-----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, Wy2Wn5BPbTI3AZnggbcew2wXItrDXZrodTBVYDptYRGgaNLXMUBjtC2He6rbAWcD BK8AbEpKtEVCuiA29jDSZg== 0000861388-06-000007.txt : 20060814 0000861388-06-000007.hdr.sgml : 20060814 20060814141029 ACCESSION NUMBER: 0000861388-06-000007 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 3 CONFORMED PERIOD OF REPORT: 20060630 FILED AS OF DATE: 20060814 DATE AS OF CHANGE: 20060814 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: 061028953 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 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: 061028954 BUSINESS ADDRESS: STREET 1: ONE QUALITY ST CITY: LEXINGTON STATE: KY ZIP: 40507 BUSINESS PHONE: 6062552100 10-Q 1 q10q0606.txt 10-Q 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 June 30, 2006 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 (NO FEE REQUIRED) Commission Registrant, State of Incorporation, IRS Employer File Number Address, and Telephone Number Identification Number 1-2893 Louisville Gas and Electric Company 61-0264150 (A Kentucky Corporation) 220 West Main Street P. O. Box 32010 Louisville, Kentucky 40232 (502) 627-2000 1-3464 Kentucky Utilities Company 61-0247570 (A Kentucky and Virginia Corporation) One Quality Street Lexington, Kentucky 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 a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12-b2 of the Exchange Act. (Check one): Large accelerated filer _____ Accelerated filer_____ Non-accelerated filer __X___ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes No X Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: Louisville Gas and Electric Company - 21,294,223 shares, without par value, as of July 31, 2006, all held by E.ON U.S. LLC Kentucky Utilities Company - 37,817,878 shares, without par value, as of July 31, 2006, all held by E.ON U.S. 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. INDEX OF ABBREVIATIONS AG Attorney General of Kentucky ARO Asset Retirement Obligation CAIR Clean Air Interstate Rule CAMR Clean Air Mercury Rule CCN Certificate of Public Convenience and Necessity Company LG&E or KU, as applicable Companies LG&E and KU DSM Demand Side Management ECR Environmental Cost Recovery EEI Electric Energy, Inc. E.ON E.ON AG E.ON U.S. E.ON U.S. LLC (formerly LG&E Energy LLC and LG&E Energy Corp.) E.ON U.S. Services E.ON U.S. Services Inc. (formerly LG&E Energy Services Inc.) EPA U.S. Environmental Protection Agency EPAct 2005 Energy Policy Act of 2005 FAC Fuel Adjustment Clause FASB Financial Accounting Standards Board FERC Federal Energy Regulatory Commission Fidelia Fidelia Corporation (an E.ON affiliate) FIN FASB Interpretation No. FGD Flue Gas Desulfurization FTR Financial Transmission Rights IMEA Illinois Municipal Electric Agency IMPA Indiana Municipal Power Agency Kentucky Commission Kentucky Public Service Commission KU Kentucky Utilities Company LIBOR London Interbank Offer Rate LG&E Louisville Gas and Electric Company MISO Midwest Independent Transmission System Operator,Inc. Moody's Moody's Investor Services, Inc. Mw Megawatts NOx Nitrogen Oxide OMU Owensboro Municipal Utilities PUHCA 1935 Public Utility Holding Company Act of 1935 PUHCA 2005 Public Utility Holding Company Act of 2005 S&P Standard & Poor's Rating Services SEC Securities and Exchange Commission SFAS Statement of Financial Accounting Standards SO2 Sulfur Dioxide TEMT Transmission and Energy Markets Tariff VDT Value Delivery Team Process Virginia Commission Virginia State Corporation Commission TABLE OF CONTENTS PART I Item 1. Financial Statements (Unaudited) Louisville Gas and Electric Company Statements of Income 1 Statements of Retained Earnings 1 Balance Sheets 2 Statements of Cash Flows 4 Statements of Comprehensive Income 5 Kentucky Utilities Company Statements of Income 6 Statements of Retained Earnings 6 Balance Sheets 7 Statements of Cash Flows 9 Statements of Comprehensive Income 10 Notes to Financial Statements 11 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 26 Item 3. Quantitative and Qualitative Disclosures About Market Risk 36 Item 4. Controls and Procedures 38 PART II Item 1. Legal Proceedings 39 Item 1A.Risk Factors 39 Item 5. Other Information 39 Item 6. Exhibits 39 Signatures 41 Exhibits 42 Part I. Financial Information - Item 1. Financial Statements (Unaudited) Louisville Gas and Electric Company Statements of Income (Unaudited) (Millions of $) Three Months Six Months Ended June 30, Ended June 30, 2006 2005 2006 2005 OPERATING REVENUES: Electric $223 $228 $435 $457 Gas 54 53 254 225 Total operating revenues 277 281 689 682 OPERATING EXPENSES: Fuel for electric generation 70 68 135 129 Power purchased 26 28 54 67 Gas supply expenses 38 36 200 171 Other operation and maintenance expenses 65 65 143 139 Depreciation and amortization 31 31 61 62 Total operating expenses 230 228 593 568 OPERATING INCOME 47 53 96 114 Other expense - net 1 - 1 - Interest expense (Note 3) 6 6 13 12 Interest expense to affiliated companies (Note 8) 3 3 7 6 INCOME BEFORE INCOME TAXES 37 44 75 96 Federal and state income taxes 12 16 25 34 NET INCOME $25 $28 $50 $62 The accompanying notes are an integral part of these financial statements. Statements of Retained Earnings (Unaudited) (Millions of $) Three Months Six Months Ended June 30, Ended June 30, 2006 2005 2006 2005 Balance at beginning of period $605 $538 $621 $534 Net income 25 28 50 62 Subtotal 630 566 671 596 Cash dividends declared on stock: Cumulative preferred 1 1 2 2 Common 20 10 60 39 Subtotal 21 11 62 41 Balance at end of period $609 $555 $609 $555 The accompanying notes are an integral part of these financial statements. Louisville Gas and Electric Company Balance Sheets (Unaudited) (Millions of $) ASSETS June 30, December 31, 2006 2005 Current Assets: Cash and cash equivalents $ 5 $ 7 Accounts receivable - less reserves of $1 million as of June 30,2006 and December 31, 2005 123 231 Accounts receivable from affiliated companies (Note 8) 19 36 Materials and supplies: Fuel (predominantly coal) 53 39 Gas stored underground 30 125 Other materials and supplies 29 28 Prepayments and other current assets 4 6 Total current assets 263 472 Other property and investments - less reserves of less than $1 million as of June 30, 2006 and December 31, 2005 1 1 Utility plant: At original cost 4,077 4,049 Less: reserve for depreciation 1,523 1,509 Net utility plant 2,554 2,540 Deferred debits and other assets: Restricted cash 7 10 Unamortized debt expense 8 8 Regulatory assets (Note 2) 78 84 Other assets 36 31 Total deferred debits and other assets 129 133 Total assets $2,947 $3,146 The accompanying notes are an integral part of these financial statements. Louisville Gas and Electric Company Balance Sheets (cont.) (Unaudited) (Millions of $) LIABILITIES AND EQUITY June 30, December 31, 2006 2005 Current liabilities: Current portion of long-term debt $248 $248 Notes payable to affiliated companies (Note 5 and Note 8) 1 141 Accounts payable 80 141 Accounts payable to affiliated companies (Note 8) 47 52 Accrued income taxes 9 6 Customer deposits 18 17 Other current liabilities 26 15 Total current liabilities 429 620 Long-term debt: Long-term debt (Note 5) 328 328 Long-term debt to affiliated company (Note 5 and Note 8) 225 225 Mandatorily redeemable preferred stock 20 20 Total long-term debt 573 573 Deferred credits and other liabilities: Accumulated deferred income taxes - net 312 322 Investment tax credit, in process of amortization 40 42 Accumulated provision for pensions and related benefits 129 143 Customer advances for construction 10 10 Asset retirement obligation 27 27 Regulatory liabilities (Note 2): Accumulated cost of removal of utility plant 225 219 Regulatory liability deferred income taxes 44 42 Other regulatory liabilities 42 20 Other liabilities 23 31 Total deferred credits and other liabilities 852 856 Cumulative preferred stock 70 70 Common equity: Common stock, without par value - Authorized 75,000,000 shares, outstanding 21,294,223 shares 424 424 Additional paid-in capital 40 40 Accumulated comprehensive loss (50) (58) Retained earnings 609 621 Total common equity 1,023 1,027 Total liabilities and equity $2,947 $3,146 The accompanying notes are an integral part of these financial statements. Louisville Gas and Electric Company Statements of Cash Flows (Unaudited) (Millions of $) Six Months Ended June 30, 2006 2005 CASH FLOWS FROM OPERATING ACTIVITIES: Net income $50 $62 Items not requiring cash currently: Depreciation and amortization 61 62 Deferred income taxes (13) (11) VDT amortization 7 15 Other (3) (3) Changes in current assets and liabilities: Accounts receivable 108 41 Accounts receivable from affiliated companies 17 (15) Fuel (14) (6) Gas stored underground 95 58 Other changes in current assets 1 - Accounts payable (61) (39) Accounts payable to affiliated companies (5) 29 Accrued income taxes 3 (6) Other changes in current liabilities 12 (7) Pension funding (Note 4) (18) - Gas supply clause receivable, net 31 2 Other (8) (3) Net cash provided by operating activities 263 179 CASH FLOWS FROM INVESTING ACTIVITIES: Construction expenditures (66) (51) Change in restricted cash 3 (2) Net cash used for investing activities (63) (53) CASH FLOWS FROM FINANCING ACTIVITIES: Repayment of long-term borrowings from affiliated company (Note 8) - (50) Repayment of short-term borrowings from affiliated company (Note 5) (140) (37) Payment of dividends (62) (41) Net cash used for financing activities (202) (128) CHANGE IN CASH AND CASH EQUIVALENTS (2) (2) CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 7 7 CASH AND CASH EQUIVALENTS AT END OF PERIOD $5 $5 The accompanying notes are an integral part of these financial statements. Louisville Gas and Electric Company Statements of Comprehensive Income (Unaudited) (Millions of $) Three Months Six Months Ended June 30, Ended June 30, 2006 2005 2006 2005 Net income $25 $28 $50 $62 Income Taxes - Minimum Pension Liability - - - (1) Gain (loss) on derivative instruments and hedging activities - net of tax benefit (expense) of $(2) million, $5 million, $(5) million and $4 million, respectively (Note 4) 3 (8) 8 (6) Comprehensive income (loss), net of tax 3 (8) 8 (7) Comprehensive income $28 $20 $58 $55 The accompanying notes are an integral part of these financial statements. Kentucky Utilities Company Statements of Income (Unaudited) (Millions of $) Three Months Six Months Ended June 30, Ended June 30, 2006 2005 2006 2005 OPERATING REVENUES $276 $265 $569 $552 OPERATING EXPENSES: Fuel for electric generation 100 84 195 172 Power purchased 44 50 90 96 Other operation and maintenance expenses 63 68 133 126 Depreciation and amortization 29 29 57 58 Total operating expenses 236 231 475 452 OPERATING INCOME 40 34 94 100 Other (income) - net (5) (2) (13) (3) Interest expense (Note 3) 4 4 7 7 Interest expense to affiliated companies (Note 5 and Note 8) 5 4 11 7 INCOME BEFORE INCOME TAXES 36 28 89 89 Federal and state income taxes 11 10 29 34 NET INCOME $25 $18 $60 $55 The accompanying notes are an integral part of these financial statements. Statements of Retained Earnings (Unaudited) (Millions of $) Three Months Six Months Ended June 30, Ended June 30, 2006 2005 2006 2005 Balance at beginning of period $753 $666 $718 $660 Net income 25 18 60 55 Subtotal 778 684 778 715 Cash dividends declared on stock: Cumulative preferred - - - 1 Common - 10 - 40 Subtotal - 10 - 41 Balance at end of period $778 $674 $778 $674 The accompanying notes are an integral part of these financial statements. Kentucky Utilities Company Balance Sheets (Unaudited) (Millions of $) June 30, December 31, ASSETS 2006 2005 Current assets: Cash and cash equivalents $5 $7 Restricted cash 10 22 Accounts receivable - less reserves of $2 million as of June 30, 2006 and December 31, 2005 113 135 Accounts receivable from affiliated companies (Note 8) 18 32 Materials and supplies: Fuel (predominantly coal) 75 55 Other materials and supplies 35 32 Prepayments and other current assets 9 5 Total current assets 265 288 Other property and investments - less reserves of less than $1 million as of June 30,2006 and December 31, 2005 22 23 Utility plant: At original cost 3,944 3,847 Less: reserve for depreciation 1,532 1,508 Net utility plant 2,412 2,339 Deferred debits and other assets: Unamortized debt expense 5 5 Regulatory assets (Note 2) 70 58 Cash surrender value of key man life insurance 34 32 Other assets 9 11 Total deferred debits and other assets 118 106 Total assets $2,817 $2,756 The accompanying notes are an integral part of these financial statements. Kentucky Utilities Company Balance Sheets (cont.) (Unaudited) (Millions of $) June 30, December 31, LIABILITIES AND EQUITY 2006 2005 Current liabilities: Current portion of long-term debt $140 $123 Notes payable to affiliated companies (Note 5 and Note 8) 52 70 Accounts payable 81 89 Accounts payable to affiliated companies (Note 8) 60 53 Accrued income taxes - 13 Customer deposits 18 17 Other current liabilities 24 18 Total current liabilities 375 383 Long-term debt: Long-term debt (Note 5) 186 240 Long-term debt to affiliated company (Note 5 and Note 8) 433 383 Total long-term debt 619 623 Deferred credits and other liabilities: Accumulated deferred income taxes - net 277 274 Accumulated provision for pensions and related benefits 97 92 Asset retirement obligation 28 27 Regulatory liabilities (Note 2): Accumulated cost of removal of utility plant 288 281 Regulatory liability deferred income taxes 22 23 Other regulatory liabilities 10 11 Other liabilities 19 20 Total deferred credits and other liabilities 741 728 Common equity: Common stock, without par value - Authorized 80,000,000 shares, outstanding 37,817,878 308 308 Additional paid-in capital 15 15 Accumulated comprehensive loss (19) (19) Retained earnings 765 704 Undistributed subsidiary earnings 13 14 Total retained earnings 778 718 Total common equity 1,082 1,022 Total liabilities and equity $2,817 $2,756 The accompanying notes are an integral part of these financial statements. Kentucky Utilities Company Statements of Cash Flows (Unaudited) (Millions of $) Six Months Ended June 30, 2006 2005 CASH FLOWS FROM OPERATING ACTIVITIES: Net income $60 $55 Items not requiring cash currently: Depreciation and amortization 57 58 Deferred income taxes 2 (4) VDT amortization 3 6 Other 6 (5) Changes in current assets and liabilities: Accounts receivable 22 26 Accounts receivable from affiliated companies 14 (21) Fuel (20) (5) Other changes in current assets (7) 3 Accounts payable (8) (20) Accounts payable to affiliated companies 7 35 Accrued income taxes (13) (2) Other changes in current liabilities 7 (12) Fuel adjustment clause receivable, net (15) (13) Other (4) 2 Net cash provided by operating activities 111 103 CASH FLOWS FROM INVESTING ACTIVITIES: Construction expenditures (121) (44) Change in restricted cash 12 - Net cash used for investing activities (109) (44) CASH FLOWS FROM FINANCING ACTIVITIES: Retirement of first mortgage bonds (Note 5) (36) (50) Short-term borrowings from affiliated company (Note 5) - 58 Long-term borrowings from affiliated company (Note 5) 50 - Repayment of short-term borrowings from affiliated company (Note 5) (18) - Repayment of other borrowings - (27) Payment of dividends - (41) Net cash used for financing activities (4) (60) CHANGE IN CASH AND CASH EQUIVALENTS (2) (1) CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 7 5 CASH AND CASH EQUIVALENTS AT END OF PERIOD $5 $4 The accompanying notes are an integral part of these financial statements. Kentucky Utilities Company Statements of Comprehensive Income (Unaudited) (Millions of $) Three Months Six Months Ended June 30, Ended June 30, 2006 2005 2006 2005 Net income $25 $18 $60 $55 Comprehensive income, net of tax - - - - Comprehensive income $25 $18 $60 $55 The accompanying notes are an integral part of these financial statements. Louisville Gas and Electric Company Kentucky Utilities Company Notes to Financial Statements (Unaudited) 1. General The unaudited financial statements include the accounts of the Companies. The common stock of each Company is wholly-owned by E.ON U.S. In the opinion of management, the unaudited condensed interim financial statements include all adjustments, consisting only of normal recurring adjustments, necessary for a fair statement of financial position, results of operations, retained earnings, 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 SEC rules and regulations, although the Companies believe that the disclosures are adequate to make the information presented not misleading. See the Companies' Annual Reports on Form 10-K for the year ended December 31, 2005, for information relevant to the accompanying financial statements, including information as to the significant accounting policies of the Companies. New Accounting Pronouncements In July 2006, the FASB issued FIN 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109, Accounting for Income Taxes. FIN 48 is effective for fiscal years beginning after December 15, 2006. FIN 48 clarifies accounting for income taxes to provide improved consistency of criteria used to recognize, derecognize and measure benefits related to income taxes. The Companies are now analyzing the future impacts of FIN 48 on results of operations and financial condition. 2. Rates and Regulatory Matters For a description of each line item of regulatory assets and liabilities for the Companies, reference is made to Part I, Item 8, Financial Statements and Supplementary Data, Note 3 of the Companies' Annual Reports on Form 10-K for the year ended December 31, 2005. The following regulatory assets and liabilities were included in LG&E's Balance Sheets as of June 30, 2006 and December 31, 2005: Louisville Gas and Electric Company (Unaudited) June 30, December 31, (in millions) 2006 2005 ARO $21 $20 Gas supply adjustments 21 29 Unamortized loss on bonds 20 21 ECR 6 2 FAC 5 - VDT - 7 Other 5 5 Total regulatory assets $78 $84 Accumulated cost of removal of utility plant $225 $219 Deferred income taxes - net 44 42 Gas supply adjustments 40 17 Other 2 3 Total regulatory liabilities $311 $281 LG&E currently earns a return on all regulatory assets, excluding the ARO regulatory assets, gas supply adjustments and the FAC. The ARO regulatory assets earn no current return and will be offset against the associated regulatory liability (included in other regulatory liabilities), ARO asset and ARO liability at the time the underlying asset is retired. The gas supply adjustments and the FAC have separate rate mechanisms with recovery within twelve months. The increase in FAC for the period is due to the higher cost of fuel being passed on to customers. The decrease in VDT for the period is due to the completion of the amortization of the VDT in the first quarter of 2006. The increase in the Gas supply adjustments net liability for the period reflects over-recovery of gas supply costs, in process of being refunded to customers. The following regulatory assets and liabilities were included in KU's Balance Sheets as of June 30, 2006 and December 31, 2005: Kentucky Utilities Company (Unaudited) June 30, December 31, (in millions) 2006 2005 ARO $21 $20 Unamortized loss on bonds 10 11 ECR 5 4 FAC 27 12 VDT - 3 Other 7 8 Total regulatory assets $70 $58 Accumulated cost of removal of utility plant $288 $281 Deferred income taxes - net 22 23 Other 10 11 Total regulatory liabilities $320 $315 KU currently earns a return on all regulatory assets, excluding the ARO regulatory assets and the FAC. The ARO regulatory assets earn no current return and will be offset against the associated regulatory liability (included in other regulatory liabilities), ARO asset and ARO liability at the time the underlying asset is retired. The FAC has a separate recovery mechanism with recovery within twelve months. The increase in FAC for the period is due to the higher cost of fuel being passed on to customers. The decrease in VDT for the period is due to the completion of the amortization of the VDT in the first quarter of 2006. ELECTRIC AND GAS RATE CASES On June 30, 2004, the Kentucky Commission issued an order approving an increase in the base electric rates of the Companies and the natural gas rates of LG&E. The rate increases took effect on July 1, 2004. During 2004 and 2005, the AG conducted an investigation of the Companies, as well as of the Kentucky Commission and its staff, requesting information regarding allegedly improper communications between the Companies and the Kentucky Commission, particularly during the period covered by the rate cases. Concurrently, the AG had filed pleadings with the Kentucky Commission requesting rehearing of the rate cases on computational components of the increased rates, including income taxes, 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 and granted rehearing on the income tax component. The Kentucky Commission agreed to hold in abeyance further proceedings in the rate case, until the AG filed its investigative report regarding the allegations of improper communication. In January 2005 and February 2005, the AG filed a motion summarizing its investigative report as containing evidence of improper communications and record-keeping errors by the Companies in their conduct of activities before the Kentucky Commission or other state governmental entities and forwarded such report to the Kentucky Commission under continued confidential treatment to allow it to consider the report, including its impact, if any, on completing its investigation and any remaining steps in the rate case. To date, the Companies have neither seen nor requested copies of the report or its contents. In December 2005, the Kentucky Commission issued an order noting completion of its inquiry, including review of the AG's investigative report. The order concludes that no improper communications occurred during the rate proceeding. The order further established a procedural schedule through the first quarter of 2006 for considering the sole issue for which rehearing was granted: state income tax rates used in calculating the granted rate increase. On March 31, 2006, the Kentucky Commission issued an order resolving this issue in the Companies' favor consistent with the original rate increase order. The Companies believe no improprieties have occurred in their communications with the Kentucky Commission and have cooperated in the proceedings before the AG and the Kentucky Commission. The Companies are currently unable to predict whether there will be any additional actions or consequences as a result of the AG's report and investigation. ECR In June 2006, the Companies filed applications to amend their ECR plans with the Kentucky Commission seeking approval to recover investments in environmental upgrades at the Companies' generating facilities. The estimated capital cost of the upgrades for the years 2006 through 2008 is approximately $391 million ($66 million for LG&E and $325 million for KU), of which $229 million is for the Air Quality Control System at Trimble County Unit 2 ($44 million for LG&E and $185 million for KU) and $95 million is for KU's Ghent Unit 2 Selective Catalytic Reduction. A final order is expected to be issued by the end of 2006. In April 2006, the Kentucky Commission initiated routine periodic reviews of the ECR mechanisms for the Companies. These proceedings are expected to be completed before the end of the third quarter of 2006. In December 2004, KU and LG&E filed applications with the Kentucky Commission for approval of a CCN to construct new SO2 control technology (FGDs) at KU's Ghent and Brown stations, and to amend LG&E's compliance plan to allow recovery of new and additional environmental compliance facilities. The estimated capital cost of the additional facilities for 2006 through 2008 is approximately $720 million ($40 million for LG&E and $680 million for KU), of which $560 million is for the KU FGDs at Brown and Ghent. Hearings in these cases occurred during May 2005 and final orders were issued in June 2005, granting approval of the CCN and amendments to the Companies' compliance plans. FAC On February 15, 2006, KU filed with the Virginia Commission an application seeking approval of an increase in its fuel cost factor to reflect higher fuel costs incurred during 2005, and anticipated to be incurred in 2006, of approximately $6 million. The Virginia Commission approved KU's request on April 5, 2006. VDT In December 2001, the Companies received an order from the Kentucky Commission permitting them to set up regulatory assets for workforce reduction costs (VDT costs) and begin amortizing them over a five-year period beginning in April 2001. The order also reduced revenues through a surcredit on bills to ratepayers over the same five-year period, reflecting a sharing (40% to the ratepayers and 60% to the Companies) of the stipulated savings, net of amortization costs, of the workforce reduction. The five-year VDT amortization period ended March 31, 2006. On February 27, 2006, the AG, Kentucky Industrial Utility Consumers, Inc. and the Companies reached a settlement agreement on the future ratemaking treatment of the VDT surcredits and costs and subsequently submitted a joint motion to the Kentucky Commission to approve the unanimous settlement agreement. Under the terms of the settlement agreement, the VDT surcredit will continue at the current level until such time as LG&E or KU file for a change in electric or natural gas base rates. The Kentucky Commission issued an order on March 24, 2006, approving the settlement agreement. MISO The MISO is a non-profit independent transmission system operator that controls more than 100,000 miles of transmission lines over 1.1 million square miles in 17 northern Midwest states and one Canadian province. The MISO operates the regional power grid and wholesale electricity market in an effort to optimize efficiency and safeguard reliability in accordance with federal energy policy. The Companies are now involved in proceedings with the Kentucky Commission and the FERC seeking the authority to exit the MISO. Based on various financial analyses performed internally due to the July 2003 Kentucky Commission investigation into MISO membership, and particularly in light of the financial impact of MISO's implementation of the new day-ahead and real-time markets, the Companies determined that the costs of MISO membership, both now and in the future, outweigh the benefits. A timeline of events regarding the MISO and various proceedings is as follows: - September 1998 - The FERC granted conditional approval for the formation of the MISO. The Companies were founding members. - October 2001 - The FERC ordered that all bundled retail loads and grandfathered wholesale loads of each member transmission owner be included in the calculation of the MISO "cost adder," the Schedule 10 charges designed to recover the MISO's cost of operation, including start-up capital (debt) costs. The Companies and several owners opposed the FERC order and filed suit with the United States Court of Appeals. - February 2002 - The MISO began commercial operations. - February 2003 - The FERC reaffirmed its position on the Schedule 10 charges and the order was subsequently upheld by the U.S. Court of Appeals. - July 2003 - The Kentucky Commission opened an investigation into the Companies' MISO membership. Testimony was filed by the Companies that supported an exit from the MISO, under certain conditions. - August 2004 - The MISO filed its FERC-required TEMT. The Companies and other owners filed opposition to certain conditions of the TEMT and sought to delay the implementation. Such opposition was denied by the FERC. - December 2004 - The Companies provided the MISO its required one-year notice of intent to exit the grid. - April 2005 - The MISO implemented its day-ahead and real-time market (MISO Day 2), including a congestion management system. - October 2005 - The Companies filed documents with the FERC seeking authority to exit the MISO. - November 2005 - The Companies requested a Kentucky Commission order authorizing the transfer of functional control of their transmission facilities from the MISO to the Companies respectively, for the purpose of withdrawing from the MISO. The request stated that the Tennessee Valley Authority ("TVA") would have control to the extent necessary to act as the Companies' Reliability Coordinator and for the Southwest Power Pool, Inc. ("SPP") to perform its function as the Companies' Independent Transmission Organization. The Kentucky Commission issued an order authorizing this transfer in July 2006. - March 2006 - the FERC issued an order conditionally approving the request of the Companies to exit the MISO. The FERC order contained a number of conditions that the Companies needed to satisfy to effect their exit from the MISO including: - Submission of various compliance filings addressing: - the Companies' hold-harmless obligations under the MISO Transmission Owners' Agreement, and the amount of the MISO exit fee to be paid by the Companies as calculated under the approved methodology; - the Companies' anticipated arrangements with Southwest Power Pool, Inc. and Tennessee Valley Authority, including revisions to address certain independence and transmission planning considerations, and reciprocity arrangements to ensure certain KU requirements customers do not incur pancaked rates for transmission and ancillary services; - the Companies' proposed Open Access Transmission Tariff as revised to address possible capacity hoarding, available transmission calculation methodology, curtailment priority and pricing, among other matters; and - the Companies' finalized arrangements with the Southwest Power Pool, Inc. and Tennessee Valley Authority. - The Companies must also file an application of the proposed Open Access Transmission Tariff under Section 205 of the Federal Power Act including a proposed return on equity. During April 2006 through the present, the Companies have submitted filings to the FERC addressing the majority of the conditions contained in the March 2006 order, including a proposed return on equity of 10.88% as part of its open access transmission tariff effective upon any exit from the MISO. - May 2006 - the Kentucky Commission issued an order approving the request of the Companies to exit the MISO. The order authorized the Companies, upon exit of the MISO, to establish a regulatory asset for the exit fee, subject to adjustment for possible future MISO credits, and a regulatory liability for certain revenues which may be collected via current base rates as a result of the existing inclusion of amounts associated with certain MISO Schedule 10 charges. - July 2006 - the Kentucky Commission issued an order approving the Companies' contractual arrangements with TVA and SPP to provide services to the Companies as reliability coordinator and independent transmission organization, respectively, upon a withdrawal from the MISO. This order was subject to certain conditions based upon a satisfactory outcome of pending FERC proceedings involving the Companies' market-based rate authority. - July 2006 - the Kentucky Commission issued further orders denying the MISO's request for a rehearing regarding the May 2006 order and denying the MISO's request for intervenor status in the proceeding concerning the Companies' TVA/SPP arrangements. - July 2006 - the FERC issued a further decision accepting, in substantial part, certain of the Companies' steps, including compliance and other filings, which constituted conditions to the FERC's March 2006 order conditionally approving their exit from the MISO. Also in July 2006, the FERC issued an order denying the MISO's request for a rehearing regarding the FERC's March 2006 order. The Companies now estimate that they may complete their exit from the MISO during late summer 2006. The Companies have tendered a contractual notice to the MISO providing for a withdrawal date of September 1, 2006. There remain certain further conditions that must be satisfied under the FERC's exit orders, which conditions the Companies currently anticipate they can accomplish. The Companies are in continuing discussions with the MISO concerning operational elements of the exit and transition. On or about the date of a completed exit from the MISO, and following initial calculation and invoicing from the MISO, the Companies would pay an exit fee to the MISO in an amount of up to approximately $41 million (allocated approximately $16 million for LG&E and $25 million for KU). The ultimate amount would be determined based upon the actual timing and circumstances of exit and, following payment, is subject to confirmation, correction and true-up, as agreed between the Companies and the MISO. The Kentucky Commission's May 2006 order granted certain relief regarding the exit fee, including the establishment of a regulatory asset relating to such fee and continuing ability to recover certain MISO charges in existing rates. While the Companies believe they can reasonably achieve the remaining conditions imposed by the FERC relating to MISO exit by the late summer, including possibly as early as September 1, 2006, the actual timing or occurrence of withdrawal cannot be assured. Market-Based Rate Authority Beginning in April 2004, the FERC initiated proceedings to modify its methods used to assess generation market power and has established more stringent interim market screen tests. During 2005, in connection with the Companies' tri-annual market-based rate tariff renewals, the FERC continued to contend that the Companies failed such market screens in certain regions. The Companies disputed this contention and, in January 2006, in an attempt to resolve the matter, the Companies submitted proposed tariff schedules to the FERC containing a mitigation mechanism with respect to applicable power sales into the control area of Big Rivers Electric Corporation ("BREC") in western Kentucky, where Western Kentucky Energy Corp., an affiliate of the Companies, maintains a long- term contractual relationship with BREC. Under the proposed tariff schedule, prices for such sales would be capped at a relevant MISO power pool index price. Should the Companies exit the MISO, the FERC contended that they would have market power in their own joint control area, potentially requiring a similar mitigation mechanism for power sales into such region. In July 2006, the FERC issued an order in the Companies' market-based rate proceeding accepting the Companies' further proposal to address certain market power issues the FERC had claimed would arise upon an exit from the MISO. In particular, the Companies received permission to sell power at market-based rates at the interface of control areas in which they may be deemed to have market power, subject to a restriction that such power not be collusively re-sold back into such control areas. Certain general FERC proceedings continue with respect to market-based rate matters, and the Companies' market-based rate authority is subject to such future developments. In some cases, recent FERC decisions in other market-based rate proceedings have proposed or required cost-based, rather than market index, price caps. The Companies cannot predict the ultimate impact of the current or potential mitigation mechanisms on their future wholesale power sales. EPAct 2005 The EPAct 2005 was enacted on August 8, 2005. Among other matters, this comprehensive legislation contains provisions mandating improved electric reliability standards and performance; providing economic and other incentives relating to transmission, pollution control and renewable generation assets; increasing funding for clean coal generation incentives (see Note 6); repealing PUHCA 1935; enacting PUHCA 2005 and expanding FERC jurisdiction over public utility holding companies and related matters via the Federal Power Act and PUHCA 2005. The FERC was directed by the EPAct 2005 to adopt rules to address many areas previously regulated by the other agencies under other statutes, including PUHCA 1935. The FERC remains in various stages of rulemaking on these issues and the Companies are monitoring these rulemaking activities and actively participating in these and other rulemaking proceedings. The Companies continue to evaluate the potential impacts of the EPAct 2005 and the associated rulemakings and cannot predict what impact the EPAct 2005, and any uncompleted rulemakings, will have on their operations or financial position. 3. Financial Instruments The Companies use over-the-counter 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 interest rate swaps as hedge instruments. Financial instruments designated as cash flow hedges have resulting gains and losses recorded within comprehensive income and stockholders' equity. 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 June 30, 2006, LG&E was party to various interest rate swap agreements with aggregate notional amounts of $211 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 3.67% at June 30, 2006. The swap agreements in effect at June 30, 2006, have been designated as cash flow hedges and mature on dates ranging from 2020 to 2033. The hedges have been deemed to be fully effective resulting in a pretax gain of $13 million for the six months ended June 30, 2006, recorded in comprehensive income. Upon expiration of these hedges, the amount recorded in comprehensive income will be reclassified into earnings. The amounts expected to be reclassified from comprehensive income to earnings in the next twelve months are immaterial. A deposit in the amount of $7 million, used as collateral for the $83 million interest rate swap, is classified as restricted cash on LG&E's Balance Sheet. The amount of the deposit required is tied to the market value of the swap. As of June 30, 2006, KU was party to an interest rate swap agreement with a notional amount of $53 million. Under this swap agreement, KU paid variable rates based on LIBOR averaging 7.24%, and received fixed rates averaging 7.92% at June 30, 2006. The swap agreement in effect at June 30, 2006 has been designated as a fair value hedge and matures in 2007. At June 30, 2006, the effect of marking this financial instrument and the underlying debt to market resulted in pretax gains recorded in interest expense of less than $1 million. Interest rate swaps hedge interest rate risk on the underlying debt. Under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended, 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 June 30, 2006, KU's debt reflects a mark-to- market adjustment of less than $1 million. At June 30, 2006, the Companies' percentage of debt having a variable rate, including the impact of interest rate swaps, was 44%($364 million) for LG&E and 47% ($378 million) for KU. 4. Pension and Other Post-retirement Benefit Plans The following table provides the components of net periodic benefit cost for pension and other benefit plans for the three and six months ended June 30, 2006 and 2005: Three Months Ended Six Months Ended June 30, June 30, 2006 2005 2006 2005 (in millions) LG&E KU LG&E KU LG&E KU LG&E KU Pension and Other Benefit Plans Components of net periodic benefit cost Service cost $2 $2 $1 $2 $3 $4 $3 $3 Interest cost 5 5 6 4 11 8 12 9 Expected return on plan assets (5) (4) (5) (4) (10) (7) (11) (8) Amortization of prior service cost 1 - 1 - 2 1 3 1 Recognized actuarial loss 1 1 1 1 2 2 1 1 Total net period benefit cost $4 $4 $4 $3 $8 $8 $8 $6 LG&E made a discretionary contribution to the pension plan of $18 million in January 2006. LG&E made no contributions during 2005. KU made no contributions to the pension plan in 2006 or 2005. 5. Short-Term and Long-Term 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 balance sheets. The average annualized interest rate for these bonds during the six months ending June 30, 2006 was 3.38% for LG&E and 3.41% for KU. During June 2006, LG&E renewed five revolving lines of credit with banks totaling $185 million. There was no outstanding balance under any of these facilities at June 30, 2006. LG&E expects to renew these facilities prior to their expiration in June 2007. LG&E, KU and E.ON U.S. participate in an intercompany money pool agreement. Details of the balances at June 30, 2006 and December 31, 2005 were as follows: Total Money Amount Balance Average Pool Available Outstanding Available Interest Rate ($ in millions) June 30, 2006: LG&E $400 $ 1 $399 4.96% KU $400 $ 52 $348 4.96% December 31, 2005: LG&E $400 $141 $259 4.21% KU $400 $ 70 $330 4.21% E.ON U.S. maintains a revolving credit facility totaling $200 million with an affiliated company, E.ON North America, Inc., to ensure funding availability for the money pool. The balance outstanding on this facility at June 30, 2006, was $64 million. Redemptions and maturities of long-term debt year-to-date through June 30, 2006, are summarized below: ($ in millions) Principal Secured/ Year Company Description Amount Rate Unsecured Maturity 2006 KU First mortgage bonds $36 5.99% Secured Jan 2006 Issuances of long-term debt year-to-date through June 30, 2006, are summarized below: ($ in millions) Principal Secured/ Year Company Description Amount Rate Unsecured Maturity 2006 KU Fidelia note $50 6.33% Unsecured Jun 2036 6. Commitments and Contingencies Except as may be discussed in this Quarterly Report on Form 10-Q (including Note 2), 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, 2005 (including in Notes 3 and 10 to the financial statements of the Companies contained therein) and Quarterly Report on Form 10-Q for the quarter ended March 31, 2006 (including in Notes 2 and 6 to the financial statements contained therein). See the above- referenced notes in the Companies' Annual Report on Form 10-K and Quarterly Report on Form 10-Q for information regarding such commitments or contingencies. TRIMBLE COUNTY UNIT 2 In June 2006, the Companies, as 75% owners, entered into and delivered notice to proceed under an engineering, procurement and construction agreement with Bechtel Power Corporation ("Bechtel"), regarding construction of Trimble County Unit 2 valued at approximately $1.1 billion. IMEA and IMPA, as 25% owners, are also parties to the contract. The contract is generally in the form of a lump-sum, turnkey agreement for the design, engineering, procurement, construction, commissioning, testing and delivery of the project, according to designated specifications, terms and conditions. The contract price and its components are subject to a number of potential adjustments which may serve to increase or decrease the ultimate construction price paid or payable to the contractor. The contract also contains standard representations, covenants, indemnities, termination and other provisions for arrangements of this type, including termination for convenience or for cause rights. In general, termination by the owners for convenience or by the contractor due to owners' default will limit payment obligations to payment for work or incentives performed or earned to date and termination by owners due to contractor's default will similarly limit payment obligations, subject however to owners' rights with respect to cover damages and to certain collateral provided. In connection with this matter, the Companies dismissed their litigation against Bechtel regarding the contract previously commenced in April 2006 in United States District Court for the Western District of Kentucky. In June 2006, the Companies filed an application with the Department of Energy ("DOE") requesting certification to be eligible for investment tax credits applicable to the construction of Trimble County Unit 2. The EPAct 2005 added a new 48A to the Internal Revenue Code, which provides for an investment tax credit to promote the commercialization of advanced coal technologies that will generate electricity in an environmentally responsible manner. The application requested up to the maximum amount of "advanced coal project" credit allowed per taxpayer, or $125 million, based on an estimate of 15% of projected qualifying Trimble County Unit 2 expenditures. The DOE is anticipated to select and certify feasible and suitable qualifying projects, in their discretion, from among the applicant group during the late fall of 2006. If selected, the Companies would submit an additional application to the Internal Revenue Service ("IRS"). IRS action on such applications would thereafter be expected to occur during the fourth quarter of 2006. If, and to the extent the Companies' applications are ultimately accepted, the Companies could thereafter claim allocated federal income tax credits on eligible expenditures, as they occur over time, relating to the Trimble County Unit 2 project. LOUISVILLE DOWNTOWN ARENA LG&E has been asked by the Louisville Arena Authority, Inc., a non- profit corporation (the "Authority"), to transfer certain property and relocate certain LG&E facilities so that an LG&E-owned site, in part, could be used for the development and construction of a new multi- purpose arena in Louisville, Kentucky. The Authority and LG&E are negotiating a non-binding letter of intent regarding the arena transactions. LG&E estimates that the cost of relocating the LG&E facilities will be approximately $63 million and LG&E expects to request that the Authority arrange for the provision of state funds necessary for the relocation, as well as up to $10 million in state funds for the purchase of the property at fair market value. Current estimates are that the arena project could be completed by approximately 2010. The anticipated letter of intent would be subject to a number of contingencies, including completion of definitive documents and regulatory approvals necessary for the transactions contemplated. OMU LITIGATION In May 2004, the City of Owensboro, Kentucky and Owensboro Municipal Utilities (collectively "OMU") commenced a suit now removed to the U.S. District Court for the Western District of Kentucky, against KU concerning a long-term power supply contract (the "OMU Agreement") with KU. The dispute involves interpretational differences regarding issues under the OMU Agreement, including various payments or charges between KU and OMU and rights concerning excess power, termination and emissions allowances. The complaint seeks approximately $6 million in damages for periods prior to 2004 and OMU is expected to claim further amounts for later-occurring periods. OMU has additionally requested injunctive and other relief, including a declaration that KU is in material breach of the contract. KU has filed an answer in that court denying the OMU claims and presenting counterclaims. During 2005, the FERC declined KU's application to exercise exclusive jurisdiction over the matter. In July 2005, the district court resolved a summary judgment motion made by KU in OMU's favor, ruling that a contractual provision grants OMU the ability to terminate the contract without cause upon four years' prior notice, for which ruling KU retains certain rights to appeal. At this time the district court case is in the discovery stage and a trial schedule has not yet been established. In May 2006, OMU issued a notification of its intent to terminate the contract in May 2010, without cause, absent any earlier termination which may be permitted by the proceeding. ENVIRONMENTAL MATTERS In April 2006, the EPA issued a notice of violation for alleged violations of the Clean Air Act involving work performed on Unit 3 of KU's E.W. Brown Station in 1997. The EPA alleges modification of a source without a permit, failure to comply with requirements under the Prevention of Significant Deterioration ("PSD") program, operation of a source in violation of the New Source Performance Standards ("NSPS"), and failure to identify the applicability of PSD and NSPS requirements in compliance certifications. Violations, if ultimately found, could result in additional expenditures on pollution controls or civil penalties. KU has responded to certain data requests of the EPA and held initial discussions with the EPA regarding this matter. Due to the early stage of this matter, KU is unable to determine its ultimate potential impact. The Companies are subject to SO2 and NOx emission limits on their electric generating units pursuant to the Clean Air Act. The Companies placed into operation significant NOx controls for their generating units prior to the 2004 summer ozone season. As of June 30, 2006, LG&E and KU have incurred total capital costs of approximately $191 million and $217 million, respectively, to reduce their NOx emissions to required levels. In addition, the Companies incur additional operating and maintenance costs in operating the new NOx controls. On March 10, 2005, the EPA issued the final CAIR which requires substantial additional reductions in SO2 and NOx emissions from electric generating units. The CAIR provides for a two-phased reduction program with Phase I reductions in NOx and SO2 emissions in 2009 and 2010, respectively, and Phase II reductions in 2015. On March 15, 2005, the EPA issued a related regulation, the final CAMR, which requires substantial mercury reductions from electric generating units. The CAMR also provides for a two-phased reduction, with the Phase I target in 2010 achieved as a "co- benefit" of the controls installed to meet the CAIR. Additional control measures will be required to meet the Phase II target in 2018. Both the CAIR and the CAMR establish a cap and trade framework, in which a limit is set on total emissions and allowances can be bought or sold on the open market to be used for compliance, unless the state chooses another approach. LG&E currently has FGDs on all its coal-fired units, but will continue to evaluate improvements to further reduce SO2 emissions. In order to meet these new regulatory requirements, KU has implemented a plan for adding significant additional SO2 controls to its generating units. Installation of additional SO2 controls will proceed on a phased basis, with construction of controls (i.e., FGDs) having commenced in September 2005 and continuing through the final installation and operation in 2009. KU estimates that it will incur $659 million in capital costs related to the construction of the FGDs to achieve compliance with current emission limits on a company-wide basis. Of this amount, $77 million has been incurred through June 30, 2006. In addition, KU will incur additional operating and maintenance costs in operating the new SO2 controls. The Companies 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 and measures to implement the EPA's Clean Air Visibility Rule. In the normal course of business, lawsuits, claims, environmental actions and various non-ratemaking governmental proceedings arise against the Companies. To the extent that damages are assessed in any lawsuits relating to the above, the Companies believe that their insurance coverage or other appropriate reserves are adequate. Management, after consultation with legal counsel, and based upon the present status of these items, does not anticipate that liabilities arising out of other currently pending or threatened lawsuits and claims of the type referenced above will have a material adverse effect on the Companies' financial position or results of operations. 7.Segments of Business LG&E's revenues, net income and total assets by business segment for the three and six months ended June 30, 2006 and 2005, follow: Three Months Six Months Ended June 30, Ended June 30, (in millions) 2006 2005 2006 2005 LG&E Electric Revenues $223 $228 $435 $457 Net income 27 30 42 54 Total assets 2,440 2,404 2,440 2,404 LG&E Gas Revenues 54 53 254 225 Net income (2) (2) 8 8 Total assets 507 454 507 454 Total Revenues 277 281 689 682 Net income 25 28 50 62 Total assets 2,947 2,858 2,947 2,858 KU is an electric utility company. It does not provide natural gas service and, therefore, is presented as a single business segment. 8. Related Party Transactions LG&E, KU, subsidiaries of E.ON U.S. and other subsidiaries of E.ON engage in related-party transactions. These transactions are generally performed at cost and in accordance with applicable FERC, Kentucky Commission and Virginia Commission regulations. The significant related-party transactions are disclosed below. Electric Purchases The Companies' intercompany electric revenues and purchased power expense from affiliated companies for the three and six months ended June 30, 2006 and 2005 were as follows: Three Months Six Months Ended June 30, Ended June 30, (in millions) 2006 2005 2006 2005 LG&E KU LG&E KU LG&E KU LG&E KU Electric operating revenues from KU $22 $- $21 $- $44 $- $47 $- Electric operating revenues from LG&E - 17 - 19 - 36 - 49 Purchased power from KU 17 - 19 - 36 - 49 - Purchased power from LG&E - 22 - 21 - 44 - 47 Interest Charges The Companies' intercompany interest income and expense for the three and six months ended June 30, 2006 and 2005 were as follows: Three Months Six Months Ended June 30, Ended June 30, (in millions) 2006 2005 2006 2005 LG&E KU LG&E KU LG&E KU LG&E KU Interest on money pool loans $- $1 $- $- $1 $2 $- $- Interest on Fidelia loans 3 4 3 4 6 9 6 7 Other Intercompany Billings Other intercompany billings related to the Companies for the three and six months ended June 30, 2006 and 2005 were as follows: Three Months Six Months Ended June 30, Ended June 30, (in millions) 2006 2005 2006 2005 E.ON U.S. Services billings to LG&E $69 $76 $105 $108 E.ON U.S. Services billings to KU 78 75 120 101 LG&E billings to E.ON U.S. Services 2 1 3 5 KU billings to E.ON U.S. Services 2 - 3 4 LG&E billings to KU 6 7 10 10 KU billings to LG&E 3 9 15 13 9. Subsequent Events On July 14, 2006, LG&E redeemed 12,500 shares of its 5.875% mandatorily redeemable preferred stock pursuant to sinking fund requirements at $100 per share. On July 20, 2006, KU completed a new tax-exempt financing totaling approximately $17 million. The new bonds, due June 1, 2036, have a variable, auction rate of interest. Effective August 1, 2006, KU and its employees represented by IBEW Local 2100 entered into a new three-year collective bargaining agreement. Such agreement provides for routine updates to wages, benefits or other provisions and provides for annual wage re-openers for the second and third years. 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 the Companies' financial results of operations and financial condition during the three and six month periods ended June 30, 2006, 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 the Companies' reports to the SEC, including the Annual Reports on Form 10-K for the year ended December 31, 2005. Executive Summary LG&E and KU, subsidiaries of E.ON U.S. (indirect subsidiaries of E.ON), are regulated public utilities. At June 30, 2006, LG&E supplied electricity to approximately 398,000 customers and natural gas to approximately 323,000 customers in Louisville and adjacent areas in Kentucky. At June 30, 2006, KU provided electricity to approximately 497,000 customers in 77 counties in central, southeastern and western Kentucky, to approximately 30,000 customers in southwestern Virginia and 5 customers in Tennessee. KU also sells wholesale electricity to 12 municipalities. The mission of the Companies is to build on our tradition and achieve world-class status providing reliable, low-cost energy services and superior customer satisfaction; and to promote safety, financial success and quality of life for our employees, communities and other stakeholders. The Companies' strategy focuses on the following: - Achieve scale as an integrated U.S. electric and gas business through organic growth; - Maintain excellent customer satisfaction; - Maintain best-in-class cost position versus U.S. utility companies; - Develop and transfer best practices throughout the company; - Invest in infrastructure to meet expanding load and comply with increasing environmental requirements; - Achieve appropriate regulated returns on all investment; - Attract, retain and develop the best people; and - Act with a commitment to corporate social responsibility that enhances the well being of our employees, demonstrates environmental stewardship, promotes quality of life in our communities and reflects the diversity of the society we serve. In a June 2004 order, the Kentucky Commission accepted the settlement agreements reached by the majority of the parties in the rate cases filed by the Companies in December 2003. Under the ruling, the LG&E utility base electric rates have increased $43 million (7.7%) and base natural gas rates have increased $12 million (3.4%) annually. Base electric rates at KU have increased $46 million (6.8%) annually. The rate increases took effect on July 1, 2004. The 2004 increases were the first increases in electric base rates for the Companies in 13 and 20 years, respectively; the previous natural gas rate increase for the LG&E gas utility took effect in September 2000. The Companies have begun construction of another base-load coal-fired unit at the Trimble County site. The Companies believe this is the least cost alternative to meet the future needs of customers. Trimble County Unit 2, with a 750 Mw capacity rating, is expected to be jointly owned by the Companies (75% owners of the unit) and IMEA and IMPA (25% owners). Trimble County Unit 2 is expected to cost $1.1 billion and be completed by 2010. The Companies' aggregate 75% share of the total Trimble County Unit 2 capital cost is approximately $885 million and is estimated to be approximately $120 million for LG&E and $510 million for KU through 2008. Through June 2006, expenditures for Trimble County Unit 2 have been $7 million for LG&E and $25 million for KU. In June 2006, the Companies entered into a construction contract regarding the Trimble County Unit 2 project. See Note 6 of the Notes to Financial Statements, in Part 1, Item 1, herein. In November 2005, the Kentucky Commission approved the CCN construction application of the Companies to expand the Trimble County generating plant. Kentucky Commission approvals for the related transmission line CCNs were granted in September 2005 and May 2006. In July 2006, certain property owners filed a motion for judicial appeal of the latter transmission line CCN ruling. A schedule for such proceeding has not been established. In November 2005, the Kentucky Division for Air Quality issued the final air permit, which was challenged via a request for remand in December 2005 by three environmental advocacy groups, including the Sierra Club. Administrative proceedings with respect to the challenge are expected to continue during 2006 with a hearing scheduled for October 2006. A ruling thereafter may be anticipated in the first half of 2007. In July 2006, the FERC issued a final report under a routine audit that its Office of Enforcement (formerly its Office of Market Oversight and Investigations) had conducted regarding the compliance of E.ON U.S. and subsidiaries, including LG&E and KU, under the FERC's standards of conduct and codes of conduct requirements, as well as other areas. The final report contained certain findings calling for improvements in E.ON U.S. and subsidiaries' structures, policies and procedures relating to transmission, generation dispatch, energy marketing and other practices. E.ON U.S. and affiliates have agreed to certain corrective actions and plan to submit procedures related to such corrective actions to the FERC. The corrective actions are in the nature of organization and operational improvements as described above and are not expected to have a material adverse impact on the Companies' results of operations or financial condition. Results of Operations The results of operations for the Companies are affected by seasonal fluctuations in temperature and other weather-related factors. Because of these and other factors, the results of one interim period are not necessarily indicative of results or trends to be expected for the full year. Three Months Ended June 30, 2006, Compared to Three Months Ended June 30, 2005 LG&E Results: LG&E's net income decreased $3 million (11%) for the three months ended June 30, 2006, as compared to the three months ended June 30, 2005, primarily due to lower electricity and natural gas retail and wholesale sales volumes resulting largely from milder weather than in the prior year. A comparison of LG&E's revenues for the three months ended June 30, 2006, with the three months ended June 30, 2005, reflects increases and (decreases) which have been segregated by the following principal causes: Cause Electric Gas (in millions) Revenues Revenues Retail sales: Fuel and gas supply adjustments $6 $7 Environmental cost recovery surcharge (3) - Variation in sales volume and other (5) (2) Total retail sales (2) 5 Wholesale sales (4) (4) Other 1 - Total $(5) $1 Electric revenues decreased $5 million (2%) primarily due to: - Decreased wholesale revenues ($4 million) largely due to 4% lower volumes - Decreased retail electric volumes delivered ($5 million) resulting from a 14% decrease in cooling degree days in the second quarter of 2006 compared to the same period in 2005 and an 16% decrease from the 20-year average - Decreased environmental cost recovery ($3 million) due to lower ECR billing rates - Increased fuel costs billed to customers through the fuel adjustment clause ($6 million) due to higher costs of coal and natural gas Gas revenues increased $1 million (2%) primarily due to: - Increased gas supply costs billed to customers through the gas supply adjustment ($7 million) due to the higher cost of natural gas - Decreased wholesale revenues ($4 million) as a result of 7% lower volumes due to lower demand from wholesale customers - Decreased retail gas volumes delivered ($2 million) resulting from a 17% decrease in heating degree days in the second quarter of 2006 compared to the same period in 2005 and an 20% decrease from the 20-year average Fuel for electric generation and gas supply expenses comprise a large component of LG&E's total operating expenses. Increases or decreases in the cost of fuel and natural gas supply are reflected in LG&E's electric and natural gas retail rates, through the fuel adjustment clause and gas supply clause, subject to the approval of the Kentucky Commission. Fuel for electric generation increased $2 million (3%) in 2006 primarily due to: - Increased unit cost of fuel burned ($4 million) due to higher fuel prices - Decreased generation ($2 million) due to lower wholesale and retail sales volumes Power purchased decreased $2 million (7%) in 2006 primarily due to: - Decreased volumes purchased ($6 million) due to lower wholesale and retail sales - Increased unit cost of purchases ($4 million) due to higher market prices Gas supply expenses increased $2 million (6%) in 2006 primarily due to: - Increased unit cost of natural gas purchased ($8 million) - Decreased volumes of natural gas delivered into the distribution system ($6 million) due to milder weather A comparison of the LG&E effective income tax rate for the three months ended June 30, 2006 and 2005 follows: Three Months Three Months Ended Ended June 30, 2006 June 30, 2005 Effective Rate Statutory federal income tax rate 35.0% 35.0% State income taxes net of federal benefit 3.5 5.2 Amortization of investment tax credits (2.7) (2.3) Other differences (3.4) (1.5) Effective income tax rate 32.4% 36.4% State income taxes in 2006 reflect Kentucky Coal Tax credits earned. The change in amortization of investment tax credits and other differences is largely attributable to the change in the levels of pre-tax income. KU Results: KU's net income increased $7 million (39%) for the three months ended June 30, 2006, as compared to the three months ended June 30, 2005, primarily due to lower maintenance costs, a lower effective income tax rate and higher earnings from EEI. A comparison of KU's revenues for the three months ended June 30, 2006, with the three months ended June 30, 2005, reflects increases and (decreases) which have been segregated by the following principal causes: Cause Electric (in millions) Revenues Retail sales: Fuel supply adjustments $17 Environmental cost recovery surcharge 3 Variation in sales volumes and other (7) Total retail sales 13 Other (2) Total $11 Electric revenues increased $11 million (4%) in 2006 primarily due to: - Increased fuel costs billed to customers through the fuel adjustment clause ($17 million) due to higher costs of coal and natural gas - Increased environmental cost recovery ($3 million) due to higher ECR billing rates - Decreased retail electric volumes delivered ($7 million) resulting from a 17% decrease in cooling degree days in the second quarter of 2006 compared to the same period in 2005 and an 19% decrease from the 20-year average Fuel for electric generation comprises a large component of KU's total operating expenses. Increases or decreases in the cost of fuel are reflected in KU's retail electric rates through the fuel adjustment clause, subject to the approval of the Kentucky Commission, the Virginia State Corporation Commission and the FERC. Fuel for electric generation increased $16 million (19%) in 2006 primarily due to: - Increased unit cost of fuel burned ($9 million) due to higher fuel prices - Increased generation ($7 million) largely due to higher unit availability Power purchased decreased $6 million (12%) in 2006 primarily due to: - Decreased volumes purchased ($8 million) largely due to higher unit availability and decreased retail demand - Increased unit cost of purchases ($2 million) due to higher market prices Other operation and maintenance expenses decreased $5 million (7%) in 2006 primarily due to: - Decreased maintenance costs ($3 million) largely due to an outage last year at Brown Unit 3 - Decreased other power supply costs ($2 million) related to lower MISO Day 2 expenses Other (income) - net increased $3 million (150%) primarily due to increased equity in earnings from EEI as a result of EEI selling electricity at market based rates, effective January 2006. Interest expense increased $1 million (13%) in 2006 primarily due to increased borrowing from Fidelia. A comparison of the KU effective income tax rate for the three months ended June 30, 2006 and 2005 follows: Three Months Three Months Ended Ended June 30, 2006 June 30, 2005 Effective Rate Statutory federal income tax rate 35.0% 35.0% State income taxes net of federal benefit 4.4 5.0 Amortization of investment tax credits (0.8) (1.4) EEI dividend (6.1) - Other differences (1.9) (2.9) Effective income tax rate 30.6% 35.7% The EEI dividend in the second quarter of 2006 reflects a tax benefit associated with the receipt of dividends from KU's investment in EEI. The change in amortization of investment tax credits and other differences is largely attributable to the change in the levels of pre-tax income. Six Months Ended June 30, 2006, Compared to Six Months Ended June 30, 2005 LG&E Results: LG&E's net income decreased $12 million (19%) for the six months ended June 30, 2006, as compared to the six months ended June 30, 2005, primarily due to lower electricity and natural gas retail and wholesale sales volumes, higher maintenance costs and higher interest expense. A comparison of LG&E's revenues for the six months ended June 30, 2006, with the six months ended June 30, 2005, reflects increases and (decreases) which have been segregated by the following principal causes: Cause Electric Gas (in millions) Revenues Revenues Retail sales: Fuel and gas supply adjustments $15 $73 Merger surcredit 1 - Weather normalization - 2 Variation in sales volume and other (8) (31) Total retail sales 8 44 Wholesale sales (32) (16) Other 2 1 Total $(22) $29 Electric revenues decreased $22 million (5%) in 2006 primarily due to: - Decreased wholesale revenues ($32 million) largely due to 10% lower volumes - Decreased retail electric volumes delivered ($8 million) resulting from a 10% decrease in cooling degree days in the first six months of 2006 compared to the same period in 2005 and an 12% decrease from the 20-year average - Increased fuel costs billed to customers through the fuel adjustment clause ($15 million) due to higher costs of coal and natural gas - Increased miscellaneous revenues ($2 million) Gas revenues increased $29 million (13%) in 2006 primarily due to: - Increased gas supply costs billed to customers through the gas supply adjustment ($73 million) due to higher natural gas costs - Increased weather normalization revenues ($2 million) due to warmer weather - Decreased retail gas volumes delivered ($31 million) resulting from a 10% decrease in heating degree days in the first six months of 2006 compared to the same period in 2005 and an 12% decrease from the 20-year average - Decreased wholesale revenues ($16 million) as a result of 7% lower volumes due to lower demand from wholesale customers Fuel for electric generation and gas supply expenses comprise a large component of LG&E's total operating expenses. Increases or decreases in the cost of fuel and natural gas supply are reflected in LG&E's electric and natural gas retail rates, through the fuel adjustment clause and gas supply clause, subject to the approval of the Kentucky Commission. Fuel for electric generation increased $6 million (5%) in 2006 primarily due to: - Increased unit cost of fuel burned ($13 million) due to higher fuel prices - Decreased generation ($5 million) due to lower wholesale and retail sales volumes Power purchased decreased $13 million (19%) in 2006 primarily due to: - Decreased volumes purchased ($22 million) due to lower wholesale and retail sales - Increased unit cost of purchases ($9 million) due to higher market prices Gas supply expenses increased $29 million (17%) in 2006 primarily due to: - Increased unit cost of natural gas purchased ($69 million) - Decreased volumes of natural gas delivered into the distribution system ($40 million) due to milder weather Other operation and maintenance expenses increased $4 million (3%) in 2006 primarily due to: - Increased steam maintenance ($3 million) largely due to the outage at Mill Creek Unit 4 - Increased distribution maintenance ($2 million) due to higher storm restoration costs Interest expense increased $2 million (11%) in 2006 primarily due to: - Increased interest rates on variable rate debt ($3 million) - Increased interest on tax deficiencies ($1 million) - Increased interest rates on money pool borrowing ($1 million) - Decreased interest on the swaps ($2 million) - Decreased interest due to refinancing fixed rate debt with variable rate debt ($1 million) The weighted average interest rate on variable-rate bonds for the six months ended June 30, 2006, was 3.33%, compared to 2.27% for the comparable period in 2005. A comparison of the LG&E effective income tax rate for the six months ended June 30, 2006 and 2005 follows: Six Months Six Months Ended Ended June 30, 2006 June 30, 2005 Effective Rate Statutory federal income tax rate 35.0% 35.0% State income taxes net of federal benefit 3.6 4.8 Amortization of investment tax credits (2.7) (2.2) Other differences (2.6) (2.2) Effective income tax rate 33.3% 35.4% State income taxes in 2006 reflect Kentucky Coal Tax credits earned. The change in amortization of investment tax credits and other differences is largely attributable to the change in the levels of pre-tax income. KU Results: KU's net income increased $5 million (9%) for the six months ended June 30, 2006, as compared to the six months ended June 30, 2005, primarily due higher earnings from EEI and a lower effective income tax rate, which is partially offset by higher transmission costs and higher interest charges. A comparison of KU's revenues for the six months ended June 30, 2006, with the six months ended June 30, 2005, reflects increases and (decreases) which have been segregated by the following principal causes: Cause Electric (in millions) Revenues Retail sales: Fuel supply adjustments $36 Environmental cost recovery surcharge 3 Merger surcredit 1 Rate and rate structure 2 Variation in sales volume and other (6) Total retail sales 36 Wholesale sales (18) Other (1) Total $17 Electric revenues increased $17 million (3%) in 2006 primarily due to: - Increased fuel costs billed to customers through the fuel adjustment clause ($36 million) due to higher costs of coal and natural gas - Increased environmental cost recovery ($3 million) due to higher ECR billing rates - Increased Virginia revenues due to a rate change for increased fuel recovery ($2 million) - Decreased wholesale sales ($18 million) largely due to 5% lower volumes - Decreased retail electric volumes delivered ($7 million) resulting from a 9% decrease in cooling degree days in the first six months of 2006 compared to the same period in 2005 and an 11% decrease from the 20-year average Fuel for electric generation comprises a large component of KU's total operating expenses. Increases or decreases in the cost of fuel are reflected in KU's retail electric rates through the fuel adjustment clause, subject to the approval of the Kentucky Commission, the Virginia State Corporation Commission and the FERC. Fuel for electric generation increased $23 million (13%) in 2006 primarily due to: - Increased unit cost of fuel burned ($20 million) due to higher fuel prices - Increased generation ($3 million) largely due to higher unit availability Power purchased decreased $6 million (6%) in 2006 primarily due to: - Decreased volumes purchased ($18 million) largely due to higher unit availability and decreased retail demand - Increased unit cost of purchases ($12 million) due to higher market prices Other operation and maintenance expenses increased $7 million (6%) in 2006 primarily due to: - Increased other power supply ($5 million) largely due to MISO Day 2 - Increased transmission expense ($3 million) largely due to MISO Day 1 Other (income) - net increased $10 million (333%) primarily due to increased equity in earnings from EEI as a result of EEI selling electricity at market based rates, effective January 2006. Interest expense increased $4 million (29%) in 2006 primarily due to: - Increased borrowing from Fidelia ($2 million) - Increased borrowing and increased interest rates on money pool debt ($2 million) A comparison of the KU effective income tax rate for the six months ended June 30, 2006 and 2005 follows: Six Months Six Months Ended Ended June 30, 2006 June 30, 2005 Effective Rate Statutory federal income tax rate 35.0% 35.0% State income taxes net of federal benefit 4.4 4.7 Amortization of investment tax credits (0.6) (0.9) EEI dividend (5.1) - Other differences (1.1) (0.6) Effective income tax rate 32.6% 38.2% The EEI dividend for the six months ended June 30, 2006, reflects a tax benefit associated with the receipt of dividends from KU's investment in EEI. Liquidity and Capital Resources The Companies' 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, in addition to debt service requirements and dividend payments. Internal and external lines of credit are maintained to fund short-term capital requirements. The Companies believe that such sources of funds will be sufficient to meet the needs of the business in the foreseeable future. At June 30, 2006, the Companies were 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. Construction expenditures for the six months ended June 30, 2006 amounted to $66 million for LG&E and $121 million for KU. At LG&E, capital expenditures included infrastructure for new customers, gas main replacements/extensions and capital repairs to Mill Creek Unit 4. At KU, capital expenditures included construction of FGD and other environmental equipment at the Ghent generating station and infrastructure for new customers. LG&E's cash balance decreased $2 million during the six months ended June 30, 2006, largely resulting from repayments of debt and the payment of dividends. KU's cash balance decreased $2 million during the six months ended June 30, 2006, primarily due to increased capital expenditures. Variations in accounts receivable, inventories and accounts payable are generally not significant indicators of the Companies' liquidity. Such variations are primarily attributable to seasonal fluctuations in weather, which have a direct effect on sales of electricity and natural gas. The decreases in LG&E's accounts receivable and natural gas stored underground relate primarily to seasonal uses of natural gas. For information regarding the Companies' use of interest rate swaps to hedge underlying variable-rate (LG&E) and fixed-rate (KU) debt obligations, see Note 3 of the Notes to Financial Statements. See Note 5 of the Notes to Financial Statements for information regarding the Companies' long-term and short-term debt including: accounting treatment of bonds permitting tender for purchase at the option of the holder, re-negotiation of revolving credit lines, intercompany debt transactions and the issuance and redemption of financial instruments during the year. Security ratings as of June 30, 2006, were: LG&E KU Moody's S&P Moody's S&P First mortgage bonds A1 A- A1 A Preferred stock Baa1 BBB- Baa1 BBB- Commercial paper P-1 A-2 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. LG&E made a discretionary contribution to the pension plan of $18 million in January 2006. LG&E made no contributions during 2005. KU made no contributions to the pension plan in 2006 or 2005. Contingencies For a description of significant contingencies that may affect the Companies, reference is made to Part I, Item 3, Legal Proceedings in the Companies' Annual Reports on Form 10-K for the year ended December 31, 2005; to Part I - Item 1 and Part II - Item 1, Legal Proceedings in the Companies' Quarterly Report on Form 10-Q for the period ended March 31, 2006; and to Notes 2 and 6 of the Notes to Financial Statements in Part I - - Item 1, and Part II - Item 1, Legal Proceedings herein. Item 3. Quantitative and Qualitative Disclosures About Market Risk. Interest Rate Risk 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 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 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 the Companies' unswapped variable debt is estimated at $4 million each at June 30, 2006. The Companies' exposure to floating interest rates did not materially change during the first six months of 2006. 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 $17 million as of June 30, 2006. 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 less than $1 million as of June 30, 2006. 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 The Companies' 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. The Companies have recognized an additional minimum liability as prescribed by SFAS No. 87, Employers' Accounting for Pensions because the accumulated benefit obligation exceeds the fair value of their plans' assets. The liabilities were recorded as a reduction to comprehensive income, and did not affect net income. The amount of the liability depends upon the discount rate, the asset returns and contributions made by the Companies to the plans. If the fair value of the plans' assets exceeds the accumulated benefit obligation, the recorded liabilities will be reduced and comprehensive income will be restored in the balance sheet. A 1% increase or decrease in the assumed discount rate could have an approximate $49 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 $33 million positive or negative impact to the accumulated benefit obligation of KU. LG&E made a discretionary contribution to the pension plan for $18 million in January 2006. LG&E made no contributions during 2005. KU made no contributions to the pension plan in 2006 or 2005. Energy & Risk Management Activities The Companies conduct energy trading and risk management activities to maximize the value of power sales from physical assets they own. Certain energy trading activities are accounted for on a mark-to-market basis in accordance with SFAS No. 133, as amended. Wholesale sales of excess asset capacity are treated as normal sales under SFAS No. 133, as amended, and are not marked to market. Since the inception of the MISO Day 2 market in April 2005, the Companies have been eligible to receive FTRs from the MISO. FTRs are assigned by the MISO to market participants for a twelve-month period of time beginning June 1, 2006, for off-peak and peak periods based on each market participant's share of generation. FTRs are utilized to manage price risk associated with transmission congestion. The value of FTRs is determined by the transmission congestion charges that arise when the transmission grid is congested in the day-ahead market. FTRs are obtained through an allocation from the MISO at zero cost, however, they can also be bought and sold. FTRs are derivatives and their fair value is insignificant due to the lack of liquidity in the forward market. The fair values of the Companies' energy trading and risk management contracts as of June 30, 2006 were each approximately $2 million. The fair values at June 30, 2005, were less than $1 million each. No changes to valuation techniques for energy trading and risk management activities occurred during 2006 or 2005. Changes in market pricing, interest rate and volatility assumptions were made during all periods. The outstanding mark- to-market value is sensitive to changes in prices, price volatilities and interest rates. The Companies estimate that a movement in prices of $1 and a change in interest and volatilities of 1% would result in a change in the mark-to-market value of less than $1 million. All contracts outstanding at June 30, 2006, have a maturity of less than one year and are valued using prices actively quoted for proposed or executed transactions or quoted by brokers. The Companies maintain policies intended to minimize credit risk and revalue credit exposures daily to monitor compliance with those policies. As of June 30, 2006, 100% of the trading and risk management commitments were with counterparties rated BBB-/Baa3 equivalent or better. Item 4. Controls and Procedures The Companies 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. The Companies 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. The Companies are not accelerated filers under the Sarbanes-Oxley Act of 2002 and associated rules (the "Act") and consequently anticipate issuing Management's Report on Internal Control over Financial Reporting pursuant to Section 404 of the Act in their first periodic report covering the fiscal year ended December 31, 2007 as permitted by SEC rulemaking. In preparation for required reporting under Section 404 of the Act, 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 control over financial reporting. There has been no change in the Companies' internal control over financial reporting that occurred during the fiscal quarter ended June 30, 2006, that has materially affected, or is reasonably likely to materially affect, the Companies' internal control over financial reporting. Part II. Other Information Item 1. Legal Proceedings. For a description of the significant legal proceedings involving the Companies, reference is made to the information under the following items and captions of the Companies' respective combined Annual Report on Form 10- K for the year ended December 31, 2005: 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 in Notes 3 and 10. Reference is also made to the matters described in Notes 2 and 6 of Part 1, Item 1 of the Companies' Quarterly Report on Form 10-Q for the three months ended March 31, 2006, and Notes 2 and 6 of the Notes to Financial Statements in Part I, Item 1 of this 10-Q. Except as described herein, to date, the proceedings reported in the Companies' respective combined Annual Report on Form 10-K have not changed materially. Other In the normal course of business, other lawsuits, claims, environmental actions, and other governmental proceedings arise against the Companies. To the extent that damages are assessed in any of these lawsuits, the Companies believe that their insurance coverage is adequate. Management, after consultation with legal counsel, does not anticipate that liabilities arising out of other currently pending or threatened lawsuits and claims will have a material adverse effect on LG&E's or KU's financial position or results of operations, respectively. Item 1A. Risk Factors. LG&E and KU currently anticipate withdrawal from the MISO effective September 1, 2006. The resulting changes to transmission and wholesale power market structures and prices are not completely estimable and may result in unforeseen effects on costs or revenues. As required by the FERC, in connection with their exit, the Companies have engaged two independent third parties to perform certain oversight and functional control activities relating to transmission and related activities. The Companies will save certain MISO membership costs and charges, but will incur an exit fee and fees related to the new transmission service vendors. The Companies believe that, over time, the benefits and savings from an exit of the MISO will outweigh the costs and expenses. However, until post-MISO market conditions and operations have matured, the effects on financial condition, liquidity or results of operations will remain difficult to fully predict. See Note 2 of LG&E's and KU's Notes to Financial Statements in Part I, Item 1 of this 10-Q. Item 5. Other Information. None. Item 6. Exhibits. Applicable to Form 10-Q of Exhibit No. LG&E KU Description 4.1 X Loan Agreement dated June 23, 2006 between Kentucky Utilities Company and Fidelia Corporation. [Filed as Exhibit 4.1 to KU's Current Report on Form 8-K dated June 23, 2006 and incorporated by reference herein.] 4.2 X Copy of Promissory Note from KU to Fidelia Corporation, dated as of June 23, 2006. [Filed as Exhibit 4.2 to KU's Current Report on Form 8-K dated June 23, 2006 and incorporated by reference herein.] 31.1 X Certification of Chairman of the Board, President and Chief Executive Officer, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.2 X Certification of Chief Financial Officer, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.3 X Certification of Chairman of the Board, President and Chief Executive Officer, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.4 X Certification of Chief Financial Officer, 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 or KU have not been filed with the SEC but will be furnished to the SEC upon request. 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: August 14, 2006 /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: August 14, 2006 /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 q10q0606ex31.txt EXHIBIT 31 Exhibit 31.1 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 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 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 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: August 14, 2006 /s/ Victor A. Staffieri Victor A. Staffieri Chairman of the Board, President and Chief Executive Officer Exhibit 31.2 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 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 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 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: August 14, 2006 /s/ S. Bradford Rives S. Bradford Rives Chief Financial Officer Exhibit 31.3 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 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 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 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: August 14, 2006 /s/ Victor A. Staffieri Victor A. Staffieri Chairman of the Board, President and Chief Executive Officer Exhibit 31.4 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 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 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 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: August 14, 2006 /s/ S. Bradford Rives S. Bradford Rives Chief Financial Officer EX-32 3 q10q0606ex32.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 June 30, 2006, as filed with the Securities and Exchange Commission on the date hereof (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 periods expressed in the Report. August 14, 2006 /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-----