================================================================================
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-Q
[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2002
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
-------- --------
Commission Registrant; State of Incorporation; IRS Employer
File Number Address; and Telephone Number Identification No.
- ------------------------------------------------------------------------------------------
1-9513 CMS ENERGY CORPORATION 38-2726431
(A Michigan Corporation)
Fairlane Plaza South, Suite 1100
330 Town Center Drive, Dearborn, Michigan 48126
(313)436-9200
1-5611 CONSUMERS ENERGY COMPANY 38-0442310
(A Michigan Corporation)
212 West Michigan Avenue, Jackson, Michigan 49201
(517)788-0550
1-2921 PANHANDLE EASTERN PIPE LINE COMPANY 44-0382470
(A Delaware Corporation)
5444 Westheimer Road, P.O. Box 4967, Houston, Texas 77210-4967
(713)989-7000
Indicate by check mark whether the Registrants (1) have filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrants were required to file such reports), and (2) have been subject to
such filing requirements for the past 90 days. Yes X* No
--- ---
Panhandle Eastern Pipe Line Company meets the conditions set forth in General
Instructions H(1)(a) and (b) of Form 10-Q and is therefore filing this Form 10-Q
with the reduced disclosure format. In accordance with Instruction H, Part I,
Item 2 has been reduced and Part II, Items 2, 3 and 4 have been omitted.
Number of shares outstanding of each of the issuer's classes of common stock at
October 31, 2002:
CMS ENERGY CORPORATION:
CMS ENERGY Common Stock, $.01 par value 144,086,749
CONSUMERS ENERGY COMPANY, $10 par value, privately held by CMS Energy 84,108,789
PANHANDLE EASTERN PIPE LINE COMPANY, no par value,
indirectly privately held by CMS Energy 1,000
================================================================================
* While this Form 10-Q has been filed on the specified due date, it does not
contain the certification required by the Sarbanes-Oxley Act of 2002 and Rule
13a-14. The Securities and Exchange Commission thus will not consider this
Form 10-Q to be timely.
Explanatory Note
Pending Restatement
As a result of certain events previously disclosed regarding round-trip trading,
CMS Energy has engaged Ernst & Young to re-audit its financial statements for
the fiscal years ended December 31, 2001 and 2000. During the course of the
re-audit, in consultation with its new auditors, CMS Energy has determined that
certain adjustments discussed below (unrelated to the round-trip trades) by CMS
Energy, Consumers, and Panhandle to their consolidated financial statements for
the fiscal years ended December 31, 2001 and December 31, 2000 are required. At
the time it adopted the accounting treatments for the items, CMS Energy believed
that such treatments were appropriate under generally accepted accounting
principles, and Arthur Andersen concurred. CMS Energy has now determined it will
adopt different accounting for certain transactions, upon the recommendation of
Ernst & Young, as discussed below. As a result, following completion of the
re-audit, CMS Energy, Consumers and Panhandle intend to file an amended Form
10-K for the fiscal year ended December 31, 2001. In addition, CMS Energy,
Consumers and Panhandle will file amended Form 10-Qs for the quarters ended
March 31, 2002, June 30, 2002 and September 30, 2002 following completion of
Ernst & Young's review of the interim financial statements for these periods. As
a result of these reviews and re-audits, there may be revisions to the financial
statements contained in the above-referenced reports, including this Form 10-Q,
which are in addition to the known revisions described below, some of which
could be material. CMS Energy has advised the staff of the SEC about the pending
restatements. CMS Energy is working with Ernst & Young to resolve these issues
and expects it will file all restated results by the end of January 2003.
The following table sets forth the estimated effects of the restatement
based on CMS Energy's knowledge to date:
NET INCOME IMPACT (MILLIONS)
Increase (Decrease)
2000 2001
MCV Partnership PPA Reserve -- $110
DIG Charge Reversal -- 130
CMS MST Changes/Reconciliations $43 (112)
---- -----
TOTAL $43 $128
ADDITIONS TO CONSOLIDATED DEBT (MILLIONS)
2000 2001
LNG Business $ 0 $215
Methanol Plant 125 125
---- ----
TOTAL $125 $340
The principal accounting restatement items include:
- - A change in the accounting treatment for reserves associated with
Consumers' PPA with the MCV Partnership. This change in accounting is
expected to result in a $110 million increase to net income in 2001 for CMS
Energy and Consumers. However, a determination as to the preferred
accounting method has not yet been completed and these adjustments are
subject to change;
- - Reversing a 2001 charge associated with the DIG complex. This is expected
to result in an increase to net income of $130 million in 2001 for CMS
Energy;
- - Changes to mark-to-market accounting and account reconciliations at CMS
MST. These are expected to result in an increase of $43 million in net
income for 2000 and a net charge of $112 million in 2001. This
reconciliation has not yet been completed and these adjustments are subject
to change for CMS Energy;
- - A change in the accounting treatment for CMS Energy's and Panhandle's
interest in the LNG business which was described in CMS Energy's and
Panhandle's 2001 Annual Report on Form 10-K. This will result in an
additional $215 million of debt on CMS Energy's and Panhandle's
consolidated balance sheet in 2001; and
- - A change in the accounting treatment for CMS Energy's financing of its
methanol plant previously disclosed in CMS Energy's 1999 Annual Report on
Form 10-K. This change will result in an increase in both debt and equity
of $125 million each to CMS Energy's 2000 and 2001 financial statements.
This debt was retired in January 2002.
Additional details of these transactions will be available in the amended
quarterly and annual reports to be filed upon completion of the re-audit and in
the restatements. See the "Round-Trip Trades" and "Change in Auditors and
Pending Restatements" sections of this Form 10-Q's MD&A and Condensed Notes to
the Consolidated Financial Statements for further discussion of these matters.
THE ACCOUNTING CONSEQUENCES OF THE RESTATEMENT ITEMS REFERENCED ABOVE ARE NOT
REFLECTED IN THE FINANCIAL INFORMATION INCLUDED IN THIS FORM 10-Q, OTHER THAN IN
THE "CHANGE IN AUDITORS AND PENDING RESTATEMENTS" SECTION OF CMS ENERGY'S MD&A.
ALL STATEMENTS IN THIS FORM 10-Q ARE QUALIFIED BY REFERENCE TO THIS EXPLANATORY
NOTE.
2
Certifications; Financial Review
As a result of the fact that the re-audit has not been completed and CMS Energy,
Consumers and Panhandle are not in a position to restate their financial
statements at this time, this Form 10-Q is not accompanied by the certifications
required by the Sarbanes-Oxley Act of 2002 and Rule 13(a)-14 of the Securities
Exchange Act of 1934, as amended. These certifications will be filed by
amendment to this Form 10-Q upon completion of the re-audit and the restatement
of the financial statements contained in this Form 10-Q.
This quarterly report includes financial statements which have not been reviewed
by an independent accountant under Rule 10-01(d) of Regulation S-X. We expect
that Ernst & Young will complete the quarterly review required by Rule 10-01(d)
of Regulation S-X following its re-audit of our historical financial statements
for the two-year period ended December 31, 2001.
3
CMS ENERGY CORPORATION
AND
CONSUMERS ENERGY COMPANY
AND
PANHANDLE EASTERN PIPE LINE COMPANY
QUARTERLY REPORTS ON FORM 10-Q TO THE
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
FOR THE QUARTER ENDED SEPTEMBER 30, 2002
This combined Form 10-Q is separately filed by each of CMS Energy Corporation,
Consumers Energy Company and Panhandle Eastern Pipe Line Company. Information
contained herein relating to each individual registrant is filed by such
registrant on its own behalf. Accordingly, except for their respective
subsidiaries, Consumers Energy Company and Panhandle Eastern Pipe Line Company
make no representation as to information relating to any other companies
affiliated with CMS Energy Corporation.
TABLE OF CONTENTS
Page
----
Glossary.................................................................................................. 6
PART I: FINANCIAL INFORMATION
CMS Energy Corporation
Management's Discussion and Analysis
Forward-Looking Statements and Risk Factors..................................................... CMS-1
Round-Trip Trades............................................................................... CMS-2
Change in Auditors and Pending Restatement...................................................... CMS-3
Other Matters................................................................................... CMS-8
Results of Operations........................................................................... CMS-9
Critical Accounting Policies.................................................................... CMS-16
Capital Resources and Liquidity................................................................. CMS-23
Market Risk Information......................................................................... CMS-29
Outlook......................................................................................... CMS-31
Consolidated Financial Statements
Consolidated Statements of Income............................................................... CMS-43
Consolidated Statements of Cash Flows........................................................... CMS-44
Consolidated Balance Sheets..................................................................... CMS-46
Consolidated Statements of Common Stockholders' Equity.......................................... CMS-48
Condensed Notes to Consolidated Financial Statements:
1. Corporate Structure and Basis of Presentation.............................................. CMS-49
2. Discontinued Operations.................................................................... CMS-54
3. Asset Disposition.......................................................................... CMS-56
4. Goodwill................................................................................... CMS-57
5. Uncertainties.............................................................................. CMS-58
6. Short-Term and Long-Term Financings, and Capitalization.................................... CMS-84
7. Earnings Per Share and Dividends........................................................... CMS-87
8. Risk Management Activities and Financial Instruments....................................... CMS-89
9. Reportable Segments........................................................................ CMS-94
4
TABLE OF CONTENTS
(CONTINUED)
Page
----
Consumers Energy Company
Management's Discussion and Analysis
Forward-Looking Statements and Risk Factors..................................................... CE - 1
Change in Auditors and Pending Restatement...................................................... CE - 2
Critical Accounting Policies.................................................................... CE - 5
Results of Operations........................................................................... CE - 12
Capital Resources and Liquidity................................................................. CE - 15
Outlook......................................................................................... CE - 19
Other Matters................................................................................... CE - 27
Consolidated Financial Statements
Consolidated Statements of Income............................................................... CE - 30
Consolidated Statements of Cash Flows........................................................... CE - 31
Consolidated Balance Sheets..................................................................... CE - 32
Consolidated Statements of Common Stockholder's Equity.......................................... CE - 34
Condensed Notes to Consolidated Financial Statements:
1. Corporate Structure and Summary of Significant Accounting Policies......................... CE - 35
2. Uncertainties.............................................................................. CE - 38
3. Short-Term Financings and Capitalization................................................... CE - 52
Panhandle Eastern Pipe Line Company
Management's Discussion and Analysis
Forward-Looking Statements and Risk Factors..................................................... PE - 1
Change in Auditors and Pending Restatements..................................................... PE - 3
Results of Operations........................................................................... PE - 6
Critical Accounting Policies.................................................................... PE - 8
Liquidity....................................................................................... PE - 11
Outlook......................................................................................... PE - 13
Other Matters................................................................................... PE - 15
Consolidated Financial Statements
Consolidated Statements of Income............................................................... PE - 18
Consolidated Statements of Cash Flows........................................................... PE - 19
Consolidated Balance Sheets..................................................................... PE - 20
Consolidated Statements of Common Stockholder's Equity.......................................... PE - 22
Condensed Notes to Consolidated Financial Statements:
1. Corporate Structure and Basis of Presentation.............................................. PE - 23
2. Regulatory Matters......................................................................... PE - 26
3. Goodwill Impairment........................................................................ PE - 27
4. Related Party Transactions................................................................. PE - 28
5. Commitments and Contingencies.............................................................. PE - 29
6. Debt Rating Downgrades .................................................................... PE - 33
7. System Gas ................................................................................ PE - 34
8. Possible Sale of Panhandle ................................................................ PE - 34
9. Pending Restatements ...................................................................... PE - 34
Quantitative and Qualitative Disclosures about Market Risk................................................ CO - 1
PART II: OTHER INFORMATION
Item 1. Legal Proceedings............................................................................ CO - 1
Item 5. Other Information............................................................................ CO - 3
Item 6. Exhibits and Reports on Form 8-K............................................................. CO - 3
Signatures........................................................................................... CO - 5
5
GLOSSARY
Certain terms used in the text and financial statements are defined below.
ABATE..................................... Association of Businesses Advocating Tariff Equity
ALJ....................................... Administrative Law Judge
AMT....................................... Alternative Minimum Tax
APB....................................... Accounting Principles Board
APB Opinion No. 18....................... APB Opinion No. 18, "The Equity Method of Accounting for Investments
in Common Stock"
APB Opinion No. 30........................ APB Opinion No. 30, "Reporting Results of Operations - Reporting the
Effects of Disposal of a Segment of a Business"
Accumulated Benefit Obligation............ The liabilities of a pension plan based on service and pay to date.
This differs from the Projected Benefit Obligation that is typically
disclosed in that it does not reflect expected future salary increases
Alliance.................................. Alliance Regional Transmission Organization
Arthur Andersen........................... Arthur Andersen LLP
Articles.................................. Articles of Incorporation
Attorney General.......................... Michigan Attorney General
bcf....................................... Billion cubic feet
BG LNG Services........................... BG LNG Services, Inc., a subsidiary of BG Group of the
........................................... United Kingdom
Big Rock.................................. Big Rock Point nuclear power plant, owned by Consumers
Board of Directors........................ Board of Directors of CMS Energy
Bookouts.................................. Unplanned netting of transactions from multiple contracts
Centennial................................ Centennial Pipeline, LLC, in which Panhandle owns a one-third interest
CEO....................................... Chief Executive Officer
CFO....................................... Chief Financial Officer
Clean Air Act............................. Federal Clean Air Act, as amended
CMS Capital............................... CMS Capital Corp., a subsidiary of Enterprises
CMS Electric and Gas...................... CMS Electric and Gas Company, a subsidiary of Enterprises
CMS Energy................................ CMS Energy Corporation, the parent of Consumers and Enterprises
CMS Energy Common Stock................... Common stock of CMS Energy, par value $.01 per share
CMS Gas Transmission...................... CMS Gas Transmission Company, a subsidiary of Enterprises
CMS Generation............................ CMS Generation Co., a subsidiary of Enterprises
CMS Holdings.............................. CMS Midland Holdings Company, a subsidiary of Consumers
CMS Land.................................. CMS Land, a subsidiary of Enterprises
CMS Midland............................... CMS Midland Inc., a subsidiary of Consumers
CMS MST................................... CMS Marketing, Services and Trading Company, a subsidiary of
Enterprises
CMS Oil and Gas .......................... CMS Oil and Gas Company, a subsidiary of Enterprises
CMS Panhandle Holdings, LLC .............. A subsidiary of Panhandle Eastern Pipe Line
CMS Trunkline ............................ CMS Trunkline Gas Company, LLC, a subsidiary of CMS Panhandle
Holdings, LLC
CMS Trunkline LNG ........................ CMS Trunkline LNG Company, LLC, a subsidiary of LNG Holdings, LLC
CMS Viron................................. CMS Viron Energy Services, a wholly owned subsidiary of CMS MST
Consumers................................. Consumers Energy Company, a subsidiary of CMS Energy
6
Consumers Campus Holdings................. Consumers Campus Holdings, L.L.C., a wholly owned subsidiary of
Consumers
Court of Appeals.......................... Michigan Court of Appeals
Customer Choice Act....................... Customer Choice and Electricity Reliability Act, a Michigan statute
enacted in June 2000 that allows all retail customers choice of
alternative electric suppliers as of January 1, 2002, provides for
full recovery of net stranded costs and implementation costs,
establishes a five percent reduction in residential rates, establishes
rate freeze and rate cap, and allows for Securitization
Detroit Edison............................ The Detroit Edison Company, a non-affiliated company
DIG....................................... Dearborn Industrial Generation, L.L.C., a wholly owned subsidiary of
CMS Generation
DIG Statement No. C16..................... Derivatives Implementation Group, Statement 133 Implementation Issue
No. C16, "Scope Exceptions: Applying the Normal Purchases and Normal
Sales Exception to Contracts That Combine a Forward Contract and a
Purchased Option Contract"
DOE....................................... U.S. Department of Energy
Dow....................................... The Dow Chemical Company, a non-affiliated company
Duke Energy............................... Duke Energy Corporation, a non-affiliated company
EITF...................................... Emerging Issues Task Force
Energy Michigan........................... Energy Michigan is a trade association for the cogeneration,
independent power and waste to energy industries in Michigan.
Enterprises............................... CMS Enterprises Company, a subsidiary of CMS Energy
EPA....................................... U. S. Environmental Protection Agency
EPS....................................... Earnings per share
ERISA..................................... Employee Retirement Income Security Act
Ernst & Young............................. Ernst & Young LLP
FASB...................................... Financial Accounting Standards Board
FERC...................................... Federal Energy Regulatory Commission
FMLP...................................... First Midland Limited Partnership, a partnership that holds a lessor
interest in the MCV facility
GCR....................................... Gas cost recovery
GTNs...................................... CMS Energy General Term Notes(R), $200 million Series D, $400 million
Series E and $300 million Series F
Guardian ................................. Guardian Pipeline, LLC, in which Panhandle owns a one-third interest
GWh....................................... Gigawatt-hour
Health Care Plan.......................... The medical, dental, and prescription drug programs offered to
eligible employees of Panhandle, Consumers and CMS Energy
INGAA..................................... Interstate Natural Gas Association of America
IPP....................................... Independent Power Producer
ISO....................................... Independent System Operator
Jorf Lasfar............................... The 1,356 MW coal-fueled power plant in Morocco, jointly owned by CMS
Generation and ABB Energy Venture, Inc.
kWh....................................... Kilowatt-hour
7
LIBOR..................................... London Inter-Bank Offered Rate
Loy Yang.................................. The 2,000 MW brown coal fueled Loy Yang A power plant and an
associated coal mine in Victoria, Australia, in which CMS Generation
holds a 50 percent ownership interest
LNG....................................... Liquefied natural gas
LNG Holdings.............................. CMS Trunkline LNG Holdings, LLC, jointly owned by CMS Panhandle
Holdings, LLC and Dekatherm Investor Trust
Ludington................................. Ludington pumped storage plant, jointly owned by Consumers and Detroit
Edison
MACT...................................... Maximum Achievable Control Technology
mcf....................................... Thousand cubic feet
MCV Facility.............................. A natural gas-fueled, combined-cycle cogeneration facility operated by
the MCV Partnership
MCV Partnership........................... Midland Cogeneration Venture Limited Partnership in which Consumers
has a 49 percent interest through CMS Midland
MD&A...................................... Management's Discussion and Analysis
MEPCC..................................... Michigan Electric Power Coordination Center
METC...................................... Michigan Electric Transmission Company, formally a subsidiary of
Consumers Energy and now an indirect subsidiary of Trans-Elect
Michigan Gas Storage...................... Michigan Gas Storage Company, a subsidiary of Consumers
MISO...................................... Midwest Independent System Operator
Moody's .................................. Moody's Investors Service, Inc.
MPSC...................................... Michigan Public Service Commission
MTH....................................... Michigan Transco Holdings, Limited Partnership
MW........................................ Megawatts
NEIL...................................... Nuclear Electric Insurance Limited, an industry mutual insurance
company owned by member utility companies
NMC....................................... Nuclear Management Company, LLC, formed in 1999 by Northern States
Power Company (now Xcel Energy Inc.), Alliant Energy, Wisconsin
Electric Power Company, and Wisconsin Public Service Company to
operate and manage nuclear generating facilities owned by the four
utilities
NRC....................................... Nuclear Regulatory Commission
OATT...................................... Open Access Transmission Tariff
OPEB...................................... Postretirement benefit plans other than pensions for retired employees
Palisades................................. Palisades nuclear power plant, which is owned by Consumers
Pan Gas Storage........................... CMS Pan Gas Storage Company, a subsidiary of Panhandle Eastern Pipe
Line Company, LLC
Panhandle................................. Panhandle Eastern Pipe Line Company, including its subsidiaries
Trunkline, Pan Gas Storage, Panhandle Storage, and Panhandle
Holdings. Panhandle is a wholly owned subsidiary of CMS Gas
Transmission
Panhandle Eastern Pipe Line............... Panhandle Eastern Pipe Line Company, a wholly owned subsidiary of CMS Gas
Transmission
Panhandle Storage......................... CMS Panhandle Storage Company, a subsidiary of Panhandle Eastern Pipe
Line Company
PCB....................................... Polychlorinated biphenyl
8
Pension Plan.............................. The trusteed, non-contributory, defined benefit pension plan of
Panhandle, Consumers and CMS Energy
Powder River.............................. CMS Oil & Gas previously owned a significant interest in coalbed
methane fields or projects developed within the Powder River Basin
which spans the border between Wyoming and Montana. The Powder River
properties have been sold and reported as a discontinued operation for
the three months ended March 31, 2002
PPA....................................... The Power Purchase Agreement between Consumers and the MCV Partnership
with a 35-year term commencing in March 1990
Price Anderson Act........................ Price Anderson Act, enacted in 1957 as an amendment to the Atomic
Energy Act of 1954, as revised and extended over the years. This act
stipulates between nuclear licensees and the U.S. government the
insurance, financial responsibility, and legal liability for nuclear
accidents
PSCR...................................... Power supply cost recovery
PUHCA..................................... Public Utility Holding Company Act of 1935
PURPA..................................... Public Utility Regulatory Policies Act of 1978
RTO....................................... Regional Transmission Organization
Sea Robin................................. Sea Robin Pipeline Company, a subsidiary of CMS Trunkline Gas Company,
LLC
SEC....................................... U.S. Securities and Exchange Commission
Securitization............................ A financing method authorized by statute and approved by the MPSC
which allows a utility to set aside and pledge a portion of the rate
payments received by its customers for the repayment of Securitization
bonds issued by a special purpose entity affiliated with such utility
SERP...................................... Supplemental Executive Retirement Plan
SFAS...................................... Statement of Financial Accounting Standards
SFAS No. 5................................ SFAS No. 5, "Accounting for Contingencies"
SFAS No. 13............................... SFAS No. 13 "Accounting for Leases"
SFAS No. 71............................... SFAS No. 71, "Accounting for the Effects of Certain Types of
Regulation"
SFAS No. 87............................... SFAS No. 87, "Employers' Accounting for Pensions"
SFAS No. 106.............................. SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other
Than Pensions"
SFAS No. 115.............................. SFAS No. 115, "Accounting for Certain Investments in Debt and Equity
Securities"
SFAS No. 121.............................. SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and
for Long-Lived Assets to be Disposed Of"
SFAS No. 133.............................. SFAS No. 133, "Accounting for Derivative Instruments and Hedging
Activities, as amended and interpreted"
SFAS No. 142.............................. SFAS No. 142, "Goodwill and Other Intangible Assets"
SFAS No. 143.............................. SFAS No. 143, "Accounting for Asset Retirement Obligations"
SFAS No. 144.............................. SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived
Assets"
SFAS No. 145.............................. SFAS No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment
of FASB Statement No. 13, and Technical Corrections"
SFAS No. 146.............................. SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal
Activities"
SFAS No. 147.............................. SFAS No. 147, "Acquisitions of Certain Financial Institutions"
SIPS...................................... State Implementation Plans
9
Special Committee......................... A special committee of independent directors, established by CMS
Energy's Board of Directors, to investigate matters surrounding
round-trip trading
Stranded Costs............................ Costs incurred by utilities in order to serve their customers in a
regulated monopoly environment, which may not be recoverable in a
competitive environment because of customers leaving their systems and
ceasing to pay for their costs. These costs could include owned and
purchased generation and regulatory assets
Superfund................................. Comprehensive Environmental Response, Compensation and Liability Act
Transition Costs.......................... Stranded Costs, as defined, plus the costs incurred in the transition
to competition
Trust Preferred Securities................ Securities representing an undivided beneficial interest in the assets
of statutory business trusts, the interests of which have a preference
with respect to certain trust distributions over the interests of
either CMS Energy or Consumers, as applicable, as owner of the common
beneficial interests of the trusts
VEBA Trusts............................... VEBA (voluntary employees' beneficiary association) Trusts are
tax-exempt accounts established to specifically set aside employer
contributed assets to pay for future expenses of the OPEB plan
10
(This page intentionally left blank)
11
CMS Energy Corporation
CMS ENERGY CORPORATION
MANAGEMENT'S DISCUSSION AND ANALYSIS
CMS Energy is the parent holding company of Consumers and Enterprises. Consumers
is a combination electric and gas utility company serving Michigan's Lower
Peninsula. Enterprises, through subsidiaries, including Panhandle and its
subsidiaries, is engaged in several domestic and international diversified
energy businesses including: natural gas transmission, storage and processing;
independent power production; and energy marketing, services and trading.
FORWARD-LOOKING STATEMENTS AND RISK FACTORS
The MD&A of this Form 10-Q should be read along with the MD&A and other parts of
CMS Energy's 2001 Form 10-K. This MD&A refers to, and in some sections
specifically incorporates by reference, CMS Energy's Condensed Notes to
Consolidated Financial Statements and should be read in conjunction with such
Consolidated Financial Statements and Notes. This Form 10-Q and other written
and oral statements that CMS Energy may make contain forward-looking statements
as defined by the Private Securities Litigation Reform Act of 1995. CMS Energy's
intentions with the use of the words "anticipates," "believes," "estimates,"
"expects," "intends," and "plans," and variations of such words and similar
expressions, are solely to identify forward-looking statements that involve risk
and uncertainty. These forward-looking statements are subject to various factors
that could cause CMS Energy's actual results to differ materially from the
results anticipated in such statements. CMS Energy has no obligation to update
or revise forward-looking statements regardless of whether new information,
future events or any other factors affect the information contained in such
statements. CMS Energy does, however, discuss certain risk factors,
uncertainties and assumptions in this MD&A and in Item 1 of the 2001 Form 10-K
in the section entitled "CMS Energy, Consumers, and Panhandle Forward-Looking
Statements Cautionary Factors and Uncertainties" and in various public filings
it periodically makes with the SEC. In addition to any assumptions and other
factors referred to specifically in connection with such forward-looking
statements, there are numerous factors that could cause our actual results to
differ materially from those contemplated in any forward-looking statements.
Such factors include our inability to predict and/or control:
- - Results of the re-audit of CMS Energy, Consumers, Panhandle and certain
of their subsidiaries by Ernst & Young and the subsequent restatement
of CMS Energy's, Consumers', Panhandle's and certain of their
subsidiaries' financial statements;
- - The efficient sale of non-strategic and under-performing international
assets and discontinuation of our international energy distribution
systems;
- - Achievement of operating synergies and revenue enhancements;
- - Capital and financial market conditions, including current price of CMS
Energy's Common Stock, interest rates and availability of financing to
CMS Energy, Consumers, Panhandle or any of their affiliates and the
energy industry;
- - CMS Energy, Consumers, Panhandle or any of their affiliates' securities
ratings;
- - Market perception of the energy industry, CMS Energy, Consumers,
Panhandle or any of their affiliates;
- - Ability to successfully access the capital markets;
- - Currency fluctuations and exchange controls;
- - Factors affecting utility and diversified energy operations such as
unusual weather conditions, catastrophic weather-related damage,
unscheduled generation outages, maintenance or repairs, unanticipated
changes to fossil fuel, nuclear fuel or gas supply costs or
availability due to higher demand, shortages, transportation problems
or other developments, environmental incidents, or electric
transmissions or gas pipeline system constraints;
- - International, national, regional and local economic, competitive and
regulatory conditions and developments;
CMS-1
CMS Energy Corporation
- - Adverse regulatory or legal decisions, including environmental laws and
regulations;
- - Federal regulation of electric sales and transmission of electricity
including re-examination by Federal regulators of the market-based
sales authorizations by which our subsidiaries participate in wholesale
power markets without price restrictions and proposals by FERC to
change the way it currently lets our subsidiaries and other public
utilities and natural gas companies interact with each other;
- - Energy markets, including the timing and extent of unanticipated
changes in commodity prices for oil, coal, natural gas liquids,
electricity and certain related products due to lower or higher demand,
shortages, transportation problems or other developments;
- - The increased competition of new pipeline and pipeline expansion
projects that transport large additional volumes of natural gas to the
Midwestern United States from Canada, which could reduce the volumes of
gas transported by our natural gas transmission business or cause them
to lower rates in order to meet competition;
- - Potential disruption, expropriation or interruption of facilities or
operations due to accidents, war and terrorism or political events and
the ability to get or maintain insurance coverage for such events;
- - Nuclear power plant performance, decommissioning, policies, procedures,
incidents, and regulation, including the availability of spent nuclear
fuel storage;
- - Technological developments in energy production, delivery and usage;
- - Changes in financial or regulatory accounting principles or policies;
- - Outcome, cost and other effects of legal and administrative
proceedings, settlements, investigations and claims, including
particularly claims, damages and fines resulting from those involving
round-trip trading;
- - Limitations on our ability to control the development or operation of
projects in which our subsidiaries have a minority interest;
- - Disruptions in the normal commercial insurance and surety bond markets
that may increase costs or reduce traditional insurance coverage,
particularly terrorism and sabotage insurance and performance bonds;
- - Other business or investment considerations that may be disclosed from
time to time in CMS Energy's, Consumers' or Panhandle's SEC filings or
in other publicly disseminated written documents; and
- - Other uncertainties, which are difficult to predict and many of which
are beyond our control.
CMS Energy designed this discussion of potential risks and uncertainties, which
is by no means comprehensive, to highlight important factors that may impact CMS
Energy's business and financial outlook. This Form 10-Q also describes material
contingencies in CMS Energy's Condensed Notes to Consolidated Financial
Statements, and CMS Energy encourages its readers to review these Notes.
ROUND-TRIP TRADES
During the period of May 2000 through January 2002, CMS MST engaged in
simultaneous, prearranged commodity trading transactions in which energy
commodities were sold and repurchased at the same price. These transactions,
which had no impact on previously reported consolidated net income, earnings per
share or cash flows, had the effect of increasing operating revenues, operating
expenses, accounts receivable, accounts payable and reported trading volumes.
After internally concluding that cessation of these trades was in CMS Energy's
best interest, these so called round-trip trades were halted in January 2002.
CMS-2
CMS Energy Corporation
CMS Energy accounted for these trades in gross revenue and expense through the
third quarter of 2001, but subsequently concluded that these round-trip trades
should have been reflected on a net basis. In the fourth quarter of 2001, CMS
Energy ceased recording these trades in either revenues or expenses. CMS
Energy's 2001 Form 10-K, issued in March 2002, restated revenue and expense for
the first three quarters of 2001 to eliminate $4.2 billion of previously
reported revenue and expense. The 2001 Form 10-K did include $5 million of
revenue and expense for 2001 from such trades, which remained uncorrected. At
the time of the initial restatement, CMS Energy inadvertently failed to restate
2000 for round-trip trades.
CMS Energy is cooperating with an SEC investigation regarding round-trip trading
and the Company's financial statements, accounting practices and controls. CMS
Energy is also cooperating with inquiries by the Commodity Futures Trading
Commission, the FERC, and the United States Department of Justice regarding
these transactions. CMS Energy has also received subpoenas from the U.S.
Attorney's Office for the Southern District of New York and from the U.S.
Attorney's Office in Houston regarding investigations of these trades and has
received a number of shareholder class action lawsuits. In addition, CMS
Energy's Board of Directors established the Special Committee of independent
directors to investigate matters surrounding round-trip trading and the Special
Committee retained outside counsel to assist in the investigation.
On October 31, 2002, the Special Committee reported the results of its
investigation to the Board of Directors. The Special Committee discovered no new
information inconsistent with the information previously reported by CMS Energy
and as reported above. The investigation also concluded that the round-trip
trades were undertaken to raise CMS MST's profile as an energy marketer, with
the goal of enhancing CMS MST's ability to promote its services to new
customers. The Special Committee found no apparent effort to manipulate the
price of CMS Energy Common Stock or to affect energy prices.
The Special Committee also made recommendations designed to prevent any
reoccurrence of this practice, some of which have already been implemented,
including the termination of the speculative trading business and revisions to
CMS Energy's risk management policy. The Board of Directors adopted, and CMS
Energy has begun implementing, the remaining recommendations of the Special
Committee.
CHANGE IN AUDITORS AND PENDING RESTATEMENTS
In May 2002, CMS Energy stated its intention to amend, by the end of January
2003, its 2001 Form 10-K. The Form 10-K/A will reflect the elimination of the
remaining $5 million of revenue and expense related to round-trip trades in
2001, the elimination of approximately $122 million of outstanding accounts
receivable and accounts payable related to these transactions, and the
elimination of approximately $1 billion of revenue and expense from round-trip
trades in 2000. No amounts related to round-trip trades were outstanding in the
consolidated balance sheet as of December 31, 2000.
Following CMS Energy's announcement that it would restate its financial
statements for 2000 and 2001 to eliminate the effects of round-trip energy
trades and form the Special Committee to investigate these trades, CMS Energy
received formal notification from Arthur Andersen that it had terminated its
relationship with CMS Energy and affiliates. Arthur Andersen notified CMS Energy
that due to the investigation, Arthur Andersen's historical opinions on CMS
Energy's financial statements for the periods being restated could not be relied
upon. Arthur Andersen also notified CMS Energy that due to Arthur Andersen's
then current situation and the work of the Special Committee, it would be unable
to give an opinion on CMS Energy's restated financial statements when they are
completed. Arthur Andersen's reports on CMS Energy's, Consumers', and
Panhandle's consolidated financial statements for each of the fiscal years ended
December 31, 2001 and December 31, 2000 contained no adverse or disclaimer of
opinion, nor were the reports qualified or modified regarding uncertainty, audit
scope or accounting principles.
CMS-3
CMS Energy Corporation
There were no disagreements between CMS Energy and Arthur Andersen on any matter
of accounting principle or practice, financial statement disclosure, or auditing
scope or procedure during the years 2000 and 2001 and through the date of their
review for the quarter ended March 31, 2002 which, if not resolved to Arthur
Andersen's satisfaction would have caused Arthur Andersen to make reference to
the subject matter in connection with its report to the Audit Committee of the
Board of Directors or its report on CMS Energy's consolidated financial
statements for the periods.
On April 22, 2002, the Board of Directors, upon the recommendation of the Audit
Committee of the Board, voted to discontinue using Arthur Andersen to audit CMS
Energy's financial statements for the year ending December 31, 2002. CMS Energy
previously had retained Arthur Andersen to review its financial statements for
the quarter ended March 31, 2002. On May 23, 2002, the Board of Directors
engaged Ernst & Young to audit CMS Energy's financial statements for the year
ending December 31, 2002.
During CMS Energy's two most recent fiscal years ended December 31, 2000 and
December 31, 2001 and the subsequent interim period through June 10, 2002, CMS
Energy did not consult with Ernst & Young regarding any matter or event
identified by SEC laws and regulations. However, as a result of the restatement
required with respect to the round-trip trading transactions, Ernst & Young is
in the process of re-auditing CMS Energy's consolidated financial statements for
each of the fiscal years ended December 31, 2001 and December 31, 2000, which
includes audit work at Consumers and Panhandle for these years. None of CMS
Energy's former auditors, some of whom are now employed by Ernst & Young, are
involved in the re-audit of CMS Energy's consolidated financial statements.
In connection with Ernst & Young's re-audit of the fiscal years ended December
31, 2001 and December 31, 2000, CMS Energy has determined, in consultation with
Ernst & Young, that certain adjustments (unrelated to the round-trip trades) by
CMS Energy, Consumers, and Panhandle to their consolidated financial statements
for the fiscal years ended December 31, 2001 and December 31, 2000 are required.
At the time it adopted the accounting treatment for these items, CMS Energy
believed that such accounting was appropriate under generally accepted
accounting principles and Arthur Andersen concurred. CMS Energy, Consumers and
Panhandle are in the process of advising the SEC of these adjustments before
restating their financial statements as discussed below, and intend to amend
their respective 2001 Form 10-Ks and each of the 2002 Form 10-Qs by the end of
January 2003.
MCV REGULATORY DISALLOWANCE ACCOUNTING: In 1992, Consumers established a reserve
for the difference between the amount that Consumers was paying for power in
accordance with the terms of the PPA, and the amount that Consumers was
ultimately allowed by the MPSC to recover from electric customers.
The reserve was adjusted in 1998 to reflect differences between management's
original assumptions and the MCV Facility's actual performance. In 2000,
Consumers reviewed its estimate of the economic losses it would experience with
respect to the PPA and re-evaluated all of the current facts and circumstances
used to calculate the disallowance reserve. Consumers concluded that no
CMS-4
CMS Energy Corporation
adjustment to the reserve was required in 2000. However, as conditions
surrounding MCV Partnership operations evolved in 2001, Consumers concluded
that it needed to increase the reserve by $126 million (pretax) in the third
quarter of 2001, and did so.
Upon recommendations from Ernst & Young, Consumers is in the process of
reviewing its 2001 PPA accounting and related assumptions. This accounting
review is currently being discussed with Ernst & Young and the SEC. Final
conclusions have not yet been reached. At a minimum, however, the 2001
accounting will change, resulting in the reversal of the 2001 charge of $126
million. Further analysis and deliberations may produce additional accounting
changes. In addition, as a result of this accounting treatment, Consumers
expects that its ongoing operating earnings through 2007 will be reduced to
reflect higher annual purchased power expense.
DIG LOSS CONTRACT ACCOUNTING: The DIG complex, a 710 MW combined-cycle facility,
was constructed during 1998 through 2001 to fulfill contractual requirements and
to sell excess power in the wholesale power market. DIG entered into Electric
Sales Agreements (ESA) with Ford Motor Company, Rouge Industries and certain
other Ford and Rouge affiliates, that require DIG to provide up to 300 MW of
electricity at pre-determined prices for a fifteen-year term beginning in June
2000. DIG also entered into Steam Sales Agreements (SSA) with Ford and Rouge,
whereby DIG is to supply process and heating steam at a fixed price commencing
no later than June 1, 2000.
During the third quarter of 2001, CMS Energy recognized a pretax charge to
earnings of $200 million for the calculated loss on portions of the power
capacity under the ESAs. At that time CMS Energy assessed whether the DIG
facility was impaired under SFAS No. 121 and concluded that the DIG facility was
not impaired.
CMS Energy, with the concurrence of Ernst & Young has now determined that
existing accounting literature precludes the recognition of anticipated losses
on executory contracts such as those involved with the ESAs at DIG. Accordingly
CMS Energy will reverse the $200 million loss on the ESA contracts and
subsequent related transactions when it restates its 2001 financial statements
and financial statements for each of the quarters in 2002.
As a result of existing impairment indicators and the pending restatement, CMS
Energy is again assessing the recoverability of the carrying value due of its
current $358 million investment in DIG in accordance with SFAS No. 144. The
investment will be $530 million after reflecting the restatement discussed
above. This assessment is expected to result in a significant impairment charge
in the fourth quarter of 2002.
ELIMINATION OF MARK-TO-MARKET GAINS AND LOSSES ON INTER-BOOK TRANSACTIONS: CMS
MST's business activities include marketing to end users of energy commodities
such as commercial and small industrial purchasers of natural gas (CMS MST's
retail business) and trading activities with such entities as other energy
trading companies (CMS MST's wholesale business). In accordance with generally
accepted accounting principles during 2000 and 2001, CMS MST used two different
methods to account for these distinct activities: it applied the mark-to-market
method of accounting to its wholesale trading business operations, and it
accounted for its retail business operations using the accrual method. Some
other energy trading companies have taken a similar approach when their business
activities have included retail operations.
EITF Issue No. 98-10, Accounting for Contracts Involved in Energy Trading and
Risk Management Activities, applies to certain parts of CMS MST's operations.
EITF Issue No. 98-10 requires that energy-trading contracts be marked to market;
that is, measured at fair value determined as of the balance sheet date, with
the gains and losses included in the earnings. According to EITF Issue No.
98-10, the determination of whether an entity is involved in energy trading
activities is a matter of judgment that depends on the relevant facts and
circumstances. CMS MST has used the mark-to-market method of accounting for its
wholesale operations because these have been considered trading activities under
EITF Issue No. 98-10. Because CMS MST's retail
CMS-5
CMS Energy Corporation
operations have not been considered trading activities, mark-to-market
accounting under EITF Issue No. 98-10 has not been applied to any retail
contracts.
During 2000 and 2001 CMS MST's wholesale business entered into certain
transactions with CMS MST's retail business (inter-book transactions). The
wholesale business marked-to-market these inter-book transactions while the
retail business did not. CMS Energy has determined that the mark-to-market
profits and losses that were recognized by the wholesale business on these
inter-book transactions should have been eliminated in consolidation. CMS Energy
will therefore recognize $54 million of pretax income and a $120 million pretax
charge to earnings in 2000 and 2001 respectively, to eliminate the effects of
mark-to-market accounting in consolidation on inter-book transactions when it
restates its financial statements.
ELIMINATION OF MARK-TO-MARKET GAINS AND LOSSES ON INTERCOMPANY TRANSACTIONS: As
explained above, during 2000 and 2001 CMS MST applied the mark-to-market method
of accounting to the energy-trading contracts of its wholesale operations. In
doing so, CMS MST did not distinguish between counterparties that were unrelated
third parties, and those that were consolidated or equity-method affiliates.
Energy-trading contracts with affiliated companies were therefore measured at
their fair values as of the balance sheet date, with the gains and losses
included in earnings. However, the affiliated counterparties accounted for these
contracts on the accrual basis, because these companies were not engaged in
energy trading activities and therefore their activities were not within the
scope of EITF Issue No. 98-10, nor were their contracts with CMS MST required to
be marked to market in 2001 under SFAS No. 133. The mark-to-market profits and
losses that CMS MST recognized on the contracts with affiliated companies were
included in the CMS Energy consolidated financial statements. CMS Energy has now
concluded that these amounts should have been eliminated in consolidation.
CMS Energy's restated consolidated financial statements for 2001 and 2000 will
eliminate the mark-to-market gains and losses on intercompany transactions which
are still being quantified and audited. Adjustments to eliminate intercompany
mark-to-market gains and losses may also be required in 2002.
CMS MST ACCOUNT RECONCILIATIONS: CMS MST's business experienced rapid growth
during 2000 and 2001. Late in 2001, CMS Energy became aware of certain control
weaknesses at CMS MST and immediately began an internal investigation. The
investigation revealed that the size and expertise of the back-office accounting
staff had not kept pace with the rapid growth and, as a result, bookkeeping
errors had occurred and account reconciliations were not prepared. Additionally,
computer interfaces of sub-ledgers to the general ledger were ineffective or
lacking. As a result, sub-ledger balances did not agree to the general ledger
and the differences were not reconciled. When Ernst & Young began its re-audit
fieldwork, an account reconstruction and reconciliation project had been under
way for some months. Most of the work has been performed by outside consultants,
although additional internal personnel have also been assigned to the task. The
effort has focused mainly on trade receivables and payables, intercompany
accounts, and cash, but other balance sheet accounts are also being reconciled
and adjusted.
The reconstruction work at CMS MST is nearing completion for December 31, 2000
and December 31, 2001 and the first three quarters of 2002. However, until all
stages of this work have been finalized, reviewed by CMS MST management, and
examined by Ernst & Young, the resulting adjustments are subject to change.
CONSOLIDATION OF LNG HOLDINGS: In late 2001, Panhandle entered into a structured
transaction to monetize a portion of the value of a long-term terminalling
contract of its LNG subsidiary. The LNG business was contributed to LNG
Holdings, which received an equity investment from an unaffiliated third party,
Dekatherm Investor Trust and obtained new loans secured by the assets. After
paying expenses, net proceeds of $235 million were distributed to Panhandle for
the contributed LNG assets, and the joint venture also loaned
CMS-6
CMS Energy Corporation
$75 million to Panhandle. While the proceeds received by Panhandle were in
excess of its book basis, a gain on the transaction was not recorded. This
excess was recorded as a deferred commitment, reflecting the fact that Panhandle
was expecting to reinvest proceeds into LNG Holdings for a planned expansion.
Panhandle is the manager and operator of the joint venture and has the primary
economic interest in it. Initially, CMS Energy and Panhandle believed that
off-balance sheet treatment for the joint venture was appropriate under
generally accepted accounting principles and Arthur Andersen concurred. Upon
further analysis of these facts at this time, CMS Energy and Panhandle have now
concluded that Panhandle did not meet the conditions precedent to account for
the contribution of the LNG business as a disposition given Panhandle's
continuing involvement and the lack of sufficient participating rights by the
third-party equity holder in the joint venture. As a result, with the
concurrence of Ernst & Young, Panhandle will restate its financial statements to
reflect consolidation of LNG Holdings at December 31, 2001, and thereby
recognize a net increase of $215 million of debt, the elimination of $183
million of deferred commitment, and minority interest of $30 million. With the
exception of certain immaterial reclassifications, there will be no impact to
2001 net income resulting from this accounting treatment. In 2002, the quarterly
income recorded would be impacted due to the timing of earnings recognition from
LNG Holdings, with income generally being recognized earlier by Panhandle upon
consolidation. In addition, the gross revenues and expenses will be recorded on
a consolidated basis versus the equity income previously recorded. For the
quarterly periods in 2002 there will be an increase in net income of $4 million
for the period ending March 31, 2002 and decrease of $1 million for each of the
quarterly periods ending June and September 2002 due to equity income previously
being recognized only to the extent cash was received by Panhandle.
STRUCTURED FINANCING OF METHANOL PLANT: In 1999, CMS Gas Transmission and an
unrelated entity financed $250 million of the costs of construction of a jointly
owned methanol plant with an off-balance sheet special purpose entity (SPE) that
entered into two separate non-recourse note borrowings containing
cross-collateral provisions only with respect to a joint collection account into
which the proceeds from shared collateral were to be deposited. Plant
construction was completed in the spring of 2001. In December 2001, CMS Gas
Transmission issued an irrevocable call for $125 million of these notes (i.e.,
the A1 Notes) and they were paid off in January 2002. As part of the 1999
financing, CMS Energy guaranteed the interest payments on the A1 Notes, subject
to a $75 million limit. CMS Energy did not guarantee repayment of the A1 Notes;
however, CMS Energy issued mandatorily convertible preferred stock to a trust as
security for the A1 Notes. If an amount to repay the A1 Notes was not deposited
within 120 days of the maturity date (or earlier date caused by, for example, a
downgrade of the credit rating of CMS Energy) the holders of 25 percent of the
A1 Notes could cause the mandatorily convertible preferred shares to be sold.
The mandatorily convertible preferred stock of CMS Energy was convertible into
the number of shares of CMS Energy common stock needed to make the note holder
whole without limit. Additional security for the A1 Notes was 60 percent of the
capital stock of CMS Methanol, an entity that held a 45 percent ownership
interest in the methanol plant. The SPE's assets comprised investments in CMS
Methanol and in another subsidiary that also owned a 45 percent interest in the
methanol plant. Because the use of non-recourse debt having cross-collateral
provisions only with respect to the joint collection account effectively
segregated the cash flows and assets, in substance this financing created two
separate SPEs. CMS Energy has now concluded, and Ernst & Young concurs, that it
should have consolidated the virtual SPE created by the non-recourse borrowing.
Therefore, CMS Energy will restate its 2000 and 2001 financial statements to
increase its equity ownership interest in the methanol plant and increase debt,
each by $125 million.
CMS-7
CMS Energy Corporation
The table below summarizes adjustments noted above and the estimated effects on
CMS Energy's financial statements.
Estimated Net Income Impact (Millions) 2000 2001 2000-2001
- ----------------------------------------------------------------------------------------------------------
Total
MCV Regulatory Disallowance $ - $110 $110
DIG Loss Contract Accounting - 130 130
Mark-to-Market Gains and Losses on
Inter-book Transactions 33 (75) (42)
Mark-to-Market Gains and Losses on
Intercompany Transactions 19 (30) (11)
CMS MST Account Reconciliations (9) (7) (16)
- ----------------------------------------------------------------------------------------------------------
Additions to Consolidated Debt (Millions) 2000 2001 2002
- ---------------------------------------------------------------------------------------------------------
Reconsolidation of LNG Facility $ - $215 $219
Structured Financing of Methanol Plant 125 125 -
- ---------------------------------------------------------------------------------------------------------
In addition to the above adjustments and the adjustments to reflect the
elimination of round-trip trades, CMS Energy's restated consolidated financial
statements will also include other adjustments identified in the re-audit, which
have not been completely quantified at this time. These other adjustments
include: 1) the recognition of CMS Energy's and Consumers' new headquarters
lease previously treated as an operating lease, as a capital lease; 2)
adjustments to SERP and OPEB liabilities and advertising costs; 3) adjustments
required to reconcile intercompany accounts payable and accounts receivable and
4) other immaterial items.
OTHER MATTERS
COMPLIANCE WITH THE SARBANES-OXLEY ACT OF 2002
In July 2002, the Sarbanes-Oxley Act of 2002 was enacted and requires companies
to: 1) make certain certifications related to their Form 10-Q's, including
financial statements, disclosure controls and procedures and internal controls;
and 2) make certain disclosures about its disclosure controls and procedures,
and internal controls as follows:
CEO AND CFO CERTIFICATIONS
The Sarbanes-Oxley Act of 2002 requires the CEOs and CFOs of public companies to
make certain certifications relating to their Form 10-Q, including the financial
statements. CMS Energy has not filed the certifications required by the
Sarbanes-Oxley Act of 2002 relating to this Form 10-Q for the period ended
September 30, 2002 because its 2000 and 2001 financial statements are in the
process of being restated as discussed above.
The restatement cannot be completed until Ernst & Young completes audit work at
CMS Energy, and their reviews of the quarterly statements for these years.
Therefore, CMS Energy's CEO and CFO are not able to make the statements required
by the Sarbanes-Oxley Act of 2002 with respect to this Form 10-Q for the period
ended September 30, 2002. CMS Energy expects its CEO and CFO to make the
certifications required by the Sarbanes-Oxley Act of 2002 when its restated
financial statements are available.
DISCLOSURE AND INTERNAL CONTROLS
CMS Energy's CEO and CFO are responsible for establishing and maintaining CMS
Energy's disclosure controls and procedures. Management, under the direction of
CMS Energy's principal executive and financial officers, has evaluated the
effectiveness of CMS Energy's disclosure controls and procedures as of September
30, 2002. Based on this evaluation, other than the control weaknesses at CMS MST
described below, CMS Energy's CEO and CFO have concluded that disclosure
controls and procedures are effective to ensure that material information was
presented to them and properly disclosed, particularly during the third quarter
of
CMS-8
CMS Energy Corporation
2002. There have been no significant changes in CMS Energy's internal controls
or in factors, other than as discussed below, that could significantly affect
internal controls subsequent to September 30, 2002.
CONTROL WEAKNESSES AT CMS MST
During the audit cycle of 2001, it was determined that there were several
weaknesses which existed in the CMS MST accounting controls, in particular those
relating to reconciling the activity and balances in subsidiary receivable and
payable ledgers with balances reflected in the general ledger. Senior
management, the Audit Committee of the Board of Directors and the independent
auditors were all notified about the situation and a plan of remediation was
begun, including replacement of key personnel. While important changes in
control have been initiated, some elements of the remediation plans have been
unavoidably delayed by the requirement to completely re-audit the CMS Energy
financial statements for years 2000 and 2001. Management believes that
supplemental procedures and personnel currently in place, along with the
significant contraction of the trading business planned by management, have
allowed for continuing business activity while the control weaknesses are
remediated and staffing positions are filled by qualified candidates. Management
further expects controls corrections to be completed before the end of the 2002
audit cycle.
RESTRUCTURING AND OTHER COSTS
CMS Energy began a series of initiatives in the aftermath of CMS Energy's
round-trip trading disclosure and the sharp drop of the company's stock price.
Significant expenses associated with these initiatives have been incurred and
are considered restructuring and other costs. These actions include: termination
of five officers, 18 CMS Field Services employees and 37 CMS MST trading group
employees, renegotiating a number of debt agreements, responding to many
investigation and litigation matters, re-audit of the 2000 and 2001 financial
statements and plans to relocate the corporate headquarters to Jackson,
Michigan. These restructuring and other costs are being accumulated and reported
as a reconciling item when calculating net income and earnings per share before
reconciling items. These restructuring and other costs are included in
consolidated net income.
Restructuring and other costs for the year-to-date September 30, 2002, which
are reported in operating expenses ($41 million) and fixed charges ($12 million)
includes:
- - Involuntary termination benefits of $17 million for officers and
employees.
- - One-time consulting and structuring fees of $12 million to assist
CMS Energy to arrange credit facilities related to the July 2002 debt
renegotiations.
- - The $12 million of expense associated with responding to and/or
defending against investigations and lawsuits related to round-trip
trading. These expenses could ultimately total $21 million for
attorneys' fees and costs through final resolution. Potential insurance
proceeds may total $12 million, reducing these expenses to $9 million.
- - Expenses for future rentals of $7 million have been accrued in
connection with relocating the corporate headquarters to Jackson,
Michigan. The relocation is expected to be complete by June 2003.
- - Other expenses, including the cost of re-auditing 2000 and 2001 total
$5 million.
Of the above $53 million, $12 million has been paid for consulting and
structuring fees and $10 million has been paid for severance and benefits as
of September 30, 2002.
Additional restructurings and other costs are expected in the fourth quarter of
2002 of approximately $5 million related to relocating the corporate
headquarters, terminating approximately 30 employees, and additional legal
expenses for litigation issues. In the first half of 2003, restructuring and
other costs related to relocating employees and other headquarters expenses are
expected to be $3 million. The relocation is expected to occur between March
and June 2003.
RESULTS OF OPERATIONS
CMS ENERGY CONSOLIDATED EARNINGS
For the three and nine months ended September 30, 2002, and 2001, consolidated
net income included gains (losses) on asset sales, asset write-downs,
restructuring costs associated with implementing CMS Energy's new strategic
direction, AMT tax credit write-offs, and the discontinued operations of CMS Oil
and Gas, CMS
CMS-9
CMS Energy Corporation
Electric & Gas, and other non-strategic businesses. The nine months ended
September 30, 2002 also reflect the adoption of SFAS No. 142 as of January 1,
2002, which required a write-down of goodwill at CMS MST and extraordinary
losses associated with early debt retirement. The following tables depict CMS
Energy's Results of Operations before and after the effects of the items
mentioned above.
In Millions, Except Per Share Amounts
- ----------------------------------------------------------------------------------------
Three months ended September 30 2002 2001
- ----------------------------------------------------------------------------------------
CONSOLIDATED NET INCOME (LOSS) OF CMS ENERGY $ 23 $ (569)
Net Asset Sales (Gain) (13) -
Net Asset Write-downs - 398
Discontinued Operations (Gain)/Loss (17) 206
Tax Credit Write-off 41 -
Restructuring and Other Costs 27 -
- ----------------------------------------------------------------------------------------
Earnings Before Reconciling Items $ 61 $ 35
============================================================================
BASIC EARNINGS PER AVERAGE COMMON SHARE OF CMS ENERGY
EARNINGS (LOSS) PER SHARE $ 0.16 $ (4.29)
Net Asset Sales (Gain) (0.09) -
Net Asset Write-downs - 3.00
Discontinued Operations (Gain)/Loss (0.12) 1.55
Tax Credit Write-off 0.28 -
Restructuring and Other Costs 0.19 -
- ----------------------------------------------------------------------------------------
Earnings Per Share Before Reconciling Items $ 0.42 $ 0.26
============================================================================
DILUTED EARNINGS PER AVERAGE COMMON SHARE OF CMS ENERGY
EARNINGS (LOSS) PER SHARE $ 0.16 $ (4.29)
Net Asset Sales (Gain) (0.09) -
Net Asset Write-downs - 3.00
Discontinued Operations (Gain)/Loss (0.12) 1.55
Tax Credit Write-off 0.28 -
Restructuring and Other Costs 0.19 -
- ----------------------------------------------------------------------------------------
Earnings Per Share Before Reconciling Items $ 0.42 $ 0.26
============================================================================
For the three months ended September 30, 2002, consolidated net income before
reconciling items increased by $26 million as compared to the same period in
2001. The increase primarily reflects Consumers' reduced electric power volumes
and costs due to higher replacement power supply costs in 2001 resulting from
the outage at Palisades in the third quarter of 2001. The increase was partially
offset by lower gas utility earnings and the impacts of expropriation and
devaluation issues in Argentina on the independent power production and natural
gas transmission businesses.
CMS-10
CMS Energy Corporation
In Millions, Except Per Share Amounts
- --------------------------------------------------------------------------------------------------
Nine months ended September 30 2002 2001
- --------------------------------------------------------------------------------------------------
CONSOLIDATED NET INCOME (LOSS) OF CMS ENERGY $ 337 $ (407)
Net Asset Sales (Gain)/Loss (48) 1
Net Asset Write-downs - 398
Discontinued Operations (Gain)/Loss (186) 186
Tax Credit Write-off 41 -
Restructuring and Other Costs 34 -
Goodwill Accounting Change 9 -
Extraordinary Item 8 -
----------------------------------------------------------------------------------------------
Earnings Before Reconciling Items $ 195 $ 178
==========================================================================================
BASIC EARNINGS PER AVERAGE COMMON SHARE OF CMS ENERGY
EARNINGS (LOSS) PER SHARE $ 2.45 $ (3.13)
Net Asset Sales (Gain)/Loss (0.35) 0.01
Net Asset Write-downs - 3.06
Discontinued Operations (Gain)/Loss (1.35) 1.43
Tax Credit Write-off 0.30 -
Restructuring and Other Costs 0.25 -
Goodwill Accounting Change 0.07 -
Extraordinary Item 0.06 -
----------------------------------------------------------------------------------------------
Earnings Per Share Before Reconciling Items $ 1.43 $ 1.37
==========================================================================================
DILUTED EARNINGS PER AVERAGE COMMON SHARE OF CMS ENERGY
EARNINGS (LOSS) PER SHARE $ 2.42 $ (3.13)
Net Asset Sales (Gain)/Loss (0.34) 0.01
Net Asset Write-downs - 3.06
Discontinued Operations (Gain)/Loss (1.31) 1.43
Tax Credit Write-off 0.29 -
Restructuring and Other Costs 0.24 -
Goodwill Accounting Change 0.07 -
Extraordinary Item 0.05 -
----------------------------------------------------------------------------------------------
Earnings Per Share Before Reconciling Items $ 1.42 $1.37
==========================================================================================
For the nine months ended September 30, 2002, consolidated net income before
reconciling items increased by $17 million as compared to the same period in
2001. The increase primarily reflects Consumers' reduced power supply costs from
the 2001 unscheduled Palisades outage, improved earnings from the IPP business
reflecting MCV mark-to-market accounting for long-term natural gas fuel supply
contracts, and lower steam costs at DIG. These increases were partially offset
by lower LNG terminalling revenue and the impacts of the Argentina expropriation
and devaluation issues.
For further information, see the individual results of operations for each CMS
Energy business segment in this MD&A.
CONSUMERS' ELECTRIC UTILITY RESULTS OF OPERATIONS
ELECTRIC UTILITY NET INCOME:
In Millions
- ---------------------------------------------------------------------
September 30 2002 2001 Change
- ---------------------------------------------------------------------
Three months ended $ 68 $(69) $137
Nine months ended 201 22 179
=====================================================================
CMS-11
CMS Energy Corporation
Three Months Nine Months
Ended September 30 Ended September 30
Reasons for change 2002 vs 2001 2002 vs 2001
- -----------------------------------------------------------------------------------------------------------------
Electric deliveries $ 25 $ 30
Power supply costs and related revenue 100 113
Other operating expenses and non-commodity revenue (12) (19)
Gain on asset sales - 38
Loss on MCV Power Purchases 126 126
Fixed charges 4 12
Income taxes (106) (121)
- -----------------------------------------------------------------------------------------------------------------
Total change $ 137 $ 179
=================================================================================================================
ELECTRIC DELIVERIES: For the three months ended September 30, 2002, electric
delivery revenues increased by $25 million from the 2001 level. Electric
deliveries, including transactions with other wholesale market participants and
other electric utilities, were 10.9 billion kWh, a decrease of 0.1 billion kWh,
or 0.9 percent from the comparable period in 2001. This reduction in electric
deliveries is primarily due to reduced transactions with other utilities and the
expiration of wholesale power sales contracts with certain Michigan municipal
utilities. Although total deliveries were below the 2001 level, increased
deliveries to the higher-margin residential and commercial sectors, along with
growth in retail deliveries, more than offset the impact of reductions to the
lower-margin customers. Even though deliveries were below the 2001 level,
Consumers set an all-time monthly sendout record during the month of July, and a
monthly hourly peak demand record of 7,318 MW was set on September 9, 2002.
For the nine months ended September 30, 2002, electric delivery revenues
increased by $30 million from the 2001 level. Electric deliveries, including
transactions with other wholesale market participants and other electric
utilities, were 29.5 billion kWh, a decrease of 0.7 billion kWh, or 2.5 percent
from the comparable period in 2001. Again, this reduction in electric deliveries
is primarily due to reduced transactions with other utilities and the expiration
of wholesale power sales contracts with certain Michigan municipal utilities.
Even though total deliveries were below the 2001 level, increased deliveries to
the higher-margin residential and commercial sectors, along with growth in
retail deliveries, more than offset the impact of reductions to the lower-margin
customers. For the year, Consumers has set an all-time monthly sendout record
during the month of July, and monthly hourly peak demand records were set on
April 16, 2002, June 25, 2002, and September 9, 2002.
POWER SUPPLY COSTS AND RELATED REVENUE: For the three months ended September 30,
2002, power supply costs decreased by $100 million from the comparable period in
2001. The decreased power costs in 2002 were primarily due to the higher
availability of the lower-priced Palisades plant. In the 2001 period, Consumers
was required to purchase greater quantities of higher-priced power to offset the
loss of internal generation resulting from an outage at Palisades. Also
contributing to the overall decrease in power costs was the lower volume and
lower priced power options and dispatchable capacity contracts that were
purchased for 2002.
For the nine months ended September 30, 2002, power supply costs and related
revenues decreased by a total of $113 million from the comparable period in
2001. This decrease was primarily the result of the Palisades plant being
returned to service in 2002. In 2001, Consumers purchased higher cost
replacement power during the refueling outage that began in March and ended in
May and the unscheduled forced outage at Palisades that began in June and ended
in January 2002. Also contributing to this decrease is lower-priced power
options and dispatchable capacity contracts that were purchased for 2002.
OTHER OPERATING EXPENSES AND NON-COMMODITY REVENUES: For the three and nine
months ended September 30, 2002, other operating expenses increased $12 million
and $19 million, respectively from the comparable period in 2001. Both of
CMS-12
CMS Energy Corporation
these increases are attributed to higher depreciation expense resulting from
higher plant in service along with increased operating costs resulting from
higher health care and storm restoration expenses.
GAIN ON ASSET SALES: For the nine months ended September 30, 2002, asset sales
increased as a result of the $31 million pretax gain associated with the May
2002 sale of Consumers' electric transmission system and a $7 million pretax
gain on the sale of nuclear equipment from the cancelled Midland project.
LOSS ON MCV POWER PURCHASES: For the three and nine months ended September 30,
2002, the earnings increase reflects a $126 million pretax loss related to the
PPA that was accounted for in September 2001. This loss is due to management's
review of the PPA liability assumptions related to increased expected long-term
dispatch of the MCV Facility and increased MCV-related costs. As a result,
Consumers increased the PPA liability in September 2001, to adequately reflect
the present value of the PPA's future effect on Consumers. For further
information see "Change in Auditors and Pending Restatement" at the beginning of
this MD&A.
INCOME TAXES: For the three and nine months ended September 30, 2002, the
earnings increase reflects the impact of a charge to income tax expense to
reflect an additional $20 million charge allocated to Consumers through CMS
Energy's consolidated Federal Income Tax return for 2001 filed in 2002.
CONSUMERS' GAS UTILITY RESULTS OF OPERATIONS
GAS UTILITY NET INCOME:
In Millions
- ----------------------------------------------------------------------------------------------------------------
September 30 2002 2001 Change
- ----------------------------------------------------------------------------------------------------------------
Three months ended $ (24) $ (10) $(14)
Nine months ended 8 20 (12)
================================================================================================================
Three Months Nine Months
Ended September 30 Ended September 30
Reasons for change 2002 vs 2001 2002 vs 2001
- ----------------------------------------------------------------------------------------------------------------
Gas deliveries $ (2) $ (2)
Gas rate increase 1 10
Gas wholesale and retail services 3 3
Operation and maintenance (17) (17)
Other operating expenses 3 (2)
Income taxes (2) (4)
- ----------------------------------------------------------------------------------------------------------------
Total change $ (14) $ (12)
================================================================================================================
For the three months ended September 30, 2002, gas revenues decreased due to
warmer temperatures compared to the third quarter 2001. Gas wholesale and retail
service revenues increased principally due to growth in the appliance service
plan. Operation and maintenance cost increases reflect recognition of gas
storage inventory losses, and additional expenditures on customer reliability
and service. System deliveries, including miscellaneous transportation volumes,
totaled 40.1 bcf, a decrease of 1.7 bcf or 4.1 percent compared with 2001. The
earnings decrease also reflects the impact of a charge to income tax expense to
reflect an additional $6 million charge allocated to Consumers through CMS
Energy's consolidated federal income tax return for 2001 filed in 2002.
CMS-13
CMS Energy Corporation
For the nine months ended September 30, 2002, gas revenues increased due to an
interim gas rate increase granted in December of 2001, partially offset by a
decrease in gas delivery revenue due to warmer temperatures and decelerated
economic demand. Operation and maintenance cost increases reflect recognition of
gas storage inventory losses, and additional expenditures on customer
reliability and service. System deliveries, including miscellaneous
transportation volumes, totaled 254.7 bcf, a decrease of 3.7 bcf or 1.4 percent
compared with 2001. The earnings decrease also reflects the impact of the $6
million income tax charge recorded in the third quarter of 2002 that is
discussed above.
NATURAL GAS TRANSMISSION RESULTS OF OPERATIONS
NET INCOME: For the three months ended September 30, 2002, net income was $12
million, an increase of $18 million from the comparable period in 2001. The
increase was primarily due to asset write-downs recorded in 2001, partially
offset by higher income taxes, and the impacts of the Argentina expropriation
and devaluation issues.
For the nine months ended September 30, 2002, net income was $64 million, an
increase of $11 million from the comparable period in 2001. The increase was
primarily due to asset write-downs recorded in 2001, the gain of $19 million on
the sale of Gas Transmission's ownership interest in Equatorial Guinea,
elimination of goodwill amortization in 2002, due to adoption of SFAS No. 142,
and lower interest expense. These increases were partially offset by a decrease
in the earnings from Panhandle, mainly LNG terminalling revenue, the impacts of
Argentine expropriation and devaluation on ongoing operations, and a decrease in
earnings from Field Services, due primarily to gas and liquids prices. In
accordance with SFAS No. 142, preliminary results of the second step of the
goodwill impairment testing indicate that most of Panhandle's goodwill is
impaired as of January 1, 2002. For further information, see Note 4, Goodwill.
INDEPENDENT POWER PRODUCTION RESULTS OF OPERATIONS
NET INCOME: For the three months ended September 30, 2002, net income was $52
million, a $302 million increase from the comparable period in 2001. The
increase was primarily due to the recognition of the DIG loss contract reserve
and reductions in asset valuations recorded in the third quarter 2001 and lower
steam costs at DIG, which had experienced construction delays in 2001 that led
to increased costs for steam generation. These increases were partially offset
by reduced earnings from international operations, including the impacts of the
Argentine expropriation and devaluation on ongoing operations.
For the nine months ended September 30, 2002, net income was $114 million, a
$320 million increase from the comparable period in 2001. The increase was
primarily due to the recognition of the DIG loss contract reserve and reductions
in asset valuations recorded in the third quarter 2001, improved earnings from
the MCV facility reflecting improved plant performance and mark-to-market
accounting for long-term natural gas fuel supply contracts and lower steam costs
at DIG. The increases were partially offset by the effects of the Argentine
expropriation and devaluation and earnings from certain domestic and
international operations.
OIL AND GAS EXPLORATION AND PRODUCTION RESULTS OF OPERATIONS
In September 2002, CMS Energy closed on the sale of the stock of CMS Oil and Gas
and the stock of a subsidiary of CMS Oil and Gas that holds property in
Venezuela. In October 2002, CMS Energy closed on the sale of CMS Oil and Gas's
properties in Colombia. As a result of these closings, CMS Energy has completed
its exit from the oil and gas exploration and production business. The proceeds
from the combined sales total approximately $212 million and have been used to
retire the remaining balance on a $150 million Enterprises term loan due in
December 2002 and a portion of a $295.8 million CMS Energy loan due March 2003.
The combined sales will result in an after-tax loss of approximately $90
million. For more information, see Note 2, Discontinued Operations, incorporated
by reference herein.
CMS-14
CMS Energy Corporation
MARKETING, SERVICES AND TRADING RESULTS OF OPERATIONS
During the second quarter of 2002, CMS MST announced its intention to sell its
ownership interest in CMS Viron, resulting in a reclassification of CMS Viron's
results to discontinued operations in the consolidated statements of income. For
more information, see Note 2, Discontinued Operations, incorporated by reference
herein.
NET INCOME: For the three months ended September 30, 2002, CMS MST's net loss
was $3 million, a decrease of $15 million from the comparable period in 2001.
Credit constraints are severely limiting the overall liquidity of the energy
trading markets, reducing CMS MST's ability to actively manage and optimize its
open positions as well as impacting its ability to execute new transactions.
These constraints have placed downward pressure on trading margins for both
wholesale power and natural gas. Operating revenues increased as a result of
sales volumes on long-term power contracts that were executed during the latter
part of 2001 and early 2002.
For the nine months ended September 30, 2002, CMS MST's net loss was $29
million, a decrease of $78 million from the comparable period in 2001. The
decrease was primarily due to credit constraints as well as the adoption of SFAS
No. 142, which required the write-down of goodwill at CMS MST related to its CMS
Viron business, retroactive to January 1, 2002. For more information, see Note
4, Goodwill.
During the third quarter of 2002, power sales volumes were 22,675 GWh, an
increase of 14,232 GWh and natural gas sales volumes were 141 bcf, a decrease of
51 bcf compared to the third quarter of 2001, which have been adjusted to
exclude the round-trip trading volumes. For nine months ended September 30,
2002, power sales volumes were 54,965 GWh, an increase of 39,021 GWh and natural
gas sales volumes were 501 bcf, a decrease of 58 bcf compared to 2001, which
have been adjusted to exlude the round-trip trading volumes. The increases in
power sales volumes reflect the addition of long-term power contracts that were
executed during the latter part of 2001 and early 2002.
Due to the extreme volatility in energy trading markets and the competitive
nature of the industry, results for this interim period are not necessarily an
indication of results to be achieved for the fiscal year.
OTHER RESULTS OF OPERATIONS
TAX LOSS ALLOCATION: The Job Creation and Worker Assistance Act of 2002 provided
to corporate taxpayers a 5-year carryback of tax losses incurred in 2001 and
2002. As a result of this legislation, CMS Energy was able to carry back a
consolidated 2001 tax loss to tax years 1996 through 1999 and obtain refunds of
prior years tax payments totaling $217 million. The tax loss carryback, however,
resulted in a reduction in AMT credit carryforwards that previously had been
recorded by CMS Energy as deferred tax assets in the amount of $41 million. This
one-time non-cash reduction in AMT credit carryforwards has been reflected in
the tax provisions of CMS Energy and each of its consolidated subsidiaries, as
of September 30, 2002, according to their contributions to the consolidated CMS
Energy tax loss.
OTHER: Interest expense after-tax effects for the three months ended September
30, 2002 and 2001 was $53 million and $58 million, respectively. Interest
expense after-tax effects for the nine months ended September 30, 2002 and 2001
was $163 million and $169 million, respectively. These expenses were partially
offset by the $20 million consolidating elimination in September 2002 of
intercompany losses recorded by CMS MST that result from mark-to-market
accounting for transactions with affiliates.
Discontinued Operations include, in addition to CMS Oil and Gas and CMS Viron
discussed above, a $31 million after-tax effect as a result of abandoning the
Zirconium Recovery Project after evaluating its future
CMS-15
CMS Energy Corporation
costs and risks, recorded in June 2002.
CRITICAL ACCOUNTING POLICIES
The results of operations, as presented above, are based on the application of
accounting principles generally accepted in the United States. The application
of these principles often requires management to make certain judgments,
assumptions and estimates that may result in different financial presentations.
CMS Energy believes that certain accounting principles are critical in terms of
understanding its financial statements. These principles include the use of
estimates for long-lived assets, equity method investments and long-term
obligations, accounting for derivatives and financial instruments,
mark-to-market accounting, and international operations and foreign currency.
USE OF ESTIMATES
The preparation of financial statements in conformity with accounting principles
generally accepted in the United States requires management to make judgments,
estimates and assumptions that affect the reported amounts of assets and
liabilities, disclosure of contingent assets and liabilities at the date of the
financial statements, and the reported amounts of revenues and expenses during
the reporting period. Certain accounting principles require subjective and
complex judgments used in the preparation of financial statements. Accordingly,
a different financial presentation could result depending on the judgment,
estimates or assumptions that are used. Such estimates and assumptions include,
but are not specifically limited to: depreciation, amortization, interest rates,
discount rates, currency exchange rates, future commodity prices, mark-to-market
valuations, investment returns, volatility in the price of CMS Energy Common
Stock, impact of new accounting standards, international economic policy, future
costs associated with long-term contractual obligations, future compliance costs
associated with environmental regulations and continuing creditworthiness of
counterparties. Actual results could materially differ from those estimates.
Periodically, in accordance with SFAS No. 144 and APB Opinion No. 18, long-lived
assets and equity method investments of CMS Energy and its subsidiaries are
evaluated to determine whether conditions, other than those of a temporary
nature, indicate that the carrying value of an asset may not be recoverable.
Management bases its evaluation on impairment indicators such as the nature of
the assets, future economic benefits, domestic and foreign state and federal
regulatory and political environments, historical or future profitability
measurements, as well as other external market conditions or factors that may be
present. If such indicators are present or other factors exist that indicate
that the carrying value of the asset may not be recoverable, CMS Energy
determines whether impairment has occurred through the use of an undiscounted
cash flow analysis of assets at the lowest level for which identifiable cash
flows exist. If impairment, other than a temporary nature, has occurred, CMS
Energy recognizes a loss for the difference between the carrying value and the
estimated fair value of the asset. The fair value of the asset is measured using
discounted cash flow analysis or other valuation techniques. The analysis of
each long-lived asset is unique and requires management to use certain estimates
and assumptions that are deemed prudent and reasonable for a particular set of
circumstances. Of CMS Energy's total assets, valued at $15 billion at September
30, 2002, approximately 60 to 65 percent represent the carrying value of
long-lived assets and equity method investments that are subject to this type of
analysis. If future market, political or regulatory conditions warrant, CMS
Energy and its subsidiaries may be subject to write-downs in future periods.
Conversely, if market, political or regulatory conditions improve, accounting
standards prohibit the reversal of previous write-downs.
CMS Energy has recently recorded write-downs of non-strategic or
under-performing long-lived assets as a result of implementing a new strategic
direction. CMS Energy is pursuing the sale of all of these non-strategic and
under-performing assets, including some assets that were not determined to be
impaired. Upon the sale of these assets, the proceeds realized may be materially
different from the remaining carrying value of these
CMS-16
CMS Energy Corporation
assets. Even though these assets have been identified for sale, management
cannot predict when, nor make any assurances that, these asset sales will occur,
or the amount of cash or the value of consideration to be received.
Similarly, the recording of estimated liabilities for contingent losses,
including estimated losses on long-term obligations, within the financial
statements is guided by the principles in SFAS No. 5 that require a company to
record estimated liabilities in the financial statements when it is probable
that a loss will be incurred in the future as a result of a current event, and
the amount can be reasonably estimated. Management uses cash flow valuation
techniques similar to those described above to estimate contingent losses on
long-term contracts.
ACCOUNTING FOR DERIVATIVE AND FINANCIAL INSTRUMENTS
DERIVATIVE INSTRUMENTS: CMS Energy uses the criteria in SFAS No. 133, as amended
and interpreted, to determine if certain contracts must be accounted for as
derivative instruments. The rules for determining whether a contract meets the
criteria for derivative accounting are numerous and complex. As a result,
significant judgment is required to determine whether a contract requires
derivative accounting, and similar contracts can sometimes be accounted for
differently.
The types of contracts CMS Energy currently accounts for as derivative
instruments include interest rate swaps, foreign currency exchange contracts,
certain electric call options, and gas fuel call options and swaps. CMS Energy
does not account for electric capacity and certain energy contracts, gas supply
contracts, coal supply contracts, or purchase orders for numerous supply items
as derivatives.
If a contract must be accounted for as a derivative instrument, the contract is
recorded as either an asset or a liability in the financial statements at the
fair value of the contract. Any difference between the recorded book value and
the fair value is reported either in earnings or other comprehensive income
depending on certain qualifying criteria. The recorded fair value of the
contract is then adjusted quarterly to reflect any change in the market value of
the contract.
In order to value the contracts that are accounted for as derivative
instruments, CMS Energy uses a combination of market quoted prices and
mathematical models. Option models require various inputs, including forward
prices, volatilities, interest rates and exercise periods. Changes in forward
prices or volatilities could significantly change the calculated fair value of
the call option contracts. The models used by CMS Energy have been tested
against market quotes to ensure consistency between model outputs and market
quotes. At September 30, 2002, CMS Energy assumed a market-based interest rate
of 4.5 percent in calculating the fair value of its electric call options.
In order for derivative instruments to qualify for hedge accounting under SFAS
No. 133, the hedging relationship must be formally documented at inception and
be highly effective in achieving offsetting cash flows or offsetting changes in
fair value attributable to the risk being hedged. If hedging a forecasted
transaction, the forecasted transaction must be probable. If a derivative
instrument, used as a cash flow hedge, is terminated early because it is
probable that a forecasted transaction will not occur, any gain or loss as of
such date is immediately recognized in earnings. If a derivative instrument,
used as a cash flow hedge, is terminated early for other economic reasons, any
gain or loss as of the termination date is deferred and recorded when the
forecasted transaction affects earnings.
Consumers believes that certain of its electric capacity and energy contracts
are not derivatives due to the lack of an active energy market in the state of
Michigan, as defined by SFAS No. 133, and the transportation cost to deliver the
power under the contracts to the closest active energy market at the Cinergy hub
in Ohio. If a market develops in the future, Consumers may be required to
account for these contracts as derivatives. The mark-to-market impact in
earnings related to these contracts, particularly related to the PPA, could be
material to the financial statements.
CMS-17
CMS Energy Corporation
FINANCIAL INSTRUMENTS: CMS Energy accounts for its investments in debt and
equity securities in accordance with SFAS No. 115. As such, debt and equity
securities can be classified into one of three categories: held-to-maturity,
trading, or available-for-sale securities. CMS Energy's investments in equity
securities are classified as available-for-sale securities and are reported at
fair value with any unrealized gains or losses resulting from changes in fair
value excluded from earnings and reported in equity as part of other
comprehensive income. Unrealized gains or losses resulting from changes in the
fair value of Consumers' nuclear decommissioning investments are reported in
accumulated depreciation. The fair value of these investments is determined from
quoted market prices.
MARK-TO-MARKET ACCOUNTING
CMS MST's trading activities are accounted for under the mark-to-market method
of accounting. Under mark-to-market accounting, energy-trading contracts are
reflected at fair market value, net of reserves, with unrealized gains and
losses recorded as an asset or liability in the consolidated balance sheets.
These assets and liabilities are affected by the timing of settlements related
to these contracts, current-period changes from newly originated transactions
and the impact of price movements. Changes in fair value are recognized as
revenues in the consolidated statements of income in the period in which the
changes occur. Market prices used to value outstanding financial instruments
reflect management's consideration of, among other things, closing exchange and
over-the-counter quotations. In certain of these markets, long-term contract
commitments may extend beyond the period in which market quotations for such
contracts are available. The lack of long-term pricing liquidity requires the
use of mathematical models to value these commitments under the accounting
method employed. These mathematical models utilize historical market data to
forecast future elongated pricing curves, which are used to value the
commitments that reside outside of the liquid market quotations. Realized cash
returns on these commitments may vary, either positively or negatively, from the
results estimated through application of forecasted pricing curves generated
through application of the mathematical model. CMS Energy believes that its
mathematical models utilize state-of-the-art technology, pertinent industry data
and prudent discounting in order to forecast certain elongated pricing curves.
These market prices are adjusted to reflect the potential impact of liquidating
the company's position in an orderly manner over a reasonable period of time
under present market conditions.
In connection with the market valuation of its energy commodity contracts, CMS
Energy maintains reserves for credit risks based on the financial condition of
counterparties. Counterparties in its trading portfolio consist principally of
financial institutions and major energy trading companies. The creditworthiness
of these counterparties will impact overall exposure to credit risk; however,
CMS Energy maintains credit policies that management believes minimize overall
credit risk with regard to its counterparties. Determination of its
counterparties' credit quality is based upon a number of factors, including
credit ratings, financial condition, and collateral requirements. When trading
terms permit, CMS Energy employs standard agreements that allow for netting of
positive and negative exposures associated with a single counterparty. Based on
these policies, its current exposures and its credit reserves, CMS Energy does
not anticipate a material adverse effect on its financial position or results of
operations as a result of counterparty nonperformance.
The following tables provide a summary of the fair value of CMS Energy's energy
commodity contracts as of September 30, 2002.
In Millions
- ------------------------------------------------------------------------------
Fair value of contracts outstanding as of June 30, 2002 $89
Contracts realized or otherwise settled during the period (a) 7
Other changes in fair value (b) 1
- ------------------------------------------------------------------------------
Fair value of contracts outstanding as of September 30, 2002 (c) $97
==============================================================================
CMS-18
CMS Energy Corporation
Fair Value of Contracts at September 30, 2002 In Millions
- ---------------------------------------------------------------------------------------------------------------------
Total Maturity (in years)
Source of Fair Value Fair Value Less than 1 1 to 3 4 to 5 Greater than 5
- ---------------------------------------------------------------------------------------------------------------------
Prices actively quoted $ 32 $ 20 $ 12 $ - $ -
Prices provided by other
external sources 3 2 (2) 2 1
Prices based on models and
other valuation methods 62 8 23 20 11
- ---------------------------------------------------------------------------------------------------------------------
Total $ 97 $ 30 $ 33 $ 22 $ 12
=====================================================================================================================
(a) Reflects value of contracts, included in June 30, 2002 values,
that expired during the third quarter of 2002.
(b) Reflects changes in price and net increase/decrease in size of
forward positions, as well as changes to mark-to-market
reserve accounts.
(c) Includes the value of contracts with affiliated companies but
excludes the credit reserve for third parties.
INTERNATIONAL OPERATIONS AND FOREIGN CURRENCY
CMS Energy, through its subsidiaries and affiliates, has acquired investments in
energy-related projects throughout the world. As a result of a change in
business strategy, CMS Energy has begun divesting its non-strategic or
under-performing foreign investments.
BALANCE SHEET: CMS Energy's subsidiaries and affiliates whose functional
currency is other than the U.S. Dollar translate their assets and liabilities
into U.S. Dollars at the exchange rates in effect at the end of the fiscal
period. The revenue and expense accounts of such subsidiaries and affiliates are
translated into U.S. Dollars at the average exchange rate during the period. The
gains or losses that result from this process, and gains and losses on
intercompany foreign currency transactions that are long-term in nature that CMS
Energy does not intend to settle in the foreseeable future, are reflected as a
component of stockholders' equity in the consolidated balance sheets as "Foreign
Currency Translation" in accordance with the accounting guidance provided in
SFAS No. 52. As of September 30, 2002, the cumulative Foreign Currency
Translation decreased stockholders' equity by $715 million.
INCOME STATEMENT: For subsidiaries operating in highly inflationary economies or
that meet the U.S. functional currency criteria outlined in SFAS No. 52, the
U.S. Dollar is deemed to be the functional currency. Gains and losses that arise
from exchange rate fluctuations on transactions denominated in a currency other
than the U.S. Dollar, except those that are hedged, are included in determining
net income.
Argentina: In January 2002, the Republic of Argentina enacted the Public
Emergency and Foreign Exchange System Reform Act. This law repealed the fixed
exchange rate of one U.S. Dollar to one Argentina Peso, converted all
Dollar-denominated utility tariffs and energy contract obligations into Pesos at
the same one-to-one exchange rate, and directed the President of Argentina to
renegotiate such tariffs.
In February 2002, the Republic of Argentina enacted additional measures that
required all monetary obligations (including current debt and future contract
payment obligations) denominated in foreign currencies to be converted into
Pesos. These February measures also authorize the Argentine judiciary
essentially to rewrite private contracts denominated in Dollars or other foreign
currencies if the parties cannot agree on how to share equitably the impact of
the conversion of their contract payment obligations into Pesos. In April 2002,
based on a consideration of these environmental factors, CMS Energy evaluated
its Argentine investments for impairment as required under SFAS No. 144 and APB
Opinion No. 18. These impairment models contain certain assumptions regarding
anticipated future exchange rates and operating performance of the investments.
CMS-19
CMS Energy Corporation
Exchange rates used in the models assume that the rate will decrease from
current levels to approximately 3.00 Pesos per U.S. Dollar over the remaining
life of these investments. Based on the results of these models, CMS Energy
determined that these investments were not impaired.
Effective April 30, 2002, CMS Energy adopted the Argentine Peso as the
functional currency for most of its Argentine investments. CMS had previously
used the U.S. Dollar as the functional currency for its Argentine investments.
As a result, on April 30, 2002, CMS Energy translated the assets and liabilities
of its Argentine entities into U.S. Dollars, in accordance with SFAS No. 52,
using an exchange rate of 3.45 Pesos per U.S. Dollar, and recorded an initial
charge to the Foreign Currency Translation component of Common Stockholders'
Equity of approximately $400 million.
For the nine months ended September 30, 2002, CMS Energy recorded losses of $40
million or $0.28 per share, reflecting the negative impact of the actions of the
Argentine government. These losses represent changes in the value of
Peso-denominated monetary assets (such as receivables) and liabilities of
Argentina-based subsidiaries and lower net project earnings resulting from the
conversion to Pesos of utility tariffs and energy contract obligations that were
previously calculated in Dollars.
While CMS Energy's management cannot predict the most likely future, average, or
end of period 2002 Peso to U.S. Dollar exchange rates, it does expect that these
non-cash charges substantially reduce the risk of further material balance sheet
impacts when combined with anticipated proceeds from international arbitration
currently in progress, political risk insurance, and the eventual sale of these
assets. As a result of the change in functional currency, and the ongoing
translation of revenue and expense accounts of these investments into U.S.
Dollars, an additional $6 million or $0.05 per share, assuming exchange rates
ranging from 3.00 to 4.00 Pesos per U.S. Dollar, may adversely affect 2002
earnings for CMS Energy. At September 30, 2002, the net foreign currency loss
due to the unfavorable exchange rate of the Argentine Peso recorded in the
Foreign Currency Translation component of Common Stockholder's Equity using an
exchange rate of 3.665 Pesos per U.S. Dollar was $400 million.
Australia: In 2000, an impairment loss of $329 million ($268 million after-tax)
was realized on the carrying amount of the investment in Loy Yang. This loss
does not include $168 million cumulative net foreign currency translation losses
due to unfavorable changes in the exchange rates, which, in accordance with SFAS
No. 52, will not be realized until there has been a sale, full liquidation, or
other disposition of CMS Energy's investment in Loy Yang, all of which are
currently being pursued but are not expected to occur in 2002.
HEDGING STRATEGY: CMS Energy uses forward exchange and option contracts to hedge
certain receivables, payables, long-term debt and equity value relating to
foreign investments. The purpose of CMS Energy's foreign currency hedging
activities is to protect the company from risk that U.S. Dollar net cash flows
resulting from sales to foreign customers and purchases from foreign suppliers
and the repayment of non-U.S. Dollar borrowings, as well as the equity reported
on the company's balance sheet, may be adversely affected by changes in exchange
rates. These contracts do not subject CMS Energy to risk from exchange rate
movements because gains and losses on such contracts are inversely correlated
with the losses and gains, respectively, on the assets and liabilities being
hedged. Foreign currency adjustments for other CMS Energy international
investments were immaterial.
ACCOUNTING FOR PENSION AND OPEB
CMS Energy provides postretirement benefits under its Pension Plan, and
postretirement health and life insurance benefits under its OPEB plans to
substantially all its retired employees. CMS Energy uses SFAS No. 87 to account
for pension costs and uses SFAS No. 106 to account for other postretirement
benefit costs. These statements require liabilities to be recorded on the
balance sheet at the present value of these future obligations to employees net
of any plan assets. The calculation of these liabilities and associated expenses
CMS-20
CMS Energy Corporation
require the expertise of actuaries and are subject to many assumptions including
life expectancies, present value discount rates, expected long-term rate of
return on plan assets, rate of compensation increase and anticipated health care
costs. Any change in these assumptions can significantly change the liability
and associated expenses recognized in any given year. As of January 2002, OPEB
plan claims are paid from the VEBA Trusts.
Pension and OPEB plan assets, net of contributions, have reduced in value from
the previous year due to the downturn in the equities market, and a decrease in
the price of CMS Energy Common Stock. As a result, CMS Energy expects to see an
increase in pension and OPEB expense levels over the next several years unless
market performance of plan assets improves. CMS Energy anticipates pension
expense and OPEB expense to rise in 2002 by approximately $10 million and $21
million, respectively, over 2001 expenses. For pension expense, this increase is
due to a downturn in the value of pension assets during the past two years,
forecasted increases in pay and added service, decline in the interest rate used
to value the liability of the plan, and expiration of the transition gain
amortization. For OPEB expense, the increase is due to the trend of rising
health care costs, the market return on plan assets being below expected levels
and a lower discount rate, based on recent economic conditions, used to compute
the benefit obligation. Under the OPEB plans' assumptions, health care costs
increase at a slower rate from current levels through 2009; however, CMS Energy
cannot predict the impact that future health care costs and interest rates or
market returns will have on pension and OPEB expense in the future.
The recent significant downturn in the equities markets has affected the value
of the Pension Plan assets. If the plan's Accumulated Benefit Obligation exceeds
the value of these assets at December 31, 2002, CMS Energy will be required to
recognize an additional minimum liability for this excess in accordance with
SFAS No 87. CMS Energy cannot predict the future fair value of the plan's assets
but it is probable, without significant appreciation in the plan's assets that
CMS Energy will need to book an additional minimum liability through a charge to
other comprehensive income. The Accumulated Benefit Obligation is determined by
the plan's actuary in the fourth quarter of each year.
In January 2002, CMS Energy contributed $85 million to the plan's trust
accounts. This amount was comprised of $64 million of pension-related benefits
and $21 million of post retirement health care and life insurance benefits. In
the second and third quarters of 2002, CMS Energy made additional contributions
for post retirement health care and life insurance benefits in the amount of $21
million and $20 million, respectively. CMS Energy expects to make an additional
contribution to the Pension Plan of approximately $219 million in the third
quarter of 2003.
In order to keep health care benefits and costs competitive, CMS Energy has
announced several changes to the Health Care Plan. These changes are effective
January 1, 2003. The most significant change is that CMS Energy's future
increases in health care costs will be shared equally with employees.
CMS Energy also provides retirement benefits under a defined contribution 401(k)
plan. CMS Energy previously offered a contribution match of 50 percent of the
employee's contribution up to six percent (three percent maximum), as well as an
incentive match in years when CMS Energy's financial performance exceeded
targeted levels. Effective September 1, 2002, the employer's match was suspended
until January 1, 2005, and the incentive match was permanently eliminated.
Amounts charged to expense for the employer's match and incentive match during
2001 were $15 million and $11 million, respectively.
NEW ACCOUNTING STANDARDS
In addition to the identified critical accounting policies discussed above,
future results will be affected by new accounting standards that recently have
been issued.
SFAS NO. 143, ACCOUNTING FOR ASSET RETIREMENT OBLIGATIONS: Beginning January 1,
2003, companies must
CMS-21
CMS Energy Corporation
comply with SFAS No. 143. The standard requires companies to record the fair
value of the legal obligations related to an asset retirement in the period in
which it is incurred. When the liability is initially recorded, the company
would capitalize an offsetting amount by increasing the carrying amount of the
related long-lived asset. Over time, the liability is accreted to its present
value each period and the capitalized cost is depreciated over the related
asset's useful life. CMS Energy is currently inventorying assets that may have a
retirement obligation and consulting with counsel to determine if a legal
retirement obligation exists. The legal retirement obligation removal cost
estimate will be determined based on fair value cost estimates as required by
the new standard. The present value of the legal retirement obligations will be
used to quantify the future effects of adoption of this standard.
SFAS NO. 145, RESCISSION OF FASB STATEMENTS NO. 4, 44, AND 64, AMENDMENT OF FASB
STATEMENT NO. 13, AND TECHNICAL CORRECTIONS: Issued by the FASB on April 30,
2002, this Statement rescinds SFAS No. 4, Reporting Gains and Losses from
Extinguishment of Debt, and SFAS No. 64, Extinguishment of Debt Made to Satisfy
Sinking-Fund Requirements. As a result, any gain or loss on extinguishment of
debt should be classified as an extraordinary item only if it meets the criteria
set forth in APB Opinion No. 30. The provisions of this section are applicable
to fiscal years beginning 2003. CMS Energy is currently studying the effects of
the new standard, but has yet to quantify the effects of adoption on its
financial statements. SFAS No. 145 amends SFAS No. 13, Accounting for Leases, to
require sale-leaseback accounting for certain lease modifications that have
similar economic impacts to sale-leaseback transactions. Finally, SFAS No. 145
amends other existing authoritative pronouncements to make various technical
corrections and rescinds SFAS No. 44, Accounting for Intangible Assets of Motor
Carriers. These provisions are effective for financial statements issued on or
after May 15, 2002.
SFAS NO. 146, ACCOUNTING FOR COSTS ASSOCIATED WITH EXIT OR DISPOSAL ACTIVITIES:
Issued by the FASB in July 2002, this standard requires companies to recognize
costs associated with exit or disposal activities when they are incurred rather
than at the date of a commitment to an exit or disposal plan. This standard is
effective for exit or disposal activities initiated after December 31, 2002. CMS
Energy believes there will be no impact on its financial statements upon
adoption of the standard, but the accounting treatment will be different.
SFAS NO. 147, ACQUISITIONS OF CERTAIN FINANCIAL INSTITUTIONS: Issued by the FASB
in October 2002, this standard amends SFAS No. 72, Accounting for Certain
Acquisitions of Banking or Thrift Institutions, and amends SFAS Interpretation
No. 9, Applying APB Opinions No. 16 and 17 When a Savings and Loan Association
or a Similar Institution Is Acquired in a Business Combination Accounted for by
the Purchase Method. SFAS No. 147 also amends SFAS No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets. These provisions are effective for
transactions occurring on or after October 1, 2002. CMS Energy is currently
studying the effects of the new standard, but has yet to quantify the effects of
adoption on its financial statements.
EITF ISSUE NO. 02-3, RECOGNITION AND REPORTING OF GAINS AND LOSSES ON ENERGY
TRADING CONTRACTS UNDER EITF ISSUES NO. 98-10 AND 00-17: In September 2002, the
EITF reaffirmed the consensus originally reached in June 2002 that requires all
gains and losses, including mark-to-market gains and losses and physical
settlements, related to energy trading activities within the scope of EITF Issue
No. 98-10 be presented as a net amount in the income statement. This consensus
is applicable to financial statement periods ending after July 15, 2002 and
requires the reclassification of comparable reporting periods.
In previous reporting periods, these amounts were reported on a gross basis as a
component of both Operating Revenues and Operating Expenses. At September 30,
2002, CMS Energy has adopted this consensus and as a result, these amounts are
netted together in "Marketing, services and trading" Operating Revenues on the
face of the Consolidated Statements of Income. The reclassification of prior
periods had no impact on previously reported net income or stockholders' equity.
CMS-22
CMS Energy Corporation
At the October 25, 2002 meeting, the EITF reached a consensus to rescind EITF
Issue No. 98-10, Accounting for Contracts Involved in Energy Trading and Risk
Management Activities. As a result, only energy contracts that meet the
definition of a derivative in SFAS No. 133 will be carried at fair value. Energy
trading contracts that do not meet the definition of a derivative must be
accounted for as an executory contract (i.e., on an accrual basis). The
consensus rescinding EITF Issue No. 98-10 must be applied to all contracts that
existed as of October 25, 2002 and must be recognized as a cumulative effect of
a change in accounting principle in accordance with APB Opinion No. 20,
Accounting Changes, effective the first day of the first interim or annual
period beginning after December 15, 2002. The consensus also must be applied
immediately to all new contracts entered into after October 25, 2002. As a
result of these recent changes, CMS Energy will evaluate its existing energy
contracts to determine if any changes in the method of reporting the results of
these contracts will be required effective January 1, 2003.
For a discussion of new accounting standards effective January 1, 2002, see Note
1, Corporate Structure and Basis of Presentation.
CAPITAL RESOURCES AND LIQUIDITY
CASH POSITION, INVESTING AND FINANCING
CMS Energy's primary ongoing source of cash is dividends and other distributions
from subsidiaries. During the first nine months of 2002, Consumers paid $255
million in common dividends and other distributions and Enterprises paid $749
million in common dividends and other distributions to CMS Energy. CMS Energy's
consolidated cash requirements are met by its operating and investing
activities.
OPERATING ACTIVITIES: CMS Energy's consolidated net cash provided by operating
activities is derived mainly from the processing, storage, transportation and
sale of natural gas and the generation, distribution and sale of electricity.
For the first nine months of 2002 and 2001, consolidated cash from operations
after interest charges totaled $323 million and $246 million, respectively.
The $77 million increase in cash from operations resulted primarily from larger
decreases in accounts receivable and accrued revenues, a smaller increase in
inventories, and a smaller decrease in accounts payable and accrued expenses.
These sources of cash were partially offset by a decrease in cash earnings and
decreases in deferred income taxes and investment tax credit. CMS Energy uses
cash derived from its operating activities primarily to maintain its energy
businesses, to maintain and expand electric and gas systems of Consumers, to
pay interest on and retire portions of its long-term debt, and to pay dividends.
INVESTING ACTIVITIES: For the first nine months of 2002, CMS Energy's
consolidated net cash provided by investing activities totaled $899 million,
while net cash used in investing activities totaled $994 million for the first
nine months of 2001. The $1,893 million increase in cash reflects increased net
proceeds from the sale of assets ($1,418 million) and a reduction in capital
expenditures and investments in partnerships and unconsolidated subsidiaries
($453 million). CMS Energy's expenditures in the first nine months of 2002 for
its utility and diversified energy businesses were $471 million and $172
million, respectively, compared to $519 million and $530 million, respectively,
during the comparable period in 2001.
FINANCING ACTIVITIES: For the first nine months of 2002, CMS Energy's net cash
used in financing activities totaled $1,004 million, while net cash provided by
financing activities totaled $779 million for the first nine months of 2001. The
decrease of $1,783 million resulted primarily from an increase in the retirement
of bonds and other long-term debt ($498 million), a decrease in proceeds from
Trust Preferred Securities ($121 million), a decrease in proceeds from notes,
bonds and other long-term debt ($956 million) and an increase in the retirement
of Trust Preferred Securities ($331 million).
CMS-23
CMS Energy Corporation
In the first nine months of 2002, CMS Energy declared and paid $124 million in
cash dividends to holders of CMS Energy Common Stock. In October 2002, the Board
of Directors declared a quarterly dividend of $0.18 per share on CMS Energy
Common Stock, payable in November 2002. The quarterly dividend is consistent
with the requirements of the new credit facilities described below.
The following table summarizes securities issued during the first nine months of
2002:
Distribution/ Amount
Month Issued Maturity Interest Rate (In Millions) Use of Proceeds
- ---------------------------------------------------------------------------------------------------------------------------
CMS ENERGY
GTNs Series F January (1) 7.33% $ 12 General corporate purposes
Common Stock (2) n/a 11 million shares 350 Repay debt and general
----- corporate purposes
$ 362
-----
CONSUMERS
Senior Notes March 2005 6.00% $ 300 Repay debt
-----
Total $ 662
=====
- -------------------------------------------------------------------------------------------------------------------
(1) GTNs are issued with varying maturity dates. The interest rate shown
herein is a weighted average interest rate.
(2) In July 2002, 8.8 million shares of Common Stock were issued in
conjunction with the conversion of the Adjustable Convertible Trust
Securities (CMS Energy Trust II). Through May 10, 2002, 1.3 million
shares were issued in conjunction with CMS Energy's Continuous Stock
Offering Program, activated in February 2002, for which 2 million
shares are registered. No shares have been issued under this program
since that date. Finally, approximately 1 million shares were issued
from time to time in conjunction with the stock purchase plan and
various employee savings and stock incentive plans.
OTHER INVESTING AND FINANCING MATTERS: At September 30, 2002, the book value per
share of CMS Energy Common Stock was $14.03.
At November 1, 2002, CMS Energy had an aggregate $1.3 billion in securities
registered for future issuance.
In May 2002, CMS Energy registered $300,000,000 Series G GTNs. The notes will be
issued from time to time with the proceeds being used for general corporate
purposes. As of November 1, 2002, no Series G GTNs had been issued.
On July 1, 2002, the 7,250,000 units of 8.75% Adjustable Convertible Trust
Securities (CMS Energy Trust II) were converted to 8,787,725 newly issued shares
of CMS Energy Common Stock.
On July 12, 2002, CMS Energy and its subsidiaries reached agreement with its
lenders on five credit facilities (facilities) totaling approximately $1.3
billion of credit for CMS Energy, Enterprises and Consumers. The agreements were
executed by various combinations of up to 21 lenders and by CMS Energy and are
as follows: a $295.8 million revolving credit facility by CMS Energy, maturing
March 31, 2003; a $300 million revolving credit facility by CMS Energy, maturing
December 15, 2003; a $150 million short-term loan by Enterprises, maturing
December 13, 2002; a $250 million revolving credit facility by Consumers,
maturing July 11, 2003; and a $300 million term loan by Consumers, maturing July
11, 2003 with a one-year extension at Consumers' option.
CMS-24
CMS Energy Corporation
The facilities are secured credits with mandatory prepayment of borrowings under
certain of the facilities with proceeds from asset sales and capital market
issuances. The CMS Energy and Enterprises facilities grant the applicable bank
groups either first or second liens on the capital stock of Enterprises and its
major direct and indirect domestic subsidiaries, including Panhandle Eastern
Pipe Line (but excluding subsidiaries of Panhandle Eastern Pipe Line). The
Consumers facilities grant the applicable bank groups security through first
mortgage bonds. Bank and legal fees associated with restructuring the Facilities
were approximately $12 million.
The facilities essentially replace or restructure previously existing credit
facilities or lines at CMS Energy or Consumers, without substantially changing
credit commitments. The three CMS Energy and Enterprises facilities aggregating
$745.8 million represent a restructuring of a prior CMS Energy $300 million
three-year revolving credit facility maturing in June 2004 and a prior CMS
Energy $450 million revolving credit facility originally maturing June 2002, but
previously extended through July 12, 2002. The two Consumers facilities
aggregating $550 million replace a $300 million revolving credit facility that
matured July 14, 2002, as well as various credit lines aggregating $200 million.
The prior credit facilities and lines were unsecured.
Pursuant to restrictive covenants in the CMS Energy $295.8 million facility, CMS
Energy is limited to quarterly dividend payments of $0.1825 per share and must
receive $250 million in net cash proceeds from the planned issuance of equity or
equity-linked securities by December 31, 2002 in order to continue to pay a
dividend thereafter. Further cost-cutting steps and sales of non-strategic
assets are expected to eliminate the need for CMS Energy to access the capital
markets for the remainder of 2002. Asset sale proceeds are expected to be used
to repay the balance of CMS Energy's $295.8 million facility, but management can
make no assurances that such payment will be made or that dividends will be
declared by the Board of Directors.
The CMS Energy $300 million facility does not have the foregoing restrictive
covenant, but does include a limitation on cash dividends if CMS Energy's level
of Cash Dividend Income (as defined by the agreement) to interest expense falls
below 1.05 to 1.00. As a result of these dividend restrictions, CMS Energy's
Board of Directors cut the CMS Energy Common Stock dividend by approximately 50
percent, to an annual rate of 72 cents per share during the third quarter of
2002. Also pursuant to restrictive covenants in its facilities, Consumers is
limited to common stock dividend payments that will not exceed $300 million in
any calendar year. In 2001, Consumers paid $189 million in common stock
dividends to CMS Energy, and has paid $154 million for the nine months ended
September 30, 2002.
The CMS Energy credit facilities have an interest rate of LIBOR plus 300 basis
points. The Consumers' $250 million credit facility has an interest rate of
LIBOR plus 200 basis points (although the rate may fluctuate depending on the
rating of Consumers First Mortgage Bonds) and the interest rate on the $300
million term loan is LIBOR plus 450 basis points, which may also fluctuate
depending on the rating of Consumers' First Mortgage Bonds.
In September 2002, Consumers' exercised its extension option on the $300 million
term loan to move the maturity date to July 11, 2004. Also in September 2002,
CMS Energy retired the $150 million short-term loan by Enterprises using
proceeds from the sale of CMS Oil and Gas and other assets. In October 2002,
Consumers simultaneously entered into a new Term Loan Agreement collateralized
by First Mortgage Bonds and a new Gas Inventory Term Loan Agreement
collateralized by Consumers' natural gas in storage. These agreements contain
complementary collateral packages that provide Consumers, as additional First
Mortgage Bonds become available, borrowing capacity of up to $225 million.
Consumers drew $220 million of the capacity upon execution of the Agreements and
is expected to be in a position to draw the full $225 million by mid-November of
2002. The interest rate under the Agreements is currently LIBOR plus 300 basis
points, but will increase by 100 basis points for any period after December 1,
2002 during which the banks thereunder have not yet received, among other
deliveries, certified restated financial statements for CMS Energy's 2000 and
2001 fiscal years. The bank and legal fees associated with the Agreement were $2
million. The first net amortization payment under these Agreements currently is
scheduled to occur at the end of 2002 with monthly amortization scheduled until
full repayment is completed in mid-April of 2003. This financing should
eliminate the need for Consumers to access the capital markets for the remainder
of 2002.
CMS-25
CMS Energy Corporation
The facilities also have contractual restrictions that require CMS Energy and
Consumers to maintain, as of the last day of each fiscal quarter, the following:
Required Ratio Limitation Ratio at September 30, 2002
- -------------------------------------------------------------------------------------------------------------------
CMS ENERGY:
Consolidated Leverage Ratio (a) not more than 5.75 to 1.00 5.32 to 1.00
Cash Dividend Coverage Ratio (a) not less than 1.25 to 1.00 1.87 to 1.00
Dividend Coverage Ratio not less than 1.15 to 1.00 3.40 to 1.00
Restricted Payment Ratio (a) not less than 1.05 to 1.00 2.11 to 1.00
CONSUMERS:
Debt to Capital Ratio (a) not more than 0.65 to 1.00 0.53 to 1.00
Interest Coverage Ratio (a) not less than 2.00 to 1.00 3.36 to 1.00
- -------------------------------------------------------------------------------------------------------------------
(a) Violation of this ratio would constitute an Event of Default under this
facility which provides the lender, among other remedies, the right to
declare the principal and interest immediately due and payable.
In 1994, CMS Energy executed an indenture (the "Indenture") with J.P.Morgan
Chase Bank pursuant to CMS Energy's general term notes program. The Indenture,
through supplements, contains certain provisions that can trigger a limitation
on CMS Energy's consolidated indebtedness. The limitation can be activated when
CMS Energy's consolidated leverage ratio, as defined in the Indenture
(essentially the ratio of consolidated debt to consolidated capital), exceeds
0.75 to 1.0. Upon activation of the limitation, CMS Energy will not and will not
permit certain material subsidiaries, excluding Consumers and its subsidiaries,
to become liable for new indebtedness. However, CMS Energy and the material
subsidiaries may incur revolving indebtedness to banks of up to $1 billion in
the aggregate and refinance existing debt outstanding at CMS Energy and at the
material subsidiaries. At September 30, 2002, CMS Energy's consolidated leverage
ratio was 0.73 to 1.0. CMS Energy expects that the aggregate effect of non-cash
charges to equity and the reconsolidation of debt on the balance sheet
anticipated to occur in the fourth quarter of 2002 will result in a year-end
debt ratio in excess of 75 percent. This debt ratio may be significantly reduced
if CMS Energy decides to proceed with its sale of Panhandle, its sale of CMS
Field Services, other asset sales or other options such as the securitization of
additional assets at Consumers.
CREDIT RATINGS: In July 2002, the credit ratings of the publicly traded
securities of each of CMS Energy, Consumers and Panhandle (but not Consumers
Funding LLC) were downgraded by the major rating agencies. The ratings downgrade
for all three companies' securities was largely a function of the uncertainties
associated with CMS Energy's financial condition and liquidity, restatement and
re-audit of 2000 and 2001 financial statements, and lawsuits, and directly
affects and limits CMS Energy's access to the capital markets.
As a result of certain of these downgrades, rights were triggered in several
contractual arrangements between CMS Energy subsidiaries and third parties. More
specifically, a loan to Panhandle made in connection with the December 2001 LNG
off balance sheet monetization transaction is subject to repayment demand by the
unaffiliated equity partner in the LNG Holdings joint venture. At September 30,
2002, Panhandle's remaining balance on the $75 million note payable to LNG
Holdings was approximately $66 million. Dekatherm Investor Trust has agreed not
to make demand for payment before November 22, 2002 in return for a fee and an
agreement for Panhandle to acquire Dekatherm Investor Trust's interest in LNG
Holdings. When Panhandle acquires Dekatherm Investor Trust's interest, it will
then own 100 percent of LNG Holdings and will not demand payment on the note
payable to LNG Holdings.
In addition, the construction lenders for each of the Guardian and Centennial
pipeline projects, each partially owned by Panhandle, requested acceptable
credit support for Panhandle's guarantee of its pro rata portion of those
construction loans, which aggregate $110 million including anticipated future
draws. On September 27, 2002 Panhandle's Centennial partners provided credit
support of $25 million each in the form of guarantees to the lender to cover
Panhandle's obligation of $50 million of loan guarantees. The partners will be
paid credit fees by Panhandle on the outstanding balance of the guarantees for
any periods for which they are in effect. This additional credit support does
not remove Panhandle from its original $50 million obligation. In October 2002,
Panhandle provided a letter of credit to the lenders which constitutes
acceptable credit support under the Guardian financing agreement. This letter of
credit was cash collateralized by Panhandle
CMS-26
CMS Energy Corporation
with approximately $63 million. As of September 30, 2002, Panhandle has also
provided $16 million of equity contributions to Guardian.
Further, one of the issuers of a joint and several surety bond in the
approximate amount of $187 million supporting a CMS MST gas supply contract has
demanded acceptable collateral for the full amount of such bond. This issuer has
commenced litigation against Enterprises and CMS MST in Michigan federal
district court and is seeking to require Enterprises and CMS MST to provide
acceptable collateral and to prevent them from disposing of or transferring any
corporate assets outside the ordinary course of business before the Court has an
opportunity to fully adjudicate the issuer's claim. Enterprises and CMS MST
continue to work with the issuer to find mutually satisfactory arrangements. The
second issuer of the $187 million surety bond has similar rights in connection
with surety bonds supporting two other CMS MST gas supply contracts, aggregating
approximately $112 million. That surety bond issuer has entered into discussions
with CMS MST about the possible posting of acceptable collateral for all three
additional surety bonds. CMS Energy has reached a settlement in principle that
would provide the surety bond issuers with collateral and resolve the
litigation. However, the settlement is subject to final documentation as well as
approval by the banks that are party to the CMS Energy secured credit lines.
CMS Energy plans to continue to pursue the sale of targeted assets throughout
2002. Even though assets have been identified for sale, management cannot
predict when, nor make assurances regarding the value of the consideration to be
received or whether these sales will occur.
The following information on CMS Energy's contractual obligations, off-balance
sheet financings and commercial commitments is provided to collect information
in a single location so that a picture of liquidity and capital resources is
readily available.
CONTRACTUAL OBLIGATIONS: Contractual obligations include CMS Energy's long-term
debt, notes payable, lease obligations, sales of accounts receivable and other
unconditional purchase obligations, that represent normal business operating
contracts used to assure adequate supply of and minimize exposure to market
price fluctuations. Consumers has long-term power purchase agreements with
various generating plants including the MCV Facility. These contracts require
monthly capacity payments based on the plants' availability or deliverability.
These payments are approximately $45 million per month for year 2002, which
includes $33 million related to the MCV Facility. If a plant is not available to
deliver electricity to Consumers, then Consumers would not be obligated to make
the capacity payment until the plant could deliver.
Contractual Obligations In Millions
- --------------------------------------------------------------------------------------------------------------
Payments Due
-------------------------------------------------------------
September 30 Total 2002 2003 2004 2005 2006 and beyond
- --------------------------------------------------------------------------------------------------------------
On-balance sheet:
Long-term debt $ 6,585 $ 158 $ 562 $ 1,424 $706 $ 3,735
Notes payable 245 10 235 - - -
Capital lease obligations 123 50 21 19 18 15
- --------------------------------------------------------------------------------------------------------------
Off-balance sheet:
Operating leases 83 5 12 9 8 49
Non-recourse debt of FMLP 276 65 8 54 41 108
Sale of accounts receivable 325 325 - - - -
Unconditional purchase
Obligations 18,038 955 1,171 925 858 14,129
- ---------------------------------------------------------------------------------------------------------------
OFF-BALANCE SHEET ARRANGEMENTS: CMS Energy, through its subsidiary companies,
has equity investments in
CMS-27
CMS Energy Corporation
partnerships and joint ventures in which they have a minority ownership
interest. As of September 30, 2002, CMS Energy's proportionate share of
unconsolidated debt associated with these investments was $2.8 billion, which
includes the operating leases and non-recourse debt of FMLP shown in the table
above. This unconsolidated debt is non-recourse to CMS Energy and is not
included in the amount of long-term debt that appears on CMS Energy's
Consolidated Balance Sheets.
COMMERCIAL COMMITMENTS: As of September 30, 2002, CMS Energy, Enterprises, and
their subsidiaries have guaranteed payment of obligations through guarantees,
indemnities and letters of credit, of unconsolidated affiliates and related
parties approximating $1.5 billion. Included in this amount, Enterprises, in the
ordinary course of its business, has guaranteed contracts of CMS MST that
contain certain schedule and performance requirements. As of September 30, 2002,
the actual amount of financial exposure covered by these guarantees and
indemnities was $473 million. Management monitors and approves these obligations
and believes it is unlikely that CMS Energy would be required to perform or
otherwise incur any material losses associated with these guarantees.
Commercial Commitments In Millions
- --------------------------------------------------------------------------------------------------------------
Commitment Expiration
------------------------------------------------------------
September 30 Total 2002 2003 2004 2005 2006 and beyond
- --------------------------------------------------------------------------------------------------------------
Off-balance sheet:
Guarantees $ 995 $ 20 - - - 975
Indemnities 267 - 5 - 36 226
Letters of Credit 240 28 191 18 - 3
- --------------------------------------------------------------------------------------------------------------
For further information, see Note 6, Short-Term and Long-Term Financings and
Capitalization, incorporated by reference herein.
CAPITAL EXPENDITURES
CMS Energy estimates that capital expenditures, including new lease commitments
and investments in new business developments through partnerships and
unconsolidated subsidiaries, will total $2.1 billion during 2002 through 2004.
These estimates are prepared for planning purposes and are subject to revision.
CMS Energy expects to satisfy a substantial portion of the capital expenditures
with cash from operations. As of September 2002, Consumers had $250 million in
credit facilities and, through its wholly owned subsidiary Consumers Receivable
Funding, a $325 million trade receivable sale program in place as anticipated
sources of funds for general corporate purposes and currently expected capital
expenditures.
CMS Energy estimates capital expenditures by business segment over the next
three years as follows:
In Millions
- -------------------------------------------------------------------------------------------------------------------
Years Ending December 31 2002 2003 2004
- -------------------------------------------------------------------------------------------------------------------
Consumers electric operations (a) (b) $ 455 $ 345 $ 410
Consumers gas operations (a) 190 145 165
Natural gas transmission 150 - -
Independent power production 50 10 80
Oil and gas exploration and production 40 - -
Marketing, services and trading 10 - -
Other 15 - -
---------------------------------------------
$910(c) $500(d) $655(d)
===================================================================================================================
CMS-28
CMS Energy Corporation
(a) These amounts include an attributed portion of Consumers' anticipated
capital expenditures for plant and equipment common to both the electric and gas
utility businesses.
(b) These amounts include estimates for capital expenditures that may be
required by recent revisions to the Clean Air Act's national air quality
standards. For further information see Note 5, Uncertainties - Electric
Environmental Matters.
(c) This amount include Panhandle's estimated capital expenditures of $124
million in 2002, which includes expenditures associated with the Trunkline LNG
terminal expansion, for which an application was filed with the FERC in December
2001, estimated at $8 million in 2002.
(d) These amounts exclude Panhandle's estimated capital expenditures of $112
million in 2003 and $124 million in 2004, which include expenditures associated
with the Trunkline LNG terminal expansion, estimated at $33 million in 2003 and
$66 million in 2004. CMS Energy is exploring the sale of Panhandle. For
further information, see Outlook section of the MD&A.
For further explanation of CMS Energy's planned investments for the years 2002
through 2004, see the Outlook section below.
MARKET RISK INFORMATION
CMS Energy is exposed to market risks including, but not limited to, changes in
interest rates, currency exchange rates, commodity prices and equity security
prices. CMS Energy's derivative activities are subject to the direction of the
Executive Oversight Committee, which is comprised of certain members of CMS
Energy's senior management, and its Risk Committee, which is comprised of CMS
Energy business unit managers and chaired by the CMS Chief Risk Officer. The
purpose of the risk management policy is to measure and limit CMS Energy's
overall energy commodity risk by implementing an enterprise-wide policy across
all CMS Energy business units. This allows CMS Energy to maximize the use of
hedges among its business units before utilizing derivatives with external
parties. The role of the Risk Committee is to review the corporate commodity
position and ensure that net corporate exposures are within the economic risk
tolerance levels established by the Board of Directors. Management employs
established policies and procedures to manage its risks associated with market
fluctuations, including the use of various derivative instruments such as
futures, swaps, options and forward contracts. When management uses these
derivative instruments, it intends that an opposite movement in the value of the
hedged item would offset any losses incurred on the derivative instruments.
CMS Energy has performed sensitivity analyses to assess the potential loss in
fair value, cash flows and earnings based upon hypothetical 10 percent increases
and decreases in market exposures. Management does not believe that sensitivity
analyses alone provide an accurate or reliable method for monitoring and
controlling risks; therefore, CMS Energy and its subsidiaries rely on the
experience and judgment of senior management and traders to revise strategies
and adjust positions as they deem necessary. Losses in excess of the amounts
determined in the sensitivity analyses could occur if market rates or prices
exceed the 10 percent shift used for the analyses.
COMMODITY PRICE RISK: CMS Energy is exposed to market fluctuations in the price
of natural gas, oil, electricity, coal, natural gas liquids and other
commodities. CMS Energy employs established policies and procedures to manage
these risks using various commodity derivatives, including futures contracts,
options and swaps (which require a net cash payment for the difference between a
fixed and variable price), for non-trading purposes. The prices of these energy
commodities can fluctuate because of, among other things, changes in the supply
of and demand for those commodities. To minimize adverse price changes, CMS
Energy also hedges certain inventory and purchases and sales contracts. Based on
a sensitivity analysis, CMS Energy estimates that if energy commodity prices
average 10 percent higher or lower, pretax operating income for the subsequent
nine months would increase or decrease by ($1.0) million and $1.0 million,
respectively. These hypothetical 10 percent shifts in quoted commodity prices
would not have had a material impact on CMS Energy's
CMS-29
CMS Energy Corporation
consolidated financial position or cash flows as of September 30, 2002. The
analysis does not quantify short-term exposure to hypothetically adverse price
fluctuations in inventories or for commodity positions related to trading
activities.
Consumers enters into electric call options, gas fuel for generation call
options and swap contracts, fixed price gas supply contracts containing embedded
put options, fixed priced weather-based gas supply call options and fixed priced
gas supply put options. The electric call options are used to protect against
risk due to fluctuations in the market price of electricity and to ensure a
reliable source of capacity to meet customers' electric needs. The gas fuel for
generation call options and swap contracts are used to protect generation
activities against risk due to fluctuations in the market price of natural gas.
The gas supply contracts containing embedded put options, the weather-based gas
supply call options, and the gas supply put options are used to purchase
reasonably priced gas supply.
As of September 30, 2002, the fair value based on quoted future market prices of
electricity-related call option and swap contracts was $8 million. At September
30, 2002, assuming a hypothetical 10 percent adverse change in market prices,
the potential reduction in fair value associated with these contracts would be
$2 million. As of September 30, 2002, Consumers had an asset of $30 million,
related to premiums incurred for electric call option contracts. Consumers'
maximum exposure associated with the call option contracts is limited to the
premiums incurred. As of September 30, 2002, the fair value based on quoted
future market prices of gas supply-related call and put option contracts was $1
million. At September 30, 2002, assuming a hypothetical 10 percent adverse
change in market prices, the potential reduction in fair value associated with
these contracts would be $.3 million.
Consumers is also planning to purchase nitrogen oxide emission credits in the
years 2005 through 2008 to supplement its environmental compliance plan. The
cost of these credits based on today's market is estimated to be $6 million per
year, however, the market for nitrogen oxide emission credits is volatile and
the price could change significantly. Based on these estimated costs, a
hypothetical 10 percent adverse change in the market price would have a result
of increasing the cost of the credits by $2 million.
INTEREST RATE RISK: CMS Energy is exposed to interest rate risk resulting from
the issuance of fixed-rate and variable-rate debt, including interest rate risk
associated with Trust Preferred Securities, and from interest rate swaps. CMS
Energy uses a combination of fixed-rate and variable-rate debt, as well as
interest rate swaps to manage and mitigate interest rate risk exposure when
deemed appropriate, based upon market conditions. CMS Energy employs these
strategies to provide a balance between risk and the lowest cost of capital. At
September 30, 2002, the carrying amounts of long-term debt and Trust Preferred
Securities were $6.6 billion and $0.9 billion, respectively, with corresponding
fair values of $6.0 billion and $0.7 billion, respectively. Based on a
sensitivity analysis at September 30, 2002, CMS Energy estimates that if market
interest rates average 10 percent higher or lower, earnings before income taxes
for the subsequent 12 months would decrease or increase, respectively, by
approximately $7 million. In addition, based on a 10 percent adverse shift in
market interest rates, CMS Energy would have an exposure of approximately $365
million to the fair value of its long-term debt and Trust Preferred Securities
if it had to refinance all of its long-term fixed-rate debt and Trust Preferred
Securities. CMS Energy does not intend to refinance its entire fixed-rate debt
and Trust Preferred Securities in the near term and believes that any adverse
change in interest rates would not have a material effect on CMS Energy's
consolidated financial position as of September 30, 2002.
At September 30, 2002, the fair value of CMS Energy's floating to fixed interest
rate swaps with a notional amount of $294 million was $9 million, which
represents the amount CMS Energy would pay to settle. The swaps mature at
various times through 2006 and are designated as cash flow hedges for accounting
purposes.
CURRENCY EXCHANGE RISK: CMS Energy is exposed to currency exchange risk arising
from investments in foreign operations as well as various international projects
in which CMS Energy has an equity interest and
CMS-30
CMS Energy Corporation
which have debt denominated in U.S. Dollars. CMS Energy typically uses forward
exchange contracts and other risk mitigating instruments to hedge currency
exchange rates. The impact of the hedges on the investments in foreign
operations is reflected in other comprehensive income as a component of foreign
currency translation adjustment. For the first nine months of 2002, the
mark-to-market adjustment for hedging was approximately zero of the total net
foreign currency translation adjustment of $420 million of which $400 million
was related to the Argentine currency translation adjustment. Based on a
sensitivity analysis at September 30, 2002, a 10 percent adverse shift in
currency exchange rates would not have a material effect on CMS Energy's
consolidated financial position or results of operations. At September 30, 2002,
the estimated fair value of the foreign exchange hedges was immaterial.
EQUITY SECURITY PRICE RISK: CMS Energy and certain of its subsidiaries have
equity investments in companies in which they hold less than a 20 percent
interest. As of September 30, 2002, a hypothetical 10 percent adverse shift in
equity securities prices would not have a material effect on CMS Energy's
consolidated financial position, results of operations or cash flows.
For a discussion of accounting policies related to derivative transactions, see
Note 8, Risk Management Activities and Financial Instruments, incorporated by
reference herein.
OUTLOOK
PENDING RESTATEMENT
As a result of certain events previously disclosed regarding round-trip trading,
CMS Energy has engaged Ernst & Young to re-audit its financial statements for
the fiscal years ended December 31, 2001 and 2000. During the course of the
re-audit, in consultation with its new auditors, CMS Energy has determined that
certain adjustments discussed elsewhere in this Form 10-Q (unrelated to the
round-trip trades) by CMS Energy, Consumers, and Panhandle to their consolidated
financial statements for the fiscal years ended December 2001 and 2000 are
required. At the time it adopted the accounting treatments for the items, CMS
Energy believed that such treatments were appropriate under generally accepted
accounting principles, and Arthur Andersen concurred. CMS Energy has now
determined it will adopt different accounting for certain transactions, upon the
recommendation of Ernst & Young, as discussed elsewhere in this Form 10-Q. As a
result, following completion of the re-audit, CMS Energy, Consumers and
Panhandle intend to file an amended Form 10-K for the fiscal year ended December
31, 2001. In addition, CMS Energy, Consumers and Panhandle will file amended
Form 10-Qs for the quarters ended March 31, 2002, June 30, 2002 and September
30, 2002 following completion of Ernst & Young's review of the interim financial
statements for these periods. As a result of these reviews and re-audits, there
may be revisions to the financial statements contained in the above-referenced
reports, including this Form 10-Q, which are in addition to the known revisions
described earlier, some of which could be material. CMS Energy has advised the
staff of the SEC about the pending restatements. CMS Energy is working with
Ernst & Young to resolve these issues and expects it will file all restated
results by the end of January 2003. For more information, see the sections
entitled "Round Trip Trades" and "Change in Auditors and Pending Restatements"
at the beginning of this MD&A.
LIQUIDITY AND CAPITAL RESOURCES
CMS Energy's liquidity and capital requirements are generally a function of its
results of operations, capital expenditures, contractual obligations, working
capital needs and collateral requirements. CMS Energy has historically met its
consolidated cash needs through its operating and investing activities and, as
needed, through access to bank financing and the capital markets. As discussed
above, for the remainder of 2002 and during 2003, CMS Energy has contractual
obligations and planned capital expenditures that would require substantial
amounts of cash. CMS Energy and its subsidiaries also have approximately $1.6
billion of publicly issued and credit facility debt maturing in 2003, including
the CMS Energy credit facilities described above. In addition, CMS Energy may
CMS-31
CMS Energy Corporation
also become subject to liquidity demands pursuant to commercial commitments
under guaranties, indemnities and letters of credit as indicated above.
CMS Energy is addressing its near-to-mid-term liquidity and capital requirements
through a financial improvement plan which involves the sale of non-strategic
and under-performing assets, reduced capital expenditures, cost reductions and
other measures. As noted elsewhere in this MD&A, CMS Energy has improved its
liquidity through asset sales, with a total of approximately $2.7 billion in
cash proceeds from such sales over the past two years. CMS Energy believes that
further targeted asset sales, together with further reductions in operating
expenses and capital expenditures, will also contribute to improved liquidity.
CMS Energy believes that, assuming the successful implementation of its
financial improvement plan, its current level of cash and borrowing capacity,
along with anticipated cash flows from operating and investing activities, will
be sufficient to meet its liquidity needs through 2003, including the
approximately $1.6 billion in 2003 debt maturities.
As discussed above, CMS Energy's, Consumers' and Panhandle's financial
statements will be restated. As a result, CMS Energy, Consumers and Panhandle
are at present unable to deliver certified September 30, 2002 financial
statements to lenders as required under certain bank facilities. Although CMS
Energy, Consumers and Panhandle believe they will be able to secure waivers of
this requirement, should they be unable to do so, they could be declared to be
in default and the debt thereunder could be accelerated and become immediately
due and payable. In addition, the occurrence of such an acceleration could
entitle the holders of other debt of CMS Energy, Consumers and Panhandle to
demand immediate repayment. The earliest date that an acceleration from a
failure to deliver certified financial statements could occur is ten business
days after receipt of notice of default after November 29, 2002.
CMS Energy's January 15, 1994 indenture restricts CMS Energy from incurring
additional indebtedness when the debt ratio is in excess of 75 percent. CMS
Energy expects that the aggregate effect of non-cash charges to equity and the
reconsolidation of debt on the balance sheet anticipated to occur in the fourth
quarter of 2002 will result in a year end debt ratio in excess of 75 percent. In
this event, CMS Energy and certain of its subsidiaries other than Consumers will
be restricted from incurring new indebtedness until this condition is remedied.
This restriction will not prevent CMS Energy from refinancing existing
indebtedness or incurring up to $1 billion in bank financing. This debt ratio
could be significantly reduced if CMS Energy decides to proceed with its sale of
Panhandle, its sale of CMS Field Services, other asset sales or other options
such as the securitization of additional assets at Consumers.
It should be noted that CMS Energy has historically met its liquidity needs
through a combination of operating and investing activities, including through
access to bank financing and the capital markets. As a result of the impact of
the re-audit and pending restatement, ratings downgrades and related changes in
its financial situation, CMS Energy's access to bank financing and the capital
markets and its ability to incur additional indebtedness may be restricted.
There can be no assurance that the financial improvement plan will be
successful, or that the necessary bank waivers will be obtained and the debt
ratio lowered. A failure to achieve any of these goals could have a material
adverse effect on CMS Energy's liquidity and operations. In such event, it would
be required to consider the full range of strategic measures available to
companies in similar circumstances.
CORPORATE OUTLOOK
CMS Energy announced in October 2001 significant changes in its business
strategy in order to strengthen its balance sheet, provide more transparent and
predictable future earnings, and lower its business risk by focusing its future
business growth primarily in North America. Specifically, CMS Energy announced
its plans to sell or optimize non-strategic and under-performing international
assets and discontinue its international energy distribution business. CMS
Energy also announced its plans to discontinue all new development outside North
America, which includes closing all non-U.S. development offices, except for
certain prior international commitments.
CMS Energy will continue to focus geographically on key growth areas where it
already has significant investments and opportunities. CMS Energy's focus will
be on North America, and on certain existing international operations and prior
commitments in the Middle East.
Consistent with this "back-to-basics" strategy, CMS Energy is actively pursuing
the sale of non-strategic and under-performing assets in order to improve cash
flow and the balance sheet and has received approximately $2.7 billion of cash
from asset sales, securitization proceeds and proceeds from LNG monetization out
of its $2.9 billion asset sales and balance sheet improvement program. Upon the
sale of additional non-strategic and under-performing assets, the proceeds
realized may be materially different than the book value of those assets. Even
though these assets have been identified for sale, management cannot predict
when, nor make any assurances that, these asset sales will occur. CMS Energy
anticipates, however, that the sales, if any, will result in additional cash
proceeds that will be used to retire existing debt of CMS Energy, Consumers
and/or Panhandle.
In June 2002, CMS Energy announced its plans to sell CMS MST's performance
contracting subsidiary, CMS Viron. CMS MST has eliminated its speculative
trading business and reduced its workforce by approximately 25 percent.
In July 2002, CMS Energy began to undertake a series of initiatives to further
sharpen its business focus and reduce operating costs. These include relocating
the corporate headquarters from Dearborn, Michigan to Jackson, Michigan, which
will result in lower operating and information technology costs starting in
2003, changes to CMS Energy's employee benefit plans, and adjustments to the
CEO's compensation package, which will be based largely on the financial
performance of CMS Energy.
In August 2002, CMS Energy began exploring the sale of Panhandle and CMS Field
Services business units as
CMS-32
CMS Energy Corporation
part of its ongoing effort to strengthen its balance sheet, improve credit
ratings and enhance financial flexibility. The Panhandle units to be considered
for sale are Panhandle Eastern Pipe Line Company, Trunkline Gas Company, Sea
Robin, Pan Gas Storage and Panhandle's interests in LNG Holdings, Guardian and
Centennial. CMS Energy has begun assessing the market's interest in purchasing
these pipeline and field services businesses and it is reviewing the financial,
legal and regulatory issues associated with the possible sale.
In September 2002, CMS Energy closed on the sale of the stock of CMS Oil and Gas
and the stock of a subsidiary of CMS Oil and Gas that holds property in
Venezuela. In October 2002, CMS Energy closed on the sale of CMS Oil and Gas's
properties in Colombia. As a result of these closings, CMS Energy has completed
its exit from the oil and gas exploration and production business. The proceeds
from the combined sales total approximately $212 million and have been used to
retire the remaining balance on a $150 million Enterprises term loan due in
December 2002 and a portion of a $295.8 million CMS Energy loan due March 2003.
The combined sales will result in an after-tax loss of approximately $90
million, which is included in discontinued operations at September 30, 2002.
In October 2002, CMS Land executed a settlement agreement abandoning its 50%
ownership interest in Bay Harbor Company, LLC, a real estate development company
located in the northwestern region of Michigan's lower peninsula. The settlement
agreement requires CMS Land to pay $16 million to Bay Harbor in consideration
for certain indemnities and past liabilities assumed by Bay Harbor. CMS Land's
investment in Bay Harbor at September 30, 2002 was $9 million.
DIVERSIFIED ENERGY OUTLOOK
NATURAL GAS TRANSMISSION OUTLOOK: Panhandle has a one-third interest in Guardian
Pipeline, L.L.C., which is currently constructing a 141-mile, 36-inch pipeline
from Illinois to southeastern Wisconsin for the transportation of natural gas
beginning late 2002. Upon completion of the project, Trunkline will operate and
maintain the pipeline. Panhandle also has a one-third interest in the Centennial
Pipeline LLC which operates a 720-mile, 26-inch pipeline extending from the U.S.
Gulf Coast to Illinois for the transportation of interstate refined petroleum
products. The pipeline began commercial service in April 2002.
In April 2001, FERC approved Trunkline's rate settlement without modification.
The settlement resulted in Trunkline reducing its maximum rates in May 2001. The
reduction is expected to reduce revenues by approximately $2 million annually.
In October 2001, Trunkline LNG, in which Panhandle owns an interest through its
equity interest in LNG Holdings, announced the planned expansion of the Lake
Charles, Louisiana facility to approximately 1.2 bcf per day of sendout
capacity, up from its current sendout capacity of 630 million cubic feet per
day. The terminal's storage capacity will also be expanded to 9 bcf from its
current storage capacity of 6.3 bcf. The Commission Staff's Environmental
Assessment determined that the Trunkline LNG expansion facilities do not
constitute a major federal action significantly affecting the environment and
recommended certain compliance and mitigation measures. Comments on the
Environmental Assessment were filed on August 30, 2002. On August 27, 2002 the
FERC issued a "Preliminary Determination on Non-Environmental Issues"
recommending approval of the planned expansion project. The application for a
certificate of public convenience and necessity of the expansion is still
pending final FERC action. The expanded facility is currently expected to be in
operation by January 2006 pending final FERC approvals. The expansion
expenditures are currently expected to be funded by Panhandle loans or equity
contributions to LNG Holdings, which would be sourced by capital markets,
operating cash flows, or other funding.
In October 2001, CMS Energy and Sempra Energy announced an agreement to jointly
develop a major new LNG receiving terminal to bring much-needed natural gas
supplies into northwestern Mexico and southern
CMS-33
CMS Energy Corporation
California. Since the October 2001 announcement, CMS Energy has adjusted its
role in the development of the terminal since CMS Energy's top priority is to
reduce debt and improve the balance sheet which will require restraint in
capital spending. As a result, Panhandle will not be an equity partner in the
project, but is negotiating to participate as the LNG plant operator and will
also provide technical support during the development of the project which is
currently estimated to commence commercial operations in 2007.
The Job Creation and Worker Assistance Act of 2002 provided to corporate
taxpayers a 5-year carryback of tax losses incurred in 2001 and 2002. As a
result of this legislation, CMS Energy was able to carry back a consolidated
2001 tax loss to tax years 1996 through 1999 and obtain refunds of prior years
tax payments totaling $217 million. The tax loss carryback, however, resulted in
a reduction in AMT credit carryforwards that previously had been recorded by CMS
Energy as deferred tax assets in the amount of $41 million. This one-time
non-cash reduction in AMT credit carryforwards has been reflected in the tax
provisions of CMS Energy and each of its consolidated subsidiaries, as of
September 2002, according to their contributions to the consolidated CMS Energy
tax loss, of which $5 million was allocated to Panhandle. This represents an
allocation of only one of CMS Energy's consolidated tax return items, which will
be calculated and allocated to various CMS Energy subsidiaries in the fourth
quarter of 2002. The amount of the final tax allocations to Panhandle may be
materially different than the $5 million recorded for this one item in
September.
CMS Energy has completed the first step of goodwill impairment testing at
Panhandle as required by SFAS No. 142, which indicated a significant impairment
of Panhandle's goodwill existed as of January 1, 2002. Panhandle has $700
million of goodwill recorded as of January 1, 2002 which is subject to this
impairment test. Pursuant to SFAS No. 142 requirements, the actual impairment is
determined in a second step involving a detailed valuation of all assets and
liabilities, the results of which will be reflected as the cumulative effect of
an accounting change, restated to the first quarter of 2002. This valuation work
is being performed utilizing an independent appraiser and will be completed in
the fourth quarter of 2002. Preliminary results of the second step appraisal
indicate that most of Panhandle's goodwill is impaired as of January 1, 2002.
For further information, see Note 4, Goodwill.
In August of 2002, the FERC issued a Notice of Proposed Rulemaking concerning
the management of funds from a FERC-regulated subsidiary by a non-FERC regulated
parent. The proposed rule would establish limits on the amount of funds that
could be swept from a regulated subsidiary to a non-regulated parent under cash
management programs. The proposed rule would require written cash management
arrangements that would specify the duties and restrictions of the participants,
the methods of calculating interest and allocating interest income and expenses,
and the restrictions on deposits or borrowings by money pool members. These cash
management agreements would also require participants to provide documentation
of certain transactions. In the NOPR, the FERC proposed that to participate in a
cash management or money pool arrangement, FERC-regulated entities would be
required to maintain a minimum proprietary capital balance (stockholder's
equity) of 30 percent and both the FERC-regulated entity and its parent would be
required to maintain investment grade credit ratings.
INDEPENDENT POWER PRODUCTION OUTLOOK: CMS Energy's independent power production
subsidiary plans to complete the restructuring of its operations during 2002 and
into 2003 by narrowing the scope of its existing operations and commitments from
four regions to two regions: the U.S. and the Middle East/North Africa. In
addition, its plans include selling designated assets and investments that are
under-performing, non-region focused and non-synergistic with other CMS Energy
business units. The independent power production business unit will continue to
optimize the operations and management of its remaining portfolio of assets in
order to contribute to CMS Energy's earnings and to maintain its reputation for
solid performance in the construction and operation of power plants. CMS Energy
is actively pursuing the sale, full liquidation, or other disposition of several
of its designated assets and investments, but management cannot predict when,
nor make any assurances that, these asset and investment sales will occur.
CMS-34
CMS Energy Corporation
MARKETING, SERVICES AND TRADING OUTLOOK: Dynamic changes in the energy trading
markets over the past year have resulted in a deterioration of credit quality,
loss of market liquidity and a heightened sensitivity to earnings volatility.
Management cannot predict what effect these events may have on the liquidity of
the trading markets in the short-term, but credit constraints continue to
severely limit CMS MST's ability to actively manage and optimize its open
positions. These changes have forced a significant change in CMS MST's business
strategy. CMS MST will continue to streamline its portfolio to reduce
outstanding credit guarantees as well as its non-core businesses. A sale of
MST's wholesale structured power and gas business is expected to be complete by
the first quarter of 2003. The sale of the company's non-core retail offices and
its energy conservation unit, CMS Viron, are expected to be complete by the
first quarter of 2003, however, management cannot make any assurances as to when
these asset sales will actually occur. In September 2002, CMS MST sold its 50
percent equity interest in Enline Energy Solutions LLC at book value. The
proceeds received were immaterial.
UNCERTAINTIES: The results of operations and financial position of CMS Energy's
diversified energy businesses may be affected by a number of trends or
uncertainties that have, or CMS Energy reasonably expects could have, a material
impact on income from continuing operations, cash flows as well as balance sheet
and credit improvement. Such trends and uncertainties include: 1) the ability to
sell or optimize assets or businesses in accordance with its financial plan; 2)
the international monetary fluctuations, particularly in Argentina, as well as
Brazil and Australia; 3) the changes in foreign laws, governmental and
regulatory policies that could significantly reduce the tariffs charged and
revenues recognized by certain foreign investments; 4) the imposition of stamp
taxes on certain South American contracts that could significantly increase
project expenses; 5) the impact of any future rate cases or FERC actions or
orders on regulated businesses and the effects of changing regulatory and
accounting related matters resulting from current events; 6) the increased
competition in the market for transmission of natural gas to the Midwest causing
pressure on prices charged by Panhandle; 7) the impact of ratings downgrades on
CMS Energy's liquidity, costs of operating, current limited access to capital
markets, and cost of capital; and 8) actual amount of goodwill impairment and
related impact on earnings and balance sheet which could negatively impact CMS
Energy's borrowing capacity.
OTHER OUTLOOK
GAS INDEX PRICING REPORTING: On November 4, 2002, CMS Energy announced that it
is conducting an internal review of the natural gas trade information provided
by CMS MST and CMS Field Services to energy industry publications that compile
and report index prices. A preliminary analysis indicates that some employees
provided inaccurate information in the voluntary reports. CMS Energy and its
subsidiaries no longer provide natural gas trade information to energy industry
publications. CMS Energy has notified the appropriate regulatory and
governmental agencies of this review. On November 5, 2002, CMS Energy received
an information request from the Commodity Futures Trading Commission pursuant to
a prior subpoena relating to round trip trading. The Commodity Futures Trading
Commission requested certain information regarding the employees involved in
providing the inaccurate natural gas trade data to industry publications as well
as details of the information provided. CMS Energy has produced documents and
information responsive to the November 5, 2002 request.
SEC INVESTIGATION: CMS Energy is cooperating with investigations concerning
round-trip trading, including an investigation by the SEC regarding round-trip
trades and the CMS Energy's financial statements, accounting policies and
controls, and investigations by the United States Department of Justice, the
Commodity Futures Trading Commission and the FERC. CMS Energy has also received
subpoenas from the United States Attorney's Office for the Southern District of
New York and from the United States Attorney's Office in Houston regarding
investigations of these trades and has received a number of shareholder class
action lawsuits. CMS Energy is unable to predict the outcome of these matters,
and what effect, if any, these investigations will have on its business.
CMS-35
CMS Energy Corporation
SECURITIES CLASS ACTION LAWSUITS: Eighteen separate civil lawsuits have been
filed in federal court in Michigan in connection with round-trip trading,
alleging (i) violation of Section 10(b) and Rule 10b-5 of the Securities
Exchange Act of 1934 ("Exchange Act") and (ii) violation of Section 20(a) of the
Exchange Act. (See Exhibit 99(d) for case names, dates instituted and principal
parties) All suits name Messrs. McCormick and Wright and CMS Energy as
defendants. Consumers Energy, Mr. Joos and Ms. Pallas are named as defendants on
certain of the suits. The cases will be consolidated into a single lawsuit.
These complaints generally seek unspecified damages based on allegations that
the defendants violated United States securities laws and regulations by making
allegedly false and misleading statements about the Company's business and
financial condition. The Company intends to vigorously defend against these
actions. CMS Energy cannot predict the outcome of this litigation.
DEMAND FOR ACTIONS AGAINST OFFICERS AND DIRECTORS: The Board of Directors
received a demand, on behalf of a shareholder of CMS Energy Common Stock,
that it commence civil actions (i) to remedy alleged breaches of fiduciary
duties by CMS Energy officers and directors in connection with round-trip
trading at CMS Energy, and (ii) to recover damages sustained by CMS Energy as a
result of alleged insider trades alleged to have been made by certain current
and former officers of CMS Energy and its subsidiaries. If the Board elects not
to commence such actions, the shareholder has stated that he will initiate a
derivative suit, bringing such claims on behalf of CMS Energy. CMS Energy is
seeking to elect two new members to its Board of Directors to serve as an
independent investigation committee to determine whether it is in the best
interest of CMS Energy to bring the action demanded by the shareholder. Counsel
for the shareholder has agreed to extend the time for CMS Energy to respond to
the demand. CMS Energy cannot predict the outcome of this litigation.
ERISA CLAIMS: On July 11, 2002 and July 18, 2002, two Consumers employees filed
separate alleged class action lawsuits on behalf of the participants and
beneficiaries of the CMS Employees' Savings and Incentive Plan in the United
States District Court for the Eastern District of Michigan. CMS Energy,
Consumers and CMS MST are defendants in one action, and CMS Energy, Consumers,
and other alleged fiduciaries are defendants in the other. The complaints allege
various counts arising under the ERISA. The two cases will be consolidated into
a single lawsuit and a single consolidated amended complaint will be filed. CMS
Energy intends to vigorously defend against these actions. CMS Energy cannot
predict the outcome of this litigation.
TERRORIST ATTACKS: Since the September 11, 2001 terrorist attacks in the United
States, CMS Energy has increased security at substantially all facilities and
infrastructure, and will continue to evaluate security on an ongoing basis. CMS
Energy may be required to comply with federal and state regulatory security
measures promulgated in the future. As a result, CMS Energy anticipates that
increased operating costs related to security after September 11, 2001 could be
significant. It is not certain that any additional costs will be recovered in
Consumers' or Panhandle's rates.
OTHER: Rouge Steel Company, with whom DIG has contracted to sell steam for
industrial use and purchase blast furnace gas as fuel at prices significantly
less than the cost of natural gas, is considering altering certain of its
operational processes as early as mid-2004. These alterations could have an
adverse operational and financial impact on DIG by significantly reducing Rouge
Steel Company's demands for steam from DIG and its ability to provide DIG with
economical blast furnace gas. However, these alterations may result in
additional electric sales to Rouge Steel Company. CMS Energy is currently
assessing these potential operational and financial impacts and DIG is
evaluating alternatives to its current contractual arrangements with Rouge Steel
Company, but CMS Energy cannot predict the ultimate outcome of these matters at
this time.
CONSUMERS' ELECTRIC UTILITY BUSINESS OUTLOOK
GROWTH: Over the next five years, Consumers expects electric deliveries
(including both full service sales and delivery service to customers who choose
to buy generation service from an alternative electric supplier, but excluding
transactions with other wholesale market participants including other electric
utilities) to grow at an
CMS-36
CMS Energy Corporation
average rate of approximately two percent per year based primarily on a steadily
growing customer base. This growth rate reflects a long-range expected trend of
growth. Growth from year to year may vary from this trend due to customer
response to abnormal weather conditions and changes in economic conditions
including, utilization and expansion of manufacturing facilities. Consumers has
experienced much stronger than expected growth in 2002 as a result of warmer
than normal summer weather. Assuming that normal weather conditions will occur
in 2003, electric deliveries are expected to grow less than one percent over the
strong 2002 electric deliveries.
COMPETITION AND REGULATORY RESTRUCTURING: The enactment in 2000 of Michigan's
Customer Choice Act and other developments will continue to result in increased
competition in the electric business. Generally, increased competition can
reduce profitability and threatens Consumers' market share for generation
services. The Customer Choice Act allowed all of the company's electric
customers to buy electric generation service from Consumers or from an
alternative electric supplier as of January 1, 2002. As a result, alternative
electric suppliers for generation services have entered Consumers' market. As of
November 2002, 446 MW of generation services were being provided by such
suppliers. To the extent Consumers experiences "net" Stranded Costs as
determined by the MPSC, the Customer Choice Act allows for the company to
recover such "net" Stranded Costs by collecting a transition surcharge from
those customers who switch to an alternative electric supplier.
Stranded and Implementation Costs: The Customer Choice Act allows electric
utilities to recover the act's implementation costs and "net" Stranded Costs
(without defining the term). The act directs the MPSC to establish a method of
calculating "net" Stranded Costs and of conducting related true-up adjustments.
In December 2001, the MPSC adopted a methodology which calculated "net" Stranded
Costs as the shortfall between: (a) the revenue required to cover the costs
associated with fixed generation assets, generation-related regulatory assets,
and capacity payments associated with purchase power agreements, and (b) the
revenues received from customers under existing rates available to cover the
revenue requirement. Consumers has initiated an appeal at the Michigan Court of
Appeals related to the MPSC's December 2001 "net" Stranded Cost order, as a
result of the uncertainty associated with the outcome of the proceeding
described in the following paragraph.
According to the MPSC, "net" Stranded Costs are to be recovered from retail open
access customers through a Stranded Cost transition charge. Even though the MPSC
set Consumers' Stranded Cost transition charge at zero for calendar year 2000,
those costs for 2000 will be subject to further review in the context of the
MPSC's subsequent determinations of "net" Stranded Costs for 2001 and later
years. The MPSC authorized Consumers to use deferred accounting to recognize the
future recovery of costs determined to be stranded. In April 2002, Consumers
made "net" Stranded Cost filings with the MPSC for $22 million and $43 million
for 2000 and 2001, respectively. In the same filing, Consumers estimated that it
would experience "net" Stranded Costs of $126 million for 2002. After a series
of appeals and hearings, Consumers, in its hearing brief, filed in August 2002,
revised its request for Stranded Costs to $7 million and $4 million for 2000 and
2001, respectively, and an estimated $73 million for 2002. The single largest
reason for the difference in the filing was the exclusion of all costs
associated with expenditures required by the Clean Air Act. Consumers, in a
separate filing, requested regulatory asset accounting treatment for its Clean
Air Act expenditures through 2003. The outcome of these proceedings before the
MPSC is uncertain at this time.
Since 1997, Consumers has incurred significant electric utility restructuring
implementation costs. The following table outlines the applications filed by
Consumers with the MPSC and the status of recovery for these costs.
CMS-37
CMS Energy Corporation
In Millions
- --------------------------------------------------------------------------------------------------------------
Year Filed Year Incurred Requested Pending Allowed Disallowed
- --------------------------------------------------------------------------------------------------------------
1999 1997 & 1998 $20 $ - $15 $5
2000 1999 30 - 25 5
2001 2000 25 - 20 5
2002 2001 8 8 - -
==============================================================================================================
The MPSC disallowed certain costs based upon a conclusion that these amounts did
not represent costs incremental to costs already reflected in electric rates. In
the orders received for the years 1997 through 2000, the MPSC also reserved the
right to review again the total implementation costs depending upon the progress
and success of the retail open access program, and ruled that due to the rate
freeze imposed by the Customer Choice Act, it was premature to establish a cost
recovery method for the allowable implementation costs. In addition to the
amounts shown, as of September 2002, Consumers incurred and deferred as a
regulatory asset, $3 million of additional implementation costs and has also
recorded as a regulatory asset $13 million for the cost of money associated with
total implementation costs. Consumers believes the implementation costs and the
associated cost of money are fully recoverable in accordance with the Customer
Choice Act. Cash recovery from customers will probably begin after the rate
freeze or rate cap period has expired. Consumers cannot predict the amounts the
MPSC will approve as allowable costs.
Consumers is also pursuing recovery, through the MISO of approximately $7
million in certain electric utility restructuring implementation costs related
to its former participation in the development of the Alliance RTO. However,
Consumers cannot predict the amounts it will be reimbursed by the MISO.
Rate Caps: The Customer Choice Act imposes certain limitations on electric rates
that could result in Consumers being unable to collect from customers its full
cost of conducting business. Some of these costs are beyond Consumers' control.
In particular, if Consumers needs to purchase power supply from wholesale
suppliers while retail rates are frozen or capped, the rate restrictions may
make it impossible for Consumers to fully recover purchased power and associated
transmission costs from its customers. As a result, Consumers may be unable to
maintain its profit margins in its electric utility business during the rate
freeze or rate cap periods. The rate freeze is in effect through December 31,
2003. The rate caps are in effect through at least December 31, 2004 for small
commercial and industrial customers, and at least through December 31, 2005 for
residential customers.
Industrial Contracts: In response to industry restructuring efforts, Consumers
entered into multi-year electric supply contracts with certain large industrial
customers to provide electricity at specially negotiated prices, usually at a
discount from tariff prices. The MPSC approved these special contracts as part
of its phased introduction to competition. Unless terminated or restructured
these contracts are in effect through 2005. As of September 2002, some contracts
have expired, but outstanding contracts involve approximately 500 MW. Consumers
cannot predict the ultimate financial impact of changes related to these power
supply contracts, or whether additional contracts will be necessary or
advisable.
Code of Conduct: In December 2000, as a result of the passage of the Customer
Choice Act, the MPSC issued a new code of conduct that applies to electric
utilities and alternative electric suppliers. The code of conduct seeks to
prevent cross-subsidization, information sharing, and preferential treatment
between a utility's regulated and unregulated services. The new code of conduct
is broadly written, and as a result, could affect Consumers' retail gas
business, the marketing of unregulated services and equipment to Michigan
customers, and internal transfer pricing between Consumers' departments and
affiliates. In October 2001, the new code of conduct was reaffirmed without
substantial modification. Consumers appealed the MPSC orders related to the code
of conduct and sought a stay of the orders until the appeal was complete;
however, the request for a stay
CMS-38
CMS Energy Corporation
was denied. Consumers filed a compliance plan in accordance with the code of
conduct. It also sought waivers to the code of conduct in order to continue
utility activities that provide approximately $50 million in annual revenues. In
October 2002, the MPSC denied waivers for three programs that provide
approximately $32 million in revenues. The waivers denied included all waivers
associated with the appliance service plan program that has been offered by
Consumers for many years. Consumers has filed a renewed motion for a stay of the
effectiveness of the Code of Conduct and an appeal of the waiver denials with
the Michigan Court of Appeals. On November 8, 2002, the Michigan Court of
Appeals denied Consumers' request for a stay. Consumers is continuing to explore
its options which may include seeking an appeal of the Michigan Court of
Appeals' ruling. The full impact of the new code of conduct on Consumers'
business will remain uncertain until the appellate courts issue definitive
rulings. Recently, in an appeal involving affiliate pricing guidelines, the
Michigan Court of Appeals struck the guidelines down because of a procedurally
defective manner of enactment by the MPSC. A similar procedure was used by the
MPSC in enacting the new code of conduct.
Energy Policy: Uncertainty exists regarding the enactment of a national
comprehensive energy policy, specifically federal electric industry
restructuring legislation. A variety of bills introduced in the United States
Congress in recent years aimed to change existing federal regulation of the
industry. If the federal government enacts a comprehensive energy policy or
electric restructuring legislation, then that legislation could potentially
affect company operations and financial requirements.
Transmission: In 1999, the FERC issued Order No. 2000, strongly encouraging
electric utilities to transfer operating control of their electric transmission
system to an RTO, or sell the facilities to an independent company. In addition,
in June 2000, the Michigan legislature passed Michigan's Customer Choice Act,
which also requires utilities to divest or transfer the operating authority of
transmission facilities to an independent company. Consumers chose to offer its
electric transmission system for sale rather than own and invest in an asset it
could not control. In May 2002, Consumers sold its electric transmission system
for approximately $290 million in cash to MTH, a non-affiliated limited
partnership whose general partner is a subsidiary of Trans-Elect, Inc.
Trans-Elect, Inc. submitted the winning bid through a competitive bidding
process, and various federal agencies approved the transaction. Consumers did
not provide any financial or credit support to Trans-Elect, Inc. Certain of
Trans-Elect's officers and directors are former officers and directors of CMS
Energy, Consumers and their subsidiaries. None of them were employed by CMS
Energy, Consumers, or their affiliates when the transaction was discussed
internally and negotiated with purchasers. As a result of the sale, Consumers
anticipates that its after-tax earnings will increase by approximately $17
million in 2002, due to the recognition of a $26 million one time gain on the
sale of the electric transmission system. This one time gain is offset by a loss
of revenue from wholesale and retail open access customers who will buy services
directly from MTH, including the loss of a return on the sold electric
transmission system. Consumers anticipates that the future impact of the loss of
revenue from wholesale and retail open access customers who will buy services
directly from MTH and the loss of a return on the sold electric transmission
system on its after-tax earnings will be a decrease of $15 million in 2003, and
a decrease of approximately $14 million annually for the next three years.
Under the agreement with MTH, and subject to certain additional RTO surcharges,
contract transmission rates charged to Consumers will be fixed at current levels
through December 31, 2005, and subject to FERC ratemaking thereafter. MTH will
complete the capital program to expand the transmission system's capability to
import electricity into Michigan, as required by the Customer Choice Act, and
Consumers will continue to maintain the system under a five-year contract with
MTH. Effective April 30, 2002, Consumers and METC withdrew from the Alliance
RTO. For further information, see Note 5, Uncertainties, "Electric Rate Matters
- - Transmission."
In July 2002, the FERC issued a 600-page notice of proposed rulemaking on
standard market design for
CMS-39
CMS Energy Corporation
electric bulk power markets and transmission. Its stated purpose is to remedy
undue discrimination in the use of the interstate transmission system and give
the nation the benefits of a competitive bulk power system. The proposal is
subject to public comment until November 15, 2002 and January 10, 2003 for
certain standard market design issues. Consumers is currently studying the
effects of the proposed rulemaking and intends to file comments with the FERC.
The proposed rulemaking is primarily designed to correct perceived problems in
the electric transmission industry. Consumers sold its electric transmission
system in 2002, but is a transmission customer. The financial impact to
Consumers is uncertain, but the final standard market design rules could
significantly increase delivered power costs to Consumers and the retail
electric customers it serves.
There are multiple proceedings pending before the FERC regarding transitional
transmission pricing mechanisms intended to mitigate the revenue impact on
transmission owners resulting from the elimination of "Rate Pancaking". "Rate
Pancaking" represents the application of the transmission rate of each
individual transmission owner whose system is utilized on the scheduled path of
an energy delivery and its elimination could result in "lost revenues" for
transmission owners. It is unknown what mechanism(s) may result from the
proceedings currently pending before the FERC, and as such, it is not possible
at this time to identify the specific effect on Consumers. It should be noted,
however, that Consumers believes the results of these proceedings could also
significantly increase the delivered power costs to Consumers and the retail
electric customers it serves.
Similarly, other proceedings before the FERC involving rates of transmission
providers of Consumers could increase Consumers' cost of transmitting power to
its customers in Michigan. As RTOs develop and mature in Consumers' area of
electrical operation, and those RTOs respond to FERC initiatives concerning the
services they must provide and the systems they maintain, Consumers believes
that there is likely to be an upward cost trend in transmission used by
Consumers, ultimately increasing the delivered cost of power to Consumers and
the retail electric customers it serves. The specific financial impact on
Consumers of such proceedings and trends are not currently quantifiable.
Wholesale Market Competition: In 1996, Detroit Edison gave Consumers its
four-year notice to terminate their joint operating agreements for the MEPCC.
Detroit Edison and Consumers restructured and continued certain parts of the
MEPCC control area and joint transmission operations, but expressly excluded any
merchant operations (electricity purchasing, sales, and dispatch operations). On
April 1, 2001, Detroit Edison and Consumers began separate merchant operations.
This opened Detroit Edison and Consumers to wholesale market competition as
individual companies. Consumers has successfully operated its independent
merchant system since April 1, 2001. Although Consumers cannot predict the
long-term financial impact of terminating these joint merchant operations, this
change places Consumers in the same competitive position as all other wholesale
market participants.
Wholesale Market Pricing: FERC authorizes Consumers to sell electricity at
wholesale market prices. In authorizing sales at market prices, the FERC
considers the seller's level of "market power," due to the seller's dominance of
generation resources and surplus generation resources in adjacent wholesale
markets. To continue its authorization to sell at market prices, Consumers filed
a traditional market dominance analysis and indicated its compliance therewith
in October 2001. In November 2001, the FERC issued an order modifying the
traditional method of determining market power. In September 2002, a Consumers'
affiliate, CMS MST, was required by the FERC to file an updated market power
study to determine if CMS MST or any of its affiliates, including Consumers, had
market power. The study, using FERC's modified method, found that neither CMS
MST nor its affiliates possess market power.
Consumers cannot predict the impact of these electric industry-restructuring
issues on its financial position, liquidity, or results of operations.
CMS-40
CMS Energy Corporation
PERFORMANCE STANDARDS: In July 2001, the MPSC proposed electric distribution
performance standards for Consumers and other Michigan electric distribution
utilities. The proposal would establish standards related to restoration after
an outage, safety, and customer relations. Failure to meet the standards would
result in customer bill credits. Consumers submitted comments to the MPSC. In
December 2001, the MPSC issued an order stating its intent to initiate a formal
rulemaking proceeding to develop and adopt performance standards. On November 7,
2002, the MPSC issued an order initiating the formal rulemaking proceeding.
Consumers will continue to participate in this process. Consumers cannot predict
the nature of the proposed standards or the likely effect, if any, on Consumers.
For further information and material changes relating to the rate matters and
restructuring of the electric utility industry, see Note 1, Corporate Structure
and Basis of Presentation, and Note 5, Uncertainties, "Electric Rate Matters -
Electric Restructuring" and "Electric Rate Matters - Electric Proceedings."
UNCERTAINTIES: Several electric business trends or uncertainties may affect
Consumers' financial results and condition. These trends or uncertainties have,
or Consumers reasonably expects could have, a material impact on net sales,
revenues, or income from continuing electric operations. Such trends and
uncertainties include: 1) the need to make additional capital expenditures and
increase operating expenses for Clean Air Act compliance; 2) environmental
liabilities arising from various federal, state and local environmental laws and
regulations, including potential liability or expenses relating to the Michigan
Natural Resources and Environmental Protection Acts and Superfund; 3)
uncertainties relating to the storage and ultimate disposal of spent nuclear
fuel and the successful operation of Palisades by NMC; 4) electric industry
restructuring issues, including those described above; 5) Consumers' ability to
meet peak electric demand requirements at a reasonable cost, without market
disruption, and successfully implement initiatives to reduce exposure to
purchased power price increases; 6) the recovery of electric restructuring
implementation costs; 7) Consumers new status as an electric transmission
customer and not as an electric transmission owner/operator; 8) sufficient
reserves for OATT rate refunds; 9) the effects of derivative accounting and
potential earnings volatility, and 10) Consumers' continuing ability to raise
funds at reasonable rates in order to meet the cash requirements of its electric
business. For further information about these trends or uncertainties, see Note
5, Uncertainties.
CONSUMERS' GAS UTILITY BUSINESS OUTLOOK
GROWTH: Over the next five years, Consumers expects gas deliveries, including
gas customer choice deliveries (excluding transportation to the MCV Facility and
off-system deliveries), to grow at an average rate of approximately one percent
per year based primarily on a steadily growing customer base. This growth rate
reflects a long-range expected trend of growth. Growth from year to year may
vary from this trend due to customer response to abnormal weather conditions,
use of gas by independent power producers, changes in competitive and economic
conditions, and the level of natural gas consumption per customer.
GAS RATE CASE: In June 2001, Consumers filed an application with the MPSC
seeking a $140 million distribution service rate increase. Contemporaneously
with this filing, Consumers requested partial and immediate relief in the annual
amount of $33 million. In October 2001, Consumers revised its filing to reflect
lower operating costs and requested a $133 million annual distribution service
rate increase. In December 2001, the MPSC authorized a $15 million annual
interim increase in distribution service revenues. In February 2002, Consumers
revised its filing to reflect lower estimated gas inventory prices and revised
depreciation expense and requested a $105 million distribution service rate
increase. On November 7, 2002, the MPSC issued a final order approving a $56
million annual distribution service rate increase, which includes the $15
million interim increase, with an 11.4 percent authorized return on equity, for
service effective November 8, 2002. See Note 5, Uncertainties "Gas Rate Matters
- - Gas Rate Case" for further information.
UNBUNDLING STUDY: In July 2001, the MPSC directed gas utilities under its
jurisdiction to prepare and file an unbundled cost of service study. The purpose
of the study is to allow parties to advocate or oppose the
CMS-41
CMS Energy Corporation
unbundling of the following services: metering, billing information,
transmission, balancing, storage, backup and peaking, and customer turn-on and
turn-off services. Unbundled services could be separately priced in the future
and made subject to competition by other providers. The subject is likely to
remain the topic of further study by the utilities in 2002 and 2003 and further
consideration by the MPSC. Consumers cannot predict the outcome of unbundling
costs on its financial results and conditions.
In September 2002, the FERC issued an order rejecting a filing by Consumers to
assess certain rates for non-physical gas title tracking services offered by
Consumers. Despite Consumer' arguments to the contrary, the Commission asserted
jurisdiction over such activities and allowed Consumers to refile and justify a
title transfer fee not based on volumes as Consumers proposed. Because the order
was issued 6 years after Consumers made its original filing initiating the
proceeding, over $3 million in non-title transfer tracking fees had been
collected. No refunds have been ordered, and Consumers sought rehearing of the
September order. Consumers has made no reservations for refunds in this matter.
If refunds were ordered they may include interest which would increase the
refund liability to more than the $3 million collected. Consumers is unable to
say with certainty what the final outcome of this proceeding might be.
UNCERTAINTIES: Several gas business trends or uncertainties may affect
Consumers' financial results and conditions. These trends or uncertainties have,
or Consumers reasonably expects could have, a material impact on net sales,
revenues, or income from continuing gas operations. Such trends and
uncertainties include: 1) potential environmental costs at a number of sites,
including sites formerly housing manufactured gas plant facilities; 2) future
gas industry restructuring initiatives; 3) any initiatives undertaken to protect
customers against gas price increases; 4) an inadequate regulatory response to
applications for requested rate increases; 5) market and regulatory responses to
increases in gas costs, including a reduced average use per residential
customer; 6) increased costs for pipeline integrity and safety and homeland
security initiatives that are not recoverable on a timely basis from customers;
and 7) Consumers' continuing ability to raise funds at reasonable rates in order
to meet the cash requirements of its gas business. For further information about
these uncertainties, see Note 5, Uncertainties.
CONSUMERS' OTHER OUTLOOK
TAX LOSS ALLOCATIONS: The Job Creation and Worker Assistance Act of 2002
provided to corporate taxpayers a 5-year carryback of tax losses incurred in
2001 and 2002. As a result of this legislation, CMS Energy was able to carry
back a consolidated 2001 tax loss to tax years 1996 through 1999 and obtain
refunds of prior years tax payments totaling $217 million. The tax loss
carryback, however, resulted in a reduction in AMT credit carryforwards that
previously had been recorded by CMS Energy as deferred tax assets in the amount
of $41 million. This one-time non-cash reduction in AMT credit carryforwards has
been reflected in the tax provisions of CMS Energy and each of its consolidated
subsidiaries, as of September 2002, according to their contributions to the
consolidated CMS Energy tax loss, of which $29 million was allocated to
Consumers. This represents an allocation of only one of CMS Energy's
consolidated tax return items, which will be calculated and allocated to various
CMS Energy subsidiaries in the fourth quarter of 2002. The amount of the final
tax allocations to Consumers may be materially different than recorded for this
one item.
ENERGY-RELATED SERVICES: Consumers offers a variety of energy-related services
to retail customers that focus on appliance maintenance, home safety, commodity
choice, and assistance to customers purchasing heating, ventilation and air
conditioning equipment. Consumers continues to look for additional growth
opportunities in providing energy-related services to its customers. The ability
to offer all or some of these services and other utility related
revenue-generating services, which provide approximately $50 million in annual
revenues, may be restricted by the new code of conduct issued by the MPSC, as
discussed above in Electric Business Outlook, "Competition and Regulatory
Restructuring - Code of Conduct."
CMS-42
CMS Energy Corporation
CMS ENERGY CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 2002 2001 2002 2001
- ---------------------------------------------------------------------------------------------------------------------------
In Millions, Except Per Share Amounts
OPERATING REVENUE
Electric utility $ 776 $ 738 $ 2,013 $ 2,027
Gas utility 134 149 1,002 928
Natural gas transmission 170 205 567 854
Independent power production 93 97 310 314
Marketing, services and trading 159 141 361 590
Other 1 3 32 15
-------------------------------------------------
1,333 1,333 4,285 4,728
- ---------------------------------------------------------------------------------------------------------------------------
OPERATING EXPENSES
Operation
Fuel for electric generation 87 95 275 266
Purchased and interchange power 172 190 308 416
Purchased power - related parties 143 155 416 399
Cost of gas sold 213 234 1,108 1,425
Other 295 259 768 792
-------------------------------------------------
910 933 2,875 3,298
Maintenance 57 59 180 189
Depreciation, depletion and amortization 103 113 329 353
General taxes 52 52 170 171
Loss contracts and reduced asset valuations - 554 - 554
-------------------------------------------------
1,122 1,711 3,554 4,565
- ---------------------------------------------------------------------------------------------------------------------------
PRETAX OPERATING INCOME (LOSS)
Electric utility 175 (63) 406 153
Gas utility (15) (2) 68 78
Natural gas transmission 41 7 140 143
Independent power production 43 (328) 154 (276)
Marketing, services and trading (4) 18 (29) 75
Other (29) (10) (8) (10)
-------------------------------------------------
211 (378) 731 163
- ---------------------------------------------------------------------------------------------------------------------------
OTHER INCOME (DEDUCTIONS)
Accretion expense (9) (9) (26) (26)
Gain (loss) on asset sales, net 12 - 60 (1)
Other, net 6 8 15 22
-------------------------------------------------
9 (1) 49 (5)
- ---------------------------------------------------------------------------------------------------------------------------
EARNINGS (LOSS) BEFORE INTEREST AND TAXES 220 (379) 780 158
- ---------------------------------------------------------------------------------------------------------------------------
FIXED CHARGES
Interest on long-term debt 142 130 385 400
Other interest 7 18 21 47
Capitalized interest (5) (7) (14) (34)
Preferred dividends - - 1 1
Preferred securities distributions 18 25 68 71
-------------------------------------------------
162 166 461 485
- ---------------------------------------------------------------------------------------------------------------------------
INCOME (LOSS) BEFORE INCOME TAXES AND MINORITY INTERESTS 58 (545) 319 (327)
INCOME TAXES (BENEFITS) 50 (184) 147 (109)
MINORITY INTERESTS 2 2 4 3
-------------------------------------------------
INCOME (LOSS) FROM CONTINUING OPERATIONS 6 (363) 168 (221)
INCOME (LOSS) FROM DISCONTINUED OPERATIONS 17 (206) 186 (186)
-------------------------------------------------
INCOME (LOSS) BEFORE CUMULATIVE EFFECT OF CHANGE IN
ACCOUNTING PRINCIPLE AND EXTRAORDINARY ITEM 23 (569) 354 (407)
CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING FOR GOODWILL - - (9) -
-------------------------------------------------
INCOME (LOSS) BEFORE EXTRAORDINARY ITEM 23 (569) 345 (407)
EXTRAORDINARY ITEM - - (8) -
-------------------------------------------------
CONSOLIDATED NET INCOME (LOSS) $ 23 $ (569) $ 337 $ (407)
===========================================================================================================================
AVERAGE COMMON SHARES OUTSTANDING 144 133 137 130
===========================================================================================================================
BASIC EARNINGS (LOSS) PER AVERAGE COMMON SHARE $ .16 $ (4.29) $ 2.45 $ (3.13)
===========================================================================================================================
DILUTED EARNINGS (LOSS) PER AVERAGE COMMON SHARE $ .16 $ (4.29) $ 2.42 $ (3.13)
===========================================================================================================================
DIVIDENDS DECLARED PER COMMON SHARE $ .18 $ .365 $ .91 $ 1.095
===========================================================================================================================
THE ACCOMPANYING CONDENSED NOTES ARE AN INTEGRAL PART OF THESE STATEMENTS.
CMS-43
CMS Energy Corporation
CMS ENERGY CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
NINE MONTHS ENDED
SEPTEMBER 30 2002 2001
- -------------------------------------------------------------------------------------------------------------
In Millions
CASH FLOWS FROM OPERATING ACTIVITIES
Consolidated net income (loss) $ 337 $ (407)
Adjustments to reconcile net income to net cash
provided by operating activities
Depreciation, depletion and amortization (includes nuclear
decommissioning of $5 and $5, respectively) 329 353
Contract losses and revaluations - 554
Discontinued operations (Note 2) (186) 186
Capital lease and debt discount amortization 17 17
Accretion expense 26 26
Undistributed earnings from related parties (102) (2)
(Gain) loss on the sale of assets (60) 1
Cumulative effect of an accounting change 9 -
Extraordinary item 8 -
Changes in other assets and liabilities:
Decrease in accounts receivable and accrued revenues 415 180
Increase in inventories (48) (365)
Decrease in accounts payable and accrued expenses (175) (334)
Decrease in deferred income taxes and investment tax credit (105) (30)
Change in postretirement benefits, net (46) -
Changes in other assets and liabilities (96) 67
-------------------------
Net cash provided by operating activities 323 246
- -------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES
Capital expenditures (excludes assets placed under capital lease) (523) (862)
Investments in partnerships and unconsolidated subsidiaries (49) (163)
Cost to retire property, net (50) (73)
Investments in nuclear decommissioning trust funds (5) (5)
Proceeds from nuclear decommissioning trust funds 19 21
Proceeds from sale of assets 1,527 109
Other (20) (21)
-------------------------
Net cash provided by (used in) investing activities 899 (994)
- -------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from notes, bonds, and other long-term debt 688 1,644
Proceeds from trust preferred securities - 121
Issuance of common stock 350 334
Retirement of bonds and other long-term debt (1,421) (923)
Retirement of trust preferred securities (331) -
Repurchase of common stock - (5)
Payment of common stock dividends (124) (135)
Decrease in notes payable, net (185) (250)
Payment of capital lease obligations (11) (17)
Other financing 30 10
-------------------------
Net cash provided by (used in) financing activities (1,004) 779
- -------------------------------------------------------------------------------------------------------------
NET INCREASE IN CASH AND TEMPORARY CASH INVESTMENTS 218 31
CASH AND TEMPORARY CASH INVESTMENTS, BEGINNING OF PERIOD 189 182
-------------------------
CASH AND TEMPORARY CASH INVESTMENTS, END OF PERIOD $ 407 $ 213
=============================================================================================================
CMS-44
CMS Energy Corporation
OTHER CASH FLOW ACTIVITIES AND NON-CASH INVESTING AND FINANCING ACTIVITIES WERE:
CASH TRANSACTIONS
Interest paid (net of amounts capitalized) $ 421 $ 450
Income taxes paid (net of refunds) (42) (6)
Pension and OPEB cash contribution 126 103
NON-CASH TRANSACTIONS
Nuclear fuel placed under capital lease $ - $ 13
Other assets placed under capital leases 65 15
=============================================================================================================
All highly liquid investments with an original maturity of three months or less
are considered cash equivalents.
THE ACCOMPANYING CONDENSED NOTES ARE AN INTEGRAL PART OF THESE STATEMENTS.
CMS-45
CMS Energy Corporation
CMS ENERGY CORPORATION
Consolidated Balance Sheets
ASSETS SEPTEMBER 30 DECEMBER 31 SEPTEMBER 30
2002 2001 2001
(UNAUDITED) (UNAUDITED) (UNAUDITED)
- --------------------------------------------------------------------------------------------------------------------------------
In Millions
PLANT AND PROPERTY (AT COST)
Electric utility $ 7,504 $ 7,661 $ 7,513
Gas utility 2,692 2,593 2,566
Natural gas transmission 2,308 2,271 2,207
Oil and gas properties (successful efforts method) 21 849 783
Independent power production 699 916 888
International energy distribution 218 228 215
Other 151 113 91
----------------------------------------------------
13,593 14,631 14,263
Less accumulated depreciation, depletion and amortization 6,523 6,833 6,735
----------------------------------------------------
7,070 7,798 7,528
Construction work-in-progress 488 564 567
----------------------------------------------------
7,558 8,362 8,095
- --------------------------------------------------------------------------------------------------------------------------------
INVESTMENTS
Independent power production 706 718 781
Natural gas transmission 269 501 540
Midland Cogeneration Venture Limited Partnership 370 300 296
First Midland Limited Partnership 250 253 249
Other 86 135 105
----------------------------------------------------
1,681 1,907 1,971
- --------------------------------------------------------------------------------------------------------------------------------
CURRENT ASSETS
Cash and temporary cash investments at cost, which approximates market 407 189 213
Accounts receivable, notes receivable and accrued revenue, less
allowances of $16, $17 and $16, respectively 309 681 585
Accounts receivable - Marketing, services and trading,
less allowances of $11, $14 and $4, respectively 441 561 634
Inventories at average cost
Gas in underground storage 630 587 630
Materials and supplies 163 174 145
Generating plant fuel stock 49 52 50
Price risk management assets 240 461 1,093
Prepayments and other 200 206 252
----------------------------------------------------
2,439 2,911 3,602
- --------------------------------------------------------------------------------------------------------------------------------
NON-CURRENT ASSETS
Regulatory Assets
Securitization costs 699 717 710
Postretirement benefits 191 209 214
Abandoned Midland Project 11 12 12
Other 173 167 89
Price risk management assets 386 424 350
Goodwill, net 740 811 824
Nuclear decommissioning trust funds 530 581 568
Notes receivable - related party 203 177 163
Notes receivable 126 134 142
Other 485 568 749
----------------------------------------------------
3,544 3,800 3,821
----------------------------------------------------
TOTAL ASSETS $ 15,222 $ 16,980 $ 17,489
================================================================================================================================
CMS-46
CMS Energy Corporation
STOCKHOLDERS' INVESTMENT AND LIABILITIES SEPTEMBER 30 DECEMBER 31 SEPTEMBER 30
2002 2001 2001
(UNAUDITED) (UNAUDITED) (UNAUDITED)
- ----------------------------------------------------------------------------------------------------------------------------------
In Millions
CAPITALIZATION
Common stockholders' equity $ 2,022 $ 1,890 $ 1,987
Preferred stock of subsidiary 44 44 44
Company-obligated convertible Trust Preferred Securities
of subsidiaries (a) 393 694 694
Company-obligated mandatorily redeemable preferred securities
of Consumer's subsidiaries (a) 490 520 520
Long-term debt 6,585 6,923 7,402
Non-current portion of capital leases 110 60 57
-------------------------------------------------------------
9,644 10,131 10,704
- ----------------------------------------------------------------------------------------------------------------------------------
MINORITY INTERESTS 74 86 82
- ----------------------------------------------------------------------------------------------------------------------------------
CURRENT LIABILITIES
Current portion of long-term debt and capital leases 604 981 802
Notes payable 246 416 153
Accounts payable 435 547 593
Accounts payable - Marketing, services and trading 274 452 392
Accrued taxes 292 125 72
Accrued interest 125 163 155
Accounts payable - related parties 65 62 68
Price risk management liabilities 208 381 1,060
Deferred income taxes 11 51 9
Other 444 510 657
-------------------------------------------------------------
2,704 3,688 3,961
- ----------------------------------------------------------------------------------------------------------------------------------
NON-CURRENT LIABILITIES
Deferred income taxes 712 773 646
Postretirement benefits 266 333 347
Deferred investment tax credit 92 102 104
Regulatory liabilities for income taxes, net 282 276 270
Price risk management liabilities 301 352 340
Power loss contract reserves 312 354 365
Gas supply contract obligations 270 287 291
Other 565 598 379
-------------------------------------------------------------
2,800 3,075 2,742
- ----------------------------------------------------------------------------------------------------------------------------------
COMMITMENTS AND CONTINGENCIES (Notes 1 and 5)
TOTAL STOCKHOLDERS' INVESTMENT AND LIABILITIES $ 15,222 $ 16,980 $ 17,489
====================================================================================================================================
(A) FOR FURTHER DISCUSSION, SEE NOTE 6 OF THE CONDENSED NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS.
THE ACCOMPANYING CONDENSED NOTES ARE AN INTEGRAL PART OF THESE STATEMENTS.
CMS-47
CMS Energy Corporation
CMS ENERGY CORPORATION
CONSOLIDATED STATEMENTS OF COMMON STOCKHOLDERS' EQUITY
(UNAUDITED)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 2002 2001 2002 2001
- -----------------------------------------------------------------------------------------------------------------------------------
In Millions
COMMON STOCK
At beginning and end of period $ 1 $ 1 $ 1 $ 1
- -----------------------------------------------------------------------------------------------------------------------------------
OTHER PAID-IN CAPITAL
At beginning of period 3,317 3,264 3,269 2,936
Common stock repurchased - (5) - (5)
Common stock reacquired (1) - (2) -
Common stock issued 303 6 352 334
-----------------------------------------------
At end of period 3,619 3,265 3,619 3,265
- -----------------------------------------------------------------------------------------------------------------------------------
REVALUATION CAPITAL
Investments
At beginning of period - (4) (4) (2)
Unrealized gain (loss) on investments (a) (5) (1) (1) (3)
-----------------------------------------------
At end of period (5) (5) (5) (5)
-----------------------------------------------
Derivative Instruments
At beginning of period (b) (25) (24) (26) 13
Unrealized gain (loss) on derivative instruments (a) (12) (15) (15) (44)
Reclassification adjustments included in consolidated net income (loss) (a) 1 - 5 (8)
-----------------------------------------------
At end of period (36) (39) (36) (39)
- -----------------------------------------------------------------------------------------------------------------------------------
FOREIGN CURRENCY TRANSLATION
At beginning of period (698) (301) (295) (254)
Change in foreign currency translation (a) (17) (17) (420) (64)
-----------------------------------------------
At end of period (715) (318) (715) (318)
- -----------------------------------------------------------------------------------------------------------------------------------
RETAINED EARNINGS (DEFICIT)
At beginning of period (838) (252) (1,055) (320)
Consolidated net income (loss) (a) 23 (569) 337 (407)
Common stock dividends declared (27) (96) (124) (190)
-----------------------------------------------
At end of period (842) (917) (842) (917)
-----------------------------------------------
TOTAL COMMON STOCKHOLDERS' EQUITY $2,022 $ 1,987 $2,022 $ 1,987
===================================================================================================================================
(a) Disclosure of Comprehensive Income (Loss):
Revaluation capital
Investments
Unrealized gain (loss) on investments, net of tax of
$3, $1, $- and $1, respectively $ (5) $ (1) $ (1) $ (3)
Derivative Instruments
Unrealized gain (loss) on derivative instruments,
net of tax of $(2), $2, $(3) and $13, respectively (12) (15) (15) (44)
Reclassification adjustments included in consolidated net income (loss),
net of tax of $-, $-, $(2) and $4, respectively 1 - 5 (8)
Foreign currency translation, net (17) (17) (420) (64)
Consolidated net income (loss) 23 (569) 337 (407)
-----------------------------------------------
Total Consolidated Comprehensive Income (Loss) $ (10) $ (602) $ (94) $ (526)
===============================================
(b) Nine months ended September 30, 2001 is the cumulative effect of change in
accounting principle, net of $(8) tax (Note 1).
THE ACCOMPANYING CONDENSED NOTES ARE AN INTEGRAL PART OF THESE STATEMENTS.
CMS-48
CMS Energy Corporation
CMS ENERGY CORPORATION
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
These interim Consolidated Financial Statements have not been reviewed by our
independent public accountants as required under Rule 10-01(d) of Regulation
S-X. In April 2002, the Board of Directors, upon the recommendation of the Audit
Committee of the Board, voted to discontinue using Arthur Andersen to audit CMS
Energy's financial statements for the year ending December 31, 2002. CMS Energy
previously retained Arthur Andersen to review its financial statements for the
quarter ended March 31, 2002. In May 2002, CMS Energy's Board of Directors
engaged Ernst & Young to audit its financial statements for the year ending
December 31, 2002.
CMS Energy expects that the review of these interim Consolidated Financial
Statements by our independent public accountants will occur upon completion of
the restatement of CMS Energy Consolidated Financial Statements for each of the
fiscal years ended December 31, 2001 and December 31, 2000. See Note 5,
Uncertainties - "Round Trip Trades" and "Change in Auditors and Restatement."
These interim Consolidated Financial Statements have been prepared by CMS Energy
in accordance with SEC rules and regulations. As such, certain information and
footnote disclosures normally included in full year financial statements
prepared in accordance with accounting principles generally accepted in the
United States have been condensed or omitted. Certain prior year amounts have
been reclassified to conform to the presentation in the current year. The
Condensed Notes to Consolidated Financial Statements and the related
Consolidated Financial Statements should be read in conjunction with the
Consolidated Financial Statements and Notes to Consolidated Financial Statements
contained in CMS Energy's Form 10-K for the year ended December 31, 2001. Due to
the seasonal nature of CMS Energy's operations, the results as presented for
this interim period are not necessarily indicative of results to be achieved for
the fiscal year.
1: CORPORATE STRUCTURE AND BASIS OF PRESENTATION
CMS Energy is the parent holding company of Consumers and Enterprises. Consumers
is a combination electric and gas utility company serving Michigan's Lower
Peninsula. Enterprises, through subsidiaries, including Panhandle and its
subsidiaries, is engaged in several domestic and international diversified
energy businesses including: natural gas transmission, storage and processing;
independent power production; and energy marketing, services and trading.
PRINCIPLES OF CONSOLIDATION: The consolidated financial statements include the
accounts of CMS Energy, Consumers and Enterprises and their majority-owned
subsidiaries. Investments in affiliated companies where CMS Energy has the
ability to exercise significant influence, but not control, are accounted for
using the equity method. For the three and nine months ended September 30, 2002,
undistributed equity earnings were $21 million and $102 million, respectively
compared to $28 million and $2 million for the three and nine months ended
September 30, 2001. Intercompany transactions and balances have been eliminated.
USE OF ESTIMATES: The preparation of financial statements in conformity with
accounting principles generally accepted in the United States requires
management to make judgments, estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of the
CMS-49
CMS Energy Corporation
financial statements and the reported amounts of revenues and expenses during
the reporting period. Actual results could materially differ from those
estimates.
The recording of estimated liabilities for contingent losses within the
financial statements is guided by the principles in SFAS No. 5. SFAS No. 5
requires a company to record estimated liabilities in the financial statements
when it is probable that a loss will be paid in the future as a result of a
current event, and that amount can be reasonably estimated. CMS Energy has used
this accounting principle to record estimated liabilities discussed in Note 5,
Uncertainties.
UTILITY REGULATION: Consumers accounts for the effects of regulation based on
SFAS No. 71. As a result, the actions of regulators affect when Consumers
recognizes revenues, expenses, assets and liabilities.
In March 1999, Consumers received MPSC electric restructuring orders and, as a
result, discontinued application of SFAS No. 71 for the electric supply portion
of its business. Discontinuation of SFAS No. 71 for the electric supply portion
of Consumers' business resulted in Consumers reducing the carrying value of its
Palisades plant-related assets by approximately $535 million and establishing a
regulatory asset for a corresponding amount. According to current accounting
standards, Consumers can continue to carry its electric supply-related
regulatory assets if legislation or an MPSC rate order allows the collection of
cash flows to recover these regulatory assets from its regulated distribution
customers. As of September 30, 2002, Consumers had a net investment in electric
supply facilities of $1.426 billion included in electric plant and property. See
Note 5, Uncertainties, "Electric Rate Matters - Electric Restructuring."
IMPLEMENTATION OF SFAS NO. 133: CMS Energy adopted SFAS No. 133 on January 1,
2001. This standard requires CMS Energy to recognize at fair value on the
balance sheet, as assets or liabilities, all contracts that meet the definition
of a derivative instrument. The standard also requires CMS Energy to record all
changes in fair value directly in earnings unless the derivative instrument
meets certain qualifying hedge criteria, in which case the changes in fair value
would be reflected in other comprehensive income. CMS Energy determines fair
value based upon quoted market prices and mathematical models using current and
historical pricing data. The ineffective portion, if any, of all hedges is
recognized in earnings.
CMS Energy believes that the majority of its contracts, power purchase
agreements and gas transportation contracts qualify for the normal purchases and
sales exception of SFAS No. 133 and are not subject to the accounting rules for
derivative instruments. CMS Energy uses derivative instruments that require
derivative accounting, to limit its exposures to electricity and gas commodity
price risk. The interest rate and foreign currency exchange contracts met the
requirements for hedge accounting under SFAS No. 133 and CMS Energy recorded the
changes in the fair value of these contracts in other comprehensive income.
The financial statement impact of recording the SFAS No. 133 transition
adjustment on January 1, 2001 is as follows:
In Millions
- --------------------------------------------------------------------------------
Fair value of derivative assets $35
Fair value of derivative liabilities 14
Increase in accumulated other comprehensive income, net of tax 7
- --------------------------------------------------------------------------------
Consumers believes that certain of its electric capacity and energy contracts do
not qualify as derivatives due to the lack of an active energy market in the
state of Michigan and the transportation cost to deliver the power under the
contracts to the closest active energy market at the Cinergy hub in Ohio. If a
market develops in the
CMS-50
CMS Energy Corporation
future, Consumers may be required to account for these contracts as derivatives.
The mark-to-market impact in earnings related to these contracts, particularly
related to the purchase power agreement with the MCV, could be material to the
financial statements.
On January 1, 2001, upon initial adoption of the standard including adjustments
for subsequent guidance, CMS Energy recorded a $7 million, net of tax,
cumulative effect adjustment as an increase in accumulated other comprehensive
income. This adjustment relates to the difference between the fair value and
recorded book value of contracts related to gas call options, gas fuel for
generation swap contracts, and interest rate swap contracts that qualified for
hedge accounting prior to the initial adoption of SFAS No. 133 and Consumers'
proportionate share of the effects of adopting SFAS No. 133 related to its
equity investment in the MCV Partnership. Based on the pretax initial transition
adjustment of $20 million recorded in accumulated other comprehensive income at
January 1, 2001, Consumers reclassified to earnings $12 million as a reduction
to the cost of gas, $1 million as a reduction to the cost of power supply, $2
million as an increase in interest expense and $8 million as an increase in
other revenues for the twelve months ended December 31, 2001. CMS Energy
recorded $12 million as an increase in interest expense during 2001, which
includes the $2 million of additional interest expense at Consumers. The
difference between the initial transition adjustment and the amounts
reclassified to earnings represents an unrealized loss in the fair value of the
derivative instruments since January 1, 2001, resulting in a decrease of other
comprehensive income.
At adoption of the standard on January 1, 2001, derivative and hedge accounting
for certain utility industry contracts, particularly electric call option
contracts and option-like contracts, and contracts subject to Bookouts was
uncertain. Consumers accounted for these types of contracts as derivatives that
qualified for the normal purchase exception of SFAS No. 133 and, therefore, did
not record these contracts on the balance sheet at fair value. In June and
December 2001, the FASB issued guidance that resolved the accounting for these
contracts. As a result, on July 1, 2001, Consumers recorded a $3 million, net of
tax, cumulative effect adjustment as an unrealized loss decreasing accumulated
other comprehensive income, and on December 31, 2001, recorded an $11 million,
net of tax, cumulative effect adjustment as a decrease to earnings. These
adjustments relate to the difference between the fair value and the recorded
book value of electric call option contracts.
As of September 30, 2002, Consumers recorded a total of $5 million, net of tax,
as an unrealized gain in other comprehensive income related to its proportionate
share of the effects of derivative accounting related to its equity investment
in the MCV Partnership. Consumers expects to reclassify this gain, if this value
remains, as an increase to other operating revenue during the next 12 months.
For further discussion of derivative activities, see Note 5, Uncertainties,
"Other Electric Uncertainties - Derivative Activities" and "Other Gas
Uncertainties - Derivative Activities".
FOREIGN CURRENCY TRANSLATION: CMS Energy's subsidiaries and affiliates whose
functional currency is other than the U.S. Dollar translate their assets and
liabilities into U.S. Dollars at the current exchange rates in effect at the end
of the fiscal period. The revenue and expense accounts of such subsidiaries and
affiliates are translated into U.S. Dollars at the average exchange rates that
prevailed during the period. The gains or losses that result from this process,
and gains and losses on intercompany foreign currency transactions that are
long-term in nature, and which CMS Energy does not intend to settle in the
foreseeable future, are shown in the stockholders' equity section of the balance
sheet. For subsidiaries operating in highly inflationary economies, the U.S.
Dollar is considered to be the functional currency, and transaction gains and
losses are included in determining net income. Gains and losses that arise from
exchange rate fluctuations on transactions
CMS-51
CMS Energy Corporation
denominated in a currency other than the functional currency, except those that
are hedged, are included in determining net income.
RECLASSIFICATIONS: CMS Energy has reclassified certain prior year amounts for
comparative purposes. For the three and nine months ended September 30, 2002 and
2001, CMS Energy reclassified a portion of cost of gas sold in 2001 to other
operating expenses, reclassified various operations to discontinued operations,
and reclassified the gain on the sale of CMS Oil and Gas' Equatorial Guinea
properties to discontinued operations. These reclassifications did not affect
consolidated net income for the years presented.
RESTRUCTURING AND OTHER COSTS: CMS Energy began a series of initiatives in the
aftermath of CMS Energy's round-trip trading disclosure and the sharp drop of
the company's stock price. Significant expenses associated with these
initiatives have been incurred and are considered restructuring and other costs.
These actions include: termination of five officers, 18 CMS Field Services
employees and 37 CMS MST trading group employees, renegotiating a number of debt
agreements, responding to many investigation and litigation matters, re-audit of
the 2000 and 2001 financial statements and plans to relocate the corporate
headquarters to Jackson, Michigan. These restructuring and other costs are being
accumulated and reported as a reconciling item when calculating net income and
earnings per share before reconciling items. These restructuring and other costs
are included in consolidated net income.
Restructuring and other costs for the year-to-date September 30, 2002, which
are reported in operating expenses ($41 million) and fixed charges ($12
million) includes:
- Involuntary termination benefits of $17 million for officers and
employees.
- One-time consulting and structuring fees of $12 million to assist
CMS Energy to arrange credit facilities related to the July 2002
debt renegotiations.
- The $12 million of expenses associated with responding to and/or
defending against investigations and lawsuits related to
round-trip trading. These expenses could ultimately total $21
million for attorneys' fees and costs through final resolution.
Potential insurance proceeds may total $12 million, reducing these
expenses to $9 million.
- Expenses for future rentals of $7 million have been accrued in
connection with relocating the corporate headquarters to Jackson,
Michigan. The relocation is expected to be complete by June 2003.
- Other expenses, including the cost of re-auditing 2000 and 2001
total $5 million.
Of the above $53 million, $12 million has been paid for consulting and
structuring fees and $10 million has been paid for severance and benefits as of
September 30, 2002.
Additional restructuring and other costs are expected in the fourth quarter of
2002 of approximately $5 million related to relocating the corporate
headquarters, terminating approximately 30 employees, and additional legal
expenses for litigation issues. In the first half of 2003, restructuring and
other costs related to relocating employees and other headquarters expenses are
expected to be $3 million. The relocation is expected to occur between March
and June 2003.
EXTRAORDINARY ITEM: Cash proceeds received from asset sales in 2002 have been
used to retire existing debt early. As a result, charges associated with the
early extinguishment of debt of $8 million, net of tax, have been reflected as
an extraordinary loss in the Consolidated Statements of Income for the nine
months ended September 30, 2002.
TAX LOSS ALLOCATION: The Job Creation and Worker Assistance Act of 2002 provided
to corporate taxpayers a 5-year carryback of tax losses incurred in 2001 and
2002. As a result of this legislation, CMS Energy was able to carry back a
consolidated 2001 tax loss to tax years 1996 through 1999 and obtain refunds of
prior years tax payments totaling $217 million. The tax loss carryback, however,
resulted in a reduction in AMT credit carryforwards that previously had been
recorded by CMS Energy as deferred tax assets in the amount of $41 million. This
one-time non-cash reduction in AMT credit carryforwards has been reflected in
the tax provisions of CMS Energy and each of its consolidated subsidiaries, as
of September 30, 2002, according to their contributions to the consolidated CMS
Energy tax loss.
CMS-52
CMS Energy Corporation
ACCOUNTING FOR HEADQUARTERS BUILDING LEASE: In April 2001, Consumers Campus
Holdings entered into a lease agreement for the construction of an office
building to be used as the main headquarters for Consumers in Jackson, Michigan.
Consumers' current headquarters building lease expires in June 2003. The new
office building lessor has committed to fund up to $65 million for construction
of the building, which is due to be completed during March 2003. Consumers is
acting as the construction agent of the lessor for this project. During
construction, the lessor has a maximum recourse of 89.9 percent against
Consumers in the event of certain defaults, which Consumers believes are
unlikely. For several events of default, primarily bankruptcy or intentional
misapplication of funds, there could be full recourse for the amounts expended
by the lessor at that time. The agreement also includes a common change in
control provision, which could trigger full payment of construction costs by
Consumers. As a result of this provision, Consumers elected to classify this
lease as a capital lease during the second quarter of 2002. This classification
represents the total obligation of Consumers under this agreement. As such,
Consumers' balance sheet as of September 30, 2002, reflects a capital lease
asset and an offsetting non-current liability equivalent to the cost of
construction at that date of $45 million.
EITF ISSUE NO. 02-3, "RECOGNITION AND REPORTING OF GAINS AND LOSSES ON ENERGY
TRADING CONTRACTS UNDER EITF ISSUES NO. 98-10 AND 00-17": In September 2002, the
EITF reaffirmed the consensus originally reached in June 2002 that requires all
gains and losses, including mark-to-market gains and losses and physical
settlements, related to energy trading activities within the scope of EITF Issue
No. 98-10 be presented as a net amount in the income statement. This consensus
is applicable to financial statement periods ending after July 15, 2002 and
requires the reclassification of comparable reporting periods.
In previous reporting periods, these amounts were reported on a gross basis as a
component of both Operating Revenues and Operating Expenses. At September 30,
2002, CMS Energy adopted this consensus and as a result, these amounts are
netted together in "Marketing, services and trading" Operating Revenues on the
face of the Consolidated Statements of Income. The reclassification of prior
periods had no impact on previously reported net income or stockholders' equity.
At the October 25,2002 meeting, the EITF reached a consensus to rescind EITF
Issue No. 98-10, Accounting for Contracts Involved in Energy Trading and Risk
Management Activities. As a result, only energy contracts that meet the
definition of a derivative in SFAS No. 133 will be carried at fair value. Energy
trading contracts that do not meet the definition of a derivative must be
accounted for as an executory contract (i.e., on an accrual basis). The
consensus rescinding EITF Issue No. 98-10 must be applied to all contracts that
existed as of October 25, 2002 and must be recognized as a cumulative effect of
a change in accounting principle in accordance with APB Opinion No. 20,
Accounting Changes, effective the first day of the first interim or annual
period beginning after December 15, 2002. The consensus also must be applied
immediately to all new contracts entered into after October 25, 2002. As a
result of these recent changes, CMS Energy will evaluate its existing energy
contracts to determine if any changes in the method of reporting the results of
these contracts will be required effective January 1, 2003.
SFAS NO. 142, GOODWILL AND OTHER INTANGIBLE ASSETS: SFAS No. 142, issued in July
2001, requires that goodwill and other intangible assets no longer be amortized
to earnings, but instead be reviewed for impairment on an annual basis. Goodwill
represents the excess of the fair value of the net assets of acquired companies
and was amortized using the straight-line method, up to a forty-year life,
through December 31, 2001. Effective January 1, 2002, CMS Energy adopted SFAS
No. 142 (see Note 4, Goodwill).
CMS-53
CMS Energy Corporation
SFAS NO. 144, ACCOUNTING FOR THE IMPAIRMENT OR DISPOSAL OF LONG-LIVED ASSETS:
This new standard was issued by the FASB in October 2001, and supersedes SFAS
No. 121 and APB Opinion No. 30. SFAS No. 144 requires that long-lived assets be
measured at the lower of either the carrying amount or the fair value less the
cost to sell, whether reported in continuing operations or in discontinued
operations. Therefore, discontinued operations will no longer be measured at net
realizable value or include amounts for operating losses that have not yet
occurred. SFAS No. 144 also broadens the reporting of discontinued operations to
include all components of an entity with operations that can be distinguished
from the rest of the entity and that will be eliminated from the ongoing
operations of the entity in a disposal transaction. The adoption of SFAS No.
144, effective January 1, 2002, has resulted in CMS Energy accounting for
impairments or disposal of long-lived assets under the provisions of SFAS No.
144, but has not changed the accounting used for previous asset impairments or
disposals.
2: DISCONTINUED OPERATIONS
In September 2002, CMS Energy closed on the sale of the stock of CMS Oil and Gas
and the stock of a subsidiary of CMS Oil and Gas that holds property in
Venezuela. In October 2002, CMS Energy closed on the sale of CMS Oil and Gas's
properties in Colombia. As a result of these closings, CMS Energy has completed
its exit from the oil and gas exploration and production business. The proceeds
from the combined sales total approximately $210 million and have been used to
retire the remaining balance on a $150 million Enterprises term loan due in
December 2002 and a portion of a $295.8 million CMS Energy loan due March 2003.
The combined sales will result in an after-tax loss of approximately $90
million, which is included in discontinued operations at September 30, 2002.
In June 2002, CMS Energy announced its plan to sell CMS MST's energy performance
contracting subsidiary, CMS Viron. CMS Viron enables building owners to improve
their facilities with equipment upgrades and retrofits and finance the work with
guaranteed energy and operational savings. CMS Viron's strongest markets are in
the mid-Atlantic, Midwest and California. CMS MST, upon announcing its intention
to put CMS Viron up for sale, was required to measure the assets and liabilities
of CMS Viron at the lower of the carrying value or the fair value less cost to
sell in accordance with SFAS No. 144. After evaluating all of the relevant facts
and circumstances including third-party bid data and liquidation analysis, $11.4
million, net of tax, has been reflected as a loss on discontinued operations in
order to appropriately reflect the fair value less selling costs of CMS Viron.
CMS Energy is actively seeking a buyer for the assets of CMS Viron and although
the timing of this sale is difficult to predict, nor can it be assured,
management expects the sale to occur in 2003.
In June 2002, CMS Energy abandoned the Zirconium Recovery Project, which was
initiated in January 2000. The purpose of the project was to extract and sell
uranium and zirconium from a pile of caldesite ore held by the Defense Logistic
Agency of the U.S. Department of Defense. After evaluating future cost and risk,
CMS Energy decided to abandon this project and recorded a $31 million after-tax
loss in discontinued operations.
In May 2002, CMS closed on the sale of CMS Oil and Gas' coalbed methane holdings
in the Powder River Basin to XTO Energy. The Powder River properties were
included in discontinued operations for the first four months of 2002, including
a gain on the sale of $20 million ($11 million net of tax).
In January 2002, CMS Energy completed the sale of its ownership interests in
Equatorial Guinea to Marathon Oil Company for approximately $993 million.
Included in the sale were all of CMS Oil and Gas' oil and gas
CMS-54
CMS Energy Corporation
reserves in Equatorial Guinea and CMS Gas Transmission's ownership interest in
the related methanol plant. The gain on the Equatorial Guinea properties of $497
million ($310 million, net of tax) is included in discontinued operations.
In September 2001, CMS Energy discontinued the operations of the International
Energy Distribution segment. CMS Energy is actively seeking a buyer for the
assets of CMS Electric and Gas, and although the timing of this sale is
difficult to predict, nor can it be assured, management expects the sale to
occur in 2003.
The following summarizes the balance sheet information of the discontinued
operations:
In Millions
September 30 2002 2001
- --------------------------------------------------------------------------------
Assets
Cash $ 8 $ 12
Accounts receivable, net 37 36
Materials and supplies 8 8
Property, plant and equipment, net 13 44
Goodwill 24 34
Other 58 59
-----------------
$148 $193
- --------------------------------------------------------------------------------
Liabilities
Accounts payable $ 29 $ 30
Current and long-term debt 14 1
Accrued taxes 17 --
Minority interest 18 47
Other 14 24
-----------------
$ 92 $102
- --------------------------------------------------------------------------------
In accordance with SFAS No. 144, the net income (loss) of the operations is
included in the consolidated statements of income under "discontinued
operations". The pretax loss on disposal recorded for the nine months ended
September 30, 2002 on the anticipated sale of these operations was $204 million,
which included a reduction in asset values, a provision for anticipated closing
costs, and a portion of CMS Energy's interest expense. Interest expense was
allocated to each discontinued operation based on its ratio of total capital to
that of CMS Energy. See the table below for income statement components of the
discontinued operations.
In Millions
- ------------------------------------------------------------------------------------------
Nine months ended September 30 2002 2001
- ------------------------------------------------------------------------------------------
Discontinued operations:
Income (loss) from discontinued operations, net of taxes of $179 $ 318 $ (3)
and $1
Loss on disposal of discontinued operations, net of tax benefit of $72
and $21 (132) (183)
--------------
Total $ 186 $(186)
==========================================================================================
CMS-55
CMS Energy Corporation
3: ASSET DISPOSITIONS
In January 2002, CMS Energy completed the sale of its ownership interests in
Equatorial Guinea to Marathon Oil Company for approximately $993 million.
Proceeds from this transaction were used primarily to retire existing debt.
Included in the sale were all of CMS Oil and Gas' oil and gas reserves in
Equatorial Guinea and CMS Gas Transmission's ownership interest in the related
methanol plant. The pretax gain on the sale was $516 million ($322 million, net
of tax, or $2.44 and $2.36 per basic and diluted share, respectively). The gain
on the Equatorial Guinea properties of $497 million ($310 million, net of tax)
is included in "Income (Loss) From Discontinued Operations" and the gain on the
methanol plant of $19 million ($12 million, net of tax) is included in "Gain
(loss) on asset sales, net" on the Consolidated Statements of Income.
In April 2002, CMS Energy sold its equity ownership interest in Toledo Power
Company electric generating facility in the Philippines for $10 million.
Proceeds from the sale were used to repay debt. The pretax loss of $11 million
($8 million, net of tax) is included in "Gain (loss) on asset sales, net" on the
Consolidated Statements of Income.
In May 2002, Consumers Energy closed on the sale of its electric transmission
system, including reactor top equipment, for approximately $290 million to a
limited partnership whose general partner is Washington D.C.-based Trans-Elect.
The pretax gain of $38 million ($31 million, net of tax) is included in "Gain
(loss) on asset sale, net" on the Consolidated Statements of Income.
Also in May 2002, CMS Energy closed on the sale of CMS Oil and Gas' coalbed
methane holdings in the Powder River Basin for $101 million. Proceeds from the
sale were used to reduce debt. The pretax gain included in "Income (Loss) From
Discontinued Operations" on the Consolidated Statements of Income was $20
million ($11 million, net of tax).
In August 2002, CMS Energy sold its equity ownership interest in The National
Power Supply Company electric generating facility in Thailand for $48 million.
The pretax gain of $13 million ($13 million, net of tax) is included in "Gain
(loss) on asset sales, net" on the Consolidated Statements of Income.
In September 2002, CMS Energy closed on the sale of the stock of CMS Oil and Gas
and the stock of a subsidiary of CMS Oil and Gas that holds property in
Venezuela. In October 2002, CMS Energy closed on the sale of CMS Oil and Gas's
properties in Colombia. As a result of these closings, CMS Energy has completed
its exit from the oil and gas exploration and production business. The proceeds
from the combined sales total approximately $212 million and have been used to
retire the remaining balance on a $150 million Enterprises term loan due in
December 2002 and a portion of a $295.8 million CMS Energy loan due March 2003.
The pretax loss included in "Income (Loss) From Discontinued Operations" on the
Consolidated Statements of Income was $140 million ($90 million, net of tax).
In October 2002, CMS Land executed a settlement agreement abandoning its 50%
ownership interest in Bay Harbor Company, LLC, a real estate development company
located in the northwestern region of Michigan's lower peninsula. The settlement
agreement requires CMS Land to pay $16 million to Bay Harbor in consideration
for certain indemnities and past liabilities assumed by Bay Harbor. CMS Land's
investment in Bay Harbor at September 30, 2002 was $9 million.
Also in October CMS Generation completed the sale of its ownership interest in
the 200 MW Vasavi Power Plant, located in Tamil Nada, India for $34 million. CMS
Generation's investment in the Vasavi Power Plant
CMS-56
CMS Energy Corporation
at September 30, 2002 was $59 million.
4: GOODWILL
CMS MST: Effective January 1, 2002, SFAS No. 142 disallowed the continued
amortization of goodwill and required the testing of goodwill for potential
impairment. During the third quarter of 1999 CMS MST purchased a 100 percent
interest in Viron Energy Services. CMS MST consolidated the activity of CMS
Viron and recorded goodwill as a result of the purchase price allocation. In
performing the analysis of CMS Viron's fair value as of January 1, 2002, CMS MST
has (a) evaluated bids, (b) measured the liquidation basis fair value and (c)
qualitatively evaluated any significant changes in the market value of CMS
Viron's business between January 1, 2002 and the date of the bids. In performing
the second step of the SFAS No. 142 analysis, CMS MST concluded that CMS Viron's
entire fair value should be properly allocated to its non-goodwill assets and
liabilities as of January 1, 2002. Based on the quantitative and qualitative
analysis, in the second quarter of 2002, CMS MST recorded a change in accounting
principle loss of $14 million ($9 million, net of tax) for goodwill impairment
in accordance with the transition provisions of SFAS No. 142.
The following table represents what net income would have been had the goodwill
impairment been recorded for the three months ended March 31, 2002.
In Millions, Except Per Share Amounts
- --------------------------------------------------------------------------------------------------------------------
Three months ended March 31 2002
- --------------------------------------------------------------------------------------------------------------------
CONSOLIDATED NET INCOME OF CMS ENERGY AS REPORTED $ 399
Goodwill Impairment (9)
---------------------------------------------------------------------------------------------------------------
Consolidated Net Income As Adjusted $ 390
====================================================================================================================
BASIC EARNINGS PER AVERAGE COMMON SHARE OF CMS ENERGY AS REPORTED $2.99
Goodwill Impairment (0.07)
---------------------------------------------------------------------------------------------------------------
Earnings Per Share As Adjusted $2.92
===============================================================================================================
DILUTED EARNINGS PER AVERAGE COMMON SHARE OF CMS ENERGY AS REPORTED $2.92
Goodwill Impairment (0.07)
---------------------------------------------------------------------------------------------------------------
Earnings Per Share As Adjusted $2.85
===============================================================================================================
PANHANDLE: In accordance with SFAS No. 142, Panhandle completed the first step
of the goodwill impairment testing which indicates a significant impairment of
Panhandle's goodwill existed as of January 1, 2002. Panhandle has $700 million
of goodwill recorded as of January 1, 2002 which is subject to this impairment
test. Pursuant to SFAS No. 142 requirements, the actual amount of impairment is
determined in a second step involving a detailed valuation of all assets and
liabilities utilizing an independent appraiser and when determined, will be
reflected as a cumulative effect of an accounting change, restated to the first
quarter of 2002. This valuation work is underway and will be completed in the
fourth quarter of 2002. Preliminary results of the second step appraisal
indicate that most of Panhandle's goodwill is impaired as of January 1, 2002.
However, CMS Energy is currently exploring the sale of Panhandle and CMS Field
Services business units. For further information, see Outlook section of the
MD&A.
CMS-57
CMS Energy Corporation
5: UNCERTAINTIES
ROUND-TRIP TRADES
During the period of May 2000 through January 2002, CMS MST engaged in
simultaneous, prearranged commodity trading transactions in which energy
commodities were sold and repurchased at the same price. These transactions,
which had no impact on previously reported consolidated net income, earnings
per share or cash flows, had the effect of increasing operating revenues,
operating expenses, accounts receivable, accounts payable and reported trading
volumes. After internally concluding that cessation of these trades was in CMS
Energy's best interest, these so called round-trip trades were halted in
January 2002.
CMS Energy accounted for these trades in gross revenue and expense through the
third quarter of 2001, but subsequently concluded that these round-trip trades
should have been reflected on a net basis. In the fourth quarter of 2001, CMS
Energy ceased recording these trades in either revenues or expenses. CMS
Energy's 2001 Form 10-K, issued in March 2002, restated revenue and expense for
the first three quarters of 2001 to eliminate $4.2 billion of previously
reported revenue and expense. The 2001 Form 10-K did include $5 million of
revenue and expense for 2001 from such trades, which remained uncorrected. At
the time of the initial restatement, CMS Energy inadvertently failed to restate
2000 for round trip trades.
CMS Energy is cooperating with an SEC investigation regarding round-trip trading
and the Company's financial statements, accounting practices and controls. CMS
Energy is also cooperating with inquiries by the Commodity Futures Trading
Commission, the FERC, and the United States Department of Justice regarding
these transactions. CMS Energy has also received subpoenas from the U.S.
Attorney's Office for the Southern District of New York and from the U.S.
Attorney's Office in Houston regarding investigations of these trades and has
received a number of shareholder class action lawsuits. In addition, CMS
Energy's Board of Directors established the Special Committee of independent
directors to investigate matters surrounding round-trip trading and the Special
Committee retained outside counsel to assist in the investigation.
On October 31, 2002, the Special Committee reported the results of its
investigation to the Board of Directors. The Special Committee discovered no new
information inconsistent with the information previously reported by CMS Energy
and as reported above. The investigation also concluded that the round-trip
trades were undertaken to raise CMS MST's profile as an energy marketer, with
the goal of enhancing CMS MST's ability to promote its services to new
customers. The Special Committee found no apparent effort to manipulate the
price of CMS Energy Common Stock or to affect energy prices.
The Special Committee also made recommendations designed to prevent any
reoccurrence of this practice, some of which have already been implemented,
including the termination of the speculative trading business and revisions to
CMS Energy's risk management policy. The Board of Directors adopted, and CMS
Energy has begun implementing, the remaining recommendations of the Special
Committee.
CMS-58
CMS Energy Corporation
PENDING RESTATEMENTS
In connection with Ernst & Young's re-audit of the fiscal years ended December
31, 2001 and 2000, CMS Energy has determined, in consultation with Ernst and
Young, that certain adjustments (unrelated to the round-trip trades) by CMS
Energy, Consumers, and Panhandle to their consolidated financial statements for
the fiscal years ended December 2001 and 2000 are required. At the time it
adopted the accounting treatment for these items, CMS Energy believed that such
accounting was appropriate under generally accepted accounting principles and
Arthur Andersen concurred. CMS Energy, Consumers and Panhandle are in the
process of advising the SEC of these adjustments before restating their
financial statements as disclosed below, and intend to amend their respective
2001 Form 10-Ks and each of the 2002 Form 10-Qs by the end of January 2003.
MCV REGULATORY DISALLOWANCE ACCOUNTING: In 1992, Consumers established a reserve
for the difference between the amount that Consumers was paying for power in
accordance with the terms of the PPA, and the amount that Consumers was
ultimately allowed by the MPSC to recover from electric customers.
CMS-59
CMS Energy Corporation
The reserve was adjusted in 1998 to reflect differences between management's
original assumptions and the MCV Facility's actual performance. In 2000,
Consumers reviewed its estimate of the economic losses it would experience with
respect to the PPA and re-evaluated all of the current facts and circumstances
used to calculate the disallowance reserve. Consumers concluded that no
adjustment to the reserve was required in 2000. However, as conditions
surrounding MCV Partnership operations evolved in 2001, Consumers concluded that
it needed to increase the reserve by $126 million (pretax) in the third quarter
of 2001, and did so.
Upon recommendations from Ernst & Young, Consumers is in the process of
reviewing its 2001 PPA accounting and related assumptions. This accounting
review is currently being discussed with Ernst & Young and the SEC. Final
conclusions have not yet been reached. At a minimum, however, the 2001
accounting will change, resulting in the reversal of the 2001 charge of $126
million. Further analysis and deliberations may produce additional accounting
changes. In addition, as a result of this accounting treatment, Consumers
expects that its ongoing operating earnings through 2002 will be reduced to
reflect higher annual purchased power expense.
DIG LOSS CONTRACT ACCOUNTING: The DIG complex, a 710 MW combined-cycle facility,
was constructed during 1998 through 2001 to fulfill contractual requirements and
to sell excess power in the wholesale power market. DIG entered into Electric
Sales Agreements (ESA) with Ford Motor Company, Rouge Industries and certain
other Ford and Rouge affiliates, that require DIG to provide up to 300 MW of
electricity at pre-determined prices for a fifteen-year term beginning in June
2000. DIG also entered into Steam Sales Agreements (SSA) with Ford and Rouge,
whereby DIG is to supply process and heating steam at a fixed price commencing
no later than June 1, 2000.
During the third quarter of 2001, CMS Energy recognized a pretax charge to
earnings of $200 million for the calculated loss on portions of the power
capacity under the ESAs. At that time CMS Energy assessed whether the DIG
facility was impaired under SFAS No. 121 and concluded that the DIG facility was
not impaired.
CMS Energy, with the concurrence of Ernst & Young has now determined that
existing accounting literature precludes the recognition of anticipated losses
on executory contracts such as those involved with the ESAs at DIG. Accordingly
CMS Energy will reverse the $200 million loss on the ESA contracts and
subsequent related transactions when it restates its 2001 financial statements
and financial statements for each of the quarters in 2002.
CMS-60
CMS Energy Corporation
As a result of existing impairment indicators and the pending restatement, CMS
Energy is again assessing the recoverability of the carrying value due of its
current $358 million investment in DIG in accordance with SFAS No. 144. The
investment will be $530 million after reflecting the restatement above. This
assessment is expected to result in a significant impairment charge in the
fourth quarter of 2002.
ELIMINATION OF MARK-TO-MARKET GAINS AND LOSSES ON INTER-BOOK TRANSACTIONS: CMS
MST's business activities include marketing to end users of energy commodities
such as commercial and small industrial purchasers of natural gas (CMS MST's
retail business) and trading activities with such entities as other energy
trading companies (CMS MST's wholesale business). In accordance with GAAP during
2000 and 2001, CMS MST used two different methods to account for these distinct
activities: it applied the mark-to-market method of accounting to its wholesale
trading business operations, and it accounted for its retail business operations
using the accrual method. Some other energy trading companies have taken a
similar approach when their business activities have included retail operations.
EITF Issue No. 98-10, Accounting for Contracts Involved in Energy Trading and
Risk Management Activities, applies to certain parts of CMS MST's operations.
EITF Issue No. 98-10 requires that energy-trading contracts be marked to market;
that is, measured at fair value determined as of the balance sheet date, with
the gains and losses included in the earnings. According to EITF Issue No.
98-10, the determination of whether an entity is involved in energy trading
activities is a matter of judgment that depends on the relevant facts and
circumstances. CMS MST has used the mark-to-market method of accounting for its
wholesale operations because these have been considered trading activities under
EITF Issue No. 98-10. Because CMS MST's retail operations have not been
considered trading activities, mark-to-market accounting under EITF Issue No.
98-10 has not been applied to any retail contracts.
During 2000 and 2001 CMS MST's wholesale business entered into certain
transactions with CMS MST's retail business (inter-book transactions). The
wholesale business marked-to-market these inter-book transactions while the
retail business did not. CMS Energy has determined that the mark-to-market
profits and losses that were recognized by the wholesale business on these
inter-book transactions should have been eliminated in consolidation. CMS Energy
will therefore recognize $54 million of pretax income and a $120 million pretax
charge to earnings in 2000 and 2001 respectively, to eliminate the effects of
mark-to-market accounting in consolidation on inter-book transactions when it
restates its financial statements.
ELIMINATION OF MARK-TO-MARKET GAINS AND LOSSES ON INTERCOMPANY TRANSACTIONS: As
explained above, during 2000 and 2001 CMS MST applied the mark-to-market method
of accounting to the energy-trading contracts of its wholesale operations. In
doing so, CMS MST did not distinguish between counterparties that were unrelated
third parties, and those that were consolidated or equity-method affiliates.
Energy-trading contracts with affiliated companies were therefore measured at
their fair values as of the balance sheet date, with the gains and losses
included in earnings. However, the affiliated counterparties accounted for these
contracts on the accrual basis, because these companies were not engaged in
energy trading activities and therefore their activities were not within the
scope of EITF Issue No. 98-10, nor were their contracts with CMS MST required to
be marked to market in 2001 under SFAS No. 133. The mark-to-market profits and
losses that CMS MST recognized on the contracts with affiliated companies were
included in the CMS Energy consolidated financial statements. CMS Energy has now
concluded that these amounts should have been eliminated in consolidation.
CMS-61
CMS Energy Corporation
CMS Energy's restated consolidated financial statements for 2001 and 2000 will
eliminate the mark-to-market gains and losses on intercompany transactions which
are still being quantified and audited. Adjustments to eliminate intercompany
mark-to-market gains and losses may also be required in 2002.
CMS MST ACCOUNT RECONCILIATIONS: CMS MST's business experienced rapid growth
during 2000 and 2001. Late in 2001, CMS Energy became aware of certain control
weaknesses at CMS MST and immediately began an internal investigation. The
investigation revealed that the size and expertise of the back-office accounting
staff had not kept pace with the rapid growth and, as a result, bookkeeping
errors had occurred and account reconciliations were not prepared. Additionally,
computer interfaces of sub-ledgers to the general ledger were ineffective or
lacking. As a result, sub-ledger balances did not agree to the general ledger
and the differences were not reconciled. When Ernst & Young began its re-audit
fieldwork, an account reconstruction and reconciliation project had been under
way for some months. Most of the work has been performed by outside consultants,
although additional internal personnel have also been assigned to the task. The
effort has focused mainly on trade receivables and payables, intercompany
accounts, and cash, but other balance sheet accounts are also being reconciled
and adjusted.
The reconstruction work at CMS MST is nearing completion for December 31, 2000
and December 31, 2001 and the first three quarters of 2002. However, until all
stages of this work have been finalized, reviewed by CMS MST management, and
examined by Ernst & Young, the resulting adjustments are subject to change.
CMS-62
CMS Energy Corporation
CONSOLIDATION OF LNG HOLDINGS: In late 2001, Panhandle entered into a structured
transaction to monetize a portion of the value of a long-term terminalling
contract of its LNG subsidiary. The LNG business was contributed to LNG
Holdings, which received an equity investment from an unaffiliated third party,
Dekatherm Investor Trust and obtained new loans secured by the assets. After
paying expenses, net proceeds of $235 million were distributed to Panhandle for
the contributed LNG assets, and the joint venture also loaned $75 million to
Panhandle. While the proceeds received by Panhandle were in excess of its book
basis, a gain on the transaction was not recorded. This excess was recorded as a
deferred commitment, reflecting the fact that Panhandle was expecting to
reinvest proceeds into LNG Holdings for a planned expansion. In addition, under
the joint venture structure, Panhandle retained substantial control over the day
to day activities of LNG Holdings and has the primary economic interest in the
joint venture. Initially, CMS Energy and Panhandle believed that off-balance
sheet treatment for the joint venture was appropriate under generally accepted
accounting principles and Arthur Andersen concurred. Upon further analysis of
these facts at this time, CMS Energy and Panhandle have now concluded that
Panhandle did not meet the conditions precedent to account for the contribution
of the LNG business as a disposition given Panhandle's continuing involvement
and the lack of sufficient participating rights by the third-party equity holder
in the joint venture. As a result, with the concurrence of Ernst & Young,
Panhandle will restate its financial statements to reflect consolidation of LNG
Holdings at December 31, 2001, and thereby recognize a net increase of $215
million of debt, the elimination of $183 million of deferred commitment, and
minority interest of $30 million. With the exception of certain immaterial
reclassifications, there will be no impact to 2001 net income resulting from
this accounting treatment. In 2002, the quarterly income recorded would be
impacted due to the timing of earnings recognition from LNG Holdings, with
income generally being recognized earlier by Panhandle upon consolidation. In
addition, the gross revenues and expenses will be recorded on a consolidated
basis versus the equity income previously recorded. For the quarterly periods in
2002 there will be an increase in net income of $4 million for the period ending
March 31, 2002 and decrease of $1 million for each of the quarterly periods
ending June and September 2002 due to equity income previously being recognized
only to the extent cash was received by Panhandle.
STRUCTURED FINANCING OF METHANOL PLANT: In 1999, CMS Gas Transmission and an
unrelated entity financed $250 million of the costs of construction of a jointly
owned methanol plant with an off-balance-sheet special purpose entity (SPE) that
entered into two separate non-recourse note borrowings containing
cross-collateral provisions only with respect to a joint collection account into
which the proceeds from shared collateral were to be deposited. Plant
construction was completed in the spring of 2001. In December 2001, CMS Gas
Transmission issued an irrevocable call for $125 million of these notes (i.e.,
the A1 Notes) and they were paid off in January 2002. As part of the 1999
financing, CMS Energy guaranteed the interest payments on the A1 Notes, subject
to a $75 million limit. CMS Energy did not guarantee repayment of the A1 Notes;
however, CMS Energy issued mandatorily convertible preferred stock to a trust as
security for the A1 Notes. If an amount to repay the A1 Notes was not deposited
within 120 days of the maturity date (or earlier date caused by, for example, a
downgrade of the credit rating of CMS Energy) the holders of 25 percent of the
A1 Notes could cause the mandatorily convertible preferred shares to be sold.
The mandatorily convertible preferred stock of CMS Energy was convertible into
the number of shares of CMS Energy Common Stock needed to make the note holder
whole without limit. Additional security for the A1 Notes was 60 percent of the
capital stock of CMS Methanol, an entity that held a 45 percent ownership
interest in the methanol plant. The SPE's assets comprised investments in CMS
Methanol and in another subsidiary that also owned a 45 percent interest in the
methanol plant. Because the use of non-recourse debt having cross-collateral
provisions only with respect to the joint collection account effectively
segregated the cash flows and assets, in substance this financing created two
separate SPEs. CMS Energy has now concluded, and Ernst & Young concurs, that it
should have consolidated the virtual SPE created by the non-recourse borrowing.
Therefore, CMS Energy will restate its 2000 and 2001 financial statements to
increase its equity ownership interest in the methanol plant and increase debt,
each by $125 million.
CMS-63
CMS Energy Corporation
The table below summarizes the adjustments noted above and the estimated effects
on CMS Energy's financial statements.
Estimated Net Income Impact (Millions) 2000 2001 2000-2001
- ----------------------------------------------------------------------------------------------------------
Total
- ----------------------------------------------------------------------------------------------------------
MCV Regulatory Disallowance $ - $110 $110
DIG Loss Contract Accounting - 130 130
Mark-to-Market Gains and Losses on
Inter-book Transactions 33 (75) (42)
Mark-to-Market Gains and Losses on
Intercompany Transactions 19 (30) (11)
CMS MST Account Reconciliations (9) (7) (16)
- ----------------------------------------------------------------------------------------------------------
Additions to Consolidated Debt (Millions) 2000 2001 2002
- ----------------------------------------------------------------------------------------------------------
Reconsolidation of LNG Facility $ - $215 $219
Structured Financing of Methanol Plant 125 125 -
- ----------------------------------------------------------------------------------------------------------
In addition to the above adjustments and the adjustments to reflect the
elimination of round-trip trades, CMS Energy's restated consolidated financial
statements will also include other adjustments identified in the re-audit, which
have not been completely quantified at this time. These other adjustments
include: 1) the recognition of CMS Energy's and Consumers' new headquarters
lease previously treated as an operating lease, as a capital lease; 2)
adjustments to SERP and OPEB liabilities and advertising costs; 3) adjustments
required to reconcile intercompany accounts payable and accounts receivable and
4) other immaterial items.
CONSUMERS' ELECTRIC UTILITY CONTINGENCIES
ELECTRIC ENVIRONMENTAL MATTERS: Consumers is subject to costly and increasingly
stringent environmental regulations. Consumers expects that the cost of future
environmental compliance, especially compliance with clean air laws, will be
significant.
Clean Air - In 1998, the EPA issued final regulations requiring the State of
Michigan to further limit nitrogen oxide emissions. The Michigan Department of
Environmental Quality is in the process of finalizing rules to comply with the
EPA final regulations. Rules are expected to be promulgated and submitted to the
EPA by the end of 2002. In addition, the EPA also issued additional final
regulations regarding nitrogen oxide emissions that require certain generators,
including some of Consumers' electric generating facilities, to achieve the same
emissions rate as that required by the 1998 regulations. The EPA and the State
final regulations will require Consumers to make significant capital
expenditures estimated to be $770 million. As of September 2002, Consumers has
incurred $372 million in capital expenditures to comply with the EPA final
regulations and anticipates that the remaining capital expenditures will be
incurred between 2002 and 2009. Additionally, Consumers will supplement its
compliance plan with the purchase of nitrogen oxide emissions credits in the
CMS-64
CMS Energy Corporation
years 2005 through 2008. The cost of these credits based on the current market
is estimated to be $6 million per year, however, the market for nitrogen oxide
emissions credits is volatile and the price could change significantly. At some
point, if new environmental standards become effective, Consumers may need
additional capital expenditures to comply with the future standards. Based on
the Customer Choice Act, beginning January 2004, an annual return of and on
these types of capital expenditures, to the extent they are above depreciation
levels, is expected to be recoverable from customers, subject to an MPSC
prudency hearing.
These and other required environmental expenditures, if not recovered from
customers in Consumers rates, may have a material adverse effect upon Consumers'
financial condition and results of operations.
Cleanup and Solid Waste - Under the Michigan Natural Resources and Environmental
Protection Act, Consumers expects that it will ultimately incur investigation
and remedial action costs at a number of sites. Consumers believes that these
costs will be recoverable in rates under current ratemaking policies.
Consumers is a potentially responsible party at several contaminated sites
administered under Superfund. Superfund liability is joint and several. Along
with Consumers, many other creditworthy, potentially responsible parties with
substantial assets cooperate with respect to the individual sites. Based upon
past negotiations, Consumers estimates that its share of the total liability for
the known Superfund sites will be between $1 million and $9 million. As of
September 30, 2002, Consumers had accrued the minimum amount of the range for
its estimated Superfund liability.
In October 1998, during routine maintenance activities, Consumers identified PCB
as a component in certain paint, grout and sealant materials at the Ludington
Pumped Storage facility. Consumers removed and replaced part of the PCB
material. In April 2000, Consumers proposed a plan to deal with the remaining
materials and is awaiting a response from the EPA.
CONSUMERS" ELECTRIC RATE MATTERS
ELECTRIC RESTRUCTURING: In June 2000, the Michigan Legislature passed electric
utility restructuring legislation known as the Customer Choice Act. This act: 1)
permits all customers to choose their electric generation supplier beginning
January 1, 2002; 2) cut residential electric rates by five percent; 3) freezes
all electric rates through December 31, 2003, and establishes a rate cap for
residential customers through at least December 31, 2005, and a rate cap for
small commercial and industrial customers through at least December 31, 2004; 4)
allows for the use of low-cost Securitization bonds to refinance qualified
costs, as defined by the act; 5) establishes a market power supply test that may
require transferring control of generation resources in excess of that required
to serve firm retail sales requirements (a requirement Consumers believes itself
to be in compliance with at this time); 6) requires Michigan utilities to join a
FERC-approved RTO or divest their interest in transmission facilities to an
independent transmission owner; (Consumers has sold its interest in its
transmission facilities to an independent transmission owner, see "Transmission"
below) 7) requires Consumers, Detroit Edison and American Electric Power to
jointly expand their available transmission capability by at least 2,000 MW; 8)
allows deferred recovery of an annual return of and on capital expenditures in
excess of depreciation levels incurred during and before the rate freeze/cap
period; and 9) allows recovery of "net" Stranded Costs and implementation costs
incurred as a result of the passage of the act. In July 2002, the MPSC issued an
order approving the plan to achieve the increased transmission capacity. Once
the increased transmission capacity projects identified in the plan are
completed, verification of compliance is required to be sent to the MPSC. Upon
submittal of verification of compliance, Consumers expects to be deemed in
CMS-65
CMS Energy Corporation
compliance with the MPSC statute. Consumers is highly confident that it will
meet the conditions of items 5 and 7 above, prior to the earliest rate cap
termination dates specified in the act. Failure to do so, however, could result
in an extension of the rate caps to as late as December 31, 2013.
In 1998, Consumers submitted a plan for electric retail open access to the MPSC.
In March 1999, the MPSC issued orders generally supporting the plan. The
Customer Choice Act states that the MPSC orders issued before June 2000 are in
compliance with this act and enforceable by the MPSC. Those MPSC orders: 1)
allow electric customers to choose their supplier; 2) authorize recovery of
"net" Stranded Costs and implementation costs; and 3) confirm any voluntary
commitments of electric utilities. In September 2000, as required by the MPSC,
Consumers once again filed tariffs governing its retail open access program and
made revisions to comply with the Customer Choice Act. In December 2001, the
MPSC approved revised retail open access tariffs. The revised tariffs establish
the rates, terms, and conditions under which retail customers will be permitted
to choose an alternative electric supplier. The tariffs, effective January 1,
2002, did not require significant modifications in the existing retail open
access program. The tariff terms allow retail open access customers, upon as
little as 30 days notice to Consumers, to return to Consumers' generation
service at current tariff rates. If any class of customers' (residential,
commercial, or industrial) retail open access load reaches 10 percent of
Consumers' total load for that class of customers, then returning retail open
access customers for that class must give 60 days notice to return to Consumers'
generation service at current tariff rates. However, Consumers may not have
sufficient, reasonably priced, capacity to meet the additional demand of
returning retail open access customers, and may be forced to purchase
electricity on the spot market at higher prices than it could recover from its
customers.
SECURITIZATION: In October 2000 and January 2001, the MPSC issued orders
authorizing Consumers to issue Securitization bonds. Securitization typically
involves issuing asset-backed bonds with a higher credit rating than
conventional utility corporate financing. The orders authorized Consumers to
securitize approximately $469 million in qualified costs, which were primarily
regulatory assets plus recovery of the Securitization expenses. Securitization
resulted in lower interest costs and a longer amortization period for the
securitized assets, and offset the majority of the impact of the required
residential rate reduction (approximately $22 million in 2000 and $49 million
annually thereafter). The orders directed Consumers to apply any cost savings in
excess of the five percent residential rate reduction to rate reductions for
non-residential customers and reductions in Stranded Costs for retail open
access customers after the bonds are sold. Excess savings are approximately $12
million annually.
In November 2001, Consumers Funding LLC, a special purpose consolidated
subsidiary of Consumers formed to issue the bonds, issued $469 million of
Securitization bonds, Series 2001-1. The Securitization bonds mature at
different times over a period of up to 14 years, with an average interest rate
of 5.3 percent. The last expected maturity date is October 20, 2015. Net
proceeds from the sale of the Securitization bonds, after issuance expenses,
were approximately $460 million. Consumers used the net proceeds to retire $164
million of its common equity from its parent, CMS Energy. From December 2001
through March 2002, the remainder of these proceeds were used to pay down
Consumers long-term debt and Trust Preferred Securities. CMS Energy used the
$164 million from Consumers to pay down its own short-term debt.
Consumers and Consumers Funding LLC will recover the repayment of principal,
interest and other expenses relating to the bond issuance through a
securitization charge and a tax charge that began in December 2001. These
charges are subject to an annual true-up until one year prior to the last
expected bond maturity date, and no more than quarterly thereafter. The first
true-up was issued in November 2002, and prospectively modified the total
securitization and related tax charges from 1.677 mills per kWh to 1.746 mills
per kWh. Current
CMS-66
CMS Energy Corporation
electric rate design covers these charges, and there will be no rate impact for
most Consumers electric customers until the Customer Choice Act rate freeze
expires. Securitization charge revenues are remitted to a trustee for the
Securitization bonds and are not available to Consumers' creditors.
Regulatory assets are normally amortized over their period of regulated
recovery. Beginning January 1, 2001, the amortization was deferred for the
approved regulatory assets being securitized, which effectively offset the loss
in revenue in 2001 resulting from the five percent residential rate reduction.
In December 2001, after the Securitization bonds were sold, the amortization was
re-established, based on a schedule that is the same as the recovery of the
principal amounts of the securitized qualified costs. In 2002, the amortization
amount is expected to be approximately $31 million and the securitized assets
will be fully amortized by the end of 2015.
TRANSMISSION: In 1999, the FERC issued Order No. 2000, strongly encouraging
electric utilities to transfer operating control of their electric transmission
system to an RTO, or sell the facilities to an independent company. In addition,
in June 2000, the Michigan legislature passed Michigan's Customer Choice Act,
which also requires utilities to divest or transfer the operating authority of
transmission facilities to an independent company. Consumers chose to offer its
electric transmission system for sale rather than own and invest in an asset
that it could not control. In May 2002, Consumers sold its electric transmission
system for approximately $290 million in cash to MTH, a non-affiliated limited
partnership whose general partner is a subsidiary of Trans-Elect Inc.
Trans-Elect, Inc. submitted the winning bid through a competitive bidding
process, and various federal agencies approved the transaction. Consumers did
not provide any financial or credit support to Trans-Elect, Inc. Certain of
Trans-Elect's officers and directors are former officers and directors of CMS
Energy, Consumers and their subsidiaries. None of them were employed by CMS
Energy, Consumers, or their affiliates when the transaction was discussed
internally and negotiated with purchasers. As a result of the sale, Consumers
anticipates that its after-tax earnings will increase by approximately $17
million in 2002, due to the recognition of a $26 million one time gain on the
sale of the electric transmission system. This one time gain is offset by a loss
of revenue from wholesale and retail open access customers who will buy services
directly from MTH, including the loss of a return on the sold electric
transmission system. Consumers anticipates that the future impact of the loss of
revenue from wholesale and retail open access customers who will buy services
directly from MTH and the loss of a return on the sold electric transmission
system on its after-tax earnings will be a decrease of $15 million in 2003, and
a decrease of approximately $14 million annually for the next three years.
Under the agreement with MTH, and subject to certain additional RTO surcharges,
contract transmission rates charged to Consumers will be fixed at current levels
through December 31, 2005, and be subject to FERC ratemaking thereafter. MTH
will complete the capital program to expand the transmission system's capability
to import electricity into Michigan, as required by the Customer Choice Act, and
Consumers will continue to maintain the system under a five-year contract with
MTH. Effective April 30, 2002, Consumers and METC withdrew from the Alliance
RTO.
When IPPs connect to transmission systems, they pay transmission companies the
capital costs incurred to connect the IPP to the transmission system and make
system upgrades needed for the interconnection. It is the FERC's policy that the
system upgrade portion of these IPP payments be credited against transmission
service charges over time as transmission service is taken. METC recorded a $34
million liability for IPP credits. Subsequently, MTH assumed this liability as
part of its purchase of the electric transmission system. Several months after
METC started operation, the FERC changed its policy to provide for interest on
IPP payments
CMS-67
CMS Energy Corporation
that are to be credited. The $34 million liability for IPP credits does not
include interest since the associated interconnection agreements do not at this
time provide for interest. METC has asserted that Consumers may be liable for
interest on the IPP payments to be credited if interest provisions are added to
these agreements.
POWER SUPPLY COSTS: During periods when electric demand is high, the cost of
purchasing electricity on the spot market can be substantial. To reduce
Consumers' exposure to the fluctuating cost of electricity, and to ensure
adequate supply to meet demand, Consumers intends to maintain sufficient
generation and to purchase electricity from others to create a power supply
reserve, also called a reserve margin. The reserve margin provides additional
power supply capability above Consumers' anticipated peak power supply demands.
It also allows Consumers to provide reliable service to its electric service
customers and to protect itself against unscheduled plant outages and
unanticipated demand. Traditionally, Consumers has planned for a reserve margin
of approximately 15 percent. However, in light of the addition of new in-state
generating capacity, additional transmission import capability, and FERC's
standard market design notice of proposed rulemaking, which calls for a minimum
reserve margin of 12 percent, Consumers is currently evaluating the appropriate
reserve margin for 2003 and beyond. The ultimate use of the reserve margin
needed will depend primarily on summer weather conditions, the level of retail
open access requirements being served by others during the summer, and any
unscheduled plant outages. As of November 2002, alternative electric suppliers
are providing 446 MW of generation supply to customers.
To reduce the risk of high electric prices during peak demand periods and to
achieve its reserve margin target, Consumers employs a strategy of purchasing
electric call option and capacity contracts for the physical delivery of
electricity primarily in the summer months and to a lesser degree in the winter
months. As of September 30, 2002, Consumers had purchased or had commitments to
purchase electric call option and capacity contracts partially covering the
estimated reserve margin requirements for 2002 through 2007. As a result
Consumers has a recognized asset of $30 million for unexpired call options and
capacity contracts. The total cost of electricity call option and capacity
contracts for 2002 is approximately $13 million, which is subject to change
based upon potential changes in fair value for certain unexpired call options.
Prior to 1998, the PSCR process provided for the reconciliation of actual power
supply costs with power supply revenues. This process assured recovery of all
reasonable and prudent power supply costs actually incurred by Consumers,
including the actual cost for fuel, and purchased and interchange power. In
1998, as part of the electric restructuring efforts, the MPSC suspended the PSCR
process, and would not grant adjustment of customer rates through 2001. As a
result of the rate freeze imposed by the Customer Choice Act, the current rates
will remain in effect until at least December 31, 2003 and, therefore, the PSCR
process remains suspended. Therefore, changes in power supply costs as a result
of fluctuating electricity prices will not be reflected in rates charged to
Consumers' customers during the rate freeze period.
ELECTRIC PROCEEDINGS: The Customer Choice Act allows electric utilities to
recover the act's implementation costs and "net" Stranded Costs (without
defining the term). The act directs the MPSC to establish a method of
calculating "net" Stranded Costs and of conducting related true-up adjustments.
In December 2001, the MPSC adopted a methodology which calculated "net" Stranded
Costs as the shortfall between: (a) the revenue required to cover the costs
associated with fixed generation assets, generation-related regulatory assets,
and capacity payments associated with purchase power agreements, and (b) the
revenues received from customers under existing rates available to cover the
revenue requirement. Consumers has initiated an appeal at the Michigan Court of
Appeals related to the MPSC's December 2001 "net" Stranded Cost order, as a
result of the uncertainty associated with the outcome of the proceeding
described in the following paragraph.
CMS-68
CMS Energy Corporation
According to the MPSC, "net" Stranded Costs are to be recovered from retail open
access customers through a Stranded Cost transition charge. Even though the MPSC
set Consumers' Stranded Cost transition charge at zero for calendar year 2000,
those costs for 2000 will be subject to further review in the context of the
MPSC's subsequent determinations of "net" Stranded Costs for 2001 and later
years. The MPSC authorized Consumers to use deferred accounting to recognize the
future recovery of costs determined to be stranded. In April 2002, Consumers
made "net" Stranded Cost filings with the MPSC for $22 million and $43 million
for 2000 and 2001, respectively. In the same filing, Consumers estimated that it
would experience "net" Stranded Costs of $126 million for 2002. After a series
of appeals and hearings, Consumers in its hearing brief, filed in August 2002,
revised its request for Stranded Costs to $7 million and $4 million for 2000 and
2001, respectively, and an estimated $73 million for 2002. The single largest
reason for the difference in the filing was the exclusion of all costs
associated with expenditures required by the Clean Air Act. Consumers, in a
separate filing, requested regulatory asset accounting treatment for its Clean
Air Act expenditures through 2003. The outcome of these proceedings before the
MPSC is uncertain at this time.
Since 1997, Consumers has incurred significant electric utility restructuring
implementation costs. The following table outlines the applications filed by
Consumers with the MPSC and the status of recovery for these costs.
In Millions
- --------------------------------------------------------------------------------------------------------------
Year Filed Year Incurred Requested Pending Allowed Disallowed
- --------------------------------------------------------------------------------------------------------------
1999 1997 & 1998 $ 20 $ - $ 15 $ 5
2000 1999 30 - 25 5
2001 2000 25 - 20 5
2002 2001 8 8 - -
==============================================================================================================
The MPSC disallowed certain costs based upon a conclusion that these amounts did
not represent costs incremental to costs already reflected in electric rates. In
the orders received for the years 1997 through 2000, the MPSC also reserved the
right to review again the total implementation costs depending upon the progress
and success of the retail open access program, and ruled that due to the rate
freeze imposed by the Customer Choice Act, it was premature to establish a cost
recovery method for the allowable implementation costs. In addition to the
amounts shown, as of September 2002, Consumers incurred and deferred as a
regulatory asset, $3 million of additional implementation costs and has also
recorded as a regulatory asset $13 million for the cost of money associated with
total implementation costs. Consumers believes the implementation costs and the
associated cost of money are fully recoverable in accordance with the Customer
Choice Act. Cash recovery from customers will probably begin after the rate
freeze or rate cap period has expired. Consumers cannot predict the amounts the
MPSC will approve as allowable costs.
Consumers is also pursuing recovery, through the MISO, of approximately $7
million in certain electric utility restructuring implementation costs related
to its former participation in the development of the Alliance RTO. However,
Consumers cannot predict the amounts it will be reimbursed by the MISO.
In 1996, Consumers filed new OATT transmission rates with the FERC for approval.
Interveners contested these rates, and hearings were held before an ALJ in 1998.
In 1999, the ALJ made an initial decision that was largely upheld by the FERC in
March 2002, which requires Consumers to refund, with interest, over-collections
for past services as measured by the FERC's finally approved OATT rates. Since
the initial decision, Consumers has been reserving a portion of revenues billed
to customers under the filed 1996 OATT
CMS-69
CMS Energy Corporation
rates. Consumers submitted revised rates to comply with the FERC final order in
June 2002. Those revised rates were accepted by the FERC in August 2002 and
Consumers is in the process of computing refund amounts for individual
customers. Consumers believes its reserve is sufficient to satisfy its estimated
refund obligation.
In November 2002, the MPSC upon its own motion commenced a contested proceeding
requiring each utility to give reason as to why its rates should not be reduced
to reflect new personal property multiplier tables, and why it should not refund
any amounts that it receives as refunds from local governments as they implement
the new multiplier tables. Consumers believes that such action may be
inconsistent with the electric rate freeze that is currently in effect, and may
otherwise be unlawful. Consumers is unable to predict the outcome of this
matter.
OTHER CONSUMERS' ELECTRIC UTILITY UNCERTAINTIES
THE MIDLAND COGENERATION VENTURE: The MCV Partnership, which leases and operates
the MCV Facility, contracted to sell electricity to Consumers for a 35-year
period beginning in 1990 and to supply electricity and steam to Dow. Consumers,
through two wholly owned subsidiaries, holds the following assets related to the
MCV Partnership and MCV Facility: 1) CMS Midland owns a 49 percent general
partnership interest in the MCV Partnership; and 2) CMS Holdings holds, through
FMLP, a 35 percent lessor interest in the MCV Facility.
Summarized Statements of Income for CMS Midland and CMS Holdings
In Millions
Nine Months Ended
September 30 2002 2001
- ------------------------------------------------------------------------------------------------------------------
Pretax operating income $63 $31
Income taxes and other 21 9
- ------------------------------------------------------------------------------------------------------------------
Net income $42 $ 22
==================================================================================================================
Power Supply Purchases from the MCV Partnership - Consumers' annual obligation
to purchase capacity from the MCV Partnership is 1,240 MW through the
termination of the PPA in 2025. The PPA requires Consumers to pay, based on the
MCV Facility's availability, a levelized average capacity charge of 3.77 cents
per kWh, a fixed energy charge, and a variable energy charge based primarily on
Consumers' average cost of coal consumed for all kWh delivered. Since January 1,
1993, the MPSC has permitted Consumers to recover capacity charges averaging
3.62 cents per kWh for 915 MW, plus a substantial portion of the fixed and
variable energy charges. Since January 1, 1996, the MPSC has also permitted
Consumers to recover capacity charges for the remaining 325 MW of contract
capacity with an initial average charge of 2.86 cents per kWh increasing
periodically to an eventual 3.62 cents per kWh by 2004 and thereafter. However,
due to the current freeze of Consumers' retail rates that the Customer Choice
Act requires, the capacity charge for the 325 MW is now frozen at 3.17 cents per
kWh. After September 2007, the PPA's terms obligate Consumers to pay the MCV
Partnership only those capacity and energy charges that the MPSC has authorized
for recovery from electric customers.
In 1992, Consumers recognized a loss for the present value of the estimated
future underrecoveries of power
CMS-70
CMS Energy Corporation
supply costs under the PPA based on MPSC cost recovery orders. Consumers
continually evaluates the adequacy of the PPA liability for future
underrecoveries. These evaluations consider management's assessment of operating
levels at the MCV Facility through 2007 along with certain other factors
including MCV related costs that are included in Consumers' frozen retail rates.
During the third quarter of 2001, in connection with Consumers' long-term
electric supply planning, management reviewed the PPA liability assumptions
related to increased expected long-term dispatch of the MCV Facility and
increased MCV related costs. As a result, in September 2001, Consumers increased
the PPA liability by $126 million. Management believes that, following the
increase, the PPA liability adequately reflects the present value of the PPA's
future effect on Consumers. At September 30, 2002 and 2001, the remaining
present value of the estimated future PPA liability associated with the loss
totaled $168 million and $188 million, respectively. For further discussion on
the impact of the frozen PSCR, see "Electric Rate Matters" in this Note.
In March 1999, Consumers and the MCV Partnership reached an agreement effective
January 1, 1999, that capped availability payments to the MCV Partnership at
98.5 percent. If the MCV Facility generates electricity at the maximum 98.5
percent level during the next six years, Consumers' after-tax cash
underrecoveries associated with the PPA could be as follows:
In Millions
- ------------------------------------------------------------------------------------------------------------------
2002 2003 2004 2005 2006 2007
- ------------------------------------------------------------------------------------------------------------------
Estimated cash underrecoveries at 98.5% net of tax $38 $37 $36 $36 $36 $25
==================================================================================================================
In February 1998, the MCV Partnership appealed the January 1998 and February
1998 MPSC orders related to electric utility restructuring. At the same time,
MCV Partnership filed suit in the United States District Court in Grand Rapids
seeking a declaration that the MPSC's failure to provide Consumers and MCV
Partnership a certain source of recovery of capacity payments after 2007
deprived MCV Partnership of its rights under the Public Utilities Regulatory
Policies Act of 1978. In July 1999, the District Court granted MCV Partnership's
motion for summary judgment. The Court permanently prohibited enforcement of the
restructuring orders in any manner that denies any utility the ability to
recover amounts paid to qualifying facilities such as the MCV Facility or that
precludes the MCV Partnership from recovering the avoided cost rate. The MPSC
appealed the Court's order to the 6th Circuit Court of Appeals in Cincinnati. In
June 2001, the 6th Circuit overturned the lower court's order and dismissed the
case against the MPSC. The appellate court determined that the case was
premature and concluded that the qualifying facilities needed to wait until 2008
for an actual factual record to develop before bringing claims against the MPSC
in federal court. For further material information, see "Pending Restatement and
Other Related Uncertainties" in this Note.
NUCLEAR FUEL COST: Consumers amortizes nuclear fuel cost to fuel expense based
on the quantity of heat produced for electric generation. Through November 2001,
Consumers expensed the interest on leased nuclear fuel as it was incurred.
Effective December 2001, Consumers no longer leases its nuclear fuel.
For nuclear fuel used after April 6, 1983, Consumers charges disposal costs to
nuclear fuel expense, recovers these costs through electric rates, and then
remits them to the DOE quarterly. Consumers elected to defer payment for
disposal of spent nuclear fuel burned before April 7, 1983. As of September 30,
2002, Consumers has a recorded liability to the DOE of $137 million, including
interest, which is payable upon the first delivery of spent nuclear fuel to the
DOE. Consumers recovered through electric rates the amount of this liability,
excluding a portion of interest. In 1997, a federal court decision has confirmed
that the DOE was to begin accepting deliveries of spent nuclear fuel for
disposal by January 31, 1998. Subsequent litigation in which
CMS-71
CMS Energy Corporation
Consumers and certain other utilities participated has not been successful in
producing more specific relief for the DOE's failure to comply.
In July 2000, the DOE reached a settlement agreement with one utility to address
the DOE's delay in accepting spent fuel. The DOE may use that settlement
agreement as a framework that it could apply to other nuclear power plants.
However, certain other utilities challenged the validity of the mechanism for
funding the settlement in an appeal, and recently the reviewing court sustained
their challenge. Additionally, there are two court decisions that support the
right of utilities to pursue damage claims in the United States Court of Claims
against the DOE for failure to take delivery of spent fuel. A number of
utilities have commenced litigation in the Court of Claims. Consumers is
evaluating its options with respect to its contract with the DOE and plans to
pursue recovery of the nuclear fuel removal costs at its Big Rock and Palisades
plants.
In July 2002, Congress approved and the President signed a bill designating the
site at Yucca Mountain, Nevada, for the development of a repository for the
disposal of high-level radioactive waste and spent nuclear fuel. The next step
will be for the DOE to submit an application to the NRC for a license to begin
construction of the repository. The application and review process is estimated
to take several years.
NUCLEAR MATTERS: In April 2002, Palisades received its annual performance review
in which the NRC stated that Palisades operated in a manner that preserved
public health and safety. With the exception of a single finding related to a
fire protection smoke detector location with low safety significance, the NRC
classified all inspection findings as having very low safety significance. Other
than the follow-up fire protection inspection associated with this one finding,
the NRC plans to conduct only baseline inspections at the facility through May
31, 2003.
The amount of spent nuclear fuel discharged from the reactor to date exceeds
Palisades' temporary on-site storage pool capacity. Consequently, Consumers is
using NRC-approved steel and concrete vaults, commonly known as "dry casks", for
temporary on-site storage. As of September 30, 2002, Consumers had loaded 18 dry
casks with spent nuclear fuel at Palisades. Palisades will need to load
additional dry casks by the fall of 2004 in order to continue operation.
Palisades currently has three empty storage-only dry casks on-site, with storage
pad capacity for up to seven additional loaded dry casks. Consumers anticipates
that licensed transportable dry casks for additional storage, along with more
storage pad capacity, will be available prior to 2004.
In December 2000, the NRC issued an amendment revising the operating license for
Palisades to extend its expiration date to March 2011, with no restrictions
related to reactor vessel embrittlement.
In 2000, Consumers made an equity investment and entered into an operating
agreement with NMC. NMC was formed in 1999 by four utilities to operate and
manage the nuclear generating plants owned by these utilities. Consumers
benefits by consolidating expertise, cost control and resources among all of the
nuclear plants being operated on behalf of the NMC member companies.
In November 2000, Consumers requested approval from the NRC to transfer
operating authority for Palisades to NMC and the request was granted in April
2001. The formal transfer of authority from Consumers to NMC took place in May
2001. Consumers retains ownership of Palisades, its 789 MW output, the current
and future spent fuel on-site, and ultimate responsibility for the safe
operation, maintenance and decommissioning of the plant. Under the agreement
that transferred operating authority of the plant to NMC, salaried Palisades'
employees became NMC employees on July 1, 2001. Union employees work under the
supervision of NMC pursuant to their existing labor contract as Consumers'
employees. NMC currently has responsibility for
CMS-72
CMS Energy Corporation
operating eight units with 4,500 MW of generating capacity in Wisconsin,
Minnesota, Iowa and Michigan.
Following a refueling outage in April 2001, the Palisades reactor was shut down
on June 20, 2001 so technicians could inspect a small steam leak on a control
rod drive assembly. There was no risk to the public or workers. In August 2001,
Consumers completed an expanded inspection that included all similar control rod
drive assemblies and elected to completely replace all the components.
Installation of the new components was completed in December 2001 and the plant
returned to service and has been operating since January 21, 2002. Consumers'
capital expenditures for the components and their installation was approximately
$31 million.
From the start of the June 20th outage through the end of 2001, the impact on
net income of replacement power supply costs associated with the outage was
approximately $59 million. Subsequently, in January 2002, the impact on 2002 net
income was $5 million.
Consumers maintains insurance against property damage, debris removal, personal
injury liability and other risks that are present at its nuclear facilities.
Consumers also maintains coverage for replacement power supply costs during
certain prolonged accidental outages at Palisades. Insurance would not cover
such costs during the first 12 weeks of any outage, but would cover most of such
costs during the next 52 weeks of the outage, followed by reduced coverage to 80
percent for 110 additional weeks. The June 2001 through January 2002 Palisades
outage, however, was not an insured event. If certain covered losses occur at
its own or other nuclear plants similarly insured, Consumers could be required
to pay maximum assessments of $25.8 million in any one year to NEIL; $88 million
per occurrence under the nuclear liability secondary financial protection
program, limited to $10 million per occurrence in any year; and $6 million if
nuclear workers claim bodily injury from radiation exposure. Consumers considers
the possibility of these assessments to be remote. NEIL limits its coverage from
multiple acts of terrorism during a twelve-month period to a maximum aggregate
of $3.24 billion, allocated among the claimants, plus recoverable reinsurance,
indemnity and other sources, which could affect the amount of loss coverage for
Consumers should multiple acts of terrorism occur. The Price Anderson Act is
currently in the process of reauthorization by the U. S. Congress. It is
possible that the Price Anderson Act will not be reauthorized or changes may be
made that significantly affect the insurance provisions for nuclear plants.
DERIVATIVE ACTIVITIES: Consumers' electric business uses purchased electric call
option contracts to meet, in part, its regulatory obligation to serve. This
obligation requires Consumers to provide a physical supply of electricity to
customers, to manage electric costs and to ensure a reliable source of capacity
during peak demand periods. These contracts are subject to SFAS No. 133
derivative accounting, and are required to be recorded on the balance sheet at
fair value, with changes in fair value recorded directly in earnings or other
comprehensive income, if the contract meets qualifying hedge criteria. On July
1, 2001, upon initial adoption of the standard for these contracts, Consumers
recorded a $3 million, net of tax, cumulative effect adjustment as an unrealized
loss, decreasing accumulated other comprehensive income. This adjustment relates
to the difference between the fair value and the recorded book value of these
electric call option contracts. The adjustment to accumulated other
comprehensive income relates to electric call option contracts that qualified
for cash flow hedge accounting prior to the initial adoption of SFAS No. 133.
After July 1, 2001, these contracts did not qualify for hedge accounting under
SFAS No. 133 and, therefore, Consumers records any change in fair value
subsequent to July 1, 2001 directly in earnings, which can cause earnings
volatility. The initial amount recorded in other comprehensive income was
reclassified to earnings as the forecasted future transactions occurred or the
call options expired. The majority of these contracts expired in the third
quarter 2001 and the remaining contracts expired in the third quarter of 2002.
As of December 31, 2001, Consumers
CMS-73
CMS Energy Corporation
reclassified from other comprehensive income to earnings, $2 million, net of
tax, as part of the cost of power supply, and the remainder, $1 million, net of
tax, was reclassified from other comprehensive income to earnings in the third
quarter of 2002.
In December 2001, the FASB issued revised guidance regarding derivative
accounting for electric call option contracts and option-like contracts. The
revised guidance amended the criteria used to determine if derivative accounting
is required. In light of the amended criteria, Consumers re-evaluated its
electric call option and option-like contracts, and determined that additional
contracts require derivative accounting. Therefore, as of December 31, 2001,
upon initial adoption of the revised guidance for these contracts, Consumers
recorded an $11 million, net of tax, cumulative effect adjustment as a decrease
to earnings. This adjustment relates to the difference between the fair value
and the recorded book value of these electric call option contracts. Consumers
will record any change in fair value subsequent to December 31, 2001, directly
in earnings, which could cause earnings volatility. As of September 30, 2002,
Consumers recorded on the balance sheet all of its unexpired purchased electric
call option contracts subject to derivative accounting at a fair value of $1
million.
Consumers believes that certain of its electric capacity and energy contracts
are not derivatives due to the lack of an active energy market, as defined by
SFAS No. 133, in the state of Michigan and the transportation cost to deliver
the power under the contracts to the closest active energy market at the Cinergy
hub in Ohio. If a market develops in the future, Consumers may be required to
account for these contracts as derivatives. The mark-to-market impact in
earnings related to these contracts, particularly related to the PPA could be
material to the financial statements.
Consumers' electric business also uses gas swap contracts to protect against
price risk due to the fluctuations in the market price of gas used as fuel for
generation of electricity. These gas swaps are financial contracts that will be
used to offset increases in the price of probable forecasted gas purchases.
These contracts do not qualify for hedge accounting. Therefore, Consumers
records any change in the fair value of these contracts directly in earnings as
part of power supply costs, which could cause earnings volatility. As of
September 30, 2002, a mark-to-market gain of $1 million has been recorded for
2002, which represents the fair value of these contracts at September 30, 2002.
These contracts expire in December 2002.
As of September 30, 2001, Consumers' electric business also used purchased gas
call option and gas swap contracts to hedge against price risk due to the
fluctuations in the market price of gas used as fuel for generation of
electricity. These contracts were financial contracts that were used to offset
increases in the price of probable forecasted gas purchases. These contracts
were designated as cash flow hedges and, therefore, Consumers recorded any
change in the fair value of these contracts in other comprehensive income until
the forecasted transaction occurs. Once the forecasted gas purchases occurred,
the net gain or loss on these contracts were reclassified to earnings and
recorded as part of the cost of power. These contracts were highly effective in
achieving offsetting cash flows of future gas purchases, and no component of the
gain or loss was excluded from the assessment of the hedge's effectiveness. As a
result, no net gain or loss was recognized in earnings as a result of hedge
ineffectiveness as of September 30, 2001. At September 30, 2001, Consumers had a
derivative liability with a fair value of $0.4 million. These contracts expired
in 2001.
CONSUMERS' GAS UTILITY CONTINGENCIES
GAS ENVIRONMENTAL MATTERS: Under the Michigan Natural Resources and
Environmental Protection Act, Consumers expects that it will ultimately incur
investigation and remedial action costs at a number of sites. These include 23
former manufactured gas plant facilities, which were operated by Consumers for
some part of
CMS-74
CMS Energy Corporation
their operating lives, including sites in which it has a partial or no current
ownership interest. Consumers has completed initial investigations at the 23
sites. For sites where Consumers has received site-wide study plan approvals, it
will continue to implement these plans. It will also work toward closure of
environmental issues at sites as studies are completed. Consumers has estimated
its costs related to further investigation and remedial action for all 23 sites
using the Gas Research Institute-Manufactured Gas Plant Probabilistic Cost
Model. The estimated total costs are between $82 million and $113 million; these
estimates are based on discounted 2001 costs and follow EPA recommended use of
discount rates between 3 and 7 percent for this type of activity. Consumers
expects to recover a significant portion of these costs through insurance
proceeds and through MPSC approved rates charged to its customers. As of
September 30, 2002, Consumers has an accrued liability of $51 million, net of
$31 million of expenditures incurred to date, and a regulatory asset of $70
million. Any significant change in assumptions, such as an increase in the
number of sites, different remediation techniques, nature and extent of
contamination, and legal and regulatory requirements, could affect Consumers'
estimate of remedial action costs.
The MPSC, in its November 7, 2002, gas distribution rate order, authorized
Consumers to continue to recover approximately $1 million of manufactured gas
plant facilities environmental clean-up costs annually. Consumers defers and
amortizes, over a period of 10 years, manufactured gas plant facilities
environmental clean-up costs above the amount currently being recovered in
rates. Additional rate recognition of amortization expense cannot begin until
after a prudency review in a gas rate case. The annual amount that the MPSC
authorized Consumers to recover in rates will continue to be offset by $2
million to reflect amounts recovered from all other sources.
CONSUMERS' GAS UTILITY RATE MATTERS
GAS RESTRUCTURING: From April 1, 1998 to March 31, 2001, Consumers conducted an
experimental gas customer choice pilot program that froze gas distribution and
GCR rates through the period. On April 1, 2001, a permanent gas customer choice
program commenced under which Consumers returned to a GCR mechanism that allows
it to recover from its bundled sales customers all prudently incurred costs to
purchase the natural gas commodity and transport it to Consumers for ultimate
distribution to customers.
GAS COST RECOVERY: As part of a settlement agreement approved by the MPSC in
July 2001, Consumers agreed not to bill a price in excess of $4.69 per mcf of
natural gas under the GCR factor mechanism through March 2002. This agreement is
not expected to affect Consumers' earnings outlook because Consumers recovers
from customers the amount that it actually pays for natural gas in the
reconciliation process. The settlement does not affect Consumers' June 2001
request to the MPSC for a distribution service rate increase. The MPSC also
approved a methodology to adjust bills for market price increases quarterly
without returning to the MPSC for approval. In December 2001, Consumers filed
its GCR Plan for the period April 2002 through March 2003. Consumers is
requesting authority to bill a GCR factor up to $3.50 per mcf for this period.
The Company also requested the MPSC approve the same methodology which adjusts
bills for market price increases that the MPSC approved, through settlement, in
the previous plan year. A settlement with all parties in the proceeding was
signed and submitted to the Commission in March 2002. The settlement stipulated
to all requests of Consumers and the MPSC approved the settlement, as filed, in
July 2002. Consistent with the terms of the settlement, Consumers filed in June
of 2002 to raise the GCR factor cap to $3.66 for the period July through
September and Consumers proceeded to bill its customers at this new rate. In
September, Consumers filed to raise the GCR factor cap to $3.79 for October
through December, but expects to be able to continue billing at the $3.66 rate.
CMS-75
CMS Energy Corporation
GAS RATE CASE: In June 2001, Consumers filed an application with the MPSC
seeking a $140 million distribution service rate increase. Consumers requested a
12.25 percent authorized return on equity. Contemporaneously with this filing,
Consumers requested partial and immediate relief in the annual amount of $33
million. The relief was primarily for higher carrying costs on more expensive
natural gas inventory than is currently included in rates. In October 2001,
Consumers revised its filing to reflect lower operating costs and requested a
$133 million annual distribution service rate increase. In December 2001, the
MPSC authorized a $15 million annual interim increase in distribution service
rate revenues. The order authorized Consumers to apply the interim increase on
its gas sales customers' bills for service effective December 21, 2001. In
February 2002, Consumers revised its filing to reflect lower estimated gas
inventory prices and revised depreciation expense and requested an annual $105
million distribution service rate increase. On November 7, 2002, the MPSC issued
a final order approving a $56 million annual distribution service rate increase,
which includes the $15 million interim increase, with an 11.4 percent authorized
return on equity, effective for service November 8, 2002.
In September 2002, the FERC issued an order rejecting a filing by Consumers to
assess certain rates for non-physical gas title tracking services offered by
Consumers. Despite Consumer' arguments to the contrary, the Commission asserted
jurisdiction over such activities and allowed Consumers to refile and justify a
title transfer fee not based on volumes as Consumers proposed. Because the order
was issued 6 years after Consumers made its original filing initiating the
proceeding, over $3 million in non-title transfer tracking fees had been
collected. No refunds have been ordered, and Consumers sought rehearing of the
September order. Consumers has made no reservations for refunds in this matter.
If refunds were ordered they may include interest which would increase the
refund liability to more than the $3 million collected. Consumers is unable to
say with certainty what the final outcome of this proceeding might be.
In November 2002, the MPSC upon its own motion commenced a contested proceeding
requiring each utility to give reason as to why its rates should not be reduced
to reflect new personal property multiplier tables, and why it should not
refund any amounts that it receives as refunds from local governments as they
implement the new multiplier tables. Consumers believes that such action may be
inconsistent with the November 7, 2002 gas rate order in case U-13000, with the
Customer Choice Act, and may otherwise be unlawful. Consumers is unable to
predict the outcome of this matter.
OTHER CONSUMERS' GAS UTILITY UNCERTAINTIES
DERIVATIVE ACTIVITIES: Consumers' gas business uses fixed price gas supply
contracts, and fixed price weather-based gas supply call options and fixed price
gas supply put options, and other types of contracts, to meet its regulatory
obligation to provide gas to its customers at a reasonable and prudent cost.
Some of the fixed price gas supply contracts require derivative accounting
because they contain embedded put options that disqualify the contracts from the
normal purchase exception of SFAS No. 133. As of September 30, 2002, Consumers'
gas supply contracts requiring derivative accounting had a fair value of $1
million, representing a fair value gain on the contracts since the date of
inception. This gain was recorded directly in earnings as part of other income,
and then directly offset and recorded on the balance sheet as a regulatory
liability. Any subsequent changes in fair value will be recorded in a similar
manner. These contracts expire in October 2002.
As of September 30, 2002, weather-based gas call options and gas put options
requiring derivative accounting had a net fair value of $1 million. The change
in value since inception in August 2002 is immaterial. Any change in fair value
will be recorded in a similar manner as stated above for the change in fair
value for fixed price gas supply contracts requiring derivative accounting.
PANHANDLE MATTERS
REGULATORY MATTERS: In conjunction with a FERC order issued in September 1997,
FERC required certain natural gas producers to refund previously collected
Kansas ad-valorem taxes to interstate natural gas pipelines, including Panhandle
Eastern Pipe Line. FERC ordered the pipelines to refund these amounts to their
customers. In June 2001, Panhandle Eastern Pipe Line filed a proposed settlement
with the FERC which was supported by most of the
CMS-76
CMS Energy Corporation
customers and affected producers. In October 2001, the FERC approved that
settlement. The settlement provided for a resolution of the Kansas ad valorem
tax matter on the Panhandle Eastern Pipe Line system for a majority of refund
amounts. Certain producers and the state of Missouri elected to not participate
in the settlement. At September 30, 2002 and December 31, 2001, accounts
receivable included $8 million due from natural gas producers, and other current
liabilities included $12 million and $11 million, respectively, for related
obligations. Remaining amounts collected but not refunded are subject to refund
pending resolution of issues remaining in the FERC docket and Kansas intrastate
proceeding.
In July 2001, Panhandle Eastern Pipe Line filed a settlement with customers on
Order 637 matters to resolve issues including capacity release and imbalance
penalties, among others. On October 12, 2001 and December 19, 2001 FERC issued
orders approving the settlement, with modifications. The settlement changes
became final effective February 1, 2002, resulting in a non-recurring gain
associated with previously collected penalties of $4 million in Other revenue
and a $2 million reversal of related interest expense. Prospectively, penalties
will be credited to customers.
In August 2001, an offer of settlement of Trunkline LNG rates sponsored jointly
by Trunkline LNG, BG LNG Services and Duke LNG Sales was filed with the FERC and
was approved on October 11, 2001. The settlement was placed into effect on
January 1, 2002. As part of the settlement, Trunkline LNG, now owned by LNG
Holdings, a joint venture between Panhandle and Dekatherm Investment Trust,
reduced its maximum rates.
In December 2001, Trunkline LNG, now partially owned by Panhandle, filed with
the FERC a certificate application to expand the Lake Charles facility to
approximately 1.2 billion cubic feet per day of sendout capacity versus the
current capacity of 630 million cubic feet per day. The BG Group has contract
rights for all of this additional capacity. Storage capacity will also be
expanded to 9 billion cubic feet, from its current capacity of 6.3 billion cubic
feet. On August 27, 2002 the FERC issued a "Preliminary Determination on
Non-Environmental Issues" recommending approval of the planned expansion
project. The FERC's July 2002 Environmental Assessment determined that the
Trunkline LNG expansion facilities do not constitute a major federal action
significantly affecting the environment and recommended certain compliance and
mitigation measures. Comments on the Environmental Assessment were filed on
August 30, 2002. The application for a certificate of public convenience and
necessity of the expansion is still pending final FERC action. The expansion
expenditures are currently expected to be funded by Panhandle loans or equity
contributions to LNG Holdings.
Panhandle has sought refunds from the State of Kansas concerning certain
corporate income tax issues for the years 1981 through 1984. On January 25, 2002
the Kansas Supreme Court entered an order affirming a previous Board of Tax
Court finding that Panhandle was entitled to refunds which with interest total
approximately $26 million. Pursuant to the provisions of the purchase agreement
between CMS Energy and a subsidiary of Duke Energy, Duke retains the benefits of
any tax refunds or liabilities for periods prior to the date of the sale of
Panhandle to CMS Energy.
In February 2002, Trunkline Gas filed a settlement with customers on Order 637
matters to resolve issues including capacity release and imbalance penalties,
among others. On July 5, 2002 FERC issued an order approving the settlement,
with modifications. On October 18, 2002 Trunkline Gas filed tariff sheets with
the FERC to implement the Order 637 changes which will become effective November
1, 2002.
ENVIRONMENTAL MATTERS: Panhandle is subject to federal, state and local
regulations regarding air and water quality, hazardous and solid waste disposal
and other environmental matters. Panhandle has identified
CMS-77
CMS Energy Corporation
environmental contamination at certain sites on its systems and has undertaken
cleanup programs at these sites. The contamination resulted from the past use of
lubricants containing PCBs in compressed air systems and the prior use of
wastewater collection facilities and other on-site disposal areas. Panhandle
communicated with the EPA and appropriate state regulatory agencies on these
matters. Under the terms of the sale of Panhandle to CMS Energy, a subsidiary of
Duke Energy is obligated to complete the Panhandle cleanup programs at certain
agreed-upon sites and to indemnify against certain future environmental
litigation and claims. Duke Energy's cleanup activities have been completed on
all but one of the agreed-upon sites. Should additional information be requested
regarding sites where compliance information has been submitted, Panhandle would
be obligated to respond to these requests.
As part of the cleanup program resulting from contamination due to the use of
lubricants containing PCBs in compressed air systems, Panhandle Eastern Pipe
Line and Trunkline have identified PCB levels above acceptable levels inside the
auxiliary building that houses the air compressor equipment at one of its
compressor station sites. Panhandle has developed and is implementing an
EPA-approved process to remediate this PCB contamination. Panhandle is also
implementing a plan to assess the interior of auxiliary buildings at other
compressor stations with similar histories of PCB containing lubricants and will
remediate as required. The results of this assessment and remediation will be
managed in accordance with federal, state and local regulations.
At some locations, PCBs have been identified in paint that was applied many
years ago. In accordance with EPA regulations, Panhandle is implementing a
program to remediate sites where such issues have been identified during
painting activities. If PCBs are identified above acceptable levels, the paint
is removed and disposed of in an EPA-approved manner. Approximately 15 percent
of the paint projects in the last few years have required this special
procedure.
The Illinois EPA notified Panhandle Eastern Pipe Line and Trunkline, together
with other non-affiliated parties, of contamination at former waste oil disposal
sites in Illinois. Panhandle and 21 other non-affiliated parties are conducting
an investigation of one of the sites. Final reports are expected in the fourth
quarter of 2002. Panhandle Eastern Pipe Line's and Trunkline's share for the
costs of assessment and remediation of the sites, based on the volume of waste
sent to the facilities, is approximately 17 percent.
Panhandle expects these cleanup programs to continue for several years and has
estimated its share of remaining cleanup costs not indemnified by Duke Energy to
be approximately $21 million. Such costs have been accrued for and are reflected
in Panhandle's Consolidated Balance Sheet in Other Non-current Liabilities.
AIR QUALITY CONTROL: In 1998, the EPA issued a final rule on regional ozone
control that requires revised SIPS for 22 states, including five states in which
Panhandle operates. This EPA ruling was challenged in court by various states,
industry and other interests, including the INGAA, an industry group to which
Panhandle belongs. In March 2000, the court upheld most aspects of the EPA's
rule, but agreed with INGAA's position and remanded to the EPA the sections of
the rule that affected Panhandle. Based on EPA guidance to these states for
development of SIPs, Panhandle expects future compliance costs to range from $15
million to $20 million for capital improvements to be incurred from 2004 through
2007.
As a result of the 1990 Clean Air Act Amendments, the EPA must issue MACT rules
controlling hazardous air pollutants from internal combustion engines and
turbines. These rules are expected in early 2003. Beginning in 2002, the Texas
Natural Resource Conservation Commission enacted the Houston/Galveston SIP
regulations requiring reductions in nitrogen oxide emissions in an eight county
area surrounding Houston. Trunkline's
CMS-78
CMS Energy Corporation
Cypress Compressor Station is affected and may require the installation of
emission controls. In 2003, the new regulations will also require all "grand
fathered" facilities to enter into the new source permit program which may
require the installation of emission controls at five additional facilities. The
company expects future capital costs for these programs to range from $14
million to $29 million.
In 1997, the Illinois Environmental Protection Agency initiated an enforcement
proceeding relating to alleged air quality permit violations at Panhandle's
Glenarm Compressor Station. On November 15, 2001 the Illinois Pollution Control
Board approved an order imposing a penalty of $850 thousand, plus fees and cost
reimbursements of $116 thousand. Under terms of the sale of Panhandle to CMS
Energy, a subsidiary of Duke Energy was obligated to indemnify Panhandle against
this environmental penalty. The state issued a permit in February of 2002
requiring the installation of certain capital improvements at the facility at a
cost of approximately $3 million. It is expected that the capital improvements
will occur in 2002 and 2003.
OTHER UNCERTAINTIES
CREDIT RATING: In July 2002, the credit ratings of the publicly traded
securities of each of CMS Energy, Consumers and Panhandle (but not Consumers
Funding LLC) were downgraded by the major rating agencies. The ratings downgrade
for all three companies' securities is largely a function of the uncertainties
associated with CMS Energy's financial condition and liquidity pending
resolution of the round-trip trading investigations and lawsuits, financial
statement restatement and re-audit, and directly affects and limits CMS Energy's
access to the capital markets.
As a result of certain of these downgrades, rights were triggered in several
contractual arrangements between CMS Energy subsidiaries and third parties. More
specifically, a loan to Panhandle made in connection with the December 2001 LNG
off-balance sheet monetization transaction is subject to repayment demand by the
unaffiliated equity partner in the LNG Holdings joint venture. At September 30,
2002, Panhandle's remaining balance on the $75 million note payable to LNG
Holdings was approximately $66 million. Dekatherm Investor Trust has agreed not
to make demand for payment before November 22, 2002 in return for a fee, and an
agreement for Panhandle to acquire Dekatherm Investor Trust's interest in LNG
Holdings. When Panhandle acquires Dekatherm Investor Trust's interest, it will
then own 100 percent of LNG Holdings and will not demand payment on the note
payable to LNG Holdings.
In addition, the construction lenders for each of the Guardian and Centennial
pipeline projects, each partially owned by Panhandle, requested acceptable
credit support for Panhandle's guarantee of its pro rata portion of those
construction loans, which aggregate $110 million including anticipated future
draws. On September 27, 2002 Panhandle's Centennial partners provided credit
support of $25 million each in the form of guarantees to the lender to cover
Panhandle's obligation of $50 million of loan guarantees. The partners will be
paid credit fees by Panhandle on the outstanding balance of the guarantees for
any periods for which they are in effect. This additional credit support does
not remove Panhandle from its original $50 million obligation. In October 2002,
Panhandle provided a letter of credit to the lenders which constitutes
acceptable credit support under the Guardian financing agreement. This letter of
credit was cash collateralized by Panhandle with approximately $63 million. As
of September 30, 2002, Panhandle has also provided $16 million of equity
contributions to Guardian.
Further, one of the issuers of a joint and several surety bond in the
approximate amount of $187 million supporting a CMS MST gas supply contract has
demanded acceptable collateral for the full amount of such bond. This
issuer has commenced litigation against Enterprises and CMS MST in Michigan
federal
CMS-79
CMS Energy Corporation
district court and is seeking to require Enterprises and CMS MST to provide
acceptable collateral and to prevent them from disposing of or transferring any
corporate assets outside the ordinary course of business before the Court has an
opportunity to fully adjudicate the issuer's claim. Enterprises and CMS MST
continue to work with the issuer to find mutually satisfactory arrangements. The
second issuer of the $187 million bond has similar rights in conjunction with
surety bonds supporting two other CMS MST gas supply contracts, aggregating
approximately $112 million. That surety bond issuer has entered discussions with
CMS MST about the possible posting of acceptable collateral for all three
additional surety bonds. CMS Energy has reached a settlement in principle that
would provide the issuers with acceptable collateral and resolve the litigation.
However, the settlement is subject to final documentation as well as approval by
the banks that are party to the CMS Energy secured credit facilities.
GAS INDEX PRICING REPORTING: On November 4, 2002, CMS Energy announced that it
is conducting an internal review of the natural gas trade information provided
by CMS MST and CMS Field Services to energy industry publications that compile
and report index prices. A preliminary analysis indicates that some employees
provided inaccurate information in the voluntary reports. CMS Energy and its
subsidiaries no longer provide natural gas trade information to energy industry
publications. CMS Energy has notified the appropriate regulatory and
governmental agencies of this review. On November 5, 2002, CMS Energy
received an information request from the Commodity Futures Trading Commission
pursuant to a prior subpoena relating to round-trip trading. The Commodity
Futures Trading Commission requested certain information regarding the employees
involved in providing the inaccurate natural gas trade data to industry
publications as well as details of the information provided. CMS Energy has
produced documents and information responsive to the November 5, 2002 request.
SECURITIES CLASS ACTION LAWSUITS: Eighteen separate civil lawsuits have been
filed in federal court in Michigan in connection with round-trip trading,
alleging (i) violation of Section 10(b) and Rule 10b-5 of the Securities
Exchange Act of 1934 ("Exchange Act") and (ii) violation of Section 20(a) of the
Exchange Act. (See Exhibit 99(d) for case names, dates instituted and principal
parties) All suits name Messrs. McCormick and Wright and CMS Energy as
defendants. Consumers Energy, Mr. Joos and Ms. Pallas are named as defendants on
certain of the suits. The cases will be consolidated into a single lawsuit.
These complaints generally seek unspecified damages based on allegations that
the defendants violated United States securities laws and regulations by making
allegedly false and misleading statements about the Company's business and
financial condition. The Company intends to vigorously defend against these
actions. CMS Energy cannot predict the outcome of this legislation.
DEMAND FOR ACTIONS AGAINST OFFICERS AND DIRECTORS: The Board of Directors
received a demand, on behalf of a shareholder of CMS Energy Common Stock,
that it commence civil actions (i) to remedy alleged breaches of fiduciary
duties by CMS Energy officers and directors in connection with round-trip
trading at CMS Energy, and (ii) to recover damages sustained by CMS Energy as a
result of alleged insider trades alleged to have been made by certain current
and former officers of CMS Energy and its subsidiaries. If the Board elects not
to commence such actions, the shareholder has stated that he will initiate a
derivative suit, bringing such claims on behalf of CMS Energy. CMS Energy is
seeking to elect two new members to its Board of Directors to serve as an
independent litigation committee to determine whether it is in the best interest
of CMS Energy to bring the action demanded by the shareholder. Counsel for the
shareholder has agreed to extend the time for CMS Energy to respond to the
demand. CMS Energy cannot predict the outcome of this legislation.
ERISA CLAIMS: On July 11, 2002 and July 18, 2002, two Consumers employees filed
separate alleged class action lawsuits on behalf of the participants and
beneficiaries of the CMS Employees' Savings and Incentive Plan in the United
States District Court for the Eastern District of Michigan. CMS Energy,
Consumers and CMS MST are defendants in one action, and CMS Energy, Consumers,
and other alleged fiduciaries are defendants in the other. The complaints allege
various counts arising under the ERISA. The two cases will be consolidated into
a single lawsuit and a single consolidated amended complaint will be filed. CMS
Energy intends to vigorously defend against these actions. CMS Energy cannot
predict the outcome of this legislation.
CMS GENERATION-OXFORD TIRE RECYCLING: In 1999, the California Regional Water
Control Board of the State of California named CMS Generation as a potentially
responsible party for the cleanup of the waste from a fire that occurred in
September 1999 at the Filbin tire pile. The tire pile was maintained as fuel for
an adjacent power plant owned by Modesto Energy Limited Partnership. Oxford Tire
Recycling of Northern California, Inc., a subsidiary of CMS Generation until
1995, owned the Filbin tire pile. CMS Generation has not owned
CMS-80
CMS Energy Corporation
an interest in Oxford Tire Recycling of Northern California, Inc. or Modesto
Energy Limited Partnership since 1995. In 2000, the California Attorney General
filed a complaint against the potentially responsible parties for cleanup of the
site and assessed penalties for violation of the California Regional Water
Control Board order. The parties have reached a settlement with the state, which
the court approved, pursuant to which CMS Energy had to pay $6 million. At the
request of the U.S. Department of Justice in San Francisco (DOJ), CMS Energy and
other parties contacted by the DOJ entered into separate Tolling Agreements with
the DOJ in September 2002 that stopped the running of any statute of limitations
until March 14, 2003 to facilitate the settlement discussions between all the
parties in connection with federal claims arising from the fire at the Filbin
tire pile. On September 23, 2002, CMS Energy received a written demand from the
U.S. Coast Guard for reimbursement of approximately $3.5 million in costs
incurred by the U.S. Coast Guard in fighting the fire.
In connection with this fire, several class action lawsuits were filed claiming
that the fire resulted in damage to the class and that management of the site
caused the fire. CMS Generation has reached a settlement in principle with the
plaintiffs in the amount of $9 million. The primary insurance carrier will cover
100 percent of the settlement once the agreement is finalized.
DEARBORN INDUSTRIAL GENERATION: In October 2001, Duke/Fluor Daniel (DFD)
presented DIG with a change order to their construction contract and filed an
action in Michigan state court claiming damages in the amount of $110 million,
plus interest and costs, which DFD states represents the cumulative amount owed
by DIG for delays DFD believes DIG caused and for prior change orders that DIG
previously rejected. DFD also filed a construction lien for the $110 million.
DIG, in addition to drawing down on three letters of credit totaling $30 million
that it obtained from DFD, has filed an arbitration claim against DFD asserting
in excess of an additional $75 million in claims against DFD. The judge in the
Michigan State Court case entered an order staying DFD's prosecution of its
claims in the court case and permitting the arbitration to proceed. CMS Energy
believes the claims are without merit and will continue to vigorously contest
them, but any change order costs ultimately paid would be capitalized as a
project construction cost.
Ford Motor Company and Rouge Steel Company, the customers of the DIG facility,
continue to be in discussion with DIG regarding several commercial issues that
have arisen between the parties.
CMS OIL AND GAS: In 1999, a former subsidiary of CMS Oil and Gas, Terra Energy
Ltd., was sued by Star Energy, Inc. and White Pine Enterprises LLC in the 13th
Judicial Circuit Court in Antrim County, Michigan, on grounds, among others,
that Terra violated oil and gas lease and other agreements by failing to drill
wells. Among the defenses asserted by Terra were that the wells were not
required to be drilled and the claimant's sole remedy was termination of the oil
and gas lease. During the trial, the judge declared the lease terminated in
favor of White Pine. The jury then awarded Star Energy and White Pine $8 million
in damages. Terra appealed this matter to the Michigan Court of Appeals, which
referred the case to it settlement program. After Star Energy refused to
participate meaningfully in the settlement program, the parties completed
briefing and oral argument was heard on October 2, 2002. The parties are now
waiting for a decision from the Court of Appeals. A reserve has been established
for this matter.
CMS-81
CMS Energy Corporation
ARGENTINA ECONOMIC EMERGENCY: In January 2002, the Republic of Argentina enacted
the Public Emergency and Foreign Exchange System Reform Act. This law repealed
the fixed exchange rate of one U.S. Dollar to one Argentina Peso, converted all
Dollar-denominated utility tariffs and energy contract obligations into Pesos at
the same one-to-one exchange rate, and directed the President of Argentina to
renegotiate such tariffs.
In February 2002, the Republic of Argentina enacted additional measures that
required all monetary obligations (including current debt and future contract
payment obligations) denominated in foreign currencies to be converted into
Pesos. These February measures also authorize the Argentine judiciary
essentially to rewrite private contracts denominated in Dollars or other foreign
currencies if the parties cannot agree on how to share equitably the impact of
the conversion of their contract payment obligations into Pesos. In April 2002,
based on a consideration of these environmental factors, CMS Energy evaluated
its Argentine investments for impairment as required under SFAS No. 144 and APB
Opinion No. 18. These impairment models contain certain assumptions regarding
anticipated future exchange rates and operating performance of the investments.
Exchange rates used in the models assume that the rate will decrease from
current levels to approximately 3.00 Pesos per U.S. Dollar over the remaining
life of these investments. Based on the results of these models, CMS Energy
determined that these investments were not impaired.
Effective April 30, 2002, CMS Energy adopted the Argentine Peso as the
functional currency for most of its Argentine investments. CMS had previously
used the U.S. Dollar as the functional currency for its Argentine investments.
As a result, on April 30, 2002, CMS Energy translated the assets and liabilities
of its Argentine entities into U.S. Dollars, in accordance with SFAS No. 52,
using an exchange rate of 3.45 Pesos per U.S. Dollar, and recorded an initial
charge to the Foreign Currency Translation component of Common Stockholders'
Equity of approximately $400 million.
For the nine months ended September 30, 2002, CMS Energy recorded losses of $40
million or $0.28 per share, reflecting the negative impact of the actions of the
Argentine government. These losses represent changes in the value of
Peso-denominated monetary assets (such as receivables) and liabilities of
Argentina-based subsidiaries and lower net project earnings resulting from the
conversion to Pesos of utility tariffs and energy contract obligations that were
previously calculated in Dollars.
While CMS Energy's management cannot predict the most likely future, average, or
end of period 2002 Peso to U.S. Dollar exchange rates, it does expect that these
non-cash charges substantially reduce the risk of further material balance
sheet impacts when combined with anticipated proceeds from international
arbitration currently in progress, political risk insurance, and the eventual
sale of these assets. As a result of the change in functional currency, and the
ongoing translation of revenue and expense accounts of these investments into
U.S. Dollars, an additional $6 million or $0.05 per share assuming exchange
rates ranging from 3.00 to 4.00 Pesos per U.S. Dollar may adversely affect 2002
earnings for CMS Energy. At September 30, 2002, the net foreign currency loss
due to the unfavorable exchange rate of the Argentine Peso recorded in the
Foreign Currency Translation component of Common Stockholder's Equity using an
exchange rate of 3.665 Pesos per U.S. Dollar was $400 million.
CMS-82
CMS Energy Corporation
CAPITAL EXPENDITURES: CMS Energy estimates capital expenditures, including
investments in unconsolidated subsidiaries and new lease commitments, of $910
million for 2002, $500 million for 2003 and $655 million for 2004. The 2002
amount includes Panhandle's estimated expenditures of $124 million, which
includes expenditures associated with the LNG terminal expansion for which an
application was filed with the FERC on December 26, 2001, estimated at $8
million. The 2003 and 2004 amounts exclude Panhandle's expenditures, estimated
at $112 million in 2003 and $124 million in 2004, which include expenditures
associated with the LNG terminal expansion of $33 million in 2003 and $66
million in 2004. CMS Energy is exploring the sale of Panhandle. For further
information, see the Outlook section of the MD&A.
PENSION: The recent significant downturn in the equities markets has affected
the value of the Pension Plan assets. If the plan's Accumulated Benefit
Obligation exceeds the value of these assets at December 31, 2002, CMS Energy
will be required to recognize an additional minimum liability for this excess in
accordance with SFAS No 87. CMS Energy cannot predict the future fair value of
the plan's assets but it is probable, without significant appreciation in the
plan's assets, that CMS Energy will need to book an additional minimum liability
through a charge to other comprehensive income. The Accumulated Benefit
Obligation is determined by the plan's actuary in the fourth quarter of each
year.
GUARANTEES: CMS Energy and Enterprises, including subsidiaries, have guaranteed
payment of obligations, through letters of credit and surety bonds, of
unconsolidated affiliates and related parties approximating $1.5 billion as of
September 30, 2002. Included in this amount, Enterprises, in the ordinary course
of business, has guarantees in place for contracts of CMS MST that contain
certain schedule and performance requirements. As of September 30, 2002, the
actual amount of financial exposure covered by these guarantees was $473
million. This amount excludes the guarantees associated with CMS MST's natural
gas sales arrangements totaling $270 million, which are recorded as liabilities
on the Consolidated Balance Sheet at September 30, 2002. Management monitors and
approves these obligations and believes it is unlikely that CMS Energy or
Enterprises would be required to perform or otherwise incur any material losses
associated with the above obligations.
OTHER: Certain CMS Gas Transmission and CMS Generation affiliates in Argentina
received notice from various Argentine provinces claiming stamp taxes and
associated penalties and interest arising from various gas transportation
transactions. Although these claims total approximately $75 million, the
affiliates and CMS Energy believe the claims are without merit and will continue
to vigorously contest them.
CMS Generation does not currently expect to incur significant capital costs at
its power facilities for compliance with current U.S. environmental regulatory
standards.
In addition to the matters disclosed in this Note, Consumers, Panhandle and
certain other subsidiaries of CMS Energy are parties to certain lawsuits and
administrative proceedings before various courts and governmental agencies
arising from the ordinary course of business. These lawsuits and proceedings may
involve personal injury, property damage, contractual matters, environmental
issues, federal and state taxes, rates, licensing and other matters.
CMS Energy has accrued estimated losses for certain contingencies discussed in
this Note. Resolution of these contingencies is not expected to have a material
adverse impact on CMS Energy's financial position, liquidity, or results of
operations.
CMS-83
CMS Energy Corporation
6: SHORT-TERM AND LONG-TERM FINANCINGS, AND CAPITALIZATION
On July 12, 2002, CMS Energy and its subsidiaries reached agreement with its
lenders on five credit facilities (facilities) totaling approximately $1.3
billion of credit for CMS Energy, Enterprises and Consumers. The agreements were
executed by various combinations of up to 21 lenders and by CMS Energy and are
as follows: a $295.8 million revolving credit facility by CMS Energy, maturing
March 31, 2003; a $300 million revolving credit facility by CMS Energy, maturing
December 15, 2003; a $150 million short-term loan by Enterprises, maturing
December 13, 2002; a $250 million revolving credit facility by Consumers,
maturing July 11, 2003; and a $300 million term loan by Consumers, maturing July
11, 2003.
In September 2002, Consumers' exercised its extension option on the $300 million
term loan to move the maturity date to July 11, 2004. Also in September 2002,
CMS Energy retired the $150 million short-term loan by Enterprises using
proceeds from the sale of CMS Oil and Gas. In October 2002, Consumers
simultaneously entered into a new Term Loan Agreement collateralized by First
Mortgage Bonds and a new Gas Inventory Term Loan Agreement collateralized by
Consumers' natural gas in storage. These agreements contain complementary
collateral packages that provide Consumers, as additional First Mortgage Bonds
become available, borrowing capacity of up to $225 million. Consumers drew $220
million of the capacity upon execution of the Agreements and is expected to be
in a position to draw the full $225 million by mid-November of 2002. The
interest rate under the Agreements is LIBOR plus 300 basis points, but will
increase by 100 basis points for any period after December 1, 2002 during which
the banks thereunder have not yet received, among other deliveries, certified
restated financial statements for CMS Energy's 2000 and 2001 fiscal years. The
bank and legal fees associated with the Agreement were $2 million. The first net
amortization payment under these Agreements currently is scheduled to occur at
the end of 2002 with monthly amortization scheduled until full repayment is
completed in mid-April of 2003. This financing should eliminate the need for
Consumers to access the capital markets for the remainder of 2002.
CMS ENERGY: As of September 30, 2002, bank commitments under CMS Energy's $295.8
million credit agreement had been reduced to $259.9 million as a result of
mandatory prepayments with proceeds of various asset sales. CMS Energy had the
full $259.9 million outstanding as of that date. Also on September 30, 2002, CMS
Energy had $88.7 million of borrowings and $210.9 million of letter-of-credit
usage outstanding under the $300 million credit agreement.
In the first nine months of 2002, CMS Energy called $270 million of Series A
through F GTNs at interest rates ranging from 7 percent to 9 percent using funds
available from asset sales proceeds. At September 30, 2002, CMS Energy had
remaining $110 million Series D GTNs, $241 million Series E GTNs and $299
million of Series F GTNs issued and outstanding with weighted average interest
rates of 6.9 percent, 7.8 percent and 7.6 percent, respectively.
In May 2002, CMS Energy registered $300,000,000 Series G GTNs. The notes will be
issued from time to time with the proceeds being used for general corporate
purposes. As of November 1, 2002, no Series G GTNs had been issued.
CMS-84
CMS Energy Corporation
Under its most restrictive debt covenant, CMS Energy has approximately $1
billion available for the payment of common dividends at September 30, 2002.
Pursuant to restrictive covenants in the CMS Energy $295.8 million facility, CMS
Energy is limited to quarterly dividend payments of $0.1825 per share and must
receive $250 million in net cash proceeds from the planned issuance of equity or
equity-linked securities by December 31, 2002 in order to continue to pay a
dividend thereafter. Further cost-cutting steps and sales of non-strategic
assets are expected to eliminate the need for CMS Energy to access the capital
markets for the remainder of 2002. Asset sale proceeds are expected to be used
to repay the balance of CMS Energy's $295.8 million facility, but management can
make no assurances that such payment will be made or that dividends will be
declared by the Board of Directors.
CONSUMERS: At September 30, 2002, Consumers had FERC authorization to issue or
guarantee through June 2004, up to $1.1 billion of short-term securities
outstanding at any one time. Consumers also had remaining FERC authorization to
issue through September 2002 up to $500 million of long-term securities for
refinancing or refunding purposes, $690 million for general corporate purposes,
and $900 million of First Mortgage Bonds to be issued solely as security for the
long-term securities.
At September 30, 2002 Consumers had a $250 million credit facility secured by
First Mortgage Bonds. This facility is available to finance seasonal working
capital requirements and to pay for capital expenditures between long-term
financings. At September 30, 2002, a total of $235 million was outstanding at a
weighted average interest rate of 3.7 percent, compared with $153 million
outstanding on a revolving credit facility at September 30, 2001, at a weighted
average interest rate of 3.5 percent.
On April 1, 2002, Consumers established a new subsidiary, Consumers Receivables
Funding, LLC. This consolidated subsidiary was established to sell accounts
receivable purchased from Consumers to an unrelated third party under the trade
receivables sale program. Consumers, through Consumers Receivable Funding,
currently has in place a $325 million trade receivables sale program. At
September 30, 2002 and 2001, receivables sold under the program totaled $325
million for each year. During 2002, $248 million cash proceeds were received
under the trade receivables sales program. Accounts receivable and accrued
revenue in the Consolidated Balance Sheets have been reduced to reflect
receivables sold.
In March 2002, Consumers sold $300 million principal amount of six percent
senior notes, maturing in March 2005. Net proceeds from the sale were $299
million. Consumers used the net proceeds to replace a first mortgage bond that
was to mature in 2003.
Consumers secures its First Mortgage Bonds by a mortgage and lien on
substantially all of its property. Consumers' ability to issue and sell
securities is restricted by certain provisions in its First Mortgage Bond
Indenture, its Articles of Incorporation and the need for regulatory approvals
to meet appropriate federal law.
Pursuant to restrictive covenants in its bank facilities, Consumers is limited
to dividend payments that will not exceed $300 million in any calendar year. In
2001, Consumers paid $189 million in common stock dividends to CMS Energy.
Consumers has declared and paid $154 million in common dividends through
September 2002.
Under the provisions of its Articles of Incorporation, Consumers had $345
million of unrestricted retained earnings available to pay common dividends at
September 30, 2002.
CMS-85
CMS Energy Corporation
REQUIRED RATIOS: The credit facilities also have contractual restrictions that
require CMS Energy and Consumers to maintain, as of the last day of each fiscal
quarter, the following:
Required Ratio Limitation Ratio at September 30, 2002
- -------------------------------------------------------------------------------------------------------------------
CMS ENERGY:
Consolidated Leverage Ratio (a) not more than 5.75 to 1.00 5.32 to 1.00
Cash Dividend Coverage Ratio (a) not less than 1.25 to 1.00 1.87 to 1.00
Dividend Coverage Ratio not less than 1.15 to 1.00 3.40 to 1.00
Restricted Payments Ratio (a) not less than 1.05 to 1.00 2.11 to 1.00
CONSUMERS:
Debt to Capital Ratio (a) not more than 0.65 to 1.00 0.53 to 1.00
Interest Coverage Ratio (a) not less than 2.00 to 1.00 3.36 to 1.00
- -------------------------------------------------------------------------------------------------------------------
(a) Violation of this ratio would constitute an Event of Default under the
facility which provides the lender, among other remedies, the right to
declare the principal and interest immediately due and payable.
In 1994, CMS Energy executed an indenture (the "Indenture") with J.P. Morgan
Chase Bank pursuant to CMS Energy's general term notes program. The Indenture,
through supplements, contains certain provisions that can trigger a limitation
on CMS Energy's consolidated indebtedness. The limitation can be activated when
CMS Energy's consolidated leverage ratio, as defined in the Indenture
(essentially the ratio of consolidated debt to consolidated capital), exceeds
0.75 to 1.0. Upon activation of the limitation, CMS Energy will not and will not
permit certain material subsidiaries, excluding Consumers and its subsidiaries,
to become liable for new indebtedness. However, CMS Energy and the material
subsidiaries may incur revolving indebtedness to banks of up to $1 billion in
the aggregate and refinance existing debt outstanding at CMS Energy and at the
material subsidiaries. At September 30, 2002, CMS Energy's consolidated leverage
ratio was 0.73 to 1.0. CMS Energy expects that the aggregate effect of non-cash
charges to equity and the reconsolidation of debt on the balance sheet
anticipated to occur in the fourth quarter of 2002 will result in a year-end
debt ratio in excess of 75 percent. This debt ratio may be significantly
reduced if CMS Energy decides to proceed with its sale of Panhandle, its sale
of CMS Field Services, other asset sales or other options such as the
securitization of additional assets at Consumers.
COMPANY-OBLIGATED PREFERRED SECURITIES: CMS Energy and Consumers each have
wholly-owned statutory business trusts that are consolidated with the respective
parent company. CMS Energy and Consumers created their respective trusts for the
sole purpose of issuing Trust Preferred Securities. In each case, the primary
asset of the trust is a note or debenture of the parent company. The terms of
the Trust Preferred Security parallel the terms of the related parent company
note or debenture. The terms, rights and obligations of the Trust Preferred
Security and related note or debenture are also defined in the related indenture
through which the note or debenture was issued, the parent guarantee of the
related Trust Preferred Security and the declaration of trust for the particular
trust. All of these documents together with their related note or debenture and
Trust Preferred Security constitute a full and unconditional guarantee by the
parent company of the trust's obligations under the Trust Preferred Security. In
addition to the similar provisions previously discussed, specific terms of the
securities follow:
CMS Energy Trust and Securities In Millions
- -------------------------------------------------------------------------------------------------------------------
Amount
Outstanding Earliest
September 30 Rate(%) 2002 2001 Maturity Redemption
- -------------------------------------------------------------------------------------------------------------------
CMS Energy Trust I (a) 7.75 $173 $173 2027 2001
CMS Energy Trust II (b) 8.75 - 301 2004 -
CMS Energy Trust III (c) 7.25 220 220 2004 -
- --------------------------------------------------------------------------------------------------------------------
Total Amount Outstanding $393 $694
===============
CMS-86
CMS Energy Corporation
(a) Represents Quarterly Income Preferred Securities that are convertible into
1.2255 shares of CMS Energy Common Stock (equivalent to a conversion price of
$40.80). Effective July 2001, CMS Energy can revoke the conversion rights if
certain conditions are met.
(b) Represents 7,250,000 Adjustable Convertible Preferred Securities that were
converted to 8,787,725 newly issued shares of CMS Energy Common Stock on July 1,
2002.
(c) Represents Premium Equity Participating Security Units in which holders are
obligated to purchase a variable number of shares of CMS Energy Common Stock by
the August 2003 conversion date.
Consumers Energy Trust and Securities In Millions
- -------------------------------------------------------------------------------------------------------------------
Amount
Outstanding Earliest
September 30 Rate(%) 2002 2001 Maturity Redemption
- -------------------------------------------------------------------------------------------------------------------
Consumers Power Company Financing I,
Trust Originated Preferred Securities 8.36 $70 $100 2015 2000
Consumers Energy Company Financing II,
Trust Originated Preferred Securities 8.20 120 120 2027 2002
Consumers Energy Company Financing III,
Trust Originated Preferred Securities 9.25 175 175 2029 2004
Consumers Energy Company Financing IV,
Trust Preferred Securities 9.00 125 125 2031 2006
- ------------------------------------------------------------------------------------------------------------------
Total Amount Outstanding $490 $520
===============
In March 2002, Consumers reduced its outstanding debt to Consumers Power Company
Financing I, Trust Originated Preferred Securities by $30 million.
7: EARNINGS PER SHARE AND DIVIDENDS
The following tables present a reconciliation of the numerators and denominators
of the basic and diluted earnings per share computations.
COMPUTATION OF EARNINGS PER SHARE:
In Millions, Except Per Share Amounts
- -----------------------------------------------------------------------------------------------------------
Three Months Ended September 30 2002 2001
- -----------------------------------------------------------------------------------------------------------
NET INCOME APPLICABLE TO BASIC AND DILUTED EPS
Consolidated Net Income (Loss) $ 23 $ (569)
=================================
Net Income Attributable to Common Stock:
CMS Energy - Basic $ 23(a) $ (569)(b)
Add conversion of 7.75% Trust
Preferred Securities (net of tax) 2 2
---------------------------------
CMS Energy - Diluted $ 25 $ (567)
=================================
CMS-87
CMS Energy Corporation
AVERAGE COMMON SHARES OUTSTANDING
APPLICABLE TO BASIC AND DILUTED EPS
CMS Energy:
Average Shares - Basic 143.9 132.6
Add conversion of 7.75% Trust
Preferred Securities 4.2 4.2
Stock Options - .1
----------------------------------------
Average Shares - Diluted 148.1 136.9
=======================================
EARNINGS PER AVERAGE COMMON SHARE
Basic $ 0.16(a) $ (4.29)(b)
Diluted $ 0.16(a) $ (4.29)(b)
==================================================================================================================
In Millions, Except Per Share Amounts
- -------------------------------------------------------------------------------------------------------------------
Nine Months Ended September 30 2002 2001
- -------------------------------------------------------------------------------------------------------------------
NET INCOME APPLICABLE TO BASIC AND DILUTED EPS
Consolidated Net Income $ 337 $ (407)
========================================
Net Income Attributable to Common Stock:
CMS Energy - Basic $ 337(c) $ (407)(d)
Add conversion of 7.75% Trust
Preferred Securities (net of tax) 7 7
----------------------------------------
CMS Energy - Diluted $ 344 $ (400)
========================================
AVERAGE COMMON SHARES OUTSTANDING
APPLICABLE TO BASIC AND DILUTED EPS
CMS Energy:
Average Shares - Basic 137.4 130.0
Add conversion of 7.75% Trust
Preferred Securities 4.2 4.2
Stock Options - .3
----------------------------------------
Average Shares - Diluted 141.6 134.5
========================================
EARNINGS PER AVERAGE COMMON SHARE
Basic $ 2.45(c) $ (3.13)(d)
Diluted $ 2.42(c) $ (3.13)(d)
==================================================================================================================
(a) Includes the effects of net asset sales gains, gain on discontinued
operations, tax credit write-off and restructuring and other costs,
which decreased net income by $38 million, or $0.26 per basic and
diluted share.
(b) Includes the effects of net asset write-downs and loss on discontinued
operations, which decreased net income by $604 million, or $4.55 per
basic and diluted share.
(c) Includes the effects of net asset sales gains, gain on discontinued
operations, tax credit write-off, restructuring and other costs,
goodwill accounting change and extraordinary item, which increased net
income by $142 million, or $1.02 and $1.00 per basic and diluted
share, respectively.
(d) Includes the effects of net asset sales losses, net asset write-downs
and loss on discontinued operations, which decreased net income by
$585 million, or $4.50 per basic and diluted share.
CMS-88
CMS Energy Corporation
In February, April and August 2002, CMS Energy paid dividends of $0.365, $0.365
and $0.18 per share, respectively on CMS Energy Common Stock. In October 2002,
the Board of Directors declared a quarterly dividend of $0.18 per share on CMS
Energy Common Stock, payable in November 2002.
8: RISK MANAGEMENT ACTIVITIES AND FINANCIAL INSTRUMENTS
The objective of the CMS Energy risk management policy is to analyze, manage and
coordinate the identified risk exposures of the individual business segments and
to exploit the presence of internal hedge opportunities that exist among its
diversified business segments. CMS Energy, on behalf of its regulated and
non-regulated subsidiaries, utilizes a variety of derivative instruments for
both trading and non-trading purposes and executes these transactions with
external parties through its marketing subsidiary, CMS MST. These derivative
instruments include futures contracts, swaps, options and forward contracts to
manage exposure to fluctuations in commodity prices, interest rates and foreign
exchange rates. In order for derivative instruments to qualify for hedge
accounting under SFAS No. 133, the hedging relationship must be formally
documented at inception and be highly effective in achieving offsetting cash
flows or offsetting changes in fair value attributable to the risk being hedged.
Derivative instruments contain credit risk if the counterparties, including
financial institutions and energy marketers, fail to perform under the
agreements. CMS Energy minimizes such risk by performing financial credit
mitigation programs including, among other things, using publicly available
credit ratings of such counterparties, internally developed statistical models
for credit scoring and use of internal hedging programs to minimize exposure to
external counterparties. No material nonperformance is expected.
COMMODITY DERIVATIVES: Prior to January 1, 2001, CMS Energy accounted for its
non-trading commodity contracts as hedges and deferred any changes in the market
value and gains/losses resulting from settlements until the hedged transaction
was completed. As of January 1, 2001, commodity contracts are now accounted for
in accordance with the requirements of SFAS No. 133, as amended and interpreted,
and may or may not qualify for hedge accounting treatment depending on the
characteristics of each contract.
Consumers' electric business uses purchased electric call option contracts to
meet its regulatory obligation to serve. This obligation requires Consumers to
provide a physical supply of electricity to customers, to manage electric costs
and to ensure a reliable source of capacity during peak demand periods. These
contracts are subject to SFAS No. 133 derivative accounting, and are required to
be recorded on the balance sheet at fair value, with changes in fair value
recorded directly in earnings or other comprehensive income, if the contract
meets qualifying hedge criteria. On July 1, 2001, upon initial adoption of the
standard for these contracts, Consumers recorded a $3 million, net of tax,
cumulative effect adjustment as an unrealized loss, decreasing accumulated other
comprehensive income. This adjustment relates to the difference between the fair
value and the recorded book value of these electric call option contracts. The
adjustment to accumulated other comprehensive income relates to electric call
option contracts that qualified for cash flow hedge accounting prior to the
initial adoption of SFAS No. 133. After July 1, 2001, these contracts did not
qualify for hedge accounting under SFAS No. 133 and, therefore, Consumers
records any change in fair value subsequent to July 1, 2001 directly in
earnings, which can cause earnings volatility. The initial amount recorded in
other comprehensive income was reclassified to earnings as the forecasted future
transactions occurred or the call options expired. The majority of these
contracts expired in the third quarter 2001 and the remaining contracts
CMS-89
CMS Energy Corporation
expired in the third quarter of 2002. As of December 31, 2001, Consumers
reclassified from other comprehensive income to earnings, $2 million, net of
tax, as part of the cost of power supply, and the remainder, $1 million, net of
tax, was reclassified from other comprehensive income to earnings in the third
quarter of 2002.
In December 2001, the FASB issued revised guidance regarding derivative
accounting for electric call option contracts and option-like contracts. The
revised guidance amended the criteria used to determine if derivative accounting
is required. In light of the amended criteria, Consumers re-evaluated its
electric call option and option-like contracts, and determined that additional
contracts require derivative accounting. Therefore, as of December 31, 2001,
upon initial adoption of the revised guidance for these contracts, Consumers
recorded an $11 million, net of tax, cumulative effect adjustment as a decrease
to earnings. This adjustment relates to the difference between the fair value
and the recorded book value of these electric call option contracts. Consumers
will record any change in fair value subsequent to December 31, 2001, directly
in earnings, which could cause earnings volatility. As of September 30, 2002,
Consumers recorded on the balance sheet all of its purchased electric call
option contracts subject to derivative accounting, at a fair value of $1
million.
Consumers believes that certain of its electric capacity and energy contracts
are not derivatives due to the lack of an active energy market, as defined by
SFAS No. 133, in the state of Michigan and the transportation cost to deliver
the power under the contracts to the closest active energy market at the Cinergy
hub in Ohio. If a market develops in the future, Consumers may be required to
account for these contracts as derivatives. The mark to market impact in
earnings related to these contracts, particularly related to the power purchase
agreement with the MCV Partnership, could be material to the financial
statements.
Consumers' electric business also uses gas swap contracts to protect against
price risk due to the fluctuations in the market price of gas used as fuel for
generation of electricity. These gas swaps are financial contracts that will be
used to offset increases in the price of probable forecasted gas purchases.
These contracts do not qualify for hedge accounting. Therefore, Consumers
records any change in the fair value of these contracts directly in earnings as
part of power supply costs, which could cause earnings volatility. As of
September 30, 2002, a mark to market gain of $1 million has been recorded for
2002, which represents the fair value of these contracts at September 30, 2002.
These contracts expire in December 2002.
As of September 30, 2001, Consumers' electric business also used purchased gas
call option and gas swap contracts to hedge against price risk due to the
fluctuations in the market price of gas used as fuel for generation of
electricity. These contracts were financial contracts that were used to offset
increases in the price of probable forecasted gas purchases. These contracts
were designated as cash flow hedges and, therefore, Consumers recorded any
change in the fair value of these contracts in other comprehensive income until
the forecasted transaction occurs. Once the forecasted gas purchases occurred,
the net gain or loss on these contracts were reclassified to earnings and
recorded as part of the cost of power. These contracts were highly effective in
achieving offsetting cash flows of future gas purchases, and no component of the
gain or loss was excluded from the assessment of the hedge's effectiveness. As a
result, no net gain or loss was recognized in earnings as a result of hedge
ineffectiveness as of September 30, 2001. At September 30, 2001, Consumers had a
derivative liability with a fair value of $.4 million. These contracts expired
in 2001.
Consumers' gas business uses fixed price gas supply contracts, and fixed price
weather-based gas supply call options and fixed price gas supply put options,
and other types of contracts, to meet its regulatory obligation to provide gas
to its customers at a reasonable and prudent cost. Some of the fixed price gas
supply contracts require derivative accounting because they contain embedded put
options that disqualify the contracts from the
CMS-90
CMS Energy Corporation
normal purchase exception of SFAS No. 133. As of September 30, 2002, Consumers'
gas supply contracts requiring derivative accounting had a fair value of $1
million, representing a fair value gain on the contracts since the date of
inception. This gain was recorded directly in earnings as part of other income,
and then directly offset and recorded on the balance sheet as a regulatory
liability. Any subsequent changes in fair value will be recorded in a similar
manner. These contracts expire in October 2002.
As of September 30, 2002, weather-based gas call options and gas put options
requiring derivative accounting had a net fair value of $1 million. The change
in value since inception in August 2002 is immaterial. Any change in fair value
will be recorded in a similar manner as stated above for the change in fair
value for fixed price gas supply contracts requiring derivative accounting.
CMS Energy, through its subsidiary CMS MST, engages in trading activities. CMS
MST manages any open positions within certain guidelines that limit its exposure
to market risk and requires timely reporting to management of potential
financial exposure. These guidelines include statistical risk tolerance limits
using historical price movements to calculate daily value at risk measurements.
CMS MST's trading activities are accounted for under the mark-to-market method
of accounting. Under mark-to-market accounting, energy-trading contracts are
reflected at fair market value, net of reserves, with unrealized gains and
losses recorded as an asset or liability in the consolidated balance sheets.
These assets and liabilities are affected by the timing of settlements related
to these contracts; current-period changes from newly originated transactions
and the impact of price movements. Changes in fair values are recognized as
revenues in the consolidated statements of income in the period in which the
changes occur. Market prices used to value outstanding financial instruments
reflect management's consideration of, among other things, closing exchange and
over-the-counter quotations. In certain of these markets, long-term contract
commitments may extend beyond the period in which market quotations for such
contracts are available. The lack of long-term pricing liquidity requires the
use of mathematical models to value these commitments under the accounting
method employed. These mathematical models utilize historical market data to
forecast future elongated pricing curves, which are used to value the
commitments that reside outside of the liquid market quotations. Realized cash
returns on these commitments may vary, either positively or negatively, from the
results estimated through application of forecasted pricing curves generated
through application of the mathematical model. CMS Energy believes that its
mathematical models utilize state-of-the-art technology, pertinent industry data
and prudent discounting in order to forecast certain elongated pricing curves.
These market prices are adjusted to reflect the potential impact of liquidating
the company's position in an orderly manner over a reasonable period of time
under present market conditions.
In connection with the market valuation of its energy commodity contracts, CMS
Energy maintains reserves for credit risks based on the financial condition of
counterparties. Counterparties in its trading portfolio consist principally of
financial institutions and major energy trading companies. The creditworthiness
of these counterparties will impact overall exposure to credit risk; however,
with regard to its counterparties, CMS Energy maintains credit policies that
management believes minimize overall credit risk. Determination of the credit
quality of its counterparties is based upon a number of factors, including
credit ratings, financial condition, and collateral requirements. When trading
terms permit, CMS Energy employs standard agreements that allow for netting of
positive and negative exposures associated with a single counterparty. Based on
these policies, its current exposures and its credit reserves, CMS Energy does
not anticipate a material adverse effect on its financial position or results of
operations as a result of counterparty nonperformance.
At September 30, 2002, CMS MST has recorded a net asset of $97 million, net of
reserves, related to the unrealized mark-to-market gains on existing
arrangements. For the nine months ended September 30, 2002
CMS-91
CMS Energy Corporation
and 2001, CMS MST reflected $23 million loss and $55 million gain, respectively,
of mark-to-market revenues, net of reserves, primarily from newly originated
long-term power sales contracts and wholesale gas trading transactions.
The following tables provide a summary of the fair value of CMS Energy's energy
commodity contracts as of September 30, 2002.
In Millions
- ------------------------------------------------------------------------------
Fair value of contracts outstanding as of June 30, 2002 $89
Contracts realized or otherwise settled during the period (a) 7
Other changes in fair value (b) 1
- ------------------------------------------------------------------------------
Fair value of contracts outstanding as of September 30, 2002 (c) $97
==============================================================================
Fair Value of Contracts at September 30, 2002 In Millions
- --------------------------------------------------------------------------------------------------------
Total Maturity (in years)
Source of Fair Value Fair Value Less than 1 1 to 3 4 to 5 Greater than 5
- --------------------------------------------------------------------------------------------------------
Prices actively quoted $ 32 $ 20 $ 12 $ - $ -
Prices provided by other
external sources 3 2 (2) 2 1
Prices based on models and
other valuation methods 62 8 23 20 11
- --------------------------------------------------------------------------------------------------------
Total $ 97 $ 30 $ 33 $ 22 $ 12
========================================================================================================
(a) Reflects value of contracts, included in June 30, 2002 values, that
expired during the third quarter of 2002.
(b) Reflects changes in price and net increase/decrease in size of forward
positions, as well as changes to mark-to-market reserve accounts.
(c) Includes the value of contracts with affiliated companies but excludes
the credit reserve for third parties.
FLOATING TO FIXED INTEREST RATE SWAPS: CMS Energy and its subsidiaries enter
into floating to fixed interest rate swap agreements to reduce the impact of
interest rate fluctuations. These swaps are designated as cash flow hedges and
the difference between the amounts paid and received under the swaps is accrued
and recorded as an adjustment to interest expense over the term of the
agreement. Changes in the fair value of these swaps are recorded in accumulated
other comprehensive income until the swaps are terminated. As of September 30,
2002, these swaps had a negative fair value of $9 million that if sustained,
will be reclassified to earnings as the swaps are settled on a quarterly basis.
No ineffectiveness was recognized during the third quarter of 2002 under the
requirements of SFAS No. 133.
Notional amounts reflect the volume of transactions but do not represent the
amount exchanged by the parties to the financial instruments. Accordingly,
notional amounts do not necessarily reflect CMS Energy's exposure to credit or
market risks. As of September 30, 2002 and 2001, the weighted average interest
rate associated with outstanding swaps was approximately 5.2 percent and 6.5
percent, respectively.
CMS-92
CMS Energy Corporation
In Millions
- -------------------------------------------------------------------------------
Floating to Fixed Notional Maturity Fair Unrealized
Interest Rate Swaps Amount Date Value Gain (Loss)
- -------------------------------------------------------------------------------
September 30, 2002 $ 294 2003-2006 $ (9) $ -
September 30, 2001 $ 1,419 2001-2006 $(14) $ 3
FIXED TO FLOATING INTEREST RATE SWAPS: CMS Energy monitors its debt portfolio
mix of fixed and variable rate instruments and from time to time enters into
fixed to floating rate swaps to maintain the optimum mix of fixed and floating
rate debt. These swaps are designated as fair value hedges and any realized
gains or losses in the fair value are amortized to earnings after the
termination of the hedge instrument over the remaining life of the hedged item.
There were no outstanding fixed to floating interest rate swaps as of September
30, 2002.
FOREIGN EXCHANGE DERIVATIVES: CMS Energy uses forward exchange and option
contracts to hedge certain receivables, payables, long-term debt and equity
value relating to foreign investments. The purpose of CMS Energy's foreign
currency hedging activities is to protect the company from the risk that U.S.
Dollar net cash flows resulting from sales to foreign customers and purchases
from foreign suppliers and the repayment of non-U.S. Dollar borrowings as well
as equity reported on the company's balance sheet, may be adversely affected by
changes in exchange rates. These contracts do not subject CMS Energy to risk
from exchange rate movements because gains and losses on such contracts offset
losses and gains, respectively, on assets and liabilities being hedged. The
estimated fair value of the foreign exchange and option contracts at September
30, 2002 and 2001 was approximately zero and $18 million, respectively;
representing the amount CMS Energy would receive or (pay) upon settlement.
The notional amount of the outstanding foreign exchange contracts at September
30, 2002 was $1 million Canadian contracts. Foreign exchange contracts
outstanding as of September 30, 2001 had a total notional amount of $223
million, which was related to CMS Energy's investments in Argentina. The
Argentine contracts matured at various times during the fourth quarter of 2001
and 2002.
FINANCIAL INSTRUMENTS: The carrying amounts of cash, short-term investments and
current liabilities approximate their fair values due to their short-term
nature. The estimated fair values of long-term investments are based on quoted
market prices or, in the absence of specific market prices, on quoted market
prices of similar investments or other valuation techniques. Judgment may also
be required to interpret market data to develop certain estimates of fair value.
Accordingly, the estimates determined as of September 30, 2002 and 2001 are not
necessarily indicative of the amounts that may be realized in current market
exchanges. The carrying amounts of all long-term investments in financial
instruments, except for those as shown below, approximate fair value.
In Millions
- ------------------------------------------------------------------------------------------------------------------
As of September 30 2002 2001
- ------------------------------------------------------------------------------------------------------------------
Carrying Fair Unrealized Carrying Fair Unrealized
Cost Value Gain Cost Value Gain
----------------------------------------------------------------------------
Long-Term Debt (a) $6,585 $6,050 $535 $7,827 $7,720 $ 107
Preferred Stock and
Trust Preferred Securities 927 699 228 1,258 1,162 96
(a) Settlement of long-term debt is generally not expected until maturity.
CMS-93
CMS Energy Corporation
9: REPORTABLE SEGMENTS
CMS Energy operates principally in the following five reportable segments:
electric utility; gas utility; independent power production; natural gas
transmission; and marketing, services and trading.
CMS Energy's reportable segments are strategic business units organized and
managed by the nature of the products and services each provides. Management
evaluates performance based on the net income of each segment. The electric
utility segment consists of regulated activities associated with the generation,
transmission and distribution of electricity in the state of Michigan through
its subsidiary, Consumers. The gas utility segment consists of regulated
activities associated with the transportation, storage and distribution of
natural gas in the state of Michigan through its subsidiary, Consumers.
Independent power production invests in, acquires, develops, constructs and
operates non-utility power generation plants in the United States and abroad.
Natural gas transmission owns, develops, and manages domestic and international
natural gas facilities. The marketing, services and trading segment provides
gas, oil, and electric marketing, risk management and energy management services
to industrial, commercial, utility and municipal energy users throughout the
United States and abroad.
The Consolidated Statements of Income show operating revenue and pretax
operating income by reportable segment. Revenues from a land development
business fall below the quantitative thresholds for reporting, and has never met
any of the quantitative thresholds for determining reportable segments. The
table below shows net income before reconciling items by reportable segment.
THREE MONTHS ENDED SEPTEMBER 30, 2002 IN MILLIONS
- -------------------------------------------------------------------------------------------------------------------------
Earnings Net Net Discontinued Tax
Before Asset Sales Operations Credit
Reconciling Gain Gain Write Restructuring Net
Items (Loss) (Loss) Off Costs Income
- -------------------------------------------------------------------------------------------------------------------------
Electric utility $ 88 $ - $ - $(20) $ - $ 68
Gas utility (18) - - (6) - (24)
Independent power production 39 14 - (1) - 52
Natural gas transmission 17 - - (5) - 12
Marketing, services and trading (2) - (2) - (1) (5)
Corporate interest and other (63) (1) (2) (9) (26) (101)
Discontinued operations - - 21 - - 21
- -------------------------------------------------------------------------------------------------------------------------
Total $ 61 $ 13 $ 17 $(41) $(27) $ 23
=========================================================================================================================
CMS-94
CMS Energy Corporation
THREE MONTHS ENDED SEPTEMBER 30, 2001 IN MILLIONS
- --------------------------------------------------------------------------------------------------------------------
Earnings Net Discontinued
Before Asset Sales Operations Asset
Reconciling Gain Gain Write Net
Items (Loss) (Loss) Downs Income
- --------------------------------------------------------------------------------------------------------------------
Electric utility $ 24 $ - $ - $ (93) $ (69)
Gas utility (10) - - - (10)
Independent power production 47 - (29) (268) (250)
Natural gas transmission 21 1 - (28) (6)
Marketing, services and trading 11 - 1 - 12
Corporate interest and other (58) (1) (11) (9) (79)
Discontinued operations -- - (167) - (167)
- --------------------------------------------------------------------------------------------------------------------
Total $ 35 $ - $(206) $(398) $(569)
====================================================================================================================
NINE MONTHS ENDED SEPTEMBER 30, 2002 IN MILLIONS
- -----------------------------------------------------------------------------------------------------------------------
Earnings Net Disc Extra Tax
Before Asset Ops Items/ Credit
Reconciling Sales Gain Gain Acctg Write Restructuring Net
Items (Loss) (Loss) Change Off Costs Income
- -----------------------------------------------------------------------------------------------------------------------
Electric utility $ 191 $ 30 $ - $ - $ (20) $ - $ 201
Gas utility 13 - - - (6) - 8
Independent power production 109 6 - - (1) - 114
Natural gas transmission 57 12 - - (5) - 64
Marketing, services and trading (16) - (11) (9) - (4) (40)
Corporate interest and other (159) - (29) (8) (9) (30) (235)
Discontinued operations - - 226 - - - 226
- -----------------------------------------------------------------------------------------------------------------------
Total $ 195 $ 48 $ 186 $ (17) $ (41) $ (34) $ 337
=======================================================================================================================
NINE MONTHS ENDED SEPTEMBER 30, 2001 IN MILLIONS
- -------------------------------------------------------------------------------------------------------------
Earnings Net Discontinued
Before Asset Sales Operations Asset
Reconciling Gain Gain Write Net
Items (Loss) (Loss) Downs Income
- -------------------------------------------------------------------------------------------------------------
Electric utility $ 115 $ - - $ (93) $ 22
Gas utility 20 - - - 20
Independent power production 92 - (30) (268) (206)
Natural gas transmission 80 1 - (28) 53
Marketing, services and trading 49 - 1 - 50
Corporate interest and other (178) (2) (19) (9) (208)
Discontinued operations - - (138) - (138)
- -------------------------------------------------------------------------------------------------------------
Total $ 178 $ (1) $(186) $(398) $(407)
=============================================================================================================
CMS-95
CMS Energy Corporation
(This page intentionally left blank)
CMS-96
Consumers Energy Company
CONSUMERS ENERGY COMPANY
MANAGEMENT'S DISCUSSION AND ANALYSIS
Consumers, a subsidiary of CMS Energy, a holding company, is an electric and gas
utility company that provides service to customers in Michigan's Lower
Peninsula. Consumers' customer base includes a mix of residential, commercial
and diversified industrial customers, the largest segment of which is the
automotive industry.
FORWARD-LOOKING STATEMENTS AND RISK FACTORS
The MD&A of this Form 10-Q should be read along with the MD&A and other parts of
Consumers' 2001 Form 10-K. This MD&A refers to, and in some sections
specifically incorporates by reference, Consumers' Condensed Notes to
Consolidated Financial Statements and should be read in conjunction with such
Consolidated Financial Statements and Notes. This Form 10-Q and other written
and oral statements that Consumers may make contain forward-looking statements
as defined by the Private Securities Litigation Reform Act of 1995. Consumers'
intentions with the use of the words, "anticipates," "believes," "estimates,"
"expects," "intends," and "plans," and variations of such words and similar
expressions, are solely to identify forward-looking statements that involve risk
and uncertainty. These forward-looking statements are subject to various factors
that could cause Consumers' actual results to differ materially from the results
anticipated in such statements. Consumers has no obligation to update or revise
forward-looking statements regardless of whether new information, future events
or any other factors affect the information contained in such statements.
Consumers does, however, discuss certain risk factors, uncertainties and
assumptions in this MD&A and in Item 1 of the 2001 Form 10-K in the section
entitled "CMS Energy, Consumers and Panhandle Forward-Looking Statements
Cautionary Factors" and in various public filings it periodically makes with the
SEC. In addition to any assumptions and other factors referred to specifically
in connection with such forward-looking statements, there are numerous factors
that could cause our actual results to differ materially from those contemplated
in any forward-looking statements. Such factors include our inability to predict
and/or control:
- - Results of the re-audit of CMS Energy, Consumers, Panhandle and certain
of their affiliates by Ernst & Young and the subsequent restatement of
CMS Energy's, Consumers', Panhandle's and certain of their affiliates'
financial statements;
- - Ability to successfully access the capital markets;
- - Achievement of operating synergies and revenue enhancements;
- - Capital and financial market conditions, including current price of CMS
Energy's Common Stock, interest rates and availability of financing to
CMS Energy, Consumers, Panhandle or any of their affiliates and the
energy industry;
- - CMS Energy, Consumers, Panhandle or any of their affiliates' securities
ratings;
- - Market perception of the energy industry, CMS Energy, Consumers,
Panhandle or any of their affiliates;
- - Factors affecting utility and diversified energy operations such as
unusual weather conditions,
CE-1
Consumers Energy Company
catastrophic weather-related damage, unscheduled generation outages,
maintenance or repairs, unanticipated changes to fossil fuel, nuclear
fuel or gas supply costs or availability due to higher demand,
shortages, transportation problems or other developments, environmental
incidents, or electric transmissions or gas pipeline system
constraints;
- - National, regional and local economic, competitive and regulatory
conditions and developments;
- - Adverse regulatory or legal decisions, including environmental laws and
regulations;
- - Federal regulation of electric sales and transmission of electricity
including re-examination by Federal regulators of the market-based
sales authorizations by which Consumers and its affiliates participate
in wholesale power markets without price restrictions and proposals by
FERC to change the way it currently lets Consumers and other public
utilities and natural gas companies interact with each other;
- - Energy markets, including the timing and extent of unanticipated
changes in commodity prices for oil, coal, natural gas liquids,
electricity and certain related products due to lower or higher demand,
shortages, transportation problems or other developments;
- - Nuclear power plant performance, decommissioning, policies, security,
procedures, incidents, and regulation, including the availability of
spent nuclear fuel storage;
- - Technological developments in energy production, delivery and usage;
- - Changes in financial or regulatory accounting principles or policies;
- - Outcome, cost and other effects of legal and administrative
proceedings, settlements, investigations and claims;
- - Disruptions in the normal commercial insurance and surety bond markets
that may increase costs or reduce traditional insurance coverage,
particularly terrorism and sabotage insurance and performance bonds.
- - Other business or investment considerations that may be disclosed from
time to time in CMS Energy's, Consumers' or Panhandle's SEC filings or
in other publicly disseminated written documents, which are difficult
to predict and many of which are beyond our control.
Consumers designed this discussion of potential risks and uncertainties, which
is by no means comprehensive, to highlight important factors that may impact
Consumers' business and financial outlook. This Form 10-Q also describes
material contingencies in Consumers Notes to Consolidated Financial Statements,
and Consumers encourages its readers to review these Notes.
CHANGE IN AUDITORS AND PENDING RESTATEMENT
In April 2002, Consumers' Board of Directors, upon the recommendation of the
Audit Committee of the Board, voted to discontinue using Arthur Andersen to
audit the Consumers' financial statements for the year ending December 31, 2002.
Consumers had previously retained Arthur Andersen to review its financial
statements for the quarter ended March 31, 2002. In May 2002, Consumers' Board
of Directors engaged Ernst & Young to audit its financial statements for the
year ending December 31, 2002.
CE-2
Consumers Energy Company
In May 2002, as a result of certain financial reporting issues surrounding
round-trip trading transactions at CMS MST, and its then current situation,
Arthur Andersen notified CMS Energy that Arthur Andersen's historical opinions
on CMS Energy's financial statements for the fiscal years ended December 31,
2001 and December 31, 2000 could not be relied upon. Arthur Andersen clarified
in its notification to CMS Energy that its decision does not apply to separate,
audited financial statements of Consumers for the applicable years. Arthur
Andersen's reports on Consumers' consolidated financial statements for each of
the fiscal years ended December 31, 2001 and December 31, 2000 contained no
adverse or disclaimer of opinion, nor were the reports qualified or modified
regarding uncertainty, audit scope or accounting principles.
There were no disagreements between Consumers and Arthur Andersen on any matter
of accounting principle or practice, financial statement disclosure, or auditing
scope or procedure during the years 2000 and 2001, and through the date of their
review for the quarter ended March 31, 2002, which, if not resolved to Arthur
Andersen's satisfaction, would have caused Arthur Andersen to make reference to
the subject matter in connection with its report to the Audit Committee of the
Board of Directors or in its report on Consumers' consolidated financial
statements for the periods.
During Consumers' two most recent fiscal years ended December 31, 2000 and
December 31, 2001 and the subsequent interim period through June 10, 2002,
Consumers did not consult with Ernst & Young regarding any matter or event
identified by SEC laws and regulations. However, as a result of the round-trip
trading transactions, Ernst & Young is in the process of re-auditing CMS
Energy's consolidated financial statements for each of the fiscal years ended
December 31, 2001 and December 31, 2000, which includes audit work at Consumers
for these years. None of Consumers' former auditors, now employed by Ernst &
Young, are involved in the re-audit of CMS Energy's consolidated financial
statements.
In connection with Ernst & Young's re-audit of the fiscal years ended December
31, 2001 and December 31, 2000, Consumers has determined, in consultation with
Ernst & Young, that certain adjustments by Consumers to its consolidated
financial statements for the fiscal years ended December 31, 2001 and December
31, 2000 are required. At the time it adopted the accounting treatment for these
items, Consumers believed that such accounting was appropriate under generally
accepted accounting principals and Arthur Andersen concurred. CMS Energy and
Consumers are in the process of advising the SEC of these adjustments before
Consumers restates its financial statements as discussed below. Consumers
intends to amend its 2001 Form 10-K and each of the 2002 Form 10-Qs for the
effects of these adjustments by the end of January 2003.
The recommended audit adjustments would: 1) reverse the charge associated with
the PPA recorded in 2001; 2) recognize Consumers' new headquarters lease as a
capital lease, and record the lease obligation and capitalize costs incurred.
Consumers had previously treated the lease as an operating lease; and 3)
recognize immaterial adjustments to SERP and OPEB liabilities and advertising
costs. Each of these transactions involved estimates, assumptions, and judgment
based on the best information available at the time the transactions occurred.
The audit adjustments are the result of our current judgment on these matters.
The most material adjustment proposed, which effects net income, relates to
reversing the charge recorded in 2001 associated with the PPA. In 1992,
Consumers established a reserve for the difference between the amount that
Consumers was paying for power in accordance with the terms of the PPA, and the
amount that Consumers was ultimately allowed by the MPSC to recover from
electric customers.
CE-3
Consumers Energy Company
The reserve was adjusted in 1998 to reflect differences between management's
original assumptions and the MCV Facility's actual performance. In 2000,
Consumers reviewed its estimate of the economic losses it would experience with
respect to the PPA and re-evaluated all of the current facts and circumstances
used to calculate the disallowance reserve. Consumers concluded that no
adjustment to the reserve was required in 2000. However, as conditions
surrounding MCV Partnership operations evolved in 2001, Consumers concluded that
it needed to increase the reserve by $126 million (pretax) in the third quarter
of 2001, and did so.
Upon recommendations from Ernst & Young, Consumers is in the process of
reviewing its 2001 PPA accounting and related assumptions. This accounting
review is currently being discussed with Ernst & Young and the SEC. Final
conclusions have not yet been reached. At a minimum, however, the 2001
accounting will change, resulting in the reversal of the 2001 charge of $126
million. Further analysis and deliberations may produce additional accounting
changes. In addition, as a result of this accounting treatment Consumers
expects that its ongoing operating earnings through 2007 will be reduced to
reflect higher annual purchased power expense.
The following table reflects effects of the adjustments (for the PPA and other
miscellaneous issues) Consumers currently expects to make to its consolidated
financial statements for the fiscal years ended December 31, 2001 and December
31, 2000:
2001 2000
---- ----
EXPECTED EXPECTED
IN MILLIONS AS REPORTED RESTATED AS REPORTED RESTATED
- ------------------------------------------------------------------------------------------------------------------------
Operating Expenses $3,669 $3,505 $3,300 $3,301
Net Income Before Taxes 160 328 452 451
Income Taxes 49 108 148 148
Net Income Before Cumulative Effect of Change in
Accounting Principle $111 $220 $304 $303
Cumulative Effect of Change in Accounting for Derivative
Instruments, Net of $6 Tax Benefit (11) (11) - -
Net Income $100 $209 $304 $303
- ------------------------------------------------------------------------------------------------------------------------
CE-4
Consumers Energy Company
COMPLIANCE WITH THE SARBANES-OXLEY ACT OF 2002
In July 2002, the Sarbanes-Oxley Act of 2002 was enacted and requires companies
to: 1) make certain certifications related to their Form 10-Q's, including
financial statements, disclosure controls and procedures and internal controls;
and 2) make certain disclosures about its disclosure controls and procedures,
and internal controls as follows:
CEO AND CFO CERTIFICATIONS
The Sarbanes-Oxley Act of 2002 requires CEOs and CFOs of public companies to
make certain certifications relating to their Form 10-Q's, including the
financial statements. Consumers has not filed the certifications required by the
Sarbanes-Oxley Act of 2002 relating to this Form 10-Q for the period ended
September 30, 2002 because its 2000 and 2001 financial statements are in the
process of being restated as discussed above.
The restatement cannot be completed until Ernst & Young completes audit work at
Consumers, and their reviews of the quarterly statements for these years.
Therefore, Consumers' CEO and CFO are not able to make the statements required
by the Sarbanes-Oxley Act of 2002 with respect to this Form 10-Q for the period
ended September 30, 2002. Consumers expects its CEO and CFO to make the
certifications required by the Sarbanes-Oxley Act of 2002 when its restated
financial statements are available.
DISCLOSURE CONTROLS AND PROCEDURES
Consumers' CEO and CFO are responsible for establishing and maintaining
Consumers' disclosure controls and procedures. Management, under the direction
of Consumers' principal executive and financial officers, has evaluated the
effectiveness of Consumers' disclosure controls and procedures as of September
30, 2002. Based on this evaluation, Consumers' CEO and CFO have concluded that
Consumers' disclosure controls and procedures are effective to ensure that
material information was presented to them, particularly during the third
quarter of 2002. There have been no significant changes in Consumers' internal
controls or in other factors that could significantly affect internal controls
subsequent to September 30, 2002.
CRITICAL ACCOUNTING POLICIES
Presenting financial statements in accordance with accounting principles
generally accepted in the United States requires using estimates, assumptions,
and accounting methods that are often subject to judgment. Presented below, are
the accounting policies and assumptions that Consumers believes are most
critical to both the presentation and understanding of its financial statements.
Applying these accounting policies to financial statements can involve very
complex judgments. Accordingly, applying different judgments, estimates or
assumptions could result in a different financial presentation.
USE OF ESTIMATES IN ACCOUNTING FOR CONTINGENCIES
The principles in SFAS No. 5 guide the recording of estimated liabilities for
contingencies within the financial statements. SFAS No. 5 requires a company to
record estimated liabilities when it is probable that a current event will cause
a future loss payment and that loss amount can be reasonably estimated.
Consumers used this principle to record or disclose estimated liabilities for
the following significant events.
ELECTRIC ENVIRONMENTAL ESTIMATES: Consumers is subject to costly and
increasingly stringent environmental regulations. Consumers expects to incur
significant costs for future environmental compliance, especially compliance
with clean air laws.
CE-5
Consumers Energy Company
The EPA has issued final regulations regarding nitrogen oxide emissions from
certain generators, including some of Consumers' electric generating facilities.
These regulations will require Consumers to make significant capital
expenditures estimated to be $770 million. As of September 2002, Consumers has
incurred $372 million in capital expenditures to comply with these regulations
and anticipates that the remaining capital expenditures will be incurred between
the remainder of 2002 and 2009. Additionally, Consumers will supplement its
compliance plan with the purchase of nitrogen oxide emissions credits in the
years 2005 through 2008. The cost of these credits based on the current market
is estimated to be $6 million per year, however, the market for nitrogen oxide
emissions credits is volatile and the price could change significantly. At some
point, if new environmental standards become effective, Consumers may need
additional capital expenditures to comply with the standards. These and other
required environmental expenditures, if not recovered in Consumers' rates, may
have a material adverse effect upon Consumers' financial condition and results
of operations. For further information see Note 2, Uncertainties, "Electric
Contingencies - Electric Environmental Matters."
GAS ENVIRONMENTAL ESTIMATES: Under the Michigan Natural Resources and
Environmental Protection Act, Consumers expects that it will incur investigation
and remedial action costs at a number of sites. Consumers estimates the costs
for 23 former Manufactured Gas Plant sites will be between $82 million and $113
million, using the Gas Research Institute-Manufactured Gas Plant Probabilistic
Cost Model. These estimates are based on discounted 2001 costs and follow EPA
recommended use of discount rates between 3 and 7 percent. Consumers expects to
recover a significant portion of these costs through MPSC-approved rates charged
to its customers. Any significant change in assumptions, such as remediation
techniques, nature and extent of contamination, and legal and regulatory
requirements, could change the remedial action costs for the sites. For further
information see Note 2, Uncertainties, "Gas Contingencies -Gas Environmental
Matters."
MCV UNDERRECOVERIES: The MCV Partnership, which leases and operates the MCV
Facility, contracted to sell electricity to Consumers for a 35-year period
beginning in 1990 and to supply electricity and steam to Dow. Consumers, through
two wholly owned subsidiaries, holds a partnership interest in the MCV
Partnership, and a lessor interest in the MCV Facility.
Consumers' annual obligation to purchase capacity from the MCV Partnership is
1,240 MW through 2025. The PPA requires Consumers to pay, based on the MCV
Facility's availability, a levelized average capacity charge of 3.77 cents per
kWh, a fixed energy charge, and a variable energy charge based primarily on
Consumers' average cost of coal consumed for all kWh delivered. Consumers has
not been allowed full recovery of the capacity charges in rates and has recorded
the estimated contract losses on this through 2007 at which time, Consumers
under the terms of the PPA agreement is obligated to pay the MCV Partnership
only those capacity and energy charges that the MPSC has authorized for recovery
from electric customers. The loss has been recorded in the income statement and
as a non-current liability on the balance sheet.
Consumers' availability payments to the MCV Partnership are capped at 98.5
percent. If the MCV Facility generates electricity at the maximum 98.5 percent
level during the next five years, Consumers' after-tax cash underrecoveries
associated with the PPA could be as follows:
In Millions
- ------------------------------------------------------------------------------------------------------------------
2002 2003 2004 2005 2006 2007
- ------------------------------------------------------------------------------------------------------------------
Estimated cash underrecoveries at 98.5% net of tax $38 $37 $36 $36 $36 $25
==================================================================================================================
For further information see "Change in Auditors and Pending Restatement" above,
Note 2, Uncertainties "Pending Restatement and Other Related Uncertainties" and
"Other Electric Uncertainties - The Midland Cogeneration Venture" for additional
detail.
CE-6
Consumers Energy Company
ACCOUNTING FOR DERIVATIVE AND FINANCIAL INSTRUMENTS AND MARKET RISK INFORMATION
DERIVATIVE INSTRUMENTS: Consumers uses SFAS No. 133 criteria to determine which
contracts must be accounted for as derivative instruments. These rules, however,
are numerous and complex. As a result, significant judgment is required, and
similar contracts can sometimes be accounted for differently.
Consumers currently accounts for the following contracts as derivative
instruments: interest rate swaps, certain electric call options and fixed priced
gas supply contracts with embedded put options, gas fuel swaps, fixed priced
weather-based gas supply call options and fixed price gas supply put options.
Consumers does not account for the following contracts as derivative
instruments: electric capacity and energy contracts, gas supply contracts
without embedded options, coal and nuclear fuel supply contracts, and purchase
orders for numerous supply items.
Consumers believes that certain of its electric capacity and energy contracts
are not derivatives due to the lack of an active energy market in the state of
Michigan, as defined by SFAS No. 133, and the transportation cost to deliver the
power under the contracts to the closest active energy market at the Cinergy hub
in Ohio. If a market develops in the future, Consumers may be required to
account for these contracts as derivatives. The mark-to-market impact on
earnings related to these contracts, particularly related to the PPA, could be
material to the financial statements.
If a contract is accounted for as a derivative instrument, it is recorded in the
financial statements as an asset or a liability, at the fair value of the
contract. Any difference between the recorded book value and the fair value is
reported either in earnings or other comprehensive income, depending on certain
qualifying criteria. The recorded fair value of the contract is then adjusted
quarterly to reflect any change in the market value of the contract.
In order to fair value the contracts that are accounted for as derivative
instruments, Consumers uses a combination of market quoted prices and
mathematical models. Option models require various inputs, including forward
prices, volatilities, interest rates and exercise periods. Changes in forward
prices or volatilities could significantly change the calculated fair value of
the call option contracts. At September 30, 2002, Consumers assumed a
market-based interest rate of 4.5 percent in calculating the fair value of its
electric call options.
In order for derivative instruments to qualify for hedge accounting under SFAS
No. 133, the hedging relationship must be formally documented at inception and
be highly effective in achieving offsetting cash flows or offsetting changes in
fair value, attributable to the risk being hedged. If hedging a forecasted
transaction, the forecasted transaction must be probable. If a derivative
instrument, used as a cash flow hedge, is terminated early because it is
probable that a forecasted transaction will not occur, any gain or loss as of
such date is immediately recognized in earnings. If a derivative instrument,
used as a cash flow hedge, is terminated early for other economic reasons, any
gain or loss as of the termination date is deferred and recorded when the
forecasted transaction affects earnings.
FINANCIAL INSTRUMENTS: Consumers accounts for its debt and equity investment
securities in accordance with SFAS No. 115. As such, debt and equity securities
can be classified into one of three categories: held-to-maturity, trading, or
available-for-sale securities. Consumers' investments in equity securities,
including its investment in CMS Energy Common Stock, are classified as
available-for-sale securities. They are reported at fair value, with any
unrealized gains or losses from changes in fair value reported in equity as part
of other comprehensive income and excluded from earnings. Unrealized gains or
losses from changes in the fair value of Consumers' nuclear decommissioning
investments are reported in accumulated depreciation. The fair value of these
investments is determined from quoted market prices.
CE-7
MARKET RISK INFORMATION: Consumers is exposed to market risks including, but not
limited to, changes in interest rates, commodity prices, and equity security
prices. Consumers' market risk, and activities designed to minimize this risk,
are subject to the direction of an executive oversight committee consisting of
designated members of senior management and a risk committee, consisting of
business unit managers. The risk committee's role is to review the corporate
commodity position and ensure that net corporate exposures are within the
economic risk tolerance levels established by Consumers' Board of Directors.
Established policies and procedures are used to manage the risks associated with
market fluctuations.
Consumers uses various contracts, including swaps, options, and forward
contracts to manage its risks associated with the variability in expected future
cash flows attributable to fluctuations in interest rates and commodity prices.
Contracts used to manage interest rate and commodity price risk may be
considered derivative instruments that are subject to derivative and hedge
accounting pursuant to SFAS No. 133. All risk management contracts are entered
to for purposes other than trading.
These instruments contain credit risk if the counterparties, including financial
institutions and energy marketers, fail to perform under the agreements.
Consumers minimizes such risk by performing financial credit reviews using,
among other things, publicly available credit ratings of such counterparties.
In accordance with SEC disclosure requirements, Consumers performs sensitivity
analyses to assess the potential loss in fair value, cash flows and earnings
based upon a hypothetical 10 percent adverse change in market rates or prices.
Management does not believe that sensitivity analyses alone provide an accurate
or reliable method for monitoring and controlling risks. Therefore, Consumers
relies on the experience and judgment of its senior management to revise
strategies and adjust positions, as it deems necessary. Losses in excess of the
amounts determined in sensitivity analyses could occur if market rates or prices
exceed the 10 percent shift used for the analyses.
INTEREST RATE RISK: Consumers is exposed to interest rate risk resulting from
the issuance of fixed-rate debt and variable-rate debt, and from interest rate
swap agreements. Consumers uses a combination of these instruments to manage and
mitigate interest rate risk exposure when it deems it appropriate, based upon
market conditions. These strategies attempt to provide and maintain the lowest
cost of capital. As of September 30, 2002, Consumers had outstanding $1.202
billion of variable-rate debt, including variable rate swaps. At September 30,
2002, assuming a hypothetical 10 percent adverse change in market interest
rates, Consumers' before tax earnings exposure on its variable rate debt would
be $2 million. As of September 30, 2002, Consumers had entered into
floating-to-fixed interest rate swap agreements for a notional amount of $75
million. These swaps exchange variable-rate interest payment obligations for
fixed-rate interest payment obligations in order to minimize the impact of
potential adverse interest rate changes. As of September 30, 2002, Consumers had
outstanding long-term fixed-rate debt, including fixed-rate swaps, of $2.768
billion, with a fair value of $2.702 billion. As of September 30, 2002, assuming
a hypothetical 10 percent adverse change in market rates, Consumers would have
an exposure of $136 million to the fair value of these instruments if it had to
refinance all of its long-term fixed-rate debt. Consumers does not intend to
refinance its fixed-rate debt in the near term and believes that any adverse
change in debt price and interest rates would not have a material effect on
either its consolidated financial position, results of operation or cash flows.
CE-8
Consumers Energy Company
COMMODITY MARKET RISK: For purposes other than trading, Consumers enters into
electric call options, gas fuel for generation call options and swap contracts,
fixed price gas supply contracts containing embedded put options, fixed priced
weather-based gas supply call options and fixed priced gas supply put options.
The electric call options are used to protect against risk due to fluctuations
in the market price of electricity and to ensure a reliable source of capacity
to meet customers' electric needs. The gas fuel for generation call options and
swap contracts are used to protect generation activities against risk due to
fluctuations in the market price of natural gas. The gas supply contracts
containing embedded put options, the weather-based gas supply call options, and
the gas supply put options are used to purchase reasonably priced gas supply.
As of September 30, 2002, the fair value based on quoted future market prices of
electricity-related call option and swap contracts was $8 million. At September
30, 2002, assuming a hypothetical 10 percent adverse change in market prices,
the potential reduction in fair value associated with these contracts would be
$2 million. As of September 30, 2002, Consumers had an asset of $30 million,
related to premiums incurred for electric call option contracts. Consumers'
maximum exposure associated with the call option contracts is limited to the
premiums incurred. As of September 30, 2002, the fair value based on quoted
future market prices of gas supply-related call and put option contracts was $1
million. At September 30, 2002, assuming a hypothetical 10 percent adverse
change in market prices, the potential reduction in fair value associated with
these contracts would be $300 thousand.
EQUITY SECURITY PRICE RISK: Consumers owns less than 20 percent of the
outstanding shares of CMS Energy Common Stock. At September 30, 2002, a
hypothetical 10 percent adverse change in market price would have resulted in a
$4 million change in its investment. This investment is currently
marked-to-market through equity. Consumers believes that such an adverse change
would not have a material effect on its consolidated financial position, results
of operation or cash flows.
For further information on market risk and derivative activities, see Note 1,
Corporate Structure and Summary of Significant Accounting Policies, "Risk
Management Activities and Derivative Transactions" and "Implementation of New
Accounting Standards", Note 2, Uncertainties, "Other Electric Uncertainties -
Derivative Activities", "Other Gas Uncertainties - Derivative Activities", and
Note 3, Short-Term Financings and Capitalization, "Derivative Activities."
ACCOUNTING FOR LEASES
Consumers uses SFAS No. 13 to account for any leases to which it may be a party.
Depending upon satisfaction of certain criteria, they are classified as
operating leases or capital leases. Under an operating lease, payments are
expensed as incurred, and there is no recognition of an asset or liability on
the balance sheet. Capital leases, on the other hand, require that an asset and
liability be recorded on the balance sheet at the inception of the lease for the
present value of the minimum lease payments required during the term of the
lease.
To determine whether to classify a lease as operating or capital under SFAS No.
13 and related statements, Consumers must use judgment. A lease must be
evaluated for transfer of ownership, provision for bargain purchase option, the
lease term relative to the estimated economic life of the leased property, and
the present value of the minimum lease payments at the beginning of the lease
term. Judgment is required for leases involving special purpose entities such as
trusts, sales and leasebacks and when the lessee is involved in the construction
of the property it will lease. Different financial presentations of leases could
result if different judgment, estimates or assumptions are made.
Consumers is party to a number of leases, the most significant are the leases
associated with its service vehicles, its new headquarters building, and its
railroad coal cars. For further information see "Contractual Obligations and
Commercial Commitments" in the Capital Resources and Liquidity section and Note
1,
CE-9
Consumers Energy Company
Corporate Structure and Summary of Significant Accounting Policies, "Accounting
for Headquarters Building Lease".
ACCOUNTING FOR THE EFFECTS OF INDUSTRY REGULATION
Because Consumers is involved in a regulated industry, regulatory decisions
affect the timing and recognition of revenues and expenses. Consumers uses SFAS
No. 71 to account for the effects of these regulatory decisions. As a result,
Consumers may defer or recognize revenues and expenses differently than a
non-regulated entity.
For example, items that a non-regulated entity would normally expense, Consumers
may capitalize as regulatory assets if the actions of the regulator indicate
such expenses will be recovered in future rates. Conversely, items that
non-regulated entities may normally recognize as revenues, Consumers may record
as regulatory liabilities if the actions of the regulator indicate they will
require such revenues to later be refunded to customers. Judgment is required to
discern the recoverability of items recorded as regulatory assets and
liabilities. As of September 30, 2002, Consumers had $1.104 billion recorded as
regulatory assets and $301 million recorded as regulatory liabilities.
ACCOUNTING FOR PENSION AND OPEB
Consumers provides postretirement benefits under its Pension Plan, and
postretirement health and life benefits under its OPEB plans to substantially
all its retired employees. Consumers uses SFAS No. 87 to account for pension
costs and uses SFAS No. 106 to account for other postretirement benefit costs.
These statements require liabilities to be recorded on the balance sheet at the
present value of these future obligations to employees net of any plan assets.
The calculation of these liabilities and associated expenses require the
expertise of actuaries and are subject to many assumptions including life
expectancies, present value discount rates, expected long-term rate of return on
plan assets, rate of compensation increase and anticipated health care costs.
Any change in these assumptions can significantly change the liability and
associated expenses recognized in any given year. As of January 2002, OPEB plan
claims are paid from the VEBA Trusts.
Pension and OPEB plan assets, net of contributions, have been reduced in value
from the previous year due to the downturn in the equities market, and a
decrease in the price of CMS Energy Common Stock. As a result, Consumers expects
to see an increase in pension and OPEB expense levels over the next several
years unless market performance of plan assets improves. Consumers anticipates
pension expense and OPEB expense to rise in 2002 by approximately $8 million and
$20 million, respectively, over 2001 expenses. For pension expense, this
increase is due to a downturn in value of pension assets during the past two
years, forecasted increases in pay and added service, decline in the interest
rate used to value the liability of the plan, and expiration of the transition
gain amortization. For OPEB expense, the increase is due to the trend of rising
health care costs, the market return on plan assets being below expected levels,
and a lower discount rate, based on recent economic conditions, used to compute
the benefit obligation. Under the OPEB plans' assumptions, health care costs
increase at a slower rate from current levels through 2009; however, Consumers
cannot predict the impact that future health care costs and interest rates or
market returns will have on pension and OPEB expense in the future.
The recent significant downturn in the equities markets has affected the value
of the Pension Plan assets. If the plan's Accumulated Benefit Obligation exceeds
the value of these assets at December 31, 2002, Consumers Energy will be
required to recognize an additional minimum liability for this excess in
accordance with SFAS No. 87. Consumers cannot predict the future fair value of
the plan's assets but it is probable, without significant appreciation in the
plan's assets, that Consumers will need to book an additional minimum liability
through a charge to other comprehensive income. The value of the Plan assets and
the Accumulated Benefit Obligation are determined by the Plan's actuary in the
fourth quarter of each year.
CE-10
Consumers Energy Company
In January 2002, Consumers contributed $62 million to the Plans' trust accounts.
This amount represents $47 million of pension related benefits and $15 million
of postretirement health care and life insurance benefits. In June 2002 and
September 2002, Consumers made additional contributions, in the amount of $21
million and $18 million, respectively, for postretirement health care and life
insurance benefits. Consumers expects to make an additional contribution to the
Pension Plan of approximately $187 million in the third quarter of 2003.
In order to keep health care benefits and costs competitive, Consumers has
announced several changes to the Health Care Plan. These changes are effective
January 1, 2003. The most significant change is that Consumers' future increases
in health care costs will be shared with employees.
Consumers also provides retirement benefits under a defined contribution 401(k)
plan. Consumers previously offered an employer's contribution match of 50
percent of the employee's contribution up to six percent (three percent
maximum), as well as an incentive match in years when Consumers' financial
performance exceeded targeted levels. Effective September 1, 2002, the
employer's match was suspended until January 1, 2005, and the incentive match
was permanently eliminated. Amounts charged to expense for the employer's match
and incentive match during 2001 were $12 million and $8 million, respectively.
ACCOUNTING FOR NUCLEAR DECOMMISSIONING COSTS
Consumers' decommissioning cost estimates for the Big Rock and Palisades plants
assume that each plant site will eventually be restored to conform to the
adjacent landscape with all contaminated equipment and material removed and
disposed of in a licensed burial facility and the site released for unrestricted
use. A March 1999 MPSC order provided for fully funding the decommissioning
trust funds for both sites. The order set the annual decommissioning surcharge
for the Palisades decommissioning at $6 million a year. Consumers estimates that
at the time of the decommissioning of Palisades, its decommissioning trust fund
will also be fully funded. Earnings assumptions are that the trust funds are
invested in equities and fixed income investments that are then converted to
fixed income and cash before expenditures are made. Decommissioning costs have
been developed, in part, by independent contractors with expertise in
decommissioning. These costs estimates use various inflation rates for labor,
non-labor, and contaminated equipment disposal costs.
On December 31, 2000, the Big Rock trust fund was considered fully funded. A
portion of its current decommissioning cost is due to the failure of the DOE to
remove fuel from the site. These costs, and similar costs incurred at Palisades,
would not be necessary but for the failure of the DOE to take possession of the
spent fuel as required by the Nuclear Waste Policy Act of 1982. Consumers
anticipates future recoveries from the DOE, after litigation that has yet to be
commenced and successfully concluded, to defray the significant costs it will
incur for the storage of spent fuel until DOE takes possession as required by
law.
The funds provided by the trusts and added to from DOE litigation are expected
to fully fund the decommissioning costs. Variance from trust earnings, recovery
of costs from the DOE, changes in decommissioning technology, regulations,
estimates or assumptions could affect the cost of decommissioning these sites.
RELATED PARTY TRANSACTIONS
Consumers enters into a number of significant transactions with related parties.
These transactions include the purchase of capacity and energy from the MCV
Partnership and from affiliates of Enterprises, the purchase of electricity and
gas supply from CMS MST, the sale of electricity to CMS MST, the purchase of gas
transportation from CMS Bay Area Pipeline, L.L.C., the purchase of gas
transportation from Trunkline, a subsidiary of Panhandle, the payment of parent
company overhead costs to CMS Energy, the sale, storage and
CE-11
Consumers Energy Company
transportation of natural gas and other services to the MCV Partnership, certain
transactions involving derivative instruments with CMS MST, and an investment in
CMS Energy Common Stock.
Transactions involving CMS Energy and its affiliates and the sale, storage and
transportation of natural gas and other services to the MCV Partnership are
based on regulated prices, market prices or competitive bidding. Transactions
involving the power supply purchases from the MCV Partnership, and certain
affiliates of CMS Enterprises, are based upon avoided costs under PURPA and
competitive bidding; and the payment of parent company overhead costs to CMS
Energy are based upon use or accepted industry allocation methodologies.
In 2002, Consumers also sold its transmission facilities to MTH, a
non-affiliated limited partnership whose general partner is a subsidiary of
Trans-Elect, Inc., an independent company, whose management includes former
executive employees of Consumers. The transaction was based on competitive
bidding.
For detailed information about related party transactions see Note 2,
Uncertainties, "Electric Rate Matters - Transmission", and "Other Electric
Uncertainties - The Midland Cogeneration Venture".
RESULTS OF OPERATIONS
CONSUMERS CONSOLIDATED EARNINGS
In Millions
- ----------------------------------------------------------------------------------------------------------------
September 30 2002 2001 Change
- ----------------------------------------------------------------------------------------------------------------
Three months ended $ 44 $(74) $118
Nine months ended 237 57 180
================================================================================================================
2002 COMPARED TO 2001: For the three months ended September 30, 2002, Consumers'
net income available to the common stockholder totaled $44 million, an increase
of $118 million from the comparable period in 2001. The earnings increase
reflects the after-tax benefit of decreased electric power costs of $65 million
from the comparable period in 2001. This reduction in power costs was primarily
due to higher replacement power supply costs in 2001, resulting from an outage
at Palisades in the third quarter of 2001 along with the lower volume and lower
cost of power options and dispatchable capacity contracts purchased for 2002.
The increase in earnings also reflects an $82 million after-tax loss related to
the PPA accounted for in September 2001. Increased electric deliveries to the
higher-margin residential and commercial sectors also contributed to the
earnings increase. Offsetting these increases is a $9 million decrease resulting
from the recognition of a 4 bcf loss of natural gas from inventory. This loss
recognition results from Consumers' refinement of its inventory measurement
techniques. Also offsetting the above increases is the impact of a charge to
income tax expense to reflect an additional $29 million charge allocated to
Consumers through CMS Energy's consolidated federal income tax return for 2001
filed in 2002. CMS Energy's carry back of a consolidated 2001 tax loss will
result in refunds to CMS Energy of prior year tax payments totaling $217
million. This tax loss carry back resulted in the loss of certain tax credits
for the years 1996 through 1999. Consumers should receive a proportionate share
of the tax refund, but is not quantifiable at this time.
For the nine months ended September 30, 2002, Consumers' net income available to
the common stockholder totaled $237 million, an increase of $180 million from
the comparable period in 2001. The earnings increase reflects the after-tax
benefit of decreased electric power costs of $73 million from the comparable
period in 2001. This reduction in power costs was primarily due to the need to
purchase higher replacement power resulting from a refueling outage and an
unscheduled forced outage at Palisades in 2001. This reduction in power costs
also can be attributed to the lower price of power options and dispatchable
capacity contracts purchased for 2002. The increase in earnings also reflects
the $82 million after-tax loss related to the PPA accounted for in September
2001 along with a $26 million gain from the May 2002 sale of Consumers' electric
transmission system to MTH. Also contributing to the earnings increase is a $22
million increase in the fair
CE-12
Consumers Energy Company
value of certain long-term gas contracts held by the MCV Partnership. The fair
value of these contracts is adjusted, through earnings, on a quarterly basis in
accordance with SFAS No. 133. For further information on SFAS No. 133, see Note
2, Uncertainties. Increased electric deliveries to the higher-margin residential
and commercial sectors also contributed to the earnings increase. Offsetting
these increases is a $9 million decrease resulting from the recognition of a 4
bcf loss of natural gas from inventory. This loss recognition results from
Consumers' refinement of its inventory measurement techniques. Also offsetting
the above increases is the $29 million income tax charge recorded in the third
quarter of 2002 that is discussed above.
For further information, see "Change in Auditors and Pending Restatement" at the
beginning of this MD&A, the Electric and Gas Utility Results of Operations
sections and Note 2, Uncertainties.
ELECTRIC UTILITY RESULTS OF OPERATIONS
In Millions
- ------------------------------------------------------------------------------------------------------------------
September 30 2002 2001 Change
- ------------------------------------------------------------------------------------------------------------------
Three months ended $ 68 $(69) $137
Nine months ended 201 22 179
==================================================================================================================
- ----------------------------------------------------------------------------------------------------------------
Three Months Nine Months
Ended September 30 Ended September 30
Reasons for change 2002 vs 2001 2002 vs 2001
- ----------------------------------------------------------------------------------------------------------------
Electric deliveries $ 25 $ 30
Power supply costs and related revenue 100 113
Other operating expenses and non-commodity revenue (12) (19)
Gain on asset sales 0 38
Loss on MCV Power Purchases 126 126
Fixed charges 4 12
Income taxes (106) (121)
- ----------------------------------------------------------------------------------------------------------------
Total change $ 137 $ 179
================================================================================================================
ELECTRIC DELIVERIES: For the three months ended September 30, 2002, electric
delivery revenues increased by $25 million from the 2001 level. Electric
deliveries, including transactions with other wholesale market participants and
other electric utilities, were 10.9 billion kWh, a decrease of 0.1 billion kWh,
or 0.9 percent from the comparable period in 2001. This reduction in electric
deliveries is primarily due to reduced transactions with other utilities and the
expiration of wholesale power sales contracts with certain Michigan municipal
utilities. Although total deliveries were below the 2001 level, increased
deliveries to the higher-margin residential and commercial sectors, along with
growth in retail deliveries, more than offset the impact of reductions to the
lower-margin customers. Even though deliveries were below the 2001 level,
Consumers set an all-time monthly sendout record during the month of July, and a
monthly hourly peak demand record of 7,318 MW was set on September 9, 2002.
For the nine months ended September 30, 2002, electric delivery revenues
increased by $30 million from the 2001 level. Electric deliveries, including
transactions with other wholesale market participants and other electric
utilities, were 29.5 billion kWh, a decrease of 0.7 billion kWh, or 2.5 percent
from the comparable period in 2001. Again, this reduction in electric deliveries
is primarily due to reduced transactions with other utilities and the expiration
of wholesale power sales contracts with certain Michigan municipal utilities.
Even though total deliveries were
CE-13
Consumers Energy Company
below the 2001 level, increased deliveries to the higher-margin residential and
commercial sectors, along with growth in retail deliveries, more than offset the
impact of reductions to the lower-margin customers. For the year, Consumers has
set an all-time monthly sendout record during the month of July, and monthly
hourly peak demand records were set on April 16, 2002, June 25, 2002, and
September 9, 2002.
POWER SUPPLY COSTS AND RELATED REVENUE: For the three months ended September 30,
2002, power supply costs decreased by $100 million from the comparable period in
2001. The decreased power costs in 2002 were primarily due to the higher
availability of the lower-priced Palisades plant. In the 2001 period, Consumers
was required to purchase greater quantities of higher-priced power to offset the
loss of internal generation resulting from an outage at Palisades. Also
contributing to the overall decrease in power costs was the lower volume and
lower priced power options and dispatchable capacity contracts that were
purchased for 2002.
For the nine months ended September 30, 2002, power supply costs and related
revenues decreased by a total of $113 million from the comparable period in
2001. This decrease was primarily the result of the Palisades plant being
returned to service in 2002. In 2001, Consumers purchased higher cost
replacement power during the refueling outage that began in March and ended in
May and the unscheduled forced outage at Palisades that began in June and ended
in January 2002. Also contributing to this decrease is lower-priced power
options and dispatchable capacity contracts that were purchased for 2002.
OTHER OPERATING EXPENSES AND NON-COMMODITY REVENUES: For the three and nine
months ended September 30, 2002, other operating expenses increased $12 million
and $19 million, respectively from the comparable period in 2001. Both of these
increases are attributed to higher depreciation expense resulting from higher
plant in service along with increased operating costs resulting from higher
health care and storm restoration expenses.
GAIN ON ASSET SALES: For the nine months ended September 30, 2002, asset sales
increased as a result of the $31 million pretax gain associated with the May
2002 sale of Consumers' electric transmission system and a $7 million pretax
gain on the sale of nuclear equipment from the cancelled Midland project.
LOSS ON MCV POWER PURCHASES: For the three and nine months ended September 30,
2002, the earnings increase reflects a $126 million pretax loss related to the
PPA that was accounted for in September 2001. This loss is due to management's
review of the PPA liability assumptions related to increased expected long-term
dispatch of the MCV Facility and increased MCV-related costs. As a result,
Consumers increased the PPA liability in September 2001 to adequately reflect
the present value of the PPA's future effect on Consumers. For further
information see "Change in Auditors and Pending Restatement" at the beginning of
this MD&A.
INCOME TAXES: For the three and nine months ended September 30, 2002, the
earnings increase reflects the impact of a charge to income tax expense to
reflect an additional $20 million charge allocated to Consumers through CMS
Energy's consolidated Federal Income Tax return for 2001 filed in 2002.
GAS UTILITY RESULTS OF OPERATIONS
In Millions
- ------------------------------------------------------------------------------------------------------------------
September 30 2002 2001 Change
- ------------------------------------------------------------------------------------------------------------------
Three months ended $ (24) $ (10) $(14)
Nine months ended 8 20 (12)
===================================================================================================================
CE-14
Consumers Energy Company
Three Months Nine Months
Ended September 30 Ended September 30
Reasons for change 2002 vs 2001 2002 vs 2001
- -------------------------------------------------------------------------------------------------------------------
Gas deliveries $ (2) $ (2)
Gas rate increase 1 10
Gas wholesale and retail services 3 3
Operation and maintenance (17) (17)
Other operating expenses 3 (2)
Income taxes (2) (4)
- --------------------------------------------------------------------------------------------------------------------
Total change $ (14) $ (12)
====================================================================================================================
For the three months ended September 30, 2002, gas revenues decreased due to
warmer temperatures compared to the third quarter 2001. Gas wholesale and retail
service revenues increased principally due to growth in the appliance service
plan. Operation and maintenance cost increases reflect recognition of gas
storage inventory losses, and additional expenditures on customer reliability
and service. System deliveries, including miscellaneous transportation volumes,
totaled 40.1 bcf, a decrease of 1.7 bcf or 4.1 percent compared with 2001. The
earnings decrease also reflects the impact of a charge to income tax expense to
reflect an additional $6 million charge allocated to Consumers through CMS
Energy's consolidated federal income tax return for 2001 filed in 2002.
For the nine months ended September 30, 2002, gas revenues increased due to an
interim gas rate increase granted in December of 2001, partially offset by a
decrease in gas delivery revenue due to warmer temperatures and decelerated
economic demand. Operation and maintenance cost increases reflect recognition of
gas storage inventory losses, and additional expenditures on customer
reliability and service. System deliveries, including miscellaneous
transportation volumes, totaled 254.7 bcf, a decrease of 3.7 bcf or 1.4 percent
compared with 2001. The earnings decrease also reflects the impact of the $6
million income tax charge recorded in the third quarter of 2002 that is
discussed above.
CAPITAL RESOURCES AND LIQUIDITY
CASH POSITION, INVESTING AND FINANCING
OPERATING ACTIVITIES: Consumers' principal source of liquidity is from cash
derived from operating activities involving the sale and transportation of
natural gas and the generation, delivery and sale of electricity. Cash from
operations totaled $420 million and $321 million for the first nine months of
2002 and 2001, respectively. The $99 million increase resulted primarily from an
increase in cash due to lower expenditures for natural gas and lower electric
power purchase costs as a result of Palisades return to service, partially
offset by a decrease in cash collected from customers and related parties.
Consumers primarily uses cash derived from operating activities to operate,
maintain, expand and construct its electric and gas systems, to retire portions
of long-term debt, and to pay dividends. A decrease in cash from operations
could reduce the availability of funds and result in additional short-term
financings, see Note 3, Short-Term Financings and Capitalization for additional
details about this source of funds.
INVESTING ACTIVITIES: Cash used for investing activities totaled $144 million
and $511 million for the first nine months of 2002 and 2001, respectively. The
change of $367 million is primarily the result of $298 million cash from the
sale of METC, Midland Nuclear Plant reactor head and other assets, and fewer
capital expenditures to comply with the Clean Air Act than the first nine months
of 2001.
FINANCING ACTIVITIES: Cash used by financing activities totaled $168 million for
the first nine months of 2002
CE-15
Consumers Energy Company
compared to $193 million provided in the first nine months of 2001,
respectively. The change of $361 million is primarily the result of $407 million
retirement of bonds and other long-term debt, $100 million decrease in
stockholder's contribution and the absence of $121 million proceeds from
preferred securities, offset by $250 million of net proceeds from issuance of
senior notes.
OFF-BALANCE SHEET ARRANGEMENTS: Consumers' use of long-term contracts for the
purchase of commodities and services, the sale of its accounts receivables, and
operating leases are considered to be off-balance sheet arrangements. Consumers
has responsibility for the collectability of the accounts receivables sold, and
the full obligation of its leases become due in case of lease payment default.
Consumers uses these off-balance sheet arrangements in its normal business
operations.
CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS: The following schedule of
material contractual obligations and commercial commitments is provided to
aggregate information in a single location so that a picture of liquidity and
capital resources is readily available. For further information see Note 2,
Uncertainties, and Note 3, Short-Term Financings and Capitalization.
Contractual Obligations In Millions
- --------------------------------------------------------------------------------------------------------------
Payments Due
------------------------------------------------------------
September 30 Total 2002 2003 2004 2005 2006 and beyond
- --------------------------------------------------------------------------------------------------------------
On-balance sheet:
Long-term debt $ 2,912 $ 144 $ 333 $ 328 $470 $ 1,637
Notes payable 235 - 235 - - -
Capital lease obligations (a) 138 50 21 19 18 30
Off-balance sheet:
Headquarters building lease (a) 20 7 13 - - -
Operating leases 83 5 12 9 8 49
Non-recourse debt of FMLP 276 65 8 54 41 108
Sale of accounts receivable 325 325 - - - -
Unconditional purchase
Obligations 18,049 956 1,175 929 860 14,129
==============================================================================================================
(a) The headquarters building capital lease is estimated to be $65 million of
which a $45 million construction obligation has been incurred and recorded on
Consumers' balance sheet.
Unconditional purchase obligations include natural gas, electricity, and coal
purchase contracts and their associated cost of transportation. These
obligations represent normal business operating contracts used to assure
adequate supply and to minimize exposure to market price fluctuations. Operating
leases are predominately railroad coal car leases, and capital leases are
predominately for leased service vehicles. Consumers has long-term power
purchase agreements with various generating plants including the MCV Facility.
These contracts require monthly capacity payments based on the plants'
availability or deliverability. These payments are approximately $45 million per
month for year 2002, which includes $33 million related to the MCV Facility. If
a plant is not available to deliver electricity to Consumers, then Consumers
would not be obligated to make the capacity payment while the plant is
unavailable to deliver. See Electric Utility Results of Operations above and
Note 2, Uncertainties, "Electric Rate Matters - Power Supply Costs" and "Other
Electric Uncertainties - The Midland Cogeneration Venture" for further
information concerning power supply costs.
CE-16
Consumers Energy Company
Commercial Commitments In Millions
- --------------------------------------------------------------------------------------------------------------
Commitment Expiration
-----------------------------------------------------------
September 30 Total 2002 2003 2004 2005 2006 and beyond
- --------------------------------------------------------------------------------------------------------------
Off-balance sheet:
Indemnities 16 - - - - 16
Letters of Credit 7 7 - - - -
==============================================================================================================
Indemnities are three-party agreements used to assure performance of contracts
by Consumers. Letters of credit are issued by banks guaranteeing Consumers'
payment of its drafts. Drafts are for a stated amount and for a specified
period; they substitute the bank's credit for Consumers' and eliminate the
credit risk for the other party.
As of September 2002, Consumers had a $250 million credit facility of which $235
million is outstanding and a $225 million term loan of which approximately $84
million is outstanding. In addition, Consumers has, through its wholly owned
subsidiary Consumers Receivables Funding, a $325 million trade receivable sale
program in place as anticipated sources of funds for general corporate purposes
and currently expected capital expenditures. At September 30, 2002 and 2001, the
receivables sold totaled $325 million for each year. During 2002, $248 million
cash proceeds were received under the trade receivables sale program. Accounts
receivable and accrued revenue in the Consolidated Balance Sheets have been
reduced to reflect receivables sold.
In July 2002, the credit rating of the publicly traded securities of Consumers
was downgraded by the major rating agencies. The rating downgrade is purported
to be largely a function of the uncertainties associated with CMS Energy's
financial condition and liquidity pending resolution of the round-trip trading
investigations and lawsuits, the special board committee investigation,
restatement and re-audit of 2000 and 2001 financial statements, and uncertain
future access to the capital markets. Consumers' actual ability to access the
capital markets in the future on a timely basis will depend on the successful
and timely resolution of the board committee investigation and the successful
and timely conclusion of the re-audit of 2000 and 2001 financial statements.
As a result of certain of these downgrades, a few commodity suppliers to
Consumers have requested advance payments or other forms of assurances in
connection with maintenance of ongoing deliveries of gas and electricity.
Consumers is addressing these issues as required.
In July 2002, Consumers reached agreement with its lenders on two credit
facilities as follows: a $250 million revolving credit facility maturing July
11, 2003 and a $300 million term loan maturing July 11, 2003. In September 2002,
the term loan maturity was extended by one year at Consumers' option and now has
a maturity date of July 11, 2004. These two facilities aggregating $550 million
replace a $300 million revolving credit facility that matured July 14, 2002, as
well as various credit lines aggregating $200 million. The prior credit
facilities and lines were unsecured. The two new credit facilities are secured
with Consumers first mortgage bonds.
Consumers' $250 million revolving credit facility has an interest rate of LIBOR
plus 200 basis points, although the rate may fluctuate depending on the rating
of Consumers' first mortgage bonds, and the interest rate on the $300 million
term loan is LIBOR plus 450 basis points which may also fluctuate depending on
the rating of Consumers' first mortgage bonds. Consumers' bank and legal fees
associated with arranging the facilities were $6 million. The term loan was
issued at a 4 percent discount.
The credit facilities have contractual restrictions that require Consumers to
maintain, as of the last day of each fiscal quarter, the following:
CE-17
Consumers Energy Company
Required Ratio Limitation Ratio at September 30, 2002
- ----------------------------------------------------------------------------------------------
Debt to Capital Ratio(a) Not more than 0.65 to 1.00 0.53 to 1.00
Interest Coverage Ratio(a) Not less than 2.00 to 1.00 3.36 to 1.00
==============================================================================================
(a) Violation of this ratio would constitute an Event of Default under the
facility which provides the lender, among other remedities, the right to
declare the principal and interest immediately due and payable.
Also pursuant to restrictive covenants in the new facilities, Consumers is
limited to dividend payments that will not exceed $300 million in any calendar
year. In 2001, Consumers paid $189 million in common stock dividends to CMS
Energy. Consumers has declared and paid $154 million in common dividends through
September 2002.
In October 2002, Consumers entered into a new Term Loan Agreement collateralized
by First Mortgage Bonds and simultaneously, a new Gas Inventory Term Loan
Agreement collateralized by Consumers' natural gas in storage. These agreements
contain complementary collateral packages that provide Consumers, as additional
first mortgage bonds become available, borrowing capacity of up to $225 million.
Consumers drew $220 million of the capacity upon execution of the Agreements and
is expected to be in a position to draw the full $225 million by mid-November of
2002. The interest rate under the Agreements is currently LIBOR plus 300 basis
points, but will increase by 100 basis points for any period after December 1,
2002 during which the banks thereunder have not yet received, among other
deliveries, certified restated financial statements for CMS Energy's 2000 and
2001 fiscal years. The bank and legal fees associated with the Agreement were $2
million. The first net amortization payment under these Agreements currently is
scheduled to occur at the end of 2002 with monthly amortization scheduled until
full repayment is completed in mid-April of 2003. This financing should
eliminate the need for Consumers to access the capital markets for the remainder
of 2002.
Consumers' debt maturities for 2003 includes $333 million of long-term debt, a
$250 million revolving credit agreement and an estimated remaining balance of
$207 million on the new Gas Inventory Term Loan Agreement. At a minimum, $500
million is expected to be refinanced. In addition, Consumers expects to put in
place a new gas inventory facility. Replacing this debt with new financing is
subject, in part, to capital market acceptance and receptivity to utility
industry securities in general and to Consumers securities issuance in
particular. Consumers cannot predict the capital market's acceptance of its
securities or the impact of its restatement of its consolidated financial
statements and is exploring other financing options.
For further information, see Note 3, Short-Term Financings and Capitalization.
CE-18
Consumers Energy Company
OUTLOOK
PENDING RESTATEMENT
As a result of certain round-trip trading transactions at CMS MST, Ernst & Young
is in the process of re-auditing CMS Energy's consolidated financial statements
for the fiscal years ended December 31, 2001 and December 31, 2000, which
includes audit work at Consumers for these years. As a result, Consumers has
determined, in consultation with Ernst & Young, that certain adjustments by
Consumers to their consolidated financial statements for the fiscal years ended
December 31, 2001 and December 31, 2000 are required. At the time it adopted the
accounting treatment for these items, Consumers believed that such accounting
was appropriate under generally accepted accounting principals and Arthur
Andersen concurred. These proposed adjustments are currently being discussed
with Ernst & Young and the SEC. Final conclusions have not yet been reached.
Consumers intends to amend its 2001 Form 10-K and each of the 2002 Form 10-Qs
for the effects of these adjustments by the end of January 2003. As a result of
these reviews and re-audits, there may be revisions to the financial statements
contained in the above-referenced reports, including this Form 10-Q, which are
in addition to the known revisions described earlier. For more information, see
the section entitled "Change in Auditors and Pending Restatement" at the
beginning of this MD&A.
LIQUIDITY AND CAPITAL RESOURCES
Consumers' liquidity and capital requirements are generally a function of its
results of operations, capital expenditures, contractual obligations, working
capital needs and collateral requirements. Consumers has historically met its
consolidated cash needs through its operating and financing activities through
access to bank financing and the capital markets. As discussed above, for the
remainder of year 2002 and during 2003, Consumers has contractual obligations
and planned capital expenditures that would require substantial amounts of cash.
Consumers also has approximately $800 million of publicly issued and credit
facility debt maturing in 2003, including the Consumers' credit facilities
described above. In addition, Consumers may also become subject to commercial
commitments as indicated above.
Consumers is addressing its near-to-mid-term liquidity and capital requirements
primarily through reduced capital expenditures. Consumers believes that its
current level of cash and borrowing capacity, along with anticipated cash flows
from operating and investing activities, will be sufficient to meet its
liquidity needs through 2003, including the approximate $800 million of debt
maturities in 2003.
As discussed above, Consumers financial statements will be restated. As a
result, Consumers is at present unable to deliver certified September 30, 2002
financial statements to lenders as required under certain bank facilities.
Although Consumers believes it will be able to secure waivers of this
requirement, should it be unable to do so, it could be declared to be in default
and the debt thereunder could be accelerated and become immediately due and
payable. In addition, the occurrence of such an acceleration could entitle the
holders of other debt of Consumers to demand immediate repayment. The earliest
date that an acceleration from a failure to deliver certified financial
statements could occur is thirty consecutive days after receipt of notice of
default after November 29, 2002.
As a result of the impact of the pending restatement, ratings downgrades and
related changes in its financial situation, Consumers' access to bank financing
and the capital markets and its ability to incur additional indebtedness may be
restricted. In the event Consumers is unable to access bank financing or the
capital markets to incur or refinance indebtedness or is unable to secure the
necessary bank waivers it could have a material adverse effect on Consumers'
liquidity and operations. In such event, it would be required to consider the
full range of strategic measures available to companies in similar
circumstances.
SEC INVESTIGATION: As a result of the round-trip trading transactions at CMS
MST, CMS Energy's Board of Directors established a Special Committee of
independent directors to investigate matters surrounding the transactions and
retained outside counsel to assist in the investigation. The Special Committee
completed its investigation and reported its findings to the Board of Directors
in October 2002. The special committee
CE-19
Consumers Energy Company
concluded, based on an extensive investigation, that the round-trip trades were
undertaken to raise CMS MST's profile as an energy marketer with the goal of
enhancing its ability to promote its services to new customers. The committee
found no apparent effort to manipulate the price of CMS Energy Common Stock or
affect energy prices. The special committee also made recommendations designed
to prevent any reoccurrence of this practice, some of which have already been
implemented, including the termination of the speculative trading business and
revisions to CMS Energy's risk management policy. The Board of Directors
adopted, and CMS Energy has begun implementing, the remaining recommendations of
the special committee.
CMS Energy is cooperating with other investigations concerning round-trip
trading, including an investigation by the SEC regarding round-trip trades and
the CMS Energy's financial statements, accounting policies and controls, and
investigations by the United States Department of Justice, the Commodity Futures
Trading Commission and the FERC. CMS Energy has also received subpoenas from the
United States Attorney's Office for the Southern District of New York and from
the United States Attorney's Office in Houston regarding investigations of these
trades and has received a number of shareholder class action lawsuits. CMS
Energy is unable to predict the outcome of these matters, and Consumers is
unable to predict what effect, if any, these investigations will have on its
business.
SECURITIES CLASS ACTION LAWSUITS: Beginning on May 17, 2002, a number of
securities class action complaints have been filed against CMS Energy,
Consumers, and certain officers and directors of CMS Energy and its affiliates.
The complaints have been filed in the United States District Court for the
Eastern District of Michigan as purported class actions by individuals who
allege that they purchased CMS Energy's securities during a purported class
period. At least two of the complaints contain purported class periods beginning
on August 3, 2000 and running through May 10, 2002 or May 14, 2002. These
complaints generally seek unspecified damages based on allegations that the
defendants violated United States securities laws and regulations by making
allegedly false and misleading statements about the company's business and
financial condition. CMS Energy believes that additional suits might be
commenced against it and that all such suits against it will eventually be
consolidated. Consumers intends to vigorously defend against these actions.
Consumers cannot predict the outcome of this litigation.
ERISA CASES: Consumers is a named defendant, along with CMS Energy, CMS MST and
certain named and unnamed officers and directors in two lawsuits brought as
purported class actions on behalf of participants and beneficiaries of the
401(k) Plan. The two cases, filed in July 2002 in the United States District
Court for the Eastern District of Michigan, were consolidated by the trial
judge. Plaintiffs allege breaches of fiduciary duties under the ERISA and seek
restitution on behalf of the Plan with respect to a decline in value of the
shares of CMS Energy Common Stock held in the Plan. Plaintiffs also seek other
equitable relief and legal fees. These cases will be vigorously defended.
Consumers cannot predict the outcome of this litigation.
CAPITAL EXPENDITURES OUTLOOK
Consumers estimates the following capital expenditures, including new lease
commitments, by expenditure type and by business segments during 2002 through
2004. Consumers prepares these estimates for planning purposes and may revise
them.
CE-20
Consumers Energy Company
In Millions
- ----------------------------------------------------------------------------------------------------------------
Years Ended December 31 2002 2003 2004
- ----------------------------------------------------------------------------------------------------------------
Construction $583 $432 $511
Nuclear fuel 9 33 32
Other capital leases 53 25 32
-------------------------------
$645 $490 $575
================================================================================================================
Electric utility operations (a)(b) $455 $345 $410
Gas utility operations (a) 190 145 165
-------------------------------
$645 $490 $575
================================================================================================================
(a) These amounts include an attributed portion of Consumers' anticipated
capital expenditures for plant and equipment common to both the electric and gas
utility businesses.
(b) These amounts include estimates for capital expenditures that may be
required by recent revisions to the Clean Air Act's national air quality
standards. For further information see Note 2, Uncertainties.
ELECTRIC BUSINESS OUTLOOK
GROWTH: Over the next five years, Consumers expects electric deliveries
(including both full service sales and delivery service to customers who choose
to buy generation service from an alternative electric supplier, but excluding
transactions with other wholesale market participants including other electric
utilities) to grow at an average rate of approximately two percent per year
based primarily on a steadily growing customer base. This growth rate reflects a
long-range expected trend of growth. Growth from year to year may vary from this
trend due to customer response to abnormal weather conditions and changes in
economic conditions including, utilization and expansion of manufacturing
facilities. Consumers has experienced much stronger than expected growth in 2002
as a result of warmer than normal summer weather. Assuming that normal weather
conditions will occur in 2003, electric deliveries are expected to grow less
than one percent over the strong 2002 electric deliveries.
COMPETITION AND REGULATORY RESTRUCTURING: The enactment in 2000 of Michigan's
Customer Choice Act and other developments will continue to result in increased
competition in the electric business. Generally, increased competition can
reduce profitability and threatens Consumers' market share for generation
services. The Customer Choice Act allowed all of the company's electric
customers to buy electric generation service from Consumers or from an
alternative electric supplier as of January 1, 2002. As a result, alternative
electric suppliers for generation services have entered Consumers' market. As of
November 2002, 446 MW of generation services were being provided by such
suppliers. To the extent Consumers experiences "net" Stranded Costs as
determined by the MPSC, the Customer Choice Act allows for the company to
recover such "net" Stranded Costs by collecting a transition surcharge from
those customers who switch to an alternative electric supplier.
Stranded and Implementation Costs: The Customer Choice Act allows electric
utilities to recover the act's implementation costs and "net" Stranded Costs
(without defining the term). The act directs the MPSC to establish a method of
calculating "net" Stranded Costs and of conducting related true-up adjustments.
In December 2001, the MPSC adopted a methodology which calculated "net" Stranded
Costs as the shortfall between: (a) the revenue required to cover the costs
associated with fixed generation assets, generation-related regulatory assets,
and capacity payments associated with purchase power agreements, and (b) the
revenues received from customers under existing rates available to cover the
revenue requirement. Consumers has
CE-21
Consumers Energy Company
initiated an appeal at the Michigan Court of Appeals related to the MPSC's
December 2001 "net" Stranded Cost order, as a result of the uncertainty
associated with the outcome of the proceeding described in the following
paragraph.
According to the MPSC, "net" Stranded Costs are to be recovered from retail open
access customers through a Stranded Cost transition charge. Even though the MPSC
set Consumers' Stranded Cost transition charge at zero for calendar year 2000,
those costs for 2000 will be subject to further review in the context of the
MPSC's subsequent determinations of "net" Stranded Costs for 2001 and later
years. The MPSC authorized Consumers to use deferred accounting to recognize the
future recovery of costs determined to be stranded. In April 2002, Consumers
made "net" Stranded Cost filings with the MPSC for $22 million and $43 million
for 2000 and 2001, respectively. In the same filing, Consumers estimated that it
would experience "net" Stranded Costs of $126 million for 2002. After a series
of appeals and hearings, Consumers, in its hearing brief, filed in August 2002,
revised its request for Stranded Costs to $7 million and $4 million for 2000 and
2001, respectively, and an estimated $73 million for 2002. The single largest
reason for the difference in the filing was the exclusion of all costs
associated with expenditures required by the Clean Air Act. Consumers, in a
separate filing, requested regulatory asset accounting treatment for its Clean
Air Act expenditures through 2003. The outcome of these proceedings before the
MPSC is uncertain at this time.
Since 1997, Consumers has incurred significant electric utility restructuring
implementation costs. The following table outlines the applications filed by
Consumers with the MPSC and the status of recovery for these costs.
In Millions
- --------------------------------------------------------------------------------------------------------------
Year Filed Year Incurred Requested Pending Allowed Disallowed
- --------------------------------------------------------------------------------------------------------------
1999 1997 & 1998 $20 $ - $15 $5
2000 1999 30 - 25 5
2001 2000 25 - 20 5
2002 2001 8 8 - -
==============================================================================================================
The MPSC disallowed certain costs based upon a conclusion that these amounts did
not represent costs incremental to costs already reflected in electric rates. In
the orders received for the years 1997 through 2000, the MPSC also reserved the
right to review again the total implementation costs depending upon the progress
and success of the retail open access program, and ruled that due to the rate
freeze imposed by the Customer Choice Act, it was premature to establish a cost
recovery method for the allowable implementation costs. In addition to the
amounts shown, as of September 2002, Consumers incurred and deferred as a
regulatory asset, $3 million of additional implementation costs and has also
recorded as a regulatory asset $13 million for the cost of money associated with
total implementation costs. Consumers believes the implementation costs and the
associated cost of money are fully recoverable in accordance with the Customer
Choice Act. Cash recovery from customers will probably begin after the rate
freeze or rate cap period has expired. Consumers cannot predict the amounts the
MPSC will approve as allowable costs.
Consumers is also pursuing recovery, through the MISO of approximately $7
million in certain electric utility restructuring implementation costs related
to its former participation in the development of the Alliance RTO. However,
Consumers cannot predict the amounts it will be reimbursed by the MISO.
Rate Caps: The Customer Choice Act imposes certain limitations on electric rates
that could result in Consumers being unable to collect from customers its full
cost of conducting business. Some of these costs are beyond Consumers' control.
In particular, if Consumers needs to purchase power supply from wholesale
suppliers while retail rates are frozen or capped, the rate restrictions may
make it impossible for Consumers to fully recover purchased power and associated
transmission costs from its customers. As a result, Consumers
CE-22
Consumers Energy Company
may be unable to maintain its profit margins in its electric utility business
during the rate freeze or rate cap periods. The rate freeze is in effect through
December 31, 2003. The rate caps are in effect through at least December 31,
2004 for small commercial and industrial customers, and at least through
December 31, 2005 for residential customers.
Industrial Contracts: In response to industry restructuring efforts, Consumers
entered into multi-year electric supply contracts with certain large industrial
customers to provide electricity at specially negotiated prices, usually at a
discount from tariff prices. The MPSC approved these special contracts as part
of its phased introduction to competition. Unless terminated or restructured
these contracts are in effect through 2005. As of September 2002, some contracts
have expired, but outstanding contracts involve approximately 500 MW. Consumers
cannot predict the ultimate financial impact of changes related to these power
supply contracts, or whether additional contracts will be necessary or
advisable.
Code of Conduct: In December 2000, as a result of the passage of the Customer
Choice Act, the MPSC issued a new code of conduct that applies to electric
utilities and alternative electric suppliers. The code of conduct seeks to
prevent cross-subsidization, information sharing, and preferential treatment
between a utility's regulated and unregulated services. The new code of conduct
is broadly written, and as a result, could affect Consumers' retail gas
business, the marketing of unregulated services and equipment to Michigan
customers, and internal transfer pricing between Consumers' departments and
affiliates. In October 2001, the new code of conduct was reaffirmed without
substantial modification. Consumers appealed the MPSC orders related to the code
of conduct and sought a stay of the orders until the appeal was complete;
however, the request for a stay was denied. Consumers filed a compliance plan in
accordance with the code of conduct. It also sought waivers to the code of
conduct in order to continue utility activities that provide approximately $50
million in annual revenues. In October 2002, the MPSC denied waivers for three
programs that provide approximately $32 million in revenues. The waivers denied
included all waivers associated with the appliance service plan program that has
been offered by Consumers for many years. Consumers filed a renewed motion
for a stay of the effectiveness of the code of conduct and an appeal of the
waiver denials with the Michigan Court of Appeals. On November 8, 2002, the
Michigan Court of Appeals denied Consumers' request for a stay. Consumers is
continuing to explore its options which may include seeking an appeal of the
Michigan Court of Appeals' ruling. The full impact of the new code of conduct on
Consumers' business will remain uncertain until the appellate courts issue
definitive rulings. Recently, in an appeal involving affiliate pricing
guidelines, the Michigan Court of Appeals struck the guidelines down because of
a procedurally defective manner of enactment by the MPSC. A similar procedure
was used by the MPSC in enacting the new code of conduct.
Energy Policy: Uncertainty exists regarding the enactment of a national
comprehensive energy policy, specifically federal electric industry
restructuring legislation. A variety of bills introduced in the United States
Congress in recent years aimed to change existing federal regulation of the
industry. If the federal government enacts a comprehensive energy policy or
electric restructuring legislation, then that legislation could potentially
affect company operations and financial requirements.
Transmission: In 1999, the FERC issued Order No. 2000, strongly encouraging
electric utilities to transfer operating control of their electric transmission
system to an RTO, or sell the facilities to an independent company. In addition,
in June 2000, the Michigan legislature passed Michigan's Customer Choice Act,
which also requires utilities to divest or transfer the operating authority of
transmission facilities to an independent company. Consumers chose to offer its
electric transmission system for sale rather than own and invest in an asset it
could not control. In May 2002, Consumers sold its electric transmission system
for approximately $290 million in cash to MTH, a non-affiliated limited
partnership whose general partner is a subsidiary of Trans-Elect, Inc.
Trans-Elect, Inc. submitted the winning bid through a competitive bidding
process, and various federal agencies approved the transaction. Consumers did
not provide any financial or credit support to Trans-Elect,
CE-23
Consumers Energy Company
Inc. Certain of Trans-Elect's officers and directors are former officers and
directors of CMS Energy, Consumers and their subsidiaries. None of them were
employed by CMS Energy, Consumers, or their affiliates when the transaction was
discussed internally and negotiated with purchasers. As a result of the sale,
Consumers anticipates that its after-tax earnings will increase by approximately
$17 million in 2002, due to the recognition of a $26 million one time gain on
the sale of the electric transmission system. This one time gain is offset by a
loss of revenue from wholesale and retail open access customers who will buy
services directly from MTH, including the loss of a return on the sold electric
transmission system. Consumers anticipates that the future impact of the loss of
revenue from wholesale and retail open access customers who will buy services
directly from MTH and the loss of a return on the sold electric transmission
system on its after-tax earnings will be a decrease of $15 million in 2003, and
a decrease of approximately $14 million annually for the next three years.
Under the agreement with MTH, and subject to certain additional RTO surcharges,
contract transmission rates charged to Consumers will be fixed at current levels
through December 31, 2005, and subject to FERC ratemaking thereafter. MTH will
complete the capital program to expand the transmission system's capability to
import electricity into Michigan, as required by the Customer Choice Act, and
Consumers will continue to maintain the system under a five-year contract with
MTH. Effective April 30, 2002, Consumers and METC withdrew from the Alliance
RTO. For further information, see Note 2, Uncertainties, "Electric Rate Matters
- - Transmission."
In July 2002, the FERC issued a 600-page notice of proposed rulemaking on
standard market design for electric bulk power markets and transmission. Its
stated purpose is to remedy undue discrimination in the use of the interstate
transmission system and give the nation the benefits of a competitive bulk power
system. The proposal is subject to public comment until November 15, 2002 and
January 10, 2003 for certain standard market design issues. Consumers is
currently studying the effects of the proposed rulemaking and intends to file
comments with the FERC. The proposed rulemaking is primarily designed to correct
perceived problems in the electric transmission industry. Consumers sold its
electric transmission system in 2002, but is a transmission customer. The
financial impact to Consumers is uncertain, but the final standard market design
rules could significantly increase delivered power costs to Consumers and the
retail electric customers it serves.
There are multiple proceedings pending before the FERC regarding transitional
transmission pricing mechanisms intended to mitigate the revenue impact on
transmission owners resulting from the elimination of "Rate Pancaking". "Rate
Pancaking" represents the application of the transmission rate of each
individual transmission owner whose system is utilized on the scheduled path of
an energy delivery and its elimination could result in "lost revenues" for
transmission owners. It is unknown what mechanism(s) may result from the
proceedings currently pending before the FERC, and as such, it is not possible
at this time to identify the specific effect on Consumers. It should be noted,
however, that Consumers believes the results of these proceedings could also
significantly increase the delivered power costs to Consumers and the retail
electric customers it serves.
Similarly, other proceedings before the FERC involving rates of transmission
providers of Consumers could increase Consumers' cost of transmitting power to
its customers in Michigan. As RTOs develop and mature in Consumers' area of
electrical operation, and those RTOs respond to FERC initiatives concerning the
services they must provide and the systems they maintain, Consumers believes
that there is likely to be an upward cost trend in transmission used by
Consumers, ultimately increasing the delivered cost of power to Consumers and
the retail electric customers it serves. The specific financial impact on
Consumers of such proceedings and trends are not currently quantifiable.
Wholesale Market Competition: In 1996, Detroit Edison gave Consumers its
four-year notice to terminate their joint operating agreements for the MEPCC.
Detroit Edison and Consumers restructured and continued certain parts of the
MEPCC control area and joint transmission operations, but expressly excluded any
merchant
CE-24
Consumers Energy Company
operations (electricity purchasing, sales, and dispatch operations). On April 1,
2001, Detroit Edison and Consumers began separate merchant operations. This
opened Detroit Edison and Consumers to wholesale market competition as
individual companies. Consumers has successfully operated its independent
merchant system since April 1, 2001. Although Consumers cannot predict the
long-term financial impact of terminating these joint merchant operations, this
change places Consumers in the same competitive position as all other wholesale
market participants.
Wholesale Market Pricing: The FERC authorizes Consumers to sell electricity at
wholesale market prices. In authorizing sales at market prices, the FERC
considers the seller's level of "market power," due to the seller's dominance of
generation resources and surplus generation resources in adjacent wholesale
markets. To continue its authorization to sell at market prices, Consumers filed
a traditional market dominance analysis and indicated its compliance therewith
in October 2001. In November 2001, the FERC issued an order modifying the
traditional method of determining market power. In September 2002, a Consumers'
affiliate, CMS MST, was required by the FERC to file an updated market power
study to determine if CMS MST or any of its affiliates, including Consumers, had
market power. The study, using FERC's modified method, found that neither CMS
MST nor its affiliates possess market power.
Consumers cannot predict the impact of these electric industry-restructuring
issues on its financial position, liquidity, or results of operations.
PERFORMANCE STANDARDS: In July 2001, the MPSC proposed electric distribution
performance standards for Consumers and other Michigan electric distribution
utilities. The proposal would establish standards related to restoration after
an outage, safety, and customer relations. Failure to meet the standards would
result in customer bill credits. Consumers submitted comments to the MPSC. In
December 2001, the MPSC issued an order stating its intent to initiate a formal
rulemaking proceeding to develop and adopt performance standards. On November 7,
2002, the MPSC issued an order initiating the formal rulemaking proceeding.
Consumers will continue to participate in this process. Consumers cannot predict
the nature of the proposed standards or the likely effect, if any, on Consumers.
For further information and material changes relating to the rate matters and
restructuring of the electric utility industry, see Note 1, Corporate Structure
and Summary of Significant Accounting Policies, and Note 2, Uncertainties,
"Electric Rate Matters - Electric Restructuring" and "Electric Rate Matters -
Electric Proceedings."
UNCERTAINTIES: Several electric business trends or uncertainties may affect
Consumers' financial results and condition. These trends or uncertainties have,
or Consumers reasonably expects could have, a material impact on net sales,
revenues, or income from continuing electric operations. Such trends and
uncertainties include: 1) the need to make additional capital expenditures and
increase operating expenses for Clean Air Act compliance; 2) environmental
liabilities arising from various federal, state and local environmental laws and
regulations, including potential liability or expenses relating to the Michigan
Natural Resources and Environmental Protection Acts and Superfund; 3)
uncertainties relating to the storage and ultimate disposal of spent nuclear
fuel and the successful operation of Palisades by NMC; 4) electric industry
restructuring issues, including those described above; 5) Consumers' ability to
meet peak electric demand requirements at a reasonable cost, without market
disruption, and successfully implement initiatives to reduce exposure to
purchased power price increases; 6) the recovery of electric restructuring
implementation costs; 7) Consumers new status as an electric transmission
customer and not as an electric transmission owner/operator; 8) sufficient
reserves for OATT rate refunds; 9) the effects of derivative accounting and
potential earnings volatility, and 10) Consumers' continuing ability to raise
funds at reasonable rates in order to meet the cash requirements of its electric
business. For further information about these trends or uncertainties, see Note
2, Uncertainties.
CE-25
Consumers Energy Company
GAS BUSINESS OUTLOOK
GROWTH: Over the next five years, Consumers expects gas deliveries, including
gas customer choice deliveries (excluding transportation to the MCV Facility and
off-system deliveries), to grow at an average rate of approximately one percent
per year based primarily on a steadily growing customer base. This growth rate
reflects a long-range expected trend of growth. Growth from year to year may
vary from this trend due to customer response to abnormal weather conditions,
use of gas by independent power producers, changes in competitive and economic
conditions, and the level of natural gas consumption per customer.
GAS RATE CASE: In June 2001, Consumers filed an application with the MPSC
seeking a $140 million distribution service rate increase. Contemporaneously
with this filing, Consumers requested partial and immediate relief in the annual
amount of $33 million. In October 2001, Consumers revised its filing to reflect
lower operating costs and requested a $133 million annual distribution service
rate increase. In December 2001, the MPSC authorized a $15 million annual
interim increase in distribution service revenues. In February 2002, Consumers
revised its filing to reflect lower estimated gas inventory prices and revised
depreciation expense and requested a $105 million distribution service rate
increase. On November 7, 2002, the MPSC issued a final order approving a $56
million annual distribution service rate increase, which includes the $15
million interim increase, with an 11.4 percent authorized return on equity, for
service effective November 8, 2002. See Note 2, Uncertainties "Gas Rate Matters
- - Gas Rate Case" for further information.
UNBUNDLING STUDY: In July 2001, the MPSC directed gas utilities under its
jurisdiction to prepare and file an unbundled cost of service study. The purpose
of the study is to allow parties to advocate or oppose the unbundling of the
following services: metering, billing information, transmission, balancing,
storage, backup and peaking, and customer turn-on and turn-off services.
Unbundled services could be separately priced in the future and made subject to
competition by other providers. The subject is likely to remain the topic of
further study by the utilities in 2002 and 2003 and further consideration by the
MPSC. Consumers cannot predict the outcome of unbundling costs on its financial
results and conditions.
In September 2002, the FERC issued an order rejecting a filing by Consumers to
assess certain rates for non-physical gas title tracking services offered by
Consumers. Despite Consumer' arguments to the contrary, the Commission asserted
jurisdiction over such activities and allowed Consumers to refile and justify a
title transfer fee not based on volumes as Consumers proposed. Because the order
was issued 6 years after Consumers made its original filing initiating the
proceeding, over $3 million in non-title transfer tracking fees had been
collected. No refunds have been ordered, and Consumers sought rehearing of the
September order. Consumers has made no reservations for refunds in this matter.
If refunds were ordered they may include interest which would increase the
refund liability to more than the $3 million collected. Consumers is unable to
say with certainty what the final outcome of this proceeding might be.
UNCERTAINTIES: Several gas business trends or uncertainties may affect
Consumers' financial results and conditions. These trends or uncertainties have,
or Consumers reasonably expects could have, a material impact on net sales,
revenues, or income from continuing gas operations. Such trends and
uncertainties include: 1) potential environmental costs at a number of sites,
including sites formerly housing manufactured gas plant facilities; 2) future
gas industry restructuring initiatives; 3) any initiatives undertaken to protect
customers against gas price increases; 4) an inadequate regulatory response to
applications for requested rate increases; 5) market and regulatory responses to
increases in gas costs, including a reduced average use per residential
customer; 6) increased costs for pipeline integrity and safety and homeland
security initiatives that are not recoverable on a timely basis from customers;
and 7) Consumers' continuing ability to raise funds at reasonable rates in order
to meet the cash requirements of its gas business. For further information about
these uncertainties, see Note 2, Uncertainties.
CE-26
Consumers Energy Company
OTHER OUTLOOK
See Outlook, "Pending Restatement", "Liquidity and Capital Resources", "SEC
Investigation", "Securities Class Action Lawsuits", and "ERISA Cases" above.
TAX LOSS ALLOCATIONS: The Job Creation and Worker Assistance Act of 2002
provided to corporate taxpayers a 5-year carryback of tax losses incurred in
2001 and 2002. As a result of this legislation, CMS Energy was able to carry
back a consolidated 2001 tax loss to tax years 1996 through 1999 and obtain
refunds of prior years tax payments totaling $217 million. The tax loss
carryback, however, resulted in a reduction in AMT credit carryforwards that
previously had been recorded by CMS Energy as deferred tax assets in the amount
of $41 million. This one-time non-cash reduction in AMT credit carryforwards has
been reflected in the tax provisions of CMS Energy and each of its consolidated
subsidiaries, as of September 2002, according to their contributions to the
consolidated CMS Energy tax loss, of which $29 million was allocated to
Consumers. This represents an allocation of only one of CMS Energy's
consolidated tax return items, which will be calculated and allocated to various
CMS Energy subsidiaries in the fourth quarter of 2002. The amount of the final
tax allocations to Consumers may be materially different than recorded for this
one item.
TERRORIST ATTACKS: Since the September 11, 2001 terrorist attacks in the United
States, Consumers has increased security at all facilities and over its
infrastructure, and will continue to evaluate security on an ongoing basis.
Consumers may be required to comply with federal and state regulatory security
measures promulgated in the future. As a result, Consumers anticipates increased
operating costs for security that could be significant. Consumers would try to
recover these costs from customers.
ENERGY-RELATED SERVICES: Consumers offers a variety of energy-related services
to retail customers that focus on appliance maintenance, home safety, commodity
choice, and assistance to customers purchasing heating, ventilation and air
conditioning equipment. Consumers continues to look for additional growth
opportunities in providing energy-related services to its customers. The ability
to offer all or some of these services and other utility related
revenue-generating services, which provide approximately $50 million in annual
revenues, may be restricted by the new code of conduct issued by the MPSC, as
discussed above in Electric Business Outlook, "Competition and Regulatory
Restructuring - Code of Conduct."
OTHER MATTERS
NEW ACCOUNTING STANDARDS
SFAS NO. 143, ACCOUNTING FOR ASSET RETIREMENT OBLIGATIONS: Beginning January 1,
2003, companies must comply with SFAS No. 143. The standard requires companies
to record the fair value of the legal obligations related to an asset retirement
in the period in which it is incurred. When the liability is initially recorded,
the company would capitalize an offsetting amount by increasing the carrying
amount of the related long-lived asset. Over time, the initial liability is
accreted to its present value each period and the capitalized cost is
depreciated over the related asset's useful life. Consumers is currently
inventorying assets that may have a retirement obligation and consulting with
counsel to determine if a legal retirement obligation exists. If one exists, any
removal cost estimate will be determined based on fair value cost estimates as
required by the new standard. The present value of the legal retirement
obligations will be used to quantify the effects of adoption of this standard.
SFAS NO. 145, RESCISSION OF FASB STATEMENTS NO. 4, 44, AND 64, AMENDMENT OF FASB
STATEMENT NO. 13, AND TECHNICAL CORRECTIONS: Issued by the FASB in April 2002,
this standard rescinds SFAS No. 4, Reporting Gains and Losses from
Extinguishment of Debt, and SFAS No. 64, Extinguishment of Debt Made to Satisfy
Sinking-Fund Requirements. As a result, any gain or loss on extinguishment of
debt should be classified as an extraordinary item only if it meets the criteria
set forth in APB Opinion No. 30. The provisions of this section are applicable
to fiscal years beginning 2003. SFAS No. 145 amends SFAS No. 13, Accounting for
Leases, to
CE-27
Consumers Energy Company
require sale-leaseback accounting for certain lease modifications that have
similar economic impacts to sale-leaseback transactions. This provision is
effective for transactions occurring after May 15, 2002. Finally, SFAS No. 145
amends other existing authoritative pronouncements to make various technical
corrections and rescinds SFAS No. 44, Accounting for Intangible Assets of Motor
Carriers. These provisions are effective for financial statements issued on or
after May 15, 2002. Consumers believes there will be no impact on its financial
statements upon adoption of the standard.
SFAS NO. 146, ACCOUNTING FOR COSTS ASSOCIATED WITH EXIT OR DISPOSAL ACTIVITIES:
Issued by the FASB in July 2002, this standard requires companies to recognize
costs associated with exit or disposal activities when they are incurred rather
than at the date of a commitment to an exit or disposal plan. This standard is
effective for exit or disposal activities initiated after December 31, 2002.
Consumers believes there will be no impact on its financial statements upon
adoption of the standard.
CE-28
Consumers Energy Company
(This page intentionally left blank)
CE-29
Consumers Energy Company
CONSUMERS ENERGY COMPANY
CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 2002 2001 2002 2001
- ----------------------------------------------------------------------------------------------------------------
In Millions
OPERATING REVENUE
Electric $ 776 $ 739 $2,016 $2,028
Gas 134 149 1,002 928
Other 11 11 66 36
-------------------------------------------------
921 899 3,084 2,992
- ----------------------------------------------------------------------------------------------------------------
OPERATING EXPENSES
Operation
Fuel for electric generation 98 102 236 250
Purchased power - related parties 143 155 416 399
Purchased and interchange power 111 187 244 401
Cost of gas sold 20 40 528 470
Cost of gas sold - related parties 34 32 96 92
Loss on MCV power purchases - 126 - 126
Other 183 154 488 456
------------------------------------------------
589 796 2,008 2,194
Maintenance 43 41 141 146
Depreciation, depletion and amortization 77 71 256 242
General taxes 43 44 144 142
-------------------------------------------------
752 952 2,549 2,724
- ----------------------------------------------------------------------------------------------------------------
PRETAX OPERATING INCOME (LOSS)
Electric 175 (62) 406 157
Gas (15) (1) 68 81
Other 9 10 61 30
------------------------------------------------
169 (53) 535 268
- ----------------------------------------------------------------------------------------------------------------
OTHER INCOME (DEDUCTIONS)
Dividends and interest from affiliates - 2 2 6
Accretion expense (2) (2) (7) (6)
Other, net 2 - 39 2
--------------------------------------------------
- - 34 2
- ----------------------------------------------------------------------------------------------------------------
INTEREST CHARGES
Interest on long-term debt 41 35 111 111
Other interest 5 14 16 35
Capitalized interest (3) (1) (8) (5)
-------------------------------------------------
43 48 119 141
- ----------------------------------------------------------------------------------------------------------------
NET INCOME (LOSS) BEFORE INCOME TAXES 126 (101) 450 129
INCOME TAXES (BENEFITS) 71 (39) 179 41
------------------------------------------------
NET INCOME (LOSS) 55 (62) 271 88
PREFERRED STOCK DIVIDENDS - - 1 1
PREFERRED SECURITIES DISTRIBUTIONS 11 12 33 30
-------------------------------------------------
NET INCOME (LOSS) AVAILABLE TO COMMON STOCKHOLDER $ 44 $ (74) $ 237 $ 57
================================================================================================================
THE ACCOMPANYING CONDENSED NOTES ARE AN INTEGRAL PART OF THESE STATEMENTS.
CE-30
CONSUMERS ENERGY COMPANY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
NINE MONTHS ENDED
SEPTEMBER 30 2002 2001
- ----------------------------------------------------------------------------------------------------------------
In Millions
CASH FLOWS FROM OPERATING ACTIVITIES
Net income $ 271 $ 88
Adjustments to reconcile net income to net cash
provided by operating activities
Depreciation, depletion and amortization (includes nuclear
decommissioning of $5 and $5, respectively) 256 242
Loss on MCV power purchase agreement - 126
Deferred income taxes and investment tax credit (20) 1
Capital lease and other amortization 11 16
Gain on sale of METC and Midland Nuclear Plant reactor head (38) -
Undistributed earnings of related parties (48) (25)
Changes in assets and liabilities
Increase in inventories (37) (340)
Decrease in accounts receivable and accrued revenue 97 251
Increase (decrease) in accounts payable (72) 15
Changes in other assets and liabilities - (53)
-----------------------
Net cash provided by operating activities 420 321
- ----------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES
Capital expenditures (excludes assets placed under capital lease) (400) (495)
Cost to retire property, net (50) (73)
Investment in Electric Restructuring Implementation Plan (6) (9)
Investments in nuclear decommissioning trust funds (5) (5)
Proceeds from nuclear decommissioning trust funds 19 21
Associated company preferred stock redemption - 50
Proceeds from sale of METC, Midland Nuclear Plant reactor head and other assets 298 -
-----------------------
Net cash used in investing activities (144) (511)
- -----------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES
Retirement of bonds and other long-term debt (409) (2)
Decrease in notes payable, net (182) (247)
Payment of common stock dividends (154) (134)
Redemption of preferred securities (30) -
Preferred securities distributions (33) (30)
Payment of capital lease obligations (11) (17)
Payment of preferred stock dividends (1) -
Proceeds from preferred securities - 121
Stockholder's contribution, net 50 150
Proceeds from senior notes and bank loans 602 352
-----------------------
Net cash used in financing activities (168) 193
- ----------------------------------------------------------------------------------------------------------------
NET INCREASE IN CASH AND TEMPORARY CASH INVESTMENTS 108 3
CASH AND TEMPORARY CASH INVESTMENTS, BEGINNING OF PERIOD 16 21
-----------------------
CASH AND TEMPORARY CASH INVESTMENTS, END OF PERIOD $ 124 $ 24
================================================================================================================
OTHER CASH FLOW ACTIVITIES AND NON-CASH INVESTING AND FINANCING ACTIVITIES WERE:
CASH TRANSACTIONS
Interest paid (net of amounts capitalized) $ 116 $ 129
Income taxes paid (net of refunds) 87 36
Pension and OPEB cash contribution 101 84
NON-CASH TRANSACTIONS
Nuclear fuel placed under capital lease $ - $ 13
Other assets placed under capital leases 65 15
================================================================================================================
All highly liquid investments with an original maturity of three months or less
are considered cash equivalents.
THE ACCOMPANYING CONDENSED NOTES ARE AN INTEGRAL PART OF THESE STATEMENTS.
CE-31
Consumers Energy Company
CONSUMERS ENERGY COMPANY
CONSOLIDATED BALANCE SHEETS
ASSETS SEPTEMBER 30 SEPTEMBER 30
2002 DECEMBER 31 2001
(UNAUDITED) 2001 (UNAUDITED)
- ---------------------------------------------------------------------------------------------------------------
In Millions
PLANT (AT ORIGINAL COST)
Electric $7,504 $7,661 $7,513
Gas 2,692 2,593 2,566
Other 66 23 16
----------------------------------------
10,262 10,277 10,095
Less accumulated depreciation, depletion and amortization 5,855 5,934 5,873
---------------------------------------
4,407 4,343 4,222
Construction work-in-progress 419 464 416
----------------------------------------
4,826 4,807 4,638
- ----------------------------------------------------------------------------------------------------------------
INVESTMENTS
Stock of affiliates 21 59 54
First Midland Limited Partnership 250 253 249
Midland Cogeneration Venture Limited Partnership 370 300 296
---------------------------------------
641 612 599
- ----------------------------------------------------------------------------------------------------------------
CURRENT ASSETS
Cash and temporary cash investments at cost, which approximates market 124 16 24
Accounts receivable and accrued revenue, less allowances
of $4, $4 and $3, respectively 36 125 22
Accounts receivable - related parties 18 17 13
Inventories at average cost
Gas in underground storage 601 569 603
Materials and supplies 71 69 70
Generating plant fuel stock 49 52 50
Accrued property taxes 82 144 86
Regulatory assets 19 19 19
Other 27 14 12
----------------------------------------
1,027 1,025 899
- ----------------------------------------------------------------------------------------------------------------
NON-CURRENT ASSETS
Regulatory assets
Securitization costs 699 717 710
Postretirement benefits 191 209 214
Abandoned Midland Project 11 12 12
Other 173 167 89
Nuclear decommissioning trust funds 530 581 568
Other 116 176 265
---------------------------------------
1,720 1,862 1,858
- ----------------------------------------------------------------------------------------------------------------
TOTAL ASSETS $8,214 $8,306 $7,994
================================================================================================================
CE-32
Consumers Energy Company
STOCKHOLDERS' INVESTMENT AND LIABILITIES SEPTEMBER 30 SEPTEMBER 30
2002 DECEMBER 31 2001
(UNAUDITED) 2001 (UNAUDITED)
- ---------------------------------------------------------------------------------------------------------------
In Millions
CAPITALIZATION
Common stockholder's equity
Common stock $ 841 $ 841 $ 841
Paid-in capital 682 632 796
Revaluation capital (8) 4 (4)
Retained earnings since December 31, 1992 456 373 373
---------------------------------------
1,971 1,850 2,006
Preferred stock 44 44 44
Company-obligated mandatorily redeemable preferred securities
of subsidiaries (a) 490 520 520
Long-term debt 2,701 2,472 2,452
Non-current portion of capital leases 110 56 53
----------------------------------------
5,316 4,942 5,075
- ----------------------------------------------------------------------------------------------------------------
CURRENT LIABILITIES
Current portion of long-term debt and capital leases 224 257 251
Notes payable 235 416 155
Accounts payable 213 291 258
Accrued taxes 192 219 115
Accounts payable - related parties 83 80 78
Deferred income taxes 17 12 17
Other 239 260 319
---------------------------------------
1,203 1,535 1,193
- ----------------------------------------------------------------------------------------------------------------
NON-CURRENT LIABILITIES
Deferred income taxes 714 747 668
Postretirement benefits 227 279 294
Regulatory liabilities for income taxes, net 282 276 270
Power purchase agreement - MCV Partnership 150 169 175
Deferred investment tax credit 92 102 104
Other 230 256 215
---------------------------------------
1,695 1,829 1,726
- ----------------------------------------------------------------------------------------------------------------
COMMITMENTS AND CONTINGENCIES (Notes 1 and 2)
TOTAL STOCKHOLDERS' INVESTMENT AND LIABILITIES $8,214 $8,306 $7,994
================================================================================================================
(a) See Note 3, Short-Term Financings and Capitalization
THE ACCOMPANYING CONDENSED NOTES ARE AN INTEGRAL PART OF THESE STATEMENTS.
CE-33
Consumers Energy Company
CONSUMERS ENERGY COMPANY
CONSOLIDATED STATEMENTS OF COMMON STOCKHOLDER'S EQUITY
(UNAUDITED)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 2002 2001 2002 2001
- ----------------------------------------------------------------------------------------------------------------
In Millions
COMMON STOCK
At beginning and end of period (a) $ 841 $ 841 $ 841 $ 841
- ----------------------------------------------------------------------------------------------------------------
OTHER PAID-IN CAPITAL
At beginning of period 682 646 632 646
Stockholder's contribution - 150 150 150
Return of Stockholder's contribution - - (100) -
-------------------------------------------------
At end of period 682 796 682 796
- ----------------------------------------------------------------------------------------------------------------
REVALUATION CAPITAL
Investments
At beginning of period (2) 26 16 33
Unrealized loss on investments (b) (7) (15) (25) (22)
-------------------------------------------------
At end of period (9) 11 (9) 11
Derivative Instruments
At beginning of period (c) (3) (10) (12) 18
Unrealized gain (loss) on derivative instruments (b) 1 (9) 6 (30)
Reclassification adjustments included in net income (b) 3 4 7 (3)
--------------------------------------------------
At end of period 1 (15) 1 (15)
- -----------------------------------------------------------------------------------------------------------------
RETAINED EARNINGS
At beginning of period 412 541 373 506
Net income (loss) 55 (62) 271 88
Cash dividends declared- Common Stock - (94) (154) (190)
Cash dividends declared- Preferred Stock - - (1) (1)
Preferred securities distributions (11) (12) (33) (30)
-------------------------------------------------
At end of period 456 373 456 373
- ----------------------------------------------------------------------------------------------------------------
TOTAL COMMON STOCKHOLDER'S EQUITY $1,971 $2,006 $1,971 $2,006
================================================================================================================
(a) Number of shares of common stock outstanding was 84,108,789 for all periods presented.
(b) Disclosure of Comprehensive Income:
Revaluation capital
Investments
Unrealized loss on investments, net of tax of
$4, $8, $14 and $12, respectively $ (7) $ (15) $ (25) $ (22)
Derivative Instruments
Unrealized gain (loss) on derivative instruments,
net of tax of $(1), $4, $(4) and $15, respectively 1 (9) 6 (30)
Reclassification adjustments included in net income,
net of tax of $(2), $(2), $(4) and $2, respectively 3 4 7 (3)
Net income (loss) 55 (62) 271 88
-------------------------------------------------
Total Comprehensive Income (Loss) $ 52 $ (82) $259 $ 33
=================================================
(c) Nine Months Ended 2001 is the cumulative effect of change in accounting principle, as of 1/1/01 and 7/1/01,
net of $(9) tax (Note 1)
THE ACCOMPANYING CONDENSED NOTES ARE AN INTEGRAL PART OF THESE STATEMENTS.
CE-34
Consumers Energy Company
CONSUMERS ENERGY COMPANY
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
These interim Consolidated Financial Statements have not been reviewed by our
independent public accountants as required under Rule 10-01(d) of Regulation
S-X. In April 2002, Consumers' Board of Directors, upon the recommendation of
the Audit Committee of the Board, voted to discontinue using Arthur Andersen to
audit the Consumers' financial statements for the year ending December 31, 2002.
Consumers previously retained Arthur Andersen to review its financial statements
for the quarter ended March 31, 2002. In May 2002, Consumers' Board of Directors
engaged Ernst & Young to audit its financial statements for the year ending
December 31, 2002.
In May 2002, as a result of certain financial reporting issues surrounding
round-trip trading transactions at CMS MST, and its then current situation,
Arthur Andersen notified CMS Energy that Arthur Andersen's historical opinions
on CMS Energy's financial statements for the fiscal years ended December 31,
2001 and 2000 could not be relied upon. As a result, Ernst & Young began the
process of re-auditing CMS Energy's consolidated financial statements for each
of the fiscal years ended December 31, 2001 and 2000. Although Arthur Andersen's
notification did not apply to separate, audited financial statements of
Consumers for the applicable years, the re-audit did include audit work at
Consumers for these years.
In connection with Ernst & Young's re-audit of the fiscal years ended December
31, 2001 and 2000, Consumers has determined, in consultation with Ernst & Young,
that certain adjustments by Consumers to their consolidated financial statements
for the fiscal years ended December 31, 2001 and 2000 are required. Consumers
expects that the review and restatement of these interim Consolidated Financial
Statements by our independent public accountants will occur upon completion of
the restatement of Consumers' Consolidated Financial Statements for each of the
fiscal years ended December 31, 2001 and 2000. For further information, see Note
2, Uncertainties, "Pending Restatement and Other Related Uncertainties."
These interim Consolidated Financial Statements have been prepared by Consumers
in accordance with SEC rules and regulations. As such, certain information and
footnote disclosures normally included in full-year financial statements
prepared in accordance with accounting principles generally accepted in the
United States have been condensed or omitted. Certain prior year amounts have
been reclassified to conform to the presentation in the current year. The
Condensed Notes to Consolidated Financial Statements and the related
Consolidated Financial Statements should be read in conjunction with the
Consolidated Financial Statements and Notes to Consolidated Financial Statements
contained in the Consumers Form 10-K for the year ended December 31, 2001. Due
to the seasonal nature of Consumers operations, the results as presented for
this interim period are not necessarily indicative of results to be achieved for
the fiscal year.
1: CORPORATE STRUCTURE AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
CORPORATE STRUCTURE: Consumers, a subsidiary of CMS Energy, a holding company,
is an electric and gas utility company that provides service to customers in
Michigan's Lower Peninsula. Consumers' customer base includes a mix of
residential, commercial and diversified industrial customers, the largest
segment of which is the automotive industry.
BASIS OF PRESENTATION: The consolidated financial statements include Consumers
and its wholly owned subsidiaries. Consumers prepared the financial statements
in conformity with accounting principles generally accepted in the United States
that include the use of management's estimates. Consumers uses the equity method
of accounting for investments in its companies and partnerships where it has
more than a twenty percent but less than a majority ownership interest and
includes these results in operating income.
CE-35
Consumers Energy Company
REPORTABLE SEGMENTS: Consumers has two reportable segments: electric and gas.
The electric segment consists of activities associated with the generation and
distribution of electricity. The gas segment consists of activities associated
with the transportation, storage and distribution of natural gas. Consumers'
reportable segments are domestic strategic business units organized and managed
by the nature of the product and service each provides. The accounting policies
of the segments are the same as those described in Consumers' 2001 Form 10-K.
Consumers' management has changed its evaluation of the performance of the
electric and gas segments from pretax operating income to net income available
to common stockholder. The Consolidated Statements of Income show operating
revenue and pretax operating income by reportable segment. Intersegment sales
and transfers are accounted for at current market prices and are eliminated in
consolidated net income available to common stockholder by segment. The net
income available to common stockholder by reportable segment is as follows:
In Millions
- ----------------------------------------------------------------------------------
Nine Months Ended
September 30 2002 2001
- ----------------------------------------------------------------------------------
Net income available to common stockholder
Electric $201 $22
Gas 8 20
Other 28 15
- ----------------------------------------------------------------------------------
Total Consolidated $237 $57
==================================================================================
UTILITY REGULATION: Consumers accounts for the effects of regulation based on
SFAS No. 71. As a result, the actions of regulators affect when Consumers
recognizes revenues, expenses, assets and liabilities.
In March 1999, Consumers received MPSC electric restructuring orders and, as a
result, discontinued application of SFAS No. 71 for the electric supply portion
of its business. Discontinuation of SFAS No. 71 for the electric supply portion
of Consumers' business resulted in Consumers reducing the carrying value of its
Palisades plant-related assets by approximately $535 million and establishing a
regulatory asset for a corresponding amount. According to current accounting
standards, Consumers can continue to carry its electric supply-related
regulatory assets if legislation or an MPSC rate order allows the collection of
cash flows to recover these regulatory assets from its regulated distribution
customers. As of September 30, 2002, Consumers had a net investment in electric
supply facilities of $1.426 billion included in electric plant and property. See
Note 2, Uncertainties, "Electric Rate Matters -- Electric Restructuring."
RISK MANAGEMENT ACTIVITIES AND DERIVATIVE TRANSACTIONS: Consumers is exposed to
market risks including, but not limited to, changes in interest rates, commodity
prices, and equity security prices. Consumers' market risk, and activities
designed to minimize this risk, are subject to the direction of an executive
oversight committee consisting of designated members of senior management and a
risk committee, consisting of business unit managers. The risk committee's role
is to review the corporate commodity position and ensure that net corporate
exposures are within the economic risk tolerance levels established by
Consumers' Board of Directors. Established policies and procedures are used to
manage the risks associated with market fluctuations.
Consumers uses various contracts, including swaps, options, and forward
contracts to manage its risks associated with the variability in expected future
cash flows attributable to fluctuations in interest rates and commodity prices.
Consumers enters into all risk management contracts for purposes other than
trading. Contracts to manage interest rate and commodity price risk may be
considered derivative instruments that are subject to derivative and hedge
accounting pursuant to SFAS No. 133.
CE-36
Consumers Energy Company
For further discussion see "Implementation of New Accounting Standards" below,
Note 2, Uncertainties, "Other Electric Uncertainties - Derivative Activities",
"Other Gas Uncertainties -- Derivative Activities" and Note 3, Short-Term
Financings and Capitalization, "Derivative Activities."
IMPLEMENTATION OF NEW ACCOUNTING STANDARDS: Consumers adopted SFAS No. 133 on
January 1, 2001. This standard requires Consumers to recognize at fair value all
contracts that meet the definition of a derivative instrument on the balance
sheet as either assets or liabilities. The standard also requires Consumers to
record all changes in fair value directly in earnings, or other comprehensive
income if the derivative meets certain qualifying hedge criteria. Consumers
determines fair value based upon quoted market prices and mathematical models
using current and historical pricing data. Any ineffective portion of all hedges
is recognized in earnings.
Consumers believes that the majority of its contracts are not subject to
derivative accounting because they qualify for the normal purchases and sales
exception of SFAS No. 133. Derivative accounting is required, however, for
certain contracts used to limit Consumers' exposure to electricity and gas
commodity price risk and interest rate risk.
Consumers believes that certain of its electric capacity and energy contracts
are not derivatives due to the lack of an active energy market, as defined by
SFAS No. 133, in the state of Michigan and the transportation cost to deliver
the power under the contracts to the closest active energy market at the Cinergy
hub in Ohio. If a market develops in the future, Consumers may be required to
account for these contracts as derivatives. The mark-to-market impact in
earnings related to these contracts, particularly related to the PPA, could be
material to the financial statements.
On January 1, 2001, upon initial adoption of the standard, Consumers recorded a
$21 million, net of tax, ($32 million, pretax) cumulative effect transition
adjustment as an unrealized gain increasing accumulated other comprehensive
income. Consumers then reclassified to earnings $12 million as a reduction to
the cost of gas; $1 million as a reduction to the cost of power supply; $2
million as an increase in interest expense; and $8 million as an increase in
other revenue for the twelve months ended December 31, 2001. The remaining $9
million difference between the initial transition adjustment and the amounts
reclassified to earnings has been reduced to zero, decreasing other
comprehensive income, and represents an unrealized loss in the fair value of the
derivative instruments since January 1, 2001. As a result, as of December 31,
2001, there were no amounts remaining in accumulated other comprehensive income
related to the initial transition adjustment.
On January 1, 2001, upon initial adoption of SFAS No. 133, derivative and hedge
accounting for certain utility industry contracts, particularly electric call
option contracts and option-like contracts, and contracts subject to Bookouts
was uncertain. Consumers did not record these contracts on the balance sheet at
fair value, but instead accounted for these types of contracts as derivatives
that qualified for the normal purchase exception of SFAS No. 133. In June and
December 2001, the FASB issued guidance that resolved the accounting for these
contracts. As a result, on July 1, 2001, Consumers recorded a $3 million, net of
tax, cumulative effect adjustment as an unrealized loss, decreasing accumulated
other comprehensive income, and on December 31, 2001, recorded an $11 million,
net of tax, cumulative effect adjustment, as a decrease to earnings. These
adjustments relate to the difference between the fair value and the recorded
book value of certain electric call option contracts.
As of September 30, 2002, Consumers recorded a total of $5 million, net of tax,
as an unrealized gain in other comprehensive income related to its proportionate
share of the effects of derivative accounting related to its equity investment
in the MCV Partnership. Consumers expects to reclassify this gain, if this value
remains, as an increase to other operating revenue during the next 12 months.
CE-37
Consumers Energy Company
For further discussion of derivative activities, see Note 2, Uncertainties,
"Other Electric Uncertainties - Derivative Activities" and "Other Gas
Uncertainties -- Derivative Activities" and Note 3, Short-Term Financings and
Capitalization, "Derivative Activities."
SFAS NO. 144, ACCOUNTING FOR THE IMPAIRMENT OR DISPOSAL OF LONG-LIVED ASSETS:
This new standard was issued by the FASB in August 2001, and supersedes SFAS No.
121, and APB Opinion No. 30. SFAS No. 144 requires long-lived assets to be
measured at the lower of either the carrying amount or of the fair value less
the cost to sell, whether reported in continuing operations or in discontinued
operations. Therefore, discontinued operations will no longer be measured at net
realizable value or include amounts for operating losses that have not yet
occurred. SFAS No. 144 also broadens the reporting of discontinued operations to
include all components of an entity with operations that can be distinguished
from the rest of the entity and that will be eliminated from the ongoing
operations of the entity in a disposal transaction. The adoption of SFAS No.
144, effective January 1, 2002, will result in Consumers accounting for any
future impairment or disposal of long-lived assets under the provisions of SFAS
No. 144, but has not changed the accounting used for previous asset impairments
or disposals.
ACCOUNTING FOR HEADQUARTERS BUILDING LEASE: In April 2001, Consumers Campus
Holdings entered into a lease agreement for the construction of an office
building to be used as the main headquarters for Consumers in Jackson, Michigan.
Consumers' current headquarters building lease expires in June 2003. The new
office building lessor has committed to fund up to $65 million for construction
of the building, which is due to be completed during March 2003. Consumers is
acting as the construction agent of the lessor for this project. During
construction, the lessor has a maximum recourse of 89.9 percent against
Consumers in the event of certain defaults, which Consumers believes are
unlikely. For several events of default, primarily bankruptcy or intentional
misapplication of funds, there could be full recourse for the amounts expended
by the lessor at that time. The agreement also includes a common change in
control provision, which could trigger full payment of construction costs by
Consumers. As a result of this provision, Consumers elected to classify this
lease as a capital lease during the second quarter of 2002. This classification
represents the total obligation of Consumers under this agreement. As such,
Consumers' balance sheet as of September 30, 2002, reflects a capital lease
asset and an offsetting non-current liability equivalent to the cost of
construction at that date of $45 million.
2: UNCERTAINTIES
PENDING RESTATEMENT AND OTHER RELATED UNCERTAINTIES
In connection with Ernst & Young's re-audit of the fiscal years ended December
31, 2001 and December 31, 2000, Consumers has determined, in consultation with
Ernst & Young, that certain adjustments by Consumers to its consolidated
financial statements for the fiscal years ended December 31, 2001 and December
31, 2000 are required. At the time it adopted the accounting treatment for these
items, Consumers believed that such accounting was appropriate under generally
accepted accounting principals and Arthur Andersen concurred. CMS Energy and
Consumers are in the process of advising the SEC of these adjustments before
Consumers restates its financial statements as discussed below. Consumers
intends to amend its 2001 Form 10-K and each of the 2002 Form 10-Qs for the
effects of those adjustments by the end of January 2003.
The recommended audit adjustments would: 1) reverse the charge associated with
the PPA recorded in 2001; 2) recognize Consumers' new headquarters lease as a
capital lease, and record the lease obligation and capitalize costs incurred.
Consumers had previously treated the lease as an operating lease; and 3)
recognize immaterial adjustments to SERP and OPEB liabilities and advertising
costs. Each of these transactions involved estimates, assumptions, and judgment
based on the best information available at the time the transactions occurred.
The audit adjustments are the result of our current judgment on these matters.
CE-38
Consumers Energy Company
The most material adjustment proposed, which effects net income, relates to
reversing the charge recorded in 2001 associated with the PPA. In 1992,
Consumers established a reserve for the difference between the amount that
Consumers was paying for power in accordance with the terms of the PPA, and the
amount that Consumers was ultimately allowed by the MPSC to recover from
electric customers.
The reserve was adjusted in 1998 to reflect differences between management's
original assumptions and the MCV Facility's actual performance. In 2000,
Consumers reviewed its estimate of the economic losses it would experience with
respect to the PPA and re-evaluated all of the current facts and circumstances
used to calculate the disallowance reserve. Consumers concluded that no
adjustment to the reserve was required in 2000. However, as conditions
surrounding MCV operations evolved in 2001, Consumers concluded that it needed
to increase the reserve by $126 million (pretax) in the third quarter of 2001.
Upon recommendations from Ernst & Young, Consumers is in the process of
reviewing its 2001 PPA accounting and related assumptions. This accounting
review is currently being discussed with Ernst & Young and the SEC. Final
conclusions have not yet been reached. At a minimum, however, the 2001
accounting will change, resulting in the reversal of the 2001 charge of $126
million. Further analysis and deliberations may produce additional accounting
changes. In addition, as a result of this accounting treatment Consumers expects
that its ongoing operating earnings through 2007 will be reduced to reflect
higher annual purchased power expense.
The following table reflects effects of the adjustments (for the PPA and other
miscellaneous issues) Consumers currently expects to make to its consolidated
financial statements for the fiscal years ended December 31, 2001 and
December 31, 2000:
2001 2000
---- EXPECTED ---- EXPECTED
IN MILLIONS AS REPORTED RESTATED AS REPORTED RESTATED
- ------------------------------------------------------------------------------------------------------------------------
Operating Expenses $3,669 $3,505 $3,300 $3,301
Net Income Before Taxes 160 328 452 451
Income Taxes 49 108 148 148
Net Income Before Cumulative Effect of Change in
Accounting Principle $111 $220 $304 $303
Cumulative Effect of Change in Accounting for Derivative
Instruments, Net of $6 Tax Benefit (11) (11) - -
Net Income $100 $209 $304 $303
- ------------------------------------------------------------------------------------------------------------------------
CE-39
Consumers Energy Company
SEC INVESTIGATION: As a result of the round-trip trading transactions at CMS
MST, CMS Energy's Board of Directors established a special committee of
independent directors to investigate matters surrounding the transactions and
retained outside counsel to assist in the investigation. The committee completed
its investigation and reported its findings to the Board of Directors in October
2002. The special committee concluded, based on an extensive investigation, that
the round-trip trades were undertaken to raise CMS MST's profile as an energy
marketer with the goal of enhancing its ability to promote its services to new
customers. The committee found no apparent effort to manipulate the price of CMS
Energy Common Stock or affect energy prices. The special committee also made
recommendations designed to prevent any reoccurrence of this practice, some of
which have already been implemented, including the termination of the
speculative trading business and revisions to CMS Energy's risk management
policy. The Board of Directors adopted, and CMS Energy has begun implementing,
the remaining recommendations of the special committee.
CMS Energy is cooperating with other investigations concerning round-trip
trading, including an investigation by the SEC regarding round-trip trades and
the CMS Energy's financial statements, accounting policies and controls, and
investigations by the United States Department of Justice, the Commodity Futures
Trading Commission and the FERC. CMS Energy has also received subpoenas from the
United States Attorney's Office for the Southern District of New York and from
the United States Attorney's Office in Houston regarding investigations of these
trades and has received a number of shareholder class action lawsuits. CMS
Energy is unable to predict the outcome of these matters, and Consumers is
unable to predict what effect, if any, these investigations will have on its
business.
SECURITIES CLASS ACTION LAWSUITS: Beginning on May 17, 2002, a number of
securities class action complaints have been filed against CMS Energy,
Consumers, and certain officers and directors of CMS Energy and its affiliates.
The complaints have been filed in the United States District Court for the
Eastern District of Michigan as purported class actions by individuals who
allege that they purchased CMS Energy's securities during a purported class
period. At least two of the complaints contain purported class periods beginning
on August 3, 2000 and running through May 10, 2002 or May 14, 2002. These
complaints generally seek unspecified damages based on allegations that the
defendants violated United States securities laws and regulations by making
allegedly false and misleading statements about the company's business and
financial condition. CMS Energy believes that additional suits might be
commenced against it and that all such suits against it will eventually be
consolidated. Consumers intends to vigorously defend against these actions.
Consumers cannot predict the outcome of this litigation.
ERISA CASES: Consumers is a named defendant, along with CMS Energy, CMS MST and
certain named and unnamed officers and directors in two lawsuits brought as
purported class actions on behalf of participants and beneficiaries of the
401(k) Plan. The two cases, filed in July 2002 in the United States District
Court for the Eastern District of Michigan, were consolidated by the trial
judge. Plaintiffs allege breaches of fiduciary duties under the ERISA and seek
restitution on behalf of the Plan with respect to a decline in value of the
shares of CMS Energy Common Stock held in the Plan. Plaintiffs also seek other
equitable relief and legal fees. These cases will be vigorously defended.
Consumers cannot predict the outcome of this litigation.
ELECTRIC CONTINGENCIES
ELECTRIC ENVIRONMENTAL MATTERS: Consumers is subject to costly and increasingly
stringent environmental regulations. Consumers expects that the cost of future
environmental compliance, especially compliance with clean air laws, will be
significant.
Clean Air -- In 1998, the EPA issued final regulations requiring the State of
Michigan to further limit nitrogen oxide emissions. The Michigan Department of
Environmental Quality is in the process of finalizing rules to comply with the
EPA final regulations. Rules are expected to be promulgated and submitted to the
EPA by the end of 2002. In addition, the EPA also issued additional final
regulations regarding nitrogen oxide emissions
CE-40
Consumers Energy Company
that require certain generators, including some of Consumers' electric
generating facilities, to achieve the same emissions rate as that required by
the 1998 regulations. The EPA and the State final regulations will require
Consumers to make significant capital expenditures estimated to be $770 million.
As of September 2002, Consumers has incurred $372 million in capital
expenditures to comply with the EPA final regulations and anticipates that the
remaining capital expenditures will be incurred between 2002 and 2009.
Additionally, Consumers will supplement its compliance plan with the purchase of
nitrogen oxide emissions credits in the years 2005 through 2008. The cost of
these credits based on the current market is estimated to be $6 million per
year, however, the market for nitrogen oxide emissions credits is volatile and
the price could change significantly. At some point, if new environmental
standards become effective, Consumers may need additional capital expenditures
to comply with the future standards. Based on the Customer Choice Act, beginning
January 2004, an annual return of and on these types of capital expenditures, to
the extent they are above depreciation levels, is expected to be recoverable
from customers, subject to an MPSC prudency hearing.
These and other required environmental expenditures, if not recovered from
customers in Consumers rates, may have a material adverse effect upon Consumers'
financial condition and results of operations.
Cleanup and Solid Waste - Under the Michigan Natural Resources and Environmental
Protection Act, Consumers expects that it will ultimately incur investigation
and remedial action costs at a number of sites. Consumers believes that these
costs will be recoverable in rates under current ratemaking policies.
Consumers is a potentially responsible party at several contaminated sites
administered under Superfund. Superfund liability is joint and several. Along
with Consumers, many other creditworthy, potentially responsible parties with
substantial assets cooperate with respect to the individual sites. Based upon
past negotiations, Consumers estimates that its share of the total liability for
the known Superfund sites will be between $1 million and $9 million. As of
September 30, 2002, Consumers had accrued the minimum amount of the range for
its estimated Superfund liability.
In October 1998, during routine maintenance activities, Consumers identified PCB
as a component in certain paint, grout and sealant materials at the Ludington
Pumped Storage facility. Consumers removed and replaced part of the PCB
material. In April 2000, Consumers proposed a plan to deal with the remaining
materials and is awaiting a response from the EPA.
ELECTRIC RATE MATTERS
ELECTRIC RESTRUCTURING: In June 2000, the Michigan Legislature passed electric
utility restructuring legislation known as the Customer Choice Act. This act: 1)
permits all customers to choose their electric generation supplier beginning
January 1, 2002; 2) cut residential electric rates by five percent; 3) freezes
all electric rates through December 31, 2003, and establishes a rate cap for
residential customers through at least December 31, 2005, and a rate cap for
small commercial and industrial customers through at least December 31, 2004; 4)
allows for the use of low-cost Securitization bonds to refinance qualified
costs, as defined by the act; 5) establishes a market power supply test that may
require transferring control of generation resources in excess of that required
to serve firm retail sales requirements (a requirement Consumers believes itself
to be in compliance with at this time); 6) requires Michigan utilities to join a
FERC-approved RTO or divest their interest in transmission facilities to an
independent transmission owner; (Consumers has sold its interest in its
transmission facilities to an independent transmission owner, see "Transmission"
below) 7) requires Consumers, Detroit Edison and American Electric Power to
jointly expand their available transmission capability by at least 2,000 MW; 8)
allows deferred recovery of an annual return of and on capital expenditures in
excess of depreciation levels incurred during and before the rate freeze/cap
period; and 9) allows recovery of "net" Stranded Costs and implementation costs
incurred as a result of the passage of the act. In July 2002, the MPSC issued an
order approving the plan to achieve the increased transmission capacity. Once
the increased
CE-41
Consumers Energy Company
transmission capacity projects identified in the plan are completed,
verification of compliance is required to be sent to the MPSC. Upon submittal of
verification of compliance, Consumers expects to be deemed in compliance with
the MPSC statute. Consumers is highly confident that it will meet the conditions
of items 5 and 7 above, prior to the earliest rate cap termination dates
specified in the act. Failure to do so, however, could result in an extension of
the rate caps to as late as December 31, 2013.
In 1998, Consumers submitted a plan for electric retail open access to the MPSC.
In March 1999, the MPSC issued orders generally supporting the plan. The
Customer Choice Act states that the MPSC orders issued before June 2000 are in
compliance with this act and enforceable by the MPSC. Those MPSC orders: 1)
allow electric customers to choose their supplier; 2) authorize recovery of
"net" Stranded Costs and implementation costs; and 3) confirm any voluntary
commitments of electric utilities. In September 2000, as required by the MPSC,
Consumers once again filed tariffs governing its retail open access program and
made revisions to comply with the Customer Choice Act. In December 2001, the
MPSC approved revised retail open access tariffs. The revised tariffs establish
the rates, terms, and conditions under which retail customers will be permitted
to choose an alternative electric supplier. The tariffs, effective January 1,
2002, did not require significant modifications in the existing retail open
access program. The tariff terms allow retail open access customers, upon as
little as 30 days notice to Consumers, to return to Consumers' generation
service at current tariff rates. If any class of customers' (residential,
commercial, or industrial), retail open access load reaches 10 percent of
Consumers' total load for that class of customers, then returning retail open
access customers for that class must give 60 days notice to return to Consumers'
generation service at current tariff rates. However, Consumers may not have
sufficient, reasonably priced, capacity to meet the additional demand of
returning retail open access customers, and may be forced to purchase
electricity on the spot market at higher prices than it could recover from its
customers.
SECURITIZATION: In October 2000 and January 2001, the MPSC issued orders
authorizing Consumers to issue Securitization bonds. Securitization typically
involves issuing asset-backed bonds with a higher credit rating than
conventional utility corporate financing. The orders authorized Consumers to
securitize approximately $469 million in qualified costs, which were primarily
regulatory assets plus recovery of the Securitization expenses. Securitization
resulted in lower interest costs and a longer amortization period for the
securitized assets, and offset the majority of the impact of the required
residential rate reduction (approximately $22 million in 2000 and $49 million
annually thereafter). The orders directed Consumers to apply any cost savings in
excess of the five percent residential rate reduction to rate reductions for
non-residential customers and reductions in Stranded Costs for retail open
access customers after the bonds are sold. Excess savings are approximately $12
million annually.
In November 2001, Consumers Funding LLC, a special purpose consolidated
subsidiary of Consumers formed to issue the bonds, issued $469 million of
Securitization bonds, Series 2001-1. The Securitization bonds mature at
different times over a period of up to 14 years, with an average interest rate
of 5.3 percent. The last expected maturity date is October 20, 2015. Net
proceeds from the sale of the Securitization bonds, after issuance expenses,
were approximately $460 million. Consumers used the net proceeds to retire $164
million of its common equity from its parent, CMS Energy. From December 2001
through March 2002, the remainder of these proceeds were used to pay down
Consumers long-term debt and Trust Preferred Securities. CMS Energy used the
$164 million from Consumers to pay down its own short-term debt.
Consumers and Consumers Funding LLC will recover the repayment of principal,
interest and other expenses relating to the bond issuance through a
securitization charge and a tax charge that began in December 2001. These
charges are subject to an annual true-up until one year prior to the last
expected bond maturity date, and no more than quarterly thereafter. The first
true-up was issued in November 2002, and prospectively modified the total
securitization and related tax charges from 1.677 mills per kWh to 1.746 mills
per kWh. Current electric rate design covers these charges, and there will be no
rate impact for most Consumers electric customers until the Customer Choice Act
rate freeze expires. Securitization charge revenues are remitted to a
CE-42
Consumers Energy Company
trustee for the Securitization bonds and are not available to Consumers'
creditors.
Regulatory assets are normally amortized over their period of regulated
recovery. Beginning January 1, 2001, the amortization was deferred for the
approved regulatory assets being securitized, which effectively offset the loss
in revenue in 2001 resulting from the five percent residential rate reduction.
In December 2001, after the Securitization bonds were sold, the amortization was
re-established, based on a schedule that is the same as the recovery of the
principal amounts of the securitized qualified costs. In 2002, the amortization
amount is expected to be approximately $31 million and the securitized assets
will be fully amortized by the end of 2015.
TRANSMISSION: In 1999, the FERC issued Order No. 2000, strongly encouraging
electric utilities to transfer operating control of their electric transmission
system to an RTO, or sell the facilities to an independent company. In addition,
in June 2000, the Michigan legislature passed Michigan's Customer Choice Act,
which also requires utilities to divest or transfer the operating authority of
transmission facilities to an independent company. Consumers chose to offer its
electric transmission system for sale rather than own and invest in an asset
that it could not control. In May 2002, Consumers sold its electric transmission
system for approximately $290 million in cash to MTH, a non-affiliated limited
partnership whose general partner is a subsidiary of Trans-Elect Inc.
Trans-Elect, Inc. submitted the winning bid through a competitive bidding
process, and various federal agencies approved the transaction. Consumers did
not provide any financial or credit support to Trans-Elect, Inc. Certain of
Trans-Elect's officers and directors are former officers and directors of CMS
Energy, Consumers and their subsidiaries. None of them were employed by CMS
Energy, Consumers, or their affiliates when the transaction was discussed
internally and negotiated with purchasers. As a result of the sale, Consumers
anticipates that its after-tax earnings will increase by approximately $17
million in 2002, due to the recognition of a $26 million one time gain on the
sale of the electric transmission system. This one time gain is offset by a loss
of revenue from wholesale and retail open access customers who will buy services
directly from MTH, including the loss of a return on the sold electric
transmission system. Consumers anticipates that the future impact of the loss of
revenue from wholesale and retail open access customers who will buy services
directly from MTH and the loss of a return on the sold electric transmission
system on its after-tax earnings will be a decrease of $15 million in 2003, and
a decrease of approximately $14 million annually for the next three years.
Under the agreement with MTH, and subject to certain additional RTO surcharges,
contract transmission rates charged to Consumers will be fixed at current levels
through December 31, 2005, and be subject to FERC ratemaking thereafter. MTH
will complete the capital program to expand the transmission system's capability
to import electricity into Michigan, as required by the Customer Choice Act, and
Consumers will continue to maintain the system under a five-year contract with
MTH. Effective April 30, 2002, Consumers and METC withdrew from the Alliance
RTO.
When IPPs connect to transmission systems, they pay transmission companies the
capital costs incurred to connect the IPP to the transmission system and make
system upgrades needed for the interconnection. It is the FERC's policy that the
system upgrade portion of these IPP payments be credited against transmission
service charges over time as transmission service is taken. METC recorded a $34
million liability for IPP credits. Subsequently, MTH assumed this liability as
part of its purchase of the electric transmission system. Several months after
METC started operation, the FERC changed its policy to provide for interest on
IPP payments that are to be credited. The $34 million liability for IPP credits
does not include interest since the associated interconnection agreements do not
at this time provide for interest. METC has asserted that Consumers may be
liable for interest on the IPP payments to be credited if interest provisions
are added to these agreements.
POWER SUPPLY COSTS: During periods when electric demand is high, the cost of
purchasing electricity on the spot market can be substantial. To reduce
Consumers' exposure to the fluctuating cost of electricity, and to
CE-43
Consumers Energy Company
ensure adequate supply to meet demand, Consumers intends to maintain sufficient
generation and to purchase electricity from others to create a power supply
reserve, also called a reserve margin. The reserve margin provides additional
power supply capability above Consumers' anticipated peak power supply demands.
It also allows Consumers to provide reliable service to its electric service
customers and to protect itself against unscheduled plant outages and
unanticipated demand. Traditionally, Consumers has planned for a reserve margin
of approximately 15 percent. However, in light of the addition of new in-state
generating capacity, additional transmission import capability, and FERC's
standard market design notice of proposed rulemaking, which calls for a minimum
reserve margin of 12 percent, Consumers is currently evaluating the appropriate
reserve margin for 2003 and beyond. The ultimate use of the reserve margin
needed will depend primarily on summer weather conditions, the level of retail
open access requirements being served by others during the summer, and any
unscheduled plant outages. As of November 2002, alternative electric suppliers
are providing 446 MW of generation supply to customers.
To reduce the risk of high electric prices during peak demand periods and to
achieve its reserve margin target, Consumers employs a strategy of purchasing
electric call option and capacity contracts for the physical delivery of
electricity primarily in the summer months and to a lesser degree in the winter
months. As of September 30, 2002, Consumers had purchased or had commitments to
purchase electric call option and capacity contracts partially covering the
estimated reserve margin requirements for 2002 through 2007. As a result
Consumers has a recognized asset of $30 million for unexpired call options and
capacity contracts. The total cost of electricity call option and capacity
contracts for 2002 is approximately $13 million, which is subject to change
based upon potential changes in fair value for certain unexpired call options.
Prior to 1998, the PSCR process provided for the reconciliation of actual power
supply costs with power supply revenues. This process assured recovery of all
reasonable and prudent power supply costs actually incurred by Consumers,
including the actual cost for fuel, and purchased and interchange power. In
1998, as part of the electric restructuring efforts, the MPSC suspended the PSCR
process, and would not grant adjustment of customer rates through 2001. As a
result of the rate freeze imposed by the Customer Choice Act, the current rates
will remain in effect until at least December 31, 2003 and, therefore, the PSCR
process remains suspended. Therefore, changes in power supply costs as a result
of fluctuating electricity prices will not be reflected in rates charged to
Consumers' customers during the rate freeze period.
ELECTRIC PROCEEDINGS: The Customer Choice Act allows electric utilities to
recover the act's implementation costs and "net" Stranded Costs (without
defining the term). The act directs the MPSC to establish a method of
calculating "net" Stranded Costs and of conducting related true-up adjustments.
In December 2001, the MPSC adopted a methodology which calculated "net" Stranded
Costs as the shortfall between: (a) the revenue required to cover the costs
associated with fixed generation assets, generation-related regulatory assets,
and capacity payments associated with purchase power agreements, and (b) the
revenues received from customers under existing rates available to cover the
revenue requirement. Consumers has initiated an appeal at the Michigan Court of
Appeals related to the MPSC's December 2001 "net" Stranded Cost order, as a
result of the uncertainty associated with the outcome of the proceeding
described in the following paragraph.
According to the MPSC, "net" Stranded Costs are to be recovered from retail open
access customers through a Stranded Cost transition charge. Even though the MPSC
set Consumers' Stranded Cost transition charge at zero for calendar year 2000,
those costs for 2000 will be subject to further review in the context of the
MPSC's subsequent determinations of "net" Stranded Costs for 2001 and later
years. The MPSC authorized Consumers to use deferred accounting to recognize the
future recovery of costs determined to be stranded. In April 2002, Consumers
made "net" Stranded Cost filings with the MPSC for $22 million and $43 million
for 2000 and 2001, respectively. In the same filing, Consumers estimated that it
would experience "net" Stranded Costs of $126 million for 2002. After a series
of appeals and hearings, Consumers in its hearing brief, filed in August 2002,
revised its request for Stranded Costs to $7 million and $4 million for 2000 and
2001, respectively, and an estimated $73 million for 2002. The single largest
reason for the difference in the filing was the exclusion
CE-44
Consumers Energy Company
of all costs associated with expenditures required by the Clean Air Act.
Consumers, in a separate filing, requested regulatory asset accounting treatment
for its Clean Air Act expenditures through 2003. The outcome of these
proceedings before the MPSC is uncertain at this time.
Since 1997, Consumers has incurred significant electric utility restructuring
implementation costs. The following table outlines the applications filed by
Consumers with the MPSC and the status of recovery for these costs.
In Millions
- --------------------------------------------------------------------------------------------------------------
Year Filed Year Incurred Requested Pending Allowed Disallowed
- --------------------------------------------------------------------------------------------------------------
1999 1997 & 1998 $ 20 $ - $ 15 $ 5
2000 1999 30 - 25 5
2001 2000 25 - 20 5
2002 2001 8 8 - -
==============================================================================================================
The MPSC disallowed certain costs based upon a conclusion that these amounts did
not represent costs incremental to costs already reflected in electric rates. In
the orders received for the years 1997 through 2000, the MPSC also reserved the
right to review again the total implementation costs depending upon the progress
and success of the retail open access program, and ruled that due to the rate
freeze imposed by the Customer Choice Act, it was premature to establish a cost
recovery method for the allowable implementation costs. In addition to the
amounts shown, as of September 2002, Consumers incurred and deferred as a
regulatory asset, $3 million of additional implementation costs and has also
recorded as a regulatory asset $13 million for the cost of money associated with
total implementation costs. Consumers believes the implementation costs and the
associated cost of money are fully recoverable in accordance with the Customer
Choice Act. Cash recovery from customers will probably begin after the rate
freeze or rate cap period has expired. Consumers cannot predict the amounts the
MPSC will approve as allowable costs.
Consumers is also pursuing recovery, through the MISO, of approximately $7
million in certain electric utility restructuring implementation costs related
to its former participation in the development of the Alliance RTO. However,
Consumers cannot predict the amounts it will be reimbursed by the MISO.
In 1996, Consumers filed new OATT transmission rates with the FERC for approval.
Interveners contested these rates, and hearings were held before an ALJ in 1998.
In 1999, the ALJ made an initial decision that was largely upheld by the FERC in
March 2002, which requires Consumers to refund, with interest, over-collections
for past services as measured by the FERC's finally approved OATT rates. Since
the initial decision, Consumers has been reserving a portion of revenues billed
to customers under the filed 1996 OATT rates. Consumers submitted revised rates
to comply with the FERC final order in June 2002. Those revised rates were
accepted by the FERC in August 2002 and Consumers is in the process of computing
refund amounts for individual customers. Consumers believes its reserve is
sufficient to satisfy its estimated refund obligation.
In November 2002, the MPSC upon its own motion commenced a contested proceeding
requiring each utility to give reason as to why its rates should not be reduced
to reflect new personal property multiplier tables, and why it should not refund
any amounts that it receives as refunds from local governments as they implement
the new multiplier tables. Consumers believes that such action may be
inconsistent with the electric rate freeze that is currently in effect, and may
otherwise be unlawful. Consumers is unable to predict the outcome of this
matter.
CE-45
Consumers Energy Company
OTHER ELECTRIC UNCERTAINTIES
THE MIDLAND COGENERATION VENTURE: The MCV Partnership, which leases and operates
the MCV Facility, contracted to sell electricity to Consumers for a 35-year
period beginning in 1990 and to supply electricity and steam to Dow. Consumers,
through two wholly owned subsidiaries, holds the following assets related to the
MCV Partnership and MCV Facility: 1) CMS Midland owns a 49 percent general
partnership interest in the MCV Partnership; and 2) CMS Holdings holds, through
FMLP, a 35 percent lessor interest in the MCV Facility.
Summarized Statements of Income for CMS Midland and CMS Holdings
In Millions
Nine Months Ended
September 30 2002 2001
- ------------------------------------------------------------------------------------------------------------------
Pretax operating income $63 $31
Income taxes and other 21 9
- ------------------------------------------------------------------------------------------------------------------
Net income $42 $ 22
==================================================================================================================
Power Supply Purchases from the MCV Partnership - Consumers' annual obligation
to purchase capacity from the MCV Partnership is 1,240 MW through the
termination of the PPA in 2025. The PPA requires Consumers to pay, based on the
MCV Facility's availability, a levelized average capacity charge of 3.77 cents
per kWh, a fixed energy charge, and a variable energy charge based primarily on
Consumers' average cost of coal consumed for all kWh delivered. Since January 1,
1993, the MPSC has permitted Consumers to recover capacity charges averaging
3.62 cents per kWh for 915 MW, plus a substantial portion of the fixed and
variable energy charges. Since January 1, 1996, the MPSC has also permitted
Consumers to recover capacity charges for the remaining 325 MW of contract
capacity with an initial average charge of 2.86 cents per kWh increasing
periodically to an eventual 3.62 cents per kWh by 2004 and thereafter. However,
due to the current freeze of Consumers' retail rates that the Customer Choice
Act requires, the capacity charge for the 325 MW is now frozen at 3.17 cents per
kWh. After September 2007, the PPA's terms obligate Consumers to pay the MCV
Partnership only those capacity and energy charges that the MPSC has authorized
for recovery from electric customers.
In 1992, Consumers recognized a loss for the present value of the estimated
future underrecoveries of power supply costs under the PPA based on MPSC cost
recovery orders. Consumers continually evaluates the adequacy of the PPA
liability for future underrecoveries. These evaluations consider management's
assessment of operating levels at the MCV Facility through 2007 along with
certain other factors including MCV related costs that are included in
Consumers' frozen retail rates. During the third quarter of 2001, in connection
with Consumers' long-term electric supply planning, management reviewed the PPA
liability assumptions related to increased expected long-term dispatch of the
MCV Facility and increased MCV related costs. As a result, in September 2001,
Consumers increased the PPA liability by $126 million. Management believes that,
following the increase, the PPA liability adequately reflects the present value
of the PPA's future effect on Consumers. At September 30, 2002 and 2001, the
remaining present value of the estimated future PPA liability associated with
the loss totaled $168 million and $188 million, respectively. For further
discussion on the impact of the frozen PSCR, see "Electric Rate Matters" in this
Note.
In March 1999, Consumers and the MCV Partnership reached an agreement effective
January 1, 1999, that capped availability payments to the MCV Partnership at
98.5 percent. If the MCV Facility generates electricity at the maximum 98.5
percent level during the next six years, Consumers' after-tax cash
underrecoveries associated with the PPA could be as follows:
CE-46
Consumers Energy Company
In Millions
- ---------------------------------------------------------------------------------------------------------------------
2002 2003 2004 2005 2006 2007
- ---------------------------------------------------------------------------------------------------------------------
Estimated cash underrecoveries at 98.5% net of tax $38 $37 $36 $36 $36 $25
=====================================================================================================================
In February 1998, the MCV Partnership appealed the January 1998 and February
1998 MPSC orders related to electric utility restructuring. At the same time,
MCV Partnership filed suit in the United States District Court in Grand Rapids
seeking a declaration that the MPSC's failure to provide Consumers and MCV
Partnership a certain source of recovery of capacity payments after 2007
deprived MCV Partnership of its rights under the Public Utilities Regulatory
Policies Act of 1978. In July 1999, the District Court granted MCV Partnership's
motion for summary judgment. The Court permanently prohibited enforcement of the
restructuring orders in any manner that denies any utility the ability to
recover amounts paid to qualifying facilities such as the MCV Facility or that
precludes the MCV Partnership from recovering the avoided cost rate. The MPSC
appealed the Court's order to the 6th Circuit Court of Appeals in Cincinnati. In
June 2001, the 6th Circuit overturned the lower court's order and dismissed the
case against the MPSC. The appellate court determined that the case was
premature and concluded that the qualifying facilities needed to wait until 2008
for an actual factual record to develop before bringing claims against the MPSC
in federal court. For further material information, see "Pending Restatement and
Other Related Uncertainties" in this Note.
NUCLEAR FUEL COST: Consumers amortizes nuclear fuel cost to fuel expense based
on the quantity of heat produced for electric generation. Through November 2001,
Consumers expensed the interest on leased nuclear fuel as it was incurred.
Effective December 2001, Consumers no longer leases its nuclear fuel.
For nuclear fuel used after April 6, 1983, Consumers charges disposal costs to
nuclear fuel expense, recovers these costs through electric rates, and then
remits them to the DOE quarterly. Consumers elected to defer payment for
disposal of spent nuclear fuel burned before April 7, 1983. As of September 30,
2002, Consumers has a recorded liability to the DOE of $137 million, including
interest, which is payable upon the first delivery of spent nuclear fuel to the
DOE. Consumers recovered through electric rates the amount of this liability,
excluding a portion of interest. In 1997, a federal court decision has confirmed
that the DOE was to begin accepting deliveries of spent nuclear fuel for
disposal by January 31, 1998. Subsequent litigation in which Consumers and
certain other utilities participated has not been successful in producing more
specific relief for the DOE's failure to comply.
In July 2000, the DOE reached a settlement agreement with one utility to address
the DOE's delay in accepting spent fuel. The DOE may use that settlement
agreement as a framework that it could apply to other nuclear power plants.
However, certain other utilities challenged the validity of the mechanism for
funding the settlement in an appeal, and recently the reviewing court sustained
their challenge. Additionally, there are two court decisions that support the
right of utilities to pursue damage claims in the United States Court of Claims
against the DOE for failure to take delivery of spent fuel. A number of
utilities have commenced litigation in the Court of Claims. Consumers is
evaluating its options with respect to its contract with the DOE and plans to
pursue recovery of the nuclear fuel removal costs at its Big Rock and Palisades
plants.
In July 2002, Congress approved and the President signed a bill designating the
site at Yucca Mountain, Nevada, for the development of a repository for the
disposal of high-level radioactive waste and spent nuclear fuel. The next step
will be for the DOE to submit an application to the NRC for a license to begin
construction of the repository. The application and review process is estimated
to take several years.
NUCLEAR MATTERS: In April 2002, Palisades received its annual performance review
in which the NRC stated that Palisades operated in a manner that preserved
public health and safety. With the exception of a single finding related to a
fire protection smoke detector location with low safety significance, the NRC
classified all
CE-47
Consumers Energy Company
inspection findings as having very low safety significance. Other than the
follow-up fire protection inspection associated with this one finding, the NRC
plans to conduct only baseline inspections at the facility through May 31, 2003.
The amount of spent nuclear fuel discharged from the reactor to date exceeds
Palisades' temporary on-site storage pool capacity. Consequently, Consumers is
using NRC-approved steel and concrete vaults, commonly known as "dry casks", for
temporary on-site storage. As of September 30, 2002, Consumers had loaded 18 dry
casks with spent nuclear fuel at Palisades. Palisades will need to load
additional dry casks by the fall of 2004 in order to continue operation.
Palisades currently has three empty storage-only dry casks on-site, with storage
pad capacity for up to seven additional loaded dry casks. Consumers anticipates
that licensed transportable dry casks for additional storage, along with more
storage pad capacity, will be available prior to 2004.
In December 2000, the NRC issued an amendment revising the operating license for
Palisades to extend its expiration date to March 2011, with no restrictions
related to reactor vessel embrittlement.
In 2000, Consumers made an equity investment and entered into an operating
agreement with NMC. NMC was formed in 1999 by four utilities to operate and
manage the nuclear generating plants owned by these utilities. Consumers
benefits by consolidating expertise, cost control and resources among all of the
nuclear plants being operated on behalf of the NMC member companies.
In November 2000, Consumers requested approval from the NRC to transfer
operating authority for Palisades to NMC and the request was granted in April
2001. The formal transfer of authority from Consumers to NMC took place in May
2001. Consumers retains ownership of Palisades, its 789 MW output, the current
and future spent fuel on-site, and ultimate responsibility for the safe
operation, maintenance and decommissioning of the plant. Under the agreement
that transferred operating authority of the plant to NMC, salaried Palisades'
employees became NMC employees on July 1, 2001. Union employees work under the
supervision of NMC pursuant to their existing labor contract as Consumers'
employees. NMC currently has responsibility for operating eight units with 4,500
MW of generating capacity in Wisconsin, Minnesota, Iowa and Michigan.
Following a refueling outage in April 2001, the Palisades reactor was shut down
on June 20, 2001 so technicians could inspect a small steam leak on a control
rod drive assembly. There was no risk to the public or workers. In August 2001,
Consumers completed an expanded inspection that included all similar control rod
drive assemblies and elected to completely replace all the components.
Installation of the new components was completed in December 2001 and the plant
returned to service and has been operating since January 21, 2002. Consumers'
capital expenditures for the components and their installation was approximately
$31 million.
From the start of the June 20th outage through the end of 2001, the impact on
net income of replacement power supply costs associated with the outage was
approximately $59 million. Subsequently, in January 2002, the impact on 2002 net
income was $5 million.
Consumers maintains insurance against property damage, debris removal, personal
injury liability and other risks that are present at its nuclear facilities.
Consumers also maintains coverage for replacement power supply costs during
certain prolonged accidental outages at Palisades. Insurance would not cover
such costs during the first 12 weeks of any outage, but would cover most of such
costs during the next 52 weeks of the outage, followed by reduced coverage to 80
percent for 110 additional weeks. The June 2001 through January 2002 Palisades
outage, however, was not an insured event. If certain covered losses occur at
its own or other nuclear plants similarly insured, Consumers could be required
to pay maximum assessments of $25.8 million in any one year to NEIL; $88 million
per occurrence under the nuclear liability secondary financial protection
program, limited to $10 million per occurrence in any year; and $6 million if
nuclear workers claim bodily injury from radiation exposure. Consumers considers
the possibility of these assessments to be remote. NEIL
CE-48
Consumers Energy Company
limits its coverage from multiple acts of terrorism during a twelve-month period
to a maximum aggregate of $3.24 billion, allocated among the claimants, plus
recoverable reinsurance, indemnity and other sources, which could affect the
amount of loss coverage for Consumers should multiple acts of terrorism occur.
The Price Anderson Act is currently in the process of reauthorization by the U.
S. Congress. It is possible that the Price Anderson Act will not be reauthorized
or changes may be made that significantly affect the insurance provisions for
nuclear plants.
CAPITAL EXPENDITURES: In 2002, 2003, and 2004, Consumers estimates electric
capital expenditures, including new lease commitments and environmental costs
under the Clean Air Act, of $455 million, $345 million, and $410 million. For
further information, see the Capital Expenditures Outlook section in the MD&A.
DERIVATIVE ACTIVITIES: Consumers' electric business uses purchased electric call
option contracts to meet, in part, its regulatory obligation to serve. This
obligation requires Consumers to provide a physical supply of electricity to
customers, to manage electric costs and to ensure a reliable source of capacity
during peak demand periods. These contracts are subject to SFAS No. 133
derivative accounting, and are required to be recorded on the balance sheet at
fair value, with changes in fair value recorded directly in earnings or other
comprehensive income, if the contract meets qualifying hedge criteria. On July
1, 2001, upon initial adoption of the standard for these contracts, Consumers
recorded a $3 million, net of tax, cumulative effect adjustment as an unrealized
loss, decreasing accumulated other comprehensive income. This adjustment relates
to the difference between the fair value and the recorded book value of these
electric call option contracts. The adjustment to accumulated other
comprehensive income relates to electric call option contracts that qualified
for cash flow hedge accounting prior to the initial adoption of SFAS No. 133.
After July 1, 2001, these contracts did not qualify for hedge accounting under
SFAS No. 133 and, therefore, Consumers records any change in fair value
subsequent to July 1, 2001 directly in earnings, which can cause earnings
volatility. The initial amount recorded in other comprehensive income was
reclassified to earnings as the forecasted future transactions occurred or the
call options expired. The majority of these contracts expired in the third
quarter 2001 and the remaining contracts expired in the third quarter of 2002.
As of December 31, 2001, Consumers reclassified from other comprehensive income
to earnings, $2 million, net of tax, as part of the cost of power supply, and
the remainder, $1 million, net of tax, was reclassified from other comprehensive
income to earnings in the third quarter of 2002.
In December 2001, the FASB issued revised guidance regarding derivative
accounting for electric call option contracts and option-like contracts. The
revised guidance amended the criteria used to determine if derivative accounting
is required. In light of the amended criteria, Consumers re-evaluated its
electric call option and option-like contracts, and determined that additional
contracts require derivative accounting. Therefore, as of December 31, 2001,
upon initial adoption of the revised guidance for these contracts, Consumers
recorded an $11 million, net of tax, cumulative effect adjustment as a decrease
to earnings. This adjustment relates to the difference between the fair value
and the recorded book value of these electric call option contracts. Consumers
will record any change in fair value subsequent to December 31, 2001, directly
in earnings, which could cause earnings volatility. As of September 30, 2002,
Consumers recorded on the balance sheet all of its unexpired purchased electric
call option contracts subject to derivative accounting at a fair value of $1
million.
Consumers believes that certain of its electric capacity and energy contracts
are not derivatives due to the lack of an active energy market, as defined by
SFAS No. 133, in the state of Michigan and the transportation cost to deliver
the power under the contracts to the closest active energy market at the Cinergy
hub in Ohio. If a market develops in the future, Consumers may be required to
account for these contracts as derivatives. The mark-to-market impact in
earnings related to these contracts, particularly related to the PPA could be
material to the financial statements.
Consumers' electric business also uses gas swap contracts to protect against
price risk due to the fluctuations in the market price of gas used as fuel for
generation of electricity. These gas swaps are financial contracts that
CE-49
Consumers Energy Company
will be used to offset increases in the price of probable forecasted gas
purchases. These contracts do not qualify for hedge accounting. Therefore,
Consumers records any change in the fair value of these contracts directly in
earnings as part of power supply costs, which could cause earnings volatility.
As of September 30, 2002, a mark-to-market gain of $1 million has been recorded
for 2002, which represents the fair value of these contracts at September 30,
2002. These contracts expire in December 2002.
As of September 30, 2001, Consumers' electric business also used purchased gas
call option and gas swap contracts to hedge against price risk due to the
fluctuations in the market price of gas used as fuel for generation of
electricity. These contracts were financial contracts that were used to offset
increases in the price of probable forecasted gas purchases. These contracts
were designated as cash flow hedges and, therefore, Consumers recorded any
change in the fair value of these contracts in other comprehensive income until
the forecasted transaction occurs. Once the forecasted gas purchases occurred,
the net gain or loss on these contracts were reclassified to earnings and
recorded as part of the cost of power. These contracts were highly effective in
achieving offsetting cash flows of future gas purchases, and no component of the
gain or loss was excluded from the assessment of the hedge's effectiveness. As a
result, no net gain or loss was recognized in earnings as a result of hedge
ineffectiveness as of September 30, 2001. At September 30, 2001, Consumers had a
derivative liability with a fair value of $0.4 million. These contracts expired
in 2001.
GAS CONTINGENCIES
GAS ENVIRONMENTAL MATTERS: Under the Michigan Natural Resources and
Environmental Protection Act, Consumers expects that it will ultimately incur
investigation and remedial action costs at a number of sites. These include 23
former manufactured gas plant facilities, which were operated by Consumers for
some part of their operating lives, including sites in which it has a partial or
no current ownership interest. Consumers has completed initial investigations at
the 23 sites. For sites where Consumers has received site-wide study plan
approvals, it will continue to implement these plans. It will also work toward
closure of environmental issues at sites as studies are completed. Consumers has
estimated its costs related to further investigation and remedial action for all
23 sites using the Gas Research Institute-Manufactured Gas Plant Probabilistic
Cost Model. The estimated total costs are between $82 million and $113 million;
these estimates are based on discounted 2001 costs and follow EPA recommended
use of discount rates between 3 and 7 percent for this type of activity.
Consumers expects to recover a significant portion of these costs through
insurance proceeds and through MPSC approved rates charged to its customers. As
of September 30, 2002, Consumers has an accrued liability of $51 million, net of
$31 million of expenditures incurred to date, and a regulatory asset of $70
million. Any significant change in assumptions, such as an increase in the
number of sites, different remediation techniques, nature and extent of
contamination, and legal and regulatory requirements, could affect Consumers'
estimate of remedial action costs.
The MPSC, in its November 7, 2002, gas distribution rate order, authorized
Consumers to continue to recover approximately $1 million of manufactured gas
plant facilities environmental clean-up costs annually. Consumers defers and
amortizes, over a period of 10 years, manufactured gas plant facilities
environmental clean-up costs above the amount currently being recovered in
rates. Additional rate recognition of amortization expense cannot begin until
after a prudency review in a gas rate case. The annual amount that the MPSC
authorized Consumers to recover in rates will continue to be offset by $2
million to reflect amounts recovered from all other sources.
GAS RATE MATTERS
GAS RESTRUCTURING: From April 1, 1998 to March 31, 2001, Consumers conducted an
experimental gas customer choice pilot program that froze gas distribution and
GCR rates through the period. On April 1, 2001, a permanent gas customer choice
program commenced under which Consumers returned to a GCR mechanism
CE-50
Consumers Energy Company
that allows it to recover from its bundled sales customers all prudently
incurred costs to purchase the natural gas commodity and transport it to
Consumers for ultimate distribution to customers.
GAS COST RECOVERY: As part of a settlement agreement approved by the MPSC in
July 2001, Consumers agreed not to bill a price in excess of $4.69 per mcf of
natural gas under the GCR factor mechanism through March 2002. This agreement is
not expected to affect Consumers' earnings outlook because Consumers recovers
from customers the amount that it actually pays for natural gas in the
reconciliation process. The settlement does not affect Consumers' June 2001
request to the MPSC for a distribution service rate increase. The MPSC also
approved a methodology to adjust bills for market price increases quarterly
without returning to the MPSC for approval. In December 2001, Consumers filed
its GCR Plan for the period April 2002 through March 2003. Consumers is
requesting authority to bill a GCR factor up to $3.50 per mcf for this period.
The Company also requested the MPSC approve the same methodology which adjusts
bills for market price increases that the MPSC approved, through settlement, in
the previous plan year. A settlement with all parties in the proceeding was
signed and submitted to the Commission in March 2002. The settlement stipulated
to all requests of Consumers and the MPSC approved the settlement, as filed, in
July 2002. Consistent with the terms of the settlement, Consumers filed in June
of 2002 to raise the GCR factor cap to $3.66 for the period July through
September and Consumers proceeded to bill its customers at this new rate. In
September, Consumers filed to raise the GCR factor cap to $3.79 for October
through December, but expects to be able to continue billing at the $3.66 rate.
GAS RATE CASE: In June 2001, Consumers filed an application with the MPSC
seeking a $140 million distribution service rate increase. Consumers requested a
12.25 percent authorized return on equity. Contemporaneously with this filing,
Consumers requested partial and immediate relief in the annual amount of $33
million. The relief was primarily for higher carrying costs on more expensive
natural gas inventory than is currently included in rates. In October 2001,
Consumers revised its filing to reflect lower operating costs and requested a
$133 million annual distribution service rate increase. In December 2001, the
MPSC authorized a $15 million annual interim increase in distribution service
rate revenues. The order authorized Consumers to apply the interim increase on
its gas sales customers' bills for service effective December 21, 2001. In
February 2002, Consumers revised its filing to reflect lower estimated gas
inventory prices and revised depreciation expense and requested an annual $105
million distribution service rate increase. On November 7, 2002, the MPSC issued
a final order approving a $56 million annual distribution service rate increase,
which includes the $15 million interim increase, with an 11.4 percent authorized
return on equity, effective for service November 8, 2002.
In September 2002, the FERC issued an order rejecting a filing by Consumers to
assess certain rates for non-physical gas title tracking services offered by
Consumers. Despite Consumer arguments to the contrary, the Commission asserted
jurisdiction over such activities and allowed Consumers to refile and justify a
title transfer fee not based on volumes as Consumers proposed. Because the order
was issued 6 years after Consumers made its original filing initiating the
proceeding, over $3 million in non-title transfer tracking fees had been
collected. No refunds have been ordered, and Consumers sought rehearing of the
September order. Consumers has made no reservations for refunds in this matter.
If refunds were ordered they may include interest which would increase the
refund liability to more than the $3 million collected. Consumers is unable to
say with certainty what the final outcome of this proceeding might be.
In November 2002, the MPSC upon its own motion commenced a contested proceeding
requiring each utility to give reason as to why its rates should not be reduced
to reflect new personal property multiplier tables, and why it should not
refund any amounts that it receives as refunds from local governments as they
implement the new multiplier tables. Consumers believes that such action may be
inconsistent with the November 7, 2002 gas rate order in case U-13000, with the
Customer Choice Act, and may otherwise be unlawful. Consumers is unable to
predict the outcome of this matter.
OTHER GAS UNCERTAINTIES
CAPITAL EXPENDITURES: In 2002, 2003, and 2004, Consumers estimates gas capital
expenditures, including new lease commitments, of $190 million, $145 million,
and $165 million. For further information, see the Capital Expenditures Outlook
section in the MD&A.
DERIVATIVE ACTIVITIES: Consumers' gas business uses fixed price gas supply
contracts, and fixed price weather-
CE-51
Consumers Energy Company
based gas supply call options and fixed price gas supply put options, and other
types of contracts, to meet its regulatory obligation to provide gas to its
customers at a reasonable and prudent cost. Some of the fixed price gas supply
contracts require derivative accounting because they contain embedded put
options that disqualify the contracts from the normal purchase exception of SFAS
No. 133. As of September 30, 2002, Consumers' gas supply contracts requiring
derivative accounting had a fair value of $1 million, representing a fair value
gain on the contracts since the date of inception. This gain was recorded
directly in earnings as part of other income, and then directly offset and
recorded on the balance sheet as a regulatory liability. Any subsequent changes
in fair value will be recorded in a similar manner. These contracts expire in
October 2002.
As of September 30, 2002, weather-based gas call options and gas put options
requiring derivative accounting had a net fair value of $1 million. The change
in value since inception in August 2002 is immaterial. Any change in fair value
will be recorded in a similar manner as stated above for the change in fair
value for fixed price gas supply contracts requiring derivative accounting.
OTHER UNCERTAINTIES
PENSION: The recent significant downturn in the equities markets has affected
the value of the Pension Plan assets. If the plan's Accumulated Benefit
Obligation exceeds the value of these assets at December 31, 2002, Consumers
Energy will be required to recognize an additional minimum liability for this
excess in accordance with SFAS No. 87. Consumers cannot predict the future fair
value of the plan's assets but it is possible, without significant appreciation
in the plan's assets, that Consumers will need to book an additional minimum
liability through a charge to other comprehensive income. The value of the Plan
assets and the Accumulated Benefits Obligation are determined by the Plan's
actuary in the fourth quarter of each year.
In addition to the matters disclosed in this note, Consumers and certain of its
subsidiaries are parties to certain lawsuits and administrative proceedings
before various courts and governmental agencies arising from the ordinary course
of business. These lawsuits and proceedings may involve personal injury,
property damage, contractual matters, environmental issues, federal and state
taxes, rates, licensing and other matters.
Consumers has accrued estimated losses for certain contingencies discussed in
this note. Resolution of these contingencies is not expected to have a material
adverse impact on Consumers' financial position, liquidity, or results of
operations.
TAX LOSS ALLOCATIONS: The Job Creation and Worker Assistance Act of 2002
provided to corporate taxpayers a 5-year carryback of tax losses incurred in
2001 and 2002. As a result of this legislation, CMS Energy was able to carry
back a consolidated 2001 tax loss to tax years 1996 through 1999 and obtain
refunds of prior years tax payments totaling $217 million. The tax loss
carryback, however, resulted in a reduction in AMT credit carryforwards that
previously had been recorded by CMS Energy as deferred tax assets in the amount
of $41 million. This one-time non-cash reduction in AMT credit carryforwards has
been reflected in the tax provisions of CMS Energy and each of its consolidated
subsidiaries, as of September 2002, according to their contributions to the
consolidated CMS Energy tax loss, of which $29 million was allocated to
Consumers. This represents an allocation of only one of CMS Energy's
consolidated tax return items, which will be calculated and allocated to various
CMS Energy subsidiaries in the fourth quarter of 2002. The amount of the final
tax allocations to Consumers may be materially different than recorded for this
one item.
3: SHORT-TERM FINANCINGS AND CAPITALIZATION
AUTHORIZATION: At September 30, 2002, Consumers had FERC authorization to issue
or guarantee through June 2004, up to $1.1 billion of short-term securities
outstanding at any one time. Consumers also had remaining FERC authorization to
issue through June 2004 up to $500 million of long-term securities for
CE-52
Consumers Energy Company
refinancing or refunding purposes, $690 million for general corporate purposes,
and $900 million of First Mortgage Bonds to be issued solely as security for the
long-term securities.
SHORT-TERM FINANCINGS: At September 30, 2002 Consumers had a $250 million credit
facility secured by First Mortgage Bonds. This facility is available to finance
seasonal working capital requirements and to pay for capital expenditures
between long-term financings. At September 30, 2002, a total of $235 million was
outstanding at a weighted average interest rate of 3.7 percent, compared with
$153 million outstanding on a revolving credit facility at September 30, 2001,
at a weighted average interest rate of 3.5 percent.
In July 2002, the credit rating of the publicly traded securities of Consumers
was downgraded by the major rating agencies. The rating downgrade is purported
to be largely a function of the uncertainties associated with CMS Energy's
financial condition and liquidity pending resolution of the round-trip trading
investigations and lawsuits, the special board committee investigation,
restatement and re-audit of 2000 and 2001 financial statements and uncertain
future access to the capital markets. Consumers' actual ability to access the
capital markets in the future on a timely basis will depend on, among other
matters, the successful and timely conclusion of the re-audit of 2000 and 2001
financial statements.
As a result of certain of these downgrades, a few commodity suppliers to
Consumers have requested advance payments or other forms of assurances in
connection with maintenance of ongoing deliveries of gas and electricity.
Consumers is addressing these issues as required.
On July 12, 2002, Consumers reached agreement with its lenders on two credit
facilities as follows: a $250 million revolving credit facility maturing July
11, 2003 and a $300 million term loan maturing July 11, 2003. In September 2002,
the term loan maturity was extended by one year at Consumers' option and now has
a maturity date of July 11, 2004. These two facilities aggregating $550 million
replace a $300 million revolving credit facility that matured July 14, 2002 as
well as various credit lines aggregating $200 million. The prior credit
facilities and lines were unsecured. The two new credit facilities are secured
with Consumers First Mortgage Bonds.
Consumers $250 million revolving credit facility has an interest rate of LIBOR
plus 200 basis points, although the rate may fluctuate depending on the rating
of Consumers' first mortgage bonds, and the interest rate on the $300 million
term loan is LIBOR plus 450 basis points which may also fluctuate depending on
the rating of Consumers' first mortgage bonds. Consumers bank and legal fees
associated with arranging the facilities were $6 million. The term loan was
issued at a 4 percent discount.
The credit facilities have contractual restrictions that require Consumers to
maintain, as of the last day of each fiscal quarter, the following:
Required Ratio Limitation Ratio at September 30, 2002
==================================================================================================================
Debt to Capital Ratio(a) Not more than 0.65 to 1.00 0.53 to 1.00
Interest Coverage Ratio(a) Not less than 2.00 to 1.00 3.36 to 1.00
===================================================================================================================
(a) Violation of this ratio would constitute an Event of Default under the
facility which provides the lender, among other remedies, the right to
declare the principal and interest immediately due and payable.
Also pursuant to restrictive covenants in its facilities, Consumers is limited
to dividend payments that will not exceed $300 million in any calendar year. In
2001, Consumers paid $189 million in common stock dividends to CMS Energy.
Consumers has declared and paid $154 million in common dividends through
September 2002.
In October 2002, Consumers simultaneously entered into a new Term Loan Agreement
collateralized by First Mortgage Bonds and a new Gas Inventory Term Loan
Agreement collateralized by Consumers' natural gas in storage. These agreements
contain complementary collateral packages that provide Consumers, as additional
CE-53
Consumers Energy Company
first mortgage bonds become available, borrowing capacity of up to $225 million.
Consumers drew $220 million of the capacity upon execution of the Agreements and
is expected to be in a position to draw the full $225 million by mid-November of
2002. The interest rate under the Agreements is currently LIBOR plus 300 basis
points, but will increase by 100 basis points for any period after December 1,
2002 during which the banks thereunder have not yet received, among other
deliveries, certified restated financial statements for CMS Energy's 2000 and
2001 fiscal years. The bank and legal fees associated with the Agreement were $2
million. The first net amortization payment under these agreements is scheduled
to occur at the end of 2002 with monthly amortization scheduled until full
repayment is completed in mid-April of 2003. This financing should eliminate the
need for Consumers to access the capital markets for the remainder of 2002.
LONG-TERM FINANCINGS: In March 2002, Consumers sold $300 million principal
amount of six percent senior notes, maturing in March 2005. Net proceeds from
the sale were $299 million. Consumers used the net proceeds to replace a first
mortgage bond that was to mature in 2003.
FIRST MORTGAGE BONDS: Consumers secures its First Mortgage Bonds by a mortgage
and lien on substantially all of its property. Consumers' ability to issue and
sell securities is restricted by certain provisions in its First Mortgage Bond
Indenture, its Articles of Incorporation and the need for regulatory approvals
to meet appropriate federal law.
MANDATORILY REDEEMABLE PREFERRED SECURITIES: Consumers has wholly owned
statutory business trusts that are consolidated within its financial statements.
Consumers created these trusts for the sole purpose of issuing Trust Preferred
Securities. The primary asset of the trusts is a note or debenture of Consumers.
The terms of the Trust Preferred Security parallel the terms of the related
Consumers' note or debenture. The term, rights and obligations of the Trust
Preferred Security and related note or debenture are also defined in the related
indenture through which the note or debenture was issued, Consumers' guarantee
of the related Trust Preferred Security and the declaration of trust for the
particular trust. All of these documents together with their related note or
debenture and Trust Preferred Security constitute a full and unconditional
guarantee by Consumers of the trust's obligations under the Trust Preferred
Security. In addition to the similar provisions previously discussed, specific
terms of the securities follow:
In Millions
- ---------------------------------------------------------------------------------------------------------------
Earliest
Trust and Securities Rate Amount Outstanding Maturity Redemption
- ---------------------------------------------------------------------------------------------------------------
September 30 2002 2001 2000 Year
- ---------------------------------------------------------------------------------------------------------------
Consumers Power Company Financing I,
Trust Originated Preferred Securities 8.36% $ 70 $100 $100 2015 2000
Consumers Energy Company Financing II,
Trust Originated Preferred Securities 8.20% 120 120 120 2027 2002
Consumers Energy Company Financing III,
Trust Originated Preferred Securities 9.25% 175 175 175 2029 2004
Consumers Energy Company Financing IV,
Trust Preferred Securities 9.00% 125 125 - 2031 2006
---------------------------
Total $490 $520 $395
===============================================================================================================
In March 2002, Consumers reduced its' outstanding debt to Consumers Power
Company Financing I, Trust Originated Preferred Securities by $30 million.
OTHER: Under the provisions of its Articles of Incorporation, Consumers had $345
million of unrestricted retained earnings available to pay common dividends at
September 30, 2002.
CE-54
Consumers Energy Company
On April 1, 2002, Consumers established a new subsidiary, Consumers Receivable
Funding, LLC. This consolidated subsidiary was established to sell accounts
receivable purchased from Consumers to an unrelated third party under a trade
receivables sale program. Prior to the establishment of Consumers Receivable
Funding, Consumers sold its accounts receivable directly to an unrelated third
party. Consumers, through Consumers Receivable Funding, currently has in place a
$325 million trade receivables sale program. At September 30, 2002 and 2001, the
receivables sold totaled $325 million for each year. During 2002, $248 million
cash proceeds were received under the trade receivables sale program. Accounts
receivable and accrued revenue in the Consolidated Balance Sheets have been
reduced to reflect receivables sold.
DERIVATIVE ACTIVITIES: Consumers uses interest rate swaps to hedge the risk
associated with forecasted interest payments on variable rate debt. These
interest rate swaps are designated as cash flow hedges. As such, Consumers will
record any change in the fair value of these contracts in other comprehensive
income unless the swap is sold. As of September 30, 2002, Consumers had entered
into a swap to fix the interest rate on $75 million of variable rate debt. This
swap will expire in June 2003. As of September 30, 2002, this interest rate swap
had a negative fair value of $2 million. This amount, if sustained, will be
reclassified to earnings, increasing interest expense when the swaps are settled
on a monthly basis. As of September 30, 2001, Consumers had entered into swaps
to fix the interest rate on $150 million of variable rate debt. The swaps
expired at varying times from June through December 2001. As of September 30,
2001, these interest rate swaps had a negative fair value of $4 million.
Consumers also uses interest rate swaps to hedge the risk associated with the
fair value of its debt. These interest rate swaps are designated as fair value
hedges. In March 2002, Consumers entered into a fair value hedge to hedge the
risk associated with the fair value of $300 million of fixed rate debt, issued
in March 2002. In June 2002, this swap was terminated and resulted in a $7
million gain that is deferred and recorded as part of the debt. It is
anticipated that this gain will be recognized over the remaining life of the
debt.
As of September 2001, Consumers had entered into interest rate swaps to hedge
the risk associated with the fair value of $400 million of fixed rate debt,
which expire in May 2003 and December 2006. As of September 30, 2001, these
interest rate swaps had a fair value of $1 million. Subsequently in November
2001, these swaps were terminated and resulted in a $4 million gain that will be
deferred and recorded as part of the debt. It is anticipated that this gain will
be recognized over the remaining life of the debt.
During the third quarter 2001, Consumers entered into fair value hedges to hedge
the risk associated with the fair value of $250 million of debt. These swaps
terminated in the third quarter 2001, and resulted in a $4 million gain that has
been deferred and recorded as part of the debt. It is anticipated that this gain
will be recognized over the remaining life of the debt.
In September 2001, Consumers entered into a cash flow hedge to fix the interest
rate on $100 million of debt to be issued. In September 2001, the swap
terminated and resulted in a $2 million loss that was recorded in other
comprehensive income and will be amortized to interest expense over the life of
the debt using the effective interest method.
CE-55
Consumers Energy Company
(This page intentionally left blank)
CE-56
PANHANDLE EASTERN PIPE LINE COMPANY
PANHANDLE EASTERN PIPE LINE COMPANY
MANAGEMENT'S DISCUSSION AND ANALYSIS
Panhandle, a subsidiary of CMS Energy, a holding company, is primarily engaged
in the interstate transportation and storage of natural gas. Panhandle also owns
an interest in an LNG regasification plant and related facilities. The rates and
conditions for service of interstate natural gas transmission and storage
operations of Panhandle as well as the LNG operations are subject to the rules
and regulations of the FERC.
FORWARD-LOOKING STATEMENTS AND RISK FACTORS
The MD&A of this Form 10-Q should be read along with the MD&A and other parts of
Panhandle's 2001 Form 10-K. This MD&A also refers to, and in some sections
specifically incorporates by reference, Panhandle's Condensed Notes to
Consolidated Financial Statements and should be read in conjunction with such
Statements and Notes. This report and other written and oral statements that
Panhandle may make contain forward-looking statements, as defined by the Private
Securities Litigation Reform Act of 1995. Panhandle's intentions with the use of
the words "anticipates," "believes," "estimates," "expects," "intends," and
"plans" and variations of such words and similar expressions, are solely to
identify forward-looking statements that involve risk and uncertainty. These
forward-looking statements are subject to various factors that could cause
Panhandle's actual results to differ materially from those anticipated in such
statements. Panhandle has no obligation to update or revise forward-looking
statements regardless of whether new information, future events or any other
factors affect the information contained in such statements. Panhandle does,
however discuss certain risk factors, uncertainties and assumptions in this MD&A
and in Item 1 of the 2001 Form 10-K in the section entitled "Forward-Looking
Statements Cautionary Factors and Uncertainties" and in various public filings
it periodically makes with the SEC.
In addition to any assumptions and other factors referred to specifically in
connection with such forward-looking statements, there are numerous factors that
could cause our actual results to differ materially from those contemplated in
any forward-looking statements. Such factors include our inability to predict
and/or control:
- - Results of the re-audit of CMS Energy, Consumers, Panhandle, and certain of
their subsidiaries by Ernst & Young and the subsequent restatement of CMS
Energy's, Consumers' and Panhandle's financial statements;
- - Achievement of operating synergies and revenue enhancements;
- - Capital and financial market conditions, including current price of CMS
Energy's Common Stock, and the effect on the Pension Plan, interest rates
and availability of financing to CMS Energy, Consumers, Panhandle or any of
their affiliates and the energy industry;
- - CMS Energy, Consumers, Panhandle or any of their affiliates' securities
ratings;
- - Market perception of the energy industry, CMS Energy, Consumers, Panhandle,
or any of their affiliates;
- - Ability to successfully assess the capital markets;
PE-1
PANHANDLE EASTERN PIPE LINE COMPANY
- - Factors affecting operations such as unusual weather conditions,
catastrophic weather-related damage, maintenance or repairs, environmental
incidents, or gas producer constraints;
- - National, regional and local economic, competitive, legislative, and
regulatory conditions and developments;
- - Adverse regulatory or legal decisions, including environmental laws and
regulations;
- - The increased competition caused by new pipeline and pipeline expansion
projects that transport large additional volumes of natural gas to the
Midwestern United States from Canada, which could reduce the volumes of gas
transported by our natural gas transmission business or cause them to lower
rates in order to meet competition;
- - Energy markets, including the timing and extent of unanticipated changes in
commodity prices for oil, coal, natural gas liquids, electricity and
certain related products due to lower or higher demand, shortages,
transportation problems or other developments;
- - Technological developments in energy production, delivery and usage;
- - Changes in financial or regulatory accounting principles or policies;
- - The actual amount of goodwill impairment and related impact on earnings and
the balance sheet which could negatively impact Panhandle's borrowing
capacity;
- - Outcome, cost and other effects of legal and administrative proceedings,
settlements, investigations and claims;
- - Disruptions in the normal commercial insurance and surety bond markets that
may increase costs or reduce traditional insurance coverage, particularly
terrorism and sabotage insurance and performance bonds;
- - Capital spending requirements for safety, environmental or regulatory
requirements that could consume capital resources and also result in
depreciation expense increases not covered by additional revenues;
- - Market and other risks associated with Panhandle's investment in the
liquids pipeline business with the Centennial Pipeline venture;
- - Other business or investment considerations that may be disclosed from time
to time in CMS Energy's, Consumers' or Panhandle's SEC filings or in other
publicly disseminated written documents; and
- - Other uncertainties, which are difficult to predict and many of which are
beyond our control.
In addition, there may be other matters which are unknown to Panhandle or are
currently believed to be immaterial.
Panhandle designed this discussion of potential risks and uncertainties, which
is by no means comprehensive, to highlight important factors that may impact
Panhandle's business and financial
PE-2
PANHANDLE EASTERN PIPE LINE COMPANY
outlook. This Form 10-Q also describes material contingencies in Panhandle's
Condensed Notes to Consolidated Financial Statements, and Panhandle encourages
its readers to review these Notes.
CHANGE IN AUDITORS AND PENDING RESTATEMENTS
Following CMS Energy's announcement that it would restate its financial
statements for 2000 and 2001 to eliminate the effects of round-trip energy
trades and form the Special Committee to investigate these trades, CMS Energy
received formal notification from Arthur Andersen that it had terminated its
relationship with CMS Energy and affiliates. Arthur Andersen notified CMS Energy
that due to the investigation, Arthur Andersen's historical opinions on CMS
Energy's financial statements for the periods being restated could not be relied
upon. Arthur Andersen also notified CMS Energy that due to Arthur Andersen's
then current situation and the work of the Special Committee, it would be unable
to give an opinion on CMS Energy's restated financial statements when they are
completed. Arthur Andersen clarified in its notification to CMS Energy that its
decision does not apply to separate, audited financial statements of Panhandle
for the applicable years. Arthur Andersen's reports on CMS Energy's and
Panhandle's consolidated financial statements for each of the fiscal years ended
December 31, 2001 and December 31, 2000 contained no adverse or disclaimer of
opinion, nor were the reports qualified or modified regarding uncertainty, audit
scope or accounting principles.
There were no disagreements between CMS Energy or Panhandle and Arthur Andersen
on any matter of accounting principle or practice, financial statement
disclosure, or auditing scope or procedure during the years 2000 and 2001 and
through the date of their review for the quarter ended March 31, 2002 which, if
not resolved to Arthur Andersen's satisfaction would have caused Arthur Andersen
to make reference to the subject matter in connection with its report to the
Audit Committee of the Board of Directors or its report on CMS Energy's and
Panhandle's consolidated financial statements for the periods.
In April 2002, the Board of Directors, upon the recommendation of the Audit
Committee, voted to discontinue using Arthur Andersen to audit CMS Energy's and
Panhandle's financial statements for the year ending December 31, 2002. CMS
Energy previously had retained Arthur Andersen to review its financial
statements for the quarter ended March 31, 2002. In May 2002, the Board of
Directors engaged Ernst & Young to audit CMS Energy's and Panhandle's financial
statements for the year ending December 31, 2002.
During Panhandle's two most recent fiscal years ended December 31, 2000 and
December 31, 2001 and the subsequent interim period through June 10, 2002,
Panhandle did not consult with Ernst & Young regarding any matter or event
identified by SEC laws and regulations. However, as a result of the restatement
required with respect to the round-trip trading transactions, Ernst & Young is
in the process of re-auditing CMS Energy's consolidated financial statements for
each of the fiscal years ended December 31, 2001 and December 31, 2000, which
includes audit work at Panhandle for these years. None of CMS Energy's former
auditors, some of whom are now employed by Ernst & Young, are involved in the
re-audit of CMS Energy's or Panhandle's consolidated financial statements.
In connection with Ernst & Young's re-audit of the fiscal years ended December
31, 2001 and 2000, Panhandle has determined, in consultation with Ernst & Young,
that certain adjustments (unrelated to the round-trip trades) by Panhandle to
its consolidated financial statements for the fiscal years ended December 2001
and 2000 are required. At the time it adopted the accounting treatment for
these items, Panhandle believed that such accounting was appropriate under
generally accepted accounting principles and Arthur Andersen concurred. CMS
Energy and Panhandle are in the process of advising the SEC of these adjustments
before Panhandle restates its financial statements as disclosed below, and
Panhandle intends to amend its 2001 Form 10-K and each of the 2002 Form 10-Qs by
the end of January 2003.
PE-3
PANHANDLE EASTERN PIPE LINE COMPANY
The significant Panhandle audit adjustment is the consolidation of LNG Holdings.
As was previously disclosed in late 2001, Panhandle entered into a structured
transaction to monetize a portion of the value of a long-term terminalling
contract of its LNG subsidiary. The LNG business was contributed to LNG
Holdings, which received an equity investment from an unaffiliated third party,
Dekatherm Investor Trust and obtained new loans secured by the assets. After
paying expenses, net proceeds of $235 million were distributed to Panhandle for
the contributed LNG assets, and the joint venture also loaned $75 million to
Panhandle. While the proceeds received by Panhandle were in excess of its book
basis, a gain on the transaction was not recorded. This excess was recorded as a
deferred commitment, reflecting the fact that Panhandle was expecting to
reinvest proceeds into LNG Holdings for a planned expansion. Panhandle is the
manager and operator of the joint venture and has the primary economic interest
in the joint venture. Initially, Panhandle believed that off-balance sheet
treatment for the joint venture was appropriate under generally accepted
accounting principles and Arthur Andersen concurred. Upon further analysis of
these facts at this time Panhandle has now concluded that it did not meet the
conditions precedent to account for the contribution of the LNG business as a
disposition given Panhandle's continuing involvement and the lack of sufficient
participating rights by the third-party equity holder in the joint venture. As a
result, with the concurrence of Ernst & Young, Panhandle will restate its
financial statements to reflect consolidation of LNG Holdings at December 31,
2001, and thereby recognize a net increase of $215 million of debt, the
elimination of $183 million of deferred commitment, minority interest of $30
million and a reduction of $19 million of equity from mark-to-market adjustments
related to debt hedges and $56 million of other net assets.
In addition to the above adjustment, Panhandle's restated consolidated financial
statements will also include adjustments to recognize immaterial adjustments to
SERP and corrections to certain intercompany and third party accounts receivable
and payable balances.
Additional details of these transactions will be available in the amended
quarterly and annual reports to be filed upon completion of the re-audit and in
the restatements. For further information, see "Change in Auditors and Pending
Restatements" in this MD&A.
PE-4
PANHANDLE EASTERN PIPE LINE COMPANY
COMPLIANCE WITH THE SARBANES-OXLEY ACT OF 2002
In July 2002, the Sarbanes-Oxley Act of 2002 was enacted and requires companies
to: 1) make certain certifications related to their Form 10-Q's, including
financial statements, disclosure controls and procedures and internal controls;
and 2) make certain disclosures about its disclosure controls and procedures,
and internal controls as follows:
CEO AND CFO CERTIFICATIONS
The Sarbanes-Oxley Act of 2002 requires the CEO's and CFO's of public companies
to make certain certifications relating to their Form 10-Q's, including the
financial statements. Panhandle has not filed the certifications required by the
Sarbanes-Oxley Act of 2002 relating to this Form 10-Q for the period ended
September 30, 2002 because its 2000 and 2001 financial statements are in the
process of being restated as discussed above.
The restatements cannot be completed until Ernst & Young completes audit work at
Panhandle, and their reviews of the quarterly statements for these years.
Therefore, Panhandle's CEO and CFO are not able to make the statements required
by the Sarbanes-Oxley Act of 2002 with respect to this Form 10-Q for the period
ended September 30, 2002. Panhandle expects its CEO and CFO to make the
certifications required by the Sarbanes-Oxley Act of 2002 when its restated
financial statements are available.
DISCLOSURE AND INTERNAL CONTROLS
Panhandle's CEO and CFO are responsible for establishing and maintaining
Panhandle's disclosure controls and procedures. Management, under the direction
of Panhandle's principal executive and financial officers has evaluated the
effectiveness of Panhandle's disclosure controls as of September 30, 2002. It is
their opinion that, based on this evaluation, Panhandle's disclosure controls
and procedures are effective to ensure that material information has been
presented and properly disclosed, particularly during the third quarter of 2002.
There have been no significant changes in Panhandle's internal controls that
could significantly affect internal controls subsequent to September 30, 2002.
The following information is provided to facilitate increased understanding of
the Consolidated Financial Statements and accompanying Notes of Panhandle and
should be read in conjunction with these financial statements. Because all of
the outstanding common stock of Panhandle Eastern Pipe Line is owned by a
wholly-owned subsidiary of CMS Energy, the following discussion uses the reduced
disclosure format
PE-5
PANHANDLE EASTERN PIPE LINE COMPANY
permitted by Form 10-Q for issuers that are wholly-owned direct or indirect
subsidiaries of reporting companies.
RESULTS OF OPERATIONS
The following results of operations and related explanations reflect LNG
Holdings as an unconsolidated off-balance sheet entity. As discussed above in
the Restatements section of this MD&A, Panhandle will restate these amounts as
soon as practicable and such restatements will be re-filed with the SEC.
PANHANDLE CONSOLIDATED EARNINGS:
In Millions
- ----------------------------------------------------------------------------------------------------------------
September 30 2002 2001 Change
- ----------------------------------------------------------------------------------------------------------------
Three months ended $10 $8 $2
Nine months ended 48 56 (8)
================================================================================================================
In Millions
- ----------------------------------------------------------------------------------------------------------------
Three Months Nine Months
Ended September 30 Ended September 30
Reasons for the change: 2002 vs 2001 2002 vs 2001
- ----------------------------------------------------------------------------------------------------------------
Reservation revenue $(2) $(6)
LNG terminalling revenue (20) (69)
Commodity revenue (1) (5)
Equity earnings and other revenue 6 12
Operation, maintenance, administrative and general 17 30
Other operating expenses 8 18
Other income, net - 1
Interest charges 2 11
Income taxes (8) (1)
Extraordinary item - 1
-------------------------------------------
Total change $ 2 $(8)
================================================================================================================
RESERVATION REVENUE: For the three and nine month periods ended September 30,
2002, reservation revenue decreased $2 million and $6 million, respectively, due
to lower average rates on capacity sold, continuing a trend.
LNG TERMINALLING REVENUE: In May 2001, CMS Trunkline LNG signed an agreement
with BG LNG Services that provides for a 22-year contract for the existing
uncommitted long-term capacity at the company's facility. The 22-year contract,
in conjunction with new rates which became effective January 2002 (see Note 2,
Regulatory Matters), along with higher natural gas prices in the first nine
months of 2001, resulted in reduced revenues for CMS Trunkline LNG from 2001
levels. In December 2001, Panhandle completed a $320 million monetization of the
CMS Trunkline LNG business which involved a new joint
PE-6
PANHANDLE EASTERN PIPE LINE COMPANY
venture, LNG Holdings (see Off-Balance Sheet Arrangements section of this MD&A).
The joint venture transaction results in a reduced share of CMS Trunkline LNG's
income and distributions being received by Panhandle due to such amounts being
after interest expense on debt of the joint venture as well as a reduced equity
ownership in the project. Panhandle has been using the Hypothetical Liquidation
at Book Value method of equity income measurement for its investment in LNG
Holdings, the unconsolidated joint venture which owns 100 percent of CMS
Trunkline LNG. Using this approach, equity income is generally recordable by
Panhandle only to the extent cash distributions are made by LNG Holdings. Such
distributions began in April 2002 and the resulting equity income is reflected
in the Consolidated Statements of Income as Equity income from unconsolidated
subsidiaries, whereas in 2001 LNG revenues were fully consolidated.
COMMODITY REVENUE: For the three month and nine month periods ended September
30, 2002, commodity revenue decreased $1 million and $5 million, respectively,
primarily due to decreased natural gas transportation volumes. Volumes decreased
9 percent in the third quarter and first nine months of 2002 versus 2001 due to
higher storage levels entering the summer months of 2002 which reduced
transportation volumes to fill storage in the second and third quarters of 2002
and unseasonably mild winter in the Midwest market area in early 2002,
respectively.
EQUITY EARNINGS AND OTHER REVENUE: Equity earnings and other revenue for the
three month and nine month periods ended September 30, 2002 increased $6 million
and $12 million, respectively. The increase was primarily due to equity earnings
of $9 million and $18 million in the third quarter and the first nine months of
2002, respectively, related to Panhandle's investment in LNG Holdings (see LNG
Terminalling Revenue section of this MD&A). Prior to the monetization of CMS
Trunkline LNG in December 2001, revenues from LNG activities were consolidated
and reflected in LNG terminalling revenue. The increases were partially offset
by equity losses of $2 million and $5 million, respectively, in the three and
nine month periods ended September 30, 2002 related to the Centennial Pipeline
equity investment. Other revenue for the nine months ended September 30, 2002
includes a non-recurring gain of $4 million in the first quarter of 2002 for the
settlement of Order 637 matters related to capacity release and imbalance
penalties (see Note 2, "Regulatory Matters"), equaling a non-recurring gain
related to a gas purchase contract in the first quarter of 2001.
OPERATION AND MAINTENANCE: Operation and maintenance expenses were reduced by
$17 million and $30 million in the third quarter and first nine months of 2002,
respectively, partially due to CMS Trunkline LNG expenses which are zero in 2002
since CMS Trunkline LNG was not consolidated with Panhandle (see Off-Balance
Sheet Arrangements section of this MD&A), versus $4 million and $8 million of
expenses for the three month and nine month periods ended September 30, 2001,
respectively. Additionally, Panhandle operating expenses were also lower due to
$3 million and $7 million of lower of cost or market adjustments to Panhandle's
current system gas inventory recorded in the second and third quarters of 2001,
respectively. Panhandle general and administrative expenses in the third quarter
and first nine months of 2002 decreased by $6 million and $4 million,
respectively due to reduced corporate charges and insurance costs for property
and liability coverage. Panhandle expenses for the first nine months of 2002
were also reduced by a non-recurring adjustment in the first quarter of 2002 of
$3 million for lower final incentive plan payouts approved in 2002 for 2001
awards.
OTHER OPERATING EXPENSES: Other operating expenses were reduced by $8 million
and $18 million in the third quarter and first nine months of 2002,
respectively, partially due to CMS Trunkline LNG expenses which are zero in 2002
since CMS Trunkline LNG was not consolidated with Panhandle (see Off-Balance
Sheet Arrangements section of this MD&A). CMS Trunkline LNG depreciation,
amortization and general
PE-7
PANHANDLE EASTERN PIPE LINE COMPANY
taxes for the three month and nine month periods ended September 30, 2001 were
$2 million and $3 million, respectively. For the three month and nine month
periods ended September 30, 2002 depreciation and amortization expense was
reduced by $5 million and $13 million, respectively, primarily due to adoption
of SFAS No. 142. Panhandle has completed the first step of the goodwill
impairment testing required upon adoption of SFAS No.142, which indicates a
significant impairment of Panhandle's goodwill existed as of January 1, 2002
under the new standard. Panhandle has $700 million of goodwill recorded as of
January 1, 2002 which is subject to this impairment test. Pursuant to SFAS No.
142 requirements, the actual impairment is determined in a second step involving
a detailed valuation of all assets and liabilities, the results of which will be
reflected as the cumulative effect of an accounting change, restated to the
first quarter of 2002. This valuation work is being performed utilizing an
independent appraiser and will be completed in the fourth quarter of 2002.
Preliminary results of the second step appraisal indicate that most of
Panhandle's goodwill is impaired as of January 1, 2002. For further information,
see Note 1, Corporate Structure and Basis of Presentation - Implementation of
New Accounting Standards and Note 3, Goodwill Impairment.
INTEREST CHARGES: Interest Charges were reduced by $2 million and $11 million in
the third quarter and first nine months of 2002, respectively, primarily due to
$249 million of net reductions of long-term debt principal in December 2001,
April 2002 and May 2002. In March 2002, Panhandle executed a fixed-to-floating
interest rate swap with notional amounts totaling $175 million related to
existing notes to take advantage of lower short-term interest rates, which
reduced interest expense on the Consolidated Income Statement compared to the
prior year. In June 2002, Panhandle unwound the swaps to monetize an increase in
the market value of the fixed-to-floating rate position. The resulting cash gain
of approximately $3 million will be amortized to income through the second and
third quarters of 2004, which are the maturity dates of the original debt
instruments that were hedged. Interest cost decreases due to reductions in debt
principal and amortization of the gain on the swaps unwind were partially offset
by credit fees and other interest charges of $1 million in the third quarter of
2002 related to the Centennial, Guardian and LNG Holdings. For further
information of Panhandle's long-term debt and guarantees, see Note 6, Debt
Rating Downgrades.
INCOME TAXES: Income taxes increased $8 million and $1 million in the third
quarter and first nine months of 2002, as compared to the same periods of 2001,
due to corresponding changes in pretax income and a charge to income tax expense
in the third quarter of 2002 to reflect a $5 million charge allocated to
Panhandle through CMS Energy's consolidated Federal Income Tax return for 2001
filed in 2002. For further information of the CMS Energy tax loss allocation,
see the Outlook section of this MD&A.
CRITICAL ACCOUNTING POLICIES
Presenting financial statements in accordance with generally accepted accounting
principles requires using estimates, assumptions, and accounting methods that
are often subject to judgment. Presented below are the accounting policies and
assumptions that Panhandle believes are most critical to both the presentation
and understanding of its financial statements. Applying these accounting
policies to financial statements can involve very complex judgments.
Accordingly, applying different judgments, estimates or assumptions could result
in a different financial presentation.
USE OF ESTIMATES
The preparation of financial statements in conformity with accounting principles
generally accepted in the United States requires management to make judgments,
estimates and assumptions that affect the reported amounts of assets and
liabilities, disclosure of contingent assets and liabilities at the date of the
PE-8
PANHANDLE EASTERN PIPE LINE COMPANY
financial statements, and the reported amounts of revenues and expenses during
the reporting period. Certain accounting principles require subjective and
complex judgments used in the preparation of financial statements. Accordingly,
a different financial presentation could result depending on the judgment,
estimates or assumptions that are used. Such estimates and assumptions, include,
but are not specifically limited to: depreciation and amortization, interest
rates, discount rates, future commodity prices, mark-to-market valuations,
investment returns, volatility in the price of CMS Energy Common Stock, impact
of new accounting standards, future compliance costs associated with
environmental regulations and continuing creditworthiness of counterparties.
Actual results could materially differ from those estimates.
OFF-BALANCE SHEET ARRANGEMENTS
In December 2001, Panhandle entered into a joint venture transaction involving
LNG Holdings, which now owns 100 percent of CMS Trunkline LNG. LNG Holdings is
jointly owned by a subsidiary of Panhandle Eastern Pipe Line and Dekatherm
Investor Trust, an unaffiliated entity. Panhandle initially contributed its
interest in Trunkline LNG to the joint venture. The joint venture then raised
$30 million from the issuance of equity to Dekatherm Investor Trust and then
$290 million from bank loans. The net proceeds were distributed to Panhandle
Eastern Pipe Line, with $75 million of the proceeds coming in the form of a
loan. While earnings are divided pursuant to a sharing formula, LNG Holdings'
owners require unanimous consent over significant governance issues, including,
among others, issuance of additional debt or equity, budgets, asset acquisitions
or dispositions, and appointment of officers.
The LNG Holdings transaction monetized a portion of the value of CMS Trunkline
LNG and the value created by a 22-year contract with BG LNG Services, which
began in January 2002, for the existing uncommitted long-term capacity at the
facility. Due to the commitment by Panhandle to reinvest the proceeds in the
joint venture to finance the LNG expansion project, the $183 million of proceeds
received by Panhandle in excess of Panhandle's book basis in CMS Trunkline LNG
was not recognized as a gain, but instead was recorded as a deferred commitment
on Panhandle's balance sheet which is reduced as Panhandle makes additional
capital investments in LNG Holdings for the proposed expansion project.
Panhandle Eastern Pipe Line has provided indemnities to certain parties involved
in the transaction for pre-closing claims and liabilities, and subsidiaries of
Panhandle have provided indemnities for certain post-closing expenses and
liabilities as the manager/operator of the joint venture. For further
information, see Note 5, "Commitments and Contingencies" and Note 6, "Debt
Rating Downgrades".
During the re-audit of Panhandle's financial statements it was concluded that
Panhandle did not meet the conditions precedent to account for the contribution
of the LNG business as a disposition given Panhandle's continuing involvement
and the lack of sufficient participating rights by the third-party equity holder
in the joint venture. As a result, with the concurrence of Ernst & Young,
Panhandle will restate its financial statements to reflect consolidation of LNG
Holdings at December 31, 2001. Panhandle's financial statements for the periods
ended December 31, 2001 and for the quarterly periods in 2002 will be restated
to fully consolidate Panhandle's majority interest in LNG Holdings. Such
restatements will be made as soon as practicable and re-filed with the SEC. For
further information regarding the restatement of Panhandle's financial
statements, see "Change in Auditors and Pending Restatements" section of this
MD&A.
ACCOUNTING FOR RETIREMENT BENEFITS
Panhandle uses SFAS No. 87 to account for pension costs and uses SFAS No. 106 to
account for other postretirement benefit costs. These statements require
liabilities to be recorded on the balance sheet at the present value of these
future obligations to employees net of any plan assets. The calculation of these
liabilities and associated expenses require the expertise of actuaries and are
subject to many assumptions,
PE-9
PANHANDLE EASTERN PIPE LINE COMPANY
including life expectancies, present value discount rates, expected long-term
rate of return on plan assets, rate of compensation increase and anticipated
health care costs. Any change in these assumptions can significantly change the
liability and associated expenses recognized in any given year. As of January
2002, OPEB Plan claims are paid from VEBA trusts. The Pension Plan and OPEB Plan
in which Panhandle participate, net of contributions, have decreased in value
from the previous year due to a downturn in the equities market and a decrease
in the price of CMS stock. If the Pension Plan's Accumulated Benefit Obligation
exceeds the value of the Pension Plan's assets at December 31, 2002, Panhandle
will be required to recognize an additional minimum liability for a share of
this excess in accordance with SFAS No. 87. Panhandle cannot predict the future
fair value of the Pension Plan's assets but it is probable, without significant
appreciation in the value of the Plan's assets, that Panhandle will need to book
an additional minimum liability through a charge to other comprehensive income.
Panhandle also expects to see an increase in pension and OPEB expense levels
over the next few years unless market performance improves. For further
information, see Outlook - Retirement Benefit Costs section of this MD&A.
RELATED PARTY TRANSACTIONS
Panhandle enters into a number of significant transactions with related parties.
These transactions include revenues for the transportation of natural gas for
Consumers, CMS MST and the MCV Partnership which are based on regulated prices,
market prices or competitive bidding. Related party expenses include payments
for services provided by affiliates and payment of overhead costs to CMS Gas
Transmission and CMS Energy, as well as allocated benefit plan costs. Other
income is primarily interest income from the Note receivable - CMS Capital.
NEW ACCOUNTING STANDARDS
In addition to the identified critical accounting policies discussed above,
future results will be affected by new accounting standards that recently have
been issued.
SFAS NO. 143, ACCOUNTING FOR ASSET RETIREMENT OBLIGATIONS: In June 2001, the
FASB issued SFAS No. 143, Accounting for Asset Retirement Obligations, which is
effective for fiscal years beginning after June 15, 2002. The Statement requires
legal obligations associated with the retirement of long-lived assets to be
recognized at their fair value at the time that the obligations are incurred.
Upon initial recognition of a liability, that cost should be capitalized as part
of the related long-lived asset and allocated to expense over the useful life of
the asset. Panhandle will adopt the Statement on January 1, 2003. Panhandle has
determined that it will be impacted by liabilities related to its offshore
gathering facilities. However, while significant progress has been made toward
the assessment, due to the significant number of documents that must be reviewed
and estimates that must be made to assess the effects of the Statement, the
expected impact of adoption of Statement No. 143 on Panhandle's financial
position or results of operations has not yet been determined.
SFAS NO. 145, RESCISSION OF FASB STATEMENTS NO. 4, 44 AND 64, AMENDMENT OF FASB
STATEMENT NO. 13, AND TECHNICAL CORRECTIONS: Issued by the FASB on April 30,
2002, this Statement rescinds SFAS No. 4, Reporting Gains and Losses from
Extinguishment of Debt, and SFAS No. 64, Extinguishment of Debt Made to Satisfy
Sinking-Fund Requirements. As a result, any gain or loss on extinguishment of
debt should be classified as an extraordinary item only if it meets the criteria
set forth in APB Opinion No. 30. The provisions of this section are applicable
to fiscal years beginning 2003. Panhandle is currently studying the effects of
the new standard, but has yet to quantify the effects, if any, of adoption on
its financial statements. SFAS No. 145 amends SFAS No. 13, Accounting for
Leases, to require sale-leaseback accounting for certain lease modifications
that have similar economic impacts to sale-
PE-10
PANHANDLE EASTERN PIPE LINE COMPANY
leaseback transactions. This provision is effective for transactions occurring
and financial statements issued after May 15, 2002.
SFAS NO. 146, ACCOUNTING FOR COSTS ASSOCIATED WITH EXIT OR DISPOSAL ACTIVITIES:
Issued by the FASB in July 2002, this standard requires companies to recognize
costs associated with exit or disposal activities when they are incurred rather
than at the date of a commitment to an exit or disposal plan. SFAS No. 146
supersedes previous accounting guidance, EITF No. 94-3, "Liability recognition
for Certain Termination Benefits and Other Costs to Exit an Activity (including
Certain Costs Incurred In a Restructuring)." This standard is effective for exit
or disposal activities initiated after December 31, 2002. The scope of SFAS No.
146 includes (1) costs related to termination benefits of employees who are
involuntarily terminated, (2) costs to terminate a contract that is not a
capital lease and (3) costs to consolidate facilities or relocate employees.
Panhandle believes there will be no impact on its financial statements upon
adoption of the standard.
SFAS NO. 147, ACQUISITIONS OF CERTAIN FINANCIAL INSTITUTIONS: Issued by the FASB
in October 2002, this standard amends SFAS No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets, and amends other pronouncements
issued previously which are unrelated to the business of Panhandle. These
provisions are effective for transactions occurring on or after October 1, 2002.
Panhandle is currently studying the effects of the new standard, but has yet to
quantify the effects of adoption on its financial statements.
LIQUIDITY
CMS ENERGY FINANCIAL CONDITION
In July of 2002, the credit ratings of the publicly traded securities of CMS
Energy and Panhandle were downgraded by the major rating agencies. The ratings
downgrade for all three companies' securities was largely a function of the
uncertainties associated with CMS Energy's financial condition and liquidity,
the Special Committee investigation of the round-trip trading, restatement and
re-audit of 2000 and 2001 financial statements, and lawsuits, that directly
affects and limits CMS Energy's access to the capital markets.
As a result of certain of these downgrades, contractual rights were triggered in
several contractual arrangements between Panhandle and third parties, as
described in the Panhandle Financial Condition section below.
PE-11
PANHANDLE EASTERN PIPE LINE COMPANY
In response to the July debt downgrades, CMS Energy and its subsidiaries
Consumers and Enterprises have replaced or restructured several of its existing
unsecured credit facilities with secured credits. The new facilities have
conditions requiring mandatory prepayment of borrowings from asset sales, debt
issuances and/or equity issuances, impose certain dividend restrictions and
grant the applicable bank groups either first or second liens on the capital
stock of Enterprises and its major direct and indirect domestic subsidiaries,
including Panhandle Eastern Pipe Line (but excluding subsidiaries of Panhandle
Eastern Pipe Line).
CMS Energy's liquidity and capital requirements are generally a function of its
results of operations, capital expenditures, contractual obligations, working
capital needs and collateral requirements. CMS Energy has historically met its
consolidated cash needs through its operating and investing activities and, as
needed, through access to bank financing and the capital markets. As discussed
above, for the remainder of 2002 and during 2003, CMS Energy has contractual
obligations and planned capital expenditures that would require substantial
amounts of cash. CMS Energy and its subsidiaries also have approximately $1.6
billion of publicly issued and credit facility debt maturing in 2003, including
the CMS Energy credit facilities described above. In addition, CMS Energy may
also become subject to liquidity demands pursuant to commercial commitments
under guaranties, indemnities and letters of credit as indicated above.
CMS Energy is addressing its near-to-mid-term liquidity and capital requirements
through a financial improvement plan which involves the sale of non-strategic
and under-performing assets, reduced capital expenditures, cost reductions and
other measures. As noted elsewhere in this MD&A, CMS Energy has improved its
liquidity through asset sales, with a total of approximately $2.7 billion in
cash proceeds from such sales over the past two years. CMS Energy believes that
further targeted asset sales, together with further reductions in operating
expenses and capital expenditures, will also contribute to improved liquidity.
CMS Energy believes that, assuming the successful implementation of its
financial improvement plan, its current level of cash and borrowing capacity,
along with anticipated cash flows from operating and investing activities, will
be sufficient to meet its liquidity needs through 2003, including the
approximately $1.6 billion in 2003 debt maturities.
As discussed above, CMS Energy's, Consumers' and Panhandle's financial
statements will be restated. As a result, CMS Energy, Consumers and Panhandle
are at present unable to deliver certified September 30, 2002 financial
statements to lenders as required under certain bank facilities. Although CMS
Energy, Consumers and Panhandle believe they will be able to secure waivers of
this requirement, should they be unable to do so, they could be declared to be
in default and the debt thereunder could be accelerated and become immediately
due and payable. In addition, the occurrence of such an acceleration could
entitle the holders of other debt of CMS Energy, Consumers and Panhandle to
demand immediate repayment. The earliest date that an acceleration from a
failure to deliver certified financial statements could occur is ten business
days after receipt of notice of default after November 29, 2002.
CMS Energy's January 15, 1994 indenture restricts CMS Energy from incurring
additional indebtedness when the debt ratio is in excess of 75 percent. CMS
Energy expects that the aggregate effect of non-cash charges to equity and the
reconsolidation of debt on the balance sheet anticipated to occur in the fourth
quarter of 2002 will result in a year end debt ratio in excess of 75 percent. In
this event, CMS Energy and certain of its subsidiaries other than Consumers will
be restricted from incurring new indebtedness until this condition is remedied.
This restriction will not prevent CMS Energy from refinancing existing
indebtedness or incurring up to $1 billion in bank financing. This debt ratio
could be significantly reduced if CMS Energy decides to proceed with its sale of
Panhandle, its sale of CMS Field Services, other asset sales or other options
such as the securitization of additional assets at Consumers.
It should be noted, that CMS Energy has historically met its liquidity needs
through a combination of operating and investing activities, including through
access to bank financing and the capital markets. As a result of the impact of
the re-audit and pending restatement, ratings downgrades and related changes in
its financial situation, CMS Energy's access to bank financing and the capital
markets and its ability to incur additional indebtedness may be restricted.
There can be no assurance that the financial improvement plan will be
successful, or that the necessary bank waivers will be obtained and the debt
ratio lowered. A failure to achieve any of these goals could have a material
adverse effect on CMS Energy's liquidity and operations. In such event, it would
be required to consider the full range of strategic measures available to
companies in similar circumstances.
PANHANDLE FINANCIAL CONDITION
On June 11, 2002, Moody's Investors Service, Inc. lowered its rating on
Panhandle's senior unsecured notes from Baa3 to Ba2 based on concerns
surrounding the liquidity and debt levels of CMS Energy (see discussion in the
CMS Energy Financial Condition section above). On July 15, 2002, Fitch Ratings,
Inc. lowered its rating on these notes from BBB to BB+ and again on September 4,
2002 to BB based on similar concerns. On July 16, 2002, S&P also lowered its
rating on these notes from BBB- to BB, in line with their rating on CMS Energy
based on their belief that CMS Energy and its subsidiaries are at equal risk of
default since the parent relies on its subsidiaries to meet its financial
commitments. Effective with these downgrades, Panhandle's debt is below
investment grade which will increase operating and financing costs going
forward. Panhandle's senior unsecured note provisions are not directly impacted
by debt rating reductions, but are subject to other requirements such as the
maintenance of a fixed charge coverage ratio and a leverage ratio which restrict
certain payments if not maintained and limitations on liens. At September 30,
2002, Panhandle was in compliance with all covenants.
In December 2001, $75 million of the proceeds from the CMS Trunkline LNG
monetization transaction came to Panhandle in the form of a note payable to LNG
Holdings. Panhandle, as a result of its debt ratings downgrade to below
investment grade, can be required to pay on demand the remaining principal and
accrued interest at any time while such downgrades exist. At September 30, 2002,
Panhandle's remaining balance on the $75 million note payable to LNG Holdings
was approximately $66 million. Dekatherm Investor Trust has agreed not to make
demand for payment before November 22, 2002 in return for a fee and an agreement
for Panhandle to acquire Dekatherm Investor Trust's interest in LNG Holdings.
When Panhandle acquires Dekatherm Investor Trust's interest, it will then own
100 percent of the LNG Holdings and will not demand payment on the note payable
to LNG Holdings. As a result, Panhandle will not demand payment on the note
payable from Panhandle to LNG Holdings.
In conjunction with the Centennial and Guardian pipeline projects, Panhandle has
provided guarantees related to the project financings during the construction
phases and initial operating periods. On July 17, 2002, following the Panhandle
debt downgrades by Moody's and S&P, the lender sent notice to Panhandle,
pursuant to the terms of the guaranty agreements, requiring Panhandle to provide
acceptable credit support for its pro rata portion of those construction loans,
which aggregate $110 million including anticipated future draws. On September
27, 2002 Centennial's other partners provided credit support of $25 million each
in the form of guarantees to the lender to cover Panhandle's obligation of $50
million of loan guarantees. The partners will be paid credit fees by Panhandle
on the outstanding balance of the guarantees for any periods for which they are
in effect. This additional credit support does not remove Panhandle from its
original $50 million obligation.
PE-12
PANHANDLE EASTERN PIPE LINE COMPANY
In October 2002, Panhandle provided a letter of credit to the lenders which
constitutes acceptable credit support under the Guardian financing agreement.
This letter of credit was cash collateralized by Panhandle with approximately
$63 million. As of September 30, 2002, Panhandle has also provided $16 million
of equity contributions to Guardian.
As discussed above, Panhandle's financial statements will be restated. As a
result, Panhandle is at present unable to deliver certified September 30, 2002
financial statements to the LNG Holdings lenders as required under that credit
facility. Although Panhandle intends to seek waivers of this requirement if it
cannot timely provide such certified financial statements, should it be unable
to do so, LNG Holdings could be declared to be in default under its credit
facility and the debt thereunder could be accelerated and become immediately due
and payable. In addition, the occurrence of such an acceleration could cause the
associated $75 million loan to Panhandle from LNG Holdings to become immediately
due and payable.
At September 30, 2002, the Note receivable - CMS Capital balance was $251
million. Due to CMS Energy's financial condition as described above, the
liquidity of this note is potentially adversely affected and proceeds may not be
immediately available upon demand by Panhandle.
At September 30, 2002, Accounts receivable includes $19 million of tax related
receivables from CMS Energy due in November 2002. Due to CMS Energy's financial
condition, the liquidity of these receivables is potentially adversely affected
and funds may not be available to Panhandle when amounts are due.
OUTLOOK
As a result of certain events previously disclosed regarding round-trip trading,
CMS Energy has engaged Ernst & Young to re-audit its fiscal years ended December
31, 2001 and 2000. During the course of the re-audit, in consultation with its
new auditors, CMS Energy has determined that certain adjustments discussed
elsewhere in this Form 10-Q (unrelated to the round-trip trades) by CMS Energy
and Panhandle to their consolidated financial statements for the fiscal years
ended December 2001 and 2000 are required. At the time it adopted the accounting
treatments for the items, CMS Energy believed that such treatments were
appropriate under generally accepted accounting principles, and Arthur Andersen
concurred. CMS Energy has now determined it will adopt different accounting for
certain transactions, upon the recommendation of Ernst & Young, as discussed
elsewhere in this Form 10-Q. As a result, following completion of the re-audit,
CMS Energy and Panhandle intend to file an amended Form 10-K for the fiscal year
ended December 31, 2001. In addition, CMS Energy and Panhandle will file amended
Form 10-Qs for the quarters ended March 31, 2002, June 30, 2002 and September
30, 2002 following completion of Ernst & Young's review of the interim financial
statements for these periods. As a result of these reviews and re-audits, there
may be revisions to the financial statements contained in the above referenced
reports, including this Form 10-Q, some of which could be material. CMS Energy
has advised the staff of the SEC about the pending restatements. CMS Energy is
working with Ernst & Young to resolve these issues and expects it will file all
restated results by the end of January 2003. For more information, see "Change
in Auditors and Pending Restatements" section in the beginning of this MD&A.
Panhandle is a leading United States interstate natural gas pipeline system and
also has a significant ownership interest in the nation's largest operating LNG
receiving terminal and intends to optimize results through expansion and better
utilization of its existing facilities and construction of new facilities. This
involves providing additional transportation, storage and other asset-based
value-added services to customers such as gas-fueled power plants, local
distribution companies, industrial and end-users, marketers and others.
Panhandle also has a one-third interest in Guardian Pipeline, L.L.C., which is
currently constructing a 141-mile, 36-inch pipeline from Illinois to
southeastern Wisconsin for the transportation of natural gas beginning late
2002. Upon completion of the project, CMS Trunkline will operate and maintain
the pipeline. Panhandle also has a one-third interest in the Centennial Pipeline
LLC which operates a 795-mile, 26 inch pipeline extending from the U.S. Gulf
Coast to Illinois for the transportation of interstate refined petroleum
products. The pipeline began commercial service in April 2002.
In April 2001, FERC approved CMS Trunkline's rate settlement without
modification. The settlement resulted in Trunkline reducing its maximum rates in
May 2001. The reduction is expected to reduce revenues by approximately $2
million annually. For further information, see Note 2, "Regulatory Matters."
PE-13
PANHANDLE EASTERN PIPE LINE COMPANY
In October 2001, CMS Trunkline LNG, in which Panhandle owns an interest through
its equity interest in LNG Holdings, announced the planned expansion of the Lake
Charles, Louisiana facility to approximately 1.2 bcf per day of sendout
capacity, up from its current sendout capacity of 630 million cubic feet per
day. The terminal's storage capacity will also be expanded to 9 bcf from its
current storage capacity of 6.3 bcf. On August 27, 2002 the FERC issued a
"Preliminary Determination on Non-Environmental Issues" recommending approval of
the planned expansion project. The FERC's July 2002 Environmental Assessment
determined that the CMS Trunkline LNG expansion facilities do not constitute a
major federal action significantly affecting the environment and recommended
certain compliance and mitigation measures. Comments on the Environmental
Assessment were filed on August 30, 2002. The application for a certificate of
public convenience and necessity of the expansion is still pending final FERC
action. The expanded facility is currently expected to be in operation by
January 2006 pending final FERC approvals. The expansion expenditures are
currently expected to be funded by Panhandle loans or equity contributions to
LNG Holdings, which would be sourced by capital markets, operating cash flows,
or other funding.
In October 2001, CMS Energy and Sempra Energy announced an agreement to jointly
develop a major new LNG receiving terminal to bring much-needed natural gas
supplies into northwestern Mexico and southern California. Since the October
2001 announcement, CMS Energy has adjusted its role in the development of the
terminal since CMS Energy's top priority is to reduce debt and improve the
balance sheet which will require restraint in capital spending. As a result,
Panhandle will not be an equity partner in the project, but is negotiating to
participate as the LNG plant operator and will also provide technical support
during the development of the project which is currently estimated to commence
commercial operations in 2006.
In August 2002, CMS Energy began exploring the sale of Panhandle and CMS Field
Services business units as part of its ongoing effort to strengthen its balance
sheet, improve its credit ratings and enhance financial flexibility. The
companies considered for sale include Panhandle Eastern Pipe Line, CMS
Trunkline, Sea Robin, Pan Gas Storage and Panhandle's interests in LNG Holdings,
Guardian and Centennial. CMS Energy had previously announced an intention to
sell Panhandle's separate interest in Centennial but these efforts have been
discontinued. CMS Energy has begun assessing the market's interest in purchasing
the pipeline and field services businesses and it is reviewing the financial,
legal and regulatory issues associated with the possible sale.
TAX LOSS ALLOCATION: The Job Creation and Worker Assistance Act of 2002 provided
to corporate taxpayers a five-year carryback of tax losses incurred in 2001 and
2002. As a result of this legislation, CMS Energy was able to carry back a
consolidated 2001 tax loss to tax years 1996 through 1999 and obtain refunds of
prior years tax payments totaling $217 million. The tax loss carryback,
however, resulted in a reduction in alternative minimum tax credit carryforwards
that previously had been recorded by CMS Energy as deferred tax assets in the
amount of $41 million. This one-time non-cash reduction in alternative minimum
tax credit carryforwards has been reflected in the tax provisions of CMS Energy
and each of its consolidated subsidiaries, as of September 2002, according to
their contributions to the consolidated CMS Energy tax loss, of which $5 million
was allocated to Panhandle. This represents an allocation of only one of CMS
Energy's consolidated tax return items, which will be calculated and allocated
to various CMS Energy subsidiaries in the fourth quarter of 2002. The amount of
the final tax allocations to Panhandle may be materially different than the $5
million recorded for this one item in September.
In August of 2002, the FERC issued a Notice of Proposed Rulemaking concerning
the management of funds from a FERC-regulated subsidiary by a non-FERC regulated
parent. The proposed rule would
PE-14
PANHANDLE EASTERN PIPE LINE COMPANY
establish limits on the amount of funds that could be swept from a regulated
subsidiary to a non-regulated parent under cash management programs. The
proposed rule would require written cash management arrangements that would
specify the duties and restrictions of the participants, the methods of
calculating interest and allocating interest income and expenses, and the
restrictions on deposits or borrowings by money pool members. These cash
management agreements would also require participants to provide documentation
of certain transactions. In the NOPR, the FERC proposed that to participate in a
cash management or money pool arrangement, FERC-regulated entities would be
required to maintain a minimum proprietary capital balance (stockholder's
equity) of 30 percent and both the FERC-regulated entity and its parent would be
required to maintain investment grade credit ratings.
UNCERTAINTIES: Panhandle's results of operations and financial position may be
affected by a number of trends or uncertainties that have, or Panhandle
reasonably expects could have, a material impact on income from continuing
operations and cash flows. Such trends and uncertainties include: 1) the
increased competition in the market for transmission of natural gas to the
Midwest causing pressure on prices charged by Panhandle; 2) the current market
conditions causing more contracts to be of shorter duration, which may increase
revenue volatility; 3) the increased potential for declining financial condition
of certain customers within the industry due to recession and other factors; 4)
exposure to customer concentration with a significant portion of revenues
realized from a relatively small number of customers; 5) the possibility of
decreased demand for natural gas resulting from a downturn in the economy and
scaling back of new power plants; 6) the impact of any future rate cases or FERC
actions or orders, for any of Panhandle's regulated operations; 7) impact of
current initiatives for additional federal rules and legislation regarding
pipeline security and safety; 8) capital spending requirements for safety,
environmental or regulatory requirements that could consume capital resources
and also result in depreciation expense increases not covered by additional
revenues; 9) market and other risks associated with Panhandle's investment in
the liquids pipeline business with the Centennial Pipeline venture; 10)
increased security and insurance costs as a result of the September 11, 2001
terrorist attack in the United States; it is not certain what these cost levels
will be or to what extent these additional costs will be recoverable through
Panhandle's rates; 11) the impact of CMS Energy and its subsidiaries' distressed
financial condition and ratings downgrades on Panhandle's liquidity and costs of
operating, including Panhandle's reduced ability to draw on the CMS Capital loan
and current limited access to capital markets; 12) actual amount of goodwill
impairment and related impact on earnings and balance sheet which could
negatively impact Panhandle's borrowing capacity; and 13) the effects of
changing regulatory and accounting related matters resulting from current
events. For further information about uncertainties, see Note 5, Commitments and
Contingencies.
OTHER MATTERS
CUSTOMER CONCENTRATION
During the first nine months of 2002, sales to Proliance Energy, LLC, a
nonaffiliated gas marketer, accounted for 16 percent of Panhandle's consolidated
revenues and sales to subsidiaries of CMS Energy accounted for 13 percent of
Panhandle's consolidated revenues. No other customer accounted for 10 percent or
more of consolidated revenues during the same period. Aggregate sales to
Panhandle's top 10 customers accounted for 61 percent of revenues during the
first nine months of 2002.
RETIREMENT BENEFIT COSTS
Panhandle, through its parent CMS Energy, provides post retirement benefits
under its Pension Plan, and post retirement health and life insurance benefits
under its OPEB plan to substantially all its employees.
PE-15
PANHANDLE EASTERN PIPE LINE COMPANY
The Pension Plan and OPEB Plan, net of contributions, have decreased in value
from the previous year due to a downturn in the equities market and the CMS
stock price. If the Pension Plan's Accumulated Benefit Obligation exceeds the
value of its assets at December 31, 2002, Panhandle will be required to
recognize an additional minimum liability for a share of this excess in
accordance with SFAS No. 87. Panhandle cannot predict the future fair value of
the Plan's assets but it is probable, without significant recovery of the
plan's assets, that Panhandle will need to book an additional minimum liability
through a charge to other comprehensive income. The Accumulated Benefit
Obligation is determined by the plan's actuary in the fourth quarter of
each year.
Panhandle also expects to see an increase in pension and post retirement benefit
expense levels over the next few years unless market performance improves
significantly. Panhandle anticipates pension and postretirement benefit expense
to rise in 2002 by approximately $500 thousand and $2 million, respectively,
over 2001 expenses based on actuarial studies, with pension expense likely to
increase further in 2003. For pension expense, this increase is due to a
downturn in value of pension assets during the past two years, forecasted
increases in pay and added service, decline in the interest rate used to value
the liability of the plan, and expiration of the transition gain amortization.
For postretirement benefit expense, the increase is due to the trend of rising
health care costs, the market return on plan assets being below expected levels
and a lower discount rate, based on recent economic conditions, used to compute
the benefit obligation. Health care cost decreases gradually under the
assumptions used in the OPEB plan from current levels through 2009; however,
Panhandle cannot predict the impact that interest rates or market returns will
have on pension and postretirement benefit expense in the future, nor whether
actual health care costs will actually be limited to the projected levels.
Through September 2002, Panhandle contributed $7 million to the Pension Trust
and a total of $6 million to the 401 (h) segment of the Pension Trust and VEBA
Trust to cover postretirement health care and life insurance benefits.
In order to keep health care benefits and costs competitive, CMS Energy
announced several changes to the Health Care Plan in which Panhandle
participates. These changes are effective January 1, 2003. The most significant
change is that Panhandle's future increases in health care costs will be shared
with employees.
Panhandle, through its parent CMS Energy, also participates in a CMS Energy plan
to provide retirement benefits under a defined contribution 401(k) plan. Prior
to September 1, 2002, Panhandle offered a contribution match of 50 percent of
the employee's contribution up to six percent (three percent maximum), as well
as an incentive match in years when performance exceeds expectations. Effective
September 1, 2002, Panhandle suspended the employer's match until January 1,
2005, and eliminated the incentive match which were originally projected to be
approximately $2 million each for the full plan year 2002.
ENVIRONMENTAL MATTERS
Panhandle is subject to federal, state, and local laws and regulations governing
environmental quality and pollution control. These laws and regulations under
certain circumstances require Panhandle to remove or remedy the effect on the
environment of the disposal or release of specified substances at its operating
sites.
PCB (POLYCHLORINATED BIPHENYL) ASSESSMENT AND CLEAN-UP PROGRAMS: Panhandle
previously identified environmental contamination at certain sites on its
systems and has undertaken clean-up
PE-16
PANHANDLE EASTERN PIPE LINE COMPANY
programs at these sites. The contamination resulted from the past use of
lubricants containing PCBs in compressed air systems and the prior use of
wastewater collection facilities and other on-site disposal areas. Panhandle is
also taking actions regarding PCBs in paints at various locations. For further
information, see Note 5, Commitments and Contingencies - Environmental Matters.
AIR QUALITY CONTROL: In 1998, the EPA issued a final rule on regional ozone
control that requires revised State Implementation Plans (SIPS) for 22 states,
including five states in which Panhandle operates. Based on EPA guidance to
these states for development of SIPs, Panhandle expects future compliance costs
to range from $15 million to $20 million for capital improvements to be incurred
from 2004 through 2007.
Panhandle expects final rules from the EPA in 2003 regarding control of
hazardous air pollutants, and Panhandle expects that some of its engines will be
affected. In 2002 the Texas Natural Resource Commission enacted the
Houston/Galveston SIP regulations requiring reductions in nitrogen oxide
emissions in an eight county area surrounding Houston. CMS Trunkline's Cypress
Compressor Station is affected and may require the installation of emission
controls. In 2003, the new regulations will also require all "grandfathered"
facilities to enter into the new source permit program which may require the
installation of emission controls at five additional facilities. The company
expects future capital costs for these programs to range from $14 million to $29
million. For further information, see Note 5, Commitments and Contingencies -
Environmental Matters.
In 1997, the Illinois Environmental Protection Agency initiated an enforcement
proceeding relating to alleged air quality permit violations at Panhandle's
Glenarm Compressor Station. On November 15, 2001 the Illinois Pollution Control
Board approved an order imposing a penalty of $850 thousand, plus fees and cost
reimbursements of $116 thousand. Under terms of the sale of Panhandle to CMS
Energy, a subsidiary of Duke Energy was obligated to indemnify Panhandle against
this environmental penalty. The state issued a permit in February 2002 requiring
the installation of certain capital improvements at the facility at a cost of
approximately $3 million. It is expected that the capital improvements will
occur in 2002 and 2003.
PE-17
PANHANDLE EASTERN PIPE LINE COMPANY
PANHANDLE EASTERN PIPE LINE COMPANY
CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)
(IN MILLIONS)
Three Months Ended Nine Months Ended
September 30, September 30,
2002 2001 2002 2001
---- ---- ---- ----
OPERATING REVENUE
Transportation and storage of natural gas $ 93 $ 96 $ 297 $ 308
LNG terminalling revenue -- 20 -- 69
Equity earnings from unconsolidated subsidiaries 8 -- 13 --
Other 2 4 12 13
----- ----- ----- -----
Total operating revenue 103 120 322 390
----- ----- ----- -----
Operation and maintenance 32 41 91 111
General and administrative 14 22 47 57
Depreciation and amortization 14 19 39 52
General taxes 5 8 17 22
----- ----- ----- -----
Total operating expenses 65 90 194 242
----- ----- ----- -----
PRETAX OPERATING INCOME 38 30 128 148
OTHER INCOME, NET 4 4 9 8
INTEREST CHARGES
Interest on long-term debt 18 20 53 63
Other interest -- -- (2) (1)
----- ----- ----- -----
Total interest charges 18 20 51 62
NET INCOME BEFORE INCOME TAXES 24 14 86 94
INCOME TAXES 14 6 39 38
----- ----- ----- -----
NET INCOME BEFORE EXTRAORDINARY ITEM 10 8 47 56
EXTRAORDINARY GAIN, NET OF TAX -- -- 1 --
----- ----- ----- -----
CONSOLIDATED NET INCOME $ 10 $ 8 $ 48 $ 56
===== ===== ===== =====
The accompanying condensed notes are an integral part of these statements.
PE-18
PANHANDLE EASTERN PIPE LINE COMPANY
PANHANDLE EASTERN PIPE LINE COMPANY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(IN MILLIONS)
Nine Months Ended
September 30,
2002 2001
---- ----
CASH FLOWS FROM OPERATING ACTIVITIES
Net income $ 48 $ 56
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation and amortization 39 52
Deferred income taxes 65 52
Changes in current assets and liabilities (29) (70)
Other, net (5) (5)
----- -----
Net cash provided by operating activities 118 85
----- -----
CASH FLOWS FROM INVESTING ACTIVITIES
Capital and investment expenditures (80) (50)
Retirements and other (3) (22)
----- -----
Net cash used in investing activities (83) (72)
----- -----
CASH FLOWS FROM FINANCING ACTIVITIES
Contribution from parent -- 150
Net decrease in current note receivable - CMS Capital 7 --
Net decrease (increase) in non-current note receivable - CMS Capital 165 (111)
Long-term debt retirements (134) --
Dividends paid (28) (50)
----- -----
Net cash provided by/(used in) financing activities 10 (11)
----- -----
Net Increase in Cash and Temporary Cash Investments 45 2
CASH AND TEMPORARY CASH INVESTMENTS, BEGINNING OF PERIOD -- --
----- -----
CASH AND TEMPORARY CASH INVESTMENTS, END OF PERIOD $ 45 $ 2
===== =====
OTHER CASH FLOW ACTIVITIES WERE:
Interest paid (net of amounts capitalized) $ 69 $ 80
Income taxes paid (net of refunds) 1 8
The accompanying condensed notes are an integral part of these statements.
PE-19
PANHANDLE EASTERN PIPE LINE COMPANY
PANHANDLE EASTERN PIPE LINE COMPANY
CONSOLIDATED BALANCE SHEETS
(IN MILLIONS)
September 30,
2002 December 31,
(Unaudited) 2001
-------------- ------------
ASSETS
PROPERTY, PLANT AND EQUIPMENT
Cost $1,704 $1,675
Less accumulated depreciation and amortization 179 142
------ ------
Sub-total 1,525 1,533
Construction work-in-progress 39 24
------ ------
Net property, plant and equipment 1,564 1,557
------ ------
INVESTMENTS IN AFFILIATES 86 66
------ ------
CURRENT ASSETS
Cash and temporary cash investments at cost, which approximates market 45 --
Accounts receivable, less allowances of $5 and $3 as of September 30, 2002
and December 31, 2001, respectively 63 114
Gas imbalances - receivable 16 26
System gas and operating supplies 61 55
Deferred income taxes 11 7
Note receivable - CMS Capital 79 86
Other 18 24
------ ------
Total current assets 293 312
------ ------
NON-CURRENT ASSETS
Goodwill, net 700 700
Note receivable - CMS Capital 172 337
Debt issuance cost 5 8
Other 45 30
------ ------
Total non-current assets 922 1,075
------ ------
TOTAL ASSETS $2,865 $3,010
====== ======
The accompanying condensed notes are an integral part of these statements.
PE-20
PANHANDLE EASTERN PIPE LINE COMPANY
PANHANDLE EASTERN PIPE LINE COMPANY
CONSOLIDATED BALANCE SHEETS
(IN MILLIONS)
September 30,
2002 December 31,
(Unaudited) 2001
------------- ------------
COMMON STOCKHOLDER'S EQUITY AND LIABILITIES
CAPITALIZATION
Common stockholder's equity
Common stock, no par, 1,000 shares authorized, issued and outstanding $ 1 $ 1
Paid-in capital 1,286 1,286
Retained earnings 15 (5)
------- -------
Total common stockholder's equity 1,302 1,282
Long-term debt 936 1,082
------- -------
Total capitalization 2,238 2,364
------- -------
CURRENT LIABILITIES
Accounts payable 16 22
Current portion of long-term debt 10 --
Gas imbalances - payable 66 64
Accrued taxes 16 8
Accrued interest 10 26
Accrued liabilities 21 35
Other 38 40
------- -------
Total current liabilities 177 195
------- -------
NON-CURRENT LIABILITIES
Deferred income taxes 194 185
Deferred commitments 174 183
Other 82 83
------- -------
Total non-current liabilities 450 451
------- -------
TOTAL COMMON STOCKHOLDER'S EQUITY AND LIABILITIES $ 2,865 $ 3,010
======= =======
The accompanying condensed notes are an integral part of these statements.
PE-21
PANHANDLE EASTERN PIPE LINE COMPANY
PANHANDLE EASTERN PIPE LINE COMPANY
CONSOLIDATED STATEMENTS OF COMMON STOCKHOLDER'S EQUITY
(UNAUDITED)
(IN MILLIONS)
Nine Months Nine Months
Ended September 30, Ended September 30,
2002 2001
------------------- -------------------
COMMON STOCK
At beginning and end of period $ 1 $ 1
------- -------
OTHER PAID-IN CAPITAL
At beginning of period 1,286 1,127
Contribution from parent -- 150
------- -------
At end of period 1,286 1,277
------- -------
RETAINED EARNINGS
At beginning of period (5) (6)
Net income 48 56
Common stock dividends (28) (50)
------- -------
At end of period 15 --
------- -------
TOTAL COMMON STOCKHOLDER'S EQUITY $ 1,302 $ 1,278
======= =======
The accompanying condensed notes are an integral part of these statements.
PE-22
PANHANDLE EASTERN PIPE LINE COMPANY
PANHANDLE EASTERN PIPE LINE COMPANY
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
These interim Consolidated Financial Statements have not been reviewed by our
independent public accountants as required under Rule 10-01(d) of Regulation
S-X. In April 2002, CMS Energy's Board of Directors, upon the recommendation of
the Audit Committee of the Board, voted to discontinue using Arthur Andersen to
audit Panhandle's financial statements for the year ending December 31, 2002.
Panhandle previously retained Arthur Andersen to review its financial statements
for the quarter ended March 31, 2002. In May 2002, CMS Energy's Board of
Directors engaged Ernst & Young to audit its financial statements for the year
ending December 31, 2002. See Note 5, Commitments and Contingencies - SEC
Investigation and Note 9, Restatements.
Panhandle expects that the review of these interim Consolidated Financial
Statements by our independent public accountants will occur upon completion of
the re-audit of the restated Panhandle Consolidated Financial Statements for
each of the fiscal years ended December 31, 2001 and December 31, 2000.
These interim Consolidated Financial Statements have been prepared by Panhandle
in accordance with SEC rules and regulations. As such, certain information and
footnote disclosures normally included in full year financial statements
prepared in accordance with accounting principles generally accepted in the
United States have been condensed or omitted. Certain prior year amounts have
been reclassified to conform to the presentation in the current year. The
Condensed Notes to Consolidated Financial Statements and the related
Consolidated Financial Statements contained within should be read in conjunction
with the Consolidated Financial Statements and Notes to Consolidated Financial
Statements contained in Panhandle's Form 10-K for the year ended December 31,
2001. Due to the seasonal nature of Panhandle's operations, the results as
presented for this interim period are not necessarily indicative of results to
be achieved for the fiscal year.
1. CORPORATE STRUCTURE AND BASIS OF PRESENTATION
Panhandle Eastern Pipe Line is a wholly owned subsidiary of CMS Gas
Transmission. Panhandle Eastern Pipe Line was incorporated in Delaware in 1929.
Panhandle is engaged primarily in interstate transportation and storage of
natural gas, and through equity investments is also engaged in LNG terminalling
and interstate liquids transportation, and is subject to the rules and
regulations of the FERC.
In December 2001, Panhandle completed a $320 million off-balance sheet
monetization transaction for a portion of its CMS Trunkline LNG business and the
value created by long-term contracts for capacity at the CMS Trunkline LNG Lake
Charles terminal. The joint venture transaction resulted in LNG Holdings owning
100 percent of CMS Trunkline LNG. LNG Holdings is jointly owned by a subsidiary
of Panhandle Eastern Pipe Line and Dekatherm Investor Trust, an unaffiliated
entity. The joint venture (including its $279 million of long-term debt at
September 30, 2002) was not consolidated with Panhandle, as more fully discussed
in Note 9, Restatements.
During the re-audit of Panhandle's financial statements it was concluded that
Panhandle did not meet the conditions precedent to account for the contribution
of the LNG business as a disposition given Panhandle's continuing involvement
and the lack of sufficient participating rights by the third-party equity holder
in the joint venture. As a result, with the concurrence of Ernst & Young,
Panhandle will restate its financial statements to reflect consolidation of LNG
Holdings at December 31, 2001. Panhandle's financial statements for the periods
ended December 31, 2001 and for the quarterly periods
PE-23
PANHANDLE EASTERN PIPE LINE COMPANY
in 2002 will be restated to fully consolidate Panhandle's majority interest in
LNG Holdings. Such restatements will be made as soon as practicable and re-filed
with the SEC. For further information regarding the restatement of Panhandle's
financial statements, see Note 9, Pending Restatements.
PRINCIPLES OF CONSOLIDATION: The consolidated financial statements include the
accounts of Panhandle Eastern Pipe Line and its wholly owned subsidiaries.
Intercompany transactions and balances have been eliminated. Investments in
affiliated companies where Panhandle has the ability to exercise significant
influence, but not control, are accounted for using the equity method. When
special conditions warrant, for example when an affiliate is a highly leveraged
entity and its capital structure is such that Panhandle's share of net income
cannot be simply stated as a percentage of net income based on its equity
ownership percentage, accounting rules dictate that the preferred approach to
equity income measurement is determined by using the Hypothetical Liquidation at
Book Value (HLBV) method. Panhandle originally believed such conditions existed
with its LNG Holdings investment, therefore Panhandle has been using the HLBV
method to account for earnings from this investment. However, with respect to
the restatement described in Note 9, Pending Restatements, Panhandle's financial
statements will be restated to fully consolidate LNG Holdings.
Panhandle owns a one-third interest in Guardian Pipeline, L.L.C. and accounts
for this interest using the equity method. Guardian accounts for the effects of
regulation based on SFAS No. 71, Accounting for the Effects of Certain Types of
Regulation. As a result, Guardian records certain assets and liabilities that
result from the effects of the ratemaking process that would not be recorded
under generally accepted accounting principles for non-regulated entities.
USE OF ESTIMATES: The preparation of financial statements, in conformity with
accounting principles generally accepted in the United States, requires
management to make judgments, estimates and assumptions that affect the reported
amounts of assets and liabilities, disclosure of contingent assets and
liabilities at the date of the financial statements, and the reported amounts of
revenues and expenses during the reporting period. Actual results could
materially differ from those estimates.
SFAS NO. 142, GOODWILL AND OTHER INTANGIBLE ASSETS: SFAS No. 142, issued in July
2001, requires that goodwill no longer be amortized to earnings, but instead be
reviewed for impairment on an annual basis. Goodwill represents the excess of
the fair value of the net assets of acquired companies and was amortized using
the straight-line method, over a forty-year life, through December 31, 2001. The
amortization of goodwill ceased upon adoption of the standard at January 1,
2002. In accordance with the new standard, the first step of testing for
potential goodwill impairment was completed in the second quarter of 2002 which
indicates a significant impairment of Panhandle's goodwill potentially existed
as of January 1, 2002 (see Note 3, Goodwill Impairment). Pursuant to SFAS No.
142 requirements, the actual impairment, when determined upon completion of the
second step of the test, will be reflected as the cumulative effect of an
accounting change, as a restatement of first quarter 2002 results. The required
valuation work is being performed by an independent appraiser and will be
completed in the fourth quarter of 2002. Preliminary results of the second step
appraisal indicate that most of Panhandle's goodwill is impaired as of January
1, 2002. The final results will be announced after completion of the appraiser's
work and review by the company.
PE-24
PANHANDLE EASTERN PIPE LINE COMPANY
For purposes of comparison, the following table presents what net income would
have been in the three month and nine month periods ended September 30, 2002 and
2001 had there been no amortization of goodwill recorded in those periods.
IN MILLIONS
- --------------------------------------------------------------------------------------
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 2002 2001 2002 2001
- --------------------------------------------------------------------------------------
Reported Net Income $10 $8 $48 $56
Add back: Goodwill amortization - 5 - 15
Tax effect - (2) - (6)
---------------------------------------------
Adjusted Net Income $10 $11 $48 $65
=============================================
SFAS NO. 143, ACCOUNTING FOR ASSET RETIREMENT OBLIGATIONS: In June 2001, the
FASB issued SFAS No. 143, Accounting for Asset Retirement Obligations, which is
effective for fiscal years beginning after June 15, 2002. The Statement requires
legal obligations associated with the retirement of long-lived assets to be
recognized at their fair value at the time that the obligations are incurred.
Upon initial recognition of a liability, that cost should be capitalized as part
of the related long-lived asset and allocated to expense over the useful life of
the asset. Panhandle will adopt the Statement on January 1, 2003. Panhandle has
determined that it will be impacted by liabilities related to its offshore
gathering facilities. However, while significant progress has been made toward
the assessment, due to the significant number of documents that must be reviewed
and estimates that must be made to assess the effects of the Statement, the
expected impact of adoption of SFAS No. 143 on Panhandle's financial position or
results of operations has not yet been determined.
SFAS NO. 144, ACCOUNTING FOR THE IMPAIRMENT OR DISPOSAL OF LONG-LIVED ASSETS:
This new standard was issued by the FASB in October 2001, and supersedes SFAS
No. 121 and APB Opinion No. 30. SFAS No. 144 requires that those long-lived
assets be measured at the lower of either the carrying amount or the fair value
less the cost to sell, whether reported in continuing operations or in
discontinued operations. Therefore, discontinued operations will no longer be
measured at net realizable value or include amounts for operating losses that
have not yet occurred. SFAS No. 144 also broadens the reporting of discontinued
operations to include all components of an entity with operations that can be
distinguished from the rest of the entity and that will be eliminated from the
ongoing operations of the entity in a disposal transaction. The adoption of SFAS
No. 144, effective January 1, 2002, has resulted in Panhandle accounting for
impairments or disposal of long-lived assets under the provisions of SFAS No.
144, but has not changed the accounting used for previous asset impairments or
disposals. The new rule significantly changes the criteria for classifying an
asset as held-for-sale. Adoption of the new standard had no material effect on
Panhandle's consolidated results of operations or financial position.
PE-25
PANHANDLE EASTERN PIPE LINE COMPANY
SFAS NO. 145, RESCISSION OF FASB STATEMENTS NO. 4, 44 AND 64, AMENDMENT OF FASB
STATEMENT NO. 13, AND TECHNICAL CORRECTIONS: Issued by the FASB on April 30,
2002, this Statement rescinds SFAS No. 4, Reporting Gains and Losses from
Extinguishment of Debt, and SFAS No. 64, Extinguishment of Debt Made to Satisfy
Sinking-Fund Requirements. As a result, any gain or loss on extinguishment of
debt should be classified as an extraordinary item only if it meets the criteria
set forth in APB Opinion No. 30. The provisions of this section are applicable
to fiscal years beginning 2003. Panhandle is currently studying the effects of
the new standard, but has yet to quantify the effects, if any, of adoption on
its financial statements. SFAS No. 145 amends SFAS No. 13, Accounting for
Leases, to require sale-leaseback accounting for certain lease modifications
that have similar economic impacts to sale-leaseback transactions. This
provision is effective for transactions occurring and financial statements
issued after May 15, 2002.
SFAS NO. 146, ACCOUNTING FOR COSTS ASSOCIATED WITH EXIT OR DISPOSAL ACTIVITIES:
Issued by the FASB in July 2002, this standard requires companies to recognize
costs associated with exit or disposal activities when they are incurred rather
than at the date of a commitment to an exit or disposal plan. SFAS No. 146
supersedes previous accounting guidance, EITF Issue No. 94-3, "Liability
recognition for Certain Termination Benefits and Other Costs to Exit an Activity
(including Certain Costs Incurred In a Restructuring)." This standard is
effective for exit or disposal activities initiated after December 31, 2002. The
scope of SFAS No.146 includes (1) costs related to termination benefits of
employees who are involuntarily terminated, (2) costs to terminate a contract
that is not a capital lease and (3) costs to consolidate facilities or relocate
employees. Panhandle believes there will be no impact on its financial
statements upon adoption of the standard.
SFAS NO. 147, ACQUISITIONS OF CERTAIN FINANCIAL INSTITUTIONS: Issued by the FASB
in October 2002, this standard amends SFAS No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets, and amends other pronouncements
issued previously which are unrelated to the business of Panhandle. These
provisions are effective for transactions occurring on or after October 1, 2002.
Panhandle is currently studying the effects of the new standard, but has yet to
quantify the effects of adoption on its financial statements.
2. REGULATORY MATTERS
In conjunction with a FERC order issued in September 1997, FERC required certain
natural gas producers to refund previously collected Kansas ad-valorem taxes to
interstate natural gas pipelines, including Panhandle Eastern Pipe Line. FERC
ordered the pipelines to refund these amounts to their customers. In June 2001,
Panhandle Eastern Pipe Line filed a proposed settlement with the FERC which was
supported by most of the customers and affected producers. In October 2001, the
FERC approved that settlement. The settlement provided for a resolution of the
Kansas ad valorem tax matter on the Panhandle Eastern Pipe Line system for a
majority of refund amounts. Certain producers and the state of Missouri elected
to not participate in the settlement. At September 30, 2002 and December 31,
2001, accounts receivable included $8 million due from natural gas producers,
and other current liabilities included $12 million and $11 million,
respectively, for related obligations. Remaining amounts collected but not
refunded are subject to refund pending resolution of issues remaining in the
FERC docket and Kansas intrastate proceeding.
In July 2001, Panhandle Eastern Pipe Line filed a settlement with customers on
Order 637 matters to resolve issues including capacity release and imbalance
penalties, among others. On October 12, 2001 and December 19, 2001 FERC issued
orders approving the settlement, with modifications. The settlement changes
became final effective February 1, 2002, resulting in a non-recurring gain
associated with previously collected penalties of $4 million in Other revenue
and a $2 million reversal of related interest expense. Prospectively, penalties
will be credited to customers.
PE-26
PANHANDLE EASTERN PIPE LINE COMPANY
In August 2001, an offer of settlement of Trunkline LNG rates sponsored jointly
by CMS Trunkline LNG, BG LNG Services and Duke LNG Sales was filed with the FERC
and was approved on October 11, 2001. The settlement was placed into effect on
January 1, 2002. As part of the settlement, CMS Trunkline LNG, now owned by LNG
Holdings, a joint venture between Panhandle and Dekatherm Investment Trust,
reduced its maximum rates.
In December 2001, CMS Trunkline LNG, now partially owned by Panhandle, filed
with the FERC a certificate application to expand the Lake Charles facility to
approximately 1.2 bcf per day of sendout capacity versus the current capacity of
630 million cubic feet per day. The BG Group has contract rights for all of this
additional capacity. Storage capacity will also be expanded to 9 bcf, from its
current capacity of 6.3 bcf. On August 27, 2002 the FERC issued a "Preliminary
Determination on Non-Environmental Issues" recommending approval of the planned
expansion project. The FERC's July 2002 Environmental Assessment determined that
the Trunkline LNG expansion facilities do not constitute a major federal action
significantly affecting the environment and recommended certain compliance and
mitigation measures. Comments on the Environmental Assessment were filed on
August 30, 2002. The application for a certificate of public convenience and
necessity of the expansion is still pending final FERC action. The expansion
expenditures are currently expected to be funded by Panhandle loans or equity
contributions to LNG Holdings.
Panhandle has sought refunds from the State of Kansas concerning certain
corporate income tax issues for the years 1981 through 1984. On January 25, 2002
the Kansas Supreme Court entered an order affirming a previous Board of Tax
Court finding that Panhandle was entitled to refunds which with interest total
approximately $26 million. Pursuant to the provisions of the purchase agreement
between CMS Energy and a subsidiary of Duke Energy, Duke retains the benefits of
any tax refunds or liabilities for periods prior to the date of the sale of
Panhandle to CMS Energy.
In February 2002, CMS Trunkline filed a settlement with customers on Order 637
matters to resolve issues including capacity release and imbalance penalties,
among others. On July 5, 2002 FERC issued an order approving the settlement,
with modifications. On October 18, 2002 CMS Trunkline filed tariff sheets with
the FERC to implement the Order 637 changes which will become effective November
1, 2002.
3. GOODWILL IMPAIRMENT
Panhandle has completed the first step of the goodwill impairment testing
required upon adoption of SFAS No. 142, which indicates a significant impairment
of Panhandle's goodwill potentially existed as of January 1, 2002 under the new
standard. Panhandle has $700 million of goodwill recorded as of January 1, 2002
which is subject to this impairment test. Pursuant to SFAS No. 142 requirements,
the actual amount of impairment is determined in a second step involving a
detailed valuation of all assets and liabilities utilizing an independent
appraiser and when determined, will be reflected as a cumulative effect of an
accounting change, restated to the first quarter of 2002. This valuation work is
underway and will be completed in the fourth quarter of 2002. Preliminary
results of the second step appraisal indicate that most of Panhandle's goodwill
is impaired as of January 1, 2002.
PE-27
PANHANDLE EASTERN PIPE LINE COMPANY
4. RELATED PARTY TRANSACTIONS
The following related party amounts and related explanations reflect LNG
Holdings as an unconsolidated off-balance sheet entity. As discussed in Note 9,
Pending Restatements, Panhandle will restate these amounts as soon as
practicable and such restatements will be re-filed with the SEC.
IN MILLIONS
- -----------------------------------------------------------------------------------------------------
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 2002 2001 2002 2001
- -----------------------------------------------------------------------------------------------------
Transportation and storage of natural gas $14 $14 $43 $41
LNG terminalling revenue - 4 - 24
Other revenues 8 - 13 4
Operation and maintenance 9 14 32 35
Other income 2 3 6 7
- -----------------------------------------------------------------------------------------------------
Panhandle has a number of significant transactions with related parties. Revenue
transactions, primarily for the transportation of natural gas for Consumers, CMS
MST and the MCV Partnership, are based on regulated prices, market prices or
competitive bidding. Related party expenses include payments for services
provided by affiliates and payment of overhead costs to CMS Gas Transmission and
CMS Energy, as well as allocated benefit plan costs. Other income is primarily
interest income from the Note receivable - CMS Capital.
Other revenue for the three month and nine month periods ended September 30,
2002 includes equity earnings of $9 million and $18 million, respectively
related to Panhandle's investment in LNG Holdings. Prior to the monetization of
CMS Trunkline LNG in December 2001, income from this business was reflected in
LNG terminalling revenue. The increases were partially offset by equity losses
related to the Centennial Pipeline of $2 million and $5 million, respectively,
in the three and nine-month periods ended September 30, 2002.
In the three months and nine months ended September 30, 2002, Other income
includes $2 million and $6 million, respectively, of interest income on the note
receivable from CMS Capital. In the three months and nine months ended September
30, 2001, Other income includes $3 million and $7 million, respectively, of
interest income on the note receivable from CMS Capital
PE-28
PANHANDLE EASTERN PIPE LINE COMPANY
A summary of certain balances due to or due from related parties included in the
Consolidated Balance Sheets is as follows:
IN MILLIONS
- --------------------------------------------------------------------------------------------------
SEPTEMBER 30, DECEMBER 31,
2002 2001
- --------------------------------------------------------------------------------------------------
Note receivable -- CMS Capital $251 $423
Accounts receivable 26 61
Accounts payable 7 7
Accrued liabilities - 2
Current portion of long-term debt -- LNG Holdings 10 -
Long-term debt -- LNG Holdings 56 75
Deferred commitments -- LNG Holdings 174 183
At September 30, 2002, Note receivable - CMS Capital represented a $251 million
note of which $79 million is shown as current based on estimated draws during
the next twelve months. During April and May 2002, $124 million of the note
receivable with CMS Capital was utilized to retire a portion of Panhandle's
long-term. Due to CMS Energy's financial condition, the liquidity of this note
is potentially adversely affected and proceeds may not be immediately available
upon demand by Panhandle.
Accounts receivable includes $19 million of tax related receivables from CMS
Energy due in November 2002. Due to CMS Energy's financial condition, the
liquidity of these receivables is adversely affected and funds may not be
available to Panhandle when amounts are due. Deferred commitments represents
proceeds received by Panhandle from the LNG monetization transaction which are
expected to be reinvested in the LNG Holdings expansion project filed with FERC
by Trunkline LNG in December 2001. The amount is reduced as Panhandle makes
additional investments in LNG Holdings but will eliminate in consolidation when
LNG Holdings is consolidated pursuant to the restatements.
5. COMMITMENTS AND CONTINGENCIES
CAPITAL EXPENDITURES: Panhandle currently estimates capital expenditures and
investments, including interest costs capitalized, to be $124 million in 2002,
$112 million in 2003 and $124 million in 2004. These amounts include
expenditures associated with an LNG terminal expansion which was filed with FERC
in December 2001 by CMS Trunkline LNG. The expansion expenditures (excluding
capitalized interest), estimated at $8 million in 2002, $33 million in 2003 and
$66 million in 2004, are currently expected to be funded by Panhandle loans or
equity contributions to LNG Holdings, sourced by repayments from CMS Capital on
the outstanding note receivable (see Note 4, Related Party Transactions).
Panhandle prepared these estimates for planning purposes and they are therefore
subject to revision. Panhandle satisfies capital expenditures using cash from
operations, repayment of loans to CMS Capital and contributions from the parent.
LITIGATION: Panhandle is involved in legal, tax and regulatory proceedings
before various courts, regulatory commissions and governmental agencies
regarding matters arising in the ordinary course of business, some of which
involve substantial amounts. Where appropriate, Panhandle has made accruals in
accordance with SFAS No. 5 in order to provide for such matters. Management
believes the final disposition of these proceedings will not have a material
adverse effect on consolidated results of operations, liquidity, or financial
position.
PE-29
PANHANDLE EASTERN PIPE LINE COMPANY
ENVIRONMENTAL MATTERS: Panhandle is subject to federal, state and local
regulations regarding air and water quality, hazardous and solid waste disposal
and other environmental matters. Panhandle has identified environmental
contamination at certain sites on its systems and has undertaken cleanup
programs at these sites. The contamination resulted from the past use of
lubricants containing PCBs in compressed air systems and the prior use of
wastewater collection facilities and other on-site disposal areas. Panhandle
communicated with the EPA and appropriate state regulatory agencies on these
matters. Under the terms of the sale of Panhandle to CMS Energy, a subsidiary of
Duke Energy is obligated to complete the Panhandle cleanup programs at certain
agreed-upon sites and to indemnify against certain future environmental
litigation and claims. Duke Energy's cleanup activities have been completed on
all but one of the agreed-upon sites. Should additional information be requested
regarding sites where compliance information has been submitted, Panhandle would
be obligated to respond to these requests.
As part of the cleanup program resulting from contamination due to the use of
lubricants containing PCBs in compressed air systems, Panhandle Eastern Pipe
Line and Trunkline have identified PCB levels above acceptable levels inside the
auxiliary building that houses the air compressor equipment at one of its
compressor station sites. Panhandle has developed and is implementing an
EPA-approved process to remediate this PCB contamination. Panhandle is also
implementing a plan to assess the interior of auxiliary buildings at other
compressor stations with similar histories of PCB containing lubricants and will
remediate as required. The results of this assessment and remediation will be
managed in accordance with federal, state and local regulations.
At some locations, PCBs have been identified in paint that was applied many
years ago. In accordance with EPA regulations, Panhandle is implementing a
program to remediate sites where such issues have been identified during
painting activities. If PCBs are identified above acceptable levels, the paint
is removed and disposed of in an EPA-approved manner. Approximately 15 percent
of the paint projects in the last few years have required this special
procedure.
The Illinois EPA notified Panhandle Eastern Pipe Line and Trunkline, together
with other non-affiliated parties, of contamination at former waste oil disposal
sites in Illinois. Panhandle and 21 other non-affiliated parties are conducting
an investigation of one of the sites. Final reports are expected in the fourth
quarter of 2002. Panhandle Eastern Pipe Line's and Trunkline's share for the
costs of assessment and remediation of the sites, based on the volume of waste
sent to the facilities, is approximately 17 percent.
Panhandle expects these cleanup programs to continue for several years and has
estimated its share of remaining cleanup costs not indemnified by Duke Energy to
be approximately $21 million. Such costs have been accrued for and are reflected
in Panhandle's Consolidated Balance Sheet in Other Non-current Liabilities.
AIR QUALITY CONTROL: In 1998, the EPA issued a final rule on regional ozone
control that requires revised SIPS for 22 states, including five states in which
Panhandle operates. This EPA ruling was challenged in court by various states,
industry and other interests, including the INGAA, an industry group to which
Panhandle belongs. In March 2000, the court upheld most aspects of the EPA's
rule, but agreed with INGAA's position and remanded to the EPA the sections of
the rule that affected Panhandle. Based on EPA guidance to these states for
development of SIPs, Panhandle expects future compliance costs to range from $15
million to $20 million for capital improvements to be incurred from 2004 through
2007.
As a result of the 1990 Clean Air Act Amendments, the EPA must issue MACT rules
controlling hazardous air pollutants from internal combustion engines and
turbines. These rules are expected in
PE-30
PANHANDLE EASTERN PIPE LINE COMPANY
early 2003. Beginning in 2002, the Texas Natural Resource Conservation
Commission enacted the Houston/Galveston SIP regulations requiring reductions in
nitrogen oxide emissions in an eight county area surrounding Houston.
Trunkline's Cypress Compressor Station is affected and may require the
installation of emission controls. In 2003, the new regulations will also
require all "grand fathered" facilities to enter into the new source permit
program which may require the installation of emission controls at five
additional facilities. The company expects future capital costs for these
programs to range from $14 million to $29 million.
In 1997, the Illinois Environmental Protection Agency initiated an enforcement
proceeding relating to alleged air quality permit violations at Panhandle's
Glenarm Compressor Station. On November 15, 2001 the Illinois Pollution Control
Board approved an order imposing a penalty of $850 thousand, plus fees and cost
reimbursements of $116 thousand. Under terms of the sale of Panhandle to CMS
Energy, a subsidiary of Duke Energy was obligated to indemnify Panhandle against
this environmental penalty. The state issued a permit in February of 2002
requiring the installation of certain capital improvements at the facility at a
cost of approximately $3 million. It is expected that the capital improvements
will occur in 2002 and 2003.
SEC INVESTIGATION: As a result of the round-trip trading transactions at CMS
MST, CMS Energy's Board of Directors established a Special Committee of
independent directors to investigate matters surrounding the transactions and
retained outside counsel to assist in the investigation. The committee completed
its investigation and reported its findings to the Board of Directors in October
2002. The special committee concluded, based on an extensive investigation, that
the round-trip trades were undertaken to raise CMS MST's profile as an energy
marketer with the goal of enhancing its ability to market its services. The
committee found no apparent effort to manipulate the price of CMS Energy Common
Stock or affect energy prices. The Special Committee also made recommendations
designed to prevent any reoccurrences of this nature, some of which have already
been implemented, including the termination of speculative trading and revisions
to CMS Energy's risk management policy. The Board of Directors adopted, and CMS
Energy has begun implementing, the remaining recommendations of the Special
Committee.
CMS Energy is cooperating with other investigations concerning round-trip
trading, including an investigation by the SEC regarding round-trip trades and
CMS Energy's financial statements, accounting policies and controls, and
investigations by the United States Department of Justice, the Commodity Futures
Trading Commission and the FERC. CMS Energy has also received subpoenas from the
U.S. Attorney's Office for the Southern District of New York and from the U.S.
Attorney's Office in Houston regarding investigations of these trades and has
received a number of shareholder class action lawsuits. CMS Energy is unable to
predict the outcome of these matters, and Panhandle is unable to predict what
effect, if any, these investigations will have on its business.
OTHER COMMITMENTS AND CONTINGENCIES: In 1993, the U.S. Department of the
Interior announced its intention to seek additional royalties from gas producers
as a result of payments received by such producers in connection with past
take-or-pay settlements, and buyouts and buydowns of gas sales contracts with
natural gas pipelines. Panhandle Eastern Pipe Line and CMS Trunkline, with
respect to certain producer contract settlements, may be contractually required
to reimburse or, in some instances, to indemnify producers against such royalty
claims. The potential liability of the producers to the government and of the
pipelines to the producers involves complex issues of law and fact which are
likely to take substantial time to resolve. If required to reimburse or
indemnify the producers, Panhandle Eastern Pipe Line and CMS Trunkline may file
with FERC to recover a portion of these costs from pipeline customers.
Management believes these commitments and contingencies will not have a material
adverse effect on consolidated results of operations, liquidity or financial
position.
PE-31
PANHANDLE EASTERN PIPE LINE COMPANY
In December 2001, Panhandle contributed its interest in CMS Trunkline LNG to LNG
Holdings which then raised $30 million from the issuance of equity to Dekatherm
Investor Trust and $290 million from non-recourse bank loans. Panhandle
guaranteed repayment of $90 million of these loans if the joint venture had not
obtained replacement lenders by March 2002. Replacement lenders were found by
LNG Holdings, and Panhandle was not required to perform under the guaranty,
which is now expired. Panhandle Eastern Pipe Line has provided indemnities to
certain parties involved in the transaction for pre-closing claims and
liabilities, and subsidiaries of Panhandle have provided indemnities for certain
post-closing expenses and liabilities as the manager/operator of the joint
venture.
Panhandle has a note payable to LNG Holdings, which now is callable due to the
lowering of Panhandle's debt ratings (See Note 6, Debt Rating Downgrades). At
September 30, 2002 the remaining balance on the original $75 million note
payable was approximately $66 million. Dekatherm Investor Trust has agreed not
to make demand for payment before November 22, 2002 in return for a fee and an
agreement for Panhandle to acquire Dekatherm Investor Trust's interest in LNG
Holdings. When Panhandle acquires Dekatherm Investor Trust's interest, it will
then own 100 percent of LNG Holdings and will not demand payment on the note
payable to LNG Holdings.
Panhandle owns a one-third interest in Centennial along with TEPPCO Partners
L.P. and Marathon Ashland Petroleum LLC. In May 2001, in conjunction with the
Centennial Pipeline project which began commercial service in April 2002,
Panhandle has provided a guaranty related to project financing in an amount up
to $50 million during the initial operating period of the project. The guaranty
will be released when Centennial reaches certain operational and financial
targets. Due to rating agency downgrades of Panhandle's debt, the Centennial
lender required additional credit support from Panhandle. On September 27, 2002
Panhandle's partners provided credit support of $25 million each in the form of
guarantees to the Centennial lender to cover Panhandle's $50 million obligation.
The partners will be paid credit fees by Panhandle on the outstanding balance of
the guarantees for any periods for which they are in effect. This additional
credit support does not remove Panhandle from its original $50 million
obligation. For further information, see Note 6, Debt Rating Downgrades.
Panhandle owns a one-third interest in Guardian along with Viking Gas
Transmission and WICOR. Guardian is currently constructing a 141-mile, 36-inch
pipeline from Illinois to Wisconsin for the transportation of natural gas. In
November 2001, in conjunction with the Guardian Pipeline project, Panhandle
provided a guaranty related to project financing for a maximum of $60 million
during the construction and initial operating period of the project, which is
expected to be completed in late 2002. The guaranty will be released when
Guardian reaches certain operational and financial targets. Due to rating agency
downgrades of Panhandle's debt, the Guardian lender assessed credit fees and
required additional credit support from Panhandle. In October 2002, Panhandle
provided a letter of credit to the lenders which constitutes acceptable credit
support under the Guardian financing agreement. This letter of credit was cash
collateralized by Panhandle with approximately $63 million. As of September 30,
2002, Panhandle has also provided $16 million of equity contributions to
Guardian. For further information, see Note 6, Debt Rating Downgrades.
As discussed above, Panhandle's financial statements will be restated. As a
result, Panhandle is at present unable to deliver certified September 30, 2002
financial statements to the LNG Holdings lenders as required under that credit
facility. Although Panhandle intends to seek waivers of this requirement if it
cannot timely provide such certified financial statements, should it be unable
to do so, LNG Holdings could be declared to be in default under its credit
facility and the debt thereunder could be accelerated and become immediately due
and payable. In addition, the occurrence of such an acceleration could cause the
associated $75 million loan to Panhandle from LNG Holdings to become immediately
due and payable.
Occasionally, Panhandle will purchase surety bonds to indemnify third parties
for unforeseen events which may occur in the course of construction or repair
projects. As of September 30, 2002, Panhandle has purchased $3.6 million of
these surety bonds.
Panhandle has a deferred state tax asset attributable to temporary differences
reflecting state tax loss carryforwards of $11 million as of September 30, 2002.
These carryforwards expire after 15 years, and their application for reduction
of future taxes is dependent on Panhandle's taxable income in 2013 and beyond
when these assets begin to expire. The possibility exists that this deferred tax
asset may not being fully realized, and a valuation allowance may be required at
some point in the future.
PE-32
PANHANDLE EASTERN PIPE LINE COMPANY
The Job Creation and Worker Assistance Act of 2002 provided to corporate
taxpayers a five-year carryback of tax losses incurred in 2001 and 2002. As a
result of this legislation, CMS Energy was able to carry back a consolidated
2001 tax loss to tax years 1996 through 1999 and obtain refunds of prior years
tax payments totaling $217 million. The tax loss carrryback, however, resulted
in a reduction in alternative minimum tax credit carryforwards that previously
had been recorded by CMS Energy as deferred tax assets in the amount of $41
million. This one-time non-cash reduction in alternative minimum tax credit
carryforwards has been reflected in the tax provisions of CMS Energy and each of
its consolidated subsidiaries, as of September 2002, according to their
contributions to the consolidated CMS Energy tax loss, of which $5 million was
allocated to Panhandle. This represents an allocation of only one of CMS
Energy's consolidated tax return items, which will be calculated and allocated
to various CMS Energy subsidiaries in the fourth quarter of 2002. The amount of
the final tax allocations to Panhandle may be materially different than the $5
million recorded for this one item in September.
6. DEBT RATING DOWNGRADES
On June 11, 2002 Moody's Investors Service, Inc. lowered its rating on
Panhandle's senior unsecured notes from Baa3 to Ba2 based on concerns
surrounding the liquidity and debt levels of CMS Energy. On July 15, 2002 Fitch
Ratings, Inc lowered its rating on these notes from BBB to BB+ and again on
September 4, 2002 to BB based on similar concerns. On July 16, 2002 S&P also
lowered its rating on these notes from BBB- to BB, in line with their rating on
CMS Energy based on their belief that CMS Energy and its subsidiaries are at
equal risk of default since the parent relies on its subsidiaries to meet its
financial commitments. Effective with this downgrade, Panhandle's debt is below
investment grade. Each of the three major ratings services currently have
negative outlooks for CMS Energy and its subsidiaries, due to uncertainties
associated with CMS Energy's financial condition and liquidity pending
resolution of the round trip trading investigations and lawsuits, the Special
Committee investigation, financial statement restatement and re-audit, and
access to the capital markets.
Panhandle, as a result of the ratings downgrade by both Moody's and S&P to below
investment grade levels, can be required to pay the balance of the demand loan
owed LNG Holdings including the remaining principal and accrued interest at any
time such downgrades exist. Dekatherm Investor Trust has agreed not to make
demand for payment of the approximately $66 million remaining of the original
$75 million note payable before November 22, 2002 in return for a fee and an
agreement for Panhandle to acquire Dekatherm Investor Trust's interest in LNG
Holdings. When Panhandle acquires Dekatherm Investor Trust's interest, it will
then own 100 percent of LNG Holdings and will not demand payment on the note
payable to LNG Holdings.
In conjunction with the Centennial and Guardian pipeline projects, Panhandle has
provided guarantees related to the project financings during the construction
phases and initial operating periods. On July 17, following the debt downgrades
by Moody's and S&P, the lender sent notice to Panhandle, pursuant to the terms
of the Guaranty Agreement, requiring Panhandle to provide acceptable credit
support for its pro rata portion of these construction loans, which aggregate
$110 million including anticipated future draws. On September 27, 2002
Panhandle's Centennial partners provided credit support of $25 million each in
the form of guarantees to the lender to cover Panhandle's obligation of $50
million of loan guarantees. The partners will be paid credit fees by Panhandle
on the outstanding balance of the guarantees for any periods for which they are
in effect. This additional credit support does not remove Panhandle from its
original $50 million obligation.
In October 2002, Panhandle provided a letter of credit to the lenders which
constitutes acceptable credit support under the Guardian financing agreement.
This letter of credit was cash collateralized by
PE-33
PANHANDLE EASTERN PIPE LINE COMPANY
Panhandle with approximately $63 million. As of September 30, 2002, Panhandle
has also provided $16 million of equity contributions to Guardian.
Panhandle's senior unsecured notes were not impacted by the debt rating
downgrades, but are subject to other requirements such as the maintenance of
certain fixed charge coverage ratios, leverage ratios and limitations on liens
which if not met, limits certain payments. At September 30, 2002, Panhandle was
in compliance with all covenants.
7. SYSTEM GAS
Panhandle classifies its current system gas at lower of cost or market. Amounts
for system gas, reflected in System gas and operating supplies on the
consolidated balance sheet, are $51 million and $45 million at an average of
$3.45 and $2.50 per dekatherm at September 30, 2002 and December 31, 2001,
respectively. Panhandle classifies its non-current system gas in Other
non-current assets and it is recorded at cost of $27 million and $18 million at
September 30, 2002 and December 31, 2001, respectively.
8. POSSIBLE SALE OF PANHANDLE
In August 2002, CMS Energy is exploring the sale of the Panhandle and CMS Field
Services business units as part of an ongoing effort to strengthen its balance
sheet, improve its credit ratings and enhance financial flexibility. The
companies considered for sale include Panhandle Eastern Pipe Line, CMS
Trunkline, Sea Robin, Pan Gas Storage and including Panhandle's interests in LNG
Holdings, Guardian and Centennial. CMS Energy had previously announced an
intention to sell Panhandle's separate interest in Centennial but these efforts
have been discontinued. CMS Energy has begun assessing the market's interest in
purchasing the pipeline and field services businesses, and it is reviewing the
financial, legal and regulatory issues associated with the possible sale.
9. PENDING RESTATEMENTS
In connection with Ernst & Young's re-audit of the fiscal years ended December
31, 2001 and 2000, Panhandle has determined, in consultation with Ernst & Young,
that certain adjustments (unrelated to the round-trip trades) by Panhandle to
its consolidated financial statements for the fiscal years ended December 2001
and 2000 are required. At the time it adopted the accounting treatment for these
items, Panhandle believed that such accounting was appropriate under generally
accepted accounting principles and Arthur Andersen concurred. CMS Energy and
Panhandle are in the process of advising the SEC of these adjustments before
Panhandle restates its financial statements as disclosed below, and Panhandle
intends to amend its 2001 Form 10-K and each of the 2002 Form 10-Qs by the end
of January 2003.
As was previously disclosed in late 2001, Panhandle entered into a structured
transaction to monetize a portion of the value of a long-term terminalling
contract of its Liquified Natural Gas (LNG) subsidiary. The LNG business was
contributed to LNG Holdings, which received an equity investment from an
unaffiliated third party, Dekatherm Investor Trust and obtained new loans
secured by the assets. After paying expenses, net proceeds of $235 million were
distributed to Panhandle for the contributed LNG assets, and the joint venture
also loaned $75 million to Panhandle. While the proceeds received by Panhandle
were in excess of its book basis, a gain on the transaction was not recorded.
This excess was recorded as a deferred commitment, reflecting the fact that
Panhandle was expecting to reinvest proceeds into LNG Holdings for a planned
expansion. In addition, under the joint venture structure, Panhandle retained
substantial control over the day to day activities of LNG Holdings and has the
primary economic interest in the joint venture. Initially, Panhandle believed
that off-balance sheet treatment for the joint venture was appropriate under
generally accepted accounting principles and Arthur Andersen concurred. Upon
further analysis of these facts at this time, Panhandle has now concluded that
it did not meet the conditions precedent to account for the contribution of
the LNG business as a disposition given Panhandle's continuing involvement
and the lack of sufficient participating rights by the third-party equity
holder in the joint venture. As a result, with the concurrence of Ernst &
Young, Panhandle will restate its financial statements to reflect consolidation
of LNG Holdings at December 31, 2001, and thereby recognize a net increase of
$215 million of debt, the elimination of $183 million of deferred commitment,
minority interest of $30 million and other net assets of $62 million.
PE-34
PANHANDLE EASTERN PIPE LINE COMPANY
With the exception of certain immaterial reclassifications, there will be no
impact to 2001 net income resulting from this accounting treatment. In 2002, the
quarterly income recorded would be impacted due to the timing of earnings
recognition from LNG Holdings, with income generally being recognized earlier by
Panhandle upon consolidation. In addition, the gross revenues and expenses will
be recorded on a consolidated basis versus the equity income previously
recorded. For the quarterly periods in 2002 there will be an increase in net
income of $4 million for the period ending March 31, 2002 and decrease of $1
million for each of the quarterly periods ending June and September 2002 due to
equity income previously being recognized only to the extent cash was received
by Panhandle. The September 2002 balance sheet impact will include a net
increase of $219 million of debt, the elimination of $174 million of deferred
commitment, minority interest of $31 million, a $19 reduction to equity
primarily from mark-to-market adjustments related to debt hedges, and $56
million of other net assets.
In addition to the above adjustment, Panhandle's restated consolidated financial
statements will also include other adjustments identified in the re-audit. These
other adjustments include immaterial adjustments to SERP liabilities and balance
sheet adjustments required to reconcile intercompany accounts payable and
accounts receivable.
CMS Energy and Panhandle are in the process of advising the SEC of these
adjustments before restating their financial statements as disclosed below, and
intends to amend their respective 2001 Form 10-Ks and each of the 2002 Form
10-Qs by the end of January 2003.
PE-35
QUANTITATIVE AND QUALITATIVE
DISCLOSURES ABOUT MARKET RISK
CMS ENERGY
Quantitative and Qualitative Disclosures about Market Risk is contained in PART
I: CMS ENERGY CORPORATION'S MANAGEMENT'S DISCUSSION AND ANALYSIS, which is
incorporated by reference herein.
CONSUMERS
Quantitative and Qualitative Disclosures about Market Risk is contained in PART
I: CONSUMERS' ENERGY COMPANY'S MANAGEMENT'S DISCUSSION AND ANALYSIS, which is
incorporated by reference herein.
CONTROLS AND PROCEDURES
DISCLOSURE AND INTERNAL CONTROLS
Each of CMS Energy's, Consumer's and Panhandle's CEOs and CFOs are responsible
for establishing and maintaining their respective disclosure controls and
procedures. Management, under the direction of their respective principal
executive and financial officers, have evaluated the effectiveness of their
respective disclosure controls and procedures as of September 30, 2002. Based on
these evaluations, other than the control weaknesses at CMS MST described below
that effects CMS Energy's evaluation, each of CMS Energy's, Consumer's and
Panhandle's CEOs and CFOs have concluded that disclosure controls and procedures
are effective to ensure that material information was presented to them and
properly disclosed, particularly during the third quarter of 2002. There have
been no significant changes in CMS Energy's, Consumer's and Panhandle's internal
controls or in factors, other than as discussed below, that could significantly
affect internal controls subsequent to September 30, 2002.
CONTROL WEAKNESSES AT CMS MST
During the audit cycle of 2001, it was determined that there were several
weaknesses which existed in the CMS MST accounting controls, in particular those
relating to reconciling the activity and balances in subsidiary receivable and
payable ledgers with balances reflected in the general ledger. Senior
management, the Audit Committee of the Board of Directors and the independent
auditors were all notified about the situation and a plan of remediation was
begun, including replacement of key personnel. While important changes in
control have been initiated, some elements of the remediation plans have been
unavoidably delayed by the requirement to completely re-audit the CMS Energy
financial statements for years 2000 and 2001. Management believes that
supplemental procedures and personnel currently in place, along with the
significant contraction of the trading business planned by management, have
allowed for continuing business activity while the control weaknesses are
remediated and staffing positions are filled by qualified candidates. Management
further expects controls corrections to be completed before the end of the 2002
audit cycle.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The discussion below is limited to an update of developments that have occurred
in various judicial and administrative proceedings, many of which are more fully
described in CMS Energy's, Consumers' and Panhandle's Form 10-K for the year
ended December 31, 2001. Reference is also made to the CONDENSED NOTES TO THE
CONSOLIDATED FINANCIAL STATEMENTS, in particular Note 5 - Uncertainties for CMS
Energy, Note 2, Uncertainties for Consumers, and Note 5 - Commitments and
Contingencies for Panhandle, included herein for additional information
regarding various pending administrative and judicial proceedings involving
rate, operating, regulatory and environmental matters.
CMS ENERGY
AMERICAN HOME ASSURANCE COMPANY LITIGATION
American Home Assurance Company ("AHA") is one of the issuers of a joint and
several surety bond, with a remaining surety amount of approximately $187
million, supporting a CMS MST gas supply contract. The issuer commenced
litigation on August 9, 2002 against Enterprises and CMS MST in the U.S.
District Court for the Eastern District of Michigan (the "U.S. District Court")
seeking to require Enterprises and CMS MST to provide acceptable collateral and
to prevent them from disposing of or transferring any corporate assets outside
the ordinary course of business before the Court has an opportunity to fully
adjudicate the issuer's claim. Enterprises and CMS MST continue to work with the
issuer to find mutually satisfactory arrangements.
St. Paul Fire and Marine Insurance Company ("St. Paul"), the co-surety on the
bond with AHA, has similar rights in connection with surety bonds supporting two
other CMS MST gas supply contracts, where the remaining surety amounts total
approximately $112 million. St. Paul has entered into discussions with CMS MST
about the possible posting of acceptable collateral for all three additional
surety bonds; however, to date no legal action has commenced.
CO-1
CMS Energy and AIG have reached a settlement in principle that would provide AHA
and St. Paul with acceptable collateral and resolve AHA's litigation. However,
the settlement is subject to final documentation as well as approval by the
banks party to the CMS Energy secured credit facilities.
DEMAND FOR ACTIONS AGAINST OFFICERS AND DIRECTORS
The Board of Directors of CMS Energy received a demand, on behalf of a
shareholder of Common Stock, that it commence civil actions (i) to remedy
alleged breaches of fiduciary duties by CMS Energy officers and directors in
connection with round-trip trading at CMS Energy, and (ii) to recover damages
sustained by CMS Energy as a result of alleged insider trades alleged to have
been made by certain current and former officers of CMS Energy and its
subsidiaries. If the Board elects not to commence such actions, the shareholder
has stated that he will initiate a derivative suit, bringing such claims on
behalf of CMS Energy. CMS Energy is seeking to elect two new members to its
Board of Directors to serve as an independent litigation committee to determine
whether it is in the best interest of the company to bring the action demanded
by the shareholder. Counsel for the shareholder has agreed to extend the time
for CMS Energy to respond to the demand.
CMS ENERGY AND CONSUMERS
EMPLOYMENT RETIREMENT INCOME SECURITY ACT CLASS ACTION LAWSUITS
CMS Energy is a named defendant, along with Consumers, CMS MST and certain named
and unnamed officers and directors, in two lawsuits brought as purported class
actions on behalf of participants and beneficiaries of the CMS Employee's
Savings and Incentive Plan (the "Plan"). The two cases, filed in July 2002 in
the U.S. District Court, were consolidated by the trial judge. Plaintiffs allege
breaches of fiduciary duties under ERISA and seek restitution on behalf of the
Plan with respect to a decline in value of the shares of CMS Energy Common
Stock held in the Plan. Plaintiffs also seek other equitable relief and legal
fees. These cases will be vigorously defended. CMS Energy and Consumers cannot
predict the outcome of this litigation.
SECURITIES CLASS ACTION LAWSUITS
Between May and July 2002, eighteen separate civil lawsuits were filed in the
U.S. District Court in connection with round-trip trading, alleging (i)
violation of Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934
("Exchange Act") and (ii) violation of Section 20(a) of the Exchange Act. All
suits name Messrs. McCormick and Wright and CMS Energy as defendants. Consumers,
Mr. Joos and Ms. Pallas are named as defendants on certain of the suits. The
cases will be consolidated into a single lawsuit. These complaints generally
seek unspecified damages based on allegations that the defendants violated
United States securities laws and regulations by making allegedly false and
misleading statements about the business and financial condition of CMS Energy
and Consumers. These cases will be vigorously defended. CMS Energy and Consumers
cannot predict the outcome of this litigation.
CO-2
CMS ENERGY, CONSUMERS AND PANHANDLE
ENVIRONMENTAL MATTERS: CMS Energy, Consumers, Panhandle and their subsidiaries
and affiliates are subject to various federal, state and local laws and
regulations relating to the environment. Several of these companies have been
named parties to various actions involving environmental issues. Based on their
present knowledge and subject to future legal and factual developments, CMS
Energy, Consumers and Panhandle believe that it is unlikely that these actions,
individually or in total, will have a material adverse effect on their financial
condition. See CMS Energy's, Consumers' and Panhandle's MANAGEMENT'S DISCUSSION
AND ANALYSIS; and CMS Energy's, Consumers' and Panhandle's CONDENSED NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS.
ITEM 5. OTHER INFORMATION
In order for a shareholder to submit a proposal for a vote at the CMS Energy
2003 Annual Meeting, the shareholder must assure that CMS Energy receives the
proposal on or before March 6, 2003. The shareholder must address the proposal
to: Michael D. VanHemert, Corporate Secretary, Fairlane Plaza South, Suite 1100,
330 Town Center Drive, Dearborn, Michigan 48126. If the shareholder fails to
submit the proposal on or before March 6, 2003, then management may use its
discretionary voting authority to decide if it will submit the proposal to vote
when the shareholder raises the proposal at the CMS Energy 2003 Annual Meeting.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(A) LIST OF EXHIBITS
(12) CMS Energy: Statements regarding computation of Ratio of
Earnings to Fixed Charges
CO-3
(B) REPORTS ON FORM 8-K
CMS ENERGY
During 3rd Quarter 2002, CMS Energy filed reports of Form 8-K on July 30, 2002,
August 8, 2002 and November 4, 2002 covering matters pursuant to ITEM 5. OTHER
EVENTS.
CONSUMERS
During 3rd Quarter 2002, Consumers filed reports of Form 8-K on July 30, 2002
and August 8, 2002 covering matters pursuant to ITEM 5. OTHER EVENTS.
PANHANDLE
During 3rd Quarter 2002, Panhandle filed reports of Form 8-K on July 30, 2002
and August 8, 2002 covering matters pursuant to ITEM 5. OTHER EVENTS.
CO-4
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, each
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized. The signature for each undersigned
company shall be deemed to relate only to matters having reference to such
company or its subsidiary.
CMS ENERGY CORPORATION
(Registrant)
Dated: November 14, 2002 By: /s/ T.J. Webb
-----------------------------------------
Thomas J. Webb
Executive Vice President and
Chief Financial Officer
CONSUMERS ENERGY COMPANY
(Registrant)
Dated: November 14, 2002 By: /s/ T.J. Webb
-----------------------------------------
Thomas J. Webb
Executive Vice President and
Chief Financial Officer
PANHANDLE EASTERN PIPE LINE COMPANY
(Registrant)
Dated: November 14, 2002 By: /s/ T.J. Webb
-----------------------------------------
Thomas J. Webb
Executive Vice President and
Chief Financial Officer
CERTIFICATIONS
The Certifications of the principal executive officer and principal financial
officer of each of CMS Energy Corporation, Consumers Energy Company and
Panhandle Eastern Pipe Line Company will not be provided as a result of the
re-auditing of CMS Energy Corporation's financial statements for each of the
fiscal years ended December 31, 2001 and December 31, 2000, which includes audit
work at Consumers Energy Company and Panhandle Eastern Pipe Line Company for
these periods. See "Explanatory Note" at the beginning of this Form 10-Q. These
certifications will be filed by amendment to this Form 10-Q.
CO-5
CMS ENERGY, CONSUMERS AND PANHANDLE EXHIBITS
Exhibit
Number Description
- --------------------------------------------------------------------------------
(12) - Statement regarding computation of CMS Energy's Ratio of
Earnings to Fixed Charges.
EXHIBIT (12)
EXHIBIT (12)
CMS ENERGY CORPORATION
Ratio of Earnings to Fixed Charges and Preferred Securities Dividends and
Distributions
(Millions of Dollars)
Nine Months
Ended Years Ended December 31 -
September 30, 2002 2001 2000 1999 1998 1997
-------------------------------------------------------------------
(b) (c) (d)
Earnings as defined (a)
Consolidated net income $337 $(545) $ 36 $ 277 $ 242 $ 244
Discontinued operations (186) 185 (3) 14 12 (1)
Income taxes 147 (73) 50 63 100 108
Exclude equity basis subsidiaries (102) - (171) (84) (92) (80)
Fixed charges as defined, adjusted to
exclude capitalized interest of $14,
$38, $48, $41, $29, and $13 million
for the nine months ended
September 30, 2002, and the years
ended December 31, 2001, 2000,
1999, 1998, and 1997, respectively 500 751 736 594 393 360
-------------------------------------------------------------------
Earnings as defined $ 696 $ 318 $ 648 $ 864 $ 655 $ 631
===================================================================
Fixed charges as defined (a)
Interest on long-term debt $ 385 $ 573 $ 591 $ 502 $ 318 $ 273
Estimated interest portion of lease rental 21 6 7 8 8 10
Other interest charges 3 58 38 62 47 49
Preferred securities dividends and
distributions 105 152 147 96 77 67
-------------------------------------------------------------------
Fixed charges as defined $ 514 $ 789 $ 784 $ 668 $ 450 $ 397
===================================================================
Ratio of earnings to fixed charges and
preferred securities dividends and
distributions 1.35 - - 1.29 1.46 1.59
===================================================================
NOTES:
(a) Earnings and fixed charges as defined in instructions for Item 503 of
Regulation S-K.
(b) For the year ended December 31, 2001, fixed charges exceeded earnings by
$471 million. Earnings as defined include $704 million of pretax contract
losses, asset revaluations and other charges. The ratio of earnings to fixed
charges and preferred securities dividends and distributions would have been
1.30 excluding these amounts.
(c) For the year ended December 31, 2000, fixed charges exceeded earnings by
$136 million. Earnings as defined include a $329 million pretax impairment loss
on the Loy Yang investment. The ratio of earnings to fixed charges and preferred
securities dividends and distributions would have been 1.25 excluding this
amount.
(d) Excludes a cumulative effect of change in accounting after-tax gain of $43
million.
