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Published:  May 17, 2010
 
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Slide 1: Texas Competitive Electric Holdings Company LLC A Delaware Limited Liability Company (State of Organization) (I.R.S. Employer Identification No.) 75-2967817 (Address of Principal Executive Offices)(Zip Code) 1601 Bryan Street, Dallas, TX 75201-3411 (Telephone Number) (214) 812-4600 Second Amended and Restated Annual Report For the Fiscal Year Ended December 31, 2007 Texas Competitive Electric Holdings Company LLC is not required to file reports with the Securities and Exchange Commission (SEC) and therefore has not filed this annual report with the SEC. While this annual report has been prepared in substantial conformity with Form 10-K under the Securities Exchange Act of 1934, it does not include all of the information contemplated by Form 10-K. As of April 14, 2008, all outstanding common membership interests in Texas Competitive Electric Holdings Company LLC were held by Energy Future Competitive Holdings Company.
Slide 2: Explanatory Note: On April 16, 2008, Texas Competitive Electric Holdings Company LLC ("TCEH") published its Annual Report for the fiscal year ended December 31, 2007 ("Annual Report") via the website of its parent company, Energy Future Holdings Corp., in order to comply with certain of TCEH's financing arrangements. On May 27, 2008, TCEH published in its entirety an Amended and Restated Annual Report for the fiscal year ended December 31, 2007 (“First Amended and Restated Annual Report”) in order to amend the Annual Report by amending the amounts reported in Item 6 – Selected Financial Data for the first through third quarters of 2007 for income from continuing operations and net income set forth under the headings “Quarterly Information (unaudited)” and “Reconciliation of Previously Reported Quarterly Information”. This Second Amended and Restated Annual Report, dated as of June 3, 2008, incorporates the Item 6 amendment reported on May 27, 2008 as well as the change described below, and replaces any previously published 2007 annual report of TCEH. This Second Amended and Restated Annual Report reflects TCEH’s adoption, effective January 1, 2008, of FASB Staff Position FIN 39-1, "Amendment of FASB Interpretation No. 39", as discussed in Note 1. As provided for by this new rule, for balance sheet presentation, TCEH elected to not adopt netting of cash collateral, and further to discontinue netting of derivative assets and liabilities under master netting agreements. Accordingly, as required by the rule, prior period amounts in the financial statements reflect the change in presentation, resulting in increases compared to previously reported amounts of $849 million and $171 million in current and noncurrent commodity and other derivative contractual assets and liabilities, respectively, at December 31, 2007 and $1.243 billion and $139 million in such current and noncurrent amounts, respectively, at December 31, 2006. The effects of the adoption of FIN 39-1 are reflected in the consolidated balance sheets, Notes 1, 18, and 22 to the Financial Statements, and in Item 6 - Selected Financial Data of this Second Amended and Restated Annual Report. ii
Slide 3: TABLE OF CONTENTS PAGE GLOSSARY ......................................................................................................................................................................... PART I Items 1 and 2. BUSINESS AND PROPERTIES ........................................................................................................... Item 1A. Item 1B. Item 3. Item 4. RISK FACTORS ....................................................................................................................................... UNRESOLVED STAFF COMMENTS ................................................................................................... LEGAL PROCEEDINGS ......................................................................................................................... SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS .......................................... PART II Item 5. Item 6. Item 7. Item 7A. Item 8. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES................................................ SELECTED FINANCIAL DATA ............................................................................................................ MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS ................................................................................................................. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK ...................... FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ........................................................ 27 28 30 71 78 1 13 25 26 27 ii Appendix A Adjusted EBITDA Reconciliation for the Years Ended December 31, 2007 and 2006 .................... 139 This Annual Report and other reports of Texas Competitive Electric Holdings Company LLC and its subsidiaries occasionally make references to TCEH, TXU Energy or Luminant when describing actions, rights or obligations of their respective subsidiaries. These references reflect the fact that the subsidiaries are consolidated with their respective parent companies for financial reporting purposes. However, these references should not be interpreted to imply that the parent company is actually undertaking the action or has the rights or obligations of the relevant subsidiary company or that the subsidiary company is undertaking an action or has the rights or obligations of its parent company or any other affiliate. i
Slide 4: GLOSSARY When the following terms and abbreviations appear in the text of this report, they have the meanings indicated below. 1999 Restructuring Legislation 2006 Form 10-K Adjusted EBITDA Texas Electric Choice Plan, the legislation that restructured the electric utility industry in Texas to provide for retail competition TCEH’s Annual Report on Form 10-K for the year ended December 31, 2006 Adjusted EBITDA means EBITDA adjusted to exclude non-cash items, unusual items and other adjustments allowable under certain debt arrangements of TCEH. See EBITDA below. Adjusted EBITDA and EBITDA are not recognized terms under GAAP and, thus, are non-GAAP financial measures. TCEH is providing Adjusted EBITDA in this document (see reconciliation in Appendix A) solely because of the important role that Adjusted EBITDA plays in respect of the certain covenants contained in the debt arrangements. TCEH does not intend for Adjusted EBITDA (or EBITDA) to be an alternative to net income as a measure of operating performance or an alternative to cash flows from operating activities as a measure of liquidity or an alternative to any other measure of financial performance presented in accordance with GAAP. Additionally, TCEH does not intend for Adjusted EBITDA (or EBITDA) to be used as a measure of free cash flow available for management’s discretionary use, as the measure excludes certain cash requirements such as interest payments, tax payments and other debt service requirements. Because not all companies use identical calculations, TCEH’s presentation of Adjusted EBITDA (and EBITDA) may not be comparable to similarly titled measures of other companies. Capgemini Energy LP, a subsidiary of Cap Gemini North America Inc. that provides business process support services to TCEH carbon dioxide Refers to earnings (net income) before interest expense, income taxes, depreciation and amortization. Refers to Energy Future Competitive Holdings Company (formerly TXU US Holdings Company), a subsidiary of EFH Corp. and the parent of TCEH, and/or its consolidated subsidiaries, depending on context. Refers to Energy Future Holdings Corp. (formerly TXU Corp.), a holding company, and/or its consolidated subsidiaries, depending on context. Its major subsidiaries include TCEH and Oncor. Emerging Issues Task Force Issue No. 02-3, "Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities" US Environmental Protection Agency engineering, procurement and construction Electric Reliability Council of Texas, the independent system operator and the regional coordinator of various electricity systems within Texas ii Capgemini CO2 EBITDA EFC Holdings EFH Corp. EITF 02-3 EPA EPC ERCOT
Slide 5: ERISA FASB Employee Retirement Income Security Act Financial Accounting Standards Board, the designated organization in the private sector for establishing standards for financial accounting and reporting US Federal Energy Regulatory Commission Financial Accounting Standards Board Interpretation FIN No. 46R (Revised 2003), "Consolidation of Variable Interest Entities" FIN No. 47, "Accounting for Conditional Asset Retirement Obligations ─ An Interpretation of FASB Statement No. 143" FIN No. 48, “Accounting for Uncertainty in Income Taxes” Fitch Ratings, Ltd. (a credit rating agency) FASB Staff Position generally accepted accounting principles gigawatt-hours the territory, largely in north Texas, being served by EFH Corp.’s regulated electric utility subsidiary at the time of entering retail competition on January 1, 2002 US Internal Revenue Service kilovolts kilowatt-hours London Interbank Offered Rate. An interest rate at which banks can borrow funds, in marketable size, from other banks in the London interbank market. Refers to the operations of TCEH established for the purpose of developing and constructing new generation facilities. Luminant Energy Company LLC (formerly TXU Portfolio Management Company LP), a subsidiary of TCEH that engages in certain wholesale markets activities Refers to wholly-owned subsidiaries of TCEH engaged in competitive market activities consisting of electricity generation, development and construction of new generation facilities, wholesale energy sales and purchases as well as commodity risk management and trading activities, all largely in Texas. These entities include Luminant Construction, Luminant Energy and Luminant Power. Refers to a program to drive ongoing productivity improvements in Luminant Power’s operations through application of lean operating techniques and deployment of a high-performance industrial culture. Refers to subsidiaries of TCEH engaged in electricity generation activities. FERC FIN FIN 46R FIN 47 FIN 48 Fitch FSP GAAP GWh historical service territory IRS kV kWh LIBOR Luminant Construction Luminant Energy Luminant Luminant Operating System Luminant Power iii
Slide 6: market heat rate Heat rate is a measure of the efficiency of converting a fuel source to electricity. The market heat rate is based on the price offer of the marginal supplier in Texas (generally natural gas plants) in generating electricity and is calculated by dividing the wholesale market price of electricity by the market price of natural gas. The transaction referred to in "Merger Agreement" (defined immediately below) that was completed on October 10, 2007. Agreement and Plan of Merger, dated February 25, 2007, under which Texas Holdings agreed to acquire TXU Corp. Texas Energy Future Merger Sub Corp, a Texas corporation and a wholly-owned subsidiary of Texas Holdings that was merged into EFH Corp. on October 10, 2007 million British thermal units Moody’s Investors Services, Inc. (a credit rating agency) megawatts megawatt-hours North American Electric Reliability Corporation nitrogen oxide US Nuclear Regulatory Commission Refers to Oncor Electric Delivery Company LLC (formerly TXU Electric Delivery Company), a direct wholly-owned subsidiary of Oncor Holdings and indirect subsidiary of EFH Corp., and/or its consolidated bankruptcy-remote financing subsidiary, Oncor Electric Delivery Transition Bond Company LLC, depending on context. Refers to Oncor Electric Delivery Holdings Company LLC, the parent of Oncor and a wholly-owned subsidiary of Energy Future Intermediate Holding Company LLC, which is a wholly-owned subsidiary of EFH Corp. other postretirement employee benefit residential and small business customer electricity rates established by the PUCT that (i) were required to be charged in a REP’s historical service territories until the earlier of January 1, 2005 or the date when 40% of the electricity consumed by such customer classes was supplied by competing REPs, adjusted periodically for changes in fuel costs, and (ii) were required to be made available to those customers until January 1, 2007 Public Utility Commission of Texas Texas Public Utility Regulatory Act The purchase method of accounting for a business combination as prescribed by SFAS 141 whereby the cost or "purchase price" of a business combination, including the amount paid for the equity and direct transaction costs are allocated to identifiable assets and liabilities (including intangible assets) based upon their fair values. The excess of the purchase price over the fair values of assets and liabilities is recorded as goodwill. retail electric provider iv Merger Merger Agreement Merger Sub MMBtu Moody’s MW MWh NERC NOx NRC Oncor Oncor Holdings OPEB price-to-beat rate PUCT PURA Purchase accounting REP
Slide 7: RRC S&P SEC SFAS SFAS 5 SFAS 34 SFAS 87 SFAS 106 SFAS 109 SFAS 115 SFAS 123R SFAS 133 SFAS 140 Railroad Commission of Texas, which has oversight of lignite mining activity Standard & Poor’s Ratings Services, a division of the McGraw Hill Companies Inc. (a credit rating agency) US Securities and Exchange Commission Statement of Financial Accounting Standards issued by the FASB SFAS No. 5, “Accounting for Contingencies” SFAS No. 34, “Capitalization of Interest Cost” SFAS No. 87, “Employers’ Accounting for Pensions” SFAS No. 106, “Employers' Accounting for Postretirement Benefits Other Than Pensions” SFAS No. 109, “Accounting for Income Taxes” SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities” SFAS No. 123 (revised 2004), “Share-Based Payment” SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” as amended and interpreted SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, a replacement of FASB Statement 125” SFAS No. 141, "Business Combinations" SFAS No. 141R (revised 2007), "Business Combinations" SFAS No. 142, “Goodwill and Other Intangible Assets” SFAS No. 143, “Accounting for Asset Retirement Obligations” SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities" SFAS No. 157, “Fair Value Measurements” SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans” SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities – Including an Amendment of FASB Statement No. 115” SFAS No. 160, "Noncontrolling Interests in Consolidated Financial Statements ─ an amendment of ARB No. 51" selling, general and administrative sulfur dioxide Collectively, the investment funds affiliated with Kohlberg Kravis Roberts & Co. L.P., TPG Capital, L.P. and GS Capital Partners, an affiliate of Goldman Sachs & Co. SFAS 141 SFAS 141R SFAS 142 SFAS 143 SFAS 144 SFAS 146 SFAS 157 SFAS 158 SFAS 159 SFAS 160 SG&A SO2 Sponsor Group v
Slide 8: TCEH Refers to Texas Competitive Electric Holdings Company LLC (formerly TXU Energy Company LLC), a direct subsidiary of EFC Holdings and an indirect subsidiary of EFH Corp., and/or its consolidated subsidiaries, depending on context, engaged in electricity generation, wholesale and retail energy markets and development and construction activities. Its major subsidiaries include Luminant and TXU Energy. Refers to TCEH Finance, Inc., a wholly-owned subsidiary of TCEH, formed for the sole purpose of serving as co-issuer with TCEH of certain debt securities. Refers collectively to the TCEH Initial Term Loan Facility, TCEH Delayed Draw Term Loan Facility, TCEH Revolving Credit Facility, TCEH Letter of Credit Facility and TCEH Commodity Collateral Posting Facility. See Note 15 to the Financial Statements for details of these facilities. Texas Commission on Environmental Quality Refers to Texas Energy Future Holdings Limited Partnership, a Delaware limited partnership controlled by the Sponsor Group that is the parent of EFH Corp. Refers to TXU Energy Retail Company LLC, a subsidiary of TCEH engaged in the retail sale of electricity to residential and business customers. TXU Energy is a REP in competitive areas of ERCOT. Refers to TXU Generation Development Company LLC, a direct, wholly-owned subsidiary of EFH Corp. established for the purpose of developing new generation facilities. This subsidiary did not become a subsidiary of TCEH in connection with the Merger. United States of America US Climate Action Partnership TCEH Finance TCEH Senior Secured Facilities TCEQ Texas Holdings TXU Energy TXU Generation Development US USCAP vi
Slide 9: PART I Items 1. and 2. BUSINESS AND PROPERTIES See Glossary on page ii for a definition of terms and abbreviations. TCEH Business and Strategy TCEH is a wholly-owned subsidiary of EFC Holdings, which is a wholly-owned subsidiary of EFH Corp. While TCEH is a wholly-owned subsidiary of EFH Corp. and EFC Holdings, TCEH is a separate legal entity from EFH Corp. and EFC Holdings and all of their other affiliates with its own assets and liabilities. TCEH is a Dallas-based holding company for subsidiaries engaged in competitive electricity market activities largely in Texas, including Luminant, which is engaged in electricity generation, development and construction of new generation facilities, wholesale energy sales and purchases and commodity risk management and trading activities and TXU Energy, which is engaged in retail electricity sales. With the closing of the Merger on October 10, 2007, EFH Corp. became a wholly-owned subsidiary of Texas Holdings, a Delaware limited partnership controlled by the Sponsor Group, and the outstanding shares of common stock of EFH Corp. were converted into the right to receive $69.25 per share. As of December 31, 2007, Luminant owned or leased 18,365 MW of generation capacity in Texas, which consists of lignite/coal, nuclear and natural gas/fuel oil-fueled generation facilities. In addition, Luminant is the largest purchaser of wind-generated electricity in Texas and the fifth largest in the US. Luminant is currently constructing three lignite/coal-fueled generation units in Texas with expected generation capacity totaling approximately 2,200 MW. Air permits have been obtained for the three units, which are expected to come online in 2009 and 2010. TXU Energy provides competitive electricity and related services to more than 2.1 million retail electricity customers in Texas. As of December 31, 2007, TXU Energy’s estimated share of the total ERCOT retail market for residential and small business electricity customers was approximately 36% and 25%, respectively (based on customer counts). At December 31, 2007, TCEH had approximately 3,900 full-time employees, including approximately 1,900 employees under collective bargaining agreements. TCEH's Market TCEH operates primarily within the ERCOT market, which represents approximately 85% of electricity consumption in Texas. ERCOT is the regional reliability coordinating organization for member electricity systems in Texas and the system operator of the interconnected transmission grid for those systems. ERCOT’s membership consists of approximately 250 members, including electric cooperatives, municipal power agencies, investor-owned independent generators, independent power marketers, transmission service providers, distribution service providers, independent REPs and consumers. The ERCOT market represents approximately 75% of the geographical area of Texas, but excludes El Paso, a large part of the Texas Panhandle and two small areas in the eastern part of the state. From 1996 through 2006, peak hourly demand in the ERCOT market grew at a compound annual rate of 2.8%, compared to a compound annual rate of growth of 2.5% for the entire US over the same period. For 2006, the most recent period for which full year data is available, hourly demand ranged from a low of 21,309 MW to a high of 62,339 MW. The ERCOT market has limited interconnections to other markets in the US, which currently limits potential imports into and exports out of the ERCOT market to 1,106 MW of generation capacity (or approximately 2% of peak demand). In addition, wholesale transactions within the ERCOT market are not subject to regulation by the FERC. 1
Slide 10: Since 1999, over 29,000 MW of mostly natural gas-fueled and wind generation capacity has been developed in the ERCOT market. As of December 2007, net generation capacity in the ERCOT market totaled approximately 81,000 MW, which included approximately 5,000 MW of mothballed capacity; approximately 68% of the 81,000 MW is natural gas-fueled. Approximately 25% of this total capacity consists of lower marginal cost, as compared to natural gas-fueled facilities, lignite/coal and nuclear-fueled baseload generation. Luminant’s baseload plants represent approximately 40% of the total ERCOT market baseload generation capacity. ERCOT currently has a target reserve margin level of approximately 12.5%; the reserve margin is projected by ERCOT to be 13.1% in 2008 and drop to 8.2% by 2013. Natural gas-fueled generation is the predominant electricity capacity resource in the ERCOT market and accounted for approximately 46% of the electricity produced in the ERCOT market in 2006. Because of the significant natural gas-fueled capacity and the ability of such plants to more readily increase or decrease production when compared to baseload generation, marginal demand for electricity is usually met by natural gasfueled plants. ERCOT’s October 1, 2005 report titled “Report on Existing and Potential Electric System Constraints and Needs” found that natural gas-fueled plants set the market price more than 90% of the time in the ERCOT market. As a result, wholesale electricity prices are highly correlated to natural gas prices. The ERCOT market is currently divided into four regions or congestion management zones, namely: North, Houston, South and West, which reflect transmission constraints that are commercially significant and which have limits as to the amount of electricity that can flow across zones. These constraints and zonal differences can result in differences between wholesale power prices among zones. Luminant’s baseload generation units are located primarily in the North region, with the Sandow unit in the South region. The ERCOT market operates under reliability standards set by the NERC. The PUCT has primary jurisdiction over the ERCOT market to ensure adequacy and reliability of power supply across Texas’s main interconnected transmission grid. The ERCOT independent system operator is responsible for maintaining reliable operations of the bulk electricity supply system in the ERCOT market. Its responsibilities include ensuring that electricity production and delivery are accurately accounted for among the generation resources and wholesale buyers and sellers. Unlike certain other regional power markets, the ERCOT market is not a centrally dispatched power pool, and the ERCOT independent system operator does not procure energy on behalf of its members, except to the extent that it acquires ancillary services as agent for market participants. Members who sell and purchase power are responsible for contracting sales and purchases of power with other members through bilateral transactions. The ERCOT independent system operator also serves as agent for procuring ancillary services for those members who elect not to provide their own ancillary services. TCEH's Strategies TCEH's businesses focus on key drivers as described below: • Luminant focuses on optimizing its existing generation fleet to provide safe, reliable and costcompetitive electricity, as well as developing and constructing additional generation capacity to help meet the growing demand for electricity in Texas, and TXU Energy focuses on providing high quality customer service and developing innovative energy products to meet customers’ needs. • 2
Slide 11: Other elements of TCEH's strategy include: • Increase value from existing businesses. TCEH's strategy focuses on striving for top quartile or better performance across its operations in terms of dependability, cost and customer service. TCEH will continue to focus on upgrading four critical skill sets: operational excellence; market leadership; a systematic risk/return mindset applied to all key decisions, and rigorous performance management targeting industry-leading performance standards for productivity, dependability and customer service. An example of how TCEH implements these principles is a program called the “Luminant Operating System,” which is a program to drive ongoing productivity improvements in Luminant Power’s operations through application of lean operating techniques and deployment of a high-performance industrial culture. Pursue growth opportunities across business lines. TCEH will selectively target growth opportunities in each of its business lines. TCEH’s scale allows it to take part in large capital investments, such as new generation projects, with a smaller fraction of overall capital at risk and with an enhanced ability to streamline costs. Specific growth initiatives for each business include: • Luminant: Construct three new lignite-fueled generation facilities with onsite lignite fuel supplies, as well as pursue wind generation projects in the near to medium term. Pursue new generation opportunities to help meet ERCOT’s growing electricity needs over the longer term from a diverse range of alternatives such as nuclear, renewables and advanced coal technologies. TXU Energy: Increase the number of customers served both in TCEH's historical service territory and in other competitive ERCOT areas such as Houston, by delivering superior value to customers through superior customer service and innovative energy products, including pioneering energy efficiency initiatives and service offerings. • • • Reduce the volatility of cash flows through a commodity risk management strategy. A key component of TCEH's risk management strategy is its plan to hedge approximately 80% of the natural gas price risk exposure of Luminant’s baseload generation output on a rolling five-year basis. The strong historical correlation between natural gas prices and wholesale electricity prices in the ERCOT market combined with the significant liquidity in certain natural gas markets provides an opportunity for management of TCEH's exposure to natural gas prices. As of March 14, 2008, approximately 2.4 billion MMBtu of natural gas (equivalent to the natural gas exposure of approximately 305,000 GWh at an assumed 8.0 MMBtu/MWh market heat rate) have been effectively sold forward by TCEH's subsidiaries over the period from 2008 to 2013 at average annual prices ranging from $7.25 per MMBtu to $8.15 per MMBtu. Taking into consideration the estimated portfolio impacts of TCEH's retail electricity business, these natural gas hedging transactions result in TCEH having effectively hedged approximately 84% of its expected baseload generation natural gas price exposure (on an average basis for 2008 through 2013). Certain of the hedging transactions are directly secured with a first-lien interest in TCEH’s assets, which eliminates liquidity requirements because no cash or letter of credit posting is required. In addition, the uncapped TCEH Commodity Collateral Posting Facility, which is also secured by a first-lien interest in TCEH's assets, supports the margin requirements for a significant portion of the remaining hedging transactions. Consequently, as of March 14, 2008, approximately 95% of the hedging transactions were secured or supported by first-lien interests in TCEH’s assets and result in no direct liquidity exposure. 3
Slide 12: • Pursue new environmental initiatives. TCEH is committed to continue to operate in compliance with all environmental laws, rules and regulations and to reduce its impact on the environment. EFH Corp. has formed a Sustainable Energy Advisory Board that will advise EFH Corp. in its pursuit of technology development opportunities that reduce EFH Corp.'s impact on the environment while balancing the need to address the energy requirements of Texas. EFH Corp.'s Sustainable Energy Advisory Board is comprised of individuals who represent the following interests, among others: the environment, customers, economic development in Texas and technology/reliability standards. In addition, Luminant is focused on and is pursuing opportunities to reduce emissions from its existing and planned new lignite/coal-fueled generation units in the ERCOT market. Luminant has voluntarily committed to reduce emissions of mercury, nitrogen oxide and sulfur dioxide at its existing units, so that the total of those emissions from both existing and new lignite/coal-fueled units is 20% below 2005 levels. Luminant expects to make these reductions through a combination of investment in new emission control equipment, new coal cleaning technologies and optimizing fuel blends. Luminant also expects such investments to provide economic benefits by reducing future costs associated with complying with environmental emissions standards. EFH Corp. expects that its subsidiaries will invest $400 million over a five year period beginning in 2008 in programs designed to encourage customer electricity demand efficiencies, including $100 million expected to be invested by subsidiaries of TCEH. Business Organization Commodity risk management and allocation of financial resources is performed at the TCEH level; consequently, there are no reportable segments. For purposes of operational accountability and performance management, TCEH has been divided into Luminant Power, Luminant Energy, Luminant Construction and TXU Energy. The operations of Luminant Power, Luminant Energy and TXU Energy are conducted through separate legal entities. Luminant Power ― Luminant Power’s electricity generation fleet consists of 19 plants in Texas with total generating capacity as of December 31, 2007 as shown in the table below: Fuel Type Nuclear Lignite/coal Natural gas (b)(c) Total Capacity (MW) 2,300 5,837 10,228 18,365 Number of Plants 1 4 14 19 Number of Units (a) 2 9 45 56 (a) Leased units consist of six natural gas-fueled units totaling 390 MW of capacity. All other units are owned. (b) Includes 1,329 MW representing five units mothballed and not currently available for dispatch. (c) Includes 585 MW representing nine combustion turbine units currently operated for an unaffiliated third party’s benefit. The generation plants are located primarily on land owned in fee. Nuclear and lignite/coal-fueled (baseload) plants are generally scheduled to run at capacity except for periods of scheduled maintenance activities or, in the case of lignite/coal units, backdown due to periods of low demand. The natural gas-fueled generation units supplement the baseload generation capacity in meeting variable consumption as production from these units can more readily be ramped up or down as demand warrants. 4
Slide 13: Nuclear Generation Assets — Luminant Power operates two nuclear generation units at the Comanche Peak plant, each of which is designed for a capacity of 1,150 MW. Comanche Peak’s Unit 1 and Unit 2 went into commercial operation in 1990 and 1993, respectively, and are generally operated at full capacity to meet the load requirements in ERCOT. Refueling (nuclear fuel assembly replacement) outages for each unit are scheduled to occur every eighteen months during the spring or fall off-peak demand periods. Every three years, the refueling cycle results in the refueling of both units during the same year, which is expected to occur in 2008. While one unit is undergoing a refueling outage, the remaining unit is intended to operate at full capacity. During a refueling outage, other maintenance, modification and testing activities are completed that cannot be accomplished when the unit is in operation. Over the last three years, excluding the 2007 55-day outage to refuel and replace the steam generators and reactor vessel head in Unit 1, the refueling outage period per unit has ranged from a high of 32 days in 2005 to a low of 18 days in 2006. The Comanche Peak plant operated at a capacity factor of 98.8% in 2006, which represents top decile performance of US nuclear generation facilities, and 93.5% in 2007, reflecting a planned extended refueling outage to replace the steam generator and reactor vessel head in Unit 1. Luminant Power has contracts in place for nuclear fuel conversion services through 2008. In addition, Luminant Power has contracts for the acquisition of 100% and 73% of its uranium requirements in 2008 and 2009, respectively and for 91% of the nuclear fuel enrichment services through 2009, as well as 100% of nuclear fuel fabrication services through 2018. Contracts for the acquisition of additional raw uranium and nuclear fuel conversion services through 2016 and 2015, respectively, are being negotiated. Additional offers to ensure a portion of nuclear fuel enrichment services through 2020 are under review. Luminant Power does not anticipate any issues with finalizing these contracts and does not anticipate any significant difficulties in acquiring raw uranium and contracting for associated conversion services and enrichment in the foreseeable future. Luminant Power’s on-site used nuclear fuel storage capability is sufficient for five to ten years. The nuclear industry is continuing to review ways to enhance security of used-fuel storage with the NRC to fully utilize physical storage capacity. Accordingly, Luminant Power is actively reviewing alternatives for used-fuel storage, including evaluation of industry techniques such as dry cask storage. The Comanche Peak nuclear generation units have an estimated useful life of 60 years from the date of commercial operation. Therefore, assuming that Luminant Power receives the requisite 20-year license extensions, similar to what has been granted by the NRC to several other commercial generation reactors over the past several years, plant decommissioning activities would be scheduled to begin in 2050 for Comanche Peak Unit 1 and 2053 for Unit 2 and common facilities. Decommissioning costs will be paid from a decommissioning trust that is funded from Oncor’s customers through an ongoing delivery surcharge. Lignite/Coal-Fueled Generation Assets — Luminant Power’s lignite/coal-fueled generation fleet capacity totals 5,837 MW and consists of the Big Brown (2 units), Monticello (3 units), Martin Lake (3 units) and Sandow (1 unit) plants. These plants are generally operated at full capacity to meet the load requirements in ERCOT. Maintenance outages are scheduled during off-peak demand periods. Over the last three years, the total annual scheduled and unscheduled outages per unit averaged 30 days. Luminant Power’s lignite/coalfueled generation fleet operated at a capacity factor of 89.1% in 2006 and 90.9% in 2007, which represents top decile performance of US coal-fueled generation facilities. Approximately 63% of the fuel used at Luminant Power’s lignite/coal-fueled generation plants in 2007 was supplied from lignite reserves owned in fee or leased surface-minable deposits dedicated to the Big Brown, Monticello and Martin Lake plants, which were constructed adjacent to the reserves. Luminant Power owns in fee or has under lease an estimated 893 million tons of lignite reserves dedicated to its generation plants, including the Oak Grove generation facilities being constructed, and including 246 million tons obtained in conjunction with the 2007 acquisition of an undivided interest in a lignite mine that fuels the Sandow plant. Luminant Power also owns in fee or has under lease in excess of 85 million tons of reserves not currently dedicated to specific generation plants. In 2007, approximately 22 million tons of lignite were recovered to fuel Luminant Power’s plants. Luminant Power utilizes owned and/or leased equipment to remove the overburden and recover the lignite. 5
Slide 14: Lignite mining operations include extensive reclamation activities that return the land to productive uses such as wildlife habitats, commercial timberland and pasture land. In 2007, Luminant Power reclaimed 1,671 acres of land and regulatory authorities approved Luminant Power’s release of approximately 200 acres from further reclamation obligation. In addition, EFH Corp. planted more than 1.6 million trees in 2007, the majority of which were part of the reclamation effort. Luminant Power supplements its lignite fuel at Big Brown, Monticello and Martin Lake with western coal from the Powder River Basin in Wyoming. The coal is purchased from multiple suppliers under contracts of various lengths and is transported from the Powder River Basin to Luminant Power’s generation plants by railcar. Based on its current usage, Luminant Power believes that it has sufficient lignite reserves for the foreseeable future and has contracted 82% of its western coal resources and 100% of the related transportation through 2009. Natural Gas-Fueled Generation Assets — Luminant Power's fleet of 45 natural gas-fueled generation units consists of 8,314 MW of currently available capacity, 585 MW of capacity being operated for an unaffiliated third party’s benefit, pursuant to the direction of that unaffiliated third party, and 1,329 MW of capacity currently mothballed. A significant number of the natural gas-fueled units have the ability to switch between natural gas and fuel oil. The gas units predominantly serve as peaking units that can be more readily ramped up or down as demand warrants. Luminant Energy — The Luminant Energy wholesale operations play a pivotal role in TCEH’s business portfolio by optimally dispatching the generation fleet, sourcing TXU Energy’s and other customers' electricity requirements and managing commodity price risk. TCEH manages commodity price exposure across the complementary Luminant generation and TXU Energy retail businesses on a portfolio basis. Under this approach, Luminant Energy manages the risks of imbalances between generation supply and sales load, which primarily represent exposures to natural gas price movements and market heat rate changes (variations in the relationships between natural gas prices and wholesale electricity prices), through wholesale markets activities that include physical purchases and sales and transacting in financial instruments. Luminant Energy manages this commodity price and heat rate exposure through asset management and hedging activities. Luminant Energy provides TXU Energy and other wholesale customers with electricity and related services to meet their retail customers' demands and the operating requirements of ERCOT. Luminant Energy also sells forward generation and seeks to maximize the economic value of the generation fleet. In consideration of operational production and customer consumption levels that can be highly variable, as well as opportunities for long-term purchases and sales with large wholesale electricity market participants, Luminant Energy buys and sells electricity in short-term transactions and executes longer-term forward electricity purchase and sales agreements. Luminant Energy is the largest purchaser of wind-generated electricity in Texas and the fifth largest in the United States. In its hedging activities, Luminant Energy enters into contracts for the physical delivery of electricity and natural gas, exchange traded and “over-the-counter” financial contracts and bilateral contracts with producers, generators and end-use customers. A major part of these hedging activities is a long-term hedging program, described above under "TCEH's Strategies", designed to reduce exposure to changes in future electricity prices due to changes in the price of natural gas, principally utilizing natural gas-related financial instruments. Luminant Energy also dispatches Luminant Power's available natural gas-fueled generation capacity. Luminant Energy’s dispatching activities are performed through a centrally managed real-time operational staff that synthesizes operational activities across the fleet and interfaces with various wholesale market channels. Luminant Energy coordinates the overall commercial strategy for these plants working closely with Luminant Power. In addition, Luminant Energy manages the natural gas procurement requirements for these plants. 6
Slide 15: Luminant Energy engages in commercial operations such as physical purchases, storage and sales of natural gas, electricity and natural gas trading and third-party energy management. Luminant Energy’s natural gas operations include well-head production contracts, transportation agreements, storage leases and retail sales. Luminant Energy currently manages approximately 19 billion cubic feet of natural gas storage capacity and has a small presence outside of Texas in both electricity and natural gas commodity trading. Luminant Energy manages exposure to wholesale commodity and credit related risk within established transactional risk management policies, limits and controls. These policies, limits and controls have been structured so that they are practical in application and consistent with stated business objectives. Risk management processes include capturing transactions, performing and validating valuations and reporting exposures on a daily basis using commodity information systems designed to support a large transactional portfolio. A risk management forum meets regularly to ensure that business practices comply with approved transactional limits, commodities, instruments, exchanges and markets. Transactional risks are monitored and limits are enforced to comply with the established risk policy. Luminant Energy has a disciplinary program to address any violations of the risk management policies and periodically reviews these policies to ensure they are responsive to changing market and business conditions. Luminant Construction — Luminant Construction is developing three new lignite-fueled units in the state of Texas with total estimated capacity of approximately 2,200 MW. The three units consist of one new generation unit at a site leased from Alcoa Inc. that is adjacent to an existing owned lignite-fueled generation plant site (Sandow) and two units at an owned site (Oak Grove) that was originally slated for the construction of a generation plant a number of years ago. Aggregate cash capital expenditures for these three units are expected to total approximately $3.25 billion including all construction, site preparation and mining development costs. Development and procurement activities for the three new lignite-fueled units are essentially complete and construction is well underway. Air permits have been obtained, and EPC agreements have been executed with Bechtel Power Corporation and Fluor Enterprises, Inc. The expected commercial operation dates of the units are as follows: Sandow in 2009 and Oak Grove’s two units in 2009 and 2010. (See Note 16 to Financial Statements for additional information about the air permits, including actions of opponents to the development of the units.) The development program includes up to $500 million for investments in state-of-the-art emissions controls for the three new units. The development program includes an environmental retrofit program under which Luminant Construction plans to install additional environmental control systems at Luminant Power's existing lignite/coal-fueled generation facilities. Estimated capital expenditures associated with these additional environmental control systems total approximately $1 billion to $1.3 billion. Luminant Construction has not yet completed detailed cost and engineering studies for the additional environmental systems, and the cost estimates could change substantially as Luminant Construction determines the details of, and further evaluates the engineering and construction costs related to, these investments. TXU Energy — TXU Energy serves more than 2.1 million retail electricity customers, of which 1.8 million are in TCEH's historical service territory. This territory, which is located in the north-central, eastern and western parts of Texas, has an estimated population in excess of 7 million, about one-third of the population of Texas, and comprises 92 counties and over 370 incorporated municipalities, including Dallas/Fort Worth and surrounding suburbs, as well as Waco, Wichita Falls, Odessa, Midland, Tyler and Killeen. Texas is one of the fastest growing states in the nation with a diverse and resilient economy and, as a result, has attracted a number of competitors into the retail electricity market; consequently, competition is expected to continue to be robust. TXU Energy, as an active participant in this competitive market, provides retail electric service to the other areas of the ERCOT market now open to competition, including the Houston, Corpus Christi, and lower Rio Grande Valley areas of Texas. TXU Energy continues to market its services in Texas to add new customers and to retain its existing customers. As of December 31, 2007, there are more than 100 REPs certified to compete within the state of Texas. 7
Slide 16: TXU Energy’s strategy focuses on providing its customers with high quality customer service and creating new products and services to meet customer needs. For the year ended December 31, 2007, call answer times averaged less than 15 seconds. Customer call satisfaction scores in North Texas improved 9% in the year ended December 31, 2007, as compared to the year ended December 31, 2006. TXU Energy offers 10 widely available residential products to meet various customer needs, currently more than any retailer in the ERCOT market. TXU Energy is also planning to invest $100 million over the next five years in energy efficiency initiatives as part of a program to offer customers a broad set of innovative energy products and services. Since March 2007, TXU Energy has implemented price reductions totaling 15% for residential customers in TCEH's historical service territory who have not already switched from the basic month-to-month plan to one of the other pricing plans offered by TXU Energy. These customers received a six percent reduction beginning in late March 2007, an additional four percent reduction in June 2007 and an additional five percent reduction effective in late October 2007. TXU Energy has committed to provide price protection to these customers through December 2008, ensuring that they receive the benefits of the majority of these savings through two summer seasons of peak energy usage. In addition, TXU Energy committed in 2006 to not increase prices above then current levels through 2009 for qualifying residential customers who remain on certain plans with rates that were then equal to the price-to-beat rate. As of December 31, 2007, TXU Energy served approximately 62% of the retail residential market share in TCEH's historical service territory and approximately 36% of the total ERCOT competitive retail residential market. Regulation — Luminant Power is an exempt wholesale generator under the Energy Policy Act of 2005 and is subject to the jurisdiction of the NRC with respect to its nuclear generation plant. NRC regulations govern the granting of licenses for the construction and operation of nuclear-fueled generation plants and subject such plants to continuing review and regulation. Luminant Energy also holds a power marketer license from the FERC. As a result of the legislation that restructured the electric utility industry in Texas to provide for retail competition (1999 Restructuring Legislation), effective January 1, 2002, REPs affiliated with electricity delivery utilities were required to charge price-to-beat retail prices, established by the PUCT, to residential and small business customers located in their historical service territories. The price-to-beat mechanism was intended to spur competition as the rates were set such that competing REPs could profitably offer lower rates. TXU Energy, as a REP affiliated with an electricity delivery utility, was required to charge the price-to-beat retail price, adjusted for fuel factor changes, to these classes of customers until the earlier of January 1, 2005 or the date on which 40% of the electricity consumed by customers in that class was supplied by competing REPs. TXU Energy met the 40% threshold target calculation for its small business customers in December 2003 and began offering rates other than the price-to-beat retail prices to this customer class. Since January 1, 2005, TXU Energy has offered rates different from the price-to-beat retail prices to all customer classes, but was required to make the price-to-beat retail prices available for residential and small business customers in TCEH's historical service territory until January 1, 2007. 8
Slide 17: Environmental Regulations and Related Considerations Climate Change and Carbon Dioxide Luminant's nine lignite/coal-fueled generation units are significant sources of CO2 emissions, generating the great majority of the average of 57 million tons of CO2 that Luminant's monitoring indicates its generation plants produced annually from 2004 to 2006. The three new lignite-fueled units currently under construction will generate additional CO2 emissions. In November 2007, Luminant applied for membership in USCAP, which is a broad-based group of businesses and leading environmental groups organized to work with the President, the Congress and all other stakeholders to enact environmentally effective and economically sustainable climate change programs. TCEH supports a mandatory cap and trade program to reduce CO2 emissions as part of its affiliation with USCAP. TCEH participates in a voluntary electric utility industry sector climate change initiative in partnership with the US Department of Energy. This initiative supports the Bush Administration’s greenhouse gas emissions intensity reduction program, Climate VISION. TCEH's strategies are consistent with “The Carbon Principles” announced in February 2008 by three major financial institutions that focus on energy efficiency, renewable and low carbon distributed energy technologies and conventional and advanced generation. TCEH's approach to addressing global climate change is based upon the following principles: • • • • • Climate change is a global issue requiring a comprehensive solution addressing all greenhouse gases, sources and economic sectors in all countries; Development of US energy and environmental policy should seek to ensure US energy security and independence; Solutions should encourage investment in a diverse supply of new generation to meet US needs to maintain adequate reserve margins and support economic growth, as well as address customer’s needs for affordable and reliable energy; Policies should encourage significant investments in research and development and deployment of a broad spectrum of solutions, including energy efficiency, renewable energy and coal, natural gas and nuclear-fueled generation technologies, and Any mandate to reduce greenhouse gas emissions should be developed under a market-based framework that is consistent with expected technology development timelines and supports the displacement of old, inefficient power generation technology with advanced, more efficient technology. TCEH's strategies for lowering greenhouse gas emissions include: • Investing in technology — TCEH expects to invest over the next five to seven years in the development and commercialization of cleaner power plant technologies, including integrated gasification combined cycle, the next generation of more efficient ultra-supercritical coal and pulverized coal emissions technology to reduce CO2 emission intensity. A number of actions, including research and development investments and partnerships, have already been initiated to advance next-generation technologies; Providing electricity from renewable sources — TCEH intends to become a leader in providing electricity from renewable sources by more than doubling its purchases of wind power to more than 1,500 MW. In 2007, Luminant added 124 MW to its wind power portfolio bringing its current total wind power portfolio to more than 900 MW. TCEH also intends to promote solar power through solar/photovoltaic rebates; Committing to demand side management initiatives — TCEH expects that its subsidiaries will invest $100 million over five years beginning in 2008 in programs designed to encourage customer electricity demand efficiencies; Reducing CO2 emissions by increasing production efficiency — Luminant expects to increase production efficiency of its existing generation facilities by up to 2 percent, and Evaluating the development of a nuclear generation facility — Luminant plans to develop an application to file with the NRC for combined construction and operating licenses for up to 3,400 MW of new nuclear generation capacity at its Comanche Peak nuclear generation plant. Nuclear generation is the lowest emission source of baseload generation available. 9 • • • •
Slide 18: Increasing public concern and political pressure from local, regional, national and international bodies may result in the passage of new laws mandating limits on greenhouse gas emissions. A series of reports by the Intergovernmental Panel on Climate Change in 2007 attracted considerable public attention and concern. Several bills addressing climate change have been introduced in the US Congress and, in April 2007, the US Supreme Court issued a decision ruling that the EPA improperly declined to address CO2 impacts in a rulemaking related to new motor vehicle emissions. While this decision is not directly applicable to power plant emissions, the reasoning of the decision could affect other regulatory programs. Various proposals in the US Congress could require TCEH to purchase offsets or allowances for some or all of its CO2 emissions, or otherwise affect TCEH based on the amount of CO2 it generates. The impact on TCEH of any future greenhouse gas regulation will depend in large part on the details of the requirements and the timetable for mandatory compliance. TCEH continues to assess the financial and operational risks posed by possible future legislative changes pertaining to greenhouse gas emissions, but because these proposals are in the formative stages, TCEH is unable to predict any future impacts on its financial condition and operations. Sulfur Dioxide, Nitrogen Oxide and Mercury Air Emissions The EPA has promulgated Acid Rain Program rules that require fossil-fueled plants to have sufficient SO2 emission allowances and meet certain NOx emission standards. Luminant's generation plants meet the SO2 allowance requirements and NOx emission rates. In 2005, the EPA issued a final rule to further reduce SO2 and NOx emissions from power plants. The SO2 and NOx reductions required under the Clean Air Interstate Rule (CAIR), which are required to be phased in between 2009 and 2015, are based on a cap and trade approach (market-based) in which a cap is put on the total quantity of emissions allowed in 28 eastern states (including Texas). Emitters are required to have allowances for each ton emitted, and emitters are allowed to trade emissions under the cap. Luminant has received its NOx allowances under CAIR for the years 2009 through 2014. In 2005, the EPA also published a final rule requiring reductions of mercury emissions from coal-fueled generation plants. The Clean Air Mercury Rule (CAMR) is based on a cap and trade approach on a nationwide basis. The mercury reductions are required to be phased in between 2010 and 2018. In February 2008, the United States Court of Appeals for the D.C. Circuit issued a decision that would vacate the CAMR rule and in March 2008, this Court issued a mandate vacating CAMR. Depending on the outcome of any appeals, CAMR could be reinstated. If appeals are unsuccessful, the EPA must begin development of rules implementing maximum achievable control technology, which will take several years. SO2 reductions required under the proposed regional haze/visibility rule (or so-called BART rule) only apply to units built between 1962 and 1977. The reductions would be required on a unit-by-unit basis. The EPA provides the option for states to use CAIR to satisfy the BART reductions for electric generating units, and Texas has chosen this option. In connection with Luminant's plan to build three new lignite-fueled generation units in Texas, Luminant has committed to reduce emissions of NOx, SO2 and mercury at its existing lignite/coal-fueled units such that the total of those emissions from both existing and new lignite/coal-fueled units are 20% below 2005 levels. This reduction is expected to be accomplished through the installation of emissions control equipment in both the new and existing units and fuel blending at some existing units. These efforts, which will involve incremental equipment investments as well as additional costs for facility operations and maintenance in the future, will be coordinated with efforts related to the CAIR, CAMR and BART rules to provide the most cost-effective compliance plan options. 10
Slide 19: The following are the major air quality improvements planned at Luminant's existing and new coal-fueled power plants to help meet the offset and reduction commitment: • To reduce NOx emissions, Luminant plans to install in-duct selective catalytic reduction (SCR) systems at its Martin Lake plant. In addition, Luminant plans to install selective non-catalytic reductions systems at its Monticello and Big Brown plants and improve the low-NOx burner technology at one of its Monticello units to further reduce NOx emissions. This is in addition to external SCR systems at the existing Sandow unit and new Oak Grove units; To reduce mercury emissions, all of Luminant's new and existing plants plan to use activated carbon injection ─ a sorbent injection system technology, and To reduce SO2 emissions, various plants plan to increase use of lower-sulfur coal. In addition, the Martin Lake, Monticello and Big Brown plants plan to employ coal-cleaning technology to reduce both SO2 and mercury emissions. • • The Clean Air Act also requires each state to monitor air quality for compliance with federal health standards. The standards for ozone are not being achieved in several areas of Texas. The TCEQ adopted new State Implementation Plan (SIP) rules in May 2007 to deal with the eight-hour ozone standards. These rules require further NOx emission reductions from certain Luminant Power peaking natural gas-fueled units in the Dallas-Fort Worth area by spring 2009. In March 2008, the EPA made the eight-hour ozone standards more stringent. Since SIP rules to address attainment of these new more stringent standards will not be required for approximately five years, Luminant Power cannot yet predict the impact of this action on its facilities. TCEH believes that it holds all required emissions permits for facilities in operation and has applied for or obtained the necessary construction permits for facilities under construction. Water The TCEQ and the EPA have jurisdiction over water discharges (including storm water) from facilities in Texas. TCEH believes its facilities are presently in material compliance with applicable state and federal requirements relating to discharge of pollutants into water. TCEH believes it holds all required waste water discharge permits from the TCEQ for facilities in operation and has applied for or obtained necessary permits for facilities under construction. TCEH believes it can satisfy the requirements necessary to obtain any required permits or renewals. Recent changes to federal rules pertaining to the Spill Prevention, Control and Countermeasure (SPCC) plans for oil-filled electrical equipment and bulk storage facilities for oil will require updating of certain plants and facilities. Diversion, impoundment and withdrawal of water for cooling and other purposes are subject to the jurisdiction of the TCEQ and the EPA. TCEH believes it possesses all necessary permits for these activities from the TCEQ for its present operations. TCEH is in the process of obtaining the necessary water rights permit from the TCEQ for the lignite mine that will support the Oak Grove units. Clean Water Act Section 316(b) regulations pertaining to existing water intake structures at large generation plants were published by the EPA in 2004. As prescribed in the regulations, TCEH began implementing a monitoring program to determine the future actions that might need to be taken to comply with these regulations. In January 2007, a federal court ruled against the EPA in a lawsuit brought by environmental groups challenging aspects of these regulations, and in July 2007, the EPA announced that it was suspending the regulations pending further rulemaking. TCEH cannot predict the impact on its operations of the suspended existing regulations or of any new regulations that replace them. 11
Slide 20: Radioactive Waste Under the federal Low-Level Radioactive Waste Policy Act of 1980, as amended, the State of Texas is required to provide, either on its own or jointly with other states in a compact, for the disposal of all low-level radioactive waste generated within the state. The State of Texas has agreed to a compact for a disposal facility that would be located in Texas. That compact was ratified by Congress and signed by the President in 1998. In 2003, the State of Texas enacted legislation allowing a private entity to be licensed to accept low-level radioactive waste for disposal, and in 2004 the State received a license application from such an entity for review. TCEH intends to continue to ship low-level waste material off-site for as long as an alternative disposal site is available. Should existing off-site disposal become unavailable, the low-level waste material will be stored on-site. (See discussion under “Business Organization — Luminant Power — Nuclear Generation Assets” above.) TCEH believes that its on-site used nuclear fuel storage capability is sufficient for five to ten years. The nuclear industry is continuing to review ways to enhance security of used-fuel storage with the NRC to fully utilize physical storage capacity. Accordingly, TCEH is actively reviewing alternatives for used-fuel storage, including evaluation of industry techniques such as dry cask storage. Solid Waste, including Fly Ash Associated with Lignite/Coal-Fueled Generation Treatment, storage and disposal of solid waste and hazardous waste are regulated at the state level under the Texas Solid Waste Disposal Act and at the federal level under the Resource Conservation and Recovery Act of 1976, as amended, and the Toxic Substances Control Act. The EPA has issued regulations under the Resource Conservation and Recovery Act of 1976 and the Toxic Substances Control Act, and the TCEQ has issued regulations under the Texas Solid Waste Disposal Act applicable to TCEH facilities. TCEH believes it is in material compliance with all applicable solid waste rules and regulations. In addition, TCEH has registered solid waste disposal sites and has obtained or applied for permits required by such regulations. Environmental Capital Expenditures Capital expenditures for TCEH's environmental projects totaled $60 million in 2007 and are expected to total approximately $200 million in 2008, exclusive of emissions control equipment investment planned as part of the three-unit Texas generation development program, which is expected to total up to $500 million over the construction period. See discussion above under "Luminant Construction" regarding planned investments in emissions control systems. 12
Slide 21: Item 1A. RISK FACTORS Some important factors, in addition to others specifically addressed in Management’s Discussion and Analysis of Financial Condition and Results of Operations, that could have a material negative impact on TCEH’s operations, financial results and financial condition, and could cause TCEH’s actual results or outcomes to differ materially from any projected outcome contained in any forward-looking statement in this report, include: Risks Relating to Substantial Indebtedness and Debt Agreements TCEH’s substantial leverage could adversely affect its ability to raise additional capital to fund its operations, limit its ability to react to changes in the economy or its industry, expose TCEH to interest rate risk to the extent of its variable rate debt and prevent TCEH from meeting obligations under the various debt agreements governing its indebtedness. TCEH is highly leveraged. As of December 31, 2007, TCEH’s consolidated debt (short term borrowings and long-term debt, including amounts due currently) totaled $29.0 billion. TCEH’s substantial leverage could have important consequences, including: • • • • • • • making it more difficult for TCEH to make payments on indebtedness; requiring a substantial portion of cash flow from operations to be dedicated to the payment of principal and interest on indebtedness, therefore reducing TCEH’s ability to use its cash flow to fund operations, capital expenditures and future business opportunities and execute its strategy; increasing vulnerability to adverse economic, industry or competitive developments; exposing TCEH to the risk of increased interest rates because certain of its borrowings are at variable rates of interest; limiting ability to make strategic acquisitions or causing TCEH to make non-strategic divestitures; limiting ability to obtain additional financing for working capital, capital expenditures, product development, debt service requirements, acquisitions and general corporate or other purposes, and limiting ability to adjust to changing market conditions and placing TCEH at a competitive disadvantage compared to competitors who are less highly leveraged and who therefore, may be able to take advantage of opportunities that TCEH’s substantial leverage prevents it from exploring. Despite TCEH’s current high indebtedness level, it may still be able to incur substantially more indebtedness. This could further exacerbate the risks associated with TCEH’s substantial indebtedness. TCEH may be able to incur additional indebtedness in the future. Although TCEH’s debt agreements contain restrictions on the incurrence of additional indebtedness, these restrictions are subject to a number of significant qualifications and exceptions, and under certain circumstances, the amount of indebtedness that could be incurred in compliance with these restrictions could be substantial. If new debt is added to TCEH’s existing debt levels, the related risks that TCEH now faces would intensify. 13
Slide 22: TCEH’s debt agreements contain restrictions that limit flexibility in operating its businesses. TCEH’s debt agreements contain various covenants and other restrictions that limit the ability of TCEH and/or its restricted subsidiaries to engage in specified types of transactions, and which may adversely affect the ability to operate its businesses. These covenants and other restrictions limit TCEH’s and its restricted subsidiaries’ ability to, among other things: • • • • • • • incur additional indebtedness or issue preferred shares; pay dividends on, repurchase or make distributions in respect of capital stock or make other restricted payments; make investments; sell or transfer assets; create liens; consolidate, merge, sell or otherwise dispose of all or substantially all of TCEH’s assets, and enter into transactions with TCEH’s affiliates. In addition, under the TCEH Senior Secured Facilities, TCEH is required to maintain a leverage ratio below specified levels. TCEH’s ability to maintain its leverage ratio below such levels can be affected by events beyond its control, and there can be no assurance that it will meet any such ratio. A breach of any of these covenants or restrictions could result in an event of default under one or more of TCEH’s debt agreements, including as a result of cross default provisions. Upon the occurrence of an event of default under one of the debt agreements, the lenders could elect to declare all amounts outstanding under that debt agreement to be immediately due and payable and terminate all commitments to extend further credit. Such actions by those lenders could cause cross defaults under TCEH’s other indebtedness. If TCEH was unable to repay those amounts, the lenders could proceed against any collateral granted to them to secure such indebtedness. If lenders accelerate the repayment of borrowings, TCEH may not have sufficient assets and funds to repay those borrowings. TCEH’s subsidiaries may not be able to generate sufficient cash to service all of TCEH’s indebtedness and may be forced to take other actions to satisfy TCEH’s and its subsidiaries’ obligations under TCEH’s debt agreements, which may not be successful. TCEH’s ability to make scheduled payments on or to refinance debt obligations depends on its financial condition and operating performance, which is subject to prevailing economic and competitive conditions and to certain financial, business and other factors beyond TCEH’s control. TCEH may not be able to maintain a level of cash flows from operating activities sufficient to permit it to pay the principal, premium, if any, and interest on its indebtedness. If cash flows and capital resources are insufficient to fund debt service obligations, TCEH may be forced to reduce or delay investments and capital expenditures, or to sell assets, seek additional capital or restructure or refinance indebtedness. These alternative measures may not be successful and may not permit TCEH to meet scheduled debt service obligations. Risks Relating to Structure EFH Corp., TCEH’s ultimate parent, is highly leveraged and will rely upon TCEH for a significant amount of its cash flows. EFH Corp. is a holding company and substantially all of its consolidated assets are held by its subsidiaries. As of December 31, 2007, TCEH and its subsidiaries held approximately 76% of EFH Corp.’s consolidated assets. Accordingly, EFH Corp. depends upon TCEH for a significant amount of its cash flows and ability to pay its obligations. For the year ended December 31, 2007, TCEH and its subsidiaries represented 81% of EFH Corp.’s consolidated revenues. However, under the terms of TCEH’s debt agreements, TCEH is restricted from making certain payments to EFH Corp., except in limited circumstances. In addition, TCEH is prohibited from making certain loans to EFH Corp. if certain events of default under the debt agreements have occurred and are continuing. 14
Slide 23: As a result of the ring-fencing measures undertaken by EFH Corp. and Oncor, EFH Corp. will depend on distributions from TCEH. Upon the consummation of the Merger, EFH Corp. and Oncor, which is a subsidiary of EFH Corp. but not a subsidiary of TCEH, implemented certain structural and operational “ring-fencing” measures based on principles articulated by rating agencies and commitments made by Texas Holdings and Oncor to the PUCT and the FERC to further separate Oncor from Texas Holdings and its other subsidiaries in order to mitigate Oncor’s credit exposure to those entities and to reduce the risk that the assets and liabilities of Oncor would be substantively consolidated with the assets and liabilities of Texas Holdings or any of its other subsidiaries in the event of a bankruptcy of one or more of those entities. The creditors of TCEH will not be entitled to look to the assets, financial condition or results of operations of Oncor for payments on its indebtedness. As part of the ring-fencing measures implemented by EFH Corp. and Oncor, a majority of the members of the board of directors of Oncor are required to be independent from EFH Corp. Other than the initial independent directors that were appointed within 30 days of the consummation of the Merger, the independent directors are required to be appointed by the nominating committee of Oncor Holdings, a majority of whose members are required to be independent from EFH Corp. The organizational documents of Oncor give these independent directors the express right, acting by majority vote, to prevent distributions from Oncor to EFH Corp. if the directors determine that it is in the best interests of Oncor to retain such amounts to meet expected future requirements. Accordingly, there can be no assurance that Oncor will make any distributions to EFH Corp. which might in turn be contributed to TCEH, and EFH Corp. will therefore rely on distributions from TCEH for a significant amount of its liquidity. Risks Relating to TCEH’s Businesses TCEH’s businesses are subject to ongoing complex governmental regulations and legislation that have impacted, and may in the future impact, its businesses and/or results of operations. TCEH’s businesses operate in changing market environments influenced by various state and federal legislative and regulatory initiatives regarding the restructuring of the energy industry, including competition in the generation and sale of electricity. TCEH will need to continually adapt to these changes. For example, the Texas retail electricity market became competitive as of January 1, 2002, and the introduction of competition has resulted in, and may continue to result in, declines in customer counts and sales volumes. TCEH’s businesses are subject to changes in state and federal laws (including PURA, the Federal Power Act, the Atomic Energy Act, the Public Utility Regulatory Policies Act of 1978, the Clean Air Act and the Energy Policy Act of 2005) and changing governmental policy and regulatory actions (including those of the PUCT, the Electric Reliability Organization, the Texas Regional Entity, the RRC, the TCEQ, the FERC, the EPA and the NRC) and also the rules, guidelines and protocols of ERCOT with respect to matters including, but not limited to, market structure and design, operation of nuclear generation facilities, construction and operation of other generation facilities, recovery of costs and investments, decommissioning costs, market behavior rules, present or prospective wholesale and retail competition and environmental matters. TCEH, along with other market participants, is subject to electricity pricing constraints and market behavior and other competitionrelated rules and regulations under PURA that are administered by the PUCT and ERCOT, and, with respect to its wholesale power sales outside the ERCOT market, is subject to market behavior and other competitionrelated rules and regulations under the Federal Power Act that are administered by the FERC. Changes in, revisions to, or reinterpretations of existing laws and regulations (for example, with respect to prices at which TCEH may sell electricity or with respect to the required permits for the three lignite-fueled generation units currently under construction) may have an adverse effect on TCEH’s businesses. Although the 2007 Texas Legislative Session closed without passage of legislation that significantly negatively impacted TCEH’s businesses, the legislature did introduce several pieces of legislation that if passed, may have had a material impact on TCEH and its financial prospects, including, for example, legislation that would have: 15
Slide 24: • • • required EFH Corp. to separate its subsidiaries into two or three stand-alone companies, including the separation of certain TCEH subsidiaries, which could have resulted in a significant tax cost or the sale of assets for an amount EFH Corp. would not have considered to be full value; required divestiture of significant wholesale power generation assets, which also could have resulted in a significant tax cost or the sale of assets for an amount TCEH would not have considered to be full value, and given new authority to the PUCT to cap retail electric prices. Although none of this legislation was passed, there can be no assurance that future action of the Texas Legislature, which could be similar or different from the proposals considered by the most recent Texas Legislature, will not have a material adverse effect on TCEH and its financial prospects. The Texas Legislature’s next session begins in January 2009. The outcome of any legislation promulgated by the Texas Legislature in 2009 is uncertain. Such legislation could have an adverse effect on TCEH’s business and financial prospects. Litigation or legal proceedings could expose TCEH to significant liabilities and reputation damage and have a material adverse effect on its results of operations, and the litigation environment in which TCEH operates poses a significant risk to its businesses. TCEH is involved in the ordinary course of business in a number of lawsuits involving employment, commercial, environmental and injuries and damages issues, among other matters, such as challenges (to which TCEH may or may not be a direct party) to the permits that have been issued or may be issued for the new lignite-fueled generation units currently under construction. TCEH evaluates litigation claims and legal proceedings to assess the likelihood of unfavorable outcomes and to estimate, if possible, the amount of potential losses. Based on these assessments and estimates, TCEH establishes reserves and discloses the relevant litigation claims or legal proceedings, as appropriate. These assessments and estimates are based on the information available to management at the time and involve a significant amount of management judgment. Actual outcomes or losses may differ materially from current assessments and estimates. The settlement or resolution of such claims or proceedings may have a material adverse effect on TCEH’s results of operations. In addition, judges and juries in the state of Texas have demonstrated a willingness to grant large verdicts, including punitive damages, to plaintiffs in personal injury, property damage and business tort cases. TCEH uses legal and appropriate means to contest litigation threatened or filed against it, but the litigation environment in the state of Texas poses a significant business risk. TCEH is also exposed to the risk that it may become the subject of regulatory investigations. For example, in March 2007, the PUCT issued a Notice of Violation (NOV) stating that the PUCT Staff is recommending an enforcement action, including the assessment of administrative penalties, against TCEH for alleged market power abuse by its power generation affiliates and Luminant Energy in ERCOT–administered balancing energy auctions during certain periods of the summer of 2005. The PUCT Staff issued a revised NOV in September 2007, in which the proposed administrative penalty amount was reduced from $210 million to $171 million. The revised NOV was necessary, according to the PUCT Staff, to correct calculation errors in the initial NOV. As revised, the NOV is premised upon the PUCT Staff’s allegation that Luminant Energy’s bidding behavior was not competitive and increased market participants’ costs of balancing energy by approximately $57 million, including approximately $19 million in incremental revenues to TCEH. A hearing requested by Luminant Energy to contest the alleged occurrence of a violation and the amount of the penalty in the NOV was initially scheduled to start in April 2008, but was stayed pending resolution of discovery disputes and Luminant Energy’s motion to dismiss, which was filed in November 2007. The motion to dismiss was denied by the state administrative law judges, and in February 2008 the PUCT declined to hear Luminant Energy’s appeal of that denial. On March 26, 2008, Luminant Energy submitted to the administrative law judges its motion for summary decision on the discrete legal issue of what the maximum lawful penalty calculation could be in this proceeding. While it believes no market power abuse was committed, TCEH is unable to predict the outcome of this matter. 16
Slide 25: TXU Energy may lose a significant number of retail customers in TCEH’s historical service territory due to competitive marketing activity by retail electric providers and face competition from incumbent providers outside TCEH’s historical service territory. TXU Energy faces competition for customers within TCEH’s historical service territory. Competitors may offer lower prices and other incentives, which, despite TXU Energy’s long-standing relationship with customers, may attract customers away from TXU Energy. In most retail electric markets outside TCEH’s historical service territory, TXU Energy’s principal competitor may be the retail affiliate of the local incumbent utility company. The incumbent retail affiliates have the advantage of long-standing relationships with their customers, including well-known brand recognition. In addition to competition from the incumbent utilities and their affiliates, TXU Energy may face competition from a number of other energy service providers, or other energy industry participants, who may develop businesses that will compete with TXU Energy and nationally branded providers of consumer products and services. Some of these competitors or potential competitors may be larger or better capitalized than TXU Energy. If there is inadequate potential margin in these retail electric markets, it may not be profitable for TXU Energy to compete in these markets. TCEH’s revenues and results of operations may be negatively impacted by decreases in market prices for power, decreases in natural gas prices, and/or decreases in market heat rates. TCEH is not guaranteed any rate of return on capital investments in its competitive businesses. TCEH markets and trades electricity and natural gas, including electricity from its own generation facilities and generation contracted from third parties, as part of its wholesale markets operation. TCEH’s results of operations depend in large part upon market prices for electricity, natural gas, uranium and coal in its regional market and other competitive markets and upon prevailing retail electricity rates, which may be impacted by actions of regulatory authorities. Market prices may fluctuate substantially over relatively short periods of time. Demand for electricity can fluctuate dramatically, creating periods of substantial under- or over-supply. During periods of over-supply, prices might be depressed. Also, at times there may be political pressure, or pressure from regulatory authorities with jurisdiction over wholesale and retail energy commodity and transportation rates, to impose price limitations, bidding rules and other mechanisms to address volatility and other issues in these markets. Further, TXU Energy granted price discounts to certain of its customers in connection with the Merger, and has agreed to provide price protection to these customers through December 2008. Some of the fuel for TCEH’s generation facilities is purchased under short-term contracts. Prices of fuel, including natural gas, coal, and nuclear fuel, may also be volatile, and the price TCEH can obtain for electricity sales may not change at the same rate as changes in fuel costs. In addition, TCEH purchases and sells natural gas and other energy related commodities, and volatility in these markets may affect costs incurred in meeting obligations. Volatility in market prices for fuel and electricity may result from the following: • • • • • • • • • • • • severe or unexpected weather conditions; seasonality; changes in electricity and fuel usage; illiquidity in the wholesale power or other markets; transmission or transportation constraints, inoperability or inefficiencies; availability of competitively-priced alternative energy sources; changes in supply and demand for energy commodities, including nuclear fuel and related enrichment and conversion services; changes in generation efficiency and market heat rates; outages at TCEH’s generation facilities or those of competitors; changes in production and storage levels of natural gas, lignite, coal, crude oil and refined products; natural disasters, wars, sabotage, terrorist acts, embargoes and other catastrophic events, and federal, state and local energy, environmental and other regulation and legislation. 17
Slide 26: All of Luminant Power’s generation facilities are located in the ERCOT market, a market with limited interconnections to other markets. Wholesale electricity prices in the ERCOT market generally correlate with the price of natural gas because marginal demand is generally supplied by natural gas-fueled generation plants. Wholesale electricity prices also correlate with market heat rates (a measure of efficiency of the marginal pricesetting generator of electricity), which could fall if demand for electricity were to decrease or if additional generation facilities are built in ERCOT. Accordingly, the contribution to earnings and the value of Luminant Power’s baseload (lignite/coal-fueled and nuclear) generation assets, which provided a substantial portion of TCEH’s supply volumes in 2007, are dependent in significant part upon the price of natural gas and market heat rates. As a result, Luminant Power’s baseload generation assets could significantly decrease in profitability and value if natural gas prices or market heat rates fall. TCEH’s assets or positions cannot be fully hedged against changes in commodity prices and market heat rates, and hedging transactions may not work as planned or hedge counterparties may default on their obligations. TCEH cannot fully hedge the risk associated with changes in natural gas prices or market heat rates because of the expected useful life of its generation assets and the size of its position relative to market liquidity. To the extent TCEH has unhedged positions, fluctuating commodity prices and/or market heat rates can materially impact its results of operations and financial position, either favorably or unfavorably. To manage its financial exposure related to commodity price fluctuations, TCEH routinely enters into contracts to hedge portions of purchase and sale commitments, weather positions, fuel requirements and inventories of natural gas, lignite, coal, crude oil and refined products, and other commodities, within established risk management guidelines. As part of this strategy, TCEH routinely utilizes fixed-price forward physical purchase and sales contracts, futures, financial swaps and option contracts traded in the over-the-counter markets or on exchanges. Although TCEH devotes a considerable amount of management time and effort to the establishment of risk management procedures, as well as the ongoing review of the implementation of these procedures, the procedures in place may not be followed or may not always function as planned and cannot eliminate all the risks associated with these activities. As a result of these and other factors, TCEH cannot precisely predict the impact that risk management decisions may have on its businesses, results of operations or financial position. To the extent it engages in hedging and risk management activities, TCEH is exposed to the risk that counterparties that owe it money, energy or other commodities as a result of market transactions will not perform their obligations. Should the counterparties to these arrangements fail to perform, TCEH might be forced to enter into alternative hedging arrangements or honor the underlying commitment at then-current market prices. In such event, TCEH might incur losses in addition to amounts, if any, already paid to the counterparties. ERCOT market participants are also exposed to risks that another ERCOT market participant may default in its obligations to pay ERCOT for power taken, in which case such costs, to the extent not offset by posted security and other protections available to ERCOT, may be allocated to various non-defaulting ERCOT market participants, including TCEH. TCEH may suffer material losses, costs and liabilities due to Luminant’s ownership and operation of the Comanche Peak nuclear generation plant. The ownership and operation of a nuclear generation plant involves certain risks. These risks include: • • • • • • • • unscheduled outages or unexpected costs due to equipment, mechanical, structural or other problems; inadequacy or lapses in maintenance protocols; the impairment of reactor operation and safety systems due to human error; the costs of storage, handling and disposal of nuclear materials; the costs of procuring nuclear fuel; the costs of securing the plant against possible terrorist attacks; limitations on the amounts and types of insurance coverage commercially available, and uncertainties with respect to the technological and financial aspects of decommissioning nuclear facilities at the end of their useful lives. 18
Slide 27: The prolonged unavailability of Comanche Peak could materially affect TCEH’s financial condition and results of operations. The following are among the more significant of these risks: • Operational Risk—Operations at any nuclear generation plant could degrade to the point where the plant would have to be shut down. If such degradations were to occur, the process of identifying and correcting the causes of the operational downgrade to return the plant to operation could require significant time and expense, resulting in both lost revenue and increased fuel and purchased power expense to meet supply commitments. Furthermore, a shut-down or failure at any other nuclear generation plant could cause regulators to require a shut-down or reduced availability at Comanche Peak. Regulatory Risk—The NRC may modify, suspend or revoke licenses and impose civil penalties for failure to comply with the Atomic Energy Act, the regulations under it or the terms of the licenses of nuclear generation facilities. Unless extended, the NRC operating licenses for Comanche Peak Unit 1 and Unit 2 will expire in 2030 and 2033, respectively. Changes in regulations by the NRC could require a substantial increase in capital expenditures or result in increased operating or decommissioning costs. Nuclear Accident Risk—Although the safety record of Comanche Peak and other nuclear generation plants generally has been very good, accidents and other unforeseen problems have occurred both in the US and elsewhere. The consequences of an accident can be severe and include loss of life, injury, lasting negative health impact, and property damage. Any accident, or perceived accident, could result in significant liabilities and damage TCEH’s reputation. Any such resulting liability from a nuclear accident could exceed TCEH’s resources, including insurance coverage. • • The operation and maintenance of electricity generation facilities involves significant risks that could adversely affect TCEH’s results of operations and financial condition. The operation and maintenance of electricity generation facilities involves many risks, including, as applicable, start-up risks, breakdown or failure of facilities, lack of sufficient capital to maintain the facilities, the dependence on a specific fuel source or the impact of unusual or adverse weather conditions or other natural events, as well as the risk of performance below expected levels of output, efficiency or dependability, the occurrence of any of which could result in lost revenues and/or increased expenses. A significant number of Luminant’s facilities were constructed many years ago. In particular, older generating equipment, even if maintained in accordance with good engineering practices, may require significant capital expenditures to keep operating at peak efficiency. The risk of increased maintenance and capital expenditures arises from (a) increased starting and stopping of generation equipment due to the volatility of the competitive generation market, (b) any unexpected failure to generate electricity, including failure caused by breakdown or forced outage and (c) damage to facilities due to storms, natural disasters, wars, terrorist acts and other catastrophic events. Further, TCEH’s ability to successfully and timely complete capital improvements to existing facilities or other capital projects is contingent upon many variables and subject to substantial risks. Should any such efforts be unsuccessful, TCEH could be subject to additional costs and/or the write-off of its investment in the project or improvement. Insurance, warranties or performance guarantees may not cover all or any of the lost revenues or increased expenses, including the cost of replacement power. Likewise, the ability to obtain insurance, and the cost of and coverage provided by such insurance, could be affected by events outside TCEH’s control. 19
Slide 28: TCEH’s cost of compliance with environmental laws and regulations and its commitments, and the cost of compliance with new environmental laws, regulations or commitments could materially adversely affect TCEH’s results of operations and financial condition. TCEH is subject to extensive environmental regulation by governmental authorities. In operating its facilities, TCEH is required to comply with numerous environmental laws and regulations and to obtain numerous governmental permits. TCEH may incur significant additional costs beyond those currently contemplated to comply with these requirements. If TCEH fails to comply with these requirements, it could be subject to civil or criminal liabilities and fines. Existing environmental regulations could be revised or reinterpreted, new laws and regulations could be adopted or become applicable to TCEH or its facilities, and future changes in environmental laws and regulations could occur, including potential regulatory and enforcement developments related to air emissions, all of which could result in significant additional costs beyond those currently contemplated to comply with existing requirements. In conjunction with the building of three new generation units, Luminant has committed to reduce emissions of mercury, nitrogen oxide (“NOX”) and sulfur dioxide (“SO2”) associated with its baseload generation units so that the total of these emissions from both existing and new lignite coal-fueled units are 20% below 2005 levels. TCEH may incur significantly greater costs than those contemplated in order to achieve this commitment. EFH Corp. has formed a Sustainable Energy Advisory Board that will advise it in its pursuit of technology developments that, among other things, are designed to reduce TCEH’s impact on the environment. If any of the Sustainable Energy Advisory Board’s recommendations are adopted, TCEH may incur significant costs in addition to the costs referenced above as it pursues these recommendations. TCEH may not be able to obtain or maintain all required environmental regulatory approvals. If there is a delay in obtaining any required environmental regulatory approvals or if TCEH fails to obtain, maintain or comply with any such approval, the operation of its facilities could be stopped, curtailed or modified or become subject to additional costs. In addition, TCEH may be responsible for any on-site liabilities associated with the environmental condition of facilities that it has acquired, leased or developed, regardless of when the liabilities arose and whether they are known or unknown. In connection with certain acquisitions and sales of assets, TCEH may obtain, or be required to provide, indemnification against certain environmental liabilities. Another party could, depending on the circumstances, assert an environmental claim against TCEH or fail to meet its indemnification obligations to TCEH. Increasing attention to potential environmental effects of “greenhouse” gas emissions may result in new regulation and restrictions on emissions of certain gases that may be contributing to warming the earth’s atmosphere. Several bills addressing climate change have been introduced in the US Congress and, in April 2007, the US Supreme Court issued a decision ruling the EPA improperly declined to address carbon dioxide impacts in a rulemaking related to new motor vehicle emissions. While this decision is not directly applicable to power plant emissions, the reasoning of the decision could affect other regulatory programs. The impact of any future greenhouse gas legislation or other regulation will depend in large part on the details of the requirements and the timetable for mandatory compliance. Although it continues to assess the financial and operational risks posed by possible future legislative changes pertaining to greenhouse gas emissions, TCEH is currently unable to predict any future impact from these changes on its financial condition and operations. TCEH’s growth strategy, including investment in three new lignite-fueled generation units, may not be executed as planned, which could adversely impact TCEH’s financial condition and results of operations. There can be no guarantee that the execution of TCEH’s growth strategy will be successful. As discussed below, TCEH’s growth strategy is dependent upon many factors. Changes in laws, regulations, markets, costs, the outcome of on-going litigation or other factors could negatively impact the execution of TCEH’s growth strategy, including causing management to change the strategy. Even if TCEH is able to execute its growth strategy, it may take longer than expected and costs may be higher than expected. 20
Slide 29: There can be no guarantee that the execution of the lignite-fueled generation development program will be successful. While Luminant has experience in operating lignite -fueled generation facilities, it has limited recent experience in developing and constructing such facilities. To the extent construction is not managed efficiently and to a timely conclusion, cost overruns may occur, resulting in the overall program costing significantly more than anticipated. This may also result in delays in the expected online dates for the facilities resulting in less overall income than projected. While Luminant believes it can acquire the resources needed to effectively execute this program, it is exposed to the risk that it may not be able to attract and retain skilled labor, at projected rates, for constructing these new facilities. Luminant’s lignite-fueled generation development program is subject to changes in laws, regulations and policies that are beyond its control. Changes in laws, regulation or policy regarding commodity prices, power prices, electric competition or solid-fuel generation facilities or other related matters could adversely impact this program. In recent months, global warming has received significant media attention, which has resulted in legislators focusing on environmental laws, regulations and policies. Changes in environmental law, regulation or policy, such as regulations of emissions of carbon dioxide, could adversely impact this program. Although Luminant has received permits to construct and operate the new units that are a part of the lignite-fueled generation development program, each of these permits is subject to ongoing litigation. An adverse ruling on these matters could materially and adversely effect the implementation of this program. Luminant’s lignite-fueled generation development program is subject to changes in the electricity market, primarily ERCOT, that are beyond its control. If demand growth is less than expected or if other generation companies build new generation assets in ERCOT, Luminant’s program could impact market prices of power such that the new generation capacity becomes uneconomical. In addition, any unanticipated reduction in wholesale electricity prices, market heat rates and natural gas prices, which could occur for a variety of reasons, could adversely impact this program. Even if Luminant enters into hedges to reduce such exposures, it would still be subject to the credit risk of its counterparties. Luminant’s lignite-fueled generation development program is subject to other risks that are beyond its control. For example, Luminant is exposed to the risk that a change in technology for electricity generation facilities and/or emissions control technologies may make other generation facilities less costly and more attractive than Luminant’s new generation facilities. Luminant is subject to risks relating to transmission capabilities and constraints. Luminant is also exposed to the risk that its contractors may default on their obligations and compensation for damages received, if any, will not cover its losses. Ongoing performance improvement initiatives may not achieve desired cost reductions and may instead result in significant additional costs if unsuccessful. The implementation of performance improvement initiatives identified by management may not produce the desired reduction in costs and may result in disruptions arising from employee displacements and the rapid pace of changes to organizational structure and operating practices and processes. Specifically, TCEH is subject to the risk that the joint venture outsourcing arrangement with Capgemini that provides business support services may not produce the desired cost savings. If the Capgemini arrangement is terminated or modified in the future, or if Capgemini becomes financially unable to perform its obligations, TCEH would incur transition costs, which would likely be significant and would be subject to operational difficulties. Such additional costs or operational difficulties could have an adverse effect on TCEH’s business and financial prospects. 21
Slide 30: TXU Energy’s retail business is subject to the risk that sensitive customer data may be compromised, which could result in an adverse impact to its reputation and/or the results of operations of the retail business. TXU Energy’s retail business requires access to sensitive customer data in the ordinary course of business. Examples of sensitive customer data are names, addresses, account information, historical electricity usage, expected patterns of use, payment history, credit bureau data, credit and debit card account numbers, drivers license numbers, social security numbers and bank account information. TXU Energy’s retail business may need to provide sensitive customer data to vendors and service providers who require access to this information in order to provide services, such as call center operations, to the retail business. If a significant or widely publicized breach occurred, the reputation of TXU Energy’s retail business may be adversely affected, customer confidence may be diminished, or TXU Energy’s retail business may be subject to legal claims, any of which may contribute to the loss of customers and have a negative impact on the business and/or results of operations. TXU Energy relies on the infrastructure of local utilities or independent transmission system operators to provide electricity to, and to obtain information about, its customers. Any infrastructure failure could negatively impact customer satisfaction and could have a material negative impact on its business and results of operations. TXU Energy depends on transmission and distribution facilities owned and operated by unaffiliated utilities, as well as Oncor’s facilities, to deliver the electricity it sells to its customers. If transmission capacity is inadequate, TXU Energy’s ability to sell and deliver electricity may be hindered, it may have to forgo sales or it may have to buy more expensive wholesale electricity than is available in the capacity-constrained area. For example, during some periods, transmission access is constrained in some areas of the Dallas-Fort Worth metroplex, where TXU Energy has a significant number of customers. The cost to provide service to these customers may exceed the cost to provide service to other customers, resulting in lower profits. In addition, any infrastructure failure that interrupts or impairs delivery of electricity to TXU Energy’s customers could negatively impact the satisfaction of its customers with its service. TXU Energy offers bundled services to its retail customers, with some bundled services offered at fixed prices and for fixed terms. If TXU Energy’s costs for these bundled services exceed the prices paid by its customers, its results of operations could be materially adversely affected. TXU Energy offers its customers a bundle of services that include, at a minimum, electricity plus transmission, distribution and related services. The prices TXU Energy charges for its bundle of services or for the various components of the bundle, any of which may be fixed by contract with the customer for a period of time, could fall below TXU Energy’s underlying cost to provide the components. TXU Energy’s retail business is subject to the risk that it will not be able to profitably serve its customers given the recent price cuts and price protection, which could result in an adverse impact to its reputation and/or results of operations. In connection with the Merger, TXU Energy implemented a 15% price reduction for residential customers in TCEH’s historical service territory who have not already switched to one of the pricing plans other than the basic month-to-month plan. In addition, TXU Energy intends to provide price protection for these customers through December 2008, ensuring that these customers receive the benefits of these savings through two summer seasons of peak energy usage. The prices TXU Energy charges during this period could fall below TXU Energy’s underlying cost to provide electricity. 22
Slide 31: TXU Energy’s REP certification is subject to PUCT review. The PUCT may at any time initiate an investigation into whether TXU Energy is compliant with PUCT Substantive Rules and whether it has met all of the requirements for REP certification, including financial requirements, so that it can maintain its REP certification. Any removal or revocation of a REP certification would mean that TCEH or TXU Energy, as applicable, would no longer be allowed to provide electric service to retail customers. Such decertification would have an adverse effect on TXU Energy and TCEH’s financial prospects. Changes in technology may reduce the value of Luminant’s generation plants and may significantly impact TCEH’s businesses in other ways as well. Research and development activities are ongoing to improve existing and alternative technologies to produce electricity, including gas turbines, fuel cells, microturbines and photovoltaic (solar) cells. It is possible that advances in these or other technologies will reduce the costs of electricity production from these technologies to a level that will enable these technologies to compete effectively with the traditional generation plants owned by Luminant. While demand for electric energy services is generally increasing throughout the US, the rate of construction and development of new, more efficient generation facilities may exceed increases in demand in some regional electric markets. Consequently, where Luminant has facilities, the profitability and market value of its generation assets could be significantly reduced. Also, electricity demand could be reduced by increased conservation efforts and advances in technology, which could likewise significantly reduce the value of Luminant’s generation assets. Changes in technology could also alter the channels through which retail electric customers buy electricity. To the extent self-generation facilities become a more cost-effective option for certain customers, TCEH’s revenues could be reduced. TCEH’s future results of operations may be negatively impacted by settlement adjustments determined by ERCOT related to prior periods. ERCOT is the independent system operator that is responsible for maintaining reliable operation of the bulk electric power supply system in the ERCOT market. Its responsibilities include the clearing and settlement of electricity volumes and related ancillary services among the various participants in the deregulated Texas market. Settlement information is due from ERCOT within two months after the operating day, and true-up settlements are due from ERCOT within six months after the operating day. Likewise, ERCOT has the ability to resettle any operating day at any time after the six month settlement period, usually the result of a lingering dispute, an alternative dispute resolution process or litigated event. As a result, TCEH is subject to settlement adjustments from ERCOT related to prior periods, which may result in charges or credits impacting TCEH’s future reported results of operations. TCEH’s results of operations and financial condition could be negatively impacted by any development or event beyond TCEH’s control that causes economic weakness in the ERCOT market. TCEH derives substantially all of its revenues from operations in the ERCOT market, which covers approximately 75% of the geographical area in the state of Texas. As a result, regardless of the state of the economy in areas outside the ERCOT market, economic weakness in the ERCOT market could lead to reduced demand for electricity in the ERCOT market. Such a reduction could have a material negative impact on TCEH’s results of operations and financial condition. TCEH’s credit ratings could negatively affect TCEH’s ability to access capital and could require TCEH or its subsidiaries to post collateral or repay certain indebtedness. Downgrades in TCEH’s long-term debt ratings generally cause borrowing costs to increase and the potential pool of investors and funding sources to decrease and might trigger liquidity demands pursuant to the terms of commodity contracts, leases and other agreements. In connection with the Merger, Fitch, Moody’s and S&P downgraded TCEH’s long term debt ratings. 23
Slide 32: Most of TCEH’s large customers, suppliers and counterparties require an expected level of creditworthiness in order for them to enter into transactions. As TCEH’s credit ratings decline, the costs to operate its businesses will likely increase because counterparties may require the posting of collateral in the form of cash-related instruments, or counterparties may decline to do business with it. TCEH’s liquidity needs could be difficult to satisfy, particularly during times of uncertainty in the financial markets and/or during times when there are significant changes in commodity prices. The inability to access liquidity, particularly on favorable terms, could materially adversely affect results of operations and/or financial condition. TCEH’s businesses are capital intensive. TCEH relies on access to financial markets as a significant source of liquidity for capital requirements not satisfied by cash-on-hand or operating cash flows. The inability to raise capital on favorable terms, particularly during times of uncertainty similar to that which is currently being experienced in the financial markets, could impact TCEH’s ability to sustain and grow its businesses and would likely increase capital costs. TCEH’s access to the financial markets could be adversely impacted by various factors, such as: • • • • • • • changes in financial markets that reduce available credit or the ability to obtain or renew liquidity facilities on acceptable terms; economic weakness in the ERCOT market; changes in interest rates; a deterioration of TCEH’s credit or the credit of its subsidiaries or a reduction in TCEH’s credit ratings; volatility in commodity prices that increases margin or credit requirements; a material breakdown in TCEH’s risk management procedures, and the occurrence of changes in TCEH’s businesses that restrict its ability to access liquidity facilities. Although TCEH expects to actively manage the liquidity exposure of existing and future hedging arrangements, given the size of the long-term hedging program, any significant increase in the price of natural gas could result in TCEH’s being required to provide cash or letter of credit collateral in substantial amounts. In addition, any perceived reduction in TCEH’s credit quality could result in clearing agents or other counterparties requesting additional collateral. In the event that the governmental agencies that regulate the activities of TCEH’s businesses determine that the creditworthiness of any such business is inadequate to support its activities, such agencies could require TCEH to provide additional cash or letter of credit collateral in substantial amounts to qualify to do business. In the event TCEH’s liquidity facilities are being used largely to support the long-term hedging program as a result of a significant increase in the price of natural gas or significant reduction in credit quality, TCEH may have to forego certain capital expenditures or other investments in its businesses or other business opportunities. Further, a lack of available liquidity could adversely impact the evaluation of TCEH’s creditworthiness by counterparties and rating agencies. In particular, such concerns by existing and potential counterparties could significantly limit TCEH’s wholesale markets activities, including its long-term hedging program. 24
Slide 33: Goodwill and/or other intangible assets not subject to amortization that TCEH has recorded in connection with the Merger are subject to mandatory annual impairment evaluations, and as a result, TCEH could be required to write off some or all of this goodwill and other intangible assets, which may reflect adverse impacts on TCEH’s financial condition and results of operations. In accordance with SFAS 142, goodwill and certain other intangible assets recorded in connection with the Merger are not amortized but are reviewed annually or more frequently for impairment, if certain conditions exist, and may be impaired. Any reduction in or impairment of the value of goodwill or other intangible assets will result in a charge against earnings which could reflect material adverse impacts on TCEH’s reported results of operations and financial position in future periods. The loss of the services of TCEH’s key management and personnel could adversely affect TCEH’s ability to operate its businesses. TCEH’s future success will depend on its ability to continue to attract and retain highly qualified personnel. TCEH competes for such personnel with many other companies, in and outside TCEH’s industry, government entities and other organizations. TCEH may not be successful in retaining current personnel or in hiring or retaining qualified personnel in the future. Additionally, the Merger may have a negative impact on TCEH’s ability to attract and retain key management and other employees. TCEH’s failure to attract new personnel or retain existing personnel could have a material adverse effect on its businesses. TCEH’s future success depends, to a significant extent, on the abilities and efforts of executive officers and other members of its management team. One or more of TCEH’s executive officers may elect to leave the company as a result of the Merger. TCEH’s executive officers have substantial experience and expertise in TCEH’s industry, which TCEH has relied upon significantly. There can be no assurance that TCEH will be able to attract and retain new members of management to replace any executive officers that may leave. If TCEH is not successful in doing so, its businesses may be adversely affected. The Sponsor Group controls and may have conflicts of interest with TCEH in the future. The Sponsor Group indirectly owns approximately 60% of EFH Corp.’s capital stock on a fully-diluted basis through their investment in Texas Holdings. As a result of this ownership and the Sponsor Group’s ownership in interests of the general partner of Texas Holdings, the Sponsor Group has control over decisions regarding TCEH’s operations, plans, strategies, finances and structure, including whether to enter into any corporate transaction and will have the ability to prevent any transaction that requires the approval of the stockholders of EFH Corp. Additionally, each member of the Sponsor Group is in the business of making investments in companies and may from time to time acquire and hold interests in businesses that compete directly or indirectly with TCEH. Members of the Sponsor Group may also pursue acquisition opportunities that may be complementary to TCEH’s businesses, and as a result, those acquisition opportunities may not be available to TCEH. So long as the members of the Sponsor Group, or other funds controlled by or associated with the members of the Sponsor Group, continue to indirectly own a significant amount of the outstanding shares of EFH Corp.’s common stock, even if such amount is less than 50%, the Sponsor Group will continue to be able to strongly influence or effectively control TCEH’s decisions. Item 1B. UNRESOLVED STAFF COMMENTS None. 25
Slide 34: Item 3. LEGAL PROCEEDINGS Litigation – Generation Facilities An administrative appeal challenging the order of the TCEQ issuing the air permit for construction and operation of the Oak Grove generation facility in Robertson County, Texas to a subsidiary of TCEH was filed on September 7, 2007 in the State District Court of Travis County, Texas. Plaintiffs ask that the District Court reverse TCEQ's approval of the Oak Grove air permit, TCEQ’s adoption and approval of the TCEQ Executive Director's Response to Comments and remand the matter back to TCEQ for further proceedings. In addition to this administrative appeal, two other petitions were filed in Travis County District Court by non-parties to the administrative hearing before TCEQ and the State Office of Administrative Hearings (SOAH) seeking to challenge the TCEQ’s issuance of the Oak Grove air permit and asking the District Court to remand the matter to the SOAH for further proceedings. Finally, the plaintiffs in these two additional lawsuits have filed a third, joint petition claiming insufficiencies in the Oak Grove application, permit, and process and seeking party status and remand to SOAH for further proceedings. TCEH believes the Oak Grove air permit granted by the TCEQ is protective of the environment and that the application for and the processing of the air permit by the TCEQ was in accordance with law. There can be no assurance that the outcome of these matters would not result in an adverse impact on the Oak Grove project. On December 1, 2006, a lawsuit was filed in the US District Court for the Western District of Texas against Luminant Generation Company LLC (then known as TXU Generation Company LP), Oak Grove Management Company, LLC and EFH Corp. (then known as TXU Corp.). The complaint sought declaratory and injunctive relief, as well as the assessment of civil penalties, with respect to the permit application for the construction and operation of the Oak Grove generation facility in Robertson County, Texas. The plaintiffs allege violations of the Federal Clean Air Act, Texas Health and Safety Code and Texas Administrative Code and sought to temporarily and permanently enjoin the construction and operation of the Oak Grove generation plant. The complaint also asserted that the permit application was deficient in failing to comply with various modeling and analyses requirements relative to the impact of emissions from the Oak Grove plant. Plaintiffs further requested that the District Court enter an order requiring the defendants to take other appropriate actions to remedy, mitigate and offset alleged harm to the public health and environment. EFH Corp. and the other defendants believe the Oak Grove air permit granted by the TCEQ on June 13, 2007 is protective of the environment and that the application for and the processing of the air permit by Oak Grove Management Company LLC with the TCEQ has been in accordance with applicable law. EFH Corp. and the other defendants filed a Motion to Dismiss the litigation, which was granted by the District Court on May 21, 2007. The Plaintiffs have appealed the District Court’s dismissal of the case to the Fifth Circuit Court of Appeals and oral argument was heard in the appeal on March 3, 2008. EFH Corp. and the other defendants believe the District Court properly granted the Motion to Dismiss and while EFH Corp. and the other defendants are unable to estimate any possible loss or predict the outcome of this litigation in the event the Fifth Circuit Court of Appeals reverses the District Court, EFH Corp. and the other defendants maintain that the claims made in the complaint are without merit. Accordingly, EFH Corp. and the other defendants intend to vigorously defend the appeal and this litigation in the event the Fifth Circuit reverses the District Court. In September 2007, a subsidiary of TCEH acquired from Alcoa Inc. the air permit related to the Sandow 5 facility that had been previously issued by the TCEQ. Although a federal district court approved a settlement pursuant to which TCEH acquired the permit, environmental groups opposed to the settlement have appealed the district court’s decision to the Fifth Circuit Court of Appeals. A hearing on the matter is scheduled for June 2, 2008. There can be no assurance that the outcome of this matter would not result in an adverse impact on the Sandow 5 project. TCEH believes the claims on appeal are without merit and will vigorously defend the appeal. In addition to the above, TCEH is involved in various other legal and administrative proceedings in the normal course of business the ultimate resolution of which, in the opinion of management, should not have a material effect on its financial position, results of operations or cash flows. 26
Slide 35: Regulatory Investigations In March 2007, the PUCT issued a Notice of Violation (NOV) stating that the PUCT Staff was recommending an enforcement action, including the assessment of administrative penalties, against EFH Corp. and certain affiliates for alleged market power abuse by its power generation affiliates and Luminant Energy in ERCOT-administered balancing energy auctions during certain periods of the summer of 2005. In September 2007, the PUCT issued a revised NOV in which the proposed administrative penalty amount was reduced from $210 million to $171 million. The revised NOV was necessary, according to the PUCT Staff, to correct calculation errors in the initial NOV. As revised, the NOV is premised upon the PUCT Staff's allegation that Luminant Energy's bidding behavior was not competitive and increased market participants' costs of balancing energy by approximately $57 million, including approximately $19 million in incremental revenues to TCEH. A hearing requested by Luminant Energy to contest the alleged occurrence of a violation and the amount of the penalty in the NOV was scheduled to start in April 2008 but was stayed pending resolution of discovery disputes and Luminant Energy's motion to dismiss, which was filed in November 2007. That motion was denied by the state administrative law judges, and in February 2008 the PUCT declined to hear Luminant Energy's appeal of that denial. On March 26, 2008, Luminant Energy submitted to the administrative law judges its motion for summary decision on the discrete legal issue of what the maximum lawful penalty calculation could be in this proceeding. EFH Corp. and TCEH believe Luminant Energy's conduct during the period in question was consistent with the PUCT's rules and policies, and no market power abuse was committed. EFH Corp. and TCEH are vigorously contesting the NOV, but are unable to predict the outcome of this matter. EFH Corp. and TCEH have taken actions to reduce the risk of future similar allegations related to the balancing energy segment of the ERCOT wholesale market, including working with the PUCT Staff and the PUCT's independent market monitor to develop a voluntary mitigation plan for approval by the PUCT. Luminant Energy has submitted a voluntary mitigation plan that was approved by the PUCT in July 2007. The PUCT’s approval action was challenged by some other market participants on procedural grounds, and a Texas District Court upheld that challenge. The PUCT did not appeal that ruling. In addition to the above, TCEH is involved in various other regulatory investigations in the normal course of business the ultimate resolution of which, in the opinion of management, should not have a material effect on its financial position, results of operations or cash flows. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II Item 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES Not applicable. All of TCEH’s common membership interests are owned by EFC Holdings. 27
Slide 36: Item 6. SELECTED FINANCIAL DATA TEXAS COMPETITIVE ELECTRIC HOLDINGS COMPANY LLC AND SUBSIDIARIES SELECTED FINANCIAL DATA (millions of dollars, except ratios) Successor Period from October 11, 2007 through December 31, 2007 Predecessor Period from January 1, 2007 through October 10, 2007 2006 Year Ended December 31, 2005 2004 2003 Operating revenues ..................................................... Income (loss) from continuing operations before cumulative effect of changes in accounting principles................................................................. Net income (loss) ........................................................ Ratio of earnings to fixed charges (a)......................... Embedded interest cost on long-term debt and exchangeable preferred membership interests ─ end of period (b) .................................................. Capital expenditures ................................................... See Notes to Financial Statements. $ 179 $ 6,330 $ 9,549 $ 9,552 $ 8,402 $ 7,917 $ (1,223) $ (1,223) — $ 1,258 $ 1,258 5.79 $ 2,394 $ 2,394 9.20 $ 1,430 $ 1,364 5.88 $ $ 408 378 2.42 $ $ 497 421 2.95 9.4% $ 496 6.7% $ 1,409 $ 6.9% 791 $ 7.5% 309 $ 6.3% 281 $ 7.2% 163 Successor December 31, 2007 2006 Predecessor December 31, 2005 2004 2003 Total assets ─ end of year (c) ................................................................ Property, plant & equipment ─ net ─ end of year................................. Capitalization – end of year Long-term debt, less amounts due currently .................................. Exchangeable preferred membership interests (net of discount) ... Membership interests ...................................................................... Total..................................................................................... Capitalization ratios – end of year Long-term debt, less amounts due currently ................................... Exchangeable preferred membership interests (net of discount) .... Membership interests....................................................................... Total...................................................................................... ___________________ (a) (b) $ 49,060 20,545 $20,196 10,340 $17,890 9,990 $14,473 9,918 $14,148 10,216 $ 28,409 — 6,216 $ 34,625 $ 2,965 — 6,789 $ 9,754 $ 3,144 528 4,380 $ 8,052 $ 3,226 511 3,591 $ 7,328 $ 3,084 497 3,999 $ 7,580 82.0 — 18.0 100.0% 30.4 — 69.6 100.0% 39.0 6.6 54.4 100.0% 44.0 7.0 49.0 100.0% 40.7 6.6 52.7 100.0% (c) For the period October 11, 2007 through December 31, 2007, fixed charges exceed earnings by $1.874 billion. Represents the annual interest using year-end rates for variable rate debt and reflecting effects of interest swaps and amortization of any discounts, premiums, issuance costs and any deferred gains/losses on reacquisitions divided by the carrying value of the debt plus or minus the unamortized balance of any discounts, premiums, issuance costs and gains/losses on reacquisitions at the end of the year. The total assets shown above for the 2007 and 2006 periods reflect the change in presentation related to TCEH’s adoption of FIN 39-1 as discussed in Note 1 to Financial Statements. Such change in presentation resulted in an increase of $1.020 billion and $1.382 billion in TCEH’s total assets (and total liabilities), as of December 31, 2007 and 2006, respectively, as compared to previously reported amounts. The selected financial data shown above for the 2003, 2004 and 2005 periods does not reflect the change in presentation as such information is not currently available. While such change would increase the amount of total assets shown above, it would not affect TCEH’s results of operations or cash flows for any such period or TCEH’s financial position since, consistent with the presentation of the 2007 and 2006 periods, such increase in total assets would be offset by a corresponding increase in total liabilities of TCEH. 28
Slide 37: Note: The consolidated financial statements of the Predecessor (results prior to October 11, 2007) have been prepared on the same basis as the audited financial statements included in TCEH’s Annual Report on Form 10-K for the year ended December 31, 2006 with the exception of the adoption of FIN 48 and FIN 39-1. The consolidated financial statements of the Successor reflect the application of “purchase accounting” and contributions of certain subsidiaries and net assets from EFH Corp. and EFC Holdings that were accounted for in a manner similar to a pooling of interests. Note: Results for 2004 are significantly impacted by charges related to EFH Corp.’s comprehensive restructuring plan. Quarterly Information (unaudited) Results of operations by quarter are summarized below. In the opinion of TCEH, all other adjustments (consisting of normal recurring accruals) necessary for a fair statement of such amounts have been made. Quarterly results are not necessarily indicative of a full year’s operations because of seasonal and other factors. Predecessor (a) Successor Period from October 11, 2007 through December 31, 2007 $ 179 (1,223) $ (1,223) First Quarter 2007: Operating revenues .................................................................... Income from continuing operations........................................... Net income ................................................................................. $ $ 1,316 9 9 Second Quarter $ 1,666 197 $ 197 Third Quarter $ 3,034 974 $ 974 ________________ (a) The 10-day period ended October 10, 2007 has not been presented as it is deemed to be immaterial. Predecessor Second Third Quarter Quarter $ 2,349 466 $ 466 $ $ 3,148 911 911 $ First Quarter 2006: Operating revenues ................................................................ Income from continuing operations....................................... Net income ............................................................................. $ $ 2,010 518 518 Fourth Quarter $ 2,042 498 498 Reconciliation of Previously Reported Quarterly Information — The following table presents changes to previously reported quarterly results, reflecting the contribution by EFH Corp. and EFC Holdings of all the outstanding equity of certain subsidiaries to TCEH and the contribution by EFH Corp. subsidiaries of certain assets and liabilities to TCEH (see Note 4 to Financial Statements for additional information). Predecessor Second Third First Quarter Quarter Quarter (Increase (Decrease) from Previously Reported) $ $ (206) (132) (132) $ $ (223) (142) (142) $ $ 145 72 72 2007: Operating revenues ................................................................ Income from continuing operations....................................... Net income ............................................................................. First Quarter 2006: Operating revenues ................................................................ Income from continuing operations....................................... Net income ............................................................................. $ $ — (2) (2) Predecessor Second Third Quarter Quarter $ $ (119) (77) (77) $ $ 57 27 27 Fourth Quarter $ $ 17 10 10 (Increase (Decrease) from Previously Reported) 29
Slide 38: This Second Amended and Restated Annual Report incorporates the amendment (reported on May 27, 2008) to certain amounts above that were previously reported in the Annual Report. The amounts previously reported in the Annual Report under “Quarterly Information (unaudited) for income from continuing operations and net income for the first through third quarters of 2007 were $65 million, $198 million and $963 million, respectively. The amounts previously reported in the Annual Report under “Reconciliation of Previously Reported Quarterly Information” for income from continuing operations and net income for the first through third quarters of 2007 were $(76) million, $(141) million and $61 million, respectively. See Explanatory Note. Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis of TCEH's financial condition and results of operations for the fiscal years ended December 31, 2007, 2006 and 2005 should be read in conjunction with Selected Financial Data and TCEH's audited consolidated financial statements and the notes to those statements. All dollar amounts in the tables in the following discussion and analysis are stated in millions of US dollars unless otherwise indicated. BUSINESS TCEH is a wholly-owned subsidiary of EFC Holdings, which is a wholly-owned subsidiary of EFH Corp. While TCEH is a wholly-owned subsidiary of EFH Corp. and EFC Holdings, TCEH is a separate legal entity from EFH Corp. and EFC Holdings and all of their other affiliates with its own assets and liabilities. TCEH is a Dallas-based holding company for subsidiaries engaged in competitive electricity market activities largely in Texas, including Luminant, which is engaged in electricity generation, development and construction of new generation facilities, wholesale energy sales and purchases and commodity risk management and trading activities and TXU Energy, which is engaged in retail electricity sales. Commodity risk management and allocation of financial resources are performed at the TCEH level; therefore, there are no reportable business segments. In connection with the Merger, which closed on October 10, 2007, certain of the subsidiaries of EFH Corp. established for the purpose of developing and constructing new generation facilities have become subsidiaries of TCEH, and certain assets and liabilities of other of these subsidiaries that did not become subsidiaries of TCEH were transferred to TCEH and its subsidiaries. Those subsidiaries holding impaired construction work-inprocess assets have not become subsidiaries of TCEH. In addition, a wholly-owned subsidiary of EFC Holdings representing a lease trust holding certain combustion turbines has become a subsidiary of TCEH. Because these transactions were between entities under the common control of EFH Corp., TCEH accounted for the transactions in a manner similar to a pooling of interests. As a result, historical operations, financial position and cash flows of TCEH and the entities and other net assets contributed are presented on a combined basis for all periods presented. Significant Developments Merger ― As a result of the Merger, EFH Corp. became a subsidiary of Texas Holdings. The outstanding shares of common stock of EFH Corp. were converted into the right to receive $69.25 per share. Texas Holdings is controlled by investment funds affiliated with the Sponsor Group. The aggregate purchase price paid for the equity securities of EFH Corp. was $31.9 billion, which purchase price was funded by $8.3 billion of equity financing from the Sponsor Group and by certain debt financings of TCEH described in Note 15 to Financial Statements and other debt financings of its indirect parent, EFH Corp. This purchase price is exclusive of $0.8 billion in costs directly associated with the Merger, consisting of legal, consulting and professional service fees incurred by the Sponsor Group. See Note 1 to Financial Statements for additional details regarding the completion of the Merger. 30
Slide 39: The Merger was recorded under purchase accounting, whereby the total purchase price of the transaction was allocated to EFH Corp.’s identifiable tangible and intangible assets acquired and liabilities assumed based on their fair values, and the excess of the purchase price over the fair value of the net assets was recorded as goodwill. For EFH Corp., the allocation resulted in $23.0 billion of goodwill and $10.0 billion in increased or new net tangible and identifiable intangible assets ($8.3 billion recorded by TCEH). Purchase accounting impacts, including goodwill recognition, have been “pushed down”, resulting in the assets and liabilities of TCEH being recorded at their respective fair values as of October 10, 2007 and the recording of $18.1 billion of goodwill by TCEH. As of December 31, 2007, TCEH had total debt (short-term borrowings and long-term debt, including amounts due currently) of $29.0 billion. TCEH’s interest expense and related charges are expected to total approximately $2.7 billion in 2008, taking into account interest rate swaps relating to $15.05 billion of TCEH’s debt. Additionally, reflecting a net increase in the carrying value of generation plants and the recording of identifiable intangible assets, depreciation and amortization expense is expected to total approximately $1.1 billion in 2008. Texas Generation Facilities Development ─ Luminant is developing three lignite-fueled generation units in the state of Texas with a total estimated capacity of approximately 2,200 MW. The three units consist of one new generation unit at a site leased from Alcoa Inc. that is adjacent to an existing owned lignite/coal-fueled generation plant site (Sandow) and two units at an owned site (Oak Grove) that was originally slated for the construction of a generation plant a number of years ago. Design and procurement activities for the three units are essentially complete and construction is well underway. Air permits for all three units have been obtained. EPC agreements have been executed with EPC contractors to engineer and construct the Sandow and Oak Grove units. Aggregate cash capital expenditures for these three units are expected to total approximately $3.25 billion including all construction, site preparation and mining development costs, of which approximately $1.7 billion was incurred as of December 31, 2007. Total recorded costs, including purchase accounting fair value adjustments and capitalized interest, are expected to total approximately $5.0 billion. The expected commercial operation dates of the units are as follows: Sandow in 2009 and Oak Grove's two units in 2009 and 2010. See discussion in Note 16 to Financial Statements under "Generation Development" regarding actions taken by opponents of the new units. The development program includes up to $500 million for investments in state-of-the-art emissions controls for the three new units. The development program includes an environmental retrofit program under which Luminant will install additional environmental control systems at its existing generation facilities. Estimated capital expenditures associated with these additional environmental control systems total approximately $1 billion to $1.3 billion. Luminant has not yet completed detailed cost and engineering studies for the additional environmental systems, and the cost estimates could materially change as Luminant determines the details of and further evaluates the engineering and construction costs related to these investments. Retail Pricing ― In May 2007, EFH Corp. and the Sponsor Group announced that residential price cuts provided by TXU Energy would total 15%, which represented a five percentage point increase over the previously announced price discount program. Accordingly, residential customers under qualifying service plans received a 6% price reduction in March 2007, an additional 4% reduction in June 2007 and a 5% reduction in October 2007. Long-Term Hedging Program ― In October 2005, TCEH initiated a long-term hedging program designed to reduce exposure to changes in future electricity prices due to changes in the price of natural gas. Under the program, subsidiaries of TCEH have entered into market transactions involving natural gas-related financial instruments. As of March 14, 2008, these subsidiaries have effectively sold forward approximately 2.4 billion MMBtu of natural gas (equivalent to the natural gas exposure of approximately 305,000 GWh at an assumed 8.0 MMBtu/MWh market heat rate) over the period from 2008 to 2013 at average annual prices ranging from $7.25 per MMBtu to $8.15 per MMBtu. TCEH currently expects to hedge approximately 80% of the equivalent natural gas price exposure of its expected baseload generation output on a rolling five-year basis. For the period from 2008 to 2013, and taking into consideration the estimated portfolio impacts of TXU Energy's retail electricity business, the hedging transactions described in the previous sentence result in TCEH having effectively hedged approximately 84% of its expected baseload generation natural gas price exposure for such period (on an average basis for such period). 31
Slide 40: Prior to March 2007, a significant portion of the instruments under the long-term hedging program were designated and accounted for as cash flow hedges. In March 2007, these instruments were dedesignated as allowed under SFAS 133. Subsequent changes in the fair value of these instruments are being recorded as unrealized gains and losses in net income, which has and could continue to result in significantly increased volatility in reported net income. Based on the size of the long-term hedging program as of March 14, 2008, a $1.00/MMBtu change in natural gas prices would result in the recognition by TCEH of approximately $2.4 billion in pretax unrealized mark-to-market gains or losses. Unrealized mark-to-market losses associated with the long-term hedging program were significant in 2007 (approximately $2 billion) and are expected to be significant in the early part of 2008 as upward pressure on forward natural gas prices has continued. Given the volatility of natural gas prices, the actual gains or losses that will ultimately be realized upon settlement of the hedge positions in future years are not possible to predict. The hedges were entered into with the continuing expectation that wholesale electricity prices in ERCOT will be highly correlated with natural gas prices. If natural gas prices at settlement are lower than the prices of the hedge positions, the hedges are expected to mitigate the otherwise negative effect on earnings of lower wholesale electricity prices. However, if natural gas prices at settlement are higher than the prices of the hedge positions, the hedges are expected to dampen the otherwise positive effect on earnings of higher wholesale electricity prices and will in this context be viewed as having resulted in an opportunity cost. Based on fair values of the positions, these hedging transactions were $1.8 billion out-of-the-money at December 31, 2007 due to higher forward natural gas prices. Reflective of the volatility of forward natural gas prices, this out-of-the-money position increased to $4.4 billion by March 14, 2008 and then decreased to $2.3 billion by March 21, 2008. These values can change materially as market conditions change. In the 2007 Predecessor period, subsidiaries of TCEH entered into several large hedging transactions involving natural gas-related financial instruments that resulted in “day one” losses totaling $227 million. In the 2007 Successor period, subsidiaries of TCEH entered into a large hedging transaction involving natural gasrelated financial instruments that resulted in a “day one” loss totaling $8 million. The "day one" losses essentially represent the cost to transact these positions given their size and long dating. As of March 14, 2008, approximately 95% of the long-term hedging transactions were secured by a firstlien interest in TCEH's assets (including the transactions supported by the TCEH Commodity Collateral Posting Facility – see discussion below under "Liquidity And Capital Resources") thereby reducing the cash and letter of credit collateral requirements of the hedging program. Interest Rate Hedges ― In the 2007 Successor period, TCEH entered into a series of interest rate swap transactions that effectively fixed the interest rates at between 7.3% and 8.3% on $15.05 billion principal amount of its senior secured debt maturing from 2009 to 2014. Taking into consideration these swap transactions, approximately 18% of TCEH’s total long-term debt portfolio at December 31, 2007 is exposed to variable interest rate risk. Based on the fair value of the positions, the interest rate swaps were $280 million out-of-themoney at December 31, 2007 and $845 million out-of-the-money at February 29, 2008 due to lower market interest rates. These fair values can change materially as market conditions change. See Note 15 to Financial Statements for additional discussion of these swaps. Nuclear Generation Development ― TCEH is proceeding with the preparation of a combined license application for two new nuclear generation facilities, each with approximately 1,700 MW (gross capacity), at its existing Comanche Peak nuclear generation site. It is currently anticipated that these new units would be developed by TCEH or its subsidiaries. Investment in Cleaner Coal-Fueled Generation Technologies ― In an initiative separate from but related to the generation development and related emissions controls program, subsidiaries of TCEH expect to invest over the next five to seven years in the development and commercialization of cleaner generation plant technologies. Luminant has initiated a number of actions, including research and development investments to advance next-generation emissions reduction technologies. Additionally, in December 2007, EFH Corp. issued a request for proposals for the potential development of two IGCC commercial demonstration facilities with carbon dioxide capture in Texas, and 14 expressions of interest were received. Detailed proposals are due by June 2008. Luminant will undertake a detailed evaluation of proposals received before deciding whether to proceed with preliminary engineering designs for these facilities. 32
Slide 41: KEY RISKS AND CHALLENGES Following is a discussion of key risks and challenges facing management and the initiatives currently underway to manage such challenges. Natural Gas Price and Market Heat-Rate Exposure Wholesale electricity prices in the ERCOT market generally move with the price of natural gas because marginal demand for electricity supply is generally met with natural gas-fueled generation facilities. Natural gas prices have increased significantly in recent years, but historically the price has fluctuated due to the effects of weather, changes in industrial demand and supply availability, and other economic and market factors. Wholesale electricity prices also move with market heat rates. Heat rate is the measure of the efficiency of the marginal supplier (generally natural gas-fueled generation facilities) in generating electricity. The wholesale market price of power divided by the market price of natural gas represents the market heat rate. In contrast to TCEH’s natural gas-fueled generation facilities, changes in natural gas prices have no significant effect on the cost of generating electricity from TCEH’s nuclear and lignite/coal-fueled plants. All other factors being equal, these baseload generation assets, which provided 70% of supply volumes in 2007, increase or decrease in value as natural gas prices rise or fall, respectively, because of the effect of natural gas prices setting marginal wholesale power prices in ERCOT. With the exposure to variability of natural gas prices, retail sales price management and hedging activities are critical to the profitability of the business. With the expiration of the regulatory price-to-beat rate mechanism on January 1, 2007 (see discussion below under “Regulation and Rates”), TXU Energy has price flexibility in all of its retail markets. Considering current and forecasted electricity supply and sales load and wholesale market positions, TCEH’s portfolio position for 2008 is largely balanced with respect to changes in natural gas prices. The supply and load forecast take into account projections of baseload unit availability and customer churn and retail sales. TCEH’s approach to managing commodity price risk focuses on the following: • • • • employing disciplined hedging and risk management strategies through physical and financial energy-related (electricity and natural gas) contracts to partially hedge gross margins; continuing reduction of fixed costs to better withstand gross margin volatility; following a retail pricing strategy that appropriately reflects the magnitude and costs of commodity price risk, and improving retail customer service to attract and retain high-value customers. As discussed above under “Significant Developments”, TCEH has implemented a long-term hedging program to mitigate the risk of future declines in wholesale electricity prices due to declines in natural gas prices. The following scenarios are presented to quantify the potential impact of movements in natural gas prices and market heat rates. Illustratively, if TXU Energy’s sales prices immediately and fully adjusted to reflect changes in wholesale electricity prices due to changes in natural gas prices, and taking into account the hedges in place at year-end 2007 under the long-term hedging program expected to settle in 2008, TCEH could experience an approximate $170 million reduction in 2008 pretax earnings for every $1.00 per MMBtu reduction in natural gas prices (approximate 13% change in current price) sustained over the full year. In the same scenario of full and immediate pass-through of wholesale electricity price changes to sales prices, where natural gas prices and other nonprice conditions remained unchanged but ERCOT wholesale electricity prices declined by $5/MWh (approximate 8% change in current price) for a full year because of a decline in market heat rates, TCEH could experience an approximate $260 million reduction in 2008 pretax earnings. 33
Slide 42: The long-term hedging program does not mitigate exposure to changes in market heat rates. TCEH’s market heat rate exposure is derived from its generation portfolio and is potentially impacted by generation capacity increases, particularly increases in lignite/coal- and nuclear-fueled capacity, which could result in lower market heat rates. TCEH expects that decreases in market heat rates would decrease the value of its generation assets because lower market heat rates generally result in lower wholesale electricity prices, and vice versa. On an ongoing basis, TCEH will continue monitoring its overall commodity risks and seek to balance its portfolio based on its desired level of exposure to natural gas prices and market heat rates and potential changes to its operational forecasts of overall generation and consumption in its native and growth business. Portfolio balancing may include the execution of incremental transactions, or the unwinding of existing transactions or the substitution of natural gas hedges with commitments for the sale of electricity at fixed prices. As a result, commodity price exposures and their effect on earnings could change from time to time. See “Liquidity and Capital Resources” below for a discussion of the liquidity effects of the long-term hedging program. Also see additional discussion of risk measures below under “Quantitative and Qualitative Disclosure about Market Risk.” Competitive Markets and Customer Retention Competitive retail activity in Texas continued to result in declines in sales volumes in TCEH's historical service territory. Total retail sales volumes declined 5%, 11% and 17% in 2007, 2006 and 2005, respectively, as retail sales volume declines in TCEH's historical service territory were partially offset by growth in other territories. While competition was a factor, the decline in 2007 also reflected unusually cool summer weather. The area representing TCEH’s historical service territory prior to deregulation, largely in north Texas, consisted of more than 3 million electricity consumers (measured by meter counts) as of year-end 2007. TXU Energy currently has approximately 1.8 million retail customers in that territory and has acquired approximately 346,000 retail customers in other competitive areas in Texas. In responding to the competitive landscape and full competition in the ERCOT marketplace since January 1, 2007, TXU Energy is focusing on the following key initiatives: • • TXU Energy has introduced competitive pricing initiatives as evidenced by the 15% cumulative price reduction applicable to residential customers under qualifying service plans; Growing the retail customer base by actively competing for new and existing customers in areas in Texas open to competition. The customer retention strategy remains focused on delivering worldclass customer service and improving the overall customer experience. In line with this strategy, TXU Energy continues to implement initiatives to improve customer service; TXU Energy intends to establish itself as the most innovative retailer in the Texas market as it is critical in the fully competitive environment and continues to develop tailored product offerings to meet customer needs. TXU Energy plans to invest $100 million over the five-year period beginning in 2008 in retail initiatives aimed at helping consumers conserve energy and other demand-side management initiatives that are intended to help reduce peak demand for electricity, and Initiatives in the business market are focused largely on programs targeted to retain the existing highest-value customers and to recapture customers who have switched REPs. Initiatives include a more disciplined contracting and pricing approach and improved economic segmentation of the business market to enhance targeted sales and marketing efforts and to more effectively deploy the direct-sales force. Tactical programs put into place include improved customer service, new product price/service offerings and a multichannel approach for the small business market. • • 34
Slide 43: Substantial Leverage, Uncertain Financial Markets and Liquidity Risk TCEH's substantial leverage, resulting in part from debt incurred to finance the Merger, will require a substantial amount of cash flow to be dedicated to principal and interest payments and could adversely affect its ability to raise additional capital to fund operations, limit its ability to react to changes in the economy or its industry, expose it to interest rate risk to the extent of its variable rate debt and limit its ability to meet its obligations. Total debt (representing short-term borrowings and long-term debt, including amounts due currently) at December 31, 2007 was $29.0 billion. In 2008, annual interest expense and related charges are expected to total approximately $2.7 billion. Taking into consideration interest rate swap transactions as of December 31, 2007, approximately 18% of TCEH’s total long-term debt portfolio is exposed to variable interest rate risk. Principal payments on TCEH’s debt in 2008 are expected to total approximately $153 million. While TCEH believes its cash flow from operations combined with availability under existing credit facilities provide sufficient liquidity to fund current obligations, projected working capital requirements and capital spending for 2008 (see “Liquidity and Capital Resources” section below), there can be no assurance that, considering the current uncertainty in financial markets, counterparties to the credit facilities will perform as expected or that substantial unexpected changes in financial markets, the economy, the requirements of regulators or TCEH’s industry or operations will not result in liquidity constraints. Texas Generation Development Program The undertaking of the development of three generation facilities in Texas as described above under “Significant Developments” involves a number of risks. Aggregate cash capital expenditures to develop these three units are expected to total approximately $3.25 billion. While TCEH believes the investment economics of the program are strong, estimates of future natural gas prices, market heat rates and effects of any CO2 emissions regulation may prove to be inaccurate, and returns on the investment could be significantly less than anticipated. The program is exposed to construction delays, failure of the units to meet performance specifications, nonperformance by equipment suppliers, increases in construction labor costs (contractually limited in part) and other project execution risks. Further, project capital spending for the three units continues despite continued public discussion of the advantages and disadvantages of coal-fueled generation. Should these development activities be canceled, TCEH would be exposed to impairment of construction work-in-process assets and project discontinuance costs, including equipment order cancellation penalties (see Note 16 to Financial Statements). Management has evaluated the potential risks and benefits of the program to both Texas consumers and TCEH and believes that in consideration of the most likely market and performance scenarios, continued progress towards completion of the program is the appropriate course of action. Energy Prices and Regulatory Risk Natural gas prices rose to unprecedented levels in the latter part of 2005, reflecting a world-wide increase in energy prices compounded by hurricane-related infrastructure damage. The related rise in retail electricity prices elevated public awareness of energy costs and dampened customer demand in 2006 and 2007. Natural gas prices remain subject to events that create price volatility, and while not at 2005 levels, forward natural gas prices have risen substantially since the end of 2006. Sustained high energy prices and/or ongoing price volatility also creates a risk for regulatory and/or legislative intervention with the mechanisms that govern the competitive wholesale and retail markets in ERCOT. TCEH believes that competitive markets result in a broad range of innovative pricing and service alternatives to consumers and ultimately the most efficient use of resources, and that regulatory bodies should continue to take actions that encourage competition in the industry. Regulatory and/or legislative intervention could disrupt the relationship between natural gas prices and wholesale electricity prices, which could negatively impact results of TCEH’s long-term hedging strategy. New and Changing Environmental Regulations TCEH is subject to various environmental laws and regulations related to SO2, NOx and mercury emissions as well as other environmental contaminants that impact air and water quality. TCEH is in compliance with all current laws and regulations, but regulatory authorities continue to evaluate existing requirements and consider proposals for changes. 35
Slide 44: EFH Corp. and TCEH continue to closely monitor any potential legislative changes pertaining to climate change and CO2 emissions. The increasing attention to potential environmental effects of greenhouse gas emissions creates risk as to the economics of TCEH’s program to develop new coal-fueled generation facilities in Texas. New legislation could result in higher costs due to new taxes, the need to acquire emissions credits or capital spending to reduce CO2 emissions. EFH Corp. and TCEH believe that any legislative actions to reduce greenhouse gas emissions should be developed under a market-based framework that is consistent with expected technology development timelines and supports the displacement of old, inefficient electricity generation technology with advanced, more efficient and cleaner-emitting technology. EFH Corp. has announced actions to address CO2 emissions concerns, including: • • • • • Investing in the development and commercialization of cleaner generation plant technologies; Initiating the process to file an application to the NRC for licenses to construct and operate a new nuclear generation facility in Texas; Doubling the renewable energy (wind generation) portfolio from 2006 levels to 1,500 MW; Investing $400 million over the five years beginning in 2008 in programs designed to encourage customer electricity demand efficiencies, including $100 million expected to be invested by TXU Energy, and Increasing production efficiency of its existing generation facilities by up to 2 percent. Exposures Related to Nuclear Asset Outages TCEH’s nuclear assets are comprised of two generation units at Comanche Peak, each with a capacity of 1,150 MW. The Comanche Peak plant represents approximately 13% of TCEH’s total generation capacity. The nuclear generation units represent TCEH’s lowest marginal cost source of electricity. Assuming both nuclear generation units experienced an outage, the unfavorable impact to pretax earnings is estimated to be approximately $3.5 million per day before consideration of any insurance proceeds. Also see discussion of nuclear facilities insurance in Note 16 to Financial Statements. The inherent complexities and related regulations associated with operating nuclear generation facilities result in environmental, regulatory and financial risks. The operation of nuclear generation facilities is complex and subject to continuing review and regulation by the NRC, covering, among other things, operations, maintenance, emergency planning, security, and environmental and safety protection. The NRC may implement changes in regulations that result in increased capital or operating costs, and it may require extended outages, modify, suspend or revoke operating licenses and impose fines for failure to comply with its existing regulations and the provisions of the Atomic Energy Act. In addition, an unplanned outage at another nuclear generation facility could result in the NRC taking action to shut down the Comanche Peak plant as a precautionary measure. The Comanche Peak plant has not experienced an extended unplanned outage, and management continues to focus on the safe, reliable and efficient operations at the plant. 36
Slide 45: APPLICATION OF CRITICAL ACCOUNTING POLICIES TCEH’s significant accounting policies are discussed in Note 1 to Financial Statements. TCEH follows accounting principles generally accepted in the US. Application of these accounting policies in the preparation of TCEH’s consolidated financial statements requires management to make estimates and assumptions about future events that affect the reporting of assets and liabilities at the balance sheet dates and revenues and expenses during the periods covered. The following is a summary of certain critical accounting policies of TCEH that are impacted by judgments and uncertainties and under which different amounts might be reported using different assumptions or estimation methodologies. Purchase Accounting The Merger has been accounted for by EFH Corp. under purchase accounting, whereby the purchase price of the transaction was allocated to EFH Corp.’s identifiable assets acquired and liabilities assumed based upon their fair values. The estimates of the fair values recorded were determined based on the principles in SFAS 157 (see Note 22 to Financial Statements) and reflect significant assumptions and judgments. Material valuation inputs for long-lived assets and liabilities included forward electricity and natural gas price curves and market heat rates, discount rates, nonperformance risk adjustments related to liabilities, retail customer attrition rates, generation plant operating and construction costs and asset lives. The valuations reflected considerations unique to the competitive wholesale power market in ERCOT as well as TCEH’s assets. For example, the valuation of the baseload generation facilities considered TCEH’s lignite fuel reserves and mining capabilities. Such assumptions and judgments that would be appropriate at the acquisition date may prove to be incorrect if market conditions change. The results of the purchase price allocation included an increase in the total carrying value of TCEH’s baseload generation plants and the recording of intangible assets related to the retail customer base, the TXU Energy trade name and emission credits. Further, commodity and other contracts not already subject to fair value accounting were valued, and amounts representing favorable or unfavorable contracts (versus market conditions as of the date of the Merger) were recorded as intangible assets or liabilities, respectively. Management believes all material intangible assets have been identified. See Notes 2 and 3 to Financial Statements for details of the purchase price allocation and intangible assets recorded, respectively. The excess of the purchase price over the estimated fair values of the net assets acquired was recorded as goodwill. The goodwill amount recorded at EFH Corp. totaled $23.0 billion. Purchase accounting impacts, including goodwill recognition, have been “pushed down”, resulting in the assets and liabilities of TCEH being recorded at their fair values as of October 10, 2007. The assignment of purchase price was based on the relative estimated enterprise value of TCEH’s operations as of the date of the Merger using discounted cash flow methodologies and resulted in TCEH recording $18.1 billion of goodwill. In accordance with SFAS 142, goodwill is not amortized to net income, but is required to be tested for impairment at least annually. Management believes the drivers of the goodwill amount assigned to TCEH include the incremental value of the future cash flow potential of the baseload generation facilities, including facilities under construction, over the values assigned to those assets under purchase accounting rules, considering the market-pricing mechanisms and growth potential in the ERCOT market, as well as the value derived from the scale of the retail business. Also see discussion below under “Impairment of Long-Lived Assets”. The purchase price allocation at December 31, 2007 is substantially complete; however, additional analysis with respect to the value of certain assets, contractual arrangements, contingent liabilities and debt could result in a change in the total amount of goodwill and amounts assigned to TCEH. See Note 2 to Financial Statements for details of the purchase price allocation. 37
Slide 46: Derivative Instruments and Mark-to-Market Accounting TCEH enters into contracts for the purchase and sale of energy-related commodities, and also enters into other derivative instruments such as options, swaps, futures and forwards primarily to manage commodity price and interest rate risks. Under SFAS 133, these instruments are subject to mark-to-market accounting, and the determination of market values for these instruments is based on numerous assumptions and estimation techniques. Mark-to-market accounting recognizes changes in the fair value of derivative instruments in the financial statements as market prices change. The default accounting treatment for a derivative is to record changes in fair value as unrealized mark-to-market gains and losses in net income with an offset to derivative assets and liabilities. The availability of quoted market prices in energy markets is dependent on the type of commodity (e.g., natural gas, electricity, etc.), time period specified and delivery point. In computing fair value for derivatives, each forward pricing curve is separated into liquid and illiquid periods. The liquid period varies by delivery point and commodity. Generally, the liquid period is supported by exchange markets, broker quotes and frequent trading activity. For illiquid periods, fair value is estimated based on forward price curves developed using modeling techniques that take into account available market information and other inputs that might not be readily observable in the market. TCEH adopted SFAS 157 concurrent with the Merger and estimates fair value as described in Note 22 to Financial Statements. SFAS 133 allows for “normal” purchase or sale elections and hedge accounting designations, which generally eliminates or defers the requirement for mark-to-market recognition in net income and thus reduces the volatility of net income that can result from fluctuations in fair values. These elections and designations are intended to better match the accounting recognition of the contract's financial performance with the economic and risk decision-making profile. “Normal” purchases and sales are contracts that provide for physical delivery of quantities expected to be used or sold over a reasonable period in the normal course of business and are not subject to mark-to-market accounting. In accounting for cash flow hedges, changes in fair value are recorded in other comprehensive income with an offset to derivative assets and liabilities to the extent the change in value is effective; that is, it mirrors the offsetting change in fair value of the forecasted hedged transaction. Changes in value that represent ineffectiveness of the hedge are recognized in net income immediately, and the effective portion of changes in fair value are initially recorded in other comprehensive income and are recognized in net income in the period that the hedged transactions are recognized. TCEH continually assesses its hedge elections and under SFAS 133 could dedesignate positions currently accounted for as cash flow hedges, the effect of which could be more volatility of reported earnings as all changes in the fair value of the positions would be included in net income. In March 2007, the instruments making up a significant portion of the long-term hedging program that were previously designated as cash flow hedges were dedesignated as allowed under SFAS 133. See further discussion of the long-term hedging program above under “Significant Developments”. 38
Slide 47: The following tables provide the effects on both net income and other comprehensive income of accounting for those derivative instruments that TCEH has determined to be subject to fair value measurement under SFAS 133. Combined (a) Successor Period from October 11, 2007 through December 31, 2007 Predecessor Period from January 1, 2007 through October 10, 2007 Year Ended December 31, 2006 2005 Year Ended December 31, 2007 Amounts recognized in net income (after-tax): Unrealized net gains (losses) on unsettled positions marked-to-market in net income......................................... Unrealized net (gains) losses representing reversals of previously recognized fair values of positions settled in the period ............................................................. Unrealized ineffectiveness net gains (losses) on unsettled positions accounted for as cash flow hedges ...................... Reversals of previously recognized unrealized net (gains) losses related to cash flow hedge positions settled in the period ............................................................. Total................................................................................. Amounts recognized in other comprehensive income (after-tax): Net gains (losses) in fair value of unsettled positions accounted for as cash flow hedges...................................... Net (gains) losses on cash flow hedge positions recognized in net income to offset hedged transactions ..... Total................................................................................. (a) $ (1,481) (58) 74 (15) (1,480) $ (959) (52) $ (522) (6) 74 (15) (469) $ 15 7 141 14 177 $ 21 (15) (24) 7 (11) $ ─ ─ (1,011) $ $ $ $ $ $ $ (425) (129) (554) $ $ (177) ─ (177) $ $ (248) (129) (377) $ $ 568 (17) 551 $ $ (47) 70 23 Combined results for the year ended December 31, 2007 represent the mathematical sum of the Predecessor period from January 1, 2007 through October 10, 2007 and the Successor period from October 11, 2007 through December 31, 2007. This presentation does not comply with GAAP or the rules for pro forma presentation, but is presented because management believes it is the most meaningful comparison of the results. Such presentation is not an indication of future results. See “Presentation and Analysis of Results” below. The effect of mark-to-market and hedge accounting for derivatives on the balance sheet is as follows: Successor December 31, 2007 $ 7 (280) ─ $ (273) $ $ $ (2,009) ─ (177) Predecessor December 31, 2006 $ 910 ─ (4) $ 906 $ $ $ 69 10 430 Net derivative asset related to commodity cash flow hedges................................ Net derivative liability related to interest rate cash flow hedges........................... Net derivative liability related to interest rate fair value hedges........................... Total net cash flow hedge and other derivative asset (liability) .............. Net commodity contract asset (liability) (a) .......................................................... Long-term debt fair value adjustments ― decrease in carrying value.................. Net accumulated other comprehensive gain (loss) included in shareholders’ equity (after-tax) amounts (b).................................................... ________________________ (a) (b) Excludes amounts not arising from recognition of fair values such as payments and receipts of cash and other consideration associated with commodity hedging and trading activities. All amounts included in other comprehensive income as of October 10, 2007, which totaled $53 million in net gains, were eliminated as part of purchase accounting. 39
Slide 48: Revenue Recognition TCEH’s revenue includes an estimate for unbilled revenue that represents estimated daily kWh consumption after the meter read date to the end of the period multiplied by the applicable billing rates. Estimated daily kWh usage is derived using historical kWh usage information adjusted for weather and other measurable factors affecting consumption. Calculations of unbilled revenues during certain interim periods are generally subject to more estimation variability because of seasonal changes in demand. Accrued unbilled revenues totaled $404 million, $406 million and $433 million at December 31, 2007, 2006 and 2005, respectively. Accounting for Contingencies The financial results of TCEH may be affected by judgments and estimates related to loss contingencies. A significant contingency that TCEH accounts for is the loss associated with uncollectible trade accounts receivable. The determination of such bad debt expense is based on factors such as historical write-off experience, aging of accounts receivable balances, changes in operating practices, regulatory rulings, general economic conditions and customers' behaviors. Changes in customer count and mix due to competitive activity and seasonal variations in amounts billed add to the complexity of the estimation process. Historical results alone are not always indicative of future results, causing management to consider potential changes in customer behavior and make judgments about the collectibility of accounts receivable. Bad debt expense totaled $13 million, $44 million, $67 million and $53 million for the period from October 11, 2007 to December 31, 2007, the period from January 1, 2007 to October 10, 2007, and the years ended December 31, 2006 and 2005, respectively. Accounting for Income Taxes EFH Corp. files a consolidated federal income tax return; however, TCEH’s income tax expense and related balance sheet amounts are recorded as if the entity was a stand-alone corporation. TCEH’s income tax expense and related balance sheet amounts involve significant management estimates and judgments. Amounts of deferred income tax assets and liabilities, as well as current and noncurrent accruals, involve judgments and estimates of the timing and probability of recognition of income and deductions by taxing authorities. In assessing the likelihood of realization of deferred tax assets, management considers estimates of the amount and character of future taxable income. Actual income taxes could vary from estimated amounts due to the future impacts of various items, including changes in income tax laws, TCEH’s forecasted financial condition and results of operations in future periods, as well as final review of filed tax returns by taxing authorities. EFH Corp.’s income tax returns are regularly subject to examination by applicable tax authorities. In management’s opinion, an adequate reserve has been made for any future taxes that may be owed as a result of any examination. FIN 48 provides interpretive guidance for accounting for uncertain tax positions, and as discussed in Note 10 to the Financial Statements, TCEH adopted this new standard January 1, 2007, as required. Also, see Notes 1 and 12 to Financial Statements for discussion of income tax matters. 40
Slide 49: Impairment of Long-Lived Assets TCEH evaluates long-lived assets (including intangible assets with finite lives) for impairment whenever indications of impairment exist, in accordance with SFAS 144. One of those indications is a current expectation that “more likely than not” a long-lived asset will be sold or otherwise disposed of significantly before the end of its previously estimated useful life. For TCEH’s baseload generation assets, another possible indication would be an expected long-term decline in natural gas prices and/or market heat rates. The determination of the existence of these and other indications of impairment involves judgments that are subjective in nature and may require the use of estimates in forecasting future results and cash flows related to an asset or group of assets. Further, the unique nature of TCEH's property, plant and equipment, which includes a fleet of generation assets with a diverse fuel mix and individual plants that have varying production or output rates, requires the use of significant judgments in determining the existence of impairment indications and the grouping of assets for impairment testing. Goodwill and intangible assets with indefinite lives are required to be tested for impairment at least annually or whenever circumstances indicate an impairment may exist, such as the possible impairments to longlived assets discussed above. TCEH tests goodwill and intangible assets with indefinite lives for impairment on October 1st each year. In 2006, TCEH recorded an impairment charge of $198 million ($129 million after-tax) related to its natural gas-fueled generation units. See Note 8 to Financial Statements for a discussion of the impairment. The estimated impairment was based on numerous judgments including forecasted production, forward prices of natural gas and electricity, overall generation availability in ERCOT and ERCOT grid congestion. Depreciation and Amortization Subsequent to the Merger, depreciation expense related to generation facilities is based on the estimates of fair value and economic useful lives as determined in the application of purchase accounting described above. The accuracy of these estimates directly affects the amount of depreciation expense. If future events indicate that the estimated lives are no longer appropriate, depreciation expense will be recalculated prospectively from the date of such determination based on the new estimates of useful lives. The estimated remaining lives range from 25 to 34 years for the lignite/coal-fueled generation units and an average 44 years for the nuclear-fueled generation units. The estimated life of these baseload units is 60 years, the same as estimates prior to purchase accounting. Depreciation expense for the entire generation fleet is expected to total approximately $1.014 billion in 2008, an increase of $694 million over the annualized 2007 pre-Merger expense amount, reflecting the effects of the increased values pursuant to purchase accounting. See Note 1 to Financial Statements under “Property, Plant and Equipment” for discussion of the change from composite to asset-by-asset depreciation effective with the Merger. Finite-lived intangibles identified as a result of purchase accounting are amortized over their estimated useful lives based on the expected realization of economic effects. See Note 3 to Financial Statements for additional information. 41
Slide 50: Defined Benefit Pension Plans and OPEB Plans TCEH is a participating employer in the pension plan sponsored by EFH Corp. and offers pension benefits through either a traditional defined benefit formula or a cash balance formula. TCEH also participates in health care and life insurance benefit plans offered by EFH Corp. to eligible employees and their eligible dependents upon the retirement of such employees from TCEH. Reported costs of providing noncontributory defined pension benefits and OPEBs are dependent upon numerous factors, assumptions and estimates. Benefit costs are impacted by actual employee demographics (including but not limited to age, compensation levels and years of accredited service), the level of contributions made to retiree plans, expected and actual earnings on plan assets and the discount rates used in determining the projected benefit obligation. Changes made to the provisions of the plans may also impact current and future benefit costs. Fluctuations in actual equity market returns as well as changes in general interest rates may result in increased or decreased benefit costs in future periods. In accordance with accounting rules, changes in benefit obligations associated with these factors may not be immediately recognized as costs in the income statement, but are recognized in future years over the remaining average service period of plan participants. As such, significant portions of benefit costs recorded in any period may not reflect the actual level of cash benefits provided to plan participants. Costs allocated from the plans are also impacted by movement of employees between participating companies. Pension and OPEB costs as determined under applicable accounting rules are summarized in the following table: Successor Period from October 11, 2007 through December 31, 2007 $ 1 2 $ 3 $ ─ Predecessor Period from January 1, 2007 through October 10, 2007 $ 4 9 $ 13 $ 1 Pension costs under SFAS 87.......................... OPEB costs under SFAS 106 .......................... Total benefit costs (a) ........................... Funding of pension and OPEB Plans .............. December 31, 2006 2005 $ 8 $ 5 10 9 $ 18 $ 14 $ 1 $ 6 _____________ (a) Includes amounts capitalized as part of construction projects, which totaled approximately $14 thousand, $65 thousand, $48 thousand and $338 thousand for the period from October 11, 2007 through December 31, 2007, the period from January 1, 2007 through October 10, 2007, and for 2006 and 2005, respectively. Pension and OPEB costs decreased $2 million in 2007 driven by a higher discount rate (5.90% from January 1, 2007 through October 10, 2007 and 6.45% from October 11, 2007 through December 31, 2007 versus 5.75% in 2006). Pension and OPEB costs increased $4 million in 2006 primarily due to a lower discount rate (5.75% in 2006 versus 6.00% in 2005) used to measure pension and OPEB obligations. Additional information regarding TCEH’s pension and OPEB costs is provided in Note 20 to Financial Statements. 42
Slide 51: PRESENTATION AND ANALYSIS OF RESULTS Although TCEH continued as the same legal entity after the Merger, the accompanying statements of consolidated income and cash flows for 2007 are presented for two periods: January 1, 2007 through October 10, 2007 (Predecessor) and October 11, 2007 through December 31, 2007 (Successor), which relate to the period before the Merger and the period after the Merger, respectively. Management's discussion and analysis of results of operations and cash flows for the year ended December 31, 2007 has been prepared by comparing the results of operations and cash flows of the Predecessor for the year ended December 31, 2006 to the combined amounts obtained by adding the Predecessor's results of operations and cash flows for the period January 1, 2007 through October 10, 2007 to the Successor's results of operations and cash flows for the period October 11, 2007 through December 31, 2007. Although this combined presentation does not comply with GAAP and the results of operations of the Predecessor and Successor are not comparable due to the change in basis resulting from the Merger, management uses this approach for its own analysis and believes it results in the most meaningful analysis of changes in the results of operations. Such presentation is not an indication of future results. Key drivers in the results of operations for the Successor and/or Predecessor periods will be discussed in more detail. RESULTS OF OPERATIONS Financial Results Combined (a) Successor Period from October 11, 2007 through December 31, 2007 $ 179 Period From January 1, 2007 through October 10, 2007 $ 6,330 Predecessor Year Ended December 31, 2007 Operating revenues .................................................................. Costs and expenses: Fuel, purchased power costs and delivery fees ................ Operating costs ................................................................. Depreciation and amortization ......................................... Selling, general and administrative expenses .................. Franchise and revenue-based taxes .................................. Other income .................................................................... Other deductions............................................................... Interest income ................................................................. Interest expense and related charges ................................ Total costs and expenses ........................................... Income (loss) from continuing operations before income taxes and cumulative effect of changes in accounting principles........................................................ Income tax (benefit) expense................................................... Income (loss) from continuing operations before cumulative effect of changes in accounting principles .......................................................................... 4,061 596 568 604 111 (24) (15) (281) 910 6,530 $ 6,509 Year Ended December 31, 2006 2005 $ 9,549 $ 9,552 852 123 315 153 30 (2) 5 (10) 587 2,053 3,209 473 253 451 81 (22) (20) (271) 323 4,477 3,928 605 334 531 126 (23) 210 (203) 392 5,900 5,545 667 313 522 114 (64) 15 (70) 393 7,435 (21) (56) (1,874) (651) 1,853 595 3,649 1,255 2,117 687 $ 35 $(1,223) $ 1,258 $ 2,394 $ 1,430 ____________________ (a) See “Presentation and Analysis of Results” above for explanation of this non-GAAP presentation. 43
Slide 52: Sales Volume Data Year Ended December 31, 2006 2005 2007 (a) Combined Predecessor Change % 2007/2006 Change % 2006/2005 Sales volumes: Retail electricity sales volumes – gigawatt hours (GWh): Historical service territory: Residential ................................................................... Small business (b) ....................................................... Total historical service territory.............................. Other territories: Residential ................................................................... Small business (b) ....................................................... Total other territories .............................................. Large business and other customers............................ Total retail electricity.............................................. Wholesale electricity sales volumes ................................ Net sales (purchases) of balancing electricity to/from ERCOT (c) ..................................................... Total sales volumes................................................. Average volume (kWh) per retail customer (d): Residential ................................................................... Small business ............................................................. Large business and other customers............................ Weather (service territory average) – percent of normal (e): Percent of normal: Cooling degree days................................................ Heating degree days................................................ 14,532 28,640 375,949 15,359 30,360 285,277 15,825 32,078 243,538 (5.4) (5.7) 31.8 (2.9) (5.4) 17.1 23,029 6,670 29,699 4,194 813 5,007 14,537 49,243 39,112 669 89,024 25,932 7,753 33,685 3,663 671 4,334 14,031 52,050 36,931 874 89,855 29,239 9,004 38,243 3,416 674 4,090 15,843 58,176 52,001 4,787 114,964 (11.2) (14.0) (11.8) 14.5 21.2 15.5 3.6 (5.4) 5.9 (23.5) (0.9) (11.3) (13.9) (11.9) 7.2 (0.4) 6.0 (11.4) (10.5) (29.0) (81.7) (21.8) 99.1% 99.6% 117.6% 79.2% 107.0% 90.0% ____________________ (a) (b) (c) (d) (e) See "Presentation and Analysis of Results" above for explanation of this non-GAAP presentation. Customers with demand of less than 1 MW annually. See Note 1 to Financial Statements for discussion of trading and ERCOT balancing activity. Calculated using average number of customers for period. Weather data is obtained from Weatherbank, Inc., an independent company that collects and archives weather data from reporting stations of the National Oceanic and Atmospheric Administration (a federal agency under the US Department of Commerce). 44
Slide 53: Customer Count Data Year Ended December 31, 2006 2005 2007 Successor Predecessor Change % 2007/2006 Change % 2006/2005 Customer counts: Retail electricity customers (end of period and in thousands) (a): Historical service territory: Residential..................................................................................... Small business (b) ......................................................................... Total historical service territory ............................................... Other territories: Residential..................................................................................... Small business (b) ......................................................................... Total other territories ................................................................ All territories: Residential..................................................................................... Small business (b) ......................................................................... Total all territories .................................................................... Large business and other customers ............................................. Total retail electricity customers .............................................. 1,543 241 1,784 1,624 258 1,882 1,769 281 2,050 (5.0) (6.6) (5.2) (8.2) (8.2) (8.2) 332 15 347 247 9 256 213 7 220 34.4 66.7 35.5 16.0 28.6 16.4 1,875 256 2,131 33 2,164 1,871 267 2,138 44 2,182 1,982 288 2,270 55 2,325 0.2 (4.1) (0.3) (25.0) (0.8) (5.6) (7.3) (5.8) (20.0) (6.2) ____________________ (a) (b) Based on number of meters. Customers with demand of less than 1 MW. 45
Slide 54: Revenue and Market Share Data Combined (a) Successor Period from October 11, 2007 through December 31, 2007 Period From January 1, 2007 through October 10, 2007 Predecessor Year Ended December 31, 2007 Operating revenues: Retail electricity revenues: Historical service territory: Residential................................................................... Small business (b) ....................................................... Total historical service territory ............................. Other territories: Residential................................................................... Small business (b) ....................................................... Total other territories .............................................. Large business and other customers ........................... Total retail electricity revenues ....................................... Wholesale electricity revenues (c)................................... Net sales (purchases) of balancing electricity to/from ERCOT (c) ..................................................... Income (loss) from risk management and trading activities ...................................................................... Amortization of intangibles (d) ....................................... Other operating revenues (e) ........................................... Total operating revenues ........................................ Risk management and trading activities: Unrealized net gains (losses), including cash flow hedge ineffectiveness, related to unsettled positions.................................................................. Unrealized net (gains) losses representing reversals of previously recognized fair values of positions settled in the current period .................................... Realized net gains (losses) on settled positions (f)..... Total income (loss) ................................................. ______________ (a) (b) (c) (d) (e) (f) Year Ended December 31, 2006 2005 $ 3,129 980 4,109 589 102 691 1,356 6,156 2,142 (23) (2,046) (50) 330 $ 6,509 $ 538 180 718 116 22 138 286 1,142 505 (9) $ 2,591 800 3,391 473 80 553 1,070 5,014 1,637 (14) (554) ─ 247 $ 6,330 $ 3,804 1,153 4,957 559 80 639 1,357 6,953 2,278 (31) 153 ─ 196 $ 9,549 $ 3,444 1,086 4,530 405 65 470 1,330 6,330 2,807 225 (164) ─ 354 $ 9,552 (1,492) (50) 83 $ 179 $ (2,165) (113) 232 $ (2,046) $ (1,476) (80) 64 $ (1,492) $ (689) (33) 168 (554) $ 240 32 (119) 153 $ (6) (12) (146) (164) $ $ $ See “Presentation and Analysis of Results” above for explanation of this non-GAAP presentation. Customers with demand of less than 1 MW annually. See Note 1 to Financial Statements for discussion of reporting of trading and ERCOT balancing activity. Represents amortization of the intangible net asset value of retail and wholesale power sales agreements resulting from purchase accounting. Includes a $162 million charge for a special customer appreciation bonus in 2006. This charge does not affect the computation of residential average revenues per MWh. See Note 9 to Financial Statements. Includes physical commodity trading activity not subject to mark-to-market accounting of $3 million in net losses in the period October 11, 2007 to December 31, 2007, $16 million in net losses in the period January 1, 2007 to October 10, 2007, $34 million in net losses for 2006 and $61 million in net gains for 2005. 46
Slide 55: Revenue and Market Share Data (cont.) 2007 Average revenues per MWh: Residential ................................................................... Estimated share of ERCOT retail markets (b)(c)(d): Historical service territory: Residential..................................................................... Small business............................................................... Total ERCOT: Residential..................................................................... Small business............................................................... Large business and other customers ............................. ________________ (a) (b) (c) (d) See “Presentation and Analysis of Results” above for explanation of this non-GAAP presentation. Based on number of meters. Estimated market share is based on the number of customers that have choice. Calculations based on TXU Energy customer segmentation and ERCOT total customer counts. Year Ended December 31, 2006 2005 Predecessor Change % 2007/2006 Change % 2006/2005 Combined (a) $ 136.55 $ 147.43 $ 117.86 (7.4) 25.1 62% 59% 36% 25% 10% 66% 64% 37% 26% 14% 73% 71% 40% 29% 20% 47
Slide 56: Production, Purchased Power and Delivery Cost Data Combined (a) Successor Period from October 11, 2007 through December 31, 2007 Period From January 1, 2007 through October 10, 2007 Predecessor Year Ended December 31, 2007 Fuel, purchased power costs and delivery fees ($ millions): Nuclear fuel ...................................................... Lignite/coal....................................................... Total baseload fuel....................................... Natural gas fuel and purchased power ............. Amortization of intangibles (b)........................ Other costs........................................................ Fuel and purchased power costs (c) ............ Delivery fees .................................................... Total ............................................................. Year Ended December 31, 2006 2005 $ 87 594 681 1,737 67 281 2,766 1,295 $ 4,061 21 127 148 302 67 68 585 267 $ 852 $ 66 467 533 1,435 ─ 213 2,181 1,028 $ 3,209 $ 85 475 560 1,787 ─ 228 2,575 1,353 $ 3,928 $ 78 475 553 3,285 ─ 281 4,119 1,426 $ 5,545 $ Combined (a) Predecessor Year Ended December 31, 2007 2006 2005 Fuel and purchased power costs (which excludes generation plant operating costs) per MWh: Nuclear fuel ...................................................... Lignite/coal (d) ................................................. Natural gas fuel and purchased power ............. Delivery fees per MWh....................................... Production and purchased power volumes (GWh): Nuclear ............................................................. Lignite/coal....................................................... Total baseload generation ............................ Natural gas-fueled generation .......................... Purchased power (c) ......................................... Total energy supply ..................................... Less line loss and power imbalances ............... Net energy supply volumes ......................... Baseload capacity factors (%): Nuclear ............................................................. Lignite/coal....................................................... Total baseload .............................................. 93.5% 90.9% 91.6% 98.8% 89.1% 91.8% 91.5% 89.8% 90.3% 18,821 46,494 65,315 3,991 24,102 93,408 4,384 89,024 19,795 45,579 65,374 3,989 24,380 93,743 3,888 89,855 18,371 45,933 64,304 3,504 50,920 118,728 3,764 114,964 $ $ $ $ 4.61 14.09 61.81 25.84 $ $ $ $ 4.29 11.73 62.99 25.71 $ $ $ $ 4.23 11.68 60.37 24.20 Change % 2007/2006 Change % 2006/2005 7.5 20.1 (1.9) 0.5 1.4 0.4 4.3 6.2 (4.9) 2.0 ─ ─ (1.1) (0.4) 12.8 (0.9) 7.8 (0.8) 1.7 13.8 (52.1) (21.0) 3.3 (21.8) (5.4) 2.0 (0.2) 8.0 (0.8) 1.7 _______________ (a) (b) (c) (d) See “Presentation and Analysis of Results” above for explanation of this non-GAAP presentation. Represents amortization of the intangible net asset values of emission credits, coal purchase contracts and power purchase agreements and the stepped up value of nuclear fuel resulting from purchase accounting. See Note 1 to Financial Statements for discussion of reporting of trading and ERCOT balancing activity. Includes depreciation and amortization of lignite mining assets, which is reported in the depreciation and amortization expense line item, but is part of overall fuel costs. 48
Slide 57: Financial Results ─ 2007 compared to 2006 Operating revenues decreased $3.040 billion, or 32%, to $6.509 billion in 2007, as shown in the following table: Combined (a) Successor Period from October 11, 2007 through December 31, 2007 $ 1,142 505 (9) (1,492) (50) 83 $ 179 Predecessor Period From January 1, 2007 through October 10, 2007 $ 5,014 1,637 (14) (554) ─ 247 $ 6,330 Total retail electricity revenues.................................. Wholesale electricity revenues................................... Wholesale balancing activities................................... Income (loss) from risk management and trading activities................................................................. Amortization of intangibles (b).................................. Other operating revenues ........................................... Total operating revenues................................... Year Ended December 31, 2007 $ 6,156 2,142 (23) (2,046) (50) 330 $ 6,509 Year Ended December 31, 2006 $ 6,953 2,278 (31) 153 ─ 196 $ 9,549 ____________________ (a) (b) See “Presentation and Analysis of Results” above for explanation of this non-GAAP presentation. Represents amortization of the intangible net asset values of retail and wholesale power sales agreements resulting from purchase accounting. The $797 million, or 11%, decrease in retail electricity revenues reflected the following: • Lower average pricing (including customer mix effects) contributed $422 million to the revenue decrease. Lower average retail pricing was driven by residential price discounts, including a six percent price discount effective with meter reads on March 27, 2007, an additional four percent price discount effective with meter reads on June 8, 2007, and another five percent price discount effective with meter reads on October 24, 2007 to those residential customers in TCEH's historical service territory with month-to-month service plans and a rate equivalent to the former price-tobeat rate. Lower average pricing also reflected new competitive product offerings in residential and small business markets and a change in customer mix in the large business market. A 5% decline in retail sales volumes contributed $375 million to the revenue decrease. Residential and small business volumes declined 9% reflecting lower average consumption per customer of 6% due in part to unusually cool summer weather in 2007 and hotter than normal weather in 2006; additionally, competitive activity resulted in net volume declines in TCEH's historical service territory that were partially offset by net increases in other territories. Large business market volumes increased 4% reflecting a change in customer mix. Total retail electricity customer counts at December 31, 2007 declined 1% from December 31, 2006. A 5% decline in total residential and small business customer counts in TCEH's historical service territory was largely offset by growth in other territories. • • Wholesale electricity revenues decreased $136 million, or 6%. Lower prices contributed $271 million to the decrease as average wholesale prices declined 11% reflecting lower natural gas prices during 2007. The pricing impact was partially offset by a $135 million contribution from volume growth of 6% due in part to the decline in retail sales volumes. Wholesale balancing activity comparisons are not meaningful because the activity represents intraday purchases and sales transactions with ERCOT for real-time balancing purposes, as measured in 15-minute intervals, that are highly variable. 49
Slide 58: Results from risk management and trading activities include realized and unrealized gains and losses associated with financial instruments used for hedging and trading purposes, as well as gains and losses on physical sales and purchases of commodities for trading purposes. Because most of the hedging and risk management activities are intended to mitigate the risk of commodity price movements on revenues and fuel and purchased power costs, these results should not be viewed in isolation, but rather taken together with the effects of pricing and cost changes on gross margin. Following is an analysis of activities for the years ended December 31, 2007 and 2006: Year Ended December 31, 2007 — Unrealized mark-to-market net losses totaling $2.278 billion ($1.556 billion recorded in the Successor period) include: • $2.098 billion in net losses related to hedge positions, which includes $2.043 billion in net losses related to unsettled positions and $55 million in net losses that represent reversals of previously recorded fair values of positions settled in the period. These losses are driven by the effect of higher natural gas prices in forward periods on positions in the long-term hedging program; $90 million in hedge ineffectiveness net gains, which includes $114 million of net gains related to unsettled positions and $24 million in net losses that represent reversals of previously recorded ineffectiveness net gains related to positions settled in the period. These amounts relate to positions accounted for as cash flow hedges; $60 million in net losses related to trading positions, which includes $13 million in net losses on unsettled positions and $47 million in net losses that represent reversals of previously recorded fair values of positions settled in the period; $239 million in "day one" losses related to large hedge positions entered into at below-market prices, and a $30 million "day one" gain related to a power purchase agreement. • • • • Realized net gains totaling $232 million ($64 million recorded in the Successor period) include: • • $198 million in net gains related to hedge positions that offset hedged electricity revenues and fuel and purchased power costs recognized in the period, and $34 million in net gains related to trading positions. Year Ended December 31, 2006 — Unrealized mark-to-market net gains totaling $272 million include: • $239 million in hedge ineffectiveness net gains, which includes $218 million in net gains related to unsettled positions and $21 million in net gains that represent reversals of previously recorded unrealized net losses related to positions settled in the period. These amounts relate to positions accounted for as cash flow hedges; $135 million in net gains related to unsettled hedge positions, and a $109 million "day one" loss on a related series of commodity price hedges entered into at belowmarket prices. • • Realized net losses totaling $119 million include: • • $65 million in net losses related to hedge positions that offset hedged electricity revenues recognized in the period, and $54 million in net losses related to trading positions. 50
Slide 59: Gross Margin Combined (a) Successor Predecessor Year Ended December 31, 2007 Operating revenues ............................... Costs and expenses: Fuel, purchased power costs and delivery fees...................... Generation plant operating costs .. Depreciation and amortization of generation assets...................... Gross margin ......................................... $ 6,509 4,061 596 482 $ 1,370 % of Revenue 100% 62 9 8 21% Period from October 11, 2007 through December 31, 2007 $ 179 852 123 234 $ (1,030) Period From January 1, 2007 through October 10, 2007 $ 6,330 3,209 473 248 $ 2,400 Year Ended December 31, 2006 $ 9,549 3,928 605 328 $ 4,688 % of Revenue 100% 41 6 4 49% ____________________ (a) See “Presentation and Analysis of Results” above for explanation of this non-GAAP measure. Gross margin is considered a key operating metric as its changes measure the effect of movements in sales volumes and pricing versus the variable and fixed costs to generate, purchase and deliver electricity. Gross margin decreased $3.318 billion, or 71%, to $1.370 billion in 2007 driven by the decrease in operating revenues. Gross margin as a percent of revenues decreased 28 percentage points to 21%. The decrease reflected: • • • the effect of results from risk management and trading activities (17 percentage point margin decrease); the effect of lower average retail electricity pricing (four percentage point margin decrease); the effect of incremental depreciation and amortization expense on the Successor resulting from stepped-up property, plant and equipment values and amortization of the intangible values recorded in connection with purchase accounting of customers, large business contracts, power sales agreements, emission credits and fuel and power purchase contracts (see Notes 2 and 3 to Financial Statements for more information), (four percentage point margin decrease); the effect of a decrease in residential and small business retail sales volumes and an increase in wholesale sales volumes (two percentage point margin decrease); the effect of higher lignite mining costs (one percentage point margin decrease), and the effect of lower nuclear generation volumes (one percentage point margin decrease). • • • Fuel, purchased power costs and delivery fees increased $133 million, or 3%, to $4.061 billion. The increase includes $67 million of net expense recorded in the 2007 Successor period representing amortization of the intangible net asset values of emission credits, coal purchase contracts and power purchase agreements and the stepped-up value of nuclear fuel resulting from purchase accounting. The increase also reflected purchases of power due to a scheduled refueling and major maintenance outage for one of the two Comanche Peak nuclear units. Maintenance work during the 55-day outage, which ended in April 2007 and drove a five percent decline in nuclear generation volumes for the year, included the replacement of the unit’s steam generators and reactor vessel head. Higher fuel costs also reflected increased mining expenses driven by significantly above normal summer rainfall. 51
Slide 60: Operating costs decreased $9 million to $596 million in 2007. The decrease reflected reductions in costs largely resulting from generation technical support outsourcing service agreements, partially offset by $8 million for the utilization of SO2 emission credits in 2007 for the lignite/coal-fueled generation units and $7 million in higher generation maintenance costs largely due to the scheduled outage in the spring of 2007 of one of the Comanche Peak nuclear generation units. During the period from October 11, 2007 to December 31, 2007, expense related to the amortization of the intangible value of SO2 emission credits recorded in connection with purchase accounting are reflected in fuel costs. Depreciation and amortization (consisting of amounts related to generation plants shown in the gross margin table above and amounts related to the retail customer relationship intangible asset resulting from purchase accounting) increased $234 million to $568 million. The increase includes $157 million of incremental depreciation expense in the Successor period resulting from stepped-up property, plant and equipment values and $79 million in incremental amortization expense in the Successor period related to the intangible value of retail customer relationships recorded in connection with purchase accounting. Higher baseload generation plant depreciation due to ongoing investments in property, plant and equipment was largely offset by lower natural gas-fueled generation plant depreciation due to the impairment of natural gas-fueled generation plants in the second quarter of 2006 and lower expense associated with mining reclamation obligations. SG&A expenses increased $73 million, or 14%, to $604 million in 2007. The increase reflected: • • • • • • $35 million in increased retail marketing expenses; $16 million in higher professional fees primarily for retail billing and customer care systems enhancements and marketing/strategic projects; $14 million in higher third-party service provider fees, primarily in the retail business, including effects of additional services and projects; $11 million in higher salary and benefit costs primarily driven by an increase in staffing in retail operations; $9 million in other individually insignificant costs, and $3 million in higher incentive compensation, partially offset by: • • $10 million in lower bad debt expense driven by a decrease in delinquencies and lower accounts receivable balances, and $6 million in severance costs in 2006. Other income totaled $24 million in 2007 and $23 million in 2006. Other deductions totaled a credit of $15 million in 2007 and totaled $210 million in charges in 2006. The 2006 other deductions amount included a net $198 million impairment charge related to natural gas-fueled generation plants. See Note 13 to Financial Statements for details of other income and deductions. Interest income increased $78 million to $281 million in 2007 reflecting $58 million due to higher average rates on advances to affiliates and $20 million due to higher average advance balances. Interest expense and related charges increased by $518 million to $910 million in 2007. The increase reflected $492 million in higher average borrowings, driven by the Merger-related financings, and $95 million due to higher average interest rates, partially offset by $69 million in increased capitalized interest. Income tax benefit totaled $56 million in 2007 compared to an expense of $1.255 billion in 2006. Due to the small pretax loss from continuing operations in 2007, the comparison of the annual effective rate to 2006 is not meaningful. See Note 12 to Financial Statements for items impacting the reconciliation of the US federal statutory rate to the effective rate for each reporting period. Income from continuing operations decreased $2.359 billion to $35 million in 2007 driven by unrealized mark-to-market losses on positions in the long-term hedging program, higher net interest expense, lower retail sales prices and the effects of purchase accounting. 52
Slide 61: Financial Results ─ 2006 compared to 2005 Operating revenues decreased $3 million to $9.549 billion in 2006, as shown in the following table. Predecessor Year Ended December 31, 2006 $6,953 (162) 2,278 (31) 153 358 $9,549 2005 $6,330 ─ 2,807 225 (164) 354 $9,552 Increase (Decrease) $623 (162) (529) (256) 317 4 $(3) Total retail electricity revenues............................................................... Accrued customer appreciation bonus .................................................... Wholesale electricity revenues................................................................ Wholesale balancing activities................................................................ Income (loss) from risk management and trading activities................... Other operating revenues ........................................................................ Total operating revenues ................................................................... The 10% increase in retail electricity revenues reflected the following: • • Higher average pricing contributed $1.290 billion to the revenue increase. Higher retail prices reflected increases in natural gas prices that resulted in the regulatory-approved price-to-beat rate increases implemented in May 2005, October 2005 and January 2006. The effect of higher retail pricing was partially offset by $667 million in lower retail volumes. Total retail sales volumes declined 11%. Residential and small business volumes fell 10% on a net loss of customers due to competitive activity and lower average consumption per customer. The lower consumption reflected customer efficiency measures in response to prices and warmer weather. Large business market sales volumes declined 11% as the effect of fewer customers was partially offset by higher average consumption per customer. A change in large business customer mix reflected a continuing strategy to improve margins. Retail electricity customer counts at December 31, 2006 declined 6% from December 31, 2005. Total residential and small business customer counts in TCEH's historical service territory declined 8% and in all combined territories declined 6%. • A $162 million ($105 million after-tax) charge was recorded in the fourth quarter of 2006 for a special residential customer appreciation bonus. See discussion in Note 9 to Financial Statements. The decline in wholesale electricity revenues reflected the reporting of wholesale electricity trading activity on a net basis in 2006 as described in Note 1 to Financial Statements. This effect was partially offset by higher wholesale sales prices. Wholesale balancing net revenues/purchases are subject to high variability as the activity represents intraday purchases and sales transactions with ERCOT for real-time balancing purposes as measured in 15minute intervals. See Note 1 for a discussion regarding the change in reporting of ERCOT balancing activities. 53
Slide 62: Following is an analysis of risk management and trading activities for the years ended December 31, 2006 and 2005: Year Ended December 31, 2006 — Unrealized mark-to-market net gains totaling $272 million include: • • • $239 million in hedge ineffectiveness net gains, which includes $218 million in net gains related to unsettled positions and $21 million in net gains that represent reversals of previously recorded unrealized net losses related to positions settled in the period; $135 million in net gains related to unsettled hedge positions, and a $109 million "day one" loss on a related series of commodity price hedges entered into at belowmarket prices. Realized net losses totaling $119 million include: • • $65 million in net losses related to hedge positions that offset hedged electricity revenues recognized in the period, and $54 million in net losses related to trading positions. Year Ended December 31, 2005 — Unrealized mark-to-market net losses totaling $18 million include: • $27 million in hedge ineffectiveness net losses, which includes $38 million in net losses related to unsettled positions and $11 million in net gains that represent reversals of previously recorded net losses related to positions settled in the period, and • $8 million in net gains related to trading positions. Realized net losses totaling $146 million include: • $259 million in net losses related to hedge positions that offset hedged electricity revenues recognized in the period, and • $113 million in net gains related to trading positions. Gross Margin Predecessor Year Ended December 31, 2006 Operating revenues ....................................................... Costs and expenses: Fuel, purchased power costs and delivery fees .... Generation plant operating costs .......................... Depreciation and amortization of generation assets.............................................. Gross margin ................................................................. $ 9,549 3,928 605 328 $ 4,688 % of Revenue 100% 41 6 4 49% 2005 $ 9,552 5,545 667 309 $ 3,031 % of Revenue 100% 58 7 3 32% Gross margin increased $1.657 billion, or 55%, to $4.688 billion in 2006. This growth primarily reflected the relatively low fuel costs of TCEH's nuclear and lignite/coal-fueled baseload plants, as well as the continued improved productivity of the baseload plants, in an environment of increasing wholesale power prices. The increased wholesale power prices were driven by rising natural gas prices. Retail prices, including price-to-beat rates, were increased in response to higher wholesale prices. In addition to higher retail prices, the gross margin increase reflected $265 million in unrealized net gains from cash flow hedge ineffectiveness and mark-to-market valuations of hedged positions. An 8% increase in production volumes at the nuclear generation plant also contributed to higher gross margin as this generation represents the lowest marginal cost of electricity to supply retail and wholesale customers. The gross margin performance was tempered by the effects of lower retail sales volumes and the effect of the customer appreciation bonus accrual. 54
Slide 63: Gross margin as a percent of revenues increased 17 percentage points to 49%. The improvement reflected the following estimated effects: • • • • higher pricing, as the average retail sales price per MWh rose 23% and the average wholesale sales price per MWh rose 17% (10 percentage point margin increase); the effect of reporting wholesale electricity trading activity on a net basis (6 percentage point margin increase); the effect of unrealized cash flow hedge ineffectiveness and mark-to-market net gains related to hedged positions (1 percentage point margin increase), and the combined effect of increased nuclear generation production volumes and less need for purchased electricity volumes (2 percentage point margin increase), partially offset by: • • lower retail sales volumes (2 percentage point margin decrease), and the customer appreciation bonus accrual (1 percentage point margin decrease). Fuel, purchased power costs and delivery fees declined $1.617 billion, or 29%, to $3.928 billion, reflecting the reporting of wholesale trading activity on a net basis in 2006 as discussed in Note 1 to the Financial Statements and the favorable impact of higher nuclear generation volumes to meet sales demand, partially offset by the effect of higher average prices of purchased electricity. Operating costs decreased $62 million, or 9%, to $605 million in 2006. The decrease reflected: • • • $49 million in lower maintenance costs due to both nuclear generation units having scheduled refueling outages in 2005 compared to one in 2006, and reduced other maintenance activity; $9 million in lower incentive compensation expense, and the absence of $10 million in combustion turbine lease expense in 2006 resulting from the purchase of a lease trust interest in early 2006 (see Note 6 to Financial Statements), partially offset by $8 million in net severance and early retirement costs associated with generation outsourcing services agreements entered into in early 2006. Depreciation and amortization (consisting almost entirely of amounts related to generation plants shown in the gross margin table above) increased $21 million, or 7%, to $334 million reflecting higher costs associated with mining land reclamation activities and increased amortization of intangible software assets, partially offset by $7 million in lower depreciation due to the impairment of natural gas-fueled generation plants in the second quarter of 2006. SG&A expenses increased by $9 million, or 2%, to $531 million in 2006. The increase reflected: • • • $14 million in higher bad debt expense reflecting higher retail accounts receivable balances due to higher prices and the effect of a temporary regulatory-mandated deferred payment arrangement and disconnect moratorium applicable to certain retail customers; $14 million in higher fees related to the sale of accounts receivable program due to higher interest rates, and $6 million in executive severance expense (including amounts allocated from EFH Corp.), partially offset by: • • • $8 million in lower consulting fees primarily reflecting expenses in 2005 for the development and implementation of the Luminant Operating System to improve productivity; $7 million in lower stock-based incentive compensation and deferred compensation expenses, and $7 million in lower salaries resulting from cost reduction initiatives in late 2005. 55
Slide 64: Franchise and revenue-based taxes increased $12 million, or 11%, to $126 million reflecting higher state gross receipts taxes due to higher revenues. Other income totaled $23 million in 2006 and $64 million in 2005. Other deductions totaled $210 million in 2006, which included a $198 million impairment charge related to natural gas-fueled generation plants and $15 million in 2005. See Note 13 to Financial Statements for details. Interest income increased by $133 million to $203 million in 2006 reflecting $91 million due to higher average advances to affiliates and $42 million due to higher average rates. Interest expense and related charges decreased by $1 million to $392 million in 2006. The decrease reflects $18 million of higher capitalized interest, partially offset by higher average interest rates of $17 million. Income tax expense on income from continuing operations totaled $1.255 billion in 2006 compared to $687 million in 2005. The effective tax rate was 34.4% in 2006 compared to 32.5% in 2005. The 2006 amount included a charge of $44 million (a 1.2 percentage point effective tax rate impact) representing an adjustment to deferred tax liabilities arising from the enactment of the Texas margin tax as described in Note 11 to the Financial Statements. The 2005 amount reflected a benefit of $29 million representing a tax reserve adjustment (1.4 percentage point effective tax rate impact) and a charge of $10 million (a 0.5 percentage point effective tax rate impact) related to the settlement of the IRS audit for the 1994 to 1996 years. Income from continuing operations increased $964 million, or 67%, to $2.394 billion in 2006 driven by improved gross margin and higher interest income, partially offset by the charge for the write-down of the natural gas-fueled generation plants. 56
Slide 65: Energy-Related Commodity Contracts and Mark-to-Market Activities ― The table below summarizes the changes in commodity contract assets and liabilities for the years ended December 31, 2007, 2006 and 2005. The net changes in these assets and liabilities, excluding “fair value adjustments”, “other activity” and “reclassification” as described below, represent the pretax effect of mark-to-market accounting on net income for positions in the commodity contract portfolio that are not subject to cash flow hedge accounting (see discussion below and in Note 18 to Financial Statements). For the year ended December 31, 2007, this effect totaled $2.368 billion in unrealized net losses, which represented $2.279 billion in net losses on unsettled positions and $89 million in net losses representing reversals of previously recognized fair values of positions settled in the current period. These positions represent both economic hedging and trading activities. Combined (a) Successor October 11, 2007 through December 31, 2007 $ (920) 144 400 (80) (1,476) 15 $(1,917) Predecessor January 1, 2007 through October 10, 2007 $ (23) ─ ─ (9) (803) (85) $ (920) $ Year Ended December 31, 2007 Commodity contract net asset (liability) at beginning of period......................................... Fair value adjustments at Merger closing date (b) ............................................................ Reclassification at Merger closing date (c) ........ Settlements of positions (d) ................................... Unrealized mark-to-market valuations of positions held at end of period (e) .................. Other activity (f)................................................. Commodity contract net asset (liability) at end of period.................................................. __________________________ (a) (b) (c) (d) (e) $ (23) 144 400 (89) (2,279) (70) $(1,917) Year Ended December 31, 2006 $ (56) ─ ─ 11 22 ─ (23) Year Ended December 31, 2005 $ 23 ─ ─ (23) 32 (88) $ (56) See “Presentation and Analysis of Results” above for explanation of this non-GAAP presentation. Represents adjustments arising primarily from the adoption of SFAS 157 (largely nonperformance risk effect ─ see Note 22 to Financial Statements). Represents reclassification of fair values of derivatives no longer accounted for as cash flow hedges as of the date of the Merger. Represents reversals of fair values recognized prior to the beginning of the period to offset gains and losses realized upon settlement of the positions in the current period. Primarily represents mark-to-market effects of positions in the long-term hedging program (see discussion above under "LongTerm Hedging Program"). Also includes an $8 million loss in the Successor period, $231 million in losses and a $30 million gain in the 2007 Predecessor period and $106 million in net losses in 2006 recorded at contract inception dates (see Note 18 to Financial Statements). These amounts do not represent unrealized gains or losses. Includes initial values of positions involving the receipt or payment of cash or other consideration. Activity in the 2007 Predecessor period included $257 million (net of amounts settled of $7 million) in liabilities related to certain power sales agreements (see Note 18 to Financial Statements), net of a $102 million cost paid related to a structured economic hedge transaction in the long-term hedging program and $74 million in natural gas provided under physical swap transactions. Activity in 2005 included $75 million of natural gas received under physical swap transactions and a $12 million charge related to nonperformance by a coal contract counterparty. (f) 57
Slide 66: In addition to the effect on net income of recording unrealized mark-to-market gains and losses that are reflected in the table above, similar effects arise in the recording of unrealized ineffectiveness gains and losses associated with commodity-related positions accounted for as cash flow hedges. These effects on net income, which include reversals of previously recorded unrealized ineffectiveness gains and losses to offset realized gains and losses upon settlement, are reflected in the balance sheet as changes in cash flow hedge and other derivative assets and liabilities (see Note 18 to Financial Statements). The total pretax effect of recording unrealized gains and losses in net income related to commodity contracts under SFAS 133 is summarized as follows: Combined (a) Successor October 11, 2007 through December 31, 2007 $(1,556) ─ $(1,556) Predecessor January 1, 2007 through October 10, 2007 $ (812) 90 $ (722) Year Ended December 31, 2007 Unrealized gains/(losses) related to contracts marked-to-market ........................................... Ineffectiveness gains/(losses) related to cash flow hedges (b).............................................. Total unrealized gains (losses) related to commodity contracts ..................................... __________________________ (a) (b) $(2,368) 90 $(2,278) Year Ended December 31, 2006 $ 33 239 $ 272 Year Ended December 31, 2005 $ 9 (27) $ (18) See “Presentation and Analysis of Results” above for explanation of this non-GAAP presentation. See Note 18 to Financial Statements. These amounts are reported in the “risk management and trading activities” component of revenues. Maturity Table — Following are the components of the net commodity contract liability at December 31, 2007: Successor Amount Net commodity contract liability .................................................................................................... Premiums paid under option agreements........................................................................................ Net receipts of natural gas under physical swap transactions ........................................................ Amount of net liability arising from recognition of fair values........................................ $ (1,917) (103) 11 $ (2,009) 58
Slide 67: The following table presents the net commodity contract liability arising from recognition of fair values as of December 31, 2007, scheduled by the source of fair value and contractual settlement dates of the underlying positions. See Note 22 to Financial Statements for fair value disclosures required under SFAS 157. Maturity dates of unrealized commodity contract liabilities at December 31, 2007 (Successor) Less than Excess of 1 year 1-3 years 4-5 years 5 years Total Source of fair value (a) Prices actively quoted............................... Prices provided by other external sources .................................................. Prices based on models............................. Total.......................................................... Percentage of total fair value.................... (a) $ 54 77 (79) $ 52 (3)% $ (41) (476) (34) $(551) 27% $ (44) (923) (27) $(994) 50% $ ─ $ (31) (353) (163) $(516) 26% (1,675) (303) $(2,009) 100% Under this analysis, a contract can have more than one source of fair value. In such cases, the value of the contract is segregated by source of value. The “prices actively quoted” category reflects only exchange traded contracts for which active quotes are readily available. The “prices provided by other external sources” category represents forward commodity positions valued using prices for which over-the-counter broker quotes are available. Over-the-counter quotes for power in ERCOT generally extend through 2012 and over-the-counter quotes for natural gas generally extend through 2015, depending upon delivery point. The “prices based on models” category contains the value of all nonexchange traded options, valued using option pricing models. In addition, this category contains other contractual arrangements that may have both forward and option components, as well as other contracts that are valued using long-term pricing models. In many instances, these contracts can be broken down into their component parts and each component valued separately. Components valued as forward commodity positions are included in the “prices provided by other external sources” category. Components valued as options are included in the “prices based on models” category. 59
Slide 68: COMPREHENSIVE INCOME – Continuing Operations Cash flow hedge activity reported in other comprehensive income from continuing operations included (all amounts after-tax): Combined (a) Successor Period from October 11, 2007 through December 31, 2007 Period From January 1, 2007 through October 10, 2007 Predecessor Year Ended December 31, 2007 Net increase (decrease) in fair value of cash flow hedges held at end of period: Commodities..................................................................... Financing – interest rate swaps ........................................ Derivative value net losses (gains) reported in net income that relate to hedged transactions recognized in the period: Commodities..................................................................... Financing – interest rate swaps ........................................ Total income (loss) effect of cash flow hedges reported in other comprehensive income from continuing operations .. $ Year Ended December 31, 2006 2005 $ (243) (182) (425) (135) 6 (129) (554) $ 5 (182) (177) ─ ─ ─ $ (248) ─ (248) (135) 6 (129) $ 568 ─ 568 (23) 6 (17) $ (47) ─ (47) 64 6 70 $ (177) $ (377) $ 551 $ 23 __________________ (a) See “Presentation and Analysis of Results” above for explanation of this non-GAAP presentation. All amounts included in accumulated other comprehensive income as of October 10, 2007, which totaled $53 million in net gains, were eliminated as part of purchase accounting. EFH Corp. has historically used, and expects to continue to use, derivative instruments that are effective in offsetting future cash flow variability in interest rates and energy commodity prices. Amounts in accumulated other comprehensive income include (i) the value of unsettled transactions accounted for as cash flow hedges (for the effective portion), based on current market conditions, and (ii) the value of dedesignated and terminated cash flow hedges at the time of such dedesignation, less amounts reclassified to earnings as the original hedged transactions are recognized, unless the hedged transactions become probable of not occurring. The effects of the hedge will be recorded in the statement of income as the hedged transactions are actually settled and affect earnings. Also see Note 18 to Financial Statements. 60
Slide 69: FINANCIAL CONDITION Liquidity and Capital Resources Cash Flows — Cash flows from operating, financing and investing activities included: Combined (a) Successor Period from October 11, 2007 through December 31, 2007 $ (1,223) ─ ─ ─ (1,223) Period From January 1, 2007 through October 10, 2007 $ 1,258 ─ ─ ─ 1,258 Predecessor Year Ended December 31, 2007 Cash flows — operating activities Net income (loss) ..................................................................... Loss from discontinued operations, net of tax effect........... Extraordinary loss, net of tax effect ..................................... Cumulative effect of changes in accounting principles, net of tax effect ................................................................. Income from continuing operations before cumulative effect of changes in accounting principles ........................... Adjustments to reconcile income from continuing operations to cash provided by (used in) operating activities: Depreciation and amortization ............................................. Deferred income tax expense (benefit) – net ....................... Impairment of natural gas-fueled generation plants ............ Customer appreciation bonus charge (net of amounts credited to customers in 2006).......................................... Net effect of unrealized mark-to-market valuations – losses (gains)..................................................................... Other, net .............................................................................. Changes in operating assets and liabilities ....................... Cash provided by (used in) operating activities ............... Cash flows — financing activities Net issuances and (repayments and repurchases) of borrowings, including premiums and discounts .................. Decrease in income tax-related note payable to Oncor (see Note 24 to Financial Statements).................................. Distributions paid to parent...................................................... Excess tax benefit on stock-based incentive compensation .... Cash provided by (used in) financing activities ............... Cash flows — investing activities Net advances to affiliates. ........................................................ Capital expenditures, including purchases of miningrelated assets and nuclear fuel.............................................. Proceeds from TCEH senior secured letter of credit facility deposited with bank ................................................. Reduction of restricted cash..................................................... Proceeds from pollution control revenue bonds deposited with trustee ........................................................................... Other......................................................................................... Cash used in investing activities....................................... Cash used in discontinued operations ......................................... Net change in cash and cash equivalents..................................... $ $ 35 ─ ─ ─ 35 Year Ended December 31, 2006 2005 $ 2,394 ─ ─ ─ 2,394 $ 1,364 8 50 8 1,430 748 (532) ─ ─ 2,278 38 (1,694) 873 442 (451) ─ ─ 1,556 18 (734) (392) 306 (81) ─ ─ 722 20 (960) 1,265 400 162 198 122 (272) 88 1,593 4,685 372 656 ─ ─ 18 (28) (614) 1,834 24,569 (33) (22,135) ─ 2,401 76 (2,104) (1,250) 215 ─ (3) (3,066) ─ 208 $ 22,502 (9) (21,000) ─ 1,493 9 (519) (1,250) 14 ─ 4 (1,742) ─ (641) $ 2,067 (24) (1,135) ─ 908 67 (1,585) ─ 201 ─ (7) (1,324) ─ 849 $ (374) (40) (1,144) 11 (1,547) (1,996) (908) ─ ─ (240) 1 (3,143) ─ (5) $ 629 (40) (700) 7 (104) (1,470) (366) ─ ─ ─ 53 (1,783) (5) (58) _______________ (a) See “Presentation and Analysis of Results” above for explanation of this non-GAAP presentation. 61
Slide 70: The $3.812 billion decrease in cash provided by operating activities in 2007 reflected: • • • • an unfavorable change of $1.747 billion in net margin deposits due to the effect of higher forward natural gas prices, primarily related to the long-term hedging program ($614 million related to the Successor periods that was largely funded by the Commodity Collateral Posting Facility); an unfavorable change in federal income taxes payable to EFH Corp., including 2007 payments of $190 million expected to be refunded in 2008, payment of $563 million in 2007 related to 2006, and a $352 million refund received in 2006 related to 2005; lower operating earnings after taking into account noncash items such as depreciation and amortization, deferred federal income tax effects and unrealized mark-to-market valuations, and an unfavorable change in working capital (accounts receivable, accounts payable and inventories) balances of $343 million primarily due to the effects of lower natural gas prices, as cash flows in 2006 included the collection of higher wholesale natural gas and electricity receivables that resulted from higher prices in late 2005. The $2.851 billion increase in cash provided by operating activities in 2006 reflected: • a favorable change of $1.685 billion in income taxes payable to EFH Corp. due to the combined effect of an increase in the 2006 liability resulting from higher taxable earnings (approximately $500 million in accrued income taxes related to 2006 taxable earnings was paid largely in the first quarter of 2007) and a refund received in 2006 related to 2005 reflecting a mark-to-market tax deduction related to a power sales agreement; a favorable change of $503 million in net margin deposits, primarily reflecting amounts received from counterparties related to natural gas positions in the long-term hedging program; higher operating earnings after taking into account noncash items, and a favorable change of $224 million in working capital (accounts receivable, accounts payable and inventories) driven by higher wholesale natural gas and electricity receivables in 2005 due to higher prices in the fourth quarter of 2005. • • • The year-to-year increases in capital expenditures over the three-year period ended December 31, 2007 were driven by spending related to the development and construction of new generation facilities. Depreciation and amortization expense reported in the statement of cash flows exceeds the amount reported in the statement of income by $127 million, $53 million, $66 million and $59 million for the period from October 11, 2007 through December 31, 2007, the period from January 1, 2007 through October 10, 2007, and the years 2006 and 2005, respectively. For the 2007, 2006 and 2005 Predecessor periods, this difference represents amortization of nuclear fuel, which is reported as fuel costs in the statement of income consistent with industry practice. For the 2007 Successor period, this difference also represents amortization of intangible net assets and debt fair value discounts arising from purchase accounting that is reported in various other income statement line items including operating revenues, fuel and purchased power costs and interest expense. Liquidity Needs, Including Capital Expenditures — Capital expenditures, including capitalized interest, for 2008 are expected to total approximately $2.2 billion for investment in TCEH’s generation facilities and include: • • • approximately $1.3 billion for construction of one generation unit at Sandow and two generation units and mine development; approximately $700 million for major maintenance capital, primarily in existing generation operations, and approximately $200 million for environmental expenditures related to existing generation units. 62
Slide 71: Because its businesses are capital intensive, TCEH expects to rely over the long-term upon access to financial markets as a significant source of liquidity for capital requirements not satisfied by cash-on-hand or operating cash flows. The inability to raise capital on favorable terms or failure of counterparties to perform under credit, hedging or other financial agreements, particularly considering the current uncertainty in the financial markets, could impact TCEH’s ability to sustain and grow its businesses and would likely increase capital costs. TCEH expects cash flows from operations combined with availability under its credit facilities discussed in Note 15 to Financial Statements to provide sufficient liquidity to fund its current obligations, projected working capital requirements, any restructuring obligations and capital spending for a period that includes the next twelve months. Additional Financial Market Uncertainty Considerations — As of December 31, 2007, TCEH and its subsidiaries had no debt that was insured. TCEH had $445.5 million of tax-exempt long-term debt backed by $455 million in letters of credit expiring in 2014. If there is a loss of confidence in the creditworthiness of the letter of credit provider and TCEH were consequently unable to substitute letters of credit from an acceptable bank, TCEH could experience an increase in its interest expense. Credit Facilities — As of March 14, 2008, TCEH had $2.466 billion of liquidity available under committed revolving credit facilities for working capital and other general corporate purposes, approximately $1.831 billion of liquidity available under the committed Delayed Draw Term Loan facility to fund certain specified capital expenditures and related expenses (of which $270 million represents expenditures already incurred for which funding is available), and unlimited availability under the committed TCEH Commodity Collateral Posting Facility. See Note 15 to Financial Statements for discussion of the facilities. Liquidity Effects of Risk Management and Trading Activities — Risk management and trading transactions typically require collateral to support potential future payment obligations. In particular, commodity transactions typically require a counterparty to post collateral if the forward price of the underlying commodity moves such that the hedging or trading instrument is out-of-the-money to such counterparty. TCEH and its subsidiaries use cash and letters of credit and other collateral structures to satisfy such collateral obligations. In addition, in connection with the Merger, TCEH entered into the TCEH Commodity Collateral Posting Facility, which is an uncapped senior secured revolving credit facility that will fund the cash collateral posting requirements due to trading counterparties for a significant portion of the positions in the long-term hedging program not otherwise secured by a first-lien in the assets of TCEH. This facility is secured on a pari passu basis with the TCEH Senior Secured Facilities. See Note 15 to Financial Statements for more information about this facility. The aggregate principal amount of this facility is determined by the out-of-the-money exposure, regardless of the amount of such exposure, on a portfolio of certain natural gas swap transactions. At February 29, 2008, approximately 94% of TCEH’s hedging transactions were secured by a first-lien interest in the assets of TCEH (including the transactions covered by the TCEH Commodity Collateral Posting Facility) that is pari passu with the TCEH Senior Secured Facilities. As of February 29, 2008, TCEH has received or posted cash and letters of credit for risk management and trading activities as follows: • • • $210 million in cash has been posted with counterparties for exchange cleared transactions (including initial margin), as compared to $672 million received as of December 31, 2006, $884 million in cash has been posted with counterparties for over-the-counter and other non-exchanged cleared transactions, as compared to $2 million received as of December 31, 2006, and $694 million in letters of credit have been posted with counterparties, as compared to $455 million posted as of December 31, 2006. Borrowings under the TCEH Commodity Collateral Posting Facility funded $1.4 billion of the above cash postings. 63
Slide 72: With respect to exchange cleared transactions, these transactions typically require initial margin (i.e. the upfront cash and/or letter of credit posted to take into account the size and maturity of the positions and credit quality) in addition to variation margin (i.e. the daily cash margin posted to take into account changes in the value of the underlying commodity). The amount of initial margin required is generally defined by exchange rules. Clearing agents, however, typically have the right to request additional initial margin based on various factors including market depth, volatility and credit quality, which may be in the form of cash, letters of credit, a guaranty or other forms as negotiated with the clearing agent. With respect to cash collateral that is received, such cash collateral is used by TCEH for working capital and other corporate purposes, including reducing shortterm borrowings under credit facilities. Such counterparties generally have the right to substitute letters of credit for such cash collateral. In such event, the cash collateral previously posted would be returned to such counterparties thereby reducing TCEH’s liquidity. As a result of the long-term hedging program, increases in natural gas prices result in increased cash collateral and letter of credit margin requirements. As a representative example, as of March 14, 2008, for each $1.00 per MMBtu increase in natural gas prices, TCEH’s cash collateral posting requirements associated with the long-term hedging program would increase by approximately $1.0 billion. Of this amount, approximately $0.9 billion would be funded by the TCEH Commodity Collateral Posting Facility. New Financing Arrangements — See Note 15 to Financial Statements for details of financing arrangements entered into at the Merger closing date to fund the Merger and provide liquidity subsequent to the Merger. Covenants and Restrictions under Financing Arrangements — Each of the TCEH Senior Secured Facilities and indentures governing the TCEH Senior Notes and Senior Toggle Notes contains covenants that could have a material impact on the liquidity and operations of TCEH and its subsidiaries. A brief description of certain of these covenants is provided below. See also Note 15 to Financial Statements for additional discussion of the covenants contained in these financing arrangements. When the term “Adjusted EBITDA” is referenced in the covenant description below, it is a reference to, and generally synonymous with, the term “Consolidated EBITDA” that is used in the TCEH Senior Secured Facilities and a reference to, and generally synonymous with, the term “EBITDA” that is used in the indenture governing the TCEH Notes. Adjusted EBITDA, as defined in the indentures governing the TCEH Notes, for the year ended December 31, 2007 totaled $3.7 billion for TCEH. See Appendix A for a reconciliation of net income to Adjusted EBITDA for TCEH for the years ended December 31, 2007 and 2006. See glossary for definition of Adjusted EBITDA. Maintenance Covenant — Under the TCEH Senior Secured Facilities, TCEH and its restricted subsidiaries will be required to maintain a consolidated secured debt to Adjusted EBITDA ratio (as defined in the TCEH Senior Secured Facilities) measured over a rolling four-quarter measurement period, which cannot exceed 7.25 to 1.00 for the first measurement period ending September 30, 2008, declining over time to 5.75 to 1.00 for the measurement periods ending March 31, 2014 and thereafter. In the event that TCEH fails to comply with this ratio, it has the right to cure its non-compliance by soliciting a cash investment in an amount necessary to become compliant. Debt Incurrence Covenant — Under the indenture governing the EFH Corp. Notes, TCEH and its restricted subsidiaries are not permitted to incur indebtedness or issue certain classes of stock unless, on a pro forma basis, after giving effect to such incurrence or issuance, the fixed charge coverage ratio (as defined in the indenture) on a consolidated basis for TCEH and its restricted subsidiaries is at least 2.0 to 1.0 or such incurrence or issuance is otherwise permitted in the indenture. The fixed charge coverage ratio is generally defined as the ratio of Adjusted EBITDA of TCEH to fixed charges of TCEH, in each case, on a consolidated basis. Under the TCEH Senior Secured Facilities, TCEH and its restricted subsidiaries are generally not permitted to incur indebtedness unless, on a pro forma basis, after giving effect to such incurrence, the Adjusted EBITDA to consolidated interest expense ratio (as defined in the credit agreement) is at least 2.0 to 1.0 or such incurrence is otherwise permitted in the TCEH Senior Secured Facilities. 64
Slide 73: Under the indenture governing the TCEH Notes, TCEH and substantially all of its subsidiaries are not permitted to incur indebtedness or issue certain classes of stock unless, on a pro forma basis, after giving effect to such incurrence or issuance, the fixed charge coverage ratio (as defined in the applicable debt agreements) on a consolidated basis for TCEH and its restricted subsidiaries is at least 2.0 to 1.0 or such incurrence or issuance is otherwise permitted in the applicable debt agreements. The fixed charge coverage ratio is generally defined as the ratio of Adjusted EBITDA of TCEH to fixed charges of TCEH, in each case, on a consolidated basis. Restricted Payments/Limitation on Investments — Under the TCEH Senior Secured Facilities and indentures governing the TCEH Notes, TCEH and its restricted subsidiaries have limitations (subject to certain exceptions) on making restricted payments or investments (as defined in the applicable debt agreements), including certain dividends, equity repurchases, debt repayments, extensions of credit and certain types of investments. Long-Term Debt-Related Activity — See Note 15 to Financial Statements for further detail of long-term debt and other financing arrangements, including the long-term debt TCEH issued or reacquired or on which it made scheduled principal payments in 2007. Capitalization — The capitalization ratios of TCEH at December 31, 2007, consisted of 82.0% long-term debt, less amounts due currently, and 18.0% membership interests. Total debt to capitalization, including shortterm debt, was 82.4% and 36.7% at December 31, 2007 and 2006, respectively. Sale of Accounts Receivable — TCEH participates in an accounts receivable securitization program established by EFH Corp., the activity under which is accounted for as a sale of accounts receivable in accordance with SFAS 140. Under the program, subsidiaries of TCEH sell trade accounts receivable to TXU Receivables Company, a consolidated wholly-owned bankruptcy-remote direct subsidiary of EFH Corp., which sells undivided interests in the purchased accounts receivable for cash to special purpose entities established by financial institutions. All new trade receivables under the program generated by TCEH are continuously purchased by TXU Receivables Company with the proceeds from collections of receivables previously purchased. Funding to TCEH under the program totaled $363 million and $541 million at December 31, 2007 and 2006, respectively. The funding decrease reflects $116 million of retail customer deposits reducing funding availability due to the downgrade in TCEH’s credit ratings and lower accounts receivable balances driven by price discounts. See Note 14 to Financial Statements for a more complete description of the program including the amendments made in connection with the Merger, the impact of the program on the financial statements for the periods presented and the contingencies that could result in a reduction of funding available under the program. 65
Slide 74: Financial Covenants, Credit Rating Provisions and Cross Default Provisions — The terms of certain financing arrangements of TCEH contain financial covenants that require maintenance of leverage ratios and/or contain minimum net worth covenants. As of December 31, 2007, TCEH was in compliance with all such applicable covenants. Credit Ratings — The rating agencies assign issuer credit ratings for EFH Corp. and its subsidiaries. The issuer credit ratings as of March 14, 2008 for EFH Corp. and its subsidiaries, except for Oncor, are B-, B2 and B by S&P, Moody’s and Fitch, respectively. Additionally, the rating agencies assign credit ratings on certain debt securities issued by EFH Corp. and its subsidiaries. The credit ratings assigned for debt securities issued by TCEH as of March 21, 2008 are presented below: TCEH (Senior Secured) ........................... TCEH (Senior Unsecured) (a) ................. TCEH (Unsecured) .................................. (a) S&P B+ CCC CCC Moody’s Ba3 B3 Caa1 Fitch BB B+ B- TCEH Cash Pay Notes and TCEH Toggle Notes The senior unsecured ratings for TCEH reflect multi-notch downgrades from all rating agencies as a result of the significant amount of debt incurred by TCEH in connection with the Merger in October 2007. All three rating agencies placed these ratings on "stable outlook". A rating reflects only the view of a rating agency, and is not a recommendation to buy, sell or hold securities. Any rating can be revised upward or downward at any time by a rating agency if such rating agency decides that circumstances warrant such a change. Material Credit Rating Covenants and Credit Worthiness Effects on Liquidity — Based upon terms of certain retail and wholesale commodity contracts, as of February 29, 2008 TCEH could have been required to post up to $162 million in additional collateral support. Certain transmission and distribution utilities in Texas have tariffs in place to assure adequate credit worthiness of any REP to support the REP’s obligation to collect securitization bond-related (transition) charges on behalf of the utility. Under these tariffs, as a result of the previous downgrade of TCEH's credit rating to below investment grade, TCEH is required to post collateral support in an amount equal to estimated transition charges over specified time periods. The amount of collateral support required to be posted, as well as the time period of transition charges covered, varies by utility. Based on requests to post collateral support from utilities that have been received by TCEH and its subsidiaries as of February 29, 2008, TCEH has posted collateral support to the applicable utilities in an aggregate amount equal to $24 million, with $14 million of this amount posted for the benefit of Oncor. The PUCT has rules in place to assure adequate credit worthiness of any REP. Under these rules, TCEH maintains availability under its credit facilities of an amount no less than the aggregate amount of customer deposits and any advanced payments received from customers, and maintains equity in an amount that exceeds the minimum required by PUCT rules. As of March 14, 2008, the amount of customer deposits received from customers held by TCEH's REP subsidiaries totaled approximately $123 million. The RRC has rules in place to assure adequate credit worthiness of parties that have mining reclamation obligations. Under these rules, should the RRC determine that the credit worthiness of Luminant Generation Company LLC is not sufficient to support Luminant’s reclamation obligations, TCEH may be required to post cash or letter of credit collateral support in an amount currently estimated to be approximately $600 million to $800 million. This amount would vary depending upon numerous factors, including Luminant Generation Company LLC’s credit worthiness and the level of mining reclamation obligations. 66
Slide 75: ERCOT also has rules in place to assure adequate credit worthiness of parties that schedule power on the ERCOT System. Under these rules, TCEH has posted collateral support totaling $91 million as of December 31, 2007 (which is subject to periodic adjustments). Oncor and Texas Holdings agreed to the terms of a stipulation with major interested parties to resolve all outstanding issues in the PUCT review related to the Merger. As part of this stipulation, TCEH will post a letter of credit in an amount equal to $170 million to secure TXU Energy’s payment obligations to Oncor if two or more of Oncor’s credit ratings fall below investment grade. Other arrangements of TCEH, including the accounts receivable securitization program and certain leases, contain terms pursuant to which the interest rates charged under the agreements may be adjusted depending on credit ratings. Material Cross Default Provisions — Certain financing arrangements contain provisions that may result in an event of default if there were a failure under other financing arrangements to meet payment terms or to observe other covenants that could or does result in an acceleration of payments due. Such provisions are referred to as “cross default” provisions. A default by TCEH or any restricted subsidiary in respect of indebtedness, excluding indebtedness relating to the trade receivables program, in an aggregate amount in excess of $200 million may result in a cross default under the TCEH Senior Secured Facilities. Under these facilities such a default may cause the maturity of outstanding balances ($21.85 billion at March 14, 2008) under such facility to be accelerated. The indenture governing the $6.75 billion of TCEH Notes contains a cross acceleration provision where a payment default at maturity or on acceleration of principal indebtedness under any instrument or instruments of TCEH and any of its restricted subsidiaries in the aggregate amount equal to or greater than $250 million may cause the acceleration of the TCEH Notes. The accounts receivable securitization program contains a cross default provision with a threshold of $200 million that applies in the aggregate to the originators, any parent guarantor of an originator and any affiliate of TCEH acting as collection agent under the program. TXU Receivables Company and EFH Corporate Services Company (formerly TXU Business Services Company), as collection agent, in the aggregate have a cross default threshold of $50,000. If any of the aforementioned defaults on indebtedness of the applicable threshold were to occur, the program could terminate. TCEH and its subsidiaries enter into energy-related and financial contracts, the master forms of which contain provisions whereby an event of default or acceleration of settlement would occur if TCEH or those subsidiaries were to default under an obligation in respect of borrowings in excess of thresholds, which vary, stated in the contracts. The entities whose default would trigger cross default vary depending on the contract. Each of TCEH’s natural gas hedging agreements that are secured with a lien on its assets on a pari passu basis with the TCEH Senior Secured Facilities contains a cross default provision. In the event of a default by TCEH or any of its subsidiaries relating to indebtedness in an amount equal to or greater than $250 million, then each counterparty under these hedging agreements would have the right to terminate its hedge agreement with TCEH and require all outstanding obligations under such agreement to be settled. In the event of a default by TCEH relating to indebtedness in an amount equal to or greater than $200 million that results in the acceleration of such debt, then each counterparty under TCEH's interest rate swap agreements with a notional value totaling $15.05 billion would have the right to terminate its interest rate swap agreement with TCEH and require all outstanding obligations under such agreement to be settled. Other arrangements, including leases, have cross default provisions, the triggering of which would not result in a significant effect on liquidity. 67
Slide 76: Long-Term Contractual Obligations and Commitments — The following table summarizes TCEH’s contractual cash obligations as of December 31, 2007 (see Note 15 to Financial Statements for additional disclosures regarding these long-term debt and noncancelable purchase obligations). Less Than One Year 153 2,445 64 3,024 $ 5,686 $ One to Three Years $ 600 4,838 127 3,184 $ 8,749 Three to Five Years $ 1,071 4,755 155 2,081 $ 8,062 More Than Five Years $26,803 6,052 384 1,318 $34,557 Contractual Cash Obligations Long-term debt – principal (a)................................................................ Long-term debt – interest (b) .................................................................. Operating and capital leases (c) .............................................................. Obligations under commodity purchase and services agreements (d) ... Total contractual cash obligations (e)............................................. ________________________ (a) (b) (c) (d) (e) Total $28,627 18,090 730 9,607 $57,054 Excludes capital lease obligations and fair value discounts related to purchase accounting. Includes net amounts payable under interest rate swaps. Variable interest payments and net amounts payable under interest rate swaps are calculated based on interest rates in effect at December 31, 2007. Includes short-term noncancelable leases. Includes capacity payments, nuclear fuel and natural gas take-or-pay contracts, coal contracts, business services and nuclear-related outsourcing and other purchase commitments. Amounts presented for variable priced contracts assumed the year-end 2007 price remained in effect for all periods except where contractual price adjustment or index-based prices were specified. Table does not include cancellable contracts associated with the construction of new generation facilities with obligations totaling approximately $1.6 billion through 2010. See Note 16 to Financial Statements. The following contractual obligations were excluded from the table above: • • • • • contracts between affiliated entities and intercompany debt; individual contracts that have an annual cash requirement of less than $1 million (however, multiple contracts with one counterparty that are more than $1 million on an aggregated basis have been included); contracts that are cancelable without payment of a substantial cancellation penalty; employment contracts with management, and liabilities related to uncertain tax positions discussed in Note 10 to Financial Statements. Guarantees — See Note 16 to Financial Statements for details of guarantees. OFF BALANCE SHEET ARRANGEMENTS Subsidiaries of TCEH participate in an accounts receivable securitization program established by EFH Corp. See discussion above under “Sale of Accounts Receivable” and in Note 14 to Financial Statements. Also see Note 16 to Financial Statements regarding guarantees. COMMITMENTS AND CONTINGENCIES See Note 16 to Financial Statements for discussion of commitments and contingencies. CHANGES IN ACCOUNTING STANDARDS See Notes 1, 10, 20 and 22 to Financial Statements for a discussion of changes in accounting standards. 68
Slide 77: REGULATION AND RATES Regulatory Investigations See Note 16 to Financial Statements for discussion of regulatory investigations. 2007 Texas Legislative Session The Texas Legislature convened its regular biennial session on January 9, 2007 and adjourned on May 28, 2007. The session was not a “sunset” session for the PUCT, so there was no requirement that the Legislature consider any electric industry-related bills. However, various measures pertaining to the electric industry were considered. The primary measures that were under consideration and would have materially affected EFH Corp.’s businesses and potentially the Merger were ultimately not enacted. New PURA provisions were enacted that ensure the PUCT shall have authority to enforce commitments made in a filing under PURA Section 14.101 on or after May 1, 2007 (such as the filing made by Texas Holdings and Oncor in April 2007 and approved by the PUCT in February 2008). REP Certification Rulemaking In October 2007, the PUCT voted to approve revisions to its REP certification rule. The approved revisions provide that REPs that serve at least one million Texas residential customers are subject to additional or different financial requirements as determined by the PUCT unless they meet one of the following specified additional financial requirements: (1) a credit rating of “BBB” for S&P or “Baa2” for Moody’s, or their financial equivalent (satisfied through the REP’s own credit rating, a guaranty of a parent or controlling shareholder with the required credit rating, or a bond, guaranty or corporate commitment of another company with the required credit rating); (2) an increased amount of equity (defined as assets in excess of liabilities); or (3) an increased amount of unused cash resources. The additional financial requirements have not significantly increased TCEH’s cost of doing business. Wholesale Market Design In August 2003, the PUCT adopted a rule that, when implemented, will alter the wholesale market design in the ERCOT market. The rule requires ERCOT: • • • • • • • to use a stakeholder process to develop a new wholesale market model; to operate a voluntary day-ahead energy market; to directly assign all congestion rents to the resources that caused the congestion; to use nodal energy prices for resources; to provide information for energy trading hubs by aggregating nodes; to use zonal prices for loads, and to provide congestion revenue rights (but not physical rights). ERCOT currently has a zonal wholesale market structure consisting of four geographic zones. The proposed location-based congestion-management market is referred to as a “nodal” market because wholesale pricing would differ across the various nodes on the transmission grid. The implementation of a nodal market is being done in conjunction with transmission improvements designed to reduce current congestion. In 2006, the PUCT approved a set of Nodal Protocols, which was filed by ERCOT and describes the operation of a wholesale nodal market, and set an implementation date of no later than January 1, 2009. In August 2006, the PUCT adopted an interim order approving ERCOT’s application for a surcharge imposed on all Qualified Scheduling Entities in the ERCOT market (including subsidiaries of TCEH) for the purpose of financing 38% of ERCOT’s expected nodal implementation costs. The surcharge took effect on October 1, 2006. Additionally, at its January 15, 2008 meeting, the ERCOT Board of Directors agreed to request an increase in the surcharge to be effective June 1, 2008. ERCOT filed this request at the PUCT in March 2008. EFH Corp. expects that the annual impact of the surcharge will be approximately $10 to $11 million in additional expenses; however, EFH Corp. is unable to predict the ultimate impact of the proposed nodal wholesale market design on its operations or financial results. 69
Slide 78: Price-to-Beat Rates As a result of the legislation that restructured the electric utility industry in Texas to provide for retail competition (1999 Restructuring Legislation), effective January 1, 2002, REPs (such as TXU Energy) affiliated with electricity delivery utilities were required to charge price-to-beat rates (adjusted for fuel factor changes), established by the PUCT, to residential and small business customers located in their historical service territories. In accordance with certain phase out provisions of the legislation, beginning January 1, 2005, TXU Energy offered rates different from the price-to-beat rate to all customer classes, but was required to make the price-to-beat rate available for residential and small business customers in its historical service territory until January 1, 2007. Under PUCT rules and because of rising natural gas prices, in 2005 TXU Energy petitioned and received approval from the PUCT for price-to-beat rate increases implemented as follows (percentage represents increase in the average monthly residential bill): • • 10% and 12% in May and October of 2005, respectively. The latter reflected a voluntary discount that expired December 31, 2005, and 12% in January of 2006 representing the expiration of the voluntary discount. As of January 1, 2007, TXU Energy is no longer required to offer the price-to-beat rate to any of its customer classes. Summary Although TCEH cannot predict future regulatory or legislative actions or any changes in economic and securities market conditions, no changes are expected in trends or commitments, other than those discussed in this report, which might significantly alter its basic financial position, results of operations or cash flows. 70
Slide 79: Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Market risk is the risk that TCEH may experience a loss in value as a result of changes in market conditions affecting commodity prices and interest rates, to which TCEH is exposed in the ordinary course of business. TCEH’s exposure to market risk is affected by a number of factors, including the size, duration and composition of its energy and financial portfolio, as well as the volatility and liquidity of markets. TCEH enters into instruments such as interest rate swaps to manage interest rate risk related to its indebtedness, as well as exchange traded, over-the-counter contracts and other contractual commitments to manage commodity price risk as part of its wholesale activities. TCEH’s interest rate risk discussed below was significantly affected by debt issuances in connection with the Merger. Risk Oversight TCEH’s wholesale operation manages the commodity price, counterparty credit and operational risk related to the unregulated energy business within limitations established by senior management and in accordance with TCEH’s overall risk management policies. Interest rate risk is managed centrally by the corporate treasury function. Market risks are monitored daily by risk management groups that operate and report independently of the wholesale commercial operations, utilizing defined practices and analytical methodologies. These techniques measure the risk of change in value of the portfolio of contracts and the hypothetical effect on this value from changes in market conditions and include, but are not limited to, Value at Risk (VaR) methodologies. Key risk control activities include, but are not limited to, credit review and approval, operational and market risk measurement, validation of transaction capture, portfolio valuation and daily portfolio reporting, including mark-to-market valuation, VaR and other risk measurement metrics. TCEH has a corporate risk management organization that is headed by a Chief Risk Officer. The Chief Risk Officer, through his designees, enforces all applicable risk limits, including the respective policies and procedures to ensure compliance with such limits and evaluates the risks inherent in the various businesses of TCEH and their associated transactions. Commodity Price Risk TCEH’s businesses are subject to the inherent risks of market fluctuations in the price of electricity, natural gas and other energy-related products they market or purchase. TCEH’s businesses actively manage their portfolio of owned generation assets, fuel supply and retail sales load to mitigate the near-term impacts of these risks on results of operations. These businesses, similar to other participants in the market, cannot fully manage the long-term value impact of structural declines or increases in natural gas and power prices and spark spreads (differences between the market price of electricity and its cost of production). In managing energy price risk, subsidiaries of TCEH enter into a variety of market transactions including, but not limited to, short- and long-term contracts for physical delivery, exchange traded and over-the-counter financial contracts and bilateral contracts with customers. Activities in the wholesale operations include hedging, the structuring of long-term contractual arrangements and proprietary trading. The wholesale operation continuously monitors the valuation of identified risks and adjusts positions based on current market conditions. Valuation adjustments are established in recognition that certain risks exist until full delivery and settlement of energy has occurred, counterparties have fulfilled their financial commitments and related contracts have either matured or are settled. TCEH strives to use consistent assumptions regarding forward market price curves in evaluating and recording the effects of commodity price risk. Long-Term Hedging Program — See discussion above under "Significant Developments" for an update of the program, including potential effects on reported results. 71
Slide 80: VaR Methodology — A VaR methodology is used to measure the amount of market risk that exists within the portfolio under a variety of market conditions. The resultant VaR produces an estimate of a portfolio’s potential for loss given a specified confidence level and considers among other things, market movements utilizing standard statistical techniques given historical and projected market prices and volatilities. A Monte Carlo simulation methodology is used to calculate VaR and is considered by management to be the most effective way to estimate changes in a portfolio’s value based on assumed market conditions for liquid markets. The use of this method requires a number of key assumptions, such as use of (i) an assumed confidence level; (ii) an assumed holding period (i.e. the time necessary for management action, such as to liquidate positions); and (iii) historical estimates of volatility and correlation data. Trading VaR — This measurement estimates the potential loss in fair value, due to changes in market conditions, of all contracts entered into for trading purposes based on a 95% confidence level and an assumed holding period of five to 60 days. Year Ended December 31, 2007 Month-end average Trading VaR: .................................... Month-end high Trading VaR:........................................... Month-end low Trading VaR:............................................ $ $ $ 9 14 6 Year Ended December 31, 2006 $ $ $ 12 30 5 VaR for Energy-Related Contracts Subject to Mark-to-Market (MtM) Accounting — This measurement estimates the potential loss in fair value, due to changes in market conditions, of all contracts marked-to-market in net income (principally hedges not accounted for as cash flow hedges and trading positions), based on a 95% confidence level and an assumed holding period of five to 60 days. Year Ended December 31, 2007 Month-end average MtM VaR: ......................................... Month-end high MtM VaR: ............................................... Month-end low MtM VaR: ................................................ $ 1,081 $ 1,576 $ 322 Year Ended December 31, 2006 $ $ $ 149 391 5 Earnings at Risk (EaR) — This measurement estimates the potential reduction of fair value of expected pretax earnings for the years presented, due to changes in market conditions, of all energy-related contracts marked-to-market in net income and contracts not marked-to-market in net income that are expected to be settled within the fiscal year (physical purchases and sales of commodities). For this purpose, cash flow hedges are also included with transactions that are not marked-to-market in net income. A 95% confidence level and a five to 60 day holding period are assumed in determining EaR. Year Ended December 31, 2007 Month-end average EaR: ................................................... Month-end high EaR:......................................................... Month-end low EaR: .......................................................... $ 1,070 $ 1,559 $ 318 Year Ended December 31, 2006 $ $ $ 156 387 21 The increases in the risk measures (MtM VaR and EaR) above reflected the dedesignation of positions in the long-term hedging program as cash flow hedges for accounting purposes in March 2007, which resulted in the positions subsequently being marked-to-market in net income, and an increase in the number of positions in the program. 72
Slide 81: Interest Rate Risk The table below provides information concerning TCEH’s financial instruments as of December 31, 2007 and 2006 that are sensitive to changes in interest rates, which include debt obligations and interest rate swaps. TCEH has entered into interest rate swaps under which it has agreed to exchange the difference between fixedrate and variable-rate interest amounts calculated with reference to specified notional principal amounts at dates that generally coincide with interest payments. The weighted average interest rate presented is based on the rate in effect at the reporting date. Capital leases and the effects of unamortized premiums and discounts and fair value hedges are excluded from the table. See Note 15 to Financial Statements for a discussion of changes in debt obligations. Expected Maturity Date (millions of dollars, except percentages) ThereAfter Successor 2007 2007 Total Total Carrying Fair Amount Value Predecessor 2006 2006 Total Total Carrying Fair Amount Value 2008 Long-term debt (including current maturities) Fixed rate debt amount (a).............. Average interest rate ............. Variable rate debt amount .............. Average interest rate ............. Total debt........................................ Debt swapped to variable: Amount....................................... Average pay rate ................... Average receive rate.............. Debt swapped to fixed: Amount....................................... Average pay rate ................... Average receive rate.............. _________________________ (a) $ ─ ─ ─ 2009 2010 2011 2012 $ (12) ─ $ 165 8.40% $ 153 $ ─ ─ ─ $ 129 6.07% $ 170 8.40% $ 299 $ ─ ─ ─ $1,250 7.33% 8.40% $ 115 4.81% $ 186 8.39% $ 301 $ ─ ─ ─ $ 500 7.43% 8.40% $ 616 5.37% $ 186 8.39% $ 802 $ ─ ─ ─ $ 600 7.57% 8.40% $ 83 5.02% $ 186 8.39% $ 269 $ ─ ─ ─ $2,600 7.99% 8.40% $ 7,441 9.94% $ 19,362 8.29% $ 26,803 $ ─ ─ ─ $10,100 8.15% 8.40% $ 8,372 9.44% $ 20,255 8.29% $ 28,627 $ ─ ─ ─ $15,050 8.01% 8.40% $ 8,194 $ 19,908 $ 28,102 $ 2,424 6.55% $ 589 4.15% $ 3,013 $ 250 8.06% 6.13% $ ─ ─ ─ $ 2,504 ─ $ 555 ─ $ 3,059 Reflects the remarketing date and not the maturity date for certain debt that is subject to mandatory tender for remarketing prior to maturity. See Note 15 to Financial Statements for details concerning long-term debt subject to mandatory tender for remarketing. In the fourth quarter of 2007, interest rate swaps dedesignated as fair value hedges related to $250 million principal amount of debt were settled upon early extinguishment of the underlying debt. As of March 14, 2008, the potential reduction of annual pretax earnings due to a one-point increase in interest rates totaled approximately $38 million, taking into account the interest rate swaps in effect. 73
Slide 82: Credit Risk Credit Risk — Credit risk relates to the risk of loss associated with nonperformance by counterparties. TCEH and its subsidiaries maintain credit risk policies with regard to their counterparties to minimize overall credit risk. These policies require an evaluation of a potential counterparty’s financial condition, credit rating and other quantitative and qualitative credit criteria and specify authorized risk mitigation tools including, but not limited to, use of standardized master netting contracts and agreements that allow for netting of positive and negative exposures associated with a single counterparty. TCEH has documented processes for monitoring and managing credit exposure of its businesses including methodologies to analyze counterparties’ financial strength, measurement of current and potential future credit exposures and contract language that provides rights for netting and set-off. Credit enhancements such as parental guarantees, letters of credit, surety bonds and margin deposits are also utilized. Additionally, individual counterparties and credit portfolios are managed to preset limits and analyzed to assess potential credit exposure. This evaluation results in establishing credit limits or collateral requirements prior to entering into an agreement with a counterparty that creates credit exposure. Additionally, TCEH has established controls to determine and monitor the appropriateness of these limits on an ongoing basis. Prospective material adverse changes in the payment history or financial condition of a counterparty or downgrade of its credit quality result in the reassessment of the credit limit with that counterparty. This process can result in the subsequent reduction of the credit limit or a request for additional financial assurances. Credit Exposure — TCEH’s gross exposure to credit risk associated with trade accounts receivable (retail and wholesale) and net asset positions arising from hedging and trading activities totaled $1.902 billion at December 31, 2007. Gross assets subject to credit risk as of December 31, 2007 include $499 million in accounts receivable from the retail sale of electricity to residential and small business customers. The risk of material loss (after consideration of bad debt allowances) from nonperformance by these customers is unlikely based upon historical experience. Allowances for uncollectible accounts receivable are established for the potential loss from nonpayment by these customers based on historical experience and market or operational conditions. Most of the remaining credit exposure is with large business retail customers and wholesale counterparties. These counterparties include energy companies, financial institutions, electric utilities, independent power producers, oil and gas producers, local distribution companies and energy trading and marketing companies. As of December 31, 2007, the exposure to credit risk from these customers and counterparties totaled $1.403 billion taking into account standardized master netting contracts and agreements described above and $21 million in credit collateral (cash, letters of credit and other security interests) held by TCEH subsidiaries. Of this $1.403 billion net exposure, 74% is with investment grade customers and counterparties, as determined using publicly available information including major rating agencies’ published ratings and TCEH’s internal credit evaluation process. Those customers and counterparties without a S&P rating of at least BBB- or similar rating from another major rating agency are rated using internal credit methodologies and credit scoring models to estimate a S&P equivalent rating. TCEH routinely monitors and manages its credit exposure to these customers and counterparties on this basis. 74
Slide 83: The following table presents the distribution of credit exposure as of December 31, 2007, for retail trade accounts receivable from large business customers, wholesale trade accounts receivable and net asset positions arising from hedging and trading activities by investment grade and noninvestment grade, credit quality and maturity. Net Exposure by Maturity Exposure before Credit Collateral Credit Collateral Net Exposure 2 years or less Between 2-5 years Greater than 5 years Total Investment grade ................. Noninvestment grade .......... Totals.......................... Investment grade ................. Noninvestment grade .......... $ $ 1,035 389 1,424 73% 27% $ $ ― 21 21 ―% 100% $ 1,035 368 $ 1,403 74% 26% $ $ 593 254 847 $ $ 109 31 140 $ $ 333 83 416 $ 1,035 368 $ 1,403 Approximately 60% of the net $1.403 billion credit exposure has a maturity date of two years or less. TCEH does not anticipate any material adverse effect on its financial position or results of operations due to nonperformance by any customer or counterparty. TCEH had credit exposure to three counterparties each having an exposure greater than 10% of the net $1.403 billion credit exposure. These three counterparties represented 15%, 12% and 10%, respectively, of the net exposure. TCEH views its exposure to these three counterparties to be within an acceptable level of risk tolerance as they are rated investment grade; however, this concentration increases the risk that a default would have a material effect on TCEH’s net income and cash flows. TCEH is exposed to credit risk related to its long-term hedging program. Of the transactions in the program, over 94% of the volumes are with counterparties with an A credit rating or better, and 100% are at least investment grade. Additionally, under the long-term hedging program, TCEH has potential credit risk exposure concentration related to a limited number of counterparties. The hedge transactions with these counterparties contain certain credit rating provisions that would require the counterparties to post collateral in the event of significant declines in natural gas prices and a material downgrade in the credit rating of the counterparties. TCEH views the potential concentration of risk with these counterparties to be within an acceptable risk tolerance due to the strong financial profile of the counterparties and their respective A or above credit rating. 75
Slide 84: FORWARD-LOOKING STATEMENTS This report and other presentations made by TCEH contain “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. All statements, other than statements of historical facts, that are included in this report, or made in presentations, in response to questions or otherwise, that address activities, events or developments that TCEH expects or anticipates to occur in the future, including such matters as projections, capital allocation and cash distribution policy, future capital expenditures, business strategy, competitive strengths, goals, future acquisitions or dispositions, development or operation of power production assets, market and industry developments and the growth of TCEH’s business and operations (often, but not always, through the use of words or phrases such as “will likely result”, “are expected to”, “will continue”, “is anticipated”, “estimated”, “projection”, “target”, “outlook”), are forward-looking statements. Although TCEH believes that in making any such forward-looking statement its expectations are based on reasonable assumptions, any such forward-looking statement involves uncertainties and is qualified in its entirety by reference to the discussion of risk factors discussed under “Risk Factors” and the following important factors, among others, that could cause the actual results of TCEH to differ materially from those projected in such forward-looking statements: • prevailing governmental policies and regulatory actions, including those of the Texas Legislature, the Governor of Texas, the US Congress, FERC, the PUCT, the RRC, the NRC, the EPA and the TCEQ, with respect to: • allowed prices; • industry, market and rate structure; • purchased power and recovery of investments; • operations of nuclear generating facilities; • operations of mines; • acquisitions and disposal of assets and facilities; • development, construction and operation of facilities; • decommissioning costs; • present or prospective wholesale and retail competition; • changes in tax laws and policies, and changes in and compliance with environmental and safety laws and policies, including • climate change initiatives; legal and administrative proceedings and settlements; general industry trends; TCEH’s ability to attract and retain profitable customers; TCEH’s ability to profitably serve its customers given the price protection and price cuts; restrictions on competitive retail pricing; changes in wholesale electricity prices or energy commodity prices; changes in prices of transportation of natural gas, coal, crude oil and refined products; unanticipated changes in market heat rates in the ERCOT electricity market; TCEH’s ability to effectively hedge against changes in commodity prices, market heat rates and interest rates; weather conditions and other natural phenomena, and acts of sabotage, wars or terrorist activities; unanticipated population growth or decline, and changes in market demand and demographic patterns; changes in business strategy, development plans or vendor relationships; access to adequate transmission facilities to meet changing demands; unanticipated changes in interest rates, commodity prices, rates of inflation or foreign exchange rates; unanticipated changes in operating expenses, liquidity needs and capital expenditures; • • • • • • • • • • • • • • • 76
Slide 85: • • • • • • • • • • commercial bank market and capital market conditions; competition for new energy development and other business opportunities; inability of various counterparties to meet their obligations with respect to TCEH’s financial instruments; changes in technology used by and services offered by TCEH; significant changes in TCEH’s relationship with its employees, including the availability of qualified personnel, and the potential adverse effects if labor disputes or grievances were to occur; changes in assumptions used to estimate future executive compensation payments; significant changes in critical accounting policies; actions by credit rating agencies; the ability of TCEH to implement cost reduction initiatives, and with respect to TCEH’s lignite coal-fueled generation construction and development program, more specifically, TCEH’s ability to fund such investments, changes in competitive market rules, changes in environmental laws or regulations, changes in electric generation and emissions control technologies, changes in projected demand for electricity, the ability of TCEH and its contractors to attract and retain, at projected rates, skilled labor for constructing the new generating units, changes in wholesale electricity prices or energy commodity prices, transmission capacity and constraints, supplier performance risk, changes in the cost and availability of materials necessary for the construction program and the ability of TCEH to manage the significant construction program to a timely conclusion with limited cost overruns. Any forward-looking statement speaks only as of the date on which it is made, and TCEH undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date on which it is made or to reflect the occurrence of unanticipated events. New factors emerge from time to time, and it is not possible for TCEH to predict all of them; nor can TCEH assess the impact of each such factor or the extent to which any factor, or combination of factors, may cause results to differ materially from those contained in any forward-looking statement. 77
Slide 86: Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEPENDENT AUDITORS’ REPORT To the Board of Managers of Texas Competitive Electric Holdings Company LLC: We have audited the accompanying consolidated balance sheets of Texas Competitive Electric Holdings Company LLC (formerly TXU Energy Company LLC) and subsidiaries (the “Company”) as of December 31, 2007 (successor) and 2006 (predecessor), and the related statements of consolidated income (loss), comprehensive income (loss), cash flows, and membership interests for the period from October 11, 2007 through December 31, 2007 (successor), the period from January 1, 2007 through October 10, 2007 (predecessor) and for the years ended December 31, 2006 and 2005 (predecessor). These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards as established by the Auditing Standards Board (United States) and in accordance with the auditing standards of the Public 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. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, 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 Texas Competitive Electric Holdings Company LLC and subsidiaries at December 31, 2007 (successor) and 2006 (predecessor), and the results of their operations and their cash flows for the period from October 11, 2007 through December 31, 2007 (successor), the period from January 1, 2007 through October 10, 2007 (predecessor) and for the years ended December 31, 2006 and 2005 (predecessor), in conformity with accounting principles generally accepted in the United States of America. As discussed in Note 1 to the consolidated financial statements, the Company is an indirect wholly owned subsidiary of EFH Corp. (formerly TXU Corp.), which was merged with Texas Energy Future Merger Sub Corp on October 10, 2007. As a result, the periods presented in the accompanying financial statements reflect a new basis of accounting beginning October 11, 2007. As also discussed in Note 1 to the consolidated financial statements, the Company accounted for the contribution of certain subsidiaries, assets, and liabilities from EFH Corp. in a manner similar to a pooling of interests. /s/ Deloitte & Touche LLP Dallas, Texas April 14, 2008, (June 2, 2008 as to the effects of the adoption of FASB Staff Position No. FIN 39-1 as described in Note 1) 78
Slide 87: TEXAS COMPETITIVE ELECTRIC HOLDINGS COMPANY LLC STATEMENTS OF CONSOLIDATED INCOME (LOSS) (Millions of Dollars) Successor Period from October 11, 2007 through December 31, 2007 Operating revenues ..................................................................................... Costs and expenses: Fuel, purchased power costs and delivery fees ........................................ Operating costs ......................................................................................... Depreciation and amortization ................................................................. Selling, general and administrative expenses........................................... Franchise and revenue-based taxes .......................................................... Other income (Note 13)............................................................................ Other deductions (Note 13) ...................................................................... Interest income ......................................................................................... Interest expense and related charges (Note 25) ....................................... Total costs and expenses...................................................................... Income (loss) from continuing operations before income taxes, extraordinary loss and cumulative effect of changes in accounting principles................................................................................................... Income tax expense (benefit) ........................................................................ Income (loss) from continuing operations before extraordinary loss and cumulative effect of changes in accounting principles ............................ Loss from discontinued operations, net of tax effect (Note 5) ..................... Extraordinary loss, net of tax effect (Note 6) ............................................... Cumulative effect of changes in accounting principles, net of tax effect (Note 7) ..................................................................................................... Net income (loss).......................................................................................... See Notes to Financial Statements. $ 179 852 123 315 153 30 (2) 5 (10) 587 2,053 Period From January 1, 2007 through October 10, 2007 $ 6,330 3,209 473 253 451 81 (22) (20) (271) 323 4,477 Predecessor Year Ended December 31, 2006 2005 $ 9,549 3,928 605 334 531 126 (23) 210 (203) 392 5,900 $ 9,552 5,545 667 313 522 114 (64) 15 (70) 393 7,435 (1,874) (651) (1,223) ─ ─ ─ $ (1,223) 1,853 595 1,258 ─ ─ ─ $ 1,258 3,649 1,255 2,394 ─ ─ ─ $ 2,394 2,117 687 1,430 (8) (50) (8) $ 1,364 79
Slide 88: TEXAS COMPETITIVE ELECTRIC HOLDINGS COMPANY LLC STATEMENTS OF CONSOLIDATED COMPREHENSIVE INCOME (LOSS) (Millions of Dollars) Successor Period from October 11, 2007 through December 31, 2007 Components related to continuing operations: Income (loss) from continuing operations before extraordinary loss and cumulative effect of changes in accounting principles.......... Other comprehensive income (loss), net of tax effects: Minimum pension liability adjustments (net of tax expense of $─, $─, $─ and $4) ......................................................................... Cash flow hedges: Net increase (decrease) in fair value of derivatives held at end of period (net of tax (expense) benefit of $97, $133, $(304) and $24) .......................................................................... Derivative value net (gains) losses related to hedged transactions recognized during the period and reported in net income (net of tax (expense) benefit of $─, $(69), $(9) and $38).................................................................... Total effect of cash flow hedges ..................................................... Total adjustments to net income from continuing operations.................. Comprehensive income (loss) from continuing operations ..................... Comprehensive loss from discontinued operations ................................. Extraordinary loss, net of tax effect ......................................................... Cumulative effect of changes in accounting principles, net of tax effect .............................................................................................. Comprehensive income (loss) ....................................................................... See Notes to Financial Statements. ─ ─ ─ 7 $ (1,223) $ 1,258 $ 2,394 $ 1,430 Period From January 1, 2007 through October 10, 2007 Predecessor Year Ended December 31, 2006 2005 (177) (248) 568 (47) ─ (177) (177) (1,400) ─ ─ ─ $ (1,400) $ (129) (377) (377) 881 ─ ─ ─ 881 (17) 551 551 2,945 ─ ─ ─ $ 2,945 70 23 30 1,460 (8) (50) (8) $ 1,394 80
Slide 89: TEXAS COMPETITIVE ELECTRIC HOLDINGS COMPANY LLC STATEMENTS OF CONSOLIDATED CASH FLOWS (Millions of Dollars) Successor Period from October 11, 2007 through December 31, 2007 Cash flows — operating activities Net income (loss)....................................................................................... Loss from discontinued operations, net of tax effect ............................ Extraordinary loss, net of tax effect....................................................... Cumulative effect of changes in accounting principles, net of tax effect ............................................................................................. Income (loss) from continuing operations before extraordinary loss and cumulative effect of changes in accounting principles................... Adjustments to reconcile income from continuing operations to cash provided by (used in) operating activities: Depreciation and amortization............................................................... Deferred income tax expense (benefit) – net......................................... Impairment of natural gas-fueled generation plants.............................. Inventory writeoff related to natural gas-fueled generation plants ....... Asset writedown charges ....................................................................... Customer appreciation bonus charge (net of amounts credited to customers in 2006) ............................................................................. Credit related to impaired leases (Note 8) ............................................. Net gains on sale of assets ..................................................................... Net effect of unrealized mark-to-market valuations – losses (gains).... Bad debt expense ................................................................................... Stock-based incentive compensation expense....................................... Recognition of losses on dedesignated cash flow hedges ..................... Charge related to coal contract counterparty claim............................... Net equity loss (income) from unconsolidated affiliate ........................ Changes in retail clawback liability....................................................... Other, net................................................................................................ Changes in operating assets and liabilities: Affiliate accounts receivable/payable – net ....................................... Accounts receivable – trade ............................................................... Impact of accounts receivable sales program .................................... Inventories .......................................................................................... Accounts payable – trade ................................................................... Commodity and other derivative contractual assets and liabilities ... Margin deposits – net ......................................................................... Other – net assets................................................................................ Other – net liabilities .......................................................................... Cash provided by (used in) operating activities from continuing operations.................................................................. Cash flows — financing activities Issuances of securities: Merger-related debt financing ............................................................... Pollution control revenue bonds ............................................................ Other long-term debt.............................................................................. Retirements/repurchases of securities: Merger-related debt repurchases............................................................ Pollution control revenue bonds ............................................................ Other long-term debt.............................................................................. Increase (decrease) in short-term borrowings: Commercial paper .................................................................................. Bank borrowings .................................................................................... Decrease in income tax-related note payable to Oncor............................. Distribution paid to parent......................................................................... Excess tax benefit on stock-based incentive compensation...................... Debt premium, discount, financing and reacquisition expenses – net...... Cash provided by (used in) financing activities from continuing operations.................................................................. Period From January 1, 2007 through October 10, 2007 Predecessor Year Ended December 31, 2006 2005 $ (1,223) ─ ─ ─ (1,223) 442 (451) ─ ─ ─ ─ ─ ─ 1,556 13 ─ 1 ─ 2 ─ 2 (79) (211) (223) (14) 260 (10) (614) (276) 433 (392) $ 1,258 ─ ─ ─ 1,258 306 (81) ─ ─ ─ ─ (48) (1) 722 44 6 8 ─ 5 ─ 6 87 308 45 (33) (444) (167) (569) 2 (189) 1,265 $ 2,394 ─ ─ ─ 2,394 400 162 198 3 ─ 122 (2) (12) (272) 67 9 10 ─ 10 ─ 3 (60) 348 (41) 1 (209) ─ 564 (281) 1,271 4,685 $ 1,364 8 50 8 1,430 372 656 ─ ─ 11 ─ (16) (42) 18 53 12 10 12 7 (63) (12) 6 (259) 171 (36) (67) 76 61 (513) (53) 1,834 33,732 ─ ─ (8,992) ─ (45) ─ (1,617) (9) (21,000) ─ (576) $ 1,493 $ ─ ─ 1,000 ─ (143) (15) (623) 1,860 (24) (1,135) ─ (12) 908 ─ 243 ─ ─ (259) (411) 317 (245) (40) (1,144) 11 (19) $(1,547) ─ 180 ─ ─ (39) (32) 306 230 (40) (700) 7 (16) $ (104) 81
Slide 90: TEXAS COMPETITIVE ELECTRIC HOLDINGS COMPANY LLC STATEMENTS OF CONSOLIDATED CASH FLOWS (CONT.) (Millions of Dollars) Successor Period from October 11, 2007 through December 31, 2007 Cash flows — investing activities Net advances to affiliates........................................................................... Capital expenditures .................................................................................. Nuclear fuel ............................................................................................... Purchase of mining-related assets ............................................................. Proceeds from sale of assets ...................................................................... Reduction of restricted cash ...................................................................... Proceeds from sales of nuclear decommissioning trust fund securities.... Investments in nuclear decommissioning trust fund securities................. Proceeds from pollution control revenue bonds deposited with trustee ... Proceeds from letter of credit facility posted with trustee ........................ Other .......................................................................................................... Cash used in investing activities from continuing operations........ Discontinued operations: Cash provided by (used in) operating activities ........................................ Cash provided by (used in) discontinued operations ..................... Net change in cash and cash equivalents ...................................................... Cash and cash equivalents ─ beginning balance .......................................... Cash and cash equivalents ─ ending balance ............................................... See Notes to Financial Statements. $ Period From January 1, 2007 through October 10, 2007 Predecessor Year Ended December 31, 2006 2005 $ 9 (496) (23) ─ 14 14 831 (835) ─ (1,250) (6) (1,742) ─ ─ (641) 856 215 $ 67 (1,409) (54) (122) 2 201 602 (614) ─ ─ 3 (1,324) ─ ─ 849 7 $(1,996) (791) (117) ─ 17 ─ 207 (223) (240) ─ ─ (3,143) ─ ─ (5) 12 $ 7 $(1,470) (309) (57) ─ 65 ─ 191 (206) ─ ─ 3 (1,783) (5) (5) (58) 70 $ 12 $ 856 82
Slide 91: TEXAS COMPETITIVE ELECTRIC HOLDINGS COMPANY LLC CONSOLIDATED BALANCE SHEETS (Millions of Dollars) Successor December 31, 2007 Predecessor December 31, 2006 ASSETS Current assets: Cash and cash equivalents ........................................................................................................... Restricted cash ............................................................................................................................. Trade accounts receivable — net (Note 14)................................................................................ Advances to parent ...................................................................................................................... Note receivable from parent ........................................................................................................ Income taxes receivable from parent........................................................................................... Inventories ................................................................................................................................... Commodity and other derivative contractual assets (Note 18) ................................................... Accumulated deferred income taxes (Note 12)........................................................................... Margin deposits related to commodity positions ........................................................................ Other current assets...................................................................................................................... Total current assets .............................................................................................................. Restricted cash ................................................................................................................................... Investments ........................................................................................................................................ Advances to parent ............................................................................................................................ Property, plant and equipment — net................................................................................................ Goodwill (Note 3).............................................................................................................................. Intangible assets (Note 3) .................................................................................................................. Commodity and other derivative contractual assets (Note 18) ......................................................... Unamortized debt issuance costs and other noncurrent assets.......................................................... Total assets ........................................................................................................................... $ 215 ─ 827 ─ 25 190 352 1,126 17 513 70 3,335 1,279 612 ─ 20,545 18,060 4,137 244 848 $ 49,060 $ 7 3 806 1,994 1,500 ─ 306 2,191 191 7 85 7,090 241 545 700 10,340 517 9 473 281 $ 20,196 LIABILITIES AND MEMBERSHIP INTERESTS Current liabilities: Short-term borrowings (Note 15) ................................................................................................ Long-term debt due currently (Note 15) ..................................................................................... Trade accounts payable – nonaffiliates ....................................................................................... Trade accounts and other payables to affiliates .......................................................................... Commodity and other derivative contractual liabilities (Note 18) ............................................. Margin deposits related to commodity positions ........................................................................ Accrued income taxes payable to parent..................................................................................... Accrued taxes other than income ................................................................................................ Other current liabilities................................................................................................................ Total current liabilities......................................................................................................... Accumulated deferred income taxes (Note 12)................................................................................. Investment tax credits ........................................................................................................................ Commodity and other derivative contractual liabilities (Note 18) ................................................... Notes or other liabilities due affiliates............................................................................................... Long-term debt, less amounts due currently (Note 15)..................................................................... Other noncurrent liabilities and deferred credits .............................................................................. Total liabilities ..................................................................................................................... Commitments and Contingencies (Note 16) Membership interests (Note 17) ........................................................................................................ Total liabilities and membership interests ........................................................................... See Notes to Financial Statements. 6,216 $ 49,060 6,789 $ 20,196 $ 438 195 754 207 1,108 5 ─ 56 588 3,351 5,919 ─ 2,452 289 28,409 2,424 42,844 $ 818 161 829 299 1,515 681 481 52 299 5,135 3,256 311 266 323 2,965 1,151 13,407 83
Slide 92: TEXAS COMPETITIVE ELECTRIC HOLDINGS COMPANY LLC STATEMENTS OF CONSOLIDATED MEMBERSHIP INTERESTS (Millions of Dollars) Successor Period from October 11, 2007 through December 31, 2007 Membership interests: Capital account: Balance at beginning of period (a) ............................................................ Net income (loss) ................................................................................... Effect of adoption of FIN 48.................................................................. Distributions paid to parent.................................................................... Intercompany payable/receivable settlements and contributions related to the Merger .......................................................................... Dividend to parent to fund Merger ........................................................ Transfer of TXU Enterprise Holdings Company LLC ownership to parent .............................................................................................. Effects of EFH Corp. stock-based incentive compensation plans ........ Acquired subsidiaries and net assets...................................................... Allocated pension assets ........................................................................ Effects of allocation of SFAS 158 transition adjustment ...................... Recapitalization of exchangeable preferred membership interests ....... Merger-related transactions ................................................................... Balance at end of period ............................................................................ Accumulated other comprehensive income (loss), net of tax effects: Minimum pension liability adjustment (Note 20): Balance at beginning of period .............................................................. Reclassification of pension and other retirement benefit costs ......... Change in minimum pension liability ................................................ Balance at end of period ........................................................................ Amounts related to cash flow hedges: Balance at beginning of period .............................................................. Change during the period ................................................................... Balance at end of period ........................................................................ Total accumulated other comprehensive gain (loss) at end of period ...... Total membership interests at end of period................................................. Period From January 1, 2007 through October 10, 2007 Predecessor Year Ended December 31, 2006 2005 $ 28,315 (1,223) ─ ─ ─ (21,000) ─ ─ ─ ─ ─ ─ 301 6,393 $ 6,359 1,258 (36) (1,135) (4,057) ─ ─ 31 ─ 8 ─ ─ ─ 2,428 $ 4,501 2,394 ─ (1,144) ─ ─ 6 22 (6) ─ 65 521 ─ 6,359 $ 3,742 1,364 ─ (700) ─ ─ ─ 18 77 ─ ─ ─ ─ 4,501 ─ ─ ─ ─ ─ (177) (177) (177) $ 6,216 ─ ─ ─ ─ 430 (377) 53 53 $ 2,481 ─ ─ ─ ─ (121) 551 430 430 $ 6,789 (7) ─ 7 ─ (144) 23 (121) (121) $ 4,380 _____________ (a) The beginning equity balance for the Successor period reflects the application of push-down accounting as a result of the Merger. See Notes to Financial Statements. 84
Slide 93: TEXAS COMPETITIVE ELECTRIC HOLDINGS COMPANY LLC NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SIGNIFICANT ACCOUNTING POLICIES Description of Business TCEH is a wholly-owned subsidiary of EFC Holdings, which is a wholly-owned subsidiary of EFH Corp. While TCEH is a wholly-owned subsidiary of EFH Corp. and EFC Holdings, TCEH is a separate legal entity from EFH Corp. and EFC Holdings and all of their other affiliates with its own assets and liabilities. TCEH is a Dallas-based holding company for subsidiaries engaged in competitive electricity market activities largely in Texas, including Luminant, which is engaged in electricity generation, development and construction of new generation facilities, wholesale energy sales and purchases and commodity risk management and trading activities and TXU Energy, which is engaged in retail electricity sales. Commodity risk management and allocation of financial resources are performed at the TCEH level; therefore, there are no reportable business segments. On October 10, 2007, EFH Corp. completed its Merger with Merger Sub. As a result of the Merger, EFH Corp. became a subsidiary of Texas Holdings, which is controlled by the Sponsor Group. In connection with the Merger, certain wholly-owned subsidiaries of EFH Corp. established for the purpose of developing and constructing new generation facilities have become subsidiaries of TCEH, and certain assets and liabilities of other of these subsidiaries that did not become subsidiaries of TCEH were transferred to TCEH and its subsidiaries. Those subsidiaries holding impaired construction work-in-process assets related to eight canceled coal-fueled generation units have not become subsidiaries of TCEH. In addition, a wholly-owned subsidiary of EFC Holdings representing a lease trust holding certain combustion turbines has become a subsidiary of TCEH. Because these transactions were between entities under the common control of EFH Corp., TCEH accounted for the transactions in a manner similar to a pooling of interests. As a result, historical operations, financial position and cash flows of TCEH and the entities and other net assets contributed are presented on a combined basis for all periods presented. Basis of Presentation The consolidated financial statements of TCEH have been prepared in accordance with US GAAP. The accompanying consolidated statements of income (loss) and cash flows present results of operations and cash flows of TCEH for periods preceding the Merger (Predecessor) and of TCEH for periods subsequent to the Merger (Successor). The consolidated financial statements of the Predecessor have been prepared on the same basis as the audited financial statements included in TCEH's 2006 Form 10-K with the exception of the adoption of FIN 48 and FIN 39-1 and changes in accounting policies as discussed below. The consolidated financial statements of the Successor reflect the application of purchase accounting and reflect the adoption of SFAS 157. The Successors financial statements also reflect the contributions by EFH Corp. of certain subsidiaries and assets and liabilities as described above, which were accounted for in a manner similar to a pooling of interests (see Note 4). All intercompany items and transactions have been eliminated in consolidation. All dollar amounts in the financial statements and tables in the notes are stated in millions of US dollars unless otherwise indicated. Discontinued Businesses Note 5 presents detailed information regarding the effects of discontinued businesses, the results of which have been classified as discontinued operations. 85
Slide 94: Use of Estimates Preparation of TCEH’s financial statements requires management to make estimates and assumptions about future events that affect the reporting of assets and liabilities at the balance sheet dates and the reported amounts of revenue and expense, including fair value measurements. In the event estimates and/or assumptions prove to be different from actual amounts, adjustments are made in subsequent periods to reflect more current information. No material adjustments, other than those disclosed elsewhere herein, were made to previous estimates or assumptions during the current year. Purchase Accounting The Merger has been accounted for under purchase accounting, whereby the total purchase price of the transaction was allocated to EFH Corp.'s identifiable tangible and intangible assets acquired and liabilities assumed based on their fair values, and the excess of the purchase price over the fair value of net assets acquired was recorded as goodwill. The allocation resulted in a significant amount of goodwill, an increase in the carrying value of property, plant and equipment and deferred income tax liabilities as well as new identifiable intangible assets and liabilities. Purchase accounting impacts, including goodwill recognition, have been “pushed down”, resulting in the assets and liabilities of TCEH being recorded at their respective fair values as of October 10, 2007 and the recording of $18.1 billion of goodwill by TCEH. Reported earnings in periods subsequent to the Merger reflect increases in interest, depreciation and amortization expense. See Note 2 for details regarding the effect of purchase accounting. Derivative Instruments and Mark-to-Market Accounting TCEH enters into contracts for the purchase and sale of electricity, natural gas and other commodities and also enters into other derivative instruments such as options, swaps, futures and forwards primarily to manage commodity price and interest rate risks. If the instrument meets the definition of a derivative under SFAS 133, changes in the fair value of the derivative are recognized in net income as unrealized gains and losses, unless the criteria for certain exceptions are met, and an offsetting derivative asset or liability is recorded in the balance sheet. This recognition is referred to as “mark-to-market” accounting. The fair values of TCEH's unsettled commodity-related derivative instruments under mark-to-market accounting are reported in the balance sheet as commodity contract assets or liabilities. When derivative instruments are settled and realized gains and losses are recorded, the previously recorded unrealized gains and losses and derivative assets and liabilities are reversed. Under the exception criteria of SFAS 133, TCEH may elect the “normal” purchase and sale exemption. A derivative contract may be designated as a “normal” purchase or sale if the commodity is to be physically received or delivered for use or sale in the normal course of business. If designated as normal, the derivative contract is accounted for under the accrual method of accounting (not marked-to-market) with no balance sheet or income statement recognition of the contract until settlement. Because derivative instruments are frequently used as economic hedges, SFAS 133 allows the designation of such instruments as cash flow or fair value hedges provided certain conditions are met. A cash flow hedge mitigates the risk associated with the variability of the future cash flows related to an asset or liability (e.g., a forecasted sale of electricity in the future at market prices or the payment of interest related to variable rate debt), while a fair value hedge mitigates risk associated with fixed future cash flows (e.g., debt with fixed interest rate payments). In accounting for changes in the fair value of cash flow hedges, derivative assets and liabilities are recorded on the balance sheet with an offset to other comprehensive income or loss to the extent the hedges are effective and the hedged transaction remains probable of occurring. If the hedged transaction becomes probable of not occurring, hedge accounting is discontinued and the amount recorded in other comprehensive income is immediately reclassified into net income. Changes in value of fair value hedges are recorded as derivative assets or liabilities with an offset to net income, and the carrying value of the related asset or liability (hedged item) is adjusted for changes in fair value with an offset to net income. If the fair value hedge is settled prior to the maturity of the hedged item, the cumulative fair value gain or loss associated with the hedge is amortized into income over the remaining life of the hedged item. In the statement of cash flow, the effects of settlements of derivative instruments are classified consistent with the related hedged transactions. 86
Slide 95: To qualify for hedge accounting, a hedge must be considered highly effective in offsetting changes in fair value of the hedged item. Assessment of the hedge’s effectiveness is tested at least quarterly throughout its term to continue to qualify for hedge accounting. Changes in fair value that represent hedge ineffectiveness, even if the hedge continues to be assessed as effective, are immediately recognized in net income. Ineffectiveness is generally measured as the cumulative excess, if any, of the change in value of the hedging instrument over the change in value of the hedged item. See Notes 15 and 18 for additional information concerning hedging activity. Revenue Recognition TCEH records revenue from electricity sales under the accrual method of accounting. Revenues are recognized when electricity is provided to customers on the basis of periodic cycle meter readings and include an estimated accrual for the revenues earned from the meter reading date to the end of the period (unbilled revenue). Under a realignment of the wholesale energy operations effective January 1, 2006, management of wholesale purchases and sales of electricity for purposes of balancing electricity supply and demand was segregated from the buying and selling of electricity for trading purposes. Previously, all wholesale electricity purchases and sales were managed in aggregate under a “portfolio management” structure, as the primary activity was energy balancing, and all wholesale activity utilized (and continues to utilize) contracts for physical delivery. Financial derivative instruments, as are common in natural gas markets, are not as readily available in the ERCOT electricity market. The realignment reflects an expectation of a growing market for electricity trading in Texas. Under the previous structure, all purchases and sales scheduled with ERCOT for delivery were reported gross in the income statement, and “booked-out” sales and purchases (agreement with the counterparty to net settle offsetting volumes of purchases and sales before scheduling for delivery) were reported net. Effective with the January 1, 2006 realignment, those contracts that are separately managed as a trading book and scheduled for physical delivery are reported net upon settlement in accordance with EITF 02-3. All transactions reported net, including booked-out contracts, are reported as a component of revenues. Gross revenues from electricity trading activities totaled $334 million in the period from October 11, 2007 through December 31, 2007, $1.1 billion from January 1, 2007 through October 10, 2007 and $1.3 billion in 2006. In addition, TCEH revised its reporting of ERCOT electricity balancing transactions effective with 2006 reporting. These transactions represent wholesale purchases and sales of electricity for real-time balancing purposes as measured in 15-minute intervals. As is industry practice, these purchases and sales with ERCOT, as the balancing energy clearinghouse agent, are reported net in the income statement. TCEH had historically reported the net amount as a component of purchased power cost as the activity consistently represented a net purchase of electricity prior to 2005 due in part to TCEH’s retail load exceeding generation volumes. Although difficult to predict, it is expected that the balancing activity will frequently result in net revenues due in part to generation volumes exceeding retail load. TCEH believes that presentation of this activity as a component of revenues more appropriately reflects TCEH’s market position. Accordingly, net electricity balancing transactions are reported in revenues and the 2005 amounts have been reclassified to revenues for comparative purposes. The amount reported in revenues totaled $9 million in net purchases in the period from October 11, 2007 through December 31, 2007, $14 million in net purchases in the period from January 1, 2007 through October 10, 2007, $31 million in net purchases in 2006 and $225 million in net sales in 2005. Realized and unrealized gains and losses from transacting in energy-related derivative instruments are reported as a component of revenues. See discussion above under “Derivative Instruments and Mark-to-Market Accounting.” 87
Slide 96: Impairment of Long-Lived Assets TCEH evaluates long-lived assets (including intangible assets with finite lives) for impairment whenever indications of impairment exist in accordance with the requirements of SFAS 144. The carrying value of such assets is deemed to be impaired if the projected undiscounted cash flows are less than the carrying value. If there is such impairment, a loss would be recognized based on the amount by which the carrying value exceeds the fair value. Fair value is determined primarily by discounted cash flows, supported by available market valuations, if applicable. See Note 8 for details of the impairment of the natural gas-fueled generation plants recorded in the second quarter of 2006. Goodwill and Intangible Assets with Indefinite Lives TCEH evaluates goodwill and intangible assets with indefinite lives for impairment at least annually (as of October 1) in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets”. The impairment tests performed are based on discounted cash flow analyses. No impairment has been recognized as of December 31, 2007 for goodwill or intangible assets with indefinite lives. See Note 3 for details of goodwill and intangible assets with indefinite lives. Finite-lived intangibles identified as a result of purchase accounting are amortized over their estimated useful lives based on the expected realization of economic effects. See Note 3 to Financial Statements for additional information. Amortization of Nuclear Fuel Amortization of nuclear fuel is calculated on the units-of-production method and is reported as fuel costs. Major Maintenance Major maintenance costs incurred during generation plant outages and the costs of other maintenance activities are charged to expense as incurred. This accounting is consistent with FASB Staff Position AUG AIR1, “Accounting for Planned Major Maintenance Activities”. Defined Benefit Pension Plans and Other Postretirement Employee Benefit Plans TCEH bears a portion of the costs of the EFH Corp. sponsored pension plan offering pension benefits based on either a traditional defined benefit formula or a cash balance formula to eligible employees and also offers certain health care and life insurance benefits to eligible employees and their eligible dependents upon the retirement of such employees from TCEH. Costs of pension and OPEB plans are determined in accordance with SFAS 87 and SFAS 106 and are dependent upon numerous factors, assumptions and estimates. See Note 20 for details with respect to the adoption of this standard and other information regarding pension and OPEB plans. Stock-Based Incentive Compensation Prior to the Merger, EFH Corp. provided discretionary awards payable in its common stock to qualified managerial employees under its shareholder-approved long-term incentive plans. These awards were accounted for based on the provisions of SFAS 123R, which provides for the recognition of stock-based compensation expense over the vesting period based on the grant-date fair value of those awards. In December 2007, EFH Corp.’s board of directors established its 2007 Stock Incentive Plan, which authorizes discretionary grants to directors, officers and qualified managerial employees of EFH Corp. and its affiliates (including TCEH) of nonqualified stock options, stock appreciation rights, restricted shares, shares of common stock, the opportunity to purchase shares of common stock and other EFH Corp. stock-based awards. Stock options have been granted to employees of TCEH under the plan and are being accounted for based upon the provisions of SFAS 123R. See Note 21 for information regarding stock-based incentive compensation. 88
Slide 97: Sales and Excise Taxes Sales and excise taxes are accounted for as a “pass through” item on the balance sheet; i.e., the tax is billed to customers and recorded as trade accounts receivable with an offsetting amount recorded as a liability to the taxing jurisdiction. Franchise and Revenue-Based Taxes Unlike sales and excise taxes, franchise and gross receipt taxes are not a “pass through” item. These taxes are assessed to TCEH by state and local government bodies, based on revenues or kWh delivered, as a cost of doing business and are recorded as an expense. Rates charged to customers by TCEH are intended to recover the taxes, but TCEH is not acting as an agent to collect the taxes from customers. Income Taxes EFH Corp. files a consolidated federal income tax return; however, TCEH’s income tax expense and related balance sheet amounts are recorded as if the entity was a stand-alone corporation. Deferred income taxes are provided for temporary differences between the book and tax basis of assets and liabilities. Previously earned investment tax credits were deferred and amortized as a reduction of income tax expense over the estimated lives of the related properties. In connection with purchase accounting, the remaining unamortized investment tax credit amount related to TCEH of $300 million was eliminated. Prior to 2007, TCEH generally accounted for uncertainty related to positions taken on tax returns based on the probable liability approach consistent with SFAS 5. Effective January 1, 2007, the company adopted FIN 48 as discussed below under “Changes in Accounting Standards” and in Note 10. Accounting for Contingencies The financial results of TCEH may be affected by judgments and estimates related to loss contingencies. Accruals for loss contingencies are recorded when management determines that it is probable that an asset has been impaired or a liability has been incurred and that such economic loss can be reasonably estimated. Such determinations are subject to interpretations of current facts and circumstances, forecasts of future events and estimates of the financial impacts of such events. See Note 16 for a discussion of contingencies. Cash Equivalents For purposes of reporting cash and cash equivalents, temporary cash investments purchased with a remaining maturity of three months or less are considered to be cash equivalents. Restricted Cash The terms of certain agreements require the restriction of cash for specific purposes. At December 31, 2007, $1.250 billion of cash is restricted to support letters of credit. See Notes 15 and 25 for more details regarding restricted cash. Property, Plant and Equipment At December 31, 2006, properties are stated at original cost. As a result of purchase accounting, TCEH property amounts at October 10, 2007 were adjusted to estimated fair values while subsequent additions will be recorded at cost. The cost of self-constructed property additions includes materials and both direct and indirect labor and applicable overhead, including payroll-related costs. 89
Slide 98: Depreciation of TCEH’s property, plant and equipment is calculated on a straight-line basis over the estimated service lives of the properties. As is common in the industry, the Predecessor historically recorded depreciation expense using composite depreciation rates that reflect blended estimates of the lives of major asset components as compared to depreciation expense calculated on an asset-by-asset basis. Effective with the Merger, depreciation expense for TCEH properties is calculated on an asset-by-asset basis. Estimated depreciable lives are based on management’s estimates of the assets’ economic useful life. Capitalized Interest Interest related to TCEH's qualifying construction projects and qualifying software projects is capitalized in accordance with SFAS 34. See Note 25 for details of amounts. Inventories All inventories are reported at the lower of cost (on a weighted average basis) or market unless expected to be used in the generation of electricity. In connection with purchase accounting, inventory amounts at October 10, 2007 were recorded at fair value. Also see discussion immediately below regarding environmental allowances and credits. Environmental Allowances and Credits Effective with the Merger, TCEH began accounting for all environmental allowances and credits as identifiable intangible assets with finite lives that are subject to amortization. The carrying values of these intangible assets at December 31, 2007 reflect fair value determinations as of the date of the Merger under purchase accounting. Amortization expense associated with these intangible assets is recognized on a unit of production basis as the allowances or credits are consumed in generation operations. In accordance with SFAS 144, the environmental allowances and credits are assessed for impairment when conditions or events occur that could affect the carrying value of the assets. TCEH previously accounted for environmental allowances and credits as inventory. Both accounting methods are acceptable under GAAP. Investments Investments in a nuclear decommissioning trust fund are carried at fair value in the balance sheet. Investments in unconsolidated business entities over which TCEH has significant influence but does not maintain effective control, generally representing ownership of at least 20% and not more than 50% of common equity, are accounted for under the equity method. Assets related to employee benefit plans represent investments held to satisfy deferred compensation liabilities and are recorded at market value. See Note 19 for details of investments. Changes in Accounting Standards In September 2006, the FASB issued SFAS 157, "Fair Value Measurements" which defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. SFAS 157 applies in situations where other accounting pronouncements either permit or require fair value measurements. SFAS 157 does not require any new fair value measurements. Although the statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, it may be adopted early. On October 11, 2007, effective with the closing of the Merger, TCEH early-adopted SFAS 157 for assets and liabilities recorded at fair value on a recurring basis. The adoption of SFAS 157 also reflects the application of FSP 157-2, "Effective Date of FASB Statement No. 157”, which was issued by the FASB in February 2008 and delays until financial statements issued after December 15, 2008 the effective date of SFAS 157 for all nonfinancial assets and nonfinancial liabilities, except those recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). See Note 22 for related disclosures. 90
Slide 99: Effective January 1, 2007, TCEH adopted FIN 48 as required. FIN 48 provides clarification of SFAS 109 with respect to the recognition of income tax benefits of uncertain tax positions in the financial statements. The adoption also reflects the application of FSP FIN 48-1, “Definition of Settlement in FASB Interpretation No. 48”, which provides guidance on how to determine whether a tax position is effectively settled for the purpose of recognizing previously unrecognized tax benefits. See Note 10 for the impacts of adopting FIN 48 and required disclosures. Effective January 1, 2008, TCEH adopted FASB Staff Position FIN 39-1, "Amendment of FASB Interpretation No. 39". This FSP provides additional guidance regarding the offsetting in the balance sheet of cash collateral and derivative fair value asset and liability amounts. As provided for by this new rule, for balance sheet presentation, TCEH elected to not adopt netting of cash collateral, and further to discontinue netting of derivative assets and liabilities under master netting agreements. Accordingly, as required by the rule, prior period amounts in the financial statements reflect the change in presentation, resulting in increases compared to previously reported amounts of $849 million and $171 million in current and noncurrent commodity and other derivative contractual assets and liabilities, respectively, at December 31, 2007 and $1.243 billion and $139 million in such current and noncurrent amounts, respectively, at December 31, 2006. In February 2007, the FASB issued SFAS 159, "The Fair Value Option for Financial Assets and Financial Liabilities ─ Including an Amendment of FASB Statement No. 115", which permits an entity to choose to measure certain financial assets and liabilities at fair value. SFAS 159 also revises provisions of SFAS 115 that apply to available-for-sale and trading securities. This statement is effective for fiscal years beginning after November 15, 2007. TCEH does not expect SFAS 159 to materially impact its financial statements. In December 2007, the FASB issued SFAS No. 141R, "Business Combinations". SFAS 141R will significantly change the accounting for business combinations and applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Earlier adoption is prohibited, so the new rule has not impacted purchase accounting related to the Merger. TCEH is evaluating whether certain aspects of SFAS 141R could impact the accounting for the Merger in future periods. In December 2007, the FASB issued SFAS 160, "Noncontrolling Interests in Consolidated Financial Statements ─ an amendment of ARB No. 51". SFAS 160 is effective for fiscal years beginning on or after December 15, 2008 and will require noncontrolling interests (now called minority interests) in subsidiaries initially to be measured at fair value and classified as a separate component of equity. Provisions are to be applied prospectively. Early adoption is prohibited. TCEH currently has no material noncontrolling interests. In March 2008, the FASB issued SFAS 161, "Disclosures about Derivative Instruments and Hedging Activities – an Amendment of FASB Statement 133". SFAS 161 enhances required disclosures regarding derivatives and hedging activities to enable investors to better understand their effects on an entity’s financial position, financial performance and cash flows. This statement is effective for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. TCEH is evaluating the impact of this statement on its financial statement disclosures. 91
Slide 100: 2. FINANCIAL STATEMENT EFFECTS OF THE MERGER EFH Corp. accounted for the Merger under purchase accounting in accordance with the provisions of SFAS 141, whereby the total purchase price of the transaction was allocated to EFH Corp.’s identifiable tangible and intangible assets acquired and liabilities assumed based on their fair values as of October 10, 2007. The fair values were determined based upon assumptions related to future cash flows, discount rates, and asset lives as well as factors more unique to EFH Corp., its industry and the competitive wholesale power market that include forward natural gas price curves and market heat rates, retail customer attrition rates, generation plant operating and construction costs, and the effect on generation facility values of lignite fuel reserves and mining capabilities using currently available information. The excess of the purchase price over the fair value of net assets acquired was recorded by EFH Corp. as goodwill, which totaled $23.0 billion. Purchase accounting impacts, including goodwill recognition, have been “pushed down”, resulting in the assets and liabilities of TCEH being recorded at their fair values as of October 10, 2007. The assignment of purchase price was based on the relative estimated enterprise value of TCEH’s operations as of the date of the Merger using discounted cash flow methodologies and resulted in TCEH recording $18.1 billion of goodwill. The following table summarizes the estimated fair values of the assets acquired and liabilities assumed (billions of dollars): Purchase price assigned to TCEH ........................................................................ Property, plant and equipment ............................................................................. Intangible assets.................................................................................................... Other assets........................................................................................................... Total assets acquired....................................................................................... Short-term borrowings and long-term debt Deferred tax liabilities .......................................................................................... Other liabilities ..................................................................................................... Total liabilities assumed ................................................................................. Net identifiable assets acquired. ..................................................................... Goodwill. ........................................................................................................ 20.3 4.4 3.8 28.5 5.9 6.9 5.5 18.3 $ 10.2 18.1 $ 28.3 Management believes the drivers of the goodwill amount include the incremental value of the future cash flow potential of the baseload generation facilities, including facilities under construction, over the values assigned to those assets under purchase accounting rules, considering the market-pricing mechanisms and growth potential in the ERCOT market, as well as the value derived from the scale of the retail business. The purchase price allocation at December 31, 2007 is substantially complete; however, additional analysis with respect to the value of certain assets, contractual arrangements, contingent liabilities, and debt could result in a change in the total amount of goodwill. The statements of consolidated income and cash flows for 2007 present Predecessor results from January 1 through October 10 and Successor results from October 11 through December 31. 92
Slide 101: 3. GOODWILL AND IDENTIFIABLE INTANGIBLE ASSETS Goodwill TCEH’s goodwill as of December 31, 2007 totaled $18.1 billion, representing the allocated portion of the Merger purchase price over the fair value of TCEH’s assets and liabilities, as discussed in Note 2. TCEH evaluates goodwill for impairment at least annually (as of October 1) in accordance with SFAS No. 142. The impairment tests performed are based on discounted cash flow analyses. No goodwill impairment was recognized in 2007. At December 31, 2006, TCEH’s goodwill (net of accumulated amortization) totaled $517 million. This goodwill amount was eliminated as a result of the Merger. Identifiable Intangible Assets Identifiable intangible assets are comprised of the following: Successor As of December 31, 2007 Gross Carrying Amount $ 463 702 41 1,525 $2,731 Accumulated Amortization $ 79 68 3 19 $ 169 Net $ 384 634 38 1,506 2,562 1,436 139 $4,137 Gross Carrying Amount $― ― 14 ― $ 14 Accumulated Amortization $― ― 5 ― $ 5 Net $― ― 9 ― 9 ― $ ― 9 Predecessor As of December 31, 2006 Retail customer relationship .................................. Favorable purchase and sales contracts ................. Capitalized in-service software.............................. Emissions and renewable energy credits ............... Total intangible assets subject to amortization .. Trade name (not subject to amortization).............. Mineral interests (not currently subject to amortization) .................................................. Total intangible assets ........................................ Amortization expense related to intangible assets consisted of: Successor Useful lives at December 31, 2007 (weighted average in years) 4 11 6 23 Period from October 11, 2007 through December 31, 2007 $ 79 72 2 20 $ 173 Period From January 1, 2007 through October 10, 2007 $ ─ ─ 4 ─ $ 4 Predecessor Retail customer relationship ............................ Favorable purchase and sales contracts ........... Capitalized in-service software........................ Emission and renewable energy credits........... Total amortization expense .......................... Year Ended December 31, 2006 2005 $ ─ $ ─ ─ ─ 2 2 ─ ─ $ 2 $ 2 Because of the immateriality of the amounts, capitalized in-service software was reported as part of property, plant and equipment in the balance sheet in previous reporting periods. 93
Slide 102: As discussed in Note 2, purchase accounting impacts have been “pushed down”, resulting in the assets and liabilities of TCEH being recorded at their fair values as of October 10, 2007. As part of that process, TCEH identified the following separately identifiable and previously unrecognized intangible assets acquired: • Retail Customer Relationship ─ Retail customer relationship intangible asset represents the value of TXU Energy’s non-contracted customer base and is being amortized using an accelerated method based on customer attrition rates and reflecting the pattern in which economic benefits are realized over their estimated useful life. Amortization expense related to retail customer relationship intangibles asset is reported as part of depreciation and amortization expense in the income statement. Favorable Purchase and Sales Contracts ─ Favorable purchase and sales contracts intangible asset primarily represents the in-the-money value of commodity contracts for which: 1) TCEH has made the “normal” purchase or sale election allowed by SFAS 133 or 2) the contracts that did not meet the definition of a derivative. The amortization periods of these intangible assets are based on the terms of the contracts, and the expense is reported as part of revenues or fuel and purchased power costs in the income statement as appropriate. Unfavorable purchase and sales contracts are recorded as other noncurrent liabilities and deferred credits (see Note 25). Trade name ─ The trade name intangible asset represents the value of the TXU Energy trade name, and as an indefinite-lived asset is not subject to amortization. This intangible asset will be evaluated for impairment at least annually (as of October 1) in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets”. Emission Allowances and Credits – This intangible asset represents the fair value of emissions credits granted to or purchased by TCEH to be used in its power generation activity. These credits will be amortized to fuel and purchase power costs utilizing a units-of-production method. • • • Estimated Amortization of Intangible Assets ─ The estimated aggregate amortization expense of intangible assets for each of the five succeeding fiscal years from December 31, 2007 is as follows: Year 2008.............................................. 2009.............................................. 2010.............................................. 2011.............................................. 2012.............................................. Successor $ 356 450 260 231 172 94
Slide 103: 4. CONTRIBUTIONS OF ENTITIES AND NET ASSETS TO TCEH In connection with the Merger, EFH Corp. or EFC Holdings contributed all of the outstanding equity of certain subsidiaries to TCEH. In addition, EFH Corp. subsidiaries contributed certain assets and liabilities to TCEH. These contributions included assets and liabilities associated with the three new lignite/coal-fueled generation units currently under development, certain natural gas hedge positions and a lease trust holding certain combustion turbines. Because these transactions were between entities under the common control of EFH Corp., TCEH accounted for the transactions in a manner similar to a pooling of interests. As a result, historical operations, financial position and cash flows of TCEH and the entities and other net assets contributed are presented on a combined basis for all periods presented. The following table presents the revenues and net income (loss) of the entities contributed and the combined amounts presented in TCEH’s consolidated income statements. Period from January 1, 2007 through October 10, 2007 Revenues: TCEH ................................................................................................... Contributed subsidiaries....................................................................... Combined ....................................................................................... Net income (loss): TCEH ................................................................................................... Contributed subsidiaries....................................................................... Combined ....................................................................................... $ 6,614 (284) $ 6,330 $ 1,448 (190) $ 1,258 Year Ended December 31, 2006 $9,595 (46) $9,549 $2,435 (41) $2,394 2005 $9,552 ─ $9,552 $1,414 (50) $1,364 The following table presents the assets, liabilities and equity of the entities and other assets and liabilities contributed and the combined amounts presented in TCEH’s consolidated balance sheets. December 31, 2006 Current assets: TCEH ................................................................................................... Subsidiaries and other assets contributed (a)....................................... Combined ....................................................................................... Total assets: TCEH ................................................................................................... Subsidiaries and other assets contributed (a)....................................... Combined ....................................................................................... Current liabilities: TCEH ................................................................................................... Subsidiaries and other liabilities contributed (a) ................................. Combined ....................................................................................... Total liabilities: TCEH ................................................................................................... Subsidiaries and other liabilities contributed (a) ................................. Combined ....................................................................................... Membership interests: TCEH ................................................................................................... Subsidiaries and other net assets contributed ...................................... Combined ....................................................................................... $ 6,266 (419) $ 5,847 $ 18,516 298 $ 18,814 $ 3,945 (53) $ 3,892 $ 11,863 162 $ 12,025 $ 6,653 136 $ 6,789 _____________ (a) Includes the effects of eliminating intercompany items. 95
Slide 104: 5. DISCONTINUED OPERATIONS The table below reflects the results of the businesses reported as discontinued operations in 2005: Strategic Retail Services 2005 Operating revenues................................................................... Operating costs and expenses................................................... Other deductions — net ........................................................... Operating loss before income taxes ......................................... Income tax benefit.................................................................... Charges related to exit (after-tax) ............................................ Loss from discontinued operations.................................... $ ─ ─ 3 (3) (1) ─ (2) Pedricktown $ 12 14 ─ (2) ─ (4) (6) $ Total 12 14 3 (5) (1) (4) (8) $ $ $ Strategic Retail Services In December 2003, TCEH finalized a formal plan to sell its strategic retail services business, which was engaged principally in providing energy management services. Results in 2005 reflect an after-tax charge of $2 million related to a litigation settlement. Pedricktown In the second quarter of 2004, TCEH initiated a plan to sell the Pedricktown, New Jersey 122 MW electricity generation business. The business was sold in July 2005 for $8.7 million in cash. A $4 million aftertax charge in 2005 represents a working capital adjustment related to the sale transaction. 6. EXTRAORDINARY ITEM In December 2005, a subsidiary of TCEH entered into an agreement to purchase, for $69 million in cash, the owner participant interest in a trust established to lease combustion turbines to another subsidiary of TCEH. The trust is a variable interest entity, and in accordance with FIN 46R, the trust was consolidated at December 31, 2005, with the trust’s combustion turbine assets and related debt recorded at estimated fair values of $35 million and $96 million, respectively. The transaction was closed in March 2006. In the fourth quarter of 2005, TCEH recorded an extraordinary loss of $50 million (net of a $28 million tax benefit) for the excess of the purchase price over the fair value of the trust’s net assets, net of the reversal of a previously established liability of $59 million related to the combustion turbine lease. Classification of the loss as extraordinary is in accordance with the provisions of FIN 46R. 7. CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES FIN 47 was effective with reporting for the fourth quarter of 2005. This interpretation clarifies the term “conditional asset retirement” under SFAS 143 and requires entities to record the fair value of legally binding asset retirement obligations, the timing or method of settlement of which is conditional on a future event. For TCEH, such liability relates to generation assets asbestos removal and disposal costs. As the new accounting rule required retrospective application to the inception of the liability, the effects of the adoption reflect the accretion and depreciation from the liability inception date through December 31, 2005. The liability is accreted each period, representing the time value of money, and the capitalized cost is depreciated over the remaining useful life of the related asset. The following table details the $8 million net charge in December 2005 arising from the adoption of FIN 47: Increase in property, plant and equipment – net ............................................................ Increase in other noncurrent liabilities and deferred credits .......................................... Increase in accumulated deferred income taxes ............................................................. Cumulative effect of change in accounting principle..................................................... $ 5 (17) 4 $ (8) 96
Slide 105: 8. IMPAIRMENT OF NATURAL GAS-FUELED GENERATION UNITS In 2006, TCEH performed an evaluation of its natural gas-fueled generation units for impairment in accordance with the requirements of SFAS 144, which provides that long-lived assets should be tested for recovery whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. In consideration of the lignite/coal-fueled generation plant development program then underway, among other factors, TCEH determined at that time that it was more likely than not that its gas-fueled generation units, which have generally been operated to meet peak demands for electricity, would be sold or otherwise disposed of before the end of their previously estimated useful lives and should be tested for impairment as an asset group. As a result, it was determined that an impairment existed, and a charge of $198 million ($129 million after-tax) was recorded in 2006 to write down the assets to fair value, which was determined based on discounted estimated future cash flows. Because of the highly judgmental nature of key assumptions and potential volatility of market conditions, the adjusted carrying value of the units did not necessarily represent the amount of proceeds from any potential transaction to sell the units. The impairment was reported in other deductions in the Statements of Consolidated Income. 9. CUSTOMER APPRECIATION BONUS In 2006, TCEH announced a special customer appreciation bonus program. Under the program, a $100 bonus was provided to residential customers receiving service as of October 29, 2006 and living in areas where TCEH offered its price-to-beat rate, which expired January 1, 2007 in accordance with applicable law. Eligible customers were not required to continue to receive service from TCEH to receive the bonus. The bonus was paid out in the form of credits on customer bills, with approximately $40 million paid out in 2006 and the balance fully settled in 2007. The bonus program resulted in a pretax charge of $162 million ($105 million aftertax) in 2006. The charge was recorded as a reduction to revenue. 10. ADOPTION OF NEW INCOME TAX ACCOUNTING RULES (FIN 48) FIN 48 requires that each tax position be reviewed and assessed with recognition and measurement of the tax benefit based on a “more-likely-than-not” standard with respect to the ultimate outcome, regardless of whether this assessment is favorable or unfavorable. TCEH applied FSP 48-1 to determine if each tax position was effectively settled for the purpose of recognizing previously uncertain tax positions. TCEH completed its review and assessment of uncertain tax positions and in the quarter ended March 31, 2007 recorded a net charge to membership interests and an increase to noncurrent liabilities of $36 million in accordance with the new accounting rule. EFH Corp. and its subsidiaries file income tax returns in US federal, state and foreign jurisdictions and are subject to examinations by the IRS and other taxing authorities. Examinations of income tax returns filed by EFH Corp. and any of its subsidiaries for the years ending prior to January 1, 1997, with few exceptions, are complete. Texas franchise tax return periods under examination or still open for examination range from 2002 to 2006. The IRS completed its examination of EFH Corp.’s US income tax returns for the years 1997 through 2002, and proposed adjustments were received in July 2007. EFH Corp. filed an appeal of the proposed adjustments in the third quarter of 2007. The proposed adjustments received from the IRS with respect to the 1997-2002 income tax returns do not materially affect EFH Corp.’s assessment of uncertain tax positions as reflected in the amounts recorded upon adoption of FIN 48. TCEH classifies interest and penalties related to uncertain tax positions as income tax expense. The amount of interest and penalties included in income tax expense totaled $6 million for the period October 11, 2007 through December 31, 2007 and $12 million for the period January 1, 2007 through October 10, 2007. Noncurrent liabilities included a total of $51 million in accrued interest at December 31, 2007. (All interest amounts are after-tax.) 97
Slide 106: The following table summarizes the changes to the uncertain tax positions, reported in other noncurrent liabilities in the consolidated balance sheet, during the year ended December 31, 2007: Balance at January 1, 2007, excluding interest and penalties Additions based on tax positions related to prior years ..................................................................................... Reductions based on tax positions related to prior years ................................................................................... Additions based on tax positions related to the current year ............................................................................. Settlements with taxing authorities .................................................................................................................... Balance at December 31, 2007, excluding interest and penalties...................................................................... $ 650 69 (39) 72 (5) 747 $ Of the balance at December 31, 2007, $693 million represents tax positions for which the uncertainty relates to the timing of recognition in tax returns. The disallowance of such positions would not affect the effective tax rate, but would accelerate the payment of cash to the taxing authority to an earlier period. With respect to tax positions for which the ultimate deductibility is uncertain (permanent items), should EFH Corp. sustain such positions on income tax returns previously filed, TCEH liabilities recorded would be reduced by $35 million, resulting in increased net income and a favorable impact on the effective tax rate. TCEH does not expect that the total amount of uncertain tax positions for the positions assessed as of the date of the adoption will significantly increase or decrease within the next 12 months. To the extent any uncertain tax positions related to permanent items are resolved prior to January 1, 2009, the effects would be recorded to goodwill and not in the income statement in accordance with SFAS 141. Upon adoption of SFAS 141R on January 1, 2009, resolution of permanent items will be recorded in the income statement and affect the effective tax rate. 11. TEXAS MARGIN TAX In May 2006, the Texas legislature enacted a new law that reformed the Texas franchise tax system and replaced it with a new tax system, referred to as the Texas margin tax. The Texas margin tax has been determined to be an income tax for accounting purposes. In accordance with the provisions of SFAS 109, which require that deferred tax assets and liabilities be adjusted for the effects of new income tax legislation in the period of enactment, TCEH estimated and recorded a deferred tax charge of $43 million in 2006. In June 2007, an amendment to this law was enacted that included clarifications and technical changes to the provisions of the tax calculation. In the 2007 Predecessor period, TCEH recorded a deferred tax benefit of $32 million, essentially all of which related to changes in the rate at which a tax credit is calculated as specified in the new law. This estimated benefit is based on the Texas margin tax law in its current form and the current guidance issued by the Texas Comptroller of Public Accounts. The effective date of the Texas margin tax for TCEH is January 1, 2008. The computation of tax liability will be based on 2007 revenues as reduced by certain deductions and was accrued in 2007. 98
Slide 107: 12. INCOME TAXES The components of TCEH’s income tax expense applicable to continuing operations are as follows: Successor Period from October 11, 2007 through December 31, 2007 Current: US federal............................................................................. State ...................................................................................... Non-US................................................................................. Total ................................................................................. Deferred: US federal............................................................................. State ...................................................................................... Non-US................................................................................. Total ................................................................................. Amortization of investment tax credits..................................... Total ................................................................................. $ (210) 10 ─ (200) (439) (12) ─ (451) ─ $ (651) Period From January 1, 2007 through October 10, 2007 $ 666 10 ─ 676 (22) (48) ─ (70) (11) $ 595 Predecessor Year Ended December 31, 2006 2005 $1,090 1 2 1,093 114 64 (1) 177 (15) $1,255 $ 33 (2) ─ 31 672 ─ ─ 672 (16) $ 687 Reconciliation of income taxes computed at the US federal statutory rate to income tax expense: Successor Period from October 11, 2007 through December 31, 2007 Income from continuing operations before income taxes and cumulative effect of changes in accounting principles........ Income taxes at the US federal statutory rate of 35% .............. Lignite depletion allowance ............................................ Production activities deduction ....................................... Amortization of investment tax credits ........................... Preferred securities cost................................................... State income taxes, net of federal tax benefit ................. Texas margin tax – deferred tax adjustments (Note 11) . Accrual of interest ........................................................... Other, including audit settlements................................... Income tax expense................................................................... Effective tax rate ....................................................................... Period From January 1, 2007 through October 10, 2007 Predecessor Year Ended December 31, 2006 2005 $3,649 $1,277 (51) (14) (15) 6 ─ 43 6 3 $1,255 34.4% $2,117 $ 741 (33) ─ (16) 7 (1) ─ ─ (11) $ 687 32.5% $(1,874) (656) (5) 6 ─ ─ (5) ─ 6 3 $ (651) 34.7% $ 1,853 649 (30) (9) (11) ─ 11 (32) 12 5 $ 595 32.1% 99
Slide 108: Deferred Income Tax Balances Deferred income taxes provided for temporary differences based on tax laws in effect at December 31, 2007 and 2006, balance sheet dates are as follows: Successor December 31, 2007 Total Deferred Income Tax Assets Alternative minimum tax credit carryforwards.... Net operating loss (NOL) carryforwards ............. Unamortized investment tax credits..................... Unfavorable purchase and sales contracts............ Employee benefit obligations............................... Other ..................................................................... Total.................................................................. Deferred Income Tax Liabilities Property, plant and equipment.............................. Commodity contracts (mark-to-market) .............. Identifiable intangible assets ................................ Debt fair value discounts...................................... Other ..................................................................... Total ................................................................. Net Deferred Income Tax (Asset) Liability .......... 4,770 257 1,564 72 ─ 6,663 $ 5,902 $ ─ 32 ─ ─ ─ 32 (17) 4,770 225 1,564 72 ─ 6,631 $ 5,919 2,600 959 43 ─ 3 3,605 $ 3,065 $ ─ 4 ─ ─ 3 7 (191) 2,600 955 43 ─ ─ 3,598 $ 3,256 $ 338 9 ─ 269 39 106 761 $ 32 ─ ─ ─ 15 2 49 $ 306 9 ─ 269 24 104 712 $ 307 12 109 ─ 38 74 540 $ 173 ─ ─ ─ 10 15 198 $ 134 12 109 ─ 28 59 342 Current Noncurrent Total Predecessor December 31, 2006 Current Noncurrent At December 31, 2007, TCEH had $338 million of alternative minimum tax credit carryforwards (AMT) available to offset future tax payments. The AMT credit carryforwards have no expiration date. At December 31, 2007, TCEH had net operating loss (NOL) carryforwards for federal income tax purposes of $27 million that expire between 2023 and 2027. The NOL carryforwards can be used to offset future taxable income. TCEH expects to utilize all of its NOL carryforwards prior to their expiration dates. The income tax effects of the components included in accumulated other comprehensive income at December 31, 2007 and 2006 totaled a net deferred tax asset of $95 million and a net deferred tax liability of $231 million, respectively. See Note 10 for discussion regarding the implementation of FIN 48, which addresses accounting for uncertain tax positions. 100
Slide 109: 13. OTHER INCOME AND DEDUCTIONS Successor Period from October 11, 2007 through December 31, 2007 Other income: Settlement penalty for coal tonnage delivery deficiency........ Royalty income from lignite leases......................................... Net gain on sale of assets (a)................................................... Sales tax refunds...................................................................... Insurance recoveries related to generation assets ................... Gain on sale of out-of-state electricity transmission project............................................................ Electricity sale agreement termination fee.............................. Other ........................................................................................ Total other income ..................................................... Other deductions: Charge related to termination of rail car lease (b) .................. Asset writedown and generation-related lease termination and impairment credit (c) ................................................... Equity losses of affiliate holding investment in Capgemini... Charge for settlement of a retail matter with the PUCT ......... Charge for impairment of natural gas-fueled generation plants (Note 8) .................................................................... Litigation settlements .............................................................. Inventory write-off related to natural gas-fueled generation plants................................................................. Capgemini outsourcing transition costs .................................. Charge (credit) related to coal contract counterparty claim (d).............................................................................. Other ........................................................................................ Total other deductions ........................................................ __________________ (a) (b) (c) $ ─ 1 ─ ─ ─ ─ ─ 1 2 ─ ─ 2 ─ ─ ─ ─ ─ ─ 3 5 Period From January 1, 2007 through October 10, 2007 $ 6 9 1 3 ─ ─ ─ 3 22 10 (48) 5 5 ─ ─ ─ ─ ─ 8 (20) Predecessor Year Ended December 31, 2006 2005 $ ─ 4 13 3 2 ─ ─ 1 23 ─ (2) 10 ─ 198 6 3 ─ (12) 7 $ 210 $ ─ ─ 35 4 8 7 4 6 64 ─ (16) 7 ─ ─ ─ ─ 9 12 3 15 $ $ $ $ $ $ $ $ $ $ $ (d) Includes gains on land sales of $1 million for the period from January 1, 2007 through October 10, 2007, $12 million in 2006 and $33 million in 2005. The 2006 period also includes a $1 million gain related to the sale of mineral interests. The 2005 period also includes a $2 million gain on the sale of surplus equipment. Represents costs associated with termination and refinancing of a rail car lease. In 2004, TCEH recorded a liability of $157 million for leases of certain natural gas-fueled combustion turbines, net of estimated sublease revenues that are no longer operated for its own benefit. Credits of $2 million and $16 million were recorded in 2006 and 2005, respectively, to adjust the liability for changes in estimated sublease proceeds, and in the third quarter of 2007, a $48 million reduction in the liability was recorded to reflect new subleases entered into in October 2007. The remaining $59 million liability was eliminated as part of purchase accounting as TCEH intends to operate these assets for its own benefit. In 2006, TCEH recorded income of $12 million upon the settlement of a claim against a counterparty for nonperformance under a coal contract. A charge in the same amount was recorded in 2005 for losses due to the nonperformance. 101
Slide 110: 14. TRADE ACCOUNTS RECEIVABLE AND SALE OF RECEIVABLES PROGRAM Sale of Receivables TCEH participates in an accounts receivable securitization program established by EFH Corp. for certain of its subsidiaries, the activity under which is accounted for as a sale of accounts receivable in accordance with SFAS 140. Under the program, subsidiaries of TCEH (originators) sell trade accounts receivable to TXU Receivables Company, a consolidated wholly-owned bankruptcy-remote direct subsidiary of EFH Corp., which sells undivided interests in the purchased accounts receivable for cash to special purpose entities established by financial institutions (the funding entities). In connection with the Merger, the accounts receivable securitization program was amended. Certain financial tests relating to TCEH and the originators that could have affected the amount of available funding under the program or caused a termination event or a default, including TCEH’s debt to capital (leverage) and fixed charge coverage ratios, were deleted and replaced with other tests. As amended, among other things, the amount of customer deposits held by the originators can reduce funding available under the program so long as TCEH’s long term senior unsecured debt rating is lower than investment grade. Also, the originators will continue to be eligible to participate in the program so long as TCEH provides the required form of parent guaranty. Subsequent to the Merger, only subsidiaries of TCEH participate in the accounts receivable securitization program. The maximum amount currently available under the accounts receivable securitization program is $700 million. As of December 31, 2007, the program funding to the originators totaled $363 million. Under certain circumstances, the amount of customer deposits held by the originators can reduce the amount of undivided interests that can be sold, thus reducing funding available under the program. Funding availability for all originators is reduced by 100% of the originators’ customer deposits if TCEH's credit rating is lower than Ba3/BB-; 50% if TCEH's credit rating is between Ba3/BB- and Ba1/BB+; and zero % if TCEH's credit rating is at least Baa3/BBB-. The originators’ customer deposits, which totaled $116 million, reduced funding availability as of December 31, 2007 as TCEH’s credit ratings were lower than Ba3/BB-. All new trade receivables under the program generated by the originators are continuously purchased by TXU Receivables Company with the proceeds from collections of receivables previously purchased. Changes in the amount of funding under the program, through changes in the amount of undivided interests sold by TXU Receivables Company, reflect seasonal variations in the level of accounts receivable, changes in collection trends as well as other factors such as changes in sales prices and volumes. TXU Receivables Company has issued subordinated notes payable to the originators for the difference between the face amount of the uncollected accounts receivable purchased, less a discount, and cash paid to the originators that was funded by the sale of the undivided interests. The balance of the subordinated notes issued to TCEH, which is reported in trade accounts receivable, was $296 million and $159 million at December 31, 2007 and 2006, respectively. 102
Slide 111: The discount from face amount on the purchase of receivables principally funds program fees paid by TXU Receivables Company to the funding entities. The discount also funds a servicing fee paid by TXU Receivables Company to EFH Corporate Services Company, a direct subsidiary of EFH Corp. The program fees, also referred to as losses on sale of the receivables under SFAS 140, consist primarily of interest costs on the underlying financing. The servicing fee compensates EFH Corporate Services Company for the collection agent services being performed, including the maintenance of detailed accounts receivable collection records. The program and servicing fees represent essentially all the net incremental costs of the program to TCEH and are reported in SG&A expenses. Fee amounts were as follows: Successor Period from October 11, 2007 through December 31, 2007 Program fees .......................................................................................... Program fees as a percentage of average funding (annualized)............ Servicing fees ........................................................................................ $ 9 9.5% 1 Predecessor Period From January 1, 2007 through October 10, 2007 $ 26 6.4% 3 Year Ended December 31, 2006 $ 34 5.8% 4 2005 $ 20 4.0% 4 The accounts receivable balance reported in the December 31, 2007 consolidated balance sheet has been reduced by $659 million face amount of trade accounts receivable sold to TXU Receivables Company, partially offset by the inclusion of $296 million of subordinated notes receivable from TXU Receivables Company. Funding under the program decreased $178 million to $363 million in 2007, decreased $41 million to $541 million in 2006 and increased $171 million to $582 million in 2005. Funding increases or decreases under the program are reflected as operating cash flow activity in the statement of cash flows. The carrying amount of the retained interests in the accounts receivable balance approximated fair value due to the short-term nature of the collection period. Activities of TXU Receivables Company related to TCEH were as follows: Successor Period from October 11, 2007 through December 31, 2007 Cash collections on accounts receivable.......................................................... Face amount of new receivables purchased..................................................... Discount from face amount of purchased receivables ..................................... Program fees paid............................................................................................. Servicing fees paid ........................................................................................... Increase (decrease) in subordinated notes payable .......................................... Operating cash flows used by (provided to) TCEH under the program.......... $ 1,538 (1,194) 9 (9) (1) (120) $ 223 Predecessor Period From January 1, 2007 through October 10, 2007 $ 5,169 (5,472) 30 (26) (3) 257 $ (45) Year Ended December 31, 2006 $ 7,274 (7,238) 38 (34) (4) 5 $ 41 2005 $ 6,480 (6,512) 24 (20) (4) (139) $ (171) The program may be terminated upon the occurrence of a number of specified events, including if the delinquency ratio (delinquent for 31 days) for the sold receivables, the default ratio (delinquent for 91 days or deemed uncollectible), the dilution ratio (reductions for discounts, disputes and other allowances) or the days collection outstanding ratio exceed stated thresholds, and the financials institutions do not waive such event of termination. The thresholds apply to the entire portfolio of sold receivables, not separately to the receivables of each originator. In addition, the program may be terminated if TXU Receivables Company or EFH Corporate Services Company, as collection agent, shall default in any payment with respect to debt in excess of $50,000 in the aggregate for TXU Receivables Company and EFH Corporate Services Company, or if TCEH, any affiliate of TCEH acting as collection agent under the program other than EFH Corporate Services Company, any parent guarantor of an originator or any originator shall default in any payment with respect to debt (other than hedging obligations) in excess of $200 million in the aggregate for such entities. 103
Slide 112: Upon termination of the program, cash flows would be delayed as collections of sold receivables would be used by TXU Receivables Company to repurchase the undivided interests from the funding entities instead of purchasing new receivables. The level of cash flows would normalize in approximately 16 to 30 days. The subordinated notes issued by TXU Receivables Company are subordinated to the undivided interests of the financial institutions in the purchased receivables. Trade Accounts Receivable Successor December 31, 2007 Gross trade accounts receivable........................................................................... Undivided interests in accounts receivable sold by TXU Receivables Company ......................................................................... Subordinated notes receivable from TXU Receivables Company ......................... Allowance for uncollectible accounts.................................................................. Trade accounts receivable ― reported in balance sheet...................................... $ $ 1,214 (659) 296 (24) 827 $ Predecessor December 31, 2006 $ 1,355 (700) 159 (8) 806 Gross trade accounts receivable at December 31, 2007 and 2006 included unbilled revenues of $404 million and $406 million, respectively. Allowance for Uncollectible Accounts Receivable Predecessor: Allowance for uncollectible accounts receivable as of January 1, 2005 ......... Increase for bad debt expense.................................................................. Decrease for account write-offs............................................................... Changes related to receivables sold......................................................... Other (a) ................................................................................................... Allowance for uncollectible accounts receivable as of December 31, 2005 ... Increase for bad debt expense.................................................................. Decrease for account write-offs............................................................... Changes related to receivables sold......................................................... Other (a) ................................................................................................... Allowance for uncollectible accounts receivable as of December 31, 2006 ... Increase for bad debt expense.................................................................. Decrease for account write-offs............................................................... Changes related to receivables sold......................................................... Allowance for uncollectible accounts receivable as of October 10, 2007 ....... Successor: Allowance for uncollectible accounts receivable as of October 11, 2007 ....... Increase for bad debt expense.................................................................. Decrease for account write-offs............................................................... Allowance for uncollectible accounts receivable as of December 31, 2007 ... (a) $ 15 53 (68) 16 15 31 67 (79) 4 (15) 8 44 (54) 25 23 $ 23 13 (12) 24 Reflects an allowance established in 2005 for a coal contract dispute that was reversed upon settlement in 2006. See Note 13. Allowances related to undivided interests in receivables sold totaled $25 million at December 31, 2006 and were reported in current liabilities. 104
Slide 113: 15. SHORT-TERM BORROWINGS AND LONG-TERM DEBT Short-Term Borrowings At December 31, 2007 and 2006, the outstanding short-term borrowings of TCEH consisted of the following: Successor December 31, 2007 Interest Outstanding Rate (a) Amount Borrowings under credit facilities .... Commercial paper ............................. Total .............................................. _______________ (a) $ 438 ― $ 438 4.47% ― Predecessor December 31, 2006 Outstanding Interest Amount Rate (a) $ 195 623 $ 818 5.97% 5.52% Weighted average interest rate at the end of the period. All commercial paper borrowings matured prior to the Merger. Credit Facilities TCEH’s credit facilities with cash borrowing and/or letter of credit availability at December 31, 2007 are presented below. All these facilities were entered into on October 10, 2007 and are all senior secured facilities. Maturity Date October 2014 October 2013 October 2014 Facility Limit $ 4,100 2,700 1,250 $ 8,050 Unlimited At December 31, 2007 Letters of Cash Credit Borrowings $ ― $ 2,150 64 ― ― 1,250 $ 64 $ 3,400 $ ― $ 820 Authorized Borrowers and Facility TCEH Delayed Draw Term Loan Facility (a) TCEH Revolving Credit Facility (b) TCEH Letter of Credit Facility (c) Sub-total TCEH TCEH Commodity Collateral Posting Facility (d) December 2012 Availability $ 1,950 2,636 ― $ 4,586 Unlimited _______________ (a) Facility to be used during the two-year period commencing on October 10, 2007 to fund expenditures for constructing new generation facilities and environmental upgrades of existing generation facilities, including previously incurred expenditures not yet funded under this facility. A total of $2.15 billion was drawn at the closing of the Merger. Borrowings are classified as long-term debt. Facility to be used for letters of credit and borrowings for general corporate purposes. Facility to be used for issuing letters of credit for general corporate purposes, including, but not limited to, providing collateral support under hedging arrangements and other commodity transactions that are not eligible for funding under the TCEH Commodity Collateral Posting Facility. The borrowings, all of which were drawn at the closing of the Merger and are classified as long-term debt, have been retained as restricted cash. Letters of credit totaling $1.241 billion issued as of December 31, 2007 are supported by the restricted cash, and the remaining letter of credit availability totals $9 million. Revolving facility to be used to fund cash collateral posting requirements under certain specified natural gas hedging transactions and general corporate purposes. A total of $382 million was drawn at the closing of the Merger and is recorded as long-term debt. Cash borrowings totaling $438 million at December 31, 2007 are classified as short-term borrowings. (b) (c) (d) On October 10, 2007, TCEH and Oncor repaid in full all outstanding borrowings totaling $2.440 billion, together with interest and all other amounts due in connection with such repayment, under their $6.5 billion of credit facilities terminated in connection with the Merger. TCEH’s outstanding borrowings under these preMerger facilities totaled $2.055 billion. Amounts used under the pre-Merger credit facilities at December 31, 2006, all of which related to TCEH, totaled $195 million in outstanding cash borrowings and $947 million of letters of credit. 105
Slide 114: Pursuant to PUCT rules, TCEH is required to maintain available capacity under its credit facilities in order to permit TXU Energy to return retail customer deposits, if necessary. As a result, at December 31, 2007, the total availability under the TCEH credit facilities should be further reduced by $124 million. Long-Term Debt At December 31, 2007 and 2006, the long-term debt of TCEH consisted of the following: Successor December 31, 2007 TCEH Pollution Control Revenue Bonds: Brazos River Authority: 5.400% Fixed Series 1994A due May 1, 2029 ........................................................................................... $ 7.700% Fixed Series 1999A due April 1, 2033 .......................................................................................... 6.750% Fixed Series 1999B due September 1, 2034, remarketing date April 1, 2013 (a) ........................ 7.700% Fixed Series 1999C due March 1, 2032 ........................................................................................ 3.600% Floating Series 2001A due October 1, 2030 (b)............................................................................ 5.750% Fixed Series 2001C due May 1, 2036, remarketing date November 1, 2011 (a) ......................... 3.600% Floating Series 2001D due May 1, 2033 (b) ................................................................................. 4.950% Floating Taxable Series 2001I due December 1, 2036 (b) ........................................................... 3.600% Floating Series 2002A due May 1, 2037 (b) ................................................................................. 6.750% Fixed Series 2003A due April 1, 2038, remarketing date April 1, 2013 (a)................................. 6.300% Fixed Series 2003B due July 1, 2032 ............................................................................................ 6.750% Fixed Series 2003C due October 1, 2038...................................................................................... 5.400% Fixed Series 2003D due October 1, 2029, remarketing date October 1, 2014 (a)........................ 5.000% Fixed Series 2006 due March 1, 2041........................................................................................... Sabine River Authority of Texas: 6.450% Fixed Series 2000A due June 1, 2021 ........................................................................................... 5.500% Fixed Series 2001A due May 1, 2022, remarketing date November 1, 2011 (a) ......................... 5.750% Fixed Series 2001B due May 1, 2030, remarketing date November 1, 2011 (a) ......................... 5.200% Fixed Series 2001C due May 1, 2028 ........................................................................................... 5.800% Fixed Series 2003A due July 1, 2022............................................................................................ 6.150% Fixed Series 2003B due August 1, 2022 ....................................................................................... 3.850% Floating Series 2006A due November 1, 2041 (interest rate in effect at March 31, 2007) (c) .... 3.850% Floating Series 2006B due November 1, 2041 (interest rate in effect at March 31, 2007) (c) .... Trinity River Authority of Texas: 6.250% Fixed Series 2000A due May 1, 2028 ........................................................................................... 3.850% Floating Series 2006 due November 1, 2041 (interest rate in effect at March 31, 2007) (c) ....... Unamortized fair value discount related to pollution control revenue bonds (d) ...................................... Senior Secured Facilities: 8.396% TCEH Initial Term Loan Facility maturing October 10, 2014 (e)(f)............................................ 8.378% TCEH Delayed Draw Term Loan Facility maturing October 10, 2014 (e)(f).............................. 8.396% TCEH Letter of Credit Facility maturing October 10, 2014 (f).................................................... 4.473% TCEH Commodity Collateral Posting Facility maturing October 10, 2012 (f)(g)....................... Other: 10.25% Fixed Senior Notes due November 1, 2015 .................................................................................. 10.25% Fixed Senior Notes Series B due November 1, 2015.................................................................... 10.50 / 11.25% Senior Toggle Notes due November 1, 2016.................................................................... 6.125% Fixed Senior Notes due March 15, 2008 (h) ................................................................................. 7.000% Fixed Senior Notes due March 15, 2013 (h) ................................................................................. 7.100% Promissory Note due January 5, 2009........................................................................................... 7.460% Fixed Secured Facility Bonds with amortizing payments through January 2015 ........................ Capital lease obligations ............................................................................................................................. Fair value adjustments related to interest rate swaps ................................................................................. Unamortized fair value discount (d) ........................................................................................................... Total TCEH ........................................................................................................................................... Less amount due currently................................................................................................................................ Total long-term debt ......................................................................................................................................... $ Predecessor December 31, 2006 39 111 16 50 71 217 268 62 45 44 39 52 31 100 51 91 107 70 12 45 ― ― 14 ― (175) 16,409 2,150 1,250 382 3,000 2,000 1,750 3 5 65 78 161 ― (9) 28,604 (195) 28,409 $ 39 111 16 50 71 217 268 62 45 44 39 52 31 100 51 91 107 70 12 45 47 46 14 50 ― ― ― ― ― ― ― ― 250 1,000 ― 85 98 10 5 3,126 (161) $ 2,965 106
Slide 115: (a) (b) (c) (d) (e) (f) (g) (h) These series are in the multiannual interest rate mode and are subject to mandatory tender prior to maturity on the mandatory remarketing date. On such date, the interest rate and interest rate period will be reset for the bonds. Interest rates in effect at December 31, 2007. These series are in a weekly interest rate mode and are classified as long-term as they are supported by long-term irrevocable letters of credit. These series were redeemed on May 8, 2007 as a result of the suspension of development of eight coal-fueled generation facilities. Amount represents unamortized fair value adjustments recorded under purchase accounting. Interest rate swapped to fixed on $15.05 billion principal amount. Initial borrowings under the TCEH Initial Term Loan Facility totaled $16.450 billion, of which TCEH repaid $41 million in December 2007 as required by the credit agreement. Interest rates in effect at December 31, 2007. See “Credit Facilities” above for more information. EFH Corp. commenced offers to purchase and consent solicitations for these series on September 25, 2007. EFH repurchased the majority of the bonds in October 2007. Long-Term Debt-Related Activity — TCEH issued, reacquired or made scheduled principal payments on long-term debt in 2007 as follows (all amounts presented are principal): Successor Merger-Date Post-Merger Repayments / Repayments / Issuances Issuances Repurchases Repurchases Senior secured facilities: Initial term loan facility.................. Delayed draw term loan facility..... Letter of credit facility.................... Commodity collateral posting facility ........................................ Senior unsecured interim facilities: Initial cash-pay loans...................... Initial toggle loans .......................... Senior notes: Senior cash-pay notes..................... Senior toggle notes ......................... Floating rate senior notes (a) .............. Fixed senior notes ............................... Secured promissory note .................... Pollution control revenue bonds......... Capital lease obligations..................... Other long-term debt........................... Total .................................................... $ ― ― ― ― ― ― 5,000 1,750 ― ― ― ― 16 ― $ 6,766 $ (41) ― ― ― (5,000) (1,750) ― ― ─ ― ― ― (4) ― $ (6,795) $16,450 2,150 1,250 382 5,000 1,750 ― ― ― ― ― ― ― ― $26,982 $ ― ― ― ― ― ― ― ― (1,000) (1,242) ― ― ― ― $ (2,242) Predecessor Repayments / Repurchases $ ― ― ― ― ― ― ― ― ― ― ― (143) (8) (7) $ (158) Issuances $ ― ― ― ― ― ― ― ― 1,000 ― 65 ― 59 ― $ 1,124 _______________ (a) Notes were subject to mandatory redemption upon closing of the Merger. Maturities ─ Long-term debt maturities as of December 31, 2007 are as follows: Year 2008 ............................................................................................................... 2009 ............................................................................................................... 2010 ............................................................................................................... 2011 ............................................................................................................... 2012 ............................................................................................................... Thereafter....................................................................................................... Unamortized fair value discount ................................................................... Capital lease obligations................................................................................ Total ....................................................................................................... $ 153 299 301 802 269 26,803 (184) 161 $ 28,604 107
Slide 116: TCEH Senior Secured Facilities — Borrowings, including letters of credit under the TCEH Initial Term Loan Facility, the TCEH Delayed Draw Term Loan Facility, the TCEH Revolving Credit Facility and the TCEH Letter of Credit Facility, which totaled $19.873 billion at December 31, 2007, bear interest at per annum rates equal to, at TCEH’s option, (i) adjusted LIBOR plus 3.50% or (ii) a base rate (the higher of (1) the prime rate as announced from time to time by the administrative agent of the facilities and (2) the federal funds effective rate plus 0.50%) plus 2.50%. There is a margin adjustment mechanism in relation to term loans, revolving loans and letter of credit fees commencing after delivery of the financial statements for the first quarter ending March 31, 2008, under which the applicable margins may be reduced based on the achievement of certain leverage ratio levels. A commitment fee is payable quarterly in arrears and upon termination of the TCEH Revolving Credit Facility at a rate per annum equal to 0.50% of the average daily unused portion of such facility. The commitment fee will be subject to reduction, commencing after delivery of the financial statements for the first quarter ending March 31, 2008, based on the achievement of certain leverage ratio levels. With respect to the TCEH Delayed Draw Term Loan Facility, a commitment fee is payable quarterly in arrears and upon termination of the undrawn portion of the commitments of such facility at a rate per annum equal to, prior to the first anniversary of October 10, 2007, 1.25% per annum, and thereafter, 1.50% per annum. Letter of credit fees under the TCEH Revolving Facility are payable quarterly in arrears and upon termination at a rate per annum equal to the spread over adjusted LIBOR under the TCEH Revolving Facility, less the issuing bank’s fronting fee. Letter of credit fees under the TCEH Letter of Credit Facility are equal to the difference between interest paid on each outstanding letter of credit at a rate of LIBOR plus 3.50% per annum and the interest earned on the total $1.25 billion TCEH Letter of Credit Facility restricted cash at a rate of LIBOR minus 0.12% per annum yielding a currently effective rate of 3.62% per annum on each outstanding letter of credit under that facility. TCEH will pay a fixed quarterly maintenance fee of approximately $11 million through maturity for having procured the TCEH Commodity Collateral Posting Facility regardless of actual borrowings under the facility. In addition, TCEH will pay interest at LIBOR on actual borrowed amounts under the TCEH Commodity Collateral Posting Facility partially offset by interest earned on collateral deposits to counterparties. The TCEH Senior Secured Facilities are unconditionally guaranteed jointly and severally on a senior secured basis, by EFC Holdings, and each existing and subsequently acquired or organized direct or indirect wholly-owned US restricted subsidiary of TCEH (other than certain subsidiaries as provided in the TCEH Senior Secured Facilities), subject to certain other exceptions. The TCEH Senior Secured Facilities, including the guarantees thereof, certain commodity hedging transactions (including those that were formerly secured by a first-lien on the Big Brown plant) and the interest rate swaps described under “TCEH Interest Rate Hedges” below are secured by (a) substantially all of the current and future assets of TCEH and TCEH’s subsidiaries who are guarantors of such facilities as described above, and (b) pledges of the capital stock of TCEH and each current and future material wholly-owned restricted subsidiary of TCEH directly owned by TCEH or any guarantor. The TCEH Senior Secured Facilities contain customary negative covenants, restricting, subject to certain exceptions, TCEH and TCEH’s restricted subsidiaries from, among other things: • • • • • • • incurring additional debt; incurring additional liens; entering into mergers and consolidations; selling or otherwise disposing of assets; making dividends, redemptions or other distributions in respect of capital stock; making acquisitions, investments, loans and advances, and paying or modifying certain subordinated and other material debt. 108
Slide 117: In addition, the TCEH Senior Secured Facilities contain a maintenance covenant that requires TCEH and its restricted subsidiaries to maintain a maximum consolidated secured leverage ratio and to observe certain customary reporting requirements and other affirmative covenants. The TCEH Initial Term Loan Facility is required to be repaid in equal quarterly installments beginning on December 31, 2007 in an aggregate annual amount equal to 1% of the original principal amount of such facility, with the balance payable on October 10, 2014. The TCEH Delayed Draw Term Loan Facility is required to be repaid in equal quarterly installments beginning on the last day of the first fiscal quarter to occur after October 10, 2009 in an aggregate annual amount equal to 1% of the actual principal outstanding under the TCEH Delayed Draw Term Loan Facility as of such date, with the balance payable on October 10, 2014. Amounts borrowed under the TCEH Revolving Facility may be reborrowed from time to time from and after the closing date until October 10, 2013. The TCEH Letter of Credit Facility will mature on October 10, 2014. The TCEH Commodity Collateral Posting Facility will mature on December 31, 2012. The TCEH Senior Secured Facilities contain certain customary events of default for senior leveraged acquisition financings, the occurrence of which would allow the lenders to accelerate all outstanding loans and terminate their commitments. TCEH Senior Unsecured Interim Facilities ─ On October 10, 2007, TCEH and TCEH Finance entered into senior unsecured credit facilities with borrowings of $6.75 billion. All amounts outstanding under this facility were repaid using proceeds from the issuances of $3.0 billion of cash-pay senior notes on October 31, 2007 and $2.0 billion of cash-pay senior notes and $1.75 billion of toggle senior notes on December 6, 2007 described immediately below. TCEH Notes Issued Subsequent to the Merger ─ Pursuant to an indenture entered into on October 31, 2007 (the TCEH Indenture), TCEH and TCEH Finance (the Co-Issuers) issued and sold $3.0 billion aggregate principal amount of 10.25% Senior Notes due November 1, 2015. On December 6, 2007 under a supplemental indenture, the Co-Issuers issued and sold $2.0 billion aggregate principal amount of 10.25% Series B Senior Notes due November 1, 2015. Interest on these notes (referred to as the TCEH Cash-Pay Notes) is payable in cash semiannually in arrears on May 1 and November 1 of each year at a fixed rate of 10.25% per annum, and the first interest payment will be made on May 1, 2008. Pursuant to the supplemental indenture, the Co-Issuers also issued and sold $1.75 billion aggregate principal amount of 10.50%/11.25% Senior Toggle Notes due November 1, 2016. The initial interest payment on these notes (referred to as the TCEH Toggle Notes) will be payable in cash. For any interest period thereafter until November 1, 2012, the Issuer may elect to pay interest on the notes, at the Issuer’s option (i) entirely in cash; (ii) by increasing the principal amount of the notes or by issuing new TCEH Toggle Notes (PIK Interest); or (iii) 50% in cash 50% in PIK Interest. Interest on the notes is payable semi-annually in arrears on May 1 and November 1 of each year at a fixed rate of 10.50% per annum for cash interest and at a fixed rate of 11.25% per annum for PIK Interest, and the first interest payment will be made on May 1, 2008. The $6.75 billion principal amount of notes issued under the TCEH Indenture and its supplement (the TCEH Cash-Pay Notes and the TCEH Toggle Notes) are collectively referred to as the TCEH Notes. The TCEH Notes are fully and unconditionally guaranteed by TCEH’s direct parent, EFC Holdings (which owns 100% of TCEH and its subsidiary guarantors) and by each subsidiary that guarantees the TCEH Senior Secured Facilities (the TCEH Guarantors). The TCEH Notes are the Co-Issuers’ senior unsecured debt and rank senior in right of payment to any future subordinated indebtedness of the Co-Issuers, equally in right of payment with all of the Co-Issuers’ existing and future senior unsecured indebtedness, and structurally subordinated in right of payment to all existing and future indebtedness and other liabilities of the Co-Issuers’ non-guarantor subsidiaries, including trade payables (other than indebtedness and liabilities owed to the Co-Issuers or the TCEH Guarantors). The TCEH Notes rank effectively junior in right of payment to all existing and future senior secured indebtedness of the Co-Issuers, including the TCEH Senior Secured Facilities to the extent of the value of the collateral securing such indebtedness. 109
Slide 118: The guarantees are joint and several guarantees of the TCEH Notes, are the TCEH Guarantors’ senior unsecured obligations and rank equal in right of payment with all existing and future senior unsecured indebtedness of the relevant TCEH Guarantor. The guarantees rank effectively junior to all secured indebtedness of the TCEH Guarantors to the extent of the assets securing that indebtedness. EFC Holdings’ guarantee of the TCEH Notes ranks equally with its guarantee of the EFH Corp. Notes discussed below. The guarantees of the TCEH Notes are structurally junior to all indebtedness and other liabilities of the Co-Issuers’ subsidiaries that do not guarantee the notes. The TCEH Indenture contains a number of covenants that, among other things, restrict, subject to certain exceptions, the Co-Issuers’ and their restricted subsidiaries’ ability to: • • • • • • make restricted payments; incur debt and issue preferred stock; create liens; engage in mergers or consolidations; permit dividend and other payment restrictions on restricted subsidiaries, and engage in certain transactions with affiliates. The TCEH Indenture also contains customary events of default, including failure to pay principal or interest on the TCEH Notes or the guarantees when due, among others. If an event of default occurs under the TCEH Indenture, the trustee or the holders of at least 30% in principal amount of the Required Debt (as such term is defined in the TCEH Indenture) may declare the principal amount on the TCEH Notes to be due and payable immediately. The Co-Issuers may redeem the TCEH Cash-Pay Notes, in whole or in part, at any time on or after November 1, 2011, or the TCEH Toggle Notes, in whole or in part, at any time on or after November 1, 2012, at specified redemption prices, plus accrued and unpaid interest, if any. In addition, before November 1, 2010, the Co-Issuers may redeem with the cash proceeds of certain equity offerings up to 35% of the aggregate principal amount of TCEH Cash-Pay Notes from time to time at a redemption price of 110.250% of the aggregate principal amount of the TCEH Cash-Pay Notes, plus accrued and unpaid interest, if any, or 110.500% of the aggregate principal amount of the TCEH Toggle Notes, plus accrued and unpaid interest, if any. The Co-Issuers may also redeem the TCEH Cash-Pay Notes at any time prior to November 1, 2011 or the TCEH Toggle Notes at any time prior to November 1, 2012 at a price equal to 100% of their principal amount, plus accrued and unpaid interest and a “make-whole” premium. Upon the occurrence of a change in control of TCEH, the CoIssuers must offer to repurchase the TCEH Notes at 101% of their principal amount, plus accrued and unpaid interest, if any. The TCEH Notes were issued in a private placement and have not been registered under the Securities Act of 1933, as amended (the Securities Act). The Co-Issuers have agreed to use their commercially reasonable efforts to register with the SEC notes having substantially identical terms as the TCEH Notes as part of an offer to exchange freely tradable exchange notes for the TCEH Notes. The Co-Issuers have agreed to use commercially reasonable efforts to cause the exchange offer to be completed or, if required, to have one or more shelf registration statements declared effective, within 360 days after the issue date of the TCEH Notes. If this obligation is not satisfied (a TCEH Registration Default), the annual interest rate on the TCEH Notes will increase by 0.25% per annum for the first 90-day period during which a Registration Default continues, and thereafter the annual interest rate on the TCEH Notes will increase by 0.50% per annum over the original interest rate for the remaining period during which the TCEH Registration Default continues. If the TCEH Registration Default is cured, the applicable interest rate on such TCEH Notes will revert to the original level. 110
Slide 119: Intercreditor Agreement — On October 10, 2007, in connection with the Merger, TCEH entered into an Intercreditor Agreement (the Intercreditor Agreement) with Citibank, N.A. and four secured commodity hedge counterparties (the Secured Commodity Hedge Counterparties). The Intercreditor Agreement provides that the lien granted to the Secured Commodity Hedge Counterparties will rank pari passu with the lien granted with respect to the collateral of the secured parties under the TCEH Senior Secured Facilities. The Intercreditor Agreement also provides that the Secured Commodity Hedge Counterparties will be entitled to share, on a pro rata basis, in the proceeds of any liquidation of such collateral in connection with a foreclosure on such collateral in an amount provided in the TCEH Senior Secured Facilities. The Intercreditor Agreement also provides that the Secured Commodity Hedge Counterparties will have voting rights with respect to any amendment or waiver of any provision of the Intercreditor Agreement that changes the priority of the Secured Commodity Hedge Counterparties’ lien on such collateral relative to the priority of lien granted to the secured parties under the TCEH Senior Secured Facilities or the priority of payments to the Secured Commodity Hedge Counterparties upon a foreclosure and liquidation of such collateral relative to the priority of the lien granted to the secured parties under the TCEH Senior Secured Facilities. TCEH Interest Rate Hedges — In the 2007 Successor period, TCEH entered into interest rate swap transactions pursuant to which payment of the floating interest rates on an aggregate of $15.05 billion of senior secured term loans of TCEH were exchanged for interest payments at fixed rates of between 7.3% and 8.3% on debt maturing from 2009 to 2014. The interest rate swaps are being accounted for as cash flow hedges related to variable interest rate cash flows. Based on the fair value of the positions, the interest rate swaps were $280 million out-of-the-money at December 31, 2007. This amount is reflected in the balance sheet as a derivative contract liability with the offset to accumulated other comprehensive income. No ineffectiveness gains or losses have been recorded. Other Debt-Related Activity in 2007 — In September 2007, EFH Corp. commenced offers to purchase and consent solicitations with respect to $250 million in aggregate principal amount of TCEH’s outstanding 6.125% Senior Notes due 2008 and $1.0 billion in aggregate principal amount of TCEH’s outstanding 7.000% Senior Notes due 2013. The offers were contingent upon the closing of the Merger. In October 2007, TCEH purchased an aggregate of $247 million and $995 million principal amounts of these notes, respectively, for $248 million and $1.097 billion, respectively, excluding unpaid interest. An interest rate swap related to $250 million principal amount of these notes was settled for $2 million upon extinguishment of the debt. In September 2007, subsidiaries of TCEH acquired certain assets of Alcoa Inc. relating to the operation of a lignite mine near Sandow, including partial ownership of the lignite reserves in the mine, for a purchase price of $135 million, including cash of $70 million and a promissory note of $65 million due January 5, 2009 at a fixed interest rate of 7.100%, which has been reported as long-term debt. In September 2007, TCEH refinanced an existing lease of rail cars, which had been accounted for as an operating lease, with a lease with another party that has been accounted for as a capital lease, resulting in a liability of $52 million reported as long-term debt. TCEH also entered into leases related to mining equipment that have been accounted for as capital leases of $7 million, $10 million and $6 million in September, October and December 2007, respectively. In May 2007, TCEH redeemed at par the Sabine River Authority of Texas Series 2006A and 2006B pollution control revenue bonds with aggregate principal amounts of $47 million and $46 million, respectively, and the Trinity River Authority of Texas Series 2006 pollution control revenue bonds with an aggregate principal amount of $50 million. All three bond series were issued in November 2006 in conjunction with the development of eight coal-fueled generation units, which has been canceled. Restricted cash retained upon issuance of the bonds was used to fund substantially all of the redemption amounts. In March 2007, TCEH issued floating rate senior notes with an aggregate principal amount of $1.0 billion with a floating rate based on LIBOR plus 50 basis points. The notes were to mature in September 2008, but in accordance with their terms, were redeemed upon closing of the Merger. 111
Slide 120: Debt-Related Activity in 2006 — In November 2006, upon the scheduled mandatory tender date, TCEH repurchased all of the Trinity River Authority of Texas Series 2001A and Brazos River Authority Series 2001B pollution control revenue bonds with aggregate principal amounts of $37 million and $19 million, respectively, at a price of 100% of the principal amount thereof. TCEH currently plans to remarket these bonds. In June 2006, upon the scheduled mandatory tender date, TCEH repurchased all of the Brazos River Authority Pollution Control Revenue (Refunding) Bonds Series 1995B with an aggregate principal amount of $114 million at a price of 100% of the principal amount thereof. TCEH currently plans to remarket these bonds. In May 2006, upon the scheduled mandatory tender date, TCEH repurchased all of the Brazos River Authority Pollution Control Revenue (Refunding) Bonds Series 1994B and 1995A with aggregate principal amounts of $39 million and $50 million, respectively, at a price of 100% of the principal amounts thereof. TCEH currently plans to remarket these bonds. In March 2006, TCEH issued the Brazos River Authority Series 2006 Pollution Control Revenue Bonds with an aggregate principal amount of $100 million. The bonds have a fixed interest rate of 5.0% and mature in March 2041. Net proceeds of $100 million (principal amount less issuance expenses) from the issuance are held in a trust and, along with related earned interest, are classified as restricted cash. Such proceeds will be released to TCEH by the trust at such time as documentation of qualified expenditures are presented and approved by the trustee. Other retirements of long-term debt in 2006 totaling $405 million represented payments at scheduled maturity dates and included $400 million of TCEH senior notes. TCEH Long-Term Debt Fair Value Hedges — TCEH has used fair value hedging strategies to manage its exposure to fixed interest rates on long-term debt. These swaps qualified for and were designated as fair value hedges in accordance with SFAS 133 (under the “short-cut method” entities are allowed under SFAS 133 to assume no hedge ineffectiveness in a hedging relationship of interest rate risk if certain conditions are met). TCEH had no fair value interest rate hedges as of December 31, 2007. Long-Term Debt Fair Value Adjustments Related to Interest Rate Swaps (fixed to variable rate) — Predecessor: Long-term debt fair value adjustments related to interest rate swaps at January 1, 2006 ― net reduction in debt carrying value (net out-of-the-money value of swaps).......................................................................................... Fair value adjustments during the period .................................................................................................................. Recognition of net gains on settled fair value hedges (a).......................................................................................... Long-term debt fair value adjustments at December 31, 2006 ― net reduction in debt carrying value...................... Fair value adjustments during the period .................................................................................................................. Recognition of net gains on settled fair value hedges (a).......................................................................................... Successor: Long-term debt fair value adjustments at October 10, 2007 ― net reduction in debt carrying value .......................... Purchase accounting adjustment (b) .......................................................................................................................... Long-term debt fair value adjustments related to interest rate swaps at December 31, 2007 ...................................... $ 9 3 (2) 10 5 (1) 14 (14) $ ― ______________ (a) (b) Net value of settled in-the-money fixed-to-variable swaps recognized in net income when the hedged transactions are recognized. Amount is pretax. Reflects the fair-valuing of debt as part of purchase accounting. Changes in market values of unsettled fair value hedge positions are accounted for as adjustments to the carrying value of related debt amounts, offset by changes in commodity and other derivative contractual asset or liability amounts. 112
Slide 121: 16. COMMITMENTS AND CONTINGENCIES Generation Development EPC agreements have been executed for the development of three lignite coal-fueled generation units in Texas. In connection therewith, orders have been placed for critical long lead-time equipment, including boilers, turbine generators and air quality control systems for the two units at Oak Grove and one unit at Sandow, and construction of the three units is underway. In September 2007, a subsidiary of TCEH acquired from Alcoa Inc. the air permit related to the Sandow facility that had been previously issued by the TCEQ. However, the air permit is the subject of an appeal as discussed below under “Litigation—Generation Facilities.” A subsidiary of TCEH has received the air permit for the Oak Grove units, which was approved by the TCEQ in June 2007. However, the air permit is the subject of an appeal and litigation as discussed below under “Litigation—Generation Facilities.” Construction work-in-process assets balances for the three generation units totaled approximately $2.8 billion as of December 31, 2007, which includes the effects of the fair value adjustments related to purchase accounting. If construction-related agreements for the three generation units had been canceled as of that date, subsidiaries of EFH Corp. would have incurred an estimated termination obligation of up to approximately $400 million. This estimated gross cancellation exposure of approximately $3.2 billion at December 31, 2007 excludes any potential recovery values for assets acquired to date and for assets already owned prior to executing such agreements that are intended to be utilized for these projects. Contractual Commitments At December 31, 2007, TCEH had noncancelable commitments under energy-related contracts, leases and other agreements as follows: Coal purchase agreements and coal transportation agreements 2008................... 2009................... 2010................... 2011................... 2012................... Thereafter .......... Total............ (a) $ 219 149 43 43 — — 454 Pipeline transportation and storage reservation fees $ 45 48 41 40 81 — 255 Capacity payments under power purchase agreements (a) $ 73 — — — — — 73 Nuclear Fuel Contracts $ 112 161 54 51 154 259 791 Water Rights Contracts $ 8 8 8 8 8 50 90 $ $ $ $ $ On the basis of TCEH’s current expectations of demand from its electricity customers as compared with its capacity and take-orpay payments, management does not consider it likely that any material payments will become due for electricity not taken beyond capacity payments. 113
Slide 122: Future minimum lease payments under both capital leases and operating leases are as follows: Capital Leases 2008 .............................................................................. 2009 .............................................................................. 2010 .............................................................................. 2011 .............................................................................. 2012 .............................................................................. Thereafter...................................................................... Total future minimum lease payments............. Less amounts representing interest............................... Present value of future minimum lease payments........ Less current portion ...................................................... Long-term capital lease obligation ............................... (a) 27 25 25 68 11 55 211 50 161 17 $ 144 $ Operating Leases (a) $ 37 38 38 37 39 328 517 $ Includes operating leases with initial or remaining noncancelable lease terms in excess of one year. Excludes TCEH’s future minimum lease payments for combustion turbines owned by a TCEH lease trust of $17 million in 2008, $17 million in 2009, $17 million in 2010, $17 million in 2011, $17 million in 2012 and $34 million in periods thereafter. Rent charged to operating cost, fuel cost and SG&A totaled $20 million for the period October 11, 2007 through December 31, 2007, $50 million for the period January 1, 2007 through October 10, 2007 and $65 million and $89 million for the years ended December 31, 2006 and 2005, respectively. Litigation-Generation Facilities An administrative appeal challenging the order of the TCEQ issuing the air permit for construction and operation of the Oak Grove generation facility in Robertson County, Texas to a subsidiary of TCEH was filed on September 7, 2007 in the State District Court of Travis County, Texas. Plaintiffs ask that the District Court reverse TCEQ's approval of the Oak Grove air permit; TCEQ’s adoption and approval of the TCEQ Executive Director's Response to Comments; and remand the matter back to TCEQ for further proceedings. In addition to this administrative appeal, two other petitions were filed in Travis County District Court by non-parties to the administrative hearing before TCEQ and the State Office of Administrative Hearings (SOAH) seeking to challenge the TCEQ’s issuance of the Oak Grove air permit and asking the District Court to remand the matter to the SOAH for further proceedings. Finally, the plaintiffs in these two additional lawsuits have filed a third, joint petition claiming insufficiencies in the Oak Grove application, permit, and process and seeking party status and remand to SOAH for further proceedings. TCEH believes the Oak Grove air permit granted by the TCEQ is protective of the environment and that the application for and the processing of the air permit by the TCEQ was in accordance with law. There can be no assurance that the outcome of these matters would not result in an adverse impact on the Oak Grove project. 114
Slide 123: On December 1, 2006, a lawsuit was filed in the US District Court for the Western District of Texas against Luminant Generation Company LLC (then known as TXU Generation Company LP), Oak Grove Management Company, LLC and EFH Corp. (then known as TXU Corp.). The complaint sought declaratory and injunctive relief, as well as the assessment of civil penalties, with respect to the permit application for the construction and operation of the Oak Grove generation facility in Robertson County, Texas. The plaintiffs allege violations of the Federal Clean Air Act, Texas Health and Safety Code and Texas Administrative Code and sought to temporarily and permanently enjoin the construction and operation of the Oak Grove generation plant. The complaint also asserted that the permit application was deficient in failing to comply with various modeling and analyses requirements relative to the impact of emissions from the Oak Grove plant. Plaintiffs further requested that the District Court enter an order requiring the defendants to take other appropriate actions to remedy, mitigate and offset alleged harm to the public health and environment. EFH Corp. and the other defendants believe the Oak Grove air permit granted by the TCEQ on June 13, 2007 is protective of the environment and that the application for and the processing of the air permit by Oak Grove Management Company LLC with the TCEQ has been in accordance with applicable law. EFH Corp. and the other defendants filed a Motion to Dismiss the litigation, which was granted by the District Court on May 21, 2007. The Plaintiffs have appealed the District Court’s dismissal of the case to the Fifth Circuit Court of Appeals and oral argument was heard in the appeal on March 3, 2008. EFH Corp. and the other defendants believe the District Court properly granted the Motion to Dismiss and while EFH Corp. and the other defendants are unable to estimate any possible loss or predict the outcome of this litigation in the event the Fifth Circuit Court of Appeals reverses the District Court, EFH Corp. and the other defendants maintain that the claims made in the complaint are without merit. Accordingly, EFH Corp. and the other defendants intend to vigorously defend the appeal and this litigation in the event the Fifth Circuit reverses the District Court. In September 2007, a subsidiary of TCEH acquired from Alcoa Inc. the air permit related to the Sandow 5 facility that had been previously issued by the TCEQ. Although a federal district court approved a settlement pursuant to which TCEH acquired the permit, environmental groups opposed to the settlement have appealed the district court’s decision to the Fifth Circuit Court of Appeals. A hearing on the matter is scheduled for June 2, 2008. There can be no assurance that the outcome of this matter would not result in an adverse impact on the Sandow 5 project. TCEH believes the claims on appeal are without merit and will vigorously defend the appeal. Regulatory Investigations In March 2007, the PUCT issued a Notice of Violation (NOV) stating that the PUCT Staff was recommending an enforcement action, including the assessment of administrative penalties, against EFH Corp. and certain affiliates for alleged market power abuse by its power generation affiliates and Luminant Energy in ERCOT-administered balancing energy auctions during certain periods of the summer of 2005. In September 2007, the PUCT issued a revised NOV in which the proposed administrative penalty amount was reduced from $210 million to $171 million. The revised NOV was necessary, according to the PUCT Staff, to correct calculation errors in the initial NOV. As revised, the NOV is premised upon the PUCT Staff's allegation that Luminant Energy's bidding behavior was not competitive and increased market participants' costs of balancing energy by approximately $57 million, including approximately $19 million in incremental revenues to EFH Corp. A hearing requested by Luminant Energy to contest the alleged occurrence of a violation and the amount of the penalty in the NOV was scheduled to start in April 2008 but was stayed pending resolution of discovery disputes and Luminant Energy's motion to dismiss, which was filed in November 2007. That motion was denied by the state administrative law judges, and in February 2008 the PUCT declined to hear Luminant Energy's appeal of that denial. On March 26, 2008, Luminant Energy submitted to the administrative law judges its motion for summary decision on the discrete legal issue of what the maximum lawful penalty calculation could be in this proceeding. EFH Corp. and TCEH believe Luminant Energy's conduct during the period in question was consistent with the PUCT's rules and policies, and no market power abuse was committed. EFH Corp. and TCEH are vigorously contesting the NOV, but are unable to predict the outcome of this matter. EFH Corp. and TCEH have taken actions to reduce the risk of future similar allegations related to the balancing energy segment of the ERCOT wholesale market, including working with the PUCT Staff and the PUCT's independent market monitor to develop a voluntary mitigation plan for approval by the PUCT. Luminant Energy has submitted a voluntary mitigation plan that was approved by the PUCT in July 2007. The PUCT’s approval action was challenged by some other market participants on procedural grounds, and a Texas District Court upheld that challenge. The PUCT did not appeal that ruling. 115
Slide 124: Commitment to Fund Demand Side Management Initiatives Related to the Merger, Texas Holdings committed to spend $100 million over the five-year period ending December 31, 2012 on demand side management or other energy efficiency initiatives. This commitment is expected to be funded by EFH Corp. and/or its subsidiaries other than Oncor. Other Proceedings In addition to the above, TCEH and its subsidiaries are involved in various other legal and administrative proceedings in the normal course of business the ultimate resolution of which, in the opinion of management, should not have a material effect on its financial position, results of operations or cash flows. Labor Contracts Certain personnel engaged in TCEH activities are represented by labor unions and covered by collective bargaining agreements with varying expiration dates. In January 2008, new one-year labor agreements were reached covering bargaining unit personnel engaged in the natural gas-fueled generation operations. Also in January 2008, a new two-year agreement was reached covering bargaining unit personnel engaged in lignite mining operations. Existing agreements for bargaining unit personnel engaged in the nuclear and lignite/coalfueled generation are in effect until August and November 2008, respectively. Negotiations are currently underway with respect to the collective bargaining agreements covering bargaining unit personnel engaged in the Three Oaks Mine and Sandow lignite-fueled generation operations. Management expects that any changes in collective bargaining agreements will not have a material effect on TCEH’s financial position, results of operations or cash flows; however, TCEH is unable to predict the ultimate outcome of these labor negotiations. Environmental Contingencies The federal Clean Air Act, as amended (Clean Air Act) includes provisions which, among other things, place limits on sulfur dioxide and nitrogen oxide emissions produced by electricity generation plants. The capital requirements of TCEH and its subsidiaries have not been significantly affected by the requirements of the Clean Air Act. In addition, all air pollution control provisions of the 1999 Restructuring Legislation have been satisfied. TCEH and its subsidiaries must comply with environmental laws and regulations applicable to the handling and disposal of hazardous waste. TCEH and its subsidiaries believe that they are in compliance with current environmental laws and regulations; however, the impact, if any, of changes to existing regulations or the implementation of new regulations is not determinable. The costs to comply with environmental regulations can be significantly affected by the following external events or conditions: • • • enactment of state or federal regulations regarding CO2 emissions; other changes to existing state or federal regulation regarding air quality, water quality, control of toxic substances and hazardous and solid wastes, and other environmental matters, and the identification of sites requiring clean-up or the filing of other complaints in which TCEH or its subsidiaries may be asserted to be potential responsible parties. 116
Slide 125: Guarantees As discussed below, TCEH and its subsidiaries have entered into contracts that contain guarantees to outside parties that could require performance or payment under certain conditions. Residual value guarantees in operating leases — TCEH is the lessee under various operating leases that guarantee the residual values of the leased assets. At December 31, 2007, both the aggregate maximum amount of residual values guaranteed and the estimated residual recoveries totaled approximately $64 million. These leased assets consist primarily of mining equipment and rail cars. The average life of the lease portfolio is approximately four years. See Note 15 regarding the refinancing of an operating lease of certain rail cars. Security Interest In 2006, a first-lien interest was placed on the two lignite/coal-fueled generation units at TCEH's Big Brown plant to support commodity hedging transactions entered into by Generation Development Company LLC (a direct, wholly-owned subsidiary of EFH Corp. that also holds assets related to cancelled generation facilities previously under development). In connection with the closing of the Merger, the hedge transactions were transferred to TCEH and became secured by a first-lien interest in substantially all of the assets of TCEH and its subsidiaries, and the prior lien on the Big Brown plant was released. See Note 15 for additional details. Letters of Credit At December 31, 2007, TCEH had outstanding letters of credit under its credit facilities totaling $1.305 billion as follows: • • • • • $592 million to support risk management and trading margin requirements in the normal course of business, including over-the-counter hedging transactions; $455 million to support (and available to fund payment of) floating rate pollution control revenue bond debt of $446 million principal amount; $135 million to support obligations under the lease agreement for EFH Corp.’s headquarters building; $52 million to support mining reclamation activities, and $71 million for miscellaneous credit support requirements. Nuclear Insurance Nuclear insurance includes liability coverage, property damage, decontamination and premature decommissioning coverage and accidental outage and/or extra expense coverage. The liability coverage is governed by the Price-Anderson Act (Act), while the property damage, decontamination and premature decommissioning coverage is promulgated by the rules and regulations of the NRC. TCEH intends to maintain insurance against nuclear risks as long as such insurance is available. TCEH is self-insured to the extent that losses (i) are within the policy deductibles, (ii) are not covered per policy exclusions, terms and limitations, (iii) exceed the amount of insurance maintained, or (iv) are not covered due to lack of insurance availability. Such losses could have a material adverse effect on TCEH’s financial condition and its results of operations and cash flows. 117
Slide 126: With regard to liability coverage, the Act provides financial protection for the public in the event of a significant nuclear generation plant incident. The Act sets the statutory limit of public liability for a single nuclear incident at $10.8 billion and requires nuclear generation plant operators to provide financial protection for this amount. The US Congress could impose revenue-raising measures on the nuclear industry to pay claims exceeding the $10.8 billion limit for a single incident mandated by the Act. As required, TCEH provides this financial protection for a nuclear incident at Comanche Peak resulting in public bodily injury and property damage through a combination of private insurance and industry-wide retrospective payment plans. As the first layer of financial protection, TCEH has $300 million of liability insurance from American Nuclear Insurers (ANI), which provides such insurance on behalf of a major stock insurance company pool, Nuclear Energy Liability Insurance Association. The second layer of financial protection is provided under an industry-wide retrospective payment program called Secondary Financial Protection (SFP). Under the SFP, in the event of an incident at any nuclear generation plant in the US, each operating licensed reactor in the US is subject to an assessment of up to $100.6 million plus a 3% insurance premium tax, subject to increases for inflation every five years. Assessments are limited to $15 million per operating licensed reactor per year per incident. TCEH’s maximum potential assessment under the industry retrospective plan would be $201.2 million (excluding taxes) per incident but no more than $30 million in any one year for each incident. The potential assessment is triggered by a nuclear liability loss in excess of $300 million per accident at any nuclear facility. The SFP and liability coverage are not subject to any deductibles. With respect to nuclear decontamination and property damage insurance, the NRC requires that nuclear generation plant license-holders maintain at least $1.1 billion of such insurance and require the proceeds thereof to be used to place a plant in a safe and stable condition, to decontaminate it pursuant to a plan submitted to and approved by the NRC before the proceeds can be used for plant repair or restoration or to provide for premature decommissioning. TCEH maintains nuclear decontamination and property damage insurance for Comanche Peak in the amount of $3.5 billion (subject to $1 million deductible per accident), above which TCEH is selfinsured. The $3.5 billion consists of a primary layer of coverage of $500 million provided by Nuclear Electric Insurance Limited (NEIL), a nuclear electric utility industry mutual insurance company, $2.25 billion of premature decommissioning coverage provided by NEIL and $737 million of other property damage coverage from other insurance markets and foreign nuclear insurance pools. TCEH maintains Accidental Outage Insurance through NEIL to cover the additional costs of obtaining replacement electricity from another source if one or both of the units at Comanche Peak are out of service for more than twelve weeks as a result of covered direct physical damage. The coverage provides for weekly payments of $3.5 million for the first fifty-two weeks and $2.8 million for the next 110 weeks for each outage, respectively, after the initial twelve-week waiting period. The total maximum coverage is $490 million per unit. The coverage amounts applicable to each unit will be reduced to 80% if both units are out of service at the same time as a result of the same accident. If NEIL’s losses exceeded its reserves for the applicable coverage, potential assessments total $14.5 million for primary property, $14.1 million for excess property and $8.3 million for accidental outage. Also, under the NEIL policies, if there were multiple terrorism losses occurring within a one-year time frame, NEIL would make available one industry aggregate limit of $3.2 billion plus any amounts it recovers from other sources up to the limits for each claimant. If terrorism losses occurred beyond the one-year period, a new set of limits and resources would apply. Under the ANI liability policy, the liability arising out of terrorist acts will be subject to one industry aggregate limit of $300 million that could be reinstated at ANI’s option depending on prevailing risk circumstances and the balance in the Industry Credit Rating Plan reserve fund. Under the US Terrorism Risk Insurance Extension Act of 2005, the US government provides reinsurance with respect to acts of terrorism in the US for losses caused by an individual or individuals acting on behalf of foreign parties. In such circumstances, the NEIL and ANI terrorism aggregates would not apply. 118
Slide 127: 17. MEMBERSHIP INTERESTS Successor Dividend to Parent to Fund Merger ― On October 10, 2007, TCEH distributed $21.0 billion to EFC Holdings, which amounts were ultimately distributed to EFH Corp. to provide partial funding of the Merger. Dividend Restrictions — The indenture governing the TCEH Senior Cash-Pay and TCEH Toggle Notes includes covenants that, among other things and subject to certain exceptions, restrict TCEH's ability to pay dividends or make other distributions in respect of its membership interests. Predecessor In conjunction with the Merger, TCEH recorded a $4.1 billion reduction in capital contributions from parent as the result of settlement of advances to, notes receivable from, and taxes payable to affiliates, as well as the net capital contribution to TCEH resulting from the contributions of entities and net assets discussed in Note 4. Cash Distributions to Parent ― During 2007, TCEH declared and paid the following cash distributions to EFC Holdings: Declaration Date October 1, 2007 July 1, 2007 April 1, 2007 January 1, 2007 Payment Date October 1, 2007 July 2, 2007 April 2, 2007 January 2, 2007 Distibution Amount $284 $284 $284 $283 Recapitalization of Exchangeable Preferred Membership Interests — Effective September 30, 2006, TCEH’s exchangeable preferred membership interests, which were held entirely by subsidiaries of EFH Corp., were recapitalized into common equity membership interests of TCEH. The principal amount of these preferred interests, net of the related discount, were reported as a noncurrent liability in the condensed consolidated balance sheet. The following amounts were reclassified to membership interests at September 30, 2006: Principal amount of the preferred interests..................................................... Remaining unamortized discount recorded at issuance.................................. Remaining unamortized issuance costs .......................................................... Total amount recapitalized .......................................................................... $ 750 (208) (21) $ 521 Noncash contributions — Under SFAS 123R, expense related to EFH Corp.’s stock-based incentive compensation awards granted to TCEH’s employees is accounted for as a noncash capital contribution from EFH Corp. Accordingly, TCEH recorded a credit to its membership interests account of $31 million in the period January 1, 2007 through October 10, 2007, and $22 million and $18 million for the years ended December 31, 2006 and 2005, respectively. 119
Slide 128: 18. COMMODITY AND OTHER DERIVATIVE CONTRACTUAL ASSETS AND LIABILITIES The following table provides detail of commodity and other derivative contractual assets and liabilities as presented in the balance sheet: Successor December 31, 2007 Cash flow hedges and other derivatives Netting (a) Commodity contracts Assets: Current assets ............................. Noncurrent assets....................... Total........................................ Liabilities: Current liabilities ....................... Noncurrent liabilities ................. Total........................................ Net assets (liabilities) ............. Total $ 1,118 239 $ 1,357 $ $ 8 5 13 $ $ ─ ─ ─ $ 1,126 244 $ 1,370 $ 1,042 2,232 $ 3,274 $ (1,917) $ $ $ 66 220 286 (273) $ $ $ ─ ─ ─ ─ $ 1,108 2,452 $ 3,560 $ (2,190) Commodity contracts Assets: Current assets ............................. Noncurrent assets....................... Total........................................ Liabilities: Current liabilities ....................... Noncurrent liabilities ................. Total........................................ Net assets (liabilities) ............. __________________ (a) Predecessor December 31, 2006 Cash flow hedges Netting (a) and other derivatives Total $ 1,438 310 $ 1,748 770 243 $ 1,013 $ $ $ (17) (80) (97) $ 2,191 473 $ 2,664 $ 1,441 330 $ 1,771 $ (23) $ $ $ 91 16 107 906 $ $ $ (17) (80) (97) ─ $ 1,515 266 $ 1,781 $ 883 Represents the effects of reclassification of the assets and liabilities to conform to the balance sheet presentation of current and long-term assets and liabilities. Margin deposits net assets of $445 million and margin deposit net liabilities of $648 million under master netting arrangements at December 31, 2007 and 2006, respectively, were not netted with derivative assets and liabilities since TCEH has elected to present the amounts of such assets and liabilities gross in the balance sheet as provided in FIN 39-1 and discussed in Note 1. 120
Slide 129: Commodity Contract Assets and Liabilities Commodity contract assets and liabilities primarily represent fair values of natural gas and electricity derivative instruments that have not been designated as cash flow hedges or “normal” purchases or sales under SFAS 133. These instruments are marked-to-market in net income. A multi-year power sales agreement was entered into with Alcoa Inc. in the 2007 Predecessor period. The agreement was determined to have a “day one” out-of-the-money value of $235 million. The agreement was entered into concurrently with the transfer of an air permit from Alcoa Inc. to a TCEH subsidiary as well as other agreements with Alcoa Inc. that provide, among other things, access to real property and a supply of lignite fuel, all of which provides value to TCEH by providing the right and ability to develop, construct and operate a new lignite coal-fueled generation unit at Sandow. In consideration of this right and ability, the initial out-of-themoney value of the sales agreement, as well as a $29 million out-of-the-money value of a related interim power sales agreement entered into in late 2006, were recorded as part of the construction work-in-process asset balance for the Sandow unit. The out-of-the-money values were recorded as commodity contract liabilities. The contracts were revalued applying the principles of SFAS 157 as part of purchase accounting, and subsequent changes in the value of the contracts continue to be marked-to-market in net income. Predecessor results include "day one" losses of $231 million associated with contracts entered into in 2007 at below market prices. Successor results include a “day one” loss of $8 million associated with a contract entered into in 2007 at below market prices. Essentially all of this amount represents losses associated with a transaction using natural gas financial instruments intended to economically hedge exposure to future changes in electricity prices. The losses were recorded as a reduction of revenues, consistent with other mark-to-market gains and losses. The “day one” losses were recorded as commodity contract liabilities. Predecessor results include a "day one" gain of $30 million associated with a long-term power purchase agreement entered into in 2007. The gain was recorded as an increase to revenues, consistent with other markto-market gains and losses. The “day one” gain was recorded as a commodity contract asset. Cash Flow Hedge and Other Derivative Assets and Liabilities Cash flow hedge and other derivative assets and liabilities primarily represent fair values of commodity contracts and interest rate swaps that have been designated as cash flow hedges. The change in fair value of derivative assets and liabilities designated as cash flow hedges are recorded as other comprehensive income or loss to the extent the hedges are effective; the ineffective portion of the change in fair value is included in net income. See Note 15 for details of interest rate swaps entered into subsequent to the Merger and designated as cash flow hedges. A significant portion of natural gas financial instruments entered into to hedge future changes in electricity prices had been designated and accounted for as cash flow hedges. In March 2007, these instruments were dedesignated as cash flow hedges as allowed under SFAS 133, thus becoming subject to mark-to-market accounting in net income as the fair values change. 121
Slide 130: A summary of cash flow hedge and other derivative assets and liabilities follows: Successor December 31, 2007 Current and noncurrent assets: Commodity-related cash flow hedges ..................... Interest rate swaps.................................................... Total...................................................................... Current and noncurrent liabilities: Commodity-related cash flow hedges ..................... Interest rate swaps.................................................... Total...................................................................... Predecessor December 31, 2006 $ $ 8 5 13 $ 1,013 ─ $ 1,013 $ $ 1 285 286 $ $ 103 4 107 Other Cash Flow Hedge Information — TCEH experienced cash flow hedge ineffectiveness of $114 million in net gains in 2007 (essentially all of which was in the Predecessor period), $218 million in net gains in 2006 and $38 million in net losses in 2005. These amounts are pretax and are reported in revenues. The net effect of recording unrealized mark-to-market gains and losses arising from hedge ineffectiveness (versus recording gains and losses upon settlement) includes the above amounts as well as the effect of reversing unrealized ineffectiveness gains and losses recorded in previous periods to offset realized gains and losses in the current period. Such net unrealized effect totaled $90 million in net gains in 2007 (essentially all of which was in the Predecessor period), $239 million in net gains in 2006 and $27 million in net losses in 2005. As of December 31, 2007, commodity positions accounted for as cash flow hedges, which represent a small portion of economic hedge positions, reduce exposure to variability of future cash flows from future revenues or purchases through 2010. Cash flow hedge amounts reported in accumulated other comprehensive income are recognized in earnings as the related forecasted transactions are settled or become probable of not occurring. No amounts were reclassified into earnings in 2007, 2006 or 2005 as a result of the discontinuance of cash flow hedge accounting because a hedged forecasted transaction became probable of not occurring. Cash flow hedge amounts reported in the Statements of Consolidated Comprehensive Income exclude net gains and losses associated with cash flow hedges entered into and settled within the periods presented. These amounts totaled less than $1 million in after-tax net losses for the period from October 11, 2007 through December 31, 2007, $39 million in after tax net losses for the period from January 1, 2007 through October 10, 2007, $31 million in after-tax net gains in 2006 and $53 million in after-tax net losses in 2005. Accumulated other comprehensive income related to cash flow hedges at December 31, 2007 totaled $177 million in net losses (after-tax), of which $182 million in net losses relates to interest rate swaps. TCEH expects that $37 million of net losses related to cash flow hedges included in accumulated other comprehensive income as of December 31, 2007 will be reclassified into net income during the next twelve months as the related hedged transactions affect net income. Of this amount, $40 million in losses relate to interest rate swaps and $3 million in gains relate to commodity hedges. 122
Slide 131: 19. INVESTMENTS The balance of investments consists of the following: Successor December 31, 2007 Nuclear decommissioning trust ...................................................................................... Assets related to employee benefit plans, including employee savings programs ........ Land................................................................................................................................. Investment in affiliate holding Capgemini-related assets .............................................. Wind investment project................................................................................................. Miscellaneous other ........................................................................................................ Total investments ..................................................................................................... $ 484 54 42 28 3 1 $ 612 Predecessor December 31, 2006 $ 447 50 33 14 ─ 1 $ 545 Nuclear Decommissioning Trust Investments in a trust that will be used to fund the costs to decommission the Comanche Peak nuclear generation plant are carried at fair value. Decommissioning costs are being recovered from Oncor’s customers as a delivery fee surcharge over the life of the plant and deposited in the trust fund. Net gains and losses on investments in the trust fund are offset by a corresponding adjustment to Oncor’s regulatory asset/liability. A summary of investments in the fund follows: Successor December 31, 2007 Unrealized gain Unrealized loss $ $ 3 129 132 $ $ (1) (8) (9) Cost (a) Debt securities.............................. Equity securities ........................... Total................................ $ $ 193 168 361 Fair market value $ $ 195 289 484 Cost (a) Debt securities.............................. Equity securities ........................... Total................................ ________________ (a) Includes realized gains and losses of securities sold. $ $ 169 162 331 Predecessor December 31, 2006 Unrealized gain Unrealized loss $ $ 5 117 122 $ $ (1) (5) (6) Fair market value $ $ 173 274 447 Debt securities held at December 31, 2007 mature as follows: $90 million in one to five years, $35 million in five to ten years and $70 million after ten years. Assets Related to Employee Benefit Plans The majority of these assets represent cash surrender values of life insurance policies that are purchased to fund liabilities under deferred compensation plans. EFH Corp. pays the premiums and is the beneficiary of these life insurance policies. As of December 31, 2007 and 2006, the face amount of these policies allocated to TCEH totaled $125 million and $129 million, and the net cash surrender values totaled $38 million and $35 million, respectively. Changes in cash surrender value are netted against premiums paid. Other investment assets held to satisfy deferred compensation liabilities are recorded at fair value. 123
Slide 132: Capgemini Agreement In May 2004, TCEH entered into a services agreement with Capgemini to outsource certain support activities. As part of the agreement, Capgemini was provided a royalty-free right, under an asset license arrangement, to use EFH Corp.’s information technology assets, consisting primarily of computer software. EFH Corp. obtained a 2.9% limited partnership interest in Capgemini in exchange for the asset license. EFH Corp. has the right to sell (the put option) its interest and the licensed software to Cap Gemini North America Inc. for $200 million, plus its share of Capgemini’s undistributed earnings, upon expiration of the services agreement or earlier upon the occurrence of certain events. Cap Gemini North America Inc. has the right to purchase these interests under the same terms and conditions. The partnership interest has been recorded at an initial value of $2.9 million and is being accounted for on the cost method. TCEH recorded its share of the fair value of the put option, estimated at $103 million, as a noncurrent asset. Of this amount, $98 million was recorded as a reduction to the carrying value of the licensed software, and the balance, which represents the fair value of the assumed cash distributions and gains while holding the partnership interest, was recorded as a noncurrent deferred credit. This accounting is in accordance with AICPA Statement of Position 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use”. Subject to certain terms and conditions, Cap Gemini North America, Inc. and its parent, Cap Gemini S.A., have guaranteed the performance and payment obligations of Capgemini under the services agreement, as well as payments under the put option. 20. PENSION AND OTHER POSTRETIREMENT EMPLOYEE BENEFITS Pension Plan TCEH is a participating employer in the EFH Retirement Plan (Retirement Plan), a defined benefit pension plan sponsored by EFH Corp. The Retirement Plan is a qualified pension plan under Section 401(a) of the Internal Revenue Code of 1986, as amended (Code) and is subject to the provisions of the Employee Retirement Income Security Act of 1974, as amended (ERISA). Eligible employees may participate in the Retirement Plan upon their completion of one year of service and the attainment of age 21. All benefits are funded by the participating employers. The Retirement Plan provides benefits to participants under one of two formulas: (i) a Cash Balance Formula under which participants earn monthly contribution credits based on their compensation and a combination of their age and years of service, plus monthly interest credits or (ii) a Traditional Retirement Plan Formula based on years of service and the average earnings of the three years of highest earnings. The interest component of the Cash Balance Formula is variable and is determined using the yield on 30-year Treasury bonds. All eligible employees hired after January 1, 2001 participated under the Cash Balance Formula. Certain employees who, prior to January 1, 2002, participated under the Traditional Retirement Plan Formula, continue their participation under that formula. Under the Cash Balance Formula, future increases in earnings will not apply to prior service costs. Effective October 1, 2007, all new employees, with the exception of employees hired by Oncor, are ineligible to participate in the Retirement Plan. New hires at Oncor are eligible to participate in the Cash Balance Formula of the Retirement Plan. It is EFH Corp.’s policy to fund the plans on a current basis to the extent deductible under existing federal tax regulations. TCEH also participates in EFH Corp.’s supplemental retirement plans for certain employees, whose retirement benefits cannot be fully earned under the qualified Retirement Plan, the information for which is included below. 124
Slide 133: Other Postretirement Employee Benefit (OPEB) Plan TCEH participates with EFH Corp. and certain other affiliated subsidiaries of EFH Corp. to offer certain health care and life insurance benefits to eligible employees and their eligible dependents upon the retirement of such employees. For employees retiring on or after January 1, 2002, the retiree contributions required for such coverage vary based on a formula depending on the retiree’s age and years of service. Pension and OPEB Costs The following details net pension and OPEB costs recognized as expense. Successor Period from Merger Date to December 31, 2007 $ 1 2 $ 3 Predecessor Period From January 1, 2007 to Merger Date $ 4 9 $ 13 Year Ended December 31, 2006 8 10 $ 18 $ 2005 5 9 $ 14 $ Pension costs under SFAS 87 ............................... OPEB costs under SFAS 106 ............................... Total benefit costs........................................ The pension and OPEB amounts provided represent allocations to TCEH of amounts related to EFH Corp.’s plans. Effective with the Merger, TCEH has not been allocated any overfunded asset or underfunded liability related to its participation in EFH Corp.’s pension and OPEB plans. In addition, associated with the Merger, the assets recorded as of October 10, 2007 were transferred to EFH Corp. Adoption of SFAS 158 in 2006 In September 2006, the FASB issued SFAS 158, which was adopted by EFH Corp. effective December 31, 2006, as required. SFAS 158 requires reporting in the balance sheet of the funded status of defined benefit pension and OPEB plans. Periodic pension and OPEB costs continue to be determined in accordance with SFAS 87 and SFAS 106. Under these standards, the accrued benefit obligation recognized in the balance sheet represented the cumulative difference between the net periodic benefit costs and cash funding of the plans. SFAS 87 also required the recording of a minimum pension liability representing the excess of the accumulated benefit obligation over the fair value of the plans’ assets and the accrued benefit obligation already recorded under SFAS 87. SFAS 158 requires that both the pension and OPEB accrued benefit obligation reported in the balance sheet represent the funded status of the plans based on the projected benefit obligation, which for the pension plan takes into account future compensation increases. For TCEH, the initial recognition of the funded status on the financial statements was largely reflected as an increase in pension assets, an increase in the accrued benefit obligation and an increase in accumulated other comprehensive income. The following summarizes the impact on the Predecessor December 31, 2006 consolidated balance sheet of adopting SFAS 158: Balances Prior to Application of SFAS 158 Noncurrent assets: Defined benefit pension assets.................................................. Accumulated deferred income taxes......................................... Noncurrent liabilities: OPEB obligations...................................................................... Accumulated deferred income taxes......................................... Membership interests: Accumulated other comprehensive income – net..................... $ $ $ $ $ 10 12 28 ─ ─ December 31, 2006 Increase (Decrease) in Balances $ $ $ $ $ 108 (12) 9 21 65 Balances After Application of SFAS 158 $ $ $ $ $ 118 ─ 37 21 65 125
Slide 134: The amounts recorded in the fourth quarter of 2006 upon adoption of SFAS 158 were based on TCEH’s allocation of the measurements of EFH Corp.’s pension and OPEB plans at the December 31, 2006 year-end date, which had been TCEH’s practice but is now required under SFAS 158. Regulatory Recovery of Pension and OPEB Costs In 2005, an amendment to PURA relating to EFH Corp.’s pension and OPEB costs was enacted by the Legislature of the State of Texas. This amendment, which was retroactively effective January 1, 2005, provides for the recovery by Oncor of pension and OPEB costs for all applicable former employees of the regulated predecessor integrated electric utility. In addition to Oncor’s active and retired employees, these former employees consist largely of active and retired personnel engaged in TCEH’s activities, related to service of those additional personnel prior to the deregulation and disaggregation of EFH Corp.’s business effective January 1, 2002. Accordingly, Oncor and TCEH entered into an agreement whereby Oncor assumed responsibility for applicable pension and OPEB costs related to those personnel. The following table summarizes the initial impact of the related transfer of pension and OPEB obligations at December 31, 2005: Decrease in intangible asset........................................................................................ Decrease in other noncurrent liabilities and deferred credits..................................... Increase in accumulated deferred income taxes ......................................................... Increase in other comprehensive income ................................................................... Total noncash reduction of pension obligation (a)..................................................... ________________________ (a) Amounts represent an increase in current affiliate payables. $ (6) 232 (82) (7) 137 $ Additionally, TCEH transferred to Oncor pension-related assets of $8 million in 2006. Assumed Discount Rate The discount rates reflected in net pension and OPEB costs are 6.45% for the period October 11, 2007 through December 31, 2007, 5.90% for the period January 1, 2007 through October 10, 2007, and 5.75% and 6.0% for the years ended December 31, 2006 and 2005, respectively. The expected rate of return on plan assets reflected in the 2007 cost amounts is 8.75% for the pension plan and 8.67% for other postretirement benefits. Pension and OPEB Plan Cash Contributions Pension plan contributions were $358 thousand, $30 thousand and $53 thousand in 2007, 2006 and 2005, respectively. OPEB plan contributions were $1 million, $1 million and $6 million in 2007, 2006 and 2005, respectively. Estimated funding to EFH Corp. in 2008 of the pension plan and OPEB plan total $458 thousand and $343 thousand, respectively. 126
Slide 135: Thrift Plan Employees of TCEH may participate in a qualified savings plan, the EFH Thrift Plan (Thrift Plan). This plan is a participant-directed defined contribution plan intended to qualify under Section 401(a) of the Code, and is subject to the provisions of ERISA. The Thrift Plan included an employee stock ownership component until October 10, 2007. Under the terms of the Thrift Plan, employees who do not earn more than the IRS threshold compensation limit used to determine highly compensated employees may contribute, through pre-tax salary deferrals and/or after-tax applicable payroll deductions, the lesser of 75% of their regular salary or wages or the maximum amount permitted under law. Employees who earn more than such threshold may contribute from 1% to 16% of their regular salary or wages. Employer matching contributions are also made in an amount equal to 100% of the first 6% of employee contributions for employees who are covered under the Cash Balance Formula of the Retirement Plan, and 75% of the first 6% of employee contributions for employees who are covered under the Traditional Retirement Plan Formula of the Retirement Plan. Prior to January 1, 2006, employer matching contributions were invested in EFH Corp. common stock. Effective January 1, 2006 through the October 10, 2007, employees could reallocate or transfer all or part of their accumulated or future employer matching contributions to any of the plan’s other investment options. As of October 10, 2007, employer matching contributions are made in cash and may be allocated by participants to any of the plan's investment options. 21. STOCK-BASED COMPENSATION PLANS Successor In connection with the Merger, in December 2007, EFH Corp. established the 2007 Stock Incentive Plan for Key Employees of EFH Corp. and its Affiliates (2007 SIP). TCEH bears the costs of EFH Corp.'s 2007 SIP for applicable management personnel engaged in its business activities. Incentive awards under the 2007 SIP may be granted to directors, officer or qualified managerial employees of EFH Corp. or its subsidiaries or affiliates in the form of non-qualified stock options, stock appreciation rights, restricted shares, shares of common stock, the opportunity to purchase shares of common stock and other awards that are valued in whole or in part by reference to, or are otherwise based on the fair market value of EFH Corp.’s shares of common stock. Under the terms of the 2007 SIP, options to purchase 14.1 million shares of EFH Corp. common stock were issued to certain TCEH management employees in December 2007. The options provide the holder the right to purchase EFH Corp. common stock for $5.00 per share, which was the fair market value at grant date. Vested awards must be exercised within 10 years of the grant date. The terms of the options were fixed at grant date. Stock Options — The stock option awards under the 2007 SIP consist of two types of stock options. Onehalf of the options awarded vest solely based upon continued employment over a specific period of time, generally five years, with the options vesting ratably on an annual basis over the period (“Time-Based Options”). One-half of the options awarded vest based upon both continued employment and the achievement of a predetermined level of EFH Corp. EBITDA over time, generally ratably over five years based upon annual EBITDA levels, with provisions for vesting if the annual levels are not achieved but cumulative two- or threeyear total EBITDA levels are achieved (“Performance-Based Options”). The Performance-Based Options may also vest in part or in full upon the occurrence of certain specified liquidity events. All options remain exercisable for ten years from the date of grant. 127
Slide 136: The fair value of the Time-Based and Performance-Based Options granted was estimated using the BlackScholes option pricing model and the assumptions noted in the table below. The weighted average grant-date fair value of the Time-Based Options granted in December 2007 was $1.92 per option. The grant-date fair value of the Performance-Based Options granted in December 2007 ranged from $1.74 to $2.09 depending upon the performance period. Assumptions Expected volatility ........................................................... Expected annual dividend................................................ Expected life (in years).................................................... Risk-free rate ................................................................... Time-Based Options 30% ─ 6.4 3.81% Performance-Based Options 30% ─ 5.4 ─ 7.4 3.92% Compensation expense for Time-Based and Performance-Based Options is based on the grant-date fair value and recognized over the vesting period as employees perform services. Less than $60 thousand was recognized during the 2007 Successor period by TCEH for Time-Based Options, essentially all to expense. EFH Corp. has applied a forfeiture assumption of 5% per annum in the calculation of such expense. As of December 31, 2007, there was approximately $13 million of unrecognized compensation expense related to nonvested Time-Based Options, which is expected to be recognized ratably over a weighted-average period of approximately 5 years. Compensation expense for Performance-Based Options is recognized over the requisite performance and service periods for each tranche of options depending upon the achievement of financial performance, or if certain liquidity events occur, as discussed above. Prior to vesting, expenses are recorded if the achievement of the EBITDA levels is probable, and amounts recorded are adjusted or reversed if the probability of achievement of such levels changes. Probability of vesting is evaluated at least each quarter. No amounts were expensed in the 2007 Successor period by TCEH for Performance-Based Options because the performance period for the first tranche of the options did not begin until January 1, 2008. EFH Corp. will apply a forfeiture assumption of 5% per annum in the calculation of such expense. As of December 31, 2007, there was approximately $13 million of unrecognized compensation expense related to nonvested Performance-Based Options, which TCEH could record as an expense over a weightedaverage period of approximately 5 years, subject to the achievement of financial performance being probable. As of December 31, 2007, certain members of executive management had agreed to forego receipt of payment of an aggregate of approximately $9 million of equity awards to which they were entitled at the closing of the Merger, in exchange for deferred common shares of EFH Corp. under the terms of deferred share agreements. Predecessor Prior to the Merger, TCEH bore the costs of the EFH Corp. shareholder-approved long-term incentive plans for applicable management personnel engaged in TCEH’s business activities. EFH Corp. provided discretionary awards of performance units to qualified management employees that were payable in its common stock. The awards generally vested over a three year period and the number of shares ultimately earned was based on the performance of EFH Corp.’s stock over the vesting period as compared to peer companies and established thresholds. EFH Corp. established restrictions that limited certain employees’ opportunities to liquidate vested awards. 128
Slide 137: EFH Corp. determined the fair value of its stock-based compensation awards utilizing a valuation model that took into account three principal factors: expected volatility of the stock price of TXU Corp. and peer group companies, dividend rate of TXU Corp. and peer group companies and the restrictions limiting liquidation of vested stock awards. Based on the fair values determined under this model, TCEH’s reported expense related to the awards totaled $6 million ($4 million after tax) for the period from January 1, 2007 through October 10, 2007 and $9 million ($6 million after-tax) and $12 million ($8 million after-tax) in 2006 and 2005, respectively. The number of awards granted, net of forfeitures, totaled 37 thousand for the period from January 1, 2007 through October 10, 2007 and 185 thousand in 2006. The number of forfeitures exceeded grants by 39 thousand in 2005. With respect to awards to personnel engaged in TCEH’s activities, the fair value of awards that vested in the period from January 1, 2007 through October 10, 2007 totaled $152 million, and for the years ended December 31, 2006 and 2005 totaled $50 million and $34 million, respectively, based on the vesting date share prices. 22. FAIR VALUE MEASUREMENTS In September 2006, the FASB issued SFAS 157, which defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. SFAS 157 applies in situations where other accounting pronouncements either permit or require fair value measurements, including purchase accounting. SFAS 157 does not require any new fair value measurements. However, SFAS 157 supersedes a previous accounting rule that prohibited the recognition of day one gains or losses on derivative instruments unless the fair value of those instruments were derived from a quoted market price. Additionally, SFAS 157 requires an entity to take its own credit risk (nonperformance risk) into consideration when measuring the fair value of liabilities. TCEH adopted SFAS 157 effective with the closing of the Merger. The adoption of SFAS 157 reflects the application of FSP 157-2, "Effective Date of FASB Statement No. 157”, which was issued by the FASB in February 2008 and delays until financial statements issued after December 15, 2008 the effective date of SFAS 157 for all nonfinancial assets and liabilities, except for those recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). SFAS 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. With the adoption of SFAS 157, TCEH uses a “mid-market” valuation convention (the mid-point price between bid and ask prices) as a practical expedient to measure fair value for the majority of its assets and liabilities subject to fair value measurement under SFAS 133 and other accounting rules that require such measurement on a recurring basis. TCEH primarily uses the market approach for recurring fair value measurements and uses valuation techniques to maximize the use of observable inputs and minimize the use of unobservable inputs. 129
Slide 138: TCEH categorizes its assets and liabilities recorded at fair value based upon the following fair value hierarchy established by SFAS 157: • Level 1 valuations use quoted prices in active markets for identical assets or liabilities that are accessible at the measurement date. An active market is a market in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis. TCEH’s Level 1 assets and liabilities normally include exchange traded commodity contracts. For example, TCEH has a significant number of derivatives that are NYMEX futures and swaps for which the exchange traded pricing is actively quoted. Level 2 valuations use inputs other than actively quoted market prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include: (a) quoted prices for similar assets or liabilities in active markets, (b) quoted prices for identical or similar assets or liabilities in markets that are not active, (c) inputs other than quoted prices that are observable for the asset or liability such as interest rates and yield curves observable at commonly quoted intervals and (d) inputs that are derived principally from or corroborated by observable market data by correlation or other means. TCEH’s Level 2 assets and liabilities utilize over the counter broker quotes, quoted prices for similar assets or liabilities that are corroborated by correlations or other mathematical means and other valuation inputs. For example, TCEH’s Level 2 assets and liabilities include forward commodity positions at locations for which over-the-counter broker quotes are available. Level 3 valuations use unobservable inputs for the asset or liability. Unobservable inputs are used to the extent observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date. TCEH uses the best information available from the market combined with its own internally developed valuation methodologies to develop its best estimate of fair value. For example, certain derivatives assets or liabilities are derived from pricing models that utilize multiple inputs to the valuations, including inputs that are not observable or easily corroborated through other means. • • TCEH utilizes several different valuation techniques to measure the fair value of assets and liabilities, relying primarily on the market approach of using prices and other market information for identical and/or comparable assets and liabilities for those items that are measured on a recurring basis. Certain derivatives and financial instruments are valued utilizing option pricing models that take into consideration multiple inputs including commodity prices, volatility factors, discount rates and other inputs. Additionally, when there is not a sufficient amount of observable market data, valuation models are developed that incorporate proprietary views of market factors. Those valuation models are generally used in developing long-term forward price curves for certain commodities. TCEH believes that development of such curves is consistent with industry practice; however, the fair value measurements resulting from such curves are classified as Level 3. With respect to amounts presented in the following fair value hierarchy table, the fair value measurement of an asset or liability (e.g. a contract) is required under SFAS 157 to fall in its entirety in one level, based on the lowest level input that is significant to the fair value measurement. Certain assets and liabilities would be classified in Level 2 instead of Level 3 of the hierarchy except for the effects of credit reserves and nonperformance risk adjustments, respectively. Assessing the significance of a particular input to the fair value measurement in its entirety requires judgment, considering factors specific to the asset or liability being measured. 130
Slide 139: At December 31, 2007, assets and liabilities measured at fair value on a recurring basis consisted of the following: Level 1 Assets: Commodity-related contracts .................. Interest rate swaps ................................... Nuclear decommissioning trust (b) ......... Salary deferral plan investments (b)........ Total assets ......................................... Liabilities: Commodity-related contracts .................. Interest rate swaps ................................... Total liabilities ..................................... _________________ (a) (b) $ 511 ─ 165 15 691 Level 2 $ 683 5 319 23 1,030 Level 3 $ 148 ─ ─ ─ 148 Reclassification (a) $ 23 ─ ─ ─ 23 $ Total 1,365 5 484 38 1,892 $ $ $ $ $ $ $ 559 ─ 559 $ $ 2,372 285 2,657 $ $ 321 ─ 321 $ $ 23 ─ 23 $ $ 3,275 285 3,560 Represents the effects of reclassification of the assets and liabilities to conform to the balance sheet presentation of current and long-term assets and liabilities. The nuclear decommissioning trust and salary deferral plan investments are included in the Investments line on the balance sheet. Commodity-related contracts primarily represent mark-to-market values of natural gas and electricity derivative instruments that have not been designated “normal” purchases or sales under SFAS 133. Interest rate swaps consist primarily of variable-to-fixed rate swap instruments that have been designated as cash flow hedges. Nuclear decommissioning trust assets represent securities held for the purpose of funding the future retirement and decommissioning of the nuclear generation units. These investments include equity, debt and other fixed-income securities consistent with investment rules established by the NRC and the PUCT. Salary deferral plan assets represent securities held for the purpose of funding the liabilities of EFH Corp.’s Salary Deferral Program. These investments include life insurance contracts, equity, debt and other fixedincome securities. The following table presents the changes in fair value of TCEH's Level 3 assets and liabilities for the year ended December 31, 2007: Commodityrelated contracts $ (133) (117) 7 28 42 (173) Balance at October 11, 2007 (net liability) ....................................................................................... Total realized and unrealized gains (losses) (a): Included in net income (loss) .................................................................................................. Included in other comprehensive income (loss)...................................................................... Purchases, sales, issuances and settlements (net) (b).................................................................. Net transfers in and/or out of Level 3 (c) .................................................................................... Balance at December 31, 2007 (net liability).................................................................................... Net change in unrealized gains (losses) included in net income relating to instruments held at December 31, 2007 (a)................................................................................................. $ $ (101) _______________ (a) Changes in values of commodity-related contracts are largely reported in operating revenues; certain of such contracts are accounted for as cash flow hedges for which changes in values are reported as other comprehensive income to the extent the hedges are effective and in operating revenues for the ineffective portion. Settlements represent amounts included in the beginning balance for the period. Includes transfers due to changes in the observability of significant inputs. Amounts transferred in and/or out represent December 31, 2007 values. (b) (c) 131
Slide 140: 23. FAIR VALUE OF NONDERIVATIVE FINANCIAL INSTRUMENTS The carrying amounts and related estimated fair values of significant nonderivative financial instruments were as follows: Successor December 31, 2007 Carrying Amount On balance sheet assets (liabilities): Long-term debt (including current maturities) (b) .......... Off balance sheet assets (liabilities): Financial guarantees ........................................................ ______________ (a) (b) Fair value determined in accordance with SFAS 157. Excludes capital leases. $ ─ $ (1) $ — $ 7 $ (28,443) $ (28,102) $ (3,028) $ (3,059) Fair Value (a) Predecessor December 31, 2006 Carrying Amount Fair Value See Note 18 for discussion of accounting for financial instruments that are derivatives. Predecessor Information The fair values of on-balance sheet instruments were estimated at the lesser of either the call price or the market value as determined by quoted market prices, where available, or, where not available, at the present value of future cash flows discounted at rates consistent with comparable maturities with similar credit risk. The fair value of each financial guarantee was based on the difference between the credit spread of the entity responsible for the underlying obligation and a financial counterparty applied, on a net present value basis, to the notional amount of the guarantee. The carrying amounts for financial assets classified as current assets and the carrying amounts for financial liabilities classified as current liabilities approximated fair value due to the short maturity of such instruments. The fair values of other financial instruments, including the Capgemini put option, for which carrying amounts and fair values have not been presented, were not materially different than their related carrying amounts. 132
Slide 141: 24. RELATED–PARTY TRANSACTIONS The following represent the significant related-party transactions of TCEH: • TCEH incurs electricity delivery fees charged by Oncor. These fees totaled $209 million for the period from October 11, 2007 through December 31, 2007, $827 million for the period from January 1, 2007 through October 10, 2007, and $1.1 billion and $1.3 billion for the years ended December 31, 2006 and 2005, respectively. Oncor’s bankruptcy-remote financing subsidiary has issued securitization bonds to recover generationrelated regulatory assets through a transition surcharge to its customers. Oncor’s incremental income taxes related to the transition surcharges it collects are being reimbursed by TCEH. Therefore, TCEH’s financial statements reflect a noninterest bearing note payable to Oncor of $323 million ($34 million reported as current liabilities) at December 31, 2007 and $356 million ($33 million reported as current liabilities) at December 31, 2006. TCEH reimburses Oncor for interest expense on Oncor’s bankruptcy-remote financing subsidiary’s securitization bonds. This interest expense totaled $11 million for the period from October 11, 2007 through December 31, 2007, $38 million for the period from January 1, 2007 through October 10, 2007, and $52 million and $55 million for the years ended December 31, 2006 and 2005, respectively. Current and noncurrent advances to parent totaled $2.7 billion at December 31, 2006 ($700 million reported as noncurrent). The average daily balances of the advances to parent totaled $3.3 billion for the period from January 1, 2007 through October 10, 2007 and $1.9 billion for the year ended December 31, 2006. Interest income earned on the advances totaled $162 million for the period from January 1, 2007 through October 10, 2007, and $105 million and $52 million for the years ended December 31, 2006 and 2005, respectively. The weighted average annual interest rates were 6.3% for the period from January 1, 2007 through October 10, 2007, and 5.4% and 4.1% for the years ended December 31, 2006 and 2005, respectively. In December 2005, TCEH received a $1.5 billion note from EFH Corp. in partial settlement of outstanding advances to parent. EFH Corp. settled the note in connection with the Merger (see Note 17). The note carried interest at a rate based on the weighted average cost of TCEH’s short-term borrowings. Interest income related to this note totaled $71 million for the period from January 1, 2007 through October 10, 2007 and $82 million and $2 million for the years ended December 31, 2006 and 2005, respectively. In November 2007, TCEH received a note from EFH Corp. to be used for the working capital and general corporate purposes of EFH Corp. The note totaled $25 million at December 31, 2007, and the average daily balance of the note from the issuance date until December 31, 2007 was $20 million. The note carries interest at a rate based on the one-month LIBOR rate plus 5.00%, and interest income totaled $257 thousand for the period from October 11, 2007 through December 31, 2007. An EFH Corp. subsidiary charges TCEH for financial, accounting, environmental and other administrative services at cost. These costs, which are primarily reported in SG&A expenses, totaled $16 million for the period from October 11, 2007 through December 31, 2007, $45 million for the period from January 1, 2007 through October 10, 2007, and $65 million and $64 million for the years ended December 31, 2006 and 2005, respectively. • • • • • • 133
Slide 142: • Under Texas regulatory provisions, the trust fund for decommissioning the Comanche Peak nuclear generation facility, reported in investments on TCEH’s balance sheet, is funded by a delivery fee surcharge billed to REPs by Oncor and remitted to TCEH, with the intent that the trust fund assets will be sufficient to fund the decommissioning liability, reported in noncurrent liabilities on TCEH’s balance sheet. Income and expenses associated with the trust fund and the decommissioning liability incurred by TCEH are offset by a net change in the intercompany receivable/payable with Oncor, which in turn results in a change in the net regulatory asset/liability. The regulatory liability, which totaled $13 million and $17 million at December 31, 2007 and 2006, respectively, is reported on Oncor’s balance sheet and represents the excess of the trust fund balance over the estimated decommissioning liability. Distributions and discount amortization (both reported as interest expense) related to TCEH’s exchangeable preferred membership interests held entirely by subsidiaries of EFH Corp. totaled $67 million and $88 million for the years ended December 31, 2006 and 2005, respectively. Effective September 30, 2006, these securities were recapitalized into common equity membership interests (see Note 17). TCEH has a 53.1% limited partnership interest, with a carrying value of $28 million and $14 million at December 31, 2007 and 2006, respectively, in an EFH Corp. subsidiary holding Capgemini-related assets. Equity losses related to this interest totaled $2 million for the period from October 11, 2007 through December 31, 2007, $5 million for the period from January 1, 2007 through October 10, 2007, and $10 million and $7 million for the years ended December 31, 2006 and 2005, respectively. These losses primarily represent amortization of software assets held by the subsidiary. The equity losses are reported as other deductions. EFH Corp. files a consolidated federal income tax return, and federal income taxes are allocated to subsidiaries based on their respective taxable income or loss. As a result, TCEH had an income tax receivable from EFH Corp. of $190 million at December 31, 2007 and an income tax payable to EFH Corp. of $501 million at December 31, 2006. Certain transmission and distribution utilities in Texas have tariffs in place to assure adequate credit worthiness of any REP to support the REP’s obligation to collect securitization bond-related (transition) charges on behalf of the utility. Under these tariffs, as a result of TCEH’s credit rating downgrade to below investment grade, TCEH is required to post collateral support in an amount equal to estimated transition charges over specified time periods. TCEH has posted a letter of credit in the amount of $14 million for the benefit of Oncor. At the closing of the Merger, TCEH entered into the TCEH Senior Secured Facilities with a syndicate of financial institutions and other lenders. This syndicate included affiliates of GS Capital Partners. In November and December 2007, TCEH offered the TCEH Notes. Affiliates of GS Capital Partners served as initial purchasers in such offerings. Affiliates of GS Capital Partners have from time to time engaged in commercial banking and financial advisory transactions with TCEH in the normal course of business. Affiliates of Goldman Sachs & Co. are party to certain commodity and interest rate hedging transactions with TCEH in the normal course of business. From time to time affiliates of the Sponsor Group may acquire debt or debt securities issued by TCEH in open market transactions or through loan syndications. • • • • • • • See Note 4 for contributions of entities and net assets to TCEH, Note 14 for information regarding the accounts receivable securitization program and related subordinated notes receivable from TXU Receivables Company, Note 17 for cash distributions to EFC Holdings and Note 20 for the assumption by Oncor of certain TCEH pension and OPEB costs. 134
Slide 143: 25. SUPPLEMENTARY FINANCIAL INFORMATION Interest Expense and Related Charges Successor Period from October 11, 2007 through December 31, 2007 Interest........................................................................... Distributions on exchangeable preferred membership interests (a) ........................................ Amortization of debt fair value discount resulting from purchase accounting ...................................... Amortization of debt discount and issuance costs........ Interest capitalized in accordance with SFAS 34 ......... Total interest expense and related charges............. $ 586 ─ 5 54 (58) $ 587 $ Predecessor Period From January 1, 2007 through October 10, 2007 $ 354 ─ ─ 10 (41) 323 $ Year Ended December 31, 2006 $ 347 51 ─ 24 (30) 392 $ 2005 $ 309 68 ─ 28 (12) 393 _______________ (a) Effective September 30, 2006, TCEH’s exchangeable preferred membership interest, which were held entirely by subsidiaries of EFH Corp., were recapitalized into common equity membership interests of TCEH. Restricted Cash Successor At December 31, 2007 Noncurrent Current Assets Assets Amounts related to TCEH’s senior secured letter of credit facility (See Note 15)............................................................ Pollution control revenue bond funds held by trustee (See Note 15)................................................................................. All other....................................................................................... Total restricted cash.............................................................. $ $ ─ ─ ─ ─ $ $ 1,250 29 ─ 1,279 $ Predecessor At December 31, 2006 Noncurrent Current Assets Assets $ ─ ─ 3 3 $ $ ─ 241 ─ 241 Inventories by Major Category Successor December 31, 2007 Materials and supplies ........................................................................................ Fuel stock ............................................................................................................ Natural gas in storage.......................................................................................... Environmental energy credits and emission allowances (a) .............................. Total inventories ........................................................................................... $ 121 138 93 ─ 352 Predecessor December 31, 2006 $ 112 94 75 25 306 $ $ ______________ (a) The Successor reports environmental energy credits and emission allowances as intangible assets. See Note 3. 135
Slide 144: Property, Plant and Equipment Successor December 31, 2007 Generation ........................................................................................................... Other assets ......................................................................................................... Total .............................................................................................................. Less accumulated depreciation ........................................................................... Net of accumulated depreciation.................................................................. Construction work in progress............................................................................ Nuclear fuel (net of accumulated amortization of $47 and $1,123)................... Property, plant and equipment — net ......................................................... $16,981 109 17,090 242 16,848 3,246 451 $20,545 Predecessor December 31, 2006 $16,295 42 16,337 7,089 9,248 933 159 $10,340 Assets related to capitalized leases included above totaled $161 million at December 31, 2007 and $96 million at December 31, 2006, net of accumulated depreciation. Asset Retirement Obligations These liabilities primarily relate to nuclear generation plant decommissioning, land reclamation related to lignite mining, removal of lignite/coal-fueled plant ash treatment facilities and generation plant asbestos removal and disposal costs. There is no earnings impact with respect to the recognition of the asset retirement costs for nuclear decommissioning, as all costs are recoverable through the regulatory process as part of Oncor’s rates. The following table summarizes the changes to the asset retirement liability, reported in other noncurrent liabilities and deferred credits in the balance sheet, during the years ended December 31, 2007 and 2006: Asset retirement liability at January 1, 2006 ........................................... Additions: Accretion ............................................................................................. Incremental mining reclamation costs ................................................ Reductions: Net change in mining land reclamation estimated liability ................ Mining reclamation ............................................................................. Asset retirement liability at December 31, 2006..................................... Additions: Accretion – January 1, 2007 through October 10, 2007..................... Accretion – October 11, 2007 through December 31, 2007............... Purchase accounting adjustment ......................................................... Reductions: Mining reclamation cost adjustments ................................................. Mining reclamation payments – January 1, 2007 through October 10, 2007 ............................................................................ Mining reclamation payments – October 11, 2007 through December 31, 2007 ........................................................................ Asset retirement liability at December 31, 2007..................................... $ 558 36 21 (4) (26) 585 29 11 176 (2) (19) (7) $ 773 136
Slide 145: Other Noncurrent Liabilities and Deferred Credits The balance of other noncurrent liabilities and deferred credits consists of the following: Successor December 31, 2007 Unfavorable purchase and sales contracts .................................................... Uncertain tax positions (including accrued interest) .................................... Asset retirement obligations ......................................................................... Retirement plan and other employee benefits .............................................. Other ............................................................................................................. Total other noncurrent liabilities and deferred credits....................... 751 798 773 50 52 $ 2,424 $ $ Predecessor December 31, 2006 ─ 273 583 151 144 $ 1,151 Unfavorable Purchase and Sales Contracts ─ Unfavorable purchase and sales contracts primarily represent the out-of-the-money value of contracts for which: 1) TCEH has made the “normal” purchase or sale election allowed or 2) the contract did not meet the definition of a derivative under SFAS 133. Under purchase accounting, TCEH recorded the out-of-the-money value as of October 10, 2007 as a deferred credit. Amortization of the deferred credit related to unfavorable contracts is based on the terms of the contract and recorded as revenues or a reduction of purchased power costs as appropriate. The amortization amount totaled $5 million in the 2007 Successor period. Favorable purchase and sales contracts are recorded as intangible assets (see Note 3). The estimated amortization of unfavorable purchase and sales contracts for each of the five succeeding fiscal years from December 31, 2007 is as follows: Year 2008........................................................................................... 2009........................................................................................... 2010........................................................................................... 2011........................................................................................... 2012........................................................................................... Successor Amount $ 26 25 24 24 24 137
Slide 146: Supplemental Cash Flow Information Successor Period from October 11, 2007 through December 31, 2007 Cash payments (receipts) related to continuing operations: Interest (net of amounts capitalized)..................................... Income taxes.......................................................................... Noncash investing and financing activities: Out-of-the-money values of power sales agreements (see Note 18)..................................................................... Noncash contribution from EFH Corp. related to Merger financing and other activities ........................................... Promissory note issued in conjunction with acquisition of mining-related assets.................................................... Capital leases......................................................................... Noncash contribution related to EFH Corp. stock-based compensation.................................................................... Noncash construction expenditures (a)................................. Noncash contribution related to allocated pension adjustment......................................................................... Recapitalization of exchangeable preferred membership interests............................................................................. Transfer of Luminant Enterprise Holdings Company LLC.. Generation plant rail spur capital lease................................. Consolidation of lease trust: Increase in assets .............................................................. Increase in debt................................................................. ________________ (a) Represents end-of-period accruals. Predecessor Period From January 1, 2007 through October 10, 2007 Year Ended December 31, 2006 2005 $ 227 ─ $ 318 916 $ 375 2 $ 358 524 ─ 301 ─ 16 ─ 129 ─ ─ ─ ─ ─ ─ 264 ─ 65 59 6 134 8 ─ ─ ─ ─ ─ ─ ─ ─ ─ 9 57 65 521 6 ─ ─ ─ ─ ─ ─ ─ 12 18 ─ ─ ─ 95 35 96 138
Slide 147: Appendix A TCEH Consolidated Adjusted EBITDA Reconciliation Year Ended December 31, 2007 Net income ..................................................................................................................... Income tax expense (benefit) ....................................................................................... Interest expense and related charges.......................................................................... Depreciation and amortization.................................................................................... EBITDA ......................................................................................................................... Interest income ............................................................................................................... Amortization of nuclear fuel .......................................................................................... Purchase accounting adjustments (a) ............................................................................. Impairment of assets and inventory write down (b) ...................................................... Unrealized net (gain) or loss resulting from hedging transactions ................................ One-time customer appreciation bonus.......................................................................... Losses on sale of receivables.......................................................................................... Noncash compensation expense (SFAS 123R) (c) ........................................................ Severance expense (d) .................................................................................................... Transition and business optimization costs (e) .............................................................. Restructuring and other (f) ............................................................................................. Expenses incurred to upgrade or expand a generation station (g) ................................. Adjusted EBITDA ........................................................................................................ 35 (56) 910 568 $ 1,457 (281) 69 128 ─ 2,278 ─ 39 8 ─ 21 (33) 5 $ 3,691 $ Year Ended December 31, 2006 $ 2,394 1,255 392 334 $ 4,375 (203) 65 ─ 201 (272) 165 38 9 15 ─ (7) 4 $ 4,390 ____________________ (a) (b) (c) (d) (e) (f) (g) Purchase accounting adjustments include amortization of the intangible net asset value of retail and wholesale power sales agreements, emission credits, coal purchase contracts and power purchase agreements and the stepped up value of nuclear fuel. Also includes certain credits not recognized in net income due to purchase accounting. Impairment of assets includes the 2006 impairment of natural gas-fueled generation units. Noncash compensation expenses exclude capitalized amounts. Severance expense includes amounts incurred related to outsourcing, restructuring and other amounts deemed to be in excess of normal recurring amounts. Transition and business optimization costs include professional fees primarily for retail billing and customer care systems enhancements and incentive compensation. Restructuring and other includes credits related to impaired combustion turbine leases and other restructuring initiatives and nonrecurring activities. Expenses incurred to upgrade or expand a generation station reflect noncapital outage costs. 139

   
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