Filed by Bowne Pure Compliance
Table of Contents

 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-Q
(Mark One)
     
þ   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2008
OR
     
o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                      to                     
 
Commission file number 1-16455
Reliant Energy, Inc.
(Exact Name of Registrant as Specified in Its Charter)
     
Delaware   76-0655566
(State or Other Jurisdiction of Incorporation or   (I.R.S. Employer Identification No.)
Organization)    
1000 Main Street
Houston, Texas 77002

(Address of Principal Executive Offices) (Zip Code)
(713) 497-3000
(Registrant’s Telephone Number, Including Area Code)
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
             
Large accelerated filer þ   Accelerated filer o   Non-accelerated filer o
(Do not check if a smaller reporting company)
  Smaller reporting company o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ
As of October 24, 2008, the latest practicable date for determination, Reliant Energy, Inc. had 349,807,872 shares of common stock outstanding and no shares of treasury stock.
 
 

 

 


 

TABLE OF CONTENTS
         
 
       
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PART I.
FINANCIAL INFORMATION
 
       
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PART II.
OTHER INFORMATION
 
       
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 Exhibit 10.1
 Exhibit 31.1
 Exhibit 31.2
 Exhibit 32.1

 

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FORWARD-LOOKING INFORMATION
This report contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements are statements that contain projections, assumptions or estimates about our revenues, income, capital structure and other financial items, our plans and objectives for future operations or about our future economic performance, transactions and dispositions and financings and approvals related thereto. In many cases, you can identify forward-looking statements by terminology such as “anticipate,” “estimate,” “believe,” “continue,” “could,” “intend,” “may,” “plan,” “potential,” “predict,” “should,” “will,” “expect,” “objective,” “projection,” “forecast,” “goal,” “guidance,” “outlook,” “effort,” “target” and other similar words. However, the absence of these words does not mean that the statements are not forward-looking.
Actual results may differ materially from those expressed or implied by the forward-looking statements as a result of many factors or events, including, but not limited to, the following:
    Demand and market prices for electricity, purchased power and fuel and emission allowances;
 
    Limitations on our ability to set rates at market prices;
 
    Legislative, regulatory and/or market developments;
 
    Our ability to obtain adequate fuel supply and/or transmission and distribution services;
 
    Interruption or breakdown of our generating equipment and processes;
 
    Failure of third parties to perform contractual obligations;
 
    Changes in environmental regulations that constrain our operations or increase our compliance costs;
 
    Failure by transmission system operators to communicate operating and system information properly and timely;
 
    Failure to meet our debt service, restrictive covenants, collateral postings or obligations related to our credit-enhanced retail structure;
 
    Ineffective hedging and other risk management activities;
 
    Changes in the wholesale energy market or in our evaluation of our generation assets;
 
    The outcome of pending or threatened lawsuits, regulatory proceedings, tax proceedings and investigations;
 
    Weather-related events or other events beyond our control;
 
    The timing and extent of changes in commodity prices or interest rates;
 
    Our ability to attract and retain retail customers or to adequately forecast their energy needs and usage;
 
    Our ability to complete ongoing negotiations for an orderly unwind of our credit-enhanced retail structure or failure of such structure;
 
    Our ability to complete ongoing negotiations with respect to the term loan component of our $1.0 billion of new capital arrangements;
 
    Financial market conditions and our access to capital; and
 
    The outcome of our strategic alternatives review.
Other factors that could cause our actual results to differ from our projected results are discussed or referred to in the “Risk Factors” section of this report and of our most recent Annual Report on Form 10-K filed with the Securities and Exchange Commission. Our filings and other important information are also available on our website at www.reliant.com.
Each forward-looking statement speaks only as of the date of the particular statement and we undertake no obligation to update or revise any forward-looking statement, whether as a result of new information, future events or otherwise.

 

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PART I.
FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
RELIANT ENERGY, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
                                 
    Three Months Ended September 30,     Nine Months Ended September 30,  
    2008     2007     2008     2007  
    (thousands of dollars, except per share amounts)  
Revenues:
                               
Revenues (including $(6,173), $7,205, $(13,130) and $10,927 unrealized gains (losses)) (including $0, $39,805, $253,001 and $39,805 from affiliates)
  $ 3,738,106     $ 3,543,192     $ 9,977,065     $ 8,555,708  
 
                       
Expenses:
                               
Cost of sales (including $(1,688,016), $(34,719), $(552,571) and $157,443 unrealized gains (losses)) (including $1,234, $37,782, $201,364 and $37,782 from affiliates)
    4,899,393       2,838,950       9,059,914       6,758,157  
Operation and maintenance
    201,987       209,374       643,888       674,081  
Selling, general and administrative
    114,870       99,796       275,934       290,477  
Western states litigation and similar settlements
    3,467             37,467       22,000  
Gains on sales of assets and emission and exchange allowances, net
    (16,561 )     (16,769 )     (39,484 )     (18,496 )
Depreciation and amortization
    84,228       121,449       261,597       324,021  
 
                       
Total operating expense
    5,287,384       3,252,800       10,239,316       8,050,240  
 
                       
Operating Income (Loss)
    (1,549,278 )     290,392       (262,251 )     505,468  
 
                       
Other Income (Expense):
                               
Income of equity investment, net
    1,405       1,549       2,600       4,075  
Debt extinguishments
    (594 )     (1,320 )     (1,017 )     (72,589 )
Other, net
    4,593       1,590       4,619       2,084  
Interest expense
    (62,484 )     (74,235 )     (188,815 )     (283,280 )
Interest income
    6,259       5,777       26,510       24,473  
 
                       
Total other expense
    (50,821 )     (66,639 )     (156,103 )     (325,237 )
 
                       
Income (Loss) from Continuing Operations Before Income Taxes
    (1,600,099 )     223,753       (418,354 )     180,231  
Income tax expense (benefit)
    (562,208 )     63,850       (110,299 )     41,028  
 
                       
Income (Loss) from Continuing Operations
    (1,037,891 )     159,903       (308,055 )     139,203  
Income (loss) from discontinued operations
    (29 )     2,479       6,035       (1,062 )
 
                       
Net Income (Loss)
  $ (1,037,920 )   $ 162,382     $ (302,020 )   $ 138,141  
 
                       
 
                               
Basic Earnings (Loss) per Share:
                               
Income (loss) from continuing operations
  $ (2.97 )   $ 0.47     $ (0.89 )   $ 0.41  
Income (loss) from discontinued operations
                0.02       (0.01 )
 
                       
Net income (loss)
  $ (2.97 )   $ 0.47     $ (0.87 )   $ 0.40  
 
                       
 
                               
Diluted Earnings (Loss) per Share:
                               
Income (loss) from continuing operations
  $ (2.97 )   $ 0.45     $ (0.89 )   $ 0.40  
Income (loss) from discontinued operations
          0.01       0.02       (0.01 )
 
                       
Net income (loss)
  $ (2.97 )   $ 0.46     $ (0.87 )   $ 0.39  
 
                       
See Notes to our Unaudited Consolidated Interim Financial Statements

 

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RELIANT ENERGY, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Unaudited)
                 
    September 30, 2008     December 31, 2007  
    (thousands of dollars, except per share amounts)  
ASSETS
               
Current Assets:
               
Cash and cash equivalents
  $ 793,857     $ 754,962  
Restricted cash
    5,956       3,251  
Accounts and notes receivable, principally customer, net of allowance of $42,780 and $36,724
    1,257,036       1,082,746  
Inventory
    325,620       285,408  
Derivative assets
    804,184       663,049  
Margin deposits
    135,308       139,834  
Accumulated deferred income taxes
    189,559       114,559  
Investment in and receivables from Channelview, net
    61,442       83,253  
Prepayments and other current assets
    132,378       104,314  
Assets held for sale
    446,458        
Current assets of discontinued operations
          2,133  
 
           
Total current assets
    4,151,798       3,233,509  
 
           
Property, plant and equipment, gross
    6,604,285       6,852,170  
Accumulated depreciation
    (1,756,344 )     (1,629,953 )
 
           
Property, Plant and Equipment, net
    4,847,941       5,222,217  
 
           
Other Assets:
               
Goodwill, net
    357,490       379,644  
Other intangibles, net
    389,381       405,338  
Derivative assets
    340,423       376,535  
Prepaid lease
    288,132       270,133  
Accumulated deferred income taxes
    175,395       70,410  
Other ($36,991 and $29,016 accounted for at fair value)
    204,824       234,014  
 
           
Total other assets
    1,755,645       1,736,074  
 
           
Total Assets
  $ 10,755,384     $ 10,191,800  
 
           
LIABILITIES AND EQUITY
               
Current Liabilities:
               
Current portion of long-term debt and short-term borrowings
  $ 12,193     $ 52,546  
Accounts payable, principally trade
    820,319       687,046  
Derivative liabilities
    1,279,446       885,346  
Margin deposits
    7,100       250  
Other
    513,253       426,839  
Liabilities held for sale
    62,483        
Current liabilities of discontinued operations
    2,952        
 
           
Total current liabilities
    2,697,746       2,052,027  
 
           
Other Liabilities:
               
Derivative liabilities
    695,063       473,516  
Other
    244,897       278,641  
Long-term liabilities of discontinued operations
    3,542       3,542  
 
           
Total other liabilities
    943,502       755,699  
 
           
Long-term Debt
    2,874,785       2,902,346  
 
           
Commitments and Contingencies
               
Temporary Equity Stock-based Compensation
    7,121       4,694  
 
           
Stockholders’ Equity:
               
Preferred stock; par value $0.001 per share (125,000,000 shares authorized; none outstanding)
           
Common stock; par value $0.001 per share (2,000,000,000 shares authorized; 349,770,636 and 344,579,508 issued)
    111       106  
Additional paid-in capital
    6,237,692       6,215,512  
Accumulated deficit
    (1,937,546 )     (1,635,526 )
Accumulated other comprehensive loss
    (68,027 )     (103,058 )
 
           
Total stockholders’ equity
    4,232,230       4,477,034  
 
           
Total Liabilities and Equity
  $ 10,755,384     $ 10,191,800  
 
           
See Notes to our Unaudited Consolidated Interim Financial Statements

 

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RELIANT ENERGY, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
                 
    Nine Months Ended September 30,  
    2008     2007  
    (thousands of dollars)  
Cash Flows from Operating Activities:
               
Net income (loss)
  $ (302,020 )   $ 138,141  
(Income) loss from discontinued operations
    (6,035 )     1,062  
 
           
Net income (loss) from continuing operations
    (308,055 )     139,203  
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
               
Depreciation and amortization
    261,597       324,021  
Deferred income taxes
    (140,798 )     25,246  
Net changes in energy derivatives
    589,054       (126,819 )
Amortization of deferred financing costs
    6,446       47,817  
Gains on sales of assets and emission and exchange allowances, net
    (39,484 )     (18,496 )
Debt extinguishments
    1,017       72,589  
Income of equity investment, net
    (2,600 )     (4,075 )
Western states litigation and similar settlements
    37,467        
Other, net
    (361 )     8,909  
Changes in other assets and liabilities:
               
Accounts and notes receivable, net
    (187,077 )     (368,989 )
Changes in notes, receivables and payables with affiliate, net
    4,183       (4,225 )
Inventory
    (42,484 )     (6,117 )
Margin deposits, net
    11,376       200,928  
Net derivative assets and liabilities
    (37,845 )     (30,949 )
Western states litigation and similar settlements payments
          (35,000 )
Accounts payable
    107,675       172,789  
Other current assets
    (16,384 )     (14,586 )
Other assets
    (2,902 )     (35,155 )
Taxes payable/receivable
    11,852       (12,334 )
Other current liabilities
    16,648       6,352  
Other liabilities
    (8,683 )     (9,168 )
 
           
Net cash provided by continuing operations from operating activities
    260,642       331,941  
Net cash provided by (used in) discontinued operations from operating activities
    7,459       (3,754 )
 
           
Net cash provided by operating activities
    268,101       328,187  
 
           
Cash Flows from Investing Activities:
               
Capital expenditures
    (215,695 )     (135,473 )
Proceeds from sales of assets, net
    18,429       30,380  
Proceeds from sales of emission and exchange allowances
    38,685       6,794  
Purchases of emission allowances
    (26,053 )     (52,160 )
Restricted cash
    (2,705 )     4,716  
Other, net
    3,312       5,295  
 
           
Net cash used in continuing operations from investing activities
    (184,027 )     (140,448 )
Net cash provided by discontinued operations from investing activities
          520  
 
           
Net cash used in investing activities
    (184,027 )     (139,928 )
 
           
Cash Flows from Financing Activities:
               
Payments of long-term debt
    (57,704 )     (1,497,887 )
Proceeds from long-term debt
          1,300,000  
Increase in short-term borrowings and revolving credit facilities, net
          6,554  
Payments of financing costs
          (31,245 )
Payments of debt extinguishments
    (1,017 )     (72,589 )
Proceeds from issuances of stock
    13,542       39,401  
 
           
Net cash used in financing activities
    (45,179 )     (255,766 )
 
           
Net Change in Cash and Cash Equivalents
    38,895       (67,507 )
Cash and Cash Equivalents at Beginning of Period
    754,962       463,909  
 
           
Cash and Cash Equivalents at End of Period
  $ 793,857     $ 396,402  
 
           
Supplemental Disclosure of Cash Flow Information:
               
Cash Payments:
               
Interest paid (net of amounts capitalized) for continuing operations
  $ 134,988     $ 218,592  
Income taxes paid (net of income tax refunds) for continuing operations
    18,000       28,115  
See Notes to our Unaudited Consolidated Interim Financial Statements

 

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RELIANT ENERGY, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED INTERIM FINANCIAL STATEMENTS
(1) Background and Basis of Presentation
(a) Background.
“Reliant Energy” refers to Reliant Energy, Inc. and “we,” “us” and “our” refer to Reliant Energy, Inc. and its consolidated subsidiaries. Our business consists primarily of two business segments, retail energy and wholesale energy. See note 13. Our consolidated interim financial statements and notes (interim financial statements) are unaudited, omit certain disclosures and should be read in conjunction with our audited consolidated financial statements and notes in our Form 10-K.
(b) Basis of Presentation.
Estimates. Management makes estimates and assumptions to prepare financial statements in conformity with accounting principles generally accepted in the United States of America (GAAP) that affect:
    the reported amount of assets, liabilities and equity;
 
    the reported amounts of revenues and expenses; and
 
    our disclosure of contingent assets and liabilities at the date of the financial statements.
Retail Energy Segment Estimates due to Hurricane Ike. In September 2008, Hurricane Ike struck the upper Texas coast causing substantial damage to the electric transmission and distribution system serving the Houston-Galveston area. Due to the diversion of meter reading personnel to assist with the restoration, the Public Utility Commission of Texas (PUCT) is allowing the transmission and distribution companies, as necessary, to estimate a customer’s electricity consumption for three consecutive meter read cycles. A true up to the customer’s actual consumption will take place when the meter is read in the subsequent months. As of September 30, 2008, we have $153 million and $225 million in billed and unbilled revenues, respectively, based on estimated meter reads. These amounts represent 5% and 4% of our retail energy segment’s revenues and consolidated revenues, respectively, for the nine months ended September 30, 2008.
Adjustments and Reclassifications. The interim financial statements reflect all normal recurring adjustments necessary, in management’s opinion, to present fairly our financial position and results of operations for the reported periods. Amounts reported for interim periods, however, may not be indicative of a full year period due to seasonal fluctuations in demand for electricity and energy services, changes in commodity prices, changes in our retail revenue rates and changes in regulations, timing of maintenance and other expenditures, dispositions, changes in interest expense and other factors. We have changed the presentation of our December 31, 2007 consolidated balance sheet due to the adoption of FSP FIN 39-1, Amendment of FASB Interpretation No. 39 (FIN 39-1). See below.
Deconsolidation of Channelview. On August 20, 2007, four of our wholly-owned subsidiaries, Reliant Energy Channelview LP (Channelview LP), Reliant Energy Channelview (Texas) LLC, Reliant Energy Channelview (Delaware) LLC and Reliant Energy Services Channelview LLC (collectively, Channelview), filed for reorganization under Chapter 11 of the Bankruptcy Code. As Channelview is currently subject to the supervision of the bankruptcy court, we deconsolidated Channelview’s financial results beginning August 20, 2007 and began reporting our investment in Channelview using the cost method.
The Channelview plant was sold on July 1, 2008. See note 14 for further discussion of Channelview.
Gross Receipts Taxes. We record gross receipts taxes for our retail energy segment on a gross basis in revenues and operations and maintenance in our consolidated statements of operations. During the three months ended September 30, 2008 and 2007, our retail energy segment’s revenues and operation and maintenance include gross receipts taxes of $32 million and $31 million, respectively, and during the nine months ended September 30, 2008 and 2007, $80 million and $76 million, respectively.

 

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New Accounting Pronouncement Adopted — Offsetting of Amounts. FIN 39-1 was applicable for us beginning January 1, 2008. This interpretation allows either (a) offsetting assets and liabilities for derivative instruments under a master netting arrangement only if the fair value amounts recognized for any related cash collateral are also offset or (b) presenting these amounts gross.
Effective January 1, 2008, we discontinued netting our derivative assets and liabilities (with the same counterparty pursuant to a master netting arrangement) and present them on a gross basis. Cash collateral amounts remain presented on a gross basis. This change has significantly increased our derivative assets and liabilities retrospectively for all financial statements presented and is accounted for as a change in accounting principle.
The effect to our December 31, 2007 consolidated balance sheet was as follows: (Note — only line items impacted are shown.)
                 
    December 31, 2007  
    As Previously        
    Reported in the     Upon Adoption  
    Form 10-K     of FIN 39-1  
    (in millions)  
 
Current derivative assets
  $ 214     $ 663  
Total current assets
    2,784       3,233  
Long-term derivative assets
    90       376  
Total other assets
    1,450       1,736  
Total assets
    9,457       10,192  
 
               
Current derivative liabilities
    437       885  
Total current liabilities
    1,602       2,050  
Long-term derivative liabilities
    187       474  
Total other liabilities
    470       757  
Total liabilities and stockholders’ equity
    9,457       10,192  
New Accounting Pronouncement Not Yet Adopted — Disclosures about Derivatives and Hedging Activities. Statement of Financial Accounting Standards (SFAS) No. 161, “Disclosures about Derivative Instruments and Hedging Activities” (SFAS No. 161) is an amendment of SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” and is intended to enhance the related qualitative and quantitative disclosures by providing for additional information about objectives, strategies, accounting treatment, volume by commodity type and credit-risk-related contingent features. SFAS No. 161 must be adopted by January 1, 2009.
(2) Stock-based Compensation
Our compensation expense for our stock-based incentive plans was:
                                 
    Three Months Ended September 30,     Nine Months Ended September 30,  
    2008     2007     2008     2007  
    (in millions)  
Stock-based incentive plans compensation expense (income) (pre-tax)
  $ (1 )(1)   $ 3     $ 7 (1)   $ 23  
 
                       
 
     
(1)   We recognized $1 million of pre-tax income primarily due to a decrease in our stock price at September 30, 2008 compared to June 30, 2008.
During February 2008, the compensation committee of our board of directors granted stock-based compensation awards to 47 of our officers under the Reliant Energy, Inc. 2002 Long-Term Incentive Plan. The committee granted 461,824 time-based stock options (exercise price of $23.38 per share, which vest in three equal installments during February 2009, 2010 and 2011), 215,527 time-based restricted stock units (which vest during February 2011) and 371,586 market-based cash units (each payable into a cash amount equal to the market value of one share of our common stock if our common stock closes at $32 or higher for 20 consecutive trading days before February 19, 2011). In addition, during February 2008, the committee granted 95,574 time-based restricted stock units and 95,574 time-based cash units to other employees under the Reliant Energy, Inc. 2002 Stock Plan. These awards will vest during February 2011.

 

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No tax benefits related to stock-based compensation were realized during the nine months ended September 30, 2008 and 2007 due to our net operating loss carryforwards.
(3) Fair Value Measurements
Summary. Effective January 1, 2008, we adopted SFAS No. 157, “Fair Value Measurements” (SFAS No. 157) on a prospective basis for our financial assets and liabilities. In connection with the adoption, no cumulative effect of an accounting change was recognized. For non-financial assets and liabilities, the adoption of SFAS No. 157 has been deferred until January 1, 2009.
Fair Value Hierarchy and Valuation Techniques. We apply recurring fair value measurements to our financial assets and liabilities. In determining fair value, we generally use the market approach and incorporate assumptions that market participants would use in pricing the asset or liability, including assumptions about risk and/or the risks inherent in the inputs to the valuation techniques. These inputs can be readily observable, market corroborated, or generally unobservable internally-developed inputs. Based on the observability of the inputs used in our valuation techniques, our financial assets and liabilities are classified as follows:
     
Level 1:
  Level 1 represents unadjusted quoted market prices in active markets for identical assets or liabilities that are accessible at the measurement date. This category primarily includes our energy derivative instruments that are exchange-traded or that are cleared and settled through the exchange.
 
   
Level 2:
  Level 2 represents quoted market prices for similar assets or liabilities in active markets, quoted market prices in markets that are not active or other inputs that are observable or can be corroborated by observable market data. This category includes emission allowances futures that are exchange-traded and over-the-counter (OTC) derivative instruments such as generic swaps and forwards.
 
   
Level 3:
  This category includes our energy derivative instruments whose fair value is estimated based on internally developed models and methodologies utilizing significant inputs that are generally less readily observable from objective sources (such as market heat rates, implied volatilities and correlations). Our OTC, complex or structured derivative instruments that are transacted in less liquid markets with limited pricing information are included in Level 3. Examples are structured power supply contracts, coal contracts, longer term natural gas contracts and options.
We value some of our OTC, complex or structured derivative instruments using valuation models, which utilize inputs that may not be corroborated by market data. When such inputs are significant to the fair value measurement, the derivative assets or liabilities are classified as Level 3 when we do not have corroborating market evidence to support significant valuation model inputs and cannot verify the model to market transactions. We believe the transaction price is the best estimate of fair value at inception under the exit price methodology. Accordingly, when a pricing model is used to value such an instrument, the resulting value is adjusted so the model value at inception equals the transaction price. Valuation models are typically impacted by Level 1 or Level 2 inputs that can be observed in the market, as well as unobservable Level 3 inputs. Subsequent to initial recognition, we update Level 1 and Level 2 inputs to reflect observable market changes. Level 3 inputs are updated when corroborated by available market evidence. In the absence of such evidence, management’s best estimate is used.
Fair Value of Derivative Instruments and Certain Other Assets.
                                         
    September 30, 2008  
                                    Total  
    Level 1     Level 2     Level 3     Reclassifications     Fair Value  
    (in millions)  
 
Total derivative assets
  $ 383     $ 592     $ 183     $ (14 )(1)   $ 1,144  
Total derivative liabilities
    382       1,451       154       (14 )(1)     1,973  
Other assets(2)
    37                         37  
 
     
(1)   Reclassifications are required to reconcile to FIN 39-1 consolidated balance sheet presentation.
 
(2)   Includes available-for-sale and trading securities, which are actively traded and are valued based upon unadjusted quoted prices.

 

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The following is a reconciliation of changes in fair value of net derivative assets and liabilities classified as Level 3:
                 
    Three Months Ended     Nine Months Ended  
    September 30, 2008     September 30, 2008  
    Net Derivatives     Net Derivatives  
    (in millions)     (in millions)  
 
Balance, beginning of period
  $ 482     $ 121  
Total gains (losses) realized/unrealized:
               
Included in earnings
    (286 )(1)     252 (1)
Purchases, issuances and settlements (net)
    (181 )     (362 )
Transfers in and/or out of Level 3 (net)
    14 (2)     18 (3)
 
           
Balance, September 30, 2008
  $ 29     $ 29  
 
           
 
               
Changes in unrealized gains/losses relating to derivative assets and liabilities still held at September 30, 2008
    (197 )(4)     36 (5)
 
     
(1)   Recorded in revenues and cost of sales.
 
(2)   Represents fair value as of June 30, 2008.
 
(3)   Represents fair value as of December 31, 2007.
 
(4)   Includes $2 million gain recorded in revenues and $199 million loss recorded in cost of sales.
 
(5)   Includes $2 million gain recorded in revenues and $34 million gain recorded in cost of sales.
See notes 2(d) and 5 to our consolidated financial statements in our Form 10-K for additional information about our derivatives.
(4) Comprehensive Income (Loss)
The components of total comprehensive income (loss) are:
                                 
    Three Months Ended September 30,     Nine Months Ended September 30,  
    2008     2007     2008     2007  
    (in millions)  
 
Net income (loss)
  $ (1,038 )   $ 162     $ (302 )   $ 138  
Other comprehensive income (loss), net of tax:
                               
Deferred income from cash flow hedges
          1             4  
Reclassification of net deferred loss from cash flow hedges realized in net income/loss
    9       24       25       69  
Amortization of prior service costs
    1       1       1       1  
Unrealized gain on available-for-sale securities
    9             9        
 
                       
Comprehensive income (loss)
  $ (1,019 )   $ 188     $ (267 )   $ 212  
 
                       
(5) Goodwill
2008 Annual Goodwill Impairment Assessments. We completed our annual goodwill impairment assessments for our wholesale energy and retail energy reporting units effective April 1, 2008. No impairments occurred.
Estimation of Our Wholesale Energy Reporting Unit’s Fair Value. We updated a number of subjective factors and significant assumptions to estimate fair value in our April 2008 test as compared to our April 2007 test, including (a) appropriate weighting of valuation approaches (income approach, market approach and comparable public company approach); (b) projections about future power generation margins; (c) estimates of our future cost structure; (d) environmental assumptions; (e) discount rates for estimated cash flows, which changed from 9.5% to 10.0% primarily due to changes in the required rate on debt capital of peer companies and (f) required level of working capital. See note 4(a) to our consolidated financial statements in our Form 10-K.

 

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Goodwill Impairment Assessments Update. Given recent changes in the business climate and the credit markets and our review of strategic alternatives to enhance stockholder value, we updated the key inputs and assumptions used to estimate the fair values of our wholesale energy and retail energy reporting units and concluded that no goodwill impairments have occurred as of September 30, 2008. We use a combination of an income approach and a market approach to estimate the fair value of our wholesale energy reporting unit. Key fair value inputs for the wholesale energy reporting unit that we changed include the weighting of the valuation approaches, projections about future power generation margins and the discount rate, which is based on the cost of capital. We primarily use an income approach to estimate the fair value of our retail energy reporting unit. Key fair value inputs for the retail energy reporting unit that we changed include projections about future margins, required levels of working capital and the discount rate, which is based on the cost of capital. See note 17(a).
(6) Derivative Instruments
For discussion of our derivative activities, see notes 2(d) and 5 to our consolidated financial statements in our Form 10-K. The income (loss) of our energy and interest rate derivative instruments is:
                                 
    Three Months Ended September 30,     Nine Months Ended September 30,  
    2008     2007     2008     2007  
    (in millions)  
 
                               
Energy derivatives:
                               
Hedge ineffectiveness gains
  $ (1)   $ 9 (1)   $ (1)   $ 11 (1)
Other net unrealized gains (losses)
    (1,694 )     (37 )     (566 )     157  
Interest rate derivatives:
                               
Other net unrealized gains (losses)
          1             (4 )
 
                       
Total(2)(3)
  $ (1,694 )   $ (27 )   $ (566 )   $ 164  
 
                       
 
     
(1)   During 2007, we de-designated our remaining cash flow hedges; the amount reflected here subsequent to that time relates to previously measured ineffectiveness reversing due to settlement of the derivative contracts.
 
(2)   No component of the derivatives’ gain or loss was excluded from the assessment of effectiveness.
 
(3)   During the three and nine months ended September 30, 2008 and 2007, no amount was recognized in our results of operations as a result of the discontinuance of cash flow hedges because it was probable that the forecasted transaction would not occur.
Amounts included in accumulated other comprehensive loss:
                 
    September 30, 2008  
            Expected to be  
            Reclassified into  
            Results of Operations  
    At the End of the Period     in Next 12 Months  
    (in millions)  
 
 
               
De-designated cash flow hedges
  $ 55     $ 19  
 
           
Although we discontinued our proprietary trading business in March 2003, we have legacy trading and non-core asset management positions. The income (loss) associated with these transactions is:
                                 
    Three Months Ended September 30,     Nine Months Ended September 30,  
    2008     2007     2008     2007  
    (in millions)  
 
Revenues
  $ 1     $     $ 1     $  
Cost of sales
    30       8       13       8  
 
                       
Total
  $ 31     $ 8     $ 14     $ 8  
 
                       

 

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(7) Debt
Our outstanding debt:
                                                 
    September 30, 2008     December 31, 2007  
    Weighted                     Weighted              
    Average                     Average              
    Stated                     Stated              
    Interest                     Interest              
    Rate(1)     Long-term     Current     Rate(1)     Long-term     Current  
    (in millions, except interest rates)  
Facilities, Bonds and Notes:
                                               
Reliant Energy:
                                               
Senior secured revolver due 2012
    5.80 %   $     $       6.45 %   $     $  
Senior secured notes due 2014(2)
    6.75       667             6.75       671       41  
Senior unsecured notes due 2013(3)
    9.50                   9.50       13        
Senior unsecured notes due 2014
    7.625       575             7.625       575        
Senior unsecured notes due 2017
    7.875       725             7.875       725        
Convertible senior subordinated notes due 2010 (unsecured)(4)
    5.00                   5.00       2        
Subsidiary Obligations:
                                               
Orion Power Holdings, Inc. senior notes due 2010 (unsecured)
    12.00       400             12.00       400        
Reliant Energy Seward, LLC PEDFA(5) fixed-rate bonds due 2036
    6.75       500             6.75       500        
Reliant Energy Power Supply, LLC working capital facility due 2012(6)
    4.15                   5.30              
 
                                       
Total facilities, bonds and notes
            2,867                     2,886       41  
 
                                       
Other:
                                               
Adjustment to fair value of debt(7)
            8       12               17       11  
 
                                       
Total other debt
            8       12               17       11  
 
                                       
Total debt(8)
          $ 2,875     $ 12             $ 2,903     $ 52  
 
                                       
 
     
(1)   The weighted average stated interest rates are as of September 30, 2008 or December 31, 2007.
 
(2)   We repurchased $45 million during the first quarter of 2008 and incurred an insignificant amount of debt extinguishment expenses.
 
(3)   In July 2008, we called the remaining $13 million.
 
(4)   During the nine months ended September 30, 2008, the remaining outstanding notes were converted to common stock.
 
(5)   PEDFA is the Pennsylvania Economic Development Financing Authority.
 
(6)   This $300 million working capital facility includes a minimum adjusted EBITDA covenant for our retail business. Merrill Lynch waived compliance with this covenant through December 5, 2008. See note 17.
 
(7)   Debt acquired in the acquisition of Orion Power Holdings, Inc. and subsidiaries was adjusted to fair value as of the acquisition date. Included in interest expense is amortization for valuation adjustments for debt of $2 million and $1 million during the three months ended September 30, 2008 and 2007, respectively, and $8 million and $8 million during the nine months ended September 30, 2008 and 2007, respectively.
 
(8)   Based on the incremental borrowing rates for similar borrowing arrangements and information from market participants, the fair value of our fixed rate debt is $2.5 billion and $3.0 billion as of September 30, 2008 and December 31, 2007, respectively.
Amounts borrowed and available for borrowing under our revolving credit agreements as of September 30, 2008:
                                 
    Total Committed     Drawn     Letters     Unused  
    Credit     Amount     of Credit     Amount  
    (in millions)  
 
Reliant Energy senior secured revolver due 2012
  $ 500     $     $ 55     $ 445  
Reliant Energy letter of credit facility due 2014
    250             234       16  
 
                       
 
  $ 750     $     $ 289     $ 461  
 
                       
See note 17 for discussion of events occurring subsequent to September 30, 2008 regarding our capital and debt structure.

 

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(8) Earnings (Loss) Per Share
Reconciliations of the amounts used in the basic and diluted earnings (loss) per common share computations are:
                                 
    Three Months Ended September 30,     Nine Months Ended September 30,  
    2008     2007     2008     2007  
    (in millions)  
 
                               
Income (loss) from continuing operations (basic)
  $ (1,038 )   $ 160     $ (308 )   $ 139  
Plus: Interest expense on 5.00% convertible senior subordinated notes, net of tax
    (1)     (2)     (1)     (2)
 
                       
Income (loss) from continuing operations (diluted)
  $ (1,038 )   $ 160     $ (308 )   $ 139  
 
                       
 
     
(1)   As we incurred a loss from continuing operations for this period, diluted loss per share is calculated the same as basic loss per share.
 
(2)   In December 2006, nearly all of these outstanding notes were converted to common stock. See also note 6.
                                 
    Three Months Ended September 30,     Nine Months Ended September 30,  
    2008     2007     2008     2007  
    (shares in thousands)  
 
                               
Diluted Weighted Average Shares Calculation:
                               
Weighted average shares outstanding (basic)
    349,200       343,835       347,086       341,768  
Plus: Incremental shares from assumed conversions:
                               
Stock options
    (1)     4,957       (1)     4,950  
Restricted stock
    (1)     521       (1)     492  
Employee stock purchase plan
    (1)           (1)     60  
5.00% convertible senior subordinated notes
    (1)     212       (1)     214  
Warrants
    (1)     4,679       (1)     4,841  
 
                       
Weighted average shares outstanding assuming conversion (diluted)
    349,200       354,204       347,086       352,325  
 
                       
 
     
(1)   See note (1) above regarding diluted loss per share.

 

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We excluded the following items from diluted earnings (loss) per common share due to the anti-dilutive effect:
                                 
    Three Months Ended September 30,     Nine Months Ended September 30,  
    2008     2007     2008     2007  
    (shares in thousands, dollars in millions)  
 
Shares excluded from the calculation of diluted earnings (loss) per share
    4,494 (1)     N/A (2)     6,872 (1)     N/A (2)
Shares excluded from the calculation of diluted earnings (loss) per share because the exercise price exceeded the average market price
    2,314 (3)     1,943 (3)     2,300 (3)     2,047 (3)
Interest expense that would be added to income if 5.00% convertible senior subordinated notes were dilutive
    (4)     N/A (2)     (4)     N/A (2)
 
     
(1)   Potential shares excluded consist of convertible senior subordinated notes, warrants, stock options, restricted stock and shares related to the employee stock purchase plan.
 
(2)   Not applicable as we included the item in the calculation of diluted earnings per share.
 
(3)   Includes stock options.
 
(4)   In December 2006, nearly all of these outstanding notes were converted to common stock. During the nine months ended September 30, 2008, the remaining outstanding notes were converted to common stock.
(9) Income Taxes
(a) Tax Rate Reconciliation.
A reconciliation of the federal statutory income tax rate to the effective income tax rate is:
                                 
    Three Months Ended September 30,     Nine Months Ended September 30,  
    2008     2007     2008     2007  
 
                               
Federal statutory rate
    35 %     35 %     35 %     35 %
Additions (reductions) resulting from:
                               
Federal tax uncertainties
                      (3 )
Federal valuation allowance
          (13 )           (13 )
State income taxes, net of federal income taxes
          3       (7 )     2  
Other, net
          4       (2 )     2  
 
                       
Effective rate
    35 %     29 %     26 %     23 %
 
                       
(b) Valuation Allowances.
We assess our future ability to use federal, state and foreign net operating loss carryforwards, capital loss carryforwards and other deferred tax assets using the more-likely-than-not criteria. These assessments include an evaluation of our recent history of earnings and losses, future reversals of temporary differences and identification of other sources of future taxable income, including the identification of tax planning strategies in certain situations.

 

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Our valuation allowances for deferred tax assets are:
                         
                    Capital, Foreign  
    Federal     State     and Other, Net  
    (in millions)  
 
As of December 31, 2007
  $ 14     $ 67     $ 22  
Changes in valuation allowances
          5       (1 )
 
                 
As of March 31, 2008
    14       72       21  
Changes in valuation allowances
          2        
 
                 
As of June 30, 2008
    14       74       21  
Changes in valuation allowances
          (2 )     (1 )
 
                 
As of September 30, 2008
  $ 14     $ 72     $ 20  
 
                 
(c) FIN 48 and Income Tax Uncertainties.
Effective January 1, 2007, we adopted FIN 48, “Accounting for Uncertainty in Income Taxes”. This interpretation addresses whether (and when) tax benefits claimed in our tax returns should be recorded in our financial statements. Pursuant to FIN 48, we may only recognize the tax benefit for financial reporting purposes from an uncertain tax position when it is more-likely-than-not that, based on the technical merits, the position will be sustained by taxing authorities or the courts. The recognized tax benefits are measured as the largest benefit having a greater than fifty percent likelihood of being realized upon settlement with a taxing authority. FIN 48 also provides guidance for derecognition, classification, interest and penalties, disclosures, transition rules and related matters. We classify accrued interest and penalties related to uncertain income tax positions in income tax expense/benefit.
We expect to continue discussions with taxing authorities regarding tax positions related to the following, and believe it is reasonably possible some of these matters could be resolved in the next 12 months; however, we cannot estimate the range of changes that might occur:
    $177 million payment to CenterPoint during 2004 related to our residential customers;
 
    $351 million charge during 2005 to settle certain civil litigation and claims relating to the Western states energy crisis (see note 14(a) to our consolidated financial statements in our Form 10-K); and
 
    the timing of tax deductions as a result of negotiations with respect to California-related revenue, depreciation, emission allowances and certain employee benefits.
(10) Guarantees and Indemnifications
We have guaranteed some non-qualified benefits of CenterPoint’s existing retirees at September 20, 2002. The estimated maximum potential amount of future payments under the guarantee was approximately $54 million as of September 30, 2008 and no liability is recorded in our consolidated balance sheets for this item.
We also guarantee the $500 million PEDFA bonds, which are included in our consolidated balance sheet as outstanding debt. Our guarantees are secured by guarantees from some of our subsidiaries. The guarantees require us to comply with covenants substantially identical to those in the 6.75% senior secured notes indenture. The PEDFA bonds will become secured by certain assets of our Seward power plant if the collateral supporting both the 6.75% senior secured notes and our guarantees are released. Our maximum potential obligation under the guarantees is for payment of the principal of $500 million and related interest charges at a fixed rate of 6.75%.
We have guaranteed payments to a third party relating to energy sales from El Dorado Energy, LLC, a former investment. The estimated maximum potential amount of future payments under this guarantee was approximately $21 million as of September 30, 2008 and no liability is recorded in our consolidated balance sheets for this item.
We enter into contracts that include indemnification and guarantee provisions. In general, we enter into contracts with indemnities for matters such as breaches of representations and warranties and covenants contained in the contract and/or against certain specified liabilities. Examples of these contracts include asset sales agreements, retail supply agreements, service agreements and procurement agreements.

 

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In our debt agreements, we typically indemnify against liabilities that arise from the preparation, entry into, administration or enforcement of the agreement.
Except as otherwise noted, we are unable to estimate our maximum potential exposure under these agreements until an event triggering payment occurs. We do not expect to make any material payments under these agreements.
(11) Contingencies
We are party to many legal proceedings, some of which may involve substantial amounts. Unless otherwise noted, we cannot predict the outcome of the matters described below.
(a) Pending Natural Gas Litigation.
The following proceedings relate to alleged conduct in the natural gas markets. In 2005 and 2006, we settled a number of proceedings that were pending in California and other Western states; however, a number of other proceedings remain pending.
We are party to approximately 30 lawsuits, several of which are class action lawsuits, in state and federal courts in California, Colorado, Kansas, Missouri, Nevada, Tennessee and Wisconsin. These lawsuits relate to alleged conduct to increase natural gas prices in violation of antitrust and similar laws. The lawsuits seek treble or punitive damages, restitution and/or expenses. The lawsuits also name a number of unaffiliated energy companies as parties.
One of the natural gas cases is a case filed by the Los Angeles Department of Water and Power (LADWP) in the California Superior Court in 2004. The lawsuit alleges that we conspired to manipulate natural gas prices in breach of our supply contract with LADWP and in violation of California’s antitrust laws and the California False Claims Act. The lawsuit seeks treble damages for the alleged overcharges (estimated to be $218 million) for gas purchased by LADWP, interest and legal costs. The lawsuit also seeks (a) a determination that an extension of the contract with LADWP was invalid in that the required municipal approvals for the extension were allegedly not obtained and (b) a return of all money paid by LADWP during that period (estimated to be $681 million).
Recent developments in these cases include:
    In October 2008, we reached an agreement in principle to settle the five cases pending in federal court in Nevada. The settlement is subject to the completion of definitive documentation. The charges anticipated to be incurred in connection with the settlement were expensed in the third quarter of 2008. This settlement and the settlement described below will resolve all of the remaining California gas cases.
 
    In May 2008, we signed a memorandum of understanding to settle the 16 cases comprising the California-based gas index litigation, including the case filed by LADWP. The settlement is subject to the completion of definitive documentation. The charges anticipated to be incurred in connection with the settlement were expensed during the first quarter of 2008.
 
    In September 2007, the Ninth Circuit Court of Appeals issued decisions in a number of the other gas cases in which we are a defendant. The Ninth Circuit Court of Appeals reversed a series of lower court decisions holding that the filed rate doctrine barred the plaintiffs’ claims in those cases. As a result of the Ninth Circuit Court of Appeals rulings, these cases have been remanded for further proceedings at the trial court level. The cases in which we are a defendant are covered by the October 2008 settlement described above.
(b) Environmental Matters.
New Source Review Matters. The United States Environmental Protection Agency (EPA) and various states are investigating compliance of coal-fueled electric generating stations with the pre-construction permitting requirements of the Clean Air Act known as “New Source Review.” In 2000 and 2001, we responded to the EPA’s information requests related to five of our stations, and in December 2007, we received supplemental requests for two of those stations. In September 2008, we received an EPA request for information related to two additional stations. The EPA has agreed to share information relating to its investigations with state environmental agencies.

 

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In December 2007, the New Jersey Department of Environmental Protection (NJDEP) filed suit against us in the United States District Court in Pennsylvania, alleging that New Source Review violations occurred at one of our power plants located in Pennsylvania. The suit seeks installation of “best available” control technologies for each pollutant, to enjoin us from operating the plant if it is not in compliance with the Clean Air Act and civil penalties. The suit also names three past owners of the plant as defendants. We believe we are indemnified by or have the right to seek indemnification from the prior owners for losses and expenses that we may incur from activities occurring prior to our ownership.
We are unable to predict the ultimate outcome of the EPA’s investigation or the NJDEP’s suit, but a final finding that we violated the New Source Review requirements could result in significant capital expenditures associated with the implementation of emissions reductions on an accelerated basis and possible penalties.
Ash Disposal Landfill Closures. We are responsible for environmental costs related to the future closures of seven ash disposal landfills. We recorded the estimated discounted costs associated with these environmental liabilities as part of our asset retirement obligations. See note 2(o) to our consolidated financial statements in our Form 10-K.
Remediation Obligations. We are responsible for environmental costs related to site contamination investigations and remediation requirements at four power plants in New Jersey. We recorded the estimated long-term liability for the remediation costs of $8 million as of September 30, 2008 and December 31, 2007.
Conemaugh Actions. In April 2007, PennEnvironment and the Sierra Club filed a citizens’ suit against us in the United States District Court, Western District of Pennsylvania. The suit alleges that the Conemaugh plant, in which we have a 16.45% interest, is in violation of its water discharge permit and related state and federal laws and seeks civil penalties, remediation and to enjoin violations. The Conemaugh plant is governed by a consent order agreement with the Pennsylvania Department of Environmental Protection (PADEP). We are confident that the Conemaugh plant has operated and will continue to operate in material compliance with the consent order agreement, its water discharge permit and related state and federal laws. However, if PennEnvironment and the Sierra Club are successful, we could incur significant capital expenditures associated with the implementation of discharge reductions on an accelerated basis and possible penalties. In October 2008, the PADEP filed to dismiss its related suit against us filed in April 2007 in the Court of Common Pleas of Indiana County, Pennsylvania.
Global Warming. In February 2008, the Native Village of Kivalina and the City of Kivalina filed a suit in the United States District Court for the Northern District of California against us and 23 other electric generating and oil and gas companies. The lawsuit seeks damages of up to $400 million for the cost of relocating the village allegedly because of global warming caused by the greenhouse gas emissions of the defendants.
(c) Other.
PUCT Cases. There are various proceedings pending before the state district court in Travis County, Texas, seeking reviews of the PUCT orders relating to the fuel factor component used in our “price-to-beat” tariff. In an earlier proceeding, a review of the PUCT’s approval of our requested fuel factor change was decided in our favor by the district court and was later affirmed by the court of appeals in Travis County. The remaining cases involve the same issues already addressed and decided in our favor by those courts.
CenterPoint Indemnity. We have agreed to indemnify CenterPoint against certain losses relating to the lawsuits described in note 11(a) under “Pending Natural Gas Litigation.”
Texas Franchise Audit. The state of Texas has issued assessment orders indicating an estimated tax liability of approximately $55 million (including interest and penalties of $18 million) relating primarily to the sourcing of receipts for 2000 through 2005. We are contesting the audit assessments related to this issue.
Sales Tax Contingencies. Some of our sales tax computations are subject to challenge under audit. As of September 30, 2008 and December 31, 2007, we have $20 million and $19 million, respectively, accrued in current and long-term liabilities relating to these contingencies.
(12) Supplemental Guarantor Information
Our wholly-owned subsidiaries are either (a) full and unconditional guarantors, jointly and severally, or (b) non-guarantors of the senior secured notes.

 

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Condensed Consolidating Statements of Operations.
                                         
    Three Months Ended September 30, 2008  
    Reliant Energy     Guarantors     Non-Guarantors     Adjustments(1)     Consolidated  
    (in millions)  
 
                                       
Revenues
  $     $ 1,003     $ 3,199     $ (464 )   $ 3,738  
 
                             
Cost of sales
          796       4,565       (462 )     4,899  
Operation and maintenance
          40       163       (1 )     202  
Selling, general and administrative
          2       114       (1 )     115  
Western states litigation and similar settlements
          3                   3  
Gains on sales of assets and emission and exchange allowances, net
          (17 )                 (17 )
Depreciation and amortization
          32       53             85  
 
                             
Total
          856       4,895       (464 )     5,287  
 
                             
Operating income (loss)
          147       (1,696 )           (1,549 )
 
                             
Income of equity investment, net
          2                   2  
Income (loss) of equity investments of consolidated subsidiaries
    (1,042 )     40             1,002        
Debt extinguishments
    (1 )                       (1 )
Other, net
                4             4  
Interest expense
    (41 )     (9 )     (13 )           (63 )
Interest income
    4       1       2             7  
Interest income (expense) — affiliated companies, net
    44       (27 )     (17 )            
 
                             
Total other income (expense)
    (1,036 )     7       (24 )     1,002       (51 )
 
                             
Income (loss) from continuing operations before income taxes
    (1,036 )     154       (1,720 )     1,002       (1,600 )
Income tax expense (benefit)
    2       38       (613 )     11       (562 )
 
                             
Income (loss) from continuing operations
    (1,038 )     116       (1,107 )     991       (1,038 )
 
                             
Net income (loss)
  $ (1,038 )   $ 116     $ (1,107 )   $ 991     $ (1,038 )
 
                             
                                         
    Three Months Ended September 30, 2007  
    Reliant Energy     Guarantors     Non-Guarantors     Adjustments(1)     Consolidated  
    (in millions)  
 
                                       
Revenues
  $     $ 1,152     $ 3,103     $ (711 )   $ 3,544  
 
                             
Cost of sales
          1,006       2,542       (709 )     2,839  
Operation and maintenance
          49       163       (1 )     211  
Selling, general and administrative
          4       96       (1 )     99  
(Gains) losses on sales of assets and emission and exchange allowances, net
          (18 )     1             (17 )
Depreciation and amortization
          36       86             122  
 
                             
Total
          1,077       2,888       (711 )     3,254  
 
                             
Operating income
          75       215             290  
 
                             
Income of equity investment, net
          1                   1  
Income of equity investments of consolidated subsidiaries
    120       30             (150 )      
Debt extinguishments
    (1 )                       (1 )
Other, net
          2                   2  
Interest expense
    (43 )     (9 )     (22 )           (74 )
Interest income
    1       2       3             6  
Interest income (expense) — affiliated companies, net
    81       (59 )     (22 )            
 
                             
Total other income (expense)
    158       (33 )     (41 )     (150 )     (66 )
 
                             
Income from continuing operations before income taxes
    158       42       174       (150 )     224  
Income tax expense (benefit)
    (4 )     5       72       (9 )     64  
 
                             
Income from continuing operations
    162       37       102       (141 )     160  
Income from discontinued operations
                2             2  
 
                             
Net income
  $ 162     $ 37     $ 104     $ (141 )   $ 162  
 
                             

 

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    Nine Months Ended September 30, 2008  
    Reliant Energy     Guarantors     Non-Guarantors     Adjustments(1)     Consolidated  
    (in millions)  
 
                                       
Revenues
  $     $ 2,992     $ 8,376     $ (1,391 )   $ 9,977  
 
                             
Cost of sales
          2,564       7,880       (1,384 )     9,060  
Operation and maintenance
          152       495       (3 )     644  
Selling, general and administrative
    1       11       268       (4 )     276  
Western states litigation and similar settlements
    34       3                   37  
Gains on sales of assets and emission and exchange allowances, net
          (38 )     (2 )           (40 )
Depreciation and amortization
          101       161             262  
 
                             
Total
    35       2,793       8,802       (1,391 )     10,239  
 
                             
Operating income (loss)
    (35 )     199       (426 )           (262 )
 
                             
Income of equity investment, net
          3                   3  
Income (loss) of equity investments of consolidated subsidiaries
    (303 )     119             184        
Debt extinguishments
    (1 )                       (1 )
Other, net
                4             4  
Interest expense
    (123 )     (25 )     (41 )           (189 )
Interest income
    14       5       8             27  
Interest income (expense) — affiliated companies, net
    146       (95 )     (51 )            
 
                             
Total other income (expense)
    (267 )     7       (80 )     184       (156 )
 
                             
Income (loss) from continuing operations before income taxes
    (302 )     206       (506 )     184       (418 )
Income tax expense (benefit)
          34       (158 )     14       (110 )
 
                             
Income (loss) from continuing operations
    (302 )     172       (348 )     170       (308 )
Income (loss) from discontinued operations
          8       (2 )           6  
 
                             
Net income (loss)
  $ (302 )   $ 180     $ (350 )   $ 170     $ (302 )
 
                             
                                         
    Nine Months Ended September 30, 2007  
    Reliant Energy     Guarantors     Non-Guarantors     Adjustments(1)     Consolidated  
    (in millions)  
 
                                       
Revenues
  $     $ 2,834     $ 7,551     $ (1,829 )   $ 8,556  
 
                             
Cost of sales
          2,610       5,968       (1,820 )     6,758  
Operation and maintenance
          153       526       (4 )     675  
Selling, general and administrative
          16       280       (5 )     291  
Western states litigation and similar settlements
          22                   22  
Gains on sales of assets and emission and exchange allowances, net
          (9 )     (10 )           (19 )
Depreciation and amortization
          122       202             324  
 
                             
Total
          2,914       6,966       (1,829 )     8,051  
 
                             
Operating income (loss)
          (80 )     585             505  
 
                             
Income of equity investment, net
          4                   4  
Income of equity investments of consolidated subsidiaries
    115       (6 )           (109 )      
Debt extinguishments
    (72 )                       (72 )
Other, net
          2                   2  
Interest expense
    (192 )     (26 )     (65 )           (283 )
Interest income
    7       6       11             24  
Interest income (expense) — affiliated companies, net
    265       (201 )     (64 )            
 
                             
Total other income (expense)
    123       (221 )     (118 )     (109 )     (325 )
 
                             
Income (loss) from continuing operations before income taxes
    123       (301 )     467       (109 )     180  
Income tax expense (benefit)
    (15 )     (110 )     181       (15 )     41  
 
                             
Income (loss) from continuing operations
    138       (191 )     286       (94 )     139  
Loss from discontinued operations
                (1 )           (1 )
 
                             
Net income (loss)
  $ 138     $ (191 )   $ 285     $ (94 )   $ 138  
 
                             
 
     
(1)   These amounts relate to either (a) eliminations and adjustments recorded in the normal consolidation process or (b) reclassifications recorded due to differences in classifications at the subsidiary levels compared to the consolidated level.

 

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Condensed Consolidating Balance Sheets.
                                         
    September 30, 2008  
    Reliant Energy     Guarantors     Non-Guarantors     Adjustments(1)     Consolidated  
    (in millions)  
ASSETS
                                       
Current Assets:
                                       
Cash and cash equivalents
  $ 634     $     $ 160     $     $ 794  
Restricted cash
          4       2             6  
Accounts and notes receivable, principally customer, net
    5       220       1,038       (6 )     1,257  
Accounts and notes receivable — affiliated companies
    1,577       228       150       (1,955 )      
Inventory
          156       170             326  
Derivative assets
          140       664             804  
Investment in and receivables from Channelview, net
    1       60                   61  
Assets held for sale
          446                   446  
Other current assets
    19       149       314       (24 )     458  
 
                             
Total current assets
    2,236       1,403       2,498       (1,985 )     4,152  
 
                             
Property, Plant and Equipment, net
          2,390       2,458             4,848  
 
                             
Other Assets:
                                       
Goodwill and other intangibles, net
          148       479       119       746  
Notes receivable — affiliated companies
    2,397       564       68       (3,029 )      
Equity investments of consolidated subsidiaries
    2,170       366             (2,536 )      
Derivative assets
          26       314             340  
Other long-term assets
    62       856       342       (591 )     669  
 
                             
Total other assets
    4,629       1,960       1,203       (6,037 )     1,755  
 
                             
Total Assets
  $ 6,865     $ 5,753     $ 6,159     $ (8,022 )   $ 10,755  
 
                             
 
                                       
LIABILITIES AND EQUITY
                                       
Current Liabilities:
                                       
Current portion of long-term debt and short-term borrowings
  $     $     $ 12     $     $ 12  
Accounts payable, principally trade
    8       38       775       (1 )     820  
Accounts and notes payable — affiliated companies
          1,706       249       (1,955 )      
Derivative liabilities
          75       1,203             1,278  
Liabilities held for sale
          62                   62  
Other current liabilities
    78       180       284       (21 )     521  
Current liabilities of discontinued operations
                3             3  
 
                             
Total current liabilities
    86       2,061       2,526       (1,977 )     2,696  
 
                             
Other Liabilities:
                                       
Notes payable — affiliated companies
          2,308       721       (3,029 )      
Derivative liabilities
          24       671             695  
Other long-term liabilities
    573       115       143       (585 )     246  
Long-term liabilities of discontinued operations
                4             4  
 
                             
Total other liabilities
    573       2,447       1,539       (3,614 )     945  
 
                             
Long-term Debt
    1,967       500       408             2,875  
 
                             
Commitments and Contingencies
                                       
Temporary Equity Stock-based Compensation
    7                         7  
 
                             
Total Stockholders’ Equity
    4,232       745       1,686       (2,431 )     4,232  
 
                             
Total Liabilities and Equity
  $ 6,865     $ 5,753     $ 6,159     $ (8,022 )   $ 10,755  
 
                             

 

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    December 31, 2007  
    Reliant Energy     Guarantors     Non-Guarantors     Adjustments(1)     Consolidated  
    (in millions)  
ASSETS
                                       
Current Assets:
                                       
Cash and cash equivalents
  $ 490     $ 1     $ 264     $     $ 755  
Restricted cash
          1       2             3  
Accounts and notes receivable, principally customer, net
    11       252       831       (11 )     1,083  
Accounts and notes receivable — affiliated companies
    2,009       368       328       (2,705 )      
Inventory
          148       137             285  
Derivative assets
          123       540             663  
Investment in and receivables from Channelview, net
    1       82                   83  
Other current assets
    19       160       197       (17 )     359  
Current assets of discontinued operations
                2             2  
 
                             
Total current assets
    2,530       1,135       2,301       (2,733 )     3,233  
 
                             
Property, Plant and Equipment, net
          2,870       2,353             5,223  
 
                             
Other Assets:
                                       
Goodwill and other intangibles, net
          184       482       119       785  
Notes receivable — affiliated companies
    2,365       656       68       (3,089 )      
Equity investments of consolidated subsidiaries
    2,212       304             (2,516 )      
Derivative assets
          44       332             376  
Other long-term assets
    55       860       356       (696 )     575  
 
                             
Total other assets
    4,632       2,048       1,238       (6,182 )     1,736  
 
                             
Total Assets
  $ 7,162     $ 6,053     $ 5,892     $ (8,915 )   $ 10,192  
 
                             
 
                                       
LIABILITIES AND EQUITY
                                       
Current Liabilities:
                                       
Current portion of long-term debt and short-term borrowings
  $ 41     $     $ 11     $     $ 52  
Accounts payable, principally trade
          68       624       (5 )     687  
Accounts and notes payable — affiliated companies
    103       2,223       379       (2,705 )      
Derivative liabilities
          112       773             885  
Other current liabilities
    11       182       256       (23 )     426  
 
                             
Total current liabilities
    155       2,585       2,043       (2,733 )     2,050  
 
                             
Other Liabilities:
                                       
Notes payable — affiliated companies
          2,213       876       (3,089 )      
Derivative liabilities
          57       417             474  
Other long-term liabilities
    539       152       284       (696 )     279  
Long-term liabilities of discontinued operations
                4             4  
 
                             
Total other liabilities
    539       2,422       1,581       (3,785 )     757  
 
                             
Long-term Debt
    1,986       500       417             2,903  
 
                             
Commitments and Contingencies
                                       
Temporary Equity Stock-based Compensation
    5                         5  
 
                             
Total Stockholders’ Equity
    4,477       546       1,851       (2,397 )     4,477  
 
                             
Total Liabilities and Equity
  $ 7,162     $ 6,053     $ 5,892     $ (8,915 )   $ 10,192  
 
                             
 
     
(1)   These amounts relate to either (a) eliminations and adjustments recorded in the normal consolidation process or (b) reclassifications recorded due to differences in classifications at the subsidiary levels compared to the consolidated level.

 

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Condensed Consolidating Statements of Cash Flows.
                                         
    Nine Months Ended September 30, 2008  
    Reliant Energy     Guarantors     Non-Guarantors     Adjustments(1)     Consolidated  
    (in millions)  
Cash Flows from Operating Activities:
                                       
Net cash provided by continuing operations from operating activities
  $ 77     $ 21     $ 163     $     $ 261  
Net cash provided by discontinued operations from operating activities
          7                   7  
 
                             
Net cash provided by operating activities
    77       28       163             268  
 
                             
Cash Flows from Investing Activities:
                                       
Capital expenditures
          (19 )     (197 )           (216 )
Investments in, advances to and from and distributions from subsidiaries, net(2)
    112       57       171       (340 )      
Proceeds from sales of assets
          18                   18  
Proceeds from sales (purchases) of emission and exchange allowances
          74       (61 )           13  
Restricted cash
          (2 )     (1 )           (3 )
Other, net
          4                   4  
 
                             
Net cash provided by (used in) investing activities
    112       132       (88 )     (340 )     (184 )
 
                             
Cash Flows from Financing Activities:
                                       
Payments of long-term debt
    (58 )                       (58 )
Changes in notes with affiliated companies, net(3)
          (161 )     (179 )     340        
Payments of debt extinguishments
    (1 )                       (1 )
Proceeds from issuances of stock
    14                         14  
 
                             
Net cash used in financing activities
    (45 )     (161 )     (179 )     340       (45 )
 
                             
Net Change in Cash and Cash Equivalents
    144       (1 )     (104 )           39  
Cash and Cash Equivalents at Beginning of Period
    490       1       264             755  
 
                             
Cash and Cash Equivalents at End of Period
  $ 634     $     $ 160     $     $ 794  
 
                             

 

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    Nine Months Ended September 30, 2007  
    Reliant Energy     Guarantors     Non-Guarantors     Adjustments(1)     Consolidated  
    (in millions)  
Cash Flows from Operating Activities:
                                       
Net cash provided by (used in) continuing operations from operating activities
  $ 144     $ (147 )   $ 335     $     $ 332  
Net cash used in discontinued operations from operating activities
                (4 )           (4 )
 
                             
Net cash provided by (used in) operating activities
    144       (147 )     331             328  
 
                             
Cash Flows from Investing Activities:
                                       
Capital expenditures
          (20 )     (115 )           (135 )
Investments in, advances to and from and distributions from subsidiaries, net(2)(3)
    59       (6 )     (159 )     106        
Proceeds from sales of assets, net
          30                   30  
Net purchases of emission and exchange allowances
          (35 )     (10 )           (45 )
Restricted cash
          (4 )     9             5  
Other, net
          5                   5  
 
                             
Net cash provided by (used in) investing activities
    59       (30 )     (275 )     106       (140 )
 
                             
Cash Flows from Financing Activities:
                                       
Payments of long-term debt
    (1,487 )           (10 )           (1,497 )
Proceeds from long-term debt
    1,300                         1,300  
Increase in short-term borrowings and revolving credit facilities, net
                7             7  
Changes in notes with affiliated companies, net(3)(4)
          154       (48 )     (106 )      
Payments of financing costs
    (31 )                       (31 )
Payments of debt extinguishments
    (72 )                       (72 )
Proceeds from issuances of stock
    39                         39  
Other, net
    (1 )     (1 )                 (2 )
 
                             
Net cash provided by (used in) financing activities
    (252 )     153       (51 )     (106 )     (256 )
 
                             
Net Change in Cash and Cash Equivalents
    (49 )     (24 )     5             (68 )
Cash and Cash Equivalents at Beginning of Period
    286       24       154             464  
 
                             
Cash and Cash Equivalents at End of Period
  $ 237     $     $ 159     $     $ 396  
 
                             
 
     
(1)   These amounts relate to either (a) eliminations and adjustments recorded in the normal consolidation process or (b) reclassifications recorded due to differences in classifications at the subsidiary levels compared to the consolidated level.
 
(2)   Net investments in, advances to and from and distributions from subsidiaries are classified as investing activities.
 
(3)   Reliant Energy converted intercompany notes payable of a guarantor subsidiary of $753 million to equity during 2007.
 
(4)   Net changes in notes with affiliated companies are classified as financing activities for subsidiaries of Reliant Energy and as investing activities for Reliant Energy.

 

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(13) Reportable Segments
See note 17(e) regarding our retail energy segment. Financial data for our segments are as follows:
                                         
    Retail     Wholesale     Other              
    Energy     Energy     Operations     Eliminations     Consolidated  
    (in millions)  
Three months ended September 30, 2008:
                                       
Revenues from external customers
  $ 2,778     $ 959     $ 1     $     $ 3,738  
Intersegment revenues
          74       3       (77 )      
Contribution margin, including historical and operational wholesale hedges and unrealized gains/losses on energy derivatives(1)(2)
    (1,754 )     311 (3)     1       (1 )     (1,443 )
 
                                       
Three months ended September 30, 2007:
                                       
Revenues from external customers
  $ 2,608     $ 936 (4)   $     $     $ 3,544  
Intersegment revenues
          117       3       (120 )      
Contribution margin, including historical and operational wholesale hedges and unrealized gains/losses on energy derivatives(2)(5)
    198       235 (6)     (1 )     (1 )     431  
 
                                       
Nine months ended September 30, 2008 (except as denoted):
                                       
Revenues from external customers
  $ 7,123     $ 2,852 (7)   $ 2     $     $ 9,977  
Intersegment revenues
          205       9       (214 )      
Contribution margin, including historical and operational wholesale hedges and unrealized gains/losses on energy derivatives(2)(8)
    (698 )     807 (9)     4       (4 )     109  
Total assets as of September 30, 2008
    2,480       7,624       1,353       (702 )     10,755  
 
                                       
Nine months ended September 30, 2007 (except as denoted):
                                       
Revenues from external customers
  $ 6,303     $ 2,253 (4)   $     $     $ 8,556  
Intersegment revenues
          345       10       (355 )      
Contribution margin, including historical and operational wholesale hedges and unrealized gains/losses on energy derivatives (2)(10)
    648       315 (11)     5       (5 )     963  
Total assets as of December 31, 2007
    2,285       7,720       1,081 (12)     (894 )     10,192  
 
     
(1)   Revenues less (a) cost of sales, (b) operation and maintenance, (c) selling and marketing and (d) bad debt expense.
 
(2)   Includes $(1.7) billion, $(40) million and $(1.7) billion in retail energy, wholesale energy and consolidated, respectively, results relating to unrealized losses on energy derivatives, which is a non-cash item.
 
(3)   Includes $117 million relating to historical and operational wholesale hedges.
 
(4)   Includes $40 million from affiliates.
 
(5)   Includes $(8) million, $(20) million and $(28) million in retail energy, wholesale energy and consolidated, respectively, results relating to unrealized losses on energy derivatives, which is a non-cash item.
 
(6)   Includes $(17) million relating to historical and operational wholesale hedges.
 
(7)   Includes $253 million from affiliates.
 
(8)   Includes $(624) million, $58 million and $(566) million in retail energy, wholesale energy and consolidated, respectively, results relating to unrealized gains (losses) on energy derivatives, which is a non-cash item.
 
(9)   Includes $231 million relating to historical and operational wholesale hedges.
 
(10)   Includes $248 million, $(80) million and $168 million in retail energy, wholesale energy and consolidated, respectively, results relating to unrealized gains (losses) on energy derivatives, which is a non-cash item.
 
(11)   Includes $(80) million relating to historical and operational wholesale hedges.
 
(12)   Other operations include discontinued operations of $2 million.

 

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    Three Months Ended September 30,     Nine Months Ended September 30,  
    2008     2007     2008     2007  
    (in millions)  
 
Contribution margin, including historical and operational wholesale hedges and unrealized gains/losses on energy derivatives
  $ (1,443 )   $ 431     $ 109     $ 963  
Other general and administrative
    35       36       112       131  
Western states litigation and similar settlements
    3             37       22  
Gains on sales of assets and emission and exchange allowances, net
    (17 )(1)     (17 )     (40 )(2)     (19 )
Depreciation
    64       71       200       244  
Amortization
    21       51       62       80  
 
                       
Operating income (loss)
    (1,549 )     290       (262 )     505  
Income of equity investment, net
    2       1       3       4  
Debt extinguishments
    (1 )     (1 )     (1 )     (72 )
Other, net
    4       2       4       2  
Interest expense
    (63 )     (74 )     (189 )     (283 )
Interest income
    7       6       27       24  
 
                       
Income (loss) from continuing operations before income taxes
    (1,600 )     224       (418 )     180  
Income tax expense (benefit)
    (562 )     64       (110 )     41  
 
                       
Income (loss) from continuing operations
    (1,038 )     160       (308 )     139  
Income (loss) from discontinued operations
          2       6       (1 )
 
                       
Net income (loss)
  $ (1,038 )   $ 162     $ (302 )   $ 138  
 
                       
 
     
(1)   Includes gains of $10 million related to sales of carbon dioxide (CO2) exchange allowances.
 
(2)   Includes gains of $36 million related to sales of CO2 exchange allowances.
(14) Sale of Channelview’s Plant and the Bankruptcy Filings
On August 20, 2007, Channelview filed voluntary petitions in the United States Bankruptcy Court for the District of Delaware for reorganization under Chapter 11 of the Bankruptcy Code. Channelview LP filed for bankruptcy protection to prevent the lenders from exercising their remedies, including foreclosing on the project. The bankruptcy cases have been jointly administered, with Channelview managing its business in the ordinary course as debtors-in-possession subject to the supervision of the bankruptcy court.
In June 2008, the bankruptcy court approved the sale of Channelview’s plant and assignment of related contracts for $500 million. During the nine months ended September 30, 2008, we recognized a $1 million gain relating to our net investment in and receivables from Channelview and incurrence of sale-related costs (classified in gains (losses) on sales of assets and emission and exchange allowances, net). As of September 30, 2008, our net investment in and receivables from Channelview was $61 million, classified as a current asset.
The sale was completed on July 1, 2008, at which time Channelview LP paid off its secured lenders. Channelview expects to distribute funds to us relating primarily to net proceeds from the sale, pre-petition sales of fuel, funds from operations and funds escrowed for potential indemnification claims of approximately $50 million to $70 million in the aggregate through the third quarter of 2009. Of this amount, $17 million was distributed to us in the third quarter of 2008.

 

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As a result of the bankruptcies, we deconsolidated Channelview’s financial results beginning August 20, 2007, and began reporting our investment in Channelview using the cost method. We will continue to account for Channelview as a cost method investment until the emergence from bankruptcy, which is expected during the third quarter of 2009. The following table contains certain combined financial information of Channelview:
                 
    September 30, 2008     December 31, 2007  
    (in millions)  
 
Cash
  $ 31     $  
Funds escrowed for potential indemnification claims
    35        
Property, plant and equipment, net
          356  
Secured debt obligations, including accrued interest
          340  
Payables to Reliant Energy and its subsidiaries, net
    69       96  
(15) Sale of Bighorn Plant
In October 2008, we sold our Bighorn natural gas-fired combined-cycle electric generation facility located in Clark County, Nevada with a nominal capacity of 598 megawatts for approximately $500 million. The Bighorn plant was in our wholesale energy segment. We will recognize a pre-tax gain on the sale of approximately $45 million during the fourth quarter of 2008. As of September 30, 2008, we have the following assets and liabilities classified as held for sale:
         
    September 30, 2008  
    (in millions)  
 
Property, plant and equipment, net
  $ 403  
Goodwill (allocated from wholesale energy segment)
    17  
Prepaid and other assets
    26  
 
     
Total held for sale assets for Bighorn
  $ 446  
 
     
 
       
Deferred tax liabilities
  $ 60  
Other
    2  
 
     
Total held for sale liabilities for Bighorn
  $ 62  
 
     
(16) Discontinued Operations
Subsequent to the sale of our New York plants in February 2006, we continue to have (a) insignificant settlements with the independent system operator and (b) property tax and sales and use tax settlements. In addition, we periodically receive contingent consideration for the 2003 sale of our European energy operations. These amounts are classified as discontinued operations in our results of operations and consolidated balance sheets, as applicable.
(17) Subsequent Events
Merrill Lynch Unwind. As a result of the impact of Hurricane Ike, ERCOT transmission constraints in the second quarter, significant volatility in commodity prices, the significant increase in the cost of capital generally and constraints in the availability of capital, in September 2008, we and Merrill Lynch determined that pursuing an orderly unwind of the credit-enhanced retail structure was in our mutual best interests. Accordingly, on September 29, 2008, we entered into a letter agreement with Merrill Lynch providing that:
   
the parties would use their commercially reasonable efforts to negotiate a definitive agreement before October 31, 2008 to unwind the structure by April 1, 2009;
 
   
Merrill Lynch would waive compliance with the minimum adjusted EBITDA covenant in the $300 million retail working capital facility through October 31, 2008, so long as all other covenants were complied with (and we incurred a $5 million fee during the three months ended September 30, 2008 in connection with this); and
 
   
we would not draw on the retail working capital facility.
Subsequently, we agreed with Merrill Lynch to extend the time period for the negotiation of the definitive agreement and the waiver of the minimum adjusted EBITDA covenant until December 5, 2008 (for an additional $5 million fee).
To provide us with sufficient capital to be able to operate our retail business without the benefit of the credit-enhanced retail structure, on September 29, 2008, we also entered into a commitment letter with GS Loan Partners (an affiliate of Goldman Sachs) for $650 million in senior secured term loans and a commitment letter with an affiliate of First Reserve Corporation (First Reserve) to issue $350 million of participating convertible preferred stock, the latter of which became a definitive agreement on October 10, 2008. We are presently negotiating the definitive agreement with GS Loan Partners. Each of these financing arrangements is contingent upon each other and on our entry into the definitive agreement with Merrill Lynch described above. There can be no assurance, however, that we will be able to reach definitive agreements with Merrill Lynch or GS Loan Partners, or that the other conditions to these arrangements or the First Reserve investment will be satisfied. If we are unable to reach a definitive agreement with GS Loan Partners or are unable to complete either the First Reserve or GS Loan Partners transactions for any reason, our ability to complete the Merrill Lynch unwind on the terms outlined in the September 29, 2008 letter agreement, as amended, could be impacted. In that event, we would, however, intend to pursue the Merrill Lynch unwind on alternative terms and, as discussed below, complete our exit of the commercial, industrial and governmental/institutional customers (C&I) portion of our retail business.

 

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If we are unable to reach a definitive agreement with Merrill Lynch, we may terminate the $300 million retail working capital facility. Merrill Lynch may dispute our right to terminate the retail working capital facility and, accordingly, could seek to exercise remedies under the credit-enhanced retail structure, including seeking to foreclose on its collateral under that arrangement. We believe that such actions by Merrill Lynch, even if successful, would not have a material impact on our wholesale business.
The agreement with First Reserve is to issue 350,000 shares of Series B convertible participating preferred stock, par value $0.001 per share, for $350 million. The preferred stock will pay cumulative quarterly cash dividends of 14% per year compounded quarterly or $49 million per year. This rate increases to 16% per year if we do not make dividend payments for two consecutive quarters, unless nonpayment is the result of existing restrictive covenants or a legal prohibition. The holders may convert the preferred stock into shares of our common stock at $8.00 per share. If converted, this preferred stock converts into approximately 43.8 million shares of our common stock. We may require the redemption of all of the preferred stock on or after the third anniversary (plus a make-whole payment approximating the present value of the unpaid portion of the fourth and fifth years’ dividends) and the holders may require the redemption of any or all of the preferred stock any time on or after the seventh anniversary. As a result of the extension of the deadline for negotiating the definitive agreement with Merrill Lynch to December 5, 2008, we will be required to pay a $35 million termination fee to First Reserve if the First Reserve transaction does not close for any reason other than a default by First Reserve.
The $650 million in term loans with GS Loan Partners would become due in November 2012. These term loans require a four percent closing payment to the lenders for a net amount to us of $624 million. In connection with this commitment, we incurred $13 million in financing costs during the three months ended September 30, 2008. The term loans will bear interest at our option at either (a) the base rate plus 3.50% (where the base rate cannot be less than 4.75% per year or (b) the reserve adjusted Eurodollar rate plus 4.50% (where the Eurodollar rate cannot be less than 3.75%) per year.
These term loans would restrict our ability to, among other actions, (a) encumber our assets, (b) enter into business combinations or divest our assets, (c) incur additional debt or engage in sale and leaseback transactions, (d) pay dividends or pay subordinated debt, (e) make investments or acquisitions, (f) enter into transactions with affiliates, (g) materially change our business, (h) repurchase capital stock, (i) make certain asset sales, (j) use cash, under certain circumstances, or (k) enter into certain hedging contracts. We will be required to achieve specified levels (which will be stricter than those under our existing credit agreements) for the ratio of consolidated secured debt to adjusted net earnings (loss) before interest expense, interest income, income taxes, depreciation and amortization (consolidated secured leverage ratio).
In addition to the contingencies discussed above, the $650 million term loans commitment is also contingent upon reducing our amount of hedging commodity contracts that require contingent collateral to no more than 300 billion cubic feet equivalent of natural gas. The commitment expires on November 26, 2008.
Strategic Alternatives Process. On October 6, 2008, our Board of Directors initiated a formal process to explore the full range of options to enhance stockholder value, including determining whether better value creation alternatives exist to closing on the new capital commitments and completing the unwind of the credit-enhanced retail structure on the terms outlined in the September 29, 2008 letter agreement with Merrill Lynch. The possible strategic actions include, among other possibilities, the sale of all or substantially all of Reliant Energy as well as the sale of some or all of our retail business.
Wind Down of C&I Portion of Our Retail Business. Without the Merrill Lynch credit support, we do not believe that the C&I margins cover our cost of capital associated with this business. As a result we have concluded that it is appropriate for us to wind down the C&I portion of our retail business and we are, except in certain limited instances, no longer entering into contracts with new C&I customers and we do not expect to renew contracts with our current customers. As part of the strategic alternatives process, we are also exploring ways to accelerate this wind down, including a possible disposition of all or part of the C&I portion of our retail business.

 

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ITEM 2.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion should be read in conjunction with our Form 10-K. This includes non-GAAP financial measures, which are not standardized; therefore it may not be possible to compare these financial measures with other companies’ non-GAAP financial measures having the same or similar names. These non-GAAP financial measures, which are discussed further in “—Consolidated Results of Operations,” reflect an additional way of viewing aspects of our operations that, when viewed with our GAAP results, may provide a more complete understanding of factors and trends affecting our business segments. Investors should review our consolidated financial statements and publicly filed reports in their entirety and not rely on any single financial measure.
Business Overview
We provide electricity and energy services to retail and wholesale customers through two business segments.
    Retail energy — provides electricity and energy services to approximately 1.8 million retail electricity customers in Texas, including residential and small business customers and commercial, industrial and governmental/institutional customers. Our next largest market is the PJM Market, where we serve commercial, industrial and governmental/institutional customers.
 
    Wholesale energy — provides electricity and energy services in the competitive wholesale energy markets in the United States through our ownership and operation or contracting for power generation capacity. We have approximately 15,000 megawatts of power generation capacity.
See discussions below under "— Liquidity and Capital Resources" regarding changes to our business and possible changes to our capital structure.
Key Earnings Drivers.
Retail Energy. The retail energy segment is an electricity resale business. We earn a margin by selling electricity to end-use customers and acquiring supply for the estimated demand. The key earnings drivers in the retail energy segment are the volume of electricity we sell to customers, the unit margins received on those sales and the cost of acquiring and serving those customers (operating costs). These earnings drivers are impacted by various factors including:
Volume of electricity sales
    Local weather patterns
 
    Number and type of customers
 
    Energy efficiency behaviors
 
    Expansion into new markets
Unit margins
    Revenue rate charged compared to cost of supply, which includes
    Commodity price volatility when actual and estimated demand differ
 
    Load-related charges
 
    Transmission congestion
 
    Hedging costs
    Competitive tactics of other retailers in the market
 
    Incremental value-added services
Operating costs
    Collateral costs
 
    Operating efficiencies
 
    Cost to acquire and retain customers
 
    Ability to collect

 

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Wholesale Energy. The wholesale energy segment is a capital-intensive, cyclical business. Earnings are significantly impacted by spark and dark spreads and capacity prices. Spark and dark spreads are driven by a number of factors, including the prices of natural gas, coal and fuel oil, the cost of emissions, transmission, weather and global macro-economic factors, none of which we control and many of which are volatile. The factor that we have the most control over is the percentage of time that our generating assets are available to run when it is economical for them to do so (commercial capacity factor). The key earnings drivers in the wholesale energy segment are the amount of time our power plants are economical to operate (economic generation) and commercial capacity factor, which both determine the amount of electricity we generate, the margin we earn for each unit of electricity sold, the availability of our generating assets to meet demand (other margin) and operating costs. These earnings drivers are impacted by various factors including:
Economic generation
    Supply and demand fundamentals
 
    Spark spreads (difference between power prices and natural gas fuel costs)
 
    Dark spreads (difference between power prices and coal fuel costs)
 
    Generation asset fuel type and efficiency
Commercial capacity factor
    Operations excellence
 
    Maintenance practices
Unit margin
    Supply and demand fundamentals
 
    Commodity prices
 
    Generation asset fuel type and efficiency
Other margin
    Capacity prices
 
    Power purchase agreements sold to others
 
    Ancillary services
Operating costs
    Operating efficiencies
 
    Maintenance practices
 
    Generation asset fuel type
Liquidity and Capital Resources
Merrill Lynch Unwind. The results in our retail energy segment in 2008 have been substantially below our expectations as a result of a variety of factors, including the record heat in the Houston area and ERCOT transmission constraints experienced in late May and early June, the devastating impact of Hurricane Ike on the Gulf Coast and the significant volatility in commodity prices experienced in 2008. As a consequence, we concluded that amending or terminating our $300 million working capital facility agreement with Merrill Lynch could be appropriate in order to address any issue that might be raised regarding the minimum adjusted retail EBITDA covenant in that facility. We believe that we have the right to terminate the working capital facility under the terms of the facility. Merrill Lynch has reserved its right to dispute our right to terminate the facility.
In addition, the ongoing turmoil in the financial markets and uncertainty in the overall economic outlook has resulted in a significant increase in the cost of capital generally and constraints in the availability of capital. The impact of this turmoil and uncertainty has been to increase Merrill Lynch’s cost to perform under the credit-enhanced retail structure. From our perspective, the credit-enhanced retail structure represents a significant concentration of credit support for us with Merrill Lynch.
As a result of the factors described above, in September 2008, we and Merrill Lynch determined that pursuing an orderly unwind of the credit-enhanced retail structure was in our mutual best interests. Accordingly, on September 29, 2008, we entered into a letter agreement with Merrill Lynch providing that:
    the parties would use their commercially reasonable efforts to negotiate a definitive agreement before October 31, 2008 to unwind the structure by April 1, 2009;
 
    Merrill Lynch would waive compliance with the minimum adjusted EBITDA covenant in the $300 million retail working capital facility through October 31, 2008, so long as all other covenants were complied with; and
 
    we would not draw on the retail working capital facility.
Subsequently, we agreed with Merrill Lynch to extend the time period for the negotiation of the definitive agreement and the waiver of the minimum adjusted EBITDA covenant until December 5, 2008.
         To provide us with sufficient capital to be able to operate our retail business without the benefit of the credit-enhanced retail structure, on September 29, 2008, we also entered into a commitment letter with GS Loan Partners (an affiliate of Goldman Sachs) for $650 million in senior secured term loans and a commitment letter with First Reserve to issue $350 million of participating convertible preferred stock, the latter of which became a definitive agreement on October 10, 2008. We are presently negotiating the definitive agreement with GS Loan Partners. Each of these financing arrangements is contingent upon each other and on our entry into the definitive agreement with Merrill Lynch described above.
If completed, we believe that these contingent capital arrangements, combined with our existing available liquidity, would provide us with adequate liquidity to facilitate the orderly unwind of the credit-enhanced retail structure and to operate our retail business in the current environment. There can be no assurance, however, that we will be able to reach definitive agreements with Merrill Lynch or GS Loan Partners, or that the other conditions to these arrangements or the First Reserve investment will be satisfied.
In the event that we are unable to reach a definitive agreement with GS Loan Partners or are unable to complete either the First Reserve or GS Loan Partners transactions for any reason, our ability to complete the Merrill Lynch unwind on the terms outlined in the September 29, 2008 letter agreement, as amended, could be impacted. In that event, we would, however, intend to pursue the Merrill Lynch unwind on alternative terms and, as discussed below, complete our exit of the C&I portion of our retail business.
In the event that we are unable to reach a definitive agreement with Merrill Lynch, as noted above we may terminate the $300 million retail working capital facility. In that event, Merrill Lynch may dispute our right to terminate the retail working capital facility and, accordingly, could seek to exercise remedies under the credit-enhanced retail structure, including seeking to foreclose on its collateral under that arrangement. We believe that such actions by Merrill Lynch, even if successful, would not have a material impact on our wholesale business and that we have sufficient available liquidity to continue to operate our wholesale business.
Strategic Alternatives Process. On October 6, 2008, our Board of Directors concluded that it would be prudent to initiate a formal process to explore other strategic alternatives prior to the funding of the financing commitments with First Reserve and GS Loan Partners and formed a special committee to oversee this process. The strategic alternatives process is intended to explore the full range of options to enhance stockholder value, including determining whether better value creation alternatives exist to closing on the new capital commitments and completing the unwind of the credit-enhanced retail structure on the terms outlined in the September 29, 2008 letter agreement with Merrill Lynch. The possible strategic actions include, among other possibilities, the sale of all or substantially all of Reliant Energy as well as the sale of some or all of our retail business.
Wind Down of C&I Portion of Our Retail Business. As of October 31, 2008, if Merrill Lynch were no longer providing credit support for our retail business, our collateral posting obligations for our retail business would be approximately $1.5 to $2.0 billion. We do not expect to assume this collateral posting obligation immediately, but rather over time, and required collateral postings will likely decrease as underlying positions roll off.
We estimate that roughly 70% of the retail collateral posting obligations is associated with C&I. In contrast, C&I represents only approximately 30% of the contribution margin associated with the retail business. Without the Merrill Lynch credit support, we do not believe that the C&I margins cover our cost of capital associated with this business. As a result we have concluded that it is appropriate for us to wind down the C&I portion of our retail business and we are, except in certain limited instances, no longer entering into contracts with new C&I customers and we do not expect to renew contracts with our current customers. As part of the strategic alternatives process, we are also exploring ways to accelerate this wind down, including a possible disposition of all or part of the C&I portion of our retail business. In addition, we are considering other methods to reduce collateral requirements, including an alternative credit support vehicle, additional internal hedges with our wholesale energy segment and commodity options to replace fixed price retail supply positions.
Available Liquidity. As of October 31, 2008, and including the $500 million in proceeds from the sale of our Bighorn plant, we had total available liquidity of $1.7 billion, comprised of unused borrowing capacity, letters of credit capacity and cash and cash equivalents. This amount includes $150 million in cash and cash equivalents related to our retail business and excludes the $300 million from the retail working capital facility.
Contingent Uses of Liquidity. The preferred stock will pay cumulative quarterly cash dividends of 14% per year compounded quarterly or $49 million per year. In connection with our $650 million senior secured term loans commitment, we expect our interest expense and payments to increase approximately $55 million per year. As a result of the extension of the deadline for negotiating the definitive agreement with Merrill Lynch to December 5, 2008, we will be required to pay a $35 million termination fee to First Reserve if the First Reserve transaction does not close for any reason other than a default by First Reserve.
See “—Recent Events’’, “Risk Factors” in Item 1A of this Form 10-Q and “Risk Factors” in Item 1A and “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources” in Item 7 of our Form 10-K and note 6 to our consolidated financial statements in our Form 10-K.

 

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Recent Events
Strategic Updates. For updates related to strategic events, including our credit-enhanced retail structure with Merrill Lynch, see "— Liquidity and Capital Resources" above.
Hurricane Ike. In September 2008, Hurricane Ike struck the upper Texas coast, which left over 2.1 million electric consumers (more than 90 percent of the metered electric consumers in the Houston-Galveston area) without power. More than 1.0 million electric consumers were without power for at least six days and more than 500,000 customers remained without power ten days after the storm. We currently estimate our contribution margin will be negatively impacted for all of 2008 by approximately $200 million (with approximately $75-$100 million during the third quarter) as a result of the effects of Hurricane Ike, including reduced sales volumes, the sale of excess supply at a loss, cancellation of planned price increases and increased storm-related operating costs. The full extent of the loss will not be known until later this year.
ERCOT. In addition, the Houston area experienced thirty-year record heat in late May and early June 2008. As a result, load demand in Houston and south Texas was greater than we expected. Additionally, transmission constraints limited the ability to move power into the Houston and south Texas zones, which caused some of our power supply to be unavailable to meet expected demand. In response, we purchased power in Houston and south Texas to meet our increased load at market prices, which resulted in negative retail contribution margin in our retail energy segment. We have secured retail supply for the remainder of 2008 and beyond from sources in Houston and south Texas for our expected load.
To reduce earnings variability in our retail energy segment, we are designing and implementing changes in our hedging approach such as matching supply and load by zone, buying heat rate for volumes above two standard deviations in some months and considering the use of gas and weather options to mitigate extreme events. These changes will result in higher expected supply costs over time, which we do not plan to pass through to customers. We are reviewing our core processes that support the business to ensure that we have the right people, skills and systems.
Bighorn Plant. In October 2008, we sold our Bighorn natural gas-fired combined-cycle electric generation facility for approximately $500 million. See note 15 to our interim financial statements.
Channelview. In July 2008, Channelview completed the sale of its plant for $500 million. See note 14 to our interim financial statements.
Environmental Matters. In July 2008, the District of Columbia Circuit Court of Appeals vacated the EPA’s Clean Air Interstate Rule (CAIR) and remanded it to the EPA. In September 2008, the EPA and three other petitioners filed petitions for the court to rehear the decision. We do not know if the court will approve or deny the petitions or if any of the parties will appeal any denial. In October 2008, the court indicated it was considering leaving CAIR in effect while the EPA works to cure defects in the rule. The court’s decision to vacate CAIR raises questions as to whether the EPA can design new cap-and-trade programs for nitrogen oxides (NOx) and sulfur dioxide (SO2) that are consistent with the Clean Air Act provisions that address upwind contributions to downwind states’ noncompliance with national ambient air quality standards for ozone and fine particulate matter. The decision to vacate would set aside CAIR’s proposed annual allowance-based NOx program and the increased surrender rate for SO2 allowances. The existing ozone season NOx program and the SO2 allowance requirements under the Clean Air Act’s acid rain program will continue. We cannot reasonably estimate changes, if any, to our capital expenditures or operating costs for this ruling or any additional regulations that may be enacted.
In June 2008, we revised our estimated capital expenditures for compliance with the first phase of Pennsylvania’s mercury control program to approximately $50 million. This amount is adjusted from our preliminary estimate for the first phase of the program of $88 million to $103 million as a result of refined site-specific engineering and technology evaluations.
See “Risk Factors” in Item 1A, “— Liquidity and Capital Resources” and note 17 to our interim financial statements in this Form 10-Q and “Risk Factors” in Item 1A of our Form 10-K.

 

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Consolidated Results of Operations
Three Months Ended September 30, 2008 Compared to Three Months Ended September 30, 2007
We reported $1.0 billion consolidated net loss, or $2.97 loss per share, for the three months ended September 30, 2008 compared to $162 million consolidated net income, or $0.46 earnings per diluted share, for the same period in 2007.
                         
    Three Months Ended September 30,  
    2008     2007     Change  
            (in millions)          
 
                       
Retail energy contribution margin, including unrealized gains/losses on energy derivatives
  $ (1,754 )   $ 198     $ (1,952 )
Wholesale energy contribution margin, including historical and operational wholesale hedges and unrealized gains/losses on energy derivatives
    311       235       76  
Other contribution margin
          (2 )     2  
Other general and administrative
    (35 )     (36 )     1  
Western states litigation and similar settlements
    (3 )           (3 )
Gains on sales of assets and emission and exchange allowances, net
    17       17        
Depreciation and amortization
    (85 )     (122 )     37  
Income of equity investment, net
    2       1       1  
Debt extinguishments
    (1 )     (1 )      
Other, net
    4       2       2  
Interest expense
    (63 )     (74 )     11  
Interest income
    7       6       1  
Income tax (expense) benefit
    562       (64 )     626  
 
                 
Income (loss) from continuing operations
    (1,038 )     160       (1,198 )
Income from discontinued operations
          2       (2 )
 
                 
Net income (loss)
  $ (1,038 )   $ 162     $ (1,200 )
 
                 
Retail Energy Segment.
In analyzing the results of our retail energy segment and in communications with investors, analysts, rating agencies, banks and other parties, we use the non-GAAP financial measures “retail gross margin” and “retail contribution margin,” which excludes the item described below, as well as our retail energy segment profit and loss measure, “contribution margin, including unrealized gains/losses on energy derivatives.” Retail gross margin and retail contribution margin should not be relied upon without considering the GAAP financial measures.
Unrealized Gains/Losses on Energy Derivatives. We use derivative instruments to manage operational or market constraints and to execute our retail energy segment’s supply procurement strategy. We are required to record in our consolidated statement of operations non-cash gains/losses related to future periods based on current changes in forward commodity prices for derivative instruments receiving mark-to-market accounting treatment. We refer to these gains and losses prior to settlement, as well as ineffectiveness on cash flow hedges, as “unrealized gains/losses on energy derivatives.” In substantially all cases, the underlying transactions being hedged receive accrual accounting treatment, resulting in a mismatch of accounting treatments. Since the application of mark-to-market accounting has the effect of pulling forward into current periods non-cash gains/losses relating to and reversing in future delivery periods, analysis of results of operations from one period to another can be difficult. We believe that excluding these unrealized gains/losses on energy derivatives provides a more meaningful representation of our economic performance in the reporting period and is therefore useful to us, investors, analysts and others in facilitating the analysis of our results of operations from one period to another.
Our retail energy segment’s contribution margin, including unrealized gains/losses on energy derivatives was $(1.8) billion during the three months ended September 30, 2008, compared to $198 million in the same period of 2007. The $2.0 billion decrease was primarily due to the net change in unrealized gains/losses on energy derivatives of $1.6 billion. The $1.6 billion loss is due to $947 million loss from changes in prices on our derivatives marked to market and $815 million loss on energy derivatives settled during the period. The 12 month NYMEX natural gas strip price changed from $13.13 per MMBTU as of June 30, 2008 to $7.96 per MMBTU as of September 30, 2008. Retail contribution margin decreased $306 million primarily due to $288 million decrease in retail gross margin and $15 million increase in selling and marketing. See “— Retail Energy Margins” below for explanations.

 

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Retail Energy Operational Data.
                 
    Three Months Ended September 30,  
    2008     2007  
    (gigawatt hours)  
Electricity Sales to End-Use Retail Customers:
               
Mass:
               
Residential:
               
Houston
    4,113       4,740  
Non-Houston
    2,692       2,774  
Small Business:
               
Houston
    817       926  
Non-Houston
    450       467  
 
           
Total Mass
    8,072       8,907  
Commercial and Industrial:
               
ERCOT(1)(2)
    9,768       10,491  
Non-ERCOT
    1,901       1,364  
 
           
Total Commercial and Industrial
    11,669       11,855  
 
           
Market usage adjustments
    47       12  
 
           
Total
    19,788       20,774  
 
           
 
     
(1)   These volumes include customers of the Texas General Land Office for whom we provide services.
 
(2)   ERCOT is the Electric Reliability Council of Texas.
                 
    Three Months Ended September 30,  
    2008     2007  
    (in thousands, metered locations)  
Weighted Average Retail Customer Count:
               
Mass:
               
Residential:
               
Houston
    995       1,052  
Non-Houston
    552       571  
Small Business:
               
Houston
    109       115  
Non-Houston
    40       37  
 
           
Total Mass
    1,696       1,775  
Commercial and Industrial(1)
    89       91  
 
           
Total
    1,785       1,866  
 
           
 
     
(1)   Includes customers of the Texas General Land Office for whom we provide services.

 

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    September 30, 2008     December 31, 2007  
    (in thousands, metered locations)  
Retail Customers:
               
Mass:
               
Residential:
               
Houston
    986       1,016  
Non-Houston
    552       555  
Small Business:
               
Houston
    109       109  
Non-Houston
    41       38  
 
           
Total Mass
    1,688       1,718  
Commercial and Industrial(1)
    89       93  
 
           
Total
    1,777       1,811  
 
           
 
     
(1)   Includes customers of the Texas General Land Office for whom we provide services.
Retail Energy Revenues.
                         
    Three Months Ended September 30,  
    2008     2007     Change  
            (in millions)          
Retail energy revenues from end-use retail customers:
                       
Mass:
                       
Residential:
                       
Houston
  $ 652     $ 722     $ (70 )(1)
Non-Houston
    392       396       (4 )
Small Business:
                       
Houston
    132       151       (19 )(2)
Non-Houston
    63       64       (1 )
 
                 
Total Mass
    1,239       1,333       (94 )
Commercial and Industrial:
                       
ERCOT
    1,035       941       94 (3)
Non-ERCOT
    179       119       60 (4)
 
                 
Total Commercial and Industrial
    1,214       1,060       154  
 
                 
Total
    2,453       2,393       60  
 
                 
 
Retail energy revenues from resales of purchased power and other hedging activities
    310       212       98 (5)
Market usage adjustments(6)
    15       3       12  
 
                 
Total retail energy revenues
  $ 2,778     $ 2,608     $ 170  
 
                 
 
     
(1)   Decrease primarily due to (a) lower volumes driven by (i) change in customer usage primarily due to Hurricane Ike and milder weather and (ii) fewer number of customers. This decrease was partially offset by higher unit sales prices.
 
(2)   Decrease primarily due to lower volumes due to (a) change in customer usage and mix primarily due to Hurricane Ike and (b) fewer number of customers.
 
(3)   Increase primarily due to higher unit sales prices due to (a) variable rate contracts, which are tied to the market price of natural gas and (b) fixed price contracts renewed at higher market rates due to higher prices of electricity when contracts were executed. This increase was partially offset by lower volumes due to change in customer usage and mix primarily due to Hurricane Ike.
 
(4)   Increase primarily due to (a) higher volumes due to increased number of customers, partially offset by change in customer usage and mix and (b) higher unit sales prices due to higher prices of electricity when contracts were executed.
 
(5)   Increase primarily due to higher unit sales prices associated with our supply management activities in various markets in Texas.
 
(6)   The revenues and the related energy supply costs in our retail energy segment include our estimates of customer usage based on initial usage information provided by the independent system operators and the distribution companies. We revise these estimates and record any changes in the period as additional settlement information becomes available (collectively referred to as “market usage adjustments”).

 

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Retail Energy Cost of Sales.
                         
    Three Months Ended September 30,  
    2008     2007     Change  
            (in millions)          
 
                       
Costs of sales
  $ 2,664     $ 2,143     $ 521  
Retail energy intersegments costs
    74       117       (43 )
 
                 
Subtotal
    2,738       2,260       478 (1)
 
                 
Market usage adjustments
    (7 )     13       (20 )
Unrealized losses on energy derivatives
    1,654       8       1,646 (2)
 
                 
Total retail energy cost of sales
  $ 4,385     $ 2,281     $ 2,104  
 
                 
 
     
(1)   Increase primarily due to higher unit prices driven by (a) higher market prices of purchased power at the time of procurement, (b) the sell back of excess power at reduced market rates due to Hurricane Ike and (c) increased cost of intra-month congestion. This increase was partially offset by lower volumes due to (a) change in customer usage and mix, (b) fewer number of mass customers and (c) milder weather.
 
(2)   See footnote 4 under “— Retail Energy Margins.”
Retail Energy Margins.
                         
    Three Months Ended September 30,  
    2008     2007     Change  
            (in millions)          
 
                       
Mass gross margin
  $ 30     $ 244     $ (214 )(1)(2)
Commercial and industrial gross margin
    (5 )     101       (106 )(2)(3)
Market usage adjustments
    22       (10 )     32  
 
                 
Retail gross margin
    47       335       (288 )
 
                 
Operation and maintenance
    (67 )     (65 )     (2 )
Selling and marketing expense
    (49 )     (34 )     (15 )(4)
Bad debt expense
    (31 )     (30 )     (1 )
 
                 
Retail contribution margin
    (100 )     206       (306 )
Unrealized losses on energy derivatives
    (1,654 )     (8 )     (1,646 )(5)
 
                 
Total retail energy contribution margin, including unrealized gains/losses on energy derivatives(6)
  $ (1,754 )   $ 198     $ (1,952 )
 
                 
 
     
(1)   Decrease primarily due to (a) lower unit margins driven by (i) higher natural gas prices and the decision not to fully pass these costs through to customers and (ii) sell back of excess supply at reduced market rates due to Hurricane Ike and (b) lower volumes driven by (i) change in customer usage and (ii) fewer number of customers.
 
(2)   See “—Recent Events—Retail Energy Segment.”
 
(3)   Decrease primarily due to lower unit margins driven by (a) higher unit prices of purchased power at the time of procurement, (b) sell back of excess supply at reduced market rates due to Hurricane Ike and (c) increased cost of intra-month congestion, partially offset by higher unit sales prices driven by (i) variable rate contracts, which are tied to the market price of natural gas and (ii) fixed price contracts renewed at higher market rates due to higher prices of electricity when contracts were executed.
 
(4)   Increase primarily due to (a) timing of marketing campaigns and (b) salaries and benefits and professional fees and services.
 
(5)   Decrease primarily due to (a) $947 million loss from changes in prices on our derivatives marked to market and (b) $815 million loss on energy derivatives settled during the period.
 
(6)   Retail energy segment profit and loss measure.
Wholesale Energy Segment.
In analyzing the results of our wholesale energy segment and in communications with investors, analysts, rating agencies, banks and other parties, we use the non-GAAP financial measures “open energy gross margin,” “open wholesale gross margin” and “open wholesale contribution margin,” which exclude the items described below, as well as our wholesale energy segment profit and loss measure, “contribution margin, including historical and operational wholesale hedges and unrealized gains/losses on energy derivatives.” Open energy gross margin, open wholesale gross margin and open wholesale contribution margin should not be relied upon without considering the GAAP financial measures.

 

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Historical and Operational Wholesale Hedges. We exclude the recurring effect of certain historical wholesale hedges that were entered into in order to hedge the economics of a portion of our wholesale operations. These amounts primarily relate to settlements of forward power hedges, long-term tolling purchases, long-term natural gas transportation contracts not serving our generation assets and our legacy energy trading. We also exclude the effect of certain on-going operational wholesale hedges that were entered into primarily to mitigate certain operational risks at our generation assets. These amounts primarily relate to settlements of fuel hedges, long-term natural gas transportation contracts and storage contracts. Operational wholesale hedges are derived based on methodology consistent with the calculation of open energy gross margin. We believe that it is useful to us, investors, analysts and others to show our results in the absence of both historical and operational hedges. The impact of these hedges on our financial results is not a function of the operating performance of our generation assets, and excluding the impact better reflects the operating performance of our generation assets based on prevailing market conditions.
Unrealized Gains/Losses on Energy Derivatives. We use derivative instruments to manage operational or market constraints and to increase the return on our generation assets. We are required to record in our consolidated statement of operations non-cash gains/losses related to future periods based on current changes in forward commodity prices for derivative instruments receiving mark-to-market accounting treatment. We refer to these gains and losses prior to settlement, as well as ineffectiveness on cash flow hedges, as “unrealized gains/losses on energy derivatives.” In some cases, the underlying transactions being hedged receive accrual accounting treatment, resulting in a mismatch of accounting treatments. Since the application of mark-to-market accounting has the effect of pulling forward into current periods non-cash gains/losses relating to and reversing in future delivery periods, analysis of results of operations from one period to another can be difficult. We believe that excluding these unrealized gains/losses on energy derivatives provides a more meaningful representation of our economic performance in the reporting period and is therefore useful to us, investors, analysts and others in facilitating the analysis of our results of operations from one period to another. These gains/losses are also not a function of the operating performance of our generation assets, and excluding their impact helps isolate the operating performance of our generation assets under prevailing market conditions.
Our wholesale energy segment’s contribution margin, including historical and operational wholesale hedges and unrealized gains/losses on energy derivatives was $311 million during the three months ended September 30, 2008 compared to $235 million in the same period of 2007. The $76 million increase was primarily due to $134 million increase in historical and operational wholesale hedges, partially offset by a net change in unrealized gains/losses on energy derivatives of $20 million. Open wholesale contribution margin decreased $38 million primarily due to $47 million decrease in open wholesale gross margin, partially offset by $10 million decrease in operation and maintenance expenses. See “— Wholesale Energy Margins” below for explanations.

 

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Wholesale Energy Operational and Financial Data.
                                 
    Three Months Ended September 30,  
    2008     2007  
    GWh     % Economic(1)     GWh     % Economic(1)  
 
                               
Economic Generation(2)(3):
                               
PJM Coal
    4,838.2       66 %     5,973.6       82 %
MISO Coal
    938.3       34 %     1,941.8       70 %
PJM/MISO Gas
    766.0       9 %     775.1       11 %
West
    1,405.9       20 %     2,303.5       33 %
Other
    63.5       3 %     1,021.5       38 %
 
                       
Total
    8,011.9       29 %     12,015.5       45 %
 
                       
 
                               
Commercial Capacity Factor(4):
                               
PJM Coal
    89.9 %             89.5 %        
MISO Coal
    94.7 %             85.7 %        
PJM/MISO Gas
    90.2 %             93.0 %        
West
    96.9 %             96.7 %        
Other
    81.7 %             93.1 %        
 
                           
Total
    91.6 %             90.8 %        
 
                           
 
                               
Generation (3):
                               
PJM Coal
    4,349.3               5,345.4          
MISO Coal
    888.5               1,664.1          
PJM/MISO Gas
    690.9               721.0          
West
    1,361.7               2,228.2          
Other
    51.9               951.3          
 
                           
Total
    7,342.3               10,910.0          
 
                           
 
                               
Open Energy Unit Margin ($/MWh)(5):
                               
PJM Coal
  $ 29.66             $ 31.05          
MISO Coal
    21.38               29.45          
PJM/MISO Gas
    28.95               38.83          
West
    5.14               12.57          
Other
    19.27               9.46          
 
                           
Total weighted average
  $ 23.97             $ 25.66          
 
                           
 
     
(1)   Represents economic generation (hours) divided by maximum generation hours (maximum plant capacity multiplied by 8,760 hours).
 
(2)   Estimated generation at 100% plant availability based on an hourly analysis of when it is economical to generate based on the price of power, fuel, emission allowances and variable operating costs.
 
(3)   Excludes generation related to power purchase agreements, including tolling agreements.
 
(4)   Generation divided by economic generation.
 
(5)   Represents open energy gross margin divided by generation.

 

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Wholesale Energy Revenues.
                         
    Three Months Ended September 30,  
    2008     2007     Change  
            (in millions)          
 
                       
Wholesale energy third-party revenues
  $ 965     $ 889     $ 76 (1)
Wholesale energy intersegment revenues
    74       117       (43 )(2)
 
                 
Subtotal
    1,039       1,006       33  
 
                 
Revenues — affiliates(3)
          40       (40 )
Unrealized gains (losses)
    (6 )     7       (13 )(4)
 
                 
Total wholesale energy revenues
  $ 1,033     $ 1,053     $ (20 )
 
                 
 
     
(1)   Increase primarily due to (a) higher power and natural gas sales prices and (b) higher capacity payments. This increase was partially offset by lower power and natural gas sales volumes.
 
(2)   Decrease primarily due to (a) lower power sales volumes and (b) lower natural gas sales volumes related to a contract that ended in October 2007. This decrease was partially offset by higher power sales prices.
 
(3)   We deconsolidated Channelview on August 20, 2007. These revenues represent sales of fuel to Channelview.
 
(4)   See footnote 9 under “— Wholesale Energy Margins.”
Wholesale Energy Cost of Sales.
                         
    Three Months Ended September 30,  
    2008     2007     Change  
            (in millions)          
 
                       
Wholesale energy third-party costs
  $ 553     $ 610     $ (57 )(1)
Cost of sales — affiliates(2)
    1       38       (37 )
Unrealized losses
    34       27       7 (3)
 
                 
Total wholesale energy cost of sales
  $ 588     $ 675     $ (87 )
 
                 
 
     
(1)   Decrease primarily due to lower purchased natural gas and coal volumes. This decrease was partially offset by (a) higher prices paid for natural gas and coal and (b) higher power volumes purchased.
 
(2)   We deconsolidated Channelview on August 20, 2007. These cost of sales represent purchases of power from Channelview.
 
(3)   See footnote 9 under “— Wholesale Energy Margins.”

 

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Wholesale Energy Margins.
                         
    Three Months Ended September 30,  
    2008     2007     Change  
            (in millions)          
Open energy gross margin(1):
                       
PJM Coal
  $ 129     $ 166     $ (37 )(2)
MISO Coal
    19       49       (30 ) (2)
PJM/MISO Gas
    20       28       (8 )
West
    7       28       (21 )(3)
Other
    1       9       (8 )
 
                 
Total
    176       280       (104 )
 
                       
Other margin(4):
                       
PJM Coal
    40       20       20 (5)
MISO Coal
    13       6       7  
PJM/MISO Gas
    46       43       3  
West
    83       48       35 (6)
Other
    10       18       (8 )
 
                 
Total
    192       135       57  
 
                 
 
                       
Open wholesale gross margin
    368       415       (47 )
 
                 
 
                       
Operation and maintenance
    (134 )     (144 )     10 (7)
Bad debt expense
          1       (1 )
 
                 
Open wholesale contribution margin
    234       272       (38 )
Historical and operational wholesale hedges
    117       (17 )     134 (8)
Unrealized losses on energy derivatives
    (40 )     (20 )     (20 )(9)
 
                 
Total wholesale energy contribution margin, including historical and operational wholesale hedges and unrealized gains/losses on energy derivatives(10)
  $ 311     $ 235     $ 76  
 
                 
 
     
(1)   Open energy gross margin is calculated using the power sales prices received by the plants less delivered spot fuel prices. This figure excludes the effects of other margin, our historical and operational wholesale hedges and unrealized gains/losses on energy derivatives.
 
(2)   Decrease primarily due to (a) lower economic generation and (b) lower open energy unit margins (higher fuel costs partially offset by higher power prices).
 
(3)   Decrease primarily due to (a) lower open energy unit margins (higher fuel costs partially offset by higher power prices) and (b) lower economic generation.
 
(4)   Other margin represents power purchase agreements, capacity payments, ancillary services revenues and selective commercial hedge strategies.
 
(5)   Increase primarily due to higher RPM capacity payments. RPM is the model utilized by the PJM Interconnection, LLC to meet load serving entities’ forecasted capacity obligations via a forward-looking commitment of capacity resources.
 
(6)   Increase primarily due to (a) higher capacity payments and (b) an increase in selective commercial hedge activity.
 
(7)   Decrease primarily due to (a) $5 million decrease in services and support and (b) the deconsolidation of Channelview on August 20, 2007.
 
(8)   Increase primarily due to (a) $103 million in increased gains on operational hedges and (b) $30 million decrease in losses on closed power hedges.
 
(9)   Increase loss primarily due to $79 million loss on energy derivatives settled during the period, partially offset by $67 million gain from changes in prices on our derivatives marked to market.
 
(10)   Wholesale energy segment profit and loss measure.

 

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Other General and Administrative.
                         
    Three Months Ended September 30,  
    2008     2007     Change  
            (in millions)          
 
                       
Salaries and benefits
  $ 14     $ 17     $ (3 )
Professional fees, contract services and information systems maintenance
    7       8       (1 )
Rent and utilities
    5       5        
Credit-enhanced retail structure fee
    5             5  
Legal costs
    2       2        
Costs in connection with Channelview’s reorganization
          2       (2 )
Other, net
    2       2        
 
                 
Other general and administrative
  $ 35     $ 36     $ (1 )
 
                 
Gains on Sales of Assets and Emission and Exchange Allowances, Net.
                         
    Three Months Ended September 30,  
    2008     2007     Change  
            (in millions)          
 
                       
Emission and exchange allowances
  $ 10 (1)   $ (1 )   $ 11  
Equipment
          18       (18 )
Investment in and receivables from Channelview
    6 (2)           6  
Other, net
    1             1  
 
                 
Gains on sales of assets and emission and exchange allowances, net
  $ 17     $ 17     $  
 
                 
 
     
(1)   Includes gains of $10 million related to sales of CO2 exchange allowances.
 
(2)   In the second quarter of 2008, we executed an agreement to sell the Channelview plant and assign related contracts. This amount represents a revision to the estimated gain on the sale. See note 14 to our interim financial statements.
Depreciation and Amortization.
                         
    Three Months Ended September 30,  
    2008     2007     Change  
          (in millions)        
 
                       
Depreciation on plants
  $ 54     $ 60     $ (6 )(1)
Depreciation on information systems
    9       9        
Other, net — depreciation
    1       2       (1 )
 
                 
Depreciation
    64       71       (7 )
 
                 
Amortization of emission allowances
    20       50       (30 )(2)
Other, net — amortization
    1       1        
 
                 
Amortization
    21       51       (30 )
 
                 
Depreciation and amortization
  $ 85     $ 122     $ (37 )
 
                 
 
     
(1)   Decrease primarily due to (a) the classification of Bighorn assets as held for sale in April 2008, which requires depreciation to cease and (b) the deconsolidation of Channelview on August 20, 2007.
 
(2)   Decrease primarily due to (a) decrease weighted average cost of SO2 allowances purchased and used and (b) decrease in allowances used.
Income of Equity Investment, Net. This represents income, which did not change significantly, from our equity method investment in Sabine Cogen, LP.
Other, Net. Other, net did not change significantly.

 

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Interest Expense.
                         
    Three Months Ended September 30,  
    2008     2007     Change  
            (in millions)          
 
                       
Fixed-rate debt
  $ 56     $ 59     $ (3 )
Fees for MWh’s delivered under credit-enhanced retail structure
    8       8        
Financing fees expensed
    3       4       (1 )
Deferred financing costs
    2       3       (1 )
Channelview
          3       (3 )(1)
Amortization of fair value adjustment of acquired debt
    (2 )     (1 )     (1 )
Capitalized interest
    (4 )     (1 )     (3 )
Other, net
          (1 )     1  
 
                 
Interest expense
  $ 63     $ 74     $ (11 )
 
                 
 
     
(1)   Decrease due to the deconsolidation of Channelview on August 20, 2007.
Interest Income.
                         
    Three Months Ended September 30,  
    2008     2007     Change  
            (in millions)          
 
                       
Interest on temporary cash investments
  $ 5     $ 4     $ 1  
Net margin deposits
    1       2       (1 )
Other, net
    1             1  
 
                 
Interest income
  $ 7     $ 6     $ 1  
 
                 
Income Tax Expense. See note 9 to our interim financial statements.
Income (Loss) from Discontinued Operations. See note 16 to our interim financial statements.

 

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Nine Months Ended September 30, 2008 Compared to Nine Months Ended September 30, 2007
We reported $302 million consolidated net loss, or $0.87 loss per share, for the nine months ended September 30, 2008 compared to $138 million consolidated net income, or $0.39 earnings per diluted share, for the same period in 2007.
                         
    Nine Months Ended September 30,  
    2008     2007     Change  
            (in millions)          
 
                       
Retail energy contribution margin, including unrealized gains/losses on energy derivatives
  $ (698 )   $ 648     $ (1,346 )
Wholesale energy contribution margin, including historical and operational wholesale hedges and unrealized gains/losses on energy derivatives
    807       315       492  
Other general and administrative
    (112 )     (131 )     19  
Western states litigation and similar settlements
    (37 )     (22 )     (15 )
Gains on sales of assets and emission and exchange allowances, net
    40       19       21  
Depreciation and amortization
    (262 )     (324 )     62  
Income of equity investment, net
    3       4       (1 )
Debt extinguishments
    (1 )     (72 )     71  
Other, net
    4       2       2  
Interest expense
    (189 )     (283 )     94  
Interest income
    27       24       3  
Income tax (expense) benefit
    110       (41 )     151  
 
                 
Income (loss) from continuing operations
    (308 )     139       (447 )
Income (loss) from discontinued operations
    6       (1 )     7  
 
                 
Net income (loss)
  $ (302 )   $ 138     $ (440 )
 
                 
Retail Energy Segment.
Our retail energy segment’s contribution margin, including unrealized gains/losses on energy derivatives was $(698) million during the nine months ended September 30, 2008, compared to $648 million in the same period of 2007. The $1.3 billion decrease was primarily due to the net change in unrealized gains/losses on energy derivatives of $872 million. The $872 million loss is due to $510 million loss from changes in prices on our derivatives marked to market and $297 million loss on energy derivatives setting during the period. Retail contribution margin decreased $474 million primarily due to $469 million decrease in retail gross margin and $25 million increase in selling and marketing, partially offset by $24 million decrease in bad debt expense. See “— Retail Energy Margins” below for explanations.

 

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Retail Energy Operational Data.
                 
    Nine Months Ended September 30,  
    2008     2007  
    (gigawatt hours)  
Electricity Sales to End-Use Retail Customers:
               
Mass:
               
Residential:
               
Houston
    10,012       10,848  
Non-Houston
    6,482       6,622  
Small Business:
               
Houston
    2,160       2,421  
Non-Houston
    1,111       1,127  
 
           
Total Mass
    19,765       21,018  
Commercial and Industrial:
               
ERCOT(1)
    28,254       27,601  
Non-ERCOT
    4,716       3,472  
 
           
Total Commercial and Industrial
    32,970       31,073  
 
           
Market usage adjustments
    (50 )     (68 )
 
           
Total
    52,685       52,023  
 
           
 
     
(1)   These volumes include customers of the Texas General Land Office for whom we provide services.
                 
    Nine Months Ended September 30,  
    2008     2007  
    (in thousands, metered locations)  
Weighted Average Retail Customer Count:
               
Mass:
               
Residential:
               
Houston
    996       1,067  
Non-Houston
    546       564  
Small Business:
               
Houston
    109       117  
Non-Houston
    39       35  
 
           
Total Mass
    1,690       1,783  
Commercial and Industrial(1)
    91       88  
 
           
Total
    1,781       1,871  
 
           
 
     
(1)   Includes customers of the Texas General Land Office for whom we provide services.

 

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Retail Energy Revenues.
                         
    Nine Months Ended September 30,  
    2008     2007     Change  
            (in millions)          
Retail energy revenues from end-use retail customers:
                       
Mass:
                       
Residential:
                       
Houston
  $ 1,529     $ 1,658     $ (129 ) (1)
Non-Houston
    911       932       (21 ) (2)
Small Business:
                       
Houston
    343       397       (54 ) (3)
Non-Houston
    158       157       1  
 
                 
Total Mass
    2,941       3,144       (203 )
Commercial and Industrial:
                       
ERCOT
    2,899       2,489       410 (4)
Non-ERCOT
    435       273       162 (5)
 
                 
Total Commercial and Industrial
    3,334       2,762       572  
 
                 
Total
    6,275       5,906       369  
 
                 
Retail energy revenues from resales of purchased power and other hedging activities
    853       401       452 (6)
Market usage adjustments
    (5 )     (4 )     (1 )
 
                 
Total retail energy revenues
  $ 7,123     $ 6,303     $ 820  
 
                 
 
     
(1)   Decrease primarily due to (a) lower volumes driven by (i) fewer number of customers and (ii) change in customer usage primarily due to Hurricane Ike, partially offset by warmer weather.
 
(2)   Decrease primarily due to lower volumes due to fewer number of customers.
 
(3)   Decrease primarily due to (a) lower volumes driven by (i) fewer number of customers and (ii) change in customer usage and mix primarily due to Hurricane Ike and (b) lower unit sales prices.
 
(4)   Increase primarily due to (a) higher unit sales prices due to (i) variable rate contracts, which are tied to the market price of natural gas and (ii) fixed price contracts renewed at higher market rates due to higher prices of electricity when contracts were executed and (b) higher volumes primarily driven by increased number of customers, partially offset by change in customer usage and mix primarily due to Hurricane Ike.
 
(5)   Increase primarily due to (a) higher volumes due to increased number of customers, partially offset by change in customer usage and mix and (b) higher unit sales prices due to higher prices of electricity when contracts were executed.
 
(6)   Increase primarily due to our supply management activities in various markets in Texas.
Retail Energy Cost of Sales.
                         
    Nine Months Ended September 30,  
    2008     2007     Change  
            (in millions)          
 
                       
Costs of sales
  $ 6,641     $ 5,204     $ 1,437  
Retail energy intersegments costs
    205       345       (140 )
 
                 
Subtotal
    6,846       5,549       1,297 (1)
 
                 
Market usage adjustments
    (2 )     6       (8 )
Unrealized (gains) losses on energy derivatives
    624       (248 )     872 (2)
 
                 
Total retail energy cost of sales
  $ 7,468     $ 5,307     $ 2,161  
 
                 
 
     
(1)   Increase primarily due to (a) higher unit prices driven by (i) higher market prices of purchased power at the time of procurement, (ii) the sell back of excess power at reduced market rates due to Hurricane Ike, (iii) increased cost of intra-month congestion, (iv) higher load related charges and (v) higher transmission and distribution losses in ERCOT and (b) higher volumes due to (i) change in customer usage and mix, (ii) increased number of commercial and industrial customers, partially offset by fewer number of mass customers and (iii) warmer weather.
 
(2)   See footnote 5 under “— Retail Energy Margins.”

 

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Retail Energy Margins.
                         
    Nine Months Ended September 30,  
    2008     2007     Change  
            (in millions)          
 
                       
Mass gross margin
  $ 225     $ 595     $ (370 )(1)(2)
Commercial and industrial gross margin
    57       163       (106 )(2)(3)
Market usage adjustments
    (3 )     (10 )     7  
 
                 
Retail gross margin
    279       748       (469 )
 
                 
Operation and maintenance
    (190 )     (186 )     (4 )
Selling and marketing expense
    (119 )     (94 )     (25 )(4)
Bad debt expense
    (44 )     (68 )     24 (5)
 
                 
Retail contribution margin
    (74 )     400       (474 )
Unrealized gains (losses) on energy derivatives
    (624 )     248       (872 )(6)
 
                 
Total retail energy contribution margin, including unrealized gains/losses on energy derivatives
  $ (698 )   $ 648     $ (1,346 )
 
                 
 
     
(1)   Decrease primarily due to (a) lower unit margins driven by (i) higher natural gas prices and the decision not to fully pass these costs through to customers, (ii) sell back of excess supply at reduced market rates due to Hurricane Ike, (iii) higher market rates on incremental volumes purchased for higher customer load due to weather and (iv) increased cost of intra-month congestion and (b) lower volumes primarily due to (i) fewer number of customers and (ii) change in customer usage.
 
(2)   See “—Recent Events—Retail Energy Segment.”
 
(3)   Decrease primarily due to lower unit margins driven by (a) sell back of excess supply at reduced market rates due to Hurricane Ike, (b) increased cost of intra-month congestion, (c) higher load related charges and (d) higher transmission and distribution losses in ERCOT.
 
(4)   Increase primarily due to (a) salaries and benefits and professional fees and services and (b) timing of marketing campaigns.
 
(5)   Decrease in bad debt expense due to improved collections.
 
(6)   Decrease primarily due to (a) $510 million loss from changes in prices on our derivatives marked to market and (b) $297 million loss on energy derivatives settled during the period.
Wholesale Energy Segment.
Our wholesale energy segment’s contribution margin, including historical and operational wholesale hedges and unrealized gains/losses on energy derivatives was $807 million during the nine months ended September 30, 2008 compared to $315 million in the same period of 2007. The $492 million increase was primarily due to (a) $311 million increase in historical and operational wholesale hedges and (b) net change in unrealized gains/losses on energy derivatives of $138 million. Open wholesale contribution margin increased $43 million primarily due to $37 million decrease in operation and maintenance expenses and $9 million increase in open wholesale gross margin. See “— Wholesale Energy Margins” below for explanations.

 

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Wholesale Energy Operational and Financial Data.
                                 
    Nine Months Ended September 30,  
    2008     2007  
    GWh     % Economic     GWh     % Economic  
 
                               
Economic Generation:
                               
PJM Coal
    16,118.7       74 %     18,100.9       83 %
MISO Coal
    4,346.0       52 %     6,186.5       75 %
PJM/MISO Gas
    1,178.8       5 %     1,189.1       6 %
West
    1,952.9       9 %     3,211.0       16 %
Other
    70.4       2 %     3,771.7       55 %
 
                       
Total
    23,666.8       31 %     32,459.2       41 %
 
                       
 
                               
Commercial Capacity Factor:
                               
PJM Coal
    86.0 %             81.5 %        
MISO Coal
    84.3 %             65.6 %        
PJM/MISO Gas
    90.8 %             90.7 %        
West
    93.9 %             96.3 %        
Other
    81.7 %             91.8 %        
 
                           
Total
    86.6 %             81.5 %        
 
                           
 
                               
Generation:
                               
PJM Coal
    13,864.4               14,752.9          
MISO Coal
    3,664.6               4,059.1          
PJM/MISO Gas
    1,070.6               1,078.6          
West
    1,834.0               3,091.9          
Other
    57.5               3,464.0          
 
                           
Total
    20,491.1               26,446.5          
 
                           
 
                               
Open Energy Unit Margin ($/MWh):
                               
PJM Coal
  $ 33.25             $ 31.45          
MISO Coal
    25.65               29.07          
PJM/MISO Gas
    37.36               35.23          
West
  NM (1)             7.76          
Other
    17.39               6.64          
 
                           
Total weighted average
  $ 29.04             $ 25.22          
 
                           
 
     
(1)   NM is not meaningful.
Wholesale Energy Revenues.
                         
    Nine Months Ended September 30,  
    2008     2007     Change  
            (in millions)          
 
                       
Wholesale energy third-party revenues
  $ 2,612     $ 2,202     $ 410 (1)
Wholesale energy intersegment revenues
    205       345       (140 )(2)
 
                 
Subtotal
    2,817       2,547       270  
 
                 
Revenues — affiliates(3)
    253       40       213  
Unrealized gains (losses)
    (13 )     11       (24 )(4)
 
                 
Total wholesale energy revenues
  $ 3,057     $ 2,598     $ 459  
 
                 
 
     
(1)   Increase primarily due to (a) higher power and natural gas sales prices and (b) higher capacity payments. This increase was partially offset by (a) lower natural gas and power sales volumes and (b) lower steam sales due to the deconsolidation of Channelview on August 20, 2007.
 
(2)   Decrease primarily due to (a) lower power sales volumes and (b) lower natural gas sales volumes related to a contract that ended in October 2007. This decrease was partially offset by higher power sales prices.
 
(3)   We deconsolidated Channelview on August 20, 2007. These revenues represent sales of fuel to Channelview.
 
(4)   See footnote 9 under “— Wholesale Energy Margins.”

 

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Wholesale Energy Cost of Sales.
                         
    Nine Months Ended September 30,  
    2008     2007     Change  
            (in millions)          
 
                       
Wholesale energy third-party costs
  $ 1,667     $ 1,667     $ (1)
Cost of sales — affiliates(2)
    201       38       163  
Unrealized (gains) losses
    (71 )     91       (162 )(3)
 
                 
Total wholesale energy cost of sales
  $ 1,797     $ 1,796     $ 1  
 
                 
 
     
(1)   No net change; however, there were significant variances primarily due to (a) higher prices paid for natural gas and coal and (b) higher power volumes purchased, offset by lower purchased natural gas and coal volumes.
 
(2)   We deconsolidated Channelview on August 20, 2007. These cost of sales represent purchases of power from Channelview.
 
(3)   See footnote 9 under “— Wholesale Energy Margins.”

 

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Wholesale Energy Margins.
                         
    Nine Months Ended September 30,  
    2008     2007     Change  
            (in millions)          
Open energy gross margin:
                       
PJM Coal
  $ 461     $ 464     $ (3 )
MISO Coal
    94       118       (24 )(1)
PJM/MISO Gas
    40       38       2  
West
    (1 )     24       (25 )(2)
Other
    1       23       (22 )(3)
 
                 
Total
    595       667       (72 )
 
                       
Other margin:
                       
PJM Coal
    84       42       42 (4)
MISO Coal
    18       11       7  
PJM/MISO Gas
    106       79       27 (5)
West
    139       107       32 (6)
Other
    29       56       (27 )(7)
 
                 
Total
    376       295       81  
 
                 
 
                       
Open wholesale gross margin
    971       962       9  
 
                 
 
                       
Operation and maintenance
    (452 )     (489 )     37 (8)
Bad debt expense
    (1 )     2       (3 )
 
                 
Open wholesale contribution margin
    518       475       43  
Historical and operational wholesale hedges
    231       (80 )     311 (9)
Unrealized gains (losses) on energy derivatives
    58       (80 )     138 (10)
 
                 
Total wholesale energy contribution margin, including historical and operational wholesale hedges and unrealized gains/losses on energy derivatives
  $ 807     $ 315     $ 492  
 
                 
 
     
(1)   Decrease primarily due to (a) lower economic generation and (b) lower open energy unit margins (higher fuel costs partially offset by higher power prices). This decrease was partially offset by increased commercial capacity factor due to lower planned and unplanned outages.
 
(2)   Decrease primarily due to (a) lower economic generation and (b) lower open energy unit margins (higher fuel costs partially offset by higher power prices).
 
(3)   Decrease primarily due to lower economic generation related to the deconsolidation of Channelview on August 20, 2007.
 
(4)   Increase primarily due to higher RPM capacity payments.
 
(5)   Increase primarily due to RPM capacity payments. This increase was partially offset by lower revenue from purchase power agreements.
 
(6)   Increase primarily due to (a) higher capacity payments and (b) an increase in selective commercial hedge activity.
 
(7)   Decrease primarily due to (a) the deconsolidation of Channelview on August 20, 2007 and (b) lower revenue from power purchase agreements.
 
(8)   Decrease primarily due to (a) the deconsolidation of Channelview on August 20, 2007 and (b) $16 million decrease in planned outages and maintenance spending.
 
(9)   Increase primarily due to (a) $224 million in increased gains on operational hedges and (b) $107 million decrease in losses on closed power hedges. This increase was partially offset by $18 million decrease on hedges of gas transportation.
 
(10)   Increase primarily due to $211 million gain from changes in prices on our energy derivatives marked to market, partially offset by $63 million loss on energy derivatives settled during the period.

 

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Other General and Administrative.
                         
    Nine Months Ended September 30,  
    2008     2007     Change  
            (in millions)          
 
                       
Salaries and benefits
  $ 56     $ 67     $ (11 )
Professional fees, contract services and information systems maintenance
    23       27       (4 )
Rent and utilities
    16       16        
Legal costs
    5       11       (6 )
Credit-enhanced retail structure fee
    5             5  
Costs in connection with Channelview’s reorganization
    1       2       (1 )
Other, net
    6       8       (2 )
 
                 
Other general and administrative
  $ 112     $ 131     $ (19 )
 
                 
Western States Litigation and Similar Settlements. See note 14(a) to our consolidated financial statements in our Form 10-K and note 11 to our interim financial statements.
Gains on Sales of Assets and Emission and Exchange Allowances, Net.
                         
    Nine Months Ended September 30,  
    2008     2007     Change  
            (in millions)          
 
                       
Emission and exchange allowances
  $ 37 (1)   $ 1     $ 36  
Equipment
          18       (18 )
Investment in and receivables from Channelview
    1 (2)           1  
Other, net
    2             2  
 
                 
Gains on sales of assets and emission and exchange allowances, net
  $ 40     $ 19     $ 21  
 
                 
 
     
(1)   Includes gains of $36 million related to sales of CO2 exchange allowances.
 
(2)   In the second quarter of 2008, we executed an agreement to sell the Channelview plant and assign related contracts. This amount represents our estimated gain on the sale. See note 14 to our interim financial statements.
Depreciation and Amortization.
                         
    Nine Months Ended September 30,  
    2008     2007     Change  
            (in millions)          
 
                       
Depreciation on plants
  $ 171     $ 212     $ (41 )(1)
Depreciation on information systems
    25       27       (2 )
Other, net — depreciation
    4       5       (1 )
 
                 
Depreciation
    200       244       (44 )
 
                 
Amortization of emission allowances
    59       77       (18 )(2)
Other, net — amortization
    3       3        
 
                 
Amortization
    62       80       (18 )
 
                 
Depreciation and amortization
  $ 262     $ 324     $ (62 )
 
                 
 
     
(1)   Decrease primarily due to (a) early retirements of plant components when replacement components are installed for upgrades (from $29 million in 2007 to $4 million in 2008), (b) the deconsolidation of Channelview on August 20, 2007 and (c) classification of Bighorn assets as held for sale in April 2008, which requires depreciation to cease.
 
(2)   Decrease primarily due to (a) decrease in allowances used and (b) decrease in average cost of SO2 allowances purchased and used.

 

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Income of Equity Investment, Net. This represents income, which did not change significantly, from our equity method investment in Sabine Cogen, LP.
Other, Net. Other, net did not change significantly.
Interest Expense.
                         
    Nine Months Ended September 30,  
    2008     2007     Change  
            (in millions)          
 
                       
Fixed-rate debt
  $ 171     $ 177     $ (6 )
Fees for MWh’s delivered under credit-enhanced retail structure
    21       20       1  
Financing fees expensed
    7       11       (4 )
Deferred financing costs
    6       48       (42 )(1)
Variable-rate debt
          14       (14 )(2)
Channelview
          16       (16 )(3)
Amortization of fair value adjustment of acquired debt
    (8 )     (8 )      
Capitalized interest
    (11 )     (3 )     (8 )
Other, net
    3       8       (5 )
 
                 
Interest expense
  $ 189     $ 283     $ (94 )
 
                 
 
     
(1)   Decrease primarily due to $39 million write-off due to early extinguishments of debt in the second quarter of 2007.
 
(2)   Decrease primarily due to decrease in debt balances.
 
(3)   Decrease due to the deconsolidation of Channelview on August 20, 2007.
Interest Income.
                         
    Nine Months Ended September 30,  
    2008     2007     Change  
            (in millions)          
 
                       
Interest on temporary cash investments
  $ 21     $ 17     $ 4  
Net margin deposits
    5       7       (2 )
Other, net
    1             1  
 
                 
Interest income
  $ 27     $ 24     $ 3  
 
                 
Income Tax Expense. See note 9 to our interim financial statements.
Income (Loss) from Discontinued Operations. See note 16 to our interim financial statements.

 

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Credit Risk
By extending credit to our counterparties, we are exposed to credit risk. As of September 30, 2008, our derivative assets and accounts receivable from our wholesale energy and retail energy power supply counterparties, after taking into consideration netting within each contract and any master netting contracts with counterparties, are:
                                         
    Exposure     Credit             Number of     Net Exposure of  
    Before     Collateral     Exposure     Counterparties     Counterparties  
Credit Rating Equivalent   Collateral(1)     Held     Net of Collateral     >10%     >10%  
                    (dollars in millions)                  
 
                                       
Investment grade
  $ 128     $ 31     $ 97           $  
Non-investment grade
    105             105              
No external ratings:
                                       
Internally rated — Investment grade
    81             81       1       68  
Internally rated — Non-investment grade
    37       4       33              
 
                             
Total
  $ 351     $ 35     $ 316       1     $ 68  
 
                             
 
     
(1)   The table excludes amounts related to contracts classified as normal purchase/normal sale and non-derivative contractual commitments that are not recorded in our consolidated balance sheets, except for any related accounts receivable. Such contractual commitments contain credit and economic risk if a counterparty does not perform. Nonperformance could have a material adverse impact on our future results of operations, financial condition and cash flows.
As of September 30, 2008, one investment grade counterparty represented 19% ($68 million) of our credit exposure. As of December 31, 2007, two non-investment grade counterparties represented 47% ($206 million) of our credit exposure. As of September 30, 2008 and December 31, 2007, we held no collateral from these counterparties. There were no other counterparties representing greater than 10% of our credit exposure.

 

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Off-Balance Sheet Arrangements
As of September 30, 2008, we have no off-balance sheet arrangements.
Historical Cash Flows
Cash Flows — Operating Activities
                         
    Nine Months Ended September 30,  
    2008     2007     Change  
            (in millions)          
 
                       
Operating income (loss)
  $ (262 )   $ 505     $ (767 )
Depreciation and amortization
    262       324       (62 )
Gains on sales of assets and emission and exchange allowances, net
    (40 )     (19 )     (21 )
Net changes in energy derivatives
    589 (1)     (127 )(2)     716  
Western states litigation and similar settlements
    37       (3)     37  
Western states litigation and similar settlements payments
          (35 )(3)     35  
Margin deposits, net
    11       201       (190 )
Change in accounts and notes receivable, net and accounts payable
    (79 )     (196 )     117  
Change in inventory
    (42 )     (6 )     (36 )
Net option premiums purchased
    (33 )     (23 )     (10 )
Settlements of exchange transactions prior to contractual period(4)
    (5 )     (8 )     3  
Interest payments
    (135 )     (219 )     84  
Income tax payments, net of refunds
    (18 )     (28 )     10  
Other, net
    (24 )     (37 )     13  
 
                 
Net cash provided by continuing operations from operating activities
    261       332       (71 )
Net cash provided by (used in) discontinued operations from operating activities
    7       (4 )     11  
 
                 
Net cash provided by operating activities
  $ 268     $ 328     $ (60 )
 
                 
 
     
(1)   Includes unrealized losses on energy derivatives of $566 million.
 
(2)   Includes unrealized gains on energy derivatives of $168 million.
 
(3)   We expensed and paid $22 million within the nine months ended September 30, 2007.
 
(4)   Represents exchange transactions financially settled within three business days prior to the contractual delivery month.
Cash Flows — Investing Activities
                         
    Nine Months Ended September 30,  
    2008     2007     Change  
            (in millions)          
 
                       
Capital expenditures
  $ (216 )   $ (135 )   $ (81 )
Proceeds from sales of emission and exchange allowances
    39 (1)     7       32  
Proceeds from sales of assets, net
    18       30       (12 )
Purchases of emission allowances
    (26 )(2)     (52 )(3)     26  
Restricted cash
    (3 )     5       (8 )
Other, net
    4       5       (1 )
 
                 
Net cash used in investing activities
  $ (184 )   $ (140 )   $ (44 )
 
                 
 
     
(1)   Includes $36 million from sales of CO2 exchange allowances.
 
(2)   Includes $14 million and $12 million for purchases of SO2 and NOX allowances, respectively.
 
(3)   Includes $52 million for purchases of SO2 allowances.

 

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Cash Flows — Financing Activities
                         
    Nine Months Ended September 30,  
    2008     2007     Change  
            (in millions)          
 
                       
Proceeds from issuance of senior unsecured notes
  $     $ 1,300     $ (1,300 )
Payments of senior secured notes
    (58 )     (1,087 )     1,029  
Payments of senior secured term loans
          (400 )     400  
Proceeds from issuance of stock
    14       39       (25 )
Payments of financing costs
          (31 )     31  
Payments of debt extinguishments
    (1 )     (72 )     71  
Other, net
          (5 )     5  
 
                 
Net cash used in financing activities
  $ (45 )   $ (256 )   $ 211  
 
                 
New Accounting Pronouncements, Significant Accounting Policies and Critical Accounting Estimates
New Accounting Pronouncements
See notes 1 and 3 to our interim financial statements.
Significant Accounting Policies
See note 2 to our consolidated financial statements in our Form 10-K.
Critical Accounting Estimates
See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Accounting Estimates — New Accounting Pronouncements, Significant Accounting Policies and Critical Accounting Estimates — Critical Accounting Estimates” in Item 7 in our Form 10-K and note 2 to our consolidated financial statements in our Form 10-K.
On January 1, 2008, we adopted SFAS No. 157, which discusses fair value measurements. See note 3 to our interim financial statements and Item 3 “Quantitative and Qualitative Disclosures About Market Risks” in this Form 10-Q.

 

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market Risks and Risk Management
Our primary market risk exposure relates to fluctuations in commodity prices. See “Quantitative and Qualitative Disclosures About Market Risk” in Item 7A of our Form 10-K.
Non-Trading Market Risks
Commodity Price Risk
As of September 30, 2008, the fair values of the contracts related to our net non-trading derivative assets and liabilities are:
                                                         
    Twelve Months                                            
    Ending                                            
    September 30,     Remainder                             2013 and     Total  
Source of Fair Value   2009     of 2009     2010     2011     2012     thereafter     fair value  
    (in millions)  
 
                                                       
Prices actively quoted (Level 1)
  $ 8     $ (1 )   $ (2 )   $ (4 )   $     $     $ 1  
Prices provided by other external sources (Level 2)
    (594 )     (104 )     (116 )     (49 )     (18 )     (2 )     (883 )
Prices based on models and other valuation methods (Level 3)
    91       (26 )     (14 )     (14 )     (2 )     (3 )     32  
 
                                         
Total mark-to-market non-trading derivatives
  $ (495 )   $ (131 )   $ (132 )   $ (67 )   $ (20 )   $ (5 )   $ (850 )
 
                                         
During the second quarter of 2008, we made changes to the methodology used for grouping derivative instruments relative to the source of their fair value. Using the fair value hierarchy parameters from SFAS No. 157 (see note 3 to our interim financial statements) we have made the following reclassifications between categories:
    Instruments whose fair value is based on adjusted quoted market prices in active markets, previously included under the category of prices actively quoted, are now included under prices provided by other external sources;
 
    Instruments that are transacted in less liquid markets, such as contracts for power and coal, previously included under the category of prices provided by other external sources, are now included under prices based on models and other valuation methods; and
 
    Valuation adjustments for liquidity and credit previously included under the category prices based on models and other valuation methods are now included in the category associated with the derivative instrument.
Under the new methodology, the fair values of the contracts related to our net non-trading derivative assets and liabilities as of March 31, 2008 would have been:
                                                         
    Twelve Months                                            
    Ending                                            
    March 31,     Remainder                             2013 and     Total  
    2009     of 2009     2010     2011     2012     thereafter     fair value  
    (in millions)  
 
Prices actively quoted
  $ (27 )   $ (2 )   $ (4 )   $ (4 )   $     $     $ (37 )
Prices provided by other external sources
    11       18       (26 )     (31 )     (10 )           (38 )
Prices based on models and other valuation methods
    349       (4 )     (10 )     (8 )                 327  
 
                                         
Total mark-to-market non-trading derivatives
  $ 333     $ 12     $ (40 )   $ (43 )   $ (10 )   $     $ 252  
 
                                         

 

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A hypothetical 10% movement in the underlying energy prices would have the following potential gain (loss) impacts on our non-trading derivatives:
                                 
            Fair Value of     Earnings Impact of     Total Potential  
As of   Market Prices     Cash Flow Hedges     Other Derivatives     Loss in Fair Value  
                    (in millions)          
 
                               
September 30, 2008(1)
  10% decrease   $     $ (328 )   $ (328 )
December 31, 2007
  10% decrease           (353 )     (353 )
 
     
(1)   The major assumptions for calculating these impacts remain the same during 2008 as disclosed in “Quantitative and Qualitative Disclosures About Market Risks” in Item 7A of our Form 10-K.
Interest Rate Risk
We remain subject to the benefits or losses associated with movements in market interest rates related to certain variable-rate debt, cash, cash equivalents and margin deposits, which are most vulnerable to changes in the federal funds rate. As we deconsolidated Channelview on August 20, 2007 and have no borrowings under our senior secured revolver or retail working capital facility, we have no variable-rate debt outstanding as of September 30, 2008.
We assess interest rate risks using a sensitivity analysis that measures the potential change in our interest expense/income based on a hypothetical one percentage point movement in the underlying variable interest rate indices. If interest rates increased/decreased by one percentage point, our interest expense would have remained the same for the twelve months ended September 30, 2008 and increased/decreased by $4 million for the twelve months ended December 31, 2007, and our interest income, net of interest expense would have increased/decreased by $9 million and $2 million, respectively. We estimated these amounts by considering the impact of hypothetical changes in interest rates on our variable-rate debt, if any, cash and cash equivalents and net margin deposits based on average balances throughout the respective periods.
If interest rates decreased by one percentage point from their September 30, 2008 and December 31, 2007 levels, the fair market values of our fixed-rate debt would have increased by $156 million and $201 million, respectively.
Our exposure to interest rate risk will increase following the closing and funding of the $650 million of additional term loans described in note 17 to our interim financial statements.
Trading Market Risks
As of September 30, 2008, the fair values of the contracts related to our legacy trading and non-core asset management positions and recorded as net derivative assets and liabilities are:
                                                         
    Twelve Months                                            
    Ending                                            
    September 30,     Remainder                             2013 and     Total  
Source of Fair Value   2009     of 2009     2010     2011     2012     thereafter     fair value  
    (in millions)  
 
                                                       
Prices actively quoted (Level 1)
  $ (2 )   $     $ 2     $     $     $     $  
Prices provided by other external sources (Level 2)
    24                                     24  
Prices based on models and other valuation methods (Level 3)
    (1 )     (1 )     (1 )                       (3 )
 
                                         
Total
  $ 21     $ (1 )   $ 1     $     $     $     $ 21  
 
                                         

 

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During the second quarter of 2008, we made changes to the methodology used for grouping derivative instruments relative to the source of their fair value; however, these changes did not have a material impact in the presentation of information for our legacy trading positions.
Our consolidated realized and unrealized margins relating to these positions are (income (loss)):
                                 
    Three Months Ended September 30,     Nine Months Ended September 30,  
    2008     2007     2008     2007  
            (in millions)          
 
Realized
  $ 3     $ 1     $ 12     $ 4  
Unrealized
    28       7       2       4  
 
                       
Total
  $ 31     $ 8     $ 14     $ 8  
 
                       
An analysis of these net derivative assets and liabilities is:
                 
    Nine Months Ended September 30,  
    2008     2007  
    (in millions)  
 
               
Fair value of contracts outstanding, beginning of period
  $ 19     $ 9  
Contracts realized or settled
    (13 )(1)     (7 )(2)
Changes in fair values attributable to market price and other market changes
    15       10  
 
           
Fair value of contracts outstanding, end of period
  $ 21     $ 12  
 
           
 
     
(1)   Amount includes realized gain of $(12) million and deferred settlements of $(1) million.
 
(2)   Amount includes realized gain of $(4) million and deferred settlements of $(3) million.
The daily value-at-risk for our trading positions is:
                 
    2008(1)     2007  
    (in millions)  
 
               
As of September 30
  $ 8     $ 2  
Three months ended September 30:
               
Average
    8       3  
High
    12       4  
Low
    1       2  
Nine months ended September 30:
               
Average
    13       3  
High
          5  
Low
    5       2  
 
     
(1)   The major parameters for calculating daily value-at-risk remain the same during 2008 as disclosed in “Quantitative and Qualitative Disclosures About Market Risk” in Item 7A of our Form 10-K.

 

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Fair Value Measurements
We apply recurring fair value measurements to our derivative assets and liabilities. See note 3 to our interim financial statements. In determining fair value, we consider the credit standing of the counterparties involved, our own non-performance risk as well as the impact of credit enhancements. The fair value of our derivative assets is reduced to reflect the estimated risk of default of counterparties on their contractual obligations. The fair value of our derivative liabilities is reduced to reflect our estimated risk of default on our contractual obligations to counterparties. Consideration of counterparty credit and non-performance risk is considered an unobservable, Level 3 input within the fair value hierarchy.
Derivative instruments classified as Level 2 primarily include OTC derivative instruments such as generic swaps and forwards. The fair value measurements of these derivative assets and liabilities are based largely on unadjusted quoted prices from independent brokers in active markets. An active market is considered to have transactions with sufficient frequency and volume to provide pricing information on an ongoing basis. Derivative instruments for which fair value is calculated using quoted prices that are deemed not active or that have been extrapolated from quoted prices in active markets are classified as Level 3. We adjust seasonal or calendar year quoted prices based on historical observations to represent fair value for each month in the season or calendar year, such that the average of all months is equal to the quoted price. A derivative instrument that has a tenor that does not span the quoted period is considered an unobservable Level 3 measurement.
We evaluate and validate the inputs we use to estimate fair value by a number of methods, including validating against market published prices and daily broker quotes obtainable from pricing services. For OTC derivative instruments classified as Level 2, quotes obtained from brokers generally represent fair value of these instruments. Adjustments to the quotes are adjustments to the bid or ask price depending on the nature of the position to appropriately reflect exit price and are considered a Level 3 input to the fair value measurement.

 

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ITEM 4. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
Our management, with the participation of our chief executive officer and chief financial officer, have evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (1934 Act)) as of September 30, 2008, the end of the period covered by this Form 10-Q. Based on this evaluation, our chief executive officer and chief financial officer concluded that, as of September 30, 2008, our disclosure controls and procedures were effective.
Changes in Internal Control Over Financial Reporting
There were no changes in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the 1934 Act) during the period ended September 30, 2008, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II.
OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
See note 11 to our interim financial statements in this Form 10-Q.
ITEM 1A. RISK FACTORS
In addition to the information set forth below, you should carefully consider the factors discussed or referred to in the “Risk Factors” section of our most recent Annual Report on Form 10-K filed with the Securities and Exchange Commission.
We may have to post significant amounts of collateral, which could adversely affect our liquidity, financial position and business.
In connection with our commitment to unwind our credit-enhanced retail structure with Merrill Lynch, we will have to post significant additional amounts of collateral. Our levels of collateral postings will be determined and impacted by the final terms and timing of the unwind agreement, the nature and volume of our commodity hedging agreements, commodity prices and other strategic alternatives that we may undertake. Depending on the specific timing of the unwind and the movement in underlying commodity prices, we could incur significant collateral posting obligations that may require us to seek additional sources of liquidity, including additional debt. The covenants in our credit agreements and our agreement with Merrill Lynch restrict our ability to, among other things, obtain additional financing. The $1.0 billion of contingent capital arrangements, if funded, will have certain restrictions and maintenance covenants, which are expected to be stricter than our existing credit agreements and could prevent us from incurring additional debt and making certain investments.
If we were unable to generate sufficient cash flows from operations or raise cash from other sources, we may not be able to meet our collateral posting obligations. These situations could result from adverse developments in the energy, fuel or capital markets, a disruption in our operations or those of third parties or other events adversely affecting our cash flows and financial performance.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
In the third quarter of 2008, we issued 1,028,224 shares of unregistered common stock pursuant to cashless warrant exercises and 375,652 shares of unregistered common stock for $1,912,069 in cash pursuant to warrant exercises, in each case under an exemption pursuant to Section 4(2) of the Securities Act of 1933, as amended.
ITEM 6. EXHIBITS
Exhibits.
See Index of Exhibits.

 

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Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
         
  RELIANT ENERGY, INC.
         (Registrant)
 
 
November 10, 2008  By:   /s/ Thomas C. Livengood    
    Thomas C. Livengood   
    Senior Vice President and Controller
(Duly Authorized Officer and Chief Accounting Officer) 
 

 

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INDEX OF EXHIBITS
Exhibits not incorporated by reference to a prior filing are designated by a cross (+); all exhibits not so designated are incorporated herein by reference to a prior filing as indicated. The exhibits with the asterisk symbol (*) are compensatory arrangements filed pursuant to Item 601(b)(10)(iii) of Regulation S-K.
                     
            SEC File or    
Exhibit       Report or Registration   Registration   Exhibit
Number   Document Description   Statement   Number   Reference
 
                   
3.1
  Third Restated Certificate of Incorporation   Reliant Energy, Inc.’s Quarterly Report on Form 10-Q for the period ended June 30, 2007   1-16455     3.1  
 
                   
3.2
  Third Amended and Restated Bylaws   Reliant Energy, Inc.’s Quarterly Report on Form 10-Q for the period ended March 31, 2007   1-16455     3.3  
 
                   
4.1
  Registrant has omitted instruments with respect to long-term debt in an amount that does not exceed 10% of the registrant’s total assets and its subsidiaries on a consolidated basis and hereby undertakes to furnish a copy of any such agreement to the Securities and Exchange Commission upon request                
 
                   
+10.1
  Amendment No. 4 to Amended and Restated Credit Sleeve and Reimbursement Agreement, dated as of July 24, 2008 (Portions of this Exhibit have been omitted pursuant to a request for confidential treatment)                
 
                   
10.2
  Participating Preferred Stock Purchase Agreement by and between Reliant Energy, Inc. and FR Reliant Holdings LP dated as of October 10, 2008   Reliant Energy, Inc.’s Current Report on Form 8-K, filed October 16, 2008   1-16455     10.1  
 
                   
+31.1
  Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                
 
                   
+31.2
  Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                
 
                   
+32.1
  Certification of Chief Executive Officer and Chief Financial Officer pursuant to Subsections (a) and (b) of Section 1350, Chapter 63 of Title 18, United States Code as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002