10-Q 1 llc93001form10q.txt MIDAMERICAN FUNDING LLC - FORM 10-Q - 9-30-2001 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended SEPTEMBER 30, 2001 ------------------ Commission Registrant's Name, State of Incorporation, IRS Employer File Number Address and Telephone Number Identification No. ----------- ---------------------------- ------------------ 333-90553 MIDAMERICAN FUNDING, LLC 47-0819200 (AN IOWA LIMITED LIABILITY COMPANY) 666 GRAND AVE. PO BOX 657 DES MOINES, IOWA 50303 515-242-4300 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: None 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 registrants were required to file such reports), and (2) have been subject to such filing requirements for the past 90 days. Yes X No ----- ----- All of the member's equity of MidAmerican Funding, LLC is held by MidAmerican Energy Holdings Company as of October 31, 2001. MIDAMERICAN FUNDING, LLC FORM 10-Q TABLE OF CONTENTS PART I. FINANCIAL INFORMATION PAGE NO. ITEM 1. Financial Statements Independent Accountants' Report................................. 3 Consolidated Statements of Income............................... 4 Consolidated Balance Sheets..................................... 5 Consolidated Statements of Cash Flows........................... 6 Notes to Consolidated Financial Statements...................... 7 ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations................... 13 PART II. OTHER INFORMATION ITEM 1. Legal Proceedings ................................................ 26 ITEM 6. Exhibits and Reports on Form 8-K.................................. 28 Signatures................................................................. 29 -2- INDEPENDENT ACCOUNTANTS' REPORT Board of Managers and Member MidAmerican Funding, LLC Des Moines, Iowa We have reviewed the accompanying consolidated balance sheet of MidAmerican Funding, LLC and subsidiaries (the Company) as of September 30, 2001, and the related consolidated statements of income for the three-month and nine-month periods ended September 30, 2001 and 2000, and the related consolidated statements of cash flows for the nine-month periods ended September 30, 2001 and 2000. These financial statements are the responsibility of the Company's management. We conducted our review in accordance with standards established by the American Institute of Certified Public Accountants. A review of interim financial information consists principally of applying analytical procedures to financial data and of making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with auditing standards generally accepted in the United States of America, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion. Based on our review, we are not aware of any material modifications that should be made to such consolidated financial statements for them to be in conformity with accounting principles generally accepted in the United States of America. We have previously audited, in accordance with auditing standards generally accepted in the United States of America, the consolidated balance sheet and statement of capitalization (not presented herein) of MidAmerican Funding, LLC and subsidiaries as of December 31, 2000, and the related consolidated statements of income, comprehensive income, retained earnings, and cash flows for the year then ended (not presented herein); and in our report dated January 18, 2001, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet as of December 31, 2000 is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived. DELOITTE & TOUCHE LLP Des Moines, Iowa October 26, 2001 -3- MIDAMERICAN FUNDING, LLC CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) (IN THOUSANDS)

The accompanying notes are an integral part of these statements. -4- MIDAMERICAN FUNDING, LLC CONSOLIDATED BALANCE SHEETS (IN THOUSANDS)

The accompanying notes are an integral part of these statements. -5- MIDAMERICAN FUNDING, LLC CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) (IN THOUSANDS)

The accompanying notes are an integral part of these statements. -6- MIDAMERICAN FUNDING, LLC NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A. GENERAL: The consolidated financial statements included herein have been prepared by MidAmerican Funding, LLC, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. In the opinion of MidAmerican Funding, all adjustments, consisting of normal recurring adjustments, have been made to present fairly the financial position, the results of operations and the changes in cash flows for the periods presented. Prior year amounts have been reclassified to a basis consistent with the current year presentation. All significant intercompany transactions have been eliminated. Although MidAmerican Funding believes that the disclosures are adequate to make the information presented not misleading, it is suggested that these financial statements be read in conjunction with the consolidated financial statements and the notes thereto included in MidAmerican Funding's latest Annual Report on Form 10-K, as amended. MidAmerican Funding is an Iowa limited liability company with MidAmerican Energy Holdings Company as its sole member. MidAmerican Funding's direct, wholly owned subsidiary is MHC Inc. MHC, MidAmerican Funding and MidAmerican Energy Holdings are exempt public utility holding companies headquartered in Des Moines, Iowa. MHC's principal subsidiary is MidAmerican Energy Company, a public utility with electric and natural gas operations. Other direct, wholly owned subsidiaries of MHC include MidAmerican Capital Company, Midwest Capital Group, Inc., MidAmerican Services Company and MEC Construction Services Co. B. ENVIRONMENTAL MATTERS: (1) MANUFACTURED GAS PLANT FACILITIES - The United States Environmental Protection Agency and the state environmental agencies have determined that contaminated wastes remaining at decommissioned manufactured gas plant facilities may pose a threat to the public health or the environment if such contaminants are in sufficient quantities and at such concentrations as to warrant remedial action. MidAmerican Energy has evaluated or is evaluating 27 properties that were, at one time, sites of gas manufacturing plants in which it may be a potentially responsible party. The purpose of these evaluations is to determine whether waste materials are present, whether the materials constitute an environmental or health risk, and whether MidAmerican Energy has any responsibility for remedial action. MidAmerican Energy is currently conducting field investigations at eighteen sites and has conducted interim removal actions at six of the eighteen sites. In addition, MidAmerican Energy has completed investigations and removals at four sites. MidAmerican Energy is continuing to evaluate several of the sites to determine the future liability, if any, for conducting site investigations or other site activity. MidAmerican Energy estimates the range of possible costs for investigation, remediation and monitoring for the sites discussed above to be $22 million to $68 million. MidAmerican Energy's estimate of the probable cost for these sites as of September 30, 2001 was $24 million. The estimate consists of $3 million for investigation costs, $8 million for remediation costs, $11 million for groundwater treatment and monitoring costs and $2 million for closure and administrative costs. This estimate has been recorded as a liability and a regulatory asset for future recovery. MidAmerican Energy projects that these amounts will be paid or incurred over the next 10 years. -7- The estimate of probable remediation costs is established on a site-specific basis. The costs are accumulated in a three-step process. First, a determination is made as to whether MidAmerican Energy has potential legal liability for the site and whether information exists to indicate that contaminated wastes remain at the site. If so, the costs of performing a preliminary investigation and the costs of removing known contaminated soil are accrued. As the investigation is performed and if it is determined remedial action is required, the best estimate of remedial costs is accrued. If necessary, the estimate is revised when a consent order is issued. The estimated recorded liabilities for these properties include incremental direct costs of the remediation effort, costs for future monitoring at sites and costs of compensation to employees for time expected to be spent directly on the remediation effort. The estimated recorded liabilities for these properties are based upon preliminary data. Thus, actual costs could vary significantly from the estimates. The estimate could change materially based on facts and circumstances derived from site investigations, changes in required remedial action and changes in technology relating to remedial alternatives. Insurance recoveries have been received for some of the sites under investigation. Those recoveries are intended to be used principally for accelerated remediation, as specified by the Iowa Utilities Board, and are recorded as a regulatory liability. The Illinois Commerce Commission has approved the use of a tariff rider which permits recovery of the actual costs of litigation, investigation and remediation relating to former manufactured gas plant sites. MidAmerican Energy's present rates in Iowa provide for a fixed annual recovery of manufactured gas plant costs. MidAmerican Energy intends to pursue recovery of the remediation costs from other potentially responsible parties and its insurance carriers. Although the timing of potential incurred costs and recovery of such costs in rates may affect the results of operations in individual periods, management believes that the outcome of these issues will not have a material adverse effect on MidAmerican Energy's financial position or results of operations. (2) CLEAN AIR ACT - On July 18, 1997, the Environmental Protection Agency adopted revisions to the National Ambient Air Quality Standards for ozone and a new standard for fine particulate matter. Based on data to be obtained from monitors located throughout each state, the Environmental Protection Agency will determine which states have areas that do not meet the air quality standards (i.e., areas that are classified as nonattainment). If a state has area(s) classified as nonattainment area(s), the state is required to submit a State Implementation Plan specifying how it will reach attainment of the standards through emission reductions or other means. In August 1998, the Iowa Environmental Protection Commission adopted by reference the National Ambient Air Quality Standards for ozone and fine particulate matter. In May 1999, the United States Court of Appeals for the District of Columbia Circuit remanded the standards adopted in July 1997 back to the Environmental Protection Agency indicating the Environmental Protection Agency had not expressed sufficient justification for the basis of establishing the standards and ruling that the Environmental Protection Agency has exceeded its constitutionally-delegated authority in setting the standards. The Environmental Protection Agency's appeal of the court's ruling to the full panel of the United States District Court of Appeals for the District of Columbia was denied. In May 2000, the United States Supreme Court granted certiorari to review the appeals court decision. On February 27, 2001, the Supreme Court, in Whitman v. American Trucking Associations, upheld the standards, ruling that the Environmental Protection Agency did not exceed its constitutional delegation of authority in establishing the standards in 1997. The court ruled that the Clean Air Act's requirement for the Environmental Protection Agency to establish National Ambient Air Quality -8- Standards at a level "requisite" to protect public health, or "sufficient, but not more than necessary", is within the constitutional scope of discretion that Congress can delegate to a federal agency. The court also explicitly held that cost cannot be taken into account when setting the standards. The court remanded the issue of implementation of the ozone standard. However, the Environmental Protection Agency is moving forward with analyzing existing monitored data and determining attainment status. The impact of the new standards on MidAmerican Energy is currently unknown. MidAmerican Energy's fossil fuel generating stations may be subject to emission reductions if the stations are located in nonattainment areas. As part of an overall state plan to achieve attainment of the standards, MidAmerican Energy could be required to install control equipment on its fossil fuel generating stations or decrease the number of hours during which these stations operate. The degree to which MidAmerican Energy may be required to install control equipment or decrease operating hours under a nonattainment scenario will be determined by the state's assessment of MidAmerican Energy's relative contribution, along with other emission sources, to the nonattainment status. The installation of control equipment would result in increased costs to MidAmerican Energy. A decrease in the number of hours during which the affected stations operate would increase operating costs and decrease wholesale electric revenues of MidAmerican Energy. C. RATE MATTERS: In 1997, pursuant to a rate proceeding before the Iowa Utilities Board, MidAmerican Energy, the Office of Consumer Advocate and other parties entered into a pricing plan settlement agreement establishing MidAmerican Energy's Iowa retail electric rates. That settlement agreement expired on December 31, 2000. On March 14, 2001, the Office of the Consumer Advocate filed a petition with the Iowa Utilities Board to reduce Iowa retail electric rates by approximately $77 million annually. On June 11, 2001, MidAmerican Energy responded to that petition by filing a request with the Iowa Utilities Board to increase MidAmerican Energy's Iowa retail electric rates by $51 million annually. On July 12, 2001, MidAmerican Energy, the Office of Consumer Advocate and other parties jointly filed a proposed settlement with the Iowa Utilities Board that, if approved, will freeze the rates in effect on December 31, 2000, through December 31, 2005, and, with modifications, will reinstate the revenue sharing provisions of the 1997 pricing plan settlement agreement. Under the proposed settlement, 50% of revenues associated with returns on equity between 12% and 14%, and 83.33% of revenues associated with returns on equity above 14%, in each year would be deferred as a regulatory liability to be used to offset a portion of the cost of future generating plant investments. The Iowa Utilities Board held a public hearing on the proposed settlement in October 2001, and interested parties submitted briefs thereafter. The Iowa Utility Board's decision on approving the proposed settlement is pending. Under an Illinois restructuring law enacted in 1997, a sharing mechanism is in place for MidAmerican Energy's Illinois regulated retail electric operations whereby earnings above a computed threshold will be shared equally between customers and shareholders. A two-year average return on common equity greater than a two-year average benchmark will trigger an equal sharing of earnings on the excess. MidAmerican Energy's computed level of return on common equity is based on a rolling two-year average of the 30-year Treasury Bond rates plus a premium of 5.50% for 1998 and 1999 and a premium of 8.5% for 2000 through 2004. The two-year average above which sharing must occur for 2000 was 12.83%. Using the same 30-year Treasury Bond average, the computed level of return would be 14.33% for 2001 through 2004. The law allows MidAmerican Energy to mitigate the sharing of earnings above the threshold return on common equity through accelerated recovery of regulatory assets. -9- On September 21, 2001, MidAmerican Energy filed a petition with the South Dakota Public Utilities Commission (SDPUC) to increase its South Dakota natural gas rates by $3.7 million annually. Under South Dakota law, the SDPUC may suspend the new rates for up to six months during the pendency of rate proceedings. On October 19, 2001 MidAmerican Energy filed a petition with the Illinois Commerce Commission to increase its Illinois natural gas rates by $3.2 million annually. A final decision on the petition is required within eleven months of the date of filing. D. ACCOUNTING FOR THE EFFECTS OF CERTAIN TYPES OF REGULATION MidAmerican Energy's utility operations are subject to the regulation of the Iowa Utilities Board, the Illinois Commerce Commission, the South Dakota Public Utilities Commission, and the Federal Energy Regulatory Commission. MidAmerican Energy's accounting policies and the accompanying Consolidated Financial Statements conform to generally accepted accounting principles applicable to rate-regulated enterprises and reflect the effects of the ratemaking process. A possible consequence of deregulation in the utility industry is that Statement of Financial Accounting Standards No. 71 (SFAS 71) may no longer apply. SFAS 71 sets forth accounting principles for operations that are regulated and meet the stated criteria. For operations that meet the criteria, SFAS 71 allows, among other things, the deferral of expense or income that would otherwise be recognized when incurred. MidAmerican Energy's electric and gas utility operations currently meet the criteria of SFAS 71, but its applicability is periodically reexamined. If portions of its utility operations no longer meet the criteria of SFAS 71, MidAmerican Energy could be required to write off the related regulatory assets and liabilities from its balance sheet and thus, a material adjustment to earnings in that period could result if regulatory assets are not recovered in transition provisions of any deregulation legislation. E. DERIVATIVE FINANCIAL INSTRUMENTS: In January 2001, MidAmerican Funding adopted Statement of Financial Accounting Standards (SFAS) Nos. 133 and 138, pertaining to the accounting for derivative instruments and hedging activities. These pronouncements require that derivative instruments be recorded at fair value on the balance sheet and changes in fair value recognized in income. To the extent that derivative instruments are used for hedging purposes, and are highly effective as hedges, hedge accounting is permitted, as discussed below, which mitigates the impact on earnings of changes in the fair value of the derivatives. MidAmerican Energy enters into derivative financial instruments, including futures, swaps, options and forward contracts, to hedge the effect of price changes on cash flows from expected future physical transactions (cash flow hedges) and the fair value of physical purchase and sale commitments (fair value hedges) and to reduce natural gas price volatility for regulated gas customers. The objective of MidAmerican Energy's hedging program is to minimize the impact of changing prices for natural gas and electricity on its cash flows. From time to time, MidAmerican Energy also enters into derivative financial instruments for trading purposes to profit from changing prices for natural gas and electricity or to take advantage of price arbitrage opportunities. Unrealized gains and losses on cash flow hedges of future transactions are recorded in other comprehensive income. Only hedges that are highly effective in offsetting the risk of variability in future cash flows are accounted for in this manner. Future transactions include purchases of gas for resale to regulated and nonregulated customers, purchases of gas for storage, and purchases and sales of wholesale electric energy. When the associated hedged future transaction occurs or if a hedging relationship is no longer appropriate, the unrealized gains and losses are reversed from other comprehensive income and -10- recognized in net income. Realized gains on cash flow hedges are recorded in Cost of Gas Sold, Regulated Cost of Fuel, Energy and Capacity or Nonregulated Operating Revenues, depending upon the nature of the physical transaction being hedged. For the nine months ended September 30, 2001, net gains of $2,000 and $43,000, representing the ineffectiveness of cash flow hedges, are reflected in Cost of Gas Sold and Regulated Cost of Fuel, Energy and Capacity, respectively. During the twelve months beginning October 1, 2001, it is anticipated that $4.9 million of the $5.7 million after-tax, net unrealized gains on cash flow hedges presently recorded as accumulated other comprehensive income will be realized and recorded in earnings. MidAmerican Energy has hedged a portion of its exposure to the variability of cash flows for future transactions through December 2002. Unrealized gains and losses on fair value hedges are recognized in income as either Nonregulated Operating Revenues or Cost of Gas Sold depending upon the nature of the item being hedged. Purchase and sales commitments hedged by fair value hedges are recorded at fair value, with the changes in values also recognized in income and substantially offsetting the impact of the hedges on earnings. For the nine months ended September 30, 2001, a net pre-tax gain of $3,000, representing the ineffectiveness of fair value hedges, is included in Nonregulated Operating Revenues. Unrealized gains and losses on MidAmerican Energy's derivatives held for trading purposes are recognized in income each reporting period as Nonregulated Operating Revenues. MidAmerican Funding is exposed to fair value risk from changes in interest rates for fixed rate sinking fund preferred and perpetual preferred stocks (fixed rate preferred stocks). MidAmerican Funding reviews the interest rate sensitivity of these securities and purchases put options on U.S. Treasury securities. MidAmerican Funding's intent is to substantially offset any change in market value of the fixed rate preferred stocks due to a change in interest rates with a change in market value of the put options. On January 1, 2001, as permitted by FAS 133, MidAmerican Funding re-characterized its portfolio of preferred stock investments as "trading" securities. Accordingly, any changes in value in the portfolio, or in the derivatives used to hedge their exposure to changes in interest rates, are now reflected in Marketable Securities Gains and Losses, Net. This change in classification resulted in an initial pre-tax loss of $2.4 million. For the nine months ended September 30, 2001, excluding the initial pre-tax loss, a net pre-tax gain of $0.3 million, representing the ineffectiveness of the related fair value hedges, is included in Marketable Securities Gains and Losses, Net. F. SEGMENT INFORMATION: MidAmerican Funding has two reportable operating segments: regulated electric and regulated gas, referred to as the electric and gas segments. The electric segment derives most of its revenue from retail sales of regulated electricity to residential, commercial, and industrial customers and from wholesale sales to other utilities, municipalities and marketers. The gas segment derives most of its revenue from retail sales of natural gas to residential, commercial, and industrial customers and also earns significant revenues by transporting gas owned by others through its distribution systems. Pricing for most electric and gas sales are established separately by regulatory agencies; therefore, management also reviews each segment separately to make decisions regarding allocation of resources and in evaluating performance. Common operating costs, interest income, interest expense, income tax expense and equity in the net income or loss of investees are allocated to each segment. -11- The following table provides MidAmerican Funding information on an operating segment basis (in thousands): Three Months Nine Months Ended September 30, Ended September 30, ------------------- ----------------------- 2001 2000 2001 2000 -------- -------- ---------- ---------- Revenues Electric.................... $386,674 $359,430 $ 986,864 $ 919,866 Gas......................... 56,354 71,573 510,509 349,628 Nonregulated and other (a).. 109,609 122,547 545,202 276,743 -------- -------- ---------- ---------- $552,637 $553,550 $2,042,575 $1,546,237 ======== ======== ========== ========== Net Income: Electric.................... $ 63,522 $ 69,765 $ 133,804 $ 123,699 Gas......................... (7,516) (4,586) 4,484 10,802 Nonregulated and other (a).. (14,603) (12,893) (35,819) (29,375) -------- -------- ---------- ---------- $ 41,403 $ 52,286 $ 102,469 $ 105,126 ======== ======== ========== ========== (a) "Nonregulated and other" consists of nonregulated gas operations, CBEC Railway and other nonregulated activities. G. OTHER COMPREHENSIVE INCOME: For the nine months ended September 30, 2001 and 2000, MidAmerican Funding's total comprehensive income was $103.0 million and $109.7 million, respectively. For the three months ended September 30, 2001 and 2000, MidAmerican Funding's total comprehensive income was $33.3 million and $58.3 million, respectively. The differences from Net Income are due to unrealized holding gains and losses of marketable securities during the periods and, beginning January 1, 2001, the effective portion of net gains and losses of derivative instruments classified as cash flow hedges. Accumulated other comprehensive income, which also includes recognition of the minimum pension liability in the fourth quarter of 2000, was $3.2 million and $2.7 million as of September 30, 2001, and December 31, 2000, respectively. -12- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS INTRODUCTION ------------ MidAmerican Funding, LLC is an Iowa limited liability company formed in March 1999. The sole member of MidAmerican Funding is MidAmerican Energy Holdings Company. MidAmerican Funding owns all of the outstanding common stock of MHC Inc. MHC's principal subsidiary is MidAmerican Energy Company, a public utility with electric and gas operations. Other direct, wholly owned subsidiaries of MHC include MidAmerican Capital Company, Midwest Capital Group, Inc., MidAmerican Services Company and MEC Construction Services Co. FORWARD-LOOKING STATEMENTS From time to time, MidAmerican Funding, or one of its subsidiaries individually, may make forward-looking statements within the meaning of the federal securities laws that involve judgments, assumptions and other uncertainties beyond the control of MidAmerican Funding or any of its subsidiaries individually. These forward-looking statements may include, among others, statements concerning revenue and cost trends, cost recovery, cost reduction strategies and anticipated outcomes, pricing strategies, changes in the utility industry, planned capital expenditures, financing needs and availability, statements of MidAmerican Funding's expectations, beliefs, future plans and strategies, anticipated events or trends and similar comments concerning matters that are not historical facts. These type of forward-looking statements are based on current expectations and involve a number of known and unknown risks and uncertainties that could cause the actual results and performance of MidAmerican Funding to differ materially from any expected future results or performance, expressed or implied, by the forward-looking statements. In connection with the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, MidAmerican Funding has identified important factors that could cause actual results to differ materially from those expectations, including weather effects on sales and revenues, fuel prices, fuel transportation and other operating uncertainties, acquisition uncertainty, uncertainties relating to economic and political conditions and uncertainties regarding the impact of regulations, changes in government policy, utility industry deregulation and competition. MidAmerican Funding assumes no responsibility to update forward-looking information contained herein. RESULTS OF OPERATIONS --------------------- REGULATED GROSS MARGIN Regulated Electric Gross Margin - Three Months Nine Months Ended September 30, Ended September 30, ------------------- ------------------- 2001 2000 2001 2000 ---- ---- ---- ---- (In millions) Operating revenues ................. $387 $359 $987 $920 Cost of fuel, energy and capacity. 88 67 215 181 ---- ---- ---- ---- Electric gross margin .......... $299 $292 $772 $739 ==== ==== ==== ==== Electric gross margin for the third quarter of 2001 increased $7 million compared to the third quarter of 2000. MidAmerican Energy's margins on wholesale sales, net of a reserve for revenue sharing, increased $28.1 million compared to the third quarter of 2000. Sales volumes for wholesale sales -13- increased 4.4%. Wholesale sales are the sales of energy to other utilities, municipalities and marketers outside of MidAmerican Energy's delivery system. An increase in fuel costs per unit for Iowa retail customers reduced electric gross margin by $20.4 million for the third quarter of 2001 compared to the third quarter of 2000. Usage factors not dependent on weather decreased electric margin by $2.0 million compared to the third quarter of 2000. A fluctuation in temperature conditions accounted for an approximate $1 million increase in gross margin compared to the third quarter of 2000. In total, retail sales of electricity increased 1.7% for the three months ended September 30, 2001. For the nine months ended September 30, 2001, compared to the first nine months of 2000, electric gross margin increased $33 million. MidAmerican Energy's margins on wholesale sales, net of a reserve for revenue sharing, increased $50.2 million compared to the first nine months of 2000, and related sales volumes increased 20.4%. Revenues from electric transmission services increased $4.0 million for the 2001 nine-month period compared to the 2000 nine-month period due to additional revenues from Mid-Continent Area Power Pool. Additionally, electric revenues for the nine months ended September 30, 2001, reflect a $3.3 million increase in gains from the sale of emission allowances. Temperatures during the nine months ended September 30, 2001, were more extreme than temperatures in the nine months ended September 30, 2000, resulting in a $16 million increase in electric margin. Other usage factors not dependent on weather decreased electric margin by $15.3 million compared to the first nine months of 2000. An increase in fuel costs per unit for Iowa retail customers and the effect of a fuel-related purchase accounting adjustment in 2000 reduced electric margin by $24.3 million for the nine months ended September 30, 2001, compared to the nine months ended September 30, 2000. In total, retail sales of electricity increased 1.8% for the nine months ended September 30, 2001. Regulated Gas Gross Margin - Three Months Nine Months Ended September 30, Ended September 30, ------------------- ------------------- 2001 2000 2001 2000 ---- ---- ---- ---- (In millions) Operating revenues ..... $56 $72 $511 $350 Cost of gas sold ....... 25 39 370 212 --- --- ---- ---- Gas gross margin ..... $31 $33 $141 $138 === === ==== ==== Regulated gas revenues include purchase gas adjustment clauses through which MidAmerican Energy is allowed to recover the cost of gas sold from its retail gas utility customers. Consequently, fluctuations in the cost of gas sold do not affect gross margin or net income because revenues reflect comparable fluctuations from the purchase gas adjustment clauses. An increase in the per-unit cost of gas for the nine-month period ended September 30, 2001, compared to the same period in 2000, increased revenues and cost of gas sold by approximately $136 million. Gas gross margin decreased $2 million for the third quarter of 2001 compared to the 2000 quarter due to conservation by customers and a fluctuation in temperature conditions. Total gas retail sales decreased 6.0%. -14- Compared to the first nine months of 2000, gas gross margin increased $3 million due to the colder-than-normal temperature conditions in the first quarter of 2001 offset partially by conservation by customers due to high natural gas prices. REGULATED OPERATING EXPENSES Regulated other operating expenses increased $14.6 million for the third quarter of 2001 compared to the third quarter of 2000. An increase in Cooper Nuclear Station costs resulted in a $4.4 million increase to other operating expenses. Other increases include a $3.9 million increase in the allowance for uncollectible accounts as a result of the high natural gas prices, a $3.0 million increase in health care benefits costs and a $2.6 million increase in pension and other post-employment benefits costs. Regulated other operating expenses increased $21.4 million for the nine months ended September 30, 2001, compared to the nine-month period in 2000. An increase in Cooper Nuclear Station costs resulted in a $12.5 million increase to other operating expenses. Other increases include a $7.2 million increase in the allowance for uncollectible accounts as a result of the high natural gas prices, a $6.2 million increase in pension and other post-employment benefits costs and a $3.4 million increase in electric distribution expense. The increases were partially offset by reductions in Quad Cities Station operating expenses, electric transmission expense, energy efficiency program costs, information technology expenses and assessments from utility regulatory agencies. Maintenance expenses for the three months ended September 30, 2001, increased $5.0 million compared to the 2000 period due principally to an increase in fossil fuel generating plant maintenance costs. For the nine months ended September 30, 2001, compared to the nine months ended September 30, 2000, maintenance expenses increased $9.2 million. Electric distribution maintenance increased $4.4 million in part due to a more aggressive tree-trimming program. Fossil fuel generating plant maintenance expense increased $3.8 million, while maintenance costs for Quad Cities Station (nuclear) decreased $2.9 million. Gas distribution system maintenance increased $1.9 million and maintenance costs for general plant increased $1.3 million. Depreciation and amortization expense increased $2.2 million for the third quarter of 2001 and $10.2 million for the first nine months of 2001 compared to the respective periods in 2000. The increases were due principally to an increase in depreciation rates implemented in 2001. An increase in utility plant also contributed to the increases. Property and other taxes for the three months and nine months ended September 30, 2001, decreased $0.8 million and $3.4 million, respectively, relative to their comparable periods in 2000 due principally to a decrease in Iowa property taxes. For the nine-month comparison, the 2000 period included an accrual for use taxes, which increased total taxes for that period. -15- NONREGULATED OPERATING REVENUES AND OPERATING EXPENSES Nonregulated Gross Margin - Three Months Nine Months Ended September 30, Ended September 30, ------------------- ------------------- 2001 2000 2001 2000 ---- ---- ---- ---- (In millions) Operating revenues ... $110 $123 $545 $277 Cost of sales ........ 105 118 523 257 ---- ---- ---- ---- Gross margin ....... $ 5 $ 5 $ 22 $ 20 ==== ==== ==== ==== Nonregulated revenues and cost of sales consist substantially of nonregulated natural gas marketing operations. The nonregulated natural gas marketing operations include wholesale and retail activities. Approximately 80% of the nonregulated natural gas revenues for the nine months ended September 30, 2001, are related to wholesale sales. Gross margin for the nonregulated natural gas operations increased $0.2 million to $1.4 million for the third quarter of 2001. The improvement in gross margin reflects an increase in sales volumes partially offset by a decrease in margin per unit. Revenues from nonregulated natural gas operations decreased for the third quarter of 2001 compared to the third quarter of 2000 due to a decrease in the average price per unit sold, reflective of a 34% decrease in the average cost of gas. The decrease in price per unit was offset partially by an increase in sales volumes of 12 million MMBtus (48%). Cost of sales decreased for the three months ended September 30, 2001, due to the variances in the per-unit cost of gas sold and sales volumes. Gross margin for the nonregulated natural gas operations increased $3.5 million to $7.2 million for the first nine months of 2001 compared to the first nine months of 2000. The improvement in gross margin reflects an increase in margin per unit and sales volumes. Revenues from nonregulated natural gas operations increased $279.5 million for the first nine months of 2001. An increase in the average price per unit sold, reflective of a 24% increase in the average cost of gas, accounted for $101.6 million of the increase in revenues. Sales volumes increased 47 million MMBtus (74%) resulting in a $177.9 million increase in revenues. Cost of sales increased $276.0 million for the nine months ended September 30, 2001, due to the increases in the per-unit cost of gas sold and sales volumes. As of December 31, 2000, all non-residential customers in Illinois had been phased in to allow them to select their electric power supplier. For the three months ended September 30, 2001, compared to the three months ended September 30, 2000, gross margin related to these sales decreased $0.2 million while gross margin for the nine-month period ended September 30, 2001, increased $0.8 million. Nonregulated revenues for the third quarter of 2000 included $4.8 million from MidAmerican Energy's market access service project. The pilot project which concluded in May, 2001, allowed larger Iowa customers that were participating in the project to choose their electric power supplier. MidAmerican Energy's revenues from project participants related to non-supply services, such as distribution and transmission, are reflected in regulated electric revenues. Cost of sales related to the market access service project totaled $4.2 million for the third quarter of 2000. For the nine-month comparison, revenues from the project totaled $6.2 million and $13.4 million for 2001 and 2000, respectively; the related cost of sales totaled $5.4 million and $12.5 million for 2001 and 2000, respectively. -16- MidAmerican Energy's nonregulated revenues in the third quarter of 2001 include $1.9 million from an award for successful performance under an incentive gas procurement program. Awards totaled $4.1 million and $1.9 million for the first nine months of 2001 and 2000, respectively. The first quarter of 2000 also includes $4.4 million of revenues and $2.6 million of cost of sales from the security system operations sold in April 2000. Nonregulated Operating Expenses: Other - Nonregulated other operating expenses decreased $2.1 million for the quarter ended September 30, 2001, compared to the 2000 quarter ended September 30 due to a decrease in nonregulated activities for MidAmerican Energy and a decrease in sales tax expense. Nonregulated other operating expenses decreased $4.8 million for the nine months ended September 30, 2001 for the same reasons as the quarter. Additionally, the 2000 period included $1.7 million in costs related to the security system operations sold in April 2000. Amortization of MidAmerican Funding goodwill decreased $0.9 million to $25.8 million for the first nine months of 2001. NON-OPERATING INCOME AND INTEREST EXPENSE Interest and Dividend Income - Interest income decreased $2.2 million for the three-month period ended September 30, 2001, and increased $2.4 million for the nine-month period ended September 30, 2001, relative to their comparable periods in 2000. A decrease in interest from a joint plant operator for funds held by it reduced interest income by approximately $2.3 million for each of the 2001 periods presented. Interest income increased $1.0 million and $5.9 million in the three-month and nine-month periods, respectively, for interest income on a note receivable related to MidAmerican Energy's accounts receivable sold. The increase in the note receivable is a result of the increased balance in receivables sold. A reduction in interest rates also reduced interest income for the periods. Dividend income decreased due to partial liquidation of the preferred stock investment portfolio in the past twelve months. Marketable Securities Gains and Losses, Net - Net losses on marketable securities for the nine months ended September 30, 2001, increased $0.2 million compared to the nine-month period ended September 30, 2000. The first quarter of 2001 includes a $2.4 million pre-tax loss related to the re-characterization of marketable securities to "trading" as allowed by Statement of Financial Accounting Standards No. 133. The first quarter of 2000 reflects a $2.0 million pre-tax gain on the sale of the remaining shares of McLeodUSA common stock held by MidAmerican Funding. These decreases for the 2001 period were offset substantially by an increase in net gains realized on marketable securities sold in 2001 compared to the 2000 nine-month period. Additionally, as a result of the re-characterization of the securities in 2001, the statement of income for the 2001 period reflects unrealized gains that would have been recorded in equity in 2000. Other, Net - Other, Net, which includes a number of non-operating income and deduction items, decreased Non-Operating Income by $0.2 million and $0.8 million for the three months ended September 30, 2001 and 2000, respectively. Other, Net reduced Non-Operating Income by $3.3 million for the nine-month period ended September 30, 2001, and increased Non-Operating Income by $5.2 million for the nine-month period ended September 30, 2000. -17- Other, Net includes a discount on sold accounts receivable, net of a subservicer fee charged to MidAmerican Energy Funding Corporation for servicing the accounts. The discount is designed to cover the expenses of MidAmerican Energy Funding Corporation, including subservicer fees, monthly administrative costs and interest. The discount is recorded in Other, Net because it is not reflected in utility cost of service for regulatory purposes. The discount, net of the subservicer fee, reduced Other, Net by $3.1 million and $2.5 million in the third quarter of 2001 and 2000, respectively, and by $11.9 million and $6.9 million for the nine months ended September 30, 2001 and 2000, respectively. Income from equity investments increased $0.4 million compared to the third quarter of 2000. For the nine months ended September 30, 2001, income from equity investments increased $1.1 million compared to the same period in 2000. Other, Net for the first nine months of 2001 reflects a $1.4 million gain on the sale of MidAmerican Energy rail cars, while the nine-month period ended September 30, 2000, includes a $4.3 million gain on the sale of security companies and $1.3 million from the sale of commercial property and rail cars. Income related to corporate-owned life insurance policies decreased $0.2 million and $1.2 million in the three months and nine months ended September 30, 2001, respectively, compared to the same periods in 2000. Other, Net, for the 2001 quarter and nine months ended September 30, reflects $0.8 million of income for an allowance for equity funds used during construction. As a regulated public utility, MidAmerican Energy is allowed to capitalize, and record as income, a cost of construction for equity funds used, based on guidelines set forth by the Federal Energy Regulatory Commission. Fixed Charges - The decrease in interest on long-term debt for the third quarter of 2001 compared to the third quarter of 2000 is due to maturities of MidAmerican Energy and MidAmerican Capital long-term debt and lower interest rates on variable rate debt. The increase in interest on long-term debt for the nine months ended September 30, 2001, compared to the nine-month period in 2000 is due to interest on $162 million of MidAmerican Energy medium-term notes issued in July 2000, net of the impact of maturities in 2000 of MidAmerican Energy and MidAmerican Capital long-term debt and lower interest rates. Other interest expense decreased in the 2001 periods compared to the respective periods in 2000 due principally to a reduction in short-term debt outstanding at MidAmerican Energy. Additionally, the second quarter of 2000 includes $0.6 million of interest related to a gas supplier refund that is refundable to customers. These decreases were partially offset by interest related to state and federal income tax assessments in 2001. -18- LIQUIDITY AND CAPITAL RESOURCES ------------------------------- MidAmerican Funding has available a variety of sources of liquidity and capital resources, both internal and external. These resources provide funds required for current operations, construction expenditures, dividends, debt retirement and other capital requirements. As reflected on the Consolidated Statements of Cash Flows, MidAmerican Funding's net cash provided from operating activities was $440 million and $285 million for the nine months ended September 30, 2001 and 2000, respectively. INVESTING ACTIVITIES AND PLANS Utility Construction Expenditures - MidAmerican Energy's primary need for capital is utility construction expenditures. For the first nine months of 2001, utility construction expenditures totaled $151 million, including allowance for funds used during construction, or capitalized financing costs, and Quad Cities Station nuclear fuel purchases. All such expenditures were met with cash generated from utility operations, net of dividends. Forecasted utility construction expenditures, including allowance for funds used during construction are $223 million for 2001. Capital expenditure needs are reviewed regularly by management and may change significantly as a result of such reviews. On July 10, 2001, MidAmerican Energy announced plans to develop and construct two electric generating plants in Iowa, requiring an investment of approximately $1.5 billion. Participation by others in a portion of the second plant is being discussed. The two plants will provide approximately 1,400 megawatts of generating capacity. MidAmerican Energy expects to begin construction in Spring 2002 on the first project, a 540-megawatt natural gas-fired combined cycle unit which has an estimated cost of $368 million. It is anticipated that the first phase of the project will be completed in 2003 with the remainder being completed in 2005. MidAmerican Energy presently expects that all utility construction expenditures for the next five years will be met with the issuance of long-term debt and cash generated from utility operations, net of dividends. The actual level of cash generated from utility operations is affected by, among other things, economic conditions in the utility service territory, weather and federal and state regulatory actions. Nuclear Decommissioning - Each licensee of a nuclear facility is required to provide financial assurance for the cost of decommissioning its licensed nuclear facility. In general, decommissioning of a nuclear facility means to safely remove the facility from service and restore the property to a condition allowing unrestricted use by the operator. Based on information presently available, MidAmerican Energy expects to contribute approximately $41 million during the period 2001 through 2005 to external trusts established for the investment of funds for decommissioning Quad Cities Station. Approximately 55% of the trusts' funds are now invested in domestic corporate debt and common equity securities. The remainder is invested in investment grade municipal and U.S. Treasury bonds. Funding for Quad Cities Station is reflected in depreciation expense in the Consolidated Statements of Income. Based on information presently available and assuming a September 2004 shutdown of Cooper, MidAmerican Energy expects to accrue approximately $55 million for Cooper decommissioning during the period 2001 through 2004. Amounts related to Cooper decommissioning are reflected in Other Operating Expenses in the Consolidated Statements of Income. MidAmerican Energy's obligation, if any, for Cooper decommissioning will be affected by the actual plant shutdown date. In July 1997, the Nebraska Public Power District filed a lawsuit in United States District Court for the District of Nebraska -19- naming MidAmerican Energy as the defendant and seeking a declaration of MidAmerican Energy's rights and obligations in connection with Cooper nuclear decommissioning funding. Refer to Part II, Item 1- Legal Proceedings, for further discussion of the litigation. Cooper and Quad Cities Station decommissioning costs charged to Iowa customers are included in base rates, and recovery of increases in those amounts must be sought through the normal ratemaking process. Cooper decommissioning costs charged to Illinois customers are recovered through a rate rider on customer billings. Investments - MidAmerican Capital re-characterized all of its marketable securities held on January 1, 2001, as "trading" securities in January 2001. Accordingly, changes in those investments are reflected in working capital in the Consolidated Statements of Cash Flows, instead of in purchases or proceeds from available-for-sale securities. FINANCING ACTIVITIES, PLANS AND AVAILABILITY Issuance of MidAmerican Funding Debt - On March 1, 2001, MidAmerican Funding retired $200 million of 5.85% Senior Secured Notes due 2001. On March 19, 2001, MidAmerican Funding issued $200 million of 6.75% Senior Secured Notes due March 1, 2011. MidAmerican Energy Debt Authorizations and Credit Facilities - MidAmerican Energy currently has authority from the Federal Energy Regulatory Commission to issue short-term debt in the form of commercial paper and bank notes aggregating $500 million. MidAmerican Energy currently has in place a $370.4 million revolving credit facility which supports its $250 million commercial paper program and its variable rate pollution control revenue obligations. In addition, MidAmerican Energy has a $5 million line of credit. MidAmerican Energy has on file with the Securities and Exchange Commission a registration statement for $500 million in various forms of senior and subordinated, unsecured long-term debt and preferred securities. MidAmerican Energy has authorization from the Federal Energy Regulatory Commission to issue up to an additional $500 million in various forms of long-term debt. MidAmerican Energy will also need authorization from the Illinois Commerce Commission prior to issuing any securities. If 90% or more of the proceeds from a securities issuance are used for refinancing purposes, MidAmerican Energy need only provide the Illinois Commerce Commission with an "informational statement" prior to the issuance which sets forth the type, amount and use of the proceeds of the securities to be issued. If less than 90% of the proceeds are used for refinancing, MidAmerican must file a comprehensive application seeking authorization prior to issuance. The Illinois Commerce Commission is required to hold a hearing before issuing its authorization. -20- Accounts Receivable Sold - In 1997, MidAmerican Energy entered into a revolving agreement, which expires in 2002, to sell all of its right, title and interest in the majority of its billed accounts receivable to MidAmerican Energy Funding Corporation, a special purpose entity established to purchase accounts receivable from MidAmerican Energy. MidAmerican Energy Funding Corporation in turn sells receivable interests to outside investors. In consideration for the sale, MidAmerican Energy received cash and a subordinated note, bearing interest at 8%, from MidAmerican Energy Funding Corporation. As of September 30, 2001, the revolving cash balance was $70 million and the amount outstanding under the subordinated note was $76.3 million. The agreement is structured as a true sale, under which the creditors of MidAmerican Energy Funding Corporation will be entitled to be satisfied out of the assets of MidAmerican Energy Funding Corporation prior to any value being returned to MidAmerican Energy or its creditors. Therefore, the accounts receivable sold are not reflected on MidAmerican Funding's Consolidated Balance Sheets. As of September 30, 2001, $146.1 million of accounts receivable, net of reserves, was sold under the agreement. Other Financing Information - As of September 30, 2001, MHC had a $4 million line of credit to provide for short-term financing needs, all of which was unused. As of September 30, 2001, MidAmerican Capital had unsecured revolving credit facilities in the amount of $6 million, under which no debt was outstanding. MidAmerican Capital has $46.7 million of long-term debt outstanding at September 30, 2001, which matures annually through 2002. MidAmerican Funding or one of its subsidiaries may from time to time seek to retire its outstanding debt through cash purchases and/or exchanges for equity securities, in open market purchases, privately negotiated transactions or otherwise. The repurchases or exchanges, if any, will depend on prevailing market conditions, the issuing company's liquidity requirements, contractual restrictions and other factors. The amounts involved may be material. OPERATING ACTIVITIES AND OTHER MATTERS Legislative and Regulatory Evolution - In December 1997, the Governor of Illinois signed into law a bill to restructure Illinois' electric utility industry and transition it to a competitive market. Under the law, larger non-residential customers in Illinois and 33% of the remaining non-residential Illinois customers were allowed to select their provider of electric supply services beginning October 1, 1999. Starting December 31, 2000, all other non-residential customers were allowed supplier choice. Residential customers all receive the opportunity to select their electric supplier beginning May 1, 2002. The law also provides for Illinois earnings above a computed level of return on common equity to be shared equally between customers and MidAmerican Energy. MidAmerican Energy's computed level of return on common equity is based on a rolling two-year average of the 30-year Treasury Bond rates plus a premium of 5.50% for 1998 and 1999 and a premium of 8.5% for 2000 through 2004. The two-year average above which sharing must occur for 2000 was 12.83%. Using the same 30-year Treasury Bond average, the computed level of return would be 14.33% for 2001 through 2004. The law allows MidAmerican Energy to mitigate the sharing of earnings above the threshold return on common equity through accelerated recovery of regulatory assets. -21- In December 1999, the Federal Energy Regulatory Commission (FERC) issued Order No. 2000 establishing among other things minimum characteristics and functions for regional transmission organizations. Public utilities that were not a member of an independent system operator at the time of the order were required to submit a plan by which its transmission facilities would be transferred to a regional transmission organization on a schedule that would allow the regional transmission organization to commence operating by December 15, 2001. On October 16, 2000, MidAmerican Energy filed with the FERC a plan for MidAmerican Energy to comply with Order No. 2000 by participating in the formation of a for profit independent transmission company. On September 28, 2001, MidAmerican Energy and five other electric utilities filed with the FERC a plan to create TRANSLink Transmission Co. LLC and integrate their electric transmission systems into a single, coordinated system. Accounting Effects of Industry Restructuring - A possible consequence of deregulation in the utility industry is that Statement of Financial Accounting Standards No. 71 may no longer apply. SFAS 71 sets forth accounting principles for operations that are regulated and meet the stated criteria. For operations that meet the criteria, SFAS 71 allows, among other things, the deferral of expense or income that would otherwise be recognized when incurred. MidAmerican Energy's electric and gas utility operations currently meet the criteria required by SFAS 71, but its applicability is periodically reexamined. If portions of its utility operations no longer meet the criteria of SFAS 71, MidAmerican Energy could be required to write off the related regulatory assets and liabilities from its balance sheet, and thus, a material adjustment to earnings in that period could result if regulatory assets are not recovered in transition provisions of any deregulation legislation. As of September 30, 2001, MidAmerican Funding had $218.1 million of regulatory assets and $9.5 million of regulatory liabilities on its Consolidated Balance Sheet. Rate Matters: Electric - In 1997, pursuant to a rate proceeding before the Iowa Utilities Board, MidAmerican Energy, the Office of Consumer Advocate and other parties entered into a pricing plan settlement agreement establishing MidAmerican Energy's Iowa retail electric rates. That settlement agreement expired on December 31, 2000. On March 14, 2001, the Office of the Consumer Advocate filed a petition with the Iowa Utilities Board to reduce Iowa retail electric rates by approximately $77 million annually. On June 11, 2001, MidAmerican Energy responded to that petition by filing a request with the Iowa Utilities Board to increase MidAmerican Energy's Iowa retail electric rates by $51 million annually. On July 12, 2001, MidAmerican Energy, the Office of Consumer Advocate and other parties jointly filed a proposed settlement with the Iowa Utilities Board that, if approved, will freeze the rates in effect on December 31, 2000, through December 31, 2005, and, with modifications, will reinstate the revenue sharing provisions of the 1997 pricing plan settlement agreement. Under the proposed settlement, 50% of revenues associated with returns on equity between 12% and 14%, and 83.33% of revenues associated with returns on equity above 14%, in each year would be deferred as a regulatory liability to be used to offset a portion of the cost of new generating plant investments. The Iowa Utilities Board held a public hearing on the proposed settlement in October 2001, and interested parties submitted briefs thereafter. The Iowa Utilities Board's decision on approving the proposed settlement is pending. MidAmerican Energy has negotiated individual electric contracts with some of its commercial and industrial customers in Iowa. The negotiated electric contracts have differing terms and conditions as well as prices. The vast majority of the contracts expire during the period 2003 through 2005, although some large customers have contracts extending to 2008. Some of the contracts have price renegotiation and early termination provisions exercisable by either party. Prices are set as fixed prices; however, many -22- contracts allow for potential price adjustments with respect to environmental costs, government imposed public purpose programs, tax changes, and transition costs. While the contract prices are fixed (except for the potential adjustment elements), the costs MidAmerican Energy incurs to fulfill these contracts will vary. On an aggregate basis the annual revenues under contract are approximately $180 million. On September 21, 2001, MidAmerican Energy filed a petition with the South Dakota Public Utilities Commission (SDPUC) to increase its South Dakota natural gas rates by $3.7 million annually. Under South Dakota law, the SDPUC may suspend the new rates for up to six months during the pendency of rate proceedings. On October 19, 2001 MidAmerican Energy filed a petition with the Illinois Commerce Commission to increase its Illinois natural gas rates by $3.2 million annually. A final decision on the petition is required within eleven months of the date of filing. Environmental Matters - The U.S. Environmental Protection Agency, or EPA, and state environmental agencies have determined that contaminated wastes remaining at decommissioned manufactured gas plant facilities may pose a threat to the public health or the environment if these contaminants are in sufficient quantities and at sufficient concentrations as to warrant remedial action. MidAmerican Energy has evaluated or is evaluating 27 properties that were, at one time, sites of gas manufacturing plants in which it may be a potentially responsible party. The purpose of these evaluations is to determine whether waste materials are present, whether the materials constitute an environmental or health risk, and whether MidAmerican Energy has any responsibility for remedial action. MidAmerican Energy's estimate of the probable costs for these sites as of September 30, 2001, was $24 million. This estimate has been recorded as a liability and a regulatory asset for future recovery through the regulatory process. Refer to Note B(1) of Notes to Consolidated Financial Statements for further discussion of MidAmerican Energy's environmental activities related to manufactured gas plant sites and cost recovery. Although the timing of potential incurred costs and recovery of costs in rates may affect the results of operations in individual periods, management believes that the outcome of these issues will not have a material adverse effect on MidAmerican Energy's financial position or results of operations. On July 18, 1997, the EPA adopted revisions to the National Ambient Air Quality Standards for ozone and a new standard for fine particulate matter. In May 1999, the U.S. Court of Appeals for the District of Columbia Circuit remanded the standards adopted in July 1997 back to the EPA indicating the EPA had not expressed sufficient justification for the basis of establishing the standards and ruling that the EPA has exceeded its constitutionally-delegated authority in setting the standards. On February 27, 2001, the United States Supreme Court upheld the standards, ruling that the EPA did not exceed its constitutional delegation of authority in establishing the standards in 1997. The impact of the new standards on MidAmerican Energy is currently unknown. MidAmerican Energy could incur increased costs and a decrease in revenues if its generating stations are located in nonattainment areas. Refer to Note B(2) of Notes to Consolidated Financial Statements for further discussion of this issue. Generating Capability - MidAmerican Energy is interconnected with Iowa and neighboring utilities and is involved in an electric power pooling agreement known as Mid-Continent Area Power Pool (MAPP). Each MAPP -23- participant is required to maintain for emergency purposes a net generating capability reserve of at least 15% above its system peak demand. MidAmerican Energy believes it has adequate electric capacity reserve through 2003 and continues to manage its generating resources to ensure an adequate reserve in the future. MidAmerican Energy has announced plans to add a 540-megawatt natural gas-fired combined cycle unit to be completed in two phases between 2003 and 2005. An additional 900 megawatts of coal-fired generation is expected to be operational later this decade. However, significantly higher-than-normal temperatures during the cooling season could cause MidAmerican Energy's reserve to fall below the 15% minimum. If MidAmerican Energy fails to maintain the appropriate reserve, significant penalties could be contractually imposed by MAPP. As a result of the 1997 pricing settlement agreement's elimination of the energy adjustment clause in Iowa, MidAmerican Energy is financially exposed to movements in energy prices. Although MidAmerican Energy believes it has sufficient generation under typical operating conditions for its retail electric needs, a loss of adequate generation by MidAmerican Energy requiring the purchase of replacement power at a time of high market prices could subject MidAmerican Energy to losses on its energy sales. MidAmerican Energy has been able to maintain its capacity reserve requirement and has not been adversely affected by seasonal price variations in the wholesale market. ACCOUNTING ISSUES In June 2001, the FASB issued SFAS No. 141, "Business Combinations", and SFAS No. 142, "Goodwill and Other Intangible Assets" which establish accounting and reporting for business combinations. SFAS No. 141 requires all business combinations entered into subsequent to June 30, 2001, to be accounted for using the purchase method of accounting. SFAS No. 142 provides that goodwill and other intangible assets with indefinite lives will not be amortized but will be tested for impairment on an annual basis. These standards are effective for MidAmerican Funding beginning on January 1, 2002. The historical impact of not amortizing goodwill would have been to increase net income for the nine months ended September 30, 2001 and 2000, by $25.8 million and $26.7 million, respectively; however, MidAmerican Funding has not quantified the impact resulting from the adoption of the other provision of these standards. In August 2001, the FASB issued SFAS No. 143, "Accounting for Asset Retirement Obligations", which addresses the accounting for legal obligations associated with the retirement of tangible, long-lived assets, and the associated asset retirement costs. This pronouncement is effective for years beginning after June 15, 2002. MidAmerican Funding is evaluating the impact that adoption of this standard will have on its financial statements. -24- QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK MidAmerican Funding is exposed to market risk, including changes in the market price of certain commodities and interest rates. To manage the price volatility relating to these exposures, MidAmerican Funding enters into various financial derivative instruments. Senior management provides the overall direction, structure, conduct and control of MidAmerican Funding's risk management activities, including the use of financial derivative instruments, authorization and communication of risk management policies and procedures, strategic hedging program guidelines, appropriate market and credit risk limits, and appropriate systems for recording, monitoring and reporting the results of transactional and risk management activities. Refer to Note E in Notes to Consolidated Financial Statements for further discussion of derivatives used to hedge price risk. MidAmerican Funding's exposure to interest rate risk did not change materially from December 31, 2000. -25- PART II - OTHER INFORMATION ITEM 1. EGAL PROCEEDINGS ------------------------- MidAmerican Funding and its subsidiaries have no material legal proceedings except for the following: Environmental Matters --------------------- For information on MidAmerican Energy's environmental matters, reference is made to Note B of Notes to Consolidated Financial Statements. Cooper Litigation ----------------- On July 23, 1997, the Nebraska Public Power District filed a complaint, in the United States District Court for the District of Nebraska, naming MidAmerican Energy as the defendant and seeking declaratory judgment as to three issues under the parties' long-term power purchase agreement for Cooper capacity and energy. More specifically, the Nebraska Public Power District sought a declaratory judgment in the following respects: (1) that MidAmerican Energy is obligated to pay 50% of all costs and expenses associated with decommissioning Cooper, and that in the event the Nebraska Public Power District continues to operate Cooper after expiration of the power purchase agreement (September 2004), MidAmerican Energy is not entitled to reimbursement of any decommissioning funds it has paid to date or will pay in the future; (2) that the current method of allocating transition costs as a part of the decommissioning cost is proper under the power purchase agreement; and (3) that the current method of investing decommissioning funds is proper under the power purchase agreement. MidAmerican Energy filed its answer and contingent counterclaims. The contingent counterclaims filed by MidAmerican Energy are generally as follows: (1) that MidAmerican Energy has no duty under the power purchase agreement to reimburse or pay 50% of the decommissioning costs unless conditions to reimbursement occur; (2) that the Nebraska Public Power District has the duty to repay all amounts that MidAmerican Energy has prefunded for decommissioning in the event the Nebraska Public Power District operates the plant after the term of the power purchase agreement; (3) that the Nebraska Public Power District is equitably estopped from continuing to operate the plant after the term of the power purchase agreement; (4) that the Nebraska Public Power District has granted MidAmerican Energy an option to continue taking 50% of the power from the plant; -26- (5) that the term "monthly power costs" as defined in the power purchase agreement does not include costs and expenses associated with decommissioning the plant; (6) that MidAmerican Energy has no duty to pay for nuclear fuel, operations and maintenance projects or capital improvements that have useful lives after the term of the power purchase agreement; (7) that transition costs are not included in any decommissioning costs and expenses; (8) that the Nebraska Public Power District has breached its duty to MidAmerican Energy in making investments of decommissioning funds; (9) that reserves in named accounts are excessive and should be refunded to MidAmerican Energy; and (10) that the Nebraska Public Power District must credit MidAmerican Energy for payments by MidAmerican Energy for low-level radioactive waste disposal. On October 6, 1999, the court rendered summary judgment for the Nebraska Public Power District on the above-mentioned issue concerning liability for decommissioning (issue one in the first paragraph above) and the related contingent counterclaims filed by MidAmerican Energy (issues one, two, three and five in the second paragraph above). The court referred all remaining issues in the case to mediation, and cancelled the November 1999 trial date. MidAmerican Energy appealed the court's summary judgment ruling. On December 12, 2000, the United States Court of Appeals for the Eighth Circuit reversed the ruling of the district court and granted summary judgment in favor of MidAmerican Energy on issues one and five in the second paragraph above. Additionally, it remanded the case for trial on all other claims and counterclaims. Since the remand to the District Court from the Eighth Circuit Court of Appeals, the Nebraska Public Power District has been granted permission, over MidAmerican Energy's objections, to amend its complaint. The amended complaint asserts that even though the Eighth Circuit Court of Appeals held that MidAmerican Energy has no liability under the power purchase agreement to reimburse or pay the Nebraska Public Power District a 50% share of decommissioning costs unless certain conditions occur, MidAmerican Energy has unconditional liability for a 50% share based on agreements other than the power purchase agreement as originally written. The Nebraska Public Power District's post-remand contentions -- all strongly disputed by MEC -- are that MidAmerican Energy has unconditional liability for a 50% share of decommissioning based on any of the following alternative theories: (i) the parties without written amendment either modified the power purchase agreement or made a separate agreement that imposes unconditional liability on MidAmerican Energy for decommissioning costs; (ii) absent unconditional liability for a 50% share of decommissioning costs, MidAmerican Energy would be unjustly enriched; (iii) MidAmerican Energy has unconditional liability for a 50% share of decommissioning costs based on promissory estoppel; or (iv) the Nebraska Public Power District is entitled to have the power purchase agreement reformed to provide that MidAmerican Energy has unconditional liability for a 50% share of decommissioning costs. MidAmerican Energy will strongly dispute at trial these contentions and theories put forth by the Nebraska Public Power District. Trial in these matters is scheduled to begin on March 4, 2002. -27- ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K ----------------------------------------- (A) EXHIBITS None (B) REPORTS ON FORM 8-K None. -28- 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. MIDAMERICAN FUNDING, LLC ----------------------------- (Registrant) Date November 9, 2001 /s/ Patrick J. Goodman ------------------ ----------------------------- Patrick J. Goodman Vice President and Treasurer -29-

MIDAMERICAN FUNDING LLC 10-Q