10-Q 1 q10q0604.txt LG&E AND KU 2ND QTR 10-Q 45 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2004 Or [_] TRANSITION REPORT PURSUANT 1TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission Registrant, State of Incorporation IRS Employer File Number Address, and Telephone Number Identification No. 1-2893 Louisville Gas and Electric Company 61-0264150 (A Kentucky Corporation) 220 West Main Street P.O. Box 32010 Louisville, KY 40232 (502) 627-2000 1-3464 Kentucky Utilities Company 61-0247570 (A Kentucky and Virginia Corporation) One Quality Street Lexington, KY 40507-1428 (859) 255-2100 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 whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes No X Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: Louisville Gas and Electric Company 21,294,223 shares, without par value, as of July 31, 2004, all held by LG&E Energy LLC Kentucky Utilities Company 37,817,878 shares, without par value, as of July 31, 2004, all held by LG&E Energy LLC This combined Form 10-Q is separately filed by Louisville Gas and Electric Company and Kentucky Utilities Company. Information contained herein related to any individual registrant is filed by such registrant on its own behalf. Each registrant makes no representation as to information related to the other registrants. - New Page - TABLE OF CONTENTS PART I Item 1 Consolidated Financial Statements Louisville Gas and Electric Company and Subsidiary Statements of Income 1 Statements of Retained Earnings 1 Balance Sheets 2 Statements of Cash Flow 4 Statements of Other Comprehensive Income 5 Kentucky Utilities Company and Subsidiary Statements of Income 6 Statements of Retained Earnings 6 Balance Sheets 7 Statements of Cash Flow 9 Statements of Other Comprehensive Income 10 Notes to Consolidated Financial Statements 11 Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations 22 Item 3 Quantitative and Qualitative Disclosures About Market Risk 36 Item 4 Controls and Procedures 37 PART II Item 1 Legal Proceedings 38 Item 6 Exhibits and Reports on Form 8-K 39 Signatures 40 Exhibits 41 - New Page - Part I. Financial Information - Item 1. Financial Statements Louisville Gas and Electric Company and Subsidiary Consolidated Statements of Income (Unaudited) (Thousands of $) Three Months Six Months Ended Ended June 30, June 30, 2004 2003 2004 2003 OPERATING REVENUES (Note 5): Electric $192,566 $173,917 $390,815 $360,936 Gas 43,646 41,456 207,360 181,280 Total operating revenues 236,212 215,373 598,175 542,216 OPERATING EXPENSES: Fuel for electric generation 47,615 46,277 100,139 95,754 Power purchased 17,345 17,313 46,233 41,440 Gas supply expenses 30,991 25,963 161,747 132,070 Other operation expenses 57,110 53,379 115,171 106,907 Maintenance 15,266 17,690 26,807 29,583 Depreciation and amortization 28,223 30,293 55,722 57,437 Federal and state income taxes 9,374 4,714 24,399 21,355 Property and other taxes 5,069 3,454 10,140 8,189 Total operating expenses 210,993 199,083 540,358 492,735 NET OPERATING INCOME 25,219 16,290 57,817 49,481 Other income (expense) - net 133 (1,395) (328) (335) Other income from affiliated company (Note 10) - 1 - 5 Interest expense (Note 3) 5,236 5,849 10,013 12,104 Interest expense to affiliated companies (Note 10) 2,976 1,292 6,117 2,027 NET INCOME $ 17,140 $ 7,755 $ 41,359 $ 35,020 Consolidated Statements of Retained Earnings (Unaudited) (Thousands of $) Three Months Six Months Ended Ended June 30, June 30, 2004 2003 2004 2003 Balance at beginning of period $521,204 $435,647 $497,441 $409,319 Net income 17,140 7,755 41,359 35,020 Subtotal 538,344 443,402 538,800 444,339 Cash dividends declared on stock: 5% cumulative preferred 269 269 538 538 Auction rate cumulative preferred 219 268 406 569 $5.875 cumulative preferred (Note 8) - 367 - 734 Common 21,000 - 21,000 - Subtotal 21,488 904 21,944 1,841 Balance at end of period $516,856 $442,498 $516,856 $442,498 The accompanying notes are an integral part of these consolidated financial statements. - New Page - Louisville Gas and Electric Company and Subsidiary Consolidated Balance Sheets (Unaudited) (Thousands of $) ASSETS June 30, December 31, 2004 2003 UTILITY PLANT: At original cost $3,857,231 $3,804,183 Less: reserve for depreciation 1,366,281 1,326,442 Net utility plant (Note 7) 2,490,950 2,477,741 OTHER PROPERTY AND INVESTMENTS - less reserve of $63 as of June 30, 2004 and December 31, 2003 507 611 CURRENT ASSETS: Cash and cash equivalents 13,984 1,706 Accounts receivable - less reserve of $3,515 as of June 30, 2004 and December 31, 2003 (Note 4) 114,072 84,585 Materials and supplies - at average cost: Fuel (predominantly coal) 32,843 25,260 Gas stored underground 21,795 69,884 Other 26,085 24,971 Prepayments and other 2,981 5,281 Total current assets 211,760 211,687 DEFERRED DEBITS AND OTHER ASSETS: Unamortized debt expense 8,653 8,753 Regulatory assets (Note 6) 113,553 143,626 Long-term derivative asset (Note 3) 2,368 - Other 33,038 40,121 Total deferred debits and other assets 157,612 192,500 Total assets $2,860,829 $2,882,539 The accompanying notes are an integral part of these consolidated financial statements. - New Page - Louisville Gas and Electric Company and Subsidiary Consolidated Balance Sheets (Unaudited) (Thousands of $) CAPITALIZATION AND LIABILITIES June 30, December 31, 2004 2003 CAPITALIZATION: Common stock, without par value - Outstanding 21,294,223 shares $ 425,170 $ 425,170 Common stock expense (836) (836) Additional paid-in capital 40,000 40,000 Accumulated other comprehensive loss (34,444) (38,111) Retained earnings 516,856 497,441 Total common equity 946,746 923,664 Cumulative preferred stock 70,425 70,425 Mandatorily redeemable preferred stock (Note 8) 22,500 22,500 Long-term debt (Note 9) 328,104 328,104 Long-term debt to affiliated company (Note 9) 225,000 200,000 575,604 550,604 Total capitalization 1,592,775 1,544,693 CURRENT LIABILITIES: Current portion of mandatorily redeemable preferred stock (Note 8) 1,250 1,250 Current portion of long-term debt 246,200 246,200 Current portion of long-term debt to affiliated company (Note 9) 50,000 - Notes payable to affiliated companies (Note 9) 25,950 80,332 Accounts payable 76,261 93,118 Accounts payable to affiliated companies (Note 10) 27,606 38,343 Accrued income taxes 2,605 11,472 Customer deposits 11,015 10,493 Accrued interest 2,146 1,999 Accrued interest to affiliated company (Note 10) 3,648 2,750 Other 14,893 11,784 Total current liabilities 461,574 497,741 DEFERRED CREDITS AND OTHER LIABILITIES: Accumulated deferred income taxes - net 344,337 337,704 Investment tax credit, in process of amortization 47,535 50,329 Accumulated provision for pensions and related benefits 106,695 140,598 Customer advances for construction 10,344 9,890 Asset retirement obligation 10,064 9,747 Regulatory liabilities (Note 6): Accumulated cost of removal of utility plant 218,022 216,948 Other 49,511 51,822 Long-term derivative liability (Note 3) 12,198 15,966 Other 7,774 7,101 Total deferred credits and other liabilities 806,480 840,105 Total capital and liabilities $2,860,829 $2,882,539 The accompanying notes are an integral part of these consolidated financial statements. - New Page - Louisville Gas and Electric Company and Subsidiary Consolidated Statement of Cash Flows (Unaudited) (Thousands of $) Six Months Ended June 30, 2004 2003 CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 41,359 $ 35,020 Items not requiring cash currently: Depreciation and amortization 55,722 57,437 Deferred income taxes - net 4,909 12,876 Investment tax credit - net (2,794) (2,105) Value Delivery Team (VDT) amortization (Note 6) 15,067 15,332 Mark-to-market financial instruments (6,136) 1,551 Other 4,957 9,557 Changes in current assets and liabilities (19,580) 14,956 Changes in accounts receivable securitization-net (Note 4) - (14,000) Pension funding (Note 9 and 12) (34,492) (83,125) Provision for post-retirement benefits (8,047) (4,201) Gas supply clause 8,340 (19,834) Earnings sharing mechanism 2,357 1,772 Combustion turbine litigation settlement 7,107 - Other 9,769 3,401 Net cash flows from operating activities 78,538 28,637 CASH FLOWS FROM INVESTING ACTIVITIES: Proceeds from sales of securities 103 163 Construction expenditures (64,958) (119,412) Net cash flows from investing activities (64,855) (119,249) CASH FLOWS FROM FINANCING ACTIVITIES: Long-term borrowings from affiliated company (Note 9) 125,000 100,000 Short-term borrowings from affiliated company (Note 9) 260,550 349,400 Repayment of long-term borrowings from affiliated company (50,000) - Repayment of short-term borrowings from affiliated company (314,932) (370,737) Issuance costs of pollution control bonds (133) - Payment of common dividends (21,000) - Payment of preferred dividends (890) (1,993) Net cash flows from financing activities (1,405) 76,670 CHANGE IN CASH AND CASH EQUIVALENTS 12,278 (13,942) CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 1,706 17,015 CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 13,984 $ 3,073 SUPPLEMENTAL DISCLOSURES: Cash paid during the period for: Income taxes $ 33,062 $ 15,947 Interest on borrowed money 8,539 10,705 Interest to affiliated companies on borrowed money 5,282 1,315 The accompanying notes are an integral part of these consolidated financial statements. -New Page - Louisville Gas and Electric Company and Subsidiary Consolidated Statements of Other Comprehensive Income (Unaudited) (Thousands of $) Three Months Six Months Ended Ended June 30, June 30, 2004 2003 2004 2003 Net income $17,140 $7,775 $41,359 $35,020 Gains/(losses) on derivative instruments and hedging activities - net of tax benefit/(expense) of $(4,866), $1,021, $(2,449) and $1,034, respectively (Note 3) 7,299 (1,531) 3,667 (1,551) Other comprehensive income (loss), net of tax 7,299 (1,531) 3,667 (1,551) Comprehensive income $24,439 $6,224 $45,026 $33,469 The accompanying notes are an integral part of these consolidated financial statements. - New Page - Kentucky Utilities Company and Subsidiary Consolidated Statements of Income (Unaudited) (Thousands of $) Three Months Six Months Ended Ended June 30, June 30, 2004 2003 2004 2003 OPERATING REVENUES $232,369 $197,174 $479,755 $422,157 OPERATING EXPENSES: Fuel for electric generation 67,631 59,641 137,515 125,964 Power purchased 30,662 33,648 71,969 74,848 Other operation expenses 36,536 38,130 74,990 77,019 Maintenance 17,024 7,403 28,908 36,369 Depreciation and amortization 25,950 27,762 51,199 51,912 Federal and state income taxes 17,461 7,467 38,562 14,067 Property and other taxes 4,284 3,968 8,537 8,163 Total operating expenses 199,548 178,019 411,680 388,342 NET OPERATING INCOME 32,821 19,155 68,075 33,815 Other income - net 1,958 2,697 3,420 4,803 Other income (expense) from affiliated company (Note 10) 4 (3) 14 - Interest expense (Note 3) 3,682 6,582 4,417 11,113 Interest expense to affiliated companies (Note 10) 3,536 1,108 7,083 1,485 NET INCOME $ 27,565 $ 14,159 $ 60,009 $ 26,020 Consolidated Statements of Retained Earnings (Unaudited) (Thousands of $) Three Months Six Months Ended Ended June 30, June 30, 2004 2003 2004 2003 Balance at beginning of period $623,050 $513,321 $591,170 $502,024 Net income 27,565 14,159 60,009 26,020 Subtotal 650,615 527,480 651,179 528,044 Cash dividends declared on stock: 4.75% cumulative preferred 237 237 475 475 6.53% cumulative preferred 327 327 653 653 Common 21,000 - 21,000 - Subtotal 21,564 564 22,128 1,128 Balance at end of period $629,051 $526,916 $629,051 $526,916 The accompanying notes are an integral part of these consolidated financial statements. - New Page - Kentucky Utilities Company and Subsidiary Consolidated Balance Sheets (Unaudited) (Thousands of $) ASSETS June 30, December 31, 2004 2003 UTILITY PLANT: At original cost $3,645,814 $3,596,657 Less: reserve for depreciation 1,377,302 1,355,055 Net utility plant (Note 7) 2,268,512 2,241,602 OTHER PROPERTY AND INVESTMENTS - less reserve of $131 as of June 30, 2004 and December 31, 2003 19,196 17,862 CURRENT ASSETS: Cash and cash equivalents 9,792 4,869 Accounts receivable - less reserve of $673 and $672 as of June 30, 2004 and December 31, 2003, respectively (Note 4) 94,804 49,289 Materials and supplies - at average cost: Fuel (predominantly coal) 35,552 45,538 Other 27,367 27,094 Prepayments and other 9,866 13,100 Total current assets 177,381 139,890 DEFERRED DEBITS AND OTHER ASSETS: Unamortized debt expense 4,349 4,481 Regulatory assets (Note 6) 64,974 72,318 Long-term derivative asset (Note 3) 7,584 12,223 Other 11,102 21,916 Total deferred debits and other assets 88,009 110,938 Total assets $2,553,098 $2,510,292 The accompanying notes are an integral part of these consolidated financial statements. - New Page - Kentucky Utilities Company and Subsidiary Consolidated Balance Sheets (cont.) (Unaudited) (Thousands of $) CAPITALIZATION AND LIABILITIES June 30, December 31, 2004 2003 CAPITALIZATION: Common stock, without par value - Outstanding 37,817,878 shares $ 308,140 $ 308,140 Common stock expense (322) (322) Additional paid-in capital 15,000 15,000 Accumulated other comprehensive loss (6,045) (6,031) Retained earnings 629,051 591,170 Total common equity 945,824 907,957 Cumulative preferred stock 39,727 39,727 Long-term debt (Note 9) 307,940 312,646 Long-term debt to affiliated company (Note 9) 333,000 283,000 640,940 595,646 Total capitalization 1,626,491 1,543,330 CURRENT LIABILITIES: Current portion of long-term debt 87,130 91,930 Notes payable to affiliated company (Note 9) 53,181 43,231 Accounts payable 48,356 69,947 Accounts payable to affiliated companies (Note 10) 15,727 26,426 Accrued income taxes 10,454 7,104 Customer deposits 13,867 13,453 Accrued interest 1,972 2,024 Accrued interest to affiliated company (Note 10) 3,493 2,454 Other 17,019 9,767 Total current liabilities 251,199 266,336 DEFERRED CREDITS AND OTHER LIABILITIES: Accumulated deferred income taxes - net 275,860 261,258 Investment tax credit, in process of amortization 4,832 5,859 Accumulated provision for pensions and related benefits 63,140 103,101 Customer advances for construction 1,624 1,564 Asset retirement obligation 20,339 19,698 Regulatory liabilities (Note 6): Accumulated cost of removal of utility plant 266,218 261,942 Other 30,908 38,027 Other 12,487 9,177 Total deferred credits and other liabilities 675,408 700,626 Total capital and liabilities $2,553,098 $2,510,292 The accompanying notes are an integral part of these consolidated financial statements. - New Page - Kentucky Utilities Company and Subsidiary Consolidated Statement of Cash Flows (Unaudited) (Thousands of $) Six Months Ended June 30, 2004 2003 CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 60,009 $ 26,020 Items not requiring cash currently: Depreciation and amortization 51,199 51,912 Deferred income taxes - net 13,346 1,485 Investment tax credit - net (1,027) (1,321) Value Delivery Team (VDT) amortization (Note 6) 5,877 6,153 Mark-to-market financial instruments (67) 2,016 Other 1,632 14,548 Changes in current assets and liabilities (52,855) 4,628 Pension funding (Note 9 and 12) (43,409) (3,515) Provision for post-retirement benefits (3,372) (3,036) Earnings sharing mechanism 344 4,464 Combustion turbine litigation settlement 11,595 - Other 6,296 11,434 Net cash flows from operating activities 49,568 114,788 CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of securities (1,334) (1,786) Construction expenditures (76,338) (175,507) Net cash flows from investing activities (77,672) (177,293) CASH FLOWS FROM FINANCING ACTIVITIES: Long-term borrowings from affiliated company (Note 9) 50,000 100,000 Short-term borrowings from affiliated company (Note 9) 255,000 360,640 Repayment of short-term borrowings from affiliated company (245,050) (333,700) Retirement of pollution control bonds (4,800) (62,000) Refund of issuance costs of pollution control bonds 5 - Payment of common dividends (21,000) - Payment of preferred dividends (1,128) (1,128) Net cash flows from financing activities 33,027 63,812 CHANGE IN CASH AND CASH EQUIVALENTS 4,923 1,307 CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 4,869 5,391 CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 9,792 $ 6,698 SUPPLEMENTAL DISCLOSURES: Cash paid during the period for: Income taxes $ 21,264 $ 13,763 Interest on borrowed money 7,562 11,045 Interest to affiliated companies on borrowed money 6,070 724 The accompanying notes are an integral part of these consolidated financial statements. - New Page - Kentucky Utilities Company and Subsidiary Consolidated Statements of Other Comprehensive Income (Unaudited) (Thousands of $) Three Months Six Months Ended Ended June 30, June 30, 2004 2003 2004 2003 Net income $27,565 $14,159 $60,009 $26,020 Losses on derivative instruments and hedging activities - net of tax benefit/(expense) of $18 and $5 respectively (Note 3) (27) - (14) - Other comprehensive loss, net of tax (27) - (14) - Comprehensive income $27,538 $14,159 $59,995 $26,020 The accompanying notes are an integral part of these consolidated financial statements. - New Page - Louisville Gas and Electric Company and Subsidiary Kentucky Utilities Company and Subsidiary Notes to Consolidated Financial Statements (Unaudited) 1. General The unaudited consolidated financial statements include the accounts of Louisville Gas and Electric Company and Subsidiary and Kentucky Utilities Company and Subsidiary (each "LG&E" and "KU", or the "Companies"). The common stock of each of LG&E and KU is wholly-owned by LG&E Energy LLC ("LG&E Energy"). In the opinion of management, the unaudited interim financial statements include all adjustments, consisting only of normal recurring adjustments, necessary for a fair statement of consolidated financial position, results of operations, comprehensive income and cash flows for the periods indicated. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to Securities and Exchange Commission ("SEC") rules and regulations, although the Companies believe that the disclosures are adequate to make the information presented not misleading. See LG&E's and KU's Annual Reports on Form 10-K for the year ended December 31, 2003, for information relevant to the accompanying financial statements, including information as to the significant accounting policies of the Companies. The accompanying financial statements for the three months and six months ended June 30, 2003, have been revised to conform to certain reclassifications in the current three months and six months ended June 30, 2004. These reclassifications had no impact on the balance sheet net assets or net income, as previously reported. 2. Mergers and Acquisitions LG&E and KU are each subsidiaries of LG&E Energy. In July 2002, E.ON AG ("E.ON"), a German company, completed its acquisition of Powergen Limited ("Powergen"), the former parent company of LG&E Energy. As a result, LG&E and KU became indirect subsidiaries of E.ON. E.ON had announced its pre-conditional cash offer of 5.1 billion pounds sterling ($7.3 billion) for Powergen in April 2001. Following the purchase of Powergen by E.ON, E.ON became a registered holding company under the Public Utility Holding Company Act of 1935 ("PUHCA"). As a result, E.ON, its utility subsidiaries, including LG&E and KU, and certain of its non-utility subsidiaries are subject to extensive regulation by the SEC under PUHCA with respect to issuances and sales of securities, acquisitions and sales of certain utility properties, and intra-system sales of certain goods and services. In addition, PUHCA generally limits the ability of registered holding companies to acquire additional public utility systems and to acquire and retain businesses unrelated to the utility operations of the holding company. LG&E and KU believe that they have adequate authority (including financing authority) under existing SEC orders and regulations to conduct their business. LG&E and KU will seek additional authorization when necessary. As contemplated in their regulatory filings in connection with the E.ON acquisition, E.ON, Powergen and LG&E Energy completed an administrative reorganization to move the LG&E Energy group from an indirect Powergen subsidiary to an indirect E.ON subsidiary. This reorganization was effective in March 2003. In early 2004, LG&E Energy began direct reporting arrangements to E.ON. - New Page - The utility operations (LG&E and KU) of LG&E Energy have continued their separate identities and continue to serve customers in Kentucky, Virginia and Tennessee under their existing names. The preferred stock and debt securities of LG&E and KU were not affected by these transactions and LG&E and KU continue to file SEC reports. Effective December 30, 2003, LG&E Energy LLC became the successor, by assignment and subsequent merger, to all the assets and liabilities of LG&E Energy Corp. Following the conversion, LG&E Energy became a registered holding company under PUHCA. 3. Financial Instruments The Companies use interest rate swaps to hedge exposure to market fluctuations in certain of their debt instruments. Pursuant to the Companies' policies, use of these financial instruments is intended to mitigate risk, earnings and cash flow volatility and is not speculative in nature. Management has designated all of the Companies' interest rate swaps as hedge instruments. Financial instruments designated as cash flow hedges have resulting gains and losses recorded within other comprehensive income and stockholders' equity. To the extent a financial instrument designated as a cash flow hedge or the underlying item being hedged is prematurely terminated or the hedge becomes ineffective, the resulting gains or losses are reclassified from other comprehensive income to net income. Financial instruments designated as fair value hedges and the underlying hedged items are periodically marked to market with the resulting net gains and losses recorded directly into net income. Upon termination of any fair value hedges, the resulting gain or loss is recorded into net income. As of June 30, 2004, LG&E was party to various interest rate swap agreements with aggregate notional amounts of $228.3 million. Under these swap agreements, LG&E paid fixed rates averaging 4.38% and received variable rates based on LIBOR or the Bond Market Association's municipal swap index averaging 1.01% at June 30, 2004. The swap agreements in effect at June 30, 2004 have been designated as cash flow hedges and mature on dates ranging from 2005 to 2033. The hedges have been deemed to be fully effective resulting in a pretax gain of $12.2 million and $6.1 million for the three months and six months ended June 30, 2004, respectively, recorded in other comprehensive income. Upon expiration of these hedges, the amount recorded in other comprehensive income will be reclassified into earnings. The amounts expected to be reclassified from other comprehensive income to earnings in the next twelve months are immaterial. As of June 30, 2004, KU was party to various interest rate swap agreements with aggregate notional amounts of $103.0 million. Under these swap agreements, KU paid variable rates based on either LIBOR or the Bond Market Association's municipal swap index averaging 2.23%, and received fixed rates averaging 7.74% at June 30, 2004. The swap agreements in effect at June 30, 2004 have been designated as fair value hedges and mature on dates ranging from 2007 to 2025. During the three months and six months ended June 30, 2004, the effect of marking these financial instruments and the underlying debt to market resulted in a net pretax gain/(loss) of $(0.5) million and $0.7 million (representing the hedges' ineffectiveness), respectively, recorded as a decrease/(increase) in interest expense. Interest rate swaps hedge interest rate risk on the underlying debt. Under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, in addition to swaps being marked to market, the item being hedged using a fair value hedge must also be marked to market. Consequently at June 30, 2004, KU's debt reflects an increase by a $10.0 million mark-to-market adjustment. - New Page - In February 2004, KU terminated the swap it had in place related to its Series 9 pollution control bonds. The notional amount of the terminated swap was $50 million and KU received a payment of $2.0 million as part of the termination, resulting in a gain of $0.8 million. 4. Accounts Receivable Securitization Programs In February 2001, LG&E and KU implemented accounts receivable securitization programs. The purpose of these programs was to enable LG&E and KU to accelerate the receipt of cash from the collection of retail accounts receivable, thereby reducing dependence upon more costly sources of working capital. In January 2004, LG&E and KU terminated their accounts receivable securitization programs and replaced them with intercompany loans from an E.ON affiliate. In May 2004, LG&E and KU dissolved their inactive accounts receivable securitization-related subsidiaries, LG&E Receivables LLC and KU Receivables LLC. The accounts receivable securitization-related subsidiaries were the only subsidiaries of LG&E and KU. 5. Segment of Business LG&E's revenues and net income by business segment for the three and six months ended June 30, 2004 and 2003, follow: Three Months Ended Six Months Ended June 30, June 30, (in thousands) 2004 2003 2004 2003 LG&E Electric Revenues 192,566 173,917 390,815 360,936 Net income 20,441 9,457 36,384 27,489 LG&E Gas Revenues 43,646 41,456 207,360 181,280 Net income (3,301) (1,682) 4,975 7,531 Total Revenues 236,212 215,373 598,175 542,216 Net income 17,140 7,775 41,359 35,020 6. Regulatory Assets and Liabilities The following regulatory assets and liabilities were included in LG&E's balance sheets as of June 30, 2004 and December 31, 2003: Louisville Gas and Electric (Unaudited) June 30, December 31, (in thousands) 2004 2003 VDT costs $ 52,743 $ 67,810 Gas supply adjustments due from customers 11,930 22,077 Unamortized loss on bonds 20,802 21,333 Earnings sharing mechanism (ESM) provision 10,002 12,359 Merger surcredit 5,529 6,220 Asset retirement obligation (ARO) 6,480 6,015 Gas performance-based ratemaking (PBR) 3,378 5,480 Other (including fuel adjustment clause (FAC), demand side management (DSM), etc.) 2,689 2,332 Total regulatory assets $ 113,553 $ 143,626 Accumulated cost of removal of utility plant $(218,022) $(216,948) Deferred income taxes - net (39,457) (41,180) Gas supply adjustments due to customers (4,999) (6,805) DSM (2,904) (1,706) Other (including environmental cost recovery (ECR), ARO, FAC and ESM) (2,151) (2,131) Total regulatory liabilities $(267,533) $(268,770) - New Page - LG&E currently earns a return on all regulatory assets except for gas supply adjustments, ESM, gas performance-based ratemaking and FAC, all of which are separate rate mechanisms with recovery within twelve months. Additionally, no current return is earned on the ARO regulatory asset. This regulatory asset will be offset against the associated regulatory liability, ARO asset, and ARO liability at the time the underlying asset is retired. The following regulatory assets and liabilities were included in KU's balance sheets as of June 30, 2004 and December 31, 2003: Kentucky Utilities (Unaudited) June 30, December 31, (in thousands) 2004 2003 VDT costs $ 20,574 $ 26,451 Unamortized loss on bonds 10,127 10,511 ESM provision 12,038 12,382 Merger surcredit 4,280 4,815 ARO 12,095 11,322 FAC 2,865 4,298 Other 2,995 2,539 Total regulatory assets $ 64,974 $ 72,318 Accumulated cost of removal of utility plant $(266,218) $(261,942) Deferred income taxes - net (22,802) (24,058) ARO (1,288) (1,162) Spare parts (1,071) (1,055) ECR (3,671) (9,189) Other (including FAC and DSM) (2,076) (2,563) Total regulatory liabilities $(297,126) $(299,969) KU currently earns a return on all regulatory assets except for ESM and FAC, both of which are separate recovery mechanisms with recovery within twelve months. Additionally, no current return is earned on the ARO regulatory asset. This regulatory asset will be offset against the associated regulatory liability, ARO asset, and ARO liability at the time the underlying asset is retired. 7. Utility Plant KU retired two steam generating units, Green River Units 1 and 2, in the amount of $17.2 million, from its books as of March 31, 2004. Approximately $4 million in common assets, which are shared by Green River Units 3 and 4, remain on KU's books. The common assets will remain on KU's books until the final retirement of Green River Units 3 and 4. The gross book value of Green River Units 1 and 2 was charged to the accumulated reserve for depreciation in accordance with FERC regulations and no gain or loss was recorded. A partial redemption of pollution control Series 14 bonds totaling $4.8 million was required in the second quarter as a result of the retirement (see Note 9). - New Page - The following data represent shares of jointly-owned additions to the Trimble County plant for four combustion turbines ("CT's") as of June 30, 2004. Trimble County CT Units 7 and 8 began commercial operation on June 1, 2004. The addition to LG&E plant in service was $37.0 million and for KU the addition was $63.2 million. Trimble County CT Units 9 and 10 began commercial operation on July 1, 2004. ($ in millions) LG&E KU Total Trimble CT 7 Ownership % 37% 63% 100% Mw capacity 59 101 160 Net book value $18.7 $32.1 $50.8 Trimble CT 8 Ownership % 37% 63% 100% Mw capacity 59 101 160 Net book value $18.6 $31.9 $50.5 Trimble CT 9 Ownership % 37% 63% 100% Mw capacity 59 101 160 Net book value (in construction work in progress) $18.7 $32.0 $50.7 Trimble CT 10 Ownership % 37% 63% 100% Mw capacity 59 101 160 Net book value (in construction work in progress) $18.6 $32.0 $50.6 8. New Accounting Pronouncements FIN 46 In January 2003, the Financial Accounting Standards Board ("FASB") issued Financial Accounting Standards Board Interpretation No. 46, Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51 ("FIN 46"). FIN 46 required certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 was effective immediately for all new variable interest entities created or acquired after January 31, 2003. In December 2003, FIN 46 was revised, delaying the effective dates for certain entities created before February 1, 2003, and making other amendments to clarify application of the guidance. For potential variable interest entities other than special purpose entities, the revised FIN 46 ("FIN 46R") is now required to be applied no later than the end of the first fiscal year or interim reporting period ending after March 15, 2004. For all special purpose entities created prior to February 1, 2003, FIN 46R is now required to be applied at the end of the first interim or annual reporting period ending after December 15, 2003. FIN 46R may be applied prospectively with a cumulative- effect adjustment as of the date it is first applied, or by restating previously issued financial statements with a cumulative-effect adjustment as of the beginning of the first year restated. FIN 46R also requires certain disclosures of an entity's relationship with variable interest entities. Both LG&E and KU hold investment interests in Ohio Valley Electric Corporation ("OVEC"), and KU holds an investment interest in Electric Energy, Inc. ("EEI"). Neither LG&E nor KU are the primary beneficiary of OVEC or EEI, and thus neither are consolidated into the financial statements of LG&E or KU. - New Page - LG&E, KU and ten other electric utilities are participating owners of OVEC, located in Piketon, Ohio. OVEC owns and operates two power plants that burn coal to generate electricity, Kyger Creek Station in Ohio and Clifty Creek Station in Indiana. LG&E's share is 7%, representing approximately 155 Mw of generation capacity and KU's share is 2.5%, approximately 55 Mw of generation capacity. LG&E's and KU's original investments in OVEC were made in 1952. LG&E's investment in OVEC is the equivalent of 4.9% of OVEC's common stock and KU's investment is the equivalent of 2.5% of OVEC's common stock. LG&E's and KU's investments in OVEC are accounted for under the cost method of accounting. As of June 30, 2004, LG&E's and KU's investments in OVEC totaled $0.5 million and $0.3 million, respectively. LG&E's and KU's maximum exposure to loss as a result of their involvement with OVEC is limited to the value of their investments. In the event of the inability of OVEC to fulfill its power provision requirements, LG&E and KU would substitute such power supply with either owned generation or market purchases and would generally recover associated incremental costs through regulatory rate mechanisms. See Note 11 and Part II, Item 1, for further discussion of developments regarding LG&E's and KU's ownership interests and power purchase rights. KU owns 20% of the common stock of EEI, which owns and operates a 1,000- Mw generating station in southern Illinois. KU is entitled to take 20% of the available capacity of the station. Purchases from EEI are made under a contractual formula which has resulted in costs which were and are expected to be comparable to the cost of other power purchased or generated by KU. Such power equated to approximately 9% of KU's net generation system output in 2003. KU's original investment in EEI was made in 1953. KU's investment in EEI is accounted for under the equity method of accounting and, as of June 30, 2004, totaled $11.9 million. KU's maximum exposure to loss as a result of its involvement with EEI is limited to the value of its investment. In the event of the inability of EEI to fulfill its power provision requirements, KU would substitute such power supply with either owned generation or market purchases and would generally recover associated incremental costs through regulatory rate mechanisms. SFAS No. 150 In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. SFAS No. 150 was effective immediately for financial instruments entered into or modified after May 31, 2003, and otherwise was effective for interim reporting periods beginning after June 15, 2003. As of June 30, 2004, LG&E had 237,500 shares of $5.875 series mandatorily redeemable preferred stock outstanding having a current redemption price of $100 per share. The preferred stock has a sinking fund requirement sufficient to retire a minimum of 12,500 shares on July 15 of each year commencing with July 15, 2003, and the remaining 187,500 shares on July 15, 2008 at $100 per share. Beginning with the three months ended September 30, 2003, LG&E reclassified its $5.875 series preferred stock as long-term debt with the minimum shares mandatorily redeemable within one year classified as current. Dividends accrued beginning July 1, 2003 are charged as interest expense. On July 15, 2004, LG&E redeemed 12,500 shares as required at a price of $100 per share. KU has no financial instruments that fall within the scope of SFAS No. 150. FSP 106-2 In May 2004, the FASB finalized FASB Staff Position ("FSP") 106-2, Accounting and Disclosure Requirements Related to the Medicare - New Page - Prescription Drug, Improvement and Modernization Act of 2003 ("Medicare Act") with guidance on accounting for subsidies provided under the Medicare Act which became law in December 2003. FSP 106-2 is effective for the first interim or annual period beginning after June 15, 2004. KU will adopt FSP 106-2 in the third quarter of 2004. LG&E's medical plan does not provide a benefit that is actuarially equivalent to Medicare Part D; therefore, FSP 106-2 is not expected to have an impact on LG&E. On the basis of actuarial estimates, the Medicare Act will result in an overall reduction of the accumulated postretirement benefit obligation ("APBO") for postretirement health and life insurance benefits for KU amounting to approximately $5.0 million as of January 1, 2004. Accordingly, KU's net periodic postretirement benefit cost for 2004 will be reduced by approximately $0.7 million. The APBO and the net periodic postretirement benefit cost as of and for the periods ending June 30, 2004 and 2003 do not reflect amounts associated with the subsidies provided by the Medicare Act. 9. Short-Term and Long-Term Debt Under the provisions for LG&E's variable-rate pollution control bonds, Series S, T, U, BB, CC, DD and EE, and KU's variable-rate pollution control bonds Series 10, 12, 13, 14 and 15, the bonds are subject to tender for purchase at the option of the holder and to mandatory tender for purchase upon the occurrence of certain events, causing the bonds to be classified as current portion of long-term debt in the Consolidated Balance Sheets. The average annualized interest rate for these bonds during the three months ending June 30, 2004 was 1.11% for the LG&E bonds and 1.18% for the KU bonds. In January 2004, LG&E entered into two long-term notes from Fidelia Corporation ("Fidelia"), an E.ON financing subsidiary, one totaling $25 million with an interest rate of 4.33% that matures in January 2012, and a one-year note totaling $100 million with an interest rate of 1.53%. The loans are secured by a lien subordinated to the first mortgage bond lien. The proceeds were used to fund a pension contribution and to repay other debt obligations. In April 2004, LG&E prepaid $50 million of the $100 million 1.53% note payable to Fidelia. The prepayment was paid out of cash balances and there was no prepayment fee. In January 2004, KU entered into an unsecured long-term loan from Fidelia totaling $50 million with an interest rate of 4.39% that matures in January 2012. The proceeds were used to fund a pension contribution and to repay other debt obligations. In May 2004, KU redeemed $4.8 million of its Series 14 pollution control bonds which were initially issued in the amount of $7.2 million. LG&E maintains five bilateral lines of credit totaling $185 million that mature in 2005. There was no outstanding balance under these facilities at June 30, 2004. Management expects to renew these facilities as they expire. LG&E and KU participate in an intercompany money pool agreement wherein LG&E Energy and KU make funds available to LG&E at market-based rates (based on an index of highly rated commercial paper issues as of the prior month end) up to $400 million. Likewise, LG&E Energy and LG&E make funds available to KU at market-based rates up to $400 million. - New Page - LG&E had $26.0 million in money pool loans from LG&E Energy (included in "Notes payable to affiliated companies") at an average rate of 1.04% at June 30, 2004, and $171.7 million at an average rate of 1.21% at June 30, 2003. The balance of the money pool loans from LG&E Energy to KU (included in "Notes payable to affiliated companies") was $53.2 million at an average rate of 1.04% and $146.4 million at an average rate of 1.21% at June 30, 2004 and 2003, respectively. The amount available to LG&E under the money pool agreement at June 30, 2004 was $374.0 million. The amount available to KU under the money pool agreement at June 30, 2004 was $346.8 million. LG&E Energy maintains a revolving credit facility totaling $150 million with an E.ON affiliate to ensure funding availability for the money pool. LG&E Energy had an outstanding balance of $69.7 million at an average rate of 1.79% under this facility as of June 30, 2004 and availability of $80.3 million remained. 10.Related Party Transactions LG&E, KU, certain subsidiaries of LG&E Energy and other subsidiaries of E.ON engage in related-party transactions. Transactions among LG&E, KU and LG&E Energy subsidiaries are eliminated upon consolidation of LG&E Energy subsidiaries. Transactions between LG&E or KU and E.ON subsidiaries are eliminated upon consolidation of E.ON subsidiaries. These transactions are generally performed at cost and are in accordance with the SEC regulations under the PUHCA and the applicable Kentucky Public Service Commission ("Kentucky Commission") regulations. Accounts payable to and receivable from related parties are netted and presented as accounts payable to affiliated companies on the balance sheets of LG&E and KU, as allowed due to the right of offset. Obligations related to intercompany debt arrangements with LG&E Energy and Fidelia are presented as separate line items on the balance sheet, as appropriate. The significant related-party transactions are disclosed below. Electric Purchases LG&E and KU intercompany electric revenues and purchased power expense (including LG&E Energy Marketing Inc. ("LEM")) for the three months and six months ended June 30, 2004 and 2003 were as follows: Three months ended Six months ended June 30, June 30, (in thousands) 2004 2003 2004 2003 LG&E Electric operating revenues from KU $8,426 $10,850 $30,504 $27,820 Electric operating revenues from LEM 622 1,077 1,350 8,226 Purchased power from KU 9,114 9,211 30,699 23,675 KU Electric operating revenues from LG&E $9,114 $9,211 $30,699 $23,675 Electric operating revenues from LEM 390 318 550 2,100 Purchased power from LG&E 8,426 10,850 30,504 27,820 Interest Charges LG&E intercompany interest income and expense for the three months and six months ended June 30, 2004 and 2003 were as follows: Three months ended Six months ended June 30, June 30, (in thousands) 2004 2003 2004 2003 Interest to affiliate (money pool) $ (13) $ 536 $ 35 $1,269 Interest to affilitate (Fidelia loans) 2,986 758 6,069 758 Interest to affiliate (KU) 4 (3) 14 - Interest from affiliate (KU) - 1 - 5 - New Page - KU intercompany interest income and expense for the three months and six months ended June 30, 2004 and 2003 were as follows: Three months ended Six months ended June 30, June 30, (in thousands) 2004 2003 2004 2003 Interest to affiliate (money pool) $ 75 $349 $ 219 $722 Interest to affiliate (Fidelia loans) 3,461 758 6,864 758 Interest to affiliate (LG&E) - 1 - 5 Interest from affiliate (LG&E) 4 (3) 14 - Other Intercompany Billings Other intercompany billings (including LG&E Energy Services Inc. ("LG&E Services")) related to LG&E and KU for the three months and six months ended June 30, 2004 and 2003 were as follows: Three months ended Six months ended June 30, June 30, (in thousands) 2004 2003 2004 2003 LG&E Services billings to LG&E $60,390 $61,404 $98,552 $88,034 LG&E Services billings to KU 44,613 64,915 75,188 86,409 LG&E billings to LG&E Services 1,490 1,281 4,525 6,143 LG&E billings to KU 33,796 39,111 94,509 91,760 KU billings to LG&E 31,683 22,203 83,516 55,795 KU billings to LG&E Services 1,097 770 3,915 7,864 11.Commitments and Contingencies Except as discussed in this Quarterly Report on Form 10-Q, material changes have not occurred in the current status of various commitments or contingent liabilities from that discussed in the Companies' Annual Report on Form 10-K for the year ended December 31, 2003 (including in Notes 3 and 11 to the financial statements of LG&E and KU contained therein and incorporated herein by reference) or Quarterly Report on Form 10-Q for the quarter ended March 31, 2004. Electric and Gas Rates Cases In December 2003, LG&E and KU filed applications with the Kentucky Commission requesting increases in LG&E's and KU's electric rates and LG&E's gas rates. The Companies requested general adjustments in electric rates and LG&E requested general adjustments in gas rates based on the twelve-month test year ended September 30, 2003. The revenue increases requested by LG&E were $63.8 million for electric and $19.1 million for gas. The revenue increase requested by KU was $58.3 million. On June 30, 2004, the Kentucky Commission issued an order approving increases in the base electric and gas rates of LG&E and the base electric rates of KU. The Kentucky Commission's order largely accepted proposed settlement agreements filed in May 2004 by LG&E, KU and a majority of the parties to the rate case proceedings. The rate increases took effect on July 1, 2004. In the Kentucky Commission's order, (a) LG&E was granted increases in annual base electric rates of approximately $43.4 million (7.7%) and in annual base gas rates of approximately $11.9 million (3.4%) and (b) KU was granted an increase in annual base electric rates of approximately $46.1 million (6.8%). Other provisions of the order include decisions on certain depreciation, gas supply clause, ECR and VDT amounts or mechanisms and a termination of the ESM with respect to all periods after 2003. The order also provided for a recovery before March 31, 2005 by the Companies of previously requested amounts relating to the ESM during 2003. - New Page - During July 2004, the Attorney General of Kentucky ("AG") served subpoenas on LG&E and KU, as well as on the Kentucky Commission and its staff, requesting information regarding allegedly improper communications between the Companies and the Kentucky Commission, particularly during the period covered by the rate cases. The Kentucky Commission has procedurally reopened the rate cases for the limited purpose of taking evidence, if any, as to the communication issues. Subsequently, the AG filed pleadings with the Kentucky Commission requesting rehearing of the rate cases on certain computational components of the increased rates, including income tax, cost of removal and depreciation amounts. In August 2004, the Kentucky Commission denied the AG's rehearing request on the cost of removal and depreciation issues, with the effect that the rate increase order is final as to these matters, subject to the parties' rights to judicial appeals. The Kentucky Commission further agreed to hold in abeyance until mid-October 2004 its further proceedings regarding the AG's concerns about alleged improper communications until the AG could file with the Kentucky Commission an investigative report regarding the latter issue. In addition, the Kentucky Commission granted a rehearing on the income tax component once the abeyance discussed above is lifted. LG&E and KU believe no improprieties have occurred in their communications with the Kentucky Commission and are cooperating with the proceedings before the AG and the Kentucky Commission. The Companies are currently unable to determine the ultimate impact, if any, of the AG's investigation on the recently concluded rate case or their operations generally. Earnings Sharing Mechanism The Companies filed their final 2003 ESM calculations with the Kentucky Commission on March 1, 2004, and applied for recovery of $13.0 million related to LG&E and $16.2 million related to KU. Based upon estimates, the Companies previously accrued $8.9 million at LG&E and $9.3 million at KU for the 2003 ESM as of December 31, 2003. On June 30, 2004, the Kentucky Commission issued an order largely accepting proposed settlement agreements by the Companies and all intervenors regarding the ESM mechanisms of LG&E and KU. Under the ESM settlements, LG&E and KU will continue to collect approximately $13.0 million and $16.2 million, respectively, of previously requested 2003 ESM revenue amounts through March 2005. As part of the settlement, the parties agreed to a termination of the ESM mechanism relating to all periods after 2003. As a result of the settlement, the Company accrued an additional $4.1 million at LG&E and $6.9 million at KU in June 2004 related to 2003 ESM revenue. OVEC Power Agreement and Share Purchase On April 30, 2004, OVEC and its shareholders, including LG&E and KU, entered into an Amended and Restated Inter-Company Power Agreement, to be effective beginning March 2006, upon the expiration of the current power contract among the parties. Under the new contract, which has a 20-year term from its effective date, LG&E and KU have purchase rights for 5.63% and 2.5%, respectively, of OVEC power at marginal cost-based rates. LG&E and KU are entitled to 7% and 2.5% of OVEC power, respectively, under the current contract. - New Page - LG&E's estimated future minimum annual demand payments under the Amended and Restated Inter-Company Power Agreement are as follows: (in thousands) 2006 $ 10,098 2007 9,726 2008 9,932 2009 10,144 2010 10,361 Thereafter 170,646 Total $220,907 In addition, LG&E will purchase from American Electric Power Company Inc. ("AEP") an additional 0.73% interest in OVEC for a purchase price of approximately $104,000, resulting in an increase in LG&E ownership in OVEC from 4.9% to 5.63%. The share purchase transaction is anticipated to be completed during the fourth quarter of 2004, subject to receipt of certain regulatory approvals. Owensboro Contract Litigation In May 2004, the City of Owensboro, Kentucky and Owensboro Municipal Utilities (collectively "OMU"), filed suit in Davies County, Kentucky District Court against KU concerning a long-term power supply contract (the "OMU Agreement") with KU. The dispute involves interpretational differences regarding certain issues under the OMU Agreement, including various payments or charges between KU and OMU and rights concerning excess power, termination and emissions allowances, respectively. The complaint seeks approximately $6 million in damages for historical periods, as well as injunctive and other relief, including a declaration that KU is in material breach. KU has removed this litigation to the U.S. District Court for the Western District of Kentucky and filed an answer in that court denying the OMU claims and presenting certain counterclaims. KU has also initiated a proceeding at the FERC to obtain the FERC's ruling on certain of the issues in dispute. Environmental Matters In September 1998, the EPA announced its final "NOx SIP Call" rule requiring states to impose significant additional reductions in NOx emissions by May 2003, in order to mitigate alleged ozone transport impacts on the Northeast region. The Commonwealth of Kentucky SIP, which was approved by EPA June 24, 2003, required reductions in NOx emissions from coal-fired generating units to the 0.15 lb./Mmbtu level on a system-wide basis. In related proceedings in response to petitions filed by various Northeast states, in December 1999, EPA issued a final rule pursuant to Section 126 of the Clean Air Act directing similar NOx reductions from a number of specifically targeted generating units including all LG&E and KU units. As a result of appeals to both rules, the compliance date was extended to May 2004. LG&E and KU have complied with these NOx emissions reduction rules by adding significant additional NOx controls to their generating units. Installation of additional NOx controls have been performed on a phased basis, commencing in late 2000 and continuing through the final compliance date. As of June 30, 2004, LG&E has incurred total capital costs of approximately $182 million to reduce its NOx emissions to the 0.15 lb./Mmbtu level on a company-wide basis. As of June 30, 2004, KU has incurred total capital costs of approximately $193 million to reduce its NOx emissions to the 0.15 lb./Mmbtu level on a company-wide basis. In addition, LG&E and KU have begun incurring additional operation and maintenance costs in operating new NOx controls. LG&E and KU believe their costs in this regard to be comparable to those of similarly situated utilities with like generation assets. In April 2001, the Kentucky Commission granted recovery of these costs under the environmental surcharge mechanism for LG&E and KU. LG&E and KU are also monitoring several other air quality issues which may potentially impact coal-fired power plants, including EPA's revised air quality standards for ozone and particulate matter, measures to - New Page - implement EPA's regional haze rule, EPA's December 2003 proposals to regulate mercury emissions from steam electric generating units and to further reduce emissions of sulfur dioxide and nitrogen oxides under the Clean Air Interstate Rule. In addition, LG&E is currently working with local regulatory authorities to review the effectiveness of remedial measures aimed at controlling particulate matter emissions from its Mill Creek Station. LG&E previously settled a number of property damage claims from adjacent residents and completed significant remedial measures as part of its ongoing capital construction program. LG&E has converted the Mill Creek Station to a wet stack operation in an effort to resolve all outstanding issues related to particulate matter emissions. 12. Pension and Other Post-retirement Benefit Plans The following table provides the components of net periodic benefit cost for pension and other benefit plans: Three Months Ended Year to Date June 30, 2004 June 30, 2004 (in thousands) LG&E KU LG&E KU Components of net periodic benefit cost: Service cost $ 934 $ 1,103 $ 3,022 $ 3,490 Interest cost 4,709 3,538 15,233 11,187 Expected return on plan assets (4,289) (3,195) (13,874) (10,104) Amortization of prior service cost (2) 148 (7) 467 Amortization of transition obligation 897 269 2,900 853 Recognized actuarial loss 494 388 1,599 1,227 $ 2,743 $ 2,251 $ 8,873 $ 7,120 In January 2004, LG&E and KU made discretionary contributions to their pension plans in the amounts of $34.5 million and $43.4 million, respectively. No contributions are required for 2004 for either LG&E or KU and no further discretionary contributions are planned. 13.Subsequent Events July Storms In July 2004 violent thunderstorms swept through Kentucky, causing significant damage and widespread power outages. At the height of the storms, 115,000 LG&E customers and 22,700 KU customers were without power. The cost to repair the damage incurred in the LG&E service territory as a result of these storms is estimated to be $8.4 million in operations and maintenance expense and $2.1 million in capital expenditures. The cost to repair the damage incurred in the KU service territory as a result of these storms is estimated to be $0.5 million in operations and maintenance expense and $0.1 million in capital expenditures. Rate Cases Update During July 2004, the AG requested a rehearing of the LG&E and KU rate cases. For a description of developments in these cases, see Note 11 of the Notes to Consolidated Financial Statements in Part 1, Item 1, of this Quarterly Report on Form 10-Q. Trimble County Combustion Turbines Units 9 & 10 Trimble County Combustion Turbines Units 9 and 10 began commercial operation on July 1, 2004. See Note 7 of the Notes to Consolidated Financial Statements on Part 1, Item 1 of this Quarterly Report on Form 10-Q. - New Page - Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. General The following discussion and analysis by management focuses on those factors that had a material effect on LG&E's and KU's financial results of operations and financial condition during the three and six month periods ended June 30, 2004, and should be read in connection with the financial statements and notes thereto. Some of the following discussion may contain forward-looking statements that are subject to certain risks, uncertainties and assumptions. Such forward-looking statements are intended to be identified in this document by the words "anticipate," "expect," "estimate," "objective," "possible," "potential" and similar expressions. Actual results may vary materially. Factors that could cause actual results to differ materially include: general economic conditions; business and competitive conditions in the energy industry; changes in federal or state legislation; unusual weather; actions by state or federal regulatory agencies; and other factors described from time to time in LG&E's and KU's reports to the SEC, including the Annual Reports on Form 10-K for the year ended December 31, 2003. Executive Summary LG&E's net income for the three months ended June 30, 2004 was $17.1 million ($9.4 million higher than the three months ended June 30, 2003). The increase was primarily related to higher electric revenues. Retail sales volumes increased due to warmer weather, while gas volumes decreased. KU's net income for the three months ended June 30, 2004, was $27.6 million ($13.4 million higher than the three months ended June 30, 2003). The increase was primarily due to higher electric revenues due to higher retail sales volumes resulting from warmer weather, partially offset by higher maintenance expense. LG&E's net income for the six months ended June 30, 2004 was $41.4 million ($6.4 million higher than the six months ended June 30, 2003). The increase was primarily related to higher electric revenues due to warmer weather. KU's net income for the six months ended June 30, 2004, was $60.0 million ($34.0 million higher than the six months ended June 30, 2003). The increase was primarily due to higher electric revenues and lower maintenance expense. As regulated utilities, LG&E and KU's financial performance is greatly impacted by regulatory proceedings. On June 30, 2004, the Kentucky Commission issued an order approving increases in the base rates of LG&E and KU. The rate increase took effect on July 1, 2004. In July 2004, the AG commenced an investigation examining communications between the Kentucky Commission and the Companies and separately, filed for a rehearing of the rate cases on such issue and certain calculation components of the increased rates. The Kentucky Commission ordered a reopening of the rate cases to take evidence in the communications issue. For a description of developments in these cases, see Note 11 of the Notes to Consolidated Financial Statements in Part 1, Item 1 of this Quarterly Report on Form 10- Q. Results of Operations The results of operations for LG&E and KU are affected by fluctuations in temperature and other weather-related factors. Because of these and other factors, the results of one period are not necessarily indicative of results or trends to be expected for another period. - New Page - Three Months Ended June 30, 2004, Compared to Three Months Ended June 30, 2003 LG&E Results: LG&E's net income increased $9.4 million (121%) for the three months ended June 30, 2004, as compared to the three months ended June 30, 2003, primarily due to higher retail electric revenues, partially offset by higher other operation expenses. A comparison of LG&E's revenues for the three months ended June 30, 2004, with the three months ended June 30, 2003, reflects increases and (decreases) which have been segregated by the following principal causes: Cause Electric Gas (in thousands) Revenues Revenues Retail sales: Fuel and gas supply adjustments $ 1,159 $ 7,751 Environmental cost recovery surcharge 5,513 - Earnings sharing mechanism 518 - LG&E/KU merger surcredit (947) - Variation in sales volume and other 17,303 (5,777) Total retail sales 23,546 1,974 Wholesale sales (4,026) 279 Provision for rate collections 1,017 - Other (1,888) (63) Total $ 18,649 $ 2,190 Electric revenues increased $18.6 million primarily as the result of an increase in sales volumes to ultimate consumers of 9.2%. The retail sales volume increase was due to warmer weather than the prior year as cooling degree days increased 89%. However, overall volumes decreased due to lower wholesale sales. Gas revenues increased $2.2 million primarily as a result of higher natural gas prices billed to customers through the gas supply clause partially offset by lower sales volumes to ultimate consumers due to warmer weather. The provision for rate collections increased $1.0 million, including a $3.4 million higher provision for the earnings sharing mechanism, offset by a $2.4 million lower provision for the environmental cost recovery surcharge. Fuel for electric generation and gas supply expenses comprise a large component of LG&E's total operating expenses. LG&E's electric and gas rates contain a fuel adjustment clause and a gas supply clause, respectively, whereby increases or decreases in the cost of fuel and gas supply are reflected in retail rates, subject to the approval of the Kentucky Commission. Fuel for electric generation increased $1.3 million (3%) for the three months ended due to an increase in the cost of coal burned ($2.0 million), partially offset by a decrease in generation ($0.7 million). Gas supply expenses increased $5.0 million (19%) due to an increase in net gas supply cost ($6.7 million), offset by a decrease in the volume of retail gas sold ($1.7 million). Other operation expenses increased $3.7 million (7%), as compared to 2003. An estimated $7.4 million was recorded in the second quarter of 2004 for costs incurred related to May 2004 storms. Results for 2003 included $1.1 million in cost to achieve amortization related to the KU/LG&E merger and the One Utility initiative, which ended June 30, 2003, and September 30, 2003, respectively. In addition, pension expense was $1.3 million lower and bad debt expense was $0.5 million lower in 2004. Maintenance expenses decreased $2.4 million (14%). A write-off of obsolete inventory of $1.1 million was included in 2003 and steam power generation was $0.7 million lower in 2004. Depreciation and amortization decreased $2.1 million (7%) due to a depreciation adjustment in the second quarter of 2003 related to assets capitalized in that period. - New Page - Property and other taxes increased $1.6 million (47%). In June 2003, property taxes reflected a $1.2 million coal incentive tax credit. Variations in income tax expense are largely attributable to changes in pre- tax income. Three Months Three Months Ended Ended June 30, 2004 June 30, 2003 Effective Rate Statutory federal income tax rate 35.0% 35.0% State income taxes net of federal benefit 5.8 6.5 Amortization of investment tax credit & R&D (6.6) (9.5) Other differences 0.6 (2.2) Effective income tax rate 34.8% 29.8% The amortization of investment tax credit and other differences were approximately the same in both periods, but lower pretax income for the three months ended June 30, 2003, caused the percentage changes to be greater in the 2003 period. Interest charges decreased $0.6 million (10%) primarily due to the $ 1.0 million savings on interest expense realized from the refinancing of fixed- rate Series V and Series W pollution control bonds to the variable-rate Series GG pollution control bonds in November 2003. Interest expense to affiliated companies increased $1.7 million (130%) primarily due to a $2.2 million increase in interest expense to Fidelia related to new notes issued in August 2003 and January 2004. Offsetting this increase is a $0.5 million decrease in interest expense on borrowings from the money pool due to lower borrowing levels. The weighted average interest rate on variable-rate bonds for the three months ended June 30, 2004, was 1.07% and the corresponding rate for the three months ended June 30, 2003, was 1.15%. KU Results: KU's net income increased $13.4 million (95%) for the three months ended June 30, 2004, as compared to the three months ended June 30, 2003. The increase was primarily due to higher revenues related to higher sales volumes, partially offset by higher maintenance expense. A comparison of KU's revenues for the three months ended June 30, 2004, with the three months ended June 30, 2003, reflects increases and (decreases) which have been segregated by the following principal causes: Cause (in thousands) Retail sales: Fuel supply adjustments $(2,503) Environmental cost recovery surcharge 1,615 Earnings sharing mechanism 1,395 LG&E/KU merger surcredit (1,071) Variation in sales volume and other 16,967 Total retail sales 16,403 Wholesale sales 5,362 Provision for rate collections 11,694 Other 1,736 Total $35,195 - New Page - Electric revenues increased $35.2 million primarily as the result of an increase in sales volumes to ultimate consumers of 11.3%. The sales volume increase was due to warmer weather than last year as cooling degree days increased 73%. Also contributing to higher revenues for the quarter were increases in the provision for rate collections and wholesale sales. The provision for rate collections included a $3.8 million higher provision for the earnings sharing mechanism, a $5.4 million higher provision related to the environmental cost recovery surcharge, and a $2.4 million higher provision related to the fuel adjustment clause. Fuel for electric generation comprises a large component of KU's total operating expenses. KU's electric rates contain a fuel adjustment clause, whereby increases or decreases in the cost of fuel are reflected in retail rates, subject to the approval of the Kentucky Commission, the Virginia State Corporation Commission, and the Federal Energy Regulatory Commission. Fuel for electric generation increased $8.0 million (13%) for the quarter because of an increase in generation ($8.1 million), partially offset by a slight decrease in the cost of coal burned ($0.1 million). Power purchased decreased $3.0 million (8%) due to a decrease in the price of power purchased ($1.7 million) and a decrease in the volume purchased ($1.3 million). Other operation expenses decreased $1.6 million (4%) as compared to 2003. Cost to achieve amortization for the KU/LG&E merger, which ended in June 2003, was $1.0 million in 2003. Maintenance expenses increased $9.6 million (130%). Maintenance expenses in 2003 were reduced by an $8.9 million insurance reimbursement received in the second quarter of 2003 for costs incurred in a February 2003 ice storm. Depreciation and amortization decreased $1.8 million (7%) because of a depreciation adjustment in the second quarter of 2003 related to assets capitalized that quarter. Variations in income tax expense are largely attributable to changes in pretax income. Three Months Three Months Ended Ended June 30, 2004 June 30, 2003 Effective Rate Statutory federal income tax rate 35.0% 35.0% State income taxes net of federal benefit 6.0 6.5 Amortization of investment tax credit & R&D (1.2) (3.1) Other differences (1.8) (4.6) Effective income tax rate 38.0% 33.8% The amortization of the investment tax credit and other differences were approximately the same in both periods, but lower pretax income for the three months ended June 30, 2003, caused the percentage change to be greater in the 2003 period. Interest expense decreased $2.9 million (44%) primarily due to $1.6 million in interest expense savings from the redemption of pollution control bonds Series Q at 6.32% and Series P at 8.55% redeemed in June and November of 2003, respectively. Additionally, interest rate swaps yielded a $1.2 million decrease in related interest expenses resulting primarily from the termination of a swap in February 2004 and better performance of the remaining swaps. Interest expense to affiliated companies increased $2.4 million (219%) primarily due to a $2.7 million increase in interest expense to Fidelia related to new notes issued in August 2003 through January 2004. Offsetting this increase is a $0.3 decrease in interest expense on borrowings from the money pool due to lower borrowing levels. The weighted average interest rate on variable-rate bonds for the three months ended June 30, 2004, was 1.11% and the corresponding rate for the three months ended June 30, 2003, was 1.14%. - New Page - Six Months Ended June 30, 2004, Compared to Six Months Ended June 30, 2003 LG&E Results: LG&E's net income increased $6.4 million (18%) for the six months ended June 30, 2004, as compared to the six months ended June 30, 2003, primarily due to higher electric and gas revenues, partially offset by higher other operations expenses and higher interest expense. A comparison of LG&E's revenues for the six months ended June 30, 2004, with the six months ended June 30, 2003, reflects increases and (decreases) which have been segregated by the following principal causes: Cause Electric Gas (in thousands) Revenues Revenues Retail sales: Fuel and gas supply adjustments $(1,646) 45,381 Environmental cost recovery surcharge 7,911 - Earnings sharing mechanism 3,774 - LG&E/KU merger surcredit (1,418) - Weather normalization - 2,419 Variation in sales volume and other 15,998 (22,275) Total retail sales 24,619 25,525 Wholesale sales 8,091 1,034 Provision for rate refunds (2,982) - Other 151 (479) Total $29,879 $ 26,080 Electric revenues increased $29.9 million primarily because of increased sales volumes to ultimate consumers of 4.4% due to warmer weather than prior year as cooling degrees days increased 94%. Increased wholesale revenues and environmental cost recovery also contributed to the increase in revenues. Gas revenues increased $26.1 million primarily as a result of higher natural gas prices billed to customers, partially offset by lower sales volumes to ultimate consumers due to warmer weather. The provision for rate refunds decreased $3.0 million, primarily due to a $3.9 million lower provision related to the environmental cost recovery surcharge. Fuel for electric generation increased $4.4 million (5%) for the six months due to an increase in the cost of coal burned ($4.4 million) while generation volume was flat. Gas supply expenses increased $29.7 million (22%) due to an increase in net gas supply cost ($40.8 million), offset by a decrease in the volume of retail gas delivered to the distribution system ($11.1 million). Power purchased increased $4.8 million (12%) due to an increase in the price of power purchased ($1.0 million) and an increase in the volume of the purchases ($3.8 million). Other operations expenses increased $8.3 million (8%) in 2004, as compared to 2003, due to higher transmission expense of $3.5 million, primarily due to higher MISO-related expense, and $7.5 million higher electric distribution expense, due to the May 2004 storms. These higher expenses were partially offset by $2.9 million lower cost to achieve amortization related to the KU/LG&E merger and One Utility initiative, and $1.5 million lower benefits expense. Maintenance expenses decreased $2.8 million (9%). In 2003, $2.1 million in obsolete inventory was written off. - New Page - Depreciation and amortization decreased $1.7 million (3%) because of a depreciation adjustment in the second quarter of 2003, related to assets capitalized in that period. Variations in income tax expense are largely attributable to changes in pre- tax income. Six Months Ended Six Months Ended June 30, 2004 June 30, 2003 Effective Rate Statutory federal income tax rate 35.0% 35.0% State income taxes net of federal benefit 5.7 5.8 Amortization of investment tax credit & R&D (4.3) (3.8) Other differences 0.2 (0.8) Effective income tax rate 36.6% 36.2% Property and other taxes increased $2.0 million (24%). Property taxes in 2003 reflected a $1.2 million coal incentive tax credit. Interest charges decreased $2.1 million (17%) primarily due to the $2.9 million savings of interest expense realized from the refinancing of fixed- rate Series V and Series W pollution control bonds into the variable-rate Series GG. Also, the redemption of the first mortgage bond in August 2003 contributed to the decrease in interest expense by $1.3 million. Offsetting these decreases is an increase of $1.9 million from interest rate swaps. Interest expense to affiliated companies increased $4.1 million (202%) primarily due to a $5.3 million increase in interest expense to Fidelia related to new notes issued in August 2003 and January 2004. Offsetting this increase is a $1.2 million decrease in interest expense on borrowings from the money pool due to lower borrowing levels. The weighted average interest rate on variable-rate bonds for the six months ended June 30, 2004 was 1.06%, compared to 1.19% for the comparable period in 2003. KU Results: KU's net income increased $34.0 million (131%) for the six months ended June 30, 2004, as compared to the six months ended June 30, 2003. The increase was primarily due to higher electric revenues and lower maintenance expense. A comparison of KU's revenues for the six months ended June 30, 2004, with the six months ended June 30, 2003, reflects increases and (decreases) which have been segregated by the following principal causes: Cause (in thousands) Retail sales: Environmental cost recovery surcharge $ 2,067 Earnings sharing mechanism 5,304 LG&E/KU merger surcredit (1,829) Variation in sales volume and other 19,541 Total retail sales 25,083 Wholesale sales 11,918 Provision for rate collections 15,863 Other 4,734 Total $57,598 - New Page - Electric revenues increased $57.6 million primarily due to increased sales volumes to ultimate consumers of 6.1% due to warmer weather than last year as cooling degree days increased 75%. Also contributing to the overall revenue increase were increases in the provision for rate collections, wholesale revenues, and earnings sharing mechanism recoveries. The provision for rate collections included higher provisions for the environmental cost recovery ($10.4 million), the earngins sharing mechanism ($3.5 million) and the fuel adjustment clause ($2.0 million). Fuel for electric generation increased $11.6 million (9%) for the six months due to an increase in the cost of coal burned ($3.5 million) and an increase in generation ($8.1 million). Power purchased decreased $2.9 million (4%) due to a decrease in the price of power purchased ($5.4 million), partially offset by an increase in volumes purchased ($2.5 million). Other operation expenses decreased $2.0 million (3%). Cost to achieve amortization of $3.2 million related to the KU/LG&E merger and One Utility initiative was recorded in 2003 and was fully amortized as of June 2003. In 2004, benefits expense decreased $1.5 million and distribution expense decreased $0.7 million due to the February 2003 ice storm. These decreases were offset by higher emission allowance expense of $2.3 million and higher transmission expense of $1.1 million. Maintenance expenses decreased $7.5 million (21%). Steam power maintenance expense decreased $5.5 million; Ghent Unit 3, Green River Unit 4 and Tyrone Unit 3 all had major overhauls in 2003. Distribution maintenance decreased $1.3 million and transmission overhead line maintenance decreased $0.6 million in 2004 due to the February 2003 ice storm. Variations in income tax expense are largely attributable to changes in pretax income. Six Months Ended Six Months Ended June 30, 2004 June 30, 2003 Effective Rate Statutory federal income tax rate 35.0% 35.0% State income taxes net of federal benefit 5.9 6.7 Amortization of investment tax credit & R&D (1.1) (3.4) Other differences (1.7) (4.4) Effective income tax rate 38.1% 33.9% The amortization of the investment tax credit and other differences were approximately the same in both periods, but lower pretax income for the six months ended June 30, 2003, caused the percentage changes to be greater in the 2003 period. Interest expense decreased $6.7 million (60%) due primarily to the redemption of pollution control bonds Series P at 8.55% and Series Q at 6.32% redeemed in November and June of 2003, respectively. Additionally, interest rate swaps yielded a $2.8 million decrease in related interest expenses resulting primarily from the February termination of a swap related to the Series 9 pollution control bonds and better performance of remaining swaps. - New Page - Interest expense to affiliated companies increased $5.6 million (377%) primarily due to a $6.1 million increase in interest expense to Fidelia related to new notes issued in August 2003 through January 2004. Offsetting this increase is a $0.5 million decrease in interest expense on borrowings from the money pool due to lower borrowing levels. The weighted average interest rate on variable-rate bonds for the six months ended June 30, 2004, was 1.08% and the corresponding rate for the six months ended June 30, 2003, was 1.16%. Liquidity and Capital Resources LG&E and KU's needs for capital funds are largely related to the construction of plant and equipment necessary to meet the needs of electric and gas utility customers. Internal and external lines of credit are maintained to fund short-term capital requirements. LG&E and KU believe that such sources of funds will be sufficient to meet the needs of the business in the foreseeable future. As of June 30, 2004, LG&E and KU are in a negative working capital position. The Companies expect to cover any deficiencies with cash flow from operations, money pool borrowings, and borrowings from Fidelia, an E.ON financing subsidiary. Construction expenditures for the six months ended June 30, 2004 for LG&E and KU amounted to $64.9 million and $76.3 million, respectively. Such expenditures include construction to meet nitrogen oxide (NOx) emission standards and the acquisition of combustion turbines to meet peak power demands. Expenditures for the six months ended June 30, 2004, by LG&E and KU for NOx construction were $5.6 million and $21.9 million, respectively. Expenditures for the six months ended June 30, 2004, for Trimble County combustion turbines, Units 7 through 10, by LG&E and KU were $5.5 million and $9.5 million, respectively. In addition, LG&E construction expenditures include $8.4 million for distribution overhead line construction, $5.8 million for Mill Creek Unit 3 ductwork installation related to the flue gas desulfurization ("FGD") project, and $5.3 million for gas main replacements. At KU, construction expenditures include $6.4 million for E.W. Brown Unit 3 cooling tower and precipitator rebuild and $6.0 million for distribution construction in the Lexington area. The expenditures were financed with internally generated funds and intercompany loans from affiliates. LG&E's cash balance increased $12.3 million during the six months ended June 30, 2004, primarily due to higher net income and increased net borrowings from affiliated companies, partially offset by pension funding, construction expenditures, and payment of common dividends to its parent company. KU's cash balance increased $4.9 million during the six months ended June 30, 2004. The increase reflects higher net income and increased net borrowings from affiliated companies, partially offset by pension funding, construction expenditures and the payment of common dividends to its parent company. Variations in accounts receivable, accounts payable and materials and supplies are generally not significant indicators of LG&E's and KU's liquidity. In general, such variations are usually attributable to seasonal fluctuations in weather, which have a direct effect on sales of electricity and natural gas. However, the increase in accounts receivable at LG&E and KU, as of June 30, 2004, was primarily due to the termination of the accounts receivable securitization programs in January 2004. Discontinuing the accounts receivable securitizations programs resulted in an increase in accounts receivable of $58.0 million at LG&E and by $50.0 million at KU. (LG&E and KU maintained a fully funded reserve for uncollectible accounts related to receivables sold during the securitization program.) The increase in accounts receivable at LG&E as of June 30, 2004 was somewhat offset by the impact of decreased gas sales in June 2004 compared to December 2003. The decrease in LG&E's gas stored underground relates to seasonal uses of gas. Interest rate swaps are used to hedge LG&E's and KU's underlying variable- rate debt obligations. These swaps hedge specific debt issuances and, consistent with management's designation, are accorded hedge accounting treatment. As of June 30, 2004, LG&E had swaps with a combined notional value of $228.3 million and KU had swaps with a combined notional value of $103.0 million. LG&E's swaps exchange floating-rate interest payments for fixed-rate interest payments to reduce the impact of interest rate changes on LG&E's pollution control bonds. KU's swaps effectively convert fixed- rate obligations on KU's first mortgage bonds Series P and R to variable- rate obligations. In February 2004, KU terminated the swap it had in place at December 31, 2003 related to its Series 9 pollution control bonds. The notional amount of the terminated swap was $50 million and KU received a payment of $2.0 million as part of the termination, resulting in a gain of $0.8 million. - New Page - At June 30, 2004, variable rate debt, including the impact of interest rate swaps, was 36.9% of LG&E's total debt at $331.9 million and 45.7% of KU's total debt at $352.2 million. At December 31, 2003, variable rate debt, including the impact of interest rate swaps, was 44.0% of LG&E's total debt at $386.3 million and 55.5% of KU's total debt at $397.1 million. Under the provisions of LG&E's variable-rate pollution control bonds, Series S, T, U, BB, CC, DD and EE, and KU's variable-rate pollution control bonds Series 10, 12, 13, 14 and 15, the bonds are subject to tender for purchase at the option of the holder and to mandatory tender for purchase upon the occurrence of certain events, causing the bonds to be classified as current portion of long-term debt in the Consolidated Balance Sheets. The average annualized interest rate for these bonds during the six months ending June 30, 2004, was 1.10% for the LG&E bonds and 1.13% for the KU bonds. In January 2004, LG&E entered into two long-term notes with Fidelia, one totaling $25 million with an interest rate of 4.33% that matures in January 2012, and a one-year note totaling $100 million with an interest rate of 1.53%. The loans are secured by a lien subordinated to the first mortgage bond lien. The proceeds were used to fund a pension contribution and to repay other debt obligations. In April 2004, LG&E prepaid $50 million of the $100 million 1.53% note payable to Fidelia. The prepayment was paid out of cash balances and there was no prepayment fee. In January 2004, KU entered into an unsecured long-term loan from Fidelia totaling $50 million with an interest rate of 4.39% that matures in January 2012. The proceeds were used to fund a pension contribution and to repay other debt obligations. LG&E maintains five bilateral lines of credit with banks totaling $185 million that mature in 2005. There was no outstanding balance under these facilities at June 30, 2004. Management expects to renew these facilities as they expire. LG&E and KU participate in an intercompany money pool agreement wherein LG&E Energy and KU make funds available to LG&E at market-based rates (based on an index of highly rated commercial paper issues as of the prior month end) up to $400 million. Likewise, LG&E Energy and LG&E make funds available to KU at market-based rates up to $400 million. LG&E had $26.0 million in money pool loans from LG&E Energy (included in "Notes payable to affiliated companies") at an average rate of 1.04% at June 30, 2004, and $171.7 million at an average rate of 1.21% at June 30, 2003. The balance of the money pool loans from LG&E Energy to KU (included in "Notes payable to affiliated companies") was $53.2 million at an average rate of 1.04% and $146.4 million at an average rate of 1.21% at June 30, 2004 and 2003, respectively. The amount available to LG&E under the money pool agreement at June 30, 2004 was $374.0 million. The amount available to KU under the money pool agreement at June 30, 2004 was $346.8 million. LG&E Energy maintains a revolving credit facility totaling $150 million with an affiliate to ensure funding availability for the money pool. LG&E Energy had an outstanding balance of $69.7 million at an average rate of 1.79% under this facility as of June 30, 2004 and availability of $80.3 million remained. In January 2004, LG&E and KU made discretionary contributions to their pension plans of $34.5 million and $43.4 million, respectively. No contributions are required for 2004 and no further discretionary contributions are planned. LG&E's security ratings as of June 30, 2004, were: Moody's S&P First mortgage bonds A1 A- Preferred stock Baa1 BBB- Commercial paper P-1 A-2 - New Page - KU's security ratings as of June 30, 2004, were: Moody's S&P First mortgage bonds A1 A Preferred stock Baa1 BBB- Commercial paper P-1 A-2 These ratings reflect the views of Moody's and S&P. A security rating is not a recommendation to buy, sell or hold securities and is subject to revision or withdrawal at any time by the rating agency. LG&E's capitalization ratios at June 30, 2004, and December 31, 2003, follow: June 30, December 31, 2004 2003 Long-term debt (including current portion) 31.2% 31.9% Long-term debt to affiliated company (including current portion) 14.3 10.7 Notes payable to affiliated companies 1.4 4.3 Preferred stock 3.7 3.8 Common equity 49.4 49.3 Total 100.0% 100.0% KU's capitalization ratios at June 30, 2004, and December 31, 2003, follow: June 30, December 31, 2004 2003 Long-term debt (including current portion) 22.4% 24.1% Long-term debt to affiliated company (including current portion) 18.8 16.8 Notes payable to affiliated companies 3.0 2.6 Preferred stock 2.3 2.4 Common equity 53.5 54.1 Total 100.0% 100.0% New Accounting Pronouncements FIN 46 In January 2003, the Financial Accounting Standards Board ("FASB") issued Financial Accounting Standards Board Interpretation No. 46, Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51 ("FIN 46"). FIN 46 required certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 was effective immediately for all new variable interest entities created or acquired after January 31, 2003. In December 2003, FIN 46 was revised, delaying the effective dates for certain entities created before February 1, 2003, and making other amendments to clarify application of the guidance. For potential variable interest entities other than special purpose entities, the revised FIN 46 ("FIN 46R") is now required to be applied no later than the end of the first fiscal year or interim reporting period ending after March 15, 2004. For all special purpose entities created prior to February 1, 2003, FIN 46R is now required to be applied at the end of the first interim or annual reporting period ending after December 15, 2003. FIN 46R may be applied prospectively with a cumulative-effect adjustment as of the date it is first applied, or by restating previously issued financial statements with a cumulative-effect adjustment as of the beginning of the first year restated. FIN 46R also requires certain disclosures of an entity's relationship with variable interest entities. - New Page - Both LG&E and KU hold investment interests in OVEC and KU holds an investment interest in EEI. Neither LG&E nor KU are the primary beneficiary of OVEC or EEI, and thus neither are consolidated into the financial statements of LG&E or KU. LG&E, KU and ten other electric utilities are participating owners of OVEC, located in Piketon, Ohio. OVEC owns and operates two power plants that burn coal to generate electricity, Kyger Creek Station in Ohio and Clifty Creek Station in Indiana. LG&E's share is 7%, representing approximately 155 Mw of generation capacity and KU's share is 2.5%, approximately 55 Mw of generation capacity. LG&E's and KU's original investments in OVEC were made in 1952. LG&E's investment in OVEC is the equivalent of 4.9% of OVEC's common stock and KU's investment is the equivalent of 2.5% of OVEC's common stock. LG&E's and KU's investments in OVEC are accounted for on the cost method of accounting. As of June 30, 2004, LG&E's and KU's investments in OVEC totaled $0.5 million and $0.3 million, respectively. LG&E's and KU's maximum exposure to loss as a result of their involvement with OVEC is limited to the value of their investment. In the event of the inability of OVEC to fulfill its power provision requirements, LG&E and KU would substitute such power supply with either owned generation or market purchases and would generally recover associated incremental costs through regulatory rate mechanisms. See Part II, Item 1, for further discussion of developments regarding LG&E's and KU's ownership interests and power purchase rights. KU owns 20% of the common stock of EEI, which owns and operates a 1,000-Mw generating station in southern Illinois. KU is entitled to take 20% of the available capacity of the station. Purchases from EEI are made under a contractual formula which has resulted in costs which were and are expected to be comparable to the cost of other power purchased or generated by KU. Such power equated to approximately 9% of KU's net generation system output in 2003. KU's original investment in EEI was made in 1953. KU's investment in EEI is accounted for on the equity method of accounting. As of June 30, 2004, KU's investment in EEI totaled $11.9 million. KU's maximum exposure to loss as a result of its involvement with EEI is limited to the value of its investment. In the event of the inability of EEI to fulfill its power provision requirements, KU would substitute such power supply with either owned generation or market purchases and would generally recover associated incremental costs through regulatory rate mechanisms. SFAS No. 150 In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. SFAS No. 150 was effective immediately for financial instruments entered into or modified after May 31, 2003, and otherwise was effective for interim reporting periods beginning after June 15, 2003. As of June 30, 2004, LG&E had 237,500 shares of $5.875 series mandatorily redeemable preferred stock outstanding having a current redemption price of $100 per share. The preferred stock has a sinking fund requirement sufficient to retire a minimum of 12,500 shares on July 15 of each year commencing with July 15, 2003, and the remaining 187,500 shares on July 15, 2008 at $100 per share. Beginning with the three months ended September 30, 2003, LG&E reclassified its $5.875 series preferred stock as long-term debt with the minimum shares mandatorily redeemable within one year classified as current. Dividends accrued beginning July 1, 2003 are charged as interest expense. KU has no financial instruments that fall within the scope of SFAS No. 150. - New Page - FSP 106-2 In May 2004, the FASB finalized FASB Staff Position ("FSP") 106-2, Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003 ("Medicare Act") with guidance on accounting for subsidies provided under the Medicare Act which became law in December 2003. FSP 106-2 is effective for the first interim or annual period beginning after June 15, 2004. KU will adopt FSP 106-2 in the third quarter of 2004. LG&E's medical plan does not provide a benefit that is actuarially equivalent to Medicare Part D; therefore, FSP 106-2 is not expected to have an impact on LG&E. On the basis of actuarial estimates, the Medicare Act will result in an overall reduction of the accumulated postretirement benefit obligation ("APBO") for postretirement health and life insurance benefits for KU amounting to approximately $5.0 million as of January 1, 2004. Accordingly, KU's net periodic postretirement benefit cost for 2004 will be reduced by approximately $0.7 million. The APBO and the net periodic postretirement benefit cost as of and for the periods ending June 30, 2004 and 2003 do not reflect amounts associated with the subsidies provided by the Medicare Act. Contingencies For a description of significant contingencies that may affect LG&E and KU, reference is made to Part I, Item 3, Legal Proceedings in LG&E's and KU's Annual Reports on Form 10-K for the year ended December 31, 2003; Quarterly Report on Form 10-Q for the quarter ended March 31, 2004; and to Part II - Item 1, Legal Proceedings herein. Electric and Gas Rates Cases On June 30, 2004, the Kentucky Commission issued an order approving increases in the base electric and gas rates of LG&E and the base electric rates of KU. In July 2004, the AG commenced an investigation examining communications between the Kentucky Commission and the Companies and separately filed for a rehearing of the rate cases on such issue and certain calculation components of the increased rates. The Kentucky Commission ordered a procedural reopening of the rate cases for the limited purpose of taking evidence, if any, as to the communication issue. For a description of developments in these cases, see Note 11 of the Notes to Consolidated Financial Statements in Part 1, Item 1 of this Quarterly Report on Form 10-Q. Earnings Sharing Mechanism The Companies filed their final 2003 ESM calculations with the Kentucky Commission on March 1, 2004, and applied for recovery of $13.0 million related to LG&E and $16.2 million related to KU. Based upon estimates, the Companies previously accrued $8.9 million at LG&E and $9.3 million at KU for the 2003 ESM as of December 31, 2003. On June 30, 2004, the Kentucky Commission issued an order largely accepting proposed settlement agreements by the Companies and all intervenors regarding the ESM mechanisms of LG&E and KU. Under the ESM settlements, LG&E and KU will continue to collect approximately $13.0 million and $16.2 million, respectively, of previously requested 2003 ESM revenue amounts through March 2005. As part of the settlement, the parties agreed to a termination of the ESM mechanism relating to all periods after 2003. As a result of the settlement, the Company accrued an additional $4.1 million at LG&E and $6.9 million at KU in June 2004 related to 2003 ESM revenue. - New Page - OVEC Power Agreement and Share Purchase On April 30, 2004, OVEC and its shareholders, including LG&E and KU, entered into an Amended and Restated Inter-Company Power Agreement, to be effective beginning March 2006, upon the expiration of the current power contract among the parties. Under the new contract, which has a 20-year term from its effective date, LG&E and KU have purchase rights for 5.63% and 2.5%, respectively, of OVEC power at marginal cost-based rates. LG&E and KU are entitled to 7% and 2.5% of OVEC power, respectively, under the current contract. LG&E's estimated future minimum annual demand payments under the Amended and Restated Inter-Company Agreement are as follows: (in thousands) 2006 $ 10,098 2007 9,726 2008 9,932 2009 10,144 2010 10,361 Thereafter 170,646 Total $220,907 In addition, LG&E will purchase from American Electric Power Company Inc. ("AEP") an additional 0.73% interest in OVEC for a purchase price of approximately $104,000, resulting in an increase in LG&E ownership in OVEC from 4.9% to 5.63%. The share purchase transaction is anticipated to be completed during the fourth quarter of 2004, subject to receipt of certain regulatory approvals. Owensboro Contract Litigation In May 2004, the City of Owensboro, Kentucky and Owensboro Municipal Utilities (collectively "OMU"), filed suit in Davies County, Kentucky District Court against KU concerning a long-term power supply contract (the "OMU Agreement") with KU. The dispute involves interpretational differences regarding certain issues under the OMU Agreement, including various payments or charges between KU and OMU and rights concerning excess power, termination and emissions allowances, respectively. The complaint seeks approximately $6 million in damages for historical periods, as well as injunctive and other relief, including a declaration that KU is in material breach. KU has removed this litigation to the U.S. District Court for the Western District of Kentucky and filed an answer in that court denying the OMU claims and presenting certain counterclaims. KU has also initiated a proceeding at the FERC to obtain the FERC's ruling on certain of the issues in dispute. Environmental Matters In September 1998, the EPA announced its final "NOx SIP Call" rule requiring states to impose significant additional reductions in NOx emissions by May 2003, in order to mitigate alleged ozone transport impacts on the Northeast region. The Commonwealth of Kentucky SIP, which was approved by EPA June 24, 2003, required reductions in NOx emissions from coal-fired generating units to the 0.15 lb./Mmbtu level on a system-wide basis. In related proceedings in response to petitions filed by various Northeast states, in December 1999, EPA issued a final rule pursuant to Section 126 of the Clean Air Act directing similar NOx reductions from a number of specifically targeted generating units including all LG&E and KU units. As a result of appeals to both rules, the compliance date was extended to May 2004. LG&E and KU have complied with these NOx emissions reduction rules. LG&E and KU have added significant additional NOx controls to their generating units. Installation of additional NOx controls have been performed on a phased basis, with installation of controls which commenced in late 2000 and continued through the final compliance date. As of June 30, 2004, LG&E has incurred total capital costs of approximately $191 million to reduce its NOx emissions to the 0.15 lb./Mmbtu level on a company-wide basis. As of June 30, 2004, KU has incurred total capital costs of approximately $252 million to reduce its NOx emissions to the 0.15 lb./Mmbtu level on a company-wide basis. In addition, LG&E and KU have begun incurring additional operation and maintenance costs in operating new NOx controls. LG&E and KU believe their costs in this regard to be comparable to those of similarly situated utilities with like generation assets. In April 2001, the Kentucky Commission granted recovery of these costs under the environmental surcharge mechanism for LG&E and KU. - New Page - LG&E and KU are also monitoring several other air quality issues which may potentially impact coal-fired power plants, including EPA's revised air quality standards for ozone and particulate matter, measures to implement EPA's regional haze rule, EPA's December 2003 proposals to regulate mercury emissions from steam electric generating units and to further reduce emissions of sulfur dioxide and nitrogen oxides under the Clean Air Interstate Rule. In addition, LG&E is currently working with local regulatory authorities to review the effectiveness of remedial measures aimed at controlling particulate matter emissions from its Mill Creek Station. LG&E previously settled a number of property damage claims from adjacent residents and completed significant remedial measures as part of its ongoing capital construction program. LG&E has converted the Mill Creek Station to a wet stack operation in an effort to resolve all outstanding issues related to particulate matter emissions. Item 3. Quantitative and Qualitative Disclosures About Market Risk. LG&E and KU, and their respective ratepayers, are exposed to market risks. Market risk exposures include changes in interest rates and commodity prices. To mitigate changes in cash flows attributable to these exposures, the Companies have entered into various derivative instruments. Derivative positions are monitored using techniques that include market value and sensitivity analysis. The Companies use interest rate swaps to hedge exposure to market fluctuations in certain of their debt instruments. Pursuant to the Companies' policies, use of these financial instruments is intended to mitigate risk and earnings volatility and is not speculative in nature. Management has designated all of the Companies' interest rate swaps as hedge instruments. Financial instruments designated as cash flow hedges have resulting gains and losses recorded within other comprehensive income and stockholders' equity. To the extent a financial instrument or the underlying item being hedged is prematurely terminated or the hedge becomes ineffective, the resulting gains or losses are reclassified from other comprehensive income to net income. Financial instruments designated as fair value hedges are periodically marked to market with the resulting gains and losses recorded directly into net income to correspond with income or expense recognized from changes in market value of the items being hedged. The potential change in interest expense associated with a 1% change in base interest rates of LG&E's and KU's unswapped debt is estimated at $3.3 million and $3.5 million, respectively, at June 30, 2004. LG&E's exposure to floating interest rates decreased $1.1 million and KU's exposure to floating interest rates decreased $1.0 million during the first six months of 2004. The potential loss in fair value of LG&E's interest rate swaps resulting from a hypothetical 1% change in base interest rates is estimated at approximately $23.6 million as of June 30, 2004. The potential loss in fair value of KU's interest rate swaps resulting from a hypothetical 1% change in base interest rates is estimated at approximately $4.3 million as of June 30, 2004. These estimates are derived from third-party valuations. Changes in the market values of these swaps, if held to maturity, will have no effect on LG&E's or KU's net income or cash flow. Pension Risk LG&E's and KU's costs of providing defined-benefit pension retirement plans is dependent upon a number of factors, such as the rates of return on plan assets, discount rate, and contributions made to the plan. At June 30, 2004, LG&E and KU have a minimum pension liability as prescribed by SFAS No. 87, Employers' Accounting for Pensions, in the pre-tax amounts of $47.6 - New Page - and $9.9 million, respectively. The liabilities are recorded as a reduction to other comprehensive income, and do not affect net income. The amount of the liabilities depends upon the asset returns experienced in 2003 and contributions made by LG&E and KU to the plan during 2003. If the fair value of the plan assets exceeds the accumulated benefit obligation, the recorded liability will be reduced and other comprehensive income will be restored in the Consolidated Balance Sheets. A 1% increase or decrease in the assumed discount rate could have an approximate $41 million positive or negative impact to the accumulated benefit obligation of LG&E. A 1% increase or decrease in the assumed discount rate could have an approximate $27 million positive or negative impact to the accumulated benefit obligation of KU. In January 2004, LG&E and KU made contributions to their pension plans of $34.5 million and $43.4 million, respectively. Energy Trading & Risk Management Activities The table below summarizes LG&E's and KU's energy trading and risk management activities for the three months and six months ended June 30, 2004, and 2003(in thousands of $). Trading volumes are evenly divided between LG&E and KU. Three Months Six Months Ended Ended June 30, June 30, 2004 2003 2004 2003 Fair value of contracts at beginning of period, net asset/(liability) $ 603 $ 403 $ 572 $(156) Fair value of contracts when entered into during the period (5) - (5) 2,620 Contracts realized or otherwise settled during the period (82) (226) (232) (283) Changes in fair value due to changes in assumptions 25 141 206 (1,863) Fair value of contracts at end of period, net asset $ 541 $ 318 $ 541 $ 318 No changes to valuation techniques for energy trading and risk management activities occurred during 2004 or 2003. Changes in market pricing, interest rate and volatility assumptions were made during all periods. All contracts outstanding at June 30, 2004, have a maturity of less than one year and are valued using prices actively quoted for proposed or executed transactions or quoted by brokers. LG&E and KU maintain policies intended to minimize credit risk and revalue credit exposures daily to monitor compliance with those policies. As of June 30, 2004, 98.9% of the trading and risk management commitments were with counterparties rated BBB-/Baa3 equivalent or better. Item 4. Controls and Procedures. LG&E and KU maintain a system of disclosure controls and procedures designed to ensure that information required to be disclosed by the Companies in reports they file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission rules and forms. LG&E and KU conducted an evaluation of such controls and procedures under the supervision and with the participation of the Companies' - New Page - management, including the Chairman, President and Chief Executive Officer ("CEO") and the Chief Financial Officer ("CFO"). Based upon that evaluation, the CEO and CFO have concluded that the Companies' disclosure controls and procedures are effective as of the end of the period covered by this report. There has been no change in the Companies' internal control over financial reporting that occurred during the fiscal quarter ended June 30, 2004, that has materially affected, or is reasonably likely to materially affect, the Companies' internal control over financial reporting. Part II. Other Information Item 1. Legal Proceedings. For a description of the significant legal proceedings involving LG&E and KU, reference is made to the information under the following items and captions of (a) LG&E's and KU's respective combined Annual Report on Form 10-K for the year ended December 31, 2003: Item 1, Business; Item 3, Legal Proceedings; Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, and Item 8, Financial Statements and Supplementary Data and (b) LG&E's and KU's Quarterly Report on Form 10-Q for the period ended March 31, 2004: Item I, Legal Proceedings. Except as described herein, to date, the proceedings reported in LG&E's and KU's respective combined Annual Report on Form 10-K or Quarterly Reports on Form 10-Q have not changed materially. Electric and Gas Rates Cases On June 30, 2004, the Kentucky Commission issued an order approving increases in the base electric and gas rates of LG&E and the base electric rates of KU. In July 2004, the AG commenced an investigation examining communications between the Kentucky Commission and the Companies and separately filed for a rehearing of the rate cases on such issue and certain calculation components of the increased rates. The Kentucky Commission ordered a procedural reopening of the rate cases for the limited purpose of taking evidence, if any, as to the communication issue. For a description of developments in these cases, see Note 11 of the Notes to Consolidated Financial Statements in Part 1, Item 1 of this Quarterly Report on Form 10-Q. MISO During March and April 2004, the Kentucky Commission held hearings in the proceedings examining the cost and benefits of MISO membership. In July 2004, the Kentucky Commission reopened the matter for further testimony and hearings on recently-filed MISO energy market tariffs and analysis of potential membership in other Regional Transmission Organizations. Proceedings in this matter are anticipated to continue into 2005. OVEC Power Agreement and Share Purchase On April 30, 2004, OVEC and its shareholders, including LG&E and KU, entered into an Amended and Restated Inter-Company Power Agreement, to be effective beginning March 2006, upon the expiration of the current power contract among the parties. Under the new contract, which has a 20-year term from its effective date, LG&E and KU have purchase rights for 5.63% and 2.5%, respectively, of OVEC power at marginal cost-based rates. LG&E and KU are entitled to 7% and 2.5% of OVEC power, respectively, under the current contract. In addition, LG&E will purchase from American Electric Power Company Inc. ("AEP") an additional 0.73% interest in OVEC for a purchase price of approximately $104,000, resulting in an increase in LG&E ownership in OVEC from 4.9% to 5.63%. The share purchase transaction is anticipated to be completed during the fourth quarter of 2004, subject to receipt of certain regulatory approvals. - New Page - Owensboro Contract Litigation In May 2004, the City of Owensboro, Kentucky and Owensboro Municipal Utilities (collectively "OMU"), filed suit in Davies County, Kentucky District Court against KU concerning a long-term power supply contract (the "OMU Agreement") with KU. The dispute involves interpretational differences regarding certain issues under the OMU Agreement, including various payments or charges between KU and OMU and rights concerning excess power, termination and emissions allowances, respectively. The complaint seeks approximately $6 million in damages for historical periods, as well as injunctive and other relief, including a declaration that KU is in material breach. KU has removed this litigation to the U.S. District Court for the Western District of Kentucky and filed an answer in that court denying the OMU claims and presenting certain counterclaims. KU has also initiated a proceeding at the FERC to obtain the FERC's ruling on certain of the issues in dispute. Item 6. Exhibits and Reports on Form 8-K. 6(a) Applicable to Form 10-Q of Exhibit No. LG&E KU Description 10.01 X X Copy of Amended and restated inter-company power agreement dated as of March 13, 2006, among Ohio Valley Electric Corporation and sponsoring companies, including LG&E and KU. 10.02 X X Copy of Fourth Amendment dated as of February 1, 2004 to Employment and Severance Agreement dated as of February 25, 2000 by and among E.ON AG, LG&E Energy, Powergen and Victor A. Staffieri. 10.03 X X Copy of Modification No. 15, dated as of April 30, 2004, to Inter-Company Power Agreement dated July 10, 1953 among Ohio Valley Electric Corporation and Sponsoring Companies. 31 X X Certification - Section 302 of Sarbanes-Oxley Act of 2002 31.1 X Certification of Chairman of the Board, President and Chief Executive Officer, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.2 X Certification of Chief Financial Officer, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.3 X Certification of Chairman of the Board, President and Chief Executive Officer, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.4 X Certification of Chief Financial Officer, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32 X X Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 Certain instruments defining the rights of holders of certain long-term debt of LG&E and KU have not been filed with the SEC but will be furnished to the SEC upon request. 6(b). Reports on Form 8-K. On July 1, 2004, LG&E and KU filed a Current Report on Form 8-K describing the June 30, 2004, order of the Kentucky Commission regarding increases in their base rates. - New Page - SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Louisville Gas and Electric Company Registrant Date: August 13, 2004 /s/ S. Bradford Rives S. Bradford Rives Chief Financial Officer (On behalf of the registrant in his capacities as Principal Financial Officer and Principal Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Kentucky Utilities Company Registrant Date: August 13, 2004 /s/ S. Bradford Rives S. Bradford Rives Chief Financial Officer (On behalf of the registrant in his capacities as Principal Financial Officer and Principal Accounting Officer) - New Page - Exhibit 31 - CERTIFICATIONS Exhibit 31.1 Louisville Gas and Electric Company I, Victor A. Staffieri, Chairman of the Board, President and Chief Executive Officer, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Louisville Gas and Electric Company; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: August 13, 2004 /s/ Victor A. Staffieri Victor A. Staffieri Chairman of the Board, President and Chief Executive Officer - New Page - Exhibit 31.2 Louisville Gas and Electric Company I, S. Bradford Rives, Chief Financial Officer, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Louisville Gas and Electric Company; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: August 13, 2004 /s/ S. Bradford Rives S. Bradford Rives Chief Financial Officer - New Page - Exhibit 31.3 Kentucky Utilities Company I, Victor A. Staffieri, Chairman of the Board, President and Chief Executive Officer, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Kentucky Utilities Company; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: August 13, 2004 /s/ Victor A. Staffieri Victor A. Staffieri Chairman of the Board, President and Chief Executive Officer - New Page - Exhibit 31.4 Kentucky Utilities Company I, S. Bradford Rives, Chief Financial Officer, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Kentucky Utilities Company; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: August 13, 2004 /s/ S. Bradford Rives S. Bradford Rives, Chief Financial Officer - New Page - Exhibit 32 Certification Pursuant to 18 U.S.C. Section 1350 As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 In connection with the Quarterly Report of Louisville Gas and Electric Company and Kentucky Utilities Company (the "Companies") on Form 10-Q for the period ended June 30, 2004, as filed with the Securities and Exchange Commission (the "Report"), each of the undersigned does hereby certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that, to such officer's knowledge, 1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and 2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Companies as of the dates and for the period expressed in the Report. August 13, 2004 /s/ Victor A. Staffieri Chairman of the Board, President and Chief Executive Officer Louisville Gas and Electric Company Kentucky Utilities Company /s/ S. Bradford Rives Chief Financial Officer Louisville Gas and Electric Company Kentucky Utilities Company The foregoing certification is being furnished solely pursuant to 18 U.S.C. Section 1350 and is not being filed as part of the Report or as a separate disclosure document.