UIL Holdings 10-Q 2010
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2010
For the transition period from to
Commission file number 1-15052
(Exact name of registrant as specified in its charter)
Registrant’s telephone number, including area code: 203-499-2000
(Former name, former address and former fiscal year, if changed since last report.)
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 T No £
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulations S-T (§232.405 of this chapter) during the preceding 12 months (or for shorter period that the registrant was required to submit and post such files).
Yes T No £
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 definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes £ No T
The number of shares outstanding of the issuer’s only class of common stock, as of October 27, 2010 was 50,429,782.
PART I. FINANCIAL INFORMATION
PART II. OTHER INFORMATION
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UIL HOLDINGS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (UNAUDITED)
(A) ORGANIZATION AND STATEMENT OF ACCOUNTING POLICIES
Basis of Presentation
The primary business of UIL Holdings Corporation (UIL Holdings) is ownership of its operating regulated utility. The utility business consists of the electric transmission and distribution operations of The United Illuminating Company (UI). UI is also a 50-50 joint venturer with NRG Energy, Inc. (NRG) in GCE Holding LLC, whose wholly owned subsidiary, GenConn Energy LLC (collectively “GenConn”), was chosen by the Connecticut Department of Public Utility Control (DPUC) to build and operate new peaking generation plants to help address Connecticut’s need for power generation during the heaviest load periods. UIL Holdings’ Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and the Notes to the Consolidated Financial Statements included in UIL Holdings’ Annual Report on Form 10-K for the year ended December 31, 2009. Such notes are supplemented below.
The year-end balance sheet data was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America (GAAP). Certain information and footnote disclosures, which are normally included in financial statements prepared in accordance with GAAP, have been condensed or omitted in accordance with Securities and Exchange Commission (SEC) rules and regulations. UIL Holdings believes that the disclosures made are adequate to make the information presented not misleading. The information presented in the Consolidated Financial Statements reflects all adjustments which, in the opinion of UIL Holdings, are necessary for a fair statement of the financial position and results of operations for the interim periods described herein. All such adjustments are of a normal and recurring nature. The results for the nine months ended September 30, 2010 are not necessarily indicative of the results for the entire fiscal year ending December 31, 2010.
Certain immaterial amounts related to discontinued operations that were reported as such in the Consolidated Financial Statements in previous periods have been reclassified to conform to the current presentation.
Pending Acquisition of The Southern Connecticut Gas Company, Connecticut Natural Gas Corporation and The Berkshire Gas Company
On May 25, 2010, UIL Holdings entered into a Purchase Agreement (the Purchase Agreement), with Iberdrola USA, Inc. (Seller), under which UIL Holdings will acquire (i) Connecticut Energy Corporation, the owner of The Southern Connecticut Gas Company (SCG), (ii) CTG Resources, Inc., the owner of Connecticut Natural Gas Corporation (CNG), and (iii) Berkshire Energy Resources, the owner of The Berkshire Gas Company (Berkshire), for $1.296 billion in cash, less net debt of approximately $411 million. Accordingly, UIL Holdings expects to make a cash payment at closing of approximately $885 million, subject to post closing adjustments. As of June 30, 2010, the companies to be acquired had a combined customer total of approximately 366,000, approximately 130,000 of which will be customers of both UI and SCG. After the closing, UIL Holdings’ customer base will increase to approximately 690,000. UIL Holdings expects the acquisition to close several days after receiving regulatory approval from the DPUC.
UIL Holdings plans to finance the acquisition with the net proceeds from its (1) September 2010 public offering of 20,355,000 shares of common stock, which amounted to approximately $501.5 million and (2) October 7, 2010 issuance of $450 million of senior unsecured notes which amounted to $443.5 million. The acquisition is expected to provide enhanced cash flow per share to UIL Holdings immediately upon consummation of the transaction, and earnings per share (EPS) accretion beginning in 2012. While not a condition of closing, UIL Holdings is in the process of securing a working capital facility to fund the gas companies’ operations.
UIL Holdings and Seller have made customary representations and warranties and covenants in the Purchase Agreement. The transaction is subject to customary closing conditions, including the receipt of required governmental approvals, such as applicable state public utility regulatory approvals, and the absence of injunctions or restraints imposed by governmental entities. On October 27, 2010, the DPUC issued a draft decision which, if adopted without change, would approve the change of control of CNG and SCG, as well as their respective holding companies, CTG and CEC, to UIL Holdings. The DPUC's schedule provides for the submission of written exceptions and the holding of oral arguments, with a final decision scheduled for November 10, 2010. For further discussion of the regulatory approval process, see Note (C) “Regulatory Proceedings.”
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UIL HOLDINGS CORPORATION>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (UNAUDITED) (Continued)
A final decision is scheduled to be issued on November 10, 2010. For further discussion of the regulatory approval process, see Note (C) “Regulatory Proceedings.”
The Purchase Agreement also contains certain termination rights for both UIL Holdings and Seller, including a termination right for either party if the closing does not occur by May 25, 2011 and the terminating party has not caused the closing not to occur by breaching in any material respect its representations, warranties, covenants or agreements contained in the Purchase Agreement (provided that either party may postpone such date to August 25, 2011, if the only closing conditions that remain to be satisfied are the receipt of governmental approvals or the expiration or termination of the HSR Act waiting period, which expired without comment in August 2010). Certain of the termination rights, such as termination by mutual agreement of the parties, do not require UIL Holdings to pay any termination fee. However, under the following remaining circumstances, the Purchase Agreement may be terminated, and UIL Holdings would be required to pay to Seller a termination fee of $50 million (the Termination Fee):
As of September 30, 2010, UIL Holdings has incurred pre-tax acquisition-related expenses of approximately $13.2 million.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (UNAUDITED) (Continued)
Earnings per Share
The components of basic and diluted EPS for common shares under the two-class method for each of the three and nine months ended September 30, 2010 and 2009 are as follows:
(1) Reflecting the effect of dilutive stock options, performance shares and restricted stock.
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For the three and nine month periods ended September 30, 2010, the average outstanding number of options to purchase shares of common stock was 136,945 and 98,079, respectively. Such options were not included in the three or nine month respective computations of diluted earnings per share, because the options’ exercise prices were greater than the average market price of the common shares during the three and nine month periods ended September 30, 2010. As of September 30, 2009, options to purchase 359,152 shares of common stock were outstanding but not included in the three and nine month respective computations of diluted earnings per share, because the options’ exercise prices were greater than the average market price of the common shares during the three and nine month periods ended September 30, 2009.
Certain members of management have the opportunity to earn a pre-determined number of performance shares, the number of which is predicated upon the achievement of various pre-defined performance measures over a three-year period. These performance shares were issued under the UIL Holdings 1999 Amended and Restated Stock Plan prior to 2009 and are now issued under the UIL Holdings 2008 Stock and Incentive Compensation Plan (the 2008 Stock Plan). Each award of performance shares vests at the end of a three-year cycle with the actual issuance of UIL Holdings’ common stock in respect of such performance shares following the end of each three-year cycle. A new three-year cycle begins in January of each year.
UIL Holdings records compensation expense for these performance shares ratably over the three-year period, except in the case of retirement-eligible employees, for whom compensation expense is immediately recognized in accordance with ASC 718 “Compensation-Stock Compensation”, based on the value of the expected payout at the end of each year relative to the performance measures achieved. An additional $0.6 million of compensation expense was recorded in the first quarter of 2010 with respect to retirement-eligible employees based on the application of ASC 718 retirement-eligible provisions.
A target amount of 89,360 performance shares was granted in March 2010; the average of the high and low market price on the date of grant was $28.24 per share. In March 2010, upon the vesting of performance shares previously granted, 15,414 shares of common stock were issued to members of management and receipt of 19,991 shares was deferred as stock units. The number of shares issued and deferred reflects the personal income tax elections of the applicable employees.
In March 2010, UIL Holdings granted a total of 2,789 shares of restricted stock to its President and Chief Executive Officer (CEO), James P. Torgerson, under the 2008 Stock Plan and in accordance with his employment agreement; the average of the high and low market price on the date of grant was $28.24 per share. Compensation expense for this restricted stock is recorded ratably over the five-year vesting period for such restricted stock.
In March 2010, UIL Holdings granted a total of 31,076 shares of restricted stock to non-employee directors under the 2008 Stock Plan; the average of the high and low market price on the date of grant was $28.24 per share. Compensation expense for this restricted stock is recorded ratably over the three-year vesting period for such restricted stock, except in the case of directors who will reach the mandatory retirement age of 72 prior to the end of the three year vesting period, for whom compensation expense is recognized ratably over the remaining service period in accordance with ASC 718 “Compensation-Stock Compensation”, based on the value of the expected payout at the end of each year.
In March 2010, 20,307 shares of previously-granted restricted stock grants to directors vested, of which 11,487 shares of common stock were issued to directors who had not elected to have their vested shares deferred as stock units. In May 2010, 10,202 shares of restricted stock previously granted to a non-employee director vested upon his retirement from the board of directors and were issued to the retiring director. As a result of the May 2010 resignation of another non-employee director, and upon approval by the board of directors, 8,551 shares of restricted stock previously granted to such director vested, all of which were elected for deferral as stock units. An additional $0.1 million of compensation expense was recorded with respect to such vesting based on the application of ASC 718. Also resulting from such resignation was the forfeiture of 1,994 shares of restricted stock previously granted to such director.
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Total stock-based compensation expense for the nine month periods ended September 30, 2010 and 2009 was $3.1 million and $2.8 million, respectively. Total stock-based compensation for the three month periods ended September 30, 2010 and 2009 was $1.0 million and $0.7 million, respectively.
In accordance with ASC 740 “Income Taxes”, UIL Holdings has provided deferred taxes for all temporary book-tax differences using the liability method. The liability method requires that deferred tax balances be adjusted to reflect enacted future tax rates that are anticipated to be in effect when the temporary differences reverse. In accordance with GAAP for regulated industries, UI has established a regulatory asset for the net revenue requirements to be recovered from customers for the related future tax expense associated with certain of these temporary differences. For ratemaking purposes, UI normalizes all investment tax credits (ITCs) related to recoverable plant investments.
Under ASC 740, UIL Holdings may recognize the tax benefit of an uncertain tax position only if management believes it is more likely than not that the tax position will be sustained on examination by the taxing authority based upon the technical merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based upon the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate settlement.
UIL Holdings’ policy is to recognize interest accrued and penalties associated with uncertain tax positions as a component of operating expense. During the quarterly and year-to-date periods ended September 30, 2010, UIL Holdings accrued an immaterial amount of interest associated with uncertain tax positions. During the quarterly and year-to-date periods ended September 30, 2010 and 2009, UIL Holdings did not accrue any penalties associated with uncertain tax positions. See Note (E) “Income Taxes” for a discussion of uncertain tax positions.
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UIL Holdings’ regulatory assets and liabilities as of September 30, 2010 and December 31, 2009 included the following:
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New Accounting Standards>
In January 2010, the FASB issued updated guidance to ASC 820 “Fair Value Measurements and Disclosures” which requires disclosure of transfers in and out of assets and liabilities that fall within Level 1 and 2 of the fair value hierarchy, as described in Note (K) “Fair Value of Financial Instruments,” as well as the gross presentation of activities within the reconciliation of changes in the fair value of Level 3 assets and liabilities. This guidance is effective in the first interim or annual reporting period beginning after December 15, 2009, except for the gross presentation of the Level 3 reconciliation information, which is required for annual reporting periods beginning after December 15, 2010, and for interim reporting periods within those years. These requirements impact footnote disclosures only. Because UIL Holdings does not currently have any Level 2 assets or liabilities, implementation of the transfer activity disclosure did not have an impact on UIL Holdings’ Consolidated Financial Statements. The implementation of the reconciliation activity disclosure is not expected to have an impact on UIL Holdings’ Consolidated Financial Statements.
In June 2009, the FASB issued updated guidance to ASC 810 “Consolidation” on the consolidation of variable interest entities (VIEs) which became effective as of January 1, 2010, for interim and annual reporting periods beginning in 2010. In the first quarter of 2010, UIL Holdings implemented this new guidance which requires an enterprise to perform an analysis to determine whether the enterprise’s variable interest or interests give it a controlling financial interest in a VIE. As a result of implementing this guidance, UIL Holdings determined that it is not currently required to consolidate any VIEs with which it is associated and therefore, this guidance did not have an impact on UIL Holdings’ Consolidated Financial Statements. As of September 30, 2010, UIL Holdings had identified Connecticut Yankee Atomic Power Company (Connecticut Yankee) and GenConn as VIEs. Neither entity is subject to consolidation because UIL Holdings is not the primary beneficiary insofar as it does not have a controlling financial interest, as defined in ASC 810, in either VIE. For further discussion of GenConn, see Note (C) “Regulatory Proceedings – Generation.” For further discussion of Connecticut Yankee, see Note (J) “Commitments and Contingencies.”
In December 2009, the FASB issued updated guidance to ASC 860 “Transfers and Servicing” which is effective for transfers of financial assets occurring in fiscal years beginning after November 15, 2009. UIL Holdings has not been a party to any transfers of financial assets, so this statement did not have an impact on UIL Holdings’ Consolidated Financial Statements.
On September 16, 2010, UIL Holdings priced a public offering of 17,700,000 shares of common stock at $25.75 per share. On September 17, 2010, the underwriters of this public offering of common stock exercised their over-allotment option to purchase an additional 2,655,000 common shares on the same terms. Net proceeds of the offering, including the over-allotment option, were $501.5 million, after expenses and underwriting discounts and were accounted for as an addition to common stock on UIL Holdings’ Consolidated Balance Sheet. The Company plans to use the net proceeds from this offering to fund a portion of the cash consideration payable in connection with the pending acquisition of SCG, CNG and Berkshire and for general corporate purposes.
UIL Holdings had 50,429,782 shares of its common stock, no par value, outstanding at September 30, 2010.
On October 7, 2010, UIL Holdings issued, through a public offering, senior unsecured 4.625% notes in the principal amount of $450 million, due on October 1, 2020. The notes were issued at a discounted price of 99.204%, resulting in net proceeds of $443.5 million.
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On May 13, 2010, UI entered into a note purchase agreement with a group of institutional accredited investors providing for the sale to such investors of senior unsecured 6.09% notes in the principal amount of $100 million, due on July 27, 2040. Such notes were issued on July 27, 2010.
On February 1, 2010, $27.5 million of tax-exempt bonds were refunded with the proceeds from the issuance of $27.5 million of new tax-exempt bonds, at a fixed interest rate of 4.5%, for a period of five years and five months.
In April 2009, UI closed on a bank financing in the amount of $121.5 million with a syndicate of banks (the Equity Bridge Loan or EBL), the proceeds of which will be used by UI to fund its commitments as a 50% owner of GenConn. GenConn has directed $55.5 million of such amount to GenConn Devon LLC (GenConn Devon), and UI expects that GenConn will direct an amount up to approximately $66.0 million borrowed under the EBL to GenConn Middletown LLC (GenConn Middletown), each of which is a wholly owned subsidiary of GenConn, for use in the construction of peaking generation facilities by those entities. UI draws on this facility as needed to fund its commitments to GenConn as construction progresses. On September 29, 2010, GenConn Devon reached its completion date, as it is described in connection with the EBL, upon which the portion of amounts borrowed for GenConn Devon were due to be repaid. Accordingly, UI repaid $55.5 million under the EBL and made its equity investment of approximately $55.5 million in GenConn Devon in September 2010. Borrowings under this facility as of September 30, 2010 were $61.2 million. In addition to the funds to be directed to GenConn that are borrowed under the EBL, UI expects to make an additional equity commitment of up to $6 million for the construction of the GenConn Middletown peaking generation facility, of which approximately $5.0 million was invested in GenConn in October 2010.
GenConn obtained project financing in April 2009 in a separate transaction that makes $243 million available to GenConn for construction and related activities, and $48 million available under a working capital facility (collectively, the Project Financing). UI expects that those funds, together with the funds committed by UI and GenConn’s other 50% owner, NRG Energy, will be sufficient to allow GenConn to complete the construction of its planned peaking generation facilities.
On September 28, 2010, UIL Holdings entered into a Sponsor Guaranty and Payment Agreement in favor of the Royal Bank of Scotland PLC, as Administrative Agent under the Project Financing arrangement, whereby UIL Holdings guarantees to pay an amount up to $6 million in respect of amounts related to the former general contractor claims and litigation expenses as they relate to the claims described in Note (J) “Commitments and Contingencies – GenConn.”
The remaining balance under the EBL must be repaid upon the earlier of its maturity date or the attainment of commercial operation for GenConn Middletown. The maturity date of the loan is April 19, 2011, and may be extended up to July 23, 2011, as long as on the date of extension, project construction is continuing and the Project Financing is not due and payable.
(C) REGULATORY PROCEEDINGS
Pending Acquisition of The Southern Connecticut Gas Company, Connecticut Natural Gas Corporation and The Berkshire Gas Company
As discussed in Note (A) “Organization and Statement of Accounting Policies,” on May 25, 2010, UIL Holdings entered into the Purchase Agreement with Seller which provides for the sale of SCG, CNG, and Berkshire to UIL Holdings. Under the HSR Act, the parties to certain proposed transactions must submit pre-merger notification to the Federal Trade Commission and the U.S. Department of Justice which includes information about each company’s business. The parties may not consummate the proposed transactions until the waiting period outlined in the HSR Act has passed. UIL Holdings and Iberdrola USA each made their respective HSR Act filings on July 14, 2010, and after the thirty day waiting period, both filings expired without comment.
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The Connecticut Department of Public Utility Control (DPUC) must approve UIL Holding’s acquisition of SCG and CNG and on July 16, 2010, UI filed its application with the DPUC requesting such approval. The DPUC completed hearings with respect to the pending Acquisition in September 2010 and on October 27, 2010, the DPUC issued a draft decision which, if adopted without change, would approve the change of control of CNG and SCG, as well as their respective holding companies, CTG and CEC, to UIL Holdings. The DPUC's schedule provides for the submission of written exceptions and the holding of oral arguments, with a final decision scheduled for November 10, 2010.
On August 31, 2010, the Massachusetts Department of Public Utilities (the “DPU”) issued an order (the “Order”) determining that DPU approval is not required for UIL Holdings to acquire Berkshire Energy Resources, parent of The Berkshire Gas Company (the “Berkshire Acquisition”), pursuant to the Purchase Agreement. On September 20, 2010, the Massachusetts Attorney General filed a motion for reconsideration in this matter and requested that the judicial appeal period be extended by fourteen days following final DPU action on the reconsideration motion. On October 4, 2010, UIL Holdings and Iberdrola USA filed their joint comments on the Massachusetts Attorney General’s petition for reconsideration. The DPU granted the request for extension of the appeal period and has not yet ruled on the petition for reconsideration.
Pursuant to the terms of the Purchase Agreement, receipt of DPU approval, to the extent required, is one of the conditions to the consummation of the Berkshire Acquisition.
In addition, SCG, CNG and Berkshire hold certain wireless radio station licenses from the Federal Communications Commission (FCC) with respect to dispatch center and certain communications equipment and devices. Applications were filed with the FCC for approval of the change of control of the holder of the licenses in connection with the Purchase Agreement. FCC approval was reported by public notice released October 13, 2010. Interested parties can request reconsideration of the approval for a 30 day period. There is an additional 10-day period during which the FCC can reconsider the approval on its own motion.
In rulings throughout 2009, the DPUC issued its final decision regarding UI’s application requesting an increase in distribution rates (the “2009 Decisions”), the results of which included a $6.8 million increase in revenue requirements for 2009, compared to 2008. Because a larger, previously approved increase in revenue requirements for 2009 had gone into effect January 1, 2009, UI returned approximately $1.0 million to ratepayers through a one-time adjustment in April 2009.
The 2009 Decisions provided for an allowed distribution return on equity of 8.75%, a decrease from the previously approved 9.75%, and a capital structure of 50% equity and 50% debt, compared to the previously approved 48% equity and 52% debt. The 2009 Decisions continued the prior earnings sharing mechanism structure, applying to the new 8.75% allowed return, whereby 50% of any earnings over the allowed twelve month level is returned to customers and 50% is retained by UI. Given the effective date of the 2009 Decisions, UI’s weighted average allowed distribution return on equity for 2009 was 8.84%. Additionally, the 2009 Decisions provided for full decoupling of distribution revenues from sales, recovery of updated pension and postretirement expense for 2010, a partial reconciliation for the as-issued cost of new debt, and an additional increase in distribution revenue requirements of $19.4 million for 2010.
The 2009 Decisions also provided for the establishment of a regulatory asset to address the portion of the actual increase in pension and postretirement expense for 2009 and 2010 that was not included in rates. For 2009, a $10.2 million regulatory asset was approved and established, for which full recovery in the 2010 rate year was subsequently approved by the DPUC. Accordingly, it will be removed from rates effective February 4, 2011. The DPUC also approved the 2010 cash recovery of $11.4 million for UI’s current estimate of 2010 pension and postretirement expense not previously included in rates.
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On April 1, 2010, UI filed its ratemaking proposal and underlying decoupling analysis for the 2009 rate year ended February 3, 2010. On September 1, 2010, the DPUC issued its final decision in this matter approving a decoupling charge totaling approximately $1.6 million to be recovered from ratepayers over a twelve month period commencing in October 2010. In addition to the decoupling charge, the DPUC also approved a pension and earnings sharing over-recovery credit totaling approximately $3.6 million to be refunded to ratepayers over the same twelve month period commencing in October 2010. The DPUC also approved the continuance of the decoupling pilot program beyond the 2010 rate year and until such time that a final decision is reached regarding whether to continue, modify or terminate the decoupling mechanism. UI expects such determination to be made in connection with UI’s 2010 rate year decoupling results filing to be submitted to the DPUC by April 4, 2011.
In December 2009, UI received a letter ruling approving rates effective January 1, 2010, incorporating the above mentioned distribution rate changes along with previously approved changes to the Generation Services Charges (GSC), Non-Bypassable Federally Mandated Congestion Charges (NBFMCC), transmission and system benefits charge, resulting in no change in the total rate for a residential Rate R customer with standard service generation. Additionally, last resort service GSC rates have been approved for the period through December 31, 2010.
Approval for the Issuance of Debt
On April 14, 2010, the DPUC approved UI’s application requesting approval of the issuance of up to $275 million principal amount of debt securities (the Proposed Notes) during 2010 through 2013. The proceeds from the sales of the Proposed Notes may be used by UI for the following purposes: (1) to finance capital expenditures; (2) to repay the EBL, the proceeds of which are being used to finance UI’s 50% share of the equity contribution in GenConn Energy LLC for the development and construction of the Devon and Middletown peaking generation plants; (3) funding UI’s pension plan; (4) to partially repay short-term borrowings that are incurred to temporarily fund the preceding needs; (5) to pay for issuance costs related to the Proposed Notes; and (6) for general corporate purposes. On July 27, 2010, UI issued $100 million principal amount of senior unsecured notes.
In February 2009, the DPUC approved an application filed by UI to afford UI additional flexibility to market outstanding tax-exempt bonds in the municipal bond market. Specifically, UI requested approval to refund with the proceeds of the issuance of new bonds, without insurance, $25.0 million, $27.5 million and $64.5 million principal amount of tax-exempt bonds outstanding. In December 2008, UI purchased $25.0 million principal amount of insured tax-exempt bonds, which were refunded with the proceeds from the issuance, without insurance, of $25.0 million tax-exempt bonds in March 2009. In February 2010, UI purchased $27.5 million principal amount of insured tax-exempt bonds which were refunded with the proceeds from the issuance, without insurance, of $27.5 million tax-exempt bonds on January 28, 2010. UI plans to refund $64.5 million principal amount of tax-exempt bonds, for which the interest rate is periodically reset by auction, at such time and on such terms as municipal bond market conditions allow.
UI is a 50-50 joint venturer with NRG Energy, Inc. (NRG) in GCE Holding LLC, whose wholly owned subsidiary, GenConn Energy LLC (collectively “GenConn”), was chosen by the DPUC to build and operate new peaking generation plants to help address Connecticut’s need for power generation during the heaviest load periods.
The two peaking generation projects, each with a nominal capacity of 200 megawatts (MW), are located at NRG’s existing Connecticut plant locations in Devon and Middletown. GenConn’s Devon plant is now operating, and its Middletown plant is scheduled to be in operation by June 2011. GenConn recovers its costs under a contract for differences (CfD) agreement which is cost of service based. GenConn has signed CfDs for both projects with The Connecticut Light & Power Company (CL&P). The cost of the contracts will be paid by customers and will be subject to a cost-sharing agreement whereby approximately 20% of the cost is borne by UI customers and approximately 80% by CL&P customers.
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GenConn filed a rate case request with the DPUC in December 2009, seeking approval of 2010 revenue requirements for the period commencing June 1, 2010 for the GenConn Devon facility. The DPUC issued a final decision on May 26, 2010, approving the proposed $18.7 million 2010 revenue requirement for the GenConn Devon plant. GenConn bid the full capacity of the GenConn Devon facility into the ISO New England, Inc. (ISO-NE) locational forward reserve market (LFRM) for the summer 2010 period (June 1, 2010 - September 30, 2010) and for the winter period (October 1, 2010 to May 31, 2011). The DPUC’s decision states that final determination regarding prudent construction costs will be made in the 2013 revenue requirements proceeding to be filed in 2012 after the GenConn Devon and GenConn Middletown facilities are operational and construction costs are complete for both facilities.
The four units at the GenConn Devon facility were released to the ISO-NE LFRM (three in June 2010 and one in July 2010), but GenConn incurred availability penalties for such units not being available to the ISO-NE LFRM as of June 1, 2010. GenConn was able to mitigate these penalties by obtaining coverage for a portion of the unavailable capacity. UI’s 50% share in the loss from equity investments of $0.6 million, included in UIL Holdings’ Consolidated Financial Statements as of September 30, 2010, includes these mitigated penalties and certain other damages, as well as ISO-NE revenues for units that were released to the ISO-NE LFRM, revenues associated with its CfD with CL&P, and normal operating expenses. On September 10, 2010, the GenConn Devon facility met its remaining CfD commercial operation requirements as defined in the CfD.
GenConn filed a rate case request with the DPUC on July 30, 2010, seeking approval of 2011 revenue requirements for the period commencing January 1, 2011 for the GenConn Devon facility and June 1, 2011 for the GenConn Middletown facility. A final decision is scheduled for December 29, 2010. As a result of changed financial market conditions and updated cost information, GenConn project costs have increased over the proposal it originally submitted to the DPUC in 2008. The increase was driven primarily by increased financing costs and the cost to build interconnection facilities at the Middletown site. The DPUC has ruled that prudently incurred financing costs, interconnection costs and taxes will be recoverable and, therefore, GenConn expects to recover such costs in DPUC-approved future revenues. The CfDs provide for a true-up of revenue from the ISO New England Markets in which GenConn participates to DPUC-approved revenue requirements.
Pension and Postretirement Expenses
In response to the Internal Revenue Service (IRS) mandated change in mortality tables utilized for certain Employee Retirement Income Security Act of 1974 (ERISA)-related liability calculations, effective January 1, 2007, the DPUC allowed regulatory treatment for the change in pension and postretirement expenses resulting from the use of the new mortality tables. In the 2009 Decisions, the DPUC approved the recovery of these expenses over a four-year period beginning in 2009. As of September 30, 2010, the remaining regulatory asset was approximately $2.4 million.
The 2009 Decisions also provide for the establishment of an annual regulatory asset to address a portion of the actual increase in pension and postretirement expense for each of 2009 and 2010. For 2009, UI recorded a regulatory asset of approximately $10.2 million which will be recovered fully in the 2010 rate year. As of September 30, 2010, the remaining annual pension regulatory asset was approximately $3.5 million. Additionally, $11.4 million will be recovered in rates in the 2010 rate year for UI’s estimate of 2010 pension and postretirement expense.
Power Supply Arrangements
UI’s retail electricity customers are able to choose their electricity supplier. Since January 1, 2007, UI has been required to offer standard service to those of its customers who do not choose a retail electric supplier and have a maximum demand of less than 500 kilowatts. In addition, UI is required to offer supplier of last resort service to customers who are not eligible for standard service and who do not choose to purchase electric generation service from a retail electric supplier licensed in Connecticut.
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UI must procure its standard service power pursuant to a procurement plan approved by the DPUC. The procurement plan must provide for a portfolio of service agreements procured in an overlapping pattern over fixed time periods (a “laddering” approach). In June 2006, the DPUC approved a procurement plan for UI. As required by Connecticut statute, a third party consultant retained by the DPUC works closely with UI in the procurement process and to provide a joint recommendation to the DPUC as to selected bids.
UI has wholesale power supply agreements in place for the supply of all of UI’s standard service customers for all of 2010 and 2011 and 30% for 2012. Supplier of last resort service is procured on a quarterly basis. UI determined that its contracts for standard service and supplier of last resort service are derivatives under ASC 815 “Derivatives and Hedging” and elected the “normal purchase, normal sale” exception under ASC 815 “Derivatives and Hedging”. As such, UI regularly assesses the accounting treatment for its power supply contracts. These wholesale power supply agreements contain default provisions that include required performance assurance, including certain collateral obligations, in the event that UI’s credit rating on senior debt was to fall below investment grade. In October 2010, Moody’s Investor Services (Moody’s) released its updated credit opinion for UI and maintained its Baa2 rating with a stable outlook. In October 2010, Standard & Poors’ Investor Services (S&P) released its updated credit opinion for UI maintaining its BBB rating. If UI’s credit rating were to decline one rating and UI were to be placed on negative credit watch, monthly amounts due and payable to the power suppliers would be accelerated to semi-monthly payments. UI’s credit rating would have to decline two ratings to fall below investment grade at either rating service. If this were to occur, UI would have to deliver collateral security in an amount equal to the receivables due to the sellers for the thirty day period immediately preceding the default notice. If such a situation had been in effect as of September 30, 2010, UI would have had to post approximately $16.6 million in collateral.
Pursuant to Connecticut’s 2005 Energy Independence Act (EIA), the DPUC initiated a process to solicit bids to create new or incremental capacity resources in order to reduce federally mandated congestion charges, and selected four new capacity resources. To facilitate the transactions between selected capacity resources and Connecticut electric customers, and provide the commitment necessary for owners of these resources to obtain necessary financing, the DPUC required that UI and CL&P execute long-term contracts with the selected resources. In August 2007, the DPUC approved four CfDs, each of which specifies a capacity quantity and a monthly settlement that reflects the difference between a forward market price and the contract price. As directed by the DPUC, UI executed two of the contracts and CL&P executed the other two contracts. In addition, UI has executed a sharing agreement with CL&P whereby UI pays 20% of the costs and obtains 20% of the benefits of the contracts.
The DPUC has determined that costs associated with these CfDs will be recoverable by UI and CL&P, and in accordance with ASC 980 “Regulated Operations”, UI has deferred recognition of costs (a regulatory asset) or obligations (a regulatory liability). The above contracts are derivatives and they, along with the contracts for standard service and supplier of last resort service discussed in the Power Supply Arrangement discussion above and the financial transmission rights (FTRs) discussed below, are the Company’s only derivative instruments. The CfDs are marked-to-market in accordance with ASC 815. For those CfDs signed by CL&P, UI records its approximate 20% portion of CL&P’s derivative, pursuant to the sharing agreement noted above. As of September 30, 2010, UI has recorded a gross derivative asset of $36.6 million ($5.9 million related to its portion of CL&P’s derivative assets), a regulatory asset of $101.2 million, a gross derivative liability of $131.8 million ($93.5 million related to its portion of CL&P’s derivative liabilities) and a regulatory liability of $5.9 million in the accompanying Consolidated Balance Sheet. See Note (K) “Fair Value of Financial Instruments” for additional CfD information.
On February 7, 2010, an explosion occurred at the construction site of the nearly completed 620-megawatt plant being built by Kleen Energy Systems, LLC (“Kleen”), one of the four capacity resources selected by the DPUC to create new or incremental capacity resources described above. As noted above, CL&P has executed CfDs with two of the selected projects, including the Kleen project. The CfD with Kleen is subject to the sharing agreement between UI and CL&P whereby UI pays 20% of the costs and obtains 20% of the benefits of the contract. The extent of damage and any resulting delay in the attainment of commercial operation is currently under review.
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On September 28, 2010, Kleen notified CL&P that it considered the explosion a continuing event of force majeure that excused Kleen from performance of its obligations under the CfD as well as for liability for any damages under the CfD. On October 5, 2010, the DPUC opened a proceeding to investigate and make a determination regarding Kleen's claim of force majeure and that force majeure excused Kleen from failure to achieve commercial operation as required under the CfD as well as associated liquidated damages. The DPUC closed the proceeding on October 21, 2010 following Kleen's compliance with the DPUC's October 20, 2010 conditional grant of approval of Kleen's October 19, 2010 notice of withdrawal and request to close the proceeding. The conditional grant required Kleen to provide CL&P with a letter stating that by seeking to withdraw: 1) Kleen forever waives any and all claims to be exempt from paying liquidated damages for failure to achieve commercial operation by November 30, 2010 and 2) as part of this waiver, Kleen agrees that it will not contest or seek exemption from and that it will timely pay to CL&P all liquidated damages associated with the delay in commercial operation commencing from December 1, 2010 up through commercial operation of the facility. Kleen provided the letter to the DPUC and CL&P on October 21, 2010.
During the first quarter of 2010, UIL Holdings adjusted an assumption in its expected cash flow analysis, significantly reducing the fair value of the related regulatory asset and derivative liability on its Consolidated Balance Sheet. A subsequent increase to the same assumption resulted in a corresponding increase in the related regulatory asset and derivative liability. These changes did not have an impact on UIL Holdings’ Consolidated Statement of Income. Based on information known to date, it remains reasonably likely that, at a minimum, there will be a delay in Kleen's attainment of commercial operation.
The unrealized gains and losses from mark-to-market adjustments to derivatives recorded in regulatory assets or regulatory liabilities for the three and nine month periods ended September 30, 2010 and 2009 were as follows:
The adjustments to the probability of Kleen’s attainment of commercial operation, as discussed above, resulted in changes in UI’s projected derivative liability relating to UI’s CfD with Kleen. The changes in this derivative liability were the primary reasons for the unrealized loss and unrealized gain during the three and nine month periods ended September 30, 2010, respectively.
The fair value of the gross derivative assets and liabilities as of September 30, 2010 and December 31, 2009 were as follows:
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Pursuant to Connecticut’s 2007 Act Concerning Electricity and Energy Efficiency, the DPUC initiated a process to create new peaking generation resources to address the state’s shortage of fast-start peaking generation that is needed to provide energy reserves. As with the CfDs entered into pursuant to the EIA and described above, the DPUC required that UI and CL&P execute long-term contracts with the selected peaking resources to facilitate the transactions and provide the commitment necessary for the owners of the peaking resources to obtain financing. During 2008, CL&P executed three peaking generation CfDs, one with GenConn relating to its Devon facility, one with GenConn relating to its Middletown facility and the other with PSEG Power Connecticut LLC (“PSEG”), to which the sharing agreement between UI and CL&P described above also applies. These contracts are not considered to be derivatives under ASC 815 and therefore will be accounted for on an accrual basis.
ISO-NE and RTO-NE
ISO-NE, an independent, not-for-profit corporation, was approved by the FERC as the regional transmission organization for New England (RTO-NE) on February 1, 2005. ISO-NE is responsible for the reliable operation of the region’s bulk electric power system and fair administration of the region’s wholesale electricity marketplace. ISO-NE also is responsible for the management of the comprehensive bulk electric power system and wholesale markets’ planning processes that address the region's electricity needs.
Transmission Return on Equity (ROE)
In March 2008, the FERC issued an order on rehearing (Rehearing Order) establishing allowable ROEs for transmission projects of transmission owners in New England, including UI. In the Rehearing Order, the FERC established the base-level ROE of 11.14% beginning in November 2006. The Rehearing Order also confirmed a 50 basis point ROE adder on Pool Transmission Facilities (PTF) for participation in the RTO-NE and a 100 basis point ROE incentive for projects included in the ISO-NE Regional System Plan that were completed and on line as of December 31, 2008. The Middletown/Norwalk Transmission Project received this 100 basis point ROE adder. For projects placed in service after December 31, 2008, incentives may be requested from the FERC, through a specific showing justifying the incentive, on a project-specific basis.
In May 2008, several public entities, including the DPUC (petitioners), filed a petition with the United States Court of Appeals for the District of Columbia Circuit (U.S. Court of Appeals) challenging the Rehearing Order. In January 2010, the U.S. Court of Appeals issued a decision upholding the FERC order, and in April 2010, it denied the petitioners request for a rehearing by the full court.
UI’s overall transmission ROE is determined by the mix of UI’s transmission rate base between new and existing transmission assets, and whether such assets are PTF or non-PTF. UI’s transmission assets are primarily PTF. For 2010, UI is estimating an overall allowed weighted-average ROE for its transmission business in the range of 12.4% to 12.5%.
New England East-West Solution
On July 14, 2010, UI entered into an agreement (Agreement) with CL&P, under which UI will have the right to invest in and own transmission assets associated with the Connecticut portion of CL&P’s New England East West Solution (NEEWS) projects to improve regional energy reliability. The Agreement is subject to state and federal regulatory approval. On July 15, 2010, UI and CL&P filed a joint application with the DPUC requesting such approval and on October 13, 2010, the DPUC approved the request. UI and CL&P expect to make filings at the FERC in the near future.
NEEWS consists of four inter-related transmission projects being developed by subsidiaries of Northeast Utilities (NU), the parent company of CL&P, in collaboration with National Grid USA. Three of the projects have portions sited in Connecticut: (1) the Greater Springfield Reliability Project, (2) the Interstate Reliability Project and (3) the Central Connecticut Reliability Project. Based on data prepared by CL&P, UI expects that the cost of building the Connecticut portions of these projects will be approximately $827 million.
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Under the terms of the Agreement, UI has the option to make quarterly payments to CL&P in exchange for ownership of specific transmission assets as they come into commercial operation. Following regulatory approval, UI will have the right to invest up to the greater of $69 million or an amount equal to 8.4% of CL&P’s costs for the Connecticut portions of these projects. As assets come into commercial operation, CL&P will transfer title to transmission assets such as poles and wires to UI in proportion to its investments, but CL&P will continue to maintain these portions of the transmission system pursuant to an operating and maintenance agreement with UI. Also, under the terms of the Agreement, there are certain circumstances under which CL&P can terminate the Agreement.
Middletown/Norwalk Transmission Project
In a May 2007 Order, the FERC approved rate incentives for the 345-kilovolt (kV) transmission line from Middletown, Connecticut to Norwalk, Connecticut (the Project). The Project was allowed to include Construction Work In Progress (CWIP) expenditures in rate base. For project costs incurred before August 8, 2005, the FERC allowed UI to include 50% of CWIP expenditures in rate base, and for project costs incurred after August 8, 2005, the FERC allowed UI to include 100% of CWIP expenditures in rate base. The FERC also accepted a 50 basis point adder which will be applied only to costs associated with advanced transmission technologies.
Certain parties requested rehearing of the FERC May 2007 order, but in January 2009, the FERC denied those requests. Also, in January 2009, the DPUC and the Attorney General of Connecticut filed a petition with the U.S. Court of Appeals seeking judicial review of the FERC’s May 2007 and January 2009 orders. In May 2010, the parties withdrew their petition for judicial review and the U.S. Court of Appeals dismissed the cases.
(D) SHORT-TERM CREDIT ARRANGEMENTS
UIL Holdings and UI have a revolving credit agreement with a group of banks that extends to December 22, 2011. The borrowing limit under the facility for UI is $175 million, with $50 million of the limit available for UIL Holdings. The facility permits borrowings at fluctuating interest rates determined by reference to Citibank’s New York base rate and the Federal Funds Rate (as defined in the facility), and also permits borrowings for fixed periods up to six months as specified by UI and UIL Holdings at fixed interest rates (London Interbank Offered Rate or LIBOR) determined by the Eurodollar Interbank Market in London. The facility also permits the issuance of letters of credit up to $50 million.
As of September 30, 2010, there were no amounts outstanding under the facility. UIL Holdings had a standby letter of credit outstanding in the amount of $1 million that expired on January 31, 2010, which was extended and is expected to be automatically extended for one year periods from the expiration date (or any future expiration date), unless the issuer bank elects not to extend. Available credit under this facility at September 30, 2010 was $174 million for UI and UIL Holdings in the aggregate. UIL Holdings records borrowings under this facility as short-term debt, but the agreement has longer term commitments from banks allowing the Company to borrow and reborrow funds, at its option, to December 22, 2011, thus affording it flexibility in managing its working capital requirements.
UIL Holdings has a money market loan arrangement with JPMorgan Chase Bank. This is an uncommitted short-term borrowing arrangement under which JPMorgan Chase Bank may make loans to UIL Holdings for fixed periods, depending on UIL Holdings’ credit rating, the Bank’s credit requirements, and conditions in the financial markets. JPMorgan Securities, Inc. acts as an agent and sells the loans to investors. As of September 30, 2010, UIL Holdings had no short-term borrowings outstanding under this arrangement.
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(E) INCOME TAXES
The combined statutory federal and state income tax rates for UIL Holdings for each of the three and nine month periods ended September 30, 2010 and 2009 were 40.4%.
Differences in the treatment of certain transactions for book and tax purposes occur which cause the rate of UIL Holdings’ reported income tax expense to differ from the statutory tax rate described above. The effective book income tax rates for the three and nine month periods ended September 30, 2010 were 44.1% and 43.1%, respectively, as compared to 38.6% and 39.7% for the three and nine month periods ended September 30, 2009, respectively. The increase in the 2010 effective book income tax rates was due primarily to the non-normalized effect associated with increased nuclear stranded cost amortization in the CTA in the third quarter of 2010.
During the third quarter of 2010, UIL Holdings recognized a significant one-time income tax deduction, which it reflected on its 2009 state and federal income tax returns, related to repair and maintenance costs it had previously capitalized for tax purposes. This one-time income tax deduction resulted in a cash benefit of approximately $40.5 million. The decreases in current income tax expense and increase in deferred income tax expense for the three and nine month periods ended September 30, 2010, compared to the three and nine month periods ended September 30, 2009, were primarily due to this one-time income tax deduction which was deferred for book purposes. As a result, as of September 30, 2010, UIL Holdings had gross unrecognized tax benefits of approximately $8.9 million, including an immaterial amount of interest, of which none would impact the effective tax rate if recognized.
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(G) PENSION AND OTHER BENEFITS>
The United Illuminating Company Pension Plan covers the majority of the officers and employees of UIL Holdings and UI. UI also has a non-qualified supplemental pension plan for certain employees and a non-qualified retiree-only pension plan for certain early retirement benefits.
UI has a supplemental retirement benefit trust and, through this trust, purchased life insurance policies on certain officers of UI to fund the future liability under the non-qualified supplemental pension plan. The cash surrender value of these policies is included in “Other investments” in UIL Holdings’ Consolidated Balance Sheet and is marked-to-market.
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The following tables represent the components of net periodic benefit cost for pension and other postretirement benefits (OPEB) for the three and nine month periods ended September 30, 2010 and 2009: