UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
ANNUAL REPORT
PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2006
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from __________ to _________
Commission file number 1-14161
KEYSPAN CORPORATION
(Exact Name of Registrant as Specified in its Charter)
NEW YORK 11-3431358
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
One MetroTech Center, Brooklyn, New York 11201
175 East Old Country Road, Hicksville, New York 11801
(Address of Principal Executive Offices) (Zip Code)
(718) 403-1000 (Brooklyn)
(516) 755-6650 (Hicksville)
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes[X] No[ ]
Indicate by check mark whether the registrant is a large accelerated filer, an
accelerated filer or a non-accelerated filer.
Large accelerated filer[X] Accelerated filer[ ] Non-accelerated filer[ ]
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Act).
Yes[ ] No[X]
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
Class of Common Stock Outstanding at October 19, 2006
--------------------- -------------------------------
$.01 par value 175,283,247
KEYSPAN CORPORATION AND SUBSIDIARIES
INDEX
-----
Part I. FINANCIAL INFORMATION Page No.
--------
Item 1. Financial Statements
Consolidated Balance Sheet -
September 30, 2006 and December 31, 2005 3
Consolidated Statement of Income -
Three and Nine Months Ended September 30, 2006 and 2005 5
Consolidated Statement of Cash Flows -
Nine Months Ended September 30, 2006 and 2005 6
Notes to Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 45
Item 3. Quantitative and Qualitative Disclosures About Market Risk 74
Item 4. Controls and Procedures 77
Part II. OTHER INFORMATION
Item 1. Legal Proceedings 77
Item 1A. Risk Factors 77
Item 2. Unregistered Sale of Equity Securities and Use of Proceeds 79
Item 3. Defaults Upon Senior Securities 79
Item 4. Submission of Matters to a Vote of Security Holders 79
Item 5. Other Information 80
Item 6. Exhibits 80
Signatures 81
2
CONSOLIDATED BALANCE SHEET
(Unaudited)
- ---------------------------------------------------------------------------------------------------------
(In Millions of Dollars) September 30, 2006 December 31, 2005
- ---------------------------------------------------------------------------------------------------------
ASSETS
Current Assets
Cash and temporary cash investments $ 40.0 $ 124.5
Restricted cash 5.6 13.2
Accounts receivable 779.9 1,035.6
Unbilled revenue 221.0 685.6
Allowance for uncollectible accounts (52.7) (62.8)
Gas in storage, at average cost 788.9 766.9
Material and supplies, at average cost 144.8 140.5
Derivative contracts 46.9 142.8
Other 172.5 173.8
--------------------------------------------------
2,146.9 3,020.1
--------------------------------------------------
Investments and Other 257.9 242.4
Property
Gas 7,545.8 7,275.9
Electric 2,549.3 2,492.3
Other 430.4 416.3
Accumulated depreciation (3,096.0) (2,922.6)
Gas exploration and production, at cost 186.0 184.2
Accumulated depletion (112.3) (109.2)
--------------------------------------------------
7,503.2 7,336.9
--------------------------------------------------
Deferred Charges
Regulatory assets:
Miscellaneous assets 710.7 688.3
Derivative contracts 260.2 30.9
Goodwill and other intangible assets 1,666.3 1,666.3
Derivative contracts 138.5 75.2
Other 754.7 752.5
--------------------------------------------------
3,530.4 3,213.2
--------------------------------------------------
Total Assets $ 13,438.4 $ 13,812.6
==================================================
- ---------------------------------------------------------------------------------------------------------
See accompanying Notes to the Consolidated Financial Statements.
3
CONSOLIDATED BALANCE SHEET
(Unaudited)
- -----------------------------------------------------------------------------------------------------------------------
(In Millions of Dollars) September 30, 2006 December 31, 2005
- -----------------------------------------------------------------------------------------------------------------------
LIABILITIES AND CAPITALIZATION
Current Liabilities
Accounts payable and other liabilities $ 681.9 $ 1,087.0
Commercial paper 330.0 657.6
Current redemption of long-term debt 13.2 13.0
Taxes accrued 150.8 176.3
Dividends payable 81.4 81.1
Customer deposits 35.6 39.1
Interest accrued 74.5 53.8
Derivative contracts 279.4 47.3
------------------------- -------------------------
1,646.8 2,155.2
------------------------- -------------------------
Deferred Credits and Other Liabilities
Regulatory liabilities:
Miscellaneous liabilities 44.8 69.9
Removal cost recovered 549.0 516.4
Derivative contracts 122.2 175.4
Asset retirement obligations 49.4 47.4
Deferred income tax 1,222.4 1,157.9
Postretirement benefits and other reserves 1,144.8 1,118.4
Derivative contracts 47.7 44.3
Other 109.1 127.5
------------------------- -------------------------
3,289.4 3,257.2
------------------------- -------------------------
Commitments and Contingencies (See Note 6) - -
Capitalization
Common stock - 184,864 shares issued, 175,232
shares outstanding at September 30, 2006, par value $0.01 3,985.6 3,975.9
Retained earnings 930.5 866.9
Other comprehensive (loss) (69.8) (74.8)
Treasury stock (278.9) (303.9)
------------------------- -------------------------
Total common shareholders' equity 4,567.4 4,464.1
Long-term debt and capital leases 3,919.3 3,920.8
------------------------- -------------------------
Total Capitalization 8,486.7 8,384.9
------------------------- -------------------------
Minority Interest in Subsidiary Companies 15.5 15.3
------------------------- -------------------------
Total Liabilities and Capitalization $ 13,438.4 $ 13,812.6
========================= =========================
- ------------------------------------------------------------------------------------------------------------------------
See accompanying Notes to the Consolidated Financial Statements.
4
CONSOLIDATED STATEMENT OF INCOME
(Unaudited)
- ------------------------------------------------------------------------------------------------------------------------------------
Three Months Ended Sept. 30, Nine Months Ended Sept. 30,
(In Millions of Dollars, Except Per Share Amounts) 2006 2005 2006 2005
- ------------------------------------------------------------------------------------------------------------------------------------
Revenues
Gas Distribution $ 595.5 $ 629.6 $ 3,648.8 $ 3,476.1
Electric Services 565.6 619.9 1,434.6 1,488.9
Energy Services 49.0 45.4 147.8 134.1
Energy Investments 8.4 8.2 26.1 27.0
--------------- ------------------- ------------------ ----------------------
Total Revenues 1,218.5 1,303.1 5,257.3 5,126.1
--------------- ------------------- ------------------ ----------------------
Operating Expenses
Purchased gas for resale 361.5 395.7 2,412.7 2,206.1
Fuel and purchased power 172.6 254.6 418.3 546.9
Operations and maintenance 372.7 364.3 1,199.3 1,143.3
Depreciation, depletion and amortization 84.2 92.1 295.7 295.8
Operating taxes 95.9 97.1 309.9 303.0
--------------- ------------------- ------------------ ----------------------
Total Operating Expenses 1,086.9 1,203.8 4,635.9 4,495.1
Income from equity investments 3.2 2.5 9.5 12.5
Sale of assets 1.0 1.0 1.4 1.2
--------------- ------------------- ------------------ ----------------------
Operating Income 135.8 102.8 632.3 644.7
--------------- ------------------- ------------------ ----------------------
Other Income and (Deductions)
Interest charges (67.1) (67.4) (192.7) (200.1)
Gain on sale of investments - - - 4.1
Cost of debt redemption - - - (20.9)
Other 8.0 (3.8) 25.6 9.4
--------------- ------------------- ------------------ ----------------------
Total Other Income and (Deductions) (59.1) (71.2) (167.1) (207.5)
--------------- ------------------- ------------------ ----------------------
Income Taxes
Current (17.9) (25.8) 104.3 119.0
Deferred 44.3 34.8 53.3 41.0
--------------- ------------------- ------------------ ----------------------
Total Income Taxes 26.4 9.0 157.6 160.0
--------------- ------------------- ------------------ ----------------------
Earnings from continuing operations 50.3 22.6 307.6 277.2
Discontinued Operations
Income (loss) from discontinued
operations, net of tax - - - (4.1)
Gain on disposal, net of tax - - - 2.3
--------------- ------------------- ------------------ ----------------------
Loss from discontinued operations - - - (1.8)
--------------- ------------------- ------------------ ----------------------
Net Income 50.3 22.6 307.6 275.4
Preferred stock dividend requirements - - - 2.2
--------------- ------------------- ------------------ ----------------------
Earnings for Common Stock $ 50.3 $ 22.6 $ 307.6 $ 273.2
=============== =================== ================== ======================
Basic Earnings Per Share:
Continuing Operations,
less preferred stock dividends $ 0.29 $ 0.13 $ 1.76 $ 1.63
Discontinued Operations - - - (0.01)
--------------- ------------------- ------------------ ----------------------
Basic Earnings Per Share $ 0.29 $ 0.13 $ 1.76 $ 1.62
=============== =================== ================== ======================
Diluted Earnings Per Share
Continuing Operations,
less preferred stock dividends $ 0.29 $ 0.13 $ 1.75 $ 1.62
Discontinued Operations - - - (0.01)
--------------- ------------------- ------------------ ----------------------
Diluted Earnings Per Share $ 0.29 $ 0.13 $ 1.75 $ 1.61
=============== =================== ================== ======================
Average Common Shares Outstanding (000) 175,114 174,332 174,935 168,465
Average Common Shares Outstanding - Diluted (000) 176,295 175,238 175,996 169,403
- ------------------------------------------------------------------------------------------------------------------------------------
See accompanying Notes to the Consolidated Financial Statements.
5
CONSOLIDATED STATEMENT OF CASH FLOWS
(Unaudited)
- -----------------------------------------------------------------------------------------------
Nine Months Ended Sept. 30,
(In Millions of Dollars) 2006 2005
- -----------------------------------------------------------------------------------------------
Operating Activities
Net income $ 307.6 $ 275.4
Adjustments to reconcile net income to net
cash provided by (used in) operating activities
Depreciation, depletion and amortization 295.7 295.8
Deferred income tax 53.3 41.0
Income from equity investments (9.5) (12.5)
Dividends from equity investments 8.7 5.3
Amortization of interest rate swap/financing fees 6.2 (2.5)
(Gain) on sale of property and investments (1.5) (5.3)
Loss from discontinued operations - 1.8
Amortization of property tax prepayments 106.9 91.8
Changes in assets and liabilities
Accounts receivable 712.5 294.3
Materials and supplies, fuel oil and gas in storage (26.3) (245.2)
Accounts payable and other liabilities (409.8) (165.2)
Insurance recovery and regulatory settlements, net 16.6 21.1
Property tax prepayment (79.4) (69.5)
Environmental payments (37.8) (24.4)
Other (35.6) (29.8)
---------------- --------------
Net Cash Provided by Operating Activities 907.6 472.1
---------------- --------------
Investing Activities
Construction expenditures (377.6) (372.1)
Cost of removal (23.1) (10.8)
Derivative margin calls (42.7) (63.3)
Net proceeds from sale of property and investments 1.5 46.9
---------------- --------------
Net Cash Used in Investing Activities (441.9) (399.3)
---------------- --------------
Financing Activities
Treasury stock issued 21.2 41.0
MEDs equity conversion - 460.0
Payment of long-term debt - (590.1)
Payment of commercial paper (327.6) (592.2)
Common and preferred stock dividends paid (243.8) (229.1)
Other - 14.0
---------------- --------------
Net Cash Used in Financing Activities (550.2) (896.4)
---------------- --------------
Net Decrease in Cash and Cash Equivalents (84.5) (823.6)
Cash Flow from Discontinued Operations - Operating - (15.1)
Cash Flow from Discontinued Operations - Investing - 0.5
Cash Flow from Discontinued Operations - Financing - 0.2
Cash and Cash Equivalents at Beginning of Period 124.5 922.0
---------------- --------------
Cash and Cash Equivalents at End of Period $ 40.0 $ 84.0
================ ==============
- -----------------------------------------------------------------------------------------------
Cash equivalents are short-term marketable securities purchased with maturities
of three months or less that were carried at cost which approximates fair value.
See accompanying Notes to the Consolidated Financial Statements.
6
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
INTRODUCTION TO THE NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
KeySpan Corporation (referred to in the Notes to the Financial Statements as
"KeySpan," "we," "us" and "our") is a holding company under the Public Holding
Company Act of 2005 ("PUHCA 2005"). KeySpan operates six regulated utilities
that distribute natural gas to approximately 2.6 million customers in New York
City, Long Island, Massachusetts and New Hampshire, making KeySpan the fifth
largest gas distribution company in the United States and the largest in the
Northeast. We also own, lease and operate electric generating plants in Nassau
and Suffolk Counties on Long Island and in Queens County in New York City and
are the largest electric generation operator in New York State. Under
contractual arrangements, we provide power, electric transmission and
distribution services, billing and other customer services for approximately 1.1
million electric customers of the Long Island Power Authority ("LIPA").
KeySpan's other operating subsidiaries are primarily involved in gas exploration
and production; underground gas storage; liquefied natural gas storage; retail
electric marketing; large energy-system ownership, installation and management;
service and maintenance of energy systems; and engineering and consulting
services. We also invest and participate in the development of natural gas
pipelines, electric generation and other energy-related projects. (See Note 2
"Business Segments" for additional information on each operating segment.)
On February 25, 2006, KeySpan entered into an Agreement and Plan of Merger (the
"Merger Agreement"), with National Grid plc, a public limited company
incorporated under the laws of England and Wales ("Parent") and National Grid
US8, Inc., a New York Corporation ("Merger Sub"), pursuant to which Merger Sub
will merge with and into KeySpan (the "Merger"), with KeySpan continuing as the
surviving company and thereby becoming an indirect wholly-owned subsidiary of
the Parent. Pursuant to the Merger Agreement, at the effective time of the
Merger, each outstanding share of KeySpan common stock, par value $0.01 per
share of KeySpan (the "Shares"), other than treasury shares and shares held by
the Parent and its subsidiaries, shall be canceled and shall be converted into
the right to receive $42.00 in cash, without interest.
Consummation of the Merger is subject to various closing conditions, including
but not limited to the adoption of the Merger Agreement by the stockholders of
KeySpan and the Parent and the receipt of requisite regulatory approvals from
certain United States federal and state public utility, antitrust and other
regulatory authorities, many of which have been filed or obtained. Specifically,
we filed our application for approval of the Merger pursuant to the Federal
Power Act in May 2006 and in October the requisite approval was obtained from
the Federal Energy Regulatory Commission ("FERC"). In early July 2006, we
cleared review by the Federal Trade Commission under the Hart-Scott-Rodino
Antitrust Improvement Act and received notification that the Committee on
Foreign Investment in the U.S. has determined that there are no issues of
national security sufficient to warrant an investigation of the transaction. On
July 20, 2006 we filed an application for approval of the transaction with the
New York Public Service Commission ("NYPSC"). KeySpan has also sought approval
of the merger from the New Hampshire Public Utility Commission. In October 2006,
the State of New Jersey Board of Public Utilities approved a change of control
of KeySpan Communication Corp., which provides telecommunications services in
New Jersey. In addition, the Merger was approved by our shareholders at our
Annual Meeting on August 17, 2006. Shareholders of National Grid plc approved
the transaction at a meeting held on July 31, 2006.
7
In addition to seeking approval of the Merger, the application filed with the
NYPSC also contained a proposed ten-year rate plan for KeySpan Energy Delivery
of New York ("KEDNY") and KeySpan Energy Delivery of Long Island ("KEDLI"), as
well as proposals concerning corporate structure, affiliate rules and
transactions and the rate treatment for contemplated synergy savings.
Specifically, the rate plan proposal provides for, among other things, a freeze
of base delivery rates for KEDNY and KEDLI for 18 months. Thereafter, KEDNY's
and KEDLI's gas adjustment clause would be increased to recover, on a
prospective basis, gas commodity-related costs of $68.6 million for KEDNY and
$28.7 million for KEDLI that would no longer be included in base rates. In
addition, KEDNY and KEDLI base delivery rates would be increased by an average
of 2.5% ($62.4 million) and 2.3% ($39.4 million), respectively in years 3, 5, 7
and 9 of the rate plan. The proposed rate plan also contemplates an allowed
return on equity of 11.0% for each entity. Cumulative earnings above 11.75%
would be shared between gas sales customers and KeySpan over the rate plan
period. On October 3, 2006 Nation Grid plc filed testimony and exhibits with the
NYSPSC that refers to both exhibits and attachments that were previously
submitted as part of the July 20, 2006 petition.
Assuming receipt of all required approvals, it is currently anticipated that the
Merger will be consummated in mid-2007. However, we are unable to predict the
outcome of the regulatory proceedings and no assurance can be given that the
Merger will occur or the timing of its completion.
In the meantime, individual applications for a proposed annual increase in
revenues for KEDNY and KEDLI were filed on October 3, 2006 with the NYPSC. The
proposed revenue increases are for 9.1% and 10.9% for KEDNY and KEDLI,
respectively. KEDNY's last base rate increase took effect October 1, 1993 and
since then base rates have been reduced twice - once in 1996 and then again in
1998. KEDLI's last base rate increase took effect December 1, 1995. Since that
time KEDLI's base rates were reduced twice in 1998. The principal factors
creating the need for rate relief are increases in operating and maintenance
expenses, increases in rate base, increased property taxes and depreciation
expense, and the need to commence recovery of previously deferred costs such as
pension and post retirement benefits, environmental expenditures and property
taxes.
The total projected increase in revenues is comprised of two components; (i) an
increase in base rates of $180.7 million for KEDNY and $145 million for KEDLI;
and (ii) projected increases of $32.8 million and $14 million for KEDNY and
KEDLI, respectively, for gas related expenses that will be recovered through the
Gas Adjustment Clause ("GAC") and/or Transportation Adjustment Clause ("TAC").
The proposed rate of return on equity is 11.0% for both KEDNY and KEDLI.
The NYPSC may suspend the implementation of the proposed tariff changes for up
to eleven months, which would mean, absent other intervening events, an
effective date of September 3, 2007 for new rates. Although KEDNY and KEDLI
proposed the new rates described above in these tariff filings, KeySpan does not
expect that the rate increases proposed therein will be implemented because
KEDNY's and KEDLI's need for rate relief on a stand alone basis will be
superseded and rendered moot by an earlier NYPSC approval of the merger between
National Grid plc and KeySpan and the approval of the related ten-year rate plan
previously noted.
8
At December 31, 2005, KeySpan was a holding company under the Public Utility
Holding Company Act of 1935, as amended ("PUHCA 1935"). In August 2005, the
Energy Policy Act of 2005 (the "Energy Act") was enacted. The Energy Act is a
broad energy bill that places an increased emphasis on the production of energy
and promotes the development of new technologies and alternative energy sources
and provides tax credits to companies that produce natural gas, oil, coal,
electricity and renewable energy. For KeySpan, one of the more significant
provisions of the Energy Act was the repeal of PUHCA 1935, which repeal became
effective on February 8, 2006. Since that time, the jurisdiction of the
Securities and Exchange Commission ("SEC") over certain holding company
activities, including the regulation of our affiliate transactions and service
companies, has been transferred to the FERC pursuant to PUHCA 2005. (For
additional information on the Energy Act and PUHCA 2005 see KeySpan's Annual
Report on Form 10-K for the year ended December 31, 2005, Item 7. Management's
Discussion and Analyses of Financial Condition and Results of Operations -
"Regulation and Rate Matters.")
1. BASIS OF PRESENTATION
In our opinion, the accompanying unaudited Consolidated Financial Statements
contain all adjustments necessary to present fairly KeySpan's financial position
as of September 30, 2006, and the results of operations for the three and nine
months ended September 30, 2006 and September 30, 2005, as well as cash flows
for the nine months ended September 30, 2006 and September 30, 2005. The
accompanying financial statements should be read in conjunction with the
consolidated financial statements and notes included in KeySpan's Annual Report
on Form 10-K for the year ended December 31, 2005. The December 31, 2005
financial statement information has been derived from the 2005 audited financial
statements. Income from interim periods may not be indicative of future results.
Certain reclassifications were made to conform prior period financial statements
to the current period financial statement presentation.
Consolidated earnings are seasonal in nature primarily due to the significant
contributions to earnings of the gas distribution operations. As a result, we
expect to earn most of our annual earnings in the first and fourth quarters.
Basic earnings per share ("EPS") is calculated by dividing earnings available
for common stock by the weighted average number of shares of common stock
outstanding during the period. No dilution for any potentially dilutive
securities is included. Diluted EPS assumes the conversion of all potentially
dilutive securities and is calculated by dividing earnings available for common
stock, as adjusted, by the sum of the weighted average number of shares of
common stock outstanding plus all potentially dilutive securities.
9
Under the requirements of Statement of Financial Accounting Standards ("SFAS")
No. 128, "Earnings Per Share" our basic and diluted EPS are as follows:
- --------------------------------------------------------------------------------------------------------------------------------
Three Months Ended Sept. 30, Nine Months Ended Sept. 30,
(In Millions of Dollars, Except Per Share Amounts) 2006 2005 2006 2005
- --------------------------------------------------------------------------------------------------------------------------------
Earnings for common stock $ 50.3 $ 22.6 $ 307.6 $ 273.2
- --------------------------------------------------------------------------------------------------------------------------------
Weighted average shares outstanding (000) 175,114 174,332 174,935 168,465
Add dilutive securities:
Options 1,045 906 970 938
Performance shares 136 - 91 -
- --------------------------------------------------------------------------------------------------------------------------------
Total weighted average shares
outstanding - assuming dilution 176,295 175,238 175,996 169,403
- --------------------------------------------------------------------------------------------------------------------------------
Basic earnings per share $ 0.29 $ 0.13 $ 1.76 $ 1.62
- --------------------------------------------------------------------------------------------------------------------------------
Diluted earnings per share $ 0.29 $ 0.13 $ 1.75 $ 1.61
- --------------------------------------------------------------------------------------------------------------------------------
2. BUSINESS SEGMENTS
We have four reportable segments: Gas Distribution, Electric Services, Energy
Services and Energy Investments.
The Gas Distribution segment consists of six gas distribution subsidiaries.
KeySpan Energy Delivery New York ("KEDNY") provides gas distribution services to
customers in the New York City Boroughs of Brooklyn, Queens and Staten Island.
KeySpan Energy Delivery Long Island ("KEDLI") provides gas distribution services
to customers in the Long Island Counties of Nassau and Suffolk and the Rockaway
Peninsula of Queens County. The remaining gas distribution subsidiaries, Boston
Gas Company, Colonial Gas Company, Essex Gas Company and EnergyNorth Natural
Gas, Inc., collectively referred to as KeySpan Energy Delivery New England
("KEDNE"), provide gas distribution service to customers in Massachusetts and
New Hampshire.
The Electric Services segment consists of subsidiaries that operate the electric
transmission and distribution system owned by LIPA; own and provide capacity to
and produce energy for LIPA from our generating facilities located on Long
Island; and manage fuel supplies for LIPA to fuel our Long Island generating
facilities. These services are provided in accordance with existing long-term
service contracts having remaining terms that range from one to seven years and
power purchase agreements having remaining terms that range from seven to 21
years. On February 1, 2006, KeySpan and LIPA agreed to extend, amend and restate
these contractual arrangements. (See Note 10, "2006 LIPA Settlement" for a
further discussion of these agreements.) The Electric Services segment also
includes subsidiaries that own or lease and operate the 2,200 MW Ravenswood
Facility located in Queens, New York, and the 250 MW combined-cycle Ravenswood
Expansion. Collectively the Ravenswood Facility and Ravenswood Expansion are
referred to as the "Ravenswood Generating Station." All of the energy, capacity
and ancillary services related to the Ravenswood Generating Station are sold to
the New York Independent Systems Operator ("NYISO") energy markets. To finance
the purchase and/or construction of the Ravenswood Generating Station, KeySpan
entered into a leasing arrangement for each facility. The Electric Services
segment also conducts retail marketing of electricity to commercial customers.
(See Note 6 "Financial Guarantees and Contingencies" for further details on the
leasing arrangements.)
10
The Energy Services segment includes companies that provide energy-related
services to customers located primarily within the northeastern United States.
Subsidiaries in this segment provide residential and small commercial customers
with service and maintenance of energy systems and appliances, as well as
operation and maintenance, design, engineering, consulting and fiber optic
services to commercial, institutional and industrial customers.
In 2005, KeySpan sold its mechanical contracting subsidiaries. The operating
results and financial position of these companies have been reflected as
discontinued operations on the Consolidated Statement of Income and Consolidated
Statement of Cash Flows for 2005.
The Energy Investments segment consists of our gas exploration and production
investments, as well as certain other domestic energy-related investments.
KeySpan's gas exploration and production activities include its wholly-owned
subsidiaries Seneca Upshur Petroleum, Inc. ("Seneca-Upshur") and KeySpan
Exploration and Production, LLC ("KeySpan Exploration"). Seneca-Upshur is
engaged in gas exploration and production activities primarily in West Virginia.
See Footnote 12 "Gas Exploration and Production Property - Depletion" for a
discussion of the September 30, 2006 ceiling test calculation.
This segment is also engaged in pipeline development activities. KeySpan and
Duke Energy Corporation each own a 50% interest in the Islander East Pipeline
Company, LLC ("Islander East"). Islander East was created to pursue the
authorization and construction of an interstate pipeline from Connecticut,
across Long Island Sound, to a terminus near Shoreham, Long Island. Once in
service, the pipeline is expected to transport up to 260,000 DTH daily to the
Long Island and New York City energy markets. Further, KeySpan has a 26.3%
interest in the Millennium Pipeline Company LLC, the developer of the Millennium
pipeline project, which is expected to have the capacity to transport up to
525,000 DTH of natural gas a day from Corning, New York to Ramapo, New York,
where it will connect to an existing pipeline. Additionally, subsidiaries in
this segment hold a 20% equity interest in the Iroquois Gas Transmission System
LP, a pipeline that transports Canadian gas supply to markets in the
northeastern United States. These investments are accounted for under the equity
method. Accordingly, equity income from these investments is reflected as a
component of operating income in the Consolidated Statement of Income.
Through its wholly owned subsidiary, KeySpan LNG, KeySpan owns a 600,000 barrel
liquefied natural gas storage and receiving facility in Providence, Rhode
Island, the operations of which are fully consolidated.
In the first quarter of 2005, KeySpan sold its 50% interest in Premier
Transmission Limited ("Premier"), a gas pipeline from southwest Scotland to
Northern Ireland. The sale generated cash proceeds of approximately $48.1
million. In the fourth quarter of 2004, KeySpan reduced its carrying value in
Premier to an amount approximating the anticipated cash proceeds from the sale.
11
The final sale of Premier resulted in a pre-tax gain of $4.1 million reflecting
the difference from earlier estimates; this gain was recorded in the first
quarter of 2005.
The accounting policies of the segments are the same as those used for the
preparation of the Consolidated Financial Statements. The segments are strategic
business units that are managed separately because of their different operating
and regulatory environments. Operating results of our segments are evaluated by
management on an operating income basis. At September 30, 2006, the total assets
of each reportable segment have not changed materially from those levels
reported at December 31, 2005. The reportable segment information is as follows:
- ----------------------------------------------------------------------------------------------------------------------------
Gas Electric Energy Energy
(In Millions of Dollars) Distribution ServiceS Services Investments Eliminations Consolidated
- ----------------------------------------------------------------------------------------------------------------------------
Three Months Ended Sept. 30, 2006
Unaffiliated revenue 595.5 565.6 49.0 8.4 - 1,218.5
Intersegment revenue - - 2.8 1.3 (4.1) -
Operating Income (10.8) 144.4 3.0 4.7 (5.5) 135.8
Three Months Ended Sept. 30, 2005
Unaffiliated revenue 629.6 619.9 45.4 8.2 - 1,303.1
Intersegment revenue - - 1.7 3.7 (5.4) -
Operating Income (45.5) 149.6 (1.1) 4.7 (4.9) 102.8
- ----------------------------------------------------------------------------------------------------------------------------
Eliminating items include intercompany interest income and expense, the
elimination of certain intercompany accounts, as well as activities of our
corporate and administrative areas.
Because of the nature of our Electric Services business, electric revenues are
derived from two large customers - the NYISO and LIPA. Electric Services
revenues from these customers of $553.5 million and $612.1 million for the three
months ended September 30, 2006 and 2005, respectively, represent approximately
45% and 47%, respectively of our consolidated revenues in these periods.
- -----------------------------------------------------------------------------------------------------------------------------------
Gas Electric Energy Energy
(In Millions of Dollars) Distribution ServiceS Services Investments Eliminations Consolidated
- -----------------------------------------------------------------------------------------------------------------------------------
Nine Months Ended Sept. 30, 2006
Unaffiliated revenue 3,648.8 1,434.6 147.8 26.1 - 5,257.3
Intersegment revenue - - 7.6 4.0 (11.6) -
Operating Income 365.1 271.7 4.6 11.3 (20.4) 632.3
Nine Months Ended Sept. 30, 2005
Unaffiliated revenue 3,476.1 1,488.9 134.1 27.0 - 5,126.1
Intersegment revenue - 4.6 7.9 3.7 (16.2) -
Operating Income 376.8 266.3 (6.7) 16.6 (8.3) 644.7
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Eliminating items include the elimination of certain intercompany accounts, as
well as activities of our corporate and administrative areas.
Because of the nature of our Electric Services business, electric revenues are
derived from two large customers - the NYISO and LIPA. Electric Services
revenues from these customers of $1,415.5 million and $1,423.4 million for the
nine months ended September 30, 2006 and 2005, respectively, represent
approximately 27%, of our consolidated revenues in both periods.
12
3. COMPREHENSIVE INCOME
The table below indicates the components of comprehensive income:
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Three Months Ended Sept. 30, Nine Months Ended Sept. 30,
(In Millions of Dollars) 2006 2005 2006 2005
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Net Income $ 50.3 $ 22.6 $ 307.6 $ 275.4
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Other comprehensive income (loss), net of tax
Reclassification of (gains) losses included in net income (4.7) 10.7 (43.6) 18.4
Foreign currency translation adjustments - - - (5.0)
Unrealized gains on marketable securities 0.2 2.9 0.5 1.4
Unrealized (losses) gains on derivative financial instruments 7.3 (59.8) 48.1 (78.0)
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Other comprehensive gain (loss), net of tax 2.8 (46.2) 5.0 (63.2)
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Comprehensive Income (Loss) $ 53.1 $ (23.6) $ 312.6 $ 212.2
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Related tax (benefit) expense
Reclassification of (gains) losses included in net income (2.6) 5.8 (23.5) 9.9
Foreign currency translation adjustments - - - (2.7)
Unrealized gains on marketable securities 0.1 1.6 0.3 0.8
Unrealized (losses) gains on derivative financial instruments 4.5 (33.6) 27.4 (44.3)
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Total Tax (Benefit) Expense $ 2.0 $ (26.2) $ 4.2 $ (36.3)
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4. HEDGING AND DERIVATIVE FINANCIAL INSTRUMENTS
Financially-Settled Commodity Derivative Instruments - Hedging Activities: From
time to time, KeySpan subsidiaries have utilized derivative financial
instruments, such as futures, options and swaps, for the purpose of hedging the
cash flow variability associated with changes in commodity prices. KeySpan is
exposed to commodity price risk primarily with regard to its gas distribution
operations, gas exploration and production activities and its electric
generating facilities at the Ravenswood Generating Station.
Derivative financial instruments are employed by our gas distribution operations
to reduce the cash flow variability associated with the purchase price for a
portion of future natural gas purchases for our regulated firm gas sales
customers. The accounting for certain of these derivative instruments is subject
to SFAS 71 "Accounting for the Effects of Certain Types of Regulation."
Therefore, the fair value of these derivatives are recorded as current or
deferred assets and liabilities, with offsetting positions recorded as
regulatory assets and regulatory liabilities on the Consolidated Balance Sheet.
Gains or losses on the settlement of these contracts are initially deferred and
then refunded to or collected from our firm gas sales customers consistent with
regulatory requirements. See the caption below "Firm Gas Sales Derivative
Instruments - Regulated Utilities" for a further discussion of these
derivatives.
Certain derivative instruments employed by our gas distribution operations,
however, are not subject to SFAS 71 and thus are not subject to deferral
accounting treatment. Utility tariffs applicable to certain large-volume
customers permit gas to be sold at prices established monthly, relative to a
13
prevailing alternate fuel price, but limited to the cost of gas plus the rate
for the highest consumption block otherwise applicable to our firm commercial
customers. During 2006, KeySpan used over-the-counter ("OTC") natural gas swaps,
with offsetting positions in OTC fuel oil swaps of equivalent energy value, to
hedge the cash-flow variability of specified portions of gas purchases and sales
associated with these customers. At September 30, 2006, there were no
outstanding derivative instruments associated with this strategy. However,
KeySpan may elect to enter into similar derivative financial instruments when
prevailing market conditions are favorable.
We have three fixed price forward sale contracts with large-volume interruptible
gas sales customers. KeySpan uses OTC natural gas swaps to hedge the cash-flow
variability of gas purchases associated with these customers. These gas swaps
are accounted for as hedges. KeySpan uses market quoted forward prices to value
these swap positions. The maximum length of time over which we have hedged such
cash flow variability is through October 2007. The fair value of these
derivative instruments at September 30, 2006 was a liability of $2.5 million,
all of which is reported in accumulated other comprehensive income and is
expected to be reclassified into earnings within the next twelve months.
Our Energy Investments subsidiary, Seneca-Upshur, utilizes OTC natural gas swaps
to hedge the cash flow variability associated with forecasted sales of a portion
of its natural gas production. At September 30, 2006, Seneca-Upshur has hedge
positions in place for approximately 90% of its estimated 2006 through 2009 gas
production, net of gathering costs. We use market quoted forward prices to value
these swap positions. The maximum length of time over which Seneca-Upshur has
hedged such cash flow variability is through December 2009. The fair value of
these derivative instruments at September 30, 2006 was a liability of $5.2
million. The estimated amount of losses associated with such derivative
instruments that are reported in accumulated other comprehensive income and that
are expected to be reclassified into earnings over the next twelve months is
$2.9 million. Ineffectiveness associated with these outstanding derivative
financial instruments was immaterial for the nine months ended September 30,
2006.
The Ravenswood Generating Station hedges the cash flow variability associated
with a portion of electric energy sales. Our strategy is to hedge up to 50% of
the on-peak capacity of the Ravenswood Generating Station. The maximum length of
time over which we have hedged cash flow variability is through March 2007. To
accomplish our stated hedging strategy, KeySpan employs financially-settled
electric-power swap contracts with offsetting financially-settled oil swap
contracts and OTC natural gas swaps. We use market quoted forward prices to
value the electric-power swap contracts. The fair value of the electric power
derivative instruments at September 30, 2006 was $17.1 million, all of which is
reported in accumulated other comprehensive income and is expected to be
reclassified into earnings within the next twelve months. We use market quoted
forward prices to value the oil swap contracts. The fair value of these
derivative instruments at September 30, 2006, was a liability of $3.8 million
all of which is reported in accumulated other comprehensive income and is
expected to be reclassified into earnings within the next twelve months. We use
market quoted forward prices to value the gas swap contracts. The fair value of
these derivative instruments at September 30, 2006, was a liability of $14.6
14
million, of which $13.6 million is reported in accumulated other comprehensive
income and is expected to be reclassified into earnings within the next twelve
months. Ineffectiveness associated with these outstanding derivative financial
instruments was immaterial for the nine months ended September 30, 2006.
The above noted derivative financial instruments are cash flow hedges that are
accounted for as hedges under SFAS 133 "Accounting for Derivative Instruments
and Hedging Activities," as amended by SFAS 149 "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities," collectively SFAS 133, and are
not considered held for trading purposes as defined by current accounting
literature. Accordingly, we carry the fair value of our derivative instruments
on the Consolidated Balance Sheet as either a current or deferred asset or
liability, as appropriate, and record the effective portion of unrealized gains
or losses in accumulated other comprehensive income. Gains and losses are
reclassified from accumulated other comprehensive income to the Consolidated
Statement of Income in the period the hedged transaction affects earnings. Gains
and losses on settled transactions are reflected as a component of either
revenue or fuel and purchased power depending on the hedged transaction. Hedge
ineffectiveness results from changes during the period in the price
differentials between the index price of the derivative contract and the price
of the purchase or sale for the cash flow that is being hedged, and is recorded
directly to earnings.
Firm Gas Sales Financial Derivative Instruments - Regulated Utilities: We use
derivative financial instruments to reduce the cash flow variability associated
with the purchase price for a portion of future natural gas purchases associated
with our Gas Distribution operations. Our strategy is to minimize fluctuations
in gas sales prices to our regulated firm gas sales customers in our New York
and New England service territories. The accounting for these derivative
instruments is subject to SFAS 71. Therefore, the fair value of these
derivatives is recorded as current or deferred assets and liabilities, with
offsetting positions recorded as regulatory assets and regulatory liabilities on
the Consolidated Balance Sheet. Gains or losses on the settlement of these
contracts are initially deferred and then refunded to or collected from our firm
gas sales customers consistent with regulatory requirements. At September 30,
2006 the fair value of these derivative instruments was a liability of $276.8
million.
Physically-Settled Commodity Derivative Instruments: SFAS 133 establishes
criteria that must be satisfied in order for option contracts, forward contracts
with optionality features, or contracts that combine a forward contract and a
purchase option contract to qualify for the normal purchases and sales
exception. Certain contracts for the physical purchase of natural gas associated
with our regulated gas utilities do not qualify for normal purchases under SFAS
133. Since these contracts are for the purchase of natural gas sold to regulated
firm gas sales customers, the accounting for these contracts is subject to SFAS
71. At September 30, 2006, these derivatives had a net fair value of $130.1
million.
Financially-Settled Commodity Derivative Instruments that Do Not Qualify for
Hedge Accounting: KeySpan subsidiaries also have financial derivatives that do
not qualify for hedge accounting treatment under SFAS 133. In 2006, we purchased
a series of call options on the spread between the price of heating oil and the
price of natural gas to further complement our hedging strategy noted above
15
regarding sales to certain large-volume customers. As of September 30, 2006,
these derivatives have expired. However, KeySpan may elect to enter into similar
derivative financial instruments when prevailing market conditions are
favorable.
The Ravenswood Generating Station also employs a limited number of financial
derivatives that have not been designated for hedge accounting treatment under
SFAS 133 to economically hedge the cash flow variability for a portion of
forecasted purchases of natural gas that will be consumed during the generation
of electricity. The fair value of these derivative instruments at September 30,
2006 was a liability of $2.3 million. In addition, the Ravenswood Generating
Station employs a limited number of financial derivatives that have not been
designated for hedge accounting treatment to economically hedge the cash flow
variability for a portion of forecasted electric energy sales. The fair value of
these derivative instruments at September 30, 2006 was $3.6 million; such amount
was recorded in the Consolidated Statement of Income to reflect the change in
the market value associated with these derivative instruments for the nine
months ended September 30, 2006.
On January 18, 2006, KeySpan entered into an International SWAP Dealers
Association Master Agreement for a fixed for float unforced capacity financial
swap (the " Swap Agreement") with Morgan Stanley Capital Group Inc. ("Morgan
Stanley"). The Swap Agreement has a three year term that began on May 1, 2006.
The notional quantity was 1,800,000kW (the "Notional Quantity") of In-City
Unforced Capacity and the fixed price is $7.57/kW-month ("Fixed Price"), subject
to adjustment upon the occurrence of certain events. Cash settlement occurs on a
monthly basis based on the In-City Unforced Capacity price determined by the
relevant New York Independent System Operator ("NYISO") Spot Demand Curve
Auction Market ("Floating Price"). For each monthly settlement period, the price
difference equals the Fixed Price minus the Floating Price. If such price
difference is less than zero, Morgan Stanley will pay KeySpan an amount equal to
the product of (a) the Notional Quantity and (b) the absolute value of such
price difference. Conversely, if such price difference is greater than zero,
KeySpan will pay Morgan Stanley an amount equal to the product of (a) the
Notional Quantity and (b) the absolute value of such price difference. This
derivative instrument does not qualify for hedge accounting treatment under SFAS
133 and is subject to fair value accounting treatment. The recognized fair value
associated with this instrument is immaterial to the financial statements at
September 30, 2006. As noted, this is a financial derivative instrument and is
unrelated to any physical production of electricity.
KeySpan has a management contract with Merrill Lynch Trading, under which
KeySpan and Merrill Lynch Trading will share the responsibilities for managing
KeySpan's upstream gas distribution assets associated with its Massachusetts gas
distribution subsidiaries, as well as providing city-gate delivered supply. This
contract, which replaces the prior arrangement with Merrill Lynch Trading,
allows for both KeySpan and Merrill Lynch Trading to employ derivative
instruments to maximize the profitability of KeySpan's portfolio of gas
distribution assets. Profits associated with these activities are shared between
KeySpan, Merrill Lynch Trading and KeySpan's Massachusetts ratepayers. At
September 30, 2006, KeySpan's proportionate share of the fair value associated
with these derivative instruments amounted to $10.8 million. KeySpan has
recorded a regulatory liability of $7.8 million on the Consolidated Balance
Sheet representing the portion to be shared with Massachusetts ratepayers. The
remaining amount was recorded as a benefit to revenues. KeySpan provides these
services internally for its New York and New Hampshire gas distribution
subsidiaries.
16
Interest Rate Derivative Instruments: KeySpan anticipates issuing, subject to
execution of definitive agreements, approximately $400 million Senior Unsecured
Notes at KEDNY and approximately $100 million Senior Unsecured Notes at KEDLI in
the fourth quarter of 2006. The Notes are anticipated to be issued with ten year
maturities. KeySpan utilized a $125 million treasury lock, at 4.77%, to hedge
the 5-year US Treasury component of the underlying notes and a $125 million
treasury lock, at 4.82%, to hedge the 10-year US Treasury component of the
underlying notes. At September 30, 2006 the fair value of these derivative
instruments was a liability of $2.9 million. The accounting for these derivative
instruments is subject to SFAS 71. Therefore, the fair value of these
derivatives was recorded as a current liability, with an offsetting position
recorded as a regulatory asset on the Consolidated Balance Sheet.
These derivative instruments settled on October 25, 2006 at which time KeySpan
paid $0.2 million to the counterparty to the contracts. The loss on the
settlement of these contracts has been deferred for future collection from firm
gas sales customers consistent with regulatory requirements.
The table below summarizes the fair value of all of the above outstanding
derivative instruments at September 30, 2006 and December 31, 2005, and the
related line item on the Consolidated Balance Sheet. Fair value is the amount at
which derivative instruments could be exchanged in a current transaction between
willing parties, other than in a forced liquidation sale.
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(In Millions of Dollars) Sept. 30, 2006 December 31, 2005
- ----------------------------------------------------------------------------
Gas Contracts:
Other current assets $ 26.2 $ 132.1
Other deferred charges 138.2 75.2
Regulatory asset 257.3 30.9
Other current liability (272.7) (39.8)
Other deferred liabilities (47.7) (44.3)
Regulatory liability (122.2) (175.4)
Oil Contracts:
Other current assets - 0.5
Other current liability (3.8) (6.8)
Electric Contracts:
Other current assets 20.7 10.2
Other deferred charges 0.3 -
Other current liability - (0.7)
Interest Rate Contracts:
Regulatory asset 2.8 -
Other current liability (2.8) -
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$ (3.7) $ (18.1)
- ----------------------------------------------------------------------------
17
Weather Derivatives: The utility tariffs associated with KEDNE's operations do
not contain weather normalization adjustments. As a result, fluctuations from
normal weather may have a significant positive or negative effect on the results
of these operations.
In 2005, we entered into heating-degree day put options, which expired during
the first quarter of 2006, to mitigate the effect of fluctuations from normal
weather on KEDNE's financial position and cash flows for the 2005/2006 winter
heating season - November 2005 through March 2006. These put options would have
paid KeySpan up to $40,000 per heating degree day when the actual temperature
was below 4,169 heating degree days, or approximately 5% warmer than normal,
based on the most recent 20-year average for normal weather. The maximum amount
KeySpan would have received on these purchased put options was $16 million. The
net premium cost for these options was $1.2 million and was amortized over the
heating season. Weather for the entire primary winter heating season -November
2005 through March 2006 - was slightly colder than normal. Therefore, there was
no earnings impact associated with these weather derivatives, except for the
amortization of the net premium cost. We account for these derivatives pursuant
to the requirements of EITF 99-2, "Accounting for Weather Derivatives." In this
regard, such instruments are accounted for using the "intrinsic value method" as
set forth in such guidance.
In the third quarter of 2006, we entered into heating-degree day put options to
mitigate the effect of fluctuations from normal weather on KEDNE's financial
position and cash flows for the upcoming 2006/2007 winter heating season -
November 2006 through March 2007. These put options will pay KeySpan up to
$37,500 per heating degree day when the actual temperature is below 4,159
heating degree days, or approximately 5% warmer than normal, based on the most
recent 20-year average for normal weather. The maximum amount KeySpan will
receive on these purchased put options is $15 million. The net premium cost for
these options is $1.7 million and will be amortized over the heating season.
Credit and Collateral:
Derivative contracts are primarily used to manage exposure to market risk
arising from changes in commodity prices and interest rates. In the event of
non-performance by a counterparty to a derivative contract, the desired impact
may not be achieved. The risk of counterparty non-performance is generally
considered a credit risk and is actively managed by assessing each counterparty
credit profile and negotiating appropriate levels of collateral and credit
support. In instances where the counterparties' credit quality has declined, or
credit exposure exceeds certain levels, we may limit our credit exposure by
restricting new transactions with counterparties, requiring additional
collateral or credit support and negotiating the early termination of certain
agreements. At September 30, 2006, KeySpan has received $5.6 million from its
counterparties as collateral associated with outstanding derivative contracts.
This amount has been recorded as restricted cash, with an offsetting position in
current liabilities on the Consolidated Balance Sheet. At September 30, 2006,
KeySpan has $51.6 million of outstanding margin calls to its counterparties for
open derivative instruments associated with its strategy to minimize
fluctuations in gas sales prices to its regulated firm gas sales customers.
18
We believe that our credit risk related to the above mentioned derivative
financial instruments is no greater than the risk associated with the primary
contracts which they hedge and that the elimination of a portion of the price
risk reduces volatility in the reported results of operations, financial
position and cash flows and lowers overall business risk.
5. RECENT ACCOUNTING PRONOUNCEMENTS
On September 29, 2006, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standard 158 ("SFAS 158") "Employers'
Accounting for Defined Benefit Pensions and Other Postretirement Benefit Plans,
an amendment of FASB Statements No. 87, 88, 106 and 132(R)." SFAS 158 requires
employers to fully recognize all postretirement plans funded status on the
balance sheet as a net liability or asset and will require an offsetting
adjustment to accumulated other comprehensive income in shareholders' equity.
KeySpan estimates, using actual results through January 1, 2006 adjusted for the
amortization of unrecognized gains and losses and prior service cost during
2006, that the pre-tax increase in its total postretirement liabilities
resulting from the adoption of the recognition provisions of SFAS 158 will be
approximately $1 billion. Certain of KeySpan's subsidiaries are subject to
deferral accounting requirements pursuant to rate agreements with the NYPSC and
the Massachusetts Department of Telecommunications and Energy ("MADTE").
Further, KeySpan has certain contractual rights to reimbursement for
postretirement liabilities in its agreements with the Long Island Power
Authority ("LIPA"). As such, a portion of the offsetting position to the
increase in the total postretirement liabilities will be reflected as a
regulatory asset and long-term receivable. The amount to be recorded as a
regulatory asset and long-term receivable and the related impact on
shareholders' equity is subject to final determination. At this point in time,
KeySpan believes that it will remain in compliance with all applicable financial
covenants upon implementation of SFAS 158. SFAS 158 does not change how
postretirement benefits are accounted for and reported in the income statement;
companies will continue to apply existing accounting guidance. KeySpan is
currently reviewing the income tax implications, if any, of SFAS 158.
The recognition and disclosure provisions of SFAS 158 are effective for fiscal
years ending after December 15, 2006, on a prospective basis. SFAS 158 does not
permit retroactive application of its provisions; however, SFAS 158 requires
footnote disclosure of the incremental effect on the balance sheet on a line
item basis in the year of adoption.
On September 15, 2006, the FASB issued SFAS 157 "Fair Value Measurements." This
statement defines fair value, establishes a framework for measuring fair value
in generally accepted accounting principles and expands disclosures about fair
value. This Statement expands the disclosures about the use of fair value to
measure assets and liabilities in interim and annual periods subsequent to
initial recognition. The disclosures focus on the inputs used to measure fair
value, the recurring fair value measurements using significant unobservable
inputs and the effect of the measurement on earnings (or changes in net assets)
for the period. The guidance in this Statement also applies for derivatives and
other financial instruments measured at fair value under Statement 133
19
"Accounting for Derivative Instruments and Hedging Activities" at initial
recognition and in all subsequent periods. This Statement is effective for
fiscal years beginning after November 15, 2007, and interim periods within those
fiscal years. KeySpan is currently reviewing the requirements of this Statement,
and at this point in time cannot determine what impact, if any, this Statement
will have on its results of operations or financial position. This Statement
will have no impact on cash flow.
On July 13, 2006, the FASB issued Interpretation No. 48 "Accounting for
Uncertainty In Income Taxes." The FASB, in its interpretation of SFAS 109,
"Accounting for Income Taxes," seeks to reduce the diversity in practice
associated with certain aspects of the recognition and measurement requirements
related to accounting for income taxes. The Interpretation requires application
for fiscal years beginning after December 15, 2006. KeySpan is currently
reviewing the requirements of this Statement, and at this point in time cannot
determine what impact, if any, this Statement will have on its results of
operations or financial position. This Statement will have no impact on cash
flow.
In December 2004 the FASB issued SFAS 123 (revised 2004 "SFAS 123R")
"Share-Based Payment." SFAS 123R focuses primarily on accounting for
transactions in which an entity obtains employee services in share-based payment
transactions. SFAS 123R revises certain provisions of SFAS 123 "Accounting for
Stock-Based Compensation" and supersedes APB Opinion 25 "Accounting for Stock
Issued to Employees." The fair-value-based method in SFAS 123R is similar to the
fair-value-based method in SFAS 123 in most respects. However, the following are
key differences between the two: entities are now required to measure
liabilities incurred to employees in share-based payment transactions at fair
value as compared to using the intrinsic method allowed under SFAS 123; entities
are now required to estimate the number of instruments for which the requisite
service is expected to be rendered, as compared to accounting for forfeitures as
they occur under SFAS 123; and incremental compensation cost for a modification
of the terms or conditions of an award are also measured differently under SFAS
123R compared to Statement 123. SFAS 123R also clarifies and expands SFAS 123's
guidance in several areas. The effective date of SFAS 123R was the beginning of
the first fiscal year beginning after June 15, 2005. KeySpan adopted the
prospective method of transition for stock options in accordance with SFAS 148
"Accounting for Stock-Based Compensation - Transition and Disclosure."
Accordingly, compensation expense has been recognized by employing the fair
value recognition provisions of SFAS 123 for grants awarded after January 1,
2003. Therefore implementation of SFAS 123R in January 2006 did not have a
material impact on KeySpan's results of operations or financial position and no
impact on its cash flows.
6. FINANCIAL GUARANTEES AND CONTINGENCIES
Variable Interest Entity: KeySpan has an arrangement with a variable interest
entity through which it leases a portion of the Ravenswood Facility. We acquired
the Ravenswood Facility, a 2,200-megawatt electric generating facility located
in Queens, New York, in part, through the variable interest entity, from
Consolidated Edison on June 18, 1999, for approximately $597 million. In order
20
to reduce the initial cash requirements, we entered into a lease agreement (the
"Master Lease") with a variable interest, unaffiliated financing entity that
acquired a portion of the facility, or three steam generating units, directly
from Consolidated Edison and leased it to our subsidiary, KeySpan Ravenswood
LLC. The variable interest unaffiliated financing entity acquired the property
for $425 million, financed with debt of $412.3 million (97% of capitalization)
and equity of $12.7 million (3% of capitalization). KeySpan has no ownership
interests in the units or the variable interest entity. KeySpan has guaranteed
all payment and performance obligations of KeySpan Ravenswood, LLC, under the
Master Lease. Monthly lease payments substantially equal the monthly interest
expense on such debt securities.
The term of the Master Lease extends through June 20, 2009. On all future
semi-annual payment dates, we have the right to: (i) either purchase the
facility for the original acquisition cost of $425 million, plus the present
value of the lease payments that would otherwise have been paid through June
2009; or (ii) terminate the Master Lease and dispose of the facility. In June
2009, when the Master Lease terminates, we may purchase the facility in an
amount equal to the original acquisition cost, subject to adjustment, or
surrender the facility to the lessor. If we elect not to purchase the property,
the Ravenswood Facility will be sold by the lessor. We have guaranteed to the
lessor, as residual value, 84% of the acquisition cost of the property.
We have classified the Master Lease as $412.3 million of long-term debt on the
Consolidated Balance Sheet based on our current status as primary beneficiary.
Further, we have an asset on the Consolidated Balance Sheet for an amount
substantially equal to the fair market value of the leased assets at the
inception of the lease, less depreciation since that date, or approximately
$311.4 million. If KeySpan Ravenswood LLC, was not able to fulfill its payment
obligations with respect to the Master Lease payments, then the maximum amount
KeySpan would be exposed to under its current guarantees would be $425 million
plus the present value of the remaining lease payments through June 20, 2009.
Sale/leaseback Transaction: KeySpan also has a leveraged lease financing
arrangement associated with the Ravenswood Expansion. In May 2004, the unit was
acquired by a lessor from our subsidiary, KeySpan Ravenswood, LLC, and
simultaneously leased back to that subsidiary. All the obligations of KeySpan
Ravenswood, LLC have been unconditionally guaranteed by KeySpan. This lease
transaction qualifies as an operating lease under SFAS 98 "Accounting for
Leases: Sale/Leaseback Transactions Involving Real Estate; Sales-Type Leases of
Real Estate; Definition of the Lease Term; an Initial Direct Costs of Direct
Financing Leases, an amendment of FASB Statements No.13, 66, 91 and a rescission
of FASB Statement No. 26 and Technical Bulletin No. 79-11."
Asset Retirement Obligations: KeySpan has various asset retirement obligations
primarily associated with its gas distribution and electric generation
activities. These obligations have remained substantially unchanged from
December 31, 2005, except for normal accretion adjustments. Generally, KeySpan's
largest asset retirement obligations relate to: (i) legal requirements to cut
(disconnect from the gas distribution system), purge (clean of natural gas and
21
PCB contaminants) and cap gas mains within its gas distribution and transmission
system when mains are retired in place; or dispose of sections of gas main when
removed from the pipeline system; (ii) cleaning and removal requirements
associated with storage tanks containing waste oil and other waste contaminants;
and (iii) legal requirements to remove asbestos upon major renovation or
demolition of structures and facilities. At September 30, 2006, these
obligations total $49.4 million. See KeySpan's Annual Report on Form 10-K for
the year ended December 31, 2005, Note 7 to the Consolidated Financial
Statements "Contractual Obligations, Financial Guarantees and Contingencies" for
additional information regarding these obligations.
Environmental Matters
New York Sites: Within the State of New York we have identified 43 historical
manufactured gas plant ("MGP") sites and related facilities, which were owned or
operated by KeySpan subsidiaries or such companies' predecessors. These former
sites, some of which are no longer owned by KeySpan, have been identified to the
Department of Environmental Conservation ("DEC") for inclusion on appropriate
site inventories. Administrative Orders on Consent ("ACO") or Voluntary Cleanup
Agreements ("VCA") have been executed with the DEC to address the investigation
and/or remediation activities associated with certain sites and one waterway. In
March 2005, KeySpan withdrew its previously filed applications under the DEC's
Brownfield Cleanup Program ("BCP") because of the uncertainty associated with
the effect emerging case law will have on contribution suits which may be
brought against other parties who impacted these sites for their share of
remedial cost. KeySpan continues to evaluate how to proceed with respect to
participation in the BCP or alternative DEC remediation programs. Regardless of
which cleanup program is ultimately employed, KeySpan fully intends to
investigate and remediate these sites, as necessary, and has adjusted its
planned expenditures accordingly.
KeySpan has identified 28 of these sites as being associated with the historical
operations of KEDNY. One site has been fully remediated. Subject to the issues
described in the preceding paragraph, the remaining 27 sites will be
investigated and, if necessary, remediated under the terms and conditions of
ACOs, VCAs, or Brownfield Cleanup Agreements ("BCA"). Expenditures incurred to
date by us with respect to KEDNY MGP-related activities total $75.2 million.
The remaining 15 sites have been identified as being associated with the
historical operations of KEDLI. One site has been fully investigated and
requires no further action. Subject to the issues described above, the remaining
sites will be investigated and, if necessary, remediated under the terms and
conditions of ACOs, VCAs, or BCAs. Expenditures incurred to date by us with
respect to KEDLI MGP-related activities total $59.1 million.
KeySpan presently estimates the remaining cost of its KEDNY and KEDLI
MGP-related environmental remediation activities will be $333.7 million, which
amount has been accrued by us as a reasonable estimate of probable cost for
known sites. However, remediation costs for each site may be materially higher
than noted, depending upon changing technologies and regulatory standards,
22
selected end use for each site, and actual environmental conditions encountered.
With respect to remediation costs, KEDNY and KEDLI rate plans generally provide
for the recovery from customers of investigation and remediation costs of
certain sites. At September 30, 2006, we have reflected a regulatory asset of
$378.4 million for KEDNY/KEDLI MGP sites. In October 2003, KEDNY and KEDLI filed
a joint petition with the NYPSC seeking rate treatment for additional
environmental costs that may be incurred at all of the New York MGP sites. That
petition is still pending. KeySpan has recently filed proposed rate plans for
KEDNY and KEDLI with the NYPSC as part of its application for approval of the
KeySpan / National Grid plc merger, as well as individual applications for a
proposed annual increase in revenues for KEDNY and KEDLI. Among other things,
these filings seek recovery of deferred expenses associated with remediation of
MGP sites, as well as recovery of ongoing remediation expenses. See the
"Introduction to the Notes to the Consolidated Financial Statements" for
additional details on the filings.
KeySpan is also responsible for environmental obligations associated with the
Ravenswood Facility, purchased from Consolidated Edison in 1999, including
remediation activities associated with its historical operations and those of
the MGP facilities that formerly operated at the site. KeySpan is not
responsible for liabilities arising from disposal of waste at off-site locations
prior to the acquisition closing and any monetary fines arising from
Consolidated Edison's pre-closing conduct. We presently estimate the remaining
environmental clean up activities for this site will be $1.5 million, which
amount has been accrued by us. Expenditures incurred to date total $3.5 million.
New England Sites: Within the Commonwealth of Massachusetts and the State of New
Hampshire, we are aware of 74 former MGP sites and related facilities within the
existing or former service territories of KEDNE.
Boston Gas Company, Colonial Gas Company and Essex Gas Company may have or share
responsibility under applicable environmental laws for the remediation of 64 of
these sites. A subsidiary of National Grid USA ("National Grid"), formerly New
England Electric System, has assumed responsibility for remediating 11 of these
sites, subject to a limited contribution from Boston Gas Company, and has
provided full indemnification to Boston Gas Company with respect to eight other
sites. In addition, Boston Gas Company, Colonial Gas Company, and Essex Gas
Company have assumed responsibility for remediating three sites each. At this
time, it is uncertain as to whether Boston Gas Company, Colonial Gas Company or
Essex Gas Company have or share responsibility for remediating any of the other
sites. No notice of responsibility has been issued to us for any of these sites
from any governmental environmental authority.
KeySpan presently estimates the remaining cost of the Massachusetts KEDNE
MGP-related environmental cleanup activities will be $10.5 million, which amount
has been accrued by us as a reasonable estimate of probable cost for known
sites, however remediation costs for each site may be materially higher than
noted, depending upon changing technologies and regulatory standards, selected
end use for each site, and actual environmental conditions encountered.
Expenditures incurred since the November 8, 2000, the acquisition date of these
subsidiaries, with respect to these MGP-related activities total $32.8 million.
23
KeySpan may have or share responsibility under applicable environmental laws for
the remediation of 10 MGP sites and related facilities associated with the
historical operations of EnergyNorth in New Hampshire. At four of these sites,
KeySpan has entered into cost sharing agreements with other parties who share
responsibility for remediation of these sites. EnergyNorth also entered into an
agreement with the United States Environmental Protection Agency ("EPA") for the
contamination from the Nashua site that was allegedly commingled with asbestos
at the so-called Nashua River Asbestos Site, adjacent to the Nashua MGP site.
The Nashua River Asbestos Site now has been fully remediated.
KeySpan presently estimates the remaining cost of EnergyNorth MGP-related
environmental cleanup activities will be $26.7 million, which amount has been
accrued as a reasonable estimate of probable cost for known sites, however,
remediation costs for each site may be materially higher than noted, depending
upon changing technologies and regulatory standards, selected end use for each
site and actual environmental conditions encountered. Expenditures incurred
since November 8, 2000, the acquisition date of this subsidiary, with respect to
the MGP-related activities total $21.7 million.
By rate orders, the Massachusetts Department of Telecommunications and Energy
("MADTE") and the New Hampshire Public Utility Commission ("NHPUC") provide for
the recovery of site investigation and remediation costs and, accordingly, at
September 30, 2006, we have reflected a regulatory asset of $49.3 million for
the KEDNE MGP sites.
KeySpan New England, LLC Sites: KeySpan is aware of three non-utility sites
associated with KeySpan New England, LLC, a successor company to Eastern
Enterprises, for which it may have or share environmental remediation or ongoing
maintenance responsibility. These three sites, located in Philadelphia,
Pennsylvania, New Haven, Connecticut and Everett, Massachusetts, were associated
with historical operations involving the production of coke and related
industrial processes. Honeywell International, Inc. and Beazer East, Inc. (both
former owners and/or operators of certain facilities at Everett (the "Everett
Facility") together with KeySpan, have entered into an ACO with the
Massachusetts Department of Environmental Protection for the investigation and
development of a remedial response plan for a portion of that site. In 1989,
KeySpan, Honeywell and Beazer East entered into a cost-sharing agreement under
which each company agreed to pay one-third of the costs of compliance with the
consent order, while preserving any claims it may have against the other
companies for, among other things, reallocation of proportionate liability. In
2002, Beazer East commenced an action in the U.S. District Court for the
Southern District of New York, which sought a judicial determination on the
allocation of liability for the Everett Facility. A confidential settlement
agreement has been executed on favorable terms to KeySpan and the Beazer lawsuit
has been discontinued.
KeySpan presently estimates the remaining cost of the environmental cleanup
activities for these three non-utility sites will be approximately $13.4
million, which amount has been accrued as a reasonable estimate of probable
costs for known sites however, remediation costs for each site may be materially
higher than noted, depending upon changing technologies and regulatory
standards, selected end use for each site, and actual environmental conditions
encountered. Expenditures incurred since November 8, 2000, with respect to these
sites total $19.5 million.
24
KeySpan believes that in the aggregate, the accrued liability for these MGP
sites and related facilities identified above are reasonable estimates of the
probable cost for the investigation and remediation of these sites and
facilities. As circumstances warrant, we periodically re-evaluate the accrued
liabilities associated with MGP sites and related facilities. We may be required
to investigate and, if necessary, remediate each site previously noted, or other
currently unknown former sites and related facility sites, the cost of which is
not presently determinable but may be material to our financial position,
results of operations or cash flows.
Insurance Settlements: KeySpan has entered into confidential settlement
agreements with certain of its insurance carriers for recovery of costs
associated with the investigation and remediation of its MGP sites and the
KeySpan New England LLC non-utility sites. Pursuant to these settlements,
KeySpan recorded a benefit of $5.5 million in its Consolidated Statement of
Income for the nine months ended September 30, 2006, reflecting the benefit
accruing to KeySpan's shareholders. Recovery of environmental costs from
insurance carriers associated with utility MGP sites are refunded to KeySpan's
ratepayers, subject to certain sharing provisions. During the past year, KeySpan
has received approximately $20 million from insurance carriers in settlements
for recovery of environmental costs associated with remediation of MGP sites.
See KeySpan's Annual Report on Form 10-K for the year ended December 31, 2005
Note 7, to those Consolidated Financial Statements "Contractual Obligations,
Financial Guarantees and Contingencies" for further information on environmental
matters.
Legal Matters
From time to time KeySpan is subject to various legal proceedings arising out of
the ordinary course of its business. Except as described below, or in KeySpan's
Annual Report on Form 10-K for the year ended December 31, 2005, we do not
consider any of such proceedings to be material to our business or likely to
result in a material adverse effect on results of operations, financial
condition or cash flows.
On March 20, 2006, a purported class action lawsuit was filed alleging breach of
fiduciary duty against KeySpan and its directors. The complaint, which was filed
in the New York State Supreme Court for the County of Kings (the "Court"),
related to the execution of the Merger Agreement with National Grid plc and
alleged that the merger consideration which KeySpan's stockholders would receive
in connection with the proposed merger transaction was inadequate and unfair
because the transaction value of $42.00 for each share of KeySpan's common stock
outstanding did not provide its stockholders with a meaningful premium over the
market price of the common stock. On April 19, 2006, we moved to dismiss the
complaint for failure to state a cause of action upon which relief could be
granted. On May 26, 2006, the plaintiff served an amended complaint adding
National Grid plc as a defendant. The amended complaint alleged that National
25
Grid plc aided and abetted the alleged breach of fiduciary duties and added
claims of inadequate disclosure with respect to KeySpan's preliminary proxy
materials. In June 2006, the parties agreed in principle to settle the case, the
terms of which provide for, among other things, the inclusion of additional
disclosures in our 2006 Annual Meeting Proxy Statement concerning the background
and principle events leading to execution of the Merger Agreement, as well as
the payment of plaintiff's counsel fees of up to $350,000 following closing of
the transaction. In October 2006, definitive settlement documents were executed
by the parties and submitted to the Court. The settlement remains subject to a
number of conditions, including Court approval following notice to shareholders.
On July 12, 2006, a purported class action was filed alleging damages resulting
from contamination associated with the historic operations of the former
manufactured gas plant in Bay Shore, New York. On September 6, 2006 KeySpan
filed a motion to dismiss this matter which is pending. In addition, on October
31, 2006, a lawsuit was filed alleging damages resulting from the contamination
associated with the historic operations of a former manufactured gas plant in
Staten Island, New York. KeySpan has been conducting site investigation and
remediation activities at this location pursuant to an Order on Consent with the
DEC. KeySpan intends to contest each of these proceedings vigorously. At this
time, we are unable to predict what effect, if any, the outcome of these
proceedings will have on our financial condition, results of operations and cash
flows.
Other Contingencies: We derive a substantial portion of our revenues in the
Electric Services segment from a series of agreements with LIPA pursuant to
which we manage LIPA's transmission and distribution system and supply the
majority of LIPA's customers' electricity needs. KeySpan and LIPA have entered
into agreements to extend, amend, and restate these contractual arrangements.
See Note 10 "2006 LIPA Settlement" for a further discussion of these agreements.
LIPA completed its strategic review initiative that it had undertaken in
connection with, among other reasons, its option under the Generation Purchase
Rights Agreement with KeySpan. As part of its review, LIPA engaged a team of
advisors and consultants, held public hearings and explored its strategic
options, including continuing its existing operations, municipalizing,
privatizing, selling some, but not all of its assets, becoming a regulator of
rates and services, or merging with one or more utilities. Upon completion of
its strategic review, LIPA determined that it would continue its existing
operations and entered into the renegotiated 2006 LIPA Agreements that are
discussed in Note 10 "2006 LIPA Settlement." Following the announcement of the
proposed acquisition of KeySpan by National Grid plc, LIPA, National Grid plc
and KeySpan have engaged in discussions concerning the impact of the transaction
on LIPA's operations. At this time, we are unable to determine what impact, if
any, such discussions may have on the 2006 LIPA Agreements and the receipt and
timing of governmental approvals relating thereto.
As reported in KeySpan's Annual Report on Form 10-K for the year ended December
31, 2005, pursuant to indemnity obligations contained in the Long Island
Lighting Company ("LILCO") / KeySpan merger agreement, KeySpan has been in
discussions with the Internal Revenue Service ("IRS") with regard to LILCO's tax
returns for the tax years ended December 31, 1996 through March 31, 1999, and
KeySpan's and the Brooklyn Union Gas Company's tax returns for the years ended
September 30, 1997 through December 31, 1998. Two issues were resolved in the
second quarter of 2006. It is anticipated that the remaining issues, including
the primary issue relating to the valuation of certain assets transferred in the
KeySpan/LILCO business combination, will be settled following approval by the
Joint Committee on
26
Taxation. The IRS submitted the case to the Joint Committee on Taxation on
October 30, 2006. Additionally, the IRS recently commenced the examination of
KeySpan's tax returns for the years ended 2002 and 2003. At this time, we cannot
predict the result of these audits. See Note 11 "Income Taxes" for additional
information.
Financial Guarantees
KeySpan has issued financial guarantees in the normal course of business, on
behalf of its subsidiaries, to various third party creditors. At September 30,
2006, the following amounts would have to be paid by KeySpan in the event of
non-payment by the primary obligor at the time payment is due:
- ------------------------------------------------------------------------------------------
Amount of Expiration
Nature of Guarantee (In Millions of Dollars) Exposure Dates
- ------------------------------------------------------------------------------------------
Guarantees for Subsidiaries
Medium-Term Notes - KEDLI (i) $ 525.0 2008 - 2010
Industrial Development Revenue Bonds (ii) 128.3 2027
Ravenswood - Master Lease (iii) 425.0 2009
Ravenswood - Sale/leaseback (iv) 403.5 2019
Surety Bonds (v) 71.4 2006 - 2008
Commodity Guarantees and Other (vi) 77.0 2006 - 2009
Letters of Credit (vii) 80.3 2006 - 2010
- ------------------------------------------------------------------------------------------
$ 1,710.5
- ------------------------------------------------------------------------------------------
The following is a description of KeySpan's outstanding subsidiary guarantees:
(i) KeySpan has fully and unconditionally guaranteed $525 million to holders of
Medium-Term Notes issued by KEDLI. These notes are due to be repaid on
January 15, 2008 and February 1, 2010. KEDLI is required to comply with
certain financial covenants under the debt agreements. The face value of
these notes is included in long-term debt on the Consolidated Balance
Sheet.
(ii) KeySpan has fully and unconditionally guaranteed the payment obligations of
its subsidiaries with regard to $128 million of Industrial Development
Revenue Bonds issued through the Nassau County and Suffolk County
Industrial Development Authorities for the construction of two
electric-generation peaking plants on Long Island. The face value of these
notes are included in long-term debt on the Consolidated Balance Sheet.
(iii) KeySpan has guaranteed all payment and performance obligations of KeySpan
Ravenswood, LLC, the lessee under the Master Lease. The term of the lease
has been extended to June 20, 2009. The Master Lease is classified as
$412.3 million long-term debt on the Consolidated Balance Sheet.
27
(iv) KeySpan has guaranteed all payment and performance obligations of KeySpan
Ravenswood, LLC, the lessee under the sale/leaseback transaction associated
with the Ravenswood Expansion, including future decommissioning costs. The
initial term of the lease is for 36 years. As noted previously, this lease
qualifies as an operating lease and is not reflected on the Consolidated
Balance Sheet.
(v) KeySpan has agreed to indemnify the issuers of various surety and
performance bonds associated with certain construction projects being
performed by certain current or former subsidiaries. In the event that the
subsidiaries fail to perform their obligations under contracts, the injured
party may demand that the surety make payments or provide services under
the bond. KeySpan would then be obligated to reimburse the surety for any
expenses or cash outlays it incurs. Although KeySpan is not guaranteeing
any new bonds for any of the former subsidiaries, KeySpan's indemnity
obligation supports the contractual obligation of these former
subsidiaries. KeySpan has also received from a former subsidiary an
indemnity bond issued by a third party insurance company, the purpose of
which is to reimburse KeySpan in an amount up to $80 million in the event
it is required to perform under all other indemnity obligations previously
incurred by KeySpan to support such company's bonded projects existing
prior to divestiture. At September 30, 2006, the total cost to complete
such remaining bonded projects is estimated to be approximately $26.5
million.
(vi) KeySpan has guaranteed commodity-related payments for subsidiaries within
the Energy Services segment, as well as KeySpan Ravenswood, LLC. These
guarantees are provided to third parties to facilitate physical and
financial transactions involved in the purchase of natural gas, oil and
other petroleum products for electric production and marketing activities.
The guarantees cover actual purchases by these subsidiaries that are still
outstanding as of September 30, 2006.
(vii) KeySpan has arranged for stand-by letters of credit to be issued to third
parties that have extended credit to certain subsidiaries. Certain vendors
require us to post letters of credit to guarantee subsidiary performance
under our contracts and to ensure payment to our subsidiary subcontractors
and vendors under those contracts. Certain of our vendors also require
letters of credit to ensure reimbursement for amounts they are disbursing
on behalf of our subsidiaries, such as to beneficiaries under our
self-funded insurance programs. Such letters of credit are generally issued
by a bank or similar financial institution. The letters of credit commit
the issuer to pay specified amounts to the holder of the letter of credit
if the holder demonstrates that we have failed to perform specified
actions. If this were to occur, KeySpan would be required to reimburse the
issuer of the letter of credit.
To date, KeySpan has not had a claim made against it for any of the above
guarantees and we have no reason to believe that our subsidiaries or former
subsidiaries will default on their current obligations. However, we cannot
predict when or if any defaults may take place or the impact any such
defaults may have on our consolidated results of operations, financial
condition or cash flows.
28
7. STOCK BASED COMPENSATION
From time to time, KeySpan awards stock based compensation to officers,
directors, consultants and certain other management employees, primarily under
the Long Term Performance Incentive Compensation Plan (the "Incentive Plan").
The Incentive Plan provides for the award of incentive stock options,
non-qualified stock options, performance shares and restricted shares. The
purpose of the Incentive Plan is to optimize KeySpan's performance through
incentives that directly link the participant's goals to those of KeySpan's
shareholders and to attract and retain participants who make significant
contributions to the success of KeySpan.
Under this Plan, 19,250,000 shares were authorized for issuance of which the
total shares awarded to date include 16.9 million stock options, 222,143 shares
of restricted stock, and 891,555 performance shares. At September 30, 2006,
after adjusting for forfeitures, there are approximately 3.1 million shares
still eligible to be granted under the Incentive Plan. In addition, under
previous plans, there were an additional 1.7 million shares authorized for which
approximately 1.2 million stock options were awarded.
In 2005, KeySpan continued to apply APB Opinion 25 "Accounting for Stock Issued
to Employees," in accounting for grants awarded prior to January 1, 2003. No
compensation cost had been recognized for these stock option awards since the
exercise prices and market values were equal on the grant dates. Had
compensation cost for these plans been determined based on the fair value at the
grant dates for awards under the plans consistent with SFAS 123 "Accounting for
Stock-Based Compensation," our net income and earnings per share for the three
and nine months ended September 30, 2005 would have decreased to the pro-forma
amounts indicated below:
- -------------------------------------------------------------------------------------------------------
Three Months Ended Nine Months Ended
(In Millions of Dollars, Except Per Share Amounts) September 30, 2005 September 30, 2005
- -------------------------------------------------------------------------------------------------------
Earnings available for common stock:
As reported $ 22.6 $ 273.2
Add: recorded stock-based compensation expense, net of tax 1.3 7.4
Deduct: total stock-based compensation expense, net of tax (1.8) (8.8)
- -------------------------------------------------------------------------------------------------------
Pro-forma earnings $ 22.1 $ 271.8
- -------------------------------------------------------------------------------------------------------
Earnings per share:
Basic - as reported $ 0.13 $ 1.62
Basic - pro-forma $ 0.13 $ 1.61
Diluted - as reported $ 0.13 $ 1.61
Diluted - pro-forma $ 0.13 $ 1.60
- -------------------------------------------------------------------------------------------------------
29
In 2003, KeySpan adopted the prospective method of transition of accounting for
stock based compensation expense in accordance with SFAS 148 "Accounting for
Stock-Based Compensation - Transition and Disclosure". Accordingly, compensation
expense has been recognized by employing the fair value recognition provisions
of SFAS 123 for grants awarded after January 1, 2003. In January 2006, KeySpan
adopted SFAS 123 (revised 2004) "Share-Based Payment ("SFAS 123R")." The
implementation of this standard required KeySpan to expense certain stock
options that had previously been accounted for under the requirements of APB
Opinion 25 and related Interpretations, i.e. awards issued prior to January 1,
2003. No compensation cost had been recognized for these fixed stock option
plans in the Consolidated Financial Statements since the exercise prices and
market values were equal on the grant dates. For the nine months ended September
30, 2006, KeySpan recorded an expense of $1.0 million for stock option awards
previously accounted for under APB 25 and which have not fully vested.
The following table presents the actual expense for all of KeySpan's stock based
compensation awards recorded in the Consolidated Statement of Income for the
periods indicated.
- ----------------------------------------------------------------------------------------------------------
Nine Months Ended
September 30, September 30,
(In Millions of Dollars, Except Per Share Amounts) 2006 2005
- ----------------------------------------------------------------------------------------------------------
Performance shares $ 6.1 $ 2.5
Restricted stock 3.9 0.6
Stock options 4.6 4.2
EDSPP discount 3.8 3.9
- ----------------------------------------------------------------------------------------------------------
Total stock-based compensation included in operations and maintenance expense 18.4 11.2
Income tax benefit (6.4) (3.9)
- ----------------------------------------------------------------------------------------------------------
Total stock based compensation expense, net of tax $ 12.0 $ 7.3
- ----------------------------------------------------------------------------------------------------------
Prior to the adoption of SFAS 123R, KeySpan presented all tax benefits for
deductions resulting from the exercise of stock options and disqualifying
dispositions as operating cash flows in its Consolidated Statement of Cash
Flows. SFAS 123R requires the benefits of tax deductions in excess of recognized
compensation expense to be reported as a financing cash flow, rather than as an
operating cash flow. This requirement will reduce net operating cash flows and
increase net financing cash flows in periods after adoption. Total cash flow
will remain unchanged from what would have been reported under prior accounting
rules.
During the nine months ended September 30, 2006 and 2005, cash received from
stock options exercised was $24.9 million and $42.7 million, respectively. The
actual tax benefit realized for tax deductions from stock options exercised was
$2.6 million and $5.3 million for the nine months ended September 30, 2006 and
2005, respectively. The benefits received from these tax deductions were less
than the recognized compensation expense and accordingly there were no excess
tax deductions reported in the financing section of the Consolidated Statement
of Cash Flows.
30
The following represents a discussion of the various awards granted under our
stock based compensation plans:
Performance shares
Performance shares were awarded under the Incentive Plan in 2004 and 2005 based
upon the attainment of overall corporate performance goals. These performance
shares are measured over a three year period by comparing KeySpan's cumulative
total shareholder return to the S&P Utilities Group. For actual performance
achieved at a threshold level, 50% of the award will be granted; for actual
performance achieved at a targeted level, 100% of the award will be granted; and
for actual performance achieved at the maximum level, 150% of the award will be
granted. The 2004 and 2005 awards are being expensed ratably over their
remaining performance periods.
The 2006 performance share award reflects the new performance condition criteria
under SFAS 123R. In 2006, 314,560 performance shares were granted to officers.
Performance shares were granted with a three-year performance period with a
threshold, target and maximum performance level. The number of performance
shares earned at the end of the performance period can range from 0% to 150% of
the shares granted and will be linked to two performance measures: the
percentage improvement in return on invested capital, or "ROIC," and KeySpan's
cumulative three-year total stockholder return, or "TSR," relative to the
cumulative three-year TSR for the Standard and Poor's Utilities Group, using a
matrix approach that encompasses both measures. The ROIC goal will act as the
primary trigger. If the ROIC goal performance is below the threshold level, all
shares shall be forfeited without payment. Upon a change of control, performance
shares shall be distributed based upon the greater of the number of performance
shares awarded at target level or the number of shares earned based on actual
performance through the change of control date. Performance share awards were
priced at fair value on the date of grant. The unearned compensation as of
September 30, 2006 associated with all of the performance share awards was $13.8
million.
Restricted Stock Awards
KeySpan has made certain grants of restricted stock to officers and directors
under the Incentive Plan. Awards of restricted stock were made in 2002, 2005 and
2006. These awards may not be sold or otherwise transferred until certain
restrictions have lapsed. The unearned stock-based compensation related to these
awards is being amortized to compensation expense over the period in which the
awards vest. The share-based expense for these awards was determined based on
the fair value of the stock at the date of grant applied to the total number of
shares that were anticipated to fully vest. The 2002 and 2005 awards will be
fully expensed by the end of this year and the 2006 award was expensed in the
first quarter of 2006. Upon a change of control, all restricted stock awards
will vest immediately. The unearned compensation as of September 30, 2006,
associated with these awards was $0.1 million.
31
Employee Discount Stock Purchase Plan
KeySpan's Employee Discount Stock Purchase Plan ("EDSPP") allows KeySpan
employees to purchase shares of KeySpan stock at a 10% discount through payroll
deductions. KeySpan is currently expensing the discount. The number of shares of
common stock authorized for issuance under the EDSPP is 1,750,000 shares and
there are 414,602 shares remaining to be issued.
Stock Options
The stock option component of the Incentive Plan entitles the participants to
purchase shares of common stock at an exercise price per share which is no less
than the closing price of the common stock on the date of the grant. Stock
options generally vest over a three-to-five year period and have an exercise
period of ten years. Upon a change of control, all stock options granted and
outstanding will vest immediately.
The value of all stock option grants are estimated on the date of the grant
using the Black-Scholes option-pricing model. There were no stock options
granted in 2006. The following table presents the weighted average fair value,
exercise price and assumptions used for the 2005 stock option grant:
- ---------------------------------------------------
2005
- ---------------------------------------------------
Fair value of grants issued $ 6.15
Dividend yield 4.64%
Expected volatility 22.63%
Risk free rate 4.10%
Expected lives 6.4 years
Exercise price $ 39.25
- ---------------------------------------------------
A summary of the status of our fixed stock option plans and changes is presented
below for the nine months ended September 30, 2006:
- ------------------------------------------------------------------------------------------
Weighted Aggregate
Average Intrinsic Value
Fixed Options Shares Exercise Price (In Millions)
- ------------------------------------------------------------------------------------------
Outstanding at beginning of period 10,443,055 $ 33.74
Granted during the year - $ -
Exercised (774,984) $ 32.18
Forfeited (136,436) $ 36.77
- ------------------------------------------------------------------------------------------
Outstanding at end of period 9,531,635 $ 33.82 $ 65.4
- ------------------------------------------------------------------------------------------
Exercisable at end of period 6,984,633 $ 32.74 $ 55.5
- ------------------------------------------------------------------------------------------
The total intrinsic value of the options exercised during the nine months ended
September 30, 2006 and 2005 was approximately $6.6 million and $11.4 million,
respectively.
32
- ------------------------------------------------------------------------------------------------------------------------------------
Remaining Options Outstanding at Weighted Average Range of Options Exercisable at Weighted Average Range of
Contractual September 30, 2006 Exercise Price Exercise Price September 30, 2006 Exercise Price Exercise Price
Life
- ------------------------------------------------------------------------------------------------------------------------------------
1 years - $ - $ - - $ - $ -
2 years 185,000 $ 32.63 $32.63 185,000 $ 32.63 $32.63
3 years 704,625 $ 28.00 $ 24.73 - 29.38 704,625 $ 28.00 $ 24.73 - 29.38
4 years 382,181 $ 26.97 $ 21.99 - 27.06 382,181 $ 26.97 $ 21.99 - 27.06
5 years 972,837 $ 22.69 $ 22.50 - 32.76 972,837 $ 22.69 $ 22.50 - 32.76
6 years 1,557,199 $ 39.50 $39.50 1,557,199 $ 39.50 $39.50
7 years 1,769,595 $ 32.66 $32.66 1,436,495 $ 32.66 $32.66
8 years 1,174,801 $ 32.40 $32.40 770,961 $ 32.40 $32.40
9 years 1,424,134 $ 37.54 $37.54 656,945 $ 37.54 $37.54
10 years 1,361,263 $ 39.25 $39.25 318,390 $ 39.25 $39.25
- ------------------------------------------------------------------------------------------------------------------------------------
9,531,635 6,984,633
- ------------------------------------------------------------------------------------------------------------------------------------
As of September 30, 2006, there are approximately 2.5 million options which have
not yet vested. The unearned compensation cost related to these stock option
awards is $4.7 million which is expected to be recognized over a weighted
average period of 2 years.
8. POSTRETIREMENT BENEFITS
Pension Plans: The following information represents the consolidated net
periodic pension cost for the three and nine months ended September 30, 2006 and
2005, for our noncontributory defined benefit pension plans which cover
substantially all employees. Benefits are based on years of service and
compensation. Funding for pensions is in accordance with requirements of federal
law and regulations. KEDLI and Boston Gas Company are subject to certain
deferral accounting requirements mandated by the NYPSC and the MADTE,
respectively for pension costs and other postretirement benefit costs. Further,
KeySpan's electric subsidiaries are subject to certain "true-up" provisions in
accordance with the LIPA service agreements.
The calculation of net periodic pension cost is as follows:
- ------------------------------------------------------------------------------------------------------------------------------------
Three Months Ended September 30, Nine Months Ended September 30,
(In Millions of Dollars) 2006 2005 2006 2005
- ------------------------------------------------------------------------------------------------------------------------------------
Service cost, benefits earned during the period $ 14.9 $ 14.2 $ 47.0 $ 42.5
Interest cost on projected benefit obligation 39.1 37.1 116.3 111.4
Expected return on plan assets (45.5) (43.2) (139.5) (129.8)
Net amortization and deferral 22.7 18.4 66.5 55.4
- ------------------------------------------------------------------------------------------------------------------------------------
Total pension cost $ 31.2 $ 26.5 $ 90.3 $ 79.5
- ------------------------------------------------------------------------------------------------------------------------------------
Other Postretirement Benefits: The following information represents the
consolidated net periodic other postretirement benefit cost for the three and
nine months ended September 30, 2006 and 2005 for our noncontributory defined
benefit plans covering certain health care and life insurance benefits for
retired employees. We have been funding a portion of future benefits over
employees' active service lives through Voluntary Employee Beneficiary
Association ("VEBA") trusts. Contributions to VEBA trusts are tax deductible,
subject to limitations contained in the Internal Revenue Code.
33
Net periodic other postretirement benefit cost included the following
components:
- ---------------------------------------------------------------------------------------------------------------------------------
Three Months Ended September 30, Nine Months Ended September 30,
(In Millions of Dollars) 2006 2005 2006 2005
- ---------------------------------------------------------------------------------------------------------------------------------
Service cost, benefits earned during the period $ 4.7 $ 6.1 $ 18.6 $ 18.3
Interest cost on accumulated
postretirement benefit obligation 15.9 19.0 56.2 56.8
Expected return on plan assets (9.2) (9.0) (27.5) (27.1)
Net amortization and deferral 9.7 14.9 43.0 44.9
- ---------------------------------------------------------------------------------------------------------------------------------
Other postretirement cost $ 21.1 $ 31.0 $ 90.3 $ 92.9
- ---------------------------------------------------------------------------------------------------------------------------------
During the first nine months of 2006, KeySpan contributed $90.0 million to its
pension plans and $18.0 million to its other postretirement benefit plans.
KeySpan anticipates contributing an additional $12.0 million to its other
postretirement benefit plans during the remainder of 2006. Estimated
contribution levels are subject to change based on future market returns,
interest rates and certain other measurements. Actual contributions, therefore,
may vary from these levels.
9. COMMERCIAL PAPER
At September 30, 2006, KeySpan had two credit facilities totaling $1.5 billion -
$920 million for five years through 2010, and $580 million through 2009, which
continue to support KeySpan's commercial paper program for ongoing working
capital needs.
The fees for the facilities are based on KeySpan's current credit ratings and
are increased or decreased based on a downgrading or upgrading of our ratings.
The current annual facility fee is 0.07% based on our credit rating of A3 by
Moody's Investor Services and A by Standard & Poor's for each facility. Both
credit facilities allow for KeySpan to borrow using several different types of
loans; specifically, Eurodollar loans, ABR loans, or competitively bid loans.
Eurodollar loans are based on the Eurodollar rate plus a margin that is tied to
our applicable credit ratings. ABR loans are based on the higher of the Prime
Rate, the base CD rate plus 1%, or the Federal Funds Effective Rate plus 0.5%.
Competitive bid loans are based on bid results requested by KeySpan from the
lenders. We do not anticipate borrowing against these facilities; however, if
the credit rating on our commercial paper program were to be downgraded, it may
be necessary to do so.
The facilities contain certain affirmative and negative operating covenants,
including restrictions on KeySpan's ability to mortgage, pledge, encumber or
otherwise subject its utility property to any lien, as well as certain financial
covenants that require us to, among other things, maintain a consolidated
indebtedness to consolidated capitalization ratio of no more than 65% at the
last day of any fiscal quarter. Violation of these covenants could result in the
termination of the facilities and the required repayment of amounts borrowed
thereunder, as well as possible cross defaults under other debt agreements. At
September 30, 2006, KeySpan's consolidated indebtedness was 48.3% of its
consolidated capitalization and KeySpan was in compliance with all covenants.
34
Subject to certain conditions set forth in the credit facility, KeySpan has the
right, at any time, to increase the commitments under the $920 million facility
up to an additional $300 million. In addition, KeySpan has the right to request
that the termination date be extended for an additional period of 365 days prior
to each anniversary of the closing date. This extension option, however,
requires the approval of lenders holding more than 50% of the total commitments
to such extension request. Under the agreements, KeySpan has the ability to
replace non-consenting lenders with other pre-approved banks or financial
institutions.
At September 30, 2006, we had cash and temporary cash investments of $40.0
million. During the first nine months of 2006, we repaid $327.6 million of
commercial paper and, at September 30, 2006, $330.0 million of commercial paper
was outstanding at a weighted average annualized interest rate of 5.38%. At
September 30, 2006, KeySpan had the ability to issue up to an additional $1.2
billion, under its commercial paper program.
10. 2006 LIPA SETTLEMENT
LIPA is a corporate municipal instrumentality and a political subdivision of the
State of New York. On May 28, 1998, certain of the Long Island Lighting
Company's ("LILCO's") business units were merged with KeySpan and LILCO's common
stock and remaining assets were acquired by LIPA. At the time of this
transaction, KeySpan and LIPA entered into three major long-term service
agreements that (i) provide to LIPA all operation, maintenance and construction
services and significant administrative services relating to the Long Island
electric transmission and distribution ("T&D") system pursuant to a Management
Services Agreement (the "1998 MSA"); (ii) supply LIPA with electric generating
capacity, energy conversion and ancillary services from our Long Island
generating units pursuant to a Power Supply Agreement (the "1998 PSA") and other
long-term agreements through which we provide LIPA with approximately one half
of its customers' energy needs; and (iii) manage all aspects of the fuel supply
for our Long Island generating facilities, as well as all aspects of the
capacity and energy owned by or under contract to LIPA pursuant to an Energy
Management Agreement (the "1998 EMA"). We also purchase energy, capacity and
ancillary services in the open market on LIPA's behalf under the 1998 EMA. The
1998 MSA, 1998 PSA and 1998 EMA all became effective on May 28, 1998 and are
collectively referred to as the 1998 LIPA Agreements.
On February 1, 2006, KeySpan and LIPA entered into (i) an amended and restated
Management Services Agreement (the "2006 MSA"), pursuant to which KeySpan will
continue to operate and maintain the electric T&D System owned by LIPA on Long
Island; (ii) a new Option and Purchase and Sale Agreement (the "2006 Option
Agreement"), to replace the Generation Purchase Rights Agreement (as amended,
the "GPRA"), pursuant to which LIPA had the option, through December 15, 2005,
to acquire substantially all of the electric generating facilities owned by
KeySpan on Long Island; and (iii) a Settlement Agreement (the "2006 Settlement
Agreement") resolving outstanding issues between the parties regarding the 1998
LIPA Agreements. The 2006 MSA, the 2006 Option Agreement and the 2006 Settlement
Agreement are collectively referred to herein as the "2006 LIPA Agreements."
35
Each of the 2006 LIPA Agreements will become effective as of January 1, 2006,
upon all of the 2006 LIPA Agreements receiving the required governmental
approvals; otherwise none of the 2006 LIPA Agreements will become effective.
Following the announcement of the proposed acquisition of KeySpan by National
Grid plc, LIPA, National Grid plc and KeySpan have engaged in discussions
concerning the impact of the transaction on LIPA's operations. At this time, we
are unable to determine what impact, if any, the results of such discussions may
have on the 2006 LIPA Agreements and the receipt and timing of governmental
approvals relating thereto.
2006 Settlement Agreement
Pursuant to the terms of the 2006 Settlement Agreement, KeySpan and LIPA agreed
to resolve issues that have existed between the parties relating to the various
1998 LIPA Agreements. In addition to the resolution of these matters, KeySpan's
entitlement to utilize LILCO's available tax credits and other tax attributes
will increase from approximately $50 million to approximately $200 million.
These credits and attributes may be used to satisfy KeySpan's previously
incurred indemnity obligation to LIPA for any federal income tax liability that
may result from the settlement of a pending Internal Revenue Service ("IRS")
audit for LILCO's tax year ended March 31, 1999. In recognition of these items,
as well as for the modification and extension of the 1998 MSA and the
elimination of the GPRA, upon effectiveness of the Settlement Agreement, KeySpan
will record a contractual asset in the amount of approximately $160 million, of
which approximately $110 million will be attributed to the right to utilize such
additional tax credits and attributes and approximately $50 million will be
amortized over the eight year term of the 2006 MSA. In order to compensate LIPA
for the foregoing, KeySpan will pay LIPA $69 million in cash and will settle
certain accounts receivable in the amount of approximately $91 million due from
LIPA.
Generation Purchase Rights Agreement and 2006 Option Agreement.
Under an amended GPRA, LIPA had the right to acquire certain of KeySpan's Long
Island-based generating assets formerly owned by LILCO, at fair market value at
the time of the exercise of such right. LIPA was initially required to make a
determination by May 2005, but KeySpan and LIPA agreed to extend the date by
which LIPA was to make this determination to December 15, 2005. As part of the
2006 Settlement between KeySpan and LIPA, the parties entered into the 2006
Option Agreement whereby LIPA has the option during the period January 1, 2006
to December 31, 2006 to purchase only KeySpan's Far Rockaway and/or E.F. Barrett
Generating Stations (and certain related assets) at a price equal to the net
book value of each facility. The 2006 Option Agreement replaces the GPRA, the
expiration of which has been stayed pending effectiveness of the 2006 LIPA
Agreements. If LIPA were to exercise the option and purchase one or both of the
generation facilities (i) LIPA and KeySpan will enter into an operation and
maintenance agreement, pursuant to which KeySpan will continue to operate these
facilities for a fixed management fee plus reimbursement for certain costs; and
(ii) the 1998 PSA and 1998 EMA will be amended to reflect that the purchased
generating facilities would no longer be covered by those agreements. It is
anticipated that the fees received pursuant to the operation and maintenance
agreement will offset the reduction in the operation and maintenance expense
recovery component of the 1998 PSA and the reduction in fees under the 1998 EMA.
In the event such agreements do not become effective by reason of failure to
secure the requisite governmental approvals, the GPRA will be reinstated for a
period of 90 days.
36
Management Services Agreements
In place of the previous compensation structure (whereby KeySpan was reimbursed
for budgeted costs, and earned a management fee and certain performance and
cost-based incentives), KeySpan's compensation for managing the T&D System under
the 2006 MSA consists of two components: a minimum compensation component of
$224 million per year and a variable component based on electric sales. The $224
million component will remain unchanged for three years and then increase
annually by 1.7%, plus inflation. The variable component, which will comprise no
more than 20% of KeySpan's compensation, is based on electric sales on Long
Island exceeding a base amount of 16,558 gigawatt hours, increasing by 1.7% in
each year. Above that level, KeySpan will receive approximately 1.34 cents per
kilowatt hour for the first contract year, 1.29 cents per kilowatt hour in the
second contract year (plus an annual inflation adjustment), 1.24 cents per
kilowatt hour in the third contract year (plus an annual inflation adjustment),
with the per kilowatt hour rate thereafter adjusted annually by inflation.
Subject to certain limitations, KeySpan will be able to retain all operational
efficiencies realized during the term of the 2006 MSA.
LIPA will continue to reimburse KeySpan for certain expenditures incurred in
connection with the operation and maintenance of the T&D System, and other
payments made on behalf of LIPA, including: real property and other T&D System
taxes, return postage, capital construction expenditures and storm costs.
11. INCOME TAXES
KeySpan's consolidated effective income tax rate, including city and state
income taxes, was 33.9% for the nine months ended September 30, 2006 compared to
36.6% for the corresponding period in 2005. During the second quarter of 2006,
KeySpan resolved its dispute with the New York City Department of Taxation and
Finance with respect to income taxes relating to the operations of its merchant
electric generating facility. In addition, pursuant to indemnity obligations
contained in the LILCO / KeySpan merger agreement, KeySpan has been in
discussions with the IRS with regard to LILCO's tax returns for the tax years
ended December 31, 1996 through March 31, 1999 and KeySpan's and The Brooklyn
Union Gas Company's tax returns for the years ended September 30, 1997 through
December 31, 1998. Two issues were resolved in the second quarter of 2006. As a
result of settling the two issues with the IRS, as well as the New York City tax
issue, KeySpan realized a tax benefit of $16.4 million for the nine months ended
September 30, 2006. It is anticipated that the remaining issues including the
primary issue relating to the valuation of certain assets transferred in the
KeySpan/LILCO business combination of May 1998 will be settled following
approval by the Joint Committee on Taxation. The IRS submitted the case to the
Joint Committee on Taxation on October 30, 2006. Further, a $3.4 million benefit
was recorded in the third quarter of 2006 reflecting an accrual for prior
investment tax credits that KeySpan is entitled to. KeySpan has recently filed
amended tax returns to reflect its entitlement to investment tax credits for the
period 2000 through 2004. The decrease in the effective tax rate for the nine
months ended September 30, 2006 compared to the same period in 2005, was
primarily due to the aforementioned items.
37
The IRS has also recently commenced the examination of KeySpan's tax returns for
the years ended December 31, 2002 and 2003. At this time, we cannot predict the
result of these audits.
12. GAS EXPLORATION AND PRODUCTION PROPERTY - DEPLETION
KeySpan has gas exploration and production activities through its two
wholly-owned subsidiaries - KeySpan Exploration and Production, LLC ("KeySpan
Exploration") and Seneca-Upshur Petroleum, Inc. ("Seneca-Upshur"). At September
30, 2006, these subsidiaries had net exploration and production property in the
amount of $73.7 million. These assets are accounted for under the full cost
method of accounting. Under the full cost method, costs of acquisition,
exploration and development of natural gas and oil reserves plus asset
retirement obligations are capitalized into a "full cost pool" as incurred.
Unproved properties and related costs are excluded from the depletion and
amortization base until a determination is made as to the existence of proved
reserves. Properties are depleted and charged to operations using the unit of
production method using proved reserve quantities.
To the extent that such capitalized costs (net of accumulated depletion) less
deferred taxes exceed the present value (using a 10% discount rate) of estimated
future net cash flows from proved natural gas and oil reserves and the lower of
cost or fair value of unproved properties, less deferred taxes, such excess
costs are charged to operations, but would not have an impact on cash flows.
Once incurred, such impairment of gas properties is not reversible at a later
date even if gas prices increase.
The ceiling test is calculated using natural gas and oil prices in effect as of
the balance sheet date, held flat over the life of the reserves. We use
derivative financial instruments that qualify for hedge accounting under SFAS
133 "Accounting for Derivative Instruments and Hedging Activities," to hedge the
volatility of natural gas prices. In accordance with current SEC guidelines, we
have included estimated future cash flows from our hedging program in ceiling
test calculations.
As of September 30, 2006, KeySpan estimated that its capitalized costs exceeded
the ceiling test limitation by $25.8 million. KeySpan used an average wellhead
price of $3.63 per MCF for this measurement. In accordance with current SEC
guidelines, we have included estimated future cash flows from our hedging
program in the ceiling test calculation. At September 30, 2006, Seneca-Upshur's
cash flow hedges had an average fixed price of approximately $7.00 per MCF.
Therefore, since the fixed price of $7.00 MCF was in excess of the average
wellhead price of $3.63 per MCF, the cash flow hedges resulted in a favorable
impact to the ceiling test calculation of $15.2 million.
Subsequent to September 30, 2006, the average wellhead price increased
substantially and was $7.77 per MCF on October 26, 2006. As permitted by current
SEC guidelines, KeySpan elected to use this measurement date to re-compute the
ceiling test limitation. Based on this price, KeySpan determined that its
capitalized costs did not exceed the ceiling test limitation, and as a result, a
38
non-cash impairment charge was not recorded in the third quarter of 2006. As
noted previously, at September 30, 2006, Seneca-Upshur's cash flow hedges had an
average fixed price of approximately $7.00 per MCF. Therefore, since the fixed
price of $7.00 MCF was below the more current average wellhead price of $7.77
per MCF, the cash flow hedges resulted in an unfavorable impact to the
re-computed ceiling test calculation of $3.5 million.
13. KEYSPAN GAS EAST CORPORATION SUMMARY FINANCIAL INFORMATION
KEDLI is a wholly owned subsidiary of KeySpan. KEDLI was formed on May 7, 1998
and on May 28, 1998 acquired substantially all of the assets related to the gas
distribution business of the Long Island Lighting Company. KEDLI established a
program for the issuance, from time to time, of up to $600 million aggregate
principal amount of Medium-Term Notes, which are fully and unconditionally
guaranteed by the parent, KeySpan Corporation. On February 1, 2000, KEDLI issued
$400 million of 7.875% Medium-Term Notes due 2010. In January 2001, KEDLI issued
an additional $125 million of Medium-Term Notes at 6.9% due January 2008. The
following condensed financial statements are required to be disclosed by SEC
regulations and set forth those of KEDLI, KeySpan Corporation as guarantor of
the Medium-Term Notes and our other subsidiaries on a combined basis.
- ---------------------------------------------------------------------------------------------------------------------------------
Statement of Income
- ---------------------------------------------------------------------------------------------------------------------------------
Three Months Ended September 30, 2006
(In Millions of Dollars) Guarantor KEDLI Other Subsidiaries Eliminations Consolidated
- --------------------------------------------------------------------------------------------------------------------------------
-----------------------------------------------------------------------------
Revenues $ 0.2 $ 163.3 $ 1,055.2 $ (0.2) $ 1,218.5
-----------------------------------------------------------------------------
Operating Expenses
Purchased gas - 112.9 248.6 - 361.5
Fuel and purchased power - - 172.6 - 172.6
Operations and maintenance 13.0 33.3 326.4 - 372.7
Intercompany expense - 1.3 (1.1) (0.2) -
Depreciation and amortization - 15.0 69.2 - 84.2
Operating taxes - 15.5 80.4 - 95.9
-----------------------------------------------------------------------------
Total Operating Expenses 13.0 178.0 896.1 (0.2) 1,086.9
-----------------------------------------------------------------------------
Income from equity investments - - 4.2 - 4.2
-----------------------------------------------------------------------------
Operating Income (Loss) (12.8) (14.7) 163.3 - 135.8
-----------------------------------------------------------------------------
Interest charges (42.5) (13.4) (20.5) 9.3 (67.1)
Other income and (deductions) 93.9 1.1 (16.8) (70.2) 8.0
-----------------------------------------------------------------------------
Total Other Income and (Deductions) 51.4 (12.3) (37.3) (60.9) (59.1)
-----------------------------------------------------------------------------
Income Taxes (Benefit) (11.7) (11.5) 49.6 - 26.4
-----------------------------------------------------------------------------
Net Income (Loss) $ 50.3 $ (15.5) $ 76.4 $ (60.9) $ 50.3
=============================================================================
- --------------------------------------------------------------------------------------------------------------------------------
39
- ---------------------------------------------------------------------------------------------------------------------------------
Statement of Income
- ---------------------------------------------------------------------------------------------------------------------------------
Three Months Ended September 30, 2005
(In Millions of Dollars) Guarantor KEDLI Other Subsidiaries Eliminations Consolidated
- --------------------------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------
Revenues $ 0.2 $ 185.1 $ 1,118.0 $ (0.2) $ 1,303.1
------------------------------------------------------------------------------
Operating Expenses
Purchased gas - 136.5 259.2 - 395.7
Fuel and purchased power - - 254.6 - 254.6
Operations and maintenance 3.5 32.6 328.2 - 364.3
Intercompany expense - 1.2 (1.0) (0.2) -
Depreciation and amortization - 14.1 78.0 - 92.1
Operating taxes - 15.5 81.6 - 97.1
------------------------------------------------------------------------------
Total Operating Expenses 3.5 199.9 1,000.6 (0.2) 1,203.8
------------------------------------------------------------------------------
Income from equity investments - - 2.5 - 2.5
Gain on sale of property - - 1.0 - 1.0
------------------------------------------------------------------------------
Operating Income (Loss) (3.3) (14.8) 120.9 - 102.8
------------------------------------------------------------------------------
Interest charges (37.3) (13.7) (22.4) 6.0 (67.4)
Other income and (deductions) 50.4 0.3 (28.3) (26.2) (3.8)
------------------------------------------------------------------------------
Total Other Income and (Deductions) 13.1 (13.4) (50.7) (20.2) (71.2)
------------------------------------------------------------------------------
Income Taxes (Benefit) (12.8) (9.9) 31.7 - 9.0
------------------------------------------------------------------------------
Net Income (Loss) $ 22.6 $ (18.3) $ 38.5 $ (20.2) $ 22.6
==============================================================================
- --------------------------------------------------------------------------------------------------------------------------------
- -----------------------------------------------------------------------------------------------------------------------------
Statement of Income
- -----------------------------------------------------------------------------------------------------------------------------
Nine Months Ended September 30, 2006
(In Millions of Dollars) Guarantor KEDLI Other Subsidiaries Eliminations Consolidated
- -----------------------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------
Revenues $ 0.5 $ 952.9 $ 4,304.4 $ (0.5) $ 5,257.3
------------------------------------------------------------------------------
Operating Expenses
Purchased gas - 631.6 1,781.1 - 2,412.7
Fuel and purchased power - - 418.3 - 418.3
Operations and maintenance 30.2 104.1 1,065.0 - 1,199.3
Intercompany expense - 4.0 (3.5) (0.5) -
Depreciation and amortization - 58.8 236.9 - 295.7
Operating taxes - 48.5 261.4 - 309.9
------------------------------------------------------------------------------
Total Operating Expenses 30.2 847.0 3,759.2 (0.5) 4,635.9
------------------------------------------------------------------------------
Income from equity investments - - 9.5 - 9.5
Gain on sale of assets - - 1.4 - 1.4
------------------------------------------------------------------------------
Operating Income (Loss) (29.7) 105.9 556.1 - 632.3
------------------------------------------------------------------------------
Interest charges (122.2) (40.7) (51.5) 21.7 (192.7)
Other income and (deductions) 418.8 2.1 (50.7) (344.6) 25.6
------------------------------------------------------------------------------
Total Other Income and (Deductions) 296.6 (38.6) (102.2) (322.9) (167.1)
------------------------------------------------------------------------------
Income Taxes (Benefit) (40.7) 23.9 174.4 - 157.6
------------------------------------------------------------------------------
Net Income $ 307.6 $ 43.4 $ 279.5 $ (322.9) $ 307.6
==============================================================================
- -----------------------------------------------------------------------------------------------------------------------------
40
- ------------------------------------------------------------------------------------------------------------------------------------
Statement of Income
- ------------------------------------------------------------------------------------------------------------------------------------
Nine Months Ended September 30, 2005
(In Millions of Dollars) Guarantor KEDLI Other Subsidiaries Eliminations Consolidated
- ------------------------------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------
Revenues $ 0.5 $ 916.1 $ 4,210.0 $ (0.5) $ 5,126.1
------------------------------------------------------------------------------
Operating Expenses
Purchased gas - 588.1 1,618.0 - 2,206.1
Fuel and purchased power - - 546.9 - 546.9
Operations and maintenance 10.9 96.4 1,036.0 - 1,143.3
Intercompany expense - 3.7 (3.2) (0.5) -
Depreciation and amortization - 59.1 236.7 - 295.8
Operating taxes - 47.8 255.2 - 303.0
------------------------------------------------------------------------------
Total Operating Expenses 10.9 795.1 3,689.6 (0.5) 4,495.1
------------------------------------------------------------------------------
Income from equity investments - - 12.5 - 12.5
Gain on sale of property - - 1.2 - 1.2
------------------------------------------------------------------------------
Operating Income (Loss) (10.4) 121.0 534.1 - 644.7
------------------------------------------------------------------------------
Interest charges (104.8) (46.1) (64.9) 15.7 (200.1)
Other income and (deductions) 364.8 3.2 (62.4) (313.0) (7.4)
------------------------------------------------------------------------------
Total Other Income and (Deductions) 260.0 (42.9) (127.3) (297.3) (207.5)
------------------------------------------------------------------------------
Income Taxes (Benefit) (25.8) 28.2 157.6 - 160.0
------------------------------------------------------------------------------
-
Earnings from Continuing Operations 275.4 49.9 249.2 (297.3) 277.2
Discontinued Operations - - (1.8) - (1.8)
------------------------------------------------------------------------------
Net Income $ 275.4 $ 49.9 $ 247.4 $ (297.3) $ 275.4
==============================================================================
- ------------------------------------------------------------------------------------------------------------------------------------
41
- ------------------------------------------------------------------------------------------------------------------------------------
Balance Sheet
- ------------------------------------------------------------------------------------------------------------------------------------
September 30, 2006
(In Millions of Dollars) Guarantor KEDLI Other Subsidiaries Eliminations Consolidated
- ------------------------------------------------------------------------------------------------------------------------------------
ASSETS
Current Assets
Cash & temporary cash investments $ 8.6 $ 3.3 $ 28.1 $ - $ 40.0
Accounts receivable, net 0.6 101.8 624.8 - 727.2
Other current assets 2.1 268.5 1,109.1 - 1,379.7
---------------------------------------------------------------------------------------
11.3 373.6 1,762.0 - 2,146.9
---------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------
Equity Investments 4,893.5 - 138.7 (4,774.3) 257.9
---------------------------------------------------------------------------------------
Property
Gas - 2,146.0 5,399.8 - 7,545.8
Other - 25.3 3,140.4 - 3,165.7
Accumulated depreciation and depletion - (425.5) (2,782.8) - (3,208.3)
---------------------------------------------------------------------------------------
- 1,745.8 5,757.4 - 7,503.2
---------------------------------------------------------------------------------------
Intercompany Accounts Receivable 976.1 289.7 1,980.7 (3,246.5) -
---------------------------------------------------------------------------------------
Deferred Charges 1,971.0 409.3 1,150.1 - 3,530.4
---------------------------------------------------------------------------------------
Total Assets $ 7,851.9 $ 2,818.4 $ 10,788.9 $ (8,020.8) $ 13,438.4
=======================================================================================
LIABILITIES AND CAPITALIZATION
Current Liabilities
Accounts payable $ 32.2 $ 102.8 $ 546.9 $ - $ 681.9
Commercial paper 330.0 - - - 330.0
Other current liabilities 207.8 84.4 342.7 - 634.9
---------------------------------------------------------------------------------------
570.0 187.2 889.6 - 1,646.8
Intercompany Accounts Payable 128.8 473.4 1,130.4 (1,732.6) -
---------------------------------------------------------------------------------------
Deferred Credits and Other Liabilities
Deferred income tax 24.3 364.1 834.0 - 1,222.4
Other deferred credits and liabilities 680.1 203.3 1,183.6 - 2,067.0
---------------------------------------------------------------------------------------
704.4 567.4 2,017.6 - 3,289.4
---------------------------------------------------------------------------------------
Capitalization
Common shareholders' equity 4,586.7 939.5 3,815.5 (4,774.3) 4,567.4
Long-term debt 1,862.0 650.9 2,920.3 (1,513.9) 3,919.3
---------------------------------------------------------------------------------------
Total Capitalization 6,448.7 1,590.4 6,735.8 (6,288.2) 8,486.7
---------------------------------------------------------------------------------------
Minority Interest in Subsidiary Companies - - 15.5 - 15.5
---------------------------------------------------------------------------------------
Total Liabilities & Capitalization $ 7,851.9 $ 2,818.4 $ 10,788.9 $ (8,020.8) $ 13,438.4
=======================================================================================
- ------------------------------------------------------------------------------------------------------------------------------------
42
- ------------------------------------------------------------------------------------------------------------------------------------
Balance Sheet
- ------------------------------------------------------------------------------------------------------------------------------------
December 31, 2005
(In Millions of Dollars) Guarantor KEDLI Other Subsidiaries Eliminations Consolidated
- ------------------------------------------------------------------------------------------------------------------------------------
ASSETS
Current Assets
Cash & temporary cash investments $ 79.6 $ 3.5 $ 41.4 $ - $ 124.5
Accounts receivable, net 0.6 149.9 822.2 - 972.7
Other current assets 4.0 368.9 1,550.0 - 1,922.9
------------------------------------------------------------------------------------
84.2 522.3 2,413.6 - 3,020.1
------------------------------------------------------------------------------------
Investments and Other 4,571.0 0.7 128.2 (4,457.5) 242.4
------------------------------------------------------------------------------------
Property
Gas - 2,111.3 5,164.6 - 7,275.9
Other - - 3,092.8 - 3,092.8
Accumulated depreciation and depletion - (400.6) (2,631.2) - (3,031.8)
------------------------------------------------------------------------------------
- 1,710.7 5,626.2 - 7,336.9
------------------------------------------------------------------------------------
Intercompany Accounts Receivable 2,813.6 44.6 95.6 (2,953.8) -
Deferred Charges 482.5 316.1 2,414.6 - 3,213.2
------------------------------------------------------------------------------------
Total Assets $ 7,951.3 $ 2,594.4 $ 10,678.2 $ (7,411.3) $ 13,812.6
====================================================================================
LIABILITIES AND CAPITALIZATION
Current Liabilities
Accounts payable $ 36.4 $ 149.7 $ 900.9 $ - $ 1,087.0
Commercial paper 657.6 - - - 657.6
Other current liabilities 196.2 128.5 85.9 - 410.6
------------------------------------------------------------------------------------
890.2 278.2 986.8 - 2,155.2
------------------------------------------------------------------------------------
Intercompany Accounts Payable 51.8 338.3 1,049.8 (1,439.9) -
------------------------------------------------------------------------------------
Deferred Credits and Other Liabilities
Deferred income tax 27.2 330.6 800.1 - 1,157.9
Other deferred credits and liabilities 634.0 225.3 1,240.0 - 2,099.3
------------------------------------------------------------------------------------
661.2 555.9 2,040.1 - 3,257.2
------------------------------------------------------------------------------------
Capitalization
Common shareholders' equity 4,485.4 897.0 3,539.3 (4,457.6) 4,464.1
Long-term debt 1,862.7 525.0 3,046.9 (1,513.8) 3,920.8
------------------------------------------------------------------------------------
Total Capitalization 6,348.1 1,422.0 6,586.2 (5,971.4) 8,384.9
------------------------------------------------------------------------------------
Minority Interest in Subsidiary Companies - - 15.3 - 15.3
------------------------------------------------------------------------------------
Total Liabilities & Capitalization $ 7,951.3 $ 2,594.4 $ 10,678.2 $ (7,411.3) $ 13,812.6
====================================================================================
- ------------------------------------------------------------------------------------------------------------------------------------
43
- -----------------------------------------------------------------------------------------------------------------------------------
Statement of Cash Flows
- -----------------------------------------------------------------------------------------------------------------------------------
Nine Months Ended September 30, 2006
------------------------------------------------------------------------
(In Millions of Dollars) Guarantor KEDLI Other Subsidiaries Consolidated
- -----------------------------------------------------------------------------------------------------------------------------------
Operating Activities
Net Cash (Used in) Provided by Operating Activities $ (11.3) $ 124.1 $ 794.8 $ 907.6
------------------------------------------------------------------------
Investing Activities
Capital expenditures - (63.1) (314.5) (377.6)
Cost of removal - (5.5) (17.6) (23.1)
Derivative margin calls - (17.6) (25.1) (42.7)
Proceeds from sale of property - - 1.5 1.5
------------------------------------------------------------------------
Net Cash Provided by (Used in) Investing Activities - (86.2) (355.7) (441.9)
------------------------------------------------------------------------
Financing Activities
Treasury stock issued 21.1 - - 21.1
Payment of debt, net (327.5) - - (327.5)
Common and preferred stock dividends paid (243.8) - - (243.8)
Intercompany dividen payments 8.4 - (8.4) -
Net intercompany accounts 482.2 (38.1) (444.1) -
------------------------------------------------------------------------
Net Cash (Used in) Financing Activities (59.6) (38.1) (452.5) (550.2)
------------------------------------------------------------------------
Net (Decrease) in Cash and Cash Equivalents $ (70.9) $ (0.2) $ (13.4) $ (84.5)
Cash and Cash Equivalents at Beginning of Period 79.5 3.5 41.5 124.5
------------------------------------------------------------------------
Cash and Cash Equivalents at End of Period $ 8.6 $ 3.3 $ 28.1 $ 40.0
========================================================================
- -----------------------------------------------------------------------------------------------------------------------------------
- ----------------------------------------------------------------------------------------------------------------------------------
Statement of Cash Flows
- ----------------------------------------------------------------------------------------------------------------------------------
Nine Months Ended September 30, 2005
-----------------------------------------------------------------------
(In Millions of Dollars) Guarantor KEDLI Other Subsidiaries Consolidated
- ----------------------------------------------------------------------------------------------------------------------------------
Operating Activities
Net Cash Provided by (Used in )Operating Activities $ (326.2) $ 156.7 $ 641.6 $ 472.1
-----------------------------------------------------------------------
Investing Activities
Capital expenditures - (70.9) (301.2) (372.1)
Cost of removal - (1.6) (9.2) (10.8)
Proceeds from sale of investment - (2.1) 49.0 46.9
Derivative margin calls - - (63.3) (63.3)
-----------------------------------------------------------------------
Net Cash (Used in) Investing Activities - (74.6) (324.7) (399.3)
-----------------------------------------------------------------------
Financing Activities
Treasury stock issued 41.0 - - 41.0
Payment of debt, net (1,092.2) - (15.1) (1,107.3)
Redemption of preferred stock (75.0) - - (75.0)
Common and preferred stock dividends paid (229.1) - - (229.1)
MEDs equity conversion 460.0 - - 460.0
Intercompany dividend payments 317.0 - (317.0) -
Net intercompany accounts 304.0 (80.0) (224.0) -
Other (2.4) - 16.4 14.0
-
-----------------------------------------------------------------------
Net Cash (Used in) Financing Activities (276.7) (80.0) (539.7) (896.4)
-----------------------------------------------------------------------
Net Increase (Decrease) in Cash and Cash Equivalents $ (602.9) $ 2.1 $ (222.8) $ (823.6)
Net Cash Flow from Discontinued Operations - - (14.4) (14.4)
Cash and Cash Equivalents at Beginning of Period 580.7 (0.9) 342.2 922.0
-----------------------------------------------------------------------
Cash and Cash Equivalents at End of Period $ (22.2) $ 1.2 $ 105.0 $ 84.0
=======================================================================
- ----------------------------------------------------------------------------------------------------------------------------------
44
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
On February 25, 2006, KeySpan entered into an Agreement and Plan of Merger (the
"Merger Agreement") with National Grid plc, a public limited company
incorporated under the laws of England and Wales ("Parent") and National Grid
US8, Inc., a New York Corporation ("Merger Sub"), pursuant to which Merger Sub
will merge with and into KeySpan (the "Merger"), with KeySpan continuing as the
surviving company and thereby becoming an indirect wholly-owned subsidiary of
the Parent.
Consummation of the Merger is subject to various closing conditions. Assuming
receipt of all required approvals, it is currently anticipated that the Merger
will be consummated in mid-2007. However, no assurance can be given that the
Merger will occur, or the timing of its completion. See the Introduction to the
Notes to the Consolidated Financial Statements for additional information
regarding the Merger.
Consolidated Review of Results
- ------------------------------
The following is a summary of transactions affecting comparative earnings for
the three and nine months ended September 30, 2006, compared to the three and
nine months ended September 30, 2005. Capitalized terms used in the following
discussion, but not otherwise defined, have the same meaning as when used in the
Notes to the Consolidated Financial Statements included under Item 1. References
to "KeySpan," "we," "us," and "our" mean KeySpan Corporation, together with its
consolidated subsidiaries.
45
Operating income by segment, as well as consolidated earnings for common stock
is set forth in the following table for the periods indicated.
- --------------------------------------------------------------------------------------------------------------------------------
(In Millions of Dollars, Except per Share)
- --------------------------------------------------------------------------------------------------------------------------------
Three Months Ended September 30, Nine Months Ended September 30,
2006 2005 2006 2005
- --------------------------------------------------------------------------------------------------------------------------------
Gas Distribution $ (10.8) $ (45.5) $ 365.1 $ 376.8
Electric Services 144.4 149.6 271.7 266.3
Energy Services 3.0 (1.1) 4.6 (6.7)
Energy Investments 4.7 4.7 11.3 16.6
Eliminations and other (5.5) (4.9) (20.4) (8.3)
- --------------------------------------------------------------------------------------------------------------------------------
Operating Income 135.8 102.8 632.3 644.7
- --------------------------------------------------------------------------------------------------------------------------------
Other Income and (Deductions)
Interest charges (67.1) (67.4) (192.7) (200.1)
Gain on sale of investments - - - 4.1
Cost of debt redemption - - - (20.9)
Other income and (deductions) 8.0 (3.8) 25.6 9.4
- --------------------------------------------------------------------------------------------------------------------------------
Total Other Income and (Deductions) (59.1) (71.2) (167.1) (207.5)
- --------------------------------------------------------------------------------------------------------------------------------
Earnings before income taxes 76.7 31.6 465.2 437.2
Income taxes 26.4 9.0 157.6 160.0
- --------------------------------------------------------------------------------------------------------------------------------
Earnings from continuing operations 50.3 22.6 307.6 277.2
Discontinued operations - - - (1.8)
- --------------------------------------------------------------------------------------------------------------------------------
Net Income 50.3 22.6 307.6 275.4
Preferred stock dividend requirements - - - 2.2
- --------------------------------------------------------------------------------------------------------------------------------
Earnings for Common Stock $ 50.3 $ 22.6 $ 307.6 $ 273.2
- --------------------------------------------------------------------------------------------------------------------------------
Basic Earnings per Share
Continuing operations, less preferred
stock dividends $ 0.29 $ 0.13 $ 1.76 $ 1.63
Discontinued operations - - - (0.01)
- --------------------------------------------------------------------------------------------------------------------------------
$ 0.29 $ 0.13 $ 1.76 $ 1.62
- --------------------------------------------------------------------------------------------------------------------------------
Results of Operations For The Quarter Ended September 30, 2006 vs 2005
KeySpan's earnings for common stock for the three months ended September 30,
2006, were $50.3 million, or $0.29 per share, compared to $22.6 million or $0.13
per share realized during the corresponding quarter last year, an increase of
$27.7 million, or $0.16 per share. The favorable comparative operating results
primarily reflect an increase in operating income of $33.0 million or 32%.
The primary driver behind the increase in operating income was lower operating
expenses in the Gas Distribution segment of $30.9 million. The Electric Services
segment results were slightly lower than last year, reflecting a decrease in net
electric revenues associated with the Ravenswood Generating Station, KeySpan's
merchant electric generating facility. During the quarter, this segment also
recognized a gain on a fixed for floating unforced capacity financial swap which
is reflected in operating results of this segment. (See the discussion under the
caption "Review of Operating Segments" for further details on each segment.)
46
For the third quarter of 2006, other income and (deductions) reflects a net
expense of $59.1 million compared to a net expense of $71.2 million for the
third quarter of 2005. Included in the caption "Other Income and (Deductions)"
are interest charges and certain other miscellaneous items. The favorable
variation of $12.1 million is due, in part, to an increase in interest income on
certain investments. Further, during the third quarter of 2005, KeySpan recorded
an $8.5 million non-cash charge associated with the fair value of outstanding
derivative financial instruments that did not qualify for hedge accounting
treatment.
Income tax expense increased $17.4 million for the third quarter of 2006
compared to the same quarter in 2005, due to the increase in pre-tax income.
Offsetting this increase, to some extent, was a $3.4 million benefit recorded in
the third quarter of 2006, reflecting an accrual for prior investment tax
credits that KeySpan is entitled to. KeySpan has recently filed amended tax
returns to reflect its entitlement to investment tax credits for the period 2000
through 2004.
Results of Operations For The Nine Months Ended September 30, 2006 vs 2005
KeySpan's earnings for common stock for the nine months ended September 30,
2006, were $307.6 million, compared to $273.2 million realized during the same
period last year, an increase of $34.4 million. The favorable comparative
earnings primarily reflect: (i) the benefits associated with the settlement of
certain outstanding issues with the New York City Department of Taxation and
Finance and the Internal Revenue Service ("IRS"); and (ii) debt redemption costs
incurred in 2005, but not repeated in 2006; offset by (iii) a decrease in
operating income.
KeySpan's earnings per share for the nine months ended September 30, 2006, were
$1.76 per share, compared to $1.62 per share realized during the same period
last year, an increase of $0.14 per share. Earnings per share for the nine
months ended September 30, 2006 reflect a higher level of outstanding common
stock compared to last year. In May 2005, KeySpan issued 12.1 million shares of
common stock upon the conversion of previously held MEDs Equity Units. The
dilutive effect on earnings per share in 2006 from this issuance, in addition to
KeySpan's employee stock purchase plans, was approximately $0.07 per share. (See
KeySpan's Annual Report of Form 10-K for the year ended December 31, 2005, Note
6 to the Consolidated Financial Statements "Long-Term Debt and Commercial Paper"
for additional details on the MEDs Equity Units.)
Operating income decreased $12.4 million, or 2% for the nine months ended
September 30, 2006, compared to the corresponding period last year. Comparative
operating income reflects lower earnings from the Gas Distribution segment and
Energy Investments segments of $11.7 million and $5.3 million, respectively,
offset by higher earnings from KeySpan's electric operations and its Energy
Services segment of $5.4 million and $11.3 million respectively. Operating
income from the Gas Distribution segment was adversely impacted by the warm
weather experienced during the first quarter of 2006 (KeySpan's primary heating
season) which resulted in a decrease to comparative net gas revenues. The
decrease in operating income from the Energy Investments segment reflects lower
earnings from KeySpan's investment in the Iroquois Gas Transmission System
47
pipeline, as well as lower earnings from the transportation of liquefied natural
gas. The Electric Services segment results were favorably affected by a gain
recognized on a fixed for floating unforced capacity financial swap. The
favorable comparative results from the Energy Services segment were due to
higher gross margins on engineering and service contracts and lower general and
administrative expenses. The operating income variation as reflected in
"elimination and other" is due primarily to incremental costs residing at
KeySpan's holding company level primarily related to the anticipated KeySpan /
National Grid plc merger including legal and consulting fees, as well as to
corporate advertising expenses. (See the discussion under the caption "Review of
Operating Segments" for further details on each segment.)
Other income and (deductions) reflects interest charges, costs associated with
debt redemptions, income from subsidiary stock transactions and other
miscellaneous items. For the nine months ended September 30, 2006, other income
and (deductions) reflects a net expense of $167.1 million compared to a net
expense of $207.5 million for the same period of 2005. The favorable variation
of $40.4 million is due, in part, to debt redemption costs incurred in 2005. In
2005, KeySpan redeemed $500 million 6.15% Series Notes due 2006. KeySpan
incurred $20.9 million in call premiums and wrote-off $1.3 million of previously
deferred financing costs. In addition, we accelerated the amortization of
approximately $11.2 million of previously unamortized benefits associated with
an interest rate swap on the redeemed bonds. The write-off of the deferred
financing costs and the amortization of the benefits associated with an interest
rate swap were recorded to interest expense.
Interest expense for the nine months ended September 30, 2006 decreased $7.4
million compared to the same period in 2005, reflecting, in part, the reversal
of a previously recorded $6 million reserve established in connection with an
income tax dispute with the New York City Department of Taxation and Finance.
During the second quarter of 2006, KeySpan resolved its dispute with the New
York City Department of Taxation and Finance with respect to income taxes
relating to the operations of its merchant electric generating facility. As a
result of the favorable settlement of this issue, KeySpan reversed a previously
recorded interest reserve established in connection with this dispute. Further,
comparative interest expense reflects lower carrying charges on regulatory
deferrals in 2006, offset by the benefits recorded in 2005 associated with the
amortization of the interest rate swap.
The favorable variation in other income and (deductions) for the nine months
ended September 30, 2006, compared to the same period in 2005, also reflects
higher interest income on certain investments. Further, in 2005, KeySpan
recorded an $8.5 million non-cash charge associated with the fair value of
outstanding derivative financial instruments that did not qualify for hedge
accounting treatment.
Other income and (deductions) for the nine months ended September 30, 2005,
reflects the sale of KeySpan's 50% interest in Premier Transmission Limited
("Premier"), a gas pipeline from southwest Scotland to Northern Ireland. The
sale generated cash proceeds of approximately $48.1 million. In the fourth
quarter of 2004, KeySpan reduced its carrying value in Premier to an amount
48
approximating the anticipated cash proceeds from the sale. The final sale of
Premier, which took place in the first quarter of 2005, resulted in a pre-tax
gain of $4.1 million reflecting the difference from earlier estimates.
Income tax expense decreased $2.4 million for the nine months ended September
30, 2006, compared to same period of 2005, despite the higher pre-tax income,
primarily reflecting the settlement of certain outstanding issues with the New
York City Department of Taxation and Finance and the IRS.
Pursuant to indemnity obligations contained in the Long Island Lighting Company
("LILCO") / KeySpan merger agreement, KeySpan has been in discussions with the
IRS with regard to LILCO's tax returns for the tax years ended December 31, 1996
through March 31, 1999, and KeySpan's and the Brooklyn Union Gas Company's tax
returns for the years ended September 30, 1997 through December 31, 1998. Two
issues were resolved in the second quarter of 2006. It is anticipated that the
remaining issues, including the primary issue relating to the valuation of
certain assets transferred in the KeySpan/LILCO business combination, will be
settled following approval by the Joint Committee on Taxation. In addition, as
noted above, KeySpan resolved its dispute with New York City Department of
Taxation and Finance with respect to income taxes relating to its merchant
electric generating facility. As a result of settling the two issues with the
IRS, as well as the New York City issue, KeySpan realized a tax benefit of $16.4
million during the nine months ended September 30, 2006. Further, as noted
previously, during the third quarter of 2006 KeySpan recorded a $3.4 million
benefit for prior investment tax credits to which KeySpan is entitled.
The IRS has also recently commenced the examination of KeySpan's tax returns for
the years ended December 31, 2002 and 2003. At this time, we cannot predict the
result of these audits.
Additionally, it should be noted that KeySpan recorded a $1.8 million loss from
discontinued operations for the nine months ended September 30, 2005. In the
fourth quarter of 2004, KeySpan's investment in its mechanical contracting
subsidiaries was written-down to fair value. During the first six months of
2005, operating losses amounting to $4.1 million after tax were incurred through
the dates of sale of these companies, including, but not limited to, costs
incurred for employee related benefits. Partially offsetting these losses was a
gain of $2.3 million associated with the related divestitures, reflecting the
difference between the fair value estimates and the financial impact of the
actual sale transactions. The net income impact of the operating losses and the
disposal gain was a loss of $1.8 million, or $0.01 per share for the nine months
ended September 30, 2005.
Consolidated earnings are seasonal in nature due to the significant contribution
to earnings of our gas distribution operations. As a result, we expect to earn
most of our annual earnings in the first and fourth quarters of our fiscal year.
In light of the pending merger between KeySpan and National Grid plc and the
widespread integration efforts being undertaken by both companies, KeySpan
believes that it is no longer relevant to comment on previously issued guidance
on projected 2006 earnings.
49
Review of Operating Segments
- ----------------------------
KeySpan reports its segment results on an Operating Income basis. Management
believes that this Generally Accepted Accounting Principle ("GAAP") based
measure provides a reasonable indication of KeySpan's underlying performance
associated with its operations. The following is a discussion of financial
results achieved by KeySpan's operating segments presented on an operating
income basis.
Gas Distribution
KeySpan Energy Delivery New York ("KEDNY") provides gas distribution service to
customers in the New York City Boroughs of Brooklyn, Staten Island and a portion
of Queens, and KeySpan Energy Delivery Long Island ("KEDLI") provides gas
distribution service to customers in the Long Island counties of Nassau and
Suffolk and the Rockaway Peninsula of Queens County. Four gas distribution
companies - Boston Gas Company, Colonial Gas Company, Essex Gas Company, and
EnergyNorth Natural Gas Inc., each doing business under the name KeySpan Energy
Delivery New England ("KEDNE"), provide gas distribution service to customers in
Massachusetts and New Hampshire.
The table below highlights certain significant financial data and operating
statistics for the Gas Distribution segment for the periods indicated.
- -------------------------------------------------------------------------------------------------------------------------------
Three Months Ended September 30, Nine Months Ended September 30,
(In Millions of Dollars) 2006 2005 2006 2005
- -------------------------------------------------------------------------------------------------------------------------------
Revenues $ 595.5 $ 629.6 $ 3,648.8 $ 3,476.1
Cost of gas 362.8 399.8 2,416.5 2,214.9
Revenue taxes 6.9 7.8 43.1 43.0
- -------------------------------------------------------------------------------------------------------------------------------
Net Revenues 225.8 222.0 1,189.2 1,218.2
- -------------------------------------------------------------------------------------------------------------------------------
Operating Expenses
Operations and maintenance 145.5 162.9 512.4 519.8
Depreciation and amortization 52.3 63.5 197.3 207.4
Operating taxes 38.8 41.1 114.4 114.2
- -------------------------------------------------------------------------------------------------------------------------------
Total Operating Expenses 236.6 267.5 824.1 841.4
- -------------------------------------------------------------------------------------------------------------------------------
Operating Income $ (10.8) $ (45.5) $ 365.1 $ 376.8
- -------------------------------------------------------------------------------------------------------------------------------
Firm gas sales and transportation (MDTH) 27,682 28,020 203,437 228,260
Transportation - Electric Generation (MDTH) 28,689 9,756 55,797 21,188
Other Sales (MDTH) 48,274 47,937 146,217 142,398
Warmer (Colder) than Normal - New York N/A N/A 14% (3%)
Warmer (Colder) than Normal - New England N/A N/A 5% (12%)
- -------------------------------------------------------------------------------------------------------------------------------
A MDTH is 10,000 therms (British Thermal Units) and reflects the heating
content of approximately one million cubic feet of gas. A therm reflects
the heating content of approximately 100 cubic feet of gas.One billion
cubic feet (BCF) of gas equals approximately 1,000 MDTH.
50
Executive Summary
For the third quarter of 2006, the Gas Distribution segment realized a seasonal
operating loss of $10.8 million, compared to a seasonal operating loss of $45.5
million realized in the third quarter of 2005. The favorable comparative
operating results were primarily due to a decrease of $30.9 million in operating
expenses as a result of a lower provision for uncollectible accounts receivable
of $16.4 million and a decrease in depreciation charges of $11.6 million.
For the nine months ended September 30, 2006, operating income decreased $11.7
million compared to the same period last year, primarily due to a decrease in
net gas revenues of $29.0 million, primarily resulting from the warm first
quarter weather. Operating expenses, however, decreased $17.3 million due to a
lower provision for uncollectible accounts receivable of $13.9 million and a
decrease in depreciation charges of $7.9 million, partially offset by higher
employee benefit costs, primarily postretirement expenses.
Net Revenues
Net gas revenues from our gas distribution operations decreased $29.0 million,
or 2%, for the nine months ended September 30, 2006, compared to the same period
last year. Both the New York and New England based gas distribution operations
were adversely impacted by the significantly warmer than normal weather
experienced throughout the northeastern United States during the 2006 heating
season - January through April. As measured in heating degree days, weather
during that period in our New York and New England service territories was
approximately 13% and 8% warmer than normal, respectively, and was approximately
15% warmer than last year across KeySpan's service territories.
Net revenues from firm gas customers (residential, commercial and industrial
customers) decreased $43.8 million in the first nine months of 2006 compared to
the same period last year. The favorable impact to net gas revenues from load
growth additions was more than offset by declining usage per customer due to the
extremely warm weather during the winter heating season, the use of more
efficient gas heating equipment and higher gas costs. KeySpan estimates that the
warm winter weather resulted in an adverse impact to net gas revenues of
approximately $26 million, net of the benefits from the weather normalization
adjustment and weather derivatives discussed below.
KEDNY and KEDLI each operate under utility tariffs that contain a weather
normalization adjustment that significantly offsets variations in firm net
revenues due to fluctuations in weather. These weather normalization adjustments
resulted in a benefit to KeySpan of $25 million during the nine months ended
September 30, 2006, but this did not fully mitigate the impact of the loss in
revenues due to the extremely warm weather experienced, as previously noted. The
New England-based gas distribution subsidiaries do not have weather
normalization adjustments. To mitigate the effect of fluctuations in normal
weather patterns on KEDNE's results of operations and cash flows, weather
derivatives were in place for the 2005/2006 winter heating season. Weather,
during the first quarter of 2006 was significantly warmer than normal as noted
earlier. However, during the entire primary winter heating season -November 2005
through March 2006 - weather was slightly colder than normal. Therefore, there
was no earnings impact associated with these weather derivatives for the first
nine months of 2006. (See Note 4 to the Consolidated Financial Statements
"Hedging and Derivative Financial Instruments" for further information).
51
Firm gas distribution rates for KEDNY, KEDLI and KEDNE in 2006, other than for
the recovery of gas costs, have remained substantially unchanged from rates
charged in 2005.
In our large-volume heating and other interruptible (non-firm) markets, which
include large apartment houses, government buildings and schools, gas service is
provided under rates that are designed to compete with prices of alternative
fuel, including No. 2 and No. 6 grade heating oil. These "dual-fuel" customers
can consume either natural gas or fuel oil for heating purposes. Net revenues in
these markets increased $14.8 million during the nine months ended September 30,
2006, compared to the same period last year primarily reflecting higher pricing.
Firm Sales, Transportation and Other Quantities
Firm gas sales and transportation quantities for the nine months ended September
30, 2006, decreased 11% compared to the same period in 2005 due primarily to the
warmer weather this year compared to last year. Customer additions and
oil-to-gas conversions offset the full impact of the warmer weather. Net
revenues are not affected by customers opting to purchase their gas supply from
other sources, since delivery rates charged to transportation customers
generally are the same as delivery rates charged to full sales service
customers. Transportation quantities related to electric generation reflect the
transportation of gas to our electric generating facilities located on Long
Island. Net revenues from these services are not material.
Other sales quantities include on-system interruptible quantities, off-system
sales quantities (sales made to customers outside of our service territories)
and related transportation. We have a management contract with Merrill Lynch
Trading, under which KeySpan and Merrill Lynch Trading will share the
responsibilities for managing KeySpan's upstream gas distribution assets
associated with its Massachusetts gas distribution subsidiaries, as well as
providing city-gate delivered supply. KeySpan, Merrill Lynch Trading and
KeySpan's Massachusetts gas sales customers will share in the profits generated
from the optimization of these assets. The Massachusetts Department of
Telecommunications and Energy ("MADTE") approved this contract in March 2006
effective April 1, 2006. KeySpan provides these services internally for its New
York and New Hampshire gas distribution subsidiaries.
Purchased Gas for Resale
The increase in gas costs for the nine months ended September 30, 2006, compared
to the same period of 2005 of $201.6 million, or 9%, reflects an increase of 20%
in the price per dekatherm of gas purchased for firm gas sales customers, offset
by a 13% decrease in the quantity of gas purchased due to the warm winter
heating season weather. The current gas rate structure of each of our gas
52
distribution utilities includes a gas adjustment clause, pursuant to which
variations between actual gas costs incurred for resale to firm sales customers
and gas costs billed to firm sales customers are deferred and refunded to or
collected from customers in a subsequent period.
Operating Expenses
Operating expenses for the third quarter of 2006 compared to the same quarter
last year decreased $30.9 million, or 12%. Operations and maintenance expense
decreased $17.4 million, or 11%, in 2006 compared to 2005 primarily reflecting a
decrease of $16.4 million in the provision for uncollectible accounts
receivable. In December 2005, The Boston Gas Company ("Boston Gas") received a
MADTE order, effective January 1, 2006, permitting Boston Gas to fully recover
the gas cost component of bad debt write-offs through its cost-of-gas adjustment
clause rather than filing for recovery as an exogenous cost. The beneficial
impact of this MADTE order was the primary driver behind the reduction in the
provision for uncollectible accounts receivable, combined with a decrease in
firm sales quantities in 2006 compared to 2005. See the discussion under the
caption "Regulation and Rate Matters - Gas Matters" for additional details of
the MADTE order.
The decrease in depreciation and amortization charges of $11.2 million, or 18%,
for the third quarter of 2006 compared to the third quarter of 2005, was
primarily due to an adjustment recorded this quarter to the depreciation
allowance to correct for an error in useful lives associated with certain gas
distribution assets.
For the nine months ended September 30, 2006, operating expenses decreased $17.3
million, or 2% compared to the same period last year. Operations and maintenance
expense decreased $7.4 million, or 1%, in 2006 compared to 2005 due to a
decrease of $13.9 million in the provision for uncollectible accounts
receivable, resulting from the MADTE order noted above and lower firm sales
quantities in 2006 compared to 2005. This beneficial impact to operations and
maintenance expense was partially offset by increases in postretirement expenses
and regulatory fees.
The decrease in depreciation and amortization charges of $10.1 million, or 5%,
for the nine months ended September 30, 2006 compared to the same period of
2005, reflects a decrease in depreciation charges of $7.9 million and lower
regulatory amortization charges of $2.2 million. As noted previously, the
decrease in depreciation charges reflects an adjustment to the depreciation
allowance to correct for an error in useful lives associated with certain gas
distribution assets.
Gas Supply and Pricing
KeySpan believes it has adequate gas supply available to meet its gas load
demand in its service territories for the 2006/2007 winter heating season as
KeySpan expects its gas storage to be 100% full at the start of the winter
heating season. The current gas rate structure of each of our gas distribution
utilities includes a gas adjustment clause, pursuant to which gas costs are
recovered in billed sales to regulated firm gas sales customers. Although
KeySpan is allowed to "pass through" the cost of gas to its customers, the
volatility of natural gas prices can have an adverse impact on customers' gas
53
bills and recovery of customer accounts receivable. High gas prices have led to
an increase in price elasticity resulting in an increase in customer
conservation measures and attrition. The MADTE order, received in the fourth
quarter of 2005, permitting Boston Gas regulatory recovery of the gas cost
component of net bad debt write-offs has helped to mitigate any increase in bad
debt expense.
With KeySpan's continuing strategy of having its storage facilities 100% full at
the start of the heating season and through the use of financial derivatives,
KeySpan anticipates that it will effectively hedge the price of approximately
two-thirds of the gas supply needed to serve its gas heating customers during
the 2006/2007 winter heating season. This strategy mitigates the volatility of
natural gas prices on customers' winter heating gas bills. Further, KeySpan has
programs in place to help customers manage their gas bills, such as balanced
billing plans, deferred payment arrangements and the low income home energy
assistance program, which we supported the expansion of through the Energy
Policy Act of 2005. Management believes that these measures help mitigate the
impact of high gas prices on customers' bills.
Other Matters
We remain committed to our ongoing gas system expansion strategies. We believe
that significant growth opportunities exist on Long Island and in our New
England service territories, as well as continued growth in the New York service
territory, despite the volatility in gas prices. We estimate that on Long Island
approximately 37% of the residential and multi-family markets, and approximately
60% of the commercial market, currently use natural gas for space heating.
Further, we estimate that in our New England service territories approximately
50% of the residential and multi-family markets, as well as approximately 60% of
the commercial market, currently use natural gas for space heating purposes. We
will continue to seek growth, in all our market segments, through the expansion
of our gas distribution system for new construction and to penetrate existing
communities where no distribution system exists, as well as through the
conversion of residential homes from oil-to-gas for space heating purposes and
the pursuit of opportunities to grow multi-family, industrial and commercial
markets.
In order to serve the anticipated market requirements in our New York service
territories, KeySpan and Duke Energy Corporation formed Islander East Pipeline
Company, LLC ("Islander East") in 2000. Once in service, the pipeline is
expected to have the capacity to transport up to 260,000 DTH of natural gas to
the Long Island and New York City energy markets, enough natural gas to heat
600,000 homes. In addition, KeySpan has a 26.3% interest in the Millennium
Pipeline development project which is anticipated to transport up to 525,000 DTH
of natural gas a day to the Algonquin pipeline. KEDLI has executed a Precedent
Agreement for 175,000 DTH of natural gas per day of transportation capacity from
the Millennium Pipeline system, increasing to 200,000 DTH in the second year of
the pipeline being in service. These pipeline projects will allow KeySpan to
diversify the geographic sources of its gas supply. See the discussion under the
caption "Energy Investments" for additional information regarding these pipeline
projects.
54
Electric Services
The Electric Services segment primarily consists of subsidiaries that own and
operate oil and gas-fired electric generating plants in the Borough of Queens
(including the "Ravenswood Generating Station" which comprises the Ravenswood
Facility and Ravenswood Expansion) and the counties of Nassau and Suffolk on
Long Island. In addition, through long-term contracts of varying lengths, we (i)
provide to the Long Island Power Authority ("LIPA") all operation, maintenance
and construction services and significant administrative services relating to
the Long Island electric transmission and distribution ("T&D") system pursuant
to a Management Services Agreement (the "1998 MSA"); (ii) supply LIPA with
electric generating capacity, energy conversion and ancillary services from our
Long Island generating units pursuant to a Power Supply Agreement (the "1998
PSA"); and (iii) manage all aspects of the fuel supply for our Long Island
generating facilities, as well as all aspects of the capacity and energy owned
by or under contract to LIPA pursuant to an Energy Management Agreement (the
"1998 EMA"). The 1998 MSA, 1998 PSA and 1998 EMA all became effective on May 28,
1998 and are collectively referred to herein as the "1998 LIPA Agreements."
On February 1, 2006, KeySpan and LIPA entered into (i) an amended and restated
Management Services Agreement (the "2006 MSA"), pursuant to which KeySpan will
continue to operate and maintain the electric T&D System owned by LIPA on Long
Island; (ii) a new Option and Purchase and Sale Agreement (the "2006 Option
Agreement"), to replace the Generation Purchase Rights Agreement as amended (the
"GPRA"), pursuant to which LIPA had the option, through December 15, 2005, to
acquire substantially all of the electric generating facilities owned by KeySpan
on Long Island; and (iii) a Settlement Agreement (the "2006 Settlement
Agreement") resolving outstanding issues between the parties regarding the 1998
LIPA Agreements. The 2006 MSA, the 2006 Option Agreement and the 2006 Settlement
Agreement are collectively referred to herein as the "2006 LIPA Agreements."
(For a further discussion on these LIPA agreements see Note 10 to the
Consolidated Financial Statements "2006 LIPA Settlement.") The Electric Services
segment also provides retail marketing of electricity to commercial customers.
55
Selected financial data for the Electric Services segment is set forth in the
table below for the periods indicated.
- --------------------------------------------------------------------------------------------------------------------
Three Months Ended September 30, Nine Months Ended September 30,
(In Millions of Dollars) 2006 2005 2006 2005
- --------------------------------------------------------------------------------------------------------------------
Revenues from Operations $ 539.0 $ 619.9 $ 1,390.3 $ 1,493.5
Purchased fuel 172.5 254.2 418.0 546.0
- --------------------------------------------------------------------------------------------------------------------
Net Revenues from Operations 366.5 365.7 972.3 947.5
Derivative Financial Instrument 26.6 - 44.3 -
- --------------------------------------------------------------------------------------------------------------------
Net Electric Revenues 393.1 365.7 1,016.6 947.5
- --------------------------------------------------------------------------------------------------------------------
Operating Expenses
Operations and maintenance 176.8 150.6 527.3 480.8
Depreciation 24.9 21.5 77.1 67.6
Operating taxes 47.5 45.0 141.0 133.8
- --------------------------------------------------------------------------------------------------------------------
Total Operating Expenses 249.2 217.1 745.4 682.2
- --------------------------------------------------------------------------------------------------------------------
Sale Of Property 0.5 1.0 0.5 1.0
- --------------------------------------------------------------------------------------------------------------------
Operating Income $ 144.4 $ 149.6 $ 271.7 $ 266.3
- --------------------------------------------------------------------------------------------------------------------
Electric sales (MWH)* 1,718,241 2,351,722 3,605,693 4,798,239
Capacity(MW)* 2,450 2,450 2,450 2,450
Cooling degree days 839 1,125 1,115 1,438
- --------------------------------------------------------------------------------------------------------------------
*Reflects the operations of the Ravenswood Generating Station only.
Executive Summary
Operating income decreased $5.2 million, or 3%, for the three months ended
September 30, 2006, compared to the same quarter last year, due primarily to a
decrease in net revenues from the Ravenswood Generating Station of $50.4 million
as a result of lower energy margins and capacity revenues, as well as to higher
operating expenses of $4.1 million, partially offset by higher revenues
associated with KeySpan's service agreements with LIPA of approximately $24
million, which are primarily timing in nature. KeySpan also recognized a gain of
$26.6 million on a fixed for floating unforced capacity financial swap.
For the nine months ended September 30, 2006, operating income increased $5.4
million, or 2%, compared to the same period last year, due, in part, to a $44.3
million gain recognized on the fixed for floating unforced capacity financial
swap, higher off-system sales associated with service agreements with LIPA of
$4.5 million, an increase of $4.4 million in revenues associated with our
electric marketing activities and slightly lower operating expenses. These
benefits to comparative operating income were partially offset by a decrease in
net revenues from the Ravenswood Generating Station of $51.6 million as a result
of lower energy margins and capacity revenues.
Net Revenues
Total electric net revenues realized during the third quarter of 2006 were $27.4
million higher than such revenues realized during the corresponding period last
year.
56
KeySpan has entered into an International SWAP Dealers Association Master
Agreement for a fixed for floating unforced capacity financial swap with Morgan
Stanley Capital Group Inc. ("Swap Agreement"). This agreement has a three year
term that began on May 1, 2006. For the three months ended September 30, 2006
KeySpan recognized a gain of $26.6 million from this derivative financial
instrument. (See Note 4 to the Consolidated Financial Statements, "Hedging and
Derivative Financial Instruments," for further information on this swap
agreement.)
Net revenues for the third quarter of 2006 from the service agreements with
LIPA, including the power purchase agreements associated with two electric
peaking facilities, increased $52.0 million compared to the third quarter of
2005. This increase reflects, in part, the recovery of operations and
maintenance costs billed to LIPA, which increased by approximately $28 million.
Therefore, approximately $24 million of the increase in net revenues resulted in
a benefit to operating income. The major portion of this increase is timing in
nature with $4.6 million resulting from an increase in off-system sales. (For a
description of the LIPA Agreements and power purchase agreements, see KeySpan's
2005 Annual Report on Form 10-K for the year ended December 31, 2005 Item 7.
Management's Discussion and Analysis of Financial Condition and Results of
Operations under the caption "Electric Services - Revenue Mechanisms.")
Net revenues associated with KeySpan's electric marketing activities decreased
$0.8 million during the third quarter of 2006 compared to the same quarter of
2005.
Net revenues from the Ravenswood Generating Station decreased $50.4 million, or
31% for the three months ended September 30, 2006, compared to the same quarter
last year reflecting lower capacity revenues of $27.0 million and a decrease in
energy margins of $23.4 million. The decrease in capacity revenues was due to
additional capacity installed in New York City in 2006.
The decrease in energy margins for the third quarter of 2006 reflects, in part,
a 28% decrease in realized "spark-spreads" (the selling price of electricity
less the cost of fuel, exclusive of hedging gains or losses). Further, the level
of megawatt hours ("MWh") sold into the New York Independent System Operator
("NYISO") energy market decreased 27% due to increased competition and cooler
comparative weather. As measured in cooling-degree days, weather was 25% cooler
during the third quarter of 2006 compared to the third quarter of 2005.
Combined, these two items reduced energy margins by $44.6 million. Partially
offsetting these adverse impacts to energy margins were the benefits recognized
from derivative financial instruments. We employ derivative financial hedging
instruments to hedge the cash flow variability for a portion of forecasted
purchases of natural gas and fuel oil consumed at the Ravenswood Generating
Station. We have also engaged in the use of derivative financial hedging
instruments to hedge the cash flow variability associated with a portion of
forecasted electric energy sales from the Ravenswood Generating Station. These
derivative instruments resulted in hedging gains, which are reflected in net
electric margins, of $9.4 million for the third quarter of 2006 compared to
hedging losses of $11.8 million for the third quarter of 2005. (See Note 4 to
the Consolidated Financial Statements "Hedging and Derivative Financial
Instruments" for further information on KeySpan's hedging strategy.)
57
Total electric net revenues realized during the nine months ended September 30,
2006, were $69.1 million higher than such revenues realized during the
corresponding period last year. For the nine months ended September 30, 2006,
KeySpan recognized a gain of $44.3 million from the fixed for floating unforced
capacity derivative financial instrument described previously.
Net revenues for the nine months ended September 30, 2006, from the service
agreements with LIPA, including the power purchase agreements associated with
two electric peaking facilities, increased $72.0 million compared to the same
period of 2005, reflecting the recovery of approximately $67 million in
operations and maintenance costs billed to LIPA and therefore had no impact on
operating income. The remaining increase reflects higher off-system energy
sales.
Net revenues associated with KeySpan's electric marketing activities increased
$4.4 million during the nine months ended September 30, 2006 compared to the
same period of 2005.
The Ravenswood Generating Station, however, realized a decrease of $51.6 million
in net revenues during the nine months ended September 30, 2006, compared to the
same period last year, reflecting lower capacity revenues of $61.7 million,
partially offset by an increase in energy margins of $10.1 million. Installed
capacity additions during 2006 in New York City were the primary driver behind
the decrease in capacity revenues.
The increase in energy margins for the nine months ended September 30, 2006
reflects the settlement of derivative financial instruments. As noted
previously, we employ derivative financial hedging instruments to hedge the cash
flow variability for a portion of forecasted purchases of natural gas and fuel
oil consumed at the Ravenswood Generating Station and to hedge the cash flow
variability associated with a portion of forecasted electric energy sales. These
derivative instruments resulted in hedging gains, which are reflected in net
electric margins, of $72.1 million during the nine months ended September 30,
2006 compared to hedging losses of $4.5 million during the same period of 2005.
The benefits to energy margins from KeySpan's hedging strategy were offset by a
36% decrease in realized "spark-spreads." Further, the level of MWh sold into
the NYISO energy market decreased 25% due to additional competition and cooler
weather. As measured in cooling-degree days, weather was 22% cooler during the
nine months ended September 30, 2006 compared to the same period of 2005.
Combined, these two items resulted in an adverse impact to comparative net
revenues of $66.5 million.
The rules and regulations for capacity, energy sales and the sale of certain
ancillary services to the NYISO energy markets continue to evolve and there are
several matters pending with the Federal Energy Regulatory Commission ("FERC").
See the discussion under the caption "Market and Credit Risk Management
Activities" for further details on these matters.
In addition, on September 29, 2006, the NYISO Management Committee recommended
approval of an in-City capacity mitigation proposal (the "Mitigation Proposal").
The Mitigation Proposal imposes a reduced capacity offer cap on bids by the
Ravenswood Generating Station and certain other generation owners of capacity
into the NYISO Spot Demand Curve Auction Market. The current offer cap is
$105/kW-year and is proposed to be reduced to $82/kW-year plus 3%.
58
The reduced offer cap would be implemented using a conduct and impact test on
the offers of capacity from the Ravenswood Generating Station and other owners
of Consolidated Edison divested generation units. Under the Mitigation Proposal,
if an offer to sell capacity is 3% or more above $82/kW-year, then the offer is
subject to possible mitigation. To determine if mitigation will be applied, a
second test, an impact test, is utilized. If the unmitigated offer causes market
clearing prices to be 3% or more above $82/kW-year, then the offer is mitigated
(reduced) to $82/kW-year. Essentially, the Ravenswood Generating Station and the
other owners of generation divested by Consolidated Edison may not set the
market clearing price in excess of this new offer cap. The Mitigation Proposal
is in addition to the existing in-City capacity mitigation measures.
The Mitigation Proposal must be approved by the NYISO Board of Directors and the
FERC. On October 11, 2006, KeySpan and other parties filed appeals to the NYISO
Board of Directors requesting that the Mitigation Proposal be rejected and more
thoroughly analyzed and revised pursuant to detailed stakeholder meetings. At
this time, we are unable to predict the outcome of this proceeding and what
effect it will have on our financial condition, results of operations, and cash
flows. However, adoption and implementation of the Mitigation Proposal in its
current form could materially adversely affect the revenue realized by KeySpan
from the sale of capacity from the Ravenswood Generating Station, as well as the
potential revenue that could be realized in connection with the fixed for
floating financial Swap Agreement.
Operating Expenses
Operating expenses increased $32.1 million during the third quarter of 2006
compared to the second quarter of 2005 primarily reflecting a $28 million
increase in recoverable costs from LIPA, as noted previously. The remaining
increase primarily reflects higher postretirement expenses and an increase in
plant overhaul costs and non-outage work performed on KeySpan's Long Island
based generating units.
Operating expenses increased $63.2 million during the nine months ended
September 30, 2006, compared to the same period of 2005 reflecting a $67 million
increase in recoverable costs from LIPA, as noted previously, partially offset
by a decrease in overhaul costs associated with the Ravenswood Generating
Station.
Other Matters
In 2003, the New York State Board on Electric Generation Siting and the
Environment issued an opinion and order which granted a certificate of
environmental capability and public need for a 250 MW combined cycle electric
generating facility in Melville, Long Island, which is final and non-appealable.
Also in 2003, LIPA issued a Request for Proposal ("RFP") seeking bids from
developers to either build and operate a Long Island generating facility, and/or
a new cable that will link Long Island to power from a non-Long Island source of
between 250 to 600 MW of electricity by no later than the summer of 2007.
59
KeySpan filed a proposal in response to LIPA's RFP. In 2004, LIPA selected
proposals submitted by two other bidders in response to the RFP. KeySpan remains
committed to the Melville project and the benefits to Long Island's energy
future that this project would supply. The project has received New York State
Article X approval by having met all operational and environmental permitting
requirements. Further, the project is strategically located in close proximity
to both the high voltage power transmission grid and the high pressure gas
distribution network. In addition, given the intense public pressure to reduce
emissions from existing generating facilities, development of the Melville
project is possible as a means to "virtually re-power" older, less efficient
generating units. Specifically, KeySpan believes that it would be able to reduce
emissions on Long Island in a cost effective manner by developing the Melville
project and retiring an older, less efficient generating facility. Additionally,
in August 2006, the NYISO included the Melville project in its Reliability
Report as one of the market solutions to help address the long-term reliability
of New York State's electric grid. At September 30, 2006, total capitalized
costs associated with the siting, permitting and procurement of equipment for
the Melville facility were $63.1 million.
On February 6, 2006, the NYISO's New York City local reliability rules that
required that 80% of the electric capacity needs of New York City be provided by
"in-City" generators was increased to 83%. However, in March 2006, the NYISO
Operating Committee reversed its decision and returned the local reliability
rules to 80%. See the discussion under the caption "Market and Credit Risk
Management Activities - Regulatory Issues and the Competitive Environment" for
further information regarding this matter.
Energy Services
The Energy Services segment includes companies that provide energy-related
services to customers located primarily within the northeastern United States.
Subsidiaries in this segment provide residential and small commercial customers
with service and maintenance of energy systems and appliances, as well as
operation and maintenance, design, engineering, consulting and fiber optic
services to commercial, institutional and industrial customers.
The table below highlights selected financial information associated with the
Energy Services segment.
- -------------------------------------------------------------------------------------------------------------------
Three Months Ended September 30, Nine Months Ended September 30,
(In Millions of Dollars) 2006 2005 2006 2005
- -------------------------------------------------------------------------------------------------------------------
Revenues $ 51.8 $ 47.1 $ 155.4 $ 142.0
Operating expenses 48.8 48.2 150.8 148.7
- -------------------------------------------------------------------------------------------------------------------
Operating Income (Loss) $ 3.0 $ (1.1) $ 4.6 $ (6.7)
- -------------------------------------------------------------------------------------------------------------------
The Energy Services segment posted operating profits of $3.0 million and $4.6
million for the three and nine months ended September 30, 2006, respectively,
compared to operating losses of $1.1 million and $6.7 million incurred for the
three and nine months ended September 30, 2005, respectively. The improved
60
performance reflects higher gross profit and operating margins on engineering
contracts and appliance service work, as well as the completion and favorable
pricing associated with these contracts, an increase in bandwidth sales and a
reduction in general and administrative expenses as a result of cost containment
measures implemented in 2005.
Energy Investments
The Energy Investments segment consists of our gas exploration and production
investments, as well as certain other domestic energy-related investments.
KeySpan's gas exploration and production activities include its wholly-owned
subsidiaries Seneca Upshur Petroleum, Inc. ("Seneca-Upshur") and KeySpan
Exploration and Production, LLC ("KeySpan Exploration"). Seneca-Upshur is
engaged in gas exploration and production activities primarily in West Virginia.
As of September 30, 2006, based on an average wellhead price of $3.63 per MCF,
adjusted for derivative instruments, KeySpan estimated that its capitalized
costs exceeded the ceiling test limitation by $25.8 million. However, as
permitted by current SEC guidelines, KeySpan elected to use a measurement date
closer to the filing of its September 30, 2006 Form 10-Q to re-compute the
ceiling test limitation. Using an average wellhead price on October 26, 2006 of
$7.77 per MCF, adjusted for derivative instruments, KeySpan determined that its
capitalized costs did not exceed the ceiling test limitation. Therefore, an
impairment charge was not considered necessary at September 30, 2006. Natural
gas prices continue to be volatile and the risk that a write down to the full
cost pool increases when, among other things, natural gas prices are low, there
are significant downward revisions in our estimated proved reserves or we have
unsuccessful drilling results. See Note 12 to the Consolidated Financial
Statements "Gas Exploration and Production Property- Depletion" for additional
details.
This segment is also engaged in pipeline development activities. KeySpan and
Duke Energy Corporation each own a 50% interest in Islander East. Islander East
was created to pursue the authorization and construction of an interstate
pipeline from Connecticut, across Long Island Sound, to a terminus near
Shoreham, Long Island. Further, KeySpan has a 26.3% interest in the Millennium
Pipeline Company LLC, the developer of the Millennium pipeline project which is
expected to have the capacity to transport up to 525,000 DTH of natural gas a
day from Corning, New York to Ramapo, New York, where it will connect to an
existing pipeline. Additionally, subsidiaries in this segment hold a 20% equity
interest in the Iroquois Gas Transmission System LP, a pipeline that transports
Canadian gas supply to markets in the northeastern United States. These
investments are accounted for under the equity method of accounting.
Accordingly, equity income from these investments is reflected as a component of
operating income in the Consolidated Statement of Income.
KeySpan also owns a 600,000 barrel liquefied natural gas ("LNG") storage and
receiving facility in Providence, Rhode Island, through its wholly owned
subsidiary KeySpan LNG, the operations of which are fully consolidated.
As noted previously, in the first quarter of 2005, KeySpan sold its 50% interest
in Premier, a gas pipeline from southwest Scotland to Northern Ireland. On March
18, 2005, the sale was completed and generated cash proceeds of $48.1 million.
In the fourth quarter of 2004, KeySpan reduced its carrying value in Premier to
61
an amount approximating the anticipated cash proceeds from the sale. The final
sale of Premier, which took place in the first quarter of 2005, resulted in a
pre-tax gain of $4.1 million reflecting the difference from earlier estimates.
This gain was recorded in other income and (deductions) on the Consolidated
Statement of Income.
Selected financial data for these energy-related investments is set forth in the
following table for the periods indicated.
- --------------------------------------------------------------------------------------------------------------------------------
Three Months Ended September 30, Nine Months Ended September 30,
(In Millions of Dollars) 2006 2005 2006 2005
- --------------------------------------------------------------------------------------------------------------------------------
Revenues $ 9.7 $ 11.9 $ 30.1 $ 30.7
Less: Operation and maintenance expense 5.5 7.0 19.5 19.0
Other operating expenses 2.7 2.7 9.0 7.7
Add: Equity earnings 3.2 2.5 9.5 12.5
Sale of assets - - 0.2 0.1
- --------------------------------------------------------------------------------------------------------------------------------
Operating Income $ 4.7 $ 4.7 $ 11.3 $ 16.6
- --------------------------------------------------------------------------------------------------------------------------------
As indicated in the above table, operating income for the Energy Investments
segment for the third quarter of 2006 remained consistent with the third quarter
of 2005, as an increase in earnings from our investment in the Iroquois Gas
Transmission System of $0.6 million was offset by lower realized gas prices
associated with our Seneca-Upshur investment.
For the nine months ended September 30, 2006, operating income decreased $5.3
million compared to the same period in 2005 due, in part, to lower earnings from
KeySpan's investment in the Iroquois Gas Transmission System. In 2005, the
Iroquois Gas Transmission System realized a benefit from a court settlement
relating to a gas supply contract that was defaulted on by a counterparty in an
earlier period. Further, a KeySpan subsidiary engaged in the transportation of
liquefied natural gas realized lower earnings due to the warm winter weather.
Finally, equity earnings were adversely impacted by the sale of Premier in March
2005.
Other Matters
In order to serve the anticipated market requirements in our New York service
territories, KeySpan and Duke Energy Corporation formed Islander East Pipeline
Company, LLC ("Islander East") in 2000. Islander East is owned 50% by KeySpan
and 50% by Duke Energy, and was created to pursue the authorization and
construction of an interstate pipeline from Connecticut, across Long Island
Sound, to a terminus near Shoreham, Long Island. Applications for all necessary
regulatory authorizations were filed in 2000 and 2001. Islander East has
received a final certificate from the FERC and all necessary permits from the
State of New York. The State of Connecticut denied Islander East's request for a
consistency determination under the Coastal Zone Management Act ("CZMA") and
application for a permit under Section 401 of the Clean Water Act. Islander East
appealed the State of Connecticut's determination on the CZMA issue to the
United States Department of Commerce. In 2004, the Secretary of Commerce
overrode Connecticut's denial and granted the CZMA authorization. The
determination of the Secretary of Commerce was appealed to the United States
62
District Court for the District of Columbia and a decision from that court is
pending. Islander East's petition for a declaratory order overriding the denial
of the Clean Water Act permit is pending with Connecticut's State Superior
Court. Pursuant to a provision of the Energy Policy Act of 2005 (the "Energy
Act"), Islander East appealed the denial of the Clean Water Act permit directly
to the United States Court of Appeals for the Second Circuit and moved to stay
the Connecticut case pending the Second Circuit's decision. The State of
Connecticut filed a motion to challenge the constitutionality of the provisions
of the Energy Act providing this appeal. The appeal was argued in January 2006
and oral arguments on the constitutional and jurisdictional issues were held in
April 2006. The Second Circuit Court of Appeals ruled on October 5, 2006 that
the Energy Act is constitutional and that the Connecticut Department of
Environmental Protection ("CTDEP") acted arbitrarily and capriciously in denying
the Clean Water Act permit. The Court remanded the matter to CTDEP to conduct,
within 75 days of October 5, 2006, "the sort of complete and reasoned review
required by law." KeySpan anticipates that this pipeline will be in service in
late 2008. As of September 30, 2006, KeySpan's total capitalized costs
associated with the siting and permitting of the Islander East pipeline were
approximately $29.5 million.
As noted, KeySpan also owns a 26.3% ownership interest in the Millennium
Pipeline Company LLC, the developer of the Millennium Pipeline project. The
other partners in the Millennium Pipeline are Columbia Gas Transmission Corp.
("Columbia Transmission"), a unit of NiSource Incorporated and DTE Energy
Company. The Millennium Pipeline project is anticipated to have the capacity to
transport up to 525,000 DTH of natural gas a day from Corning to Ramapo, New
York, interconnecting with the pipeline systems of various other utilities in
New York. The project received a FERC certificate to construct, acquire and
operate the facilities in 2002, subject to certain conditions. On August 1,
2005, the project filed an application to amend the FERC certificate requesting,
among other things, authority to phase in over time the construction of the
proposed pipeline system, approval of a reduction in capacity and maximum
allowable operating pressure, minor route modifications, the addition of certain
facilities and the acquisition of certain facilities from Columbia Transmission.
Additionally, in November and December 2005, Consolidated Edison, KEDLI and
Columbia Transmission each entered into amended precedent agreements to purchase
capacity on the pipeline. KEDLI has agreed to purchase 175,000 DTH per day from
the Millennium Pipeline system, increasing to 200,000 DTH in the second year of
the pipeline being in service. This will provide KEDLI with new, competitively
priced supplies of natural gas from Canada and other North American supply
basins. The conditions in the precedent agreements are subject to, among other
things, the receipt of necessary regulatory approvals and financing. On May 3,
2006, Millennium filed a further amendment to its August 1, 2005 filing
requesting, among other things, that the FERC vacate those portions of its
certificate not included in its August 1, 2005 filing; that request is pending
before the FERC. On June 9, 2006, the FERC issued a favorable draft supplemental
environmental impact statement. On July 11, 2006, Millennium informed the FERC
that the anticipated in-service date for Millennium Phase 1 will be extended
from November 1, 2007 to November 1, 2008, or earlier, if feasible. On October
13, 2006, the FERC issued its Final Supplemental Environmental Impact Statement
with respect to Millennium and its companion applicants. Millennium's amended
application and those of its companion applicants are pending decision by the
FERC. As of September 30, 2006, KeySpan's investment in the Millennium Pipeline
project was $17.7 million.
63
In 2005, KeySpan LNG entered into a precedent agreement with BG LNG Services, a
subsidiary of British Gas, to provide liquefied natural gas terminalling
service. KeySpan LNG proposed to upgrade the liquefied natural gas facility to
accept marine deliveries and to triple vaporization (or regasification) capacity
to provide these services. In June 2005, the FERC denied KeySpan LNG's
application to expand the facility citing concerns that the proposed upgraded
facility would not meet current federal new construction standards. KeySpan
sought a rehearing with FERC, and on January 20, 2006, the FERC denied such
request, although the order provided that KeySpan LNG could file an amendment to
its original application addressing a revised expansion project which would
differ substantially from that originally proposed by KeySpan. Any amended
application would need to include a detailed analysis of the new project scope,
including upgrades to the existing facilities and alternative plans for any
service disruptions that may be necessary during construction of a new expanded
project. KeySpan has filed a petition for judicial review of the FERC order with
the United States Circuit Court for the District of Columbia. The Court is
expected to issue a decision affirming or vacating the FERC orders by the second
quarter of 2007.
In addition to the proceeding at FERC, KeySpan LNG also is involved in seeking
other required regulatory approvals and the resolution of certain litigation
regarding such approvals. In February 2005, KeySpan LNG filed an action in
Federal District Court in Rhode Island seeking a declaratory judgment that it is
not required to obtain a "Category B Assent" from the State of Rhode Island and
an injunction preventing the Rhode Island Coastal Resources Management Council
("CRMC") from enforcing the Category B assent requirements. In March 2005, the
Rhode Island Attorney General answered the complaint and moved to substitute the
State of Rhode Island as the defendant and filed a counterclaim seeking a
declaratory judgment that the expansion requires a Category B Assent. In April,
the parties filed cross motions for summary judgment with respect to all issues
presented to the Court. On April 14, 2005, the Attorney General also filed on
behalf of the State a complaint against KeySpan LNG in Rhode Island State
Superior Court raising substantially the same issues as the federal court
action. KeySpan LNG removed that action to federal court and moved for summary
judgment. The Attorney General subsequently withdrew both the motion to
substitute defendants and the counterclaim. Although the Court had indicated its
intention to issue a decision in the pending cases by August 2005, the Court
subsequently stayed the litigation pending resolution of the FERC appeal process
discussed above. As of September 30, 2006, our investment in this project was
$16.8 million, a portion of which may be subject to reimbursement from BG LNG
pursuant to the terms of the precedent agreement.
Allocated Costs
We are subject to the jurisdiction of the FERC under PUHCA 2005. As part of the
regulatory provisions of PUHCA 2005, the FERC regulates various transactions
among affiliates within a holding company system. In accordance with regulations
under PUHCA 2005 and regulations and policies of the New York State Public
Service Commission, the Massachusetts Department of Telecommunications and
Energy and the New Hampshire Public Utility Commission, we established service
companies that provide: (i) traditional corporate and administrative services;
(ii) gas and electric transmission and distribution system planning, marketing,
and gas supply planning and procurement; and (iii) engineering and surveying
64
services to subsidiaries. The operating income variation as reflected in
"elimination and other" is due primarily to costs residing at KeySpan's holding
company level such as incremental costs associated with the anticipated merger
with National Grid plc, as well as corporate advertising expenses. Also, KeySpan
entered into confidential settlement agreements with certain of its insurance
carriers for recovery of environmental costs associated with investigation and
remediation of gas plant sites and non-utility sites. KeySpan recorded a $5.5
million benefit in its Consolidated Statement of Income for the nine months
ended September 30, 2006 associated with these settlement agreements.
Liquidity
Cash flow from operations increased $435.5 million, or 90%, for the nine months
ended September 30, 2006 compared to the same period last year primarily due to
favorable working capital requirements and income tax payments. The favorable
working capital requirements were primarily driven by receipt of customer
payments associated with winter heating season gas sales. In addition, KeySpan's
income tax payments were $74.1 million lower during the nine months ended
September 30, 2006, compared to the same period last year.
At September 30, 2006, we had cash and temporary cash investments of $40.0
million. During the nine months ended September 30, 2006, we repaid $327.6
million of commercial paper and, at September 30, 2006, $330.0 million of
commercial paper was outstanding at a weighted-average annualized interest rate
of 5.38%. We had the ability to borrow up to an additional $1.2 billion at
September 30, 2006, under the terms of our credit facility.
KeySpan has two credit facilities which total $1.5 billion - $920 million for
five years through 2010, and $580 million through 2009 - which continue to
support KeySpan's commercial paper program for ongoing working capital needs.
The fees for the facilities are based on KeySpan's current credit ratings and
are increased or decreased based on a downgrading or upgrading of our ratings.
The current annual facility fee is 0.07% based on our credit rating of A3 by
Moody's Investor Services and A by Standard & Poor's for each facility. Both
credit facilities allow for KeySpan to borrow using several different types of
loans; specifically, Eurodollar loans, ABR loans, or competitively bid loans.
Eurodollar loans are based on the Eurodollar rate plus a margin that is tied to
our applicable credit ratings. ABR loans are based on the higher of the Prime
Rate, the base CD rate plus 1%, or the Federal Funds Effective Rate plus 0.5%.
Competitive bid loans are based on bid results requested by KeySpan from the
lenders. We do not anticipate borrowing against these facilities; however, if
the credit rating on our commercial paper program were to be downgraded, it may
be necessary to do so.
The facilities contain certain affirmative and negative operating covenants,
including restrictions on KeySpan's ability to mortgage, pledge, encumber or
otherwise subject its utility property to any lien, as well as certain financial
covenants that require us to, among other things, maintain a consolidated
indebtedness to consolidated capitalization ratio of no more than 65% as of the
65
last day of any fiscal quarter. Violation of these covenants could result in the
termination of the facilities and the required repayment of amounts borrowed
thereunder, as well as possible cross defaults under other debt agreements. At
September 30, 2006, KeySpan's consolidated indebtedness was 48.3% of its
consolidated capitalization and KeySpan was in compliance with all covenants.
Subject to certain conditions set forth in the credit facility, KeySpan has the
right, at any time, to increase the commitments under the $920 million facility
up to an additional $300 million. In addition, KeySpan has the right to request
that the termination date be extended for an additional period of 365 days prior
to each anniversary of the closing date. This extension option, however,
requires the approval of lenders holding more than 50% of the total commitments
to such extension request. Under the agreements, KeySpan has the ability to
replace non-consenting lenders with other pre-approved banks or financial
institutions. Upon effectiveness of PUHCA 2005, KeySpan's ability to issue
commercial paper was no longer limited by the SEC. Accordingly, subject to
compliance with the foregoing conditions, KeySpan is currently able to issue up
to $1.5 billion of commercial paper.
A substantial portion of consolidated revenues are derived from the operations
of businesses within the Electric Services segment, that are largely dependent
upon two large customers - LIPA and the NYISO. Accordingly, our cash flows are
dependent upon the timely payment of amounts owed to us by these counterparties.
(See Note 10. to the Consolidated Financial Statements "2006 LIPA Settlement"
for information regarding the recent settlement between KeySpan and LIPA
regarding the current contractual agreements.)
We satisfy our seasonal working capital requirements primarily through
internally generated funds and the issuance of commercial paper. We believe that
these sources of funds are sufficient to meet our seasonal working capital
needs.
Capital Expenditures and Financing
Construction Expenditures
The table below sets forth our construction expenditures by operating segment
for the periods indicated:
- -------------------------------------------------------------------------
Nine Months Ended September 30,
(In Millions of Dollars) 2006 2005
- -------------------------------------------------------------------------
Gas Distribution $ 288.6 $ 270.1
Electric Services 58.3 72.8
Energy Investments 5.0 17.8
Energy Services and other 25.7 11.4
- -------------------------------------------------------------------------
$ 377.6 $ 372.1
- -------------------------------------------------------------------------
66
Construction expenditures related to the Gas Distribution segment are primarily
for the renewal, replacement and expansion of the distribution system.
Construction expenditures for the Electric Services segment reflect costs to
maintain our generating facilities. The increase in capital expenditures for the
nine months ended September 30, 2006 compared to the same period last year of
$5.5 million reflects an increase in the Gas Distribution segment due, in part,
to the timing of capital main and service work, as well as to upgrades to
KeySpan's New York LNG facility. In total, KeySpan anticipates incurring
approximately the same amount of construction expenditures in 2006 as it
incurred in 2005.
Financing
KeySpan did not engage in any financing activities in the first nine months of
2006, other than commercial paper repayments as noted earlier. However, KeySpan
anticipates issuing, subject to execution of definitive agreements,
approximately $400 million Senior Unsecured Notes at KEDNY and approximately
$100 million Senior Unsecured Notes at KEDLI in the fourth quarter of 2006,
pursuant to a private placement that is exempt from registration under the
Securities Act of 1933. The Notes were priced on October 26, 2006 at 5.55% and
are anticipated to be issued with ten year maturities. The net proceeds from the
issuance of the Notes will be used by KEDNY and KEDLI to refinance existing
intercompany indebtedness and/or for general working capital purposes.
The following table represents the ratings of our long-term debt at September
30, 2006. In 2004 Standard & Poor's reaffirmed its ratings on KeySpan's and its
subsidiaries' long-term debt and removed its negative outlook. Further in 2005,
Fitch Ratings revised its ratings on KeySpan's and its subsidiaries' long-term
debt to positive outlook. Moody's Investor Services, however, continues to
maintain its negative outlook ratings on KeySpan's and its subsidiaries'
long-term debt.
- -------------------------------------------------------------------------------
Moody's Investor Standard
Services & Poor's FitchRatings
- -------------------------------------------------------------------------------
KeySpan Corporation A3 A A-
KEDNY N/A A+ A+
KEDLI A2 A+ A-
Boston Gas A2 A N/A
Colonial Gas A2 A+ N/A
KeySpan Generation A3 A N/A
- -------------------------------------------------------------------------------
Off-Balance Sheet Arrangements
Guarantees
KeySpan had a number of financial guarantees with its subsidiaries at September
30, 2006. KeySpan has fully and unconditionally guaranteed: (i) $525 million of
medium-term notes issued by KEDLI; (ii) the obligations of KeySpan Ravenswood,
LLC, which is the lessee under the $425 million Master Lease associated with the
Ravenswood Facility and the lessee under the $385 million sale/leaseback
transaction for the Ravenswood Expansion including future decommission costs of
$19 million; and (iii) the payment obligations of our subsidiaries related to
$128 million of tax-exempt bonds issued through the Nassau County and Suffolk
67
County Industrial Development Authorities for the construction of two
electric-generation peaking facilities on Long Island. The medium-term notes,
the Master Lease and the tax-exempt bonds are reflected on the Consolidated
Balance Sheet; the sale/leaseback obligation is not recorded on the Consolidated
Balance Sheet. Further, KeySpan has guaranteed: (i) up to $71.4 million of
surety bonds associated with certain construction projects currently being
performed by former subsidiaries; (ii) certain supply contracts, margin accounts
and purchase orders for certain subsidiaries in an aggregate amount of $77.0
million; and (iii) $80.3 million of subsidiary letters of credit. These
guarantees are not recorded on the Consolidated Balance Sheet. KeySpan's
guarantees on certain performance bonds relating to current construction
projects of the discontinued mechanical contracting companies will remain in
place throughout the construction period for these projects. KeySpan has
received an indemnity bond issued by a third party to offset potential exposure
related to a significant portion of the continuing guarantee. At this time, we
have no reason to believe that our subsidiaries or former subsidiaries will
default on their current obligations. However, we cannot predict when or if any
defaults may take place or the impact such defaults may have on our consolidated
results of operations, financial condition or cash flows. (See Note 6 to the
Consolidated Financial Statements, "Financial Guarantees and Contingencies" for
additional information regarding KeySpan's guarantees.)
Contractual Obligations
KeySpan has certain contractual obligations related to its outstanding long-term
debt, outstanding credit facility borrowings, outstanding commercial paper
borrowings, operating and capital leases, and demand charges associated with
certain commodity purchases. These obligations have remained substantially
unchanged since December 31, 2005. (For additional details regarding these
obligations see KeySpan's Annual Report on Form 10-K for the year ended December
31, 2005, Item 7 Management's Discussion and Analysis of Financial Condition and
Results of Operations, as well as Note 6 "Long-Term Debt" and Note 7
"Contractual Obligations, Financial Guarantees and Contingencies" to those
Consolidated Financial Statements.)
Discussions of Critical Accounting Policies and Assumptions
In preparing our financial statements, the application of certain accounting
policies requires difficult, subjective and/or complex judgments. The
circumstances that make these judgments difficult, subjective and/or complex
have to do with the need to make estimates about the impact of matters that are
inherently uncertain. Actual effects on our financial position and results of
operations may vary significantly from expected results if the judgments and
assumptions underlying the estimates prove to be inaccurate.
Below is a discussion of KeySpan's critical accounting policies and assumptions
at September 30, 2006. For a more detailed discussion of these policies and
assumptions see KeySpan's Annual Report on Form 10-K for the year ended December
31, 2005, Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations "Discussion of Critical Accounting Policies and
Assumptions."
68
Valuation of Goodwill
KeySpan records goodwill on purchase transactions, representing the excess of
acquisition cost over the fair value of net assets acquired. In testing for
goodwill impairment under Statement of Financial Accounting Standards ("SFAS")
142 "Goodwill and Other Intangible Assets," significant reliance is placed upon
a number of estimates regarding future performance that require broad
assumptions and significant judgment by management. A change in the fair value
of our investments could cause a significant change in the carrying value of
goodwill. The assumptions used to measure the fair value of our investments are
the same as those used by us to prepare annual operating segment and
consolidated earnings and cash flow forecasts. In addition, these assumptions
are used to set annual budgetary guidelines. At September 30, 2006, KeySpan has
$1.7 billion of recorded goodwill and has concluded that the fair value of the
business units that have recorded goodwill exceed their carrying value.
Accounting for the Effects of Rate Regulation on Gas Distribution Operations
The financial statements of the Gas Distribution segment reflect the ratemaking
policies and orders of the New York Public Service Commission ("NYPSC"), the New
Hampshire Public Utilities Commission ("NHPUC"), and the Massachusetts
Department of Telecommunications and Energy ("MADTE").
Four of our six regulated gas utilities (KEDNY, KEDLI, Boston Gas Company and
EnergyNorth Natural Gas, Inc.) are subject to the provisions of SFAS 71,
"Accounting for the Effects of Certain Types of Regulation." This statement
recognizes the actions of regulators, through the ratemaking process, to create
future economic benefits and obligations affecting rate-regulated companies.
In separate orders issued by the MADTE relating to the Eastern Enterprise
acquisition in 2000, the base rates charged by Colonial Gas Company and Essex
Gas Company have been frozen at their current levels for a ten-year period
ending 2009. Due to the length of these base rate freezes, the Colonial and
Essex Gas Companies had previously discontinued the application of SFAS 71.
As is further discussed under the caption "Regulation and Rate Matters," the
rate plans previously in effect for KEDNY and KEDLI have expired. The continued
application of SFAS 71 to record the activities of these subsidiaries is
contingent upon the actions of regulators with regard to future rate plans. As
part of its application for approval of the KeySpan / National Grid plc merger,
KeySpan has filed proposed rate plans for KEDNY and KEDLI with the NYPSC. In
addition, individual applications for a proposed annual increase in revenues for
KEDNY and KEDLI were filed. The ultimate resolution of any future rate plans
could have a significant impact on the application of SFAS 71 to these entities
and, accordingly, on our financial position, results of operations and cash
flows. However, management believes that currently available facts support the
continued application of SFAS 71 and that all regulatory assets and liabilities
are recoverable or refundable through the regulatory environment.
69
Pension and Other Postretirement Benefits
KeySpan participates in both non-contributory defined benefit pension plans, as
well as other post-retirement benefit ("OPEB") plans (collectively
"postretirement plans"). KeySpan's reported costs of providing pension and OPEB
benefits are dependent upon numerous factors resulting from actual plan
experience and assumptions of future experience. Pension and OPEB costs
(collectively "postretirement costs") are impacted by actual employee
demographics, the level of contributions made to the plans, earnings on plan
assets, and health care cost trends. Changes made to the provisions of these
plans may also impact current and future postretirement costs. Postretirement
costs may also be significantly affected by changes in key actuarial
assumptions, including anticipated rates of return on plan assets and the
discount rates used in determining the postretirement costs and benefit
obligations. Actual results that differ from our assumptions are accumulated and
amortized over ten years.
Historically, we have funded our qualified pension plans in excess of the amount
required to satisfy minimum ERISA funding requirements. At September 30, 2006,
we had a funding credit balance in excess of the ERISA minimum funding
requirements. Although we have presently exceeded ERISA funding requirements,
our pension plans, on an actuarial basis, are currently underfunded. Therefore,
for 2006, KeySpan expects to contribute a total of $120 million to its funded
and unfunded post-retirement plans. Future funding requirements are heavily
dependent on actual return on plan assets and prevailing interest rates. (In
addition to Item 7 Management's Discussion and Analysis of Financial Condition
and Results of Operations in KeySpan's Annual Report on Form 10-K for the year
ended December 31, 2005, see also Note 4 of those Consolidated Financial
Statements, "Postretirement Benefits.")
Regulation and Rate Matters
Gas Matters
The rate agreements for KEDNY and KEDLI have expired. Under the terms of the
KEDNY and KEDLI rate agreements, gas distribution rates and all other provisions
will remain in effect until changed by the NYPSC. KeySpan has recently filed
proposed rate plans for KEDNY and KEDLI with the NYPSC as part of its
application for approval of the KeySpan / National Grid plc merger, as well as
individual applications for a proposed annual increase in revenues for KEDNY and
KEDLI. See the "Introduction to the Notes to the Consolidated Financial
Statements" for additional details on the filings.
Effective November 1, 2003, the MADTE approved a $25.9 million increase in base
revenues for Boston Gas with an allowed return on equity of 10.2% reflecting an
equal balance of debt and equity. On January 27, 2004, the MADTE issued its
order on Boston Gas Company's Motion for Recalculation, Reconsideration and
Clarification that granted an additional $1.1 million in base revenues, for a
total of $27 million. The MADTE also approved a Performance Based Rate Plan (the
"Plan") for up to ten years, as well as a true-up mechanism for pension and
other postretirement benefit costs under which variations between actual pension
and other postretirement benefit costs and amounts used to establish rates are
deferred and collected from or refunded to customers in subsequent periods. This
70
true-up mechanism allows for carrying charges on deferred assets and liabilities
at Boston Gas's weighted-average cost of capital. On October 31, 2006, the MADTE
approved a base rate increase of $8.6 million under the Plan. In addition, an
increase of $2.7 million in the local distribution adjustment clause was
approved to recover pension and other postretirement costs subject to further
review by the MADTE.
In connection with the Eastern Enterprises acquisition of Colonial Gas in 1999,
the MADTE approved a merger and rate plan that resulted in a ten year freeze of
base rates to Colonial Gas's firm customers. The base rate freeze is subject
only to certain exogenous factors, such as changes in tax laws, accounting
changes, or regulatory, judicial, or legislative changes. Due to the length of
the base rate freeze, Colonial Gas discontinued its application of SFAS 71.
Essex Gas is also under a ten-year base rate freeze and has also discontinued
its application of SFAS 71. EnergyNorth base rates continue as set by the NHPUC
in 1993.
In December 2005, Boston Gas received a MADTE order permitting regulatory
recovery of the 2004 gas cost component of bad debt write-offs. This was
approved for full recovery as an exogenous cost effective November 1, 2005. In
addition, effective January 1, 2006, Boston Gas was permitted to fully recover
the gas cost component of bad debt write-offs through its cost-of-gas adjustment
clause rather than filing for recovery as an exogenous cost. On October 31,
2006, the MADTE granted Boston Gas recovery of $12 million of the 2005 gas cost
component of bad debt write-offs from Boston Gas ratepayers beginning November
1, 2006. This amount will also be recovered through the cost-of-gas adjustment
clause.
For an additional discussion of our current gas distribution rate agreements,
see KeySpan's Annual Report on Form 10-K for the year ended December 31, 2005,
Item 7 Management's Discussion and Analysis of Financial Condition and Results
of Operations "Regulation and Rate Matters."
Electric Matters
KeySpan sells to LIPA all of the capacity and, to the extent requested, energy
conversion services from our existing Long Island based oil and gas-fired
generating plants. Sales of capacity and energy conversion services are made
under rates approved by the FERC in accordance with the PSA entered into between
KeySpan and LIPA in 1998. The original FERC approved rates, which had been in
effect since May 1998, expired on December 31, 2003. On October 1, 2004 the FERC
approved a settlement reached between KeySpan and LIPA to reset rates effective
January 1, 2004. Under the new agreement, KeySpan's rates reflect a cost of
equity of 9.5% with no revenue increase in the first year. The FERC approved
updated operating and maintenance expense levels and recovery of certain other
costs as agreed to by the parties.
As noted earlier, on February 1, 2006, KeySpan and LIPA entered into (i) an
amended and restated Management Services Agreement; (ii) a new Option and
Purchase and Sale Agreement, to replace the Generation Purchase Rights Agreement
as amended; and (iii) a Settlement Agreement resolving outstanding issues
between the parties regarding the 1998 LIPA Agreements. (For a further
discussion on the LIPA agreements see Note 10 to the Consolidated Financial
Statements "2006 LIPA Settlement," as well as KeySpan's Annual Report on Form
10-K for the year ended December 31, 2005, Item 7 Management's Discussion and
Analysis of Financial Condition and Results of Operations "Electric Services -
LIPA Agreements.")
71
The Energy Policy Act of 2005 and the Public Utility Holding Company Acts of
1935 and 2005
In August 2005, the Energy Policy Act of 2005 (the "Energy Act") was enacted by
Congress and signed into law by the President. The Energy Act is a broad based
energy bill that places an increased emphasis on the production of energy and
promotes the development of new technologies and alternative energy sources by
providing tax credits to companies that produce natural gas, oil, coal,
electricity and renewable energy. For KeySpan, one of the more significant
provisions of the Energy Act was the repeal of PUHCA 1935, effective February 8,
2006, and the transfer of certain holding company oversight from the SEC to FERC
pursuant to PUHCA 2005.
Pursuant to PUHCA 2005, the SEC no longer has jurisdiction over our holding
company activities, other than those traditionally associated with the
registration and issuance of our securities under the federal securities laws.
FERC now has jurisdiction over certain of our holding company activities,
including (i) regulating certain transactions among our affiliates within our
holding company system; (ii) governing the issuance, acquisition and disposition
of securities and assets by certain of our public utility subsidiaries; and
(iii) approving certain utility mergers and acquisitions.
Moreover, our affiliate transactions also remain subject to certain regulations
of the NYPSC, MADTE and NHPUC, in addition to FERC.
Environmental Matters
KeySpan is subject to various federal, state and local laws and regulatory
programs related to the environment. Through various rate orders issued by the
NYPSC, MADTE and NHPUC, costs related to MGP environmental cleanup activities
are recovered in rates charged to gas distribution customers and, as a result,
adjustments to these reserve balances do not impact earnings. However,
environmental cleanup activities related to the three non-utility sites are not
subject to rate recovery.
We estimate that the remaining cost of our MGP related environmental cleanup
activities, including costs associated with the Ravenswood Generating Station,
will be approximately $372.4 million and we have recorded a related liability
for such amount. We have also recorded an additional $13.4 million liability,
representing the estimated environmental cleanup costs related to a former coal
tar processing facility. As of September 30, 2006, we have expended a total of
$211.8 million on environmental investigation and remediation activities. (See
Note 6 to the Consolidated Financial Statements, "Financial Guarantees and
Contingencies.")
Market and Credit Risk Management Activities
Market Risk: KeySpan is exposed to market risk arising from potential changes in
one or more market variables, such as energy commodity prices, interest rates,
volumetric risk due to weather or other variables. Such risk includes any or all
changes in value whether caused by commodity positions, asset ownership,
business or contractual obligations, debt covenants, exposure concentration,
72
currency, weather, and other factors regardless of accounting method. We manage
our exposure to changes in market prices using various risk management
techniques for non-trading purposes, including hedging through the use of
derivative instruments, both exchange-traded and over-the-counter contracts,
purchase of insurance and execution of other contractual arrangements.
KeySpan is exposed to price risk due to investments in equity and debt
securities held to fund benefit payments for various employee pension and other
postretirement benefit plans. To the extent that the value of investments held
change, or long-term interest rates change, the effect will be reflected in
KeySpan's recognition of periodic cost of such employee benefit plans and the
determination of contributions to the employee benefit plans.
Credit Risk: KeySpan is exposed to credit risk arising from the potential that
our counterparties fail to perform on their contractual obligations. Our credit
exposures are created primarily through the sale of gas and transportation
services to residential, commercial, electric generation, and industrial
customers and the provision of retail access services to gas marketers, by our
regulated gas businesses; the sale of commodities and services to LIPA and the
NYISO; the sale of power and services to our retail customers by our unregulated
energy service businesses; entering into financial and energy derivative
contracts with energy marketing companies and financial institutions; and the
sale of gas, oil and processing services to energy marketing and oil and gas
production companies.
We have regional concentration of credit risk due to receivables from
residential, commercial and industrial customers in New York, New Hampshire and
Massachusetts, although this credit risk is spread over a diversified base of
residential, commercial and industrial customers. Customers' payment records are
monitored and action is taken, when appropriate and in accordance with various
regulatory requirements.
We also have credit risk from LIPA, our largest customer, and from other energy
and financial services companies. Counterparty credit risk may impact overall
exposure to credit risk in that our counterparties may be similarly impacted by
changes in economic, regulatory or other considerations. We actively monitor the
credit profile of our wholesale counterparties in derivative and other
contractual arrangements, and manage our level of exposure accordingly. In
instances where counterparties' credit quality has declined, or credit exposure
exceeds certain levels, we may limit our credit exposure by restricting new
transactions with the counterparty, requiring additional collateral or credit
support and negotiating the early termination of certain agreements.
Regulatory Issues and Competitive Environment: We are subject to various other
risk exposures and uncertainties associated with our gas and electric
operations. The most significant contingency involves the evolution of the gas
distribution and electric industries towards more competitive and deregulated
environments. The risks associated with KeySpan's gas distribution activities
have not changed substantially since December 31, 2005. For additional
information regarding these risks see KeySpan's Annual Report on Form 10-K for
the year ended December 31, 2005, Item 7 Management's Discussion and Analysis of
Financial Condition and Results of Operations "Market and Credit Risk Management
Activities." The following is an update to certain matters related KeySpan's
electric operations.
73
The Ravenswood Generating Station and KeySpan's New York City Operations
On February 9, 2006, the NYISO Operating Committee increased the "in-City"
locational capacity requirements (LCR) from 80% to 83% beginning in May 2006
through the period ending April 2007, based in part on the statewide reserve
margin of 118% set by the New York State Reliability Council. However, in early
March 2006, the NYISO discovered data inconsistencies in the input files used in
the Multi Area Reliability Simulation (MARS) computer program that is used to
determine the statewide installed reserve margin (Statewide IRM) and the
corresponding minimum LCRs for New York City and Long Island. Revisions to the
data, and rerunning the MARS computer program resulted in a shift in the
relationship between the Statewide IRM and the minimum LCRs. On March 20, 2006,
the New York State Reliability Council voted to retain the Statewide IRM of 118%
and reported the corresponding revised minimum LCRs to the NYISO. On March 28,
2006, the NYISO Operating Committee approved revised minimum LCRs of 80% and 99%
for New York City and Long Island, respectively. For New York City, this action
effectively returned the locational requirement to the minimum level used for
the last six years (80%) and negated the increase to 83%.
KeySpan appealed this decision to the NYISO Board of Directors claiming the
revised study was hastily prepared and that there were historic factors that
justified using 83% as the New York City LCR. The NYISO Board of Directors
denied KeySpan's appeal on April 3, 2006 and the "in-City" locational capacity
requirement beginning May 1, 2006 through the period ending April 30, 2007 is
currently 80%.
In addition, for information concerning the pending in-City capacity mitigation
proposal, see the discussion in "Item 2 Management's Discussion and Analysis of
Financial Condition and Results of Operations - Electric Services."
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Financially-Settled Commodity Derivative Instruments - Hedging Activities: From
time to time, KeySpan subsidiaries have utilized derivative financial
instruments, such as futures, options and swaps, for the purpose of hedging the
cash flow variability associated with changes in commodity prices. KeySpan is
exposed to commodity price risk primarily with regard to its gas distribution
operations, gas exploration and production activities and its electric
generating facilities. Our gas distribution operations utilize over-the-counter
("OTC") natural gas and fuel oil swaps to hedge the cash-flow variability of
specified portions of gas purchases and sales associated with certain
large-volume customers when economically appropriate to do so. Seneca-Upshur
utilizes OTC natural gas swaps to hedge cash flow variability associated with
forecasted sales of natural gas. The Ravenswood Generating Station uses
derivative financial instruments to hedge the cash flow variability associated
with the purchase of a portion of natural gas and oil that will be consumed
during the generation of electricity. The Ravenswood Generating Station also
hedges the cash flow variability associated with a portion of electric energy
sales using OTC electricity swaps.
KeySpan uses market quoted forward prices to value OTC swap contracts.
74
Financially-Settled Commodity Derivative Instruments that Do Not Qualify for
Hedge Accounting: KeySpan subsidiaries also have employed a limited number of
financial derivatives that do not qualify for hedge accounting treatment under
SFAS 133. We had purchased a series of call options on the spread between the
price of heating oil and the price of natural gas to further complement our
hedging strategy noted above regarding sales to certain large-volume customers.
As of September 30, 2006, these options, as well as the OTC gas and oil swaps,
have expired. The Ravenswood Generating Station has also employed a limited
number of financial derivatives that do not qualify for hedge accounting
treatment under SFAS 133 associated with the purchase of fuel oil. Additionally,
KeySpan entered into an International SWAP Dealers Association Master Agreement
for a fixed for floating unforced capacity financial swap with Morgan Stanley
Capital Group Inc., as well as a gas distribution asset optimization contract
that employs derivative financial instruments.
The following tables set forth selected financial data associated with these
derivative financial instruments noted above that were outstanding at September
30, 2006.
- -------------------------------------------------------------------------------------------------
Year of Volumes Fixed Current Fair Value
Type of Contract Maturity mmcf Price $ Price $ (In $ Millions)
- -------------------------------------------------------------------------------------------------
Gas
Swaps/Futures - Long Natural Gas 2006 4,101 4.82 - 11.94 4.20 - 7.35 (11.7)
2007 3,651 9.82 - 11.94 7.20 - 8.76 (5.1)
2008 360 9.82 7.26 - 9.14 (0.3)
OTC Swaps - Short Natural Gas 2006 683 6.17 - 10.69 4.20 - 7.35 2.5
2007 2,622 5.86 - 11.54 7.20 - 8.76 (4.6)
2008 1,596 6.77 - 6.85 7.26 - 9.14 (2.7)
2009 1,300 7.60 - 10.90 7.02 - 8.89 1.0
- -------------------------------------------------------------------------------------------------
14,313 (20.9)
- -------------------------------------------------------------------------------------------------
- ------------------------------------------------------------------------------------------------------------------------------------
Year of Volumes Fixed Current Fair Value
Type of Contract Maturity Barrels Price $ Price $ (In Millions)
- ------------------------------------------------------------------------------------------------------------------------------------
Oil
Swaps - Long Fuel Oil 2006 51,755 57.90 - 67.60 46.80 (0.8)
2007 251,812 59.20 - 69.08 53.69 - 58.18 (2.7)
2008 34,544 67.60 58.18 (0.3)
- ------------------------------------------------------------------------------------------------------------------------------------
338,111 (3.8)
- ------------------------------------------------------------------------------------------------------------------------------------
- ---------------------------------------------------------------------------------------------------------------------------------
Year of Fixed Margin/ Current Fair Value
Type of Contract Maturity MWh Price $ Price $ (In $ Millions)
- ---------------------------------------------------------------------------------------------------------------------------------
Electricity
Swaps - Energy 2006 471,800 59.90 - 123.00 44.75 - 88.25 11.6
2007 144,800 97.60 - 150.50 78.92 - 108.69 9.4
- ---------------------------------------------------------------------------------------------------------------------------------
616,600 21.0
- ---------------------------------------------------------------------------------------------------------------------------------
75
- -----------------------------------------------------------------
2006
Change in Fair Value of Derivative Instruments (In $ Millions)
- -----------------------------------------------------------------
Fair value of contracts at January 1, (18.1)
Net (gains) on contracts realized (67.1)
Increase in fair value of all open contracts 81.5
- -----------------------------------------------------------------
Fair value of contracts outstanding at September 30, (3.7)
- -----------------------------------------------------------------
- ------------------------------------------------------------------------------
(In Millions of Dollars)
- ------------------------------------------------------------------------------
Fair Value of Contracts
- ------------------------------------------------------------------------------
Mature Within Total
Sources of Fair Value 12 Months Thereafter Fair Value
- ------------------------------------------------------------------------------
Prices actively quoted $ (18.6) $ (2.2) $ (20.8)
Local published indicies 17.1 - 17.1
- ------------------------------------------------------------------------------
$ (1.5) $ (2.2) $ (3.7)
- ------------------------------------------------------------------------------
We measure the commodity risk of our derivative hedging instruments (indicated
in the above table) using a sensitivity analysis. Based on a sensitivity
analysis as of September 30, 2006 a 10% increase/decrease in natural gas prices
would decrease/increase the value of derivative instruments maturing in one year
by $5.1 million.
Firm Gas Sales Derivative Instruments - Regulated Utilities: We use derivative
financial instruments to reduce the cash flow variability associated with the
purchase price for a portion of future natural gas purchases associated with our
Gas Distribution operations. The accounting for these derivative instruments is
subject to SFAS 71 "Accounting for the Effects of Certain Types of Regulation."
Therefore, changes in the fair value of these derivatives have been recorded as
a regulatory asset or regulatory liability on the Consolidated Balance Sheet.
Gains or losses on the settlement of these contracts are initially deferred and
then refunded to or collected from our firm gas sales customers consistent with
regulatory requirements.
The following table sets forth selected financial data associated with these
derivative financial instruments that were outstanding at September 30, 2006.
- -----------------------------------------------------------------------------------------
Year of Volumes Fixed Current Fair Value
Type of Contract Maturity mmcf Price ($) Price ($) (In $ Millions)
- -----------------------------------------------------------------------------------------
Swaps 2006 29,636 6.05 - 12.29 5.62 - 7.35 (94.2)
2007 66,936 6.81 - 12.29 7.20 - 8.76 (159.4)
2008 11,985 7.16 - 11.64 7.26 - 9.14 (23.2)
- -----------------------------------------------------------------------------------------
108,557 (276.8)
- -----------------------------------------------------------------------------------------
See Note 4 to the Consolidated Financial Statements "Hedging and Derivative
Financial Instruments" for a further description of all our derivative
instruments.
76
Item 4. Controls and Procedures
We maintain disclosure controls and procedures (as defined under Exchange Act
Rule 13a-15(e) and 15d-15(e)) that are designed to ensure that information
required to be disclosed by us in the reports we file or submit under the
Exchange Act is recorded, processed, summarized and reported within the time
periods specified in the Securities and Exchange Commission's rules and forms,
and that such information is accumulated and communicated to KeySpan's
management, including our Chief Executive Officer and Chief Financial Officer,
as appropriate, to allow timely decisions regarding required disclosure. Any
control system, no matter how well designed and operated, can provide only
reasonable assurance of achieving the desired control objectives. Our
management, under the supervision and with the participation of our Chief
Executive Officer and Chief Financial Officer, has evaluated the effectiveness
of our disclosure controls and procedures as of September 30, 2006. Based upon
that evaluation, our Chief Executive Officer and Chief Financial Officer
concluded that the design and operation of our disclosure controls and
procedures were effective at the reasonable assurance level in alerting them
timely to material information required to be included in KeySpan's periodic SEC
reports.
Furthermore, there has been no change in KeySpan's internal control over
financial reporting that occurred during KeySpan's last fiscal quarter, which
has materially affected, or is reasonably likely to materially affect, KeySpan's
internal control over financial reporting.
PART II. OTHER INFORMATION
- ---------------------------
Item 1. Legal Proceedings
See Note 6 to the Consolidated Financial Statements "Financial Guarantees and
Contingencies".
Item 1A. Risk Factors
Certain statements contained in this Quarterly Report on Form 10-Q concerning
expectations, beliefs, plans, objectives, goals, strategies, future events or
performance and underlying assumptions and other statements that are other than
statements of historical facts, are "forward-looking statements" within the
meaning of Section 21E of the Securities Exchange Act of 1934, as amended.
Without limiting the foregoing, all statements under the captions "Item 2.
Management's Discussion and Analysis of Financial Condition and Results of
Operations" and "Item 3. Quantitative and Qualitative Disclosures About Market
Risk" relating to our future outlook, anticipated capital expenditures, future
cash flows and borrowings, pursuit of potential future acquisition opportunities
and sources of funding, are forward-looking statements. Such forward-looking
statements reflect numerous assumptions and involve a number of risks and
uncertainties and actual results may differ materially from those discussed in
such statements.
77
Among the factors that could cause actual results to differ materially are:
- - the occurrence of any event, change or other circumstances that could give
rise to the termination of the merger agreement with National Grid plc or
the failure of the merger to close for any reason;
- - volatility of energy prices used to generate electricity;
- - fluctuations in weather and in gas and electric prices;
- - general economic conditions, especially in the Northeast United States;
- - our ability to manage our cost structure successfully and operate
efficiently;
- - our ability to successfully contract for natural gas supplies required to
meet the needs of our customers;
- - implementation of new accounting standards or changes in accounting
standards or GAAP which may require adjustments to financial statements;
- - inflationary trends and interest rates;
- - the ability of KeySpan to identify and make complementary acquisitions, as
well as the successful integration of such acquisitions;
- - available sources and cost of fuel;
- - creditworthiness of counterparties to derivative instruments and commodity
contracts;
- - the resolution of certain disputes with LIPA concerning each party's rights
and obligations under various agreements;
- - retention of key personnel;
- - federal and state regulatory initiatives that threaten cost and investment
recovery and place limits on the type and manner in which we invest in new
businesses and conduct operations;
- - the impact of federal, state and local utility regulatory policies,
legislation and orders on our regulated and unregulated businesses;
- - potential write-down of our investment in natural gas properties when
natural gas prices are depressed or if we have significant downward
revisions in our estimated proved gas reserves;
- - competition facing our unregulated Energy Services businesses;
- - the degree to which we develop unregulated business ventures, as well as
federal, state and local regulatory policies affecting our ability to
retain and operate such business ventures profitably;
78
- - a change in the fair value of our investments that could cause a
significant change in the carrying value of such investments or the
carrying value of related goodwill;
- - timely receipts of payments from our two largest customers LIPA and the
NYISO;
- - changes in the UCAP pricing structure;
- - timing of approval of the 2006 LIPA Agreements and;
- - other risks detailed from time to time in other reports and other documents
filed by KeySpan with the SEC.
For any of these statements, KeySpan claims the protection of the safe harbor
for forward-looking information contained in the Private Securities Litigation
Reform Act of 1995, as amended. For additional discussion on these risks,
uncertainties and assumptions, see "Item 2. Management's Discussion and Analysis
of Financial Condition and Results of Operations" and "Item 3. Quantitative and
Qualitative Disclosures About Market Risk."
Item 2. Unregistered Sale of Equity Securities and Use of Proceeds
None
Item 3. Defaults Upon Senior Securities
None
Item 4. Submission of Matters to a Vote of Security Holders
(a) Date of Meeting
The Annual Meeting of Stockholders of KeySpan Corporation was held on
August 17, 2006.
(b) and (c) Name of Each Director Elected at the Meeting and Description of Each
Matter Voted on and Number of Votes Cast
79
For Against Withheld
--------------- --------- --------------
1. The proposal to elect directors to serve until the next meeting of
stockholders or until their successors are elected.
Robert B. Catell 141,113,738 -- 8,301,560
Andrea S. Christensen 142,856,453 -- 6,558,845
Robert J. Fani 143,069,405 -- 6,345,893
Alan H. Fishman 133,692,168 -- 15,723,130
James R. Jones 142,516,931 -- 6,898,367
James L. Larocca 142,674,326 -- 6,740,972
Gloria C. Larson 142,588,762 -- 6,826,536
Stephen W. McKessy 142,533,304 -- 6,881,994
Edward D. Miller 142,520,380 -- 6,894,918
Vikki L. Pryor 142,790,782 6,624,516
For Against Abstain Non-Vote
----------------------------- ------------- ----------------
2. The proposal to ratify the appointment of
Deloitte & Touche LLP as independent registered
public accounting firm as auditors of the Company
for the fiscal year ending December 31, 2006. 143,871,717 3,332,653 2,210,928 --
For Against Abstain Non-Vote
----------------------------- ------------- ----------------
3. The proposal to adopt the Agreement and Plan of
Merger dated February 25, 2006, among National
Grid plc, National Grid US8 Inc. and KeySpan 109,184,628 7,442,564 2,160,682 30,627,424
Corporation.
For Against Abstain Non-Vote
------------------------------- ------------- ----------------
4. The shareholder proposal to adopt simple 65,114,814 48,536,898 5,136,162 30,627,424
majority vote.
Item 5. Other Information
None
Item 6. Exhibits
31.1* Certification of the Chairman and Chief Executive Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002
31.2* Certification of the Executive Vice President and Chief Financial
Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1* Certification of the Chairman and Chief Executive Officer pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002
32.2* Certification of the Executive Vice President and Chief Financial
Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
- ----------------------
*Filed Herewith
80
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on behalf of the undersigned
there unto duly authorized.
KEYSPAN CORPORATION
(Registrant)
By: /s/Gerald Luterman
------------------
Name: Gerald Luterman
Title: Executive Vice President and
Chief Financial Officer
Date: November 3, 2006 /s/ Gerald Luterman
----------------------
Gerald Luterman
Executive Vice President and
Chief Financial Officer
Date: November 3, 2006 /s/ Theresa A. Balog
--------------------
Theresa A. Balog
Vice President and
Chief Accounting Officer
81