    Tennessee Valley Authority: Plans to Reduce Debt While Meeting
    Demand for Power (31-AUG-06, GAO-06-810).

    Competition in the electricity industry is expected to intensify,
    and restructuring legislation may dramatically change the way
    electric utilities do business in the future. To be competitive,
    the Tennessee Valley Authority (TVA) needs to reduce fixed costs
    and increase its flexibility in order to meet market prices for
    power. TVA plans to reduce its financing obligations, which
    include statutory debt and other financing arrangements, by $7.1
    billion by the end of fiscal year 2015. GAO was asked to (1)
    describe how TVA plans to meet its goal for reducing financing
    obligations, (2) assess the reasonableness of TVA's approach in
    developing its plan, (3) identify key factors that could impact
    TVA's ability to successfully carry out its plan, and (4)
    identify how TVA's plans for meeting the growing demand for power
    in the Tennessee Valley may impact its ability to reduce
    financing obligations. To fulfill these objectives, GAO
    interviewed TVA officials and others, and reviewed budget
    submissions, financial projections, and other documentation
    supporting the plan.
    -------------------------Indexing Terms-------------------------
    REPORTNUM:   GAO-06-810
        ACCNO:   A59990
      TITLE:     Tennessee Valley Authority: Plans to Reduce Debt While
    Meeting Demand for Power
         DATE:   08/31/2006
      SUBJECT:   Competition
    	     Cost control
    	     Electric energy
    	     Electric power generation
    	     Electric utilities
    	     Energy costs
    	     Energy demand
    	     Financial analysis
    	     Program evaluation
    	     Public utilities
    	     Risk assessment
    	     Strategic planning

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    GAO-06-810

         * Results in Brief
         * Background
         * Scope and Methodology
         * TVA Plans to Increase Revenue, Control Operating Expenses, a
              * TVA Projects Several Sources of Additional Revenue
              * TVA Plans to Control the Growth of Its Operating Costs
              * TVA Plans to Spend $12.1 Billion on Capital Expenditures thr
         * TVA Used a Reasonable Approach to Developing Its Plan to Red
              * TVA Assessed Its Business and Market Risks to Prepare Its St
              * TVA Uses an Accounting Model to Refine Its TFO Reduction Tar
         * Several Key Factors Could Impact TVA's Ability to Successful
              * The Timing of Restructuring within the Electricity Industry
              * Future Rate Increases and a Fuel-cost Adjustment Clause Will
              * Limiting the Growth of Operating and Maintenance Expenses Wi
              * Planned Reduction in Interest Expense Could Be Affected by I
              * Changes to Current Environmental Regulations Could Require S
              * Building New Generating Capacity Could Require Capital Expen
              * TVA Will Require Continued Management Commitment to Reducing
         * Growing Demand for Power Could Affect TVA's Ability to Meet
         * Conclusions
         * Recommendations
         * Agency Comments and Our Evaluation
         * Appendix I: Comments from the Tennessee Valley Authority
         * Appendix II: GAO Contact and Staff Acknowledgments
              * GAO Contact
              * Acknowledgments
                   * Order by Mail or Phone

    Report to the Chairman, Subcommittee on Water Resources and Environment,
    Committee on Transportation and Infrastructure, House of Representatives

    United States Government Accountability Office

    GAO

    August 2006

    TENNESSEE VALLEY AUTHORITY

    Plans to Reduce Debt While Meeting Demand for Power

    GAO-06-810

    Contents

    Letter 1

    Results in Brief 2
    Background 4
    Scope and Methodology 11
    TVA Plans to Increase Revenue, Control Operating Expenses, and Limit
    Capital Expenditures 12
    TVA Used a Reasonable Approach to Developing Its Plan to Reduce TFOs 17
    Several Key Factors Could Impact TVA's Ability to Successfully Carry Out
    Its Plan for Reducing TFOs 21
    Growing Demand for Power Could Affect TVA's Ability to Meet Its TFO
    Reduction Goal 27
    Conclusions 30
    Recommendations 30
    Agency Comments and Our Evaluation 31
    Appendix I Comments from the Tennessee Valley Authority 32
    Appendix II GAO Contact and Staff Acknowledgments 34

    Tables

    Table 1: TVA's Total Financing Obligations at Year-end for Fiscal Years
    1997 through 2005 10
    Table 2: TVA's Actual and Targeted Reduction of Total Financing
    Obligations for Fiscal Years 2004 through 2015 14
    Table 3: TVA's Planned Capital Expenditures by Major Category from Fiscal
    Year 2006 through Fiscal Year 2015 16

    Figures

    Figure 1: TVA's Service Territory 4
    Figure 2: Generation Capacity by Fuel Type, TVA vs. Nearest NERC Regions
    25

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    separately.

    United States Government Accountability Office

    Washington, DC 20548

    August 31, 2006

    The Honorable John J. Duncan, Jr. Chairman, Subcommittee on Water
    Resources and Environment Committee on Transportation and Infrastructure
    House of Representatives

    Dear Mr. Chairman:

    Competition in the electricity industry is expected to intensify, and
    restructuring legislation may dramatically change the way electric
    utilities do business in the future. To remain competitive, the Tennessee
    Valley Authority (TVA) needs to have low fixed costs and the flexibility
    to meet market prices for power. Recognizing this, in 1997, TVA embarked
    on a plan to reduce its debt by one half to about $13.2 billion by 2007.
    It will not meet this goal, however, and in fiscal year 2004 it issued a
    strategic plan that included a target to reduce debt by $3 to $5 billion
    from 2004 through 2015. TVA continues to carry a relatively high level of
    debt, currently about $23.1 billion, and acknowledges that reducing debt
    is critical to improving its financial condition and competitive
    prospects.

    Because of concerns that TVA might not meet the targets in its debt
    reduction plan and that this could negatively impact its future
    competitiveness, you asked us to (1) describe how TVA plans to meet the
    debt reduction goal identified in its 2004 strategic plan, (2) assess the
    reasonableness of TVA's approach in developing its debt reduction plan,
    (3) identify key factors that could impact TVA's ability to successfully
    carry out its debt reduction plan, and (4) identify how TVA's plans for
    meeting the growing demand for power in the Tennessee Valley may impact
    its ability to meet its debt reduction goal.

    In performing our work, we interviewed officials from TVA, TVA's inspector
    general's office, the Tennessee Valley Public Power Association, the
    Congressional Budget Office, and the Knoxville Utilities Board. We also
    reviewed TVA's 2004 strategic plan, budget submissions, annual reports,
    and documents and analyses supporting the debt reduction plan. To
    determine the types of revenue and costs TVA had reported, we reviewed
    TVA's audited financial statements. In addition, we reviewed prior GAO
    reports. We conducted our work from June 2005 through August 2006 in
    accordance with generally accepted government auditing standards.

                                    Results in Brief

    TVA set a goal of reducing statutory debt by $3 to $5 billion in its 2004
    strategic plan. Subsequently, TVA expanded the scope of its debt reduction
    efforts to include debt-like transactions such as lease-leasebacks and
    energy prepayment arrangements, referred to in this report as alternative
    financing. TVA calls this larger group of obligations total financing
    obligations, or TFOs. In its 2007 budget, TVA increased its TFO reduction
    goal to $7.1 billion. This includes reducing statutory debt by $6.7
    billion and alternative financing obligations by $0.4 billion. TVA plans
    to meet this goal by increasing revenue, controlling the growth of its
    operating expenses, and limiting capital expenditures. TVA projects it
    will gain additional revenue through its October 2005 rate increase, a
    fuel-cost adjustment clause to automatically adjust rates up or down when
    fuel prices change, and increased sales from growth in the demand for
    electricity. TVA's plan also calls for controlling the growth of operating
    costs and limiting spending on capital expenditures to $12.1 billion for
    fiscal years 2006 through 2015. TVA officials believe that this plan will
    allow it to be financially flexible while continuing to offer competitive
    electricity rates.

    Overall, we found TVA's approach to developing its plan to reduce
    financing obligations to be reasonable. TVA used a strategic planning
    process to develop its plan, which focused on its core mission as a
    long-term provider of low-cost power. As part of this process, TVA looked
    not only at its financing obligations, but at external business and market
    risks. To assess these outside risks, TVA performed detailed competitive
    analyses and modeled different market scenarios to estimate its future
    competitive environment. It considered the results of these market risk
    analyses in formulating its strategic plan and determining the initial
    possible range for reducing financing obligations through 2015. As part of
    its annual internal budget process, TVA then used an accounting model to
    project annual cash flows and refine its goal. Many of the variables used
    in the models were based on data from Global Insight, The Wall Street
    Journal, and other recognized sources of economic data and forecasts. TVA
    estimated the price volatility of commodities such as coal and natural gas
    with a combination of historical data and projected trends. It did not,
    however, use prices from options markets, which could help identify more
    accurate estimates of the range of possible prices in volatile markets. In
    using the results of the accounting model to refine its TFO reduction
    goals, TVA also made assumptions about actions it would or would not take,
    such as building new baseload generation, and events outside its control,
    such as the speed of electricity market restructuring and the advent of
    new environmental regulations. While these assumptions are reasonable,
    they carry uncertainty that is not reflected in the model. Modeling them
    as variables rather than fixed assumptions might better reflect that
    uncertainty and provide TVA with a broader range of potential outcomes for
    planning purposes.

    We identified several key factors that could impact TVA's ability to
    successfully carry out its plan. The timing of electricity industry
    restructuring, potential increases in interest rates, and costs associated
    with meeting potential new environmental requirements are key factors that
    are difficult for TVA to control. TVA has more control over other key
    factors, such as its decisions not to build new power generating capacity
    before 2015 and to limit operating and maintenance expenses, but these are
    also affected by outside forces and contain an element of uncertainty.
    Rate increases that were not considered in TVA's current plan, as well as
    adding a fuel-cost adjustment clause to its customer contracts in fiscal
    year 2007, are factors that should help cover any unforeseen costs,
    capital expenditures, or revenue shortfalls.

    TVA's plan includes the capital expenditures it believes will be needed to
    meet the growing demand for power in the Tennessee Valley through 2015;
    however, any additional, unplanned capital expenditures prior to 2015
    could affect TVA's ability to achieve its plan. By 2015, TVA has estimated
    that it will need more electricity generation to meet growth in demand and
    its plan includes the estimated costs to restart one of its idle nuclear
    generating units, Browns Ferry Nuclear Unit 1. TVA officials are
    considering a number of additional options to meet this projected increase
    in demand for power, including partnering with outside parties. Since
    TVA's current projections assume that it will not invest in any new
    generation through 2015, other than restarting Browns Ferry Nuclear Unit
    1, any new or unplanned capital expenditures would use cash otherwise
    intended to be used to reduce financing obligations, thus affecting TVA's
    ability to meet its planned TFO reduction.

    We are making two recommendations to help TVA (1) augment its data sources
    for estimates of key input variables in the model, and (2) better
    illustrate the range of outcomes in its cash flow model for planning
    purposes. In comments on a draft of this report, TVA agreed with these
    recommendations.

                                       Background

    TVA is an independent, wholly owned federal corporation established by the
    TVA Act of 1933 (TVA Act), as amended.1 The act established TVA to improve
    the quality of life in the Tennessee River Valley by improving navigation,
    promoting regional agricultural and economic development, and controlling
    the floodwaters of the Tennessee River. To those ends, TVA built dams and
    hydropower facilities on the Tennessee River and its tributaries. To meet
    the subsequent need for more electric power, TVA expanded beyond
    hydropower to other types of power generation such as natural gas, coal,
    and nuclear plants. As of September 30, 2005, TVA sold electricity at
    wholesale rates to 158 retail distributors that resell electricity to
    consumers, and sold electricity directly to 61 large retail customers. As
    illustrated in figure 1, TVA's service territory includes most of
    Tennessee and parts of Alabama, Georgia, Kentucky, Mississippi, North
    Carolina, and Virginia. The area covers 80,000 square miles with a
    population of more than 8.6 million.

    Figure 1: TVA's Service Territory

    1 16 U.S.C. S:S: 831-831ee.

    From its inception in 1933 through fiscal year 1959, TVA received
    appropriations to finance its internal cash and capital requirements. In
    1959, however, the Congress amended the TVA Act to provide TVA the means
    to self-finance its power program and required it to repay a substantial
    portion of appropriations2 it had received to pay for its capital
    projects. At the same time, the Congress required that TVA's power
    programs be self-financing through revenues from electricity sales. For
    its capital needs in excess of funds generated from operations, TVA was
    authorized to borrow by issuing bonds and notes. TVA's authority to issue
    bonds and notes is set by the Congress and cannot exceed $30 billion
    outstanding at any given time.

    Until recently, TVA had been administered by a three-member board of
    directors appointed by the President of the United States and confirmed by
    the U.S. Senate. An Executive Committee worked with the board to determine
    TVA's strategic mission and future direction, provide management
    oversight, and ensure policies of the board were carried out. The
    Consolidated Appropriations Act, 2005, which was signed into law in
    December 2004, changed the structure of TVA's management. The act
    contained provisions that restructured the board from three full-time
    members to nine part-time members, established the position of Chief
    Executive Officer (CEO) to be appointed by the board, required TVA to
    begin filing financial reports with the Securities and Exchange Commission
    (SEC), and required TVA's new board to create an Audit Committee to be
    composed solely of board members independent of management. The audit
    committee will be responsible for reviewing inspector general and external
    audit reports and making recommendations to the board. The legislation
    specifies that seven of the nine board members must be legal residents of
    TVA's service area and that the members will be appointed by the President
    and confirmed by the Senate. After a transition period, members will serve
    5-year rather than the current 9-year terms. In general, the board will
    establish TVA's strategic direction and policies while the CEO will
    oversee their implementation as well as TVA's overall operations. The new
    board became effective on March 31, 2006, when six new board members took
    the oath of office and joined two existing members to hold the first board
    meeting under the new governance structure.3

    2 16 U.S.C. S: 831n-4(e). TVA makes annual principal payments to Treasury
    from net power proceeds plus interest expense on the balance of this
    amount, which was about $428 million as of September 30, 2005. The annual
    principal payments, which totaled $20 million for fiscal year 2005, are to
    continue until the unpaid balance of the appropriation debt is paid down
    to $258.3 million. TVA is to continue paying interest on the remaining
    balance each year. The interest on the unpaid appropriation balance was
    $16 million in fiscal year 2005.

    Along with annual reporting to the SEC, in fiscal year 2006 TVA will also
    be required to comply with certain provisions of the Sarbanes-Oxley Act of
    2002, including the requirement that its officers certify annual and
    quarterly financial reports and report on the effectiveness of internal
    controls over financial reporting. TVA's external auditor, in addition to
    auditing and issuing an opinion on TVA's financial statements, will be
    required to issue an opinion on the effectiveness of TVA's internal
    controls over financial reporting. Based on the current guidance from the
    SEC, TVA will file the first report on internal controls with its
    September 30, 2007, financial statements.

    Under the TVA Act, as amended, TVA has not been subject to most of the
    regulatory oversight requirements that commercial utilities must satisfy.
    Legislation has also limited competition between TVA and other utilities.
    When the TVA Act was amended in 1959, it prohibited TVA, with some
    exceptions, from entering into contracts to sell power outside the service
    area that it and its distributors were serving on July 1, 1957. This is
    commonly referred to as the "fence" because it limits TVA's ability to
    expand outside its July 1, 1957, service area. In addition, the Energy
    Policy Act of 1992 (EPAct) exempted TVA from being required to allow other
    utilities to use its transmission lines to send power to customers within
    its service area, effectively reducing the opportunities for TVA's
    wholesale customers to choose other suppliers. This exemption is often
    referred to as the "anti-cherrypicking" provision. TVA is still subject to
    some forms of indirect competition common to all utilities. For example,
    the cost of power would affect decisions by TVA's customers to move or
    expand outside TVA's service area or by businesses to move into its
    service area. In addition, customers can decide to generate their own
    power for on-site use. However, as long as the legislative framework
    continues to insulate TVA from direct competition for its wholesale
    customers, it will remain in a position similar to that of a regulated
    utility monopoly.

    3 As of August 15, 2006, the ninth member of the board had been nominated
    by the President, but not yet confirmed by the Senate.

    For more than 20 years, the federal government has been taking a variety
    of steps to restructure the electricity industry with the goal of
    increasing competition in wholesale markets and thereby increasing
    benefits to consumers, including lower electricity prices and a wider
    variety of retail services. Electricity restructuring is evolving against
    a backdrop of constraints and challenges, including shared responsibility
    for implementing and enforcing local, state, and federal laws affecting
    the electricity industry and an expected substantial increase in
    electricity demand by 2025, which will require significant investment in
    new power plants and transmission lines.

    Prior to this restructuring, electricity was generally provided by
    electric utilities that exclusively served all customers within a specific
    geographic region. Under these conditions, the federal government, through
    the Federal Energy Regulatory Commission (FERC) and its predecessors,
    regulated wholesale electricity sales (sales for resale) and interstate
    transmission by electric utilities4 and set prices at cost-based rates.
    Because the utilities were monopolies, states regulated retail markets,
    approving utility company investments and rates paid by customers. In
    1978, the federal government laid the groundwork for restructuring and
    competition in the electricity industry with the Public Utility Regulatory
    Policies Act, which opened wholesale power markets to electricity
    producers that were not regulated utility monopolies. In the 1990s the
    federal government greatly expanded these efforts. First the EPAct
    provided for broader participation in wholesale electricity markets by
    nonutilities5 and allowed these entities to produce and sell electricity
    at market prices. Second, in 1996 the FERC issued Orders 888 and 889,
    which greatly expanded opportunities for competition by requiring
    utilities to provide access to their transmission lines to all users under
    the same prices, terms, and conditions. This change allowed the new
    nonutilities to compete with utilities and others for the opportunity to
    sell electricity in wholesale markets on more equal terms.6 By 2002 a
    number of states had made efforts to introduce competition to the retail
    markets that they oversee, allowing nonutilities to compete with utilities
    and others for the opportunity to sell electricity directly to consumers.

    4 Some entities such as utilities owned by municipalities, rural electric
    cooperatives, and others were not generally subject to federal oversight
    on rates.

    5 Nonutility generators or power producers can be corporations, persons,
    or other entities that own electric-generating capacity and are not
    electric utilities. They can include mining and manufacturing
    establishments, railroads, and other small or independent power producers
    that do not have a designated service area.

    6 Although it was not required by the Federal Power Act to comply with
    these orders, TVA took steps to do so, consistent with its obligations
    under the TVA Act.

    Beginning in 2000, some restructured wholesale and retail electricity
    markets encountered a number of problems. From the summer of 2000 through
    early 2001, California saw a sharp increase in wholesale electricity
    prices, electricity shortages leading to rolling blackouts, and the
    deteriorating financial stability of its three major investor-owned
    utilities. These problems, along with the largest blackout in U.S. history
    along the East Coast in 2003, drew attention to the need to examine the
    operation and direction of the industry. Efforts to expand restructuring
    slowed down as many states analyzed the factors that contributed to these
    problems, among them failure to meet increasing demand for electricity
    with new generation and transmission capacity.

    TVA management and many industry experts, however, expect that TVA will
    eventually be drawn into the restructuring of the electric utility
    industry and will eventually lose its legislative protections from
    competition. There have already been some indications of such changes. For
    instance, S.1499, introduced in July 2005, would remove any area within
    Kentucky from coverage by the "anti-cherrypicking" provision in the EPAct.
    If the bill becomes law, TVA would be required to transmit power from
    another supplier over its transmission lines for use inside the Kentucky
    portion of its service area without being able to similarly expand its
    service area. The bill was referred to the Senate Energy and Natural
    Resources Committee, where it remained as of August 15, 2006.

    Our prior reports have indicated that TVA's high debt and related interest
    expense could place it at a disadvantage in continuing to offer
    competitively priced power if it were to lose its legislative protections
    from competition.7 TVA's management has also recognized the need to reduce
    its debt and other financing obligations to increase its flexibility to
    meet competitive challenges. In July 1997, TVA issued a 10-year business
    plan with steps necessary to improve its financial position for an era of
    increasing competition. Two key strategic objectives of the plan were (1)
    to reduce the cost of power by reducing debt and the corresponding
    financing costs, and (2) increase financial flexibility by reducing fixed
    costs. To help meet these objectives, the plan called for TVA to reduce
    its debt by half over a 10-year period to about $13.2 billion by
    increasing its electricity rates beginning in 1998, reducing certain
    expenses, and limiting capital expenditures.

    7 GAO, Tennessee Valley Authority: Financial Problems Raise Questions
    About Long-Term Viability, GAO/AIMD/RCED-95-134 (Washington, D.C.: Aug.
    17, 1995); Federal Electricity Activities: The Federal Government's Net
    Cost and Potential for Future Losses, Volumes 1 and 2, GAO/AIMD-97-110 and
    110A (Washington, D.C.: Sept. 19, 1997); Tennessee Valley Authority:
    Assessment of the 10-Year Business Plan, GAO/AIMD-99-142 (Washington,
    D.C.: Apr. 30, 1999); Tennessee Valley Authority: Debt Reduction Efforts
    and Potential Stranded Costs, GAO-01-237 (Washington, D.C.: Feb. 28,
    2001); and Tennessee Valley Authority: Information on Lease-Leaseback and
    Other Financing Arrangements, GAO-03-784 (Washington, D.C.: June 30,
    2003).

    TVA did not meet the 1997 debt reduction goal because it used cash
    intended for debt reduction to cover greater than estimated annual
    operating costs and capital expenditures. In fiscal year 2000, TVA began
    entering into alternative financing in the form of lease-leaseback
    arrangements to obtain a lower cost of capital than it could by selling
    bonds. TVA entered into these arrangements in fiscal years 2000, 2002, and
    2003 to refinance 24 existing power generators that were designed for use
    during periods of peak power demand. TVA financed and built the generating
    units and leased them to investors in exchange for cash. It then leased
    the generators back and is making payments to investors. TVA also
    implemented other alternative financing arrangements that allowed its
    customers to prepay for power in exchange for discounted rates. For
    example, in November 2003, TVA entered into an energy prepayment agreement
    with its largest customer, Memphis Light, Gas, and Water Division (MLGW).
    Under this agreement, MLGW prepaid TVA $1.5 billion for electricity to be
    delivered over a 15-year period. TVA also offered a discounted energy
    units program in fiscal years 2003 and 2004, under which TVA customers
    could purchase power, usually in $1 million increments, in return for a
    discount on a specified quantity of power over a certain period of years.
    TVA did not offer the DEU program in 2005. During our review, TVA's
    management8 told us they have no current plans to enter into additional
    alternative financing arrangements.

    8 The majority of our field work was conducted before the restructured
    board took office on March 31, 2006, and included interviews with key
    members of TVA's management, including the Chairman of the Board; Chief
    Operating Officer; Executive Vice President and General Counsel; Chief
    Financial Officer; Senior Vice President for Strategic Planning and
    Analysis; and Vice President, Risk Management and Economic Analysis. Our
    references to TVA management in this report apply to the TVA management
    team in place before the new board took effect on March 31, 2006.

    Generally accepted accounting principles require that lease-leaseback and
    other alternative financing arrangements be classified as liabilities. In
    2003 we reported9 that the lease-leaseback arrangements, while not
    considered debt for purposes of financial reporting, had the same effect
    on TVA's financial condition as traditional debt financing. The Office of
    Management and Budget (OMB) treats the cash proceeds TVA receives from
    private parties at the inception of lease-leaseback arrangements as
    borrowing. Accordingly, in the President's Budget for fiscal year 2004,
    OMB began classifying TVA's lease-leaseback arrangements as debt. Table 1
    shows that although TVA reduced its outstanding statutory debt by about
    $4.3 billion from fiscal years 1997 through 2005, its use of alternative
    financing arrangements rose, adding nearly $2.5 billion to its total
    financing obligations as of September 30, 2005, resulting in a net
    reduction of about $1.8 billion.

    Table 1: TVA's Total Financing Obligations at Year-end for Fiscal Years
    1997 through 2005

    Dollars in
    millions
    Debt and
    obligations        1997    1998    1999    2000    2001    2002    2003    2004    2005
    Statutory debt  $27,379 $26,684 $26,376 $25,985 $25,375 $25,255 $24,875 $23,250 $23,088
    Lease-leaseback       0       0       0     300     271     559   1,238   1,178   1,143
    Energy                0       0       0       0       0       0      47   1,455   1,350
    prepayments
    Total financial $27,379 $26,684 $26,376 $26,285 $25,646 $25,814 $26,160 $25,883 $25,581
    obligations

    (Debt +
    alternative
    financing)

    Source: GAO analysis of information obtained from TVA.

    In fiscal year 2004, burdened with total financing obligations of almost
    $26 billion, TVA's board adopted a new strategic plan for reducing debt
    that called for increasing revenue, controlling costs, and reducing the
    growth of capital expenditures. However, TVA also began measuring its debt
    reduction more realistically and transparently in terms of TFOs, which, as
    shown in table 1, are comprised of its statutory debt as well as its
    liabilities under alternative financing arrangements.

    Since issuing its strategic plan in 2004, TVA has raised its power rates
    twice-a 7.52 percent increase in firm wholesale electric rates effective
    October 1, 2005, and a 9.95 percent increase effective April 1, 2006. On
    July 28, 2006, TVA's board approved a 4.5 percent decrease in firm
    wholesale power rates in conjunction with a fuel-cost adjustment clause.
    Utilities surrounding the Tennessee Valley also increased rates in 2005,
    and 12 of the 14 surrounding utilities have fuel-cost adjustment clauses
    that allow them to pass increases in the price of fuel to customers
    automatically. TVA is working with distributors and the Tennessee Valley
    Public Power Association (TVPPA)10 to develop future wholesale pricing
    options and new long-term contract options.

    9 GAO, Tennessee Valley Authority: Information on Lease-Leaseback and
    Other Financing Arrangements, GAO-03-784 (Washington, D.C.: June 30,
    2003).

                                 Scope and Methodology

    To determine how TVA plans to meet the debt reduction goal identified in
    its 2004 strategic plan, we: (1) interviewed TVA officials, (2) reviewed
    documentation and analyses supporting TVA's debt reduction plan including
    its 2004 strategic plan and budget submissions for fiscal years 2006 and
    2007, and (3) reviewed TVA's fiscal years 2004 and 2005 annual reports,
    information statements, and audited financial statements.

    To assess the reasonableness of TVA's approach in developing its debt
    reduction plan, we interviewed TVA officials responsible for developing
    the 2004 Strategic Plan and performing analyses with the Competitive Risk
    Model and the Enterprise Risk Model. To assess these models, we obtained
    documentation describing the structure of the models and the sources of
    variables used in the models, and discussed this information with relevant
    TVA staff. We examined the structure of the models in order to ascertain
    whether the relationships between the variables in the models were logical
    and included the most important sources of costs and revenues, and
    considered the extent to which the data are independent, widely used, and
    relevant.

    To identify the key factors that could impact TVA's ability to
    successfully carry out its debt reduction plan we (1) interviewed
    officials from TVA, TVA's Office of Inspector General, the Tennessee
    Valley Public Power Association, and the Knoxville Utilities Board; (2)
    reviewed prior GAO reports on issues confronting TVA; (3) reviewed TVA's
    fiscal years 2004 and 2005 annual reports, information statements, and
    audited financial statements to determine the types of revenue and costs
    TVA had reported; and (4) interviewed an official from CBO with expertise
    in issues pertaining to TVA.

    10 TVPPA is a nonprofit, regional service organization that represents the
    interests of consumer-owned electric utilities operating within the TVA
    service area.

    To identify the impact that growth in demand for power in the Tennessee
    Valley may have on TVA's ability to meet its debt reduction plan, we (1)
    interviewed officials from TVA, TVA's Office of Inspector General, the
    Tennessee Valley Public Power Association, and the Knoxville Utilities
    Board; (2) reviewed prior GAO reports on issues confronting TVA; (3)
    reviewed TVA's fiscal years 2004 and 2005 annual reports, information
    statements, and audited financial statements to determine the types of
    revenue and costs TVA had reported; and (4) interviewed an official from
    CBO with expertise in issues pertaining to TVA.

    During the course of our work, we contacted the following organizations:

               o  Congressional Budget Office
               o  Tennessee Valley Authority
               o  Tennessee Valley Authority, Office of Inspector General
               o  Tennessee Valley Public Power Association, Chattanooga,
               Tennessee
               o  Knoxville Utilities Board, Knoxville, Tennessee

    We provided a draft of this report to officials at TVA for their review
    and incorporated their comments where appropriate. We conducted our work
    from June 2005 through August 2006 in accordance with generally accepted
    government auditing standards.

      TVA Plans to Increase Revenue, Control Operating Expenses, and Limit Capital
                                      Expenditures

    TVA set a goal of reducing statutory debt by $3 to $5 billion in its 2004
    strategic plan. Subsequently, TVA expanded the scope of its debt reduction
    efforts to include debt-like transactions such as lease-leasebacks and
    energy prepayment arrangements, referred to in this report as alternative
    financing. TVA calls this larger group of obligations total financing
    obligations, or TFOs. In its 2007 budget, TVA increased its TFO reduction
    goal to $7.1 billion.11 This includes reducing statutory debt by $6.7
    billion and alternative financing obligations by $0.4 billion. TVA plans
    to meet this goal by increasing revenue, controlling the growth of its
    operating expenses, and limiting capital expenditures. TVA projects it
    will gain additional revenue through its October 2005 rate increase, a
    fuel-cost adjustment clause to adjust rates up or down automatically when
    fuel prices change, and increased sales from growth in the demand for
    electricity. TVA's plan also calls for controlling the growth of operating
    costs and limiting spending on capital expenditures to $12.1 billion
    through fiscal year 2015.

    11 GAO was asked to look at TVA's 2004 Strategic Plan, which addressed
    debt reduction plans through 2015. This report is based on information
    supporting the $7.1 billion figure made public in December 2005, which
    covers the original debt reduction period. Subsequently, TVA expanded its
    debt reduction period to 2016 and raised its TFO reduction goal to $7.8
    billion. This increased TVA's goal for reducing statutory debt to $7.3
    billion and alternative financing arrangements to $0.5 billion.

    TVA's management told us that they are committed to reducing TFOs and that
    achieving the $7.1 billion TFO reduction goal would give TVA an estimated
    3.1 interest rate coverage ratio12 by fiscal year 2015. As of fiscal year
    2005, TVA's interest coverage ratio was 2. The interest coverage ratio is
    a quick way to identify a company's ability to pay interest on debt, which
    TVA uses to gauge its financial health. TVA officials said the 3.1 ratio
    would allow TVA to be a financially flexible enterprise and continue to
    offer competitive electricity rates. Table 2 shows TVA's annual and
    cumulative targets for reducing total financing obligations for fiscal
    years 2004 through 2015.

    12 An interest coverage ratio of 1.5 is considered the minimum for any
    company in any industry. For an established utility, an interest coverage
    ratio of 2 is acceptable, while 3 is the minimum for more volatile
    industries. This ratio is generally calculated by dividing a company's
    earnings before interest expense and taxes by its interest expense.
    Because TVA's capital structure differs from investor-owned utilities, it
    calculates this ratio by dividing the sum of cash from operations plus
    interest expense by interest expense, which we believe is reasonable.

    Table 2: TVA's Actual and Targeted Reduction of Total Financing
    Obligations for Fiscal Years 2004 through 2015

    Dollars in
    millions
    Actual and
    projected
    reductions
    by fiscal
    year        2004a, b 2005a 2006   2007   2008   2009   2010   2011   2012   2013   2014   2015  Total
    Alternative $(1,347)  $140 $140   $142   $148   $147   $152   $160   $165   $172   $169   $176   $364
    financing
    Statutory      1,625   161  200    387    404    545    556    537    605    654    412    649  6,735
    debt
    Total
    annual TFO
    reduction       278c  301c  340    529    552    692    708    697    770    826    581    825 $7,099
    Cumulative
    TFO
    reduction       $278  $579 $919 $1,448 $2,000 $2,692 $3,400 $4,097 $4,867 $5,693 $6,274 $7,099

    Source: GAO analysis of information obtained from TVA.

    aReflects actual amount.

    bDuring fiscal year 2004, TVA reduced the balance of its TFOs by $278
    million by using $1.5 billion from a prepayment agreement with Memphis
    Light, Gas, and Water Division (MLGW) plus $125 million generated from
    operations to reduce statutory debt by $1.625 billion. At the same time,
    the balance of TVA's alternative financing arrangements increased by $1.5
    billion from the MLGW prepayment agreement minus a reduction in the
    balance of other alternative arrangements of $153 million for a net
    increase of $1.347 billion.

    cTargeted reduction was $225 million.

    TVA exceeded its targets for reducing TFOs for the first 2 years of the
    plan. In fiscal year 2004, TVA reduced its TFOs by $278 million, or 24
    percent more than its target of $225 million. In fiscal year 2005, TVA
    reduced its TFOs by $301 million, or 34 percent more than its target of
    $225 million.

    TVA Projects Several Sources of Additional Revenue

    The projections supporting TVA's current TFO reduction goal show that the
    annual increases in operating revenue over the fiscal year 2004 level for
    fiscal years 2005 through 2015 will total $16.7 billion. TVA plans to use
    the additional revenue to cover projected increases in operating costs and
    capital expenditures, and to reduce TFOs. About $9.6 billion of this
    additional revenue will come primarily from increased sales from growth in
    demand. TVA also projects that about $5.7 billion will come from the
    October 1, 2005, rate increase. From fiscal years 2007 through 2015, TVA
    expects about $1.4 billion to come from the fuel-cost adjustment (FCA)
    clause that will be added to customer contracts in fiscal year 2007. The
    FCA will automatically increase or decrease rates to cover changes in the
    cost of fuel and purchased power. TVA plans to use the budgeted fuel and
    purchased power estimates for fiscal year 2006 as the baseline for fuel
    and purchased power prices it pays. In subsequent years, it will compare
    those prices to the baseline and automatically adjust rates upward or
    downward for changes in these expenses. Although the FCA will not generate
    additional cash that can be applied to TFO reduction, it will prevent
    increases in the cost of fuel and purchased power from eroding cash
    balances that TVA planned to apply toward TFO reduction.

    The revenue projections supporting the current TFO reduction goal do not
    include several factors, such as the 9.95 percent rate increase that took
    effect on April 1, 2006, the 4.5 percent decrease approved on July 28, or
    any future rate increases. The April 1, 2006, increase took effect after
    TVA approved its 2007 budget and was undertaken to cover projected
    increases in the cost of fuel and purchased power. The rate decrease was
    approved in conjunction with the FCA. Future rate increases (excluding the
    FCA) were not included because TVA plans to use them as necessary to cover
    increases in operating costs (excluding fuel and purchased power) that
    exceed estimates that were used in formulating the current TFO reduction
    goal. The revenue projections also assume that an environmental surcharge
    that was added to rates on October 1, 2003, to fund anticipated clean air
    compliance costs for the next 10 years will be discontinued at fiscal year
    end 2013, as originally planned.

    TVA Plans to Control the Growth of Its Operating Costs

    TVA's TFO reduction plan includes an emphasis on controlling the growth of
    operating costs. Management plans to constrain TVA's baseline operating
    and maintenance (O&M) costs, excluding fuel and purchased power, by
    limiting the growth of these expenses to one-half of a percentage point
    below inflation, as measured by the consumer price index (CPI). TVA
    estimates that this will make about $1.1 billion in cash available from
    fiscal year 2007 through fiscal year 2015. TVA plans to hold O&M expenses
    down by implementing better discretionary spending discipline through
    top-down budgeting guidance and performance measures, and then maintaining
    the efficiency gains throughout the planning period. The plan includes
    establishing overall financial targets and allocating them to TVA's
    individual business units.

    TVA officials also project that bringing Browns Ferry Nuclear Unit 1 (BFN
    1)13 on line will help control the growth of operating costs. A 2002
    analysis prepared by TVA shows that the completion of BFN 1 will allow TVA
    to reduce the cost of its fuel, purchased power, and other operating
    costs. Because completion of BFN 1 is embedded in TVA's current forecasts,
    it could not provide current projections of the incremental savings from
    completing and bringing BFN 1 on line. The 2002 analysis projected that
    TVA's cash flow would improve when BFN 1 is brought on line in May 2007,
    and TVA would recover all of its costs from the project, including
    interest expense, by 2015. This analysis, however, could not consider
    subsequent changes, such as the significant increases in power supply
    costs that have occurred since 2002, which will increase TVA's projected
    savings from bringing BFN 1 on line. TVA also projects that its interest
    expense will be reduced over time as it lowers the balance of its
    outstanding debt.

    13 BFN 1 was taken off line in 1985 for plant modifications and regulatory
    improvements. In May 2002, TVA's Board determined the restart of BFN 1
    could reduce TVA's delivered cost of power relative to the market and
    initiated activities to return BFN 1 to service.

    TVA Plans to Spend $12.1 Billion on Capital Expenditures through Fiscal Year
    2015

    TVA's TFO reduction plan includes $12.1 billion from fiscal year 2006
    through fiscal year 2015 for capital expenditures to complete BFN 1, meet
    known requirements of the Clean Air Act, and cover ongoing efforts to
    uprate its generating assets and maintain transmission assets. Any changes
    in this amount would affect the cash available for TFO reduction. Table 3
    shows TVA's planned capital expenditures by major category from fiscal
    year 2006 through fiscal year 2015.

    Table 3: TVA's Planned Capital Expenditures by Major Category from Fiscal
    Year 2006 through Fiscal Year 2015

    Dollars in millions
                                                            Percentage of planned
    Category                  Planned expenditures                expenditures
    Browns Ferry Nuclear Unit                 $501                           4
    1
    Clean Air Act                            3,481                          29
    Requirements
    Fossil                                   2,552                          21
    Nuclear                                  1,462                          12
    Transmission                             2,828                          24
    Hydro                                      762                           6
    Corporate                                  529                           4
    Total                                  $12,115                         100

    Source: TVA.

    To help meet its capital expenditure goals, TVA will consider deferring or
    canceling capital projects when necessary and adjusting its investment
    criteria to reflect changes in its customer contracts and commitments.

    TVA's plan includes estimated capital expenditures for its current
    environmental program to reduce sulfur dioxide, nitrogen oxide, and
    particulates, which are expected to reach a cumulative total of about $5.7
    billion by 2010. TVA had already spent about $4.4 billion, or 77 percent
    of this amount, by September 30, 2005. TVA's plan, however, does not
    factor in costs for additional reductions in airborne pollutants that it
    may be required to meet in the future, or the potential cost to comply
    with proposed legislation that would require reductions in carbon dioxide.
    Projections for meeting TVA's TFO reduction goal do not include capital
    expenditures for building any major new generating assets through 2015,
    other than completing BFN 1.

          TVA Used a Reasonable Approach to Developing Its Plan to Reduce TFOs

    Overall, we found TVA's approach to developing its TFO reduction goal was
    reasonable. TVA used a strategic planning process to develop its current
    goal, which focused on its core mission as a long-term provider of
    low-cost electricity. As part of this process, TVA looked not only at its
    financing obligations, but at external business and market risks. To
    assess these outside risks, TVA performed detailed competitive analyses
    and modeled different market scenarios to estimate its future competitive
    environment. It considered the results of these market risk analyses in
    formulating its strategic plan and determining the initial range of
    possible debt reduction through 2015. As part of its annual internal
    budget process, TVA used an accounting model to project annual cash flows
    and refine its goal. TVA continues to project cash flows annually and to
    analyze changing market conditions as necessary using the accounting
    model.

    TVA Assessed Its Business and Market Risks to Prepare Its Strategic Plan

    TVA assessed its competitive environment and performed detailed analyses
    of business and market risks to determine the effect of possible future
    conditions on its ability to reduce debt. Among the tools used in TVA's
    strategic planning process was a competitive risk model (CRM). The CRM is
    a scenario model that shows the range of financial outcomes TVA might face
    if electricity industry restructuring moved forward and its distributors
    were free to choose alternative suppliers. Scenario analysis develops a
    set of potential events and conditions that management may wish to
    consider, and calculates the likely impact on cash flow and debt reduction
    in each. TVA's CRM shows the probability of loss of load, or customer
    demand for energy, over many market scenarios. The model calculated the
    potential impact of each market scenario on TVA assuming that distributors
    could choose other suppliers and modeled the potential for loss of load
    using three pricing scenarios:

               o  holding prices flat at current levels,
               o  setting prices equal to TVA's projected costs, and
               o  setting prices equal to the projected average competitor price.

    The results were then used to produce probabilities of different potential
    financial outcomes to identify types of market conditions under which load
    loss was likely to occur.

    TVA included the following assumptions in the CRM:

               o  it would begin facing competitive pressures in 2008;
               o  its contracts would include provisions for distributors to
               satisfy some of their power needs from sources other than TVA,
               referred to as partial requirements; and
               o  it could sell power elsewhere.

    TVA conducted its competitive risk analysis in 2003. In a little less than
    one-third of the scenarios, the CRM showed that TVA could lose load if
    other utilities had both cheap natural gas and high reserve margins, or
    unused available capacity. Because natural gas prices have risen and
    movement toward electricity competition has slowed, TVA has not considered
    it necessary to run the model again.

    TVA used the results of its competitive risk analysis as well as
    professional judgment in developing its 2004 strategic plan and the
    initial range of $3 billion to $5 billion for its statutory debt reduction
    goal. The plan looks at the larger picture of what TVA needs to do to
    succeed in a more competitive environment. It concluded that TVA needs to
    concentrate on four areas over the next few years. These are:

               o  developing new, more differentiated pricing structures,
               services, and contract terms that more closely tie the cost and
               risk of TVA's products to their terms and pricing;
               o  addressing issues related to wholesale market design and
               transmission pricing, including how it will interface with
               surrounding markets to ensure reliable power and how it will
               charge for transmitting power inside its service area when
               distributors can choose other suppliers;
               o  accelerating debt reduction to increase financial flexibility;
               and
               o  maintaining and operating company assets to continue to meet
               electricity supply obligations safely and reliably.

    TVA Uses an Accounting Model to Refine Its TFO Reduction Targets by Determining
    Likely Cash Flow

    TVA uses the Enterprise Risk Model (ERM) as part of its annual internal
    budgeting process to refine its TFO reduction targets by determining
    likely cash flow in given situations. The ERM is a simplified cash-based
    accounting model that can project key financial data by modeling TVA's
    system based on a power supply plan and a long-range financial plan. The
    ERM uses Monte Carlo simulation14 to assess the probable range of
    uncertain inputs, or variables, such as interest rates or coal prices,
    redispatch the TVA system,15 and recalculate cash flows multiple times
    while showing a range of probable values for each variable.

    The ERM's Monte Carlo simulations use 13 variables that include key costs
    and key determinants of revenue:

               o  electricity market peak ($/MWh)
               o  electricity market off-peak ($/MWh)
               o  natural gas prices ($/mmBtu)
               o  coal prices ($/mmBtu)
               o  long-term interest rates (%)
               o  short-term interest rates (%)
               o  total operating and maintenance expenses
               o  capital expenditures
               o  selling, general and administrative expenses
               o  benefits expense
               o  coal plant availability
               o  nuclear plant availability
               o  hydro generation

    For example, a simulation might use key costs such as prices for coal and
    natural gas, and combine this information with key determinants of
    revenue, such as peak and off-peak electricity prices, and quantities sold
    at those prices. The output of the model is an estimate of the annual net
    cash flow for TVA. For each scenario estimated, the model shows net cash
    flows and financing obligations repayment over each of the next 20 years
    for the values assumed in that scenario. Assuming that this net cash flow
    is applied to reducing financing obligations, the model provides an
    estimate of the level of obligations at the end of the simulation, which
    can then be used to refine projections used in coming up with its goals.

    14 Monte Carlo simulation is an approach to risk assessment that allows an
    analyst to assess the probable range of various uncertain inputs, such as
    interest rates or coal prices, and recalculate cash flows multiple times
    while drawing values that fall within a probability distribution for each
    of the uncertain inputs. The results are examined in the context of their
    probability distribution covering all potential outcomes of the analysis
    as well as reporting the average or other values.

    15 Dispatch is the process of allocating load among the available
    generation units so that the cost of operation is minimized. The ERM uses
    an economic dispatch routine to simulate the operation of TVA generating
    assets to achieve the lowest possible cost of generation.

    The model uses a variety of reliable sources for estimates of the key
    input variables. For instance, the variability of rainfall for hydropower
    is calculated using historical data. Interest rates are based on forecasts
    from Global Insight and the Wall Street Journal. The volatility of
    commodity prices for coal or natural gas is estimated with a combination
    of historical data and projected trends. Other sources may also provide
    reasonable estimates for key variables in the model, however. For example,
    some of the commodities used in the model, such as natural gas, have
    active options markets, which could help identify more accurate estimates
    of the range of possible future prices in volatile markets. For example,
    when Hurricane Katrina destroyed a large number of natural gas rigs in the
    Gulf of Mexico, there was an enormous increase in implied volatility for
    natural gas prices. This was because no one knew how long it would take to
    repair the rigs or what the market consequences would be of a sudden
    withdrawal of a large percentage of the natural gas supply. In such a
    case, the options market may provide a more accurate estimate of price
    volatility than historical activity and might result in a more
    comprehensive characterization of the distribution of possible TFO
    reduction levels.16

    In designing the ERM and using its output to devise its current goal for
    reducing financing obligations, TVA made the following key business
    assumptions:

               o  Brown's Ferry Nuclear Unit 1 will be completed on time,
               o  TVA will not self-fund any new baseload generation,
               o  distributors who have given notice they will not be renewing
               contracts are excluded,
               o  TVA will meet or exceed current environmental regulations,
               o  TVA's credit rating remains AAA,17 and
               o  distributors do not gain rights to partial requirements or
               transmission.

    16 In many energy markets, options are traded that give purchasers the
    right to buy or sell commodities in the future at a set price. From the
    prices on these options, it is possible to determine traders' expectations
    about the extent to which prices are likely to fluctuate in the future. At
    times of fundamental changes in a market, such as storm damage to
    production facilities, traders may reasonably believe that price
    fluctuations in the future will be larger than those based on past
    history.

    TVA has generally made reasonable assumptions concerning the level and
    variability of the key inputs to its Monte Carlo model. As with any
    modeling effort, there are some inherent limitations, and areas in which
    the modeling may be improved. TVA's key business assumptions, while
    reasonable, limit the range of outcomes from the model by making certain
    events appear more fixed or settled than they are. Allowing the range of
    possible outcomes attached to some of the fixed assumptions to be modeled
    as variables may better reflect the uncertainty attached to TVA's TFO
    reduction estimates. For example, TVA could determine a range of likely
    dates for the completion of Brown's Ferry Nuclear Unit 1, and use these
    dates as part of the Monte Carlo simulation. Another example might be to
    use the range of possible costs from potential environmental legislation
    as inputs to the model. Modeling these and other fixed assumptions as
    variables might better illustrate the range of outcomes for TVA to
    evaluate in setting and refining its TFO reduction goals.

      Several Key Factors Could Impact TVA's Ability to Successfully Carry out Its
                                 Plan for Reducing TFOs

    We identified several key factors that could impact TVA's ability to
    successfully carry out its plan. Some factors are more difficult for TVA
    to control than others. The timing of electricity industry restructuring,
    potential increases in interest rates, and costs associated with meeting
    potential new environmental regulations are factors outside TVA's control.
    Future rate increases and a fuel-cost adjustment clause are factors that
    will help TVA cover unforeseen costs, which will help TVA meet its TFO
    reduction goal. TVA's planned reduction in interest expense could be
    affected by increases in interest rates. Although the TFO reduction plan
    includes the capital expenditures TVA estimates it will need to comply
    with all existing environmental regulations, the plan does not include
    potential capital expenditures needed to comply with any changes to the
    current environmental regulations. Building new generating capacity could
    require capital expenditures not included in the plan.

    17 AAA is a bond rating category assigned to an electric utility by bond
    analysts to represent their opinion on the general creditworthiness of an
    entity. AAA is the highest bond rating category representing the smallest
    degree of investment risk and an extremely strong ability to pay interest
    and principal.

    The Timing of Restructuring within the Electricity Industry and the Changes It
    May Impose Are Key Variables in TVA's TFO Reduction Plan

    Restructuring is the major reason TVA has undertaken TFO reduction, and
    its timing and the organizational and structural changes it may impose are
    key variables in TVA's plans. TVA's management and industry experts
    believe TVA may eventually lose its legislative protections from
    competition and have to compete with other utilities. Even if TVA does not
    lose its legislative protections, its management has recognized the need
    to take action to better position the agency to be competitive in an era
    of increasing competition and customer choice. TVA management undertook
    both the 1997 business plan and the 2004 strategic plan to position TVA to
    meet the challenges it would likely face in the coming restructured
    marketplace.

    The extent to which TVA would be affected by loss of its legislative
    protections from competition would be influenced by (1) when TVA loses its
    protections, which would affect how much time it has to continue to
    improve its competitive position; (2) how TVA would be structured to
    operate in a competitive environment, including whether it would be given
    the ability to compete for customers outside its service area; and (3) how
    TVA's financial condition compares to its competitors at the time it loses
    its protections from competition. Loss of its protections from competition
    could affect TVA's ability to set rates at levels sufficient to recover
    all costs, which could negatively impact the amount of cash available to
    reduce TFOs.

    According to a TVA official, one option TVA could pursue to help meet its
    goal for reducing TFOs is to negotiate long-term contracts with its
    customers. Long-term contracts would help reduce TVA's risk by providing a
    steady revenue stream for a certain period of time. If TVA's distributors
    were to gain the rights to purchase a portion of their electric power
    requirements from other utilities, it could have a negative material
    effect on TVA's ability to meet its TFO reduction goal. For example,
    excluding the Kentucky portion of TVA's service area from the
    anti-cherrypicking provision of the EPAct is currently under
    consideration.18 In the event this legislation is enacted, TVA officials
    believe other distributors would seek similar treatment.

    18In July 2005, Senators Jim Bunning and Mitch McConnell introduced
    S.1499, which would remove any area within Kentucky from coverage by the
    "anti-cherrypicking" provision in EPAct.

    Future Rate Increases and a Fuel-cost Adjustment Clause Will Help TVA Reduce
    Total Financing Obligations

    Future rate increases and a fuel-cost adjustment clause allowing TVA to
    adjust rates for the rise and fall in the prices of fuel and purchased
    power that result from changes in market conditions will help TVA meet its
    TFO reduction goal. TVA's TFO reduction goal reflects the October 2005
    rate increase and the FCA that TVA plans to implement in fiscal year 2007.
    The plan does not reflect any additional rate increases through 2015. TVA
    estimates that the FCA will cover net increases in the cost of fuel and
    purchased power of $1.4 billion from fiscal year 2007 through 2015, which
    will free this amount of cash to apply toward TFO reduction. In addition,
    TVA's management told us that they would consider additional rate
    increases if necessary to cover increases in operating costs other than
    fuel and purchased power. In determining whether to raise rates, TVA's
    management recognizes that they would need to consider current markets and
    any potential negative consequences, such as the impact on power sales and
    the regional economy. The April 2006 rate increase and any future
    increases will help TVA cover any unforeseen increases in projected
    operating costs or capital expenditures, as well as shortfalls in
    projected revenue.

    Limiting the Growth of Operating and Maintenance Expenses Will Be Difficult for
    TVA to Achieve

    TVA will be challenged to meet its goal of reducing projected O&M expenses
    by $1.1 billion from fiscal year 2007 through 2015. TVA has been focusing
    on reducing O&M expenses since it issued its 1997 business plan, and has
    already taken many steps to trim these expenses. TVA officials have said
    that the $1.1 billion savings will come from baseline O&M expenses, which
    TVA defines as the ongoing costs of operating and maintaining its internal
    business units that are routine and recurring. In fiscal year 2005, these
    expenses represented about $1.3 billion, or about 54 percent of the $2.4
    billion reported for O&M expenses, and about 20 percent of TVA's total
    operating expenses. According to a TVA official, the growth limit for the
    baseline O&M expenses will be applied to the total for all business units
    and any excess increases in these expenses by one unit will have to be
    absorbed by the other business units. For example, the amount budgeted for
    one of TVA's business units in fiscal year 2007 was $30.7 million over
    what it would have been if it had been limited to projected inflation less
    one half of a percentage point, and according to a TVA official, this
    excess will have to be absorbed by the other business units in order for
    TVA to meet its overall growth limit.

    Planned Reduction in Interest Expense Could Be Affected by Increases in Interest
    Rates

    TVA projects that it will continue to reduce annual interest expense as it
    reduces the balance of outstanding debt and, if the situation presents
    itself, refinance debt at lower interest rates. Like all outstanding debt
    approaching maturity dates, TVA's interest expense is subject to interest
    rate risk. As TVA's outstanding debt matures, the portion that is not
    repaid will need to be refinanced at current rates, thus exposing TVA to
    the risk of rising interest rates and higher interest costs. TVA has
    reduced its annual interest expense from more than $2 billion in fiscal
    year 1997 to about $1.3 billion in fiscal year 2005, a 35 percent
    reduction. TVA was able to lower its interest expense by refinancing debt
    at lower interest rates, reducing the outstanding balance of debt, and
    entering into alternative financing arrangements. Alternative financing
    arrangements help reduce interest expense because they are classified as
    liabilities in TVA's financial statements. This means that rather than
    being classified as interest on debt, the costs of these arrangements are
    recorded as increases in operating expenses or reductions in revenue. TVA
    attributes approximately 80 percent of the reduction of interest expense
    from fiscal year 1997 to 2005 to refinancing debt at lower interest rates.

    As of September 30, 2005, TVA had about $8.3 billion in outstanding debt
    that will mature and either need to be repaid or refinanced over the next
    5 years ($3.1 billion in long-term debt and about $5.2 billion in
    short-term debt). By the end of this 5-year period, for every 1 percentage
    point change in TVA's average borrowing costs for the $8.3 billion, its
    annual interest expense would increase or decrease by about $83 million.
    If future interest rates are higher than the rates used in TVA's
    projections, TVA may have difficulty meeting its targets for reducing
    interest expense.

    Changes to Current Environmental Regulations Could Require Substantial Capital
    Expenditures

    Although TVA's TFO reduction plan includes all of the capital expenditures
    it projects will be needed to comply with existing environmental
    regulations, the plan does not include potential capital expenditures
    needed to comply with any changes to the current environmental
    regulations. According to TVA's 2005 Information Statement, several
    existing regulatory programs are being made more stringent in their
    application to fossil-fuel units19 and additional regulatory programs
    affecting fossil-fuel units have been announced. According to TVA, its TFO
    reduction plan does not include the estimated future costs to comply with
    more stringent regulations because it is difficult to predict how these
    regulations would affect TVA. However, TVA officials estimate that the
    cost to comply with future regulations could run between $3.0 billion and
    $3.5 billion through 2020. TVA officials said they would include an
    estimate of these costs in the plan if their level of certainty ever
    increases. The plan also does not include the potential cost of complying
    with legislation that has been introduced, but not yet passed, in the
    Congress to require reductions in carbon dioxide. If this legislation is
    enacted, TVA estimates that the cost of complying with it could be
    substantial.

    19 Fossil-fuel plants use coal, petroleum, or gas as their source of
    energy.

    The extent to which new environmental regulations affect any utility
    depends on several factors, including the type and condition of its
    generating equipment, the portion of its power generated by fossil fuels,
    the types of controls it chooses to meet the new environmental
    regulations, and the availability of excess generating capacity. Compared
    to surrounding regions, TVA has roughly the same amount of coal-fired
    capacity, nearly twice as much nuclear, nearly four times as much hydro,
    and less than half as much natural gas fired capacity. Figure 2 shows
    TVA's generation mix compared to the surrounding North American Electric
    Reliability Council (NERC) regions.

    Figure 2: Generation Capacity by Fuel Type, TVA vs. Nearest NERC Regions

    The extent to which different producers will be affected by new
    environmental regulations, and the resultant impact on their power prices,
    is unknown at this time. Although new environmental regulations would
    likely present challenges to TVA in meeting its TFO reduction goal, they
    may not necessarily affect its competitive position relative to its
    neighboring utilities.

    Building New Generating Capacity Could Require Capital Expenditures Not Included
    in the Plan

    Building new generating capacity during the current TFO reduction period
    to meet the projected demand for power beginning in 2015 would likely
    cause TVA to incur new debt and use cash that is currently projected to be
    available to reduce TFOs. TVA officials told us they plan to meet load
    growth in the TVA service area through 2015 by completing BFN 1,
    increasing the capacity of existing generating units, and purchasing power
    from the marketplace. TVA's current projections include the capital
    expenditures it projects will be needed to meet this plan. TVA also
    projects that it will need additional generating capacity beginning in
    2015. TVA plans to satisfy this need by partnering with other power
    providers. Its current goal assumes that it will not finance any new
    baseload plants,20 other than BFN1, through 2015. If growth in demand or
    market changes force TVA to build new generation, as happened after its
    1997 plan, TVA's ability to reduce TFOs could be affected.

    TVA Will Require Continued Management Commitment to Reducing TFOs

    TVA officials told us they recognize that in order to improve TVA's
    financial situation, it will need to operate within its means and reduce
    TFOs. TVA will require continued management commitment to continue
    reducing financing obligations. According to officials, TVA did not meet
    the debt reduction goal in the 1997 business plan because the amount of
    cash left over after meeting its other business needs was not sufficient
    to meet the goal. Since issuing its 2004 strategic plan, TVA's management
    has demonstrated its commitment by exceeding the planned targets for the
    first 2 years of the TFO reduction plan. In addition, their actions have
    included adding annual TFO reduction targets as revenue requirements in
    the budgets used for its annual rate reviews, tying portions of its
    overall incentive payroll compensation to accomplishing the TFO reduction
    goal, and demonstrating a willingness to raise rates to meet the goal.
    Although TVA has a new board structure as of March 31, 2006, the continued
    commitment of the board toward TFO reduction will be needed to meet the
    current goal.

    20 Baseload plants are normally operated to take all or part of the
    minimum load of a system, and consequently run continuously, producing
    electricity at an essentially constant rate. These units are operated to
    maximize system mechanical and thermal efficiency and minimize system
    operating costs.

     Growing Demand for Power Could Affect TVA's Ability to Meet Its TFO Reduction
                                          Goal

    The growing demand for power could affect TVA's ability to meet its goal
    since TVA's current projections assume that it will not invest in any new
    generation through 2015, other than restarting BFN 1. TVA's plan includes
    the capital expenditures needed to expand generating capacity in existing
    generating facilities to meet projected increases in demand for power
    through 2015. By 2015, however, TVA estimates that it will need more
    baseload generation to meet growth in demand. As a result, it will need to
    take action to meet that need during the current TFO reduction period. TVA
    officials are considering a number of options to meet this projected
    increase in demand for power, including partnering with outside parties.

    TVA's current plan assumes that one option for meeting the growth in
    demand for electricity is by uprating, which is the process of increasing
    the capacity of existing generating assets. To its 30,644 megawatts of
    generating capacity, TVA currently plans to add:

               o  1,280 total megawatts of capacity a year by restarting Browns
               Ferry Unit 1 in fiscal year 2007;
               o  125 megawatts each, for a total of 250 megawatts a year, by
               uprating or adding capacity to Browns Ferry Units 2 and 3;
               o  approximately 15-30 megawatts of capacity a year through 2015,
               or a total of approximately 150 to 300 megawatts of annual
               capacity by the end of the TFO reduction period, by continuing to
               modernize its hydropower facilities;
               o  36 total megawatts a year by uprating the Raccoon Mountain
               Pumped Storage Plant; and
               o  16 total megawatts a year by uprating the Cumberland Fossil
               Plant through 2010.

    TVA also plans to meet future needs by continuing to purchase low-cost
    power from the Southeastern Power Administration and through other
    long-term contracts. In addition, TVA plans to purchase power from the
    market when it is cheaper than generating its own power.

    Even with these plans in place, TVA expects that it will still need new
    baseload capacity beginning in 2015. TVA officials told us they will
    consider partnering with others to help finance the acquisition of new
    assets or they will consider building new assets themselves if they cannot
    find a suitable partner. TVA expects a partner would help share risk.
    Although the benefits, costs, and risks would vary depending on the type
    of partnership it eventually enters into, according to TVA officials,
    forming a partnership would help meet new demand for electricity while
    reducing the cash requirements for building new generating assets. As of
    April 2006, TVA management did not have any firm plans for a partnership,
    but were discussing potential partnerships with several interested
    parties.

    One partnering option TVA is considering includes working with the NuStart
    Consortium,21 which selected TVA's Bellefonte site as one of the two
    potential sites in the country for a new advanced design nuclear plant. In
    the late 1980s, TVA stopped construction on Bellefonte, a nuclear plant
    which has never been operated. NuStart plans to use the Bellefonte site,
    as well as one other potential site, on applications for licenses it plans
    to submit for new nuclear plants, but currently there have been no
    decisions to construct a plant. Another option being considered by TVA is
    entering into a partnership with another industry consortium22 to build an
    Advanced Boiling Water Reactor on the Bellefonte site.

    TVA and TVPPA also indicated that TVA's customers are interested in
    partnering with TVA. Partnering with a customer would allow TVA to earn
    fee income for operating a new generating asset, while its customer would
    finance and own all or a share of the asset. TVA officials also noted that
    TVA's customers have not owned generating assets before and, as a result,
    may not have the needed in-house expertise, or be familiar with the risks
    involved. Despite ongoing conversations between TVA and potential
    partners, however, there are no current firm plans to partner with another
    party, and TVA could not provide us with criteria it would use in
    selecting partners. As a result, it is difficult to determine TVA's
    likelihood of finding suitable partners to help meet the growth in demand
    projected in its service territory.

    21 NuStart Energy Development, LLC, is a limited liability company formed
    in 2004 with nine member companies. These members, plus TVA and two
    reactor vendors, form the NuStart Consortium. The consortium objectives
    are to: 1) demonstrate the U.S. Nuclear Regulatory Commission's licensing
    process for obtaining a combined Construction and Operating License for an
    advanced nuclear power plant, and 2) complete the design engineering for
    the two selected reactor technologies.

    22 TVA led an industry consortium that prepared a cost and schedule study
    on building an Advanced Boiling Water Reactor on the Bellefonte site. This
    consortium included Toshiba Corp., General Electric Corp., Bechtel Corp.,
    United States Enrichment Corp., and Global Nuclear Fuels-Americas.

    One of TVA's largest distributors noted that TVA could also pursue other
    options to reduce the demand for power. These include giving customers
    access to obtaining a portion of their power needs from other suppliers or
    changing the rate structure to provide incentives to reduce the peak
    demand for electricity. In 2002, we reported that TVA's demand-side
    management programs, which are designed to reduce the amount of energy
    consumed or to change the time of day when it is consumed, were limited in
    scope and impact when compared to similar programs managed by other
    utilities and recommended that, as appropriate, TVA expand its demand-side
    management programs.23 TVA officials told us they have continued to expand
    the use of demand-side-management programs, which will reduce the amount
    of power TVA would need to generate or purchase from the market.

    TVA's decision to complete BFN 1 reversed a policy dating from the late
    1990s to rely primarily on purchasing power from other power suppliers
    when its own power system cannot meet demand. Building new capacity itself
    provides two potential key benefits for TVA. First, TVA would likely be
    able to generate power at a lower cost than purchasing a like amount of
    power from other utilities, thereby reducing its cost of power. Second, a
    decision to build new generating capacity would give TVA control over its
    source of power and remove the uncertainty of having to rely on other
    utilities for power. It would reduce the chances that TVA would need to
    purchase power from the market when there may be limited excess capacity
    and high prices, but increases the risk that its generating costs could be
    higher than market prices. According to TVA, if it can recover the cost of
    building new generating assets through rates, increased demand would have
    no effect on its ability to meet its TFO reduction goal. However, TVA
    officials acknowledged the need to be sensitive to rate increases, stating
    that raising rates too quickly could trigger action that would jeopardize
    its relationship with customers and ultimately threaten its current
    monopoly status.

    TVA's $7.1 billion goal for reducing TFOs through 2015 assumes that any
    demand for power not met by its generating capacity will be purchased from
    the marketplace. TVA's 1997 business plan also assumed that it would not
    invest in any new generating capacity. Ultimately, the need to build its
    own additional generating capacity in lieu of purchasing power from the
    market in the late 1990s meant that TVA increased its capital expenditures
    and reduced the amount of cash available for debt reduction, which
    contributed to its failure to meet the debt reduction goal in its 1997
    business plan. Although TVA currently has no specific plans to build new
    generation, any decision to build new generating assets would likely
    affect its ability to fully meet its TFO reduction goal.

    23 GAO, Air Quality: TVA Plans to Reduce Air Emissions Further, but Could
    Do More to Reduce Power Demand, GAO-02-301 (Washington, D.C.: Mar. 8,
    2002).

                                      Conclusions

    TVA's TFO reduction goal was based on a strategic planning approach and an
    assessment of market risks and projected cash flow. As with any effort
    that incorporates economic models, there are some limitations and areas
    where they could be improved. While TVA's key business assumptions are
    reasonable, holding them fixed, rather than modeling them as variable
    assumptions, limits the range of outcomes from the model. Modeling
    different scenarios under which TVA may need to meet new environmental
    regulations or pay for new capacity, for instance, would allow TVA to
    better illustrate the possible range of outcomes, and thus the
    uncertainties of many factors in its plan. In addition, while TVA uses a
    variety of factors to estimate key variables, in the case of commodity
    prices, expanding the sources would provide a more comprehensive
    characterization of the range of possible TFO reduction levels in
    situations where markets are volatile. Finally, given the numerous factors
    that could affect TVA's ability to meet its goal, management's continued
    commitment to reducing TFOs will be necessary to keep TVA on course.

                                    Recommendations

    We are making two recommendations to the Chairman of the Board of
    Directors of the Tennessee Valley Authority to (1) explore additional data
    sources for estimates of key input variables in the Enterprise Risk Model,
    and (2) better illustrate the range of outcomes in the Enterprise Risk
    Model used for planning purposes. Specifically, we are recommending that:

               o  TVA consider incorporating the variability surrounding certain
               assumptions that are now held fixed, such as the starting date for
               Browns Ferry Nuclear Unit 1 or possible new environmental
               legislation. In cases where professional judgment is used to
               quantify the uncertainty, the effects of incorporating that
               judgment should be documented.
               o  TVA augment its sources for projections of key model inputs
               with sources such as commodity prices and the volatility of those
               prices. Market prices for commodities with active futures and
               options markets can be used to determine the expectations of
               market participants concerning prices and their volatility.

                           Agency Comments and Our Evaluation

    In written comments on a draft of this report, TVA's Acting Chief
    Executive Officer, President, and Chief Operating Officer agreed with our
    report and recommendations. We also discussed technical comments with TVA
    officials, which we have incorporated into the final report as
    appropriate. TVA's written comments are reproduced in appendix I.

    As agreed with your office, unless you publicly announce its contents
    earlier, we plan no further distribution of this report until 30 days from
    its date. At that time, we will send copies of this report to appropriate
    House and Senate committees, interested members of the Congress, TVA's
    board of directors, and the Director of the Office of Management and
    Budget. We will also make copies available to others upon request. In
    addition, the report will be available at no charge on GAO's Web site at
    http://www.gao.gov .

    If you or your staff have any questions on matters discussed in this
    report, please contact me at (202) 512-6131, or martinr@gao.gov . Contact
    points for our Offices of Congressional Relations and Public Affairs may
    be found on the last page of this report. GAO staff who made major
    contributions to this report are listed in appendix II.

    Sincerely yours,

    Robert E. Martin Director, Financial Management and Assurance

    Appendix I: Comments from the Tennessee Valley Authority

    Appendix II: GAO Contact and Staff Acknowledgments

                                      GAO Contact

    Robert E. Martin, (202) 512-6131 or martinr@gao.gov

                                    Acknowledgments

    In addition to the contact named above, Donald Neff (Assistant Director),
    Lisa Crye, Austin Kelly, Mary Mohiyuddin, and Brooke Whittaker made key
    contributions to this report.

    (197008)

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    www.gao.gov/cgi-bin/getrpt? GAO-06-810 .

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    Highlights of GAO-06-810 , a report to the Chairman, Subcommittee on Water
    Resources and Environment, Committee on Transportation and Infrastructure,
    House of Representatives

    August2006

    TENNESSEE VALLEY AUTHORITY

    Plans to Reduce Debt While Meeting Demand for Power

    Competition in the electricity industry is expected to intensify, and
    restructuring legislation may dramatically change the way electric
    utilities do business in the future. To be competitive, the Tennessee
    Valley Authority (TVA) needs to reduce fixed costs and increase its
    flexibility in order to meet market prices for power. TVA plans to reduce
    its financing obligations, which include statutory debt and other
    financing arrangements, by $7.1 billion by the end of fiscal year 2015.
    GAO was asked to (1) describe how TVA plans to meet its goal for reducing
    financing obligations, (2) assess the reasonableness of TVA's approach in
    developing its plan, (3) identify key factors that could impact TVA's
    ability to successfully carry out its plan, and (4) identify how TVA's
    plans for meeting the growing demand for power in the Tennessee Valley may
    impact its ability to reduce financing obligations. To fulfill these
    objectives, GAO interviewed TVA officials and others, and reviewed budget
    submissions, financial projections, and other documentation supporting the
    plan.

    What GAO Recommends

    GAO makes two recommendations to help TVA (1) augment its data sources for
    estimates of key input variables in its cash flow model, and (2) better
    illustrate the range of outcomes of the model. In comments on a draft of
    this report, TVA agreed with these recommendations.

    TVA plansto reduce its financing obligations by about $7.1 billion from
    fiscal years 2004 through 2015 by increasing revenue, controlling the
    growth of its operating expenses, and limiting capital expenditures. TVA's
    financing obligations include statutory debt, which it plans to reduce by
    $6.7 billion, and alternative financing obligations such as energy
    prepayments, which it plans to reduce by $0.4 billion.

    Overall, GAO's review found TVA's approach to developing its plan to
    reduce financing obligations reasonable. TVA performed detailed
    competitive analyses and modeled different market scenarios to estimate
    its future competitive environment, then used its internal budget process
    to project annual cash flows and refine its goal with a cash-based
    accounting model. Many of the variables used in the models were based on
    recognized data sources. Augmenting these sources with prices from options
    markets could provide more accurate estimates in volatile markets. TVA
    also made fixed assumptions about actions it would take, such as building
    new power generation, and events, such as the advent of new environmental
    regulations. While these assumptions are reasonable, they carry
    uncertainty that is not reflected in the model. Modeling them as variables
    might better reflect that uncertainty and provide broader information for
    planning purposes.

    GAO identified several key factors that could impact TVA's ability to
    successfully carry out its plan. Factors such as the timing of electricity
    industry restructuring, potential increases in interest rates, and costs
    associated with meeting potential new environmental requirements, are key
    factors that are difficult for TVA to control. TVA has more control over
    other key factors, such as its decisions on whether or not to construct
    new power generating facilities before 2015 and to limit operating and
    maintenance expenses, but these are also affected by outside forces and
    contain an element of uncertainty. Future rate increases and a fuel-cost
    adjustment clause are factors that should help cover any unforeseen costs,
    capital expenditures, or revenue shortfalls.

    TVA's plan includes the capital expenditures it believes will be needed to
    expand capacity of existing generating facilities to meet the growing
    demand for power in its service area through 2015; however, any new or
    unplanned expenditures prior to 2015 could lessen TVA's ability to achieve
    the $7.1 billion goal. By 2015, TVA has estimated that it will need more
    baseload generation to meet growth in demand. TVA officials are
    considering a number of options to meet this projected increase in demand
    for power, including partnering with outside parties to build new
    generation. TVA's current projections assume that it will not invest in
    any new generation through 2015 other than restarting Browns Ferry Nuclear
    Plant Unit 1; however, any new or unplanned capital expenditures could use
    cash otherwise intended to be used to reduce financing obligations.
    *** End of document. ***