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Slide 1: C O M M I T M E N T T O VA L U E 2005 Annual Report
Slide 2: “We need to be smart about energy delivery and customer service. By listening to our customers, we strive to meet their needs economically and efficiently.” Larry Borgard, President and Chief Operating Officer – Energy Delivery, Wisconsin Public Service CONTENTS 1 Highlights 2 WPS Resources Corporation At A Glance 4 Letter to Shareholders 10 Commitment to Value 20 Forward-Looking Statements 21 Management’s Discussion and Analysis 55 Consolidated Statements of Income 56 Consolidated Balance Sheets “Our commitment, when it comes to generating power, is to provide customers with energy that’s always there, at a price that’s reasonable, and safely within environmental standards. We focus on using demonstrated technology to ensure that we can follow through on that commitment.” 57 Consolidated Statements of Common Shareholders’ Equity 58 Consolidated Statements of Cash Flows 60 Notes to Consolidated Financial Statements 100 Report of Independent Registered Public Accounting Firm 101 Financial Statistics 102 Board of Directors 103 Officers 104 Investor Information Charlie Schrock, President and Chief Operating Officer – Generation, Wisconsin Public Service C O M M I T M E N T T O VA L U E WPS RESOURCES CORPORATION
Slide 3: HIGHLIGHTS Year Ended December 31 Consolidated revenues – nonregulated (Millions) * Consolidated revenues – utility (Millions) Margins – nonregulated (Millions) * Margins – utility (Millions) Income before cumulative effect of change in accounting principles (Millions) * Income available for common shareholders (Millions) Earnings per average share of common stock Income before cumulative effect of change in accounting principles – basic * Income before cumulative effect of change in accounting principles – diluted * Income available for common shareholders – basic Income available for common shareholders – diluted Dividends per share Book value per share Common stock price at year end Shares outstanding at year end (excludes treasury stock and shares in deferred compensation trust) Total assets (Millions) * Refer to Management’s Discussion and Analysis for an explanation of changes from prior year. 2005 $5,438.5 1,524.2 224.3 717.5 162.1 157.4 2004 $3,658.8 1,292.0 138.7 720.1 142.8 139.7 Percent Change 48.6 18.0 61.7 (0.4) 13.5 12.7 $4.15 4.11 4.11 4.07 $ 2.24 32.76 $55.31 39,807,407 $5,455.2 $3.74 3.72 3.74 3.72 $ 2.20 29.30 $49.96 37,259,553 $4,376.8 11.0 10.5 9.9 9.4 1.8 11.8 10.7 6.8 24.6 CASH FLOW SUMMARY Year Ended December 31 Net cash operating activities * Net cash investing activities * Net cash financing activities * Change in cash and cash equivalents * * Refer to Management’s Discussion and Analysis for an explanation of changes from prior year. (Millions) 2005 $ 62.4 (73.9) (0.8) $ (12.3) 2004 $230.8 (315.0) 73.5 $ (10.7) 2003 $ 59.2 (247.4) 195.6 $ 7.4 2005 EARNINGS BY SEGMENT (Millions) Electric Utility Gas Utility WPS Energy Services Other Total Earnings $ 64.2 13.2 74.1 5.9 $157.4 1 WPS RESOURCES CORPORATION
Slide 4: REGULATED OPERATIONS AT A G L A N C E WPS Resources Corporation WPS Resources Corporation is a holding company headquartered in Green Bay, Wisconsin. Subsidiaries provide products and services in both regulated and nonregulated energy markets. Wisconsin Public Service Corporation Upper Peninsula Power Company NONREGULATED OPERATIONS WPS Energy Services, Inc. WPS RESOURCES CORPORATION 2
Slide 5: WISCONSIN PUBLIC SERVICE CORPORATION Business ■ ■ ■ UPPER PENINSULA POWER COMPANY Business ■ ■ ■ Established in 1883. Regulated electric and natural gas utility. Operates in northeast and central Wisconsin and an adjacent portion of Upper Michigan (see map at left). 2,310 employees. Established in 1884. Regulated electric utility. Operates in primarily rural countryside covering 10 of the 15 counties in the Upper Peninsula of Michigan (see map at left). 165 employees. ■ ■ Market ■ ■ Market ■ ■ ■ Serves 424,615 electric and 307,540 natural gas customers. Provides electric and natural gas products and services to residential, farm, commercial, and industrial customers. Also provides electric power to wholesale customers. Electric operations accounted for 64% and natural gas operations accounted for 36% of 2005 revenues. Electric revenues are comprised of 90% retail sales and 10% wholesale sales. Wisconsin customers accounted for 97% and Michigan customers accounted for 3% of 2005 revenues. Serves 52,167 electric customers in 99 communities. Provides electric energy to 37 wholesale customers. Main industries served are forest products, tourism, and small manufacturing. Electric revenues are comprised of 77% retail sales and 23% wholesale sales. ■ ■ ■ Facilities ■ ■ Electric generating capacity based on summer capacity ratings is 77.6 megawatts. A peak demand was reached on December 19, 2005, with a system demand of 147.2 megawatts. Electric property includes 3,070 miles of electric distribution lines. Facilities ■ ■ Electric generating capacity based on summer capacity ratings is 1,861.1 megawatts, including share of jointly owned facilities. A peak demand was reached on August 2, 2005, with a system demand of 2,349 megawatts. Electric property includes 21,029 miles of electric distribution lines, 92% of which are operated at 24.9 kV. Gas property includes 7,579 miles of gas main, 70% of which is plastic main, and 86 gate and city regulator stations. ■ ■ WPS ENERGY SERVICES, INC. In 2005, WPS Energy Services and WPS Power Development combined to create a single organization to better serve customers and capitalize on opportunities in the marketplace. The integration of the generating and marketing businesses are yielding results in streamlined operations, improved efficiencies, synergies between operating units and an integrated business focus. Improved results are reflected in better service to customers and an enhanced bottom-line. Products and Services ■ Provides individualized energy supply solutions, structured products, and strategies that allow customers to manage energy needs while capitalizing on opportunities resulting from deregulation. Provides natural gas, electric, and alternate fuel products, real-time energy management services, energy utilization consulting, and project development and management. Provides market management services and optimization of energy assets in the competitive marketplace. Patented DENet ®and eMiner ™ computer technology allows customers to monitor and manage their energy usage. Provides engineering and management services and operations and maintenance services. Generation areas of expertise include cogeneration, distributed generation, generation from renewables, and generation plant repowering projects. ■ Business ■ ■ ■ Established in 1994. Diversified nonregulated energy supply and services company, which also owns and operates various nonregulated electric generation facilities and a minority interest in a synthetic fuel facility. Principal energy marketing operations include Illinois, Maine, Michigan, New York, Ohio, Texas, Virginia, and Wisconsin in the United States and Alberta, Ontario, and Quebec in Canada. Subsidiaries own and/or operate energy assets in Maine, New York, Oregon, Kentucky, Pennsylvania, and Wisconsin, as well as electric generation facilities in New Brunswick, Canada (see map at left). Provides retail and wholesale products in nonregulated energy markets in the United States and Canada. Develops nonregulated assets and provides electric power generation services. 423 employees. ■ ■ ■ ■ Facilities ■ ■ 74 megawatts of hydroelectric and diesel generation facilities in the state of Maine and in New Brunswick, Canada. 503 megawatts of primarily coal-fired generation facilities in Pennsylvania. 259 megawatts of combined cycle and fluidized bed generation facilities in upstate New York. 50-megawatt cogeneration facility in Combined Locks, Wisconsin. 53-megawatt coal-fired generation facility in Cassville, Wisconsin. A minority interest in a synthetic fuel facility located in Kentucky. Landfill and wood waste gas generating facilities in Wisconsin and steam boilers in other states. 3 billion cubic foot natural gas storage facility in southeast Michigan. ■ ■ ■ ■ ■ ■ ■ ■ Market ■ ■ Operates in the retail and wholesale nonregulated energy marketplace. Emphasis is on serving aggregated residential and small commercial, large commercial, industrial, and wholesale customers in the United States and Canada. Geographic footprint includes services to the northeast quadrant of the United States and adjacent portions of Canada, and also includes services targeted toward energy intensive regions of Texas and Alberta, Canada. ■ ■ WPS RESOURCES CORPORATION 3
Slide 6: Larry L. Weyers, Chairman, President, and Chief Executive Officer of WPS Resources Corporation D E A R F E L LO W S H A R E HOL D E R S Over the past year natural disasters tested our country’s fortitude and created an unstable oil market and high energy prices. However, it was uplifting to see Americans pull together to assist those whose lives were devastated by loss. Working together, Americans are recreating value that was destroyed and creating new value for their countrymen. That is our strength. At WPS Resources Corporation we are taking steps to provide outstanding value to shareholders, customers, employees, and communities. We are committed to value— creating it, protecting what exists, and providing it to others. Let’s take a closer look at what this commitment means. 4 WPS RESOURCES CORPORATION
Slide 7: Creating Value by Growing our Utility Investments At WPS Resources we know customers value our ability to ensure that they have adequate supplies of low-cost, reliable, environmentally-friendly energy. We are investing hundreds of millions of dollars in our utility infrastructure to make certain these needs are met. These investments will also provide competitive returns to our investors. Construction of our Weston 4 generating facility began in October 2004. This is a 500-megawatt, state-of-the-art coalfired facility in central Wisconsin. We will invest an estimated $549 million in Weston 4. We will own approximately 70 percent of the facility and be the operator. Our partner, Dairyland Power Cooperative, will own the other 30 percent. Commercial operations are scheduled to begin in 2008. In addition, we continue to invest in American Transmission Company’s (ATC) 220-mile transmission line being built between Wausau, Wisconsin, and Duluth, Minnesota. We will provide an estimated $61 million for this project between 2006 and 2008. Wisconsin Public Service is also constructing the line for ATC. The Minnesota portion of the line was completed in early 2005. Construction of the Wisconsin portion began in August 2005, and we expect completion of the entire project in 2008. We continue to increase our ownership share in ATC. At the end of 2005, we owned 31 percent of the company and intend to continue investing in their construction program, which has a capital expenditure budget of $3.4 billion over the 10-year period ending 2015. The ATC investment is a utility investment that provides a good return with reasonable risk. Proposed Natural Gas Distribution Operations Acquisition Minnesota Proposed Acquisition Michigan Proposed Acquisition Wisconsin Public Service Corporation Upper Peninsula Power Company Creating Value with Strong Nonregulated Business WPS Energy Services, our nonregulated energy supply and services company, is continuing to deliver strong performance. Its net income increased by almost 78 percent in 2005, made possible by providing products that satisfy the unique needs of customers in competitive energy markets. Our long-term financial goal is for 20 to 30 percent of our earnings to come from WPS Energy Services. Our nonregulated business provides earnings diversity for our company rather than depending solely on utility earnings that are somewhat dependent upon the regulatory environment and weather. We took steps this past year to reduce the risk profile of our company. Creating Value with a Reduced Risk Profile We took steps this past year to reduce the risk profile of our company. We accomplished this in part through enhancement of our portfolio strategy. This strategy helps diversify our investments into regulated and nonregulated energy businesses, with electric and natural gas product lines sold into retail and Last year we agreed to acquire natural gas distribution operations in Michigan and Minnesota. This utility investment of approximately $558 million, which is subject to post-closing adjustments including working capital, will provide stable returns for investors and job opportunities for employees. We expect to close on these acquisitions in the first half of 2006. We believe that each of these investments is a great opportunity that will benefit shareholders, customers, and employees. wholesale markets. We transferred ownership of the Kewaunee nuclear power plant to a larger, more experienced operator while maintaining the right to purchase output from the facility through 2013, when the current operating license expires. We also have exclusive rights through 2011 to negotiate with the new owner to extend our purchasing rights should the operating license be renewed. C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 5
Slide 8: an overview of Our Financial Performance WPS Resources Corporation Revenues (Millions) One of the initiatives, which we call “Competitive Excellence,” is being deployed across our entire enterprise. Competitive Excellence strives to eliminate work that does not provide value for our customers. This creates more efficient processes, improves the effectiveness of our employees, and reduces costs. Net Income $8,000 (Millions) $200 Another major cost-reduction initiative is our focus on improving project management skills. Our goal is to complete every project on schedule, within budget, and with the functionality we expect. We are accomplishing this by following defined project management procedures, using state-of-the-art project management tools, and ensuring that we have welltrained, experienced project managers assigned responsibility for our projects. $6,962.7 $4,950.8 $6,000 $157.4 $139.7 $150 $4,000 $100 $2,000 $50 $0 $0 2004 2005 2004 2005 Basic Earnings (Per Share) Market Capitalization (Millions) $5.00 $4.00 $2,500 Creating Value with Financial Strength Success in the challenging business environment we face today requires financial strength. WPS Resources recognizes the importance of financial strength in the eyes of stakeholders, and we protect and build upon this strength in several ways. Our balance sheet is strong, with 52.4 percent equity in our capital structure at year end. We sold 1.9 million shares of common stock in November, which increased the equity component of our balance sheet. We anticipate issuing up to 2.7 million additional shares in 2006 under a forward-sale agreement we have with an investment bank, which we arranged $3.74 $4.11 $2,201.7 $1,861.5 $2,000 $1,500 $1,000 $500 $0 $3.00 $2.00 $1.00 $0.00 2004 2005 2004 2005 WPS Energy Services reduced its risk profile by selling emission allowances allocated to the Sunbury generation plant. Proceeds received enabled Sunbury to eliminate its nonrecourse debt obligation, which provides greater flexibility as WPS Energy Services evaluates its options for the future of this plant, including closure, retention and operation during favorable economic periods, or divestiture. WPS Energy Services also protected a portion of its synthetic fuel tax credits against phase outs that could be triggered by the rising cost of oil. Risk reduction is part of our long-term strategy and, by taking these steps in 2005, we made considerable progress toward that goal. with our planned natural gas distribution acquisitions in mind. We also increased our credit facilities by entering into five-year, unsecured, revolving credit agreements totaling $615 million. WPS Resources has a $500 million agreement and Wisconsin Public Service has a $115 million agreement. WPS Resources continues to offer dividends on which investors can rely. We paid dividends for the 65th consecutive year and increased our quarterly dividend for the 47th consecutive year. We delivered a 15.2 percent total shareholder return for our investors who reinvested their $2.24 in dividends per share and held their WPS Resources common stock from December 31, 2004, through December 31, 2005. Our credit ratings for debt obligations remain among the best Creating Value Through Cost Reductions This past year we began several major initiatives to reduce future costs of our products for customers. This will aid us in fulfilling our corporate mission, which is “To provide customers with the best value in energy and related services.” in the industry, with an “A1” from Moody’s and an “A” from Standard & Poor’s. This is a major accomplishment in view of the cash requirements of our construction and acquisition initiatives. Corporate governance has garnered more attention since the advent of Sarbanes-Oxley, and we have responded by improving 6 WPS RESOURCES CORPORATION
Slide 9: our governance structure and operations. Our results are very positive. As of January 1, 2006, Institutional Shareholder Services indicated that we have a Corporate Governance Quotient that is better than 95.7 percent of the S&P 400 companies and 93.4 percent of utility companies. cost of energy for our customers. This past year, the prices of gasoline, natural gas, coal, and oil all rose to unprecedented levels. WPS Resources and its subsidiaries are determined to provide better protection for our electric and natural gas customers from volatile and high prices. We have already taken steps to strengthen our capabilities and be successful in this effort. However, we have more to do. Creating Value with a Strategy for the Future Our strategy is simple. It has proven to be successful for many years, and we believe it will create significant value for years to come. First, we will continue investing in quality utility operations and become a stronger regional utility. This aspect of our strategy will provide stable returns for investors and job opportunities for employees. Another challenge comes from the impact we have on our environment. We are searching for new ways to protect the environment. This involves a renewed commitment to energy conservation, the use of renewable energy resources, a reduction of emissions from combustion processes, and the deployment of new and better technologies. You can learn more about our commitment to the environment by reading our 2005 Environmental Performance Report, which is available on our Web site at www.wpsr.com, under Investor Information. We have also faced a changing regulatory environment at WPS Energy Services. High wholesale prices and regulatory rulings negatively impacted our ability to grow or even renew existing customer contracts in the Michigan retail electric markets. WPS Energy Services also did not extend an offer to provide service to electric aggregation programs for the Ohio cities of Cleveland and Euclid when the contracts expired last year. We also ended service to direct sign-up electric customers in the Toledo Edison territory. The decision to exit the Cleveland We will continue investing in quality utility operations and become a stronger regional utility. Second, we plan to expand the businesses and footprint of WPS Energy Services. Our focus remains on the northeast quadrant of the United States and adjacent portions of Canada, as well as other markets where we can leverage our existing capabilities. For instance, we are entering the Texas retail electric market, which is a thriving, liquid market. We already have Houston operations serving natural gas producer customers, and we will expand these operations to offer electricity to commercial and industrial customers. The third leg of our strategy is asset and portfolio management across the entire enterprise. Our goal is a portfolio of energy and energy-related investments that manages our risk profile through diversity. We will manage assets to provide our targeted returns. This may include the acquisition of new assets, the divestiture of existing assets, or modification of the operations of certain assets. and Euclid territories is related to the regulatory changes adopted by the Public Utilities Commission of Ohio, which makes it more difficult to provide competitively priced power in that market area. At the same time, we have made progress in expanding our retail electric activity in other markets by offering products to customers in Illinois and establishing a retail electric operation in Texas. Long-Term Financial Goals ■ ■ Provide investors with a solid return on their investments. Grow our earnings per share from continuing operations at 6 to 8 percent on an average annualized basis. ■ Achieve 20 to 30 percent of our earnings from our nonregulated energy supply and services company. Creating Value by Managing the Challenges As always, WPS Resources must address numerous challenges for continued success. One of those challenges is the rising ■ ■ Manage the risk profile of our business portfolio. Continue our growth in the annual dividend paid. C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 7
Slide 10: returns on investment Basic Earnings Per Common Share $5.00 Creating Value with Operational Excellence Customers rely on us to provide for their energy needs around the clock, every day. Meeting their needs requires dedicated and diligent employees willing to go the extra mile. As evidence of our commitment to reliability, this past summer we $3.00 $3.45 $3.74 $4.11 $4.00 $2.53 $2.75 $2.87 met ten new electric system demand peaks. This resulted in an overall increase in peak demand of more than 8 percent. This is just one example of the operational excellence our employees provide. Other organizations have recognized our success with a number of awards we received in 2005, including the following: ■ $2.24 $1.99 $2.10 $2.00 $1.76 $1.00 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 $0.00 The United Way of Brown County, Wisconsin, presented WPS Resources with the Outstanding Corporate Support Award. (January 2005) Dividends Per Common Share $2.50 ■ The Wausau Region Chamber of Commerce Cornerstone Award was presented to Wisconsin Public Service for its support of small business, economic development, and community involvement efforts in Wausau and Marathon County, Wisconsin. (April 2005) $2.12 $2.16 $2.20 $2.24 $1.88 $1.92 $1.96 $2.00 $2.04 $2.08 $2.00 $1.50 ■ $1.00 The National Arbor Day Foundation named Wisconsin Public Service a Tree Line USA utility for the tenth year and Upper Peninsula Power Company a Tree Line USA Utility for the second year. The program recognizes energy companies with a dedicated commitment to quality tree care, tree planting, and public education. (April 2005) $0.50 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 $0.00 ■ Wisconsin Public Service was named “Communicator of the Year” in May 2005 by Utility Communicators International. Cumulative Total Return* ■ $300.00 Mergent, Inc.** named WPS Resources a Mergent Dividend Achiever™ in 2005, an honor shared with only 3 percent of United States-listed dividend-paying companies, for consistently delivering dividend increases to shareholders, for at least the past ten years or longer. We tied for eighth place by increasing dividends for 46 consecutive years. (June 2005) $288.05 $220.98 $250.09 $250.00 $200.00 $150.00 $100.00 $50.00 $0.00 $124.59 $148.89 $157.06 $176.33 $112.90 $89.08 $95.15 ■ The 2005 J. D. Power and Associates electric and natural gas customer satisfaction studies indicated that Wisconsin Public Service achieved an overall satisfaction ranking within the Midwest of fourth (out of 19 utilities) in the electric study and fifth (out of 20 utilities) in the natural gas study. J. D. Power and Associates classified Wisconsin Public Service as an “All Time Best Residential Electric Performer” because we ranked in the top quartile nationally over a seven-year period—an indication of Wisconsin Public Service’s strong record of performance. (July and September 2005) 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Equivalent average annual return of 11.16%. * Assumes $100 investment in common stock at year-end 1995 and all dividends reinvested quarterly. Cumulative total return for the ten-year period is equivalent to an average annual return of 11.16%. ** Mergent’s Dividend Achievers®and Dividend Achievers™ are trademarks of Mergent, Inc. 8 WPS RESOURCES CORPORATION
Slide 11: ■ Standard & Poor’s named WPS Resources to its High Yield Dividend Aristocrats Index. This index measures the performance of the 50 highest dividend-yielding stocks in the S&P Composite 1500 that have followed a dividend policy of consistent annual increases for at least 25 consecutive years. (November 2005) employees and retirees can be found lending a hand. Their contributions of thousands of volunteer hours and millions of dollars in benevolent gifts enrich and sustain communities. For more information about our commitment to communities, please see our 2005 Community Report, which is available on our Web site at www.wpsr.com, under Investor Information. ■ The 2005 MastioGale customer satisfaction survey listed WPS Energy Services fourth out of 38 in overall customer satisfaction and fourth in the regional energy marketer category. Since first appearing in the survey in 1999, WPS Energy Services’ customers have consistently rated it in the top 10 in MastioGale’s customer satisfaction ratings. A new feature of the 2005 MastioGale study, the Customer Value Index score, combines price and customer satisfaction rankings into a single rating of the company. WPS Energy Services finished second in the Customer Value Index. (December 2005) Creating Value with Strong Leadership In addition to having skilled, compassionate employees, I am fortunate to have a talented and capable management team at WPS Resources and all of our subsidiaries. The people who make up this management team are invaluable to our success. Once again, there were changes in this team. ■ Gary Erickson is moving from President of Upper Peninsula Power Company to become the President of our new natural gas subsidiary in Michigan. Customers rely on us to provide for their energy needs around the clock, every day. ■ Chuck Cloninger, Assistant Vice President - Operations and Engineering for Wisconsin Public Service, has been named President of our new natural gas subsidiary in Minnesota. ■ Neal Siikarla, Vice President of WPS Resources, retired. This year we will have many new employees joining our ranks in ■ Forbes magazine designated WPS Resources as the utility industry’s “Best Managed Company in America” in its January 9, 2006, issue. Michigan and Minnesota. I welcome each and every one of you to the WPS Resources team. You are a great addition. In 2005, the efforts of our management team and the employees who support them resulted in another successful year. Our hard work and achievements were recognized by many. My thanks to all employees for their role in bringing about this success and providing value to our shareholders, customers, and communities. I’m proud to be a part of the WPS Resources team. I also want to thank our shareholders and customers for their continued support through a year full of uncertainty. We appreciate the trust placed in our company and our ability to create and deliver value in challenging times. You have my word ■ The Wall Street Journal ranked WPS Resources sixth among 44 electric utilities in five-year average total shareholder returns for 2005 with a 14.1 percent average. (February 27, 2006) ■ FORTUNE magazine designated WPS Resources Corporation as the most admired energy company on its prestigious 2006 list of “America’s Most Admired Companies” in its March 6, 2006, issue. Creating Value for Communities At WPS Resources we have a strong commitment to the communities we call home. Each year employees and retirees invest time, talent, and resources to help improve the quality of life in their neighborhoods. Our employees and retirees can be found enthusiastically helping out wherever there are charitable needs in their particular communities. From teaching second graders to volunteering with the local Habitat for Humanity, WPS Resources’ that you can count on WPS Resources’ commitment to value as we head into the future. With Warmest Regards, Larry L. Weyers Chairman, President & CEO March 6, 2006 C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 9
Slide 12: “UPPCO is a relatively small company with a deep commitment to its customers, who are often our friends and neighbors. Our focus on efficient, prompt, quality service is a natural extension of those close community relationships.” Frank Stipech, Operations Manager at Upper Peninsula Power C O M M I T M E N T TO VA L U E Concern about rising energy costs dominated the public consciousness in 2005. From the gasoline pump to the natural gas meter, customers experienced the far-reaching effects of volatile market conditions and rising prices. The people of WPS Resources Corporation share our customers’ and other stakeholders’ growing concern. The challenges of the 2005 energy market have made it even more critical to proceed with a clear, compelling commitment to value—value achieved through both our strong utility base and our strategically focused nonregulated energy business. 10 WPS RESOURCES CORPORATION
Slide 13: Value to Customers Every day, enterprise-wide, the nearly 3,000 employees of WPS Resources show their personal commitment to offering measurable value—to our customers, to the communities we serve, to our shareholders, and to each other. As we reflect on the year, we invite you to weigh the value of our commitment for yourself. Transmitting Value Part of WPS Resources’ long-term strategy to serve customers reliably at competitive prices is to pursue cost-effective changes to the electric system. An important step in this strategy unfolded as MISO implemented a new energy market on April 1, 2005. In MISO’s new energy market, less costly generation output is dispatched and transmitted before more costly energy is brought online. The goal is to provide electric utility customers throughout the region with access to economically priced energy. With continued improvements, MISO has the potential to decrease energy costs. For example, MISO’s efforts to develop a single electric transportation rate for the entire Midwest, a joint market with transmission organizations in the eastern United States, and updated systems can further reduce the delivery cost of electricity. Key to ensuring access to the benefits of MISO’s energy market is expansion of the transmission infrastructure within and across state boundaries—eliminating congestion so more economically priced energy can be imported across state lines. Because we operate in an area that experiences more than 500 hours of transmission congestion annually, we are encouraging both American Transmission Company (the transmission owner in our region) and MISO (the operator of that system) to act with greater urgency to provide a system that can meet emerging needs with cost-competitive energy pricing. Peak Performance Drives Reliability One of the most important measures of our value is our ability to deliver reliable power during adverse conditions. Throughout 2005, reliability was continuously tested and expectations met. This was due to the commitment of employees system-wide, from the energy supply supervisors who managed the logistics of meeting peak electric load to veteran dispatchers who deployed line crews in response to power outages. Driven by wave after wave of sultry summer weather, a sequence of successive peak usage days pushed demand at both Wisconsin Public Service Corporation and Upper Peninsula Power Company, our regulated utilities, to record levels. During one hour on August 2, 2005, Wisconsin Public Service customers used a record 2,349 megawatts of electricity— making it the tenth record-breaking day of peak electric use in 2005 alone. Upper Peninsula Power reached a peak demand as well, at 147.2 megawatts on December 19. To meet this intense demand, the energy supply group worked closely with its generation facilities and the Midwest Independent System Operator (MISO)—a regional transmission organization—to deliver the available energy resources and meet each of the new peaks. To manage costs, measures were taken to ensure that the maximum output could be attained from the existing generation fleet and, when necessary, to reduce system load via customer load reduction programs. In addition, contractual resources were evaluated in terms of cost and accessed as needed to support our energy portfolio. Demand for energy in our region continues to climb. Our efforts to build resources for future energy needs, along with efforts by regional and local transmission organizations, are progressing. Until these projects are complete, our employees will continue working through unusual challenges in an effort to provide adequate power from the MISO energy market at a fair cost for our customers. Demand for energy in our region continues to climb. Pilot Programs Have the Potential to Generate Savings Through innovative pilot programs, we continue looking for ways to increase value for customers who seek to manage energy costs. Led by the Customer Solutions Development team, Wisconsin Public Service has infused new cost-management possibilities into the consumer and business markets. Most recently, our development team has turned its focus to an innovative energy-saving option for customers. The team is piloting a Thermostat Load Reduction Program, which uses new “smart technologies” to create energy savings. C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 11
Slide 14: Programmable thermostats with automated paging units are installed for a test group of customers in the Wisconsin Public Service area for use during summer’s peak energy-use periods. Temperature settings are controlled automatically by the utility, with cooling points adjusted to reduce energy use during peak times of electric demand. Test participants can also selfmanage their thermostat or override the utility’s settings by visiting a special Web site. The technology provides an alternate solution to help lower cumulative load, especially on peak demand days. customer service. Our utilities increased the promotion of flexible payment options such as Budget Billing, which allows customers to pay average monthly bills, eliminating seasonal lows and highs. When circumstances made it difficult for customers to pay their bills, our customer service representatives negotiated extended pay plans based on the customers’ ability to pay. In some instances, customer assistance advisors provided these customers with information on weatherization, conservation, and other payment assistance options, such as the Federal Home Heating Assistance programs, the Keep Wisconsin Warm fund, and local organizations such as the Salvation Army. Concern for Customers Drives Solutions Concern for customers as heating costs continue to rise has generated new and better ways for our customers and our own companies to control the cost of energy. Gift Certificates Warm Holiday Giving As temperatures dipped in early winter, the popularity of our energy gift certificate program heated up. The certificates, available to both Wisconsin Public Service and Upper Peninsula Power customers, provided a warm and practical way for gift givers, especially during the holiday season, to ease the pinch on others’ energy budgets. Friends and families of utility customers purchased a record 3,121 certificates in the fourth quarter of 2005—a 70 percent increase over the same quarter in the previous year—making it the most successful program year ever. The gift certificates Concern for customers has generated new and better ways to control the cost of energy. Throughout the year, we asked, “What can we do to provide the lowest possible cost, given market conditions? How can we help customers make wise decisions and manage their energy dollars? How can we assist customers on low or fixed incomes who are having difficulty paying their bills?” The answers came in many forms. could be used on natural gas and electric bills. Lift-Off in Houston WPS Energy Services, WPS Resources’ nonregulated energy services company, continues bringing competitive new choices to communities in nonregulated energy markets. In 2005, WPS Energy Services expanded its product offerings to the state of Texas with the opening of a Houston Service Center. Expected to be fully operational in the second quarter of 2006, the office will be staffed by retail electric marketing specialists. Experienced energy traders are also joining the team to help the Gulf region’s independent natural gas producers market their supplies, bridging the gap between producers and consumers. Tools to Understand Costs and Control Energy Use To help customers stretch their energy dollars, Wisconsin Public Service launched an informational campaign via the Web and other media. This alerted customers to energy costs affecting the heating season, offering online tools to help them understand their energy use, as well as outline preventive measures they could take to lower costs. The campaign—with the tagline “Log On. Learn More. Use Less.”—promoted a range of cost-management ideas, from “quick fixes” such as lowering thermostats and simple maintenance, to the purchase of more energy-efficient appliances. A feature on our Web site even helps them forecast their energy costs. Award-Winning Value Online Throughout WPS Resources, a paradigm shift is having a profound effect on value. The growing use of Web-based solutions is delivering value to busy customers, offering 24/7 access to information and resources, contact options, energymanagement tools, and more. In 2005, the Wisconsin Public Service and Upper Peninsula Power Web sites together hosted more than 1,000,000 visits—a 52 percent increase over 2004. Payment Options and Assistance As the year unfolded, providing help with monthly energy bills became increasingly more critical as a component of The Wisconsin Public Service Web site contains helpful information about a host of issues. Our “For Farms” area 12 WPS RESOURCES CORPORATION
Slide 15: “We’ve received more calls than usual this winter from customers who are having trouble paying their bills. I work with a lot of small businesses that are really stretched to absorb the higher energy costs. Their operating budgets are pretty tight. I want to help them find a way to work through this difficult time.” Andy Summers, Credit Management Coordinator at Wisconsin Public Service “The challenge of natural gas rate design is to balance the cost of providing our customers with world-class service while maintaining a reasonable rate for that service.” Les Nishida, Supervisor of Gas Rates for Wisconsin Public Service C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 13
Slide 16: “What’s different about building the Weston 4 plant is the involvement we’ve asked for from the people who will be operating the plant on a daily basis. It’s just one way we’re ensuring that this plant will operate reliably for the next 50 years.” Jeff Jensen, Director of Energy Supply Projects for Wisconsin Public Service 14 WPS RESOURCES CORPORATION
Slide 17: of the site is a case in point. Enhanced Web pages for farm customers deliver farm-specific energy tools and information, including online calculators to assess power use and energy savings of various technologies. Information is also available on our Farm Rewiring Program, including grant and financing resources, safety information, stray voltage information, and links to farm-related sites. Upper Peninsula Power expanded www.uppco.com to help small business owners deal with rising energy costs. Featuring helpful online Equipment Buying and Maintenance Advice, the site addresses the nuts-and-bolts issues of purchasing and maintaining the best heating, cooling, and lighting system equipment. Simply by logging on and learning more, businesses can drive more efficiencies through the systems that account for the lion’s share of their energy bills. WPS Energy Services now offers real-time power data through the Energy Manager portion of its Web site (www.wpsenergy.com). As regional transmission organizations and utilities provide financial incentives for customers to reduce their energy demand during peak pricing periods, up-to-the-minute pricing data becomes more important for customers. The new Power Price Analyst component of the Energy Manager provides day-ahead, hour-ahead, and real-time prices for a variety of electric power markets. Customers can display the information in graphical, tabular, or spreadsheet formats to suit their needs. This new feature reflects the company’s belief that better data means better decisions for our customers. NOx emissions result from burning coal. The proposed project includes not only new equipment, but structural modifications, alterations to existing equipment, and enhanced instrumentation and controls to monitor the upgraded system. While the plant meets current environmental requirements, the new emission-control technologies will reduce emissions further than required by new standards. Power Recycling During construction of the new Weston 4 power plant, near Wausau, Wisconsin, Wisconsin Public Service, with assistance from a company called WasteCap, is undertaking the largest construction waste reduction and recycling program in Wisconsin to date. Better data means better decisions for our customers. Thanks to the shared ingenuity of employees and our construction partners, 85 percent of all waste building materials generated during construction of the plant have been recycled—nearly 3,500 tons of materials since the project’s beginning in 2005. Together, we pitched in and creatively found ways to reuse materials from scrap metal to wood, cardboard to asphalt. More Value to Communities Throughout WPS Resources, we are committed to bringing value to the communities we serve, balancing global vision with local responsibility. Our commitment is evident through wise decisions on issues that impact the world in which we live and work. We develop programs that add to the quality of life, serve with dedication, and act with concern for the environment. than 2,000 tons of rock and reclaimed materials were used in constructing roadways, and 15 tons of drywall scrap was used on nearby farmland as a soil additive. What has been the value of the project? To date, we have achieved a dollar savings of $182,000 in materials. We have also diverted approximately 500 dumpsters’ worth of waste from Wisconsin’s landfills. Ultimately, the true value of the project is our reduced impact on the environment. Proactive Emissions Reductions Value means going beyond basic compliance requirements for the greater good, acting prudently and proactively to reduce emissions. In line with this belief, Wisconsin Public Service has applied to state utility regulators to retrofit new emission-control equipment on the Weston 3 power plant near Wausau, Wisconsin. To cultivate and sustain a culture of value, we first actively If approved, the $7.5 million upgrade will reduce nitrogen oxide (NOx) emissions by 40 percent from existing levels. create value for our employees, offering them opportunities to learn, grow, and contribute to the business. Value to Employees How is value created? It begins with the people of WPS Resources, a concept inherent in our vision of “People Creating a World-Class Energy Company.” C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 15
Slide 18: Our collective effort remains a powerful way to achieve our corporate mission to “Provide Customers with the Best Value in Energy and Related Services.” Collaborative Safety We strongly believe in forming strategic partnerships and involving outside stakeholders in the value process. In a collaborative new program, contractors, trade unions, workers, agencies, and other stakeholders working on the new Weston 4 power plant came together to sign a partnership agreement with the Occupational Safety and Health Administration (OSHA). This new model for safety transforms the role of OSHA from Cultivating World-Class Talent It takes world-class people to create world-class value. Continuous learning and education drives the performance we need as we ask our workforce to stretch their competencies and expand their roles in pursuing excellence. Increasingly, we’re deploying electronic learning options with our employees. This flexible medium allows WPS Resources to offer a wide range of training opportunities to geographically dispersed employees. They can self-manage the process and learn whenever and wherever it fits their needs. Careerdevelopment benefits such as tuition reimbursement and interest-free educational loans encourage learning throughout an individual’s career. We’re deliberate about cultivating new leaders, providing a range of tools from mentoring programs to educating emerging leaders in competencies such as conflict management and strategic thinking. Using talent-management tactics such as succession planning, we proactively manage transitions within the organization. an “enforcer” into a valued resource with a vast wealth of knowledge and experience. The program allows OSHA and its partners to work together to assess areas of mutual concern, identify potential hazards, agree upon individual responsibilities and tactics to meet performance measures, and resolve safety issues that arise. It’s a shared focus built on our mutual concern for sending our employees and partners home healthy every day. Value to Shareholders Throughout 2005, WPS Resources maintained a strategic value focus through savvy asset management. We continued to acquire and dispose of assets, or modify the operations of assets, in a manner that enhanced earnings, mitigated risk, balanced our energy portfolio, and achieved regulated and nonregulated growth. The addition of natural gas distribution operations in Michigan and Minnesota, expected to close in the first half of 2006, will transition WPS Resources to a larger, stronger regional energy company. When the acquisitions are complete, WPS Resources will serve roughly 660,000 natural gas customers through its Increasing value became a compelling responsibility. As demographics change and our customers and the labor pool become increasingly diverse, our diversity initiatives add value throughout the organization. We actively engage the differences that define each individual. This richness of perspectives expands our ability to create, innovate, and meet customer needs. Finally, as management of health care costs becomes a key cost issue for our employees personally, as well as for the organization, we stress preventive care for self and family. Health and wellness partnerships, like our health risk assessment program with a local healthcare leader, strive to help employees make healthy choices in diet, exercise, and early detection of disease. regulated utilities, with annual gas throughput of 189 billion cubic feet. Creative Approach Offers New Paradigm Providing value through customer service must remain a focus during times of rapid growth. We studied many options for providing customer care and related information technology services (including call handling, billing, payment processing, and dispatching) to our future Michigan and Minnesota customers. We performed this analysis to ensure we would maximize not only their service, but also the effectiveness of our current resources and the value our shareholders receive. After carefully considering the costs and benefits of the options before us, we decided to work with a highly respected, experienced customer care provider for these services. 16 WPS RESOURCES CORPORATION
Slide 19: “My role is to sell our organization to students, career centers, campus organizations, clubs, and professors. It’s really very easy, and my excitement for this organization really shows. I truly feel that we are world class, and we are recruiting world-class individuals to join our organization. The key is building relationships, not only with students, but with the centers of influence that revolve around the students.” Laura Charette, Corporate Recruiter for Wisconsin Public Service C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 17
Slide 20: “One of our Competitive Excellence goals is to involve every leader in lean improvement so we can create sustainable change to the ‘way of life’ at our nonregulated entities. I spend a lot of time talking with the leaders, asking them about their plans, what they’re doing to incorporate lean principles, and how we can build on the momentum of change to achieve our Competitive Excellence goals.” Ann Farrell, Director of Competitive Excellence at WPS Energy Services “My group’s mission is to develop an energy asset portfolio that maximizes economic value to the company and its shareholders. We work to optimize our current assets and look at creative ways to develop new assets, such as projects that enhance customer value, lower production costs, or produce renewable energy.” Joel Jansen, Asset Development Manager at WPS Energy Services 18 WPS RESOURCES CORPORATION
Slide 21: This approach will provide a scalable, efficient way to deliver customer care, and allow us to continue concentrating on core business processes during the transition. It’s a new paradigm for our utility business in terms of serving customers. We look forward to the learning our employees will gain, and the benefits for our customers, the company, and our shareholders. Lean Thinking Leads the Way to Competitive Excellence In 2005, increasing value became a compelling responsibility across the enterprise through our new Competitive Excellence initiative. The program grew out of increasing costs and conversations Creating Powerful Synergies Between Generation and Marketing Creating powerful new synergies between our nonregulated generating and marketing businesses in 2005, WPS Resources combined its subsidiaries WPS Energy Services and WPS Power Development which now operate under an integrated business focus that better drives operational efficiency and competitive advantage in the nonregulated market. WPS Energy Services owns and operates about 939 megawatts of nonregulated generation assets, including natural gas, hydroelectric, coal, and alternative energy facilities. with customers, who shared concerns about how rising costs were impacting their competitive stance. These customers challenged us clearly: “What are you doing to control costs?” Based on the Lean Enterprise philosophy, Competitive Excellence is a process approach that gives employees the tools and knowledge to eliminate waste and work more efficiently. Through the program, we’re examining how value is delivered in key business processes and outlining areas of individual employee control and ownership. Employees are exploring how their work connects with the work of others, creating agreed-upon standards of performance, and identifying operational improvements that affect value up and down stream. Any practices that are barriers to value, keeping us from being a lean and agile organization, are identified and resolved. In the end, we permanently reduce costs. Nonregulated Marketplace Energizes Return Rapid expansion of WPS Energy Services’ infrastructure is paving the way for continued growth and solid earnings. One rising star is our Asset Management and Portfolio Optimization capability. Now in its third year, this area is responsible for managing risk and maximizing returns for the entire portfolio of nonregulated generation assets, wholesale customers, and retail sales. The team has generated strong performance throughout 2005 and is helping our integrated business lines in the nonregulated energy marketplace capture economies of scale, deliver clear value to customers, and capitalize on market opportunities. WPS Resources energized people, resources, and new ways of working to deliver value. Sunbury Operates for Maximum Return WPS Energy Services’ Sunbury generation facility, located in Shamokin Dam, Pennsylvania, benefited from favorable market conditions in 2005 and the expiration of a fixed price outtake contract. When the plant was initially purchased in 1999, power from the plant was sold at a predetermined price established in an outtake contract. Now that contract has expired, and the plant can truly operate in the open market. In 2005, warmerthan-normal weather, higher regional demand for electricity, and stronger power prices all led to improved profitability at the Sunbury plant. In line with serving a competitive marketplace, the Sunbury plant will be run differently than in the past. Rather than running every day, the plant will operate when it is most economical to do so—normally anticipated to be during the summer or winter peak demand periods. This will optimize the plant’s operations for maximum return. The Value of Our Commitment As you can see, throughout 2005, WPS Resources energized people, resources, and new ways of working to deliver value in a complex and competitive marketplace. Strong shareholder earnings, engaged community partnerships, and caring customer relationships speak volumes about our commitment to those we serve. The many changes we are making to become a leaner organization, grow in both our utility operations and nonregulated markets, and strengthen our employees’ knowledge base are exciting. When all is said and done, these efforts all have one thing in common—they are designed to improve WPS Resources’ ability to create value. That is our most important task, and we are committed to it. C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 19
Slide 22: FORWARD-LOOKING STATEMENTS This report contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934. You can identify these statements by the fact that they do not relate strictly to historical or current facts and often include words such as “anticipate,” “believe,” “estimate,” “expect,” “intend,” “plan,” “project,” and other similar words. Although we believe we have been prudent in our plans and assumptions, there can be no assurance that indicated results will be realized. Should known or unknown risks or uncertainties materialize, or should underlying assumptions prove inaccurate, actual results could vary materially from those anticipated. Forward-looking statements speak only as of the date on which they are made, and we undertake no obligation to update any forward-looking statements, whether as a result of new information, future events, or otherwise. We recommend that you consult any further disclosures we make on related subjects in our 10-Q, 8-K, and 10-K reports to the Securities and Exchange Commission. The following is a cautionary list of risks and uncertainties that may affect the assumptions which form the basis of forwardlooking statements relevant to our business. These factors, and other factors not listed here, could cause actual results to differ materially from those contained in forward-looking statements. ■ ■ Resolution of audits by the Internal Revenue Service and various state revenue agencies; The effects, extent, and timing of additional competition or regulation in the markets in which WPS Resources Corporation’s subsidiaries operate; The impact of fluctuations in commodity prices, interest rates, and customer demand; Available sources and costs of fuels and purchased power; Ability to control costs (including asset retirement obligations); Investment performance of employee benefit plan assets; Advances in technology; Effects of and changes in political, legal, and economic conditions and developments in the United States and Canada; The performance of projects undertaken by nonregulated businesses and the success of efforts to invest in and develop new opportunities; Potential business strategies, including acquisitions or dispositions of assets or businesses, which cannot be assured to be completed (such as the acquisition of the Michigan and Minnesota natural gas distribution operations from Aquila, construction of the Weston 4 power plant, and construction of the Wausau, Wisconsin, to Duluth, Minnesota, transmission line); The direct or indirect effect resulting from terrorist incidents, natural disasters, or responses to such events; Financial market conditions and the results of financing efforts, including credit ratings and risks associated with commodity prices, interest rates, and counterparty credit; Weather and other natural phenomena; and The effect of accounting pronouncements issued periodically by standard-setting bodies. ■ ■ ■ ■ ■ ■ ■ ■ ■ Timely completion of the purchase of the Michigan and Minnesota natural gas distribution operations from Aquila, Inc. and the successful integration of these businesses, including receipt of the required regulatory approval in Minnesota; ■ ■ Resolution of pending and future rate cases and negotiations (including the recovery of deferred costs) and other regulatory decisions regarding Wisconsin Public Service Corporation and Upper Peninsula Power Company; The impact of recent and future federal and state regulatory changes, including legislative and regulatory initiatives regarding deregulation and restructuring of the electric utility industry, changes in environmental, tax, and other laws and regulations to which WPS Resources Corporation and its subsidiaries are subject, as well as changes in application of existing laws and regulations; Current and future litigation, regulatory investigations, proceedings or inquiries, including manufactured gas plant site cleanup and pending Environmental Protection Agency investigations of Wisconsin Public Service Corporation’s generation facilities, and the Weston 4 air permit; ■ ■ ■ ■ ■ 20 WPS RESOURCES CORPORATION
Slide 23: MANAGEMENT’S DISCUSSION AND ANALYSIS Introduction WPS Resources is a holding company. Our wholly owned subsidiaries include two regulated utilities, Wisconsin Public Service Corporation (WPSC) and Upper Peninsula Power Company (UPPCO). Another wholly owned subsidiary, WPS Resources Capital Corporation, is a holding company for our nonregulated WPS Energy Services, Inc. (ESI) subsidiary. Our regulated and nonregulated businesses have distinct competencies and business strategies, offer differing energy and energy related products and services, experience a wide array of risks and challenges, and are viewed uniquely by management. The following summary provides a strategic overview and insight into the operations of our subsidiaries. ■ At December 31, 2005, WPS Resources owned 31.0% of American Transmission Company LLC (ATC), which is a utility operation that owns, builds, maintains, and operates high voltage electric transmission lines primarily in Wisconsin and Upper Michigan. We continue to increase our ownership interest in ATC through additional equity interest received as consideration for funding a portion of the Duluth, Minnesota, to Wausau, Wisconsin, transmission line. ■ WPSC continues to invest in environmental projects to improve air quality and meet the requirements set by environmental regulators. Capital projects to construct and upgrade equipment to meet or exceed required environmental standards are planned each year. Throughout the 2006 to 2008 time period, WPSC expects to invest approximately $167 million in various environmental projects. ■ In 2006, WPSC entered into a natural gas transportation precedent agreement with Guardian Pipeline, LLC. The agreement is subject to various approvals, including approvals by WPS Resources’ and Guardian’s Boards of Directors as well as approval by the Public Service Commission of Wisconsin (PSCW) and the Federal Energy Regulatory Commission (FERC). The agreement is also contingent upon Guardian Pipeline obtaining financing. To meet the requirements of the agreement, Guardian Pipeline will expand its current pipeline approximately 106 miles in Wisconsin. Integrate Resources to Provide Operational Excellence – WPS Resources is committed to integrating resources of its regulated business units and also its nonregulated business units, while maintaining any and all applicable regulatory restrictions, in order to leverage the individual capabilities and expertise of each unit to provide the best value to all customers. ■ This strategy is demonstrated by the integration of resources at our nonregulated subsidiaries. We started the integration by first implementing tolling agreements to move the market management of our plants to our portfolio management group, reducing our merchant generation market risk. Then we restructured the management teams of ESI and WPS Power Development, LLC (PDI) so that one team oversees all the operations of our nonregulated businesses. ■ This strategy will also be demonstrated in our regulated business by optimally sourcing work and combining resources to achieve best practices of WPSC and the natural gas distribution operations in Michigan and Minnesota (expected to be acquired in the first half of 2006), operational excellence, and sustainable value for customers and shareholders. Strategically Grow Nonregulated Businesses – ESI will grow its electric and natural gas business (through strategic acquisitions, market penetration by existing businesses, and new product offerings) by targeting growth in areas where it has the most market expertise and through “strategic hiring” in other areas. ESI also focuses on optimizing the operational efficiency of its existing portfolio of assets Strategic Overview The focal point of WPS Resources’ business plan is the creation of long-term value for our shareholders through growth, operational excellence, asset management, and risk management and the continued emphasis on reliable, competitively priced, and environmentally sound energy and energy related services for our customers. We are seeking growth of our regulated and nonregulated portfolio and placing an emphasis on regulated growth. A discussion of the essential components of our business plan is set forth below: Maintain and Grow a Strong Regulated Utility Base – We are focusing on growth in our regulated operations. A strong regulated utility base is important in order to maintain a strong balance sheet, more predictable cash flows, a desired risk profile, attractive dividends, and quality credit ratings, which are critical to our success. WPS Resources believes the following recent developments have helped, or will help maintain and grow its regulated utility base: ■ WPSC is expanding its regulated generation fleet in order to meet growing electric demand and ensure continued reliability. Construction of the 500-megawatt coal-fired Weston 4 base-load power plant near Wausau, Wisconsin, is underway, in partnership with Dairyland Power Cooperative (DPC). Commercial operation is expected in 2008. WPSC continues to pursue plans to construct other electric generating facilities and will determine the details relating to fuel type and in-service dates in the future. ■ In September 2005, WPS Resources entered into a definitive agreement with Aquila to acquire its natural gas distribution operations in Michigan and Minnesota. The addition of regulated assets in complementary vicinities to WPS Resources’ existing regulated electric and natural gas operations in Wisconsin and Michigan will transition WPS Resources to a larger and stronger regional energy company. Michigan Public Service Commission (MPSC) approval has already been received for the acquisition of the gas distribution operations in Michigan, while the regulatory process required for approval of the acquisition of the Minnesota operations is progressing on schedule. We expect to complete both transactions in the first half of 2006. C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 21
Slide 24: MANAGEMENT’S DISCUSSION AND ANALYSIS and pursues compatible development projects that strategically fit with its customer base and market expertise. ■ The acquisition of Advantage Energy in July 2004 provided ESI with enhanced opportunities to compete in the New York market and had a positive impact on ESI’s margin in 2005. In 2005, ESI expanded Advantage Energy’s customer base, and began introducing natural gas products to these customers. The increase in Advantage Energy’s customer base was aided by expanding its product offering, including offering both fixed and variable priced products. Prior to ESI’s acquisition of Advantage Energy, only variable priced products were offered. ■ In the third quarter of 2005, ESI began offering retail electric products primarily to large commercial and industrial customers in Illinois. Previously, ESI was only offering natural gas products and energy management services to customers in Illinois. ■ In the fourth quarter of 2005, ESI began developing a product offering in the Texas retail electric market. Due to the thriving Texas market structure (unencumbered by a regulated offering that is not market based) and having been presented with a good opportunity and approach to enter the Texas retail market, ESI hired experienced personnel in that region and expects to be an approved competitive supplier before the end of the second quarter of 2006. ESI previously had a market presence in Houston with natural gas producer services originators. While historically, ESI limited its retail activities to the northeastern quadrant of the United States and adjacent portion of Canada, the entry into the Texas market offers an opportunity to leverage the infrastructure and capability ESI developed to provide products and services that it believes customers will value. ■ ESI began marketing electric products to customers in Massachusetts in 2005 and has had initial success in signing up commercial and industrial customers. Place Strong Emphasis on Asset and Risk Management – One aspect of our asset management strategy calls for the continuing acquisition of assets that complement our existing business and strategy. The utilities are the backbone of our earnings. We expect ESI to provide between 20 and 30 percent of our earnings in the future. Another aspect of this strategy calls for the disposition of assets, including plants and entire business units, which are either no longer strategic to ongoing operations or would reduce our risk profile. The risk management portion of this strategy includes the management of market, credit and operational risk through the normal course of business. ■ The pending acquisitions of Aquila’s natural gas distribution operations in Michigan and Minnesota will transition WPS Resources to a larger and stronger regional energy company. ■ The sale of Sunbury’s allocated emission allowances was completed in May 2005 for $109.9 million. The proceeds received from the sale enabled Sunbury to eliminate its non-recourse debt obligation, which provides greater flexibility as ESI evaluates its options related to Sunbury. These options range from closing the plant, operating the plant only during favorable economic periods, to a future sale. ■ We also sold WPSC’s 59% interest in the Kewaunee plant in July 2005. The major benefits of the Kewaunee sale include transferring financial risk from WPSC’s electric customers and WPS Resources’ shareholders to Dominion, greater certainty of future energy costs through a fixed price power purchase agreement, and being able to return the non-qualified decommissioning funds to our customers. ■ In the fourth quarter of 2005, WPSC sold a 30% interest in the Weston 4 power plant to DPC. The sale of a portion of this plant reduces construction risk associated with the project, considering its magnitude, and reduces WPSC’s funding requirements. Jointly owned plants also reduce the risk profile of WPS Resources. ■ In December 2005, UPPCO sold a portion of real estate no longer needed for operations. The gains from the sale of UPPCO’s real estate assets will be shared between customers and shareholders as approved by the MPSC. We continue to evaluate alternatives for the sale of the balance of our identified real estate holdings no longer needed for operation. ■ Forward purchases and sales of electric capacity, energy, natural gas, and other commodities allow for opportunities to secure prices in a volatile price market. ■ An initiative we call “Competitive Excellence” is being deployed across our entire company. Competitive Excellence strives to eliminate work that does not provide value for our customers. This creates more efficient processes, improves the effectiveness of employees, and reduces costs. Regulated Utilities Our regulated utilities include WPSC and UPPCO. WPSC derives its revenues primarily from the purchase, production, distribution, and sale of electricity, and the purchase, distribution, and sale of natural gas to retail customers in a service area of approximately 11,000 square miles in northeastern Wisconsin and an adjacent portion of the Upper Peninsula of Michigan. The PSCW and the MPSC regulate these retail sales. UPPCO derives revenues from the purchase, production, distribution, and sale of electricity in a service area of approximately 4,500 square miles in the Upper Peninsula of Michigan and is regulated by the MPSC. WPSC and UPPCO both provide wholesale electric service to numerous utilities and cooperatives for resale. FERC regulates wholesale sales. The regulatory commissions allow the utilities to earn a return on common stock equity that is commensurate with an investor’s expected return, compensating for the risks investors face when providing funds to the utility. The return on common stock equity approved by the PSCW, the FERC, and the MPSC was 11.5%, 11.0%, and 11.4%, respectively, in 2005 and 12.0%, 11.0%, and 11.4%, 22 WPS RESOURCES CORPORATION
Slide 25: respectively, in 2004. The utilities bear volume risk as rates are based upon normal sales volumes as projected by the utility. Historically, consumers bear most of the price risk for fuel and purchased power costs as our regulators typically have allowed the utilities to recover most of these costs (to the extent they are prudently incurred), through various cost recovery mechanisms. However, the electric utility is exposed to the risk of not recovering increased fuel costs for Wisconsin retail customers under the current electric fuel recovery rules. Under the Wisconsin fuel recovery mechanism, certain costs are only recoverable on a pro rata basis for the portion of the year after PSCW approval. As such, the ability of our regulated utilities to earn their approved return on equity is dependent upon accurate forecasting, the ability to obtain timely rate increases to account for rising cost structures (while minimizing the required rate increases in order to maintain the competitiveness of our core industrial customer base and keep these customers in our service area), and certain conditions that are outside of their control (such as macroeconomic factors and weather conditions). To mitigate the risk of unrecoverable fuel costs in 2006 due to market price volatility, WPSC is employing risk management techniques pursuant to its risk policy approved by the PSCW, including the use of derivative instruments such as futures and options. On April 1, 2005, Midwest Independent Transmission System Operator (MISO), of which WPSC and UPPCO are members, began operation of its “Day 2” energy market. Within the Day 2 market, MISO centrally dispatches wholesale electricity and provides transmission service to an area mainly in the Midwest. MISO determines prices in the market based on a locational marginal pricing system determined by accepted generation bids and offers and the load to be served by market participants. The introduction of the MISO Day 2 market has shown positive results in that the system allows a more efficient use of the transmission system. In addition to this, the MISO Day 2 market may provide increased opportunities to reduce our generation costs and regulatory risks due to the changes in the regulatory environment explained above. See “Other Future Considerations” in “Liquidity and Capital Resources” below for more information related to MISO. Uncertainties related to the restructuring of the regulated environment are a risk for our regulated utilities. The restructuring of natural gas service has begun in Wisconsin. Currently, some of the largest natural gas customers are purchasing natural gas from suppliers other than their local utility. Efforts are underway to make it easier for smaller natural gas customers to do the same. Restructuring of electric regulation inside Wisconsin is not currently being pursued. The state is focused on improving reliability by building more generation and transmission facilities and creating fair market rules. Restructuring of electric regulation is present in Michigan. In the Upper Peninsula of Michigan, no customers have chosen an alternative electric supplier and few alternative electric suppliers have offered to serve any customers in Michigan’s Upper Peninsula due to lack of transmission access and generating capacity in the areas we serve, which represents a barrier to competitive suppliers entering the market. We have little or no control over some construction risks associated with projects that can negatively affect completion time and project costs. These risks include, but are not limited to, the shortage of or inability to obtain labor or materials, unfavorable weather conditions, events in the economy, and changes in applicable laws or regulations. ESI ESI offers nonregulated natural gas, electric, and alternate fuel supplies, as well as energy management and consulting services, to retail and wholesale customers primarily in the northeastern quadrant of the United States and adjacent portions of Canada. As discussed above, ESI is also developing a product offering in the Texas retail electric market. Although ESI has a wide array of products and services, revenues are primarily derived through sales of electricity and natural gas to retail and wholesale customers. ESI’s marketing and trading operations manage power and natural gas procurement as an integrated portfolio with its retail and wholesale sales commitments and sales of generation from power plants. ESI strives to maintain a low risk portfolio, balancing natural gas and electricity purchase commitments with corresponding sales commitments. In 2005, ESI purchased electricity required to fulfill these sales commitments primarily from independent generators, energy marketers, and organized electric power markets. ESI purchased natural gas from a variety of producers and suppliers under daily, monthly, seasonal, and long-term contracts, with pricing delivery and volume schedules to accommodate customer requirements. ESI’s customers include utilities, municipalities, cooperatives, commercial and industrial consumers, aggregators, and other marketing and retail entities. ESI uses derivative financial instruments to provide flexible pricing to customers and suppliers, manage purchase and sales commitments, and reduce exposure relative to volatile market prices. ESI also owns several merchant electric generation plants, primarily in the Midwest and northeastern United States and adjacent portions of Canada. ESI markets the power from plants not under contract to third parties. ESI utilizes power from its New England and Canadian assets primarily to serve firm load commitments in northern Maine and certain other sales agreements with customers. For most of the remaining capacity available from these plants, ESI utilizes financial tools, including forwards, options, and swaps, to mitigate exposure, as well as to maximize value from the merchant generation fleet. Power purchase agreements are also in place with third-party customers for approximately 90 megawatts of the total capacity, which includes the Stoneman facility in Cassville, Wisconsin, and the Combined Locks facility in Combined Locks, Wisconsin. The table on the next page discloses future natural gas and electric sales volumes under contract as of December 31, 2005. Contracts are generally one to three years in duration. ESI expects that its ultimate sales volumes in 2006 and beyond will exceed the volumes shown in the table as it continues to seek growth opportunities and C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 23
Slide 26: MANAGEMENT’S DISCUSSION AND ANALYSIS existing customers who do not have long-term contracts continue to buy their short-term requirements from ESI. Forward Contracted Volumes at 12/31/2005 (1) Wholesale sales volumes – billion cubic feet Retail sales volumes – billion cubic feet Total natural gas sales volumes Wholesale sales volumes – million kilowatt-hours Retail sales volumes – million kilowatt-hours Total electric sales volumes (1) 2006 107.3 171.1 278.4 13,951 1,962 15,913 2007 13.2 39.7 52.9 4,144 391 4,535 After 2007 4.3 40.3 44.6 3,160 126 3,286 volumes under contract have increased slightly, while retail electric volumes under contract have decreased primarily due to a combination of industry restructuring and high energy prices in the Michigan and Ohio retail electric markets (see “Liquidity and Capital Resources – Other Future Considerations,” for more information). ESI continues to look for opportunities that fit within its growth strategy. In 2004, ESI grew its retail electric business through the acquisition of retail operations in New York. As discussed above, ESI also began developing a product offering in the Texas retail electric market. ESI expects to continue to target acquisitions and increase its customer base in existing markets. As a company that participates in energy commodity markets, ESI is exposed to a variety of risks, including market, operational, liquidity, and credit risks. Market risk is measured as the potential gain or loss of a portfolio that is associated with a price movement within a given probability over a specific period of time, known as Value-at-Risk. Through the use of derivative financial instruments, ESI believes it manages its Value-at-Risk to acceptable levels (see Quantitative and Qualitative Disclosures About Market Risk, for more information about Value-at-Risk). Operational risk is the risk related to execution of transactions, forecasting, scheduling, or other operational activities and is common to all companies participating in the energy marketing industry. ESI’s continued investment in system infrastructure, business process improvement, employee training, and internal controls have helped mitigate operational risk to date. Liquidity risk is risk that has historically been less applicable to ESI than many industry participants because of the financial support provided by WPS Resources in the form of guarantees to counterparties. A significant downgrade in WPS Resources’ credit ratings, however, could cause counterparties to demand additional assurances of payment. WPS Resources’ Board of Directors imposes restrictions on the amount of guarantees WPS Resources is allowed to provide to these counterparties in order to manage this risk. ESI believes it would have adequate capital to continue core operations unless WPS Resources’ credit ratings fall below investment grade (Standard & Poor’s rating of BBB- and Moody’s rating of Baa3). The other category of risk mentioned above that ESI faces is credit risk from retail and wholesale counterparties. In order to mitigate its exposure to credit risk, ESI developed credit policies. As a result of these credit policies, ESI has not experienced significant write-offs from its large wholesale counterparties to date. Write-offs pertaining to retail customers were $0.7 million (0.0%) in 2005 and 2004, and $3.1 million (0.2%), in 2003. ESI believes its writeoff percentage is within the range experienced by similar energy companies. The table at the top of page 25 summarizes wholesale counterparty credit exposure, categorized by maturity date, as of December 31, 2005 (in millions). At December 31, 2005, ESI had net exposure with three investment grade counterparties that were more than 10% of total exposure. Total exposure with these counterparties was $89.3 million and is included in the table on the next page. These tables represent physical sales contracts for natural gas and electric power for delivery or settlement in future periods; however, there is a possibility that some of the contracted volumes reflected in the above table could be net settled. Management has no reason to believe that gross margins that will be generated by these contracts will vary significantly from those experienced historically. For comparative purposes, future natural gas and electric sales volumes under contract at December 31, 2004, are shown below. Actual electric and natural gas sales volumes for 2005 are disclosed within “Results of Operations, ESI Segment Operations.” Forward Contracted Volumes at 12/31/2004 (1) Wholesale sales volumes – billion cubic feet Retail sales volumes – billion cubic feet Total natural gas sales volumes Wholesale sales volumes – million kilowatt-hours Retail sales volumes – million kilowatt-hours Total electric sales volumes After 2006 2.2 8.4 10.6 880 339 1,219 2005 98.1 184.8 282.9 6,890 3,413 10,303 2006 8.0 33.1 41.1 785 1,308 2,093 (1) These tables represent physical sales contracts for natural gas and electric power for delivery or settlement in future periods; however, there is a possibility that some of the contracted volumes reflected in the above table could be net settled. Management has no reason to believe that gross margins that will be generated by these contracts will vary significantly from those experienced historically. Wholesale electric and wholesale natural gas volumes under contract have increased at December 31, 2005, compared to December 31, 2004. Natural gas throughput volumes in Canada continue to increase and more volatile natural gas prices have provided increased structured wholesale natural gas opportunities. The emphasis ESI is placing on its originated wholesale customer electric business is also producing encouraging results, and in the fourth quarter of 2005, ESI added contracts to provide approximately 7,300 million kilowatt-hours of electricity to customers in the future. Despite a challenging price environment, retail natural gas sales 24 WPS RESOURCES CORPORATION
Slide 27: Counterparty Rating (Millions) (1) Exposure $ 7.6 244.5 0.1 10.1 1.3 96.5 $360.1 (2) Exposure Less Than 1 Year $ 7.6 171.9 0.1 10.1 1.3 82.5 $273.5 Exposure 1 to 3 Years $ – 65.5 – – – 12.4 $77.9 Exposure 4 to 5 Years $– 7.1 – – – 1.6 $8.7 Investment grade – regulated utility Investment grade – other Non-investment grade – regulated utility Non-investment grade – other Non-rated – regulated utility Non-rated – other (3) Total Exposure (1) (3) The investment and non-investment grade categories are determined by publicly available credit ratings of the counterparty or the rating of any guarantor, whichever is higher. Investment grade counterparties are those with a senior unsecured Moody’s rating of Baa3 or above or a Standard & Poor’s rating of BBB- or above. Exposure considers netting of accounts receivable and accounts payable where netting agreements are in place as well as netting mark-to-market exposure. Exposure is before consideration of collateral from counterparties. Collateral, in the form of cash and letters of credit, received from counterparties totaled $80.8 million at December 31, 2005, $66.6 million from investment grade counterparties and $14.2 million from non-rated counterparties. Non-rated counterparties include stand-alone companies, as well as unrated subsidiaries of rated companies without parental credit support. These counterparties are subject to an internal credit review process. (2) (3) The $2.0 billion increase in consolidated operating revenue for the year ended December 31, 2005, compared to the same period in 2004, was primarily related to a $1.8 billion (48.4%) increase in revenue at ESI, driven by a 46% increase in the average price of natural gas, higher natural gas throughput volumes in Canada, and an increase in structured natural gas transactions with wholesale customers. Electric utility revenue increased approximately $140 million (15.7%), largely due to an approved electric rate increase for WPSC’s Wisconsin retail customers and an increase in electric sales volumes. Natural gas utility revenue increased approximately $101 million (24.0%), primarily as a result of an increase in the per-unit cost of natural gas, a natural gas rate increase, and higher natural gas throughput volumes. Income available for common shareholders was $157.4 million ($4.11 basic earnings per share) for the year ended December 31, 2005, compared to $139.7 million ($3.74 basic earnings per share) for the year ended December 31, 2004. Significant factors impacting the change in earnings and earnings per share are as follows (and are discussed in more detail below): ■ ESI’s earnings increased $32.4 million (77.7%), for the year ended December 31, 2005, compared to 2004. Higher earnings were driven by an $85.6 million increase in margin, partially offset by a $19.5 million increase in operating and maintenance expenses, a $4.6 million decrease in miscellaneous income, a $1.7 million decrease in Section 29 federal tax credits, and the negative impact of a $1.6 million after-tax cumulative effect of change in accounting principle recorded in 2005. ESI’s earnings were also negatively impacted by an $80.6 million pre-tax impairment loss that was required to write down Sunbury’s long-lived assets to fair market value and the recognition of $9.1 million in interest expense related to the termination of Sunbury’s interest rate swap. However, these losses were substantially offset by an $87.1 million pre-tax gain recognized on the sale of Sunbury’s allocated emission allowances. ■ Earnings at the Holding Company and Other segment decreased $6 million in 2005, compared to 2004, driven by lower gains from land sales, an income tax benefit recognized in 2004 from the donation of land to the Wisconsin Department of Natural Resources (WDNR), and an increase in interest expense. These items were partially offset by higher equity earnings from our investment in ATC. ESI, through a subsidiary ECO Coal Pelletization #12 LLC, also owns an interest in a synthetic fuel producing facility. See “Other Future Considerations,” within the Liquidity section below for more information on the risks related to ESI’s investment in this synthetic fuel operation. ESI is subject to clean air regulations enforced by the United States Environmental Protection Agency (EPA) and state and local governments. New legislation could require significant capital outlays. See Note 17 “Commitments and Contingencies,” in Notes to Consolidated Financial Statements for more information on ESI’s environmental exposure. Results of Operations 2005 Compared with 2004 WPS Resources Overview WPS Resources’ 2005 and 2004 results of operations are shown in the following table: WPS Resources’ Results (Millions, except share amounts) 2005 $6,962.7 $157.4 $4.11 $4.07 2004 $4,950.8 $139.7 $3.74 $3.72 Change 40.6% 12.7% 9.9% 9.4% Consolidated operating revenues Income available for common shareholders Basic earnings per share Diluted earnings per share C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 25
Slide 28: MANAGEMENT’S DISCUSSION AND ANALYSIS ■ Electric utility earnings decreased $4.6 million (6.7%) for the year ended December 31, 2005, compared to 2004. Electric utility earnings were negatively impacted by fuel and purchased power costs that were $13.7 million in excess of what WPSC was allowed to recover from customers due to inefficiencies in the fuel recovery process ($10 million related to retail customers and $3.7 million related to wholesale customers). In addition, the PSCW’s ruling in the 2006 rate case, which disallowed recovery of costs that were deferred related to the 2004 Kewaunee nuclear plant outage and a portion of the loss on the Kewaunee sale, resulted in the write-off of $13.7 million of regulatory assets. ■ Gas utility earnings for the year ended December 31, 2005, decreased $4.1 million, primarily due to an increase in operating and maintenance expenses and depreciation expense incurred by the gas utility. ■ The change in basic earnings per share was also impacted by an increase of 0.9 million shares in the weighted average number of outstanding shares of WPS Resources’ common stock for the year ended December 31, 2005, compared to the same period in 2004. Additional shares were issued in 2005 under the Stock Investment Plan and certain stock-based employee benefit plans. WPS Resources’ issuance of 1.9 million additional shares of common stock through a public offering in November 2005 also contributed to the increase in the weighted average number of shares outstanding. construction of the Weston 4 power plant, and benefit costs. Electric sales volumes increased 8.3%, primarily due to significantly warmer weather during the 2005 cooling season, compared to the same period in 2004, and new power sales agreements that were entered into with wholesale customers. As a result of the warm weather, both WPSC and UPPCO set all-time records for peak electric demand in the second and third quarters of 2005. The electric utility margin decreased $8.2 million (1.4%) for the year ended December 31, 2005, compared to the year ended December 31, 2004. The decrease in margin can be attributed to a $9.0 million (1.6%) decrease in WPSC’s electric margin, which was largely driven by the sale of Kewaunee on July 5, 2005, and the related power purchase agreement. Prior to the sale of Kewaunee, only nuclear fuel expense was reported as a component of fuel and purchased power costs. Subsequent to the sale, all payments to Dominion for power purchased from Kewaunee are reported as a component of fuel and purchased power costs. These include both variable payments for energy delivered and fixed payments. As a result of the sale, WPSC no longer incurs operating and maintenance expense, depreciation and decommissioning expense, or interest expense for Kewaunee. Excluding the $43.2 million of fixed payments made to Dominion in 2005, WPSC’s electric utility margin increased $34.2 million compared to 2004. Excluding the fixed payments, the increase in margin was primarily related to the approved 2005 retail electric rate increase discussed above and the warm summer weather conditions, partially offset by higher fuel and purchased power costs associated with high natural gas prices and the PSCW’s disallowance of certain costs in its decision on the 2006 rate case for WPSC (these costs were previously approved for deferral). Fuel and purchased power costs incurred in 2005 exceeded the amount recovered from ratepayers by $13.7 million (of which $10 million related to Wisconsin retail customers and $3.7 million related to wholesale customers), negatively impacting margin. The increase in fuel and purchased power costs resulted primarily from the destruction of certain natural gas production facilities in the Gulf of Mexico by hurricanes in the third quarter of 2005, driving up the per-unit cost of natural gas used in generation. The quantity of power generated from WPSC’s natural gas-fired units was also up 162% over the prior year, driven by the warm summer weather conditions experienced during 2005, increased dispatch by the MISO for reliability purposes, and purchases through a purchase power agreement from the Fox Energy Center (which began operating in June 2005). Certain costs related to the MISO were approved for deferral. Authorization was requested from the PSCW to defer increased natural gas costs related to the hurricanes, but this request was denied, leaving the Wisconsin fuel recovery mechanism as the only option for recovery. However, because of the way the Wisconsin fuel recovery mechanism works, the increase in fuel and purchased power costs (primarily related to the combination of rising natural gas prices caused by the hurricanes and the increase in natural gas-fired generation) were essentially unrecoverable since they were incurred late in the year. To mitigate the risk of unrecoverable fuel costs in 2006 due to market price volatility, WPSC is employing risk management techniques pursuant Overview of Utility Operations Utility operations include the electric utility segment, consisting of the electric operations of WPSC and UPPCO, and the gas utility segment comprising the natural gas operations of WPSC. Income available for common shareholders attributable to the electric utility segment was $64.2 million for the year ended December 31, 2005, compared to $68.8 million for the year ended December 31, 2004. Income available for common shareholders attributable to the gas utility segment was $13.2 million for the year ended December 31, 2005, compared to $17.3 million for the year ended December 31, 2004. Electric Utility Segment Operations WPS Resources’ Electric Utility Segment Results (Millions) 2005 $1,037.1 444.2 $ 592.9 15,660.1 2004 $896.6 295.5 $601.1 14,465.7 Change 15.7% 50.3% (1.4%) 8.3% Revenues Fuel and purchased power costs Margins Sales in kilowatt-hours Electric utility revenue increased $140.5 million (15.7%) for the year ended December 31, 2005, compared to the same period in 2004. Electric utility revenue increased largely due to an approved electric rate increase for WPSC’s Wisconsin retail customers and an increase in electric sales volumes. On December 21, 2004, the PSCW approved a retail electric rate increase of $60.7 million (8.6%), effective January 1, 2005. The rate increase was required primarily to recover increased costs related to fuel and purchased power, the 26 WPS RESOURCES CORPORATION
Slide 29: to its risk policy approved by the PSCW, including the use of derivative instruments such as futures and options. The PSCW also disallowed recovery of $5.5 million of increased fuel and purchased power costs related to an extended outage at Kewaunee in 2004, resulting in this deferral being written off in the fourth quarter of 2005. Electric utility earnings decreased $4.6 million (6.7%) for the year ended December 31, 2005, compared to 2004. The decrease in earnings resulted from the high fuel and purchased power costs that WPSC was unable to recover from its Wisconsin retail and wholesale customers, the PSCW’s disallowance of previously deferred costs related to Kewaunee, and an increase in operating and maintenance expenses. Gas Utility Segment Operations WPS Resources’ Gas Utility Segment Results (Millions) Overview of ESI Operations ESI offers nonregulated natural gas, electric, and alternative fuel supplies, as well as energy management and consulting services, to retail and wholesale customers. ESI also owns several merchant electric generation plants, primarily in the Midwest and Northeastern United States and adjacent portions of Canada. Prior to the fourth quarter of 2005, WPS Resources reported two nonregulated segments, ESI and PDI. In the fourth quarter of 2005, WPS Resources’ Chief Executive Officer and its Board of Directors decided to view ESI and PDI as one business, and corresponding changes were made to the segment information reported to them. The change in reportable segments is the culmination of changes over the past two years that caused these businesses to become integrated. These changes included combining the management teams, restructuring the ownership structure of ESI and PDI, and having ESI optimize the value of PDI’s merchant generation fleet and reduce market price risk through the use of various financial and physical instruments (such as futures, options, and swaps). Effective in the fourth quarter of 2005, WPS Resources began reporting one nonregulated segment, ESI. Segment information related to prior periods has been reclassified to reflect this change. Income available for common shareholders attributable to ESI was $74.1 million for the year ended December 31, 2005, compared to $41.7 million for the year ended December 31, 2004. ESI’s Segment Operations (Millions, except natural gas sales volumes) 2005 $522.0 397.4 $124.6 827.2 2004 $420.9 301.9 $119.0 801.3 Change 24.0% 31.6% 4.7% 3.2% Revenues Purchased gas costs Margins Throughput in therms Gas utility revenue increased $101.1 million (24.0%) for the year ended December 31, 2005, compared to 2004. Gas utility revenue increased primarily as a result of an increase in the per-unit cost of natural gas, a natural gas rate increase, and higher natural gas throughput volumes. Natural gas costs increased 24.6% (on a per-unit basis) for the year ended December 31, 2005, compared to 2004. Following regulatory practice, WPSC passes changes in the total cost of natural gas on to customers through a purchased gas adjustment clause, as allowed by the PSCW and the MPSC. The PSCW issued an order authorizing a natural gas rate increase of $5.6 million (1.1%), effective January 1, 2005. The rate increase was primarily driven by higher benefit costs and the cost of natural gas distribution system improvements. Natural gas throughput volumes increased 3.2%, driven by an increase in interdepartmental sales from the natural gas utility to the electric utility as a result of increased generation from combustion turbines. Higher natural gas throughput volumes from interdepartmental sales to the electric utility were partially offset by lower natural gas throughput volumes to residential customers, driven by milder weather conditions in 2005, compared to 2004. WPSC also believes customers are taking measures to conserve energy as a result of the high natural gas prices. The natural gas utility margin increased $5.6 million (4.7%) for the year ended December 31, 2005, compared to 2004. The higher natural gas utility margin was largely due to the rate increase mentioned above. The increase in interdepartmental sales volumes to WPSC’s electric utility also had a positive impact on the natural gas margin. Gas utility earnings for the year ended December 31, 2005, decreased $4.1 million, primarily due to an increase in operating and maintenance expenses and depreciation expense incurred by the gas utility. 2005 $5,452.1 5,227.8 $ 224.3 274.0 281.2 2,770.6 6,626.9 2004 $3,674.2 3,535.5 $ 138.7 235.4 276.7 5,256.5 7,235.7 Change 48.4% 47.9% 61.7% 16.4% 1.6% (47.3%) (8.4%) Nonregulated revenues Nonregulated cost of fuel, natural gas, and purchased power Margins Wholesale natural gas sales volumes in billion cubic feet * Retail natural gas sales volumes in billion cubic feet * Wholesale electric sales volumes in kilowatt-hours * Retail electric sales volumes in kilowatt-hours * * Represents gross physical volumes. Revenues ESI’s revenue increased $1.8 billion (48.4%) for the year ended December 31, 2005, compared to 2004. Natural gas revenue increased $1.7 billion (54.8%), driven by a 46% increase in the average price of natural gas, higher natural gas throughput volumes in Canada, and an increase in structured natural gas transactions with wholesale customers. Electric revenue increased approximately $118 million, largely due to an $88 million increase in revenue from retail electric operations in New York, resulting from an increase in the per-unit price of electricity sold and a 115% increase in sales volumes (the New York business had its first full year of operation in 2005). Revenue at ESI’s Sunbury generation facility (Sunbury) C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 27
Slide 30: MANAGEMENT’S DISCUSSION AND ANALYSIS increased $56 million, due to improved opportunities to sell power into the market (made possible by the expiration of a fixed price outtake contract on December 31, 2004, and higher energy market prices). Revenue also increased due to an increase in structured energy transactions. These items were partially offset by a $78.2 million decrease in wholesale electric revenue related to ESI’s prior participation in the New Jersey Basic Generation Services Program, which ended on May 31, 2004, and a $31.1 million decrease in revenue from retail electric operations in Michigan, driven by lower sales volumes in 2005. Margins ESI’s margins increased $85.6 million (61.7%), from $138.7 million for the year ended December 31, 2004, to $224.3 million for 2005. Many items contributed to the year-over-year net increase in margin and, as a result, a table has been provided to summarize significant changes. Variances included under “Other significant items” in the table below are related to the timing of gain and loss recognition on certain transactions pursuant to generally accepted accounting principles and gains and losses that do not frequently occur in ESI’s business. All variances depicted in the table are discussed in more detail below. Increase (Decrease) in Margin in 2005 Compared to 2004 $43.7 7.5 3.0 (15.7) 25.1 8.7 8.2 80.5 margin. The profitability and volume of transactions related to ESI’s optimization strategies were higher due to increased variability in the price of energy in 2005 compared to 2004. In the first quarter of 2004, ESI first implemented the portfolio optimization strategies to optimize the value of the merchant generation fleet to reduce market price risk and extract additional value from these assets through the use of various financial and physical instruments (such as forward contracts and options). ■ New York retail – The first full year of retail electric operations in New York (as discussed in “Revenues” above) contributed $3.0 million to the overall margin increase. ■ Michigan retail – The margin contributed by retail electric operations in Michigan decreased $15.7 million in 2005, compared to 2004. Higher transmission-related charges resulting from the Seams Elimination Charge Adjustment, which was implemented on December 1, 2004, and continues through March 2006, as ordered by the FERC, have negatively impacted the margin from retail electric operations in Michigan. In addition, tariff changes granted to the regulated utilities in Michigan in 2004, coupled with high wholesale energy prices, have significantly lowered the savings customers can obtain from contracting with non-utility suppliers. The tariff changes enable Michigan utilities to charge a fee to electric customers choosing non-utility suppliers in order to recover certain stranded costs. ESI has experienced significant customer attrition as a result of the tariff changes and higher wholesale prices. Customer attrition, high wholesale energy prices, and the tariff changes have also negatively impacted the margin from retail electric operations in Michigan. ■ All other electric operations – A $25.1 million increase in margin was primarily related to realized and unrealized gains on structured power transactions in the latter half of 2005. These transactions included the execution of purchase and sales contracts with municipalities, merchant generators, retail aggregators, and other power marketers made possible by changing market conditions. Additionally, ESI experienced increased margins from its merchant generation fleet as a result of increased dispatch levels due to improved market conditions. Period-by-period variability in the margin contributed by structured transactions and the merchant generation fleet is expected due to constantly changing market conditions and the timing of gain and loss recognition on certain transactions pursuant to generally accepted accounting principles. ■ Oil option activity, net – Mark-to-market gains recognized in 2005 on derivative instruments utilized to protect the value of a portion of ESI’s Section 29 federal tax credits in 2006 and 2007 contributed $8.4 million to the increase in margin. The derivative contracts have not been designated as hedging instruments and, as a result, changes in the fair value are recorded currently in earnings. This will result in mark-to-market gains being recognized in different periods, compared to any offsetting tax credit phaseouts that may occur. For the year ended December 31, 2005, unrealized mark-to-market gains of $4.0 million and $4.4 million (Millions, except natural gas sales volumes) Electric and other margins Sunbury generation Physical asset management New York retail Michigan retail All other electric operations Other significant items: Oil option activity, net Liquidation of electric purchase contract Net increase in electric and other margins Natural gas margins Gas margins (principally Canada, Michigan, and Wisconsin retail markets) Other significant items: Counterparty settlement Unrealized gain on Ohio options Spot to forward differential Net increase in natural gas margins Net increase in ESI margin 6.1 3.3 2.9 (7.2) 5.1 $85.6 ESI’s electric and other margins increased $80.5 million (98.1%) for the year ended December 31, 2005, compared to 2004. The following items were the most significant contributors to the net change in ESI’s electric and other margins: ■ Sunbury generation – The margin at Sunbury increased $43.7 million, primarily due to improved opportunities to sell power into the market (as discussed in “Revenues” above). ■ Physical asset management – Optimization strategies related to ESI’s generation facilities resulted in a $7.5 million increase in 28 WPS RESOURCES CORPORATION
Slide 31: were recognized for the 2006 and 2007 oil options, respectively, while no tax credit phase-out was recognized because 2006 and 2007 tax credits will not be recognized until fuel is produced and sold in those periods. Hedges of 2005 exposure contributed an additional $0.3 million increase in margin ($1.9 million gain on settlement, net of $1.6 million of premium amortization). ■ Liquidation of electric purchase contract – In 2005, an electricity supplier exiting the wholesale market in Maine forced ESI to liquidate a firm contract to buy power in 2006 and 2007. ESI recognized a gain of $8.2 million related to the liquidation of this contract, and entered into a new contract with another supplier for firm power in 2006 and 2007 to supply its customers in Maine. The cost to purchase power under the new contract will be more than the cost under the liquidated contract. As a result, purchased power costs will be $6.4 million higher in 2006 and slightly higher than the original contracted amount in 2007, substantially offsetting the 2005 gain. The natural gas margin at ESI increased $5.1 million (9.0%) for the year ended December 31, 2005, compared to 2004. The following items were the most significant contributors to the change in ESI’s natural gas margin: ■ Gas margins (principally Canada, Michigan, and Wisconsin retail) – Major contributors to growth in ESI’s gas margins include the continued expansion of our Canadian retail and wholesale business, as well as increased margins from our retail operations in Michigan and Wisconsin. ■ Counterparty settlement – The natural gas margin increased $3.3 million as a result of a favorable settlement with a counterparty. ■ Unrealized gain on Ohio options – A $2.9 million mark-to-market gain on options utilized to manage supply costs for Ohio customers, which expire in varying months through September 2006, also contributed to the margin increase. These contracts are utilized to reduce the risk of price movements and changes in load requirements during customer signup periods. Earnings volatility results from the application of derivative accounting rules to the options (requiring that these derivative instruments be marked-to-market), without a corresponding offset related to the customer contracts. Full requirements gas contracts with ESI’s customers are not considered derivatives and, therefore, no gain or loss is recognized on these contracts until settlement. ■ Spot to forward differential – The natural gas storage cycle (described in more detail below) accounted for a $7.2 million decrease in the wholesale natural gas margin (for the year ended December 31, 2005, the natural gas storage cycle had a $5.2 million negative impact on margin, compared with a $2.0 million favorable impact on margin for the same period in 2004). ESI experiences earnings volatility associated with the natural gas storage cycle, which runs annually from April through March of the next year. Generally, injections of natural gas into storage inventory take place in the summer months and natural gas is withdrawn from storage in the winter months. ESI’s policy is to hedge the value of natural gas storage with sales in the over-the-counter and futures markets, effectively locking in a margin on the natural gas in storage. However, fair market value hedge accounting rules require the natural gas in storage to be marked-to-market using spot prices, while the future sales contracts are marked-to-market using forward prices. When the spot price of natural gas changes disproportionately to the forward price of natural gas, ESI experiences volatility in its earnings. Consequently, earnings volatility may occur within the contract period for natural gas in storage. The accounting treatment does not impact the underlying cash flows or economics of these transactions. At December 31, 2005, there was a $5.8 million difference between the market value of natural gas in storage and the market value of future sales contracts (net unrealized loss), related to the 2005/2006 natural gas storage cycle. This difference between the market value of natural gas in storage and the market value of future sales contracts related to the 2005/2006 storage cycle is expected to vary with market conditions, but will reverse entirely and have a positive impact on earnings when all of the natural gas is withdrawn from storage. Earnings ESI’s earnings increased $32.4 million (77.7%), for the year ended December 31, 2005, compared to 2004. Higher earnings were driven by the $85.6 million increase in margin, partially offset by a $19.5 million increase in operating and maintenance expenses, a $4.6 million decrease in miscellaneous income, a $1.7 million decrease in Section 29 federal tax credits, and the negative impact of a $1.6 million after-tax cumulative effect of change in accounting principle recorded in 2005. ESI’s earnings were also negatively impacted by an $80.6 million pre-tax impairment loss that was required to write down Sunbury’s long-lived assets to fair market value and the recognition of $9.1 million in interest expense related to the termination of Sunbury’s interest rate swap. However, these losses were substantially offset by an $87.1 million pre-tax gain recognized on the sale of Sunbury’s allocated emission allowances. Overview of Holding Company and Other Segment Operations Holding Company and Other operations include the operations of WPS Resources’ and the nonutility activities at WPSC and UPPCO. Holding Company and Other operations recognized earnings of $5.9 million during the year ended December 31, 2005, compared to earnings of $11.9 million in 2004. The decrease in earnings is primarily due to a $9.4 million decrease in pre-tax gains related to land sales, an income tax benefit recognized in 2004 from the donation of land to the WDNR, and a $5.5 million increase in interest expense. Pretax land sale gains of $10.3 million were recognized in 2005, compared to $19.7 million of pre-tax land sale gains in 2004. Interest expense increased primarily as a result of restructuring Sunbury’s debt to a WPS Resources’ obligation in June 2005 and higher average shortterm debt in 2005, compared to 2004. Partially offsetting the items discussed above was a $9.1 million increase in pre-tax equity earnings from ATC and $1.5 million of deferred financing costs that were written C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 29
Slide 32: MANAGEMENT’S DISCUSSION AND ANALYSIS off in the first quarter of 2004. Pre-tax equity earnings from ATC were $25.1 million in 2005, compared to $16.0 million in 2004. WPS Resources’ ownership interest in ATC increased from approximately 23% at December 31, 2004, to approximately 31.0% at December 31, 2005. The higher ownership interest was primarily the result of WPS Resources continued funding of a portion of the Wausau, Wisconsin, to Duluth, Minnesota, transmission line. activities were performed in 2005 to better ensure the plant’s ability to capitalize on high market prices. Depreciation and Decommissioning Expense Depreciation and decommissioning expense increased $35.8 million (33.5%) for the year ended December 31, 2005, compared to 2004, largely due to an increase of $35.0 million at WPSC. The increase at WPSC was driven by higher gains on decommissioning trust assets prior to the sale of Kewaunee of approximately $35 million. Realized gains on decommissioning trust assets (included as a component of miscellaneous income) offset the increased decommissioning expense pursuant to regulatory practice. Continued capital investment at WPSC also resulted in an increase in depreciation expense. These items were partially offset by a $7.0 million decrease in depreciation resulting from the sale of the Kewaunee assets in July 2005. Gain on Sale of Emission Allowances ESI completed the sale of Sunbury’s allocated emission allowances in May 2005. The sales proceeds were $109.9 million, resulting in a pre-tax gain of $85.9 million. ESI also sold other emission allowances throughout the year, recognizing a gain on these additional sales of $1.2 million. Impairment Loss The sale of Sunbury’s allocated emission allowances in May 2005 provides ESI with more time to evaluate various options related to Sunbury. These options range from closing the plant, retaining the plant and operating it during favorable economic periods, or a future sale. Because ESI is no longer committed to the sale of Sunbury as its only option, generally accepted accounting principles require all long-lived assets that were previously classified as “held for sale” to be reclassified as “held and used” at the lower of their carrying value before they were classified as “held for sale,” adjusted for depreciation that would have been recognized had the assets been continuously classified as “held and used,” or fair value at the date the “held for sale” criteria was no longer met. Upon reclassification of the Sunbury plant and related assets as “held and used” in the second quarter of 2005, ESI recorded a non-cash, pre-tax impairment charge of $80.6 million. The impairment charge reflects the reduction in the fair value of the Sunbury plant without the related emission allowances. Operating Expenses WPS Resources’ Operating Expenses (Millions) 2005 $568.1 142.8 (87.1) 80.6 47.9 2004 $537.6 107.0 – – 46.1 Change 5.7% 33.5% – – 3.9% Operating and maintenance expense Depreciation and decommissioning expense Gain on sale of emission allowances Impairment loss Taxes other than income Operating and Maintenance Expense Operating and maintenance expenses increased $30.5 million (5.7%) for the year ended December 31, 2005, compared to 2004. Utility operating and maintenance expenses increased $12.9 million, primarily as a result of a $13.6 million increase in WPSC’s operating and maintenance expenses. The following items were the most significant contributors to the change in operating and maintenance expenses at WPSC: ■ The combined increase in pension expense, active and postretirement medical expense, salaries, and customer service expense was approximately $25 million. ■ Transmission-related expenses increased $9.9 million. ■ In WPSC’s 2006 rate case, the PSCW concluded that only half of the loss related to the sale of Kewaunee could be collected from ratepayers. As a result, WPSC wrote off $6.1 million of the regulatory asset established for the loss on the sale of Kewaunee. ■ In WPSC’s 2006 rate case, the PSCW also disallowed recovery of increased operating and maintenance expenses related to the 2004 extended outage at Kewaunee, resulting in a $2.1 million write-off of previously deferred costs. ■ The increases discussed above were partially offset by a decrease in operating and maintenance expenses of approximately $28 million related to Kewaunee, due to the sale of this facility on July 5, 2005. Operating and maintenance expenses at ESI increased $19.5 million. Approximately $11 million of the increase related to higher payroll and benefit costs associated with recent business expansion. Commissions paid to brokers and third-party agents increased $2.4 million and bad debt expense increased $2.3 million, primarily as a result of higher energy prices. Operating and maintenance expenses at Sunbury also increased $2.7 million. Maintenance Other Income (Expense) WPS Resources’ Other Income (Expense) (Millions) 2005 $86.2 (72.4) 4.5 $18.3 2004 $52.0 (59.9) 3.4 $ (4.5) Change 65.8% 20.9% 32.4% – Miscellaneous income Interest expense Minority interest Other (expense) income Miscellaneous Income Miscellaneous income increased $34.2 million (65.8%) for the year ended December 31, 2005, compared to 2004. The following items were the largest contributors to the change in miscellaneous income: 30 WPS RESOURCES CORPORATION
Slide 33: ■ Approximately $35 million of the increase in miscellaneous income related to realized gains on nuclear decommissioning trust assets. The nonqualified decommissioning trust assets were placed in more conservative investments in the second quarter of 2005 in anticipation of the sale of Kewaunee, which was completed on July 5, 2005. Pursuant to regulatory practice, the increase in miscellaneous income related to the realized gains was offset by an increase in decommissioning expense. Overall, the change in the investment strategy for the nonqualified decommissioning trust assets had no impact on income available for common shareholders. ■ Pre-tax equity earnings from WPS Resources’ investment in ATC increased $9.1 million. Pre-tax equity earnings from ATC were $25.1 million in 2005, compared to $16.0 million in 2004. ■ WPSC sold a 30% interest in the Weston 4 power plant to DPC in the fourth quarter of 2005. Proceeds received from the sale included reimbursement for approximately $8 million of carrying costs incurred by WPSC for capital expenditures related to DPC’s portion of the facility, which were funded by WPSC in 2004 and 2005. The $8 million reimbursement was recorded as miscellaneous income in 2005. ■ Land sale gains of $10.3 million were recognized in 2005, compared to land sale gains of $19.7 million in 2004, resulting in a $9.4 million decrease in miscellaneous income. ■ Other income at ESI decreased $4.6 million, primarily related to a $4.4 million termination payment received from Duquesne Power in December 2004 as a result of Duquesne’s termination of the former asset purchase agreement for Sunbury. Interest Expense Interest expense increased $12.5 million (20.9%) for the year ended December 31, 2005, compared to 2004. The increase in interest expense was primarily related to terminating the interest rate swap pertaining to Sunbury’s non-recourse debt obligation in the second quarter of 2005. The interest rate swap was previously designated as a cash flow hedge and, as a result, the mark-to-market losses had been recorded as a component of other comprehensive income. WPS Resources is required to recognize the amount accumulated within other comprehensive income as a component of interest expense when the hedged transactions (future interest payments on the Sunbury debt obligation) are no longer probable of occurring. As a result, the restructuring of the Sunbury non-recourse debt to a WPS Resources’ obligation in June 2005 triggered the recognition of $9.1 million of interest expense related to the mark-to-market value of the swap at the date of restructuring. The remaining increase in interest expense was primarily related to an increase in the average level of short-term debt outstanding in 2005, compared to 2004. increase in income before taxes, while Section 29 federal tax credits recognized decreased $1.7 million. Other factors contributing to the increase in the effective tax rate in 2005, compared to 2004, were a tax benefit recorded in 2004 for land donated to the WDNR, and a $2.9 million increase in the year-over-year provision for income taxes related to favorable settlements of certain tax audits and refund claims in 2004. Our ownership interest in the synthetic fuel operation resulted in recognizing the tax benefit of Section 29 federal tax credits totaling $26.1 million in 2005 and $27.8 million in 2004. Cumulative Effect of Change in Accounting Principles In March 2005, the Financial Accounting Standards Board (FASB) issued Interpretation No. 47, Accounting for Conditional Asset Retirement Obligations. This Interpretation clarifies when companies are required to recognize conditional legal asset retirement obligations that result from the acquisition, construction, and normal operation of a long-lived asset. Because the accounting for conditional asset retirement obligations has been interpreted differently between companies, Statement of Financial Accounting Standards (SFAS) No. 143, Accounting for Asset Retirement Obligations, had been inconsistently applied in practice. The adoption of Interpretation No. 47 at ESI on December 31, 2005, resulted in a negative $1.6 million after-tax cumulative effect of change in accounting principle, related to recording a liability for asbestos remediation at certain of ESI’s generation plants. For the utility segments of WPS Resources, we concluded it was probable that any differences between expenses under Interpretation No. 47 and expenses currently recovered through customer rates will be recoverable in future customer rates. Accordingly, the adoption of this statement had no impact on the utility segments’ income. 2004 Compared with 2003 WPS Resources Overview WPS Resources’ 2004 and 2003 results of operations are shown in the following table: WPS Resources’ Results (Millions, except share amounts) 2004 $4,950.8 $139.7 $3.74 $3.72 2003 $4,402.5 $94.7 $2.87 $2.85 Change 12.5% 47.5% 30.3% 30.5% Consolidated operating revenues Income available for common shareholders Basic earnings per share Diluted earnings per share Provision for Income Taxes The effective tax rate was 22.4% for the year ended December 31, 2005, compared to 13.2% for the year ended December 31, 2004. The increase in the effective tax rate was primarily driven by a 26.9% The $548.3 million increase in consolidated operating revenue for the year ended December 31, 2004, compared to the same period in 2003, was largely driven by a $449.6 million (13.9%) increase in revenue at ESI and an $82.5 million (10.1%) increase in electric utility revenue. Higher natural gas prices, portfolio optimization strategies (implemented in 2004), and expansion of the Canadian C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 31
Slide 34: MANAGEMENT’S DISCUSSION AND ANALYSIS retail natural gas business were the primary contributors to increased revenue at ESI. Higher electric utility revenue was primarily the result of authorized retail electric rate increases for WPSC’s Wisconsin and Michigan customers. Revenue changes by reportable segment are discussed in more detail below. Income available for common shareholders was $139.7 million ($3.74 basic earnings per share) for the year ended December 31, 2004, compared to $94.7 million ($2.87 basic earnings per share) for the year ended December 31, 2003. Significant factors impacting the change in earnings and earnings per share are as follows (and are discussed in more detail below). ■ Approved rate increases (including the impact of timely retail electric rate relief in 2004, compared to the delay in receiving retail electric rate relief in 2003) favorably impacted year-over-year margin at the utilities. ■ Natural gas utility throughput volumes were 6.2% lower in 2004 due to weather that was 4.3% warmer during the heating season, compared to 2003. ■ Higher throughput volumes and improved supply management in Ohio favorably impacted ESI’s year-over-year retail natural gas margin. ■ Portfolio optimization strategies, better management of retail electric operations in Ohio and positive operating results from Advantage Energy contributed to improved year-over-year electric margins at ESI. ■ As part of our overall asset management strategy, WPS Resources realized earnings of $15.0 million from the sale and donation of land in 2004, compared to $6.5 million in 2003. ■ Earnings from equity method investments (primarily from ATC) increased in 2004, compared to 2003. ■ Earnings were negatively impacted by higher operating and maintenance expenses in 2004. ■ Synthetic fuel related tax credits recognized were higher in 2004 when compared to 2003. ■ The weighted average number of shares of WPS Resources’ common stock increased by 4.4 million shares for the year ended December 31, 2004, compared to the same period in 2003. The increase was largely due to issuing 4,025,000 additional shares of common stock through a public offering in November 2003. Additional shares were also issued under the Stock Investment Plan and certain stock-based employee benefit plans. 2003. Income available for common shareholders attributable to the gas utility segment was $17.3 million for the year ended December 31, 2004, compared to $15.7 million for the year ended December 31, 2003. Electric Utility Segment Operations WPS Resources’ Electric Utility Segment Results (Millions) 2004 $896.6 295.5 $601.1 14,465.7 2003 $814.1 266.3 $547.8 14,346.7 Change 10.1% 11.0% 9.7% 0.8% Revenues Fuel and purchased power costs Margins Sales in kilowatt-hours Electric utility revenue increased $82.5 million (10.1%), for the year ended December 31, 2004, compared to the same period in 2003. Electric utility revenue increased largely due to authorized retail and wholesale electric rate increases for WPSC’s Wisconsin and Michigan customers (as summarized below) to recover higher fuel and purchased power costs, increased operating expenses, and expenditures incurred for infrastructure improvements. ■ Effective March 21, 2003, the PSCW approved a retail electric rate increase of $21.4 million (3.5%). ■ Effective May 11, 2003, the FERC approved a $4.1 million (21%), interim increase in wholesale electric rates. ■ Effective July 22, 2003, the MPSC approved a $0.3 million (2.2%), increase in retail electric rates for WPSC’s Michigan customers and authorized recovery of $1.0 million of increased transmission costs through the power supply cost recovery process. ■ Effective January 1, 2004, the PSCW approved a retail electric rate increase of $59.4 million (9.3%). Electric utility sales volumes were also slightly higher in 2004, increasing 0.8% over 2003 sales volumes. A 1.6% increase in sales volumes to commercial and industrial customers was partially offset by a 1.2% decrease in sales volumes to residential customers. Higher sales volumes to our commercial and industrial customers reflect an improving economy and growth within our service area, while the decrease in sales volumes to residential customers reflects weather that was 6.6% cooler during the 2004 cooling season, compared to 2003. The electric utility margin increased $53.3 million (9.7%), for the year ended December 31, 2004, compared to 2003. The majority of this increase can be attributed to a $52.3 million (10.5%), increase in WPSC’s electric margin. The increase in WPSC’s electric margin is primarily related to the retail and wholesale electric rate increases, partially offset by a $20.4 million increase in purchased power costs. The quantity of power purchased in 2004 increased 9.3% over 2003 purchases, and purchased power costs were 17.4% higher (on a perunit basis) in 2004, compared to 2003. The PSCW, in 2004, allowed WPSC to adjust prospectively the amount billed to Wisconsin retail Overview of Utility Operations Income available for common shareholders attributable to the electric utility segment was $68.8 million for the year ended December 31, 2004, compared to $60.0 million for the year ended December 31, 32 WPS RESOURCES CORPORATION
Slide 35: “WPS Resources aspires to prudently expand its utility businesses. The announced acquisition of natural gas distribution assets in Michigan and Minnesota provides a unique opportunity to continue our proven and successful strategy of creating value through customer focus, capital investment in our regulated assets, and efficient operations. The transaction announcement was well received by the markets, and we are pleased to bring our utility services to the customers of our neighboring states.” Boris Brevnov, Vice President – Business Development and Implementation, WPS Energy Services, on his role in WPS Resources’ recent acquisition “Our wellness program is really a grassroots initiative. Regional committees become involved in deciding what wellness activities they would like to do. They also make sure the wellness activities complement our long-standing safety programs and activities. That way, both programs and the employees who participate in them get maximum results.” Stephanie Wavrunek, Health and Wellness Consultant at Wisconsin Public Service C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 33
Slide 36: MANAGEMENT’S DISCUSSION AND ANALYSIS customers for fuel and purchased power if costs were in excess of plus or minus 2% from approved levels. In response to a request for additional fuel cost recovery filed early in 2004, WPSC was allowed to recover $3.2 million of its increased fuel and purchased power costs during 2004. The PSCW also allowed WPSC to defer $5.4 million of unanticipated fuel and purchased power costs directly associated with the extension of the Kewaunee refueling outage in the fourth quarter of 2004. The Kewaunee outage was extended three weeks due primarily to an unexpected problem encountered with equipment used for lifting internal vessel components to perform a required ten-year in-service inspection. It was anticipated that these costs would be recovered in 2006; however, in the PSCW’s final decision allowing WPSC authority to increase retail electric and natural gas rates in 2006, the PSCW determined WPSC could not recover the costs for the 2004 extended outage. For more information on this determination, see Note 23, “Regulatory Environment,” in Notes to Consolidated Financial Statements. Electric utility earnings increased $8.8 million (14.7%), for the year ended December 31, 2004, compared to 2003. The increased earnings were largely driven by the higher margin at WPSC (including the effect of timely retail electric rate relief in 2004 compared to a delay in receiving retail electric rate relief in 2003), partially offset by higher operating and maintenance expenses. Gas Utility Segment Operations WPS Resources’ Gas Utility Segment Results (Millions) negatively impacted WPSC’s ability to benefit from the full amount of the rate increase. The higher margin drove a $1.6 million (10.2%), increase in natural gas utility earnings for the year ended December 31, 2004. Overview of ESI Operations Income available for common shareholders attributable to ESI was $41.7 million for the year ended December 31, 2004, compared to $21.1 million for the same period in 2003. The increase in income available for common shareholders resulted from higher overall margins, an increase in the amount of tax credits recognized, and a $4.4 million termination payment received from Duquesne Power in December 2004, as a result of Duquesne’s termination of the asset sale agreement with Sunbury. These items were offset by an increase in operating and maintenance expenses and a $3.2 million after-tax cumulative effect of change in accounting principles that was recorded in 2003. ESI’s Segment Operations (Millions except natural gas sales volumes) 2004 $3,674.2 3,535.5 $ 138.7 235.4 276.7 5,256.5 7,235.7 2003 $3,224.6 3,100.7 $ 123.9 250.8 240.6 6,460.8 6,468.9 Change 13.9% 14.0% 11.9% (6.1%) 15.0% (18.6%) 11.9% Nonregulated revenues Nonregulated cost of fuel, natural gas, and purchased power Margins Wholesale natural gas sales volumes in billion cubic feet * Retail natural gas sales volumes in billion cubic feet * Wholesale electric sales volumes in kilowatt-hours * Retail electric sales volumes in kilowatt-hours * * Represents gross physical volumes. 2004 $420.9 301.9 $119.0 801.3 2003 $404.2 291.0 $113.2 854.5 Change 4.1% 3.7% 5.1% (6.2%) Revenues Purchased gas costs Margins Throughput in therms Gas utility revenue increased $16.7 million (4.1%), for the year ended December 31, 2004, compared to 2003. Higher revenue was driven by an authorized rate increase and an increase in the per-unit cost of natural gas, partially offset by an overall 6.2% decrease in natural gas throughput volumes. The PSCW issued a final order authorizing a retail natural gas rate increase of $8.9 million (2.2%), effective January 1, 2004. Natural gas prices increased 14.2% per unit in 2004. Higher natural gas prices reflect higher marketplace natural gas costs in 2004. The PSCW and the MPSC allow WPSC to pass changes in the total cost of natural gas on to customers. As a result, changes in the price of the natural gas commodity do not have a direct impact on WPSC’s margin. The decrease in natural gas throughput volumes was driven by weather that was 4.3% warmer during the heating season for the year ended December 31, 2004, compared to 2003. The natural gas utility margin increased $5.8 million (5.1%), for the year ended December 31, 2004, compared to 2003. The higher natural gas utility margin is largely due to the authorized rate increase mentioned above. The ability of WPSC to realize the full benefit of an authorized rate increase is dependent upon normal throughput volumes; therefore, the decrease in natural gas throughput volumes Natural gas revenues increased $343.2 million, driven by higher natural gas prices and the expansion of the Canadian retail natural gas business (as a result of obtaining new customers), partially offset by lower sales volumes from physical wholesale transactions. Sales volumes from physical wholesale transactions declined as a result of reduced price volatility of natural gas during the first half of 2004 (volatility provides more opportunity for profitable physical wholesale transactions). Electric and other revenues increased $106.4 million, largely due to higher volumes from portfolio optimization strategies resulting in an $83.7 million increase in revenue. In the first quarter of 2004, ESI first implemented the portfolio optimization strategies to optimize the value of its merchant generation fleet and its retail supply portfolios to reduce market price risk and extract additional value from these assets through the use of various financial and physical instruments (such as forward contracts and options). Electric revenue also increased as a result of the July 1, 2004, acquisition of Advantage Energy and higher energy prices compared to the prior year. These increases were partially offset by a $21.5 million decrease in revenue recognized at Sunbury. The decrease in revenue from Sunbury was driven by fewer opportunities to sell power into the spot market. 34 WPS RESOURCES CORPORATION
Slide 37: The natural gas margin at ESI increased $12.5 million for the year ended December 31, 2004, compared to 2003. The margin related to retail natural gas operations increased $12.3 million, primarily driven by higher natural gas throughput volumes in Ohio (driven by the addition of new customers), operational improvements, and better management of supply for residential and small commercial customers. Customer growth in Canada also contributed to the increase in the retail natural gas margin. The margin attributed to wholesale natural gas operations increased $0.2 million. The increase in wholesale natural gas margin was driven by a $4.6 million margin increase related to the natural gas storage cycle, a $2.2 million increase in the Canadian wholesale natural gas margin, and increased margins from other structured wholesale natural gas transactions. Favorable settlements of liabilities with several counterparties in 2003 (in the amount of $8.4 million) largely offset these increases in the wholesale natural gas margin. For the year ended December 31, 2004, the natural gas storage cycle had a $2.0 million positive impact on margin, compared with a $2.6 million negative impact on margin for the same period in 2003. At December 31, 2004, there was a $0.6 million difference between the market value of natural gas in storage and the market value of future sales contracts (net unrealized loss), related to the 2004/2005 natural gas storage cycle. This difference between the market value of natural gas in storage and the market value of future sales contracts related to the 2004/2005 storage cycle is expected to vary with market conditions, but will reverse entirely and have a positive impact on earnings when all of the natural gas is withdrawn from storage. The increase in the Canadian wholesale natural gas margin is related to higher volumes (more structured wholesale transactions) as ESI continued to increase its wholesale natural gas operations in this region. The remaining $2.3 million increase in margin at ESI was driven by an increase in the electric and other margin. The higher margin was driven by a $10.3 million increase from portfolio optimization strategies discussed above and a $7.6 million increase in margin related to retail electric operations in Ohio, which can be attributed to better management of retail operations and improved supply procurement. These items were partially offset by an $8.9 million decrease in the margin related to Sunbury and a $5.7 million decrease in margin from ESI no longer participating in the New Jersey Basic Generation Services Program (ESI participated in this program from August 2003 until May 2004, but higher margins were recognized in the summer months). The lower margin at Sunbury was largely due to an increase in the per-ton cost of coal utilized in the generation process and by fewer opportunities to sell power into the spot market in 2004, compared to 2003. ATC were $16.0 million in 2004, compared to $10.1 million in 2003. WPSC nonutility operations recognized a $13.3 million pre-tax gain on the sale of land located near the Peshtigo River in the fourth quarter of 2004, compared to a $6.2 million pre-tax gain that was recognized on the sale of land in the fourth quarter of 2003. WPSC also realized an income tax benefit in the fourth quarter of 2004 from the donation of land to the WDNR. Operating Expenses WPS Resources’ Operating Expenses (Millions) 2004 $537.6 107.0 46.1 2003 $486.2 141.3 44.3 Change 10.6% (24.3%) 4.1% Operating and maintenance expense Depreciation and decommissioning expense Taxes other than income Operating and Maintenance Expense Operating and maintenance expenses increased $51.4 million (10.6%), for the year ended December 31, 2004, compared to 2003. Utility operating and maintenance expenses increased $36.3 million. Electric transmission and distribution costs were up $15.2 million at the utilities primarily due to an increase in transmission rates. Pension and postretirement medical costs incurred at the utilities increased $11.0 million. Additionally, $6.8 million of the increase was driven by amortization of costs incurred in conjunction with the implementation of the automated meter reading system and the purchase of the De Pere Energy Center (previously deferred as regulatory assets). Maintenance expenses at WPSC’s coal-fired generation facilities were $4.2 million higher in 2004, compared to 2003, driven by an extension of the annual planned outage at the Pulliam 6 generation facility in 2004. Higher payroll and other benefit costs also contributed to the increase in operating and maintenance expenses. The fall refueling outage at Kewaunee did not significantly impact the year-over-year change in operating and maintenance expenses as there was also a refueling outage at Kewaunee in spring 2003, and the PSCW approved the deferral of incremental operating and maintenance expenses that were incurred as a direct result of the refueling outage extension ($1.8 million of operating and maintenance expenses were deferred in the fourth quarter of 2004). It was anticipated that these costs would be recovered in 2006; however, in the PSCW’s final decision allowing WPSC authority to increase retail electric and natural gas rates in 2006, the PSCW determined WPSC could not recover the costs for the 2004 extended outage. For more information on this determination, see Note 23, “Regulatory Environment,” in Notes to Consolidated Financial Statements. Operating expenses at ESI increased $9.9 million mostly due to higher payroll, benefits, and other costs associated with continued business expansion. Depreciation and Decommissioning Expense Depreciation and decommissioning expense decreased $34.3 million (24.3%), for the year ended December 31, 2004, compared to 2003, due primarily to a decrease of $35.9 million resulting from lower realized gains on decommissioning trust assets and because the Overview of Holding Company and Other Segment Operations Holding Company and Other operations had income available for common shareholders of $11.9 million for the year ended December 31, 2004, compared to a net loss of $2.1 million for the year ended December 31, 2003. This favorable variance can be attributed to an increase in earnings recognized from the sale of land located along the Peshtigo River in Wisconsin and an increase in equity earnings from ATC and Wisconsin River Power Company. Equity earnings from C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 35
Slide 38: MANAGEMENT’S DISCUSSION AND ANALYSIS decommissioning trust was not funded in 2004 in anticipation of selling Kewaunee. Realized gains on decommissioning trust assets are substantially offset by depreciation expense pursuant to regulatory practice (see detailed discussion in “Miscellaneous Income” below). An increase in depreciation expense from plant asset additions at WPSC partially offset the decrease in decommissioning expense. Provision for Income Taxes The effective tax rate was 13.2% for the year ended December 31, 2004, compared to 22.2% for the year ended December 31, 2003. The decrease in the effective tax rate was driven by tax deductions pertaining to items that exceed the related book expense (including land donated to the WDNR in the fourth quarter of 2004), resulting in a $5.7 million decrease in the 2004 provision for income taxes compared to 2003, and a $9.6 million increase in the amount of tax credits recognized in 2004 (related to an increase in synthetic fuel tax credits produced in 2004 and the favorable settlement of several tax audits and refund claims related to prior tax years). Our ownership interest in the synthetic fuel operation resulted in the recognition of $27.8 million of Section 29 federal tax credits for the year ended December 31, 2004, and $18.2 million of tax credits for 2003. The increase in synthetic fuel related tax credits was primarily due to an increase in tax credits produced and allocable to ESI, an increase in the value of the credits produced resulting from the higher Btu content of coal and the annual inflation adjustment allowed, and the favorable settlement of several tax audits and refund claims related to prior tax years. Other Income (Expense) WPS Resources’ Other Income (Expense) (Millions) 2004 $52.0 (59.9) 3.4 $ (4.5) 2003 $63.6 (61.8) 5.6 $ 7.4 Change (18.2%) (3.1%) (39.3%) Miscellaneous income Interest expense and distributions of preferred securities Minority interest Other (expense) income Miscellaneous Income Miscellaneous income decreased $11.6 million (18.2%), for the year ended December 31, 2004, compared to 2003. The decrease in miscellaneous income is largely due to a decrease in realized gains on decommissioning trust assets of $33.5 million. There were significant realized gains recognized on decommissioning trust assets in the fourth quarter of 2003, which were driven by a change in the investment strategy for WPSC’s qualified nuclear decommissioning trust assets. Qualified decommissioning trust assets were placed in more conservative investments in anticipation of the sale of Kewaunee. Pursuant to regulatory practice, realized gains on decommissioning trust assets are substantially offset by depreciation expense. A $1.5 million write-off of previously deferred financing costs associated with the redemption of our trust-preferred securities in the first quarter of 2004 also unfavorably impacted miscellaneous income. Partially offsetting the decreases discussed above were an $8.7 million increase in equity earnings from investments, a $7.1 million increase in income recognized from the sale of land located along the Peshtigo River in Wisconsin (discussed previously), a $4.4 million termination payment received from Duquesne Power in December 2004 as a result of Duquesne’s termination of the asset sale agreement for Sunbury, and a combined $3.1 million increase related to higher royalties and a decrease in operating losses realized from ESI’s investment in a synthetic fuel producing facility. The increase in equity earnings was primarily related to our investments in ATC, Wisconsin River Power Company, and Wisconsin Valley Improvement Company. Equity earnings from ATC were $16.0 million in 2004, compared to $10.1 million in 2003. Royalty income recognized from the synthetic fuel facility increased as a result of higher production levels at this facility. Minority Interest The decrease in minority interest is related to the fact that ESI’s partner in its subsidiary, ECO Coal Pelletization #12, LLC, was allocated more production from the synthetic fuel operation in 2003 compared to 2004. ESI’s partner was not allocated any production from the synthetic fuel facility in the first quarter of 2004 as they requested additional production in the fourth quarter of 2003. Cumulative Effect of Change in Accounting Principles On January 1, 2003, WPS Resources recorded a positive after-tax cumulative effect of a change in accounting principle of $3.5 million (primarily related to the operations of ESI) to income available for common shareholders as a net result of removing from its balance sheet the mark-to-market effects of contracts that do not meet the definition of a derivative. This change in accounting resulted from the decision of the Emerging Issues Task Force to preclude mark-tomarket accounting for energy contracts that are not derivatives. The required change in accounting had no impact on the underlying economics or cash flows of the contracts. In addition, the adoption of SFAS No. 143, “Accounting for Asset Retirement Obligations,” at ESI resulted in a $0.3 million negative after-tax cumulative effect of a change in accounting principle in the first quarter of 2003, related to recording a liability for the closure of an ash basin at Sunbury. Balance Sheet 2005 Compared with 2004 Accounts receivable increased $474.3 million (89.3%), from $531.3 million at December 31, 2004, to $1,005.6 million at December 31, 2005. Accounts receivable at ESI increased $396.5 million (96.0%), largely driven by a 53% increase in the average price of natural gas experienced in the fourth quarter of 2005, compared to the fourth quarter of 2004. A 27.1% increase in natural gas volumes at ESI in the fourth quarter of 2005, compared to the fourth quarter of 2004, also contributed to the increase in accounts receivable. Accounts receivable at the regulated utilities increased $78.3 million (67.3%), largely due to a 49.7% per-unit increase in natural gas costs in the fourth quarter of 2005, 36 WPS RESOURCES CORPORATION
Slide 39: compared to the fourth quarter of 2004. An 8.6% increase in retail electric rates combined with an 8.0% increase in electric sales volumes in the fourth quarter of 2005, compared to the fourth quarter of 2004 also contributed to the increase in accounts receivable at the regulated utilities. Inventories increased $115.3 million (58.8%), from $196.1 million at December 31, 2004, to $311.4 million at December 31, 2005. The increase in inventories was primarily related to an $89.4 million (80.6%) increase in natural gas in storage at ESI and a $20.9 million (34.7%) increase in natural gas in storage at WPSC. Higher natural gas prices and a 22% increase in natural gas volumes in storage at ESI drove the increase in inventory at ESI. Volatility in the price of natural gas in the latter half of 2005 resulted in more natural gas storage opportunities, which drove the volume increase at ESI. The average per-unit price of natural gas purchased by WPSC increased 24.6% in 2005, compared to 2004, driving the increase in natural gas in storage at WPSC. Current assets from risk management activities increased $529.9 million (140.7%), at December 31, 2005, compared to December 31, 2004, and current liabilities from risk management activities increased $514.2 million (151.9%). Long-term assets from risk management activities increased $151.9 million (203.6%), at December 31, 2005, compared to December 31, 2004, and long-term liabilities from risk management activities increased $125.9 million (201.4%). The increase in short-term and long-term risk management assets and liabilities was primarily related to increases in the forward price of natural gas and electricity. ESI also had more wholesale electric volumes under contract at December 31, 2005, compared to December 31, 2004. Property, plant, and equipment, net, decreased $27.1 million to $2,049.4 million at December 31, 2005, compared to $2,076.5 million at December 31, 2004. The major contributors to the change in property, plant, and equipment are summarized below: ■ Kewaunee was sold in 2005, driving a $165.4 million decrease in property, plant, and equipment. ■ Depreciation expense of $142.8 million was recorded in 2005. ■ WPSC sold a 30% interest in Weston 4, contributing an $83.9 million decrease to property, plant, and equipment. ■ An impairment charge was recorded at Sunbury, contributing a $74.1 million decrease to property, plant, and equipment. ■ Substantially offsetting these decreases, capital expenditures recorded in 2005 were $415.2 million, primarily related to the construction of Weston 4. Nuclear decommissioning trusts decreased from $344.5 million at December 31, 2004, to $0 at December 31, 2005. The qualified decommissioning trust assets were sold along with the other Kewaunee assets (see Note 6, “Acquisitions and Sales of Assets,” in Notes to Consolidated Financial Statements for more information) and the nonqualified decommissioning trust assets were liquidated in connection with the Kewaunee sale. Regulatory assets increased $111.1 million (69.0%), from $160.9 million at December 31, 2004, to $272.0 million at December 31, 2005, largely due to $56.4 million of costs that were deferred related to the unplanned outage at Kewaunee in 2005, a $26.2 million increase in the regulatory asset related to the minimum pension liability, deferral of $21.2 million of MISO charges, and a $6.3 million deferral of a portion of the loss on the sale of Kewaunee. Other assets increased $51.9 million (14.9%), from $347.6 million at December 31, 2004, to $399.5 million at December 31, 2005. The increase in other assets was driven by a $72.7 million increase in WPS Resources’ investment in ATC. Accounts payable increased $489.5 million (83.1%), from $589.4 million at December 31, 2004, to $1,078.9 million at December 31, 2005. Accounts payable at ESI increased $403.0 million (91.8%), largely driven by the 53% increase in the average price of natural gas experienced in the fourth quarter of 2005, compared to the fourth quarter of 2004. Natural gas volumes at ESI also increased 27.1% in the fourth quarter of 2005, compared to the fourth quarter of 2004. Accounts payable at the utilities increased $86.2 million (57.6%), driven primarily by higher per-unit natural gas costs and higher per-unit fuel and purchased power costs in 2005, compared to 2004. Other current liabilities increased $44.6 million (60.9%), from $73.2 million at December 31, 2004, to $117.8 million at December 31, 2005, primarily due to an accrued pension contribution of $25.3 million recorded at December 31, 2005. Accrued employee benefits and wages and customer prepayments also increased at December 31, 2005, compared to December 31, 2004. Regulatory liabilities increased $84.9 million (29.4%), from $288.3 million at December 31, 2004, to $373.2 million at December 31, 2005, driven by a $126.9 million regulatory liability related to proceeds received from the liquidation of the nonqualified decommissioning trust in connection with the Kewaunee sale. The regulatory liability related to mark-to-market gains on derivative instruments also increased $25.4 million, primarily related to mark-tomarket gains recorded on financial transmission rights related to our participation in MISO. These increases were partially offset by a $46.6 million decrease in the regulatory liability pertaining to the asset retirement obligation recorded related to the decommissioning of Kewaunee (as this plant was sold on July 5, 2005), and a $26.8 million reduction in deferred unrealized gains on decommissioning trust assets as the decommissioning trust assets were either liquidated or transferred in the sale of Kewaunee. Asset retirement obligations decreased from $366.6 million at December 31, 2004, to $14.9 million at December 31, 2005, driven by the termination of our obligation to decommission Kewaunee (as this plant was sold on July 5, 2005). C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 37
Slide 40: MANAGEMENT’S DISCUSSION AND ANALYSIS Liquidity and Capital Resources We believe that our cash balances, liquid assets, operating cash flows, access to equity capital markets and borrowing capacity made available because of strong credit ratings, when taken together, provide adequate resources to fund ongoing operating requirements and future capital expenditures related to expansion of existing businesses and development of new projects. However, our operating cash flow and access to capital markets can be impacted by macroeconomic factors outside of our control. In addition, our borrowing costs can be impacted by short-term and long-term debt ratings assigned by independent rating agencies. Currently, we believe our ratings are among the best in the energy industry (see “Financing Cash Flows – Credit Ratings” on next page). WPS Resources’ funding of ATC’s Wausau, Wisconsin, to Duluth, Minnesota, transmission line in 2005, compared to 2004. Net cash used for investing activities was $315.0 million in 2004, compared to $247.4 million in 2003. The increase was largely related to a $114.0 million increase in utility capital expenditures (see “Capital Expenditures” below), partially offset by a $50.4 million decrease in cash used for the purchase of equity investments and other acquisitions. Purchase of equity investments and other acquisitions consisted primarily of additional investments in ATC, capital contributions to ECO Coal Pelletization #12, LLC, and the acquisition of Advantage Energy in 2004. In 2003, purchase of equity investments and other acquisitions consisted primarily of WPSC’s final payment for the purchase of the De Pere Energy Center, WPSC’s purchase of a one-third interest in Guardian Pipeline, additional investments in ATC, and capital contributions to ECO Coal Pelletization. WPS Resources contributed capital of $15.7 million to ECO Coal Pelletization in 2004 and $14.0 million in 2003. See Note 6, “Acquisitions and Sales of Assets,” in Notes to Consolidated Financial Statements for more information. Capital Expenditures Capital expenditures by business segment for the years ended December 31, 2005, 2004, and 2003 are as follows: Years Ended December 31, 2005 2004 2003 $373.9 36.4 4.0 0.9 $415.2 $223.0 62.7 6.4 0.3 $292.4 $131.0 40.7 6.3 (0.2) $177.8 Operating Cash Flows During 2005, net cash provided by operating activities was $62.4 million, compared to $230.8 million in 2004. The decrease was driven by a $98.2 million increase in cash required to fund working capital requirements, primarily at ESI. Net cash provided by operating activities also decreased due to various expenditures incurred in 2005 at WPSC, which will not be collected from ratepayers until future years. In 2005, expenditures incurred related to the unplanned Kewaunee outage were approximately $56 million, expenditures incurred related to MISO were approximately $21 million, and increased costs related to coal shortages were approximately $6 million (see Note 23, “Regulatory Environment,” in Notes to Consolidated Financial Statements for more information on these regulatory assets). During 2004, net cash provided by operating activities was $230.8 million, compared with $59.2 million in 2003. The increase was driven by operating activities at ESI and WPSC. In 2003, operating activities at ESI used cash due primarily to increasing working capital requirements resulting from business growth and natural gas storage opportunities near the end of the year. ESI’s natural gas operations did not experience the same level of growth in 2004 compared to 2003, and storage opportunities were similar at the end of both years, which enabled ESI to generate additional operating cash flow in 2004. The increase in net cash provided by operating activities at WPSC was driven by improved operating results. (Millions) Electric utility Gas utility ESI Other WPS Resources’ consolidated The increase in capital expenditures at the electric utility in 2005 compared to 2004 is mainly due to higher capital expenditures associated with the construction of Weston 4. Gas utility capital expenditures decreased primarily due to the completion of the automated meter reading project. The increase in capital expenditures at the electric utility in 2004 as compared to 2003 was mainly due to higher capital expenditures associated with the construction of Weston 4. Investing Cash Flows Net cash used in investing activities decreased $241.1 million (76.5%), from $315.0 million in 2004 to $73.9 million in 2005. The decrease was driven by proceeds of $127.1 million received from the liquidation of the non-qualified decommissioning trust in connection with the Kewaunee sale, $112.5 million of proceeds received from the sale of Kewaunee, $111.5 million of proceeds received from the sale of Sunbury’s emission allowances in 2005, and $95.1 million of proceeds received from DPC upon closing of the sale of a 30% ownership interest in Weston 4. The decreases were partially offset by a $122.8 million increase in capital expenditures (primarily related to the construction of Weston 4), purchases of emission allowances of $35.3 million (primarily related to operations at Sunbury), and a $30.3 million increase in the purchase of equity investments and other acquisitions, driven by a $41.3 million increase in Financing Cash Flows Net cash used for financing activities was $0.8 million in 2005, compared to net cash provided by financing activities of $73.5 million in 2004. Although cash provided by operating activities decreased in 2005, compared to 2004, this decrease was more than offset by a decrease in cash used for investing activities, related to proceeds received from various asset sales in 2005. Net cash provided by financing activities was $73.5 million in 2004, compared to $195.6 million in 2003. Less cash was required from financing activities as a result of the increase in cash generated from operating activities in 2004, partially offset by higher capital expenditures incurred in 2004. 38 WPS RESOURCES CORPORATION
Slide 41: Significant Financing Activities WPS Resources had outstanding commercial paper borrowings of $254.8 million and $279.7 million at December 31, 2005, and 2004, respectively. WPS Resources had other outstanding short-term debt of $10.0 million and $12.7 million as of December 31, 2005, and 2004, respectively. In 2005, 2004, and 2003 WPS Resources issued new shares of common stock under its Stock Investment Plan and under certain stock-based employee benefit and compensation plans. As a result of these plans, equity increased $29.0 million, $28.3 million, and $31.0 million in 2005, 2004, and 2003, respectively. WPS Resources did not repurchase any existing common stock during 2005 or 2004. In November 2005, WPS Resources issued and sold 1.9 million shares of common stock at a public offering price of $53.70 per share. The proceeds to us were $98.3 million, net of underwriting discounts and commissions. The proceeds were used to reduce shortterm debt and fund equity contributions to subsidiary companies. In June 2005, $62.9 million of non-recourse debt at an ESI subsidiary that was used to finance the purchase of Sunbury was restructured to a five-year WPS Resources obligation in connection with the sale of Sunbury’s allocated emission allowances. An additional $2.7 million drawn on a line of credit at ESI was rolled into the five-year WPS Resources obligation. The floating interest rate on the total five-year WPS Resources’ obligation of $65.6 million was fixed at 4.595% through two interest rate swaps. In January 2004, WPSC retired $49.9 million of its 7.125% series first mortgage bonds. These bonds had an original maturity date of July 1, 2023. In January 2004, WPS Resources retired $50.0 million of its 7.0% trust preferred securities. As a result of this transaction, WPSR Capital Trust I, a Delaware business trust, was dissolved. WPSC issued $125.0 million of 4.80% 10-year senior notes in December 2003. The senior notes are collateralized by a pledge of first mortgage bonds and may become non-collateralized if WPSC retires all of its outstanding first mortgage bonds. The net proceeds from the issuance of the senior notes were used to call $49.9 million of 7.125% first mortgage bonds in January 2004, fund construction costs and capital additions, reduce short-term indebtedness, and for other corporate utility purposes. In November 2003, 4,025,000 shares of WPS Resources’ common stock were sold in a public offering at $43.00 per share, which resulted in a net increase in equity of $166.8 million. Net proceeds from this offering were used to retire the trust preferred securities in January 2004, reduce short-term debt, fund equity contributions to subsidiary companies, and for general corporate purposes. In November 2003, ESI retired all of its notes payable under a revolving credit note, in the amount of $12.5 million. WPSC called $9.1 million of 6.125% tax-exempt bonds in May 2003. In March 2003, UPPCO retired $15.0 million of 7.94% first mortgage bonds that had reached maturity. WPSC used short-term debt to retire $50.0 million of 6.8% first mortgage bonds on February 1, 2003, that had reached maturity. Credit Ratings WPS Resources and WPSC use internally generated funds and commercial paper borrowing to satisfy most of their capital requirements. WPS Resources also periodically issues long-term debt and common stock to reduce short-term debt, maintain desired capitalization ratios, and fund future growth. WPS Resources may seek nonrecourse financing for funding nonregulated acquisitions. WPS Resources’ commercial paper borrowing program provides for working capital requirements of the nonregulated businesses and UPPCO. WPSC has its own commercial paper borrowing program. WPSC also periodically issues long-term debt, receives equity contributions from WPS Resources, and makes payments for return of capital to WPS Resources to reduce short-term debt, fund future growth, and maintain capitalization ratios as authorized by the PSCW. The specific forms of long-term financing, amounts, and timing depend on the availability of projects, market conditions, and other factors. The current credit ratings for WPS Resources and WPSC are listed in the table below. Credit Ratings WPS Resources Senior unsecured debt Commercial paper Credit facility WPSC Senior secured debt Preferred stock Commercial paper Credit facility Standard & Poor’s A A-1 – A+ AA-1 – Moody’s A1 P-1 A1 Aa2 A2 P-1 Aa3 In September 2005, Standard & Poor’s had placed all of WPS Resources’ and WPSC’s credit ratings on CreditWatch with negative implications as a result of WPS Resources’ announcement that it entered into a definitive agreement with Aquila to acquire its natural gas distribution operations in Michigan and Minnesota. However, in January 2006, Standard & Poor’s removed WPS Resources and WPSC from CreditWatch and affirmed WPS Resources’ “A” corporate credit rating and “A” senior unsecured debt rating. Also, the corporate credit ratings of WPSC were affirmed at “A+” and removed from CreditWatch. Standard & Poor’s stated that the consolidated ratings of WPS Resources reflected the strength and cash flow stability of its utility subsidiaries and the two relatively low risk natural gas utilities being acquired. The outlook continues to be negative for WPS Resources and WPSC as the companies have several events that must be successfully completed before the companies’ performance can be considered stable. WPS Resources must successfully complete the integration of the retail natural gas operations it is acquiring in Michigan and Minnesota and WPSC must complete the construction of Weston 4 on time and on budget. C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 39
Slide 42: MANAGEMENT’S DISCUSSION AND ANALYSIS In September 2005, Moody’s announced no change to the current ratings as a result of WPS Resources’ announcement that it entered into a definitive agreement with Aquila to acquire its natural gas distribution operations in Michigan and Minnesota, but changed the rating outlook for WPS Resources and WPSC from stable to negative, citing a potential risk that the company’s leverage may increase over the next several years. In January 2005, Standard & Poor’s downgraded its ratings for WPSC one ratings level and established a negative outlook. At the same time, Standard & Poor’s affirmed WPS Resources’ ratings but changed the outlook from stable to negative. In taking these actions, Standard & Poor’s cited WPSC’s substantial capital spending program and the risk profile of WPS Resources’ nonregulated businesses. In November 2003, Moody’s downgraded its long-term ratings for WPS Resources and WPSC one ratings level, leaving only commercial paper ratings unchanged. Moody’s downgrade of WPS Resources was based principally on a gradual shift in the company’s financial and business risk profile attributable to the growth of nonregulated businesses, the impact of weaker wholesale power markets, and a relatively high dividend payout. Moody’s downgrade of WPSC was based on the expectation that the utility’s substantial capital spending program will exceed its retained cash flow through 2007, which is likely to lead to a meaningful increase in debt. Following the 2003 downgrade, Moody’s set the ratings outlook at stable for both WPS Resources and WPSC. We believe these ratings continue to be among the best in the energy industry and allow us to access commercial paper and long-term debt markets on favorable terms. Credit ratings are not recommendations to buy, are subject to change, and each rating should be evaluated independently of any other rating. Rating agencies use a number of both quantitative and qualitative measures in determining a company’s credit rating. These measures include business risk, liquidity risk, competitive position, capital mix, financial condition, predictability of cash flows, management strength, and future direction. Some of the quantitative measures can be analyzed through a few key financial ratios, while the qualitative ones are more subjective. WPS Resources and WPSC hold credit lines to back 100% of their commercial paper borrowing and letters of credit. These credit facilities are based on a credit rating of A-1/P-1 for both Contractual Obligations As of December 31, 2005 (Millions) WPS Resources and WPSC. A significant decrease in the commercial paper credit ratings could adversely affect the companies by increasing the interest rates at which they can borrow and potentially limiting the availability of funds to the companies through the commercial paper market. A restriction in the companies’ ability to use commercial paper borrowing to meet their working capital needs would require them to secure funds through alternate sources resulting in higher interest expense, higher credit line fees, and a potential delay in the availability of funds. ESI maintains underlying agreements to support its electric and natural gas trading operations. In the event of a deterioration of WPS Resources’ credit rating, many of these agreements allow the counterparty to demand additional assurance of payment. This provision could pertain to existing business, new business, or both with the counterparty. The additional assurance requirements could be met with letters of credit, surety bonds, or cash deposits and would likely result in WPS Resources being required to maintain increased bank lines of credit or incur additional expenses, and could restrict the amount of business ESI would be able to conduct. ESI uses the New York Mercantile Exchange (NYMEX) and over-the-counter financial markets to mitigate its exposure to physical customer obligations. These contracts are closely correlated to the customer contracts, but price movements on the contracts may require financial backing. Certain movements in price for contracts through the NYMEX exchange require posting of cash deposits equal to the market move. For the over-the-counter market, the underlying contract may allow the counterparty to require additional collateral to cover the net financial differential between the original contract price and the current forward market. Increased requirements related to market price changes usually only result in a temporary liquidity need that will unwind as the sales contracts are fulfilled. Future Capital Requirements and Resources Contractual Obligations The table below summarizes the contractual obligations of WPS Resources’, including its subsidiaries. Long-term debt principal and interest payments represent bonds issued, notes issued, and loans made to WPS Resources and its subsidiaries. We record all principal obligations on the balance Payments Due By Period 2006 $ 28.1 5.1 4,000.6 352.4 2007–2008 $ 111.0 7.4 1,528.8 122.9 39.1 72.5 $1,881.7 2009–2010 $262.0 4.9 610.7 0.8 – 38.9 $917.3 2011 and Thereafter $ 875.1 6.9 717.5 – – 227.6 $1,827.1 Total Amounts Committed $1,276.2 24.3 6,857.6 476.1 79.0 384.1 $9,097.3 Long-term debt principal and interest payments Operating leases Commodity purchase obligations Purchase orders Capital contributions to equity method investment Other Total contractual cash obligations 39.9 45.1 $4,471.2 40 WPS RESOURCES CORPORATION
Slide 43: sheet. Commodity purchase obligations represent mainly commodity purchase contracts of WPS Resources and its subsidiaries. Energy supply contracts at ESI included as part of commodity purchase obligations are generally entered into to meet obligations to deliver energy to customers. WPSC and UPPCO expect to recover the costs of their contracts in future customer rates. Purchase orders include obligations related to normal business operations and large construction obligations, including 100% of Weston 4 obligations. The sale of a 30% interest in Weston 4 to DPC was completed in November 2005, but WPSC retains the legal obligation to initially remit payment to third parties for 100% of all construction costs incurred, 30% of which will subsequently be billed to DPC. Capital contributions to equity method investment include our commitment to fund a portion of ATC’s Wausau, Wisconsin, to Duluth, Minnesota, transmission line together with ATC. The table on the prior page does not reflect obligations under the definitive agreement with Aquila to acquire its natural gas distribution operations in Michigan and Minnesota, which are discussed in Note 6, “Acquisitions and Sales of Assets,” in Notes to Consolidated Financial Statements. Other mainly represents expected pension and postretirement funding obligations. Capital Requirements WPSC makes large investments in capital assets. Net construction expenditures are expected to be $856.5 million in the aggregate for the 2006 through 2008 period, not including obligations under the definitive agreement with Aquila. The largest of these expenditures is for the construction of Weston 4. WPSC is expected to incur costs of approximately $278 million from 2006 through 2008 related to its 70% ownership interest in this facility. As part of its regulated utility operations, on September 26, 2003, WPSC submitted an application for a Certificate of Public Convenience and Necessity to the PSCW seeking approval to construct Weston 4, a 500-megawatt coal-fired generation facility near Wausau, Wisconsin. The facility is estimated to cost approximately $779 million (including the acquisition of coal trains), of which WPSC is responsible for slightly more than 70% (approximately $549 million) of the costs. In November 2005, DPC purchased a 30% ownership interest in Weston 4, remitting proceeds of $95.1 million for its share of the construction costs (including carrying charges) as of the closing date of the sale. WPSC is responsible for slightly more than 70% of the costs because of certain common facilities that will be installed as part of the project. WPSC will have a larger than 70% interest in these common facilities. DPC will be billed by WPSC for 30% of all remaining costs to complete the construction of the plant. As of December 31, 2005, WPSC has incurred a total cost of $271.6 million related to its ownership interest in the project. In addition to the costs discussed above, WPSC expects to incur additional construction costs through the date the plant goes into service of approximately $61 million to fund construction of the transmission facilities required to support Weston 4. ATC will reimburse WPSC for the construction costs of these transmission facilities and related carrying costs when Weston 4 becomes commercially operational, which is expected to occur in June 2008. Other significant anticipated construction expenditures for WPSC during the three-year period 2006 through 2008 include approximately $310 million of electric distribution projects (including replacement of utility poles, transformers, meters, etc.), environmental projects of approximately $167 million, other expenditures at WPSC generation plants to ensure continued reliability of these facilities of approximately $63 million, and corporate services infrastructure projects of approximately $33 million. On April 18, 2003, the PSCW approved WPSC’s request to transfer its interest in the Wausau, Wisconsin, to Duluth, Minnesota, transmission line to ATC. WPS Resources committed to fund 50% of total project costs incurred up to $198 million. WPS Resources will receive additional equity in ATC in exchange for the project funding. WPS Resources may terminate funding if the project extends beyond January 1, 2010. The total cost of the project is estimated at $420.3 million and it is expected that the line will be completed and placed in service in 2008. WPS Resources has the right, but not the obligation, to provide additional funding in excess of $198 million up to 50% of the revised cost estimate. However, WPS Resources’ future funding of the line will be reduced by the amount funded by Allete, Inc. Allete has exercised an option to fund a portion of WPS Resources’ commitment and is expected to fund $60 million of the project cost in 2006. Considering this, for the period 2006 through 2008, WPS Resources expects to fund up to approximately $61 million for its portion of the Wausau to Duluth transmission line. WPS Resources expects to provide additional capital contributions to ATC of approximately $78 million for the period 2006 through 2008 for other projects. UPPCO is expected to incur construction expenditures of about $48 million in the aggregate for the period 2006 through 2008, primarily for electric distribution improvements and repairs and safety measures at hydroelectric facilities. Capital expenditures identified at ESI for 2006 through 2008 are expected to be approximately $22 million, largely due to scheduled major maintenance projects at ESI’s generation facilities, and computer equipment related to business expansion and normal technology upgrades. All projected capital and investment expenditures are subject to periodic review and revision and may vary significantly from the estimates depending on a number of factors, including, but not limited to, industry restructuring, regulatory constraints, acquisition opportunities, market volatility, and economic trends. Other capital expenditures for WPS Resources and its subsidiaries for 2006 through 2008 could be significant depending on its success in pursuing development and acquisition opportunities. When appropriate, WPS Resources may seek nonrecourse financing for a portion of the cost of these acquisitions. C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 41
Slide 44: MANAGEMENT’S DISCUSSION AND ANALYSIS Capital Resources As of December 31, 2005, both WPS Resources and WPSC were in compliance with all of the covenants under their lines of credit and other debt obligations. For the period 2006 through 2008, WPS Resources plans to use internally generated funds net of forecasted dividend payments, cash proceeds from asset sales, and debt and equity financings to fund capital requirements. WPS Resources plans to maintain debt to equity ratios at appropriate levels to support current credit ratings and corporate growth. Management believes WPS Resources has adequate financial flexibility and resources to meet its future needs. WPS Resources currently has the ability to issue up to $200 million of debt and/or equity under its existing shelf registration statement. WPSC currently has the ability to issue up to an additional $375 million of debt under its existing shelf registration statements. The shelf registrations are subject to the ultimate terms and conditions to be determined prior to the actual issuance of specific securities. In November 2005, WPS Resources entered into two unsecured revolving credit agreements of $557.5 million and $300 million with J.P Morgan Chase Bank and Banc of America Securities LLC. These . credit facilities are bridge facilities intended to backup commercial paper borrowings related to the purchase of the Michigan and Minnesota natural gas distribution operations from Aquila and to support purchase price adjustments related to working capital at the time of the closing of the transactions. The capacity under the bridge facilities will be reduced by the amount of proceeds from any longterm financing we complete prior to closing, with the exception of proceeds from the November 2005 equity offering. The credit agreements will be further reduced as permanent or replacement financing is secured. Under the $300 million credit agreement, loans cannot exceed the purchase price adjustments in connection with the Aquila acquisitions and no more than $200 million can be borrowed at the time of the first acquisition. Under the $300 million facility, these loan commitments will be reduced by one-third 90 days after the consummation of the applicable acquisition with the remaining two-thirds due 180 days after the consummation of the applicable acquisition (or earlier if long-term financing or replacement credit agreements are executed). Both of these credit agreements mature on September 5, 2007. These credit agreements have representations and covenants that are similar to those in our existing credit facilities. In November 2005, WPS Resources entered into a forward equity sale agreement with an affiliate of J.P Morgan Securities, Inc., as . forward purchaser, relating to 2.7 million shares of WPS Resources’ common stock. In connection with the forward agreement, and at WPS Resources’ request, J.P Morgan Securities borrowed an equal . number of shares of WPS Resources’ common stock from stock lenders and sold the borrowed shares to the public. Subject to certain exceptions, WPS Resources has the right to elect physical or cash settlement of the forward sale agreement on a date or dates to be specified by WPS Resources within approximately one year of the date of the public offering. WPS Resources expects to physically settle the forward agreement and use the proceeds to partially finance the proposed acquisition of the Michigan and Minnesota natural gas distribution operations from Aquila and for general corporate purposes. If the forward agreement would have been physically settled by delivery of shares at December 31, 2005, WPS Resources would have received $139.3 million, based on the December 31, 2005, forward share price of $51.58 per share for the 2.7 million shares, net of underwriting discounts and commissions. See Note 21, “Common Equity,” in Notes to Consolidated Financial Statements for more information on settlement methods. The use of a forward agreement allowed WPS Resources to avoid market uncertainty by pricing a stock offering under then existing market conditions, while mitigating share dilution by postponing the issuance of stock until funds are needed. In June 2005, WPS Resources entered into an unsecured $500 million 5-year credit agreement. This revolving credit line replaces the former 364-day credit line facilities, which had a borrowing capacity of $400 million. WPSC also entered into a new 5-year credit facility, for $115 million, to replace its former 364-day credit line facility for the same amount. The credit lines are used to back 100% of WPS Resources’ and WPSC’s commercial paper borrowing programs and the majority of letters of credit for WPS Resources and WPSC. As of December 31, 2005, there was a total of $249.1 million and $36.2 million available under WPS Resources’ and WPSC’s credit lines, respectively. Other Future Considerations Agreement to Purchase Aquila’s Michigan and Minnesota Natural Gas Distribution Operations On September 21, 2005, WPS Resources, through wholly owned subsidiaries, entered into two definitive agreements with Aquila to acquire its natural gas distribution operations in Michigan and Minnesota for approximately $558 million, exclusive of direct costs of the acquisition. The purchase price will increase for certain adjustments related to working capital, including accounts receivable, unbilled revenue, inventory, and certain other current assets. The purchase price is also subject to other closing and post-closing adjustments, primarily net plant adjustments. The Michigan natural gas assets provide natural gas distribution service to about 161,000 customers in 147 cities and communities throughout Otsego, Grand Haven, and Monroe counties. Annual natural gas throughput for the Michigan natural gas assets are approximately half those of the Minnesota natural gas assets. The assets operate under a cost-of-service environment and are currently allowed an 11.4% return on equity on a 45% equity component of the regulatory capital structure. The Minnesota natural gas assets provide natural gas distribution service to about 200,000 customers throughout the state in 165 cities and communities including Grand Rapids, Pine City, Rochester, and Dakota County. Annual natural gas throughput volumes have historically been just slightly less than throughput volumes experienced by WPSC’s natural gas utility. Like Michigan, the assets also operate under a cost-of-service environment and are currently 42 WPS RESOURCES CORPORATION
Slide 45: allowed an 11.7% return on equity on a 50% equity component of the regulatory capital structure. WPS Resources anticipates permanent financing for the acquisition to be raised through the issuance of a combination of equity and long-term debt. See “Capital Resources” on the prior page and Note 21, “Common Equity” in Notes to Consolidated Financial Statements, for a discussion of the forward equity sale agreement entered into to fund a portion of this acquisition. The transaction is subject to various state and other regulatory approvals, such as the MPSC and the Minnesota Public Utilities Commission, and is subject to compliance with the Hart-Scott-Rodino Act. MPSC approval was received in November 2005 and the waiting period under the Hart-Scott-Rodino Act has expired. Assuming an approval from the Minnesota Public Utilities Commission is obtained in a timely manner, WPS Resources anticipates closing both transactions in the first half of 2006. WPS Resources anticipates maintaining its current dividend policy following the closing. Sunbury WPS Resources made capital contributions of $1.0 million to Sunbury in 2005. In 2004, WPS Resources made capital contributions of $24.5 million to Sunbury. Contributions made in 2005 were necessary to meet certain working capital requirements. In 2004, the capital contributions were used to cover operating losses, make principal and interest payments on debt, and purchase emission allowances. In 2004, WPS Resources’ Board of Directors granted authorization to contribute up to $32.8 million of capital to Sunbury. At December 31, 2005, $7.3 million of the originally authorized amount remains available for contribution. Financial results for Sunbury have improved in 2005, compared to 2004, primarily due to more opportunities to sell power into the market as the result of the expiration of a fixed price out-take contract on December 31, 2004. Current energy market prices are significantly higher than the fixed price received under the expired contract. The sale of Sunbury’s allocated emission allowances was completed in May 2005. Total sales proceeds of $109.9 million were utilized by Sunbury to eliminate its nonrecourse debt obligation, which was subsequently restructured as a WPS Resources’ obligation in 2005, which provides ESI with flexibility to consider various alternatives for the plant. All available solid fuel units at the Sunbury plant were operated for most of 2005, as market conditions were generally favorable. When market conditions are unfavorable, ESI plans to place the plant in a stand-by mode of operation, which serves to minimize future operating expenses while maintaining several options for the plant (including closing the plant, retaining the plant and operating it during favorable economic periods, or a potential future sale of the plant). Dispatching Sunbury in a stand-by mode of operation helps focus production on higher-priced periods, generally in the winter and mid-summer months. The success of a stand-by mode of operation depends on Sunbury’s ability to minimize costs during non-operating periods. Kewaunee See Note 6, “Acquisitions and Sale of Assets,” in Notes to Consolidated Financial Statements for information related to the Kewaunee sale. See Note 23, “Regulatory Environment,” in Notes to Consolidated Financial Statements for an update on deferrals related to Kewaunee. Beaver Falls ESI’s Beaver Falls generation facility in New York has been out of service since late June 2005. The unplanned outage was caused by the failure of the first stage turbine blades. Inclusive of estimated insurance recoveries, ESI estimates, at this time, that it will cost between $3 million and $5 million to repair the turbine and replace the damaged blades. Depending on the amount of insurance recovery, ESI could incur significantly higher net out-ofpocket costs than originally estimated to repair the damage. In addition, ESI is attempting to renegotiate an existing steam off-take agreement with a counterparty, which will significantly impact its ability to recover costs. If significant repair costs are not recoverable through insurance or ESI is not able to renegotiate the terms of the steam off-take agreement, then a possibility exists that ESI would not repair the plant, in which case the undiscounted cash flows related to future operations may be insufficient to recover the carrying value of the plant, resulting in impairment. The carrying value of the Beaver Falls generation facility at December 31, 2005 was $18.1 million. Asset Management Strategy As a part of our asset management strategy, in December 2005, UPPCO sold a portion of its real estate holdings that were no longer needed for operations. See Note 6, “Acquisitions and Sales of Assets,” in Notes to Consolidated Financial Statements for more information. WPS Resources continues to evaluate alternatives for the sale of the balance of our identified real estate holdings no longer needed for operation. Regulatory Matters and Rate Trends Under the prevailing Wisconsin fuel rules, WPSC’s 2006 electric rates are subject to adjustment when electric generation fuel and purchased power costs fall outside of a pre-determined band. This band is set at +2.0% and -0.5%, for 2006 by the PSCW. Because a significant portion of WPSC’s electric load is served by natural gasfired generation, the volatile nature of natural gas prices, and the relatively narrow tolerance band in Wisconsin, the likelihood for an electric rate adjustment in 2006 in Wisconsin is strong. Any such rate adjustment would be on a prospective basis only and could impact WPSC’s operating results. To mitigate the risk of the potential for unrecoverable fuel costs in 2006 due to market price volatility, WPSC is employing risk management techniques pursuant to its PSCW approved Risk Policy, including the use of derivative instruments such as futures and options. The price of natural gas is currently high compared to historical levels. While the WPSC gas utility is authorized one-for-one recovery of prudently incurred natural gas costs in both the Wisconsin and C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 43
Slide 46: MANAGEMENT’S DISCUSSION AND ANALYSIS Michigan jurisdictions, the currently high natural gas rates could impact the ability of retail customers to pay for natural gas service and, therefore, increase WPSC’s write-offs during 2006. In WPSC’s 2006 retail electric rate proceeding, the PSCW applied a “financial harm” test when considering the rate recovery of deferred costs previously authorized for accounting purposes. While the application of a financial harm test is authorized, it has not been applied in the past by the PSCW when considering the rate recovery of costs that were previously authorized for deferral. In WPSC’s 2006 rate proceeding, after applying the financial harm test, the PSCW disallowed rate recovery of the 2004 extended outage at Kewaunee. The PSCW also disallowed recovery of 50% of the pre-tax loss realized on the sale of Kewaunee. None of these disallowed costs were found to be imprudent by the PSCW. In light of the PSCW’s decision, WPSC still believes it is probable that all regulatory assets recorded at December 31, 2005, will be able to be collected from ratepayers. For a discussion of regulatory filings and decisions, see Note 23, “Regulatory Environment,” in Notes to Consolidated Financial Statements. See Note 9, “Regulatory Assets and Liabilities,” in Notes to Consolidated Financial Statements for a list of regulatory assets recorded at December 31, 2005. Industry Restructuring to give the Public Utilities Commission of Ohio explicit authority to implement rate stabilization plans in certain circumstances. The Ohio Senate held meetings during March 2005 to hear from all parties involved as they develop a statewide energy policy (natural gas and electric). The Senate heard and considered such issues as rolling back Senate Bill 3, pushing ahead with electric deregulation, and the need for rate-based utility construction of new power plants in the state. In addition to the electric issues, the Senate also heard about natural gas issues. ESI participated and testified, urging the Senate to move forward to implement a competitive environment. ESI remains prepared to offer future retail electric service in Ohio as the regulatory climate and market conditions allow. Michigan Under the current Electric Choice program in Michigan, ESI, through its subsidiary, established itself as a significant supplier to the industrial and commercial markets. However, recent high wholesale energy prices coupled with both approved and pending tariff changes for the regulated utilities significantly lowered the savings customers can obtain from contracting with non-utility suppliers. As a result, many customers returned to the bundled tariff service of the incumbent utility. The high wholesale energy prices and tariff changes caused a reduction in new business and renewals for ESI. ESI’s Michigan retail electric business as of the beginning of 2006 declined to approximately one-third the peak megawatts it was at the start of 2005. The MPSC is expected to provide orders in two significant proceedings by the end of 2006 that will clarify the outlook for Electric Choice. The status of Michigan’s electric markets has been the subject of hearings in both the Senate and House Energy Committees. If legislation rolling back the Electric Choice market is enacted, it could diminish the benefits of competitive supply for Michigan business customers. The impact on ESI could range from maintaining Michigan business with little or no growth to an inability to re-contract any business, leading to a possible decision by ESI to exit Michigan’s electric market and redirect resources to more vibrant markets. It is not unreasonable to expect changes, either from the legislature or the MPSC, to have some level of negative impact on ESI, but it is unlikely that Michigan customers will lose all of the benefits of competition and revert back to a fully regulated monopoly supply. ESI is actively participating in the legislative and regulatory process in order to protect its interests in Michigan. Expansion of Operations into Texas In the fourth quarter of 2005, ESI began developing a product offering in the Texas retail electric market. Due to the thriving Texas market structure (unencumbered by a regulated offering that is not market based) and having been presented with a good opportunity and approach to enter the Texas retail market, ESI hired experienced personnel in that region and expects to be an approved competitive supplier before the end of the second quarter of 2006. ESI previously had a market presence in Houston with natural gas producer services originators. While historically, ESI limited its retail activities to the northeastern quadrant of the United States and the adjacent portion of Canada, the entry into the Texas market offers an opportunity to Ohio In May 1999, the Ohio Legislature passed Senate Bill 3, which introduced market-based rates and instituted competitive retail electric services. The bill also established a market development period beginning January 1, 2001, and extending no later than December 31, 2005, after which rates would be set at marketbased prices. During this market development period, ESI contracted to be the supplier for approximately 100,000 residential, small commercial, and government facilities in the FirstEnergy service areas under the State of Ohio provisions for Opt-out Electric Aggregation Programs. The Public Utilities Commission of Ohio requested the Ohio electric distribution utilities to file rate stabilization plans covering the 2006-2008 time period to avoid rate shock at the end of the market development period. A plan submitted by FirstEnergy established electric rates for consumers beginning in 2006 if a competitive bid auction ordered by the Public Utilities Commission of Ohio did not produce better benefits. The price resulting from an auction conducted on December 8, 2004, was inadequate. Because the FirstEnergy plan is priced lower than current market power prices, ESI took final meter readings and discontinued service to customers of the existing aggregation programs with the expiration of those contracts in December 2005. On September 23, 2004, an Ohio House Bill was introduced, proposing a change to the electric restructuring law. The bill proposes 44 WPS RESOURCES CORPORATION
Slide 47: leverage the infrastructure and capability ESI developed to provide products and services that it believes customers will value. Seams Elimination Charge Adjustment Through a series of orders issued by the FERC, Regional Through and Out Rates for transmission service between the MISO and the PJM Interconnection were eliminated effective December 1, 2004. To compensate transmission owners for the revenue they will no longer receive due to this elimination, the FERC ordered a transitional pricing mechanism called the Seams Elimination Charge Adjustment (SECA) to be put into place. Load-serving entities will pay these SECA charges during a 16-month transition period from December 1, 2004, through March 31, 2006. ESI is a load-serving entity and will be billed based on its power imports into MISO from PJM during 2002 and 2003. Total exposure for the 16-month transitional period, taken from proposed compliance filings by the transmission owners, is approximately $19 million for ESI, of which approximately $17 million is for Michigan and approximately $2 million is for Ohio. Through December 31, 2005, ESI has made payments totaling $15.3 million for these charges, of which $11.1 million has been expensed. On February 10, 2005, the FERC issued an order requesting compliance filings from transmission providers implementing the SECA effective December 1, 2004, subject to refund and surcharge, as appropriate. The application and legality of the SECA is being challenged by many load-serving entities, including ESI. On February 28, 2005, ESI filed a motion for a Partial Stay of the February 10, 2005, FERC order, proposing that SECA charges on its Michigan load be postponed until a FERC order approves a decision or settlement in the formal hearing proceeding. The FERC denied this motion on May 4, 2005. On June 3, 2005, ESI filed with the FERC a request for rehearing of the order denying stay. ESI also participated in a joint petition to the District of Columbia Circuit Court in an attempt to obtain a final order from the FERC on rehearing of the initial SECA order. This joint petition was denied. In the interim, the exposure will be managed through customer charges and other available avenues, where feasible. It is probable that ESI’s total exposure will be reduced by at least $4.2 million because of inconsistencies between the FERC’s SECA order and the transmission owners’ compliance filings (representing the difference between the amount ESI has paid for SECA charges and the amount that has been expensed as of December 31, 2005, as discussed above). ESI anticipates settling a significant portion of its SECA matters through vendor negotiations in the first half of 2006 and reached a $1 million settlement agreement with one of its vendors in January 2006. Resolution of issues to be raised in the SECA hearing offer the possibility of further reductions in ESI’s exposure, but the extent is unknown at present. Through existing contracts, ESI has the ability to pass a portion of the SECA charges on to customers and has been doing so. Since SECA is a transition charge ending on March 31, 2006, it does not directly impact ESI’s long-term competitiveness. The SECA is also an issue for WPSC and UPPCO, who have intervened and protested a number of proposals in this docket because those proposals could result in unjust, unreasonable, and discriminatory charges for electric customers. It is anticipated that most of the SECA charges and any refunds will be passed to customers through rates. Coal Supply In May 2005, WPSC received notification from its coal transportation suppliers that extensive maintenance was required on the railroad tracks that lead into and out of the Powder River Basin in Wyoming. The extensive maintenance ended on November 23, 2005. During the maintenance efforts, WPSC received approximately 87% of its expected coal deliveries. WPSC took steps to conserve coal usage and secured alternative coal supplies at its affected generation facilities during that time. On September 23, 2005, the PSCW approved WPSC’s request for deferred treatment of the incremental fuel costs resulting from the coal supply issues. As of December 31, 2005, $6.4 million was deferred related to this matter. These costs are expected to be addressed in WPSC’s next retail electric rate case. The Union Pacific Railroad experienced a number of force majeure events in December 2005 and January 2006, including a software conversion problem and heavy snow falls. WPSC is closely monitoring the delivery of coal to its power plants and is analyzing options to be prepared if future coal deliveries are constrained. Income Taxes American Jobs Creation Act of 2004 On October 22, 2004, the President of the United States signed into law the American Jobs Creation Act of 2004 (2004 Jobs Act). The 2004 Jobs Act introduces a new tax deduction, the “United States production activities deduction.” This domestic production provision allows as a deduction an amount equal to a specified percent of the lesser of the qualified production activities income of the taxpayer for the taxable year or taxable income for the taxable year. The deduction is phased in, providing a deduction of 3% of income through 2006, 6% of income through 2009, and 9% of income after 2009. On December 8, 2004, the PSCW issued an order authorizing WPSC to defer the revenue requirements impacts resulting from the 2004 Jobs Act. WPSC has recorded the estimated tax impact of this deduction in its financial statements for the year ended December 31, 2005. However, the majority of the tax benefits derived were deferred and will be passed on to customers in future rates. Section 29 Federal Tax Credits We have significantly reduced our consolidated federal income tax liability through tax credits available to us under Section 29 of the Internal Revenue Code for the production and sale of solid synthetic fuel from coal. These tax credits are scheduled to expire at the end of 2007 and are provided as an incentive for taxpayers to produce fuel from alternate sources and reduce domestic dependence on imported oil. This incentive is not deemed necessary if the price of oil increases sufficiently to provide a natural market for the fuel. Therefore, the tax credits in a given year are subject to phase-out if the annual average reference price of oil within that year exceeds a minimum threshold price set by the Internal Revenue Service (IRS) and are eliminated entirely if the average annual reference price increases beyond a maximum threshold price set by the IRS. The C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 45
Slide 48: MANAGEMENT’S DISCUSSION AND ANALYSIS reference price of a barrel of oil is an estimate of the annual average wellhead price per barrel for domestic crude oil, which has in recent history been approximately $6 below the NYMEX price of a barrel of oil. The threshold price at which the credit begins to phase out was set in 1980 and is adjusted annually for inflation; the IRS releases the final numbers for a given year in the first part of the following year. Numerous events have increased domestic crude oil prices, including concerns about terrorism, storm-related supply disruptions, and worldwide demand. Therefore, in order to manage exposure to the risk of an increase in oil prices that could reduce the amount of Section 29 federal tax credits that could be recognized, ESI entered into a series of derivative contracts, beginning in the first quarter of 2005, covering a specified number of barrels of oil. While no apparent phase-out of Section 29 federal tax credits occurred in 2005, ESI had mitigated essentially all of its 2005 phase-out risk at no net cost. Through optimization strategies, ESI realized a $0.3 million gain on oil options entered into to mitigate the 2005 phase-out risk, net of premium amortization. If no phase-out were to occur in 2006 and 2007, ESI would expect to recognize approximately $24 million of Section 29 federal tax credits in each of the next two years. Based upon forward oil prices, we are anticipating significant phase-outs of 2006 and 2007 Section 29 federal tax credits. However, we cannot predict with certainty the future price of a barrel of oil and, therefore, have no way of knowing what portion of our tax credits will be phased out, or if any phase-out will result. Based upon the average annual NYMEX price of a barrel of oil, ESI estimates that Section 29 federal tax credits will begin phasing out if the annual average NYMEX price of a barrel of oil reaches approximately $60, with a total phase out if the annual average NYMEX price of a barrel of oil reaches approximately $73. At December 31, 2005, ESI had derivative contracts that mitigate substantially all of the Section 29 tax credit exposure in 2006 and 40% of the exposure in 2007. The derivative contracts involve purchased and written call options that provide for net cash settlement at expiration based on the average NYMEX trading price of oil in relation to the strike price of each option. Premiums paid for options to mitigate exposure to Section 29 federal tax credit phaseout in 2006 and 2007 totaled $15.3 million ($12.0 million for 2006 options and $3.3 million for 2007 options), all of which are recorded as risk management assets on the balance sheet. Essentially, ESI has paid $12.0 million for options ($7.2 million after-tax) to protect the value of approximately $24 million of tax credits in 2006 and $3.3 million for options ($2.0 million after-tax) to protect the value of approximately $10 million of tax credits in 2007. ESI has not hedged $14 million of 2007 tax credits; however, ESI will continue to look for opportunities to mitigate the exposure on the remaining 2007 tax credits. As annual average oil prices become more transparent and if opportunities arise, ESI will also look for ways to lower its investment in derivative instruments utilized to protect its Section 29 federal tax credits. The derivative contracts have not been designated as hedging instruments and, as a result, changes in the fair value of the options are recorded currently in earnings. This could result in mark-to-market gains being recognized in earnings in different periods, compared to the offsetting tax credit phase-outs. For example, as of December 31, 2005, unrealized pre-tax mark-to-market gains of $4.0 million and $4.4 million were recorded for the 2006 and 2007 options, respectively, while no tax credit phase-out was recognized because 2006 and 2007 tax credits are not recognized until fuel is produced and sold in those periods. In 2006, ESI will only record Section 29 federal tax credits expected to be recognized, based upon the expected annual average price of a barrel of oil. In addition to exposure to federal tax credits, ESI has also historically received royalties tied to the amount of synthetic fuel produced as well as variable payments from a counterparty related to its 30% selldown of ECO Coal Pelletization #12 in 2002. Royalties and variable payments contributed $7.1 million, $7.6 million, and $5.9 million to income before taxes in 2005, 2004, and 2003, respectively. Royalties and variable payments received in 2006 and 2007 could decrease if a phase-out occurs and synthetic fuel production is reduced. The following table shows the total impact ESI’s investment in the synthetic fuel production facility had on the Consolidated Statements of Income. See Note 6, “Acquisitions and Sales of Assets,” in Notes to Consolidated Financial Statements for more information on these items. Amounts are pre-tax, except tax credits (Millions) Income (Loss) 2005 2004 2003 Provision for income taxes: Section 29 federal tax credits recognized Miscellaneous income: Operating losses – synthetic fuel facility Variable payments received Royalty income recognized Deferred gain recognized Interest received on fixed note receivable Minority interest $26.1 $27.8 $18.2 (16.8) 3.6 3.5 2.3 1.2 4.7 (14.1) 3.5 4.1 2.3 1.7 3.4 (15.5) 3.3 2.6 2.3 2.0 5.6 Peshtigo River Land Donation In 2004, WPS Resources submitted a request to have the IRS conduct a pre-filing review of a tax position related to its 2004 tax return. The tax position related to the value of the Peshtigo River land donated to the WDNR in 2004. A pre-filing review of the land donation deduction was initiated by the IRS in the first quarter of 2005; however, in the second quarter, WPS Resources and the IRS mutually agreed to withdraw this issue from the pre-filing review process, citing an inability to reach a consensus on the tax treatment and value of the land donated. In 2004, WPS Resources recorded a $4.1 million income tax benefit related to the Peshtigo River land donation. We believe our position is appropriate and will pursue this matter if challenged by the IRS upon examination of the tax return. Environmental See Note 17, “Commitments and Contingencies,” in Notes to Consolidated Financial Statements for a detailed discussion of environmental considerations. 46 WPS RESOURCES CORPORATION
Slide 49: Energy and Capacity Prices Prices for electric energy and capacity have been extremely volatile over the past three years. WPS Resources’ nonregulated entities are impacted by this volatility, which has been driven by the exit of many of the largest speculative traders, equilibrium between natural gas supply and demand, changes in the economy, and significant overbuilding of generation capacity. Increased natural gas prices for fuel used in electric generation have caused current electric energy prices to increase significantly. Electric capacity prices, however, are expected to be depressed for several years. Pressure on capacity prices will continue until existing reserve margins are depleted either by load growth or capacity retirements. Market structure changes could also significantly influence capacity prices. ESI’s generation facilities have been negatively impacted by the depressed capacity prices; however, certain plants within ESI have been positively impacted by the high energy prices discussed above. Midwest Independent Transmission System Operator WPSC, UPPCO, and ESI are members of the MISO, which introduced its “Day 2” energy markets on April 1, 2005, when it began centrally dispatching wholesale electricity along with providing transmission service throughout much of the Midwest. The new market is based on a locational marginal pricing system, which is similar to that used by the PJM regional transmission organization. The pricing mechanism expands the existing market from a physical market to also include financial instruments and is intended to send price signals to stakeholders where generation or transmission system expansion is needed. Based upon the early results of the transition, it does not appear that the new market will have a material ongoing impact on the financial results of WPS Resources. WPS Resources will continue to work closely with the MISO and the FERC to ensure that any issues are dealt with such that any adverse financial impacts continue to be minimal. WPSC has been granted approval by the PSCW to defer most costs and benefits related to the new market for inclusion in future rates for its Wisconsin retail electric customers. Most costs and benefits related to WPSC’s and UPPCO’s Michigan and wholesale electric customers will also flow through fuel adjustment mechanisms. Although the market is running well so far, there are still market issues that must be resolved. MISO Day 2 has the potential to significantly impact the cost of transmission for eastern Wisconsin and the Upper Peninsula of Michigan system, including WPSC and UPPCO, as well as our marketing affiliates in the MISO footprint, such as ESI. Under this market-based approach, where there is abundant transmission capacity, overall costs should be less due to the ability to access cheaper generation from across the MISO footprint. For areas with narrowly constrained transmission capacity, such as Wisconsin and the Upper Peninsula of Michigan, costs could be higher due to the congestion and marginal loss pricing components. For the utilities in eastern Wisconsin and the Upper Peninsula of Michigan, mechanisms have been deployed to offset these potential increased costs in the first five years of the Day 2 market. If the market works appropriately, the costs to ESI, excluding the SECA (discussed above), should be similar to the pre-Day 2 market costs. If there are incremental costs or savings to WPSC and UPPCO, they will be passed through to our customers under existing tariffs. WPSC and UPPCO received approval from their respective commissions to defer costs associated with implementation of the MISO Day 2 market ($21.2 million has been deferred through December 31, 2005); however, WPSC and UPPCO face regulatory risk associated with being able to collect these costs from customers in future periods. WPSC has established an energy market risk policy and a risk management plan to facilitate utilization of financial instruments for managing market risks associated with the Day 2 energy market. The PSCW has approved this plan, allowing WPSC to pass the costs and benefits of several specific risk management strategies through the PSCW’s fuel rules, deferral, or escrow processes. As of December 31, 2005, risk mitigation opportunities have been limited due to the current high price of energy. MISO participants offer their generation and bid their demand into the market on an hourly basis. This results in net receipts from or net obligations to MISO for each hour of each day. MISO aggregates these hourly transactions and currently provides updated settlement statements to market participants 7, 14, 55, 105, and 155 days after each operating day. MISO also indicated that it may begin performing a 365-day settlement run on April 1, 2006. The 365-day settlement statements could continue until all operating day transactions from April 1, 2005, through August 31, 2005, have been resettled. These updated settlement statements may reflect billing adjustments, resulting in an increase or decrease to the net receipt from or net obligation to MISO, which may or may not be recovered through the rate recovery process. These updated settlement statements and related charges may be disputed by market participants. At the end of each month, the amount due from or payable to MISO is estimated for those operating days where a 7-day settlement statement is not yet available, thus significant changes in the estimates and new information provided by MISO in subsequent settlement statements could have a material impact on our results of operations. New Accounting Pronouncements See Note 1(w), “New Accounting Pronouncements,” in Notes to Consolidated Financial Statements for a detailed discussion of new accounting pronouncements. Guarantees and Off Balance Sheet Arrangements See Note 18, “Guarantees,” in Notes to Consolidated Financial Statements for information regarding guarantees. See Note 24, “Variable Interest Entities,” in Notes to the Consolidated Financial Statements for information on the implementation of FASB Interpretation No. 46R. C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 47
Slide 50: MANAGEMENT’S DISCUSSION AND ANALYSIS Market Price Risk Management Activities ESI Mark-to-Market Roll Forward (Millions) Fair value of contracts at January 1, 2005 Less contracts realized or settled during period Plus changes in fair value of contracts in existence at December 31, 2005 Fair value of contracts at December 31, 2005 Oil Options $ – – Natural Gas $ 31.6 (26.6) (50.0) $ 8.2 Electric $13.7 (4.9) 11.2 $29.8 Total $ 45.3 (31.5) (15.2) $ 61.6 23.6 $23.6 Market price risk management activities include the electric and natural gas marketing and related risk management activities of ESI. ESI’s marketing and trading operations manage power and natural gas procurement as an integrated portfolio with its retail and wholesale sales commitments. Derivative instruments are utilized in these operations. ESI measures the fair value of derivative instruments (including NYMEX exchange and over-the-counter contracts, options, natural gas and electric power physical fixed price contracts, basis contracts, and related financial instruments) on a mark-to-market basis. The fair value of derivatives are shown as assets or liabilities from risk management activities on the Consolidated Balance Sheets. The offsetting entry to assets or liabilities from risk management activities is to other comprehensive income or earnings, depending on the use of the derivative, how it is designated, and if it qualifies for hedge accounting. The fair values of derivative instruments are adjusted each reporting period using various market sources and risk management systems. The primary input for natural gas and oil pricing is the settled forward price curve of the NYMEX exchange, which includes outright contracts and options. Basis pricing is derived from published indices and documented broker quotes. ESI bases electric prices on published indices and documented broker quotes. The table above provides an assessment of the factors impacting the change in the net value of ESI’s assets and liabilities from risk management activities for the year ended December 31, 2005. The fair value of contracts at January 1, 2005, and December 31, 2005, reflects the values reported on the balance sheet for net mark-to-market current and long-term risk management assets and liabilities as of those dates. Contracts realized or settled during the period includes the value of contracts in existence at January 1, 2005, that were no longer included in the net mark-to-market assets as of December 31, 2005, along with the amortization of those derivatives later designated as normal purchases and sales under SFAS No. 133. Changes in fair value of existing contracts include unrealized gains and losses on contracts that existed at January 1, 2005, and contracts that were entered into subsequent to January 1, 2005, which are included in ESI’s portfolio at December 31, 2005. There were, in many cases, offsetting positions entered into and settled during the period resulting in gains or losses being realized during the current period. The realized gains or losses from these offsetting positions are not reflected in the table above. Market quotes are more readily available for short duration contracts. The table below shows the sources of fair value and maturity of ESI’s risk management instruments. We derive the pricing for most contracts in the table below from active quotes or external sources. “Prices actively quoted” includes exchange traded contracts such as NYMEX contracts and basis swaps. “Prices provided by external sources” includes electric and natural gas contract positions for which pricing information, used by ESI to calculate fair value, is obtained primarily through broker quotes and other publicly available sources. “Prices based on models and other valuation methods” includes electric contracts for which reliable external pricing information does not exist. ESI employs a variety of physical and financial instruments offered in the marketplace to limit risk exposure associated with fluctuating commodity prices and volumes, enhance value, and minimize cash flow volatility. However, the application of SFAS No. 133 and its related hedge accounting rules causes ESI to experience earnings volatility associated with electric and natural gas operations, as well as oil options utilized to protect the value of a portion of ESI’s Section 29 federal tax credits. While risks associated with power generating capacity and power and natural gas sales are economically hedged, certain transactions do not meet the definition of a derivative or do not qualify for hedge accounting under generally accepted accounting principles. Consequently, gains and losses from these positions may not match with the related physical and financial hedging instruments in some reporting periods. The result can cause volatility in ESI’s reported period-by-period earnings; however, the financial impact of this timing difference will reverse at the time of physical delivery and/or settlement. The accounting treatment does not impact the underlying cash flows or economics of these transactions. See “Results of Operations” above for information regarding earnings volatility caused by the natural gas storage cycle. ESI Risk Management Contract Aging at Fair Value As of December 31, 2005 Source of Fair Value (Millions) Prices actively quoted Prices provided by external sources Prices based on models and other valuation methods Total fair value Maturity Less Than 1 Year $ (6.6) 30.1 0.1 $23.6 Maturity 1 to 3 Years $ 9.0 20.4 – $29.4 Maturity 4 to 5 Years $1.1 7.5 – $8.6 Maturity in Excess of 5 Years $– – – $– Total Fair Value $ 3.5 58.0 0.1 $61.6 48 WPS RESOURCES CORPORATION
Slide 51: Critical Accounting Policies We have identified the following accounting policies to be critical to the understanding of our financial statements because their application requires significant judgment and reliance on estimations of matters that are inherently uncertain. WPS Resources’ management has discussed these critical accounting policies with the Audit Committee of the Board of Directors. Change in Assumption (Millions) Effect on Operating Reserve at December 31, 2005 $15.0 increase $ (7.5) decrease 100% increase 50% decrease Risk Management Activities WPS Resources has entered into contracts that are accounted for as derivatives under the provisions of SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended. At December 31, 2005, those derivatives not designated as hedges are primarily commodity contracts used to manage price risk associated with natural gas and electricity purchase and sale activities, as well as oil options used to manage exposure to the risk of an increase in oil prices that could reduce the amount of Section 29 federal tax credits we could recognize from ESI’s investment in a synthetic fuel production facility. Cash flow hedge accounting treatment may be used when WPS Resources contracts to buy or sell a commodity at a fixed price for future delivery to protect future cash flows corresponding with anticipated physical sales or purchases. Fair value hedge accounting may be used when WPS Resources holds assets or firm commitments and enters into transactions that hedge the risk that the price of a commodity may change between the contract’s inception and the physical delivery date of the commodity. To the extent that the hedging instrument is fully effective in offsetting the transaction being hedged, there is no impact on income available for common shareholders prior to settlement of the hedge. In addition, WPS Resources may apply the normal purchases and sales exception, provided by SFAS No. 133, as amended, to certain contracts. The normal purchases and sales exception provides that recognition of the contract’s fair value in the Consolidated Financial Statements is not required until the settlement of the contract. Derivative contracts that are determined to fall within the scope of SFAS No. 133, as amended, are recorded at fair value on the Consolidated Balance Sheets. Changes in fair value, except those related to derivative instruments designated as cash flow hedges, are generally included in the determination of income available for common shareholders at each financial reporting date until the contracts are ultimately settled. When available, quoted market prices are used to determine a contract’s fair value. If no active trading market exists for a commodity or for a contract’s duration, fair value is estimated through the use of internally developed valuation techniques or models using external information wherever possible. Such estimates require significant judgment as to assumptions and valuation methodologies deemed appropriate by WPS Resources’ management. As a component of the fair value determination, WPS Resources maintains operating reserves to account for the estimated direct costs of servicing and holding certain of its contracts based upon administrative costs, counterparty credit risk, and liquidity risk. The effect of changing the underlying assumptions for these operating reserves is as follows above: These potential changes to the operating reserve would be included in current and long-term liabilities from risk management activities on the Consolidated Balance Sheets and as part of the nonregulated cost of fuel, gas, and purchased power on the Consolidated Statements of Income unless the related contracts are designated as cash flow hedges, in which case potential changes would be included in Other Comprehensive Income – Cash Flow Hedges on the Consolidated Statements of Common Shareholders’ Equity. Asset Impairment WPS Resources annually reviews its assets for impairment. SFAS No. 144, “Accounting for the Impairment and Disposal of Long-Lived Assets,” and SFAS No. 142, “Goodwill and Other Intangible Assets,” form the basis for these analyses. The review for impairment of tangible assets is more critical to ESI than to our other segments because of its significant investment in property, plant, and equipment and lack of access to regulatory relief that is available to our regulated segments. At December 31, 2005, the carrying value of ESI’s property, plant, and equipment totaled $141.6 million. We believe that the accounting estimate related to asset impairment of power plants is a “critical accounting estimate” because: (1) the estimate is susceptible to change from period to period because it requires management to make assumptions about future market sales pricing, production costs, capital expenditures, and generation volumes and (2) the impact of recognizing an impairment could be material to our financial position or results of operations. Management’s assumptions about future market sales prices and generation volumes require significant judgment because actual market sales prices and generation volumes have fluctuated in the past as a result of changing fuel costs, environmental changes, and required plant maintenance and are expected to continue to do so in the future. The primary estimates used at ESI in the impairment analysis are future revenue streams and operating costs. A combination of inputs from both internal and external sources is used to project revenue streams. ESI forecasts future operating costs with input from external sources for fuel costs and forward energy prices. These estimates are modeled over the projected remaining life of the power plants using the methodology defined in SFAS No. 144. ESI evaluates property, plant, and equipment for impairment whenever indicators of impairment exist. These indicators include a significant underperformance of the assets relative to historical or projected future operating results, a significant change in the use of the assets or business strategy related to such assets, and significant negative industry or economic trends. SFAS No. 144 requires that if the sum of the undiscounted expected future cash flows from a company’s asset is less than the carrying value of the asset, an asset impairment must be recognized in the financial C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 49
Slide 52: MANAGEMENT’S DISCUSSION AND ANALYSIS statements. For assets held for sale, impairment charges are recorded if the carrying value of such assets exceeds the estimated fair value less costs to sell. The amount of impairment recognized is calculated by reducing the carrying value of the asset to its fair value. Throughout 2005, ESI tested its power plants for impairment whenever events or changes in circumstances indicated that their carrying amount might not be recoverable. There was an impairment charge recorded on the Sunbury plant in 2005 (see Note 4, “Sunbury Plant,” in Notes to Consolidated Financial Statements for more information). No other impairment charges were recorded in 2005 as a result of the recoverability tests. Results of past impairment tests may not necessarily be an indicator of future tests given the criticality of the accounting estimates involved, as discussed more fully above. Changes in actual results or assumptions could result in an impairment. WPSC recorded goodwill of $36.4 million in its gas utility segment following the merger of Wisconsin Fuel and Light into WPSC in 2001. The goodwill is tested for impairment annually based on the guidance of SFAS No. 142. The test for impairment includes assumptions about future profitability of the gas utility segment and the correlation between our gas utility segment and published projections for other similar gas utility segments. A significant change in the natural gas utility market and/or our projections of future profitability could result in a loss being recorded on the income statement related to a decrease in the goodwill asset as a result of the impairment test. specific customer identification where practical. If the assumption that historical uncollectible experience matches current customer default is incorrect, or if a specific customer with a large account receivable that has not previously been identified as a risk defaults, there could be significant changes to the expense and uncollectible reserve balance. Pension and Postretirement Benefits The costs of providing non-contributory defined benefit pension benefits and other postretirement benefits, described in Note 19, “Employee Benefit Plans,” in Notes to Consolidated Financial Statements, are dependent upon numerous factors resulting from actual plan experience and assumptions regarding future experience. Pension costs and other postretirement benefit costs are impacted by actual employee demographics (including age, compensation levels, and employment periods), the level of contributions we make to the plan, and earnings on plan assets. Pension and other postretirement benefit costs may be significantly affected by changes in key actuarial assumptions, including anticipated rates of return on plan assets, discount rates used in determining the projected benefit and other postretirement benefit obligation and pension and other postretirement benefit costs, and health care cost trends. Changes made to the plan provisions may also impact current and future pension and other postretirement benefit costs. WPS Resources’ pension plan assets and other postretirement benefit plan assets are primarily made up of equity and fixed income investments. Fluctuations in actual equity market returns as well as changes in general interest rates may result in increased or decreased pension costs in future periods. Management believes that such changes in costs would be recovered at our regulated segments through the ratemaking process. The table below shows how a given change in certain actuarial assumptions would impact the projected benefit obligation, the net amount recognized on the balance sheet, and the reported annual pension cost on the income statement as they relate to all of our defined benefit pension plans. Each factor below reflects an evaluation of the change based on a change in that assumption only. The table on the next page shows how a given change in certain actuarial assumptions would impact the projected other postretirement benefit obligation, the reported other postretirement benefit liability on the balance sheet, and the reported annual other postretirement benefit cost on the income statement. Each factor on the next page reflects an evaluation of the change based on a change in that assumption only. Receivables and Reserves Our regulated natural gas and electric utilities and ESI accrue estimated amounts of revenue for services rendered but not yet billed. Estimated unbilled sales are calculated using actual generation and throughput volumes, recorded sales, and weather factors. The estimated unbilled sales are assigned different rates based on historical customer class allocations. At December 31, 2005, and 2004, the amount of unbilled revenues was $151.3 million and $113.2 million, respectively. Any difference between actual sales and the estimates or weather factors would cause a change in the estimated revenue. WPS Resources records reserves for potential uncollectible customer accounts as an expense on the income statement and an uncollectible reserve on the balance sheet. WPSC, however, records a regulatory asset to offset its uncollectible reserve. Because the nonregulated energy marketing business involves higher credit risk, the reserve is more critical to ESI than to our other segments. At ESI, the reserve is based on historical uncollectible experience and Actuarial Assumption (Millions, except percentages) Percent Change in Assumption (0.5) 0.5 (0.5) 0.5 Impact on Projected Benefit Obligation $45.0 (42.5) N/A N/A Impact on Net Amount Recognized $(4.1) 4.0 (2.6) 2.6 Impact on Pension Cost $4.1 (4.0) 2.6 (2.6) Discount rate Discount rate Rate of return on plan assets Rate of return on plan assets 50 WPS RESOURCES CORPORATION
Slide 53: Actuarial Assumption (Millions, except percentages) Percent Change in Assumption (0.5) 0.5 (1.0) 1.0 (0.5) 0.5 Impact on Postretirement Benefit Obligation $20.6 (18.2) (33.0) 37.0 N/A N/A Impact on Postretirement Benefit Liability $(2.2) 1.9 5.4 (6.0) (0.7) 0.7 Impact on Postretirement Benefit Cost $2.2 (1.9) (5.4) 6.0 0.7 (0.7) Discount rate Discount rate Health care cost trend rate Health care cost trend rate Rate of return on plan assets Rate of return on plan assets In selecting an assumed discount rate, we use the Mercer Pension Discount Yield Curve, which considers bonds, rated by Moody’s as “Aa” or better, selected from the Lehman Brothers database that are non-callable. Regression analysis is applied to construct a best-fit curve that makes coupon yields to maturity a function of time to maturity. The pension or retiree medical cash flows are then matched to the appropriate spot rates and discounted back to the measurement date. To select an assumed long-term rate of return on qualified plan assets, we consider the historical returns and the future expectations for returns for each asset class, as well as the target allocation of the benefit trust portfolios. The assumed long-term rate of return was 8.5% in 2005 and 8.75% in 2004 and 2003. For 2005, the actual return on plan assets, net of fees, was a gain of $39.7 million. The actual return on plan assets, net of fees, was a gain of $54.5 million and $92.7 million in 2004 and 2003, respectively. We base our determination of the expected return on qualified plan assets on a market-related valuation of assets, which reduces year-toyear volatility. Cumulative gains and losses in excess of 10% of the greater of the pension benefit obligation or market-related value are amortized over the average remaining future service to expected retirement ages. Realized and unrealized gains and losses are recognized over a five-year period. Because of this method, the future value of assets will be impacted as previously deferred gains or losses are recorded. In selecting assumed health care cost trend rates, we consider past performance and forecasts of health care costs. More information on health care cost trend rates can be found in Note 19, “Employee Benefit Plans,” in Notes to Consolidated Financial Statements. For a table showing future payments that WPS Resources expects to make for pension and other postretirement benefits, see Note 19, “Employee Benefit Plans,” in Notes to Consolidated Financial Statements. recovery of regulatory assets is not assured, but is generally subject to review by regulators in rate proceedings for matters such as prudence and reasonableness. Management regularly assesses whether these regulatory assets and liabilities are probable of future recovery or refund by considering factors such as regulatory environment changes, earnings at the utility segments, and the status of any pending or potential deregulation legislation. Once approved, we amortize the regulatory assets and liabilities into income over the rate recovery period. If recovery of costs is not approved or is no longer deemed probable, these regulatory assets or liabilities are recognized in current period income. If our regulated electric and gas utility segments no longer meet the criteria for application of SFAS No. 71, we would discontinue its application as defined under SFAS No. 101, “Regulated Enterprises – Accounting for the Discontinuation of Application of SFAS No. 71.” Assets and liabilities recognized solely due to the actions of rate regulation would no longer be recognized on the balance sheet and would be classified as an extraordinary item in income for the period in which the discontinuation occurred. A write-off of all WPS Resources’ regulatory assets and regulatory liabilities at December 31, 2005, would result in a 5.0% decrease in total assets, a 9.1% decrease in total liabilities, and a 48.5% increase in income before taxes. Tax Provision As part of the process of preparing our Consolidated Financial Statements, we are required to estimate our income taxes for each of the jurisdictions in which we operate. This process involves estimating our actual current tax exposure together with assessing temporary differences resulting from differing treatment of items, such as depreciation, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our Consolidated Balance Sheet. We must also assess the likelihood that our deferred tax assets will be recovered from future taxable income and, to the extent we believe that recovery is not likely, we must establish a valuation allowance, which is offset by an expense within the tax provisions in the income statement. Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities, and any valuation allowance recorded against our deferred tax assets. The assumptions involved are supported by historical data and reasonable projections. Significant changes in these assumptions could have a material impact on WPS Resources’ financial condition and results of operations. Regulatory Accounting The electric and gas utility segments of WPS Resources follow SFAS No. 71, “Accounting for the Effects of Certain Types of Regulation,” and our financial statements reflect the effects of the different ratemaking principles followed by the various jurisdictions regulating these segments. We defer certain items that would otherwise be immediately recognized as expenses and revenues because our regulators have authorized deferral as regulatory assets and regulatory liabilities for future recovery or refund to customers. Future C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 51
Slide 54: MANAGEMENT’S DISCUSSION AND ANALYSIS Impact of Inflation Our financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and report operating results in terms of historic cost. The statements provide a reasonable, objective, and quantifiable statement of financial results; but they do not evaluate the impact of inflation. Under rate treatment prescribed by utility regulatory commissions, WPSC’s and UPPCO’s projected operating costs are recoverable in revenues. Because rate forecasting assumes inflation, most of the inflationary effects on normal operating costs are recoverable in rates. However, in these forecasts, WPSC and UPPCO are only allowed to recover the historic cost of plant via depreciation. Our nonregulated businesses include inflation in forecasted costs. However, any increase from inflation is offset with projected business growth. Therefore, the estimated effect of inflation on our nonregulated businesses is minor. of our regulated utilities to earn their approved return on equity is dependent upon accurate forecasting, the ability to obtain timely rate increases to account for rising cost structures (while minimizing the required rate increases in order to maintain the competitiveness of our core industrial customer base and keep these customers in our service area), and certain conditions that are outside of their control (such as macroeconomic factors and weather conditions). To mitigate the risk of unrecoverable fuel costs in 2006 due to market price volatility, WPSC is employing risk management techniques pursuant to its risk policy approved by the PSCW, including the use of derivative instruments such as futures and options. An additional risk within the ratemaking process, regulatory lag risk, occurs between the time we submit rate proceedings and the time we receive the final approval or denial from the PSCW, MPSC, or FERC. The regulatory lag risk may increase or decrease with any change in commodity prices, unplanned outages, or unscheduled maintenance during the approval period. Although the PSCW grants WPSC the ability to defer costs related to fuel and purchased power, the PSCW does not guarantee us the ability to recover the deferred costs from the ratepayers at a later point in time. To further manage commodity price risk and the associated regulatory lag risk, our regulated utilities enter into contracts of various durations for the purchase and/or sale of natural gas, fuel for electric generation, and electricity. For purposes of risk management disclosure, ESI’s activities are classified as non-trading. ESI has the ability to reduce market price risk and extract additional value from its merchant generation plants through the use of various financial and physical tools (including forward contracts and options). ESI also utilizes derivative financial instruments to manage market risks related to its retail supply portfolio. Value-at-Risk A Value-at-Risk analysis is utilized in order to measure commodity price risk exposure at ESI. ESI’s Value-at-Risk calculation is utilized to quantify exposure to market risk associated with its marketing and trading portfolio (primarily natural gas and power positions), which includes near term positions managed under its asset management strategy through tolling agreements with the merchant generating fleet, but excludes the long-dated positions created by the merchant generating fleet and associated coal, sulfur dioxide emission allowances, and other ancillary fuels. Value-at-Risk is used to describe a probabilistic approach to quantifying the exposure to market risk. The Value-at-Risk amount represents an estimate of the potential change in fair value that could occur from changes in market factors, within a given confidence level, if an instrument or portfolio is held for a specified time period. Value-at-Risk models are relatively sophisticated. However, the quantitative risk information is limited by the parameters established in creating the model. The instruments being used may have features that could trigger a potential loss in excess of the calculated amount if the changes in the underlying commodity price exceed the confidence level of the model used. Value-at-Risk is not necessarily indicative of actual results that may occur. In addition to Value-at-Risk, ESI employs other risk Quantitative and Qualitative Disclosures About Market Risk Market Risks and Other Significant Risks WPS Resources has potential market risk exposure related to commodity price risk (including regulatory recovery risk), interest rate risk, equity return risk, and principal preservation risk. WPS Resources is also exposed to other significant risks due to the nature of our subsidiaries’ business and the environment from which we operate. WPS Resources has risk management policies in place to monitor and assist in controlling these risks and may use derivative and other instruments to manage some of these exposures, as further described below. Commodity Price Risk and Regulatory Recovery Risk WPSC burns natural gas in several of its peaking power plants, as a supplemental fuel at several coal-fired plants, and supplies natural gas as fuel to generate energy as part of a purchased power agreement with Fox Energy Center. Natural gas costs typically impact the cost of fuel used in electric generation as well as purchased power costs. Regulatory commissions allow utilities to earn a return on common stock equity that is commensurate with an investor’s expected return, compensating for the risks investors face when providing funds to the utility. The return on common stock equity approved by the PSCW, the FERC, and the MPSC was 11.5%, 11.0%, and 11.4%, respectively, in 2005 and 12.0%, 11.0%, and 11.4%, respectively, in 2004. The utilities bear volume risk as rates are based upon normal sales volumes as projected by the utility. Historically, consumers bear most of the price risk for fuel and purchased power costs as our regulators typically have allowed the utilities to recover most of these costs (to the extent they are prudently incurred), through various cost recovery mechanisms. However, WPSC is exposed to the risk of not recovering increased fuel costs for Wisconsin retail customers under the current electric fuel recovery rules. Under the Wisconsin fuel recovery mechanism, certain costs are only recoverable on a pro rata basis for the portion of the year after PSCW approval. As such, the ability 52 WPS RESOURCES CORPORATION
Slide 55: measurements including mark-to-market valuations and stress testing. In conjunction with the Value-at-Risk, these other risk measurements provide the risk management analysis for ESI’s risk exposure. ESI’s Value-at-Risk is estimated using a delta-normal approximation based on a one-day holding period and a 95% confidence level. The delta-normal approximation is based on the assumption that changes in the value of the portfolio over short time periods, such as one day, are normally distributed. ESI’s Value-at-Risk calculation includes derivative financial and commodity instruments, such as forwards, futures, swaps, and options as well as commodities held in inventory, such as natural gas held in storage to the extent such positions are significant. The Value-at-Risk for ESI’s trading portfolio is presented in the following table: Value-at-Risk (VaR) Disclosure for ESI Value-at-Risk Calculations Trading VaR (Millions) 95% confidence level, one-day holding period, one-tailed December 31 Average for 12 months ended December 31 High for 12 months ended December 31 Low for 12 months ended December 31 $1.0 million at WPSC. These amounts were determined by performing a sensitivity analysis on the impact of a hypothetical 100 basis points increase in interest rates on the variable rate debt of WPS Resources and WPSC outstanding as of December 31, 2005, and 2004. The sensitivity analysis was performed assuming a constant level of variable rate debt during the period and an immediate increase in the levels of interest rates, with no other subsequent changes for the remainder of the period. In the event of a significant change in interest rates, management would take action to mitigate WPS Resources’ and WPSC’s exposure to the change. Equity Return and Principal Preservation Risk WPS Resources and WPSC currently fund liabilities (accumulated benefit obligations) related to employee benefits through various external trust funds. The trust funds are managed by numerous investment managers and hold investments in debt and equity securities. Changes in the market value of these investments can have an impact on the future expenses related to these liabilities. WPS Resources maintains a qualified pension plan for employees’ retirement. The liability (accumulated benefit obligation) of the qualified plan was less than the value of the qualified plan’s assets by $35.8 million at December 31, 2005, and WPS Resources was required to recognize a minimum pension liability as prescribed by SFAS No. 87. Declines in the equity markets or declines in interest rates may result in increased future pension costs for the plan and possible future required contributions. Changes in the market value of investments related to other employee benefits could also impact future contributions. WPS Resources monitors the trust fund portfolio by benchmarking the performance of the investments against certain security indices. Most of the employee benefit costs relate to WPS Resources’ regulated utilities. As such, the majority of these costs are recovered in customers’ rates, mitigating the equity return and principal preservation risk on these exposures. 2005 $1.7 1.0 1.7 0.5 2004 $0.5 0.6 0.8 0.5 The Value-at-Risk amount for ESI increased $1.2 million from December 31, 2004, to December 31, 2005, due to extreme price volatility in the market, post hurricane production shut-ins, and unusual fluctuations in the various portfolios. The average, high, and low amounts were computed using the Value-at-Risk amounts at the beginning of the reporting period and the four quarter-end amounts. Interest Rate Risk WPS Resources and WPSC are exposed to interest rate risk resulting from their variable rate long-term debt and short-term commercial paper borrowing. Exposure to interest rate risk is managed by limiting the amount of variable rate obligations and continually monitoring the effects of market changes in interest rates. WPS Resources and WPSC enter into long-term fixed rate debt when it is advantageous to do so. WPS Resources and WPSC may also enter into derivative financial instruments, such as swaps, to mitigate interest rate exposure. In the second quarter of 2005, a variable rate non-recourse debt instrument used to finance the purchase of Sunbury was restructured to a WPS Resources obligation. An interest rate swap used to fix the interest rate on the Sunbury non-recourse debt was previously designated as a cash flow hedge. Subsequent to the restructuring, the interest rate swap was re-designated as a cash flow hedge, along with an additional interest rate swap, to fix the interest rate on the WPS Resources obligation. Based on the variable rate debt of WPS Resources and WPSC outstanding at December 31, 2005, a hypothetical increase in market interest rates of 100 basis points in 2005 would have increased annual interest expense in 2005 by approximately $2.9 million at WPS Resources and $0.9 million at WPSC. Comparatively, based on the variable rate debt outstanding at December 31, 2004, an increase in interest rates of 100 basis points would have increased interest expense in 2004 by approximately $3.2 million at WPS Resources and Foreign Currency Exchange Rate Risk WPS Resources is exposed to foreign currency risk as a result of foreign operations owned and operated in Canada and transactions denominated in Canadian dollars for the purchase and sale of natural gas and electricity by our nonregulated subsidiaries. Forward foreign exchange contracts are utilized to manage the risk associated with currency fluctuations on certain firm sales and sales commitments denominated in Canadian dollars and certain Canadian dollar denominated asset and liability positions. WPS Resources’ exposure to foreign currency risk was not significant at December 31, 2005, or 2004. Construction Risk Large construction projects, such as Weston 4, are subject to various construction risks, which we have little or no control over, and can negatively affect completion time and project costs. These risks include, but are not limited to, the shortage of or inability to obtain labor or materials, unfavorable weather conditions, events in the economy, and changes in applicable laws or regulations. C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 53
Slide 56: “The pending acquisition of natural gas companies in Michigan and Minnesota has been a tremendous opportunity for our employees to grow and learn. For instance, we now better understand several different approaches for delivering high-quality customer care services to our customers.” Mary Kay Duket, Outsourcing Contract Manager at Wisconsin Public Service “Transmission is the bridge between the power plants that generate electricity and the local system that delivers it to customers. We don’t own transmission assets anymore, but we provide value to our customers by influencing the policies and plans affecting the transmission system in Wisconsin—advocating on behalf of our customers.” Chris Plante, Director of Transmission Analysis for WPS Resources 54 WPS RESOURCES CORPORATION
Slide 57: CONSOLIDATED STATEMENTS OF INCOME Year Ended December 31 (Millions, except per share data) Nonregulated revenue Utility revenue Total revenues Nonregulated cost of fuel, natural gas, and purchased power Utility cost of fuel, natural gas, and purchased power Operating and maintenance expense Depreciation and decommissioning expense Gain on sale of emission allowances Impairment loss Taxes other than income Operating income Miscellaneous income Interest expense and distributions on trust preferred securities Minority interest Other income (expense) Income before taxes Provision for income taxes Net income before cumulative effect of change in accounting principles Cumulative effect of change in accounting principles, net of tax Net income before preferred stock dividends of subsidiary Preferred stock dividends of subsidiary Income available for common shareholders Average shares of common stock Basic Diluted Earnings (loss) per common share (basic) Net income before cumulative effect of change in accounting principles Cumulative effect of change in accounting principles Earnings per common share (basic) Earnings (loss) per common share (diluted) Net income before cumulative effect of change in accounting principles Cumulative effect of change in accounting principles Earnings per common share (diluted) Dividends per common share 2005 $5,438.5 1,524.2 6,962.7 5,218.7 801.2 568.1 142.8 (87.1) 80.6 47.9 190.5 86.2 (72.4) 4.5 18.3 208.8 46.7 162.1 (1.6) 160.5 3.1 $ 157.4 2004 $3,658.8 1,292.0 4,950.8 3,514.9 576.2 537.6 107.0 – – 46.1 169.0 52.0 (59.9) 3.4 (4.5) 164.5 21.7 142.8 – 142.8 3.1 $ 139.7 $ 2003 $3,218.8 1,183.7 4,402.5 3,084.2 532.3 486.2 141.3 – – 44.3 114.2 63.6 (61.8) 5.6 7.4 121.6 27.0 94.6 3.2 97.8 3.1 94.7 38.3 38.7 37.4 37.6 33.0 33.2 $4.15 (0.04) $4.11 $3.74 – $3.74 $2.77 0.10 $2.87 $4.11 (0.04) $4.07 $2.24 $3.72 – $3.72 $2.20 $2.75 0.10 $2.85 $2.16 The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 55
Slide 58: CONSOLIDATED BALANCE SHEETS At December 31 (Millions) Assets Cash and cash equivalents Accounts receivable – net of reserves of $12.7 and $8.0, respectively Accrued unbilled revenues Inventories Current assets from risk management activities Assets held for sale Other current assets Current assets Property, plant, and equipment, net Nuclear decommissioning trusts Regulatory assets Long-term assets from risk management activities Other Total assets Liabilities and Shareholders’ Equity Short-term debt Current portion of long-term debt Accounts payable Current liabilities from risk management activities Deferred income taxes Other current liabilities Current liabilities Long-term debt Deferred income taxes Deferred investment tax credits Regulatory liabilities Environmental remediation liabilities Pension and postretirement benefit obligations Long-term liabilities from risk management activities Asset retirement obligations Other Long-term liabilities Commitments and contingencies Preferred stock of subsidiary with no mandatory redemption Common stock equity Total liabilities and shareholders’ equity 2005 2004 $ 27.7 1,005.6 151.3 311.4 906.4 – 105.4 2,507.8 2,049.4 – 272.0 226.5 399.5 $5,455.2 $ 40.0 531.3 113.2 196.1 376.5 24.1 91.5 1,372.7 2,076.5 344.5 160.9 74.6 347.6 $4,376.8 $ 264.8 4.0 1,078.9 852.8 13.5 117.8 2,331.8 867.1 58.8 14.5 373.2 67.4 82.1 188.4 14.9 101.7 1,768.1 $ 292.4 6.7 589.4 338.6 9.1 73.2 1,309.4 865.7 71.0 16.2 288.3 68.4 94.6 62.5 366.6 91.2 1,924.5 51.1 1,304.2 $5,455.2 51.1 1,091.8 $4,376.8 The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. 56 WPS RESOURCES CORPORATION
Slide 59: CONSOLIDATED STATEMENTS OF COMMON SHAREHOLDERS’ EQUITY (Millions) Balance at December 31, 2002 Income available for common shareholders Other comprehensive income – cash flow hedges (net of tax of $4.8) Other comprehensive income – minimum pension liability (net of tax of $8.2) Other comprehensive income – currency translation Comprehensive income Issuance of common stock Purchase of common stock Dividends on common stock Other Balance at December 31, 2003 Income available for common shareholders Other comprehensive income – cash flow hedges (net of tax of $3.1) Other comprehensive income – minimum pension liability (net of tax of $4.0) Other comprehensive income – currency translation Comprehensive income Issuance of common stock Dividends on common stock Other Balance at December 31, 2004 Income available for common shareholders Other comprehensive income – cash flow hedges (net of tax of $7.9) Other comprehensive income – minimum pension liability (net of taxes of $11.4) Other comprehensive income – available for sale securities (net of tax of $0.4) Other comprehensive income – currency translation (net of taxes of $0.1) Comprehensive income Issuance of common stock Dividends on common stock Other Balance at December 31, 2005 Comprehensive Income Total Employee Stock Plan Guarantees and Deferred Compensation Trust Common Stock Capital in Excess of Par Value Retained Earnings Treasury Stock Accumulated Other Comprehensive Income (Loss) $ – 94.7 7.2 $782.8 94.7 7.2 $(5.4) – – $32.0 – – $351.8 – – $415.9 94.7 – $(1.5) – – $(10.0) – 7.2 (12.3) 0.1 89.7 – – – – $ – 139.7 4.6 (12.3) 0.1 – 197.7 (1.0) (71.8) 5.8 $1,003.2 139.7 4.6 – – – – (1.0) – (0.1) $(6.5) – – – – – 4.8 – – – $36.8 – – – – – 191.8 – – 5.9 $549.5 – – – – – – – (71.8) – $438.8 139.7 – – – – 1.1 – – – $(0.4) – – (12.3) 0.1 – – – – – $(15.0) – 4.6 (6.0) 0.3 138.6 – – – $ – (6.0) 0.3 – 26.3 (81.3) 5.0 $1,091.8 157.4 (12.1) – – – – – (1.9) $ (8.4) – – – – – 0.6 – 0.1 $37.5 – – – – – 25.6 – 7.0 $582.1 – – – – – – (81.3) (0.2) $497.0 157.4 – – – – 0.1 – – $(0.3) – – (6.0) 0.3 – – – – $(16.1) – (12.1) 157.4 (12.1) 17.1 17.1 – – – – – 17.1 0.6 0.6 – – – – – 0.6 0.1 163.1 – – – $ – 0.1 – 127.3 (85.4) 7.4 $1,304.2 – – – – (2.5) $(10.9) – – 2.5 – 0.1 $40.1 – – 124.8 – 10.1 $717.0 – – – (85.4) (0.3) $568.7 – – – – – $(0.3) 0.1 – – – – $(10.4) The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 57
Slide 60: CONSOLIDATED STATEMENTS OF CASH FLOWS Year Ended December 31 (Millions) Operating Activities Net income before preferred stock dividends of subsidiary Adjustments to reconcile net income to net cash provided by operating activities Depreciation and decommissioning Amortization of nuclear fuel and other Realized gain on investments held in trust, net of regulatory deferral Unrealized (gains) loss on nonregulated energy contracts Pension and postretirement expense Pension and postretirement funding Deferred income taxes and investment tax credit Gain on sales of partial interest in synthetic fuel operation Gain on sale of property, plant, and equipment Gain on sale of emission allowances Impairment loss Deferral of Kewaunee outage expenses, net Cumulative effect of change in accounting principles, net of tax Other Changes in working capital, net of businesses acquired Receivables, net Inventories Other current assets Accounts payable Other current liabilities Net cash provided by operating activities Investing Activities Capital expenditures Sale of property, plant, and equipment Purchase of emission allowances Proceeds from sale of emission allowances Purchase of equity investments and other acquisitions Proceeds from sale of Kewaunee nuclear power plant Proceeds from sale of partial interest in Weston 4 power plant Proceeds from liquidation of non-qualified decommissioning trust Purchases of nuclear decommissioning trust investments Sales of nuclear decommissioning trust investments Decommissioning funding Other Net cash used for investing activities Financing Activities Short-term debt - net Issuance of long-term debt Repayment of long-term debt, note to preferred stock trust and capital lease Payment of dividends Preferred stock Common stock Issuance of common stock Purchase of common stock Other Net cash (used for) provided by financing activities Change in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year 2005 2004 2003 $160.5 $142.8 $ 97.8 142.8 62.7 (15.7) (39.2) 50.5 (28.6) (16.9) (7.1) (5.5) (87.1) 80.6 (49.2) 1.6 (50.1) (515.8) (111.9) (19.5) 485.1 25.2 62.4 107.0 49.0 (5.5) (10.3) 39.8 (17.8) (1.8) (7.5) (16.2) – – (7.2) – (2.8) (67.7) (14.7) (1.2) 48.2 (3.3) 230.8 141.3 47.2 (38.7) 10.4 26.4 (15.6) 1.3 (7.6) (7.0) – – – (3.2) (33.7) (183.4) (76.2) (19.3) 106.8 12.7 59.2 (415.2) 12.0 (35.3) 111.5 (82.6) 112.5 95.1 127.1 (18.6) 18.6 – 1.0 (73.9) (292.4) 26.9 – – (52.3) – – – (213.3) 213.3 (0.3) 3.1 (315.0) (177.8) 31.9 – – (102.7) – – – (349.5) 349.5 (3.0) 4.2 (247.4) (25.0) – (4.2) (3.1) (85.4) 127.3 – (10.4) (0.8) (12.3) 40.0 $ 27.7 251.2 – (108.4) (3.1) (81.3) 26.3 – (11.2) 73.5 (10.7) 50.7 $ 40.0 14.7 125.0 (90.7) (3.1) (71.8) 197.7 (1.0) 24.8 195.6 7.4 43.3 $ 50.7 The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. 58 WPS RESOURCES CORPORATION
Slide 61: “In 2005 we focused on strengthening our project management skills in preparation for managing several large natural gas system reinforcement projects. Effective planning and management of these projects will help assure their completion on schedule and within budget to provide reliable natural gas service to our customers for the years ahead.” Ted Prosser, Director of Gas Distribution at Wisconsin Public Service “I am grateful for this wonderful opportunity to work more closely with the executive team and employees across the enterprise. It has been a terrific way to learn more about our WPS Resources businesses and the complex energy industry.” Suzan Murray, Assistant to the President at WPS Resources, on her experience in this shortterm assignment that has been created to build knowledge within the company C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 59
Slide 62: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1—Summary of Significant Accounting Policies (a) Nature of Operations—WPS Resources is a holding company. Our wholly owned subsidiary, Wisconsin Public Service Corporation (WPSC), is an electric and natural gas utility. WPSC supplies and distributes electric power and natural gas in its franchised service territory in northeastern Wisconsin and an adjacent portion of the Upper Peninsula of Michigan. Our other wholly owned utility subsidiary, Upper Peninsula Power Company (UPPCO), is an electric utility. UPPCO supplies and distributes electric energy to a portion of the Upper Peninsula of Michigan. Our wholly owned nonregulated subsidiary, WPS Energy Services, Inc. (ESI), offers nonregulated natural gas, electric, and alternative fuel supplies, as well as energy management and consulting services to retail and wholesale customers. ESI also owns several merchant electric generation plants, primarily in the Midwest and Northeastern United States and adjacent portions of Canada. The term “utility” refers to the regulated activities of WPSC and UPPCO, while the term “nonutility” refers to the activities of WPSC and UPPCO that are not regulated. The term “nonregulated” refers to activities other than those of WPSC and UPPCO. (b) Consolidation Basis of Presentation—The Consolidated Financial Statements include the accounts of WPS Resources and all majority owned subsidiaries, after eliminating significant intercompany transactions and balances. If a minority owner’s equity is reduced to zero, our policy is to record 100% of the subsidiary’s losses until the minority owner makes capital contributions or commitments to fund its share of the operating costs. The cost method of accounting is used for investments when WPS Resources owns less than 20% of the voting equity of the company, unless other evidence indicates we have significant influence over the operating and financial policies of the investee. Investments in businesses not controlled by WPS Resources, but over which we have significant influence regarding the operating and financial policies of the investee, are accounted for using the equity method. For additional information on our equity method investments, see Note 10, “Investments in Affiliates, at Equity Method.” (c) Use of Estimates—We prepare our financial statements in conformity with accounting principles generally accepted in the United States of America. We make estimates and assumptions that affect reported amounts. These estimates and assumptions affect assets, liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results may differ from these estimates. (d) Cash and Cash Equivalents—We consider short-term investments with an original maturity of three months or less to be cash equivalents. Cash paid for taxes during 2005, 2004, and 2003 was $50.4 million, $37.0 million, and $21.9 million, respectively. During 2005, 2004, and 2003, cash paid for interest totaled $59.6 million, $54.4 million, and $57.9 million, respectively. Non-cash transactions were as follows: (Millions) 2005 2004 2003 Weston 4 construction costs funded through accounts payable Minimum pension liability equity adjustment Restricted cash Debt assumed in Advantage acquisition Exchange of transmission assets for equity interest in American Transmission Company LLC (ATC) $16.6 (17.1) – – $22.6 6.0 3.2 3.2 $ – 12.3 1.0 – – – 5.9 (e) Revenue and Customer Receivables—Revenues are recognized on the accrual basis and include estimated amounts for electric and natural gas services rendered but not billed. Of WPS Resources’ total revenue, 6.3%, 6.5%, and 5.7% was from companies in the paper products industry in 2005, 2004, and 2003, respectively. Of WPSC’s total revenue, 11.2%, 10.1%, and 8.6% was from companies in the paper products industry in 2005, 2004, and 2003, respectively. WPSC and UPPCO use automatic fuel and purchased power adjustment clauses for the Michigan Public Service Commission (MPSC) retail electric portions of their business. WPSC also uses automatic fuel and purchased power adjustment clauses for its Federal Energy Regulatory Commission (FERC) wholesale electric business; however, at UPPCO, most wholesale electric contracts are special contracts and have no automatic fuel and purchased power adjustment clauses. The Wisconsin retail electric portion of WPSC’s business uses a “cost variance range” approach, based on a specific estimated fuel and purchased power cost for the forecast year. If WPSC’s actual fuel and purchased power costs fall outside this range, the Public Service Commission of Wisconsin (PSCW) can authorize an adjustment to future rates. Decreases to rates can be implemented without a hearing, unless requested by WPSC, PSCW staff, or interveners, while increases to rates are generally subject to a hearing. Billings to UPPCO’s customers under the MPSC’s jurisdiction include base rate charges and a power supply cost recovery factor. Power supply cost recovery factors are established annually to recover projected power supply costs approved by the MPSC. The MPSC reconciles these factors to actual costs annually and permits 100% recovery of allowed power supply costs. UPPCO recognizes any over or under recovery currently in its revenues, and the payable or receivable is recognized on the balance sheet until settlement. The deferrals are relieved with additional billings or refunds. The PSCW approved a modified one-for-one gas cost recovery plan for WPSC. This plan allows WPSC to pass changes in the cost of natural gas on to system natural gas customers, subject to regulatory review by the PSCW for reasonableness. The MPSC has approved one-for-one recovery of prudently incurred natural gas costs for WPSC, subject to regulatory review. The 60 WPS RESOURCES CORPORATION
Slide 63: MPSC also approved a natural gas cost recovery factor adjustment mechanism for WPSC for the period November 2005 through October 2006. This adjustment mechanism allows WPSC to adjust the maximum natural gas rates that can be charged to customers in Michigan based on upward or downward changes to the NYMEX natural gas futures price without further MPSC action. WPSC and UPPCO are required to provide service and grant credit to customers within their service territories. The two companies continually review their customers’ credit-worthiness and obtain or refund deposits accordingly. Both utilities are precluded from discontinuing service to residential customers during winter moratorium months. The regulated segments calculate a reserve for potential uncollectible customer receivables using a four-year average of bad debts net of recoveries as a percentage of total accounts receivable. The historical percentage is reviewed in light of the current year conditions, and an appropriate percentage is applied to the current year-end accounts receivable balance to determine the required reserve balance. For ESI’s merchant electric generation plants, electric power revenues related to fixed-price contracts are recognized at the lower of amounts billable under the contract or an amount equal to the volume of the capacity made available or the energy delivered during the period multiplied by the estimated average revenue per kilowatt-hour per the terms of the contract. Under floating-price contracts, electric power revenues are recognized when capacity is provided or energy is delivered. For its nonregulated business of supplying energy, management, and consulting services to retail and wholesale customers, ESI accrues revenues in the month that energy is delivered and/or services are rendered. With the January 1, 2003, adoption of Emerging Issues Task Force (EITF) Issue No. 02-03, “Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities,” revenues related to derivative instruments classified as trading are reported net of related cost of sales for all periods presented. Most revenues in 2005, 2004, and 2003 continue to be reported on a gross basis. See Note 1(u), “Cumulative Effect of Change in Accounting Principles,” for more information. In the fourth quarter of 2003, WPS Resources adopted Issue No. 03-11, “Reporting Realized Gains and Losses on Derivative Instruments that are Subject to FASB Statement No. 133 and Not ‘Held for Trading Purposes’ as Defined in EITF Issue No. 02-03,” which resulted in recording nonregulated revenues net of cost of fuel, natural gas, and purchased power for energy-related transactions entered into after October 1, 2003, that settle financially and for which the commodity does not physically transfer. Had the provisions of Issue No. 03-11 been applied to arrangements entered into prior to October 1, 2003, previously reported nonregulated revenue would have decreased $62.9 million for the nine months ended September 30, 2003, with a corresponding $62.9 million decrease to nonregulated cost of fuel, natural gas, and purchased power. Previously reported wholesale natural gas sales volumes for the nine months ended September 30, 2003 would have decreased 10.8 billion cubic feet. Neither margins, income, or cash flows were impacted by the adoption of Issue No. 03-11. ESI calculates the reserve for potential uncollectible customer receivable balances by applying an estimated bad debt experience rate to each past due aging category and reserving for 100% of specific customer receivable balances deemed to be uncollectible. The basis for calculating the reserve for receivables from wholesale counterparties considers netting agreements, collateral, and guarantees. (f) Inventories—Inventories consist of natural gas in storage and fossil fuels, including coal. Average cost is used to value fossil fuels and natural gas in storage for our regulated segments. Inventories at ESI are valued at the lower of cost or market unless hedged pursuant to a fair value hedge, in which case it is marked to the spot rate. (g) Risk Management Activities—As part of our regular operations, WPS Resources enters into contracts, including options, swaps, futures, forwards, and other contractual commitments, to manage market risks such as changes in commodity prices and interest rates. WPS Resources accounts for its derivative contracts in accordance with Statement of Financial Accounting Standards (SFAS) No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended and interpreted. SFAS No. 133 establishes accounting and financial reporting standards for derivative instruments and requires, in part, that we recognize certain derivative instruments on the balance sheet as assets or liabilities at their fair value. Subsequent changes in fair value of the derivatives are recorded currently in earnings unless certain hedge accounting criteria are met. If the derivatives qualify for regulatory deferral subject to the provisions of SFAS No. 71, “Accounting for the Effects of Certain Types of Regulation,” the derivatives are marked to fair value pursuant to SFAS No. 133 and are offset with a corresponding regulatory asset or liability. WPS Resources classifies mark-to-market gains and losses on derivative instruments not qualifying for hedge accounting as a component of revenues. (h) Emission Allowances—ESI accounts for emission allowances using an intangible asset model, with cash inflows and outflows related to purchases and sales of emission allowances recorded as investing activities in the Consolidated Statements of Cash Flows. ESI uses the guidance in SFAS No. 144, “Accounting for the Impairment and Disposal of Long-Lived Assets,” to test for impairment. The utilities generally do not purchase or sell emission allowances, but use the inventory accounting model for emission allowances granted at zero cost and utilized in operating the utilities’ generation plants. (i) Property, Plant, and Equipment—Utility plant is stated at the original cost of construction including an allowance for funds used during construction. The cost of renewals and betterments of units of property (as distinguished from minor items of property) is capitalized as an addition to the utility plant accounts. Except for land, C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 61
Slide 64: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS no gain or loss is recognized in connection with ordinary retirements of utility property units. Maintenance, repair, replacement, and renewal costs associated with items not qualifying as units of property are considered operating expenses. The utility charges the cost of units of property retired, sold, or otherwise disposed of, less salvage, to the accumulated provision for depreciation. The cost of removal associated with the retirement is charged to a regulatory liability. We record straight-line depreciation expense over the estimated useful life of utility property and include amounts for estimated removal and salvage. The PSCW approved new depreciation rates for WPSC effective January 1, 2005, which have not had a material impact on annual depreciation expense. Depreciation rates for UPPCO were approved by the MPSC effective January 1, 2002. Annual utility composite depreciation rates are shown below. Annual Utility Composite Depreciation Rates Electric Gas used during construction (AFUDC) calculation, which includes both a debt and an equity component as required by regulatory accounting. Approximately 50% of WPSC’s retail jurisdictional construction work-in-progress expenditures are subject to AFUDC, except on specific projects approved by the PSCW. For 2005, WPSC’s AFUDC retail rate was 9.0%. A current return for construction funds related to Weston 4 is being recovered from ratepayers as incurred. WPSC’s construction work-in-progress AFUDC debt and equity percentage formula for the wholesale jurisdiction is specified in the FERC’s Uniform System of Accounts. The 2005 average AFUDC wholesale rate was 7.13%. WPSC’s allowance for equity funds used during construction for 2005, 2004, and 2003 was $1.5 million, $2.0 million, and $2.4 million, respectively. WPSC’s allowance for borrowed funds used during construction for 2005, 2004, and 2003 was $0.4 million, $0.7 million, and $1.0 million, respectively. UPPCO did not record AFUDC for 2005, 2004, or 2003, as UPPCO did not have significant construction projects during these years. Our nonregulated subsidiaries calculate capitalized interest on long-term construction projects for periods during which financing is provided by WPS Resources through interim debt. The interest rate capitalized is based upon the monthly short-term borrowing rate WPS Resources incurs for such funds. The amount of interest capitalized during 2005, 2004, and 2003 was not significant. (k) Asset Impairment—We review the recoverability of long-lived tangible and intangible assets, excluding goodwill, other indefinite lived intangible assets, and regulatory assets, in accordance with SFAS No. 144. This Statement requires review of assets when circumstances indicate that the carrying amount may not be recoverable. The carrying amount of assets held and used is not recoverable if it exceeds the undiscounted sum of cash flows expected to result from the use and eventual disposition of the asset. If the carrying value is not recoverable, the impairment loss is measured as the excess of the asset’s carrying value over its fair value. The carrying value of assets held for sale is not recoverable if it exceeds the fair value less cost to sell the asset. An impairment charge is recorded for any excess of the carrying value over the fair value less cost to sell. If events or circumstances indicate the carrying value of investments accounted for under the equity method of accounting may not be recoverable, potential impairment is assessed by comparing the future anticipated cash flows from these investments to their carrying values. Impairment charges are recorded if the carrying value of such assets exceeds the future anticipated cash flows. See Note 4, “Sunbury Plant,” for information related to the impairment charge recorded at Sunbury in 2005. (l) Regulatory Assets and Liabilities—WPSC and UPPCO are subject to the provisions of SFAS No. 71. Regulatory assets represent probable future revenue associated with certain incurred costs that will be recovered from customers through the ratemaking process. Regulatory liabilities represent amounts that are refundable in future 2005 3.59% 3.61% 2004 3.59% 3.65% 2003 3.63% 3.63% Nonutility property interest capitalization takes place during construction, and gain and loss recognition occurs in connection with retirements. Nonutility property is depreciated using straight-line depreciation. Asset lives range from 3 to 20 years. Nonregulated plant is stated at the original construction cost, which includes capitalized interest, or estimated fair value at the time of acquisition pursuant to a business combination. The costs of renewals, betterments, and major overhauls are capitalized as an addition to plant. The gains or losses associated with ordinary retirements are recorded in the period of retirement. Maintenance, repair, and minor replacement costs are expensed as incurred. Most of the nonregulated subsidiaries compute depreciation using the straight-line method over the following estimated useful lives: Structures and improvements Office and plant equipment Office furniture and fixtures Vehicles Computer equipment Leasehold improvements 15 to 40 years 5 to 35 years 3 to 10 years 5 years 3 years Shorter of: life of the lease or life of the asset The Combined Locks Energy Center uses the units of production depreciation method for selected pieces of equipment having defined lives stated in terms of hours of production. WPS Resources capitalizes certain costs related to software developed or obtained for internal use and amortizes those costs to operating expense over the estimated useful life of the related software, which is usually three to seven years. (j) Capitalized Interest and Allowance for Funds Used During Construction—Our nonregulated subsidiaries capitalize interest for construction projects, while our utilities use an allowance for funds 62 WPS RESOURCES CORPORATION
Slide 65: customer rates. Based on a current evaluation of the various factors and conditions that are expected to impact future cost recovery, we believe that future recovery of our regulatory assets is probable. (m) Goodwill and Other Intangible Assets—In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” goodwill and other assets with indefinite lives are not amortized, but are subject to annual impairment tests. WPSC performs its impairment test during the second quarter of each year, while ESI performs its impairment test annually during the third quarter. The impairment tests are updated whenever events or changes in circumstances indicate that the assets might be impaired. Based upon the results of testing, no impairments were noted in 2005, 2004, or 2003. Other intangible assets with definite lives, consisting primarily of emission allowances and customer related intangible assets, are amortized over periods from 1 to 30 years. For more information on WPS Resources’ intangible assets, see Note 11, “Goodwill and Other Intangible Assets.” (n) Retirement of Debt—Premiums, discounts, and expenses incurred with the issuance of outstanding long-term debt are amortized over the terms of the debt issues. Any call premiums or unamortized expenses associated with refinancing higher-cost debt obligations used to finance regulated assets and operations are amortized consistent with regulatory treatment of those items, where appropriate. (o) Research and Development—Electric research and development expenditures for WPSC totaled $0.7 million, $0.7 million, and $0.6 million, in 2005, 2004, and 2003, respectively. No other research and development expenditures were significant. (p) Asset Retirement Obligations—Effective January 1, 2003, WPS Resources adopted SFAS No. 143, “Accounting for Asset Retirement Obligations.” Under this accounting standard, WPS Resources recognized, at fair value, legal obligations associated with the retirement of tangible long-lived assets that resulted from the acquisition, construction or development, and/or normal operation of the asset. The asset retirement obligation is accreted using a credit-adjusted risk-free interest rate commensurate with the expected settlement date of the asset retirement obligation. The associated retirement costs were capitalized as part of the related long-lived asset and depreciated over the useful life of the asset. The total of the depreciation and accretion from the initial date of obligation through the adoption date of SFAS No. 143 were recorded as a cumulative effect of change in accounting principle for ESI and as a net regulatory asset for our regulated operations. In March 2005, the Financial Accounting Standards Board (FASB) issued Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations.” SFAS No. 143 had been inconsistently applied in practice because the accounting for conditional asset retirement obligations was interpreted differently among companies. An asset retirement obligation is conditional when the timing and/or method of settling the obligation is conditioned on a future event. Many companies, including WPS Resources, did not record a liability for conditional asset retirement obligations under the guidance of SFAS No. 143, concluding that either (1) the conditional nature of the obligation did not create a liability until the retirement activity occurred or (2) the timing and/or method of settling the obligation was unknown. Interpretation No. 47 concludes that, if required legally, an obligation associated with an asset’s retirement is inevitable, even though uncertainties may exist regarding the timing and/or method of settling the obligation. According to the Interpretation, these uncertainties affect the fair value of the liability, rather than negate the need to record one at all. Additionally, the ability of a company to indefinitely postpone settlement of the obligation, or to sell the asset prior to its retirement, does not relieve a company of its present duty to settle the obligation. Therefore, the Interpretation concluded that conditional asset retirement obligations are within the scope of SFAS No. 143. WPS Resources adopted Interpretation No. 47 as of December 31, 2005. Asset retirement obligations included within the scope of Interpretation No. 47 are calculated and recorded utilizing the methodology in SFAS No. 143. See Note 1(u), “Cumulative Effect of Change in Accounting Principles,” and Note 15, “Asset Retirement Obligations,” for additional information regarding SFAS No. 143 and Interpretation No. 47. (q) Income Taxes—We account for income taxes using the liability method as prescribed by SFAS No. 109, “Accounting for Income Taxes.” Under this method, deferred income taxes have been recorded using currently enacted tax rates for the differences between the tax basis of assets and liabilities and the basis reported in the financial statements. Due to the effects of regulation on WPSC and UPPCO, certain adjustments made to defer income taxes are, in turn, recorded as regulatory assets or liabilities. Investment tax credits, which have been used to reduce our federal income taxes payable, have been deferred for financial reporting purposes. These deferred investment tax credits are being amortized over the useful lives of the property to which they relate. WPS Resources is an indirect part owner of a facility that produces synthetic fuel that qualifies for tax credits under Section 29 if certain requirements are satisfied. Section 29 tax credits are currently scheduled to expire at the end of 2007. Tax credits that are not used to reduce tax expense as a result of alternative minimum tax rules relating to United States federal income taxes are carried forward as alternative minimum tax credits to reduce current tax expense in future years. Under current federal law, alternative minimum tax credits do not expire. In the fourth quarter of 2005, WPS Resources was informed that partnership returns for the facility filed for the 2002 and 2003 tax years were under review by the IRS. It is our understanding that this review of the partnership returns is part of the examination the IRS is conducting of the consolidated corporate filings of one of the partners for the same period. WPS Resources files a consolidated United States income tax return that includes domestic subsidiaries of which its ownership is 80% or more. WPS Resources and its consolidated subsidiaries are parties C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 63
Slide 66: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS to a tax allocation arrangement under which each entity determines its income tax provision on a stand-alone basis, after which the effects of federal consolidation are accounted for. In several states, combined or consolidated filing is required for certain members of the WPS Resources group doing business in that state. The tax allocation arrangement is used to equitably allocate the state taxes associated with these combined or consolidated filings. WPS Resources records a reserve for uncertain tax positions based upon management’s assessment of the probabilities that certain deductions or income tax positions may not be sustained when income tax returns are audited by taxing jurisdictions. Our identified tax exposures are discussed below. WPS Resources and its subsidiaries have routinely been subject to examination by various taxing jurisdictions, including the IRS, Wisconsin Department of Revenue, and other state and local taxing jurisdictions. At any given time there might be several of these audits open covering multiple tax years. Management has not been informed by any taxing jurisdictions of any material adjustment to any filed or proposed tax position as a result of the ongoing examinations. WPS Resources had submitted a request to have the IRS conduct a pre-filing review of a tax position related to the 2004 tax return. The tax position related to the value of land located near the Peshtigo River that was donated to the Wisconsin Department of Natural Resources (WDNR). A pre-filing review of the land donation deduction was initiated by the IRS in the first quarter of 2005; however, in the second quarter, WPS Resources and the IRS mutually agreed to withdraw this issue from the pre-filing review process, citing an inability to reach a consensus on the tax treatment and value of the land donated. WPS Resources believes the value placed on the donated land was reasonable and will continue to pursue this matter if challenged by the IRS upon examination of the tax return. The combined current benefit of Section 29 tax credits and the deferred benefit of alternative minimum tax credits (arising from Section 29 tax credits) is limited to an amount equal to the WPS Resources regular consolidated federal tax liability. In 2004, and in some previous years, this limitation has impacted the amount of the tax benefit recorded as compared to actual Section 29 tax credits produced. For 2005, this limitation did not impact the tax benefit recorded. Section 29 tax credits are subject to phase out if the reference price of oil within that year exceeds a threshold price set by the IRS and is eliminated entirely if the reference price increases beyond a phase-out price. WPS Resources does not believe a phase-out will be applicable to 2005. WPS Resources records a tax benefit with respect to Section 29 tax credits based upon its assessment of the probability of sustaining the filing position for federal tax returns and its judgment related to the potential for a phase-out of credits. (r) Excise Taxes—WPS Resources presents revenue net of pass-through taxes on the Consolidated Statements of Income. (s) Guarantees—FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees Including Indirect Guarantees of Indebtedness of Others,” requires that the guarantor recognize, at the inception of the guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. See Note 18, “Guarantees,” for additional information on Interpretation No. 45. (t) Stock-Based Employee Compensation—WPS Resources has stock-based employee compensation plans, which are described more fully in Note 22, “Stock-Based Compensation.” WPS Resources accounts for these plans under the recognition and measurement provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Upon grant of stock options, no stock-based employee compensation cost is reflected in net income, as all options granted under these plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on income available for common shareholders and earnings per share if WPS Resources had applied the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” to stock-based employee compensation: (Millions, except per share amounts) 2005 2004 2003 Income available for common shareholders As reported Add: Stock-based compensation expense using intrinsic value method – net of tax Deduct: Stock-based compensation expense using the fair value method – net of tax Pro forma Basic earnings per common share As reported Pro forma Diluted earnings per common share As reported Pro forma $157.4 2.0 $139.7 1.4 $94.7 2.0 (1.9) $157.5 (1.1) $140.0 (1.1) $95.6 $4.11 4.11 $3.74 3.74 $2.87 2.90 $4.07 4.07 $3.72 3.72 $2.85 2.88 The fair value of each stock option grant is estimated on the date of grant using the Black-Scholes stock option pricing model assuming: 2005 Expected life Risk-free interest rate Expected dividend yield Expected volatility 6 years 4.38% 4.73% 11.77% 2004 10 years 4.40% 5.19% 15.44% 2003 10 years 4.40% to 4.65% 5.68% to 6.23% 18.25% to 19.97% (u) Cumulative Effect of Change in Accounting Principles—The adoption of Interpretation No. 47 on December 31, 2005, resulted in a $1.6 million after-tax cumulative effect of change in accounting principle, decreasing income available for common shareholders, related to recording a liability for asbestos remediation at certain ESI generating plants. The adoption of SFAS No. 143 on January 1, 2003, resulted in a $0.3 million after-tax cumulative effect of change in accounting principle, decreasing income available for 64 WPS RESOURCES CORPORATION
Slide 67: common shareholders, related to recording a liability for the closure of an ash basin at Sunbury. For the utility segments of WPS Resources, we concluded it was probable that any differences between expenses under Interpretation No. 47 and SFAS No. 143, and expenses currently recovered through customer rates, will be recoverable or refundable in future customer rates. Accordingly, neither the adoption of Interpretation No. 47 nor the adoption of SFAS No. 143 had any impact on the utility segments’ income, as its effect is offset by the establishment of regulatory assets or liabilities pursuant to SFAS No. 71. Prior to its rescission in 2002, ESI had been applying the accounting standards of Issue No. 98-10. ESI was defined as a trading company under Issue No. 98-10 and was required to mark all of its energyrelated contracts to market. On October 25, 2002, the Emerging Issues Task Force rescinded Issue No. 98-10, thus precluding markto-market accounting for energy trading contracts entered into after that date that are not derivatives and requiring a cumulative effect of change in accounting principle to be recorded effective January 1, 2003, for all nonderivative contracts entered into on or prior to October 25, 2002. On January 1, 2003, WPS Resources recorded an after-tax cumulative effect of a change in accounting principle of $3.5 million (related to ESI operations) to increase income available for common shareholders as a result of removing from its balance sheet the mark-to-market effects of those contracts entered into on or prior to October 25, 2002, that do not meet the definition of a derivative under SFAS No. 133. The required change in accounting had no impact on the underlying economics or cash flows of the contracts. (v) Reclassifications—We reclassified certain prior year financial statement amounts to conform to the current year presentation. (w) New Accounting Pronouncements—In December 2004, the FASB issued SFAS No. 123R, “Share-Based Payment,” which addresses the accounting for share-based payment transactions. SFAS No. 123R eliminates the ability to account for share-based compensation transactions using Accounting Principles Board Opinion No. 25, and requires companies to measure the cost of share-based awards at their grant date fair value. That cost is recognized over the period during which an employee is required to provide service in exchange for the award. SFAS No. 123R is effective for WPS Resources beginning in the first quarter of 2006. WPS Resources has chosen the modified prospective method of adopting the Statement. Under this method, all share-based payment awards granted after December 31, 2005, will be measured at fair value and recognized as a component of income available for common shareholders over the requisite service period of the award. Additionally, compensation cost for the portion of awards granted on or before December 31, 2005, for which the requisite service has not been rendered, but which are outstanding as of the beginning of the first quarter of 2006 will be recognized as the remaining requisite service is rendered. The impact on WPS Resources’ financial position and results of operations will be dependent upon a number of factors, including share-based awards granted in 2006. Because we do not know the number of share-based awards that will be granted in 2006, we cannot estimate the precise effect that SFAS No. 123R will have on our financial position and results of operations. However, assuming the number of share-based awards granted in 2006 remains consistent with prior years, we do not anticipate that the incremental impact to income available for common shareholders of adopting SFAS No. 123R in 2006 will differ significantly from the pro forma amounts disclosed in Note 1(t), “Stock-Based Employee Compensation,” for prior years. NOTE 2—Fair Value of Financial Instruments The following methods and assumptions were used to estimate the fair value of each class of financial instrument for which it is practicable to estimate such value: Cash, Short-Term Investments, Energy Conservation Loans, Notes Payable, and Outstanding Commercial Paper: The carrying amount approximates fair value due to the short maturity of these investments and obligations. Nuclear Decommissioning Trusts: Nuclear decommissioning trust investments were recorded at fair value, net of taxes payable on unrealized gains and losses. In 2005, the qualified nuclear decommissioning trust assets were sold in conjunction with the sale of Kewaunee and the nonqualified nuclear decommissioning trust assets were liquidated. See Note 6, “Acquisitions and Sales of Assets,” for more information. Long-Term Debt and Preferred Stock: The fair values of long-term debt and preferred stock are estimated based on the quoted market price for the same or similar issues or on the current rates offered to WPS Resources for debt of the same remaining maturity. Risk Management Activities: Assets and liabilities from risk management activities are recorded at fair value pursuant to SFAS No. 133. The estimated fair values of our financial instruments as of December 31 were: 2005 (Millions) 2004 Carrying Amount $ 40.0 1.6 344.5 26.8 12.7 279.7 874.4 51.1 50.0 Fair Value $ 40.0 1.6 344.5 26.8 12.7 279.7 925.2 50.0 50.0 Carrying Amount $ 27.7 1.5 – – 10.0 254.8 872.9 51.1 91.7 Fair Value $ 27.7 1.5 – – 10.0 254.8 901.7 49.0 91.7 Cash and cash equivalents Energy conservation loans Nuclear decommissioning trusts Nuclear decommissioning trusts – other assets Notes payable Commercial paper Long-term debt Preferred stock Risk management activities – net C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 65
Slide 68: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 3—Risk Management Activities The following table shows WPS Resources’ assets and liabilities from risk management activities as of December 31, 2005, and 2004: Assets (Millions) Liabilities 2005 $ – 1.8 2004 $ – 0.6 2005 $ 22.0 14.5 2004 $ 11.0 – Utility segments Electric purchase contracts Financial transmission rights Nonregulated segments Commodity and foreign currency contracts Fair value hedges Cash flow hedges Commodity contracts Interest rate swaps Total Balance sheet presentation Current Long-term Total 1,058.6 4.2 33.6 – $1,132.9 396.5 3.8 39.8 – $451.1 971.7 12.9 50.1 4.7 $1,041.2 366.6 2.3 22.9 8.7 $401.1 Our nonregulated segments also enter into derivative contracts that are designated as either fair value or cash flow hedges. Fair value hedges are used to mitigate the risk of changes in the price of natural gas held in storage. The changes in the fair value of these hedges are recognized currently in earnings, as are the changes in fair value of the hedged items. Fair value hedge ineffectiveness recorded in nonregulated revenue on the Consolidated Statements of Income was a pre-tax loss of $2.5 million in 2005 and was not significant in 2004 or 2003. At December 31, 2005, and 2004, pre-tax mark-to-market losses of $5.8 million and $0.6 million, respectively, related to changes in the difference between the spot and forward prices of natural gas were excluded from the assessment of hedge effectiveness. These losses were reported directly in earnings. Commodity contracts that are designated as cash flow hedges extend through December 2007 and are used to mitigate the risk of cash flow variability associated with the future purchases and sales of natural gas and electricity. To the extent they are effective, the changes in the values of these contracts are included in other comprehensive income, net of taxes. Cash flow hedge ineffectiveness recorded in nonregulated revenue on the Consolidated Statements of Income was a pre-tax loss of $2.6 million in 2005 and was not significant in 2004 or 2003. When testing for effectiveness, no portion of the derivative instruments was excluded. Amounts recorded in other comprehensive income related to these cash flow hedges will be recognized in earnings as the related contracts are settled, or if it is probable that the hedged transaction will not occur. During 2005 and 2004, we reclassified after-tax gains of $3.1 million and $1.9 million, respectively, from other comprehensive income into earnings as a result of the discontinuance of cash flow hedge accounting for certain hedge transactions. The amount reclassified in 2003 was not significant. In the next 12 months, subject to changes in market prices of natural gas and electricity, we expect that an aftertax loss of $8.6 million will be recognized in earnings as contracts are settled. We expect this amount to be substantially offset by settlement of the related nonderivative contracts that are being hedged. In the second quarter of 2005, a variable rate non-recourse debt instrument used to finance the purchase of Sunbury was restructured to a WPS Resources obligation. An interest rate swap used to fix the interest rate on the Sunbury non-recourse debt had been previously designated as a cash flow hedge. As a result of the debt restructuring, the hedged transaction will no longer occur. This resulted in the recognition of a $9.1 million pre-tax loss (equivalent to the mark-to-market value of the swap at the date of restructuring), which was recorded as a component of interest expense in the second quarter of 2005. This loss was previously deferred as a component of other comprehensive income pursuant to hedge accounting rules. Subsequent to the restructuring, the interest rate swap was re-designated as a cash flow hedge, along with an additional interest rate swap, to fix the interest rate on the WPS Resources obligation. The changes in the fair value of the effective portion of these swaps are included in other comprehensive $ 906.4 226.5 $1,132.9 $376.5 74.6 $451.1 $ 852.8 188.4 $1,041.2 $338.6 62.5 $401.1 Assets and liabilities from risk management activities are classified as current or long-term based upon the maturities of the underlying financial instruments. Utility Segments WPSC has entered into a limited number of electric purchase contracts that are accounted for as derivatives and are shown in the above table. Financial transmission rights in the above table include financial instruments used to manage the transmission congestion costs of the electric utilities. In 2005, WPSC’s portion of the assets and liabilities related to financial transmission rights was $13.6 million and $1.7 million, respectively. In 2004, all of the utility segments’ financial transmission rights belonged to WPSC. The PSCW approved the recognition of a regulatory asset or liability for the fair value of derivative instruments. Thus, management believes any gains or losses resulting from the eventual settlement of these derivative instruments will be collected from or refunded to customers. Nonregulated Segments The derivatives in the nonregulated segments not designated as hedges under generally accepted accounting principles are primarily commodity contracts used to manage price risk associated with natural gas and electric energy purchase and sale activities, and foreign currency contracts used to manage foreign currency exposure related to ESI’s Canadian operations. In addition, ESI entered into a series of derivative contracts (options) covering a specified number of barrels of oil in order to manage exposure to the risk of an increase in oil prices that could result in a phase-out of Section 29 federal tax credits that can be recognized from ESI’s investment in a synthetic fuel production facility for 2006 and 2007. See Note 1(q), “Income Taxes,” and Note 17, “Commitments and Contingencies,” for more information. Changes in the fair value of non-hedge derivatives are recognized currently in earnings. 66 WPS RESOURCES CORPORATION
Slide 69: income, net of deferred taxes, while the changes related to the ineffective portion are recorded in earnings. During the year ended December 31, 2005, cash flow hedge ineffectiveness recorded in earnings related to these swaps was not significant. Amounts recorded in other comprehensive income related to these swaps will be recognized as a component of interest expense as the interest becomes due. In the next 12 months, we expect to recognize a $0.2 million pre-tax reduction to interest expense related to these swaps, assuming interest rates comparable to those at December 31, 2005. We did not exclude any component of the derivative instruments’ change in fair value from the assessment of hedge effectiveness. NOTE 4—Sunbury Plant In the second quarter of 2005, ESI sold all of Sunbury’s allocated emission allowances. Prior to this decision, ESI had marketed for sale the Sunbury plant and certain other related assets (primarily inventory and unallocated emission allowances) in combination with the allocated emission allowances. The Sunbury facility sells power on a wholesale basis and is located in the PJM. Following Duquesne Power, L.P.’s termination of the previously announced agreement to sell Sunbury to Duquesne for approximately $120 million, ESI continued to pursue the sale of Sunbury with the assistance of an investment banking firm, but a suitable buyer was not found. Total sales proceeds from the sale of Sunbury’s emission allowances were $109.9 million, resulting in a pre-tax gain of $85.9 million. The sale of the emission allowances provides ESI with more time to consider various alternatives for the Sunbury plant. All available solid fuel units at the Sunbury plant were operated for most of 2005, as market conditions were generally favorable. When market conditions are unfavorable, ESI plans to place the plant in a stand-by mode of operation, which serves to minimize future operating expenses while maintaining several options for the plant (including closing the plant, retaining the plant and operating it during favorable economic periods, repowering the plant, or a potential future sale of the plant). Dispatching Sunbury in a stand-by mode of operation helps focus production on higherpriced periods, generally in the winter and mid-summer months. The success of a stand-by mode of operation depends on Sunbury’s ability to minimize costs during non-operating periods. Prior to the decision to sell the emission allowances separately, the Sunbury plant, allocated emission allowances, and other related assets had been classified as held for sale as a combined asset disposal group. However, because ESI is no longer committed to the sale of Sunbury as its only option, those assets and liabilities previously classified as held for sale that no longer meet the held for sale criteria outlined in SFAS No. 144, were required to be reclassified to the appropriate held and used categories for all periods presented. As a result, the allocated emission allowances that were sold in May 2005 remain classified as held for sale at December 31, 2004, but the Sunbury plant, unallocated emission allowances, and other related assets and liabilities were reclassified as held and used. All long-lived assets reclassified as held and used are required to be recorded individually at the lower of their carrying value before they were classified as assets held for sale (adjusted for any depreciation expense that would have been recognized had they been continuously classified as held and used) or fair value at the date the held for sale criteria were no longer met. Upon reclassification of the Sunbury plant and related assets as held and used in 2005, ESI recorded a non-cash, pre-tax impairment charge of $80.6 million. The impairment charge substantially offsets the gain on the sale of the emission allowances. The major classes of assets held for sale at December 31, 2004, were as follows: (Millions) Property, plant, and equipment, net Other assets: Emission allowances Assets held for sale $ 0.8 23.3 $24.1 C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 67
Slide 70: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 5—Property, Plant, and Equipment Property, plant, and equipment consists of the following utility, nonutility, and nonregulated assets. (Millions) 2005 $2,108.3 548.5 2,656.8 1,054.7 1,602.1 286.6 – 1,888.7 19.9 5.9 14.0 168.2 6.7 20.1 195.0 48.3 146.7 $2,049.4 2004 $2,409.4 510.0 2,919.4 1,260.9 1,658.5 154.5 24.6 1,837.6 19.5 5.3 14.2 247.1 6.6 20.1 273.8 49.1 224.7 $2,076.5 Electric utility Gas utility Total utility plant Less: Accumulated depreciation Net Construction in progress Nuclear fuel, less accumulated amortization Net utility plant Nonutility plant Less: Accumulated depreciation Net nonutility plant Electric nonregulated Gas nonregulated Other nonregulated Total nonregulated property, plant, and equipment Less: Accumulated depreciation Net nonregulated property, plant, and equipment Total property, plant, and equipment The accumulated provision for nuclear fuel, which represents nuclear fuel purchases and amortization, totaled approximately $273 million at December 31, 2004. NOTE 6—Acquisitions and Sales of Assets Agreement to Purchase Aquila’s Michigan and Minnesota Natural Gas Distribution Operations On September 21, 2005, WPS Resources, through wholly owned subsidiaries, entered into two definitive agreements with Aquila to acquire its natural gas distribution operations in Michigan and Minnesota for approximately $558 million, exclusive of direct costs of the acquisition. The purchase price will increase for certain adjustments related to working capital, including accounts receivable, unbilled revenue, inventory, and certain other current assets. The purchase price is also subject to other closing and post-closing adjustments, primarily net plant adjustments. The purchase price will be paid in cash at the time of closing. The Michigan natural gas assets provide natural gas distribution service in 147 cities and communities throughout Otsego, Grand Haven, and Monroe counties. The assets operate under a cost-of-service environment and are currently allowed an 11.4% return on equity on a 45% equity component of the regulatory capital structure. The Minnesota natural gas assets provide natural gas distribution service throughout the state in 165 cities and communities including Grand Rapids, Pine City, Rochester, and Dakota County. Like Michigan, the assets also operate under a cost-of-service environment and are currently allowed an 11.7% return on equity on a 50% equity component of the regulatory capital structure. WPS Resources anticipates permanent financing for the acquisition to be raised through the issuance of a combination of equity and long-term debt. See Note 21, “Common Equity,” for a discussion of the forward equity sale agreement entered into to fund a portion of this acquisition. The transaction is subject to various state and other regulatory approvals, such as the MPSC and the Minnesota Public Utilities Commission, and is subject to compliance with the Hart-ScottRodino Act. MPSC approval was received in November 2005 and the waiting period under the Hart-Scott-Rodino Act has expired. Assuming an approval from the Minnesota Public Utilities Commission is obtained in a timely manner, WPS Resources anticipates closing both transactions in the first half of 2006. Sale of UPPCO Lands In December 2005, UPPCO sold a portion of its real estate holdings that were no longer needed for operations for $5.9 million and recognized a pre-tax gain of $5.5 million in 2005, with the possibility of recognizing up to an additional $3.0 million of pre-tax gains related to these sales, as certain contingencies are resolved. See Note 23, “Regulatory Environment,” for details on how the MPSC has agreed to handle these land sales. Dairyland Power Cooperative (DPC) In November 2005, WPSC and DPC closed a transaction in which DPC acquired a 30% ownership interest in Weston 4. Under terms of the 68 WPS RESOURCES CORPORATION
Slide 71: agreement, WPSC received $95.1 million in cash from DPC for its share of the costs through the date of the closing. DPC will also remit payments to WPSC for its 30% share of all remaining costs to complete the construction of Weston 4 as well as reimburse WPSC for its share of operating costs after the plant is completed and operational, which is anticipated in 2008. Kewaunee In July 2005, Kewaunee returned to service following an unplanned outage that began in February 2005. On July 5, 2005, WPSC completed the sale of its 59% ownership interest in Kewaunee to Dominion Energy Kewaunee, LLC, a subsidiary of Dominion Resources, Inc. At the same time, Wisconsin Power and Light Company sold its 41% ownership interest in Kewaunee to Dominion. WPSC’s share of the cash proceeds from the sale was $112.5 million. Dominion received the assets in WPSC’s qualified decommissioning trust and assumed responsibility for the eventual decommissioning of Kewaunee. These trust assets had a pre-tax fair value of $243.6 million at closing. The sale of Kewaunee resulted in a loss of $12.5 million, which includes the proceeds from the sale less the net assets sold, adjusted by several additional items. The most significant of these adjustments is the fair value of an indemnity issued to cover certain costs Dominion may incur related to the recent unplanned outage (see Note 18, “Guarantees,” for more information). In addition, the adjustments include certain costs related to the termination of the plant operating agreement and withdrawal from WPS Resources’ investment in the Nuclear Management Company (NMC), which served as the licensed operator of Kewaunee. As part of the sale, WPSC retained ownership of the assets contained in its nonqualified decommissioning trust. Proceeds received from the liquidation of the nonqualified decommissioning trust were $127.1 million and will be refunded to ratepayers. See Note 23, “Regulatory Environment,” for details regarding regulatory treatment of the proceeds received from the nonqualified decommissioning trust and the loss on the sale of Kewaunee. At the closing date, WPSC’s share of the carrying value of the assets and liabilities that were included within the sale agreement, or that were otherwise eliminated pursuant to the sale, were as follows: (Millions) under the power purchase agreement will approximate the expected costs of production had WPSC continued to own the plant. Therefore, management believes that the sale of Kewaunee and the related power purchase agreement provides more price certainty for WPSC’s customers and reduces WPSC’s risk profile. In April 2004, WPSC entered into an exclusivity agreement with Dominion. Under this agreement, if Dominion decides to extend the operating license of Kewaunee, Dominion can negotiate only with WPSC during the exclusivity period for 59% of the plant output under a new power purchase agreement that would extend beyond Kewaunee’s current operating license termination date. The exclusivity period started on the closing date of the sale, July 5, 2005, and extends through December 21, 2011, after which Dominion can negotiate with other parties. Wausau, Wisconsin, to Duluth, Minnesota, Transmission Line On April 18, 2003, the PSCW approved WPSC’s request to transfer its interest in the Wausau, Wisconsin, to Duluth, Minnesota, transmission line to ATC in exchange for an ownership interest in ATC. ATC is a forprofit transmission-only company created by the transfer of transmission assets previously owned by multiple electric utilities serving the upper Midwest. WPSC sold, at book value, $20.1 million of assets related to the Wausau to Duluth transmission line to ATC in June 2003. No gain or loss was recognized on the transaction. In December 2003, WPSC also transferred other transmission assets to ATC, increasing its investment an additional $5.9 million. In 2005, 2004, and 2003, WPS Resources invested $57.0 million, $15.7 million, and $14.0 million, respectively, in ATC, related to its agreement to fund approximately half of the Wausau, Wisconsin, to Duluth, Minnesota, transmission line. At December 31, 2005, WPS Resources’ ownership interest in ATC (held through its WPS Investments, LLC subsidiary) was 31.0%. Our investment in ATC is described more fully in Note 10, “Investments in Affiliates, at Equity Method.” Sale of Peshtigo River Lands On October 5, 2004, WPSC sold at auction 279 acres of Peshtigo River development lands located in Wisconsin for $12.2 million. Under terms of a multi-phase agreement reached with the WDNR in 2001 related to lands near the Peshtigo River, the WDNR bought more than 5,000 acres of land for $13.5 million in 2001. In December 2003, WPSC sold an additional 542 acres of land to the WDNR for $6.5 million. WPSC completed the multi-phase agreement with the sale of 179 acres for $5.0 million to the WDNR on December 9, 2004. Following the close of this final phase of the WDNR agreement, WPSC donated an additional 5,176 acres to the state of Wisconsin. July 5, 2005 $243.6 165.4 5.5 $414.5 $ (72.1) 2.5 376.4 $306.8 Qualified decommissioning trust fund Other utility plant, net Other current assets Total assets Regulatory liabilities Accounts payable Asset retirement obligations Total liabilities Advantage Energy, Inc. On July 1, 2004, ESI acquired all of the outstanding stock of Advantage Energy, Inc., a New York based energy-marketing company founded in 1997. On the date of acquisition, Advantage served approximately 8,200 residential and commercial customers with a peak load of approximately 275 megawatts. Consideration for the purchase consisted of an initial cash payment for the tangible and intangible net worth of the company and an earn-out with a maximum cap and a declining percentage to the seller. Upon the closing of the sale, WPSC entered into a long-term power purchase agreement with Dominion to purchase energy and capacity consistent with volumes available when WPSC owned Kewaunee. The power purchase agreement extends through 2013 when the plant’s current operating license will expire. Fixed monthly payments C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 69
Slide 72: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Guardian Pipeline On May 30, 2003, WPS Resources purchased a one-third interest in Guardian Pipeline, LLC from CMS Gas Transmission Company for approximately $26 million. Guardian Pipeline owns a natural gas pipeline, which began operating in 2002, that stretches about 140 miles from near Joliet, Illinois, into southern Wisconsin. The pipeline can transport up to 750 million cubic feet of natural gas daily. Our interest in Guardian Pipeline is accounted for as an equity method investment and is described more fully in Note 10, “Investments in Affiliates, at Equity Method.” As a result of prior transactions in which ECO #12 sold synthetic fuel producing machinery to a third party, ESI held $3.5 million in escrow at December 31, 2002. As a result of the expiration of contingencies in the sale agreement and related matters, ESI recognized this as a gain in 2003. On December 19, 2002, ESI sold approximately 30% interest in ECO #12 to a third party. The buyer purchased the Class A interest in ECO #12, giving the buyer a preferential allocation of tons of synthetic fuel produced and sold annually. The buyer may be allocated additional tons of synthetic fuel if ESI makes them available, but neither party is obligated beyond the required annual allocation of tons. The buyer’s share of operating losses generated from the synthetic fuel operation, $4.7 million, $3.4 million, and $5.6 million, in 2005, 2004, and 2003, respectively, are recorded as minority interest in the Consolidated Statements of Income. ESI received consideration of $3.0 million cash, as well as a fixed and variable note for this sale transaction. Payments under the variable Note are contingent upon the achievement of specified levels of synthetic fuel production by the facility. In conjunction with the sale, ESI agreed to make certain payments to a third-party broker, consisting of an up-front payment of $1.5 million (which was paid at the time of closing), $1.4 million in 2003, $1.9 million in 2004, and $0.5 million in 2005. A deferred gain of $4.6 million and $6.9 million was reflected on ESI’s balance sheet at December 31, 2005, and 2004, respectively. This deferred gain represents the present value of future payments under the fixed Note and the up-front cash payments net of transaction costs. It does not include an amount for the variable note, which is contingent upon the synthetic fuel production. Payments on the variable note are a function of fuel production and recognized as a component of the gain when received. Pre-tax gains of $7.1 million, $7.5 million, and $7.6 million were recognized as a component of miscellaneous income in 2005, 2004, and 2003, respectively, related to the 2002 transaction. De Pere Energy Center On December 16, 2002, WPSC completed the purchase of the 180-megawatt De Pere Energy Center from Calpine Corporation, a California-based independent power producer. Prior to this purchase, the power from the De Pere Energy Center was under long-term contract to WPSC and was accounted for as a capital lease. This power purchase agreement required Calpine to expand the facility in the future. The contract was terminated concurrent with the purchase of the De Pere Energy Center. The $120.4 million purchase included a $72.0 million payment upon closing and a $48.4 million payment in December 2003. As a result of the purchase, the capital lease obligation was reversed and the difference between the capital lease asset and the $120.4 million purchase price was recorded as a regulatory asset. Of the $47.8 million regulatory asset initially recorded, $45.6 million is under the jurisdiction of the PSCW and is being amortized over a 20-year period beginning on January 1, 2004. Amortization of the remaining regulatory asset, which is under the jurisdiction of the FERC and the MPSC, began in 2003 and will also occur over 20 years. ECO Coal Pelletization #12 At December 31, 2005, ESI holds a 70% ownership interest in ECO Coal Pelletization #12, LLC, which holds an investment in an entity that produces synthetic fuel for tax credits under Section 29 of the Internal Revenue Code. NOTE 7—Jointly Owned Utility Facilities Information regarding WPSC’s share of significant jointly owned electric-generating facilities in service at December 31, 2005, is set forth below: West Marinette Unit No. 33 68.0% 56.8 $18.5 $ 8.4 1993 Columbia Energy Center 31.8% 335.2 $146.8 $ 90.1 1975 and 1978 Edgewater Unit No. 4 31.8% 105.0 $31.7 $18.7 1969 (Millions, except for percentages) Ownership WPSC’s share of plant nameplate capacity (megawatts) Utility plant in service Accumulated depreciation In-service date WPSC’s share of direct expenses for these plants is included in the corresponding operating expenses in the Consolidated Statements of Income. WPSC has supplied its own financing for all jointly owned projects. 70 WPS RESOURCES CORPORATION
Slide 73: NOTE 8—Nuclear Decommissioning Trust In conjunction with the sale of Kewaunee in July 2005 (see Note 6, “Acquisitions and Sales of Assets,” for details regarding the sale of Kewaunee), the qualified decommissioning trust assets were transferred to Dominion and WPSC liquidated the assets contained in the nonqualified decommissioning trust. Proceeds received from the liquidation of the nonqualified decommissioning trust will be refunded to ratepayers. See Note 23, “Regulatory Environment,” for details regarding regulatory treatment of the proceeds received from the nonqualified decommissioning trust. As of December 31, 2004, the market value of the external nuclear decommissioning trusts totaled $344.5 million, net of tax. Investments in the nuclear decommissioning trusts were recorded at fair value at December 31, 2004. The investments were presented net of related income tax effects on unrealized gains, and represented the amount of assets that were available to accomplish decommissioning. The nonqualified trust investments designated to pay income taxes when unrealized gains became realized were classified as other assets. At December 31, 2004, the amount classified as other assets was $26.8 million with an offsetting regulatory liability of the same amount reflecting the expected reduction in future rates as unrealized gains in the nonqualified trust would have been realized. Information regarding the cost and fair value of the nuclear decommissioning trusts at December 31, 2004, net of tax, is set forth below: Security Type (Millions) Fair Value $243.9 100.6 $344.5 Cost $243.9 60.6 $304.5 Unrealized Gain $– 40.0 $40.0 Cash and cash equivalents Equity Balance at December 31 Decommissioning costs collected in customer rates and charges for realized earnings from the trusts were included in depreciation expense. Realized after-tax trust earnings totaled $41.0 million in 2005 as the trust assets were liquidated due to the sale of Kewaunee. Realized after-tax trust earnings totaled $5.5 million in 2004 and $38.7 million in 2003. NOTE 9—Regulatory Assets and Liabilities The following regulatory assets and liabilities are reflected in our Consolidated Balance Sheets as of December 31: WPS Resources’ Regulatory Assets/Liabilities (Millions) Regulatory assets Environmental remediation costs (net of insurance recoveries) Deferred nuclear costs De Pere Energy Center Minimum pension liability Deferred Midwest Independent Transmission System Operator (MISO) costs Reserve for uncollectible accounts Income tax related items Reduced coal deliveries Asset retirement obligations Plant related costs Unamortized loss on debt Funding for enrichment facilities Other Total Regulatory liabilities Cost of removal reserve Non-qualified decommissioning trust Derivatives Income tax related items Deferred ATC and MISO costs Deferred gain on emission allowance sales Weston 4 costs Demand-side management expenditures Asset retirement obligations Unrealized gain on decommissioning trust Other Total 2005 $ 73.6 63.8 42.9 32.6 21.2 8.5 6.8 6.4 3.8 2.7 1.2 1.2 7.3 $272.0 $190.7 126.9 36.4 8.8 3.8 2.4 2.3 1.4 – – 0.5 $373.2 2004 $ 72.7 10.9 45.3 6.4 – 5.5 1.6 – – 6.5 2.4 1.8 7.8 $160.9 $186.2 – 11.0 11.2 1.6 3.7 – 1.1 46.6 26.8 0.1 $288.3 Our utility subsidiaries expect to recover their regulatory assets and return their regulatory liabilities through rates charged to customers based on specific ratemaking decisions or precedent for each item over periods specified by the regulators or over the normal operating period of the assets and liabilities to which they relate. Except for amounts expended for manufactured gas plant remediation, WPSC is recovering carrying costs for all regulatory assets. Historically, WPSC has recognized carrying costs at its weighted average cost of capital; however, pursuant to PSCW order, carrying costs related to some regulatory assets such as the 2005 Kewaunee outage and MISO C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 71
Slide 74: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS costs are being recovered based on the composite short-term debt rate. UPPCO may recover carrying costs on environmental regulatory assets. Based on prior and current rate treatment for such costs, we believe it is probable that WPSC and UPPCO will continue to recover from customers the regulatory assets described above. See Note 3, “Risk Management Activities”; Note 6, “Acquisitions and Sales of Assets”; Note 15, “Asset Retirement Obligations”; Note 17, “Commitments and Contingencies”; Note 19, “Employee Benefit Plans”; and Note 23, “Regulatory Environment,” for more information on some of the more significant regulatory assets and liabilities listed in the table on the prior page. NOTE 10—Investments in Affiliates, at Equity Method Investments in corporate joint ventures and other companies accounted for under the equity method at December 31, 2005, and 2004 follow. (Millions) were $50.8 million, $42.6 million, and $33.6 million in 2005, 2004, and 2003, respectively. UPPCO recorded network transmission service costs of $3.4 million, $4.0 million, and $4.2 million in 2005, 2004, and 2003, respectively. WPS Resources recorded dividends received of $17.8 million, $11.7 million, and $7.5 million from ATC in 2005, 2004, and 2003, respectively. 2005 $186.1 30.8 10.1 3.0 $230.0 2004 $113.4 29.0 12.8 6.8 $162.0 ATC Guardian Pipeline Wisconsin River Power Company Other Investments in affiliates, at equity method Guardian Pipeline Investments in affiliates under the equity method are a component of other assets on the Consolidated Balance Sheets, and the equity income is recorded in miscellaneous income on the Consolidated Statements of Income. Most of the equity income is taxable to the investor, rather than the investees, due to the flow through nature of several of the investees’ business structures. Accordingly, the provision for income taxes includes our taxes on this equity income. WPS Investments, LLC, a consolidated subsidiary of WPS Resources, purchased a 33% ownership interest in Guardian Pipeline, LLC on May 30, 2003. Guardian Pipeline owns a natural gas pipeline, which began operating in 2002, that stretches about 140 miles from near Joliet, Illinois, into southern Wisconsin. It can transport up to 750 million cubic feet of natural gas daily. ESI records related party transactions for purchases from Guardian Pipeline. These purchases amounted to $0.6 million, $0.4 million, and $0.1 million in 2005, 2004, and 2003, respectively. ATC WPS Investments, LLC, a consolidated subsidiary of WPS Resources, had a 31.0% ownership interest in ATC at December 31, 2005. ATC is a for-profit, transmission-only company. It owns, maintains, monitors, and operates, electric transmission assets in portions of Wisconsin, Michigan, and Illinois. Its assets previously were owned and operated by multiple electric utilities serving the upper Midwest, all of which transferred their transmission assets to ATC in exchange for an ownership interest. A Wisconsin law encouraged utilities in the state to transfer ownership and control of their transmission assets to a state-wide transmission company. The MISO directs ATC’s operation of the transmission system. During 2003, WPSC transferred its interest in the Wausau, Wisconsin, to Duluth, Minnesota, transmission line to ATC. WPS Resources has funded 50% of the construction expenditures for this line through 2005, resulting in an increased investment in ATC. See Note 6, “Acquisitions and Sales of Assets,” for more information on these transactions. WPSC and UPPCO record related-party transactions for services provided to and network transmission services received from ATC. The charges to ATC for services provided by WPSC were $8.7 million, $9.3 million, and $14.4 million in 2005, 2004, and 2003, respectively. UPPCO charged $2.6 million, $6.7 million, and $4.8 million in 2005, 2004, and 2003, respectively for services provided. Network transmission service costs paid to ATC by WPSC Wisconsin River Power Company WPSC owns 50% of the voting stock of Wisconsin River Power Company, which operates two hydroelectric plants on the Wisconsin River and an oil-fired combustion turbine. Two-thirds of the energy output of the hydroelectric plants is sold to WPSC, and the remaining one-third is sold to Wisconsin Power and Light. The electric power from the combustion turbine is sold in equal parts to WPSC and Wisconsin Power and Light. WPSC records related party transactions for sales to and purchases from Wisconsin River Power. Revenues from services provided to Wisconsin River Power were $1.8 million, $1.1 million, and $1.4 million for 2005, 2004, and 2003, respectively. Purchases from Wisconsin River Power by WPSC were $4.3 million, $3.2 million, and $2.3 million for 2005, 2004, and 2003, respectively. WPSC recorded dividends received of $7.8 million, $6.0 million, and $1.5 million from Wisconsin River Power in 2005, 2004, and 2003, respectively. Other Investments Other investments accounted for under the equity method include various investments, including a 20% investment in the NMC at December 31, 2004. After the sale of Kewaunee, WPS Resources’ 72 WPS RESOURCES CORPORATION
Slide 75: investment in the NMC was liquidated. The NMC operates nuclear power plants in the upper Midwest. WPSC recorded related party transactions for services provided by the NMC for the management and operation of Kewaunee prior to its sale to Dominion in July 2005. Management service fees paid to the NMC by WPSC were $15.1 million, $26.7 million, and $25.6 million in 2005, 2004, and 2003, respectively. Other investments accounted for under the equity method are not significant at December 31, 2005. Financial Data Combined financial data of ATC, Wisconsin River Power, and Guardian Pipeline follows. (Millions) 2005 $ 339.8 (189.4) (37.8) $ 112.6 $ 31.8 2004 $ 305.2 (180.6) (29.8) $ 94.8 $ 23.9 2003 $ 252.9 (147.6) (29.5) $ 75.8 $ 16.0 Income statement data Revenues Operating expenses Other expense Net income WPS Resources’ equity in net income Balance sheet data Current assets Non-current assets Total assets Current liabilities Long-term debt Other non-current liabilities Shareholders’ equity Total liabilities and shareholders’ equity $ 40.3 1,791.8 $1,832.1 $ 158.5 796.9 102.4 774.3 $1,832.1 $ 44.2 1,444.5 $1,488.7 $ 209.1 610.8 9.2 659.6 $1,488.7 $ 48.8 1,219.5 $1,268.3 89.3 613.8 14.6 550.6 $1,268.3 $ Of WPS Resources’ equity in net income disclosed above, $4.9 million, $6.2 million, and $4.7 million relates to WPSC’s investment in Wisconsin River Power in 2005, 2004, and 2003, respectively. NOTE 11—Goodwill and Other Intangible Assets Goodwill recorded by WPS Resources was $36.8 million at December 31, 2005, 2004, and 2003. Of this amount, $36.4 million is recorded in WPSC’s natural gas segment relating to its merger with Wisconsin Fuel and Light. The remaining $0.4 million of goodwill relates to ESI. (Millions) Goodwill and purchased intangible assets are included in other assets on the Consolidated Balance Sheets. Information in the tables below relates to total purchased identifiable intangible assets for the years indicated (excluding assets held for sale). December 31, 2005 Average Life (Years) 1 to 30 1 to 8 1 to 30 Gross Carrying Amount $41.2 10.2 4.2 $55.6 Accumulated Amortization $(22.2) (5.6) (0.9) $(28.7) Net $19.0 4.6 3.3 $26.9 Asset Class Emission allowances Customer related Other Total (Millions) December 31, 2004 Average Life (Years) 1 to 30 1 to 8 1 to 30 Gross Carrying Amount $15.8 11.2 4.2 $31.2 Accumulated Amortization $(0.9) (4.6) (0.7) $(6.2) Net $14.9 6.6 3.5 $25.0 Asset Class Emission allowances Customer related Other Total An impairment charge related to Sunbury, which was recorded in the second quarter of 2005, included the write-down of $6.6 million of unallocated emission allowances. These emission allowances were reflected in the above table at December 31, 2004 (see Note 4, “Sunbury Plant,” for more information). Because ESI sold all of Sunbury’s allocated emission allowances in the first half of 2005, emission allowances are currently purchased in the market as needed for the operation of this plant, which resulted in the increase in emission allowances at December 31, 2005, compared to December 31, 2004. C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 73
Slide 76: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A customer related intangible asset in the amount of $7.3 million was recorded in conjunction with a 2004 acquisition. This intangible asset was adjusted to $7.0 million in 2005 as a result of certain purchase price adjustments. The asset is being amortized over a period of eight years. Intangible asset amortization expense, in the aggregate, for the years ended December 31, 2005, 2004, and 2003, was $24.1 million, $2.4 million, and $1.7 million, respectively. Amortization expense increased in 2005 due to Sunbury’s current policy of purchasing emission allowances as required to operate the plant. The purchased emission allowances are amortized to expense as they are used in the production of power. Amortization expense for the next five fiscal years is estimated as follows: Estimated Amortization Expense: For For For For For year year year year year ending ending ending ending ending December December December December December 31, 2006 31, 2007 31, 2008 31, 2009 31, 2010 $17.8 1.4 1.5 1.2 1.0 million million million million million NOTE 12—Leases WPS Resources leases various property, plant, and equipment. Terms of the leases vary, but generally require WPS Resources to pay property taxes, insurance premiums, and maintenance costs associated with the leased property. Rental expense attributable to operating leases was $6.6 million, $5.7 million, and $5.2 million in 2005, 2004, and 2003, respectively. Future minimum rental obligations under non-cancelable operating leases, are payable as follows: Year Ending December 31 (Millions) 2006 2007 2008 2009 2010 Later years Total payments $ 5.1 4.0 3.4 2.5 2.4 6.9 $24.3 NOTE 13—Short-Term Debt and Lines of Credit WPS Resources has a syndicated $500 million five-year revolving credit facility, which expires in June 2010. WPSC has a syndicated $115 million five-year revolving credit facility containing annual trigger date provisions to provide short-term borrowing flexibility and security for commercial paper outstanding. In November 2005, WPS Resources entered into two unsecured revolving credit agreements of $557.5 million and $300 million with J.P Morgan Chase Bank and Banc of America Securities LLC. These . credit facilities are bridge facilities intended to backup commercial paper borrowings related to the purchase of the Michigan and Minnesota natural gas distribution operations from Aquila and to support purchase price adjustments related to working capital at the time of the closing of the transactions. The capacity under the bridge facilities will be reduced by the amount of proceeds from any longterm financing we complete prior to closing, with the exception of proceeds from the November 2005 equity offering. The credit agreements will be further reduced as permanent or replacement financing is secured. Under the $300 million credit agreement, loans cannot exceed the purchase price adjustments in connection with the Aquila acquisitions and no more than $200 million can be borrowed at the time of the first acquisition. Under the $300 million facility, these loan commitments will be reduced by one-third 90 days after the consummation of the applicable acquisition with the remaining two-thirds due 180 days after the consummation of the applicable acquisition (or earlier if long-term financing or replacement credit agreements are executed). Both of these credit agreements mature on September 5, 2007. These credit agreements have representations and covenants that are similar to those in our existing credit facilities. The information in the table below relates to short-term debt and lines of credit for the years indicated. (Millions, except for percentages) 2005 $254.8 4.54% $ 10.0 4.32% $249.1 2004 $279.7 2.46% $ 12.7 2.52% $161.9 2003 $ 28.0 1.15% $ 10.0 1.12% $288.9 As of end of year Commercial paper outstanding Average discount rate on outstanding commercial paper Short-term notes payable outstanding Average interest rate on short-term notes payable Available (unused) lines of credit (1) For the year Maximum amount of short-term debt Average amount of short-term debt Average interest rate on short-term debt (1) $310.7 $174.4 3.21% $312.5 $ 75.3 1.82% $194.2 $104.3 1.38% Amount does not include bridge credit facilities of $857.5 million. The commercial paper has varying maturity dates ranging from January 5, 2006, through January 20, 2006. 74 WPS RESOURCES CORPORATION
Slide 77: NOTE 14—Long-Term Debt At December 31 (Millions) First mortgage bonds – WPSC Series 6.90% 7.125% Senior notes – WPSC Series 6.125% 4.875% 4.80% 6.08% First mortgage bonds – UPPCO Series 9.32% Year Due 2011 2012 2013 2028 Year Due 2021 150.0 150.0 125.0 50.0 150.0 150.0 125.0 50.0 Year Due 2013 2023 2005 2004 May 1 and November 1 with a sinking fund payment of $900,000 due each November 1. The final sinking fund payment due November 1, 2021, will completely retire the series. Borrowings by ESI under term loans and collateralized by nonregulated assets totaled $16.4 million at December 31, 2005. The assets of WPS New England Generation, Inc. and WPS Canada Generation, Inc., subsidiaries of ESI, collateralize $4.7 million and $11.7 million, respectively, of the total outstanding amount. Both have semiannual installment payments, an interest rate of 8.75%, and mature in May 2010. In April 2001, the Schuylkill County Industrial Development Authority issued $27.0 million of refunding tax-exempt bonds. At the time of issuance of the refunding bonds, WPS Westwood Generation, LLC, a subsidiary of ESI, owned the original bonds, the proceeds of which were used in substantial part to purchase facilities. Upon issuance of the refunding bonds, the original bonds were paid off. WPS Westwood Generation was paid $27.0 million from the proceeds of the refunding bonds for the retirement of the original bonds plus accrued interest. WPS Westwood Generation is now obligated to pay the refunding bonds with monthly payments that have a floating interest rate that is reset weekly. At December 31, 2005, the interest rate was 3.5%. The bonds mature in April 2021. WPS Resources agreed to guarantee WPS Westwood Generation’s obligation to provide sufficient funds to pay the refunding bonds and the related obligations and indemnities. Upper Peninsula Building Development Corporation has a senior secured Note of $2.4 million as of December 31, 2005, which requires semiannual payments at an interest rate of 9.25%, and matures in 2011. The Note is secured by a first mortgage lien on the building they own, which is also leased to UPPCO for use as their corporate headquarters. At December 31, 2005, WPS Resources and its subsidiaries were in compliance with all covenants relating to outstanding debt. A schedule of all principal debt payment amounts, including bond maturities and early retirements, for WPS Resources is as follows: Year Ending December 31 (Millions) 2006 2007 2008 2009 2010 Later years Total payments $ 4.0 4.5 5.2 155.6 69.2 634.4 $872.9 $ 22.0 0.1 $ 22.0 0.1 14.4 15.3 Unsecured senior notes – WPS Resources Series Year Due 7.00% 2009 5.375% 2012 Unsecured term loan due 2010 – WPS Resources Term loans – nonrecourse, collateralized by nonregulated assets Tax exempt bonds Senior secured note Total Unamortized discount and premium on bonds and debt Total long-term debt Less current portion Total long-term debt 150.0 100.0 65.6 16.4 27.0 2.4 872.9 (1.8) 871.1 (4.0) $867.1 150.0 100.0 – 82.3 27.0 2.7 874.4 (2.0) 872.4 (6.7) $865.7 On June 17, 2005, $62.9 million of non-recourse debt at ESI collateralized by nonregulated assets was restructured to a five-year WPS Resources obligation as a result of the sale of Sunbury’s allocated emission allowances. In addition, $2.7 million drawn on a line of credit at ESI was rolled into the five-year WPS Resources obligation. The floating interest rate on the total five-year WPS Resources’ obligation of $65.6 million has been fixed at 4.595% through two interest rate swaps. All of WPSC’s debt securities are subject to the terms and conditions of WPSC’s First Mortgage Indenture. Under the terms of the indenture, substantially all property owned by WPSC is pledged as collateral for these outstanding debt securities. All these debt securities require semiannual payments of interest. All principal payments are due on the maturity date of each series. All WPSC senior notes become non-collateralized if WPSC retires all of its outstanding first mortgage bonds. Under the terms of UPPCO’s First Mortgage Indenture, substantially all property owned by UPPCO is pledged as collateral for this outstanding debt series. Interest payments are due semiannually on C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 75
Slide 78: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 15—Asset Retirement Obligations Adoption of SFAS No. 143 Legal retirement obligations previously identified at WPSC under the provisions of SFAS No. 143, “Accounting for Asset Retirement Obligations,” related primarily to the final decommissioning of Kewaunee. As discussed in Note 6, “Acquisitions and Sales of Assets,” the sale of Kewaunee to Dominion was completed on July 5, 2005. As a result of the sale, Dominion assumed the asset retirement obligation related to Kewaunee. Upon adoption of SFAS No. 143, other legal obligations were also identified related to WPSC, but these obligations were not significant. In connection with the implementation of SFAS No. 143, ESI identified a legal retirement obligation related to the closure of an ash basin located at Sunbury. The asset retirement obligation associated with Sunbury is recorded as a liability on the Consolidated Balance Sheet. The adoption of SFAS No. 143 at ESI resulted in a $0.3 million negative after-tax cumulative effect of change in accounting principle in the first quarter of 2003 related to recording a liability for the closure of this ash basin. $1.5 million and an asset retirement obligation of $8.2 million. This resulted in a $6.7 million cumulative effect of change in accounting principle before taxes. This amount was deferred as a regulatory asset as we obtained approval to defer the cumulative effect of adopting the Interpretation and believe it is probable that the actual cost to dispose of the assets will be recoverable in future rates. At December 31, 2005, the utilities had already recorded a $3.1 million regulatory liability related to the conditional asset retirement obligations discussed above, pertaining to amounts previously recovered in customer rates for the disposal of these assets. This $3.1 million regulatory liability was netted against the regulatory assets recorded upon adoption of the Interpretation. Conditional asset retirement obligations identified at ESI relate to asbestos abatement at certain generation facilities. Upon implementation of Interpretation No. 47 on December 31, 2005, ESI recorded a net asset retirement cost of $1.3 million and an asset retirement obligation of $3.9 million, resulting in an after-tax cumulative effect of change in accounting principles of $1.6 million ($2.6 million before taxes). If WPS Resources and WPSC had applied the provisions of Interpretation No. 47 as of January 1, 2003, the pro forma impacts on prior periods’ Consolidated Balance Sheets would not differ materially from the conditional asset retirement obligations recorded as of December 31, 2005, and the pro forma impacts on income available for common shareholders, as well as basic and diluted earnings per common share, would not be material. Adoption of Interpretation No. 47 WPS Resources adopted the provisions of Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations,” as of December 31, 2005. Upon adoption of this interpretation, WPS Resources recorded liabilities for conditional asset retirement obligations, which previously we believed to be outside the scope of SFAS No. 143. The utility segments identified conditional asset retirement obligations related to asbestos abatement at certain generation facilities, office buildings, and service centers; disposal of PCB-contaminated transformers; and closure of fly-ash landfills at certain generation facilities. Upon implementation of Interpretation No. 47 on December 31, 2005, the utility segments recorded a net asset retirement cost of Changes to Asset Retirement Obligation Liabilities The following table describes all changes to the asset retirement obligations of WPS Resources through December 31, 2005, including the adoption of Interpretation No. 47. Regulated Utilities (Millions) WPSC $324.8 19.2 344.0 20.4 364.4 12.4 (376.4) 7.3 $ 7.7 UPPCO $– – – – – – – 0.9 $0.9 ESI $2.0 0.1 2.1 0.1 2.2 0.2 – 3.9 $6.3 Total $326.8 19.3 346.1 20.5 366.6 12.6 (376.4) 12.1 $ 14.9 Asset retirement obligations at January 1, 2003 Accretion expense Asset retirement obligations at December 31, 2003 Accretion expense Asset retirement obligations at December 31, 2004 Accretion expense Asset retirement obligation transferred to Dominion Adoption of Interpretation No. 47 Asset retirement obligations at December 31, 2005 76 WPS RESOURCES CORPORATION
Slide 79: NOTE 16—Income Taxes The principal components of our deferred tax assets and liabilities recognized in the balance sheets as of December 31 are as follows: (Millions) 2005 $ 77.8 65.6 32.1 31.3 21.2 13.1 8.0 2.5 251.6 (2.5) $249.1 $ 20.2 273.2 17.2 3.5 3.2 1.3 2.8 $321.4 $ 13.5 58.8 $ 72.3 2004 $ 59.0 74.0 31.5 1.8 17.5 11.3 16.4 7.5 219.0 (1.5) $217.5 $ 8.0 252.5 13.2 3.5 11.0 5.8 3.6 $297.6 $ 9.1 71.0 $ 80.1 Deferred tax assets: Plant related Deferred tax credit carryforwards Employee benefits Regulatory deferrals Deferred income and deductions State capital and operating loss carryforwards Other comprehensive income Other Total deferred tax assets Valuation allowance Net deferred tax assets Deferred tax liabilities: Risk management activities, net Plant related Regulatory deferrals Deferred income and deductions Employee benefits Other comprehensive income Other Total deferred tax liabilities Consolidated balance sheet presentation: Current deferred tax liabilities Long-term deferred tax liabilities Net deferred tax liabilities Deferred tax credit carryforwards include $63.7 million of alternative minimum tax credits related to tax credits available under Section 29 of the Internal Revenue Code. These alternative minimum tax credit carryforwards can be carried forward indefinitely. Carryforward periods for state capital and operating loss carryforwards vary, but in the majority of states in which we do business, the period is 15 years or more. The balance of the carryforwards of state net operating losses is $235.0 million for all states. Valuation allowances have been established for certain state operating and capital loss carryforwards due to the uncertainty of the ability to realize the benefit of these losses in the future. The following table presents a reconciliation of federal income taxes (which are calculated by multiplying the statutory federal income tax rate by book income before federal income tax) to the provision for income taxes reported in the Consolidated Statements of Income. 2005 2004 Rate 35.0% 3.5 0.1 (2.3) (0.9) (19.9) (2.3) 13.2% Amount $57.6 5.8 0.1 (3.7) (1.5) (32.8) (3.8) $21.7 $11.4 11.7 0.4 23.5 2.4 (2.7) (1.5) $21.7 Rate 35.0% 8.0 (0.9) (1.8) (1.4) (15.5) (1.2) 22.2% 2003 Amount $42.5 9.8 (1.1) (2.2) (1.7) (18.9) (1.4) $27.0 $ 9.9 14.0 1.8 25.7 3.2 (0.2) (1.7) $27.0 (Millions, except for percentages) Rate 35.0% 4.2 0.3 (2.3) (0.8) (14.5) 0.5 22.4% Amount $73.1 8.8 0.6 (4.8) (1.7) (30.3) 1.0 $46.7 $43.2 17.2 3.2 63.6 (12.6) (2.6) (1.7) $46.7 Statutory federal income tax State income taxes, net Plant related Benefits and compensation Investment tax credit Federal tax credits Other differences, net Effective income tax Current provision Federal State Foreign Total current provision Deferred provision (benefit) Net operating loss carryforwards Investment tax credit Total income tax expense C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 77
Slide 80: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Foreign income before taxes was $10.2 million in 2005, $8.3 million in 2004, and $4.3 million in 2003. As the related temporary differences reverse, WPSC and UPPCO are prospectively refunding taxes to customers for which deferred taxes were recorded in prior years at rates different than current rates. The regulatory liability for these refunds and other regulatory tax effects totaled $8.8 million as of December 31, 2005, and $11.2 million as of December 31, 2004. NOTE 17—Commitments and Contingencies Commodity and Purchase Order Commitments WPS Resources routinely enters into long-term purchase and sale commitments that have various quantity requirements and durations. The commitments described below are as of December 31, 2005. ESI has unconditional purchase obligations related to energy supply contracts that total $4.8 billion. Substantially all of these obligations end by 2008, with obligations totaling $154.6 million extending from 2009 through 2016. The majority of the energy supply contracts are to meet ESI’s obligations to deliver energy to its customers. WPSC has obligations related to coal, purchased power, and natural gas. Obligations related to coal supply and transportation extend through 2016 and total $413.9 million. Through 2016, WPSC has obligations totaling $1.4 billion for either capacity or energy related to purchased power, including the obligation under the power purchase agreement with Dominion. Also, there are natural gas supply and transportation contracts with total estimated demand payments of $128.5 million through 2017. WPSC expects to recover these costs in future customer rates. Additionally, WPSC has contracts to sell electricity and natural gas to customers. UPPCO has made commitments for the purchase of commodities, mainly capacity or energy related to purchased power, which total $42.3 million and extend through 2010. WPS Resources also has commitments in the form of purchase orders issued to various vendors. At December 31, 2005, these purchase orders totaled $476.1 million and $462.0 million for WPS Resources and WPSC, respectively. The majority of these commitments relate to large construction projects, including construction of the 500-megawatt Weston 4 coal-fired generation facility near Wausau, Wisconsin. WPSC’s life extension program for Pulliam Units 3 through 8 and Weston Units 1 and 2. WPSC made an initial response to the EPA’s follow-up information request on June 12, 2002, and filed a final response on June 27, 2002. In 2000 and 2002, Wisconsin Power and Light Company received a similar series of EPA information requests relating to work performed on certain coal-fired boilers and related equipment at the Columbia generation station (a facility located in Portage, Wisconsin, jointly owned by Wisconsin Power and Light Company, Madison Gas and Electric Company, and WPSC). Wisconsin Power and Light Company is the operator of the plant and is responsible for responding to governmental inquiries relating to the operation of the facility. Wisconsin Power and Light Company filed its most recent response for the Columbia facility on July 12, 2002. Depending upon the results of the EPA’s review of the information provided by WPSC and Wisconsin Power and Light Company, the EPA may issue “notices of violation” or “findings of violation” asserting that a violation of the Clean Air Act occurred and/or seek additional information from WPSC and/or third parties who have information relating to the boilers or close out the investigation. To date, the EPA has not responded to the filings made by WPSC and Wisconsin Power and Light. In addition, under the federal Clean Air Act, citizen groups may pursue a claim. WPSC has no notice of such a claim based on the information submitted to the EPA. In response to the EPA’s Clean Air Act enforcement initiative, several utilities have elected to settle with the EPA, while others are in litigation. In general, those utilities that have settled have entered into consent decrees which require the companies to pay fines and penalties, undertake supplemental environmental projects, and either upgrade or replace pollution controls at existing generating units or shut down existing units and replace these units with new electric generating facilities. Several of the settlements involve multiple facilities. The fines and penalties (including the capital costs of supplemental environmental projects) associated with these settlements range between $7 million and $30 million. The regulatory interpretations upon which the lawsuits or settlements are based may change based on future court decisions that may be rendered in the pending litigations. In May 2003, WPSC initiated discussions with the EPA Region V aimed at negotiating a settlement. The discussions were preliminary and did not progress. No further action has been taken by the EPA. If the federal government decided to bring a claim against WPSC and if it were determined by a court that historic projects at WPSC’s Environmental United States Environmental Protection Agency (EPA) Section 114 Request In December 2000, WPSC received from the EPA a request for information under Section 114 of the Clean Air Act. The EPA sought information and documents relating to work performed on the coal-fired boilers located at WPSC’s Pulliam and Weston electric generation stations. WPSC filed a response with the EPA in early 2001. On May 22, 2002, WPSC received a follow-up request from the EPA seeking additional information regarding specific boiler-related work performed on Pulliam Units 3, 5, and 7, as well as information on 78 WPS RESOURCES CORPORATION
Slide 81: Pulliam and Weston plants required either a state or federal Clean Air Act permit, WPSC may, under the applicable statutes, be required to: ■ shut down any unit found to be operating in non-compliance, ■ install additional pollution control equipment, ■ pay a fine, and/or ■ pay a fine and conduct a supplemental environmental project in order to resolve any such claim. Pulliam Air Permit Violation Lawsuit The Sierra Club and Clean Wisconsin filed a complaint in the Eastern District of Wisconsin on October 19, 2005. The lawsuit was filed pursuant to the citizen suit provisions of the Clean Air Act. The complaint references opacity exceedances reported by the Pulliam facility located in Green Bay, Wisconsin, from 1999 through the first quarter of 2005. The notice also alleges monitoring violations from 1999 through 2004, exceedances of the Clean Air Act operating permit in 2002, exceedances of the permit issued for eight diesel generators in 2001, and exceedances of the permit for the combustion turbine, P32. The lawsuit seeks penalties, injunctive relief, and the costs of litigation. The Sierra Club and Clean Wisconsin have stated a willingness to discuss the alleged violations and the parties have engaged in settlement negotiations. Weston 4 Air Permit On November 15, 2004, the Sierra Club filed a petition with the WDNR under Section 285.61, Wis. Stats., seeking a contested case hearing on the air permit issued for the Weston 4 generation station. On December 2, 2004, the WDNR granted the petition and forwarded the matter to the Division of Hearings and Appeals. In its petition, Sierra Club raised legal and factual issues with the permit and with the process used by the WDNR to develop the air emission limits and conditions. In addition, both WPSC and the Sierra Club filed motions for summary judgment on certain of the issues. A decision regarding summary judgment was issued. In the ruling, the Administrative Law Judge denied the motion of Sierra Club and granted summary judgment to WPSC with respect to certain claims of Sierra Club consistent with the rulings rendered in Wisconsin Energy’s Elm Road proceeding. The contested case hearing in the matter was held during the last week of September 2005. The hearing addressed the remaining issues, which are generally related to the emission limits specified in the permit and the pollution controls to be used to achieve these limits. In February 2006, the Administrative Law Judge affirmed the Weston 4 air permit with modifications to the emission limits for sulfur dioxide and nitrogen oxide from the coal-fired boiler and particulate from the cooling tower. The modifications set limits that are more stringent than those set by the WDNR. WPS Resources is currently evaluating the impact this decision may have on future operating costs. Weston Site Operating Permit On April 18 and April 26, 2005, WPS Resources notified the WDNR that the existing Weston facility was not in compliance with certain provisions of the “Title V” air operating permit that was issued to the facility in October 2004. These provisions include: (1) the particulate emission limits applicable to the coal handling equipment; (2) the carbon monoxide (CO) limit for Weston combustion turbines; and (3) the limitation on the sulfur content of the fuel oil stored at the Weston facility. On July 25, 2005, WPSC received a notice of violation (NOV) from the WDNR asserting that the existing Weston facility is not in compliance with certain provisions of the permit. In response to the NOV, a compliance plan was submitted to the WDNR. Subsequently, stack testing was performed, which indicated continuing exceedances of the particulate limits from the coal handling equipment. On January 19, 2006, WPSC received from the WDNR a Notice of Noncompliance (NON) seeking further information about the alleged noncompliance event. WPSC provided a response to the WDNR and is in the process of seeking to have the permit revised. On February 20, 2005, the WDNR issued a NOV which incorporated most of the alleged noncompliance events described above (the alleged exceedances of the CO limit was not included) and added issues relating to opacity monitoring and the operation of a particulate source for three days without a functioning baghouse. Under the WDNR’s stepped enforcement process, a NOV is the first step in the WDNR’s enforcement procedure. If the WDNR decides to continue the enforcement process, the next step is a “referral” of the matter to the Wisconsin Attorney General’s Office. In addition, citizen groups may seek to initiate enforcement or may seek to initiate enforcement prior to the filing of any lawsuit by the Wisconsin Attorney General’s Office or may seek to intervene in the Title V operating permit revision process. WPSC is seeking to amend the applicable permit limits and is taking corrective action. At this time, we believe that our exposure to fines or penalties related to this noncompliance would not have a material impact on our financial results. Mercury and Interstate Air Quality Rules On October 1, 2004, the mercury emission control rule became effective in Wisconsin. The rule requires WPSC to control annual system mercury emissions in phases. The first phase will occur in 2008 and 2009. In this phase, the annual mercury emissions are capped at the average annual system mercury emissions for the period 2002 through 2004. The next phase will run from 2010 through 2014 and requires a 40% reduction from average annual 2002 through 2004 mercury input amounts. After 2015, a 75% reduction is required with a goal of an 80% reduction by 2018. Because federal regulations were promulgated in March 2005, we believe the State of Wisconsin will revise the Wisconsin rule to be consistent with the federal rule. However, the State of Wisconsin has filed suit against the federal government along with other states in opposition to the rule. WPSC estimates capital costs of approximately $14 million to achieve the proposed 75% reductions. The capital costs are expected to be recovered in a future rate case. In December 2003, the EPA proposed mercury “maximum achievable control technology” standards and an alternative mercury “cap and trade” program substantially modeled on the Clear Skies legislation initiative. The EPA also proposed the Clean Air Interstate Rule (formerly known as the Interstate Air Quality Rule), which would C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 79
Slide 82: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS reduce sulfur dioxide and nitrogen oxide emissions from utility boilers located in 29 states, including Wisconsin, Michigan, Pennsylvania, and New York. In March 2005, the EPA finalized both the mercury rule and the Clean Air Interstate Rule. The final mercury rule establishes New Source Performance Standards for new units based upon the type of coal burned. Weston 4 will install and operate mercury control technology with the aim of achieving a mercury emission rate less than that in the final EPA mercury rule. The final mercury rule also establishes a mercury cap and trade program, which requires a 21% reduction in national mercury emissions in 2010 and a 70% reduction in national mercury emissions beginning in 2018. Based on the final rule and current projections, WPSC anticipates meeting the mercury rule cap and trade requirements at a cost similar to the cost to comply with the Wisconsin rule. ESI’s current analysis indicates that additional emission control equipment on its existing units may be required. Excluding Sunbury, ESI estimates the capital cost for the remaining units to be approximately $1 million to achieve a 70% reduction. Including Sunbury, the total ESI mercury control costs could approximate $33 million, depending upon how this facility is operated. The final Clean Air Interstate Rule requires reduction of sulfur dioxide and nitrogen oxide emissions in two phases. The first phase requires about a 50% reduction beginning in 2009 for nitrogen oxide and beginning in 2010 for sulfur dioxide. The second phase begins in 2015 for both pollutants and requires about a 65% reduction in emissions. The rule allows the affected states (including Wisconsin, Michigan, Pennsylvania, and New York) to either require utilities located in the state to participate in the EPA’s interstate cap and trade program or meet the state’s emission budget for sulfur dioxide and nitrogen oxide through measures to be determined by the state. The states have not adopted a preference as to which option they would select, but the states are investigating the cap and trade program, as well as alternatives or additional requirements. Consequently, the effect of the rule on WPSC’s and ESI’s facilities is uncertain, since it depends upon how the states choose to implement the final Clean Air Interstate Rule. Currently, WPSC is evaluating a number of options that include using the cap and trade program and/or installing controls. For planning purposes, it is assumed that additional sulfur dioxide and nitrogen oxide controls will be needed on existing units or the existing units will need to be converted to natural gas by 2015. The installation of any controls and/or any conversion to natural gas will need to be scheduled as part of WPSC’s long-term maintenance plan for its existing units. As such, controls or conversions may need to take place before 2015. On a preliminary basis and assuming controls or conversion are required, WPSC estimates capital costs of $257 million in order to meet an assumed 2015 compliance date. This estimate is based on costs of current control technology and current information regarding the final EPA rule. The costs may change based on the requirements of the final state rules. ESI is evaluating the compliance options for the Clean Air Interstate Rule. Additional nitrogen oxide controls on some of ESI’s facilities may be necessary, and would cost approximately $40 million. The cost estimate is largely dependent upon how Sunbury will be operated going forward. See Note 4, “Sunbury Plant,” for additional information on Sunbury. Additional sulfur dioxide reductions are unlikely. Also, ESI will evaluate a number of options including using the cap and trade program, fuel switching, and/or installing controls. Clean Air Regulations Most of the generation facilities owned by ESI are located in an ozone transport region. As a result, these generation facilities are subject to additional restrictions on emissions of nitrogen oxide and sulfur dioxide. ESI began 2005 with 17,000 sulfur dioxide emission allowances for its generation facilities that are required to participate in the sulfur dioxide emission program. However, a majority of these allowances were sold in the second quarter of 2005, requiring a higher level of purchases for the remainder of the year. In future years, ESI expects to purchase sulfur dioxide and nitrogen oxide emission allowances at market rates, as needed, to meet its requirements for the Sunbury generation facility. Spent Nuclear Fuel Disposal The federal government is responsible for the disposal or permanent storage of spent nuclear fuel. The United States Department of Energy (DOE) is currently preparing an application to license a permanent spent nuclear fuel storage facility in the Yucca Mountain area of Nevada. Spent nuclear fuel is currently being stored at the Kewaunee plant. At current production levels, the plant has sufficient storage for all fuel assemblies until 2009 with full core offload. Additional capacity will be needed by 2010 to maintain full core offload capability. The United States government through the DOE was under contract with WPSC for the pick up and long-term storage of Kewaunee’s spent nuclear fuel. Because the DOE has failed to begin scheduled pick up of the spent nuclear fuel, WPSC incurred costs for the storage of the spent nuclear fuel. WPSC is a participant in a suit filed against the federal government for breach of contract and failure to pick up and store the spent nuclear fuel. The case was filed on January 22, 2004, in the United States Court of Federal Claims. The case has been temporarily stayed until June 30, 2006. In July 2005, WPSC sold Kewaunee to a subsidiary of Dominion Resources, Inc. Pursuant to the terms of the sale, Dominion has the right to pursue the spent nuclear fuel claim and WPSC will retain the contractual right to an equitable share of any future settlement or verdict. The total amount of damages sought are unknown at this time. Other Environmental Issues Groundwater testing at a former ash disposal site of UPPCO indicated elevated levels of boron and lithium. Supplemental remedial investigations were performed, and a revised remedial action plan was developed. The Michigan Department of 80 WPS RESOURCES CORPORATION
Slide 83: Environmental Quality approved the plan in January 2003. UPPCO received an order from the MPSC permitting deferral and future recovery of these costs. A liability of $1.3 million and an associated regulatory asset of $1.3 million were recorded at December 31, 2005, for estimated future expenditures associated with remediation of the site. UPPCO has an informal agreement, with the owner of another landfill, under which UPPCO has agreed to pay 17% of the investigation and remedial costs. It is estimated that the cost of addressing the site over the next year will be $1.8 million. UPPCO has recorded $0.3 million of this amount as its share of the liability as of December 31, 2005. There is increasing concern over the issue of climate change and the effect of emissions of greenhouse gases. WPS Resources is evaluating both the technical and cost implications, which may result from a future greenhouse gas regulatory program. This evaluation indicates that it is probable that any regulatory program that caps emissions or imposes a carbon tax will increase costs for WPS Resources and its customers. At this time, there is no commercially available technology for removing carbon dioxide from a pulverized coal-fired plant, but significant research is in progress. Efforts are underway within the utility industry to develop cleaner ways to burn coal. The use of alternate fuels is also being explored by the industry, but there are many cost and availability issues. Based on the complexity and uncertainty of the climate issues, a risk exists that future carbon regulation will increase the cost of electricity produced at coal-fired generation units. However, we believe the capital expenditures we are making at our generation units are appropriate under any reasonable mandatory greenhouse gas program. WPS Resources will continue to monitor and manage potential risks and opportunities associated with future greenhouse gas regulatory actions. Manufactured Gas Plant Remediation WPSC continues to investigate the environmental cleanup of ten manufactured gas plant sites. Cleanup of the land portion of the Oshkosh, Stevens Point, Green Bay, Manitowoc, and two Sheboygan sites in Wisconsin is completed. Groundwater treatment and monitoring at these sites will continue into the future. Cleanup of the land portion of four sites will be addressed in the future. River sediment remains to be addressed at sites with sediment contamination, and priorities will be determined in consultation with the EPA. The additional work at the sites remains to be scheduled. WPSC is currently in the process of transferring sites with sediment contamination formally under WDNR jurisdiction to the EPA Superfund Alternatives Program. WPSC received special notice letters that initiated the transfer process. Under the EPA’s program, the remedy decision will be based on risk-based criteria typically used at Superfund sites. WPSC estimated the future undiscounted investigation and cleanup costs as of December 31, 2005, to be $66 million. WPSC may adjust these estimates in the future contingent upon remedial technology, regulatory requirements, remedy determinations, and the assessment of natural resource damages. WPSC has received $12.7 million to date in insurance recoveries. WPSC expects to recover actual cleanup costs, net of insurance recoveries, in future customer rates. Under current PSCW policies, WPSC will not recover carrying costs associated with the cleanup expenditures. Flood Damage On May 14, 2003, a fuse plug at the Silver Lake reservoir owned by UPPCO was breached. This breach resulted in subsequent flooding downstream on the Dead River, which is located in Michigan’s Upper Peninsula near Marquette, Michigan. A dam owned by Marquette Board of Light and Power, which is located downstream from the Silver Lake reservoir near the mouth of the Dead River, also failed during this event. In addition, high water conditions and siltation resulted in damage at the Presque Isle Power Plant owned by Wisconsin Electric Power Company. Presque Isle, which is located downstream from the Marquette Board of Light and Power dam, was ultimately forced into a temporary shutdown. The FERC’s Independent Board of Review issued its report in December 2003 and concluded that the root cause of the incident was the failure of the design of the fuse plug to take into account the highly erodible nature of the fuse plug’s foundation materials and spillway channel, resulting in the complete loss of the fuse plug, foundation, and spillway channel, which caused the release of Silver Lake far beyond the intended design of the fuse plug. The fuse plug for the Silver Lake reservoir was designed by an outside engineering firm. UPPCO has worked with federal and state agencies in their investigations. UPPCO is still in the process of investigating the incident. WPS Resources maintains a comprehensive insurance program that includes UPPCO and which provides both property insurance for its facilities and liability insurance for liability to third parties. WPS Resources is insured in amounts that it believes are sufficient to cover its responsibilities in connection with this event. Deductibles and self-insured retentions on these policies are not material to WPS Resources. As of May 13, 2005, several lawsuits were filed by the claimants and putative defendants relating to this incident. The suits that have been filed against UPPCO, WPS Resources, and WPSC include the following claimants: WE Energies, Cleveland Cliffs, Inc., Board of Light and Power of the City of Marquette, the City of Marquette, the County of Marquette, Dead River Campers, Inc., Marquette County Road Commission, SBC, ATC, and various land and homeowners along the Silver Lake reservoir and Dead River system. UPPCO filed a suit against the engineering company that designed the fuse plug (MWH Americas, Inc.) and the contractor who built it (Moyle Construction, Inc.). UPPCO has reached a confidential settlement with WE Energies resolving WE Energies’ claims. The settlement payment will be reimbursed by WPS Resources’ insurer and, therefore, did not have a material impact on the Consolidated Financial Statements. WPS Resources is defending the remaining lawsuits filed against it and is seeking resolution of all claims and litigation where possible. C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 81
Slide 84: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS In November 2003, UPPCO received approval from the MPSC and the FERC for deferral of costs that are not reimbursable through insurance or recoverable through the power supply cost recovery mechanism. Recovery of costs deferred will be addressed in future rate proceedings. In November 2005, UPPCO announced it had not made a final decision whether to restore Silver Lake as a reservoir for power generation or to forego refilling the reservoir and that more time is needed to study the ramifications of design changes recommended by consultants and FERC. UPPCO will undertake additional studies of the new design recommendations to see if there are alternatives that would make restoring the Silver Lake Dam and refilling the reservoir economically beneficial for its customers. UPPCO expects to make its final decision on Silver Lake in the first half of 2006. defined what constitutes “stray voltage,” established a level of concern at which some utility corrective action is required, and set forth test protocols to be employed in evaluating whether a stray voltage problem exists. However, in 2003, the Supreme Court of Wisconsin ruled in the case Hoffmann v. WEPCO that a utility could be liable in tort to a farmer for damage from stray voltage even though the utility had complied with the PSCW’s established level of concern. Thus, despite the fact that WPSC believes it abides by the applicable PSCW requirements, it is not immune from the tort suits such as these under Wisconsin law. WPSC has insurance coverage for the pending claims, but the policies have customary self-insured retentions per occurrence. Based upon the information known at this time and the availability of insurance, WPSC believes that the total cost to it of resolving these five actions will not be material. Stray Voltage Claims From time to time, WPSC has been sued by dairy farmers who allege that they have suffered loss of milk production and other damages supposedly due to “stray voltage” from the operation of WPSC’s electrical system. One case, Allen v. WPSC, has been remanded from the court of appeals to the trial court for a determination of whether a post-verdict injunction is warranted. A second case, Pollack v. WPSC, was tried and ended in a defense verdict on May 5, 2005, and that case is concluded. A third case, Seidl v. WPSC, was dismissed on June 21, 2005, when the trial judge granted WPSC’s motion for a directed verdict. The Seidl plaintiffs have filed a notice of appeal of that dismissal. WPSC believes it has meritorious arguments supporting the dismissal and WPSC plans to vigorously contest the appeal. On February 15, 2005, the Court of Appeals affirmed the jury verdict in Allen v. WPSC, which awarded the plaintiff $0.8 million for economic damages and $1.0 million for nuisance. All appeals have been exhausted and the judgment has been paid to the plaintiff, but the plaintiff is still seeking an injunction. The injunction issues are scheduled to be tried in September 2006. The expert witnesses retained by WPSC do not believe that there is any scientific basis for concluding that electricity from the utility system is currently creating any problem on the plaintiff’s land. Accordingly, WPSC does not believe there is any basis for issuing an injunction, and intends to contest the plaintiff’s claim. Three cases, Theuerkauf v. WPSC, Wojciehowski Brothers Farms v. WPSC, and Schmoker v. WPSC were filed in the fourth quarter of 2005 and are still in the pleadings stage and it is too early to predict their outcomes. The Theuerkauf case was brought by Michigan farmers and is being heard in federal court in Green Bay. We believe Michigan law will govern this action. The Wojciehowski case was brought in state court in Wisconsin in Marinette County. The Schmoker case was brought in Wisconsin state court in Winnebago County. WPSC believes it has meritorious defenses to the plaintiffs’ claims in these cases, and intends to vigorously defend them. The PSCW has established certain requirements regarding stray voltage for all utilities subject to its jurisdiction. The PSCW has Wausau, Wisconsin, to Duluth, Minnesota, Transmission Line Construction of the 220-mile, 345-kilovolt Wausau, Wisconsin, to Duluth, Minnesota, transmission line began in the first quarter of 2004 with the Minnesota portion completed in early 2005. Construction in Wisconsin began on August 8, 2005. ATC has assumed primary responsibility for the overall management of the project and will own and operate the completed line. WPSC received approval from the PSCW and the FERC to transfer ownership of the project to ATC. WPSC will continue to manage obtaining the private property rights, design, and construction of the Wisconsin portion of the project. The Certificate of Public Convenience and Necessity and other permits needed for construction have been received and are final. In addition, on August 5, 2005, the new law allowing condemnation of county land for transmission lines approved by the PSCW became effective. In light of this legislation, Douglas County negotiated an easement agreement with ATC that allows the project to be constructed across county land on the route originally selected by the PSCW. On September 15, 2005, the Douglas County Board approved that agreement. Accordingly, the lawsuit against Douglas County to force it to provide easements for the project is being dismissed as moot, and ATC has asked the PSCW to close the docket, which was opened to examine alternative routes in Douglas County. WPS Resources committed to fund 50% of total project costs incurred up to $198 million and will receive additional equity in ATC in exchange for the project funding. Under its agreement, WPS Resources invested $57.0 million in ATC in 2005, bringing WPS Resources’ investment in ATC related to the project to $86.7 million since inception. WPS Resources may terminate funding if the project extends beyond January 1, 2010. On December 19, 2003, WPSC and ATC received approval from the PSCW to continue the project at a revised cost estimate of $420.3 million to reflect additional costs for the project resulting from time delays, added regulatory requirements, changes and additions to the scope of the project, and ATC overhead costs. The final portion of the line is expected to be placed in service in 82 WPS RESOURCES CORPORATION
Slide 85: 2008. WPS Resources has the right, but not the obligation, to provide additional funding in excess of $198 million for up to 50% of the revised cost estimate. Allete has exercised its option to fund a portion of the Wausau to Duluth transmission line. WPSC and Allete agreed that Allete will fund up to $60 million of the capital calls for the line in 2006. Considering this, for the period January 2006 through November 2008, WPS Resources expects to fund up to approximately $61 million for its portion of the Wausau to Duluth transmission line. Beaver Falls ESI’s Beaver Falls generation facility in New York has been out of service since late June 2005. The unplanned outage was caused by the failure of the first stage turbine blades. Inclusive of estimated insurance recoveries, ESI estimates at this time that it will cost between $3 million and $5 million to repair the turbine and replace the damaged blades. Depending on the amount of insurance recovery, ESI could incur significantly higher net out-of-pocket costs than originally estimated to repair the damage. In addition, ESI is attempting to renegotiate an existing steam off-take agreement with a counterparty, which will significantly impact its ability to recover costs. If significant repair costs are not recoverable through insurance or ESI is not able to renegotiate the terms of the steam off-take agreement, then a possibility exists that ESI would not repair the plant, in which case undiscounted cash flows related to future operations may be insufficient to recover the carrying value of the plant, resulting in impairment. The carrying value of the Beaver Falls generation facility at December 31, 2005, was $18.1 million. a specified number of barrels of oil. While no apparent phase-out of Section 29 federal tax credits occurred in 2005, ESI had mitigated essentially all of its 2005 phase-out risk at no net cost. Through optimization strategies, ESI realized a $0.3 million gain on oil options entered into to mitigate the 2005 phase-out risk, net of premium amortization. If no phase-out were to occur in 2006 and 2007, ESI would expect to recognize approximately $24 million of Section 29 federal tax credits in each of the next two years. Based upon forward oil prices, we are anticipating significant phase-outs of 2006 and 2007 Section 29 federal tax credits. However, we cannot predict with certainty the future price of a barrel of oil and, therefore, have no way of knowing what portion of our tax credits will be phased out, or if any phase-out will result. Based upon the average annual NYMEX price of a barrel of oil, ESI estimates that Section 29 federal tax credits will begin phasing out if the annual average NYMEX price of a barrel of oil reaches approximately $60, with a total phase-out if the annual average NYMEX price of a barrel of oil reaches approximately $73. At December 31, 2005, ESI had derivative contracts that mitigate substantially all of the Section 29 tax credit exposure in 2006 and 40% of the exposure in 2007. The derivative contracts involve purchased and written call options that provide for net cash settlement at expiration based on the average NYMEX trading price of oil in relation to the strike price of each option. Premiums paid for options to mitigate exposure to Section 29 federal tax credit phaseout in 2006 and 2007 totaled $15.3 million ($12.0 million for 2006 options and $3.3 million for 2007 options), all of which are recorded as risk management assets on the balance sheet. Essentially, ESI has paid $12.0 million for options ($7.2 million after-tax) to protect the value of approximately $24 million of tax credits in 2006 and $3.3 million for options ($2.0 million after-tax) to protect the value of approximately $10 million of tax credits in 2007. ESI has not hedged $14 million of 2007 tax credits. The derivative contracts have not been designated as hedging instruments and, as a result, changes in the fair value of the options are recorded currently in earnings. This could result in mark-to-market gains being recognized in earnings in different periods, compared to the offsetting tax credit phase-outs. For example, as of December 31, 2005, unrealized pre-tax mark-to-market gains of $4.0 million and $4.4 million were recorded for the 2006 and 2007 options, respectively, while no tax credit phase-out was recognized because 2006 and 2007 tax credits are not recognized until fuel is produced and sold in those periods. In 2006, ESI will only record Section 29 federal tax credits expected to be recognized, based upon the expected annual average price of a barrel of oil. In addition to exposure to federal tax credits, ESI has also historically received royalties tied to the amount of synthetic fuel produced as well as variable payments from a counterparty related to its 30% selldown of ECO Coal Pelletization #12 in 2002. Royalties and variable payments contributed $7.1 million, $7.6 million, and $5.9 million to income before taxes in 2005, 2004, and 2003, respectively. Royalties and variable payments received in 2006 and 2007 could decrease if a phase-out occurs and synthetic fuel production is reduced. Synthetic Fuel Production Facility We have significantly reduced our consolidated federal income tax liability over past years through tax credits available to us under Section 29 of the Internal Revenue Code for the production and sale of solid synthetic fuel from coal. These tax credits are scheduled to expire at the end of 2007 and are provided as an incentive for taxpayers to produce fuel from alternate sources and reduce domestic dependence on imported oil. This incentive is not deemed necessary if the price of oil increases sufficiently to provide a natural market for the fuel. Therefore, the tax credits in a given year are subject to phase out if the annual average reference price of oil within that year exceeds a minimum threshold price set by the IRS and are eliminated entirely if the average annual reference price increases beyond a maximum threshold price set by the IRS. The reference price of a barrel of oil is an estimate of the annual average wellhead price per barrel for domestic crude oil, which has in recent history been approximately $6 below the NYMEX price of a barrel of oil. The threshold price at which the credit begins to phase out was set in 1980 and is adjusted annually for inflation; the IRS releases the final numbers for a given year in the first part of the following year. Numerous events have increased domestic crude oil prices, including concerns about terrorism, storm-related supply disruptions, and worldwide demand. Therefore, in order to manage exposure to the risk of an increase in oil prices that could reduce the amount of Section 29 federal tax credits that could be recognized, ESI entered into a series of derivative contracts, beginning in the first quarter of 2005, covering C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 83
Slide 86: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 18—Guarantees As part of normal business, WPS Resources and its subsidiaries enter into various guarantees providing financial or performance assurance to third parties on behalf of certain subsidiaries. These guarantees are entered into primarily to support or enhance the creditworthiness otherwise attributed to a subsidiary on a stand-alone basis, thereby facilitating the extension of sufficient credit to accomplish the subsidiaries’ intended commercial purposes. Most of the guarantees issued by WPS Resources include intercompany guarantees between parents and their subsidiaries, WPS Resources’ Outstanding Guarantees (Millions) which are eliminated in consolidation, and guarantees of the subsidiaries’ own performance. As such, these guarantees are excluded from the recognition and measurement requirements of FASB Interpretation No. 45, “Guarantors’ Accounting and Disclosure Requirements for Guarantees, including Indirect Guarantees of Indebtedness of Others.” At December 31, 2005, 2004, and 2003, outstanding guarantees totaled $1,310.6 million, $977.9 million, and $981.8 million, respectively, as follows: December 31, 2005 $ 27.2 1,154.7 114.3 0.8 13.6 $1,310.6 Total Amounts Committed at December 31, 2005 $ 27.2 1,154.7 114.3 0.8 13.6 $1,310.6 December 31, 2004 $ 27.2 863.9 80.9 0.6 5.3 $977.9 December 31, 2003 $ 39.7 874.4 61.1 1.1 5.5 $981.8 Guarantees of subsidiary debt Guarantees supporting commodity transactions of subsidiaries Standby letters of credit Surety bonds Other guarantees Total guarantees WPS Resources’ Outstanding Guarantees (Millions) Commitments Expiring Guarantees of subsidiary debt Guarantees supporting commodity transactions of subsidiaries Standby letters of credit Surety bonds Other guarantees Total guarantees Less Than 1 Year $ – 1,063.0 109.4 0.8 – $1,173.2 1 to 3 Years $– 33.1 4.9 – – $38.0 4 to 5 Years $– 15.0 – – 13.6 $28.6 Over 5 Years $27.2 43.6 – – – $70.8 At December 31, 2005, WPS Resources had outstanding $27.2 million in corporate guarantees supporting indebtedness. Of that total, $27.0 million supports outstanding debt at one of ESI’s subsidiaries. The underlying debt related to these guarantees is reflected on WPS Resources’ Consolidated Balance Sheet. WPS Resources’ Board of Directors has authorized management to issue corporate guarantees in the aggregate amount of up to $1.35 billion to support the business operations of ESI. WPS Resources primarily issues the guarantees to counterparties in the wholesale electric and natural gas marketplace to provide them assurance that ESI will perform on its obligations and permit ESI to operate within these markets. At December 31, 2005, WPS Resources provided parental guarantees in the amount of $1,150.0 million, reflected in the above table, for ESI’s indemnification obligations for business operations, including $8.1 million of guarantees that received specific authorization from WPS Resources’ Board of Directors and are not included in the $1.35 billion general authorized amount. Of the parental guarantees provided by WPS Resources, the outstanding balance at December 31, 2005, which WPS Resources would be obligated to support, is approximately $299 million. Another $4.7 million of corporate guarantees support energy and transmission supply at UPPCO and are not reflected on WPS Resources’ Consolidated Balance Sheet. In February 2005, WPS Resources’ Board of Directors authorized management to issue corporate guarantees in the aggregate amount of up to $15.0 million to support the business operations of UPPCO. Corporate guarantees issued in the future under the Board authorized limit may or may not be reflected on WPS Resources’ Consolidated Balance Sheet, depending on the nature of the guarantee. At WPS Resources’ request, financial institutions have issued $114.3 million in standby letters of credit for the benefit of third parties that have extended credit to certain subsidiaries. If a subsidiary does not pay amounts when due under a covered contract, the counterparty may present its claim for payment to the financial institution, which will request payment from WPS Resources. Any amounts owed by our subsidiaries are reflected in WPS Resources’ Consolidated Balance Sheet. At December 31, 2005, WPS Resources furnished $0.8 million of surety bonds for various reasons including worker compensation coverage and obtaining various licenses, permits, and rights-of-way. Liabilities incurred as a result of activities covered by surety bonds are included in the WPS Resources’ Consolidated Balance Sheet. A guarantee of $4.7 million listed in the above table under other guarantees was issued by WPSC to indemnify a third party for exposures related to the construction of utility assets. This amount is not reflected on the WPS Resources’ Consolidated Balance Sheet, 84 WPS RESOURCES CORPORATION
Slide 87: as this agreement was entered into prior to the effective date of FASB Interpretation No. 45. In conjunction with the sale of Kewaunee, WPSC and WP&L agreed to indemnify Dominion for 70% of any and all reasonable costs asserted or initiated against, suffered, or otherwise existing, incurred or accrued, resulting from or arising from the resolution of any design bases documentation issues that are incurred prior to completion of Kewaunee’s scheduled maintenance period for 2009 up to a maximum combined exposure of $15 million for WPSC and WP&L. WPSC believes that it will expend its share of costs related to this indemnification and, as a result, recorded the fair value of the liability, or $8.9 million, as a component of the loss on the sale of Kewaunee. WPSC also agreed to indemnify Dominion for losses resulting from potential breaches of WPSC’s representations and warranties under the sale agreement. The indemnification is limited to approximately $18 million and expires in July 2006. WPSC believes the likelihood of having to make any material cash payments under the sale agreement as a result of breaches of representations and warranties is remote. NOTE 19—Employee Benefit Plans WPS Resources has a non-contributory-qualified retirement plan covering substantially all employees. WPS Resources also sponsors several nonqualified retirement plans, which are not funded. WPS Resources also currently offers medical, dental, and life insurance benefits to employees and their dependents. We expense these items for active employees as incurred. We fund benefits for retirees through irrevocable trusts as allowed for income tax purposes. WPSC serves as plan sponsor and administrator for the qualified retirement plan and the postretirement plans. Accordingly, WPSC’s Consolidated Balance Sheets reflect the assets and liabilities associated with these plans. With the exception of UPPCO’s Supplemental Employee Retirement Plan, the assets and liabilities related to the non-qualified pension plans are also recorded on WPSC’s Consolidated Balance Sheets. The net periodic benefit cost associated with the plans is allocated among WPS Resources’ subsidiaries. Actuarial calculations are performed (based upon specific employees and their related years of service) in order to determine the appropriate benefit cost allocation. The costs of pension and postretirement benefits are expensed over the period in which the employee renders service. The transition obligation for postretirement benefits of current and future retirees is being recognized over a 20-year period beginning in 1993. WPS Resources uses a December 31 measurement date for the majority of its plans. The Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the Act) provides a prescription drug benefit under Medicare Part D as well as a federal subsidy to sponsors of certain retiree health care benefit plans. In May 2004, the FASB staff issued FSP 106-2, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003.” WPS Resources and its actuarial advisors determined that benefits provided by the plan as of the date of enactment were at least actuarially equivalent to Medicare Part D, and, accordingly, WPS Resources will be entitled to the federal subsidy. WPS Resources performed a measurement of the effects of the Act on its accumulated postretirement benefit obligation as of July 1, 2004 (the date FSP 106-2 was adopted). As of July 1, 2004, WPS Resources’ and WPSC’s accumulated postretirement benefit obligation decreased $40.3 million and $33.5 million, respectively, as a result of the Act. The change in the accumulated postretirement benefit obligation due to the Act is considered an actuarial gain that will be recognized in future periods and, therefore, had no cumulative effect on WPS Resources or WPSC’s retained earnings as of July 1, 2004. The effect of the subsidy served to reduce the net postretirement benefit cost by $6.5 million and $2.6 million for WPS Resources for the years ended December 31, 2005, and 2004, respectively. The tables on the following page provide a reconciliation of the changes in the plan’s benefit obligations and fair value of assets during 2005, 2004, and 2003, as well as a statement of the funded status as of December 31 for each year. C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 85
Slide 88: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Pension Benefits (Millions) Other Benefits 2003 2005 2004 2003 2005 2004 Reconciliation of benefit obligation (qualified and non-qualified plans) Obligation at January 1 Service cost Interest cost Plan amendments Plan spin off – Kewaunee sale Actuarial (gain) loss – net Benefit payments Obligation at December 31 Reconciliation of fair value of plan assets (qualified plans) Fair value of plan assets at January 1 Actual return on plan assets Employer contributions Plan spin off – Kewaunee sale Benefit payments Fair value of plan assets at December 31 Funded status of plans Funded status at December 31 Unrecognized transition obligation Unrecognized prior-service cost Unrecognized loss Net asset (liability) recognized $ 720.7 23.9 40.3 – (25.7) 8.2 (39.6) $ 727.8 $ 588.9 39.7 8.2 (15.5) (38.3) $ 583.0 $(144.8) 0.2 39.4 120.3 $ 15.1 $ 637.2 20.5 39.8 – – 62.0 (38.8) $ 720.7 $ 569.9 54.5 1.6 – (37.1) $ 588.9 $(131.8) 0.4 44.8 127.0 $ 40.4 $553.8 15.2 36.9 – – 67.0 (35.7) $637.2 $511.6 92.7 – – (34.4) $569.9 $ (67.3) 0.6 50.5 78.0 $ 61.8 $ 294.7 8.0 16.5 – (13.3) (9.6) (9.4) $ 286.9 $ 170.9 11.3 20.4 (10.4) (9.2) $ 183.0 $(103.9) 2.9 (17.1) 74.2 $ (43.9) $ 281.6 7.5 16.9 – – (3.4) (7.9) $ 294.7 $ 149.7 12.9 16.2 – (7.9) $ 170.9 $(123.8) 3.4 (19.4) 91.1 $ (48.7) $ 234.3 7.1 15.3 (15.3) – 49.5 (9.3) $ 281.6 $ 119.7 23.7 15.6 – (9.3) $ 149.7 $(131.9) 3.8 (21.5) 99.7 $ (49.9) Amounts recognized in the Consolidated Balance Sheets related to the benefit plans consist of: Pension Benefits (Millions) Other Benefits 2005 $(43.9) – – – $(43.9) 2004 $(48.7) – – – $(48.7) 2005 $(63.6) 39.7 32.6 6.4 $ 15.1 2004 $(45.9) 45.0 6.4 34.9 $ 40.4 Accrued benefit cost Intangible assets Regulatory asset Accumulated other comprehensive income (before tax effect of $2.6 million and $14.0 million, respectively) Net asset (liability) recognized We record a minimum pension liability to reflect the funded status of our pension plans. Substantially all of the minimum pension liability relates to unrecognized pension costs of the utilities. Regulatory assets are recorded for costs that are probable of recovery when recognized. Included in the above table is an accrued benefit cost of $1.6 million at December 31, 2005, and $1.7 million at December 31, 2004, related to UPPCO’s Supplemental Employee Retirement Plan. The accumulated benefit obligation for all defined benefit pension plans was $646.5 million and $634.8 million at December 31, 2005, and 2004, respectively. Information for pension plans with an accumulated benefit obligation in excess of plan assets is presented in the following table. At December 31 (Millions) Projected benefit obligation Accumulated benefit obligation Fair value of plan assets 2005 $727.8 646.5 583.0 2004 $720.7 634.8 588.9 The following table presents the components of the consolidated net periodic benefit cost (credit) for the plans for 2005, 2004, and 2003: Pension Benefits Other Benefits 2003 $15.2 36.9 (46.7) – 5.8 0.7 0.8 $12.7 2005 $ 8.0 16.5 (12.5) 0.4 (2.2) 5.5 – $15.7 2004 $ 7.5 16.9 (11.6) 0.4 (2.2) 4.1 – $15.1 2003 $ 7.1 15.3 (10.6) 1.0 (1.8) 2.6 – $13.6 (Millions) 2005 $23.9 40.3 (43.6) 0.2 5.3 8.7 – $34.8 2004 $20.5 39.8 (45.9) 0.2 5.7 4.5 – $24.8 Net periodic benefit cost Service cost Interest cost Expected return on plan assets Amortization of transition asset Amortization of prior-service cost (credit) Amortization of net loss Special termination benefits Net periodic benefit cost 86 WPS RESOURCES CORPORATION
Slide 89: Net periodic benefit cost recorded by WPSC related to pension benefits was $25.2 million in 2005, $16.3 million in 2004, and $6.7 million in 2003. Net periodic benefit cost recorded by WPSC related to other benefits was $13.6 million in 2005, $12.4 million in 2004, and $12.0 million in 2003. Assumptions The weighted average assumptions used at December 31 in accounting for the plans are as follows: Pension Benefits 2005 Discount rate for benefit obligations Discount rate for net periodic benefit cost Expected return on assets Rate of compensation increase 5.65% 5.75% 8.50% 5.50% 2004 5.75% 6.25% 8.75% 5.50% 2003 6.25% 6.75% 8.75% 5.50% 2005 5.65% 5.75% 8.50% – Other Benefits 2004 5.75% 6.25% 8.75% – 2003 6.25% 6.75% 8.75% – The assumptions used for WPS Resources’ medical and dental cost trend rates are shown in the following table: 2005 Assumed medical cost trend rate (under age 65) Ultimate trend rate Ultimate trend rate reached in Assumed medical cost trend rate (over age 65) Ultimate trend rate Ultimate trend rate reached in Assumed dental cost trend rate Ultimate trend rate Ultimate trend rate reached in 9.0% 5.0% 2010 11.0% 6.5% 2011 5.0% 5.0% 2004 2004 10.0% 5.0% 2010 12.0% 6.5% 2011 5.0% 5.0% 2004 2003 11.0% 5.0% 2010 13.0% 6.5% 2011 5.0% 5.0% 2004 and debt securities 35%. Because of market volatility, the Committee periodically reviews the asset allocation and the portfolio is rebalanced when considered appropriate. Cash Flows WPS Resources’ funding policy is to contribute at least the minimum amounts that are required to be funded under the Employee Retirement Income Security Act, but not more than the maximum amounts that are currently deductible for income tax purposes. We expect to contribute $25.3 million to our pension plans and $19.8 million to our other postretirement benefit plans in 2006. The following table shows the payments, reflecting expected future service, which WPS Resources expects to make for pension and other postretirement benefits. In addition, the table shows the expected federal subsidies under Medicare Part D, which will partially offset other postretirement benefits, as discussed earlier. Pension Benefits $ 40.9 42.7 42.8 44.1 45.2 235.3 Other Benefits $11.7 12.7 13.7 14.8 15.6 89.5 Federal Subsidies $ (1.4) (1.5) (1.7) (1.8) (2.0) (11.7) Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. A 1% change in assumed health care cost trend rates would have the following effects: (Millions) 1% Increase 1% Decrease (Millions) Effects on total of service and interest cost components of net periodic postretirement health care benefit cost Effect on the health care component of the accumulated postretirement benefit obligation $ 3.5 $37.0 $ (3.2) $(33.0) Plan Assets Weighted-average asset allocations of the plans at December 31, 2005, and 2004, are as follows: Pension Plan Assets at December 31, 2005 Asset category Equity securities Debt securities Real estate Total 63% 32% 5% 100% 2004 63% 33% 4% 100% Postretirement Plan Assets at December 31, 2005 62% 38% 0% 100% 2004 63% 37% 0% 100% 2006 2007 2008 2009 2010 2011–2015 Defined Contribution Benefit Plans WPS Resources maintains a 401(k) Savings Plan for substantially all full-time employees. Employees generally may contribute from 1% to 30% of their base compensation to individual accounts within the 401(k) Savings Plan. Participation in this plan automatically qualifies eligible non-union employees for participation in the Employee Stock Ownership Plan (ESOP). The company match, in the form of shares of WPS Resources’ common stock, is contributed to an employee’s ESOP account. The plan requires a match equivalent to 100% of the first 4% and 50% of the next 2% contributed by nonunion employees. Certain union employees receive a contribution to their ESOP account regardless of their participation in the 401(k) Savings Plan. The ESOP held 2.2 million shares of WPS Resources’ common stock (market value of $120.8 million) at December 31, 2005. Total costs incurred under these plans were $8.2 million in 2005, $7.7 million in 2004, and $5.7 million in 2003. WPSC’s share of the total costs was $6.8 million in 2005, $6.5 million in 2004, and $4.6 million in 2003. The Board of Directors has established the Employee Benefits Administrator Committee to manage the operations and administration of all benefit plans and related trusts. The Committee has investment policies for the plan assets that establish target asset allocations for the above listed asset classes as follows: pension plan – equity securities 60%, debt securities 35%, and real estate 5%; postretirement plan – equity securities 65% C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 87
Slide 90: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS WPS Resources maintains a deferred compensation plan that enables certain key employees and non-employee directors to defer a portion of their compensation or fees on a pre-tax basis. Non-employee directors can defer up to 100% of their director fees. There are essentially two separate investment programs available to plan participants. The first program (Program 1) offers WPS Resources’ common stock as a hypothetical investment option for participants; deemed dividends paid on the common stock are automatically reinvested; and all distributions must be made in WPS Resources’ common stock. The second program (Program 2) offers a variety of hypothetical investment options indexed to mutual funds, WPS Resources’ return on equity, and WPS Resources’ common stock. Participants may not redirect investments between the two programs. All employee deferrals are remitted to WPSC and, therefore, the liabilities and costs associated with the deferred compensation plans are included on WPSC’s Consolidated Balance Sheets and Consolidated Statements of Income, respectively. Program 1 is accounted for as a plan that does not permit diversification. As a result, the deferred compensation arrangement is classified as an equity instrument and changes in the fair value of the deferred compensation obligation are not recognized. The deferred compensation obligation associated with Program 1 was $16.1 million at December 31, 2005, and $13.0 million at December 31, 2004. Program 2 is accounted for as a plan that permits diversification. As a result, the deferred compensation obligation associated with this program is classified as a liability in the Consolidated Balance Sheets and adjusted, with a charge or credit to expense, to reflect changes in the fair value of the deferred compensation obligation. The obligation, classified within other long-term liabilities, was $23.6 million at December 31, 2005, and $21.0 million at December 31, 2004. The costs incurred under Program 2 were $2.6 million in 2005, $2.1 million in 2004, and $2.4 million in 2003. The deferred compensation programs are partially funded through shares of WPS Resources’ common stock that is held in a rabbi trust. The common stock held in the rabbi trust is classified in equity in a manner similar to accounting for treasury stock. The total cost of WPS Resources’ common stock held in the rabbi trust was $10.9 million at December 31, 2005, and $8.4 million at December 31, 2004. NOTE 20—Preferred Stock of Subsidiary WPSC has 1,000,000 authorized shares of preferred stock with no mandatory redemption and a $100 par value. Outstanding shares are as follows at December 31: 2005 (Millions, except share amounts) 2004 Carrying Value $13.1 3.0 5.0 15.0 15.0 $51.1 Shares Outstanding 130,799 29,920 49,928 150,000 150,000 510,647 Carrying Value $13.1 3.0 5.0 15.0 15.0 $51.1 Series 5.00% 5.04% 5.08% 6.76% 6.88% Shares Outstanding 130,778 29,920 49,928 150,000 150,000 510,626 Total All shares of preferred stock of all series are of equal rank except as to dividend rates and redemption terms. Payment of dividends from any earned surplus or other available surplus is not restricted by the terms of any indenture or other undertaking by WPSC. Each series of outstanding preferred stock is redeemable in whole or in part at WPSC’s option at any time on 30 days’ notice at the respective redemption prices. WPSC may not redeem less than all, nor purchase any, of its preferred stock during the existence of any dividend default. In the event of WPSC’s dissolution or liquidation, the holders of preferred stock are entitled to receive (a) the par value of their preferred stock out of the corporate assets other than profits before any of such assets are paid or distributed to the holders of common stock and (b) the amount of dividends accumulated and unpaid on their preferred stock out of the surplus or net profits before any of such surplus or net profits are paid to the holders of common stock. Thereafter, the remainder of the corporate assets, surplus, and net profits shall be paid to the holders of common stock. The preferred stock has no pre-emptive, subscription, or conversion rights, and has no sinking fund provisions. 88 WPS RESOURCES CORPORATION
Slide 91: NOTE 21—Common Equity Shares outstanding at December 31 Common stock, $1 par value, 200,000,000 shares authorized Treasury stock Average cost of treasury shares Shares in deferred compensation rabbi trust Average cost of deferred compensation rabbi trust shares 2005 40,089,898 12,000 $25.19 270,491 $40.29 2004 37,500,791 12,000 $25.19 229,238 $36.84 determines is not in the best interests of our shareholders. The plan gives our existing shareholders, under certain circumstances, the right to purchase stock at a discounted price. The rights expire on December 11, 2006. Dividends WPS Resources is a holding company and our ability to pay dividends is largely dependent upon the ability of our subsidiaries to pay dividends to us. The PSCW has by order restricted our principal subsidiary, WPSC, to paying normal dividends on its common stock of no more than 109% of the previous year’s common stock dividend. The PSCW also requires WPSC to maintain a capital structure (i.e., the percentages by which each of common stock, preferred stock, and debt constitute the total capital invested in a utility), which has a common equity range of 50% to 55%. Each of these limitations may be modified by a future order of the PSCW. Our right to receive dividends on the common stock of WPSC is also subject to the prior rights of WPSC’s preferred shareholders and to provisions in WPSC’s Restated Articles of Incorporation which limit the amount of common stock dividends which WPSC may pay if its common stock and common stock surplus accounts constitute less than 25% of its total capitalization. These limitations are not expected to limit any dividend payments in the foreseeable future. UPPCO’s indentures relating to its first mortgage bonds contain certain limitations on the payment of cash dividends on its common stock, which is held solely by WPS Resources. Under the most restrictive of these provisions, $27.7 million of retained earnings were available at December 31, 2005, for the payment of common stock cash dividends by UPPCO. At December 31, 2005, WPS Resources had $551.4 million of retained earnings available for dividends. Treasury shares at December 31, 2005, relate to our Non-Employee Directors Stock Option Plan. The number of stock options granted under this plan may not exceed 100,000 shares. All options under this plan have a ten-year life, but may not be exercised until one year after the date of grant. Effective January 2001, we began issuing new stock under our Stock Investment Plan and under certain of our stock-based employee benefit plans. These stock issuances increased equity $29.0 million, $28.3 million, and $31.0 million in 2005, 2004, and 2003, respectively. In November 2005, 1,900,000 shares of WPS Resources’ common stock were issued at $53.70 per share and resulted in a net increase in equity of $98.3 million, inclusive of underwriting commissions and other expenses directly related to the issuance. In November 2003, 4,025,000 shares of WPS Resources’ common stock were issued at $43.00 per share and resulted in a net increase in equity of $166.8 million, inclusive of underwriting commissions and other expenses directly related to the issuance. Common Stock Shares Outstanding 31,808,779 4,025,000 764,681 49,950 (26,434) 36,621,976 670,235 3,700 (36,358) 37,259,553 1,900,000 689,107 (41,253) 39,807,407 Reconciliation of Common Shares Balance at December 31, 2002 Common stock offering Stock Investment Plan and other stock-based employee benefit plans Stock issued from treasury stock Increase in deferred compensation rabbi trust shares Balance at December 31, 2003 Stock Investment Plan and other stock-based employee benefit plans Stock issued from treasury stock Increase in deferred compensation rabbi trust shares Balance at December 31, 2004 Common stock offering Stock Investment Plan and other stock-based employee benefit plans Increase in deferred compensation rabbi trust shares Balance at December 31, 2005 Forward Equity Transaction In November 2005, WPS Resources entered into a forward equity sale agreement with an affiliate of J.P Morgan Securities, Inc., as forward . purchaser, relating to 2.7 million shares of WPS Resources’ common stock. In connection with the forward agreement, J.P Morgan Securities . borrowed an equal number of shares of WPS Resources’ common stock from stock lenders and, at WPS Resources’ request, sold the borrowed shares to the public. WPS Resources will not receive any proceeds from J.P Morgan Securities’ sale of the common shares . until the forward agreement is settled, which may occur any time prior to November 21, 2006. Except in specified circumstances or events that would require physical share settlement, WPS Resources may elect to settle the forward agreement by means of physical shares or through cash settlement. Under a physical share settlement, the maximum number of shares deliverable by WPS Resources is 2.7 million shares. Depending upon the share price at the date of settlement, we could either owe or be owed funds if we elect the cash settlement option. If the cash settlement option was elected, the forward purchaser would purchase shares in the market and return those shares to the lenders. The amount we would receive Shareholder Rights Plan In December 1996, we adopted a Shareholder Rights Plan. The plan is designed to enhance the ability of the Board of Directors to protect shareholders of WPS Resources if efforts are made to gain control of our company in a manner that the Board of Directors C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 89
Slide 92: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS or be required to pay would be dependent upon the price at which the forward purchaser acquired the shares in the open market in relation to the contracted forward price. Generally, if the forward purchase price is lower than the price at which the forward purchaser is able to acquire the shares, then we would owe cash; and if the price at which the forward purchaser is able to acquire shares is less than the forward share price, we would receive cash. At December 31, 2005, the forward price was $51.58 per share, representing the initial public offering price of $53.70 per share, net of underwriting discounts and commissions. The forward sale price is increased daily based on a floating interest factor equal to the federal funds rate, less a 75 basis point fixed spread. The federal funds rate was 4.25% at December 31, 2005. The forward sales price will also be subject to decrease by $0.565 on February 28, 2006, $0.565 on May 31, 2006, and $0.575 on August 31, 2006. If the forward agreement had been settled by delivery of shares at December 31, 2005, WPS Resources would have received $139.3 million, based on the December 31, 2005, forward share price of $51.58 for the 2.7 million shares. The forward equity agreement had no initial fair value. At settlement, the forward equity sale agreement will be recorded within equity. The use of a forward agreement allows WPS Resources to avoid market uncertainty by pricing a stock offering under then existing market conditions, while mitigating share dilution by postponing the issuance of stock until funds are needed. WPS Resources currently anticipates settling the forward equity transaction through physical share settlement and expects to use proceeds received under the forward equity agreement to partially finance the proposed acquisition of the Minnesota and Michigan natural gas distribution operations of Aquila and for general corporate purposes. Earnings Per Share Earnings per share is computed by dividing income available for common shareholders by the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share is computed by dividing income available for common shareholders by the weighted average number of shares of common stock outstanding during the period adjusted for the exercise and/or conversion of all potentially dilutive securities. Such dilutive items include in-the-money stock options, restricted shares, performance share grants, and shares related to the forward equity transaction discussed above. The calculation of diluted earnings per share for the years shown excludes some stock option plan shares that had an anti-dilutive effect. The shares having an anti-dilutive effect are not significant for any of the years shown. The following table reconciles the computation of basic and diluted earnings per share: Reconciliation of Earnings Per Share (Millions except per share amounts) 2005 $157.4 38.3 0.4 38.7 $ 4.11 $ 4.07 2004 $139.7 37.4 0.2 37.6 $ 3.74 $ 3.72 2003 $94.7 33.0 0.2 33.2 $2.87 $2.85 Income available for common shareholders Basic weighted average shares Incremental issuable shares Diluted weighted average shares Basic earnings per common share Diluted earnings per common share NOTE 22—Stock-Based Compensation WPS Resources has four stock-based compensation plans: the 2005 Omnibus Incentive Compensation Plan (2005 Omnibus Plan), the 2001 Omnibus Incentive Compensation Plan (2001 Omnibus Plan), the 1999 Stock Option Plan (Employee Plan), and the 1999 NonEmployee Directors Stock Option Plan (Director Plan). No additional stock options will be issued under the 2001 Omnibus Plan or the Employee Plan, although the plans will continue to exist for purposes of the existing outstanding stock-based compensation. The number of shares issuable under each of the aforementioned stock-based compensation plans, each outstanding award, and stock option exercise prices are subject to adjustment in the event of any stock split, stock dividend, or other similar transaction. options for more than 150,000 shares during any calendar year. Stock options are granted by the Compensation Committee of the Board of Directors and may be granted at any time. No stock options will have a term longer than ten years. The exercise price of each stock option is equal to the fair market value of the stock on the date the stock option was granted. One-fourth of the stock options granted under the 2005 and 2001 Omnibus Plans and the Employee Plan will become vested and exercisable each year on the anniversary date of the grant. The number of stock options granted under the Director Plan may not exceed 100,000, and the shares to be delivered will consist solely of treasury shares. Stock options are granted at the discretion of the Board of Directors. No options may be granted under this plan after December 31, 2008. All options have a ten-year life, but they may not be exercised until one year after the date of grant. Options granted under this plan are immediately vested. The exercise price of each option is equal to the fair market value of the stock on the date the stock options were granted. Stock Options Under the provisions of the 2005 Omnibus Plan, the number of shares for which stock options may be granted may not exceed 2 million, and no single employee that is the chief executive officer of WPS Resources or any of the other four highest compensated officers of WPS Resources and its subsidiaries can be granted 90 WPS RESOURCES CORPORATION
Slide 93: A summary of the activity of the stock option plans for 2005 is presented below: Weighted-Average Exercise Price $41.35 33.51 25.50 54.85 35.99 32.65 42.30 41.72 54.85 33.99 25.50 39.31 33.99 25.50 $4.40 Stock Options Options outstanding at beginning of year 2001 Omnibus Plan Employee Plan Director Plan Granted during 2005 2005 Omnibus Plan Exercised during 2005 2001 Omnibus Plan Employee Plan Forfeited during 2005 2001 Omnibus Plan Outstanding at end of year 2001 Omnibus Plan 2005 Omnibus Plan Employee Plan Director Plan Options exercisable at year-end 2001 Omnibus Plan Employee Plan Director Plan Weighted-average fair value of options granted during 2005 2005 Omnibus Plan Shares 1,279,684 245,320 12,000 325,347 83,306 88,347 1,937 1,194,441 325,347 156,973 12,000 703,491 156,973 12,000 A summary of the activity of the stock option plans for 2004 is presented below: Weighted-Average Exercise Price $38.97 33.11 25.49 48.11 35.17 30.53 25.44 41.23 41.35 33.51 25.50 37.37 33.51 25.50 $4.75 Stock Options Options outstanding at beginning of year 2001 Omnibus Plan Employee Plan Director Plan Granted during 2004 2001 Omnibus Plan Exercised during 2004 2001 Omnibus Plan Employee Plan Director Plan Forfeited during 2004 2001 Omnibus Plan Outstanding at end of year 2001 Omnibus Plan Employee Plan Director Plan Options exercisable at year-end 2001 Omnibus Plan Employee Plan Director Plan Weighted-average fair value of options granted during 2004 2001 Omnibus Plan Shares 993,677 283,621 15,700 321,313 30,431 38,301 3,700 4,875 1,279,684 245,320 12,000 459,425 245,320 12,000 C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 91
Slide 94: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A summary of the activity of the stock option plans for 2003 is presented below: Weighted-Average Exercise Price $36.11 31.56 25.48 44.56 34.65 29.49 25.44 36.30 23.19 38.97 33.11 25.49 35.47 33.09 25.49 $4.88 Stock Options Options outstanding at beginning of year 2001 Omnibus Plan Employee Plan Director Plan Granted during 2003 2001 Omnibus Plan Exercised during 2003 2001 Omnibus Plan Employee Plan Director Plan Forfeited during 2003 2001 Omnibus Plan Employee Plan Outstanding at end of year 2001 Omnibus Plan Employee Plan Director Plan Options exercisable at year-end 2001 Omnibus Plan Employee Plan Director Plan Weighted-average fair value of options granted during 2003 2001 Omnibus Plan Shares 663,548 492,021 19,400 335,424 4,420 207,150 3,700 875 1,250 993,677 283,621 15,700 241,076 225,116 15,700 The following table summarizes the status of the stock options outstanding and exercisable at December 31, 2005, under the 2005 Omnibus Plan. Stock Options Outstanding Weighted-Average Remaining Contractual Life (In Years) 10.0 Weighted-Average Exercise Price Per Share $54.85 Stock Options Exercisable Weighted-Average Exercise Price Per Share N/A Exercise Price $54.85 Shares 325,347 Shares – The following table summarizes the status of the stock options outstanding and exercisable at December 31, 2005, under the 2001 Omnibus Plan. Stock Options Outstanding Weighted-Average Remaining Contractual Life (In Years) 6.5 8.5 Weighted-Average Exercise Price Per Share $36.29 46.40 $41.72 Stock Options Exercisable Weighted-Average Exercise Price Per Share $35.97 45.81 $39.31 Exercise Price $34.09 – $38.25 $41.29 – $48.11 Shares 552,495 641,946 1,194,441 Shares 464,836 238,655 703,491 The following table summarizes the status of the stock options outstanding and exercisable at December 31, 2005, under the Employee Plan. Stock Options Outstanding Weighted-Average Remaining Contractual Life (In Years) 4.7 Weighted-Average Exercise Price Per Share $33.99 Stock Options Exercisable Weighted-Average Exercise Price Per Share $33.99 Exercise Price $23.19 – $34.75 Shares 156,973 Shares 156,973 92 WPS RESOURCES CORPORATION
Slide 95: The following table summarizes the status of the stock options outstanding and exercisable at December 31, 2005, under the Director Plan. Stock Options Outstanding Weighted-Average Remaining Contractual Life (In Years) 4.0 Weighted-Average Exercise Price Per Share $25.50 Stock Options Exercisable Weighted-Average Exercise Price Per Share $25.50 Exercise Price $25.44 – $25.69 Shares 12,000 Shares 12,000 Other Stock-Based Compensation Awards A portion of the long-term incentive is awarded in the form of performance stock rights. These stock rights vest over a three-year performance period and are paid out in shares of WPS Resources’ common stock. The number of shares paid out is calculated by multiplying a performance percentage by a target number of shares. The performance multiplier is based on the performance of WPS Resources’ common stock relative to the stock performance of a specific peer group of companies. The payout may range from 0% to 200% of target. Based upon these criteria, 177,426 shares are included in the denominator of the diluted earnings per share computation at December 31, 2005. In accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” WPS Resources accrues the plan expense over the three-year period in which the services are performed. Pre-tax compensation cost recorded was $3.4 million in 2005, $2.3 million in 2004, and $3.3 million in 2003. The following table summarizes the performance stock rights granted in 2005, 2004, and 2003. Performance Stock Rights Granted Year 2005 2004 2003 Shares 82,874 57,201 35,640 Grant-Date Fair Value $48.37 41.62 38.27 Restricted stock shares granted on April 18, 2002, totaled 12,186 shares and had a one-year vesting period. Beginning April 18, 2003, 15% of the shares became unrestricted, with an additional 15% release of restriction at each six-month interval thereafter until fully unrestricted. Restricted shares have a value equal to the fair market value of the shares on the grant date. Compensation cost was recorded for these shares over their one-year vesting period. NOTE 23—Regulatory Environment Wisconsin On December 22, 2005, the PSCW issued a final written order authorizing a retail electric rate increase of $79.9 million (10.1%) and a retail natural gas rate increase of $7.2 million (1.1%), effective January 1, 2006. The 2006 rates reflect an 11.0% return on common equity. The PSCW also approved a common equity ratio of 59.7%. The retail electric rate increase was required because of higher fuel and purchased power costs (including costs associated with the Fox Energy Center power purchase agreement), costs related to the construction of Weston 4, increased transmission costs, and costs related to the 2005 Kewaunee outage and 50% of the loss on the Kewaunee sale. The rates also reflect the refund of a portion of the proceeds received from the liquidation of the nonqualified decommissioning trust fund. The retail natural gas rate increase was driven by infrastructure improvements necessary to ensure the reliability of the natural gas distribution system. On June 7, 2005, WPSC filed with the PSCW and the FERC a request for establishment of a cooperative joint proceeding for approval of the Kewaunee wind-up plan. The wind-up plan proposed that the refunds due to both retail and wholesale customers related to proceeds received from the liquidation of the nonqualified decommissioning trust fund be offset by the net loss on the sale of the plant and also by certain costs related to the 2004 and 2005 Kewaunee outages. The wind-up plan proposed to begin the amortization of the net regulatory liability as a credit to customer rates as of the effective date of the PSCW’s order (expected to be January 1, 2006). The FERC subsequently denied the request for joint proceeding with the PSCW. The wind-up plan was addressed by the PSCW in WPSC’s 2006 rate case (discussed above). The PSCW ruled in the 2006 rate case that the deferred assets and liabilities related to the Kewaunee matters should be treated separately and not netted as WPSC initially proposed in its wind-up plan. In the 2006 rate case, the PSCW determined that Wisconsin retail customers were entitled to be refunded approximately 85% of the proceeds received from the liquidation of the nonqualified decommissioning trust fund based on a historical allocation methodology, or approximately $108 million of the total $127.1 million of proceeds received, over a two-year period beginning on January 1, 2006 (including the refund of carrying costs on the unamortized balance at the authorized pre-tax weighted average cost of capital). In 2005, the MPSC ruled that WPSC’s Michigan customers were entitled to be refunded approximately 2% of the proceeds received from the liquidation of the nonqualified decommissioning fund and refunding to Michigan customers began in 2005. The $126.9 million regulatory liability recorded at December 31, 2005, related to the required refunding of proceeds received from the liquidation of the nonqualified decommissioning trust fund to both retail and wholesale customers. The proposal to refund the nonqualified decommissioning trust fund to wholesale customers was also approved by the FERC with no specification of the details for distribution. On August 8, 2005, the FERC accepted the proposed refund plan for filing and implemented the plan effective January 1, 2006, subject to refund upon final resolution. A preliminary settlement discussion between WPSC and parties contesting WPSC’s refund plan was held in the fourth quarter of 2005, but a final resolution has not been determined on this matter. The PSCW’s C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 93
Slide 96: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS treatment of costs related to the 2004 and 2005 Kewaunee outages, as well as the loss on the sale of Kewaunee are discussed below. The PSCW disallowed recovery of 50% of the loss on the sale of Kewaunee. The entire loss had previously been approved for deferral, resulting in WPSC writing off $6.1 million of the regulatory asset previously recorded. WPSC petitioned the PSCW for rehearing on this matter; however, the request for rehearing was denied and this decision is now final. On February 20, 2005, Kewaunee was temporarily removed from service after a potential design weakness was identified in its auxiliary feedwater system. On March 17, 2005, the PSCW authorized WPSC to defer replacement fuel costs related to the outage. On April 8, 2005, the PSCW approved deferral of the operating and maintenance costs, including carrying costs at the most recently authorized pre-tax weighted average cost of capital. In the order granted for WPSC’s 2006 rate case, which was finalized on December 22, 2005 (discussed above), the PSCW determined that it was reasonable for WPSC to recover all deferred costs related to the 2005 Kewaunee forced outage over a five-year period, beginning on January 1, 2006, including carrying costs on the unamortized balance at the composite short-term debt rate. Because the PSCW had initially approved deferral of carrying costs based upon the weighted average cost of capital, WPSC was required to write off $2.2 million of carrying costs in the fourth quarter of 2005. WPSC also filed with the FERC for approval to defer these costs in the wholesale jurisdiction. The FERC is in the process of investigating the justness and reasonableness of the recovery of the costs and will subsequently rule on the filing. WPSC believes recovery of the FERC portion of these costs is probable. For WPSC’s Michigan retail customers, fuel costs are recovered through a pass through fuel adjustment clause and no deferral request is needed. Through December 31, 2005, WPSC had deferred $56.4 million of replacement power costs and operating and maintenance expenses related to this outage. On July 5, 2005, WPSC sold its 59% share of Kewaunee to Dominion. See Note 6, “Acquisitions and Sales of Assets,” for further information on the sale of Kewaunee. In WPSC’s 2006 rate case, the PSCW determined that it was reasonable for WPSC to continue to defer the MISO Day 2 charges associated with net congestion and financial transmission rights costs and revenues, and the cost differences between marginal losses and average losses. At December 31, 2005, WPSC had deferred $21.2 million of costs related to these matters. In May 2005, WPSC received notification from its coal transportation suppliers that extensive maintenance was required on the railroad tracks that lead into and out of the Powder River Basin. The extensive maintenance ended on November 23, 2005. During the maintenance efforts, WPSC received approximately 87% of the expected coal deliveries. WPSC took steps to conserve coal usage and secured alternative coal supplies at its affected generation facilities during that time. On September 23, 2005, the PSCW approved WPSC’s request for deferred treatment of the incremental fuel costs resulting from the coal supply issues. As of December 31, 2005, $6.4 million was deferred related to this matter. These costs are expected to be addressed in WPSC’s next retail electric rate case. On November 5, 2004, WPSC filed an application with the PSCW to defer all incremental costs, including carrying costs, resulting from unexpected problems encountered in the 2004 refueling outage at Kewaunee. During the refueling outage, an unexpected problem was encountered with equipment used for lifting the reactor vessel internal components to perform a required 10-year inspection. These equipment problems caused the outage to be extended by approximately three weeks. On November 11, 2004, the PSCW authorized WPSC to defer the replacement fuel costs related to the extended outage. On November 23, 2004, the PSCW authorized WPSC to defer purchased power costs and operating and maintenance expenses related to the extended outage, effective from when the problems were discovered, including carrying costs at WPSC’s authorized weighted average cost of capital. Kewaunee returned to service on December 4, 2004. In the order granted for WPSC’s 2006 rate case, which was finalized on December 22, 2005 (discussed above), the PSCW disallowed recovery of these costs, resulting in the write-off of the $7.6 million regulatory asset WPSC had previously recorded. WPSC petitioned the PSCW for rehearing on this matter; however, the request for rehearing was denied and this decision is now final. On December 21, 2004, the PSCW issued a final written order authorizing a retail electric rate increase of $60.7 million (8.6%) and a retail natural gas rate increase of $5.6 million (1.1%), effective January 1, 2005. The 2005 rates reflected an 11.5% return on equity. The PSCW also approved a common equity ratio of 57.35% in the utility’s regulatory capital structure. The retail electric rate increase was related to increased costs pertaining to fuel and purchased power, construction of Weston 4, benefit costs, and the MISO costs. The natural gas rate increase was primarily related to increases in benefit costs and the cost of distribution system improvements. Michigan On January 3, 2006, UPPCO filed a request to increase its retail electric rates by $6.6 million (8.1%), with an 11.5% return on equity, and a 55% common equity ratio. It is anticipated that the MPSC will act on this request in the third quarter of 2006. UPPCO asked for the new rates to go into effect in the second quarter, subject to refund, while the MPSC reviews the entire request. The retail electric rate increase is required in order to improve service quality and reliability, upgrade technology, and manage rising employee and retiree benefit costs. UPPCO’s last retail electric rate increase was in December 2002. On December 8, 2004, UPPCO submitted a request to the MPSC to approve UPPCO’s proposed treatment of the pre-tax gains from certain sales of undeveloped and partially developed land located in the Upper Peninsula of Michigan as appropriate for ratemaking purposes. On February 4, 2005, UPPCO submitted an application to the MPSC for a 7.6% increase in retail electric rates ($5.7 million in revenues). UPPCO also requested interim rate recovery of 6.0% ($4.5 million in revenues) to allow UPPCO to recover costs during 94 WPS RESOURCES CORPORATION
Slide 97: the time the MPSC was reviewing the full case. On April 28, 2005, the MPSC issued an order authorizing UPPCO to retain 100% of the pre-tax gains on certain lands owned up to $18.5 million and 73% of any pre-tax gains over that amount, so UPPCO withdrew the rate increase request. in ESI’s exposure, but the extent is unknown at present. Through existing contracts, ESI has the ability to pass a portion of the SECA charges on to customers and has been doing so. Since SECA is a transition charge ending on March 31, 2006, it does not directly impact ESI’s long-term competitiveness. The SECA is also an issue for WPSC and UPPCO, who have intervened and protested a number of proposals in this docket because those proposals could result in unjust, unreasonable, and discriminatory charges for customers. It is anticipated that most of the SECA charges incurred by WPSC and UPPCO and any refunds will be passed on to customers through rates. Federal Through a series of orders issued by the FERC, Regional Through and Out Rates for transmission service between the MISO and the PJM Interconnection were eliminated effective December 1, 2004. To compensate transmission owners for the revenue they will no longer receive due to this elimination, the FERC ordered a transitional pricing mechanism called SECA to be put into place. Load serving entities will pay these SECA charges during a 16-month transition period from December 1, 2004, through March 31, 2006. Total exposure for the 16-month transitional period, taken from proposed compliance filings by the transmission owners, is approximately $19 million for ESI, of which approximately $17 million relates to its Michigan operations and $2 million relates to its Ohio operations. Through December 31, 2005, ESI has received billings totaling $15.3 million, of which $11.1 million have been expensed. The application and legality of the SECA is being challenged by many load-serving entities, including ESI. ESI has been and will continue pursuing all avenues to appeal and/or reduce the SECA obligations. It is probable that ESI’s total exposure will be reduced by at least $4.2 million because of inconsistencies between the FERC’s SECA order and the transmission owners’ compliance filings (representing the difference between the amount ESI has paid for SECA charges and the amount that has been expensed as of December 31, 2005, as discussed above). ESI anticipates settling a significant portion of its SECA matters through vendor negotiations in the first half of 2006 and reached a $1 million settlement agreement with one of its vendors in January 2006. Resolution of issues to be raised in an upcoming SECA hearing offer the possibility of further reductions Other On September 21, 2005, WPS Resources announced the acquisition of the Michigan and Minnesota natural gas distribution operations of Aquila. See Note 6, “Acquisitions and Sales of Assets,” for further information on the acquisition of these assets. In relation to the acquisition, WPS Michigan Utilities, Inc. (which subsequently changed its name to Michigan Gas Utilities Corporation) and Aquila jointly filed with the MPSC on October 10, 2005, for approval of the termination of Aquila’s duty to provide natural gas service in Michigan and for WPS Michigan Utilities to provide natural gas service in the Michigan service territory of Aquila pursuant to the rates, terms, and conditions in Aquila’s current tariff book. Also in relation to the acquisition, on October 17, 2005, WPS Minnesota Utilities, Inc. (which subsequently changed its name to Minnesota Energy Resources Corporation) and Aquila jointly filed with the Minnesota Public Utilities Commission to approve the sale of the Minnesota assets of Aquila’s two divisions, Aquila Networks-PNG and Aquila Networks-NMU, to WPS Minnesota Utilities pursuant to the Asset Purchase Agreement dated September 21, 2005. On November 10, 2005, approval was obtained from the MPSC for the Michigan transaction. The Minnesota Public Utilities Commission has not yet ruled on this matter. NOTE 24—Variable Interest Entities The FASB has issued Interpretation No. 46R (as revised), “Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51,” in order to improve financial reporting by companies involved with variable interest entities. Interpretation No. 46R requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional financial support from other parties. The primary beneficiary is the party that absorbs the majority of the expected losses and/or receives the majority of the expected residual returns of the variable interest entity’s activities. The application of Interpretation No. 46R was required for financial statements of public entities that have interests in special-purpose entities for periods ending after December 15, 2003. WPS Resources identified WPSR Capital Trust I as a special purpose entity that is within the scope of Interpretation No. 46R. Refer to Note 25, “Company-Obligated Mandatorily Redeemable Trust Preferred Securities of Preferred Stock Trust,” for further discussion of the impacts of implementing this portion of Interpretation No. 46R on the financial statement of WPS Resources. WPS Resources adopted the provisions of Interpretation No. 46R for variable interest entities not defined as special purpose entities effective March 31, 2004. The required adoption had no impact on our Consolidated Financial Statements, as we did not identify significant variable interests in any unconsolidated variable interest entities where we were determined to be the primary beneficiary. We have identified our equity ownership in a synthetic fuel producing facility as a variable interest in a variable interest entity. Through an affiliate of ESI, WPS Resources owns a partial interest in a synthetic fuel facility located in Kentucky and receives tax credits pursuant to Section 29 of the Internal Revenue Code based on sales to unaffiliated third-party purchasers of synthetic fuel produced from coal. At December 31, 2005, WPS Resources had a 23% ownership C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 95
Slide 98: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS interest in the synthetic fuel facility. No other variable interests were identified. WPS Resources’ maximum exposure to loss as a result of our involvement with this variable interest entity is limited to our investment in this entity, which was not significant at December 31, 2005. We were not identified as the primary beneficiary of this entity and, therefore, were not required to consolidate the synthetic fuel facility into our financial statements at December 31, 2005. The adoption of Interpretation No. 46R also included an analysis of our power purchase and sale agreements. We do not believe that any of our power purchase or sale agreements constitute significant variable interests that would lead us to consolidate entities not currently consolidated or deconsolidate any entities currently consolidated. NOTE 25—Company-Obligated Mandatorily Redeemable Trust Preferred Securities of Preferred Stock Trust On July 30, 1998, WPSR Capital Trust I, a Delaware business trust, issued $50.0 million of trust preferred securities to the public. WPS Resources owned all of the outstanding trust common securities of the Trust, and the only asset of the Trust was $51.5 million of subordinated debentures issued by WPS Resources. The debentures were due on June 30, 2038, and bore interest at 7% per year. The terms and interest payments on the debentures corresponded to the terms and distributions on the trust preferred securities. As discussed in Note 24, “Variable Interest Entities,” it was determined that WPSR Capital Trust I qualified as a special purpose entity and, therefore, the provisions of Interpretation No. 46R were applied to the Trust at December 31, 2003. Prior to this date, we consolidated the preferred securities of the Trust into our financial statements as we held all of the voting securities. Per the provisions of Interpretation No. 46R, however, it was determined that the preferred security holders held the majority of the residual economic risks associated with WPSR Capital Trust I and, therefore, the Trust was deconsolidated effective December 31, 2003. As a result of the deconsolidation, WPS Resources recorded a $1.5 million investment in trust within other current assets and a $51.5 million note payable to preferred stock trust, respectively, within the Consolidated Balance Sheet at December 31, 2003. On January 8, 2004, WPS Resources redeemed all of the subordinated debentures that were initially issued to the Trust for $51.5 million and paid accrued interest of $0.1 million. This action required the Trust to redeem an equal amount of trust securities at face value plus any accrued interest and unpaid distributions. As a result of these transactions, the Trust was dissolved effective January 8, 2004. NOTE 26—Segments of Business SFAS No. 131, “Disclosures About Segments of an Enterprise and Related Information,” requires that companies disclose segment information based on how management makes decisions about allocating resources to segments and measuring their performance. Prior to the fourth quarter of 2005, WPS Resources reported two nonregulated segments, ESI and WPS Power Development, LLC (PDI). In the fourth quarter of 2005, WPS Resources’ Chief Executive Officer and its Board of Directors decided to view ESI and PDI as one business, and corresponding changes were made to the segment information reported to them. The change in reportable segments is the culmination of changes over the past two years that caused these businesses to become integrated. These changes included combining the management teams, restructuring the ownership structure of ESI and PDI, and having ESI optimize the value of PDI’s merchant generation fleet and reduce market price risk through the use of various financial and physical instruments (such as futures, options, and swaps) in order to provide more predictable revenues and margins. Effective in the fourth quarter of 2005, WPS Resources began reporting to the Chief Executive Officer and Board of Directors one nonregulated segment, ESI. Segment information related to prior periods has been reclassified to reflect this change. Currently, WPS Resources reports four segments, which are described below. Our two regulated segments include the regulated electric utility operations of WPSC and UPPCO, and the regulated natural gas utility operations of WPSC. WPSC’s revenues are primarily derived from the service of electric and natural gas retail customers in northeastern and central Wisconsin and an adjacent portion of Upper Michigan. WPSC also provides wholesale electric service to various customers, including municipal utilities, electric cooperatives, energy marketers, other investor-owned utilities, and a municipal joint action agency. Portions of WPSC’s electric and natural gas operations cannot be specifically identified as electric or natural gas and instead are allocated using either actual labor hours, revenues, number of customers, or number of meters. UPPCO derives revenues from the sale of electric energy in the Upper Peninsula of Michigan. ESI is our primary nonregulated segment. ESI offers nonregulated natural gas, electric, and alternate fuel supplies as well as energy management and consulting services to retail and wholesale customers and competes in the wholesale merchant electric power generation industry, primarily in the northeastern quadrant of the United States, adjacent portions of Canada, and now Texas. Although ESI has a widening array of products and services, revenues are primarily derived through sales of electricity and natural gas to retail and wholesale customers. ESI’s marketing and trading operations manage power and natural gas procurement as an integrated portfolio with its retail and wholesale sales commitments. Electricity required to fulfill these sales commitments is procured from both ESI merchant electric power generation and from independent generators, energy marketers, and organized electric power markets. Natural gas 96 WPS RESOURCES CORPORATION
Slide 99: is purchased from a variety of suppliers under daily, monthly, seasonal, and long-term contracts with pricing delivery and volume schedules to accommodate customer requirements. ESI’s customers include utilities, municipalities, cooperatives, commercial and industrial consumers, aggregators, and other marketing and retail entities. ESI also owns several merchant electric generation plants, primarily in the Midwest and northeastern United States and adjacent portions of Canada. ESI markets power from these plants that is not under contract to third parties. ESI utilizes power from its New England and Canadian assets primarily to serve firm load commitments in northern Maine and certain other sales agreements with customers. For most of the remaining capacity available from these plants, ESI utilizes financial tools, including forwards, options, and swaps to mitigate exposure, as well as to maximize value from the merchant generation fleet. Power purchase agreements are also in place with third-party customers for approximately 95 megawatts of capacity, which includes the Stoneman facility in Cassville, Wisconsin, and the Combined Locks facility in Combined Locks, Wisconsin. The Holding Company and Other segment, another nonregulated segment, includes the operations of WPS Resources and WPS Resources Capital Corporation as holding companies and the nonutility activities at WPSC and UPPCO. Equity earnings from our investments in ATC, Wisconsin River Power Company, and Guardian Pipeline, LLC are included in the Holding Company and Other segment. The tables below present information for the respective years pertaining to our operations segmented by lines of business. Nonutility and Nonregulated Operations ESI $5,438.5 13.6 11.7 (0.8) 14.8 4.7 1.6 74.1 2,435.6 4.0 $ Other – 1.1 0.3 39.4 26.3 (2.3) – 5.9 455.4 0.9 Reconciling Eliminations $ – (49.6) – (4.5) (4.5) – – – (178.9) – WPS Resources Consolidated $6,962.7 – 142.8 86.2 72.4 46.7 1.6 157.4 5,455.2 415.2 Regulated Utilities 2005 (Millions) Income Statement External revenues Internal revenues Depreciation and decommissioning Miscellaneous income Interest expense Provision for income taxes Cumulative effect of change in accounting principle Income available for common shareholders Total assets Cash expenditures for long-lived assets (1) Electric Utility (1) $1,003.6 33.5 113.4 51.6 27.1 37.0 – 64.2 2,082.3 373.9 Gas Utility (1) $520.6 1.4 17.4 0.5 8.7 7.3 – 13.2 660.8 36.4 Total Utility (1) $1,524.2 34.9 130.8 52.1 35.8 44.3 – 77.4 2,743.1 410.3 Includes only utility operations. Nonutility operations are included in the Other column. Regulated Utilities 2004 (Millions) Income Statement External revenues Internal revenues Depreciation and decommissioning Miscellaneous income Interest expense Provision for income taxes Income available for common shareholders Total assets Cash expenditures for long-lived assets (1) Nonutility and Nonregulated Operations ESI $3,658.8 15.4 11.0 3.8 9.0 (23.9) 41.7 1,390.9 6.4 $ Other – 1.1 0.5 40.6 20.8 (3.8) 11.9 329.8 0.3 Reconciling Eliminations $ – (42.0) – (3.2) (3.2) – – (147.0) – WPS Resources Consolidated $4,950.8 – 107.0 52.0 59.9 21.7 139.7 4,376.8 292.4 Electric Utility (1) $ 875.6 21.0 79.5 10.4 25.6 39.2 68.8 2,225.2 223.0 Gas Utility (1) $416.4 4.5 16.0 0.4 7.7 10.2 17.3 577.9 62.7 Total Utility (1) $1,292.0 25.5 95.5 10.8 33.3 49.4 86.1 2,803.1 285.7 Includes only utility operations. Nonutility operations are included in the Other column. C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 97
Slide 100: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Regulated Utilities 2003 (Millions) Income Statement External revenues Internal revenues Depreciation and decommissioning Miscellaneous income Interest expense Provision for income taxes Cumulative effect of change in accounting principle Income available for common shareholders Cash expenditures for long-lived assets (1) Nonutility and Nonregulated Operations ESI $3,218.7 5.9 13.6 (3.8) 9.5 (13.5) 3.2 21.1 6.3 Other $ 0.1 1.1 0.6 30.7 27.3 (2.6) – (2.1) (0.2) Reconciling Eliminations $ – (41.6) – (8.2) (6.6) – – – – WPS Resources Consolidated $4,402.5 – 141.3 63.6 61.8 27.0 3.2 94.7 177.8 Electric Utility (1) $785.6 28.5 112.8 43.6 24.9 33.9 – 60.0 131.0 Gas Utility (1) $398.1 6.1 14.3 1.3 6.7 9.2 – 15.7 40.7 Total Utility (1) $1,183.7 34.6 127.1 44.9 31.6 43.1 – 75.7 171.7 Includes only utility operations. Nonutility operations are included in the Other column. 2005 Geographic Information (Millions) 2004 Long-Lived Assets $2,679.6 21.7 $2,701.3 Revenues $3,823.8 1,127.0 $4,950.8 Long-Lived Assets $2,906.6 22.9 $2,929.5 2003 Revenues $3,830.8 571.7 $4,402.5 Revenues $4,797.0 2,165.7 $6,962.7 United States Canada (1) Total (1) Revenues and assets of Canadian subsidiaries. NOTE 27—Quarterly Financial Information (Unaudited) Three Months Ended 2005 (Millions, except for share amounts) March $1,486.9 92.9 65.9 37.8 38.1 $1.74 1.73 June $1,327.5 7.3 23.9 38.0 38.4 $0.63 0.62 September $1,757.3 72.0 48.2 38.2 38.6 $1.26 1.25 December $2,391.0 18.3 19.4 39.1 39.6 $0.50 0.49 Total $6,962.7 190.5 157.4 38.3 38.7 $4.11 4.07 Operating revenues Operating income Income available for common shareholders Average number of shares of common stock (basic) Average number of shares of common stock (diluted) Earnings per common share (basic) (1) Earnings per common share (diluted) (1) Three Months Ended 2004 (Millions, except for share amounts) March $1,387.0 67.6 42.6 37.1 37.3 $1.15 1.14 June $1,059.5 10.1 4.6 37.3 37.5 $0.12 0.12 September $1,091.9 48.7 34.8 37.4 37.6 $0.93 0.93 December $1,412.4 42.6 57.7 37.5 37.8 $1.54 1.53 Total $4,950.8 169.0 139.7 37.4 37.6 $3.74 3.72 Operating revenues Operating income Income available for common shareholders Average number of shares of common stock (basic) Average number of shares of common stock (diluted) Earnings per common share (basic) (1) Earnings per common share (diluted) (1) (1) Earnings per share for the individual quarters do not total the year ended earnings per share amount because of changes to the average number of shares outstanding and changes in incremental issuable shares throughout the year. Because of various factors, the quarterly results of operations are not necessarily comparable. 98 WPS RESOURCES CORPORATION
Slide 101: “My group’s commitment? Giving our business customers one point of contact that can deliver one-call resolution to any of their energy needs. Our business customers value getting the information they need when they need it.” Tom Russell, Business Solutions Center Leader at Wisconsin Public Service, describing his staff of 18 business specialists. “Our job is getting the power to our customers safely. It can be dangerous, but we’re well trained, and we take all needed safety precautions.” Todd Welsing, Line Electrician for Wisconsin Public Service C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 99
Slide 102: REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Shareholders and Board of Directors of WPS Resources Corporation We have audited the accompanying consolidated balance sheets of WPS Resources Corporation and subsidiaries (the “Company”) as of December 31, 2005 and 2004, and the related consolidated statements of income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2005. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of WPS Resources Corporation and subsidiaries as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005, in conformity with accounting principles generally accepted in the United States of America. As discussed in Note 1 to the consolidated financial statements, effective January 1, 2003 the Company changed its method of accounting for certain energy trading contracts to adopt EITF 02-3, “Issues Involved in Accounting for Derivatives Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities.” As discussed in Notes 1 and 15 to the consolidated financial statements, effective January 1, 2003, the Company changed its method of accounting for asset retirement obligations to adopt Statement of Financial Accounting Standards No. 143, “Accounting for Asset Retirement Obligations.” As discussed in Notes 1 and 15 to the consolidated financial statements, effective December 31, 2005, the Company changed its method of accounting for conditional asset retirement obligations to adopt FASB Interpretation No. 47, “Conditional Asset Retirement Obligations.” We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report (not presented herein) dated February 28, 2006 expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting. DELOITTE & TOUCHE LLP Milwaukee, Wisconsin February 28, 2006 100 WPS RESOURCES CORPORATION
Slide 103: FINANCIAL STATISTICS As of or for Year Ended December 31 (Millions, except per share amounts, stock price, return on average equity and number of shareholders and employees) Total revenues * Income available for common shareholders Total assets Preferred stock of subsidiaries Long-term debt and capital lease obligation (excluding current portion) Shares of common stock (less treasury stock and shares in deferred compensation trust) Outstanding Average Earnings per common share (basic) Earnings per common share (diluted) Dividend per share of common stock Stock price at year-end Book value per share Return on average equity Number of common stock shareholders Number of employees 2005 $6,962.7 157.4 5,455.2 51.1 2004 $4,950.8 139.7 4,376.8 51.1 2003 $4,402.5 94.7 4,296.5 51.1 2002 $1,548.3 109.4 3,671.2 51.1 2001 $1,431.8 77.6 3,346.5 51.1 867.1 865.7 871.9 824.4 727.8 39.8 38.3 $4.11 4.07 2.24 $55.31 $32.76 13.6% 20,701 2,945 37.3 37.4 $3.74 3.72 2.20 $49.96 $29.30 13.5% 21,358 3,048 36.6 33.0 $2.87 2.85 2.16 $46.23 $27.40 11.5% 22,172 3,080 31.8 31.7 $3.45 3.42 2.12 $38.82 $24.62 14.6% 22,768 2,963 31.1 28.2 $2.75 2.74 2.08 $36.55 $23.02 12.8% 23,478 2,856 * Approximately $1,127 million of the increase in revenue in 2003 compared to 2002 relates to WPS Energy Services, Inc.’s required adoption of Emerging Issues Task Force Issue No. 02-03, “Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities,” effective January 1, 2003. “The facts can't be denied. Competitive Excellence steered us to the right numbers. One division took a 30-day process, built up over the years, and streamlined it to 7 days, which will reduce costs in the long run. This was to the benefit of the team members themselves and all of their customers down the line.” Mike Watkins, Coal and Yard Crew Leader – Pulliam at Wisconsin Public Service, on Competitive Excellence, the company's effort to become a lean enterprise. C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 101
Slide 104: T H E B O A R D OF D I R E C TOR S * Richard A. Bemis Age 64 Sheboygan Falls, Wisconsin President and Chief Executive Officer Bemis Manufacturing Company (Director since 1983) Albert J. Budney, Jr. Age 58 Cazenovia, New York Former President Niagara Mohawk Holdings, Inc. and Niagara Mohawk Power Corporation (Director since 2002) Ellen Carnahan Age 50 Chicago, Illinois Managing Director William Blair Capital Partners, LLC (Director since 2003) Robert C. Gallagher Age 67 Green Bay, Wisconsin Chairman of the Board Associated Banc-Corp (Director since 1992) Kathryn M. Hasselblad-Pascale Age 57 Green Bay, Wisconsin Managing Partner Hasselblad Machine Company, LLP (Director since 1987) Audit Committee Financial Committee Financial Committee (Chair) Governance Committee Lead Director Financial Committee Governance Committee Compensation Committee Audit Committee Governance Committee (Chair) Financial Committee James L. Kemerling Age 66 Wausau, Wisconsin President and Chief Executive Officer Riiser Oil Company, Inc. Chairman and Chief Executive Officer Award Hardwood Floors, LLP (Director since 1988) John C. Meng Age 61 Green Bay, Wisconsin Chairman of the Board Schreiber Foods, Inc. (Director since 2000) William F. Protz, Jr. Age 61 Northfield, Illinois Former President and Chief Executive Officer Santa’s Best, LLP (Director since 2001) Larry L. Weyers Age 60 Green Bay, Wisconsin Chairman, President, and Chief Executive Officer WPS Resources Corporation (Director since 1996) Compensation Committee (Chair) Financial Committee Audit Committee Compensation Committee Audit Committee (Chair) * Age, title, and committee membership are as of December 31, 2005. 102 WPS RESOURCES CORPORATION
Slide 105: OFFICERS * Larry L. Weyers Chairman, President, and Chief Executive Officer Age 60/Years of service 20 WPS Resources Corporation Bernard J. Treml Senior Vice President Human Resources Age 56/Years of service 33 William L. Bourbonnais, Jr. Vice President - Transmission Age 60/Years of service 37 Diane L. Ford Vice President - Controller and Chief Accounting Officer Age 52/Years of service 30 Richard E. James Vice President Corporate Planning Age 52/Years of service 30 Bradley A. Johnson Vice President and Treasurer Age 51/Years of service 26 Barbara A. Nick Vice President Corporate Services Age 47/Years of service 21 Michael W. Charles Assistant Vice President Development Age 56/Years of service 28 Glen R. Schwalbach Assistant Vice President Corporate Planning Age 60/Years of service 37 Barth J. Wolf Secretary and Manager Legal Services Age 48/Years of service 17 Craig A. Vanderwerff Assistant Controller Age 32/Years of service 1 George R. Wiesner Assistant Controller Age 48/Years of service 21 Thomas P. Meinz Executive Vice President Public Affiars Age 59/Years of service 36 Phillip M. Mikulsky Executive Vice President Development Age 57/Years of service 34 Joseph P. O’Leary Senior Vice President and Chief Financial Officer Age 51/Years of service 4 Larry L. Weyers Chairman and Chief Executive Officer Age 60/Years of service 20 Wisconsin Public Service Corporation Joseph P. O’Leary Senior Vice President and Chief Financial Officer Age 51/Years of service 4 Bernard J. Treml Senior Vice President Human Resources Age 56/Years of service 33 Diane L. Ford Vice President - Controller and Chief Accounting Officer Age 52/Years of service 30 David W. Harpole Vice President - Energy Supply - Projects Age 50/Years of service 28 Bradley A. Johnson Vice President and Treasurer Age 51/Years of service 26 James F. Schott Vice President - Regulatory Affairs Age 48/Years of service 2 Charles A. Cloninger Assistant Vice President Operations and Engineering Age 47/Years of service 24 Terry P. Jensky Assistant Vice President Energy Supply - Operations Age 52/Years of service 28 Barth J. Wolf Secretary and Manager Legal Services Age 48/Years of service 17 Janet K. McKee Assistant Treasurer Age 52/Years of service 9 Pamela R. Clausen Assistant Controller Age 55/Years of service 18 Lawrence T. Borgard President and Chief Operating Officer - Energy Delivery Age 44/Years of service 21 Charles A. Schrock President and Chief Operating Officer - Generation Age 52/Years of service 26 Thomas P. Meinz Executive Vice President Public Affairs Age 59/Years of service 36 Thomas P. Meinz Chairman Age 59/Years of service 36 Upper Peninsula Power Company Gary W. Erickson President Age 63/Years of service 37 Barth J. Wolf Secretary Age 48/Years of service 17 Bradley A. Johnson Treasurer Age 51/Years of service 26 Lawrence T. Borgard Chief Executive Officer Age 44/Years of service 21 Mark A. Radtke President Age 44/Years of service 22 Daniel J. Verbanac Chief Operating Officer Age 42/Years of service 21 Mark W. Stiers Vice President Age 43/Years of service 3 Richard J. Bissing Vice President Age 45/Years of service 16 Darrell W. Bragg Vice President Age 46/Years of service 10 Boris A. Brevnov Vice President - Business Development and Implementation Age 37/Years of service 3 Ronnie E. Cardwell Vice President Age 37/Years of service 1 Bruce A. Rizor Vice President - Structured Energy Trading Age 44/Years of service 6 Ruqaiyah Z. Stanley Vice President Age 51/Years of service 7 Howard R. Giesler ** Assistant Vice President Age 42/Years of service 19 Barth J. Wolf Secretary Age 48/Years of service 17 Bradley A. Johnson Treasurer Age 51/Years of service 26 William J. Guc Controller Age 36/Years of service 1 Denean V. Smith Assistant Controller Age 53/Years of service 1 * Title, age, and years of service are as of December 31, 2005. Years of service take into consideration service with WPS Resources Corporation or a system company. ** Title reflects position at a subsidiary of WPS Energy Services, Inc. C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 103
Slide 106: INVESTOR INFORMATION Shareholder Inquiries Our transfer agent, American Stock Transfer & Trust Company, can be reached via telephone between 7 a.m. and 6 p.m., Central time, Monday through Thursday, or 7 a.m. and 4 p.m., Central time, Friday, by calling 800-236-1551. You also have direct access to your account 24 hours a day through the Internet at www.amstock.com. Our Investor Relations staff is also available to assist you by calling 920-433-1050 between 8 a.m. and 4:30 p.m., Central time, Monday through Friday. Mailing addresses and Internet addresses, along with additional telephone numbers, are listed on the back cover of this report. Dividends We have paid quarterly cash dividends on our common stock since 1953, and we expect to continue that trend. Future dividends are dependent on regulatory limitations, earnings, capital requirements, cash flows, and other financial considerations. Anticipated record and payment dates for common stock dividends to be paid in 2006 are: Record Date February 28 May 31 August 31 November 30 Payment Date March 20 June 20 September 20 December 20 Common Stock The New York Stock Exchange is the principal market for WPS Resources Corporation common stock, which trades under the ticker symbol of WPS. You may purchase or sell our common stock through our Stock Investment Plan described below or through brokerage firms and banks that offer brokerage services. Common stock certificates issued before September 1, 1994, bear the name of Wisconsin Public Service Corporation and remain valid certificates. Effective December 16, 1996, each share of our common stock has a Right associated with it, which would entitle the owner to purchase additional shares of common stock under specified terms and conditions. The Rights are not presently exercisable. The Rights would become exercisable ten days after a person or group (1) acquires 15% or more of WPS Resources Corporation’s common stock or (2) announces a tender offer to acquire at least 15% of WPS Resources’ common stock. On December 31, 2005, we had 39,807,407 shares of common stock outstanding, which were owned by 20,701 holders of record. If you are a record holder of our common stock, you may have your dividends electronically deposited in a checking or savings account at a financial institution. If you are a record holder and your dividends are not electronically deposited, we will mail your dividend check directly to you. If you are a record holder of our common stock and your dividend check is not received on the payment date, wait approximately ten days to allow for delays in mail delivery. Then, contact American Stock Transfer & Trust Company to request a replacement check. Stock Investment Plan We maintain a Stock Investment Plan for the purchase of common stock, which allows persons who are not already shareholders to become participants by making a minimum initial cash investment of $100. Our Plan enables you to maintain registration with us in your own name rather than with a broker in “street name.” The Stock Investment Plan also provides you with options for reinvesting your dividends and making optional cash purchases of common stock directly through the Plan without paying brokerage commissions, fees, or service charges. Optional cash payments of not less than $25 per payment may be made subject to a maximum of $100,000 per calendar year. An automatic investment option allows you to authorize the deduction of payments from your checking or savings account automatically once each month, on the third day of the month, by electronic means for investment in the Plan. Cash for investment must be received by the 3rd or 18th day of the month. Investment generally commences on or about the 5th or 20th day of the month, or as soon thereafter as practicable. The shares you hold in our Stock Investment Plan may be sold by the agent for the Plan as you direct us, or you may request a Year Ended December 31 (By Quarter) Dividends Per Share 2005 1st quarter 2nd quarter 3rd quarter 4th quarter 1st quarter 2nd quarter 3rd quarter 4th quarter $ .555 .555 .565 .565 $2.24 $ .545 .545 .555 .555 $2.20 Price Range High Low $54.90 56.90 60.00 58.95 $48.93 48.70 48.81 50.53 $47.67 51.11 54.50 51.50 $44.99 43.50 44.85 45.35 2004 104 WPS RESOURCES CORPORATION
Slide 107: certificate for sale through a broker you select. We will accumulate sale requests from participants and, approximately every five business days, will submit a sale request to the independent broker-dealer on behalf of those participants. Participation in the Stock Investment Plan is being offered only by means of a prospectus. If you would like a copy of the Stock Investment Plan prospectus, you may use American Stock Transfer & Trust Company’s Web site at www.amstock.com, call American Stock Transfer & Trust Company at 800-236-1551, contact us by sending an e-mail to investor@wpsr.com, or you may order or download the prospectus and enrollment forms from our Web site at www.wpsr.com under Investor Information. Internet Visit our award-winning Web site at www.wpsr.com to find a wealth of information about our company and its subsidiaries. The site will give you instant access to Annual Reports, SEC filings, proxy statements, financial news, presentations, news releases, corporate governance, career opportunities, and much more. You may also download a copy of the prospectus for the Stock Investment Plan and the associated forms for participation in the Plan. The site is updated regularly, so visit it often. Safekeeping Services As a participant in the Stock Investment Plan, you may transfer shares of common stock registered in your name into a Plan account for safekeeping. Contact American Stock Transfer & Trust Company or our Investor Relations staff for details. Annual Shareholders’ Meeting Our Annual Shareholders’ Meeting will be held on Thursday, May 18, 2006, at 10 a.m. at the Weidner Center, University of Wisconsin – Green Bay, 2420 Nicolet Drive, Green Bay, Wisconsin. Proxy statements for our May 18, 2006, Annual Shareholders’ Meeting were mailed to shareholders of record on April 7, 2006. Preferred Stock of Subsidiary The preferred stock of Wisconsin Public Service Corporation trades on over-the-counter markets. Payment and record dates for preferred stock dividends to be paid in 2006 are: Record Date January 13 April 13 July 14 October 13 Payment Date February 1 May 1 August 1 November 1 Annual Report If you or another member of your household receives more than one Annual Report because of differences in the registration of your accounts, please contact American Stock Transfer & Trust Company so account mailing instructions can be modified accordingly. This Annual Report is prepared primarily for the information of our shareholders and is not given in connection with the sale of any security or offer to sell or buy any security. Stock Transfer Agent and Registrar Questions about transferring common or preferred stock, lost certificates, or changing the name in which certificates are registered should be directed to our transfer agent, American Stock Transfer & Trust Company, at the addresses or telephone numbers listed on the back cover. Corporate Governance Information Corporate governance information, including our Corporate Governance Guidelines, our Code of Conduct, charters for the committees of our Board of Directors, By-Laws, and Articles of Incorporation, is available on our Web site at www.wpsr.com under Investor Information. You may also obtain the information by written request to the Corporate Secretary at the mailing address for the corporate office indicated on the back cover of this report. Address Changes If your address changes, write to American Stock Transfer & Trust Company at the address on the back of this report or use their Web site at www.amstock.com. Availability of Information Company financial information is available on our Web site at www.wpsr.com under Investor Information. You may obtain, without charge, a copy of our 2005 Form 10-K, without exhibits, as filed with the Securities and Exchange Commission, by contacting the Corporate Secretary, at the corporate office mailing address listed on the back cover, or by using our Web site. Certifications We have filed as exhibits to our Annual Report on Form 10-K for the fiscal year ended December 31, 2005, the certifications of our Chief Executive Officer and Chief Financial Officer required by Section 302 of the Sarbanes-Oxley Act. We also submitted to the New York Stock Exchange during 2005 the Annual CEO Certification required by Section 303A.12(a) of the New York Stock Exchange Listed Company Manual. C O M M I T M E N T TO VA L U E WPS RESOURCES CORPORATION 105
Slide 108: Corporate Office 700 North Adams Street Green Bay, WI 54301 Mailing Address: WPS Resources Corporation P O. Box 19001 . Green Bay, WI 54307-9001 Telephone: 920-433-4901 Fax: 920-433-1526 Web Site: www.wpsr.com Stock Exchange Listing New York Stock Exchange Ticker Symbol: WPS Listing Abbreviation: WPS Res Transfer Agent and Registrar For General Information: American Stock Transfer & Trust Company 59 Maiden Lane New York, NY 10038 Web Site: www.amstock.com E-Mail: info@amstock.com Telephone: 800-236-1551 (toll free) 718-921-8124 (international) Fax: 718-236-2641 For Dividend Reinvestment and Direct Stock Purchase American Stock Transfer & Trust Company Wall Street Station P O. Box 922 . New York, NY 10269-0560 Telephone: 800-236-1551 (toll free) WISCONSIN UTILITY INVESTORS, INC. Wisconsin Utility Investors, Inc. (“WUI”) is an independent, non-profit organization representing the collective voices of more than 16,000 shareholders in Wisconsin utilities. It monitors and evaluates industry issues and trends and is a resource for its members, regulators, and the public. WUI can be reached by calling 608-663-5813 or by e-mail at contact@wuiinc.org. EQUAL EMPLOYMENT OPPORTUNITY WPS Resources Corporation is committed to equal employment opportunity for all qualified individuals without regard to race, creed, color, religion, sex, age, national origin, sexual orientation, disability, or veteran status. To that end, we support and will cooperate fully with all applicable laws, regulations, and executive orders in all of our employment policies, practices, and decisions. Investor Relations WPS Resources Corporation 700 North Adams Street Green Bay, WI 54301 Mailing Address: WPS Resources Corporation P O. Box 19001 . Green Bay, WI 54307-9001 Telephone: 920-433-1050 or 920-433-1857 E-Mail: investor@wpsr.com Printed on paper that contains 10% post-consumer fiber, using environmentally conscientious vegetable inks. Subjects in photos were not placed in unsafe conditions for the production of this Annual Report. © 2006 WPS Resources Corporation Financial Inquiries Mr. Joseph P O’Leary . Senior Vice President and Chief Financial Officer WPS Resources Corporation P O. Box 19001 . Green Bay, WI 54307-9001 Telephone: 920-433-1463