1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K (Mark One) [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998 OR [ ] 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 1-3701 AVISTA CORPORATION (Exact name of Registrant as specified in its charter) Washington 91-0462470 ----------------------------------------- ---------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 1411 East Mission Avenue, Spokane, Washington 99202-2600 - ---------------------------------------------- ---------------- (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: 509-489-0500 Web site: http://www.avistacorp.com SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: <TABLE> <CAPTION> <S> <C> Name of Each Exchange Title of Class on Which Registered --------------------------------------------------- ------------------------ Common Stock, no par value, together with New York Stock Exchange Preferred Share Purchase Rights appurtenant thereto Pacific Stock Exchange 7 7/8% Trust Originated Preferred Securities, Series A New York Stock Exchange $12.40 Preferred Stock, Convertible Series L (depositary shares) New York Stock Exchange </TABLE> SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: Title of Class -------------- Preferred Stock, Cumulative, Without Par Value Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days: --------------------------- Yes [X] No [ ] --------------------------- Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (Section 229.405 of this chapter) is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X] The aggregate market value of the Registrant's outstanding Common Stock, no par value (the only class of voting stock), held by non-affiliates is $662,429,812.38, based on the last reported sale price thereof on the consolidated tape on February 26, 1999. At February 26, 1999, 40,453,729 shares of Registrant's Common Stock, no par value (the only class of common stock), were outstanding. Documents Incorporated By Reference Part of Form 10-K into Which Document Document is Incorporated -------------------------------------- ---------------------------- Proxy Statement to be filed in Part III, Items 10, 11, connection with the annual meeting 12 and 13 of shareholders to be held May 13, 1999
2 AVISTA CORPORATION - -------------------------------------------------------------------------------- INDEX <TABLE> <CAPTION> Item Page No. No. - ---- ---- <S> <C> <C> Acronyms and Terms................................................... iv Part I 1. Business............................................................. 1 Company Overview................................................... 1 Energy Delivery.................................................... 4 General............................................................ 4 Electric Operations................................................ 4 Natural Gas Operations............................................. 4 Natural Gas Resources.............................................. 5 Energy Delivery Regulatory Issues.................................. 5 Energy Delivery Operating Statistics............................... 8 Generation and Resources........................................... 10 General............................................................ 10 Electric Requirements.............................................. 10 Electric Resources................................................. 10 Hydroelectric Relicensing.......................................... 11 Generation and Resources Regulatory Issues......................... 11 Generation and Resources Operating Statistics...................... 13 National Energy Trading and Marketing.............................. 14 Avista Energy...................................................... 14 Avista Advantage................................................... 15 Avista Power....................................................... 15 National Energy Trading and Marketing Operating Statistics......... 16 Non-Energy Business................................................ 17 Pentzer............................................................ 17 Other Non-Energy Companies......................................... 17 Industry Restructuring............................................. 18 Federal Level...................................................... 18 State Level........................................................ 18 Experimental Programs.............................................. 19 Environmental Issues............................................... 21 2. Properties........................................................... 22 Energy Delivery.................................................... 22 Generation and Resources........................................... 23 3. Legal Proceedings.................................................... 23 4. Submission of Matters to a Vote of Security Holders.................. 23 Part II 5. Market for Registrant's Common Equity and Related Stockholder Matters................................................ 24 6. Selected Financial Data.............................................. 25 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.......................................... 26 Results of Operations.............................................. 26 Liquidity and Capital Resources.................................... 31 Future Outlook..................................................... 33 7A. Quantitative and Qualitative Disclosure about Market Risk............ 41 8. Financial Statements and Supplementary Data.......................... 41 Independent Auditors' Report....................................... 42 Financial Statements............................................... 43 Notes to Financial Statements...................................... 49 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure........................................... * Part III 10. Directors and Executive Officers of the Registrant................... 70 11. Executive Compensation............................................... 71 12. Security Ownership of Certain Beneficial Owners and Management....... 71 13. Certain Relationships and Related Transactions....................... 71 </TABLE> ii
3 <TABLE> <CAPTION> Item Page No. No. - ---- ---- <S> <C> <C> Part IV 14. Financial Statements, Financial Statement Schedules, Exhibits and Reports on Form 8-K................................... 72 Signatures........................................................... 73 Independent Auditors' Consent........................................ 74 Exhibit Index........................................................ 75 </TABLE> * = not an applicable item in the 1998 calendar year for the Company iii
4 ACRONYMS AND TERMS (The following acronyms and terms are found in multiple locations within the document) <TABLE> <CAPTION> Acronym/Term Meaning <S> <C> aMW - Average Megawatt - a measure of electrical energy over time AFUCE - Allowance for Funds Used to Conserve Energy; a carrying charge similar to AFUDC (see below) for conservation-related capital expenditures AFUDC - Allowance for Funds Used During Construction; represents the cost of both the debt and equity funds used to finance utility plant additions during the construction period Avista Corp. - Avista Corporation, the Company Avista Capital - Parent company to the Company's non-regulated businesses BPA - Bonneville Power Administration Capacity - a measure of the rate at which a particular generating source produces electricity Centralia - the coal fired Centralia Power Plant in western Washington State Colstrip - the coal fired Colstrip Generating Project in southeastern Montana CPUC - California Public Utilities Commission CT - combustion turbine; a natural gas fired unit used primarily for peaking needs DSM - Demand Side Management - the process of helping customers manage their use of energy resources Energy - a measure of the amount of electricity produced from a particular generating source over time FERC - Federal Energy Regulatory Commission IPUC - Idaho Public Utilities Commission KV - Kilovolt - a measure of capacity on transmission lines KW, KWH - Kilowatt, kilowatthour, 1000 watts or 1000 watt hours MW, MWH - Megawatt, megawatthour, 1000 KW or 1000 KWH OPUC - Public Utility Commission of Oregon Pentzer - Pentzer Corporation, a wholly owned subsidiary of the Company which is the parent company to the majority of the Company's non-energy businesses Therm - Unit of measurement for natural gas; a therm is equal to one hundred cubic feet (volume) or 100,000 BTUs (energy) Watt - Unit of measurement for electricity; a watt is equal to the rate of work represented by a current of one ampere under a pressure of one volt WUTC - Washington Utilities and Transportation Commission </TABLE> iv
5 AVISTA CORPORATION - -------------------------------------------------------------------------------- PART I This Form 10-K contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934. Forward-looking statements should be read with the cautionary statements and important factors included in this Form 10-K at Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operations - Safe Harbor Forward-Looking Statements." Forward-looking statements are all statements other than statements of historical fact, including without limitation those that are identified by the use of the words "will," "anticipates," "seeks to," "estimates," "expects," "intends," "plans," "predicts," and similar expressions. ITEM 1. BUSINESS COMPANY OVERVIEW Avista Corporation (Avista Corp., or the Company), formerly known as The Washington Water Power Company, was incorporated in the State of Washington in 1889, and is a diversified energy services company. The name change to Avista Corporation became effective on January 1, 1999. At December 31, 1998, the Company's employees included 1,536 people in its utility operations and approximately 2,153 people in its majority-owned non-regulated businesses (energy and non-energy). The Company's corporate headquarters are in Spokane, Washington (Spokane), which serves as the Inland Northwest's center for manufacturing, transportation, health care, education, communication, agricultural and service businesses. Regulatory, economic and technological changes have brought about the accelerating transformation of the electric utility industry from a vertically integrated monopoly to separate market driven businesses. Changes underway in the utility and energy industries are creating new opportunities to expand the Company's businesses and serve new markets. In pursuing such opportunities, the Company is shifting its strategic direction to growth in order to achieve its goal of becoming a diversified North American energy company. The Company's strategies are described below. The Company seeks to strengthen its position of leadership in energy delivery and generation as well as energy trading and marketing on a local, regional and national basis. The Company will seek to increase its asset and customer base through a focus on acquisitions and strategic alliances in all parts of its business. The Company intends to focus on growing its core energy business by seeking to acquire control of physical assets, specifically power generation assets and electric and natural gas transmission and distribution assets. The Company expects that initial growth will come at a local and regional level, with national growth to follow. Key strengths of the Company today include its position as one of the lowest cost producers of power in the nation, expertise in hydroelectric and power system management, plus capabilities in trading and wholesale and retail marketing of natural gas and electric energy. Locally. The Company is a long-standing leader in the Northwest region of the United States, providing some of the lowest cost energy to its customers. The Company's strategy is to add selectively to its already strong foundation of state-regulated utility assets to solidify its position as a leading supplier of low-cost electric and natural gas energy services. Regionally. The Company intends to add to its regulated and non-regulated assets on a regional basis and participate in industry consolidation to further optimize its assets and create greater economies of scale. In addition to energy delivery and generation, the Company plans to concentrate on growing its energy trading and marketing business. The strong growth in this business is expected to be driven by the Company's significant base of knowledge and experience in the operation of physical systems - for both natural gas and electric energy - in the region, as well as its relationship-focused approach to the customer. The Company will also focus on expanding its telecommunications business through its newest subsidiary, Avista Communications. (See Non-Energy business for additional information.) Nationally. The Company's strong regional energy trading and marketing skills serve as a platform for the Company's growing national presence. The Company will seek to expand its customer base through Internet-based specialty billing and information services and relationships with other energy providers outside the Northwest, thereby leveraging its existing trading and marketing skills. On February 1, 1999, Avista Energy, Inc., (Avista Energy) a national energy trading and marketing subsidiary of Avista Corp. acquired Vitol Gas & Electric LLC, one of the top 20 energy marketing companies in the United States. (See National Energy Trading and Marketing for additional information.) The Company conducts the majority of its Non-energy business through its wholly owned subsidiary, Pentzer Corporation (Pentzer). Pentzer's business strategy is to acquire controlling interests in a broad range of middle market companies, facilitate improved productivity and growth, and ultimately sell such companies to the public or a strategic buyer. The Company's growth strategy will expose the Company to risks associated with rapid expansion, challenges in recruiting and retaining qualified personnel, risks associated with acquisitions, joint ventures and increasing competition. In addition, growth in the energy and trading and marketing business will expose the Company to increased financial and credit risks associated with commodity trading activities. The Company believes however, that its extensive experience in the electric and natural gas business, coupled with its strong management team, will allow the Company to effectively manage its transition to a diversified North American energy company. In order to implement its growth strategies, the Company has reorganized its operations into four lines of business - Energy Delivery, Generation and Resources, National Energy Trading and Marketing and Non-energy. The regulated utility 1
6 AVISTA CORPORATION - -------------------------------------------------------------------------------- operations fall within Energy Delivery and Generation and Resources. The Energy Delivery business includes retail electric and natural gas distribution and transmission services. The Generation and Resources business includes generation and production, resource optimization, electric and natural gas commodity trading and wholesale marketing. Both the Energy Delivery and Generation and Resources lines of business fall within Avista Utilities, an operating division of Avista Corp. Avista Capital, which is a wholly-owned subsidiary of Avista Corp., owns all of the companies engaged in the National Energy Trading and Marketing and Non-energy lines of Business. The National Energy Trading and Marketing line of business includes Avista Advantage, Inc. (Avista Advantage), Avista Energy, Inc. (Avista Energy) and Avista Power, Inc. (Avista Power). See Item 1. Business - National Energy Trading and Marketing and Notes 1, 3 and 4 of Notes to Financial Statements for additional information. As of December 31, 1998 the Company had common equity investments of $216.6 million ($493.4 million including convertible securities) and $271.8 million in Avista Utilities and Avista Capital, respectively. The Non-energy line of business, also owned by Avista Capital, includes Avista Fiber, Inc. (Avista Fiber), Avista Development, Inc. (Avista Development), Avista Labs, Inc. (Avista Labs), Avista Communications, Inc. (Avista Communications) and Pentzer Corporation, which is the parent company to the majority of the Company's non-energy businesses. See Item 1. Business - Non-energy Business and Notes 1 and 17 of Notes to Financial Statements for additional information. Below is the list of major companies owned by Avista Capital: Avista Energy - An electricity and natural gas marketing and trading company. Avista Advantage - A leading provider of Internet-based specialty billing and information services. Avista Power - Created in December 1998 to develop and own generation assets, primarily in support of Avista Energy. Pentzer - A wholly owned subsidiary of Avista Capital and the parent company for a majority of Avista Corp.'s Non-energy subsidiaries. Avista Fiber - Designs, builds and manages metropolitan area fiber optic cable networks. Avista Development - Real-estate and other investments. Avista Labs - The developer of proton exchange membrane fuel cell technology. Avista Communications - Created in January 1999 to provide local high-speed telecommunications services to under- served Northwest communities. The Company's lines of business are illustrated below: [FLOW CHART] [ ] - denotes a business entity. o - denotes an operating division or line of business. 2
7 AVISTA CORPORATION - -------------------------------------------------------------------------------- For the twelve months ended December 31, 1998, 1997 and 1996, respectively, the Company derived operating revenues and income/(loss) from operations in the following proportions: <TABLE> <CAPTION> Income/(Loss) from Operating Revenues Gross Margins Operations (pre-tax) -------------------- -------------------- -------------------- 1998 1997 1996 1998 1997 1996 1998 1997 1996 ---- ---- ---- ---- ---- ---- ---- ---- ---- <S> <C> <C> <C> <C> <C> <C> <C> <C> <C> Energy Delivery 11% 29% 40% 70% 69% 67% 68% 60% 48% Generation and Resources 18% 39% 45% 18% 27% 33% 15% 34% 45% National Energy Trading and Marketing 65% 19% -- 12% 4% 0% 12% 1% (1%) Non-energy 6% 13% 15% N/A N/A N/A 5% 5% 8% </TABLE> N/A - Not Applicable Gross margin is calculated by subtracting resource costs from operating revenues. (See Schedule of Information by Business Segments for further information). 3
8 AVISTA CORPORATION - -------------------------------------------------------------------------------- ENERGY DELIVERY GENERAL Energy Delivery provides electricity and natural gas distribution and transmission services in a 26,000 square mile area in eastern Washington and northern Idaho with a population of approximately 825,000. Energy Delivery also provides natural gas service in a 4,000 square mile area in northeast and southwest Oregon and in the South Lake Tahoe region of California, with the population in these areas approximating 495,000. At the end of 1998, retail electric service was supplied to approximately 305,000 customers in eastern Washington and northern Idaho; retail natural gas service was supplied to approximately 262,000 customers in parts of Washington, Idaho, Oregon and California. The Company expects economic growth to continue in its eastern Washington and northern Idaho service area. The Company, along with others in the service area, is continuing its efforts to facilitate expansion of existing businesses and attract new businesses to the Inland Northwest. Agriculture, mining and lumber were the primary industries for many years, but health care, education, electronic and other manufacturing, tourism and the service sectors have become increasingly important industries that operate in the Company's service area. The Company also anticipates moderate economic growth to continue in its Oregon service area. The Company anticipates residential and commercial electric load growth to average approximately 2.3% annually for the next five years primarily due to increases in both population and the number of businesses in its service territory. The number of electric customers is expected to increase and the average annual usage by residential customers is expected to remain steady on a weather-adjusted basis. The Company anticipates natural gas load growth, including transportation volumes, in its Washington and Idaho service area to average approximately 2.7% annually for the next five years. The Oregon and South Lake Tahoe, California service areas are anticipated to realize 3.1% growth annually during that same period. Refer to Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: Results of Operations: Future Outlook for additional information. ELECTRIC OPERATIONS Energy Delivery currently receives all of its electric supply from Generation and Resources. (See Generation and Resources - Electric Resources for additional information.) Challenges facing the retail electric business include cost management, self-generation and fuel switching by commercial and industrial customers, the costs of increasingly stringent environmental laws and the potential for stranded or non-recoverable utility assets. In April 1996, the Federal Energy Regulatory Commission (FERC) issued Orders No. 888 and No. 889 which require electric utility companies to provide third-party access to their transmission systems and to establish an Open Access Same-time Information System (OASIS) to provide transmission customers with information about available transmission capacity, prices and other information, by electronic means. In addition, state legislatures in the Company's service territory are continuing to evaluate restructuring the retail electric business to full competition. When electric utility companies are required to provide retail wheeling service, which is the transmission of electric power from another supplier to a customer located within such utility's service area, the Company believes it will face minimal risk for stranded generation, transmission or distribution assets due to its low cost structure. However, the Company cannot predict the potential impact, if any, of restructuring the electric utility industry on the Company's future financial condition and results of operations. (See Industry Restructuring and Note 1 of Notes to Financial Statements for additional information.) NATURAL GAS OPERATIONS Natural gas remains competitively priced compared to alternative fuel sources for residential, commercial and industrial customers. Because of abundant supplies and competitive markets, natural gas should sustain its market advantage. The Company continues to advise electric customers as to the cost advantages of converting space and water heating needs to natural gas. Significant growth has occurred in the Company's natural gas business in recent years due to increased demand for natural gas in new construction. The Company also makes sales and provides transportation service directly to large natural gas customers and makes non-retail sales to marketers and producers where points of delivery are outside the Company's retail distribution area. 4
9 AVISTA CORPORATION - -------------------------------------------------------------------------------- Most of the Company's large industrial customers purchase their own natural gas requirements through gas marketers. For these customers, the Company provides transportation from the Company's pipeline interconnection to the customer's plant. The Company has numerous special contracts for natural gas transportation service, most of which contain negotiated rates for Company distribution service based on the customer's competitive alternatives. Seven of the Company's largest natural gas customers are provided natural gas transportation service by the Company under special contracts. These negotiated contracts were entered into to retain these customers who can either by-pass the Company's distribution system or have competitive alternative fuel capability. All special contracts are subject to regulatory review and approval. The competitive nature of the spot natural gas market results in savings in the cost of purchased natural gas, which encourages large customers with fuel-switching capabilities to continue to utilize natural gas for their energy needs. The total volume transported on behalf of transportation customers for 1998, 1997 and 1996 was approximately 226.1, 245.1 and 237.9 million therms, which represented approximately 39%, 43% and 40% of the Company's total system deliveries. In addition, the Company sells firm transportation to third parties when it is not needed to serve the Company's customers. NATURAL GAS RESOURCES Natural Gas Supply A diverse portfolio of resources allows the Company to capture market opportunities that benefit the Company's natural gas customers. Natural gas supplies are available from both domestic and Canadian sources through both long- and short-term, or spot market, purchases. The Company holds capacity on six pipelines and owns natural gas storage facilities which allow the Company to optimize its available resources. Firm natural gas supplies are purchased by the Company through negotiated agreements having terms ranging between one month and seven years. During 1998, approximately one-third of the Company's purchases were in the short-term market, with contracts on a month-to-month basis. Approximately 14% of the natural gas supply was obtained from domestic sources, with the remaining 86% from Canadian sources. Nearly all natural gas purchased from Canadian sources is contracted in U.S. dollar denominations, limiting any foreign currency exchange exposure. The Company does not consider Canadian natural gas supplies to be at greater risk of non-delivery than U.S. supplies. The Company holds capacity on six natural gas pipelines, Northwest Pipeline Company (NWP), Pacific Gas Transmission (PGT), Paiute Pipeline (Paiute), Tuscarora Gas Transmission Company (Tuscarora), NOVA Pipeline, Ltd. (NOVA) and Alberta Natural Gas Co. Ltd. (ANG), which provide the Company access to both domestic and Canadian natural gas supplies. In 1998, the Company obtained gas from over 25 different suppliers. The Company contracts with NWP for three types of firm service (transportation, liquefied natural gas storage and underground storage), with Paiute for firm transportation and liquefied natural gas storage and with PGT, Tuscarora, NOVA and ANG for firm transportation only. Jackson Prairie Natural Gas Storage Project (Storage Project) The Company owns a one-third interest in the Storage Project, which is an underground natural gas storage field located near Chehalis, Washington. The role of the Storage Project in providing flexible natural gas supplies is increasingly important to the Company's natural gas operations. It enables the Company to place natural gas into storage when prices are low or to meet minimum natural gas purchasing requirements, as well as to withdraw natural gas from storage when spot prices are high or as needed to meet high demand periods. The Company is in the process of increasing the capacity at the Storage Project. The increased capacity will be optimized by Avista Energy for the next 10 years, and in return, Avista Energy will be responsible for the capital costs related to the project expansion. The Company has contracted to release some of its Storage Project capacity to two other utilities until 2000 and 2001, with a provision under one of the releases to partially recall the released capacity if the Company determines additional natural gas is required for its own system supply. ENERGY DELIVERY REGULATORY ISSUES The Company, as a regulated public utility, is currently subject to regulation by state utility commissions with respect to prices, accounting, the issuance of securities and other matters. The retail electric operations are subject to the jurisdiction of the Washington Utilities and Transportation Commission (WUTC), the Idaho Public Utilities Commission (IPUC) and the Montana Public Service Commission (MPSC). The retail natural gas operations are subject to the jurisdiction of the WUTC, the IPUC, the Oregon Public Utility Commission (OPUC) and the California Public Utilities Commission (CPUC). The Company is also subject to the jurisdiction of the FERC for its (wholesale) natural gas rates charged for the release of capacity from the Jackson Prairie Storage Project. In each regulatory jurisdiction, the price the Company may charge for retail electric and natural gas services (other than specially negotiated retail rates for industrial or large commercial customers, which are subject to regulatory review and approval) is currently determined on a "cost of service" basis and is designed to provide, after recovery of allowable 5
10 AVISTA CORPORATION - -------------------------------------------------------------------------------- operating expenses, an opportunity to earn a reasonable return on "rate base." "Rate base" is generally determined by reference to the original cost (net of accumulated depreciation) of utility plant in service, subject to various adjustments for deferred taxes and other items (see Note 1 of Notes to Financial Statements for additional information about regulation, depreciation and deferred taxes). Over time, rate base is increased by additions to utility plant in service and reduced by depreciation of utility plant. As the energy business is restructured, traditional "cost of service" ratemaking may evolve into some other form of ratemaking. Rates for transmission services are based on the "cost of service" principles and are set forth in tariffs on file with the FERC. (See Industry Restructuring for additional information.) General Rate Cases The Company's last general electric rate cases were effective in March 1987 for the State of Washington and September 1986 for the State of Idaho; both allowed a return on equity of 12.90%. On December 18, 1998, the Company filed for a general electric rate increase of $14,223,000 or 11.56% with the IPUC. The Company is requesting a return on equity of 12.00%. An order is expected in the latter part of 1999. The Company anticipates filing for a retail increase in the State of Washington later in 1999. On June 27, 1997, the Company filed a general natural gas rate increase of $7.87 million with the WUTC. A settlement agreement resulted in a $5 million, or 7.5%, increase effective January 1, 1998. Included in the settlement agreement was a stated return on equity of 10.75%. However, the agreements reached in the settlement do not set a precedent for future rate filings. The Company's last general natural gas rate cases involving litigated cost of capital resulted in allowed return on equity of 12.90% for the State of Washington, effective August 1990 and 12.75% for the State of Idaho, effective October 1989. Power Cost Adjustment (PCA) The Company has a PCA in Idaho which tracks changes in hydroelectric generation, surplus energy prices, related changes in thermal generation and the Public Utility Regulatory Policies Act of 1978 (PURPA) contracts, but not changes in revenues or costs associated with other wheeling or power contracts. Rate changes are triggered when the deferred balance reaches $2.2 million, provided no more than two surcharges or rebates are in effect at the same time. See Note 1 of Notes to Financial Statements for additional information. Service Territory Agreement In August 1998, the Company executed a new electric service territory agreement with Inland Power and Light Company. Inland Power and Light is an electric cooperative serving approximately 30,000 customers in various suburban and rural areas of Eastern Washington, including areas around Spokane. The Company had an existing service territory agreement with Inland Power and Light that was due to expire in December 1998. The Company entered into the new agreement in order to protect service provided to existing customers and to establish rules for service to new customers. Under the agreement, generally, the utility with the closest electric facilities will serve a new customer. However, new customers with loads larger than 3 megawatts can choose their service provider. The agreement is for a fifteen year term and was approved by the WUTC on October 9, 1998. Purchased Gas Adjustment (PGA or Natural Gas Trackers) Natural gas trackers are supplemental tariffs filed with state regulatory commissions which are designed to pass through changes in purchased natural gas costs and therefore, do not normally result in any changes in net income to the Company. On September 30, 1998, the Company filed a PGA with the WUTC. This filing requested a net revenue reduction of $42,000 or .06%. On December 1, 1998, a modified version of the original filing became effective with rates subject to change based on the WUTC's continuing audit. In January 1999, the audit was concluded with no adjustment to rates, and in February 1999, the Commission closed the investigation. In November 1998, the OPUC approved a $1.1 million, or 2.25% decrease effective December 1, 1998. In October 1998, the Company filed a natural gas tracker with the IPUC requesting a $1.1 million, or 4.0%, increase which was approved, effective December 7, 1998. Natural Gas Benchmark Mechanism On December 1, 1998, the Company filed a proposal with the WUTC and IPUC to eliminate gas procurement operations within Avista Utilities and consolidate gas procurement operations under Avista Energy. A smaller natural gas staff would remain in Avista Utilities to prepare load forecasts and support regulatory activities. The ownership of the natural gas assets would remain with Avista Utilities, but would be managed by Avista Energy through an agency agreement. Consolidation of natural gas procurement operations under Avista Energy would allow the Company to gain synergies and better manage its risk by combining and operating the two portfolios as one portfolio and to gain efficiencies by eliminating duplicate functions. The proposal to state regulators includes a Gas Benchmark mechanism that is designed to provide certain guaranteed benefits to retail customers as well as provide Avista Corp. the opportunity to improve earnings, i.e., a performanced-based mechanism. 6
11 AVISTA CORPORATION - -------------------------------------------------------------------------------- The Idaho Gas Benchmark mechanism sets three separate benchmarks or targets: commodity, pipeline capacity and Jackson Prairie storage. To the extent that Avista Energy optimizes these three components of gas costs, Avista Energy will retain the benefits. Likewise, if Avista Energy incurs costs in excess of the targets, it will absorb the loss. The Gas Benchmark Mechanism was approved by the IPUC on February 1, 1999. The proposal is currently pending before the WUTC and the Company is currently working with WUTC staff to resolve issues in the proceeding. The Company is preparing a similar proposal for its Oregon natural gas procurement operations. The Company plans to file with the OPUC in March 1999. 7
12 AVISTA CORPORATION - -------------------------------------------------------------------------------- ENERGY DELIVERY OPERATING STATISTICS <TABLE> <CAPTION> Years Ended December 31, ------------------------------------- 1998 1997 1996 --------- --------- --------- <S> <C> <C> <C> RETAIL ELECTRIC OPERATIONS ELECTRIC OPERATING REVENUES (Thousands of Dollars): Residential ....................................... $ 157,019 $ 160,411 $ 160,345 Commercial ........................................ 149,767 144,952 144,717 Industrial ........................................ 64,662 58,391 62,067 Public street and highway lighting ................ 3,387 3,352 3,359 --------- --------- --------- Total retail electric revenue .................. 374,835 367,106 370,488 Transmission revenues ............................. 19,455 19,503 11,907 Other revenues .................................... 6,636 8,685 6,740 Transfer to Generation and Resources(1) ........... (184,381) (180,544) (180,018) --------- --------- --------- Total electric energy delivery revenues ........ $ 216,545 $ 214,750 $ 209,117 ========= ========= ========= ELECTRIC ENERGY SALES (Thousands of MWhs): Residential ....................................... 3,217 3,270 3,220 Commercial ........................................ 2,810 2,716 2,674 Industrial ........................................ 1,878 1,759 1,839 Public street and highway lighting ................ 24 24 24 --------- --------- --------- Total retail energy sales ...................... 7,929 7,769 7,757 ========= ========= ========= ELECTRIC AVERAGE HOURLY LOAD (aMW) ................... 971 954 973 ========= ========= ========= NUMBER OF ELECTRIC CUSTOMERS (Average for Period): Residential ....................................... 265,891 261,873 257,726 Commercial ........................................ 34,407 33,681 33,043 Industrial ........................................ 1,169 1,145 1,133 Public street and highway lighting ................ 383 371 363 --------- --------- --------- Total retail electric customers ................ 301,850 297,070 292,265 ========= ========= ========= ELECTRIC RESIDENTIAL SERVICE AVERAGES: Annual use per customer (KWh) ..................... 12,099 12,489 12,493 Revenue per KWh (in cents) ....................... 4.88 4.90 4.98 Annual revenue per customer ....................... $ 590.54 $ 612.55 $ 622.15 NATURAL GAS OPERATIONS NATURAL GAS OPERATING REVENUES (Thousands of Dollars): Residential ....................................... $ 92,614 $ 81,855 $ 85,904 Commercial ........................................ 49,539 42,731 51,006 Industrial - firm ................................. 3,685 3,563 3,949 Industrial - interruptible ........................ 1,639 512 1,131 --------- --------- --------- Total retail natural gas revenues .............. 147,477 128,661 141,990 Non-retail sales .................................. 24,846 19,559 9,862 Transportation .................................... 12,100 12,678 12,154 Other revenues .................................... 8,715 4,884 7,305 --------- --------- --------- Total natural gas energy delivery revenues ..... $ 193,138 $ 165,782 $ 171,311 ========= ========= ========= THERMS DELIVERED (Thousands of Therms): Residential ....................................... 187,571 182,037 183,927 Commercial ........................................ 122,263 118,494 132,744 Industrial - firm ................................. 11,494 12,509 12,757 Industrial - interruptible ........................ 6,053 3,217 4,174 --------- --------- --------- Total retail sales ............................. 327,381 316,257 333,602 Non-retail sales .................................. 126,522 105,297 67,656 Transportation .................................... 226,139 245,139 237,894 Interdepartmental sales and Company use ........... 32,647 2,087 22,215 --------- --------- --------- Total therms - sales and transportation ........ 712,689 668,780 661,367 ========= ========= ========= </TABLE> (1) Transfer to Generation and Resources represents the portion of revenues collected by Energy Delivery from retail customers attributable to the sale of the electric energy commodity delivered by Energy Delivery. 8
13 AVISTA CORPORATION - -------------------------------------------------------------------------------- <TABLE> <CAPTION> Years Ended December 31, --------------------------------------- 1998 1997 1996 --------- --------- --------- <S> <C> <C> <C> SOURCES OF NATURAL GAS SUPPLY (Thousands of Therms): Purchases ............................................. 491,100 431,646 422,194 Storage - injections .................................. (32,023) (31,288) (26,260) Storage - withdrawals ................................. 32,917 22,183 24,572 Natural gas for transportation ........................ 226,139 245,139 237,894 Distribution system gains (losses) .................... (5,444) 1,100 2,967 --------- --------- --------- Total supply ....................................... 712,689 668,780 661,367 ========= ========= ========= NET SYSTEM MAXIMUM CAPABILITY (Thousands of Therms): Net system maximum demand (winter) .................... 3,284 3,134 3,273 Net system maximum firm contractual capacity (winter) . 4,220 4,220 4,210 NUMBER OF NATURAL GAS CUSTOMERS (Average for Period): Residential ........................................... 226,165 214,927 203,245 Commercial ............................................ 28,236 27,171 25,747 Industrial - firm ..................................... 310 306 300 Industrial - interruptible ............................ 26 25 28 --------- --------- --------- Total retail customers ............................. 254,737 242,429 229,320 Non-retail sales ...................................... 19 17 7 Transportation ........................................ 119 111 93 --------- --------- --------- Total natural gas customers ........................ 254,875 242,557 229,420 ========= ========= ========= NATURAL GAS RESIDENTIAL SERVICE AVERAGES: Washington and Idaho Annual use per customer (therms) ................... 861 927 1,007 Revenue per therm (in cents) ....................... 44.97 40.44 41.90 Annual revenue per customer ........................ $ 387.17 $ 374.90 $ 421.91 Oregon and California Annual use per customer (therms) .................. 772 703 724 Revenue per therm (in cents) ...................... 58.32 55.71 58.55 Annual revenue per customer ........................ $ 450.13 $ 391.56 $ 424.00 HEATING DEGREE DAYS: ..................................... (1) Spokane, WA Actual ............................................. 5,951 6,510 7,477 30 year average .................................... 6,842 6,842 6,842 % of average ....................................... 87% 95% 109% Medford, OR Actual ............................................. 4,421 4,144 4,088 30 year average .................................... 4,611 4,611 4,611 % of average ....................................... 96% 90% 89% INCOME FROM ENERGY DELIVERY OPERATIONS (After tax) ........... $ 86,676 $ 77,788 $ 64,345 ========= ========= ========= </TABLE> (1) Heating degree days are the measure of the coldness of weather experienced, based on the extent to which the average of high and low temperatures for a day falls below 65 degrees Fahrenheit (annual degree days below historic average indicate warmer than average temperatures). 9
14 AVISTA CORPORATION - -------------------------------------------------------------------------------- GENERATION AND RESOURCES GENERAL The Generation and Resources line of business manages the Company's natural gas and electric energy resource portfolio, which is used to serve Energy Delivery's retail customers and Generation and Resources' wholesale customers. The primary business focus of Generation and Resources is to optimize the availability and operation of generation resources. The Company owns and operates eight hydroelectric projects, a wood-waste fueled generating station and two natural gas combustion turbine (CT) peaking units. See Item 2. Properties Generation and Resources for additional information. The Company also owns a 15% share in two coal-fired generating facilities and leases two additional gas CT peaking units. With this diverse energy resource portfolio, the Company remains one of the nation's lowest-cost producers and sellers of electric energy services. The Company's wholesale marketing and trading business units within the Generation and Resources line of business are a secondary, but very important part of the Company's overall business strategy. Since 1987, the Company has entered into a number of long-term power sales contracts that have increased its wholesale electric revenues, and the Company is continuing to actively pursue electric wholesale marketing and energy trading business opportunities. Energy trading includes short-term sales and purchases such as next hour, next day and monthly blocks of energy. Wholesale marketing includes sales and purchases under long-term contracts with one-year and longer terms. Wholesale sales are affected by weather and streamflow conditions and may eventually be affected by the restructuring of the electric utility industry. (See Industry Restructuring for additional information.) Generation and Resources competes in the wholesale electric market with other western utilities, federal marketing agencies and power marketers. The Company's participation in the wholesale electric market allows the Company to maintain presence in and knowledge of the market, resulting in maximum optimization of the Company's resources. The wholesale electric market has changed significantly over the last few years with respect to market participants, level of activity, variability of prices, and per-unit margins. These changes have contributed to the increased liquidity of the market, which in turn has increased transactional volumes in the market. It is expected that competition in the wholesale power market will remain vigorous. Challenges facing Generation and Resources include evolving technologies, which provide alternate energy supplies and deregulation of the retail electric market. The Company believes it faces minimal risk for stranded generation assets resulting from deregulation due to its low cost generation portfolio. However, in a deregulated environment, evolving technologies which provide alternate energy supplies could affect the market price of power, and certain generating assets could have operating costs above the adjusted market price. The Company continues to assess the costs and operation of its generation portfolio in order to optimize the resources of the Company. ELECTRIC REQUIREMENTS The Company's 1998 annual peak requirements, including long-term and short-term contractual obligations, were 4,765 MW. This peak occurred on December 21, 1998, at which time the maximum capacity available from the Company's generating facilities, including long-term and short-term purchases, was 4,991 MW. The electric requirements include both Energy Delivery's electric needs and Generation and Resources' wholesale short-term and long-term commitments, which limits the amount of excess capacity available to support Generation and Resources energy trading business. ELECTRIC RESOURCES The Company's diverse resource mix of hydroelectric projects, thermal generating facilities and power purchases and exchanges, combined with strategic access to regional electric transmission systems, enables the Company to remain one of the nation's lowest-cost producers and sellers of electric energy services. At December 31, 1998, the Company's total owned resources available were 58% hydroelectric and 42% thermal. See Generation and Resources Operating Statistics on page 13 for the Company's energy resource statistics. Hydroelectric Resources Hydroelectric generation is the Company's lowest cost source of electricity and the availability of hydroelectric generation has a significant effect on the Company's total energy costs. Under average operating conditions, the Company meets about one-third of its total energy requirements (both retail and long-term wholesale), with its own hydroelectric generation and long-term hydroelectric contracts. The streamflows to Company-owned hydroelectric projects were 94%, 172% and 145% of normal in 1998, 1997 and 1996, respectively. Total hydroelectric resources provide 524 aMW annually. Thermal Resources The Company has a 15% interest in each of two twin-unit coal-fired facilities - the Centralia Power Plant in western Washington and Units 3 and 4 of the Colstrip Generating Project in southeastern Montana. In addition, the Company owns a wood-waste-fired facility known as the Kettle Falls Generating Station in northeastern Washington and two natural gas-fired CTs, located in Spokane, used for peaking needs. The Company also operates and leases two natural gas-fired CTs in northern Idaho, used for peaking needs. Total thermal resources provide 339 aMW annually. 10
15 AVISTA CORPORATION - -------------------------------------------------------------------------------- Centralia, which is operated by PacifiCorp, is supplied with coal under both a fuel supply agreement in effect through December 2020 and various spot market purchases. In 1998, 1997 and 1996, Centralia provided approximately 37%, 38% and 46%, respectively, of the Company's thermal generation. (See Environmental Issues for additional information.) Colstrip is supplied with fuel under coal supply and transportation agreements in effect through December 2019 from adjacent coal reserves. The Montana Power Company is the operator of Colstrip. In 1998, 1997 and 1996, Colstrip provided approximately 46%, 47% and 34% of the Company's thermal generation, respectively. Kettle Falls' primary fuel is wood-waste generated as a by-product from forest industry operations within one hundred miles of the plant. Natural gas may be used as an alternate fuel. A combination of long-term contracts plus spot purchases provides the Company the flexibility to meet expected future fuel requirements for the plant. In 1998, 1997 and 1996, Kettle Falls provided approximately 9%, 11% and 10% of the Company's thermal generation, respectively. The four CTs are natural gas-fired units, primarily used for peaking needs. Two CTs have access to domestic and Canadian natural gas supplied through PGT. In 1998, 1997 and 1996, these four units provided approximately 8%, 4% and 10%, respectively, of the Company's thermal generation. Thermal generation from CTs during 1997 was lower than other years primarily due to the cost of natural gas as compared to alternative energy supplies. Purchases, Exchanges and Sales In 1998, the Company had various long-term purchase contracts with non-coincidental peak (peak that does not occur during the same hour) equating to 457 MW, with an average remaining life of 5.3 years. Additionally, long-term hydro purchase contracts of 197 MW peak were available with an average remaining contract life of 12.8 years. The Company also enters into a significant number of short-term sales and purchases with durations of up to one year. Energy purchases and exchanges for the years 1998, 1997 and 1996 provided approximately 70%, 65% and 54%, respectively, of the Company's total electric energy requirements, which reflects increased wholesale trading and resource optimization activity. Under PURPA, the Company is required to purchase generation from qualifying facilities, including small hydroelectric and cogeneration projects, at avoided cost rates adopted by the WUTC and the IPUC. The Company purchased approximately 563,000 MWH, or about 2% of the Company's total energy requirements, from these sources at a cost of approximately $27 million in 1998. These contracts expire in 1999-2022. HYDROELECTRIC RELICENSING The Company is a licensee under the Federal Power Act, which regulates certain of the Company's generation resources and is administered by the FERC, and its licensed projects are subject to the provisions of Part I of that Act. These provisions include payment for headwater benefits, condemnation of licensed projects upon payment of just compensation and take-over of such projects after the expiration of the license upon payment of the lesser of "net investment" or "fair value" of the project, in either case plus severance damages. All but one of the Company's hydroelectric plants are regulated by the FERC through project licenses issued for 30-50 year periods. See Item 2. Properties - Generation and Resources for additional information. The Cabinet Gorge and Noxon Rapids plants are currently in the process of relicensing with licenses expiring February 2001. The Company filed a Notice of Intent to relicense in 1996 and has since consulted with resource agencies, Native American tribes, special interest groups and the general public regarding its relicensing. The Company's approach to relicensing departed significantly from the conventional FERC process. Early FERC involvement and Environmental Impact Statement scoping occurred prior to the application and the consultation process was expanded to a comprehensive collaborative process including all stakeholders. The collaborative process used by the Company is nationally recognized as the model for FERC's alternative approach to relicensing. The Company reached a settlement agreement with all parties on January 28, 1999 that resolved all environmental, tribal, and operational issues regarding relicensing of Cabinet Gorge and Noxon Rapids. As part of the agreement, Avista Corp. committed to early implementation of protection, mitigation, and enhancement measures beginning in March 1999. Measures in the agreement which will cost approximately $4.7 million annually, address fisheries, water quality, wildlife, recreation, land use, cultural resources and erosion, and represents the results of studies and interests of over 40 organizations and 100 individuals. See Item 2. Properties - Generation and Resources and Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: Future Outlook for additional information. The license application for Cabinet Gorge and Noxon Rapids was filed with FERC on February 18, 1999 and included the settlement agreement signed by 27 parties and a collaboratively written environmental assessment report. For hydroelectric projects of this size, it is unprecedented to have reached settlement two years before the license expires, while preserving the projects economic peaking and load following operations. GENERATION AND RESOURCES REGULATORY ISSUES The Company, with respect to Generation and Resources, is subject to the jurisdiction of the FERC for its accounting procedures and its wholesale electric rates. Some wholesale electric rates are determined on a "cost-of-service" basis in a 11
16 AVISTA CORPORATION - -------------------------------------------------------------------------------- manner similar to retail rates. See Energy Delivery - Regulatory Issues for additional information. Generally, rates for wholesale electric sales by the Company for terms up to five years are based on market prices. 12
17 AVISTA CORPORATION - -------------------------------------------------------------------------------- GENERATION AND RESOURCES OPERATING STATISTICS <TABLE> <CAPTION> Years Ended December 31, --------------------------------------------- 1998 1997 1996 --------- --------- --------- <S> <C> <C> <C> ELECTRIC ENERGY RESOURCES (Thousands of MWhs): Hydro generation (from Company facilities) ... 3,860 4,863 5,045 Thermal generation (from Company facilities) . 3,522 2,627 2,764 Purchased power - long-term hydro ............ 910 1,212 1,170 Purchased power - other ...................... 19,405 16,038 10,641 Power exchanges .............................. 26 178 102 --------- --------- --------- Total power resources .................... 27,723 24,918 19,722 Energy losses and Company use ................ (579) (739) (790) --------- --------- --------- Total energy resources (net of losses) ... 27,144 24,179 18,932 ========= ========= ========= ELECTRIC ENERGY REQUIREMENTS (Thousands of MWhs): Energy Delivery .............................. 7,929 7,769 7,757 Long-term wholesale .......................... 3,680 4,307 4,507 Short-term wholesale ......................... 15,535 12,103 6,668 --------- --------- --------- Total energy requirements ................ 27,144 24,179 18,932 ========= ========= ========= RESOURCE AVAILABILITY at time of system peak (MW): Total requirements (winter) (1) .............. 4,765 4,226 3,180 Total resource availability (winter) ......... 4,991 4,684 3,340 Total requirements (summer) (2) .............. 5,093 4,345 2,978 Total resource availability (summer) ......... 5,340 4,766 3,357 ELECTRIC OPERATING REVENUES (Thousands of Dollars): Long-term wholesale .......................... $ 102,189 $ 138,730 $ 139,116 Short-term wholesale ......................... 349,674 187,190 91,443 Other revenues ............................... 3,285 4,669 7,989 Transfer from Energy Delivery (3) ............ 184,381 180,544 180,018 --------- --------- --------- Total electric energy trading revenues ... $ 639,529 $ 511,133 $ 418,566 ========= ========= ========= NUMBER OF ELECTRIC CUSTOMERS (Average for Period): Wholesale customers .......................... 85 91 60 ========= ========= ========= INCOME FROM GENERATION AND RESOURCES OPERATIONS (After tax) .................................. $ 21,148 $ 47,737 $ 65,048 ========= ========= ========= </TABLE> (1) Includes long-term contract obligations of 663 MW, 1,022 MW and 744 MW and 2,401 MW, 1,688 MW and 725 MW of short-term sales in 1998, 1997 and 1996, respectively. (2) Includes long-term contract obligations of 780 MW, 1,011 MW and 839 MW in 1998, 1997 and 1996, respectively, and short-term sales of 2,792 MW, 1,966 MW and 739 MW in 1998, 1997 and 1996, respectively. (3) Transfer from Energy Delivery represents the portion of revenues collected by Energy Delivery from retail customers attributable to the sale of the electric energy commodity delivered by Energy Delivery. 13
18 AVISTA CORPORATION - -------------------------------------------------------------------------------- NATIONAL ENERGY TRADING AND MARKETING The companies within the National Energy Trading and Marketing line of business are Avista Energy, Avista Advantage and Avista Power, each of which is a wholly-owned subsidiary of Avista Capital. Avista Capital's total equity investment in this line of business was approximately $104.6 million on December 31, 1998. Avista Energy Avista Energy is one of the nation's fastest growing electricity and natural gas marketing and trading companies. Avista Energy's headquarters are in Spokane, Washington with offices in Houston, Texas; Boston, Massachusetts; Vancouver, British Columbia, Canada; and Portland, Oregon. Avista Energy is in the business of buying and selling natural gas and electricity. Avista Energy purchases natural gas and electricity directly from producers and other trading companies, and Avista Energy's customers include commercial and industrial end-users, electric utilities, natural gas distribution companies and other trading companies. Avista Energy also trades natural gas and electricity derivative financial instruments, including futures, options, swaps and other contractual arrangements on national exchanges and through other unregulated exchanges and brokers from whom these commodity derivatives are available. In 1998, Avista Energy sold approximately 54.4 million MWh of electric energy and 424.2 million dekatherms of natural gas. This compares with approximately 4.5 million MWh of electric energy and 67.3 million dekatherms of natural gas during five months of operations in 1997. Avista Energy's business is affected by several factors, including: o the demand for and availability of energy throughout the United States, o lower unit margins on new sales contracts, o fewer long-term power contracts being entered into, resulting in a heavier reliance on short-term power contracts which have lower margins than long-term contracts, o marginal fuel prices, and o deregulation of the electric utility industry Avista Energy operates in North America, principally within the West and Mid-West United States and Western Canada. Avista Energy seeks to strengthen its position of leadership in energy trading and marketing on a regional and national basis through a focus on acquisitions and strategic alliances. Avista Energy has entered new markets throughout North America, and will continue to strategically acquire additional assets and customers. Effective February 1, 1999, Avista Energy purchased Vitol Gas & Electric, LLC, one of the top 20 energy marketing companies in the United States. With this acquisition, Avista Energy now has an additional platform from which it can further grow its national presence. The combined operation expands Avista Energy's successful coast-to-coast commercial energy platform to the eastern seaboard. On December 16, 1998, Avista Energy Canada, Ltd., a wholly-owned subsidiary of Avista Energy, acquired Coast Pacific Management, Inc. (Coast Pacific), a natural gas marketing company based in Vancouver, British Columbia, Canada. Coast Pacific manages and transports approximately 70,000 MMBtu of natural gas per day to some 70 large and medium size industrial customers throughout British Columbia. Coast Pacific acts as gas manager for more than 40 percent of the large industrial market in the interior of British Columbia. The Coast Pacific acquisition strengthened Avista Energy's Canadian operations with more access to end-use customers, ties with British Columbia natural gas producers and expanded Avista Energy's presence in Pacific Northwest natural gas markets. In April 1997, Avista Energy contracted with Chelan County Public Utility District (Chelan PUD), located in Washington State. The terms of the alliance made this announcement the first of its kind in the Northwest. The agreement allows the Company to market, on a "real-time" basis, a portion of the significant output from Chelan PUD's hydroelectric resources and to jointly market energy products and services to other utilities in the region. Twenty-eight percent or 557 megawatts of total generated capacity of the dams are available for real-time scheduling and resource optimization. The two entities offer a variety of products, all designed to help smaller utilities adjust to the emerging energy market. On October 20, 1997, a complaint for declaratory and injunctive relief was filed in Chelan County Superior Court by James A. Brown, a taxpayer and ratepayer of the District, in order to determine whether the joint marketing and real-time scheduling efforts of Chelan PUD and Avista Energy are within Chelan PUD's lawful authority to undertake. Avista Energy and Chelan PUD continue to operate under the contractual alliance. The outcome of this litigation is still pending and Avista Energy is unable to assess the likelihood of an adverse outcome or estimate an amount or range of potential loss in the event of an adverse outcome. In June 1997, Avista Energy formed an alliance with Energy West Incorporated, a diversified energy and retail propane company in Montana, to develop and implement a direct access, retail power marketing business in Montana. The alliance has not been active since its formation and both companies have agreed to discontinue the alliance in 1999. Effective November 30, 1998, Avista Energy sold its 50% ownership interest in Howard/Avista Energy, LLC to H&H Star Energy, Inc. The sales price, which represented Avista Energy's equity investment, was $25 million in the form of a short term unsecured note receivable from H&H Star Energy, Inc. The Note is guaranteed by H&H Star Energy, Inc.'s parent 14
19 AVISTA CORPORATION - -------------------------------------------------------------------------------- company, Howard Publications, Inc and is due April 30, 1999. In 1997, Avista Energy entered into a contract with Mock Energy Services to form Avista/Mock Energy, LLC to provide integrated energy services to customers throughout the state of California. Avista Energy agreed to the dissolution of Avista/Mock Energy, LLC and affairs were wound up November 30, 1998. Avista/Mock Energy, LLC conducted no business. All related costs of this investment were recognized in 1998. The participants in the emerging wholesale energy market are public utility companies and, increasingly, power marketers which may or may not be affiliated with public utility companies or other entities. The participants in this market trade not only electricity and natural gas as commodities but also derivative commodity instruments such as futures, forwards, swaps, options and other instruments. This market is largely unregulated and most transactions are conducted on an "over-the-counter" basis, there being no central clearing mechanism (except in the case of specific instruments traded on the commodity exchanges). Power marketers, whether or not affiliated with other entities, generally do not own production facilities and are not subject to net capital or other requirements of any regulatory agency. Avista Energy is subject to the various risks inherent in commodity trading including, particularly, market risk and credit risk. Avista Capital provides guarantees for Avista Energy's line of credit agreement, and in the course of business may provide guarantees to other parties with whom Avista Energy may be doing business. Refer to Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: Results of Operations: National Energy Trading and Marketing Operations and Notes 1, 3 and 4 of Notes to Financial Statements for additional information regarding the market and credit risks inherent in the energy trading business, the Company's and Avista Energy's risk management policies and procedures, accounting practices and positions held at December 31, 1998. Avista Advantage Avista Advantage is a leading provider of Internet-based specialty billing and information services. Avista Advantage has established itself as a leader in the development and implementation of customer-focused, non-traditional energy solutions. Avista Advantage has developed a distinctive line of services that starts with a proprietary customer information system. The system impacts the customer's bottom line by providing four valuable tools in one: a consolidated billing tool; an accounting/auditing tool; an energy management tool; and a deregulation tool. Avista Advantage conveniently delivers all of these services through the Internet using the ACIS (Advantage Customer Internet Site) system. The ACIS product creates a flexible paperless reporting system. Avista Advantage offers consolidated bill payment and analytical services for customers' maintenance and repair bills. Avista Advantage is the only company in the energy services industry to offer its customers this service. Avista Power Avista Power was created in December 1998 to develop and own generation assets, primarily in support of Avista Energy's commodity trading activities. Avista Power and Cogentrix Energy, Inc. have entered into an agreement to jointly build and/or buy interests in natural gas-fired electric generation plants in the Pacific Northwest states of Washington, Oregon and Idaho. The first project under the new agreement is an approximately 270 megawatt facility to be located in Rathdrum, Idaho. The total cost of the project is estimated at $150 million; Avista Power's share of the costs is approximately $75 million. 15
20 AVISTA CORPORATION - -------------------------------------------------------------------------------- NATIONAL ENERGY TRADING AND MARKETING OPERATING STATISTICS <TABLE> <CAPTION> Years Ended December 31, -------------------------- 1998 1997 --------- ------- <S> <C> <C> AVISTA ENERGY REVENUES (Thousands of Dollars): Natural gas marketing ....................... 743,386 135,684 Electric power marketing .................... 1,665,348 111,344 --------- ------- Total revenues ........................... 2,408,734 247,028 ========= ======= VOLUMES: Natural gas (Thousands of Therms) ........... 424,152 67,319 Electricity (Thousands of MWhs) ............. 54,430 4,540 </TABLE> 16
21 AVISTA CORPORATION - -------------------------------------------------------------------------------- NON-ENERGY BUSINESS Pentzer, which is a wholly-owned subsidiary of Avista Capital, is the dominant company in the Non-energy line of business. At December 31, 1998, Avista Capital's total equity investment in this line of business was approximately $167.2 million, of which $140.1 million related to Pentzer. Pentzer Pentzer is the parent company for a majority of Avista Corp.'s non-utility subsidiaries. Pentzer's portfolio of investments includes companies involved in consumer product promotion, store fixtures, specialty tool manufacturing, metal fabrication, financial services and electronic technology. Pentzer's current investment profile focuses on manufacturers and distributors of industrial and consumer products as well as service businesses. The Company seeks businesses with above average records of earnings growth in industries that are not cyclical or dependent upon high levels of research and development. Emphasis is placed on leading companies with strong market franchises, dominant or proprietary product lines or other significant competitive advantages. Pentzer is particularly interested in companies serving niche markets. Total equity investment in any one company is generally limited to $15 million, and control of the acquired company's board of directors is generally required. Pentzer's business strategy is to acquire controlling interest in a broad range of middle-market companies, to help these companies grow through internal development and strategic acquisitions, and to sell the portfolio investments either to the public or to strategic buyers when it becomes most advantageous in meeting Pentzer's return on invested capital objectives. Pentzer's goal is to produce financial returns for the Company's shareholders that, over the long-term, should be higher than that of the utility operations. From time to time, a significant portion of Pentzer's earnings contributions may be the result of transactional gains. Transactional gains arise from a one-time event or a specific transaction, such as the sale of an investment or individual company from Pentzer's portfolio of investments. Non-transactional earnings arise out of the ongoing operations of the individual portfolio companies. Accordingly, although the income stream is expected to be positive, it is not predictable from year to year and may be uneven. Other Non-Energy Companies Other non-energy subsidiaries under Avista Capital include Avista Development, Avista Labs, Avista Communications and Avista Fiber. Avista Development manages and markets the corporation's community investments, including real-estate and other assets. Avista Labs develops fuel cells and multiple fuel processing approaches using propane, methane and methanol as base fuels to integrate into its fuel cell subsystem. In September 1998, Avista Labs was awarded a $2.0 million technology development grant from the Department of Commerce's National Institute of Standards and Technology Advanced Technology Program to fund continuing research in alternate power solutions. Avista Communications, formed in January 1999, is the newest of the non-energy subsidiaries. It will provide local high-speed telecommunications services to under-served Northwest communities. Avista Communications is a sister company to Avista Fiber, which focuses on building high-speed local dark fiber networks in Northwest communities. Refer to Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: Results of Operations: Non-Energy Operations and Notes 1 and 21 of Notes to Financial Statements for additional information. 17
22 AVISTA CORPORATION - -------------------------------------------------------------------------------- INDUSTRY RESTRUCTURING FEDERAL LEVEL Industry restructuring to remove certain barriers to competition in the electric utility industry was initially promoted by federal legislation. The Energy Policy Act of 1992 (Energy Act) confers expanded authority upon the FERC to issue orders requiring electric utilities to transmit power and energy to or for wholesale purchasers and sellers, and to require electric utilities to enlarge or construct additional transmission capacity for the purpose of providing these services. The FERC issued its final rule in Order No. 888 in April 1996. That order requires public utilities operating under the Federal Power Act to provide access to their transmission systems to third parties pursuant to the terms and conditions of the FERC's pro-forma open access transmission tariff. Utilities were required to file an open access tariff, allowing only limited variations to the pro-forma tariff to reflect regional operating practices. Utilities were also required to take transmission service under this same tariff. The Company filed its open access tariff with the FERC in July 1996 and subsequently began providing transmission service under the tariff. The FERC issued its initial order accepting the non-rate terms and conditions of the Company's tariff in November 1996. In the FERC's Order No. 889, the companion rule to Order No. 888, the FERC required public utilities to establish a system, OASIS, to provide transmission customers with information about available transmission capacity, prices and other information, by electronic means. This enables customers to obtain transmission service in a non-discriminatory fashion. The final rule requires each public utility subject to the rule to functionally separate its transmission and wholesale power merchant functions, and prescribed standards of conduct under which it assures that the utility's wholesale power merchant function and competitors obtain information about its transmission system in the same manner. The Company filed its "Procedures for Implementing Standards of Conduct under FERC Order No. 889" with the FERC in December 1996 and adopted these Procedures effective January 3, 1997. FERC Orders No. 888 and No. 889 have not had a significant material effect on the operating results of the Company. The Company and various Northwest utilities began investigating the feasibility of transferring certain operational responsibilities associated with a regional transmission grid to an independent grid operator. In November 1997, the Company withdrew from the effort to establish an independent grid operator in the Northwest because the costs were greater than the perceived benefits. The Company is exploring other regional transmission alternatives intended to help facilitate a competitive electric power market, including the development of an independent grid scheduling entity which might provide quantifiable efficiencies in administering access to the Northwest transmission system in a non-discriminatory fashion. The North American Electric Reliability Council and the WSCC have undertaken initiatives to establish a series of security coordinators to oversee the reliable operation of the regional transmission system. Accordingly, the Company, in cooperation with other utilities in the Pacific Northwest, has established the Pacific Northwest Security Coordinator (PNSC) which will oversee daily and short-term operations of the northwest sub-regional transmission grid, and have limited authority to direct certain actions of control area operators in the case of a pending transmission system emergency. The Company executed its service agreement with the PNSC in September 1998. The PNSC is currently operating in a limited fashion and is expected to be fully operational by May 1999. STATE LEVEL Further competition may be introduced by state action. Competition for retail customers is not generally allowed in the Company's service territory. While the Energy Act precludes the FERC from mandating retail wheeling, state regulators and legislators could open service territories to full competition at the retail level. Legislative action at the state level would be required for full retail wheeling to occur in Washington and Idaho. During 1997, the Idaho Legislature enacted legislation requiring the IPUC to compile utilities' costs separately by generation, transmission and distribution. Early in 1998, the IPUC opened individual cases for each of the investor owned utilities and pursued audits of their cost of service studies, including results of operations, methodology, and allocations. In August 1998, the Commission ordered the cases closed, concluding that these studies met the legislative requirement and that further examination of unbundled costs would be more appropriate in general rate proceedings. Two restructuring "study bills" were adopted in the 1998 Washington Legislative session covering examination of cost unbundling, development and disclosure of consumer protection policies, and studies of deregulation and system reliability. The first study bill, known as "ESSHB2831", was implemented by the WUTC as a collaborative effort, including stakeholders, to examine unbundling and related issues. Unbundling would require utilities to compile costs separately by generation, transmission and distribution. In September 1998, unbundled cost filings were submitted by Washington's investor-owned utilities and by various public utilities that met certain size or customer density parameters. The WUTC staff and the State Auditor jointly reviewed the studies and prepared a report presenting the results of the individual utilities' studies. The report was prepared in a format intended to allow the legislature to analyze the potential impacts of restructuring and deregulation. The WUTC staff summary report did not include recommendations for restructuring, it merely presented pros and cons of restructuring on an issue by issue basis. From this, the legislature will determine whether or not to pursue changes in the laws governing the industry. 18
23 AVISTA CORPORATION - -------------------------------------------------------------------------------- The second study bill "ESSB 6560" called for the examination of potential quality of service, public purposes (e.g. conservation) and reliability issues resulting from electric restructuring. The WUTC and the Washington Department of Community, Trade and Economic Development launched the study, which was intended to assist in the determination of appropriate reliability measures and the feasibility of statewide compliance standards. Direct recommendations to the legislature for implementation were not included, rather the focus was on a "macro" analysis of the utilities' existing operations and theoretical impacts on customer service quality and system reliability (generation, transmission, and distribution) under various restructuring scenarios. In 1998, the WUTC closed its Electric Industry Restructuring Inquiry initiated in December 1995. The WUTC issued eight guiding principles including, a directive that future WUTC regulatory oversight will balance such issues as reliability, pricing responsive to customers needs and selected public policy concerns. The Company has developed a model offering broader customer choice to small customers. The Portfolio Access Model (PA Model) was developed as a transition to full direct access. Under the PA Model, large-use customers would receive direct access; small-use customers would be provided a menu of services priced at market rates such as monthly and annual pricing, as well as optional "green rates" for renewable power. The PA Model has served as a regional proposal under discussion by legislative committees and work groups in Washington, Idaho and Oregon. More Options for Power Services II (MOPS II) is the Company's PA Model regulatory pilot. (See Experimental Programs below for additional information.) On December 31, 1997, the Company filed an application for exemption from the California Public Utilities Commission's Affiliate Transaction Rules. These rules require that a utility's energy marketing affiliates follow detailed operating and reporting protocols as well as full separation from the regulated entity for any business activity in California. On January 20, 1999, the CPUC granted the Company a full exemption to these rules, providing that the Company complies with its voluntary agreement that none of its affiliates will participate in its South Lake Tahoe service territory. The Company will also provide periodic reports from an independent auditor verifying that its affiliates have not participated within this service territory. EXPERIMENTAL PROGRAMS To assess impacts of competition and customer choice, the Company implemented the following experimental programs: Direct Access and Delivery Service Tariff (DADS), More Options for Power Services (MOPS) tariff and More Options for Power Services II (MOPS II) tariff. The Company has received regulatory approval to defer all costs incurred from implementing the MOPS and MOPS II pilot programs. In each case, the Company may lose some margin. However, the Company experienced a margin gain of $250,000 in 1998, due to electric market prices. Direct Access and Delivery Service Tariff (DADS) To proactively respond to the potential regulatory change of customer choice in the electric business, the Company filed the DADS tariff to better understand how customer choice could affect the Company and its large industrial customers. The Company concluded its Direct Access and Delivery Service pilot (DADS-Schedule 26) in August 1998, which was one of the first open-access pilots in the U.S. The pilot was a two-year experiment that allowed twenty-six of the Company's largest customers to purchase up to one-third of their energy requirements from an energy supplier other than Avista Corp. Ten of the fifteen eligible Washington customers and five of the eleven eligible Idaho customers participated in the pilot. The Company agreed to absorb any of the resulting lost margin on the commodity no longer supplied by the Company. The pilot provided useful information to the company, participants, suppliers and other interested parties. As echoed in the responses to the customer surveys, even many of the Company's largest customers are not ready to embrace an open-access environment because of concerns regarding reliability and potential price volatility. More Options for Power Services (MOPS) A MOPS experimental tariff was filed in February 1997 with the WUTC and IPUC to help the Company assess the potential benefits of direct access for its electric residential and commercial customers and to collect information that will assist in the transition to customer choice for those classes of customers. The pilot allows only the customers in the towns of Odessa and Harrington, Washington to participate. This trial tariff is effective through June 30, 1999. Since its implementation date of July 1, 1997, 25% of the 980 eligible customers have elected Grant County PUD as their supplier. This represents a bill savings of approximately 6% - 10% to customers. Originally, six power marketers signed up to participate; all but Grant County PUD withdrew upon California's announcement of full direct access by January 1, 1998. 19
24 AVISTA CORPORATION - -------------------------------------------------------------------------------- More Options for Power Services II (MOPS II) While MOPS allowed customers to purchase from alternative energy suppliers, MOPS II provides access to the Company's portfolio of traditional service, monthly market, annual market and renewable resource pricing. (See PA Model above for additional information.) Approximately 7,300 customers in the towns of Deer Park, Washington and Hayden, Idaho were able to elect alternative energy service from the Company as of July 1998. The Company received approval on this program on December 31, 1997 and January 27, 1998 from the WUTC and IPUC, respectively. This trial tariff is effective through mid-2000. Avista Utilities' average production cost for a Washington residential customer is 2.37 cents/kWh. For customers to save money under MOPS II, the average monthly or annual market prices would need to be below this rate. During the first eight months of MOPS II implementation, electric market rates were above Avista Utilities' average retail rate in every month except February 1999. Thus, participation in the annual and monthly market options has been low, with only 69 customers. Participation in the renewable resource offerings was also low. 20
25 AVISTA CORPORATION - -------------------------------------------------------------------------------- ENVIRONMENTAL ISSUES The Company is subject to environmental regulation by federal, state and local authorities. The generation, transmission, distribution, service and storage facilities in which the Company has an ownership interest have been designed to comply with all environmental laws presently applicable. Furthermore, the Company conducts periodic reviews of all its facilities and operations to anticipate emerging environmental issues. The Company's Board of Directors has an Environmental Committee to deal specifically with these issues. Air Quality. The Company continues to assess both the potential and actual impact of the 1990 Clean Air Act Amendments (CAAA) on the thermal generating plants in which it maintains an ownership interest. Centralia, which is operated by PacifiCorp, is classified as a "Phase II" coal-fired plant under the CAAA and, as such, will be required to reduce sulfur dioxide (SO2) emissions. Centralia is also impacted by "visibility impairment" issues related to Mt. Rainier National Park in southwestern Washington, which requires additional reductions in emissions. A RACT (Reasonably Available Control Technology) order was issued by SWAPCA (Southwest Washington Air Pollution Control Agency) which requires a reduction in SO2 emissions of approximately 90% by the year 2000. The standards in the RACT order were established by a collaborative decision-making group consisting of representatives from federal and state agencies and the plant owners. The owners of the Centralia project have collectively offered the plant for sale through an auction process. Bids are being accepted until April 19, 1999. Should the owners not accept any bid, the remaining options include bringing the units into compliance with provisions of the CAAA through adding scrubbers or some other SO2 removal process. Plant closure will be another option if economics prove it to be a viable option. The Company's estimated share of this option would be incurred over several years and is currently estimated to be $35 million of capital costs. These estimates of future obligations are included in the projected Total Company Cash Requirements in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: Liquidity. Colstrip, which is also a "Phase II" coal-fired plant and is operated by Montana Power, is not expected to be required to implement any additional SO2 mitigation in the foreseeable future in order to continue operations. Reduction in nitrogen oxides (NOX) will be required at both Centralia and Colstrip prior to the year 2000. The anticipated share of costs for NOX compliance are not expected to have a major economic impact on the Company. The Company's other thermal projects also are subject to various CAAA standards. Every five years each project requires an updated operating permit (known as a Title V permit) which addresses, among other things, the compliance of the plant with the CAAA. The permit for the Spokane CTs was received in 1995. The permit for the Company's Kettle Falls plant was issued in 1996. The operating permit application for the Rathdrum CTs in northern Idaho received approval and was issued in 1997. Refer to Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: Future Outlook and Note 20 to Financial Statements for additional information. 21
26 AVISTA CORPORATION - -------------------------------------------------------------------------------- ITEM 2. PROPERTIES ENERGY DELIVERY Electric Distribution and Transmission Plant The Company operates approximately 12,200 miles of primary and secondary distribution lines in its electric system in addition to a transmission system of approximately 550 miles of 230 kV line and 1,550 miles of 115 kV line. The Company also owns a 10% interest in 495 miles of a 500 kV line between Colstrip, Montana and Townsend, Montana, and a 15% interest in three miles of a 500 kV line from Centralia, Washington to the nearest Bonneville Power Administration (Bonneville) interconnection. The 230 kV lines are used to transmit power from the Company's Noxon Rapids and Cabinet Gorge hydroelectric generating stations to major load centers in the Company's service area as well as to transfer power between points of interconnection with adjoining electric transmission systems. These lines interconnect with Bonneville at five locations and at one location each with PacifiCorp, Montana Power and Idaho Power Company. The Bonneville interconnections serve as points of delivery for power from the Colstrip and Centralia generating stations as well as for the interchange of power with entities outside the Pacific Northwest. The interconnection with PacifiCorp is used to integrate Mid-Columbia hydroelectric generating facilities to the Company's loads as well as for the interchange of power with entities within the Pacific Northwest. The 115 kV lines provide for transmission of energy as well as providing for the integration of the Spokane River hydroelectric and Kettle Falls wood-waste generating stations with service area load centers. These lines interconnect with Bonneville at nine locations, Grant County Public Utility District (PUD), Seattle City Light and Tacoma City Light at two locations and one interconnection each with Chelan County PUD, PacifiCorp and Montana Power. Natural Gas Plant The Company has natural gas distribution mains of approximately 3,897 miles in Washington and Idaho and 1,755 miles in Oregon and California, as of December 31, 1998. The Company, NWP and Puget Sound Energy each own a one-third undivided interest in the Storage Project, which has a total peak day deliverability of 5.7 million therms, with a total working natural gas inventory of 155.2 million therms. 22
27 AVISTA CORPORATION - -------------------------------------------------------------------------------- GENERATION AND RESOURCES The Company's electric generation properties, located in the States of Washington, Idaho and Montana, include the following: Generating Plant <TABLE> <CAPTION> Nameplate Present Year of No. of Rating Capability FERC License Units (MW)(1) (MW)(2) Expiration --------- --------- ------------- ------------ <S> <C> <C> <C> <C> Hydroelectric Generating Stations (River) Washington: Long Lake (Spokane) 4 70.0 83.0 2007 Little Falls (Spokane) 4 32.0 36.0 N/A Nine Mile (Spokane) 4 26.4 29.0 2007 Upper Falls (Spokane) 1 10.0 10.2 2007 Monroe Street (Spokane) 1 14.8 14.8 2007 Meyers Falls (Colville) 2 1.2 1.3 2023(6) Idaho: Cabinet Gorge (Clark Fork) 4 221.9 236.0 2001(3) Post Falls (Spokane) 6 14.8 18.0 2007 Montana: Noxon Rapids (Clark Fork) 5 466.2 528.0 2001(3) ------- ------ Total Hydroelectric 857.3 956.3 Thermal Generating Stations Washington: Centralia(4) 2 199.5 201.0 Kettle Falls 1 50.7 48.0 Northeast (Spokane) CT(5) 2 61.2 69.0 Idaho: Rathdrum CT(5) 2 167.0 176.0 Montana: Colstrip (Units 3 and 4)(4) 2 233.4 222.0 ------- ------- Total Thermal 711.8 716.0 Total Generation Properties 1,569.1 1,672.3 ======= ======= </TABLE> N/A Not applicable. (1) Nameplate Rating, also referred to as "installed capacity", is the manufacturer's assigned power rating under specified conditions. (2) Capability is the maximum generation of the plant without exceeding approved limits of temperature, stress and environmental conditions. (3) The formal relicensing process began in September 1995 for Cabinet Gorge and Noxon Rapids. (See Generation and Resources - Hydroelectric Relicensing for additional information.) (4) Jointly owned; data above refers to Company's respective 15% interests. (5) Used primarily for peaking needs. (6) Sold in early 1999. ITEM 3. LEGAL PROCEEDINGS In December 1996, the Company filed a Complaint for declaratory relief and money damages against Underwriters at Lloyds of London (Lloyds) in Spokane County Superior Court. The purpose of this action was to seek a declaration of the insurance policies issued to the Company by Lloyds with respect to any liabilities of the Company for environmental damage associated with the oil spill at the Central Steam Plant and other environmental remediation efforts. The policies at issue were in effect during the period between 1926 and 1966; thereafter, the Company maintained its policies with another underwriter, Aegis. The Company's Complaint sought money damages in excess of $16 million. On March 10, 1999, Avista Corp. and Lloyds signed a settlement agreement resolving the claim. Refer to Note 20 of Notes to Financial Statements and Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations, Future Outlook: Other for additional information on this and other legal proceedings. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. 23
28 AVISTA CORPORATION - -------------------------------------------------------------------------------- PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Outstanding shares of Common Stock are listed on the New York and Pacific Stock Exchanges. As of February 26, 1999, there were approximately 23,758 registered shareholders of the Company's no par value Common Stock. See Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: Future Outlook for additional information about common stock dividends. Refer to Notes 1 and 17 of Notes to Financial Statements for additional information. For high and low stock price information, refer to Note 23 of Notes to Financial Statements. 24
29 AVISTA CORPORATION - -------------------------------------------------------------------------------- ITEM 6. SELECTED FINANCIAL DATA <TABLE> <CAPTION> Years Ended December 31, --------------------------------------------------------------------------------------- 1998 1997 1996 1995 1994 ----------- ----------- ----------- ----------- ----------- (Thousands of Dollars except Per Share Data and Ratios) <S> <C> <C> <C> <C> <C> Operating Revenues: Energy Delivery and Generation and Resources * ....... $ 1,041,716 $ 890,516 $ 798,994 $ 661,216 $ 608,067 National Energy Trading and Marketing 2,409,920 247,646 116 -- -- Non-energy ........................... 232,348 164,010 145,847 93,793 62,698 ----------- ----------- ----------- ----------- ----------- Total ................................ 3,683,984 1,302,172 944,957 755,009 670,765 Operating Income/(Loss): Energy Delivery and Generation and Resources * ....... 143,153 178,289 173,658 176,344 149,051 National Energy Trading and Marketing 19,922 2,191 (1,801) -- -- Non-energy ........................... 9,745 8,984 15,064 13,496 6,407 ----------- ----------- ----------- ----------- ----------- Total ................................ 172,820 189,464 186,921 189,840 155,458 Net Income/(Loss): Energy Delivery and Generation and Resources * ......... 56,297 100,777(3) 62,404 72,310 63,567 National Energy Trading and Marketing 12,064 2,488 (1,161) -- -- Non-energy ........................... 9,778 11,532 22,210 14,811 13,630 ----------- ----------- ----------- ----------- ----------- Total ................................ 78,139 114,797 83,453 87,121 77,197 Preferred Stock Dividend Requirements .. 8,399(1) 5,392 7,978 9,123 8,656 Income Available for Common Stock ...... 69,740 109,405(3) 75,475 77,998 68,541 Outstanding Common Stock (000s): Weighted Average ..................... 54,604(1) 55,960 55,960 55,173 53,538 Year-End ............................. 40,454(1) 55,960 55,960 55,948 54,421 Book Value per Share ................... $ 12.07(1) $ 13.36 $ 12.70 $ 12.82 $ 12.45 Earnings per Share: Energy Delivery and Generation and Resources ........... 0.88 1.71(3) 0.97 1.14 1.03 National Energy Trading and Marketing 0.22 0.04 (0.02) -- -- Non-energy ........................... 0.18 0.21 0.40 0.27 0.25 ----------- ----------- ----------- ----------- ----------- Total, Basic and Diluted ............. 1.28(1) 1.96(3) 1.35 1.41 1.28 Dividends Paid per Common Share ...... 1.05(2) 1.24 1.24 1.24 1.24 Total Assets at Year-End: Energy Delivery and Generation and Resources ........... 2,004,935 1,926,739 1,921,429 1,869,180 1,817,815 National Energy Trading and Marketing 957,421 214,630 899 -- -- Non-energy ........................... 291,280 270,416 254,970 229,722 176,438 ----------- ----------- ----------- ----------- ----------- Total .................................. 3,253,636 2,411,785 2,177,298 2,098,902 1,994,253 Long-term Debt at Year-End ............. 730,022 762,185 764,526 738,287 721,146 Company-Obligated Mandatorily Redeemable Preferred Trust Securities 110,000 110,000 -- -- -- Preferred Stock Subject to Mandatory Redemption at Year-End ............... 35,000 45,000 65,000 85,000 85,000 Convertible Preferred Stock ............ 269,227(1) -- -- -- -- Ratio of Earnings to Fixed Charges ..... 2.66 3.49 2.97 3.22 3.24 Ratio of Earnings to Fixed Charges and Preferred Dividend Requirements ........ 2.25 3.12 2.50 2.61 2.59 </TABLE> * Energy Delivery and Generation and Resources figures contain some minor consolidating intersegment eliminations. (1) The change from 1997 was affected by the conversion of shares of common stock for Convertible Preferred Stock. The 1998 earnings per share would have been $1.35 had the conversion occurred on January 1, 1998. (See Notes 14 and 18 of Notes to Financial Statements for additional information.) (2) The Company reduced its common stock dividend from the $0.31 per share paid in each of the first three quarters of the year to $0.12 per share in the fourth quarter of 1998. (3) Includes the $41.4 million after-tax effect of the income tax recovery (see Note 8 of Notes to Financial Statements for additional information). 25
30 AVISTA CORPORATION - -------------------------------------------------------------------------------- ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Avista Corporation (Avista Corp. or the Company), formerly The Washington Water Power Company, operates as a regional utility providing electric and natural gas sales and services and as a national entity providing both energy and non-energy products and services. The utility portion of the Company, doing business as Avista Utilities, consists of two lines of business which are subject to state and federal price regulation -- (1) Energy Delivery and (2) Generation and Resources. The national businesses are conducted under Avista Capital, which is the parent company to the Company's subsidiaries. The Energy Delivery line of business includes transmission and distribution services for retail electric operations, all utility natural gas operations, and other energy products and services. Costs associated with electric energy commodities, such as purchased power expense, as well as the revenues attributable to the recovery of such costs from retail customers, have been eliminated from the Energy Delivery line of business and are reflected in the results of the Generation and Resources line of business. The results of all natural gas operations are included in the Energy Delivery line of business because natural gas trackers allow natural gas costs to pass through within this line of business without the commodity prices having a material income effect. Usage by retail customers varies from year to year primarily as a result of weather conditions, customer growth and the economy in the Company's service area. Other factors which may influence long-term energy usage include conservation efforts, appliance efficiency and other technology. The Generation and Resources line of business includes the generation and production of electric energy, and short- and long-term electric and natural gas sales trading and wholesale marketing, primarily to other utilities and power brokers in the Western Systems Coordinating Council (WSCC). Energy trading includes short-term sales and purchases, such as next hour, next day and monthly blocks of energy. Wholesale marketing includes sales and purchases under long-term contracts with one-year and longer terms. Generation and Resources manages the Company's electric energy resource portfolio, which is used to serve Energy Delivery's retail electric customers and Generation and Resources' wholesale electric customers. In managing the electric energy resource portfolio, Generation and Resources seeks to optimize the availability and operations of generation resources. Revenues and the cost of electric power purchases vary from year to year depending on the electric wholesale power market, which is affected by several factors, including the availability of water for hydroelectric generation, the availability of base load plants in the region, marginal fuel prices and the demand for power in other areas of the country. Other factors affecting the wholesale power market include lower unit margins on new sales contracts than were realized in the past, fewer long-term power contracts being entered into, deregulation of the electric utility industry and competition from low cost generation being developed by independent power producers. Avista Capital is the parent company to the National Energy Trading and Marketing and Non-energy businesses. In order to proactively respond to deregulation, the Company created the National Energy Trading and Marketing line of business, which is comprised of Avista Energy, Avista Advantage and Avista Power. Avista Energy focuses on commodity trading, energy marketing and other related businesses on a national basis, which includes conducting business within the WSCC. Avista Energy's business is affected by several factors, including the demand for and availability of power throughout the United States, lower unit margins on new sales contracts, fewer long-term power contracts being entered into, marginal fuel prices and deregulation of the electric utility industry. Avista Advantage provides a variety of energy-related products and services to commercial and industrial customers on a national basis. Its primary product lines include consolidated billing, resource accounting, energy analysis and load profiling. Avista Power was formed in December 1998 to develop and own generation assets primarily in support of Avista Energy. See Liquidity and Capital Resources: Energy Trading Business and Risk Management. The Non-energy business is conducted primarily by Pentzer Corporation (Pentzer), which is the parent company to the majority of the Company's Non-energy businesses. Pentzer's business strategy is such that its earnings result from both transactional and non-transactional earnings. Transactional gains arise from a one-time event or a specific transaction, such as the sale of an investment or individual company from Pentzer's portfolio of investments. Non-transactional earnings arise out of the ongoing operations of the individual portfolio companies. Changes underway in the utility and energy industries are creating new opportunities to expand the Company's businesses and serve new markets. In pursuing such opportunities, the Company is shifting its strategic direction to growth in order to achieve its goal of becoming a diversified North American energy company. RESULTS OF OPERATIONS OVERALL OPERATIONS 1998 COMPARED TO 1997 Overall reported earnings per share for 1998 were $1.28, compared to $1.96 in 1997. The primary factors causing the decrease from 1997 were an income tax recovery, net of associated items, which increased 1997 earnings per share by $0.49, and decreased operating income from the Generation and Resources line of business in 1998. In addition, in December 1998, the Company exchanged 15,404,595 shares of its common stock for shares of 26
31 AVISTA CORPORATION - -------------------------------------------------------------------------------- Convertible Preferred Stock (see Notes 14 and 18 of Notes to Financial Statements for additional information about the new Convertible Preferred Stock and earnings per share). If these shares had been exchanged at the beginning of the year, basic and diluted earnings per share for 1998 would have been $1.39 and $1.35, respectively. Net income available for common stock decreased $39.7 million in 1998 from 1997. The 1998 results primarily reflect hydroelectric generation 21% lower than 1997 and increased purchased power prices and volumes, partially offset by improved earnings at Avista Energy. In addition, the 1997 results include the impact of $41.4 million, after-tax, in an income tax recovery from the Internal Revenue Service, which was partially offset by $14.0 million, after-tax, in environmental reserves and non-recurring adjustments (see below and Note 8 of Notes to Financial Statements for additional information about the income tax recovery). Excluding these items, utility (Energy Delivery and Generation and Resources) income available for common stock decreased $20.2 million, or 30%, in 1998, contributing $0.88 to earnings per share in 1998, compared to $1.22 in 1997. National Energy Trading and Marketing income available for common stock increased $9.6 million, contributing $0.22 to earnings per share in 1998 as compared to $0.04 in 1997 when there were only 5 months of operations. Non-energy operating income available for common stock decreased $1.8 million, or 15%, in 1998 and contributed $0.18 to earnings per share in 1998, compared to $0.21 in 1997. Transactional gains recorded by Pentzer totaled $4.3 million, or $0.08 per share, and $7.3 million, or $0.13 per share, in 1998 and 1997, respectively. Interest expense increased $2.8 million in 1998, as compared to 1997, primarily due to higher levels of outstanding debt during the year. During 1998, $84.0 million of long-term debt was issued, while $14.0 million of long-term debt matured or was redeemed. At December 31, 1998, there was no short-term debt outstanding, compared to $108.5 million at December 31, 1997. Long-term debt outstanding at December 31, 1998 was $32.2 million lower than at the end of 1997. Income taxes decreased $17.7 million, or 29%, in 1998 from 1997, primarily due to higher taxes in 1997 on the interest income received as a part of the income tax recovery, partially offset by adjustments related to revised estimates on certain tax issues. Preferred stock dividend requirements increased $3.0 million in 1998 over 1997 due to the exchange of shares of common stock for shares of $12.40 Convertible Preferred Stock, Series L, which occurred in December 1998. This was partially offset by the redemption of $10 million in Preferred Stock, Series I in June 1998. 1997 COMPARED TO 1996 Overall earnings per share for 1997 were $1.96, compared to $1.35 in 1996. The 1997 results include the receipt of $41.4 million, after-tax, in an income tax recovery from the Internal Revenue Service, which was partially offset by environmental reserves and non-recurring adjustments (see below and Note 8 of Notes to Financial Statements for additional information about the income tax recovery). The 1996 results reflect $11.1 million in after-tax operating expenses related to storm damage on the electric distribution system and the expensing of $10.3 million in after-tax non-operating costs related to the terminated proposed merger between the Company and Sierra Pacific Resources (see Note 22 of Notes to Financial Statements for additional information about the merger termination). The 1996 results also reflect transactional gains totaling $15.1 million recorded by Pentzer primarily as a result of the sale of property by one of its subsidiary companies and the sale of stock in Itron, Inc. (Itron). Excluding all of these unusual items, earnings per share in 1997 would have been $1.47 as compared to $1.73 for 1996. Net income available for common stock increased $33.9 million, or 45%, in 1997 over 1996. In 1997, the income tax recovery resulted in an increase of $0.74 in earnings per share for 1997, which was offset by $0.25 per share in environmental reserves and other miscellaneous non-recurring adjustments. The ice storm (see below) and merger-related expenses resulted in decreases of $0.20 and $0.18, respectively, in earnings per share for 1996. Utility income contributed $1.71 in 1997, compared to $0.97 in 1996. National Energy Trading and Marketing income available for common stock increased $3.6 million in 1997, contributing $0.04 to earnings per share in 1997 compared to a loss of $0.02 in 1996. Non-energy operating income available for common stock decreased $10.7 million, or 48%, in 1997 and contributed $0.20 to earnings per share in 1997 and $0.40 in 1996. Transactional gains recorded by Pentzer totaled $7.3 million, or $0.13 per share, in 1997, and $15.1 million, or $0.27, in 1996. Interest expense increased $3.0 million in 1997, as compared to 1996, primarily due to higher levels of outstanding debt and new Preferred Trust Securities issued during the year. In 1997 and 1996, $70 million and $20 million, respectively, in preferred stock was redeemed, which resulted in higher levels of short-term borrowings. In addition, a total of $110 million in Preferred Trust Securities were issued in January and June 1997, distributions on which are included in interest expense. (See Note 15 of Notes to Financial Statements and Liquidity and Capital Resources for additional information.) During 1997 and 1996, $51.5 million and $38.0 million, respectively, of long-term debt matured or was redeemed, while $20.0 million in long-term debt was issued in 1997. At December 31, 1997, there was $108.5 million of short-term debt outstanding, compared to $85.0 million at December 31, 1996. Long-term debt outstanding at December 31, 1997 was $2.3 million lower than at the end of 1996. In June 1997, the Company received $81 million from the Internal Revenue Service (IRS) to settle an income tax claim relating to its investment in the terminated nuclear project 3 of the Washington Public Power Supply System (WNP3). The $81 million recovery included $34 million in income taxes the Company overpaid in prior years plus 27
32 AVISTA CORPORATION - -------------------------------------------------------------------------------- $47 million in accrued interest, which in total contributed $41.4 million, or $0.74 per share, to net income. (See Note 8 of Notes to Financial Statements for additional information about the income tax recovery.) Income taxes increased $11.6 million, or 23%, in 1997 over 1996. The increased taxes in 1997 were primarily due to the taxes on the interest income received as a part of the income tax recovery, partially offset by an $11.4 million income tax benefit associated with the income tax recovery and adjustments related to revised estimates on certain tax issues. Preferred stock dividend requirements decreased $2.6 million in 1997 from 1996 due to the redemption of $20 million in Preferred Stock, Series I in June 1997 and the redemption of the entire $50 million Flexible Auction Preferred Stock, Series J in August 1997. These securities were redeemed with a portion of the proceeds of the Preferred Trust Securities which were issued in January and June 1997. However, as described above, distributions on the Preferred Trust Securities are accounted for in interest expense, not preferred dividends. ENERGY DELIVERY 1998 COMPARED TO 1997 Energy Delivery's income from operations increased $3.2 million in 1998 over 1997 primarily due to increased revenues in 1998. Energy Delivery's operating revenues increased $29.2 million, while operating expenses increased $26.0 million during 1998 as compared to 1997. Total electric retail revenues increased $1.8 million in 1998 as compared to 1997, primarily as a result of increased commercial and industrial revenues, partially offset by decreased revenues from residential customers. Total natural gas revenues increased $27.4 million in 1998 over 1997, primarily due to a combination of 4.4% customer growth, increased natural gas prices approved by the Washington Utilities and Transportation Commission (WUTC), effective in January 1998, and an increase in non-retail sales, partially offset by decreased customer usage as a result of weather 13% warmer than normal in 1998 as compared to 5% warmer than normal in 1997. Natural gas purchased costs increased $15.3 million in 1998 due to increased sales volumes as a result of customer growth and higher non-retail sales. Administrative and general expenses increased $7.0 million due primarily to executive changes, corporate name change expenses and incentives. Depreciation and amortization increased $2.0 million due to higher amounts of plant-in-service. 1997 COMPARED TO 1996 Energy Delivery's income from operations increased $24.3 million, or 27%, in 1997 over 1996 primarily due to $17.1 million in pre-tax expenses associated with the storm damage on the Company's electric distribution system in 1996. Energy Delivery's operating revenues increased $0.1 million, while expenses decreased $24.2 million during 1997 as compared to 1996. On November 19, 1996, the eastern Washington and northern Idaho region experienced an ice storm that resulted in damage to the Company's electric transmission and distribution system. The Company's service area was affected by continuing snow and rain, which hampered the Company's efforts to restore electric service to some customers until December 1, 1996. Initially, over one-third, or 100,000, of the Company's retail electric customers were without electric service. Repairing the damage to the Company's system cost approximately $21.8 million, of which $17.1 million (pre-tax) was attributable to operations and maintenance expenses, including labor and materials, for the repair of damaged lines, transformers and other equipment. The remainder of the cost represents capital expenditures to replace poles and other equipment damaged beyond repair. Total electric retail revenues increased $5.6 million in 1997 as compared to 1996, primarily as a result of increased transmission revenues, partially offset by decreased revenues from retail electric customers. Transmission revenues increased $7.6 million in 1997 over 1996 due to increased wholesale electric sales. Electric retail revenues decreased $3.4 million, primarily due to decreased industrial sales as a result of the DADS tariff and other adjustments, partially offset by a 1.6% growth in retail customers during 1997. Total natural gas revenues decreased $5.5 million in 1997 from 1996, primarily due to decreased therm sales as a result of weather 5% warmer than normal in 1997, compared to 9% colder than normal in 1996, and decreased natural gas prices, partially offset by an increase in non-retail sales and 5.7% customer growth. Operating and maintenance expenses decreased $21.4 million in 1997 from 1996 primarily due to the $17.1 million in expenses recorded in 1996 related to the storm damage on the Company's electric distribution system. Natural gas purchased expense decreased $2.7 million in 1997 from 1996 primarily due to lower therm sales as a result of warmer weather. GENERATION AND RESOURCES 28
33 AVISTA CORPORATION - -------------------------------------------------------------------------------- 1998 COMPARED TO 1997 Generation and Resources' income from operations decreased $38.4 million, or 59%, in 1998 from 1997. The decrease was due to hydroelectric generation 21% lower than 1997, which resulted in increased purchased power costs due to both increased prices and volumes. Generation and Resources' operating revenues and expenses increased $128.4 million and $166.8 million, respectively, during 1998 as compared to 1997. Generation and Resources' revenues increased 25% in 1998 over 1997, primarily due to increased short-term sales; however, this was more than offset by increased purchased power and fuel costs. Revenues from short-term sales increased $163.2 million, while long-term revenues decreased $35.8 million in 1998 as compared to 1997. Total sales volumes during 1998 increased 17% over 1997. Short-term sales volumes increased 3.4 million mwhs, or 28%, while long-term sales decreased 0.6 million mwhs. Increased short-term sales volumes and prices 30% higher than the previous year resulted in a $160.4 million, or 52%, increase in electric purchased power expense in 1998 over 1997, which accounts for the majority of the increase in Generation and Resources' operating expenses. Fuel costs increased $9.8 million in 1998 compared to 1997 as a result of increased generation at the thermal generating plants to meet the demand for energy. 1997 COMPARED TO 1996 Generation and Resources' income from operations decreased $19.6 million, or 23%, in 1997 from 1996. The decrease was due to an $11.8 million decrease from the expiration of older sales contracts with higher margins, lower unit margins on new sales contracts and higher transmission expenses due to increased sales. Generation and Resources' operating revenues and expenses increased $92.6 million and $112.2 million, respectively, during 1997 as compared to 1996. Results from this business segment included activities for the first seven months of 1997 that as of August 1997 were conducted by Avista Energy. Generation and Resources' revenues increased 22% in 1997 over 1996, primarily due to increased short-term sales. Revenues from short-term sales increased $99.8 million, while long-term revenues decreased $0.4 million in 1997 as compared to 1996. Total sales volumes during 1997 increased 47% over 1996. Short-term sales volumes increased 5.4 million mwhs, or 82%, while long-term sales decreased 0.2 million mwhs. Increased short-term sales resulted in a $119.4 million, or 63%, increase in electric purchased power expense in 1997 over 1996. Fuel costs decreased $6.1 million in 1997 compared to 1996 as a result of economic dispatch of the thermal generating plants. NATIONAL ENERGY TRADING AND MARKETING National Energy Trading and Marketing includes the results of Avista Energy, the national energy marketing subsidiary, Avista Advantage, the energy services subsidiary, and Avista Power, which was formed in December 1998 to develop and own generation assets primarily in support of Avista Energy. Avista Power operations had no impact on 1998 earnings. Although Avista Energy and Avista Advantage began incurring start-up costs during 1996, Avista Energy only became operational in July 1997 and began trading operations in August 1997. Year to year results are not comparable since 1997 only represents five months of operations. Avista Energy maintains a trading portfolio which it marks to fair market value on a daily basis (mark-to-market accounting), and which may cause earnings variability in the future. 1998 COMPARED TO 1997 National Energy Trading and Marketing's income available for common stock increased $9.6 million over 1997, while income from operations increased $17.7 million in 1998 over 1997, primarily due to a full year of operations at Avista Energy. This increase was partially offset by a loss from the energy services business, due to customers and revenue streams that did not materialize as expected and a longer than anticipated sales cycle. National Energy Trading and Marketing's operating revenues and expenses increased $2.16 billion and $2.14 billion, respectively, during 1998 as compared to 1997 when the Company only had five months of operations. Avista Energy provided positive results in 1998 despite the price volatility experienced in power markets in the Midwest and East during various periods of the year. The company was well-positioned in its market, which allowed net gains in its portfolio during periods of high volatility. Avista Energy expected high volatility in Eastern electric markets in the summer of 1998 based on expected demand and the high probability of a weather-related impact on energy prices. As a result, Avista Energy established positions in anticipation of volatile market swings, and in turn experienced positive earnings in its portfolio during this period. However, there is no guarantee that positive results can or will always be achieved. For additional information about market risk and credit risk, see Liquidity and Capital Resources: Risk Management. National Energy Trading and Marketing's total assets and liabilities increased by approximately $739.9 million from December 31, 1997 to December 31, 1998. This increase resulted primarily from the increased volume of 29
34 AVISTA CORPORATION - -------------------------------------------------------------------------------- transactions, as well as the impact of the market's price volatility on forward price curves, which increased the valuation of Avista Energy's mark-to-market assets and liabilities. 1997 COMPARED TO 1996 National Energy Trading and Marketing's income from operations increased $4.0 million in 1997 over 1996. This increase was primarily due to Avista Energy becoming operational, partially offset by continued start-up costs at both Avista Energy and Avista Advantage and, for the energy services business, customers and revenue streams that did not materialize as expected and a longer than anticipated sales cycle. National Energy Trading and Marketing's operating revenues and expenses increased $247.5 million and $243.5 million, respectively, during 1997 as compared to 1996. NON-ENERGY 1998 COMPARED TO 1997 Non-energy income available for common stock for 1998 was $9.8 million, which was a $1.8 million decrease from 1997 earnings. Transactional gains decreased to $4.3 million in 1998 from $7.3 million in 1997, while non-transactional earnings from Pentzer's portfolio companies increased $2.2 million. The non-transactional earnings included an approximate $4.4 million after-tax loss in the fourth quarter at a Pentzer operating company due to a business repositioning and an inventory adjustment. Income from operations totaled $9.7 million, which was a $0.8 million increase over 1997. Non-energy operating revenues and expenses increased $68.3 million and $67.5 million, respectively, primarily as a result of acquisitions and increased business activity from several of Pentzer's portfolio companies. 1997 COMPARED TO 1996 Non-energy net income for 1997 was $11.5 million, which represents a $10.7 million, or 48%, decrease from 1996. The decrease in 1997 earnings primarily resulted from transactional gains recorded by Pentzer in 1997 totaling $7.3 million, from the sale of Itron stock and the sale of a portfolio company, compared to transactional gains during 1996 totaling $15.1 million, net of taxes and other adjustments, as a result of the sale of property by one of its subsidiary companies and the sale of stock in Itron. Operating income decreased $6.1 million in 1997 from 1996 primarily as a result of lower earnings contributions from Pentzer portfolio companies. Non-energy operating revenues and expenses increased $18.2 million and $24.2 million, respectively, primarily as a result of acquisitions. 30
35 AVISTA CORPORATION - ------------------------------------------------------------------------------- LIQUIDITY AND CAPITAL RESOURCES Overall Operations Operating Activities Cash from operating activities less cash dividends paid provided all funds needed for capital expenditures in 1998, 1997 and 1996. Net cash provided by operating activities in 1998 increased over 1997 due primarily to the $143.4 million provided by the monetization of a contract (see below and Note 1 of Notes to Financial Statements for additional information). In addition, changes in various working capital components, such as receivables and payables, caused cashflows to decrease by $44.6 million from 1997, primarily due to the growth in Avista Energy's operations. Investing Activities Net cash used in investing activities decreased in 1998 from 1997 primarily due to the sale of marketable securities held for investing activities by Pentzer, compared to the sale of subsidiary assets by Pentzer in 1997. Utility operations' capital expenditures, excluding Allowance for Funds Used During Construction (AFUDC) and Allowance for Funds Used to Conserve Energy (AFUCE, a carrying charge similar to AFUDC for conservation-related capital expenditures), were $268 million for the 1996-1998 period. Financing Activities Net cash used in financing activities totaled $108.7 million in 1998 compared to $66.2 million in 1997. In 1998, $84.0 million of proceeds were received from the issuance of Medium-Term Notes. These proceeds, plus cash provided from operating activities, were used to retire $14.0 million of long-term debt, redeem $10 million of preferred stock and pay down $108.5 million of short-term debt. In 1997, $110 million of preferred trust securities were issued (see Note 15 of Notes to Financial Statements for additional information), the proceeds of which, along with an additional $20.0 million from the issuance of Secured Medium-Term Notes, were used for the maturity and redemption of $70.0 million of preferred stock and $51.5 million of long-term debt. During the 1996-1998 period, $203.5 million of long-term debt and preferred stock matured, was mandatorily redeemed or was optionally redeemed and refinanced at a lower cost. During 1998, the Company entered into an agreement that increased the amount of customer accounts receivable the Company could sell from $40 million to $80 million to provide additional funds for capital expenditures, maturing long-term debt and preferred stock sinking fund requirements. At December 31, 1998, $25.0 million in receivables had been sold pursuant to the agreement. In August 1998, the Company announced a dividend restructuring plan that reduced the Company's annual common stock dividend from $1.24 per share to $0.48 per share, a 61% reduction, which was effective with the payment of the common stock dividend paid on December 15, 1998. At the same time, an exchange offer was made whereby shareholders were provided the opportunity to exchange their shares of common stock for mandatorily convertible preferred shares, each of which pays an annual dividend of $1.24 per share for a period of about three years. After three years, the new-issue preferred shares will automatically convert back to common stock, based on the shares converted. The Company has the option of converting some or all of the new-issue shares to common stock prior to the end of the three-year period. Shareholders who chose not to participate in the exchange plan retained their ownership in Avista Corporation common stock. The annual savings resulting from the dividend restructuring are approximately $30 million for the next three years, increasing to about $42 million annually once the convertible preferred shares are converted back to common stock, which will assist in funding a portion of the Company's capital expenditures, maturing long-term debt and preferred stock sinking fund requirements. See Note 14 of Notes to Financial Statements for additional information about the new convertible preferred stock. ENERGY DELIVERY AND GENERATION AND RESOURCES OPERATIONS The Company funds capital expenditures with a combination of internally-generated cash and external financing. The level of cash generated internally and the amount that is available for capital expenditures fluctuates annually. Cash provided by operating activities remains the Company's primary source of funds for operating needs, dividends and capital expenditures. Capital expenditures are financed on an interim basis with notes payable (due within one year). The Company has $200 million in committed lines of credit. In addition, the Company may currently borrow up to $100 million through other borrowing arrangements with banks. As of December 31, 1998, there were no outstanding borrowings under the committed lines of credit or the other short-term borrowing arrangements. 31
36 AVISTA CORPORATION - ------------------------------------------------------------------------------- From time to time the Company enters into sale/leaseback arrangements for various long-term assets which provide additional sources of funds. See Note 12 of Notes to Financial Statements for additional information. In December 1998, the Company assigned and transferred certain rights under a long-term power sales contract to a funding trust. In return, the Company received approximately $143.4 million, representing the present value of the cash flows for the majority of the remaining payments due under the long-term sales contract. The Company utilized the funds to repay short-term bank borrowings and other debt. The Company is restricted under various agreements as to the additional securities it can issue. Under the most restrictive test of the Company's Mortgage, an additional $623 million of First Mortgage Bonds could be issued as of December 31, 1998. As of December 31, 1998, under its Restated Articles of Incorporation, approximately $715 million of additional preferred stock could be issued at an assumed dividend rate of 6.95%. During the 1999-2001 period, utility capital expenditures are expected to be $283 million, and $127.5 million will be required for long-term debt maturities and preferred stock sinking fund requirements. During this three-year period, the Company estimates that internally-generated funds will provide approximately 80% of the funds needed for its capital expenditure program. External financing will be required to fund a portion of capital expenditures, maturing long-term debt and preferred stock sinking fund requirements. Sources of funds would include, but are not necessarily limited to, cash flows from the reduction in the Company's common stock dividend, sales of certain assets, additional long-term debt, leasing or other equity securities. These estimates of capital expenditures are subject to continuing review and adjustment. Actual capital expenditures may vary from these estimates due to factors such as changes in business conditions, construction schedules and environmental requirements. See Notes 2, 10, 11, 12, 13, 14, 15, 16 and 17 of Notes to Financial Statements for additional details related to financing activities. NATIONAL ENERGY TRADING AND MARKETING OPERATIONS During 1998, the Company invested $65.1 million in the common equity of Avista Capital. Avista Capital utilized the majority of the proceeds from this investment to increase its total investment in the common equity of Avista Energy to $106.7 million. Avista Energy funds its ongoing operations with a combination of internally-generated cash and external financing. The Company expects continued significant growth in Avista Energy's national energy trading and marketing business activities. This rapid growth will require increased capital investment, as well as an increased need for credit and financial support. Effective December 23, 1998, Avista Energy arranged for an increase in its credit facility with a commercial bank from $50 million to $100 million. The credit agreement expires April 1, 1999. The facility provides capital resources to accommodate growth, principally in the form of letters of credit used to enhance credit for natural gas and electricity purchases. The credit facility also provides Avista Energy liquidity in the form of short-term borrowings used to finance inventory and receivables. The maximum cash component of credit extended by the bank is $30 million, with availability of up to $100 million in the issuance of letters of credit. The credit agreement may be terminated by the bank at any time and all extension of credit under the agreement are payable upon demand, in either case at the bank's sole discretion. The facility is guaranteed by Avista Capital and is secured by substantially all of Avista Energy's assets. At December 31, 1998 and 1997, there were no cash advances (demand notes payable) outstanding. Letters of credit outstanding under the facility totaled approximately $20.2 million and $2.8 million at December 31, 1998 and 1997, respectively. See Note 11 of Notes to Financial Statements for additional information. At December 31, 1998, the National Energy Trading and Marketing operations had $38.0 million in cash and cash equivalents and $0.9 million in long-term debt outstanding. The 1999-2001 National Energy Trading and Marketing capital expenditures are expected to be $10.1 million. NON-ENERGY OPERATIONS Capital expenditures for the non-energy operations were $28.0 million for the 1996-1998 period. During this period, $45.5 million of debt was repaid and capital expenditures were partially financed by the $62.6 million in proceeds from new long-term debt. 32
37 AVISTA CORPORATION - ------------------------------------------------------------------------------- The non-energy operations have $54.0 million in short-term borrowing arrangements ($21.4 million outstanding as of December 31, 1998) to fund corporate requirements on an interim basis. At December 31, 1998, the non-energy operations had $18.0 million in cash and marketable securities with $54.0 million in long-term debt outstanding. The 1999-2001 non-energy capital expenditures are expected to be $17.8 million, and $32.3 million in debt maturities will also occur. During the next three years, internally-generated cash and other debt obligations are expected to provide the majority of the funds for the non-energy capital expenditure requirements. Avista Labs, a subsidiary of Avista Capital, recently announced the receipt of a $2 million technology development award from the Department of Commerce's National Institute of Standards and Technology Advanced Technology Program. The Company will contribute another $1.22 million over a two-year period. Avista Labs plans to work on technology that will increase the energy density of its fuel cell design and develop multiple fuel processing approaches using propane, methane and methanol as base fuels to integrate into its fuel cell subsystem. <TABLE> <CAPTION> TOTAL COMPANY CASH REQUIREMENTS - ------------------------------- (Millions of Dollars) Actual Projected ------------------------ ------------------------ 1996 1997 1998 1999 2000 2001 ---- ---- ---- ---- ---- ---- <S> <C> <C> <C> <C> <C> Utility operations: Avista Utilities capital expenditures(1) $ 89 $ 87 $ 92 $ 92 $108 $103 Debt and preferred stock maturities(2) 63 121 24 47 55 40 ---- ---- ---- ---- ---- ---- Total utility 152 208 116 139 163 143 ---- ---- ---- ---- ---- ---- Avista Capital operations: Capital expenditures 2 12 14 16 6 6 Investments 4 59 53 40 41 56 Debt maturities 10 12 18 12 11 9 ---- ---- ---- ---- ---- ---- Total Avista Capital 16 83 85 68 58 71 ---- ---- ---- ---- ---- ---- Total Company $168 $291 $201 $207 $221 $214 ==== ==== ==== ==== ==== ==== </TABLE> (1) Capital expenditures exclude AFUDC and AFUCE. (2) Excludes notes payable (due within one year). The Company's total common equity decreased $260.8 million to $488.0 million at the end of 1998. The 1998 decrease was primarily due to the exchange of shares of common stock for shares of $12.40 Convertible Preferred Stock, Series L (see Note 14 of Notes to Financial Statements for additional information). The Company's consolidated capital structure at December 31, 1998, was 45% debt, 25% preferred securities (including the Preferred Trust Securities) and 30% common equity as compared to 46% debt, 9% preferred securities (including the Preferred Trust Securities) and 45% common equity at year-end 1997. Had the convertible preferred stock been converted back to common stock, the Company's consolidated capital structure at December 31, 1998, would have been 45% debt, 9% preferred securities (including the Preferred Trust Securities) and 46% common equity. ADDITIONAL FINANCIAL DATA At December 31, 1998, the total long-term debt of the Company and its consolidated subsidiaries, as shown in the Company's consolidated financial statements, was approximately $730.0 million. Of such amount, $237.5 million represents long-term unsecured and unsubordinated indebtedness of the Company, and $449.3 million represents secured indebtedness of the Company. The balance of $43.2 million represents indebtedness of the subsidiaries. Consolidated long-term debt does not include the Company's subordinated indebtedness held by the issuers of Company-obligated preferred trust securities. FUTURE OUTLOOK Business Strategy Changes underway in the utility and energy industries are creating new opportunities to expand the Company's businesses and serve new markets. In pursuing such opportunities, the Company is shifting its strategic direction to growth in order to achieve its goal of becoming a diversified North American energy company. 33
38 AVISTA CORPORATION - ------------------------------------------------------------------------------- The Company's growth strategy will expose the Company to risks associated with rapid expansion, challenges in recruiting and retaining qualified personnel, risks associated with acquisitions and joint ventures and increasing competition. In addition, growth in the energy trading and marketing business will expose the Company to increased financial and credit risks associated with commodity trading activities. The Company believes that its extensive experience in the electric and natural gas business, coupled with its strong management team, will allow the Company to effectively manage its transition to a diversified North American energy company. Energy The Company seeks to strengthen its position of leadership in energy delivery and generation as well as energy trading and marketing on a local, regional and national basis. The Company will seek to increase its asset and customer base through a focus on acquisitions and strategic alliances in all parts of its business. The Company intends to focus on growing its core energy business by seeking to acquire control of physical assets, specifically power generation assets and electric and natural gas transmission and distribution assets. The Company expects that initial growth will come at a local and regional level, with national growth to follow. Key strengths of the Company today include its position as one of the lowest cost producers of power in the nation, expertise in hydroelectric and power system management, plus capabilities in trading and wholesale and retail marketing of natural gas and electric energy. The Company is also continuing to develop a unique approach to commercialization of fuel cell technology. Locally. The Company is a long-standing leader in the Northwest region of the United States, providing some of the lowest cost energy to its customers. The Company's strategy is to add selectively to its already strong foundation of state-regulated utility assets to solidify its position as a leading supplier of low-cost electric and natural gas energy services. Regionally. The Company intends to add to its regulated and non-regulated assets on a regional basis and participate in industry consolidation to further optimize its assets and create greater economies of scale. In addition to energy delivery and generation, the Company plans to concentrate on growing its energy trading and marketing business. The strong growth in this business is driven by the Company's significant base of knowledge and experience in the operation of physical systems - for both natural gas and electric energy in the region, as well as its relationship-focused approach to the customer. The Company will also focus on expanding its telecommunications business through its newest subsidiary, Avista Communications. (See Note 21 of Notes to Financial Statements for additional information about this subsidiary.) Nationally. The Company's strong regional energy trading and marketing skills serve as a platform for the Company's growing national presence. The Company will seek to expand its customer base through relationships with other energy providers outside the Company's Northwest stronghold, thereby leveraging its existing trading and marketing skills, as well as through its Internet-based specialty billing and information services. Non-Energy The Company conducts the majority of its non-energy business through Pentzer, its wholly owned subsidiary. Pentzer's business strategy is to acquire controlling interests in a broad range of middle market companies, facilitate improved productivity and growth, and ultimately sell such companies to the public or a strategic buyer. Competition and Business Risk The Company continues to compete for new retail electric customers with various rural electric cooperatives and public utility districts in and adjacent to its service territories. Challenges facing the retail electric business include evolving technologies that provide alternate energy supplies, the cost of the energy supplied, the potential for retail wheeling, self-generation and fuel switching by commercial and industrial customers and increasingly stringent environmental laws. When electric utility companies are required to provide retail wheeling service, the Company believes it will be in a position to benefit since it is committed to remaining one of the country's lowest-cost providers of electric energy. Consequently, the Company believes it faces minimal risk for stranded generation, transmission or distribution assets due to its low cost structure. The Company's need for new future electric resources to serve retail loads is expected to remain very minimal. Natural gas remains priced competitively compared to other alternative fuel sources for residential, commercial and industrial customers and is projected to remain so into the future due to abundant supplies and competition. Challenges facing the Company's retail natural gas business include the potential for customers to by-pass the Company's natural gas system. To reduce the potential for such by-pass, the Company prices its natural gas services, 34
39 AVISTA CORPORATION - ------------------------------------------------------------------------------- including transportation contracts, competitively and has varying degrees of flexibility to price its transportation and delivery rates by means of special contracts. The Company has long-term transportation contracts with seven of its largest industrial customers which reduces the risks of these customers by-passing the Company's system in the foreseeable future. Generation and Resources and Avista Energy continue to compete in the wholesale electric market with other utilities, federal marketing agencies and power marketers. It is expected that competition to sell capacity will remain vigorous, and that prices will remain depressed for at least the next several years, due to increased competition and surplus capacity in the western United States. Competition related to the sale of capacity and energy is influenced by many factors, including the availability of capacity in the western United States, the availability and prices of natural gas and oil, spot energy prices and transmission access. Business challenges affecting the Generation and Resources and National Energy Trading and Marketing lines of business include competition from low-cost generation being developed by independent power producers, declining margins due to a greater reliance on short-term sales, evolving technologies that provide alternate energy supplies and deregulation of electric and natural gas markets. The Company's energy-related businesses are exposed to risks relating to changes in certain commodity prices and counterparty performance. In order to manage the various risks relating to these exposures, the Company utilizes electric, natural gas and related commodity derivatives, and has established risk management oversight for these risks for each area of the Company's energy-related business. The Company has implemented procedures to manage such risk and has established a comprehensive Risk Management Committee, separate from the units that create such risk exposure and overseen by the Audit and Finance Committee of the Company's Board of Directors, to monitor compliance with the Company's risk management policies and procedures. Economic and Load Growth The Company expects economic growth to continue in its eastern Washington and northern Idaho service area. The Company, along with others in the service area, is continuing its efforts to facilitate expansion of existing businesses and attract new businesses to the Inland Northwest. Agriculture, mining and lumber were the primary industries for many years, but health care, education, electronic and other manufacturing, tourism and the service sectors have become increasingly important industries that operate in the Company's service area. The Company also anticipates moderate economic growth to continue in its Oregon service area. The Company anticipates residential and commercial electric load growth to average approximately 2.3% annually for the next five years primarily due to increases in both population and the number of businesses in its service territory. The number of electric customers is expected to increase and the average annual usage by residential customers is expected to remain steady on a weather-adjusted basis. A Public Utility Regulatory Policies Act of 1978 (PURPA) contract with the Company's largest customer expires in 2002. The customer is expected to self-generate at that time, which will reduce the load to this customer by the amount the Company has been purchasing and then reselling to them. Although it will have no material impact on loads, it will reduce the Company's costs since the PURPA contract is at above-market prices. Overall, the load growth, adjusted for this situation, is 2.4% annually. The Company anticipates natural gas load growth, including transportation volumes, in its Washington and Idaho service area to average approximately 2.7% annually for the next five years. The Oregon and South Lake Tahoe, California service areas are anticipated to realize 3.1% growth annually during that same period. The forward-looking projections set forth above regarding retail sales growth are based, in part, upon publicly available population and demographic studies conducted independently. The Company's expectations regarding retail sales growth are also based upon various assumptions including, without limitation, assumptions relating to weather and economic and competitive conditions and an assumption that the Company will incur no material loss of retail customers due to self-generation or retail wheeling. Changes in the underlying assumptions can cause actual experience to vary significantly from forward-looking projections. Environmental Issues Since December 1991, a number of species of fish in the Northwest, including the Snake River sockeye salmon and chinook salmon, the Kootenai River white sturgeon, the upper Columbia River steelhead and the bull trout have been listed as threatened or endangered under the Federal Endangered Species Act (ESA). A listing of the upper Columbia River spring chinook is anticipated by mid-1999. Thus far, measures which have been adopted and implemented to save the Snake River sockeye salmon and chinook salmon have not directly impacted generation levels at any of the 35
40 AVISTA CORPORATION - ------------------------------------------------------------------------------- Company's hydroelectric dams. The Company does, however, purchase power from four projects on the Columbia River that are being directly impacted by ongoing mitigation measures for spring chinook, salmon and steelhead. The reduction in generation at these projects is relatively minor, resulting in minimal economic impact on the Company at this time. It is currently not possible to accurately predict the likely economic costs to the Company resulting from all future actions. The Company is currently in the process of relicensing the Cabinet Gorge and Noxon Rapids hydroelectric projects on the Clark Fork River in northern Idaho and western Montana. The restoration of native salmonid fish, in particular bull trout, is a principal focus for the members of the collaborative relicensing team. Bull trout are native to this area and a "threatened" listing for bull trout occurred in 1998 under the ESA. The Company is working closely with the U.S. Fish and Wildlife Service, Native American tribes and the states of Idaho and Montana to institute coordinated recovery measures on the lower Clark Fork River. A settlement agreement reached in conjunction with the filing in February 1999 for new FERC licenses establishes a plan for bull trout restoration, including annual budget estimates. Relicensing studies in 1997 and 1998 indicated very high levels of atmospheric gas supersaturation below Cabinet Gorge Dam during periods of heavy spill. The settlement agreement provides for additional studies to identify what, if any, effects there are to aqueous resources and whether abatement measures, and what type, will be required at Cabinet Gorge. See Note 20 of Notes to Financial Statements for additional information. YEAR 2000 The Company continues to move forward with a comprehensive program to address areas of risk associated with the Year 2000. Systems and programs that may be affected by the Year 2000 problem have been identified and activities are underway to make these systems Year 2000 ready. At this time, it is the Company's belief that all identified modifications that are within the Company's operating control will be made within the required time frames. State of Readiness In order to address Year 2000 issues, several project activity teams were created and a comprehensive readiness plan was developed to bring the Company's business critical systems into Year 2000 readiness by the middle of 1999. The Company defines business critical systems as systems that directly affect the Company's ability to deliver energy services to customers. The Company's Year 2000 project was originally divided into four major categories of activities: Desktop Computer Systems, Business Systems, Supply Chain and Embedded Systems. Contingency Planning developed into its own category in late 1998. Desktop Computer Systems All desktop computer hardware has been Year 2000 tested and an inventory and assessment of desktop resident third-party software has been completed. The Company expects hardware remediation to be completed by mid-1999. All non-compliant third-party software programs and critical business desktop applications are expected to be upgraded, converted, tested and made Year 2000 ready by the middle of 1999. Business Systems Many of the Company's critical business systems would not have operated correctly in the year 2000 and beyond, and thus have been or are in the process of being re-programmed, upgraded or replaced. Key business systems have been inventoried and assessed. The Company has completed remediating all mainframe computer code that required fixing to address the Year 2000 issue and testing has been completed on all but two of the Company's mainframe computer business systems. Testing of the two remaining mainframe business systems is scheduled to be completed before the end of April 1999. Implementation of a new Materials Management system is scheduled for late 1999. The Company is in the process of developing alternative plans in the unlikely event the Company is unable to implement the new Materials Management System before the year 2000. A failure of these systems would not jeopardize the Company's ability to deliver energy services to customers, but might affect its ability to perform selected accounting and business-related functions. The Company has completed testing and remediation of approximately 85% of its business critical systems. Supply Chain The Company recognizes its dependence on outside suppliers of goods and services and is working to assure that the necessary products and services are available. To address these issues, the Company has communicated with suppliers and identified critical suppliers in order to investigate their efforts to become Year 2000 ready. In addition, the Company has made site visits to select key suppliers and will be reviewing their contingency plans. 36
41 AVISTA CORPORATION - ------------------------------------------------------------------------------- Embedded Systems The Embedded System team is responsible for locating, assessing, testing, fixing or replacing microprocessor-controlled devices. Inventory and assessment is 99 percent complete, and to date very few embedded systems have been found that require remediation. None of these requiring remediation would have caused a disruption in service to customers. Remediation and testing is complete at all eleven of the Company's generation sites and these sites are Year 2000 ready. The Company's Supervisory Control and Data Acquisition (SCADA) system, which monitors and controls the majority of the Company's generating and substation equipment and the transmission system, was run "in the Year 2000" for three days without incident. Testing of electric metering and devices in the Company's transmission and distribution substations systems has been completed and full testing of selected substations is in process and scheduled to be completed by mid-1999. Contingency Planning The Company has developed contingency plans for the Company's electric and natural gas services and has also participated in the development of region-wide contingency plans for electric service through the Company's electric reliability region - the Western Systems Coordinating Council (WSCC). A major Year 2000 project activity for the Company during 1999 will be the development and implementation of detailed operational plans to support the Company's contingency plans. Key activities in 1999 include the assignment of resources to key locations for the evening of December 31, 1999 and the morning of January 1, 2000, training of personnel, testing of backup procedures and the completion of tasks that support the Company's contingency plans. The Company will continue to participate in the further development and testing of the region-wide contingency plans. This includes region-wide drills coordinated by the WSCC scheduled for April 9, 1999 and September 9, 1999. Costs The Company estimates that the cost of its Year 2000 project will be approximately $6-7 million in incremental costs during the 1997-1999 time period. Through December 31, 1998, the Company has spent $3.5 million in incremental costs. These costs are being funded through operating cashflows. The Company does not expect costs associated with the Year 2000 project to materially affect the Company's earnings in any one year. Risks Based upon information to date, the Company believes that, in the most reasonably likely worst-case scenario, Year 2000 issues could result in abnormal operating conditions, such as short-term interruption of generation, transmission and distribution functions, as well as Company-wide loss of system monitoring and control functions and loss of voice communications. These conditions, along with disruptions in natural gas service caused by failures of gas suppliers or interstate gas pipelines coupled with power outages due to the possible instability of the regional electric transmission grid, could result in the possible temporary interruption of service to customers. The Company does not believe the overall impact of this scenario will have a material impact on its financial condition or operations due to the anticipated short-term nature of interruptions. The Company believes the primary areas of Year 2000 risk to be internal business systems, which are discussed above, and external factors, which include the regional electric transmission grid and natural gas pipelines. There can be no guarantee that systems of other companies on which the Company's systems rely will be timely converted. A failure to convert by another company or a conversion that is incompatible with the Company's systems could have an effect on the Company's ability to provide energy services. Electric The Company is working with the other energy suppliers in the area to address risks related to the regional electric transmission grid, which consists of the interconnected transmission systems of each utility within the WSCC. Such interconnected systems are critical to the reliability of each interconnected electric service provider, as the failure of one such interconnected provider to achieve Year 2000 compliance could disrupt the others from providing electric services. Should the regional electric transmission grid become unstable, power outages may occur. The Company cannot assure Year 2000 compliance or assess the effect of non-compliance by systems or parties that the Company does not control. In addition to the traditional electric utility operations of the Company, the energy trading business conducted by Avista Energy is subject to Year 2000 risk. Most of Avista Energy's internal business systems do not require any 37
42 AVISTA CORPORATION - ------------------------------------------------------------------------------- significant upgrading and those that do are being addressed. However, if any of Avista Energy's counterparties experience Year 2000 problems (including, but not limited to, problems arising out of failures in the generation or transmission systems of utilities or other energy suppliers), such problems could impair the ability of Avista Energy or any of its counterparties to fulfill their contractual obligations. Avista Energy is in the process of contacting its counterparties to assess their Year 2000 readiness and of developing contingency plans. See "Energy Trading Business". Natural Gas The Company has performed an inventory and assessment of the equipment in its natural gas distribution systems and believes that there are no devices in the systems that will cause a disruption in the delivery of natural gas to customers due to a Year 2000 problem. However, the Company depends on natural gas pipelines which it does not own or control, and if one or more of the pipelines is unable to deliver natural gas, the Company in turn will be unable to deliver natural gas to customers. In order to address this issue, the Company has contacted each of the natural gas pipeline companies with which it has contracts to assess their Year 2000 readiness efforts and will continue to take reasonable steps to ensure that these suppliers are addressing any Year 2000 related problems that would result in a disruption in natural gas services to customers. ENERGY TRADING BUSINESS The participants in the emerging wholesale energy market are public utility companies and, increasingly, power marketers which may or may not be affiliated with public utility companies or other entities. The participants in this market trade not only electricity and natural gas as commodities but also derivative commodity instruments such as futures, forwards, swaps, options and other instruments. This market is largely unregulated and most transactions are conducted on an "over-the-counter" basis, there being no central clearing mechanism (except in the case of specific instruments traded on the commodity exchanges). Power marketers, whether or not affiliated with other entities, generally do not own production facilities and are not subject to net capital or other requirements of any regulatory agency. The Company (to the extent that the Generation and Resources segment conducts energy trading) and Avista Energy are subject to the various risks inherent in commodity trading including, particularly, market risk and credit risk. Market risk is, in general, the risk of fluctuation in the market price of the commodity being traded and is influenced primarily by supply (in the case of electricity, adequacy of generating reserve margins as well as scheduled and unscheduled outages of generating facilities) and demand (extreme variations in the weather, whether or not predicted). Market risk includes the risk of fluctuation in the market price of associated derivative commodity instruments. All market risk is influenced to the extent that the performance or non-performance by market participants of their contractual obligations and commitments affect the supply of, or demand for, the commodity. Credit risk relates to the risk of loss that the Company (to the extent of Generation and Resources' trading activities) and/or Avista Energy would incur as a result of non-performance by counterparties of their contractual obligations under the various instruments with the Company or Avista Energy, as the case may be. Credit risk may be concentrated to the extent that one or more groups of counterparties have similar economic, industry or other characteristics that would cause their ability to meet contractual obligations to be similarly affected by changes in market or other conditions. In addition, credit risk includes not only the risk that a counterparty may default due to circumstances relating directly to it, but also the risk that a counterparty may default due to circumstances which relate to other market participants which have a direct or indirect relationship with such counterparty. The Company and Avista Energy seek to mitigate credit risk (and concentrations thereof) by applying specific eligibility criteria to prospective counterparties. However, despite mitigation efforts, defaults by counterparties occur from time to time. To date, no such default has had a material adverse effect on the Company or Avista Energy. Avista Capital provides guarantees for Avista Energy's line of credit agreement, and in the course of business may provide guarantees to other parties with whom Avista Energy may be doing business. The Company's investment in Avista Capital totaled $271.8 million at December 31, 1998. RISK MANAGEMENT The risk management process established by the Company is designed to measure both quantitative and qualitative risk in the business. The Company and Avista Energy have adopted policies and procedures to manage the risks inherent in their businesses and have established a comprehensive Risk Management Committee, separate from the units that 38
43 AVISTA CORPORATION - ------------------------------------------------------------------------------- create the risk exposure and overseen by the Audit and Finance Committee of the Company's Board of Directors, to monitor compliance with the Company's risk management policies and procedures on a regular basis. Nonetheless, adverse changes in interest rates, commodity prices and foreign currency exchange rates may result in losses in earnings, cash flow and/or fair values. The forward-looking information presented below provides only estimates of what may occur in the future, assuming certain adverse market conditions, due to reliance on model assumptions. As a result, actual future results may differ materially from those presented. These disclosures are not indicators of expected future losses, but only indicators of reasonably possible losses. Interest Rate Risk The Company is subject to the risk of fluctuating interest rates in the normal course of business. The fair value of the Company's cash and short-term investment portfolio and the fair value of notes payable at December 31, 1998 approximated carrying value. Given the short-term nature of these instruments, market risk, as measured by the change in fair value resulting from a hypothetical change in interest rates, is immaterial. The Company manages interest rate risk by taking advantage of market conditions when timing the issuance of long-term financings and optional debt redemptions and through the use of fixed rate long-term debt with varying maturities. A portion of the Company's capitalization consists of floating rate Company-Obligated Mandatorily Redeemable Preferred Trust Securities, of which the interest portion of the $50 million Series B resets on a quarterly basis, reflecting current market conditions. As of December 31, 1998, a hypothetical 15% change in interest rates would result in an immaterial change in the Company's cash flows related to the increased interest expense associated with these floating rate securities. Commodity Price Risk The Company and Avista Energy are exposed to market fluctuations in the price and transportation costs of electric and natural gas commodities and, therefore, enter into contracts to hedge the impact of these fluctuations on their energy-related assets, liabilities, and other contractual arrangements. In addition, Avista Energy enters into these contracts for trading purposes to take advantage of market opportunities. At times this may create a net open position in its portfolio that could result in material losses if prices do not move in the manner or direction anticipated. The Company and Avista Energy's risk management program and policies are designed to manage the risks associated with market fluctuations in the price of electricity and natural gas commodities (see Note 3 of Notes to Financial Statements for additional information). Avista Energy measures the risk in its derivative commodity portfolio on a daily basis utilizing a Value-at-Risk (VAR) model and monitors its risk in comparison to established thresholds. VAR measures the worst expected loss over a given time interval under normal market conditions at a given confidence level. The Company and Avista Energy also use other measures to monitor the risk in their derivative commodity portfolios on a monthly, quarterly and annual basis. The VAR computations are based on an historical simulation, which utilizes price movements over a specified period to simulate forward price curves in the energy markets to estimate the unfavorable impact of one-day's price movement in the existing portfolio. The quantification of market risk using VAR provides a consistent measure of risk across diverse energy markets and products. VAR represents an estimate of reasonably possible net losses in earnings that would be recognized on its portfolio assuming hypothetical movements in future market rates and is not necessarily indicative of actual results that may occur. Avista Energy's VAR computations utilize several key assumptions, including a 95% confidence level for the resultant price movement and a one-day holding period. The calculation includes derivative commodity instruments held for trading purposes and excludes the effects of written and embedded physical options in the trading portfolio. At December 31, 1998, Avista Energy's estimated potential one-day unfavorable impact on gross margin was $3.3 million, as measured by VAR, related to its commodity trading and marketing business. The average daily VAR for 1998 was $3.0 million. Changes in markets inconsistent with historical trends or assumptions used could cause actual results to exceed predicted limits. Market risks associated with derivative commodity instruments held for purposes other than trading were not material at December 31, 1998. In addition to commodity price risk, the Company's commodity positions are also subject to operational and event risks including, among others, increases in load demand, transmission or transport disruptions, fuel quality specifications and forced outages at generating plants. 39
44 AVISTA CORPORATION - ------------------------------------------------------------------------------- Foreign Currency Risk The Company has investments in several Canadian companies through Pentzer's acquisition of Universal Showcase, Inc. and Avista Energy Canada, Ltd. and its acquisition of Coast Pacific Management, Inc. (see Note 21 for additional information about these acquisitions). The Company's exposure to foreign currency risk and other foreign operations risk was immaterial to the Company's consolidated results of operations and financial position in 1998 and is not expected to change materially in the near future. OTHER On July 28, 1998, the United States District Court for the District of Idaho issued its finding that the Coeur d' Alene Tribe of Idaho (Tribe) owns the bed and banks of the Coeur d' Alene Lake and the St. Joe River lying within the current boundaries of the Coeur d' Alene Reservation. The disputed bed and banks comprise approximately the southern one-third of the Coeur d' Alene Lake. This action had been brought by the United States on behalf of the Tribe against the State of Idaho. The decision has been appealed by the State of Idaho to the Ninth Circuit. While the Company is not a party to this action, it is meeting with the Tribe to evaluate the impact of this decision on storage rights on the reservoir and operation of the Company's hydroelectric facilities on the Spokane River, downstream of the Coeur d' Alene Lake, which is the reservoir for these plants. The Board of Directors considers the level of dividends on the Company's common stock on a continuing basis, taking into account numerous factors including, without limitation, the Company's results of operations and financial condition, as well as general economic and competitive conditions. The Company's net income available for dividends is derived from its retail electric and natural gas utility operations. SAFE HARBOR FOR FORWARD-LOOKING STATEMENTS The Company is including the following cautionary statement in this Form 10-K to make applicable and to take advantage of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 for any forward-looking statements made by, or on behalf of, the Company. Forward-looking statements include statements concerning plans, objectives, goals, strategies, future events or performance, and underlying assumptions (many of which are based, in turn, upon further assumptions) and are all statements which are other than statements of historical fact, including without limitation those that are identified by the use of the words "anticipates," "estimates," "expects," "intends," "plans," "predicts," and similar expressions. From time to time, the Company may publish or otherwise make available forward-looking statements of this nature. All such subsequent forward-looking statements, whether written or oral and whether made by or on behalf of the Company, are also expressly qualified by these cautionary statements. Forward-looking statements involve risks and uncertainties which could cause actual results or outcomes to differ materially from those expressed. The Company's expectations, beliefs and projections are expressed in good faith and are believed by the Company to have a reasonable basis, including without limitation management's examination of historical operating trends, data contained in the Company's records and other data available from third parties, but there can be no assurance that the Company's expectations, beliefs or projections will be achieved or accomplished. Furthermore, any forward-looking statement speaks only as of the date on which such statement is made, and the Company undertakes no obligation to update any forward-looking statement or statements to reflect events or circumstances that occur after the date on which such statement is made or to reflect the occurrence of unanticipated events. New factors emerge from time to time, and it is not possible for management to predict all of such factors, nor can it assess the impact of each such factor on the Company's business or the extent to which any such factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statement. Energy Delivery and Generation and Resources Operations - In addition to other factors and matters discussed elsewhere herein, some important factors that could cause actual results or outcomes for the Company and its Energy Delivery and Generation and Resources operations to differ materially from those discussed in forward-looking statements include prevailing legislative developments, governmental policies and regulatory actions with respect to allowed rates of return, financings, or industry and rate structures, weather conditions, wholesale and retail competition (including but not limited to electric retail wheeling and transmission cost), availability of economic supplies of natural gas, present or prospective natural gas distribution or transmission competition (including but not limited to prices of alternative fuels and system deliverability costs), recovery of purchased power and purchased gas costs, present or prospective generation, operations and construction 40
45 AVISTA CORPORATION - ------------------------------------------------------------------------------- of plant facilities, and acquisition and disposal of assets or facilities. National Energy Trading and Marketing Operations - In addition to other factors and matters discussed elsewhere herein, some important factors that could cause actual results or outcomes for the National Energy Trading and Marketing operations to differ materially from those discussed in forward-looking statements include further industry restructuring evolving from federal and/or state legislation, regulatory actions by state utility commissions, demand for and availability of energy throughout the country, wholesale competition, availability of economic supplies of natural gas, margins on purchased power, and the formation of additional alliances or entities. Non-Energy Operations - Certain important factors which could cause actual results or outcomes for the Company's non-energy operations to differ materially from those discussed in forward-looking statements include competition from other companies, the ability to obtain new customers and retain old ones, reliability of customer orders, business acquisitions, disposal of assets, the ability to obtain funds from operations, debt or equity, research and development findings and the availability of economic expansion or development opportunities. Factors Common to All Operations - The business and profitability of the Company are also influenced by economic risks, changes in and compliance with environmental and safety laws and policies, weather conditions, population growth rates and demographic patterns, market demand for energy from plants or facilities, changes in tax rates or policies, unanticipated project delays or changes in project costs, unanticipated changes in operating expenses or capital expenditures, labor negotiation or disputes, changes in credit ratings or capital market conditions, inflation rates, inability of the various counterparties to meet their obligations with respect to the Company's financial instruments, changes in accounting principles and/or the application of such principles to the Company, changes in technology and legal proceedings. ITEM 7a. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK See "Management's Discussion and Analysis of Results and Operations: Liquidity and Capital Resources: Risk Management." ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Independent Auditor's Report and Financial Statements begin on the next page. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. 41
46 INDEPENDENT AUDITORS' REPORT Avista Corporation Spokane, Washington We have audited the accompanying consolidated balance sheets and statements of capitalization of Avista Corporation and subsidiaries (the Company) as of December 31, 1998 and 1997, and the related and consolidated statements of income, comprehensive income and retained earnings, and cash flows for each of the three years in the period ended December 1998, which included the schedules of information by business segments. These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company at December 31, 1998 and 1997, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1998, in conformity with generally accepted accounting principles. /s/ Deloitte & Touche LLP Deloitte & Touche LLP Seattle, Washington January 29, 1999 (February 1, 1999 as to Note 21 and March 10, 1999 as to Note 20) 42
47 CONSOLIDATED STATEMENTS OF INCOME, COMPREHENSIVE INCOME AND RETAINED EARNINGS Avista Corporation - -------------------------------------------------------------------------------- For the Years Ended December 31 Thousands of Dollars <TABLE> <CAPTION> 1998 1997 1996 ----------- ----------- ----------- <S> <C> <C> <C> OPERATING REVENUES $ 3,683,984 $ 1,302,172 $ 944,957 ----------- ----------- ----------- OPERATING EXPENSES: Resource costs ........................................................ 3,021,046 719,905 378,664 Operations and maintenance ............................................ 229,620 176,354 181,298 Administrative and general ............................................ 129,771 96,611 76,972 Depreciation and amortization ......................................... 70,547 69,893 72,097 Taxes other than income taxes ......................................... 60,180 49,945 49,005 ----------- ----------- ----------- Total operating expenses ............................................ 3,511,164 1,112,708 758,036 ----------- ----------- ----------- INCOME FROM OPERATIONS .................................................... 172,820 189,464 186,921 ----------- ----------- ----------- OTHER INCOME (EXPENSE): Interest expense ...................................................... (69,077) (66,275) (63,255) Interest on income tax recovery ....................................... -- 47,338 -- Net gain on subsidiary transactions ................................... 7,937 11,218 23,953 Merger-related expenses ............................................... -- -- (15,848) Other income (deductions)-net ......................................... 9,794 (5,873) 1,191 ----------- ----------- ----------- Total other income (expense)-net .................................... (51,346) (13,592) (53,959) ----------- ----------- ----------- INCOME BEFORE INCOME TAXES ................................................ 121,474 175,872 132,962 INCOME TAXES .............................................................. 43,335 61,075 49,509 ----------- ----------- ----------- NET INCOME ................................................................ 78,139 114,797 83,453 DEDUCT-Preferred stock dividend requirements .............................. 8,399 5,392 7,978 ----------- ----------- ----------- INCOME AVAILABLE FOR COMMON STOCK ......................................... $ 69,740 $ 109,405 $ 75,475 =========== =========== =========== Average common shares outstanding (thousands) ............................. 54,604 55,960 55,960 EARNINGS PER SHARE OF COMMON STOCK, BASIC ................................. $ 1.28 $ 1.96 $ 1.35 EARNINGS PER SHARE OF COMMON STOCK, DILUTED (Note 18) .................... $ 1.28 $ 1.96 $ 1.35 Dividends paid per common share ........................................... $ 1.05 $ 1.24 $ 1.24 NET INCOME ................................................................ $ 78,139 $ 114,797 $ 83,453 ----------- ----------- ----------- OTHER COMPREHENSIVE INCOME, NET OF TAX: Foreign currency translation adjustment ............................... (366) -- -- Unrealized investment gains/(losses)-net of reclassification adjustment ............................................................ (2,052) (3,627) (13,516) ----------- ----------- ----------- OTHER COMPREHENSIVE INCOME (LOSS) ......................................... (2,418) (3,627) (13,516) ----------- ----------- ----------- COMPREHENSIVE INCOME ...................................................... $ 75,721 $ 111,170 $ 69,937 =========== =========== =========== RETAINED EARNINGS, JANUARY 1 .............................................. $ 171,776 $ 131,301 $ 125,031 NET INCOME ................................................................ 78,139 114,797 83,453 DIVIDENDS DECLARED: Preferred stock ....................................................... (7,639) (5,339) (8,213) Common stock .......................................................... (56,898) (69,390) (69,390) Transfer to Preferred Stock, Series L ..................................... (64,844) -- -- Restricted stock .......................................................... (419) -- -- ESOP dividend tax savings ................................................. 330 407 420 ----------- ----------- ----------- RETAINED EARNINGS, DECEMBER 31 ............................................ $ 120,445 $ 171,776 $ 131,301 =========== =========== =========== </TABLE> THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE STATEMENTS. 43
48 CONSOLIDATED BALANCE SHEETS Avista Corporation - -------------------------------------------------------------------------------- At December 31 Thousands of Dollars <TABLE> <CAPTION> 1998 1997 ---------- ---------- <S> <C> <C> ASSETS: CURRENT ASSETS: Cash and cash equivalents ................................ $ 72,836 $ 30,593 Temporary cash investments ............................... 5,786 22,641 Accounts and notes receivable-net ........................ 456,857 176,882 Energy commodity assets .................................. 335,224 76,449 Materials and supplies, fuel stock and natural gas stored ................................................ 42,140 42,148 Prepayments and other .................................... 55,753 28,130 ---------- ---------- Total current assets ................................... 968,596 376,843 ---------- ---------- UTILITY PROPERTY: Utility plant in service-net ............................. 2,095,301 2,031,026 Construction work in progress ............................ 45,391 37,446 ---------- ---------- Total .................................................. 2,140,692 2,068,472 Less: Accumulated depreciation and amortization ......... 669,750 635,349 ---------- ---------- Net utility plant ...................................... 1,470,942 1,433,123 ---------- ---------- OTHER PROPERTY AND INVESTMENTS: Investment in exchange power-net ......................... 62,577 69,013 Non-utility properties and investments-net ............... 206,773 195,046 Energy commodity assets .................................. 236,644 13,103 Other-net ................................................ 26,016 20,065 ---------- ---------- Total other property and investments ................... 532,010 297,227 ---------- ---------- DEFERRED CHARGES: Regulatory assets for deferred income tax ................ 171,037 176,682 Conservation programs .................................... 49,114 53,338 Unamortized debt expense ................................. 28,414 23,978 Prepaid power purchases .................................. 5,273 18,134 Other-net ................................................ 28,250 32,460 ---------- ---------- Total deferred charges ................................. 282,088 304,592 ---------- ---------- TOTAL ................................................ $3,253,636 $2,411,785 ========== ========== LIABILITIES AND CAPITALIZATION: CURRENT LIABILITIES: Accounts payable ......................................... $ 406,457 $ 154,312 Energy commodity liabilities ............................. 330,957 70,135 Taxes and interest accrued ............................... 38,628 35,705 Other .................................................... 88,151 79,586 ---------- ---------- Total current liabilities .............................. 864,193 339,738 ---------- ---------- NON-CURRENT LIABILITIES AND DEFERRED CREDITS: Non-current liabilities .................................. 34,815 25,515 Deferred revenue (Note 1) ................................ 145,124 -- Energy commodity liabilities ............................. 207,948 10,556 Deferred income taxes .................................... 357,702 352,749 Other deferred credits ................................... 11,571 17,230 ---------- ---------- Total non-current liabilities and deferred credits ..... 757,160 406,050 ---------- ---------- CAPITALIZATION (See Consolidated Statements of Capitalization) ............................................ 1,632,283 1,665,997 ---------- ---------- COMMITMENTS AND CONTINGENCIES (Notes 9, 12 and 20) TOTAL ................................................ $3,253,636 $2,411,785 ========== ========== </TABLE> THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE STATEMENTS. 44
49 CONSOLIDATED STATEMENTS OF CAPITALIZATION Avista Corporation - ------------------------------------------------------------------------------- At December 31 Thousands of Dollars <TABLE> <CAPTION> 1998 1997 ----------- ----------- <S> <C> <C> LONG-TERM DEBT: First Mortgage Bonds: 7 1/8% due December 1, 2013 ....................................................... $ 66,700 $ 66,700 7 2/5% due December 1, 2016 ....................................................... 17,000 17,000 Secured Medium-Term Notes: Series A - 5.95% to 8.06% due 2000 through 2023 ................................. 211,500 211,500 Series B - 6.20% to 8.25% due 1999 through 2010 ................................. 150,000 150,000 ----------- ----------- Total first mortgage bonds ...................................................... 445,200 445,200 ----------- ----------- Pollution Control Bonds: 6% Series due 2023 ................................................................ 4,100 4,100 Unsecured Medium-Term Notes: Series A - 7.94% to 9.57% due 1999 through 2007 ................................... 38,500 52,500 Series B - 6.75% to 8.23% due 1999 through 2023 ................................... 115,000 115,000 Series C - 5.99% to 6.88% due 2007 through 2028 ................................... 84,000 -- ----------- ----------- Total unsecured medium-term notes ............................................... 237,500 167,500 ----------- ----------- Notes payable (due within one year) to be refinanced ................................ -- 108,500 Other ............................................................................... 43,222 36,885 ----------- ----------- Total long-term debt .............................................................. 730,022 762,185 ----------- ----------- COMPANY-OBLIGATED MANDATORILY REDEEMABLE PREFERRED TRUST SECURITIES: 7 7/8%, Series A, due 2037 ........................................................ 60,000 60,000 Floating Rate, Series B, due 2037 ................................................. 50,000 50,000 ----------- ----------- Total company-obligated mandatorily redeemable preferred trust securities .................................................................... 110,000 110,000 ----------- ----------- PREFERRED STOCK-CUMULATIVE: 10,000,000 shares authorized: Subject to mandatory redemption: $8.625 Series I; 0 and 100,000 shares outstanding ($100 stated value) ............. -- 10,000 $6.95 Series K; 350,000 shares outstanding ($100 stated value) .................... 35,000 35,000 ----------- ----------- Total subject to mandatory redemption ........................................... 35,000 45,000 ----------- ----------- CONVERTIBLE PREFERRED STOCK: Not subject to mandatory redemption: $12.40 Convertible Series L; 1,540,460 shares outstanding ($182.80 stated value)... 269,227 -- ----------- ----------- Total convertible preferred stock ............................................... 269,227 -- ----------- ----------- COMMON EQUITY: Common stock, no par value; 200,000,000 shares authorized; 40,453,729 and 55,960,360 shares outstanding ...................................... 381,401 594,852 Note receivable from employee stock ownership plan .................................. (9,295) (9,750) Capital stock expense and other paid in capital ..................................... (4,176) (10,143) Other comprehensive income .......................................................... (341) 2,077 Retained earnings ................................................................... 120,445 171,776 ----------- ----------- Total common equity ............................................................... 488,034 748,812 ----------- ----------- TOTAL CAPITALIZATION .................................................................... $ 1,632,283 $ 1,665,997 =========== =========== </TABLE> THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE STATEMENTS. 45
50 CONSOLIDATED STATEMENTS OF CASH FLOWS Increase (Decrease) in Cash and Cash Equivalents Avista Corporation - ------------------------------------------------------------------------------- For the Years Ended December 31 Thousands of Dollars <TABLE> <CAPTION> 1998 1997 1996 -------- -------- -------- <S> <C> <C> <C> OPERATING ACTIVITIES: Net income ..................................................... $ 78,139 $ 114,797 $ 83,453 NON-CASH ITEMS INCLUDED IN NET INCOME: Depreciation and amortization ................................ 70,547 69,893 72,097 Provision for deferred income taxes .......................... 10,402 37,122 12,505 Allowance for equity funds used during construction .......... (1,283) (1,323) (1,072) Power and natural gas cost deferrals and amortizations ....... (3,512) (16,470) 666 Monetization of contract Deferred revenues and other-net .............................. (6,313) (389) (215) (Increase) decrease in working capital components: Sale of customer accounts receivables-net .................. (15,000) -- -- Receivables and prepaid expense ............................ (246,873) (39,733) (26,333) Materials & supplies, fuel stock and natural gas stored .... 9,524 (8,050) 7,741 Payables and other accrued liabilities ..................... 246,208 55,163 21,618 Other ...................................................... (17,336) 13,774 7,103 Monetization of contract ....................................... 143,400 -- -- --------- ---------- ---------- NET CASH PROVIDED BY OPERATING ACTIVITIES .......................... 267,903 224,784 177,563 --------- ---------- ---------- INVESTING ACTIVITIES: Construction expenditures (excluding AFUDC-equity funds) ....... (92,942) (89,016) (91,279) Other capital requirements ..................................... (14,920) (11,696) (1,399) (Increase) decrease in other noncurrent balance sheet items-net .................................................... 27,266 (3,765) 18,565 Proceeds from sale of subsidiary investments ................... 16,385 11,606 -- Assets acquired and investments in subsidiaries ................ (52,780) (43,308) (29,225) --------- ---------- -------- NET CASH USED IN INVESTING ACTIVITIES .............................. (116,991) (136,179) (103,338) --------- ---------- ---------- FINANCING ACTIVITIES: Increase (decrease) in short-term borrowings ................... (108,500) 23,500 55,500 Proceeds from issuance of preferred trust securities ........... -- 110,000 -- Proceeds from issuance of long-term debt ....................... 84,000 20,000 -- Redemption and maturity of long-term debt ...................... (14,000) (51,500) (38,000) Redemption of preferred stock .................................. (10,000) (70,000) (20,000) Sale (repurchase) of common stock .............................. (1,475) -- 216 Cash dividends paid ............................................ (64,548) (75,329) (77,318) Other-net ...................................................... 5,854 (22,894) 8,424 --------- ---------- ---------- NET CASH USED IN FINANCING ACTIVITIES .............................. (108,669) (66,223) (71,178) --------- ---------- ---------- NET INCREASE IN CASH & CASH EQUIVALENTS ............................ 42,243 22,382 3,047 CASH & CASH EQUIVALENTS AT BEGINNING OF PERIOD ..................... 30,593 8,211 5,164 --------- ---------- ---------- CASH & CASH EQUIVALENTS AT END OF PERIOD ........................... $ 72,836 $ 30,593 $ 8,211 ========= ========== ========== SUPPLEMENTAL CASH FLOW INFORMATION: Cash paid during the period: Interest ..................................................... $ 64,402 $ 63,608 $ 56,893 Income taxes ................................................. 40,716 29,132 49,447 Noncash financing and investing activities: Property purchased under capitalized leases .................. 1,209 4,521 4,356 Notes receivable in exchange for land ........................ -- -- 29,913 Net unrealized holding gains (losses) ........................ -- (5,050) (13,680) Notes receivable for sale of investment ...................... 25,000 -- -- Common stock and retained earnings transfer to preferred stock........................................................ 276,821 -- -- </TABLE> THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE STATEMENTS. 46
51 SCHEDULE OF INFORMATION BY BUSINESS SEGMENTS Avista Corporation - ------------------------------------------------------------------------------- For the Years Ended December 31 Thousands of Dollars <TABLE> <CAPTION> 1998 1997 1996 ----------- ----------- ----------- <S> <C> <C> <C> OPERATING REVENUES: Energy Delivery .............................. $ 409,683 $ 380,532 $ 380,428 Generation and Resources ..................... 639,529 511,133 418,566 National Energy Trading and Marketing ........ 2,409,920 247,646 116 Non-energy ................................... 232,292 164,010 145,847 Intersegment eliminations .................... (7,440) (1,149) -- ----------- ----------- ----------- Total operating revenues ................... $ 3,683,984 $ 1,302,172 $ 944,957 =========== =========== =========== RESOURCE COSTS: Energy Delivery: Natural gas purchased for resale ........... $ 109,182 $ 93,880 $ 96,585 PCA and other .............................. (2,586) (2,050) 1,151 Generation and Resources: Power purchased ............................ 469,824 309,439 190,040 Fuel for generation ........................ 44,281 34,461 40,578 Other ...................................... 47,675 50,694 50,237 National Energy Trading and Marketing: Cost of sales .............................. 2,360,110 232,389 -- Intersegment eliminations .................... (7,440) (1,081) -- ----------- ----------- ----------- Total resource costs (excluding Non-energy) .............................. $ 3,021,046 $ 717,732 $ 378,591 =========== =========== =========== GROSS MARGINS: Energy Delivery .............................. $ 303,087 $ 288,702 $ 282,692 Generation and Resources ..................... 77,749 116,539 137,711 National Energy Trading and Marketing ........ 49,810 15,257 116 ----------- ----------- ----------- Total gross margins (excluding Non-energy) .............................. $ 430,646 $ 420,498 $ 420,519 =========== =========== =========== OPERATIONS AND MAINTENANCE EXPENSES: Energy Delivery .............................. $ 60,847 $ 59,138 $ 74,675 National Energy Trading and Marketing ........ 2,173 2,173 73 Non-energy ................................... 166,600 117,215 106,623 ----------- ----------- ----------- Total operations and maintenance expenses .. $ 229,620 $ 178,526 $ 181,371 =========== =========== =========== ADMINISTRATIVE AND GENERAL EXPENSES: Energy Delivery .............................. $ 53,643 $ 46,688 $ 47,664 Generation and Resources ..................... 16,050 16,312 15,339 National Energy Trading and Marketing ........ 26,720 10,442 1,844 Non-energy ................................... 33,358 23,169 12,125 ----------- ----------- ----------- Total administrative and general expenses .. $ 129,771 $ 96,611 $ 76,972 =========== =========== =========== DEPRECIATION AND AMORTIZATION EXPENSES: Energy Delivery .............................. $ 34,436 $ 32,483 $ 33,875 Generation and Resources ..................... 25,102 25,432 27,899 National Energy Trading and Marketing ........ 970 442 -- Non-energy ................................... 10,039 11,536 10,323 ----------- ----------- ----------- Total depreciation and amortization expenses ................................. $ 70,547 $ 69,893 $ 72,097 =========== =========== =========== INCOME/(LOSS) FROM OPERATIONS (PRE-TAX): Energy Delivery .............................. $ 116,944 $ 113,745 $ 89,447 Generation and Resources ..................... 26,209 64,613 84,211 National Energy Trading and Marketing ........ 19,922 2,191 (1,801) Non-energy ................................... 9,745 8,984 15,064 Intersegment eliminations .................... -- (69) -- ----------- ----------- ----------- Total income from operations ............... $ 172,820 $ 189,464 $ 186,921 =========== =========== =========== </TABLE> 47
52 <TABLE> <CAPTION> 1998 1997 1996 ----------- ----------- ----------- <S> <C> <C> <C> INCOME AVAILABLE FOR COMMON STOCK: Energy Delivery and Generation and Resources . $ 47,898 $ 95,385 $ 54,426 National Energy Trading and Marketing ........ 12,064 2,488 (1,161) Non-energy ................................... 9,778 11,532 22,210 ----------- ----------- ----------- Total income available for common stock .... $ 69,740 $ 109,405 $ 75,475 =========== =========== =========== ASSETS: Energy Delivery .............................. $ 1,120,323 $ 1,051,585 $ 1,014,451 Generation and Resources ..................... 619,086 620,142 683,599 Other utility ................................ 265,526 255,012 223,379 National Energy Trading and Marketing ........ 957,421 214,630 899 Non-energy ................................... 291,280 270,416 254,970 ----------- ----------- ----------- Total assets ............................... $ 3,253,636 $ 2,411,785 $ 2,177,298 =========== =========== =========== CAPITAL EXPENDITURES (excluding AFUDC/AFUCE): Energy Delivery .............................. $ 76,587 $ 75,499 $ 80,095 Generation and Resources ..................... 15,708 11,676 8,726 National Energy Trading and Marketing ........ 2,985 4,056 -- Non-energy ................................... 10,990 7,951 2,339 ----------- ----------- ----------- Total capital expenditures ................. $ 106,270 $ 99,182 $ 91,160 =========== =========== =========== </TABLE> THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE STATEMENTS. 48
53 AVISTA CORPORATION - -------------------------------------------------------------------------------- NOTES TO FINANCIAL STATEMENTS - -------------------------------------------------------------------------------- NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES NATURE OF OPERATIONS Avista Corporation (Avista Corp. or the Company), formerly The Washington Water Power Company, was incorporated in the State of Washington in 1889, and operates as a regional utility providing electric and natural gas sales and services and as a national entity providing both energy and non-energy products and services. The utility portion of the Company, doing business as Avista Utilities, consists of two lines of business which are subject to state and federal price regulation - -- (1) Energy Delivery and (2) Generation and Resources. The national businesses are conducted under Avista Capital, which is the parent company to the Company's subsidiaries. Changes underway in the utility and energy industries are creating new opportunities to expand the Company's businesses and serve new markets. In pursuing such opportunities, the Company is shifting its strategic direction to growth in order to achieve its goal of becoming a diversified North American energy company. The Company's growth strategy will expose the Company to risks associated with rapid expansion, challenges in recruiting and retaining qualified personnel, risks associated with acquisitions and joint ventures and increasing competition. In addition, growth in the energy trading and marketing business will expose the Company to increased financial and credit risks associated with commodity trading activities. The Company believes that its extensive experience in the electric and natural gas business, coupled with its strong management team, will allow the Company to effectively manage its transition to a diversified North American energy company. The Energy Delivery line of business includes transmission and distribution services for retail electric operations, all utility natural gas operations, and other energy products and services. Usage by retail customers varies from year to year primarily as a result of weather conditions, customer growth, the economy in the Company's service area, conservation efforts, appliance efficiency and other technology. The Generation and Resources line of business includes the generation and production of electric energy, and short- and long-term electric and natural gas sales trading and wholesale marketing primarily to other utilities and power brokers in the western United States. Energy trading includes short-term sales and purchases, such as next hour, next day and monthly blocks of energy. Wholesale marketing includes sales and purchases under long-term contracts with one-year and longer terms. Generation and Resources manages the Company's electric energy resource portfolio, which is used to serve Energy Delivery's retail electric customers and Generation and Resources' wholesale electric customers. In managing the electric energy resource portfolio, Generation and Resources seeks to optimize the availability and operations of generation resources. Revenues and the cost of electric power purchases vary from year to year depending on the electric wholesale power market, which is affected by several factors, including the availability of water for hydroelectric generation, the availability of base load plants in the region, marginal fuel prices and the demand for power in other areas of the country. Other factors affecting the wholesale power market include lower unit margins on new sales contracts than were realized in the past, fewer long-term power contracts being entered into, deregulation of the electric utility industry and competition from low cost generation being developed by independent power producers. Avista Capital is the parent company to the National Energy Trading and Marketing and Non-energy businesses. The National Energy Trading and Marketing businesses are conducted by Avista Energy, Avista Advantage and Avista Power. Avista Energy focuses on commodity trading, energy marketing and other related businesses on a national basis. Avista Energy's business is affected by several factors, including the demand for and availability of power throughout the United States, lower unit margins on new sales contracts, fewer long-term power contracts being entered into, marginal fuel prices and deregulation of the electric utility industry. Avista Advantage provides a variety of energy-related products and services to commercial and industrial customers on a national basis. Its primary product lines include consolidated billing, resource accounting, energy analysis and load profiling. Avista Power was formed in December 1998 to develop and own generation assets primarily in support of Avista Energy. Avista Power operations had no impact on 1998 earnings. The Non-energy business is conducted primarily by Pentzer Corporation (Pentzer), which is the parent company to the majority of the Company's Non-energy businesses. Pentzer's business strategy is such that its earnings result from both transactional and non-transactional earnings. Transactional gains arise from a one-time event or a specific transaction, such as the sale of an investment or individual company from Pentzer's portfolio of investments. Non-transactional earnings arise out of the ongoing operations of the individual portfolio companies. BASIS OF REPORTING The financial statements are presented on a consolidated basis and, as such, include the assets, liabilities, revenues and expenses of the Company and its wholly owned subsidiaries. All material intercompany transactions have been eliminated in the consolidation. The accompanying financial statements include the Company's proportionate share of utility plant and related operations resulting from its interests in jointly owned plants (See Note 6). The financial activity of each of the Company's lines of business is reported in the "Schedule of Information by Business 49
54 AVISTA CORPORATION - -------------------------------------------------------------------------------- Segments." Such information is an integral part of these financial statements. The preparation of the Company's consolidated financial statements in conformity with generally accepted accounting principles necessarily requires management to make estimates and assumptions that directly affect the reported amounts of assets, liabilities, revenues and expenses. ALLOCATION OF REVENUES AND EXPENSES FOR REPORTING BUSINESS SEGMENTS A portion of the utility's revenues and expenses have been allocated between the two business segments in order to report results of operations by the individual lines of business - (1) Energy Delivery and (2) Generation and Resources. The Energy Delivery business reports the results of the Company's transmission and distribution services for retail electric operations and all natural gas operations. Costs associated with electric energy commodities, such as purchased power expense, as well as the revenues attributable to the recovery of such costs from retail customers, have been eliminated from the Energy Delivery line of business and are reflected in the results of the Generation and Resources line of business. The transfer of revenues between the two utility lines of business occurs through the use of a transfer price, primarily based on cost of production studies, that is associated with the sale of a kilowatthour of electricity. The results of all natural gas operations are included in the Energy Delivery line of business because natural gas trackers allow natural gas costs to pass through within that line of business without the commodity prices having a material income effect. The Generation and Resources line of business includes the generation and production of electric energy, and short- and long-term electric and natural gas commodity trading and wholesale marketing primarily to other utilities and power brokers in the western United States. SYSTEM OF ACCOUNTS The accounting records of the Company's utility operations are maintained in accordance with the uniform system of accounts prescribed by the Federal Energy Regulatory Commission (FERC) and adopted by the appropriate state regulatory commissions. REGULATION The Company is subject to state regulation in Washington, Idaho and Montana for its electric operations. Natural gas operations are regulated in Washington, Idaho, Oregon and California. The Company is subject to regulation by the FERC with respect to its wholesale electric transmission rates and the natural gas rates charged for the release of capacity from the Jackson Prairie Storage Project. OPERATING REVENUES The Company accrues estimated unbilled revenues for electric and natural gas sales and services provided through month-end. Avista Energy follows the mark-to-market method of accounting for energy contracts entered into for trading and price risk management purposes. Avista Energy recognized revenue based on the change in the market value of outstanding derivative commodity sales contracts, net of future servicing costs and reserves, in addition to revenue related to physical and financial contracts that have matured. OTHER INCOME (DEDUCTIONS)--NET Other income (deductions)-net is composed of the following items: <TABLE> <CAPTION> YEARS ENDED DECEMBER 31, -------------------------------------- 1998 1997 1996 -------- -------- -------- (Thousands of Dollars) <S> <C> <C> <C> Interest income .................... $ 9,560 $ 6,392 $ 5,760 Capitalized interest (debt) ........ 1,592 1,549 1,290 Gain (loss) on property dispositions 12 (1,222) (152) Minority interest .................. 296 (574) (1,193) Capitalized interest (equity) ...... 1,283 1,323 1,072 Other .............................. (2,949) (13,341) (5,586) -------- -------- -------- Total ......................... $ 9,794 $ (5,873) $ 1,191 ======== ======== ======== </TABLE> EARNINGS PER SHARE Financial Accounting Standard (FAS) No. 128, "Earnings Per Share," became effective in the fourth quarter of 1997 and requires two presentations of earnings per share - "basic" and "diluted." Basic earnings per share (EPS) is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if dilutive securities, such as stock options and convertible stock, were exercised or converted into common stock that then shared in the earnings of the Company. See Note 18 for more information regarding the EPS calculations. UTILITY PLANT The cost of additions to utility plant, including an allowance for funds used during construction and replacements of units of property and betterments, is capitalized. Costs of depreciable units of property retired plus costs of removal less salvage are charged to accumulated depreciation. 50
55 AVISTA CORPORATION - -------------------------------------------------------------------------------- ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION The Allowance for Funds Used During Construction (AFUDC) represents the cost of both the debt and equity funds used to finance utility plant additions during the construction period. In accordance with the uniform system of accounts prescribed by regulatory authorities, AFUDC is capitalized as a part of the cost of utility plant and is credited currently as a noncash item to Other Income (see Other Income above). The Company generally is permitted, under established regulatory rate practices, to recover the capitalized AFUDC, and a fair return thereon, through its inclusion in rate base and the provision for depreciation after the related utility plant has been placed in service. Cash inflow related to AFUDC does not occur until the related utility plant investment is placed in service. The effective AFUDC rate was 10.67% in 1998, 1997 and 1996. The Company's AFUDC rates do not exceed the maximum allowable rates as determined in accordance with the requirements of regulatory authorities. DEPRECIATION For utility operations, depreciation provisions are estimated by a method of depreciation accounting utilizing unit rates for hydroelectric plants and composite rates for other properties. Such rates are designed to provide for retirements of properties at the expiration of their service lives. The rates for hydroelectric plants include annuity and interest components, in which the interest component is 6%. For utility operations, the ratio of depreciation provisions to average depreciable property was 2.60% in 1998, 2.59% in 1997 and 2.58% in 1996. The average service lives and remaining average service lives, respectively, for the following broad categories of property are: electric thermal production - 35 and 18 years; hydroelectric production - 100 and 80 years; electric transmission - - 60 and 29 years; electric distribution - 40 and 32 years; and natural gas distribution property - 44 and 31 years. CASH AND CASH EQUIVALENTS For the purposes of the Consolidated Statements of Cash Flows, the Company considers all temporary investments with an initial maturity of three months or less to be cash equivalents. TEMPORARY INVESTMENTS Investments in debt and marketable equity securities are classified as "available for sale" and are recorded at fair value. Investments totaling $4.3 million and $5.8 million are included on the Consolidated Balance Sheets at December 31, 1998 as other property and investments and current assets, respectively. Investments totaling $28.2 million and $22.6 million are included on the Consolidated Balance Sheets at December 31, 1997 as other property and investments and current assets, respectively. Unrealized investment gains, as of December 31, 1998 and 1997, of $0.02 million and $2.1 million, respectively, net of taxes, are reflected as a component of other comprehensive income. DEFERRED CHARGES AND CREDITS The Company prepares its financial statements in accordance with the provisions of FAS No. 71, "Accounting for the Effects of Certain Types of Regulation." A regulated enterprise can prepare its financial statements in accordance with FAS No. 71 only if (i) the enterprise's rates for regulated services are established by or subject to approval by an independent third-party regulator, (ii) the regulated rates are designed to recover the enterprise's cost of providing the regulated services and (iii) in view of demand for the regulated services and the level of competition, it is reasonable to assume that rates set at levels that will recover the enterprise's costs can be charged to and collected from customers. FAS No. 71 requires a cost-based, rate-regulated enterprise to reflect the impact of regulatory decisions in its financial statements. In certain circumstances, FAS No. 71 requires that certain costs and/or obligations (such as incurred costs not currently recovered through rates, but expected to be so recovered in the future) be reflected in a deferral account in the balance sheet and not be reflected in the statement of income or loss until matching revenues are recognized. If at some point in the future the Company determines that it no longer meets the criteria for continued application of FAS No. 71 to all or a portion of the Company's regulated operations, the Company could be required to write off its regulatory assets and could be precluded from the future deferral in the Consolidated Balance Sheet of costs not recovered through rates at the time such costs were incurred, even if such costs were expected to be recovered in the future. The Company's primary regulatory assets include Investment in Exchange Power, conservation programs, deferred income taxes, the provision for postretirement benefits and debt issuance and redemption costs. Those items without a specific line on the Consolidated Balance Sheets are included in Deferred Charges - Other-net. Deferred credits include natural gas deferrals, unrecovered purchased gas costs and the gain on the general office building sale/leaseback which is being amortized over the life of the lease, and are included on the Consolidated Balance Sheets as Non-current Liabilities and Deferred Credits - Other Deferred Credits. DEFERRED REVENUES In December 1998, the Company received cash proceeds of $143.4 million from the monetization of a contract in which the Company assigned and transferred certain rights under a long-term power sales contract to a funding trust. The proceeds were recorded as deferred revenue and are being amortized into revenues over the 16-year period of the long-term sales contract. 51
56 AVISTA CORPORATION - -------------------------------------------------------------------------------- POWER AND NATURAL GAS COST ADJUSTMENT PROVISIONS The Company has a power cost adjustment mechanism (PCA) in Idaho which allows the Company to modify electric rates to recover or rebate a portion of the difference between actual and allowed net power supply costs. The PCA tracks changes in hydroelectric generation, secondary prices, related changes in thermal generation and Public Utility Regulatory Policies Act of 1978 (PURPA) contracts. Rate changes are triggered when the deferred balance reaches $2.2 million. A $3.1 million (2.7%) rebate was effective February 1, 1999, which will expire January 31, 2000. The following surcharges and rebates were in effect during the past three years: a $2.7 million (2.4%) rebate effective June 1, 1998, which will expire May 31, 1999; a $2.6 million (2.3%) rebate effective September 1, 1997, which expired August 31, 1998; a $2.6 million (2.4%) rebate effective June 1, 1997, which expired May 31, 1998; a $2.5 million (2.3%) rebate effective September 1, 1996, which expired August 31, 1997; and a $2.3 million (2.4%) surcharge effective September 1, 1995, which expired August 31, 1996. The rebates balance and the deferred balance are included in the Current Liabilities - - Other and Non-Current Liabilities and Deferred Credits - Other Deferred Credits lines, respectively, on the Consolidated Balance Sheets. Under established regulatory practices, the Company is also allowed to adjust its natural gas rates from time to time to reflect increases or decreases in the cost of natural gas purchased. Differences between actual natural gas costs and the natural gas costs allowed in rates are deferred and charged or credited to expense when regulators approve inclusion of the cost changes in rates. In Oregon, regulatory provisions include a sharing of benefits and risks associated with changes in natural gas prices, as well as a sharing of benefits if certain threshold earnings levels are exceeded. The balance is included on the Consolidated Balance Sheets as Non-current Liabilities and Deferred Credits - Other Deferred Credits. INCOME TAXES The Company and its eligible subsidiaries file consolidated federal income tax returns. Subsidiaries are charged or credited with the tax effects of their operations on a stand-alone basis. The Company's federal income tax returns have been examined with all issues resolved, and all payments made, through the 1994 return. STOCK-BASED COMPENSATION Compensation cost for stock options is measured as the excess of the quoted market price of the Company's stock at the date of grant over the amount an employee must pay to acquire the stock. Restricted stock is recorded as compensation cost over the requisite vesting periods based on the market value on the date of grant. The Company accounts for its stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" rather than using the fair-value-based method of accounting for stock-based employee compensation plans as prescribed under FAS No. 123, "Accounting for Stock-Based Compensation." However, the Company has adopted the disclosure requirements of FAS No. 123. See Note 20 for more information about the Company's stock-based compensation plans. OTHER COMPREHENSIVE INCOME Effective January 1, 1998, the Company adopted FAS No. 130, "Reporting Comprehensive Income," which establishes new rules for the reporting and display of comprehensive income (net income plus all other changes in net assets from nonowner sources) and its components. The adoption had no impact on the Company's net income or stockholders' equity. Prior year financial statements have been reclassified to conform to these requirements. The following table reflects the accumulated balances of other comprehensive income: <TABLE> <CAPTION> Foreign Unrealized Currency Investment Translation Comprehensive Gain/(Loss) Adjustment Income - ----------------------------------------------------------------------------------------- <S> <C> <C> <C> Balance at January 1, 1996 $19,220 $ 19,220 Unrealized investment gain/(loss), net of tax of $4,769 (8,856) (8,856) Less: reclassification adjustment, net of tax of $2,510 (4,660) (4,660) - ----------------------------------------------------------------------------------------- Balance at December 31, 1996 5,704 5,704 Unrealized investment gain/(loss), net of tax of $810 1,504 1,504 Less: reclassification adjustment, net of tax of $2,762 (5,131) (5,131) - ----------------------------------------------------------------------------------------- Balance at December 31, 1997 2,077 2,077 Unrealized investment gain/(loss), net of tax of $1,105 (2,052) (2,052) Foreign currency translation adjustment (366) (366) - ----------------------------------------------------------------------------------------- Balance at December 31, 1998 $ 25 $ (366) $ (341) ========================================================================================= </TABLE> 52
57 AVISTA CORPORATION - -------------------------------------------------------------------------------- CUMULATIVE FOREIGN CURRENCY TRANSLATION ADJUSTMENT Assets and liabilities of one of Pentzer's portfolio companies are denominated in Canadian dollars and translated to U. S. dollars at exchange rates in effect on the balance sheet date. Revenues, costs and expenses for the company are translated using an average rate. Cumulative translation adjustments resulting from this process are reflected as a component of other comprehensive income in the shareholders' equity section in the Consolidated Statements of Capitalization. NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued FAS No. 132, entitled "Employers' Disclosures about Pensions and Other Postretirement Benefits," which is effective for fiscal years beginning after December 15, 1997. This statement revises disclosures, but does not change the measurement or recognition of the plans. The Company adopted FAS No. 132 in 1998 and the required disclosure can be found in Note 7. The FASB issued FAS No. 133, entitled "Accounting for Derivative Instruments and Hedging Activities" which will be effective for fiscal years beginning after June 15, 1999. The statement requires that all derivative financial instruments be recognized as either assets or liabilities on the company's balance sheets at fair value. The accounting for changes in the fair value of a derivative will depend on the intended use of the derivative and the resulting designation. Avista Energy currently accounts for derivative commodity instruments entered into for trading purposes using the mark-to-market method of accounting, in compliance with EITF 98-10, "Accounting for Energy Trading and Risk Management Activities." The Company is in the process of researching the statement and its possible impact on the Company's financial position and results of operations. RECLASSIFICATIONS Certain prior year amounts have been reclassified to conform to current statement format. These reclassifications were made for comparative purposes and have not affected previously reported total net income or common shareholders' equity. NOTE 2. ACCOUNTS RECEIVABLE SALE In July 1997, WWP Receivables Corp. (WWPRC) was incorporated as a wholly owned, bankruptcy-remote subsidiary of the Company for the purpose of acquiring or purchasing interests in certain accounts receivable, both billed and unbilled, of the Company. Subsequently, WWPRC and the Company have entered into an agreement whereby WWPRC can sell without recourse, on a revolving basis, up to $80.0 million in those receivables. WWPRC is obligated to pay fees which approximate the purchaser's cost of issuing commercial paper equal in value to the interests in receivables sold. On a consolidated basis, the amount of such fees is included in operating expenses of the Company. At December 31, 1998 and 1997, $25.0 million and $40.0 million, respectively, in receivables had been sold pursuant to the agreement, which qualify as sales of assets under FAS No. 125. NOTE 3. ENERGY COMMODITY TRADING The Company's energy-related businesses are exposed to risks relating to changes in certain commodity prices and counterparty performance. In order to manage the various risks relating to these exposures, the Company utilizes electric, natural gas and related derivative commodity instruments, such as forwards, futures, swaps and options, and Avista Energy engages in the trading of such instruments. The Company and Avista Energy have adopted policies and procedures to manage the risks inherent these activities and have established a comprehensive Risk Management Committee, separate from the units that create such risk exposure and overseen by the Audit and Finance Committee of the Company's Board of Directors, to monitor compliance with the Company's risk management policies and procedures. GENERATION AND RESOURCES The Company protects itself against price fluctuations on electric energy and natural gas by limiting the aggregate level of net open positions which are exposed to market price changes and through the use of electric, natural gas and related derivative commodity instruments for hedging purposes. The net open position is actively managed with strict policies designed to limit the exposure to market risk and which require daily and weekly reporting to management of potential financial exposure. The Risk Management Committee has limited the types of commodity instruments the Company may trade to those related to electricity and natural gas commodities and those instruments are to be used for hedging price fluctuations associated with the management of resources. Commodity instruments are not generally held by the Company for speculative trading purposes. Gains and losses related to derivative commodity instruments which qualify as hedges are recognized in the Consolidated Statements of Income when the underlying hedged physical transaction closes (the deferral method) and are included in the same category as the hedged item (natural gas purchased or purchased power expense, as the case may be). At December 31, 1998 and 1997, the Company's derivative commodity instruments outstanding were immaterial. 53
58 AVISTA CORPORATION - -------------------------------------------------------------------------------- NATIONAL ENERGY TRADING AND MARKETING Avista Energy purchases natural gas and electricity directly from producers and other trading companies, and its customers include commercial and industrial end-users, electric utilities, natural gas distribution companies, and other trading companies. Avista Energy's marketing and energy risk management services are provided through the use of a variety of derivative commodity contracts to purchase or supply natural gas and electric energy at specified delivery points and at specified future dates. Avista Energy also trades natural gas and electricity derivative financial instruments on national exchanges and through other unregulated exchanges and brokers from whom these commodity derivatives are available, and therefore experiences net open positions in terms of price, volume, and specified delivery point. The open position exposes Avista Energy to the risk that fluctuating market prices may adversely impact its financial position or results of operations. However, the net open position is actively managed with strict policies designed to limit the exposure to market risk and which require daily reporting to management of potential financial exposure. These policies include statistical risk tolerance limits using historical price movements to calculate daily earnings at risk as well as total Value-at-Risk (VAR) measurement. Derivative commodity instruments sold and purchased by Avista Energy include: forward contracts, involving physical delivery of an energy commodity; futures contracts, which involve the buying or selling of natural gas, electricity or other energy-related commodities at a fixed price; over-the-counter swap agreements which require Avista Energy to receive or make payments based on the difference between a specified price and the actual price of the underlying commodity; and options, which mitigate price risk by providing for the right, but not the requirement, to buy or sell energy-related commodities at a fixed price. Foreign currency risks associated with the fair value of the energy commodity portfolio are managed using a variety of financial instruments, including forward rate agreements. Avista Energy's trading activities are subject to mark-to-market accounting, under which changes in the market value of outstanding electric, natural gas and related derivative commodity instruments are recognized as gains or losses in the period of change. Gains and losses on electric, natural gas and related derivative commodity instruments utilized for trading are recognized in income on a current basis (the mark-to-market method) and are included on the Consolidated Statements of Income in operating revenues or resource costs, as appropriate, and on the Consolidated Balance Sheets as current or non-current energy commodity assets or liabilities. Contracts in a receivable position, as well as the options held, are reported as assets. Similarly, contracts in a payable position, as well as options written, are reported as liabilities. Cashflows are recognized during the period of settlement. Contract Amounts and Terms Under Avista Energy's derivative instruments, Avista Energy either (i) as "fixed price payor," is obligated to pay a fixed price or amount and is entitled to receive the commodity (or currency) or a variable amount or (ii) as "fixed price receiver," is entitled to receive a fixed price or amount and is obligated to deliver the commodity (or currency) or pay a variable amount. The contract or notional amounts and terms of Avista Energy's derivative commodity investments outstanding at December 31, 1998 are set forth below (volumes in thousands of mmBTUs and MWhs, dollars in thousands): <TABLE> <CAPTION> Fixed Price Fixed Price Maximum Payor Receiver Terms in Years ----------- ----------- -------------- <S> <C> <C> <C> Energy commodities (volumes) Natural gas 755,714,915 792,456,145 5 Electric 70,921,632 62,018,852 10 Financial products Foreign currency -- $ 15,691 5 </TABLE> At December 31, 1998, Avista Energy also had sales and purchase commitments associated with contracts based on market prices totaling 898,316,063 mmBTUs, with terms extending up to 12 years. Fixed index electric transactions totaled 1,875,576 MWhs, with terms extending up to 10 years. Contract or notional amounts reflect the volume of transactions, but do not necessarily represent the amounts exchanged by the parties to the derivative instruments. Accordingly, contract or notional amounts do not accurately measure Avista Energy's exposure to market or credit risks. The maximum terms in years detailed above are not indicative of likely future cash flows as these positions may be offset in the markets at any time in response to Avista Energy's risk management needs. 54
59 AVISTA CORPORATION - -------------------------------------------------------------------------------- Fair Value The fair value of Avista Energy's derivative commodity instruments outstanding at December 31, 1998, and the average fair value of those instruments held during the year are set forth below (dollars in thousands): <TABLE> <CAPTION> Fair Value Average Fair Value for the as of December 31, 1998 year ended December 31, 1998 --------------------------------------- --------------------------------------- Current Long-term Current Long-term Current Long-term Current Long-term Assets Assets Liabilities Liabilities Assets Assets Liabilities Liabilities -------- --------- ----------- ----------- -------- --------- ----------- ----------- <S> <C> <C> <C> <C> <C> <C> <C> <C> Natural gas $139,400 $102,271 $143,201 $ 92,161 $ 94,918 $ 35,326 $ 95,959 $ 31,982 Electric 195,824 134,373 187,756 115,787 123,053 110,170 116,593 99,754 -------- --------- ----------- ----------- -------- --------- ----------- ----------- Total $335,224 236,644 $330,957 $207,948 $217,971 $145,496 $212,552 $131,736 </TABLE> The weighted average term of Avista Energy's natural gas and related derivative commodity instruments as of December 31, 1998 was approximately three months. The weighted average term of Avista Energy's electric derivative commodity instruments at year-end was approximately ten months. The change in the fair value position of Avista Energy's energy commodity portfolio, net of the reserves for credit and market risk from December 31, 1997 to December 31, 1998 was $22.8 million and is included on the Consolidated Statements of Income in operating revenues. MARKET RISK The Company manages, on a portfolio basis, the market risks inherent in its activities subject to parameters established by its Risk Management Committee. Market risks are monitored by the Risk Management Committee to ensure compliance with the Company's stated risk management policies. The Company measures the risk in its portfolio on a daily basis in accordance with value-at-risk and other risk methodologies established by the Risk Management Committee. The quantification of market risk using value-at-risk provides a consistent measure of risk across diverse energy markets and products. CREDIT RISK The Company is exposed to credit risk in the event of nonperformance by customers or counterparties of their contractual obligations. The concentration of customers and/or counterparties may impact overall exposure to credit risk, either positively or negatively, in that the counterparties may be similarly affected by changes in economic, regulatory or other conditions. However, the Company maintains credit policies with regard to their customers and counterparties that management believes significantly minimize overall credit risk. These policies include an evaluation of potential customers' and counterparties' financial condition and credit rating, collateral requirements or other credit enhancements such as letters of credit or parent company guarantees, and the use of standardized agreements which allow for the netting or offsetting of positive and negative exposures associated with a single counterparty. The Company maintains credit reserves which are based on management's evaluation of the credit risk of the overall portfolio. Based on these policies, exposures and the credit reserves, the Company does not anticipate a materially adverse effect on financial position or results of operations as a result of customer or counterparty nonperformance. New York Mercantile Exchange traded futures and option contracts are financially guaranteed by the Exchange and have nominal credit risk. Avista Energy has concentrations of suppliers and customers in the electric and natural gas industries, including electric utilities, natural gas distribution companies and other energy marketing and trading companies. In addition, Avista Energy has concentrations of credit risk related to geographic location. Avista Energy operates in North America, principally within the West and Mid-West United States and Western Canada. These concentration of counterparties and concentrations of geographic location may impact Avista Energy's overall exposure to credit risk, either positively or negatively, in that the counterparties may be similarly affected by changes in economic, regulatory or other conditions. NOTE 4. NATIONAL ENERGY TRADING AND MARKETING EQUITY INVESTMENT Effective November 30, 1998, Avista Energy sold its 50% ownership interest in Howard/Avista Energy LLC to H&H Star Energy, Inc. The sales price, which represented Avista Energy's equity investment, was $25 million in the form of a short-term unsecured note receivable from H&H Star Energy, Inc., and is guaranteed by H&H Star Energy, Inc.'s parent company, Howard Publications, Inc. The note is due April 30, 1999. The Company's initial equity investment in Howard/Avista Energy, LLC was $25 million and the investment in the net assets of the unconsolidated subsidiary amounted to $26.8 million at December 31, 1997. Dividends of $0.7 million were received from Howard/Avista Energy, LLC in 1998. Avista Energy's pre-tax equity in earnings of Howard/Avista Energy LLC were $(1.0) million and $1.8 million for the eleven months ended November 30, 1998 and the five months ended December 31, 1997, respectively. 55
60 AVISTA CORPORATION - -------------------------------------------------------------------------------- NOTE 5. PROPERTY, PLANT AND EQUIPMENT The year-end balances of the major classifications of property, plant and equipment are detailed in the following table (thousands of dollars): <TABLE> <CAPTION> AT DECEMBER 31, ------------------------------ 1998 1997 ---------- ---------- <S> <C> <C> Energy Delivery: Electric distribution ........................ $ 593,787 $ 567,552 Electric transmission ........................ 266,344 262,393 Natural gas underground storage .............. 18,732 18,646 Natural gas distribution ..................... 352,332 329,232 Natural gas transmission ..................... 3,217 3,059 Construction work in progress (CWIP) and other 176,022 163,949 ---------- ---------- Energy Delivery total ...................... 1,410,434 1,344,831 ---------- ---------- Generation and Resources: Electric production .......................... 709,144 702,092 CWIP and other ............................... 21,114 21,549 ---------- ---------- Generation and Resources total ............. 730,258 723,641 ---------- ---------- Total utility ................................. 2,140,692 2,068,472 National Energy Trading and Marketing ......... 7,304 4,345 Non-energy .................................... 37,749 44,831 ---------- ---------- Total ......................................... $2,185,745 $2,117,648 ========== ========== </TABLE> National Energy Trading and Marketing's and Non-energy's plant, property and equipment under capital leases totaled $13.3 million and $12.9 million and the associated accumulated depreciation totaled $2.8 million and $2.6 million in 1998 and 1997, respectively. NOTE 6. JOINTLY OWNED ELECTRIC FACILITIES The Company has investments in jointly owned generating plants. Financing for the Company's ownership in the projects is provided by the Company. The Company's share of related operating and maintenance expenses for plants in service is included in corresponding accounts in the Consolidated Statements of Income. See Note 17 for additional information related to potential impacts of Clean Air Act Amendments on these plants. The following table indicates the Company's percentage ownership and the extent of the Company's investment in such plants at December 31, 1998: <TABLE> <CAPTION> COMPANY'S CURRENT SHARE OF ------------------------------------------------------------------ KW of Construction Installed Fuel Ownership Plant in Accumulated Net Plant Work in Project Capacity Source (%) Service Depreciation In Service Progress - ------- --------- ------ --------- --------- ------------ ----------- ------------ (Thousands of Dollars) <S> <C> <C> <C> <C> <C> <C> <C> Centralia ....... 1,330,000 Coal 15% $ 57,536 $ 38,352 $ 19,184 $-- Colstrip 3 & 4... 1,556,000 Coal 15 275,976 114,927 161,049 $-- </TABLE> NOTE 7. PENSION PLANS AND OTHER POSTRETIREMENT BENEFIT PLANS The Company has a pension plan covering substantially all of its regular full-time employees. Certain of the Company's subsidiaries also participate in this plan. Individual benefits under this plan are based upon years of service and the employee's average compensation as specified in the Plan. The Company's funding policy is to contribute annually an amount equal to the net periodic pension cost, provided that such contributions are not less than the minimum amounts required to be funded under the Employee Retirement Income Security Act, nor more than the maximum amounts which are currently deductible for tax purposes. Pension fund assets are invested primarily in marketable debt and equity securities. The Company also has other plans which cover the executive officers and key managers. The Company provides certain health care and life insurance benefits for substantially all of its retired employees. The Company accrues the estimated cost of postretirement benefit payments during the years that employees provide services and allows recognition of the unrecognized transition obligation in the year of adoption or the amortization of such obligation over a period of up to twenty years. The Company elected to amortize this obligation of approximately $34,500,000 over a period of twenty years, beginning in 1993. 56
61 AVISTA CORPORATION - -------------------------------------------------------------------------------- The following table sets forth the pension and health care plan disclosures: <TABLE> <CAPTION> Pension Benefits Other Benefits -------------------------- -------------------------- 1998 1997 1998 1997 --------- --------- --------- --------- (Thousands of Dollars) <S> <C> <C> <C> <C> CHANGE IN BENEFIT OBLIGATION Benefit obligation at beginning of year $ 155,565 $ 143,237 $ 31,802 $ 30,977 Service cost 4,982 4,761 585 637 Interest cost 11,247 10,601 2,100 2,247 Amendments 5,454 -- -- (1,389) Actuarial loss 10,088 4,930 108 1,359 Benefits paid (8,747) (7,964) (2,250) (2,029) --------- --------- --------- --------- Benefit obligation at end of year $ 178,589 $ 155,565 $ 32,345 $ 31,802 --------- --------- --------- --------- CHANGE IN PLAN ASSETS Fair value of plan assets at beginning of year $ 166,242 $ 149,846 $ 11,098 $ 5,388 Actual return on plan assets 21,384 21,042 1,374 973 Employer contributions -- 3,318 731 5,016 Benefits paid (8,747) (7,964) (744) (279) --------- --------- --------- --------- Fair value of plan assets at end of year $ 178,879 $ 166,242 $ 12,459 $ 11,098 --------- --------- --------- --------- Funded status $ 289 $ 10,677 $ (19,886) $ (20,704) Unrecognized net actuarial gain (19,767) (23,802) (5,626) (5,639) Unrecognized prior service cost 19,455 15,655 -- -- Unrecognized net transition obligation/(asset) (7,015) (8,101) 21,467 23,000 --------- --------- --------- --------- Accrued benefit cost $ (7,038) $ (5,571) $ (4,045) $ (3,343) ========= ========= ========= ========= ASSUMPTIONS AS OF DECEMBER 31 Discount rate 6.75% 7.25% 6.75% 7.25% Expected return on plan assets 9.00% 9.00% 9.00% 9.00% Rate of compensation increase 4.00% 4.00% Medical cost trend - initial 5.00% 5.00% Medical cost trend - ultimate 5.00% 5.00% Year for ultimate medical cost trend 1998 1997 COMPONENTS OF NET PERIODIC BENEFIT COST Service cost $ 4,982 $ 4,762 $ 585 $ 637 Interest cost 11,247 10,601 2,100 2,247 Expected return on plan assets (14,768) (13,152) (953) (973) Transition (asset)/obligation recognition (1,086) (1,086) 1,533 1,570 Amortization of prior service cost 1,654 1,365 -- 13 Net gain recognition (562) (265) (326) (248) Asset gain deferred -- -- -- 336 --------- --------- --------- --------- Net periodic benefit cost $ 1,467 $ 2,225 $ 2,939 $ 3,582 --------- --------- --------- --------- </TABLE> Assumed health cost trend rates have a significant effect on the amounts reported for the health care plans. A one-percentage-point increase in the assumed health care cost trend rate for each year would increase the accumulated postretirement benefit obligation as of December 31, 1998 by approximately $2.6 million and the service and interest cost by approximately $212,000. The Company also sponsors an employee savings plan which covers substantially all employees. Employer matching contributinos of $2.8 million, $2.9 million and $2.8 million were expensed in 1998, 1997 and 1996, respectively. NOTE 8. ACCOUNTING FOR INCOME TAXES In June 1997, the Company received $81 million from the Internal Revenue Service (IRS) to settle an income tax claim relating to its investment in the terminated nuclear project 3 of the Washington Public Power Supply System (WNP3). The $81 million recovery included $34 million in income taxes the Company overpaid in prior years plus $47 million in accrued interest, which in total contributed $41.4 million, or $0.74 per share, to net income. 57
62 AVISTA CORPORATION - -------------------------------------------------------------------------------- The Company had claimed that it realized a loss in 1985 relating to its $195 million investment in WNP3 entitling it to current tax deductions. The IRS, however, originally denied the Company's claim and ruled that the investment should be written off over 32.5 years, the term of a settlement agreement between the Company and the Bonneville Power Administration relating to WNP3. The Company disagreed with this ruling and had been pursuing a reversal for several years. The IRS has now agreed with the Company's position. The Company entered into settlement agreements with the WUTC and the IPUC in 1987 and 1988 providing for the recovery through retail prices of approximately 60% of the Company's $195 million investment in WNP3. As a result of these agreements, customers have been and will continue to receive the tax benefits relating to the recoverable portion of WNP3 over the recovery periods specified in the settlement agreements. The settlement agreements resulted in a write-off of approximately $75 million of the Company's WNP3 investment, with the entire write-off charged to shareholders. The tax recovery and related accrued interest from the IRS will flow through to the benefit of shareholders. The cash was used to fund new business investment, including growth opportunities in national energy markets, and reduced the need for issuance of long-term debt during 1997. As of December 31, 1998 and 1997, the Company had recorded net regulatory assets of $171.0 million and $176.7 million, respectively, related to the probable recovery of FAS No. 109, "Accounting for Income Taxes," deferred tax liabilities from customers through future rates. Such regulatory assets will be adjusted by amounts recovered through rates. Deferred income taxes reflect the net tax effects of (a) temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes, and (b) tax credit carryforwards. The net deferred federal income tax liability consists of the following (thousands of dollars): <TABLE> <CAPTION> 1998 1997 -------- -------- <S> <C> <C> Deferred tax liabilities: Differences between book and tax bases of utility plant $375,881 $368,137 Loss on reacquired debt 4,979 5,504 Other 7,462 5,825 -------- -------- Total deferred tax liabilities 388,322 379,466 -------- -------- Deferred tax assets: Reserves not currently deductible 11,727 12,630 Contributions in aid of construction 7,159 6,277 Deferred natural gas credits -- 1,138 Centralia Trust 2,325 2,515 Gain on sale of office building 1,190 1,279 Other 8,219 2,878 -------- -------- Total deferred tax assets 30,620 26,717 -------- -------- Net deferred tax liability $357,702 $352,749 ======== ======== </TABLE> A reconciliation of federal income taxes derived from statutory tax rates applied to income from continuing operations and federal income tax as set forth in the accompanying Consolidated Statements of Income and Retained Earnings is as follows (the current and deferred effective tax rates are approximately the same during all periods): <TABLE> <CAPTION> FOR THE YEARS ENDED DECEMBER 31, -------------------------------------- 1998 1997 1996 -------- -------- -------- (Thousands of Dollars) <S> <C> <C> <C> Computed federal income taxes at statutory rate $ 50,468 $ 60,552 $ 46,103 Increase (decrease) in tax resulting from: Accelerated tax depreciation 9,929 5,014 23 Prior year audit adjustments (1,526) (31,458) (3,491) Reserve for WNP3 -- 10,402 -- Other (18,793) 12,500 3,955 -------- -------- -------- Total federal income tax expense* $ 40,078 $ 57,010 $ 46,590 ======== ======== ======== INCOME TAX EXPENSE CONSISTS OF THE FOLLOWING: Federal taxes currently provided $ 20,094 $ 51,104 $ 37,456 Deferred income taxes 19,984 5,906 9,134 -------- -------- -------- Total federal income tax expense 40,078 57,010 46,590 State income tax expense 3,257 4,065 2,919 -------- -------- -------- Federal and state income taxes $ 43,335 $ 61,075 $ 49,509 ======== ======== ======== </TABLE> 58
63 AVISTA CORPORATION - -------------------------------------------------------------------------------- <TABLE> <CAPTION> FOR THE YEARS ENDED DECEMBER 31, -------------------------------------- 1998 1997 1996 -------- -------- -------- (Thousands of Dollars) <S> <C> <C> <C> *Federal Income Tax Expense: Utility $ 28,582 $ 50,409 $ 34,866 National Energy Trading and Marketing 7,021 1,415 (625) Non-energy 4,475 5,186 12,349 -------- -------- -------- Total Federal Income Tax Expense $ 40,078 $ 57,010 $ 46,590 ======== ======== ======== Federal statutory rate 35% 35% 35% </TABLE> NOTE 9. LONG-TERM PURCHASED POWER CONTRACTS WITH REQUIRED MINIMUM PAYMENTS Under fixed contracts with Public Utility Districts (PUD), the Company has agreed to purchase portions of the output of certain generating facilities. Although the Company has no investment in such facilities, these contracts provide that the Company pay certain minimum amounts (which are based at least in part on the debt service requirements of the supplier) whether or not the facility is operating. The cost of power obtained under the contracts, including payments made when a facility is not operating, is included in operations and maintenance expense in the Consolidated Statements of Income. Information as of December 31, 1998, pertaining to these contracts is summarized in the following table: <TABLE> <CAPTION> COMPANY'S CURRENT SHARE OF -------------------------------------------------------------- Contract Debt Revenue Expira- Kilowatt Annual Service Bonds tion Output Capability Costs(1) Costs(2) Outstanding Date ------- ---------- --------- --------- ----------- ------- (Thousands of Dollars) <S> <C> <C> <C> <C> <C> <C> PUD CONTRACTS: Chelan County PUD: Rocky Reach Project ... 2.9% 37,000 $ 1,660 $ 817 $ 6,493 2011 Grant County PUD: Priest Rapids Project . 6.1 55,000 1,464 854 10,485 2005 Wanapum Project ....... 8.2 75,000 2,289 1,525 15,965 2009 Douglas County PUD: Wells Project ......... 3.7 30,000 822 583 6,383 2018 ------- -------- -------- -------- Totals ........ 197,000 $ 6,235 $ 3,779 $ 39,326 ======= ======== ======== ======== </TABLE> (1) The annual costs will change in proportion to the percentage of output allocated to the Company in a particular year. Amounts represent the operating costs for the year 1998. (2) Included in annual costs. Actual expenses for payments made under the above contracts for the years 1998, 1997 and 1996, were $6.2 million, $5.9 million and $5.4 million, respectively. The estimated aggregate amounts of required minimum payments (the Company's share of debt service costs) under the above contracts for the next five years are $3.9 million in 1999, $4.0 million in 2000, $4.0 million in 2001, $5.5 million in 2002 and $5.2 million in 2003 (minimum payments thereafter are dependent on then market conditions). In addition, the Company will be required to pay its proportionate share of the variable operating expenses of these projects. 59
64 AVISTA CORPORATION - -------------------------------------------------------------------------------- NOTE 10. LONG-TERM DEBT The annual sinking fund requirements and maturities for the next five years for long-term debt outstanding at December 31, 1998 are as follows: <TABLE> <CAPTION> YEAR ENDING SINKING FUND DECEMBER 31 MATURITIES REQUIREMENTS TOTAL - ----------- ---------- ------------ -------- (Thousands of Dollars) <S> <C> <C> <C> 1999............... $47,500 $ 4,452 $51,952 2000............... 55,000 4,242 59,242 2001............... 40,000 3,692 43,692 2002............... 50,000 3,542 53,542 2003............... 31,000 3,142 34,142 </TABLE> The sinking fund requirements may be met by certification of property additions at the rate of 167% of requirements. All of the utility plant is subject to the lien of the Mortgage and Deed of Trust securing outstanding First Mortgage Bonds. In 1998, $84.0 million of Unsecured Medium-Term Notes were issued, while $14.0 million of Unsecured Medium-Term Notes matured or were redeemed. In 1997, $20.0 million of First Mortgage Bonds in the form of Secured Medium-Term Notes were issued, while $26.5 million of Secured Medium-Term Notes and $25.0 million of Unsecured Medium-Term Notes matured or were repurchased. As of December 31, 1998, the Company had remaining authorization to issue up to $89.0 million of Secured Medium-Term Notes, which were issued in January 1999, and $166.0 million of Unsecured Medium-Term Notes. At December 31, 1998, the Company had no outstanding balances under borrowing arrangements. See Note 11 for details of credit agreements. Included in other long-term debt are the following items related to non-energy operations (thousands of dollars): <TABLE> <CAPTION> OUTSTANDING AT DECEMBER 31, -------------------------- 1998 1997 ------- ------- <S> <C> <C> Notes payable - variable rates through 2002 $50,288 $40,480 Capital lease obligations ................. 7,176 7,601 ------- ------- Total non-energy ..................... 57,464 48,081 Less: current portion ................... 15,165 12,177 ------- ------- Net non-utility long-term debt ....... $42,299 $35,904 ======= ======= </TABLE> NOTE 11. BANK BORROWINGS At December 31, 1998, the Company maintained lines of credit with various banks under two separate credit agreements amounting to $200.0 million. The Company has one revolving line of credit, expiring June 29, 1999, which provides a total credit commitment of $125 million. The second revolving credit agreement, which expires on June 29, 2001, provides a total credit commitment of $75 million. The Company pays commitment fees of up to 0.09% per annum on the average daily unused portion of each credit agreement. In addition, under various agreements with banks, the Company can have up to $100.0 million in loans outstanding at any one time, with the loans available at the banks' discretion. These arrangements provide, if funds are made available, for fixed-term loans for up to 180 days at a fixed rate of interest. The amount of unused letter of credit available to Avista Corp. for use in Generation and Resources activities totaled $2.5 million at December 31, 1998. This letter of credit expires on February 28, 1999. 60
65 AVISTA CORPORATION - -------------------------------------------------------------------------------- Balances and interest rates of bank borrowings under these arrangements were as follows: <TABLE> <CAPTION> YEARS ENDED DECEMBER 31, ----------------------- 1998 1997 ------- ------- (Thousands of Dollars) <S> <C> <C> BALANCE OUTSTANDING AT END OF PERIOD: Fixed-term loans .......................... $ -- $60,000 Revolving credit agreement ................ -- 48,500 MAXIMUM BALANCE DURING PERIOD: Fixed-term loans .......................... $94,000 $60,000 Revolving credit agreement ................ 51,000 48,500 AVERAGE DAILY BALANCE DURING PERIOD: Fixed-term loans .......................... $47,651 $23,737 Revolving credit agreement ................ 21,340 8,981 AVERAGE ANNUAL INTEREST RATE DURING PERIOD: Fixed-term loans .......................... 5.69% 5.81% Revolving credit agreement ................ 5.80 5.66 AVERAGE ANNUAL INTEREST RATE AT END OF PERIOD: Fixed-term loans .......................... --% 6.20% Revolving credit agreement ................ -- 6.39 </TABLE> Avista Energy and its subsidiary, Avista Energy Canada, Ltd., as co-borrowers, have a credit agreement with a commercial bank in the aggregate amount of $100 million, expiring April 1, 1999. The credit agreement may be terminated by the bank at any time and all extensions of credit under the agreement are payable upon demand, in either case at the bank's sole discretion. The agreement also provides, on an uncommitted basis, for the issuance of letters of credit to secure contractual obligations to counterparts. The facility is guaranteed by Avista Capital and is secured by substantially all of Avista Energy's assets. The maximum cash component of credit extended by the bank is $30 million, with availability of up to $100 million for the issuance of letters of credit. At December 31, 1998 and 1997, there were no cash advances (demand notes payable) outstanding. Letters of credit outstanding under the facility totaled approximately $20.2 million and $2.8 million at December 31, 1998 and 1997, respectively. The total amount of unused credit available to the Company at December 31, 1998 was $79.8 million. Non-energy operations have $54.0 million in short-term borrowing arrangements available. At December 31, 1998 and 1997, $21.4 million and $18.6 million, respectively, were outstanding. NOTE 12. LEASES The Company has entered into several lease arrangements involving various assets, with minimum terms ranging from one to thirteen years and expiration dates from 1999 to 2011. Certain of the lease arrangements require the Company, upon the occurrence of specified events, to purchase the leased assets for varying amounts over the term of the lease. The Company's management believes that the likelihood of the occurrence of the specified events under which the Company could be required to purchase the property is remote. Rent expense for the years ended December 31, 1998, 1997 and 1996 was $17.6 million, $16.9 million and $15.2 million, respectively. Future minimum lease payments (in thousands of dollars) required under operating leases that have initial or remaining noncancelable lease terms in excess of one year as of December 31, 1998 are estimated as follows: <TABLE> <S> <C> Year ending December 31: 1999 $ 9,173 2000 8,356 2001 8,022 2002 7,164 2003 6,573 Later years 32,645 ------- Total minimum payments required $ 71,933 ======== </TABLE> The Company also has various other cancelable operating leases, which are charged to operating expense, consisting of the Rathdrum combustion turbines, the Company airplane and a large number of small, relatively short-term, renewable agreements for various items, such as office equipment and office space. 61
66 AVISTA CORPORATION - -------------------------------------------------------------------------------- The payments under National Energy Trading and Marketing's and Non-energy's capital leases for the next five years are $3.0 million in 1999, $2.4 million in 2000, $1.0 million in 2001, $0.5 million in 2002 and $0.1 million in 2003. NOTE 13. PREFERRED STOCK CUMULATIVE PREFERRED STOCK NOT SUBJECT TO MANDATORY REDEMPTION: In December 1998, as part of a dividend restructuring plan, the Company issued 1,540,460 shares of its $12.40 Convertible Preferred Stock, Series L. See Note 14 for additional information. The Company redeemed its $50 million of Flexible Auction Preferred Stock, Series J in August 1997. The dividend rate on this preferred stock was reset every 49 days based on an auction. CUMULATIVE PREFERRED STOCK SUBJECT TO MANDATORY REDEMPTION: Redemption requirements: $6.95, Series K - On September 15, 2002, 2003, 2004, 2005 and 2006, the Company must redeem 17,500 shares at $100 per share plus accumulated dividends through a mandatory sinking fund. Remaining shares must be redeemed on September 15, 2007. The Company has the right to redeem an additional 17,500 shares on each September 15 redemption date. There are $3.5 million in mandatory redemption requirements during the 1999-2003 period. In June 1998, the Company redeemed the final $10 million, or 100,000 shares, of its $8.625 Series I. NOTE 14. CONVERTIBLE PREFERRED STOCK In December 1998, as part of a dividend restructuring plan, the Company issued 1,540,460 shares of its $12.40 Convertible Preferred Stock, Series L, in exchange for 15,404,595 shares of common stock, on the basis of a one-tenth interest in one share of preferred stock for each share of common stock. The Convertible Preferred Stock, Series L has a liquidation preference of $182.8125 per share. Unless previously converted into common stock by the Company, on November 1, 2001 each share of the Convertible Preferred Stock, Series L will be converted into (1) ten shares of common stock (subject to antidilution adjustments) and (2) the right to receive an amount, in cash, equal to accrued and unpaid dividends. The Convertible Preferred Stock, Series L may be converted, at the option of the Company, at any time prior to November 1, 2001, in whole but not in part, into, for each share so converted (1) a number of shares of common stock equal to the Optional Conversion Price then in effect, plus (2) the right to receive an amount, in cash, equal to the accrued and unpaid dividends thereon to but excluding the conversion date, plus (3) the right to receive the Optional Conversion Premium. As used above, * the "Optional Conversion Price" will be, for each share of Convertible Preferred Stock, Series L so converted, a number of shares of common stock equal to the lesser of (a) the amount of $24 divided by an amount equal to the current market price of the common stock, multiplied by ten and (b) one share of common stock (subject to antidilution adjustments); and * the "Optional Conversion Premium" will be, for each share of Convertible Preferred Stock, Series L so converted, an amount in cash, initially equal to $20.90, declining by $0.02111 for each day following December 15, 1998 to and including the optional conversion date and equal to zero on and after September 15, 2001; provided, however, that in lieu of delivering such amount in cash, the Company may, at its option, deliver a number of shares of common stock equal to the quotient of such amount divided by an amount equal to the current market price of the common stock. NOTE 15. COMPANY-OBLIGATED MANDATORILY REDEEMABLE PREFERRED TRUST SECURITIES On January 23, 1997, Avista Capital I, a business trust, issued to the public $60,000,000 of Preferred Trust Securities having a distribution rate of 7 7/8%. Concurrent with the issuance of the Preferred Trust Securities, the Trust issued $1,855,675 of Common Trust Securities to the Company. The sole assets of the Trust are the 62
67 AVISTA CORPORATION - -------------------------------------------------------------------------------- Company's 7 7/8% Junior Subordinated Deferrable Interest Debentures, Series A, with a principal amount of $61,855,675. These debt securities may be redeemed at the Company's option on or after January 15, 2002 and mature January 15, 2037. On June 3, 1997, Avista Capital II, a business trust, issued to the public $50,000,000 of Preferred Trust Securities having a floating distribution rate of LIBOR plus 0.875%, calculated and reset quarterly (initially 6.6875%). The distribution rate paid during 1998 ranged from 6.77734% to 6.13625%, which was the rate outstanding at December 31, 1998. Concurrent with the issuance of the Preferred Trust Securities, the Trust issued $1,547,000 of Common Trust Securities to the Company. The sole assets of the Trust are the Company's Floating Rate Junior Subordinated Deferrable Interest Debentures, Series B, with a principal amount of $51,547,000. These debt securities may be redeemed at the Company's option on or after June 1, 2007 and mature June 1, 2037. The Company has guaranteed the payment of distributions on, and redemption price and liquidation amount in respect of, the Preferred Trust Securities to the extent that the Trust has funds available for such payment from the debt securities. Upon maturity or prior redemption of such debt securities, the Trust Securities will be mandatorily redeemed. The Company's Consolidated Statements of Capitalization reflect only the $60 million and $50 million of Preferred Trust Securities, accordingly all intercompany transactions have been eliminated. NOTE 16. FAIR VALUE OF FINANCIAL SECURITIES The fair value of the Company's long-term debt (excluding notes payable and other) at December 31, 1998 and 1997 is estimated to be $735.5 million, or 107% of the carrying value and $647.3 million, or 105% of the carrying value, respectively. The fair value of the Company's mandatorily redeemable preferred stock at December 31, 1998 and 1997 is estimated to be $38.5 million, or 110% of the carrying value and $49.8 million, or 111% of the carrying value, respectively. The fair value of the Company's preferred trust securities at December 31, 1998 and 1997 is estimated to be $106.9 million, or 97% of the carrying value and $109.4 million, or 99% of the carrying value, respectively. These estimates are all based on available market information. The fair value of the Company's convertible preferred securities at December 31, 1998 was $301.4 million, or 112%, of the carrying value. This valuation was based on the closing price of the securities on December 31, 1998. NOTE 17. COMMON STOCK In April 1990, the Company sold 1,000,000 shares of its common stock to the Trustee of the Investment and Employee Stock Ownership Plan for Employees of the Company (Plan) for the benefit of the participants and beneficiaries of the Plan. In payment for the shares of Common Stock, the Trustee issued a promissory note payable to the Company in the amount of $14,125,000. Dividends paid on the stock held by the Trustee, plus Company contributions to the Plan, if any, are used by the Trustee to make interest and principal payments on the promissory note. The balance of the promissory note receivable from the Trustee ($9.3 million at December 31, 1998) is reflected as a reduction to common equity. The shares of Common Stock are allocated to the accounts of participants in the Plan as the note is repaid. During 1998, the cost recorded for the Plan was $3.7 million. Interest on the note payable to the Company, cash and stock contributions to the Plan and dividends on the shares held by the Trustee were $0.9 million, $2.8 million and $0.9 million, respectively. In February 1990, the Company adopted a shareholder rights plan, which was subsequently amended, pursuant to which holders of Common Stock outstanding on March 2, 1990, or issued thereafter, have been granted one preferred share purchase right (Right) on each outstanding share of Common Stock. Each Right, initially evidenced by and traded with the shares of Common Stock, entitles the registered holder to purchase one two-hundredth of a share of Preferred Stock of the Company, without par value, at an exercise price of $40, subject to certain adjustments, regulatory approval and other specified conditions. The Rights will be exercisable only if a person or group acquires 10% or more of the Common Stock or announces a tender offer, the consummation of which would result in the beneficial ownership by a person or group of 10% or more of the Common Stock. Upon any such acquisition, each Right would entitle the holder to purchase a number of shares of Common Stock of the Company (or, in the case of a merger of the Company into another person or group, common stock of the acquiring person) having a fair market value equal to twice the exercise price. In no event will the Rights be exercisable by a person which has acquired 10% or more of the Company's Common Stock. The Rights may be redeemed, at a redemption price of $0.005 per Right, by the Board of Directors of the Company at any time until any person or group has acquired 10% or more of the Common Stock. The Rights will expire on February 16, 2000. During 1992, the Company received authorization to issue 1.5 million shares of Common Stock under a second Periodic Offering Program (POP). No shares were issued under the POP during 1996, 1997 or 1998. At December 31, 1998, 572,400 shares remained authorized but unissued. 63
68 AVISTA CORPORATION - -------------------------------------------------------------------------------- The Company has a Dividend Reinvestment and Stock Purchase Plan under which the Company's stockholders may automatically reinvest their dividends and make optional cash payments for the purchase of the Company's Common Stock at current market value. The Company purchases stock on the open market to fulfill obligations of the 401(K) and Dividend Reinvestment Plans. Sales of Common Stock for 1998, 1997 and 1996 are summarized below (thousands of dollars): <TABLE> <CAPTION> 1998 1997 1996 ------------------------- -------------------------- -------------------------- Shares Amount Shares Amount Shares Amount ----------- ----------- ----------- ----------- ----------- ----------- <S> <C> <C> <C> <C> <C> <C> Balance at January 1 ............... 55,960,360 $ 594,852 55,960,360 $ 594,852 55,947,967 $ 594,636 Exchange for preferred stock ..... (15,404,595) (213,451) -- -- -- -- Stock options/restricted stock ... (102,036) -- -- -- -- -- Employee Investment Plan (401-K).. -- -- -- -- -- Dividend Reinvestment Plan ......... -- -- -- -- 12,393 216 ----------- ----------- ----------- ----------- ----------- ----------- Total issues (exchanges/purchases) (15,506,631) (213,451) -- -- 12,393 216 ----------- ----------- ----------- ----------- ----------- ----------- Balance at December 31 ............. 40,453,729 $ 381,401 55,960,360 $ 594,852 55,960,360 $ 594,852 =========== =========== =========== =========== =========== =========== </TABLE> NOTE 18. EARNINGS PER SHARE Average shares outstanding for basic EPS were 54,603,926 in 1998. At December 31, 1998, 1,540,460 shares of $12.40 Convertible Preferred Stock, Series L, which were convertible into 15,404,595 million shares of common stock, were outstanding. All of these potential common shares were excluded from the computation of diluted EPS for 1998 because their inclusion had an antidilutive effect on EPS. Options to purchase 647,900 shares of common stock were outstanding during 1998, but 150,000 shares were not included in the computation of diluted earnings per share because the options' exercise price was greater than the average market price of the common shares for the year and, therefore, the effect would be antidilutive. Average number of common shares outstanding for both basic and diluted EPS was 55,960,360 for both 1997 and 1996. Basic and diluted EPS were the same in 1997 and 1996 as the Company did not have any common stock equivalents outstanding in either of those years. The computation of basic and diluted earnings per common share is as follows (in thousands, except per share amounts): <TABLE> <CAPTION> 1998 1997 1996 -------- -------- -------- <S> <C> <C> <C> Net income $ 78,139 $114,797 $ 83,453 Less: Preferred stock dividends 8,399 5,392 7,978 -------- -------- -------- Income available for common stock-basic 69,740 109,405 75,475 Convertible Preferred Stock, Series L, dividend requirements -- -- -- -------- -------- -------- Income available for common stock-diluted $ 69,740 $109,405 $ 75,475 ======== ======== ======== Weighted-average number of common shares outstanding-basic 54,604 55,960 55,960 Conversion of Convertible Preferred Stock, Series L -- -- -- Exercise of stock options 54 -- -- -------- -------- -------- Weighted-average number of common shares outstanding-diluted 54,658 55,960 55,960 Earnings per common share Basic $ 1.28 $ 1.96 $ 1.35 Diluted $ 1.28 $ 1.96 $ 1.35 </TABLE> For additional information regarding the convertible preferred stock and stock option plans, see Notes 14 and 19, respectively. NOTE 19. STOCK COMPENSATION PLANS The Company and certain subsidiaries have adopted stock-based compensation plans. Avista Corp. In 1998, the Company adopted and shareholders approved an incentive compensation plan, the Long-Term Incentive Plan (Plan). Under the Plan, certain key employees, directors and officers of the Company and its 64
69 AVISTA CORPORATION - -------------------------------------------------------------------------------- subsidiaries may be granted stock options, stock appreciation rights, stock awards (including restricted stock) and other stock-based awards and dividend equivalent rights. The Company has made available a maximum of 2.5 million shares of its common stock for grant under the Plan. The shares issued under the Plan will be purchased by the trustee on the open market. The following summarizes stock options activity for 1998 under the Plan: <TABLE> <CAPTION> Number Exercise Price of Shares Range ---------- --------------- <S> <C> <C> Granted 589,800 $18.31 - 22.62 Exercised -- -- Cancelled -- -- ------- Unexercised options outstanding - December 31, 1998 589,800 ======= Exercisable Options - December 31, 1998 -- Option grants vest 25% per year over four years and expire 10 years after issuance. Weighted average exercise price of options granted during the year $ 20.14 Weighted average fair value of options granted during the year $ 4.74(1) </TABLE> (1) The fair values of these options were estimated at the dates of the grants using a Black-Scholes option pricing model using the following assumptions: dividend yield of 3.01%, expected volatility of 22.19%, risk-free interest rate range of 4.81% to 5.53% depending on the grant date, and an expected life of 7 years. The Company granted 102,036 shares of restricted common stock under the Plan in 1998. Plan participants are entitled to dividends and to vote their respective shares. The sale or transfer of restricted stock is prohibited during the vesting period except as specified in the award agreements. The value of restricted stock awards is established by the average market price on the date of grant. Restricted stock awarded in 1998 have vesting periods from 4 - 5 years. Common equity was reduced in the accompanying Consolidated Balance Sheets by the cost of restricted shares acquired by the Plan trustee on the open market. Accordingly, the Company is recording compensation expense ratably over the restriction periods based on the reduction to common equity. The Company accounts for stock based compensation using APB Opinion No. 25, "Accounting for Stock Issued to Employees." Under this method, compensation cost is recognized on the excess, if any, of the market price of the stock at grant date over the exercise price of the option. As the exercise price for options granted under the Plan was equal to the market price at grant date, no compensation expense has been recorded by the Company in connection this the Plan. In accordance with FAS No. 123, "Accounting for Stock-Based Compensation," compensation expense is determined based on the fair value of the award and recognizes that cost over the service period. Had compensation costs for these plans been determined based on the fair value at the grant dates with FAS No. 123, the Company's net income would have been reduced to the pro forma amounts indicated below: <TABLE> <CAPTION> 1998 ------- <S> <C> Net income (in thousands): As reported $78,139 Pro forma $76,891(2) Basic EPS as reported $1.28 Proforma Basic EPS $1.25 Diluted EPS as Reported $1.28 Proforma Diluted EPS $1.25 </TABLE> (2) Includes pro forma effect of subsidiary companies stock option plans. Subsidiary Companies Certain subsidiaries of the Company have adopted employee stock incentive plans under which key employees and directors were granted the opportunity to purchase shares of subsidiary common stock at prices equal to the fair market value as determined by each subsidiary's Board of Directors. Restricted shares are subject to transfer agreements and vest over various periods as defined in the plans. The subsidiaries record compensation expense based on the increase in the adjusted net book value of the shares subject to the plans. Certain subsidiaries of the Company have adopted employee stock incentive plans under which certain employees and directors of the Company and the subsidiaries are granted options to purchase subsidiary shares at prices no less than the fair market value on the date of grant. Options outstanding under these plans usually become fully 65
70 AVISTA CORPORATION - -------------------------------------------------------------------------------- exercisable between three and five years from the date granted and terminate ten years from the date granted. Upon termination of employment, vested options may be exercised and the related subsidiary shares may be, but are not required to be, repurchased by the applicable subsidiary at fair value. NOTE 20. COMMITMENTS AND CONTINGENCIES The Company believes, based on the information presently known, the ultimate liability for the matters discussed in this note, individually or in the aggregate, taking into account established accruals for estimated liabilities, will not be material to the consolidated financial position of the Company, but could be material to results of operations or cash flows for a particular quarter or annual period. No assurance can be given, however, as to the ultimate outcome with respect to any particular lawsuit. NEZ PERCE TRIBE On December 6, 1991, the Nez Perce Tribe filed an action against the Company in U. S. District Court for the District of Idaho alleging, among other things, that two dams formerly operated by the Company, the Lewiston Dam on the Clearwater River and the Grangeville Dam on the South Fork of the Clearwater River, provided inadequate passage to migrating anadromous fish in violation of rights under treaties between the Tribe and the United States made in 1855 and 1863. The Lewiston and Grangeville Dams, which had been owned and operated by other utilities under hydroelectric licenses from the Federal Power Commission (the "FPC", predecessor of the FERC) prior to acquisition by the Company, were acquired by the Company in 1937 with the approval of the FPC, but were dismantled and removed in 1973 and 1963, respectively. Allegations of actual loss under different assumptions ranged between $425 million and $650 million, together with $100 million in punitive damages. On November 21, 1994, the Company filed a Motion for Summary Judgment of Dismissal. On March 28, 1996, a U.S. District judge entered a summary judgment in favor of the Company dismissing the complaint. The Tribe filed a notice of appeal to the Ninth Circuit Court of Appeals on April 24, 1996. A mediation conference was held on October 11, 1996. Following the conclusion of that conference, briefing schedules were vacated indefinitely to accommodate a mediation process, which ultimately resulted in a settlement of this matter on January 15, 1999. In accordance with that settlement, the Company will pay the Nez Perce Tribe $2.5 million initially, part of which was already expensed and the remainder deferred for possible future rate recovery. The Company will provide 44 annual payments thereafter in the amount of $835,498 for utility taxes, Tribal employment rights, fees and rights-of-ways, which will be expensed as paid. OIL SPILL The Company completed an updated investigation of an oil spill from an underground storage tank that occurred several years ago in downtown Spokane at the site of the Company's steam heat plant. Underground soil testing conducted in 1993 showed that the oil had migrated approximately one city block beyond the steam plant property. The Clean-up Action Plan determined by the Department of Ecology (DOE) is underway, and remediation facilities have been constructed and installed and are being operated. On August 17, 1995, a lawsuit was filed against the Company in Superior Court of the State of Washington for Spokane County by Davenport Sun International Hotels and Properties, Inc., the owner of a hotel property in downtown Spokane, Washington. The Complaint alleged that the oil released from the Company's Central Steamplant trespassed on property owned by the plaintiff. In addition, the plaintiff claimed that the Steamplant has caused a diminution of value of plaintiff's land. After mediation, the matter was resolved by settlement and compromise, subject to certain conditions. In December 1997, the settlement was restructured, certain amounts were paid, the litigation was dismissed with prejudice, a release was obtained, and other conditions remain to be fulfilled, none of which would affect the dismissal of this action. The Company pursued recovery from insurers and reached settlement with one of the two insurance carriers. On December 13, 1996, the Company filed a Complaint for declaratory relief and money damages against Underwriters at Lloyds of London (Lloyds), the remaining carrier, in Spokane County Superior Court. The purpose of this action was to seek a declaration of the insurance policies issued to the Company by Lloyds with respect to any liabilities of the Company for environmental damage associated with the oil spill at the Central Steamplant and other environmental remediation efforts. The policies at issue were in effect during the period between 1926 and 1966; thereafter, the Company maintained its policies with a new underwriter, Aegis. The Company's Complaint sought money damages in excess of $16 million. On March 10, 1999, Avista Corp. and Lloyds signed a settlement agreement resolving the claim. SPOKANE GAS PLANT The Company is participating with the Washington State Department of Transportation in an environmental study relating to the former Spokane Natural Gas Plant site (which was operated as a coal gasification plant for 66
71 AVISTA CORPORATION - -------------------------------------------------------------------------------- approximately 60 years until 1948) acquired by the Company through a merger in 1958. The Company no longer owns the property. Initial core samples taken from the site indicate environmental contamination at the site. On January 15, 1999, the Company received notice from the State of Washington's Department of Ecology that it had been designated as a potentially liable person (PLP) with respect to any hazardous substances located on this site, stemming from the Company's past ownership of the former Gas Plant. In its notice, the DOE stated that it intended to complete an on-going remedial investigation of this site, complete a feasibility study to determine the most effective means of halting or controlling future releases of substances from the site, and implement appropriate remedial measures. The Company responded to the DOE acknowledging its listing as a PLP, but requested that additional parties also be listed as PLPs. The Company also committed to pursue additional characterization of the site, with more drillings and samples, and is in the process of determining the extent of further work. The Company will be negotiating with the DOE on the remedial measures. EASTERN PACIFIC ENERGY On October 9, 1998, Eastern Pacific Energy (Eastern Pacific), an energy aggregator participating in the restructured retail energy market in California, filed suit against the Company and its affiliates, Avista Advantage and Avista Energy in the United States District Court for the Central District of California. Eastern Pacific alleges, among other things, a breach of an oral or implied joint venture agreement whereby the Company agreed to supply not less than 300 megawatts of power to Eastern Pacific's California customers and that Avista Advantage agreed to provide energy-related products and services. The complaint seeks an unspecified amount of damages and also seeks to recover any future profits earned from sales of the aforementioned amount of power to California consumers. The Company and its affiliates intend to vigorously defend against all of the claims. On December 4, 1998, Avista Advantage, Avista Energy and the Company jointly filed a motion to dismiss the complaint for failure to state a claim upon which relief can be granted. Following a responsive pleading from the plaintiff, the court took the matter under advisement and notified the parties that a decision will be issued in due course concerning this motion to dismiss. OTHER CONTINGENCIES The Company routinely assesses, based on in-depth studies, expert analyses and legal reviews, its contingencies, obligations and commitments for remediation of contaminated sites, including assessments of ranges and probabilities of recoveries from other responsible parties who have and have not agreed to a settlement and recoveries from insurance carriers. The Company's policy is to immediately accrue and charge to current expense identified exposures related to environmental remediation sites based on estimates of investigation, cleanup and monitoring costs to be incurred. The Company must be in compliance with requirements under the Clean Air Act Amendments (CAAA) by the year 2000 at both the Colstrip and Centralia thermal generating plants, in which the Company maintains an ownership interest. The anticipated share of costs at Colstrip are not expected to have a major economic impact on the Company, but estimates at Centralia are expected to be approximately $35 million, which have been included in the Company's future projected capital expenditures. The Company has potential liabilities under the Federal Endangered Species Act (ESA) for species of fish that have either already been added to the endangered species list, been listed as "threatened" or been petitioned for listing. Thus far, measures which have been adopted and implemented have had minimal impact of the Company. Future actions to save these, and other as yet unidentified fish or wildlife species, particularly as the Company is relicensing several of its hydroelectric facilities, could impact the Company's operations. It is currently not possible to determine the likely financial impact of any further actions. The Company has long-term contracts related to the purchase of fuel for thermal generation, natural gas and hydroelectric power. Terms of the natural gas purchase contracts range from one month to five years and the majority provide for minimum purchases at the then effective market rate. The Company also has various agreements for the purchase, sale or exchange of electric energy with other utilities, cogenerators, small power producers and government agencies. As of December 31, 1998, the Company's collective bargaining agreement with the International Brotherhood of Electrical Workers represented approximately 50% of employees. The current agreement with the union local representing the majority of the bargaining unit employees expires on March 25, 2002. A local agreement in the South Lake Tahoe area, which represents 7 employees, also expires on March 25, 1999. The Company and the union are currently negotiating this agreement. 67
72 AVISTA CORPORATION - -------------------------------------------------------------------------------- NOTE 21. ACQUISITIONS AND DISPOSITIONS In April 1998, Pentzer completed the purchase of two new companies that produce store fixtures -- Universal Showcase, Ltd., in Toronto, Canada and Triangle Systems, Inc., in New York. In October 1998, Pentzer acquired two additional store fixtures companies -- Horizon Terra, Inc., in Indiana and Pacific Coast Showcase, Inc., in Washington. During 1997, Pentzer acquired three new companies: Target Woodworks, Inc., a Florida-based company; White Plus, a California-based company; and Proco Wood Products, a Minnesota-based company. All three companies provide point-of-purchase and in-store merchandising services. During 1996, Pentzer acquired one company that provides point-of-purchase and in-store merchandising services. During the first quarter of 1998, Pentzer sold Systran Financial Services, resulting in an after-tax gain of $5.5 million. In May 1997, Pentzer sold its interest in a portfolio company, Safety Speed Cut, resulting in a gain of approximately $2.0 million, net of taxes. In 1996, Pentzer Development Corporation, a subsidiary of Pentzer, sold the Spokane Industrial Park, resulting in a gain of approximately $10.8 million, net of taxes and other adjustments. In November 1998, the Company reached an agreement in principal to purchase a majority ownership in One Eighty Communications, a competitive local exchange carrier that provided local dial tone and data services to commercial accounts in local communities. The acquisition was completed in January 1999, and the new company was renamed Avista Communications. It will provide local high-speed telecommunications services to under-served Northwest communities. In December 1998, Avista Energy Canada, Ltd. acquired Coast Pacific Management, Inc. (Coast Pacific), a natural gas marketing company based in Vancouver, British Columbia, Canada. Coast Pacific manages and transports approximately 70,000 MMBtu of natural gas per day to some 70 large and medium size industrial customers throughout British Columbia. Coast Pacific also acts as gas manager for more than 40% of the large industrial market in the interior of British Columbia. Effective February 1, 1999, Avista Energy completed and closed the purchase of Vitol Gas & Electric, LLC (Vitol), based in Boston, Massachusetts. Vitol is one of the top 20 energy marketing companies in the United States. Vitol trades gas, electricity, coal and SO2 allowances in markets in the eastern half of the United States. The acquisition was funded through the issuance of additional shares of common stock to Avista Capital. NOTE 22. MERGER TERMINATION On June 28, 1996, the Board of Directors of the Company terminated the Agreement and Plan of Reorganization and Merger, dated as of June 27, 1994 by and among the Company, Sierra Pacific Resources (SPR), Sierra Pacific Power Company, a subsidiary of SPR (SPPC), and Altus Corporation, a wholly owned subsidiary of the Company (Altus, formerly named Resources West Energy Corporation), which would have provided for the merger of the Company, SPR and SPPC with and into Altus. The Company had approximately $15.8 million, or $10.3 million after-tax, in merger-related transaction and transition costs that were expensed in 1996. No increase in rates occurred as a result of these costs being expensed. 68
73 AVISTA CORPORATION - -------------------------------------------------------------------------------- NOTE 23. SELECTED QUARTERLY INFORMATION (UNAUDITED) The Company's energy operations are significantly affected by weather conditions. Consequently, there can be large variances in revenues, expenses and net income between quarters based on seasonal factors such as temperatures and streamflow conditions. A summary of quarterly operations (in thousands of dollars except per share amounts) for 1998 and 1997 follows: <TABLE> <CAPTION> THREE MONTHS ENDED ---------------------------------------------------------------------- MARCH JUNE SEPTEMBER DECEMBER 31 30 30 31 ----------- ----------- ----------- ----------- <S> <C> <C> <C> <C> 1998 Operating revenues .................... $ 571,678 $ 632,995 $ 1,434,055 $ 1,045,256 Operating income ...................... 56,633 41,942 24,303 49,942 Net income ............................ 32,232 15,643 8,707 21,557 Income available for common stock ..... 31,408 14,855 8,099 15,378 Outstanding common stock (000s): Weighted average .................... 55,960 55,960 55,960 50,669 Actual .............................. 55,960 55,960 55,960 40,454 Earnings per share: Energy Delivery and Generation and Resources ......... $ 0.40 $ 0.17 $ 0.10 $ 0.21 National Energy Trading and Marketing 0.03 0.07 (0.01) 0.13 Non-energy .......................... 0.13 0.03 0.05 (0.03) ----------- ----------- ----------- ----------- Total, Basic and Diluted ............ $ 0.56 $ 0.27 $ 0.14 $ 0.31 Dividends paid per common share ....... $ 0.31 $ 0.31 $ 0.31 $ 0.12 Trading price range per share: High ................................ $ 24 13/16 $ 24 7/8 $ 22 13/16 $ 20 3/16 Low ................................. $ 21 11/16 $ 20 13/16 $ 16 1/4 $ 17 1/2 1997 Operating revenues .................... $ 284,046 $ 236,274 $ 295,076 $ 486,776 Operating income ...................... 64,060 34,669 29,707 61,028 Net income ............................ 29,848 48,475 13,237 23,237 Income available for common stock ..... 28,070 46,663 12,258 22,414 Outstanding common stock (000s): Weighted average .................... 55,960 55,960 55,960 55,960 Actual .............................. 55,960 55,960 55,960 55,960 Earnings per share: Energy Delivery and Generation and Resources ......... $ 0.49 $ 0.81 $ 0.12 $ 0.29 National Energy Trading and Marketing (0.01) (0.03) (0.02) 0.10 Non-energy .......................... 0.02 0.05 0.12 0.02 ----------- ----------- ----------- ----------- Total, Basic and Diluted ............ $ 0.50 $ 0.83 $ 0.22 $ 0.41 Dividends paid per common share ....... $ 0.31 $ 0.31 $ 0.31 $ 0.31 Trading price range per share: High ................................ $ 19 $ 19 7/8 $ 21 1/4 $ 24 13/16 Low ................................. $ 17 3/8 $ 17 3/8 $ 18 7/8 $ 18 15/16 </TABLE> The effects of the conversion from common stock to convertible preferred stock are reflected in the fourth quarter 1998 results. See Notes 14 and 18. 69
74 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information regarding the directors of the Registrant has been omitted pursuant to General Instruction G to Form 10-K. Reference is made to the Registrant's Proxy Statement to be filed with the Securities and Exchange Commission in connection with the Registrant's annual meeting of shareholders to be held on May 13, 1999. Executive Officers of the Registrant <TABLE> <CAPTION> Name Age Business Experience During Past 5 Years - ---- --- --------------------------------------- <S> <C> <C> Thomas M. Matthews 55 Chairman of the Board, President & Chief Executive Officer since October 1998; Chairman of the Board & Chief Executive Officer July 1998 - October 1998; prior to employment with the Registrant: President - Dynegy 1996 to July 1998; Vice President - Texaco, Inc. 1994 - 1996. Jon E. Eliassen 52 Senior Vice President & Chief Financial Officer since November 1998; Senior Vice President, Chief Financial Officer & Treasurer December 1997 - November 1998; Senior Vice President & Chief Financial Officer August 1996 - December 1997; Vice President - Finance & Chief Financial Officer February 1986 - August 1996. Gary G. Ely 51 Executive Vice President since February 1999; Senior Vice President & General Manager August 1996 - February 1999; Vice President - Natural Gas February 1991- August 1996. David J. Meyer 45 Senior Vice President & General Counsel since September 1998; prior to employment with the Registrant: Attorney - Paine Hamblen Coffin Brooke & Miller 1974 - September 1998. Robert D. Fukai 49 Vice President - External Relations since August 1996; Vice President - Human Resources, Corporate Services & Marketing January 1993 August 1996. JoAnn G. Matthiesen 58 Vice President - Human Resources since August 1996; Vice President - Organization Effectiveness, Public Relations & Assistant to the Chairman January 1993 - August 1996. Ronald R. Peterson 46 Vice President and Treasurer since November 1998; Vice President and Controller February 1998 - November 1998; Controller August 1996 - February 1998; Treasurer February 1992 - August 1996. Terry L. Syms 50 Vice President and Corporate Secretary since February 1998; Corporate Secretary March 1988 - February 1998. Edward H. Turner 43 Vice President & General Manager - Energy Delivery since November 1998; prior to employment with the Registrant: Director of Industrial Sales and various other positions - Houston Lighting & Power Company and Houston Industries Incorporated for 24 years. Roger D. Woodworth 42 Vice President - Corporate Development since November 1998; Director of Corporate Development and various other positions with the Company since 1979. </TABLE> All of the Company's executive officers, with the exception of Messrs. Turner and Woodworth, were officers or directors of one or more of the Company's subsidiaries in 1998. Executive officers are elected annually by the Board of Directors. 70
75 ITEM 11. EXECUTIVE COMPENSATION Information regarding executive compensation has been omitted pursuant to General Instruction G to Form 10-K. Reference is made to the Registrant's Proxy Statement to be filed with the Securities and Exchange Commission in connection with the Registrant's annual meeting of shareholders to be held on May 13, 1999. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT (a) Security ownership of certain beneficial owners (owning 5% or more of Registrant's voting securities): None. (b) Security ownership of management: Information regarding security ownership of management has been omitted pursuant to General Instruction G to Form 10-K. Reference is made to the Registrant's Proxy Statement to be filed with the Securities and Exchange Commission in connection with the Registrant's annual meeting of shareholders to be held on May 13, 1999. (c) Changes in control: None. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information regarding certain relationships and related transactions has been omitted pursuant to General Instruction G to Form 10-K. Reference is made to the Registrant's Proxy Statement to be filed with the Securities and Exchange Commission in connection with the Registrant's annual meeting of shareholders to be held on May 13, 1999. 71
76 PART IV ITEM 14. FINANCIAL STATEMENTS, FINANCIAL STATEMENT SCHEDULES, EXHIBITS AND REPORTS ON FORM 8-K (a) 1. Financial Statements (Included in Part II of this report): Independent Auditors' Report Consolidated Statements of Income, Comprehensive Income and Retained Earnings for the Years Ended December 31, 1998, 1997 and 1996 Consolidated Balance Sheets, December 31, 1998 and 1997 Consolidated Statements of Capitalization, December 31, 1998 and 1997 Consolidated Statements of Cash Flows for the Years Ended December 31, 1998, 1997 and 1996 Schedule of Information by Business Segments for the Years Ended December 31, 1998, 1997 and 1996 Notes to Financial Statements (a) 2. Financial Statement Schedules: None (a) 3. Exhibits: Reference is made to the Exhibit Index commencing on page 75. The Exhibits include the management contracts and compensatory plans or arrangements required to be filed as exhibits to this Form 10-K by Item 601(10)(iii) of Regulation S-K. (b) Reports on Form 8-K: Dated June 4, 1998, announcing the appointment of the Company's new Chief Executive Officer. Dated August 19, 1998, regarding a dividend restructuring plan, a broad corporate refocus and the corporate name change. Dated October 21, 1998, announcing third quarter earnings, a potential future rate increase in Idaho, a lawsuit filed against the Company, a potential change in capital expenditures in future periods and an update on the Company's progress on the Year 2000 issue. Dated January 6, 1999, regarding the corporate name change effective January 1, 1999. 72
77 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. THE WASHINGTON WATER POWER COMPANY March 19, 1999 By /s/ T. M. Matthews - ------------------------- -------------------------------------------- Date T. M. Matthews Chairman of the Board, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. <TABLE> <CAPTION> Signature Title Date --------- ----- ---- <S> <C> <C> /s/ T. M. Matthews Principal Executive March 19, 1999 - ------------------------------------------- Officer and Director T. M. Matthews (Chairman of the Board, President and Chief Executive Officer) /s/ J. E. Eliassen Principal Financial March 19, 1999 - ------------------------------------------ and Accounting Officer J. E. Eliassen (Senior Vice President and Chief Financial Officer) /s/ David A. Clack Director March 19, 1999 - ------------------------------------------- David A. Clack /s/ Sarah M. R. Jewell Director March 19, 1999 - ------------------------------------------- Sarah M. R. Jewell /s/ John F. Kelly Director March 19, 1999 - ------------------------------------------- John F. Kelly /s/ Eugene W. Meyer Director March 19, 1999 - ------------------------------------------- Eugene W. Meyer /s/ Bobby Schmidt Director March 19, 1999 - ------------------------------------------- Bobby Schmidt /s/ Larry A. Stanley Director March 19, 1999 - ------------------------------------------- Larry A. Stanley /s/ R. John Taylor Director March 19, 1999 - ------------------------------------------- R. John Taylor /s/ Daniel J. Zaloudek Director March 19, 1999 - ------------------------------------------- Daniel J. Zaloudek </TABLE> 73
78 INDEPENDENT AUDITORS' CONSENT We consent to the incorporation by reference in Registration Statement Nos. 2-81697, 2-94816, 33-54791, and 33-32148 on Form S-8, and in Registration Statement Nos. 33-49662, 33-53655, 333-39551,333-16353, 333-16353-01, 333-16353-02, and 333-16353-03 on Form S-3 of our report dated January 29, 1999 (February 1, 1999 as to Note 21 and March 10, 1999 as to Note 20), appearing in this Annual Report on Form 10-K of Avista Corporation for the year ended December 31, 1998. /s/ Deloitte & Touche LLP Deloitte & Touche LLP Seattle, Washington March 19, 1999 74
79 EXHIBIT INDEX <TABLE> <CAPTION> Previously Filed* ------------------------------- With Registration As Exhibit Number Exhibit - ------- --------------- ------- <S> <C> <C> 3(a) ** Restated Articles of Incorporation of Avista Corporation as restated February 25, 1999. 3(b) ** Bylaws of Avista Corporation, as amended January 1, 1999. 4(a)-1 2-4077 B-3 Mortgage and Deed of Trust, dated as of June 1, 1939. 4(a)-2 2-9812 4(c) First Supplemental Indenture, dated as of October 1, 1952. 4(a)-3 2-60728 2(b)-2 Second Supplemental Indenture, dated as of May 1, 1953. 4(a)-4 2-13421 4(b)-3 Third Supplemental Indenture, dated as of December 1, 1955. 4(a)-5 2-13421 4(b)-4 Fourth Supplemental Indenture, dated as of March 15, 1967. 4(a)-6 2-60728 2(b)-5 Fifth Supplemental Indenture, dated as of July 1, 1957. 4(a)-7 2-60728 2(b)-6 Sixth Supplemental Indenture, dated as of January 1, 1958. 4(a)-8 2-60728 2(b)-7 Seventh Supplemental Indenture, dated as of August 1, 1958. 4(a)-9 2-60728 2(b)-8 Eighth Supplemental Indenture, dated as of January 1, 1959. 4(a)-10 2-60728 2(b)-9 Ninth Supplemental Indenture, dated as of January 1, 1960. 4(a)-11 2-60728 2(b)-10 Tenth Supplemental Indenture, dated as of April 1, 1964. 4(a)-12 2-60728 2(b)-11 Eleventh Supplemental Indenture, dated as of March 1, 1965. 4(a)-13 2-60728 2(b)-12 Twelfth Supplemental Indenture, dated as of May 1, 1966. 4(a)-14 2-60728 2(b)-13 Thirteenth Supplemental Indenture, dated as of August 1, 1966. 4(a)-15 2-60728 2(b)-14 Fourteenth Supplemental Indenture, dated as of April 1, 1970. 4(a)-16 2-60728 2(b)-15 Fifteenth Supplemental Indenture, dated as of May 1, 1973. 4(a)-17 2-60728 2(b)-16 Sixteenth Supplemental Indenture, dated as of February 1, 1975. 4(a)-18 2-60728 2(b)-17 Seventeenth Supplemental Indenture, dated as of November 1, 1976. 4(a)-19 2-69080 2(b)-18 Eighteenth Supplemental Indenture, dated as of June 1, 1980. 4(a)-20 1-3701 (with 4(a)-20 Nineteenth Supplemental Indenture, dated as 1980 Form 10-K) of January 1, 1981. 4(a)-21 2-79571 4(a)-21 Twentieth Supplemental Indenture, dated as of August 1, 1982. 4(a)-22 1-3701 (with 4(a)-22 Twenty-First Supplemental Indenture, dated Form 8-K dated as of September 1, 1983. September 20, 1983) 4(a)-23 2-94816 4(a)-23 Twenty-Second Supplemental Indenture, dated as of March 1, 1984. </TABLE> - ------------ *Incorporated herein by reference. **Filed herewith. 75
80 EXHIBIT INDEX (continued) <TABLE> <CAPTION> Previously Filed* ------------------------------- With Registration As Exhibit Number Exhibit - ------- --------------- ------- <S> <C> <C> 4(a)-24 1-3701 (with 4(a)-24 Twenty-Third Supplemental Indenture, dated 1986 Form 10-K) as of December 1, 1986. 4(a)-25 1-3701 (with 4(a)-25 Twenty-Fourth Supplemental Indenture, dated 1987 Form 10-K) as of January 1, 1988. 4(a)-26 1-3701 (with 4(a)-26 Twenty-Fifth Supplemental Indenture, dated as 1989 Form 10-K) of October 1, 1989. 4(a)-27 33-51669 4(a)-27 Twenty-Sixth Supplemental Indenture, dated as of April 1, 1993. 4(a)-28 1-3701 (with 4(a)-28 Twenty-Seventh Supplemental Indenture, dated 1993 Form 10-K) as of January 1, 1994. 4(b)-1 1-3701 (with 4(e)-1 Loan Agreement between City of Forsyth, 1989 Form 10-K) Rosebud County, and the Company, dated as of November 1, 1989 (Series 1989 A and 1989 B). Replaces Exhibit 4(e)-1 (agreement between the Company and City of Forsyth, Rosebud County, Montana, dated as of October 1, 1986) filed with Form 10-K for 1986 and Exhibit 4(g)-1 (agreement between the Company and City of Forsyth, Rosebud County, Montana, dated as of April 1, 1987) filed with Form 10-K for 1987. 4(b)-2 1-3701 (with 4(e)-2 Indenture of Trust, Pollution Control 1989 Form 10-K) Revenue Refunding Bonds (Series 1989 A and 1989 B) between City of Forsyth, Rosebud County, Montana and Chemical Bank, dated as of November 1, 1989. Replaces Exhibit 4(e)-2 (Indenture of Trust between City of Forsyth, Rosebud County, Montana and Chemical Bank dated as of October 1, 1986) filed with Form 10-K for 1986 and Exhibit 4(g)-2 (Indenture of Trust between City of Forsyth, Rosebud County, Montana and Chemical Bank, dated as of April 1, 1987) filed with Form 10-K for 1987. 4(c)-1 1-3701 (with 4(h)-1 Indenture between the Company and Chemical 1988 Form 10-K) Bank dated as of July 1, 1988 (Series A and B Medium-Term Notes). 4(d)-1 ** Credit Agreement between the Company and Toronto Dominion (Texas), Bank of America National Trust and Savings Association and The Bank of New York with Toronto Dominion as the agent, dated June 30, 1998. 4(d)-2 ** Credit Agreement between the Company and Toronto Dominion (Texas), Bank of America National Trust and Savings Association and The Bank of New York with Toronto Dominion as the agent, dated June 30, 1998. 4(e)-1 1-3701 (with 4(n) Rights Agreement, dated as of February 16, Form 8-K dated 1990, between the Company and the Bank February 16, 1990) of New York as successor Rights Agent. 4(e)-2 1-3701 (with 4(b) Amendment No. 1 to Rights Agreement, dated 1994 First Quarter as of May 10, 1994. Form 10-Q) </TABLE> - ------------- *Incorporated herein by reference. **Filed herewith. 76
81 EXHIBIT INDEX (continued) <TABLE> <CAPTION> Previously Filed* ------------------------------- With Registration As Exhibit Number Exhibit - ------- --------------- ------- <S> <C> <C> 4(e)-3 1-3701 (with 1994 4(b) Amendment No. 2 to Rights Agreement, Third Quarter dated as of June 27, 1994. Form 10-Q) 10(a)-l 2-13788 13(e) Power Sales Contract (Rocky Reach Project) with Public Utility District No. 1 of Chelan County, Washington, dated as of November 14, 1957. 10(a)-2 2-60728 10(b)-1 Amendment to Power Sales Contract (Rocky Reach Project) with Public Utility District No. 1 of Chelan County, Washington, dated as of June 1, 1968. 10(b)-1 2-13421 13(d) Power Sales Contract (Priest Rapids Project) with Public Utility District No. 2 of Grant County, Washington, dated as of May 22, 1956. 10(b)-2 2-60728 5(d)-1 Second Amendment to Power Sales Contract (Priest Rapids Project) with Public Utility District No. 2 of Grant County, Washington, dated as of December 19, 1977. 10(c)-1 2-60728 5(e) Power Sales Contract (Wanapum Project) with Public Utility District No. 2 of Grant County, Washington, dated as of June 22, 1959. 10(c)-2 2-60728 5(e)-1 First Amendment to Power Sales Contract (Wanapum Project) with Public Utility District No. 2 of Grant County, Washington, dated as of December 19, 1977. 10(d)-1 2-60728 5(g) Power Sales Contract (Wells Project) with Public Utility District No. 1 of Douglas County, Washington, dated as of September 18, 1963. 10(d)-2 2-60728 5(g)-1 Amendment to Power Sales Contract (Wells Project) with Public Utility District No. 1 of Douglas County, Washington, dated as of February 9, 1965. 10(d)-3 2-60728 5(h) Reserved Share Power Sales Contract (Wells Project) with Public Utility District No. 1 of Douglas County, Washington, dated as of September 18, 1963. 10(d)-4 2-60728 5(h)-1 Amendment to Reserved Share Power Sales Contract (Wells Project) with Public Utility District No. 1 of Douglas County, Washington, dated as of February 9, 1965. 10(e) 2-60728 5(i) Canadian Entitlement Exchange Agreement executed by Bonneville Power Administration Columbia Storage Power Exchange and the Company, dated as of August 13, 1964. 10(f) 2-60728 5(j) Pacific Northwest Coordination Agreement, dated as of September 15, 1964. 10(g)-1 2-60728 5(k) Ownership Agreement between the Company, Pacific Power & Light Company, Puget Sound Power & Light Company, Portland General Electric Company, Seattle City Light, Tacoma City Light and Grays Harbor and Snohomish County Public Utility Districts as owners of the Centralia Steam Electric Generating Plant, dated as of May 15, 1969. </TABLE> - --------- *Incorporated herein by reference. **Filed herewith. 77
82 EXHIBIT INDEX (continued) <TABLE> <CAPTION> Previously Filed* ------------------------------- With Registration As Exhibit Number Exhibit - ------- --------------- ------- <S> <C> <C> 10(g)-2 1-3701 (with Form 10(h)-3 Centralia Fuel Supply Agreement between 10-K for 1991) PacifiCorp Electric Operations, as the Seller, and the Company, Puget Sound Power & Light Company, Portland General Electric Company, Seattle City Light, Tacoma City Light and Grays Harbor and Snohomish County Public Utility Districts, as the Buyers of coal for the Centralia Steam Electric Generating Plant, dated as of January 1, 1991. 10(h)-l 2-47373 13(y) Agreement between the Company, Bonneville Power Administration and Washington Public Power Supply System for purchase and exchange of power from the Nuclear Project No. 1 (Hanford), dated as of January 6, 1973. 10(h)-2 2-60728 5(m)-1 Amendment No. 1 to the Agreement between the Company between the Company, Bonneville Power Administration and Washington Public Power Supply System for purchase and exchange of power from the Nuclear Project No. 1 (Hanford), dated as of May 8, 1974. 10(h)-3 1-3701 (with 10(i)-3 Agreement between Bonneville Power Form 10-K for Administration, the Montana Power Company, Pacific 1986) Power & Light, Portland General Electric, Puget Sound Power & Light, the Company and the Supply System for relocation costs of Nuclear Project No. 1 (Hanford) dated as of July 9, 1986. 10(i)-1 2-60728 5(n) Ownership Agreement of Nuclear Project No. 3, sponsored by Washington Public Power Supply System, dated as of September 17, 1973. 10(i)-2 1-3701 (with 1 Settlement Agreement and Covenant Not to Form 10-Q for Sue executed by the United States quarter ended Department of Energy acting by and through September 30, the Bonneville Power Administration and 1985) the Company, dated as of September 17, 1985, describing the settlement of Project 3 litigation. 10(i)-3 1-3701 (with 2 Agreement to Dismiss Claims and Covenant Form 10-Q for Not to Sue between the Washington Public quarter ended Power Supply System and the Company, dated September 30, as of September 17, 1985, describing the 1985) settlement of Project 3 litigation with the Supply System. 10(i)-4 1-3701 (with 3 Agreement among Puget Sound Power & Light Form 10-Q for Company, the Company, Portland General quarter ended Electric Company and PacifiCorp, dba September 30, Pacific Power & Light Company, agreeing to 1985) execute contemporaneously an irrevocable offer, to and for the benefit of the Bonneville Power Administration, dated as of September 17, 1985. 10(j)-1 2-66184 5(r) Service Agreement (Natural Gas Storage Service), dated as of August 27, 1979, between the Company and Northwest Pipeline Corporation. 10(j)-2 2-60728 5(s) Service Agreement (Liquefaction-Storage Natural Gas Service), dated as of December 7, 1977, between the Company and Northwest Pipeline Corporation. </TABLE> - --------- *Incorporated herein by reference. **Filed herewith. 78
83 EXHIBIT INDEX (continued) <TABLE> <CAPTION> Previously Filed* ------------------------------- With Registration As Exhibit Number Exhibit - ------- --------------- ------- <S> <C> <C> 10(j)-3 1-3701 (with 10(k)-4 Amendment dated as of January 1, 1990, to 1989 Form 10-K) Firm Transportation Agreement, dated as of June 15, 1988, between the Company and Northwest Pipeline Corporation. 10(j)-4 1-3701 (with 10(k)-6 Firm Transportation Service Agreement, dated 1992 Form 10-K) as of April 25, 1991, between the Company and Pacific Gas Transmission Company. 10(j)-5 1-3701 (with 10(k)-7 Service Agreement Applicable to Firm 1992 Form 10-K) Transportation Service, dated June 12, 1991, between the Company and Alberta Natural Gas Company Ltd. 10(k)-1 1-3701 (with 13(b) Letter of Intent for the Construction and Form 8-K for Ownership of Colstrip Units No. 3 and 4, August 1976) sponsored by The Montana Power Company, dated as of April 16, 1974. 10(k)-2 1-3701 (with 10(s)-7 Ownership and Operation Agreement for 1981 Form 10-K) Colstrip Units No. 3 and 4, sponsored by The Montana Power Company, dated as of May 6, 1981. 10(k)-3 1-3701 (with 10(s)-2 Coal Supply Agreement for Colstrip Units No. 1981 Form 10-K) 3 and 4 between The Montana Power Company, Puget Sound Power & Light Company, Portland General Electric Company, Pacific Power & Light Company, Western Energy Company and the Company, dated as of July 2, 1980. 10(k)-4 1-3701 (with 10(s)-3 Amendment No. 1 to Coal Supply Agreement for 1981 Form 10-K) Colstrip Units No. 3 and 4, dated as of July 10, 1981. 10(k)-5 1-3701 (with 10(l)-5 Amendment No. 4 to Coal Supply Agreement for 1988 Form 10-K) Colstrip Units No. 3 and 4, dated as of January 1, 1988. 10(l)-1 1-3701 (with 10(n)-2 Lease Agreement between the Company and IRE-4 1986 Form 10-K) New York, Inc., dated as of December 15, 1986, relating to the Company's central operating facility. 10(m) 1-3701 (with 10(v) Supplemental Agreement No. 2, Skagit/Hanford 1983 Form 10-K) Project, dated as of December 27, 1983, relating to the termination of the Skagit/Hanford Project. 10(n) 1-3701 (with 10(p)-l Agreement for Purchase and Sale of Firm 1986 Form 10-K) Capacity and Energy between Puget Sound Power & Light Company and the Company, dated as of August 1, 1986. 10(o) 1-3701 (with 10(q)-1 Electric Service and Purchase Agreement 1991 Form 10-K) between Potlatch Corporation and the Company, dated as of January 3, 1991. 10(p) 1-3701 (with 10(s)-1 Agreements for Purchase and Sale of Firm 1992 Form 10-K) Capacity between the Company and Portland General Electric Company dated March and June 1992. </TABLE> - ----------- *Incorporated herein by reference. **Filed herewith. 79
84 EXHIBIT INDEX (continued) <TABLE> <CAPTION> Previously Filed* ------------------------------- With Registration As Exhibit Number Exhibit - ------- --------------- ------- <S> <C> <C> 10(q)-1 1-3701 (with 10(t)-8 Executive Deferral Plan of the Company. (***) 1992 Form 10-K) 10(q)-2 1-3701 (with 10(t)-10 The Company's Unfunded Supplemental 1992 Form 10-K) Executive Retirement Plan. (***) 10(q)-3 1-3701 (with 10(t)-11 The Company's Unfunded Supplemental 1992 Form 10-K) Executive Disability Plan. (***) 10(q)-4 1-3701 (with 10(t)-12 Income Continuation Plan of the Company. (***) 1992 Form 10-K) 10(q)-5 ** Long-Term Incentive Plan. (***) 10(q)-6 ** Employment Agreement between the Company and T. M. Matthews. (***) 12 ** Statement re computation of ratio of earnings to fixed charges and preferred dividend requirements. 21 ** Subsidiaries of Registrant. 27 ** Financial Data Schedule. </TABLE> - ------------ * Incorporated herein by reference. ** Filed herewith. *** Management contracts or compensatory plans filed as exhibits by reference per Item 601(10)(iii) of Regulation S-K.