate. The winter/summer rate differential for
residential customers has been eliminated and large commercial and industrial
rates no longer have an energy-based component, but are demand driven. This new
rate design will tend to lessen some of the pronounced seasonal variation of
revenues which has been experienced in prior periods. For estimates of
historical Electric Generation revenues, please read Note 14 to our Interim
Financial Statements.
Although our retail sales are now conducted by Reliant Resources, retail
customers remained regulated customers of Reliant Energy HL&P through the date
of their first meter reading in 2002. Sales during this transition period
produced EBIT of $14 million in the first quarter of 2002, reflected in the
Electric Transmission and Distribution business segment. We expect to incur
additional transition expenses during the remainder of the year and a
substantial portion of these earnings are expected to be offset.
The new Electric Generation business segment is comprised of over 14,000
Megawatts of electric generation located entirely in the state of Texas, and
will be called Texas Genco after the Restructuring. This business segment
reported a $52 million loss before interest and taxes for the first quarter of
2002 primarily due to low natural gas prices and ample generating capacity in
Texas, which created a weak price environment for the capacity auctions
described below.
The new Electric Transmission & Distribution business segment reported EBIT
of $259 million for the first quarter of 2002. This reflected EBIT of $104
million for the regulated electric transmission and distribution business, EBIT
of $ 14 million from sales during the transition period as discussed above and
EBIT of $141 million associated with certain generation-related regulatory
assets (ECOM, or Excess Cost Over Market, true-up) recorded pursuant to the
Texas restructuring law as explained below.
Under the deregulation law, each power generator that is unbundled from an
integrated electric utility in Texas has an obligation to conduct state-mandated
capacity auctions of 15 percent of its capacity. In addition, under a master
separation agreement between Reliant Energy and Reliant Resources, Texas Genco
is contractually obligated to auction all capacity in excess of the
state-mandated capacity auctions. The auctions conducted periodically between
September 2001 and March 2002 were consummated at prices below those assumed by
the ECOM model of the Public Utility Commission of Texas (Texas Utility
Commission). Under the Texas electric restructuring law, a regulated utility may
recover any difference between market prices received through the state-mandated
auctions and the Texas Utility Commission's earlier estimates of those market
prices. This difference, recorded as a regulatory asset, produced $141 million
of EBIT in the first quarter of 2002.
40
In the Electric Transmission and Distribution business segment, throughput
declined 5 percent compared to the first quarter of 2001 due to reduced energy
delivery in the industrial sector. Customer growth was strong with an addition
of 7,000 metered customers since December 31, 2001, or approximately 2 percent
growth on an annualized basis.
Operation and maintenance expenses for the first quarter of 2002 decreased
by $12 million compared to the same period in 2001. The decrease was primarily
due to the elimination of factoring expense and fewer plant outages in 2002,
partially offset by higher benefits expense.
Depreciation and amortization expense in the first quarter of 2002
increased $25 million compared to the same period in 2001. The increase was
primarily due to the discontinuance of redirection of depreciation expense to
generation assets for financial reporting purposes, offset by decreased
amortization of the book impairment loss recorded in June 1999, which was fully
amortized in December 2001.
Other operating expense in the first quarter of 2002 decreased $28 million
compared to the same period in 2001. The decrease was primarily due to lower
franchise fees and gross receipts taxes.
NATURAL GAS DISTRIBUTION
Our Natural Gas Distribution business 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.
For information regarding factors that may affect the future results of
operations of our Natural Gas Distribution business segment, please read
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Certain Factors Affecting Our Future Earnings -- Factors Affecting
the Results of RERC's Operations" in the Reliant Energy Form 10-K, which is
incorporated herein by reference.
The following table provides summary data, including EBIT, of our Natural
Gas Distribution business segment for the three months ended March 31, 2001 and
2002:
THREE MONTHS ENDED MARCH 31,
-----------------------------
2001 2002
------------ ------------
(IN MILLIONS)
Operating Revenues ...................... $ 2,323 $ 1,180
Operating Expenses:
Natural Gas ........................... 1,977 885
Operation and Maintenance ............. 133 131
Depreciation and Amortization ......... 36 30
Other Operating Expenses .............. 42 28
------------ ------------
Total Operating Expenses ............ 2,188 1,074
------------ ------------
Operating Income ........................ 135 106
Other Income, net ...................... 2 4
------------ ------------
Earnings Before Interest and Income Taxes $ 137 $ 110
============ ============
Throughput Data (in Bcf(1)):
Residential and Commercial Sales ...... 153 132
Industrial Sales ...................... 11 11
Transportation ........................ 15 15
Retail ................................ 132 121
------------ ------------
Total Throughput .................... 311 279
============ ============
- ---------------
(1) Billion cubic feet.
41
Our Natural Gas Distribution business segment's EBIT decreased $27 million
for the first quarter of 2002 as compared to the same period in 2001. This
decrease was largely due to significantly milder weather, lower gas prices and
decreased usage in 2002 as compared to 2001 and a related decrease in forfeited
discounts, late payment fees and recoverable franchise taxes. Depreciation and
amortization expense decreased approximately $6 million in the first quarter of
2002 compared to the same period in 2001 primarily as a result of the
discontinuance of goodwill amortization in accordance with SFAS No. 142 as
further discussed in Note 6 to our Interim Financial Statements. Goodwill
amortization in the first quarter of 2001 was $8 million. Other operating
expenses, primarily franchise taxes, decreased $14 million in the first quarter
of 2002 as compared to the same period in 2001 primarily due to reduced revenues
subject to taxes, and were offset by reduced revenue recovery as discussed
above.
PIPELINES AND GATHERING
Our Pipelines and Gathering business segment operates two interstate
natural gas pipelines as well as provides gathering and pipeline services.
For information regarding factors that may affect the future results of
operations of our Pipelines and Gathering business segment, please read
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Certain Factors Affecting Our Future Earnings -- Factors Affecting
the Results of RERC's Operations" in the Reliant Energy Form 10-K, which is
incorporated herein by reference.
The following table provides summary data, including EBIT, of our Pipelines
and Gathering business segment for the three months ended March 31, 2001 and
2002:
THREE MONTHS ENDED MARCH 31,
------------------------------
2001 2002
------------ ------------
(IN MILLIONS)
Operating Revenues ...................... $ 130 $ 92
Operating Expenses:
Natural Gas ........................... 45 7
Operation and Maintenance ............. 28 34
Depreciation and Amortization ......... 14 10
Other Operating Expenses .............. 4 4
------------ ------------
Total Operating Expenses ............ 91 55
------------ ------------
Operating Income ........................ 39 37
Other Income, net ....................... -- 1
------------ ------------
Earnings Before Interest and Income Taxes $ 39 $ 38
============ ============
Throughput Data (in Bcf):
Natural Gas Sales ..................... 6 5
Transportation ........................ 246 238
Gathering ............................. 70 71
Eliminations(1) ....................... (1) --
------------ ------------
Total Throughput ........................ 321 314
============ ============
- ----------
(1) Elimination of volumes both transported and sold.
Our Pipelines and Gathering business segment's EBIT for the first quarter
of 2002 declined slightly to $38 million compared to $39 million for the same
period in 2001. Depreciation and amortization expense decreased $4 million as a
result of the discontinuance of goodwill amortization in accordance with SFAS
No. 142 as further discussed in Note 6 to our Interim Financial Statements.
WHOLESALE ENERGY
Our Wholesale Energy business segment, which is conducted through Reliant
Resources, includes our non-rate regulated power generation operations in the
United States and our wholesale energy trading, marketing, 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.
42
For information regarding factors that may affect the future results of
operations of our Wholesale Energy business segment, please read "Management's
Discussion and Analysis of Financial Condition and Results of Operations --
Certain Factors Affecting Our Future Earnings -- Factors Affecting the Results
of Our Wholesale Energy Operations" in the Reliant Energy Form 10-K, which is
incorporated herein by reference.
The following table provides summary data, including EBIT, of our Wholesale
Energy business segment for the three months ended March 31, 2001 and 2002:
THREE MONTHS ENDED MARCH 31,
-----------------------------
2001 2002
------------ ------------
(IN MILLIONS)
Operating Revenues ....................................... $ 8,362 $ 5,533
Operating Expenses:
Fuel and Cost of Gas Sold .............................. 5,654 2,732
Purchased Power ........................................ 2,316 2,474
Operation and Maintenance .............................. 133 156
Depreciation and Amortization .......................... 41 50
Other Operating Expenses ............................... 2 13
------------ ------------
Total Operating Expenses ............................. 8,146 5,425
------------ ------------
Operating Income ......................................... 216 108
Other Income:
Income of Equity Investment of Unconsolidated Subsidiaries 13 4
Other, net ............................................... -- 2
------------ ------------
Earnings Before Interest and Income Taxes ................ $ 229 $ 114
============ ============
Operations Data:
Electricity Wholesale Power Sales
(in thousand MWh (1)) ................................ 55,994 120,534
Natural Gas Sales (in Bcf) ............................. 767 1,017
- ----------
(1) Megawatt hours.
Our Wholesale Energy business segment's EBIT decreased by $115 million for
the three months ended March 31, 2002 compared to the same period in 2001. The
decrease in EBIT is primarily due to decreases in gross margin (revenues less
fuel and cost of gas sold and purchased power), increases in operating expenses
and decreases in other income as further discussed below. These decreases in
EBIT were partially offset by changes in the provisions related to energy sales
in California. In the first quarter of 2002, $33 million of a previously accrued
credit provision for energy sales in California was reversed. The reversal
resulted from collections of outstanding receivables during the period coupled
with a determination that credit risk had been reduced on the remaining
outstanding receivables as a result of payments in 2002 to the California Power
Exchange. In the first quarter of 2001, our Wholesale Energy business segment
recorded a $38 million provision against receivable balances related to energy
sales in the West region.
Our Wholesale Energy business segment's revenues decreased by $2.8 billion
(34%) in the first quarter of 2002 compared to the same period in 2001. The
decreased revenues were primarily due to decreased prices for natural gas sales
(approximately $4.5 billion) and decreased prices for power sales (approximately
$3.7 billion) compared to 2001. These decreases in revenues were partially
offset by increased volumes for natural gas (approximately $1.7 billion) and
increased volumes for power sales (approximately $3.6 billion), including those
attributed to our February 19, 2002 acquisition of Orion Power. Our Wholesale
Energy business segment's cost of gas sold and fuel and purchased power
decreased by $2.8 billion in the first quarter of 2002, largely due to decreased
prices for natural gas and purchased power compared to 2001. These decreases in
cost of gas sold and fuel and purchased power were partially offset by increased
volumes for natural gas and purchased power.
Our Wholesale Energy business segment's gross margins decreased by $65
million in the first quarter of 2002 compared to the same period in 2001
primarily due to decreased margins from both our power generation operations
43
and our trading and marketing activities, partially offset by changes in
provisions related to energy sales in California totaling $71 million, as
discussed above. Margins on power sales from our generation facilities,
decreased by $158 million partially offset by $87 million from the Orion Power
acquisition that closed in February 2002. Favorable market conditions in the
first three months of 2001 in the West region resulting from a combination of
factors, including reduction in available hydroelectric generation resources,
increased demand and decreased electric imports, positively impacted our
Wholesale Energy business segment's operating margins. We do not expect these
favorable conditions to return in 2002 in the West region, because, among other
reasons, prices are now subject to Federal Energy Regulatory Commission price
mitigation controls. Trading and marketing gross margins decreased $66 million
from $113 million in 2001 to $47 million in 2002 primarily as a result of
natural gas and power trading activities. Higher natural gas and power
volatility levels provided for greater trading opportunities in the first
quarter of 2001 compared to the first quarter of 2002, particularly in the West
region.
The following table provides further summary data regarding gross margins
by commodity of our Wholesale Energy business segment for the three months ended
March 31, 2001 and 2002:
THREE MONTHS ENDED MARCH 31,
------------------------------
2001 2002
------------ ------------
(IN MILLIONS)
Gas revenues ................. $ 5,290 $ 2,490
Power revenues ............... 3,055 3,039
Other commodity revenues ..... 17 4
------------ ------------
Total revenues ............. 8,362 5,533
------------ ------------
Cost of gas sold ............. 5,211 2,437
Fuel and purchased power ..... 2,749 2,764
Other commodity costs ........ 10 5
------------ ------------
Total cost of sales ........ 7,970 5,206
------------ ------------
Gross margin .............. $ 392 $ 327
============ ============
Operation and maintenance expenses for our Wholesale Energy business
segment increased $23 million in the first quarter of 2002 compared to the same
period in 2001, primarily due to $35 million of operation and maintenance
expenses of generating plants related to the Orion Power acquisition in February
2002.
Depreciation and amortization expense increased by $9 million in the first
quarter of 2002 compared to the same period in 2001 primarily as a result of
depreciation expense related to our Orion Power plants, and other generating
plants placed into service during 2001, partially offset by a decrease in
amortization of air emissions regulatory allowances of $21 million. For the
three months ended March 31, 2001, our Wholesale Energy business segment
recorded $1 million in amortization expense related to goodwill. For information
regarding the discontinuance of goodwill amortization in accordance with SFAS
No. 142, please read Note 6 to our Interim Financial Statements.
Our Wholesale Energy business segment reported income from equity
investments for the three months ended March 31, 2002 of $4 million compared to
$13 million in the same period in 2001. The equity income in both periods
primarily resulted from an investment in an electric generation plant in Boulder
City, Nevada. The equity income related to our investment in the plant declined
primarily due to reduced power prices realized by the project company in 2002.
For information regarding the reserve against receivables and uncertainties
in the California wholesale energy market, please read Notes 13(a) and 13(d) to
our Interim Financial Statements.
EUROPEAN ENERGY
Our European Energy business segment, which is conducted through Reliant
Resources, generates and sells power from its generation facilities in the
Netherlands and participates in the emerging wholesale energy trading and power
origination industry in Northwest Europe.
For information regarding factors that may affect the future results of
operations of our European Energy business segment, please read "Management's
Discussion and Analysis of Financial Condition and Results of
44
Operations -- Certain Factors Affecting Our Future Earnings -- Factors Affecting
the Results of Our European Energy Operations" in the Reliant Energy Form 10-K,
which is incorporated herein by reference.
The following table provides summary data, including EBIT, of our European
Energy business segment for the three months ended March 31, 2001 and 2002:
EUROPEAN ENERGY
-----------------------------
THREE MONTHS ENDED MARCH 31,
-----------------------------
2001 2002
------------ ------------
(IN MILLIONS)
Operating Revenues ...................... $ 248 $ 535
Operating Expenses:
Fuel .................................. 101 80
Purchased Power ....................... 81 391
Operation and Maintenance ............. 29 35
Depreciation and Amortization ......... 19 13
------------ ------------
Total Operating Expenses ........... 230 519
------------ ------------
Operating Income ........................ 18 16
Other Income, net ....................... 3 2
------------ ------------
Earnings Before Interest and Income Taxes $ 21 $ 18
============ ============
Electricity (in thousand MWh):
Wholesale Sales ....................... 3,765 4,565
Trading Sales ......................... 3,010 15,079
Our European Energy business segment's EBIT decreased $3 million for the
three months ended March 31, 2002 compared to the same period in 2001.
Our European Energy business segment's operating revenues increased $287
million for the first quarter of 2002 compared to the same period in 2001. The
increase was primarily due to increased trading volumes associated with our
participation in the Dutch, Scandinavian, German, Austrian and United Kingdom
power markets, fuels trading and to a lesser extent increased volumes of
electric generation sales, which increased 21% in the first quarter of 2002
compared to the same period in 2001. The increases in revenues due to increases
in volumes related to trading and power generation sales were partially offset
by decreases in power prices, which decreased approximately 13% period to
period. Fuel and purchased power costs increased $289 million in the first
quarter of 2002 compared to the same period in 2001 primarily due to increased
purchased power for trading activities, certain non-recurring costs related to
out-of-market contracts totaling $4 million, and to a lesser extent, increased
fuel costs due to increased output from our generating facilities. Partially
offsetting the increase in fuel costs was a $19 million gain related to changes
in the valuation of certain out-of-market contracts in the first quarter of 2002
recorded in fuel expense. For further discussion of these out-of-market
contracts, please read Note 5 and Note 14(h) to the Reliant Energy 10-K Notes,
which notes are incorporated herein by reference and Note 13(e) to our Interim
Financial Statements.
Gross margins (revenues less fuel and purchased power) decreased $2 million
in the first quarter of 2002 compared to the same period in 2001 primarily due
to decreased margins from (a) ancillary services of $3 million, (b) district
heating sales of $4 million, and (c) other changes in power generation gross
margins totaling $8 million primarily due to reduced power prices and increased
fuel and fuel-related costs in 2002 compared to 2001. In addition, the first
quarter of 2001 results included activity under a protocol agreement under which
the Dutch generators provided capacity and energy to distributors in exchange
for regulated production payments. Further contributing to the decline in gross
margins were unscheduled plant outages at certain of our electric generating
facilities in the first quarter of 2002. We estimate that these unplanned
outages resulted in losses of approximately $7 million. A $19 million net gain
recognized in fuel expense related to the changes in valuation of certain
out-of-market contracts partially offset the overall decline in gross margin. In
addition, trading and power origination gross margins increased by $2 million
from $1 million in the first quarter of 2001 compared to $3 million in the first
quarter of 2002, primarily due to a significant increase in power trading
volumes and trading origination transactions.
45
Operation and maintenance expenses increased by $6 million for the three
months ended March 31, 2002 compared to the same period in 2001. These expenses
increased primarily due to the reversal of an accrual for environmental tax
subsidies receivable in 2001 of $4 million and a $2 million accrual recorded in
the first quarter of 2002 for environmental expenditures.
Depreciation and amortization expenses decreased during the first quarter
of 2002 compared to the same period in 2001 primarily due to the discontinuance
of goodwill amortization effective January 1, 2002. During the three months
ended March 31, 2001, our European Energy business segment recorded $6 million
in amortization expense related to goodwill. For additional discussion regarding
the discontinuance of goodwill amortization in accordance with SFAS No. 142,
please read Note 6 to our Interim Financial Statements.
Other non-operating income primarily relates to the amortization of the
deferred gains related to cross border lease transactions. In addition, during
the first quarter of 2002, our European Energy business segment recognized a
gain of $1 million related to the termination of certain cross border lease
agreements. For additional information regarding these cross border lease
transactions, please read Note 14(c) to the Reliant Energy 10-K Notes, which
note is incorporated herein by reference.
RETAIL ENERGY
Our Retail Energy business segment, which is conducted by Reliant
Resources, provides energy products and services to end-use customers, ranging
from residential and small commercial customers to large commercial, industrial
and institutional customers. In addition, our Retail Energy business segment
provided billing, customer service, credit and collection services to our
Electric Operations business segment and remittance services to our Electric
Operations business segment and two of the divisions of our Natural Gas
Distribution business segment. The service agreement governing these services
terminated on December 31, 2001. Our Retail Energy business segment charged the
regulated electric and natural gas utilities for these services at cost. Our
Retail Energy business segment acquired approximately 1.7 million electric
retail customers in the Houston metropolitan area when the Texas market opened
to full competition in January 2002. During the first half of 2002, the Texas
electric retail market will be largely focused on the extensive efforts
necessary to transition customers from the utilities to the affiliated retail
electric providers.
For information regarding factors that may affect the future results of
operations of our Retail Energy business segment, please read "Management's
Discussion and Analysis of Financial Condition and Results of Operations --
Certain Factors Affecting Our Future Earnings -- Factors Affecting the Results
of Our Retail Energy Operations" in the Reliant Energy Form 10-K, which is
incorporated herein by reference.
The following table provides summary data, including EBIT, of our Retail
Energy business segment for the three months ended March 31, 2001 and 2002:
RETAIL ENERGY
------------------------------
THREE MONTHS ENDED MARCH 31,
------------------------------
2001 2002
------------ ------------
(IN MILLIONS)
Operating Revenues ............................. $ 27 $ 979
Operating Expenses:
Fuel and Purchased Power ..................... -- 843
Operation and Maintenance .................... 28 83
Depreciation and Amortization ................ 2 5
------------ ------------
Total Operating Expenses .................. 30 931
------------ ------------
Operating (Loss) Income ........................ (3) 48
Other, net ..................................... -- --
------------ ------------
(Loss) Earnings Before Interest and Income Taxes $ (3) $ 48
============ ============
46
THREE MONTHS
ENDED
MARCH 31, 2002
--------------
Operations Data:
Electric Sales (GWh):
Residential .................................. 3,155
Small commercial ............................. 3,287
Large commercial, industrial and institutional 4,395
--------------
Total ...................................... 10,837
==============
Customers (in thousands, metered locations):
Residential .................................. 1,463
Small commercial ............................. 213
Large commercial, industrial and institutional 17
--------------
Total ...................................... 1,693
==============
Our Retail Energy business segment's EBIT increased $51 million in the
first quarter of 2002 compared to the same period in 2001. The increase in EBIT
was primarily due to increased gross margins (revenues less fuel and purchased
power) related to retail electric sales to residential and small commercial
customers and, to a lesser extent, retail electric sales to large commercial,
industrial and institutional customers due to the Texas retail market opening to
full competition in January 2002. The increase in gross margins was partially
offset by increased operating expenses as further discussed below.
Operating revenues increased $952 million in the first quarter of 2002
compared to the same period in 2001, due to revenues of $730 million from retail
electric sales in the Texas retail market which opened to full competition in
January 2002. Trading activities related to the selling of energy in Texas
contributed to $235 million of the increase in revenues. Cost of sales increased
$843 million due to costs of $609 million associated with the retail electric
sales and $234 million associated with trading activities. Our Wholesale Energy
business segment purchases and manages our Retail Energy business segment's
wholesale energy supply requirements to fulfill its retail energy commitments.
Our Wholesale Energy business segment charges our Retail Energy business segment
for its energy supply requirements at its actual cost and charges an
administrative fee for such services. During the first quarter of 2002, our
Wholesale Energy business segment charged an administrative fee of $2 million
for such services.
Our Retail Energy business segment's gross margins increased $109 million
in the first quarter of 2002 compared to the same period in 2001 primarily due
to increased margins of $127 million from retail electric sales. Contracted
energy sales to large commercial, industrial and institutional customers are
accounted for under the mark-to-market method of accounting. These energy
contracts are recorded at fair value in revenues upon contract execution. The
net changes in their market values are recognized in the income statement in
revenues in the period of the change. Mark-to-market gains related to these
contracts were $5.5 million in the first quarter of 2002 compared to $3.6
million in the same period in 2001. For information regarding the accounting for
contracted energy sales to large commercial, industrial and institutional
customers, please read Notes 2(d) and 5 to the Reliant Energy 10-K Notes, which
notes are incorporated herein by reference.
In addition, in the first quarter of 2001, $13 million of revenues was
recorded for the services provided to the Electric Operations and Natural Gas
Distribution business segments, for which the associated costs are included in
operation and maintenance expenses. The service agreement governing these
services terminated on December 31, 2001.
Operation and maintenance expenses increased $55 million in the first
quarter of 2002 compared to the same period in 2001, primarily due to (a)
increased gross receipts taxes of $14 million, (b) personnel and employee
related costs and other administrative costs of $26 million due to the Texas
retail market opening to full competition in January 2002, (c) increased bad
debt reserves of $10 million associated with increased retail electric sales and
(d) increased marketing costs of $5 million due to the Texas retail market
opening to full competition.
Depreciation and amortization expense increased $3 million in the first
quarter of 2002 compared to the same period in 2001 primarily due to
depreciation of information systems developed and placed in service to meet the
needs of our retail businesses. In addition, for the three months ended March
31, 2001, our Retail Energy business
47
segment recorded $1 million in amortization expense related to goodwill. For
information regarding the discontinuance of goodwill amortization in accordance
with SFAS No. 142, please read Note 6 to our Interim Financial Statements.
We are dependent on the local transmission and distribution utilities for
the reading of our customers' energy meters. We are required to rely on the
local utility or, in some cases, the independent transmission system operator,
to provide us with our customers' information regarding energy usage, and we may
be limited in our ability to confirm the accuracy of the information. The
provision of inaccurate information or delayed provision of such information by
the local utilities or system operators could have a material negative impact on
our business and results of operations and cash flows.
The Electric Reliability Council of Texas (ERCOT) independent system
operator (ERCOT ISO) is the independent system operator responsible for
maintaining reliable operations of the bulk electric power supply system in the
ERCOT market. Its responsibilities include ensuring that information relating to
a customer's choice of retail electric provider is conveyed in a timely manner
to anyone needing the information. Problems in the flow of information between
the ERCOT ISO, the transmission and distribution utilities and the retail
electric providers have resulted in delays in switching and billing customers.
While the flow of information is improving, operational problems in the new
systems and processes are still being worked out.
The ERCOT ISO is also responsible for handling scheduling and settlement
for all electricity supply volumes in the Texas deregulated electricity market.
In addition, the ERCOT ISO plays a vital role in the collection and
dissemination of metering data from the transmission and distribution utilities
to the retail electric providers. We and other retail electric providers
schedule volumes based on forecasts. As part of settlement, the ERCOT ISO
communicates the actual volumes delivered compared to the forecast volumes
scheduled. The ERCOT ISO calculates an additional charge or credit based on the
difference between the actual and forecast volumes, based on a market clearing
price for the difference. Settlement charges also include allocated costs such
as unaccounted-for energy. Preliminary settlement information is due from ERCOT
within two months after electricity is delivered. Final settlement information
is due from ERCOT six months after electricity is delivered. As a result, we
must record our supply costs using scheduled supply volumes and adjust those
costs upon receipt of settlement information.
The Texas Utility Commission regulations allow Reliant Resources to adjust
the fuel factor in their price to beat to their Houston residential and small
commercial customers based on the percentage change in the price of natural gas.
In addition, Reliant Resources may also request an adjustment as a result of
changes in the price of purchased energy. On May 2, 2002, Reliant Resources
filed a request with the Texas Utility Commission to increase the fuel factor in
their price to beat. Reliant Resources' price to beat was initially set by the
Texas Utility Commission in November 2001 at the then average forward 12 month
gas prices strip of approximately $3.11/mmbtu. Since the initial setting, the
market price of natural gas has increased 20% to $3.73/mmbtu during April 2002.
The earliest the new price could go into effect would be June 17, 2002.
OTHER OPERATIONS
Our Other Operations business segment includes the operations of Reliant
Energy Thermal Systems, Inc., Reliant Energy Power Systems, Inc., new ventures
businesses, various real estate used in business operations, remaining
operations in Latin America and unallocated corporate costs. After Restructuring
and Distribution, our Other Operations business segment will consist primarily
of Reliant Energy Thermal Systems, Inc., Reliant Energy Power Systems, Inc.,
office buildings and other real estate used in our business operations and
unallocated corporate costs.
48
The following table shows EBIT of Other Operations for the three months
ended March 31, 2001 and 2002:
OTHER OPERATIONS
------------------------------
THREE MONTHS ENDED MARCH 31,
------------------------------
2001 2002
------------ ------------
(IN MILLIONS)
Operating Revenues .................. $ 30 $ 2
Operating Expenses .................. 163 3
------------ ------------
Operating Loss ...................... (133) (1)
Other Income (Expense), net ......... 2 (12)
------------ ------------
Loss Before Interest and Income Taxes $ (131) $ (13)
============ ============
Other Operation's loss before interest and income taxes decreased by $118
million for the three months ended March 31, 2002 compared to the same period in
2001. The decline in loss before interest and income taxes is primarily due to a
$101 million pre-tax, non-cash charge related to the redesign of certain of our
benefit plans in anticipation of our separation from Reliant Resources incurred
in 2001, partially offset by an increased non-cash unrealized loss of $16
million on our AOL Time Warner investment and related indexed debt securities.
TRADING AND MARKETING OPERATIONS
We trade and market power, natural gas and other energy-related commodities
and provide related risk management services to our customers. We apply
mark-to-market accounting for all of our energy trading, marketing, power
origination and risk management services activities. For information regarding
mark-to-market accounting, please read Notes 2(d) and 5(a) to the Reliant Energy
10-K, which notes are incorporated herein by reference. These trading activities
consist of:
- the domestic energy trading, marketing, power origination and risk
management services operations of our Wholesale Energy business
segment;
- the European energy trading and power origination operations of our
European Energy business segment; and
- the large commercial, industrial and institutional customers under
retail electricity contracts of our Retail Energy business segment.
Our domestic and European energy trading and marketing operations enter
into derivative transactions with goals of optimizing our current power
generation asset position and taking a market position.
Our realized and unrealized trading, marketing and risk management services
margins are as follows:
THREE MONTHS ENDED MARCH 31,
-----------------------------
2001 2002
------------ ------------
(IN MILLIONS)
Realized ................................... $ 102 $ 76
Unrealized ................................. 16 (20)
------------ ------------
Total ...................................... $ 118 $ 56
============ ============
Below is an analysis of our net trading and marketing assets and
liabilities for 2002 (in millions):
Fair value of contracts outstanding at December 31, 2001....................................... $ 218
Fair value of new contracts when entered into during the period................................ 20
Contracts realized or settled during the period................................................ (76)
Changes in fair values attributable to changes in valuation techniques and assumptions......... --
Changes in fair value attributable to market price and other market changes.................... 41
---------
Fair value of contracts outstanding at March 31, 2002........................................ $ 203
=========
During the three months ended March 31, 2002, our Retail Energy business
segment entered into contracts with large commercial, industrial and
institutional customers ranging from one-half to four years in duration. We
recorded a $20 million dealer profit upon the origination of these contracts.
49
The dealer profit was determined by comparing the contractual pricing to the
market price for the retail energy delivery and applying the estimated volumes
under the provisions of these contracts. This calculation involves estimating
the customer's anticipated load volume, and using the forward ERCOT
over-the-counter (OTC) commodity prices, adjusted for the customer's anticipated
load pattern. Load characteristics in the valuation model include: the
customer's expected hourly electricity usage profile, the potential variability
in the electricity usage profile (due to weather or operational uncertainties),
and the electricity usage limits included in the customer's contract. In
addition, estimates include anticipated delivery costs, such as regulatory and
transmission charges, electric line losses, ERCOT system operator administrative
fees and other market interaction charges, estimated credit risk and
administrative costs to serve. The weighted-average duration of these
transactions is approximately twenty months.
Below are the maturities of our contracts related to our trading and
marketing assets and liabilities as of March 31, 2002 (in millions):
FAIR VALUE OF CONTRACTS AT MARCH 31, 2002
-------------------------------------------------------------------------
2007 AND TOTAL FAIR
SOURCE OF FAIR VALUE 2002 2003 2004 2005 2006 THEREAFTER VALUE
- -------------------------- ------ ------ ------ ------ ------ ---------- ----------
Prices actively quoted ... $ (18) $ 5 $ (10) $ -- $ -- $ -- $ (23)
Prices provided by other
external sources ....... 158 80 12 5 8 -- 263
Prices based on models and
other valuation methods (14) (35) 1 (6) (2) 19 (37)
------ ------ ------ ------ ------ ------ ------
Total .................... $ 126 $ 50 $ 3 $ (1) $ 6 $ 19 $ 203
====== ====== ====== ====== ====== ====== ======
The "prices actively quoted" category represents our New York Mercantile
Exchange (NYMEX) futures positions in natural gas and crude oil. At March 31,
2002, NYMEX had quoted prices for natural gas and crude oil for the next 60 and
36 months, respectively.
The "prices provided by other external sources" category represents our
forward positions in natural gas and power at points for which OTC broker quotes
are available. On average, OTC quotes for natural gas and power extend 60 and 36
months into the future, respectively. We value these positions against
internally developed forward market price curves that are constantly validated
and recalibrated against OTC broker quotes. This category also includes some
transactions whose prices are obtained from external sources and then modeled to
hourly, daily or monthly prices, as appropriate.
The "prices based on models and other valuation methods" category contains
(a) the value of our valuation adjustments for liquidity, credit and
administrative costs, (b) the value of options not quoted by an exchange or OTC
broker, (c) the value of transactions for which an internally developed price
curve was constructed as a result of the long-dated nature of the transaction or
the illiquidity of the market point, and (d) the value of structured
transactions. In certain instances, structured transactions can be composed and
modeled by us as simple forwards and options based on prices actively quoted.
Options are typically valued using Black-Scholes option valuation models.
Although the valuation of the simple structures might not be different from the
valuation of contracts in other categories, the effective model price for any
given period is a combination of prices from two or more different instruments
and therefore has been included in this category due to the complex nature of
these transactions.
The fair values in the above table are subject to significant changes based
on fluctuating market prices and conditions. Changes in the assets and
liabilities from trading, marketing, power origination and price risk management
services result primarily from changes in the valuation of the portfolio of
contracts, newly originated transactions and the timing of settlements. The most
significant parameters impacting the value of our portfolio of contracts include
natural gas and power forward market prices, volatility and credit risk. For the
Retail Energy business segment sales discussed above, significant variables
affecting contract values also include the variability in electricity
consumption patterns due to weather and operational uncertainties (within
contract parameters). Market prices assume a normal functioning market with an
adequate number of buyers and sellers providing market liquidity. Insufficient
market liquidity could significantly affect the values that could be obtained
for these contracts, as well as the costs at which these contracts could be
hedged. Please read "Quantitative and Qualitative Disclosures About Market Risk"
in Item 7A of the Reliant Energy Form 10-K for further discussion and
measurement of the market exposure in the trading and marketing businesses and
discussion of credit risk management.
50
For additional information, please read "Management's Discussion and
Analysis of Financial Condition and Results of Operations -- Certain Factors
Affecting Our Future Earnings -- Factors Affecting the Results of Our Wholesale
Energy Operations - Price Volatility," and " - Risks Associated with Our Hedging
and Risk Management Activities" in Item 7 of the Reliant Energy Form 10-K.
For a description of accounting policies for our trading and marketing
activities, please read Notes 2(d) and 5 to the Reliant Energy 10-K Notes, which
notes are incorporated herein by reference.
We seek to monitor and control our trading risk exposures through a variety
of processes and committees. For additional information, please read
"Quantitative and Qualitative Disclosures About Market Risk - Risk Management
Structure" in Item 7A of the Reliant Energy Form 10-K.
CERTAIN FACTORS AFFECTING OUR FUTURE EARNINGS
For information on other developments, factors and trends that may have an
impact on our future earnings, including information relating to an anticipated
decline in earnings of our electric business segments due to deregulation of the
Texas electric industry, 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 (a) the California wholesale
market and related litigation, please read Notes 13(a) and 13(d) to our Interim
Financial Statements, and (b) the Dutch stranded costs, please read Note 13(e)
to our Interim Financial Statements.
FINANCIAL CONDITION
The following table summarizes the net cash provided by (used in)
operating, investing and financing activities for the three months ended March
31, 2001 and 2002:
THREE MONTHS ENDED MARCH 31,
------------------------------
2001 2002
------------ ------------
(in millions)
Cash provided by (used in):
Operating activities ........... $ 120 $ 236
Investing activities ........... (497) (3,324)
Financing activities ........... 278 3,231
Net cash provided by operating activities during the three months ended
March 31, 2002 increased $116 million compared to the same period in 2001
primarily due to (a) an increase in recovered fuel costs by our Electric
Transmission and Distribution business segment; (b) a reduction in lease
prepayments related to the Reliant Energy Mid-Atlantic Power Holdings, LLC
(REMA) sale-leaseback agreements; (c) a decrease in restricted cash related to
Reliant Resources' REMA operations and Reliant Resources' Orion Power operations
partially offset by restricted escrow funds related to the settlement of an
indemnity agreement for certain energy obligations (please read Note 13(e) to
our Interim Financial Statements); (d) the return of collateral deposits related
to an equipment financing structure; and (e) cash flows provided by our Retail
Energy business segment for retail sales in the first quarter of 2002 due to the
Texas retail market opening to full competition in January 2002. These items
were partially offset by decreased cash flows provided by our Wholesale Energy
and Natural Gas Distribution business segments in the first quarter of 2002
compared to the same period in 2001 as a result of decreased operating income.
Net cash used in investing activities increased $2.8 billion during the
three months ended March 31, 2002 compared to the same period in 2001 primarily
due to funding of the acquisition of Orion Power for $2.9 billion on February
19, 2002, partially offset by a decrease in capital expenditures related to the
construction of domestic power generation projects during the three months ended
March 31, 2002.
Cash flows provided by financing activities increased $3.0 billion during
the three months ended March 31, 2002 compared to the same period in 2001
primarily due to an increase in short-term borrowings used to fund the
acquisition of Orion Power and repurchase of customer accounts receivable,
partially offset by a decrease in proceeds from long-term debt.
51
FUTURE SOURCES AND USES OF CASH FLOWS
The following discussion regarding future sources and uses of cash over the
next twelve months is presented separately for our regulated businesses and
unregulated businesses consistent with the separate liquidity plans that our
management has developed for CenterPoint Energy and Reliant Resources. We
believe that our borrowing capability combined with cash flows from operations
will be sufficient to meet the operational needs of our businesses for the next
twelve months.
RELIANT ENERGY (TO BECOME CENTERPOINT ENERGY SUBSEQUENT TO THE RESTRUCTURING)
Credit Facilities. As of March 31, 2002, we had credit facilities,
including facilities of Houston Industries FinanceCo LP (FinanceCo) and RERC
Corp., that provided for an aggregate of $5.2 billion in committed credit. As of
March 31, 2002, $3.6 billion was outstanding under these facilities including
$2.1 billion of commercial paper supported by the facilities, borrowings of $1.5
billion and letters of credit of $2.5 million.
The following table summarizes amounts available under these credit
facilities at March 31, 2002 and commitments expiring in 2002 (in millions):
AMOUNT OF
TOTAL UNUSED COMMITMENTS
COMMITTED AMOUNT AT EXPIRING
BORROWER TYPE OF FACILITY CREDIT 3/31/02 IN 2002
--------- ---------------- --------- ---------- -----------
Reliant Energy Revolver $ 400 $ -- $ 400
FinanceCo..... Revolvers 4,300 1,256 4,300
RERC Corp..... Revolver 350 347 --
RERC Corp..... Receivables 150 -- 150
------- -------- -------
Total $ 5,200 $ 1,603 $ 4,850
======= ======== =======
The RERC Corp. receivables facility was reduced from $350 million to $150
million in January 2002. Proceeds for the repayment of $196 million of advances
under the facility were obtained from bank borrowings and the sale of commercial
paper.
The revolving credit facilities contain various business and financial
covenants requiring us to, among other things, maintain leverage (as defined in
the credit facilities) below specified ratios. We are in compliance with the
covenants under all of these credit agreements. For additional discussion,
please read Note 8 to our Interim Financial Statements.
The revolving credit facilities support commercial paper programs. The
maximum amount of outstanding commercial paper of an issuer is limited to the
amount of the issuer's aggregate revolving credit facilities less any direct
loans or letters of credit obtained under its revolvers. Due to an inability to
consistently satisfy all short-term borrowing needs by issuing commercial paper,
short-term borrowing needs have been met with a combination of commercial paper
and bank loans. The extent to which commercial paper will be issued in lieu of
bank loans will depend on market conditions and our credit ratings.
Pursuant to the terms of the existing agreements (but subject to certain
conditions precedent which we anticipate will be met) the revolving credit
agreements aggregating $4.3 billion of FinanceCo will terminate and CenterPoint
Energy revolving credit facilities of the same amount and with the same
termination dates will become effective on the date of Restructuring.
We are currently in negotiations with banks to replace an aggregate of $4.7
billion of existing credit facilities of Reliant Energy and FinanceCo which
expire on July 12, 2002. The anticipated maturity dates of these new facilities
range from four months to 364 days. The terms of any new credit facilities are
expected to be adversely affected by the leverage of Reliant Energy, the amount
of bank capacity utilized by Reliant Energy, any delay in the date of
Restructuring and Distribution and conditions in the bank market. These same
factors are expected to make the syndication of new credit facilities more
difficult. Proceeds from any issuance of debt in the capital markets are
expected to be used to retire a portion of our short-term debt and reduce our
need for committed revolving credit facilities.
Credit Ratings. On May 20, 2002, Moody's Investors Service announced it is
revising its outlook for Reliant Energy (Baa1 Senior Unsecured), Reliant Energy
Finance Co. II LP (Baa1 Senior Unsecured), RERC Corp. (Baa2 Senior Unsecured)
and CenterPoint Energy (indicative rating Baa2 Senior Unsecured) to negative
from stable in response to ratings pressure originating in Reliant Energy's 83%
ownership interest of Reliant Resources.
52
Shelf Registrations. The following table lists shelf registration
statements existing at March 31, 2002 for securities expected to be sold in
public offerings (in millions).
TERMINATING ON
DATE OF
REGISTRANT SECURITY AMOUNT(1) RESTRUCTURING
---------- -------- --------- --------------
Reliant Energy....... Preferred Stock $230 Yes
Reliant Energy....... Debt Securities 480 Yes
Reliant Energy....... Common Stock 387 No
REI Trust II/........ Trust Preferred and related Junior
Reliant Energy.... Subordinated Debentures 125 Yes
RERC Corp............ Debt Securities 50 No
- ----------
(1) The amount reflects the principal amount of debt securities, the aggregate
liquidation value of trust preferred securities and the estimated market
value of common stock based on the number of shares registered as of March
31, 2002 and the closing market price of Reliant Energy common stock on
that date.
We expect to register $2.5 billion of debt securities, some or all of which
may be issued either by Reliant Energy prior to the Restructuring or by
CenterPoint Energy after the Restructuring. Debt securities aggregating
approximately $500 million may also be issued by the transmission and
distribution subsidiary of CenterPoint Energy following the Restructuring.
Proceeds from the sale of these debt securities are expected to be used to repay
short-term borrowings. The amount actually issued will depend on interest rates
and other market conditions.
Debt Service Requirements. Excluding the repayments expected to be made on
the transition bonds described in Note 4(a) to the Reliant Energy 10-K Notes,
which note is incorporated herein by reference, we have maturing long-term debt
in 2002 aggregating $500 million. Maturing debt is expected to be refinanced
with new debt. In addition, Reliant Energy has $175 million of 5.20% pollution
control bonds that are expected to be remarketed in 2002 as multi-year
fixed-rate debt.
Debt service requirements will be affected by the overall level of interest
rates in 2002 and credit spreads applicable to the various issuers of debt in
2002. Up to $3.2 billion of long-term debt is expected to be issued or
remarketed in 2002, and we expect to have large amounts of short-term
floating-rate debt in 2002. At March 31, 2002, we had entered into five-year
forward starting interest rate swaps having an aggregate notional amount of $1.5
billion to hedge the interest rate on an anticipated 2002 offering of five-year
notes. The weighted average rate on the swaps was 5.7%. At March 31, 2002, we
also had entered into interest rate swaps to fix the rate on $1.5 billion of our
floating rate debt. The weighted average rate on these swaps was 3.9% and the
swaps expire in 2002 through 2004. While we have, in some instances, hedged our
exposure to changes in interest rates by entering into interest rate swaps, the
swaps leave us exposed to changes in our credit spread relative to the market
indices reflected in the swaps.
Money Fund. We have a "money fund" through which Reliant Energy and
participating subsidiaries can borrow or invest on a short-term basis. Funding
needs are aggregated and external borrowing or investing is based on the net
cash position. The money fund's net funding requirements are generally met with
commercial paper and/or bank loans. At March 31, 2002, Reliant Resources had
$432 million invested in the money fund. Reliant Resources is expected to
withdraw its investment from the money fund on or before the Distribution. Funds
for repayment of the notes payable to Reliant Resources will be obtained from
bank loans or the issuance of commercial paper.
Environmental Issues. We anticipate investing up to $397 million in capital
and other special project expenditures between 2002 and 2006 for environmental
compliance. Of this amount, we anticipate expenditures to be approximately $234
million and $132 million in 2002 and 2003, respectively. For additional
information related to environmental issues, please read Note 13(b) to our
Interim Financial Statements.
Initial Public Offering of Texas Genco. In 2002, approximately 20% of Texas
Genco is expected to be sold in an initial public offering or distributed to
holders of CenterPoint Energy common stock. The decision whether to distribute
the Texas Genco shares or to sell the shares in an initial public offering will
depend on numerous factors, including market conditions. Proceeds, if any, are
expected to be used to retire short-term debt.
53
Fuel Filing. As of March 31, 2002, Reliant Energy HL&P was under-collected
on fuel recovery by $62 million. Reliant Energy plans to file its final fuel
reconciliation with the Texas Utility Commission in July 2002. The filing will
cover the period August 1997 through the end of regulation. Under the Texas
electric restructuring law, the final fuel balance will be included in the 2004
true-up proceeding.
Reliant Energy HL&P Rate Matters. An order issued by the Texas Utility
Commission on October 3, 2001 (October 3, 2001 Order) established the
transmission and distribution rates that became effective in January 2002. The
Texas Utility Commission determined that Reliant Energy HL&P had overmitigated
its stranded costs by redirecting transmission and distribution depreciation and
by accelerating depreciation of generation assets as provided under the 1998
transition to competition plan (Transition Plan) and Texas electric
restructuring law. In this final order, Reliant Energy HL&P was required to
reverse the amount of redirected depreciation and accelerated depreciation taken
for regulatory purposes as allowed under the Transition Plan and the Texas
electric restructuring law. Per the October 3, 2001 Order, our Electric
Transmission and Distribution business segment recorded a regulatory liability
to reflect the prospective refund of the accelerated depreciation. Our Electric
Transmission and Distribution business segment began refunding excess mitigation
credits with the January 2002 unbundled bills, to be refunded over a seven year
period. The annual cash flow impact of the reversal of both redirected and
accelerated depreciation is a decrease of approximately $225 million. Under the
Texas electric restructuring law, a final settlement of these stranded costs
will occur in 2004. For further discussion, please read Note 4(a) to the Reliant
Energy 10-K Notes, which note is incorporated herein by reference.
Treasury Stock Purchases. As of March 31, 2002, we were authorized under
our common stock repurchase program to purchase an additional $271 million of
our common stock. Our purchases under our repurchase program depend on market
conditions, might not be announced in advance and may be made in open market or
privately negotiated transactions. CenterPoint Energy has no current plans to
engage in a significant stock buy-back program, but may seek to repurchase
shares in the open market for use in various benefit and employee compensation
plans, or to maintain a targeted balance of outstanding shares to the extent
that original issue stock is used for such purposes.
Pension and Postretirement Benefits Funding. We make contributions to
achieve adequate funding of company sponsored pension and postretirement
benefits in accordance with applicable regulations and rate orders. Based on
current estimates, we expect to have funding requirements, excluding Reliant
Resources, of approximately $330 million for the period 2002-2006.
RELIANT RESOURCES - UNREGULATED BUSINESSES
Credit Facilities. As of March 31, 2002, Reliant Resources had $8.2 billion
in committed credit facilities, including facilities of subsidiaries of Reliant
Energy Power Generation, Inc. (REPG), Orion Power and REPGB, of which $1.9
billion remained unused. Credit facilities aggregating $5.4 billion were
unsecured. As of March 31, 2002, letters of credit outstanding under these
facilities aggregated $571 million. As of March 31, 2002, borrowings of $5.8
billion were outstanding under these facilities of which $591 million were
classified as long-term debt, based upon the availability of committed credit
facilities and management's intention to maintain these borrowings in excess of
one year.
Of the committed credit facilities described above, $6.3 billion will
expire by March 31, 2003. To the extent that Reliant Resources still needs these
facilities, Reliant Resources expects to be able to renew or replace them on
normal commercial terms prior to their expiration.
As a result of the Orion Power acquisition, Reliant Resources' consolidated
debt obligations increased by the amount of Orion Power's debt obligations of
$2.4 billion ($2.1 billion net of restricted cash pursuant to debt covenants) as
of February 19, 2002. For additional information regarding these debt
obligations, please read Note 5 to our Interim Financial Statements.
Liquidity Concerns. As of March 31, 2002, Reliant Resources has $2.8
billion of committed credit facilities which will expire in 2002. To the extent
that Reliant Resources continues to need access to this amount of committed
credit, Reliant Resources expects to extend or replace these facilities. The
credit environment currently impacting Reliant Resources' industry may require
Reliant Resources' future facilities to include terms that are more restrictive
or burdensome or at higher borrowing rates than those of their current
facilities. In addition, the terms of
54
any new credit facilities may be adversely affected by any delay in the date of
the Distribution. For a discussion of other factors affecting Reliant Resources'
sources of cash and liquidity, please read "Management's Discussion and Analysis
of Financial Condition and Results of Operations -- Liquidity and Capital
Resources" in the Reliant Energy Form 10-K, which is incorporated herein by
reference, and Note 5 to our Interim Financial Statements.
Orion Power and its Subsidiaries Credit Facilities. The Orion Credit
Agreements contain various business and financial covenants requiring Orion NY
or Orion MidWest to, among other things, maintain a debt service coverage ratio
of at least 1.5 to 1.0. For the three months ended March 31, 2002, Orion MidWest
did not meet its debt service coverage ratio, and alternatively made a $25
million prepayment on March 22, 2002, as permitted by the MidWest Credit
Agreement in order to maintain compliance. Orion MidWest may not be able to meet
this debt service coverage ratio for the quarter ending June 30, 2002. It is
Reliant Resources' current intention to arrange for the repayment, refinancing
or amendment of these facilities prior to June 30, 2002. If the MidWest Credit
Agreement facility is not repaid, refinanced or amended prior to that date, and
if a waiver is required under this credit facility, Reliant Resources believes
that they will be able to obtain such a waiver. However, Reliant Resources
currently has no assurance that they will be able to obtain such a waiver or
amendment from the lender group if required under the MidWest Credit Agreement.
The senior credit facility of Orion Power contains various business and
financial covenants that require Orion Power to, among other things, maintain a
debt service coverage ratio of at least 1.4 to 1.0. Orion Power did not meet the
debt service coverage ratio for the quarter ended March 31, 2002. In the event
that Orion Power is unable to meet this financial covenant for a second
consecutive fiscal quarter it would constitute a default under its credit
facility. It is Reliant Resources' current intention to arrange for the
repayment, refinancing or amendment of this facility prior to June 30, 2002. If
this facility is not repaid, refinanced or amended prior to that date, and if a
waiver is required under this credit facility, Reliant Resources believes that
they will be able to obtain such a waiver. However, Reliant Resources currently
has no assurance that they will be able to obtain such a waiver or amendment
from the lender groups if required under this credit facility.
For additional information regarding Orion Power and its subsidiaries' debt
obligations, please read Note 5 to our Interim Financial Statements.
California Trade Receivables. As of March 31, 2002, Reliant Resources was
owed a total of $267 million by the California Independent System Operator, the
California Power Exchange, the California Department of Water Resources and
California Energy Resources Scheduling for energy sales in the California
wholesale market during the fourth quarter of 2000 through March 31, 2002. From
March 31, 2002 through May 10, 2002, Reliant Resources has collected $3 million
of these receivable balances. As of March 31, 2002, Reliant Resources had a
pre-tax provision of $35 million against these receivable balances. For
additional information regarding uncertainties in the California wholesale
market, please read Notes 13(a) and 13(d) to our Interim Financial Statements
and Notes 14(f) and 14(g) to the Reliant Energy 10-K Notes, which notes are
incorporated herein by reference.
Acquisition of Orion Power Holdings, Inc. On February 19, 2002, Reliant
Resources acquired all of the outstanding shares of common stock of Orion Power
for $26.80 per share in cash for an aggregate purchase price of $2.9 billion. As
of February 19, 2002, Orion Power's debt obligations were $2.4 billion ($2.1
billion net of restricted cash pursuant to debt covenants). Reliant Resources
funded the purchase of Orion Power with a $2.9 billion credit facility and $41
million of cash on hand.
Generating Projects. As of March 31, 2002, Reliant Resources had five
generating facilities under construction. Total estimated costs of constructing
these facilities are $1.5 billion. As of March 31, 2002, Reliant Resources had
incurred $1.1 billion of the total projected costs of these projects, which were
funded primarily from equity and debt facilities. Of this $1.1 billion, $315
million had been incurred by Orion Power related to two of these projects as of
February 19, 2002. In addition, Reliant Resources has commitments to purchase
additional power generation equipment, consisting of steam and combustion
turbines and heat recovery steam generators, for a total estimated cost of $697
million, with a remaining commitment of $533 million. Reliant Resources is
actively attempting to market this equipment, having determined that it is in
excess of its current needs. In addition to these facilities, Reliant Resources
is constructing facilities as construction agents under construction agency
agreements, which permit it to lease or buy each of these facilities at the
conclusion of their construction.
55
Construction Agency Agreement and Equipment Financing Structure. In 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. These
special purpose entities are not consolidated by Reliant Resources. For
information regarding these transactions, please read Note 13(f) to our Interim
Financial Statements. In addition, Reliant Resources, through its subsidiary,
REPG, has entered into an agreement with a bank whereby the bank, as owner,
entered or will enter into contracts for the purchase and construction of power
generation equipment and REPG, or its subagent, acts as the bank's agent in
connection with administering the contracts for such equipment.
Payment to Reliant Energy. To the extent that Reliant Resources' price for
providing retail electric service to residential and small commercial customers
in Reliant Energy's Houston service territory during 2002 and 2003, which price
is mandated by the Texas electric restructuring law, exceeds the market price of
electricity, Reliant Resources may be required to make a payment to Reliant
Energy in early 2004 unless the Texas Utility Commission determines that, on or
prior to January 1, 2004, 40% or more of the amount of electric power that was
consumed in 2000 by residential or small commercial customers, as applicable,
within Reliant Energy's electric utility's Houston service territory as of
January 1, 2002 is committed to be served by retail electric providers other
than Reliant Resources.
Treasury Stock Purchases. On December 6, 2001, Reliant Resources' Board of
Directors authorized the purchase of up to 10 million additional shares of their
common stock through June 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.
Since the date of this authorization through May 10, 2002, Reliant Resources has
not purchased any shares of their common stock under this program.
Credit Ratings. Credit ratings impact Reliant Resources' ability to obtain
short-term and long-term financing, the cost of such financing and the execution
of their commercial strategies. As of May 17, 2002, Reliant Resources' credit
ratings for their senior unsecured debt were as follows:
DATE ASSIGNED RATING AGENCY RATING
------------- ------------- ------
March 22, 2002 Moody's (1) Baa3, review for potential downgrade
February 14, 2002 Fitch (2) BBB, Rating Watch Negative
March 21, 2002 Standard & Poor's (3) BBB, Credit Watch with negative implications
- ----------
(1) On May 13, 2002, Moody's placed Reliant Resources on review for potential
downgrade. Moody's action was in response to Reliant Resources' decision to
cancel a private placement of $500 million of debt securities on May 10,
2002, in order to review the financial or other implications of certain
trading transactions (see discussion in Note 1 to our Interim Financial
Statements).
(2) On May 17, 2002, Fitch placed Reliant Resources' ratings on Rating Watch
Negative. Fitch's rating action primarily related to the continuing adverse
impact on Reliant Resources' financial flexibility resulting from the
negative market reaction to Reliant Resources' recent disclosure of certain
trading transactions (see discussion in Note 1 to our Interim Financial
Statements).
(3) On May 13, 2002, Standard & Poor's placed Reliant Resources' ratings on
Credit Watch with negative implications, reflecting the concern that a lack
of market confidence or the risk that another rating agency would lower
Reliant Resources' ratings to non-investment grade could create liquidity
issues as counterparties demand increased collateral to maintain trading
relationships.
Reliant Resources cannot assure you that these ratings will remain in
effect for any given period of time or that one or more of these ratings will
not be lowered or withdrawn entirely by a rating agency. Reliant Resources notes
that these credit ratings are not recommendations to buy, sell or hold their
securities and may be revised or withdrawn at any time by such rating agency.
Each rating should be evaluated independently of any other rating. Any future
reduction or withdrawal of one or more of Reliant Resources' credit ratings
could have a material adverse impact on Reliant Resources' ability to access
capital on acceptable terms.
Reliant Resources has commercial contracts and/or guarantees related to
their trading, marketing and risk management and hedging operations that require
Reliant Resources to maintain an investment grade credit rating. If Reliant
Resources' credit rating declines below investment grade, Reliant Resources
estimates that they could be
56
obligated to provide significant credit support to the counterparties in the
form of a pledge of cash collateral, a letter of credit or other similar credit
support.
Furthermore, if Reliant Resources' credit ratings decline below an
investment grade credit rating, Reliant Resources' trading partners may refuse
to trade with them or trade only on terms less favorable to them. As of March
31, 2002, Reliant Resources had $66 million of margin deposits on energy trading
and hedging activities posted as collateral with counterparties. As of March 31,
2002, Reliant Resources had $1.6 billion available under their credit facilities
to satisfy future commodity obligations.
In addition, certain of Reliant Resources' retail electricity contracts
with large commercial, industrial and institutional customers of their Retail
Energy business segment provide the customers the ability to terminate their
contracts early upon the occurrence of Reliant Resources' credit ratings for
their unsecured debt ratings falling below investment grade or if their
investment grade rating is withdrawn entirely by a rating agency.
Termination of Debt Offering. On May 10, 2002, Reliant Resources canceled
their $500 million, ten-year debt private placement when they became aware
subsequent to the pricing of the debt offering, that Reliant Resources had
likely engaged in round trip trades. See Note 1 to our Interim Financial
Statements for more information regarding round trip trades.
Other Sources/Uses of Cash. Reliant Resources' liquidity and capital
requirements are affected primarily by the results of operations, capital
expenditures, debt service requirements and working capital needs. Reliant
Resources expects to grow through the construction of new generation facilities
and the acquisition of generation facilities, the expansion of its energy
trading and marketing activities and the expansion of its energy retail
business. Reliant Resources expects any resulting capital requirements to be met
with cash flows from operations, and proceeds from debt and equity offerings,
project financings, securitization of assets, other borrowings and off-balance
sheet financings. Additional capital expenditures, some of which may be
substantial, depend to a large extent upon the nature and extent of future
project commitments which are discretionary. Reliant Resources believes that its
current level of cash and borrowing capability, along with its future
anticipated cash flows from operations and assuming successful refinancings of
credit facilities as they mature, will be sufficient to meet the existing
operational needs of its business for the next 12 months. If cash generated from
operations is insufficient to satisfy its liquidity requirements, Reliant
Resources may seek to sell either equity or debt securities or obtain additional
credit facilities or long-term financings from financial institutions.
OFF-BALANCE SHEET TRANSACTIONS
Construction Agency Agreements. In 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 are not
consolidated by the Company. The special purpose entities have an aggregate
financing commitment from equity and debt participants (Investors) of $2.5
billion of which the last $1.1 billion is currently available only if cash
collaterized. The availability of the commitment is subject to satisfaction of
various conditions, including the obligation to provide cash collateral for the
loans and letters of credit outstanding on November 29, 2004. 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 December 31, 2004, but Reliant Resources has generally limited its
risk during construction to an amount not in excess of 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, they must purchase the project or remarket the
project on behalf of the special purpose entities. Reliant Resources' ability to
exercise the lease option is subject to certain conditions. Reliant Resources
must guarantee that the Investors will receive an amount at least equal to 89.9%
of their investment in the equipment 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 an amount not to exceed 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
57
lease option is exercised, each lessee's obligations during the lease period. At
any time during the construction period or during the lease, Reliant Resources
may purchase a facility by paying an amount approximately equal to the
outstanding balance plus costs. As of March 31, 2002, the special purpose
entities had property, plant and equipment of $798 million, net other
liabilities of $1 million and debt obligations of $766 million. As of March 31,
2002, the special purpose entities had equity from unaffiliated third parties of
$31 million.
Equipment Financing Structure. Reliant Resources, through its subsidiary,
REPG, has entered into an agreement with a bank whereby the bank, as owner,
entered or will enter into contracts for the purchase and construction of power
generation equipment and REPG, or its subagent, acts as the bank's agent in
connection with administering the contracts for such equipment. Under the
agreement, the bank has agreed to provide up to a maximum aggregate amount of
$650 million. REPG and its subagents must cash collateralize their obligation to
administer the contracts. This cash collateral is approximately equivalent to
the total payments by the bank for the equipment, interest and other fees. As of
March 31, 2002, the bank had assumed contracts for the purchase of three
turbines, two heat recovery steam generators and one air cooled condenser with
an aggregate cost of $140 million. REPG, or its designee, has the option at any
time to purchase, or, at equipment completion, subject to certain conditions,
including the agreement of the bank to extend financing, to lease the equipment,
or to assist in the remarketing of the equipment under terms specified in the
agreement. All costs, including the purchase commitment on the turbines, are the
responsibility of the bank. The cash collateral is deposited by REPG or an
affiliate into a collateral account with the bank and earns interest at the
London inter-bank offered rate (LIBOR) less 0.15%. Under certain circumstances,
the collateral deposit or a portion of it, will be returned to REPG or its
designee. Otherwise, it will be retained by the bank. At December 31, 2001 and
March 31, 2002, REPG and its subsidiary had deposited $230 million and $100
million, respectively, into the collateral account. In January 2002, the bank
sold to the parties to the construction agency agreements discussed above,
equipment contracts with a total contractual obligation of $258 million, under
which payments and interest during construction totaled $142 million.
Accordingly, $142 million of Reliant Resources' collateral deposits were
returned to Reliant Resources. As of March 31, 2002, there were equipment
contracts with a total contractual obligation of $140 million under which
payments during construction totaled $99.5 million. Currently this equipment is
not designated for current planned power generation construction projects.
Therefore, Reliant Resources anticipates that it will either purchase the
equipment, assist in the remarketing of the equipment or negotiate to cancel the
related contracts.
CRITICAL ACCOUNTING POLICIES
A critical accounting policy is one that is both important to the portrayal
of our financial condition and results of operations and requires management to
make difficult, subjective or complex judgments. The circumstances that make
these judgments difficult, subjective and/or complex have to do with the need to
make estimates about the effect of matters that are inherently uncertain.
Estimates and assumptions about future events and their effects cannot be
perceived with certainty. We base our estimates on historical experience and on
various other assumptions that are believed to be reasonable under the
circumstances, the results of which form the basis for making judgments. These
estimates may change as new events occur, as more experience is acquired, as
additional information is obtained and as our operating environment changes.
We believe the following are the most significant estimates used in the
preparation of our consolidated financial statements.
ACCOUNTING FOR RATE REGULATION
SFAS No. 71, "Accounting for the Effects of Certain Types of Regulation"
(SFAS No. 71), provides that rate-regulated entities account for and report
assets and liabilities consistent with the recovery of those costs in rates if
the rates established are designed to recover the costs of providing the
regulated service and if the competitive environment makes it probable that such
rates can be charged and collected. Our rate-regulated businesses follow the
accounting and reporting requirements of SFAS No. 71. Certain expenses and
revenues subject to utility regulation or rate determination normally reflected
in income are deferred on the balance sheet and are recognized in income as the
related amounts are included in service rates and recovered from or refunded to
customers. The total amounts of regulatory assets and liabilities reflected in
the Consolidated Balance Sheets are $3.2 billion and $1.1 billion at March 31,
2002, and $3.3 billion and $1.4 billion at December 31, 2001, respectively.
58
Application of SFAS No. 71 to the generation portion of our business was
discontinued as of June 30, 1999. Only the electric transmission and
distribution business, the natural gas distribution companies and one of our
interstate pipelines are subject to SFAS No. 71 after January 1, 2002. We have
recorded regulatory assets and liabilities related to stranded costs associated
with our electric generation operations. Under the Texas electric restructuring
law, a final settlement of these stranded costs will occur in 2004. In the event
that regulation significantly changes the probability for us to recover our
costs in the future, a write-down of all or a portion of our existing regulatory
assets and liabilities could result.
IMPAIRMENT OF LONG-LIVED ASSETS
Long-lived assets, which include property, plant and equipment, goodwill
and other intangibles and equity investments comprise a significant amount of
our total assets. We make judgments and estimates in conjunction with the
carrying value of these assets, including amounts to be capitalized,
depreciation and amortization methods and useful lives. Additionally, the
carrying values of these assets are periodically reviewed for impairment or
whenever events or changes in circumstances indicate that the carrying amounts
may not be recoverable. An impairment loss is recorded in the period in which it
is determined that the carrying amount is not recoverable. This requires us to
make long-term forecasts of future revenues and costs related to the assets
subject to review. These forecasts require assumptions about demand for our
products and services, future market conditions and regulatory developments.
Significant and unanticipated changes to these assumptions could require a
provision for impairment in a future period.
UNBILLED ENERGY REVENUES
Revenues related to the sale of energy are generally recorded when service
is rendered or energy is delivered to customers. However, the determination of
the energy sales to individual customers is based on the reading of their meters
which are read on a systematic basis throughout the month. At the end of each
month, amounts of energy delivered to customers since the date of the last meter
reading are estimated and the corresponding unbilled revenue is estimated. This
unbilled electric revenue is estimated each month based on daily generation
volumes, line losses and applicable customer rates based on analyses reflecting
significant historical trends and experience. Unbilled natural gas sales are
estimated based on estimated purchased gas volumes, estimated lost and
unaccounted for gas and tariffed rates in effect. Accrued unbilled revenues
recorded in the Consolidated Balance Sheet as of March 31, 2002 were $72 million
related to our Electric Transmission and Distribution business segment, $342
million related to our Retail Energy business segment and $63 million related to
our Natural Gas Distribution business segment. Accrued unbilled revenues
recorded in the Consolidated Balance Sheet as of December 31, 2001 were $33
million related to our Electric Transmission and Distribution business segment,
$19 million related to our Retail Energy business segment and $188 million
related to our Natural Gas Distribution business segment.
ACCOUNTING FOR DERIVATIVES AND HEDGING INSTRUMENTS
SFAS No. 133 established accounting and reporting standards for derivative
instruments, including certain derivative instruments embedded in other
contracts, and for hedging activities. It requires an entity to recognize the
fair value of derivative instruments held as assets or liabilities on the
balance sheet. In accordance with SFAS No. 133, the effective portion of the
change in the fair value of a derivative instrument designated as a cash flow
hedge is reported in other comprehensive income, net of tax. Amounts in
accumulated other comprehensive income are ultimately recognized in earnings
when the related hedged forecasted transaction occurs. The change in the fair
value of the ineffective portion of the derivative instrument designated as a
cash flow hedge is recorded in earnings. Derivative instruments that have not
been designated as hedges are adjusted to fair value through earnings.
We utilize derivative instruments such as futures, physical forward
contracts, swaps and options to mitigate the impact of changes in electricity,
natural gas and fuel prices on our operating results and cash flows. We utilize
cross-currency swaps, forward contracts and options to hedge our net investments
in and cash flows of our foreign subsidiaries, interest rate swaps to mitigate
the impact of changes in interest rates and other financial instruments to
manage various other market risks.
The determination of fair values of trading and marketing assets and
liabilities for our energy trading, marketing and price risk management
operations and non-trading derivative assets and liabilities, including stranded
cost obligations related to our European Energy operations, are based on
estimates. For further discussion, please read
59
"-- Trading and Marketing Operations" and "Quantitative and Qualitative
Disclosure About Market Risk" in Item 3 of this Form 10-Q and Note 4 to our
Interim Financial Statements.
NEW ACCOUNTING PRONOUNCEMENTS
In July 2001, the FASB issued SFAS No. 141 "Business Combinations" (SFAS
No. 141). 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. We adopted the provisions of the statement which
apply to goodwill and intangible assets acquired prior to June 30, 2001 on
January 1, 2002. The adoption of SFAS No. 141 did not have a material impact on
our historical results of operations or financial position.
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, "Reporting the Results of Operations - Reporting the Effects of Disposal of
a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring
Events and Transactions," 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 did not materially change the methods
used by us to measure impairment losses on long-lived assets, but may result in
additional future dispositions being reported as discontinued operations than
was previously permitted. We adopted SFAS No. 144 on January 1, 2002.
See Note 4 to our Interim Financial Statements for a discussion of our
adoption of SFAS No. 133 on January 1, 2001 and adoption of subsequent cleared
guidance. See Note 6 to our Interim Financial Statements for a discussion of our
adoption of SFAS No. 142, "Goodwill and Other Intangible Assets".
During the first quarter of 2002, the Financial Accounting Standards Board
(FASB) considered proposed approaches related to identifying and accounting for
special-purpose entities. The current proposal being considered by the FASB is
likely to limit special purpose entities used by a company for financing and
other purposes not being consolidated with its results of operations. One
criterion being considered is to require consolidation of a special purpose
entity if the equity investments held by third-party owners in the special
purpose entity are less than 10% of capitalization. The FASB likely will not
grandfather special purpose entities existing at the date the final
interpretation is issued. Special purpose entities in existence at the date of
adoption of this interpretation will likely be consolidated by the primary
beneficiary. For information regarding special purpose entities affiliated with
Reliant Resources, please read Notes 13(f) and (g) to our Interim Financial
Statements.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
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. A decrease of 10% in the market prices of energy commodities from their
March 31, 2002 levels would have decreased the fair value of our Energy
Derivatives from their levels on those respective dates by $60 million,
excluding non-trading derivatives liabilities associated with our European
Energy business segment's out-of-market import contracts.
Our European Energy business segment's out-of-market import contracts have
exposure to commodity price movements. For information regarding these
contracts, please read Notes 4 and 13(e) to our Interim Financial Statements. A
decrease of 10% in market prices of energy commodities from their March 31, 2002
levels would result in a loss of $90 million.
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 $28 million, $15 million and
$19 million, respectively, during the first quarter of 2002 based on a 95%
confidence level and primarily a one day holding
60
period. During the first quarter of 2001, our highest, lowest and average
monthly VAR were $18 million, $4 million and $9 million, respectively, based on
a 95% confidence level and primarily 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 trading, marketing and risk management activities.
INTEREST RATE RISK
We have issued long-term debt and have obligations under bank facilities
which subject us to the risk of loss associated with movements in market
interest rates.
We have outstanding long-term debt and commercial paper obligations under
bank facilities, mandatory redeemable preferred securities of subsidiary trusts
holding solely our junior subordinated debentures (Trust Preferred Securities),
securities held in our nuclear decommissioning trust, some lease obligations and
our obligations under the 2.0% Zero-Premium Exchangeable Subordinated Notes due
2029 (ZENS) that subject us to the risk of loss associated with movements in
market interest rates. We utilize interest-rate swaps in order to hedge portions
of our floating-rate debt and to hedge a portion of the interest rate applicable
to future offerings of long-term debt.
Our floating-rate obligations borrowed from third parties aggregated $9.3
billion at March 31, 2002. If the floating rates were to increase by 10% from
March 31, 2002 rates, our combined interest expense to third parties would
increase by a total of $2.4 million each month in which such increase continued.
At March 31, 2002, we had outstanding fixed-rate debt (excluding indexed
debt securities) and Trust Preferred Securities aggregating $7.0 billion in
principal amount and having a fair value of $6.9 billion. These instruments are
fixed-rate and, therefore, do not expose us to the risk of loss in earnings due
to changes in market interest rates. However, the fair value of these
instruments would increase by approximately $913 million if interest rates were
to decline by 10% from their levels at March 31, 2002. In general, such an
increase in fair value would impact earnings and cash flows only if we were to
reacquire all or a portion of these instruments in the open market prior to
their maturity.
As discussed in Note 14(k) to the Reliant Energy 10-K Notes, which note is
incorporated herein by reference, we contributed $14.8 million in 1999, 2000 and
2001 to a trust established to fund our share of the decommissioning costs for
the South Texas Project. In 2002, we will begin contributing $2.9 million per
year to this trust. The securities held by the trust for decommissioning costs
had an estimated fair value of $168 million as of March 31, 2002, of which
approximately 45% were fixed-rate debt securities that subject us to risk of
loss of fair value with movements in market interest rates. If interest rates
were to increase by 10% from their levels at March 31, 2002, the decrease in
fair value of the fixed-rate debt securities would decrease by approximately $11
million. In addition, the risk of an economic loss is mitigated. Any unrealized
gains or losses are accounted for in accordance with SFAS No. 71 as a regulatory
asset/liability because we believe that our future contributions, which are
currently recovered through the ratemaking process, will be adjusted for these
gains and losses. For further discussion regarding the recovery of
decommissioning costs pursuant to the Texas electric restructuring law, please
read Note 4(a) to the Reliant Energy 10-K Notes, which note is incorporated
herein by reference.
As discussed in Note 10(b) to the Reliant Energy 10-K Notes, which note is
incorporated herein by reference, RERC Corp.'s $500 million aggregate principal
amount of 6 3/8% Term Enhanced Remarketable Securities include 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 March 31, 2002,
we could terminate the option at a cost of $15 million. A decrease of 10% in the
March 31, 2002 level of interest rates would increase the cost of termination of
the option by approximately $13 million.
As discussed in Note 8 to the Reliant Energy 10-K Notes, which note is
incorporated herein by reference, 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. The debt component of
$122 million is a fixed-rate obligation and, therefore, does not expose us to
the risk of loss in earnings due to changes in market interest rates. However,
the fair value of the debt component would increase by approximately $18 million
if interest rates were to
61
decline by 10% from levels at March 31, 2002. Changes in the fair value of the
derivative component will be recorded in our Statements of Consolidated Income
and, 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 March 31, 2002 levels,
the fair value of the derivative component would increase by approximately $9
million, which would be recorded as a loss in our Statements of Consolidated
Income.
As of March 31, 2002, we hold interest rate swaps having an aggregate
notional amount of $2.7 billion to fix the interest rate applicable to floating
rate short-term debt and long-term debt. At March 31, 2002, the swaps relating
to short-term and long-term debt could be terminated at a cost of $16 million.
Of these swaps, $1.5 billion relating to short-term debt do not qualify as cash
flow hedges under SFAS No. 133, and are marked to market in the Company's
Consolidated Balance Sheets with changes reflected in interest expense in the
Statements of Consolidated Income. The remaining $1.2 billion in swaps relating
to both short-term and long-term debt qualify for hedge accounting under SFAS
No. 133 and the periodic settlements are recognized as an adjustment to interest
expense in the Statements of Consolidated Income over the term of the swap
agreements. A decrease of 10% in the March 31, 2002 level of interest rates
would increase the cost of terminating the swaps related to short-term debt and
long-term debt outstanding at March 31, 2002 by $20 million.
As of March 31, 2002, we have entered into forward-starting interest rate
swaps having an aggregate notional amount of $2.5 billion to hedge the interest
rate on future offerings of long-term fixed-rate notes. At March 31, 2002, these
swaps could be terminated at a cost of $17 million. These swaps qualify as cash
flow hedges under SFAS No. 133. Should the expected issuance of the debt no
longer be probable, any deferred amount will be recognized immediately into
income. A decrease of 10% in the March 31, 2002 level of interest rates would
increase the cost of terminating these swaps by $40 million.
FOREIGN CURRENCY EXCHANGE RATE RISK
As of March 31, 2002, 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 business 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 March 31, 2002, we have recorded a $106
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 March 31, 2002, our European Energy business segment had entered into
transactions to purchase approximately $263 million at fixed exchange rates in
order to hedge future fuel purchases payable in U.S. dollars. As of March 31,
2002, the fair value of these financial instruments was an $8 million asset. An
increase in the value of the Euro of 10% compared to the U.S. dollar from its
March 31, 2002 level would result in a loss in the fair value of these foreign
currency financial instruments of $28 million. For information regarding the
accounting for these financial instruments, see Note 4 to our Interim Financial
Statements and Note 5(b) to the Reliant Energy 10-K Notes, which is incorporated
by reference herein.
Our European Energy business segment's out-of-market import contracts have
foreign currency exposure. An increase of 10% in the U.S. dollar relative to the
Euro from their March 31, 2002 levels would result in a loss of $10 million.
EQUITY MARKET VALUE RISK
We are exposed to equity market value risk through our ownership of
approximately 26 million shares of AOL TW Common, which we hold to facilitate
our ability to meet our obligations under the ZENS. Please read Note 8 to the
Reliant Energy 10-K Notes, which is incorporated by reference herein, 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 March 31, 2002 market value
of AOL TW Common would result in a net loss of approximately $3 million, which
would be recorded as a loss in our Statements of Consolidated Income.
As discussed above under "-- Interest Rate Risk," we contribute to a trust
established to fund our share of the decommissioning costs for the South Texas
Project, which held debt and equity securities as of March 31, 2002. The
62
equity securities expose us to losses in fair value. If the market prices of the
individual equity securities were to decrease by 10% from their levels at March
31, 2002, the resulting loss in fair value of these securities would not be
material to us. Currently, the risk of an economic loss is mitigated as
discussed above under "-- Interest Rate Risk."
We have an investment in Itron, Inc. (Itron), which is classified as
"available-for-sale" under SFAS No. 115, "Accounting for Certain Investments in
Debt and Equity Securities". As of March 31, 2002, the value of the Itron
investment was $9 million. The Itron investment exposes us to losses in the fair
value of Itron common stock. A 10% decline in the market value per share of
Itron common stock from the March 31, 2002 level would decrease the fair value
by $1 million.
63
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS.
For a description of legal proceedings affecting Reliant Energy, please
read Note 13 to our Interim Financial Statements, the discussion under "Our
Business -- Environmental Matters" and Item 3 of the Reliant Energy Form 10-K
and Notes 4 and 14 to the Reliant Energy 10-K Notes, all of which are
incorporated herein by reference.
Restatement of Second and Third Quarter 2001 Results of Operations.
On February 5, 2002, Reliant Energy announced that it was restating its
earnings for the second and third quarters of 2001. As more fully described in
Reliant Energy's March 15, 2002 Current Report on Form 8-K, the restatement
related to a correction in accounting treatment for a series of four structured
transactions that were inappropriately accounted for by Reliant Resources as
cash flow hedges for the period of May 2001 through September 2001, rather than
as derivatives with changes in fair value recognized through the income
statement. Each structured transaction involved a series of forward contracts to
buy and sell an energy commodity in 2001 and to buy and sell an energy commodity
in 2002 or 2003.
At the time of the public announcement of Reliant Energy's intention to
restate its reporting of the structured transactions, the Audit Committee of
each of the Boards of Directors of Reliant Energy and Reliant Resources
instructed Reliant Resources to conduct an internal audit review to determine
whether there were any other transactions included in the asset books as cash
flow hedges that failed to meet the cash flow hedge requirements under SFAS No.
133. This targeted internal audit review found no other similar transactions.
The Audit Committees also directed an internal investigation by outside
legal counsel of the facts and circumstances leading to the restatement, which
investigation has been completed. In connection with the restatement and related
investigations, the Audit Committees have met eight times to hear and assess
reports from the investigative counsel regarding its investigation and contacts
with the Staff of the SEC. To address the issues identified in the investigation
process, the Audit Committees and management have begun analyzing and
implementing remedial actions, including, among other things, changes in
organizational structure and enhancement of internal controls and procedures.
On April 5, 2002, Reliant Resources was advised that the Staff of the
Division of Enforcement of the SEC is conducting an informal inquiry into the
facts and circumstances surrounding the restatement. Reliant Resources is
cooperating with this inquiry. Before releasing its 2001 earnings, Reliant
Energy received concurrence from the SEC's accounting staff on the accounting
treatment of the restatement, which increased its earnings for the two quarters
by a total of $107 million. At this time, we cannot predict the outcome of the
SEC's inquiry. In addition, we cannot predict what effect the inquiry may have
on our pending application to the SEC under the 1935 Act, which is required for
our Restructuring. For more information about our Restructuring, please read
"Our Business - Status of Business Separation" and " - Business Separation" in
Item 1 of the Reliant Energy Form 10-K, which is incorporated herein by
reference.
The Staff of the Division of Enforcement of the SEC has indicated it may
expand the scope of its inquiry to include the round trip trades as described in
Note 1 to our Interim Financial Statements.
ITEM 5. OTHER INFORMATION.
Forward-Looking Statements. From time to time, we make statements
concerning our 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. Actual results may differ materially from those expressed or implied by
these statements. You can generally identify our forward-looking statements by
the words "anticipate," "believe," "continue," "could," "estimate," "expect,"
"intend," "may," "plan," "potential," "predict," "should," "will," "forecast,"
"goal," "objective," "projection," or other similar words.
We have based our forward-looking statements on our management's beliefs
and assumptions based on
64
information available to our management at the time the statements are made. We
caution you that assumptions, beliefs, expectations, intentions and projections
about future events may and often do vary materially from actual results.
Therefore, we cannot assure you that actual results will not differ materially
from those expressed or implied by our 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:
- 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, siting and other laws and regulations to which we are
subject;
- timing of the implementation of our business separation plan,
including the receipt of necessary approvals from the Securities and
Exchange Commission and an extension relating to a private letter
ruling from the Internal Revenue Service;
- the effects of competition, including the extent and timing of the
entry of additional competitors in our markets;
- industrial, commercial and residential growth in our service
territories;
- our pursuit of potential business strategies, including acquisitions
or dispositions of assets or the development of additional power
generation facilities;
- 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;
- the timing and extent of changes in commodity prices, particularly
natural gas;
- weather variations and other natural phenomena;
- 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;
- financial market conditions and the results of our financing efforts;
- ramifications from the bankruptcy filing of Enron Corp.;
- any direct or indirect effect on our business resulting from the
September 11, 2001 terrorist attacks or any similar incidents or
responses to such incidents;
- the performance of our projects; and
- other factors we discuss in the Reliant Energy Form 10-K, including
those outlined in "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Certain Factors Affecting Our
Future Earnings."
You should not place undue reliance on forward-looking statements. Each
forward-looking statement speaks only as of the date of the particular
statement, and we undertake no obligation to publicly update or revise any
forward-looking statements.
65
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.
(a) Exhibits.
Exhibit 99 Items incorporated by reference from the Reliant Energy
Form 10-K: Item 1 "Business," 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 "- Liquidity and Capital Resources" and
Notes 1 (Background and Basis of Presentation), 2(d)
(Revenues), 2(e) (Long-Lived Assets and Intangibles),
2(f) (Regulatory Assets and Liabilities), 3 (Business
Acquisitions), 4 (Regulatory Matters), 5 (Derivative
Financial Instruments), 6 (Jointly Owned Electric
Utility Plant), 8 (Indexed Debt Securities (ACES and
ZENS) and AOL Time Warner Securities), 10 (Long-term
Debt and Short-term Borrowings), 11 (Trust Preferred
Securities), 14 (Commitments and Contingencies), 21
(Bankruptcy of Enron Corp. and its Affiliates) and 22
(Subsequent Events) of the Reliant Energy 10-K Notes.
(b) Reports on Form 8-K.
On January 11, 2002, we filed a Current Report on Form 8-K dated December
18, 2001, relating to the execution of a settlement agreement regarding European
stranded cost indemnification.
On February 5, 2002, we filed a Current Report on Form 8-K dated February
5, 2002, regarding a delay in the release of earnings and restatement of 2001
results.
On March 6, 2002, we filed a Current Report on Form 8-K dated February 19,
2002, regarding Reliant Resources' acquisition of Orion Power Holdings, Inc.
On March 15, 2002, we filed a Current Report on Form 8-K dated March 15,
2002, regarding our 2001 earnings and the effects of our restatement.
On April 8, 2002, we filed a Current Report on Form 8-K dated April 5,
2002, announcing the SEC informal inquiry.
On April 29, 2002, we filed a Current Report on Form 8-K dated April 29,
2002, relating to the announcement of first quarter 2002 results.
66
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: May 20, 2002
67
EXHIBIT INDEX
EXHIBIT
NUMBER DESCRIPTION
- ------- -----------
99 Items incorporated by reference from the Reliant Energy Form
10-K: Item 1 "Business," 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 "- Liquidity and Capital Resources" and
Notes 1 (Background and Basis of Presentation), 2(d)
(Revenues), 2(e) (Long-Lived Assets and Intangibles), 2(f)
(Regulatory Assets and Liabilities), 3 (Business
Acquisitions), 4 (Regulatory Matters), 5 (Derivative Financial
Instruments), 6 (Jointly Owned Electric Utility Plant), 8
(Indexed Debt Securities (ACES and ZENS) and AOL Time Warner
Securities), 10 (Long-term Debt and Short-term Borrowings), 11
(Trust Preferred Securities), 14 (Commitments and
Contingencies), 21 (Bankruptcy of Enron Corp. and its
Affiliates) and 22 (Subsequent Events) of the Reliant Energy
10-K Notes.