10-Q 1 d69846_10q.txt QUARTERLY REPORT SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 -------------------------------------------------------------------------------- FORM 10-Q -------------------------------------------------------------------------------- [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXHANGE ACT OF 1934 For the quarterly period ended September 30, 2006 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 -------------------------------------------------------------------------------- Commission file number 33-42125 CHUGACH ELECTRIC ASSOCIATION, INC. Incorporated pursuant to the Laws of Alaska State -------------------------------------------------------------------------------- Internal Revenue Service - Employer Identification No. 92-0014224 5601 Electron Drive, Anchorage, AK 99518 (907) 563-7494 -------------------------------------------------------------------------------- Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark whether the registrant is an accelerated filer, (as defined in Rule 12b-2 of the Exchange Act). [ ] Yes [X] No Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer, (as defined in Rule 12b-2 of the Act). 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 Act. [ ] Yes [X] No Indicate the number of shares outstanding of each of the issuer's class of common stock, as of the latest practicable date. CLASS OUTSTANDING AT NOVEMBER 1, 2006 NONE NONE
Page Number ----------- CAUTION REGARDING FORWARD-LOOKING STATEMENTS PART I FINANCIAL INFORMATION Item 1. Financial Statements (Unaudited) 2 Balance Sheets, September 30, 2006 and December 31, 2005 3 Statements of Revenues, Expenses and Patronage Capital, Three and Nine Months Ended September 30, 2006 and 2005 5 Statements of Cash Flows, Nine Months Ended September 30, 2006 and 2005 6 Notes to Financial Statements 7 Item 2. Management's Discussion and Analysis of Results of Operations and Financial Condition 16 Item 3. Quantitative and Qualitative Disclosures About Market Risk 25 Item 4. Controls and Procedures 27 PART II OTHER INFORMATION Item 1. Legal Proceedings 27 Item 1A. Risk Factors 31 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 32 Item 3. Defaults Upon Senior Securities 32 Item 4. Submission of Matters to a Vote of Security Holders 32 Item 5. Other Information 32 Item 6. Exhibits 32 Signatures 33 Exhibits 34
CAUTION REGARDING FORWARD-LOOKING STATEMENTS Statements in this report that do not relate to historical facts, including statements relating to future plans, events or performance, are forward-looking statements that involve risks and uncertainties. Actual results, events or performance may differ materially. Readers are cautioned not to place undue reliance on these forward-looking statements, that speak only as of the date of this report and the accuracy of which is subject to inherent uncertainty. Chugach Electric Association, Inc. (Chugach) undertakes no obligation to publicly release any revisions to these forward-looking statements to reflect events or circumstances that may occur after the date of this report or the effect of those events or circumstances on any of the forward-looking statements contained in this report, except as required by law. PART I FINANCIAL INFORMATION Item 1. Financial Statements The unaudited financial statements and notes to the financial statements of Chugach as of and for the three and nine months ended September 30, 2006, follow: 2 CHUGACH ELECTRIC ASSOCIATION, INC. Balance Sheets (Unaudited)
Assets September 30, 2006 December 31, 2005 ------ ------------------ ----------------- Utility Plant: Electric plant in service $ 788,485,820 $ 762,859,198 Construction work in progress 15,163,275 32,505,401 ------------------ ----------------- Total utility plant 803,649,095 795,364,599 Less accumulated depreciation (343,184,338) (327,384,961) ------------------ ----------------- Net utility plant 460,464,757 467,979,638 Other property and investments, at cost: Non-utility property 24,461 24,461 Investments in associated organizations 11,880,310 11,883,053 ------------------ ----------------- Total other property and investments 11,904,771 11,907,514 Current assets: Cash and cash equivalents 5,201,173 10,650,594 Special deposits 206,191 216,191 Fuel cost under-recovery 1,867,108 1,781,833 Accounts receivable, net 27,756,437 27,436,278 Materials and supplies 27,019,195 23,809,691 Prepayments 1,810,447 1,801,104 Other current assets 316,356 282,939 ------------------ ----------------- Total current assets 64,176,907 65,978,630 Deferred charges, net 21,144,267 19,269,718 ------------------ ----------------- Total assets $ 557,690,702 $ 565,135,500 ================== =================
See accompanying notes to financial statements. 3 CHUGACH ELECTRIC ASSOCIATION, INC. Balance Sheets (Continued) (Unaudited)
Liabilities and Equities September 30, 2006 December 31, 2005 ------------------------ ------------------ ----------------- Equities and margins: Memberships $ 1,286,758 $ 1,250,398 Patronage capital 141,440,991 136,185,378 Other 7,457,629 7,603,376 ------------------ ----------------- Total equities and margins 150,185,378 145,039,152 Long-term obligations, excluding current installments: 2001 Series A Bond payable 150,000,000 150,000,000 2002 Series A Bond payable 120,000,000 120,000,000 2002 Series B Bond payable 35,500,000 41,000,000 National Bank for Cooperatives promissory notes payable 45,803,530 53,532,099 ------------------ ----------------- Total long-term obligations 351,303,530 364,532,099 Current liabilities: Current installments of long-term obligations 13,728,569 8,325,687 Accounts payable 7,207,452 9,598,958 Consumer deposits 2,083,073 1,980,285 Accrued interest 2,216,886 6,360,652 Salaries, wages and benefits 5,124,316 5,373,496 Fuel 19,117,537 18,123,139 Other current liabilities 4,010,207 3,035,915 ------------------ ----------------- Total current liabilities 53,488,040 52,798,132 Deferred credits 2,713,754 2,766,117 ------------------ ----------------- Total liabilities and equities $ 557,690,702 $ 565,135,500 ================== =================
See accompanying notes to financial statements. 4 CHUGACH ELECTRIC ASSOCIATION, INC. Statement of Revenues, Expenses and Patronage Capitals (Unaudited)
Three months ended September 30 Nine months ended September 30 2006 2005 2006 2005 -------------- -------------- ------------- -------------- Operating revenues $ 63,243,634 $ 54,323,791 $ 190,377,774 $ 161,850,226 Operating expenses: Fuel 27,721,572 20,877,682 82,870,065 59,043,658 Power production 4,331,051 3,799,930 11,002,135 10,213,754 Purchased power 8,164,009 6,279,848 21,620,093 17,778,235 Transmission 2,019,552 1,433,318 4,553,234 4,362,254 Distribution 2,372,131 3,014,476 8,096,796 8,830,785 Consumer accounts 1,187,437 1,487,133 3,722,437 4,034,971 Administrative, general and other 4,498,643 5,249,736 13,993,330 14,879,950 Depreciation 7,070,812 7,624,509 21,280,580 21,907,024 -------------- -------------- ------------- -------------- Total operating expenses 57,365,207 49,766,632 167,138,670 141,050,631 Interest expense: On long-term obligations 6,218,457 5,903,604 18,348,879 17,391,282 On short-term obligations 0 44,412 0 46,649 Charged to construction-credit (145,112) (199,534) (344,096) (605,708) -------------- -------------- ------------- -------------- Net interest expense 6,073,345 5,748,482 18,004,783 16,832,223 -------------- -------------- ------------- -------------- Net operating margins (194,918) (1,191,323) 5,234,321 3,967,372 Nonoperating margins: Interest income 261,131 155,968 673,365 411,946 Capital credits, patronage dividends and other 51,844 40,395 113,471 108,494 -------------- -------------- ------------- -------------- Total nonoperating margins 312,975 196,363 786,836 520,440 -------------- -------------- ------------- -------------- Assignable margins $ 118,057 $ (994,960) $ 6,021,157 $ 4,487,812 ============== ============== ============= ============== Patronage capital at beginning of period 141,584,126 136,091,073 136,185,378 130,750,269 Retirement of capital credits and estate payments (261,192) (353,912) (765,544) (495,880) -------------- -------------- ------------- -------------- Patronage capital at end of period $ 141,440,991 $ 134,742,201 $ 141,440,991 $ 134,742,201 ============== ============== ============= ==============
See accompanying notes to financial statements. 5 CHUGACH ELECTRIC ASSOCIATION, INC. Statements of Cash Flows (Unaudited)
Nine months ended September 30 2006 2005 ------------- -------------- Cash flows from operating activities: Assignable margins $ 6,021,157 $ 4,487,812 ------------- -------------- Adjustments to reconcile assignable margins to net cash provided by operating activities: Depreciation and amortization 23,503,261 24,083,566 Capitalized interest (470,081) (713,201) Write off of deferred charges 345,899 0 Other (10,013) 404 Changes in assets and liabilities: (Increase) decrease in assets: Accounts receivable (320,159) 3,499,535 Fuel cost under-recovery (85,275) (571,701) Materials and supplies (3,209,504) (352,689) Prepayments (9,343) (783,718) Other assets (23,417) (26,730) Deferred charges (4,549,202) (1,913,573) Increase (decrease) in liabilities: Accounts payable (2,391,506) (2,848,218) Consumer deposits 102,788 41,887 Fuel cost over-recovery 0 (2,714,345) Accrued interest (4,143,766) (4,187,608) Salaries, wages and benefits (249,180) 740,987 Fuel 994,398 1,008,375 Other liabilities 974,292 951,167 Deferred credits 148,920 (52,866) ------------- -------------- Net cash provided by operating activities 16,629,269 20,649,084 ------------- -------------- Investing activities: Extension and replacement of plant (13,176,789) (19,005,361) ------------- -------------- Net cash used for investing activities (13,176,789) (19,005,361) ------------- -------------- Cash flows from financing activities: Repayments of long-term obligations (7,825,687) (5,931,393) Memberships and donations received (109,387) 58,505 Retirement of patronage capital and estate payments, including discounted capital credits transferred to other equities and margins (765,544) (495,880) Net refunds of consumer advances for constructions (201,283) 227,299 ------------- -------------- Net cash used for financing activities (8,901,901) (6,141,469) ------------- -------------- Net decrease in cash and cash equivalents (5,449,421) (4,497,746) Cash and cash equivalents at beginning of period $ 10,650,594 $ 10,465,004 ------------- -------------- Cash and cash equivalents at end of period $ 5,201,173 $ 5,967,258 ============= ============== Supplemental disclosure of non cash investing activities - retirement of plant $ 5,566,466 $ 2,136,775 ------------- -------------- Supplemental disclosure of cash flow information - interest expense paid, excluding amounts capitalized $ 22,148,549 $ 21,019,831 ============= ==============
See accompanying notes to financial statements. 6 CHUGACH ELECTRIC ASSOCIATION, INC. Notes to Financial Statements (Unaudited) 1. Presentation of Financial Information The accompanying unaudited interim financial statements include the accounts of Chugach Electric Association, Inc. (Chugach) and have been prepared in accordance with generally accepted accounting principles for interim financial information. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. They should be read in conjunction with our audited financial statements for the year ended December 31, 2005, filed as part of our annual report on Form 10-K. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. The results of operations for interim periods are not necessarily indicative of the results that may be expected for an entire year or any other period. 2. Description of Business and Significant Accounting Policies a. Description of Business Chugach Electric Association, Inc., (Chugach) is the largest electric utility in Alaska. Chugach is engaged in the generation, transmission and distribution of electricity to directly serve retail customers in the Anchorage and upper Kenai Peninsula areas. Through an interconnected regional electrical system, Chugach's power flows throughout Alaska's Railbelt, a 400-mile-long area stretching from the coastline of the southern Kenai Peninsula to the interior of the state, including Alaska's largest cities, Anchorage and Fairbanks. Chugach also supplies much of the power requirements of three wholesale customers, Matanuska Electric Association, Inc. (MEA), Homer Electric Association, Inc. (HEA) and the City of Seward (Seward). Chugach's members are the consumers of the electricity sold. Chugach operates on a not-for-profit basis and, accordingly, seeks only to generate revenues sufficient to pay operating and maintenance costs, the cost of purchased power, capital expenditures, depreciation, and principal and interest on all indebtedness and to provide for reasonable margins and reserves. Chugach is subject to the regulatory authority of the Regulatory Commission of Alaska (RCA). b. Management Estimates In preparing the financial statements, management of Chugach is required to make estimates and assumptions relating to the reporting of assets and liabilities and the disclosure of contingent assets and liabilities as of the date of the balance sheet and revenues and expenses for the reporting period. Critical estimates include the provision for rate refund and allowance for doubtful accounts. Actual results could differ from those estimates. 7 CHUGACH ELECTRIC ASSOCIATION, INC. Notes to Financial Statements (Unaudited) c. Regulation The accounting records of Chugach conform to the Uniform System of Accounts as prescribed by the Federal Energy Regulatory Commission (FERC). Chugach meets the criteria, and accordingly, follows the accounting and reporting requirements of Statement of Financial Accounting Standards (SFAS) No. 71, Accounting for the Effects of Certain Types of Regulation (SFAS 71). d. Income Taxes Chugach is exempt from federal income taxes under the provisions of Section 501(c)(12) of the Internal Revenue Code, except for unrelated business income. For the three and nine months ended September 30, 2006 and 2005, Chugach received no unrelated business income. 3. Lines of credit Chugach maintains a $7.5 million line of credit with CoBank, ACB (CoBank). On October 18, 2006, the Board of Directors approved a resolution to renew this line of credit. The CoBank line of credit expires October 31, 2007, subject to annual renewal at the discretion of the parties. At September 30, 2006, there was no outstanding balance on this line of credit and it was not utilized during the third quarter of 2006. At September 30, 2006, the borrowing rate would have been 6.68% and at December 31, 2005, the borrowing rate would have been 5.95%. In addition, Chugach has an annual line of credit of $50 million available at the National Rural Utilities Cooperative Finance Corporation (NRUCFC). At September 30, 2006, there was no outstanding balance on this line of credit and it was not utilized during the third quarter of 2006. At September 30, 2006, the borrowing rate would have been 7.15% and at December 31, 2005, the borrowing rate would have been 6.10%. The NRUCFC line of credit expires October 15, 2007. 4. Legal Proceedings Matanuska Electric Association, Inc., v. Chugach Electric Association, Inc., Superior Court Case No. 3AN-99-8152 Civil In this action filed in 1999, MEA alleged that Chugach breached the Power Sales Agreement under which Chugach is obligated to sell MEA power for 25 years, from 1989 through 2014. MEA asserted that Chugach failed to provide it certain information, failed to properly manage Chugach's long-term debt, and failed to bring Chugach's base rate action to a Joint Committee before presenting it to the RCA. All of MEA's claims were dismissed by the Superior Court. On April 29, 2002, MEA appealed to the Alaska Supreme Court the Superior Court's dismissal of its claims related to Chugach's financial management and Chugach's decision not to bring its base rate action to the Joint Committee before filing with the RCA. Chugach 8 CHUGACH ELECTRIC ASSOCIATION, INC. Notes to Financial Statements (Unaudited) cross-appealed the Superior Court's decision not to also dismiss the financial management claim on jurisprudential and res judicata grounds. The Alaska Supreme Court, on October 8, 2004, issued an order upholding Chugach's right to not bring its base rate action to the Joint Committee before filing with the RCA. But the Court rejected Chugach's cross-appeal and reversed the Superior Court's decision dismissing MEA's financial management claim. The Supreme Court remanded that claim to the Superior Court for further proceedings. On January 24, 2005, Chugach filed for summary judgment on that claim asserting that in the 2000 Test Year rate case the RCA had fully reviewed and decided the prudency of Chugach's financial management. In a decision dated August 22, 2005, the Superior Court granted Chugach's summary judgment motion, finding that the RCA had adjudicated the question of Chugach's financial management and that its decision should be given res judicata effect. The Superior Court also found that the RCA had exercised its primary jurisdiction in reviewing Chugach's financial management, and that its decision should be given deference. The Superior Court entered final judgment on November 10, 2005, after which Chugach sought its costs and fees. On December 14, 2005, the Superior Court entered judgment awarding Chugach fees and costs from MEA in the amount of $104,732, which has not, as yet, been recorded in the financial statements. On December 9, 2005, MEA appealed to the Alaska Supreme Court the Superior Court's grant of summary judgment. On December 23, 2005, Chugach cross-appealed the Superior Court's failure to also grant summary judgment based on the doctrine of collateral estoppel. This appeal is pending. The ultimate resolution of this matter is not currently determinable. In the opinion of management, an adverse outcome is not likely to have a material adverse effect on Chugach's results of operations, financial condition or liquidity. No reserves have been established for this matter. Matanuska Electric Association, Inc. v. Chugach Electric Association, Inc., Superior Court Case No. 3AN-04-11776 Civil On October 12, 2004, MEA filed suit in Superior Court alleging that Chugach had violated its bylaws in allocating margins (capital credits) during the years 1998 through 2003. The margins Chugach earns each year are allocated to the customers who contributed them and are booked as capital credits to those customers' accounts. Capital credits are eventually repatriated to customers at the discretion of the board of directors, typically many years after the margins are earned. On February 17, 2006, MEA filed a Motion to File an Amended Complaint and an Amended Complaint in this case. The Amended Complaint is identical to MEA's initial Complaint except for changes made to accommodate one new claim. The new claim challenges Chugach's failure to provide MEA with a capital credit allocation for 2004. We expect the Court will allow MEA's proposed amendment. 9 CHUGACH ELECTRIC ASSOCIATION, INC. Notes to Financial Statements (Unaudited) In this suit, MEA asks the Court to hold that Chugach breached its bylaws in the manner in which it allocated capital credits in 1998 through 2003 and if the Amended Complaint is allowed by the Court, through 2004. MEA also asks the court to enjoin Chugach to re-calculate MEA's capital credits applying MEA's interpretation of Chugach's bylaws and in accordance with what MEA refers to as "generally accepted accounting practices for nonprofit cooperatives and cooperative principles". The suit also seeks damages in an unspecified amount to compensate MEA for the alleged breach of contract. The trial date has been rescheduled for January 16, 2007. Management is vigorously defending against the claim. The ultimate resolution of this matter is not currently determinable. In the opinion of management, an adverse outcome is not likely to have a material adverse effect on Chugach's results of operations, financial condition or liquidity because the matter relates primarily to issues of margin allocation among customers. No reserves have been established for this matter. Matanuska Electric Association, Inc. v. State of Alaska, Regulatory Commission of Alaska, Superior Court Case No. 3AN-06-8243 Civil On May 17, 2006, MEA appealed and on May 30, 2006, Homer Electric Association, Inc., (HEA) cross appealed the RCA's decision in Commission Docket No. U-04-102, see "Item 4 - Regulatory Matters - Docket No. U-04-102 (Revision to Current Depreciation Rates)." On appeal, MEA claims the Commission's decision dated January 10, 2006, to authorize Chugach to implement new depreciation rates as of January 1, 2005 constituted illegal retroactive ratemaking. MEA also contends that the Commission's reliance on avoidance of regulatory lag as a basis for its decision was improper. HEA's points on appeal challenge several decisions by the Commission on estimated lives of General Plant on the ground that there is not substantial evidence in the record to support such a decision. HEA and MEA both challenge the discovery rulings of the Commission. Chugach will join the State of Alaska in defending the Commission's rulings. No briefing schedule has been set. The ultimate resolution of this matter is not currently determinable. In the opinion of management, an adverse outcome is not likely to have a material adverse effect on Chugach's results of operations, financial condition or liquidity. No reserves have been established for this matter. Matanuska Electric Association, Inc. v. Chugach Electric Association, Inc., Superior Court Case No. 3PA-06-1295 Civil On May 17, 2006, MEA filed suit against Chugach in Superior Court asserting three claims. In this action, MEA contends that by publishing unbundled financial statements Chugach has in effect stated that MEA owes Chugach a debt. Chugach denies having made statements to this effect. Unbundled financial statements are an analytic tool developed by Chugach that separate the financial statements into two business units consisting of the Generation and Transmission (G&T) and the Distribution functions of the company. The unbundled financial statements 10 CHUGACH ELECTRIC ASSOCIATION, INC. Notes to Financial Statements (Unaudited) reflect the operating results of each separate entity. Statements of Revenues, Expenses and Patronage Capital, Balance Sheets and Statements of Cash Flows are prepared monthly for each business unit. MEA's action is based on the result of Chugach's financial analysis showing intercompany receivable/payable entries on the unbundled balance sheets. The first of MEA's claims is that it is entitled to declaratory judgment to the effect that MEA does not owe a debt to Chugach or to Chugach's Distribution function. Second, MEA claims that Chugach has breached its Bylaws and the Power Sales Agreement under which Chugach is obligated to sell MEA power and by publishing its unbundled financial analysis and seeks a declaration that Chugach's actions violate the Bylaws and the Power Sales Agreement. MEA also asks for an injunction against further assertions, which Chugach denies having made, that MEA owes Chugach or Chugach's Distribution function a debt. Finally, MEA seeks damages, including punitive damages, to punish Chugach and deter it from continuing to publish the analysis. Chugach has moved to dismiss the first (declaratory judgment) and third (defamation) counts of the complaint. Oral argument on this motion occurred on October 13, 2006 and a decision on Chugach's motion to dismiss counts one and three of the complaint is expected soon. Trial is currently scheduled for June 2007. Chugach believes the claims are without merit and will vigorously defend against them. Management is uncertain of the outcome of the proceeding before the Superior Court. The ultimate resolution of this matter is not currently determinable. In the opinion of management, an adverse outcome is not likely to have a material adverse effect on Chugach's results of operations, financial condition or liquidity. Matanuska Electric Association, Inc. v. Chugach Electric Association, Inc., Superior Court Case No. 3PA-06-1591 Civil On August 7, 2006, MEA served Chugach with a Summons and Complaint requesting the Court grant MEA declaratory judgment, breach of contract and costs and attorney fees. MEA seeks a declaratory judgment that Chugach has wrongfully refused to grant MEA access to the books and records of the cooperative in violation of state statute, common law and Chugach bylaws. MEA also alleges that by refusing to grant access to these records, Chugach has breached its bylaws on which MEA bases a breach of contract claim against Chugach. MEA asks the Court to grant it access to, and the right to inspect and copy, unspecified Chugach's records and order Chugach to cooperate in facilitating MEA's inspection and copying of the same. Chugach has answered MEA's Complaint and believes the claims are without merit and will vigorously defend against them. Management is uncertain of the outcome of the proceeding before the Superior Court. The ultimate resolution of this matter is not currently determinable. In the opinion of management, an adverse outcome is not likely to have a material adverse effect on Chugach's results of operations, financial condition or liquidity. 11 CHUGACH ELECTRIC ASSOCIATION, INC. Notes to Financial Statements (Unaudited) Chugach has certain additional litigation matters and pending claims that arise in the ordinary course of Chugach's business. In the opinion of management, no individual matter or the matters in the aggregate is likely to have a material adverse effect on Chugach's results of operations, financial condition or liquidity. 5. Regulatory Matters Docket No. U-04-102 (Revision to Current Depreciation Rates) In 2004, Chugach implemented new depreciation rates based on an update of the 1999 Depreciation Study utilizing Electric Plant in Service balances as of December 31, 2002. The 2002 Depreciation Study resulted in an increase to 2004 depreciation expense of approximately $259 thousand, which, in aggregate, was not material to the financial statements. The 2002 Depreciation Study was submitted to the RCA for approval on November 19, 2004, resulting in the RCA opening a docket to review the proposed new rates. Chugach, however, implemented the new rates effective January 1, 2004. Chugach did not request a change in electric rates charged to customers based on the proposed revisions to depreciation rates. Order No. 2 On March 9, 2005, the RCA ruled in Order No. 2 that depreciation rates may not be implemented without prior approval of the RCA. On August 8, 2005, Chugach filed a motion proposing an implementation plan. Order No. 8 On September 21, 2005, the RCA issued Order No. 8 denying our motion and granting a motion filed by a wholesale customer of Chugach to enforce Order No. 2. Order No. 8 required that Chugach adjust its underlying 2004 financial records to reflect the results as if Chugach had not implemented unapproved rates. In November of 2005, Chugach reversed the 2004 depreciation expense and depreciation reserves that were previously recorded using the 2002 Depreciation Study rates and calculated 2004 depreciation expense for all categories of plant using the 1999 Depreciation Study rates as approved by the RCA in Docket U-01-108. The adjustment was not material to Chugach's financial statements. Order No. 9 In Order No. 9 dated January 10, 2006, the RCA ruled substantially in Chugach's favor approving the 2002 Depreciation Study with certain changes to the proposed depreciation rates. The main effect of this decision is to allow Chugach to revise its depreciation rates effective as of January 1, 2005. The overall impact to Chugach is an estimated decrease in annual depreciation expense of $1.0 million. Because Chugach did not request changes to the electric rates charged to our customers based on the proposed new depreciation rates, there was no immediate electric rate impact. Wholesale customers MEA and HEA were active in the proceeding. MEA filed a motion for reconsideration of the effective date of 12 CHUGACH ELECTRIC ASSOCIATION, INC. Notes to Financial Statements (Unaudited) January 1, 2005, for the changes to depreciation rates based on the RCA's ruling. The Commission did not rule on MEA's motion for reconsideration resulting in its automatic denial. Subsequently, MEA filed an appeal of the RCA's decision in Superior Court, see "Part II Other Information - Item 1 - Legal Proceedings - Mantanuska Electric Association, Inc. v. State of Alaska, Regulatory Commission of Alaska, Superior Court Case No. 3AN-06-8243 Civil." Seward Contract request for review and approval We currently provide nearly all the power needs of the City of Seward. Sales to Seward represent approximately 2.5% of Chugach's total sales of energy (including both retail and wholesale). In February 1998, we entered into a power sales agreement (Old Contract) with Seward that allowed us to interrupt service to Seward up to 12 times per year, not to exceed seventy-two cumulative hours annually and also reduce the demand charge by 1/3 (approximately $350,000 annually). This agreement was scheduled to expire January 31, 2006, however, Seward and Chugach jointly requested, and the RCA granted a four-month extension to May 31, 2006, of the old contract to allow the parties to complete negotiations on a new contract. Negotiations with Seward were successful and on April 14, 2006, Chugach filed a request for approval by the RCA of a proposed new power sales agreement with the City of Seward (2006 Agreement) with a nominal effective date of June 1, 2006. The contract is for five years with two automatic five-year extensions unless notice of termination is given by either party. If approved, the 2006 Agreement results in a 5 percent increase in revenues in relation to the Old Contract. The 2006 Agreement is an interruptible, all-requirements/no reserves contract. It has many of the attributes of firm service, especially in the requirement that so long as Chugach has sufficient power available, it must meet Seward's needs for power. However, service is interruptible because Chugach is under no obligation to supply or plan for generation capacity reserves to supply Seward and there is no limit on the number of times or hours per year that the supply can be interrupted. Counterbalancing this is the requirement that Chugach must provide power to Seward if Chugach has the power available after first meeting its obligations to its other customers for whom Chugach has an obligation to provide reserves (MEA, HEA and Chugach retail customers). The price under the 2006 Agreement reflects the reduced level of service because no costs of generation in excess of that needed to meet the system peak will be assigned to Seward. In Order No. 1 the RCA opened the docket and suspended the filing. However, the RCA has allowed the parties to operate under the terms of the proposed new 2006 Contract pending review. Approval is being contested by Chugach's wholesale customer, MEA and a hearing is set to begin November 30, 2006. Chugach expects that a contract in some form allowing continued service to Seward will be approved. 13 CHUGACH ELECTRIC ASSOCIATION, INC. Notes to Financial Statements (Unaudited) 2005 Test Year General Rate Case On September 27, 2006, the Chugach Board of Directors authorized and instructed management to file a general rate case with the RCA. On September 29, 2006, Chugach filed a general rate case based on a 2005 test year and requesting a revenue increase of $10.6 million for the Generation and Transmission (G&T) function and a revenue decrease of $7.8 million for the Distribution function. Overall revenues are proposed to increase $2.8 million. 6. New Accounting Standards SFAS 155 "Accounting for Certain Hybrid Instruments" In February 2006, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Standard "(SFAS") No. 155, "Accounting for Certain Hybrid Instruments", which is an amendment of SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities", and SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities -- a replacement of FASB Statement No. 125." SFAS No. 155 allows financial instruments that have embedded derivatives to be accounted for as a whole (eliminating the need to bifurcate the derivative from its host) if the holder elects to account for the whole instrument on a fair value basis. The Statement also establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation and clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives. SFAS No. 155 is effective for all financial instruments acquired or issued after January 1, 2007. We are currently evaluating the impact this Statement may have on our results of operations or financial condition. SFAS 156 "Accounting for Servicing of Financial Assets" In March 2006, the FASB issued SFAS No. 156, "Accounting for Servicing of Financial Assets -- an amendment of FASB Statement No. 140." SFAS No. 156 requires an entity to recognize a servicing asset or servicing liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract in specific situations. Additionally, the servicing asset or servicing liability is initially measured at fair value; however, an entity may elect the "amortization method" or "fair value method" for subsequent balance sheet reporting periods. SFAS No. 156 is effective on January 1, 2007. Adoption of this statement is not expected to have a material effect on our results of operations or financial condition. SFAS 157 "Fair Value Measurements" In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements." SFAS No. 157 provides guidance for using fair value to measure assets and liabilities. In addition, this statement defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. This statement applies when other 14 CHUGACH ELECTRIC ASSOCIATION, INC. Notes to Financial Statements (Unaudited) accounting pronouncements require fair value measurement; it does not require new fair value measurements. This statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. We will begin application of SFAS No. 157 on January 1, 2008, and do not expect it to have a material affect on our results of operations, financial position, and cash flows. SFAS 158 "Employers' Accounting for Defined Pension and Other Postretirement Plans" In September 2006, the FASB issued SFAS No. 158, "Employers' Accounting for Defined Pension and Other Postretirement Plans." SFAS No. 158 requires an employer to recognize in its statement of financial position the overfunded or underfunded status of a defined benefit postretirement plan measured as the difference between the fair value of plan assets and the benefit obligation. Employers must also recognize as a component of other comprehensive income, net of tax, the actuarial gains and losses and the prior service costs and credits that arise during the period. The Statement is effective for public entities for fiscal years ending after December 15, 2006 (December 31, 2006 financial statements for public entities with a calendar year end), and for nonpublic entities for fiscal years ending after June 15, 2007. We have multi-employer plans and a defined contribution plan and adoption of this statement is not expected to have a material effect on our results of operations or financial condition. SAB 108 "The Effect of Prior-Years Errors on Current-Year Materiality Evaluations" In September 2006, the SEC issued Staff Accounting Bulletin ("SAB") No. 108, "The Effect of Prior-Years Errors on Current-Year Materiality Evaluations." SAB 108 provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. We will implement the guidance in the fourth quarter of 2006. We are evaluating the impact, if any, that SAB No. 108 will have on our financial statements. FSP AUG AIR-1 "Accounting for Planned Major Maintenance Activities" In September 2006, the FASB issued FASB Staff Position ("FSP") AUG AIR-1, "Accounting for Planned Major Maintenance Activities." FSP AUG AIR-1 prohibits the use of the accrue-in-advance method of accounting for planned major maintenance activities in annual and interim financial reporting periods. An entity shall apply the same method of accounting for planned major maintenance activities in annual and interim financial reporting periods. The guidance in this FSP is effective for the first fiscal year beginning after December 15, 2006. Adoption of this position is not expected to have a material effect on our results of operations or financial condition. 15 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Reference is made to the information contained under the caption "CAUTION REGARDING FORWARD-LOOKING STATEMENTS" at the beginning of this Report. Results Of Operations Current Year Quarter Versus Prior Year Quarter Operating revenues, which include sales of electric energy to retail, wholesale and economy energy customers and other miscellaneous revenues, increased by $8.9 million, or 16.4%, for the quarter ended September 30, 2006, over the same quarter in 2005. The increase in revenues was primarily due to an increase in revenue recovered through the fuel surcharge mechanism due to higher fuel prices. With regard to retail sales, the Municipality of Anchorage, our primary service area, experienced less economic growth in the third quarter of 2006, compared to the same period in 2005. With regard to wholesale sales, actual sales to one wholesale customer increased due to increased job growth and continued state and federal spending in their geographic area, which generated additional economic activity. However, this increase was offset by a decrease in sales to another wholesale customer due to lower activity in their industrial sector. Based on the results of fixed and variable cost recovery established in Chugach's last rate case, wholesale rates contributed approximately $5.8 million and $5.6 million to Chugach's fixed costs for the quarter ended September 30, 2006 and 2005, respectively. 16 The following table shows the base rate sales revenue and fuel and purchased power revenue by customer class that is included in revenue for the quarters ending September 30, 2006, and 2005.
(In millions) Fuel and Purchased Power Base Rate Sales Revenue Revenue Total Revenue -------------------------- -------------------------- -------------------------- % % % -------------------------- -------------------------- -------------------------- 2006 2005 Variance 2006 2005 Variance 2006 2005 Variance ------ ------ -------- ------ ------ -------- ------ ------ -------- Retail Residential $ 10.3 $ 10.3 0.0% $ 6.9 $ 5.0 38.0% $ 17.2 $ 15.3 12.4% Small Commercial $ 1.9 $ 1.9 0.0% $ 1.5 $ 1.0 50.0% $ 3.4 $ 2.9 17.2% Large Commercial $ 7.5 $ 7.5 0.0% $ 7.7 $ 5.7 35.1% $ 15.2 $ 13.2 15.2% Lighting $ 0.3 $ 0.3 0.0% $ 0.0 $ 0.0 0.0% $ 0.3 $ 0.3 0.0% Total Retail $ 20.0 $ 20.0 0.0% $ 16.1 $ 11.7 37.6% $ 36.1 $ 31.7 13.9% Wholesale HEA $ 2.6 $ 2.6 0.0% $ 6.7 $ 5.2 28.8% $ 9.3 $ 7.8 19.2% MEA $ 4.1 $ 3.9 5.1% $ 8.8 $ 6.0 46.7% $ 12.9 $ 9.9 30.3% SES $ 0.3 $ 0.3 0.0% $ 0.9 $ 0.7 28.6% $ 1.2 $ 1.0 20.0% Total Wholesale $ 7.0 $ 6.8 2.9% $ 16.4 $ 11.9 37.8% $ 23.4 $ 18.7 25.1% Economy Sales $ 0.7 $ 0.9 (22.2%) $ 2.2 $ 2.1 4.8% $ 2.9 $ 3.0 (3.3%) Miscellaneous $ 0.8 $ 0.9 (11.1%) $ 0.0 $ 0.0 0.0% $ 0.8 $ 0.9 (11.1%) Total Revenue $ 28.5 $ 28.6 (0.3%) $ 34.7 $ 25.7 35.0% $ 63.2 $ 54.3 16.4%
The following table summarizes kWh sales for the quarter ended September 30: 2006 2005 Customer kWh kWh ----------- ----------- Retail 279,445,748 281,179,408 Wholesale 295,729,561 297,906,849 Economy Energy 41,836,320 61,124,910 ----------- ----------- Total 617,011,629 640,211,167 =========== =========== Retail demand and energy rates and wholesale demand and energy rates charged to HEA, MEA, and Seward Electric System (SES) did not change in the third quarter of 2006 compared to the third quarter of 2005. Fuel expense increased by $6.8 million, or 32.8%, for the quarter ended September 30, 2006, compared to the same period in 2005 primarily due to higher fuel prices. For the quarter ended September 30, 2006, Chugach used 5,554,871 MCF of fuel at an average effective price of $4.99 per MCF, which does not include 499,980 MCF of fuel that is recorded in purchased power. For the same period in 2005, Chugach used 5,806,994 MCF of fuel at an average effective price of $3.60 per MCF, which does not include 633,413 MCF of fuel recorded in purchased power. Purchased power increased $1.9 million, or 30.0% compared to the same quarter in 2005 due primarily to higher fuel prices. In the third quarter of 2006, Chugach purchased 140,151 MWH of energy at an average effective price of 5.60 cents per 17 kWh. For the same period in 2005, Chugach purchased 157,289 MWH of energy at an average effective price of 3.81 cents per kWh. Fuel and purchased power is collected through the fuel surcharge mechanism. Production expense increased $531.1 thousand, or 14.0%, for the three-month period ended September 30, 2006, compared to the same period in 2005, primarily due to higher overall maintenance costs associated with Beluga and Bernice Lake power plants in the third quarter of 2006 compared to the same period in 2005. Transmission expense increased by $586.2 thousand, or 40.9% and distribution expense decreased $642.3, or 21.3% due primarily to unexpected costs for transmission tower repairs in the third quarter of 2006. Chugach has submitted a claim with the Federal Emergency Management Agency (FEMA) for approximately $398.0 thousand for the cost of repairs and is awaiting a determination for reimbursement of these costs. The majority of these costs have been expensed. We will recognize this claim when and if it is approved. During the third quarter of 2006 there was a higher concentration on transmission work compared to a higher concentration of distribution work in the same quarter of 2005. Consumer accounts decreased $299.7 thousand, or 20.2% primarily due to lower labor expense as a result of unfilled positions and decreased spending on professional services associated with television safety advertising in the third quarter of 2006 compared to the same quarter of 2005. Administrative, general and other expense decreased $751.1 thousand or 14.3% primarily due lower labor expense as a result of vacancies related to retirements and unfilled positions in the third quarter of 2006 compared to the same quarter of 2005. Depreciation expenses decreased $553.7 thousand, or 7.3% primarily due to retirements associated with the Beluga unit 6 "C" Inspection in the third quarter of 2006 compared to the same quarter of 2005. Interest on long-term debt increased by $314.9 thousand, or 5.3%, due to higher interest rates on the variable CoBank and 2002 Series B bonds. Interest charged to construction decreased by $54.4 thousand, or 27.3%, due to a lower average balance in construction work-in-progress in the third quarter of 2006 compared to 2005. Nonoperating margins increased $116.6 thousand, or 59.4%, for the three-month period ended September 30, 2006, compared to the same period in 2005 primarily due to an increase in interest income associated with higher interest rates on our investment account as well as a higher average cash balance in the third quarter of 2006 compared to the same quarter in 2005. Current Year to Date Versus Prior Year to Date Operating revenues increased $28.5 million, or 17.6%, due to an increase in revenue recovered through the fuel surcharge mechanism due to higher fuel prices, as well as increased retail and wholesale kWh sales, which was offset by a decrease in economy energy sales. With regard to retail sales, the Municipality of Anchorage, our primary service area, experienced average economic activity in the first nine months of 2006, compared to the 18 same period in 2005. With regard to wholesale revenue, actual sales increased due to increased job growth and continued state and federal spending, which generated additional economic activity. Based on the results of fixed and variable cost recovery established in Chugach's last rate case, wholesale rates contributed approximately $18.5 million and $17.8 million to Chugach's fixed costs for the year ended September 30, 2006 and 2005, respectively. The following table shows the base rate sales revenue and fuel and purchased power revenue by customer class that is included in revenue at September 30, 2006, and 2005.
(In millions) Fuel and Purchased Power Base Rate Sales Revenue Revenue Total Revenue -------------------------- -------------------------- -------------------------- % % % -------------------------- -------------------------- -------------------------- 2006 2005 Variance 2006 2005 Variance 2006 2005 Variance ------ ------ -------- ------ ------ -------- ------ ------ -------- Retail Residential $ 34.2 $ 34.0 0.6% $ 21.1 $ 15.0 40.7% $ 55.3 $ 49.0 12.9% Small Commercial $ 6.1 $ 6.0 1.7% $ 4.4 $ 3.1 41.9% $ 10.5 $ 9.1 15.4% Large Commercial $ 21.7 $ 21.5 0.9% $ 20.9 $ 14.8 41.2% $ 42.6 $ 36.3 17.4% Lighting $ 1.0 $ 1.0 0.0% $ 0.1 $ 0.1 0.0% $ 1.1 $ 1.1 0.0% Total Retail $ 63.0 $ 62.5 0.8% $ 46.5 $ 33.0 40.9% $109.5 $ 95.5 14.7% Wholesale HEA $ 7.6 $ 7.8 -2.6% $ 17.9 $ 13.4 33.6% $ 25.5 $ 21.2 20.3% MEA $ 13.6 $ 12.9 5.4% $ 25.6 $ 17.2 48.8% $ 39.2 $ 30.1 30.2% SES $ 0.8 $ 0.8 0.0% $ 2.1 $ 1.7 23.5% $ 2.9 $ 2.5 16.0% Total Wholesale $ 22.0 $ 21.5 2.3% $ 45.6 $ 32.3 41.2% $ 67.6 $ 53.8 25.7% Economy Sales $ 2.9 $ 3.3 -12.1% $ 8.2 $ 7.1 15.5% $ 11.1 $ 10.4 6.7% Miscellaneous $ 2.2 $ 2.2 0.0% $ 0.0 $ 0.0 0.0% $ 2.2 $ 2.2 0.0% Total Revenue $ 90.1 $ 89.5 0.7% $100.3 $ 72.4 38.5% $190.4 $161.9 17.6%
The following table summarizes kWh sales for the nine months ended September 30: 2006 2005 Customer kWh kWh ------------- ------------- Retail 888,399,387 882,411,034 Wholesale 914,797,999 909,893,201 Economy Energy 187,746,390 226,125,700 ------------- ------------- Total 1,990,943,776 2,018,429,935 ============= ============= Fuel expense increased by $23.8 million, or 40.4%, for the first nine months of 2006, compared to the same period in 2005 due primarily to higher fuel prices and an increase in quantity used. In the first nine months of 2006, Chugach used 18,037,375 MCF of fuel at an average effective price of $4.59 per MCF, which does not include 1,329,142 MCF of fuel that is recorded in purchased power. For the same period in 2005, Chugach used 17,569,823 MCF of fuel at an average effective price of $3.36 per MCF, which does not include 1,898,585 MCF of fuel recorded in purchased power. Purchased power expense increased by $3.8 million, or 21.6%, primarily due to higher fuel prices. In the first nine months of 2006, 19 Chugach purchased 374,906 MWH of energy at an average effective price of 5.52 cents per kWh. For the same period in 2005, Chugach purchased 434,533 MWH of energy at an average effective price of 3.90 cents per kWh. Fuel expense is collected through the fuel surcharge mechanism. Power production expense increased $788.4 thousand, or 7.7% due to higher maintenance costs for Beluga and Bernice Lake power plants for the nine-month period ended September 30, 2006, compared to the same period in 2005. Transmission expense increased $191.0 thousand, or 4.4% due primarily to the aforementioned unexpected costs for transmission tower repairs at Dynamite Slough in the third quarter of 2006. The increase, however was offset by the timing of transmission line clearing during the first nine months of 2006 compared to the first nine months of 2005. Distribution expense decreased $734.0 thousand, or 8.3% due to lower maintenance costs in the first nine months of 2006 compared to 2005. In the first nine months of 2005, distribution expense was high due to increased labor and professional services related to outages caused by windstorms. Consumer accounts expense decreased $312.5 thousand, or 7.7% in the nine-month period ended September 30, 2006 compared to the same period in 2005 due to decreased spending on professional services associated with safety advertising as well as lower labor expense as a result of unfilled positions. Administrative, general and other expense decreased $886.6 thousand, or 6.0% due to lower labor expense as a result of retirements and unfilled positions in the first nine months of 2006 compared to same period in 2005. Interest on long-term debt increased by $957.6 thousand, or 5.5%, due to higher interest rates on our 2002 Series B bonds and our CoBank promissory notes, which carry variable interest rates. Interest charged to construction decreased by $261.6 thousand, or 43.2%, in the first nine months of 2006 compared to the same period in 2005, due to the completion of the South Anchorage substation and the related transmission line, which resulted in a lower average balance in construction work-in-progress in the first nine months of 2006 compared to 2005. Other non-operating margins increased by $266.4 thousand, or 51.2%, for the nine-month period ended September 30, 2006, compared to the same period in 2005, due to an increase in interest income associated with higher interest rates on our investment account as well as higher average cash balances. Financial Condition Total assets decreased $7.4 million, or 1.3% from December 31, 2005, to September 30, 2006. The decrease was due in part to a $7.5 million, or 1.6% decrease in net plant due to depreciation expense in excess of extension and replacement of plant. The decrease was also due to a $5.4 million, or 51.2%, decrease in cash and cash equivalents at September 30, 2006, compared to December 31, 2005 caused by the semi-annual interest payments on the 2001 and 2002 Series A bonds in the third quarter of 2006. 20 The decreases were offset by increases in materials and supplies and deferred charges. Materials and supplies increased $3.2 million, or 13.5% due to the timing and scope of work of several projects. Deferred charges increased $1.9 million, or 9.7% due to the Beluga River gas compression project. Notable changes to total liabilities and equities include a $7.8 million decrease in long-term debt, including current installments, due to the installment payments on the 2002 Series B bonds as well as the CoBank 3, 4 and 5 bonds. Accounts payable decreased $2.4 million, or 24.9%, as a result of the payment of invoices that were accrued but not paid at December 31, 2005. Accrued interest decreased $4.1 million, or 65.2% due to the semi-annual interest payments on the 2002 and 2002 Series A Bonds in the third quarter of 2006. These decreases were offset by a $5.1 million, or 3.6%, increase in total equities and margins due to the margins generated in the first three quarters of 2006, as well as a $994.4 thousand, or 5.5%, increase in fuel payable primarily caused by higher fuel prices. Other current liabilities increased $974.3 thousand, or 32.1%, due to a state and municipal underground compliance charge on retail revenue that was implemented June 1, 2005. Liquidity and Capital Resources Chugach has satisfied its operational and capital cash requirements primarily through internally-generated funds, an annual $7.5 million line of credit with CoBank and a $50 million line of credit from NRUCFC. At September 30, 2006, there was no outstanding balance with NRUCFC or CoBank, however, the line of credit amounts are available for immediate borrowing unconditionally. Chugach also has a term loan facility with CoBank. Loans made under this facility are evidenced by promissory notes governed by the Master Loan Agreement, which became effective on January 22, 2003. At September 30, 2006, Chugach had the following promissory notes outstanding under this facility:
Principal Interest rate at Principal Promissory Note balance September 30, 2006 Maturity Date Payment Dates --------------- ------------ ------------------ ------------- ------------- CoBank 2 $ 8,000,000 5.50% 2010 2005 - 2010 CoBank 3 $ 19,604,225 6.68% 2022 2003 - 2022 CoBank 4 $ 21,427,874 6.68% 2022 2003 - 2022 CoBank 5 $ 5,000,000 6.68% 2007 2007 Total $ 54,032,099
On January 22, 2003, Chugach and CoBank finalized a new Master Loan Agreement pursuant to which the CoBank term loan facility was converted from secured to unsecured debt and the obligations represented by the outstanding bonds then held by CoBank were 21 converted into promissory notes governed by the new Master Loan Agreement. Chugach's mortgage indenture was replaced in its entirety by an Amended and Restated Indenture dated April 1, 2001. All liens and security interests imposed under the indenture were terminated and all outstanding Chugach bonds (including new bonds of 2001 Series A, 2002 Series A and 2002 Series B) became unsecured obligations governed by the terms of the Amended and Restated Indenture. Capital construction in 2006 is estimated at $30.8 million. At September 30, 2006, approximately $13.2 million had been expended. Capital improvement expenditures are expected to increase in the fourth quarter of 2006 as the construction season ends. Chugach management continues to expect that cash flows from operations and external funding sources will be sufficient to cover operational and capital funding requirements in 2006 and thereafter. Critical Accounting Policies Our accounting and reporting policies comply with accounting principles generally accepted in the United States of America. The preparation of financial statements in conformity with Generally Accepted Accounting Principles (GAAP) requires that management apply accounting policies and make estimates and assumptions that affect results of operations and reported amounts of assets and liabilities in the financial statements. Significant accounting policies are described in Note 1 to the financial statements (See "Financial Statements and Supplementary Data"). Critical accounting policies are those policies that management believes are the most important to the portrayal of Chugach's financial condition and results of its operations, and require management's most difficult, subjective, or complex judgments, often as a result of the need to make estimates about matters that are inherently uncertain. Most accounting policies are not considered by management to be critical accounting policies. Several factors are considered in determining whether or not a policy is critical in the preparation of financial statements. These factors include, among other things, whether the estimates are significant to the financial statements, the nature of the estimates, the ability to readily validate the estimates with other information including third parties or available prices, and sensitivity of the estimates to changes in economic conditions and whether alternative accounting methods may be utilized under accounting principles general accepted in the United States of America. For all of these policies management cautions that future events rarely develop exactly as forecast, and the best estimates routinely require adjustment. Management has discussed the development and the selection of critical accounting policies with Chugach's Audit Committee. The following policies are considered to be critical accounting policies for the quarter ended September 30, 2006. Electric Utility Regulation Chugach is subject to regulation by the Regulatory Commission of Alaska (RCA). The RCA sets the rates Chugach is permitted to charge customers based on allowable costs. As a result, Chugach applies Statement of Financial Accounting Standards (SFAS) No. 71, Accounting for the Effects of Certain Types of Regulation (SFAS 71). Through the ratemaking process, the regulators may require the inclusion of costs or revenues in periods different than when 22 they would be recognized by a non-regulated company. This treatment may result in the deferral of expenses and the recording of related regulatory assets based on anticipated future recovery through rates or the deferral of gains or creation of liabilities and the recording of related regulatory liabilities. The application of Statement No. 71 has a further effect on Chugach's financial statements as a result of the estimates of allowable costs used in the ratemaking process. These estimates may differ from those actually incurred by the Company; therefore, the accounting estimates inherent in specific costs such as depreciation and pension and post-retirement benefits have less of a direct impact on Chugach's results of operations than they would on a non-regulated company. Significant regulatory assets and liabilities have been recorded. Management reviews the ultimate recoverability of these regulatory assets and liabilities based on applicable regulatory guidelines. However, adverse legislation and judicial or regulatory actions could materially impact the amounts of such regulatory assets and liabilities and could adversely impact Chugach's financial statements. Critical estimates also include allowance for doubtful accounts. The allowance for doubtful accounts is management's best estimate of the amount of probable credit losses in existing accounts receivable. Chugach determines the allowance based on its historical write-off experience and current economic conditions. Chugach reviews its allowance for doubtful accounts monthly. Past due balances over 90 days in a specified amount are reviewed individually for collectibility. All other balances are reviewed in aggregate. Account balances are charged off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote. Chugach does not have any off-balance-sheet credit exposure related to its customers. Actual results could differ from those estimates. New Accounting Standards SFAS 155 "Accounting for Certain Hybrid Instruments" In February 2006, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Standard "(SFAS") No. 155, "Accounting for Certain Hybrid Instruments", which is an amendment of SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities", and SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities -- a replacement of FASB Statement No. 125." SFAS No. 155 allows financial instruments that have embedded derivatives to be accounted for as a whole (eliminating the need to bifurcate the derivative from its host) if the holder elects to account for the whole instrument on a fair value basis. The Statement also establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation and clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives. SFAS No. 155 is effective for all financial instruments acquired or issued after January 1, 2007. We are currently evaluating the impact this Statement may have on our results of operations or financial condition. 23 SFAS 156 "Accounting for Servicing of Financial Assets" In March 2006, the FASB issued SFAS No. 156, "Accounting for Servicing of Financial Assets -- an amendment of FASB Statement No. 140." SFAS No. 156 requires an entity to recognize a servicing asset or servicing liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract in specific situations. Additionally, the servicing asset or servicing liability is initially measured at fair value; however, an entity may elect the "amortization method" or "fair value method" for subsequent balance sheet reporting periods. SFAS No. 156 is effective on January 1, 2007. Adoption of this statement is not expected to have a material effect on our results of operations or financial condition. SFAS 157 "Fair Value Measurements" In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements." SFAS No. 157 provides guidance for using fair value to measure assets and liabilities. In addition, this statement defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. This statement applies when other accounting pronouncements require fair value measurement; it does not require new fair value measurements. This statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. We will begin application of SFAS No. 157 on January 1, 2008, and do not expect it to have a material affect on our results of operations, financial position, and cash flows. SFAS 158 "Employers' Accounting for Defined Pension and Other Postretirement Plans In September 2006, the FASB issued SFAS No. 158, "Employers' Accounting for Defined Pension and Other Postretirement Plans." SFAS No. 158 requires an employer to recognize in its statement of financial position the overfunded or underfunded status of a defined benefit postretirement plan measured as the difference between the fair value of plan assets and the benefit obligation. Employers must also recognize as a component of other comprehensive income, net of tax, the actuarial gains and losses and the prior service costs and credits that arise during the period. The Statement is effective for public entities for fiscal years ending after December 15, 2006 (December 31, 2006 financial statements for public entities with a calendar year end), and for nonpublic entities for fiscal years ending after June 15, 2007. We have multi-employer plans and a defined contribution plan and adoption of this statement is not expected to have a material effect on our results of operations or financial condition. SAB 108 "The Effect of Prior-Years Errors on Current-Year Materiality Evaluations" In September 2006, the SEC issued Staff Accounting Bulletin ("SAB") No. 108, "The Effect of Prior-Years Errors on Current-Year Materiality Evaluations." SAB 108 provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. We will 24 implement the guidance in the fourth quarter of 2006. We are evaluating the impact, if any, that SAB No. 108 will have on our financial statements. FSP AUG AIR-1 "Accounting for Planned Major Maintenance Activities" In September 2006, the FASB issued FASB Staff Position ("FSP") AUG AIR-1, "Accounting for Planned Major Maintenance Activities." FSP AUG AIR-1 prohibits the use of the accrue-in-advance method of accounting for planned major maintenance activities in annual and interim financial reporting periods. An entity shall apply the same method of accounting for planned major maintenance activities in annual and interim financial reporting periods. The guidance in this FSP is effective for the first fiscal year beginning after December 15, 2006. Adoption of this position is not expected to have a material effect on our results of operations or financial condition. Outlook Not applicable Environmental Matters Compliance with Environmental Standards Chugach's operations are subject to certain federal, state and local environmental laws. The costs associated with environmental compliance are included as a component of both the operating and capital budget processes. Chugach accrues for costs associated with environmental remediation obligations when such costs are probable and reasonably estimable. Item 3. Quantitative and Qualitative Disclosures About Market Risk Chugach is exposed to a variety of risks, including changes in interest rates and changes in commodity prices due to repricing mechanisms inherent in gas supply contracts. In the normal course of business, Chugach manages exposure to these risks as described below. Chugach does not engage in trading market risk-sensitive instruments for speculative purposes. 25 Interest Rate Risk The following table provides information regarding auction dates and rates in 2006 on the 2002 Series B bonds. The maximum rate on the 2002 Series B bonds is 15%. Auction Date Interest Rate ----------------- ------------- January 25, 2006 4.49% February 22, 2006 4.55% March 22, 2006 4.69% April 19, 2006 4.80% May 17, 2006 5.05% June 14, 2006 5.18% July 12, 2006 5.35% August 9, 2006 5.35% September 6, 2006 5.29% October 4, 2006 5.31% November 1, 2006 5.30% Chugach is exposed to market risk from changes in interest rates. A 100 basis-point change (up or down) would increase or decrease our interest expense by approximately $87,032 based on $87,032,099 of variable rate debt outstanding at September 30, 2006. The following table provides information regarding principal payments on total debt by maturity date (dollars in thousands) as of September 30, 2006.
Fair Total Debt* 2006 2007 2008 2009 2010 Thereafter Total Value ------------------------ -------- -------- -------- -------- -------- ---------- --------- --------- Fixed rate debt $ 500 $ 2,000 $ 2,000 $ 2,000 $ 1,500 $ 270,000 $ 278,000 $ 290,729 Average interest rate 5.50% 5.50% 5.50% 5.50% 5.50% 6.39% 6.37% Annual interest expense $ 17,740 $ 17,628 $ 17,518 $ 17,405 $ 17,297 $ 10,107 Variable rate debt 0 $ 11,729 $ 7,241 $ 7,763 $ 8,297 $ 52,002 $ 87,032 $ 87,032 Average interest rate 6.02% 5.55% 5.54% 5.55% 6.22% 6.01%
* Includes current portion Commodity Price Risk Chugach's gas contracts provide for adjustments to gas costs based on fluctuations of certain commodity prices and indices. Because fuel and purchased power costs are passed directly to wholesale and retail customers through a fuel surcharge rate, fluctuations in the price paid 26 for gas pursuant to long-term gas supply contracts do not normally impact margins. The fuel surcharge mechanism mitigates the commodity price risk of market fluctuations in the price of fuel and purchased power. Item 4. Controls and Procedures As of the end of the period covered by this report, Chugach evaluated the effectiveness of the design and operation of our disclosure controls and procedures. Our principal executive officer (CEO) and principal financial officer (CFO) supervised and participated in this evaluation. Based on this evaluation, our CEO and CFO each concluded that our disclosure controls and procedures are effective and timely in alerting them to material information required to be included in our periodic reports to the Securities and Exchange Commission. The design of any system of controls is based in part upon various assumptions about the likelihood of future events and there can be no assurance that any of our plans, products, services or procedures will succeed in achieving their intended goals under future conditions. In addition, there were no changes in our internal controls during the last fiscal quarter that materially affected, or are reasonable likely to materially affect, our internal controls over financial reporting. Chugach is in the process of implementing the requirements of Section 404 of the Sarbanes-Oxley Act of 2002, which requires our management to assess the effectiveness of our internal controls over financial reporting and include an assertion in our annual report as of December 31, 2007 as to the effectiveness of our controls. Subsequently, our independent registered public accounting firm, KPMG LLP, will be required to attest to whether our assessment of the effectiveness of our internal controls over financial reporting is fairly stated in all material respects and separately report on whether it believes Chugach maintained, in all material respects, effective internal controls over financial reporting as of December 31, 2008, as Chugach is considered a non-accelerated filer under Section 404 of the Sarbanes-Oxley Act of 2002. Chugach is in the process of performing the system and process documentation, evaluation and testing required for management to make this assessment and for KPMG LLP to provide its attestation report. This process will continue to require significant amounts of management time and resources. In the course of evaluation and testing, management may identify deficiencies that will need to be addressed and remediated. PART II OTHER INFORMATION Item 1. Legal Proceedings Matanuska Electric Association, Inc., v. Chugach Electric Association, Inc., Superior Court Case No. 3AN-99-8152 Civil In this action filed in 1999, Matanuska Electric Association, Inc. (MEA) alleged that Chugach breached the Power Sales Agreement under which Chugach is obligated to sell MEA power for 25 years, from 1989 through 2014. MEA asserted that Chugach failed to provide it certain information, failed to properly manage Chugach's long-term debt, and failed to bring Chugach's base rate action to a Joint Committee before presenting it to the 27 Regulatory Commission of Alaska (RCA). All of MEA's claims were dismissed by the Superior Court. On April 29, 2002, MEA appealed to the Alaska Supreme Court the Superior Court's dismissal of its claims related to Chugach's financial management and Chugach's decision not to bring its base rate action to the Joint Committee before filing with the RCA. Chugach cross-appealed the Superior Court's decision not to also dismiss the financial management claim on jurisprudential and res judicata grounds. The Alaska Supreme Court, on October 8, 2004, issued an order upholding Chugach's right to not bring its base rate action to the Joint Committee before filing with the RCA. But the Court rejected Chugach's cross-appeal and reversed the Superior Court's decision dismissing MEA's financial management claim. The Supreme Court remanded that claim to the Superior Court for further proceedings. On January 24, 2005, Chugach filed for summary judgment on that claim asserting that in the 2000 Test Year rate case the RCA had fully reviewed and decided the prudency of Chugach's financial management. In a decision dated August 22, 2005, the Superior Court granted Chugach's summary judgment motion, finding that the RCA had adjudicated the question of Chugach's financial management and that its decision should be given res judicata effect. The Superior Court also found that the RCA had exercised its primary jurisdiction in reviewing Chugach's financial management, and that its decision should be given deference. The Superior Court entered final judgment on November 10, 2005, after which Chugach sought its costs and fees. On December 14, 2005, the Superior Court entered judgment awarding Chugach fees and costs from MEA in the amount of $104,732, which has not, as yet, been recorded in the financial statements. On December 9, 2005, MEA appealed to the Alaska Supreme Court the Superior Court's grant of summary judgment. On December 23, 2005, Chugach cross-appealed the Superior Court's failure to also grant summary judgment based on the doctrine of collateral estoppel. This appeal is pending. The ultimate resolution of this matter is not currently determinable. In the opinion of management, an adverse outcome is not likely to have a material adverse effect on Chugach's results of operations, financial condition or liquidity. No reserves have been established for this matter. Matanuska Electric Association, Inc. v. Chugach Electric Association, Inc., Superior Court Case No. 3AN-04-11776 Civil On October 12, 2004, MEA filed suit in Superior Court alleging that Chugach had violated its bylaws in allocating margins (capital credits) during the years 1998 through 2003. The margins Chugach earns each year are allocated to the customers who contributed them and are booked as capital credits to those customers' accounts. Capital credits are eventually repatriated to customers at the discretion of the board of directors, typically many years after the margins are earned. 28 On February 17, 2006, MEA filed a Motion to File an Amended Complaint and an Amended Complaint in this case. The Amended Complaint is identical to MEA's initial Complaint except for changes made to accommodate one new claim. The new claim challenges Chugach's failure to provide MEA with a capital credit allocation for 2004. We expect the Court will allow MEA's proposed amendment. In this suit, MEA asks the Court to hold that Chugach breached its bylaws in the manner in which it allocated capital credits in 1998 through 2003 and if the Amended Complaint is allowed by the Court, through 2004. MEA also asks the court to enjoin Chugach to re-calculate MEA's capital credits applying MEA's interpretation of Chugach's bylaws and in accordance with what MEA refers to as "generally accepted accounting practices for nonprofit cooperatives and cooperative principles". The suit also seeks damages in an unspecified amount to compensate MEA for the alleged breach of contract. The trial date has been rescheduled for January 16, 2007. Management is vigorously defending against the claim. The ultimate resolution of this matter is not currently determinable. In the opinion of management, an adverse outcome is not likely to have a material adverse effect on Chugach's results of operations, financial condition or liquidity because the matter relates primarily to issues of margin allocation among customers. No reserves have been established for this matter. Matanuska Electric Association, Inc. v. State of Alaska, Regulatory Commission of Alaska, Superior Court Case No. 3AN-06-8243 Civil On May 17, 2006, MEA appealed and on May 30, 2006, Homer Electric Association, Inc., (HEA) cross appealed the RCA's decision in Commission Docket No. U-04-102, see "Item 4 - Regulatory Matters - Docket No. U-04-102 (Revision to Current Depreciation Rates)." On appeal, MEA claims the Commission's decision dated January 10, 2006, to authorize Chugach to implement new depreciation rates as of January 1, 2005 constituted illegal retroactive ratemaking. MEA also contends that the Commission's reliance on avoidance of regulatory lag as a basis for its decision was improper. HEA's points on appeal challenge several decisions by the Commission on estimated lives of General Plant on the ground that there is not substantial evidence in the record to support such a decision. HEA and MEA both challenge the discovery rulings of the Commission. Chugach will join the State of Alaska in defending the Commission's rulings. No briefing schedule has been set. The ultimate resolution of this matter is not currently determinable. In the opinion of management, an adverse outcome is not likely to have a material adverse effect on Chugach's results of operations, financial condition or liquidity. No reserves have been established for this matter. Matanuska Electric Association, Inc. v. Chugach Electric Association, Inc., Superior Court Case No. 3PA-06-1295 Civil On May 17, 2006, MEA filed suit against Chugach in Superior Court asserting three claims. In this action, MEA contends that by publishing unbundled financial statements Chugach has in effect stated that MEA owes Chugach a debt. Chugach denies having made statements to this effect. 29 Unbundled financial statements are an analytic tool developed by Chugach that separate the financial statements into two business units consisting of the Generation and Transmission (G&T) and the Distribution functions of the company. The unbundled financial statements reflect the operating results of each separate entity. Statements of Revenues, Expenses and Patronage Capital, Balance Sheets and Statements of Cash Flows are prepared monthly for each business unit. MEA's action is based on the result of Chugach's financial analysis showing intercompany receivable/payable entries on the unbundled balance sheets. The first of MEA's claims is that it is entitled to declaratory judgment to the effect that MEA does not owe a debt to Chugach or to Chugach's Distribution function. Second, MEA claims that Chugach has breached its Bylaws and the Power Sales Agreement under which Chugach is obligated to sell MEA power and by publishing its unbundled financial analysis and seeks a declaration that Chugach's actions violate the Bylaws and the Power Sales Agreement. MEA also asks for an injunction against further assertions, which Chugach denies having made, that MEA owes Chugach or Chugach's Distribution function a debt. Finally, MEA seeks damages, including punitive damages, to punish Chugach and deter it from continuing to publish the analysis. Chugach has moved to dismiss the first (declaratory judgment) and third (defamation) counts of the complaint. Oral argument on this motion occurred on October 13, 2006 and a decision on Chugach's motion to dismiss counts one and three of the complaint is expected soon. Trial is currently scheduled for June 2007. Chugach believes the claims are without merit and will vigorously defend against them. Management is uncertain of the outcome of the proceeding before the Superior Court. The ultimate resolution of this matter is not currently determinable. In the opinion of management, an adverse outcome is not likely to have a material adverse effect on Chugach's results of operations, financial condition or liquidity. Matanuska Electric Association, Inc. v. Chugach Electric Association, Inc., Superior Court Case No. 3PA-06-1591 Civil On August 7, 2006, MEA served Chugach with a Summons and Complaint requesting the Court grant MEA declaratory judgment, breach of contract and costs and attorney fees. MEA seeks a declaratory judgment that Chugach has wrongfully refused to grant MEA access to the books and records of the cooperative in violation of state statute, common law and Chugach bylaws. MEA also alleges that by refusing to grant access to these records, Chugach has breached its bylaws on which MEA bases a breach of contract claim against Chugach. MEA asks the Court to grant it access to, and the right to inspect and copy, unspecified Chugach's records and order Chugach to cooperate in facilitating MEA's inspection and copying of the same. Chugach has answered MEA's Complaint and believes the claims are without merit and will vigorously defend against them. Management is uncertain of the outcome of the proceeding before the Superior Court. The ultimate resolution of this matter is not currently determinable. In the opinion of management, an adverse outcome is not likely to have a material adverse effect on 30 Chugach's results of operations, financial condition or liquidity. Chugach has certain additional litigation matters and pending claims that arise in the ordinary course of Chugach's business. In the opinion of management, no individual matter or the matters in the aggregate is likely to have a material adverse effect on Chugach's results of operations, financial condition or liquidity. Item 1A. Risk Factors Chugach's financial results will be impacted by weather, the economy of our service territory, fuel availability and prices, the future direction customers may take and the decisions of regulatory agencies. Our creditworthiness will be affected by national and international monetary trends, general market conditions and the expectations of the investment community, all of which are largely beyond our control. In addition, the following statements highlight risk factors that may affect our consolidated financial condition and results of operations. The statements below must be read together with factors discussed elsewhere in this document and in our other filings with the SEC. Fuel and Purchased Power Surcharge Mechanism The fuel and purchased power surcharge mechanism allows Chugach to reflect current fuel cost and to recover under-recoveries and refund over-recoveries with a three-month lag. If Chugach were to materially under-recover fuel costs, we may seek an increase in the surcharge to recover those costs at the time of the next fuel surcharge filing. During periods of significant increases in natural gas prices such as occurred in 2004 and 2005, Chugach realizes a lag in the ability to reflect unanticipated increases in fuel costs in its fuel and purchased power surcharge mechanism. As a result, cash flow may be impacted due to the lag in collection of fuel costs from customers. At September 30, 2006, Chugach had under-recovered $1.9 million and at December 31, 2005, Chugach had under-recovered $1.8 million. To the extent the regulated fuel recovery process does not provide for the timely recovery of fuel costs, Chugach could experience a material negative impact on its cash flows. Equipment Failures and Other External Factors The generation and transmission of electricity requires the use of expensive and complex equipment. While we have a maintenance program in place, generating plants are subject to unplanned outages because of equipment failure. We are particularly vulnerable to this due to the advanced age of several of our gas-fired generating units. In the event of unplanned outages, we must acquire power from others at unpredictable costs in order to supply our customers and comply with our contractual agreements. The fuel and purchased power surcharge mechanism allows Chugach to reflect current purchased power cost and to recover under-recoveries and refund over-recoveries with a three-month lag. If Chugach were to materially under-recover purchased power costs due to an unplanned outage, we may seek an increase in the surcharge to recover those costs at the time of the next fuel surcharge filing. As a result, cash flow may be impacted due to the lag in payments of purchased power costs and collection of purchased power costs from customers. To the extent the regulated 31 purchased power recovery process does not provide for the timely recovery of purchased power costs, Chugach could experience a material negative impact on its cash flows. This factor, as well as weather, interest rates, economic conditions, fuel supply and prices, are largely beyond our control, but may have a material adverse effect on our consolidated earnings, cash flows and financial position. Item 2. Unregistered Sales of Equity Securities and Use of Proceeds Not applicable Item 3. Defaults Upon Senior Securities Not applicable Item 4. Submission of Matters to a Vote of Security Holders Not applicable Item 5. Other Information Effective July 1, 2006, William R. Stewart, Interim Chief Executive Officer was appointed as Chugach's Chief Executive Officer. Mr. Stewart, age 59, is a 37-year employee of Chugach and has served in a variety of management positions including 20 years as a senior executive. Prior to being appointed Chief Executive Officer, Stewart held the positions of General Manager, Corporate Services Division, Sr. Vice President, Administration, Executive Manager, Corporate Services Division, Executive Manager, Administration, Division Director of Administration and Staff Assistant to the General Manager of Chugach. Item 6. Exhibits Exhibits: Employment Agreement between the Registrant and William R. Stewart dated effective July 1, 2006 Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 Certification of Principal Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 Certification of Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 32 Signatures Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. CHUGACH ELECTRIC ASSOCIATION, INC. By: /s/ William R. Stewart ---------------------- William R. Stewart Chief Executive Officer Date: November 10, 2006 By: /s/ Michael R. Cunningham ------------------------- Michael R. Cunningham Chief Financial Officer Date: November 10, 2006 33 EXHIBITS Listed below are the exhibits, which are filed as part of this Report: Exhibit Number Description -------------- ------------------------------------------------------- 10.54 Employment Agreement between the Registrant and William R. Stewart dated effective July 1, 2006. 31.1 Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.2 Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32.1 Certification of Principal Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 32.2 Certification of Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 34