Summary Analysis of Results of Operations and Financial Condition

The condensed financial information on the following pages is presented to the stakeholders of the Tennessee Valley Authority as a review of TVA’s power program operations for the fiscal year ended September 30, 2003. It is not considered a substitute for the full financial statements, inclusive of footnotes, which are included in the 2003 Information Statement (PDF, 484KB). The 2003 Information Statement is an integral part of this annual report and is incorporated herein by reference. Investors should read the 2003 Information Statement in its entirety before making an investment decision.

General

TVA is a wholly owned corporate agency and instrumentality of the United States government created in 1933 by Congress and charged with providing navigation, flood control, and agricultural and industrial development, while providing reliable electric power to the Tennessee Valley region. TVA has developed and operates one of the largest electric power systems in the United States, having produced over 151 billion kilowatt-hours (kWh) of electricity in 2003. TVA is administered by a board of three persons appointed by the President and confirmed by the United States Senate. Appointments are for nine-year staggered terms, with one term expiring each three-year interval.

TVA is primarily a wholesaler of power with three major customer groups: distributors, industries, and federal agencies. In addition, TVA sells and buys power through exchange power arrangements with most of the surrounding electric systems. TVA receives no appropriations from Congress to fund TVA’s power system or river-management functions.

Key Objectives and Indicators

The Tennessee Valley Authority serves the people of the TVA region by providing reliable, affordable electric power, supporting sustainable economic development and maintaining stewardship of the region’s natural resources. TVA’s business operations utilize the best practices of private enterprise to achieve excellence in business operations and public service.

TVA’s Six Strategic Objectives

TVA’s strategic objectives encompass excellence in operating performance, leadership in economic development and sensitivity to its stakeholders’ needs. Critical success factors have been developed and targets established to reach performance goals. TVA’s six strategic objectives are:

• Improve life in the TVA region through integrated management of the river system and environmental stewardship. TVA will improve the quality of life in the region by managing the Tennessee River system in accordance with a strategy that balances the diverse benefits of navigation, flood control, power production, water quality and recreation for the greatest public good.
• Meet customers’ needs with affordable, reliable electric power. Electric power is the fuel of TVA’s regional economy, and TVA’s power system is growing and improving to keep pace with the ever-increasing demand. In step with America’s energy policy for the 21st century, TVA is prepared to play a vital role as a public power provider, dedicated to public service and providing competitively priced electricity in an increasingly open energy marketplace.
• Demonstrate leadership in sustainable economic development in the TVA region. TVA will continue to work with the communities it serves in order to help attract and retain new and better jobs for the people of the region.
• Continue the trend of debt reduction. TVA is committed to reducing its level of total financing obligations in order to create more financial flexibility for the future business environment.
• Reduce TVA’s delivered cost of power relative to the market. TVA’s bottom line is the creation of value for the public. TVA will be responsive to the marketplace through its initiatives for promoting innovation and continuous improvement. TVA will generate more for less for the good of many.
• Strengthen working relationships with all of TVA’s stakeholders. TVA will strengthen its relationships with the region's residents, communities and businesses; with customers and suppliers; and with leaders at all levels of government.

Strategic Plan

During 2003, TVA developed a draft strategic plan to guide decision- making as it prepares for a more competitive market and customer choice. Despite the current uncertainty, TVA believes that wholesale competitive markets are going to continue to evolve and bring four fundamental changes to the business environment:

• The emerging wholesale electricity markets that surround TVA either already have or are expected to include the following core features:
  • Independent, real-time operation of the regional transmission system, integrated with
  • Voluntary day-ahead and real-time energy markets
  • Locational marginal pricing to reflect locational differences in generation costs caused by transmission constraints, and
  • Financial congestion revenue rights to allow buyers and sellers to hedge the cost of energy delivered to a particular location.
• TVA must begin to prepare for a future where the laws restricting competition are modified, allowing distributors to choose other suppliers for all or part of the their energy needs and allowing TVA to sell surplus power outside the region.
• TVA’s historic monopoly position with respect to bulk power sales in the TVA region appears likely to change.
• The cyclical and capital-intensive nature of unregulated power generation poses significant financial risk and will require more financial flexibility.

The draft plan was made available to members of Congress and the Administration, distributors of TVA power, employees, and other stakeholders. With input from the various stakeholder groups, the plan was approved by the TVA Board of Directors (Board) in January 2004. Because the plan is a “living” document, it will continue to evolve, providing a framework for TVA to respond to future market challenges.

Measure

Results of Operations

Net income for 2003 was $456 million, compared with net income of $73 million for 2002. A portion of the increase, $217 million, was due to two non-cash accounting changes implemented during the first quarter of 2003: a $412 million gain related to a change in accounting for unbilled revenue and a $195 million charge related to a change in accounting for asset retirement obligations. In 2002, TVA elected not to complete a gas-fired combined cycle plant. Accumulated costs of the project totaled $154 million, which TVA recognized as a loss on plant cancellation during 2002.

Operating Revenues

Operating revenues were $6,952 million in 2003 and $6,796 million in 2002. The increase in operating revenues was primarily related to the $167 million increase in sales of electricity related to increased volume, primarily due to the impacts of colder winter weather, higher average rates, and increased demand in the industrial sector. Accordingly, total kWh sales to customers increased slightly, from 158.7 billion in 2002 to 161.5 billion in 2003, or 2 percent.

Operating Expenses

Total operating expenses increased $228 million, or 4 percent, from $5,147 million in 2002 to $5,375 million in 2003. Fuel cost decreased $32 million, or 2 percent, resulting from reduced system availability related to several forced outages at TVA generating plants. A portion of TVA’s native load demand was met by purchasing power. Purchased power costs increased $113 million, or 35 percent. Operating and maintenance expenses (O&M) consisting of base O&M, outage, project, and other expenses increased $178 million, or 10 percent. Base O&M costs increased $77 million over the prior year due to several unplanned outages. Planned outage costs were $16 million lower than the prior year as a result of rescheduling outages necessitated by the unplanned outages and system load requirements. Project costs were also $32 million lower than the prior year due to project costs for Browns Ferry Unit 1 being capitalized during 2003. Other O&M costs increased $135 million in comparison with the prior year due to increased pension expense of $94 million resulting from actuarial decreases in asset returns and the change in related discount rate, increased benefit costs of $19 million, increased workers’ compensation costs of $27 million, and increased provisions for inventory obsolescence of $9 million. Depreciation, amortization, and accretion expense increased $35 million from the same period last year. The increase is due to increased depreciation expense of $24 million for capital projects placed in service during the year and increased accretion expense of $11 million related to the adoption of Statement of Financial Accounting Standards (SFAS) No. 143, Accounting for Asset Retirement Obligations. Accelerated amortization decreased $66 million in 2003 as compared to 2002 due to complete amortization of certain regulatory assets.

Other Income

TVA had net other income of $12 million in 2003 compared with $7 million in 2002. The increase in net other income relates to an increase in non-electric business activity.

Loss on Plant Cancellation

Due to changes in the market forecast for electricity, TVA elected during 2002 not to complete a gas-fired combined-cycle plant that would have provided 510 megawatts of power beginning in 2004. Accumulated costs of the project totaled $154 million, which TVA recognized as a loss on plant cancellation in 2002.

Interest Expense

Net interest expense declined $79 million, from $1,429 million in 2002 to $1,350 million in 2003. Total outstanding indebtedness, excluding discounts and premiums, as of September 30, 2003, was $24.9 billion, with a blended average interest rate (of long-term and short-term debt) of 5.66 percent; as of September 30, 2002, outstanding indebtedness, excluding discounts and premiums, was $25.3 billion, with a blended average interest rate of 6.06 percent.

Cumulative Effects of Accounting Changes

The net gain of $217 million from accounting changes during 2003 included a gain related to a change in accounting for unbilled revenues of $412 million, partially offset by a charge related to a change in accounting for asset retirement obligations of $195 million.

A degree day is a unit of measure used to express the extent to which temperatures vary from a specific reference temperature during a given period. TVA uses 65 degrees Fahrenheit as its reference temperature.

Liquidity and Capital Resources

Capital Structure

In 1959, TVA received Congressional approval to issue bonds in order to finance its growing power program. Since that time, TVA’s power program has been required to be self-supporting. As a result, TVA funds its capital requirements through internal cash generation, debt issuances (subject to a congressionally mandated $30 billion limit), and other financing arrangements, including lease/leaseback transactions and sales of discounted energy units (DEUs). DEUs allow a distributor customer to prepay a portion of the price of a block of kilowatt-hours and receive a credit on its power bill over a period of years.

Primarily during the first 25 years of TVA’s existence, the U.S. Government made appropriation investments in TVA power facilities. TVA is required to pay the U.S. government a return on the appropriation investment in TVA power facilities, plus a repayment of the investment as specified by law. The combined payment for 2003 was $42 million. Cumulative repayments and return on investment paid by TVA’s power program to the U.S. Treasury are about $3.5 billion. Approximately $975 million of the government’s appropriation investment of $1.4 billion has been repaid by TVA.

Net cash provided by power program operating activities increased $285 million from 2002 to 2003. The increase was primarily due to an increase in operating revenues of $156 million as a result of increased sales volume, increased rates for certain customers, and net weather effects as compared with the prior year. Cash expended for interest was $72 million less than the prior year. Cash margin from power sales was partially offset by an increase in cash paid for purchased power of $98 million to meet higher demand and replace power lost during unplanned outages, and an increase in cash operating and maintenance costs of $60 million as a result of several unplanned outages and higher generation expenses. The change in certain working capital components increased $152 million, from $21 million in 2002 to $173 million in 2003. The increase resulted from a larger reduction of accounts receivable of $12 million and an increase in accounts payable and accrued liabilities of $158 million as opposed to a reduction of those items of $3 million, partially offset by a larger increase in inventories and other of $16 million and a smaller increase in accrued interest of $5 million. Other items requiring cash decreased $50 million, primarily due to the receipt of distributor prepayments.

Cash used in investing activities increased $597 million, primarily due to additional construction expenditures for capital projects of $462 million mainly related to the Browns Ferry Unit 1 restart and clean air initiatives, an increase in fabrication of nuclear fuel of $41 million due to timing of enrichment services received, and other investing activities of $107 million, primarily due to an increase in investment purchases of $99 million.

Net cash provided by financing activities increased $389 million during 2003, primarily as a result of an increase in net proceeds from alternative financing activities of $645 million partially offset by a $264 million net reduction in long- and short-term bonds and notes from 2002 to 2003.

Capital Requirements

TVA has incurred and continues to require construction expenditures for maintenance and improvements to facilities to enhance their efficiency and reliability, to extend their useful lives, and to maintain and improve the safety and reliability of TVA’s electric transmission system as well as projects associated with customer service improvements and environmental laws and regulations. TVA’s total construction expenditures, including the allowance for funds used during construction (AFUDC), were $1,693 million for 2003. Capital requirements are forecast for future years, and because of changing requirements these forecasts are updated quarterly. It is anticipated that environmental requirements will become more stringent and that compliance costs will increase. Although TVA cannot, with certainty, project the costs of additional emission control requirements for nitrogen oxides, sulfur dioxide, and particulate matter beyond those required by the acid rain provisions of the 1990 Clean Air Act Amendments, the total costs through 2020 could exceed $4 billion, exclusive of the costs of the planned selective catalytic reduction systems, or other advanced systems, and scrubbers.

Reflecting the renewed interest in nuclear generation, the Board initiated the recovery and restart of Unit 1 at Browns Ferry Nuclear Plant in northern Alabama in 2002 in order to meet long-term energy needs in the Tennessee Valley. It is anticipated that the Browns Ferry Unit 1 recovery project will cost approximately $1.8 billion, excluding AFUDC. Unit 1 is expected to return to service in 2007 and the additional nameplate capacity of approximately 1,280 megawatts is expected to help lower the average cost of power and provide additional cash flow. As of September 30, 2003, TVA had incurred approximately $406 million in costs on the restart project, which is in line with the total planned costs for the project.

The funds necessary for capital requirements will be obtained from internal sources, principally cash flows from operations, and external sources, including short-term financing, long-term financing, and prepaid revenue.

Capital Resources

For purposes of refinancing outstanding debt, TVA continued to access capital markets through cost-effective, long-term financing structures and continued to expand its global investor base, as well as its domestic retail investor base. From October 1, 2002, to September 30, 2003, TVA issued $564 million of electronotes® with an average interest rate of 4.49 percent. In addition, in June 2003, TVA issued £150 million ($245 million) of 2003 Series A global bonds, which were swapped back to a U.S. dollar interest rate of 4.96 percent, and $500 million of 2003 Series B global bonds with an interest rate of 4.70 percent. TVA also issued $1 billion of 2003 Series C global bonds in August 2003 with an interest rate of 4.75 percent. During 2003, TVA redeemed $303 million of electronotes® carrying an average interest rate of 5.28 percent. TVA also redeemed other issues totaling $982 million with an average interest rate of 7.02 percent.

During October 2002, TVA introduced the Discounted Energy Units program as another way of providing value to its customers. Annually for program fiscal years 2003 to 2007, TVA customers may purchase DEUs in $1 million increments, which entitle them to a 0.025 dollar/kilowatt-hour discount on a specified quantity of firm load over a period of years (five,10, 15, or 20) for each kilowatt-hour in the prepaid block. The remainder of the price of the kilowatt-hours delivered is due upon billing. As of September 30, 2003, TVA had entered into sales agreements totaling over $50 million, which are recorded in Other liabilities on the Balance Sheet.

TVA monetized the call provisions on a $1 billion public bond issue and a second public bond issue of $476 million by entering into swaption agreements with third parties in exchange for proceeds of approximately $256 million during 2003. The swaptions essentially grant the third party the right to exercise the embedded call provision of the applicable bond while TVA continues to pay the holders of the swaptions pursuant to the original bond issuance. The swaptions are recorded in Other liabilities on the Balance Sheet.

During the summer of 2002, TVA completed construction of two sets of four combustion turbine units that were part of a series of new peaking combustion turbine units. Of the financing options available to TVA for these units, long-term lease and leaseback arrangements provided outcomes that were the most economically favorable to TVA. The lease/leaseback agreement for the first set of four units was finalized during the first quarter of 2003 and provided about $163 million in lease proceeds. The cost of the first lease/leaseback agreement approximated a full-term implicit rate just above 4 percent. The lease/leaseback for the second set of four units was finalized during the third quarter of 2003 and provided about $162 million in lease proceeds. The cost of the second lease/leaseback agreement approximated a full-term implicit rate of slightly more than 3.5 percent.

Following on the success of the favorable lease/leaseback financing for the combustion turbines described above, TVA entered into a similar financing arrangement for qualified technological equipment (QTE), consisting of certain transmission equipment and related software, late in 2003. The transaction resulted in financing proceeds of about $389 million. The cost of the QTE lease/leaseback agreement approximated a full-term implicit rate of slightly less than 4 percent.

TVA accounted for the respective lease proceeds as financing obligations in accordance with SFAS No. 66, Accounting for Sales of Real Estate, and SFAS No. 98, Accounting for Leases. As of September 30, 2002, the outstanding financing obligations of $561 million were included in Current liabilities ($18 million) and Other liabilities ($543 million), respectively, in TVA’s 2002 year-end Balance Sheet. The outstanding financing obligations of $1,239 million at September 30, 2003, are included in Current liabilities ($68 million) and Other liabilities ($1,171 million), respectively, in TVA’s Balance Sheet for the year ended September 30, 2003.

Other Matters

Rate Actions

The TVA Act requires the power program to be self-supporting from power system revenues and from power program financings. The Act also gives the Board sole responsibility for establishing the rates TVA charges for power and authorizes the Board to include in power contracts terms and conditions that it judges necessary or desirable for carrying out the purposes of the Act.

On August 27, 2003, the Board approved rate actions to fund certain clean-air improvements for the next 10 years and to help retain manufacturing jobs in the TVA region. The three member Board approved a 6.1 percent increase in electric rates. The Board also approved a change in the rate structure to more equitably distribute TVA’s costs to serve various customer groups and to make manufacturing rates more competitive with neighboring utilities.

These rate actions became effective beginning with October 2003 wholesale billing months, and together are expected to result in a 7.4 percent increase in wholesale residential and non-manufacturing rates and a 2 percent decrease in wholesale rates for large manufacturers. Corresponding changes and adjustments were approved for distributor resale rates and for TVA’s rates to directly served customers.

The rate adjustment is expected to provide approximately $365 million of additional revenue in 2004.

Risk Policies

Through its normal business operations, TVA is exposed to many risks, including the following:

• Operational risks, including weather
• Volatility of certain commodity and equity market prices
• Changes in interest rates
• Foreign currency exchange rates
• Losses in the event of counterparties’ nonperformance.

To manage the volatility attributed to certain of these exposures, TVA has entered into various non-trading derivative transactions, principally an interest rate swap agreement, foreign currency swap contracts, swaptions, and electricity, coal, and natural gas contracts. TVA has a Risk Management Committee that is charged with the responsibility of reviewing and approving controls and procedures for TVA-wide risk management activities, including the oversight of models and assumptions used to measure risk, the review of counterparty exposure limits, and the establishment of formal procedures regarding the use of financial hedging instruments.

With respect to hedging activities, TVA risk management policies provide for the use of derivative financial instruments to manage financial exposures. A financial trading pilot program to reduce TVA’s economic risk exposure associated with TVA’s physical electric generation, purchases, and sales was approved by the Board in September 2003. The program allows TVA to trade certain futures contracts and options on futures for hedging purposes only. Trading covered by this authorization will be for the purpose of hedging risks associated with the cost of natural gas and fuel oil for TVA’s power generation operations and risks under power purchase or sale arrangements where the energy price varies based upon a fuel index. Trading of authorized futures and options on futures contracts shall be limited solely to those transactions that hedge or otherwise limit economic risks directly associated with TVA’s fuel requirements for power generation or with the aforementioned type of power purchase or sale arrangement. Transactions shall be limited to trading of the NYMEX futures contracts and options on futures contracts related to natural gas and fuel oil. The pilot program shall end on August 31, 2005. Speculative trading is explicitly prohibited.

TVA generally does not purchase commercial general liability, auto liability, workers’ compensation, accidental property damage, or business interruption insurance. Additionally, although TVA uses private companies to administer its health care plans for eligible active and retired employees not covered by Medicare, TVA does not purchase health insurance. Consulting actuaries assist TVA in determining certain liabilities for self-assumed claims. TVA pays for losses in these areas through power revenues or through power financings.

The Price-Anderson Act sets forth an indemnification and limitation of liability plan for the U. S. nuclear industry. All Nuclear Regulatory Commission nuclear plant licensees, including TVA, participate in the plan of protection for the general public established by the Price-Anderson Act.

The Federal Employees’ Compensation Act governs liabilities for service-connected injuries to employees.

Contingencies

The Environmental Protection Agency (EPA) issued an administrative order directing TVA to put “new source requirements” controls on 14 of its coal-fired units and to evaluate whether more controls should be installed on other units. TVA has challenged the validity of this order, and although the U.S. Court of Appeals for the Eleventh Circuit did not rule on the merits of the case, the court held that the procedure used by EPA against TVA was “unconstitutional” and that “TVA is free to ignore” EPA’s administrative order. EPA may still seek review of the matter by the U.S. Supreme Court. It is not possible to predict with certainty what impact implementation of the EPA’s order will have on TVA if EPA prevails on the merits. If the EPA substantially prevails, TVA could be required to incur capital costs in excess of $3 billion by 2010 to 2012 in order to implement the EPA’s order. However, any additional controls that TVA installs to comply with the order would also achieve emission reductions required under other EPA rules. TVA fully supports the need to further reduce emissions from coal-fired plants and seeks a resolution that will not put TVA customers and the region at a disadvantage.

TVA has exposure to a number of additional significant contingencies including, but not limited to, potential costs associated with spent nuclear fuel and low-level radioactive waste disposal, environmental matters, and pending litigation. These, as well as other matters, are discussed in Management’s Discussion and Analysis and Notes to Financial Statements contained in the Information Statement.

Resource Management

TVA’s responsibilities for managing public resources began with its creation in 1933. These responsibilities include reservoir operations, navigation, dam safety, and the general stewardship of land, water, and wildlife resources. Today these resource management activities help sustain the interconnected tributaries and main stem of the Tennessee River, the nation’s fifth largest river system. Similar resource management responsibilities are funded with taxpayer dollars elsewhere in the nation, and funding for these TVA programs had historically included federal appropriations. Since 1999, TVA has received no appropriations for these activities. The 652-mile-long river, 148 miles of navigable tributaries, and 14 locks, combined with TVA’s 49 dams, are a vital part of the nation’s navigation system. TVA’s other responsibilities in managing the river system include reducing flood risk, producing hydropower, and providing cooling water for TVA’s fossil and nuclear plants. Encompassing 41,000 square miles, the river and its tributary watersheds touch 125 counties in portions of seven states.

Because Congress has not provided any appropriations to TVA to fund such activities since 1999, TVA spent $83 million in both 2003 and 2002 for essential stewardship activities, primarily using power revenues and funding the remainder with a combination of user fees, other forms of nonpower revenues, and fund balances unused in prior years.

TVA retains responsibility for management of the remaining nonpower assets. TVA remains committed to carrying out those stewardship activities related to its management of the Tennessee River system and TVA properties and to safeguarding and maintaining the public benefits that are central to management of its integrated system.

TVA has direct stewardship responsibility for 650,000 reservoir surface acres available for recreation and other purposes, 11,000 miles of shoreline, and 293,000 acres of public land. Reservoirs and recreation areas throughout the region provide outdoor recreation for millions of visitors each year, and TVA has set aside over 228,000 acres of public land for resource management purposes, including enhancement of wildlife habitat and protection of sensitive resources.

Accounting Policies and Practices

TVA prepares its financial statements in conformity with accounting principles generally accepted in the United States of America, applied on a consistent basis. In some cases, financial statements reflect amounts based on the best estimates and judgment of management, giving due consideration to materiality, and in certain circumstances amounts are based on the Board’s ability to effectively set rates under the provisions of the TVA Act.

TVA accounts for the financial effects of regulation in accordance with SFAS No. 71, Accounting for the Effects of Certain Types of Regulation. As a result, TVA records certain regulatory assets and liabilities that would not be recorded on the balance sheet under generally accepted accounting principles for nonregulated entities.

Effective October 1, 2002, the Board approved a change in the methodology for estimating unbilled revenue from electricity sales. The change in calculating unbilled revenue was from a method using cumulative generation to a method that uses only generation for the current billing period. TVA was able to make this change based on improved metering technology that allows TVA to more accurately capture the number of days power has been generated and transferred to its customers but not yet billed to those customers. Changing to this more accurate estimating methodology resulted in an increase in accounts receivable of $412 million.

On October 1, 2002, TVA adopted SFAS No. 143, Accounting for Asset Retirement Obligations, which requires the recognition of a liability and capitalization of the associated asset retirement cost as part of the carrying amount of the long-lived asset for “legal obligations” associated with the retirement of long-lived assets that result from the acquisition, construction, development, and/or normal operation of long-lived assets. The effect of the adoption of SFAS No. 143 during the first quarter of 2003 included a cumulative effect charge to income of $195 million, a corresponding additional long-term liability of $734 million, an increase in assets of $745 million, and related accumulated depreciation of $206 million.

Additionally, TVA’s system of internal controls is designed to provide reasonable assurance that assets are safeguarded from loss, unauthorized use, or disposition and that transactions are executed in accordance with management’s authorization and properly recorded to permit the preparation of financial statements in accordance with accounting principles generally accepted in the United States of America.

Controls and Procedures

TVA’s records are subject to review by numerous oversight bodies including TVA’s Inspector General, the General Accounting Office, the Congressional Budget Office, and the Office of Management and Budget, as well as congressional committees upon request.

TVA’s management, including the Chief Financial Officer (CFO) and the members of the Board, have conducted an evaluation of the effectiveness of TVA’s disclosure controls and procedures as of the end of the period covered by this annual report consistent with section 302, Corporate Responsibility for Financial Reports, of the Sarbanes-Oxley Act of 2002. Based on that evaluation, the Board and the CFO concluded that the disclosure controls and procedures are effective in providing reasonable assurance that all material information necessary and appropriate in this Summary Analysis of Results of Operations and Financial Condition has been made known to them in a timely fashion. TVA’s disclosure controls and procedures are effective in providing reasonable assurance that information disclosed in TVA’s annual financial reports is accumulated and communicated to management, including the members of the Board and the CFO, as appropriate, to allow timely decisions regarding disclosure. There have been no significant changes in internal controls, or in factors that could significantly affect internal controls, subsequent to the date the Board and the CFO completed their evaluation.