EXHIBIT 99
ITEM 3. LEGAL PROCEEDINGS
For a description of certain legal and regulatory proceedings affecting us,
see Notes 4, 14(f), 14(g) and 21 to our consolidated financial statements, which
notes 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 Committees 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 Statement
of Financial Accounting Standards (SFAS) No. 133 "Accounting for Derivative
Instruments and Hedging Activities" (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 this Form 10-K.
1
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
CERTAIN FACTORS AFFECTING OUR FUTURE EARNINGS
Our past earnings are not necessarily indicative of our future earnings and
results of operations. The magnitude of our future earnings and results of our
operations will depend on numerous factors including:
- state, federal and international legislative and regulatory developments,
including deregulation, re-regulation and restructuring of the electric
utility industry, changes in or application of environmental and other
laws and regulations to which we are subject and changes in or
application of laws or regulations applicable to other aspects of our
business, such as commodities trading and hedging activities;
- the timing of the implementation of our Business Separation Plan;
- the effects of competition, including the extent and timing of the entry
of additional competitors in our markets;
- liquidity concerns in our markets;
- industrial, commercial and residential growth in our service territories;
- the degree to which Reliant Resources successfully integrates the
operations and assets of Orion Power into the Wholesale Energy business
segment;
- the determination of the amount of our Texas generation business'
stranded costs and the recovery of these costs;
- the availability of adequate supplies of fuel, water, and associated
transportation necessary to operate our generation facilities;
- 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 interest rates and commodity prices,
particularly natural gas prices;
- weather variations and other natural phenomena, which can affect the
demand for power from, or our ability to produce power at our generating
facilities;
- our ability to cost-effectively finance and refinance;
- the degree to which we successfully integrate the operations and assets
of Orion Power into our Wholesale Energy segment;
- the successful and timely completion of our construction programs, as
well as the successful start-up of completed projects;
- financial market conditions, our access to and cost of capital and the
results of our financing and refinancing efforts, including availability
of funds in the debt/capital markets for merchant generation companies;
- the credit worthiness or bankruptcy or other financial distress of our
trading, marketing and risk management services counterparties;
- actions by rating agencies with respect to us or our competitors;
- acts of terrorism or war;
- the availability and price of insurance;
- the reliability of the systems, procedures and other infrastructure
necessary to operate our retail electric business, including the systems
owned and operated by ERCOT;
- political, legal, regulatory 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;
- the resolution of the refusal by California market participants to pay
our receivables balances due to the recent energy crisis in the West
region; and
- the successful operation of deregulating power markets.
In order to adapt to the increasingly competitive environment in our
industry, we continue to evaluate a wide array of potential business strategies,
including business combinations or acquisitions involving other utility or
non-utility businesses or properties, dispositions of currently owned
businesses, as well as developing new generation projects, products, services
and customer strategies.
2
FACTORS AFFECTING THE RESULTS OF OUR ELECTRIC OPERATIONS
Deregulation. In June 1999, the Texas legislature adopted the Texas
Electric Restructuring Law, which substantially amended the regulatory structure
governing electric utilities in Texas in order to allow retail competition.
Retail pilot projects for up to 5% of each utility's load in all customer
classes began in August 2001 and retail electric competition for all other
customers began on January 1, 2002. We have made significant changes in the
electric utility operations previously conducted through Reliant Energy HL&P.
For additional information regarding these changes, please read "Our
Business -- Deregulation," "-- Electric Operations," "-- Regulation -- State and
Local Regulations -- Texas -- Electric Operations -- The Texas Electric
Restructuring Law" and "-- Our Business Going Forward" in Item 1 of this Form
10-K and Note 4 to our consolidated financial statements.
Transmission and Distribution. Under the Texas Electric Restructuring Law,
our T&D Utility will remain subject to traditional rate regulation by the Texas
Utility Commission, and we will collect from retail electric providers the rates
approved in the T&D Utility's rate case (Wires Case) to cover the cost of
providing transmission and distribution service and any other expenses. Our
ability to earn the rate of return built into the T&D Utility's rates may be
affected, positively or negatively, to the extent that the T&D Utility's actual
expenses or revenues differ from the estimates used to set the T&D Utility's
rates.
Generation. As described under "Electric Operations -- Generation," since
January 1, 2002, we have been obligated to sell substantially all of the
generating capacity and related ancillary services of our Texas generation
business through auctions. As a result, we are not guaranteed any rate of return
on our investment in these generation facilities through mandated rates, and our
revenues and results of operations are likely to depend, in large part, upon
prevailing market prices for electricity in the Texas market and the related
results of our capacity auctions. These market prices may fluctuate
substantially over relatively short periods of time. In addition, ERCOT, the
independent system operator for the Texas markets, may impose price limitations,
bidding rules and other mechanisms that may impact wholesale power prices in the
Texas market and the outcome of our capacity auctions. Our historical financial
results represent the results of our Texas generation business as part of an
integrated utility in a regulated market and may not be representative of its
results as a stand-alone wholesale electric power generation company in an
unregulated market. Therefore, the historical financial information included in
this report does not necessarily reflect what our financial position, results of
operations and cash flows would have been had our generation facilities been
operated in an unregulated market.
Under the terms of the auctions pursuant to which we are obligated to sell
our capacity, we are obligated to provide specified amounts of capacity to
successful bidders. The products we sell in the auctions are only entitlements
to capacity dispatched from our units and do not convey the right to have power
dispatched from a particular unit. This flexibility exposes us to the risk that,
depending on the availability of our units, we could be required to supply
energy from a higher cost unit to meet an obligation for lower cost generation
or to obtain the energy on the open market. Obtaining such replacement
generation could involve significant additional costs. We manage this risk by
maintaining appropriate reserves within our generation asset base but these
reserves may not cover an entire exposure in the event of a significant outage
at one of our facilities. For information about operating risks associated with
our Texas generation business, please read "Factors Affecting the Results of Our
Wholesale Energy Operations -- Operating Risks" below.
Also, market volatility in the price of fuel for our generation operations,
as well as in the price of purchased power, could have an effect on our cost to
generate or acquire power. For additional information regarding commodity prices
and supplies, please read "-- Factors Affecting the Results of Our Wholesale
Energy Operations -- Price Volatility."
3
Pursuant to the Texas Electric Restructuring Law, we will be entitled to
recover our stranded costs (i.e., the excess of regulatory net book value of
generation assets, as defined by the Texas Electric Restructuring Law, over the
market value of those assets) and our regulatory assets related to generation.
The Texas Electric Restructuring Law prescribes specific methods for determining
the amount of stranded costs and the details for their recovery, and our
recovery of stranded costs is dependent upon the outcome of regulatory
proceedings in which we will be required to establish the extent of our stranded
costs and related underlying matters. During the base rate freeze period from
July 1999 through 2001, earnings above the utility's authorized rate of return
formula were applied in a manner to accelerate depreciation of generation
related plant assets for regulatory purposes. In addition, depreciation expense
for transmission and distribution related assets was redirected to generation
assets for regulatory purposes from 1998. The Texas Electric Restructuring Law
also provided for us, or a special purpose entity formed by us, to issue
securitization bonds for the recovery of generation related regulatory assets
and a portion of stranded costs. Reliant Energy Transition Bond Company LLC, our
wholly owned subsidiary, issued $749 million of securitization bonds on October
24, 2001. Any stranded costs not recovered through the sale of securitization
bonds may be recovered through a charge to transmission and distribution
customers. For additional information regarding these securitization bonds,
please read Note 4(a) to our consolidated financial statements. For information
regarding recovery of under-collected fuel expenses, please read "Liquidity and
Capital Resources -- Future Sources and Uses of Cash -- Fuel Filing in Item 7 of
this Form 10-K".
The Texas Utility Commission issued a final order on October 3, 2001
(October 3, 2001 Order) that established the transmission and distribution rates
that became effective January 2002. In this Order, the Texas Utility Commission
found that we had overmitigated our stranded costs by redirecting transmission
and distribution depreciation and by accelerating depreciation of generation
assets as provided under the Transition Plan and Texas Electric Restructuring
Law. In December 2001, we recorded a regulatory liability of $1.1 billion to
reflect the prospective refund of accelerated depreciation, removed our
previously recorded embedded regulatory asset of $841 million related to
redirected depreciation and recorded a regulatory asset of $2.0 billion based
upon current projections of market value of the Reliant Energy HL&P generation
assets to be covered by the 2004 true-up proceeding provided for in the Texas
Electric Restructuring Law. Recovery of this asset is subject to regulatory
risk. We began refunding the excess mitigation credits in January 2002 and will
continue over a seven year period. If events occur that make the recovery of all
or a portion of the regulatory assets no longer probable, we will write off the
corresponding balance of these assets as a charge against earnings. One of the
results of discontinuing the application of regulatory accounting for the
generation operations is the elimination of the regulatory accounting effects of
excess deferred income taxes and investment tax credits related to these
operations. We believe it is probable that some parties will seek to return
these amounts to ratepayers and, accordingly, we have recorded an offsetting
liability.
The Texas Electric Restructuring Law requires us to auction 15% of the
output of the installed generating capacity of our Texas generation business
until January 1, 2007 unless certain criteria are met (state mandated auctions).
In addition, the master separation agreement between Reliant Energy and Reliant
Resources requires us to auction to third parties, including Reliant Resources,
the capacity available in excess of amounts included in the state mandated
auctions (contractually mandated auctions). Beginning January 2002, our Texas
generation business began delivering power sold through the state mandated
auctions and contractually mandated auctions at market rates. However, the Texas
Electric Restructuring Law provides for recovery of any difference between
market power prices received in these capacity auctions and the Texas Utility
Commission's earlier estimates of those market prices. This capacity auction
true-up should provide for revenues earned by our Texas generation business
during the two-year period ending December 2003 to approximate a regulated
return on the invested capital of our Texas generation business. The Texas
Utility Commission's estimate serves as a preliminary identification of stranded
costs for recovery through securitization. This component of the true-up is
intended to ensure that neither the customers nor we are disadvantaged
economically as a result of the two-year transition period by providing this
pricing structure. The underlying data for the true-up calculation has not been
finalized. Because the capacity true-up process provided for in the Texas
Electric Restructuring Law will take into account only the prices we receive in
the state mandated auctions, lower prices that we may receive in the
contractually mandated auctions will not be considered and
4
we may therefore not recover all of our stranded costs. We cannot predict the
amount, if any, of these costs that would not be recovered.
Retail. For a discussion of factors affecting our retail operations,
please read "-- Factors Affecting the Results of Our Retail Operations."
Other. For additional information regarding litigation over franchise
fees, please read Note 14(f) to our consolidated financial statements.
5
RELIANT ENERGY, INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(14) COMMITMENTS AND CONTINGENCIES
(a) COMMITMENTS AND GUARANTEES
The following information is presented separately for the Company's
regulated and unregulated businesses:
RELIANT ENERGY (TO BECOME CENTERPOINT ENERGY SUBSEQUENT TO THE RESTRUCTURING)
Capital and Environmental Commitments. Reliant Energy anticipates
investing up to $397 million in capital and other special project expenditures
between 2002 and 2006 for environmental compliance. Reliant Energy anticipates
expenditures to be as follows (in millions):
<Table>
2002........................................................ $234
2003........................................................ 132
2004........................................................ 28
2005........................................................ 3
2006........................................................ --
----
Total..................................................... $397
====
</Table>
Fuel and Purchased Power. Fuel commitments include several long-term coal,
lignite and natural gas contracts related to Texas power generation operations,
which have various quantity requirements and durations that are not classified
as non-trading derivatives assets and liabilities or trading and marketing
assets and liabilities in the Company's Consolidated Balance Sheets as of
December 31, 2001 as these contracts meet the SFAS No. 133 exception to be
classified as "normal purchases contracts" (see Note 5) or do not meet the
definition of a derivative. Minimum payment obligations for coal and
transportation agreements that extend through 2009 are approximately $199
million in 2002, $129 million in 2003, $133 million in 2004, $137 million in
2005 and $141 million in 2006. Purchase commitments related to lignite mining
and lease agreements, natural gas purchases and storage contracts, and purchased
power are not material to Reliant Energy's operations. Prior to January 1, 2002,
the Electric Operations business segment was allowed recovery of these costs
through rates for electric service. As of December 31, 2001, some of these
contracts are above market. Reliant Energy anticipates that stranded costs
associated with these obligations will be recoverable through the stranded cost
recovery mechanisms contained in the Texas Electric Restructuring Law. For
information regarding the Texas Electric Restructuring Law, see Note 4(a).
Reliant Energy's other long-term fuel supply commitments which have various
quantity requirements and durations are not considered material either
individually or in the aggregate to its results of operations or cash flows.
6
RELIANT ENERGY, INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
RELIANT RESOURCES -- UNREGULATED BUSINESSES
As of December 31, 2001, the Wholesale Energy business segment had entered
into commitments associated with various non-rate regulated electric generating
projects, including commitments for the purchase of combustion turbines,
aggregating $440 million. In addition, the Wholesale Energy business segment has
options to purchase additional generating equipment for a total estimated cost
of $42 million for future generation projects. Reliant Resources is actively
attempting to remarket this equipment.
Reliant Resources is a party to several fuel supply contracts, commodity
transportation contracts, and purchase power and electric capacity contracts,
that have various quantity requirements and durations that are not classified as
non-trading derivatives assets and liabilities or trading and marketing assets
and liabilities in the Consolidated Balance Sheets as of December 31, 2001 as
these contracts meet the SFAS No. 133 exception to be classified as "normal
purchases contracts" (see Note 5) or do not meet the definition of a derivative.
The maximum duration of any of these commitments is 21 years. Minimum purchase
commitment obligations under these agreements are as follows for the next five
years, as of December 31, 2001 (in millions):
<Table>
<Caption>
PURCHASED POWER
AND ELECTRIC AND
TRANSPORTATION GAS CAPACITY
FUEL COMMITMENTS COMMITMENTS COMMITMENTS
---------------- -------------- ----------------
2002.................................... $105 $ 45 $315
2003.................................... 39 84 119
2004.................................... 45 101 61
2005.................................... 45 101 61
2006.................................... 45 101 61
---- ---- ----
Total................................. $279 $432 $617
==== ==== ====
</Table>
The maximum duration under any individual fuel supply contract and
transportation contract is 18 years and 21 years, respectively.
Reliant Resources' aggregate electric capacity commitments, including
capacity auction products, are for 7,496 MW, 1,800 MW, 1,000 MW, 1,000 MW and
1,000 MW for 2002, 2003, 2004, 2005 and 2006, respectively. The maximum duration
under any individual commitment is five years. Included in the above purchase
power and electric capacity commitments are amounts to be acquired from Texas
Genco in 2002 and 2003 of $213 million and $57 million, respectively.
As of December 31, 2001, Reliant Resources has commitments, including
electric energy and capacity sale contracts and district heating contracts (see
Note 14(h)) which are not classified as non-trading derivative assets and
liabilities or trading and marketing assets and liabilities in the Consolidated
Balance Sheets as these contracts meet the SFAS No. 133 exception to be
classified as "normal sales contracts" or do not meet the definition of a
derivative. The estimated minimum sale commitments under these contracts are
$450 million, $211 million, $194 million, $174 million and $159 million in 2002,
2003, 2004, 2005 and 2006, respectively.
In addition, in January 2002, Reliant Resources began providing retail
electric services to approximately 1.5 million residential and small commercial
customers previously served by Reliant Energy's electric utility division.
Within Reliant Energy's electric utility division's territory, prices that may
be charged to residential and small commercial customers by this retail electric
service provider are subject to a fixed, specified price (price to beat) at the
outset of retail competition. The Texas Utility Commission's regulations allow
this retail electric provider to adjust its price to beat fuel factor based on a
percentage change in the price of natural gas. In addition, the retail electric
provider may also request an adjustment as a result of changes in its price of
purchased energy. The retail electric provider may request that its price to
beat be adjusted twice a year.
7
RELIANT ENERGY, INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Reliant Resources will not be permitted to sell electricity to residential and
small commercial customers in the incumbent's traditional service territory at a
price other than the price to beat until January 1, 2005, unless before that
date the Texas Utility Commission determines that 40% or more of the amount of
electric power that was consumed in 2000 by the relevant class of customers is
committed to be served by other retail electric providers.
Reliant Resources guarantees the performance of certain of its
subsidiaries' trading and hedging obligations. As of December 31, 2001, the
fixed maximum amount of such guarantees was $4.7 billion. In addition, Reliant
Resources has issued letters of credit totaling $51 million in connection with
its trading activities. Reliant Resources does not consider it likely that it
would be required to perform or otherwise incur any losses associated with these
guarantees.
In addition to the above discussions, Reliant Resources' other commitments
have various quantity requirements and durations and are not considered material
either individually or in the aggregate to its results of operations or cash
flows.
(b) LEASE COMMITMENTS
In August 2000, the Company, entered into separate sale-leaseback
transactions with each of three owner-lessors covering the subsidiaries'
respective 16.45%, 16.67% and 100% interests in the Conemaugh, Keystone and
Shawville generating stations, respectively, acquired in the REMA acquisition.
As lessee, the Company leases an interest in each facility from each
owner-lessor under a facility lease agreement. The equity interests in all the
subsidiaries of REMA are pledged as collateral for REMA's lease obligations. In
addition, the subsidiaries have guaranteed the lease obligations. The lease
documents contain restrictive covenants that restrict REMA's ability to, among
other things, make dividend distributions unless REMA satisfies various
conditions. The covenant restricting dividends would be suspended if the direct
or indirect parent of REMA, meeting specified criteria, including having a
rating on REMA's long-term unsecured senior debt of at least BBB from Standard
and Poor's and Baa2 from Moody's, guarantees the lease obligations. The Company
will make lease payments through 2029. The lease term expires in 2034. As of
December 31, 2001, REMA had $167 million of restricted funds that are available
for REMA's working capital needs and to make future lease payments, including a
lease payment of $55 million which was made in January 2002.
In the first quarter of 2001, Reliant Resources entered into tolling
arrangements with a third party to purchase the rights to utilize and dispatch
electric generating capacity of approximately 1,100 MW extending through 2012.
This electricity will be generated by two gas-fired, simple-cycle peaking
plants, with fuel oil backup which are being constructed by a tolling partner.
Reliant Resources anticipates construction to be completed by the summer of
2002, at which time Reliant Resources will commence tolling payments. The
tolling arrangements qualify as operating leases.
In February 2001, the Company entered into a lease for office space for
Reliant Resources in a building under construction. The lease agreement was
assigned by the Company to Reliant Resources by an assignment and assumption
agreement in June 2001. The lease term, which commences in the second quarter
2003, is 15 years with two five-year renewal options. Reliant Resources has the
right to name the building.
The following table sets forth information concerning the Company's
obligations under non-cancelable long-term operating leases at December 31,
2001, which primarily relate to the REMA leases mentioned above. Other
non-cancelable, long-term operating leases for Reliant Energy and Reliant
Resources principally
8
RELIANT ENERGY, INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
consist of tolling arrangements, as discussed above, rental agreements for
building space, data processing equipment and vehicles, including major work
equipment.
<Table>
<Caption>
REMA SALE-LEASE RELIANT RESOURCES RELIANT ENERGY
OBLIGATION OTHER OTHER TOTAL
--------------- ----------------- -------------- ------
(IN MILLIONS)
2002............................ $ 136 $ 52 $ 14 $ 202
2003............................ 77 72 12 161
2004............................ 84 87 7 178
2005............................ 75 89 6 170
2006............................ 64 90 5 159
2007 and beyond................. 1,124 469 66 1,659
------ ---- ---- ------
Total......................... $1,560 $859 $110 $2,529
====== ==== ==== ======
</Table>
Total lease expense for all operating leases was $39 million, $62 million
and $112 million during 1999, 2000 and 2001, respectively. During 2001, the
Company made lease payments related to the REMA lease of $259 million. As of
December 31, 2001, the Company had recorded a prepaid lease obligation related
to the REMA sale-leaseback of $59 million and $122 million in other current
assets and other long-term assets, respectively.
(c) CROSS BORDER LEASES
During the period from 1994 through 1997, under cross border lease
transactions, REPGB leased several of its power plants and related equipment and
turbines to non-Netherlands based investors (the head leases) and concurrently
leased the facilities back under sublease arrangements with remaining terms as
of December 31, 2001 of 1 to 23 years. REPGB utilized proceeds from the head
lease transactions to prepay its sublease obligations and to provide a source
for payment of end of term purchase options and other financial undertakings.
The initial sublease obligations totaled $2.4 billion of which $1.6 billion
remained outstanding as of December 31, 2001. These transactions involve REPGB
providing to a foreign investor an ownership right in (but not necessarily title
to) an asset, with a leaseback of that asset. The net proceeds to REPGB of the
transactions were recorded as a deferred gain and are currently being amortized
to income over the lease terms. At December 31, 2000 and 2001, the unamortized
deferred gain on these transactions totaled $77 million and $68 million,
respectively. The power plants, related equipment and turbines remain on the
financial statements of REPGB and continue to be depreciated.
REPGB is required to maintain minimum insurance coverages, perform minimum
annual maintenance and, in specified situations, post letters of credit. REPGB's
shareholder is subject to some restrictions with respect to the liquidation of
REPGB's shares. In the case of early termination of these contracts, REPGB would
be contingently liable for some payments to the sublessors, which at December
31, 2001, are estimated to be $272 million. Starting in March 2000, REPGB was
required by some of the lease agreements to obtain standby letters of credit in
favor of the sublessors in the event of early termination. The amount of the
required letters of credit was $272 million as of December 31, 2001. Commitments
for these letters of credit have been obtained as of December 31, 2001.
(d) NAMING RIGHTS TO HOUSTON SPORTS COMPLEX
In October 2000, Reliant Resources acquired the naming rights for the new
football stadium for the Houston Texans, the National Football League's newest
franchise. In addition, the naming rights cover the entertainment and convention
facilities included in the stadium complex. The agreement extends for 32 years.
In addition to naming rights, the agreement provides Reliant Resources with
significant sponsorship rights.
9
RELIANT ENERGY, INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The aggregate cost of the naming rights will be approximately $300 million.
During the fourth quarter of 2000, Reliant Resources incurred an obligation to
pay $12 million in order to secure the long-term commitment and for the initial
advertising of which $10 million was expensed in the Statement of Consolidated
Income in 2000. Starting in 2002, when the new stadium is operational, Reliant
Resources will pay $10 million each year through 2032 for annual advertising
under this agreement.
(e) TRANSPORTATION AGREEMENT
A subsidiary of RERC Corp. had an agreement (ANR Agreement) with ANR
Pipeline Company (ANR) that contemplated that this subsidiary would transfer to
ANR an interest in some of RERC Corp.'s pipeline and related assets. As of
December 31, 2000 and 2001, the Company had recorded $41 million in other
long-term liabilities in the Company's Consolidated Balance Sheets to reflect
the Company's obligation to ANR for the use of 130 million cubic feet (Mmcf)/day
of capacity in some of the Company's transportation facilities. The level of
transportation will decline to 100 Mmcf/day in the year 2003 with a refund of $5
million to ANR. The ANR Agreement will terminate in 2005 with a refund of $36
million.
(f) LEGAL, ENVIRONMENTAL AND OTHER REGULATORY MATTERS
Legal Matters
Reliant Energy HL&P Municipal Franchise Fee Lawsuits. In February 1996,
the cities of Wharton, Galveston and Pasadena filed suit, for themselves and a
proposed class of all similarly situated cities in Reliant Energy HL&P's service
area, against Reliant Energy and Houston Industries Finance, Inc. (formerly a
wholly owned subsidiary of Reliant Energy) alleging underpayment of municipal
franchise fees. Plaintiffs claim that they are entitled to 4% of all receipts of
any kind for business conducted within these cities over the previous four
decades. Because the franchise ordinances at issue affecting Reliant Energy HL&P
expressly impose fees only on its own receipts and only from sales of
electricity for consumption within a city, the Company regards all of
plaintiffs' allegations as spurious and is vigorously contesting the case. The
plaintiffs' pleadings asserted that their damages exceeded $250 million. The
269th Judicial District Court for Harris County granted partial summary judgment
in favor of Reliant Energy dismissing all claims for franchise fees based on
sales tax collections. Other motions for partial summary judgment were denied. A
six-week jury trial of the original claimant cities (but not the class of
cities) ended on April 4, 2000 (Three Cities case). Although the jury found for
Reliant Energy on many issues, they found in favor of the original claimant
cities on three issues, and assessed a total of $4 million in actual and $30
million in punitive damages. However, the jury also found in favor of Reliant
Energy on the affirmative defense of laches, a defense similar to a statute of
limitations defense, due to the original claimant cities having unreasonably
delayed bringing their claims during the 43 years since the alleged wrongs
began.
The trial court in the Three Cities case granted most of Reliant Energy's
motions to disregard the jury's findings. The trial court's rulings reduced the
judgment to $1.7 million, including interest, plus an award of $13.7 million in
legal fees. In addition, the trial court granted Reliant Energy's motion to
decertify the class and vacated its prior orders certifying a class. Following
this ruling, 45 cities filed individual suits against Reliant Energy in the
District Court of Harris County.
The 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
10
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
opinions over the past decade. The Company estimates the range of possible
outcomes for the plaintiffs to be between zero and $18 million inclusive of
interest and attorneys' fees.
California Wholesale Market. Reliant Energy, Reliant Energy Services, REPG
and several other subsidiaries of Reliant Resources, as well as three officers
of some of these companies, have been named as defendants in class action
lawsuits and other lawsuits filed against a number of companies that own
generation plants in California and other sellers of electricity in California
markets. Pursuant to the terms of the master separation agreement between
Reliant Energy and Reliant Resources (see Note 4(c)), 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.
Plaintiffs have voluntarily dismissed Reliant Energy from two of the three
class actions in which it was named as a defendant. The ultimate outcome of the
lawsuits cannot be predicted with any degree of certainty at this time. However,
the Company believes, based on its analysis to date of the claims asserted in
these lawsuits and the underlying facts, that resolution of these lawsuits will
not have a material adverse effect on the Company's financial condition, results
of operations or cash flows.
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 (see Note 4(c)), 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 ultimate outcome of this lawsuit cannot be predicted with any
degree of certainty at this time.
On March 19, 2002, the California Attorney General filed a complaint with
the 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. The ultimate outcome of this complaint proceeding cannot be
predicted with any degree of certainty at this time. However, the Company
believes, based on its analysis to date of the claims asserted in the complaint,
the underlying facts, and the relevant statutory and regulatory provisions, that
resolution of this
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
lawsuit will not have a material adverse effect on the Company's financial
condition, results of operations or cash flows.
Natural Gas Measurement Lawsuits. In 1997, a suit was filed under the
Federal False Claim Act against RERC 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 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, REGT, REFS and 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.
Environmental Matters
Clean Air Standards. The Company has participated in a lawsuit against the
Texas Natural Resource Conservation Commission (TNRCC) regarding the limitation
of the emission of oxides of nitrogen (NOx) in the Houston area. A settlement of
the lawsuit was reached with the TNRCC in the second quarter of 2001 and revised
emissions limitations were adopted by the TNRCC in the third quarter of 2001.
The revised limitations provide for an increase in allowable NOx emissions,
compared to the original TNRCC requirements, through 2004. Further emission
reduction requirements may or may not be required through 2007, depending upon
the outcome of further investigations of regional air quality issues. To achieve
the TNRCC NOx reduction requirements, the Company anticipates investing up to
$721 million in capital and other special project expenditures by 2004,
including costs incurred through December 31, 2001, and potentially up to an
additional $88 million between 2004 and 2007. The Texas Electric Restructuring
Law provides for stranded cost recovery for expenditures incurred before May 1,
2003 to achieve the NOx reduction requirements.
Hydrocarbon Contamination. On August 24, 2001, 37 plaintiffs filed suit
against Reliant Energy Gas Transmission Company, Inc., Reliant Energy Pipeline
Services, Inc., RERC, Reliant Energy Services, Inc., 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 March 11, 2002, there were 628 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.
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RELIANT ENERGY, INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
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 Reliant Energy Gas Transmission Company in the
late 1940s and was operated until Arkansas Louisiana Gas Company ceased
operations of the plant in the late 1970s.
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 December
31, 2001, 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 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 has substantially
completed remediation of the main site other than ongoing water monitoring and
treatment. The manufactured gas was stored in separate holders. RERC is
negotiating clean-up of one such holder. There are six other former MGP sites in
the Minnesota service territory. Remediation has been completed on one site. Of
the remaining five sites, RERC believes that two were neither owned nor operated
by RERC. RERC believes it has no liability with respect to the sites it neither
owned nor operated.
At December 31, 2000 and 2001, RERC had accrued $18 million and $23
million, respectively, for remediation of the Minnesota sites. At December 31,
2001, 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.
Other Minnesota Matters. At December 31, 2000 and 2001, RERC had recorded
accruals of $4 million and $5 million, respectively for other environmental
matters in Minnesota for which remediation may be required. At December 31, 2001
the estimated range of possible remediation costs was $4 million to $8 million.
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 sites found to be contaminated.
Although the Company is not aware of additional specific sites, it is possible
that other contaminated sites may exist and that remediation costs may be
incurred for these sites. Although the total
13
RELIANT ENERGY, INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
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 REMA (see Note 3(a)), 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
December 31, 2000 and 2001, REMA has liabilities associated with six future ash
disposal site closures and six current site investigations and environmental
remediations. The Company has recorded its estimate of these environmental
liabilities in the amount of $36 million as of December 31, 2000 and 2001. 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)), REPGB had a $25 million obligation
primarily related to asbestos abatement, as required by Dutch law, and soil
remediation at six sites. During 2000, the Company initiated a review of
potential environmental matters associated with REPGB's properties. REPGB began
remediation in 2000 of the properties identified to have exposed asbestos and
soil contamination, as required by Dutch law and the terms of some leasehold
agreements with municipalities in which the contaminated properties are located.
All remediation efforts are to be fully completed by 2005. As of December 31,
2000 and 2001, the recorded estimated undiscounted liability for this asbestos
abatement and soil remediation was $24 million and $18 million, respectively.
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.
The Company has from time to time received notices from regulatory authorities
regarding alleged noncompliance with environmental regulatory requirements. In
addition, the Company has been named as a defendant in litigation related to
allegedly contaminated 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.
Other 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.
14
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(g) 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 Southern California Edison Company (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 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 California Department of Water Resources (CDWR) has
negotiated and purchased power through short and long-term contracts on behalf
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 most real-time energy deliveries subsequent to
January 17, 2001.
In addition, certain contracts intended to serve as collateral for sales to
the California Power Exchange (Cal PX) were seized by California Governor Gray
Davis in February 2001. The Ninth Circuit Court of Appeals subsequently ruled
that Governor Davis' seizure of these contracts was wrongful. The Company has
filed a lawsuit, currently pending in California, to require the state of
California to compensate it for the seizure of these contracts. Although SCE
made a payment on March 1, 2002 to the Cal PX that included amounts it owed to
the Company under these contracts, the Company is still seeking to recover the
market value of the contracts at the time they were seized by Governor Davis,
which was significantly higher than the contract value, and to collect amounts
owed as a result of payment defaults by PG&E under the contracts. The timing and
ultimate resolution of these claims is uncertain at this time.
On September 20, 2001, PG&E filed a Plan of Reorganization and an
accompanying disclosure statement with the bankruptcy court. Under this plan,
PG&E 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 Energy Regulatory Commission, in addition to
the bankruptcy court. PG&E has stated it seeks to have this plan confirmed by
December 31, 2002. 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
details of the CPUC's proposal are unknown at this time. 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.
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
15
RELIANT ENERGY, INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
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, 2000, the Company was owed a total of $282 million by
the Cal PX and the Cal ISO. As of December 31, 2001, the Company was owed a
total of $302 million by the Cal ISO, the Cal PX, the CDWR, and California
Energy Resources Scheduling for energy sales in the California wholesale market
during the fourth quarter of 2000 through December 31, 2001. From January 1,
2002 through March 26, 2002, the Company has collected $45 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, including $39 million recorded in 2000 and $29 million
recorded in 2001. Management will continue to assess the collectability of these
receivables based on further developments affecting the California electricity
market and the market participants described herein.
FERC Market Mitigation. In response to the filing of a number of
complaints challenging the level of wholesale prices, the FERC initiated a staff
investigation and issued a number of orders implementing a series of wholesale
market reforms. Under these orders, and subject to review and adjustment based
on the pending refund proceeding described below, the Company may face an as yet
undetermined amount of refund liability. See "-- FERC Refunds" below. Under
these orders, for the period January 1, 2001 through June 19, 2001,
approximately $20 million of the $149 million charged by the Company for sales
in California to the Cal ISO and the Cal PX were identified as being subject to
possible refunds. 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 the 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 and emissions allowance costs to establish the market-clearing price
in real-time based on the marginal cost of the highest-cost generator called to
run. The plan also requires generators in California to offer all their
available capacity for sale in the real-time market, and conditions sellers'
market-based rate authority such that sellers engaging in certain bidding
practices will be subject to increased scrutiny by the FERC, potential refunds
and even revocation of their market-based rate authority.
On June 19, 2001, the FERC issued an order modifying the market monitoring
and mitigation plan adopted in its April 26 order, to apply price controls to
all hours, instead of just hours of low operating reserve, and to extend the
mitigation measures to other Western states 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 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 establishing
higher actual gas costs than the proxy calculation averages and making a showing
that conditions in natural gas markets changed significantly. The modified
monitoring and mitigation plan went into effect June 20, 2001, and will
terminate on September 30, 2002, covering two summer peak seasons, or
approximately 16 months.
On December 19, 2001, the FERC issued a series of orders on price
mitigation in California and the West region. These orders largely maintained
existing mitigation mechanisms, but did make a temporary modifica-
16
RELIANT ENERGY, INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
tion to the way that mitigated market clearing prices will be set during the
winter months, allowing the maximum prices to rise if gas prices rise. The FERC
removed the requirement that non-reserve deficiency prices be limited to 85% of
the most recent reserve deficiency prices, allowing prices to rise to a
mitigated clearing price of $108/MWh (above which price transactions must be
justified as described above). In addition, the FERC determined that if gas
prices in California rise by 10%, the mitigated price may be revised to take
that change into account. The formula will then track subsequent cumulative
changes of at least 10%, but may not fall below a maximum price of $108/MWh.
This modification is effective December 20, 2001 through April 30, 2002, at
which point the previous mitigation formula is reinstated.
Also, the December 19 orders affirm the June 19 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 in the future may be reduced. During 2001, the
Company recorded $42 million in revenues related to ancillary services in the
West region.
In addition to the impact on ancillary services sales, certain aspects of
the December 19, 2001 orders may have retroactive application that may affect
prices charged in the West region since June 21, 2001. Because the precise
application of the December 19, 2001 order is not known at this time, the
Company cannot anticipate the resulting impact on earnings.
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. 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. Finally, any adverse impacts of the
mitigation plan on the Company's operations would be mitigated, in part, by the
Company's forward hedging activities.
FERC Refunds. The FERC issued an order on July 25, 2001 adopting a refund
methodology and initiating a hearing schedule to determine (1) revised mitigated
prices for each hour from October 2, 2000 through June 20, 2001; (2) the amount
owed in refunds by each supplier according to the methodology (these amounts may
be in addition to or in place of the refund amounts previously determined by the
FERC); and (3) 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 conditions the market-based rate authority of all sellers on their not
engaging in anti-competitive behavior. Such condition will apply upon a further
order from FERC establishing a refund effective date. This condition allows 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
17
RELIANT ENERGY, INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
further action by FERC is uncertain. 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 open-ended 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 Western 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 in the Company's long-term contracts entered into after January 1, 2000
for sales in the West region should be altered.
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 14(f)). Adverse findings or rulings could result in
punitive legislation, sanctions, fines or even criminal charges against the
Company or its employees. The Company is cooperating with both investigations
and has produced a substantial amount of information requested in subpoenas
issued by each body. The Washington and Oregon attorneys general have also begun
similar investigations.
Legislative Efforts. Since the inception of the California energy crisis,
various pieces of legislation, 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 and the Company does not
believe that the legislation that has been enacted to date on these issues will
have a material adverse effect on the Company. However, it is possible that
legislation could be enacted on either the state or federal level that could
have a material adverse effect on the Company's financial condition, results of
operations and cash flows.
(h) INDEMNIFICATION OF 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
NEA. 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.
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RELIANT ENERGY, INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
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
2005, and (b) 600 MW through March 2002 and 750 MW through 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 heating water supply
contacts entered into with various municipalities and expire from 2013 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 also authorized the government to purchase from NEA at
least a majority of the shares in the Dutch national transmission grid company
which was sold to the Dutch government on October 25, 2001 for approximately NLG
2.6 billion (approximately $1.05 billion based on an exchange rate of 2.48 NLG
per U.S. dollar as of December 31, 2001).
Prior to December 31, 2001, the former shareholders agreed pursuant to a
share purchase agreement to indemnify REPGB for up to NLG 1.9 billion in
stranded cost liabilities (approximately $766 million). The indemnity obligation
of the former shareholders and various provincial and municipal entities
(including the city of Amsterdam), was secured by a NLG 900 million escrow
account (approximately $363 million).
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.
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. Pursuant to SFAS No. 133, the gas and electric
contracts are marked-to-market (see Note 5). As of December 31, 2001, the
Company has recorded a liability of $369 million for its stranded cost gas and
electric commitments in non-trading derivative liabilities and a liability of
$206 million for its district heating commitments in current and non-current
other liabilities. As of December 31, 2001, the Company has recorded an
indemnification receivable from the Dutch government for the district heating
stranded cost liability of $206 million. The settlement of the indemnification
related to gas and electric contract commitments in December 2001 is discussed
below.
Settlement of Stranded Cost Indemnification. In December 2001, REPGB and
its former shareholders entered into a settlement agreement immediately
resolving the former shareholders of their stranded cost indemnity obligations
related to the gas supply and power contracts under the original share purchase
agreement, and provides conditional terms for the possible settlement of their
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.
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. Any remaining escrow funds as of January
1, 2004 will be distributed to REPGB.
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RELIANT ENERGY, INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Under the settlement agreement, the former shareholders will continue to
indemnify REPGB for the 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 cost 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.
Under the terms of the original indemnification agreement, the former
shareholders were entitled to receive any and all distributions and dividends
above NLG 125 million ($51 million) paid by NEA. Under the settlement agreement,
the former shareholders waived all rights under the original indemnification
agreement to claim distributions of NEA.
Reliant Resources 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 Reliant Resources' 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 Consolidated Balance Sheets.
Investment in NEA. During the second quarter of 2001, Reliant Resources
recorded a $51 million pre-tax gain (NLG 125 million) recorded as equity income
for the preacquisition gain contingency related to the acquisition of REPGB for
the value of its equity investment in NEA. This gain was based on Reliant
Resources' evaluation of NEA's financial position and fair value. The fair value
of Reliant Resources' investment in NEA is dependent upon the ultimate
resolution of its existing contingencies and proceeds received from liquidating
its remaining net assets. Prior to the settlement agreement discussed above,
pursuant to the purchase agreement of REPGB, as amended, REPGB was entitled to a
NLG 125 million dividend from NEA with any remainder owing to the former
shareholders. As mentioned above, REPGB entered into an agreement with its
former shareholders to settle the original indemnification agreement and the
former shareholders waived all rights to distributions of NEA. Accordingly, as a
component of the net gain recognized from the settlement of the stranded cost
indemnity, Reliant Resources recorded a $248 million increase in its investment
in NEA. As of December 31, 2001, Reliant Resources has recorded $299 million in
equity investments of unconsolidated subsidiaries for its investment in NEA.
(i) OPERATIONS AGREEMENT WITH CITY OF SAN ANTONIO
As part of the 1996 settlement of certain litigation claims asserted by the
City of San Antonio with respect to the South Texas Project, the Company entered
into a 10-year joint operations agreement under which the Company and the City
of San Antonio, acting through the City Public Service Board of San Antonio
(CPS), share savings resulting from the joint dispatching of their respective
generating assets in
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RELIANT ENERGY, INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
order to take advantage of each system's lower cost resources. In January 2000,
the contract term was extended for three years and is expected to terminate in
2009. Under the terms of the joint operations agreement entered into between CPS
and Electric Operations, the Company has guaranteed CPS minimum annual savings
of $10 million up to a total cumulative savings of $150 million over the term of
the agreement. The cumulative obligation was met in the first quarter of 2001.
In 1999, 2000 and 2001, savings generated for CPS' account were $14 million, $60
million and $65 million, respectively. Through December 31, 2001, cumulative
savings generated for CPS' account were $189 million.
(j) NUCLEAR INSURANCE
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 December 31, 2001. 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.
(k) NUCLEAR DECOMMISSIONING
The Company contributed $14.8 million per year in 1999, 2000 and 2001 to a
trust established to fund its share of the decommissioning costs for the South
Texas Project. Pursuant to the October 3, 2001 Order, 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 $169
million as of December 31, 2001, of which approximately 46% were fixed-rate debt
securities and the remaining 54% were equity securities. For a discussion of the
accounting treatment for the securities held in the Company's nuclear
decommissioning trust, see Note 2(l). 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 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. For
information regarding the effect of the Business Separation Plan on funding of
the nuclear decommissioning trust fund, see Note 4(b).
(l) 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
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RELIANT ENERGY, INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
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 the cash is collateralized. 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 27, 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 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 December 31, 2001, the bank had
assumed contracts for the purchase of eleven turbines, two heat recovery steam
generators and one air-cooled condenser with an aggregate cost of $398 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, REPG and its subsidiary had deposited $230 million into the collateral
account. The bank's payments for equipment under the contracts totaled $227
million as of December 31, 2001. 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
December 31, 2001, there were equipment contracts with a total contractual
obligation of $140 million under which payments during construction totaled $83
million. Currently this equipment is not designated for current planned power
generation construction projects. Therefore, the Company anticipates that it
will either purchase the equipment, assist in the remarketing of the equipment
or negotiate to cancel the related contracts.
22