COMMITMENTS AND CONTINGENCIES

6 Months Ended

Jun. 30, 2011

COMMITMENTS AND CONTINGENCIES.

COMMITMENTS AND CONTINGENCIES

NOTE 6—COMMITMENTS AND CONTINGENCIES

Commodity Purchase Obligations and Purchase Order Commitments

We routinely enter into long-term purchase and sale commitments for various quantities and lengths of time.  We have obligations to distribute and sell electricity and natural gas to our customers and expect to recover costs related to these obligations in future customer rates.

The purchase obligations described below were as of June 30, 2011.

· Our electric utility segment had obligations of $176.0 million related to coal supply and transportation that extend through 2016, obligations of $1,008.3 million for either capacity or energy related to purchased power that extend through 2030, and obligations of $5.4 million for other commodities that extend through 2013.

· Our natural gas utility segment had obligations of $369.9 million related to natural gas supply and transportation contracts that extend through 2024.

· We also had commitments of $227.6 million in the form of purchase orders issued to various vendors that relate to normal business operations, including construction projects.

Environmental

CAA New Source Review Issues

Weston and Pulliam Plants:

In November 2009, the EPA issued us an NOV alleging violations of the CAA’s New Source Review requirements relating to certain projects completed at the Weston and Pulliam plants from 1994 to 2009.  We continue to meet with the EPA and exchange proposals on a possible resolution.  We are currently unable to estimate the possible loss or range of loss related to this matter.

In May 2010, we received from the Sierra Club an NOI to file a civil lawsuit based on allegations that we violated the CAA at the Weston and Pulliam plants.  We entered into a Standstill Agreement with the Sierra Club by which the parties agreed to negotiate as part of the EPA NOV process, rather than litigate.  We are working on a possible resolution with the Sierra Club and the EPA.  We are currently unable to estimate the possible loss or range of loss related to this matter.

Columbia and Edgewater Plants:

In December 2009, the EPA issued an NOV to Wisconsin Power and Light (WP&L), the operator of the Columbia and Edgewater plants, and the other joint owners of these plants (including us).  The NOV alleges violations of the CAA’s New Source Review requirements related to certain projects completed at those plants.  WP&L and the other joint owners exchanged proposals with the EPA on a possible resolution.  We are currently unable to estimate the possible loss or range of loss related to this matter.

In September 2010, the Sierra Club filed a lawsuit against WP&L, which included allegations that modifications made at the Columbia plant did not comply with the CAA.  The Court stayed the proceeding until September 11, 2011, to allow the Sierra Club to participate in settlement negotiations with the EPA and the joint owners of the Columbia plant.  We are currently unable to estimate the possible loss or range of loss related to this matter.

In December 2009, we, along with the other co-owners of the Edgewater plant, received from the Sierra Club a copy of an NOI to file a civil lawsuit against the EPA.  The Sierra Club cited the EPA’s failure to take actions against the joint owners and operator of the Edgewater plant based upon allegations of failure to comply with the CAA.  If the EPA does not take action against us and/or the other joint owners, it is likely that the Sierra Club will.

In September 2010, the Sierra Club filed a lawsuit against WP&L, which included allegations that modifications made at the Edgewater plant did not comply with the CAA.  The Court stayed the proceeding until October 4, 2011, to allow the Sierra Club to participate in settlement negotiations with the EPA and the joint owners of the Edgewater plant.  We are currently unable to estimate the possible loss or range of loss related to this matter.

EPA Settlements with Other Utilities:

In response to the EPA’s CAA enforcement initiative, several utilities elected to settle with the EPA, while others are in litigation.  The fines, penalties, and costs of supplemental environmental projects associated with settlements involving comparably-sized facilities to Weston and Pulliam combined ranged between $6 million and $30 million.  The regulatory interpretations upon which the lawsuits or settlements are based may change depending on future court decisions made in the pending litigation.

If it were settled or determined that historical projects at the Weston, Pulliam, Columbia, and Edgewater plants required either a state or federal CAA permit, we may, under the applicable statutes, be required to complete the following remedial steps:

·      shut down the facility,

·      install additional pollution control equipment and/or impose emission limitations, and/or

·      conduct a supplemental environmental project.

In addition, we may also be required to pay a fine. Finally, under the CAA, citizen groups may pursue a claim.

Weston Air Permits

Weston 4 Construction Permit:

From 2004 to 2009, the Sierra Club filed various petitions objecting to the construction permit issued for the Weston 4 plant.  In June 2010, the Wisconsin Court of Appeals affirmed the Weston 4 construction permit, but directed the WDNR to reopen the permit to set specific visible emissions limits.  In July 2010, we, the WDNR, and the Sierra Club filed Petitions for Review with the Wisconsin Supreme Court.  In March 2011, the Wisconsin Supreme Court denied all Petitions for Review.  Other than the specific visible emissions limits issue, all other challenges to the construction permit are now resolved.  We are working with the WDNR and the Sierra Club to resolve this issue.  We do not expect this matter to have a material impact on our financial statements.

Weston Title V Air Permit:

In November 2010, the WDNR provided a draft revised permit.  We objected to proposed changes in mercury limits and requirements on the boiler as beyond the authority of the WDNR.  We continue to meet with the WDNR to resolve these issues.  We do not expect this matter to have a material impact on our financial statements.

WDNR Issued NOVs:

Since 2008, we received four NOVs from the WDNR alleging various violations of the different air permits for the Weston plant, Weston 4, Weston 1, and Weston 2, as well as one NOV for a clerical error involving pages missing from a quarterly report for Weston.  Corrective actions have been taken for the events in the five NOVs.  Discussions with the WDNR on the severity classification of the events continue.  Management believes it is likely that the WDNR will refer at least some of the NOVs to the state Justice Department for enforcement.  We do not expect this matter to have a material impact on our financial statements.

Pulliam Title V Air Permit

The WDNR issued the renewal of the permit for the Pulliam plant in April 2009.  In June 2010, the EPA issued an order directing the WDNR to respond to comments raised by the Sierra Club in its June 2009 Petition objecting to this permit.  We have been working with the WDNR to address the order.

We also challenged the permit in a contested case proceeding and Petition for Judicial Review.  The Petition was dismissed in an order remanding the matter to the WDNR.  In February 2011, the WDNR granted a contested case proceeding on the issues we raised, which included averaging times in the emission limits in the permit.  We are participating in the contested case proceeding and a hearing has been set for August 31, 2011.

In October 2010, we received from the Sierra Club a copy of an NOI to file a civil lawsuit against the EPA based on what the Sierra Club alleges to be the EPA’s unreasonable delay in performing its duties related to the grant or denial of the permit.

We are reviewing all of these matters but we do not expect them to have a material impact on our financial statements.

Columbia Title V Air Permit

In October 2009, the EPA issued an order objecting to the permit renewal issued by the WDNR for the Columbia plant.  The order determined that the WDNR did not adequately analyze whether a project in 2006 constituted a “major modification that required a permit.”  The EPA’s order directed the WDNR to resolve the objections within 90 days and “terminate, modify, or revoke and reissue” the permit accordingly.

In July 2010, we, along with our co-owners, received from the Sierra Club a copy of an NOI to file a civil lawsuit against the EPA.  The Sierra Club alleges that the EPA should assert jurisdiction over the permit because the WDNR failed to respond to the EPA’s objection within 90 days.

In September 2010, the WDNR issued a draft construction permit and a draft revised Title V permit in response to the EPA’s order.  In November 2010, the EPA notified the WDNR that the EPA “does not believe the WDNR’s proposal is responsive to the order.”  In January 2011, the WDNR issued a letter stating that upon review of the submitted public comments, the WDNR has determined not to issue the draft permits that were proposed to respond to the EPA’s order.  In February 2011, the Sierra Club filed for a declaratory action, claiming that the EPA had to assert jurisdiction over the permits.  In May 2011, the WDNR issued a second draft Title V permit in response to the EPA’s order.  We are monitoring this situation with WP&L and meeting with the WDNR.  We do not expect this matter to have a material impact on our financial statements.

Mercury and Interstate Air Quality Rules

Mercury:

The State of Wisconsin’s mercury rule, Chapter NR 446, requires a 40% reduction from the 2002 through 2004 baseline mercury emissions in Phase I, beginning January 1, 2010, through the end of 2014.  In Phase II, which begins in 2015, electric generating units above 150 megawatts will be required to reduce mercury emissions by 90%.  Reductions can be phased in and the 90% target delayed until 2021 if additional sulfur dioxide and nitrogen oxide reductions are implemented.  By 2015, electric generating units above 25 megawatts but less than 150 megawatts must reduce their mercury emissions to a level defined by the BACT rule.  As of June 30, 2011, we estimate capital costs of approximately $19 million, which includes estimates for both wholly owned and jointly owned plants, to achieve the required Phase I and Phase II reductions.  The capital costs are expected to be recovered in future rate cases.

In March 2011, the EPA issued a draft rule that will regulate emissions of mercury and other hazardous air pollutants.  A final rule is expected in November 2011.

Sulfur Dioxide and Nitrogen Oxide:

The EPA issued the Clean Air Interstate Rule (CAIR) in 2005 in order to reduce sulfur dioxide and nitrogen oxide emissions from utility boilers located in 29 states, including Wisconsin and Michigan.  In July 2008, the United States Court of Appeals (Court of Appeals) issued a decision vacating CAIR, which the EPA appealed.  In December 2008, the Court of Appeals reinstated CAIR and directed the EPA to address the deficiencies noted in its previous ruling to vacate CAIR.  In July 2011, the EPA issued a final CAIR replacement rule known as CSAPR.  The new rule becomes effective January 1, 2012, and as such, CAIR is still in place for the remainder of 2011.  In comparison to the CAIR rule, CSAPR significantly reduces the emission allowances allocated to our existing units for sulfur dioxide and nitrogen oxide in 2012, with a further reduction in 2014.

CSAPR also establishes new sulfur dioxide and nitrogen oxide emission allowances and does not allow carryover of the existing nitrogen oxide emission allowances allocated to WPS under CAIR.  We did not acquire any CAIR nitrogen oxide emission allowances for 2011 and beyond, other than those allocated by the EPA.  Sulfur dioxide emission allowances allocated under the Acid Rain Program will continue to be issued and surrendered independent of the CSAPR emission allowance program.  Thus, we do not expect any material impact on our consolidated financial statements as a result of being unable to carryover existing emission allowances.

Under CAIR, units affected by the Best Available Retrofit Technology (BART) rule are considered in compliance with BART for sulfur dioxide and nitrogen oxide emissions if they are in compliance with CAIR. Although particulate emissions also contribute to visibility impairment, the WDNR’s modeling has shown the impairment to be so insignificant that additional capital expenditures on controls are not warranted.  The EPA has not indicated whether units in compliance with CSAPR will also be considered in compliance with BART.

We are currently reviewing the EPA’s final rule and its potential impact on us.  In order to be in compliance with CSAPR, additional sulfur dioxide and nitrogen oxide controls will need to be installed or we will have to make other changes in how we operate our existing units.  The installation of these controls will be scheduled as part of our long-term maintenance plan for existing units.  Due to the fact that the rule has only recently been finalized, we are currently unable to estimate the cost of compliance.  However, we expect to recover capital costs incurred to comply with CSAPR in future rates.

Manufactured Gas Plant Remediation

We operated facilities in the past at multiple sites for the purpose of manufacturing and storing manufactured gas.  In connection with these activities, waste materials were produced that may have resulted in soil and groundwater contamination at these sites.  Under certain laws and regulations relating to the protection of the environment, we are required to undertake remedial action with respect to some of these materials.  We are coordinating the investigation and cleanup of the sites subject to EPA jurisdiction under what is called a “multi-site” program.  This program involves prioritizing the work to be done at the sites, preparation and approval of documents common to all of the sites, and use of a consistent approach in selecting remedies.

We are responsible for the environmental remediation of ten manufactured gas plant sites, of which seven have been transferred to the EPA Superfund Alternative Sites Program.  Under the EPA’s program, the remedy decisions at these sites will be made using risk-based criteria typically used at Superfund sites.  As of June 30, 2011, we estimated and accrued for $75.2 million of future undiscounted investigation and cleanup costs for all sites.  We may adjust these estimates in the future, due to remedial technology, regulatory requirements, remedy determinations, and any claims of natural resource damages.  As of June 30, 2011, we recorded a regulatory asset of $72.8 million, which is net of insurance recoveries of $22.2 million, related to the expected recovery of both cash expenditures and estimated future expenditures through rates.  Under current PSCW policies, we may not recover carrying costs associated with the cleanup expenditures.

Management believes that any costs incurred for environmental activities relating to former manufactured gas plant operations that are not recoverable through contributions from other entities or from insurance carriers have been prudently incurred and are, therefore, recoverable through rates.  Accordingly, management believes that these costs will not have a material adverse effect on our consolidated financial statements.  However, any changes in the approved rate mechanisms for recovery of these costs, or any adverse conclusions by the various regulatory commissions with respect to the prudence of costs actually incurred, could materially adversely affect rate recovery of such costs.

Greenhouse Gases

The EPA began regulating greenhouse gas emissions under the CAA in January 2011, by applying the BACT requirements (associated with the New Source Review program) to new and modified larger greenhouse gas emitters.  Technology to remove and sequester greenhouse gas emissions is not commercially available at scale.  Therefore, the EPA issued guidance that defines BACT in terms of improvements in energy efficiency as opposed to relying on pollution control equipment.  In December 2010, the EPA announced its intent to develop new source performance standards for greenhouse gas emissions.  The standards would apply to new and modified, as well as existing, electric utility steam generating units.  The EPA plans to propose these standards in 2011 and finalize them in 2012.  Currently there is no applicable federal or state legislation pending that specifically addresses greenhouse gas emissions.

We periodically evaluate both the technical and cost implications that may result from future state, regional, or federal greenhouse gas regulatory programs.  This evaluation indicates it is probable that any regulatory program that caps emissions or imposes a carbon tax will increase costs for us and our customers.  The greatest impact is likely to be on fossil fuel-fired generation, with a less significant impact on natural gas storage and distribution operations.  Efforts are underway within the utility industry to find a feasible method for capturing carbon dioxide from pulverized coal-fired units and to develop cleaner ways to burn coal.

A risk exists that any greenhouse gas legislation or regulation will increase the cost of producing energy using fossil fuels.  However, we believe the capital expenditures being made at our plants are appropriate under any reasonable mandatory greenhouse gas program.  We also believe that our future expenditures to control greenhouse gas emissions or meet renewable portfolio standards will be recoverable in rates.  We will continue to monitor and manage potential risks and opportunities associated with future greenhouse gas legislative or regulatory actions.