UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

Form 10-K

 

 

 

 

 

Commission file number 1-16455

 

Reliant Energy, Inc.
(Exact Name of Registrant as Specified in Its Charter)

 

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act: None

 

 

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes þ     No o

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the 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.  þ

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes o     No þ

 

The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant was $7,291,274,515 (computed by reference to the closing sale price of the registrant’s common stock on the New York Stock Exchange on June 30, 2008, the last business day of the registrant’s most recently completed second fiscal quarter).

 

As of February 13, 2009, the registrant had 350,362,189 shares of common stock outstanding and no shares of common stock were held by the registrant as treasury stock.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the registrant’s definitive proxy statement for its 2009 Annual Meeting of Stockholders, which will be filed with the Securities and Exchange Commission within 120 days of December 31, 2008, are incorporated by reference into Part III of this Form 10-K.

 

 

TABLE OF CONTENTS

 

 

This report contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements are statements that contain projections, assumptions or estimates about the outcome of pending legal actions, our revenues, income, capital structure and other financial items, our plans and objectives for future operations or about our future economic performance, transactions and dispositions, financings or offerings and approvals related thereto. In many cases, you can identify forward-looking statements by terminology such as “anticipate,” “estimate,” “believe,” “continue,” “could,” “intend,” “may,” “plan,” “potential,” “predict,” “should,” “will,” “expect,” “objective,” “projection,” “forecast,” “goal,” “guidance,” “outlook,” “effort,” “target” and other similar words. However, the absence of these words does not mean that the statements are not forward-looking.

 

Actual results may differ materially from those expressed or implied by the forward-looking statements as a result of many factors or events, including, but not limited to, the following:

 

 

Other factors that could cause our actual results to differ from our projected results are discussed or referred to in Item 1A of this report. Each forward-looking statement speaks only as of the date of the particular statement and we undertake no obligation to update or revise any forward-looking statement, whether as a result of new information, future events or otherwise. Our filings and other important information are also available on our website at www.reliant.com.

 

 

 

We provide electricity and energy services to wholesale and retail customers through two business segments.

 

 

As discussed in “Management’s Discussion and Analysis of Financial Conditions and Results of Operations—Business Overview and—2008 Significant Events” in Item 7 of this Form 10-K, we are exploring a full range of possible strategic alternatives to enhance stockholder value, including, among other possibilities, the sale of all or substantially all of Reliant Energy, as well as the sale of some or all of our retail business. We are exiting the C&I portion of our retail energy business either through a wind down or sale of our C&I contracts. In late 2008, we sold all of our PJM market (excluding Illinois) and New York (collectively referred to as Northeast) C&I contracts.

 

Sale of Our Texas Retail Business.  On February 28, 2009, we entered into several agreements related to the sale of our Texas retail business. We entered into a purchase agreement to sell our interests in the affiliates that operate our Texas retail mass and C&I business to a subsidiary (the buyer) of NRG Energy, Inc. (NRG) for $287.5 million in cash plus the value of the net working capital. This sale includes the rights to our name. NRG has guaranteed the obligations of the buyer. Upon closing, our affiliates that are party to the credit sleeve and reimbursement agreement with Merrill Lynch will be owned by the buyer. We have agreed to pay Merrill Lynch a $7.5 million fee and to increase the fees under the credit sleeve and reimbursement agreement by $3 million per month until the close. The bulk of the fees payable to Merrill Lynch are payable only upon and at closing. When the sale closes, the litigation with Merrill Lynch against our affiliates that conduct our retail business related to the termination of the working capital facility supporting our retail business will be dismissed. We and Merrill Lynch have agreed to stay further proceedings in the litigation until June 1, 2009, or in the event regulatory approvals delay closing, July 1, 2009. The sale is subject to customary closing conditions, including the Hart-Scott-Rodino review. The buyer may terminate the agreement in connection with certain takeover proposals that it may receive prior to closing subject to the payment of a $45 million termination fee. We expect to close in the second quarter of 2009. We will enter a one-year transition services agreement with the buyer in connection with the closing, which will include terms and conditions for information technology services, accounting services and human resources. NRG’s guarantee will also apply to this transition services agreement. As required by our debt agreements, a par exchange offer will be made with the net proceeds to holders of our secured notes and PEDFA bonds.

 

For information about our corporate history, business segments and disposition activities, see notes 1, 18, 19, 20 and 21 to our consolidated financial statements and “Selected Financial Data” in Item 6 of this Form 10-K.

 

As of December 31, 2008, we owned, had an interest in or leased 36 operating electric power generation facilities with an aggregate net generating capacity of 14,580 MW in five regions of the United States. The net generating capacity of these facilities consists of approximately 38% base-load, 37% intermediate and 25% peaking capacity.

We sell electricity and energy services from our generation portfolio in hour-ahead, day-ahead and forward markets in bilateral and ISO markets. We sell these products to investor-owned utilities, municipalities, cooperatives and other companies that serve end users or purchase power at wholesale for resale. For our power generation, we obtain transmission and distribution services from various RTOs, ISOs, utilities and municipalities. Because our facilities are not subject to traditional cost-based regulation, we can generally sell electricity at market-determined prices. The following table identifies the principal markets where we own, lease or have under contract wholesale generation assets:

 

 

Through the PJM Market’s reliability pricing model auctions, we have committed approximately 6,400 MW of capacity through the planning year ending May 2012. We expect that a substantial portion of our capacity that clears a PJM auction will continue to be committed to the PJM Market up to three years in advance. Revenue from these capacity sales is determined by market rules designed to ensure regional reliability, encourage competition and reduce price volatility. The California Public Utility Commission and Cal ISO are considering possible enhancements to existing resource adequacy requirements, including alternatives similar to capacity markets designed in New England and PJM.

 

To ensure adequate fuel supplies, we contract for natural gas, coal and fuel oil for our generation facilities. For our natural gas-fired plants, we also arrange for, schedule and balance natural gas from our suppliers and through transporting pipelines. To perform these functions, we lease natural gas transportation and storage capacity.

 

In February 2006, we completed an evaluation of our wholesale energy segment’s hedging strategy and use of capital. As a result of our evaluation, we substantially reduced hedging activity. See “Quantitative and Qualitative Disclosures about Market Risk” in Item 7A of this Form 10-K and notes 2(f) and 5 to our consolidated financial statements.

 

The following table describes our electric power generation facilities as of December 31, 2008:

 

 

 

 

Operations Data

 

See discussion of our wholesale energy strategy in “Management’s Discussion and Analysis of Financial Condition and Results of Operation—Business Overview” in Item 7 of this Form 10-K. See discussion of ‘‘—Competition and Seasonality” below and a discussion of competition, weather events and other factors that

could have an adverse effect on our wholesale energy business in “Risk Factors” in Item 1A of this Form 10-K.

 

 

 

 

 

As a retail electricity provider, we arrange for the transmission and delivery of electricity to our customers, bill customers, collect payment for electricity sold and maintain call centers to provide customer service. We purchase the electricity we sell to customers from generation companies, utilities and power marketers and other retail energy companies in the wholesale market. We obtain our transmission and distribution services in Texas from entities regulated by the PUCT and ERCOT.

 

Our retail business for residential and small business customers is in Texas. Based on metered locations, as of December 31, 2008, we had approximately 1.5 million residential and 150,000 small business customers, making us the second largest mass market electricity provider in Texas. Approximately 65% of our Texas customers are in the Houston area. We also have customers in other parts of Texas, including the Dallas, Ft. Worth and Corpus Christi areas.

 

We market electricity and energy services to C&I customers in Texas and, until the end of 2008, the Northeast. These customers include refineries, chemical plants, manufacturing facilities, hospitals, universities, governmental agencies, restaurants and other facilities. In connection with our intention to unwind our credit-enhanced retail structure with Merrill Lynch and to reduce our future collateral posting obligations, we decided to exit the C&I portion of our retail business over time. Except where we are contractually obligated to do so,

we are no longer entering into contracts with new C&I customers and we do not expect to renew contracts with our current customers. We sold all of our Northeast C&I contracts and are actively seeking to sell our Illinois C&I contracts. For discussion of our agreement to sell our Texas retail business, see “— General.”

 

Under our supply strategy for our retail business, we structure our supply portfolio to match our load demands by procuring sufficient power prior to or concurrent with entering into retail sales commitments. See “Quantitative and Qualitative Disclosures about Market Risk” in Item 7A of this Form 10-K and notes 2(f) and 5 to our consolidated financial statements. Because of our credit-enhanced retail structure, we are not required to post collateral for our retail supply purchases. However, we intend to wind down this structure because, among other things, of disagreements with Merrill Lynch regarding the minimum adjusted retail EBITDA covenant in our working capital facility and ongoing turmoil in the financial markets has created uncertainty regarding our significant concentration of credit risk with Merrill Lynch. See discussion of the status of our credit-enhanced retail structure in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources” in Item 7 of this Form 10-K and related legal action in note 13(b) to our consolidated financial statements.

 

Operations Data

 

See discussion of our retail energy strategy in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Business Overview” in Item 7 of this Form 10-K. See discussion of “—Competition and Seasonality” below and a discussion of competition, weather events and other factors that could have an adverse effect on our retail energy business in “Risk Factors” in Item 1A of this Form 10-K.

 

 

 

 

 

 

 

 

 

 

Texas

 

We are certified by the PUCT to sell electricity to retail customers in Texas. Effective January 1, 2007, we began selling electricity in the competitive areas of ERCOT to customers at unregulated prices. Our activities in Texas are subject to standards and regulations adopted by the PUCT and ERCOT. See “Risk Factors” in Item 1A of this Form 10-K.

 

Until January 1, 2007, we were required to make electricity available to Houston area residential and small business customers at the PUCT-approved “price-to-beat.” Any residential “price-to-beat” customers who did not select an alternative product by December 31, 2006 continued being served under our residential services plan.

Other States

 

We are licensed in several states outside ERCOT to supply C&I customers. As a result of our decision to exit the C&I portion of our retail business over time and the sale of our Northeast C&I contracts, in 2009 we will have C&I customers only in Texas and Illinois. Our C&I retail activities in Illinois are subject to standards and regulations adopted by PJM and the Illinois Commerce Commission.

 

We operate electric generation facilities in regions administered by PJM, Cal ISO and MISO. These ISOs operate under FERC-approved market rules. The market rules include price limits or caps applicable to all generators and numerous other FERC-approved requirements relative to the manner in which we must operate our generating facilities.

 

Federal Energy Regulatory Commission

 

A number of our subsidiaries are public utilities under the Federal Power Act and are subject to FERC rules and oversight regulations. As public utilities, these subsidiaries sell power at either market-based rates (if FERC has granted market-based rate authority) or cost-based rates. Each of these subsidiaries has been granted market-based rate authority, although a limited number of services sold by some of them is sold at cost-based rates.

 

The retail and wholesale energy industries are intensely competitive. Our competitors include merchant energy companies, utilities, retail electric service providers and other companies, including in recent years companies owned by investment banking firms, hedge funds and private equity funds. Our principal competitors in the retail electricity markets outside of Houston are typically incumbent retail electric providers, which have the advantage of long-standing relationships with customers. In general, competition in the retail energy markets is on the basis of price, service, brand image, product offerings and market perceptions of creditworthiness and competition in the wholesale energy markets is on the basis of price, service and market perceptions of creditworthiness. For additional information on the effect of competition and for a discussion of how seasonality impacts our business, see “Risk Factors” in Item 1A of this Form 10-K and note 17 to our consolidated financial statements.

 

We are subject to numerous federal, state and local requirements relating to the protection of the environment and the safety and health of personnel and the public. These requirements relate to a broad range of our activities, including the discharge of compounds into the air, water and soil; the proper handling of solid, hazardous and toxic materials and waste; noise and safety and health standards applicable to the workplace.

 

Based on existing regulations, our market outlook, and our current assessment of the costs of labor and materials and the state of evolving technologies, we estimate that we will invest approximately $123 million in 2009, $27 to $52 million in 2010 and $28 million to $306 million in 2011 through 2014 on projects to reduce our emission levels and lessen the environmental impact of our operations. These amounts include $45 million for future ash landfill expansions from 2009 through 2014. As described below, a significant amount of these expenditures relate to our election to upgrade the SO₂ emissions controls at some of our facilities.

 

In some cases, which are described below, environmental laws and regulations are pending, are under consideration, are in dispute or could be revised. Unless otherwise noted, we cannot predict the outcome or ultimate effect of these matters on our business. For additional information on how environmental matters may impact our business, including a January 2009 Notice of Violation from the EPA regarding New Source Review, see “Risk Factors” in Item 1A of this Form 10-K and note 13(c) to our consolidated financial statements.

Air Quality

 

Under the Clean Air Act, the EPA has implemented a number of emission control programs that affect industrial sources, including power plants, by limiting emissions of nitrogen oxides (NO_x) and sulfur dioxide (SO₂). NO_x and SO₂ are precursors to the formation of acid rain, fine particulate matter and regional haze. NO_x is also a precursor to the formation of ozone.

 

NO_x and SO₂ Emissions

 

In March 2005, the EPA finalized the Clean Air Interstate Rule (CAIR), to further reduce emissions of NO_x and SO₂ in the Eastern United States in two phases. The first phase, which takes effect in 2009 for NO_x and 2010 for SO₂, requires overall reductions within the area of approximately 50% in NO_x and SO₂ emissions on an annual basis. The second phase, which takes effect in 2015, requires additional reductions of approximately 10% for a 60% total reduction in NO_x and approximately 15% for a 65% reduction in SO₂. The EPA regulations include the use of cap-and-trade programs to achieve these reductions. These regulations require us to provide an allowance for each ton of NO_x and SO₂ that we emit under a cap-and-trade program. We maintain emission allowances that at a minimum correspond with forward power sales. In general, we do not have emission allowances for all of our generation. We purchase emission allowances, as needed, to correspond with our generation of electricity.

 

In July 2008, the District of Columbia Circuit Court of Appeals ruled that CAIR was legally flawed, vacated CAIR in its entirety and remanded CAIR to the EPA for revision of CAIR consistent with the Court’s opinion. On rehearing, in December 2008, the Court decided that CAIR will remain in effect pending EPA’s modification to cure the defects identified by the Court. The Court’s most recent decision will reinstate CAIR’s proposed annual allowance-based NO_x program beginning in 2009 and the increased surrender rate for SO₂ allowances beginning in 2010. The existing ozone season NO_x program and the SO₂ allowance requirements under the Clean Air Act’s acid rain program will continue to be in force.

 

We have undertaken studies to evaluate possible impacts of CAIR and similar legislative and regulatory proposals, which will primarily affect our coal-fired facilities in the Eastern United States. Based on an economic analysis that includes plant operability, changes in the emission allowances market, potential impact of state-imposed regulations and our estimates at this time of capital expenditures, we have elected to invest $64 million in 2009 and up to an estimated $304 million in 2010 through 2013 to principally reduce our emissions of SO₂.

 

Mercury Emissions

 

In December 2000, the EPA found that regulation of mercury emissions from power plants is “appropriate and necessary,” triggering the requirement to regulate such emissions using the Maximum Achievable Control Technology standard (MACT) of the Clean Air Act. However, the EPA pursued an alternate market-based approach for regulating mercury emissions from power plants, known as the Clean Air Mercury Rule (CAMR). In February 2008, the D.C. Circuit Court of Appeals struck down CAMR. The EPA appealed, but in February 2009, it withdrew the appeal and stated its intent to proceed with rulemaking under the MACT standard. This approach considers the most effective control technologies in operation, without regard to cost effectiveness. Despite the EPA’s statement of regulatory intent, there are multiple legal actions pending with respect to regulation of mercury from power plants.

 

While the EPA was pursuing CAMR, a number of states, including Pennsylvania, pursued mercury regulations that were more stringent than CAMR. The Pennsylvania rule generally requires mercury reductions on a facility basis in two phases, with 80% reductions in 2010 and 90% reductions in 2015. This rule is the subject of current litigation, and a state court declared Pennsylvania’s rule unlawful in January 2009.

 

Our capital investment plan is based on compliance with the Pennsylvania rule. Our estimate of capital expenditures to comply primarily with the first phase of Pennsylvania’s mercury control program is $49 million in 2009. However, we are continuing to evaluate our plan given that regulation of mercury from power plants at both federal and state levels is uncertain.

Air Particulates

 

In September 2006, the EPA issued revised national ambient air quality standards for fine particulate matter with an aerodynamic diameter less than or equal to 2.5 microns, or PM2.5. In December 2008, the EPA identified geographic areas that are not in compliance with the revised standard (nonattainment areas). Ten of our 11 coal-fired power generation facilities are located in nonattainment areas. States must develop emission reduction plans by April 2012 that bring nonattainment areas into compliance by 2014. These plans may be state-specific or regional in scope. The EPA has estimated that the power generation sector SO₂ and NO_x emissions reductions required by CAIR will allow many of the nonattainment areas to achieve compliance with the revised PM2.5 standard. However, states are not precluded from developing plans that would require further reductions in NO_x and SO₂ emissions.

 

Greenhouse Gas Emissions

 

There is an increased focus within the United States over the direction of domestic climate change policy. Several states in the northeast, midwest and west are increasingly active in developing state-specific or regional regulatory initiatives to stimulate CO₂ emission reductions in the electric power generation industry and other industries. The United States Congress is considering legislation that would impose mandatory limitation of CO₂ and other greenhouse gas emissions for the domestic power generation sector. The specific impact on our business will depend upon the form of emissions-related legislation or regulations ultimately adopted by the federal government or states in which our facilities are located.

 

Ten northeastern states, including New Jersey and Maryland, have formed the Regional Greenhouse Gas Initiative, or RGGI, which requires power generators to reduce CO₂ emissions by ten percent by 2019, beginning in 2009. California adopted legislation designed to reduce greenhouse gas emissions to 25% below 1990 levels by 2020, beginning in 2012. In July 2008, the Pennsylvania Climate Change Act was adopted. This legislation requires development of reports of the impacts of climate change in Pennsylvania and potential economic opportunities resulting from mitigation strategies. It also requires development of an annual greenhouse gas emissions inventory and establishment of cost-effective strategies for reducing or offsetting greenhouse gases.

 

In addition, the EPA has announced plans to consider regulations to address CO₂ emissions as part of the Clean Air Act’s New Source Review program. Individual states may also begin to take into account CO₂ emissions when considering permits to construct or modify significant sources of emissions.

 

In September 2007, we joined the Chicago Climate Exchange, a voluntary greenhouse gas registry, reduction and trading system. By joining the exchange, we have committed to reduce our greenhouse gas emissions to six percent below the average of our 1998-2001 levels by 2010. We expect to satisfy our reduction targets through previously implemented unit retirements and capacity factor reductions, ongoing heat rate improvement efforts and transacting on the exchange.

 

Water Quality

 

In July 2007, the EPA suspended its 2004 regulations relating to cooling water intake structures at large existing power plants pending further rulemaking. This action was in response to the Second Circuit Court of Appeals’ January 2007 remand of the 2004 regulations. The EPA retained interim requirements that plant intakes employ best technology available controls as determined on a plant-by-plant, best professional judgment basis. The Supreme Court is reviewing the Second Circuit’s decision and is expected to rule in 2009.

 

Other

 

As a result of their age, many of our facilities contain significant amounts of asbestos insulation, other asbestos containing materials, as well as lead-based paint. Existing state and federal rules require the proper management and disposal of these potentially toxic materials. We believe we properly manage and dispose of such materials in compliance with these state and federal rules. See note 13(c) to our consolidated financial statements.

We do not believe we have any material liabilities or obligations under the Comprehensive Environmental Response Corporation and Liability Act of 1980 or similar state laws. These laws impose clean up and restoration liability on owners and operators of facilities from or at which there has been a release or threatened release of hazardous substances, together with those who have transported or arranged for the disposal of those substances.

 

As of December 31, 2008, we had 3,816 full-time and part-time employees. Of these employees, 1,125 are covered by collective bargaining agreements, which expire on various dates from March 31, 2009 through October 31, 2013. The following table sets forth the number of our employees as of December 31, 2008:

 

 

 

 

 

Mark M. Jacobs has served as our President and Chief Executive Officer since May 2007. Prior to that, he served as our Executive Vice President and Chief Financial Officer from July 2002 to October 2007.

 

Brian Landrum has served as our Executive Vice President and Chief Operating Officer since May 2007. Prior to that, he served as our Executive Vice President, Operations from February 2006 to May 2007. He was Senior Vice President, Commercial and Retail Operations, IT from February 2005 to February 2006; Senior Vice President, Customer Operations and Information Technology from January 2004 to February 2005; President, Reliant Energy Retail Services from June 2003 to January 2004.

 

Rick J. Dobson has served as our Executive Vice President and Chief Financial Officer since October 2007. Prior to that, he served as Senior Vice President and Chief Financial Officer of Novelis Inc., an international aluminum rolling and recycling company, from July 2006 to August 2007 and Senior Vice

President and Chief Financial Officer of Aquila, Inc., an electric and natural gas distribution company that also owns and operates generation assets, from October 2002 to July 2006.

 

Charles S. Griffey has served as our Senior Vice President, Market Design and Regulatory Affairs since December 2007. Prior to that, he was Senior Vice President, Regulatory Affairs from February 2003 to December 2007.

 

D. Rogers Herndon has served as our Senior Vice President, Strategic Planning and Business Development since November 2007. He was Senior Vice President, Commercial Operations and Origination from May 2006 to November 2007. Prior to that, he was a Managing Director for PSEG Energy Resources and Trade from April 2003 to December 2005.

 

Michael L. Jines has served as our Senior Vice President, General Counsel and Corporate Secretary since May 2003.

 

Suzanne L. Kupiec has served as our Senior Vice President, Chief Risk and Compliance Officer since July 2007. She served as our Senior Vice President, Risk and Structuring from January 2004 to June 2007. She was our Vice President and Chief Risk and Corporate Compliance Officer from June 2003 to January 2004.

 

Thomas C. Livengood has served as our Senior Vice President and Controller since May 2005. Prior to that, he served as our Vice President and Controller from August 2002 to May 2005.

 

Albert H. Myres has served as our Senior Vice President, Government and Public Affairs since December 2007. He served as Shell Oil Corporation’s Chief of Staff and Senior Advisor to the President and Country Chairman from August 2005 to December 2007 and Senior Advisor, Government Affairs from June 2002 to August 2005.

 

Karen D. Taylor has served as our Senior Vice President, Human Resources since December 2003. In November 2005, she was appointed as our Chief Diversity Officer.

 

Our principal offices are at 1000 Main, Houston, Texas 77002 (713-497-7000). The following information is available free of charge on our website (http://www.reliant.com):

 

 

You can request a free copy of these documents by contacting our investor relations department. It is our intention to disclose amendments to, or waivers from, our business ethics policy on our website. No information on our website is incorporated by reference into this Form 10-K. In addition, certain of these materials are available on the SEC’s website at (http://www.sec.gov) or at its public reference room: 100 F Street, NE, Room 1580, Washington, D.C. 20549 (1-800-SEC-0330).

 

We will timely provide the annual certification of our Chief Executive Officer to the New York Stock Exchange. We filed last year’s certification in June 2008. In addition, our Chief Executive Officer and Chief Financial Officer each have signed and filed the certifications under Section 302 of the Sarbanes-Oxley Act of 2002 with this Form 10-K.

 

 

The financial results of our wholesale and retail energy segments are subject to market risks beyond our control.

 

Our results of operations, financial condition and cash flows are significantly impacted by the prevailing demand and market prices for electricity, purchased power, fuel and emission allowances over which we have no control. Market prices can fluctuate dramatically in response to many factors, including weather conditions; changes in the prices of related commodities; changes in law and regulation; regulatory intervention (including the imposition of price limitations, bidding rules or similar mechanisms); market illiquidity; transmission constraints; environmental limitations; generation unit outages; fuel supply issues; national and world-wide economic conditions; and other events. Current national and world-wide conditions may result in ongoing reduced demand for electricity, commodity price volatility, changes in law or regulation and other events.

 

The markets in which we operate are relatively immature markets that are characterized by elements of both deregulated and regulated markets. Changes in the regulatory environment in which we operate could adversely affect our ability to set rates, or the cost, manner or feasibility of conducting our business.

 

We operate in a regulatory environment that is undergoing varying restructuring initiatives. In many instances, the regulatory structures governing the electricity markets are still evolving, creating gaps in the regulatory framework and associated uncertainty. In addition, existing regulations may be revised or reinterpreted and new laws and regulations may be adopted or become applicable to our facilities or our commercial activities. We cannot predict the future direction of these initiatives or the ultimate effect that this changing regulatory environment will have on our business. Consequently, future regulatory restrictions, regulatory or political intervention or changes in laws and regulations, may constrain our ability to set rates at market prices or otherwise have an adverse effect on our business. See “Business—Regulation” in Item 1 of this Form 10-K.

 

The tightening of the supply and demand balance for electricity may result in significant long- and short-term price volatility in both our wholesale and retail businesses. Price volatility may result in legislative, regulatory or judicial initiatives intended to mitigate the impact of such volatility.

 

The permitting and construction of new generation facilities is a lengthy process. Additionally, the progressive tightening of environmental regulatory requirements and their reflection in permits and regulations may result in generation facilities being removed from service prior to their end of useful life or derated permanently or temporarily. As a result, there may be periods when the supply of electricity is reduced or constrained relative to the demand for electricity. During these periods the wholesale price and retail price of electricity may increase significantly. In response to this, legislators, regulators, consumers and others may seek legislative, regulatory or judicial relief in an attempt to control or limit the wholesale price and/or the retail price of electricity.

We depend on sources, facilities and systems that we do not own or control for our fuel and fuel supply and to deliver electricity to and bill our customers. Any disruption in these sources, facilities or systems could have an adverse effect on our business.

 

We depend on fuel sources and fuel supply facilities owned and operated by third parties to supply our generation plants. We depend on power transmission and distribution facilities and metering systems owned and operated by third parties to deliver electricity to our customers and provide energy usage data. If these sources, facilities or systems fail, are disrupted or become unavailable to us, we may be unable to generate and/or provide electricity, our cost of doing so may significantly increase and/or we may be subject to contractual or other penalties. In addition, inaccurate or untimely information from third parties could hinder our ability to bill customers and collect amounts owed. We also participate in regional power pools, reliability councils and transmission organizations and changes in the rules governing such groups and/or in the composition of such groups may have an adverse effect on our business. Participation in RTOs is voluntary, and transmission owning companies may exit an RTO so long as they do so in compliance with the applicable FERC tariffs and agreements and FERC approval.

 

The operation of generation facilities involves significant risks that could interrupt operations and increase our costs.

 

Ownership of generation assets exposes us to risks relating to the breakdown of equipment or processes; fuel supply or transportation interruptions; construction delays or cost overruns; shortages of or delays in obtaining equipment, material and labor; operational restrictions resulting from environmental limitations and governmental interventions; as well as other risks. In addition, many of our facilities are old and require significant maintenance expenditures. We are party to collective bargaining agreements with labor unions at several of our plants. If our workers were to engage in a strike, work stoppage or other slowdown, other employees were to become unionized or the terms and conditions in future labor agreements were renegotiated, we could experience a significant disruption in our operations and higher ongoing labor costs. Similarly, we have an aging workforce at a number of our plants creating potential knowledge and expertise gaps as those workers retire. If we are unable to secure fuel, we will not be able to run our generation units. Construction delays could cause extended and/or unplanned outages of our generation facilities. If a generation unit fails or is unavailable, we may have to purchase replacement power from third parties at higher prices. We have insurance, subject to limits and deductibles, covering some types of physical damage and business interruption related to our generation units. However, this insurance may not always be available on commercially reasonable terms. In addition, there is no assurance that insurance proceeds will be sufficient to cover all losses, insurance payments will be timely made or the policies themselves will be free of substantial deductibles.

 

Our business operations expose us to the risk of loss if third parties fail to perform their contractual obligations.

 

We may incur losses if third parties default on their contractual obligations, such as obligations to pay us money; buy or sell electricity, fuel, emission allowances and other commodities; or provide us with fuel transportation services, power transmission or distribution services. For additional information about third party default risk, including our efforts to mitigate against this risk, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—Credit Risk” in Item 7 of this Form 10-K and note 2(g) to our consolidated financial statements.

 

Our costs of compliance with environmental laws are significant and can affect our future financial results.

 

Our wholesale energy business is subject to extensive and evolving environmental regulations, particularly our coal- and oil-fired generation facilities. We incur significant costs in complying with these regulations and, if we fail to comply, could incur significant penalties. Our cost estimates for compliance with environmental regulations are based on our current assessment of the cost of labor and materials and the state of evolving technologies. Changes to the preceding factors, revisions of environmental regulations, litigation and new

legislation and/or regulations (including new climate change legislation and regulations), as well as other factors, could cause our actual costs to vary outside the range of our estimates. In addition, failure to comply with environmental requirements could require us to shut down or reduce production on our generation facilities or create liability exposure. New environmental laws or regulations may be adopted that would further constrain our operations or increase our environmental compliance costs. We also may be responsible for the environmental liabilities associated with generation facilities even if a prior owner caused the liabilities. We are required to surrender emission allowances equal to emissions of specific substances to operate our facilities. Surrender requirements may require purchase of allowances which may be unavailable or only available at costs that would make it uneconomical to operate our generating assets. See “Business—Environmental Matters” in Item 1 of this Form 10-K and note 13(c) to our consolidated financial statements.

 

Failure to obtain or maintain any required permits or approvals could prevent or limit us from operating our business.

 

To operate our generating facilities and retail electric business, we must obtain and maintain various permits, licenses, approvals and certificates from governmental agencies. In some jurisdictions, we must also meet minimum requirements for customer service and comply with local consumer protection and other laws. Our failure to obtain or maintain any necessary governmental permits or licenses or to satisfy these legal requirements, including environmental compliance provisions, could limit our ability to operate our business or create liability exposure.

 

We could be liable for a share of the payment defaults of other market participants.

 

If a market participant defaults on its payment obligations to an ISO, we, together with other market participants, are liable for a portion of the default obligation that is not otherwise covered by the defaulting market participant. Each ISO establishes credit requirements applicable to market participants and the basis for allocating payment default amounts to market participants. In ERCOT, the allocation is based on share of the total load. As of December 31, 2008, we would have been liable for approximately 21% of any defaulted amount in ERCOT. In PJM, MISO and Cal ISO, the methods of allocating the share of defaults differ, and our exposure from these markets is currently relatively small.

 

Significant events beyond our control, such as hurricanes and other weather-related problems or acts of terrorism, could have a material adverse effect on our business.

 

The uncertainty associated with events beyond our control, such as significant weather events and the risk of future terrorist activity, may affect our results of operations and financial condition in unpredictable ways. These events could result in adverse changes in the insurance markets and disruptions of power and fuel markets. In addition, significant weather events or terrorist actions could damage or shut down our generation facilities or the fuel and fuel supply facilities or the power transmission and distribution facilities upon which our generation and retail businesses are dependent. Power supply may be sold at a loss if these events cause a significant loss of retail customer load. We do not have business interruption insurance related to our retail energy business. These events could also adversely affect the United States economy, create instability in the financial markets and, as a result, have an adverse effect on our ability to access capital on terms and conditions acceptable to us.

 

Merrill Lynch, credit support provider for our retail business, contends we have violated the terms of the credit support agreement.

 

Under the terms of our credit-enhanced retail structure entered into in December 2006, Merrill Lynch provides guarantees and posts collateral for the supply purchases and related transactions of our retail energy business. Merrill Lynch contends that we violated the credit sleeve and reimbursement agreement (the agreement) when we terminated our working capital facility with them in December 2008, and has filed an

action in a New York Court seeking a judgment declaring an event of default under the agreement. If Merrill Lynch is successful with its claim, it could seek to exercise remedies under the agreement. There is a range of possible remedies available to Merrill Lynch under the agreement, including, without limitation:

 

 

Depending on the specific remedy that Merrill Lynch may elect to pursue, cross defaults could occur under our June 2007 credit facilities. Although we would seek a waiver from the lenders to avoid any cross defaults, such waiver may not be available on commercially reasonable terms and we may choose to terminate the June 2007 credit facilities. If we were to do so, we may be required to post cash for outstanding letters of credit. For these credit facilities, as of December 31, 2008, we have $0 outstanding in debt, $296 million outstanding as letters of credit and $454 million as available liquidity. There are a number of events, including non-payments of obligations and a non-investment-grade credit rating that could cause Merrill Lynch to default under our credit-enhanced retail structure. Furthermore, if Merrill Lynch experiences downgrades in its credit rating or credit outlook, our suppliers may require other credit support or cease doing business with us pursuant to the credit-enhanced retail structure. If any of these events occurs, our ability to operate our retail business could be impaired and our liquidity, cash flows and results of operations could be adversely affected. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources” in Item 7 of this Form 10-K and notes 7 and 13(b) to our consolidated financial statements.

 

We may have to post significant amounts of collateral, which could adversely affect our liquidity, financial position and business.

 

In connection with any unwind of our credit-enhanced retail structure with Merrill Lynch, we will have to post collateral for new retail supply and hedging transactions. Our levels of collateral postings would be determined and impacted by the terms and timing of the unwind, the nature and volume of our commodity hedging agreements, commodity prices and other strategic alternatives that we may undertake. Depending on the specific timing and the movement in underlying commodity prices, we could incur significant collateral posting obligations that may require us to seek additional sources of liquidity, including additional debt. The covenants in our credit agreements and our agreement with Merrill Lynch restrict our ability to, among other things, obtain additional financing. If we were unable to generate sufficient cash flows from operations or raise cash from other sources, we may not be able to meet our collateral posting obligations. These situations could result from further adverse developments in the energy, fuel or capital markets, a disruption in our operations or those of third parties or other events adversely affecting our cash flows and financial performance. We cannot make any assurances that we would be able to obtain such additional liquidity on commercially reasonable terms or at all.

 

Volatile power supply costs and demand for power could adversely affect the financial performance of our retail business.

 

We purchase substantially all of our supply requirements from third parties. As a result, our financial performance depends on our ability to obtain adequate supplies of electric generation from third parties at prices below the prices we charge our customers. Our earnings and cash flows could be adversely affected in any period in which our power supply costs rise at a greater rate than our rates charged to customers. The price of our power supply purchases associated with our energy commitments can be different than that reflected in the rates charged to customers due to, among other factors:

 

 

 

Our earnings and cash flows could also be adversely affected in any period in which the demand for power significantly varies from our forecasted supply, which could occur due to, among other factors, weather events, competition and economic conditions.

 

We may lose further market share in the Houston retail electricity market.

 

In recent years, we have experienced declines in our share of the Houston retail electricity market, which represents approximately 65% of our residential and small business customer base. This trend could continue. The new competitive market has attracted a number of new participants. Competitors are putting downward pressure on our Houston sales volumes and may put downward pressure on our margins over time. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Business Overview” in Item 7 of this Form 10-K.

 

Violations of market power standards may negatively impact the wholesale cost of power.

 

In 2006, the PUCT implemented a new rule on resource adequacy and market power in the ERCOT Region. In this rule, the PUCT increased the current price cap applicable to generation offers into the ERCOT energy market, eliminated current market power mitigation measures and adopted new market power standards. If a market participant violates the market power standards and it is not adequately mitigated, such violation could have the impact of increasing the wholesale cost of power, which could adversely impact our gross margins in the Texas retail market.

 

We depend on the ISOs to communicate operating and system information in a timely and accurate manner. Information that is not accurate or timely can have an impact on our current and future reported financial results.

 

Each ISO communicates information relating to a customer’s choice of retail electric provider and other data needed for servicing of customer accounts to utilities and retail electric providers. Any failure to perform these tasks will result in delays and other problems in enrolling, switching and billing customers. Some of the ISOs are also responsible for settling all electricity supply volumes in their region. Information that is not accurate or timely may result in incorrect estimates of our settled volumes and supply costs that would need to be corrected when such information is received. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—New Accounting Pronouncements, Significant Accounting Policies and Critical Accounting Estimates—Critical Accounting Estimates” in Item 7 of this Form 10-K.

 

Our borrowing levels, debt service obligations and restrictive covenants may adversely affect our business. We may be vulnerable to reductions in our cash flow.

 

As of December 31, 2008, we had total debt of $2.9 billion:

 

 

 

If we were unable to generate sufficient cash flows, access funds from operations or raise cash from other sources, we would not be able to meet our debt service and other obligations. These situations could result from adverse developments in the energy, fuel or capital markets, a disruption in our operations or those of third parties or other events adversely affecting our cash flows and financial performance. See further discussion of risks related to our credit-enhanced retail structure under “Risks Related to our Retail Business.”

 

Our hedging and other risk management activities may not work as planned.

 

Our hedges may not be effective as a result of basis price differences, transmission issues, price correlation, volume variations or other factors, including margins being compressed as a result of market prices behaving differently than expected. See “Quantitative and Qualitative Disclosures About Market Risk” in Item 7A of this Form 10-K.

 

Changes in the wholesale energy market or changes in our evaluation of generation assets could result in impairments.

 

If our outlook for the wholesale energy market changes negatively, or if our ongoing evaluation of our wholesale energy segment results in decisions to mothball, retire or dispose of generation assets, we could have impairment charges related to our fixed assets. See note 2(i) to our consolidated financial statements.

 

Lawsuits, regulatory proceedings and tax proceedings could adversely affect our future financial results.

 

From time to time, we are named as a party to, or our property is the subject of, lawsuits, regulatory proceedings or tax proceedings. These proceedings involve highly subjective matters with complex factual and legal questions. Their outcome is uncertain. Any claim that is successfully asserted against us could result in significant damage claims and other losses. Even if we prevail, any proceedings could be costly and time-consuming and would divert the attention of our management and key personnel from our business operations, which could adversely affect our financial condition, results of operations or cash flows. See notes 11, 13 and 14 to our consolidated financial statements.

 

We have entered into outsourcing arrangements with third party service providers. In addition, our operations are highly dependent on computer and other operating systems, including telecommunications systems. Any interruptions in these arrangements or systems could significantly disrupt our business operations.

 

In recent years, we have entered into outsourcing arrangements, such as information technology production software, infrastructure and development and certain functions within customer operations, with third party service providers. If these service providers do not perform their obligations, we may incur significant costs and experience interruptions in our business operations in connection with switching to other service providers or assuming these obligations ourselves. We are also highly dependent on our specialized computer and communications systems, the operation of which could be interrupted by fire, flood, power loss, computer viruses or similar disruptions. There is no guarantee that our backup systems and disaster recovery plans will be effective.

If we acquire or develop additional generation assets, or dispose of existing generation assets, we may incur additional costs and risks.

 

We may seek to purchase or develop additional generation facilities or dispose of existing generation facilities. There is no assurance that these efforts will be successful. In any sale, we may be required to indemnify a purchaser against liabilities. To finance future acquisitions, we may be required to issue additional equity securities or incur additional debt. We cannot make any assurances that we would be able to obtain such additional liquidity on commercially reasonable terms or at all.

 

Our process of exploring strategic alternatives may not be successful.

 

On October 6, 2008, we announced that our Board of Directors authorized the exploration of strategic alternatives to enhance stockholder value. There can be no assurance that the exploration of strategic alternatives will result in a transaction, or that the benefits of any strategic alternative pursued will in fact be realized. The pendency of this process may create uncertainties with current and potential customers, employees, suppliers and business partners. In addition, the market price of our stock may be volatile as we explore strategic alternatives, and volatility may persist or be increased if and when a decision to pursue an alternative is announced or we announce that we are no longer exploring strategic alternatives.

 

For other company risks, see “Business” in Item 1 and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7 of this Form 10-K.

 

 

None.

 

 

Our principal executive offices are leased through 2018, subject to two five-year renewal options. Our principal generation facilities are described under “Business—Wholesale Energy” in Item 1 of this Form 10-K. We believe that our properties are adequate for our present needs. We have satisfactory title, rights and possession to our owned facilities, subject to exceptions, which, in our opinion, would not have a material adverse effect on the use or value of the facilities.

 

 

For a description of our material pending legal and regulatory proceedings and settlements, see notes 13 and 14 to our consolidated financial statements.

 

 

None.

 

 

Our common stock trades on the New York Stock Exchange under the ticker symbol “RRI.” On February 13, 2009, we had 34,659 stockholders of record.

 

The closing price of our common stock on December 31, 2008 was $5.78.

 

 

We have never paid dividends. Some of our debt agreements restrict the payment of dividends. See note 6 to our consolidated financial statements.

 

Stock Price Performance Graph.  The following line graph compares the yearly percentage change in our cumulative total stockholder return on common stock with cumulative total return of a broad equity market index (Standard & Poor’s 500 Stock Index) and the cumulative total return of a group of our peer companies comprised of Calpine Corporation, Constellation Energy Group, Inc., Dominion Resources, Inc., Dynegy Inc., Exelon Corporation, Mirant Corporation, NRG Energy, Inc., Sempra Energy and TXU Corp. TXU Corp. has been excluded from the graph for 2007 and 2008 because it was acquired and is no longer a publicly-traded company.

 

 

This stock price performance graph is furnished in this Form 10-K and is not filed, as permitted by 17 CFR 229.201(e).

 

 

 

 

 

 

 

Financial Flexibility.  Given the ongoing turmoil in the financial markets and the uncertainty in the overall economic outlook, our focus has been and continues to be on our liquidity and financial flexibility. We are regularly assessing the impact on our business of a wide variety of economic and commodity price scenarios. We believe we have the ability to operate through a significant downturn.

 

Review of Strategic Alternatives.  In October 2008, our Board of Directors initiated a process to review strategic alternatives and formed a special committee to oversee this process. We are exploring a full range of possible strategic alternatives to enhance stockholder value, including, among other possibilities, the sale of all or substantially all of Reliant Energy, as well as the sale of some or all of our retail business. For discussion of our agreement to sell our Texas retail business, see “Business—General” in Item 1 of this Form 10-K.

 

Ongoing Operations.  Our objective is to be a leader in delivering the benefits of competitive electricity markets to customers. Our business focuses on the competitive mass retail and wholesale electricity markets. We are committed to delivering superior returns from competitive markets through insights into the fundamentals of our core markets and a commitment to risk-weighted investments whose return on invested capital exceeds our weighted-average cost of capital.

 

Company-wide.  We are focusing on the following value-creation levers:

 

 

We also believe that stockholder value is enhanced through the development of a highly motivated and customer-focused work force. We continue to focus on:

 

 

Wholesale Energy.  The wholesale energy segment is a capital-intensive, cyclical business. Earnings are significantly impacted by spark and dark spreads and capacity prices. Our margins are driven by a number of factors, including the prices of power, natural gas, coal and fuel oil, the cost of emissions, transmission, weather and global macro-economic factors, none of which we control and many of which are volatile. The factor that we have the most control over is the percentage of time that our generating assets are available to run when it is economical for them to do so (commercial capacity factor). The key earnings drivers in the wholesale energy segment are the amount of time our power plants are economical to operate (economic generation) and commercial capacity factor, which both determine the amount of electricity we generate, the margin we earn for each unit of electricity sold, the availability of our generating assets to meet demand and capacity revenues (other margin) and operating costs. These earnings drivers are impacted by various factors including:

 

Economic generation

 

 

Commercial capacity factor

 

 

Unit margin

 

 

Other margin

 

 

Operating costs

 

 

We are focusing on the following value-creation levers:

 

 

For a discussion of our plans for investment to comply with existing environmental regulations, see “Business—Regulation—Environmental Matters” in Item 1 of this Form 10-K and “—Liquidity and Capital Resources” below. For a discussion of pending and contingent matters related to environmental regulations, see note 13(c) to our consolidated financial statements.

 

Retail Energy.  The retail energy segment is an electricity resale business. We earn a margin by selling electricity to end-user customers, meeting the service needs of such customers and acquiring supply for the estimated demand. The key earnings drivers in the retail energy segment are the volume of electricity we sell to customers, the unit margins received on those sales and the cost of acquiring and serving those customers (operating costs). These earnings drivers are impacted by various factors including:

 

Volume of electricity sales

 

 

Unit margins

 

 

 

 

Operating costs

 

 

We are focusing on the following value-creation levers:

 

 

To reduce the risk of extreme earnings variability in our retail energy segment, we have designed and are implementing changes in our hedging approach such as matching supply and load by geographic zone, buying heat rate and fixed-price call options for volumes significantly above expected levels and considering the use of gas, power and weather options to mitigate extreme events. These changes will result in higher expected supply costs over time. We are reviewing our core processes that support the business to ensure that we have the right people, skills and systems.

 

For a discussion of our ongoing plan to exit the C&I portion of our retail business over time and the related reduction in our long-term capital requirements for collateral, see “—2008 Significant Events” and “—Liquidity and Capital Resources” below.

 

Our ability to achieve these objectives and execute these actions is subject to a number of factors, some of which we may not be able to control. See “Cautionary Statement Regarding Forward-Looking Information” and “Risk Factors” in Item 1A of this Form 10-K.

 

2008 Significant Events

 

ERCOT.  The Houston area experienced thirty-year record heat in late May and early June 2008. As a result, load demand in Houston and south Texas was greater than we expected. Additionally, transmission constraints limited the ability to move power into the Houston and south Texas zones, which caused some of our power supply to be unavailable to meet expected demand. In response, we purchased power in Houston and south Texas to meet our increased load at market prices. This extraordinary event negatively impacted our retail contribution margin by approximately $150 million during primarily the second quarter of 2008.

 

Hurricane Ike Stranded Supply Costs.  In September 2008, Hurricane Ike struck the upper Texas coast, which left over 2.1 million electric consumers (more than 90 percent of the metered electric consumers in the Houston-Galveston area) without power. More than 1.0 million electric consumers were without power for at least six days and more than 500,000 customers remained without power ten days after the storm. Retail contribution margin was negatively impacted by approximately $75 million as a result of the effects of Hurricane Ike, including reduced sales volumes and the sale of excess supply at a loss.

 

Hurricane Ike, Higher Supply Costs and Pricing Decisions.  Due to a substantial increase in natural gas prices, we incurred much higher supply costs in the second and third quarters of 2008 compared to 2007. Natural gas prices declined rapidly in the third quarter and after Hurricane Ike, we decided to not take pricing actions that would have immediately and fully offset the higher supply costs at that time. The combination of increased supply costs and the associated pricing decisions lowered 2008 retail contribution margin by approximately $250 million.

 

Merrill Lynch.  The results in our retail energy segment in 2008 were substantially below our expectations as a result of a variety of factors, including the record heat in the Houston area and ERCOT transmission constraints experienced in late May and early June, the devastating impact of Hurricane Ike on the Gulf Coast and the significant volatility in commodity prices experienced in 2008. As a consequence, we concluded that terminating our $300 million retail working capital facility agreement with Merrill Lynch would be appropriate in order to address any issue that might be asserted regarding the minimum adjusted retail EBITDA covenant in that facility. In December 2008, we terminated the working capital facility and Merrill Lynch contends that we did not have this right. See further discussion of Merrill Lynch’s claim and related legal actions in “—Liquidity and Capital Resources” below and note 13(b) to our consolidated financial statements.

 

Exit from C&I Portion of Our Retail Business.  Prior to our decision to exit the C&I portion of our retail energy business either through a wind down or sale of our C&I contracts, roughly 70% of our retail collateral posting obligations were associated with C&I. In contrast, C&I represented only approximately 30% of the contribution margin associated with our retail business. Without the Merrill Lynch credit support under the credit sleeve and reimbursement agreement, we do not believe that the C&I margins covered our cost of capital associated with this business. As a result, we decided to exit the C&I portion of our retail business. Except where we are contractually obligated to do so, we are no longer entering into contracts with new C&I customers and we do not expect to renew contracts with our current customers. In December 2008, we sold all

of our Northeast C&I contracts. The Northeast C&I activity was (a) $505 million of our consolidated revenues (or 4%) and (b) $18 million of our consolidated gross margin, excluding unrealized gains/losses on energy derivatives (or 1%) during 2008. We expect that approximately 13,000 MW (36%), 7,000 MW (19%) and 15,000 MW (45%) of our remaining contracted volumes for the C&I activity will roll off during 2009, 2010 and thereafter, respectively.

 

The following details the C&I activity in our consolidated results of operations:

 

 

 

 

Disposition of Generation Facilities.  In July 2008, Channelview completed the sale of its plant for $500 million. In October 2008, we sold our Bighorn plant for $500 million. See notes 19 and 20 to our consolidated financial statements.

 

The following discussion includes non-GAAP financial measures, which are not standardized; therefore, it may not be possible to compare these financial measures with other companies’ non-GAAP financial measures having the same or similar names. These non-GAAP financial measures, which are discussed below, reflect an additional way of viewing aspects of our operations that, when viewed with our GAAP results, may provide a more complete understanding of factors and trends affecting our business segments. Investors should review our consolidated financial statements and publicly filed reports in their entirety and not rely on any single financial measure.

 

2008 Compared to 2007 and 2007 Compared to 2006

 

We reported $740 million consolidated net loss, or $2.13 loss per share, for 2008 compared to $365 million consolidated net income, or $1.04 diluted income per share, for 2007 and $328 million consolidated net loss, or $1.07 loss per share, for 2006.

 

 

 

 

Wholesale Energy Segment.

 

In analyzing the results of our wholesale energy segment and in communications with investors, analysts, rating agencies, banks and other parties, we use the non-GAAP financial measures “open energy gross margin,” “open wholesale gross margin” and “open wholesale contribution margin,” which exclude the items described below, as well as our wholesale energy segment profit and loss measure, “contribution margin, including wholesale hedges and unrealized gains/losses on energy derivatives.” Open energy gross margin, open wholesale gross margin and open wholesale contribution margin should not be relied upon without considering the GAAP financial measures.

 

Wholesale Hedges.  We exclude the recurring effect of certain wholesale hedges that were entered into primarily to mitigate certain operational risks at our generation assets. These amounts primarily relate to settlements of fuel hedges, long-term natural gas transportation contracts and storage contracts. We also exclude the effect of our wholesale energy segment’s 2008 sale of natural gas contracts to our retail energy segment. We entered into this intersegment transaction to reduce Merrill Lynch’s collateral posting obligations. The wholesale hedges described above are derived based on methodology consistent with the calculation of open energy gross margin. We also exclude the recurring effect of certain historical wholesale hedges that were entered into in order to hedge the economics of a portion of our wholesale operations. These amounts primarily relate to settlements of forward power hedges, long-term tolling purchases, long-term natural gas transportation contracts not serving our generation assets and our legacy energy trading. We believe that it is

useful to us, investors, analysts and others to show our results in the absence of hedges. The impact of these hedges on our financial results is not a function of the operating performance of our generation assets, and excluding the impact better reflects the operating performance of our generation assets based on prevailing market conditions. We previously referred to these hedges as “Historical and Operational Wholesale Hedges.”

 

Unrealized Gains/Losses on Energy Derivatives.  We use derivative instruments to manage operational or market constraints and to increase the return on our generation assets. We are required to record in our consolidated statement of operations non-cash gains/losses related to future periods based on current changes in forward commodity prices for derivative instruments receiving mark-to-market accounting treatment. We refer to these gains and losses prior to settlement, as well as ineffectiveness on cash flow hedges, as “unrealized gains/losses on energy derivatives.” In some cases, the underlying transactions being hedged receive accrual accounting treatment, resulting in a mismatch of accounting treatments. Since the application of mark-to-market accounting has the effect of pulling forward into current periods non-cash gains/losses relating to and reversing in future delivery periods, analysis of results of operations from one period to another can be difficult. We believe that excluding these unrealized gains/losses on energy derivatives provides a more meaningful representation of our economic performance in the reporting period and is therefore useful to us, investors, analysts and others in facilitating the analysis of our results of operations from one period to another. These gains/losses are also not a function of the operating performance of our generation assets, and excluding their impact helps isolate the operating performance of our generation assets under prevailing market conditions.

 

Our wholesale energy segment’s contribution margin, including wholesale hedges and unrealized gains/losses on energy derivatives was $877 million in 2008 compared to $524 million in 2007. The $353 million increase was primarily due to reduced negative effect of wholesale hedges of $339 million partially offset by net change in unrealized gains/losses on energy derivatives of $24 million. Open wholesale contribution margin increased $38 million primarily due to $48 million decrease in operation and maintenance expense partially offset by $8 million decrease in open wholesale gross margin. Our wholesale energy segment’s contribution margin, including wholesale hedges and unrealized gains/losses on energy derivatives was $524 million in 2007 compared to $146 million in 2006. The $378 million increase was primarily due to (a) reduced negative effect of wholesale hedges of $272 million partially offset by net change in unrealized gains/losses on energy derivatives of $49 million. Open wholesale contribution margin increased $155 million primarily due to $196 million increase in open wholesale gross margin partially offset by $40 million increase in operation and maintenance expense. See “—Wholesale Energy Margins” below for explanations.

 

Wholesale Energy Revenues.

 

 

 

 

 

Wholesale Energy Cost of Sales.

 

 

 

 

Wholesale Energy Margins.