10-Q 1 k80589e10vq.txt QUARTERLY REPORT DATED SEPTEMBER 30, 2003 ================================================================================ 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, 2003 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) One Energy Plaza, Jackson, Michigan 49201 (517) 788-0550 1-5611 CONSUMERS ENERGY COMPANY 38-0442310 (A Michigan Corporation) One Energy Plaza, Jackson, Michigan 49201 (517) 788-0550 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 [ ] Indicate by check mark whether the Registrants are accelerated filers (as defined in Rule 12b-2 of the Exchange Act). CMS ENERGY CORPORATION: Yes [X] No [ ] CONSUMERS ENERGY COMPANY: Yes [ ] No [X] Number of shares outstanding of each of the issuer's classes of common stock at November 1, 2003: CMS ENERGY CORPORATION: CMS Energy Common Stock, $.01 par value 161,130,925 CONSUMERS ENERGY COMPANY, $10 par value, privately held by CMS Energy Corporation 84,108,789
================================================================================ CMS ENERGY CORPORATION AND CONSUMERS ENERGY COMPANY QUARTERLY REPORTS ON FORM 10-Q TO THE UNITED STATES SECURITIES AND EXCHANGE COMMISSION FOR THE QUARTER ENDED SEPTEMBER 30, 2003 This combined Form 10-Q is separately filed by CMS Energy Corporation and Consumers Energy Company. Information contained herein relating to each individual registrant is filed by such registrant on its own behalf. Accordingly, except for its subsidiaries, Consumers Energy Company makes no representation as to information relating to any other companies affiliated with CMS Energy Corporation. TABLE OF CONTENTS
Page -------- Glossary.................................................................................................. 4 PART I: FINANCIAL INFORMATION CMS Energy Corporation Management's Discussion and Analysis Forward-Looking Statements and Risk Factors..................................................... CMS - 1 Critical Accounting Policies.................................................................... CMS - 1 Results of Operations........................................................................... CMS - 14 Capital Resources and Liquidity................................................................. CMS - 20 Outlook......................................................................................... CMS - 26 Other Matters................................................................................... CMS - 40 Consolidated Financial Statements Consolidated Statements of Income............................................................... CMS - 44 Consolidated Statements of Cash Flows........................................................... CMS - 46 Consolidated Balance Sheets..................................................................... CMS - 48 Consolidated Statements of Common Stockholders' Equity.......................................... CMS - 50 Condensed Notes to Consolidated Financial Statements: 1. Corporate Structure and Summary of Significant Accounting Policies......................... CMS - 51 2. Asset Sales and Restructuring.............................................................. CMS - 54 3. Discontinued Operations.................................................................... CMS - 57 4. Uncertainties.............................................................................. CMS - 61 5. Financings and Capitalization.............................................................. CMS - 82 6. Earnings Per Share......................................................................... CMS - 89 7. Risk Management Activities and Financial Instruments....................................... CMS - 91 8. Equity Method Investments.................................................................. CMS - 95 9. Reportable Segments........................................................................ CMS - 96 10. Implementation of New Accounting Standards................................................. CMS - 98
2 TABLE OF CONTENTS (CONTINUED)
Page -------- Consumers Energy Company Management's Discussion and Analysis Forward-Looking Statements and Risk Factors..................................................... CE - 1 Critical Accounting Policies.................................................................... CE - 1 Results of Operations........................................................................... CE - 11 Capital Resources and Liquidity................................................................. CE - 14 Outlook......................................................................................... CE - 19 Other Matters................................................................................... CE - 28 Consolidated Financial Statements Consolidated Statements of Income............................................................... CE - 32 Consolidated Statements of Cash Flows........................................................... CE - 33 Consolidated Balance Sheets..................................................................... CE - 34 Consolidated Statements of Common Stockholder's Equity.......................................... CE - 36 Condensed Notes to Consolidated Financial Statements: 1. Corporate Structure and Summary of Significant Accounting Policies.......................... CE - 38 2. Uncertainties............................................................................... CE - 40 3. Financings and Capitalization............................................................... CE - 56 4. Financial and Derivative Instruments........................................................ CE - 61 5. Implementation of New Accounting Standards.................................................. CE - 64 Quantitative and Qualitative Disclosures about Market Risk................................................ CO - 1 PART II: OTHER INFORMATION Item 1. Legal Proceedings............................................................................ CO - 1 Item 2. Changes in Securities and Use of Proceeds.................................................... CO - 3 Item 5. Other Information............................................................................ CO - 3 Item 6. Exhibits and Reports on Form 8-K............................................................. CO - 3 Signatures........................................................................................... CO - 5
3 GLOSSARY Certain terms used in the text and financial statements are defined below ABATE........................................ Association of Businesses Advocating Tariff Equity 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. AEP.......................................... American Electric Power, a non-affiliated company ALJ.......................................... Administrative Law Judge Alliance..................................... Alliance Regional Transmission Organization 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. 20........................... APB Opinion No. 20, "Accounting Changes" APB Opinion No. 30........................... APB Opinion No. 30, "Reporting Results of Operations - Reporting the Effects of Disposal of a Segment of a Business" APT.......................................... Australian Pipeline Trust ARO.......................................... Asset retirement obligation 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, formerly a wholly owned subsidiary of CMS Gas Transmission, owned a one-third interest CEO.......................................... Chief Executive Officer CFO.......................................... Chief Financial Officer Clean Air Act................................ Federal Clean Air Act, as amended 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 Field Services........................... CMS Field Services, formerly a wholly owned subsidiary of CMS Gas Transmission. The sale of this subsidiary closed in July 2003. CMS Gas Transmission......................... CMS Gas Transmission Company, a subsidiary of Enterprises CMS Generation............................... CMS Generation Co., a subsidiary of Enterprises
4 CMS Holdings................................. CMS Midland Holdings Company, a subsidiary of Consumers CMS Land..................................... CMS Land Company, 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, formerly a subsidiary of Enterprises CMS Pipeline Assets.......................... CMS Enterprises pipeline assets in Michigan and Australia CMS Viron.................................... CMS Viron Energy Services, formerly a wholly owned subsidiary of CMS MST. The sale of this subsidiary closed in July 2003. Common Stock................................. All classes of Common Stock of CMS Energy and each of its subsidiaries, or any of them individually, at the time of an award or grant under the Performance Incentive Stock Plan Consumers.................................... Consumers Energy Company, a subsidiary of CMS Energy Consumers Receivables Funding II............. Consumers Receivables Funding II LLC, 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, LLC, a wholly owned subsidiary of CMS Generation 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 EITF Issue No. 02-03......................... Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities El Chocon.................................... The 1,200 MW hydro power plant located in Argentina, which CMS Generation holds a 17.23 percent ownership interest 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 Exchange Act................................. Securities Exchange Act of 1934, as amended FASB......................................... Financial Accounting Standards Board FERC......................................... Federal Energy Regulatory Commission
5 FIN 46....................................... FASB Interpretation No. 46, "Consolidation of Variable Interest Entities" FMB.......................................... First Mortgage Bonds FMLP......................................... First Midland Limited Partnership, a partnership that holds a lessor interest in the MCV facility FondElec..................................... FondElec Essential Services Growth Fund, an investment at Enterprises, formed in 1997 to invest in companies whose business is to invest in communications and utility sectors, primarily in Latin America FTC.......................................... Federal Trade Commission 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 CMS Gas Transmission formerly owned a one-third interest GWh.......................................... Gigawatt-hour Health Care Plan............................. The medical, dental, and prescription drug programs offered to eligible employees of Consumers and CMS Energy HL Power..................................... H.L. Power Company, a California Limited Partnership, owner of the Honey Lake generation project in Wendel, California INGAA........................................ Interstate Natural Gas Association of America Integrum..................................... Integrum Energy Ventures, LLC IPP.......................................... Independent Power Production IRA.......................................... Individual Retirement Account ISO.......................................... Independent System Operator ITC.......................................... Investment tax credit JEC.......................................... Jubail Energy Company JOATT........................................ Joint Open Access Transmission Tariff 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 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 Ludington.................................... Ludington pumped storage plant, jointly owned by Consumers and Detroit Edison MACT......................................... Maximum Achievable Control Technology MAPL......................................... Marathon Ashland Petroleum, LLC, partner in Centennial
6 Marysville................................... CMS Marysville Gas Liquids Company, a Michigan corporation and a subsidiary of CMS Gas Transmission that holds a 100 percent interest in Marysville Fractionation Partnership and a 51 percent interest in St. Clair Underground Storage Partnership mcf.......................................... Thousand cubic feet MCV Expansion, LLC........................... An agreement entered into with General Electric Company to expand the MCV Facility 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 METC......................................... Michigan Electric Transmission Company, formerly a subsidiary of Consumers Energy and now an indirect subsidiary of Trans-Elect Michigan Gas Storage......................... Michigan Gas Storage Company, a former subsidiary of Consumers that merged into Consumers in November 2002 Michigan Power............................... CMS Generation Michigan Power, LLC, owner of the Kalamazoo River Generating Station and the Livingston Generating Station MISO......................................... Midwest Independent System Operator Moody's...................................... Moody's Investors Service, Inc. MPSC......................................... Michigan Public Service Commission MSBT......................................... Michigan Single Business Tax 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 NOPR......................................... Notice of Proposed Rulemaking NPS.......................................... National Power Supply Company, Ltd., owner of two generating facilities in Thailand. CMS Generation sold its 66.2 percent interest in NPS in 2002 NRC.......................................... Nuclear Regulatory Commission NYMEX........................................ New York Mercantile Exchange 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
7 Panhandle.................................... Panhandle Eastern Pipe Line Company, including its subsidiaries Trunkline, Pan Gas Storage, Panhandle Storage, and Panhandle Holdings. Panhandle was a wholly owned subsidiary of CMS Gas Transmission. The sale of this subsidiary closed in June 2003. Panhandle Eastern Pipe Line.................. PanhandleEastern Pipe Line Company, formerly a wholly owned subsidiary of CMS Gas Transmission. The sale of this subsidiary closed in June 2003. PCB.......................................... Polychlorinated biphenyl Pension Plan................................. The trusteed, non-contributory, defined benefit pension plan of Panhandle, Consumers and CMS Energy PJM.......................................... PJM Interconnection, a non-affiliated company 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. 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 Public Act 141............................... Public Act 141, Customer Choice and Electricity Reliability Act Public Act 142............................... Public Act 142, Securitization Act PURPA........................................ Public Utility Regulatory Policies Act of 1978 ROA.......................................... Retail Open Access RTO.......................................... Regional Transmission Organization 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. 34.................................. SFAS No. 34, "Capitalization of Interest Cost" SFAS No. 52.................................. SFAS No. 52, "Foreign Currency Translation" 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. 88.................................. SFAS No. 88, "Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits"
8 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. 123................................. SFAS No. 123, "Accounting for Stock-Based Compensation" 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. 148................................. SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure" SFAS No. 149................................. SFAS No. 149, "Amendment of Statement No. 133 on Derivative Instruments and Hedging Activities" SFAS No. 150................................. SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity" SIPS......................................... State Implementation Plans Southern Union............................... Southern Union Company, a non-affiliated company 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 Taweelah..................................... Al Taweelah A2, a power and desalination plant of Emirates CMS Power Company, a forty percent owned subsidiary of CMS Generation TEPPCO....................................... TE Products Pipeline Company, Limited Partnership Toledo Power................................. Toledo Power Company, the 135 MW coal and fuel oil power plant located on Cebu Island, Phillipines, in which CMS Generation held a 47.5 percent interest. Toledo Power was sold to Mirant Toledo Holdings Corporation on April 24, 2002. Transition Costs............................. Stranded Costs, as defined, plus the costs incurred in the transition to competition.
9 Trunkline.................................... Trunkline Gas Company, LLC, formerly a subsidiary of CMS Panhandle Holdings, LLC Trunkline LNG................................ Trunkline LNG Company, LLC, formerly a subsidiary of LNG Holdings, LLC 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 Union........................................ Utility Workers of America, AFL-CIO 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, is engaged in domestic and international diversified energy businesses including: natural gas transmission, storage and processing; independent power production; and energy services. 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 2002 Form 10-K/A, filed on July 1, 2003. This MD&A refers to 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 intention with the use of the words "anticipates," "believes," "estimates," "expects," "intends," and "plans," and variations of such words and similar expressions, is 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 2002 Form 10-K/A, filed on July 1, 2003, in the section entitled "Forward-Looking Statements Cautionary Factors and Uncertainties" and in various public filings it periodically makes with the SEC. 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. All note references within this MD&A refer to CMS Energy's Notes to the Consolidated Financial Statements. CRITICAL ACCOUNTING POLICIES CMS Energy's consolidated financial statements 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 consolidated financial statements. These principles include the use of estimates in accounting for contingencies and long-lived assets, accounting for derivatives and financial instruments, mark-to-market accounting, international operations and foreign currency, regulatory accounting, and pension and postretirement benefits. 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 CMS-1 CMS Energy Corporation 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, 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 differ materially 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 under SFAS No. 144 through the use of an undiscounted cash flow analysis of assets at the lowest level for which identifiable cash flows exist and under APB Opinion No. 18 by analyzing the ability to recover the carrying amount of the equity method investment and/or the ability of the investee to sustain an earnings capacity that justifies the carrying amount of the investment. If impairment, other than of 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 $12 billion at September 30, 2003, approximately 58 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 recorded write-downs of non-strategic or under-performing long-lived assets as a result of implementing a new strategic direction. See Outlook section of this MD&A. 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 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 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 payment will be made in the future as a result of a current event, and when that amount can be reasonably estimated. CMS Energy has used this accounting principle to record 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. The EPA has issued regulations regarding nitrogen oxide emissions from certain generators, including some of Consumers' electric generating facilities. These regulations require Consumers to make significant capital expenditures estimated to be $770 million. As of September 30, 2003, Consumers has incurred $437 million CMS-2 CMS Energy Corporation in capital expenditures to comply with these regulations and anticipates that the remaining capital expenditures will be incurred between 2003 and 2009. Additionally, Consumers expects to 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 average $6 million per year; however, the market for nitrogen oxide emissions credits and their cost can change substantially. As new environmental standards become effective, Consumers will need additional capital expenditures to comply with the standards. Capital expenditures will depend upon the composition of the final regulations. The EPA has proposed changes to the rules that govern generating plant cooling water intake systems. The proposed rules will require significant abatement of fish mortality. The proposed rules are scheduled to become final in the first quarter of 2004 and some of Consumers' facilities would be required to comply by 2006. Consumers is studying the proposed rules to determine the most cost-effective solutions for compliance. Until the method of compliance is determined, Consumers is unable to estimate the cost of compliance with the proposed rules. The EPA has alleged that some utilities have incorrectly classified plant modifications as "routine maintenance" rather than seek permits from the EPA. Consumers has received and responded to information requests from the EPA on this subject. Consumers believes that it has properly interpreted the requirements of "routine maintenance". If Consumers' interpretation is eventually found to be incorrect, it may be required to install additional pollution controls at some or all of its coal-fired plants and could call into question the viability of certain plants remaining in operation. For further information on electric environmental matters see Note 4, Uncertainties, "Consumers' Electric Utility 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 using the Gas Research Institute-Manufactured Gas Plant Probabilistic Cost Model. A revised cost estimate, completed in September 2003, estimated remaining costs to be between $37 million and $90 million. The range reflects multiple alternatives with various assumptions for resolving the environmental issues at each site. The estimates are based on discounted 2003 costs using a discount rate of three percent. The discount rate represents a ten-year average of U.S. Treasury bond rates reduced for increases in the consumer price index. 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 4, Uncertainties, "Consumers' Gas Utility 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 49 percent partnership interest in the MCV Partnership, and a 35 percent lessor interest in the MCV Facility. Consumers' annual obligation to purchase capacity from the MCV Partnership is 1,240 MW through the term of the PPA ending 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 and a fixed energy charge, and also to pay 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 and fixed energy charges in rates. After CMS-3 CMS Energy Corporation September 2007, the PPA's regulatory out 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 and established a PPA liability for the present value of the estimated future underrecoveries of power supply costs under the PPA based on MPSC cost recovery orders. Primarily as a result of the MCV Facility's actual availability being greater than management's original estimates, the PPA liability has been reduced at a faster rate than originally anticipated. The remaining estimated future PPA liability associated with the loss totaled $34 million at September 30, 2003 and $59 million at September 30, 2002. The PPA liability is expected to be depleted in late 2004. In March 1999, Consumers and the MCV Partnership reached a settlement agreement effective January 1, 1999, that addressed, among other things, the ability of the MCV Partnership to count modifications increasing the capacity of the existing MCV Facility for purposes of computing the availability of contract capacity under the PPA for billing purposes. That settlement agreement capped payments made on the basis of availability that may be billed by the MCV Partnership at a maximum 98.5 percent availability level. Under Michigan's electric restructuring law, Consumers will return to unfrozen rates for large industrial customers beginning January 1, 2004, including the resumption of the PSCR process. Under the PSCR process, Consumers will recover from customers capacity and fixed energy charges on the basis of availability, to the extent that availability does not exceed 88.7 percent availability established in previous MPSC orders. Recovery of capacity and fixed energy charges will be subject to certain rate caps as discussed in Note 4, Uncertainties, "Consumers' Electric Utility Rate Matters - Electric Restructuring." For capacity and energy payments billed by the MCV Partnership after September 15, 2007, and not recovered from customers, Consumers would expect to claim a regulatory out under the PPA. The regulatory out provision relieves Consumers of the obligation to pay more for capacity and energy payments than the MPSC allows Consumers to collect from its customers. Consumers estimates that 51 percent of the actual cash underrecoveries for the years 2003 and 2004 will be charged to the PPA liability, with the remaining portion charged to operating expense as a result of Consumers' 49 percent ownership in the MCV Partnership. All cash underrecoveries will be expensed directly to income once the PPA liability is depleted. If the MCV Facility's generating availability remains at the maximum 98.5 percent level, Consumers' cash underrecoveries associated with the PPA could be as follows:
In Millions -------------------------------------------------------------------------------------------- 2003 2004 2005 2006 2007 -------------------------------------------------------------------------------------------- Estimated cash underrecoveries at 98.5% (a) $57 $56 $56 $55 $39 Amount to be charged to operating expense $28 $27 $56 $55 $39 Amount to be charged to PPA liability $29 $29 $ - $ - $ - ===========================================================================================
(a) For the nine months ended September 30, 2003, Consumers' cash underrecoveries associated with the PPA were $43 million. As previously noted, until September 2007, the PPA and settlement require Consumers to pay capacity costs based on the MCV Facility's actual availability up to the 98.5 percent cap. After September 2007, Consumers expects to exercise the "regulatory out" clause in the PPA, limiting its capacity payments to the MCV Partnership to the amount collected from its customers. Depending on the MPSC's future actions with respect to the capacity payments recoverable from its customers subsequent to September 2007, the earnings of the MCV Partnership and the value of Consumers' equity interest in the MCV Partnership, may be affected negatively. CMS-4 CMS Energy Corporation Further, under the PPA, energy payments to the MCV Partnership are based on the cost of coal burned in Consumers' coal plants and costs associated with fuel inventory, operations and maintenance, and administrative and general expenses associated with Consumers' coal plants. However, the MCV Partnership's costs of producing electricity are tied, in large part, to the cost of natural gas. Because natural gas prices have increased substantially in recent years, while energy charge payments to the MCV Partnership have not, the MCV Partnership's financial performance has been impacted negatively. As of January 1, 2004, Consumers intends to return to forced (uneconomic) dispatch of the MCV Facility in order to maximize recovery of its capacity payments. As such, if the spread between MCV Facility's variable electricity production costs and its energy payment revenues stays constant or widens, the negative impacts on MCV Partnership's financial performance, and on the value of Consumers' equity interest in the MCV Partnership, will be worse. Consumers cannot estimate, at this time, the impact of these issues on its future earnings or cash flow from its interest in the MCV Partnership. The forward price of natural gas for the next 22 years and the MPSC decision in 2007 or later related to Consumers' recovery of capacity payments are the two most significant variables in the analysis of MCV Partnership's future financial performance. Natural gas prices have historically been volatile and presently there is no consensus in the marketplace on the price or range of prices of natural gas beyond the next five years. Further, it is not presently possible for Consumers to predict the actions of the MPSC in 2007 or later. For these reasons, at this time Consumers cannot predict the impact of these issues on its future earnings, cash flows, or on the value of its $404 million equity interest in the MCV Partnership. Consumers is exploring possible alternatives for utilizing the MCV Facility without increasing costs to customers. Any changes regarding the recovery of MCV capacity costs would require MPSC approval. Consumers cannot predict the outcome of this matter. For further information see Note 4, Uncertainties, "Consumers' Other Electric Utility Uncertainties - The Midland Cogeneration Venture." ACCOUNTING FOR DERIVATIVE AND FINANCIAL INSTRUMENTS AND MARKET RISK INFORMATION 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 typically classifies as derivative instruments are interest rate swaps, foreign currency exchange contracts, certain electric call options, gas fuel options, fixed priced weather-based gas supply call options, fixed price gas supply call and put options, gas futures, and gas and power swaps and forward purchases and sales. CMS Energy does not account for electric capacity and energy contracts, gas supply contracts, coal and nuclear fuel supply contracts, or purchase orders for numerous supply items as derivatives. Certain of Consumers' 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 CMS-5 CMS Energy Corporation 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 accumulated 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 determine the fair value of contracts that are accounted for as derivative instruments, Consumers uses a combination of quoted market prices and mathematical valuation models. Valuation 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 certain contracts. At September 30, 2003, Consumers assumed a market-based interest rate of one percent (six-month U.S. Treasury) and an average volatility rate of 55 percent to calculate the fair value of its gas 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: 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. They are reported at fair value with any unrealized gains or losses resulting from changes in fair value reported in equity as part of accumulated other comprehensive income and are excluded from earnings unless such changes in fair value are other than temporary. Unrealized gains or losses resulting from changes in the fair value of Consumers' nuclear decommissioning investments are reported as regulatory liabilities. The fair value of these investments is determined from quoted market prices. MARKET RISK INFORMATION: CMS Energy is exposed to market risks including, but not limited to, changes in interest rates, commodity prices, currency exchange rates, and equity security prices. CMS Energy's 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 certain business unit managers. Established policies and procedures are used to manage the risks associated with market fluctuations. CMS Energy may use 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. When management uses these instruments, it intends that an opposite movement in the value of the at-risk item would offset any losses incurred on the contracts. 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. CMS Energy enters into all risk management contracts 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. CMS Energy minimizes such risk by performing financial CMS-6 CMS Energy Corporation credit reviews using, among other things, publicly available credit ratings of such counterparties. In accordance with SEC disclosure requirements, CMS Energy 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, CMS Energy and its subsidiaries rely on the experience and judgment of senior management to revise strategies and adjust positions, as they deem necessary. Changes 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: CMS Energy is exposed to interest rate risk resulting from the issuance of fixed-rate and variable-rate financing, including interest rate risk associated with trust preferred securities, and from interest rate swap agreements. CMS Energy uses a combination of these instruments to manage and mitigate interest rate risk exposure when deemed appropriate, based upon market conditions. These strategies are designed to provide and maintain a balance between risk and the lowest cost of capital. As of September 30, 2003, CMS Energy had outstanding variable-rate financing of $633 million, a $1.015 billion decrease (62 percent) from the December 31, 2002 balance of $1.648 billion. The decline in variable-rate financing is primarily due to a shift toward fixed-rate financing. As of September 30, 2003, assuming a hypothetical 10 percent adverse change in market interest rates, CMS Energy's before tax annual earnings exposure on its variable-rate financing would be $1 million. As of September 30, 2003, CMS Energy had outstanding fixed-rate financing, including trust preferred securities, of $6.772 billion, a $768 million increase (13 percent) over the December 31, 2002 balance of $6.004 billion. As of September 30, 2003, the fair value of CMS Energy's fixed-rate financing was $6.861 billion, a $1.364 billion increase (25 percent) over the December 31, 2002 fair value of $5.497 billion. The change in the fair value of the fixed-rate financing is due to both an increase in outstanding fixed-rate debt obligations as well as a decline in market interest rates. At September 30, 2003, assuming a hypothetical 10 percent adverse change in market interest rates, the fair value of CMS Energy's fixed rate financing and trust preferred securities would increase by $252 million. At September 30, 2003 and December 31, 2002, the fair value of CMS Energy's floating to fixed interest rate swaps with notional amounts of $14 million and $294 million, were negative $1 million and negative $7 million, which represent the amounts CMS Energy would pay to settle. The swaps mature at various times through 2006 and are designated as cash flow hedges for accounting purposes. Commodity Price Risk: CMS Energy is exposed to market fluctuations in the price of energy commodities, including natural gas, oil, electricity, coal, natural gas liquids and other commodities. CMS Energy employs established policies and procedures to manage these risks and may use 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 may also hedge certain inventory and purchases and sales contracts. Based on a sensitivity analysis, CMS Energy estimates that if energy commodity prices change by an average 10 percent, operating income for the subsequent three months would change by $0.8 million. These hypothetical 10 percent shifts in quoted commodity prices would not have had a material impact on CMS Energy's consolidated financial position or cash flows. The analysis does not quantify short-term exposure to hypothetically adverse price fluctuations in inventories. CMS-7 CMS Energy Corporation For purposes other than trading, Consumers entered into electric call options, fixed priced weather-based gas supply call options and fixed priced gas supply call and 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 weather-based gas supply call options, and the gas supply call and put options are used to purchase reasonably priced gas supply. Call options allow Consumers the right but not the obligation to purchase gas supply at predetermined fixed prices. Put options allow third-party suppliers the right but not the obligation to sell Consumers gas supply at predetermined fixed prices. As of September 30, 2003 and December 31, 2002, the fair value of electricity-related call option contracts, based on quoted market prices and mathematical valuation models using current and historical pricing data, was $3 million and $9 million, respectively. As of September 30, 2003 assuming a hypothetical 10 percent adverse change in market prices, the potential reduction in fair value associated with these contracts would be $1 million. As of September 30, 2003 and December 31, 2002, Consumers had an asset of $21 million and $30 million, respectively, 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, 2003, the fair value of the fixed priced weather-based gas supply call options and fixed priced gas supply call and put options, based on quoted market prices and mathematical valuation models, was less than $1 million. As of September 30, 2003, assuming a hypothetical 10 percent adverse change in market prices, the potential reduction in fair value associated with these contracts would be $1 million. 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 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 accumulated other comprehensive income as a component of foreign currency translation adjustment. For the nine months ended September 30, 2003, there was no mark-to-market adjustment included in the total net foreign currency translation adjustment of $39 million. At September 30, 2003, there were no foreign exchange hedges. 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. At September 30, 2003, 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 further information on market risk and derivative activities, see Note 7, Risk Management Activities and Financial Instruments. MARK-TO-MARKET ACCOUNTING Through December 31, 2002, CMS MST's wholesale power and gas trading activities were accounted for under the mark-to-market method of accounting. Effective, January 1, 2003, EITF Issue No. 98-10 was rescinded by EITF Issue No. 02-03 and as a result, only energy contracts that meet the definition of a derivative in SFAS No. 133 can be carried at fair value. The impact of this change for CMS MST was recognized as a cumulative effect of a change in accounting principle loss of $23 million, net of tax. See Note 10, Implementation of New Accounting Standards. 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. CMS-8 CMS Energy Corporation Changes in fair value of the energy trading contracts 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 contracts, long-term commitments may extend beyond the period in which market quotations for such contracts are available and volumetric obligations may not be defined. Mathematical models are developed to determine various inputs into the fair value calculation including price, anticipated volumetric obligations and other inputs that may be required to adequately address the determination of fair value of the contracts. Realized cash returns on these commitments may vary, either positively or negatively, from the results estimated 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. Market prices are adjusted to reflect the 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 trading contracts, CMS Energy maintains reserves for credit risks based on the financial condition of counterparties. 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. Where contractual 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 trading contracts as of September 30, 2003.
In Millions ------------------------------------------------------------------------------------------------- Fair value of contracts outstanding as of December 31, 2002 $ 81 Fair value of new contracts when entered into during the period - Implementation of EITF Issue No. 02-03 (a) (36) Fair value of derivative contracts sold and received from asset sales (b) (30) Changes in fair value attributable to changes in valuation techniques and assumptions - Contracts realized or otherwise settled during the period (9) Other changes in fair value (c) 8 ------------------------------------------------------------------------------------------------- Fair value of contracts outstanding as of September 30, 2003 $ 14 =================================================================================================
(a) Reflects the removal of contracts that do not qualify as derivatives under SFAS No. 133 as of January 1, 2003. (b) Reflects $(60) million of price risk management assets sold and $30 million of price risk management assets received related to the sales of the gas and power books. (c) Reflects changes in price and net increase/(decrease) in position size of forward positions as well as changes to mark-to-market and credit reserves. CMS-9 CMS Energy Corporation
Fair Value of Contracts at September 30, 2003 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 $ (39) $ (5) $ (17) $ (15) $ (2) Prices based on models and other valuation methods 53 11 27 13 2 --------------------------------------------------------------------------------------------------------------------- Total $ 14 $ 6 $ 10 $ (2) $ - =====================================================================================================================
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, over the last two years, CMS Energy has been 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, 2003, the cumulative Foreign Currency Translation decreased stockholders' equity by $419 million. Included in this amount is an unrealized loss of $118 million related to CMS Energy's investment in Loy Yang. This loss, and the impact of certain deferred taxes associated with the Loy Yang investment will be realized upon sale, full liquidation, or other disposition of CMS Energy's investment in Loy Yang, for a total loss of approximately $168 million. In July 2003, a conditional share sale agreement for CMS Energy's investment in Loy Yang was executed. See Outlook, "Corporate Outlook" section in this MD&A for further discussion. 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. Effective April 30, 2002, CMS Energy adopted the Argentine peso as the functional currency for most of its Argentine investments. CMS previously had 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. While CMS Energy's management cannot predict the most likely future, or average peso to U.S. dollar exchange rates, it does expect that these non-cash charges reduce substantially 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. At September 30, 2003, the net foreign currency loss due to the unfavorable exchange rate of the Argentine peso recorded in the Foreign Currency Translation component of Common Stockholders' Equity using an exchange rate of 2.975 pesos per U.S. dollar was $259 million. This amount also reflects the effect of recording U.S. income taxes with respect to CMS-10 CMS Energy Corporation temporary differences between the book and tax basis of foreign investments, including the foreign currency translation associated with CMS Energy's Argentine investments, that were determined to no longer be essentially permanent in duration. 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. HEDGING STRATEGY: CMS Energy may use 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 associated with adverse changes in currency exchange rates that could affect materially cash flow. These contracts would 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 not significant. 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 normally would 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 be refunded to customers. Judgment is required to discern the recoverability of items recorded as regulatory assets and liabilities. As of September 30, 2003, Consumers had $1.113 billion recorded as regulatory assets and $461 million recorded as regulatory liabilities. In 1999, Consumers received MPSC electric restructuring orders, which, among other things, identified the terms and timing for implementing electric restructuring in Michigan. Consistent with these orders and EITF No. 97-4, Consumers discontinued the application of SFAS No. 71 for the energy supply portion of its business because Consumers expected to implement retail open access at competitive market-based rates for its electric customers. However, since 1999, there has been a significant legislative and regulatory change in Michigan that has resulted in: 1) electric supply customers of utilities remaining on cost-based rates and 2) utilities being given the ability to recover Stranded Costs associated with electric restructuring, from customers who choose an alternative electric supplier. During 2002, Consumers re-evaluated the criteria used to determine if an entity or a segment of an entity meets the requirements to apply regulated utility accounting, and determined that the energy supply portion of its business could meet the criteria if certain regulatory events occurred. In December 2002, Consumers received a MPSC Stranded Cost order that allowed Consumers to re-apply regulatory accounting standard SFAS No. 71 to the energy supply portion of its business. Re-application of SFAS No. 71 had no effect on the prior discontinuation accounting, but allowed Consumers to apply regulatory accounting treatment to the energy supply portion of its business beginning in the fourth quarter of 2002, including regulatory accounting treatment of costs required to be recognized in accordance with SFAS No. 143. See Note 10, Implementation of New Accounting Standards, "SFAS No. 143, Accounting for Asset Retirement Obligations." CMS-11 CMS Energy Corporation For further information on industry regulation, see Note 1, Corporate Structure and Summary of Significant Accounting Policies, "Utility Regulation". 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 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. The Pension Plan includes amounts for employees of CMS Energy and affiliates which are not distinguishable from the Pension Plan's total assets. In June 2003, CMS Energy completed the sale of Panhandle to Southern Union Panhandle Corp. No portion of the Pension Plan was transferred with the sale. Panhandle employees are no longer eligible to accrue additional benefits. The Pension Plan retained pension payment obligations for Panhandle employees that were vested under the Pension Plan. Because of the significant change in the makeup of the plan, SFAS No. 87 required a remeasurement of the obligation at the date of sale. The estimated remeasurement resulted in an increase in pension expense of approximately $4 million and OPEB expense of approximately $6 million for 2003, as well as an additional charge to accumulated other comprehensive income of approximately $30 million ($20 million after tax), as a result of the increase in the additional minimum pension liability. Additionally, a significant number of Panhandle employees elected to retire as of July 1, 2003 under the CMS Energy Employee Pension Plan. As a result, CMS Energy has recorded a $13 million after-tax settlement loss pursuant to the provisions of SFAS No. 88, which is reflected in discontinued operations. The actuary is in the process of finalizing the effects of the mid-year remeasurement. Although actual results may differ from the estimates recorded, CMS Energy does not expect those differences to be material. CMS Energy estimates consolidated OPEB expense will approximate $58 million in 2003, $66 million in 2004, and $63 million in 2005. Additionally, CMS Energy estimates consolidated pension expense will approximate $47 million in 2003, $51 million in 2004 and $53 million in 2005. Future actual pension expense will depend on future investment performance, changes in future discount rates and various other factors related to the populations participating in the Pension Plan. In August 2003, CMS Energy made its planned contribution of $210 million to the Pension Plan. CMS Energy has announced amendments to the Pension Plan for salaried employees, whereby, the method used to convert an employee's benefit to a lump sum payment is being changed. Employees who elect the lump sum payment option will not earn any additional early retirement subsidy. As a result, employees who choose the lump sum payment option, and retire before age 65, will receive lower lump sum payments. In addition, CMS Energy has implemented a cash balance plan for employees hired on or after July 1, 2003. Under a cash balance plan, an employee's retirement account is credited annually with a percentage of base pay. Accounts will be valued at the end of each year, using an annual variable interest rate to determine growth. Employees who leave the company and are vested in the cash balance version of the pension plan can either start receiving the benefit immediately, postpone receiving benefits until a future date while receiving an earnings credit on the account (payment cannot be deferred beyond age 70-1/2), or roll 100 percent of the cash balance account into an IRA or another qualified plan. If a participant is not vested (less than five years of service under the terms of the plan), the cash balance account is forfeited. CMS-12 CMS Energy Corporation In 2003, a large majority of retiring employees elected the lump sum payment option instead of receiving pension benefits as an annuity over time. As a result, CMS Energy may be required to record a settlement loss in accordance with SFAS No. 88, which requires a settlement loss to be recognized when the cost of all settlements paid during the year exceeds the sum of the service and interest costs for the same year. CMS Energy cannot yet determine if the amount of lump sum payments for 2003 will exceed the threshold, but estimates that, if the threshold is exceeded, between $60 million and $70 million could be recognized as a loss in the fourth quarter of 2003. 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. The MPSC orders received in March and December of 1999 for Big Rock and Palisades plants, respectively, provided for fully funding the decommissioning trust funds for both sites. The December 1999 order set the annual decommissioning surcharge for the Palisades decommissioning at $6 million. Consumers estimates that at the time of the decommissioning of Palisades, its decommissioning trust fund will be fully funded. This conclusion assumes that the trust funds are invested in equities and fixed income investments, equities will be converted to fixed income investments during decommissioning and fixed income investments are converted to cash as needed. Decommissioning costs have been developed, in part, by independent contractors with expertise in decommissioning. These cost estimates use various inflation rates for labor, non-labor, and contaminated equipment disposal costs. In December 2000, funding of the Big Rock trust fund was stopped since it was considered fully funded, subject to further review. A portion of future decommissioning cost will result from the failure of the DOE to remove fuel from the site. These costs, and similar costs incurred at Palisades, would not be necessary if the DOE took possession of the spent fuel as required by the Nuclear Waste Policy Act of 1982. A number of utilities, including Consumers, which filed its complaint in December 2002, have commenced litigation in the Court of Claims. The Chief Judge of the Court of Claims identified six lead cases to be used as vehicles for resolving dispositive motions. Consumers' case is not a lead case. It is unclear what impact this decision by the Chief Judge will have on the outcome of Consumers' litigation. If the litigation that was commenced in the fourth quarter of 2002 against the DOE is successful, Consumers anticipates future recoveries from the DOE to defray the significant costs it will incur for the storage of spent fuel until the DOE takes possession as required by law. However, there is no assurance that the litigation against the DOE will be successful. The funds provided by the trusts and additional potential funds from DOE litigation are expected to fully fund the decommissioning costs. Variance from trust earnings, a lesser recovery of costs from the DOE, changes in decommissioning technology, regulations, estimates or assumptions could affect the cost of decommissioning these sites and the adequacy of the decommissioning trust funds. For further information see Note 4, Uncertainties, "Other Consumers' Electric Utility Uncertainties - Nuclear Matters." In March 2003, the Michigan Environmental Council, the Public Interest Research Group in Michigan, and the Michigan Consumer Federation submitted a complaint to the MPSC, which was served on Consumers by the MPSC in April 2003. The complaint asks the MPSC to commence a generic investigation and contested case to review all facts and issues concerning costs associated with spent nuclear fuel storage and disposal. The complaint seeks a variety of relief with respect to Consumers, Detroit Edison, Indiana & Michigan Electric Company, Wisconsin Electric Power Company and Wisconsin Public Service Corporation, including establishing external trusts to which amounts collected in electric rates for spent nuclear fuel storage and disposal should be transferred, and the adoption of additional measures related to the storage and disposal of spent nuclear fuel. In May 2003, Consumers and the other named utilities each filed a motion to dismiss the complaint. Consumers is unable to predict the outcome of this matter. CMS-13 CMS Energy Corporation RESULTS OF OPERATIONS CMS ENERGY CONSOLIDATED RESULTS OF OPERATIONS
In Millions (except for per share amounts) -------------------------------------------------------------------------------- Three months ended September 30 2003 2002 -------------------------------------------------------------------------------- CMS Energy Net Income (Loss) $ (77) $ 37 CMS Energy Basic Earnings (Loss) per Share $ (0.51) $ 0.26 CMS Energy Diluted Earnings (Loss) Per Share $ (0.51) $ 0.26 --------------------------------------------------------------------------------
CMS Energy's results of operations continue to reflect the implementation of a back-to-basics strategy that focuses on a growing healthy utility and divesting under performing or other non-strategic assets. The strategy is designed to generate cash to pay down debt, to reduce business risk, and to provide for more predictable future operating revenues and earnings. Through this strategy, CMS Energy is continuing to rightsize and to restructure its business operations. In 2003, CMS Energy has experienced increased competition, cooler summer temperatures, slow general economic recovery in Michigan, costs associated with debt retirement and refinancing, and the loss of earnings from businesses and assets sold.
In Millions (except for per share amounts) ---------------------------------------------------------------------------------------- Three months ended September 30 2003 2002 Change ---------------------------------------------------------------------------------------- Electric Utility $ 59 $ 88 $ (29) Gas Utility (19) (18) (1) Enterprises 13 58 (45) Corporate Interest and Other (87) (117) 30 ---------------------------------------------------------------------------------------- Income (Loss) from Continuing Operations (34) 11 (45) ---------------------------------------------------------------------------------------- Discontinued Operations (43) 25 (68) Accounting Changes - 1 (1) ---------------------------------------------------------------------------------------- Net Income (Loss) $ (77) $ 37 $(114) ========================================================================================
For the three months ended September 30, 2003, CMS Energy's net loss totaled $77 million. The net loss reflects a $42 million after-tax asset impairment charge at Enterprises, $28 million after-tax of debt retirement and refinancing costs, and cooler summer weather. COMPARISON TO COMPARABLE PERIOD IN 2002 Results from continuing operations ($34 million loss) were $45 million worse than the $11 million of income earned in 2002. The decrease in results from continuing operations reflects decreased Electric Utility deliveries due to a cooler summer in 2003 and more industrial and commercial customers choosing different electricity suppliers (see Electric Utility section in Results of Operations). The decrease also reflects lower Enterprises' earnings due to the absence of a $15 million after-tax gain on 2002 asset sales and the loss of CMS-14 CMS Energy Corporation earnings from businesses and assets sold (see Enterprises Outlook section in MD&A). These reductions in earnings were partially offset by a $30 million after-tax reduction in Corporate Interest and Other expenses. This expense reduction reflects the absence of a $41 million after-tax income tax valuation allowance recorded in 2002 attributable to a reduction in AMT carryforwards (see Corporate Interest and Other section in Results of Operations). Loss from discontinued operations was $43 million, a decrease of $68 million from the comparable period in 2002, due to a $42 million after-tax asset impairment at Enterprises and reduced earnings resulting from the sale of CMS Oil and Gas in 2002, Panhandle in 2003, and other businesses as CMS Energy continues to implement its back-to-basics strategy.
In Millions (except for per share amounts) ----------------------------------------------------------------------------------------------- Nine months ended September 30 2003 2002 ----------------------------------------------------------------------------------------------- CMS Energy Net Income (Loss) $ (43) $ 5 CMS Energy Basic Earnings (Loss) per Share $ (0.29) $ 0.04 CMS Energy Diluted Earnings (Loss) Per Share $ (0.29) $ 0.04
In Millions (except for per share amounts) ------------------------------------------------------------------------------------------- Nine months ended September 30 2003 2002 Change ------------------------------------------------------------------------------------------- Electric Utility $ 145 $ 222 $ (77) Gas Utility 40 13 27 Enterprises 48 126 (78) Corporate Interest and Other (196) (221) 25 ------------------------------------------------------------------------------------------- Income (Loss) from Continuing Operations 37 140 (103) ------------------------------------------------------------------------------------------- Discontinued Operations (56) (153) 97 Accounting Changes (24) 18 (42) ------------------------------------------------------------------------------------------- Net Income (Loss) $ (43) $ 5 $ (48) ===========================================================================================
For the nine months ended September 30, 2003, CMS Energy's net loss totaled $43 million. The net loss reflects a $42 million after-tax asset impairment at Enterprises, a $30 million after-tax loss on the Panhandle sale, $25 million after-tax of debt retirement and refinancing costs, cooler summer weather, and improved Gas Utility earnings. COMPARISON TO COMPARABLE PERIOD IN 2002 Income from continuing operations was $103 million lower than the $140 million of income earned in 2002. The decrease in income from continuing operations primarily reflects a decline at the Electric Utility resulting from reduced electric deliveries due to a cooler summer in 2003 and more industrial and commercial customers choosing different electricity suppliers, the absence of after-tax gains of $31 million primarily from the sale of transmission assets in 2002, and a scheduled refueling outage at Palisades (see Electric Utility Results of Operations). The decrease is also due to a decline in Enterprises' earnings reflecting the absence of an after-tax gain of $15 million associated with asset sales in 2002 and the continuing implementation of the back-to-basics strategy and the resulting loss of earnings from businesses and assets sold (see Enterprises Results of Operations and Enterprises Outlook section in the MD&A). The decrease was partially offset by improved Gas Utility earnings reflecting increased gas deliveries and the impacts of a final gas rate order issued in 2002 that increased tariff rates; and Enterprises' foreign currency gains from the stabilization of the Argentine Peso. For the nine months ended September 30, 2003, Loss From Discontinued Operations which totaled $56 million includes a $30 million after-tax loss resulting from the sale of Panhandle and a $42 million after-tax asset CMS-15 CMS Energy Corporation impairment at CMS Electric and Gas, an improvement of $97 million from the comparable period in 2002. Loss from Discontinued Operations for the nine months ended September 30, 2002 reflects an after-tax gain on the sale of CMS Energy's ownership interests in Equatorial Guinea properties of $310 million, and the cumulative effect on a change in accounting for goodwill impairments, net of tax, at both Panhandle of $(369) million and CMS Viron of $(10) million. The change in results also reflects the loss of earnings of businesses and assets sold and asset impairments and writedowns. The nine months ended September 30, 2003 net income includes a $23 million charge related to the cumulative effect of a change in accounting resulting from the implementation of EITF Issue No. 02-03 and a $1 million charge associated with the implementation of SFAS No. 143. The nine months ended September 30, 2002 net income reflects $18 million of after-tax earnings due to an accounting change to adjust the fair value of certain long-term contracts held at the MCV Partnership recorded in the second quarter of 2002. CONSUMERS' ELECTRIC UTILITY RESULTS OF OPERATIONS ELECTRIC UTILITY NET INCOME:
In Millions ------------------------------------------------------------------------------ September 30 2003 2002 Change ------------------------------------------------------------------------------ Three months ended $ 59 $ 88 $(29) Nine months ended $145 $222 $(77) ==============================================================================
Three Months Ended Nine Months Ended ------------------------------------------------------------------------------------------------------------------ Reasons for change September 30, 2003 vs. 2002 September 30, 2003 vs. 2002 ------------------------------------------------------------------------------------------------------------------ Electric deliveries $ (34) $ (38) Power supply costs and related revenue 2 14 Other operating expenses and non-commodity revenue (5) (43) Asset sales - (38) General taxes (3) 12 Fixed charges (5) (18) Income taxes 16 34 ----------------------------------------------------------- Total change $ (29) $ (77) ==================================================================================================================
ELECTRIC DELIVERIES: For the three months ended September 30, 2003, electric delivery revenues decreased by $34 million from the previous year. Electric deliveries, including transactions with other wholesale market participants and other electric utilities, were 10.3 billion kWh, a decrease of 0.6 billion kWh or 4.9 percent from 2002. The decrease in revenue is primarily the result of decreased deliveries to the higher margin residential sector due to milder summer temperatures in 2003 compared to the same period in 2002, which included record setting monthly sendout and monthly hourly peak demand volumes. Commercial and industrial customers switching to alternative electric suppliers as allowed by the Customer Choice Act further reduced electric delivery revenues. For the nine months ended September 30, 2003, electric delivery revenues decreased by $38 million from the previous year. Electric deliveries, including transactions with other wholesale market participants and other electric utilities, were 29.3 billion kWh, a decrease of 0.2 billion kWh or 0.6 percent from 2002. CMS-16 CMS Energy Corporation The decrease in delivery revenues can be attributed to the continuing switch by commercial and industrial customers to alternative electric suppliers allowed by the Customer Choice Act. Also contributing to decreased electric deliveries was a reduction in residential consumption due to milder summer temperatures in 2003 compared to the same period in 2002, which included record setting monthly send out and monthly hourly peak demand volumes. POWER SUPPLY COSTS AND RELATED REVENUE: For the three months ended September 30, 2003, power supply costs and related revenues increased electric net income by $2 million from 2002. For the nine months ended September 30, 2003, power supply costs and related revenues increased electric net income by $14 million from 2002. This increase is primarily the result of increased intersystem revenues due to higher market prices and sales made from additional surplus capacity. OTHER OPERATING EXPENSES AND NON-COMMODITY REVENUE: For the three months ended September 30, 2003, net operating expenses and non-commodity revenue decreased operating income by $5 million compared to 2002. This decrease relates primarily to increased amortization expense from securitized assets and reduced miscellaneous electric service revenues. For the nine months ended September 30, 2003, operating expenses increased compared to 2002. This increase can be attributed to storm restoration expenses, a scheduled refueling outage at Palisades, which began on March 16, 2003 and ended on April 20, 2003, and higher transmission costs due to the loss of a financial return on the Consumers' transmission system asset sold in May 2002. Slightly offsetting these increased operating expenses were increased non-commodity revenues associated with miscellaneous service revenues. ASSET SALES: For the nine months ended September 30, 2003, pretax income from asset sales decreased $38 million from the comparable period in 2002. This is the result of the $31 million pretax gain associated with the May 2002 sale of Consumers' electric transmission system and the $7 million pretax gain associated with the June 2002 sale of nuclear equipment from the cancelled Midland project. GENERAL TAXES: For the three months ended September 30, 2003, general taxes increased $3 million compared to 2002 primarily due to larger property tax expense from increased investment. For the nine months ended September 30, 2003, general taxes decreased $12 million from the comparable period in 2002. This decrease is due to reduced MSBT expenses related to the years 2000 and 2001. This is the result of CMS Energy receiving approval to file consolidated tax returns for the years 2000 and 2001. These returns were filed during the second quarter of 2003. FIXED CHARGES: For the three and nine months ended September 30, 2003, fixed charges increased $5 million and $18 million, respectively, from the comparable period in 2002. These increases can be attributed to increased financing activities. INCOME TAXES: For the three and nine months ended September 30, 2003, income tax expense decreased $16 million and $34 million, primarily due to a decrease in earnings by the electric utility compared to 2002. CMS-17 CMS Energy Corporation CONSUMERS' GAS UTILITY RESULTS OF OPERATIONS GAS UTILITY NET INCOME:
In Millions ----------------------------------------------------------------------- September 30 2003 2002 Change ----------------------------------------------------------------------- Three months ended $(19) $(18) $ (1) Nine months ended $ 40 $ 13 $ 27 =======================================================================
Three Months Ended Nine Months Ended ------------------------------------------------------------------------------------------------------------------ Reasons for change September 30, 2003 vs. 2002 September 30, 2003 vs. 2002 ------------------------------------------------------------------------------------------------------------------ Gas deliveries $ (14) $ 14 Gas rate increase 5 35 Gas wholesales and retail services 1 4 Operation and maintenance 8 (6) General taxes, depreciation, and other income (1) (2) Fixed charges (1) (4) Income taxes 1 (14) --------------------------------------------------- Total change $ (1) $ 27 ==================================================================================================================
GAS DELIVERIES: For the three months ended September 30, 2003, gas delivery revenues decreased by $14 million from the previous year. The decrease primarily reflects $7 million of increased expense associated with Consumers' annual analysis of gas losses related to the gas transmission and distribution system. The adjustment is recorded as a reduction to accrued gas revenues. System deliveries, including miscellaneous transportation, totaled 38.2 bcf, a decrease of 1.9 bcf or 4.8 percent compared with 2002. For the nine months ended September 30, 2003, gas delivery revenues increased by $14 million from the previous year. System deliveries, including miscellaneous transportation, totaled 272.7 bcf, an increase of 18 bcf or 7.1 percent compared with 2002. This increase is primarily due to colder weather during the first quarter that resulted in increased deliveries to the residential and commercial sectors in 2003. GAS RATE INCREASE: In November 2002, the MPSC issued a final gas rate order authorizing a $56 million annual increase in Consumers' gas tariff rates. As a result of this order, for the three and nine months ended September 30, 2003, Consumers recognized increased gas revenues of $5 million and $35 million, respectively. OPERATION AND MAINTENANCE: For the three months ended September 30, 2003, operation and maintenance expenses decreased $8 million when compared to 2002. This decrease reflects the absence of gas storage inventory losses recorded in 2002. For the nine months ended September 30, 2003, operation and maintenance expenses increased $6 million when compared to 2002. This increase reflects the recognition of additional expenditures on safety, reliability and customer service. INCOME TAXES: For the three months ended September 30, 2003, income tax expense decreased primarily CMS-18 CMS Energy Corporation due to decreased earnings of the gas utility compared to 2002. For the nine months ended September 30, 2003, income tax expense increased primarily due to improved earnings of the gas utility. ENTERPRISES RESULTS OF OPERATIONS
In Millions ------------------------------------------------------------------------------- September 30 2003 2002 Change ------------------------------------------------------------------------------- Three months ended $ 13 $ 58 $ (45) Nine months ended $ 48 $ 126 $ (78) -------------------------------------------------------------------------------
For the three months ended September 30, 2003, Enterprises' net income was $13 million, a decrease of $45 million from the comparable period in 2002. The decrease in earnings reflects the absence of a $15 million after-tax benefit associated with the sale of an ownership interest in NPS in 2002, foreign currency losses in 2003, and the shift in business strategy and sale of Enterprises assets and businesses (see the Enterprises Outlook section in the MD&A). For the nine months ended September 30, 2003, Enterprises' net income was $48 million, a decrease of $78 million from the comparable period in 2002. The decrease in earnings reflects the absence of a $15 million after-tax benefit associated with the sale of an ownership interest in NPS in 2002, and the shift in business strategy and sale of Enterprises assets and businesses (see the Enterprises Outlook section in the MD&A). The decrease was partially offset by foreign currency gains related to the stabilization of the Argentine Peso and increased earnings at CMS Generation due to lower depreciation expenses. OTHER RESULTS OF OPERATIONS CORPORATE INTEREST AND OTHER:
In Millions -------------------------------------------------------------------------------- September 30 2003 2002 Change -------------------------------------------------------------------------------- Three months ended $ (87) $ (117) $ 30 Nine months ended $ (196) $ (221) $ 25 --------------------------------------------------------------------------------
For the three months ended September 30, 2003, corporate interest and other net expenses were $87 million, a decrease of $30 million from the comparable period in 2002. The decrease is primarily due to a $41 million reduction of income tax expense due to the absence of a 2002 valuation allowance recorded on AMT credit carryfowards, and a $26 million after-tax reduction in restructuring charges. These decreases were offset by a $28 million after-tax increase in debt retirement and refinancing costs, and an increase in other corporate interest expenses. For the nine months ended September 30, 2003, corporate interest and other net expenses were $196 million, a decrease of $25 million from the comparable period in 2002. The decrease is primarily due to a $41 million reduction of income tax expense due to the absence of a 2002 valuation allowance recorded on AMT credit carryfowards, a $28 million after-tax reduction of restructuring charges, and $20 million of MSBT refunds received in 2003. These decreases were offset partially by a $25 million after-tax increase in debt retirement and refinancing costs, the establishment in June 2003 of a $24 million deferred tax asset valuation allowance that may not be used in the future due to changes in CMS Energy's tax planning strategy, and an increase in other corporate interest expenses. CMS-19 CMS Energy Corporation DISCONTINUED OPERATIONS: For the nine months ended September 30, 2003, discontinued operations included International Energy Distribution and Marysville, as well as Panhandle, CMS Viron, and CMS Field Services through their respective dates of sale. For the nine months ended September 30, 2002, discontinued operations included Panhandle, CMS Viron, CMS Field Services, International Energy Distribution, and Marysville, and CMS Oil and Gas through its respective date of sale. For more information, see Note 3, Discontinued Operations. CAPITAL RESOURCES AND LIQUIDITY CASH POSITION, INVESTING, AND FINANCING CMS Energy's primary ongoing source of cash is dividends and other distributions from subsidiaries, including proceeds from asset sales. For the first nine months of 2003, Consumers paid $162 million in common dividends and Enterprises paid $179 million in common dividends and other distributions to CMS Energy. Included in Enterprises' distributions to CMS Energy was a $16 million stock dividend, discussed below. In October 2003, Consumers declared a $57 million common dividend to CMS Energy, payable in November 2003. CMS Energy's consolidated cash requirements are met by its operating, investing, and financing activities. Consistent with CMS Energy's liquidity objectives, $869 million consolidated cash was on hand at September 30, 2003, which includes $205 million of restricted cash. Restricted cash includes cash collateral for letters of credit to satisfy certain debt agreements and is classified as a current asset as all restricted cash relates to letters of credit maturing within one year. The following discussion of operating, investing, and financing activities summarizes CMS Energy's Consolidated Statements of Cash Flows found in CMS Energy's consolidated financial statements. OPERATING ACTIVITIES: CMS Energy's 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, cash used in operations after interest charges totaled $14 million in 2003 and cash provided from operations after interest charges totaled $333 million in 2002. The $347 million decrease in cash from operations resulted primarily from an increased pension contribution, an increase in inventories, and a decrease in accounts payable and accrued expenses. CMS Energy uses cash derived from its operating activities primarily to maintain and expand its businesses and to pay interest on and retire portions of its long-term debt. INVESTING ACTIVITIES: For the first nine months, CMS Energy's net cash provided by investing activities totaled $501 million in 2003 and $884 million in 2002. The $383 million decrease in cash provided primarily reflects a decrease of $685 million in proceeds received from the sale of assets. CMS Energy's expenditures, including investments and assets placed under capital lease, in the first nine months of 2003 for its utility and diversified energy businesses were $326 million and $46 million, respectively, compared to $461 million and $187 million, respectively, for the first nine months of 2002. FINANCING ACTIVITIES: For the first nine months, CMS Energy's net cash used in financing activities totaled $184 million in 2003 and $1,008 million in 2002. The $824 million change in financing cash flow resulted primarily from an increase in proceeds received from notes, bonds and other long-term debt of $1.576 billion, a decrease in the retirement of trust preferred securities of $111 million, and a decrease in the payment of common stock dividends of $124 million. These improvements in financing activities were offset partially by a decrease in the proceeds received from the issuance of common stock of $133 million, an increase in retirement of notes, bonds and other long-term debt of $378 million, and a decrease in notes payable of $324 million. CMS-20 CMS Energy Corporation OTHER INVESTING AND FINANCING MATTERS: In January 2003, the Board of Directors suspended the payment of CMS Energy's common stock dividend in order to improve liquidity. In June 2003, Enterprises transferred its 1,967,640 shares of CMS Energy Common Stock, valued at $16 million, to CMS Energy in the form of a stock dividend. There was no impact on shares outstanding or the consolidated income statement. OBLIGATIONS AND COMMITMENTS The following information on CMS Energy's contractual obligations, off-balance sheet arrangements and commercial commitments is provided to collect information in a single location so that a picture of liquidity and capital resources is readily available. For further information see Note 4, Uncertainties and Note 5, Financings and Capitalization. The following table shows a summary of CMS Energy's contractual obligations, including off-balance sheet commitments at September 30, 2003.
Contractual Obligations In Millions ------------------------------------------------------------------------------------------------------------------------- Payments Due ------------------------------------------------------------------------ September 30 Total 2003 2004 2005 2006 2007 Beyond ------------------------------------------------------------------------------------------------------------------------- On-balance sheet Long-term debt $ 6,291 $ - $ 205 $ 602 $ 513 $ 537 $ 4,434 Current portion of debt 172 43 129 - - - - Notes payable 4 1 3 - - - - Capital Lease Obligations 128 4 15 14 13 12 70 ------------------------------------------------------------------------------------------------------------------------- Total on-balance sheet $ 6,595 $ 48 $ 352 $ 616 $ 526 $ 549 $ 4,504 ------------------------------------------------------------------------------------------------------------------------- Off-balance sheet: Non-recourse debt $ 2,647 $ 229 $ 152 $ 116 $ 409 $ 13 $ 1,728 Operating leases 92 7 14 12 12 10 37 Sale of accounts receivable 254 254 - - - - - Unconditional purchase Obligations 17,897 601 1,577 1,197 905 743 12,874 ------------------------------------------------------------------------------------------------------------------------- Total off-balance sheet $20,890 $ 1,091 $ 1,743 $ 1,325 $ 1,326 $ 766 $14,639 =========================================================================================================================
LONG-TERM DEBT CMS Energy Long-Term Financings: In July 2003, CMS Energy issued, in a private placement to institutional investors, $150 million of 3.375 percent convertible senior notes due July 15, 2023. The notes are putable to CMS Energy by the note holders at par on July 15, 2008, July 15, 2013 and July 15, 2018. The notes are convertible into CMS Energy common stock at the option of the holder under certain circumstances. The initial conversion price is $10.671 per share, which translates into 93.7137 shares of common stock for each $1,000 principal note converted, and a total of 14,057,055 shares of CMS Energy common stock if all notes are converted. CMS has agreed to file a shelf registration statement with the SEC by October 14, 2004 relating to the resale of the notes and the common stock issuable upon conversion thereof. Also in July 2003, CMS Energy issued $300 million of 7.75 percent senior notes due 2010. CMS Energy has agreed to file a registration statement with the SEC by March 14, 2004 to permit holders of these notes to exchange the notes for new notes that will be registered under the Securities Act of 1933. The approximately $433 million of CMS-21 CMS Energy Corporation proceeds from these issuances were used to retire a portion of debt outstanding under CMS Energy's Second Amended and Restated Senior Credit Agreement and to redeem a portion of CMS Energy's 6.75 percent Senior Notes due January 2004. In July 2003, CMS Energy retired $150 million principal amount of CMS Energy's 8.375 percent Reset Put Securities due 2013. As a result, CMS Energy recorded a charge in July 2003 of approximately $19 million after-tax related to the accelerated amortization of debt issuance costs and the premium paid associated with the discharge of these securities. In October 2003, $82 million of the 6.75 percent senior notes were called and redeemed. In October 2003, approximately $15 million of Series E GTNs were called and redeemed. Consumers Long-Term Financings: The following is a summary of Consumers' Long-Term debt issuances during 2003:
------------------------------------------------------------------------------------------------------------- Facility Principal Use of Type (millions) Issue Rate Issue Date Maturity Date Proceeds Collateral ------------------------------------------------------------------------------------------------------------- Term Loan $ 140 LIBOR + March 2003 March 2009 GCP FMB (f) 475 bps Term Loan 150 LIBOR + March 2003 March 2006 (c) GCP FMB (f) 450 bps FMB (a) 375 5.375% April 2003 April 2013 (c) - FMB (a) 250 4.250% April 2003 April 2008 (c) - FMB (a) 250 4.000% May 2003 May 2010 (d) - FMB (b) 200 4.800% August 2003 February 2009 (e) - FMB (b) 200 6.000% August 2003 February 2014 (e) - ------- Total $ 1,565 =============================================================================================================
(GCP - General Corporate Purposes) (FMB - First Mortgage Bonds) (bps - basis points) (a) Consumers has agreed to file a registration statement with the SEC by December 26, 2003 to permit holders of these first mortgage bonds to exchange the bonds for new bonds that will be registered under the Securities Act of 1933. (b) Consumers has agreed to file a registration statement with the SEC by April 14, 2004 to permit holders of these first mortgage bonds to exchange the bonds for new bonds that will be registered under the Securities Act of 1933. (c) Consumers used the net proceeds to replace a $250 million senior reset put bond that matured in May 2003, to pay an associated $32 million option call payment and for general corporate purposes that included paying down additional debt. (d) Consumers used the net proceeds to prepay a portion of a term loan that was due to mature in July 2004. (e) Consumers used the net proceeds to pay off the $150 million term loan negotiated in March 2003 that was due to mature in March 2006 as well as the remaining $50 million balance on a term loan that was due to mature in March 2004, and for general corporate purposes. (f) Refer to "Regulatory Authorization for Financings" below for information about Consumers' remaining FERC debt authorization. As part of Consumers' ongoing cost reduction measures in an attempt to reduce its financing costs, Consumers will continue to monitor financial markets. CMS-22 CMS Energy Corporation Short-Term Financings: On March 30, 2003, CMS Energy entered into an amendment and restatement of its then existing $300 million and $295.8 million revolving credit facilities under which $409 million was outstanding. The Second Amended and Restated Senior Credit Agreement included a $159 million tranche with a maturity date of April 30, 2004 and a $250 million tranche with a maturity date of September 30, 2004. The facility was underwritten by several banks at a total annual cost to CMS Energy of approximately ten percent which included the initial commitment fee. Any proceeds of debt or equity issuances by CMS Energy and its subsidiaries or any asset sales by CMS Energy or its subsidiaries, other than Consumers, were required to be used to prepay this facility. This facility was collateralized primarily by the stock of Consumers, Enterprises and certain Enterprises subsidiaries. In July 2003, the facility was paid down to $5 million with a combination of a portion of the proceeds of the sale of CMS Field Services and a portion of the proceeds of the issuance of the $300 million 7.75 percent Senior Notes due 2010. On September 12, 2003, this credit agreement was amended and restated in the amount of $5 million. The amended and restated credit facility does not include any restrictive financial covenants. As of September 30, 2003, $5 million is outstanding on this facility. In March 2003, Consumers obtained a replacement revolving credit facility in the amount of $250 million secured by first mortgage bonds. In September 2003, this facility was amended and restated as a $400 million revolving credit facility. The interest rate of the facility was reduced from LIBOR plus 350 to LIBOR plus 175 basis points. The new credit facility matures in March 2004 with two annual extensions at Consumers' option, which would extend the maturity to March 2006. At September 30, 2003, all of the $400 million is available for general corporate purposes. In May 2003, CMS Energy entered into a revolving credit facility in an aggregate amount of $185 million. The maturity date of this facility is May 21, 2004. This facility is primarily used to provide letter of credit support for Enterprises' subsidiary activities - principally credit support for project debt. Enterprises provides funds to cash collateralize all letters of credit issued through this facility. As of September 30, 2003, approximately $167 million of letters of credit were issued under this facility and the cash that collateralizes the letters of credit is included on the balance sheet as restricted cash. Regulatory Authorization for Financings: At September 30, 2003, Consumers had FERC authorization, through June 2004, to issue or guarantee up to $1.1 billion of short-term securities outstanding at any one time. As of September 30, 2003, Consumers had $400 million outstanding as collateral for the revolving credit facility (discussed below) and had an additional $700 million available for future issuances of short-term securities. At September 30, 2003, Consumers also had remaining FERC authorization, through June 2004, to issue up to $800 million of long-term securities for refinancing or refunding purposes, $560.3 million of long-term securities for general corporate purposes, and $2.06 billion of long-term first mortgage bonds to be issued solely as collateral for other long-term securities. Also, FERC has granted waivers of its competitive bid/negotiated placement requirements applicable to the long-term securities authorization indicated above. Required Ratios: CMS Energy's amended and restated $5 million credit facility does not include any restrictive financial covenants. Consumers' credit facilities have restrictive financial covenants that require Consumers to maintain, as of the last day of each fiscal quarter, the following: CMS-23 CMS Energy Corporation
Required Ratio Limitation Ratio at September 30, 2003 ---------------------------------------------------------------------------------------------------------- CONSUMERS: Debt to Capital Ratio(a)(b) not more than 0.65 to 1.00 0.58 to 1.00 Interest Coverage Ratio-Revolver(a) not less than 2.00 to 1.00 3.34 to 1.00 ==========================================================================================================
(a) Violation of this ratio would constitute an event of default under the facility that provides the lender, among other remedies, the right to declare the principal and interest immediately due and payable. (b) The terms of the credit facility provide for the exclusion of securitization bonds in the calculation of the debt to capital ratio. In 1994, CMS Energy executed an indenture with JPMorgan Chase Bank, ultimate successor to The Chase Manhattan 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. At September 30, 2003, CMS Energy's consolidated leverage ratio was 0.76 to 1.0. As a result, 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 may refinance existing debt that was incurred while CMS Energy was in compliance with the consolidated leverage ratio. In 1992, CMS Energy executed an indenture with Bank One Trust Company, N.A. (successor to NBD Bank, National Association) pursuant to which CMS Energy issues its senior notes. The indenture, through supplements, contains certain provisions that can trigger a limitation on consolidated indebtedness and the ability of Consumers to incur indebtedness. The limitation can be activated when CMS Energy's consolidated coverage ratio, as defined in the indenture, is below 1.70 to 1.0. At September 30, 2003, CMS Energy's consolidated coverage ratio was 2.02 to 1.0. Consumers is subject to covenants in its financing agreements that could limit its ability to incur additional indebtedness. Consumers has agreed in several of its financing agreements to maintain specified levels of cash coverage of its interest requirements and to not allow its indebtedness to exceed specified levels of its consolidated capitalization (the "Debt Percentage Tests"). Consumers is in compliance with these requirements as of the most recent measurement date, September 30, 2003. These covenants make use of both generally accepted accounting principles and defined contractual terms in specifying how the relevant calculations are made. Consumers sought and received amendments to certain of its financing agreements to modify the terms of the Debt Percentage Tests in order to, among other things, remove the effect of the adoption of SFAS No. 150, portions of which have now been deferred indefinitely, regarding Trust Preferred Securities on the calculations. Restricted Payments: Under the provisions of its articles of incorporation, Consumers had $412 million of unrestricted retained earnings available to pay common dividends at September 30, 2003. However, covenants in Consumers' debt facilities cap common stock dividend payments at $300 million in a calendar year. Through September 30, 2003, Consumers paid $162 million in common dividends. In October 2003, Consumers declared a $57 million common dividend payable in November 2003. For information on the potential cap on common dividends payable included in the MPSC Securitization order see Consumers' Electric Utility Business Outlook, "Competition and Regulatory Restructuring - Securitization." Also, for information on the potential cap on common dividends payable included in the MPSC Staff's recommendation in Consumers' 2003 gas rate case see Consumers' Gas Utility Business Outlook, "2003 Gas Rate Case." CMS-24 CMS Energy Corporation PREFERRED SECURITIES In August 2003, 8,800,000 units of outstanding 7.25% Premium Equity Participating Security Units (CMS Energy Trust III) were converted to 16,643,440 newly issued shares of CMS Energy Common Stock. OTHER BALANCE SHEET OBLIGATIONS CMS Energy has other contractual obligations including notes payable and capital lease obligations. Notes payable include Consumers' $400 million revolving credit agreement. Capital leases include leased service vehicles and the new headquarters building. On November 7, 2003, Consumers closed a three-year $60 million term loan at an interest rate of LIBOR plus 135 basis points. The term loan is secured by First Mortgage bonds. The proceeds of the loan were used to purchase Consumers' headquarters building lease from the lessor, resulting in cost savings to Consumers. OFF-BALANCE SHEET ARRANGEMENTS CMS Energy's use of long-term contracts for the purchase of commodities and services, the sale of Consumers' accounts receivable, and operating leases are considered to be off-balance sheet arrangements. CMS Energy's operating leases are predominately railroad coal car leases, vehicles and miscellaneous office equipment. The full lease obligation becomes due in case of lease payment default. In addition, CMS Energy, through its subsidiary companies, has equity investments in partnerships and joint ventures in which they have a minority ownership interest. CMS Energy's proportionate share of unconsolidated debt associated with these investments is non-recourse to CMS Energy. In July 2003, CMS Energy and the National Power Company, through their joint venture, Jubail Energy Company, closed a $170 million project financing for construction of a co-generation plant designed to produce up to 250 MW of electricity and 510 tons of industrial steam per hour. This financing did not require any additional project investment by CMS Energy. The debt is non-recourse to CMS Energy and its subsidiaries and is not included on CMS Energy's balance sheet. At September 30, 2003, $14 million of this facility is drawn and is included in non-recourse debt in the "Contractual Obligations" table above. Sale of Accounts Receivable: Under a revolving accounts receivable sales program, Consumers currently sells certain accounts receivable to a wholly owned, consolidated, bankruptcy remote special purpose entity, Consumers Receivables Funding II. In turn, Consumers Receivables Funding II may sell an undivided interest in up to $325 million of the receivables to a bank-sponsored commercial paper conduit. The amount sold to the conduit was $254 million at September 30, 2003 and $325 million at September 30, 2002. These amounts are excluded from accounts receivable in Consumers' consolidated balance sheets. Consumers continues to service the receivables sold; however, the purchaser of the receivables has no recourse against Consumers' other assets for failure of a debtor to pay when due and the purchaser has no right to any receivables not sold. No gain or loss has been recorded on the receivables sold and Consumers retains no interest in the receivables sold. Unconditional Purchase Obligations: 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. Included in unconditional purchase obligations are 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 $47 million per month for the remaining three months of 2003, including $34 million related to the MCV Facility. For the period that a plant is not available to deliver electricity to Consumers, Consumers is not obligated to make the capacity payments to the plant. See Consumers' Electric Utility Results of Operations above and Note 4, Uncertainties, "Consumers' Electric Utility Rate Matters - Power Supply Costs" and "Other Consumers' Electric Utility Uncertainties - The Midland Cogeneration Venture" for further information concerning power supply costs. CMS-25 CMS Energy Corporation COMMERCIAL COMMITMENTS As of September 30, 2003, 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 $477 million. 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, 2003, the actual amount of financial exposure covered by these guarantees and indemnities was $52 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. Indemnities are three-party agreements used to assure performance of contracts by CMS Energy. Letters of credit are issued by banks guaranteeing CMS Energy's payments of its drafts. Drafts are for a stated amount and for a specified period; they substitute the bank's credit for CMS Energy's and reduce the credit risk for the other party.
Commercial Commitments In Millions ---------------------------------------------------------------------------------------------------------------- Commitment Expiration ---------------------------------------------------------------------------------------------------------------- September 30 Total 2003 2004 2005 2006 2007 Beyond ---------------------------------------------------------------------------------------------------------------- Off-balance sheet: Guarantees $ 208 $ - $ - $ - $ 4 $ - $ 204 Indemnities 65 - - 35 - - 30 Letters of Credit (a) 204 5 195 - - - 4 ---------------------------------------------------------------------------------------------------------------- Total $ 477 $ 5 $195 $ 35 $ 4 $ - $ 238 ================================================================================================================
(a) At September 30, 2003, CMS Energy had $176 million of cash collateralized letters of credit and the cash used to collateralize the letters of credit is included in Restricted Cash on the consolidated balance sheet. For further information, see Note 5, Financings and Capitalization. OUTLOOK CAPITAL RESOURCES AND LIQUIDITY CMS Energy's liquidity and capital requirements generally are 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. CMS Energy has contractual obligations and planned capital expenditures that would require substantial amounts of cash. As of January 2003, CMS Energy at the parent level had approximately $598 million and Consumers and its subsidiaries had approximately $727 million of publicly issued and credit facility debt maturing in 2003. During 2003, CMS Energy and Consumers have taken steps to address their 2003 maturities, as described below. As of September 30, 2003, CMS Energy at the parent level had approximately $28 million, Consumers and its subsidiaries had approximately $7 million, and Enterprises had approximately $8 million of publicly issued and credit facility debt maturing in 2003. In addition, CMS Energy could become subject to liquidity demands pursuant to commercial commitments under guarantees, indemnities and letters of credit. CMS ENERGY PARENT LEVEL LIQUIDITY CMS Energy has reduced debt through asset sales and securitization proceeds, with a total of approximately $3.5 billion in cash proceeds from such events over the two preceding calendar years. For the nine months CMS-26 CMS Energy Corporation ended September 30, 2003, CMS Energy has received gross cash proceeds of approximately $848 million and stock valued at September 30, 2003 of approximately $54 million as a result of additional asset sales as described below. Refer to Capital Resources and Liquidity, "Long-Term Debt" above for information about CMS Energy's 2003 debt financings. In January 2003, CMS Energy closed on the sale of a substantial portion of CMS MST's natural gas trading contracts for $17 million of gross cash proceeds. The sale of Centennial, resulting in gross proceeds to CMS Energy of $40 million, closed in February 2003. In March 2003, CMS MST sold the majority of its wholesale power book and related supply portfolio to Constellation Power Source, Inc. for gross cash proceeds of $34 million. The sale contains a potential to increase proceeds to $40 million dependent upon future years' performance of the sold assets. Additionally, during the first quarter of 2003, CMS MST sold its 50 percent joint venture ownership interest in Texon, its 50 percent interest in Premstar and its Tulsa retail contracts, resulting in net cash proceeds of approximately $6 million. In June 2003, CMS Energy completed the sale of its one-third membership interest in the Guardian Pipeline, L.L.C., to a subsidiary of WPS Resources Corporation. Gross proceeds from the sale were $26 million and were used to reduce debt. In conjunction with the sale, approximately $63 million of cash that CMS Energy had committed to collateralize a letter of credit was released. CMS Energy recorded a loss on the sale of Guardian of $4 million ($3 million, net of tax) in the second quarter of 2003. In June 2003, CMS Energy completed the previously announced sale of all of the outstanding capital stock of Panhandle to Southern Union Panhandle Corp., a newly formed entity owned by Southern Union. CMS Energy received gross cash proceeds of approximately $582 million and three million shares of Southern Union common stock, worth approximately $49 million based on the June 11, 2003 closing price of $16.48 per share. The sale agreement allowed CMS Energy to sell the stock 90 days after the closing date of June 11, 2003. The Southern Union common stock was recorded as a current asset on CMS Energy's balance sheet. In July 2003, Southern Union declared a five percent common stock dividend payable July 31, 2003, to shareholders of record as of July 17, 2003. As a result of the stock dividend, on September 30, 2003, CMS Energy held 3.15 million shares of Southern Union common stock, worth approximately $54 million, based on the closing price of $17.00 per share. The increase in CMS Energy's value of the Southern Union common stock of approximately $2 million was recorded in dividend income. In October 2003, CMS Energy sold its 3.15 million shares of Southern Union common stock to a private investor for $17.77 per share. The proceeds from the stock sale of approximately $56 million will be used to reduce debt. Southern Union Panhandle Corp. also assumed approximately $1.166 billion of Panhandle debt. CMS Energy used the initial cash proceeds from the sale of Panhandle to pay off and terminate Enterprises' $441 million and $75 million revolving credit facilities. The $30 million after-tax loss on the sale is included in discontinued operations. In June 2003, CMS MST's energy conservation unit, CMS Viron closed on the sale of the majority of its assets associated with its non-federal business to Chevron Energy Solutions Company, a division of Chevron U.S.A. and in April 2003, closed on the sale of its assets associated with its federal business to Pepco Energy Services. The total loss on the sale of CMS Viron was $14 million ($9 million, net of tax). In July 2003, CMS Energy completed the sale of CMS Field Services to Cantera Resources Inc. for gross cash proceeds of approximately $113 million and a $50 million face value note of Cantera Resources Inc. The note is payable to CMS Energy for up to $50 million subject to the financial performance of the Fort Union and Bighorn natural gas gathering systems from 2004 through 2008. The sale resulted in a $5 million loss ($1 million, net of tax), which is included in discontinued operations. The net sales proceeds of approximately $100 million were used to reduce debt. CMS-27 CMS Energy Corporation CMS Energy believes that further targeted asset sales, together with its planned reductions in operating expenses, capital expenditures, and the suspension of the common dividend also will contribute to improved liquidity. CMS Energy believes that its present level of cash, along with anticipated cash flows from operating and investing activities will be sufficient to meet its liquidity needs through 2003. CMS Energy believes, but can provide no assurance, that it will have sufficient liquidity to meet its debt maturities through 2004. CONSUMERS ENERGY LIQUIDITY Consumers' liquidity and capital requirements generally are a function of its results of operations, capital expenditures, contractual obligations, debt maturities, working capital needs and collateral requirements. During the summer months, Consumers purchases natural gas and stores it for resale primarily during the winter heating season. Recently, the market price for natural gas has increased. Although Consumers' natural gas purchases are recoverable from its customers, the amount paid for natural gas stored as inventory could require additional liquidity due to the timing of the cost recoveries. In addition, certain commodity suppliers to Consumers have requested advance payments or other forms of assurances, including margin calls, in connection with maintenance of ongoing deliveries of gas and electricity. This will also affect Consumers' liquidity position. Historically, Consumers has met its consolidated cash needs through its operating and financing activities and access to bank financing and the capital markets. In 2003, Consumers has contractual obligations and planned capital expenditures that would require substantial amounts of cash. Consumers may also become subject to liquidity demands pursuant to commercial commitments under guarantees, indemnities and letters of credit as indicated above. Consumers plans to meet its liquidity and capital requirements in 2003 through a combination of borrowings, reduced capital expenditures, cash flow generated from operations, and other measures. Refer to Capital Resources and Liquidity, "Long Term Debt" above for information about Consumers' 2003 debt financings. Consumers believes that its present level of cash and borrowing capacity (assuming access to capital markets), along with anticipated cash flows from operating and investing activities, will be sufficient to meet its liquidity needs through 2004. CORPORATE OUTLOOK During 2003, CMS Energy continues to implement a back-to-basics strategy that focuses on a growing healthy utility and divesting under-performing or other non-strategic assets. The strategy is designed to generate cash to pay down debt, to reduce business risk, and to provide for more predictable future operating revenues and earnings. Consistent with its back-to-basics strategy, CMS Energy is pursuing actively the sale of non-strategic and under-performing assets and has received approximately $3.5 billion of cash from asset sales, securitization proceeds and proceeds from LNG monetization since 2001. These assets are recorded at current fair value, however, upon the sale of additional non-strategic and under-performing assets, the proceeds realized may be different than the recorded value of those assets if market conditions change. Even though these assets have been identified for sale, management cannot predict when, nor make any assurance 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 or Consumers. Earnings (loss) from equity method investments in Jorf Lasfar and the MCV Partnership were $11 million and $(7) million, respectively for the three months ended September 30, 2003 and $46 million and $19 million, respectively for the nine months ended September 30, 2003. As CMS Energy continues to implement its back-to-basics strategy and further reduces its ownership of non-utility assets, the percentage of CMS Energy's future earnings relating to Jorf Lasfar and the MCV Partnership may increase and CMS Energy's total future earnings may depend more significantly upon the performance of Jorf Lasfar and the MCV Partnership. An affiliate of CMS Generation owns a 49.6 percent interest in the Loy Yang Power Partnership ("LYPP"), which owns the 2,000 MW Loy Yang coal-fired power project in Victoria, Australia. Due to unfavorable CMS-28 CMS Energy Corporation power prices in the Australian market, the LYPP is not generating cash flow sufficient to meet its debt-service obligations. LYPP has A$500 million of term bank debt that, pursuant to extensions from the lenders, is scheduled to mature on February 12, 2004. The partners in LYPP (including affiliates of CMS Generation, NRG Energy Inc. and Horizon Energy Australia Investments) have been exploring the possible sale of the project (or control of the project) and a restructuring of the finances of LYPP. In July 2003, a conditional share sale agreement was executed by the LYPP partners and partners of the Great Energy Alliance Corporation ("GEAC") to sell the project to GEAC for A$3.5 billion (approximately $2.4 billion in U.S. dollars), including A$165 million (approximately $111 million in U.S. dollars) for the project equity. The Australian Gas Light Company, the Tokyo Electric Power Company, Inc. and a group of financial investors led by the Commonwealth Bank of Australia formed GEAC earlier this year to explore the possible acquisition of Loy Yang. The conditions to completion of the sale to GEAC include consents from LYPP's lenders to a restructuring of the project's debt, satisfactory resolution of regulatory issues and approvals, rulings on tax and stamp duty obligations, and approvals from the investors in Horizon Energy Australia Investments and the creditors committee of NRG Energy Inc. It should be noted in particular that the Australian federal antitrust regulator has disapproved the transaction because of its perceived anticompetitive effects, and GEAC has brought an action for declaratory relief against the regulator to reverse that disapproval. Closing was targeted for early September 2003, but given the regulatory uncertainties, the parties to the share sale agreement have agreed to extend the date for resolution of the regulatory conditions to closing to not later than December 19, 2003, assuming satisfactory interim resolution of other closing conditions. The share sale agreement provides GEAC a period of exclusivity while the conditions of the purchase are satisfied. The ultimate net proceeds to CMS Energy for its equity share in LYPP may be subject to reduction based on the ultimate resolution of many of the factors described above as conditions to completion of the sale, as well as closing adjustments and transaction costs, and could likely range between $20 million and a nominal amount. CMS Energy cannot predict whether this sale to GEAC will be consummated or, if not, whether any of the other initiatives will be successful, and it is possible that CMS Generation may lose all or a substantial part of its remaining equity investment in the LYPP. CMS Energy previously has written off its equity investment in the LYPP, and further write-offs would be limited to cumulative net foreign currency translation losses. The amount of such cumulative net foreign currency translation losses is approximately $168 million at September 30, 2003. Any such write-off would flow through CMS Energy's income statement but would not result in a reduction in shareholders' equity or cause CMS Energy to be in noncompliance with its financing agreements. 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 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 experienced higher electric deliveries in 2002 as a result of warmer than normal summer weather. For 2003, a slight decline in electric deliveries from 2002 is anticipated. This short-term outlook for 2003 assumes higher levels of manufacturing activity than in 2002 and normal weather conditions in the last three months of the year. CMS-29 CMS Energy Corporation 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 Consumers' 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 October 2003, alternative electric suppliers are providing 603 MW of generation supply to retail open access customers. 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. Consumers cannot predict the total amount of electric supply load that may be lost to competitor suppliers, nor whether the stranded cost recovery method adopted by the MPSC will be applied in a manner that will fully offset any associated margin loss. Stranded 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. The MPSC authorized Consumers to use deferred accounting to recognize the future recovery of costs determined to be stranded. According to the MPSC, "net" Stranded Costs are to be recovered from retail open access customers through a Stranded Cost transition charge. In April 2002, Consumers made "net" Stranded Cost filings with the MPSC for $22 million for 2000 and $43 million for 2001. Consumers in its hearing brief, filed in August 2002, revised its request for Stranded Costs to $7 million for 2000 and $4 million for 2001. The single largest reason for the difference in the filing was the exclusion, as ordered by the MPSC, of all costs associated with expenditures required by the Clean Air Act. As discussed below in "Securitization", Consumers filed a request with the MPSC for authority to issue Securitization bonds that would allow recovery of the Clean Air Act expenditures that were excluded from the Stranded Cost calculation. In December 2002, the MPSC issued an order finding that Consumers experienced zero "net" Stranded Costs in 2000 and 2001, but declined to resolve numerous issues regarding the "net" Stranded Cost methodology in a way that would allow a reliable prediction of the level of Stranded Costs for 2002 and future years. In January 2003, Consumers filed a petition for rehearing of the December 2002 Stranded Cost order in which it asked the MPSC to grant a rehearing and revise certain features of the order. Several other parties have also filed rehearing petitions with the MPSC. Consumers has also initiated an appeal at the Michigan Court of Appeals related to the MPSC's December 2001 "net" Stranded Cost order. In March 2003, Consumers filed an application with the MPSC seeking approval of "net" Stranded Costs incurred in 2002, and for approval of a "net" Stranded Cost recovery charge. In the application, Consumers indicated that if Consumers' proposal to securitize Clean Air Act expenditures and Palisades expenditures previously not securitized were approved as proposed in its securitization case as discussed below in "Securitization", then Consumers' "net" Stranded Costs incurred in 2002 would be approximately $35 million. If the proposal to securitize those costs is not approved, then Consumers indicated that the costs would be CMS-30 CMS Energy Corporation properly included in the 2002 "net" Stranded Cost calculation, which would increase Consumers' 2002 "net" Stranded Costs to approximately $103 million. In June 2003, the MPSC issued a financing order in the securitization case, authorizing the issuance of Securitization bonds in the amount of approximately $554 million. Included in this amount were Clean Air Act expenditures. However, the MPSC rejected Palisades expenditures previously not securitized as eligible securitized costs. As a result, the Palisades expenditures previously not securitized should be included as a component of "net" Stranded Costs and will be included as a component of a future electric rate case proceeding with the MPSC. With the inclusion of the Palisades expenditures previously not securitized, Consumers' "net" Stranded Costs incurred in 2002 are estimated to be approximately $50 million. In July 2003, Consumers filed a petition for rehearing and clarification on a number of features in the MPSC's financing order on securitization. Once a final financing order by the MPSC on securitization is issued, the amount of Consumers' request for "net" Stranded Cost recovery for 2002 will be known. Consumers cannot predict how the MPSC will rule on its request for the recoverability of Stranded Costs, and therefore Consumers has not recorded any regulatory assets to recognize the future recovery of such costs. The MPSC staff has scheduled a collaborative process to discuss Stranded Costs and related issues and to identify and make recommendations to the MPSC. Consumers has participated in this collaborative process. In July 2003, the staff suspended formal discussion while it considers possible conclusions and recommendations. Implementation Costs: 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 - 2003 2002 2 2 Pending Pending ======================================================================================
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 order received for the year 2001, the MPSC also reserved the right to review again the 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 above, as of September 30, 2003, Consumers incurred and deferred as a regulatory asset, $2 million of additional implementation costs and has also recorded a regulatory asset of $16 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 is expected to begin after the rate freeze or rate cap period has expired. As discussed below, Consumers has asked to include implementation costs through December 31, 2000 in the pending securitization case. If approved, the sale of Securitization bonds will allow for the recovery of these costs. Consumers cannot predict the amounts the MPSC will approve as allowable costs. CMS-31 CMS Energy Corporation Also, Consumers is pursuing authorization at the FERC for MISO to reimburse Consumers for approximately $8 million in certain electric utility restructuring implementation costs related to its former participation in the development of the Alliance RTO, a portion of which has been expensed. In May 2003, the FERC issued an order denying MISO's request for authorization to reimburse Consumers. In June 2003, Consumers and MISO filed a joint petition for rehearing with the FERC. In September 2003, the FERC denied Consumers' and MISO's joint request. Consumers plans to appeal the FERC ruling at the United States Court of Appeals for the District of Columbia and pursue other potential means of recovery. In November 2003, in conjunction with Consumers' appeal of the September Order denying recovery, Consumers persuaded MISO to file a request with the FERC seeking authority to reimburse METC, the legal successor in interest to the Alliance RTO start-up costs. As part of the contract for sale of Consumers' former transmission system, should the Commission approve the new MISO filing, METC is contractually obligated to flow-through to Consumers the full amount of any Alliance RTO start-up costs that it is authorized to recover through FERC. Consumers cannot predict the outcome of the appeal process, the MISO request, or the amount of implementation costs, if any; the FERC ultimately will allow to be collected. Securitization: In March 2003, Consumers filed an application with the MPSC seeking approval to issue Securitization bonds in the amount of approximately $1.084 billion. The application sought recovery of costs associated with Clean Air Act expenditures, Palisades expenditures previously not securitized, retail open access implementation costs through December 31, 2003, certain pension fund costs, and expenses associated with the issuance of the bonds. In June 2003, the MPSC issued a financing order authorizing the issuance of Securitization bonds in the amount of approximately $554 million. This amount relates to Clean Air Act expenditures and associated return on those expenditures through December 31, 2002, retail open access implementation costs and previously authorized return on those expenditures through December 31, 2000, and the "up front" other qualified costs related to issuance of the Securitization bonds. The MPSC rejected Palisades expenditures previously not securitized as eligible securitized costs. Therefore, Palisades expenditures previously not securitized should be included as a component of "net" Stranded Costs and will be included as a component of a future electric rate case proceeding with the MPSC. In the June 2003 financing order, the MPSC also adopted a rate design that would allow retail open access customers to pay a securitization charge (and related tax charge) that are a small fraction of the amounts paid by full service bundled sales customers and special contract customers of the utility. The financing order provides that the securitization charges (and related tax charges) for the full service and bundled sales customers are increased under the rate design in the financing order in order to be sufficient to repay the principal, interest and all other "ongoing" qualified costs related to servicing the Securitization bonds. The financing order also restricts the amount of common dividends payable by Consumers to its "earnings." In July 2003, Consumers filed for rehearing and clarification on a number of features in the financing order, including the rate design, accounting treatment of unsecuritized qualified costs and dividend restriction. Also in July 2003, the Attorney General filed a claim of appeal related to the financing order and the Attorney General indicated it would challenge the lawfulness of the rate design. In October 2003, the Court of Appeals dismissed the appeal and indicated that the Attorney General could resubmit the appeal after the MPSC acted on Consumers' rehearing request. Subsequently, the Attorney General filed a motion of rehearing asking for reconsideration of the Court of Appeals' dismissal. The financing order will become effective after rehearing, resolution of appeals and upon acceptance by Consumers. Rate Caps: The Customer Choice Act imposes certain limitations on electric rates that could result in Consumers being unable to collect from electric 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. After December 31, 2003, the statute would allow customers to petition the MPSC for rate reductions below the cap. Consumers would have the opportunity to respond to such a petition before rates could be reduced. CMS-32 CMS Energy Corporation As a result of Consumers meeting the transmission capability expansion requirements and the market power test, as discussed in Note 4, Uncertainties, "Consumers' Electric Utility Rate Matters - Electric Restructuring", Consumers has met the requirements under Public Act 141 to return to the PSCR process. On September 30, 2003, Consumers submitted a PSCR filing to the MPSC that would reinstate the PSCR process for customers whose rates will no longer be frozen or capped as of January 1, 2004. The proposed PSCR charge allows Consumers to recover a portion of its increased power supply costs from large commercial and industrial customers effective January 1, 2004. This is the first customer class for which the rate freeze and cap expire. Consumers will, pursuant to its right under applicable law, self-implement the proposed PSCR charge on January 1, 2004, unless the MPSC issues an order before that date establishing a different charge. The charge is subject to subsequent change by the MPSC during the PSCR period (calendar-year 2004). The revenues received pursuant to the PSCR charge by statute are also subject to subsequent reconciliation when the year is finished and actual costs have been reviewed for reasonableness and prudence. Consumers cannot predict the outcome of this filing. Included in Consumers' retail electric customers' frozen rates is a nuclear decommissioning surcharge related to the decommissioning of Big Rock. The MPSC authorized collection of the surcharge through December 2000. Consumers has continued to collect the Big Rock nuclear decommissioning surcharge consistent with the provisions of the Customer Choice Act rate freeze in effect through December 31, 2003. Beginning in January 2004, the Big Rock decommissioning surcharge will be eliminated, reducing Consumers' annual electric revenues by approximately $35 million in 2004. A portion of this reduction is expected to be offset by the collection of increased PSCR revenues. Industrial Contracts: In response to industry restructuring efforts, in 1995 and 1996, 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, totaling a maximum of approximately 685 MW of load, as part of its phased introduction to competition. Unless terminated or restructured, the majority of these contracts are in effect through 2005. As of September 30, 2003, contracts for 200 MW of load have terminated. Of the contracts that have terminated, contracts for 64 MW have gone to an alternative electric supplier, and contracts for 136 MW have returned to bundled tariff rates. Consumers cannot predict the ultimate financial impact of changes related to these power supply contracts, or whether additional special 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 transfer pricing between Consumers' departments and affiliates. In October 2001, the new code of conduct was reaffirmed by the MPSC 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 electric and gas revenues. In October 2002, the MPSC denied waivers for three programs that provided approximately $32 million in gas revenues in 2001, of which $30 million relates to the appliance service plan. 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. In November 2002, the Michigan CMS-33 CMS Energy Corporation Court of Appeals denied Consumers' request for a stay. Consumers filed an application for leave to appeal with the Michigan Supreme Court with respect to the Michigan Court of Appeals' November ruling denying the stay. In February 2003, the Michigan Supreme Court denied the application. In December 2002, Consumers filed a renewed request with the MPSC for a temporary waiver until April 2004 for the appliance service plan, which generated $33 million in gas revenues in 2002. In February 2003, the MPSC granted an extension of the temporary waiver until December 31, 2003. 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 down the guidelines 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. In July 2003, legislation was introduced in the Michigan legislature that, if enacted, would clarify the application of the code of conduct in a manner that would allow Consumers to continue to offer the appliance service plan. In October 2003, the Michigan Senate passed legislation to preserve the appliance service plan. The House of Representatives of Michigan is scheduled to review the legislation in early 2004; however, in the interim passed a bill to extend the MPSC's waiver for the program to July 1, 2004. Energy Policy: Uncertainty exists regarding the enactment of a national comprehensive energy policy, specifically federal electric industry restructuring legislation. A variety of bills that have been introduced in the United States Congress in recent years were designed to change existing federal regulation of the industry. If the federal government enacts a comprehensive energy policy, then that legislation could potentially affect company operations and financial requirements. Transmission: In May 2002, Consumers sold its electric transmission system for approximately $290 million to MTH, a non-affiliated limited partnership whose general partner is a subsidiary of Trans-Elect, Inc. The pretax gain was $31 million ($26 million, net of tax). Remaining open issues are not expected to substantially impact the amount of the gain. As a result of the sale, Consumers anticipates its after-tax earnings will decrease by $15 million in 2003, and decrease by approximately $14 million annually for the next three years due to a 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. Under an agreement with MTH, and subject to certain additional RTO surcharges, transmission rates charged to Consumers are fixed by contract at current levels through December 31, 2005, and subject to FERC ratemaking thereafter. MTH has completed 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 until May 1, 2007 under a contract with MTH. CMS-34 CMS Energy Corporation There are multiple proceedings and a proposed rulemaking pending before the FERC regarding transmission pricing mechanisms and standard market design for electric bulk power markets and transmission. The results of these proceedings and proposed rulemaking could significantly affect the trend of transmission costs and increase the delivered power costs to Consumers and the retail electric customers it serves. The specific financial impact on Consumers of such proceedings, rulemaking and trends are not currently quantifiable. In addition, Consumers is evaluating whether or not there may be impacts on electric reliability associated with the outcomes of these various transmission related proceedings. Consumers cannot assure that all risks to reliability can be avoided. August 14, 2003 Blackout: On August 14, 2003, the electric transmission grid serving parts of the Midwest and the Northeast experienced a significant disturbance, which impacted electric service to millions of homes and businesses throughout a vast region. In Michigan, more than 2 million electric customers were without electricity. Consumers had five fossil-fueled generating unit outages and, of Consumers' 1.7 million electric customers, approximately 100,000 were without power for approximately 24 hours as a result of the disturbance. The impact was felt most heavily in the southeastern part of Consumers' service territory. As discussed above in "Transmission", Consumers sold its electric transmission system in May 2002 to MTH, with Consumers providing transmission system maintenance under a five-year contract with MTH. MTH now owns, controls, and plans for the transmission system that serves Consumers. Consumers incurred approximately $1 million of immediate financial impact as a result of the blackout. Consumers continues to cooperate with investigations of the blackout by several federal and state agencies. Consumers cannot predict the outcome of these investigations. In November 2003, the MPSC released its report on the August 14, 2003 blackout, which found no evidence to suggest that the events in Michigan or actions taken by the Michigan utilities or transmission operators were factors contributing to the cause of the blackout. As a result of its investigation, the MPSC is recommending that Congress pass legislation that would empower the FERC, where necessary, to order membership into a RTO and that Congress should provide the FERC with the authority to develop and enforce mandatory transmission reliability standards with penalties for noncompliance. 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. In November 2002, the MPSC issued an order initiating the formal rulemaking proceeding. Consumers has filed comments on the proposed rules and 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 4, Uncertainties, "Consumers' Electric Utility Rate Matters - Electric Restructuring" and "Consumers' Electric Utility 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) pending litigation and government investigations; 2) the need to make additional capital expenditures and increase operating expenses for Clean Air Act compliance; 3) 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; 4) pending litigation filed by PURPA qualifying facilities; 5) uncertainties relating to the storage and ultimate disposal of spent nuclear fuel; 6) electric industry restructuring issues, including those described above; 7) 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; 8) the recovery of electric restructuring CMS-35 CMS Energy Corporation implementation costs; 9) Consumers' status as an electric transmission customer and not as an electric transmission owner/operator; 10) sufficient reserves for transmission rate refunds; 11) the effects of derivative accounting and potential earnings volatility; 12) increased costs for safety and homeland security initiatives that are not recoverable on a timely basis from customers; 13) potentially rising pension costs due to market losses and lump sum payments (as discussed above in Accounting for Pension and OPEB); 14) Consumers' ability to recover any of its "net" Stranded costs under the regulatory policies being followed by the MPSC; 15) the effects of lost electric supply load from retail open access and the recovery of associated margin loss; 16) the uncertain effects, including exposure to liability, increased regulatory requirement and new legislation, due to the future conclusions about the causes of the August 14, 2003 blackout. For further information about these trends or uncertainties, see Note 4, Uncertainties. CONSUMERS' GAS UTILITY BUSINESS OUTLOOK GROWTH: Over the next five years, Consumers expects gas deliveries, including gas full service and customer choice deliveries (excluding transportation to the MCV Facility and off-system deliveries), to grow at an average rate of less than one percent per year based primarily on a steadily growing customer base. Actual gas deliveries in future periods may be affected by abnormal weather, use of gas by independent power producers, changes in competitive and economic conditions, the level of natural gas consumption per customer, and the recent significant increases in gas commodity prices. GAS COST RECOVERY: As part of the on-going GCR process, which includes an annual reconciliation case with the MPSC, Consumers expects to recover all of its gas costs. In June 2003, Consumers filed a reconciliation of GCR costs and revenues for the 12-months ended March 2003. Consumers proposes to recover from its customers a net under-recovery of approximately $6 million using a roll-in methodology. The roll-in methodology incorporates the under-recovery in the GCR factor charged in the next GCR year. The roll-in tariff provision was approved by the MPSC in a November 2002 order. In July 2003, the MPSC approved a settlement agreement authorizing Consumers to increase its gas cost recovery factor for the remainder of the current GCR plan year (August 2003 through March 2004) and to implement a quarterly ceiling price adjustment mechanism, based on a formula that tracks changes in NYMEX natural gas prices. Consistent with the terms of the settlement, the ceiling price is $6.11 per mcf. However, Consumers will utilize a GCR factor of $5.41 per mcf commencing in November 2003 bills. All recoveries pursuant to such factors are subject to final reconciliation by the MPSC. 2001 GAS RATE CASE: In June 2001, Consumers filed an application with the MPSC seeking a distribution service rate increase. In November 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 2002. As part of this order, the MPSC approved Consumers' proposal to absorb the assets and liabilities of Michigan Gas Storage Company into Consumers' rate base and rates. This has occurred through a statutory merger of Michigan Gas Storage Company into Consumers and this is not expected to have an impact on Consumers' consolidated financial statements. 2003 GAS RATE CASE: In March 2003, Consumers filed an application with the MPSC seeking a $156 million increase in its gas delivery and transportation rates, which includes a 13.5 percent return on equity, based on a 2004 test year. Contemporaneously with this filing, Consumers has requested interim rate relief in the same amount. In August 2003, the MPSC Staff recommended interim rate relief of $80 million be granted in this proceeding, subject to Consumers voluntarily agreeing to limit its dividends to its parent, CMS Energy, to a maximum of $190 million in any calendar year. CMS-36 CMS Energy Corporation In September 2003, Consumers filed an update to its gas rate case that lowered the requested revenue increase from $156 million to $139 million and revised the return on common equity from 13.5 percent to 12.75 percent. The majority of the reduction is related to lower debt costs and changes in the projected capital structure. The MPSC Staff and ABATE filed their cases in early October. The Staff made no change to its interim position of $80 million and continued to propose the same dividend limitation. ABATE did not make a specific recommendation for a final rate increase, but did discuss the rate design used to recover any rate increase granted. A proposal for decision is expected from the administrative law judge in January 2004. 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 $36 million in annual gas revenues, may be restricted by the new code of conduct issued by the MPSC, as discussed above in Consumers' Electric Utility Business Outlook, "Competition and Regulatory Restructuring - Code of Conduct." 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) pending litigation and government investigations; 2) potential environmental costs at a number of sites, including sites formerly housing manufactured gas plant facilities; 3) future gas industry restructuring initiatives; 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 consumption per residential customer; 6) increase in costs for pipeline integrity, safety, and homeland security initiatives that are not recoverable on a timely basis from customers; 7) potentially rising pension costs due to market losses and lump sum payments (as discussed above in Accounting for Pension and OPEB); and 8) potential adverse appliance service plan ruling or related legislation. For further information about these uncertainties, see Note 4, Uncertainties. CONSUMERS' OTHER OUTLOOK SECURITY COSTS: Since the September 11, 2001 terrorist attacks in the United States, Consumers has increased security at all critical facilities and over its critical 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. Through September 30, 2003, Consumers has incurred approximately $7 million in incremental security costs, including operating, capital, and decommissioning and removal costs, mainly relating to its nuclear facilities. Consumers estimates it may incur additional incremental security costs for the last three months of 2003 of approximately $3 million, of which $2 million relates to nuclear security costs. Consumers will attempt to seek recovery of these costs from its customers. In December 2002, the Michigan legislature passed, and the governor signed, a bill that would allow Consumers to seek recovery of additional nuclear electric division security costs incurred during the rate freeze and cap periods imposed by the Customer Choice Act. In February 2003, the MPSC adopted filing requirements for the recovery of enhanced security costs. ENTERPRISES OUTLOOK CMS Energy's IPP subsidiary plans to complete the restructuring of its operations by narrowing the scope of its existing operations and commitments to two regions: North America and the Middle East/North Africa. In addition, its plans include selling, over time, designated assets and investments that are under-performing, non- CMS-37 CMS Energy Corporation region focused and non-synergistic with other CMS Energy business units. The IPP 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 MST has continued to streamline its portfolio in order to reduce its business risk and outstanding credit guarantees. CMS MST's future activities are centered around meeting contractual obligations, as well as purchasing fuel for and marketing the merchant power from DIG, Michigan Power, LLC and other IPPs as their current power purchase agreements expire. For the nine months ended September 30, 2003, CMS Energy's operating revenue was $4.059 billion, a decrease of $2.784 billion from the comparable period in 2002. This decrease in operating revenue was due primarily to the sale of CMS MST's gas and power books in the first quarter of 2003. CMS Gas Transmission continues to narrow its scope of existing operations and commitments. In doing so, CMS Energy is pursuing actively the sale, liquidation, or other disposition of certain of its assets and investments, but management cannot predict when, nor make any assurances that, these asset and investment sales will occur. 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 and 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 increase substantially 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; and 6) the impact of ratings downgrades on CMS Energy's liquidity, costs of operating, and cost of capital. OTHER OUTLOOK SEC AND OTHER INVESTIGATIONS: As a result of round-trip trading transactions by CMS MST, CMS Energy's Board of Directors established a Special Committee 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 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 Special Committee found no 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. Previously, CMS Energy terminated its speculative trading business and revised its risk management policy. The Board of Directors adopted, and CMS Energy has implemented the 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. The FERC issued an order on April 30, 2003 directing eight companies, including CMS MST, to submit written demonstrations within 45 days that they have taken certain specified remedial measures with respect to the reporting of natural gas trading data to publications that compile and CMS-38 CMS Energy Corporation publish price indices. CMS MST made a written submission to the FERC on June 11, 2003 in compliance with the FERC's directives. On July 29, 2003, the FERC issued an order stating that CMS MST met the requirements of the FERC's April 30, 2003 order. Other than the FERC investigation, CMS Energy is unable to predict the outcome of these matters, and 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 were filed against CMS Energy, Consumers, and certain officers and directors of CMS Energy and its affiliates. The complaints were filed as purported class actions in the United States District Court for the Eastern District of Michigan by shareholders who allege that they purchased CMS Energy's securities during a purported class period. The cases were consolidated into a single lawsuit and an amended and consolidated class action complaint was filed on May 1, 2003. The consolidated complaint contains a purported class period beginning on May 1, 2000 and running through March 31, 2003. It generally seeks unspecified damages based on allegations that the defendants violated United States securities laws and regulations by making allegedly false and misleading statements about CMS Energy's business and financial condition, particularly with respect to revenues and expenses recorded in connection with round-trip trading by CMS MST. The companies intend to defend vigorously against this action but cannot predict the outcome of this litigation. DEMAND FOR ACTIONS AGAINST OFFICERS AND DIRECTORS: The Board of Directors of CMS Energy 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 by CMS MST, 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 has elected two new members to its Board of Directors who are serving 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 litigation. ERISA 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 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, and an amended and consolidated complaint was filed. 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 defended vigorously. CMS Energy cannot predict the outcome of this litigation. GAS INDEX PRICE REPORTING INVESTIGATION: CMS Energy has notified appropriate regulatory and governmental agencies that some employees at CMS MST and CMS Field Services appeared to have provided inaccurate information regarding natural gas trades to various energy industry publications which compile and report index prices. CMS Energy is cooperating with investigations by the Commodity Futures Trading Commission, Department of Justice and FERC regarding this matter. CMS Energy is unable to predict the outcome of these matters and what effect, if any, these investigations will have on its business. GAS INDEX PRICE REPORTING LITIGATION: In August 2003, Cornerstone Propane Partners, L.P. ("Cornerstone") filed a putative class action complaint in the United States District Court for the Southern District of New York against CMS Energy and 40 other energy companies. The complaint alleges that false natural gas price reporting by the defendants manipulated the prices of NYMEX natural gas futures and options. The complaint contains two counts under the Commodity Exchange Act, one for manipulation and one for aiding and abetting CMS-39 CMS Energy Corporation violations. Cornerstone has agreed to provide a blanket 60-day extension of time for all defendants to answer or otherwise respond to the complaint. CMS Energy intends to defend vigorously against this action but cannot predict the outcome of this litigation. INTEGRUM LAWSUIT: A complaint was filed in Wayne County, Michigan Circuit Court on July 17, 2003 by Integrum against CMS Energy, Enterprises and APT. Integrum alleges several causes of action against APT, CMS Energy and Enterprises in connection with an offer by Integrum to purchase the CMS Pipeline Assets. In addition to seeking unspecified money damages, Integrum is seeking an order enjoining Enterprises and CMS Energy from selling and APT from purchasing the CMS Pipeline Assets and an order of specific performance mandating that CMS Energy, Enterprises and APT complete the sale of the CMS Pipeline Assets to APT and Integrum. An officer and director of Integrum is a former officer and director of CMS Energy, Consumers and certain of its subsidiaries. The individual was not employed by CMS Energy, Consumers or its subsidiaries when Integrum made the offer to purchase the CMS Pipeline Assets. CMS Energy and Enterprises intend to vigorously defend against this action. CMS Energy and Enterprises cannot predict the outcome of this litigation. OTHER MATTERS CONTROLS AND PROCEDURES DISCLOSURE CONTROLS AND PROCEDURES: CMS Energy's management, with the participation of its CEO and CFO, has evaluated the effectiveness of CMS Energy's disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this report. Based on such evaluation, CMS Energy's CEO and CFO have concluded that, as of the end of such period, CMS Energy's disclosure controls and procedures are effective. INTERNAL CONTROL OVER FINANCIAL REPORTING: There have not been any changes in CMS Energy's internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, CMS Energy's internal control over financial reporting. CONTROL WEAKNESSES AT CMS MST In late 2001 and during 2002, CMS Energy identified a number of deficiencies in CMS MST's systems of internal accounting controls. The internal control deficiencies related to, among other things, a lack of account reconciliations, unidentified differences between subsidiary ledgers and the general ledger, and procedures and processes surrounding the CMS Energy accounting for energy trading contracts, including mark-to-market accounting. Senior management, the Audit Committee of the Board of Directors, the Board of Directors, and the independent auditors were notified of these deficiencies as they were discovered, and CMS Energy commenced a plan of remediation that included the replacement of certain key personnel and the deployment of additional internal and external accounting personnel to CMS MST. Certain aspects of the remediation plan, which includes the implementation of improvements and changes to CMS MST's internal accounting controls, were postponed to enable CMS Energy to prepare restated financial statements for 2000 and 2001. While a number of these control improvements and changes were implemented in late 2002, the most important ones occurred in the first quarter of 2003. The implementation of certain elements of its remediation plan enabled CMS Energy to prepare reliable restated financial statements for CMS MST for December 31, 2000, 2001 and 2002, as well as for the quarterly periods of 2001 and 2002. CMS-40 CMS Energy Corporation Management believes that the improvements to its system of internal accounting controls are appropriate and responsive to the internal control deficiencies that were identified. Management will continue to monitor the operation of the improved internal controls to assess their sustained effectiveness through 2003. CASH MANAGEMENT In August 2002, FERC issued a NOPR concerning the management of funds by certain FERC-regulated companies. The proposed rule could establish limits on the amount of funds that may 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 also may require participants to provide documentation of certain transactions. In the NOPR, 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. In October 2003, a final rule was issued by FERC. The rule will require Consumers, as a FERC-regulated company, to file its cash management agreements with the FERC and to notify the FERC within 45 days after the end of each calendar quarter when their proprietary capital ratio drops below 30 percent, and when it subsequently returns to or exceeds 30 percent. The rule also requires certain information about cash management agreements and transactions to be maintained. The rule becomes effective in late November 2003. Consumers operates its cash management program independent of CMS Energy and, therefore, does not anticipate additional reporting requirements as a result of this final rule. IMPLEMENTATION OF NEW ACCOUNTING STANDARDS SFAS NO. 149, AMENDMENT OF STATEMENT 133 ON DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES: Issued by the FASB in April 2003, this statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities. This statement is effective for contracts entered into or modified after June 30, 2003. Implementation of this statement has not had an impact on CMS Energy's Consolidated Financial Statements. SFAS NO. 150, ACCOUNTING FOR CERTAIN FINANCIAL INSTRUMENTS WITH CHARACTERISTICS OF BOTH LIABILITIES AND EQUITY: Issued by the FASB in May 2003, this statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. The statement requires an issuer to classify financial instruments within its scope as liabilities. Those instruments were previously classified as mezzanine equity. SFAS No. 150 became effective July 1, 2003. CMS Energy has one, and Consumers has four, trust preferred securities outstanding as of September 30, 2003. The trust preferred securities are issued by consolidated subsidiaries of CMS Energy and Consumers. Each trust holds a subordinated debenture from the parent company. The terms of the debentures are identical to those of the trust preferred securities, except that the debenture has an explicit maturity date. The trust documents, in turn, require that the trust be liquidated upon the repayment of the debenture. The preferred securities are redeemable upon the liquidation of the subsidiary; and therefore, are considered equity in the financial statements of the subsidiary. At their October 29, 2003 Board meeting, the FASB deferred the implementation of the portion of SFAS CMS-41 CMS Energy Corporation No. 150 relating to mandatorily redeemable noncontrolling interests in subsidiaries when the noncontrolling interests are classified as equity in the financial statements of the subsidiary. CMS Energy and Consumers trust preferred securities are included in the deferral. As such, the CMS Energy and Consumers trust preferred securities continue to be accounted for under existing accounting guidance and are included in mezzanine equity. CMS Energy and Consumers continue to study the FASB developments regarding the SFAS No. 150 deferral. EITF ISSUE NO. 01-08, DETERMINING WHETHER AN ARRANGEMENT CONTAINS A LEASE: In May 2003, the EITF reached consensus in EITF Issue No. 01-08 to clarify the requirements of identifying whether an arrangement should be accounted for as a lease at its inception. The guidance in the consensus is designed to mandate reporting revenue as rental or leasing income that otherwise would be reported as part of product sales or service revenue. EITF Issue No. 01-08 requires both parties to an arrangement to determine whether a service contract or similar arrangement is or includes a lease within the scope of SFAS No. 13, Accounting for Leases. Historically, CMS Energy has entered into power purchase and similar service arrangements. Prospective accounting under EITF Issue No. 01-08, could affect the timing and classification of revenue and expense recognition. Certain product sales and service revenue and expenses may be required to be reported as rental or leasing income and/or expenses. The consensus is to be applied prospectively to arrangements agreed to, modified, or acquired in business combinations in fiscal periods beginning July 1, 2003. The adoption of EITF Issue No. 01-08 has not impacted CMS Energy's results of operations, cash flows, or financial position. CMS Energy will evaluate new or modified contracts under EITF Issue No. 01-08 prospectively. ACCOUNTING STANDARDS NOT YET EFFECTIVE FASB INTERPRETATION NO. 46, CONSOLIDATION OF VARIABLE INTEREST ENTITIES: Issued by the FASB in January 2003, FIN 46 requires the primary beneficiary of a variable interest entity's activities to consolidate the variable interest entity. The primary beneficiary is the party that absorbs a majority of the expected losses and/or receives a majority of the expected residual returns of the variable interest entity's activities. The consolidation requirements of the interpretation apply immediately to variable interest entities created after January 31, 2003. CMS Energy has not created any variable interest entities in 2003. Therefore, this portion of the interpretation has no impact on its consolidated financial statements. Public companies, whose fiscal year is a calendar year, were originally required to implement the guidance in this interpretation by the third quarter of 2003. However, on October 9, 2003, the FASB issued FASB Staff Position No. 46-6, Effective Date of FASB Interpretation No. 46, and deferred implementation of FIN 46 until the fourth quarter of 2003 for variable interest entities and potential variable interest entities created before February 1, 2003. CMS Energy is evaluating all of its interests in entities, including approximately 30 minority-held investments that are not currently consolidated, to determine their treatment under FIN 46. The majority of these investments are electric generation and gas transmission projects. CMS Energy's investment in these entities totaled approximately $1,425 million as of September 30, 2003. Jorf Lasfar and the MCV Partnership are the two largest entities impacting CMS Energy's operations. For further information see Note 8, Equity Method Investments. If the completed analysis were to require CMS Energy to disclose information about or consolidate in its financial statements, the assets, liabilities and activities of the MCV Partnership and the First Midland Limited Partnership, including the recognition of the debt of the MCV Partnership on CMS Energy's financial statements, this could impact negatively CMS Energy's and Consumers' various financial covenants under their financing agreements. As a result, CMS Energy and Consumers may have to seek amendments to the relevant financing agreements to modify the terms of certain of these covenants in order to remove the effect of this potential consolidation or refinance the relevant debt. As of September 30, 2003, Consumers' investments CMS-42 CMS Energy Corporation in the MCV Partnership and in the FMLP were $404 million and $222 million, respectively. For a further description of the nature, purpose, size and activities of the MCV Partnership see Note 4, Uncertainties, Other Consumers' Electric Utility Uncertainties, "The Midland Cogeneration Venture" and Note 8, Equity Method Investments. CMS Energy is continuing to study the implementation of this interpretation and has yet to determine the effects, if any, on its consolidated financial statements. EITF ISSUE 03-04, ACCOUNTING FOR CASH BALANCE PENSION PLANS: In May 2003, the EITF reached consensus in EITF Issue No. 03-04 to specifically address the accounting for certain cash balance pension plans. EITF Issue No. 03-04 concluded that certain cash balance plans be accounted for as defined benefit plans under SFAS No. 87, Employers' Accounting for Pensions. EITF No. 03-04 requires the use of the traditional unit credit method for the purposes of measuring the benefit obligation and annual cost of benefits earned as opposed to the projected unit credit method. The EITF concluded that the requirements of this Issue be applied as of the next plan measurement date, which is December 31, 2003 for CMS Energy. CMS Energy commenced a cash balance pension plan that covers employees hired after June 30, 2003. CMS Energy does account for this plan as a defined benefit plan under SFAS No. 87. CMS Energy continues to evaluate the impact, if any, this Issue will have upon adoption. STATEMENT OF POSITION, ACCOUNTING FOR CERTAIN COSTS AND ACTIVITIES RELATED TO PROPERTY, PLANT, AND EQUIPMENT: At its September 9, 2003 meeting, the Accounting Standards Executive Committee voted to approve the Statement of Position, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment. The Statement of Position is expected to be presented for FASB clearance late in the fourth quarter of 2003 and would be applicable for fiscal years beginning after December 15, 2004. The Accounting Standards Executive Committee concluded that at transition, a company would have the flexibility to adopt a property, plant and equipment component accounting policy for transition-date property, plant and equipment accounts. The property, plant and equipment component accounting policy may differ from the componentization policy, if any, previously used by the enterprise. Selecting a policy that differs from the company's prior level of componentization at the date of adoption of the Statement of Position would not result in any cumulative effect difference for adopting such a policy. A company would not have to restate its pre-adoption assets to conform with its post-adoption componentization policy. The Accounting Standards Executive Committee concluded that companies would be required to disclose meaningful ranges with respect to property, plant and equipment depreciable lives. CMS Energy continues to evaluate the impact, if any, this Statement of Position will have upon adoption. CMS-43 CMS ENERGY CORPORATION CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30 2003 2002 2003 2002 -------------------------------------------------------------------------------------------------------------------- In Millions, Except Per Share Amounts OPERATING REVENUE $ 1,016 $ 2,534 $ 4,059 $ 6,843 EARNINGS FROM EQUITY METHOD INVESTEES 20 41 120 126 OPERATING EXPENSES Operation Fuel for electric generation 80 87 247 264 Purchased and interchange power 136 1,224 506 2,341 Purchased power - related parties 131 143 383 416 Cost of gas sold 168 500 1,304 2,088 Other 208 247 608 640 ----------------------------------------------- 723 2,201 3,048 5,749 Maintenance 48 49 166 157 Depreciation, depletion and amortization 86 89 300 297 General taxes 50 46 115 150 ----------------------------------------------- 907 2,385 3,629 6,353 -------------------------------------------------------------------------------------------------------------------- OPERATING INCOME 129 190 550 616 OTHER INCOME (DEDUCTIONS) Accretion expense (7) (8) (23) (23) Gain (loss) on asset sales, net - 13 (8) 61 Other, net 7 (3) 28 (4) ----------------------------------------------- - 2 (3) 34 -------------------------------------------------------------------------------------------------------------------- FIXED CHARGES Interest on long-term debt 134 109 357 305 Other interest 31 5 48 19 Capitalized interest (2) (5) (7) (12) Preferred dividends - - 1 1 Preferred securities distributions 16 18 52 68 ----------------------------------------------- 179 127 451 381 -------------------------------------------------------------------------------------------------------------------- INCOME (LOSS) BEFORE INCOME TAXES AND MINORITY INTERESTS (50) 65 96 269 INCOME TAX EXPENSE (BENEFIT) (16) 54 58 128 MINORITY INTERESTS - - 1 1 ----------------------------------------------- INCOME (LOSS) FROM CONTINUING OPERATIONS (34) 11 37 140 INCOME (LOSS) FROM DISCONTINUED OPERATIONS, NET OF $16 TAX BENEFIT AND $2 TAX EXPENSE IN 2003 AND $6 AND $100 TAX BENEFIT IN 2002 (43) 25 (56) (153) ----------------------------------------------- INCOME (LOSS) BEFORE CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE (77) 36 (19) (13) CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING, NET OF $13 TAX BENEFIT IN 2003 AND $1 AND $10 TAX EXPENSE IN 2002 ENERGY TRADING CONTRACTS, EITF 02-03 (NOTE 10) - 1 (23) 18 ASSET RETIREMENT OBLIGATIONS, SFAS NO. 143 (NOTE 10) - - (1) - ----------------------------------------------- - 1 (24) 18 ----------------------------------------------- NET INCOME (LOSS) $ (77) $ 37 $ (43) $ 5 ====================================================================================================================
THE ACCOMPANYING CONDENSED NOTES ARE AN INTEGRAL PART OF THESE STATEMENTS. CMS-44
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30 2003 2002 2003 2002 ---------------------------------------------------------------------------------------------------------------------------- In Millions, Except Per Share Amounts CMS ENERGY NET INCOME (LOSS) Net Income (Loss) Attributable to Common Stock $ (77) $ 37 $ (43) $ 5 ======================================== BASIC EARNINGS (LOSS) PER AVERAGE COMMON SHARE Income (Loss) from Continuing Operations $ (0.22) $ 0.08 $ 0.25 $ 1.02 Income (Loss) from Discontinued Operations (0.29) 0.17 (0.38) (1.11) Income (Loss) from Cumulative Effect of Changes in Accounting - 0.01 (0.16) 0.13 ---------------------------------------- $ (0.51) $ 0.26 $ (0.29) $ 0.04 ======================================== DILUTED EARNINGS (LOSS) PER AVERAGE COMMON SHARE Income (Loss) from Continuing Operations $ (0.22) $ 0.08 $ 0.25 $ 1.02 Income (Loss) from Discontinued Operations (0.29) 0.17 (0.38) (1.11) Income (Loss) from Cumulative Effect of Changes in Accounting - 0.01 (0.16) 0.13 ---------------------------------------- $ (0.51) $ 0.26 $ (0.29) $ 0.04 ======================================== DIVIDENDS DECLARED PER COMMON SHARE $ - $ 0.18 $ - $ 0.91 ----------------------------------------------------------------------------------------------------------------------------
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE STATEMENTS. CMS-45 CMS ENERGY CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
NINE MONTHS ENDED SEPTEMBER 30 2003 2002 --------------------------------------------------------------------------------------------- In Millions CASH FLOWS FROM OPERATING ACTIVITIES Net income (loss) $ (43) $ 5 Adjustments to reconcile net income (loss) to net cash provided by operating activities Depreciation, depletion and amortization (includes nuclear decommissioning of $4 and $5, respectively) 300 297 Loss on disposal of discontinued operations 93 127 Capital lease and debt discount amortization 16 14 Deferred income taxes and investment tax credit 56 (294) Accretion expense 23 23 Bad debt expense 17 16 Undistributed earnings from related parties (38) (71) (Gain) loss on asset sales, net 8 (61) Cumulative effect of accounting changes 24 (18) Pension contribution (210) (64) Changes in other assets and liabilities: Decrease in accounts receivable and accrued revenues 350 306 Increase in inventories (354) (47) Decrease in accounts payable and accrued expenses (404) (130) Changes in other assets and liabilities 148 230 --------------------- Net cash provided by (used in) operating activities (14) 333 --------------------------------------------------------------------------------------------- CASH FLOWS FROM INVESTING ACTIVITIES Capital expenditures (excludes assets placed under capital lease) (352) (538) Investments in partnerships and unconsolidated subsidiaries - (49) Cost to retire property, net (52) (53) Investment in Electric Restructuring Implementation Plan (5) (6) Investments in nuclear decommissioning trust funds (4) (5) Proceeds from nuclear decommissioning trust funds 26 19 Proceeds from sale of assets 848 1,533 Other investing 40 (17) --------------------- Net cash provided by investing activities 501 884 --------------------------------------------------------------------------------------------- CASH FLOWS FROM FINANCING ACTIVITIES Proceeds from notes, bonds, and other long-term debt 2,302 726 Issuance of common stock 229 362 Retirement of bonds and other long-term debt (1,831) (1,453) Retirement of trust preferred securities (220) (331) Restricted cash on hand (167) (14) Payment of common stock dividends - (124) Decrease in notes payable, net (487) (163) Payment of capital lease obligations (10) (11) --------------------- Net cash used in financing activities (184) (1,008) --------------------------------------------------------------------------------------------- EFFECT OF EXCHANGE RATES ON CASH 2 - --------------------------------------------------------------------------------------------- NET INCREASE IN CASH AND TEMPORARY CASH INVESTMENTS 305 209 CASH AND TEMPORARY CASH INVESTMENTS, BEGINNING OF PERIOD 359 123 --------------------- CASH AND TEMPORARY CASH INVESTMENTS, END OF PERIOD $ 664 $ 332 =============================================================================================
CMS-46
NINE MONTHS ENDED SEPTEMBER 30 2003 2002 ---------------------------------------------------------------------------------------------------- In Millions OTHER CASH FLOW ACTIVITIES AND NON-CASH INVESTING AND FINANCING ACTIVITIES WERE: CASH TRANSACTIONS Interest paid (net of amounts capitalized) $ 417 $ 326 Income taxes paid (net of refunds) (33) (42) Pension and OPEB cash contribution 268 126 NON-CASH TRANSACTIONS Other assets placed under capital leases $ 11 $ 50 ====================================================================================================
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-47 CMS ENERGY CORPORATION CONSOLIDATED BALANCE SHEETS ASSETS
SEPTEMBER 30 DECEMBER 31 SEPTEMBER 30 2003 2002 2002 (UNAUDITED) (UNAUDITED) ---------------------------------------------------------------------------------------------------------------------- In Millions PLANT AND PROPERTY (AT COST) Electric utility $ 7,583 $ 7,523 $ 7,504 Gas utility 2,841 2,719 2,692 Enterprises 477 462 935 Other 31 45 51 ----------------------------------------- 10,932 10,749 11,182 Less accumulated depreciation, depletion and amortization 5,550 6,068 6,018 ----------------------------------------- 5,382 4,681 5,164 Construction work-in-progress 360 549 466 ----------------------------------------- 5,742 5,230 5,630 ---------------------------------------------------------------------------------------------------------------------- EQUITY METHOD INVESTMENTS Enterprises Investments 797 748 945 Midland Cogeneration Venture Limited Partnership 404 388 370 First Midland Limited Partnership 222 255 250 Other 2 2 2 ----------------------------------------- 1,425 1,393 1,567 ---------------------------------------------------------------------------------------------------------------------- CURRENT ASSETS Cash and temporary cash investments at cost, which approximates market 664 359 332 Restricted cash 205 38 18 Accounts receivable, notes receivable and accrued revenue, less allowances of $14, $8 and $5, respectively 178 319 99 Accounts receivable - Marketing, services and trading, less allowances of $8, $8 and $9, respectively 74 248 276 Accounts receivable and notes receivable - related parties 164 186 103 Inventories at average cost: Gas in underground storage 815 491 635 Materials and supplies 96 89 87 Generating plant fuel stock 44 37 49 Assets held for sale 84 648 342 Price risk management assets 80 115 211 Prepayments and other 271 218 138 ----------------------------------------- 2,675 2,748 2,290 ---------------------------------------------------------------------------------------------------------------------- NON-CURRENT ASSETS Regulatory Assets Securitized costs 659 689 699 Postretirement benefits 168 185 191 Abandoned Midland Project 10 11 11 Other 257 168 173 Assets held for sale 24 2,094 2,263 Price risk management assets 179 135 276 Nuclear decommissioning trust funds 553 536 530 Notes receivable - related parties 129 160 203 Notes receivable 125 126 126 Other 365 440 438 ----------------------------------------- 2,469 4,544 4,910 ----------------------------------------- TOTAL ASSETS $ 12,311 $ 13,915 $ 14,397 ======================================================================================================================
CMS-48 STOCKHOLDERS' EQUITY AND LIABILITIES
SEPTEMBER 30 DECEMBER 31 SEPTEMBER 30 2003 2002 2002 (UNAUDITED) (UNAUDITED) ------------------------------------------------------------------------------------------------------------------- In Millions CAPITALIZATION Common stockholders' equity Common stock, authorized 250.0 shares; outstanding 161.1 shares, 144.1 shares and 144.1 shares, respectively $ 2 $ 1 $ 1 Other paid-in-capital 3,834 3,605 3,619 Accumulated other comprehensive loss (720) (753) (721) Retained deficit (1,763) (1,720) (1,070) ------------------------------------------ 1,353 1,133 1,829 Preferred stock of subsidiary 44 44 44 Company-obligated convertible Trust Preferred Securities of subsidiaries (a) 173 393 393 Company-obligated mandatorily redeemable preferred securities of Consumers' subsidiaries (a) 490 490 490 Long-term debt 6,291 5,356 5,648 Non-current portion of capital leases 116 116 110 ------------------------------------------ 8,467 7,532 8,514 ------------------------------------------------------------------------------------------------------------------- MINORITY INTERESTS 23 21 12 ------------------------------------------------------------------------------------------------------------------- CURRENT LIABILITIES Current portion of long-term debt and capital leases 184 640 601 Notes payable 4 458 235 Accounts payable 328 363 308 Accounts payable - Marketing, services and trading 18 119 170 Accrued interest 112 131 114 Accrued taxes 151 291 259 Accounts payable - related parties 50 53 56 Liabilities held for sale 21 467 317 Price risk management liabilities 70 96 180 Current portion of purchase power contract 26 26 29 Current portion of gas supply contract obligations 28 25 24 Deferred income taxes 16 15 11 Other 189 214 243 ------------------------------------------ 1,197 2,898 2,547 ------------------------------------------------------------------------------------------------------------------- NON-CURRENT LIABILITIES Postretirement benefits 590 725 306 Deferred income taxes 417 414 570 Deferred investment tax credit 86 91 92 Regulatory liabilities for income taxes, net 309 297 282 Other regulatory liabilities 152 4 - Asset retirement obligation 363 - - Liabilities held for sale 36 1,243 1,321 Price risk management liabilities 175 135 178 Gas supply contract obligations 218 241 246 Power purchase agreement - MCV Partnership 8 27 30 Other 270 287 299 ------------------------------------------ 2,624 3,464 3,324 ------------------------------------------------------------------------------------------------------------------- COMMITMENTS AND CONTINGENCIES (Notes 1, 4 and 5) TOTAL STOCKHOLDERS' EQUITY AND LIABILITIES $ 12,311 $ 13,915 $ 14,397 ===================================================================================================================
(a) For further discussion, see Note 5 of the Condensed Notes to Consolidated Financial Statements. THE ACCOMPANYING CONDENSED NOTES ARE AN INTEGRAL PART OF THESE STATEMENTS. CMS-49 CMS ENERGY CORPORATION CONSOLIDATED STATEMENTS OF COMMON STOCKHOLDERS' EQUITY (UNAUDITED)
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30 2003 2002 2003 2002 ----------------------------------------------------------------------------------------------------------------------------------- In Millions COMMON STOCK At beginning of period $ 1 $ 1 $ 1 $ 1 Common stock issued 1 - 1 - ----------------------------------------------- At end of period 2 1 2 1 ----------------------------------------------------------------------------------------------------------------------------------- OTHER PAID-IN CAPITAL At beginning of period 3,608 3,317 3,605 3,257 Common stock reacquired (4) (1) (5) (2) Common stock reissued 1 - 1 - Common stock issued 229 303 233 364 ----------------------------------------------- At end of period 3,834 3,619 3,834 3,619 ----------------------------------------------------------------------------------------------------------------------------------- ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) Minimum Pension Liability At beginning of period (261) - (241) - Minimum pension liability adjustment (1) - (21) - ----------------------------------------------- At end of period (262) - (262) - ----------------------------------------------- Investments At beginning of period 5 (7) 2 (5) Unrealized gain (loss) on investments (a) 1 1 4 (1) ----------------------------------------------- At end of period 6 (6) 6 (6) ----------------------------------------------- Derivative Instruments (b) At beginning of period (56) (29) (56) (31) Unrealized gain (loss) on derivative instruments (a) 17 (21) 15 (22) Reclassification adjustments included in consolidated net income (loss) (a) (6) 2 (4) 5 ----------------------------------------------- At end of period (45) (48) (45) (48) ----------------------------------------------- Foreign Currency Translation At beginning of period (412) (650) (458) (233) Change in foreign currency translation (a) (7) (17) 39 (434) ----------------------------------------------- At end of period (419) (667) (419) (667) ----------------------------------------------- At end of period (720) (721) (720) (721) ----------------------------------------------------------------------------------------------------------------------------------- RETAINED EARNINGS (DEFICIT) At beginning of period (1,686) (1,080) (1,720) (951) Consolidated net income (loss) (a) (77) 37 (43) 5 Common stock dividends declared - (27) - (124) ----------------------------------------------- At end of period (1,763) (1,070) (1,763) (1,070) ----------------------------------------------- TOTAL COMMON STOCKHOLDERS' EQUITY $ 1,353 $ 1,829 $ 1,353 $ 1,829 =================================================================================================================================== (a) Disclosure of Other Comprehensive Income (Loss): Minimum Pension Liability Minimum pension liability adjustments, net of tax of $1, $-, $11 and $-, respectively $ (1) $ - $ (21) $ - Investments Unrealized gain (loss) on investments, net of tax of $(1), $(1), $(2) and $-, respectively 1 1 4 (1) Derivative Instruments Unrealized gain (loss) on derivative instruments, net of tax of $-, $3, $(2) and $2, respectively 17 (21) 15 (22) Reclassification adjustments included in net income (loss), net of tax of $3, $(2), $2 and $(3), respectively (6) 2 (4) 5 Foreign currency translation, net (7) (17) 39 (434) Net income (loss) (77) 37 (43) 5 ----------------------------------------------- Total Other Comprehensive Income (Loss) $ (73) $ 2 $ (10) $ (447) =============================================== (b) Included in these amounts is CMS Energy's proportionate share of the effects of derivative accounting related to its equity investment in the MCV Partnership and Taweelah as follows: MCV Partnership: At beginning of period $ 13 $ 1 $ 8 $ (8) Unrealized gain (loss) on derivative instruments (5) 1 8 7 Reclassification adjustments included in net income (2) 2 (10) 5 ----------------------------------------------- At end of period $ 6 $ 4 $ 6 $ 4 =============================================== Taweelah: At beginning of period $ (37) $ - $ (32) $ - Unrealized gain (loss) on derivative instruments 15 (24) 10 (24) ----------------------------------------------- At end of period $ (22) $ (24) $ (22) $ (24) ===============================================
THE ACCOMPANYING CONDENSED NOTES ARE AN INTEGRAL PART OF THESE STATEMENTS. CMS-50 CMS Energy Corporation CMS ENERGY CORPORATION CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) These interim Consolidated Financial Statements have been prepared by CMS Energy in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. 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. In management's opinion, the unaudited information contained in this report reflects all adjustments of a normal recurring nature necessary to assure the fair presentation of financial position, results of operations and cash flows for the periods presented. 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 2002 Form 10-K/A, filed on July 1, 2003, which includes the Reports of Independent Auditors. 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 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES CORPORATE STRUCTURE: 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, is engaged in domestic and international diversified energy businesses including: natural gas transmission, storage and processing; independent power production; and energy services. 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. 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 estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The 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 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 when an amount can be reasonably estimated. CMS Energy has used this accounting principle to record estimated liabilities as discussed in Note 4, Uncertainties. REVENUE RECOGNITION POLICY: Revenues from deliveries of electricity and the transportation and storage of natural gas are recognized as services are provided. Revenues on sales of marketed electricity, natural gas, and other energy products, as well as natural gas and LNGs, are recognized at delivery. Revenues on sales CMS-51 CMS Energy Corporation of oil and natural gas produced are recognized when production occurs, a sale is completed, and the risk of loss transfers to a third-party purchaser. Mark-to-market changes in the fair value of energy trading contracts that qualify as derivatives are recognized as revenues in the periods in which the changes occur. CAPITALIZED INTEREST: SFAS No. 34 requires capitalization of interest on certain qualifying assets that are undergoing activities to prepare them for their intended use. SFAS No. 34 limits the capitalization of interest for the period to the actual interest cost that is incurred and prohibits imputing interest costs on any equity funds. The nonregulated portions of CMS Energy are subject to these rules. The regulated businesses of CMS Energy are permitted to capitalize an allowance for funds used during construction on regulated construction projects and to include such amounts in plant in service. COLLECTIVE BARGAINING AGREEMENT: As of December 31, 2002, 44 percent of Consumers' workforce was represented by the Utility Workers Union of America. Consumers and the Union negotiated a collective bargaining agreement that became effective as of June 1, 2000, and will continue in full force and effect until June 1, 2005. On March 26, 2003, Consumers reached a tentative agreement with the Union for a collective bargaining agreement for its Call Center employees. The agreement was subsequently ratified by the membership and became effective April 1, 2003, and covers approximately 300 employees. The agreement will continue in full force and effect until August 1, 2005. EARNINGS PER SHARE: Basic and diluted earnings per share are based on the weighted average number of shares of common stock and potential common stock outstanding during the period. Potential common stock, for purposes of determining diluted earnings per share, includes the effects of dilutive stock options and convertible securities. The effect of such potential common stock is computed using the treasury stock method or the if-converted method, as applicable. For earnings per share computation, see Note 6. 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. They are reported at fair value with any unrealized gains or losses resulting from changes in fair value reported in equity as part of accumulated other comprehensive income and are excluded from earnings unless such changes in fair value are other than temporary. Unrealized gains or losses from changes in the fair value of Consumers' nuclear decommissioning investments are reported as regulatory liabilities. The fair value of these investments is determined from quoted market prices. 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 denominated in a currency other than the functional currency, except those that are hedged, are included in determining net income. The change in the foreign currency translation adjustment decreased equity by $7 million for the three months ended September 30, 2003 and increased equity by $39 million for the nine months ended September 30, 2003, net of after-tax hedging proceeds. The change in the foreign currency translation adjustment decreased equity by $17 million for the three months ended September 30, 2002 and decreased equity by $434 million for the nine months ended September 30, 2002, net of after-tax hedging proceeds. IMPAIRMENT OF INVESTMENTS AND LONG-LIVED ASSETS: In accordance with APB Opinion No. 18 and SFAS No. 144, CMS Energy evaluates the potential impairment of its investments in projects and other long-lived assets, other than goodwill, based on various analyses, including the projection of undiscounted cash flows, whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. If the carrying amount of the investment or asset exceeds the amount of the expected CMS-52 CMS Energy Corporation future undiscounted cash flows, an impairment loss is recognized and the investment or asset is written down to its estimated fair value. PLANT AND PROPERTY: Plant and Property, including improvements, are stated at cost. Construction-related labor and material costs, as well as indirect construction costs such as engineering and interest costs, are capitalized. Property repairs, minor property replacements and maintenance are charged to maintenance expense as incurred. When depreciable plant and property maintained by CMS Energy's regulated operations are retired or sold, the original cost (net of salvage credits), is charged to accumulated depreciation. RESTRICTED CASH: At September 30, 2003, CMS Energy's restricted cash on hand totaled $205 million. Restricted cash primarily includes cash collateral for letters of credit to satisfy certain debt agreements and cash dedicated for repayment of securitization bonds. It is classified as a current asset as the related letters of credit mature within one year and the payments on the related securitization bonds occur within one year. STOCK-BASED COMPENSATION: In December 2002, the FASB issued SFAS No. 148. This standard provides for alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In the fourth quarter of 2002, CMS Energy adopted the fair value method of accounting for stock-based compensation under SFAS No. 123 as amended by SFAS No. 148, applying the prospective method. If compensation cost for stock options had been determined in accordance with SFAS No. 123 for the three and nine month periods ended September 30, 2002, consolidated net income as reported and pro forma would have been as follows:
In Millions, Except Per Share Amounts ------------------------------------------------------------------------------------------------------- Three Months Ended September 30 2002 Basic Diluted ------------------------------------------------------------------------------------------------------- Net income, as reported $ 37 $0.26 $0.26 Add: Stock-based employee compensation expense included in reported net income, net of taxes - - - Deduct: Total stock-based compensation expense determined under fair value based method for all awards, net of tax (1) - - ------------------------------------------------------------------------------------------------------- Pro forma net income $ 36 $0.26 $0.26 =======================================================================================================
In Millions, Except Per Share Amounts ------------------------------------------------------------------------------------------------------- Nine Months Ended September 30 2002 Basic Diluted ------------------------------------------------------------------------------------------------------- Net income, as reported $ 5 $0.04 $0.04 Add: Stock-based employee compensation expense included in reported net income, net of taxes - - - Deduct: Total stock-based compensation expense determined under fair value based method for all awards, net of tax (3) (0.02) (0.02) ------------------------------------------------------------------------------------------------------- Pro forma net income $ 2 $0.02 $0.02 =======================================================================================================
In the third quarter of 2003, CMS Energy granted 1.6 million stock options to employees. As a result, CMS Energy expensed approximately $5 million related to the fair value of those stock options as of the grant date. Fair value is estimated using the Black Scholes model, a mathematical formula used to value options traded on the securities exchange. UTILITY REGULATION: Consumers accounts for the effects of regulation based on the regulated utility CMS-53 CMS Energy Corporation accounting standard SFAS No. 71. As a result, the actions of regulators affect when Consumers recognizes revenues, expenses, assets and liabilities. In 1999, Consumers received MPSC electric restructuring orders, which, among other things, identified the terms and timing for implementing electric restructuring in Michigan. Consistent with these orders and EITF No. 97-4, Consumers discontinued the application of SFAS No. 71 for the energy supply portion of its business because Consumers expected to implement retail open access at competitive market based rates for its electric customers. However, since 1999, there has been a significant legislative and regulatory change in Michigan that has resulted in: 1) electric supply customers of utilities remaining on cost-based rates and 2) utilities being given the ability to recover Stranded Costs associated with electric restructuring, from customers who choose an alternative electric supplier. During 2002, Consumers re-evaluated the criteria used to determine if an entity or a segment of an entity meets the requirements to apply regulated utility accounting, and determined that the energy supply portion of its business could meet the criteria if certain regulatory events occurred. In December 2002, Consumers received a MPSC Stranded Cost order that allowed Consumers to re-apply regulatory accounting standard SFAS No. 71 to the energy supply portion of its business. Re-application of SFAS No. 71 had no effect on the prior discontinuation accounting, but allowed Consumers to apply regulatory accounting treatment to the energy supply portion of its business beginning in the fourth quarter of 2002, including regulatory accounting treatment of costs required to be recognized in accordance with SFAS No. 143. See Note 10, Implementation of New Accounting Standards, "SFAS No. 143, Accounting for Asset Retirement Obligations." SFAS No. 144 imposes strict criteria for retention of regulatory-created assets by requiring that such assets be probable of future recovery at each balance sheet date. Management believes these assets are probable of future recovery. 2: ASSET SALES AND RESTRUCTURING CMS Energy continues to implement its financial plan and on-going asset sales program that was initiated in late 2001. The asset sales program encompasses the sale of all non-strategic and under-performing assets. The impacts of these sales are included in "Gain (loss) on asset sales, net" in the Consolidated Statements of Income. ASSET SALES In July 2003, CMS Energy completed the sale of CMS Field Services to Cantera Resources Inc. In June 2003, CMS Energy completed the sales of Panhandle and the assets of CMS Viron. See Note 3, Discontinued Operations. In June 2003, CMS Energy completed the sale of its one-third membership interest in the Guardian Pipeline, L.L.C., to a subsidiary of WPS Resources Corporation. Proceeds from the sale were $26 million and were used to reduce debt. In conjunction with the sale, approximately $63 million of cash that CMS Energy had committed to collateralize a letter of credit was released. CMS Energy recorded a loss on the sale of Guardian of $4 million ($3 million after-tax) in the second quarter of 2003. In January 2003, CMS Energy closed on the sale of a substantial portion of CMS MST's wholesale natural gas trading contracts and inventory to Sempra Energy Trading, the wholesale commodity trading unit of CMS-54 CMS Energy Corporation Sempra Energy and received $17 million of cash proceeds. In February 2003, Panhandle sold its one-third interest in Centennial Pipeline, LLC for $40 million to Centennial's two other partners, Marathon Ashland Petroleum, LLC and TE Products Pipeline Company, Limited Partner, through its general partner, Texas Eastern Products Pipeline Company. In March 2003, CMS MST sold a majority of its wholesale power book and related supply portfolio for $34 million cash proceeds to Constellation Power Source, Inc. The sale contains a potential to increase proceeds to $40 million in 2006 dependent upon future years' performance of the sold contracts. In addition, during the first quarter of 2003, CMS MST sold its 50 percent joint venture ownership interest in Texon, its 50 percent interest in Premstar and its Tulsa retail contracts, resulting in net cash proceeds of approximately $6 million. 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 $15 million ($15 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 to a limited partnership whose general partner is Washington D.C.-based Trans-Elect, Inc. Also, in May 2002, Consumers sold certain reactor top equipment. The sales totaled approximately $295 million. The pretax gain on these sales, which totaled $38 million ($31 million, net of tax), are included in "Gain (loss) on asset sales, net" in the accompanying Consolidated Statements of Income in 2002. In April 2002, CMS Energy sold its equity ownership interest in Toledo Power for $10 million. Proceeds from the sale were used to repay debt. The pretax loss, as shown on the Consolidated Statements of Income, was $11 million ($8 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. 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 gain on the methanol plant of $19 million ($12 million, net of tax) is included in "Gain (loss) on asset sales, net" in the accompanying Consolidated Statements of Income. The gain on the sale of CMS Oil & Gas' Equatorial Guinea properties of $497 million ($310 million, net of tax) is included in discontinued operations in 2002.
Nine Months ended September 30 In Millions ------------------------------------------------------------------------------------- Pre-tax After-tax Pre-tax After-tax 2003 2003 2002 2002 ------------------------------------------------------------------------------------- Asset Sales - Gain (Loss) Consumers $ - $ - $ 38 $ 31 Enterprises (9) (6) 23 19 Other 1 1 - - ------------------------------------------------------------------------------------ Total Gain (Loss) on Asset Sales $ (8) $ (5) $ 61 $ 50 ====================================================================================
PENDING ASSET SALE An affiliate of CMS Generation owns a 49.6 percent interest in the Loy Yang Power Partnership ("LYPP"), which owns the 2,000 MW Loy Yang coal-fired power project in Victoria, Australia. Due to unfavorable power prices in the Australian market, the LYPP is not generating cash flow sufficient to meet its debt-service obligations. LYPP has A$500 million of term bank debt that, pursuant to extensions from the CMS-55 CMS Energy Corporation lenders, is scheduled to mature on February 12, 2004. The partners in LYPP (including affiliates of CMS Generation, NRG Energy Inc. and Horizon Energy Australia Investments) have been exploring the possible sale of the project (or control of the project) and a restructuring of the finances of LYPP. In July 2003, a conditional share sale agreement was executed by the LYPP partners and partners of the Great Energy Alliance Corporation ("GEAC") to sell the project to GEAC for A$3.5 billion (approximately $2.4 billion in U.S. dollars), including A$165 million (approximately $111 million in U.S. dollars) for the project equity. The Australian Gas Light Company, the Tokyo Electric Power Company, Inc. and a group of financial investors led by the Commonwealth Bank of Australia formed GEAC earlier this year to explore the possible acquisition of Loy Yang. The conditions to completion of the sale to GEAC include consents from LYPP's lenders to a restructuring of the project's debt, satisfactory resolution of regulatory issues and approvals, rulings on tax and stamp duty obligations, and approvals from the investors in Horizon Energy Australia Investments and the creditors committee of NRG Energy Inc. It should be noted in particular that the Australian federal antitrust regulator has disapproved the transaction because of its perceived anticompetitive effects, and GEAC has brought an action for declaratory relief against the regulator to reverse that disapproval. Closing was targeted for early September 2003, but given the regulatory uncertainties, the parties to the share sale agreement have agreed to extend the date for resolution of the regulatory conditions to closing to not later than December 19, 2003, assuming satisfactory interim resolution of other closing conditions. The share sale agreement provides GEAC a period of exclusivity while the conditions of the purchase are satisfied. The ultimate net proceeds to CMS Energy for its equity share in LYPP may be subject to reduction based on the ultimate resolution of many of the factors described above as conditions to completion of the sale, as well as closing adjustments and transaction costs, and could likely range between $20 million and a nominal amount. CMS Energy cannot predict whether this sale to GEAC will be consummated or, if not, whether any of the other initiatives will be successful, and it is possible that CMS Generation may lose all or a substantial part of its remaining equity investment in the LYPP. CMS Energy previously has written off its equity investment in the LYPP, and further write-offs would be limited to cumulative net foreign currency translation losses. The amount of such cumulative net foreign currency translation losses is approximately $168 million at September 30, 2003. Any such write-off would flow through CMS Energy's income statement but would not result in a reduction in shareholders' equity or cause CMS Energy to be in noncompliance with its financing agreements. RESTRUCTURING AND OTHER COSTS CMS Energy announced in June 2002 a series of new initiatives intended to sharpen its business focus and help restore its financial health by reducing operating costs by an estimated $50 million annually. The initiatives announced included the following: - Relocating CMS Energy's corporate headquarters from Dearborn, Michigan to a new combined CMS Energy and Consumers headquarters building then under construction in Jackson, Michigan. The Jackson headquarters building opened in March 2003 and houses an estimated 1,450 CMS Energy and Consumers Energy employees. The relocation will ultimately reduce corporate operating expenses. - Implementing changes to CMS Energy's 401(K) savings program which provided additional savings for CMS Energy and enhanced investment options for employee participants. - Implementing changes to CMS Energy's health care plan in order to keep benefits and costs CMS-56 CMS Energy Corporation competitive. - Terminating 64 employees, including five officers. Prior to December 31, 2002, 123 employees elected severance arrangements. Of these 187 officers and employees, 65 had been terminated as of December 31, 2002. All remaining terminations were completed in 2003. The following table shows the amount charged to expense for restructuring costs, the payments made, and the unpaid balance of accrued costs at September 30, 2003.
In Millions -------------------------------------------------------------------------------------- September 30, 2003 -------------------------------------------------------------------------------------- Involuntary Lease Termination Termination Total -------------------------------------------------------------------------------------- Beginning accrual balance, January 1, 2003 $ 12 $ 8 $ 20 Expense 4 - 4 Payments (11) (1) (12) -------------------------------------------------------------------------------------- Ending accrual balance $ 5 $ 7 $ 12 ======================================================================================
Restructuring costs for the three and nine months ended September 30, 2003, which are included in operating expenses, include $1 million and $4 million, respectively, of involuntary employee termination benefits. In addition, in 2003, restructuring costs related to relocating employees and other headquarters expenses were approximately $2 million. The relocation was completed July 2003 and such costs were expensed as incurred. 3: DISCONTINUED OPERATIONS In accordance with SFAS No. 144, discontinued operations include components of entities or entire entities that, through disposal transactions, will be eliminated from the ongoing operations of CMS Energy. The assets and liabilities of these entities were measured at the lower of the carrying value or the fair value less cost to sell as required by SFAS No. 144. A description of the entities included in discontinued operations is as follows: In September 2001, CMS Energy reclassified the operations of the International Energy Distribution segment to discontinued operations. Subsequently to CMS Energy's decision to sell the assets of CMS Electric and Gas, severe political and economic events occurred in Venezuela outside CMS Energy's control that prohibited the sale process. CMS Energy continues to actively pursue the sale of CMS Electric and Gas in the current political and economic environment. Although the timing is difficult to predict or ensure, management expects the sale to occur within one year. 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 reserves in Equatorial Guinea and CMS Gas Transmission's ownership interest in the related methanol plant. The gain on the CMS Oil and Gas Equatorial Guinea properties of $497 million ($310 million, net of tax) is included in discontinued operations. In the first quarter of 2003, CMS Energy settled a liability with the purchaser of Equatorial Guinea and reversed the remaining excess reserve. This settlement resulted in a gain of $6 million, net of tax, which is included in discontinued operations in 2003. In May 2002, CMS Energy closed on the sale of CMS Oil and Gas' coalbed methane holdings in the CMS-57 CMS Energy Corporation 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 $17 million ($11 million net of tax). 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 $47 million loss ($31 million, net of tax) in discontinued operations. 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. At December 31, 2002, after evaluating all of the relevant facts and circumstances including third-party bid data and liquidation analysis, an impairment charge of $6 million, net of tax, was reflected as an estimated loss on discontinued operations in accordance with the provisions of SFAS No. 144. The provisions limited the impairment charge to the book value of the noncurrent assets of CMS Viron at that time. In June 2003, CMS Energy closed on the sale of the majority of the assets of CMS Viron and recognized an additional loss of $3 million, net of tax, in discontinued operations. The total loss on the sale of CMS Viron was $14 million ($9 million, net of tax). In December 2002, CMS Energy reclassified the operations of Panhandle to discontinued operations. In June 2003, CMS Energy completed the previously announced sale of all of the outstanding capital stock of Panhandle to Southern Union Panhandle Corp., a newly formed entity owned by Southern Union. CMS Energy received gross cash proceeds of approximately $582 million and three million shares of Southern Union common stock, worth approximately $49 million based on the June 11, 2003 closing price of $16.48 per share. The sale agreement allowed CMS Energy to sell the stock 90 days after the closing date of June 11, 2003. The Southern Union common stock was recorded as a current asset on CMS Energy's balance sheet. In July 2003, Southern Union declared a five percent common stock dividend payable July 31, 2003, to shareholders of record as of July 17, 2003. As a result of the stock dividend, on September 30, 2003, CMS Energy held 3.15 million shares of Southern Union common stock worth approximately $54 million based on the closing price of $17.00 per share. The increase in value of the Southern Union common stock of approximately $2 million was recorded in dividend income. In October 2003, CMS Energy sold its 3.15 million shares of Southern Union common stock to a private investor for $17.77 per share. The proceeds from the stock sale of approximately $56 million will be used to reduce debt. Southern Union Panhandle Corp. also assumed approximately $1.166 billion of Panhandle debt. CMS Energy used the initial cash proceeds from the sale of Panhandle to pay off and terminate Enterprises' $441 million and $75 million revolving credit facilities. The $30 million after-tax loss on the sale is included in discontinued operations. No portion of CMS Energy's Pension Plan was transferred with the sale. Panhandle employees are no longer eligible to accrue additional benefits. The Pension Plan retained pension payment obligations for Panhandle employees that were vested under the Pension Plan. Because of the significant change in the makeup of the plan, SFAS No. 87 required a remeasurement of the obligation at the date of sale. The estimated remeasurement, subject to receipt of the final actuarial report, resulted in a $4 million increase in CMS Energy's 2003 pension expense and a $6 million increase in CMS Energy's 2003 OPEB expense, as well as an additional charge to accumulated other comprehensive income of approximately $30 million ($20 million after-tax), as a result of the increase in the additional minimum pension liability. Additionally, a significant number of Panhandle employees elected to retire as of July 1, CMS-58 CMS Energy Corporation 2003 under the CMS Energy Employee Pension Plan. As a result, CMS Energy has recorded a $13 million after-tax settlement loss pursuant to the provisions of SFAS No. 88, which is reflected in discontinued operations. In December 2002, CMS Energy reclassified the operations of CMS Field Services, a subsidiary of CMS Gas Transmission to discontinued operations. In July 2003, CMS Energy completed the sale of CMS Field Services to Cantera Resources Inc. for gross cash proceeds of approximately $113 million, subject to post closing adjustments, and a $50 million face value note of Cantera Resources Inc.. The note is payable to CMS Energy for up to $50 million subject to the financial performance of the Fort Union and Bighorn natural gas gathering systems from 2004 through 2008. The sale resulted in a $5 million loss ($1 million, net of tax) which is included in discontinued operations. The net sales proceeds of approximately $100 million were used to reduce debt. In June 2003, CMS Energy reclassified the operations of its gas transmission plant in Marysville, Michigan to discontinued operations. In September 2003, CMS Energy executed a definitive purchase and sale agreement for Marysville. It is anticipated that the closing will occur in November 2003. In September 2003, CMS Land, holding mainly real property assets, reclassified a 6,000 acre tract of undeveloped land along two miles of Lake Michigan's shoreline near Arcadia, Michigan, having a net book value of $14 million, from property, plant and equipment to "Assets held for sale". Neither CMS Land nor the Arcadia assets are separate operating components of CMS Energy's business, and therefore are not considered discontinued operations. CMS Land's Board of Directors approved a resolution to offer a sales option agreement to the Grand Traverse Regional Land Conservancy (GTRLC) for the purchase of Arcadia. On May 13, 2003, CMS Land granted GTRLC the option which, by its terms, expired on September 15, 2003, but gave GTRLC the right to extend that expiration date to December 11, 2003. In September 2003, GTRLC extended the option to purchase Arcadia. In September 2003, after performing an evaluation of fair value, CMS Energy reduced the carrying amount of its investment in CMS Electric and Gas' Venezuelan electric distribution utility and an associated equipment lease to reflect the current assessment of fair value. The assessment was based on estimates of the utility's future cash flows, incorporating certain assumptions about Venezuela's regulatory, political, and economic environment. The adjustment, which resulted in a $42 million after-tax charge, is reported in discontinued operations. As a result of the sale of CMS Oil and Gas, CMS Energy recorded liabilities for certain sale indemnification obligations and other matters. In September 2003, CMS Energy performed an evaluation of its likely exposure to the obligations and reduced the carrying value of these liabilities by $8 million after-tax, to reflect the current estimate of the obligations. This adjustment is reported in discontinued operations. The summary of balance sheet information below represents those entities that are still in the disposal process. At September 30, 2003, "Assets held for sale" includes International Energy Distribution, Marysville, and Arcadia. At September 30, 2002, "Assets held for sale" includes Panhandle, CMS Viron, CMS Field Services, International Energy Distribution, and Marysville. The assets and liabilities of entities held for sale are shown as separate components in the consolidated balance sheets of CMS Energy. CMS-59 CMS Energy Corporation
In Millions ----------------------------------------------------------------------- September 30 2003 2002 ----------------------------------------------------------------------- Assets Cash $ 11 $ 60 Accounts receivable, net 31 141 Materials and supplies 7 87 Other 35 54 ----------------------------------------------------------------------- Total current assets held for sale $ 84 $ 342 Property, plant and equipment, net $ (30) $1,962 Unconsolidated investments 16 109 Goodwill 32 141 Other 6 51 ----------------------------------------------------------------------- Total non-current assets held for sale $ 24 $2,263 ----------------------------------------------------------------------- Liabilities Accounts payable $ 10 $ 95 Current portion of long-term debt 2 3 Accrued taxes - 16 Other current liabilities 9 203 ----------------------------------------------------------------------- Total current liabilities held for sale $ 21 $ 317 Long-term debt $ 5 $1,155 Minority interest 13 91 Other non-current liabilities 18 75 ----------------------------------------------------------------------- Total non-current liabilities held for sale $ 36 $1,321 -----------------------------------------------------------------------
Revenues from discontinued operations were $498 million and $662 million for the nine months ended September 30, 2003 and 2002, respectively, including Panhandle, CMS Field Services, and CMS Viron through their respective sale dates. In accordance with SFAS No. 144, the net income (loss) of the operations is included in the Consolidated Statements of Income under "Income (loss) from discontinued operations". The income (loss) related to discontinued operations includes a reduction in asset values, a provision for anticipated closing costs, and a portion of CMS Energy's interest expense. Interest expense of $26 million and $55 million for the nine months ended September 30, 2003 and 2002, respectively, has been allocated to discontinued operations based on the ratio of total capital of each discontinued operation to that of CMS Energy. See the table below for income statement components of the discontinued operations. CMS-60 CMS Energy Corporation
In Millions --------------------------------------------------------------------- Three Months ended September 30 2003 2002 --------------------------------------------------------------------- Discontinued operations: Income from discontinued operations, net of tax benefit of $10 and $8 $ 8 $ 20 Gain (loss) on disposal of discontinued operations, net of tax benefit of $6 and tax of $2 (51) 5 --------------------------------------------------------------------- Income (loss) from discontinued operations $(43) $ 25 =====================================================================
In Millions --------------------------------------------------------------------- Nine Months ended September 30 2003 2002 --------------------------------------------------------------------- Discontinued operations: Income (loss) from discontinued operations, net of tax of $8 and tax benefit of $33 $ 37 $ (26) Loss on disposal of discontinued operations, net of tax benefit of $6 and $67 (93) (127) --------------------------------------------------------------------- Loss from discontinued operations $(56) $(153) =====================================================================
4: UNCERTAINTIES Several business trends or uncertainties may affect CMS Energy's financial results. These trends or uncertainties have, or CMS Energy reasonably expects could have, a material impact on net sales, revenues, or income from continuing operations. Such trends and uncertainties are discussed in detail below. SEC AND OTHER INVESTIGATIONS: As a result of round-trip trading transactions by CMS MST, CMS Energy's Board of Directors established a Special Committee 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 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 Special Committee found no 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. Previously, CMS Energy terminated its speculative trading business and revised its risk management policy. The Board of Directors adopted, and CMS Energy has implemented the 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. The FERC issued an order on April 30, 2003 directing eight companies, including CMS MST, to submit written demonstrations within 45 days that they have taken certain specified remedial measures with respect to the reporting of natural gas trading data to publications that compile and publish price indices. CMS MST made a written submission to the FERC on June 11, 2003 in compliance with the FERC's directives. On July 29, 2003, the FERC issued an order stating that CMS MST met the requirements of the FERC's April 30, 2003 order. Other than the FERC investigation, CMS-61 CMS Energy Corporation CMS Energy is unable to predict the outcome of these matters, and 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 were filed against CMS Energy, Consumers, and certain officers and directors of CMS Energy and its affiliates. The complaints were filed as purported class actions in the United States District Court for the Eastern District of Michigan by shareholders who allege that they purchased CMS Energy's securities during a purported class period. The cases were consolidated into a single lawsuit and an amended and consolidated class action complaint was filed on May 1, 2003. The consolidated complaint contains a purported class period beginning on May 1, 2000 and running through March 31, 2003. It generally seeks unspecified damages based on allegations that the defendants violated United States securities laws and regulations by making allegedly false and misleading statements about CMS Energy's business and financial condition, particularly with respect to revenues and expenses recorded in connection with round-trip trading by CMS MST. The companies intend to defend vigorously against this action but cannot predict the outcome of this litigation. DEMAND FOR ACTIONS AGAINST OFFICERS AND DIRECTORS: The Board of Directors of CMS Energy 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 by CMS MST, 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 has elected two new members to its Board of Directors who are serving 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 litigation. ERISA 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 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, and an amended and consolidated complaint was filed. 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 defended vigorously. CMS Energy cannot predict the outcome of this litigation. GAS INDEX PRICE REPORTING INVESTIGATION: CMS Energy has notified appropriate regulatory and governmental agencies that some employees at CMS MST and CMS Field Services appeared to have provided inaccurate information regarding natural gas trades to various energy industry publications which compile and report index prices. CMS Energy is cooperating with investigations by the Commodity Futures Trading Commission, Department of Justice and FERC regarding this matter. CMS Energy is unable to predict the outcome of these matters and what effect, if any, these investigations will have on its business. GAS INDEX PRICE REPORTING LITIGATION: In August 2003, Cornerstone Propane Partners, L.P. ("Cornerstone") filed a putative class action complaint in the United States District Court for the Southern District of New York against CMS Energy and 40 other energy companies. The complaint alleges that false natural gas price reporting by the defendants manipulated the prices of NYMEX natural gas futures CMS-62 CMS Energy Corporation and options. The complaint contains two counts under the Commodity Exchange Act, one for manipulation and one for aiding and abetting violations. Cornerstone has agreed to provide a blanket 60-day extension of time for all defendants to answer or otherwise respond to the complaint. CMS Energy intends to defend vigorously against this action but cannot predict the outcome of this litigation. 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 regulations requiring the state of Michigan to further limit nitrogen oxide emissions. The Michigan Department of Environmental Quality finalized rules to comply with the EPA regulations in December 2002 and submitted these rules for approval to the EPA in the first quarter of 2003. The EPA has issued additional 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 regulations require Consumers to make significant capital expenditures estimated to be $770 million. As of September 30, 2003, Consumers has incurred $437 million in capital expenditures to comply with the EPA regulations and anticipates that the remaining capital expenditures will be incurred between 2003 and 2009. 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. Consumers expects to supplement its environmental regulation compliance plan with the purchase of nitrogen oxide emissions credits for years 2005 through 2008. The cost of these credits based on the current market is estimated to average $6 million per year; however, the market for nitrogen oxide emissions credits and their price could change substantially. The EPA has proposed changes to the rules which govern generating plant cooling water intake systems. The proposed rules will require significant abatement of fish mortality. The proposed rules are scheduled to become final in the first quarter of 2004 and some of Consumers' facilities would be required to comply by 2006. Consumers is studying the proposed rules to determine the most cost-effective solutions for compliance. Until the method of compliance is determined, Consumers is unable to estimate the cost of compliance with the proposed rules. The EPA has alleged that some utilities have incorrectly classified plant modifications as "routine maintenance" rather than seek permits from the EPA. Consumers has received and responded to information requests from the EPA on this subject. Consumers believes that it has properly interpreted the requirements of "routine maintenance". If Consumers' interpretation is eventually found to be incorrect, it may be required to install additional pollution controls at some or all of its coal-fired plants and could call into question the viability of certain plants remaining in operation. 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. CMS-63 CMS Energy Corporation 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, 2003, 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. Consumers has proposed a plan to deal with the remaining materials and is awaiting a response from the EPA. LITIGATION: In October 2003, a group of eight PURPA qualifying facilities selling power to Consumers filed a lawsuit in Ingham County Circuit Court against Consumers. The lawsuit alleges that Consumers incorrectly calculated the energy charge payments made pursuant to power purchase agreements between the qualifying facilities and Consumers. More specifically, the lawsuit alleges that Consumers should be basing the energy charge calculation on the cost of more expensive eastern coal, rather than on the cost of the coal actually burned by Consumers for use in its coal-fired generating plants. Consumers believes it has been performing the calculation in the manner prescribed by the power purchase agreements, and has filed a request with the MPSC (as a supplement to the PSCR plan) that asks the MPSC to review this issue and to confirm that Consumers' method of performing the calculation is correct. Also, Consumers has filed a motion to dismiss the lawsuit in the Ingham County Circuit Court due to the pending request at the MPSC in regard to the PSCR plan case. Although only eight qualifying facilities have currently raised the issue, the same energy charge methodology is used in the PPA with the MCV Partnership and in approximately 20 additional power purchase agreements with Consumers, representing approximately 1,670 MW of electric capacity. Consumers cannot predict the outcome of this litigation. CONSUMERS' ELECTRIC UTILITY 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 Securitization bonds to refinance qualified costs, as defined by the act; 5) establishes a market power supply test that if not met may require transferring control of generation resources in excess of that required to serve firm retail sales requirements (In September 2003, the MPSC issued an order finding that Consumers is in compliance with the market power test set forth in the Customer Choice Act.); 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. (In July 2002, the MPSC issued an order approving the plan to achieve the increased transmission capacity. The MPSC found that once the planned projects were completed and verification was submitted, a utility was in technical compliance. Consumers has completed the transmission capacity projects identified in the plan and has submitted verification of this fact to the MPSC. Consumers believes it is in full compliance.); 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 CMS-64 CMS Energy Corporation implementation costs incurred as a result of the passage of the act. Under Public Act 141, Consumers currently offers standby generation services to certain retail open access customers. The obligation to offer this service does not extend beyond the later of December 31, 2001 or the date the MPSC finds that Consumers complies with the market power test set forth in the Customer Choice Act and has completed the projects necessary to meet Consumers', Detroit Edison's and American Electric Power's obligation to jointly expand their available transmission capability by at least 2,000 MW. As stated above, in September 2003, the MPSC issued an order finding that Consumers is in compliance with the market power test and in December 2002, Consumers filed verification with the MPSC indicating that Consumers met the transmission capability expansion requirements. As a result, Consumers filed a notice with the MPSC indicating that it was terminating retail open access standby service on December 31, 2003. Also, as a result of Consumers meeting the transmission capability expansion requirements and the market power test, Consumers has met the requirements under Public Act 141 to return to the PSCR process. For further discussion on the PSCR process see, "Power Supply Costs" in this Note. The rate-freeze imposed by Public Act 141 ends at December 31, 2003. After that date, the statute would allow customers to petition the MPSC for rate reductions below the cap. Consumers would have the opportunity to respond to such a petition before rates could be reduced. 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. Consumers cannot predict the total amount of electric supply load that may be lost to competitor suppliers (as noted below in "Power Supply Costs" in this Note 603 MW of load is currently being served by competitor suppliers), nor whether the stranded cost recovery method adopted by the MPSC will be applied in a manner that will fully offset any associated margin loss. SECURITIZATION: The Customer Choice Act allows for the use of Securitization bonds to refinance certain qualified costs, as defined by the act. Securitization typically involves issuing asset-backed bonds with a higher credit rating than conventional utility corporate financing. In 2000 and 2001, the MPSC issued orders authorizing Consumers to issue Securitization bonds. Consumers issued its first Securitization bonds in late 2001. Securitization resulted in lower interest costs and a longer amortization period for the securitized assets, and offset the impact of the required residential rate reduction. The Securitization orders CMS-65 CMS Energy Corporation 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. Consumers and Consumers Funding 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 occurred 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 and cap period expire and an electric rate case is processed. Securitization charge collections, $37 million for the nine months ended September 30 2003, and $39 million for the nine months ended September 30, 2002, are remitted to a trustee for the Securitization bonds. Securitization charge collections are dedicated to the repayment of the principal and interest on the Securitization bonds and payment of the ongoing expenses of Consumers Funding and can only be used for those purposes. Consumers Funding is legally separate from Consumers. The assets and income of Consumers Funding, including without limitation, the securitized property, are not available to creditors of Consumers or CMS Energy. In March 2003, Consumers filed an application with the MPSC seeking approval to issue Securitization bonds in the amount of approximately $1.084 billion. The application sought recovery of costs associated with Clean Air Act expenditures, Palisades expenditures previously not securitized, retail open access implementation costs through December 31, 2003, certain pension fund costs, and expenses associated with the issuance of the bonds. In June 2003, the MPSC issued a financing order authorizing the issuance of Securitization bonds in the amount of approximately $554 million. This amount relates to Clean Air Act expenditures and associated return on those expenditures through December 31, 2002, retail open access implementation costs and previously authorized return on those expenditures through December 31, 2000, and the "up front" other qualified costs related to issuance of the Securitization bonds. The MPSC rejected Palisades expenditures previously not securitized as eligible securitized costs. Therefore, Palisades expenditures previously not securitized should be included as a component of "net" Stranded Costs and will be included as a component of a future electric rate case proceeding with the MPSC. In the June 2003 financing order, the MPSC also adopted a rate design that would allow retail open access customers to pay a securitization charge (and related tax charge) that are a small fraction of the amounts paid by full service bundled sales customers and special contract customers of the utility. The financing order provides that the securitization charges (and related tax charges) for the full service and bundled sales customers are increased under the rate design in the financing order in order to be sufficient to repay the principal, interest and all other "ongoing" qualified costs related to servicing the Securitization bonds. The financing order also restricts the amount of common dividends payable by Consumers to its "earnings." In July 2003, Consumers filed for rehearing and clarification on a number of features in the financing order, including the rate design, accounting treatment of unsecuritized qualified costs and dividend restriction. Also in July 2003, the Attorney General filed a claim of appeal related to the financing order and the Attorney General indicated it would challenge the lawfulness of the rate design. In October 2003, the Court of Appeals dismissed the appeal and indicated that the Attorney General could resubmit the appeal after the MPSC acted on Consumers' rehearing request. Subsequently, the Attorney General filed a motion of rehearing asking for reconsideration of the Court of Appeals' dismissal. The financing order will become effective after rehearing, resolution of appeals and upon acceptance by Consumers. ELECTRIC PROCEEDINGS: Stranded Costs - The Customer Choice Act allows electric utilities to recover the CMS-66 CMS Energy Corporation 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. The MPSC authorized Consumers to use deferred accounting to recognize the future recovery of costs determined to be stranded. According to the MPSC, "net" Stranded Costs are to be recovered from retail open access customers through a Stranded Cost transition charge. In April 2002, Consumers made "net" Stranded Cost filings with the MPSC for $22 million for 2000 and $43 million for 2001. Consumers in its hearing brief, filed in August 2002, revised its request for Stranded Costs to $7 million for 2000 and $4 million for 2001. The single largest reason for the difference in the filing was the exclusion, as ordered by the MPSC, of all costs associated with expenditures required by the Clean Air Act. As discussed above in "Securitization", Consumers filed a request with the MPSC for authority to issue Securitization bonds that would allow recovery of the Clean Air Act expenditures that were excluded from the Stranded Cost calculation. In December 2002, the MPSC issued an order finding that Consumers experienced zero "net" Stranded Costs in 2000 and 2001, but declined to resolve numerous issues regarding the "net" Stranded Cost methodology in a way that would allow a reliable prediction of the level of Stranded Costs for 2002 and future years. In January 2003, Consumers filed a petition for rehearing of the December 2002 Stranded Cost order in which it asked the MPSC to grant a rehearing and revise certain features of the order. Several other parties have also filed rehearing petitions with the MPSC. Consumers has also initiated an appeal at the Michigan Court of Appeals related to the MPSC's December 2001 "net" Stranded Cost order. In March 2003, Consumers filed an application with the MPSC seeking approval of "net" Stranded Costs incurred in 2002, and for approval of a "net" Stranded Cost recovery charge. In the application, Consumers indicated that if Consumers' proposal to securitize Clean Air Act expenditures and Palisades expenditures, previously not securitized, were approved as proposed in its securitization case as discussed above in "Securitization", then Consumers' "net" Stranded Costs incurred in 2002 would be approximately $35 million. If the proposal to securitize those costs is not approved, then Consumers indicated that the costs would be properly included in the 2002 "net" Stranded Cost calculation, which would increase Consumers' 2002 "net" Stranded Costs to approximately $103 million. In June 2003, the MPSC issued a financing order in the securitization case, authorizing the issuance of Securitization bonds in the amount of approximately $554 million. Included in this amount were Clean Air Act expenditures. However, the MPSC rejected Palisades expenditures previously not securitized as eligible securitized costs. As a result, the Palisades expenditures previously not securitized should be included as a component of "net" Stranded Costs and will be included as a component of a future electric rate case proceeding with the MPSC. With the inclusion of the Palisades expenditures previously not securitized, Consumers' "net" Stranded Costs incurred in 2002 are estimated to be approximately $50 million. In July 2003, Consumers filed a petition for rehearing and clarification on a number of features in the MPSC's financing order on securitization. Once a final financing order by the MPSC on securitization is issued, the amount of Consumers' request for "net" Stranded Cost recovery for 2002 will be known. Consumers cannot predict how the MPSC will rule on its request for the recoverability of Stranded CMS-67 CMS Energy Corporation Costs, and therefore Consumers has not recorded any regulatory assets to recognize the future recovery of such costs. The MPSC staff has scheduled a collaborative process to discuss Stranded Costs and related issues and to identify and make recommendations to the MPSC. Consumers has participated in this collaborative process. In July 2003, the staff suspended formal discussion while it considers possible conclusions and recommendations. Implementation Costs - 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 - 2003 2002 2 2 Pending Pending =========================================================================
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 order received for the year 2001, the MPSC also reserved the right to review again the 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 above, as of September 30, 2003, Consumers incurred and deferred as a regulatory asset, $2 million of additional implementation costs and has also recorded a regulatory asset of $16 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 is expected to begin after the rate freeze or rate cap period has expired. As discussed above, Consumers has asked to include implementation costs through December 31, 2000 in the pending securitization case. If approved, the sale of Securitization bonds will allow for the recovery of these costs. Consumers cannot predict the amounts the MPSC will approve as allowable costs. Also, Consumers is pursuing authorization at the FERC for MISO to reimburse Consumers for approximately $8 million in certain electric utility restructuring implementation costs related to its former participation in the development of the Alliance RTO, a portion of which has been expensed. In May 2003, the FERC issued an order denying MISO's request for authorization to reimburse Consumers. In June 2003, Consumers and MISO filed a joint petition for rehearing with the FERC. In September 2003, the FERC denied Consumers' and MISO's joint request. Consumers plans to appeal the FERC ruling at the United States Court of Appeals for the District of Columbia and pursue other potential means of recovery. In November 2003, in conjunction with Consumers' appeal of the September Order denying recovery, Consumers persuaded MISO to file a request with the FERC seeking authority to reimburse METC, the legal successor in interest to the Alliance RTO start-up costs. As part of the contract for sale of Consumers' former transmission system, should the Commission approve the new MISO filing, METC is contractually obligated to flow-through to Consumers the full amount of any Alliance RTO start-up costs that it is authorized to recover through FERC. Consumers cannot predict the outcome of the appeal process, the MISO request or the amount of implementation costs, if any; the FERC ultimately will allow to be collected. Transmission Rates - In 1996, Consumers filed new OATT transmission rates with the FERC for approval. CMS-68 CMS Energy Corporation 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 final FERC 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 and Detroit Edison used the same rates for JOATT transmission rates. Approval of the JOATT transmission rates application is pending FERC approval. Consumers believes its reserve is sufficient to satisfy its refund obligation under current rate applications. As of October 2003, Consumers has paid $27 million in refunds. In October 2003, Consumers filed with FERC its formal notice of cancellation of its transmission tariffs since Consumers no longer has any transmission customers. TRANSMISSION: In May 2002, Consumers sold its electric transmission system for approximately $290 million to MTH, a non-affiliated limited partnership whose general partner is a subsidiary of Trans-Elect, Inc. The pretax gain was $31 million ($26 million, net of tax). Remaining open issues are not expected to materially impact the amount of the gain. As a result of the sale, Consumers anticipates its after-tax earnings will decrease by $15 million in 2003, and decrease by approximately $14 million annually for the next three years due to a 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. Under an agreement with MTH, and subject to certain additional RTO surcharges, transmission rates charged to Consumers are fixed by contract at current levels through December 31, 2005, and subject to FERC ratemaking thereafter. MTH has completed 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 until May 1, 2007 under a contract with MTH. AUGUST 14, 2003 BLACKOUT: On August 14, 2003, the electric transmission grid serving parts of the Midwest and the Northeast experienced a significant disturbance, which impacted electric service to millions of homes and businesses throughout a vast region. In Michigan, more than 2 million electric customers were without electricity. Consumers had five fossil-fueled generating unit outages and, of Consumers' 1.7 million electric customers, approximately 100,000 were without power for approximately 24 hours as a result of the disturbance. The impact was felt most heavily in the southeastern part of Consumers' service territory. As discussed above in "Transmission", Consumers sold its transmission system in May 2002 to MTH, with Consumers providing transmission system maintenance under a five-year contract with MTH. MTH now owns, controls, and plans for the transmission system that serves Consumers. Consumers incurred approximately $1 million of immediate financial impact as a result of the blackout. Consumers continues to cooperate with investigations of the blackout by several federal and state agencies. Consumers cannot predict the outcome of these investigations. In November 2003, the MPSC released its report on the August 14 blackout, which found no evidence to suggest that the events in Michigan or actions taken by the Michigan utilities or transmission operators were factors contributing to the cause of the blackout. As a result of its investigation, the MPSC is recommending that Congress pass legislation that would empower the FERC, where necessary, to order CMS-69 CMS Energy Corporation membership into a RTO and that Congress should provide the FERC with the authority to develop and enforce mandatory transmission reliability standards with penalties for noncompliance. 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. As it did in 2003, Consumers is currently planning for a reserve margin of approximately 11 percent for summer 2004 or supply resources equal to 111 percent of projected summer peak load. Of the 111 percent, approximately 100 percent is expected to be met from owned electric generating plants and long-term power purchase contracts and 11 percent from short-term contracts and options for physical deliveries and other agreements. The ultimate use of the reserve margin 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 October 2003, alternative electric suppliers are providing 603 MW of generation supply to ROA customers. Consumers' reserve margin does not include generation being supplied by other alternative electric suppliers under the ROA program. Currently, Consumers is required to provide backup service to ROA customers on a "best efforts" basis. In October 2003, Consumers provided notice to the MPSC that it would terminate the provision of backup service in accordance with Public Act 141, effective January 1, 2004. 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 and energy 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, 2003, Consumers purchased capacity and energy contracts partially covering the estimated reserve margin requirements for 2004 through 2007. As a result, Consumers has a recognized asset of $21 million for unexpired capacity and energy contracts. The total premium cost of electricity call option and capacity and energy contracts for 2003 is expected to be approximately $10 million. 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, effective 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. On September 30, 2003, Consumers submitted a PSCR filing to the MPSC that would reinstate the PSCR process for customers whose rates will no longer be frozen or capped as of January 1, 2004. The proposed PSCR charge allows Consumers to recover a portion of its increased power supply costs from large CMS-70 CMS Energy Corporation commercial and industrial customers effective January 1, 2004. This is the first customer class for which the rate freeze and cap expire. Consumers will, pursuant to its right under applicable law, self-implement the proposed PSCR charge on January 1, 2004, unless the MPSC issues an order before that date establishing a different charge. The charge is subject to subsequent change by the MPSC during the PSCR period (calendar-year 2004). The revenues received pursuant to the PSCR charge by statute are also subject to subsequent reconciliation when the year is finished and actual costs have been reviewed for reasonableness and prudence. Consumers cannot predict the outcome of this filing. 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. Consumers' consolidated retained earnings include undistributed earnings from the MCV Partnership, which at September 30, 2003 and 2002 are $238 million and $217 million, respectively. Summarized Statements of Income for CMS Midland and CMS Holdings
In Millions ------------------------------------------------------------------------------------------------------------------- Three Months Ended Nine Months Ended September 30 2003 2002 2003 2002 ------------------------------------------------------------------------------------------------------------------- Earnings (loss) from equity method investees $ (3) $ 8 $ 31 $ 35 Operating taxes and other (1) 2 18 11 ------------------------------------------- Income (loss) before cumulative effect of accounting change (2) 6 13 24 Cumulative effect of change in method of accounting for derivatives, net of $1 and $10 million tax expense in 2002 (a) - 1 - 18 ------------------------------------------- Net income (loss) $ (2) $ 7 $ 13 $ 42 ===================================================================================================================
CMS-71 CMS Energy Corporation Summarized Statements of Income for the MCV Partnership
In Millions -------------------------------------------------------------------------------------------------------------------- Three Months Ended Nine Months Ended September 30 2003 2002 2003 2002 -------------------------------------------------------------------------------------------------------------------- Operating revenue $ 148 $ 156 $ 443 $ 451 Operating expenses 138 120 322 318 -------------------------------------------- Operating income 10 36 121 133 Other expense, net 25 27 82 86 -------------------------------------------- Income (loss) before cumulative effect of accounting change (15) 9 39 47 Cumulative effect of change in method of accounting for derivative option contracts (a) - - - 58 -------------------------------------------- Net income (loss) $ (15) $ 9 $ 39 $ 105 ====================================================================================================================
(a) On April 1, 2002, the MCV Partnership implemented Derivative Implementation Group Issue C-16, an interpretation of SFAS No. 133. The MCV Partnership began accounting for several natural gas contracts containing an option component at fair value. As a result, a cumulative effect adjustment for the change in accounting principle was recorded as an increase to earnings. Power Supply Purchases from the MCV Partnership - Consumers' annual obligation to purchase capacity from the MCV Partnership is 1,240 MW through the term of the PPA ending 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 and a fixed energy charge, and also to pay 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. Recovery of both the 915 MW and 325 MW portions of the PPA are subject to certain limitations discussed below. After September 2007, the PPA's regulatory out 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 and established a PPA liability for the present value of the estimated future underrecoveries of power supply costs under the PPA based on MPSC cost recovery orders. Primarily as a result of the MCV Facility's actual availability being greater than management's original estimates, the PPA liability has been reduced at a faster rate than originally anticipated. The remaining estimated future PPA liability associated with the loss totaled $34 million at September 30, 2003 and $59 million at September 30, 2002. The PPA liability is expected to be depleted in late 2004. For further discussion on the impact of the frozen PSCR, see "Consumers' Electric Utility Rate Matters" in this Note. In March 1999, Consumers and the MCV Partnership reached a settlement agreement effective January 1, CMS-72 CMS Energy Corporation 1999, that addressed, among other things, the ability of the MCV Partnership to count modifications increasing the capacity of the existing MCV Facility for purposes of computing the availability of contract capacity under the PPA for billing purposes. That settlement agreement capped payments made on the basis of availability that may be billed by the MCV Partnership at a maximum 98.5 percent availability level. Under Michigan's electric restructuring law, Consumers will return to unfrozen rates for large industrial customers beginning January 1, 2004, including the resumption of the PSCR process. Under the process, Consumers will recover from customers capacity and fixed energy charges on the basis of availability, to the extent that availability does not exceed 88.7 percent availability established in previous MPSC orders. Recovery of capacity and fixed energy charges will be subject to certain rate caps as discussed in Note 4, Uncertainties, "Consumers' Electric Utility Rate Matters - Electric Restructuring." For capacity and energy payments billed by the MCV Partnership after September 15, 2007, and not recovered from customers, Consumers would expect to claim a regulatory out under the PPA. The regulatory out provision relieves Consumers of the obligation to pay more for capacity and energy payments than the MPSC allows Consumers to collect from its customers. Consumers estimates that 51 percent of the actual cash underrecoveries for the years 2003 and 2004 will be charged to the PPA liability, with the remaining portion charged to operating expense as a result of Consumers' 49 percent ownership in the MCV Partnership. All cash underrecoveries will be expensed directly to income once the PPA liability is depleted. If the MCV Facility's generating availability remains at the maximum 98.5 percent level, Consumers' cash underrecoveries associated with the PPA could be as follows:
In Millions ------------------------------------------------------------------------------------------------------ 2003 2004 2005 2006 2007 ------------------------------------------------------------------------------------------------------ Estimated cash underrecoveries at 98.5% (a) $ 57 $ 56 $ 56 $ 55 $ 39 Amount to be charged to operating expense $ 28 $ 27 $ 56 $ 55 $ 39 Amount to be charged to PPA liability $ 29 $ 29 $ - $ - $ - ======================================================================================================
(a) For the nine months ended September 30, 2003, Consumers' cash underrecoveries associated with the PPA were $43 million. As previously noted, until September 2007, the PPA and settlement require Consumers to pay capacity costs based on the MCV Facility's actual availability up to the 98.5 percent cap. After September 2007, Consumers expects to exercise the "regulatory out" clause in the PPA, limiting its capacity payments to the MCV Partnership to the amount collected from its customers. Depending on the MPSC's future actions with respect to the capacity payments recoverable from its customers subsequent to September 2007, the earnings of the MCV Partnership and the value of Consumers' equity interest in the MCV Partnership, may be affected negatively. Further, under the PPA, energy payments to the MCV Partnership are based on the cost of coal burned at Consumers' coal plants and costs associated with fuel inventory, operations and maintenance, and administrative and general expenses associated with Consumers' coal plants. However, the MCV Partnership's costs of producing electricity are tied, in large part, to the cost of natural gas. Because natural gas prices have increased substantially in recent years, while energy charge payments to the MCV Partnership have not, the MCV Partnership's financial performance has been impacted negatively. CMS-73 CMS Energy Corporation As of January 1, 2004, Consumers intends to return to forced (uneconomic) dispatch of the MCV Facility in order to maximize recovery of its capacity payments. As such, if the spread between MCV Facility's variable electricity production costs and its energy payment revenues stays constant or widens, the negative impacts on MCV Partnership's financial performance, and on the value of Consumers' equity interest in the MCV Partnership, will be worse. Consumers cannot estimate, at this time, the impact of these issues on its future earnings or cash flow from its interest in the MCV Partnership. The forward price of natural gas for the next 22 years and the MPSC decision in 2007 or later related to Consumers' recovery of capacity payments are the two most significant variables in the analysis of MCV Partnership's future financial performance. Natural gas prices have historically been volatile and presently there is no consensus in the marketplace on the price or range of prices of natural gas beyond the next five years. Further, it is not presently possible for Consumers to predict the actions of the MPSC in 2007 or later. For these reasons, at this time Consumers cannot predict the impact of these issues on its future earnings, cash flows, or on the value of its $404 million equity interest in the MCV Partnership. Consumers is exploring possible alternatives for utilizing the MCV Facility without increasing costs to customers. Any changes regarding the recovery of MCV capacity costs would require MPSC approval. Consumers cannot predict the outcome of this matter. 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 PURPA. In July 1999, the district court granted MCV Partnership's motion for summary judgment. The district 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. NUCLEAR MATTERS: Significant progress continues to be made in the decommissioning of Big Rock. Following the successful loading of spent fuel into dry storage (see below under "Spent Nuclear Fuel Storage"), the spent fuel storage racks were removed and disposed of and the spent fuel pool cleaned and drained. The reactor vessel closure head was shipped for disposal in May 2003 and in August 2003, the reactor vessel was moved from the plant and sealed into a specially designed shipping container. In October 2003, the shipping container was transported to the licensed disposal facility in Barnwell, South Carolina. The License Termination Plan was submitted to the NRC staff for review in April 2003. System dismantlement and building demolition continue on a schedule to return the 560-acre site to a natural setting for unrestricted use in early 2006. The NRC and Michigan Department of Environmental Quality continue to find that all decommissioning activities at Big Rock are being performed in accordance with applicable regulatory and license requirements. In July 2003, the NRC completed its mid-cycle plant performance assessment of Palisades. The mid-cycle review for Palisades covered the period from January 1, 2003 through the end of July 2003. The NRC determined that Palisades was operated in a manner that preserved public health and safety and fully met all cornerstone objectives. Based on the plant's performance, only regularly scheduled inspections are CMS-74 CMS Energy Corporation planned through September 2004. Spent Nuclear Fuel Storage: During the fourth quarter of 2002, equipment fabrication, assembly and testing was completed at Big Rock on NRC-approved transportable steel and concrete canisters or vaults, commonly known as "dry casks." Spent fuel was then loaded into the dry casks from the fuel pool and transported to the temporary onsite storage pad. A total of seven dry casks have been loaded with spent fuel. An additional eighth cask, containing high-level radioactive waste material, was also loaded. This radioactive material was made up of reactor vessel components that could not be shipped or stored with the reactor vessel. These transportable dry casks will remain onsite until the DOE moves the material to a national fuel repository. At Palisades, the amount of spent nuclear fuel discharged from the reactor to date exceeds Palisades' temporary onsite storage pool capacity. Consequently, Consumers is using dry casks for temporary onsite storage. As of September 30, 2003, 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 onsite, 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. As of September 30, 2003, Consumers has a recorded liability to the DOE of $139 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 the interest. In 1997, a U.S. Court of Appeals decision confirmed that the DOE was to begin accepting deliveries of spent nuclear fuel for disposal by January 31, 1998. Subsequent U.S. Court of Appeals 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 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, including Consumers, which filed its complaint in December 2002, have commenced litigation in the Court of Claims. The Chief Judge of the Court of Claims identified six lead cases to be used as vehicles for resolving dispositive motions. Consumers' case is not a lead case. It is unclear what impact this decision by the Chief Judge will have on the outcome of Consumers' litigation. If the litigation that was commenced in the fourth quarter of 2002 against the DOE is successful, Consumers anticipates future recoveries from the DOE to defray the significant costs it will incur for the storage of spent fuel until the DOE takes possession as required by law. However, there is no assurance that the litigation against the DOE will be successful. 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. CMS-75 CMS Energy Corporation In March 2003, the Michigan Environmental Council, the Public Interest Research Group in Michigan, and the Michigan Consumer Federation submitted a complaint to the MPSC, which was served on Consumers by the MPSC in April 2003. The complaint asks the MPSC to commence a generic investigation and contested case to review all facts and issues concerning costs associated with spent nuclear fuel storage and disposal. The complaint seeks a variety of relief with respect to Consumers, Detroit Edison, Indiana & Michigan Electric Company, Wisconsin Electric Power Company and Wisconsin Public Service Corporation, including establishing external trusts to which amounts collected in electric rates for spent nuclear fuel storage and disposal should be transferred, and the adoption of additional measures related to the storage and disposal of spent nuclear fuel. In May 2003, Consumers and the other named utilities each filed a motion to dismiss the complaint. Consumers is unable to predict the outcome of this matter. Palisades Plant Operations: In March 2002, corrosion problems were discovered in the reactor head at an unaffiliated nuclear power plant in Ohio. As a result, the NRC requested that all United States nuclear plants utilizing pressurized water reactors provide reports detailing their reactor head inspection histories, design capabilities and future inspection plans. In response to the issues identified at this and other nuclear plants worldwide, a bare metal visual inspection was completed on the Palisades reactor vessel head during the spring 2003 refueling outage. No indication of leakage was detected on any of the 54 penetrations of the reactor head. Consumers will continue to comply with the more aggressive reactor head inspection requirements in future planned outages at Palisades. Insurance: Consumers maintains primary and excess nuclear property insurance from NEIL, totaling $2.750 billion in recoverable limits for the Palisades nuclear plant. Consumers also procures coverage from NEIL that would partially cover the cost of replacement power during certain prolonged accidental outages at Palisades. NEIL's policies include coverage for acts of terrorism. Consumers retains the risk of loss to the extent of the insurance deductibles and to the extent that its loss exceeds its policy limits. Because NEIL is a mutual insurance company, Consumers could be subject to assessments from NEIL up to $26 million in any policy year if insured losses in excess of NEIL's maximum policyholders surplus occur at its, or any other member's, nuclear facility. Consumers maintains nuclear liability insurance for injuries and off-site property damage resulting from the nuclear hazard at Palisades for up to approximately $10.862 billion, the maximum insurance liability limits established by the Price-Anderson Act. Congress enacted the Price-Anderson Act to provide financial protection for persons who may be liable for a nuclear accident or incident and persons who may be injured by a nuclear incident. The Price-Anderson Act was extended to December 31, 2003. Part of the Price-Anderson Act's financial protection consists of a mandatory industry-wide program under which owners of nuclear generating facilities could be assessed if a nuclear incident occurs at any of such facilities. The maximum assessment against Consumers could be $101 million per occurrence, limited to maximum annual installment payments of $10 million. Consumers also maintains insurance under a master worker program that covers tort claims for bodily injury to workers caused by nuclear hazards. The policy contains a $300 million nuclear industry aggregate limit. Under a previous insurance program providing coverage for claims brought by nuclear workers, Consumers remains responsible for a maximum assessment of up to $6 million. The Big Rock plant remains insured for nuclear liability by a combination of insurance and United States government indemnity totaling $544 million. CMS-76 CMS Energy Corporation Insurance policy terms, limits and conditions are subject to change during the year as Consumers renews its policies. 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 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 resolution of environmental issues at sites as studies are completed. Consumers has estimated its costs related to investigation and remedial action for all 23 sites using the Gas Research Institute-Manufactured Gas Plant Probabilistic Cost Model. A revised cost estimate, completed in September 2003, estimated remaining costs to be between $37 million and $90 million. The range reflects multiple alternatives with various assumptions for resolving the environmental issues at each site. The estimates are based on discounted 2003 costs using a discount rate of three percent. The discount rate represents a ten-year average of U.S. Treasury bond rates reduced for increases in the consumer price index. Consumers expects to fund a significant portion of these costs through insurance proceeds and through MPSC approved rates charged to its customers. As of September 30, 2003, Consumers has an accrued liability of $47 million, net of $35 million of expenditures incurred to date, and a regulatory asset of $68 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 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 COST RECOVERY: As part of the on-going GCR process, which includes an annual reconciliation case with the MPSC, Consumers expects to recover all of its gas costs. In June 2003, Consumers filed a reconciliation of GCR costs and revenues for the 12-months ended March 2003. Consumers proposes to recover from its customers a net under-recovery of approximately $6 million using a roll-in methodology. The roll-in methodology incorporates the under-recovery in the GCR factor charged in the next GCR year. The roll-in tariff provision was approved by the MPSC in a November 2002 order. In July 2003, the MPSC approved a settlement agreement authorizing Consumers to increase its gas cost recovery factor for the remainder of the current GCR plan year (August 2003 through March 2004) and to implement a quarterly ceiling price adjustment mechanism, based on a formula that tracks changes in NYMEX natural gas prices. Consistent with the terms of the settlement, the ceiling price is $6.11 per mcf. However, Consumers will utilize a GCR factor of $5.41 per mcf commencing in November 2003 bills. All CMS-77 CMS Energy Corporation recoveries pursuant to such factors are subject to final reconciliation by the MPSC. 2003 GAS RATE CASE: In March 2003, Consumers filed an application with the MPSC seeking a $156 million increase in its gas delivery and transportation rates, which included a 13.5 percent return on equity, based on a 2004 test year. Contemporaneously with this filing, Consumers requested interim rate relief in the same amount. In August 2003, the MPSC Staff recommended interim rate relief of $80 million be granted in this proceeding, subject to Consumers voluntarily agreeing to limit its dividends to its parent, CMS Energy, to a maximum of $190 million in any calendar year. In September 2003, Consumers filed an update to its gas rate case that lowered the requested revenue increase from $156 million to $139 million and revised the return on common equity from 13.5 percent to 12.75 percent. The majority of the reduction is related to lower debt costs and changes in the projected capital structure. The MPSC Staff and ABATE filed their cases in early October. The Staff made no change to its interim position of $80 million and continued to propose the same dividend limitation. ABATE did not make a specific recommendation for a final rate increase, but did discuss the rate design used to recover any rate increase granted. A proposal for decision is expected from the administrative law judge in January 2004. OTHER CONSUMERS' UNCERTAINTIES SECURITY COSTS: Since the September 11, 2001 terrorist attacks in the United States, Consumers has increased security at all critical facilities and over its critical 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. Through September 30, 2003, Consumers has incurred approximately $7 million in incremental security costs, including operating, capital, and decommissioning and removal costs, mainly relating to its nuclear facilities. Consumers estimates it may incur additional incremental security costs for the last three months of 2003 of approximately $3 million, of which $2 million relates to nuclear security costs. Consumers will attempt to seek recovery of these costs from its customers. In December 2002, the Michigan legislature passed, and the governor signed, a bill that would allow Consumers to seek recovery of additional nuclear electric division security costs incurred during the rate freeze and cap periods imposed by the Customer Choice Act. In February 2003, the MPSC adopted filing requirements for the recovery of enhanced security costs. DERIVATIVE ACTIVITIES: Consumers may use a variety of contracts to protect against commodity price and interest rate risk. Some of these contracts may be subject to derivative accounting, which requires that the value of the contracts be adjusted to fair value through earnings or equity depending upon certain criteria. Such adjustments to fair value could cause earnings volatility. For further information about derivative activities, see Note 7, Risk Management Activities and Financial Instruments. OTHER: 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. CMS-78 CMS Energy Corporation OTHER UNCERTAINTIES INTEGRUM LAWSUIT: A complaint was filed in Wayne County, Michigan Circuit Court on July 17, 2003 by Integrum against CMS Energy, Enterprises and APT. Integrum alleges several causes of action against APT, CMS Energy and Enterprises in connection with an offer by Integrum to purchase the CMS Pipeline Assets. In addition to seeking unspecified money damages, Integrum is seeking an order enjoining Enterprises and CMS Energy from selling and APT from purchasing the CMS Pipeline Assets and an order of specific performance mandating that CMS Energy, Enterprises and APT complete the sale of the CMS Pipeline Assets to APT and Integrum. An officer and director of Integrum is a former officer and director of CMS Energy, Consumers and certain of its subsidiaries. The individual was not employed by CMS Energy, Consumers or its subsidiaries when Integrum made the offer to purchase the CMS Pipeline Assets. CMS Energy and Enterprises intend to vigorously defend against this action. CMS Energy and Enterprises cannot predict the outcome of this litigation. 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 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. The tolling agreement stopped the running of any statute of limitations during the period between September 13, 2002 and (through several extensions of the original tolling period) December 30, 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 with the plaintiffs in the amount of $9 million. The primary insurance carrier paid $8 million of this amount, and the Secondary insurer paid the remaining $1 million. 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. DFD has appealed the decision by the judge in the Michigan state court case to stay the arbitration. DIG will continue to vigorously defend itself and pursue its claims. DIG cannot predict the outcome of this matter. CMS-79 CMS Energy Corporation DIG CUSTOMER DISPUTES: As a result of the continued delays in the DIG project becoming fully operational, DIG's customers, Ford Motor Company and Rouge Industries, have asserted claims that the continued delays relieve them of certain contractual obligations totaling $43 million. In addition, Ford and/or Rouge have asserted several other commercial claims against DIG relating to operation of the DIG plant. In February 2003, Rouge filed an Arbitration Demand against DIG and CMS MST Michigan, LLC with the American Arbitration Association. Rouge is seeking a total of $27 million plus additional accrued damages at the time of any award, plus interest. More specifically, Rouge is seeking at least $20 million under a Blast Furnace Gas Delivery Agreement in connection with DIG's purported failure to declare a Blast Furnace Gas Delivery Date within a reasonable time period, plus approximately $7 million for assorted damage claims under several legal theories. As part of this arbitration, DIG has filed claims against Rouge and Ford and Ford has filed claims against DIG for unspecified amounts. DIG and CMS MST Michigan, LLC intend to vigorously defend themselves, but cannot predict the outcome of this matter. In October 2003, Rouge filed bankruptcy under Chapter 11 of the United States Bankruptcy Code and as a result, the arbitration is subject to the automatic stay imposed by the Bankruptcy Code. Rouge has indicated that it will continue to honor its contractual obligations to pay for the steam and electricity DIG provides. DIG is in the process of exploring its options relative to the bankruptcy action but cannot predict the eventual outcome of the matter. DIG NOISE ABATEMENT LAWSUIT: In February 2003, DIG was served with a three-count first amended complaint in the matter of Ahmed, et al. v. Dearborn Industrial Generation, LLC, that was filed in Wayne County Michigan Circuit Court. The complaint seeks damages "in excess of $25,000" and injunctive relief based upon allegations of excessive noise and vibration created by operation of the power plant. The first amended complaint was filed on behalf of six named plaintiffs, all alleged to be adjacent or nearby residents or property owners. The damages alleged are injury to persons and property of the landowners. Certification of a class of "potentially thousands" who have been similarly affected is requested. DIG intends to aggressively defend this action. DIG cannot predict the outcome of this matter. MCV EXPANSION, LLC: Under an agreement entered into with General Electric Company ("GE") in October 2002, MCV Expansion, LLC has a remaining contingent obligation to GE in the amount of $2.2 million that may become payable in the fourth quarter of 2003. The agreement provides that this contingent obligation is subject to a pro rata reduction under a formula based upon certain purchase orders being entered into with GE by June 30, 2003. MCV Expansion, LLC anticipates but cannot assure that purchase orders will be executed with GE sufficient to eliminate contingent obligations of $2.2 million. 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 $7.6 million in damages. Terra appealed this matter to the Michigan Court of Appeals. The Court of Appeals reversed the trial court judgment with respect to the appropriate measure of damages and remanded the case for a new trial on damages. A reserve has been established for this matter. ARGENTINA ECONOMIC SITUATION: 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 CMS-80 CMS Energy Corporation obligations into pesos at the same one-to-one exchange rate, and directed the President of Argentina to renegotiate such tariffs. 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. While CMS Energy's management cannot predict the most likely future, or average 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. At September 30, 2003, the net foreign currency loss due to the unfavorable exchange rate of the Argentine peso recorded in the Foreign Currency Translation component of Common Stockholders' Equity using an exchange rate of 2.975 pesos per U.S. dollar was $259 million. This amount also reflects the effect of recording U.S. income taxes with respect to temporary differences between the book and tax basis of foreign investments, including the foreign currency translation associated with CMS Energy's Argentine investments, that were determined to no longer be essentially permanent in duration. 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 $91 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 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-81 CMS Energy Corporation 5: FINANCINGS AND CAPITALIZATION The following is a summary of CMS Energy's Long-Term Debt as of September 30, 2003 and December 31, 2002:
LONG-TERM DEBT in Millions --------------------------------------------------------------------------------------------------------------------------- September 30 December 31 Interest Rate (%) Maturity 2003 2002 --------------------------------------------------------------------------------------------------------------------------- CMS ENERGY Senior Notes 7.625 2004 $ 176 $ 176 6.750 (a) 2004 82 287 9.875 2007 468 468 8.900 2008 260 260 7.500 2009 409 409 7.750 2010 300 - 8.500 2011 300 300 8.375 2013 - 150 3.375 (b) 2023 150 - ------------------------------- 2,145 2,050 ------------------------------- General Term Notes : Series D 6.938 (c) 2005 - 2008 65 94 Series E 7.718 (c)(a) 2003 - 2009 163 227 Series F 7.487 (c) 2003 - 2016 296 298 ------------------------------- 524 619 ------------------------------- Extendible Tenor Rate Adjusted Securities 7.000 2005 180 180 Revolving Credit Facilities Floating 2003-2004 5 291 Other 8 29 ------------------------------- 193 500 ------------------------------- CONSUMERS ENERGY Senior Notes 6.000 2005 300 300 6.250 2006 332 332 6.375 2008 159 159 6.200 (d) 2008 - 250 6.875 2018 180 180 6.500 (e) 2018 141 141 6.500 (f) 2028 142 142 ------------------------------- 1,254 1,504 ------------------------------- Securitization Bonds 5.075 (c) 2005-2015 434 453 First Mortgage Bonds 5.240 (c) 2008-2023 1,482 208 Long-Term Bank Debt Floating 2009 140 328 Nuclear Fuel Disposal Liability (g) 139 138 Pollution Control Revenue Bonds Various 2010-2018 126 126 Other 6 8 ------------------------------- 2,327 1,261 OTHER SUBSIDIARIES 56 77 ------------------------------- Principal Amount Outstanding 6,499 6,011 Current Amounts (172) (627) Net Unamortized Discount (36) (28) --------------------------------------------------------------------------------------------------------------------------- Total Long-Term Debt $ 6,291 $ 5,356 ===========================================================================================================================
CMS-82 CMS Energy Corporation (a) Senior notes of $82 million and Series E GTNs of $14.7 million were called and redeemed as of October 15, 2003. (b) These notes are convertible into shares of common stock at $10.671 per share under certain circumstances. (c) Represents the weighted average interest rate at September 30, 2003. (d) These notes were subject to a Call Option by the Callholder or a Mandatory Put on May 1, 2003. (e) Senior Remarketed Notes subject to optional redemption by Consumers after June 15, 2005. (f) Callable at par on or after October 1, 2003. (g) Maturity date uncertain. CMS ENERGY On March 30, 2003, CMS Energy entered into an amendment and restatement of its then existing $300 million and $295.8 million revolving credit facilities under which $409 million was outstanding. The Second Amended and Restated Senior Credit Agreement included a $159 million tranche with a maturity date of April 30, 2004 and a $250 million tranche with a maturity date of September 30, 2004. The facility was underwritten by several banks at a total annual cost to CMS Energy of approximately ten percent which included the initial commitment fee. Any proceeds of debt or equity issuances by CMS Energy and its subsidiaries or any asset sales by CMS Energy or its subsidiaries, other than Consumers, were required to be used to prepay this facility. This facility was collateralized primarily by the stock of Consumers, Enterprises and certain Enterprises subsidiaries. In July 2003, the facility was paid down to $5 million with a combination of a portion of the proceeds of the sale of CMS Field Services and a portion of the proceeds of the issuance of the $300 million 7.75 percent Senior Notes due 2010. On September 12, 2003, this credit agreement was amended and restated in the amount of $5 million. The amended and restated credit facility does not include any restrictive financial covenants. As of September 30, 2003, $5 million was outstanding on this facility. LONG-TERM FINANCINGS: In July 2003, CMS Energy issued, in a private placement to institutional investors, $150 million of 3.375 percent convertible senior notes due July 15, 2023. The notes are putable to CMS Energy by the note holders at par on July 15, 2008, July 15, 2013 and July 15, 2018. The notes are convertible into CMS Energy common stock at the option of the holder under certain circumstances. The initial conversion price is $10.671 per share, which translates into 93.7137 shares of common stock for each $1,000 principal note converted. CMS has agreed to file a shelf registration statement with the SEC by October 14, 2004 relating to the resale of the notes and the common stock issuable upon conversion thereof. Also in July 2003, CMS Energy issued $300 million of 7.75 percent senior notes due 2010. CMS has agreed to file a registration statement with the SEC by March 14, 2004 to permit holders of these notes to exchange the notes for new notes that will be registered under the Securities Act of 1933. The approximately $433 million of proceeds from these issuances were used to retire a portion of debt outstanding under CMS Energy's Second Amended and Restated Senior Credit Agreement and to redeem a portion of CMS Energy's 6.75 percent Senior Notes due January 2004. In July 2003, CMS Energy retired $150 million principal amount of CMS Energy's 8.375 percent Reset Put Securities due 2013. As a result, CMS Energy recorded a charge in July 2003 of approximately $19 million after-tax related to the accelerated amortization of debt issuance costs and the premium paid associated with the discharge of these securities. In October 2003, $82 million of the 6.75 percent senior notes were called and redeemed. GENERAL TERM NOTES: At September 30, 2003, CMS Energy had issued and outstanding $524 million GTNs, comprised of $65 million Series D GTNs, $163 million Series E GTNs and $296 million of Series CMS-83 CMS Energy Corporation F GTNs with weighted average interest rates of 6.94 percent, 7.72 percent and 7.49 percent, respectively. No Series G GTNs have been issued since their registration in May 2002. In October 2003, approximately $15 million of Series E GTNs were called and redeemed. ENTERPRISES In May 2003, CMS Energy entered into a revolving credit facility in an aggregate amount of $185 million. The maturity date of this facility is May 21, 2004. This facility is primarily used to provide letter of credit support for Enterprises' subsidiary activities - principally credit support for project debt. Enterprises provides funds to cash collateralize all letters of credit issued through this facility. As of September 30, 2003, approximately $167 million of letters of credit were issued under this facility and the cash that collateralizes the letters of credit is included on the balance sheet as restricted cash. CONSUMERS REGULATORY AUTHORIZATION FOR FINANCINGS: At September 30, 2003, Consumers had FERC authorization, through June 2004, to issue or guarantee up to $1.1 billion of short-term securities outstanding at any one time. As of September 30, 2003, Consumers had $400 million outstanding as collateral for the revolving credit facility (discussed below) and had an additional $700 million available for future issuances of short-term securities. At September 30, 2003, Consumers also had remaining FERC authorization, through June 2004, to issue up to $800 million of long-term securities for refinancing or refunding purposes, $560.3 million of long-term securities for general corporate purposes, and $2.06 billion of long-term first mortgage bonds to be issued solely as collateral for other long-term securities. Also, FERC has granted waivers of its competitive bid/negotiated placement requirements applicable to the long-term securities authorization indicated above. SHORT-TERM FINANCINGS: In March 2003, Consumers obtained a replacement revolving credit facility in the amount of $250 million secured by first mortgage bonds. In September 2003, this facility was amended and restated as a $400 million revolving credit facility. The interest rate of the facility was reduced from LIBOR plus 350 to LIBOR plus 175 basis points. The new credit facility matures in March 2004 with two annual extensions at Consumers' option, which would extend the maturity to March 2006. At September 30, 2003, all of the $400 million is available for general corporate purposes. At September 30, 2003, a total of $4 million was outstanding on all short-term financings at a weighted average interest rate of 2.79 percent, compared with $235 million outstanding at September 30, 2002 at a weighted average interest rate of 3.7 percent. FIRST MORTGAGE BONDS: In April 2003, Consumers sold $625 million principal amount of first mortgage bonds in a private offering to institutional investors; $250 million were issued at an interest rate of 4.25 percent, maturing in April 2008, and net proceeds were approximately $248 million; $375 million were issued at an interest rate 5.375 percent, maturing in April 2013, and net proceeds were approximately $371 million. Consumers used the net proceeds to replace a $250 million senior reset put bond that matured in May 2003, to pay an associated $32 million option call payment, and for general corporate purposes that included paying down additional debt. The $32 million option call payment was deferred and is being amortized to interest expense over the term of the replacement debt in accordance with SFAS No. 71. Consumers agreed to file a registration statement with the SEC by December 26, 2003 to permit holders of the first mortgage bonds to exchange the bonds for new bonds that will be registered under the Securities Act of 1933. In May 2003, Consumers sold $250 million principal amount of first mortgage bonds in a private offering CMS-84 CMS Energy Corporation to institutional investors; the bonds were issued at an interest rate of 4.00 percent, maturing May 2010, and net proceeds were approximately $247 million. Consumers used the net proceeds to pay down existing debt. Consumers agreed to file a registration statement with the SEC by December 26, 2003 to permit holders of the first mortgage bonds to exchange the bonds for new bonds that will be registered under the Securities Act of 1933. In August 2003, Consumers sold $400 million principal amount of first mortgage bonds in a private offering to institutional investors; $200 million were issued at an interest rate of 4.80 percent, maturing in February 2009, and net proceeds were approximately $198 million and $200 million were issued at an interest rate of 6.00 percent, maturing in February 2014, and net proceeds were approximately $198 million. Consumers used the net proceeds to pay down existing debt and for general corporate purposes. Consumers agreed to file a registration statement with the SEC by April 14, 2004 to permit holders of the first mortgage bonds to exchange the bonds for new bonds that will be registered under the Securities Act of 1933. SENIOR NOTES: In March 2003, Consumers entered into a $140 million term loan secured by first mortgage bonds with a private investor bank. This loan has a term of six years at a cost of LIBOR plus 475 basis points. Proceeds from this loan were used for general corporate purposes. In March 2003, Consumers entered into a $150 million term loan secured by first mortgage bonds. This term loan had a three-year maturity expiring in March 2006. This term loan was paid in full with the proceeds of first mortgage bonds issued in August 2003. REQUIRED RATIOS CMS Energy's amended and restated $5 million credit facility does not include any restrictive financial covenants. Consumers' credit facilities have restrictive financial covenants that require Consumers to maintain, as of the last day of each fiscal quarter, the following:
Required Ratio Limitation Ratio at September 30, 2003 --------------------------------------------------------------------------------------------------- CONSUMERS: Debt to Capital Ratio(a)(b) not more than 0.65 to 1.00 0.58 to 1.00 Interest Coverage Ratio-Revolver(a) not less than 2.00 to 1.00 3.34 to 1.00 ===================================================================================================
(a) Violation of this ratio would constitute an event of default under the facility that provides the lender, among other remedies, the right to declare the principal and interest immediately due and payable. (b) The terms of the credit facility provide for the exclusion of securitization bonds in the calculation of the debt to capital ratio. In 1994, CMS Energy executed an indenture with JPMorgan Chase Bank, ultimate successor to The Chase Manhattan 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. At September 30, 2003, CMS Energy's consolidated leverage ratio was 0.76 to 1.0. As a result, 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 may refinance existing debt that CMS-85 CMS Energy Corporation was incurred while CMS Energy was in compliance with the consolidated leverage ratio. In 1992, CMS Energy executed an indenture with Bank One Trust Company, N.A. (successor to NBD Bank, National Association) pursuant to which CMS Energy issues its senior notes. The indenture, through supplements, contains certain provisions that can trigger a limitation on consolidated indebtedness. The limitation can be activated when CMS Energy's consolidated coverage ratio, as defined in the indenture, is below 1.70 to 1.0. At September 30, 2003, CMS Energy's consolidated coverage ratio was 2.02 to 1.0. Consumers is subject to covenants in its financing agreements that could limit its ability to incur additional indebtedness. Consumers has agreed in several of its financing agreements to maintain specified levels of cash coverage of its interest requirements and to not allow its indebtedness to exceed specified levels of its consolidated capitalization (the "Debt Percentage Tests"). Consumers is in compliance with these requirements as of the most recent measurement date, September 30, 2003. These covenants make use of both generally accepted accounting principles and defined contractual terms in specifying how the relevant calculations are made. Consumers sought and received amendments to certain of its relevant financing agreements to modify the terms of the Debt Percentage Tests in order to, among other things, remove the effect of the adoption of SFAS No. 150, portions of which have now been deferred indefinitely, regarding Trust Preferred Securities on the calculations. RESTRICTED PAYMENTS: Under the provisions of its articles of incorporation, Consumers had $412 million of unrestricted retained earnings available to pay common dividends at September 30, 2003. However, covenants in Consumers' debt facilities cap common stock dividend payments at $300 million in a calendar year. Through September 30, 2003, Consumers paid $162 million in common dividends. In October 2003, Consumers declared a $57 million common dividend payable in November 2003. For information on the potential cap on common dividends payable included in the MPSC Securitization order see Note 4, Uncertainties, Consumers' Electric Utility Rate Matters, "Securitization." Also, for information on the potential cap on common dividends payable included in the MPSC Staff's recommendation in Consumers' gas rate case see Note 4, Uncertainties, "Consumers' Gas Utility Rate Matters - 2003 Gas Rate Case." 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 these 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. For further information, see Note 7, Risk Management Activities and Financial Instruments, Financial Instruments, and Note 10, Implementation of New Accounting Standards. CMS-86 CMS Energy Corporation
In Millions ---------------------------------------------------------------------------------------------------------------- Amount Earliest Trust and Securities Rate Outstanding Maturity Redemption ---------------------------------------------------------------------------------------------------------------- September 30 2003 2002 ---------------------------------------------------------------------------------------------------------------- CMS Energy Trust I (a) 7.75% $ 173 $ 173 2027 2001 CMS Energy Trust III (b) 7.25% - 220 2004 2003 Consumers Power Company Financing I, Trust Originated Preferred Securities (c) 8.36% 70 70 2015 2000 Consumers Energy Company Financing II, Trust Originated Preferred Securities (c) 8.20% 120 120 2027 2002 Consumers Energy Company Financing III, Trust Originated Preferred Securities (d) 9.25% 175 175 2029 2004 Consumers Energy Company Financing IV, Trust Preferred Securities (e) 9.00% 125 125 2031 2006 ---------------- Total Amount Outstanding $ 663 $ 883 ================================================================================================================
(a) Represents 3,450,000 shares of Quarterly Income Preferred Securities that are convertible into 1.2255 shares of CMS Energy Common Stock (equivalent to a conversion price of $40.80). Conversion is unlikely as of September 30, 2003, based upon the market price of CMS Energy's Common Stock of $7.37. If conversion were to occur in the future, the securities would be converted into 4,227,975 shares of CMS Energy Common Stock. Effective July 2001, CMS Energy can revoke the conversion rights if certain conditions are met. (b) In August 2003, 8,800,000 units of outstanding 7.25 percent Premium Equity Participating Security Units (CMS Energy Trust III) were converted to 16,643,440 newly issued shares of CMS Energy Common Stock. (c) Consumers can currently redeem these securities at par value. (d) Consumers cannot redeem these securities until 2004. If Consumers were to redeem these securities as of September 30, 2003, they would be required to pay market value, which is approximately $180 million. (e) Consumers cannot redeem these securities until 2006. If Consumers were to redeem these securities as of September 30, 2003, they would be required to pay market value, which is approximately $128 million. CMS-87 CMS Energy Corporation OTHER: Under a revolving accounts receivable sales program, Consumers currently sells certain accounts receivable to a wholly owned, consolidated, bankruptcy remote special purpose entity, Consumers Receivables Funding II. In turn, Consumers Receivables Funding II may sell an undivided interest in up to $325 million of the receivables to a bank-sponsored commercial paper conduit. The amount sold to the conduit was $254 million at September 30, 2003 and $325 million at September 30, 2002. These amounts are excluded from accounts receivable in Consumers' consolidated balance sheets. Consumers continues to service the receivables sold, however, the purchaser of the receivables has no recourse against Consumers' other assets for failure of a debtor to pay when due and the purchaser has no right to any receivables not sold. No gain or loss has been recorded on the receivables sold and Consumers retains no interest in the receivables sold. Certain cash flows received from and paid to Consumers under its accounts receivable sales program are shown below:
In Millions ---------------------------------------------------------------------------------------------------- Three Months Ended Nine Months Ended September 30 2003 2002 2003 2002 ---------------------------------------------------------------------------------------------------- Proceeds from sales (remittance of collections) under the program $ 204 $ 14 $ (71) $ (9) Collections reinvested under the program 920 918 3,379 3,141 ====================================================================================================
FASB INTERPRETATION NO. 45, GUARANTOR'S ACCOUNTING AND DISCLOSURE REQUIREMENTS FOR GUARANTEES, INCLUDING INDIRECT GUARANTEES OF INDEBTEDNESS OF OTHERS: Effective January 1, 2003, CMS Energy adopted the provisions of this interpretation that requires additional disclosures by a guarantor about its obligations under certain guarantees that it has issued. It also requires that a guarantor recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial recognition and measurement provision of this Interpretation does not apply to certain guarantee contracts, such as warranties, derivatives, or guarantees between either parent and subsidiaries or corporations under common control, although disclosure of such guarantees is required. For contracts that are within the initial recognition and measurement provision of this interpretation, the provisions are to be applied to guarantees issued or modified after December 31, 2002; no cumulative effect adjustments are required. The following table is a summary of CMS Energy's guarantees as required by FASB Interpretation No. 45:
September 30, 2003 In Millions -------------------------------------------------------------------------------------------------------------------------- Issue Expiration Maximum Carrying Recourse Guarantee Description Date Date Obligation Amount(b) Provision(c) -------------------------------------------------------------------------------------------------------------------------- Indemnifications from asset sales and other agreements(a) Various Various $ 1,971 $ 0.7 $ - Letters of credit Various Various 204 - - Surety bonds and other indemnifications Various Various 65 - - Other guarantees Various Various 208 - - Nuclear insurance retrospective premiums Various Various 133 - - ==========================================================================================================================
(a) The majority of this amount arises from routine provisions in stock and asset sales agreements under which the purchaser is indemnified by CMS Energy or a subsidiary for losses resulting from CMS-88 CMS Energy Corporation events such as failure of title to the assets or stock sold by CMS Energy or a subsidiary to the purchaser. CMS Energy believes the likelihood of a loss arising from such events to be remote. (b) The carrying amount represents the fair market value of guarantees and indemnities on CMS Energy's balance sheet that are entered into subsequent to January 1, 2003. (c) Recourse provision indicates the approximate recovery from third parties including assets held as collateral. CMS Energy has entered into typical tax indemnity agreements in connection with a variety of transactions including transactions for the sale of subsidiaries and assets, equipment leasing and financing agreements. These indemnity agreements generally are not limited in amount and, while a maximum amount of exposure cannot be identified, the amount and probability of liability is considered remote. The off-balance sheet commitments at September 30, 2003 are as follows:
Commercial Commitments In Millions ------------------------------------------------------------------------------------------------------------ Commitment Expiration ------------------------------------------------------------------------------------------------------------ September 30 Total 2003 2004 2005 2006 2007 Beyond ------------------------------------------------------------------------------------------------------------ Off-balance sheet: Guarantees $ 208 $ - $ - $ - $ 4 $ - $ 204 Indemnities 65 - - 35 - - 30 Letters of Credit (a) 204 5 195 - - - 4 ------------------------------------------------------------------------------------------------------------ Total $ 477 $ 5 $ 195 $ 35 $ 4 $ - $ 238 ============================================================================================================
(a) At September 30, 2003, CMS Energy had $176 million of cash collateralized letters of credit and the cash used to collateralize the letters of credit is included in Restricted Cash on the consolidated balance sheet. 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 $477 million as of September 30, 2003. 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, 2003, the actual amount of financial exposure covered by these guarantees was $52 million. This amount excludes the guarantees associated with CMS MST's natural gas supply contract obligations totaling $246 million, which are recorded as liabilities on the Consolidated Balance Sheet at September 30, 2003. 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. CAPITALIZATION: The authorized capital stock of CMS Energy consists of 250 million shares of CMS Energy Common Stock and 10 million shares of CMS Energy Preferred Stock, $.01 par value. 6: EARNINGS PER SHARE The following table presents a reconciliation of the numerators and denominators of the basic and diluted earnings per share computations. CMS-89 CMS Energy Corporation
In Millions, Except Per Share Amounts --------------------------------------------------------------------------------------------------------------------- Three Months Ended September 30 2003 2002 --------------------------------------------------------------------------------------------------------------------- NET INCOME (LOSS) ATTRIBUTABLE TO COMMON STOCK: CMS Energy - Basic $ (77) $ 37 Add conversion of Trust Preferred Securities (net of tax) - (a) - (a) ------------------------------------- CMS Energy - Diluted $ (77) $ 37 ===================================== AVERAGE COMMON SHARES OUTSTANDING APPLICABLE TO BASIC AND DILUTED EPS CMS Energy: Average Shares - Basic 152.2 143.9 Add conversion of Trust Preferred Securities - (a) - (a) Stock Options and Warrants - (b) - ------------------------------------- Average Shares - Diluted 152.2 143.9 ===================================== EARNINGS (LOSS) PER AVERAGE COMMON SHARE Basic $ (0.51) $ 0.26 Diluted $ (0.51) $ 0.26 =====================================================================================================================
In Millions, Except Per Share Amounts --------------------------------------------------------------------------------------------------------------------- Nine Months Ended September 30 2003 2002 --------------------------------------------------------------------------------------------------------------------- NET INCOME (LOSS) ATTRIBUTABLE TO COMMON STOCK: CMS Energy - Basic $ (43) $ 5 Add conversion of Trust Preferred Securities (net of tax) - (a) - (a) ------------------------------------- CMS Energy - Diluted $ (43) $ 5 ===================================== AVERAGE COMMON SHARES OUTSTANDING APPLICABLE TO BASIC AND DILUTED EPS CMS Energy: Average Shares - Basic 146.8 137.4 Add conversion of Trust Preferred Securities - (a) - (a) Stock Options and Warrants - (b) - ------------------------------------- Average Shares - Diluted 146.8 137.4 ===================================== EARNINGS (LOSS) PER AVERAGE COMMON SHARE Basic $ (0.29) $ 0.04 Diluted $ (0.29) $ 0.04 =====================================================================================================================
(a) The effects of converting the trust preferred securities were not included in the computation of diluted earnings per share because to do so would have been antidilutive. (b) Shares of outstanding stock options and warrants of 0.3 million for three months ended 2003 and 0.2 million for nine months ended 2003 were not included in the computation of diluted earnings per share because to do so would have been antidilutive. CMS-90 CMS Energy Corporation 7: 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. CMS Energy and its regulated and non-regulated subsidiaries, may utilize a variety of instruments to manage risk and may execute these transactions with external parties either directly, or through CMS Enterprises or its marketing subsidiary, CMS MST. These instruments may include futures contracts, swaps, options and forward contracts to manage exposure to fluctuations in commodity prices, interest rates and foreign exchange rates. These 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. DERIVATIVE INSTRUMENTS: Contracts used to manage commodity price, interest rate, and foreign exchange rate risk may be considered derivative instruments that are subject to derivative and hedge accounting pursuant to SFAS No. 133. If a contract is accounted for as a derivative instrument, it is recorded in the consolidated 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 accumulated 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 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. CMS Energy uses a combination of quoted market prices and mathematical valuation models to determine fair value of those contracts requiring derivative accounting. The ineffective portion, if any, of all hedges is recognized in earnings. The majority of CMS Energy's 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 CMS Energy's exposures to electricity and gas commodity price risk and interest rate and foreign currency exchange risk. ELECTRIC CONTRACTS: 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. As of September 30, 2003, Consumers did not have any unexpired purchased electric call option contracts subject to derivative accounting. All remaining purchased electric CMS-91 CMS Energy Corporation call option contracts subject to derivative accounting as of June 2003, expired in the third quarter of 2003. 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 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. Consumers' electric business also uses gas option and 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 contracts are financial contracts that are used to offset increases in the price of potential 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. As of September 30, 2003, gas fuel for generation call option contracts entered into in the second quarter of 2003 had expired. As of September 30, 2002, gas fuel for generation swap contracts had a fair value of less than $1 million. These contracts expired in December 2002. For the three months ended September 30, 2003, Consumers recorded an unrealized loss in accumulated other comprehensive income related to its proportionate share of the effects of derivative accounting related to its equity investment in the MCV Partnership of $5 million, net of tax. For the nine months ended September 30, 2003, Consumers recorded an unrealized gain in accumulated other comprehensive income related to its proportionate share of the effects of derivative accounting related to its equity investment in the MCV Partnership of $8 million, net of tax. As of September 30, 2003, the cumulative total of unrealized gains recorded in other accumulated comprehensive income related to Consumers' proportionate share of the effects of derivative accounting related to its equity investment in the MCV Partnership is $6 million, net of tax. Consumers expects to reclassify this gain, if this value remains, as an increase to earnings from equity method investees during the next 12 months. GAS CONTRACTS: Consumers' gas business uses fixed price gas supply contracts, and fixed price weather-based gas supply call options and fixed price gas supply call and put options, and other types of contracts, to meet its regulatory obligation to provide gas to its customers at a reasonable and prudent cost. As of September 30, 2003, weather-based gas call options and gas call and put options requiring derivative accounting had a net fair value that was less than $1 million. The original cost of the options was a net $3 million. Consumers recorded an unrealized loss of $3 million associated with these options directly in earnings as part of other income, and then directly offset this loss and recorded it on the balance sheet as a regulatory asset. Any subsequent changes in fair value will be recorded in a similar manner. As of September 30, 2002, Consumers gas supply contracts and weather-based gas call options and gas put options requiring derivative accounting had a fair value of $1 million, representing a fair value gain on the contracts since the date of inception. Changes in fair value were recorded in a similar manner as stated above for weather-based gas call options and gas call and put options. INTEREST RATE RISK CONTRACTS: 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 records any change in the fair value of these contracts in accumulated other CMS-92 CMS Energy Corporation comprehensive income unless the swaps are sold. As of September 30, 2003, Consumers did not have any interest rate swaps outstanding. 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 expired in June 2003. As of September 30, 2002, this interest rate swap had a negative fair value of $2 million. Consumers was able to apply the shortcut method to all interest rate hedges; therefore, there was no ineffectiveness associated with these hedges. ENERGY TRADING ACTIVITIES: Through December 31, 2002, CMS MST's wholesale power and gas trading activities were accounted for under the mark-to-market method of accounting. Effective, January 1, 2003, EITF Issue No. 98-10 was rescinded by EITF Issue No. 02-03 and as a result, only energy contracts that meet the definition of a derivative in SFAS No. 133 can be carried at fair value. The impact of this change for CMS MST was recognized as a cumulative effect of a change in accounting principle loss of $23 million, net of tax. See Note 10, Implementation of New Accounting Standards. 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 contracts, long-term commitments may extend beyond the period in which market quotations for such contracts are available and volumetric obligations may not be defined. Mathematical models are developed to determine various inputs into the fair value calculation including price, anticipated volumetric obligations and other inputs that may be required to adequately address the determination of fair value of the contracts. Realized cash returns on these commitments may vary, either positively or negatively, from the results estimated 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. Market prices are adjusted to reflect the 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. 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. Where contractual 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, 2003 and 2002, CMS Energy has recorded a net price risk management asset of $14 million and $129 million respectively, net of reserves, related to the unrealized mark-to-market gains on existing wholesale power contracts, gas contracts, and hedges for retail activities that are marked as derivatives. FLOATING TO FIXED INTEREST RATE SWAPS: CMS Energy and its subsidiaries have entered into floating to CMS-93 CMS Energy Corporation 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, 2003, these swaps had a negative fair value of $1 million that, if sustained, will be reclassified to earnings as the swaps are settled on a quarterly basis. 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. The weighted average interest rate associated with outstanding swaps was approximately 7.4 percent at September 30, 2003 and 5.2 percent at September 30, 2002.
In Millions --------------------------------------------------------------------------------------------------------------------- Floating to Fixed Notional Maturity Interest Rate Swaps Amount Date Fair Value --------------------------------------------------------------------------------------------------------------------- September 30, 2003 $ 14 2005-2006 $ (1) September 30, 2002 $ 294 2003-2006 $ (9) =====================================================================================================================
FIXED TO FLOATING INTEREST RATE SWAPS: CMS Energy monitors its debt portfolio mix of fixed and variable rate instruments and may enter into fixed to floating rate swaps to maintain an appropriate 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, 2003 and 2002. FOREIGN EXCHANGE DERIVATIVES: CMS Energy may use 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 associated with adverse changes in currency exchange rates that could affect materially cash flow. These contracts would 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. There were no outstanding foreign exchange contracts at September 30, 2003. The notional amount of the outstanding foreign exchange contracts at September 30, 2002 was $1 million Canadian contracts. The estimated fair value of the foreign exchange and option contracts at September 30, 2002 was zero. 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, 2003 and 2002 are not necessarily indicative of the amounts that may be realized in current market exchanges. The carrying amounts of all long-term financial instruments, except for those as shown below, approximate fair value. CMS-94 CMS Energy Corporation
In Millions ---------------------------------------------------------------------------------------------------------------------- As of September 30 2003 2002 ---------------------------------------------------------------------------------------------------------------------- Carrying Fair Unrealized Carrying Fair Unrealized Cost Value Gain(Loss) Cost Value Gain ---------------------------------------------------------------------------------------------------------------------- Long-Term Debt (a) $ 6,291 $ 6,439 $ (148) $ 5,648 $ 5,206 $ 442 Trust Preferred Securities 663 603 60 883 676 207 Preferred Stock 44 33 11 44 23 21 Available-for-Sale Securities: Nuclear Decommissioning (b) $ 450 $ 553 $ 103 $ 464 $ 530 $ 66 SERP 55 62 7 54 56 2 Southern Union Stock 54 54 - - - - ======================================================================================================================
(a) Settlement of long-term debt is generally not expected until maturity. (b) On January 1, 2003, CMS Energy adopted SFAS No. 143 and began classifying its unrealized gains and losses on nuclear decommissioning investments as regulatory liabilities. CMS Energy previously classified these investments in accumulated depreciation. 8: EQUITY METHOD INVESTMENTS Certain of CMS Energy's investments in companies, partnerships and joint ventures, where ownership is more than 20 percent but less than a majority, are accounted for by the equity method of accounting in accordance with APB Opinion No. 18. Net income from these investments included distributions in excess of earnings of $33 million for the three months ended September 30, 2003 and undistributed earnings of $14 million for the three months ended September 30, 2002. Net income from these investments included undistributed earnings of $38 million for the nine months ended September 30, 2003 and $71 million for the nine months ended September 30, 2002. The most significant of these investments is CMS Energy's 50 percent interest in Jorf Lasfar and its 49 percent interest in the MCV Partnership. Summarized income statement information of CMS Energy's most significant equity method investments follows. Income Statement Data
In Millions ----------------------------------------------------------------------------------------- Three Months Ended September 30, 2003 Jorf Lasfar MCV Total ----------------------------------------------------------------------------------------- Operating revenue $ 89 $ 148 $ 237 Operating expenses 52 138 190 ---------------------------------- Operating income 37 10 47 Other expense, net 17 25 42 ---------------------------------- Net income (loss) $ 20 $ (15) $ 5 =========================================================================================
In Millions ----------------------------------------------------------------------------------------- Three Months Ended September 30, 2002 Jorf Lasfar MCV Total ----------------------------------------------------------------------------------------- Operating revenue $ 87 $ 156 $ 243 Operating expenses 47 120 167 ---------------------------------- Operating income 40 36 76 Other expense, net 14 27 41 ---------------------------------- Net income $ 26 $ 9 $ 35 =========================================================================================
CMS-95 CMS Energy Corporation Income Statement Data
In Millions ----------------------------------------------------------------------------------------- Nine Months Ended September 30, 2003 Jorf Lasfar MCV Total ----------------------------------------------------------------------------------------- Operating revenue $ 270 $ 443 $ 713 Operating expenses 138 322 460 --------------------------------- Operating income 132 121 253 Other expense, net 41 82 123 --------------------------------- Net income $ 91 $ 39 $ 130 =========================================================================================
In Millions ----------------------------------------------------------------------------------------- Nine Months Ended September 30, 2002 Jorf Lasfar MCV Total ----------------------------------------------------------------------------------------- Operating revenue $ 274 $ 451 $ 725 Operating expenses 136 318 454 --------------------------------- Operating income 138 133 271 Other expense, net 36 86 122 Cumulative effect of change in method of accounting for derivative options contracts (a) - 58 58 --------------------------------- Net income $ 102 $ 105 $ 207 =========================================================================================
(a) On April 1, 2002, the MCV Partnership implemented Derivative Implementation Group Issue C-16, an interpretation of SFAS No. 133. The MCV Partnership began accounting for several natural gas contracts containing an option component at fair value. As a result, a cumulative effect adjustment for the change in accounting principle was recorded as an increase to earnings. 9: REPORTABLE SEGMENTS 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 upon the net income of each segment. Previously, CMS Energy operated in five reportable segments: electric utility, gas utility, natural gas transmission, independent power production and marketing, services and trading. As a result of recent changes in its business strategy, including the sale of non-strategic and under-performing assets, and management reorganization, CMS Energy now operates principally in the following three reportable segments: electric utility, gas utility, and enterprises. 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. The enterprises segment consists of investing in, acquiring, developing, constructing, managing and operating non-utility power generation plants and natural gas facilities in the United States and abroad; and providing gas, oil, and electric marketing services to energy users. The tables below show revenues, net income, and total assets by reportable segment. The "Other" net income segment includes corporate interest and other, discontinued operations and the cumulative effect of accounting changes. The 2002 information has been restated to reflect the management reorganization and the change in CMS Energy's business strategy from five to three operating segments. CMS-96 CMS Energy Corporation
Reportable Segments In Millions ---------------------------------------------------------- Three Months Ended September 30 2003 2002 ---------------------------------------------------------- Revenues Electric utility $ 714 $ 774 Gas utility 164 134 Enterprises 138 1,626 Other - - -------------------- $ 1,016 $ 2,534 ==========================================================
Reportable Segments In Millions ---------------------------------------------------------- Nine Months Ended September 30 2003 2002 ---------------------------------------------------------- Revenues Electric utility $ 1,966 $ 2,013 Gas utility 1,252 1,002 Enterprises 841 3,826 Other - 2 -------------------- $ 4,059 $ 6,843 ==========================================================
Reportable Segments In Millions ---------------------------------------------------------- Three Months Ended September 30 2003 2002 ---------------------------------------------------------- Net Income (Loss) Electric utility $ 59 $ 88 Gas utility (19) (18) Enterprises 13 58 Other (130) (91) -------------------- $ (77) $ 37 ==========================================================
Reportable Segments In Millions ---------------------------------------------------------- Nine Months Ended September 30 2003 2002 ---------------------------------------------------------- Net Income (Loss) Electric utility $ 145 $ 222 Gas utility 40 13 Enterprises 48 126 Other (276) (356) -------------------- $ (43) $ 5 ==========================================================
Reportable Segments In Millions ---------------------------------------------------------- September 30 2003 2002 ---------------------------------------------------------- Total Assets Electric utility $ 6,210 $ 5,483 Gas utility 2,331 2,024 Enterprises 3,610 6,728 Other 160 162 -------------------- $ 12,311 $ 14,397 ==========================================================
CMS-97 CMS Energy Corporation 10: IMPLEMENTATION OF 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. CMS Energy has determined that it has legal asset retirement obligations, particularly in regard to Consumers' nuclear plants. Prior to adoption of SFAS No. 143, Consumers classified the removal cost liability of assets included in the scope of SFAS No. 143 as part of the reserve for accumulated depreciation. For these assets, the removal cost of $448 million which was classified as part of the reserve at December 31, 2002, was reclassified in January 2003, in part, as: 1) a $364 million ARO liability; 2) a $134 million regulatory liability; 3) a $42 million regulatory asset; and 4) a $7 million net increase to property, plant, and equipment as prescribed by SFAS No. 143. As required by SFAS No. 71 for regulated entities, Consumers is reflecting a regulatory asset and liability instead of a cumulative effect of a change in accounting principle. The fair value of ARO liabilities has been calculated using an expected present value technique. This technique reflects assumptions, such as costs, inflation, and profit margin that third parties would consider in order to take on the settlement of the obligation. Fair value, to the extent possible, should include a market risk premium for unforeseeable circumstances. No market risk premium was included in Consumers' ARO fair value estimate since a reasonable estimate could not be made. If a five percent market risk premium were assumed, Consumers' ARO liability would be $381 million. If a reasonable estimate of fair value cannot be made in the period the asset retirement obligation is incurred, such as assets with an indeterminate life, the liability is to be recognized when a reasonable estimate of fair value can be made. Generally, transmission and distribution assets have an indeterminate life, retirement cash flows cannot be determined and there is a low probability of a retirement date, therefore no liability has been recorded for these assets. No liability has been recorded for assets that have an insignificant cumulative disposal cost, such as substation batteries. The initial measurement of the ARO liability for Consumers' Palisades Nuclear Plant and Big Rock Nuclear Plant is based on decommissioning studies, which are based largely on third party cost estimates. In addition, in 2003, CMS Energy recorded an ARO liability for certain pipelines and non-utility generating plants and a $1 million, net of tax, cumulative effect of change in accounting for accretion and depreciation expense for ARO liabilities incurred prior to 2003. The pro forma effect on results of operations would not have been material for the nine months ended September 30, 2002. The following table is a general description of the AROs and their associated long-lived assets.
September 30, 2003 In Millions ------------------------------------------------------------------------------------------------------------ In Service Trust ARO Description Date Long Lived Assets Fund ------------------------------------------------------------------------------------------------------------ Palisades-decommission plant site 1972 Palisades nuclear plant $ 462 Big Rock-decommission plant site 1962 Big Rock nuclear plant 90 JHCampbell intake/discharge water line 1980 Plant intake/discharge water line - Closure of coal ash disposal areas Various Generating plants coal areas - Closure of wells at gas storage fields Various Gas storage fields - Indoor gas services equipment relocations Various Gas meters located inside structures - Closure of gas pipelines Various Gas transmission pipelines - Dismantle natural gas-fired power plant 1997 Gas fueled power plant - ============================================================================================================
CMS-98 CMS Energy Corporation The following table is a reconciliation of the carrying amount of the AROs:
September 30, 2003 In Millions ------------------------------------------------------------------------------------------------------------------- Pro Forma ARO Liability ARO Liability Cashflow ARO 1/1/02 1/1/03 Incurred Settled Accretion Revisions 9/30/03 ------------------------------------------------------------------------------------------------------------------- Palisades-decommission $ 232 $ 249 $ - $ - $ 14 $ - $ 263 Big Rock-decommission 94 61 - (28) 10 - 43 JHCampbell intake line - - - - - - - Coal ash disposal areas 46 51 - (2) 4 - 53 Wells at gas storage fields 2 2 - - - - 2 Indoor gas services relocations 1 1 - - - - 1 Closure of gas pipelines (a) 7 8 - (8) - - - Dismantle natural gas-fired power plant 1 1 - - - - 1 ------------------------------------------------------------------------------------------------------------------ Total $ 383 $ 373 $ - $ (38) $ 28 $ - $ 363 ==================================================================================================================
a) ARO Liability was settled during 2003 as a result of the sales of Panhandle and CMS Field Services. SFAS NO. 149, AMENDMENT OF STATEMENT 133 ON DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES: Issued by the FASB in April 2003, this statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities. This statement is effective for contracts entered into or modified after June 30, 2003. Implementation of this statement has not had an impact on CMS Energy's Consolidated Financial Statements. SFAS NO. 150, ACCOUNTING FOR CERTAIN FINANCIAL INSTRUMENTS WITH CHARACTERISTICS OF BOTH LIABILITIES AND EQUITY: Issued by the FASB in May 2003, this statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. The statement requires an issuer to classify financial instruments within its scope as liabilities. Those instruments were previously classified as mezzanine equity. SFAS No. 150 became effective July 1, 2003. CMS Energy has one, and Consumers has four, trust preferred securities outstanding as of September 30, 2003. The trust preferred securities are issued by consolidated subsidiaries of CMS Energy and Consumers. Each trust holds a subordinated debenture from the parent company. The terms of the debentures are identical to those of the trust preferred securities, except that the debenture has an explicit maturity date. The trust documents, in turn, require that the trust be liquidated upon the repayment of the debenture. The preferred securities are redeemable upon the liquidation of the subsidiary; and therefore, are considered equity in the financial statements of the subsidiary. At their October 29, 2003 Board meeting, the FASB deferred the implementation of the portion of SFAS No. 150 relating to mandatorily redeemable noncontrolling interests in subsidiaries when the noncontrolling interests are classified as equity in the financial statements of the subsidiary. CMS Energy and Consumers trust preferred securities are included in the deferral. As such, the CMS Energy and Consumers trust preferred securities continue to be accounted for under existing accounting guidance and are included in mezzanine equity. CMS Energy and Consumers continue to study the FASB developments regarding the SFAS No. 150 deferral. CMS-99 CMS Energy Corporation EITF ISSUE NO. 02-03, RECOGNITION AND REPORTING OF GAINS AND LOSSES ON ENERGY TRADING CONTRACTS UNDER EITF ISSUES NO. 98-10 AND 00-17: 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 was required to be applied to all contracts that existed as of October 25, 2002 and was required to 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 was required to be applied immediately to all new contracts entered into after October 25, 2002. The full adoption of EITF Issue No. 02-03 effective January 1, 2003, resulted in CMS Energy recognizing a cumulative effect of change in accounting principle loss of $23 million, net of tax, for the nine months ended September 30, 2003. EITF ISSUE NO. 01-08, DETERMINING WHETHER AN ARRANGEMENT CONTAINS A LEASE: In May 2003, the EITF reached consensus in EITF Issue No. 01-08 to clarify the requirements of identifying whether an arrangement should be accounted for as a lease at its inception. The guidance in the consensus is designed to mandate reporting revenue as rental or leasing income that otherwise would be reported as part of product sales or service revenue. EITF Issue No. 01-08 requires both parties to an arrangement to determine whether a service contract or similar arrangement is or includes a lease within the scope of SFAS No. 13, Accounting for Leases. Historically, CMS Energy has entered into power purchase and similar service arrangements. Prospective accounting under EITF Issue No. 01-08, could affect the timing and classification of revenue and expense recognition. Certain product sales and service revenue and expenses may be required to be reported as rental or leasing income and/or expenses. The consensus is to be applied prospectively to arrangements agreed to, modified, or acquired in business combinations in fiscal periods beginning July 1, 2003. The adoption of EITF Issue No. 01-08 has not impacted CMS Energy's results of operations, cash flows, or financial position. CMS Energy will evaluate new or modified contracts under EITF Issue No. 01-08 prospectively. ACCOUNTING STANDARDS NOT YET EFFECTIVE FASB INTERPRETATION NO. 46, CONSOLIDATION OF VARIABLE INTEREST ENTITIES: Issued by the FASB in January 2003, this interpretation requires the primary beneficiary of a variable interest entity's activities to consolidate the variable interest entity. The primary beneficiary is the party that absorbs a majority of the expected losses and/or receives a majority of the expected residual returns of the variable interest entity's activities. The consolidation requirements of the interpretation apply immediately to variable interest entities created after January 31, 2003. CMS Energy has not created any variable interest entities in 2003. Therefore, this portion of the interpretation has no impact on its consolidated financial statements. Public companies, whose fiscal year is a calendar year, were originally required to implement the guidance in this interpretation by the third quarter of 2003. However, on October 9, 2003, the FASB issued FASB Staff Position No. 46-6, Effective Date of FASB Interpretation No. 46, and deferred implementation of Interpretation No. 46 until the fourth quarter of 2003 for variable interest entities and potential variable interest entities created before February 1, 2003. CMS Energy is evaluating all of its interests in entities, including approximately 30 minority-held investments that are not currently consolidated, to determine their treatment under FIN 46. The majority of CMS-100 CMS Energy Corporation these investments are electric generation and gas transmission projects. CMS Energy's investment in these entities totaled approximately $1,425 million as of September 30, 2003. Jorf Lasfar and the MCV Partnership are the two largest entities impacting CMS Energy's operations. For further information, see Note 8, Equity Method Investments. If the completed analysis were to require CMS Energy to disclose information about or consolidate in its financial statements, the assets, liabilities and activities of the MCV Partnership and the First Midland Limited Partnership, including the recognition of the debt of the MCV Partnership on Consumers' financial statements, this could impact negatively CMS Energy's and Consumers' various financial covenants under their financing agreements. As a result, CMS Energy and Consumers may have to seek amendments to the relevant financing agreements to modify the terms of certain of these covenants in order to remove the effect of this potential consolidation or refinance the relevant debt. As of September 30, 2003, Consumers' investments in the MCV Partnership and in the FMLP were $404 million and $222 million, respectively. For further description of the nature, purpose, size and activities of the MCV Partnership see Note 4, Uncertainties, Other Consumers' Electric Utility Uncertainties, "The Midland Cogeneration Venture" and Note 8, Equity Method Investments. CMS Energy is continuing to study the implementation of this interpretation and has yet to determine the effects, if any, on its consolidated financial statements. EITF ISSUE 03-04, ACCOUNTING FOR CASH BALANCE PENSION PLANS: In May 2003, the EITF reached consensus in EITF Issue No. 03-04 to specifically address the accounting for certain cash balance pension plans. EITF Issue No. 03-04 concluded that certain cash balance plans be accounted for as defined benefit plans under SFAS No. 87, Employers' Accounting for Pensions. EITF No. 03-04 requires the use of the traditional unit credit method for the purposes of measuring the benefit obligation and annual cost of benefits earned as opposed to the projected unit credit method. The EITF concluded that the requirements of this Issue be applied as of the next plan measurement date, which is December 31, 2003 for CMS Energy. CMS Energy commenced a cash balance pension plan that covers employees hired after June 30, 2003. CMS Energy does account for this plan as a defined benefit plan under SFAS No. 87. CMS Energy continues to evaluate the impact, if any, this Issue will have upon adoption. STATEMENT OF POSITION, ACCOUNTING FOR CERTAIN COSTS AND ACTIVITIES RELATED TO PROPERTY, PLANT, AND EQUIPMENT: At its September 9, 2003 meeting, the Accounting Standards Executive Committee voted to approve the Statement of Position, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment. The Statement of Position is expected to be presented for FASB clearance late in the fourth quarter of 2003 and would be applicable for fiscal years beginning after December 15, 2004. The Accounting Standards Executive Committee concluded that at transition, a company would have the flexibility to adopt a property, plant and equipment component accounting policy for transition-date property, plant and equipment accounts. The property, plant and equipment component accounting policy may differ from the componentization policy, if any, previously used by the enterprise. Selecting a policy that differs from the company's prior level of componentization at the date of adoption of the Statement of Position would not result in any cumulative effect difference for adopting such a policy. A company would not have to restate its pre-adoption assets to conform with its post-adoption componentization policy. The Accounting Standards Executive Committee concluded that companies would be required to disclose meaningful ranges with respect to property, plant and equipment depreciable lives. CMS Energy continues to evaluate the impact, if any, this Statement of Position will have upon adoption. CMS-101 CMS Energy Corporation (This page intentionally left blank) CMS-102 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 This MD&A refers to Consumers' 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' intention with the use of the words "anticipates," "believes," "estimates," "expects," "intends," and "plans," and variations of such words and similar expressions, is 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 2002 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. 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' Condensed Notes to Consolidated Financial Statements, and Consumers encourages its readers to review these Notes. All note references within this MD&A refer to Consumers' Notes to Consolidated Financial Statements. CRITICAL ACCOUNTING POLICIES Consumers' consolidated financial statements 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. Consumers believes that certain accounting principles are critical in terms of understanding its consolidated financial statements. These principles include the use of estimates in accounting for contingencies and long-lived assets, accounting for derivatives and financial instruments, regulatory accounting, and pension and postretirement benefits. 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, future commodity prices, mark-to-market valuations, investment returns, impact of new accounting standards, future costs associated with long-term contractual CE-1 Consumers Energy Company obligations, future compliance costs associated with environmental regulations and continuing creditworthiness of counterparties. Actual results could differ materially from those estimates. The recording of estimated liabilities for contingencies 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 payment will be made in the future as a result of a current event, and when that amount can be reasonably estimated. Consumers has used this accounting principle to record 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. The EPA has issued regulations regarding nitrogen oxide emissions from certain generators, including some of Consumers' electric generating facilities. These regulations require Consumers to make significant capital expenditures estimated to be $770 million. As of September 30, 2003, Consumers has incurred $437 million in capital expenditures to comply with these regulations and anticipates that the remaining capital expenditures will be incurred between 2003 and 2009. Additionally, Consumers expects to 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 average $6 million per year; however, the market for nitrogen oxide emissions credits and their cost can change substantially. As new environmental standards become effective, Consumers will need additional capital expenditures to comply with the standards. Capital expenditures will depend upon the composition of the final regulations. The EPA has proposed changes to the rules that govern generating plant cooling water intake systems. The proposed rules will require significant abatement of fish mortality. The proposed rules are scheduled to become final in the first quarter of 2004 and some of Consumers' facilities would be required to comply by 2006. Consumers is studying the proposed rules to determine the most cost-effective solutions for compliance. Until the method of compliance is determined, Consumers is unable to estimate the cost of compliance with the proposed rules. The EPA has alleged that some utilities have incorrectly classified plant modifications as "routine maintenance" rather than seek permits from the EPA. Consumers has received and responded to information requests from the EPA on this subject. Consumers believes that it has properly interpreted the requirements of "routine maintenance". If Consumers' interpretation is eventually found to be incorrect, it may be required to install additional pollution controls at some or all of its coal-fired plants and could call into question the viability of certain plants remaining in operation. For further information on electric environmental matters 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 using the Gas Research Institute-Manufactured Gas Plant Probabilistic Cost Model. A revised cost estimate, completed in September 2003, estimated remaining costs to be between $37 million and $90 million. The range reflects multiple alternatives with various assumptions for resolving the environmental issues at each site. The estimates are based on discounted 2003 costs using a discount rate of three percent. The discount rate represents a ten-year average of U.S. Treasury bond rates reduced for increases in the consumer price index. Any significant change in assumptions, such as remediation techniques, nature and extent of contamination, and legal and regulatory CE-2 Consumers Energy Company 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 49 percent partnership interest in the MCV Partnership, and a 35 percent lessor interest in the MCV Facility. Consumers' annual obligation to purchase capacity from the MCV Partnership is 1,240 MW through the term of the PPA ending 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 and a fixed energy charge, and also to pay 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 and fixed energy charges in rates. After September 2007, the PPA's regulatory out 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 and established a PPA liability for the present value of the estimated future underrecoveries of power supply costs under the PPA based on MPSC cost recovery orders. Primarily as a result of the MCV Facility's actual availability being greater than management's original estimates, the PPA liability has been reduced at a faster rate than originally anticipated. The remaining estimated future PPA liability associated with the loss totaled $34 million at September 30, 2003 and $59 million at September 30, 2002. The PPA liability is expected to be depleted in late 2004. In March 1999, Consumers and the MCV Partnership reached a settlement agreement effective January 1, 1999, that addressed, among other things, the ability of the MCV Partnership to count modifications increasing the capacity of the existing MCV Facility for purposes of computing the availability of contract capacity under the PPA for billing purposes. That settlement agreement capped payments made on the basis of availability that may be billed by the MCV Partnership at a maximum 98.5 percent availability level. Under Michigan's electric restructuring law, Consumers will return to unfrozen rates for large industrial customers beginning January 1, 2004, including the resumption of the PSCR process. Under the PSCR process, Consumers will recover from customers capacity and fixed energy charges on the basis of availability, to the extent that availability does not exceed 88.7 percent availability established in previous MPSC orders. Recovery of capacity and fixed energy charges will be subject to certain rate caps as discussed in Note 2, Uncertainties, "Electric Rate Matters - Electric Restructuring." For capacity and energy payments billed by the MCV Partnership after September 15, 2007, and not recovered from customers, Consumers would expect to claim a regulatory out under the PPA. The regulatory out provision relieves Consumers of the obligation to pay more for capacity and energy payments than the MPSC allows Consumers to collect from its customers. Consumers estimates that 51 percent of the actual cash underrecoveries for the years 2003 and 2004 will be charged to the PPA liability, with the remaining portion charged to operating expense as a result of Consumers' 49 percent ownership in the MCV Partnership. All cash underrecoveries will be expensed directly to income once the PPA liability is depleted. If the MCV Facility's generating availability remains at the maximum 98.5 percent level, Consumers' cash underrecoveries associated with the PPA could be as follows:
In Millions ----------------------------------------------------------------------------------------------- 2003 2004 2005 2006 2007 ----------------------------------------------------------------------------------------------- Estimated cash underrecoveries at 98.5% (a) $57 $56 $56 $55 $39 Amount to be charged to operating expense $28 $27 $56 $55 $39 Amount to be charged to PPA liability $29 $29 $ - $ - $ - ===============================================================================================
CE-3 Consumers Energy Company (a) For the nine months ended September 30, 2003, Consumers' cash underrecoveries associated with the PPA were $43 million. As previously noted, until September 2007, the PPA and settlement require Consumers to pay capacity costs based on the MCV Facility's actual availability up to the 98.5 percent cap. After September 2007, Consumers expects to exercise the "regulatory out" clause in the PPA, limiting its capacity payments to the MCV Partnership to the amount collected from its customers. Depending on the MPSC's future actions with respect to the capacity payments recoverable from its customers subsequent to September 2007, the earnings of the MCV Partnership and the value of Consumers' equity interest in the MCV Partnership, may be affected negatively. Further, under the PPA, energy payments to the MCV Partnership are based on the cost of coal burned in Consumers' coal plants and costs associated with fuel inventory, operations and maintenance, and administrative and general expenses associated with Consumers' coal plants. However, the MCV Partnership's costs of producing electricity are tied, in large part, to the cost of natural gas. Because natural gas prices have increased substantially in recent years, while energy charge payments to the MCV Partnership have not, the MCV Partnership's financial performance has been impacted negatively. As of January 1, 2004, Consumers intends to return to forced (uneconomic) dispatch of the MCV Facility in order to maximize recovery of its capacity payments. As such, if the spread between MCV Facility's variable electricity production costs and its energy payment revenues stays constant or widens, the negative impacts on MCV Partnership's financial performance, and on the value of Consumers' equity interest in the MCV Partnership, will be worse. Consumers cannot estimate, at this time, the impact of these issues on its future earnings or cash flow from its interest in the MCV Partnership. The forward price of natural gas for the next 22 years and the MPSC decision in 2007 or later related to Consumers' recovery of capacity payments are the two most significant variables in the analysis of MCV Partnership's future financial performance. Natural gas prices have historically been volatile and presently there is no consensus in the marketplace on the price or range of prices of natural gas beyond the next five years. Further, it is not presently possible for Consumers to predict the actions of the MPSC in 2007 or later. For these reasons, at this time Consumers cannot predict the impact of these issues on its future earnings, cash flows, or on the value of its $404 million equity interest in the MCV Partnership. Consumers is exploring possible alternatives for utilizing the MCV Facility without increasing costs to customers. Any changes regarding the recovery of MCV capacity costs would require MPSC approval. Consumers cannot predict the outcome of this matter. For further information see Note 2, Uncertainties, "Other Electric Uncertainties - The Midland Cogeneration Venture." ACCOUNTING FOR DERIVATIVE AND FINANCIAL INSTRUMENTS AND MARKET RISK INFORMATION DERIVATIVE INSTRUMENTS: Consumers 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 Consumers typically classifies as derivative instruments are interest rate swaps, certain CE-4 Consumers Energy Company electric call options, gas fuel options, fixed priced weather-based gas supply call options and fixed price gas supply call and put options. Consumers does not account for electric capacity and energy contracts, gas supply contracts, coal and nuclear fuel supply contracts, or purchase orders for numerous supply items as derivatives. Certain of Consumers' 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 accumulated 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 determine the fair value of contracts that are accounted for as derivative instruments, Consumers uses a combination of quoted market prices and mathematical valuation models. Valuation 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 certain contracts. At September 30, 2003, Consumers assumed a market-based interest rate of one percent (six-month U.S. Treasury) and an average volatility rate of 55 percent to calculate the fair value of its gas 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 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. 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 resulting from changes in fair value reported in equity as part of accumulated other comprehensive income and are excluded from earnings unless such changes in fair value are other than temporary. In 2002, Consumers determined that the decline in value related to its investment in CMS Energy Common Stock was other than temporary as the fair value was below the cost basis for a period greater than six months. As a result, Consumers recognized a loss on its investment in CMS Energy Common Stock through earnings of $12 million in the fourth quarter of 2002, and an additional $12 million in the first quarter of 2003. As of September 30, 2003, Consumers held 2.4 million shares of CMS Energy Common Stock with a fair value of $17 million. Consumers believes that any further adverse change in the market price of this investment would not have a material effect on its consolidated financial position, results of operation or cash flows. Unrealized gains or losses resulting from changes in the fair value of Consumers' nuclear decommissioning investments are reported as regulatory liabilities. The fair value of these investments is determined from quoted market prices. CE-5 Consumers Energy Company 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 certain business unit managers. Established policies and procedures are used to manage the risks associated with market fluctuations. Consumers may use 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. When management uses these instruments, it intends that an opposite movement in the value of the at-risk item would offset any losses incurred on the contracts. 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. Consumers enters into all risk management contracts 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 they deem necessary. Changes 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 and variable-rate financing, and from interest rate swap agreements. Consumers uses a combination of these instruments to manage and mitigate interest rate risk exposure when deemed appropriate, based upon market conditions. These strategies are designed to provide and maintain a balance between risk and the lowest cost of capital. As of September 30, 2003, Consumers had no outstanding interest rate swap agreements. As of September 30, 2003, Consumers had outstanding variable-rate financing of $628 million, a $640 million decrease (50 percent) from the December 31, 2002 balance of $1.268 billion. The decline in variable-rate financing is primarily due to a shift toward fixed-rate financing. As of September 30, 2003, assuming a hypothetical 10 percent adverse change in market interest rates, Consumers' before tax annual earnings exposure on its variable-rate financing would be $1 million. As of September 30, 2003, Consumers had outstanding fixed-rate financing of $3.694 billion, a $934 million increase (34 percent) over the December 31, 2002 balance of $2.760 billion. As of September 30, 2003, the fair value of Consumers' fixed-rate financing was $3.804 billion, a $1.127 billion increase (42 percent) over the December 31, 2002 fair value of $2.677 billion. The change in the fair value of the fixed-rate financing is due to both an increase in outstanding fixed-rate debt obligations as well as a decline in market interest rates. As of September 30, 2003, assuming a hypothetical 10 percent adverse change in market interest rates, the fair value of Consumers' fixed-rate financing would increase by $155 million. As discussed below in Electric Business Outlook - Securitization, Consumers has filed an application with the MPSC to securitize certain costs. Upon final approval, Consumers intends to use the proceeds from the securitization to retire higher cost debt, which could include a portion of its current fixed-rate debt. Consumers does not believe that any adverse change in debt price and interest rates would have a material CE-6 Consumers Energy Company adverse effect on either its consolidated financial position, results of operation or cash flows. Commodity Market Risk: For purposes other than trading, Consumers entered into electric call options, fixed priced weather-based gas supply call options and fixed priced gas supply call and 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 weather-based gas supply call options, and the gas supply call and put options are used to purchase reasonably priced gas supply. Call options allow Consumers the right but not the obligation to purchase gas supply at predetermined fixed prices. Put options allow third-party suppliers the right but not the obligation to sell Consumers gas supply at predetermined fixed prices. As of September 30, 2003 and December 31, 2002, the fair value of electricity-related call option contracts, based on quoted market prices and mathematical valuation models using current and historical pricing data, was $3 million and $9 million, respectively. As of September 30, 2003 assuming a hypothetical 10 percent adverse change in market prices, the potential reduction in fair value associated with these contracts would be $1 million. As of September 30, 2003 and December 31, 2002, Consumers had an asset of $21 million and $30 million, respectively, 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, 2003, the fair value of the fixed priced weather-based gas supply call options and fixed priced gas supply call and put options, based on quoted market prices and mathematical valuation models, was less than $1 million. As of September 30, 2003, assuming a hypothetical 10 percent adverse change in market prices, the potential reduction in fair value associated with these contracts would be $1 million. For further information on market risk and derivative activities, see Note 4, Financial and Derivative Instruments. 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 normally would 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 be refunded to customers. Judgment is required to discern the recoverability of items recorded as regulatory assets and liabilities. As of September 30, 2003, Consumers had $1.113 billion recorded as regulatory assets and $461 million recorded as regulatory liabilities. In 1999, Consumers received MPSC electric restructuring orders, which, among other things, identified the terms and timing for implementing electric restructuring in Michigan. Consistent with these orders and EITF No. 97-4, Consumers discontinued the application of SFAS No. 71 for the energy supply portion of its business because Consumers expected to implement retail open access at competitive market-based rates for its electric customers. However, since 1999, there has been a significant legislative and regulatory change in Michigan that has resulted in: 1) electric supply customers of utilities remaining on cost-based rates and 2) utilities being given the ability to recover Stranded Costs associated with electric restructuring, from customers who choose an alternative electric supplier. During 2002, Consumers re-evaluated the criteria used to determine if an entity or a segment of an entity meets the requirements to apply regulated utility accounting, and determined that the energy supply portion of its business could meet the criteria if certain CE-7 Consumers Energy Company regulatory events occurred. In December 2002, Consumers received a MPSC Stranded Cost order that allowed Consumers to re-apply regulatory accounting standard SFAS No. 71 to the energy supply portion of its business. Re-application of SFAS No. 71 had no effect on the prior discontinuation accounting, but allowed Consumers to apply regulatory accounting treatment to the energy supply portion of its business beginning in the fourth quarter of 2002, including regulatory accounting treatment of costs required to be recognized in accordance with SFAS No. 143. See Note 5, Implementation of New Accounting Standards, "SFAS No. 143, Accounting for Asset Retirement Obligations." For further information on industry regulation, see Note 1, Corporate Structure and Summary of Significant Accounting Policies, "Utility Regulation". 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 requires the expertise of actuaries and is 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. The Pension Plan includes amounts for employees of CMS Energy and non-utility affiliates, including Panhandle, which are not distinguishable from the Pension Plan's total assets. In June 2003, CMS Energy completed the sale of Panhandle to Southern Union Panhandle Corp. No portion of the Pension Plan was transferred with the sale. Panhandle employees are no longer eligible to accrue additional benefits. The Pension Plan retained pension payment obligations for Panhandle employees that were vested under the Pension Plan. Because of the significant change in the makeup of the plan, SFAS No. 87 required a remeasurement of the obligation at the date of sale. The estimated remeasurement resulted in an increase in pension expense of approximately $3 million and OPEB expense of approximately $5 million for 2003, as well as an additional charge to accumulated other comprehensive income of approximately $27 million ($17 million after tax) as a result of the increase in the additional minimum pension liability. The actuary is in the process of finalizing the effects of the mid-year remeasurement. Although actual results may differ from the estimates recorded, Consumers does not expect those differences to be material. Consumers estimates OPEB expense will approximate $54 million in 2003, $62 million in 2004, and $60 million in 2005. Consumers estimates pension expense will approximate $38 million in 2003, $46 million in 2004, and $47 million in 2005. Future actual pension expense will depend on future investment performance, changes in future discount rates and various other factors related to the populations participating in the Pension Plan. In August 2003, Consumers made its planned contribution of $172 million to the Pension Plan. Consumers has announced amendments to the Pension Plan for salaried employees, whereby, the method used to convert an employee's benefit to a lump sum payment is being changed. Employees who elect the lump sum payment option will not earn an additional early retirement subsidy. As a result, employees who choose the lump sum payment option, and retire before age 65, will receive lower lump sum payments. In addition, Consumers has implemented a cash balance plan for employees hired on or after July 1, 2003. Under a cash balance plan, an employees' retirement account is credited annually with a percentage of their base pay. Accounts will be valued at the end of each year, using an annual variable interest rate to determine growth. Employees who leave the company and are vested in the cash balance version of the pension plan can either start receiving their benefit immediately, postpone receiving benefits until a future date while receiving an CE-8 Consumers Energy Company earnings credit on their account (payment cannot be deferred beyond age 70-1/2), or roll 100 percent of the cash balance account into an IRA or another qualified plan. If a participant is not vested (less than five years of service under the terms of the plan), the cash balance account is forfeited. In 2003, a large majority of retiring employees elected the lump sum payment option instead of receiving pension benefits as an annuity over time. As a result, Consumers may be required to record a settlement loss in accordance with SFAS No. 88, which requires a settlement loss to be recognized when the cost of all settlements paid during the year exceeds the sum of the service and interest costs for the same year. Consumers cannot yet determine if the amount of lump sum payments for 2003 will exceed the threshold, but estimates that if the threshold is exceeded, between $55 million and $65 million could be recognized as a loss in the fourth quarter of 2003. 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. The MPSC orders received in March and December of 1999 for Big Rock and Palisades plants, respectively, provided for fully funding the decommissioning trust funds for both sites. The December 1999 order set the annual decommissioning surcharge for the Palisades decommissioning at $6 million. Consumers estimates that at the time of the decommissioning of Palisades, its decommissioning trust fund will be fully funded. This conclusion assumes that the trust funds are invested in equities and fixed income investments, equities will be converted to fixed income investments during decommissioning and fixed income investments are converted to cash as needed. Decommissioning costs have been developed, in part, by independent contractors with expertise in decommissioning. These cost estimates use various inflation rates for labor, non-labor, and contaminated equipment disposal costs. In December 2000, funding of the Big Rock trust fund was stopped since it was considered fully funded, subject to further review. A portion of future decommissioning cost will result from the failure of the DOE to remove fuel from the site. These costs, and similar costs incurred at Palisades, would not be necessary if the DOE took possession of the spent fuel as required by the Nuclear Waste Policy Act of 1982. A number of utilities, including Consumers, which filed its complaint in December 2002, have commenced litigation in the Court of Claims. The Chief Judge of the Court of Claims identified six lead cases to be used as vehicles for resolving dispositive motions. Consumers' case is not a lead case. It is unclear what impact this decision by the Chief Judge will have on the outcome of Consumers' litigation. If the litigation that was commenced in the fourth quarter of 2002 against the DOE is successful, Consumers anticipates future recoveries from the DOE to defray the significant costs it will incur for the storage of spent fuel until the DOE takes possession as required by law. However, there is no assurance that the litigation against the DOE will be successful. The funds provided by the trusts and additional potential funds from DOE litigation are expected to fully fund the decommissioning costs. Variance from trust earnings, a lesser recovery of costs from the DOE, changes in decommissioning technology, regulations, estimates or assumptions could affect the cost of decommissioning these sites and the adequacy of the decommissioning trust funds. For further information see Note 2, Uncertainties, "Other Electric Uncertainties - Nuclear Matters." In March 2003, the Michigan Environmental Council, the Public Interest Research Group in Michigan, and the Michigan Consumer Federation submitted a complaint to the MPSC, which was served on Consumers by the MPSC in April 2003. The complaint asks the MPSC to commence a generic investigation and contested case to review all facts and issues concerning costs associated with spent nuclear fuel storage and disposal. The complaint seeks a variety of relief with respect to Consumers, Detroit Edison, Indiana & Michigan Electric Company, Wisconsin Electric Power Company and Wisconsin Public Service Corporation, including CE-9 Consumers Energy Company establishing external trusts to which amounts collected in electric rates for spent nuclear fuel storage and disposal should be transferred, and the adoption of additional measures related to the storage and disposal of spent nuclear fuel. In May 2003, Consumers and the other named utilities each filed a motion to dismiss the complaint. Consumers is unable to predict the outcome of this matter. 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 for generation from CMS MST, the sale of electricity to CMS MST, the purchase of gas transportation from CMS Bay Area Pipeline, L.L.C., the payment of parent company overhead costs to CMS Energy, the sale of storage and transportation of natural gas and other services to the MCV Partnership, and an investment in CMS Energy Common Stock. Transactions involving CMS Energy and its affiliates and the sale of storage and transportation of natural gas and other services to the MCV Partnership are generally based on regulated prices, market prices or competitive bidding. Transactions involving the power supply purchases from the MCV Partnership, and certain affiliates of 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 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. Consumers continues to use the transmission facilities now owned by MTH, and a director of Consumers is currently a stockholder of Trans-Elect, Inc. For detailed information about related party transactions see Note 2, Uncertainties, "Electric Rate Matters - Transmission", and "Other Electric Uncertainties - The Midland Cogeneration Venture". CE-10 Consumers Energy Company RESULTS OF OPERATIONS CONSUMERS' NET INCOME AVAILABLE TO COMMON STOCKHOLDER
In Millions ------------------------------------------------------------------------------ September 30 2003 2002 Change ------------------------------------------------------------------------------ Three months ended $ 33 $ 74 $ (41) Nine months ended $172 $267 $ (95) ==============================================================================
2003 COMPARED TO 2002: For the three months ended September 30, 2003, Consumers' net income available to common stockholder totaled $33 million, a decrease of $41 million from the previous year. A decrease in electric delivery revenues reduced earnings by $22 million after-tax. This decrease was primarily due to reduced deliveries to the higher margin residential sector resulting from milder summer weather compared to the same period in 2002, which included record setting monthly sendout and monthly hourly peak demand volumes. Commercial and industrial customers switching to alternative electric suppliers as allowed by the Customer Choice Act further reduced electric delivery revenues. Lower gas deliveries reduced after-tax earnings by $9 million. Earnings were also reduced $10 million after-tax due to a decrease in the fair value of certain long-term gas contracts held by the MCV Partnership. The earnings decrease also reflects increased costs of borrowing that reduced earnings by $4 million after-tax, and increased general tax expense of $3 million after-tax. Offsetting the earnings decrease is an after-tax benefit of $3 million due to the final gas rate order issued in 2002 authorizing Consumers to increase its gas tariff rates. For the nine months ended September 30, 2003, Consumers' net income available to common stockholder totaled $172 million, a decrease of $95 million from the previous year. This decrease in earnings reflects the absence of the nonrecurring benefits from 2002, including the $31 million after-tax gain on asset sales, and the $18 million of after-tax earnings related to an adjustment to the fair value of certain long-term gas contracts held by the MCV Partnership. Reduced earnings also reflect a $12 million charge to non-utility expense in order to recognize a decline in market value of CMS Energy Common Stock held by Consumers. Decreased electric deliveries reduced after tax earnings by $25 million. This decrease can be attributed to the continuing switch by commercial and industrial customers to alternative electric suppliers allowed by the Customer Choice Act. A reduction in residential consumption also contributed to the decrease in electric deliveries. This decrease was due to milder summer temperatures in 2003 compared to the same period in 2002, which included record setting monthly send out and monthly hourly peak demand volumes. Increased electric and gas operating expenses reduced after-tax earnings by $32 million. Increased costs of borrowings reduced after-tax earnings by $16 million, and a $7 million after-tax charge at CMS Midland Holdings reflecting the loss of certain tax credits also contributed to the earnings decrease. Offsetting these decreases is an after-tax benefit of $9 million due to increased gas deliveries reflecting colder winter weather in early 2003, a $23 million after-tax benefit due to the final gas rate order issued in 2002 authorizing Consumers to increase its gas tariff rates, and the $13 million after-tax benefit relating to the reduction in MSBT expenses relating to years 2000 and 2001. The reduction in MSBT expense is a result of CMS Energy receiving approval to file consolidated tax returns for years 2000 and 2001. These returns were filed in the second quarter of 2003. Finally, earnings for the three and nine month period ended September 30, 2003, were reduced by $1 million CE-11 Consumers Energy Company after-tax as a result of the Northeast United States blackout that commenced August 14, 2003. For further information, see the Electric and Gas Utility Results of Operations sections and Note 2, Uncertainties. ELECTRIC UTILITY RESULTS OF OPERATIONS
In Millions ------------------------------------------------------------------------------ September 30 2003 2002 Change ------------------------------------------------------------------------------ Three months ended $ 59 $ 88 $ (29) Nine months ended $145 $222 $ (77) ==============================================================================
Three Months Ended Nine Months Ended Reasons for change September 30, 2003 vs. 2002 September 30, 2003 vs. 2002 -------------------------------------------------------------------------------------------------------------- Electric deliveries $ (34) $ (38) Power supply costs and related revenue 2 14 Other operating expenses and non-commodity revenue (5) (43) Asset sales - (38) General taxes (3) 12 Fixed charges (5) (18) Income taxes 16 34 ------------------------------------------------ Total change $ (29) $ (77) ==============================================================================================================
ELECTRIC DELIVERIES: For the three months ended September 30, 2003, electric delivery revenues decreased by $34 million from the previous year. Electric deliveries, including transactions with other wholesale market participants and other electric utilities, were 10.3 billion kWh, a decrease of 0.6 billion kWh or 4.9 percent from 2002. The decrease in revenue is primarily the result of decreased deliveries to the higher margin residential sector due to milder summer temperatures in 2003 compared to the same period in 2002, which included record setting monthly sendout and monthly hourly peak demand volumes. Commercial and industrial customers switching to alternative electric suppliers as allowed by the Customer Choice Act further reduced electric delivery revenues. For the nine months ended September 30, 2003, electric delivery revenues decreased by $38 million from the previous year. Electric deliveries, including transactions with other wholesale market participants and other electric utilities, were 29.3 billion kWh, a decrease of 0.2 billion kWh or 0.6 percent from 2002. The decrease in delivery revenues can be attributed to the continuing switch by commercial and industrial customers to alternative electric suppliers allowed by the Customer Choice Act. Also contributing to decreased electric deliveries was a reduction in residential consumption due to milder summer temperatures in 2003 compared to the same period in 2002, which included record setting monthly send out and monthly hourly peak demand volumes. POWER SUPPLY COSTS AND RELATED REVENUE: For the three months ended September 30, 2003, power supply costs and related revenues increased electric net income by $2 million from 2002. For the nine months ended September 30, 2003, power supply costs and related revenues increased electric net income by $14 million from 2002. This increase is primarily the result of increased intersystem revenues due to higher market prices and sales made from additional surplus capacity. CE-12 Consumers Energy Company OTHER OPERATING EXPENSES AND NON-COMMODITY REVENUE: For the three months ended September 30, 2003, net operating expenses and non-commodity revenue decreased operating income by $5 million compared to 2002. This decrease relates primarily to increased amortization expense from securitized assets and reduced miscellaneous electric service revenues. For the nine months ended September 30, 2003, operating expenses increased compared to 2002. This increase can be attributed to storm restoration expenses, a scheduled refueling outage at Palisades, which began on March 16, 2003 and ended on April 20, 2003, and higher transmission costs due to the loss of a financial return on the Consumers' transmission system asset sold in May 2002. Slightly offsetting these increased operating expenses were increased non-commodity revenues associated with miscellaneous service revenues. ASSET SALES: For the nine months ended September 30, 2003, pretax income from asset sales decreased $38 million from the comparable period in 2002. This is the result of the $31 million pretax gain associated with the May 2002 sale of Consumers' electric transmission system and the $7 million pretax gain associated with the June 2002 sale of nuclear equipment from the cancelled Midland project. GENERAL TAXES: For the three months ended September 30, 2003, general taxes increased $3 million compared to 2002 primarily due to larger property tax expense from increased investment. For the nine months ended September 30, 2003, general taxes decreased $12 million from the comparable period in 2002. This decrease is due to reduced MSBT expenses related to the years 2000 and 2001. This is the result of CMS Energy receiving approval to file consolidated tax returns for the years 2000 and 2001. These returns were filed during the second quarter of 2003. FIXED CHARGES: For the three and nine months ended September 30, 2003, fixed charges increased $5 million and $18 million, respectively, from the comparable period in 2002. These increases can be attributed to increased financing activities. INCOME TAXES: For the three and nine months ended September 30, 2003, income tax expense decreased $16 million and $34 million, primarily due to a decrease in earnings by the electric utility compared to 2002. GAS UTILITY RESULTS OF OPERATIONS
In Millions ---------------------------------------------------------------------- September 30 2003 2002 Change ---------------------------------------------------------------------- Three months ended $(19) $(18) $(1) Nine months ended $ 40 $ 13 $27 ======================================================================
Three Months Ended Nine Months Ended Reasons for change September 30, 2003 vs. 2002 September 30, 2003 vs. 2002 -------------------------------------------------------------------------------------------------------------- Gas deliveries $ (14) $ 14 Gas rate increase 5 35 Gas wholesales and retail services 1 4 Operation and maintenance 8 (6) General taxes, depreciation, and other income (1) (2) Fixed charges (1) (4) Income taxes 1 (14) -------------------------------------------------- Total change $ (1) $ 27 ==============================================================================================================
CE-13 Consumers Energy Company GAS DELIVERIES: For the three months ended September 30, 2003, gas delivery revenues decreased by $14 million from the previous year. The decrease primarily reflects $7 million of increased expense associated with Consumers' annual analysis of gas losses related to the gas transmission and distribution system. The adjustment is recorded as a reduction to accrued gas revenues. System deliveries, including miscellaneous transportation, totaled 38.2 bcf, a decrease of 1.9 bcf or 4.8 percent compared with 2002. For the nine months ended September 30, 2003, gas delivery revenues increased by $14 million from the previous year. System deliveries, including miscellaneous transportation, totaled 272.7 bcf, an increase of 18 bcf or 7.1 percent compared with 2002. This increase is primarily due to colder weather during the first quarter that resulted in increased deliveries to the residential and commercial sectors in 2003. GAS RATE INCREASE: In November 2002, the MPSC issued a final gas rate order authorizing a $56 million annual increase in Consumers' gas tariff rates. As a result of this order, for the three and nine months ended September 30, 2003, Consumers recognized increased gas revenues of $5 million and $35 million, respectively. OPERATION AND MAINTENANCE: For the three months ended September 30, 2003, operation and maintenance expenses decreased $8 million when compared to 2002. This decrease reflects the absence of gas storage inventory losses recorded in 2002. For the nine months ended September 30, 2003, operation and maintenance expenses increased $6 million when compared to 2002. This increase reflects the recognition of additional expenditures on safety, reliability and customer service. INCOME TAXES: For the three months ended September 30, 2003, income tax expense decreased primarily due to decreased earnings of the gas utility compared to 2002. For the nine months ended September 30, 2003, income tax expense increased primarily due to improved earnings of the gas utility. CAPITAL RESOURCES AND LIQUIDITY CASH POSITION, INVESTING, AND FINANCING The following discussion of operating, investing and financing activities summarizes Consumers' consolidated statements of cash flows found in Consumers' consolidated financial statements. OPERATING ACTIVITIES: Consumers' principal source of liquidity is cash from the sale and transportation of natural gas and the generation, delivery and sale of electricity. For the nine months ended September 30, cash from operations totaled $130 million in 2003 and $420 million in 2002. The $290 million decrease in cash from operations resulted primarily from an increase in a depleted natural gas inventory due to colder weather and higher gas prices, an increase in the pension contribution for 2003, and an increase in accounts receivable and accrued revenues. 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, Financings and Capitalization for additional details about this source of funds. INVESTING ACTIVITIES: For the nine months ended September 30, cash used for investing activities totaled $326 million in 2003 and $144 million in 2002. The change of $182 million is primarily due to the absence of CE-14 Consumers Energy Company $283 million of proceeds from the sale of METC and other asset sales, partially offset by a $94 million decrease in capital expenditures. FINANCING ACTIVITIES: For the nine months ended September 30, cash provided by financing activities totaled $103 million in 2003 and cash used for financing activities totaled $182 million in 2002. The change of $285 million is primarily due to an increase of $941 million in proceeds from senior notes and bank loans, offset partially by $371 million of payments for retirement of bonds and other long-term debt and a $271 million additional payment of notes payable. Refer below to discussion of Consumers' refinancing. 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, Financings and Capitalization.
Contractual Obligations In Millions ------------------------------------------------------------------------------------------------ Payments Due --------------------------------------------------- 2008 and September 30 Total 2003 2004 2005 2006 2007 beyond ------------------------------------------------------------------------------------------------ On-balance sheet: Long-term debt $ 3,531 $ - $ 8 $ 329 $ 361 $ 31 $ 2,802 Current portion of long- term debt 28 8 20 - - - - Notes payable 4 1 3 - - - - Capital lease obligations 127 4 15 14 13 12 69 ------------------------------------------------------------------------------------------------ Total on-balance sheet $ 3,690 $ 13 $ 46 $ 343 $ 374 $ 43 $ 2,871 ------------------------------------------------------------------------------------------------ Off-balance sheet: Operating leases $ 76 $ 6 $ 11 $ 9 $ 9 $ 8 $ 33 Non-recourse debt of FMLP 194 - 57 41 26 13 57 Sale of accounts receivable 254 254 - - - - - Unconditional purchase obligations 17,897 601 1,577 1,197 905 743 12,874 ------------------------------------------------------------------------------------------------ Total off-balance sheet $18,421 $861 $1,645 $1,247 $ 940 $ 764 $ 12,964 ================================================================================================
CE-15 Consumers Energy Company LONG-TERM FINANCINGS: The following is a summary of Consumers' Long-Term debt issuances during 2003:
Principal Facility Type (millions) Issue Rate Issue Date Maturity Date Use of Proceeds Collateral ------------------------------------------------------------------------------------------------------------ Term Loan $ 140 LIBOR + 475 March 2003 March 2009 GCP FMB (f) bps Term Loan 150 LIBOR + 450 March 2003 March 2006 (c) GCP FMB (f) bps FMB (a) 375 5.375% April 2003 April 2013 (c) - FMB (a) 250 4.250% April 2003 April 2008 (c) - FMB (a) 250 4.000% May 2003 May 2010 (d) - FMB (b) 200 4.800% August 2003 February 2009 (e) - FMB (b) 200 6.000% August 2003 February 2014 (e) - ------ Total $1,565 ============================================================================================================
(GCP - General Corporate Purposes) (bps - basis points) (FMB - First Mortgage Bonds) (a) Consumers has agreed to file a registration statement with the SEC by December 26, 2003 to permit holders of these first mortgage bonds to exchange the bonds for new bonds that will be registered under the Securities Act of 1933. (b) Consumers has agreed to file a registration statement with the SEC by April 14, 2004 to permit holders of these first mortgage bonds to exchange the bonds for new bonds that will be registered under the Securities Act of 1933. (c) Consumers used the net proceeds to replace a $250 million senior reset put bond that matured in May 2003, to pay an associated $32 million option call payment and for general corporate purposes that included paying down additional debt. (d) Consumers used the net proceeds to prepay a portion of a term loan that was due to mature in July 2004. (e) Consumers used the net proceeds to pay off the $150 million term loan negotiated in March 2003 that was due to mature in March 2006 as well as the remaining $50 million balance on a term loan that was due to mature in March 2004, and for general corporate purposes. (f) Refer to "Regulatory Authorization for Financings" below for information about Consumers' remaining FERC debt authorization. As part of Consumers' ongoing cost reduction measures in an attempt to reduce its financing costs, Consumers will continue to monitor financial markets REGULATORY AUTHORIZATION FOR FINANCINGS: At September 30, 2003, Consumers had FERC authorization, through June 2004, to issue or guarantee up to $1.1 billion of short-term securities outstanding at any one time. As of September 30, 2003, Consumers had $400 million outstanding as collateral for the revolving credit facility (discussed below) and had an additional $700 million available for future issuances of short-term securities. At September 30, 2003, Consumers also had remaining FERC authorization, through June 2004, to issue up to $800 million of long-term securities for refinancing or refunding purposes, $560.3 million of long-term securities for general corporate purposes, and $2.06 billion of long-term first mortgage bonds to be issued solely as collateral for other long-term securities. Also, FERC has granted waivers of its CE-16 Consumers Energy Company competitive bid/negotiated placement requirements applicable to the long-term securities authorization indicated above. SHORT-TERM FINANCINGS: In March 2003, Consumers obtained a replacement revolving credit facility in the amount of $250 million secured by first mortgage bonds. In September 2003, this facility was amended and restated as a $400 million revolving credit facility. The interest rate of the facility was reduced from LIBOR plus 350 to LIBOR plus 175 basis points. The new credit facility matures in March 2004 with two annual extensions at Consumers' option, which would extend the maturity to March 2006. At September 30, 2003, all of the $400 million is available for general corporate purposes. The revolving credit facility mentioned above has contractual restrictions that require Consumers to maintain, as of the last day of each fiscal quarter, the following:
Limitation Ratio at September 30, 2003 -------------------------------------------------------------------------------------------------- Debt to Capital Ratio (a)(b) Not more than 0.65 to 1.00 0.58 to 1.00 Interest Coverage Ratio - Revolver (a) Not less than 2.00 to 1.00 3.34 to 1.00 ==================================================================================================
(a) Violation of this ratio would constitute an event of default under the facility that provides the lender, among other remedies, the right to declare the principal and interest immediately due and payable. (b) The terms of the credit facility provide for the exclusion of securitization bonds in the calculation of the debt to capital ratio. Consumers is subject to covenants in its financing agreements that could limit its ability to incur additional indebtedness. Consumers has agreed in several of its financing agreements to maintain specified levels of cash coverage of its interest requirements and to not allow its indebtedness to exceed specified levels of its consolidated capitalization (the "Debt Percentage Tests"). Consumers is in compliance with these requirements as of the most recent measurement date, September 30, 2003. These covenants make use of both generally accepted accounting principles and defined contractual terms in specifying how the relevant calculations are made. Consumers sought and received amendments to certain of its financing agreements to modify the terms of the Debt Percentage Tests in order to, among other things, remove the effect of the adoption of SFAS No. 150, portions of which have now been deferred indefinitely, regarding Trust Preferred Securities on the calculations. Under the provisions of its articles of incorporation, Consumers had $412 million of unrestricted retained earnings available to pay common dividends at September 30, 2003. However, covenants in Consumers' debt facilities cap common stock dividend payments at $300 million in a calendar year. Through September 30, 2003, Consumers paid $162 million in common dividends. In October 2003, Consumers declared a $57 million common dividend payable in November 2003. For information on the potential cap on common dividends payable included in the MPSC Securitization order see Electric Business Outlook, "Competition and Regulatory Restructuring - Securitization." Also, for information on the potential cap on common dividends payable included in the MPSC Staff's recommendation in Consumers' 2003 gas rate case see Gas Business Outlook, "2003 Gas Rate Case." LEASES: Consumers' capital leases are predominately for leased service vehicles and the new headquarters building. On November 7, 2003, Consumers closed a three-year $60 million term loan at an interest rate of LIBOR plus 135 basis points. The term loan is secured by first mortgage bonds. The proceeds of the loan were used to purchase Consumers' headquarters building lease from the lessor, resulting in cost savings to Consumers. Operating leases are predominately for railroad coal cars. OFF-BALANCE SHEET ARRANGEMENTS: Consumers' use of long-term contracts for the purchase of commodities and services, the sale of its accounts receivable, and operating leases are considered to be off-balance sheet CE-17 Consumers Energy Company arrangements. Consumers has responsibility for the collectability of the accounts receivable 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. SALE OF ACCOUNTS RECEIVABLE: Under a revolving accounts receivable sales program, Consumers currently sells certain accounts receivable to a wholly owned, consolidated, bankruptcy remote special purpose entity, Consumers Receivables Funding II. In turn, Consumers Receivables Funding II may sell an undivided interest in up to $325 million of the receivables to a bank-sponsored commercial paper conduit. The amount sold to the conduit was $254 million at September 30, 2003 and $325 million at September 30, 2002. These amounts are excluded from accounts receivable in Consumers' consolidated balance sheets. Consumers continues to service the receivables sold; however, the purchaser of the receivables has no recourse against Consumers' other assets for failure of a debtor to pay when due and the purchaser has no right to any receivables not sold. No gain or loss has been recorded on the receivables sold and Consumers retains no interest in the receivables sold. UNCONDITIONAL PURCHASE OBLIGATIONS: 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. Included in unconditional purchase obligations are 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 $47 million per month for the remaining three months of 2003, including $34 million related to the MCV Facility. For the period that a plant is not available to deliver electricity to Consumers, Consumers is not obligated to make the capacity payments to the plant. 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. COMMERCIAL COMMITMENTS: Indemnities are agreements by Consumers to reimburse other companies, such as an insurance company, if those companies have to complete Consumers' performance involving a third party contract. Letters of credit are issued by a bank on behalf of Consumers, guaranteeing payment to a third party. Letters of credit substitute the bank's credit for Consumers' and reduce credit risk for the third party beneficiary. The amount and time period for drawing on a letter of credit is limited.
Commercial Commitments In Millions -------------------------------------------------------------------------------- Commitment Expiration ------------------------------------------------ 2008 and September 30 Total 2003 2004 2005 2006 2007 beyond -------------------------------------------------------------------------------- Off-balance sheet: Indemnities $8 $- $- $- $- $- $8 Letters of credit 7 - 7 - - - - ================================================================================
CE-18 Consumers Energy Company OUTLOOK LIQUIDITY AND CAPITAL RESOURCES Consumers' liquidity and capital requirements generally are a function of its results of operations, capital expenditures, contractual obligations, debt maturities, working capital needs and collateral requirements. During the summer months, Consumers purchases natural gas and stores it for resale primarily during the winter heating season. Recently, the market price for natural gas has increased. Although Consumers' natural gas purchases are recoverable from its customers, the amount paid for natural gas stored as inventory could require additional liquidity due to the timing of the cost recoveries. In addition, certain commodity suppliers to Consumers have requested advance payments or other forms of assurances, including margin calls, in connection with maintenance of ongoing deliveries of gas and electricity. This will also affect Consumers' liquidity position. Historically, Consumers has met its consolidated cash needs through its operating and financing activities and access to bank financing and the capital markets. In 2003, Consumers has contractual obligations and planned capital expenditures that would require substantial amounts of cash. Consumers may also become subject to liquidity demands pursuant to commercial commitments under guarantees, indemnities and letters of credit as indicated above. Consumers plans to meet its liquidity and capital requirements in 2003 through a combination of borrowings, reduced capital expenditures, cash flow generated from operations, and other measures. Refer to Capital Resources and Liquidity, "Long Term Debt" above for information about Consumers' 2003 debt financings. Consumers believes that its present level of cash and borrowing capacity (assuming access to capital markets), along with anticipated cash flows from operating and investing activities, will be sufficient to meet its liquidity needs through 2004. 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 experienced higher electric deliveries in 2002 as a result of warmer than normal summer weather. For 2003, a slight decline in electric deliveries from 2002 is anticipated. This short-term outlook for 2003 assumes higher levels of manufacturing activity than in 2002 and normal weather conditions in the last three months of the year. CE-19 Consumers Energy Company 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 Consumers' 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 October 2003, alternative electric suppliers are providing 603 MW of generation supply to retail open access customers. 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. Consumers cannot predict the total amount of electric supply load that may be lost to competitor suppliers, nor whether the stranded cost recovery method adopted by the MPSC will be applied in a manner that will fully offset any associated margin loss. Stranded 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. The MPSC authorized Consumers to use deferred accounting to recognize the future recovery of costs determined to be stranded. According to the MPSC, "net" Stranded Costs are to be recovered from retail open access customers through a Stranded Cost transition charge. In April 2002, Consumers made "net" Stranded Cost filings with the MPSC for $22 million for 2000 and $43 million for 2001. Consumers in its hearing brief, filed in August 2002, revised its request for Stranded Costs to $7 million for 2000 and $4 million for 2001. The single largest reason for the difference in the filing was the exclusion, as ordered by the MPSC, of all costs associated with expenditures required by the Clean Air Act. As discussed below in "Securitization", Consumers filed a request with the MPSC for authority to issue Securitization bonds that would allow recovery of the Clean Air Act expenditures that were excluded from the Stranded Cost calculation. In December 2002, the MPSC issued an order finding that Consumers experienced zero "net" Stranded Costs in 2000 and 2001, but declined to resolve numerous issues regarding the "net" Stranded Cost methodology in a way that would allow a reliable prediction of the level of Stranded Costs for 2002 and future years. In January 2003, Consumers filed a petition for rehearing of the December 2002 Stranded Cost order in which it asked the MPSC to grant a rehearing and revise certain features of the order. Several other parties have also filed rehearing petitions with the MPSC. Consumers has also initiated an appeal at the Michigan Court of Appeals related to the MPSC's December 2001 "net" Stranded Cost order. In March 2003, Consumers filed an application with the MPSC seeking approval of "net" Stranded Costs incurred in 2002, and for approval of a "net" Stranded Cost recovery charge. In the application, Consumers indicated that if Consumers' proposal to securitize Clean Air Act expenditures and Palisades expenditures previously not securitized were approved as proposed in its securitization case as discussed below in "Securitization", then Consumers' "net" Stranded Costs incurred in 2002 would be approximately $35 million. If the proposal to securitize those costs is not approved, then Consumers indicated that the costs would be properly included in the 2002 "net" Stranded Cost calculation, which would increase Consumers' 2002 "net" Stranded Costs to approximately $103 million. CE-20 Consumers Energy Company In June 2003, the MPSC issued a financing order in the securitization case, authorizing the issuance of Securitization bonds in the amount of approximately $554 million. Included in this amount were Clean Air Act expenditures. However, the MPSC rejected Palisades expenditures previously not securitized as eligible securitized costs. As a result, the Palisades expenditures previously not securitized should be included as a component of "net" Stranded Costs and will be included as a component of a future electric rate case proceeding with the MPSC. With the inclusion of the Palisades expenditures previously not securitized, Consumers' "net" Stranded Costs incurred in 2002 are estimated to be approximately $50 million. In July 2003, Consumers filed a petition for rehearing and clarification on a number of features in the MPSC's financing order on securitization. Once a final financing order by the MPSC on securitization is issued, the amount of Consumers' request for "net" Stranded Cost recovery for 2002 will be known. Consumers cannot predict how the MPSC will rule on its request for the recoverability of Stranded Costs, and therefore Consumers has not recorded any regulatory assets to recognize the future recovery of such costs. The MPSC staff has scheduled a collaborative process to discuss Stranded Costs and related issues and to identify and make recommendations to the MPSC. Consumers has participated in this collaborative process. In July 2003, the staff suspended formal discussion while it considers possible conclusions and recommendations. Implementation Costs: 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 - 2003 2002 2 2 Pending Pending ==============================================================================================================
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 order received for the year 2001, the MPSC also reserved the right to review again the 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 above, as of September 30, 2003, Consumers incurred and deferred as a regulatory asset, $2 million of additional implementation costs and has also recorded a regulatory asset of $16 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 is expected to begin after the rate freeze or rate cap period has expired. As discussed below, Consumers has asked to include implementation costs through December 31, 2000 in the pending securitization case. If approved, the sale of Securitization bonds will allow for the recovery of these costs. Consumers cannot predict the amounts the MPSC will approve as allowable costs. Also, Consumers is pursuing authorization at the FERC for MISO to reimburse Consumers for approximately $8 million in certain electric utility restructuring implementation costs related to its former participation in the development of the Alliance RTO, a portion of which has been expensed. In May 2003, the FERC issued an order denying MISO's request for authorization to reimburse Consumers. In June 2003, Consumers and MISO filed a joint petition for rehearing with the FERC. In September 2003, the FERC denied Consumers' CE-21 Consumers Energy Company and MISO's joint request. Consumers plans to appeal the FERC ruling at the United States Court of Appeals for the District of Columbia and pursue other potential means of recovery. In November 2003, in conjunction with Consumers' appeal of the September Order denying recovery, Consumers persuaded MISO to file a request with the FERC seeking authority to reimburse METC, the legal successor in interest to the Alliance RTO start-up costs. As part of the contract for sale of Consumers' former transmission system, should the Commission approve the new MISO filing, METC is contractually obligated to flow-through to Consumers the full amount of any Alliance RTO start-up costs that it is authorized to recover through FERC. Consumers cannot predict the outcome of the appeal process, the MISO request, or the amount of implementation costs, if any; the FERC ultimately will allow to be collected. Securitization: In March 2003, Consumers filed an application with the MPSC seeking approval to issue Securitization bonds in the amount of approximately $1.084 billion. The application sought recovery of costs associated with Clean Air Act expenditures, Palisades expenditures previously not securitized, retail open access implementation costs through December 31, 2003, certain pension fund costs, and expenses associated with the issuance of the bonds. In June 2003, the MPSC issued a financing order authorizing the issuance of Securitization bonds in the amount of approximately $554 million. This amount relates to Clean Air Act expenditures and associated return on those expenditures through December 31, 2002, retail open access implementation costs and previously authorized return on those expenditures through December 31, 2000, and the "up front" other qualified costs related to issuance of the Securitization bonds. The MPSC rejected Palisades expenditures previously not securitized as eligible securitized costs. Therefore, Palisades expenditures previously not securitized should be included as a component of "net" Stranded Costs and will be included as a component of a future electric rate case proceeding with the MPSC. In the June 2003 financing order, the MPSC also adopted a rate design that would allow retail open access customers to pay a securitization charge (and related tax charge) that are a small fraction of the amounts paid by full service bundled sales customers and special contract customers of the utility. The financing order provides that the securitization charges (and related tax charges) for the full service and bundled sales customers are increased under the rate design in the financing order in order to be sufficient to repay the principal, interest and all other "ongoing" qualified costs related to servicing the Securitization bonds. The financing order also restricts the amount of common dividends payable by Consumers to its "earnings." In July 2003, Consumers filed for rehearing and clarification on a number of features in the financing order, including the rate design, accounting treatment of unsecuritized qualified costs and dividend restriction. Also in July 2003, the Attorney General filed a claim of appeal related to the financing order and the Attorney General indicated it would challenge the lawfulness of the rate design. In October 2003, the Court of Appeals dismissed the appeal and indicated that the Attorney General could resubmit the appeal after the MPSC acted on Consumers' rehearing request. Subsequently, the Attorney General filed a motion of rehearing asking for reconsideration of the Court of Appeals' dismissal. The financing order will become effective after rehearing, resolution of appeals and upon acceptance by Consumers. Rate Caps: The Customer Choice Act imposes certain limitations on electric rates that could result in Consumers being unable to collect from electric 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. After December 31, 2003, the statute would allow customers to petition the MPSC for rate reductions below the cap. Consumers would have the opportunity to respond to such a petition before rates could be reduced. As a result of Consumers meeting the transmission capability expansion requirements and the market power test, as discussed in Note 2, Uncertainties, "Electric Rate Matters - Electric Restructuring", Consumers has met the requirements under Public Act 141 to return to the PSCR process. On September 30, 2003, Consumers submitted a PSCR filing to the MPSC that would reinstate the PSCR process for customers whose rates will no longer be frozen or capped as of January 1, 2004. The proposed PSCR charge allows Consumers CE-22 Consumers Energy Company to recover a portion of its increased power supply costs from large commercial and industrial customers effective January 1, 2004. This is the first customer class for which the rate freeze and cap expire. Consumers will, pursuant to its right under applicable law, self-implement the proposed PSCR charge on January 1, 2004, unless the MPSC issues an order before that date establishing a different charge. The charge is subject to subsequent change by the MPSC during the PSCR period (calendar-year 2004). The revenues received pursuant to the PSCR charge by statute are also subject to subsequent reconciliation when the year is finished and actual costs have been reviewed for reasonableness and prudence. Consumers cannot predict the outcome of this filing. Included in Consumers' retail electric customers' frozen rates is a nuclear decommissioning surcharge related to the decommissioning of Big Rock. The MPSC authorized collection of the surcharge through December 2000. Consumers has continued to collect the Big Rock nuclear decommissioning surcharge consistent with the provisions of the Customer Choice Act rate freeze in effect through December 31, 2003. Beginning in January 2004, the Big Rock decommissioning surcharge will be eliminated, reducing Consumers' annual electric revenues by approximately $35 million in 2004. A portion of this reduction is expected to be offset by the collection of increased PSCR revenues. Industrial Contracts: In response to industry restructuring efforts, in 1995 and 1996, 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, totaling a maximum of approximately 685 MW of load, as part of its phased introduction to competition. Unless terminated or restructured, the majority of these contracts are in effect through 2005. As of September 30, 2003, contracts for 200 MW of load have terminated. Of the contracts that have terminated, contracts for 64 MW have gone to an alternative electric supplier, and contracts for 136 MW have returned to bundled tariff rates. Consumers cannot predict the ultimate financial impact of changes related to these power supply contracts, or whether additional special 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 transfer pricing between Consumers' departments and affiliates. In October 2001, the new code of conduct was reaffirmed by the MPSC 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 electric and gas revenues. In October 2002, the MPSC denied waivers for three programs that provided approximately $32 million in gas revenues in 2001, of which $30 million relates to the appliance service plan. 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. In November 2002, the Michigan Court of Appeals denied Consumers' request for a stay. Consumers filed an application for leave to appeal with the Michigan Supreme Court with respect to the Michigan Court of Appeals' November ruling denying the stay. In February 2003, the Michigan Supreme Court denied the application. In December 2002, Consumers filed a renewed request with the MPSC for a temporary waiver until April 2004 for the appliance service plan, which generated $33 million in gas revenues in 2002. In February 2003, the MPSC granted an extension of the temporary waiver until December 31, 2003. 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 CE-23 Consumers Energy Company Michigan Court of Appeals struck down the guidelines 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. In July 2003, legislation was introduced in the Michigan legislature that, if enacted, would clarify the application of the code of conduct in a manner that would allow Consumers to continue to offer the appliance service plan. In October 2003, the Michigan Senate passed legislation to preserve the appliance service plan. The House of Representatives of Michigan is scheduled to review the legislation in early 2004; however, in the interim they passed a bill to extend the MPSC's waiver for the program to July 1, 2004. Energy Policy: Uncertainty exists regarding the enactment of a national comprehensive energy policy, specifically federal electric industry restructuring legislation. A variety of bills that have been introduced in the United States Congress in recent years were designed to change existing federal regulation of the industry. If the federal government enacts a comprehensive energy policy, then that legislation could potentially affect company operations and financial requirements. Transmission: In May 2002, Consumers sold its electric transmission system for approximately $290 million to MTH, a non-affiliated limited partnership whose general partner is a subsidiary of Trans-Elect, Inc. The pretax gain was $31 million ($26 million, net of tax). Remaining open issues are not expected to substantially impact the amount of the gain. As a result of the sale, Consumers anticipates its after-tax earnings will decrease by $15 million in 2003, and decrease by approximately $14 million annually for the next three years due to a 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. Under an agreement with MTH, and subject to certain additional RTO surcharges, transmission rates charged to Consumers are fixed by contract at current levels through December 31, 2005, and subject to FERC ratemaking thereafter. MTH has completed 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 until May 1, 2007 under a contract with MTH. CE-24 Consumers Energy Company There are multiple proceedings and a proposed rulemaking pending before the FERC regarding transmission pricing mechanisms and standard market design for electric bulk power markets and transmission. The results of these proceedings and proposed rulemaking could significantly affect the trend of transmission costs and increase the delivered power costs to Consumers and the retail electric customers it serves. The specific financial impact on Consumers of such proceedings, rulemaking and trends are not currently quantifiable. In addition, Consumers is evaluating whether or not there may be impacts on electric reliability associated with the outcomes of these various transmission related proceedings. Consumers cannot assure that all risks to reliability can be avoided. August 14, 2003 Blackout: On August 14, 2003, the electric transmission grid serving parts of the Midwest and the Northeast experienced a significant disturbance, which impacted electric service to millions of homes and businesses throughout a vast region. In Michigan, more than 2 million electric customers were without electricity. Consumers had five fossil-fueled generating unit outages and, of Consumers' 1.7 million electric customers, approximately 100,000 were without power for approximately 24 hours as a result of the disturbance. The impact was felt most heavily in the southeastern part of Consumers' service territory. As discussed above in "Transmission", Consumers sold its electric transmission system in May 2002 to MTH, with Consumers providing transmission system maintenance under a five-year contract with MTH. MTH now owns, controls, and plans for the transmission system that serves Consumers. Consumers incurred approximately $1 million of immediate financial impact as a result of the blackout. Consumers continues to cooperate with investigations of the blackout by several federal and state agencies. Consumers cannot predict the outcome of these investigations. In November 2003, the MPSC released its report on the August 14, 2003 blackout, which found no evidence to suggest that the events in Michigan or actions taken by the Michigan utilities or transmission operators were factors contributing to the cause of the blackout. As a result of its investigation, the MPSC is recommending that Congress pass legislation that would empower the FERC, where necessary, to order membership into a RTO and that Congress should provide the FERC with the authority to develop and enforce mandatory transmission reliability standards with penalties for noncompliance. 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. In November 2002, the MPSC issued an order initiating the formal rulemaking proceeding. Consumers has filed comments on the proposed rules and 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) pending litigation and government investigations; 2) the need to make additional capital expenditures and increase operating expenses for Clean Air Act compliance; 3) 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; 4) pending litigation filed by PURPA qualifying facilities; 5) uncertainties relating to the storage and ultimate disposal of spent nuclear fuel; 6) electric industry restructuring issues, including those described above; 7) 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; 8) the recovery of electric restructuring implementation costs; 9) Consumers' status as an electric transmission customer and not as an electric transmission owner/operator; 10) sufficient reserves for transmission rate refunds; 11) the effects of derivative accounting and potential earnings volatility; 12) increased costs for safety and homeland security initiatives that are not recoverable on a timely basis from customers; 13) potentially rising pension costs due to market losses and lump sum payments (as discussed above in Accounting for Pension and OPEB); 14) Consumers' ability to recover any of its "net" Stranded costs under the regulatory policies being followed by the MPSC; 15) the effects of lost electric supply load from retail open access and the recovery of associated margin loss; 16) the uncertain effects, including exposure to liability, increased regulatory requirement and new legislation, due to the future conclusions about the causes of the August 14, 2003 blackout. 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 full service and customer choice deliveries (excluding transportation to the MCV Facility and off-system deliveries), to grow at an average rate of less than one percent per year based primarily on a steadily growing customer base. Actual gas deliveries in future periods may be affected by abnormal weather, use of gas by independent power producers, changes in competitive and economic conditions, the level of natural gas consumption per customer, and the recent significant increases in gas commodity prices. GAS COST RECOVERY: As part of the on-going GCR process, which includes an annual reconciliation case with the MPSC, Consumers expects to recover all of its gas costs. In June 2003, Consumers filed a reconciliation of GCR costs and revenues for the 12-months ended March 2003. Consumers proposes to recover from its customers a net under-recovery of approximately $6 million using a roll-in methodology. The roll-in methodology incorporates the under-recovery in the GCR factor charged in the next GCR year. The roll-in tariff provision was approved by the MPSC in a November 2002 order. In July 2003, the MPSC approved a settlement agreement authorizing Consumers to increase its gas cost recovery factor for the remainder of the current GCR plan year (August 2003 through March 2004) and to implement a quarterly ceiling price adjustment mechanism, based on a formula that tracks changes in NYMEX natural gas prices. Consistent with the terms of the settlement, the ceiling price is $6.11 per mcf. However, Consumers will utilize a GCR factor of $5.41 per mcf commencing in November 2003 bills. All recoveries pursuant to such factors are subject to final reconciliation by the MPSC. 2001 GAS RATE CASE: In June 2001, Consumers filed an application with the MPSC seeking a distribution service rate increase. In November 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 2002. As part of this order, the MPSC approved Consumers' proposal to absorb the assets and liabilities of Michigan Gas Storage Company into Consumers' rate base and rates. This has occurred through a statutory merger of Michigan Gas Storage Company into Consumers and this is not expected to have an impact on Consumers' consolidated financial statements. 2003 GAS RATE CASE: In March 2003, Consumers filed an application with the MPSC seeking a $156 million increase in its gas delivery and transportation rates, which includes a 13.5 percent return on equity, based on a 2004 test year. Contemporaneously with this filing, Consumers has requested interim rate relief in the same amount. In August 2003, the MPSC Staff recommended interim rate relief of $80 million be granted in this proceeding, subject to Consumers voluntarily agreeing to limit its dividends to its parent, CMS Energy, to a maximum of $190 million in any calendar year. In September 2003, Consumers filed an update to its gas rate case that lowered the requested revenue increase from $156 million to $139 million and revised the return on common equity from 13.5 percent to 12.75 percent. The majority of the reduction is related to lower debt costs and changes in the projected capital structure. The MPSC Staff and ABATE filed their cases in early October. The Staff made no change to its interim position of $80 million and continued to propose the same dividend limitation. ABATE did not make a specific recommendation for a final rate increase, but did discuss the rate design used to recover any rate increase granted. A proposal for decision is expected from the administrative law judge in January 2004. 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 $36 million in CE-26 Consumers Energy Company annual gas 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." 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) pending litigation and government investigations; 2) potential environmental costs at a number of sites, including sites formerly housing manufactured gas plant facilities; 3) future gas industry restructuring initiatives; 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 consumption per residential customer; 6) increase in costs for pipeline integrity, safety, and homeland security initiatives that are not recoverable on a timely basis from customers; 7) potentially rising pension costs due to market losses and lump sum payments (as discussed above in Accounting for Pension and OPEB); and 8) potential adverse appliance service plan ruling or related legislation. For further information about these uncertainties, see Note 2, Uncertainties. OTHER OUTLOOK SECURITY COSTS: Since the September 11, 2001 terrorist attacks in the United States, Consumers has increased security at all critical facilities and over its critical 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. Through September 30, 2003, Consumers has incurred approximately $7 million in incremental security costs, including operating, capital, and decommissioning and removal costs, mainly relating to its nuclear facilities. Consumers estimates it may incur additional incremental security costs for the last three months of 2003 of approximately $3 million, of which $2 million relates to nuclear security costs. Consumers will attempt to seek recovery of these costs from its customers. In December 2002, the Michigan legislature passed, and the governor signed, a bill that would allow Consumers to seek recovery of additional nuclear electric division security costs incurred during the rate freeze and cap periods imposed by the Customer Choice Act. In February 2003, the MPSC adopted filing requirements for the recovery of enhanced security costs. LITIGATION AND REGULATORY INVESTIGATIONS SEC AND OTHER INVESTIGATIONS: As a result of round-trip trading transactions by CMS MST, CMS Energy's Board of Directors established a Special Committee 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 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 Special Committee found no 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. Previously, CMS Energy terminated its speculative trading business and revised its risk management policy. The Board of Directors adopted, and CMS Energy has implemented the 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. The FERC issued an order on April 30, 2003 directing eight companies, including CMS MST, to submit written demonstrations within 45 days that they have taken certain specified remedial measures with respect to the reporting of natural gas trading data to publications that compile and CE-27 Consumers Energy Company publish price indices. CMS MST made a written submission to the FERC on June 11, 2003 in compliance with the FERC's directives. On July 29, 2003, the FERC issued an order stating that CMS MST met the requirements of the FERC's April 30, 2003 order. Other than the FERC investigation, 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 were filed against CMS Energy, Consumers, and certain officers and directors of CMS Energy and its affiliates. The complaints were filed as purported class actions in the United States District Court for the Eastern District of Michigan by shareholders who allege that they purchased CMS Energy's securities during a purported class period. The cases were consolidated into a single lawsuit and an amended and a consolidated class action complaint was filed on May 1, 2003. The consolidated complaint contains a purported class period beginning on May 1, 2000 and running through March 31, 2003. It generally seeks unspecified damages based on allegations that the defendants violated United States securities laws and regulations by making allegedly false and misleading statements about CMS Energy's business and financial condition, particularly with respect to revenues and expenses recorded in connection with round-trip trading by CMS MST. The companies intend to defend vigorously against this action but cannot predict the outcome of this litigation. ERISA LAWSUITS: 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 and an amended and consolidated complaint was filed. 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 defended vigorously. Consumers cannot predict the outcome of this litigation. OTHER MATTERS CONTROLS AND PROCEDURES DISCLOSURE CONTROLS AND PROCEDURES: Consumers' management, with the participation of its CEO and CFO, has evaluated the effectiveness of Consumers' disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this report. Based on such evaluation, Consumers' CEO and CFO have concluded that, as of the end of such period, Consumers' disclosure controls and procedures are effective. INTERNAL CONTROL OVER FINANCIAL REPORTING: There have not been any changes in Consumers' internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, Consumers' internal control over financial reporting. CE-28 Consumers Energy Company CASH MANAGEMENT In August 2002, FERC issued a NOPR concerning the management of funds by certain FERC-regulated companies. The proposed rule could establish limits on the amount of funds that may 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 also may require participants to provide documentation of certain transactions. In the NOPR, 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. In October 2003, a final rule was issued by FERC. The rule will require Consumers, as a FERC-regulated company, to file its cash management agreements with the FERC and to notify the FERC within 45 days after the end of each calendar quarter when their proprietary capital ratio drops below 30 percent, and when it subsequently returns to or exceeds 30 percent. The rule also requires certain information about cash management agreements and transactions to be maintained. The rule becomes effective in late November 2003. Consumers operates its cash management program independent of CMS Energy and, therefore, does not anticipate additional reporting requirements as a result of this final rule. IMPLEMENTATION OF NEW ACCOUNTING STANDARDS SFAS NO. 149, AMENDMENT OF STATEMENT 133 ON DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES: Issued by the FASB in April 2003, this statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities. This statement is effective for contracts entered into or modified after June 30, 2003. Implementation of this statement has not had an impact on Consumers' consolidated financial statements. SFAS NO. 150, ACCOUNTING FOR CERTAIN FINANCIAL INSTRUMENTS WITH CHARACTERISTICS OF BOTH LIABILITIES AND EQUITY: Issued by the FASB in May 2003, this statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. The statement requires an issuer to classify financial instruments within its scope as liabilities. Those instruments were previously classified as mezzanine equity. SFAS No. 150 became effective July 1, 2003. Consumers has four trust preferred securities outstanding as of September 30, 2003. The trust preferred securities are issued by consolidated subsidiaries of Consumers. Each trust holds a subordinated debenture from Consumers. The terms of the debentures are identical to those of the trust preferred securities, except that the debenture has an explicit maturity date. The trust documents, in turn, require that the trust be liquidated upon the repayment of the debenture. The trust preferred securities are redeemable upon the liquidation of the subsidiary; and therefore, are considered equity in the financial statements of the subsidiary. At their October 29, 2003 Board meeting, the FASB deferred the implementation of the portion of SFAS No. 150 relating to mandatorily redeemable noncontrolling interests in subsidiaries when the noncontrolling interests are classified as equity in the financial statements of the subsidiary. Consumers' trust preferred securities are included under the deferral. As such, the Consumers trust preferred securities continue to be accounted for under existing accounting guidance and are included in mezzanine equity. Consumers continues to study the FASB developments regarding the SFAS No. 150 deferral. CE-29 Consumers Energy Company EITF ISSUE NO. 01-08, DETERMINING WHETHER AN ARRANGEMENT CONTAINS A LEASE: In May 2003, the EITF reached consensus in EITF Issue No. 01-08 to clarify the requirements of identifying whether an arrangement should be accounted for as a lease at its inception. The guidance in the consensus is designed to mandate reporting revenue as rental or leasing income that otherwise would be reported as part of product sales or service revenue. EITF Issue No. 01-08 requires both parties to an arrangement to determine whether a service contract or similar arrangement is or includes a lease within the scope of SFAS No. 13, Accounting for Leases. Historically, Consumers has entered into power purchase and similar service arrangements. Prospective accounting under EITF Issue No. 01-08, could affect the timing and classification of revenue and expense recognition. Certain product sales and service revenue and expenses may be required to be reported as rental or leasing income and/or expenses. The consensus is to be applied prospectively to arrangements agreed to, modified, or acquired in business combinations in fiscal periods beginning July 1, 2003. The adoption of EITF Issue No. 01-08 has not impacted Consumers' results of operations, cash flows, or financial position. Consumers will evaluate new or modified contracts under EITF Issue No. 01-08 prospectively. ACCOUNTING STANDARDS NOT YET EFFECTIVE FASB INTERPRETATION NO. 46, CONSOLIDATION OF VARIABLE INTEREST ENTITIES: Issued by the FASB in January 2003, this Interpretation requires the primary beneficiary of a variable interest entity's activities to consolidate the variable interest entity. The primary beneficiary is the party that absorbs a majority of the expected losses and/or receives a majority of the expected residual returns of the variable interest entity's activities. The consolidation requirements of the interpretation apply immediately to variable interest entities created after January 31, 2003. Consumers has not created any variable interest entities in 2003. Therefore, this portion of the interpretation has no impact on its consolidated financial statements. Public companies, whose fiscal year is a calendar year, were originally required to implement the guidance in this interpretation by the third quarter of 2003. However, on October 9, 2003, the FASB issued FASB Staff Position No. 46-6, Effective Date of FASB Interpretation No. 46, which defers implementation of FIN 46 until the fourth quarter of 2003, for variable interest entities and potential variable interest entities created before February 1, 2003. If the completed analysis were to require Consumers to disclose information about or consolidate in its financial statements, the assets, liabilities and activities of the MCV Partnership and the First Midland Limited Partnership, including the recognition of the debt of the MCV Partnership on Consumers' financial statements, this could impact negatively Consumers' various financial covenants under its financing agreements. As a result, Consumers may have to seek amendments to the relevant financing agreements to modify the terms of certain of these covenants in order to remove the effect of this potential consolidation or refinance the relevant debt. As of September 30, 2003, Consumers' investments in the MCV Partnership and in the FMLP were $404 million and $222 million, respectively. For a further description of the nature, purpose, size and activities of the MCV Partnership, see Note 2, Uncertainties, Other Electric Uncertainties, "The Midland Cogeneration Venture." Consumers is continuing to study the implementation of this interpretation and has yet to determine the effects, if any, on its consolidated financial statements. EITF ISSUE 03-04, ACCOUNTING FOR CASH BALANCE PENSION PLANS: In May 2003, the EITF reached consensus in EITF Issue No. 03-04 to specifically address the accounting for certain cash balance pension plans. EITF Issue No. 03-04 concluded that certain cash balance plans be accounted for as defined benefit plans under SFAS No. 87, Employers' Accounting for Pensions. EITF No. 03-04 requires the use of the traditional unit credit method for the purposes of measuring the benefit obligation and annual cost of benefits earned as opposed to the projected unit credit method. The EITF concluded that the requirements of this Issue be applied as of the next plan measurement date, which is December 31, 2003 for Consumers. Consumers commenced a cash balance pension plan that covers employees hired after June 30, 2003. Consumers does account for this plan as a defined benefit plan under SFAS No. 87. Consumers continues to evaluate the CE-30 Consumers Energy Company impact, if any, this Issue will have upon adoption. STATEMENT OF POSITION, ACCOUNTING FOR CERTAIN COSTS AND ACTIVITIES RELATED TO PROPERTY, PLANT, AND EQUIPMENT: At its September 9, 2003 meeting, the Accounting Standards Executive Committee voted to approve the Statement of Position, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment. The Statement of Position is expected to be presented for FASB clearance late in the fourth quarter of 2003 and would be applicable for fiscal years beginning after December 15, 2004. The Accounting Standards Executive Committee concluded that at transition, a company would have the flexibility to adopt a property, plant and equipment component accounting policy for transition-date property, plant and equipment accounts. The property, plant and equipment component policy may differ from the componentization policy, if any, previously used by the enterprise. Selecting a policy that differs from the company's prior level of componentization at the date of adoption of the Statement of Position would not result in any cumulative effect difference for adopting such a policy. A company would not have to restate its pre-adoption assets to conform with its post-adoption componentization policy. The Accounting Standards Executive Committee concluded that companies would be required to disclose meaningful ranges with respect to property, plant and equipment depreciable lives. Consumers continues to evaluate the impact, if any, this Issue will have upon adoption. CE-31 CONSUMERS ENERGY COMPANY CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30 2003 2002 2003 2002 ------------------------------------------------------------------------------------------------------------------------------- In Millions OPERATING REVENUE $ 879 $ 911 $ 3,223 $ 3,020 EARNINGS (LOSS) FROM EQUITY METHOD INVESTEES (3) 8 31 35 OPERATING EXPENSES Operation Fuel for electric generation 89 98 245 236 Purchased power - related parties 131 143 383 416 Purchased and interchange power 103 111 260 244 Cost of gas sold 90 20 793 528 Cost of gas sold - related parties 2 34 27 96 Other 178 182 505 487 ----------------------------------------------- 593 588 2,213 2,007 ----------------------------------------------- Maintenance 41 43 149 141 Depreciation, depletion and amortization 80 77 275 256 General taxes 47 43 130 144 ----------------------------------------------- 761 751 2,767 2,548 ------------------------------------------------------------------------------------------------------------------------------- OPERATING INCOME 115 168 487 507 OTHER INCOME (DEDUCTIONS) Dividends and interest from affiliates - - - 2 Accretion expense (1) (1) (5) (4) Other, net 2 1 (3) 37 ----------------------------------------------- 1 - (8) 35 ------------------------------------------------------------------------------------------------------------------------------- INTEREST CHARGES Interest on long-term debt 51 41 144 111 Other interest 2 5 10 16 Capitalized interest (2) (3) (7) (8) ----------------------------------------------- 51 43 147 119 ------------------------------------------------------------------------------------------------------------------------------- INCOME BEFORE INCOME TAXES 65 125 332 423 INCOME TAXES 21 41 126 140 ----------------------------------------------- INCOME BEFORE CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE 44 84 206 283 CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING FOR DERIVATIVE INSTRUMENTS, NET OF $1 AND $10 TAX EXPENSE IN 2002, RESPECTIVELY - 1 - 18 ----------------------------------------------- NET INCOME 44 85 206 301 PREFERRED STOCK DIVIDENDS - - 1 1 PREFERRED SECURITIES DISTRIBUTIONS 11 11 33 33 ----------------------------------------------- NET INCOME AVAILABLE TO COMMON STOCKHOLDER $ 33 $ 74 $ 172 $ 267 ===============================================================================================================================
THE ACCOMPANYING CONDENSED NOTES ARE AN INTEGRAL PART OF THESE STATEMENTS. CE-32 CONSUMERS ENERGY COMPANY CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
NINE MONTHS ENDED September 30 2003 2002 ---------------------------------------------------------------------------------------------------------------- In Millions CASH FLOWS FROM OPERATING ACTIVITIES Net income $ 206 $ 301 Adjustments to reconcile net income to net cash provided by operating activities Depreciation, depletion and amortization (includes nuclear decommissioning of $4 and $5, respectively) 275 256 Gain on sale of METC and other assets - (38) Deferred income taxes and investment tax credit 72 (18) Loss on CMS Energy stock 12 - Capital lease and other amortization 20 11 Distributions from related parties in excess of (less than) earnings 14 (20) Cumulative effect of accounting changes - (18) Pension contribution (172) (47) Changes in other assets and liabilities: Increase in inventories (335) (37) Decrease in accounts receivable and accrued revenue 156 98 Decrease in accounts payable (39) (79) Changes in other assets and liabilities (79) 11 ------------------------ Net cash provided by operating activities 130 420 ---------------------------------------------------------------------------------------------------------------- CASH FLOWS FROM INVESTING ACTIVITIES Capital expenditures (excludes assets placed under capital lease) (306) (400) Cost to retire property, net (52) (50) Investment in Electric Restructuring Implementation Plan (5) (6) Investments in nuclear decommissioning trust funds (4) (5) Proceeds from nuclear decommissioning trust funds 26 19 Proceeds from sale of METC and other assets 15 298 ------------------------ Net cash used in investing activities (326) (144) ---------------------------------------------------------------------------------------------------------------- CASH FLOWS FROM FINANCING ACTIVITIES Proceeds from senior notes and bank loans, net 1,543 602 Retirement of bonds and other long-term debt (780) (409) Decrease in notes payable, net (453) (182) Payment of common stock dividends (162) (154) Preferred securities distribution (33) (33) Payment of capital lease obligations (10) (11) Payment of preferred stock dividends (1) (1) Restricted cash on hand (1) (14) Redemption of preferred securities - (30) Stockholder's contribution, net - 50 ------------------------ Net cash provided by (used in) financing activities 103 (182) ---------------------------------------------------------------------------------------------------------------- NET INCREASE (DECREASE) IN CASH AND TEMPORARY CASH INVESTMENTS (93) 94 CASH AND TEMPORARY CASH INVESTMENTS, BEGINNING OF PERIOD 253 13 ------------------------ CASH AND TEMPORARY CASH INVESTMENTS, END OF PERIOD $ 160 $ 107 ================================================================================================================ OTHER CASH FLOW ACTIVITIES AND NON-CASH INVESTING AND FINANCING ACTIVITIES WERE: CASH TRANSACTIONS Interest paid (net of amounts capitalized) $ 156 $ 116 Income taxes paid (net of refunds) 32 83 Pension and OPEB cash contribution 226 101 NON-CASH TRANSACTIONS Other assets placed under capital leases $ 11 $ 50 ================================================================================================================
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-33 CONSUMERS ENERGY COMPANY CONSOLIDATED BALANCE SHEETS ASSETS
SEPTEMBER 30 SEPTEMBER 30 2003 DECEMBER 31 2002 (UNAUDITED) 2002 (UNAUDITED) ------------------------------------------------------------------------------------------------------------ In Millions PLANT (AT ORIGINAL COST) Electric $ 7,583 $ 7,523 $ 7,504 Gas 2,841 2,719 2,692 Other 15 23 22 -------------------------------------------- 10,439 10,265 10,218 Less accumulated depreciation, depletion and amortization 5,365 5,900 5,856 -------------------------------------------- 5,074 4,365 4,362 Construction work-in-progress 359 548 463 -------------------------------------------- 5,433 4,913 4,825 ------------------------------------------------------------------------------------------------------------ INVESTMENTS Stock of affiliates 17 22 19 First Midland Limited Partnership 222 255 250 Midland Cogeneration Venture Limited Partnership 404 388 370 Consumers Nuclear Services, LLC 2 2 2 -------------------------------------------- 645 667 641 ------------------------------------------------------------------------------------------------------------ CURRENT ASSETS Cash and temporary cash investments at cost, which approximates market 160 253 107 Restricted cash 19 18 18 Accounts receivable, notes receivable and accrued revenue, less allowances of $7, $4 and $4 respectively 81 236 36 Accounts receivable - related parties 7 13 18 Inventories at average cost Gas in underground storage 813 486 601 Materials and supplies 72 71 71 Generating plant fuel stock 44 37 49 Deferred property taxes 88 142 82 Regulatory assets 19 19 19 Other 94 38 27 -------------------------------------------- 1,397 1,313 1,028 ------------------------------------------------------------------------------------------------------------ NON-CURRENT ASSETS Regulatory Assets Securitized costs 659 689 699 Postretirement benefits 168 185 191 Abandoned Midland Project 10 11 11 Other 257 168 173 Nuclear decommissioning trust funds 553 536 530 Other 147 218 108 -------------------------------------------- 1,794 1,807 1,712 -------------------------------------------- TOTAL ASSETS $ 9,269 $ 8,700 $ 8,206 ============================================================================================================
CE-34 STOCKHOLDER'S EQUITY AND LIABILITIES
SEPTEMBER 30 SEPTEMBER 30 2003 DECEMBER 31 2002 (UNAUDITED) 2002 (Unaudited) ------------------------------------------------------------------------------------------------------------ In Millions CAPITALIZATION Common stockholder's equity Common stock $ 841 $ 841 $ 841 Paid-in capital 682 682 682 Accumulated other comprehensive loss (191) (179) (8) Retained earnings since December 31, 1992 555 545 525 -------------------------------------------- 1,887 1,889 2,040 Preferred stock 44 44 44 Company-obligated mandatorily redeemable preferred securities of subsidiaries 490 490 490 Long-term debt 3,531 2,442 2,701 Non-current portion of capital leases 116 116 110 -------------------------------------------- 6,068 4,981 5,385 ------------------------------------------------------------------------------------------------------------ CURRENT LIABILITIES Current portion of long-term debt and capital leases 39 318 224 Notes payable 4 457 235 Accounts payable 241 261 212 Accrued taxes 84 214 152 Accounts payable - related parties 65 84 85 Deferred income taxes 23 25 18 Current portion of purchase power contract 26 26 29 Other 168 200 226 -------------------------------------------- 650 1,585 1,181 ------------------------------------------------------------------------------------------------------------ NON-CURRENT LIABILITIES Deferred income taxes 1,009 949 762 Postretirement benefits 431 563 244 Regulatory liabilities for income taxes, net 309 297 282 Asset retirement obligations 362 - - Other regulatory liabilities 152 4 - Deferred investment tax credit 86 91 92 Power purchase agreement - MCV Partnership 8 27 30 Other 194 203 230 -------------------------------------------- 2,551 2,134 1,640 ------------------------------------------------------------------------------------------------------------ COMMITMENTS AND CONTINGENCIES (Notes 1 and 2) TOTAL STOCKHOLDER'S EQUITY AND LIABILITIES $ 9,269 $ 8,700 $ 8,206 ============================================================================================================
THE ACCOMPANYING CONDENSED NOTES ARE AN INTEGRAL PART OF THESE STATEMENTS. CE-35 CONSUMERS ENERGY COMPANY CONSOLIDATED STATEMENTS OF COMMON STOCKHOLDER'S EQUITY (UNAUDITED)
THREE MONTHS ENDED NINE MONTHS ENDED September 30 2003 2002 2003 2002 ------------------------------------------------------------------------------------------------------------------- In Millions COMMON STOCK At beginning and end of period (a) $ 841 $ 841 $ 841 $ 841 ------------------------------------------------------------------------------------------------------------------- OTHER PAID-IN CAPITAL At beginning of period 682 682 682 632 Stockholders' contribution - - - 150 Return of Stockholders' contribution - - - (100) --------------------------------------------------- At end of period 682 682 682 682 ------------------------------------------------------------------------------------------------------------------- ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) Minimum Pension Liability At beginning of period (202) - (185) - Minimum liability pension adjust (b) - - (17) - --------------------------------------------------- At end of period (202) - (202) - --------------------------------------------------- Investments At beginning of period 8 (5) 1 16 Unrealized gain (loss) on investments (c) (2) (4) 5 (25) --------------------------------------------------- At end of period 6 (9) 6 (9) --------------------------------------------------- Derivative Instruments At beginning of period (d) 11 (3) 5 (12) Unrealized gain on derivative instruments (c) (4) 1 9 6 Reclassification adjustments included in consolidated net income (loss) (c) (2) 3 (9) 7 --------------------------------------------------- At end of period 5 1 5 1 ------------------------------------------------------------------------------------------------------------------- Total Accumulated Other Comprehensive Income (Loss) (191) (8) (191) (8) ------------------------------------------------------------------------------------------------------------------- RETAINED EARNINGS At beginning of period 522 480 545 441 Net income 44 85 206 301 Cash dividends declared - Common Stock - (29) (162) (183) Cash dividends declared - Preferred Stock - - (1) (1) Preferred securities distributions (11) (11) (33) (33) --------------------------------------------------- At end of period 555 525 555 525 ------------------------------------------------------------------------------------------------------------------- TOTAL COMMON STOCKHOLDER'S EQUITY $ 1,887 $ 2,040 $ 1,887 $ 2,040 ===================================================================================================================
CE-36
THREE MONTHS ENDED NINE MONTHS ENDED September 30 2003 2002 2003 2002 ------------------------------------------------------------------------------------------------------------------------------ (a) Number of shares of common stock outstanding was 84,108,789 for all periods presented. (b) Because of the significant change in the makeup of the pension plan due to the sale of Panhandle, SFAS No. 87 required a remeasurement of the obligation at the date of sale. The remeasurement resulted in an additional charge to Accumulated Other Comprehensive Income (Loss) of approximately $27 million ($17 million after tax) as a result of the increase in the additional minimum pension liability. (c) Disclosue of Comprehensive Income: Minimum pension liability adjustment (b) $ - $ - $ (17) $ - Investments Unrealized gain (loss) on investments, net of tax of $-, $3, $(3) and $14, respectively (2) (4) 5 (25) Derivative Instruments Unrealized gain (loss) on derivative instruments, net of tax of $2, $(1), $(4) and $(4), respectively (4) 1 9 6 Reclassification adjustments included in net income, net of tax of $1, $(2), $5 and $(4), respectively (2) 3 (9) 7 Net income 44 85 206 301 ------------------------------------------------------------ Total Comprehensive Income $ 36 $ 85 $ 194 $ 289 ============================================================ (d) Included in these amounts is Consumers' proportionate share of the effects of derivative accounting related to its equity investment in the MCV Partnership as follows: At the beginning of the period $ 13 $ 1 $ 8 $ (8) Unrealized gain (loss) on derivative instruments (5) 1 8 7 Reclassification adjustments included in net income (2) 2 (10) 5 ------------------------------------------------------------ At the end of the period $ 6 $ 4 $ 6 $ 4 ============================================================
THE ACCOMPANYING CONDENSED NOTES ARE AN INTEGRAL PART OF THESE STATEMENTS. CE-37 Consumers Energy Company CONSUMERS ENERGY COMPANY CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) These interim Consolidated Financial Statements have been prepared by Consumers in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. As such, certain information and footnote disclosures normally included in 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. In management's opinion, the unaudited information contained in this report reflects all adjustments of a normal recurring nature necessary to assure the fair presentation of financial position, results of operations and cash flows for the periods presented. 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, 2002, which includes the Reports of Independent Auditors. 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. COLLECTIVE BARGAINING AGREEMENT: As of December 31, 2002, 44 percent of Consumers' workforce was represented by the Utility Workers Union of America. Consumers and the Union negotiated a collective bargaining agreement that became effective as of June 1, 2000, and will continue in full force and effect until June 1, 2005. On March 26, 2003, Consumers reached a tentative agreement with the Union for a collective bargaining agreement for its Call Center employees. The agreement was subsequently ratified by the membership and became effective April 1, 2003, and covers approximately 300 employees. The agreement will continue in full force and effect until August 1, 2005. BASIS OF PRESENTATION: The consolidated financial statements include Consumers and its wholly owned subsidiaries. Consumers uses the equity method of accounting for investments in 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. Consumers prepared the financial statements in conformity with accounting principles generally accepted in the United States that include the use of management's estimates. USE OF ESTIMATES: The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The 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 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 when an amount can be reasonably estimated. Consumers has used this accounting principle to record estimated liabilities as discussed in Note 2, Uncertainties. 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 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' 2002 Form 10-K. Consumers' management has changed its evaluation of the performance of the electric and gas segments from operating income to net income available to common stockholder. 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 other business unit includes Consumers' consolidated statutory business trusts, which were created to issue preferred securities and Consumers' consolidated special purpose entity for the sale of trade receivables. The operating revenue and net income (loss) available to common stockholder by CE-38 Consumers Energy Company reportable segment are as follows:
In Millions ------------------------------------------------------------------------------------------------------ Three Months Ended Nine Months Ended September 30 2003 2002 2003 2002 ------------------------------------------------------------------------------------------------------ Operating revenue Electric $ 714 $ 775 $ 1,970 $ 2,015 Gas 164 135 1,252 1,002 Other 1 1 1 3 ------------------------------------------------------------------------------------------------------ Total Operating Revenue $ 879 $ 911 $ 3,223 $ 3,020 ====================================================================================================== Net income available to common stockholder Electric $ 59 $ 88 $ 145 $ 222 Gas (19) (18) 40 13 Other (7) 4 (13) 32 ------------------------------------------------------------------------------------------------------ Total Net Income $ 33 $ 74 $ 172 $ 267 ======================================================================================================
FINANCIAL INSTRUMENTS: Consumers 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. 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 accumulated other comprehensive income and are excluded from earnings, unless such changes in fair value are other than temporary. Unrealized gains or losses from changes in the fair value of Consumers' nuclear decommissioning investments are reported as regulatory liabilities. The fair value of these investments is determined from quoted market prices. For further information regarding financial instruments, see Note 4, Financial and Derivative Instruments - Financial Instruments. UTILITY REGULATION: Consumers accounts for the effects of regulation based on the regulated utility accounting standard SFAS No. 71. As a result, the actions of regulators affect when Consumers recognizes revenues, expenses, assets and liabilities. In 1999, Consumers received MPSC electric restructuring orders, which, among other things, identified the terms and timing for implementing electric restructuring in Michigan. Consistent with these orders and EITF No. 97-4, Consumers discontinued the application of SFAS No. 71 for the energy supply portion of its business because Consumers expected to implement retail open access at competitive market based rates for its electric customers. However, since 1999, there has been a significant legislative and regulatory change in Michigan that has resulted in: 1) electric supply customers of utilities remaining on cost-based rates and 2) utilities being given the ability to recover Stranded Costs associated with electric restructuring, from customers who choose an alternative electric supplier. During 2002, Consumers re-evaluated the criteria used to determine if an entity or a segment of an entity meets the requirements to apply regulated utility accounting, and determined that the energy supply portion of its business could meet the criteria if certain regulatory events occurred. In December 2002, Consumers received a MPSC Stranded Cost order that allowed Consumers to re-apply regulatory accounting standard SFAS No. 71 to the energy supply portion of its business. Re-application of SFAS No. 71 had no effect on the prior discontinuation accounting, but allowed Consumers to apply regulatory accounting treatment to the energy supply portion of its business beginning in the fourth quarter of 2002, including regulatory accounting treatment of costs required to be recognized in accordance with SFAS No. 143. See Note 5, Implementation of New Accounting Standards, "SFAS No. 143, Accounting for Asset Retirement Obligations." CE-39 Consumers Energy Company SFAS No. 144 imposes strict criteria for retention of regulatory-created assets by requiring that such assets be probable of future recovery at each balance sheet date. Management believes these assets are probable of future recovery. RESTRICTED CASH: At September 30, 2003, Consumers' restricted cash on hand totaled $19 million. Restricted cash primarily consists of cash dedicated for repayment of securitization bonds. It is classified as a current asset as the payments on the related securitization bonds occur within one year. STOCK-BASED COMPENSATION: In December 2002, the FASB issued SFAS No. 148. This standard provides for alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In the fourth quarter of 2002, Consumers adopted the fair value method of accounting for stock-based compensation under SFAS No. 123 as amended by SFAS No. 148, applying the prospective method. If compensation cost for stock option had been determined in accordance with SFAS No. 123 for the three and nine month periods ended September 30, 2002, consolidated net income as reported and pro forma would have been as follows:
In Millions ------------------------------------------------------------------------------------------------------ Three Months Ended September 30 2002 ------------------------------------------------------------------------------------------------------ Net income, as reported $ 85 Add: Stock-based employee compensation expense included in reported net income, net of taxes - Deduct: Total stock-based compensation expense determined under fair value based method for all awards, net of tax - ------------ Pro forma net income $ 85 ======================================================================================================
In Millions ------------------------------------------------------------------------------------------------------ Nine Months Ended September 30 2002 ------------------------------------------------------------------------------------------------------ Net income, as reported $ 301 Add: Stock-based employee compensation expense included in reported net income, net of taxes - Deduct: Total stock-based compensation expense determined under fair value based method for all awards, net of tax (1) ------------ Pro forma net income $ 300 ======================================================================================================
In the third quarter of 2003, Consumers granted 500,000 stock options to employees. As a result, Consumers expensed approximately $3 million related to the fair value of those stock options. Fair value is estimated using the Black Scholes model, a mathematical formula used to value options traded on the securities exchange. 2: UNCERTAINTIES Several 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 and gas operations. Such trends and uncertainties are discussed in detail below and include: 1) pending litigation and government investigations; 2) the need to make additional capital expenditures and increase operating expenses for Clean Air Act compliance; 3) 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; 4) pending litigation regarding PURPA qualifying facilities; 5) electric industry restructuring issues; 6) 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; 7) the recovery of electric restructuring implementation costs; 8) Consumers' status as an electric transmission customer and not as an electric transmission owner/operator; 9) sufficient reserves for transmission rate refunds; 10) uncertainties relating to the storage and ultimate disposal of spent nuclear fuel; 11) the effects of derivative accounting and CE-40 Consumers Energy Company potential earnings volatility; 12) potential environmental costs at a number of sites, including sites formerly housing manufactured gas plant facilities; 13) future gas industry restructuring initiatives; 14) an inadequate regulatory response to applications for requested rate increases; 15) market and regulatory responses to increases in gas costs, including a reduced average use per residential customer; 16) increased costs for pipeline integrity and safety and homeland security initiatives that are not recoverable on a timely basis from customers; 17) Consumers' ability to recover any of its net stranded costs under the regulatory policies being followed by the MPSC; 18) the effects of lost electric supply load from retail open access and the recovery of associated margin loss; and 19) the uncertain effects, including exposure to liability, increased regulatory requirement and new legislation, due to the future conclusions about the causes of the August 14, 2003 blackout. SEC AND OTHER INVESTIGATIONS: As a result of round-trip trading transactions by CMS MST, CMS Energy's Board of Directors established a Special Committee 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 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 Special Committee found no 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. Previously, CMS Energy terminated its speculative trading business and revised its risk management policy. The Board of Directors adopted, and CMS Energy has implemented the 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. The FERC issued an order on April 30, 2003 directing eight companies, including CMS MST, to submit written demonstrations within 45 days that they have taken certain specified remedial measures with respect to the reporting of natural gas trading data to publications that compile and publish price indices. CMS MST made a written submission to the FERC on June 11, 2003 in compliance with the FERC's directives. On July 29, 2003, the FERC issued an order stating that CMS MST met the requirements of the FERC's April 30, 2003 order. Other than the FERC investigation, 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 were filed against CMS Energy, Consumers, and certain officers and directors of CMS Energy and its affiliates. The complaints were filed as purported class actions in the United States District Court for the Eastern District of Michigan by shareholders who allege that they purchased CMS Energy's securities during a purported class period. The cases were consolidated into a single lawsuit and an amended and a consolidated class action complaint was filed on May 1, 2003. The consolidated complaint contains a purported class period beginning on May 1, 2000 and running through March 31, 2003. It generally seeks unspecified damages based on allegations that the defendants violated United States securities laws and regulations by making allegedly false and misleading statements about CMS Energy's business and financial condition, particularly with respect to revenues and expenses recorded in connection with round-trip trading by CMS MST. The companies intend to defend vigorously against this action but cannot predict the outcome of this litigation. ERISA 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 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, and an amended and consolidated complaint was filed. Plaintiffs allege breaches of fiduciary duties under ERISA and seek restitution on behalf of the plan CE-41 Consumers Energy Company 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 defended vigorously. 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 regulations requiring the state of Michigan to further limit nitrogen oxide emissions. The Michigan Department of Environmental Quality finalized rules to comply with the EPA regulations in December 2002 and submitted these rules for approval to the EPA in the first quarter of 2003. The EPA has issued additional 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 regulations require Consumers to make significant capital expenditures estimated to be $770 million. As of September 30, 2003, Consumers has incurred $437 million in capital expenditures to comply with the EPA regulations and anticipates that the remaining capital expenditures will be incurred between 2003 and 2009. 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. Consumers expects to supplement its environmental regulation compliance plan with the purchase of nitrogen oxide emissions credits for years 2005 through 2008. The cost of these credits based on the current market is estimated to average $6 million per year; however, the market for nitrogen oxide emissions credits and their price could change substantially. The EPA has proposed changes to the rules which govern generating plant cooling water intake systems. The proposed rules will require significant abatement of fish mortality. The proposed rules are scheduled to become final in the first quarter of 2004 and some of Consumers' facilities would be required to comply by 2006. Consumers is studying the proposed rules to determine the most cost-effective solutions for compliance. Until the method of compliance is determined, Consumers is unable to estimate the cost of compliance with the proposed rules. The EPA has alleged that some utilities have incorrectly classified plant modifications as "routine maintenance" rather than seek permits from the EPA. Consumers has received and responded to information requests from the EPA on this subject. Consumers believes that it has properly interpreted the requirements of "routine maintenance". If Consumers' interpretation is eventually found to be incorrect, it may be required to install additional pollution controls at some or all of its coal-fired plants and could call into question the viability of certain plants remaining in operation. 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, 2003, Consumers had accrued the minimum amount of the range for its estimated Superfund liability. CE-42 Consumers Energy Company 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. Consumers has proposed a plan to deal with the remaining materials and is awaiting a response from the EPA. LITIGATION: In October 2003, a group of eight PURPA qualifying facilities selling power to Consumers filed a lawsuit in Ingham County Circuit Court against Consumers. The lawsuit alleges that Consumers incorrectly calculated the energy charge payments made pursuant to power purchase agreements between the qualifying facilities and Consumers. More specifically, the lawsuit alleges that Consumers should be basing the energy charge calculation on the cost of more expensive eastern coal, rather than on the cost of the coal actually burned by Consumers for use in its coal-fired generating plants. Consumers believes it has been performing the calculation in the manner prescribed by the power purchase agreements, and has filed a request with the MPSC (as a supplement to the PSCR plan) that asks the MPSC to review this issue and to confirm that Consumers' method of performing the calculation is correct. Also, Consumers has filed a motion to dismiss the lawsuit in the Ingham County Circuit Court due to the pending request at the MPSC in regard to the PSCR plan case. Although only eight qualifying facilities have currently raised the issue, the same energy charge methodology is used in the PPA with the MCV Partnership and in approximately 20 additional power purchase agreements with Consumers, representing approximately 1,670 MW of electric capacity. Consumers cannot predict the outcome of this litigation. 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 Securitization bonds to refinance qualified costs, as defined by the act; 5) establishes a market power supply test that if not met may require transferring control of generation resources in excess of that required to serve firm retail sales requirements (In September 2003, the MPSC issued an order finding that Consumers is in compliance with the market power test set forth in the Customer Choice Act.); 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. (In July 2002, the MPSC issued an order approving the plan to achieve the increased transmission capacity. The MPSC found that once the planned projects were completed and verification was submitted, a utility was in technical compliance. Consumers has completed the transmission capacity projects identified in the plan and has submitted verification of this fact to the MPSC. Consumers believes it is in full compliance.); 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. Under Public Act 141, Consumers currently offers standby generation services to certain retail open access customers. The obligation to offer this service does not extend beyond the later of December 31, 2001 or the date the MPSC finds that Consumers complies with the market power test set forth in the Customer Choice Act and has completed the projects necessary to meet Consumers', Detroit Edison's and American Electric Power's obligation to jointly expand their available transmission capability by at least 2,000 MW. As stated above, in September 2003, the MPSC issued an order finding that Consumers is in compliance with the market power test and in December 2002, Consumers filed verification with the MPSC indicating that Consumers met the CE-43 Consumers Energy Company transmission capability expansion requirements. As a result, Consumers filed a notice with the MPSC indicating that it was terminating retail open access standby service on December 31, 2003. Also, as a result of Consumers meeting the transmission capability expansion requirements and the market power test, Consumers has met the requirements under Public Act 141 to return to the PSCR process. For further discussion on the PSCR process see, "Power Supply Costs" in this Note. The rate-freeze imposed by Public Act 141 ends at December 31, 2003. After that date, the statute would allow customers to petition the MPSC for rate reductions below the cap. Consumers would have the opportunity to respond to such a petition before rates could be reduced. 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. Consumers cannot predict the total amount of electric supply load that may be lost to competitor suppliers (as noted below in "Power Supply Costs" in this Note, 603 MW of load is currently being served by competitor suppliers), nor whether the stranded cost recovery method adopted by the MPSC will be applied in a manner that will fully offset any associated margin loss. SECURITIZATION: The Customer Choice Act allows for the use of Securitization bonds to refinance certain qualified costs, as defined by the act. Securitization typically involves issuing asset-backed bonds with a higher credit rating than conventional utility corporate financing. In 2000 and 2001, the MPSC issued orders authorizing Consumers to issue Securitization bonds. Consumers issued its first Securitization bonds in late 2001. Securitization resulted in lower interest costs and a longer amortization period for the securitized assets, and offset the impact of the required residential rate reduction. The Securitization 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. Consumers and Consumers Funding 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 occurred 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 and cap period expire and an electric rate case is processed. Securitization charge collections, $37 million for the nine months ended September 30 2003, and $39 million for the nine months ended September 30, 2002, are remitted to a trustee for the Securitization bonds. Securitization charge collections are dedicated to the repayment of the principal and interest on the Securitization bonds and payment CE-44 Consumers Energy Company of the ongoing expenses of Consumers Funding and can only be used for those purposes. Consumers Funding is legally separate from Consumers. The assets and income of Consumers Funding, including without limitation, the securitized property, are not available to creditors of Consumers or CMS Energy. In March 2003, Consumers filed an application with the MPSC seeking approval to issue Securitization bonds in the amount of approximately $1.084 billion. The application sought recovery of costs associated with Clean Air Act expenditures, Palisades expenditures previously not securitized, retail open access implementation costs through December 31, 2003, certain pension fund costs, and expenses associated with the issuance of the bonds. In June 2003, the MPSC issued a financing order authorizing the issuance of Securitization bonds in the amount of approximately $554 million. This amount relates to Clean Air Act expenditures and associated return on those expenditures through December 31, 2002, retail open access implementation costs and previously authorized return on those expenditures through December 31, 2000, and the "up front" other qualified costs related to issuance of the Securitization bonds. The MPSC rejected Palisades expenditures previously not securitized as eligible securitized costs. Therefore, Palisades expenditures previously not securitized should be included as a component of "net" Stranded Costs and will be included as a component of a future electric rate case proceeding with the MPSC. In the June 2003 financing order, the MPSC also adopted a rate design that would allow retail open access customers to pay a securitization charge (and related tax charge) that are a small fraction of the amounts paid by full service bundled sales customers and special contract customers of the utility. The financing order provides that the securitization charges (and related tax charges) for the full service and bundled sales customers are increased under the rate design in the financing order in order to be sufficient to repay the principal, interest and all other "ongoing" qualified costs related to servicing the Securitization bonds. The financing order also restricts the amount of common dividends payable by Consumers to its "earnings." In July 2003, Consumers filed for rehearing and clarification on a number of features in the financing order, including the rate design, accounting treatment of unsecuritized qualified costs and dividend restriction. Also in July 2003, the Attorney General filed a claim of appeal related to the financing order and the Attorney General indicated it would challenge the lawfulness of the rate design. In October 2003, the Court of Appeals dismissed the appeal and indicated that the Attorney General could resubmit the appeal after the MPSC acted on Consumers' rehearing request. Subsequently, the Attorney General filed a motion of rehearing asking for reconsideration of the Court of Appeals' dismissal. The financing order will become effective after rehearing, resolution of appeals and upon acceptance by Consumers. ELECTRIC PROCEEDINGS: Stranded 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. The MPSC authorized Consumers to use deferred accounting to recognize the future recovery of costs determined to be stranded. According to the MPSC, "net" Stranded Costs are to be recovered from retail open access customers through a Stranded Cost transition charge. In April 2002, Consumers made "net" Stranded Cost filings with the MPSC for $22 million for 2000 and $43 million for 2001. Consumers in its hearing brief, filed in August 2002, revised its request for Stranded Costs to $7 million for 2000 and $4 million for 2001. The single largest reason for the difference in the filing was the exclusion, as ordered by the MPSC, of all costs associated with expenditures required by the Clean Air Act. As discussed above in "Securitization", Consumers filed a request with the MPSC for authority to issue Securitization bonds that would allow recovery of the Clean Air Act expenditures that were excluded from the Stranded Cost calculation. CE-45 Consumers Energy Company In December 2002, the MPSC issued an order finding that Consumers experienced zero "net" Stranded Costs in 2000 and 2001, but declined to resolve numerous issues regarding the "net" Stranded Cost methodology in a way that would allow a reliable prediction of the level of Stranded Costs for 2002 and future years. In January 2003, Consumers filed a petition for rehearing of the December 2002 Stranded Cost order in which it asked the MPSC to grant a rehearing and revise certain features of the order. Several other parties have also filed rehearing petitions with the MPSC. Consumers has also initiated an appeal at the Michigan Court of Appeals related to the MPSC's December 2001 "net" Stranded Cost order. In March 2003, Consumers filed an application with the MPSC seeking approval of "net" Stranded Costs incurred in 2002, and for approval of a "net" Stranded Cost recovery charge. In the application, Consumers indicated that if Consumers' proposal to securitize Clean Air Act expenditures and Palisades expenditures, previously not securitized, were approved as proposed in its securitization case as discussed above in "Securitization", then Consumers' "net" Stranded Costs incurred in 2002 would be approximately $35 million. If the proposal to securitize those costs is not approved, then Consumers indicated that the costs would be properly included in the 2002 "net" Stranded Cost calculation, which would increase Consumers' 2002 "net" Stranded Costs to approximately $103 million. In June 2003, the MPSC issued a financing order in the securitization case, authorizing the issuance of Securitization bonds in the amount of approximately $554 million. Included in this amount were Clean Air Act expenditures. However, the MPSC rejected Palisades expenditures previously not securitized as eligible securitized costs. As a result, the Palisades expenditures previously not securitized should be included as a component of "net" Stranded Costs and will be included as a component of a future electric rate case proceeding with the MPSC. With the inclusion of the Palisades expenditures previously not securitized, Consumers' "net" Stranded Costs incurred in 2002 are estimated to be approximately $50 million. In July 2003, Consumers filed a petition for rehearing and clarification on a number of features in the MPSC's financing order on securitization. Once a final financing order by the MPSC on securitization is issued, the amount of Consumers' request for "net" Stranded Cost recovery for 2002 will be known. Consumers cannot predict how the MPSC will rule on its request for the recoverability of Stranded Costs, and therefore Consumers has not recorded any regulatory assets to recognize the future recovery of such costs. The MPSC staff has scheduled a collaborative process to discuss Stranded Costs and related issues and to identify and make recommendations to the MPSC. Consumers has participated in this collaborative process. In July 2003, the staff suspended formal discussion while it considers possible conclusions and recommendations. Implementation Costs - 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 - 2003 2002 2 2 Pending Pending ====================================================================================
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 order received for the year 2001, the MPSC also reserved the right to review again the implementation costs depending upon the progress and success of the CE-46 Consumers Energy Company 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 above, as of September 30, 2003, Consumers incurred and deferred as a regulatory asset, $2 million of additional implementation costs and has also recorded a regulatory asset of $16 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 is expected to begin after the rate freeze or rate cap period has expired. As discussed above, Consumers has asked to include implementation costs through December 31, 2000 in the pending securitization case. If approved, the sale of Securitization bonds will allow for the recovery of these costs. Consumers cannot predict the amounts the MPSC will approve as allowable costs. Also, Consumers is pursuing authorization at the FERC for MISO to reimburse Consumers for approximately $8 million in certain electric utility restructuring implementation costs related to its former participation in the development of the Alliance RTO, a portion of which has been expensed. In May 2003, the FERC issued an order denying MISO's request for authorization to reimburse Consumers. In June 2003, Consumers and MISO filed a joint petition for rehearing with the FERC. In September 2003, the FERC denied Consumers' and MISO's joint request. Consumers plans to appeal the FERC ruling at the United States Court of Appeals for the District of Columbia and pursue other potential means of recovery. In November 2003, in conjunction with Consumers' appeal of the September Order denying recovery, Consumers persuaded MISO to file a request with the FERC seeking authority to reimburse METC, the legal successor in interest to the Alliance RTO start-up costs. As part of the contract for sale of Consumers' former transmission system, should the Commission approve the new MISO filing, METC is contractually obligated to flow-through to Consumers the full amount of any Alliance RTO start-up costs that it is authorized to recover through FERC. Consumers cannot predict the outcome of the appeal process, the MISO request or the amount of implementation costs, if any; the FERC ultimately will allow to be collected. Transmission Rates - 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 final FERC 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 and Detroit Edison used the same rates for JOATT transmission rates. Approval of the JOATT transmission rates application is pending FERC approval. Consumers believes its reserve is sufficient to satisfy its refund obligation under current rate applications. As of October 2003, Consumers has paid $27 million in refunds. In October 2003, Consumers filed with FERC its formal notice of cancellation of its transmission tariffs since Consumers no longer has any transmission customers. TRANSMISSION: In May 2002, Consumers sold its electric transmission system for approximately $290 million to MTH, a non-affiliated limited partnership whose general partner is a subsidiary of Trans-Elect, Inc. The pretax gain was $31 million ($26 million, net of tax). Remaining open issues are not expected to materially impact the amount of the gain. As a result of the sale, Consumers anticipates its after-tax earnings will decrease by $15 million in 2003, and decrease by approximately $14 million annually for the next three years due to a 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. Under an agreement with MTH, and subject to certain additional RTO surcharges, transmission rates charged to Consumers are fixed by contract at current levels through December 31, 2005, and subject to FERC ratemaking thereafter. MTH has completed 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 until May 1, 2007 under a contract with MTH. CE-47 Consumers Energy Company AUGUST 14, 2003 BLACKOUT: On August 14, 2003, the electric transmission grid serving parts of the Midwest and the Northeast experienced a significant disturbance, which impacted electric service to millions of homes and businesses throughout a vast region. In Michigan, more than 2 million electric customers were without electricity. Consumers had five fossil-fueled generating unit outages and, of Consumers' 1.7 million electric customers, approximately 100,000 were without power for approximately 24 hours as a result of the disturbance. The impact was felt most heavily in the southeastern part of Consumers' service territory. As discussed above in "Transmission", Consumers sold its transmission system in May 2002 to MTH, with Consumers providing transmission system maintenance under a five-year contract with MTH. MTH now owns, controls, and plans for the transmission system that serves Consumers. Consumers incurred approximately $1 million of immediate financial impact as a result of the blackout. Consumers continues to cooperate with investigations of the blackout by several federal and state agencies. Consumers cannot predict the outcome of these investigations. In November 2003, the MPSC released its report on the August 14 blackout, which found no evidence to suggest that the events in Michigan or actions taken by the Michigan utilities or transmission operators were factors contributing to the cause of the blackout. As a result of its investigation, the MPSC is recommending that Congress pass legislation that would empower the FERC, where necessary, to order membership into a RTO and that Congress should provide the FERC with the authority to develop and enforce mandatory transmission reliability standards with penalties for noncompliance. 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. As it did in 2003, Consumers is currently planning for a reserve margin of approximately 11 percent for summer 2004 or supply resources equal to 111 percent of projected summer peak load. Of the 111 percent, approximately 100 percent is expected to be met from owned electric generating plants and long-term power purchase contracts and 11 percent from short-term contracts and options for physical deliveries and other agreements. The ultimate use of the reserve margin 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 October 2003, alternative electric suppliers are providing 603 MW of generation supply to ROA customers. Consumers' reserve margin does not include generation being supplied by other alternative electric suppliers under the ROA program. Currently, Consumers is required to provide backup service to ROA customers on a "best efforts" basis. In October 2003, Consumers provided notice to the MPSC that it would terminate the provision of backup service in accordance with Public Act 141, effective January 1, 2004. 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 and energy 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, 2003, Consumers purchased capacity and energy contracts partially covering the estimated reserve margin requirements for 2004 through 2007. As a result, Consumers has a recognized asset of $21 million for unexpired capacity and energy contracts. The total premium cost of electricity call option and capacity and energy contracts for 2003 is expected to be approximately $10 million. CE-48 Consumers Energy Company 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, effective 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. On September 30, 2003, Consumers submitted a PSCR filing to the MPSC that would reinstate the PSCR process for customers whose rates will no longer be frozen or capped as of January 1, 2004. The proposed PSCR charge allows Consumers to recover a portion of its increased power supply costs from large commercial and industrial customers effective January 1, 2004. This is the first customer class for which the rate freeze and cap expire. Consumers will, pursuant to its right under applicable law, self-implement the proposed PSCR charge on January 1, 2004, unless the MPSC issues an order before that date establishing a different charge. The charge is subject to subsequent change by the MPSC during the PSCR period (calendar-year 2004). The revenues received pursuant to the PSCR charge by statute are also subject to subsequent reconciliation when the year is finished and actual costs have been reviewed for reasonableness and prudence. Consumers cannot predict the outcome of this filing. 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. Consumers' consolidated retained earnings include undistributed earnings from the MCV Partnership, which at September 30, 2003 and 2002 are $238 million and $217 million, respectively. Summarized Statements of Income for CMS Midland and CMS Holdings
In Millions ------------------------------------------------------------------------------------------------------------------ Three Months Ended Nine Months Ended September 30 2003 2002 2003 2002 ---------------------------------------------------------------------------------------------------------------- Earnings (loss) from equity method investees $ (3) $ 8 $ 31 $ 35 Operating taxes and other (1) 2 18 11 ---------------------------------------- Income (loss) before cumulative effect of accounting change (2) 6 13 24 Cumulative effect of change in method of accounting for derivatives, net of $1 and $10 million tax expense in 2002 (a) - 1 - 18 ---------------------------------------- Net income (loss) $ (2) $ 7 $ 13 $ 42 ================================================================================================================
CE-49 Consumer Energy Company Summarized Statements of Income for the MCV Partnership
In Millions Three Months Ended Nine Months Ended September 30 2003 2002 2003 2002 ------------------------------------------------------------------------------------------------------------------- Operating revenue $148 $156 $443 $451 Operating expenses 138 120 322 318 ------------------------------------------- Operating income 10 36 121 133 Other expense, net 25 27 82 86 ------------------------------------------- Income (loss) before cumulative effect of accounting change (15) 9 39 47 Cumulative effect of change in method of accounting for derivative option contracts (a) - - - 58 ------------------------------------------- Net income (loss) $(15) $ 9 $ 39 $ 105 ===================================================================================================================
(a) On April 1, 2002, the MCV Partnership implemented Derivative Implementation Group Issue C-16, an interpretation of SFAS No. 133. The MCV Partnership began accounting for several natural gas contracts containing an option component at fair value. As a result, a cumulative effect adjustment for the change in accounting principle was recorded as an increase to earnings. Power Supply Purchases from the MCV Partnership - Consumers' annual obligation to purchase capacity from the MCV Partnership is 1,240 MW through the term of the PPA ending 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 and a fixed energy charge, and also to pay 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. Recovery of both the 915 MW and 325 MW portions of the PPA are subject to certain limitations discussed below. After September 2007, the PPA's regulatory out 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 and established a PPA liability for the present value of the estimated future underrecoveries of power supply costs under the PPA based on MPSC cost recovery orders. Primarily as a result of the MCV Facility's actual availability being greater than management's original estimates, the PPA liability has been reduced at a faster rate than originally anticipated. The remaining estimated future PPA liability associated with the loss totaled $34 million at September 30, 2003 and $59 million at September 30, 2002. The PPA liability is expected to be depleted in late 2004. 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 a settlement agreement effective January 1, 1999, that addressed, among other things, the ability of the MCV Partnership to count modifications increasing the capacity of the existing MCV Facility for purposes of computing the availability of contract capacity under the PPA for billing purposes. That settlement agreement capped payments made on the basis of availability that may be billed by the MCV Partnership at a maximum 98.5 percent availability level. CE-50 Consumers Energy Company Under Michigan's electric restructuring law, Consumers will return to unfrozen rates for large industrial customers beginning January 1, 2004, including the resumption of the PSCR process. Under the process, Consumers will recover from customers capacity and fixed energy charges on the basis of availability, to the extent that availability does not exceed 88.7 percent availability established in previous MPSC orders. Recovery of capacity and fixed energy charges will be subject to certain rate caps as discussed in Note 2, Uncertainties, "Electric Rate Matters - Electric Restructuring." For capacity and energy payments billed by the MCV Partnership after September 15, 2007, and not recovered from customers, Consumers would expect to claim a regulatory out under the PPA. The regulatory out provision relieves Consumers of the obligation to pay more for capacity and energy payments than the MPSC allows Consumers to collect from its customers. Consumers estimates that 51 percent of the actual cash underrecoveries for the years 2003 and 2004 will be charged to the PPA liability, with the remaining portion charged to operating expense as a result of Consumers' 49 percent ownership in the MCV Partnership. All cash underrecoveries will be expensed directly to income once the PPA liability is depleted. If the MCV Facility's generating availability remains at the maximum 98.5 percent level, Consumers' cash underrecoveries associated with the PPA could be as follows:
In Millions ---------------------------------------------------------------------------------------------- 2003 2004 2005 2006 2007 ---------------------------------------------------------------------------------------------- Estimated cash underrecoveries at 98.5% (a) $ 57 $ 56 $ 56 $ 55 $ 39 Amount to be charged to operating expense $ 28 $ 27 $ 56 $ 55 $ 39 Amount to be charged to PPA liability $ 29 $ 29 $ - $ - $ - ==============================================================================================
(a) For the nine months ended September 30, 2003, Consumers' cash underrecoveries associated with the PPA were $43 million. As previously noted, until September 2007, the PPA and settlement require Consumers to pay capacity costs based on the MCV Facility's actual availability up to the 98.5 percent cap. After September 2007, Consumers expects to exercise the "regulatory out" clause in the PPA, limiting its capacity payments to the MCV Partnership to the amount collected from its customers. Depending on the MPSC's future actions with respect to the capacity payments recoverable from its customers subsequent to September 2007, the earnings of the MCV Partnership and the value of Consumers' equity interest in the MCV Partnership, may be affected negatively. Further, under the PPA, energy payments to the MCV Partnership are based on the cost of coal burned at Consumers' coal plants and costs associated with fuel inventory, operations and maintenance, and administrative and general expenses associated with Consumers' coal plants. However, the MCV Partnership's costs of producing electricity are tied, in large part, to the cost of natural gas. Because natural gas prices have increased substantially in recent years, while energy charge payments to the MCV Partnership have not, the MCV Partnership's financial performance has been impacted negatively. As of January 1, 2004, Consumers intends to return to forced (uneconomic) dispatch of the MCV Facility in order to maximize recovery of its capacity payments. As such, if the spread between MCV Facility's variable electricity production costs and its energy payment revenues stays constant or widens, the negative impacts on MCV Partnership's financial performance, and on the value of Consumers' equity interest in the MCV Partnership, will be worse. Consumers cannot estimate, at this time, the impact of these issues on its future earnings or cash flow from its interest in the MCV Partnership. The forward price of natural gas for the next 22 years and the MPSC decision in 2007 or later related to Consumers' recovery of capacity payments are the two most significant variables in CE-51 Consumers Energy Company the analysis of MCV Partnership's future financial performance. Natural gas prices have historically been volatile and presently there is no consensus in the marketplace on the price or range of prices of natural gas beyond the next five years. Further, it is not presently possible for Consumers to predict the actions of the MPSC in 2007 or later. For these reasons, at this time Consumers cannot predict the impact of these issues on its future earnings, cash flows, or on the value of its $404 million equity interest in the MCV Partnership. Consumers is exploring possible alternatives for utilizing the MCV Facility without increasing costs to customers. Any changes regarding the recovery of MCV capacity costs would require MPSC approval. Consumers cannot predict the outcome of this matter. 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 PURPA. In July 1999, the district court granted MCV Partnership's motion for summary judgment. The district 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. NUCLEAR MATTERS: Significant progress continues to be made in the decommissioning of Big Rock. Following the successful loading of spent fuel into dry storage (see below under "Spent Nuclear Fuel Storage"), the spent fuel storage racks were removed and disposed of and the spent fuel pool cleaned and drained. The reactor vessel closure head was shipped for disposal in May 2003 and in August 2003, the reactor vessel was moved from the plant and sealed into a specially designed shipping container. In October 2003, the shipping container was transported to the licensed disposal facility in Barnwell, South Carolina. The License Termination Plan was submitted to the NRC staff for review in April 2003. System dismantlement and building demolition continue on a schedule to return the 560-acre site to a natural setting for unrestricted use in early 2006. The NRC and Michigan Department of Environmental Quality continue to find that all decommissioning activities at Big Rock are being performed in accordance with applicable regulatory and license requirements. In July 2003, the NRC completed its mid-cycle plant performance assessment of Palisades. The mid-cycle review for Palisades covered the period from January 1, 2003 through the end of July 2003. The NRC determined that Palisades was operated in a manner that preserved public health and safety and fully met all cornerstone objectives. Based on the plant's performance, only regularly scheduled inspections are planned through September 2004. Spent Nuclear Fuel Storage: During the fourth quarter of 2002, equipment fabrication, assembly and testing was completed at Big Rock on NRC-approved transportable steel and concrete canisters or vaults, commonly known as "dry casks." Spent fuel was then loaded into the dry casks from the fuel pool and transported to the temporary onsite storage pad. A total of seven dry casks have been loaded with spent fuel. An additional eighth cask, containing high-level radioactive waste material, was also loaded. This radioactive material was made up of reactor vessel components that could not be shipped or stored with the reactor vessel. These transportable dry casks will remain onsite until the DOE moves the material to a national fuel repository. At Palisades, the amount of spent nuclear fuel discharged from the reactor to date exceeds Palisades' temporary onsite storage pool capacity. Consequently, Consumers is using dry casks for temporary onsite storage. As of September 30, 2003, Consumers had loaded 18 dry casks with spent nuclear fuel at Palisades. Palisades will CE-52 Consumers Energy Company 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 onsite, 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. As of September 30, 2003, Consumers has a recorded liability to the DOE of $139 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 the interest. In 1997, a U.S. Court of Appeals decision confirmed that the DOE was to begin accepting deliveries of spent nuclear fuel for disposal by January 31, 1998. Subsequent U.S. Court of Appeals 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 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, including Consumers, which filed its complaint in December 2002, have commenced litigation in the Court of Claims. The Chief Judge of the Court of Claims identified six lead cases to be used as vehicles for resolving dispositive motions. Consumers' case is not a lead case. It is unclear what impact this decision by the Chief Judge will have on the outcome of Consumers' litigation. If the litigation that was commenced in the fourth quarter of 2002 against the DOE is successful, Consumers anticipates future recoveries from the DOE to defray the significant costs it will incur for the storage of spent fuel until the DOE takes possession as required by law. However, there is no assurance that the litigation against the DOE will be successful. 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. In March 2003, the Michigan Environmental Council, the Public Interest Research Group in Michigan, and the Michigan Consumer Federation submitted a complaint to the MPSC, which was served on Consumers by the MPSC in April 2003. The complaint asks the MPSC to commence a generic investigation and contested case to review all facts and issues concerning costs associated with spent nuclear fuel storage and disposal. The complaint seeks a variety of relief with respect to Consumers, Detroit Edison, Indiana & Michigan Electric Company, Wisconsin Electric Power Company and Wisconsin Public Service Corporation, including establishing external trusts to which amounts collected in electric rates for spent nuclear fuel storage and disposal should be transferred, and the adoption of additional measures related to the storage and disposal of spent nuclear fuel. In May 2003, Consumers and the other named utilities each filed a motion to dismiss the complaint. Consumers is unable to predict the outcome of this matter. Palisades Plant Operations: In March 2002, corrosion problems were discovered in the reactor head at an unaffiliated nuclear power plant in Ohio. As a result, the NRC requested that all United States nuclear plants utilizing pressurized water reactors provide reports detailing their reactor head inspection histories, design capabilities and future inspection plans. In response to the issues identified at this and other nuclear plants worldwide, a bare metal visual inspection was completed on the Palisades reactor vessel head during the spring 2003 refueling outage. No indication of leakage was detected on any of the 54 penetrations of the reactor head. Consumers will continue to comply with the more aggressive reactor head inspection requirements in future CE-53 Consumers Energy Company planned outages at Palisades. Insurance: Consumers maintains primary and excess nuclear property insurance from NEIL, totaling $2.750 billion in recoverable limits for the Palisades nuclear plant. Consumers also procures coverage from NEIL that would partially cover the cost of replacement power during certain prolonged accidental outages at Palisades. NEIL's policies include coverage for acts of terrorism. Consumers retains the risk of loss to the extent of the insurance deductibles and to the extent that its loss exceeds its policy limits. Because NEIL is a mutual insurance company, Consumers could be subject to assessments from NEIL up to $26 million in any policy year if insured losses in excess of NEIL's maximum policyholders surplus occur at its, or any other member's, nuclear facility. Consumers maintains nuclear liability insurance for injuries and off-site property damage resulting from the nuclear hazard at Palisades for up to approximately $10.862 billion, the maximum insurance liability limits established by the Price-Anderson Act. Congress enacted the Price-Anderson Act to provide financial protection for persons who may be liable for a nuclear accident or incident and persons who may be injured by a nuclear incident. The Price-Anderson Act was extended to December 31, 2003. Part of the Price-Anderson Act's financial protection consists of a mandatory industry-wide program under which owners of nuclear generating facilities could be assessed if a nuclear incident occurs at any of such facilities. The maximum assessment against Consumers could be $101 million per occurrence, limited to maximum annual installment payments of $10 million. Consumers also maintains insurance under a master worker program that covers tort claims for bodily injury to workers caused by nuclear hazards. The policy contains a $300 million nuclear industry aggregate limit. Under a previous insurance program providing coverage for claims brought by nuclear workers, Consumers remains responsible for a maximum assessment of up to $6 million. The Big Rock plant remains insured for nuclear liability by a combination of insurance and United States government indemnity totaling $544 million. Insurance policy terms, limits and conditions are subject to change during the year as Consumers renews its policies. 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 resolution of environmental issues at sites as studies are completed. Consumers has estimated its costs related to investigation and remedial action for all 23 sites using the Gas Research Institute-Manufactured Gas Plant Probabilistic Cost Model. A revised cost estimate, completed in September 2003, estimated remaining costs to be between $37 million and $90 million. The range reflects multiple alternatives with various assumptions for resolving the environmental issues at each site. The estimates are based on discounted 2003 costs using a discount rate of three percent. The discount rate represents a ten-year average of U.S. Treasury bond rates reduced for increases in the consumer price index. Consumers expects to fund a significant portion of these costs through insurance proceeds and through MPSC approved rates charged to its customers. As of September 30, 2003, Consumers has an accrued liability of $47 million, net of $35 million of expenditures incurred to date, and a regulatory asset of $68 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. CE-54 Consumers Energy Company The MPSC, in its November 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 COST RECOVERY: As part of the on-going GCR process, which includes an annual reconciliation case with the MPSC, Consumers expects to recover all of its gas costs. In June 2003, Consumers filed a reconciliation of GCR costs and revenues for the 12-months ended March 2003. Consumers proposes to recover from its customers a net under-recovery of approximately $6 million using a roll-in methodology. The roll-in methodology incorporates the under-recovery in the GCR factor charged in the next GCR year. The roll-in tariff provision was approved by the MPSC in a November 2002 order. In July 2003, the MPSC approved a settlement agreement authorizing Consumers to increase its gas cost recovery factor for the remainder of the current GCR plan year (August 2003 through March 2004) and to implement a quarterly ceiling price adjustment mechanism, based on a formula that tracks changes in NYMEX natural gas prices. Consistent with the terms of the settlement, the ceiling price is $6.11 per mcf. However, Consumers will utilize a GCR factor of $5.41 per mcf commencing in November 2003 bills. All recoveries pursuant to such factors are subject to final reconciliation by the MPSC. 2003 GAS RATE CASE: In March 2003, Consumers filed an application with the MPSC seeking a $156 million increase in its gas delivery and transportation rates, which included a 13.5 percent return on equity, based on a 2004 test year. Contemporaneously with this filing, Consumers requested interim rate relief in the same amount. In August 2003, the MPSC Staff recommended interim rate relief of $80 million be granted in this proceeding, subject to Consumers voluntarily agreeing to limit its dividends to its parent, CMS Energy, to a maximum of $190 million in any calendar year. In September 2003, Consumers filed an update to its gas rate case that lowered the requested revenue increase from $156 million to $139 million and revised the return on common equity from 13.5 percent to 12.75 percent. The majority of the reduction is related to lower debt costs and changes in the projected capital structure. The MPSC Staff and ABATE filed their cases in early October. The Staff made no change to its interim position of $80 million and continued to propose the same dividend limitation. ABATE did not make a specific recommendation for a final rate increase, but did discuss the rate design used to recover any rate increase granted. A proposal for decision is expected from the administrative law judge in January 2004. OTHER UNCERTAINTIES SECURITY COSTS: Since the September 11, 2001 terrorist attacks in the United States, Consumers has increased security at all critical facilities and over its critical 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. Through September 30, 2003, Consumers has incurred approximately $7 million in incremental security costs, including operating, capital, and decommissioning and removal costs, mainly relating to its nuclear facilities. Consumers estimates it may incur additional incremental security costs for the last three months of 2003 of approximately $3 million, of which $2 million relates to nuclear security costs. Consumers will attempt to seek recovery of these costs from its customers. In December 2002, the Michigan legislature passed, and the governor signed, a bill that would allow Consumers to seek recovery of additional nuclear electric division security costs incurred during the rate freeze and cap periods imposed by the Customer CE-55 Consumers Energy Company Choice Act. In February 2003, the MPSC adopted filing requirements for the recovery of enhanced security costs. DERIVATIVE ACTIVITIES: Consumers may use a variety of contracts to protect against commodity price and interest rate risk. Some of these contracts may be subject to derivative accounting, which requires that the value of the contracts be adjusted to fair value through earnings or equity depending upon certain criteria. Such adjustments to fair value could cause earnings volatility. For further information about derivative activities, see Note 4, Financial and Derivative Instruments. OTHER: 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. 3: FINANCINGS AND CAPITALIZATION REGULATORY AUTHORIZATION FOR FINANCINGS: At September 30, 2003, Consumers had FERC authorization, through June 2004, to issue or guarantee up to $1.1 billion of short-term securities outstanding at any one time. As of September 30, 2003, Consumers had $400 million outstanding as collateral for the revolving credit facility (discussed below) and had an additional $700 million available for future issuances of short-term securities. At September 30, 2003, Consumers also had remaining FERC authorization, through June 2004, to issue up to $800 million of long-term securities for refinancing or refunding purposes, $560.3 million of long-term securities for general corporate purposes, and $2.06 billion of long-term first mortgage bonds to be issued solely as collateral for other long-term securities. Also, FERC has granted waivers of its competitive bid/negotiated placement requirements applicable to the long-term securities authorization indicated above. SHORT-TERM FINANCINGS: In March 2003, Consumers obtained a replacement revolving credit facility in the amount of $250 million secured by first mortgage bonds. In September 2003, this facility was amended and restated as a $400 million revolving credit facility. The interest rate of the facility was reduced from LIBOR plus 350 to LIBOR plus 175 basis points. The new credit facility matures in March 2004 with two annual extensions at Consumers' option, which would extend the maturity to March 2006. At September 30, 2003, all of the $400 million is available for general corporate purposes. At September 30, 2003, a total of $4 million was outstanding on all short-term financings at a weighted average interest rate of 2.79 percent, compared with $235 million outstanding at September 30, 2002 at a weighted average interest rate of 3.7 percent. CE-56 Consumers Energy Company LONG-TERM DEBT: The following is a summary of Consumers' Long-Term Debt as of September 30, 2003 and December 31, 2002:
In Millions ----------------------------------------------------------------------------------------------------------- September 30 December 31 Interest Rate (%) Maturity 2003 2002 ----------------------------------------------------------------------------------------------------------- Senior Notes 6.000 2005 $ 300 $ 300 6.250 2006 332 332 6.375 2008 159 159 6.200(a) 2008 - 250 6.875 2018 180 180 6.500(b) 2018 141 141 6.500(c) 2028 142 142 --------------------------- 1,254 1,504 --------------------------- Securitization Bonds 5.075(d) 2005-2015 434 453 First Mortgage Bonds 5.240(d) 2008-2023 1,482 208 Long-Term Bank Debt Floating 2009 140 328 Nuclear Fuel Disposal Liability (e) 139 138 Pollution Control Revenue Bonds Various 2010-2018 126 126 Other 6 8 --------------------------- 2,327 1,261 --------------------------- Principal Amount Outstanding 3,581 2,765 Current Amounts (28) (305) Net Unamortized Discount (22) (18) --------------------------- Total Long-Term Debt $ 3,531 $2,442 ===========================================================================================================
(a) These notes were subject to a call option by the callholder or a mandatory put on May 1, 2003. (b) Senior remarketed notes subject to optional redemption by Consumers after June 15, 2005. (c) Callable at par on or after October 1, 2003. (d) Represents the weighted average interest rate at September 30, 2003. (e) Maturity date uncertain. FIRST MORTGAGE BONDS: In April 2003, Consumers sold $625 million principal amount of first mortgage bonds in a private offering to institutional investors; $250 million were issued at an interest rate of 4.25 percent, maturing in April 2008, and net proceeds were approximately $248 million; $375 million were issued at an interest rate 5.375 percent, maturing in April 2013, and net proceeds were approximately $371 million. Consumers used the net proceeds to replace a $250 million senior reset put bond that matured in May 2003, to pay an associated $32 million option call payment, and for general corporate purposes that included paying down additional debt. The $32 million option call payment was deferred and is being amortized to interest expense over the term of the replacement debt in accordance with SFAS No. 71. Consumers agreed to file a registration statement with the SEC by December 26, 2003 to permit holders of the first mortgage bonds to exchange the bonds for new bonds that will be registered under the Securities Act of 1933. CE-57 Consumers Energy Company In May 2003, Consumers sold $250 million principal amount of first mortgage bonds in a private offering to institutional investors; the bonds were issued at an interest rate of 4.00 percent, maturing May 2010, and net proceeds were approximately $247 million. Consumers used the net proceeds to pay down existing debt. Consumers agreed to file a registration statement with the SEC by December 26, 2003 to permit holders of the first mortgage bonds to exchange the bonds for new bonds that will be registered under the Securities Act of 1933. In August 2003, Consumers sold $400 million principal amount of first mortgage bonds in a private offering to institutional investors; $200 million were issued at an interest rate of 4.80 percent, maturing in February 2009, and net proceeds were approximately $198 million and $200 million were issued at an interest rate of 6.00 percent, maturing in February 2014, and net proceeds were approximately $198 million. Consumers used the net proceeds to pay down existing debt and for general corporate purposes. Consumers agreed to file a registration statement with the SEC by April 14, 2004 to permit holders of the first mortgage bonds to exchange the bonds for new bonds that will be registered under the Securities Act of 1933. SENIOR NOTES: In March 2003, Consumers entered into a $140 million term loan secured by first mortgage bonds with a private investor bank. This loan has a term of six years at a cost of LIBOR plus 475 basis points. Proceeds from this loan were used for general corporate purposes. In March 2003, Consumers entered into a $150 million term loan secured by first mortgage bonds. This term loan had a three-year maturity expiring in March 2006. This term loan was paid in full with the proceeds of first mortgage bonds issued in August 2003. COMPANY-OBLIGATED 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. In each case, the primary asset of the trust 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 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, 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. For further information, see Note 5, Implementation of New Accounting Standards.
In Millions ------------------------------------------------------------------------------------------------------ Amount Earliest Trust and Securities Rate Outstanding Maturity Redemption ------------------------------------------------------------------------------------------------------ September 30 2003 2002 ------------------------------------------------------------------------------------------------------ Consumers Power Company Financing I, Trust Originated Preferred Securities (a) 8.36% $ 70 $ 70 2015 2000 Consumers Energy Company Financing II, Trust Originated Preferred Securities (a) 8.20% 120 120 2027 2002 Consumers Energy Company Financing III, Trust Originated Preferred Securities (b) 9.25% 175 175 2029 2004 Consumers Energy Company Financing IV, Trust Preferred Securities (c) 9.00% 125 125 2031 2006 ------------ Total Amount Outstanding $ 490 $490 ======================================================================================================
CE-58 Consumers Energy Company (a) Consumers can currently redeem these securities at par value. (b) Consumers cannot redeem these securities until 2004. If Consumers were to redeem these securities as of September 30, 2003, they would be required to pay market value, which is approximately $180 million. (c) Consumers cannot redeem these securities until 2006. If Consumers were to redeem these securities, as of September 30, 2003, they would be required to pay market value, which is approximately $128 million. REQUIRED RATIOS: The revolving credit facility has contractual restrictions that require Consumers to maintain, as of the last day of each fiscal quarter, the following:
Limitation Ratio at September 30, 2003 ==================================================================================================================== Debt to Capital Ratio (a)(b) Not more than 0.65 to 1.00 0.58 to 1.00 Interest Coverage Ratio - Revolver (a) Not less than 2.00 to 1.00 3.34 to 1.00 ====================================================================================================================
(a) Violation of this ratio would constitute an event of default under the facility that provides the lender, among other remedies, the right to declare the principal and interest immediately due and payable. (b) The terms of the credit facility provide for the exclusion of securitization bonds in the calculation of the debt to capital ratio. Consumers is subject to covenants in its financing agreements that could limit its ability to incur additional indebtedness. Consumers has agreed in several of its financing agreements to maintain specified levels of cash coverage of its interest requirements and to not allow its indebtedness to exceed specified levels of its consolidated capitalization (the "Debt Percentage Tests"). Consumers is in compliance with these requirements as of the most recent measurement date, September 30, 2003. These covenants make use of both generally accepted accounting principles and defined contractual terms in specifying how the relevant calculations are made. Consumers sought and received amendments to certain of its relevant financing agreements to modify the terms of the Debt Percentage Tests in order to, among other things, remove the effect of the adoption of SFAS No. 150, portions of which have now been deferred indefinitely, regarding Trust Preferred Securities on the calculations. OTHER: Under a revolving accounts receivable sales program, Consumers currently sells certain accounts receivable to a wholly owned, consolidated, bankruptcy remote special purpose entity, Consumers Receivables Funding II. In turn, Consumers Receivables Funding II may sell an undivided interest in up to $325 million of the receivables to a bank-sponsored commercial paper conduit. The amount sold to the conduit was $254 million at September 30, 2003 and $325 million at September 30, 2002. These amounts are excluded from accounts receivable in Consumers' consolidated balance sheets. Consumers continues to service the receivables sold, however, the purchaser of the receivables has no recourse against Consumers' other assets for failure of a debtor to pay when due and the purchaser has no right to any receivables not sold. No gain or loss has been recorded on the receivables sold and Consumers retains no interest in the receivables sold. CE-59 Consumers Energy Company Certain cash flows received from and paid to Consumers under its accounts receivable sales program are shown below:
In Millions -------------------------------------------------------------------------------------------------- Three Months Ended Nine Months Ended September 30 2003 2002 2003 2002 -------------------------------------------------------------------------------------------------- Proceeds from sales (remittance of collections) under the program $ 204 $ 14 $ (71) $ (9) Collections reinvested under the program 920 918 3,379 3,141 ==================================================================================================
DIVIDEND RESTRICTIONS: Under the provisions of its articles of incorporation, Consumers had $412 million of unrestricted retained earnings available to pay common dividends at September 30, 2003. However, covenants in Consumers' debt facilities cap common stock dividend payments at $300 million in a calendar year. Through September 30, 2003, Consumers paid $162 million in common dividends. In October 2003, Consumers declared a $57 million common dividend payable in November 2003. For information on the potential cap on common dividends payable included in the MPSC Securitization order see Note 2, Uncertainties, Electric Rate Matters, "Securitization." Also, for information on the potential cap on common dividends payable included in the MPSC Staff's recommendation in Consumers' gas rate case see Note 2, Uncertainties, "Gas Rate Matters - 2003 Gas Rate Case." FASB INTERPRETATION NO. 45, GUARANTOR'S ACCOUNTING AND DISCLOSURE REQUIREMENT FOR GUARANTEES, INCLUDING INDIRECT GUARANTEES OF INDEBTEDNESS OF OTHERS: Effective January 2003, this interpretation elaborates on the disclosure to be made by a guarantor about its obligations under certain guarantees that it has issued. It also requires that a guarantor recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial recognition and measurement provision of this interpretation does not apply to certain guarantee contracts, such as warranties, derivatives, or guarantees between either parent and subsidiaries or corporations under common control, although disclosure of such guarantees is required. For contracts that are within the initial recognition and measurement provision of this interpretation, the provisions are to be applied to guarantees issued or modified after December 31, 2002; no cumulative effect adjustments are required. Following is a general description of Consumers' guarantees as required by this Interpretation:
September 30, 2003 In Millions ------------------------------------------------------------------------------------------------------------- Expiration Maximum Carrying Recourse Guarantee Description Issue Date Date Obligation Amount Provision(a) ------------------------------------------------------------------------------------------------------------- Standby letters of credit Various Various $ 7 $ - $ - Surety bonds Various Various 8 - - Nuclear insurance retrospective premiums Various Various 133 - - =============================================================================================================
(a) Recourse provision indicates the approximate recovery from third parties including assets held as collateral. CE-60 Consumers Energy Company Following is additional information regarding Consumers' guarantees:
September 30, 2003 ------------------------------------------------------------------------------------------------------------------ Events That Would Require Guarantee Description How Guarantee Arose Performance ------------------------------------------------------------------------------------------------------------------ Standby letters of credit Normal operations of coal power plants Noncompliance with environmental regulations Self-insurance requirement Nonperformance Surety bonds Normal operating activity, permits and Nonperformance license Nuclear insurance retrospective Normal operations of nuclear plants Call by NEIL and Price Anderson premiums Act for nuclear incident ==================================================================================================================
4: FINANCIAL AND DERIVATIVE INSTRUMENTS FINANCIAL INSTRUMENTS: The carrying amounts of cash, short-term investments and current liabilities approximate their fair values due to their short-term nature. Consumers estimates the fair values of long-term investments based on quoted market prices or, in the absence of specific market prices, on quoted market prices of similar investments or other valuation techniques. The carrying amounts of all long-term financial instruments, except as shown below, approximate fair value. For held-to-maturity securities and related-party financial instruments, see Note 1.
In Millions -------------------------------------------------------------------------------------------------------------------------- September 30 2003 2002 -------------------------------------------------------------------------------------------------------------------------- Cost Fair Unrealized Cost Fair Unrealized Value Gain (Loss) Value Gain (Loss) -------------------------------------------------------------------------------------------------------------------------- Long-Term Debt (a) $3,531 $3,633 $ (102) $2,701 $2,694 $ 7 Trust Preferred Securities 490 497 (7) 490 439 51 Preferred Stock 44 33 11 44 23 21 Available for sale securities: Common stock of CMS Energy (b) 10 17 7 35 19 (16) SERP 17 20 3 18 19 1 Nuclear decommissioning investments (c) 450 553 103 464 530 66 ==========================================================================================================================
(a) Settlement of long-term debt is generally not expected until maturity. (b) Consumers recognized a $12 million loss on this investment in 2002 and an additional $12 million loss in the first quarter of 2003 because the loss was other than temporary, as the fair value was below the cost basis for a period greater than six months. As of September 30, 2003, Consumers held 2.4 million shares of CMS Energy Common Stock. (c) On January 1, 2003, Consumers adopted SFAS No. 143 and began classifying its unrealized gains and losses on nuclear decommissioning investments as regulatory liabilities. Consumers previously classified these investments in accumulated depreciation. CE-61 Consumers Energy Company 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 certain business unit managers. Established policies and procedures are used to manage the risks associated with market fluctuations. Consumers may use 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. When management uses these instruments, it intends that an opposite movement in the value of the at-risk item would offset any losses incurred on the contracts. Consumers enters into all risk management contracts 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. 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. 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 accumulated 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 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 uses a combination of quoted market prices and mathematical valuation models to determine fair value of those contracts requiring derivative accounting. The ineffective portion, if any, of all hedges is recognized in earnings. The majority of Consumers' 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. CE-62 Consumers Energy Company The following table reflects the fair value of contracts requiring derivative accounting:
In Millions ----------------------------------------------------------------------------------------- September 30 2003 2002 ----------------------------------------------------------------------------------------- Fair Fair Derivative Instruments Cost Value Cost Value ----------------------------------------------------------------------------------------- Electric - related contracts $ - $ - $ 8 $ 1 Gas contracts 3 - - 1 Interest rate risk contracts - - - (2) Derivative contracts associated with Consumers' equity investment in the MCV Partnership - 10 - 7 =========================================================================================
The fair value of all derivative contracts, except the fair value of derivative contracts associated with Consumers' equity investment in the MCV Partnership, is included in either Other Assets or Other Liabilities on the Balance Sheet. The fair value of derivative contracts associated with Consumers' equity investment in the MCV Partnership is included in Investments - Midland Cogeneration Venture Limited Partnership on the Balance Sheet. Effective April 1, 2002, the MCV Partnership changed its accounting for derivatives, see Note 2, Uncertainties, Other Electric Uncertainties, The Midland Cogeneration Venture. ELECTRIC CONTRACTS: 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. As of September 30, 2003, Consumers did not have any unexpired purchased electric call option contracts subject to derivative accounting. All remaining purchased electric call option contracts subject to derivative accounting as of June 2003, expired in the third quarter of 2003. 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 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. Consumers' electric business also uses gas option and 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 contracts are financial contracts that are used to offset increases in the price of potential 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. As of September 30, 2003, gas fuel for generation call option contracts entered into in the second quarter of 2003 had expired. As of September 30, 2002, gas fuel for generation swap contracts had a fair value of less than $1 million. These contracts expired in December 2002. For the three months ended September 30, 2003, Consumers recorded an unrealized loss in accumulated other comprehensive income related to its proportionate share of the effects of derivative accounting related to its equity investment in the MCV Partnership of $5 million, net of tax. For the nine months ended September 30, 2003, Consumers recorded an unrealized gain in accumulated other comprehensive income related to its proportionate share of the effects of derivative accounting related to its equity investment in the MCV Partnership of $8 million, net of tax. As of September 30, 2003, the cumulative total of unrealized gains recorded in other accumulated comprehensive income related to Consumers' proportionate share of the effects CE-63 Consumers Energy Company of derivative accounting related to its equity investment in the MCV Partnership is $6 million, net of tax. Consumers expects to reclassify this gain, if this value remains, as an increase to earnings from equity method investees during the next 12 months. GAS CONTRACTS: Consumers' gas business uses fixed price gas supply contracts, and fixed price weather-based gas supply call options and fixed price gas supply call and put options, and other types of contracts, to meet its regulatory obligation to provide gas to its customers at a reasonable and prudent cost. As of September 30, 2003, weather-based gas call options and gas call and put options requiring derivative accounting had a net fair value that was less than $1 million. The original cost of the options was a net $3 million. Consumers recorded an unrealized loss of $3 million associated with these options directly in earnings as part of other income, and then directly offset this loss and recorded it on the balance sheet as a regulatory asset. Any subsequent changes in fair value will be recorded in a similar manner. As of September 30, 2002, Consumers' gas supply contracts and weather-based gas call options and gas put options requiring derivative accounting had a fair value of $1 million, representing a fair value gain on the contracts since the date of inception. Changes in fair value were recorded in a similar manner as stated above for weather-based gas call options and gas call and put options. INTEREST RATE RISK CONTRACTS: 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 records any change in the fair value of these contracts in accumulated other comprehensive income unless the swaps are sold. As of September 30, 2003, Consumers did not have any interest rate swaps outstanding. 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 expired in June 2003. As of September 30, 2002, this interest rate swap had a negative fair value of $2 million. Consumers was able to apply the shortcut method to all interest rate hedges; therefore, there was no ineffectiveness associated with these hedges. 5: IMPLEMENTATION OF NEW ACCOUNTING STANDARDS SFAS NO. 143, ACCOUNTING FOR ASSET RETIREMENT OBLIGATIONS: Beginning January 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. Consumers has determined that it has legal asset retirement obligations, particularly in regard to its nuclear plants. Prior to adoption of SFAS No. 143, Consumers classified the removal cost liability of assets included in the scope of SFAS No. 143 as part of the reserve for accumulated depreciation. For these assets, the removal cost of $448 million which was classified as part of the reserve at December 31, 2002, was reclassified in January 2003, in part, as: 1) a $364 million ARO liability; 2) a $134 million regulatory liability; 3) a $42 million regulatory asset; and 4) a $7 million net increase to property, plant, and equipment as prescribed by SFAS No. 143. As required by SFAS No. 71 for regulated entities, Consumers is reflecting a regulatory asset and liability instead of a cumulative effect of a change in accounting principle. The fair value of ARO liabilities has been calculated using an expected present value technique. This technique reflects assumptions, such as costs, inflation, and profit margin that third parties would consider in order to take on the settlement of the obligation. Fair value, to the extent possible, should include a market risk premium for unforeseeable circumstances. No market risk premium was included in Consumers' ARO fair value estimate since a reasonable estimate could not be made. If a five percent market risk premium were assumed, Consumers' ARO liability would be $381 million. CE-64 Consumers Energy Company If a reasonable estimate of fair value cannot be made in the period the asset retirement obligation is incurred, such as assets with an indeterminate life, the liability is to be recognized when a reasonable estimate of fair value can be made. Generally, transmission and distribution assets have an indeterminate life, retirement cash flows cannot be determined and there is a low probability of a retirement date, therefore no liability has been recorded for these assets. No liability has been recorded for assets that have an insignificant cumulative disposal cost, such as substation batteries. The initial measurement of the ARO liability for Consumers' Palisades Nuclear Plant and Big Rock Nuclear Plant is based on decommissioning studies, which are based largely on third party cost estimates. The following table is a general description of the AROs and their associated long-lived assets.
September 30, 2003 In Millions -------------------------------------------------------------------------------------------------------------------- In Service Trust ARO Description Date Long Lived Assets Fund -------------------------------------------------------------------------------------------------------------------- Palisades - decommission plant site 1972 Palisades nuclear plant $ 462 Big Rock - decommission plant site 1962 Big Rock nuclear plant 90 JHCampbell intake/discharge water line 1980 Plant intake/discharge water line Closure of coal ash disposal areas Various Generating plants coal ash areas Closure of wells at gas storage fields Various Gas storage fields Indoor gas services equipment relocations Various Gas meters located inside structures ====================================================================================================================
The following table is a reconciliation of the carrying amount of the AROs.
September 30, 2003 In Millions -------------------------------------------------------------------------------------------------------------------- Pro forma ARO Liability ARO ARO liability --------------------------- Cash flow liability ARO 1/1/02 1/1/03 Incurred Settled Accretion Revisions 9/30/03 --------------------------------------------------------------------------------------------------------------------- Palisades - decommission $ 232 $ 249 $ - $ - $ 14 $ - $ 263 Big Rock - decommission 94 61 - (28) 10 - 43 JHCampbell intake line - - - - - - - Coal ash disposal areas 46 51 - (2) 4 - 53 Wells at gas storage fields 2 2 - - - - 2 Indoor gas services relocations 1 1 - - - - 1 --------------------------------------------------------------------------- Total $ 375 $ 364 $ - $ (30) $ 28 $ - $ 362 ==================================================================================================================
SFAS NO. 149, AMENDMENT OF STATEMENT 133 ON DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES: Issued by the FASB in April 2003, this statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities. This statement is effective for contracts entered into or modified after June 30, 2003. Implementation of this statement has not had an impact on Consumers' Consolidated Financial Statements. CE-65 Consumers Energy Company SFAS NO. 150, ACCOUNTING FOR CERTAIN FINANCIAL INSTRUMENTS WITH CHARACTERISTICS OF BOTH LIABILITIES AND EQUITY: Issued by the FASB in May 2003, this statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. The statement requires an issuer to classify financial instruments within its scope as liabilities. Those instruments were previously classified as mezzanine equity. SFAS No. 150 became effective July 1, 2003. Consumers has four trust preferred securities outstanding as of September 30, 2003. The trust preferred securities are issued by consolidated subsidiaries of Consumers. Each trust holds a subordinated debenture from Consumers. The terms of the debentures are identical to those of the trust preferred securities, except that the debenture has an explicit maturity date. The trust documents, in turn, require that the trust be liquidated upon the repayment of the debenture. The trust preferred securities are redeemable upon the liquidation of the subsidiary; and therefore, are considered equity in the financial statements of the subsidiary. At their October 29, 2003 Board meeting, the FASB deferred the implementation of the portion of SFAS No. 150 relating to mandatorily redeemable noncontrolling interests in subsidiaries when the noncontrolling interests are classified as equity in the financial statements of the subsidiary. Consumers' trust preferred securities are included under the deferral. As such, the Consumers trust preferred securities continue to be accounted for under existing accounting guidance and are included in mezzanine equity. Consumers continues to study the FASB developments regarding the SFAS No. 150 deferral. EITF ISSUE NO. 01-08, DETERMINING WHETHER AN ARRANGEMENT CONTAINS A LEASE: In May 2003, the EITF reached consensus in EITF Issue No. 01-08 to clarify the requirements of identifying whether an arrangement should be accounted for as a lease at its inception. The guidance in the consensus is designed to mandate reporting revenue as rental or leasing income that otherwise would be reported as part of product sales or service revenue. EITF Issue No. 01-08 requires both parties to an arrangement to determine whether a service contract or similar arrangement is or includes a lease within the scope of SFAS No. 13, Accounting for Leases. Historically, Consumers has entered into power purchase and similar service arrangements. Prospective accounting under EITF Issue No. 01-08, could affect the timing and classification of revenue and expense recognition. Certain product sales and services revenue and expenses may be required to be reported as rental or leasing income and/or expenses. The consensus is to be applied prospectively to arrangements agreed to, modified, or acquired in business combinations in fiscal periods beginning July 1, 2003. The adoption of EITF Issue No. 01-08 has not impacted Consumers' results of operations, cash flows, or financial position. Consumers will evaluate new or modified contracts under EITF Issue No. 01-08 prospectively. NEW ACCOUNTING STANDARDS NOT YET EFFECTIVE FASB INTERPRETATION NO. 46, CONSOLIDATION OF VARIABLE INTEREST ENTITIES: Issued by the FASB in January 2003, FIN 46 requires the primary beneficiary of a variable interest entity's activities to consolidate the variable interest entity. The primary beneficiary is the party that absorbs a majority of the expected losses and/or receives a majority of the expected residual returns of the variable interest entity's activities. The consolidation requirements of the interpretation apply immediately to variable interest entities created after January 31, 2003. Consumers has not created any variable interest entities in 2003. Therefore, this portion of the interpretation has no impact on its consolidated financial statements. Public companies, whose fiscal year is a calendar year, were originally required to implement the guidance in this interpretation by the third quarter of 2003. However, on October 9, 2003, the FASB issued FASB Staff Position No. 46-6, Effective Date of FASB Interpretation No. 46, which defers implementation of FIN 46 until the fourth quarter of 2003 for variable interest entities and potential variable interest entities created before February 1, 2003. If the completed analysis were to require Consumers to disclose information about or consolidate in its financial statements, the assets, liabilities and activities of the MCV Partnership and the First Midland Limited CE-66 Consumers Energy Company Partnership, including the recognition of the debt of the MCV Partnership on its financial statements, this could impact negatively Consumers' various financial covenants under its financing agreements. As a result, Consumers may have to seek amendments to the relevant financing agreements to modify the terms of certain of these covenants in order to remove the effect of this potential consolidation or refinance the relevant debt. As of September 30, 2003, Consumers' investments in the MCV Partnership and in the FMLP were $404 million and $222 million, respectively. For further description of the nature, purpose, size and activities of the MCV Partnership, see Note 2, Uncertainties, Other Electric Uncertainties, "The Midland Cogeneration Venture." Consumers is continuing to study the implementation of this interpretation and has yet to determine the effects, if any, on its consolidated financial statements. EITF ISSUE 03-04, ACCOUNTING FOR CASH BALANCE PENSION PLANS: In May 2003, the EITF reached consensus in EITF Issue No. 03-04 to specifically address the accounting for certain cash balance pension plans. EITF Issue No. 03-04 concluded that certain cash balance plans be accounted for as defined benefit plans under SFAS No. 87, Employers' Accounting for Pensions. EITF No. 03-04 requires the use of the traditional unit credit method for the purposes of measuring the benefit obligation and annual cost of benefits earned as opposed to the projected unit credit method. The EITF concluded that the requirements of this Issue be applied as of the next plan measurement date, which is December 31, 2003 for Consumers. Consumers commenced a cash balance pension plan that covers employees hired after June 30, 2003. Consumers does account for this plan as a defined benefit plan under SFAS No. 87. Consumers continues to evaluate the impact, if any, this Issue will have upon adoption. STATEMENT OF POSITION, ACCOUNTING FOR CERTAIN COSTS AND ACTIVITIES RELATED TO PROPERTY, PLANT, AND EQUIPMENT: At its September 9, 2003 meeting, the Accounting Standards Executive Committee voted to approve the Statement of Position, Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment. The Statement of Position is expected to be presented for FASB clearance late in the fourth quarter of 2003 and would be applicable for fiscal years beginning after December 15, 2004. The Accounting Standards Executive Committee concluded that at transition, a company would have the flexibility to adopt a property, plant and equipment component accounting policy for transition-date property, plant and equipment accounts. The property, plant and equipment component policy may differ from the componentization policy, if any, previously used by the enterprise. Selecting a policy that differs from the company's prior level of componentization at the date of adoption of the Statement of Position would not result in any cumulative effect difference for adopting such a policy. A company would not have to restate its pre-adoption assets to conform with its post-adoption componentization policy. The Accounting Standards Executive Committee concluded that companies would be required to disclose meaningful ranges with respect to property, plant and equipment depreciable lives. Consumers continues to evaluate the impact, if any, this Issue will have upon adoption. CE-67 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. 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 Form 10-K/A filed on July 1, 2003 and Consumers' Form 10-K, for the year ended December 31, 2002. Reference is also made to the CONDENSED NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS, in particular Note 4 - Uncertainties for CMS Energy and Note 2, Uncertainties for Consumers, included herein for additional information regarding various pending administrative and judicial proceedings involving rate, operating, regulatory and environmental matters. CMS ENERGY DEMAND FOR ACTIONS AGAINST OFFICERS AND DIRECTORS The Board of Directors of CMS Energy 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 MST, 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 has elected two new members to its Board of Directors who are serving 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 cannot predict the outcome of this litigation. INTEGRUM LAWSUIT A complaint was filed in Wayne County, Michigan Circuit Court on July 17, 2003 by Integrum Energy Ventures LLC ("Integrum") against CMS Energy, CMS Enterprises and Australian Pipeline Trust ("APT"). Integrum alleges several causes of action against APT, CMS Energy and CMS Enterprises in connection with an offer by Integrum to purchase certain CMS Enterprises pipeline assets in Michigan and Australia (the "CMS Pipeline Assets"). In addition to seeking unspecified money damages, Integrum is seeking an order enjoining CMS Enterprises and CMS Energy from selling, and APT from purchasing, the CMS Pipeline Assets and an order of specific performance mandating that CMS Energy, CMS CO-1 Enterprises and APT complete the sale of the CMS Pipeline Assets to APT and Integrum. A certain officer and director of Integrum is a former officer and director of CMS Energy, Consumers and its subsidiaries. The individual was not employed by CMS Energy, Consumers or its subsidiaries when Integrum made the offer to purchase the CMS Pipeline Assets. CMS Energy and CMS Enterprises intend to defend vigorously against this action. CMS Energy and CMS Enterprises cannot predict the outcome of this litigation. GAS INDEX PRICE REPORTING LITIGATION In August 2003, Cornerstone Propane Partners, L.P. ("Cornerstone") filed a putative class action complaint in the United States District Court for the Southern District of New York against CMS Energy and 40 other energy companies. The complaint alleges that false natural gas price reporting by the defendants manipulated the prices of NYMEX natural gas futures and options. The complaint contains two counts under the Commodity Exchange Act, one for manipulation and one for aiding and abetting violations. Cornerstone has agreed to provide a blanket sixty-day extension of time for all defendants to answer or otherwise respond to the complaint. CMS Energy intends to defend vigorously against this action but cannot predict the outcome of this litigation. CMS ENERGY AND CONSUMERS ERISA 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 for the Eastern District of Michigan, were consolidated by the trial judge, and an amended consolidated complaint was filed. 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 Common Stock held in the Plan. Plaintiffs also seek other equitable relief and legal fees. These cases will be defended vigorously. CMS Energy and Consumers cannot predict the outcome of this litigation. SECURITIES CLASS ACTION LAWSUITS Beginning on May 17, 2002, a number of securities class action complaints were filed against CMS Energy, Consumers, and certain officers and directors of CMS Energy and its affiliates. The complaints were filed as purported class actions in the United States District Court for the Eastern District of Michigan by individuals who allege that they purchased CMS Energy's securities during a purported class period. The cases were consolidated into a single lawsuit and an amended and consolidated class action complaint was filed on May 1, 2003. The consolidated complaint contains a purported class period beginning on May 1, 2000 and running through March 31, 2003. It generally seeks unspecified damages based on allegations that the defendants violated United States securities laws and regulations by making allegedly false and misleading statements about CMS Energy's business and financial condition, particularly with respect to revenues and expenses recorded in connection with round-trip trading by CMS MST. The companies intend to defend vigorously against this action but cannot predict the outcome of this litigation. ENVIRONMENTAL MATTERS CMS Energy, Consumers 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 CO-2 legal and factual developments, CMS Energy and Consumers 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 and Consumers' MANAGEMENT'S DISCUSSION AND ANALYSIS; and CMS Energy's and Consumers' CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS On May 6, 2003, CMS Energy issued 136,109 CMS Energy Common Stock warrants to Miller Buckfire Lewis & Co., LLC and 67,891 CMS Energy Common Stock warrants to Dresdner Klienwort Wasserstein, Inc. (herein collectively referred to as the "warrants"). The warrants were issued at a price of $8.25 per share and were granted as partial compensation for general financial advisory and investment banking services provided to CMS Energy. The warrants were issued pursuant to Section 4(2) of the Securities Act of 1933, as amended, as a transaction by an issuer not involving any public offering. On July 16, 2003, CMS Energy issued, in a private placement to institutional investors pursuant to Rule 144A of the Securities Act of 1933, as amended, $150 million of 3.375 percent convertible senior notes due July 15, 2023 (the "notes"). The notes were initially sold to Citigroup Global Markets Inc., Merrill Lynch, Pierce, Fenner & Smith Incorporated, and Deutsche Bank Securities Inc., as initial purchasers. CMS Energy received proceeds of $145,500,000 after the initial purchasers' discounts and commissions and offering expenses. The notes are convertible into CMS Energy Common Stock at the option of the holder under certain circumstances. The initial conversion price is $10.671 per share, which translates into 93.7137 shares of CMS Energy Common Stock for each $1,000 principal note converted. CMS Energy has agreed to file a shelf registration statement with the SEC by October 14, 2004 relating to the resale of the notes and the CMS Energy Common Stock issuable upon conversion thereof. ITEM 5. OTHER INFORMATION A shareholder who wishes to submit a proposal for consideration at the CMS Energy 2004 Annual Meeting pursuant to the applicable rules of the SEC must send the proposal to reach CMS' Corporate Secretary on or before December 24, 2003. In any event if CMS has not received written notice of any matter to be proposed at that meeting by March 8, 2004, the holders of the proxies may use their discretionary voting authority on any such matter. The proposals should be addressed to: Mr. Michael D. VanHemert, Corporate Secretary, One Energy Plaza, Jackson, Michigan 49201. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) LIST OF EXHIBITS (4)(a) 91st Supplemental Indenture, dated as of May 23, 2003, between Consumers Energy Company and JPMorgan Chase Bank as Trustee (4)(b) 92nd Supplemental Indenture, dated as of August 26, 2003, between Consumers Energy Company and JPMorgan Chase Bank as Trustee (4)(c) 93rd Supplemental Indenture, dated as of September 19, 2003, between Consumers Energy Company and JPMorgan Chase Bank as Trustee (4)(d) Registration Rights Agreement dated as of April 30, 2003 between Consumers Energy Company and the Initial Purchasers, as defined therein CO-3 (4)(e) Registration Rights Agreement dated as of May 23, 2003 between Consumers Energy Company and the Initial Purchasers, as defined therein (4)(f) Registration Rights Agreement dated as of August 26, 2003 between Consumers Energy Company and the Initial Purchasers, as defined therein (4)(g) Amended and Restated Credit Agreement dated September 19, 2003 among Consumers Energy Company, the Banks, the Agent, the Syndication Agent and the Co-Documentation Agents, all as defined therein (10)(a) Purchase Agreement dated April 23, 2003 between Consumers Energy Company and the Initial Purchasers, as defined therein (10)(b) Purchase Agreement dated May 20, 2003 between Consumers Energy Company and the Initial Purchasers, as defined therein (10)(c) Purchase Agreement dated August 19, 2003 between Consumers Energy Company and the Initial Purchasers, as defined therein (31)(a) CMS Energy Corporation's certification of the CEO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (31)(b) CMS Energy Corporation's certification of the CFO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (31)(c) Consumers Energy Company's certification of the CEO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (31)(d) Consumers Energy Company's certification of the CFO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (32)(a) CMS Energy Corporation's certifications pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (32)(b) Consumers Energy Company's certifications pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (b) REPORTS ON FORM 8-K CMS ENERGY During 3rd Quarter 2003, CMS Energy filed a report on Form 8-K on July 11, 2003 (covering matters pursuant to ITEM 5. OTHER EVENTS), and furnished a report on Form 8-K on August 13, 2003 (covering matters pursuant to ITEM 12. RESULTS OF OPERATIONS AND FINANCIAL CONDITION). CONSUMERS During 3rd Quarter 2003, Consumers furnished a report on Form 8-K on August 13, 2003 (covering matters pursuant to ITEM 12. RESULTS OF OPERATIONS AND FINANCIAL CONDITION). 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 12, 2003 By: /s/ Thomas J. Webb ----------------------------- Thomas J. Webb Executive Vice President and Chief Financial Officer CONSUMERS ENERGY COMPANY (Registrant) Dated: November 12, 2003 By: /s/ Thomas J. Webb ----------------------------- Thomas J. Webb Executive Vice President and Chief Financial Officer C0-5 EXHIBIT INDEX Exhibit No. Description ----------- ----------- (4)(a) 91st Supplemental Indenture, dated as of May 23, 2003, between Consumers Energy Company and JPMorgan Chase Bank as Trustee (4)(b) 92nd Supplemental Indenture, dated as of August 26, 2003, between Consumers Energy Company and JPMorgan Chase Bank as Trustee (4)(c) 93rd Supplemental Indenture, dated as of September 19, 2003, between Consumers Energy Company and JPMorgan Chase Bank as Trustee (4)(d) Registration Rights Agreement dated as of April 30, 2003 between Consumers Energy Company and the Initial Purchasers, as defined therein (4)(e) Registration Rights Agreement dated as of May 23, 2003 between Consumers Energy Company and the Initial Purchasers, as defined therein (4)(f) Registration Rights Agreement dated as of August 26, 2003 between Consumers Energy Company and the Initial Purchasers, as defined therein (4)(g) Amended and Restated Credit Agreement dated September 19, 2003 among Consumers Energy Company, the Banks, the Agent, the Syndication Agent and the Co-Documentation Agents, all as defined therein (10)(a) Purchase Agreement dated April 23, 2003 between Consumers Energy Company and the Initial Purchasers, as defined therein (10)(b) Purchase Agreement dated May 20, 2003 between Consumers Energy Company and the Initial Purchasers, as defined therein (10)(c) Purchase Agreement dated August 19, 2003 between Consumers Energy Company and the Initial Purchasers, as defined therein (31)(a) CMS Energy Corporation's certification of the CEO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (31)(b) CMS Energy Corporation's certification of the CFO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (31)(c) Consumers Energy Company's certification of the CEO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (31)(d) Consumers Energy Company's certification of the CFO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (32)(a) CMS Energy Corporation's certifications pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (32)(b) Consumers Energy Company's certifications pursuant to Section 906 of the Sarbanes-Oxley Act of 2002