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EXHIBIT 99B
[ITEMS INCORPORATED
FROM THE RESOURCES 10-K]
ITEM 3. LEGAL PROCEEDINGS.
(b) Resources.
For a description of certain legal and regulatory proceedings affecting
Resources, see Note 8(g) to Resources' Consolidated Financial Statements, which
note is incorporated herein by reference.
ITEM. 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS OF THE COMPANY
CERTAIN FACTORS AFFECTING FUTURE EARNINGS
OF THE COMPANY AND ITS SUBSIDIARIES
Earnings for the past three years are not necessarily indicative of future
earnings and results. The level of future earnings depends on numerous factors
including (i) the future growth in the Company's and its subsidiaries' energy
sales; (ii) weather; (iii) the success of the Company's and its subsidiaries'
entry into non-rate regulated businesses such as energy marketing and
international and domestic power projects; (iv) the Company's and its
subsidiaries' ability to respond to rapid changes in a competitive environment
and in the legislative and regulatory framework under which they have
traditionally operated; (v) rates of economic growth in the Company's and its
subsidiaries' service areas; (vi) the ability of the Company and its
subsidiaries to control costs and to maintain pricing structures that are both
attractive to customers and profitable; (vii) the outcome of future rate
proceedings; (viii) the effect that foreign exchange rate changes may have on
the Company's investments in international operations; and (ix) future
legislative initiatives.
In order to adapt to the increasingly competitive environment in which the
Company operates, the Company continues to evaluate a wide array of potential
business strategies, including business combinations or acquisitions involving
other utility or non-utility businesses or properties, internal restructuring,
reorganizations or dispositions of currently owned properties or currently
operating business units and new products, services and customer strategies. In
addition, the Company continues to engage in new business ventures, such as
electric power trading and marketing, which arise from competitive and
regulatory changes in the utility industry.
COMPETITION AND RESTRUCTURING OF THE ELECTRIC UTILITY INDUSTRY
The electric utility industry is becoming increasingly competitive due to
changing government regulations, technological developments and the availability
of alternative energy sources.
Long-Term Trends in Electric Utility Industry. The electric utility
industry historically has been composed of vertically integrated companies
providing electric service on an exclusive basis within governmentally-defined
geographic areas. Prices for electric service have typically been set by
governmental authorities under principles designed to provide the utility with
an opportunity to recover its cost of providing electric service plus a
reasonable return on its invested capital. Federal legislation and regulation as
well as legislative and regulatory initiatives in various states have encouraged
competition among electric utility and non-utility owned power generators. These
developments, combined with increased demand for lower-priced electricity and
technological advances in electric generation, have continued to move the
electric utility industry in the direction of more competition.
Based on a strategic review of the Company's business and of ongoing
developments in the electric utility and related industries regarding
competition, regulation and consolidation, the Company's management believes
that the electric utility industry will continue its path toward competition,
albeit on a state-by-state basis. The Company's management also believes the
business of electricity and natural gas are converging and consolidating and
these trends will alter the structure and business practices of companies
serving these markets in the future.
Competition in Wholesale Market. The Federal Energy Policy Act of 1992, the
Public Utility Regulatory Act of 1995 (now the Texas Utilities Code) and
regulations promulgated by the Federal Energy Regulatory Commission (FERC)
contain provisions intended to facilitate the development of a wholesale energy
market. Although Reliant Energy HL&P's wholesale sales traditionally have
accounted for less than 1% of its total revenues, the expansion of competition
in the wholesale electric market is significant in that it has increased the
range of non-utility competitors, such as exempt wholesale generators (EWGs) and
power marketers, in the Texas electric market as well as resulted in fundamental
changes in the operation of the state transmission grid.
In February 1996, the Texas Utility Commission adopted rules granting
third-party users of transmission systems open access to such systems at rates,
terms and conditions comparable to those available to utilities owning such
transmission assets. Under the Texas Utility Commission order implementing the
rule, Reliant Energy HL&P was required to separate, on an operational basis, its
wholesale power marketing operations from the operations of the transmission
grid and, for purposes of transmission pricing, to disclose each of its separate
costs of generation, transmission and distribution.
Within ERCOT, an independent system operator (ISO) manages the state's
electric grid, ensuring system reliability and providing non-discriminatory
transmission access to all power producers and traders. The ERCOT ISO, the first
in the nation, is a key component for implementing the Texas Utility
Commission's overall strategy to create a
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competitive wholesale market. ERCOT formed an ad hoc committee in early 1998 to
investigate the potential impacts of a competitive retail market on the ISO. The
ERCOT committee report was released in December 1998 and concluded that the
ISO's role and function would necessarily expand in a competitive retail
environment, but the changes required of the ISO to support retail choice should
not impede introduction of retail choice.
Competition in Retail Market. The Company estimates that, since 1978,
cogeneration projects representing approximately one-third of current total peak
generating capability have been built in the Houston area and that, as a result,
Reliant Energy HL&P has seen a reduction of approximately 2,500 MW in customer
load to self-generation. Reliant Energy HL&P has utilized flexible pricing to
respond to situations where large industrial customers have an alternative to
buying power from it, primarily by constructing their own generating facilities.
Under a tariff option approved by the Texas Utility Commission in 1995, Reliant
Energy HL&P was permitted to implement contracts based upon flexible pricing for
up to 700 MW. Currently, this rate is fully subscribed.
Texas law currently does not permit retail sales by unregulated entities
such as cogenerators. The Company anticipates that cogenerators and other
interests will continue to exert pressure to obtain access to the electric
transmission and distribution systems of regulated utilities for the purpose of
making retail sales to customers of regulated utilities.
Legislative Proposals. A number of proposals to restructure the electric
utility industry have been introduced in the 1999 session of the Texas
legislature. If adopted, legislation may permit and encourage alternative
suppliers to compete to serve Reliant Energy HL&P's current rate-regulated
retail customers. The various legislative proposals include provisions governing
recovery of stranded costs and permitting securitization of those costs;
freezing rates until 2002; requiring firm sales of energy to competing retail
electric providers; requiring disaggregation of generation, transmission and
distribution, and retail sales into separate companies and limiting the ability
of existing utilities' affiliates competing for retail electric customers on the
basis of price until they have lost a substantial percentage of their
residential and small commercial load to alternative retail providers. In
addition to the Texas legislative proposals, a number of federal legislative
proposals to promote retail electric competition or restructure the U.S.
electric utility industry have been introduced during the current congressional
session.
At this time, the Company is unable to make any prediction as to whether
any legislation to restructure electric operations or provide retail competition
will be enacted or as to the content or impact on the Company of any legislation
which may be enacted. However, because the proposed legislation is intended to
fundamentally restructure electric utility operations, it is likely that enacted
legislation would have a material impact on the Company.
Stranded Costs. As the U.S. electric utility industry continues its
transition to a more competitive environment, a substantial amount of fixed
costs previously approved for recovery under traditional utility regulatory
practices (including regulatory assets and liabilities) may become "stranded,"
i.e., unrecoverable at competitive market prices. The issue of stranded costs
could be particularly significant with respect to fixed costs incurred in
connection with the past construction of generation plants, such as nuclear
power plants, which, because of their high fixed costs, would not command the
same price for their output as they have in a regulated environment.
In January 1997, the Texas Utility Commission delivered a report to the
Texas legislature on stranded investments in the electric utility industry in
Texas (referred to by the Texas Utility Commission as "Excess Cost Over Market")
(ECOM). In April 1998, the Texas Utility Commission submitted to the Texas
Senate Interim Committee on Electric Utility Restructuring an updated study of
ECOM estimates. Assuming that retail competition is adopted at the beginning of
2002, the updated study estimated that the total amount of stranded costs for
all Texas electric utilities could be $4.5 billion. If instead, retail
competition is adopted one year later, the study estimates statewide ECOM to be
$3.3 billion. Estimates of ECOM vary widely and there is inherent uncertainty in
calculating these costs.
Transition Plan. In June 1998, the Texas Utility Commission approved the
Transition Plan filed by Reliant Energy HL&P in December 1997. The Transition
Plan included base rate credits to residential and certain commercial
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customers in 1998 and 1999, an overall rate of return cap formula for 1998 and
1999 and approval of accounting procedures designed to accelerate recovery of
stranded costs which may arise under restructuring legislation. The Transition
Plan permits the redirection of depreciation expense to generation assets that
Electric Operations otherwise would apply to transmission, distribution and
general plant assets. In addition, the Transition Plan provides that all
earnings above a 9.844% overall annual rate of return on invested capital be
used to recover Electric Operations' investment in generation assets. In
1998, Reliant Energy HL&P recorded an additional $194 million in depreciation
under the Transition Plan. Certain parties have appealed the order approving the
Transition Plan. For additional information, see Notes 1(f) and 3(b) to the
Company's Consolidated Financial Statements.
COMPETITION -- OTHER OPERATIONs
Natural Gas Distribution competes primarily with alternate energy sources
such as electricity and other fuel sources as well as with providers of energy
conservation products. In addition, as a result of federal regulatory changes
affecting interstate pipelines, it has become possible for other natural gas
suppliers and distributors to bypass Natural Gas Distribution's facilities and
market, sell and/or transport natural gas directly to small commercial and/or
large volume customers.
The Interstate Pipeline segment competes with other interstate and
intrastate pipelines in the transportation and storage of natural gas. The
principal elements of competition among pipelines are rates, terms of service,
and flexibility and reliability of service. Interstate Pipeline competes
indirectly with other forms of energy available to its customers, including
electricity, coal and fuel oils. The primary competitive factor is price.
Changes in the availability of energy and pipeline capacity, the level of
business activity, conservation and governmental regulations, the capability to
convert to alternative fuels, and other factors, including weather, affect the
demand for natural gas in areas served by Interstate Pipeline and the level of
competition for transport and storage services.
Reliant Energy Services competes for sales in its gas and power trading and
marketing business with other natural gas and power merchants, producers and
pipelines based on its ability to aggregate supplies at competitive prices from
different sources and locations and to efficiently utilize transportation from
third-party pipelines and transmission from electric utilities. Reliant Energy
Services also competes against other energy marketers on the basis of its
relative financial position and access to credit sources. This competitive
factor reflects the tendency of energy customers, natural gas suppliers and
natural gas transporters to seek financial guarantees and other assurances that
their energy contracts will be satisfied. As pricing information becomes
increasingly available in the energy trading and marketing business and as
deregulation in the electricity markets continues to accelerate, the Company
anticipates that Reliant Energy Services will experience greater competition and
downward pressure on per-unit profit margins in the energy marketing industry.
Competition for acquisition of international and domestic non-rate
regulated power projects is intense. International and Power Generation compete
against a number of other participants in the non-utility power generation
industry, some of which have greater financial resources and have been engaged
in non-utility power projects for periods longer than the Company and have
accumulated greater portfolios of projects. Competitive factors relevant to the
non-utility power industry include financial resources, access to non-recourse
funding and regulatory factors.
FLUCTUATIONS IN COMMODITY PRICES AND DERIVATIVE INSTRUMENTS
For information regarding the Company's exposure to risk as a result of
fluctuations in commodity prices and derivative instruments, see "Quantitative
and Qualitative Disclosures About Market Risk" in Item 7A of this Report.
ACCOUNTING TREATMENT OF ACES
The Company accounts for its investment in Time Warner Convertible
Preferred Stock (TW Preferred) under the cost method. As a result of the
Company's issuance of the ACES, a portion of the increase in the market value
above $27.7922 per share of Time Warner common stock (the security into which
the TW Preferred is convertible) (TW
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Common) results in unrealized accounting losses to the Company, pending the
conversion of the Company's TW Preferred into TW Common. For consistency
purposes, the TW Common and related per share prices retroactively reflect a 2
for 1 stock split effective December 15, 1998.
Prior to the conversion of the TW Preferred into TW Common, when the market
price of TW Common increases above $27.7922, the Company records in Other Income
(Expense) an unrealized, non-cash accounting loss for the ACES equal to the
aggregate amount of such increase as applicable to all ACES multiplied by
0.8264. In accordance with generally accepted accounting principles, this
accounting loss (which reflects the unrealized increase in the Company's
indebtedness with respect to the ACES) may not be offset by accounting
recognition of the increase in the market value of the TW Common that underlies
the TW Preferred. Upon conversion of the TW Preferred (which is anticipated to
occur in June 1999 when the preferential dividend on the TW Preferred expires),
the Company will begin recording future unrealized net changes in the market
prices of the TW Common and the ACES as a component of common stock equity and
other comprehensive income.
As of December 31, 1998, the market price of TW Common was $62.062 per
share. Accordingly, the Company recognized an increase of $1.2 billion in 1998
in the unrealized liability relating to its ACES indebtedness (which resulted in
an after-tax earnings reduction of $764 million or $2.69 basic earnings per
share in 1998). The Company believes that the cumulative unrealized loss for the
ACES of approximately $1.3 billion is more than economically offset by the
approximately $1.8 billion unrecorded unrealized gain at December 31, 1998
relating to the increase in the fair value of the TW Common underlying the
investment in TW Preferred since the date of its acquisition. Any gain related
to the increase in fair value of TW Common would be recognized as a component of
net income upon the sale of the TW Preferred or the shares of TW Common into
which such TW Preferred is converted. As of March 11, 1999, the price of TW
Common was $70.75 per share, which would have resulted in the Company
recognizing an additional increase of $329 million in the unrealized liability
represented by its indebtedness under the ACES. The related unrecorded
unrealized gain as of March 11, 1999 would have been computed as an additional
$398 million.
Excluding the unrealized, non-cash accounting loss for ACES, the Company's
retained earnings and total common stock equity would have been $2.3 billion and
$5.2 billion, respectively.
IMPACT OF THE YEAR 2000 ISSUE AND OTHER SYSTEM IMPLEMENTATION ISSUES
Year 2000 Problem. At midnight on December 31, 1999, unless the proper
modifications have been made, the program logic in many of the world's computer
systems will start to produce erroneous results because, among other things, the
systems will incorrectly read the date "01/01/00" as being January 1 of the year
1900 or another incorrect date. In addition, certain systems may fail to detect
that the year 2000 is a leap year. Problems can also arise earlier than January
1, 2000, as dates in the next millennium are entered into non-Year 2000
compliant programs.
Compliance Program. In 1997, the Company initiated a corporate-wide Year
2000 project to address mainframe application systems, information technology
(IT) related equipment, system software, client-developed applications, building
controls and non-IT embedded systems such as process controls for energy
production and delivery. Incorporated into this project were Resources' and
other Company subsidiaries' mainframe applications, infrastructures, embedded
systems and client-developed applications that will not be migrated into
existing or planned Company or Resources systems prior to the year 2000. The
evaluation of Year 2000 issues included those related to significant customers,
key vendors, service suppliers and other parties material to the Company's and
its subsidiaries' operations. In the course of this evaluation, the Company has
sought written assurances from such third parties as to their state of Year 2000
readiness.
State of Readiness. Work has been prioritized in accordance with business
risk. The highest priority has been assigned to activities that would disrupt
the physical delivery of energy (Priority 1); activities that would impact back
office activities such as billing (Priority 2); activities that would cause
inconvenience or productivity loss in normal business operations (e.g. air
conditioning systems and elevators) (Priority 3). All business units have
completed an analysis of critical systems and equipment that control the
production and delivery of energy, as well as corporate, departmental and
personnel systems and equipment. The remediation and replacement work on the
majority of IT
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systems, non-IT systems and infrastructure began in the first quarter of 1998
and is expected to be completed by the second quarter of 1999. Testing of these
systems began in the second quarter of 1998 and is scheduled to be completed in
third quarter of 1999. The following table illustrates the Company's completion
percentages for the Year 2000 activities as of February 28, 1999:
PRIORITY 1 PRIORITY 2 PRIORITY 3
-------------- -------------- ---------------
Assessment.............................................. 95% 86% 96%
Conversion.............................................. 86% 70% 91%
Testing................................................. 80% 61% 87%
Implementation.......................................... 76% 54% 75%
Costs to Address Year 2000 Compliance Issues. Based on current internal
studies, as well as recently solicited bids from various computer software
vendors, the Company estimates that the total direct cost of resolving the Year
2000 issue with respect to the Company and its subsidiaries will be between $35
and $40 million. This estimate includes approximately $7 million related to
salaries and expenses of existing employees and approximately $3 million in
hardware purchases that the Company expects to capitalize. In addition, the $35
to $40 million estimate includes approximately $2 million spent prior to 1998
and approximately $12 million during 1998. The remaining costs related to
resolving the Year 2000 issue are expected to be expended in 1999.
The Company expects to fund these expenditures through internal sources.
In September 1997, the Company entered into an agreement with SAP America,
Inc. (SAP) to license SAP proprietary R/3 enterprise software. The licensed
software includes customer care, finance and accounting, human resources,
materials management and service delivery components. The Company's purchase of
this software license and related computer hardware is part of its response to
changes in the electric utility and energy services industries, as well as
changes in the Company's businesses and operations resulting from the
acquisition of Resources and the Company's expansion into the energy trading and
marketing business. Although it is anticipated that the implementation of the
SAP system will have the incidental effect of negating the need to modify many
of the Company's computer systems to accommodate the Year 2000 problem, the
Company does not deem the costs of the SAP system as directly related to its
Year 2000 compliance program. Portions of the SAP system were implemented in
December 1998 and March 1999, and it is expected that the final portion of the
SAP system will be fully implemented by July 2000. The estimated costs of
implementing the SAP system is approximately $182 million, inclusive of internal
costs. In 1998, the Company and its subsidiaries spent $108 million of such
costs. In 1999, the Company and its subsidiaries expect to spend $59 million
with the remaining amounts to be spent in 2000.
The estimated Year 2000 project costs do not give effect to any future
corporate acquisitions or divestitures made by the Company or its subsidiaries.
Risks and Contingency Plans. The major systems which pose the greatest Year
2000 risks for the Company and its subsidiaries if implementation of the Year
2000 compliance program is not successful are the process control systems for
energy delivery systems; the time in use, demand and recorder metering system
for commercial and industrial customers; the outage analysis system; and the
power billing systems. The potential problems related to these systems are
temporary electric service interruptions to customers, temporary interruptions
in revenue data gathering and temporary poor customer relations resulting from
delayed billing. Although the Company does not believe that this scenario will
occur, the Company has considerable experience responding to emergency
situations, including computer failure. Existing emergency operations, disaster
recovery and business continuation plans are being enhanced to ensure
preparedness and to mitigate the long-term effect of such a scenario.
The North American Electric Reliability Council (NERC) is coordinating
electric utility industry contingency planning on a national level. Additional
contingency planning is being done at the regional electric reliability council
level. Reliant Energy HL&P filed a draft Year 2000 Contingency Plan with NERC
and with the Texas Utility Commission in December 1998. The draft plan addresses
restoration of electric service and related business processes, and is designed
to work in conjunction with the Emergency Operating Plan and with the plans of
NERC and ERCOT.
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A final contingency plan is scheduled to be complete by June 30, 1999. In
addition, Reliant Energy HL&P will participate in industry preparedness drills,
such as the two NERC drills scheduled to be held on April 9, 1999 and September
9, 1999.
The existing business continuity disaster recovery and emergency operations
plans are being reviewed and enhanced, and where necessary, additional plans
will be developed to include mitigation strategies and action plans specifically
addressing potential Year 2000 scenarios. The expected completion date for these
plans is June 30, 1999.
In order to assist in preparing for and mitigating the foregoing scenarios,
the Company intends to complete all mission critical Year 2000 remediation and
testing activity by the end of the second quarter of 1999. In addition, the
Company has initiated Year 2000 communications with significant customers, key
vendors, service suppliers and other parties material to the Company's
operations and is diligently monitoring the progress of such third parties' Year
2000 projects. The Company expects to meet with mission-critical third parties,
including suppliers, in order to ascertain and assess the relative risks of
Year-2000-related issues, and to mitigate such risks. Notwithstanding the
foregoing, the Company cautions that (i) the nature of testing is such that it
cannot comprehensively address all future combinations of dates and events and
(ii) it is impossible for the Company to assess with precision or certainty the
compliance of third parties with Year 2000 remediation efforts. Due to the
speculative and uncertain nature of contingency planning, there can be no
assurance that such plans actually will be sufficient to reduce the risk of
material impacts on the Company's and its subsidiaries' operations.
RISKS OF INTERNATIONAL OPERATIONS
The Company's international operations are subject to various risks
incidental to investing or operating in emerging market countries. These risks
include political risks, such as governmental instability, and economic risks,
such as fluctuations in currency exchange rates, restrictions on the
repatriation of foreign earnings and/or restrictions on the conversion of local
currency earnings into U.S. dollars. The Company's international operations are
also highly capital intensive and, thus, dependent to a significant extent on
the continued availability of bank financing and other sources of capital on
commercially acceptable terms.
Impact of Currency Fluctuations on Company Earnings. The Company, through
Reliant Energy International's subsidiaries, owns 11.69% of the stock of Light
and, through its investment in Light, an 8.753% interest in the stock of
Metropolitana Electricidade de Sao Paulo S.A. (Metropolitana). The Company
accounts for its investment in Light under the equity method of accounting and
records its proportionate share, based on stock ownership, in the net income of
Light and its affiliates (including Metropolitana) as part of the Company's
consolidated net income.
At December 31, 1998, Light and Metropolitana had total borrowings of
approximately $3.2 billion denominated in non-local currencies. Because of the
devaluation of the Brazilian real subsequent to December 31, 1998, Light and
Metropolitana are expected to record a charge to March 31, 1999 earnings that
reflects the increase in the liability represented by their non-local currency
denominated bank borrowings relative to the Brazilian real. Because the Company
uses the Brazilian real as the functional currency in which it reports Light's
equity earnings, the resulting decrease in Light's earnings will also be
reflected in the Company's consolidated earnings to the extent of the Company's
11.69% ownership interest in Light. At December 31, 1998, one U. S. dollar could
be exchanged for 1.21 Brazilian reais. Using the exchange rate of 2.06 Brazilian
reais in effect at the end of February, and the average exchange rate in effect
since the end of the year, the Company estimates that its share of the after-tax
charge to be recorded by Light would be approximately $125 million. This
estimate does not reflect the possibility of additional fluctuations in the
exchange rate and does not include other non-debt-related impacts of Brazil's
currency devaluation on Light's and Metropolitana's future earnings.
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None of Light's or Metropolitana's tariff adjustment mechanisms are
directly indexed to the U.S. dollar or other non-local currencies. Each company
currently is evaluating various options including regulatory rate relief to
mitigate the impact of the devaluation of the Brazilian real. For example, the
long-term concession contracts under which Light and Metropolitana operate
contain mechanisms for adjusting electricity tariffs to reflect changes in
operating costs resulting from inflation. If the devaluation of the Brazilian
real results in an increase in the local rate of inflation and if an adjustment
to tariff rates is made promptly to reflect such increase, the Company believes
that the financial results of Light and Metropolitana should be protected, at
least in part, from the effects of devaluation. However, there can be no
assurance the implementation of such tariff adjustments will be timely or that
the economic impact of the devaluation will be completely reflected in increased
inflation rates.
Certain of Reliant Energy International's other foreign electric
distribution companies have incurred U.S. dollar and other non-local currency
indebtedness (approximately $71 million at December 31, 1998). For further
analysis of foreign currency fluctuations in the Company's earnings and cash
flows, see "Quantitative and Qualitative Disclosures About Market Risk --
Foreign Currency Exchange Rate Risk" in Item 7A of this Form 10-K.
Impact of Foreign Currency Devaluation on Project Capital Resources. In the
first quarter of 1999, approximately $117 million of Metropolitana's U.S. dollar
denominated debt will mature. In the second quarter of 1999, approximately $980
million of Light's and approximately $696 million of Metropolitana's U.S. and
non-local currency denominated bank debt will mature. In March 1999, Light
refinanced approximately $130 million of its U.S. dollar denominated debt
through a local - currency denominated loan. The ability of Light and
Metropolitana to repay or refinance their debt obligations at maturity is
dependent on many factors, including local and international economic conditions
prevailing at the time such debt matures.
If economic conditions in the international markets continue to be
unsettled or deteriorate, it is possible that Light, Metropolitana and the other
foreign electric distribution companies in which the Company holds investments
might encounter difficulties in refinancing their debt (both local currency and
non-local currency borrowings) on terms and conditions that are commercially
acceptable to them and their shareholders. In such circumstances, in lieu of
declaring a default or extending the maturity, it is possible that lenders might
seek to require, among other things, higher borrowing rates, and additional
equity contributions and/or increased levels of credit support from the
shareholders of such entities. The availability or terms of refinancing such
debt cannot be assured.
Currency fluctuation and instability affecting Latin America may also
adversely affect Reliant Energy International's ability to refinance its equity
investments with debt. In 1998, Reliant Energy International invested $411
million in Colombia and El Salvador. As of January 1999, $100 million of these
investments were refinanced with debt. Reliant Energy International intends to
refinance approximately $75 million more of such initial investments with debt.
ENVIRONMENTAL EXPENDITURES
The Company and its subsidiaries, including Resources, are subject to
numerous environmental laws and regulations, which require them to incur
substantial costs to operate existing facilities, construct and operate new
facilities, and mitigate or remove the effect of past operations on the
environment.
Clean Air Act Expenditures. The Company expects the majority of capital
expenditures associated with environmental matters to be incurred by Electric
Operations in connection with new emission limitations under the Federal Clean
Air Act (Clean Air Act) for oxides of nitrogen (NOx). The standards applicable
to Electric Operations' generating units in the Houston, Texas area will become
effective in November 1999. NOx reduction costs incurred by Electric Operations
totaled approximately $7 million in 1998. The Company estimates that Electric
Operations will incur approximately $8 million in 1999 and $10 million in 2000
for such expenditures. The Texas Natural Resources Conservation Commission
(TNRCC) has indicated that additional NOx reduction will be required after 2000;
however, since the magnitude and timing of these reductions have not yet been
established, it is impossible for the Company to estimate a reasonable range of
such expenditures at this time.
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In 1998, the Wholesale Energy spent approximately $100,000 in order to
comply with NOx reduction with respect to Southern California generating
facilities acquired by Power Generation from Southern California Edison (SCE) in
1998. In 1999, based on existing requirements, the Company projects that it will
spend an additional $100,000 on NOx reduction standards with respect to such
plants and approximately $1 million on continuous emission monitoring system
upgrades for such plants.
Site Remediation Expenditures. From time to time the Company and its
subsidiaries have received notices from regulatory authorities or others
regarding their status as potentially responsible parties in connection with
sites found to require remediation due to the presence of environmental
contaminants.
The Company's identified sites with respect to which it may be claimed to
have a remediation liability include several sites for which there is a lack of
current available information, including the nature and magnitude of
contamination, and the extent, if any, to which the Company may be held
responsible for contributing to any costs incurred for remediating these sites.
Thus, no reasonable estimate of cleanup costs can now be made for these sites.
Based on currently available information, the Company believes that such costs
ultimately will not materially affect its financial position, results of
operations or cash flows. There can be no assurance, however, that future
developments, including additional information about existing sites or the
identification of new sites, will not require material revisions to such
estimates. For information about specific sites that are the subject of
remediation claims, see Note 12(h) to the Company's Consolidated Financial
Statements and Note 8(g) to Resources' Consolidated Financial Statements, each
of which is incorporated herein by reference.
Mercury Contamination. Like other natural gas pipelines, Resources'
pipeline operations have in the past employed elemental mercury in meters used
on its pipelines. Although the mercury has now been removed from the meters, it
is possible that small amounts of mercury have been spilled at some of those
sites in the course of normal maintenance and replacement operations and that
such spills have contaminated the immediate area around the meters with
elemental mercury. Such contamination has been found by Resources at some sites
in the past, and Resources has conducted remediation at sites found to be
contaminated. Although Resources is not aware of additional specific sites, it
is possible that other contaminated sites exist and that remediation costs will
be incurred for such sites. Although the total amount of such costs cannot be
known at this time, based on experience of Resources and others in the natural
gas industry to date and on the current regulations regarding remediation of
such sites, the Company and Resources believe that the cost of any remediation
of such sites will not be material to the Company's or Resources' financial
position, results of operations or cash flows.
Other. In addition, the Company has been named as a defendant in litigation
related to such sites and in recent years has been named, along with numerous
others, as a defendant in several lawsuits filed by a large number of
individuals who claim injury due to exposure to asbestos while working at sites
along the Texas Gulf Coast. Most of these claimants have been workers who
participated in construction of various industrial facilities, including power
plants, and some of the claimants have worked at locations owned by the Company.
The Company anticipates that additional claims like those received may be
asserted in the future and intends to continue its practice of 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 CONTINGENCIES
For a description of certain other legal and regulatory proceedings
affecting the Company and its subsidiaries, see Notes 3, 4, 5 and 12 to the
Company's Consolidated Financial Statements and Note 8 to Resources'
Consolidated Financial Statements, which notes are incorporated herein by
reference.
8
9
NEW ACCOUNTING ISSUES
In 1998, the Company and Resources adopted SFAS No. 130, "Reporting
Comprehensive Income" (SFAS No. 130), SFAS No. 131, "Disclosures about Segments
of an Enterprise and Related Information" (SFAS No. 131) and SFAS No. 132,
"Employers Disclosures about Pensions and Other Postretirement Benefits" (SFAS
No. 132). For further discussion of these accounting statements, see Note 15 to
the Company's Consolidated Financial Statements and Note 9 to Resources'
Consolidated Financial Statements.
In 2000, the Company and Resources expect to adopt SFAS No. 133,
"Accounting for Derivative Instruments and Hedging Activities" (SFAS No. 133),
which establishes accounting and reporting standards for derivative instruments,
including certain derivative instruments embedded in other contracts
(collectively referred to as derivatives) and for hedging activities. The
Company is in the process of determining the effect of adoption of SFAS No. 133
on its consolidated financial statements.
In December 1998, The Emerging Issues Task Force of the Financial
Accounting Standards Board reached consensus on Issue 98-10, "Accounting for
Contracts Involved in Energy Trading and Risk Management Activities" (EITF Issue
98-10). EITF Issue 98-10 requires energy trading contracts to be recorded at
fair value on the balance sheet, with the changes in fair value included in
earnings. EITF Issue 98-10 is effective for fiscal years beginning after
December 15, 1998. The Company expects to adopt EITF Issue 98-10 in the first
quarter of 1999. The Company does not expect the implementation of EITF Issue
98-10 to be material to its consolidated financial statements.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
INTEREST RATE RISK
The Company and its subsidiaries have long-term debt, Company/ Resources
obligated mandatorily redeemable preferred securities of subsidiary trusts
holding solely junior subordinated debentures of the Company/Resources (Trust
Securities), securities held in the Company's nuclear decommissioning trust,
bank facilities, certain lease obligations and interest rate swaps which subject
the Company, Resources and certain of their subsidiaries to the risk of loss
associated with movements in market interest rates.
At December 31, 1998, the Company and certain of its subsidiaries had
issued fixed-rate long-term debt (excluding ACES) and Trust Securities
aggregating $5.0 billion in principal amount and having a fair value of $5.2
billion. These instruments are fixed-rate and, therefore, do not expose the
Company and its subsidiaries to the risk of earnings loss due to changes in
market interest rates (see Notes 8 and 9 to the Company's Consolidated Financial
Statements). However, the fair value of these instruments would increase by
approximately $260.6 million if interest rates were to decline by 10% from their
levels at December 31, 1998. In general, such an increase in fair value would
impact earnings and cash flows only if the Company and its subsidiaries were to
reacquire all or a portion of these instruments in the open market prior to
their maturity.
The Company and certain of its subsidiaries' floating-rate obligations
aggregated $1.8 billion at December 31, 1998 (see Note 8 to the Company's
Consolidated Financial Statements), inclusive of (i) amounts borrowed under
short-term and long-term credit facilities of the Company and its subsidiaries
(including the issuance of commercial paper supported by such facilities), (ii)
borrowings underlying Resources' receivables facility and (iii) amounts subject
to a master leasing agreement of Resources under which lease payments vary
depending on short-term interest rates. These floating-rate obligations expose
the Company, Resources and their subsidiaries to the risk of increased interest
and lease expense in the event of increases in short-term interest rates. If the
floating rates were to increase by 10% from December 31, 1998 levels, the
Company's consolidated interest expense and expense under operating leases would
increase by a total of approximately $0.9 million each month in which such
increase continued.
As discussed in Notes 1(o), 4(c) and 13 to the Company's Consolidated
Financial Statements, the Company contributes $14.8 million per year to a trust
established to fund the Company's share of the decommissioning costs for the
South Texas Project. The securities held by the trust for decommissioning costs
had an estimated fair value of $119.1 million as of December 31, 1998, of which
approximately 44% were fixed-rate debt securities that subject the Company to
risk of loss of fair value with movements in market interest rates. If interest
rates were to increase by 10% from their levels at December 31, 1998, the
decrease in fair value of the fixed-rate debt securities would not be material
to the Company. In addition, the risk of an economic loss is mitigated at this
time as a result of the Company's regulated status. Any unrealized gains or
losses are accounted for in accordance with SFAS No. 71 as a regulatory
asset/liability because the Company believes that its future contributions which
are currently recovered through the rate-making process will be adjusted for
these gains and losses.
9
10
Certain subsidiaries of the Company have entered into interest rate swaps
for the purpose of decreasing the amount of debt subject to interest rate
fluctuations. At December 31, 1998, these interest rate swaps had an aggregate
notional amount of $75.4 million, which the Company could terminate at a cost of
$3.2 million (see Notes 2 and 13 to the Company's Consolidated Financial
Statements). An increase of 10% in the December 31, 1998 level of interest rates
would not increase the cost of termination of the swaps by a material amount to
the Company. Swap termination costs would impact the Company's and its
subsidiaries' earnings and cash flows only if all or a portion of the swap
instruments were terminated prior to their expiration.
As discussed in Note 8(h) to the Company's Consolidated Financial
Statements, Resources sold $500 million aggregate principal amount of its 6 3/8%
TERM Notes which included an embedded option to remarket the securities. The
option is expected to be exercised in the event that the ten-year Treasury rate
in 2003 is below 5.66%. At December 31, 1998, the Company could terminate the
option at a cost of $30.7 million. A decrease of 10% in the December 31, 1998
level of interest rates would not increase the cost of termination of the option
by a material amount to the Company.
The change in exposure to loss in earnings and cash flows related to
interest rate risk from December 31, 1997 to December 31, 1998 is not material
to the Company.
EQUITY MARKET RISK
The Company holds an investment in TW Preferred which is convertible into
Time Warner common stock (TW Common) as described in "Management's Discussion
and Analysis of Financial Condition and Results of Operations of the Company --
Certain Factors Affecting Future Earnings of the Company and its Subsidiaries --
Accounting Treatment of ACES" in Item 7 of this Form 10-K. As a result, the
Company is exposed to losses in the fair value of this security. For purposes of
analyzing market risk in this Item 7A, the Company assumed that the TW Preferred
was converted into TW Common. In addition, Resources' investment in the common
stock of Itron, Inc. (Itron) exposes the Company and Resources to losses in the
fair value of Itron common stock. A 10% decline in the market value per share of
TW Common and Itron common stock from the December 31, 1998 levels would result
in a loss in fair value of approximately $284.4 million and $1.1 million,
respectively.
The Company's and its subsidiaries' ability to realize gains and losses
related to the TW Preferred and the Itron common stock is limited by the
following: (i) the TW Preferred is not publicly traded and its sale is subject
to certain limitations and (ii) the market for the common stock of Itron is
fairly illiquid.
The ACES expose the Company to accounting losses as the Company is required
to record in Other Income (Expense) an unrealized accounting loss equal to (i)
the aggregate amount of the increase in the market price of TW Common above
$27.7922 as applicable to all ACES multiplied by (ii) 0.8264. Prior to the
conversion of the TW Preferred into TW Common, such loss would affect earnings.
After conversion, such loss would be recognized as an adjustment to common stock
equity through a reduction of other comprehensive income. However, there would
be an offsetting increase in common stock equity through an increase in
accumulated other comprehensive income on the Company's Statements of
Consolidated Retained Earnings and Comprehensive Income for the fair value
increase in the investment in TW Common. For additional information on the
accounting treatment of the ACES and related accounting losses recorded in 1998,
see Note 1(n) to the Company's Consolidated Financial Statements. An increase of
15% in the price of the TW Common above its December 31, 1998 market value of
$62.062 per share would result in the recognition of an additional unrealized
accounting loss (net of tax) of approximately $229.1 million. The Company
believes that this additional unrealized loss for the ACES would be more than
economically hedged by the unrecorded unrealized gain relating to the increase
in the fair value of the TW Common underlying the investment in TW Preferred
since the date of its acquisition.
For a discussion of the non-cash, unrealized accounting loss recorded in
1998 and 1997 related to the ACES, see "-- Certain Factors Affecting Future
Earnings of the Company and its Subsidiaries -- Accounting Treatment of ACES" in
Item 7 of this Form 10-K.
As discussed above under "-- Interest Rate Risk," the Company contributes
to a trust established to fund the Company's share of the decommissioning costs
for the South Texas Project which held debt and equity securities as of December
31, 1998. The equity securities expose the Company to losses in fair value. If
the market prices of the individual equity securities were to decrease by 10%
from their levels at December 31, 1998, the resulting loss in fair value of
these securities would not be material to the Company. Currently, the risk of an
economic loss is mitigated as a result of the Company's regulated status as
discussed above under "--Interest Rate Risk."
10
11
FOREIGN CURRENCY EXCHANGE RATE RISK
As further described in "Certain Factors Affecting Future Earnings of the
Company and Its Subsidiaries -- Risks of International Operations" in Item 7 of
this Form 10-K, the Company, through Reliant Energy International invests in
certain foreign operations which to date have been primarily in South America.
As of December 31, 1998, the Company's Consolidated Balance Sheets reflected
$1.1 billion of foreign investments, a substantial portion of which represent
investments accounted for under the equity method. These foreign investments
expose the Company to risk of loss in earnings and cash flows due to the
fluctuation in foreign currencies relative to the Company's consolidated
reporting currency, the U.S. dollar. The Company accounts for adjustments
resulting from translation of its investments with functional currencies other
than the U.S. dollar as a charge or credit directly to a separate component of
stockholders' equity. For further discussion of the accounting for foreign
currency adjustments, see Note 1(p) in the Notes to the Company's Consolidated
Financial Statements. The cumulative translation loss of $34 million, recorded
as of December 31, 1998, will be realized as a loss in earnings and cash flows
only upon the disposition of the related investment. The foreign currency loss
in earnings and cash flows related to debt obligations held by foreign
operations in currencies other than their own functional currencies was not
material to the Company as of December 31, 1997.
In addition, certain of Reliant Energy International's foreign operations
have entered into obligations in currencies other than their own functional
currencies which expose the Company to a loss in earnings. In such cases, as the
respective investment's functional currency devalues relative to the non-local
currencies, the Company will record its proportionate share of its investments'
foreign currency transaction losses related to the non-local currency
denominated debt. At December 31, 1998, Light and Metropolitana had borrowings
of approximately $3.2 billion denominated in non-local currencies. Because of
the devaluation of the Brazilian real subsequent to December 31, 1998, Light and
Metropolitana are expected to record a charge to earnings for the quarter ended
March 31, 1999, primarily related to foreign currency transaction losses on
their non-local currency denominated debt. For further discussion and analysis
of the possible effect on the Company's Consolidated Financial Statements, see
"Certain Factors Affecting Future Earnings of the Company and Its Subsidiaries
- -- Risks of International Operations" in Item 7 of this Form 10-K.
The company attempts to manage and mitigate this foreign risk by properly
balancing the higher cost of financing with local denominated debt against the
risk of devaluation of that local currency and including a measure of the risk
of devaluation in all its financial plans. In addition, where possible, Reliant
Energy International attempts to structure its tariffs and revenue contracts to
ensure some measure of adjustment due to changes in inflation and currency
exchange rates; however, there can be no assurance that such efforts will
compensate for the full effect of currency devaluation, if any.
ENERGY COMMODITY PRICE RISK
As further described in Note 2 to the Company's Consolidated Financial
Statements, certain of the Company's subsidiaries utilize a variety of
derivative financial instruments (Derivatives), including swaps and
exchange-traded futures and options, as part of the Company's overall hedging
strategies and for trading purposes. To reduce the risk from the adverse effect
of market fluctuations in the price of electric power, natural gas, crude oil
and refined products and related transportation, Resources and certain
subsidiaries of the Company and Resources enter into futures transactions,
forward contracts, swaps and options (Energy Derivatives) in order to hedge
certain commodities in storage, as well as certain expected purchases, sales and
transportation of energy commodities (a portion of which are firm commitments at
the inception of the hedge). The Company's policies prohibit the use of
leveraged financial instruments. In addition, Reliant Energy Services, a
subsidiary of Resources, maintains a portfolio of Energy Derivatives to provide
price risk management services and for trading purposes (Trading Derivatives).
The Company uses value-at-risk and a sensitivity analysis method for
assessing the market risk of its derivatives.
11
12
With respect to the Energy Derivatives (other than Trading Derivatives)
held by subsidiaries of the Company and Resources as of December 31, 1998, a
decrease of 10% in the market prices of natural gas and electric power from
year-end levels would decrease the fair value of these instruments by
approximately $3 million. As of December 31, 1997, a decrease of 10% in the
prices of natural gas would have resulted in a loss of $7 million in fair values
of the Energy Derivatives (other than for trading purposes).
The above analysis of the Energy Derivatives utilized for hedging purposes
does not include the favorable impact that the same hypothetical price movement
would have on the Company's and its subsidiaries' physical purchases and sales
of natural gas and electric power to which the hedges relate. The portfolio of
Energy Derivatives held for hedging purposes is no greater than the notional
quantity of the expected or committed transaction volume of physical commodities
with equal and opposite commodity price risk for the same time periods.
Furthermore, the Energy Derivative portfolio is managed to complement the
physical transaction portfolio, reducing overall risks within limits. Therefore,
the adverse impact to the fair value of the portfolio of Energy Derivatives held
for hedging purposes associated with the hypothetical changes in commodity
prices referenced above would be offset by a favorable impact on the underlying
hedged physical transactions, assuming (i) the Energy Derivatives are not closed
out in advance of their expected term, (ii) the Energy Derivatives continue to
function effectively as hedges of the underlying risk and (iii) as applicable,
anticipated transactions occur as expected.
The disclosure with respect to the Energy Derivatives relies on the
assumption that the contracts will exist parallel to the underlying physical
transactions. If the underlying transactions or positions are liquidated prior
to the maturity of the Energy Derivatives, a loss on the financial instruments
may occur, or the options might be worthless as determined by the prevailing
market value on their termination or maturity date, whichever comes first.
With respect to the Trading Derivatives held by Reliant Energy Services,
consisting of natural gas, electric power, crude oil and refined products,
physical forwards, swaps, options and exchange-traded futures, this subsidiary
is exposed to losses in fair value due to changes in the price and volatility of
the underlying derivatives. During the year ended December 31, 1998 and 1997,
the highest, lowest and average monthly value-at-risk in the Trading Derivative
portfolio was less than $5 million at a 95% confidence level and for a holding
period of one business day. The Company uses the variance/covariance method for
calculating the value-at-risk and includes the delta approximation for options
positions.
The Company has established a Corporate Risk Oversight Committee comprised
of corporate and business segment officers that oversees all corporate price and
credit risk activities, including derivative trading activities discussed above.
The committee's duties are to establish the Company's policies and to monitor
and ensure compliance with risk management policies and procedures and the
trading limits established by the Company's board of directors.
12
13
ITEM 7. MANAGEMENT'S NARRATIVE ANALYSIS OF THE RESULTS OF OPERATIONS OF RELIANT
ENERGY RESOURCES CORP. AND CONSOLIDATED SUBSIDIARIES.
The following narrative and analysis should be read in combination with the
consolidated financial statements and notes (Resources' Consolidated Financial
Statements) of Reliant Energy Resources Corp. (formerly NorAm Energy Corp.)
(Resources) contained in Item 8 of the Form 10-K of Resources.
RELIANT ENERGY RESOURCES CORP.
On August 6, 1997 (Acquisition Date), the former parent corporation (Former
Parent) of Houston Industries Incorporated d/b/a Reliant Energy, Incorporated
(Reliant Energy) merged with and into Reliant Energy, and NorAm Energy Corp.
(Former Resources) merged with and into Resources. Effective upon the mergers
(collectively, the Merger), each outstanding share of common stock of Former
Parent was converted into one share of common stock (including associated
preference stock purchase rights) of Reliant Energy, and each outstanding share
of common stock of Former Resources was converted into the right to receive
$16.3051 cash or 0.74963 shares of common stock of Reliant Energy. The aggregate
consideration paid to Former Resources stockholders in connection with the
Merger consisted of $1.4 billion in cash and 47.8 million shares of Reliant
Energy's common stock valued at approximately $1.0 billion. The overall
transaction was valued at $4.0 billion consisting of $2.4 billion for Former
Resources' common stock and common stock equivalents and $1.6 billion of Former
Resources debt ($1.3 billion of which was long-term debt.)
The Merger was recorded under the purchase method of accounting with assets
and liabilities of Resources reflected at their estimated fair values as of the
Acquisition Date, resulting in a "new basis" of accounting. In Resources'
Consolidated Financial Statements, periods which reflect the new basis of
accounting are labeled as "Current Resources" and periods which do not reflect
the new basis of accounting are labeled as "Former Resources." Former Resources'
Statement of Consolidated Income for the seven months ended July 31, 1997
included certain adjustments from August 1, 1997 to the Acquisition Date for
pre-merger transactions.
Effective January 1, 1998, Resources adopted SFAS No. 131, "Disclosures
about Segments of an Enterprise and Related Information" (SFAS No. 131). Because
Resources is a wholly owned subsidiary of Reliant Energy, Resources'
determination of reportable segments considers the strategic operating units
under which Reliant Energy manages sales of various products and services to
wholesale or retail customers in differing regulatory environments. In
accordance with SFAS No. 131, Reliant Energy has identified the following
reportable segments: Electric Operations, Natural Gas Distribution, Interstate
Pipelines, Wholesale Energy Marketing and Generation (Wholesale Energy),
International and Corporate. Of these segments, the following operations are
conducted by Resources: Natural Gas Distribution, Interstate Pipelines,
Wholesale Energy (which includes the energy trading and marketing operations and
natural gas gathering operations of the Wholesale Energy segment but excludes
the operations of Reliant Energy Power Generation, Inc.) and Corporate
(excluding the impact of ACES).
Resources meets the conditions specified in General Instruction I to Form
10-K and is thereby permitted to use the reduced disclosure format for wholly
owned subsidiaries of reporting companies specified therein. Accordingly,
Resources has omitted from this Combined Annual Report the information called
for by Item 4 (submission of matters to a vote of security holders), Item 10
(directors and executive officers), Item 11 (executive compensation), Item 12
(security ownership of certain beneficial owners and management) and Item 13
(certain relationships and related transactions) of Form 10-K. In lieu of the
information called for by Item 6 (selected financial data) and Item 7
(management's discussion and analysis of financial condition and results of
operations) of Form 10-K, Resources has included the following Management's
Narrative Analysis of the Results of Operations to explain material changes in
the amount of revenue and expense items of Resources between 1998 and 1997.
Reference is hereby made to Item 1 (business), Item 2 (properties), Item 3
(legal proceedings), Item 5 (market for common equity and related stockholder
matters), Item 7A (quantitative and qualitative disclosures about market risk)
and Item 9 (changes in and disagreements with accountants on accounting and
financial disclosure) of this Combined Annual Report for additional information
regarding Resources required by the reduced disclosure format of General
Instruction I to Form 10-K.
CONSOLIDATED RESULTS OF OPERATIONS
Seasonality and Other Factors. Resources' results of operations are
affected by seasonal fluctuations in the demand for and, to a lesser
extent, the price of natural gas. Resources' results of operations are also
affected by,
14
among other things, the actions of various federal and state governmental
authorities having jurisdiction over rates charged by Resources and its
subsidiaries, competition in Resources' various business operations, debt
service costs and income tax expense. For a discussion of certain other factors
that may affect Resources' future earnings see "Management's Discussion and
Analysis of Financial Condition and Results of Operations of the Company --
Certain Factors Affecting Future Earnings of the Company and its Subsidiaries
- -- Competition -- Other Operations"; "-- Impact of the Year 2000 Issue and Other
System Implementation Issues" and "-- Environmental Expenditures -- Mercury
Contamination" in Item 7 of Reliant Energy's Form 10-K.
Accounting Impact of the Merger. The Merger created a new basis of
accounting for Resources, resulting in new carrying values for certain of
Resources' assets, liabilities and equity commencing upon the Acquisition Date.
Resources' financial statements for periods subsequent to the Acquisition Date
are not comparable to prior periods because of the following purchase
accounting adjustments:
1. The impact of the amortization of newly-recognized goodwill ($39.4
million);
2. The amortization (to interest expense) of the revaluation of
long-term debt ($9.8 million);
3. The removal of the amortization (to operating expense) previously
associated with the pension and postretirement obligations ($2.1
million); and
4. The deferred income tax expense associated with these adjustments
($4.9 million).
Interest expense and related debt incurred by Reliant Energy to fund the cash
portion of the purchase consideration has not been pushed down to Resources and
its subsidiaries.
Because results of operations and other financial information for periods
before and after the Acquisition Date are not comparable, Resources is
presenting certain financial data on: (i) an actual basis for Resources for
1998 and 1997 and (ii) a pro forma basis for 1997 as if the Merger had taken
place at the beginning of the period. These results do not necessarily reflect
the results which would have been obtained if the Merger had actually occurred
on the dates indicated or the results that may be expected in the future.
The following table sets forth selected financial and operating data on an
actual and pro forma basis for the years ended December 31, 1998 and 1997,
followed by a discussion of significant variances in period-to-period results:
SELECTED FINANCIAL RESULTS:
UNAUDITED
ACTUAL PRO FORMA (1)
--------------------------------------------- --------------
YEAR FIVE MONTHS SEVEN MONTHS YEAR ACTUAL TO
ENDED ENDED ENDED ENDED PRO FORMA
DECEMBER 31, DECEMBER 31, JULY 31, DECEMBER 31, PERCENTAGE
----------- ----------- ----------- ----------- CHANGE
1998 1997 1997 1997
----------- ----------- ----------- -----------
(THOUSANDS OF DOLLARS)
Operating Revenues .................. $ 6,758,412 $ 2,526,182 $ 3,313,591 $ 5,839,773 16%
Operating Expenses .................. 6,448,107 2,434,282 3,141,295 5,597,716 15%
Operating Income .................... 310,305 91,900 172,296 242,057 28%
Merger Transaction Costs (2) ........ 1,144 17,256
Consolidated ........................ 310,305 90,756 155,040 242,057 28%
Interest Expense, Net ............... 111,337 47,490 78,660 112,996 (1%)
Distributions on Subsidiary Trust
Securities .......................... 632 279 6,317 1,479 (57%)
Other (Income) and Deductions ....... (7,318) (2,243) (7,210) (9,453) (23%)
Income Tax Expense .................. 111,830 24,383 31,398 71,093 57%
Extraordinary (Gain), Less Taxes .... (237)
----------- ----------- ----------- -----------
Net Income ........................ $ 93,824 $ 20,847 $ 46,112 $ 65,942 42%
=========== =========== =========== ===========
2
15
- ----------
(1) Pro forma results reflect purchase accounting adjustments as if the Merger
had occurred on January 1, 1997.
(2) For expenses associated with the completion of the business combination
with Reliant Energy, see Note 1(o) to Resources' Consolidated Financial
Statements.
1998 Compared to 1997 (Actual). Resources' consolidated net income for 1998 was
$94 million compared to consolidated net income of $67 million in 1997. The
increase in net income for 1998 as compared to 1997 was due to increased
operating income from several business segments as discussed below, partially
offset by a decrease in operating income from Resources' Natural Gas
Distribution segment due to the effects of warm weather. Also contributing to
the increase in net income was a reduction in interest expense due to the
refinancing of debt and reduced interest expense due to debt fair value
devaluation at the time of the Merger.
Resources operating revenues for 1998 were $6.8 billion as compared to
$5.8 billion in 1997. The $900 million, or 16% increase was primarily
attributable to a $1.4 billion increase in wholesale trading revenue. Wholesale
trading revenue increased due to increased power and natural gas trading
volumes. The increase in trading revenues was offset by reduced revenues at
Resources' Natural Gas Distribution unit of approximately $400 million,
principally due to warmer weather.
Resources operating expenses for 1998 were $6.4 billion compared to $5.6
billion in 1997. The $800 million, or 16% increase was primarily due to
increased natural gas and purchased power expenses associated with increased
wholesale trading activities. The increase in operating expenses was offset by
decreased natural gas purchases at Resources' Natural Gas Distribution unit
because of lower volumes resulting from the warmer weather.
Operating income increased in 1998 by $65 million over 1997 due to improved
operating results at Interstate Pipelines, Corporate retail operations and
Wholesale Energy, partially offset by the unfavorable effects of warm weather on
the operations of Natural Gas Distribution. Operating income for 1997 included
approximately $18 million of merger-related costs that did not recur in 1998.
Improved results at Interstate Pipelines were due to continued cost control
initiatives and reduced benefits expenses, as well as the effects of a rate case
settlement and a dispute settlement which contributed to the increase in
operating income. In addition, margins at Wholesale Energy improved over margins
in 1997; however, this effect was partially offset by increased staffing
expenses to support increased sales and marketing efforts and an increase in
credit reserves. Improved results at Wholesale Energy were also due to the fact
that operating income in 1997 for Wholesale Energy was negatively impacted by
hedging losses associated with sales under peaking contracts and losses from the
sale of natural gas held in storage and unhedged in the first quarter of 1997
totaling $17 million.
1998 (Actual) Compared to 1997 (Pro Forma). Resources' consolidated net income
for 1998 was $94 million compared to pro forma net income of $66 million in
1997. The increase in earnings for 1998 as compared to pro forma 1997 was due
to increased operating income from several business segments, as discussed
below, offset by the effects of unfavorable weather at Resources' Natural Gas
Distribution unit. Also contributing to the increase in earnings is a
reduction in interest expense due to the refinancing of debt.
Resources operating revenues for 1998 were $6.8 billion compared to pro
forma operating revenues of $5.8 billion in 1997. The $919 million, or 16%
increase was primarily attributable to an $1.4 billion increase in wholesale
trading revenue. Wholesale trading revenue increased due to increased electric
and natural gas trading volumes. The increase in trading revenues was offset by
reduced revenues at Resources' Natural Gas Distribution unit of approximately
$400 million, principally due to warmer weather.
Resources operating expenses for 1998 were $6.4 billion compared to pro
forma operating expense of $5.6 billion in 1997. The $800 million, or 16%
increase was primarily due to increased natural gas and purchased power
expenses associated with increased wholesale trading activities. The increase
in operating expense was offset by decreased natural gas purchases at
Resources' Natural Gas Distribution unit because of lower volumes resulting
from warmer weather.
3
16
Operating income increased in 1998 by $68 million over pro forma 1997 due
to improved operating results at Interstate Pipelines, Corporate retail
operations and Wholesale Energy, partially offset by the unfavorable effects of
Warm weather on the operations of Natural Gas Distribution. Improved results at
Interstate Pipelines are due to continued cost control initiatives and reduced
benefits expenses as well as the effects of a rate case settlement and a dispute
settlement. In addition, margins at Wholesale Energy improved over margins in
1997, however, this effect was partially offset by increased staffing expenses
to support increased sales and marketing efforts and an increase in credit
reserves at Wholesale Energy also contributed to the increase in operating
income. Operating income in 1997 for Wholesale Energy was negatively impacted by
hedging losses associated with sales under peaking contracts and losses from the
sale of natural gas held in storage and unhedged in the first quarter of 1997
totaling $17 million.
Resources estimates that its total direct cost of resolving the Year 2000
issues will be between $5 and $6 million. This estimate includes approximately
$3.4 million spent through year-end 1998. For additional information regarding
Year 2000 issues, see "Management's Discussion and Analysis of Financial
Condition and Results of Operations of the Company -- Certain Factors Affecting
Future Earnings of the Company and its Subsidiaries -- Impact of the Year 2000
Issue and Other System Implementation Issues" in Item 7 of the Form 10-K of
Reliant Energy, which has been jointly filed with the Resources Form 10-K.
NEW ACCOUNTING ISSUES
Reference is made to "Management's Discussion and Analysis of Financial
Condition and Results of Operations of the Company -- New Accounting Issues" in
Item 7 of the Form 10-K of Reliant Energy, which has been jointly filed with
the Resources Form 10-K, for discussion of certain new accounting issues.
RESOURCES 10-K NOTES
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(c) Regulatory Assets and Regulation.
In general, Resources' Interstate Pipelines operations are subject to
regulation by the Federal Energy Regulatory Commission, while its Natural Gas
Distribution operations are subject to regulation at the state or municipal
level. Historically, all of Resources' rate-regulated businesses have followed
the accounting guidance contained in Statement of Financial Accounting Standards
No. 71, "Accounting for the Effects of Certain Types of Regulation" (SFAS No.
71). Resources discontinued application of SFAS No. 71 to REGT in 1992. As a
result of the continued application of SFAS No. 71 to MRT and the Natural Gas
Distribution operations, Resources' financial statements contain assets and
liabilities which would not be recognized by unregulated entities.
At December 31, 1998 Resources' Consolidated Balance Sheet included
approximately $12 million in regulatory assets recorded as deferred debits.
These assets represent probable future revenue to Resources associated with
certain incurred costs as these costs are recovered through the rate making
process. These costs are being recovered through rates over varying periods up
to 40 years.
(2) DERIVATIVE FINANCIAL INSTRUMENTS
(a) Price Risk Management and Trading Activities.
Resources, through its subsidiary, Reliant Energy Services, offers energy
price risk management services primarily in the natural gas, electric and crude
oil and refined product industries. Reliant Energy Services provides these
services by utilizing a variety of derivative financial instruments, including
fixed and variable-priced physical forward contracts, fixed-price swap
agreements, variable-price swap agreements, exchange-traded energy futures and
option contracts, and swaps and options traded in the over-the-counter financial
markets (Trading Derivatives). Fixed-price swap agreements require payments to,
or receipts of payments from, counterparties based on the differential between a
fixed and variable price for the commodity. Variable-price swap agreements
require payments to, or receipts of payments from, counterparties based on the
differential between industry pricing publications or exchange quotations.
Prior to 1998 Reliant Energy Services applied hedge accounting to certain
physical commodity activities that qualified for hedge accounting. In 1998,
Reliant Energy Services adopted mark-to-market accounting for all of its price
risk management and trading activities. Accordingly, as of such date, such
Trading Derivatives are recorded at fair value with realized and unrealized
gains (losses) recorded as a component of operating revenues in Resources'
Consolidated Statements of Income. The recognized, unrealized balance is
recorded as price risk management assets/liabilities and deferred debits/credits
on Resources' Consolidated Balance Sheets (See Note 1(r)).
The notional quantities, maximum terms and the estimated fair value of
Trading Derivatives at December 31, 1998 are presented below (volumes in
billions of British thermal units equivalent (BBtue) and dollars in millions):
VOLUME-FIXED
VOLUME-FIXED PRICE MAXIMUM
1998 PRICE PAYOR RECEIVER TERM (YEARS)
---- ----------- -------- ------------
Natural gas.................................................. 937,264 977,293 9
Electricity.................................................. 122,950 124,878 3
Crude oil and products....................................... 205,499 204,223 3
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AVERAGE FAIR
FAIR VALUE VALUE (a)
--------------------------- ---------------------------
1998 ASSETS LIABILITIES ASSETS LIABILITIES
---- ------ ----------- ------ -----------
Natural gas.............................................. $ 224 $ 213 $ 124 $ 108
Electricity.............................................. 34 33 186 186
Crude oil and products................................... 29 23 21 17
--------- --------- --------- ---------
$ 287 $ 269 $ 331 $ 311
The notional quantities, maximum terms and the estimated fair value of
derivative financial instruments at December 31, 1997 are presented below
(volumes in BBtue and dollars in millions):
VOLUME-FIXED
VOLUME-FIXED PRICE MAXIMUM
1997 PRICE PAYOR RECEIVER TERM (YEARS)
----
Natural gas.................................................. 85,701 64,890 4
Electricity.................................................. 40,511 42,976 1
AVERAGE FAIR
FAIR VALUE VALUE (A)
--------------------------- ---------------------------
1997 ASSETS LIABILITIES ASSETS LIABILITIES
---- ------ ----------- ------ -----------
Natural gas.............................................. $ 46 $ 39 $ 56 $ 48
Electricity.............................................. 6 6 3 2
------- ------- ------- -------
$ 52 $ 45 $ 59 $ 50
- ---------
(a) Computed using the ending balance of each month.
In addition to the fixed-price notional volumes above, Reliant Energy
Services also has variable-priced agreements, as discussed above, totaling
1,702,977 and 101,465 BBtue as of December 31, 1998 and 1997, respectively.
Notional amounts reflect the volume of transactions but do not represent the
amounts exchanged by the parties to the financial instruments. Accordingly,
notional amounts do not accurately measure Resources' exposure to market or
credit risks.
All of the fair values shown in the table above at December 31, 1998 and
substantially all at December 31, 1997 have been recognized in income. The fair
value as of December 31, 1998 and 1997 was estimated using quoted prices where
available and considering the liquidity of the market for the Trading
Derivatives. The prices are subject to significant changes based on changing
market conditions.
At December 31, 1998, $22 million of the fair value of the assets and $41
million of the fair value of the liabilities are recorded as long-term in
deferred debits and deferred credits, respectively, on Resources' Consolidated
Balance Sheets.
The weighted-average term of the trading portfolio, based on volumes, is
less than one year. The maximum and average terms disclosed herein are not
indicative of likely future cash flows, as these positions may be changed by
new transactions in the trading portfolio at any time in response to changing
market conditions, market liquidity and Resources' risk management portfolio
needs and strategies. Terms regarding cash settlements of these contracts vary
with respect to the actual timing of cash receipts and payments.
In addition to the risk associated with price movements, credit risk is
also inherent in Resources', and its subsidiaries' risk management activities.
Credit risk relates to the risk of loss resulting from non-performance of
contractual obligations by a counterparty. The following table shows the
composition of the total price risk management assets of Reliant Energy
Services as of December 31, 1998.
5
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INVESTMENT
GRADE (1) TOTAL
----------------- -----------------
(THOUSANDS OF DOLLARS)
Energy marketers.......................................................... $ 102,458 $ 123,779
Financial institutions.................................................... 61,572 61,572
Gas and electric utilities................................................ 46,880 48,015
Oil and gas producers..................................................... 7,197 8,323
Industrials............................................................... 1,807 3,233
Independent power producers............................................... 1,452 1,463
Others.................................................................... 45,421 46,696
------------- -------------
Total................................................................ $ 266,787 293,081
=============
Credit and other reserves................................................. (6,464)
-------------
Energy price risk management assets(2).................................... $ 286,617
=============
- ---------
(1) "Investment Grade" is primarily determined using publicly available credit
ratings along with the consideration of credit support (e.g., parent
company guarantees) and collateral, which encompass cash and standby
letters of credit.
(2) Resources has credit risk exposure with respect to two investment grade
customers, each of which represents an amount greater than 5% but less than
10% of Price Risk Management Assets.
(b) Non-Trading Activities.
To reduce the risk from market fluctuations in the price of electric
power, natural gas and related transportation, Resources and certain of its
subsidiaries enter into futures transactions, swaps and options (Energy
Derivatives) in order to hedge certain natural gas in storage, as well as
certain expected purchases, sales and transportation of natural gas and
electric power (a portion of which are firm commitments at the inception of the
hedge). Energy Derivatives are also utilized to fix the price of compressor
fuel or other future operational gas requirements, although usage to date for
this purpose has not been material. Resources applies hedge accounting with
respect to its derivative financial instruments.
Certain subsidiaries of Resources also utilize interest rate derivatives
(principally interest rate swaps) in order to adjust the portion of its overall
borrowings which are subject to interest rate risk and also utilize such
derivatives to effectively fix the interest rate on debt expected to be issued
for refunding purposes.
For transactions involving either Energy Derivatives or interest rate
derivatives, hedge accounting is applied only if the derivative (i) reduces the
price risk of the underlying hedged item and (ii) is designated as a hedge at
its inception. Additionally, the derivatives must be expected to result in
financial impacts which are inversely correlated to those of the item(s) to be
hedged. This correlation (a measure of hedge effectiveness) is measured both at
the inception of the hedge and on an ongoing basis, with an acceptable level of
correlation of at least 80% for hedge designation. If and when correlation
ceases to exist at an acceptable level, hedge accounting ceases and
mark-to-market accounting is applied.
In the case of interest rate swaps associated with existing obligations,
cash flows and expenses associated with the interest rate derivative
transactions are matched with the cash flows and interest expense of the
obligation being hedged, resulting in an adjustment to the effective interest
rate. When interest rate swaps are utilized to effectively fix the interest
rate for an anticipated debt issuance, changes in the market value of the
interest rate derivatives are deferred and recognized as an adjustment to the
effective interest rate on the newly issued debt.
Unrealized changes in the market value of Energy Derivatives utilized as
hedges are not generally recognized in Resources' Consolidated Statements of
Income until the underlying hedged transaction occurs. Once it becomes
6
19
probable that an anticipated transaction will not occur, deferred gains and
losses are recognized. In general, the financial impact of transactions
involving these Energy Derivatives is included in Resources' Statements of
Consolidated Income under the captions (i) fuel expenses, in the case of
natural gas transactions and (ii) purchased power, in the case of electric
power transactions. Cash flows resulting from these transactions in Energy
Derivatives are included in Resources' Statements of Consolidated Cash Flows in
the same category as the item being hedged.
At December 31, 1998, subsidiaries of Resources were fixed-price payors
and fixed-price receivers in Energy Derivatives covering 42,498 billion British
thermal units (BBtu) and 3,930 BBtu of natural gas, respectively. At December
31, 1997, subsidiaries of Resources were fixed-price payors and fixed-price
receivers in Energy Derivatives covering 38,754 BBtu and 7,647 BBtu of natural
gas, respectively. Also, at December 31, 1998 and 1997, subsidiaries of
Resources were parties to variable-priced Energy Derivatives totaling 21,437
BBtu and 3,630 BBtu of natural gas, respectively. The weighted average maturity
of these instruments is less than one year.
The notional amount is intended to be indicative of Resources' and its
subsidiaries' level of activity in such derivatives, although the amounts at
risk are significantly smaller because, in view of the price movement
correlation required for hedge accounting, changes in the market value of these
derivatives generally are offset by changes in the value associated with the
underlying physical transactions or in other derivatives. When Energy
Derivatives are closed out in advance of the underlying commitment or
anticipated transaction, however, the market value changes may not offset due
to the fact that price movement correlation ceases to exist when the positions
are closed, as further discussed below. Under such circumstances, gains
(losses) are deferred and recognized as a component of income when the
underlying hedged item is recognized in income.
The average maturity discussed above and the fair value discussed in Note
10 are not necessarily indicative of likely future cash flows as these
positions may be changed by new transactions in the trading portfolio at any
time in response to changing market conditions, market liquidity and Resources'
risk management portfolio needs and strategies. Terms regarding cash
settlements of these contracts vary with respect to the actual timing of cash
receipts and payments.
(c) Trading and Non-trading -- General Policy.
In addition to the risk associated with price movements, credit risk is
also inherent in Resources' and its subsidiaries' risk management activities.
Credit risk relates to the risk of loss resulting from non-performance of
contractual obligations by a counterparty. While as yet Resources and its
subsidiaries have experienced only minor losses due to the credit risk
associated with these arrangements, Resources has off-balance sheet risk to the
extent that the counterparties to these transactions may fail to perform as
required by the terms of each such contract. In order to minimize this risk,
Resources and/or its subsidiaries, as the case may be, enter into such
contracts primarily with those counterparties with a minimum Standard & Poor's
or Moody's rating of BBB- or Baa3, respectively. For long-term arrangements,
Resources and its subsidiaries periodically review the financial condition of
such firms in addition to monitoring the effectiveness of these financial
contracts in achieving Resources' objectives. Should the counterparties to
these arrangements fail to perform, Resources would seek to compel performance
at law or otherwise or obtain compensatory damages in lieu thereof. Resources
might be forced to acquire alternative hedging arrangements or be required to
honor the underlying commitment at then-current market prices. In such event,
Resources might incur additional loss to the extent of amounts, if any, already
paid to the counterparties. In view of its criteria for selecting
counterparties, its process for monitoring the financial strength of these
counterparties and its experience to date in successfully completing these
transactions, Resources believes that the risk of incurring a significant
financial statement loss due to the non-performance of counterparties to these
transactions is minimal.
Resources' policies prohibit the use of leveraged financial instruments.
(4) LONG-TERM AND SHORT-TERM FINANCING
(a) Short-term Financing.
In 1998, Resources met its short-term financing needs primarily through a
bank facility, bank lines of credit, a receivables facility and the issuance of
commercial paper. In March 1998, Resources replaced its $400 million revolving
credit facility with a five-year $350 million revolving credit facility
(Resources Credit Facility). Borrowings under the Resources Credit Facility are
unsecured and bear interest at a rate based upon either the London interbank
offered rate (LIBOR) plus a margin, a base rate or a rate determined through a
bidding process. The Resources Credit Facility is used to support Resources'
issuance of up to $350 million of commercial paper. There were no commercial
paper borrowings and no loans outstanding under the Resources Credit Facility
at December 31, 1998. Borrowings under Resources' prior credit facility at
December 31, 1997 were $340 million. In addition, Resources had $50 million of
outstanding loans under uncommitted lines of credit at December 31, 1997 having
a weighted average interest rate of 6.82%.
7
20
A $65 million committed bank facility under which Resources obtained
letters of credit and all of Resources' uncommitted lines of credit were
terminated in 1998. Subsequent to the December 1998 termination, Resources
obtained letters of credit under an uncommitted line. Resources expects to amend
the Resources Credit Facility in March 1999 to add a $65 million letter of
credit subfacility.
Under a trade receivables facility (Receivables Facility) which expires in
August 1999, Resources sells, with limited recourse, an undivided interest
(limited to a maximum of $300 million) in a designated pool of accounts
receivable. The amount of receivables sold and uncollected was $300 million at
December 31, 1998 and at December 31, 1997. The weighted average interest rate
was approximately 5.54% at December 31, 1998 and 5.65% at December 31, 1997.
Certain of Resources' remaining receivables serve as collateral for receivables
sold and represent the maximum exposure to Resources should all receivables sold
prove ultimately uncollectible. Resources has retained servicing responsibility
under the Receivables Facility for which it is paid a servicing fee. Pursuant to
SFAS No. 125, "Accounting for Transfers and Servicing of Financial Assets and
Extinguishment of Liabilities", Resources accounts for amounts transferred
pursuant to the Receivables Facility as collateralized borrowings. As a result,
these receivables are recorded as assets on Resources' Consolidated Balance
Sheet and amounts received by Resources pursuant to this facility are recorded
as a current liability under the caption "Receivables Facility."
(b) Long-term Debt.
Resources' consolidated long-term debt outstanding, which is summarized in
the following table, is noncallable and without sinking fund requirements
except as noted. Carrying amounts and amounts due in one year reflect $33.2
million and $3.4 million, respectively, for fair value adjustments recorded in
connection with the Merger.
DECEMBER 31, 1998
--------------------------------------------------------
CARRYING AMOUNTS
----------------------------
EFFECTIVE PRINCIPAL NON-CURRENT CURRENT
RATE AMOUNT PORTION PORTION
---- ------ ------- -------
(MILLIONS OF DOLLARS)
Medium-term notes, Series A and B due through
2001, weighted average rate of 8.96% at
December 31, 1998................................... 6.4% $ 165.6 $ 177.6
8.875% Series due 1999................................. 6.3% 200.0 $ 202.7
7.5% Series due 2000................................... 6.4% 200.0 203.1
8.9% Series due 2006................................... 6.8% 145.1 163.4
6% Convertible Subordinated Debentures due 2012........ 6.5% 109.6 104.6
10% Series due 2019(1)................................. 8.8% 42.8 47.6
6 1/2% Series due 2008................................. 6.5% 300.0 300.0
6 %% Series due 2003................................... 6.4% 517.0 517.0
Other.................................................. 0.7
---------- ---------- ----------
$ 1,680.1 $ 1,513.3 $ 203.4
========== ========== ==========
DECEMBER 31, 1997
--------------------------------------------------------
CARRYING AMOUNTS
----------------------------
EFFECTIVE PRINCIPAL NON-CURRENT CURRENT
RATE AMOUNT PORTION PORTION
---- ------ ------- -------
(MILLIONS OF DOLLARS)
Medium-term notes, Series A and B due through
2001, weighted average rate of 8.90% at
December 31, 1997............................ 6.4% $ 241.6 $ 183.8 $ 78.8
Bank Term Loan due 1998................................ 6.2% 150.0 153.3
8.875% Series due 1999................................. 6.3% 200.0 207.2
7.5% Series due 2000................................... 6.4% 200.0 205.0
8.9% Series due 2006................................... 6.8% 145.1 165.1
6% Convertible Subordinated Debentures due 2012........ 6.5% 116.3 107.2
10% Series due 2019(1)................................. 8.8% 42.8 47.8
Other.................................................. 4.1% 0.6 0.6
---------- ---------- -----------
$ 1,096.4 $ 916.7 $ 232.1
========== ========== ===========
- ----------
(1) In the fourth quarter of 1997 Resources purchased $101.4 million aggregate
principal amount of its 10% Debentures due 2019 at an average price of
111.98% plus accrued interest. Because Resources' debt was stated at fair
market value as of the Acquisition Date, the loss on the reacquisition of
these debentures was not material.
8
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Consolidated maturities of long-term debt and sinking fund requirements
for Resources are approximately $207 million for 1999, $228 million in 2000,
$151 million in 2001, $7 million in 2002 and $7 million in 2003.
Resources' retirements and reacquisitions of long-term debt are summarized
in the following table. In cases where premiums were paid or discounts were
realized in association with these reacquisitions and retirements, such amounts
are reported in Resources' Statements of Consolidated Income as "Extraordinary
gain (loss) on early retirement of debt, less taxes" and are net of taxes of
$0.1 million and ($2.5) million in 1997 and 1996, respectively. For retirements
and reacquisitions after the Acquisition Date, gains or losses on early
retirement are immaterial since the carrying amounts reflect the fair value
adjustments described above.
YEAR ENDED DECEMBER 31,
------------------------------------
1998(1) 1997(1)
------- -------
Reacquisition of 10% Debentures due 2019................................. $ 101.4
Reacquisition of 6% Convertible Subordinated Debentures due 2012(2)...... $ 6.7 5.8
Retirement, at maturity, of Medium Term Notes(3)......................... 76.0 52.0
Retirement of Bank Term Loan due 2000.................................... 150.0
Retirement of 9.875% Notes due 1997...................................... 225.0
Net (gain) loss on reacquisition of debt, less taxes..................... (0.2)
-------------- --------------
$ 232.7 $ 384.0
============== ==============
- ----------
(1) Excludes the conversion of 6% Convertible Subordinated Debentures due 2012
in the amount of approximately $0 and $.7 million at December 31, 1998 and
December 31, 1997, respectively.
(2) These reacquired debentures may be credited against sinking fund
requirements.
(3) Weighted average interest rate of 8.75% and 9.25% in 1998 and 1997,
respectively.
In June 1996, Resources exercised its right to exchange the $130 million
principal amount of its $3.00 Convertible Exchangeable Preferred Stock, Series
A for its 6% Convertible Subordinated Debentures due 2012 (Subordinated
Debentures). The holders of the Subordinated Debentures receive interest
quarterly and have the right at any time on or before the maturity date thereof
to convert each Subordinated Debenture into 0.65 shares of common stock of
Reliant Energy and $14.24 in cash. The Subordinated Debentures are callable
beginning in 1999 at redemption prices beginning at 105.0% and declining to par
in November 2009. Resources is required to make annual sinking fund payments of
$6.5 million on the Subordinated Debentures which began on March 15, 1997 and
will continue on each succeeding March 15 up to and including March 15, 2011.
Resources (i) may credit against the sinking fund requirements any Subordinated
Debentures redeemed by Resources and Subordinated Debentures which have been
converted at the option of the holder and (ii) may deliver purchased
Subordinated Debentures in satisfaction of the sinking fund requirements.
Resources satisfied its 1998 sinking fund requirement of $6.5 million by
delivering Subordinated Debentures purchased in 1996 and 1997.
In February 1998, Resources issued $300 million principal amount of 6.5%
debentures due February 1, 2008. The proceeds from the sale of the debentures
were used to repay short-term indebtedness of Resources, including the
indebtedness incurred in connection with the 1997 purchase of $101 million
aggregate principal amount of its 10% debentures and the repayment of $53
million aggregate principal amount of Resources debt that matured in December
1997 and January 1998. In connection with the issuance of the 6.5% debentures,
Resources received approximately $1 million upon unwinding a $300 million
treasury rate lock agreement, which was tied to the interest rate on 10-year
treasury bonds. The rate lock agreement was executed in January 1998, and
proceeds from the unwind will be amortized over the 10 year life of Resources'
6.5% debentures.
In November 1998, Resources sold $500 million aggregate principal amount
of its 6 3/8% Term Enhanced ReMarketable Securities (TERM Notes). Included
within the TERM Notes is an embedded option sold to an investment bank which
gives the investment bank the right to remarket the TERM Notes in 2003 if it
chooses to exercise the option. The net proceeds of $514 million from the
offering of the TERM Notes were used for general corporate purposes, including
the repayment of (i) $178.5 million of Resources' outstanding commercial paper
and (ii) a $150 million term loan of Resources that matured on November 13,
1998. The TERM Notes are unsecured obligations of Resources which bear interest
at an annual rate of 6 3/8% through November 1, 2003. On November 1, 2003, the
holders of the TERM Notes are required to tender their notes at 100% of their
principal amount. The portion of the proceeds attributable to the option
premium will be amortized over the stated term of the securities. If the option
is not exercised, Resources will repurchase the TERM Notes at 100% of their
principal amount on November 1, 2003. If the option is exercised, the TERM
Notes will be remarketed on a date, selected by Resources, within the 52-week
period beginning November 1, 2003. During such period and prior to remarketing,
the TERM Notes will bear interest at rates, adjusted weekly, based on an index
selected by Resources. If the TERM Notes are
9
22
remarketed, the final maturity date of the TERM Notes will be November 1, 2013,
subject to adjustment, and the effective interest rate on the remarketed TERM
Notes will be 5.66% plus Resources' applicable credit spread at the time of
such remarketing.
(b) Restrictions on Debt.
Under the provisions of the Resources Credit Facility, Resources' total
debt is limited to 55% of its total capitalization. This provision did not
significantly restrict Resources' ability to issue debt or to pay dividends in
1998. At December 31, 1998, Resources' total debt to total capitalization
equaled 40%.
(5) TRUST SECURITIES
In June 1996, a Delaware statutory business trust (Resources Trust)
established by Resources issued in a public offering $172.5 million of
convertible preferred securities and sold approximately $5.3 million of
Resources Trust common stock (106,720 shares, representing 100% of the
Resources Trust's common equity) to Resources. The convertible preferred
securities have a distribution rate of 6.25% payable quarterly in arrears, a
stated liquidation amount of $50 per convertible preferred security and must be
redeemed by 2026. The proceeds from the sale of the preferred and common
securities were used by Resources Trust to purchase $177.8 million of 6.25%
Convertible Junior Subordinated Debentures from Resources having an interest
rate corresponding to the distribution rate of the convertible preferred
securities and a maturity date corresponding to the mandatory redemption date
of the convertible preferred securities. Under existing law, interest payments
made by Resources for the junior subordinated debentures are deductible for
federal income tax purposes. Resources has the right at any time and from time
to time to defer interest payments on the junior subordinated debentures for
successive periods not to exceed 20 consecutive quarters for each such
extension period. In such case, (1) quarterly distributions on the junior
subordinated debentures would also be deferred and (2) Resources has agreed to
not declare or pay any dividend on any common or preferred stock, except in
certain instances.
The Resources Trust is accounted for as a wholly owned consolidated
subsidiary of Resources. The junior subordinated debentures are the sole assets
of the Resources Trust. Resources has fully and unconditionally guaranteed, on
a subordinated basis, the Resources Trust's obligations, including the payment
of distributions and all other payments, with respect to the convertible
preferred securities. The convertible preferred securities are mandatorily
redeemable upon the repayment of the related junior subordinated debentures at
their stated maturity or earlier redemption. Each convertible preferred security
is convertible at the option of the holder into $33.62 of cash and 1.55 shares
of Reliant Energy common stock. During 1998, convertible preferred securities
aggregating $15.5 million were converted, leaving $0.9 million liquidation
amount of convertible preferred securities outstanding at December 31, 1998.
(8) COMMITMENTS AND CONTINGENCIES
(a) Lease Commitments.
The following table sets forth certain information concerning Resources'
obligations under operating leases:
Minimum Lease Commitments at December 31, 1998(1)
(millions of dollars)
1999........................................................................ $ 19
2000........................................................................ 15
2001........................................................................ 14
2002........................................................................ 10
2003........................................................................ 9
2004 and beyond............................................................. 61
----------
Total......................................................................... $ 128
==========
- ----------
(1) Principally consisting of rental agreements for building space and data
processing equipment and vehicles (including major work equipment);
approximately $16 million represents rental agreements with Reliant
Energy.
10
23
Resources has a master leasing agreement which provides for the lease of
vehicles, construction equipment, office furniture, data processing equipment
and other property. For accounting purposes, the lease is treated as an
operating lease. At December 31, 1998, the unamortized value of equipment
covered by the master leasing agreement was $26.9 million. Resources does not
expect to lease additional property under this lease agreement.
Total rental expense for all leases was $25.0 million, $24.0 million and
$33.4 million in 1998, 1997 and 1996, respectively.
(b) Letters of Credit.
At December 31, 1998, Resources had letters of credit incidental to its
ordinary business operations totaling approximately $30 million under which
Resources is obligated to reimburse drawings, if any.
(c) Indemnity Provisions.
At December 31, 1998, Resources had a $5.8 million accounting reserve on
its Consolidated Balance Sheets in "Estimated obligations under indemnification
provisions of sale agreements" for possible indemnity claims asserted in
connection with its disposition of former subsidiaries or divisions, including
the sale of (i) Louisiana Intrastate Gas Corporation, a former subsidiary
engaged in the intrastate pipeline and liquids extraction business (1992); (ii)
Arkla Exploration Company, a former subsidiary engaged in oil and gas
exploration and production activities (June 1991); and (iii) Dyco Petroleum
Company, a former subsidiary engaged in oil and gas exploration and production
(1991).
(d) Sale of Receivables.
Certain of Resources' receivables are collateral for receivables which
have been sold pursuant to the terms of the Receivables Facility. For
information regarding these receivables, see Note 4(a).
(e) Gas Purchase Claims.
In conjunction with settlements of "take-or-pay" claims, Resources has
prepaid for certain volumes of gas, which prepayments have been recorded at
their net realizable value and, to the extent that Resources is unable to
realize at least the carrying amount as the gas is delivered and sold,
Resources' earnings will be reduced, although such reduction is not expected to
be material. In addition to these prepayments, Resources is a party to a number
of agreements which require it to either purchase or sell gas in the future at
prices which may differ from then prevailing market prices or which require it
to deliver gas at a point other than the expected receipt point for volumes to
be purchased. To the extent that Resources expects that these commitments will
result in losses over the contract term, Resources has established reserves
equal to such expected losses. As of December 31, 1998, these reserves were not
material.
(f) Transportation Agreement.
Resources had an agreement (ANR Agreement) with ANR Pipeline Company (ANR)
which contemplated that Resources would transfer to ANR an interest in certain
of Resources' pipeline and related assets. The interest represented capacity of
250 Mmcf/day. Under the ANR Agreement, an ANR affiliate advanced $125 million
to Resources. Subsequently, the parties restructured the ANR Agreement and
Resources refunded in 1995 and 1993, respectively, $50 million and $34 million
to ANR or an affiliate. Resources recorded $41 million as a liability
reflecting ANR's or its affiliates' use of 130 Mmcf/ day of capacity in certain
of Resources' transportation facilities. The level of transportation will
decline to 100 Mmcf/day in the year 2003 with a refund of $5 million to an ANR
affiliate. The ANR Agreement will terminate in 2005 with a refund of the
remaining balance.
(g) Environmental Matters.
To the extent that potential environmental remediation costs are
quantified within a range, Resources establishes reserves equal to the most
likely level of costs within the range and adjusts such accruals as better
information becomes available. In determining the amount of the liability,
future costs are not discounted to their present value and the liability is not
offset by expected insurance recoveries. If justified by circumstances within
Resources' business subject to SFAS No. 71, corresponding regulatory assets are
recorded in anticipation of recovery through the rate making process.
Manufactured Gas Plant Sites. Resources and its predecessors operated a
manufactured gas plant (MGP) adjacent to the Mississippi River in Minnesota
formerly known as Minneapolis Gas Works (FMGW) until 1960. Resources has
substantially completed remediation of the main site other than ongoing water
monitoring and treatment. There are six other former MGP sites in the Minnesota
service territory. Remediation has been completed on one site. Of the remaining
five sites, Resources believes that two were neither owned nor operated by
Resources; two were owned by Resources at one time but were operated by others
and are currently owned by others; and one site was previously owned and
operated by Resources but is currently owned by others. Resources believes it
has no liability with respect to the sites it neither owned nor operated.
At December 31, 1998, Resources had estimated a range of $12 million to
$70 million for possible remediation of the Minnesota sites. The low end of the
range was determined based on only those sites presently owned or known to have
been operated by Resources, assuming use of Resources' proposed remediation
methods. The upper end of the range was determined based on the sites once
owned by Resources, whether or not operated by Resources. The cost estimates of
the FMGW site are based on studies of that site. The remediation costs for the
other sites are based on industry average costs for remediation of sites of
similar size. The actual remediation costs will be dependent upon the number of
sites remediated, the participation of other potentially responsible parties,
if any, and the remediation methods used.
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At December 31, 1998 and 1997, Resources had recorded accruals of $5.4
million and $3.3 million, respectively (with a maximum estimated exposure of
approximately $8 million and $18 million at December 31, 1998 and 1997,
respectively) and an offsetting regulatory asset for environmental matters in
connection with a former fire training facility, a landfill and an underground
gas storage facility for which future remediation may be required. This accrual
is in addition to the accrual for MGP sites as previously discussed.
In its 1995 rate case, Reliant Energy Minnegasco was allowed to recover
approximately $7 million annually for remediation costs. In 1998, Reliant
Energy Minnegasco received approval to reduce its annual recovery rate to zero.
Remediation costs are subject to a true-up mechanism whereby any over or under
recovered amounts, net of certain insurance recoveries, plus carrying charges,
would be deferred for recovery or refund in the next rate case. At December 31,
1998 and 1997, Reliant Energy Minnegasco had over recovered $13 million and
$1.8 million, respectively. At December 31, 1998 and 1997, Minnegasco had
recorded a liability of $20.7 million and $21.7 million, respectively, to cover
the cost of future remediation. In addition, at December 31, 1998, Minnegasco
had receivables from insurance settlements of $.6 million. These insurance
settlements will be collected in 1999. Minnegasco expects that approximately
43% of its accrual as of December 31, 1998 will be expended within the next
five years. The remainder will be expended on an ongoing basis for an estimated
40 years. In accordance with the provisions of SFAS No. 71, a regulatory asset
has been recorded equal to the liability accrued. Minnegasco is continuing to
pursue recovery of at least a portion of these costs from insurers. Minnegasco
believes the difference between any cash expenditures for these costs and the
amount recovered in rates during any year will not be material to Resources'
overall cash requirements, results of operations or cash flows.
Issues relating to the identification and remediation of MGPs are common
in the natural gas distribution industry. Resources has received notices from
the United States Environmental Protection Agency (EPA) and others regarding
its status as a potentially responsible party (PRP) for other sites. Based on
current information, Resources has not been able to quantify a range of
environmental expenditures for potential remediation expenditures with respect
to other MGP sites.
Mercury Contamination. Like other natural gas pipelines, Resources'
pipeline operations have in the past employed elemental mercury in meters used
on its pipelines. Although the mercury has now been removed from the meters, it
is possible that small amounts of mercury have been spilled at some of those
sites in the course of normal maintenance and replacement operations and that
such spills have contaminated the immediate area around the meters with
elemental mercury. Such contamination has been found by Resources at some sites
in the past, and Resources has conducted remediation at sites found to be
contaminated. Although Resources is not aware of additional specific sites, it
is possible that other contaminated sites exist and that remediation costs will
be incurred for such sites. Although the total amount of such costs cannot be
known at this time, based on experience by Resources and others in the natural
gas industry to date and on the current regulations regarding remediation of
such sites, Resources believes that the cost of any remediation of such sites
will not be material to Resources' financial position, results of operation or
cash flows.
Potentially Responsible Party Notifications. From time to time Resources
and its subsidiaries have been notified that they are PRP's with respect to
properties which environmental authorities have determined warrant remediation
under state or federal environmental laws and regulations. In October 1994 the
EPA issued such a notice with respect to the South 8th Street landfill site in
West Memphis, Arkansas, and in December 1995, the Louisiana Department of
Environmental Quality advised that one of Resources' subsidiaries had been
identified as a PRP with respect to a hazardous waste site in Shreveport,
Louisiana.
In 1998, MRT received a notice of potential liability from the EPA
regarding MRT's PRP status with respect to the Gurley Pit Superfund Site. The
notice stated that MRT is a PRP for the response costs at this site because MRT
allegedly generated materials that were disposed of at the site. MRT
subsequently notified the EPA that it does not believe that it has liability
because it did not have operations in the state from which the material was
allegedly hauled. In December 1998, MRT learned that the South 8th Street
Superfund Site Group and the EPA reached a tentative settlement regarding the
South 8th Street and Gurley Pit Superfund Sites.
Considering the information currently known about such sites and the
involvement of Resources or its subsidiaries in activities at these sites,
Resources does not believe that these matters will have a material adverse
effect on Resources' financial position, results of operation or cash flows.
Resources is a party to litigation (other than that specifically noted)
which arises in the normal course of business. Management regularly analyzes
current information and, as necessary, provides accruals for probable
liabilities on the eventual disposition of these matters. Management believes
that the effect on Resources' Consolidated Financial Statements, if any, from
the disposition of these matters will not be material.
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