-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, F9r2XR9f6e6Uc1cU1WmvFbEzG9q8hzOwcIJIRAzY+sTp3/vlpvzAQNuHYdfUPo9r KadNVYRJ2tX+SECCsazDpw== 0000861388-04-000014.txt : 20041112 0000861388-04-000014.hdr.sgml : 20041111 20041112162158 ACCESSION NUMBER: 0000861388-04-000014 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 3 CONFORMED PERIOD OF REPORT: 20040930 FILED AS OF DATE: 20041112 DATE AS OF CHANGE: 20041112 FILER: COMPANY DATA: COMPANY CONFORMED NAME: KENTUCKY UTILITIES CO CENTRAL INDEX KEY: 0000055387 STANDARD INDUSTRIAL CLASSIFICATION: ELECTRIC SERVICES [4911] IRS NUMBER: 610247570 STATE OF INCORPORATION: KY FISCAL YEAR END: 1229 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 001-03464 FILM NUMBER: 041139639 BUSINESS ADDRESS: STREET 1: ONE QUALITY ST CITY: LEXINGTON STATE: KY ZIP: 40507 BUSINESS PHONE: 6062552100 FILER: COMPANY DATA: COMPANY CONFORMED NAME: LOUISVILLE GAS & ELECTRIC CO /KY/ CENTRAL INDEX KEY: 0000060549 STANDARD INDUSTRIAL CLASSIFICATION: ELECTRIC & OTHER SERVICES COMBINED [4931] IRS NUMBER: 610264150 STATE OF INCORPORATION: KY FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 001-02893 FILM NUMBER: 041139637 BUSINESS ADDRESS: STREET 1: 220 W MAIN ST STREET 2: P O BOX 32030 CITY: LOUISVILLE STATE: KY ZIP: 40232 BUSINESS PHONE: 5026272000 MAIL ADDRESS: STREET 1: 220 WEST MAIN ST CITY: LUUISVILLE STATE: KY ZIP: 40232 10-Q 1 q10q0904.txt LG&E AND KU 3RD QUARTER 10Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2004 Or [_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission Registrant, State of Incorporation IRS Employer File Number Address, and Telephone Number Identification No. 1-2893 Louisville Gas and Electric Company 61-0264150 (A Kentucky Corporation) 220 West Main Street P.O. Box 32010 Louisville, KY 40232 (502) 627-2000 1-3464 Kentucky Utilities Company 61-0247570 (A Kentucky and Virginia Corporation) One Quality Street Lexington, KY 40507-1428 (859) 255-2100 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X. No _. Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes No X Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: Louisville Gas and Electric Company 21,294,223 shares, without par value, as of October 31, 2004, all held by LG&E Energy LLC Kentucky Utilities Company 37,817,878 shares, without par value, as of October 31, 2004, all held by LG&E Energy LLC This combined Form 10-Q is separately filed by Louisville Gas and Electric Company and Kentucky Utilities Company. Information contained herein related to any individual registrant is filed by such registrant on its own behalf. Each registrant makes no representation as to information related to the other registrants. New Page TABLE OF CONTENTS PART I Item 1 Consolidated Financial Statements Louisville Gas and Electric Company and Subsidiary Statements of Income 1 Statements of Retained Earnings 1 Balance Sheets 2 Statements of Cash Flow 4 Statements of Other Comprehensive Income 5 Kentucky Utilities Company and Subsidiary Statements of Income 6 Statements of Retained Earnings 6 Balance Sheets 7 Statements of Cash Flow 9 Statements of Other Comprehensive Income 10 Notes to Consolidated Financial Statements 11 Item 2 Management's Discussion and Analysis of F Financial Condition and Results of Operations 23 Item 3 Quantitative and Qualitative Disclosures About Market Risk 38 Item 4 Controls and Procedures 39 PART II Item 1 Legal Proceedings 40 Item 2 Unregistered Sales of Equity Securities and Use of Proceeds 41 Item 4 Submission of Matters to a Vote of Security Holders 41 Item 6 Exhibits 42 Signatures 43 Exhibits 44 New Page Part I. Financial Information - Item 1. Financial Statements Louisville Gas and Electric Company and Subsidiary Consolidated Statements of Income (Unaudited) (Thousands of $) Three Months Nine Months Ended Ended September 30, September 30, 2004 2003 2004 2003 OPERATING REVENUES (Note 5): Electric (Note 10) $227,024 $230,174 $617,839 $591,110 Gas 34,818 32,659 242,178 213,939 Total operating revenues 261,842 262,833 860,017 805,049 OPERATING EXPENSES: Fuel for electric generation 53,653 55,628 153,792 151,382 Power purchased (Note 10) 19,344 18,805 65,578 60,245 Gas supply expenses 20,172 19,509 181,919 151,579 Other operation expenses 48,129 51,890 163,300 158,797 Maintenance 23,072 12,526 49,879 42,109 Depreciation and amortization 30,299 28,429 86,021 85,866 Federal and state income taxes 21,089 23,707 45,487 45,062 Property and other taxes 4,343 4,659 14,483 12,848 Total operating expenses 220,101 215,153 760,459 707,888 NET OPERATING INCOME 41,741 47,680 99,558 97,161 Other income (expense) - net (1,091) 285 (1,419) (49) Other income from affiliated company (Note 10) - 2 - 6 Interest expense (Note 3) 5,072 5,985 15,086 18,090 Interest expense to affiliated companies (Note 10) 3,040 2,111 9,157 4,137 NET INCOME $ 32,538 $ 39,871 $ 73,896 $ 74,891 Consolidated Statements of Retained Earnings (Unaudited) (Thousands of $) Three Months Nine Months Ended Ended September 30, September 30, 2004 2003 2004 2003 Balance at beginning of period $516,856 $442,498 $497,441 $409,319 Net income 32,538 39,871 73,896 74,891 Subtotal 549,394 482,369 571,337 484,210 Cash dividends declared on stock: 5% cumulative preferred 269 269 807 807 Auction rate cumulative preferred 244 174 649 743 $5.875 cumulative preferred (Note 9) - - - 734 Common 21,000 - 42,000 - Subtotal 21,513 443 43,456 2,284 Balance at end of period $527,881 $481,926 $527,881 $481,926 The accompanying notes are an integral part of these consolidated financial statements. Page 1 Louisville Gas and Electric Company and Subsidiary Consolidated Balance Sheets (Unaudited) (Thousands of $) ASSETS September 30, December 31, 2004 2003 UTILITY PLANT: At original cost $3,880,901 $3,804,183 Less: reserve for depreciation 1,390,301 1,326,899 Net utility plant (Note 7) 2,490,600 2,477,284 OTHER PROPERTY AND INVESTMENTS - less reserve of $63 as of September 30, 2004 and December 31, 2003 508 611 CURRENT ASSETS: Cash and cash equivalents 5,902 1,706 Restricted cash 11,524 - Accounts receivable - less reserve of $1,415 and $3,515 as of September 30, 2004 and December 31, 2003, respectively (Note 4) 108,761 84,585 Materials and supplies - at average cost: Fuel (predominantly coal) 22,268 25,260 Gas stored underground 76,416 69,884 Other 26,214 24,971 Prepayments and other 1,634 5,281 Total current assets 252,719 211,687 DEFERRED DEBITS AND OTHER ASSETS: Unamortized debt expense 8,555 8,753 Regulatory assets (Note 6) 100,183 143,626 Other 32,789 40,121 Total deferred debits and other assets 141,527 192,500 Total assets $2,885,354 $2,882,082 The accompanying notes are an integral part of these consolidated financial statements. Page 2 Louisville Gas and Electric Company and Subsidiary Consolidated Balance Sheets (Unaudited) (Thousands of $) CAPITALIZATION AND LIABILITIES September 30, December 31, 2004 2003 CAPITALIZATION: Common stock, without par value - Outstanding 21,294,223 shares $ 425,170 $ 425,170 Common stock expense (836) (836) Additional paid-in capital 40,000 40,000 Accumulated other comprehensive loss (39,902) (38,111) Retained earnings 527,881 497,441 Total common equity 952,313 923,664 Cumulative preferred stock 70,425 70,425 Mandatorily redeemable preferred stock (Note 9) 21,250 22,500 Long-term debt (Note 9) 328,104 328,104 Long-term debt to affiliated company (Note 9) 225,000 200,000 Total long-term debt 574,354 550,604 Total capitalization 1,597,092 1,544,693 CURRENT LIABILITIES: Current portion of mandatorily redeemable preferred stock (Note 9) 1,250 1,250 Current portion of long-term debt (Note 9) 246,200 246,200 Current portion of long-term debt to affiliated company (Note 9) 50,000 - Notes payable to affiliated companies (Note 9) 40,700 80,332 Accounts payable 62,959 93,118 Accounts payable to affiliated companies (Note 10) 22,455 38,343 Accrued income taxes 8,330 11,472 Customer deposits 12,255 10,493 Accrued interest 2,593 1,999 Accrued interest to affiliated company (Note 10) 2,996 2,750 Other 18,493 11,784 Total current liabilities 468,231 497,741 DEFERRED CREDITS AND OTHER LIABILITIES: Accumulated deferred income taxes - net 347,092 337,704 Investment tax credit, in process of amortization 47,202 50,329 Accumulated provision for pensions and related benefits 109,436 140,598 Customer advances for construction 10,637 9,890 Asset retirement obligation 10,155 9,747 Regulatory liabilities (Note 6): Accumulated cost of removal of utility plant 214,950 216,491 Other 53,535 51,822 Long-term derivative liability (Note 3) 18,883 15,966 Other 8,141 7,101 Total deferred credits and other liabilities 820,031 839,648 Total capital and liabilities $2,885,354 $2,882,082 The accompanying notes are an integral part of these consolidated financial statements. Page 3 Louisville Gas and Electric Company and Subsidiary Consolidated Statement of Cash Flows (Unaudited) (Thousands of $) Nine Months Ended September 30, 2004 2003 CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 73,896 $ 74,891 Items not requiring cash currently: Depreciation and amortization 86,021 85,866 Deferred income taxes - net 6,803 24,589 Investment tax credit - net (3,127) (3,156) Value Delivery Team (VDT) amortization (Note 6) 22,601 22,866 Mark-to-market financial instruments (Note 3) 2,916 (651) Provision for post-retirement benefits (Note 8) (8,047) (4,801) Other (147) 7,997 Changes in current assets and liabilities (10,576) (28,028) Changes in accounts receivable securitization-net (Note 4) (58,000) 11,600 Pension funding (Notes 9 and 12) (34,492) (89,125) Gas supply clause (Note 6) 12,008 (14,970) Earnings sharing mechanism (Note 6) 6,913 6,189 Combustion turbine litigation settlement 7,003 - Other 15,460 10,698 Net cash flows from operating activities 119,232 103,965 CASH FLOWS FROM INVESTING ACTIVITIES: Proceeds from sales of securities 103 153 Construction expenditures (94,220) (153,064) Net cash flows from investing activities (94,117) (152,911) CASH FLOWS FROM FINANCING ACTIVITIES: Increase in restricted cash (11,524) - Long-term borrowings from affiliated company (Note 9) 125,000 200,000 Short-term borrowings from affiliated company (Note 9) 399,550 478,800 Repayment of long-term borrowings from d affiliated company (Note 9) (50,000) - Repayment of short-term borrowings from affiliated company (Note 9) (439,182) (596,721) Retirement of mandatorily redeemable preferred stock (Note 9) (1,250) (1,250) Retirement of first mortgage bonds - (42,600) Issuance costs of pollution control bonds (135) - Payment of common dividends (42,000) - Payment of preferred dividends (1,378) (2,898) Net cash flows from financing activities (20,919) 35,331 CHANGE IN CASH AND CASH EQUIVALENTS 4,196 (13,615) CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 1,706 17,015 CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 5,902 $ 3,400 SUPPLEMENTAL DISCLOSURES: Cash paid during the period for: Income taxes $ 42,375 $ 12,968 Interest on borrowed money 12,674 17,204 Interest to affiliated companies on borrowed money 8,937 1,707 The accompanying notes are an integral part of these consolidated financial statements. Page 4 Louisville Gas and Electric Company and Subsidiary Consolidated Statements of Other Comprehensive Income (Unaudited) (Thousands of $) Three Months Nine Months Ended Ended September 30, September 30, 2004 2003 2004 2003 Net income $32,538 $39,871 $73,896 $74,891 Gains/(losses) on derivative instruments and hedging activities - net of tax benefit/(expense) of $3,639, $(1,416), $1,189 and $(382), respectively (Note 3) (5,457) 2,123 (1,790) 573 Comprehensive income $27,081 $41,994 $72,106 $75,464 The accompanying notes are an integral part of these consolidated financial statements. Page 5 Kentucky Utilities Company and Subsidiary Consolidated Statements of Income (Unaudited) (Thousands of $) Three Months Nine Months Ended Ended September 30, September 30, 2004 2003 2004 2003 OPERATING REVENUES (Note 10) $252,669 $235,426 $732,424 $657,583 OPERATING EXPENSES: Fuel for electric generation 78,151 75,300 215,666 201,264 Power purchased (Note 10) 33,182 31,702 105,152 106,550 Other operation expenses 37,844 35,603 112,834 112,622 Maintenance 12,070 13,031 40,978 49,400 Depreciation and amortization 29,065 24,751 80,265 76,663 Federal and state income taxes 19,565 18,196 58,127 32,263 Property and other taxes 4,406 4,067 12,942 12,230 Total operating expenses 214,283 202,650 625,964 590,992 NET OPERATING INCOME 38,386 32,776 106,460 66,591 Other income - net 3,094 2,140 6,514 6,944 Other income (expense) from affiliated company (Note 10) 11 5 26 4 Interest expense (Note 3) 3,116 2,695 7,532 13,808 Interest expense to affiliated companies (Note 10) 3,557 1,916 10,641 3,401 NET INCOME $ 34,818 $ 30,310 $ 94,827 $ 56,330 Consolidated Statements of Retained Earnings (Unaudited) (Thousands of $) Three Months Nine Months Ended Ended September 30, September 30, 2004 2003 2004 2003 Balance at beginning of period $629,051 $526,916 $591,170 $502,024 Net income 34,818 30,310 94,827 56,330 Subtotal 663,869 557,226 685,997 558,354 Cash dividends declared on stock: 4.75% cumulative preferred 237 237 712 711 6.53% cumulative preferred 327 327 980 981 Common 21,000 - 42,000 - Subtotal 21,564 564 43,692 1,692 Balance at end of period $642,305 $556,662 $642,305 $556,662 The accompanying notes are an integral part of these consolidated financial statements. Page 6 Kentucky Utilities Company and Subsidiary Consolidated Balance Sheets (Unaudited) (Thousands of $) ASSETS September 30, December 31, 2004 2003 UTILITY PLANT: At original cost $3,670,707 $3,596,657 Less: reserve for depreciation 1,403,583 1,360,253 Net utility plant (Note 7) 2,267,124 2,236,404 OTHER PROPERTY AND INVESTMENTS - less reserve of $131 as of September 30, 2004 and December 31, 2003 19,721 17,862 CURRENT ASSETS: Cash and cash equivalents 4,677 4,869 Accounts receivable - less reserve of $482 and $672 as of September 30, 2004 and December 31, 2003, respectively (Note 4) 97,437 49,289 Materials and supplies - at average cost: Fuel (predominantly coal) 30,260 45,538 Other 27,653 27,094 Prepayments and other 6,802 13,100 Total current assets 166,829 139,890 DEFERRED DEBITS AND OTHER ASSETS: Unamortized debt expense 4,295 4,481 Regulatory assets (Note 6) 62,668 72,318 Long-term derivative asset (Note 3) 7,530 12,223 Other 12,164 21,916 Total deferred debits and other assets 86,657 110,938 Total assets $2,540,331 $2,505,094 The accompanying notes are an integral part of these consolidated financial statements. Page 7 Kentucky Utilities Company and Subsidiary Consolidated Balance Sheets (Unaudited) (Thousands of $) CAPITALIZATION AND LIABILITIES September 30, December 31, 2004 2003 CAPITALIZATION: Common stock, without par value - Outstanding 37,817,878 shares $ 308,140 $ 308,140 Common stock expense (322) (322) Additional paid-in capital 15,000 15,000 Accumulated other comprehensive loss (6,071) (6,031) Retained earnings 642,305 591,170 Total common equity 959,052 907,957 Cumulative preferred stock 39,727 39,727 Long-term debt (Note 9) 307,564 312,646 Long-term debt to affiliated company (Note 9) 333,000 283,000 Total long-term debt 640,564 595,646 Total capitalization 1,639,343 1,543,330 CURRENT LIABILITIES: Current portion of long-term debt (Note 9) 87,130 91,930 Notes payable to affiliated company (Note 9) 29,830 43,231 Accounts payable 41,317 69,947 Accounts payable to affiliated companies (Note 10) 18,979 26,426 Accrued income taxes 12,337 7,104 Customer deposits 14,163 13,453 Accrued interest 3,019 2,024 Accrued interest to affiliated company (Note 10) 3,866 2,454 Other 20,566 9,767 Total current liabilities 231,207 266,336 DEFERRED CREDITS AND OTHER LIABILITIES: Accumulated deferred income taxes - net 274,207 261,258 Investment tax credit, in process of amortization 4,318 5,859 Accumulated provision for pensions and related benefits 65,260 103,101 Customer advances for construction 1,608 1,564 Asset retirement obligation 20,661 19,698 Regulatory liabilities (Note 6): Accumulated cost of removal of utility plant 262,971 256,744 Other 28,301 38,027 Other 12,455 9,177 Total deferred credits and other liabilities 669,781 695,428 Total capital and liabilities $2,540,331 $2,505,094 The accompanying notes are an integral part of these consolidated financial statements. Page 8 Kentucky Utilities Company and Subsidiary Consolidated Statement of Cash Flows (Unaudited) (Thousands of $) Nine Months Ended September 30, 2004 2003 CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 94,827 $ 56,330 Items not requiring cash currently: Depreciation and amortization 80,265 76,663 Deferred income taxes - net 11,064 10,277 Investment tax credit - net (1,540) (1,981) Value Delivery Team (VDT) amortization (Note 6) 8,816 9,091 Mark-to-market financial instruments (Note 3) (389) 1,231 Provision for post-retirement benefits (Note 8) (3,373) (4,417) Deferred storm costs (3,760) - Other 2,401 15,212 Changes in current assets and liabilities 3,164 (4,888) Changes in accounts receivable securitization - net (Note 4) (50,000) - Pension funding (Notes 9 and 12) (43,409) (9,515) Earnings sharing mechanism (Note 6) 4,920 7,708 Environmental cost recovery mechanism (Note 6) (7,089) 1,157 Combustion turbine litigation settlement 11,426 - Other 10,231 23,242 Net cash flows from operating activities 117,554 180,110 CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of securities (1,858) (2,818) Construction expenditures (103,992) (263,899) Net cash flows from investing activities (105,850) (266,717) CASH FLOWS FROM FINANCING ACTIVITIES: Long-term borrowings from affiliated company (Note 9) 50,000 175,000 Short-term borrowings from affiliated company (Note 9) 380,500 520,840 Repayment of short-term borrowings from affiliated company (Note 9) (393,900) (541,600) Retirement of first mortgage bonds - (62,000) Retirement of pollution control bonds (4,800) - Refund of issuance costs of pollution control bonds (4) - Payment of common dividends (42,000) - Payment of preferred dividends (1,692) (1,692) Net cash flows from financing activities (11,896) 90,548 CHANGE IN CASH AND CASH EQUIVALENTS (192) 3,941 CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 4,869 5,391 CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 4,677 $ 9,332 SUPPLEMENTAL DISCLOSURES: Cash paid during the period for: Income taxes $ 40,792 $ 19,012 Interest on borrowed money 9,195 12,681 Interest to affiliated companies on borrowed money 9,269 1,060 The accompanying notes are an integral part of these consolidated financial statements. Page 9 Kentucky Utilities Company and Subsidiary Consolidated Statements of Other Comprehensive Income (Unaudited) (Thousands of $) Three Months Nine Months Ended Ended September 30, September 30, 2004 2003 2004 2003 Net income $34,818 $30,310 $94,827 $56,330 Losses on derivative instruments and hedging activities - net of tax benefit/(expense) of $17, ($121), $23 and ($121), respectively (Note 3) (26) 182 (40) 182 Comprehensive income $34,792 $30,492 $94,787 $56,512 The accompanying notes are an integral part of these consolidated financial statements. Page 10 Louisville Gas and Electric Company and Subsidiary Kentucky Utilities Company and Subsidiary Notes to Consolidated Financial Statements (Unaudited) 1. General The unaudited condensed financial statements include the accounts of Louisville Gas and Electric Company and Subsidiary and Kentucky Utilities Company and Subsidiary (each "LG&E" and "KU", or the "Companies"). The common stock of each of LG&E and KU is wholly-owned by LG&E Energy LLC ("LG&E Energy"). In the opinion of management, the unaudited interim financial statements include all adjustments, consisting only of normal recurring adjustments, necessary for a fair statement of consolidated financial position, results of operations, comprehensive income and cash flows for the periods indicated. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to Securities and Exchange Commission ("SEC") rules and regulations, although the Companies believe that the disclosures are adequate to make the information presented not misleading. See LG&E's and KU's Annual Reports on Form 10-K for the year ended December 31, 2003, for information relevant to the accompanying financial statements, including information as to the significant accounting policies of the Companies. The accompanying financial statements for the three months and nine months ended September 30, 2003, have been revised to conform to certain reclassifications in the current three months and nine months ended September 30, 2004. These reclassifications had no impact on the balance sheet net assets or net income, as previously reported. 2. Mergers and Acquisitions LG&E and KU are each subsidiaries of LG&E Energy. In July 2002, E.ON AG ("E.ON"), a German company, completed its acquisition of Powergen Limited ("Powergen"), the former parent company of LG&E Energy. As a result, LG&E and KU became indirect subsidiaries of E.ON. Following the purchase of Powergen by E.ON, E.ON became a registered holding company under the Public Utility Holding Company Act of 1935 ("PUHCA"). As a result, E.ON, its utility subsidiaries, including LG&E and KU, and certain of its non-utility subsidiaries are subject to extensive regulation by the SEC under PUHCA with respect to issuances and sales of securities, acquisitions and sales of certain utility properties, and intra-system sales of certain goods and services. In addition, PUHCA generally limits the ability of registered holding companies to acquire additional public utility systems and to acquire and retain businesses unrelated to the utility operations of the holding company. LG&E and KU believe that they have adequate authority (including financing authority) under existing SEC orders and regulations to conduct their business. LG&E and KU will seek additional authorization when necessary. As contemplated in their regulatory filings in connection with the E.ON acquisition, E.ON, Powergen and LG&E Energy completed an administrative reorganization to move the LG&E Energy group from an indirect Powergen subsidiary to an indirect E.ON subsidiary. This reorganization was effective in March 2003. In early 2004, LG&E Energy began direct reporting arrangements to E.ON. The utility operations (LG&E and KU) of LG&E Energy have continued their separate identities and continue to serve customers in Kentucky, Virginia and Tennessee under their existing names. The preferred stock and debt securities of LG&E and KU were not affected by these transactions and LG&E and KU continue to file SEC reports. Page 11 Effective December 30, 2003, LG&E Energy LLC became the successor, by assignment and subsequent merger, to all the assets and liabilities of LG&E Energy Corp. Following the conversion, LG&E Energy became a registered holding company under PUHCA. 3. Financial Instruments The Companies use interest rate swaps to hedge exposure to market fluctuations in certain of their debt instruments. Pursuant to the Companies' policies, use of these financial instruments is intended to mitigate risk, earnings and cash flow volatility and is not speculative in nature. Management has designated all of the Companies' interest rate swaps as hedge instruments. Financial instruments designated as cash flow hedges have resulting gains and losses recorded within other comprehensive income and stockholders' equity. To the extent a financial instrument designated as a cash flow hedge or the underlying item being hedged is prematurely terminated or the hedge becomes ineffective, the resulting gains or losses are reclassified from other comprehensive income to net income. Financial instruments designated as fair value hedges and the underlying hedged items are periodically marked to market with the resulting net gains and losses recorded directly into net income. Upon termination of any fair value hedge, the resulting gain or loss is recorded into net income. As of September 30, 2004, LG&E was party to various interest rate swap agreements with aggregate notional amounts of $228.3 million. Under these swap agreements, LG&E paid fixed rates averaging 4.38% and received variable rates based on LIBOR or the Bond Market Association's municipal swap index averaging 1.37% at September 30, 2004. The swap agreements in effect at September 30, 2004 have been designated as cash flow hedges and mature on dates ranging from 2005 to 2033. The hedges have been deemed to be fully effective resulting in a pretax loss of $9.1 million and a pretax loss of $2.9 million for the three months and nine months ended September 30, 2004, respectively, recorded in other comprehensive income. Upon expiration of these hedges, the amount recorded in other comprehensive income will be reclassified into earnings. The amounts expected to be reclassified from other comprehensive income to earnings in the next twelve months are immaterial. As of September 30, 2004, KU was party to various interest rate swap agreements with aggregate notional amounts of $103.0 million. Under these swap agreements, KU paid variable rates based on either LIBOR or the Bond Market Association's municipal swap index averaging 2.70%, and received fixed rates averaging 7.74% at September 30, 2004. The swap agreements in effect at September 30, 2004 have been designated as fair value hedges and mature on dates ranging from 2007 to 2025. During the three months and nine months ended September 30, 2004, the effect of marking these financial instruments and the underlying debt to market resulted in a net pretax gain of $0.3 million and $1.0 million (representing the hedges' ineffectiveness), respectively, recorded as a decrease in interest expense. Interest rate swaps hedge interest rate risk on the underlying debt. Under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, in addition to swaps being marked to market, the item being hedged using a fair value hedge must also be marked to market. Consequently at September 30, 2004, KU's debt reflects an increase of $9.7 million related to such mark-to-market adjustment. In February 2004, KU terminated the swap it had in place related to its Series 9 pollution control bonds. The notional amount of the terminated swap was $50 million and KU received a payment of $2.0 million as part of the termination, resulting in a gain of $0.8 million. Page 12 4. Accounts Receivable Securitization Programs In January 2004, LG&E and KU terminated their accounts receivable securitization programs, originally implemented in February 2001, and replaced them with intercompany loans from an E.ON affiliate. In May 2004, LG&E and KU dissolved their inactive accounts receivable securitization-related subsidiaries, LG&E Receivables LLC and KU Receivables LLC. The accounts receivable securitization-related subsidiaries were the only subsidiaries of LG&E and KU. 5. Segments of Business LG&E's revenues and net income by business segment for the three and nine months ended September 30, 2004 and 2003, follow: Three Months Ended Nine Months Ended September 30, September 30, (in thousands) 2004 2003 2004 2003 LG&E Electric Revenues $227,024 $230,174 $617,839 $591,110 Net income 34,648 41,924 71,031 69,413 LG&E Gas Revenues 34,818 32,659 242,178 213,939 Net income (2,110) (2,053) 2,865 5,478 Total Revenues 261,842 262,833 860,017 805,049 Net income 32,538 39,871 73,896 74,891 KU is an electric utility company. It does not provide gas service and therefore, is presented as a single business segment. 6. Regulatory Assets and Liabilities The following regulatory assets and liabilities were included in LG&E's balance sheets as of September 30, 2004 and December 31, 2003: Louisville Gas and Electric Company (Unaudited) September 30,December 31, (in thousands) 2004 2003 VDT costs $ 45,209 $ 67,810 Gas supply adjustments due from customers 11,068 22,077 Unamortized loss on bonds 20,537 21,333 Earnings sharing mechanism (ESM) provision 5,446 12,359 Merger surcredit 5,183 6,220 Asset retirement obligation (ARO) 6,674 6,015 Gas performance-based ratemaking (PBR) 3,467 5,480 Other (including fuel adjustment clause (FAC), demand side management (DSM), etc.) 2,599 2,332 Total regulatory assets $100,183 $143,626 Accumulated cost of removal of utility plant $214,950 $216,491 Deferred income taxes - net 38,595 41,180 Gas supply adjustments due to customers 7,804 6,805 DSM 2,602 1,706 Other (including environmental cost recovery (ECR), ARO, FAC and ESM) 4,534 2,131 Total regulatory liabilities $268,485 $268,313 Page 13 LG&E currently earns a return on all regulatory assets except for gas supply adjustments, ESM, gas performance-based ratemaking, FAC, and DSM, all of which are separate rate mechanisms with recovery within twelve months. Additionally, no current return is earned on the ARO regulatory asset. This regulatory asset will be offset against the associated regulatory liability, ARO asset, and ARO liability at the time the underlying asset is retired. The following regulatory assets and liabilities were included in KU's balance sheets as of September 30, 2004 and December 31, 2003: Kentucky Utilities Company (Unaudited) September 30, December 31, (in thousands) 2004 2003 VDT costs $ 17,635 $ 26,451 Unamortized loss on bonds 9,946 10,511 ESM provision 7,462 12,382 Merger surcredit 4,012 4,815 ARO 12,464 11,322 FAC 1,713 4,298 Deferred storm costs 3,760 - Other 5,676 2,539 Total regulatory assets $ 62,668 $ 72,318 Accumulated cost of removal of utility plant $262,971 $256,744 Deferred income taxes - net 22,174 24,058 ARO 1,351 1,162 Spare parts 1,062 1,055 ECR 2,100 9,189 Other (including FAC and DSM) 1,614 2,563 Total regulatory liabilities $291,272 $294,771 KU currently earns a return on all regulatory assets except for ESM, FAC, and DSM, all of which are separate recovery mechanisms with recovery within twelve months. Additionally, no current return is earned on the ARO regulatory asset. This regulatory asset will be offset against the associated regulatory liability, ARO asset, and ARO liability at the time the underlying asset is retired. In September 2004, KU reclassified from maintenance expense to a regulatory asset, $4.0 million related to unreimbursed costs from the 2003 ice storm based on an order from the Kentucky Commission. These costs will be amortized through June 2009. KU earns a return of these amortized costs, which are included in KU's jurisdictional operating expenses. During May and July, LG&E and KU incurred $17.0 million and $3.5 million, respectively, of storm restoration costs associated with severe storms in their service territories. Of these amounts LG&E incurred $12.6 million of Operations and Maintenance ("O&M") expense and $4.4 million of expenditures that were capitalized and KU incurred $2.7 million of O&M expense and $0.8 million of expenditures that were capitalized. The Companies are considering requesting the Kentucky Commission to allow deferral of these O&M expenses for recovery in a future rate proceeding during the fourth quarter of 2004. Page 14 7. Utility Plant KU retired two steam generating units, Green River Units 1 and 2, in the amount of $17.2 million, from its books as of March 31, 2004. Approximately $4 million in common assets, which are shared by Green River Units 3 and 4, remain on KU's books. The common assets will remain on KU's books until the final retirement of Green River Units 3 and 4. The gross book value of Green River Units 1 and 2 was charged to the accumulated reserve for depreciation in accordance with FERC regulations and no gain or loss was recorded. The impact of the retirement of Green River Units 1 and 2 on the ARO is immaterial. A partial redemption of pollution control Series 14 bonds totaling $4.8 million was required in the second quarter as a result of the retirement (see Note 9). The following data represent shares of jointly-owned additions to the Trimble County plant for four combustion turbines ("CTs") as of September 30, 2004. Trimble County CT Units 7 and 8 began commercial operation on June 1, 2004. The addition to LG&E plant in service was $37.0 million and for KU the addition was $63.2 million. Trimble County CT Units 9 and 10 began commercial operation on July 1, 2004, resulting in an increase to plant in service of $37.3 and $63.8 million for LG&E and KU, respectively. ($ in millions) LG&E KU Total Trimble CT 7 Ownership % 37% 63% 100% Mw capacity 59 101 160 Cost $18.5 $31.7 $50.2 Depreciation 0.2 0.3 0.5 Net book value $18.3 $31.4 $49.7 Trimble CT 8 Ownership % 37% 63% 100% Mw capacity 59 101 160 Cost $18.5 $31.5 $50.0 Depreciation 0.2 0.3 0.5 Net book value $18.3 $31.2 $49.5 Trimble CT 9 Ownership % 37% 63% 100% Mw capacity 59 101 160 Cost $18.7 $31.9 $50.6 Depreciation 0.1 0.2 0.3 Net book value $18.6 $31.7 $50.3 Trimble CT 10 Ownership % 37% 63% 100% Mw capacity 59 101 160 Cost $18.6 $31.9 $50.5 Depreciation 0.1 0.2 0.3 Net book value $18.5 $31.7 $50.2 8. New Accounting Pronouncements FIN 46 In January 2003, the Financial Accounting Standards Board ("FASB") issued Financial Accounting Standards Board Interpretation No. 46, Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51 ("FIN 46"). FIN 46 required certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 was effective immediately for all new variable interest entities created or acquired after January 31, 2003. Page 15 In December 2003, FIN 46 was revised, delaying the effective dates for certain entities created before February 1, 2003, and making other amendments to clarify application of the guidance. For potential variable interest entities other than special purpose entities, the revised FIN 46 ("FIN 46R") is now required to be applied no later than the end of the first fiscal year or interim reporting period ending after March 15, 2004. For all special purpose entities created prior to February 1, 2003, FIN 46R is now required to be applied at the end of the first interim or annual reporting period ending after December 15, 2003. FIN 46R may be applied prospectively with a cumulative- effect adjustment as of the date it is first applied, or by restating previously issued financial statements with a cumulative-effect adjustment as of the beginning of the first year restated. FIN 46R also requires certain disclosures of an entity's relationship with variable interest entities. Both LG&E and KU hold investment interests in Ohio Valley Electric Corporation ("OVEC"), and KU holds an investment interest in Electric Energy, Inc. ("EEI"). Neither LG&E nor KU are the primary beneficiary of OVEC or EEI, and thus neither are consolidated into the financial statements of LG&E or KU. LG&E, KU and ten other electric utilities are participating owners of OVEC, located in Piketon, Ohio. OVEC owns and operates two power plants that burn coal to generate electricity, Kyger Creek Station in Ohio and Clifty Creek Station in Indiana. LG&E's share is 7%, representing approximately 155 Mw of generation capacity and KU's share is 2.5%, representing approximately 55 Mw of generation capacity. LG&E's and KU's original investments in OVEC were made in 1952. LG&E's investment in OVEC is the equivalent of 4.9% of OVEC's common stock and KU's investment is the equivalent of 2.5% of OVEC's common stock. LG&E's and KU's investments in OVEC are accounted for under the cost method of accounting. As of September 30, 2004, LG&E's and KU's investments in OVEC totaled $0.5 million and $0.3 million, respectively. LG&E's and KU's maximum exposure to loss as a result of their involvement with OVEC is limited to the value of their investments. In the event of the inability of OVEC to fulfill its power provision requirements, LG&E and KU would substitute such power supply with either owned generation or market purchases and would generally recover associated incremental costs through regulatory rate mechanisms. See Note 11 and Part II, Item 1, for further discussion of developments regarding LG&E's and KU's ownership interests and power purchase rights. KU owns 20% of the common stock of EEI, which owns and operates a 1,000- Mw generating station in southern Illinois. KU is entitled to take 20% of the available capacity of the station. Purchases from EEI are made under a contractual formula which has resulted in costs which were and are expected to be comparable to the cost of other power purchased or generated by KU. Such power equated to approximately 9% of KU's net generation system output in 2003. KU's original investment in EEI was made in 1953. KU's investment in EEI is accounted for under the equity method of accounting and, as of September 30, 2004, totaled $12.7 million. KU's direct exposure to loss as a result of its involvement with EEI is generally limited to the value of its investment. In the event of the inability of EEI to fulfill its power provision requirements, KU would substitute such power supply with either owned generation or market purchases and would generally recover associated incremental costs through regulatory rate mechanisms. FSP 106-2 In May 2004, the FASB finalized FASB Staff Position ("FSP") 106-2, Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003 ("Medicare Act") with guidance on accounting for subsidies provided under the Medicare Act which became law in December 2003. FSP 106-2 is effective for the first interim or annual period beginning after June 15, 2004. FSP 106-2 does not have a material impact on the Companies. Page 16 9. Debt Under the provisions for LG&E's variable-rate Pollution Control Bonds, Series S, T, U, BB, CC, DD and EE, and KU's variable-rate Pollution Control Bonds, Series 10, 12, 13, 14 and 15, the bonds are subject to tender for purchase at the option of the holder and to mandatory tender for purchase upon the occurrence of certain events, causing the bonds to be classified as current portion of long-term debt in the Consolidated Balance Sheets. The average annualized interest rate for these bonds during the three months and nine months ending September 30, 2004 was 1.20% and 1.14%, respectively, for the LG&E bonds and 1.30% and 1.18%, respectively, for the KU bonds. In January 2004, LG&E entered into two long-term loans from Fidelia Corporation ("Fidelia"), an E.ON financing subsidiary, one totaling $25 million with an interest rate of 4.33% that matures in January 2012, and one totaling $100 million with an interest rate of 1.53% that matures in January 2005. The loans are secured by a lien subordinated to the first mortgage bond lien. The proceeds were used to fund a pension contribution and to repay other debt obligations. In April 2004, LG&E prepaid $50 million of the $100 million 1.53% note payable to Fidelia. The prepayment was paid out of cash balances and there was no prepayment fee. In January 2004, KU entered into an unsecured long-term loan from Fidelia totaling $50 million with an interest rate of 4.39% that matures in January 2012. The proceeds were used to fund a pension contribution and to repay other debt obligations. In May 2004, KU redeemed $4.8 million of its Series 14 Pollution Control Bonds which were initially issued in the amount of $7.2 million. On October 20, 2004, KU completed a refinancing transaction regarding $50 million in existing pollution control indebtedness. The original indebtedness, 5.75% Pollution Control Bonds, Series 9, due December 1, 2023, will be discharged on November 22, 2004, with the proceeds from the replacement indebtedness, KU Pollution Control Bonds, Series 17, due October 1, 2034, which will carry a variable, auction rate of interest. LG&E maintains five bilateral lines of credit totaling $185 million that mature in 2005. There was no outstanding balance under these facilities at September 30, 2004. Management expects to renew these facilities as they expire. LG&E and KU participate in an intercompany money pool agreement wherein LG&E Energy and KU make funds available to LG&E at market-based rates (based on an index of highly rated commercial paper issues as of the prior month end) up to $400 million. Likewise, LG&E Energy and LG&E make funds available to KU at market-based rates up to $400 million. LG&E had $40.7 million in money pool loans from LG&E Energy (included in "Notes payable to affiliated companies") at an average rate of 1.60% at September 30, 2004, and $75.1 million at an average rate of 1.06% at September 30, 2003. The balance of the money pool loans from LG&E Energy to KU (included in "Notes payable to affiliated companies") was $29.8 million at an average rate of 1.60% and $98.7 million at an average rate of 1.06% at September 30, 2004 and 2003, respectively. The amount available to LG&E under the money pool agreement at September 30, 2004, was $359.3 million. The amount available to KU under the money pool agreement at September 30, 2004, was $370.2 million. LG&E Energy maintains a revolving credit facility totaling $150 million with an E.ON affiliate to ensure funding availability for the money pool. LG&E Energy had an outstanding balance of $79.1 million at an average rate of 2.13% under this facility as of September 30, 2004, and availability of $70.9 million remained. Page 17 As of September 30, 2004, LG&E had 225,000 shares of $5.875 series mandatorily redeemable preferred stock outstanding having a current redemption price of $100 per share. The preferred stock has a sinking fund requirement sufficient to retire a minimum of 12,500 shares on July 15 of each year commencing with July 15, 2003, and the remaining 187,500 shares on July 15, 2008 at $100 per share. Beginning September 30, 2003, LG&E reclassified its $5.875 series preferred stock as long- term debt with the minimum shares mandatorily redeemable within one year classified as current. Dividends accrued are charged as interest expense, pursuant to SFAS No. 150. On July 15, 2004, LG&E redeemed 12,500 shares as required at a price of $100 per share. 10. Related Party Transactions LG&E, KU, certain subsidiaries of LG&E Energy and other subsidiaries of E.ON engage in related-party transactions. Transactions among LG&E, KU and LG&E Energy subsidiaries are eliminated upon consolidation of LG&E Energy subsidiaries. Transactions between LG&E or KU and E.ON subsidiaries are eliminated upon consolidation of E.ON subsidiaries. These transactions are generally performed at cost and are in accordance with the SEC regulations under the PUHCA and the applicable Kentucky Public Service Commission ("Kentucky Commission") regulations. Accounts payable to and receivable from related parties are netted and presented as accounts payable to affiliated companies on the balance sheets of LG&E and KU, as allowed due to the right of offset. Obligations related to intercompany debt arrangements with LG&E Energy and Fidelia are presented as separate line items on the balance sheet, as appropriate. The significant related-party transactions are disclosed below. Electric Purchases LG&E and KU intercompany electric revenues and purchased power expense (including LG&E Energy Marketing Inc. ("LEM")) for the three months and nine months ended September 30, 2004 and 2003, were as follows: Three months endedNine months ended September 30, September 30, (in thousands) 2004 2003 2004 2003 LG&E Electric operating revenues from KU $10,095 $11,980 $40,598 $39,799 Electric operating revenues from LEM 1,092 537 2,443 8,691 Purchased power from KU 12,206 11,000 42,905 34,675 KU Electric operating revenues from LG&E $12,206 $11,000 $42,905 $34,675 Electric operating revenues from LEM 346 174 895 2,196 Purchased power from LG&E 10,095 11,980 40,598 39,799 Interest Income and Expense LG&E intercompany interest income and expense for the three months and nine months ended September 30, 2004 and 2003, were as follows: Three months ended Nine months ended September 30, September 30, (in thousands) 2004 2003 2004 2003 Interest to affiliate (money pool) $ 102 $ 305 $ 137 $1,573 Interest to affiliate (Fidelia loans) 2,927 1,801 8,995 2,560 Interest to affiliate (KU) 11 5 25 4 Interest expense to affiliated companies $3,040 $2,111 $9,157 $4,137 Interest income from affiliate (KU) - $ 2 - $ 6 Page 18 KU intercompany interest income and expense for the three months and nine months ended September 30, 2004 and 2003, were as follows: Three months ended Nine months ended September 30, September 30, (in thousands) 2004 2003 2004 2003 Interest to affiliate (money pool) $ 96 $ 279 $ 315 $1,001 Interest to affiliate (Fidelia loans) 3,461 1,635 10,326 2,394 Interest to affiliate (LG&E) - 2 - 6 Interest expense to affiliated companies $3,557 $1,916 $10,641 $3,401 Interest income from affiliate (LG&E) $ 11 $ 5 $ 26 $ 4 Other Intercompany Billings Other intercompany billings (including LG&E Energy Services Inc. ("LG&E Services")) related to LG&E and KU for the three months and nine months ended September 30, 2004 and 2003, were as follows: Three months ended Nine months ended September 30, September 30, (in thousands) 2004 2003 2004 2003 LG&E Services billings to LG&E $40,221 $44,607 $138,796 $132,894 LG&E Services billings to KU 42,342 48,508 117,530 134,916 LG&E billings to LG&E Services 5,951 12,801 10,475 18,944 LG&E billings to KU 14,962 25,127 48,464 61,248 KU billings to LG&E Services 516 4,774 4,430 12,638 KU billings to LG&E 2,097 3,104 26,928 11,549 11.Commitments and Contingencies Except as discussed in this Quarterly Report on Form 10-Q, material changes have not occurred in the current status of various commitments or contingent liabilities from that discussed in the Companies' Annual Report on Form 10-K for the year ended December 31, 2003, (including in Notes 3 and 11 to the financial statements of LG&E and KU contained therein and incorporated herein by reference) or Quarterly Reports on Form 10-Q for the quarters ended March 31, 2004 and June 30, 2004. Electric and Gas Rates Cases In December 2003, LG&E and KU filed applications with the Kentucky Commission requesting increases in LG&E's and KU's electric rates and LG&E's gas rates. The Companies requested general adjustments in electric rates and LG&E requested general adjustments in gas rates based on the twelve-month test year ended September 30, 2003. The revenue increases requested by LG&E were $63.8 million for electric and $19.1 million for gas. The revenue increase requested by KU was $58.3 million. On June 30, 2004, the Kentucky Commission issued an order approving increases in the base electric and gas rates of LG&E and the base electric rates of KU. The Kentucky Commission's order largely accepted proposed settlement agreements filed in May 2004 by LG&E, KU and a majority of the parties to the rate case proceedings. The rate increases took effect on July 1, 2004. Page 19 In the Kentucky Commission's order, (a) LG&E was granted increases in annual base electric rates of approximately $43.4 million (7.7%) and in annual base gas rates of approximately $11.9 million (3.4%) and (b) KU was granted an increase in annual base electric rates of approximately $46.1 million (6.8%). Other provisions of the order include decisions on certain depreciation, gas supply clause, ECR and VDT amounts or mechanisms and a termination of the ESM with respect to all periods after 2003. The order also provided for a recovery before March 31, 2005, by the Companies of previously requested amounts relating to the ESM during 2003. During July 2004, the Attorney General of Kentucky ("AG") served subpoenas on KU and LG&E, as well as on the Kentucky Commission and its staff, requesting information regarding allegedly improper communications between KU and LG&E and the Kentucky Commission, particularly during the period covered by the rate cases. The Kentucky Commission has procedurally reopened the rate cases for the limited purpose of taking evidence, if any, as to the communication issues. Subsequently, the AG filed pleadings with the Kentucky Commission requesting rehearing of the rate cases on certain computational components of the increased rates, including income tax, cost of removal and depreciation amounts. In August 2004, the Kentucky Commission denied the AG's rehearing request on the cost of removal and depreciation issues, with the effect that the rate increase order is final as to these matters, subject to the parties' rights to judicial appeals. The Kentucky Commission further agreed to hold in abeyance further proceedings in the rate cases, including the AG's concerns about alleged improper communications, until the AG could file with the Kentucky Commission an investigative report regarding the latter issue. In addition, the Kentucky Commission granted a rehearing on the income tax component once the abeyance discussed above is lifted. In September and October 2004, various proceedings were held in circuit courts in Franklin and Jefferson Counties, Kentucky regarding the scope and timing of document production or other information required or agreed to be produced under the AG's subpoenas. On October 12, 2004, the AG filed a status report with the Kentucky Commission in which the AG indicated that it had not completed its investigation and requested that the Kentucky Commission continue to hold these matters in abeyance. On October 21, 2004, the AG filed a motion with the Kentucky Commission requesting that the previously granted rate increases be set aside, that the Companies resubmit any applications for rate increases and that relevant Kentucky Commission personnel be recused from participation in rate case proceedings. On November 8, 2004, the Franklin County, Kentucky court denied an AG request for sanctions on KU and LG&E relating to production matters and narrowed the AG's permitted scope of discovery. As so required, LG&E's and KU's production of materials requested by the AG is expected to continue. LG&E and KU believe no improprieties have occurred in their communications with the Kentucky Commission and are cooperating with the proceedings before the AG and the Kentucky Commission. LG&E and KU are currently unable to estimate the general status or progress of the AG investigation, including when the AG will submit its report to the Kentucky Commission, and the content, findings and recommendations contained in any such report. The Companies are currently unable to determine the ultimate impact, if any, of, or any possible future actions of the AG or the Kentucky Commission arising out of, the AG's report and investigation, including whether there will be further actions to appeal, review or otherwise challenge the granted increases in base rates. Page 20 Earnings Sharing Mechanism The Companies filed their final 2003 ESM calculations with the Kentucky Commission on March 1, 2004, and applied for recovery of $13.0 million related to LG&E and $16.2 million related to KU. Based upon estimates, the Companies previously accrued $8.9 million at LG&E and $9.3 million at KU for the 2003 ESM as of December 31, 2003. On June 30, 2004, the Kentucky Commission issued an order largely accepting proposed settlement agreements by the Companies and all intervenors regarding the ESM mechanisms of LG&E and KU. Under the ESM settlements, LG&E and KU will continue to collect approximately $13.0 million and $16.2 million, respectively, of previously requested 2003 ESM revenue amounts through March 2005. As part of the settlement, the parties agreed to a termination of the ESM mechanism relating to all periods after 2003. As a result of the settlement, the Company accrued an additional $4.1 million at LG&E and $6.9 million at KU in June 2004, related to 2003 ESM revenue. OVEC Power Agreement and Share Purchase On April 30, 2004, OVEC and its shareholders, including LG&E and KU, entered into an Amended and Restated Inter-Company Power Agreement, to be effective beginning March 2006, upon the expiration of the current power contract among the parties. Under the new contract, which has a 20-year term from its effective date, LG&E and KU have purchase rights for 5.63% and 2.5%, respectively, of OVEC power at marginal cost-based rates. LG&E and KU are entitled to 7% and 2.5% of OVEC power, respectively, under the current contract. LG&E's estimated future minimum annual demand payments under the Amended and Restated Inter-Company Power Agreement are as follows: (in thousands) 2006 $ 10,098 2007 9,726 2008 9,932 2009 10,144 2010 10,361 Thereafter 170,646 Total $220,907 In addition, LG&E will purchase from American Electric Power Company Inc. ("AEP") an additional 0.73% interest in OVEC for a purchase price of approximately $104,000, resulting in an increase in LG&E ownership in OVEC from 4.9% to 5.63%. The share purchase transaction is anticipated to be completed during 2005, subject to receipt of certain regulatory approvals. The change to the power agreement and the share purchase are expected to have no impact on the accounting for OVEC under FIN 46R as discussed in Footnote 8. Owensboro Contract Litigation In May 2004, the City of Owensboro, Kentucky and Owensboro Municipal Utilities (collectively "OMU"), filed suit in Davies County, Kentucky District Court against KU concerning a long-term power supply contract (the "OMU Agreement") with KU. The dispute involves interpretational differences regarding certain issues under the OMU Agreement, including various payments or charges between KU and OMU and rights concerning excess power, termination and emissions allowances, respectively. The complaint seeks approximately $6 million in damages for historical periods, as well as injunctive and other relief, including a declaration that KU is in material breach. KU has removed this litigation to the U.S. District Court for the Western District of Kentucky, filed an answer in that court denying the OMU claims and presenting certain counterclaims and commenced a FERC proceeding to request FERC jurisdiction on certain issues. In October 2004, FERC declined to exercise exclusive jurisdiction regarding the issues in dispute, which ruling KU has appealed. Environmental Matters In September 1998, the EPA announced its final "NOx SIP Call" rule requiring states to impose significant additional reductions in NOx emissions by May 2003, in order to mitigate alleged ozone transport impacts on the Northeast region. The Commonwealth of Kentucky SIP, Page 21 which was approved by EPA June 24, 2003, required reductions in NOx emissions from coal-fired generating units to the 0.15 lb./Mmbtu level on a system-wide basis. In related proceedings in response to petitions filed by various Northeast states, in December 1999, the EPA issued a final rule pursuant to Section 126 of the Clean Air Act directing similar NOx reductions from a number of specifically targeted generating units including all LG&E and KU units. As a result of appeals to both rules, the compliance date was extended to May 2004. LG&E and KU have complied with these NOx emissions reduction rules by installing additional NOx controls to their generating units. Installations of additional NOx controls were performed on a phased basis, which commenced in late 2000 and continued through the final compliance date. As of September 30, 2004, LG&E has incurred total capital costs of approximately $185 million to reduce its NOx emissions to the 0.15 lb./Mmbtu level on a company-wide basis. As of September 30, 2004, KU has incurred total capital costs of approximately $203 million to reduce its NOx emissions to the 0.15 lb./Mmbtu level on a company-wide basis. In addition, LG&E and KU have begun incurring additional operation and maintenance costs in operating new NOx controls. LG&E and KU believe their costs in this regard to be comparable to those of similarly situated utilities with like generation assets. In April 2001, the Kentucky Commission granted recovery of these costs under the environmental surcharge mechanism for LG&E and KU. During August 2004, KU, the EPA and the Department of Justice agreed in principle to settle outstanding matters concerning a 1999 oil discharge at KU's E.W. Brown plant for approximately $0.6 million, a portion of which may be satisfied by KU's construction of a separate environmental capital project. The settlement is subject to completion of final definitive documents. In December 2003, KU recorded an accrual and expense to operations of $0.6 million. LG&E and KU are also monitoring several other air quality issues which may potentially impact coal-fired power plants, including the EPA's revised air quality standards for ozone and particulate matter, measures to implement the EPA's regional haze rule, and the EPA's December 2003 proposals to regulate mercury emissions from steam electric generating units and to further reduce emissions of sulfur dioxide and nitrogen oxides under the Clean Air Interstate Rule. In addition, LG&E is currently reviewing and making comments on proposed regulations concerning toxic air emissions within Metro Louisville, where the company operates two coal-fired generating stations. LG&E is also working with local regulatory authorities to review the effectiveness of remedial measures aimed at controlling particulate matter emissions from its Mill Creek Station. LG&E previously settled a number of property damage claims from adjacent residents and completed significant remedial measures as part of its ongoing capital construction program. LG&E has converted the Mill Creek Station to a wet stack operation in an effort to resolve all outstanding issues related to particulate matter emissions. FERC Developments A number of regional or industry-wide FERC proceedings regarding transmission market structure changes are in varying stages of development. In August 2004, MISO filed its FERC-required proposed Transmission and Energy Markets Tariff ("TEMT"). In September and October 2004, many MISO-related parties filed proposals with the FERC regarding pending MISO-filed changes to transmission pricing principles, including the TEMT and elimination of through-and-out transmission ("T&O") charges. Additional filings of the Companies before FERC in September 2004 sought to address issues relating to the Page 22 treatment of certain "grandfathered" transmission agreements ("GFA's") should TEMT become effective. The utility proposals generally seek to appropriately delay the T&O and TEMT tariff effective dates based upon errors in administrative or procedural processes used by FERC or to appropriately limit potential reductions in transmission revenues received by LG&E and KU should the T&O, TEMT or GFA tariffs structures be implemented. At present, existing FERC orders conditionally approve elimination of T&O rates and implementation of general TEMT rates in MISO of December 1, 2004 and March 1, 2005, respectively. At this time, LG&E and KU cannot predict the outcome or effects of the various FERC proceedings described above, including whether such will have a material impact on the financial conditions or results of operations of the Companies. 12.Pension and Other Post-retirement Benefit Plans The following table provides the components of net periodic benefit cost for pension and other benefit plans: Three Months Ended Year to Date September 30, 2004 September 30, 2004 (in thousands) LG&E KU LG&E KU Components of net periodic benefit cost: Service cost $ 977 $ 1,152 $ 3,997 $ 4,754 Interest cost 4,910 3,692 20,092 15,240 Expected return on plan assets (4,469) (3,334) (18,287) (13,764) Amortization of prior service cost (2) 154 (9) 636 Amortization of transition obligation 939 281 3,843 1,161 Recognized actuarial loss 515 331 2,107 1,369 $ 2,870 $ 2,276 $11,743 $ 9,396 In January 2004, LG&E and KU made discretionary contributions to their pension plans in the amounts of $34.5 million and $43.4 million, respectively. No contributions are required for 2004 for either LG&E or KU and no further discretionary contributions are planned for 2004. 13. Subsequent Events On October 20, 2004, KU completed a refinancing transaction regarding $50 million in existing pollution control indebtedness. The original indebtedness, 5.75% Pollution Control Bonds, Series 9, due December 1, 2023, will be discharged on November 22, 2004, with the proceeds from the replacement indebtedness, KU Pollution Control Bonds, Series 17, due October 1, 2034, which will carry a variable, auction rate of interest. Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. General The following discussion and analysis by management focuses on those factors that had a material effect on LG&E's and KU's financial results of operations and financial condition during the three and nine month periods ended September 30, 2004, and should be read in connection with the financial statements and notes thereto. Some of the following discussion may contain forward-looking statements that are subject to certain risks, uncertainties and assumptions. Such forward-looking statements are intended to be identified in this document by the words "anticipate," "expect," "estimate," "objective," "possible," "potential" and similar expressions. Actual results may vary materially. Factors that could cause actual results to differ materially include: general economic conditions; business and competitive conditions in the energy industry; changes in federal or state legislation; unusual weather; actions by state or federal regulatory agencies; and other factors described from time to time in LG&E's and KU's reports to the SEC, including the Annual Reports on Form 10-K for the year ended December 31, 2003. Executive Summary LG&E's net income for the three months ended September 30, 2004 was $32.5 million ($7.3 million lower than the three months ended September 30, 2003). The decrease was primarily related to maintenance costs resulting from severe storms which swept through the service territory in July and lower electric sales due to milder weather. KU's net income for the three months ended September 30, 2004, was $34.8 million ($4.5 million higher than the three months ended September 30, 2003). The increase was primarily due to higher retail electric revenues resulting from the general rate increase, partially offset by higher depreciation expense. Page 23 LG&E's net income for the nine months ended September 30, 2004 was $73.9 million ($1.0 million lower than the nine months ended September 30, 2003). The decrease was primarily related to higher operations and maintenance expense, offset by higher electric revenues resulting from the general rate increase and a higher environmental cost recovery surcharge. KU's net income for the nine months ended September 30, 2004 was $94.8 million ($38.5 million higher than the nine months ended September 30, 2003). The increase was primarily due to higher electric revenues and lower maintenance expense (KU service territory experienced a severe ice storm in 2003). As regulated utilities, LG&E and KU's financial performance is greatly impacted by regulatory proceedings. On June 30, 2004, the Kentucky Commission issued an order approving increases in the base rates of LG&E and KU. The rate increase took effect on July 1, 2004. Subsequently, the AG commenced an investigation examining communications between the Kentucky Commission and the Companies and, separately, filed for a rehearing of the rate cases on such issue and certain calculation components of the increased rates and filed for the existing rate increases to be set aside. The Kentucky Commission is considering the matters relating to the AG's actions. For a description of developments in these cases, see Note 11 of the Notes to Consolidated Financial Statements in Part 1, Item 1 of this Quarterly Report on Form 10-Q. Results of Operations The results of operations for LG&E and KU are affected by fluctuations in temperature and other weather-related factors. Because of these and other factors, the results of one period are not necessarily indicative of results or trends to be expected for another period. Three Months Ended September 30, 2004, Compared to Three Months Ended September 30, 2003 LG&E Results: LG&E's net income decreased $7.3 million (18%) for the three months ended September 30, 2004, as compared to the three months ended September 30, 2003, primarily due to higher maintenance expenses related to July storms and lower electric sales. A comparison of LG&E's revenues for the three months ended September 30, 2004, with the three months ended September 30, 2003, reflects increases and (decreases) which have been segregated by the following principal causes: (in thousands) Electric Gas Cause Revenues Revenues Retail sales: Fuel and gas supply adjustments $ (425) $1,243 Environmental cost recovery surcharge 3,707 - Earnings sharing mechanism 139 - LG&E/KU merger surcredit 123 - Value delivery surcredit (256) 28 Demand side management 3 (42) General rate increase 10,105 1,443 Variation in sales volume and other (11,353) (647) Total retail sales 2,043 2,025 Wholesale sales (2,448) - Provision for rate refunds (2,689) - Other (56) 134 Total $(3,150) $2,159 Page 24 Electric revenues decreased $3.2 million primarily as a result of lower sales volumes from cooler weather as cooling degree days declined 3.2% from last year. Also contributing to the decrease were lower wholesale revenues and higher provisions for rate refunds. The provision for rate refunds decreased revenues $2.7 million, largely as a result of a higher provision for the environmental cost recovery surcharge. The revenue decreases were partially offset by the general rate increase, effective with service rendered July 1, 2004, and an increase in environmental cost recovery. Gas revenues increased $2.2 million primarily as a result of the general rate increase, effective with service rendered July 1, 2004, and an increase in recovery of higher natural gas prices billed to customers through the gas supply clause. Fuel for electric generation and gas supply expenses comprise a large component of LG&E's total operating expenses. LG&E's electric and gas rates contain a fuel adjustment clause and a gas supply clause, respectively, whereby increases or decreases in the cost of fuel and gas supply are reflected in retail rates, subject to the approval of the Kentucky Commission. Fuel for electric generation decreased $2.0 million (4%) due to a decrease in generation ($1.8 million) and a decrease in the cost of coal burned ($0.2 million). Gas supply expenses increased $0.7 million (3%) due to an increase in net gas supply cost ($1.2 million), offset by a decrease in the volume of retail gas sold ($0.5 million). Other operation expenses decreased $3.8 million (7%), as compared to 2003. Pension expense decreased $1.2 million. Electric distribution operations expense decreased $2.9 million due to transfer of $4.0 million to maintenance (related to storms) offset by higher non-storm related distribution operations of $1.1 million. Maintenance expenses increased $10.5 million (84%) primarily due to storms ($8.8 million, including $4.0 million transferred from Operations to Maintenance in third quarter 2004). Non-storm related distribution maintenance increased $2.1 million. Depreciation and amortization increased $1.9 million (7%) due to a corresponding increase in plant in service of $199.4 million (5.8%). The increase in plant included $37.2 million related to the completion of Trimble County CT's 9 and 10, as well as increases to steam production plant of $59.3 million, to electric distribution plant of $31.0 million and to gas distribution plant of $29.9 million. The increase in depreciation and amortization was partially offset by a reduction in amortization expense related to certain software, which became fully amortized in the final quarter of 2003. Other income decreased $1.4 million, resulting from a $1.3 million write- off in July 2004 related to the cancellation of the "Pay As You Go" metering project. Variations in income tax expense are largely attributable to changes in pre- tax income. Three Months Three Months Ended Ended Sept. 30, 2004 Sept. 30, 2003 Statutory federal income tax rate 35.0% 35.0% State income taxes net of federal benefit 4.6 4.9 Amortization of investment tax credit & R&D (0.6) (1.7) Other differences (0.7) (2.4) Effective income tax rate 38.3% 35.8% Page 25 The variation in the tax rate is largely attributable to excess deferred tax benefits recorded in 2003, reflecting the benefits of deferred taxes reversing at lower tax rates than what were provided, and lower amortization of the investment tax credit. Interest expense decreased $0.9 million (15%) primarily due to savings on interest expense realized from the refinancing of fixed-rate Series V and Series W Pollution Control Bonds to the variable-rate Series GG Pollution Control Bonds in November 2003. Interest expense to affiliated companies increased $0.9 million (44%) primarily due to a $1.1 million increase in interest expense to Fidelia related to new notes issued in August 2003 and January 2004. Offsetting this increase is a $0.2 million decrease in interest expense on borrowings from the money pool due to lower borrowing levels. The weighted average interest rate on variable-rate bonds for the three months ended September 30, 2004, was 1.30% and the corresponding rate for the three months ended September 30, 2003, was 0.99%. KU Results: KU's net income increased $4.5 million (15%) for the three months ended September 30, 2004, as compared to the three months ended September 30, 2003. The increase was primarily due to higher revenues due to July 2004 rate increases, partially offset by higher depreciation expense. A comparison of KU's revenues for the three months ended September 30, 2004, with the three months ended September 30, 2003, reflects increases and (decreases) which have been segregated by the following principal causes: (in thousands) Electric Cause Revenues Retail sales: Fuel supply adjustments $ 2,297 Environmental cost recovery surcharge 1,151 Earnings sharing mechanism 1,332 LG&E/KU merger surcredit (615) Value delivery surcredit (111) Demand side management 404 General rate increase 9,596 Variation in sales volume and other (446) Total retail sales 13,608 Wholesale sales 1,465 Provision for rate collections 1,794 Other 376 Total $17,243 Electric revenues increased $17.2 million primarily as the result of the general rate increase, effective with service rendered July 1, 2004, and increases in fuel adjustment clause recoveries, recovery of environmental costs, earnings sharing mechanism revenues, wholesale revenues and an increase in provision for rate collections. The provision for rate collections increased $1.8 million largely as the result of a higher provision for the environmental cost recovery surcharge ($4.2 million), partially offset by lower provisions for the earnings sharing mechanism ($1.3 million) and fuel clause recovery ($1.1 million). Fuel for electric generation comprises a large component of KU's total operating expenses. KU's electric rates contain a fuel adjustment clause, whereby increases or decreases in the cost of fuel are reflected in retail rates, subject to the approval of the Kentucky Commission, the Virginia State Corporation Commission, and the Federal Energy Regulatory Commission. Fuel for electric generation increased $2.9 million (4%) for the quarter because of an increase in generation ($3.2 million), partially offset by a slight decrease in the cost of coal burned ($0.3 million). Page 26 Power purchased increased $1.5 million (5%) due to an increase in the price of power purchased ($3.1 million), offset by a decrease in the volume purchased ($1.6 million). Other operation expenses increased $2.2 million (6%) as compared to 2003. Steam power operations increased $1.9 million, primarily due to increased emission allowance expense ($1.2 million) and higher expense related to SCR/NOX reduction ($0.4 million). Maintenance expense decreased $1.0 million, primarily due to a decrease of $1.4 million in distribution maintenance. In September 2004, $4.0 million in costs related to the 2003 ice storm were reclassified from maintenance expense to a regulatory asset, based on an order from the Kentucky Commission, to be amortized through June 2009. KU earns a return of these amortized costs, which are included in KU's jurisdictional operating expenses. Offsetting this decrease was $1.3 million in expense related to 2004 storms, $0.6 million higher vegetation management expense, and $0.2 million amortization of the ice storm deferral. Depreciation and amortization increased $4.3 million (17%) due to a corresponding increase in plant in service of $155.4 million (5%). The increase in plant included $63.8 million related to the completion of Trimble County CT's 9 and 10, as well as increases to transmission plant of $11.1 million and to electric distribution plant of $30.6 million. Variations in income tax expense are largely attributable to changes in pretax income. Three Months Three Months Ended Ended Sept. 30, 2004 Sept. 30, 2003 Statutory federal income tax rate 35.0% 35.0% State income taxes net of federal benefit 4.1 5.0 Amortization of investment tax credit & R&D (1.0) (1.4) Other differences (3.2) (2.9) Effective income tax rate 34.9% 35.7% Interest expense increased $0.4 million (16%). A reduction in the savings associated with interest rate swaps, caused primarily by the termination of a swap, increased interest expense by $1.2 million. This increase was offset by $0.7 million in interest expense savings from the redemption of 8.55% Series P Pollution Control Bonds redeemed in November of 2003. Interest expense to affiliated companies increased $1.6 million (86%) primarily due to a $1.8 million increase in interest expense to Fidelia related to new notes issued from August 2003 through January 2004. Offsetting this increase is a $0.2 million decrease in interest expense on borrowings from the money pool due to lower borrowing levels. The weighted average interest rate on variable-rate bonds for the three months ended September 30, 2004, was 1.32% and the corresponding rate for the three months ended September 30, 2003, was 0.91%. Nine Months Ended September 30, 2004, Compared to Nine Months Ended September 30, 2003 LG&E Results: LG&E's net income decreased $1.0 million (1%) for the nine months ended September 30, 2004, as compared to the nine months ended September 30, 2003, primarily due to higher operations and maintenance expense, offset by higher electric revenues. Page 27 A comparison of LG&E's revenues for the nine months ended September 30, 2004, with the nine months ended September 30, 2003, reflects increases and (decreases) which have been segregated by the following principal causes: (in thousands) Electric Gas Cause Revenues Revenues Retail sales: Fuel and gas supply adjustments $(1,493) $ 46,625 Environmental cost recovery surcharge 11,618 - Earnings sharing mechanism 3,913 - LG&E/KU merger surcredit (1,296) - Value delivery surcredit (786) 5 Demand side management 357 (420) Weather normalization - 2,419 General rate increase 10,105 1,443 Variation in sales volume and other 4,244 (22,523) Total retail sales 26,662 27,549 Wholesale sales 5,642 1,034 Provision for rate refunds (5,670) - Other 95 (344) Total $26,729 $ 28,239 Electric revenues increased $26.7 million primarily as a result of increased environmental cost recovery, the general rate increase, effective with service rendered July 1, 2004, wholesale revenues (4% higher pricing offset by 3% lower volumes), and higher retail sales volumes. The provision for rate refunds decreased revenues $5.7 million due to a decrease in environmental cost recovery surcharge ($6.7 million) and earnings sharing mechanism recoveries ($0.9 million), partially offset by higher fuel adjustment clause recoveries ($1.9 million). Gas revenues increased $28.2 million primarily as a result of higher natural gas prices passed on to customers through the gas supply clause, partially offset by lower sales volumes resulting from milder weather during the heating months than in the prior period. Fuel for electric generation increased $2.4 million (2%) for the nine months due to an increase in the cost of coal burned ($1.4 million) and higher generation ($1.0 million). Gas supply expenses increased $30.3 million (20%) due to an increase in net gas supply cost ($42.0 million), offset by a decrease in the volume of retail gas delivered to the distribution system ($11.5 million). Power purchased increased $5.3 million (9%) due to an increase in the price of power purchased ($4.3 million) and a 2% increase in the volume of the purchases ($1.0 million) primarily to meet slightly higher load requirements. Other operations expenses increased $4.5 million (3%) in 2004, as compared to 2003, due to higher transmission expense of $2.7 million, primarily due to higher MISO-related expense, and $4.6 million higher electric distribution expense, due in part to the May and July 2004 storms. These higher expenses were partially offset by $2.8 million lower amortization of costs to achieve the KU/LG&E merger and One Utility initiative. These costs were fully amortized by June 2003 (KU/LG&E merger) and September 2003 (One Utility). Maintenance expenses increased $7.8 million (18%). Distribution maintenance increased $9.6 million, primarily due to the May and July storm restoration. In 2003, $2.1 million of obsolete inventory was written off. Page 28 Depreciation and amortization increased $0.2 million (0.2%). The net increase in depreciation and amortization expense for the nine months ended was due to an increase in depreciation related to an increase in plant in service of $199.4 million (5.8%) which was largely offset by a decrease in amortization expense related to certain software, which became fully amortized in the final quarter of 2003. Variations in income tax expense are largely attributable to changes in pre- tax income. Nine Months Ended Nine Months Ende d Sept. 30, 2004 Sept. 30, 2003 Statutory federal income tax rate 35.0% 35.0% State income taxes net of federal benefit 5.2 5.3 Amortization of investment tax credit & R&D (2.7) (2.7) Other differences (0.1) (1.6) Effective income tax rate 37.4% 36.0% The variation in the other differences is largely attributable to excess deferred tax benefits recorded in 2003, reflecting the benefits of deferred taxes reversing at lower tax rates than what were provided. Property and other taxes increased $1.6 million (13%). Property tax expense reflected a $1.2 million coal incentive tax credit in 2003, and a $0.7 million credit in 2004. The remaining increase related primarily to increased property tax accruals, as a result of capital expansion, and higher employment taxes. Interest expense decreased $3.0 million (17%). Interest related to long- term debt decreased $5.8 million due to the refinancing of fixed-rate Series V and Series W Pollution Control Bonds into the variable-rate Series GG Pollution Control Bonds and the redemption of the first mortgage bond in August 2003. These savings were partially offset by an increase in interest expense related to interest rate swaps associated with the Series GG bonds totaling $2.6 million. Interest expense to affiliated companies increased $5.0 million (121%) primarily due to a $6.4 million increase in interest expense to Fidelia related to new notes issued in August 2003 and January 2004. Offsetting this increase is a $1.4 million decrease in interest expense on borrowings from the money pool due to lower borrowing levels. The weighted average interest rate on variable-rate bonds for the nine months ended September 30, 2004 was 1.14%, compared to 1.12% for the comparable period in 2003. KU Results: KU's net income increased $38.5 million (68%) for the nine months ended September 30, 2004, as compared to the nine months ended September 30, 2003. The increase was primarily due to higher electric revenues and lower maintenance expense. Page 29 A comparison of KU's revenues for the nine months ended September 30, 2004, with the nine months ended September 30, 2003, reflects increases and (decreases) which have been segregated by the following principal causes: (in thousands) Electric Cause Revenues Retail sales: Fuel supply adjustments $ 2,683 Environmental cost recovery surcharge 3,218 Earnings sharing mechanism 6,636 LG&E/KU merger surcredit (2,443) Value delivery surcredit (296) Demand side management 424 General rate increase 9,596 Variation in sales volume and other 18,874 Total retail sales 38,692 Wholesale sales 13,382 Provision for rate collections 17,657 Other 5,110 Total $74,841 Electric revenues increased $74.8 million primarily due to increased sales volumes to ultimate consumers of 3.9% due to warmer weather than last year as cooling degree days increased 3%. The general rate increase, effective with service rendered July 1, 2004, increased revenues approximately $9.6 million. Also contributing to the overall revenue increase were increases in the provision for rate collections, wholesale revenues (26% higher pricing offset by 3% lower volumes), earnings sharing mechanism recoveries and the recovery of fuel and environmental costs. The provision for rate collections included higher provisions for the environmental cost recovery ($14.6 million), the earnings sharing mechanism ($2.2 million) and the fuel adjustment clause ($0.9 million). Fuel for electric generation increased $14.4 million (7%) for the nine months due to an increase in the cost of coal burned ($6.4 million) and an increase in generation ($8.0 million). Power purchased decreased $1.4 million (1%) due to a decrease in the price of power purchased ($2.1 million), partially offset by an increase in volumes purchased ($0.7 million) due to higher retail and wholesale loads. Other operation expenses increased $0.2 million. Steam generation expense increased $4.3 million, primarily due to higher emission allowance expense, and transmission expense increased $0.5 million. Amortization of $2.9 million related to costs to achieve the KU/LG&E merger and One Utility initiative was recorded in 2003 and was fully amortized as of June 2003. Pension expense decreased $0.8 million, and bad debt expense decreased $0.7 million. Maintenance expenses decreased $8.4 million (17%). Steam power maintenance expense decreased $3.2 million; Ghent Unit 3, Green River Unit 4 and Tyrone Unit 3 all had major overhauls in 2003. Distribution maintenance decreased $2.8 million. In September 2004, $4.0 million in costs related to the 2003 ice storm were reclassified from maintenance expense to a regulatory asset, based on an order from the Kentucky Commission, to be amortized through June 2009. KU earns a return of these amortized costs, which are included in KU's jurisdictional operating expenses. Offsetting this decrease was $2.2 million in expense related to the 2004 storms. Transmission overhead line maintenance decreased $0.4 million. Page 30 Depreciation and amortization increased $3.6 million (5%) due to an increase in plant in service of $155.4 million (4.8%). The increase in plant included $63.8 million related to the completion of Trimble County CTs 9 and 10, as well as increases to transmission plant of $11.1 million and to electric distribution plant of $30.6 million. Variations in income tax expense are largely attributable to changes in pretax income. Nine Months Ended Nine Months Ended Sept. 30, 2004 Sept. 30, 2003 Statutory federal income tax rate 35.0% 35.0% State income taxes net of federal benefit 5.3 5.8 Amortization of investment tax credit & R&D (1.0) (2.3) Other differences (2.4) (3.6) Effective income tax rate 36.9% 34.9% The amortization of the investment tax credit and other differences were approximately the same in both periods, but lower pretax income for the nine months ended September 30, 2003, caused the percentage changes to be greater in the 2003 period. Interest expense decreased $6.3 million (45%) due primarily to the redemption of 8.55% Series P Pollution Control Bonds and 6.32% Series Q Pollution Control Bonds redeemed in November and June of 2003, respectively. Additionally, interest rate swaps yielded a $1.6 million decrease in related interest expenses resulting primarily from the February termination of a swap related to the Series 9 Pollution Control Bonds and better performance of remaining swaps. Interest expense to affiliated companies increased $7.2 million (213%) primarily due to a $7.9 million increase in interest expense to Fidelia related to new notes issued in August 2003 through January 2004. Offsetting this increase is a $0.7 million decrease in interest expense on borrowings from the money pool due to lower borrowing levels. The weighted average interest rate on variable-rate bonds for the nine months ended September 30, 2004, was 1.16% and the corresponding rate for the nine months ended September 30, 2003, was 1.08%. Liquidity and Capital Resources LG&E and KU's needs for capital funds are largely related to the construction of plant and equipment necessary to meet the needs of electric and gas utility customers. Internal and external lines of credit are maintained to fund short-term capital requirements. LG&E and KU believe that such sources of funds will be sufficient to meet the needs of the business in the foreseeable future. As of September 30, 2004, LG&E and KU are in a negative working capital position in part because of the classification of certain variable-rate pollution control bonds that are subject to tender for purchase at the option of the holder as current portion of long-term debt. The Companies expect to cover any working capital deficiencies with cash flow from operations, money pool borrowings, and borrowings from Fidelia, an E.ON financing subsidiary. Construction expenditures for the nine months ended September 30, 2004 for LG&E and KU amounted to $94.2 million and $104.0 million, respectively. Such expenditures include construction to meet nitrogen oxide (NOx) emission standards and the acquisition of combustion turbines to meet peak power demands. Expenditures for the nine months ended September 30, 2004, by LG&E and KU for NOx construction were $4.1 million and $29.2 million, respectively. Expenditures for the nine months ended September 30, 2004, for Trimble County combustion turbines, Units 7 through 10, by LG&E and KU were $7.0 million and $12.0 million, respectively. In addition, LG&E construction expenditures include $10.0 million for distribution overhead line construction, $4.1 million for Mill Creek Unit 3 ductwork installation related to the flue gas desulfurization ("FGD") project, and $8.3 million for gas main replacements. At KU, construction expenditures include $6.4 million for E.W. Brown Unit 3 cooling tower and precipitator rebuild and $9.0 million for distribution construction in the Lexington area. The expenditures were financed with internally generated funds and intercompany loans from affiliates. Page 31 LG&E's cash balance increased $4.2 million due to increased net borrowings from affiliated companies, partially offset by pension funding and payment of common dividends to its parent company. LG&E's restricted cash balance increased $11.5 million during the nine months ended September 30, 2004, primarily due to an increase in collateral held by third parties related to interest rate swaps. KU's cash balance remained level, decreasing $0.2 million during the nine months ended September 30, 2004, as higher net income and increased net borrowings from affiliated companies offset pension funding, construction expenditures and the payment of common dividends to its parent company. Variations in accounts receivable, accounts payable and materials and supplies are generally not significant indicators of LG&E's and KU's liquidity. In general, such variations are usually attributable to seasonal fluctuations in weather, which have a direct effect on sales of electricity and natural gas. However, the increase in accounts receivable at LG&E and KU, as of September 30, 2004, was primarily due to the termination of the accounts receivable securitization programs in January 2004. Discontinuing the accounts receivable securitization programs resulted in an increase in accounts receivable of $58.0 million at LG&E and $50.0 million at KU. (LG&E and KU maintained a reserve for uncollectible accounts related to receivables sold during the securitization program). The increase in accounts receivable at LG&E as of September 30, 2004 was somewhat offset by the impact of decreased gas sales in September 2004 compared to December 2003. The decrease in fuel inventory at KU as of September 30, 2004, was due to an increase in tons burned and a slow down of coal deliveries. Interest rate swaps are used to hedge LG&E's and KU's underlying variable- rate debt obligations. These swaps hedge specific debt issuances and, consistent with management's designation, are accorded hedge accounting treatment. As of September 30, 2004, LG&E had swaps with a combined notional value of $228.3 million and KU had swaps with a combined notional value of $103.0 million. LG&E's swaps exchange floating-rate interest payments for fixed-rate interest payments to reduce the impact of interest rate changes on LG&E's pollution control bonds. KU's swaps effectively convert fixed-rate obligations on KU's First Mortgage Bonds Series P and R to variable-rate obligations. In February 2004, KU terminated the swap it had in place at December 31, 2003 related to its Series 9 Pollution Control Bonds. The notional amount of the terminated swap was $50 million and KU received a payment of $2.0 million as part of the termination, resulting in a gain of $0.8 million. At September 30, 2004, variable rate debt, including the impact of interest rate swaps, was 38.0% of LG&E's total debt at $346.7 million and 44.0% of KU's total debt at $328.9 million. At December 31, 2003, variable rate debt, including the impact of interest rate swaps, was 44.0% of LG&E's total debt at $386.3 million and 55.5% of KU's total debt at $397.1 million. Under the provisions of LG&E's variable-rate Pollution Control Bonds, Series S, T, U, BB, CC, DD and EE, and KU's variable-rate Pollution Control Bonds, Series 10, 12, 13, 14 and 15, the bonds are subject to tender for purchase at the option of the holder and to mandatory tender for purchase upon the occurrence of certain events, causing the bonds to be classified as current portion of long-term debt in the Consolidated Balance Sheets. The average annualized interest rate for these bonds during the three months and nine months ending September 30, 2004, was 1.20% and 1.14%, respectively, for the LG&E bonds and 1.30% and 1.18%, respectively, for the KU bonds. In January 2004, LG&E entered into two long-term loans with Fidelia, one totaling $25 million with an interest rate of 4.33% that matures in January 2012, and one totaling $100 million with an interest rate of 1.53% that matures in January 2005. The loans are secured by a lien subordinated to the first mortgage bond lien. The proceeds were used to fund a pension contribution and to repay other debt obligations. In April 2004, LG&E prepaid $50 million of the $100 million 1.53% note payable to Fidelia. The prepayment was paid out of cash balances and there was no prepayment fee. In January 2004, KU entered into an unsecured long-term loan from Fidelia totaling $50 million with an interest rate of 4.39% that matures in January 2012. The proceeds were used to fund a pension contribution and to repay other debt obligations. Page 32 In May 2004, KU redeemed $4.8 million of its Series 14, Pollution Control Bonds which were initially issued in the amount of $7.2 million. On October 20, 2004, KU completed a refinancing transaction regarding $50 million in existing pollution control indebtedness. The original indebtedness, 5.75% Pollution Control Bonds, Series 9, due December 1, 2023, will be discharged on November 22, 2004, by the proceeds from the replacement indebtedness, KU Pollution Control Bonds, Series 17, due October 1, 2034, which will carry a variable, auction rate of interest. LG&E maintains five bilateral lines of credit with banks totaling $185 million that mature in 2005. There was no outstanding balance under these facilities at September 30, 2004. Management expects to renew these facilities as they expire. LG&E and KU participate in an intercompany money pool agreement wherein LG&E Energy and KU make funds available to LG&E at market-based rates (based on an index of highly rated commercial paper issues as of the prior month end) up to $400 million. Likewise, LG&E Energy and LG&E make funds available to KU at market-based rates up to $400 million. LG&E had $40.7 million in money pool loans from LG&E Energy (included in "Notes payable to affiliated companies") at an average rate of 1.60% at September 30, 2004, and $75.1 million at an average rate of 1.06% at September 30, 2003. The balance of the money pool loans from LG&E Energy to KU (included in "Notes payable to affiliated companies") was $29.8 million at an average rate of 1.60% and $98.7 million at an average rate of 1.06% at September 30, 2004 and 2003, respectively. The amount available to LG&E under the money pool agreement at September 30, 2004, was $359.3 million. The amount available to KU under the money pool agreement at September 30, 2004, was $370.2 million. LG&E Energy maintains a revolving credit facility totaling $150 million with an affiliate to ensure funding availability for the money pool. LG&E Energy had an outstanding balance of $79.1 million at an average rate of 2.13% under this facility as of September 30, 2004 and availability of $70.9 million remained. As of September 30, 2004, LG&E had 225,000 shares of $5.875 series mandatorily redeemable preferred stock outstanding having a current redemption price of $100 per share. The preferred stock has a sinking fund requirement sufficient to retire a minimum of 12,500 shares on July 15 of each year commencing with July 15, 2003, and the remaining 187,500 shares on July 15, 2008 at $100 per share. Beginning with the three months ended September 30, 2003, LG&E reclassified its $5.875 series preferred stock as long-term debt with the minimum shares mandatorily redeemable within one year classified as current. Dividends accrued are charged as interest expense, pursuant to SFAS No. 150. On July 15, 2004, LG&E redeemed 12,500 shares as required at a price of $100 per share. In January 2004, LG&E and KU made discretionary contributions to their pension plans of $34.5 million and $43.4 million, respectively. No contributions are required for 2004 and no further discretionary contributions are planned in 2004. LG&E's security ratings as of September 30, 2004, were: Moody's S&P First mortgage bonds A1 A- Preferred stock Baa1 BBB- Commercial paper P-1 A-2 KU's security ratings as of September 30, 2004, were: Moody's S&P First mortgage bonds A1 A Preferred stock Baa1 BBB- Commercial paper P-1 A-2 These ratings reflect the views of Moody's and S&P. A security rating is not a recommendation to buy, sell or hold securities and is subject to revision or withdrawal at any time by the rating agency. Page 33 LG&E's capitalization ratios at September 30, 2004, and December 31, 2003, follow: September 30,December 31, 2004 2003 Long-term debt (including current portion) 30.8% 31.9% Long-term debt to affiliated company (including current portion) 14.2 10.7 Notes payable to affiliated companies 2.1 4.3 Preferred stock 3.6 3.8 Common equity 49.3 49.3 Total 100.0% 100.0% KU's capitalization ratios at September 30, 2004, and December 31, 2003, follow: September 30,December 31, 2004 2003 Long-term debt (including current portion) 22.4% 24.1% Long-term debt to affiliated company (including current portion) 19.0 16.8 Notes payable to affiliated companies 1.7 2.6 Preferred stock 2.3 2.4 Common equity 54.6 54.1 Total 100.0% 100.0% New Accounting Pronouncements FIN 46 In January 2003, the Financial Accounting Standards Board ("FASB") issued Financial Accounting Standards Board Interpretation No. 46, Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51 ("FIN 46"). FIN 46 required certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 was effective immediately for all new variable interest entities created or acquired after January 31, 2003. In December 2003, FIN 46 was revised, delaying the effective dates for certain entities created before February 1, 2003, and making other amendments to clarify application of the guidance. For potential variable interest entities other than special purpose entities, the revised FIN 46 ("FIN 46R") is now required to be applied no later than the end of the first fiscal year or interim reporting period ending after March 15, 2004. For all special purpose entities created prior to February 1, 2003, FIN 46R is now required to be applied at the end of the first interim or annual reporting period ending after December 15, 2003. FIN 46R may be applied prospectively with a cumulative-effect adjustment as of the date it is first applied, or by restating previously issued financial statements with a cumulative-effect adjustment as of the beginning of the first year restated. FIN 46R also requires certain disclosures of an entity's relationship with variable interest entities. Both LG&E and KU hold investment interests in OVEC and KU holds an investment interest in EEI. Neither LG&E nor KU is the primary beneficiary of OVEC or EEI, and thus neither is consolidated into the financial statements of LG&E or KU. Page 34 LG&E, KU and ten other electric utilities are participating owners of OVEC, located in Piketon, Ohio. OVEC owns and operates two power plants that burn coal to generate electricity, Kyger Creek Station in Ohio and Clifty Creek Station in Indiana. LG&E's share is 7%, representing approximately 155 Mw of generation capacity and KU's share is 2.5%, representing approximately 55 Mw of generation capacity. LG&E's and KU's original investments in OVEC were made in 1952. LG&E's investment in OVEC is the equivalent of 4.9% of OVEC's common stock and KU's investment is the equivalent of 2.5% of OVEC's common stock. LG&E's and KU's investments in OVEC are accounted for on the cost method of accounting. As of September 30, 2004, LG&E's and KU's investments in OVEC totaled $0.5 million and $0.3 million, respectively. LG&E's and KU's maximum exposure to loss as a result of their involvement with OVEC is limited to the value of their investment. In the event of the inability of OVEC to fulfill its power provision requirements, LG&E and KU would substitute such power supply with either owned generation or market purchases and would generally recover associated incremental costs through regulatory rate mechanisms. See Part II, Item 1, for further discussion of developments regarding LG&E's and KU's OVEC ownership interests and power purchase rights. KU owns 20% of the common stock of EEI, which owns and operates a 1,000-Mw generating station in southern Illinois. KU is entitled to take 20% of the available capacity of the station. Purchases from EEI are made under a contractual formula which has resulted in costs which were and are expected to be comparable to the cost of other power purchased or generated by KU. Such power equated to approximately 9% of KU's net generation system output in 2003. KU's original investment in EEI was made in 1953. KU's investment in EEI is accounted for on the equity method of accounting. As of September 30, 2004, KU's investment in EEI totaled $12.7 million. KU's maximum exposure to loss as a result of its involvement with EEI is limited to the value of its investment. In the event of the inability of EEI to fulfill its power provision requirements, KU would substitute such power supply with either owned generation or market purchases and would generally recover associated incremental costs through regulatory rate mechanisms. FSP 106-2 In May 2004, the FASB finalized FASB Staff Position ("FSP") 106-2, Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003 ("Medicare Act") with guidance on accounting for subsidies provided under the Medicare Act which became law in December 2003. FSP 106-2 is effective for the first interim or annual period beginning after June 15, 2004. FSP 106-2 does not have a material impact on the Companies. Contingencies For a description of significant contingencies that may affect LG&E and KU, reference is made to Part I, Item 3, Legal Proceedings in LG&E's and KU's Annual Reports on Form 10-K for the year ended December 31, 2003; to Part II, Item 1, Legal Proceedings in LG&E's and KU's Quarterly Reports on Form 10-Q for the quarters ended March 31, 2004 and June 30, 2004; and to Part II, Item 1, Legal Proceedings herein. Page 35 Electric and Gas Rates Cases On June 30, 2004, the Kentucky Commission issued an order approving increases in the base electric and gas rates of LG&E and the base electric rates of KU. Subsequently, the AG commenced an investigation examining communications between the Kentucky Commission and the Companies and separately filed for a rehearing of the rate cases on such issue and certain calculation components of the increased rates and filed for the existing rate increases to be set aside. The Kentucky Commission is considering the matters relating to the AG's actions. For a description of developments in these cases, see Note 11 of the Notes to Consolidated Financial Statements in Part 1, Item 1 of this Quarterly Report on Form 10- Q. Earnings Sharing Mechanism The Companies filed their final 2003 ESM calculations with the Kentucky Commission on March 1, 2004, and applied for recovery of $13.0 million related to LG&E and $16.2 million related to KU. Based upon estimates, the Companies previously accrued $8.9 million at LG&E and $9.3 million at KU for the 2003 ESM as of December 31, 2003. On June 30, 2004, the Kentucky Commission issued an order largely accepting proposed settlement agreements by the Companies and all intervenors regarding the ESM mechanisms of LG&E and KU. Under the ESM settlements, LG&E and KU will continue to collect approximately $13.0 million and $16.2 million, respectively, of previously requested 2003 ESM revenue amounts through March 2005. As part of the settlement, the parties agreed to a termination of the ESM mechanism relating to all periods after 2003. As a result of the settlement, the Companies accrued an additional $4.1 million at LG&E and $6.9 million at KU in June 2004, related to 2003 ESM revenue. OVEC Power Agreement and Share Purchase On April 30, 2004, OVEC and its shareholders, including LG&E and KU, entered into an Amended and Restated Inter-Company Power Agreement, to be effective beginning March 2006, upon the expiration of the current power contract among the parties. Under the new contract, which has a 20-year term from its effective date, LG&E and KU have purchase rights for 5.63% and 2.5%, respectively, of OVEC power at marginal cost-based rates. LG&E and KU are entitled to 7% and 2.5% of OVEC power, respectively, under the current contract. LG&E's estimated future minimum annual demand payments under the Amended and Restated Inter-Company Agreement are as follows: (in thousands) 2006 $ 10,098 2007 9,726 2008 9,932 2009 10,144 2010 10,361 Thereafter 170,646 Total $220,907 In addition, LG&E will purchase from American Electric Power Company Inc. ("AEP") an additional 0.73% interest in OVEC for a purchase price of approximately $104,000, resulting in an increase in LG&E ownership in OVEC from 4.9% to 5.63%. The share purchase transaction is anticipated to be completed during 2005, subject to receipt of certain regulatory approvals. The changes to the power agreement and the share purchases are expected to have no impact on the accounting for OVEC under FIN 46R as described in Footnote 8. Owensboro Contract Litigation In May 2004, the City of Owensboro, Kentucky and Owensboro Municipal Utilities (collectively "OMU"), filed suit in Davies County, Kentucky District Court against KU concerning a long-term power supply contract (the "OMU Agreement") with KU. The dispute involves interpretational differences regarding certain issues under the OMU Agreement, including various payments or charges between KU and OMU and rights concerning excess power, termination and emissions allowances, respectively. The complaint seeks approximately $6 million in damages for historical periods, as well as injunctive and other relief, including a declaration that KU is in material breach. KU has removed this litigation to the U.S. District Court for the Western District of Kentucky, filed an answer in that court denying the OMU claims and presenting certain counterclaims and commenced a FERC proceeding to request FERC jurisdiction on certain issues. In October 2004, FERC declined to exercise exclusive jurisdiction regarding the issues in dispute, which ruling KU has appealed. Page 36 Environmental Matters In September 1998, the EPA announced its final "NOx SIP Call" rule requiring states to impose significant additional reductions in NOx emissions by May 2003, in order to mitigate alleged ozone transport impacts on the Northeast region. The Commonwealth of Kentucky SIP, which was approved by EPA June 24, 2003, required reductions in NOx emissions from coal-fired generating units to the 0.15 lb./Mmbtu level on a system-wide basis. In related proceedings in response to petitions filed by various Northeast states, in December 1999, the EPA issued a final rule pursuant to Section 126 of the Clean Air Act directing similar NOx reductions from a number of specifically targeted generating units including all LG&E and KU units. As a result of appeals to both rules, the compliance date was extended to May 2004. LG&E and KU have complied with these NOx emissions reduction rules by installing additional NOx controls to their generating units. Installations of additional NOx controls were performed on a phased basis, which commenced in late 2000 and continued through the final compliance date. As of September 30, 2004, LG&E has incurred total capital costs of approximately $185 million to reduce its NOx emissions to the 0.15 lb./Mmbtu level on a company-wide basis. As of September 30, 2004, KU has incurred total capital costs of approximately $203 million to reduce its NOx emissions to the 0.15 lb./Mmbtu level on a company-wide basis. In addition, LG&E and KU have begun incurring additional operation and maintenance costs in operating new NOx controls. LG&E and KU believe their costs in this regard to be comparable to those of similarly situated utilities with like generation assets. In April 2001, the Kentucky Commission granted recovery of these costs under the environmental surcharge mechanism for LG&E and KU. During August 2004, KU, the EPA, and the Department of Justice agreed in principle to settle outstanding matters concerning a 1999 oil discharge at KU's E.W. Brown plant for approximately $0.6 million, a portion of which may be satisfied by KU's construction of a separate environmental capital project. The settlement is subject to completion of final definitive documents. In December 2003, KU recorded an accrual and expense to operations of $0.6 million. LG&E and KU are also monitoring several other air quality issues which may potentially impact coal-fired power plants, including the EPA's revised air quality standards for ozone and particulate matter, measures to implement the EPA's regional haze rule, and the EPA's December 2003 proposals to regulate mercury emissions from steam electric generating units and to further reduce emissions of sulfur dioxide and nitrogen oxides under the Clean Air Interstate Rule. In addition, LG&E is currently reviewing and making comments on proposed regulations concerning toxic air emissions within Metro Louisville, where the company operates two coal-fired generating stations. LG&E is also working with local regulatory authorities to review the effectiveness of remedial measures aimed at controlling particulate matter emissions from its Mill Creek Station. LG&E previously settled a number of property damage claims from adjacent residents and completed significant remedial measures as part of its ongoing capital construction program. LG&E has converted the Mill Creek Station to a wet stack operation in an effort to resolve all outstanding issues related to particulate matter emissions. Item 3. Quantitative and Qualitative Disclosures About Market Risk. LG&E and KU, and their respective ratepayers, are exposed to market risks. Market risk exposures include changes in interest rates and commodity prices. To mitigate changes in cash flows attributable to these exposures, the Companies have entered into various derivative instruments. Derivative positions are monitored using techniques that include market value and sensitivity analysis. Page 37 The Companies use interest rate swaps to hedge exposure to market fluctuations in certain of their debt instruments. Pursuant to the Companies' policies, use of these financial instruments is intended to mitigate risk and earnings volatility and is not speculative in nature. Management has designated all of the Companies' interest rate swaps as hedge instruments. Financial instruments designated as cash flow hedges have resulting gains and losses recorded within other comprehensive income and stockholders' equity. To the extent a financial instrument or the underlying item being hedged is prematurely terminated or the hedge becomes ineffective, the resulting gains or losses are reclassified from other comprehensive income to net income. Financial instruments designated as fair value hedges are periodically marked to market with the resulting gains and losses recorded directly into net income to correspond with income or expense recognized from changes in market value of the items being hedged. The potential change in interest expense associated with a 1% change in base interest rates of LG&E's and KU's unswapped debt is estimated at $3.5 million and $3.3 million, respectively, at September 30, 2004. LG&E's exposure to floating interest rates decreased $1.0 million and KU's exposure to floating interest rates decreased $1.2 million during the first nine months of 2004. The potential loss in fair value of LG&E's interest rate swaps resulting from a hypothetical 1% change in base interest rates is estimated at approximately $25.8 million as of September 30, 2004. The potential loss in fair value of KU's interest rate swaps resulting from a hypothetical 1% change in base interest rates is estimated at approximately $2.4 million as of September 30, 2004. These estimates are derived from third-party valuations. Changes in the market values of these swaps, if held to maturity, will have no effect on LG&E's or KU's net income or cash flow. Pension Risk LG&E's and KU's costs of providing defined-benefit pension retirement plans is dependent upon a number of factors, such as the rates of return on plan assets, discount rate, and contributions made to the plan. At September 30, 2004, LG&E and KU have a minimum pension liability as prescribed by SFAS No. 87, Employers' Accounting for Pensions, in the pre-tax amounts of $47.6 and $9.9 million, respectively. The liabilities are recorded as a reduction to other comprehensive income, and do not affect net income. The amount of the liabilities depends upon the asset returns experienced in 2003 and contributions made by LG&E and KU to the plan during 2003. If the fair value of the plan assets exceeds the accumulated benefit obligation, the recorded liability will be reduced and other comprehensive income will be restored in the Consolidated Balance Sheets. A 1% increase or decrease in the assumed discount rate could have an approximate $41 million positive or negative impact to the accumulated benefit obligation of LG&E. A 1% increase or decrease in the assumed discount rate could have an approximate $27 million positive or negative impact to the accumulated benefit obligation of KU. In January 2004, LG&E and KU made contributions to their pension plans of $34.5 million and $43.4 million, respectively. Page 38 Energy Trading & Risk Management Activities The table below summarizes LG&E's and KU's energy trading and risk management activities for the three months and nine months ended September 30, 2004, and 2003 (in thousands of $). Trading volumes are evenly divided between LG&E and KU. Three Months Nine Months Ended Ended September 30, September 30, 2004 2003 2004 2003 Fair value of contracts at beginning of period, net asset/(liability) $ 541 $ 318 $572 $(156) Fair value of contracts when entered into during the period (70) (30) (75) 2,590 Contracts realized or otherwise settled during the period (431) (356) (663) (639) Changes in fair value due to changes in assumptions 107 148 313 (1,715) Fair value of contracts at end of period, net asset $ 147 $ 80 $ 147 $ 80 No changes to valuation techniques for energy trading and risk management activities occurred during 2004. Changes in market pricing, interest rate and volatility assumptions were made during both periods. All contracts outstanding at September 30, 2004, have a maturity of less than one year and are valued using prices actively quoted for proposed or executed transactions or quoted by brokers. LG&E and KU maintain policies intended to minimize credit risk and revalue credit exposures daily to monitor compliance with those policies. As of September 30, 2004, 100% of the trading and risk management commitments were with counterparties rated BBB-/Baa3 equivalent or better. Item 4. Controls and Procedures. LG&E and KU maintain a system of disclosure controls and procedures designed to ensure that information required to be disclosed by the Companies in reports they file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission rules and forms. LG&E and KU conducted an evaluation of such controls and procedures under the supervision and with the participation of the Companies' management, including the Chairman, President and Chief Executive Officer ("CEO") and the Chief Financial Officer ("CFO"). Based upon that evaluation, the CEO and CFO have concluded that the Companies' disclosure controls and procedures are effective as of the end of the period covered by this report. In preparation for required reporting under Section 404 of the Sarbanes- Oxley Act of 2002, the Companies are conducting a thorough review of their internal controls over financial reporting, including disclosure controls and procedures. Based on this review, the Companies have made internal controls enhancements and will continue to make future enhancements to their internal controls over financial reporting. There has been no change in the Companies' internal controls over financial reporting that occurred during the fiscal quarter ended September 30, 2004, that has materially affected, or is reasonably likely to materially affect, the Companies' internal controls over financial reporting. Page 39 Part II. Other Information Item 1. Legal Proceedings. For a description of the significant legal proceedings involving LG&E and KU, reference is made to the information under the following items and captions of (a) LG&E's and KU's respective combined Annual Report on Form 10-K for the year ended December 31, 2003: Item 1, Business; Item 3, Legal Proceedings; Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, and Item 8, Financial Statements and Supplementary Data and (b) LG&E's and KU's Quarterly Reports on Form 10-Q for the periods ended March 31, 2004 and June 30, 2004: Item I, Legal Proceedings. Except as described herein, to-date, the proceedings reported in LG&E's and KU's respective combined Annual Report on Form 10-K or Quarterly Reports on Form 10-Q have not changed materially. Electric and Gas Rates Cases On June 30, 2004, the Kentucky Commission issued an order approving increases in the base electric and gas rates of LG&E and the base electric rates of KU. Subsequently, the AG commenced an investigation examining communications between the Kentucky Commission and the Companies and separately filed for a rehearing of the rate cases on such issue and certain calculation components of the increased rates and filed for the existing rate increases to be set aside. The Kentucky Commission is considering the matters relating to the AG's actions. For a description of developments in these cases, see Note 11 of the Notes to Consolidated Financial Statements in Part 1, Item 1 of this Quarterly Report on Form 10- Q. MISO During 2004 to-date, the Kentucky Commission has continued its proceedings examining the costs and benefits of MISO membership, including reopening the matter for further testimony and hearings on recently-filed MISO energy market tariffs and analysis of potential membership in other Regional Transmission Organizations. Proceedings in this matter are anticipated to continue into 2005. In September 2004, in response to requests of the Kentucky Commission, the Companies filed pleadings indicating that MISO membership will not provide benefits commensurate with its costs to the Companies and to Kentucky ratepayers. The Companies requested an order of the Kentucky Commission directing their ultimate exit from MISO, if approved by the FERC and under other appropriate conditions. OVEC Power Agreement and Share Purchase On April 30, 2004, OVEC and its shareholders, including LG&E and KU, entered into an Amended and Restated Inter-Company Power Agreement, to be effective beginning March 2006, upon the expiration of the current power contract among the parties. Under the new contract, which has a 20-year term from its effective date, LG&E and KU have purchase rights for 5.63% and 2.5%, respectively, of OVEC power at marginal cost-based rates. LG&E and KU are entitled to 7% and 2.5% of OVEC power, respectively, under the current contract. In addition, LG&E will purchase from American Electric Power Company Inc. ("AEP") an additional 0.73% interest in OVEC for a purchase price of approximately $104,000, resulting in an increase in LG&E ownership in OVEC from 4.9% to 5.63%. The share purchase transaction is anticipated to be completed during 2005, subject to receipt of certain regulatory approvals. Page 40 Owensboro Contract Litigation In May 2004, the City of Owensboro, Kentucky and Owensboro Municipal Utilities (collectively "OMU"), filed suit in Davies County, Kentucky District Court against KU concerning a long-term power supply contract (the "OMU Agreement") with KU. The dispute involves interpretational differences regarding certain issues under the OMU Agreement, including various payments or charges between KU and OMU and rights concerning excess power, termination and emissions allowances, respectively. The complaint seeks approximately $6 million in damages for historical periods, as well as injunctive and other relief, including a declaration that KU is in material breach. KU has removed this litigation to the U.S. District Court for the Western District of Kentucky, filed an answer in that court denying the OMU claims and presenting certain counterclaims and commenced a FERC proceeding to request FERC jurisdiction on certain issues. In October 2004, FERC declined to exercise exclusive jurisdiction regarding the issues in dispute, which ruling KU has appealed. Environmental Matter During August 2004, KU and the EPA and Department of Justice agreed in principle to settle outstanding matters concerning a 1999 oil discharge at KU's E.W. Brown plant for approximately $628,750, a portion of which may be satisfied by KU's construction of a separate environmental capital project. The settlement is subject to completion of final definitive documents. Item 2. Unregistered Sales of Equity Securities and Use of Proceeds. 2(c) LG&E has an existing $5.875 series of mandatorily redeemable preferred stock outstanding having a current redemption price of $100 per share. The preferred stock has a sinking fund requirement sufficient to retire a minimum of 12,500 shares on July 15 of each year commencing with July 15, 2003, and a minimum of 187,500 shares on July 15, 2008 at $100 per share. LG&E redeemed 12,500 shares in accordance with these provisions on July 15, 2004, leaving 225,500 shares currently outstanding. Beginning with the three months ended September 30, 2003, LG&E reclassified, at fair value, its $5.875 series preferred stock as long-term debt with the minimum shares mandatorily redeemable within one year classified as current portion of long-term debt. Dividends accrued beginning July 1, 2003 are charged as interest expense, pursuant to SFAS No. 150. July August September Period 2004 2004 2004 Total number of shares (or units) 12,500 n/a n/a purchased ($5.875 Pref.) Average price paid per share (or unit)$100 n/a n/a Total number of shares (or units) purchased as part of publicly 12,500 announced plans or programs ($5.875 Pref.) n/a n/a Maximum number (or approximate dollar value) of shares (or units) that may yet be purchased 225,000 under the plans or programs ($5.875 Pref.) n/a n/a Item 4. Submission of Matters to a Vote of Security Holders. a)LG&E's and KU's Annual Meetings of Shareholders were held on July 8, 2004. b)Not applicable. Page 41 c)The matters voted upon and the results of the voting at the Annual Meetings are set forth below: 1. LG&E i)The shareholders voted to elect LG&E's nominees for election to the Board of Directors, as follows: Victor A. Staffieri - 21,294,223 common shares and 88,855 preferred shares cast in favor of election and 5,725 preferred shares withheld. S. Bradford Rives - 21,294,223 common shares and 89,005 preferred shares cast in favor of election and 5,575 preferred shares withheld. John R. McCall - 21,294,223 common shares and 89,191 preferred shares cast in favor of election and 5,389 preferred shares withheld. No holders of common or preferred shares abstained from voting on this matter. ii)The shareholders voted 21,294,223 common shares and 91,600 preferred shares in favor of and 991 preferred shares against the approval of PricewaterhouseCoopers LLP as independent accountants for 2004. Holders of 1,989 preferred shares abstained from voting on this matter. 2. KU i)The sole shareholder voted to elect KU's nominees for election to the Board of Directors, as follows: 37,817,878 common shares cast in favor of election and no shares withheld for each of Victor A. Staffieri, S. Bradford Rives and John R. McCall, respectively. ii)The sole shareholder voted 37,817,878 common shares in favor of and no shares withheld for approval of PricewaterhouseCoopers LLP as independent accountants for 2004. No holders of common shares abstained from voting on these matters. d) Not applicable. Item 6. Exhibits. Applicable to Form 10-Q of Exhibit No. LG&E KU Description 31 X X Certifications pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32 X X Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 Certain instruments defining the rights of holders of certain long-term debt of LG&E and KU have not been filed with the SEC but will be furnished to the SEC upon request. Page 42 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Louisville Gas and Electric Company Registrant Date: November 12, 2004 /s/ S. Bradford Rives S. Bradford Rives Chief Financial Officer (On behalf of the registrant in his capacities as Principal Financial Officer and Principal Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Kentucky Utilities Company Registrant Date: November 12, 2004 /s/ S. Bradford Rives S. Bradford Rives Chief Financial Officer (On behalf of the registrant in his capacities as Principal Financial Officer and Principal Accounting Officer) EX-31 2 q10q0904ex31.txt EXHIBIT 31 Exhibit 31 - CERTIFICATIONS Louisville Gas and Electric Company I, Victor A. Staffieri, Chairman of the Board, President and Chief Executive Officer, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Louisville Gas and Electric Company; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: November 12, 2004 /s/ Victor A. Staffieri Victor A. Staffieri Chairman of the Board, President and Chief Executive Officer New Page Exhibit 31 Louisville Gas and Electric Company I, S. Bradford Rives, Chief Financial Officer, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Louisville Gas and Electric Company; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: November 12, 2004 /s/ S. Bradford Rives S. Bradford Rives Chief Financial Officer New Page Exhibit 31 Kentucky Utilities Company I, Victor A. Staffieri, Chairman of the Board, President and Chief Executive Officer, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Kentucky Utilities Company; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: November 12, 2004 /s/ Victor A. Staffieri Victor A. Staffieri Chairman of the Board, President and Chief Executive Officer New Page Exhibit 31 Kentucky Utilities Company I, S. Bradford Rives, Chief Financial Officer, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Kentucky Utilities Company; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: November 12, 2004 /s/ S. Bradford Rives S. Bradford Rives Chief Financial Officer EX-32 3 q10q0904ex32.txt EXHIBIT 32 Exhibit 32 Certification Pursuant to 18 U.S.C. Section 1350 As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 In connection with the Quarterly Report of Louisville Gas and Electric Company and Kentucky Utilities Company (the "Companies") on Form 10-Q for the period ended September 30, 2004, as filed with the Securities and Exchange Commission (the "Report"), each of the undersigned does hereby certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that, to such officer's knowledge, 1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and 2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Companies as of the dates and for the period expressed in the Report. November 12, 2004 /s/ Victor A. Staffieri Chairman of the Board, President and Chief Executive Officer Louisville Gas and Electric Company Kentucky Utilities Company /s/ S. Bradford Rives Chief Financial Officer Louisville Gas and Electric Company Kentucky Utilities Company The foregoing certification is being furnished solely pursuant to 18 U.S.C. Section 1350 and is not being filed as part of the Report or as a separate disclosure document. -----END PRIVACY-ENHANCED MESSAGE-----