10-K 1 d10k.htm FORM 10-K Form 10-K
Table of Contents

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-K

 

FOR ANNUAL AND TRANSITION REPORTS

PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

 

(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, 2008 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 1-1232

 

DUKE ENERGY OHIO, INC.

(Exact name of registrant as specified in its charter)

 

Ohio   31-0240030

(State or other jurisdiction of

incorporation or organization)

  (I.R.S. Employer Identification No.)
139 East Fourth Street, Cincinnati, Ohio   45202
(Address of principal executive offices)   (Zip Code)

 

704-594-6200

(Registrant’s telephone number, including area code)

 

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

 

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

 

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 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

 

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.

 

Large accelerated filer  ¨

   Accelerated filer  ¨

Non-accelerated filer  x

   Smaller reporting company  ¨
(Do not check if a smaller reporting company)   

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Securities Exchange Act of 1934). Yes ¨ No x

 

The registrant meets the conditions set forth in General Instructions (I)(1)(a) and (b) of Form 10-K and is therefore filing this Form 10-K with the reduced disclosure format. Part II Items 4 and 6 and Part III Items 10, 11, 12 and 13 have been omitted in accordance with Instruction (I)(2)(a) and (c).

 

All of the registrant’s common stock is indirectly owned by Duke Energy Corporation (File No. 1-32853), which files reports and proxy material pursuant to the Securities Exchange Act of 1934, as amended.


Table of Contents

TABLE OF CONTENTS

 

DUKE ENERGY OHIO, INC.

FORM 10-K FOR THE YEAR ENDED

DECEMBER 31, 2008

 

Item

        Page
PART I.   
1.    BUSINESS    3
  

GENERAL

   3
  

ENVIRONMENTAL MATTERS

   5
1A.    RISK FACTORS    5
1B.    UNRESOLVED STAFF COMMENTS    10
2.    PROPERTIES    10
3.    LEGAL PROCEEDINGS    10
PART II.   
5.    MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES    11
7.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS    12
7A.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK    17
8.    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA    20
9.    CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE    77
9A.    CONTROLS AND PROCEDURES    77
PART III.   
14.    PRINCIPAL ACCOUNTING FEES AND SERVICES    78
PART IV.   
15.    EXHIBITS, FINANCIAL STATEMENT SCHEDULES    79
  

SIGNATURES

   80
  

EXHIBIT INDEX

   E-1

 

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION

 

This document includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements are based on management’s beliefs and assumptions. These forward-looking statements are identified by terms and phrases such as “anticipate,” “believe,” “intend,” “estimate,” “expect,” “continue,” “should,” “could,” “may,” “plan,” “project,” “predict,” “will,” “potential,” “forecast,” “target,” and similar expressions. Forward-looking statements involve risks and uncertainties that may cause actual results to be materially different from the results predicted. Factors that could cause actual results to differ materially from those indicated in any forward-looking statement include, but are not limited to:

   

State and federal legislative and regulatory initiatives, including costs of compliance with existing and future environmental requirements;

   

State and federal legislative and regulatory initiatives and rulings that affect cost and investment recovery or have an impact on rate structures;

   

Costs and effects of legal and administrative proceedings, settlements, investigations and claims;

   

Industrial, commercial and residential growth in Duke Energy Ohio, Inc.’s (Duke Energy Ohio) service territories;

   

Additional competition in electric markets and continued industry consolidation;

   

The influence of weather and other natural phenomena on Duke Energy Ohio’s operations, including the economic, operational and other effects of storms, hurricanes, droughts and tornados;

   

The timing and extent of changes in commodity prices and interest rates;

   

Unscheduled generation outages, unusual maintenance or repairs and electric transmission system constraints;

   

The performance of electric generation facilities;

   

The results of financing efforts, including Duke Energy Ohio’s ability to obtain financing on favorable terms, which can be affected by various factors, including Duke Energy Ohio’s credit ratings and general economic conditions;

   

Declines in the market prices of equity securities and resultant cash funding requirements of Duke Energy Ohio for Cinergy Corp.’s defined benefit pension plans;

   

The level of credit worthiness of counterparties to Duke Energy Ohio’s transactions;

   

Employee workforce factors, including the potential inability to attract and retain key personnel;

   

Growth in opportunities for Duke Energy Ohio’s business units, including the timing and success of efforts to develop domestic power and other projects; and

   

The effect of accounting pronouncements issued periodically by accounting standard-setting bodies.

In light of these risks, uncertainties and assumptions, the events described in the forward-looking statements might not occur or might occur to a different extent or at a different time than Duke Energy Ohio has described. Duke Energy Ohio undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.


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PART I

 

Item  1. Business.

 

GENERAL

Overview. Duke Energy Ohio, Inc. (Duke Energy Ohio), an Ohio corporation organized in 1837, is a wholly-owned subsidiary of Cinergy Corp. (Cinergy). Cinergy is a wholly-owned subsidiary of Duke Energy Corporation (Duke Energy). Duke Energy Ohio is a combination electric and gas public utility company that provides service in the southwestern portion of Ohio and through its wholly-owned subsidiary, Duke Energy Kentucky, Inc. (Duke Energy Kentucky), in nearby areas of Kentucky, as well as electric generation in parts of Ohio, Illinois, Indiana and Pennsylvania through Duke Energy Ohio’s Commercial Power business segment operations, which are discussed further below. Duke Energy Ohio’s principal lines of business include generation, transmission and distribution of electricity, the sale of and/or transportation of natural gas, and energy marketing. Duke Energy Kentucky’s principal lines of business include generation, transmission and distribution of electricity, as well as the sale of and/or transportation of natural gas in northern Kentucky. Except where separately noted, references to Duke Energy Ohio herein relate to the consolidated operations of Duke Energy Ohio, including Duke Energy Kentucky.

In the second quarter of 2006, Duke Energy and Cinergy consummated a merger which combined the Duke Energy and Cinergy regulated franchises as well as deregulated generation in the Midwestern United States (U.S.).

Business Segments. At December 31, 2008, Duke Energy Ohio operated two business segments, both of which are considered reportable segments under the provisions of Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards (SFAS) No. 131, “Disclosures about Segments of an Enterprise and Related Information”: Franchised Electric and Gas and Commercial Power. Duke Energy Ohio’s chief operating decision maker regularly reviews financial information about each of these business segments in deciding how to allocate resources and evaluate performance. For additional information on each of these business segments, including financial information about each reportable business segment, see Note 2 to the Consolidated Financial Statements, “Business Segments.”

The following is a brief description of the nature of operations of each of Duke Energy Ohio’s reportable business segments, as well as Other.

Franchised Electric and Gas. Franchised Electric and Gas consists of Duke Energy Ohio’s regulated electric and gas transmission and distribution systems, including its regulated electric generation in Kentucky. Franchised Electric and Gas plans, constructs, operates and maintains Duke Energy Ohio’s transmission and distribution systems, which generate, transmit and distribute electric energy to consumers in southwestern Ohio and northern Kentucky. Franchised Electric and Gas also transports and sells natural gas in southwestern Ohio and northern Kentucky. These electric and gas operations are subject to the rules and regulations of the Federal Energy Regulatory Commission (FERC), the Public Utilities Commission of Ohio (PUCO) and the Kentucky Public Service Commission (KPSC). Substantially all of Franchised Electric and Gas’ operations are regulated and, accordingly, these operations are accounted for under the provisions of SFAS No. 71, “Accounting for the Effects of Certain Types of Regulation” (SFAS No. 71).

Franchised Electric and Gas’ service area covers about 3,000 square miles with an estimated population of 2.1 million in southern Ohio and northern Kentucky. Franchised Electric and Gas supplies electric service to approximately 820,000 residential, commercial and industrial customers over approximately 19,500 miles of distribution lines and an approximate 2,500-mile transmission system in Ohio and Kentucky. Franchised Electric and Gas provides regulated transmission and distribution services for natural gas to approximately 500,000 customers via approximately 7,100 miles of gas mains (gas distribution lines that serve as a common source of supply for more than one service line) and service lines. See Item 2. “Properties” for further discussion of Franchised Electric and Gas’ generating facilities.

Commercial Power. Commercial Power owns, operates and manages power plants and engages in the wholesale marketing and procurement of electric power, fuel and emission allowances related to these plants, as well as other contractual positions. Commercial Power’s asset portfolio comprises approximately 7,550 net megawatts (MW) and its generation assets consist of a diversified fuel mix with baseload and mid-merit coal-fired units, as well as combined cycle (CC) and peaking natural gas-fired units. Commercial Power’s portfolio includes the five Midwestern gas-fired generation assets that were transferred from Duke Energy in 2006. See Item 2. “Properties” for further discussion of Commercial Power’s generating facilities. Most of the generation asset output in Ohio has been contracted through the Rate Stabilization Plan (RSP), which expired on December 31, 2008. Effective January 1, 2009, Commercial Power began operating under an Electric Security Plan (ESP), which expires on December 31, 2011. As a result of the approval of the ESP, certain of Commercial Power’s operations reapplied the provisions of SFAS No. 71 effective December 17, 2008. See Notes 1 and 4, “Summary of Significant Accounting Policies,” and “Regulatory Matters,” to the Consolidated Financial Statements, respectively, for a discussion of the reapplication of SFAS No. 71 to certain of Commercial Power’s operations, as well as for further discussion related to the RSP and ESP.

 

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Other. The remainder of Duke Energy Ohio’s operations is presented as Other. While it is not considered a business segment, Other for Duke Energy Ohio includes certain allocated governance costs.

General. Duke Energy Ohio is an Ohio corporation. Duke Energy Ohio’s principal executive offices are located at 139 East Fourth Street, Cincinnati, Ohio 45202. The telephone number is 704-594-6200. Duke Energy Ohio electronically files reports with the Securities and Exchange Commission (SEC), including annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to such reports. The public may read and copy any materials that Duke Energy Ohio files with the SEC at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC also maintains an internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC at http://www.sec.gov. Additionally, information about Duke Energy Ohio, including its reports filed with the SEC, is available through Duke Energy’s web site at http://www.duke-energy.com. Such reports are accessible at no charge through Duke Energy’s web site and are made available as soon as reasonably practicable after such material is filed with or furnished to the SEC.

 

GLOSSARY OF TERMS

The following terms or acronyms used in this Form 10-K are defined below:

Term or Acronym

  

Definition

AAC

   Annually Adjusted Component

AFUDC

   Allowance for Funds Used During Construction

APB

   Accounting Principles Board

CC

   Combined Cycle

Cinergy

   Cinergy Corp. (collectively with its subsidiaries)

CO2

   Carbon dioxide

CT

   Combustion Turbine

DOE

   Department of Energy

DOJ

   Department of Justice

Duke Energy

   Duke Energy Corporation (collectively with its subsidiaries)

Duke Energy Kentucky

   Duke Energy Kentucky, Inc.

Duke Energy Ohio

   Duke Energy Ohio, Inc.

EITF

   Emerging Issues Task Force

EPA

   Environmental Protection Agency

ESP

   Electric Security Plan

EWG

   Exempt Wholesale Generator

FASB

   Financial Accounting Standards Board

FERC

   Federal Energy Regulatory Commission

FIN

   Financial Accounting Standards Board Interpretation

FPP

   Fuel and Purchased Power

FSP

   Financial Accounting Standards Board Staff Position

FTC

   United States Federal Trade Commission

GAAP

   United States Generally Accepted Accounting Principles

KPSC

   Kentucky Public Service Commission

LIBOR

   London Interbank Offered Rate

Midwest ISO

   Midwest Independent Transmission System Operator

MMBtu

   Million British thermal units

MW

   Megawatt

 

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Term or Acronym

  

Definition

NOx

   Nitrogen oxide

OCC

   Office of the Ohio Consumers’ Counsel

PUCO

   Public Utilities Commission of Ohio

RSP

   Rate Stabilization Plan

RTC

   Regulatory Transition Charges

SAB

   Securities and Exchange Commission Staff Accounting Bulletin

SEC

   Securities and Exchange Commission

SFAS

   Statement of Financial Accounting Standards

SO2

   Sulfur dioxide

 

ENVIRONMENTAL MATTERS

Duke Energy Ohio is subject to federal, state and local laws and regulations with regard to air and water quality, hazardous and solid waste disposal and other environmental matters. Environmental laws and regulations affecting Duke Energy Ohio include, but are not limited to:

   

The Clean Air Act, as well as state laws and regulations impacting air emissions, including State Implementation Plans related to existing and new national ambient air quality standards for ozone and particulate matter. Owners and/or operators of air emission sources are responsible for obtaining permits and for annual compliance and reporting.

   

The Clean Water Act which requires permits for facilities that discharge wastewaters into the environment.

   

The Comprehensive Environmental Response, Compensation and Liability Act, which can require any individual or entity that currently owns or in the past may have owned or operated a disposal site, as well as transporters or generators of hazardous substances sent to a disposal site, to share in remediation costs.

   

The Solid Waste Disposal Act, as amended by the Resource Conservation and Recovery Act, which requires certain solid wastes, including hazardous wastes, to be managed pursuant to a comprehensive regulatory regime.

   

The National Environmental Policy Act, which requires federal agencies to consider potential environmental impacts in their decisions, including siting approvals.

(For more information on environmental matters involving Duke Energy Ohio, including possible liability and capital costs, see Notes 4 and 18 to the Consolidated Financial Statements, “Regulatory Matters,” and “Commitments and Contingencies,” respectively.)

Except to the extent discussed in Note 4 to the Consolidated Financial Statements, “Regulatory Matters,” and Note 18 to the Consolidated Financial Statements, “Commitments and Contingencies,” compliance with current federal, state and local provisions regulating the discharge of materials into the environment, or otherwise protecting the environment, is incorporated into the routine cost structure of our various business segments and is not expected to have a material adverse effect on the competitive position, consolidated results of operations, cash flows or financial position of Duke Energy Ohio.

 

Item 1A. Risk Factors.

The risk factors discussed herein relate specifically to risks associated with Duke Energy Ohio.

 

Duke Energy Ohio’s electric revenues, earnings and results are dependent on federal and state legislation and regulation that affect electric generation, transmission, distribution and related activities, which may limit Duke Energy Ohio’s ability to recover costs.

Duke Energy Ohio’s franchised electric businesses are regulated on a cost-of-service/rate-of-return basis subject to the statutes and regulatory commission rules and procedures of Ohio and Kentucky. If Duke Energy Ohio’s franchised electric earnings exceed the returns established by the state regulatory commissions, Duke Energy Ohio’s retail electric rates may be subject to review by the commissions and possible reduction, which may decrease Duke Energy Ohio’s future earnings. Additionally, if regulatory bodies do not allow recovery of costs incurred in providing service on a timely basis, Duke Energy Ohio’s future earnings could be negatively impacted. Additionally, certain portions of Duke Energy Ohio’s Commercial Power operations are regulated on a partial cost-of-service/rate-of-return basis under the ESP.

 

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Duke Energy Ohio’s business is subject to extensive regulation that will affect Duke Energy Ohio’s operations and costs.

Duke Energy Ohio is subject to regulation by FERC and by federal, state and local authorities under environmental laws and by state public utility commissions under laws regulating Duke Energy Ohio’s businesses. Regulation affects almost every aspect of Duke Energy Ohio’s businesses, including, among other things, Duke Energy Ohio’s ability to: take fundamental business management actions; determine the terms and rates of Duke Energy Ohio’s transmission and distribution businesses’ services as well as its regulated generation business; make acquisitions; issue debt securities; engage in transactions between Duke Energy Ohio’s utilities and other subsidiaries and affiliates; and pay dividends to its ultimate parent, Duke Energy. Changes to these regulations are ongoing, and Duke Energy Ohio cannot predict the future course of changes in this regulatory environment or the ultimate effect that this changing regulatory environment will have on Duke Energy Ohio’s businesses. However, changes in regulation (including re-regulating previously deregulated markets) can cause delays in or affect business planning and transactions and can substantially increase Duke Energy Ohio’s costs.

 

New laws or regulations could have a negative impact on Duke Energy Ohio’s results of operations, cash flows or financial position.

Changes in laws and regulations affecting Duke Energy Ohio, including new accounting standards could change the way Duke Energy Ohio is required to record revenues, expenses, assets and liabilities. These types of regulations could have a negative impact on Duke Energy Ohio’s results of operations, cash flows or financial position or access to capital.

 

Deregulation or restructuring in the electric industry may result in increased competition and unrecovered costs that could adversely affect Duke Energy Ohio’s consolidated results of operations, cash flows or financial position and its utilities’ businesses.

Increased competition resulting from deregulation or restructuring efforts could have a significant adverse financial impact on Duke Energy Ohio and consequently on its consolidated results of operations, cash flows or financial position. Increased competition could also result in increased pressure to lower costs, including the cost of electricity. Duke Energy Ohio cannot predict the extent and timing of entry by additional competitors into the electric markets. Duke Energy Ohio cannot predict when it will be subject to changes in legislation or regulation, nor can it predict the impact of these changes on its consolidated results of operations, cash flows or financial position.

 

Duke Energy Ohio may be unable to secure long-term power sales agreements or transmission agreements, which could expose Duke Energy Ohio’s sales to increased volatility.

In the future, Duke Energy Ohio may not be able to secure long-term power sales agreements for Duke Energy Ohio’s unregulated power generation facilities. If Duke Energy Ohio is unable to secure these types of agreements, Duke Energy Ohio’s sales volumes would be exposed to increased volatility. Without the benefit of long-term customer power purchase agreements, Duke Energy Ohio cannot assure that it will be able to operate profitably. The inability to secure these agreements could materially adversely affect Duke Energy Ohio’s results and business.

 

Competition in the unregulated markets in which Duke Energy Ohio operates may adversely affect the growth and profitability of Duke Energy Ohio’s business.

Duke Energy Ohio may not be able to respond in a timely or effective manner to the many changes designed to increase competition in the electricity industry. To the extent competitive pressures increase, the economics of Duke Energy Ohio’s business may come under long-term pressure.

Duke Energy Ohio may also face competition from new competitors that have greater financial resources than Duke Energy Ohio does, seeking attractive opportunities to acquire or develop energy assets or energy trading operations both in the United States and abroad. These new competitors may include sophisticated financial institutions, some of which are already entering the energy trading and marketing sector, and international energy players, which may enter regulated or unregulated energy businesses. This competition in generation assets in non-regulated competitive markets may adversely affect Duke Energy Ohio’s ability to make investments or acquisitions.

 

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Duke Energy Ohio must meet credit quality standards and there is no assurance that Duke Energy Ohio will maintain investment grade credit ratings. If Duke Energy Ohio or its rated subsidiary is unable to maintain an investment grade credit rating, it would be required under credit agreements to provide collateral in the form of letters of credit or cash, which may materially adversely affect its liquidity.

Both Duke Energy Ohio’s and its rated subsidiary’s senior unsecured long-term debt is rated investment grade by various rating agencies. Duke Energy Ohio cannot be sure that its or its rated subsidiary’s senior unsecured long-term debt will continue to be rated investment grade.

If the rating agencies were to rate Duke Energy Ohio or its rated subsidiary below investment grade, Duke Energy Ohio’s borrowing costs would increase, perhaps significantly. In addition, Duke Energy Ohio would likely be required to pay a higher interest rate in future financings, and its potential pool of investors and funding sources would likely decrease. Any downgrade or other event negatively affecting the credit ratings of Duke Energy Ohio or its rated subsidiary could also increase Cinergy’s or Duke Energy’s need to provide liquidity in the form of capital contributions or loans, thus reducing the liquidity and borrowing availability of the consolidated group.

A downgrade below investment grade could also trigger termination clauses in some interest rate and foreign exchange derivative agreements, which would require cash payments. All of these events would likely reduce Duke Energy Ohio’s liquidity and profitability and could have a material adverse effect on its consolidated results of operations, cash flows or financial position.

 

Duke Energy Ohio relies on access to short-term intercompany borrowings and longer-term capital markets to finance its capital requirements and support its liquidity needs, and Duke Energy Ohio’s access to those markets can be adversely affected by a number of conditions, many of which are beyond its control.

Duke Energy Ohio’s business is financed to a large degree through debt and the maturity and repayment profile of debt used to finance investments often does not correlate to cash flows from its assets. Accordingly, Duke Energy Ohio relies on access to short-term borrowings via Duke Energy’s money pool arrangement and financings from longer-term capital markets as a source of liquidity for capital requirements not satisfied by the cash flow from its operations and to fund investments originally financed through debt instruments with disparate maturities. If Duke Energy Ohio is not able to access capital at competitive rates or Duke Energy Ohio cannot obtain short-term borrowings via the money pool arrangement, its ability to finance its operations and implement its strategy could be adversely affected.

Market disruptions may increase Duke Energy Ohio’s cost of borrowing or adversely affect its ability to access one or more financial markets. Such disruptions could include: economic downturns; the bankruptcy of an unrelated energy company; capital market conditions generally; market prices for electricity and gas; terrorist attacks or threatened attacks on Duke Energy Ohio’s facilities or unrelated energy companies; or the overall health of the energy industry. Restrictions on Duke Energy Ohio’s ability to access financial markets may also affect its ability to execute its business plan as scheduled. An inability to access capital may limit Duke Energy Ohio’s ability to pursue improvements or acquisitions that it may otherwise rely on for future growth.

Duke Energy Ohio’s ultimate parent, Duke Energy, maintains revolving credit facilities to provide back-up for commercial paper programs and/or letters of credit at various entities. These facilities typically include financial covenants which limit the amount of debt that can be outstanding as a percentage of the total capital for the specific entity. Failure to maintain these covenants at a particular entity could preclude that entity from issuing commercial paper or letters of credit or borrowing under the revolving credit facility and could require other of Duke Energy Ohio’s affiliates to immediately pay down any outstanding drawn amounts under other revolving credit agreements.

 

Current levels of market volatility are unprecedented.

The capital and credit markets have been experiencing extreme volatility and disruption. In recent months, the volatility and disruption have reached unprecedented levels. In some cases, the markets have exerted downward pressure on credit capacity for certain issuers. If current levels of market disruption and volatility continue or worsen, Duke Energy Ohio may be forced to meet its other liquidity needs by further drawing upon contractually committed lending agreements primarily provided by global banks, although there is no assurance that the commitments made by lenders under Duke Energy’s master credit facility will be available if needed due to the recent turmoil throughout the financial services industry. This could require Duke Energy Ohio to seek other funding sources. However, under such extreme market conditions, there can be no assurance other funding sources would be available or sufficient.

 

Duke Energy Ohio is exposed to credit risk of customers and counterparties with whom it does business.

Adverse economic conditions affecting, or financial difficulties of customers and counterparties with whom Duke Energy Ohio does business could impair the ability of these customers and counterparties to pay for Duke Energy Ohio’s services or fulfill their contractual

 

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obligations, including loss recovery payments under insurance contracts or cause them to delay such payments or obligations. Duke Energy Ohio depends on these customers and counterparties to remit payments on a timely basis. Any delay or default in payment could adversely affect Duke Energy Ohio’s consolidated results of operations, cash flows or financial position.

 

Poor investment performance of Cinergy’s pension plan holdings and other factors impacting pension plan costs could unfavorably impact Duke Energy Ohio’s liquidity and results of operations.

Duke Energy Ohio participates in certain employee benefit plans sponsored by its parent, Cinergy. Duke Energy Ohio is allocated costs and obligations related to these plans. Cinergy’s costs of providing non-contributory defined benefit pension plans are dependent upon a number of factors, such as the rates of return on plan assets, discount rates, the level of interest rates used to measure the required minimum funding levels of the plans, future government regulation and required or voluntary contributions made to the plans. While Cinergy has complied with the minimum funding requirements as of December 31, 2008, Cinergy’s qualified pension plans had obligations which exceeded the value of plan assets by approximately $882 million. Without sustained growth in the pension investments over time to increase the value of plan assets and depending upon the other factors impacting Cinergy’s costs as listed above, Duke Energy Ohio could be required to fund its parent’s plans with significant amounts of cash. Such cash funding obligations could have a material impact on Duke Energy Ohio’s consolidated results of operations, cash flows or financial position.

 

Duke Energy Ohio is subject to numerous environmental laws and regulations that require significant capital expenditures, can increase its cost of operations, and which may impact or limit its business plans, or expose it to environmental liabilities.

Duke Energy Ohio is subject to numerous environmental laws and regulations affecting many aspects of its present and future operations, including air emissions (such as reducing nitrogen oxide, sulfur dioxide and mercury emissions or potential future control of greenhouse gas emissions), water quality, wastewater discharges, solid waste and hazardous waste. These laws and regulations can result in increased capital, operating and other costs. These laws and regulations generally require Duke Energy Ohio to obtain and comply with a wide variety of environmental licenses, permits, inspections and other approvals. Compliance with environmental laws and regulations can require significant expenditures, including expenditures for clean up costs and damages arising out of contaminated properties, and failure to comply with environmental regulations may result in the imposition of fines, penalties and injunctive measures affecting operating assets. The steps Duke Energy Ohio takes to ensure that its facilities are in compliance could be prohibitively expensive. As a result, Duke Energy Ohio may be required to shut down or alter the operation of its facilities, which may cause it to incur losses. Further, Duke Energy Ohio’s regulatory rate structure and its contracts with customers may not necessarily allow it to recover capital costs Duke Energy Ohio incurs to comply with new environmental regulations. Also, Duke Energy Ohio may not be able to obtain or maintain from time to time all required environmental regulatory approvals for its operating assets or development projects. If there is a delay in obtaining any required environmental regulatory approvals, if Duke Energy Ohio fails to obtain and comply with them or if environmental laws or regulations change and become more stringent, then the operation of Duke Energy Ohio’s facilities or the development of new facilities could be prevented, delayed or become subject to additional costs. Although it is not expected that the costs of complying with current environmental regulations will have a material adverse effect on Duke Energy Ohio’s consolidated results of operations, cash flows or financial position, no assurance can be made that the costs of complying with environmental regulations in the future will not have such an effect.

There is growing consensus that some form of regulation will be forthcoming at the federal level with respect to greenhouse gas emissions, including carbon dioxide (CO2), and such regulation could result in the creation of substantial compliance costs.

In addition, Duke Energy Ohio is generally responsible for on-site liabilities, and in some cases off-site liabilities, associated with the environmental condition of Duke Energy Ohio’s power generation facilities and natural gas assets which it has acquired or developed, regardless of when the liabilities arose and whether they are known or unknown. In connection with some acquisitions and sales of assets, Duke Energy Ohio may obtain, or be required to provide, indemnification against some environmental liabilities. If Duke Energy Ohio incurs a material liability, or the other party to a transaction fails to meet its indemnification obligations to Duke Energy Ohio, Duke Energy Ohio could suffer material losses.

 

Duke Energy Ohio is involved in numerous legal proceedings, the outcomes of which are uncertain, and resolution adverse to Duke Energy Ohio could negatively affect its consolidated results of operations, cash flows or financial position.

Duke Energy Ohio is subject to numerous legal proceedings. Litigation is subject to many uncertainties and Duke Energy Ohio cannot predict the outcome of individual matters with assurance. It is reasonably possible that the final resolution of some of the matters in which Duke Energy Ohio is involved could require it to make additional expenditures, in excess of established reserves, over an extended period

 

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of time and in a range of amounts that could have a material effect on its consolidated results of operations and cash flows. Similarly, it is reasonably possible that the terms of resolution could require Duke Energy Ohio to change its business practices and procedures, which could also have a material effect on its consolidated results of operations, cash flows or financial position.

 

Duke Energy Ohio’s consolidated results of operations may be negatively affected by sustained downturns or sluggishness in the economy, including low levels in the market prices of commodities, all of which are beyond Duke Energy Ohio’s control.

Sustained downturns or sluggishness in the economy generally affect the markets in which Duke Energy Ohio operates and negatively influence its operations. Declines in demand for electricity as a result of economic downturns in Duke Energy Ohio’s franchised electric service territories will reduce overall electricity sales and lessen Duke Energy Ohio’s cash flows, especially as its industrial customers reduce production and, therefore, consumption of electricity and gas. Although Duke Energy Ohio’s franchised electric business is subject to regulated allowable rates of return and recovery of fuel costs under a fuel adjustment clause, overall declines in electricity sold as a result of economic downturn or recession could reduce revenues and cash flows, thus diminishing results of operations. Additionally, prolonged economic downturns that negatively impact Duke Energy Ohio’s result of operations and cash flows could result in future material impairment charges being recorded to write down the carrying value of certain assets, including goodwill, to their respective fair values.

Duke Energy Ohio also sells electricity into the spot market or other competitive power markets on a contractual basis. With respect to such transactions, Duke Energy Ohio is not guaranteed any rate of return on Duke Energy Ohio’s capital investments through mandated rates, and Duke Energy Ohio’s revenues and results of operations are likely to depend, in large part, upon prevailing market prices in Duke Energy Ohio’s regional markets and other competitive markets. These market prices may fluctuate substantially over relatively short periods of time and could reduce Duke Energy Ohio’s revenues and margins and thereby diminish its consolidated results of operations.

Factors that could impact sales volumes, generation of electricity and market prices at which Duke Energy Ohio is able to sell electricity are as follows:

   

weather conditions, including abnormally mild winter or summer weather that cause lower energy usage for heating or cooling purposes, respectively, and periods of low rainfall that decrease Duke Energy Ohio’s ability to operate its facilities in an economic manner;

   

supply of and demand for energy commodities;

   

illiquid markets including reductions in trading volumes which result in lower revenues and earnings;

   

general economic conditions, including downturns in the U.S. or other economies which impact energy consumption particularly in which sales to industrial or large commercial customers comprise a significant portion of total sales;

   

transmission or transportation constraints or inefficiencies which impact Duke Energy Ohio’s non-regulated energy operations;

   

availability of competitively priced alternative energy sources, which are preferred by some customers over electricity produced from coal, or gas plants, and of energy-efficient equipment which reduces energy demand;

   

natural gas prices;

   

ability to procure satisfactory levels of fuel supplies and inventory, such as coal and natural gas;

   

electric generation capacity surpluses which cause Duke Energy Ohio’s non-regulated energy plants to generate and sell less electricity at lower prices and may cause some plants to become non-economical to operate;

   

capacity and transmission service into, or out of, Duke Energy Ohio’s markets;

   

natural disasters, acts of terrorism, wars, embargoes and other catastrophic events to the extent they affect Duke Energy Ohio’s operations and markets, as well as the cost and availability of insurance covering such risks; and

   

federal, and state energy and environmental regulation and legislation.

 

Duke Energy Ohio’s operating results may fluctuate on a seasonal and quarterly basis.

Electric power generation is generally a seasonal business. In most parts of the United States and in markets in which Duke Energy Ohio operates, demand for electricity peaks during the warmer summer months and demand for natural gas peaks during the cold winter months, with market prices also peaking during the warmer summer months for electricity and cold winter months for natural gas. Further, extreme weather conditions such as heat waves or winter storms could cause these seasonal fluctuations to be more pronounced. As a result, in the future, the overall operating results of Duke Energy Ohio’s businesses may fluctuate substantially on a seasonal and quarterly basis and thus make period comparison less relevant.

 

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Potential terrorist activities or military or other actions could adversely affect Duke Energy Ohio’s business.

The continued threat of terrorism and the impact of retaliatory military and other action by the United States and its allies may lead to increased political, economic and financial market instability and volatility in prices for natural gas and oil which may materially adversely affect Duke Energy Ohio in ways it cannot predict at this time. In addition, future acts of terrorism and any possible reprisals as a consequence of action by the United States and its allies could be directed against companies operating in the United States. Infrastructure and generation facilities could be potential targets of terrorist activities. The potential for terrorism has subjected Duke Energy Ohio’s operations to increased risks and could have a material adverse effect on Duke Energy Ohio’s business. In particular, Duke Energy Ohio may experience increased capital and operating costs to implement increased security for its plants, such as additional physical plant security, additional security personnel or additional capability following a terrorist incident.

The insurance industry has also been disrupted by these events. As a result, the availability of insurance covering risks that Duke Energy Ohio and its competitors typically insure against may decrease. In addition, the insurance Duke Energy Ohio is able to obtain may have higher deductibles, higher premiums and more restrictive policy terms.

Additional risks and uncertainties not currently known to Duke Energy Ohio or that Duke Energy Ohio currently deems to be insignificant also may adversely affect Duke Energy Ohio’s consolidated results of operations, cash flows or financial condition.

 

Item 1B. Unresolved Staff Comments.

None.

 

Item 2. Properties.

 

FRANCHISED ELECTRIC AND GAS

 

As of December 31, 2008, Franchised Electric and Gas operated two coal-fired stations with a combined net capacity of 577 MW and one combustion turbine (CT) station with a net capacity of 501 MW. Franchised Electric and Gas also owns two underground caverns with a total storage capacity of approximately 16 million gallons of liquid propane. The stations and caverns are located in Ohio and Kentucky.

In addition, as of December 31, 2008, Duke Energy Ohio owned approximately 2,500 conductor miles of electric transmission lines, including 1,000 miles of 345 kilovolts, 700 miles of 100 to 161 kilovolts, and 800 miles of 13 to 69 kilovolts. Duke Energy Ohio also owned approximately 19,500 conductor miles of electric distribution lines, including 14,000 miles of overhead lines and 5,500 miles of underground lines, as of December 31, 2008 and approximately 7,100 miles of gas mains and service lines. As of December 31, 2008, the electric transmission and distribution systems had approximately 280 substations. In addition, Duke Energy Ohio has access to 5.5 million gallons of liquid propane storage and product loaned through a commercial services agreement with a third party. This liquid propane is used in the three propane/air peak shaving plants located in Ohio and Kentucky. Propane/air peak shaving plants vaporize the propane and mix with natural gas to supplement the natural gas supply during peak demand periods and emergencies.

Substantially all of Franchised Electric and Gas’ electric plant in service is mortgaged under the mortgage bond indenture of Duke Energy Ohio.

 

COMMERCIAL POWER

 

As of December 31, 2008, Commercial Power jointly owns six coal-fired stations with a combined net capacity of 3,529 MW, of which Duke Energy Ohio operates three. Commercial Power also owns and operates five CT stations, one of which is jointly owned, with a combined net capacity of 1,544 MW and three CC stations with a combined net capacity of 2,480 MW. The stations are located in Ohio, Illinois, Indiana and Pennsylvania.

 

Item 3. Legal Proceedings.

For information regarding legal proceedings, including regulatory and environmental matters, see Note 4 to the Consolidated Financial Statements, “Regulatory Matters” and Note 18 to the Consolidated Financial Statements, “Commitments and Contingencies—Litigation” and “Commitments and Contingencies—Environmental.”

 

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Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

 

Cinergy owns all of the common stock of Duke Energy Ohio. Duke Energy owns all of the common stock of Cinergy. Duke Energy Ohio anticipates making periodic dividends to provide funding support for Duke Energy’s dividend. During the years ended December 31, 2008, 2007 and 2006, Duke Energy Ohio paid dividends to its parent, Cinergy, of $200 million, $135 million and $102 million, respectively.

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

INTRODUCTION

Management’s Discussion and Analysis should be read in conjunction with the accompanying Consolidated Financial Statements and Notes for the years ended December 31, 2008, 2007 and 2006.

 

BASIS OF PRESENTATION

The results of operations and variance discussion for Duke Energy Ohio is presented in a reduced disclosure format in accordance with General Instruction (I)(2)(a) of Form 10-K.

 

RESULTS OF OPERATIONS

 

Results of Operations and Variances

 

Summary of Results (in millions)

 

     Years Ended December 31,  
      2008    2007     Increase
(Decrease)
 

Operating revenues

   $ 3,424    $ 3,455     $ (31 )

Operating expenses

     2,965      2,964       1  

Gains (losses) on sales of other assets and other, net

     59      (8 )     67  
                       

Operating income

     518      483       35  

Other income and expenses, net

     34      32       2  

Interest expense

     94      100       (6 )
                       

Income before income taxes

     458      415       43  

Income tax expense

     171      151       20  
                       

Income before extraordinary items

     287      264       23  

Extraordinary items, net of tax

     67      —         67  
                       

Net income

   $ 354    $ 264     $ 90  
                       

 

Net Income

The $90 million increase in Duke Energy Ohio’s net income was primarily due to the following factors:

Operating Revenues. The decrease was due primarily to:

   

A $38 million decrease from coal sales due to the expiration of contracts,

   

A $30 million decrease in retail electric revenues resulting from lower retail volumes due to the weakening economy,

   

A $21 million decrease in wholesale electric revenues due to lower hedge realization and lower generation volumes primarily resulting from increased plant outages in 2008 compared to 2007,

   

A $21 million decrease in net mark-to-market revenues on non-qualifying hedge accounting power and capacity contracts, consisting of $74 million of net mark-to-market losses in 2008, as compared to net mark-to-market losses of $53 million in 2007,

   

A $17 million decrease in revenues due to lower generation volumes from the Midwest gas-fired assets resulting from milder weather net of increased PJM capacity revenues in 2008 compared to 2007, and

   

An $11 million decrease related to native load due to milder weather in 2008 compared to 2007.

Partially offsetting these decreases were:

   

A $45 million increase in regulated fuel revenues driven primarily by higher natural gas costs,

   

A $21 million increase in retail electric revenues resulting from higher retail pricing primarily related to environmental and capacity riders that were approved in the fourth quarter of 2007 by the PUCO and increased amortization of purchase accounting valuation liability of the Rate Stabilization Plan (RSP) in 2008 compared to 2007,

 

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A $19 million increase due to implementation of new gas rates in Ohio,

   

A $9 million increase related to the Ohio electric Demand Side Management (DSM) rider implemented in the third quarter of 2007, and

   

A $9 million increase in Ohio electric base transmission due to a change in the Transmission Cost Recovery rider.

Operating Expenses. The increase was due primarily to:

   

An $82 million impairment of emission allowances due to the invalidation of the Clean Air Interstate Rule (CAIR) in July 2008,

   

A $69 million increase in fuel expense due to mark-to-market losses on non-qualifying fuel hedge contracts, consisting of mark-to-market losses of $3 million in 2008, as compared to gains of $66 million in 2007,

   

A $40 million increase in regulated fuel expense primarily due to higher natural gas costs, and

   

A $16 million increase in regulatory amortization of the Ohio and Kentucky DSM costs and Ohio regulatory transition charge.

Partially offsetting these increases were:

   

A $63 million decrease in emission allowance expenses due to lower cost basis emission allowances consumed and lower overall emission allowance consumption due to installation of flue gas desulfurization equipment and lower generation volumes due to increased plant outages in 2008 compared to 2007,

   

A $46 million decrease in net fuel and purchased power expense for retail load due to realized gains on fuel hedges, partially offset by higher purchased power as a result of increased plant outages in 2008 compared to 2007,

   

A $31 million decrease in expenses associated with coal sales due to the expiration of contracts,

   

A $24 million decrease in fuel and operating expenses for the Midwest gas-fired assets primarily due to lower generation volumes and lower amortization of locked-in hedge losses in 2008 compared to 2007, net of an approximate $15 million bad debt reserve related to the Lehman Bros. bankruptcy and higher plant maintenance expenses,

   

A $21 million decrease in other post-employment benefits due to an adjustment to the liability recorded for these benefits, and

   

An $18 million decrease in short-term incentive costs.

Gains (Losses) on Sales of Other Assets and Other, net. The increase in 2008 as compared to 2007 was attributable to gains on sales of emission allowances in 2008 compared to losses on sales of emission allowances in 2007. Gains in 2008 were a result of sales of zero cost basis emission allowances, while losses in 2007 were as a result of sales of emission allowances acquired in connection with Duke Energy’s merger with Cinergy in 2006 which were written up to fair value as part of purchase accounting.

Income Tax Expense. The increase was primarily the result of higher pre-tax income.

Extraordinary Items, net of tax. The reapplication of SFAS No. 71, “Accounting for the Effects of Certain Types of Regulation” (SFAS No. 71), on December 17, 2008 resulted in an approximate $67 million after-tax (approximately $103 million pre-tax) extraordinary gain related to total mark-to-market losses previously recorded in earnings associated with open forward native load economic hedge contracts for fuel, purchased power and emission allowances, which the Electric Security Plan (ESP) allows to be recovered through a fuel and purchased power rider. See further discussion under the “Matters Impacting Future Results” below.

 

Matters Impacting Future Results

Sales, especially in the industrial sector, were impacted by the economic downturn in 2008. Duke Energy Ohio expects this trend to continue for some period into 2009, and perhaps beyond, until the economy begins to recover. Duke Energy Ohio’s current strategy is focused on maximizing the returns and cash flows from its current portfolio. Results for Duke Energy Ohio are sensitive to changes in power supply, power demand and weather.

On December 17, 2008, the PUCO approved Duke Energy Ohio’s ESP price structure, which establishes generation rates for 2009 through 2011. The base cost for generation service will increase by approximately 2 percent annually in 2009 and 2010 for residential customers, and each year from 2009 through 2011 for non-residential customers. Additionally, the ESP provides for a new Infrastructure Modernization rider to maintain distribution system reliability and to purchase and deploy SmartGrid technology. As discussed further below, the approval of the ESP also resulted in the reapplication of SFAS No. 71 to portions of generation within Duke Energy Ohio’s Commercial Power business segment. As a result of the reapplication of SFAS No. 71 to certain portions of Duke Energy Ohio’s operations, Duke Energy Ohio’s future results will be subject to less volatility than had been caused by the timing of under-and-over collections of certain costs, as well as the impacts of mark-to-market activity on certain coal and power derivatives.

 

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The outcome of the pending Duke Energy Ohio electric distribution rate case could impact future results through the increase of base rates.

Duke Energy Ohio’s generation operations within its Commercial Power business segment include generation assets located in Ohio that are dedicated to serve Ohio native load customers. These assets, as excess capacity allows, also generate revenues through sales outside the native load customer base, and such revenue is termed non-native.

Prior to December 17, 2008, Duke Energy Ohio’s Commercial Power business segment did not apply the provisions of SFAS No. 71 due to the comprehensive electric deregulation legislation passed by the state of Ohio in 1999. As described further below, effective December 17, 2008, the Public Utilities Commission of Ohio (PUCO) approved Duke Energy Ohio’s ESP, which resulted in the reapplication of SFAS No. 71 to certain portions of Commercial Power’s operations as of that date.

From January 1, 2005 through December 31, 2008, Duke Energy Ohio, including its Commercial Power business segment, had been operating under a RSP, which was a market-based standard service offer. Although the RSP contained certain trackers that enhanced the potential for cost recovery, there was no assurance of stranded cost recovery upon the expiration of the RSP on December 31, 2008 since it was initially anticipated that, upon the expiration of the RSP, there would be a move to full competitive markets. Accordingly, Duke Energy Ohio’s Commercial Power business segment did not apply the provisions of SFAS No. 71 to any of its generation operations prior to December 17, 2008. As discussed further in Note 4 to the Consolidated Financial Statements, “Regulatory Matters,” in April 2008, new legislation (SB 221) was passed in Ohio and signed by the Governor of Ohio on May 1, 2008. The new law codified the PUCO’s authority to approve an electric utility’s standard service offer either through an ESP or a Market Rate Option (MRO). The MRO is a price determined through a competitive bidding process. On July 31, 2008, Duke Energy Ohio filed an ESP, and with certain amendments, the ESP was approved by the PUCO on December 17, 2008. The ESP became effective on January 1, 2009.

In connection with the approval of the ESP, Duke Energy Ohio reassessed the applicability of SFAS No. 71 to Commercial Power’s generation operations as SB 221 substantially increased the PUCO’s oversight authority over generation in the state of Ohio, including giving the PUCO complete approval of generation rates and the establishment of an earnings test to determine if a utility has earned significantly excessive earnings. Duke Energy Ohio determined that certain costs and related rates (riders) of Commercial Power’s operations related to generation serving native load meet the criteria established by SFAS No. 71 for regulatory accounting treatment as SB 221 and Duke Energy Ohio’s approved ESP solidified the automatic recovery of certain costs of its generation serving native load within its Commercial Power business segment and increased the likelihood that Commercial Power’s operations will remain under a cost recovery model for certain costs for the foreseeable future.

Under the ESP, Duke Energy Ohio will bill for its native load generation via numerous riders. SB 221 and the ESP resulted in the approval of the automatic recovery of certain of these riders, which includes, but is not limited to, a fuel and purchased power (FPP) rider and certain portions of a cost of environmental compliance (AAC) rider. Accordingly, Duke Energy Ohio’s Commercial Power business segment began applying SFAS No. 71 to the corresponding RSP riders granting automatic recovery under the ESP on December 17, 2008. The remaining portions of Commercial Power’s native load generation operations, revenues from which are reflected in rate riders for which the ESP does not specifically allow automatic cost recovery, as well as all generation operations associated with non-native customers, including Commercial Power’s Midwest gas-fired generation assets, continue to not apply regulatory accounting as those operations do not meet the criteria of SFAS No. 71. Moreover, generation remains a competitive market in Ohio and native load customers continue to have the ability to switch to alternative suppliers for their electric generation service. As customers switch, there is a risk that some or all of the regulatory assets will not be recovered through the established riders. Duke Energy Ohio will continue to monitor the amount of native load customers that have switched to alternative suppliers when assessing the recoverability of its regulatory assets established for its native load generation operations within its Commercial Power business segment.

Duke Energy Ohio evaluates the carrying amount of its recorded goodwill for impairment under the guidance of SFAS No. 142, “Goodwill and Intangible Assets.” As of the date of the 2008 annual impairment analysis, the estimated fair value of Duke Energy Ohio’s reporting units exceeded their respective carrying value, thus no goodwill impairment charges were recorded. However, management is continuing to monitor the impact of recent market and economic events to determine if it is more likely than not that the carrying value of any of Duke Energy Ohio’s reporting units have been impaired. Should any such triggering events or circumstances occur in 2009 that would more likely than not reduce the fair value of a reporting unit below its carrying value, management would perform an impairment assessment of Duke Energy Ohio’s goodwill and it is possible that goodwill impairment charges could be recorded as a result of any such assessments. At December 31, 2008, Duke Energy Ohio had total goodwill of approximately $2,360 million.

 

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Other Matters

General. Duke Energy Ohio’s fixed charges coverage ratio, as calculated using SEC guidelines, was 4.6 times for the year ended December 31, 2008, 3.8 times for the year ended December 31, 2007, 1.9 times for the nine months ended December 31, 2006 and 6.2 times for the three months ended March 31, 2006.

As of December 31, 2008, Duke Energy Ohio had approximately $390 million of auction rate pollution control bonds outstanding. While these debt instruments are long-term in nature and cannot be put back to Duke Energy Ohio prior to maturity, the interest rates on these instruments are designed to reset periodically through an auction process. In February 2008, Duke Energy Ohio began to experience failed auctions on these debt instruments. When failed auctions occur on a series of this debt, Duke Energy Ohio is required to pay the maximum auction rate as prescribed by the bond document. The maximum auction rate for the auction rate debt is 2.0 times one-month London Interbank Offered Rate. Payment of the failed-auction interest rates will continue until Duke Energy Ohio is able to either successfully remarket these instruments through the auction process or refund and refinance the existing debt through the issuance of an equivalent amount of tax exempt bonds. While Duke Energy Ohio intends to refund and refinance these tax exempt auction rate bonds, the timing of such refinancing transactions is uncertain and subject to market conditions. However, even if Duke Energy Ohio is unable to successfully refund and refinance these debt instruments, the impact of paying higher interest rates on the outstanding auction rate debt is not expected to materially affect Duke Energy Ohio’s consolidated results of operations, cash flows or financial position. The weighted-average interest rate, associated with Duke Energy Ohio’s auction rate pollution control bonds, was 1.58% as of December 31, 2008 and 4.56% as of December 31, 2007.

Global Climate Change. A body of scientific evidence now accepted by a growing majority of the public and policymakers suggests that the Earth’s climate is changing, caused in part by greenhouse gases emitted into the atmosphere from human activities. Although there is still much to learn about the causes and long-term effects of climate change, many, including Duke Energy Ohio, advocate taking steps now to begin reducing emissions with the aim of stabilizing the atmospheric concentration of greenhouse gases at a level that avoids the potentially worst-case effects of climate change.

Greenhouse gas (GHG) emissions are produced from a wide variety of human activities. The U.S. EPA publishes an inventory of these emissions annually. Carbon dioxide (CO2), an essential trace gas, is a by product of fossil fuel combustion and currently accounts for about 85% of U.S. greenhouse gas emissions. Duke Energy Ohio currently accounts for about 0.30% of total U.S. CO2 emissions, and about 0.26% of total U.S. GHG emissions.

Duke Energy Ohio’s long-term strategies for how best to meet its customers’ growing demand for electricity are impacted by the issues surrounding global warming. These strategies include significant commitments to customer energy efficiency and renewable energy. Each of these actions will or has the potential to reduce Duke Energy Ohio’s CO2 emissions and therefore its exposure to the costs of future GHG regulation.

Duke Energy Ohio’s cost of complying with any federal GHG emissions law that may be enacted will depend on the design details of the program. If potential future GHG legislation adopts a cap-and-trade approach, the design elements of such a program that will have the greatest influence on Duke Energy Ohio’s compliance costs include (1) the required levels and timing of the cap, which will drive emission allowance prices, (2) the emission sources covered under the cap, (3) the number of allowances that Duke Energy Ohio might be allocated at no cost on a year-to-year basis, (4) the type and effectiveness of any cost control mechanisms included in the program, (5) the role of emission offsets, which will also influence allowance prices, and (6) the availability and cost of technologies that Duke Energy Ohio can deploy to lower its emissions. While Duke Energy Ohio believes it is very likely that Congress will adopt mandatory GHG emission reduction legislation at some point, the timing and design details of any such legislation are highly uncertain.

While there were many bills introduced in both houses of Congress during the 110th Congress that proposed mandatory limits on GHG emissions, S. 2191—America’s Climate Security Act of 2007 (commonly referred to as the Lieberman-Warner bill after the sponsors Senators Joseph Lieberman of Connecticut and John Warner of Virginia) became the primary climate change related legislative vehicle. The bill was approved by the Senate Environment and Public Works Committee in December 2007, but failed to advance on the Senate floor in June 2008 when the bill fell considerably short of the 60 votes necessary to invoke cloture and cut off debate. No subsequent action was taken in the 110th Congress related to mandatory federal GHG legislation.

Numerous bills mandating reductions in GHG emissions are expected to be introduced in both houses of Congress in 2009. The leadership in both the House and Senate has publicly stated it is their intent to proceed with climate legislation. President Obama, in his presidential campaign and after the election, indicated passage of climate change legislation is a priority. Still, as the Senate debate in 2008 revealed, there are wide-ranging views in Congress regarding what constitutes acceptable GHG legislation. The current condition of the U.S. economy could add a degree of uncertainty, and there are indications that, in the 111th Congress multiple committees will be involved in crafting GHG legislation, which will make the process of developing GHG legislation potentially more challenging.

 

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Duke Energy Ohio supports the enactment of federal GHG cap-and-trade legislation. Due to Duke Energy Ohio’s concern about patchwork policies focused on a single industrial sector or particular region of the country, Duke Energy Ohio believes this legislation should establish a program that applies to all parts of the economy, including power generation, industrial and commercial sources and motor vehicles. To permit the economy to adjust rationally to the policy, legislation should establish a long-term program that first slows the growth of emissions, stops them and then transitions to a gradually declining emissions cap as new lower-and non-emitting technologies are developed and become available for wide-scale deployment. Legislation should also include adequate cost-containment measures to protect the U.S. economy from grave and unintended impacts of the policy.

Duke Energy Ohio is unable to estimate the potential cost of complying with currently unspecified and unknowable future GHG legislation or any indirect costs that might result. Compliance costs are sensitive to numerous policy design details, allowance prices, and technology availability and cost. During the Senate debate on the Lieberman-Warner legislation in 2007 and 2008, Duke Energy Ohio attempted to estimate its cost of complying with that legislation over a range of potential allowance prices. Duke Energy Ohio estimated its compliance costs under the Lieberman-Warner model to be between approximately $230 million to $680 million in the first year of the program (2012), which represented the cost to purchase emission allowances needed for compliance over and above what might be allocated to Duke Energy Ohio at zero cost. Duke Energy Ohio would have continued to incur similar or greater annual compliance costs in subsequent years for continued allowance purchases until such time as new lower-and zero-emitting technologies could be deployed to reduce emissions. Duke Energy Ohio’s compliance costs at that time would then include the cost of purchasing and deploying new generation technologies. Duke Energy Ohio would only be able to reduce its allowance purchase costs after new technologies were actually deployed.

There is no way to know how similar or different the requirements of the Lieberman-Warner legislation might be to any future GHG legislation that Congress may eventually adopt, so it is uncertain whether these costs are at all representative of compliance costs that Duke Energy Ohio might incur as a result of any potential future GHG legislation. Under any future scenario involving mandatory GHG limitations, Duke Energy Ohio would plan to seek to recover its compliance costs through appropriate regulatory mechanisms in the jurisdictions in which it operates.

At the state level, the Midwestern Governors Association has an initiative under way called the Midwestern Greenhouse Gas Reduction Accord. One of the ongoing activities of the initiative is the design of a regional GHG cap-and-trade system, with the anticipated end product to be a Model Rule for implementing a GHG cap-and-trade system. Once complete, the Model Rule would go to participating states for their consideration and possible adoption. The state of Ohio is currently only an observer to the accord process. The outcome of this initiative is highly uncertain and Duke Energy Ohio is unable to determine at this time whether there might be direct or indirect cost impacts from any new regulations that might result from the initiative.

While Duke Energy Ohio’s near-term compliance strategy associated with any potential future GHG legislation that incorporates a cap-and-trade mechanism will likely be focused on allowance purchases, it is expected that at some point in the future Duke Energy Ohio would begin reducing emissions by replacing existing coal-fired generation with new lower-and zero-emitting generation technologies, and/or installing new carbon capture and sequestration technology on existing coal-fired generating plants when the technologies become available and cost-effective. It is not possible at this time, however, to predict with certainty what new technologies might be developed, when they will be ready to be deployed, or what their costs will be. There is also uncertainty as to how or when certain non-technical issues, such as legal and liability questions, that could affect the cost and availability of new technologies might be resolved by regulators. Duke Energy Ohio currently is focused on integrated gasification combined cycle generation with carbon capture and sequestration, and capture and storage retrofit technology for existing pulverized coal-fired generation as promising new technologies for generating electricity with lower or no CO2 emissions.

Duke Energy Ohio has regulatory requirements in Ohio to meet increasing percentages of customer demand for electricity with renewable energy. The requirement reaches a minimum of 12.5% in 2024. Duke Energy Ohio also anticipates the Congress will consider a federal renewable portfolio standard in 2009. Previous attempts have passed in the U.S. House of Representatives but fallen short in the Senate. Duke Energy Ohio believes, however, chances of passage in the 111th Congress have increased.

In addition to relying on new technologies to reduce its CO2 emissions, Duke Energy Ohio has received regulatory approval in Ohio for a first-of-its-kind innovative approach in the utility industry to help meet growing customer demand with new and creative ways to increase energy efficiency, thereby reducing demand (Save-A-Watt) instead of relying almost exclusively on new power plants to generate electricity.

Each of these activities has the potential to reduce Duke Energy Ohio’s future CO2 emissions which will reduce Duke Energy Ohio’s exposure to future GHG regulation.

 

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Duke Energy Ohio recognizes the potential for more frequent and severe extreme weather events as a result of climate change and the possibility that these weather events could have a material impact on its future results of operations should these events occur. However, the uncertain nature of potential changes in extreme weather events (such as increased frequency, duration, and severity) and the long period of time over which any changes might take place make estimating any potential future financial risk to Duke Energy Ohio’s operations that may be caused by the physical risks of climate change extremely challenging. Currently, Duke Energy Ohio plans and prepares for extreme weather events that it experiences from time to time, such as ice storms, tornados, severe thunderstorms, high winds and droughts. Duke Energy Ohio’s past experiences preparing for and responding to the impacts of these types of weather-related events would reasonably be expected to help management plan and prepare for future climate change-related severe weather events to reduce, but not eliminate, the operational, economic and financial impacts of such events.

For additional information on other issues related to Duke Energy Ohio, see Note 4 to the Consolidated Financial Statements, “Regulatory Matters” and Note 18 to the Consolidated Financial Statements, “Commitments and Contingencies.”

 

Item 7A. Quantitative and Qualitative Disclosures About Market Risk.

 

Risk Management Policies

 

Duke Energy Ohio is exposed to market risks associated with commodity prices, credit exposure and interest rates. Management has established comprehensive risk management policies to monitor and manage these market risks. The Treasurer of Duke Energy, the ultimate parent entity of Duke Energy Ohio, is responsible for the overall governance of managing credit risk and commodity price risk, including monitoring exposure limits for Duke Energy Ohio.

 

Commodity Price Risk

Duke Energy Ohio is exposed to the impact of market fluctuations in the prices of electricity, coal, natural gas and other energy-related products marketed and purchased within its non-regulated operations, as well as within its regulated operations, to the extent there is excess capacity from generation assets that are dedicated to serve Ohio native load customers. Price risk represents the potential risk of loss from adverse changes in the market price of electricity or other energy commodities, such as gas and coal. For Duke Energy Ohio, this price risk has been somewhat reduced by the December 17, 2008 PUCO approval of Duke Energy Ohio’s ESP, which resulted in the reapplication of SFAS No. 71 to certain portions of Duke Energy Ohio’s Commercial Power business segment operations as of that date. Duke Energy Ohio employs established policies and procedures to manage its risks associated with these market fluctuations using various commodity derivatives, such as swaps, futures, forwards and options. See Note 1 to the Consolidated Financial Statements, “Summary of Significant Accounting Policies” and Note 8 to the Consolidated Financial Statements, “Risk Management and Hedging Activities and Credit Risk,” for additional information.

Validation of a contract’s fair value is performed by an internal group separate from Duke Energy Ohio’s deal origination areas. Duke Energy Ohio’s derivative contract portfolio is predominantly valued using observable market inputs with little internally developed assumptions. However, for contracts valued beyond the observable market period, Duke Energy Ohio uses common industry practices to develop its valuation techniques and changes in its pricing methodologies or the underlying assumptions could result in significantly different fair values and income recognition.

Hedging Strategies. Duke Energy Ohio closely monitors the risks associated with commodity price changes on its future operations and, where appropriate, uses various commodity instruments such as electricity, coal and natural gas forward contracts to mitigate the effect of such fluctuations on operations. Duke Energy Ohio’s primary use of energy commodity derivatives is to hedge the generation portfolio against exposure to changes in the prices of power and fuel.

Certain derivatives used to manage Duke Energy Ohio’s commodity price exposure are accounted for as either cash flow hedges or fair value hedges. To the extent that instruments accounted for as hedges are effective in offsetting the transaction being hedged, there is no impact to the Consolidated Statements of Operations until delivery or settlement occurs. Accordingly, assumptions and valuation techniques for these contracts have no impact on reported earnings prior to settlement. Several factors influence the effectiveness of a hedge contract, including the use of contracts with different commodities or unmatched terms and counterparty credit risk. Hedge effectiveness is monitored regularly and measured at least quarterly.

In addition to the hedge contracts described above and recorded on the Consolidated Balance Sheets, Duke Energy Ohio enters into other contracts that qualify for the normal purchases and sales exception described in paragraph 10 of SFAS No. 133, as amended and interpreted by Derivatives Implementation Group Issue C15, “Scope Exceptions: Normal Purchases and Normal Sales Exception for Option-Type Contracts and Forward Contracts in Electricity,” and SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments

 

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and Hedging Activities.” On a limited basis, Franchised Electric and Gas and Commercial Power apply the normal purchase and normal sales exception to certain contracts. Income recognition and realization related to normal purchases and normal sales contracts generally coincide with the physical delivery of power. For contracts qualifying for the scope exception, no recognition of the contract’s fair value in the Consolidated Financial Statements is required until settlement of the contract unless the contract ceases to qualify for the normal purchase and normal sale exception at some point during the contract period. Recognition of the contracts in the Consolidated Statements of Operations will be the same regardless of whether the contracts are accounted for as cash flow hedges or as normal purchases and sales assuming no hedge ineffectiveness.

Other derivatives used to manage Duke Energy Ohio’s commodity price exposure are either not designated as a hedge or do not qualify for hedge accounting. Derivatives related to regulated businesses reflect changes in the fair value of the derivative instruments as a regulatory asset or liability on the Consolidated Balance Sheets. Derivatives related to unregulated businesses are marked-to-market each period, with changes in the fair value of the derivative instruments reflected in earnings.

Generation Portfolio Risks for 2009. Duke Energy Ohio is primarily exposed to market price fluctuations of wholesale power, coal, natural gas and emission allowance prices associated with its excess capacity from generation assets that are dedicated to serve Ohio native load customers and its non-regulated operations. Duke Energy Ohio closely monitors the risks associated with these commodity price changes on its future generation operations and, where appropriate, uses various commodity instruments such as electricity, coal and natural gas forward contracts to mitigate the effect of such fluctuations on operations, in addition to optimizing the value of its non-regulated generation portfolio. The portfolio includes generation assets (power and capacity), fuel, and emission allowances. Modeled forecasts of future generation output, fuel requirements, and emission allowance requirements are based on forward power, fuel and emission allowance markets. The component pieces of the portfolio are bought and sold based on this model in order to manage the economic value of the portfolio, where such market transparency exists. The generation portfolio not utilized to serve native load or committed load is subject to commodity price fluctuations. Based on a sensitivity analysis as of December 31, 2008 and 2007, it was estimated that a ten percent price change per megawatt hour in forward wholesale power prices would have a corresponding effect on Duke Energy Ohio’s pre-tax income of approximately $5 million in 2009 and $13 million in 2008, respectively, excluding the impact of mark-to-market changes on non-qualifying or undesignated hedges relating to periods in excess of one year from the respective date, which are discussed further below. Based on a sensitivity analysis as of December 31, 2008 and 2007, it was estimated that a ten percent change in the forward price per ton of coal would have a corresponding effect on Duke Energy Ohio’s pre-tax income of approximately $10 million in 2009 and $4 million in 2008, respectively, excluding the impact of mark-to-market changes on non-qualifying or undesignated hedges relating to periods in excess of one year from the respective date, which are discussed further below. Based on a sensitivity analysis as of December 31, 2008 and 2007, it was estimated that a ten percent price change per MMBtu (one million British thermal units) in natural gas prices would have a corresponding effect on Duke Energy Ohio’s pre-tax income of approximately $5 million in 2009 and $9 million in 2008 respectively, excluding the impact of mark-to-market changes on undesignated hedges relating to periods in excess of one year from the respective date.

Sensitivities for derivatives beyond 2009. Derivative contracts executed to manage generation portfolio risks for delivery periods beyond 2009 are also exposed to changes in fair value due to market price fluctuations of wholesale power and coal. Based on a sensitivity analysis as of December 31, 2008 and 2007, it was estimated that a ten percent price change in the forward price per megawatt hour of wholesale power would have a corresponding effect on Duke Energy Ohio’s pre-tax income of approximately $11 million in 2009 and $16 million in 2008, respectively, resulting from the impact of mark-to-market changes on non-qualifying and undesignated power contracts pertaining to periods in excess of one year from the respective date. Based on a sensitivity analysis as of December 31, 2008 and 2007, it was estimated that a ten percent change in the forward price per ton of coal would have a corresponding effect on Duke Energy Ohio’s pre-tax income of approximately $10 million in 2009 and $14 million in 2008, respectively, resulting from the impact of mark-to-market changes on non-qualifying and undesignated coal contracts pertaining to periods in excess of one year from the respective date.

Comparability of sensitivity analysis. As Commercial Power began reapplying the provisions of SFAS No. 71 on December 17, 2008 to portions of its operations, certain derivative contracts that historically resulted in earnings volatility receive regulatory deferral of gains and losses. Accordingly, the mark-to-market associated with these contracts will not impact earnings until recovered in revenues. However, to achieve comparability of sensitivity information between periods, the portion of the derivative contracts that receive regulatory treatment has been included in the sensitivity amounts for both periods presented. Since certain derivative contracts included in the sensitivity analysis for 2009 will not result in earnings impacts, the forecasted sensitivities for 2009 are less than the pre-tax income amounts disclosed above.

 

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The commodity price sensitivity calculations above consider existing hedge positions and estimated production levels, but do not consider other potential effects that might result from such changes in commodity prices.

 

Credit Risk

Credit risk represents the loss that Duke Energy Ohio would incur if a counterparty fails to perform under its contractual obligations.

Retail. Credit risk associated with Duke Energy Ohio’s service to residential, commercial and industrial customers is generally limited to outstanding accounts receivable. Duke Energy Ohio mitigates this credit risk by requiring customers to provide a cash deposit or letter of credit until a satisfactory payment history is established, at which time the deposit is typically refunded. Charge-offs for the retail customers have historically been insignificant to the operations of Duke Energy Ohio and are typically recovered through the retail rates. However, in light of current overall economic conditions, management continues to monitor customer charge-offs and payment patterns to ensure the adequacy of bad debt reserves. Duke Energy Ohio sells certain of their accounts receivable and related collections through Cinergy Receivables Company, LLC a bankruptcy remote, special purpose entity. While no direct recourse to Duke Energy Ohio exists, it risks loss in the event collections are not sufficient to allow for full recovery of its retained interests or in the event the level of charge-offs in future periods increases. See Note 13 to the Consolidated Financial Statements, “Sales of Accounts Receivable.”

Wholesale and Non-native Sales. To reduce credit exposure related to non-native sales, Duke Energy Ohio seeks to enter into netting agreements with counterparties that permit it to offset receivables and payables with such counterparties. Duke Energy Ohio attempts to further reduce credit risk with certain counterparties by entering into agreements that enable it to obtain collateral or to terminate or reset the terms of transactions after specified time periods or upon the occurrence of credit-related events. Where exposed to credit risk, Duke Energy Ohio analyzes the counterparties’ financial condition prior to entering into an agreement, establishes credit limits and monitors the appropriateness of those limits on an ongoing basis. Duke Energy Ohio’s industry has historically operated under negotiated credit lines for physical delivery contracts. Duke Energy Ohio may use master collateral agreements to mitigate certain credit exposures. The collateral agreements provide for a counterparty to post cash or letters of credit to the exposed party for exposure in excess of an established threshold. The threshold amount represents an unsecured credit limit, determined in accordance with the corporate credit policy. Collateral agreements also provide that the inability to post collateral is sufficient cause to terminate contracts and liquidate all positions.

Duke Energy Ohio also obtains cash or letters of credit from customers to provide credit support outside of collateral agreements, where appropriate, based on its financial analysis of the customer and the regulatory or contractual terms and conditions applicable to each transaction.

Based on Duke Energy Ohio’s policies for managing credit risk, its exposures and its credit and other reserves, Duke Energy Ohio does not anticipate a materially adverse effect on its consolidated results of operations, cash flows or financial position as a result of non-performance by any counterparty.

 

Interest Rate Risk

Duke Energy Ohio is exposed to risk resulting from changes in interest rates as a result of its issuance of variable and fixed rate debt. Duke Energy Ohio manages its interest rate exposure by limiting its variable-rate exposures to a percentage of total capitalization and by monitoring the effects of market changes in interest rates. Duke Energy Ohio also enters into financial derivative instruments, including interest rate swaps, swaptions and U.S. Treasury lock agreements to manage and mitigate interest rate risk exposure. See Notes 1, 8, and 16 to the Consolidated Financial Statements, “Summary of Significant Accounting Policies,” “Risk Management and Hedging Activities and Credit Risk” and “Debt and Credit Facilities,” respectively.

Based on a sensitivity analysis as of December 31, 2008, it was estimated that if market interest rates average 1% higher (lower) in 2009 than in 2008, interest expense, net of offsetting impacts in interest income, would increase (decrease) by approximately $11 million. Comparatively, based on a sensitivity analysis as of December 31, 2007, had interest rates averaged 1% higher (lower) in 2008 than in 2007, it was estimated that interest expense, net of offsetting impacts in interest income, would have increased (decreased) by approximately $8 million. These amounts were estimated by considering the impact of the hypothetical interest rates on variable-rate securities outstanding, including money pool balances, adjusted for interest rate hedges and cash and cash equivalents outstanding as of December 31, 2008 and 2007. If interest rates changed significantly, management would likely take actions to manage its exposure to the change. However, due to the uncertainty of the specific actions that would be taken and their possible effects, the sensitivity analysis assumes no changes in Duke Energy Ohio’s financial structure.

 

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Item 8. Financial Statements and Supplementary Data.

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Board of Directors of Duke Energy Ohio, Inc.

Charlotte, North Carolina

 

We have audited the accompanying consolidated balance sheets of Duke Energy Ohio, Inc. and subsidiaries (the “Company”) as of December 31, 2008 and 2007, and the related consolidated statements of operations, common stockholder’s equity and comprehensive income, and cash flows for the years ended December 31, 2008 and 2007, the nine months ended December 31, 2006 (successor period), and the three months ended March 31, 2006 (predecessor period). Our audits also included the financial statement schedule listed in the Index at Item 15. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statements and financial statement schedule based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Duke Energy Ohio, Inc. and subsidiaries at December 31, 2008 and 2007, and the results of their operations their cash flows for the periods stated above, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

 

/s/ DELOITTE & TOUCHE LLP

Charlotte, North Carolina

March 13, 2009

 

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DUKE ENERGY OHIO, INC.

Consolidated Statements of Operations

(In millions)

 

     Successor           Predecessor  
      Year Ended
December 31, 2008
   Year Ended
December 31, 2007
    Nine Months Ended
December 31, 2006
          Three Months Ended
March 31, 2006
 

Operating Revenues

              

Non-regulated electric and other

   $ 1,646    $ 1,751     $ 1,236          $ 421  

Regulated electric

     988      984       638            220  

Regulated natural gas

     790      720       387            322  

Total operating revenue

     3,424      3,455       2,261            963  

Operating Expenses

              

Fuel used in electric generation and purchased power—non-regulated

     847      916       712            172  

Fuel used in electric generation and purchased power—regulated

     157      154       92            24  

Cost of natural gas and coal sold

     486      496       313            276  

Operation, maintenance and other

     743      756       505            173  

Depreciation and amortization

     409      392       280            68  

Property and other taxes

     241      250       165            68  

Impairment charges

     82                        

Total operating expenses

     2,965      2,964       2,067            781  

Gains (Losses) on Sales of Other Assets and Other, net

     59      (8 )     (28 )          26  

Operating Income

     518      483       166            208  

Other Income and Expenses, net

     34      32       17            8  

Interest Expense

     94      100       81            30  

Income From Continuing Operations Before Income Taxes

     458      415       102            186  

Income Tax Expense from Continuing Operations

     171      151       41            68  

Income From Continuing Operations

     287      264       61            118  

Loss From Discontinued Operations, net of tax

                (6 )          (2 )

Income Before Extraordinary Items

     287      264       55            116  

Extraordinary Items, net of tax

     67                        

Net Income

   $ 354    $ 264     $ 55          $ 116  
   

 

See Notes to Consolidated Financial Statements

 

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DUKE ENERGY OHIO, INC.

Consolidated Balance Sheets

(In millions)

 

     December 31,
      2008    2007

ASSETS

     

Current Assets

     

Cash and cash equivalents

   $ 27    $ 33

Receivables (net of allowance for doubtful accounts of $18 at December 31,
2008 and $3 at December 31, 2007)

     303      334

Inventory

     180      212

Unrealized gains on mark-to-market and hedging transactions

     51      22

Other

     336      94

Total current assets

     897      695

Investments and Other Assets

     

Restricted funds held in trust

     10      62

Goodwill

     2,360      2,325

Intangibles, net

     403      551

Unrealized gains on mark-to-market and hedging transactions

     17      17

Other

     55      33

Total investments and other assets

     2,845      2,988

Property, Plant and Equipment

     

Cost

     10,047      9,577

Less accumulated depreciation and amortization

     2,277      2,097

Net property, plant and equipment

     7,770      7,480

Regulatory Assets and Deferred Debits

     

Deferred debt expense

     23      23

Regulatory assets related to income taxes

     103      90

Other

     451      401

Total regulatory assets and deferred debits

     577      514

Total Assets

   $ 12,089    $ 11,677
 

 

See Notes to Consolidated Financial Statements

 

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DUKE ENERGY OHIO, INC.

Consolidated Balance Sheets—(Continued)

(In millions, except share and per-share amounts)

 

 

     December 31,  
      2008     2007  

LIABILITIES AND COMMON STOCKHOLDER'S EQUITY

    

Current Liabilities

    

Accounts payable

   $ 511     $ 602  

Notes payable

     343       189  

Taxes accrued

     134       172  

Interest accrued

     24       24  

Current maturities of long-term debt

     27       126  

Unrealized losses on mark-to-market and hedging transactions

     47       24  

Other

     93       86  

Total current liabilities

     1,179       1,223  

Long-term Debt

     1,856       1,810  

Deferred Credits and Other Liabilities

    

Deferred income taxes

     1,619       1,436  

Investment tax credit

     14       16  

Accrued pension and other post-retirement benefit costs

     406       259  

Unrealized losses on mark-to-market and hedging transactions

     15       25  

Asset retirement obligations

     33       31  

Other

     297       343  

Total deferred credits and other liabilities

     2,384       2,110  

Commitments and Contingencies

    

Common Stockholder's Equity

    

Common Stock, $8.50 par value, 120,000,000 shares authorized; 89,663,086 shares outstanding at December 31, 2008 and December 31, 2007

     762       762  

Additional paid-in capital

     5,570       5,570  

Retained earnings

     381       227  

Accumulated other comprehensive loss

     (43 )     (25 )

Total common stockholder's equity

     6,670       6,534  

Total Liabilities and Common Stockholder's Equity

   $ 12,089     $ 11,677  
   

 

See Notes to Consolidated Financial Statements

 

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DUKE ENERGY OHIO, INC.

Consolidated Statements of Cash Flows

(In millions)

 

 

     Successor           Predecessor  
     

Year Ended

December 31, 2008

   

Year Ended

December 31, 2007

    Nine Months Ended
December 31, 2006
          Three Months Ended
March 31, 2006
 

CASH FLOWS FROM OPERATING ACTIVITIES

             

Net income

   $ 354     $ 264     $ 55          $ 116  

Adjustments to reconcile net income to net cash provided by operating activities:

             

Depreciation and amortization

     412       395       280            68  

Extraordinary items, net of taxes

     (67 )                       

(Gains) losses on sales of other assets and other, net

     (59 )     8       31            (26 )

Impairment charges

     82                         

Deferred income taxes

     53       18       (120 )          7  

Accrued pension and other post-retirement benefit costs

     4       37       40            9  

Contribution to company-sponsored pension and other post-retirement benefit plans

           (92 )     (22 )           

(Increase) decrease in:

             

Net realized and unrealized mark-to-market and hedging transactions

     10       21       (6 )          (30 )

Receivables

     47       (25 )     132            10  

Inventory

     (70 )     5       (84 )          56  

Other current assets

     (28 )     22       25            68  

Increase (decrease) in:

             

Accounts payable

     (130 )     181       (86 )          (157 )

Taxes accrued

     (43 )     (144 )     54            50  

Other current liabilities

     9       1       (63 )          (78 )

Regulatory asset/liability deferrals

     (50 )     (19 )     (7 )          (1 )

Other assets

     19       165       184            24  

Other liabilities

     4       (89 )     (50 )           

Net cash provided by operating activities

     547       748       363            116  

CASH FLOWS FROM INVESTING ACTIVITIES

             

Capital expenditures

     (565 )     (593 )     (391 )          (135 )

Purchases of emission allowances

     (17 )     (23 )     (167 )          (162 )

Sales of emission allowances

     74       29       138            105  

Net proceeds from the sales of other assets

     4             32             

Change in restricted funds held in trust

     52       (31 )     22            8  

Other

     1                         

Net cash used in investing activities

     (451 )     (618 )     (366 )          (184 )

CASH FLOWS FROM FINANCING ACTIVITIES

             

Issuance of long-term debt

     136       205       88            141  

Redemption of long-term debt

     (191 )     (153 )     (80 )          (1 )

Redemption of preferred stock of subsidiaries

                            (21 )

Notes payable and commercial paper

     279                         

Notes payable to affiliate, net

     (126 )     (85 )     36            50  

Dividends to parent

     (200 )     (135 )                (102 )

Capital contribution from parent

           29                   

Other

           (3 )     (4 )          (1 )

Net cash (used in) provided by financing activities

     (102 )     (142 )     40            66  

Net (decrease) increase in cash and cash equivalents

     (6 )     (12 )     37            (2 )

Cash and cash equivalents at beginning of period

     33       45       8            10  

Cash and cash equivalents at end of period

   $ 27     $ 33     $ 45          $ 8  
   

Supplemental Disclosures:

             

Cash paid for interest, net of amount capitalized

   $ 91     $ 91     $ 103          $ 21  

Cash paid for income taxes

   $ 187     $ 159     $ 77          $  

Significant non-cash transactions:

             

Purchase accounting adjustments

   $     $ (14 )   $ 2,894          $  

Accrued capital expenditures

   $ 81     $ 62     $ 49          $  

Transfer of generating assets from Duke Energy

   $     $     $ 1,462          $  

 

See Notes to Consolidated Financial Statements

 

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DUKE ENERGY OHIO, INC.

Consolidated Statements of Common Stockholder's Equity

and Comprehensive Income

(In millions)

 

                      Accumulated Other Comprehensive Income (Loss)        
      Common
Stock
   Additional
Paid-in
Capital
    Retained
Earnings
    Net Gains
(Losses) on
Cash Flow
Hedges
    Minimum
Pension
Liability
Adjustment
   

Pension and
OPEB

Related
Adjustments

to AOCI

    Total  

Successor

               

Nine Months Ended December 31, 2006

                                                       

Balance at April 1, 2006

   $ 762    $ 4,123     $     $     $     $     $ 4,885 (b)

Net income

                55                         55  

Other comprehensive income

               

Cash flow hedges (d)

                      3                   3  
                     

Total comprehensive income

                  58  

Transfer of generating assets from Duke Energy (a)

          1,462             (39 )                 1,423  

Contribution from parent company for reallocation of taxes

          16                               16  

SFAS No. 158 funded status provision

                                  (2 )     (2 )

Balance at December 31, 2006

   $ 762    $ 5,601     $ 55     $ (36 )   $     $ (2 )   $ 6,380  

Year Ended December 31, 2007

                                                       

Balance at December 31, 2006

   $ 762    $ 5,601     $ 55     $ (36 )   $     $ (2 )   $ 6,380  

Net income

                264                         264  

Other comprehensive income

               

Cash flow hedges (d)

                      4                   4  

SFAS 158 net actuarial gain (c), (e)

                                  11       11  
                     

Total comprehensive income

                  279  

Capital contribution from parent

          29                               29  

Push-down accounting adjustments

          (14 )                             (14 )

Adoption of SFAS No. 158 —measurement date provision

                (3 )                 (2 )     (5 )

Dividends to Cinergy Corp.

          (46 )     (89 )                       (135 )

Balance at December 31, 2007

   $ 762    $ 5,570     $ 227     $ (32 )   $     $ 7     $ 6,534  

Year Ended December 31, 2008

                                                       

Balance at December 31, 2007

   $ 762    $ 5,570     $ 227     $ (32 )   $     $ 7     $ 6,534  

Net income

                354                         354  

Other comprehensive income

               

Cash flow hedges (d)

                      17                   17  

Pension and OPEB related adjustments to AOCI (f)

                                  (35 )     (35 )
                     

Total comprehensive income

                  336  

Dividends to Cinergy Corp.

                (200 )                       (200 )

Balance at December 31, 2008

   $ 762    $ 5,570     $ 381     $ (15 )   $     $ (28 )   $ 6,670  

Predecessor

               

Three Months Ended March 31, 2006

                                                       

Balance at December 31, 2005

   $ 762    $ 603     $ 657     $ (14 )   $ (33 )   $     $ 1,975  

Net income

                116                         116  

Other comprehensive income

               

Minimum pension liability adjustment

                            1             1  

Cash flow hedges

                      1                   1  
                     

Total comprehensive income

                  118  

Dividends to Cinergy Corp.

                (102 )                       (102 )

Balance at March 31, 2006

   $ 762    $ 603     $ 671     $ (13 )   $ (32 )   $     $ 1,991 (b)

 

(a) Includes $39 (net of tax benefit of $24) related to deferred losses on terminated cash flow hedges included in Accumulated Other Comprehensive Income (Loss).
(b) Difference in equity balances at March 31, 2006 and April 1, 2006 is due to the application of push-down accounting reflecting Duke Energy's merger with Cinergy (see Notes 1 and 3 to the Consolidated Financial Statements).
(c) Excludes $50 reflected as regulatory assets.
(d) Net of $10 tax expense in 2008, $3 tax expense in 2007 and $2 tax expense for the nine months ended December 31, 2006.
(e) Net of $5 tax expense in 2007.
(f) Net of $19 tax benefit in 2008.

 

See Notes to Consolidated Financial Statements

 

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DUKE ENERGY OHIO, INC.

Notes To Consolidated Financial Statements

For the Years Ended December 31, 2008, 2007 and 2006

 

1. Summary of Significant Accounting Policies

Nature of Operations and Basis of Consolidation. Duke Energy Ohio, Inc. (Duke Energy Ohio), an Ohio corporation organized in 1837, is a wholly-owned subsidiary of Cinergy Corp. (Cinergy). Cinergy is a wholly-owned subsidiary of Duke Energy Corporation (Duke Energy). Duke Energy Ohio is a combination electric and gas public utility company that provides service in the southwestern portion of Ohio and through its wholly-owned subsidiary, Duke Energy Kentucky, Inc. (Duke Energy Kentucky), in nearby areas of Kentucky, as well as electric generation in parts of Ohio, Illinois, Indiana and Pennsylvania through Duke Energy Ohio’s Commercial Power business segment operations, which are discussed further below. Duke Energy Ohio’s principal lines of business include generation, transmission and distribution of electricity, the sale of and/or transportation of natural gas and energy marketing. Duke Energy Kentucky’s principal lines of business include generation, transmission and distribution of electricity, as well as the sale of and/or transportation of natural gas. Except where separately noted, references to Duke Energy Ohio herein relate to the consolidated operations of Duke Energy Ohio, including Duke Energy Kentucky.

On April 3, 2006, Duke Energy Corporation (Old Duke Energy) and Cinergy merged into wholly-owned subsidiaries of Duke Energy Holding Corp. (Duke Energy HC), resulting in Duke Energy HC becoming the parent entity. In connection with the closing of the merger transactions, Duke Energy HC changed its name to Duke Energy Corporation (New Duke Energy or Duke Energy) and Old Duke Energy converted into a limited liability company named Duke Power Company LLC (subsequently renamed Duke Energy Carolinas, LLC effective October 1, 2006). As a result of the merger transactions, each outstanding share of Cinergy common stock was converted into 1.56 shares of common stock of New Duke Energy, which resulted in the issuance of approximately 313 million shares of Duke Energy common stock. See Note 3 for additional information regarding the merger. Both Old Duke Energy and New Duke Energy are referred to as Duke Energy herein.

These Consolidated Financial Statements include, after eliminating intercompany transactions and balances, the accounts of Duke Energy Ohio and all majority-owned subsidiaries where Duke Energy Ohio has control, as well as Duke Energy Ohio’s proportionate share of certain generation and transmission facilities in Ohio, Kentucky and Indiana.

Predecessor and Successor Reporting. In connection with the merger between Duke Energy and Cinergy, Duke Energy acquired all of the outstanding common stock of Cinergy. The merger was accounted for under the purchase method of accounting with Duke Energy treated as the acquirer for accounting purposes. As a result, the assets and liabilities of Cinergy were recorded at their respective fair values as of the merger consummation date. Purchase accounting impacts, including goodwill recognition, have been “pushed down” to Duke Energy Ohio, resulting in the assets and liabilities of Duke Energy Ohio being recorded at their respective fair values as of April 3, 2006 (see Note 3). Except for an adjustment related to pension and other post-retirement benefit obligations, as mandated by the Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards (SFAS) No. 87, “Employers’ Accounting for Pensions,” and SFAS No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions,” the accompanying consolidated financial statements do not reflect any adjustments related to Duke Energy Ohio’s regulated operations that were accounted for pursuant to SFAS No. 71, “Accounting for the Effects of Certain Types of Regulation” (SFAS No. 71) at the time of the merger, which are comprised of Duke Energy Ohio’s regulated transmission and distribution operations and Duke Energy Kentucky. Under the rate setting and recovery provisions currently in place for these regulated operations which provide revenues derived from cost, the fair values of the individual tangible and intangible assets and liabilities are considered to approximate their carrying values.

Duke Energy Ohio’s Consolidated Statements of Operations subsequent to the merger include amortization expense relating to purchase accounting adjustments and depreciation of fixed assets based upon their fair value as of the merger date. Therefore, the Duke Energy Ohio financial data prior to the merger will not generally be comparable to its financial data subsequent to the merger. See Note 3 for additional information.

Due to the impact of push-down accounting, the financial statements and certain note presentations separate Duke Energy Ohio’s presentations into two distinct periods, the period before the consummation of the merger (labeled “Predecessor”) and the period after that date (labeled “Successor”), to indicate the application of different bases of accounting between the periods presented.

Use of Estimates. To conform to generally accepted accounting principles (GAAP) in the United States (U.S.), management makes estimates and assumptions that affect the amounts reported in the Consolidated Financial Statements and Notes. Although these estimates are based on management’s best available information at the time, actual results could differ.

 

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Reapplication of SFAS No. 71 to Portions of Generation in Ohio. Duke Energy Ohio’s generation operations within its Commercial Power business segment (see Note 2) include generation assets located in Ohio that are dedicated to serve Ohio native load customers. These assets, as excess capacity allows, also generate revenues through sales outside the native load customer base, and such revenue is termed non-native.

Prior to December 17, 2008, Duke Energy Ohio’s Commercial Power business segment did not apply the provisions of SFAS No. 71 due to the comprehensive electric deregulation legislation passed by the state of Ohio in 1999. As described further below, effective December 17, 2008, the Public Utilities Commission of Ohio (PUCO) approved Duke Energy Ohio’s Electric Security Plan (ESP), which resulted in the reapplication of SFAS No. 71 to certain portions of Commercial Power’s operations as of that date.

From January 1, 2005 through December 31, 2008, Duke Energy Ohio, including its Commercial Power business segment, had been operating under a rate stabilization plan (RSP), which was a market-based standard service offer. See “Cost-Based Regulation” section below for further information on the RSP and the market-based standard service offer. Although the RSP contained certain trackers that enhanced the potential for cost recovery, there was no assurance of stranded cost recovery upon the expiration of the RSP on December 31, 2008 since it was initially anticipated that, upon the expiration of the RSP, there would be a move to full competitive markets. Accordingly, Duke Energy Ohio’s Commercial Power business segment did not apply the provisions of SFAS No. 71 to any of its generation operations prior to December 17, 2008. As discussed further in Note 4, in April 2008, new legislation (SB 221) was passed in Ohio and signed by the Governor of Ohio on May 1, 2008. The new law codified the PUCO’s authority to approve an electric utility’s standard service offer either through an ESP or a Market Rate Option (MRO). The MRO is a price determined through a competitive bidding process. On July 31, 2008, Duke Energy Ohio filed an ESP, and with certain amendments, the ESP was approved by the PUCO on December 17, 2008. The ESP became effective on January 1, 2009.

In connection with the approval of the ESP, Duke Energy Ohio reassessed the applicability of SFAS No. 71 to Commercial Power’s generation operations as SB 221 substantially increased the PUCO’s oversight authority over generation in the state of Ohio, including giving the PUCO complete approval of generation rates and the establishment of an earnings test to determine if a utility has earned significantly excessive earnings. Duke Energy Ohio determined that certain costs and related rates (riders) of Commercial Power’s operations related to generation serving native load meet the criteria established by SFAS No. 71 for regulatory accounting treatment as SB 221 and Duke Energy Ohio’s approved ESP solidified the automatic recovery of certain costs of its generation serving native load within its Commercial Power business segment and increased the likelihood that Commercial Power’s operations will remain under a cost recovery model for certain costs for the foreseeable future.

Under the ESP, Duke Energy Ohio will bill for its native load generation via numerous riders. SB 221 and the ESP resulted in the approval of the automatic recovery of certain of these riders, which includes, but is not limited to, a fuel and purchased power (FPP) rider and certain portions of a cost of environmental compliance (AAC) rider. Accordingly, Duke Energy Ohio’s Commercial Power business segment began applying SFAS No. 71 to the corresponding RSP riders granting automatic recovery under the ESP on December 17, 2008. The remaining portions of Commercial Power’s native load generation operations, revenues from which are reflected in rate riders for which the ESP does not specifically allow automatic cost recovery, as well as all generation operations associated with non-native customers, including Commercial Power’s Midwest gas-fired generation assets, continue to not apply regulatory accounting as those operations do not meet the criteria of SFAS No. 71. Moreover, generation remains a competitive market in Ohio and native load customers continue to have the ability to switch to alternative suppliers for their electric generation service. As customers switch, there is a risk that some or all of the regulatory assets will not be recovered through the established riders. Duke Energy Ohio will continue to monitor the amount of native load customers that have switched to alternative suppliers when assessing the recoverability of its regulatory assets established for its native load generation operations within its Commercial Power business segment.

Despite certain portions of the Ohio native load operations not being subject to the accounting provisions of SFAS No. 71, all of Duke Energy Ohio’s native load operations’ rates are subject to approval by the PUCO, and thus these operations are referred to herein as Duke Energy Ohio’s regulated operations.

Extraordinary item. The reapplication of SFAS No. 71 to certain portions of generation in Ohio on December 17, 2008, as discussed above, resulted in an approximate $67 million after-tax (approximately $103 million pre-tax) extraordinary gain related to mark-to-market losses previously recorded in earnings associated with open forward native load economic hedge contracts for fuel, purchased power and emission allowances, which the RSP and ESP allow to be recovered through a FPP rider. There were no other immediate income statement impacts on the date of reapplication of SFAS No. 71. A corresponding regulatory asset was established for the value of these contracts.

 

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Cash and Cash Equivalents. All highly liquid investments with maturities of three months or less at the date of acquisition are considered cash equivalents.

Restricted Funds Held in Trust. At December 31, 2008 and 2007, Duke Energy Ohio had approximately $10 million and $62 million, respectively, of restricted cash related primarily to proceeds from debt issuances that are held in trust, primarily for the purpose of funding future environmental expenditures.

Inventory. Inventory consists primarily of coal held for electric generation, materials and supplies and natural gas held in storage for transmission and sales commitments, and is recorded primarily using the average cost method. Inventory related to Duke Energy Ohio’s regulated operations is valued at historical cost consistent with ratemaking treatment. Materials and supplies are recorded as inventory when purchased and subsequently charged to expense or capitalized to plant when installed. Inventory related to Duke Energy Ohio’s non-regulated operations is valued at the lower of cost or market.

 

Components of Inventory

 

     December 31,
     2008    2007
     (in millions)

Inventory

     

Fuel for use in electric generation

   $ 89    $ 77

Materials and supplies

     88      66

Gas held in storage

     3      69
             

Total Inventory

   $ 180    $ 212
             

Effective November 1, 2008, Duke Energy Ohio and Duke Energy Kentucky executed agreements with a third party to transfer title of natural gas inventory purchased by Duke Energy Ohio and Duke Energy Kentucky to the third party. Under the agreements, the gas inventory will be stored and managed for Duke Energy Ohio and Duke Energy Kentucky and will be delivered on demand. The gas storage agreements will expire on October 31, 2009, unless extended by the third party for an additional 12 months. As a result of the agreements, the combined natural gas inventory of approximately $81 million being held by a third party as of December 31, 2008 has been classified as Other within Current Assets on the Consolidated Balance Sheets. At December 31, 2008, this balance exceeded 5% of total current assets.

Cost-Based Regulation. Duke Energy Ohio accounts for certain of its regulated operations under the provisions of SFAS No. 71. The economic effects of regulation can result in a regulated company recording assets for costs that have been or are expected to be approved for recovery from customers in a future period or recording liabilities for amounts that are expected to be returned to customers in the rate-setting process in a period different from the period in which the amounts would be recorded by an unregulated enterprise. Accordingly, Duke Energy Ohio records assets and liabilities that result from the regulated ratemaking process that would not be recorded under GAAP for non-regulated entities. Regulatory assets and liabilities are amortized consistent with the treatment of the related costs in the ratemaking process. Management continually assesses whether regulatory assets are probable of future recovery by considering factors such as applicable regulatory changes, recent rate orders applicable to other regulated entities and the status of any pending or potential deregulation legislation. Additionally, management continually assesses whether any regulatory liabilities have been incurred. Based on this continual assessment, management believes the existing regulatory assets are probable of recovery and that no regulatory liabilities, other than those recorded, have been incurred. These regulatory assets and liabilities are primarily classified in the Consolidated Balance Sheets as Regulatory Assets and Deferred Debits, and Deferred Credits and Other Liabilities. Duke Energy Ohio periodically evaluates the applicability of SFAS No. 71, and considers factors such as regulatory changes and the impact of competition. If cost-based regulation ends or competition increases, Duke Energy Ohio may have to reduce its asset balances to reflect a market basis less than cost and write off the associated regulatory assets and liabilities. For further information see Note 4.

In order to apply the accounting provisions of SFAS No. 71 and record regulatory assets and liabilities, the scope criteria in SFAS No. 71 must be met. Management makes significant judgments in determining whether the scope criteria of SFAS No. 71 are met for its operations, including determining whether revenue rates for services provided to customers are subject to approval by an independent, third-party regulator, whether the regulated rates are designed to recover specific costs of providing the regulated service, and a determination of whether, in view of the demand for the regulated services and the level of competition, it is reasonable to assume that

 

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rates set at levels that will recover the operations’ costs can be charged to and collected from customers. This final criterion requires consideration of anticipated changes in levels of demand or competition, direct and indirect, during the recovery period for any capitalized costs. If facts and circumstances change so that a portion of Duke Energy Ohio’s regulated operations meet all of the scope criteria set forth in SFAS No. 71 when such criteria had not been previously met, SFAS No. 71 would be reapplied to all or a separable portion of the operations. Such reapplication includes adjusting the balance sheet for amounts that meet the definition of a regulatory asset or regulatory liability of SFAS No. 71. Refer to the above section titled, “Reapplication of SFAS No. 71 to Portions of Generation in Ohio.”

From January 1, 2005 through December 31, 2008, Duke Energy Ohio operated under a RSP, a market-based standard service offer which was approved by the PUCO in November 2004, and which provided price certainty through December 31, 2008. See Note 4 for additional information. The RSP consisted of the following discrete charges:

   

Annually Adjusted Component—intended to provide cost recovery primarily for environmental compliance expenditures. This component was avoidable (or by-passable) for the first 25% of residential load and 50% of non-residential load to switch to an alternative electric service provider.

   

Infrastructure Maintenance Fund Charge—intended to compensate Duke Energy Ohio for committing its physical capacity. This charge was unavoidable (or non-by-passable).

   

System Reliability Tracker—intended to provide actual cost recovery for capacity purchases, purchased power, reserve capacity, and related market costs for purchases to meet capacity needs. This charge was non-by-passable for residential load and by-passable for non-residential load under certain circumstances.

   

Rate Stabilization Charge—intended to compensate Duke Energy Ohio for maintaining a fixed price through 2008. This charge was by-passable by the first 25% of residential load and 50% of non-residential load to switch.

   

Generation Prices and Fuel Recovery—A market price has been established for generation service. A component of the market price was a fuel cost recovery mechanism that was adjusted quarterly for fuel, emission allowances, and certain purchased power costs, that exceed the amount originally included in the rates frozen in the Duke Energy Ohio transition plan. These new prices were applied to non-residential customers beginning January 1, 2005 and to residential customers beginning January 1, 2006.

   

Transmission Cost Recovery—A transmission cost recovery mechanism was established beginning January 1, 2005 for non-residential customers and beginning January 1, 2006 for residential customers. The transmission cost recovery mechanism was designed to permit Duke Energy Ohio to recover certain Midwest Independent Transition System Operator, Inc. (Midwest ISO) charges, all Federal Energy Regulatory Commission (FERC) approved transmission costs, and all congestion costs allocable to retail ratepayers that are provided service by Duke Energy Ohio.

Energy Purchases and Fuel Costs. A cost tracking recovery mechanism is used to recover costs of retail fuel and emission allowances that exceed the amount originally included in the rates frozen in the Duke Energy Ohio transition plan. Also, Duke Energy Ohio began utilizing a tracking mechanism approved by the PUCO for the recovery of system reliability capacity costs related to certain specified purchases of power.

Accounting for Risk Management and Hedging Activities and Financial Instruments. Duke Energy Ohio may use a number of different derivative and non-derivative instruments in connection with its commodity price and interest rate risk management activities, including swaps, futures, forwards and options. All derivative instruments not designated and qualifying for the normal purchases and normal sales exception under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended (SFAS No. 133), are recorded on the Consolidated Balance Sheets at their fair value. Cash inflows and outflows related to derivative instruments, except those that contain financing elements and those related to other investing activities, are presented as a component of operating cash flows in the accompanying Consolidated Statements of Cash Flows. Cash inflows and outflows related to derivative instruments containing financing elements are presented as a component of financing cash flows in the accompanying Consolidated Statements of Cash Flows while cash inflows and outflows from derivatives related to investing activities are presented as a component of investing cash flows in the accompanying Consolidated Statements of Cash Flows.

 

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Duke Energy Ohio has designated all energy commodity derivatives as non-trading subsequent to the October 2006 sale of Cinergy Marketing and Trading, LP, and Cinergy Canada, Inc. (collectively CMT), which is discussed further in Note 14. Gains and losses for all derivative contracts that do not represent physical delivery contracts are reported on a net basis in the Consolidated Statements of Operations. For each of Duke Energy Ohio’s physical delivery contracts that are derivatives, the accounting model and presentation of gains and losses, or revenue and expense in the Consolidated Statements of Operations is shown below.

 

Classification of Contract

  

Duke Energy Ohio

Accounting Model

  

Presentation of Gains & Losses or Revenue & Expense

Trading derivatives

  

Mark-to-market(a)

   Net basis in Non-regulated electric and other

Non-trading derivatives:

     

Cash flow hedge

  

Accrual(b)

   Gross basis in the same Statement of Operations category as the related hedged item

Fair value hedge

  

Accrual(b)

   Gross basis in the same Statement of Operations category as the related hedged item

Normal purchase or sale

  

Accrual(b)

   Gross basis upon settlement in the corresponding Statement of Operations category based on commodity type

Undesignated

  

Mark-to-market(a)

   Net basis in the related Statement of Operations category for interest rate and commodity derivatives in the non-regulated business. For derivatives related to the regulated business, gains and losses are deferred as regulatory liabilities and assets, respectively.

 

(a) An accounting term used by Duke Energy Ohio to refer to derivative contracts for which an asset or liability is recognized at fair value and the change in the fair value of that asset or liability is generally recognized in the Consolidated Statements of Operations for the non-regulated business and the Consolidated Balance Sheets within regulatory assets or regulatory liabilities for the regulated business. This term is applied to trading and undesignated non-trading derivative contracts. As this term is not explicitly defined within GAAP, Duke Energy Ohio’s application of this term could differ from that of other companies.
(b) An accounting term used by Duke Energy Ohio to refer to contracts for which there is generally no recognition in the Consolidated Statements of Operations for any changes in fair value until the service is provided, the associated delivery period occurs or there is hedge ineffectiveness. As discussed further below, this term is applied to derivative contracts that are accounted for as cash flow hedges, fair value hedges, and normal purchases or sales, as well as to non-derivative contracts used for commodity risk management purposes. As this term is not explicitly defined within GAAP, Duke Energy Ohio’s application of this term could differ from that of other companies.

On January 1, 2008, Duke Energy Ohio adopted FASB Staff Position (FSP) No. FIN 39-1, “Amendment of FASB Interpretation No. (FIN) 39, Offsetting of Amounts Related to Certain Contracts” (FSP No. FIN 39-1). In accordance with FSP No. FIN 39-1, Duke Energy Ohio offsets fair value amounts (or amounts that approximate fair value) recognized on its Consolidated Balance Sheets related to cash collateral amounts receivable or payable against fair value amounts recognized for derivative instruments executed with the same counterparty under the same master netting agreement. Prior to the adoption of FSP No. FIN 39-1, Duke Energy Ohio offset the fair value amounts recognized for derivative instruments executed with the same counterparty under the same master netting agreement in accordance with FIN 39, “Offsetting of Amounts Related to Certain Contracts,” but presented cash collateral on a gross basis within the Consolidated Balance Sheets. At December 31, 2008 and 2007, Duke Energy Ohio had receivables related to the right to reclaim cash collateral of approximately $85 million and $5 million, respectively, and had payables related to obligations to return cash collateral of an insignificant amount at each balance sheet date that have been offset against net derivative positions in the Consolidated Balance Sheets. Additionally, Duke Energy Ohio had cash collateral receivables of approximately $53 million and $15 million under master netting arrangements that have not been offset against net derivative positions at December 31, 2008 and 2007, respectively, as these amounts primarily represent initial margin deposits related to New York Mercantile Exchange (NYMEX) futures contracts. Duke Energy Ohio had insignificant cash collateral payables under master netting arrangements that have not been offset against net derivative positions at December 31, 2008 and December 31, 2007.

Cash Flow and Fair Value Hedges. Qualifying energy commodity and other derivatives may be designated as either a hedge of a forecasted transaction or future cash flows (cash flow hedge) or a hedge of a recognized asset, liability or firm commitment (fair value hedge). For all contracts accounted for as a hedge, Duke Energy Ohio prepares formal documentation of the hedge in accordance with SFAS No. 133. In addition, at inception and at least every three months thereafter, Duke Energy Ohio formally assesses whether the hedge contract is highly effective in offsetting changes in cash flows or fair values of hedged items. Duke Energy Ohio documents hedging activity by transaction type (futures/swaps) and risk management strategy (commodity price risk/interest rate risk).

 

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Changes in the fair value of a derivative designated and qualified as a cash flow hedge, to the extent effective, are included in the Consolidated Statements of Common Stockholder’s Equity and Comprehensive Income as Accumulated Other Comprehensive Income (Loss) (AOCI) until earnings are affected by the hedged item. Duke Energy Ohio discontinues hedge accounting prospectively when it has determined that a derivative no longer qualifies as an effective hedge, or when it is no longer probable that the hedged forecasted transaction will occur. When hedge accounting is discontinued because the derivative no longer qualifies as an effective hedge, the derivative is subject to the Mark-to-Market model of accounting (MTM Model) prospectively. Gains and losses related to discontinued hedges that were previously accumulated in AOCI will remain in AOCI until the underlying contract is reflected in earnings, unless it is probable that the hedged forecasted transaction will not occur, at which time associated deferred amounts in AOCI are immediately recognized in earnings.

For derivatives designated as fair value hedges, Duke Energy Ohio recognizes the gain or loss on the derivative instrument, as well as the offsetting loss or gain on the hedged item in earnings, to the extent effective, in the current period. All derivatives designated and accounted for as hedges are classified in the same category as the item being hedged in the Consolidated Statements of Cash Flows. In addition, all components of each derivative gain or loss are included in the assessment of hedge effectiveness.

Normal Purchases and Normal Sales (NPNS). On a limited basis, Duke Energy Ohio applies the NPNS exception to certain contracts. If contracts cease to meet this exception, the fair value of the contracts is recognized on the Consolidated Balance Sheets and the contracts are accounted for prospectively using the MTM Model unless immediately designated as a cash flow or fair value hedge.

Valuation. When available, quoted market prices or prices obtained through external sources are used to measure a contract’s fair value. For contracts with a delivery location or duration for which quoted market prices are not available, fair value is determined based on internally developed valuation techniques or models. For derivatives recognized under the MTM Model, valuation adjustments are also recognized in the Consolidated Statements of Operations.

Goodwill. Duke Energy Ohio evaluates goodwill for potential impairment under the guidance of SFAS No. 142, “Goodwill and Other Intangible Assets” (SFAS No. 142). Under this provision, goodwill is subject to an annual test for impairment. Duke Energy Ohio has designated August 31 as the date it performs the annual review for goodwill impairment for its reporting units. Under the provisions of SFAS No. 142, Duke Energy Ohio performs the annual review for goodwill impairment at the reporting unit level, which Duke Energy Ohio has determined to be an operating segment.

Impairment testing of goodwill consists of a two-step process. The first step involves a comparison of the determined fair value of a reporting unit with its carrying amount. If the carrying amount of the reporting unit exceeds its fair value, the second step of the process involves a comparison of the fair value and carrying value of the goodwill of that reporting unit. If the carrying value of the goodwill of a reporting unit exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to the excess. Additional impairment tests are performed between the annual reviews if events or changes in circumstances make it more likely than not that the fair value of a reporting unit is below its carrying amount.

Duke Energy Ohio primarily uses a discounted cash flow analysis to determine fair value. Key assumptions in the determination of fair value include the use of an appropriate discount rate, estimated future cash flows and estimated run rates of operation, maintenance, and general and administrative costs. In estimating cash flows, Duke Energy Ohio incorporates expected growth rates, regulatory stability and ability to renew contracts as well as other factors into its revenue and expense forecasts. See Note 10 for further information.

Property, Plant and Equipment. As discussed under “Predecessor and Successor Reporting” above, recorded balances for property, plant and equipment existing as of April 3, 2006 were adjusted to reflect fair values as of that date. Due to rate-setting and recovery provisions currently in place for regulated operations, the fair values of property plant and equipment of the regulated operations were considered to approximate their carrying values as of the date of Duke Energy’s merger with Cinergy. Accumulated depreciation was not reset to zero as of the merger date for the regulated property, plant and equipment due primarily to regulatory reporting implications. Unregulated property, plant and equipment were recorded at respective fair values and accumulated deprecation was reset to zero as of the merger date. Otherwise, property, plant and equipment are stated at the lower of historical cost less accumulated depreciation or fair value, if impaired. Duke Energy Ohio capitalizes all construction-related direct labor and material costs, as well as indirect construction costs. Indirect costs include general engineering, taxes and the cost of funds used during construction (see “Allowance for Funds Used During Construction (AFUDC),” discussed below). The cost of renewals and betterments that extend the useful life of property, plant and equipment are also capitalized. The cost of repairs, replacements and major maintenance projects, which do not extend the useful life or increase the expected output of the asset, is expensed as incurred. Depreciation is generally computed over the asset’s estimated useful life using the composite straight-line method. The composite weighted-average depreciation rates were 2.6% for 2008, 2.6% for 2007

 

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and 2.7% for 2006. Depreciation studies are conducted periodically to update the composite rates and are approved by the PUCO and the Kentucky Public Service Commission (KPSC).

When Duke Energy Ohio retires its regulated property, plant and equipment, it charges the original cost plus the cost of retirement, less salvage value, to accumulated depreciation. When it sells entire regulated operating units, or retires or sells non-regulated properties, the cost is removed from the property account and the related accumulated depreciation and amortization accounts are reduced. Any gain or loss is recorded in earnings, unless otherwise required by the applicable regulatory body.

See Note 15 for further information on the components and estimated useful lives of Duke Energy Ohio’s property, plant and equipment balance.

Asset Retirement Obligations. Duke Energy Ohio recognizes asset retirement obligations in accordance with SFAS No. 143, “Accounting For Asset Retirement Obligations” (SFAS No. 143), for legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and/or normal use of the asset and FIN No. 47, “Accounting for Conditional Asset Retirement Obligations” (FIN 47), for conditional asset retirement obligations. The term conditional asset retirement obligation as used in SFAS No. 143 and FIN 47 refers to a legal obligation to perform an asset retirement activity in which the timing and (or) method of settlement are conditional on a future event that may or may not be within the control of the entity. The obligation to perform the asset retirement activity is unconditional even though uncertainty exists about the timing and (or) method of settlement. Thus, the timing and (or) method of settlement may be conditional on a future event. Both SFAS No. 143 and FIN 47 require that the present value of the projected liability for an asset retirement obligation be recognized in the period in which it is incurred, if a reasonable estimate of fair value can be made. The present value of the liability is added to the carrying amount of the associated asset. This additional carrying amount is then depreciated over the estimated useful life of the asset. See Note 7 for further information regarding Duke Energy Ohio’s asset retirement obligations.

Long-Lived Asset Impairments, Assets Held For Sale and Discontinued Operations. Duke Energy Ohio evaluates whether long-lived assets, excluding goodwill, have been impaired when circumstances indicate the carrying value of those assets may not be recoverable. For such long-lived assets, an impairment exists when its carrying value exceeds the sum of estimates of the undiscounted cash flows expected to result from the use and eventual disposition of the asset. When alternative courses of action to recover the carrying amount of a long-lived asset are under consideration, a probability-weighted approach is used for developing estimates of future undiscounted cash flows. If the carrying value of the long-lived asset is not recoverable based on these estimated future undiscounted cash flows, the impairment loss is measured as the excess of the asset’s carrying value over its fair value, such that the asset’s carrying value is adjusted to its estimated fair value.

Management assesses the fair value of long-lived assets using commonly accepted techniques, and may use more than one source. Sources to determine fair value include, but are not limited to, recent third party comparable sales, internally developed discounted cash flow analysis and analysis from outside advisors. Significant changes in market conditions resulting from events such as changes in commodity prices or the condition of an asset, or a change in management’s intent to utilize the asset may generally require management to re-assess the cash flows related to the long-lived assets.

Duke Energy Ohio uses the criteria in SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets” (SFAS No. 144), to determine when an asset is classified as “held for sale.” Upon classification as “held for sale,” the long-lived asset or asset group is measured at the lower of its carrying amount or fair value less cost to sell, depreciation is ceased and the asset or asset group is separately presented on the Consolidated Balance Sheets. When an asset or asset group meets the SFAS No. 144 criteria for classification as held for sale within the Consolidated Balance Sheets, Duke Energy Ohio does not retrospectively adjust prior period balance sheets to conform to current year presentation.

Duke Energy Ohio uses the criteria in SFAS No. 144 and Emerging Issues Task Force (EITF) Issue No. 03-13, “Applying the Conditions in Paragraph 42 of FASB Statement No. 144 in Determining Whether to Report Discontinued Operations” (EITF 03-13), to determine whether components of Duke Energy Ohio that are being disposed of, are classified as held for sale or have been wound down are required to be reported as discontinued operations in the Consolidated Statements of Operations. To qualify as a discontinued operation under SFAS No. 144, the component being disposed of must have clearly distinguishable operations and cash flows. Additionally, pursuant to EITF 03-13, Duke Energy Ohio must not have significant continuing involvement in the operations after the disposal (i.e., Duke Energy Ohio must not have the ability to influence the operating or financial policies of the disposed component) and cash flows of the operations being disposed of must have been eliminated from Duke Energy Ohio’s ongoing operations (i.e., Duke Energy Ohio does not

 

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expect to generate significant direct cash flows from activities involving the disposed component after the disposal transaction is completed). Assuming both preceding conditions are met, the related results of operations for the current and prior periods, including any related impairments, are reflected within discontinued operations, net of tax, in the Consolidated Statements of Operations. If an asset held for sale does not meet the requirements for discontinued operations classification, any impairments and gains or losses on sales are recorded as a component of continuing operations in the Consolidated Statements of Operations. Impairments for all other long-lived assets are recorded in Operating Expenses in the Consolidated Statements of Operations.

Unamortized Debt Premium, Discount and Expense. Premiums, discounts and expenses incurred with the issuance of outstanding long-term debt are amortized over the terms of the debt issues. Any call premiums or unamortized expenses associated with refinancing higher-cost debt obligations to finance regulated assets and operations are amortized consistent with regulatory treatment of those items, where appropriate. The amortization expense is recorded as a component of interest expense in the Consolidated Statements of Operations and is reflected as Depreciation and amortization within Net cash provided by operating activities on the Consolidated Statements of Cash Flows.

Loss Contingencies. Duke Energy Ohio is involved in certain legal and environmental matters that arise in the normal course of business. Loss contingencies are accounted for under SFAS No. 5, “Accounting for Contingencies” (SFAS No. 5). Under SFAS No. 5, contingent losses are recorded when it is determined that it is probable that a loss has occurred and the amount of the loss can be reasonably estimated. When a range of the probable loss exists and no amount within the range is a better estimate than any other amount, Duke Energy Ohio records a loss contingency at the minimum amount in the range. Unless otherwise required by GAAP, legal fees are expensed as incurred. See Note 18 for further information.

Environmental Expenditures. Duke Energy Ohio expenses environmental expenditures related to conditions caused by past operations that do not generate current or future revenues. Environmental expenditures related to operations that generate current or future revenues are expensed or capitalized, as appropriate. Liabilities are recorded on an undiscounted basis when the necessity for environmental remediation becomes probable and the costs can be reasonably estimated, or when other potential environmental liabilities are reasonably estimable and probable.

Revenue Recognition and Unbilled Revenue. Revenues on sales of electricity and gas are recognized when either the service is provided or the product is delivered. Unbilled revenues are estimated by applying an average revenue per kilowatt-hour or per thousand cubic feet (Mcf) for all customer classes to the number of estimated kilowatt-hours or Mcfs delivered but not billed. The amount of unbilled revenues can vary significantly from period to period as a result of factors, including seasonality, weather, customer usage patterns and customer mix. Unbilled revenues, which are included in Receivables on the Consolidated Balance Sheets, primarily relate to wholesale sales at Commercial Power and were approximately $40 million and $38 million, at December 31, 2008 and 2007, respectively. Additionally, receivables for unbilled revenues of approximately $149 million and $145 million at December 31, 2008 and 2007, respectively, related to retail accounts receivable at Duke Energy Ohio and Duke Energy Kentucky are included in the sales of accounts receivable to Cinergy Receivables Company, LLC (Cinergy Receivables). See Note 13 for additional information.

Fuel Cost Deferrals. Fuel expense includes fuel costs or other recoveries that are deferred through fuel clauses established by Duke Energy Ohio’s regulators. These clauses allow Duke Energy Ohio to recover fuel costs, fuel-related costs and portions of purchased power costs through surcharges on customer rates. These deferred fuel costs are recognized in revenues and fuel expenses as they are billable to customers.

AFUDC. In accordance with regulatory treatment, Duke Energy Ohio records AFUDC, which represents the estimated debt and equity costs of capital funds necessary to finance the construction of new regulated facilities. Both the debt and equity components of AFUDC are non-cash amounts within the Consolidated Statements of Operations. AFUDC is capitalized as a component of the cost of Property, Plant and Equipment, with an offsetting credit to Other Income and Expenses, net on the Consolidated Statements of Operations for the equity component and as an offset to Interest Expense on the Consolidated Statements of Operations for the debt component. After construction is completed, Duke Energy Ohio is permitted to recover these costs through inclusion in the rate base and the corresponding depreciation expense. The total amount of AFUDC included in the Consolidated Statements of Operations was $26 million in 2008, which consisted of an after-tax equity component of $7 million and a before-tax interest expense component of $19 million. The total amount of AFUDC included in the Consolidated Statements of Operations was $34 million in 2007, which consisted of an after-tax equity component of $4 million and a before-tax interest expense component of $30 million. The total amount of AFUDC included in the Consolidated Statements of Operations for the nine months ended December 31, 2006 was $16 million, which consisted of an after-tax

 

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equity component of $2 million and a before-tax interest expense component of $14 million. The total amount of AFUDC included in the Consolidated Statements of Operations for the three months ended March 31, 2006 was $4 million, which consisted of an after-tax equity component of $1 million and a before-tax interest expense component of $3 million.

AFUDC equity is recorded in the Consolidated Statements of Operations on an after-tax basis and is a permanent difference item for income tax purposes (i.e., a permanent difference between financial statement and income tax reporting), thus reducing Duke Energy Ohio’s income tax expense and effective tax rate during the construction phase in which AFUDC equity is being recorded. The effective tax rate is subsequently increased in future periods when the completed property, plant and equipment is placed in service and depreciation of the AFUDC equity commences.

Accounting For Purchases and Sales of Emission Allowances. Emission allowances are issued by the Environmental Protection Agency (EPA) at zero cost and permit the holder of the allowance to emit certain gaseous by-products of fossil fuel combustion, including sulfur dioxide (SO2) and nitrogen oxide (NOx). Allowances may also be bought and sold via third party transactions or consumed as the emissions are generated. Allowances allocated to or acquired by Duke Energy Ohio are held primarily for consumption. Duke Energy Ohio records emission allowances as Intangibles, net on its Consolidated Balance Sheets and recognizes the allowances in earnings as they are consumed or sold. Gains or losses on sales of emission allowances for non-regulated businesses are presented on a net basis in Gains (Losses) on Sales of Other Assets and Other, net, in the accompanying Consolidated Statements of Operations. For regulated businesses that provide for direct recovery of emission allowances, any gain or loss on sales of recoverable emission allowances are included in the rate structure of the regulated entity and are deferred as a regulatory asset or liability. Future rates charged to retail customers are impacted by any gain or loss on sales of recoverable emission allowances and, therefore, as the recovery of the gain or loss is recognized in operating revenues, the regulatory asset or liability related to the emission allowance activity is recognized as a component of Fuel Used in Electric Generation and Purchased Power—Regulated in the Consolidated Statements of Operations. Purchases and sales of emission allowances are presented gross as investing activities on the Consolidated Statements of Cash Flows. See Note 11 for discussion regarding the impairment of the carrying value of certain emission allowances in 2008.

Income Taxes. As a result of Duke Energy’s merger with Cinergy, Duke Energy Ohio entered into a tax sharing agreement with Duke Energy, where the separate return method is used to allocate tax expenses and benefits to the subsidiaries whose investments or results of operations provide these tax expenses or benefits. The accounting for income taxes essentially represents the income taxes that Duke Energy Ohio would incur if Duke Energy Ohio were a separate company filing its own federal tax return as a C-Corporation. The current tax sharing agreement Duke Energy Ohio has with Duke Energy is substantially the same as the tax sharing agreement between Duke Energy Ohio and Cinergy prior to the merger. Deferred income taxes have been provided for temporary differences between the GAAP and tax carrying amounts of assets and liabilities. These differences create taxable or tax-deductible amounts for future periods. Investment tax credits have been deferred and are being amortized over the estimated useful lives of the related properties in Duke Energy Ohio’s regulated operations.

Management evaluates and records uncertain tax positions in accordance with FIN 48, “Accounting For Uncertainty in Income Taxes—an Interpretation of FASB Statement 109” (FIN 48), which was adopted by Duke Energy Ohio on January 1, 2007. Duke Energy Ohio records tax benefits for uncertain positions taken or expected to be taken on tax returns, including the decision to exclude certain income or transactions from a return, when a more-likely-than-not threshold is met for a tax position and management believes that the position will be sustained upon examination by the taxing authorities. Management evaluates each position based solely on the technical merits and facts and circumstances of the position, assuming the position will be examined by a taxing authority having full knowledge of all relevant information. In accordance with FIN 48, Duke Energy Ohio records the largest amount of the uncertain tax benefit that is greater than 50% likely of being realized upon settlement or effective settlement. Management considers a tax position effectively settled for the purpose of recognizing previously unrecognized tax benefits when the following conditions exist: (i) the taxing authority has completed its examination procedures, including all appeals and administrative reviews that the taxing authority is required and expected to perform for the tax positions, (ii) Duke Energy Ohio does not intend to appeal or litigate any aspect of the tax position included in the completed examination, and (iii) it is remote that the taxing authority would examine or reexamine any aspect of the tax position. See Note 6 for further information.

Duke Energy Ohio records, as it relates to taxes, interest expense as Interest Expense and interest income and penalties in Other Income and Expenses, net, in the Consolidated Statements of Operations.

 

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Excise Taxes. Certain excise taxes levied by state or local governments are collected by Duke Energy Ohio from its customers. These taxes, which are required to be paid regardless of Duke Energy Ohio’s ability to collect from the customer, are accounted for on a gross basis. When Duke Energy Ohio acts as an agent, and the tax is not required to be remitted if it is not collected from the customer, the taxes are accounted for on a net basis. Duke Energy Ohio’s excise taxes accounted for on a gross basis and recorded as revenues in the accompanying Consolidated Statements of Operations were as follows:

 

Successor(a)              Predecessor(a)

Year Ended

December 31, 2008

  

Year Ended

December 31, 2007

   Nine Months Ended
December 31, 2006
             Three Months Ended
March 31, 2006
(in millions)

$121

   $119    $77          $38

 

(a) See “Predecessor and Successor Reporting” section above for additional information on Predecessor and Successor reporting.

Segment Reporting. SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information” (SFAS No. 131), establishes standards for a public company to report financial and descriptive information about its reportable operating segments in annual and interim financial reports. Operating segments are components of an enterprise about which separate financial information is available and evaluated regularly by the chief operating decision maker in deciding how to allocate resources and evaluate performance. Two or more operating segments may be aggregated into a single reportable segment provided aggregation is consistent with the objective and basic principles of SFAS No. 131, if the segments have similar economic characteristics, and the segments are considered similar under criteria provided by SFAS No. 131. There is no aggregation within Duke Energy Ohio’s reportable business segments. SFAS No. 131 also establishes standards and related disclosures about the way the operating segments were determined, including products and services, geographic areas and major customers, differences between the measurements used in reporting segment information and those used in the general-purpose financial statements, and changes in the measurement of segment amounts from period to period. The description of Duke Energy Ohio’s reportable segments, consistent with how business results are reported internally to management and the disclosure of segment information in accordance with SFAS No. 131, are presented in Note 2.

Statements of Consolidated Cash Flows. Duke Energy Ohio has made certain classification elections within its Consolidated Statements of Cash Flows related to discontinued operations and debt restricted for qualified capital and maintenance expenditures. Cash flows from discontinued operations are combined with cash flows from continuing operations within operating, investing and financing cash flows within the Consolidated Statements of Cash Flows. Proceeds from debt issued with restrictions to fund future capital and maintenance expenditures are presented on a gross basis, with the debt proceeds classified as a financing cash inflow and the changes in the restricted funds held in trust presented as a component of investing activities.

New Accounting Standards. The following new accounting standards were adopted by Duke Energy Ohio during the year ended December 31, 2008 and the impact of such adoption, if applicable, has been presented in the accompanying Consolidated Financial Statements:

SFAS No. 157, “Fair Value Measurements” (SFAS No. 157). Refer to Note 9 for a discussion of Duke Energy Ohio’s adoption of SFAS No. 157.

SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities- including an amendment of FASB Statement No. 115” (SFAS No. 159). Refer to Note 9 for a discussion of Duke Energy Ohio’s adoption of SFAS No. 159.

FASB Staff Position (FSP) No. FIN 39-1, “Amendment of FASB Interpretation No 39, Offsetting of Amounts Related to Certain Contracts” (FSP No. FIN 39-1). Refer to “Accounting for Risk Management and Hedging Activities and Financial Instruments” above for a discussion of Duke Energy Ohio’s adoption of FSP No. FIN 39-1.

The following new accounting standards were adopted by Duke Energy Ohio during the year ended December 31, 2007 and the impact of such adoption, if applicable, has been presented in the accompanying Consolidated Financial Statements:

SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments—an amendment of FASB Statements No. 133 and 140” (SFAS No. 155). In February 2006, the FASB issued SFAS No. 155, which amends SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” and SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” (SFAS No. 140). SFAS No. 155 allows financial instruments that have embedded derivatives to be accounted for at fair value at acquisition, at issuance, or when a previously recognized financial instrument is subject to a remeasurement (new basis) event, on an instrument-by-instrument basis, in cases in which a derivative would otherwise have to be bifurcated. SFAS No. 155 was effective for Duke

 

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Energy Ohio for all financial instruments acquired, issued, or subject to remeasurement after January 1, 2007, and for certain hybrid financial instruments that had been bifurcated prior to the effective date, for which the effect is to be reported as a cumulative-effect adjustment to beginning retained earnings. The adoption of SFAS No. 155 did not have a material impact on Duke Energy Ohio’s consolidated results of operations, cash flows or financial position.

SFAS No. 156, “Accounting for Servicing of Financial Assets—an amendment of FASB Statement No. 140” (SFAS No. 156). In March 2006, the FASB issued SFAS No. 156, which amends SFAS No. 140. SFAS No. 156 requires recognition of a servicing asset or liability when an entity enters into arrangements to service financial instruments in certain situations. Such servicing assets or servicing liabilities are required to be initially measured at fair value, if practicable. SFAS No. 156 also allows an entity to subsequently measure its servicing assets or servicing liabilities using either an amortization method or a fair value method. SFAS No. 156 was effective for Duke Energy Ohio as of January 1, 2007, and must be applied prospectively, except that where an entity elects to remeasure separately recognized existing arrangements and reclassify certain available-for-sale securities to trading securities, any effects must be reported as a cumulative-effect adjustment to retained earnings. The adoption of SFAS No. 156 did not have a material impact on Duke Energy Ohio’s consolidated results of operations, cash flows or financial position.

SFAS No. 158, “Employer’s Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132(R)” (SFAS No. 158). In October 2006, the FASB issued SFAS No. 158, which changes the recognition and disclosure provisions and measurement date requirements for an employer’s accounting for defined benefit pension and other post-retirement plans. The recognition and disclosure provisions require an employer to (1) recognize the funded status of a benefit plan—measured as the difference between plan assets at fair value and the benefit obligation—in its statement of financial position, (2) recognize as a component of other comprehensive loss, net of tax, the gains or losses and prior service costs or credits that arise during the period but are not recognized as components of net periodic benefit cost, and (3) disclose in the notes to financial statements certain additional information. SFAS No. 158 does not change the amounts recognized in the income statement as net periodic benefit cost. Duke Energy Ohio recognized the funded status of its defined benefit pension and other post-retirement plans and provided the required additional disclosures as of December 31, 2006. The adoption of SFAS No. 158 recognition and disclosure provisions resulted in an increase in total assets of approximately $33 million (consisting of an increase in regulatory assets of $31 million and an increase in deferred tax assets of $2 million), an increase in total liabilities of approximately $35 million and a decrease in AOCI, net of tax, of approximately $2 million as of December 31, 2006. The adoption of SFAS No. 158 did not have a material impact on Duke Energy Ohio’s consolidated results of operations or cash flows.

Under the measurement date requirements of SFAS No. 158, an employer is required to measure defined benefit plan assets and obligations as of the date of the employer’s fiscal year-end statement of financial position (with limited exceptions). Historically, Duke Energy Ohio has measured its plan assets and obligations up to three months prior to the fiscal year-end, as allowed under the authoritative accounting literature. Duke Energy Ohio adopted the change in measurement date effective January 1, 2007 by remeasuring plan assets and benefit obligations as of that date, pursuant to the transition requirements of SFAS No. 158. Net periodic benefit cost of approximately $3 million for the three-month period between September 30, 2006 and December 31, 2006 was recognized, net of tax, as a separate adjustment of retained earnings as of January 1, 2007. Additionally, in the first quarter of 2007, the changes in plan assets and plan obligations between the September 30, 2006 and December 31, 2006 measurement dates not related to net periodic benefit cost was required to be recognized, net of tax, as a separate adjustment of the opening balance of AOCI and regulatory assets. This adjustment was not material. During the second quarter of 2007, Duke Energy Ohio completed these calculations. The finalization of these actuarial calculations resulted in a $2 million adjustment to AOCI and an insignificant adjustment to regulatory assets.

FIN 48. In July 2006, the FASB issued FIN 48, which provides guidance on accounting for income tax positions about which Duke Energy Ohio has concluded there is a level of uncertainty with respect to the recognition of a tax benefit in Duke Energy Ohio’s financial statements. FIN 48 prescribes the minimum recognition threshold a tax position is required to meet. Tax positions are defined very broadly and include not only tax deductions and credits but also decisions not to file in a particular jurisdiction, as well as the taxability of transactions. Duke Energy Ohio adopted FIN 48 effective January 1, 2007. See Note 6 for additional information.

FASB Staff Position (FSP) No. FIN 48-1, Definition of “Settlement” in FASB Interpretation No. 48 (FSP No. FIN 48-1). In May, 2007, the FASB staff issued FSP No. FIN 48-1 which clarifies the conditions under FIN 48 that should be met for a tax position to be considered effectively settled with the taxing authority. Duke Energy Ohio’s adoption of FIN 48 as of January 1, 2007 was consistent with the guidance in this FSP.

 

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The following new accounting standard was adopted by Duke Energy Ohio during the year ended December 31, 2006 and the impact of such adoption, if applicable, has been presented in the accompanying Consolidated Financial Statements:

Staff Accounting Bulletin (SAB) No. 108, “Considering the Effects of Prior Year Misstatements When Quantifying Misstatements in Current Year Financial Statements” (SAB No. 108). In September 2006 the Securities and Exchange Commission (SEC) issued SAB No. 108, which provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. Traditionally, there have been two widely-recognized approaches for quantifying the effects of financial statement misstatements. The income statement approach focuses primarily on the impact of a misstatement on the income statement—including the reversing effect of prior year misstatements—but its use can lead to the accumulation of misstatements in the balance sheet. The balance sheet approach, on the other hand, focuses primarily on the effect of correcting the period-end balance sheet with less emphasis on the reversing effects of prior year errors on the income statement. The SEC staff believes that registrants should quantify errors using both a balance sheet and an income statement approach (a “dual approach”) and evaluate whether either approach results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material.

SAB No. 108 was effective for Duke Energy Ohio’s year ending December 31, 2006. SAB No. 108 permits existing public companies to initially apply its provisions either by (i) restating prior financial statements as if the “dual approach” had always been used or (ii), under certain circumstances, recording the cumulative effect of initially applying the “dual approach” as adjustments to the carrying values of assets and liabilities as of January 1, 2006 with an offsetting adjustment recorded to the opening balance of retained earnings. Duke Energy Ohio has historically used a dual approach for quantifying identified financial statement misstatements. Therefore, the adoption of SAB No. 108 did not have a material impact on Duke Energy Ohio’s consolidated results of operations, cash flows or financial position.

The following new accounting standards have been issued, but have not yet been adopted by Duke Energy Ohio as of December 31, 2008:

SFAS No. 141 (revised 2007), “Business Combinations” (SFAS No. 141(R)). In December 2007, the FASB issued SFAS No. 141(R), which replaces SFAS No. 141, “Business Combinations.” SFAS No. 141(R) retains the fundamental requirements in SFAS No. 141 that the acquisition method of accounting be used for all business combinations and that an acquirer be identified for each business combination. This statement also establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any noncontrolling (minority) interests in an acquiree, and any goodwill acquired in a business combination or gain recognized from a bargain purchase. For Duke Energy Ohio, SFAS No. 141(R) must be applied prospectively to business combinations for which the acquisition date occurs on or after January 1, 2009. The impact to Duke Energy Ohio of applying SFAS No. 141(R) for periods subsequent to implementation will be dependent upon the nature of any transactions within the scope of SFAS No. 141(R). SFAS No. 141(R) changes the accounting for income taxes related to prior business combinations, such as Duke Energy’s merger with Cinergy. Subsequent to the effective date of SFAS No. 141(R), the resolution of tax contingencies relating to Cinergy that existed as of the date of the merger will be required to be reflected in the Consolidated Statements of Operations instead of being reflected as an adjustment to the purchase price via an adjustment to goodwill.

SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities—an amendment to FASB Statement No. 133” (SFAS No. 161). In March 2008, the FASB issued SFAS No. 161, which amends and expands the disclosure requirements for derivative instruments and hedging activities prescribed by SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” SFAS No. 161 requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of and gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative agreements. Duke Energy Ohio will adopt SFAS No. 161 as of January 1, 2009 and SFAS No. 161 encourages, but does not require, comparative disclosure for earlier periods at initial adoption. The adoption of SFAS No. 161 will not have any impact on Duke Energy Ohio’s consolidated results of operations, cash flows or financial position.

 

2. Business Segments

Duke Energy Ohio operates the following business segments, which are all considered reportable business segments under SFAS No. 131: Franchised Electric and Gas and Commercial Power. Duke Energy Ohio’s management believes these reportable business segments properly align the various operations of Duke Energy Ohio with how the chief operating decision maker views the business.

 

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Duke Energy Ohio’s chief operating decision maker regularly reviews financial information about each of these reportable business segments in deciding how to allocate resources and evaluate performance. There is no aggregation within Duke Energy Ohio’s defined business segments.

Franchised Electric and Gas generates, transmits, distributes and sells electricity in southwestern Ohio and northern Kentucky. Franchised Electric and Gas also transports and sells natural gas in southwestern Ohio and northern Kentucky. It conducts operations primarily through Duke Energy Ohio and Duke Energy Kentucky. These electric and gas operations are subject to the rules and regulations of the FERC, the PUCO and the KPSC. Substantially all of Franchised Electric and Gas’ operations are regulated and, accordingly, these operations are accounted for under the provisions of SFAS No. 71.

Commercial Power owns, operates and manages power plants and engages in the wholesale marketing and procurement of electric power, fuel and emission allowances related to these plants, as well as other contractual positions. Commercial Power’s asset portfolio comprises approximately 7,550 net megawatts (MW) and its generation assets consist of a diversified fuel mix with baseload and mid-merit coal-fired units, as well as combined cycle and peaking natural gas-fired units. Commercial Power’s portfolio includes the five Midwestern gas-fired generation assets that were transferred from Duke Energy in 2006. Most of the generation asset output in Ohio has been contracted through the RSP, which expired on December 31, 2008 (see Note 4). Effective January 1, 2009, Commercial Power began operating under an ESP, which expires on December 31, 2011. As a result of the approval of the ESP, certain of Commercial Power’s operations reapplied the provisions of SFAS No. 71 effective December 17, 2008. See Notes 1 and 4 for a discussion of the reapplication of the provisions of SFAS No. 71 to certain of Commercial Power’s operations, as well as for further discussion related to the RSP and ESP.

The remainder of Duke Energy Ohio’s operations is presented as Other. While it is not considered a business segment, Other primarily includes certain allocated governance costs (see Note 12).

Duke Energy Ohio’s reportable business segments offer different products and services or operate under different competitive environments and are managed separately as business units. Accounting policies for Duke Energy Ohio’s segments are the same as those described in Note 1. Management evaluates segment performance based on earnings before interest and taxes from continuing operations (EBIT). On a segment basis, EBIT excludes discontinued operations and represents all profits from continuing operations (both operating and non-operating and excluding corporate governance costs) before deducting interest and taxes.

Cash, cash equivalents and short-term investments, if any, are managed centrally by Cinergy and Duke Energy, so the interest and dividend income on those balances are excluded from the segments’ EBIT. Transactions between reportable business segments, if any, are accounted for on the same basis as revenues and expenses in the accompanying Consolidated Financial Statements.

 

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Business Segment Data(a)

    

Unaffiliated

Revenues

 

Intersegment

Revenues

   

Total

Revenues

   

Segment EBIT/

Consolidated

Income

from Continuing

Operations before

Income Taxes

   

Depreciation

and

Amortization

 

Capital

Expenditures

 

Segment

Assets(b)(d)

 
    (in millions)  

Successor(c)

             

Year Ended December 31, 2008

             

Franchised Electric and Gas

  $ 1,778   $     $ 1,778     $ 291     $ 243   $ 305   $ 5,857  

Commercial Power

    1,646           1,646       301       166     260     6,249  

Total reportable segments

    3,424           3,424       592       409     565     12,106  

Other

                    (67 )             17  

Eliminations and reclassifications

                                  (34 )

Interest expense

                    (94 )              

Interest income and other

                    27                

Total consolidated

  $ 3,424   $     $ 3,424     $ 458     $ 409   $ 565   $ 12,089  
   

Successor(c)

             

Year Ended December 31, 2007

             

Franchised Electric and Gas

  $ 1,707   $     $ 1,707     $ 257     $ 228   $ 275   $ 5,530  

Commercial Power

    1,748           1,748       304       164     318     6,147  

Total reportable segments

    3,455           3,455       561       392     593     11,677  

Other

                    (75 )              

Eliminations and reclassifications

                                   

Interest expense

                    (100 )              

Interest income and other

                    29                

Total consolidated

  $ 3,455   $     $ 3,455     $ 415     $ 392   $ 593   $ 11,677  
   

Successor(c)

             

Nine Months Ended December 31, 2006

             

Franchised Electric and Gas

  $ 1,027   $     $ 1,027     $ 130     $ 160   $ 198   $ 5,381  

Commercial Power

    1,234     1       1,235       93       120     193     6,349  

Total reportable segments

    2,261     1       2,262       223       280     391     11,730  

Other

                    (56 )              

Eliminations and reclassifications

        (1 )     (1 )                    

Interest expense

                    (81 )              

Interest income and other

                    16                

Total consolidated

  $ 2,261   $     $ 2,261     $ 102     $ 280   $ 391   $ 11,730  
   

Predecessor(c)

             

Three Months Ended March 31, 2006

             

Franchised Electric and Gas

  $ 543   $     $ 543     $ 80     $ 50   $ 75  

Commercial Power

    420     1       421       166       18     60        

Total reportable segments

    963     1       964       246       68     135  

Other

                    (39 )          

Eliminations and reclassifications

        (1 )     (1 )                

Interest expense

                    (30 )          

Interest income and other

                    9                  

Total consolidated

  $ 963   $     $ 963     $ 186     $ 68   $ 135  
   

 

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(a) Segment results exclude results of entities classified as discontinued operations.
(b) Segment assets at December 31, 2006 include assets held for sale.
(c) See Note 1 for additional information on Predecessor and Successor reporting.
(d) Amounts include goodwill recorded as of December 31, 2008 and December 31, 2007 resulting from Duke Energy’s merger with Cinergy in the amount of $2,360 million and $2,325 million, respectively. Franchised Electric and Gas’ allocated amount as of December 31, 2008 and December 31, 2007 was $1,154 million and $1,137 million, respectively. Commercial Power’s allocated amount as of December 31, 2008 and December 31, 2007 was $1,206 million and $1,188 million, respectively.

All of Duke Energy Ohio’s revenues are generated domestically and its long-lived assets are all in the U.S.

 

3. Merger, Transfer of Generating Assets and Sales of Other Assets

Acquisitions. Duke Energy Ohio consolidates assets and liabilities from acquisitions as of the purchase date, and includes earnings from acquisitions in consolidated earnings after the purchase date. Assets acquired and liabilities assumed are recorded at estimated fair values on the date of acquisition. The purchase price minus the estimated fair value of the acquired assets and liabilities meeting the definition of a business as defined in EITF Issue No. 98-3, “Determining Whether a Nonmonetary Transaction Involves Receipt of Productive Assets or of a Business” (EITF 98-3), is recorded as goodwill. The allocation of the purchase price may be adjusted if additional, requested information is received during the allocation period, which generally does not exceed one year from the consummation date, however, it may be longer for certain income tax items. As discussed in Note 1, effective January 1, 2009, Duke Energy Ohio adopted SFAS No. 141(R) and will apply the provisions of this standard to any future acquisitions.

Cinergy Merger. On April 3, 2006, the merger between Duke Energy and Cinergy was consummated (see Note 1 for additional information on the merger, purchase accounting and Predecessor and Successor reporting). For accounting purposes, the effective date of the merger was April 1, 2006. The merger combined the Duke Energy and Cinergy regulated franchises as well as deregulated generation in the Midwestern United States.

Based on the market price of Duke Energy common stock during the period, including the two trading days before, through the two trading days after, May 9, 2005, the date Duke Energy and Cinergy announced the merger, the transaction was valued at approximately $9,115 million and resulted in goodwill recorded at Duke Energy Ohio at the time of the merger of approximately $2,348 million.

As discussed in Note 1, purchase accounting impacts, including goodwill recognition, have been “pushed down” to Duke Energy Ohio, resulting in the assets and liabilities of Duke Energy Ohio being recorded at their respective fair values as of April 3, 2006. The following unaudited consolidated pro forma financial results for Duke Energy Ohio are presented as if the merger with Duke Energy had occurred at the beginning of 2006:

 

Unaudited Consolidated Pro Forma Results (Predecessor)

     Three Months Ended
March 31, 2006
     (in millions)

Operating revenues

   $ 966

Income from continuing operations

     88

Net income

     86

Earnings available for common stockholder

     86

Pro forma results for the nine months ended December 31, 2006 are not presented since the merger occurred at the beginning of such period. Additionally, pro forma results do not include any significant transactions completed by Duke Energy Ohio other than the impact of Cinergy’s merger with Duke Energy.

Prior to consummation of the merger, certain regulatory approvals were received from the state utility commissions and the FERC. See Note 4 for a discussion of the regulatory impacts of the merger.

Transfer of Certain Duke Energy Generating Assets to Duke Energy Ohio. In April 2006, Duke Energy contributed to Duke Energy Ohio its ownership interest in five plants, representing a mix of combined cycle and peaking plants, with a combined capacity of 3,600 MW. The transaction was effective in April 2006 and was accounted for at Duke Energy’s net book value for these assets. The entities holding these generating plants, which were indirect subsidiaries of Duke Energy, were first distributed to Duke Energy, which then contributed them to Cinergy which, in turn, contributed them to Duke Energy Ohio. In the final step, the entities were then merged into Duke Energy Ohio.

 

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The following unaudited consolidated pro forma financial results for Duke Energy Ohio are presented as if the contribution of the Duke Energy generating assets to Duke Energy Ohio had occurred at the beginning of the periods presented:

 

Unaudited Consolidated Pro Forma Results (Predecessor)

     Three Months Ended
March 31, 2006
     (in millions)

Operating revenues

   $ 971

Income from continuing operations

     106

Net income

     104

Earnings available for common stockholder

     104

 

These pro forma results do not include any significant transactions completed by Duke Energy Ohio other than the impact of the transfer of the ownership interest in the five plants as discussed above. As part of this transaction, Duke Energy agreed to reimburse Duke Energy Ohio, on a quarterly basis, through April 2016 in the event of certain cash shortfalls related to the performance of the five plants. Based on the assessment of the performance of the five plants on a quarterly basis during 2008 and 2007, Duke Energy Ohio did not incur any qualifying shortfalls related to the performance of the five plants and thus no cash reimbursement was required from Duke Energy. During the third quarter of 2006, Duke Energy reimbursed Duke Energy Ohio $1.9 million for certain cash shortfalls that occurred during the second quarter of 2006. However, as a result of the calculation pertaining to the third quarter 2006 performance of the five plants, the $1.9 million received by Duke Energy Ohio from Duke Energy was returned to Duke Energy during the fourth quarter of 2006. Duke Energy Ohio accounts for any payments from or return of payments to Duke Energy in Common Stockholder’s Equity as an adjustment to Additional paid-in capital.

Other Asset Sales. For the year ended December 31, 2008, the sale of other assets resulted in approximately $77 million in proceeds and net pre-tax gains of approximately $59 million, which is recorded in Gains (Losses) on Sales of Other Assets and Other, net in the Consolidated Statements of Operations. These gains primarily relate to Commercial Power’s sales of zero cost basis emission allowances.

For the year ended December 31, 2007 and the nine months ended December 31, 2006, the sale of other assets resulted in proceeds of approximately $29 million and $138 million, respectively, and net pre-tax losses of approximately $8 million and $28 million, respectively, recorded in Gains (Losses) on Sales of Other Assets and Other, net in the Consolidated Statements of Operations. These losses primarily relate to Commercial Power’s sales of emission allowances that were written up to fair value in purchase accounting in connection with Duke Energy’s merger with Cinergy in April 2006.

See Note 14 for dispositions related to discontinued operations.

For the three months ended March 31, 2006, the sale of other assets resulted in approximately $105 million in proceeds and net pre-tax gains of approximately $26 million recorded in Gains (Losses) on Sales of Other Assets and Other, net in the Consolidated Statements of Operations. These gains primarily relate to Commercial Power’s sales of emission allowances.

 

4. Regulatory Matters

Regulatory Assets and Liabilities. Substantially all of Franchised Electric and Gas’ operations and certain portions of Commercial Power’s operations apply the provisions of SFAS No. 71. Accordingly, these businesses record assets and liabilities that result from the regulated ratemaking process that would not be recorded under GAAP for non-regulated entities. See Note 1 for further information.

 

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Duke Energy Ohio’s Regulatory Assets and Liabilities:

 

     As of December 31,    Recovery/Refund
Period Ends
 
      2008    2007   
     (in millions)       

Regulatory Assets(a)

        

Regulatory Transition Charges (RTC)(d)(e)

   $ 138    $ 239    2011  

Accrued pension and post-retirement(e)

     191      120    (b )

Net regulatory asset related to income taxes

     103      90    ( i)

Capital-related distribution costs(e)

     15      22    (m )

Unamortized costs of reacquiring debt (f)

     10      11    2025  

Vacation accrual(g)

     12      10    2009  

Deferred operating expense(e)(c)

     8      7    2067  

Hedge costs and other deferrals(h)(n)

     106      5    2009  

Storm cost deferrals(e)

     36         (b )

Other(h)

     15      9    (b )
                

Total Regulatory Assets

   $ 634    $ 513   
                

Regulatory Liabilities(a)

        

Removal costs(c)(k)

   $ 189    $ 181    (j )

Accrued pension and post-retirement(k)

          27    (b )

Over-recovery of fuel costs(l)

     36      1    2009  

Other(l)

     29      7    (b )
                

Total Regulatory Liabilities

   $ 254    $ 216   
                

 

(a) All regulatory assets and liabilities are excluded from rate base unless otherwise noted.
(b) Recovery/Refund period currently unknown.
(c) Included in rate base.
(d) The state of Ohio passed comprehensive electric deregulation legislation in 1999, and in 2000, the PUCO approved a stipulation agreement relating to Duke Energy Ohio’s transition plan creating a RTC designed to recover Duke Energy Ohio’s generation-related regulatory assets and transition costs over a ten-year period beginning January 1, 2001.
(e) Included in Other within Regulatory Assets and Deferred Debits on the Consolidated Balance Sheets.
(f) Included in Deferred Debt Expense on the Consolidated Balance Sheets.
(g) Included in Other within Current Assets on the Consolidated Balance Sheets.
(h) Included in Other within Current Assets and Other within Regulatory Assets and Deferred Debits on the Consolidated Balance Sheet.
(i) Recovery/refund is over the life of the associated asset or liability.
(j) Liability is extinguished over the lives of the associated assets.
(k) Included in Other within Deferred Credits and Other Liabilities on the Consolidated Balance Sheets.
(l) Included in Accounts Payable or Other within Deferred Credits and Other Liabilities on the Consolidated Balance Sheets.
(m) Recovered via revenue rider.
(n) Approximately $95 million of the balance at December 31, 2008 relates to mark-to-market deferrals associated with open hedge positions at Commercial Power as a result of the reapplication of SFAS No. 71.

 

Regulatory Merger Approvals. On April 3, 2006, the merger between Duke Energy and Cinergy was consummated to create a newly-formed company, Duke Energy Holding Corp. (subsequently renamed Duke Energy Corporation). As a condition to the merger approval, the PUCO and the Kentucky Public Service Commission (KPSC) required that certain merger related savings be shared with consumers in Ohio and Kentucky, respectively. The commissions also required Duke Energy Ohio and Duke Energy Kentucky to meet additional conditions. Key elements of these conditions include:

   

The PUCO required that Duke Energy Ohio provide (i) a rate reduction of approximately $15 million for one year to facilitate economic development in a time of increasing rates and market prices and (ii) a reduction of approximately $21 million to its gas and electric consumers in Ohio for one year, with both credits beginning January 1, 2006. During the first quarter of 2007, Duke Energy Ohio completed its merger related rate reductions and filed a report with the PUCO to terminate the merger credit riders. Approximately $2 million and $34 million of the rate reductions was passed through to customers during the year ended December 31, 2007 and 2006, respectively.

 

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The KPSC required that Duke Energy Kentucky provide $8 million in rate reductions to its customers over five years, ending when new rates are established in the next rate case after January 1, 2008. Approximately $2 million of the rate reduction was passed through to customers during the years ended December 31, 2008, 2007 and 2006, respectively.

   

The FERC approved the merger without conditions.

Restrictions on the Ability of Duke Energy Ohio to Make Dividends, Advances and Loans to Duke Energy Corporation. As discussed above, on April 3, 2006, the merger between Duke Energy and Cinergy was consummated. As a condition of the merger approval the state utility commissions imposed conditions (the Merger Conditions) on the ability of Duke Energy Ohio and Duke Energy Kentucky to transfer funds to Duke Energy through loans or advances, as well as restricted amounts available to pay dividends to Duke Energy. Pursuant to the Merger Conditions, Duke Energy Ohio will not declare and pay dividends out of capital or unearned surplus without the prior authorization of the PUCO and Duke Energy Kentucky is required to pay dividends solely out of retained earnings and to maintain a minimum of 35% equity in its capital structure. At December 31, 2008, Duke Energy Ohio had restricted net assets of approximately $6.3 billion that may not be transferred to Duke Energy without appropriate approval based on the aforementioned Merger Conditions.

 

Franchised Electric and Gas.

Rate Related Information. The KPSC approves rates for retail electric and gas services within the Commonwealth of Kentucky. The PUCO approves rates and market prices for retail gas and electric service within the state of Ohio, except that non-regulated sellers of gas and electric generation also are allowed to operate in Ohio (see “Commercial Power” below). The FERC approves rates for electric sales to wholesale customers served under cost-based rates.

Duke Energy Ohio Electric Rate Filings. Duke Energy Ohio operated under a RSP, a market-based standard service approved by the PUCO in November 2004, from January 1, 2005 through December 31, 2008. In March 2005, the Office of the Ohio Consumers’ Counsel (OCC) appealed the PUCO’s approval of the RSP to the Supreme Court of Ohio which issued its decision in November 2006. It upheld the RSP in virtually every respect but remanded to the PUCO on two issues. The Supreme Court of Ohio ordered the PUCO to support a certain portion of its order with reasoning and record evidence and to require Duke Energy Ohio to disclose certain confidential commercial agreements with other parties previously requested by the OCC. Duke Energy Ohio has complied with the disclosure order.

In October 2007, the PUCO issued its ruling affirming the RSP, with certain modifications, and maintained the then current price. The ruling provided for continuation of the existing rate components, including the recovery of costs related to new pollution control equipment and capacity costs associated with power purchase contracts to meet customer demand, but provided customers an enhanced opportunity to avoid certain pricing components if they are served by a competitive supplier. The ruling also attempted to modify the statutory requirement that Duke Energy Ohio transfer its generating assets to an exempt wholesale generator (EWG) and ordered Duke Energy Ohio to retain ownership for the remainder of the RSP period. The ruling also incorrectly implied that Duke Energy Ohio’s non-residential RTC will terminate at the end of 2008. On November 23, 2007, Duke Energy Ohio filed an application for rehearing on the portions of the PUCO’s ruling relating to whether certain pricing components may be avoided by customers, the right to transfer generating assets, and the termination date of the RTC. On December 19, 2007, the PUCO issued its Entry on Rehearing granting in part and denying in part Duke Energy Ohio’s Application for Rehearing. Among other things, the PUCO modified and clarified the applicability of various rate riders during customer shopping situations. It also clarified that the residential RTC terminates at the end of 2008 and that the non-residential RTC terminates at the end of 2010 and agreed to give further consideration to whether Duke Energy Ohio may transfer its generating assets to an EWG.

On February 15, 2008, Duke Energy Ohio filed a notice of appeal with the Ohio Supreme Court challenging a portion of the PUCO’s decision on remand regarding Duke Energy Ohio’s RSP. The October 2007 order permits non-residential customers to avoid certain charges associated with the costs of Duke Energy Ohio standing ready to serve such customers if they return after being served by another supplier. Duke Energy Ohio believes the PUCO exceeded its authority in modifying the charges that may be avoided, resulting in Duke Energy Ohio having to subsidize Ohio’s competitive electric market. Duke Energy Ohio asked the Ohio Supreme Court to reverse the PUCO ruling and require that non-residential customers pay the charges associated with Duke Energy Ohio standing ready to serve them should they return from a competitive supplier. On March 28, 2008, Duke Energy Ohio voluntarily withdrew its appeal. The OCC filed a notice of appeal challenging the PUCO’s October 2007 decision as unlawful and unreasonable. The OCC and Ohio Partners for Affordable Energy (OPAE) also filed appeals from the PUCO’s November 20, 2007 order approving Duke Energy Ohio’s RSP riders. Duke Energy

 

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Ohio intervened in each appeal. Pending the Ohio Supreme Court’s consideration of its initial appeal, the OCC requested that the PUCO stay implementation of the Infrastructure Maintenance Fund charge to be collected from customers approved in the October 2007 order. The Commission denied the OCC’s request and the OCC filed a similar request with the Ohio Supreme Court. On July 9, 2008, the court denied the OCC’s request to stay implementation of the Infrastructure Maintenance Fund. On April 30, 2008, the Ohio Supreme Court granted Duke Energy Ohio’s motion to intervene in the OCC’s appeal. Oral arguments were conducted on November 18, 2008. On January 2, 2009, the PUCO filed a motion to dismiss the action as moot. The PUCO argued that the rates at issue in this matter expired on January 1, 2009, with the implementation of Duke Energy Ohio’s ESP. On February 19, 2009, the Ohio Supreme Court issued its decision on OCC’s appeal. The Ohio Supreme Court granted the PUCO’s motion to dismiss ruling that because the challenged rate structure is no longer in effect, it can neither order lower prospective rates nor order a refund.

New legislation (SB 221) was passed on April 23, 2008 and signed by the Governor of Ohio on May 1, 2008. The new law codifies the PUCO’s authority to approve an electric utility’s standard service offer through an ESP, which would allow for pricing structures similar to the current RSP. Electric utilities are required to file an ESP and may also file an application for a market rate option (MRO) at the same time. The MRO is a price determined through a competitive bidding process. If a MRO price is approved, the utility would blend in the RSP or ESP price with the MRO price over a six- to ten-year period, subject to the PUCO’s discretion. SB 221 provides for the PUCO to approve non-by-passable charges for new generation, including construction work-in-process from the outset of construction, as part of an ESP. The new law grants the PUCO discretion to approve single issue rate adjustments to distribution and transmission rates and establishes new alternative energy resources (including renewable energy) portfolio standards, such that the utility’s portfolio must consist of at least 25% of these resources by 2025. SB 221 also provides a separate requirement for energy efficiency, which must reduce 22% of a utility’s load by 2025. The utility’s earnings under the ESP can be subject to an annual earnings test and the PUCO must order a refund if it finds that the utility’s earnings significantly exceed the earnings of benchmark companies with similar business and financial risks. The earnings test acts as a cap to the ESP price. SB 221 also limits the ability of a utility to transfer its designated generating assets to an EWG absent PUCO approval.

On July 31, 2008, Duke Energy Ohio filed a new generation pricing formula to be effective January 1, 2009, when the current RSP expired. Among other things, the plan provides pricing mechanisms for compensation related to the advanced energy, renewables and energy efficiency portfolio standards established by SB 221.

On October 27, 2008, Duke Energy Ohio filed a Stipulation and Recommendation (Stipulation) for consideration by the PUCO regarding Duke Energy Ohio’s July 31, 2008 ESP filing. The Stipulation reflects agreement on all but two issues in this proceeding and was filed with the support of most of the parties to this proceeding. In addition to the Stipulation, the ability for residential governmental aggregation customers to avoid certain charges and to receive a shopping credit will be presented to the PUCO for a ruling. Parties to this proceeding who do not support the Stipulation were free to litigate any, or all, issues.

The Stipulation agrees to a net increase in base generation revenues of approximately $36 million, $74 million and $98 million in 2009, 2010 and 2011, respectively, including termination of the residential and non-residential RTC. Such amounts result in a residential net rate increase of 2% in 2009 and in 2010, and a non-residential net rate increase of 2% in 2009, 2010 and 2011. The Stipulation also allows the recovery of expenditures incurred to deploy SmartGrid infrastructure modernization technology on the distribution system. The recovery of such expenditures, net of savings, is subject to an annual residential revenue cap. Further, the Stipulation allows for the implementation of a new energy efficiency compensation model, referred to as Save-A-Watt, to achieve the energy efficiency mandate pursuant to the recent electric energy legislation. The criteria customers must meet to be exempt from Duke Energy Ohio’s program will also presented to the PUCO for a ruling in this case. Also, under the Stipulation, Duke Energy Ohio may defer up to $50 million of certain operation and maintenance costs incurred at the W.C. Beckjord generating station and amortize such costs over a three-year period.

The ESP hearing occurred on November 10, 2008. On December 17, 2008, the PUCO issued its finding and order resolving the two litigated issues and adopting a modified Stipulation. Specifically, the PUCO modified the Stipulation to permit certain non-residential customers to opt out of utility-sponsored energy efficiency initiatives and to allow residential governmental aggregation customers who leave Duke Energy Ohio’s system to avoid some charges. Applications for rehearing of the PUCO’s decision have been filed by environmental groups and a residential customer advocate group. On February 11, 2009 the PUCO issued an Entry denying the rehearing requests.

As discussed further below within “Commercial Power” and in Note 1, as a result of the approval of the ESP, effective December 17, 2008, Commercial Power reapplied the provisions of SFAS No. 71 to certain portions of its operations.

 

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Duke Energy Ohio Gas Rate Case. In July 2007, Duke Energy Ohio filed an application with the PUCO for an increase in its base rates for gas service. Duke Energy Ohio sought an increase of approximately $34 million in revenue, or approximately 5.7%, to be effective in the spring of 2008. The application also requested approval to continue tracker recovery of costs associated with the accelerated gas main replacement program. The staff of the PUCO issued a Staff Report in December 2007 recommending an increase of approximately $14 million to $20 million in revenue. The Staff Report also recommended approval for Duke Energy Ohio to continue tracker recovery of costs associated with the accelerated gas main replacement program. On February 28, 2008, Duke Energy Ohio reached a settlement agreement with the PUCO Staff and all of the intervening parties on its request for an increase in natural gas base rates. The settlement called for an annual revenue increase of approximately $18 million in base revenue, or 3% over current revenue, permitted continued recovery of costs through 2018 for Duke Energy Ohio’s accelerated gas main replacement program and permitted recovery of carrying costs on gas stored underground via its monthly gas cost adjustment filing. The settlement did not resolve a proposed rate design for residential customers, which involved moving more of the fixed charges of providing gas service, such as capital investment in pipes and regulating equipment, billing and meter reading, from the per unit charges to the monthly charge. On May 28, 2008, the PUCO approved the settlement in its entirety and the proposed rate design. On June 28, 2008, the OCC and OPAE filed Applications for Rehearing opposing the rate design. On July 23, 2008, the Ohio Commission issued an Entry denying the rehearing requests of OCC and OPAE. On September 16 and 19, 2008 respectively, OCC and OPAE filed their notices of appeal to the Ohio Supreme Court opposing the residential rate design issue. Merit briefs were filed with the Ohio Supreme Court on February 2, 2009. At this time, Duke Energy Ohio cannot predict whether the Ohio Supreme Court will reverse the PUCO’s decision of May 28, 2008.

Duke Energy Ohio Electric Distribution Rate Case. On June 25, 2008, Duke Energy Ohio filed notice with the PUCO that it will seek a rate increase for electric delivery service of approximately $86 million, or 4.8% on total electric revenues, to be effective in the second quarter of 2009. Among other things, the rate request includes a proposal to increase the monthly residential customer charge from $4.50 to $10, with an offsetting reduction in the usage-based charge. This change in rate design will make customer bills more even throughout the year. Duke Energy Ohio also proposes a distribution modernization tracker that would allow smaller annual increases to reflect increased investment in the delivery system. On December 22, 2008, Duke Energy Ohio filed an application requesting deferral of approximately $31 million related to damage to its distribution system from a September 14, 2008 windstorm. On January 14, 2009, the PUCO granted Duke Energy Ohio’s deferral request. Accordingly, a regulatory asset was recorded as of December 31, 2008 for $31 million. The staff of the PUCO issued a Staff Report in January 2009 recommending an increase of approximately $54 million to $62 million associated with the Ohio distribution rate case. The staff report did not recommend approval of the distribution modernization tracker. The report also recommended approval of a rider to recover the deferred storm costs from the September 14, 2008 windstorm and recommended a future hearing be established to evaluate the windstorm related costs and implement a rider. An evidentiary hearing with the PUCO is scheduled to begin March 31, 2009.

Duke Energy Kentucky Gas Rate Cases. In 2002, the KPSC approved Duke Energy Kentucky’s gas base rate case which included, among other things, recovery of costs associated with an accelerated gas main replacement program. The approval authorized a tracking mechanism to recover certain costs including depreciation and a rate of return on the program’s capital expenditures. The Kentucky Attorney General appealed to the Franklin Circuit Court the KPSC’s approval of the tracking mechanism as well as the KPSC’s subsequent approval of annual rate adjustments under this tracking mechanism. In 2005, both Duke Energy Kentucky and the KPSC requested that the court dismiss these cases.

In February 2005, Duke Energy Kentucky filed a gas base rate case with the KPSC requesting approval to continue the tracking mechanism and for a $14 million annual increase in base rates. A portion of the increase is attributable to recovery of the current cost of the accelerated gas main replacement program in base rates. In June 2005, the Kentucky General Assembly enacted Kentucky Revised Statue 278.509 (KRS 278.509), which specifically authorizes the KPSC to approve tracker recovery for utilities’ gas main replacement programs. In December 2005, the KPSC approved an annual rate increase of $8 million and re-approved the tracking mechanism through 2011. In February 2006, the Kentucky Attorney General appealed the KPSC’s order to the Franklin Circuit Court, claiming that the order improperly allows Duke Energy Kentucky to increase its rates for gas main replacement costs in between general rate cases, and also claiming that the order improperly allows Duke Energy Kentucky to earn a return on investment for the costs recovered under the tracking mechanism which permits Duke Energy Kentucky to recover its gas main replacement costs.

In August 2007, the Franklin Circuit Court consolidated all the pending appeals and ruled that the KPSC lacks legal authority to approve the gas main replacement tracking mechanism, which were approved prior to the enactment of KRS 278.509. To date, Duke Energy Kentucky has collected approximately $9 million in annual rate adjustments under the tracking mechanism. Per the KPSC order,

 

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Duke Energy Kentucky collected these revenues subject to refund pending the final outcome of this litigation. Duke Energy Kentucky and the KPSC have requested that the Kentucky Court of Appeals grant a rehearing of its decision. On February 5, 2009, the Kentucky Court of Appeals denied the rehearing requests of both Duke Energy Kentucky and the KPSC. Duke Energy Kentucky filed a motion for discretionary review to the Kentucky Supreme Court on March 9, 2009. At this time, Duke Energy Kentucky cannot predict whether the Kentucky Supreme Court will accept the case for review.

Energy Efficiency. On July 11, 2007, the PUCO approved Duke Energy Ohio’s Demand Side Management/Energy Efficiency Program (DSM Program). The DSM programs were first proposed in 2006 and were endorsed by the Duke Energy Community Partnership, which is a collaborative group made up of representatives of organizations interested in energy conservation, efficiency and assistance to low-income customers. The program costs are recouped through a cost recovery mechanism that will be adjusted annually to reflect the previous year’s activity. Duke Energy Ohio is permitted to recover lost revenues, program costs and shared savings (once the programs reach 65% of the targeted savings level) through the cost recovery mechanism based upon impact studies to be provided to the Staff of the PUCO. Duke Energy Ohio filed the Save-A-Watt Energy Efficiency Plan as part of its ESP filed with the PUCO on July 31, 2008 (discussed above). A Stipulation and Recommendation for consideration by the PUCO regarding Duke Energy Ohio’s ESP filing, including implementation of Save-A-Watt, was filed on October 27, 2008. The ESP hearing occurred on November 10, 2008. On December 17, 2008, the PUCO approved the ESP, including allowing for the implementation of a new Save-A-Watt energy efficiency compensation model. However, the PUCO determined that certain non-residential customers may opt out of Duke Energy Ohio’s energy efficiency initiative. Applications for rehearing of this decision have been filed by environmental groups and a residential customer advocate group.

On November 15, 2007, Duke Energy Kentucky filed its annual application to continue existing energy efficiency programs, consisting of nine residential and two commercial and industrial programs, and to true-up its gas and electric tracking mechanism for recovery of lost revenues, program costs and shared savings. On February 11, 2008, Duke Energy Kentucky filed a motion to amend its energy efficiency programs and applied to reinstitute a low income Home Energy Assistance Program. The KPSC bifurcated the proposed Home Energy Assistance Program from the other energy efficiency programs. On May 14, 2008, the KPSC approved the energy efficiency programs. On September 25, 2008, the KPSC approved Duke Energy Kentucky’s Home Energy Assistance program, making it available for customers at or below 150% of the federal poverty level. On December 1, 2008, Duke Energy Kentucky filed an application for a Save-A-Watt Energy Efficiency Plan. The application seeks a new energy efficiency recovery mechanism similar to what was proposed in Ohio. An evidentiary hearing with the KPSC is expected to occur in the third quarter of 2009.

 

Other Franchised Electric and Gas Matters.

 

Ohio Riser Leak Investigation. In April 2005, the PUCO issued an order opening a statewide investigation into riser leaks in gas pipeline systems throughout Ohio. The investigation followed four explosions since 2000 caused by gas riser leaks, including an April 2000 explosion in Duke Energy Ohio’s service area. In November 2006, the PUCO Staff released the expert report, which concluded that certain types of risers are prone to leaks under various conditions, including over-tightening during initial installation. The PUCO Staff recommended that natural gas companies continue to monitor the situation and study the cause of any further riser leaks to determine whether further remedial action is warranted. As of January 1, 2008, Duke Energy Ohio had approximately 87,000 of these risers on its distribution system. If the PUCO orders natural gas companies to replace all of these risers, Duke Energy Ohio estimates a replacement cost of approximately $40 million. As part of the rate case filed in July 2007 (see “Duke Energy Ohio Gas Rate Case” above), Duke Energy Ohio requested approval from the PUCO to accelerate its riser replacement program. The riser replacement program is contained in the settlement reached with all intervenors and expected to be completed at the end of 2012.

Midwest Independent Transmission System Operator, Inc. (Midwest ISO) Resource Adequacy Filing. On December 28, 2007, the Midwest ISO filed its Electric Tariff Filing Regarding Resource Adequacy in compliance with the FERC’s request of Midwest ISO to file Phase II of its long-term Resource Adequacy plan by December 2007. The proposal includes establishment of a resource adequacy requirement in the form of planning reserve margin. On March 26, 2008, the FERC ruled on the Midwest ISO’s Resource Adequacy filing and ordered that the new Module E tariff be effective March 27, 2008. This action established a Midwest ISO-wide resource adequacy requirement for the first Planning Year, which begins June 2009. In the Order, the FERC, among other things, clarified that States have the authority to set their own Planning Reserve Margins, as long as they are not inconsistent with any reliability standard approved by the FERC.

 

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Midwest ISO’s Establishment of an Ancillary Services Market. On February 25, 2008, the FERC conditionally accepted the Midwest ISO proposal to implement a day-ahead and real-time ancillary services market (ASM), including a scarcity pricing proposal. By approving the ASM proposal, the FERC essentially approved the transfer and consolidation of Balancing Authority for the entire Midwest ISO area. This will allow the Midwest ISO to determine operating reserve requirements and procure operating reserves from all qualified resources from an organized market, in place of the current system of local management and procurement of reserves by the 24 Balancing Authorities. The Midwest ISO launched the ASM on January 6, 2009.

 

Commercial Power.

As discussed in Note 1, effective December 17, 2008, Commercial Power reapplied the provisions of SFAS No. 71 to certain portions of its operations due to the passing of SB 221 and the PUCO’s approval of the ESP. However, since certain portions of Commercial Power’s operations are not subject to regulatory accounting pursuant to SFAS No. 71, reported results for Commercial Power are subject to volatility due to the over- or under-collection of certain costs for which recovery is not automatic under the ESP. Commercial Power may be impacted by certain of the regulatory matters discussed above, including the Duke Energy Ohio electric rate filings.

FERC 203 Application. On April 23, 2008 (supplemented on May 6, 2008), Duke Energy Ohio and certain affiliates filed an application with the FERC requesting approval to transfer Duke Energy Ohio’s electric generating facilities, some of which are designated to serve Ohio customers, to affiliate companies. The FERC filing, if approved, does not obligate Duke Energy to make the transfer of the electric generating facilities, and does not impact Duke Energy Ohio’s current rates. On October 10, 2008, Duke Energy Ohio and affiliates filed a notice with the FERC reporting that Duke Energy Ohio was in settlement discussions with all parties in the Ohio proceeding regarding Duke Energy Ohio’s application to establish an ESP, as discussed above. Duke Energy Ohio advised the FERC that it believes that in light of those discussions good cause exists for the FERC to extend the time to consider Duke Energy Ohio’s Section 203 application. On October 17, 2008, the FERC issued an order extending the time for the FERC to act on the application by 180 additional days, and ordered Duke Energy Ohio to inform the FERC of the status of settlement discussions by November 16, 2008. As part of the settlement that was approved by the PUCO on December 17, 2008 (see discussion above) Duke Energy Ohio agreed to withdraw that portion of its application for approval related to the transfer of its generating facilities designated to serve Ohio customers and the PUCO approved of the transfer for the remaining generating facilities. Duke Energy Ohio filed a new application requesting FERC approval to transfer to affiliate companies only the remaining generating facilities not designated to serve Ohio customers, which was conditionally approved by the FERC on February 19, 2009. As a condition of approval, the FERC requires that all acquisition premiums related to generating assets being transferred to Cinergy Power be removed from Duke Energy Ohio’s financial statements when Duke Energy Ohio submits its final accounting entries and that any debt associated with the generation assets being transferred be transferred to the generating facility before Duke Energy Ohio submits its final accounting entries. In addition, the FERC will hold Duke Energy Ohio to its commitments to have the affiliate company receiving assets pay taxes associated with the proposed transaction rather than Duke Energy Ohio, to maintain a minimum equity to total capital ratio of 30%, and to retain an amount of debt that will accommodate the preservation of Duke Energy Ohio’s current credit ratings.

PJM Interconnection Reliability Pricing Model (RPM) Buyers’ Complaint. On May 30, 2008, a group of public utility commissions, state consumer counsels, industrial power customers and load serving entities, known collectively as the RPM Buyers, filed a complaint at FERC. The complaint asks FERC to find that the results of the three transitional base residual auctions conducted by PJM to procure capacity for its RPM capacity market during the years 2008-2011 are unjust and unreasonable because, allegedly, they have produced excessive capacity prices, have failed to prevent suppliers from exercising market power, and have not produced benefits commensurate with costs. In their complaint, the RPM Buyers propose revised, administratively determined auction clearing prices. Certain Duke Energy Ohio revenues during the years 2008-2011 are at risk, as Duke Energy Ohio planned to supply capacity to this market. On July 11, 2008, Duke Energy Ohio filed a response to the complaint with the FERC. On September 19, 2008, the FERC issued an Order denying and dismissing the RPM Buyer’s complaint, finding that, for the transition auctions, no party violated PJM’s tariff and the prices determined during the auctions were in accordance with the tariff provisions governing the auctions. On October 20, 2008, the RPM Buyers filed a Request for Rehearing with the FERC that raised the same issues as in the initial complaint that was denied by the FERC.

 

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Other Matters.

Application for the Establishment of a Regulatory Asset. On November 14, 2008, Duke Energy Kentucky petitioned the KPSC for permission to create a regulatory asset to defer for future recovery approximately $5 million for its expenses incurred to repair damage and restore service to its customers following extensive storm-related damage caused by Hurricane Ike on September 14, 2008. The KPSC approved the requested accounting order on January 7, 2009.

 

5. Joint Ownership of Generating and Transmission Facilities

Duke Energy Ohio, Columbus Southern Power Company (CSP), and Dayton Power & Light (DP&L) jointly own electric generating units and related transmission facilities in Ohio. Duke Energy Kentucky and DP&L jointly own an electric generating unit. Duke Energy Ohio and Wabash Valley Power Association Inc. jointly own the Vermillion generating station in Indiana.

Duke Energy Ohio’s share of jointly-owned plant or facilities included on the December 31, 2008 Consolidated Balance Sheet were as follows:

 

     Ownership
Share
    Property, Plant,
and Equipment
   Accumulated
Depreciation
   Construction Work
in Progress
     (in millions)

Duke Energy Ohio

          

Production:

          

Miami Fort Station (Units 7 and 8)(b)

   64.0 %   $ 591    $ 160    $ 4

W.C. Beckjord Station (Unit 6)(b)

   37.5       55      31      1

J.M. Stuart Station(a)(b)

   39.0       426      200      342

Conesville Station (Unit 4)(a)(b)

   40.0       82      56      174

W.M. Zimmer Station(b)

   46.5       1,321      509      10

Killen Station(a)(b)

   33.0       207      128      96

Vermillion(b)

   75.0       197      47     

Transmission(c)

   Various       90      51     

Duke Energy Kentucky

          

Production:

          

East Bend Station(c)

   69.0       423      219      5

 

(a) Station is not operated by Duke Energy Ohio.
(b) Included in Commercial Power segment.
(c) Included in Franchised Electric and Gas segment.

Duke Energy Ohio’s share of revenues and operating costs of the above jointly owned generating facilities are included within the corresponding line on the Consolidated Statements of Operations. Each participant in the jointly owned facilities must provide its own financing.

 

6. Income Taxes

Prior to the merger of Cinergy and Duke Energy on April 3, 2006, the taxable income of Duke Energy Ohio was reflected in Cinergy’s U.S. federal and state income tax returns. After the merger, the taxable income of Duke Energy Ohio is reflected in Duke Energy’s U.S. federal and state income tax returns. As a result of Duke Energy’s merger with Cinergy, Duke Energy Ohio entered into a tax sharing agreement with Duke Energy, where the separate return method is used to allocate tax expenses and benefits to the subsidiaries whose investments or results of operations provide these tax expenses and benefits. The accounting for income taxes essentially represents the income taxes that Duke Energy Ohio would incur if Duke Energy Ohio were a separate company filing its own tax return as a C-Corporation. The current tax sharing agreement Duke Energy Ohio has with Duke Energy is substantially the same as the tax sharing agreement between Duke Energy Ohio and Cinergy prior to the merger.

 

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The following details the components of income tax expense from continuing operations:

 

Income Tax Expense

 

     Successor(a)           Predecessor(a)  
     Year Ended
December 31, 2008
    Year Ended
December 31, 2007
    Nine Months Ended
December 31, 2006
          Three Months Ended
March 31, 2006
 
     (in millions)              

Current income taxes

             

Federal

   $ 110     $ 120     $ 139          $ 55  

State

     9       13       22            6  
                                     

Total current income taxes(b)

     119       133       161            61  
                                     

Deferred income taxes

             

Federal

     52       19       (100 )          11  

State

     2       1       (18 )          (3 )
                                     

Total deferred income taxes

     54       20       (118 )          8  
                                     

Investment tax credit amortization

     (2 )     (2 )     (2 )          (1 )
                                     

Total income tax expense from continuing operations

     171       151       41            68  

Total income tax benefit from discontinued operations

                 (3 )          (1 )

Total income tax expense from extraordinary item

     37                         
                                     

Total income tax expense included in Consolidated Statements of Operations

   $ 208     $ 151     $ 38          $ 67  
                                     

 

(a) See Note 1 for additional information on Predecessor and Successor reporting.
(b) Included are FIN 48 benefits of approximately $17 million in 2008 and $13 million in 2007.

 

Reconciliation of Income Tax Expense at the U.S. Federal Statutory Tax Rate to the Actual Tax Expense from Continuing Operations (Statutory Rate Reconciliation)

 

     Successor(a)           Predecessor(a)  
     Year Ended
December 31, 2008
    Year Ended
December 31, 2007
    Nine Months Ended
December 31, 2006
          Three Months Ended
March 31, 2006
 
     (in millions)              

Income tax expense, computed at the statutory rate of 35%

   $ 160     $ 145     $ 36          $ 65  

State income tax, net of federal income tax effect

     7       9       3            2  

Depreciation and other PP&E related differences

     7       9       6            2  

ITC amortization

     (2 )     (2 )     (2 )          (1 )

Manufacturing deduction

     (6 )     (10 )     (2 )           

Other items, net

     5                         
                                     

Total income tax expense from continuing operations

   $ 171     $ 151     $ 41          $ 68  
                                     

Effective Tax Rates

     37.3 %     36.4 %     40.2 %          36.6 %
                                     

 

(a) See Note 1 for additional information on Predecessor and Successor reporting.

 

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The manufacturing deduction was created by the American Job Creation Act of 2004 (the Act). The Act provides a deduction for income from qualified domestic production activities. During the year ended December 31, 2006, the Act provided for a 3% deduction on qualified production activities. During the years ended December 31, 2008 and 2007, the deduction increased to 6% on qualified production activities.

 

Net Deferred Income Tax Liability Components

 

     As of
December 31,
 
     2008     2007  
     (in millions)  

Deferred credits and other liabilities

   $ 13     $ 100  

Other

     52       54  
                

Total deferred income tax assets

     65       154  
                

Investments and other assets

     (111 )     (68 )

Accelerated depreciation rates

     (1,373 )     (1,311 )

Regulatory assets and deferred debits

     (142 )     (195 )
                

Total deferred income tax liabilities

     (1,626 )     (1,574 )
                

Total net deferred income tax liabilities

   $ (1,561 )   $ (1,420 )
                

The above amounts have been classified in the Consolidated Balance Sheets as follows:

 

Net Deferred Income Tax Liabilities

 

     As of
December 31,
 
     2008     2007  
     (in millions)  

Current deferred tax assets, included in other current assets

   $ 64     $ 26  

Current deferred tax liabilities, included in other current liabilities

     (6 )     (10 )

Non-current deferred tax liabilities

     (1,619 )     (1,436 )
                

Total net deferred income tax liabilities

   $ (1,561 )   $ (1,420 )
                

 

Changes to Unrecognized Tax Benefits

 

     2008     2007  
     Increase/
(Decrease)
    Increase/
(Decrease)
 
     (in millions)     (in millions)  

Unrecognized Tax Benefits—January 1

   $ 47     $ 63  
                

Unrecognized Tax Benefits Changes

    

Gross increases—tax positions in prior periods

           9  

Gross decreases—tax positions in prior periods

     (22 )     (19 )

Gross increases—current period tax positions

            

Settlements

     (10 )     (6 )
                

Total Changes

     (32 )     (16 )
                

Unrecognized Tax Benefits—December 31

   $ 15     $ 47  
                

At December 31, 2008 and December 31, 2007, no portion of the total unrecognized tax benefits would, if recognized, affect the effective tax rate.

 

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It is reasonably possible that Duke Energy Ohio will reflect an approximate $6 million reduction in unrecognized tax benefits within the next twelve months due to expected settlements.

During the years ended December 31, 2008 and December 31, 2007, Duke Energy Ohio recognized net interest income of approximately $7 million and a net interest expense of approximately $2 million, respectively. At December 31, 2008 and December 31, 2007, Duke Energy Ohio had approximately $1 million of interest receivable and $7 million of interest payable, respectively, which reflects all interest related to income taxes. No amount has been accrued for the payment of penalties in the Consolidated Balance Sheets at either December 31, 2008 or 2007.

Duke Energy Ohio has the following tax years open:

 

Jurisdiction    Tax Years

Federal

   2000 and after

State

   Closed through 2001, with the exception of any adjustments related to open federal years

As of December 31, 2008 and 2007, approximately $64 million and $26 million, respectively, of deferred income taxes were included in Other within Current Assets on the Consolidated Balance Sheets. At December 31, 2008 this balance exceeded 5% of total current assets.

 

7. Asset Retirement Obligations

Asset retirement obligations, which represent legal obligations associated with the retirement of certain tangible long-lived assets, are computed as the present value of the projected costs for the future retirement of specific assets and are recognized in the period in which the liability is incurred, if a reasonable estimate of fair value can be made. The present value of the liability is added to the carrying amount of the associated asset in the period the liability is incurred. This additional carrying amount is then depreciated over the life of the asset. Subsequent to the initial recognition, the liability is adjusted for any revisions to the estimated future cash flows associated with the asset retirement obligation (with corresponding adjustments to property, plant and equipment), which can occur due to a number of factors including, but not limited to, cost escalation, changes in technology applicable to the assets to be retired and changes in federal, state or local regulations, as well as for accretion of the liability due to the passage of time until the obligation is settled. Depreciation expense is adjusted prospectively for any increases or decreases to the carrying amount of the associated asset. There is no impact on the earnings of Duke Energy Ohio’s regulated operations within the Franchised Electric and Gas business segment when an asset retirement obligation is recognized as the effects of the recognition and subsequent accounting are offset by the establishment of regulatory assets and liabilities to defer all income statement impacts related to SFAS No. 143.

Asset retirement obligations at Duke Energy Ohio relate primarily to the retirement of gas mains, asbestos abatement at certain generating stations and closure and post-closure activities of landfills. In accordance with SFAS No. 143, Duke Energy Ohio identified certain assets that have an indeterminate life, and thus the fair value of the retirement obligation is not reasonably estimable. These assets included transmission pipelines. A liability for these asset retirement obligations will be recorded when a fair value is determinable.

The following table presents the changes to liability associated with asset retirement obligations during the years ended December 31, 2008 and 2007:

 

     Years Ended
December 31,
 
     2008    2007  
     (in millions)  

Balance as of January 1,

   $ 31    $ 41  

Accretion expense

     2      2  

Liabilities settled(a)

          (12 )
               

Balance as of December 31,

   $ 33    $ 31  
               

 

(a) Liabilities settled during 2007 were related to the retirement of gas mains.

 

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Duke Energy Ohio’s regulated electric and regulated natural gas operations accrue costs of removal for property that does not have an associated legal retirement obligation based on regulatory orders from the PUCO and the KPSC. These costs of removal are recorded as a regulatory liability in accordance with regulatory treatment under SFAS No. 71. Duke Energy Ohio does not accrue the estimated cost of removal when no legal obligation associated with retirement or removal exists for any non-regulated assets (including Duke Energy Ohio’s generation assets). The total amount of removal costs included in Other within Deferred Credits and Other Liabilities on the Consolidated Balance Sheets was $189 million and $181 million as of December 31, 2008 and 2007, respectively. Duke Energy Ohio’s non-regulated operations expense cost of removal as incurred.

 

8. Risk Management and Hedging Activities and Credit Risk

Duke Energy Ohio is exposed to the impact of market fluctuations in the prices of electricity, coal, natural gas and other energy-related products marketed and purchased within its non-regulated operations, as well as within its regulated operations, to the extent there is excess capacity from generation assets that are dedicated to serve Ohio native load customers. Exposure to interest rate risk exists as a result of the issuance of variable and fixed rate debt. Duke Energy Ohio employs established policies and procedures to manage its risks associated with these market fluctuations using various commodity and financial derivative instruments, including swaps, futures, forwards and options. For Duke Energy Ohio, commodity price risk has been somewhat reduced by the December 17, 2008 PUCO approval of Duke Energy Ohio’s ESP, which resulted in the reapplication of SFAS No. 71 to certain portions of Duke Energy Ohio’s Commercial Power business segment operations as of that date.

As discussed in Note 1, on January 1, 2008, Duke Energy Ohio adopted FSP No. FIN 39-1. In accordance with FSP No. FIN 39-1, Duke Energy offsets fair value amounts (or amounts that approximate fair value) recognized on its Consolidated Balance Sheets related to cash collateral amounts receivable or payable against fair value amounts recognized for derivative instruments executed with the same counterparty under the same master netting agreement. Amounts presented in the table below exclude cash collateral amounts which are disclosed separately in Note 1.

 

Net Derivative Portfolio Assets (Liabilities) reflected in the Consolidated Balance Sheets:

 

     Years Ended
December 31,
 
     2008     2007  
     (in millions)  

Hedging

   $ (9 )   $ (23 )

Undesignated

     (70 )     7  
                

Total

   $ (79 )   $ (16 )
                

The amounts in the table above represent the combination of amounts presented as assets and liabilities for unrealized gains and losses on mark-to-market and hedging transactions on Duke Energy Ohio’s Consolidated Balance Sheets.

Transfer of Certain Duke Energy Assets and Commodity Cash Flow Hedges. As part of the merger with Duke Energy on April 3, 2006, Duke Energy Ohio acquired certain generation assets from Duke Energy, representing approximately 3,600 MW of power generation and those assets were added to Duke Energy Ohio’s non-regulated generation portfolio. Duke Energy Ohio also assumed approximately $63 million of pre-tax deferred losses ($39 million, after-tax) associated with contracts formerly designated as cash flow hedges of forecasted power sales and gas purchases from Duke Energy’s Midwestern generation fleet. These contracts were sold by Duke Energy in 2005 and the deferred losses remain on the Consolidated Balance Sheet in AOCI until the related hedged transactions (gas purchases and power sales) occur. See Note 1 and Note 3 for further details on the completed merger and for details on the transfer of generation assets. During 2007, Duke Energy Ohio entered into additional contracts to protect margins for a portion of future sales and generation revenues and fuel expenses for the Midwestern generation fleet. Duke Energy Ohio is hedging exposures to the price variability of these commodities for a maximum period of 2 years. All derivatives related to the Midwestern generation fleet are included in Duke Energy Ohio’s Consolidated Balance Sheets at December 31, 2008 and 2007.

As of December 31, 2008, $24 million of pre-tax deferred net losses on derivative instruments related to commodity cash flow hedges accumulated on the Consolidated Balance Sheet in AOCI are expected to be recognized in earnings during the next twelve

 

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months. However, due to the volatility of the commodities markets, the corresponding value in AOCI will likely change prior to its reclassification into earnings.

Other Derivative Contracts. Trading. Duke Energy Ohio had been exposed to the impact of market fluctuations in the prices of natural gas, electricity and other energy-related products marketed and purchased as a result of proprietary trading activities. In June 2006, Cinergy sold CMT, including certain of Duke Energy Ohio’s trading contracts, to Fortis. The results of this trading activity up through the date of the sale, which was completed in October 2006, has been reflected in Loss from Discontinued Operations, net of tax, in the Consolidated Statements of Operations. In connection with the sale, Duke Energy Ohio entered into a series of Total Return Swaps (TRS) with Fortis (see Note 14). As of December 31, 2008, all of the underlying contracts that were part of the TRS had been transferred to Fortis and, as a result, Duke Energy Ohio has no future exposure associated with these TRS.

Undesignated. Duke Energy Ohio uses derivative contracts to manage the market risk exposures that arise from energy supply, structured origination, marketing, risk management, and commercial optimization services to large energy customers, energy aggregators and other wholesale companies, and to manage interest rate exposures. This category would include changes in fair value for derivatives that no longer qualify for the NPNS scope exception and disqualified hedge contracts, unless the derivative contract is subsequently re-designated as a hedge. The contracts in this category as of December 31, 2008 are primarily associated with forward power sales and coal purchases, as well as forward contracts to purchase SO2 emission allowances and certain interest rate derivatives, for the Commercial Power and Franchised Electric and Gas operations. Duke Energy Ohio’s exposure to price risk is influenced by a number of factors, including contract size, length, market liquidity, location and unique or specific contract terms.

During the years ended December 31, 2008 and 2007, Duke Energy Ohio included in earnings approximately $75 million of pre-tax losses and approximately $13 million of pre-tax gains, respectively, related to mark-to-market adjustments within Commercial Power, which are reported primarily in operating revenues within Non-regulated electric and other and Fuel used in electric generation and purchased power—non-regulated on the Consolidated Statements of Operations. As discussed in Note 1 and Note 4, beginning on December 17, 2008, Commercial Power reapplied the provisions of SFAS No. 71 to certain portions of its operations due to the passing of SB 221 and the approval of the ESP. The reapplication of SFAS No. 71 on December 17, 2008 resulted in an approximate $67 million after-tax (approximately $103 million pre-tax) extraordinary gain related to total mark-to-market losses previously recorded in earnings associated with open forward hedge contracts, which the ESP allows to be recovered through an FPP rider. Subsequent to December 17, 2008, mark-to-market gains and losses on certain open hedge positions related to native load generation will be deferred as regulatory assets or liabilities and recovered through the FPP rider.

Interest Rate (Fair Value or Cash Flow) Hedges. Changes in interest rates expose Duke Energy Ohio to risk as a result of its issuance of variable and fixed rate debt. Duke Energy Ohio manages its interest rate exposure by limiting its variable-rate exposures to a percentage of total capitalization and by monitoring the effects of market changes in interest rates. Duke Energy Ohio also enters into financial derivative instruments, including interest rate swaps, swaptions and U.S. Treasury lock agreements to manage and mitigate interest rate risk exposure. Duke Energy Ohio’s existing interest rate derivative instruments and related ineffectiveness were insignificant to its consolidated results of operations, cash flows and financial position in 2008, 2007, and 2006.

As of December 31, 2008, approximately $2 million of pre-tax net losses on terminated interest rate hedges were accumulated on the Consolidated Balance Sheets in AOCI and are expected to be recognized in earnings during the next twelve months as the hedged transactions occur.

Normal Purchases and Normal Sales Exception. Duke Energy Ohio has applied the normal purchases and normal sales scope exception, as provided in SFAS No. 133 and interpreted by Derivatives Implementation Group Issue C15, “Scope Exceptions: Normal Purchases and Normal Sales Exception for Option-Type Contracts and Forward Contracts in Electricity,” and amended by SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities,” to certain contracts involving the purchase and sale of electricity at fixed prices in future periods. These contracts, which relate primarily to the delivery of electricity over the next 6 years, are not included in the table above.

Credit Risk. Where exposed to credit risk, Duke Energy Ohio analyzes the counterparties’ financial condition prior to entering into an agreement, establishes credit limits and monitors the appropriateness of those limits on an ongoing basis.

Duke Energy Ohio’s industry has historically operated under negotiated credit lines for physical delivery contracts. Duke Energy Ohio may use master collateral agreements to mitigate certain credit exposures. The collateral agreements provide for a counterparty to post

 

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cash or letters of credit to the exposed party for exposure in excess of an established threshold. The threshold amount represents an unsecured credit limit, determined in accordance with the corporate credit policy. Collateral agreements also provide that the inability to post collateral is sufficient cause to terminate contracts and liquidate all positions.

Duke Energy Ohio also obtains cash or letters of credit from customers to provide credit support outside of collateral agreements, where appropriate, based on its financial analysis of the customer and the regulatory or contractual terms and conditions applicable to each transaction.

 

9. Fair Value of Financial Assets and Liabilities

On January 1, 2008, Duke Energy Ohio adopted SFAS No. 157. Duke Energy Ohio’s adoption of SFAS No. 157 is currently limited to financial instruments and to non-financial derivatives as, in February 2008, the FASB issued FSP No. 157-2, which delayed the effective date of SFAS No. 157 until January 1, 2009 for non-financial assets and liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis. There was no cumulative effect adjustment to retained earnings for Duke Energy Ohio as a result of the adoption of SFAS No. 157.

SFAS No. 157 defines fair value, establishes a framework for measuring fair value in GAAP in the U.S. and expands disclosure requirements about fair value measurements. Under SFAS No. 157, fair value is considered to be the exchange price in an orderly transaction between market participants to sell an asset or transfer a liability at the measurement date. The fair value definition under SFAS No. 157 focuses on an exit price, which is the price that would be received by Duke Energy Ohio to sell an asset or paid to transfer a liability versus an entry price, which would be the price paid to acquire an asset or received to assume a liability. Although SFAS No. 157 does not require additional fair value measurements, it applies to other accounting pronouncements that require or permit fair value measurements. In October 2008, the FASB issued FSP No. FAS 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active” (FSP FAS 157-3), which illustrated key considerations in determining the fair value of a financial asset when the market for that asset is not active. The application of FSP FAS 157-3 did not change the way Duke Energy Ohio determined fair value of its financial assets and liabilities.

Duke Energy Ohio determines fair value of financial assets and liabilities based on the following fair value hierarchy, as prescribed by SFAS No. 157, which prioritizes the inputs to valuation techniques used to measure fair value into three levels:

Level 1 inputs—unadjusted quoted prices in active markets for identical assets or liabilities that Duke Energy Ohio has the ability to access. An active market for the asset or liability is one in which transactions for the asset or liability occur with sufficient frequency and volume to provide ongoing pricing information. Duke Energy Ohio does not adjust quoted market prices on Level 1 inputs for any blockage factor.

Level 2 inputs—inputs other than quoted market prices included in Level 1 that are observable, either directly or indirectly, for the asset or liability. Level 2 inputs include, but are not limited to, quoted prices for similar assets or liabilities in an active market, quoted prices for identical or similar assets or liabilities in markets that are not active and inputs other than quoted market prices that are observable for the asset or liability, such as interest rate curves and yield curves observable at commonly quoted intervals, volatilities, credit risk and default rates.

Level 3 inputs—unobservable inputs for the asset or liability.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities-including an amendment of FASB Statement No. 115” (SFAS No. 159), which permits entities to elect to measure many financial instruments and certain other items at fair value. For Duke Energy Ohio, SFAS No. 159 was effective as of January 1, 2008 and had no impact on amounts presented for periods prior to the effective date. Duke Energy Ohio does not currently have any financial assets or financial liabilities for which the provisions of SFAS No. 159 have been elected. However, in the future, Duke Energy Ohio may elect to measure certain financial instruments at fair value in accordance with this standard.

 

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The following table provides the fair value measurement amounts for assets and liabilities recorded in both current and non-current Unrealized gains on mark-to-market and hedging transactions and Unrealized losses on mark-to-market and hedging transactions on Duke Energy Ohio’s Consolidated Balance Sheets at fair value at December 31, 2008. Amounts presented in the table below exclude cash collateral amounts which are disclosed separately in Note 1.

 

     Total Fair
Value
Amounts at
December 31,
2008
    Level 1     Level 2     Level 3  
     (in millions)  

Description

        

Derivative assets

   $ 68     $ 9     $     $ 59  

Derivative liabilities

   $ (147 )   $ (88 )   $ (8 )   $ (51 )

The following table provides a reconciliation of beginning and ending balances of assets and liabilities measured at fair value on a recurring basis where the determination of fair value includes significant unobservable inputs (Level 3):

 

Rollforward of Level 3 Measurements

 

      Derivatives
(net)
 
     (in millions)  
Year Ended December 31, 2008       

Balance at January 1, 2008

   $ (22 )

Total pre-tax realized or unrealized gains (losses) included in earnings:

  

Revenue, non-regulated electric and other

     (1 )

Fuel used in electric generation and purchased power—non-regulated

     96  

Net purchases, sales, issuances and settlements

     (63 )

Total losses included on balance sheet as regulatory asset or liability or as non-current liability

     (2 )
        

Balance at December 31, 2008

   $ 8  
        

Pre-tax gains (losses) included in the Consolidated Statements of Operations related to Level 3 measurements outstanding at December 31, 2008:

  

Revenue, non-regulated electric and other

   $ 7  

Fuel used in electric generation and purchased power—non-regulated

     30  
        

Total

   $ 37  
        

The valuation method of the primary fair value measurements disclosed above is as follows:

Commodity derivatives: The pricing for commodity derivatives is primarily a calculated value which incorporates the forward price and is adjusted for liquidity (bid-ask spread), credit or non-performance risk (after reflecting credit enhancements such as collateral) and discounted to present value. The primary difference between a Level 2 and a Level 3 measurement has to do with the level of activity in forward markets for the commodity. If the market is relatively inactive, the measurement is deemed to be a Level 3 measurement. Some commodity derivatives are NYMEX contracts, which Duke Energy Ohio classifies as Level 1 measurements.

Fair Value Disclosures Required Under SFAS No. 107, “Disclosures About Fair Value of Financial Instruments. The fair value of financial instruments, excluding financial assets and liabilities included in the scope of SFAS No. 157 disclosed in the tables above, is summarized in the following table. Judgment is required in interpreting market data to develop the estimates of fair value. Accordingly, the estimates determined as of December 31, 2008 and 2007, are not necessarily indicative of the amounts Duke Energy Ohio could have realized in current markets.

 

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Financial Instruments

 

     As of December 31,
     2008    2007
     Book
Value
   Approximate
Fair Value
   Book
Value
   Approximate
Fair Value
     (in millions)

Long-term debt, including current maturities

   $ 1,883    $ 1,729    $ 1,936    $ 1,914

The fair value of cash and cash equivalents, accounts receivable, restricted funds held in trust, accounts payable and notes payable are not materially different from their carrying amounts because of the short-term nature of these instruments and/or because the stated rates approximate market rates.

 

10. Goodwill and Intangibles

Duke Energy Ohio evaluates the impairment of goodwill under the guidance of SFAS No. 142. There were no goodwill impairment charges in 2008, 2007 or 2006 as a result of the annual impairment tests required by SFAS No. 142. As discussed further in Note 3, in April 2006, Duke Energy and Cinergy consummated their merger, which resulted in Duke Energy Ohio recording goodwill of approximately $2.3 billion. Duke Energy Ohio had no goodwill prior to this date. The following table shows the components of goodwill at December 31, 2008 and 2007:

 

Carrying Amount of Goodwill

 

     Balance at
December 31,
2007
   Changes     Balance at
December 31,
2008
     (in millions)

Commercial Power

   $ 1,188    $ 18     $ 1,206

Franchised Electric and Gas

     1,137      17       1,154
                     

Total Goodwill

   $ 2,325    $ 35     $ 2,360
                     
     Balance at
December 31,
2006
   Changes     Balance at
December 31,
2007
     (in millions)

Commercial Power

   $ 1,200    $ (12 )   $ 1,188

Franchised Electric and Gas

     1,148      (11 )     1,137
                     

Total Goodwill

   $ 2,348    $ (23 )   $ 2,325
                     

 

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Intangible Assets

The carrying amount and accumulated amortization of intangible assets as of December 31, 2008 and December 31, 2007 are as follows:

 

     December 31,
2008
    December 31,
2007
 
     (in millions)  

Emission allowances

   $ 239     $ 365  

Gas, coal, and power contracts

     271       271  

Other

     9       9  
                

Total gross carrying amount

     519       645  
                

Accumulated amortization—gas, coal, and power contracts

     (111 )     (89 )

Accumulated amortization—other

     (5 )     (5 )
                

Total accumulated amortization

     (116 )     (94 )
                

Total intangible assets, net

   $ 403     $ 551  
                

Emission allowances in the table above include emission allowances which were recorded at fair value on the date of Duke Energy’s merger with Cinergy and emission allowances purchased by Duke Energy Ohio. Additionally, Duke Energy Ohio is allocated certain zero cost emission allowances on an annual basis. The change in the gross carrying value of emission allowances during the years ended December 31, 2008 and 2007 is as follows:

 

     December 31,
2008
    December 31,
2007
 
     (in millions)  

Gross carrying value at beginning of period

   $ 365     $ 495  

Purchases of emission allowances

     17       23  

Sales and consumption of emission allowances(a)(b)

     (69 )     (154 )

Impairment of emission allowances(c)

     (82 )      

Other changes

     8       1  
                

Gross carrying value at end of period

   $ 239     $ 365  
                

 

(a) Carrying values of emission allowances are recognized via a charge to expense when consumed. Carrying values of emission allowances sold or consumed during the years ended December 31, 2008 and 2007, the nine months ended December 31, 2006 and the three months ended March 31, 2006 were $69 million, $154 million, $267 million and $36 million, respectively.
(b) See Note 3 for a discussion of gains and losses on sales of emission allowances by Commercial Power during the years ended December 31, 2008, 2007 and 2006.
(c) See Note 11 for discussion of impairments of the carrying value of emission allowances during the year ended December 31, 2008.

Amortization expense for gas, coal and power contracts and other intangible assets for Duke Energy Ohio was approximately $22 million and $51 million for the years ended December 31, 2008 and 2007, respectively, approximately $43 million for the nine months ended December 31, 2006 and approximately $1 million for the three months ended March 31, 2006.

The table below shows the expected amortization expense for the next five years for intangible assets as of December 31, 2008. The expected amortization expense includes estimates of emission allowances consumption and estimates of consumption of commodities such as gas and coal under existing contracts. The amortization amounts discussed below are estimates. Actual amounts may differ from these estimates due to such factors as changes in consumption patterns, sales or impairments of emission allowances or other intangible assets, additional intangible acquisitions and other events.

 

     2009    2010    2011    2012    2013
     (in millions)

Expected amortization expense

   $ 90    $ 31    $ 29    $ 29    $ 26

 

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Intangible Liabilities

In connection with the merger with Cinergy in April 2006, Duke Energy recorded an intangible liability of approximately $113 million associated with the market-based standard service offer in Ohio, which was recognized in earnings over the regulatory period that ended on December 31, 2008. The carrying amount of this intangible liability was zero and approximately $67 million at December 31, 2008 and 2007, respectively. Duke Energy also recorded approximately $56 million of intangible liabilities associated with other power sale contracts in connection with the merger with Cinergy. The carrying amount of these intangible liabilities was approximately $16 million and $22 million at December 31, 2008 and 2007, respectively. During the years ended December 31, 2008, 2007 and 2006, Duke Energy amortized approximately $73 million, $45 million and $35 million, respectively, to income related to intangible liabilities. The remaining balance of approximately $16 million will be amortized to income as follows: approximately $6 million in each of the years 2009 through 2010, and approximately $4 million in 2011. Intangible liabilities are classified as Other within Deferred Credits and Other Liabilities on the Consolidated Balance Sheets.

 

11. Impairment Charges

Emission Allowances. On July 11, 2008, the U.S. Court of Appeals for the District of Columbia issued a decision vacating the Clean Air Interstate Rule (CAIR). In December 2008, a federal appeals court reinstated the CAIR while the EPA develops a new clean air program (see Note 18 for additional information). However, as a result of the July 11, 2008 decision temporarily vacating the CAIR, there were sharp declines in market prices of SO2 and NOx allowances in the third quarter of 2008 due to uncertainty associated with future federal requirements to reduce emissions. Accordingly, pursuant to SFAS No. 144, Duke Energy Ohio evaluated the carrying value of emission allowances held by its regulated and non-regulated businesses for impairment during the third quarter of 2008.

At the time of its repeal, the CAIR required 50% reductions in SO2 emissions beginning in 2010 and further 30% reductions in SO2 emissions in 2015 beyond specified requirements. These reductions were to be achieved by requiring the surrender of SO2 allowances in a ratio of two allowances per ton of SO2 emitted beginning in 2010, up from a current one-to-one ratio, escalating to 2.86 allowances per ton of SO2 emitted beginning in 2015. Taking into account these increases in emission allowance requirements under the CAIR, Commercial Power’s forecasted SO2 emissions needed through 2037 exceeded the number of emission allowances held prior to the vacating of the CAIR. Subsequent to the decision to vacate the CAIR, Commercial Power determined that it had SO2 allowances in excess of forecasted emissions and those allowances held in excess of forecasted emissions from future generation required an impairment evaluation. In performing the impairment evaluation for SO2 allowances in the third quarter of 2008, management compared quoted market prices for each vintage year allowance to the carrying value of the related allowances in excess of forecasted emissions through 2038. Due to the sharp decline in market prices of SO2 allowances, as discussed above, during the third quarter of 2008, Commercial Power recorded pre-tax impairment charges of approximately $77 million related to forecasted excess SO2 allowances held. Additionally, Commercial Power recorded pre-tax impairment charges of approximately $5 million in the third quarter of 2008 related to annual NOx allowances as these were also affected by the decision to vacate the CAIR. These impairment charges are recorded in Impairment Charges within Operating Expenses on the Consolidated Statements of Operations.

As a result of the reinstatement of the CAIR, as discussed above, all emission allowances and certain commitments to purchase emission allowances held by Commercial Power as of December 31, 2008 are anticipated to be utilized for future emission allowance requirements under the CAIR, unless the EPA develops a new clean air program that changes the existing requirements under the CAIR.

See Note 10 for further information regarding the carrying value of emission allowances.

 

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Notes To Consolidated Financial Statements—(Continued)

 

12. Related Party Transactions

Duke Energy Ohio engages in related party transactions, which are generally performed at cost and in accordance with the applicable state and federal commission regulations. Balances due to or due from related parties included in the Consolidated Balance Sheets as of December 31, 2008 and December 31, 2007 are as follows:

 

     December 31,
2008(a)
    December 31,
2007(a)
 
     (in millions)  

Current assets(b)

   $ 55     $ 58  

Non-current assets(c)

   $ 5     $  

Current liabilities(d)

   $ (138 )   $ (266 )

Non-current liabilities(e)

   $ (4 )   $  

Net deferred tax liabilities(f)

   $ (1,519 )   $ (1,385 )
(a) Balances exclude assets or liabilities associated with accrued pension and other post-retirement benefits, Cinergy Receivables and money pool arrangements as discussed below.
(b) Of the balance at December 31, 2008, approximately $18 million is classified as Receivables, approximately $2 million is classified as Unrealized gains on mark-to-market and hedging transactions and approximately $35 million is classified as Other within Current Assets on the Consolidated Balance Sheets. The balance at December 31, 2007 is classified as Receivables on the Consolidated Balance Sheets.
(c) The balance at December 31, 2008 is classified as Unrealized gains on mark-to-market and hedging transactions within Investments and Other Assets on the Consolidated Balance Sheets.
(d) Of the balance at December 31, 2008, approximately ($133) million is classified as Accounts payable, approximately ($2) million is classified as Taxes accrued and approximately ($3) million is classified as Unrealized losses on mark-to-market and hedging transactions within Current Liabilities on the Consolidated Balance Sheets. Of the balance at December 31, 2007, approximately ($256) million is classified as Accounts payable and approximately ($10) million is classified as Taxes accrued on the Consolidated Balance Sheets.
(e) The balance at December 31, 2008 is classified as Unrealized losses on mark-to-market and hedging transactions within Deferred Credits and Other Liabilities on the Consolidated Balance Sheets.
(f) Of the balance at December 31, 2008, approximately ($1,580) million is classified as Deferred income taxes and approximately $61 million is classified as Other within Current Assets on the Consolidated Balance Sheets. Of the balance at December 31, 2007, approximately ($1,409) million is classified as Deferred income taxes and approximately $24 million is classified as Other within Current Assets on the Consolidated Balance Sheets.

Duke Energy Ohio is charged its proportionate share of corporate governance and other costs by a consolidated affiliate of Duke Energy. Corporate governance and other shared services costs are primarily related to human resources, legal and accounting fees, as well as other third party costs. The expenses associated with certain allocated corporate governance and other service costs for Duke Energy Ohio, which are recorded in Operation, Maintenance and Other within Operating Expenses on the Consolidated Statements of Operations were as follows:

 

     Successor(a)         Predecessor(a)
     Year Ended
December 31,
2008
   Year Ended
December 31,
2007
   Nine Months Ended
December 31,
2006
        Three Months Ended
March 31,
2006
     (in millions)

Corporate governance and shared services expenses

   $ 319    $ 249    $ 290        $ 112
(a) See Note 1 for additional information on Predecessor and Successor reporting.

Duke Energy Ohio incurs expenses related to certain insurance coverages through Bison Insurance Company Limited, Duke Energy’s wholly-owned captive insurance subsidiary. These expenses, which are recorded in Operation, maintenance and other within Operating Expenses on the Consolidated Statements of Operations, were approximately $18 million, $24 million, and $12 million for the years ended December 31, 2008, 2007 and 2006, respectively. Additionally, Duke Energy Ohio records income associated with the rental of office space to a consolidated affiliate of Duke Energy, as well as income associated with certain other recoveries of cost. Rental income and other cost recoveries were approximately $13 million, $12 million, $9 million and $2 million for the years ended December 31, 2008 and 2007, the nine months ended December 31, 2006 and the three months ended March 31, 2006, respectively.

 

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Duke Energy Ohio participates in Cinergy’s qualified pension plan, non-qualified pension plan and other post-retirement benefit plans and is allocated its proportionate share of expenses associated with these plans (see Note 19). Additionally, Duke Energy Ohio has been allocated accrued pension and other post-retirement and post-employment benefit obligations from Cinergy of approximately $416 million and $266 million at December 31, 2008 and 2007, respectively. The above amounts have been classified in the Consolidated Balance Sheets as follows:

 

     December 31,
2008
   December 31,
2007
     (in millions)

Other current liabilities

   $ 5    $ 5

Accrued pension and other post-retirement benefit costs

   $ 406    $ 259

Other deferred credits and other liabilities

   $ 5    $ 2

Additionally, certain trade receivables have been sold by Duke Energy Ohio to Cinergy Receivables, an unconsolidated entity formed by Cinergy. The proceeds obtained from the sales of receivables are largely cash but do include a subordinated note from Cinergy Receivables for a portion of the purchase price. This subordinated note is classified by Duke Energy Ohio as Receivables in the Consolidated Balance Sheets and was approximately $174 million and $189 million as of December 31, 2008 and December 31, 2007, respectively. The interest income associated with the subordinated note, which is recorded in Other Income and Expenses, net on the Consolidated Statements of Operations, was approximately $21 million and $25 million for the years ended December 31, 2008 and 2007, respectively.

See Note 17 for a discussion of dividends Duke Energy Ohio paid to its parent, Cinergy.

During the second quarter of 2007 Duke Energy Ohio received a $29 million capital contribution from its parent, Cinergy.

See Note 3 for a discussion of amounts paid to Duke Energy Ohio as a result of the agreement between Duke Energy and Duke Energy Ohio related to Duke Energy’s contribution of its ownership interests in five plants to Duke Energy Ohio.

As discussed further in Note 16, Duke Energy Ohio participates in a money pool arrangement with Duke Energy and other Duke Energy subsidiaries. As of December 31, 2008 and December 31, 2007, Duke Energy Ohio was in a payable position of $63 million and $189 million, respectively, classified within Notes payable in the accompanying Consolidated Balance Sheets. The expenses associated with money pool activity, which are recorded in Interest Expense on the Consolidated Statements of Operations, for the years ended December 31, 2008 and 2007, nine months ended December 31, 2006 and three months ended March 31, 2006 were approximately $3 million, $11 million, $6 million and $2 million, respectively.

 

13. Sales of Accounts Receivable

Accounts Receivable Securitization. Duke Energy Ohio and Duke Energy Kentucky sell, on a revolving basis, nearly all of their retail accounts receivable and related collections to Cinergy Receivables, a bankruptcy remote, special purpose entity that is a wholly-owned limited liability company of Cinergy. The securitization transaction was structured to meet the criteria for sale treatment under SFAS No. 140, and, accordingly, Cinergy does not consolidate Cinergy Receivables and the transfers of receivables are accounted for as sales.

The proceeds obtained from the sales of receivables are largely cash but do include a subordinated note from Cinergy Receivables for a portion of the purchase price (typically approximates 25 percent of the total proceeds). The note, which amounts to approximately $174 million and $189 million at December 31, 2008 and 2007, respectively, is subordinate to senior loans that Cinergy Receivables obtain from commercial paper conduits controlled by unrelated financial institutions which is the source of funding for the subordinated note. This subordinated note is a retained interest (right to receive a specified portion of cash flows from the sold assets) under SFAS No. 140 and is classified within Receivables in the accompanying Consolidated Balance Sheets at December 31, 2008 and 2007.

The carrying values of the retained interests are determined by allocating the carrying value of the receivables between the assets sold and the interests retained based on relative fair value. The key assumptions in estimating fair value are the anticipated credit losses, the selection of discount rates, and expected receivables turnover rate. Because (a) the receivables generally turnover in less than two months, (b) credit losses are reasonably predictable due to Duke Energy Ohio’s broad customer base and lack of significant concentration, and (c) the purchased beneficial interest is subordinate to all retained interests and thus would absorb losses first, the allocated bases of the subordinated notes are not materially different than their face value. Interest accrues to Duke Energy Ohio on the retained

 

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interests using the accretable yield method, which generally approximates the stated rate on the notes since the allocated basis and the face value are nearly equivalent. An impairment charge is recorded against the carrying value of both the retained interests and purchased beneficial interest whenever it is determined that an other-than-temporary impairment has occurred (which is unlikely unless credit losses on the receivables far exceed the anticipated level).

The key assumptions used in estimating the fair value are as follows:

 

     Years Ended
December 31,
 
     2008     2007     2006  

Anticipated credit loss rate

   0.7 %   0.7 %   0.8 %

Discount rate on expected cash flows

   5.3 %   7.7 %   7.4 %

Receivables turnover rate

   12.4 %   12.4 %   12.7 %

 

The hypothetical effect on the fair value of the retained interests assuming both a 10% and a 20% unfavorable variation in credit losses or discount rates is not material due to the short turnover of receivables and historically low credit loss history.

Duke Energy Ohio retains servicing responsibilities for its role as a collection agent on the amounts due on the sold receivables. However, Cinergy Receivables assumes the risk of collection on the purchased receivables without recourse to Duke Energy Ohio in the event of a loss. While no direct recourse to Duke Energy Ohio exists, it risks loss in the event collections are not sufficient to allow for full recovery of its retained interests. No servicing asset or liability is recorded since the servicing fee paid to Duke Energy Ohio approximates a market rate.

The following table shows the gross and net receivables sold, retained interests, sales, and cash flows during the periods ending:

 

     Successor(a)          Predecessor(a)
     Year
Ended
December 31,
2008
   Year
Ended
December 31,
2007
   Nine Months
Ended
December 31,
2006
         Three Months
Ended
March 31,
2006
     (in millions)

Receivables sold as of period end

   $ 473    $ 437    $ 370        

Less: Retained interests

     174      189      133        
                            

Net receivables sold as of period end

   $ 299    $ 248    $ 237        

Sales during period

                

Receivables sold

   $ 3,316    $ 3,189    $ 1,982         $ 869

Loss recognized on sale

     38      46      29           12

Cash flows during period

                

Cash proceeds from receivables sold

   $ 3,276    $ 3,086    $ 1,935         $ 919

Collection fees received

     3      3      2          

Return received on retained interests

     21      25      13           8

 

(a) See Note 1 for additional information on Predecessor and Successor reporting.

 

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Notes To Consolidated Financial Statements—(Continued)

 

14. Discontinued Operations and Assets Held for Sale

In June 2006, Cinergy agreed to sell CMT, including certain of Duke Energy Ohio’s trading contracts, to Fortis, a Benelux-based financial services group. In October 2006, the sale was completed. Results of operations for these trading contracts have been reflected in Loss from Discontinued Operations, net of tax in the accompanying Consolidated Statements of Operations. In October 2006, in connection with this transaction, Duke Energy Ohio entered into a series of TRS with Fortis, which were accounted for as mark-to-market derivatives. The TRS was cancelled for each underlying contract as each was transferred to Fortis. As of December 31, 2008, all of the underlying contracts that were part of the TRS had been transferred to Fortis and, as a result, Duke Energy Ohio has no future exposure associated with these TRS.

The following table summarizes the results classified as Loss from Discontinued Operations, net of tax, in the accompanying Consolidated Statements of Operations. There was no discontinued operations activity in 2008 or 2007.

 

     Successor(a)           Predecessor(a)  
     Nine Months
Ended
December 31,
2006
          Three Months
Ended
March 31,
2006
 
     (in millions)  

Revenues

   $ 5          $ 9  

Operating Loss

         

Loss before taxes

     (6 )          (3 )

Income tax benefit

     (2 )          (1 )
                     

Loss from Discontinued Operations, net of tax

   $ (4 )        $ (2 )

Net Loss on Dispositions

         

Pre-tax loss on dispositions

   $ (3 )        $  

Income tax benefit

     (1 )           
                     

Loss on dispositions, net of tax

   $ (2 )        $  
                     

Total Loss from Discontinued Operations, net of tax

   $ (6 )        $ (2 )
                     

 

(a) See Note 1 for additional information on Predecessor and Successor reporting.

 

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15. Property, Plant and Equipment

 

     Estimated
Useful Life
   December 31,
2008
    December 31,
2007
 
     (Years)    (in millions)  

Land

      $ 126     $ 129  

Plant—Regulated

       

Electric generation, distribution and transmission(a)

   8 – 100      3,262       3,197  

Natural gas transmission and distribution(a)

   12 – 60      1,566       1,436  

Other buildings and improvements(a)

   25 – 100      103       129  

Plant—Unregulated

       

Electric generation, distribution and transmission

   8 – 100      3,710       3,813  

Other buildings and improvements

   30      190       25  

Equipment

   5 – 25      60       64  

Construction in process

        843       594  

Other

   5 – 20      187       190  
                   

Total property, plant and equipment

        10,047       9,577  

Total accumulated depreciation—regulated(b)

        (1,646 )     (1,640 )

Total accumulated depreciation—unregulated

        (631 )     (457 )
                   

Total net property, plant and equipment

      $ 7,770     $ 7,480  
                   

 

(a) Includes capitalized leases of approximately $109 million for 2008 and $88 million for 2007.
(b) Includes accumulated amortization of capitalized leases: $6 million for 2008 and $10 million for 2007.

Capitalized interest, which includes the interest expense component of AFUDC, amounted to $19 million for the year ended December 31, 2008, $30 million for the year ended December 31, 2007, $14 million for the nine months ended December 31, 2006 and $3 million for the three months ended March 31, 2006.

 

16. Debt and Credit Facilities

 

Summary of Debt and Related Terms

 

     Weighted-
Average
Rate
    Year Due    December 31,
2008
    December 31,
2007
 
                (in millions)  

Unsecured debt

   5.8 %   2012 – 2036    $ 1,225     $ 1,345  

Capital leases

   5.2 %   2009 – 2020      51       59  

Other debt(a)

   2.0 %   2011 – 2041      646       572  

Notes payable

   2.2 %        280        

Money pool

   0.5 %        63       189  

Unamortized debt discount and premium, net

          (39 )     (40 )
                     

Total debt

          2,226       2,125  

Current maturities of long-term debt

          (27 )     (126 )

Short-term notes payable

          (343 )     (189 )
                     

Total long-term debt

        $ 1,856     $ 1,810  
                     

 

(a) Includes $538 million of Duke Energy Ohio pollution control bonds as of both December 31, 2008 and 2007. As of December 31, 2008 and 2007, zero and $84 million, respectively, was secured by first and refunding mortgage bonds and $62 million and $12 million, respectively, was secured by a letter of credit.

 

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Unsecured and Other Debt. In December 2008, Duke Energy Kentucky refunded $50 million of tax-exempt auction rate bonds through the issuance of $50 million of tax-exempt variable-rate demand bonds, which are supported by a direct-pay letter of credit. The variable-rate demand bonds, which are due August 1, 2027, had an initial interest rate of 0.65% which is reset on a weekly basis.

In December 2007, Duke Energy Ohio issued $140 million in tax-exempt floating-rate bonds. The bonds are structured as insured auction rate securities, subject to an auction process every 35 days and bear a final maturity of 2041. The bonds were issued through the Ohio Air Quality Development Authority to fund a portion of the environmental capital expenditures at the Conesville, Stuart and Killen Generation Stations in Ohio.

Money Pool. Duke Energy Ohio and its wholly-owned subsidiary, Duke Energy Kentucky, receive support for their short-term borrowing needs through their participation with Duke Energy and other Duke Energy subsidiaries in a money pool arrangement. Under this arrangement, those companies with short-term funds may provide short-term loans to affiliates participating under this arrangement. The money pool is structured such that Duke Energy Ohio and Duke Energy Kentucky separately manage their cash needs and working capital requirements. Accordingly, there is no net settlement of receivables and payables of Duke Energy Ohio and Duke Energy Kentucky, as each of these entities independently participate in the money pool. As of December 31, 2008 and December 31, 2007, Duke Energy Ohio and Duke Energy Kentucky had combined net borrowings of approximately $63 million and $189 million, respectively, classified within Notes payable in the accompanying Consolidated Balance Sheets. During the year ended December 31, 2008, the $126 million decrease in the money pool activity is reflected as a cash outflow in Notes payable to affiliate, net within Net cash (used in) provided by financing activities on the Consolidated Statements of Cash Flows. During the year ended December 31, 2007, the $85 million decrease in the money pool activity is reflected as a cash outflow in Notes payable to affiliate, net within Net cash (used in) provided by financing activities on the Consolidated Statements of Cash Flows. During the nine months ended December 31, 2006, the $52 million increase in the money pool activity is reflected as a cash inflow in Notes payable to affiliate, net within Net cash (used in) provided by financing activities on the Consolidated Statements of Cash Flows. During the three months ended March 31, 2006, the $108 million increase in the money pool activity is reflected as a cash inflow in Notes payable to affiliate, net within Net cash (used in) provided by financing activities on the Consolidated Statements of Cash Flows.

Floating Rate Debt. Unsecured debt and other debt included approximately $611 million and $538 million of floating-rate debt as of December 31, 2008 and 2007, respectively. Floating-rate debt is primarily based on commercial paper rates or a spread relative to an index such as a London Interbank Offered Rate (LIBOR) for debt denominated in U.S. dollars. As of December 31, 2008 and 2007, the weighted-average interest rate associated with floating-rate debt was approximately 1.9% and 4.4%, respectively.

Auction Rate Debt. As of December 31, 2008, Duke Energy Ohio had approximately $390 million of auction rate pollution control bonds outstanding. While these debt instruments are long-term in nature and cannot be put back to Duke Energy Ohio prior to maturity, the interest rates on these instruments are designed to reset periodically through an auction process. In February 2008, Duke Energy Ohio began to experience failed auctions on these debt instruments. When failed auctions occur on a series of this debt, Duke Energy Ohio is required to pay the maximum auction rate as prescribed by the bond document. The maximum auction rate for the auction rate debt is 2.0 times one-month LIBOR. Payment of the failed-auction interest rates will continue until Duke Energy Ohio is able to either successfully remarket these instruments through the auction process or refund and refinance the existing debt through the issuance of an equivalent amount of tax exempt bonds. While Duke Energy Ohio intends to refund and refinance these tax exempt auction rate bonds, the timing of such refinancing transactions is uncertain and subject to market conditions. However, even if Duke Energy Ohio is unable to successfully refund and refinance these debt instruments, the impact of paying higher interest rates on the outstanding auction rate debt is not expected to materially affect Duke Energy Ohio’s consolidated results of operations, cash flows or financial position. The weighted-average interest rate associated with Duke Energy Ohio’s auction rate pollution control bonds, was 1.58% as of December 31, 2008 and 4.56% as of December 31, 2007.

 

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Maturities, Call Options and Acceleration Clauses.

 

Annual Maturities as of December 31, 2008

 

     (in millions)

2009

   $ 27

2010

     6

2011

     31

2012

     579

2013

     5

Thereafter

     1,235
      

Total long-term debt including current maturities(a)

   $ 1,883
      
(a) Excludes short-term notes payable of $343 million.

Duke Energy Ohio has the ability under certain debt facilities to call and repay the obligation prior to its scheduled maturity. Therefore, the actual timing of future cash repayments could be materially different than the above as a result of Duke Energy Ohio’s ability to repay these obligations prior to their scheduled maturity.

Available Credit Facilities and Capacity Utilized Under Available Credit Facilities. In June 2007, Duke Energy closed the syndication of an amended and restated credit facility, which replaced existing credit facilities, with a 5-year, $2.65 billion master credit facility. In March 2008, Duke Energy entered into an amendment to its $2.65 billion master credit facility whereby the borrowing capacity was increased by $550 million to $3.2 billion. In October 2008, Duke Energy terminated the participation of one of the financial institutions supplying approximately $63 million of credit commitment under its master credit facility. The total credit facility capacity under the master credit facility subsequent to this termination is approximately $3.14 billion. Duke Energy has the unilateral ability under the master credit facility to increase or decrease the borrowing sub limits of each borrower, subject to maximum cap limitation, at any time. At December 31, 2008, Duke Energy Ohio and Duke Energy Kentucky had borrowing sub limits under Duke Energy’s master credit facility of $650 million and $100 million, respectively. The amount available to Duke Energy Ohio and Duke Energy Kentucky under their sub limits to Duke Energy’s master credit facility has been reduced by drawdowns of cash, borrowings through the money pool arrangement, and the use of the master credit facility to backstop issuances of letters of credit and pollution control bonds, as discussed below.

In September 2008, Duke Energy and its wholly-owned subsidiaries, including Duke Energy Ohio and Duke Energy Kentucky, borrowed a total of approximately $1 billion under Duke Energy’s master credit facility, of which Duke Energy Ohio’s and Duke Energy Kentucky’s portions are approximately $279 million and $74 million, respectively. Duke Energy Ohio’s and Duke Energy Kentucky’s amounts remained outstanding as of December 31, 2008. The loans, which are revolving credit loans, bear interest at one-month LIBOR plus an applicable spread ranging from 19 to 24 basis points and are due in September 2009; however, Duke Energy Ohio and Duke Energy Kentucky have the ability under the master credit facility to renew the loan up through the date the master credit facility matures, which is in June 2012. As Duke Energy Kentucky has the intent and ability to refinance this obligation on a long-term basis, either through renewal of the terms of the loan through the master credit facility, which has non-cancelable terms in excess of one-year, or through issuance of long-term debt to replace the amounts drawn under the master credit facility, Duke Energy Kentucky’s borrowing is reflected as Long-Term Debt on the Consolidated Balance Sheets at December 31, 2008. Since Duke Energy Ohio does not have the intent to refinance these obligations on a long-term basis, Duke Energy Ohio’s borrowing is reflected in Notes payable within Current Liabilities on the Consolidated Balance Sheets at December 31, 2008. These borrowings reduce Duke Energy Ohio’s and Duke Energy Kentucky’s available credit capacity under Duke Energy’s Master Credit Facility, as discussed above.

At December 31, 2008 and December 31, 2007, approximately $146 million and $96 million, respectively, of certain pollution control bonds, which are short-term obligations by nature, are classified as Long-Term Debt on the Consolidated Balance Sheets due to Duke Energy Ohio’s intent and ability to utilize such borrowings as long-term financing. Duke Energy’s credit facilities with non-cancelable terms in excess of one year as of the balance sheet date give Duke Energy Ohio the ability to refinance these short-term obligations on a long-term basis. Of the $146 million of pollution control bonds outstanding at December 31, 2008, approximately $84 million were backstopped by Duke Energy’s master credit facility, with the remaining balance backstopped by other specific credit facilities separate from the master credit facility.

 

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In September 2008, Duke Energy Kentucky and Duke Energy Indiana, Inc. (Duke Energy Indiana), a wholly-owned subsidiary of Duke Energy, collectively entered into a $330 million letter of credit agreement with a syndicate of banks. Under this letter of credit agreement, Duke Energy Kentucky may request the issuance of letters of credit up to approximately $51 million on its behalf to support various series of variable rate demand bonds issued or to be issued on behalf of Duke Energy Kentucky. This credit facility, which is not part of Duke Energy’s master credit facility, may not be used for any purpose other than to support variable rate demand bonds issued by Duke Energy Kentucky and Duke Energy Indiana, Inc.

Restrictive Debt Covenants. Duke Energy’s debt and credit agreement contains various financial and other covenants, including, but not limited to, a covenant regarding the debt-to-total capitalization ratio at Duke Energy, Duke Energy Ohio and Duke Energy Kentucky to not exceed 65%. Duke Energy Ohio’s debt agreements also contain various financial and other covenants. Failure to meet these covenants beyond applicable grace periods could result in accelerated due dates and/or termination of the agreements. As of December 31, 2008, Duke Energy, Duke Energy Ohio and Duke Energy Kentucky were in compliance with all covenants that would impact Duke Energy Ohio’s or Duke Energy Kentucky’s ability to borrow funds under the debt and credit facilities. In addition, some credit agreements may allow for acceleration of payments or termination of the agreements due to nonpayment, or the acceleration of other significant indebtedness of the borrower or some of its subsidiaries. None of the debt or credit agreements contain material adverse change clauses.

Other Assets Pledged as Collateral. As of December 31, 2008, substantially all of Franchised Electric and Gas’ electric plant in service is mortgaged under the mortgage bond indenture of Duke Energy Ohio.

 

17. Common and Preferred Stock

Common Stock. Cinergy owns all of the common stock of Duke Energy Ohio. In April 2006, Duke Energy acquired 100 percent of Cinergy’s outstanding stock. See Note 3 for additional information.

In April 2006, Duke Energy Ohio filed a petition with the FERC for a declaratory ruling that its payment of dividends out of its paid-in capital account, using the balance transferred from the retained earnings account, resulting from purchase accounting arising from the Duke Energy/Cinergy merger, would not violate section 305(a) of the Federal Power Act, which generally precludes the payment of dividends out of paid-in capital. Such a ruling was necessary because purchase/push-down accounting reset retained earnings to zero as of April 3, 2006, thus potentially precluding Duke Energy Ohio from using pre-merger retained earnings to pay dividends. Without this approval, Duke Energy Ohio’s ability to pay dividends to Duke Energy or Cinergy would have been constrained to earnings since April 3, 2006. In May 2006, the FERC issued an order approving Duke Energy Ohio’s petition. For further discussion of restrictions on Duke Energy Ohio’s ability to pay dividends to its parent, see Note 4.

During the years ended December 31, 2008, 2007 and 2006, Duke Energy Ohio paid dividends to its parent, Cinergy, of $200 million, $135 million and $102 million, respectively.

Preferred Stock. In March 2006, Duke Energy Ohio redeemed all outstanding shares of its $16.98 million notional amount 4% Cumulative Preferred Stock and its $3.5 million notional amount 4.75% Cumulative Preferred Stock at a price of $108 per share and $101 per share, respectively, plus accrued and unpaid dividends.

 

18. Commitments and Contingencies

 

General Insurance

Effective with the date of the merger between Duke Energy and Cinergy, Duke Energy Ohio carries, either directly or through Duke Energy’s captive insurance company, Bison Insurance Company Limited, insurance and reinsurance coverages consistent with companies engaged in similar commercial operations with similar type properties. Duke Energy Ohio’s insurance coverage includes (1) commercial general public liability insurance for liabilities arising to third parties for bodily injury and property damage resulting from Duke Energy Ohio’s operations; (2) workers’ compensation liability coverage to required statutory limits; (3) automobile liability insurance for all owned, non-owned and hired vehicles covering liabilities to third parties for bodily injury and property damage; (4) insurance policies in support of the indemnification provisions of Duke Energy Ohio’s by-laws and (5) property insurance covering the replacement value of all real and personal property damage, excluding electric transmission and distribution lines, including damages arising from boiler and machinery breakdowns, earthquake, flood damage and extra expense. All coverages are subject to certain deductibles, terms and conditions common for companies with similar types of operations.

 

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Duke Energy Ohio also maintains excess liability insurance coverage above the established primary limits for commercial general liability and automobile liability insurance. Limits, terms, conditions and deductibles are comparable to those carried by other companies with similar types of operations.

The cost of Duke Energy Ohio’s general insurance coverages continued to fluctuate over the past year reflecting the changing conditions of the insurance markets.

 

Environmental

Duke Energy Ohio is subject to federal, state and local regulations regarding air and water quality, hazardous and solid waste disposal and other environmental matters. These regulations can be changed from time to time, imposing new obligations on Duke Energy Ohio.

Remediation Activities. Duke Energy Ohio and its affiliates are responsible for environmental remediation at various contaminated sites. These include some properties that are part of ongoing Duke Energy Ohio operations, sites formerly owned or used by Duke Energy Ohio entities, and sites owned by third parties. Remediation typically involves management of contaminated soils and may involve groundwater remediation. Managed in conjunction with relevant federal, state and local agencies, activities vary with site conditions and locations, remedial requirements, complexity and sharing of responsibility. If remediation activities involve statutory joint and several liability provisions, strict liability, or cost recovery or contribution actions, Duke Energy Ohio or its affiliates could potentially be held responsible for contamination caused by other parties. In some instances, Duke Energy Ohio may share liability associated with contamination with other potentially responsible parties, and may also benefit from insurance policies or contractual indemnities that cover some or all cleanup costs. All of these sites generally are managed in the normal course of business or affiliate operations. Management, in the normal course of business, continually assesses the nature and extent of known or potential environmental-related contingencies and records liabilities when losses become probable and are reasonably estimable.

Clean Water Act 316(b). The EPA finalized its cooling water intake structures rule in July 2004. The rule established aquatic protection requirements for existing facilities that withdraw 50 million gallons or more of water per day from rivers, streams, lakes, reservoirs, estuaries, oceans, or other U.S. waters for cooling purposes. Three of six coal-fired generating facilities in which Duke Energy Ohio is either a whole or partial owner are affected sources under that rule. On January 25, 2007, the U.S. Court of Appeals for the Second Circuit issued its opinion in Riverkeeper, Inc. v. EPA, Nos. 04-6692-ag(L) et. al. (2d Cir. 2007) remanding most aspects of the EPA’s rule back to the agency. The court effectively disallowed those portions of the rule most favorable to industry, and the decision creates a great deal of uncertainty regarding future requirements and their timing. On April 14, 2008, the U.S. Supreme Court issued an order granting review of the case and briefs were filed on July 14, 2008. Oral argument occurred on December 2, 2008. A decision is expected in 2009. If the Supreme Court upholds the lower court decision, it is expected that costs will increase as a result of the court’s decision, however, Duke Energy Ohio is unable to estimate at this time its costs to comply.

Clean Air Interstate Rule (CAIR). The EPA finalized its CAIR in May 2005. The CAIR limits total annual and summertime NOx emissions and annual SO2 emissions from electric generating facilities across the Eastern U.S. through a two-phased cap-and-trade program. Phase 1 begins in 2009 for NOx and in 2010 for SO2. Phase 2 begins in 2015 for both NOx and SO2. On March 25, 2008, the U.S. Court of Appeals for the District of Columbia (D.C. Circuit) heard oral argument in a case involving multiple challenges to the CAIR. On July 11, 2008, the D.C. Circuit issued its decision in North Carolina v. EPA No. 05-1244 vacating the CAIR. The EPA filed a petition for rehearing on September 24, 2008 with the D.C. Circuit asking the court to reconsider various parts of its ruling vacating the CAIR. In December 2008, the D.C. Circuit issued a decision remanding the CAIR to the EPA without vacatur. The EPA must now conduct a new rulemaking to modify the CAIR in accordance with the court’s July 11, 2008 opinion. This decision means that the CAIR as initially finalized in 2005 remains in effect until the new EPA rule takes effect. The court did not impose a deadline or schedule on the EPA. It is uncertain how long the current CAIR will remain in effect or how the new rulemaking will alter the CAIR.

Duke Energy Ohio plans to spend approximately $85 million between 2009 and 2013 to comply with Phase 1 of the CAIR. Duke Energy Ohio is currently unable to estimate the costs to comply with any new rule the EPA will issue in the future as a result of the D.C. District Court’s December 2008 decision discussed above. Duke Energy Ohio received partial recovery of depreciation and financing costs related to environmental compliance projects for 2005-2008 through its RSP. See Note 11 for a discussion of the impacts of the D.C. Circuit Court’s July 11, 2008 decision to vacate the CAIR on the carrying value of emission allowances.

 

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Clean Air Mercury Rule (CAMR). The EPA finalized its CAMR in May 2005. The CAMR was to have limited total annual mercury emissions from coal-fired power plants across the U.S. through a two-phased cap-and-trade program beginning in 2010. On February 8, 2008, the D.C. Circuit issued its opinion in New Jersey v. EPA, No. 05-1097 vacating the CAMR. Requests for rehearing were denied. The U.S. EPA and the Utility Air Regulatory Group have requested that the U.S. Supreme Court review the D.C. Circuit’s decision. The D.C. Circuit’s decision creates uncertainty regarding future mercury emission reduction requirements and their timing, but makes it fairly certain that there will be a delay in the implementation of federal mercury requirements for existing coal-fired power plants. On January 29, 2009, the EPA requested the U.S. Department of Justice withdraw its Petition for Writ of Certiorari filed on October 17, 2008. On February 23, 2009, the Supreme Court denied the Utility Air Regulatory Group’s petition. The EPA will now develop emission standards for utility units under section 112 of the Clean Air Act, thus abiding by the D.C. Circuit’s decision. At this point, Duke Energy Ohio is unable to estimate the costs to comply with any future mercury regulations that might result from the D.C. Circuit’s decision.

Coal Combustion Product (CCP) Management. Duke Energy Ohio currently estimates that it will spend approximately $68 million over the period 2009-2013 to install synthetic caps and liners at existing and new CCP landfills and to convert CCP handling systems from wet to dry systems.

Comprehensive Environmental Response, Compensation, and Liability Act Matter. In August 2008, Duke Energy Ohio received a notice from the EPA that it has been identified as a potentially responsible party under the Comprehensive Environmental Response, Compensation, and Liability Act at the LWD, Inc., Superfund Site in Calvert City, Kentucky. At this time, Duke Energy Ohio does not have any further information regarding the scope of potential liability associated with this matter.

Extended Environmental Activities and Accruals. Included in Other within Deferred Credits and Other Liabilities on the Consolidated Balance Sheets were total accruals related to extended environmental-related activities of approximately $11 million and $8 million as of December 31, 2008 and 2007, respectively. These accruals represent Duke Energy Ohio’s provisions for costs associated with remediation activities at some of its current and former sites, as well as other relevant environmental contingent liabilities. Management, in the normal course of business, continually assesses the nature and extent of known or potential environmental-related contingencies and records liabilities when losses become probable and are reasonably estimable.

 

Litigation

New Source Review (NSR). In 1999-2000, the U.S. Department of Justice (DOJ), acting on behalf of the EPA and joined by various citizen groups and states, filed a number of complaints and notices of violation against multiple utilities across the country for alleged violations of the NSR provisions of the Clean Air Act (CAA). Generally, the government alleges that projects performed at various coal-fired units were major modifications, as defined in the CAA, and that the utilities violated the CAA when they undertook those projects without obtaining permits and installing the best available emission controls for SO2, NOx and particulate matter. The complaints seek injunctive relief to require installation of pollution control technology on various generating units that allegedly violated the CAA, and unspecified civil penalties in amounts of up to $32,500 per day for each violation. Two of Duke Energy Ohio’s plants have been subject to these allegations. Duke Energy Ohio asserts that there were no CAA violations because the applicable regulations do not require permitting in cases where the projects undertaken are “routine” or otherwise do not result in a net increase in emissions.

In November 1999, the U.S. brought a lawsuit in the U.S. Federal District Court for the Southern District of Indiana against Duke Energy Ohio alleging various violations of the CAA at Duke Energy Ohio’s W.C. Beckjord and Miami Fort Stations. Three northeast states and two environmental groups have intervened in the case. A jury trial commenced on May 5, 2008 and jury verdict was returned on May 22, 2008. The jury found in favor of Cinergy, Duke Energy Ohio and Duke Energy Indiana, Inc. on all but three units at Wabash River. Additionally, the plaintiffs had claimed that Duke Energy Ohio violated an Administrative Consent Order entered into in 1998 between the EPA and Cinergy relating to alleged violations of Ohio’s State Implementation Plan (SIP) provisions governing particulate matter at Duke Energy Ohio’s W.C. Beckjord Station.

On October 21, 2008, Plaintiffs filed a motion for a new liability trial claiming that defendants misled the Plaintiffs and the jury by, among other things, not disclosing a consulting agreement with a fact witness and by referring to that witness as “retired” during the liability trial when in fact he was working for Duke Energy under the referenced consulting agreement in connection with the trial. On December 18, 2008, the court granted Plaintiffs’ motion for a new liability trial on claims for which Duke Energy Ohio was not previously found liable. That trial is scheduled to begin on May 11, 2009. The remedy trial for violations already established at the Wabash River

 

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Station and W.C. Beckjord Station was held during the week beginning February 2, 2009. The parties are awaiting a decision from the trial court.

Duke Energy Ohio has been informed by Dayton Power and Light (DP&L) that in June 2000, the EPA issued a Notice of Violation (NOV) to DP&L for alleged violations of CAA requirements at a station operated by DP&L and jointly-owned by DP&L, Columbus Southern Power Company (CSP), and Duke Energy Ohio. The NOV indicated the EPA may issue an order requiring compliance with the requirements of the Ohio SIP, or bring a civil action seeking injunctive relief and civil penalties of up to $27,500 per day for each violation. In September 2004, Marilyn Wall and the Sierra Club brought a lawsuit against Duke Energy Ohio, DP&L and CSP for alleged violations of the CAA at this same generating station. The parties reached an agreement to settle this matter in the form of a consent decree which was submitted for comment to the EPA and ultimately approved and entered by the court on October 23, 2008. The consent decree did not have a material adverse effect on Duke Energy Ohio’s consolidated results of operations, cash flows or financial position.

It is not possible to estimate the damages, if any, that Duke Energy Ohio might incur in connection with these matters. Ultimate resolution of these matters relating to NSR, even in settlement, could have a material adverse effect on Duke Energy Ohio’s consolidated results of operations, cash flows or financial position. However, Duke Energy Ohio will pursue appropriate regulatory treatment for any costs incurred in connection with such resolution.

Section 126 Petitions. In March 2004, the state of North Carolina filed a petition under Section 126 of the CAA in which it alleges that sources in 13 upwind states, including Ohio, significantly contribute to North Carolina’s non-attainment with certain ambient air quality standards. In August 2005, the EPA issued a proposed response to the petition. The EPA proposed to deny the ozone portion of the petition based upon a lack of contribution to air quality by the named states. The EPA also proposed to deny the particulate matter portion of the petition based upon the CAIR Federal Implementation Plan (FIP) that would address the air quality concerns from neighboring states. On April 28, 2006, the EPA denied North Carolina’s petition based upon the final CAIR FIP described above. North Carolina has filed a legal challenge to the EPA’s denial. Briefing in that case is under way. On March 5, 2009 the D.C. Circuit remanded the case to the EPA for reconsideration. The EPA has conceded that the D.C. Circuit’s July 18, 2008 decision in the CAIR litigation, North Carolina v. EPA No. 05-1244, discussed above, and a subsequent order issued by the D.C. Circuit on December 23, 2008, have eliminated the legal basis for the EPA’s denial of North Carolina’s Section 126 petition. At this time, Duke Energy Ohio cannot predict the outcome of this proceeding.

Carbon Dioxide (CO2) Litigation. In July 2004, the states of Connecticut, New York, California, Iowa, New Jersey, Rhode Island, Vermont, Wisconsin and the City of New York brought a lawsuit in the U.S. District Court for the Southern District of New York against Cinergy, American Electric Power Company, Inc., American Electric Power Service Corporation, The Southern Company, Tennessee Valley Authority, and Xcel Energy Inc. A similar lawsuit was filed in the U.S. District Court for the Southern District of New York against the same companies by Open Space Institute, Inc., Open Space Conservancy, Inc., and The Audubon Society of New Hampshire. These law